An Introduction to FINRA
The Financial Industry Regulatory Authority (FINRA) is the primary regulator of broker-dealers.[REF] It regulates 3,895 broker-dealers and 641,761 registered representatives.[REF] The Securities Exchange Act requires that a broker-dealer be a member of a registered “national securities organization,”[REF] and FINRA is the only extant registered “national securities association.”[REF] Thus, broker-dealers must be members of FINRA in order to do business, and if FINRA revokes their membership, they may not do business.
In 2015, FINRA levied $94 million in fines against broker-dealers, took 1,512 disciplinary actions against broker-dealers, and ordered $97 million in restitution to harmed investors.[REF] FINRA conducts the arbitration of almost all disputes between a customer and a broker-dealer as well as the arbitration of intra-industry disputes.[REF] Investors are generally barred from pursuing relief in state or federal courts.[REF] As discussed below, if conducted fairly, arbitration can be a cost-effective means of resolving disputes.
FINRA maintains an Office of the Ombudsman to resolve investor, broker-dealer and other complaints about FINRA operations.[REF] This office handles more than 500 inquiries annually.[REF]
FINRA is a Delaware not-for-profit corporation that is tax exempt under section 501(c)(6) of the Internal Revenue Code.[REF] The Securities and Exchange Commission (SEC) is responsible for the oversight of FINRA.[REF] In 2015, FINRA had 3,500 employees.[REF] In fiscal year (FY) 2015, the SEC had 4,300 employees.[REF] FINRA has an annual budget of $1 billion,[REF] and has $2 billion in cash and investments on hand.[REF] The SEC has an annual budget of $1.6 billion.[REF] FINRA contracts to perform regulatory functions for a wide variety of exchanges. The fees it receives from these contracts account for $126 million of its annual revenues.[REF]
FINRA was formed when the regulatory functions of the New York Stock Exchange (NYSE) and the National Association of Securities Dealers (NASD) were merged and given to FINRA[REF] as part of a series of transactions in which both the NYSE and NASDAQ[REF] became public, investor-owned enterprises.[REF] These changes were approved by the SEC on July 26, 2007.[REF]
FINRA is commonly called a self-regulatory organization (SRO) by both commentators and the SEC.[REF] By “SRO,” commentators typically mean an organization whereby the industry regulates itself. Although FINRA’s predecessor organizations (the NASD and the NYSE’s regulatory arm) were once true SROs,[REF] FINRA is not.[REF] FINRA is governed by a 23-member board.[REF] Under the eighth article of its articles of incorporation, the number of its “public governors” (those not chosen by industry) “shall exceed the number of Industry Governors.”[REF] Industry governors are those elected by the industry. Currently, there are 10 board members who are industry governors. There are 12 public governors. In addition, FINRA’s CEO, Robert Cook, also serves on its board. Thus, the industry controls only 10 of 23 governors, 43 percent of the board.[REF] Because the industry does not control FINRA, it is inappropriate to regard FINRA as an SRO.
The Potential Virtues of Self-Regulation. Private individuals have the right to conduct their business, within the law, as they see fit. Firms should be free to hold themselves to higher standards than the law requires, or to establish standards, procedures, and practices by mutual agreement that improve the functioning of a market. True self-regulation by industry is one way to do that, and has potential merit.[REF] Self-regulation may be thought of as spontaneous private legal ordering.[REF]
Law professors William Birdthistle and Todd Henderson argue that “[i]ndustry professionals have strong incentives to police their own, since many of the costs of misbehavior are born by all members of the profession, while the benefits inure only to the misbehaving few. So long as the few do not control the regulatory process, self-regulation could in theory work as well or better than external regulation.”[REF] Industry representatives often have greater expertise than government regulators and are closer to the market. They may be able to more rapidly respond to changing circumstances and their regulatory response may be more proportional or scaled.[REF]When the “self-regulator” becomes intertwined with government, however, self-regulation presents potential conflicts of interest and is often a guise for erecting barriers to entry in a market to protect incumbent firms and to extract economic rents at the expense of customers or clients.[REF]
Why Reform Is Necessary
FINRA is an unusual entity. FINRA is a key regulator with a budget nearly two-thirds the size of the SEC’s budget and a staff numbering more than 80 percent that of the SEC, but it is not a government agency. While critical to the functioning of the finance industry, and having industry representation on its board, it is not controlled by the industry. While it serves a governmental function and has coercive power, including the ability to completely bar firms and individuals from the marketplace,[REF] it is not subject to any of the normal transparency, regulatory review, or due-process protections normally associated with government. It is not, for example, subject to the notice-and-comment provisions of the Administrative Procedure Act,[REF] the Freedom of Information Act,[REF] the Regulatory Flexibility Act,[REF] the Sunshine Act,[REF] the Paperwork Reduction Act,[REF] or cost-benefit-analysis requirements.[REF] In contrast to a court, FINRA’s arbitration and disciplinary hearings are not generally open to the public.[REF] Its arbitrators are not usually required to provide reasons for their decisions.[REF] Its rule-making is generally done in private,[REF] and its Board of Governors meetings are closed.
