Brokerage Regulators: NASD & FINRA

The National Association of Securities Dealers (NASD) was the original regulator of the brokerage industry. The NASD was created in 1939 under the oversight of the Securities and Exchange Commission (SEC). The Securities Exchange Act of 1934 created a registration requirement for the securities market which had not previously existed.

This new statute meant that companies that wanted their stocks or other securities to be publicly traded on an exchange had to be registered and disclose certain information publicly. It also meant that companies in the business of buying and selling those securities for other people, called broker-dealers, had to register as well.

The NASD developed and administered licensing exams for individuals who wanted to work in the securities business for a broker-dealer. There are a number of different exams tailored to different types of trading responsibilities.

There is an exam to trade only investment company shares like mutual funds. There is a bond exam, an options exam, and so forth.

There is a requirement that all brokers must have a designated supervisor, so there is a separate exam to qualify for supervision. These exams have changed repeatedly over time as the markets themselves developed, but ultimately the NASD was the entity responsible for setting minimum requirements for what licensed brokers needed to know about particular sections of the securities industry in order to be permitted to sell those kinds of investments.

While the NASD was doing this oversight, the New York Stock Exchange (NYSE) was simultaneously operating with its own set of rules and regulations for anyone buying or selling securities over that exchange. However, this led to various problems, including some inconsistencies between a rule of the NYSE and the NASD.

As a result, in 2007, the New York Stock Exchange regulatory, enforcement, and arbitration divisions merged with the National Association of Securities Dealers to form the Financial Industry Regulatory Authority (FINRA).

Today, FINRA essentially has two main divisions: enforcement and arbitration.

Enforcement Division

FINRA’s stated purpose is to “protect the investing public against broker fraud and bad practices.” That is a very broad mission statement that can mean a number of different things. However, one thing many people in public do not understand is FINRA’s limited jurisdiction.

FINRA is a self-regulatory organization, or SRO for short. The organization’s authority is derived as a result of FINRA’s charge from the Securities and Exchange Commission under the 1934 Exchange Act.

Under this structure, anyone who wants to legally conduct securities trading in the United States is required to register with the organization, either as a broker-dealer or as a registered representative of a broker-dealer (which is what is commonly thought of as a “broker”).

However, that also means that FINRA’s authority is limited to its membership. If a person or entity does not obtain a securities license and conduct securities trading, the SRO has no authority or jurisdiction to do anything about that person or entity.

Other regulators, like the SEC or state-level securities regulators, have the authority to regulate and potentially punish bad actors who are not FINRA members but nevertheless hurt the investing public, committing fraud or other bad practices.

The Financial Industry Regulatory Authority writes rules for its members to follow in conducting their business. These rules cover a wide range of issues, from what licenses are required for certain kinds of business, what kinds of sales practices with the public are acceptable, and what kind of supervisory and compliance systems are required.

As the organization is under SEC oversight, FINRA cannot simply create new rules at will but rather must receive SEC approval.

The rule-making process progresses in the following manner:

  • FINRA has a committee composed of representatives of small-broker dealers, large-broker dealers, and non-industry individuals that meet and discuss changes those committee members believe should be adopted into FINRA’s rules.
  • The committee will make its recommended rule change, which is then passed on to the organization’s board of directors.
  • If the board of directors believes the rule change should move forward, the FINRA Board will put out a public notice for comment, during which time anyone can write in and essentially advocate for or against the rule change.
  • Once that comment period is over, the FINRA Board will either make changes to the rule proposal based upon the feedback the board received (and then put the amended proposed rule out for public comment yet again), decide not to move forward with the rule change, or forward the rule change as written to the SEC for approval.
  • Unless and until the SEC approves a new FINRA rule, it is ineffective.

FINRA also enforces its rules against its members. When the organization believes a firm or individual licensed through FINRA has violated one or more rules, the SRO can conduct its own investigation of the issue and bring disciplinary action against the violator.

The investigation can be lengthy or short, depending on the issue, but FINRA staff will typically conduct interviews with harmed investors, review records of the transactions, and conduct interviews of the broker or firm personnel involved. Most FINRA disciplinary actions end in something called an “acceptance, waiver, and consent.”

After FINRA concludes its investigation, it essentially negotiates an agreed penalty with the firm or individual. In exchange for the member agreeing to the disciplinary action, whatever that discipline may be, they waive any rights to contest the action or have a formal hearing on the matter.

The members also avoid any admission that they actually did anything wrong, which those accused of wrongdoing would prefer to avoid. In exchange, FINRA receives some amount of discipline against the violator without the expense or risk of a contested hearing. The discipline that FINRA levies can range from a cash fine to a short suspension of a few days, all the way to the final termination of the firm’s or individual’s license to do securities business in the United States.

Arbitration Division

FINRA also conducts and administers an arbitration forum, formally called FINRA’s Division of Dispute Resolution Services.

The arbitration forum is an alternative to court-sponsored and run by FINRA, where customers of the organization’s members can have private disputes heard and decided (FINRA members also use the FINRA arbitration forum to resolve disputes between FINRA members, such as employment disputes between brokers and broker-dealers).

Although the same broker and conduct can end up in either division of FINRA, in the enforcement division, the affected customers are merely witnesses, just like they would be in a criminal proceeding in court. The investor can testify, but they do not have any control over the proceeding, and the ultimate goal in a disciplinary proceeding is not really to help the customer but rather to discipline the wrongdoer.

In the arbitration forum, FINRA does not decide the ultimate outcome at all. Instead, FINRA has developed a roster of arbitrators who have taken certain training classes and met other requirements to be a part of a pool that FINRA arbitration participants draw from to be appointed to decide the outcome of claims being asserted.

There are a variety of pros and cons that go into any discussion of arbitration vs. court for private lawsuits.

Ultimately, however, almost all broker-dealers in the United States include arbitration agreements in their account agreements, where customers agree that any and all disputes they may have against the firm or its employees will be decided in FINRA arbitration rather than in court.

In all but very rare circumstances, these contract terms are enforceable, meaning FINRA arbitration is where all but the rarest of disputes against a brokerage firm or its employees are resolved.

Work With Our FINRA Attorneys

At Shepherd Smith Edwards & Kantas (SSEK Law Firm), our FINRA arbitration attorneys and FINRA lawyers have represented many investors across the United States in recovering investment, stock and bond losses they suffered through the process of arbitration or investment scam.

Contact us today for a free, no-obligation case consultation if you believe that a registered broker or financial advisor acted negligently or fraudulently when handling your investment portfolio.

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