President and CEO, FINRA
Protecting Investors From Bad Actors
McDonough School of Business
As prepared for delivery
Good morning, and thank you, Professor [Reena] Aggarwal for that kind introduction and the invitation to join you today. Under your leadership, Georgetown’s Center for Financial Markets and Policy has come to be an important forum for discussing current policy and regulatory issues facing the global financial markets. We all owe you and your colleagues at the Center a debt of gratitude for your work identifying new perspectives and practical solutions that can help policymakers and practitioners alike improve the quality and efficiency of our markets.
Strong, vibrant securities markets are central to the U.S. financial system. Companies and individuals around the world rely on them to finance growth, job creation, and new ideas; to plan for the future; and to protect against unexpected events. Trillions of dollars are raised by issuers in the U.S. securities markets every year, and the ability of investors to access these markets depends on thousands of firms and hard working brokers who serve their customers with diligence and integrity.
FINRA plays an integral role in protecting the fundamental trust that investors and other market participants place in this financial system every day. As the self regulatory organization for some 3,800 securities firms and more than 630,000 individuals, FINRA administers comprehensive regulatory programs designed to help our members maintain this trust from their very first days in the business through, in many cases, decades of operations and interactions with tens of thousands of customers.
These programs serve multiple purposes in advancing FINRA’s mission of protecting investors and market integrity—including promoting compliance with applicable rules, creating a level playing field, and enhancing transparency and access to information. But perhaps one of their most important purposes is to protect investors from bad actors: those who seek to evade regulatory requirements and harm investors for their own personal gain.
As the Chairman of the Securities and Exchange Commission (SEC), Jay Clayton, has remarked, “There is zero room for bad actors in our capital markets.” A few bad actors can not only devastate the investors they target, but also threaten confidence in the wider financial system. Markets simply cannot function well if there is an undue risk—whether real or perceived—that one’s hard-earned savings could line the pocket of a fraudster instead of providing a good retirement, sending kids to college, or helping to start a new business.
Today, I would like discuss the regulatory programs FINRA has in place and is continuing to develop to protect investors and markets from bad actors—as well as the role that the industry itself must play in the process.
Before doing so, however, I should make two preliminary observations. First, FINRA is not alone in dealing with the challenge of bad actors. After all, we have authority over only one slice of the financial industry—broker-dealer services. We generally do not regulate firms or individuals when they provide other financial services—such as selling insurance, banking products, commodities, or futures, or handling customer money in other ways. And even in the securities industry, we do not regulate investment advisory services, which is an important and growing channel through which many retail and other investors access the securities markets.
Bad actors can lurk in all of these areas of the financial services sector, just as they can be found in other professions and industries. Thus, an important part of our effort must be focused on coordinating closely with the SEC and other federal and state regulators, sharing information and referring matters outside our jurisdiction to those who can take action. A persistent challenge for policymakers and regulators is making sure that our shared regulatory framework does not create incentives or opportunities for bad actors to move from one area to another to avoid detection or to “start over” after they have been caught.
My second observation is that we should bring some perspective to this discussion. Our securities markets are fundamentally sound, and the vast majority of the firms and individuals FINRA oversees are dedicated to serving their clients with integrity and professionalism. I am not suggesting that there is no room for improvement—certainly there is additional work to be done. But the statistics demonstrate that bad actors who cause customer harm account for a small percentage of the industry. Nevertheless, as I have travelled around the country on my listening tour and visited with our members, many of these firms have urged that FINRA be aggressive in dealing with bad actors. As they emphasize, the damage caused by even a few bad actors can hurt not just the investors involved, but the reputation of the entire industry.
I share this sense of urgency. In this year’s exam priorities letter—my first as FINRA’s President and CEO—addressing brokers who may cause customer harm was the very first priority we identified. And many elements of our regulatory programs today are focused on preventing bad actors—whether they be firms or individuals—from entering the securities industry, identifying those that emerge, and, where necessary, pursuing discipline for misconduct and restitution for investors to the fullest extent of our authority.