Unless FINRA is ultimately held to be a state actor, constitutional due-process protections, either for broker-dealers or for investors, do not apply.[REF] In Jackson v. Metropolitan Edison Co., the Supreme Court held that in determining whether the actions of a private party constitute state action, “the inquiry must be whether there is a sufficiently close nexus between the State and the challenged action of the regulated entity so that the action of the latter may be fairly treated as that of the State itself.”[REF] In Blum v. Yaretsky, the Supreme Court held that “a State normally can be held responsible for a private decision only when it has exercised coercive power or has provided such significant encouragement, either overt or covert, that the choice must in law be deemed to be that of the State. [T]he required nexus may be present if the private entity has exercised powers that are ‘traditionally the exclusive prerogative of the State.’”[REF]
In an unpublished[REF] 2015 opinion, the Second Circuit held that FINRA is not a state actor.[REF] In a similarly unpublished 2011 opinion, the Eleventh Circuit raised, and then side-stepped, the issue by finding that even if FINRA were a state actor, FINRA had provided due process in the case being considered.[REF] Courts determining whether FINRA’s predecessor organizations, the NASD and the NYSE, were a state actor were divided (although a majority found in most contexts relating to due process that they were not).[REF] These cases, however, are of uncertain relevance given the differences between FINRA and NASD or NYSE governance structures, the monopoly status that FINRA enjoys, changes in the statutory and regulatory structure over time, and evolution in the judicial state action doctrine and the Supreme Court’s separation of powers jurisprudence.
The IRS, however, has found that “FINRA is a corporation serving as an agency or instrumentality of the government of the United States” for purposes of determining whether FINRA fines are deductible as a business expense.[REF] A “penalty paid to a government for the violation of any law” is not deductible under Internal Revenue Code section 162(f).
Furthermore, courts have routinely held that FINRA and its predecessor organizations aregovernment actors for purposes of immunity from private lawsuits against them.[REF] For example, in Standard Investment Chartered Inc. v. National Association of Securities Dealers,[REF] the Second Circuit held that:
There is no question that an SRO and its officers are entitled to absolute immunity from private damages suits in connection with the discharge of their regulatory responsibilities. This immunity extends both to affirmative acts as well as to an SRO’s omissions or failure to act.… It is patent that the consolidation that transferred NASD’s and NYSE’s regulatory powers to the resulting FINRA is, on its face, an exercise of the SRO’s delegated regulatory functions and thus entitled to absolute immunity.… The statutory and regulatory framework highlights to us the extent to which an SRO’s bylaws are intimately intertwined with the regulatory powers delegated to SROs by the SEC and underscore our conviction that immunity attaches to the proxy solicitation here.[REF] (Emphasis added.)
Thus, when dealing with FINRA, the many protections afforded to the public when dealing with government are unavailable, and the recourse that one would normally have when dealing with a private party—both access to the courts and the ability to decline to do business—is also unavailable. Like Schrödinger’s cat, simultaneously dead and alive, FINRA is, under current rulings, both a state actor (for purposes of barring liability and for tax purposes) and, generally, not a state actor (for purposes of absolving it of due process and other requirements and for liability purposes).
