A new twist to an on-going debate about securities self-regulation: it's time to end FINRA's federal income tax exemption.
TABLE OF CONTENTS I. INTRODUCTION. 136 II. FINRA'S HISTORY, ORGANIZATION, AND ACTIVITIES 141 A. FINRA 's History 141 B. FINRA 's Regulatory and Governance Profile 149 1. Governance 155 2. Rulemaking, Enforcement and Member Discipline 157 C. A Brief Profile of FINRA 's Finances 158 D. Measuring the Value of Membership in FINRA 160 E. Assessing the Cost of FINRA 's Tax Exemption to American 164 Taxpayers III. THE PARAMETERS OF SECTION501(C)(6) AND FEDERAL TAX EXEMPTION 167 A. History of Section 501(c)(6) 167 B. Organizational and Operational Requirements in Brief 167 IV. APPLYING THE SECTION 501(C)(6) TESTS TO FINRA 169 A. Common Business Interest and Membership Organization 169
The Financial Industry Regulatory Authority (FINRA) is the largest non-commercial securities self-regulatory authority in the United States, with responsibility for governing the over-the-counter (OTC) market for equity securities and certain fixed-income securities. (1) FINRA regulates virtually every securities broker-dealer that conducts business in the United States, most of which are required by statute to be a FINRA member. (2) FINRA is organized as a private, nonprofit membership corporation domiciled in Delaware. (3) Its profits are exempt from federal income tax pursuant to Section 501(c)(6) of the Internal Revenue Code (Code). (4) FINRA has undergone significant change in its organizational character and method of operation in the roughly seven decades since it registered with the Securities and Exchange Commission (SEC) as a "national securities association." In this article, I contend that these changes are so profound as to undermine FINRA's claim to exemption from federal income tax under the Code. Further, there does not appear to be a strong tax policy or public policy rationale for altering existing tax law to maintain FINRA's tax exemption in its current form.
FINRA's corporate predecessor, the National Association of Securities Dealers, Inc. (NASD), traces its origins as a regulator to the widespread devastation caused by the Great Crash of 1929 (Crash). In the wake of the enormous losses suffered by public investors, Congress passed the Securities Exchange Act of 1934 (Exchange Act), (5) which created an elaborate system of regulation that included the SEC (an independent government agency chiefly responsible for regulating the securities markets) and private associations known as "self-regulatory organizations" (SROs). (6) SROs were designed to act as the "first line" regulatory authorities (7) over much of the securities markets by overseeing the day-today operations of these venues and regulating their members by adopting and enforcing rules requiring fair and ethical business practices. (8) Securities exchanges were required to register with the SEC, which was given oversight responsibility for them. (9)
When the Exchange Act was enacted, it provided for a self-regulatory system for stock exchanges but not the OTC market. This gap was closed in 1938 with the passage of the Maloney Act, (10) which amended the Exchange Act to provide a framework for self-regulation in the OTC market. The Exchange Act required the SRO for this market (which the NASD eventually became) to adopt rules intended to regulate its members and "to promote just and equitable principles of trade." (11)
The merits of self-regulation, and FINRA's effectiveness as an SRO, have been extensively analyzed by the SEC and a wide range of business and legal groups. (12) Little attention has been given to FINRA's tax exemption under the Code. Section 501(c)(6) provides a tax exemption to entities known as "business leagues," as well as certain other enumerated organizations. (13) The term "business league" is unique to tax law. (14) It is generally equivalent to a trade association, (15) whose most important characteristic is its member-centric orientation (i.e., it is governed by and on behalf of its members). Its primary function is to foster and promote its members' collective business interests, often by improving the conditions of the industry in which its members conduct business. (16) Membership funding and meaningful member participation in governance and operations are important attributes of a business league under Section 501(c)(6) (17)
To qualify for a tax exemption under the Code, an organization must generally be a nonprofit organization. Nonprofit corporations include charitable organizations as well as other less well-known associations such as "mutual benefit" groups. Unlike charitable organizations, which are established to serve the public interest, (18) mutual benefit organizations are created to serve their members' business interests (business mutuals) or social interests (consumer mutuals). (19) Business leagues (including trade associations) are a type of business mutual, and their nonprofit status informs their mission and activities. The principal characteristic that sets apart business leagues and other nonprofit corporations from their for-profit counterparts is what Professor Henry Hansmann famously calls the "non distribution constraint," which means that no part of a nonprofit corporation's net earnings may inure to the personal benefit of any person 20 or entity that controls the corporation's affairs (including the CEO). (20)
When FINRA's predecessor, the NASD, first became an SRO, it was a new and fledgling voluntary association of securities firms with a dual role. Its statutory mandate was to be the front-line regulator for the OTC market. Yet it retained its identity as a member-centric association governed autonomously by its members and dedicated to fostering and promoting their collective economic interests. (21) This duality was not accidental. The legislative history of the Maloney Act clearly indicates Congress'1 preference for a self-regulatory system for the OTC market rather than direct regulation by a government agency. Self-regulation was thought by lawmakers to be far less burdensome and intrusive than a purely governmental approach, and SROs were regarded as better able than the SEC to adopt and enforce ethical norms of business conduct. (22)
