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FINRA or the SEC: Who Will Regulate Advisors?

There is not unanimous agreement within the industry that FINRA is the best home for investment advisor regulation.

Judith A. Hasenauer, 05/03/2012

It appears we are well on our way toward the decision whether FINRA will take over regulation of investment advisors that are not exclusively regulated by the states. Legislation to establish FINRA as the "self-regulatory" organization for federally regulated investment advisors is already under way, but there seems to be some disagreement whether investment advisors prefer FINRA regulation or the continued regulation by the SEC.

The Securities Exchange Act of 1934 provided that "self-regulatory" organizations, operating under SEC oversight, could be established to provide a form of self-regulation for broker-dealers that were in the securities business. Thus was formed the National Association of Securities Dealers that, for nearly 60 years, acted as a combination trade association and self-regulatory body for broker-dealers. Over the years, the NASD acted as "an association of business people" to bring ethics and discipline to the securities business. It also very effectively acted to forward the best interests of the securities business and its members. Throughout the nearly six decades of its existence, the NASD often initiated action to ensure that there was a "level playing field" among the various elements of the financial services industry so that broker-dealers and the financial products they sold were not disadvantaged against competing segments of the industry.

There comes to mind the active participation by the NASD in the mid-1950s to bring variable annuities under the regulatory control of the SEC. This resulted in the U.S. Supreme Court decision that variable annuities were investment company securities and not insurance products that were exempt from federal securities regulation. At all parts of the proceedings, the NASD was an active participant and believed that it was protecting its members from competition from a non-federally regulated product that had substantially similar features to the mutual funds that were sold by broker-dealers.

As the years passed, the self-regulatory activities of the NASD became more comprehensive, and after the establishment of NASDAQ, it appeared that the self-regulatory functions of the association were divergent from the other NASD activities. The result was the changing of the name of the self-regulatory function to NASDR and eventually to FINRA. The selection of the name "Financial Institution Regulatory Authority" is significant in that it denotes a pure regulatory function. No longer does the association purport to be a trade group. Other entities have taken over the trade association functions for the securities industry. Although FINRA still has members and still maintains rules that date back to the trade association days of the NASD (for instance, the requirement that members do business only with other members), few other trade association activities remain. In essence, FINRA is a non-governmental regulatory authority that now seems possible to be the regulatory authority for an even broader segment of the financial services industry.

Human beings like to move from the unknown to the known. Thus, it is likely that if FINRA is actually given regulatory jurisdiction over non-state-regulated investment advisors, the format will look a lot like the format currently used to regulate broker-dealers. Many of FINRA's existing rules lend themselves to both broker-dealers and to investment advisors. The judicial function currently in place for broker-dealer arbitrations can easily be adapted to the investment advisory business. The proposal to have FINRA assume jurisdiction over investment advisors seems to be based on the argument that FINRA's pre-existing infrastructures would make it less expensive to have FINRA take on the function than to beef up the investment advisor regulatory function at the SEC. This is particularly true when so many investment advisors already have broker-dealer divisions or affiliates.

There is not unanimous agreement within the industry that FINRA is the best home for investment advisor regulation. Some members of the industry have expressed a desire to continue the regulation of advisors by the SEC, rather than by FINRA. It is by no means certain what will be the end result. If the decision is to retain jurisdiction by the SEC, there will be a requirement for additional resources of the SEC to be able to take a more robust stance in the investment advisory regulatory structure. The Dodd/Frank financial reform legislation mandated a more robust regulatory framework for the element of the investment advisory business that is not regulated by the states. In order to comply with these requirements, the SEC would have to develop much of the infrastructure that is currently in place at FINRA.

In either event, the cost for the new regulation will be passed on to investment advisors in the form of new and increased fees. It remains to be seen whether these costs will be higher or lower with whichever regulator ends up with the job. Politics being what they are in an election year, it is impossible to predict what the eventual result will be or even if there will actually be any resolution this year. Public statements have indicated there will be congressional hearings as early as this month, but it is impossible to predict when actual resolution takes place.


Judith A. Hasenauer, JD, CLU, is an attorney with the law firm of Blazzard & Hasenauer, P.C. She devotes her practice exclusively to the financial services industry, providing consulting on the development and regulatory clearance of products, compliance issues, distribution issues and related matters, such as advisory activities and industry initiatives.

The author is not an employee of Morningstar, Inc. The views expressed in this article are the author's. They do not necessarily reflect the views of Morningstar.

The author is a freelance contributor to MorningstarAdvisor.com. The views expressed in this article may or may not reflect the views of Morningstar.

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