Licensing and Registration
Let me begin with prevention, which starts at the point of entry into the brokerage business. A person wanting to be a broker cannot hang up her shingle unless she has passed qualification exams that test her knowledge regarding the operation of the markets, the securities industry, and its regulation, and then maintains her qualification through continuing education. The qualification requirements are tailored to the specific business that the broker will be doing—for example, the requirements for interacting with customers are different from the requirements for performing an internal function.
A broker also must be associated with a firm, which is responsible for supervising that individual. And the firm itself must also be registered with the SEC and approved by FINRA to operate—it cannot do business as a broker-dealer otherwise.1 To become a FINRA member, a firm is subject to a rigorous vetting process and must meet numerous substantive and operational requirements, such as minimum capital standards and supervisory systems. FINRA’s membership application program reviews a firm’s planned operations, finances, personnel, internal controls, and other core areas prior to approving the firm to operate as a broker-dealer. In the last five years, FINRA reviewed more than 670 of these new member applications.
In reviewing a membership application, FINRA evaluates the regulatory history of individuals associated with the applicant for events that could pose risk to investors. We give special scrutiny to those persons who will have control over the firm, including whether they have been formerly associated with a firm with a disciplinary history. When FINRA has strong cause for concern, such as where brokers with pending enforcement actions seek to start their own broker-dealer, we deny membership or impose restrictions to mitigate the risk.
FINRA review is also generally required when a member firm seeks to change its ownership or make a material change in its business, such as by broadly expanding the number of brokers it employs or opening a string of new branch offices. In the last five years, FINRA reviewed more than 2,300 such applications and consulted with member firms on more than 2,100 occasions where they sought guidance on whether a formal application was required.
Here too, when the proposed changes involve individuals who could pose a risk to investors, there is heightened scrutiny. FINRA reviews the firm’s hiring practices, its supervisory framework, and the regulatory and employment history of individuals it is seeking to hire. In many instances, applicants voluntarily withdraw or amend their applications when well-founded issues are identified and raised to their attention.
Monitoring and Examinations
Once a firm has satisfied these qualification standards, it is assigned a regulatory coordinator who is responsible for continuously assessing that firm’s business activities and their risks. The coordinator is responsible for acting as the principal point of contact between the firm and FINRA, reviewing a wide range of information—including regulatory filings, personnel changes, and other news and events—and developing a deep understanding of the firm’s operations and controls.
Over the years, FINRA has refined and improved its monitoring of member firms. For example, we have developed a unified risk hierarchy against which all firms are assessed, taking into account both the likelihood and potential impact of the risk. Coupled with other enhanced tools for regulatory coordinators, this hierarchy has enabled continuous assessment, with scores set against each of the risks whenever appropriate.
Ultimately, these assessments form the basis for determining the frequency with which a firm should be routinely examined and provide the foundation for each exam strategy. Every new member firm is examined within their first year of operation and thereafter every member firm is subject to an on-site routine examination based on its risk assessment—but in no case less frequent than once every four years. During routine exams, FINRA generally examines the core areas of a firm’s business, including its dealings with customers, financial integrity and operations, and books and records.
FINRA also conducts a branch office examination program, which is important for an industry with over 165,000 branch offices. These exams, which are also based on a risk assessment of the brokers operating in each branch, place our staff with the relevant brokers at the point of sale where they interact with customers.2
We also have dedicated resources responsible for conducting “cause” examinations, meaning non-routine exams triggered by customer complaints or other events. These examinations often arise from the actions of individual brokers, and can occur even where the firm has not previously been considered a higher risk.
Discipline and Restitution
FINRA complements the thousands of routine, branch office, and cause exams of its members each year—not to mention the many exams we undertake related to market oversight—with additional surveillance designed to rapidly respond to potential fraud or market manipulation that could harm investors. The Office of Fraud Detection and Market Intelligence (OFDMI), for example, is the central repository within FINRA for gathering and evaluating information about such misconduct. It operates a whistleblower office and triages information from a number of sources, including tips from FINRA field examiners, regulatory filings, media reports and investor complaints. It expedites the review of high-risk tips and fraud-related matters by senior staff and coordinates closely with federal and state law enforcement.