Professors Birdthistle and Henderson have written that:
SROs have been losing their independence, growing distant from their industry members, and accruing rulemaking, enforcement, and adjudicative powers that more closely resemble governmental agencies such as the Securities and Exchange Commission and the Commodity Futures Trading Commission.… This process by which these self-regulatory organizations shed their independence for an increasingly governmental role is highly undesirable from an array of normative viewpoints. For those who are skeptical of governmental regulation, deputizing private bodies to increase governmental involvement is clearly problematic.[REF]
Former SEC Commissioner Daniel M. Gallagher has raised similar concerns:
This decrease in the “self” aspect of FINRA’s self-regulatory function has been accompanied by an exponential increase in its regulatory output. As FINRA acts more and more like a “deputy” SEC, concerns about its accountability grow more pronounced.[REF]
Law professor Emily Hammond refers to FINRA’s current status as “double deference” and argues that “the combination of oversight agencies’ deference to SROs and judicial deference to oversight agencies undermines both the constitutional and regulatory legitimacy of SROs” and that reforms would “better promote accountability and guard against arbitrariness not only for SROs but also for the modern regulatory state.”[REF]
The U.S. Chamber of Commerce, referring to FINRA and the proxy adviser firm Institutional Shareholder Services, wrote:
Despite their tremendous influence over the workings of the capital markets, these organizations are generally subject to few or none of the traditional checks and balances that constrain government agencies. This means they are devoid of or substantially lack critical elements of governance and operational transparency, substantive and procedural standards for decision making, and meaningful due process mechanisms that allow market participants to object to their determinations.[REF]
It is also unclear how well FINRA is discharging its core mission of preventing fraud, misappropriation of funds, and other misconduct by those it regulates.[REF] A recent empirical analysis found:
Roughly 7% of advisers have misconduct records. At some of the largest financial advisory firms in the United States, more than 15% of advisers have misconduct records. Prior offenders are five times as likely to engage in new misconduct as the average financial adviser. Firms discipline misconduct: approximately half of financial advisers lose their job after misconduct.… [O]f these advisers, 44% are reemployed in the financial services industry within a year.[REF]
Some of the largest firms have committed multibillion dollar frauds with few consequences for the individuals who committed this fraud.[REF] There is bipartisan, bi-ideological concern about FINRA enforcement.[REF] It is, of course, possible that the high level of advisers with misconduct records is due to aggressive FINRA enforcement, and that the high level (44 percent) of re-employment in the financial industry of advisers with misconduct records is because the misconduct involved was minor. Given the information currently available to the public and policymakers, it is simply impossible to know.
FINRA’s Office of the Chief Economist[REF] has conducted research on FINRA enforcement. In August 2015, it released a working paper that found that the “20% of brokers with the highest ex-ante predicted probability of investor harm are associated with more than 55% of investor harm events and the total dollar harm in our sample.”[REF] Thus, the one-fifth of brokers that FINRA’s algorithm predicts have the highest likelihood of misconduct do, in fact, account for over half of the misconduct. Presumably, FINRA’s Enforcement Department is taking this predictive algorithm into account when assessing its enforcement priorities. The study also found that “[w]ith respect to the impact of releasing additional non-public CRD information on BrokerCheck, we find that HAC [harm associated with co-workers] leads to an economically meaningful increase in the overall power to predict investor harm.”[REF] HAC is FINRA jargon that means if a firm employs or has employed brokers that engage in misconduct, other brokers at that firm are more likely to engage in misconduct, presumably because of the culture at the firm or poor internal controls. Releasing additional CRD information, then, may allow the public to better assess whether their broker, or a broker whom they are considering, is likely to harm them by engaging in misconduct. Among other things, unreleased information includes complaints, test scores, felonies, and bankruptcies, and some of the information is quite old. Release of unadjudicated complaint information where there has been no finding of fault by the broker-dealer is probably not warranted. FINRA should evaluate whether additional information should be released.
The bottom line is this. FINRA has a monopoly. It is the only SRO for broker-dealers. Broker-dealers must be a member of FINRA in order to do business. Quitting FINRA is not an option given the legal requirement to be a member of an SRO. FINRA is virtually immune to legal challenges to its regulatory decisions. Thus, the normal recourse when dealing with a private party is not available. FINRA also has a virtual monopoly on arbitration of disputes between FINRA members and between a FINRA member and investors. Both investors and broker-dealers are generally barred from accessing the courts. FINRA has coercive authority over its members and investors. The federal government has effectively delegated regulatory and dispute-resolution authority to a private organization. When they are dealing with FINRA, neither broker-dealers nor investors enjoy the many protections that the law affords in dealing with government regulators in any court[REF]or in the regulation formulation process. Furthermore, it is far from clear that FINRA is doing an adequate job of policing fraud, misappropriation, and other serious misconduct. FINRA is not adequately accountable to Congress, to the public, or to those it regulates. Reforms, discussed below, are necessary.
