Millions of securities transactions of all types and sizes take place every day in the United States. You may invest in mutual funds through your 401k at work, or engage in derivatives trading through your online brokerage account. Fortunately, a plethora of information is available to you regarding your transactions and investments. The financial firms with whom you transact business also have great incentive to treat you fairly.
Although the Securities and Exchange Commission (SEC) is primarily responsible for creating this “safe” trading environment, another organization known as FINRA acts as the first line of defense in protecting investors and regulating the securities industry.
Nature and Purpose of FINRA
Financial Industry Regulatory Authority (FINRA) functions under the umbrella and jurisdiction of the SEC as the self-regulatory organization (SRO) for the securities industry in the United States. It monitors and regulates all securities trading, operations and records, exchange platforms, and personnel in the industry, and acts as a buffer organization between the securities markets and the SEC.
The securities industry is huge. It includes over 4,500 brokerage firms with over 160,000 office locations around the country, nearly 635,000 registered brokers and principals, and administrative and compliance personnel who are also licensed to sell securities. FINRA oversees them all. Not only does it require and control the licensing of those that would sell securities, but it also creates and approves all licensing materials and exams. It further requires securities professionals to register with FINRA and fulfill continuing education requirements.
History of FINRA
FINRA’s origins can be traced back to the stock market crash of 1929 when governmental analysis revealed that unregulated securities markets played a major role in causing it. So in order to prevent a future crash, several new regulatory organizations were created. One of these was the SEC and another was the National Association of Securities Dealers (NASD), which became the first self-regulatory organization in the securities industry.
For decades, the NASD functioned primarily as a regulatory and administrative entity, overseeing daily market activity and enforcing regulations. However, once the technology became available, the NASD expanded its influence:
- The NASD introduced a new type of platform for securities trading in 1971 known as the National Association of Securities Dealers Automated Quotations market (NASDAQ). This market quickly grew in size and rivaled the exchanges in volume. It became the go-to platform for established companies that could not meet the requirements to trade on an exchange.
- In 1998, NASDAQ merged with the American Stock Exchange (AMEX) and eventually merged with most other American exchanges as well.
- However, once the NASD merged with the self-regulatory branch of the New York Stock Exchange (NYSE) known as NYSE Regulation, Inc., FINRA was born. The NASD had stood as the leading self-regulatory authority in the securities industry until 2007. The SEC approved the merger on July 26, 2007 and the two organizations became the Financial Industry Regulatory Authority. FINRA continues to fulfill all of the functions previously assigned to the NASD with an added emphasis on investor education.
FINRA is the largest self-regulatory organization in the country and has headquarters in both New York City and Washington, D.C. with 20 additional satellite offices located throughout the U.S. These offices house about 3,000 educators, administrators, and compliance personnel. This organization is headed by a board of governors that includes:
- The CEOs of both FINRA and the NYSE Regulation branch
- Eleven Governors of the public
- Ten Governors of the securities industry
The latter 21 governors include:
- A Floor Member Governor
- A Governor of independent dealer/insurance affiliates
- Three Governors for small-sized firms
- Three Governors for large-sized firms
- A single Governor for mid-sized firms
The Firm Governors are elected by the members of FINRA according to their size classification.
FINRA’s main sources of revenue come from the dues and fees paid by its member firms and their employees, as well as from fines that are levied to regulatory offenders each year. Annual dues assessed to member firms include a basic membership fee, a fee based on a percentage of the firm’s gross annual income, and a fee for each securities licensed individual that works at the firm. A fee is also assessed for every branch location each firm maintains. This all adds up to a pretty penny; FINRA’s revenue in 2009 exceeded $750 million.
FINRA Investor Education Foundation
One of FINRA’s chief concerns is investor education. The Investor Education Foundation (IEF) was therefore created in 2003 as a means of achieving this goal. It now stands as the single largest educational foundation for investors in the country.
The foundation has approved over $60 million worth of grants, research projects, and programs designed to help educate and protect investors by informing them about the risks, benefits, and characteristics of securities in general and specific investments. These grants have also been used to explore investor behavior in order to help future investors from repeating the mistakes of the past.
The IEF also works in conjunction with other nonprofit organizations to reach segments of our society that are often financially illiterate, such as the military, high school and college students, and those in or near retirement.
Arbitration and Mediation
FINRA is also responsible for sponsoring and administrating the largest and most primary platform for arbitration and mediation in the securities industry. When disputes arise between brokers and clients, for example, FINRA’s dispute resolution process is the first avenue taken before the SEC or federal courts get involved. In fact, ideally and often, civil disputes are resolved via FINRA and no further action is necessary.
Mediation is less formal in nature and less expensive than arbitration. In fact, FINRA mediators do not have legal authority to make binding legal decisions. Their aim, rather, is to help both parties come to a voluntary agreement. Mediation proceedings have the following characteristics:
- Unlike arbitration, mediation does not have a prescribed structure and can vary widely according to the issue at hand and the style and personality of the mediator. In some cases, the mediator might act as a messenger between the opposing parties, whereas in other cases he or she may insist on a group meeting.
- The mediator’s job is to ultimately help both parties see the issues clearly and to understand the other’s point of view. He or she has no real power or legal authority of any kind over the results of the mediation process, but can often provide a clear, professional, and impartial analysis of each side’s case. This can help both parties gauge their chance of success if they decide to pursue arbitration or litigation.
