Can the SEC Continue to Oversee FINRA ? (By guest bloggers Broy and Chepucavage)

February 5, 2009

Can the SEC Continue to Oversee FINRA with its Current Conflicts? Yes But?

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By Tony Broy and Peter J. Chepucavage  

One yet unexamined aspect of the Madoff case is the SEC'S role in the oversight of FINRA with regard to the Madoff matter. The legislation that empowers FINRA made very clear according to former SEC Chairman and Supreme Court Justice Douglas that the SEC would stand behind the door with a shotgun to insure that the self-regulatory organizations did their job. In addition, conflicts have been a major concern of the SEC examining staff over the last 10 years. But given the Madoff issues the SEC surely has its own conflicts. These include the number of former SEC staff at FINRA together with FINRA's former CEO as the new chair of the SEC and a former senior FINRA official as a commissioner. Prior to the mid 90's it was a rare occasion for SEC staff to migrate west to the NASD. But after the proceedings against the NASD for price fixing in the mid 90's, SEC employees migrated for better compensation. Those migrating included the new SEC chairperson who became NASD CEO in 1996. After the NASD agreed to changes in a 1996 settlement, the SEC proceeded against the firms involved in the alleged price fixing. REGISTERED REP magazine described the final settlement in SEC Settles Nasdaq Price-Fixing Case; Cites Broad Supervisory Failures (February 1, 1999) as follows:  

Last month, the SEC concluded its nearly five-year-old investigation of widespread price-fixing and manipulation on Nasdaq. Twenty-eight firms and 51 individuals were cited and fined a total of $26 million.

But top industry execs are off the hook despite almost complete supervisory collapses at several firms.

In its enforcement order, the SEC says some (unspecified) firms simply failed to supervise their head traders. In other cases, compliance personnel and senior management to whom the traders reported were not adequately staffed or were not familiar with trading operations, the SEC says.

In fact, the "head traders of these firms sometimes themselves engaged in underlying violations," the SEC claims.

Yet out of 28 firms, only three head traders were sanctioned--the OTC trading chiefs from Paine Webber, J.P. Morgan and UBS Securities (which merged with Warburg Dillon Read last summer). No senior executives of any firms were personally cited in the case regarding Nasdaq problems--one of the largest and most widespread Wall Street scandals ever.

Paul Gerlach, an associate director in the SEC's division of enforcement, defends the settlement. "We went as high [up in the firms] as we thought appropriate based on the facts of the investigation."

The three trading heads were sanctioned because "the evidence disclosed that they were aware of red flags ... that there was misconduct occurring by their subordinates," Gerlach says.

Because the overall settlement dealt with inadequate or nonexistent procedures, "that caused us to conclude that the firm should be charged with failure to supervise, rather than single out a particular person in management or compliance."

PaineWebber got an especially tough punishment--a $6.3 million fine, and eight individuals cited. Bill Singer, a New York securities attorney who both sues and defends market makers, speculates that PaineWebber and other hard-hit firms simply had more trader tapes archived. Tapes were a principal source of evidence in the cases.

Gerlach dismisses that idea, saying some firms that had tapes were not punished, and some of the dealers named had no tapes.

The tapes, covering trading activity during parts of 1994, show rampant price manipulation and collusion. For example, instead of competing, traders routinely colluded to move prices up before selling to clients, or vice versa.

The current enforcement action is a follow-up to an investigation of Nasdaq and the NASD completed in 1996. In that action, the SEC ordered the NASD to undertake a series of reforms. Evidence disclosed in a report from that investigation showed that an "even-eighth" pricing convention between most Nasdaq dealers occurred for as long as three decades. The current action penalizes firms and traders for specific cases of illegal quote movement.

While no NASD personnel were disciplined many were forced from their senior positions in what is known as the Saturday Night Massacre and were replaced by SEC staff.

Many, including us, viewed this westward migration to the NASD  as a positive development that strengthened both entities,. However it had the seeds of conflict because the NASD was so heavily regulated by the SEC though examination and the type of disciplinary proceedings brought in 1996.Thus the more SEC lawyers who moved West the more they were being regulated by their former colleagues who had a reasonable desire to move there with them and continued to do so. This of course came full circle with the two most senior FINRA officials becoming SEC commissioners. The SEC has two distinct powers; it can force the NASD to enforce its rules and discipline them for not doing so. It also has veto power over those rules. Subsequent to the '96 proceeding there was little or no such enforcement, even when the SEC acknowledged its concern about the NASD and NYSE' enforcement of the short sale rules. Instead the SEC proposed and adopted Reg SHO to consolidate such enforcement and rulemaking. Reg. SHO effectively federalized the NASD'S rules on short sales, when a better course might have been to aggressively require enforcement of those rules by the NASD. The SEC did move against the Amex but that case has yet to be resolved.

