FINRA Makes Its Case for SRO Role Overseeing Advisors

WASHINGTON -- In testimony before members of a House committee on Wednesday, Richard Ketchum, the chairman and CEO of the Financial Industry Regulatory Authority, or FINRA, offered an enthusiastic endorsement of a legislative proposal to establish a self-regulatory organization to oversee RIAs, an issue that has sparked considerable controversy throughout the industry.

CHECK OUT COMPLETE COVERAGE OF THE SRO DEBATE

The bill "has it right," Ketchum told members of the Financial Services Committee. "There should be provisions for one or more SRO whether or not it is FINRA."

But of course, FINRA, the nation's largest non-governmental securities regulator, is widely expected to begin overseeing investment advisors, just as it currently reviews broker-dealers, should the Investment Advisor Oversight Act become law.

That bill, backed by Financial Services Committee Chairman Spencer Bachus (R-Ala.) and Carolyn McCarthy (D-N.Y.), would authorize the SEC to tap one or more SROs to regulate retail investment advisors, a proposal developed in response to the SEC's admission that it lacks the resources to effectively oversee the industry.

Ketchum didn't need to nominate FINRA by name to take on that responsibility, especially at this early stage. It was implied. Like most discussions of the SRO issue, Wednesday's hearing to consider the Bachus bill framed it as a binary choice: either responsibility for examining non-state-regulated advisors would remain at the SEC or it would shift to FINRA.

And FINRA has been pressing its case both to industry members and lawmakers that it is equipped to assume oversight authority over investment advisors. The group has been assuring the industry that it is sensitive to the unique distinctions between the broker-dealer and advisor models, and that it would hire additional expert staff and set up a distinct board to oversee regulation of advisors.

At the same time, FINRA has been pointing to a convergence between the two sectors. Roughly 87 percent of registered investment advisor representatives are dually registered as representatives of a broker-dealer, according to Ketchum.

"This means that firms offer customers a combination of brokerage and advisory services in a product menu, and that, in many cases, financial professionals offer commercially indistinguishable brokerage and investment advisory services to the same customer," he wrote in written testimony submitted to the Financial Services Committee. "This makes it highly unlikely that the customer can distinguish between those services and the differing obligations and protections that are present in advisory and brokerage channels."

FINRA has also argued that its current regulatory reviews would be improved if it could evaluate both sides of a dually registered business. Bachus seized on that point during Wednesday's hearing, pointing out that the massive fraud underway within Bernard Madoff's investment firm was occurring on the advisor side -- the SEC's purview -- not the broker-dealer business overseen by FINRA.

Updating the regulatory landscape for advisors seeks to increase the frequency of examinations, with the ultimate effect of promoting best practices across the industry, shutting down bad actors and improving investor confidence. To that end, FINRA has a compelling argument to make with the numbers. The SEC has reported that it only evaluated 8% of investment advisors in 2011. In the broker-dealers space, where examinations are conducted by both FINRA and the SEC, about 55% of practitioners are reviewed each year.

"No one involved in regulating securities and protecting investors can be satisfied with a system where only 8% of investment advisor firms are examined each year by the SEC. Yet that is the system we have," Ketchum told lawmakers. "It is an unacceptably low level of oversight and represents a major gap in investor protection."

Critics of the SRO proposal readily acknowledge that the regulatory gap should be closed. Groups such as the Investor Advisor Association and the Certified Financial Planner Board of Standards are advocating against the Bachus bill, instead calling for additional funding for the SEC to ramp up its own reviews, likely through increased user fees.

Their objections to the SRO model in general, and FINRA specifically, are many, some of which were aired at this morning's hearing, including the fear that an SRO, working under the aegis of the SEC, would simply add another layer of bureaucracy and compliance for investment advisors to navigate.

"Additional regulations are not needed to address the issue at hand," said David Tittsworth, executive director and executive vice president of the Investment Advisor Association. "We strongly support efforts to enhance SEC inspections."

FINRA's own estimates of the additional costs that regulating advisors would entail, which are paid by fees assessed to industry practitioners, have come under fire. Tittsworth's organization was one of several SRO critics organized under the Financial Planning Coalition that commissioned the Boston Consulting Group to study the issue. The researchers concluded that FINRA substantially lowballed its estimates in areas such as setup, operating and enforcement costs.

Addressing the cost concerns before the House committee, Ketchum said the researchers had made a number of false assumptions, among them overstating the number of advisor firms that would actually be evaluated by the SRO once all the exemptions in the legislation were applied, and the streamlined startup costs thanks to FINRA's existing nationwide reach. Moreover, Ketchum pointed out that the Boston Consulting Group researchers never contacted FINRA as they prepared their critical study of the group's own cost estimates.

Ketchum also defended his organization from charges that FINRA lacks the accountability and transparency ingrained in the proceedings of federal regulators. As a non-governmental organization, FINRA's board meets outside of the open requirements codified in the Sunshine Act, for instance, and it is not held to the same expectation of conducting a cost-benefit analysis before implementing a particular policy. It is also not governed by the Administrative Procedures Act, which sets the rules for regulators to initiate rulemaking proceedings, including periods of public notice and comment.

"Outsourcing oversight to a private organization that lacks transparency, lacks accountability, lacks any sort of external constraint on its budget and, you know, has a checkered record in terms of investor protection is definitely not the solution," Marilyn Mohrman-Gillis, managing director for public policy and communications with the CFP Board, said in an interview, noting that those problems are not unique to FINRA, but are typical of the SRO model.

At the House hearing, Ketchum emphasized that in its current role overseeing broker-dealers, which would serve as a model for expanding to cover advisors, FINRA is highly accountable to the SEC. Federal authorities approve FINRA's rulemakings and can later modify or delete its regulations, and the SEC is required to publish FINRA's proposals through a notice seeking comment in the Federal Register.