Last year, OFDMI referred 785 matters to the SEC and other law enforcement agencies. These matters cover a wide range of misconduct, including potential insider trading and fraud, and many do not involve brokers within FINRA’s jurisdiction. Since 2013, moreover, OFDMI has operated a process dedicated to identifying and escalating cases where a broker is believed to be engaged in misconduct or to pose imminent harm to investors. In such cases, a team of investigators and enforcement attorneys conduct expedited investigations and disciplinary actions regarding the broker. Through this process, we have barred nearly 300 individuals from the industry.
Let me give you an example. FINRA recently launched a toll-free helpline that senior investors, or individuals caring for them, can call to raise concerns about their brokerage accounts and investments. In the first two years of its operation, the helpline fielded more than 9,700 calls from all 50 states from individuals ranging in age from 17 to 102 years old (the average caller age is 70 years old), produced nearly 650 referrals of matters to state, federal and foreign regulators, and helped return millions of dollars to customers. One of these calls came from an investor’s accountant, who had found a suspicious document among his 82-year-old client’s tax receipts. FINRA immediately launched an investigation and discovered the client’s broker had borrowed $220,000 on a 30-year note in 2012 and was repaying her $1,200 every month. FINRA expedited its review. Within 10 days of notifying the broker’s firm, which was unaware of the loan, the firm terminated the broker. The customer was reimbursed and FINRA barred the broker from the industry.
Another example: Last year, we investigated and barred a broker from the industry within 39 days of receiving worrisome information from a firm. The firm had begun an internal review of the broker after a customer received what appeared to be a fake account statement from the broker. FINRA’s investigation found that the broker had stolen money from the customer and created fictitious account statements to hide it. Here too, the customer got her money back.
In these instances and others where the actions of a firm or individual threaten investors, there are a range of interventions available to FINRA. The appropriate response depends on the facts and circumstances: in some cases, a broker may be required to be qualified by FINRA again; in others, like those arising from the OFDMI process, FINRA may need to act to suspend or bar someone from the industry, or levy a fine. Taking action is important not just for stopping the potential harm, but also for giving investors—and others in the industry, including competitor firms—confidence that standards will be enforced.
Our enforcement team is essential to seeing these actions through. And they are achieving results. In 2016 alone, we brought 1,434 disciplinary actions against registered individual brokers and firms; 1,244 individuals and 50 firms were suspended or barred from the industry. Perhaps most importantly, in the last two years (not including 2017), we have ordered some $124 million in restitution to harmed investors.
Reinforcing our Focus on High-Risk Firms and Brokers
This comprehensive program of regulation that I just outlined—from registration to examination to enforcement—has matured over many years. While it has permitted FINRA to identify and address a range of compliance issues—many of which pose no direct harm to investors—it has also successfully identified and provided the basis for action against many bad actors, including firms and brokers. And many of FINRA’s other regulatory programs that I do not have time to describe today, including our extensive investor education and public disclosure requirements, as well as our work conducting trading surveillance in the equity and fixed income markets, have also helped keep investors away from bad actors.
But given how challenging it can be to identify bad actors, and how important it is to do everything we can to prevent them from harming investors, FINRA has been working to further augment these long-standing regulatory programs. In particular, in the last few years we have initiated more targeted efforts to better identify and supervise those firms and individual brokers who may pose the greatest risk of harm to investors—or “high-risk” firms and brokers. A key objective of this targeted program is to ensure we are using a risk based methodology to allocate our finite monitoring and examination resources in ways that will best protect investors.
Identifying High-Risk Firms and Brokers
As I noted earlier, FINRA has developed a program-wide risk hierarchy for member firms to help us calibrate our monitoring and examination efforts to the particular firm. Key risks that we focus on include sales practices, fraud and deception, and the protection of client assets. Clearly, the assessment of the risks associated with key personnel at a firm is an important element in weighing whether the firm itself should be considered high risk. This analysis informs both what we look for at a particular firm, and how frequently we examine that firm. In addition, in connection with our branch office examination program, we are also using models to determine those branches—and those firms whose network of branches—may present the greatest risk.
With respect to individual brokers, FINRA has developed another risk model that takes into account a range of quantitative and qualitative information regarding a particular broker. This information is derived from a variety of sources, including regulatory reports by firms and brokers, our examination program, employment histories, past associations with problematic firms, customer complaints, and any history of informal actions levied by FINRA. Using the output of this model, we then review an individual’s background more closely, focusing on aggravating factors such as patterns of behavior, conflicts of interest, and links to previously disciplined individuals.
