Outside voices and views for advisers

Warning: This regulator eats what it kills

At Finra, fines are less than 10% of the annual budget but make no mistake, they are important, says Mark Elzweig

Jun 24, 2014 @ 12:01 am

By Mark Elzweig

Finra, SEC, fines, regulatory structure,
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The Financial Industry Regulatory Authority Inc. is banging relentlessly on its regulatory drum. The self-regulatory organization for the nation's broker-dealers is angling to seize oversight of the nation's registered investment advisers from the Securities and Exchange Commission, the traditional cop on the beat. The commission beat isn't big enough.

But there's one key difference that Finra doesn't talk about very loudly or very often: The fines it garners from nabbing the bad guys go directly to its bottom line. By contrast, the SEC doesn't get to keep any of its bounties. The checks from the likes of Steve Cohen and Rajesh Gupta go directly back to the Treasury, home of the taxpayer, or to victims in need of restitution. The fines from Joe Broker go directly to Finra coffers. You could say that Finra eats what it kills. You could also say conflict of interest.

Fines are less than 10% of the annual budget at the self-regulatory organization. But they are important. Finra often spends more than it takes in from member fees, fines, and the rather unpredictable realized earnings from its $1.9 billion investment portfolio.

In both 2013 and 2012, for example, Finra posted operating losses on more than $800 million in revenue. Losses topped $70 million in 2013 and reached nearly $90 million in 2012. Fines accounted for $60 million in 2013 and $69 million in 2012. Last year, investment gains tipped the organization into the black as it eked out a $1.7 million profit compared with a $10.5 million profit in 2012.

Finra is struggling to keep the level of fines from dwindling. Law firm Sutherland Asbill and Brennan reports that Finra fines have been dwindling over the past few years while the number of disciplinary actions has been rising at a rapid clip, up 43% from 2008 to 1,535 in 2013.

Finra regulates 4,100 brokerage firms, about 161,000 branch offices and nearly 636,000 registered representatives — a job that requires a staff of 3,400 in 20 offices. Finra regularly trumpets its commitment to exposing industry conflicts of interest and to ensuring transparency of fees and commissions for investors.

The SRO recently asked the SEC to approve a rule that would require advisers to disclose any recruiting bonuses in excess of $100, 000 to clients. (Finra has pulled that proposal but plans to issue a revised version.) It also is considering requiring brokerage firm websites to link directly to its BrokerCheck website so investors can more easily review an adviser's compliance history. When it comes to fines, Finra doesn't apply these high-minded strictures about the virtues of transparency to itself.

Even if individual SEC staffers receive bonuses for uncovering malfeasance, the SEC and state securities regulators have no incentive to levy fines to fill funding gaps. It's no wonder that Finra is regarded less as a consultative partner in helping broker-dealers adopt policies and procedures to protect investors and more as an aggressive bounty hunter with an agenda to levy fines.

Until this conflict-ridden business model is somehow fixed, at the very least it should be more fully and more widely disclosed. This would enable market participants to evaluate Finra's actions more accurately.

To be true to its stated philosophy, Finra should publish this disclosure on its home page: “Fees and fines levied by Finra are retained to fund its operations.” It should be required to issue this same disclosure to all parties whenever it initiates any legal action against an individual or firm.

The structure has real-life consequences. Smaller broker-dealers complain routinely about Finra's heavy hand. Many feel that they've been singled out as easy targets for fines. They don't have big legal departments like the wirehouses, which can more comfortably fend off Finra's legal challenges. Moreover, many smaller broker-dealers feel that the skyrocketing cost of complying with Finra's ever-expanding universe of regulations has made it more difficult for them to stay in business. It's contributed to the decline of the number of smaller broker-dealers.

This taps into a more basic issue. Some suggest that Finra's rules-based regulatory process encourages it to promulgate more rules as a means of levying more fines. Here's how compliance expert Christopher Winn, managing principal of Advisor Assist, contrasts the SEC's approach with that of Finra: “The principles-based approach describes outcomes, whereby the Finra model looks at each step.”

In addition, Mr. Winn said: “The SEC scrutinizes advisers [RIAs] to ensure that their actions are in alignment with their fiduciary duty to clients. In contrast, the Finra structure is more onerous. Finra automatically assumes that a sale is in conflict and therefore must check each step in the process.”

Finra thereby has an incentive to pile on one rule after another because each new regulation is a kind of regulatory trip wire that affords Finra more opportunity to ring the cash register.

In one recently reported case, a firm complained that Finra's advertising rules forced it to spend 13,000 hours creating 50,000 PDFs for Finra to review. The cost: $55,000 in filing fees.

Is it any wonder that advisers with a broker-dealer who are opting for the fast-growing RIA model can't wait to trade Finra's gotcha style of regulation for that of the principles-based SEC?

One final point: Hiring firms routinely review the credit history of prospective advisers. They know that it's risky to allow an adviser with shaky finances to handle client accounts. These advisers may be tempted to overtrade portfolios and make self-serving recommendations.

Given that, why is the broker-dealer world governed by a regulator with such dicey finances?

Until somebody figures out a way to rectify this untenable situation, Finra should be compelled to more regularly and fully disclose its own glaring conflicts of interest.

Only then will industry participants be able to evaluate Finra's actions more accurately and then decide if this is the kind of regulatory process that they want.

Mark Elzweig is the president of Mark Elzweig Co. Ltd., a national executive search firm servicing financial advisers and the asset management community.


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