Congress may hand oversight of almost 12,000 investment advisers to Wall Street’s self-funded regulator as a cost-saving measure. The price could be paid by investors.
The Financial Industry Regulatory Authority, deputized by the government to oversee brokers, is lobbying to replace the U.S. Securities and Exchange Commission as a regulator of registered investment advisers who manage about $40 trillion. Congress is considering the move as a cheaper alternative to increasing resources for the SEC, since Finra’s $877 million budget is paid by the brokers it regulates.
“It’s a very bad idea to expand the notion of self- regulation,” said Denise Voigt Crawford, former commissioner of the Texas State Securities Board. “They’re supposed to oversee the activity of the industry, but they are industry.”
Finra, established in 2007 by the merger of the National Association of Securities Dealers and most of the New York Stock Exchange’s regulatory unit, has done a poor job of protecting investors, said Crawford, who retired in February after 17 years as a securities commissioner. Fines imposed are usually a fraction of the damages suffered, and Finra fails to share information regularly with state regulators, she said.
The regulator fined members almost $43 million last year, while the SEC, working with a similar budget, issued more than $1 billion in penalties.
The Finra arbitration process is flawed, said Lynn E. Turner, who served as the SEC’s chief accountant from 1998 to 2001. Investors who won Finra arbitration awards last year got back less than half of what they sought, data from Securities Arbitration Commentator Inc. show.
Compensation exceeding $11 million in 2009 for the top 10 Finra executives makes them reluctant to “make waves” in the industry that provides the funding, Turner said. Finra’s chairman and chief executive officer, Richard Ketchum, said that level of pay keeps them from losing their best staff.
In a January report required by the Dodd-Frank financial- overhaul bill, the SEC gave Congress the option of naming an outside regulator to strengthen oversight of investment advisers as the agency faces strained resources. Only about 9 percent of advisers registered with the SEC were examined in 2010 because of decreased numbers of agency examiners, the report said.
Advisers are currently required to register with the SEC if they are paid to give retail investment advice about securities and have more than $25 million in assets under management. The limit is scheduled to switch to $100 million next year.
Investment advisers must uphold a fiduciary duty to put their clients’ best interests first, generally charge fees and may provide services ranging from saving for retirement to tax planning. Brokers usually are held to a suitability standard that only requires that advice meets their clients’ needs when a product is sold. They generally charge commissions. The number of registered investment advisers increased by almost 40 percent to 11,888 advisers as of Sept. 30 since October 2004, the SEC report said.
“The likelihood of an SEC government solution working and working consistently in a difficult budget environment I think is low,” Ketchum, 60, said in an interview last month on the 48th floor of the agency’s New York office. The current environment “is simply not an appropriate level of investor protection.”
Finra is a “natural organization to be part of the solution” because of its infrastructure and technological capabilities and the fact that most advisers are affiliated with broker-dealers already, Ketchum said.
The regulator would need as many as 200 more people to do the job and would create a new board to represent members of the adviser community, he said. Michael Oxley, the former congressman who co-sponsored the Sarbanes-Oxley Act of 2002, registered earlier this year as a lobbyist for Finra to advance its case. The regulator spent $300,000 in the first quarter lobbying Congress on issues including adviser oversight.
Finra has stepped up its enforcement efforts this year. From January through May, fines levied by Finra increased by 118 percent to $28.1 million compared with a year earlier. During the first five months of 2009, in the wake of the financial crisis, fines were $30.5 million. The number of disciplinary actions taken this year through May was 463, the most in at least five years.
Morgan Keegan, a division of Birmingham, Alabama-based Regions Financial Corp., agreed to pay about $200 million to settle investigations into subprime mortgage-backed securities by the SEC, Finra and state regulators, the company said last week. Morgan Keegan’s actions may have resulted in $1.5 billion of losses, Joseph Borg, director of the Alabama Securities Commission, said during a call with reporters. The investigation was a “collaborative effort,” said Nancy Condon, a Finra spokeswoman.