It is important to be clear about the challenges and limitations inherent in these risk assessments, and care is required both in how we conduct the assessment and in what we do with it. FINRA does not possess a crystal ball—someone who we may identify as a high-risk broker for oversight purposes is not necessarily a bad actor, and we must remain concerned about bad actors who may not be caught by our assessment. In addition, the risk profile of firms and brokers will change over time. We must continually seek to update our assessments and improve our approach based on practical experience, additional information, and new analytical techniques.
The quantitative data we use for our risk assessments includes certain types of information disclosed on BrokerCheck. As you may know, BrokerCheck is the online system we maintain to allow investors to look up their broker’s employment and disciplinary history. It is an important tool for investors to make informed decisions when deciding whether to use a particular broker—and as such it is another vital element of our program for protecting investors from bad actors. When performing our risk assessments across the entire population of brokers, however, we also use other quantitative and qualitative information that is available to us through our regulatory programs. In addition, we must consider that not all events – including events disclosed on BrokerCheck – pose the same level of risk. For example, a broker who has an unpaid lien because of debt accrued due to a medical issue in her family must disclose that lien. That event should not be treated the same as fraud or stealing money from customers.
Monitoring and Examining High-Risk Firms and Brokers
Where we identify a high-risk firm, we typically examine that firm annually with specialized, experienced examiners, often accompanied by enforcement attorneys to facilitate follow-up action. This heightened scrutiny has had an impact. Of the firms assessed as higher risk in the last five years, more than 40 percent are no longer FINRA members, in many cases because of regulatory action. In other cases, close scrutiny by our examination team has caused firms to take steps to address our concerns, such as by making changes or improvements in personnel, operations, and the quality of their supervisory controls. As a result, FINRA has been able to downgrade the risk level of these firms and re-focus its examination resources elsewhere. And as I have noted, our branch office exam program focuses on those branches that present the greatest risk, either as a stand-alone branch exam or in conjunction with a broader exam of the firm as a whole.
When individuals have been identified as high-risk brokers, FINRA begins heightened monitoring and deploys staff from our fourteen district offices across the country to conduct examinations. This oversight has been conducted under a special program since 2014, and it has produced numerous enforcement referrals since its inception. FINRA has barred approximately 120 individuals who were identified as high-risk brokers, and more than 420 such individuals are no longer registered with a member firm.
Let me give you an example of the type of activity we are seeking to identify and address through this program. FINRA closely tracks groups of brokers who move from one high-risk firm to another. So when a New York firm opened a branch office to register seven individuals, all of whom were discharged from a high-risk firm, we immediately took notice. Among other red flags, both firms had similar business models—cold-calling customers, including senior citizens, to make unsolicited recommendations of securities.
These brokers were already on our radar screen because of their prior employment, and we flagged them as high-risk brokers in their new roles. We interviewed their customers and found securities violations, such as misleading sales pitches, customer account churning, and other sales practice misconduct. Ultimately, FINRA permanently barred seven of the brokers from the securities industry, suspended an eighth person whose bar will become effective in October, and barred two former branch managers from serving as supervisors.
We have continued to expand and strengthen this program. For example, we recently centralized the identification and monitoring of high-risk brokers in a new, dedicated unit. This unit is composed of examiners and managers with the specialized skills and experience necessary for dealing with this broker population. And it works closely with examiners in our district offices and a team of enforcement lawyers who act quickly to bring disciplinary actions if misconduct is identified. These additional resources—which augment the focus on high-risk brokers that continues across the rest of our exam program—should enable us to improve our identification efforts and double the number of examinations we conduct in the program this year as compared to 2016.
Due Process Considerations
Some have asked why we do not publish the names of the high-risk firms and brokers we identify for our risk-assessment purposes. As a regulator, we must consider fairness and due process. Our risk assessment program has been developed for internal supervisory purposes and takes into account various non-public and qualitative factors. As I have already noted, we must be cognizant that our assessments are not perfect, although they are being refined and updated every year. In this respect, our approach is no different than that of many other regulators who develop internal watch lists of firms or individuals to prioritize supervisory resources without publishing their names.
