In Finance, Private Regulation Vs. Government Regulation
Self-regulation sounds like such a good concept. Not surprisingly, though, self-regulation, as it has come to be interpreted in Washington, is little more than government regulation conducted by a private entity without due process, accountability, or transparency. The House Financial Services Committee should keep the Washington reality in mind as it undertakes consideration of a bill to establish self-regulation for investment advisers.
The Washington version of a self-regulator is exemplified by the Financial Industry Regulatory Authority. FINRA, which is the successor to the National Association of Securities Dealers, regulates securities firms and is hoping to expand its reach to include investment advisers. Membership is compelled by law. If a brokerage firm wants to deal with the public, securities laws require it to be a member of a national securities association. The catch is that there is only one such association -- FINRA.
Failing to comply with FINRA's code of conduct is a punishable offense. Securities laws give FINRA the power to act in place of the SEC, as front-line regulator for brokerage firms and their employees. FINRA, using the power delegated by the SEC, writes the rules that govern what firms and their employees can do and how they can interact with customers. FINRA examines firms and doles out punishments for violations of FINRA's rules and the securities laws, including imposing fines and kicking people out of the industry.
FINRA's functions and powers look a lot like those of a government regulator, but that is where the similarities end. FINRA is not subject to the Administrative Procedure Act or cost-benefit analysis requirements of SEC rulemaking, and FINRA's decision-making process is less transparent than the SEC's process. Further, when FINRA takes a disciplinary action, even one that can destroy a member's reputation and livelihood, it is not subject to the due process requirements that a government regulator would be.
When FINRA fails to do its job well, it is not subject to the same degree of scrutiny to which a government regulator would be held. For example, FINRA regulated both Madoff and Stanford, but it did not pay much of a price for failing to detect and stop either of those multi-billion dollar Ponzi schemes. FINRA attributes the Madoff failure to FINRA's lack of authority over Madoff's investment adviser activities. Yet for most of the decades-long Ponzi scheme, Madoff was registered only as a broker-dealer and thus the firm -- Ponzi scheme and all -- was well within FINRA's scope. With respect to the Stanford fraud, FINRA's own internal report found that it failed to respond appropriately to five credible tips, including one from the SEC, about the fraud.
While FINRA is subject to SEC oversight, a recent Government Accountability Office report found the SEC's oversight lacking. And an unintended consequence of relegating the SEC to overseeing FINRA is that the SEC loses touch with the industry about which it is supposed to be expert. It is much more difficult for the SEC to know what is going on if it is not conducting the mundane regulatory functions of writing rules, examining, and disciplining.
Proponents of expanding the SRO model to investment advisers correctly point out that the SEC has not performed well as the front-line regulator of investment advisers. The SEC does not conduct investment adviser exams frequently enough, and senselessly built a wall between the employees charged with examining investment advisers and those charged with writing the rules. Recent statutory changes that moved smaller advisers under the umbrella of state regulation and directed the reintegration of the SEC's examiners and rule-writers should help remedy those problems.
When most people think of self-regulation, they think of a voluntary organization that vets the qualifications of would-be members, sets rules of conduct, and monitors the performance of its members. Firms join the organization not because they are compelled to do so, but to signal to potential customers that they adhere to the organization's high standards. By contrast, in the securities industry, self -regulation is just another name for government regulation. It is worth considering whether we'd be better off shedding the euphemism and holding Washington's so-called self-regulators to the same standards to which government regulators are held.