Reforming the SEC and FINRA: Evolution or Revolution?
By: Richard A. Kirby and Melissa S. Holmes
Last week, FINRA released a report by the 2009 Special Review Committee that examines in detail the failure of FINRA’s examination program to detect the Stanford and Madoff frauds (the FINRA Report). The Special Committee recommends a series of reforms to FINRA examinations for adoption by FINRA management and its board, including items that would require SEC approval and – with respect to jurisdiction over registered investment advisers - Congressional action. These reforms would significantly expand FINRA’s enforcement and regulatory reach beyond its current mandate.
The FINRA Report follows on the heels of the final recommendations of the SEC Inspector General for reforming the agency’s Division of Enforcement operations (the SEC Report), which grew out of his earlier scathing critique of the SEC’s failures to identify the Madoff fraud. The Director of Enforcement has agreed to adopt and implement all of the SEC Report’s recommendations. While many of the proposed FINRA reforms outlined in the FINRA Report would take time to implement (if they are implemented at all), the immediate changes to the respective examination and enforcement programs of FINRA and the SEC triggered by these reviews are being felt by financial services firms immediately and they will need to react to these changes.
FINRA Reforms.
A. The FINRA Report concludes that FINRA should seek authority from Congress to regulate activities under the Investment Advisers Act. It suggests that if FINRA had this authority, it may have discovered Madoff’s Ponzi scheme through its regular examination process after he registered as an investment adviser in 2006. The SEC has not taken a public position on this proposal. The current Obama Financial Regulatory Reform does not contemplate an SRO regulatory structure for investment advisers, nor do any of the current proposals being considered by House Financial Services Chairman Barney Frank or Senate Banking Chairman Chris Dodd. Please see recent Blog posting called "House and Senate Take Expedited But Divergent Approaches to Financial Regulatory Reform Plan." It would be surprising if this jurisdictional reach by FINRA gets traction in the present Congress.
B. The FINRA Report also recommends that FINRA seek SEC authority to broaden its authority to examine not only outside business activities of associated persons of members, but also affiliates of member firms. This expansion of FINRA’s regulatory reach would give it broader investigative powers than the SEC itself. It remains to be seen how the SEC will react to this proposal.
C. The FINRA Report notes that FINRA staff declined to pursue inquiries into complaints about Stanford’s high-pressure sales of CDs issued by its off-shore Antigua bank affiliate because of a concern that the CDs were not securities. This decision apparently was made by non-attorneys and contrary to the specific position of the SEC Fort Worth Regional Office on the issue, and was taken without fully informed consultation with FINRA General Counsel. The FINRA staff’s surprisingly and well-documented timid view of its jurisdictional limits, which appear to have had a material impact on its failure to pursue complaints related to Stanford, provides an interesting contrast to the Special Committee’s recommendation of a much more expanded and robust jurisdictional scope for FINRA going forward.
D. One recommendation from the FINRA Report that FINRA itself can implement is the proposal to increase FINRA’s fraud detection capacity and to focus more heavily on so-called “cause” examinations. The shift to an examination program focused primarily on items triggered for cause, however, would transform the examination staff to an adjunct of the FINRA enforcement division. Assuming this recommendation is adopted by the FINRA board, it could require members and associated persons to prepare for and approach future examinations with a much more guarded approach. Management will need to promptly assess the allegations that trigger the cause examination and independently determine whether the cause determination is warranted and, if so, whether remedial action is appropriate.
E. The FINRA Report notes that it is standard practice of FINRA not to defer to another regulatory agency’s parallel enforcement efforts, unless there is an express request to defer made by the SEC or other agency. This statement will come as a surprise to many practitioners who have successfully persuaded FINRA to defer its own review of an enforcement matter on burdensomeness grounds where there is a parallel SEC or DOJ investigation into the same conduct. It remains to be seen how this newly announced FINRA policy will be applied in practice.
SEC Enforcement Reforms.
While the SEC IG proposed myriad reforms regarding training and oversight at the SEC, financial services firms are most likely to be affected by reforms relating to the staffing and handling of complaints as well as a proposed more targeted focus of examinations.
A. A new Office of Market Intelligence will be created within the Enforcement Division to coordinate the process of reviewing and evaluating tips and complaints. In addition, SEC Chairman Mary Schapiro is seeking Congressional authority to reward whistleblowers with financial incentives.
B. The SEC will work to deploy adequately qualified staff with experience tailored to the matters at issue in a specific investigation. The Office of Compliance Inspections and Examinations (OCIE) hopes to fill new “Senior Specialized Examiner” positions with professionals with experience in areas such as valuation, sales and forensic accounting. Dealing with such specialized professionals could result in a streamlining and acceleration of the enforcement investigation and examination process for financial services firms. Whether this results in a fairer process for these firms remains to be seen.
C. Finally, the Enforcement Division will institute a more rigorous and systematized process for the planning, oversight and management of the investigation process, including the processes for both opening and closing investigations. Although more targeted investigations may lighten the burden on financial services firms in some respects, OCIE, like FINRA, intends to increase its focus on “cause” investigations. This focus raises the same concerns as it does with FINRA’s shift in emphasis and puts greater burdens on financial services firms to more carefully prepare for and respond to issues raised in examinations and investigations. It will also increase the need for management to conduct its own independent review of the matter under scrutiny.