The regulator has been “digging deeper” into “areas of concern” such as structured products and private placements, Ketchum said last month at Finra’s annual conference in Washington. Finra has fined brokerage firms for misleading investors about the safety of “principal-protected” notes and ignoring signs of fraud when selling high-yield securities issued by Provident Royalties LLC and Medical Capital Holdings Inc.
Investors lost about $2.5 billion on those three products after Lehman Brothers Holdings Inc. failed and the SEC shut down Provident and Medical Capital. Finra has fined the brokers who sold those securities a total of about $3.25 million, according to the regulator’s data.
$6 Million Restitution
Customers filed 3,208 complaints last year either online or through the mail with Finra. Every complaint was reviewed, responded to and investigated when warranted, Condon said.
The total amount of fines brought by Finra was about $42.5 million in 2010, compared with about $1.03 billion by the SEC last fiscal year. The SEC figure includes a $535 million penalty for Goldman Sachs Group Inc. to settle claims that it misled investors in collateralized debt obligations linked to subprime mortgages. The SEC doesn’t break out separate numbers for fines of brokers, said John Nester, a spokesman for the SEC. Finra may refer cases to the SEC, which has civil law enforcement powers.
Finra also ordered $6 million in restitution to harmed investors last year. That compares with about $1.82 billion in illegal profits that the SEC has ordered repaid and returned to investors when possible. This year through May, Finra restitution was $9.8 million. The self-regulator has almost as much funding as the SEC, which had a budget of $960 million in 2009.
“When you look at the types of misconduct compared to the fines, you have to wonder if it will really deter the misconduct they’re tasked with cracking down on,” said Michael Smallberg, an investigator at the Washington-based nonprofit Project on Government Oversight. “Would Finra ever take serious action against who it’s relying on for its funding?”
Richard and Anne Laese, retirees in Casselberry, Florida, sunk $250,000 into Provident oil and gas partnerships on the advice of John Michael Leonard, a broker who worked for brokerage firm Workman Securities Corp. Most of the high-yield investments turned out to be worthless when the SEC sued Provident for fraud in July 2009. Provident is in receivership and the SEC settled its case against the firm in March.
“We’re not rolling in dough,” said Richard Laese, a 72- year-old former police officer. “It was a pretty nasty blow.” The Laeses settled with Workman last year for $81,250.
Credit for Claims
Workman didn’t conduct adequate due diligence of the Provident and Medical Capital securities and kept selling the Medical Capital notes even after it found out that Medical Capital was missing interest payments, Finra said in its settlement with the firm. The firm sold $9.3 million of certain Provident and Medical Capital notes, Finra said.
Finra ordered Workman, based in Eden Prairie, Minnesota, to repay $700,000 to investors and allowed Workman to count the $642,802 it had already paid to settle claims toward its sanction.
“We were settling cases for business reasons,” said Benjamin Skjold, a lawyer in Minneapolis who represents Workman. “I presume they looked at our overall business methodology and how we were resolving claims and said, ‘We would rather encourage this kind of behavior.’”
The decision to give Workman credit for settlements was determined in part by the firm’s resources, said Steve Luparello, Finra’s vice chairman who oversees regulatory operations. The regulator has sanction guidelines that help determine what appropriate fines are in general, Luparello said.
Finra hasn’t sanctioned Leonard, whose Florida regulatory record shows more than 21 complaints from his clients at Workman, claiming more than $8 million in losses. Leonard, who couldn’t be located, denied wrongdoing in the Florida regulatory record. Finra is still investigating individuals associated with Workman, Condon said.
Clients must generally resolve disputes with brokers through arbitration rather than through lawsuits because of clauses in their contracts. In 2010, the median amount won by investors through Finra arbitration was $129,800, or 42 percent of the median amount of $310,000 in compensatory damages sought by investors who won, according to data compiled by Securities Arbitration Commentator Inc., a Maplewood, New Jersey-based legal publishing and research firm.