It is an open question whether FINRA, as currently constituted, is constitutional.[REF] It is arguably unconstitutional for at least two reasons: (1) the separation of powers, and (2) the Fifth Amendment due-process clause and the associated private non-delegation doctrine. No matter how the courts ultimately rule on the constitutionality of FINRA’s current structure, the due-process, transparency, accountability, and governance questions raised are policy questions that Congress should address.
The Supreme Court in Free Enterprise Fund v. Public Company Accounting Oversight Board[REF] held the dual “for cause” provisions[REF] in the section of Sarbanes–Oxley creating the Public Company Accounting Oversight Board (PCAOB)[REF] to be unconstitutional on separation-of-powers grounds.
In Free Enterprise, the Supreme Court asked: “May the President be restricted in his ability to remove a principal officer, who is in turn restricted in his ability to remove an inferior officer, even though that inferior officer determines the policy and enforces the laws of the United States?”[REF]
The Supreme Court’s answer:
We hold that such multilevel protection from removal is contrary to Article II’s vesting of the executive power in the President. The President cannot “take Care that the Laws be faithfully executed” if he cannot oversee the faithfulness of the officers who execute them. Here the President cannot remove an officer who enjoys more than one level of good-cause protection, even if the President determines that the officer is neglecting his duties or discharging them improperly.[REF]
Because FINRA is tasked with enforcing the securities laws,[REF] and its board and officers are not removable by the President, and SEC Commissioners are only removable for cause, it is quite possible that a court would conclude that FINRA, as currently structured, violates the separation-of-powers clause. The Supreme Court, however, did distinguish the PCAOB from “private self-regulatory organizations in the securities industry—such as the New York Stock Exchange.”[REF] So the central question becomes whether FINRA is exercising “executive power” within the meaning of the Constitution, or whether it is a truly private self-regulatory organization.[REF]
Discussing the Supreme Court’s private non-delegation doctrine in another context, Heritage Foundation Legal Research Fellow Paul Larkin wrote:
The Fifth Amendment Due Process Clause ensures that the actors in each department cannot evade the Framers’ carefully constructed regulatory scheme by delegating their federal lawmaking power to unaccountable private parties, individuals beyond the direct legal and political control of superior federal officials and the electorate. That is, the due process requirement that federal government officials act pursuant to “the law of the land” when the life, liberty, or property interests of the public are at stake prohibits the officeholders in any of those branches from delegating lawmaking authority to private parties who are neither legally nor politically accountable to the public or to the individuals whose conduct they may regulate.[REF]
In Todd & Co. v. SEC[REF] and R. H. Johnson & Co. v. Securities & Exchange Commission,[REF] two circuits ruled the Maloney Act[REF] delegation to the NASD (FINRA’s predecessor organization) to be constitutionally compliant. The Todd court, however, explicitly disclaimed making a ruling on the 1975 amendments to the Securities Act,[REF] let alone changes since FINRA was created.[REF] As discussed above, the NASD and the NYSE were controlled by members of the organizations, while FINRA is not. Moreover, at the time of those decisions, the NYSE and NASDAQ were mutualized. Furthermore, the decisions predate the SEC’s role in approving all SRO rules. Finally, the courts’ state action and separation-of-powers jurisprudence has evolved considerably since the Todd and R.H. Johnson courts considered the issue.
Three Paths to Reform
There are three basic approaches to reforming FINRA. First, it could be changed back into a truly private SRO, controlled by the industry, with the SEC resuming its traditional regulatory role. This would, in effect, be a return to the regulatory environment before the NYSE and NASD handed off their regulatory function to FINRA.[REF] Second, FINRA could be incorporated into the SEC. FINRA’s status as a “national securities organization” would be terminated, its employees would have the option of becoming government employees,[REF] and FINRA’s regulatory functions would be discharged by the SEC, presumably by its Division of Trading and Markets. Those educational functions not conducted by its foundation and perhaps its market surveillance[REF] and intra-industry dispute resolution functions could be retained. As discussed below, ideally, its arbitration function would be spun off. This approach would provide the transparency, due-process protections, and congressional oversight typically associated with government. Significant changes to the Securities Exchange Act provisions governing national securities organizations would be required. Third, the existing framework could be substantially reformed. This latter, incremental, approach is likely to have the best chance of success in the current policy environment.
