A recent report that details Finra's inability to detect R. Allen Stanford's long-running, $7.2 billion fraud clearly shows that the securities industry self-regulator has gaping and significant problems related to its exams of broker-dealers.
The
Financial Industry Regulatory Authority Inc. needs to address those shortcomings right away if it is to fulfill its stated mission of protecting investors.
To be sure, Finra has huge scope. At the end of last year, it oversaw 4,895 broker-dealers and 664,975 registered representatives.
Titled “Report of the 2009 Special Review Committee on Finra's Examination Program in Light of the Stanford and Madoff Schemes,” the report was released Oct. 2. Finra's board of governors appointed the committee to examine the organization's processes for the detection of fraud and Ponzi schemes.
Of course, the report discusses Bernard Madoff, but the detail of how Finra bungled any potential investigation into Mr. Stanford's brokerage operations reveals an overly bureaucratic organization with employees who don't understand their roles, power or authority, industry observers said.
“Finra has to make sure that the staff is not making ultimate determinations in regard to jurisdiction, such as whether Stanford's [certificates of deposit] were securities,” said Brian L. Rubin, a Washington-based partner in Sutherland Asbill & Brennan LLP and a former NASD attorney. “That question needs to be taken to higher levels.”
In the report, the committee said that it agrees with Finra's management's proposal to create a dedicated fraud detection unit.
The report is only one element of a nuts-and-bolts makeover Finra is currently going through to improve its detection of fraud, said Nancy Condon, a Finra spokeswoman.
“In March 2009, Finra established its Office of the Whistleblower, a dedicated team to handle high-risk tips,” she said. Finra also wants to improve its technology and work better with the Securities and Exchange Commission and other regulators.
Perhaps most importantly, Finra sees the Stanford and Madoff cases as an opportunity to expand its oversight to include registered investment advisers, Ms. Condon noted.
“Finra's examination program is fundamentally hampered by its lack of jurisdiction over investment advisory activities,” Ms. Condon said.
“In providing these services and managing investors' assets, therefore, these firms and individuals are largely beyond the reach of Finra and under a less robust regulatory scheme. Finra should proactively seek jurisdiction to regulate activities under the Investment Advisers Act,” she said.
According to the report, a Dallas office of NASD, Finra's predecessor, had five opportunities in the forms of tips or exams from 2003 to 2005 that officials could have used to put a halt to Mr. Stanford's alleged scheme.
Stanford International Bank of Antigua created the certificates of deposit and sold them through its Stanford Financial Group broker-dealer in Houston.
Although the report concluded that NASD mishandled “striking” tips from whistle-blowers looking to take down Mr. Stanford, what is perhaps more worrisome is that NASD examiners and officials appeared to lack an understanding of the basic scope of their jobs.
For example, in 2005, an NASD team made a routine exam of Stanford Financial Group. The lead examiner focused on the CD program and concluded that Mr. Stanford's firm was “smarter than
Goldman Sachs” if it was really creating such high rates of return, the report stated.
The rest of the exam team, however, failed to nail down key facts about the firm's clients that would have given them the authority to take action against the firm without any argument about NASD's jurisdiction. Those three junior examiners on the team had less than a year on the job with NASD.
“A showing that the firm's customers were liquidating securities in order to buy into the CD program would have provided Finra's staff with jurisdiction to proceed against the firm under the anti-fraud provisions of the federal securities laws,” according to the report
In other words, the examiners missed looking into one of the most routine aspects of an exam into a broker-dealer or rep. Asking how a client paid for an investment, whether it was suitable and following that trail of money is one of the most fundamental parts of any brokerage exam.
In the end, the lead examiner “was uncertain as to whether Finra could show that [the CDs] were securities. The issue wasn't pursued further in the 2005 cycle exam,” according to the report.
NASD staffers, meanwhile, could have questioned Mr. Stanford personally about the CDs but didn't. He was the broker-dealer's sole director, and therefore NASD had jurisdiction over him.
Another observer's assessment was more blunt.
“For the past 20 years, Finra and NASD always have had a much tougher agenda for regional and independent firms and individual brokers,” said Bill Singer, a shareholder in the securities practice group of Stark & Stark. He is also a former NASD attorney.
Mr. Singer said that attorneys bouncing between Finra and well-paying jobs at large national securities firms are part of the problem, and he pointed to the Stanford case as particularly revealing of such “cronyism.”
According to a footnote in the report, from 2006 to 2009 a key former NASD staff member, Bernard Young, was the managing director of compliance for Stanford Financial Group. He was the head of NASD's Dallas office from 1999 to 2003, when he was replaced.
The report insists that Mr. Young's role as head of compliance at Stanford Financial had no effect on NASD and Finra staff members.
According to the report, “the interviews of current Finra employees and review of exam files identified no information to suggest that Young's presence at the firm compromised Finra's subsequent examination of the firm discussed in this report.”
Ms. Condon said that Finra had nothing to add about Mr. Young beyond the comment in the report.
E-mail Bruce Kelly at [email protected].
