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.

Senators Elizabeth Warren (D-MA), Bob Menendez (D-NJ), Sherrod Brown (D-OH) and Brian Schatz (D-HI) urged SEC Inspector General Carl W. Hoecker to investigate actions taken by Acting Chair Michael Piwowar during his transitional appointment. In their letter, the Senators ask that Mr. Hoecker “determine whether [Piwowar’s actions] are legally permissible and in keeping with the SEC’s core mission.”

The Senators asserted that:

“[t]here is no evidence that any of these changes in the SEC’s course are desired, or have been sought, by the person nominated to be the next SEC Chair. At his confirmation hearing, SEC Chair-nominee Jay Clayton testified that he had not been consulted about Acting Chairman Piwowar’s change to enforcement policy, did not know enough to know whether it was appropriate to reopen the pay ratio rule, and had no specific plans to revisit any Dodd-Frank-mandated rules.”

The Senators requested that Mr. Hoecker investigate the following “questionable action[s]”:

• January 31, 2017 – a request that SEC staff reconsider the SEC 2014 guidance on the Conflict Minerals Rule (see previous coverage) – a decision, the Senators allege, that Commissioner Piwowar made “based exclusively” on stories he heard while visiting Africa;
• February 6, 2017 – a request for public comment on the Pay Ratio Rule (see previous coverage); and
• February 15, 2017 – “unilateral administrative action to ‘impos[e] fresh curbs on the agency’s enforcement staff, scaling back their powers to initiate subpoenas and conduct investigations of alleged financial misdeeds,'” as reported by The Wall Street Journal.

Lofchie Comment: As to the assertions of Senator Warren and her colleagues, please note:

• Section 4B of the Securities Exchange Act gives the SEC Chair essentially plenary power to direct the activities of SEC staff. There is no distinction in the Statute between the authority of an Acting Chair and a permanent Chair. Therefore, Acting Chair Piwowar has the authority granted to the Chair of the SEC by Section 4B.
• Contrary to the Senators’ concern that Chair Piwowar acted exclusively on the basis of his visit to Africa, Chair Piwower has stated consistently during his tenure at the SEC that the Conflict Minerals Rule diverts the SEC from its primary mission of protecting U.S. investors and strengthening the U.S. economy. Further, there are numerous studies, including studies by the U.S. Government Accountability Office, that suggest the Conflict Minerals rule (however well intentioned) does no good.
• Notwithstanding the Senators’ worry that Chair Piwowar’s action to reduce the subpoena powers of SEC staff reduces the powers of the SEC to conduct investigations, it in no way reduces the SEC’s authority. Rather, it centralizes the authority in more senior officers, which seems completely appropriate, given that the SEC’s issuance of a subpoena can be a material event that is very damaging to the recipient; for example, in the case of an individual, the person may be fired because that individual’s employer does not want the hassle or expense of dealing with the subpoena. Thus, Chair Piwowar acts quite appropriately in limiting the persons who have authority to issue subpoenas.

There is some degree of irony in Senator Warren’s criticism of Acting Chair Piwowar, since Senator Warren was relentlessly critical of former SEC Chair Mary Jo White. In fact, given the Senator’s former criticism of Chair White, a good argument may be made that Chair Piwowar is actually continuing, and not reversing, the policies of the prior Chair.