In August 2016, Robert Cook became president and CEO of FINRA, and chairman of the FINRA Investor Education Foundation.[REF] Jack Brennan was named FINRA’s chairman.[REF] Previously, Richard Ketchum had been both chairman and CEO. In addition, Bob Muh, the CEO of Sutter Securities, Inc., was elected in September as a small-firm governor on a platform of reducing the regulatory burden on small broker-dealers.[REF] With new leadership may come a new openness to reform.
Incremental Reforms. Incremental—although major—reforms that would address the most substantial problems with FINRA’s current structure are outlined below. In principle, many of these reforms could be implemented by FINRA itself, with SEC approval. Alternatively, Congress could amend § 15A and § 19 of the Securities Exchange Act, such that a national securities association (that is, an SRO) must meet the outlined requirements as a condition of registration. Current law already imposes more than 20 requirements.[REF]
Transparency. Given FINRA’s importance to U.S. financial markets, and the effective delegation to it of key regulatory functions by the SEC and Congress, openness and transparency in its regulatory and adjudicatory functions is entirely appropriate. FINRA should comply with a set of rules substantially similar to the requirements imposed on government agencies under the Freedom of Information Act.[REF]
FINRA’s Board of Governors meetings should be open to the public, unless the board votes to meet in executive session. The criteria for whether they can close the meeting should be established in advance and carefully circumscribed. FINRA currently does not make available in advance rule-makings that the FINRA board is expected to consider.[REF] The complete board agenda should be made available to the public in advance, and board minutes describing actions taken should be published with alacrity. Such requirements are analogous to, but less stringent than, the requirements imposed on government agencies by the Sunshine Act.[REF]
Given that under current law FINRA proceedings supplant a civil trial and there is no means of accessing the courts, FINRA arbitration hearings should be open to the public and reported. This is analogous to the public-trial requirement in the Sixth Amendment and the long-standing presumption that all court proceedings in the United States are open to the public.[REF] Just as trials in criminal and civil courts and hearings in administrative courts are open to the public, so should disciplinary hearings.
In 1884, Oliver Wendell Holmes, then a justice on the Massachusetts Supreme Court, held in Cowley v. Pulsifer[REF] that members of the public enjoy a right of access to civil trials. This right, he said, is rooted in democratic principles:
It is desirable that the trial of [civil] causes should take place under the public eye…not because the controversies of one citizen with another are of public concern, but because it is of the highest moment that those who administer justice should always act under the sense of public responsibility, and that every citizen should be able to satisfy himself with his own eyes as to the mode in which a public duty is performed.
Although proceedings are not public, adverse results in many disciplinary matters are made public via a database called Broker-Check.[REF] Broker-Check, however, reports only some of the information available on FINRA’s Central Registration Depository. FINRA’s Office of the Chief Economist has found that the unreported information is relevant to predicting broker misconduct.[REF] Other than unauthenticated complaint data,[REF] FINRA should consider whether this information should be made public. As discussed below, FINRA’s rule-making process should also be made more transparent.
Arbitration and Dispute Resolution. FINRA handles about 4,000 arbitration cases annually. About 70 percent of these involve customer complaints, and the remainder consist of intra-industry cases.[REF]
Arbitration can be a lower cost, fair way of resolving disputes.[REF] However, for the reasons discussed below in detail, FINRA’s arbitration system is flawed and should be improved.
Alternatively, Congress should consider a different approach. It could create a specialized court, analogous to the Tax Court, to hear intra-industry and customer-securities cases. This could be a specialized Article III court with limited jurisdiction, or a non-Article III court, such as the U.S. Tax Court[REF] or the U.S. Court of Federal Claims.[REF] It should have a small claims division like the Tax Court and many state courts so that small claims can be handled in a less-formal and less-expensive manner. The small-claims division should be open to pro se litigants, and judges should take a more active role in fact finding. Such an approach would have two primary advantages. First, there would be no doubt about its impartiality as there is in the case of FINRA. These doubts arise because, although not controlled by industry, FINRA certainly has strong industry influence. Second, its judges would develop expertise in securities-law cases. Often, neither an Article III court of general jurisdiction nor current FINRA arbitrators have expertise in securities cases.
