Fixing Finra: SRO's Incoming CEO Will Have Work Cut Out
February 2, 2009
Regulators at the Financial Industry Regulatory Authority (Finra) are clearly worried that the alleged fraud at Bernard L. Madoff Investment Securities has exposed major gaps in the system of broker-dealer self-regulation.
In full reaction mode, Finra sent out a five-question e-mail last month to an undisclosed number of broker-dealers, seeking to get a sense of investment adviser or hedge fund activity within the firms. A second, more detailed letter sought to determine whether broker-dealers acted properly with respect to referrals to investment advisers, including Madoff.
The reason for Finra's concern is readily apparent. Spurred by the plight of municipalities, pension funds, charities and individuals who have collectively lost billions as a result of the Ponzi scheme, Congress is bearing down hard on the Securities and Exchange Commission and self-regulatory organization (SRO) Finra as it attempts to find out what went wrong and swiftly enact reforms. Calling the situation at Finra "deeply troubling," Christopher Dodd, chairman of the Senate Banking Committee, said the Madoff fraud is "a regulatory failure of historic proportions," adding that what is most disturbing is that it went undetected until Madoff confessed.
"How could regulators have missed so many warning signs?" said Dodd, D-Conn., at a Jan. 27 hearing on regulatory oversight and the Madoff scandal. "Did examination staffs lack legal authority, or, as I suspect, are there deeper problems?" Dodd asked whether there was any indication that Finra did not want to deal with Madoff because of his involvement with predecessor NASD as a former vice chairman, member of its board and chairman of the New York region.
Broad Jurisdiction
Should Madoff's investment advisory arm, which was part of the same legal entity as its broker-dealer, have been examined by Finra? At the hearing, John Coffee Jr., a professor at Columbia University Law School, took issue with Finra officials who have claimed that the SRO did not have jurisdiction over Madoff's investment advisory business. "Finra did have jurisdiction over Madoff that extended to all of its activities," Coffee told the committee.
He explained that after 2006, when Madoff registered with the SEC as an investment adviser, the only way he could conduct his business was by using his own firm as the custodian. Finra has broad jurisdiction in this area, he said: "I see no reason that Finra--or at that time NASD--should have abstained from examining and monitoring the advisory side of Madoff Securities. The enforcement powers were there."
Not so, countered Stephen Luparello, who on Jan. 26 replaced Mary Schapiro--now chairman of the SEC--as Finra chief executive on an interim basis. Luparello, Finra's senior EVP for regulatory operations and a veteran of NASD, the SEC and the Commodity Futures Trading Commission, said that Madoff had been registered with Finra as a broker-dealer since 1960, but its investment adviser, although part of the same legal entity, was nonetheless out of bounds. "Only the SEC has the authority to force compliance with the Investment Advisers Act of 1940," he added.
Nonetheless, Luparello conceded that Finra "has long expressed concerns about broker-dealers operating outside of the regulatory limits of Finra ... Referring to your business as an investment adviser, and therefore not being able to bring it under Finra jurisdiction, has been a source of frustration."
