Fix the flaw in financial self-regulation

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Much of Wall Street regulates itself through self-regulatory organizations overseen by the continually underfunded Securities and Exchange Commission (SEC).  

The Financial Industry Regulatory Authority (FINRA), a trade association comprised of Wall Street’s brokerage firms, sits atop the pack, marketing itself as focused on “investor protection.” As a regulator, FINRA protects investors from one of the largest sources of investor harm — FINRA’s own members.  

{mosads}FINRA faces a difficult task in overseeing its members. FINRA members directly elect much of FINRA’s governing board. All too often, FINRA members book profits by steering investors into the products that pay them bigger kickbacks instead of the ones that generate the best returns for investors.


This basic conflict of interest explains why FINRA’s members may fight investor protection measures that reduce their profits.

Supporters of this tainted system argue that self-regulation saves the public money because the industry funds its own regulation. Tell that to Bruce Wilkerson, or any of the other investors that lost their retirements in instances where FINRA failed to achieve its investor protection mission.  

Sports fans may know Wilkerson’s name. He protected quarterbacks as an offensive lineman for the Raiders, Jaguars and Packers. After football, he set to work as a machinist and trusted FINRA member Resource Horizon Group to protect his savings. 

Wilkerson later lost over $600,000 to a fraud run by a financial advisor associated with that member. The SEC eventually kicked the financial advisor out of the industry. 

Like many other investors, Wilkerson went after the FINRA member whose representative swindled him. Unlike most investors that fight all the way to an award in FINRA’s arbitration forum, Wilkerson won. The arbitrators declared that the firm should give Wilkerson his money back, and then some. Sadly, he never recovered his retirement savings. Rather than pay the award, the firm shut down. 

Too many burned investors share Wilkerson’s story. The Government Accountability Office estimated that FINRA’s members failed to pay about $129 million in 1998. FINRA recently disclosed that its members stiffed customers on a total of $199 million in arbitration awards between 2012 and 2016. A 2018 study estimated another $20 million went unpaid in 2017.

These figures undoubtedly understate the problem: Investors typically won’t bring claims against defunct brokers and firms, because they know they’ll never be paid on an award.  

Two weeks ago, Sen. Elizabeth Warren (D-Mass.) introduced legislation to fix this problem. Her bill would require FINRA to make good on any arbitration award against one of its members.  

The legislation calls for FINRA to pay investors out of the fines it levies for misconduct and to assess fees on its membership if the fine money proves insufficient.

FINRA must adopt a system to remedy the unpaid award problem, by legislative mandate or otherwise, because it fixes a critical flaw with the self-regulatory model. Under the current system, FINRA’s members may prefer lax oversight because the harm lands on investors when other members misbehave.  

The industry would care more about investor protection if it paid the bill for misconduct. Consider the fraudster that fleeced Wilkerson. Although his regulatory record contained red flags, FINRA allowed him to serve the public. FINRA would likely raise its standards if it bore responsibility for its members’ behavior.

To be sure, it is impossible to gauge precisely the optimal amount of resources FINRA should devote to overseeing its members’ operations. How much more would the industry do if it picked up the tab?

Did FINRA allow Bernie Madoff’s record-shattering Ponzi scheme to grow under its nose for decades because it failed to put enough resources into inspecting its members operations?  This question may be unanswerable. But we can trust FINRA to make the right decision if it actually pays out on its investor protection pledge.

The industry has long promoted the virtues of a self-regulated system. While self-regulation can certainly work and while we acknowledge that an industry-funded regulator decreases the burden on taxpayers, a regulator incentivized to pursue its mission is undoubtedly a good thing.  

As things stand now, and as they have stood since the General Accounting Office first addressed this issue 18 years ago, the financial services industry is allowed (if not encouraged) to be reckless with its own finances, knowing that investors will bear the burden of its poor decision-making.  

A national investor recovery pool funded first by the fines FINRA levies against its wayward members places the burden squarely where it belongs: on those who flout the industry’s rules and regulations.  

FINRA, which answers to its members, would do well to hold those costs down by ensuring its members follow the rules and regulations (or face monetary fines for their failure to do so), and those who do run afoul of the rules are capable of making whole those whom they have harmed. 

Benjamin Edwards is an associate professor of law at the University of Las Vegas where he specializes in business and securities law, corporate governance and consumer protection.

Hugh Berkson is a principal with the firm of McCarthy, Lebit, Crystal & Liffman Co., L.P.A., in Cleveland, Ohio. A past president and current board member of the Public Investors Arbitration Bar Association, he represents investors with claims against their brokers, investment advisors, and insurance agents.

Tags economy Elizabeth Warren Financial Industry Regulatory Authority FINRA Law Securities regulation in the United States Self-regulatory organization U.S. Securities and Exchange Commission United States securities law

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