The firm excluded cases where the customer asked for less than $25,000 as well as cases that didn’t specify the amount of compensatory damages requested. Of the 882 arbitration cases that were decided in 2010, 47 percent resulted in customers being awarded damages, based on Finra data.
Arbitration is “far from perfect,” but it’s cheaper and faster than the public courts, said Finra’s Ketchum. Starting in February, investors were given the option to pick an all-public panel of three arbitrators to decide the case instead of a panel composed of two public arbitrators and one from the industry. Since February, 77 percent of claims filed have selected the all-public panel, Condon said. It can take up to two years from when investors file their arbitration claims until the case is closed, said Jeffrey Erez, a securities attorney in Fort Lauderdale, Florida.
It’s rare that arbitration claims lead to disciplinary actions such as fines or suspensions, according to Stuart Meissner, a securities attorney in New York and former state assistant attorney general.
“There’s a breakdown between arbitration claims and enforcement actions,” Meissner said. “It’s only the most egregious cases.”
Less than 1 percent of arbitration cases on average have resulted in disciplinary actions against brokers or brokerage firms, based on interviews with five securities attorneys around the country including Steve Miller, an attorney in Denver who also serves as a Finra arbitrator.
Every arbitration claim is reviewed and may be a source of future cases, Finra’s Luparello said. A single enforcement action may result from multiple arbitration claims.
Investors aren’t contacted by Finra as often as they should be after filing claims, which could help its enforcement arm take faster disciplinary action since they would hear from customers directly, said Brian Levin, who focuses on securities arbitration at Miami-based Dimond Kaplan & Rothstein.
One of his clients, Coralie Marlowe, a 74-year-old retiree, filed a claim with Finra in 2009 after she and her husband lost their $50,000 investment in a structured product recommended by a UBS AG broker. The securities became almost worthless when Lehman failed in September 2008. Marlowe said she was misled by the investment’s name: “100 Percent Principal-Protection Notes.”
“It’s a lot of money for us. We were ill-prepared for retirement,” said Marlowe, who lives in Calabasas, California. Finra’s investigators never called her after she filed the claim, she said. Marlowe reached a confidential settlement with UBS in March.
Finra contacted about 100 investors who bought the Lehman notes out of 170 who either filed complaints or arbitration claims, said Condon, the regulator’s spokeswoman.
UBS, Switzerland’s biggest bank, sold $1 billion of the notes to U.S. investors like Marlowe. Finra took action against the Zurich-based bank saying it “effectively misled” some investors when selling the products about two and a half years after Lehman’s failure. UBS agreed to pay $8.25 million to some investors and a $2.5 million fine. The bank was represented by Barry Goldsmith, an attorney at law firm Gibson Dunn & Crutcher LLP in New York who used to be executive vice president for enforcement at Finra’s predecessor, NASD. He declined to comment.
The $2.5 million fine of UBS is “the biggest crime of the century since Madoff,” said Seth Lipner, a Garden City, New York-based attorney, who has represented more than 50 investors in Lehman notes. “They pay more for paperclips.” UBS used about $9 million worth of paper last year, according to calculations based on numbers in its annual report.
Allison Chin-Leong, a UBS spokeswoman in New York, said the “significant majority” of its sales were conducted properly and losses resulted from Lehman’s “unprecedented and unexpected” failure.
High compensation packages for top executives at Finra may hinder forceful action that protects investors, according to Turner, the former chief accountant for the SEC.
“The economic incentives are so strong and these executives don’t want to make waves and upset the industry,” Turner said.
SEC Chairman Mary Schapiro, who was head of Finra and had worked at its predecessor NASD since 1996, received $8.99 million as a “final distribution,” including $7.6 million in vested retirement benefits, when she left for the SEC, according to a Finra report. She makes $163,500 at the SEC. Schapiro recused herself from voting on the report about regulation of investment advisers.
