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GADFLY: The Financial Industry's Home-Grown Keystone Cops

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Back when the Madoff scandal was "hot off the presses," my faithful readers may recall I did a piece in The Flyer online entitled "As You Reap’ -- The Meaning of the Madoff Case." In it, I examined the role and responsibility of securities regulators in failing to catch that scam before it exploded. And, while I acknowledged the SEC's responsibility for ignoring the "red flags" (whistle blower Harry Markopolos tried to give them for several years), I also highlighted what I thought was the culpability of another, lesser-known, regulator in the mess, namely FINRA, the Financial Industry Regulatory Authority, the so-called "self-regulatory organization," or SRO, which has the responsibility for overseeing the nation's brokerage firms and their employees.

I mentioned, among other things, that FINRA ignored warning signs at the Madoff entity that was registered with FINRA, and pointed out the cozy relationship Madoff and his family members had with the regulator. Markopolos himself told the House committee he testified before that, while he considered the SEC to be incompetent (NOTE: politicized, neutered, maybe; but incompetent, unh-unh), the reason he never tried to sic FINRA on the Madoff apparatus was that he considered FINRA to be corrupt and beholden to the industry it regulates. So, which would you rather be if you were in the regulation business, incompetent or corrupt?

But, of course, very few focused on FINRA's responsibility for the Madoff disaster, preferring to focus on the SEC's. Maybe that's because it's more than just FINRA who are beholden to the securities industry. Or maybe it's because no one wanted to rain on the parade of Mary Schapiro, FINRA's CEO, who was in the process of being appointed as the next chairman of the SEC, in spite of a poor track record during her tenure there. FINRA even tried, incredibly, to suggest it had no jurisdiction over the Madoff entities, but, as anyone who knows that Madoff ran his scam out of his registered broker-dealer will tell you, that claim won't pass the "yuh, right" test.

Well, now we have yet another investment scam of similarly biblical proportions to Madoff's, namely Stanford Financial, and guess what? FINRA is, once again, up to its eyeballs in responsibility for failing to ferret out the fraud that was going on at that member firm, even though it knew about some of it as early as six years ago.

Let me, briefly, detail FINRA's role in the regulation of the securities markets, because, unlike the SEC, FINRA flies, for the most part, under the public's radar as a watchdog of those markets, and yet is equally (and sometimes more) pivotal to the SEC in that role. FINRA is the successor to the National Association of Securities Dealers (NASD). The NASD was formed, in 1934, as part of the regulatory reform that resulted in the federal securities laws and the formation of the SEC following the excesses in the securities markets that contributed to the "crash" of 1929 (is this a deja vu moment, or what?). The NASD also used to run the securities market known as the NASDAQ, which is now an independent entity. NASDAQ is the little brother to the other stock exchanges, like the "Big Board" (the NYSE), and lists the stocks of over 3,000 companies who, for one reason or another (typically the number of shareholders and level of capitalization) aren't qualified to be listed on the Big Board.

In 2007, FINRA was formed from the merger of the NASD and the regulation and enforcement functions of the NYSE. It is the entity responsible for licensing and overseeing the country's 5,000 "broker dealers," and the nearly 700,000 licensed brokers who work at those "BDs." It has 3,000 employees and a budget of nearly $700 million (by comparison, the SEC employs 3,500 and has a budget of $900 million). FINRA conducts regular examinations of its member firms, and promulgates (subject to SEC approval) and enforces the rules and regulations those firms and individuals are required to comply with. It has virtually plenary authority over the firms and individuals it licenses, including the ability to fine them, and to suspend or revoke their registrations.

FINRA is a strange hybrid. It is a nongovernmental entity, but it has a regulatory, policing function. It regulates and polices itself, hence its characterization as a “SRO." You will have to look far and wide for another industry that is allowed to police itself, and for good reason. We've seen how ineffectual the financial and securities industries have been at policing themselves lately.

FINRA has another important function, which most investors are also unaware of (though more will become aware of in the fallout of Wall Street's latest excesses). It manages a system of "alternative dispute resolution," under which customers who have grievances against their brokers are required to bring those disputes to FINRA for resolution by means of arbitration. So, when you, as a customer, open an account with a securities firm, you sign a document that relinquishes your right to have your day in court if he defrauds you. I'm guessing you didn't know that. Instead, you must file your claim with FINRA, which is then heard by a panel of (typically, three) arbitrators, at least one of whom is a member of the very industry your broker comes from. I have served (but do not, any longer) as a so-called public (i.e., unaffiliated with the securities industry) arbitrator, and have represented clients in such arbitrations.

Not surprisingly, the results of these securities-industry-run arbitrations are predictably bad for the customer, with fewer than 40 percent of the arbitrations resulting in a finding in favor of the customer, and a process of choosing arbitrators that is skewed in favor of the broker. Yet another example of how FINRA is an apologist for the industry it supposedly regulates.

Now, getting back to Stanford: FINRA, it turns out, had Stanford on its radar screen for years. It also turns out that, as early as 2003, a former Stanford employee warned FINRA that Stanford was running a Ponzi scheme, as the SEC has now alleged in its amended complaint against the firm and others. The infraction by Stanford that should have gotten the most attention from FINRA, and that bears most directly on the cause of the current scandal, the apocryphal CDs, occurred in 2007. FINRA found, back then, that the unit of Stanford that was registered with it as a broker dealer (Stanford Group), and through which the CD's that are at the heart of the current scandal were issued:

...failed to present fair and balanced treatment of the risks and potential benefits of a CD investment ... and [provided] misleading, unfair and unbalanced information [concerning CD investments

Talk about a smoking gun! So, what did FINRA do about this discovery? Why, it fined Stanford a grand total of $10,000, without even requiring it to admit it had done anything wrong, and sent it on its way to, as it turned out, continue "misleading" investors.

A year earlier, Stanford committed an infraction of FINRA's rules that could (and should) have resulted in the suspension of its license to do business. FINRA found that Stanford;

... failed to establish and maintain a supervisory system reasonably designed to achieve compliance with applicable securities laws, regulations and NASD rules ...

and that, most seriously of all, it:

"conducted a securities business while failing to maintain its required minimum net capital."

Violation of the net capital rule (i.e., having enough capital to assure a firm's financial responsibility) is one of the most serious infractions a securities firm can commit, and can result in shutting down its operation. In this case? Once again, a fine (this time a whole $20,000), and again, with no requirement that it admit it had done anything wrong. "You were bad boys, Stanford; now run along and rob people of their life's savings."

And to cap off all this "Keystone Koppery" by FINRA, it turns out that, just as Mr. Madoff and his family were FINRA insiders, so, too, were some of Stanford's executives.

All of which is to say that there is more than enough blame to go around for the Madoff and Stanford scandals, and that the system of regulation of the securities markets, to the extent it relies on the "honor system" of self regulation, for which FINRA is the poster child, needs to be seriously re-examined and substantially overhauled. As a regulator, FINRA has shown itself to be an abysmal failure. Its reign must end.

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