Due Process. Due process may be summarized as providing to a person who may suffer loss of life, liberty, or property “notice, an opportunity to be heard, and a determination by a neutral decisionmaker”[REF] in an open forum. In the words of the Supreme Court:
Secrecy is not congenial to truthseeking.... No better instrument has been devised for arriving at truth than to give a person in jeopardy of serious loss notice of the case against him and opportunity to meet it. Nor has a better way been found for generating the feeling, so important to a popular government, that justice has been done.[REF]
Due-process protections would, at a minimum, include (1) adequate notice of the charges or complaint; (2) the right to be present at a hearing or trial; (3) a public forum; (4) the right to be heard and to present evidence; (5) the right to retain counsel; (6) trial by jury or, at least, an impartial, neutral decision maker; (7) an adequate ability to compel the opposing party to disclose facts and documents that are material to the dispute (adequate discovery); (8) an adequate ability to call witnesses and to cross-examine witnesses called by the opposing party; (9) a requirement that findings of fact are made and legal reasons are given for a decision; and (10) an adequate review by an impartial party of the triers’ decision to ensure that it is not arbitrary or capricious and has a rational basis in law and in fact (adequate appeal rights). Each of these is addressed in turn below.
1. Notice. FINRA appears to provide adequate notice both in disciplinary hearings and in its arbitrations.[REF]
2. The Right to be Present. FINRA allows the parties to be present during proceedings.[REF]
3. Public Forum. FINRA does not generally provide a public forum. Its proceedings are generally closed to the public.[REF] As discussed above under “Transparency,” these proceedings should generally be open to the public.[REF]
4. The Right to Be Heard and Present Evidence. FINRA provides the opportunity for parties to be heard and to present evidence. As discussed below, however, parties’ rights to present and obtain evidence are circumscribed, and the federal rules of evidence do not apply.[REF]
5. The Right to Retain Counsel. The right to retain and be represented by counsel is preserved in FINRA proceedings.[REF]
6. Impartial Decision Maker. FINRA does not provide the right to a trial by jury as is guaranteed in federal court by the Seventh Amendment[REF] and in state courts by most state constitutions.[REF] FINRA arbitration chairpersons are not judges. Although there are some requirements for arbitration chairpersons, there is no requirement that arbitrators have any special expertise in finance or the law. In fact, FINRA actively recruits from outside those fields.[REF] FINRA arbitrators must be approved by FINRA and complete 13.5 hours of FINRA training.[REF] FINRA maintains a list of 6,000 approved arbitrators[REF] and generates a random list of arbitrators (typically 10 public arbitrators, 10 non-public arbitrators, and 10 chairpersons) from which the parties can choose.[REF] FINRA changed its rules in 2011,[REF] however, so that in arbitrations involving a dispute between customers and a firm, the customer may elect to have the arbitration panel composed of entirely public arbitrators rather than industry representatives.[REF]
7. Adequate Discovery. FINRA discovery rules differ depending on the type of proceeding.[REF]Discovery is more limited than it would be in a federal court.[REF] In particular, the ability to depose witnesses is severely circumscribed.[REF] This may make it more difficult for a party to pursue a claim. FINRA discovery is, however, more extensive than discovery made under American Arbitration Association rules.[REF] Excess discovery costs are one of the primary reasons why conventional litigation is so expensive, and controlling dispute resolution costs is one of the primary advantages of arbitration.[REF] Controlling costs is one of the core rationales underlying the Federal Arbitration Act,[REF] which generally requires courts to enforce arbitration awards and bars access to courts when the parties have entered into a pre-dispute arbitration agreement[REF](as would be the case in virtually every customer-broker agreement). Whether FINRA discovery rules should be modified should be studied further.
8. Calling Witnesses and Witness Cross-Examination. Witnesses may generally be called, and opposing witnesses cross-examined. The limits on conducting witness deposition discussed above make it much more difficult to adequately rebut surprise testimony or to impeach a witness.
9. Findings of Fact and Law. In general, FINRA arbitrators need not explain their reasoning or make findings of fact or law. If, however, all parties agree in advance,[REF] they may request and pay $400 for an “explained decision.”[REF] But even an explained decision need not include “legal authorities and damage calculations.”[REF] Thus, neither the parties nor anyone reviewing the arbitrators’ decision can meaningfully assess how much, or how little, thought or analysis about the facts or the law went into deciding the case or the amount, if any, of the award. Neither the parties nor anyone else can meaningfully assess whether the arbitrators’ reasoning was flawed or sound. In contrast to very high compensation for FINRA employees,[REF] arbitrators are paid between $300 (for a session up to four hours) and $600 (for a session lasting up to a day).[REF]This amounts to $75 per hour—and substantially less than that, once the time traveling to and from the hearing and preparation time is considered. In contrast, the reimbursement rate for attorneys under the Equal Access to Justice Act is about $190 per hour.[REF] Arbitrators are not paid for time spent on preparation, analysis, or discussion outside the actual arbitration session. Thus, they have every incentive to make a quick decision rather than a well-reasoned decision.