We are also asked why firms or individuals with a regulatory history are allowed to remain in the industry in the first place. On the one hand, I share the desire to be aggressive in this space and to address recidivist misconduct promptly—and we need to make sure we are doing all we can. On the other hand, like other regulators, FINRA does not—and should not—have unfettered discretion. Formal action to bar or suspend a broker requires satisfying procedural safeguards established by federal law and FINRA rules to prevent enforcement overreach by regulators (including FINRA) and to protect the rights of brokers to engage in business unless proven guilty of serious misconduct. Those safeguards include the right to defend oneself before a hearing panel and the right to appeal to FINRA’s National Adjudicatory Council, the SEC, and ultimately the federal courts.
In addition, federal law and regulations define the types of misconduct that presumptively disqualify a broker from associating with a firm, and also govern the standards and procedures FINRA must follow when a broker who was found to have engaged in such misconduct applies to re-enter the industry. These requirements, which are complex and beyond what I can address today, impose significant constraints on FINRA. I do not mean to profess that we are perfect—we must continually work to improve our programs within these constraints to protect investors, while doing so in a manner that is transparent and fair to those involved. A critical factor in ensuring that we are meeting this objective is the comprehensive SEC oversight that occurs with respect to our regulatory programs, including the standards and processes governing our examination, enforcement, sanctions, and adjudication activities.
Striving for Continuous Improvement
Taken together, all of these measures demonstrate FINRA’s continued commitment to maintaining high business and compliance standards for the entire brokerage industry, and using the full array of risk-based tools to better target bad actors. But of course, we must always seek out opportunities to do more and do better. As I previously have announced, FINRA is embarking on a multi-year exercise focused on creating an organization that is committed to continuous improvement. This exercise—which we call FINRA360—is guided by our mission to protect investors and market integrity while promoting vibrant capital markets. It has many elements, but one of them is working to ensure our policies and programs are as effective and efficient as they can be—and that includes considering how we can better address bad actors.
Last year, we established an internal senior staff working group to consider new approaches to identify and address the risk of broker misconduct. In addition, our Board of Governors has formed a special working group, led by former SEC Chair Elisse Walter, to focus on FINRA’s oversight of high risk brokers.
A series of steps approved by the Board last month marks the latest fruit of this effort. Among them is a proposed rule amendment to require brokerage firms to adopt heightened supervisory procedures for individuals while a disciplinary case is pending appeal. We also intend to reinforce and clarify firms’ existing supervisory obligations concerning brokers they employ that have disciplinary histories. Among other measures, the proposals would also expand sanction guidelines to enable adjudicators to consider more severe sanctions when an individual's disciplinary history includes additional types of past misconduct. They also would allow hearing panels, in appropriate circumstances, to restrict the activities of firms and individuals while a disciplinary matter is on appeal.3
On top of these initiatives, we are also advancing a number of operational improvements. We are working to strengthen our analytics and integrate additional data points into our risk model, such as the location of where a broker works or the degree to which his or her co-workers have committed misconduct, to inform our risk assessments. We are also seeking ways to leverage data to better understand when new events may indicate broader issues or concerns, such as recidivist behavior. In addition, this year we are implementing improvements to our branch office risk model to include additional branch-level characteristics that may be indicative of future misconduct, such as the proportion of employees that are high-risk brokers.
We are also considering additional measures that could help address the risk that may be posed by high risk firms and brokers. For example, one approach would be to amend our rules to establish additional requirements when a firm or individual meets specified risk criteria in order to further deter misconduct and incentivize greater focus on the relevant risks. Any such rule amendments would require careful consideration by FINRA, based on public and industry comment, and ultimately would need to be filed with and approved by the SEC.
The Responsibility of the Industry
As FINRA works to enhance its efforts to protect investors from bad actors, the vigilance of our member firms is also critical. As I highlighted at the outset, stopping bad actors is an area in which we have a shared interest. Firms must do their part by, among other steps, reviewing their hiring practices, monitoring their brokers, improving supervisory systems, and investigating red flags suggestive of misconduct.
