Saturday, April 27, 2013

FINRA's Failure: It Is NOT a "Professional Regulatory Organization"

I was recently asked to provide the distinctions between a professional regulatory organization and a self-regulatory organization.  The distinction is a fine one, but an important one.

A PRO serves the public interest. An SRO, as we have seen through the prominent example of FINRA, only gives lip service to serving the public interest, while in reality it keeps the standards of conduct observed by its members ("suitability") so low as to permit the firms to extract excessive rents at the expense of the consumer.


FINRA (formerly known as NASD) fails the important test of serving the public interest. As Tamar Frankel, America’s leading scholar on fiduciary law as applied to the securities industry, wrote in 1965:  “NASD … [does] not, as do the professions, consider the public interest as one of [its] goals … Let us consider the attitude of the professions toward the public interest. The goal of public service is embedded in the definition of a profession. (Pound, The Lawyer from antiquity to modern times 5 1963). A profession performs a unique service; it requires a long period of academic training. Service to the community rather than economic gain is the dominant motive. We may measure the broker-dealer’s activities against these criteria … Although at least part of his trade is to give service, profit is his goal. The public interest is stated in negative terms: he should refrain from wrongdoing because it does not pay. This attitude is the crux of the matter, the heart of the difference between a profession and the broker-dealer’s activity … The industry emphasizes its merchandising aspect, and argues that the broker-dealer is subject to the duties of a merchandiser even when he is also acting is his advisory capacity … the NASD [has] proved incapable of establishing accepted standards of behavior for the activities of the trade … Past experience has proved that it is unrealistic to expect the NASD to regulate in the public interest ….” (Tamar Frankel, f/k/a Tamar Hed-Hoffman, “The Maloney Act Experiment,” 6 Boston College L.R. 186, 217 1965).

Nearly half a century has passed since Professor Frankel's article appeared, and FINRA's failure continues. In fact, FINRA's failure goes all the way back to 1942, when FINRA first adopted Rules of Conduct for its members which omitted any reference to the broker's fiduciary duty when in a relationship of trust and confidence with a client (despite, as my earlier blog post observed, the application of state common law fiduciary duties which existed at such time). 

Going back further, to 1945, FINRA (f/k/a NASD) stated: “The entire program of [our SRO] is based upon the principle of self-regulation and self-discipline.  We believe the standards of business ethics in the business are as high as in any other business or profession.  It is the purpose of NASD to keep them high and to seek improvement.” - N.A.S.D. News, published by the National Association of Securities Dealers, Volume VI, Number 1 (May 1945). Of course, anyone who believes that the failed standard called "suitability" is "as high as any other ... profession" is simply off their rocker. And, unfortunately, the basic requirements of the suitability standard have not changed since the Maloney Act of 1938 authorized the creation of the SRO now know as FINRA.

Going back even further, FINRA (f/k/a NASD) commented upon the necessity of raising the standards of conduct, when the Chairman of the NASD early on opined: “[T]he time may come when we can arrive at a more professional status and we can give more of our attention as to who should be in the investment business ... The principal by-product [of formation of the SRO], which I don’t believe the founding fathers of this Association ever thought of, is that for the first time in history the securities dealer begins to see what he looks like and it hasn’t been altogether a pleasing sight.”  - statement of NASD Chairman Robert W. Baird in an address before the convention of the National Association of Securities Commissioners, as quoted in N.A.S.D. News, published by the National Association of Securities Dealers, Volume II, Number 1 (Nov. 15, 1941).  [Emphasis added.]  Of course, FINRA has failed miserably to attain "professional status" for the "securities profession," primarily because it has never raised its standards of conduct for its members and has never put the interests of the consumer first.

Why is a true Professional Regulatory Organization for financial planners and investment advisers important as a long-term goal? 

By maintaining and enhancing the professional standards of its members over time, the services of its members become more attractive to the public, fueling demand for the services of its members. The standards that are adopted must serve the public interest. They must be high enough to protect the consumer from the utilization of the professional's superior knowledge in a way adverse to the interests of the client. This is especially so in today's modern age, where the complexity of financial instruments, the ever-developing knowledge of investment strategies (both as to those shown to work and those shown to not work), and the emergence of new understandings with respect to risks faced by individual investors, demands that nearly all individual investors would be served by having a trusted, expert guide to navigate through the many shoals existing in the financial markets.