Administrative-law courts are required to make “findings and conclusions, and the reasons or basis therefore, on all the material issues of fact, law, or discretion presented on the record.”[REF]FINRA arbitrators should be required to do the same for those cases where more than $100,000[REF] is at stake or severe disciplinary sanctions are possible. This may be difficult for many existing FINRA arbitrators who do not have training in finance or in the law. If raising FINRA arbitrator honoraria is necessary in order to attract those with the requisite skills, FINRA should do so.
10. Adequate Review of Arbitration Decisions. Either party can appeal the result of a disciplinary hearing to the National Adjudicatory Council (NAC).[REF] The NAC is a FINRA committee[REF] with 14 members.[REF] Any governor may request that FINRA’s Board of Governors review the decision of the NAC.[REF] A respondent may ask the SEC to review a final FINRA decision.[REF]The SEC’s decision, in turn, is subject to limited judicial review.[REF]
There is no comparable review in customer or intra-industry arbitrations. The arbitrators’ decisions are final.[REF] The combination of arbitrators not needing to provide reasons for their decision and the near-total lack of review for customer or intra-industry arbitrations is fundamentally unfair and affords no recourse to either customers or firms that are the victims of poorly reasoned, unjust, or arbitrary decisions. Some of these disputes, of course, involve modest amounts of money. But others involve substantial sums and can, in the case of customers, involve their life savings. Similarly, a firm that is forced to unjustly pay an award has no recourse.
FINRA arbitrators should be required to make findings of fact based on the evidentiary record and to demonstrate how those facts led to the award given. These written FINRA arbitration decisions should be subject to SEC review and limited judicial review. Policymakers should carefully evaluate whether the current practice in disciplinary proceedings is sufficient to provide adequate review. Specifically, those reviewing the outcome in a disciplinary decision should be able to assess whether the findings of fact actually have an adequate basis, and to assess a written finding of how, in light of those facts, a specific FINRA rule or provision in the securities law was violated.
Improved Oversight. The Government Accountability Office (GAO) has found the SEC’s oversight of FINRA to be insufficient.[REF] In response, in October 2016, the SEC started a new office called the FINRA and Securities Industry Oversight (FISIO) group, designed to enhance its oversight of FINRA.[REF] The new FISIO should issue annual reports describing its oversight of FINRA and addressing the issues raised in this Backgrounder.
Congressional oversight of FINRA has been light. To improve oversight, Congress should:
- Require that FINRA submit an annual report to Congress with detailed, specified information about its budget and fees; its enforcement activities (including sanctions and fines imposed by type of violation and type of firm or individual); its dispute resolution activities; and its rule-making activities;
- Conduct annual oversight hearings on FINRA, its budget, its enforcement activities, its dispute resolution activities, and its rule-making activities;
- Require an annual GAO review of FINRA with respect to its budget, its enforcement activities, its dispute resolution activities, and its rule-making activities and a separate review of the SEC’s oversight of FINRA; and
- Consider making FINRA, the Municipal Securities Rulemaking Board (MSRB),[REF] and the National Futures Association (NFA)[REF] each a “designated federal entity”[REF] and establishing an inspector general with respect to financial SROs, including FINRA, the MSRB, and the NFA or, alternatively, placing FINRA, the MSRB, and the NFA within the ambit of an existing inspector general.[REF]
Small Broker-Dealer Relief. As Chart 2 shows, the number of broker-dealers has declined by nearly 13 percent over the past five years (2011–2016), and 23 percent in the nine years since FINRA was created in 2007.[REF]
Since 2009, the number of registered representatives who work for broker-dealers has remained fairly constant, but the number of firms has continued to decline. This reflects the concentration in the market and the decline in the number of small broker-dealers. The registered representatives that once worked for these smaller firms have found employment with the remaining firms.
