FINRA President and CEO Robert Cook examined the advantages and disadvantages of self-regulatory organizations (“SROs”), and addressed the “core question” of self-interest in self-regulation. He delivered his remarks at the Columbia University Law and Business Schools Program in the Law and Economics of Capital Markets.
Mr. Cook argued that SROs play a critical role in the markets because they offer three distinct advantages: (i) access to expertise, (ii) the proven ability to improve industry conduct, and (iii) sustainable funding from the regulated entities themselves, which can help to finance heightened supervision. He noted that FINRA has been able to protect investors and promote healthy capital markets in more practical ways than the government has done, including through investor education initiatives and tools that support compliance efforts among members.
Mr. Cook addressed issues surrounding securities exchanges, including questions about regulatory effectiveness now that the exchanges are for-profit entities. He highlighted debates around conflicts of interest, particularly concerning exchanges tasked with supervising members that are also their competitors, and exchanges running National Market System plans. Mr. Cook said that the core question for FINRA about self-interest in self-regulation concerns industry influence and, conversely, the criticism that FINRA members are insufficiently involved in the agency’s agenda and operations. If the criticism is true, he argued, then the “lack of sufficient industry engagement in FINRA’s deliberations could mean that one of the benefits of self-regulation . . . – ready access to and use of member expertise in order to craft creative regulatory solutions – is not being fully realized.”
As previously reported, a new “Special Study” of the securities markets (which was modeled after the 1963 Special Study) will offer recommendations for financial market regulatory reform. Mr. Cook noted that the 1963 study was the “catalyst” for crucial refinements to the self-regulation framework. Although the model has been questioned and scrutinized over the years by policymakers, he said, the importance of SROs for the success of markets has always been affirmed. Mr. Cook asked the conductors of the new Special Study to consider the ways in which the self-regulation model can fulfill its mission more effectively, avoid regulatory duplication, and better allocate responsibilities between the SEC and SROs (especially when the consolidated audit trail is in place). He concluded by advising those who craft the new study to strike a balance:
“We must not shy away from changes that can improve the SRO model. But we also should be sure that any interventions are based on careful study of the different structures and features of each of today’s SROs and are well designed to better protect investors and promote safe and vibrant markets.”
Lofchie Comment: From the perspective of a longtime industry participant, the extent to which FINRA may be properly viewed as a “self-regulatory” organization is fair to question.
SEA Section 19 gives the SEC tremendous authority over FINRA, including the right to reject rules adopted by FINRA, but also the authority to require that FINRA adopt rules. Further, the SEC has the authority to bring enforcement actions against FINRA (and it has done so). As a result, FINRA and its employees must be concerned that, should they fail to fully enforce their own rules that regulate broker-dealers, they themselves may become subject to an SEC enforcement action. By contrast, FINRA does not have reason to fear any adverse reaction of its members to being subject to enforcement action, and it is clear that FINRA is in no way hesitant to bring enforcement actions against its members. In short, FINRA is in no way “captive” to its members. In fact, rather than describing FINRA as a self-regulatory organization, it would probably be more accurate to describe it as a non-governmental rulemaking and enforcement organization that operates through a governmentally approved system of “taxes” (fees on members) and allows for limited input from regulated entities (just as the government allows regulated firms to comment on proposed SEC rules).
This is not to suggest that FINRA’s existence should be questioned. It has been a primary direct regulator of securities firms for almost eighty years (since it was established by the 1938 amendments to the Exchange Act). Any attempt to transfer its responsibilities to the federal government would be enormously disruptive and would serve no practical result. Indeed, it would be more reasonable to ask that the role of regulated broker-dealers within FINRA be expanded, so that FINRA would become slightly less of a pseudo-governmental entity and slightly more of a self-regulatory organization.
A good amount of literature on this topic has been published over the past decade, which was when the SEC last took a fresh look at self-regulation. See, e.g., Daniel Gallagher, “Market 2012: Time for a Fresh Look at Equity Market Structure and Self-Regulation” (speech at SIFMA’s 15th Annual Market Structure Conference, October 4, 2012); Roberta Karmel, “Should Securities Industry Self-Regulatory Organizations Be Considered Government Agencies?” (unpublished paper, 2008); Onnig H. Dombalagian, “Self and Self-Regulation: Resolving the SRO Identity Crisis” (Brooklyn Journal of Corporate, Financial and Commercial Law, 2006). Perhaps the SEC’s last significant statement on this topic appeared in a concept release in 2004.