SEC Commissioner Gallagher Says FINRA. Bill Singer Says Finito.

September 18, 2014

The Securities and Exchange Commission's ("SEC's) human lightning rod, Commissioner Daniel M. Gallagher, is at it again -- and he's got my attention (as usual).This time, the commissioner is asking questions about the so-called self regulation of Wall Street and even though I suspect that we disagree on the ultimate conclusion, I give him credit for striking the flint and starting the fire.  

Self Regulatory Crossroads

According to content posted on the SEC's website: "Remarks at the 2014 SRO Outreach Conference" (September 16, 2014), Commissioner Gallagher reminded his audience that (footnote omitted):

At the January 2012 SRO Outreach Conference, I stated that we were at a crossroads with respect to the status of self-regulation. I posed fundamental questions to the audience, such as whether we should continue to have exchanges with statutory self-regulatory responsibilities when the vast majority of those responsibilities have been outsourced to another SRO and whether the Commission should impose limits on the ability of SROs to contract with others.

Well, we're still at that crossroads, and the questions discussed at that conference are still pressing today. . .

As readers of the Blog know, I am an outspoken and long-time opponent of the current form of self regulation on Wall Street. As I noted a few months ago in "SEC Commissioner Gallagher Takes A Sledge-O-Matic To Wall Street Regulation" ( Blog, May 16, 2014):

Troubling for me is Gallagher's foray into the creation or perpetuation of the whole self-regulatory organization ("SRO") construct for the RIA community. My inference is that he appears to favor an SRO for RIAs, and I fear that he may be leaning towards some role for FINRA as the solution. 

BrokeAndBroker Blog readers know that I believe the current form of Wall Street self-regulation is a failure and should be abandoned. Similarly, I do not believe that FINRA has been an effective SRO, and I see no laudatory track record commending FINRA as a candidate to take on an even more expansive regulatory docket pertaining to an industry with which it has virtually no experience. If Commissioner Gallagher is leaning towards expanding FINRA's reach into the RIA community, he is terribly mistaken. Hopefully, he will keep an open mind on this issue. 

Still -- I have to compliment Gallagher for not shying away from controversy and having the guts to wield his sledge-o-matic down upon far too many sacred compliance procedures and sacrosanct regulatory policies.

Breathing Life Into Dinosaurs?

Given my above commentary, I read with great interest Commissioner Gallagher's observations that he shared with attendees at the September 16, 2014 conference:

In doing so, we must evaluate the SROs and markets as they are today and acknowledge that, in many cases, SROs today are fundamentally different from what Congress conceived of as self regulation decades ago. The circumstances under which the self-regulatory framework was put into place almost eighty years ago - private, mutualized, self-regulating exchanges and a simple association of dealers - no longer exist.

The fact that the majority of the equities exchanges outsource their SRO obligations and market surveillance to FINRA, for example, calls into question the very meaning of the SRO concept as it exists today. There are benefits that arise from the consolidation of oversight in a single entity with access to market data from transactions on multiple exchanges. With the majority of exchanges subject to FINRA's rules, market participants know what to expect in the event of disciplinary action, and a single arbitration regime facilitates the dispute resolution process.

For all these advantages, however, we still need to ask whether this is the optimal solution. Indeed, we need to ask whether exchanges that outsource their regulatory responsibilities to FINRA are still SROs at all, or whether they've instead effectively become FROs - FINRA-regulated organizations. A related question is whether the benefits of rule standardization amongst exchanges are canceled out by the lack of a competition of ideas among exchange regulatory regimes contributing to the development of best practices.

And as for FINRA itself, we need to ask whether it has inappropriately exceeded its mandate, or is simply evolving with the markets. Regardless of the answer, we need to consider what that means for both the SEC and SROs. This is especially pressing as we continue to consider the possibility of subjecting investment advisers to self regulation. Although FINRA has ceased to actively pursue the possibility of expanding its mission to encompass IAs, were Congress to pursue new legislation to establish an investment adviser SRO, the conversation would inevitably turn to FINRA as a possibility again.

In addition, as I have noted in the past, leveraging the current resources and expertise of broker-dealer SROs to serve as third-party examiners for investment advisers examinations could greatly facilitate our ability to examine "dual-hatted" investment advisers without having to rely on Congressional action to create a new investment adviser SRO out of whole cloth.

Regardless of the path we ultimately end up taking to strengthen our examination program for investment advisers, one thing is clear: an "SEC-only" approach would not work for investment advisers any more than it did for broker-dealers. In other words, the answer is not to exponentially expand the SEC staff by adding a brigade of new investment adviser examiners when there are third parties that could perform that role.

. . .

The fact that the investment adviser industry has operated without SRO supervision offers an opportunity for what could be considered a control experiment: two regimes alongside one another, one with SROs, one without. Even as we continue to ponder whether that situation needs to be changed, we should compare and contrast the two industries to better examine some of the strengths and weaknesses of self-regulation. We certainly must do this before even considering a fiduciary duty rulemaking for brokers.

Bill Singer's Comment

Some of Commissioner Gallagher's points I like -- some, however . . . well, let's just say that I respect the evolving nature of his opinion and will wait and see where he ultimately comes down.

