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Feb 20, 2009 8:54 pm

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by Bill Singer

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GUEST BLOG: FINRA Should Use the Benefits of Selling NASDAQ and Merging with the NYSE (Chepucavage and Broy)

Written: February 20, 2009



FINRA Should Use the Benefits of Selling NASDAQ and Merging with the NYSE
to Double its Exam Force and Enhance Member Compliance

By Peter J. Chepucavage and Tony Broy

Now that former senior Financial Industry Regulatory Authority (FINRA) officials Rick Ketchum and Mary Schapiro are in charge of FINRA and the SEC respectively, together they should use FINRA'S significant reserve funds to 

·         double the self-regulatory organization's (SRO's) examination force, or 

·         to increase the number of experienced examination personnel. 

This allocation of funds would prove to the investing public that these newly hired regulators are serious about change. It is not well known that FINRA has a huge investment portfolio as a result of the proceeds it received from the sale of NASDAQ. Also, FINRA should have reaped financial benefits and savings from the promised efficiencies achieved in the merger of the NASD with the New York Stock Exchange (NYSE) Member Regulation.

FINRA 2007 Year in Review and Annual Financial Report

FINRA generated cash inflows from operating activities of $640.4 million in 2007, compared with $149.3 million in the prior year, driven primarily by the sale of securities in its trading portfolio during the first quarter of 2007. Net cash used in investing activities from continuing operations was $321.6 million in 2007 and $729.7 million in 2006. In both years, cash used in investing activities consisted primarily of net purchases of available-for-sale securities and other investments (hedge funds, funds of hedge funds and private investments), as well as payments related to the consolidation of NASD and the member regulation operations of NYSE in 2007. Net cash provided by financing activities was $10.8 million and $49.7 million in 2007 and 2006, respectively, representing contributions to the Foundation from external parties. 

Overall cash and cash equivalents, trading investments and available-for-sale investments totaled $1,901.4 million as of December 31, 2007, and $2,049.8 million as of December 31, 2006. This overall decrease of $148.4 million or 7.2 percent was driven primarily by the $178.3 million special payment to members made in connection with the consolidation of NASD and the member regulation operations of NYSE, as well as net purchases of other investments of $33.6 million. 

FINRA’s working capital was $1,560.5 million as of December 31, 2007, and $1,834.8 million as of December 31, 2006. FINRA has been able to generate sufficient funds from operations to meet working capital requirements. FINRA has a line of credit of up to $50.0 million that has a variable interest rate; no amounts were outstanding under this credit agreement as of December 31, 2007, and 2006. FINRA believes that the liquidity provided by existing cash and cash equivalents, investments and cash generated from operations will provide sufficient capital to meet current and future operating requirements.

See, Page 14 of Report

In view of the Madoff and Stanford matters, it is clear that more regulatory surveillance is necessary. While we previously argued that more efficient allocation of state, federal and FINRA forces might work (Regulatory Reform in the Obama Era, Guest Blog), it has since come to our attention that FINRA is sitting on a pile of cash. We also recall that FINRA argued it was prohibited from refunding more than $35,000 per member in the merger vote. 

·         The accumulation of cash by the self-regulator and the capping of refunds to its members occurred in the midst of the ongoing fraud now coming to light in both the Madoff and Stanford scandals...and likely others to come. 

·         The federal government is financially strapped because of the various bailout and stimulus plans now in place. 

What's our point? What's our concern? 

SRO'S are intended to supplement the federal government's efforts and provide business expertise to the regulatory regime. If there was ever a time to prove the rationale for SROs, that time is now. This is not the time for any SRO to build a war chest. This is not the time for any SRO to pay out excessive salaries or bonuses. FINRA's financials show that the regulator has well financially for itself, its members, and employees.  In this time of great regulatory failure, we don't think that a FINRA flush with cash that is not being put to regulatory use is a good thing.

We have previously argued that regulation by enforcement is not wise or efficient. The prevention of problems is the goal. The punishment of wrongdoers comes second. Isn't it compellingly logic to use the industry's own funds to supplement the federal and state examination and surveillance forces? 

We can also see an alternative or complementary use of FINRA's accumulated funds: Refund the dollars to the membership for use on compliance, risk or audit. The SEC warned that members should not use the current economic crisis to skimp on compliance. Accordingly, we don't think FINRA should withhold funds that could be effectively used for its members' compliance efforts. This is the type of change that requires no legislation or rulemaking. It's the type of change that would restore public confidence and make robust the compliance engine. It's also a change that the new leadership understands and should embrace.

This situation also raises the ongoing debate about the SEC'S supervisory role over FINRA. The SEC has historically stayed clear of FINRA'S corporate governance. But we believe the SEC has inherent authority to insure that FINRA is using adequate funds for its role. The SEC has the authority to withdraw FINRA'S SRO status and to force it to enforce its rules under Section 15A of the 1934 Act. Certainly, the SEC should require SROs to commit to a level of staffing commensurate with the task of effective regulation.

Richard Ketchum and Mary Schapiro are experienced leaders and should be able to agree to the changes we propose and implement them immediately. We encourage them to do so.

About the Author:

Peter J. Chepucavage
Plexus Consulting Group, LLC
1620 Eye Street, NW
Suite 210
Washington, DC 20006
Phone:  1.202-785-8940
Fax:      1.202-785-8949
Email:   [email protected]

has 30 years of experience in both the public and private sectors of the securities industry. He has worked for the National Association of Securities Dealers (NASD) and U.S. Securities and Exchange Commission (SEC), as well as a private law firm and a major international investment bank. He is familiar with all aspects of broker-dealer and hedge fund regulation, including broker dealer operations and stock loans.

Chepucavage was also heavily involved in the post-9/11 efforts by the securities industry to strengthen their resilience to terrorist attacks. He is a General Counsel to the firm and the head of its broker-dealer/hedge fund compliance and expert testimony sections.

Chepucavage most recently worked as an Attorney Fellow in the SEC's Division of Market Regulation where his main projects were post-9/11 resiliency and short sales, including the drafting of Reg. SHO. Prior to his position at the SEC, he practiced at Fulbright & Jaworski in New York city. At various times between 1984-1997, he was a managing director in charge of Nomura Securities' legal, compliance and audit functions and served on its management and credit committees. He also worked with its derivatives' affiliate.

Mr. Chepucavage has been a member of many Securities Industry Association (SIA) and other regulatory and legal securities industry committees and written extensively about regulation. One of his main interests is the effect of regulation on small businesses and he provides regulatory advice to small and medium enterprises, including Washington representation. Mr. Chepucavage also served as an Assistant General counsel with the NASD, a law clerk to Judge George R. Gallagher (D.C. Court of Appeals), and as an infantry officer in South Korea.

Peter Chepucavage is also a member of the advisory board of The Public Company Management Corporation (OTCBB:PUBC), an emerging company providing consulting and advising services to companies seeking to access public capital markets.

Anthony Broy

has almost 40 years experience as both an NASD examiner and very successful market-maker. He cares deeply about the survival of self-regulation.