A similar phenomenon is occurring in the banking sector.[REF] The number of small banks has declined by 28 percent since 2000, and small banks’ share of total domestic deposits has declined from 40 percent to less than 22 percent.[REF] There are many reasons for the decline in small broker-dealers and small banks, but one obvious factor common to both banks and broker-dealers is the ever-increasing rise in the regulatory burden on small broker-dealers and small banks. FINRA rules are a major component of that regulatory burden for broker-dealers. Regulatory compliance costs do not increase linearly with size, and place a disproportionate burden on small firms, making them less competitive in the marketplace.[REF] Small broker-dealers are more willing to underwrite the offerings of small and start-up businesses. The decline in the number of small broker-dealers impedes the ability of entrepreneurs to raise capital.
FINRA needs to undertake a systematic review of it rules and regulatory practices comparable to the small-entity impact review required of federal agencies under the Regulatory Flexibility Act.[REF] This review should include the impact of stress tests, the nature of FINRA audits, FINRA rules relating to the interaction between research and corporate finance, FINRA rules and practices relating to sanctions for inadequate policies and procedures or failure to supervise, the operation of “remedial” sanctions imposed without a hearing,[REF] and other matters. FINRA needs to be open to experimentation and financial-technological innovation that most commonly occurs in small firms.
Budget and Finance. FINRA fees are not voluntary. As a matter of economics, though not law, they are effectively a tax. And, at $789 million in 2015, they are substantial.[REF] The businesses that pay these fees must recover the costs.[REF] Before raising these fees, FINRA should be required to obtain an affirmative vote by Congress or, at least, by the SEC.
The fines leveled by FINRA in 2015 ($94 million) were 263 percent higher than the $25.9 million in fines levied in 2008, its first full year of operation.[REF] Average fines per member were $5,286 in 2008, and $23,755 in 2015, a 349 percent increase.[REF] It is difficult to judge the appropriateness of FINRA fines without additional information, but FINRA should not have a budgetary incentive to impose fines. Currently, it is FINRA policy that FINRA fines are used to fund “capital expenditures and specified regulatory projects.”[REF] Revenues from fines imposed ($97 million in FY 2015)[REF] should go to either a newly established investor reimbursement fund[REF] or to the Treasury, not to FINRA’s budget.
Congress should consider making FINRA “on budget” for purposes of the federal budget, along with various other government-sponsored enterprises, quasi-governmental entities, agency-related nonprofit organizations, and the like that currently escape congressional oversight during the budget process.[REF] The Securities Protection Investors Corporation and the PCAOB are District of Columbia not-for-profit organizations but are on budget.[REF] The MSRB and NFA are not.[REF]
Regulatory Process. FINRA’s rule-making process should also be made more transparent. Currently, it solicits comments from the public for many of its rules.[REF] But this solicitation is not required. Its committee process is opaque and its Board of Governors’ meetings, where final rules decisions are made, are closed. The proposed rules are subject to public scrutiny once they are submitted to the SEC for approval.[REF] But, by this juncture, it is unusual for changes to be made, and the SEC rarely disapproves a rule proposed by FINRA.[REF] In its rule-making process, FINRA should comply with a set of rules substantially similar to the requirements imposed on government agencies relating to the notice-and-comment provisions of the Administrative Procedure Act.[REF]
Although FINRA made improvements in the economic analysis of its rules by creating its Office of the Chief Economist in 2013, its efforts are still relatively rudimentary compared to those of the SEC and most other government agencies.[REF] FINRA should also examine whether its rules have a disproportionate impact on small, more entrepreneurial broker-dealers.[REF]
FINRA is a key regulator of central importance to the functioning of U.S. capital markets. It is neither a true self-regulatory organization nor a government agency. It is largely unaccountable to the industry or to the public. Due process, transparency, and regulatory-review protections normally associated with regulators are not present, and its arbitration process is flawed. Reforms are necessary. FINRA itself, the SEC, and Congress should reform FINRA to improve it rule-making and arbitration process. Congress should amend § 15A and § 19 of the Securities Exchange Act such that a national securities association (FINRA) must meet the reforms outlined in this Backgrounder as a condition of registration.
—David R. Burton is Senior Fellow in Economic Policy in the Thomas A. Roe Institute for Economic Policy Studies, of the Institute for Economic Freedom, at The Heritage Foundation.
This report is part of Prosperity Unleashed: Smarter Financial Regulation. Government policies have—for decades—empowered regulators to manage private risks and mitigate private losses in an effort to prevent financial-sector turmoil from spreading to the rest of the economy. This approach, rarely contemplated in nonfinancial industries, has demonstrably failed. Prosperity Unleashed: Smarter Financial Regulation provides solutions to the core regulatory problems that existed in U.S. financial markets long before the 2008 financial crisis.