The key ingredient of a true profession is that the needs of the client always come first – i.e., a bona fide fiduciary standard is maintained. Without a bona fide principles-based fiduciary standard of conduct a true profession - bound to serve the public interest - cannot be created.

It should also be emphasized that members of a professional regulatory oganization must be individuals, not firms. Why? Because individuals, not bound to represent the commercial intersts of their firms when elected to membership of the professional organization, are far more likely to keep professional standards at high levels.


Permit me to contrast FINRA with my vision for a PRO for financial planners (including all those providing personalized investment advice):

Broker-dealer firms (i.e., business entities, which possess commercial interests)
Individuals (not firms) who are qualified to become members of the profession (see educational qualifications below; also, character requirements exist)
To protect its firms (and, by its charge, the public)
Primary mission is to protect the public. Also, to maintain a proper discipline of the members of the PRO accordance with the principles of the profession as a public calling. Also, to initiate and supervise, with the approval of the SEC and/or state securities regulators and/or other oversight body, appropriate means to insure a continuing high standard of professional competence on the part of the members of the PRO.
Initial Education
Series 6 or 7 licensure (for registered representatives)
4-year college degree from accredited institution is required, plus an advanced course of study in financial planning and investments; passage of comphrensive entrance exam is required for licensure to provide "personalized investment advice" to "consumers"
Continuing education
As necessary for licensure
30-80 hours of continuing education (CE) are required every two years, as determined by overseeing body
Standard of conduct applicable
Suitability + other specific rules; regulations are enumerated in FINRA’s “Rules of Conduct”
Principles-based bona fide fiduciary duties of due care, loyalty, and utmost good faith are applied at all times; principles are enumerated (while still quite broad) through “Professional Standards of Conduct” similar to the Model Rules of Professional Conduct for attorneys. While "scope of the engagement" can be defined, core fiduciary duties are incapable of "waiver" by the client.
Peer review upon receipt of a complaint
Initial investigation by PRO representative; Can initiate legal action to protect investors; can initiate disciplinary proceedings in certain cases where judgment of the member in adherence to his or her duties is not the issue; Otherwise, peer review of a complaint is required, and complaint is regarded as confidential until probable cause is found. Then hearing proceeds before a hearing officer; if an appeal is undertaken therefrom, the appeal is heard by a different peer review panel, and all decisions of such panel are published for purposes of educating members as to future actions.
Inspections and examinations
Periodic and upon receipt of a complaint
Generally, upon receipt of a complaint. However, periodic inspections occur of all firms relative to custody (i.e., ensuring safety of client investments) would occur, using a focused process designed to detect instances of actual fraud.
Governing body
FINRA, consisting of “public” members and industry members. However, most "public" members possess strong ties to member firms.
Board of Governors.  Initially, appointed individuals by state securities regulators (subject to SEC approval), consisting of professionals committed to the fiduciary standard. Transitioning to election over time (with elected members subject to state securities regulator and/or SEC approval)
Legal authority to control entrance into, and expulsion from, the organization
Act of Congress (Maloney Act) and SEC rules
Act of Congress + (for states to participate) legislative actions over time by state legislatures + federal/state enabling rules. Or, alternatively, authorizing legislation in specific states (usually accomplished through a "Model Act" which is first drafted, then adopted over time by the many states).
Funding sources
Fees imposed on securities transactions and on FINRA’s members, and additional revenue secured via fines
Professional annual membership fees only; all fines paid to U.S. Treasury and/or the states, to avoid the inevitable conflict of interest arising from using fines imposed upon members of the expenses of the professional organization. (Also, fines should not indirectly benefit the very persons who are fined, by providing revenue to the professional organization which, in turn, permits it to reduce its membership fees.)
Pro bono
Not required
Required: either hours of service to individuals and/or the community every year, or monetary donation to an organization that serves such purpose, in order to ensure access to the services of its members by all members of the 

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