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An irreverent Wall Street Blog
by Bill Singer

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A Pat On The Back Too Many?

Written: October 23, 2008

On October 23, 2008, the Financial Industry Regulatory Authority (FINRA) announced that it had reached agreements in principle with City National Securities (CNS), of Beverly Hills, CA, BNY Mellon Capital Markets, LLC of New York and Harris Investor Services, Inc. of Chicago, to settle charges relating to the sale of Auction Rate Securities (ARS) (terms subject to being formalized in an approved FINRA settlement document called a Letter of Acceptance, Waiver and Consent (AWC), in which the firms will neither admit nor deny the charges, but will consent to the entry of FINRA's findings). 

The good news for investors is that three firms agreed to 

offer to repurchase at par ARS that were purchased by individual investors and some institutions between May 31, 2006, and Feb. 28, 2008 (more than $60 million of ARS are eligible for repurchase); and make whole individual investors who sold ARS below par after Feb. 28, 2008; and the appointment of an independent, non-industry arbitrator to resolve investor claims for any consequential damages (suffered from their inability to access funds invested in ARS).

The regulatory consequences for the three firms, is that FINRA will impose the following fines:

CNS: $315,000; BNY Mellon: $250,000; and  Harris: $150,000.

For the actual press release, read "FINRA Announces Agreements in Principle with Three Additional Firms to Settle Auction Rate Securities Violations."

Okay, FINRA got the three firms to agree to repurchase these dead-in-the-water ARS. Frankly, you sort of have to ask yourself why it took so long to get that concession; but in these days, bloodied investors should be thankful for such gifts. 

As to the bally-hooed appointment of an independent, non-industry arbitrator for consequential damages, ehh.  That strikes me as a self-serving pat on the back undertaken by FINRA in an effort to make it look like it was tough on its own member firms.  I mean, think about it--investors are supposed to be thankful that FINRA member firms agree that arbitration disputes will be heard by truly independent arbitrators?  On the other hand, be careful of the slight of hand here.  Note that FINRA's press release seems to exclude such a pristine panel for punitive damages.

Then there is the whole issue of the fines.  $715,000 in fines versus some $60 million in ARS sales; if you do the math, that's about 1.2 %.  I wonder how much the firms made in commissions on the sales and how much they earned on those same receipts?  Of course, I would also love to see where that money actually goes after its paid in to FINRA.

Still, there is an even more nettlesome aspect to this settlement and the regulator's trumpeting of its own efforts.  Let me quote one paragraph from the FINRA release:

FINRA's investigation has found evidence that each firm sold ARS using advertising, marketing materials or other internal communications with its sales force that were not fair and balanced and therefore did not provide a sound basis for investors to evaluate the benefits and risks of purchasing ARS. FINRA's investigation also found evidence that each firm failed to establish and maintain a supervisory system reasonably designed to achieve compliance with the securities laws and FINRA rules with respect to the marketing and sale of ARS.

Let's dissect that paragraph.

The transactions at issue are stated as occurring as early as May 31, 2006.  One would suspect that the advertising/marketing materials cited by FINRA were in existence prior to mid-2006; let's just say that they were no more than a few weeks or months older than the sales.  If those sales materials are unfair and unbalanced as of today, October 23, 2008, then they must also have been unfair and unbalanced some two years ago.  Similarly, if the firms had inadequate supervisory systems today, then it is only logical that they were so two years ago.  Welcome to  the exposed underbelly of failed regulation.

What happened here is that some FINRA firms sold ARS, which was not exactly a product that the industry fully understood (after all, no sellers truly disclosed the now apparent risks) and it now seems that the regulators were equally in the dark.  When the ARS market imploded, the regulated and the regulators awoke to a nightmare. At that point, a lot of folks went back and read the source documents, the marketing materials, the internal memos--and a lot of folks turned pale and trembled.  We wrote that?  We actually said that? We promised that? We agreed to that?

For starters, you have to blame the folks who packaged and sold this crap because there was simply a lack of reasonable disclosure.  You package fireworks in a box that describes them as "fireworks" and with a large warning that there is danger in handling explosives, and, okay, no one can blame you if the buyer mishandles the merchandise and is injured.  On the other hand, if you sell fireworks in a box that says they are night lights, well, now you're in trouble if someone gets hurt.

But, there is more than enough blame to go around--beyond what we press on the shoulders of the selling firms; there is plenty of finger pointing at the regulators.Why didn't FINRA review the now criticized advertising and marketing materials and timely detect the problems--and if the answer is that the regulator did a thorough  review of the documents, then how can they sanction the member firms when FINRA didn't timely spot the disclosure deficiencies and immediately shut down further sales and issue extensive warnings?  What was written two years or one year ago, doesn't miraculously change itself.  Similarly, if the supervisory systems were not "reasonably designed" when designed, then that was a failure at the inception.  All FINRA member firms are required to submit written supervisory procedures (WSP).  Why didn't FINRA's staff detect the shortcomings within days or weeks of their being drafted?  The fact is, the supervisory flaws were in place from day one and apparently escaped the detection of FINRA.

While FINRA is busy patting itself on the back, I would hope that there is far more soul searching underway behind the self regulator's closed doors.  Ultimately, it is a good sign (and a commendable one) that FINRA exacts from its wayward members the types of concessions demonstrated in this settlement.  However, there is little here for the sellers or the regulator to be proud of.  Our markets can no longer tolerate belated regulation. If the folks regulating our markets can't figure a way to detect problems earlier, then it may be time to change the guard and bring in new blood.