Finra paid its top 10 executives a combined $11.6 million in 2009, based on data in an annual report. Ketchum received $2.24 million in salary, incentive pay and retirement benefits in 2009, the annual report said.
Compensation doesn’t affect Finra’s independence and helps prevent turnover, said Ketchum. “It hopefully impacts the willingness of people to make a career out of regulation. I’m not sure that it is a great strategy if you’re looking for effective oversight to underpay regulators,” he said.
“I can promise you that nobody in the industry thinks that Finra is their friend or Finra is on their side,” said Mark Astarita, who has been representing brokers and firms in Finra investigations since 1984. “It’s almost comical that that’s the perception because that is completely untrue.”
The regulator, along with the SEC, missed schemes operated by Bernard L. Madoff and R. Allen Stanford, whose brokerage firms were registered with Finra. Madoff’s brother Peter, deceased son Mark and niece Shana served on NASD or Finra committees. Madoff didn’t receive lenient treatment because of these ties, Finra said in a 2009 report.
Stanford hired the former head of Finra’s Dallas office as managing director of compliance in 2006. The group’s probe of Stanford resulted in a $10,000 fine for advertising violations in November 2007, about a year before the SEC shut down the alleged $7 billion fraud.
“Any regulatory organization can be noted as missing things,” Ketchum said. “The question is not whether we’re going to miss things, the question is what we effectively find and how we can continue to make steps to try to make us continuously better.”
Lack of Jurisdiction
One of the reasons Finra may have missed the Madoff Ponzi scheme was because of a lack of jurisdiction over the investment advisory side of dually registered firms, the 2009 report said. “We at Finra are limited in our ability to look fully at what is an equally integrated business,” Ketchum said in prepared remarks for a March 22 speech.
Although Finra examines more than half of its broker-dealer firm members, it doesn’t mean that the quality of those examinations is good, said Smallberg of the Project on Government Oversight. There also aren’t enough mechanisms in place to review their regulatory operations, he said.
“Giving more authority to Finra should come with additional transparency and accountability,” Smallberg said. “I worry sometimes about the façade of a really robust examination or investigation process providing a false sense of confidence for investors.”
State securities regulators say the issue for them with Finra is a lack of cooperation on sharing examination information. About two years ago, Finra stopped routinely sending examination reports on brokers to state securities regulators, said Bob Webster, a spokesman for the North American Securities Administrators Association.
“State securities regulators were outraged,” said Crawford, a former NASAA president. Regulators relied on the reports to help spot potential fraud committed by brokers in their own states, she said.
Finra told the regulators it couldn’t routinely share investigative information with them because active collaboration could make Finra a “government actor,” Webster said. That would mean Finra would have to give certain rights to brokers during investigations that it doesn’t currently.
Finra received more than 100 access requests from state regulators in the past year and fulfilled all of them, Finra’s Luparello said. “I know of no example where we didn’t provide information when we would have before,” he said.
State regulators won’t know to request examination results if they don’t know that there’s something they should be on the lookout for, said Borg of the Alabama Securities Commission. “Just like the Morgan Keegan case, I’m hoping that all of our cases working with Finra in the future will work out just as cooperatively,” Borg said.
Self-regulatory organizations work if there’s aggressive SEC oversight, and the SEC has an “effective program” in place for overseeing Finra, Ketchum said.
The Boston Consulting Group found in a March report ordered by the Dodd-Frank Act that self-regulatory organizations, including Finra, don’t have to regularly disclose information to the SEC regarding their regulatory operations. The SEC also doesn’t have a consistent set of metrics or standards to assess Finra, the report said. Nester, the SEC spokesman, declined to comment on the agency’s oversight of Finra or Finra’s regulation of brokers.
As more investors turn to investment advisers for financial help, who regulates them will matter even more, said Lipner, the attorney who’s also a law professor at Baruch College in New York. “If we want to seriously regulate investment advisers, we would not give it to Finra because it hasn’t proved it’s competent to protect the public interest.”
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