The Madoff scandal however has lifted the skirt of a tenuous and subtle relationship. Chairman Cox admitted immediately that the SEC had failed. FINRA took a different approach and has said both that they were unaware of the problem and that they had no authority over the business. Yet Madoff was considered the founding father of the NASDAQ miracle. It would seem that the SEC would naturally have asked FINRA to investigate and given them the many warnings it had. Indeed it's surprising to many that if the SEC did not take the warnings seriously it also did not refer the problem to FINRA with at least a warning that the Madoff clan is the subject of rumors. But FINRA has said this was never done. Congress asked Harry Markopolis, who early on had warned of the Madoff scandal, why he didn't take his reports to the NASD/FINRA? Mr. Markopolos explained that the NASD was a "corrupt organization" that does everything to protect its members.  

Given this allegation and the SEC'S duty of oversight, the ability to aggressively investigate has become impossible.  Can the commissioners now return to FINRA and oversight their activity in this regard? Wouldn't the Chair and other FINRA Commissioner have to recuse themselves and pity the poor SEC employee who would depose them in any event? Wouldn't any former SEC employee now on the NASD staff be conflicted as to who should have caught Madoff or passed on the Markopolis materials? Can the SEC'S Inspector general do anything about FINRA's role? These are difficult questions but we believe the concept of self- regulation should be preserved and the SEC'S role in it should be preserved.  

We propose the following solution to this problem and future similar problems. As was done in '96 the FINRA board should appoint an outside special investigator who would report to the board and to Congress. Congress should then determine whether the SEC had done its job in overseeing FINRA and the FINRA board should determine whether FINRA had done its job. We assume that the SEC Inspector General would be performing a similar analysis for the SEC and Congress. Congress should thereafter maintain a permanent oversight committee for SRO oversight with the SEC inspector general reporting directly to them? This solution does not require any major changes but instead creates another layer of oversight and preserves self-regulation. This congressional oversight committee should have resources and authority beyond the GAO. That includes the ability to make significant SRO changes on its own after consultation with the SEC. While many would deem this the end of self -regulation, many of our correspondents believe that happened many years ago culminating with the end of the one firm one vote rule last year. Finally we believe the committee should work directly with the SEC and FINRA to refine their oversight techniques, a subject we will address in our next column.

About the Authors:

Peter J. Chepucavage
Plexus Consulting Group, LLC

1620 Eye Street, NW
Suite 210
Washington, DC 20006
Phone:  1.202-785-8940
Fax:      1.202-785-8949
Email:   info@plexusconsulting.com

has 30 years of experience in both the public and private sectors of the securities industry. He has worked for the National Association of Securities Dealers (NASD) and U.S. Securities and Exchange Commission (SEC), as well as a private law firm and a major international investment bank. He is familiar with all aspects of broker-dealer and hedge fund regulation, including broker dealer operations and stock loans.

Chepucavage was also heavily involved in the post-9/11 efforts by the securities industry to strengthen their resilience to terrorist attacks. He is a General Counsel to the firm and the head of its broker-dealer/hedge fund compliance and expert testimony sections.

Chepucavage most recently worked as an Attorney Fellow in the SEC's Division of Market Regulation where his main projects were post-9/11 resiliency and short sales, including the drafting of Reg. SHO. Prior to his position at the SEC, he practiced at Fulbright & Jaworski in New York city. At various times between 1984-1997, he was a managing director in charge of Nomura Securities' legal, compliance and audit functions and served on its management and credit committees. He also worked with its derivatives' affiliate.

Mr. Chepucavage has been a member of many Securities Industry Association (SIA) and other regulatory and legal securities industry committees and written extensively about regulation. One of his main interests is the effect of regulation on small businesses and he provides regulatory advice to small and medium enterprises, including Washington representation. Mr. Chepucavage also served as an Assistant General counsel with the NASD, a law clerk to Judge George R. Gallagher (D.C. Court of Appeals), and as an infantry officer in South Korea.

Peter Chepucavage is also a member of the advisory board of The Public Company Management Corporation (OTCBB:PUBC), an emerging company providing consulting and advising services to companies seeking to access public capital markets.

Anthony Broy

has almost 40 years experience as both an NASD examiner and very successful market-maker. He cares deeply about the survival of self-regulation.