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Opinion: FINRA Is an Ineffective Regulator

Opinion: FINRA Is an Ineffective Regulator

The brokerage business is dead. With commission rates hovering around zero, making a living by buying and selling securities on behalf of customers is a thing of the past. Some brokers are reinventing themselves as investment advisers within brokerage firms, but many are fleeing brokerage firms and landing at registered investment advisory firms (RIAs).

FINRA, the brokerage industry’s self-regulatory organization (SRO), finds itself in caught up in the industry’s death spiral. This non-government, private corporation’s fortunes are tied to brokerage firms. When a broker defects to an RIA firm, they take their clients’ accounts and the revenues tied to them. As a big chunk of FINRA’s funding is tied directly to the revenues of brokerage firms, this spells financial disaster for FINRA.

FINRA sees greener pastures ahead. They have their eye on taking over a potentially new SRO that is being proposed to regulate RIAs. Although for the past 70 years RIA firms have been well regulated by the SEC and state securities regulators, there is currently a bill in Congress that would create this new SRO and FINRA is lobbying hard to get the bill passed.

We have serious reservations about FINRA’s ability to protect investors (see our comment, “FINRA’s Land Grab”) and we’re not alone. In a 2010 letter to Congress, the Project On Government Oversight stated that FINRA had an “abysmal track record” and highlighted the “incestuous relationship between FINRA and the securities industry.”

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FINRA & Investor Protection

The rule of thumb for securities regulators is to look for patterns of violations, and once a pattern is detected regulators are expected to protect investors by exercising their enforcement authority.

The matter of Westrock Advisors, Inc. (Westrock) illustrates FINRA’s extreme shortcomings with respect to investor protection. Westrock was a small New York based, independent broker-dealer, and was a FINRA member from 2002 until 2011.

The firm’s rap sheet is a mile long and includes a litany of formal investor complaints. Many of the complaints allege fraud, breach of fiduciary duty, misrepresentation, churning, unauthorized trading, negligence, failure to supervise, breach of good faith and fair dealing, and unjust enrichment, as well as other violations.

Besides the investor complaints, Westrock also had a long list of serious regulatory violations. However, notwithstanding these chronic violations, the firm was able to continue operating by entering into FINRA’s version of plea bargains. Without admitting or denying any wrongdoing, Westrock paid modest fines and continued with business as usual.

A look at the record reveals a firm that operated with contempt for both investors and the rules. Some of the more serious FINRA violations included chronic violations of minimum net capital requirements, covering up customer complaints, a variety of substandard supervision policies, refusal to produce documents ordered by FINRA, and failure to develop an anti-money laundering program as required by the Bank Secrecy Act.

In 2007, FINRA found that Westrock failed to disclose to investors that it received restricted shares from a company in exchange for the issuance of research reports on that company. They also didn’t disclose that the analysts earned a percentage of the commissions made by the firm on the sale of the underlying stock.

By all accounts Westrock was nothing more than a modern day boiler room and FINRA turned a blind eye by allowing it to continue operating.

Enter State Securities Regulators

In stark contrast to FINRA, state securities regulators were more heavy-handed with Westrock.

In 2002, Westrock applied for registration as a broker-dealer in the state of Alabama. Citing Westrock’s president/CEO’s past disciplinary history, the application was not approved. But that didn’t stop Westrock from doing business in Alabama, and ultimately the Alabama’s securities commission issued a cease and desist order barring them from doing business in their state.

In 2008, the state of Connecticut issued a cease and desist order and fined Westrock. Connecticut concluded that Westrock engaged in dishonest or unethical business practices, sold unregistered securities, employed unregistered agents, and failed to reasonably supervise its brokers. Connecticut ordered Westrock to cease and desist from selling to Connecticut customers any penny stocks, private placements, and initial public offerings, and forbid Westrock from opening and maintaining option, discretionary, or margin accounts in the state of Connecticut.

Not surprisingly, Westrock violated the terms of the Connecticut cease and desist order and in the summer of 2010 Connecticut regulators revoked Westrock’s registration as a broker dealer and fined the firm $250,000.

The Connecticut action apparently was a deathblow to Westrock and the firm withdrew its registration with FINRA in late 2010. Ironically, months later, FINRA suspended Westrock’s membership for failure to pay FINRA fines.

FINRA is Not the Answer

The Westrock matter paints a vivid picture of how FINRA protects their own, and how they enable rogue broker-dealers to continue even in the face of a well-established pattern of investor abuse. What’s most shocking is that this activity was allowed to continue in the post Madoff world. Hats off to the regulators in Alabama and Connecticut who protected their residents from the ills of this boiler room.

Congress needs to recognize that FINRA is not the answer, and creating a new SRO for RIAs won’t necessarily increase investor protection. If the SEC needs help supervising RIAs, perhaps they should enlist the help of state securities regulators, they seem to understand investor protection.

Andrew J. Haigney is managing director of EL CAP, Inc. (, a Registered Investment Adviser registered with the Securities Division of the State of Vermont. The firm provides investment-consulting services to individual investors, corporations, foundations, trustees, and endowments.

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