A firm’s obligations start with the hiring process. As a general matter, FINRA requires that member firms investigate and ascertain the good character, business reputation, qualifications, and experience of an individual broker before they register that broker with FINRA. A firm must obtain all the necessary information to determine whether it should associate with a particular individual, and we recently strengthened the background check obligations of firms: they are now required to adopt written procedures reasonably designed to verify the accuracy and completeness of the information contained in a broker's mandated disclosure forms. A firm’s verification process must, at a minimum, provide for a national search of reasonably available public records conducted by the firm or a third-party service provider to verify the accuracy and completeness of the information.
Once an individual is hired, reasonable supervision is critical. FINRA requires firms to establish and maintain supervisory systems for each of their brokers and to test and verify annually that they have established reasonable procedures. Firms must ensure that supervisors have the requisite knowledge and experience to review the specific business activities of their brokers.
Firms should consider the need to adopt more rigorous supervisory procedures tailored to individuals who may pose a higher risk based on factors such as a recent history of customer complaints or disciplinary actions involving sales practice abuse or other customer harm. With respect to such individuals, the firm should consider additional supervisory actions appropriate to the circumstances, which could include, for example, additional on-site visits of the broker’s location in addition to any required branch inspections, or having the supervisor contact customers to confirm trades and money movements.
As outlined in the 2017 exam priorities letter, this year FINRA is paying particular attention to firms’ hiring or retaining of high-risk brokers, including whether firms establish appropriate supervisory and compliance controls for such persons. We are looking at whether firms develop and implement a supervisory plan reasonably tailored to detect and prevent future misconduct by a particular broker based on prior misconduct and regulatory disclosures. In addition, we are focused on firms with a concentration of brokers with significant past disciplinary records or a number of sales practice complaints or arbitrations. Our membership application program is identifying new and continuing member applicants that employ, or seek to employ, brokers with problematic regulatory histories, and is considering carefully whether these applicants have the experience and controls to adequately supervise these brokers. And FINRA is evaluating firms’ branch office inspection programs, as well as their supervisory systems for branch and non-branch office locations, including independent contractor branches.
As I mentioned, FINRA intends to publish additional guidance in the coming months regarding firms’ supervisory obligations related to brokers that may pose higher risk. In the meantime, it is imperative that broker-dealers continue to work with us to reduce the risk of misconduct and ensure that investors can have confidence in their investment professionals.
FINRA and its members have a vital stake in ensuring the fairness and stability of the financial markets by doing everything we can to address bad actors. This goal is an important part of our oversight programs, and it is a challenging one to get right: we must avoid unduly broad measures that fail to recognize that most individuals and firms are seeking to do good work for their customers every day; but so too must we avoid overly cautious efforts that risk delaying necessary corrective action.
Our effort to strike this balance is just one part of a broader regulatory program that ensures investors will continue to have confidence to participate in our capital markets and help drive a vibrant economy. The stakes are high, and investors deserve the best efforts of FINRA and our members to address the threat posed by a few who would undermine the hard work of so many.
1 Firms and brokers must also be licensed in one or more states before doing business. Each state may deny or revoke licenses of firms or individuals who do not meet their respective financial and investor protection standards.
2 In addition, FINRA recently created an “off-site” firm examination program that will supplement our other examinations. Beginning this year, this program will seek to address compliance at firms who maintain an active business in one or more of the areas noted by FINRA in its annual exam priorities letter, but who are not slated for a routine examination in 2017.
3 The proposals would also: (1) increase FINRA's statutory disqualification application fee for individuals; (2) enact a new fee for firms to reflect the additional time it takes FINRA staff to thoroughly screen those applications; and (3) revise the guidelines for reviewing requests for a waiver from FINRA exam requirements to more broadly consider the past misconduct of an individual, including arbitration awards and settlements.
4 FINRA rules also require that if a certain percentage of a firm’s brokers were employed within the last three years by a broker-dealer expelled in connection with sales practices involving the offer, purchase, or sale of any security, the firm is required to tape record all of its brokers’ phone calls with investors. Among the recent proposals approved by FINRA’s Board with respect to high-risk brokers, BrokerCheck would be expanded to include a mandatory disclosure of a firm’s status as a “taping” firm. BrokerCheck currently indicates whether an individual broker has been employed by a firm that has been expelled from FINRA membership.