INVESTMENT ADVISER SRO – Where did we get Self-Regulatory Organizations in the first place? Part One

Written by: Phil Feigin

Anyone who works with me learns pretty quickly that I am an historian at heart. To understand what is happening now, I need to know what led to it. That imperative led me to review the origins and history of self-regulatory organizations in considering the “Investment Adviser Oversight Act of 2012” proposed by (retiring) Rep. Spencer Bachus (R-Ala.), Chair of the House Financial Services Committee.

When you think about it, self-regulatory organizations (“SROs”) are weird ducks, peculiar to federal securities regulation. There probably are such entities elsewhere in the economy, but I can’t think of any offhand. There’s no federal SRO in banking or insurance or real estate. Members of an industry/profession regulating themselves at the national level, with federal government oversight? Isn’t that a bit like having convicts on the parole board—after all, who would know better if someone has truly learned his lesson and reformed?

So, how did the SRO concept come to be in federal securities regulation?* It was 1933, and Franklin Delano Roosevelt brought us the New Deal. A hallmark of the New Deal was the creation of permanent administrative agencies, the so-called “fourth branch of government.” Along with that development, the idealistic administration sought to jump start the economy from Washington by organizing its components and encouraging self-discipline. Under the National Industrial Recovery Act (“NIRA”) (among an alphabet soup of others), the National Recovery Administration (“NRA”) divvied up American industry into sectors, each to be led by a committee of private sector luminaries, charged with deriving, adopting and, using moral suasion, implementing best practices, wages, production, allocation of resources, competition and more. On the long list of foundational flaws in the concept was the absence of any realistic enforcement mechanism. It was all based on the premise of mutual cooperation in the face of a crisis.

The committees all met with varying degrees of failure. Activity was confused with productivity. While it all may appear quaint today, it is important to reflect that this was a period of worldwide crisis. In the U.S. and across the globe, unionism, socialism, even Bolshevism, were on the rise. They were also legitimate topics of discussion, and of real influence, in national politics as U.S. citizens increasingly sought answers from their federal government. Where the private sector had failed them and misery was pervasive, people turned to their central governments for solutions. At the extremes, we saw from the right, Italian and German Fascism and our own Bunds in America; from the left, the Soviet Union and the American Socialist and Communist Parties. The Roosevelt Administration was certainly more centrist than either, but from the dire circumstances of the worldwide Depression, people turned to national governments and leaders for answers.

The first, most venerated and well-known American financial SRO was the New York Stock Exchange, formed under the Buttonwood Agreement of 1792. The NYSE was in existence for 120 years before FDR and the New Deal came to power. Save for the piecemeal securities registration and broker licensing requirements of state “blue sky” agencies starting in 1911, in 1932, the only real national force and focus for the securities industry was the NYSE (other exchanges of the day tended to be more regional). The lack of intensity and depth of the oversight imposed by the Exchange were in evidence in the collapse of 1929. Even so, in 1932, any federal regulatory scheme was going to have to assume and incorporate the reality of pre-existing Exchange self-regulation. Even given the Crash in 1929 and the Whitney scandal a few years later, the securities industry and the NYSE still had considerable influence over Congressional decisions.

Sensing its vulnerability given these calamities, the Investment Bankers Association undertook in FDR’s “First 100 Days” to adopt its own code of practice for the securities industry. Codes of fair competition and trade under the NIRA, and gained NRA approval, to be administered by the Investment Banking Code Committee. With the beginning of the end for the NRA in 1935, industry leaders urged the new SEC to enforce the codes itself. While the NYSE was firmly in place when federal securities regulation was being fashioned, there was no such complement when it came to the over-the-counter securities market. There was no convenient centralizing focus for these brokers. Without the NRA to give some spine to the Committee, there was no statutory imperative for OTC firms to join any national group.

Again, we need to consider the times. In 1935, it still took days to cross the country, in person or by mail. Historically, the federal government hadn’t regulated much of anything, let alone any realm like the securities markets. There were no international models either. They were inventing securities market regulation on the fly, laying track just in front of the engine. The SEC had its hands full with attempting to reel in Wall Street, what was perceived to be the core problem.

