The Irregulator

Feb 28, 2014 · 4 min read

Slouching Towards Wall Street… Notes for the Week Ending Friday, 9 November 2012

By Hook Or By…

One way or another I’m gonna win ya, I’m gonna getcha getcha getcha getcha…

- Blondie, “One Way Or Another”

In a bold move FINRA, the securities industry self regulatory organization, has taken a Facts On The Ground approach in its bid to become the primary regulator for the managed funds industry.

Speaking at a meeting of arbitration attorneys last month, the head of FINRA Dispute Resolution announced that the SRO’s arbitration and mediation arm is now open for registered investment advisers and their clients to participate on a voluntary basis (WSJ, 2 November, “Finra Arbitration For Investment Advisers Explained.”) Without citing details, Dispute Resolution head Linda Feinberg said there are already several RIA cases making their way through FINRA’s arbitration and mediation system.

Some observers think this is a smart move. FINRA’s arbitration system has been around for a long time, with well established rules of the road. Significantly, it is also cheaper than the American Arbitration Association, which is where most disputes between RIAs and investors currently are heard. FINRA proudly promotes its own statistics showing that their mediation process resolves 80% of cases.

“Resolution” is a technical term. It does not necessarily mean “satisfaction.” Investors have lost out time and again in arbitration, and a number of studies have appeared over the years indicating the process may be slanted heavily in favor of the industry. Studies from the 1990s into this decade indicate a low percentage of wins for the customer, and widespread investor dissatisfaction with the FINRA arbitration process. We have witnessed anecdotally that arbitration panels largely lay responsibility on the investor, promoting a caveat emptor model. But this arises from the regulatory structure of the industry itself. Until Congress either passes a law, or permits the SEC to enact a Rule creating a blanket fiduciary standard for investment professionals, arbitration panels are technically right in what many consumer advocates view as blaming the victim.

Large numbers of RIAs are horrified at the notion of FINRA becoming their primary regulator. Many senior hedge fund professionals cut their teeth in the brokerage and investment banking business, where they dealt with FINRA’s maddeningly uneven examination process, often driven by uninformed and arbitrary regulators. At the same time, FINRA’s approach makes a lot of sense. It gives them an opportunity to build goodwill with the RIA sector and may in time lead to a cozy relationship. Cozy relationships, remember, is what regulation is all about.

This could lead to a split regulatory marketplace, as smaller RIAs start to select FINRA arbitration for its lower price and predictable process, while larger firms, who can afford better lawyers, remain with the SEC. Last year House Financial Services Committee chair Spencer Bachus proposed the creation of an SRO for advisers, a bill that was met by criticism from both Rep. Barney Frank and the managed funds industry. A voluntary slicing and dicing of the industry may be the best Congress and the regulators can do, as there will not be funding to enable the SEC to add the staff they desperately need for hedge fund and adviser oversight.

What we found particularly interesting was where the notice about the new voluntary program for non-FINRA member RIA arbitration is posted. It appears on the FINRA website under Arbitration — Special Procedures. The first Notice posted on that list covers Auction Rate Securities and advises that “Investors covered by ARS final settlements with securities regulators may participate in a Special Arbitration Process to recover consequential damages.” We know this is ancient history, but we recall a spate of articles (see, for example, Bloomberg, 29 April 2009, “FINRA Oversees Auction-Rate Arbitrations After Exit”) describing how FINRA’s predecessor, the NASD, held ARS in its endowment portfolio. Between 2003-2006, NASD’s ARS holdings ballooned from $257.7 million to $862.2 million. A FINRA spokesman said the ARS were held as liquid cash equivalents for short-term needs — this, despite the fact that the ARS market froze completely, leaving investors with billions of losses as they were unable to access their holdings.

The Bloomberg piece points out that “the SEC was investigating auction-rate dealers while Finra was buying the securities, and fined 15 dealers $13 million in May 2006.” By spring 2007, FINRA had launched a review of ARS sales practices. At about the same time, FINRA liquidated $647 million of ARS, getting out of their position months before the entire market froze up in February 2008.

FINRA enforcement says they have returned over $2 billion to ARS investors. As though it were an automatic action, FINRA said the disposition of the ARS securities was a repositioning occasioned by the merger of NASD Regulation with NYSE Regulation in 2007, which gave birth to FINRA.

To our knowledge, there has never been a follow-up on the timing of the ARS sale by FINRA. Nor, by the way, have the courts taken note of complaints over millions in compensation paid to Mary Schapiro and other NASD top officials who engineered the merger, while NASD member firms received no more than $35,000 each, supposedly because of tax restrictions.

Come to think of it, FINRA might be the perfect place for hedge funds to hang their hats.


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    A Wall Street compliance professional tells you how it’s really done. How the 1% guarantee they stay that way.

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