Time to Reform FINRA: Mercatus Paper

What’s more, FINRA is not subject to the Freedom of Information Act, which would provide the public with access to documents about its internal workings, nor is it bound by the Administrative Procedure Act, which requires public agencies to seek public comment about costs and benefits before adopting rules.

Peirce cites as a current example FINRA’s current Comprehensive Automated Risk Data System (CARDS) proposal, which would establish a centralized database collecting individual investor account information. The rule would be costly for FINRA members who would have to oversee the monthly data collection.

While she says the proposal has gotten “negative comments from industry folks” such as the Securities and Financial Markets Association, Peirce points out that the move to adopt CARDS comes precisely at a time when the industry is struggling to implement FINRA’s Consolidated Audit Trail (CAT) requirement.

“It’s just an odd structure [FINRA’s governance model], because you don’t have the industry running it,” Peirce comments. “Members of the industry feel it’s an outside regulator that doesn’t particularly understand their business. They’re saying [of CARDS and CAT] that ‘you’re not taking into account that we have limited resources [to handle both at same time].’”

Another unusual aspect of FINRA’s neither-fish-nor-fowl organizational model relates to its disciplinary discretion to impose fines on members.

“I have grave concerns that they can impose fines and it goes right into their coffers [unlike government agencies that turn such monies over to the U.S. Treasury] — that creates very strange incentives,” Peirce said. “It’s generally not healthy when the regulator imposing a fine can take that fine and use it for its own purposes … That’s a wrongheaded approach. It takes the blinders off justice and creates an incentive to get money.”

Relatedly, Peirce’s paper notes the high level of compensation for FINRA’s leadership. Its CEO earns $2.25 million a year, considerably more than the SEC chairwoman’s annual salary of $165,300.

Finally, the area of potential abuse that is perhaps most acutely felt at the street level is the organization’s enforcement actions against advisors.

Not unlike the currently publicized witch hunts on college campuses where accused students are not afforded the rights defendants have in U.S. courts, advisors accused of suitability violations sometimes settle even when they disagree with the charges against them.

She cites a case she read about in which such an advisor “just settled and got out of the industry… because the process was very expensive” and the lack of due process protections added to the advisor’s difficulties.

While Peirce says it is possible that FINRA had a great case against the advisor (“I didn’t look at the details”), she adds based on anecdotal information that “surely there are cases where the person who [refused to fight FINRA] had a meritorious case.”

The Mercatus research fellow concludes that the American public is most hurt by an unreformed FINRA — “that’s because we’re being sold a regulatory scheme that looks a lot more just than it actually is,” she explained. “A close second to that are people interested in being in that industry. Because it does change their decision about whether to enter the industry and whether that’s a system they want to subject themselves to.”

Peirce says that it’s not just the rogues but honest financial advisors whose lives are adversely affected by FINRA’s procedures. “Even a good broker is going to have customer complaints because when people lose money, they complain,” the expert says.

While there are two approaches — one governmental and one industry-based — to increasing public disclosure and procedural obligations to increase accountability, Peirce advocates making FINRA into a true SRO.

That, she argues, is the longstanding tradition in U.S. securities markets going back to the New York Stock Exchange and over-the-counter markets. The combination of industry expertise and funding, and a self-interest in rooting out crooks, beats the track record of government regulators and trumps the inadequacies she finds in FINRA, her research paper argues.

— Related on ThinkAdvisor:

• FINRA’s ‘Total Warfare’ Against Brokers in Arbitration
• The SEC Is Broken
• FINRA Appoints Arbitration Task Force
• SIFMA Chief Slams CARDS Plan