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Under pressure, FINRA rolls dice with enforcement overhaul

Mar 19, 2018 9:40:48 AM / by Behavox Regulatory Intelligence

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A shrinking number of brokerage firms and exchange markets to oversee, industry consolidation, and discontent from government and members regarding its oversight procedures has left US Financial Industry Regulatory Authority facing a critical juncture. Behavox Regulatory Intelligence interviewed the regulator and industry experts on the future of enforcement under the agency.

 

In July, FINRA announced it would merge its two enforcement teams into one unit under a new head of enforcement, Susan Schroeder, who reports directly to its president and chief executive Robert Cook.

 

The change was largely welcomed by FINRA’s members as a logical step, given the disparity in size and results that the two teams produced, however experts are questioning whether this marks a new dawn or more dramatically perhaps the beginning of the end for the agency.

 

Speaking to Behavox Regulatory Intelligence, FINRA said it has taken the wider criticisms on board and has made changes it hopes will provide greater clarity to the compliance departments that are saddled with its oversight.

 

“Enforcement is one of FINRA’s most critical functions, and these changes are designed to recognize its central role, enable us to better target developing issues that can harm investors and market integrity, and ensure a uniform approach to charging and sanctions,” the regulator said.

 

FINRA said this was one of the major outcomes of a “listening tour” it undertook in 2017 and a self-evaluation, but recent remarks by Schroeder indicate broader ill-feeling about the lack of consistency and transparency may have been the true driver.

 

The two teams were originally comprised of one focused on disciplinary actions found through market regulation’s surveillance and examination programs, known as Market Regulation Legal, and the other was handling cases referred from other regulatory oversight divisions, known as Enforcement.

 

“Previously, there were two separate departments, which sometimes made simultaneous requests for information from firms,” FINRA said. “Merging the two groups will help streamline the disciplinary process across the organization.”

 

Much of the frustration has been levied at Market Regulation Legal, due to its focus on small dollar trade reporting cases and use of quasi-strict liability standards.

 

“The majority of the Market Regulation cases involve no impact to retail investors and are resolved for minor fines in the $20,000 to $50,000 range,” said Brad Bennett, partner at Baker Botts law firm and former chief of enforcement at FINRA. “This docket has created significant friction with the regulated firms, which view it akin to being caught in a speed camera,” he told Behavox Regulatory Intelligence.

 

The largest source of Enforcement cases comes via the examination program, where examiners scrutinize the largest and highest risk firms on an annual basis. This program is overseen by the US Securities and Exchange Commission Office of Compliance Inspections and Examinations; “which is quite vigorous in monitoring the quality of examinations,” Bennett said.

 

Examiners will then refer any conduct to FINRA Enforcement that they believe is a material violation of the securities laws.

 

Between 2011 and 2016, the docket was between 1,200 and 1,500 cases annually, which came through in various ways such as examinations, the review of broker disclosure on Forms U-4 and U-5, tip lines, customer complaints, and internal initiatives at Enforcement.

 

The agency’s Market Regulation business differs through its contracts with various exchanges for performing their regulatory and enforcement functions. “Market Regulation focuses on the quality of the markets in terms of execution and trade reporting,” said Bennett. It also looks for manipulation and other illegitimate market activity.

 

“Historically their enforcement matters have been handled by Market Regulation Legal, which operated apart from FINRA’s Enforcement department,” Bennett added.

 

Many of the industry’s gripes have concerned the mixed messages the regulator has sent with two departments levying often substantially different fines, and how the lack of consistency makes it difficult for firms to understand what behavior needs to change.

 

It has also faced questions as to whether it is more concerned with protecting investors or its members, as given its self-regulatory nature it cannot hope to do both.

 

“FINRA needs to figure out how to work with members in a proactive manner to achieve better compliance; regulation by enforcement is never a good idea, and engenders considerable ill-will and distrust,” said Alan Wolper of law firm Ulmer & Berne. “FINRA largely reaps what it sows when it comes to its dicey relationship with its member firms.”

 

The agency said it did not believe it was “confusing” firms, but believed the merger would improve the relationship issues by creating “more effective disciplinary processes”, alongside greater consistency and transparent outcomes.

 

“This isn’t a change in direction, by any means; rather, it is a clarification of our existing philosophy as we bring two groups together,” FINRA told Behavox Regulatory Intelligence. “We wanted to be sure we are asking the same questions, and considering the same factors in the same way on the cases we handle every day.”

 

Brokers can use this to their advantage, said Daniel Nathan, partner at the law firm Orrick, Herrington & Sutcliffe, in Washington, D.C. “Firms and counsel who deal with FINRA in enforcement matters should hold the regulator to these principles. In short, firms now have a template for engaging more constructively with FINRA Enforcement.”

 

Slimming down may make the agency more effective in delivering its message and giving greater clarity to the, at last count, 3,835 brokerages and 159,529 branches it oversees. However the number of member firms it oversees has dropped annually each year since 2002, and there are less branches than at any point since 2003.

 

One big reason for the decline is the rise of registered investment adviser firms (RIA), which FINRA does not presently regulate and is unlikely to any time in the future; there are now more than 12,000 such US Securities and Exchange Commission-registered firms, which are less burdened with red tape.

 

While the organization has sent the message it is going back to basics, compliance staff are concerned this could mean more potential enforcements on the table or larger fines as the regulator attempts to stay relevant with less under its remit.

 

Historically, and peaking in the years when Bennett steered the ship, the Enforcement department’s cases have contributed significantly more to retail investor protection than those brought by Market Regulation. Bennett said this was understandable given the trade reporting focus of Market Regulation, and the difficulty of detecting and prosecuting manipulation schemes.

 

It is the right time to consolidate, Bennett said, given the current relative lack of instability in the market.

 

“The absence of a market crisis gives FINRA the breathing space necessary to restructure the enforcement programs, and I have complete confidence in enforcement leadership to come up with a structure that serves its constituents well,” he said. “If FINRA were to veer away from rigorous enforcement of its rules, it risks political blowback when the political or market climate changes.”

 

Regulatory rollback has been on the agenda at Washington under the Trump administration, and questions have been asked of FINRA, so does this also mean it will be stepping back?

 

The regulator pointed to recent remarks made by Schroeder, effectively distancing it from this approach. ‘’To me, there's no change in the mindset,” she said. “We will continue to be extremely committed to vigorous enforcement.”

 

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Behavox runs regular closed-door roundtables for compliance, risk and surveillance professionals as part of its Compliance Community service in the UK, the US and Asia where peers get to share their knowledge and experience of market practice confidentially. Anyone interested in attending should email alex.viall@behavox.com.

 

Disclaimer: This content is intended to provide general information in summary form on legal and regulatory topics, current at the time of publication. It does not constitute legal advice and should not be relied upon as such. 

Topics: enforcement, compliance