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Friday, August 26, 2016

Selecting the Public's Representatives in the Financial Regulatory Process

Financial regulations issued and enforced by the Financial Industry Regulatory Authority (FINRA) affect the public by setting the level of investor protection available.  If things go awry, FINRA regulation also governs the rights the public has in industry-controlled arbitration. 

Structurally, FINRA is a quasi-governmental organization that allows the industry to regulate itself under supervision from the SEC.  While the industry elects a substantial number of FINRA's board members, its bylaws also call for the majority of the board to be "public" governors. The board's nominating committee, which includes industry-elected members, selects the "public" representatives.  

This picking process has resulted in some surprising choices for public representatives.  I took a close look at the current board and discovered some interesting things.  According to one version of FINRA's annual report, Robert W. Scully served as one of the "public" board members as of June 15, 2016.  In May 2016 he was elected to serve on the board of UBS--a major financial services firm.  It struck me as odd that a public representative would concurrently serve on a financial service's firm's board.  Interestingly, the contents of FINRA's previously issued annual report recently changed to omit Mr. Scully's name.  His name was also scrubbed from FINRA's website.  I am not aware of any information about when Mr. Scully actually stopped serving as a public representative on FINRA's board or when any discussions about joining the UBS board began.  It may be that he promptly resigned as soon as he began to discuss joining UBS's board.

 Susan Antilla at The Street reached out to FINRA for comment about the industry connections of FINRA's public board members.  In her evaluation, the reality is that a majority of FINRA's board appears to have very close industry connections:

But by my count, only eight represent the public -- the result, in part, of the wide berth Finra allows for recent retirees from the finance industry to fill pubic seats. So if you're wondering why things don't always turn out so well for Mom and Pop when they entrust money to a broker, you might ponder the balance of power on Finra's board.

Is there a better way to pick public representatives?  I give my idea after the jump.

The difficulty with the current process is that it may be particularly vulnerable to industry capture.  If the nominating committee has five members, with three public members and two industry members, a single public member that votes with the industry members to select future board members can result in a radically different board.  Of course, picking public representatives is a difficult task.  We want people with sufficient sophistication to be effective but without the sort of entangling ties that might make them too tame.

I suggest we shift the appointment power for public representatives outside FINRA and to public processes.  Perhaps public entities such as the Consumer Financial Protection Bureau, SEC, Department of Labor, and Treasury should nominate candidates.  It's hard to say who would emerge from this process, but it seems like these agencies have a strong interest in FINRA's performance and would be able to select reasonably competent candidates that might not be as likely to be torn in different directions.

Consider Randal Quarles as an example of a public representative that might possibly feel pulled in different directions.  Both versions of FINRA's 2015 annual report identify him as a public representative.  The U.S. Chamber of Commerce also identifies him as one of its board members.   The U.S. Chamber describes itself as "representing the interests of more than 3 million businesses of all sizes, sectors, and regions."  While the business and public interests often align, concurrent board service raises questions about how to balance these interests if they conflict.  



Posted by Benjamin P. Edwards on August 26, 2016 at 02:12 PM | Permalink


While there may be no perfect answer, providing more oversight of the nomination process by the federal agencies tasked with investor protection would presumably improve investor protection. Industry experience is important, but that is undoubtedly provided by the non-public board members who also happen to serve as strong advocates for industry interests. It is equally important to assure that the public has strong advocates, given that the board approves all proposed rules that regulate the industry. These rules govern the conduct of brokers, which in turn have a significant impact on retail investors, I.e., the duty to make "suitable" recommendations allows brokers to place their customers (not clients) into more expensive "suitable" investments that have a negative impact on the investor's life savings. Why do we still have "suitability" when the fundamental nature of brokers as mere "order takers" is a thing of the past? FINRA rules also govern the forum all investors must ultimately use to resolve disputes against their brokers, because of the widespread use of predispute arbitration provisions. FINRA has a perception problem in this regard-- our investor clients at the clinic frequently ask how can a process operated and funded by the industry be fair? Finding a way to a real "majority public" board will go a long way to improve both perception and conduct rules that impact millions of small investors.

Posted by: Teresa Verges | Aug 27, 2016 8:43:41 AM

It's definitely a tricky thing to balance. You want independence and expertise. I would rather have something like the PCAOB model: https://pcaobus.org/About/Pages/default.aspx The SEC appoints in consultation with other agencies. Rather than focusing on any one individual, I would prefer to put a more public process in place.

Posted by: Ben Edwards | Aug 26, 2016 7:46:30 PM

When you suggest that various federal agencies make nominations to the FINRA board, just who at the agency gets to do that? The head of it, who is a political appointee of the President? This effectively becomes a political appointment as well, presumably one that pays well and isn't subject to all those annoying rules that control political appointments within the government. I don't have an idea of a perfect process but I don't see that someone with experience in financial services, as long as she does not have continuing ties through board membership and the like, as necessarily a flawed choice.

Posted by: PaulB | Aug 26, 2016 6:45:08 PM

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