- Mediation costs less than arbitration and is considerably cheaper than settling disputes in court, even though many parties still employ an attorney during these proceedings. Plus, approximately 80% of all mediation cases are resolved with some degree of success within a few months of their commencement.
Arbitration, on the other hand, is a much more formal process. That said, it is still faster and cheaper than litigation. However, both parties must agree to forfeit any claim on the other in court before this procedure can be used. The arbitrators employed by FINRA are thoroughly trained in the matters over which they preside and the decisions they render are almost always final and can rarely be challenged in court. There are a few different organizations within the securities industry that host arbitration proceedings, including:
- The Chicago Board of Options Exchange (CBOE)
- The National Stock Exchange
- FINRA’s Dispute Resolution Department
Each sponsor keeps a list of arbitrators that it draws from, but the arbitrators are not employees of the sponsor, although they do receive a stipend for their services. The rules pertaining to arbitration vary somewhat from one sponsor to another in matters such as how arbitrators are chosen and whether the proceedings will be public or private.
However, all sponsors use the Uniform Code of Arbitration to ultimately govern their proceedings. This code contains a statute of limitations of 6 years for any transaction or incident that leads to arbitration, though shorter statutes according to states or other SROs may apply. Any arbitration claim that qualifies legally as a class action suit is ineligible for the arbitration process, and claims for less than a certain amount are routed through the Small Claims Process, which is a streamlined version of the normal proceedings.
Before the arbitration process can commence, the following must occur:
- A statement of claim must be filed, followed by a statement of proceedings that includes all pertinent motions, documents, and other information to be given to all involved parties.
- The plaintiff must sign a submission agreement waiving their legal rights to court action and pay the appropriate filing fee.
- Once the defending party receives the statement of claim from the plaintiff, the defendant then has 20 days to answer it for a small claims case and 45 days for other cases. The plaintiff has 10 days to respond to a counterclaim.
- The parties involved will choose a time and place for the proceedings as well as the number and qualifications of the arbitrators.
The arbitrators are then chosen via the Neutral List Selection System (NLSS). This produces a list of possible arbitrators for a given case, from which the parties involved choose the person or persons they want to use. Both parties also have the right to submit a written challenge to an arbitrator during the proceedings.
Cause for a challenge can include visible bias on the part of the arbitrator or discovery or admittance of any possible conflict of interest. Both parties are further expected to cooperate with each other in sharing pertinent information to the case. A discovery guide was made available in 1999 that outlines required documents and information for specific situations.
Arbitrators are also authorized to:
- Issue subpoenas to witnesses
- Request documents or other pertinent information
- Set deadlines and rules as necessary in order to move the proceedings forward in a timely manner
The hearing procedure itself consists of the following steps:
- Both parties are sworn in and make their opening statements.
- Each party presents its case, using documentation or other evidence as well as cross-examination if necessary.
- Counterclaims, rebuttal statements, and closing arguments are given.
- Both parties are notified in writing of the arbitrator’s decision, which must be signed by the majority of the arbitrators if there are more than one. The arbitrator must give a ruling within 30 days of the close of the case.
Any judgement that is awarded can then be submitted to a legal court of the appropriate jurisdiction for collection. But it should be noted here that though arbitration awards are ultimately backed by state and federal laws, many of them are uncollectible because the person or firm who must pay the judgement has declared bankruptcy.
Other Avenues of Complaint
Those who need to file a compliant on an issue that does not involve arbitration can notify FINRA’s Investor Complaint Center or Office of the Whistleblower. The Complaint Center provides a forum for customers and securities personnel to instantly alert FINRA of suspicious activities or behavior, and the Office of the Whistleblower should be contacted by those who have material evidence of securities-related wrongdoing.
Enforcement and Recordkeeping
As the first line of defense against corruption and unfair practices in the securities industry, FINRA has considerable authority to enforce its regulations and decisions through the following means:
- Levy of fines on offenders and awards to injured parties
- Suspension or revocation of securities licenses of those who commit substantial or repeated securities violations
- Detailed recordkeeping of the disciplinary history of each registered representative, known as Form U-5, which can alert potential clients and employers to a history of wrongdoing
These records are available for public inspection and can be accessed via the BrokerCheck portal on FINRA’s website. Anyone can log on to this site and instantly download a report that details the professional background and disciplinary history of any person or firm in the securities industry that carries a securities license of any kind.
These reports are drawn from the Central Information Depository, the computer database in the securities industry that receives the registration forms of every person and firm who has ever carried a securities license. The database currently has reports on about 1.3 million registered representatives and 17,000 firms, both past and present.
FINRA’s regulatory and educational efforts are vast so that individual consumers are not taken advantage of by “experts” in a highly specialized arena. That said, some criticize FINRA’s enforcement arm as weak, particularly because of the SRO’s “incestuous” ties to industry professionals. For example, Bernie Madoff was vice president of the NASD during the time he was illegally running his Ponzi scheme. In that sense, FINRA as a “self-regulatory” agency has failed in its task.
However, it still provides valuable services and guidance to the public and securities professionals alike that should not be discounted because of the larger flaws that need be addressed.