Further, the thought of trying to impose and administer a regulatory structure on the over-the-counter market was seen as daunting (there were over 6,000 OTC brokerage firms spread all over the country), a distraction from the perceived main mission, and (perhaps rationalizing) as potentially compromising. An SEC Commissioner and a Division Director at that time were on record suggested that assuming day-to-day oversight of OTC brokers would be viewed as akin to getting “in bed” with them.

Perhaps the most compelling force on this and many other formative issues was the SEC’s second Chairman, William O. Douglas. He favored self-regulation for OTC brokers because he viewed competent oversight from Washington unworkable given the lack of OTC market centricity. Chairman Douglas also posited that self-regulation could establish ethical standards for the industry that were beyond those the government could ever hope to adopt or apply. In his view, the proper role of the SEC was to oversee the performance of the SROs, with a “well oiled shotgun behind the door” to use when necessary. This was consistent with the NIRA concept. 

This position of Chairman Douglas was ultimately manifested in the Maloney Act of 1938, granting to the SEC the authority to register national securities associations under the Securities Exchange Act of 1934. The Investment Banking Code Committee morphed into the National Association of Securities Dealers (“NASD”) in 1939.

In my view, this attitude of treating the OTC market as a sort of regulatory stepchild was pervasive at the SEC, and would last for decades well into the present day. Spending time on OTC regulation was viewed as detracting from the staff’s main mission of dealing with Wall Street and the NYSE.

The exchanges and NASD muddled along for the next few decades, until 1963, when a scathing SEC Special Study gave rise to an effort to strengthen their self-regulation. In 1975, sea change amendments were made to the Exchange Act to give the SEC far more oversight authority over SROs. The SROs were sorely tested in the 1987 Market Break. The Nasdaq market was reamed in the SEC’s 1996 “§21(a) Investigatory Report,” which led to the splitting of the NASD’s market and regulatory functions into two separate subsidiaries, Nasdaq and NASD Regulation (“NASDR”).

In 2007, the regulatory arms of both the NYSE and NASDR merged to form the Financial Industry Regulatory Authority, FINRA. The regulatory responsibilities and functions of the exchanges and the NASD had evolved dramatically from the original conception in 1939. Today’s FINRA may have a board of directors and committees composed of brokerage industry representatives, but its staff is a private army of highly paid enforcement and regulatory professionals that lords over its domain all but unchecked. The SEC required that FINRA receive unparalleled and unprecedented funding for its regulation and enforcement functions when it rose independent from the fetters of Nasdaq and the NYSE market. Like the machines of Skynet in the Terminator saga, with the split and funding, FINRA had become “self-aware” and proceeded to wreak havoc on its subjects.

My points in going through all this, in asking Where did we get Self-Regulatory Organizations?, are as follows:

1.      the exchanges as SROs for markets and exchange member brokers were already in place in 1933 and 1934 when the securities acts were fashioned, and industry governing itself was a compromise concept borne of the physical limitations of communication and travel of the era, not the first choice;

2.      notwithstanding the efforts of Chairman Douglas to convince the investment companies to form their own SRO along with the brokers, they showed no interest in doing so and the idea died;

3.      as a practical matter, the 1934 OTC market was too diffused to be regulated effectively from any centralized headquarters, be it governmental or self-regulatory;

4.      until 1995, SROs combined both competing securities market and member oversight; and

5.      SROs’ regulatory roles have evolved and transformed significantly since 1934—historically, both (before and) after 1934, the SROs underperformed as regulators, leading to successive substantive and radical reforms, and ultimately to the complete disengagement of the regulatory and market functions.

In the next three parts, I’ll discuss how the history and concepts I discussed here figure into the calculation for whether an SRO for investment advisers is needed, desirable or appropriate today. I’ll finish off with an anecdote about my own dabbling with the IA SRO concept.


*I’ll be happy to share my sources with anyone interested, but suffice to say I did a little research on the question, but owe general credit to Joel Seligman (“Transformation of Wall Street”) and Arthur M. Schlesinger (“The Coming of the New Deal”). The glory of blogging is that you get to write like you know what you are talking about. It is up to the reader to agree or disagree.

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One thought on “INVESTMENT ADVISER SRO – Where did we get Self-Regulatory Organizations in the first place? Part One

  1. Phil – I would “like” your blog for Facebook, ’cause it’s great, but it would violate my internal policies that prohibit any work related communications on my FB account, and I know you wouldn’t want me to violate my own policy & procedures manual…

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