On the plus side, he certainly has it right when he warns that the self-regulatory organization construct, which was promulgated in the late 1930s, must now be held up to the light of the evolved modern day markets. As Gallagher properly cautions, many of the circumstances that existed when the SRO legislation and regulation were created, no longer exist. All of which calls into question whether the very premise of self regulation is valid in this age of high frequency trading, the rigging of the FOREX and LIBOR markets, and an explosion in market manipulation and insider trading.

Commissioner Gallagher and I clearly part company when it comes to the nearly monolithic (and paleolithic) nature of Wall Street self regulation, which, these days, has essentially been reduced to FINRA. Gallagher waxes somewhat fondly about the "benefits that arise from the consolidation of oversight in a single entity with access to market data from transactions on multiple exchanges. " In contrast, I worry about a regulatory monopoly that suffocates regulation through a lack of competition and dampens innovation. 

I have had and continue to play multiple roles on Wall Street. I started out in-house in the legal department of Smith Barney, Harris Upham & Co. I then became a regulatory attorney for both the American Stock Exchange and NASD (FINRA's predecessor). My next job was as an in-house lawyer for a mutual fund complex and investment advisory firm. Finally, I became a Series 7 and 63 registered representative and also entered the private practice of law, where I have represented industry participants, defrauded public investors, and, more recently, whistleblowers.  Given the panoramic perspective of a three decade career that has taken me to all sides of the table, I objectively take issue with Gallagher's inference that the consolidation of the SRO landscape into FINRA and only FINRA fosters a healthy expectation by market participants when it comes to "disciplinary action, and a single arbitration regime . . ." To the contrary, there has been more than enough evidence that the unhealthy concentration of SRO power into one organization has resulted in the: 
  • uneven discipline between smaller and larger members;
  • disenfranchisement of registered men and women in the SRO process; and 
  • ability of FINRA member firms (who are the only enfranchised participants in FINRA's rulemaking and election processes) to compel mandatory arbitration upon public customers and industry personnel.
I would urge Commissioner Gallagher to very, very carefully consider the legacy we have inherited from an emasculated SRO landscape dominated by one, and only one, SRO in the form of FINRA. Perhaps he does not fully appreciate the ramifications in his musings:

Although FINRA has ceased to actively pursue the possibility of expanding its mission to encompass IAs, were Congress to pursue new legislation to establish an investment adviser SRO, the conversation would inevitably turn to FINRA as a possibility again.

Inevitably? What, may I ask, is FINRA's impressive track record that it should be the "inevitable" SRO for investment advisers?  Has the good commissioner reviewed FINRA's track record with Madoff or Stanford?  Has the commissioner reviewed FINRA's history of internecine warfare with its "small" member firm community?  And, please, remind me of all the effective pre-emptive regulation that this purportedly vaunted SRO implemented that helped hold back the devastation of the Great Recession

SIDE BAR: For a more detailed consideration of my antagonism towards FINRA's assumption of the role as the investment adviser SRO, see "Crony Politics Of Congress Wants Crony Regulation Of Investment Advisers" ( Blog, June 4, 2012).

The danger with Commissioner Gallagher's proposed regulatory experiment, however, is that it gets rigged.  You know, like LIBOR, like FOREX, like the municipal bond markets -- rigged. First you rig the qualifications to bid. Then you rig the request for proposals. Then you rig the selection system. When it comes time to bid, we are left with a carefully tailored pool of only one qualified candidate. That anointed bidder then runs up the costs and in the absence of competition, often screws up the program under consideration. Going forward, vested interests in Washington, D.C. will draft legislation eviscerating meaningful reform and embed crippling exemptions within thousands of pages of unread provisions. 

In the end, the investing public and industry inherit legislation based upon a wink and a knowing nod from folks who inevitably wind up with lucrative seats on the boards of regulatory organizations that they mandated or they wind up in the employ of corporations they protected -- and, to boot, those who play the game often find ways for their family and friends to wind up with high-paying consultancies and no-show jobs.Oh my, how the politicos and the lobbyists in our nation's capital love to experiment. See, for example: "Lap Dances, The World Series, And A Highway Bill" ( Blog, August 20, 2014). 

I always get nervous when folks in political and regulatory leadership advocate for monopolies or unhealthy concentrations of power rather than the robust competition that is the very basis for the capitalism upon which Wall Street was built. The clash of ideas in the marketplace is the bedrock principle of our economy.  When the private sector or the government wrongfully interferes with competition, when steps are taken to unfairly weight one side of the scales against the other, when we suck the air out of any industry by exalting one player among all others, that is a danger against which we must all rally.  That is my fear and that is why I will oppose any effort to make FINRA the self regulatory organization for the investment adviser community.

I urge Commissioner Gallagher to get out the needle and thread necessary to do the bespoke tailoring needed to create a new investment adviser SRO. I would suggest that a 21st Century solution for a 21st Century marketplace is a far better route than trying to cobble together the failures of 20th Century legislation and regulation into yet another half-assed nightmare of a bloated Washington, D.C.-based bureaucracy. Sometimes, we need to get out the whole cloth rather than attempt another round of alterations.

Notwithstanding our considerable disagreements about FINRA and the viability of self-regulation, I still give Commissioner Gallagher credit for raising the testy and unpopular issue about an investment adviser SRO, and for suggesting an experiment in regulation for the investment adviser industry.  His plays a very valuable role and one that has been absent from the SEC for too long.