Over the past seven decades, as the securities industry has grown, FINRA has become a powerful organization. Its financial resources are substantial; as of December 31, 2010, it had more than $2 billion in assets and its 2010 net revenues were approximately $850 million. (23) Through the mid-1990s, FINRA's efforts were dedicated primarily to the promotion of its members' financial and reputational interests. As part of these efforts, it created NASDAQ, an electronic trading system that eventually became a resounding commercial success. (24) Although the NASD was required by statute to regulate trading on NASDAQ, the NASD seemed to regard its principal purpose as enhancing the trading system's profitability. In 1996, however, the SEC and the Department of Justice identified widespread price fixing, market manipulation, and fraud by NASDAQ market makers, for which the NASD was faulted. (25) Thereafter, the NASD was completely overhauled. In a paradigm shift from the dual-function SRO model Congress envisioned in 1938, the NASD members' historically dominant role in FINRA's affairs was eliminated. (26) The NASD's staff, once deferential to the members' business judgment, was deliberately reconstituted to be independent of the members. The staff is now primarily responsible for setting FINRA's agenda and for the organization's operation, with the members relegated to little more than captive dues payers. (27)
Since 2007, when the NASD completed the process of spinning off NASDAQ into an independent private entity, FINRA's mission has been almost entirely regulatory. (28) Nonetheless, it gives its executive officers million-dollar pay packages that are far more typical of for-profit corporations than government agencies and nonprofit corporations. (29) FINRA's Board of Governors (Board) has formulated its compensation practices for senior executives largely on the basis of "benchmarking" studies conducted by an independent compensation consultant, and upon the consultant's general advice. Yet several of the assumptions underlying the consultant's studies are questionable, leaving the studies1 accuracy and reliability open to doubt. (30) In addition, compensation studies of nonprofit organizations conducted by the Internal Revenue Service (Service) and prominent organizations that monitor the nonprofit sector suggest that FINRA's pay packages for senior executives are excessive. (31)
In light of the significant changes in the management, purpose, and Wall Street-based compensation practices, it is now time to re-evaluate whether FINRA qualifies as a tax-exempt entity under Section 501(c)(6) or general tax policy. Taken together, the developments described above should be fatal to FINRA's Section 501(c)(6) exemption. Congress could certainly reformulate the Code by creating a unique class of tax exemption for FINRA, but as a matter of public policy this would be a bad idea. At a time when the Nation's debt is spiraling out of control and the Federal Government's budget deficit is increasing at an alarming rate, American taxpayers can no longer afford to fund FINRA's exemption, whose annual cost is nearly $100 million.
This article is organized into seven parts, beginning with this Introduction. Part IT explains FINRA's history, describes its governance, rulemaking, disciplinary, and financial affairs, and explores the transformation of FINRA from a business-oriented, member-centric-organization to a non-commercial organization devoted entirely to regulation. Part III briefly describes the parameters of Section 501(c)(6), and Parts IV and V explain why FINRA is no longer entitled to its current exemption as a matter of tax law and policy as well as public policy. Part VI explores the degree to which a private person can challenge FINRA's tax-exemption in a federal court or through the Service. Part VII summarizes the major points in this article.
II. FINRA's History, Organization, and Activities
A. FINRA's History
In the wake of the Crash, the United States was in a deep depression. The market value of securities traded on the securities exchanges and OTC markets declined enormously and investor confidence was at an all-time low. The Crash was precipitated by rampant speculation, market manipulation, self-dealing, and fraud in connection with the purchase and sale of securities on the primary and secondary securities markets. At the time of the Crash, the domestic securities markets existed with little or no government regulation. (32) After the Crash, Congress decided that the Nation's capital markets required federal oversight. (33) To provide a framework for such oversight, Congress enacted the Securities Act (34) and the Exchange Act. (35) Together, these laws were intended "to substitute a philosophy of full disclosure for the philosophy of caveat emptor and thus to achieve a high standard of business ethics in the securities industry." (36 )The Securities Act principally regulated the initial dissemination of securities to the public, (37) while the Exchange Act applied to securities transactions subsequent to their initial distribution, both on securities exchanges and the OTC market.38 The Exchange Act also sought to ensure that stock exchanges were no longer operated as "private clubs to be conducted in accordance with the interest of their members," but as "public utilities" available to the public to facilitate the post-distribution purchase and sale of securities. (39) To this end, all exchanges were required to register with the SEC and to promulgate rules that disciplined their members and protected investors. (40)
The Exchange Act did not adequately address self-regulation for the OTC market. Abuses in this market continued (41) until Congress filled the regulatory void in 1938 by enacting the Maloney Act. (42) This law amended the Exchange Act by creating "[a] program based upon cooperative regulation, in which the task [of regulating the over-the-counter market was] largely performed by representative organizations of investment bankers, dealers and brokers, with the [SEC] exercising appropriate supervision in the public interest, and exercising supplementary powers of direct regulation." (43) Direct government regulation was explicitly rejected as "heavy handed," and Congress sought to avoid "the impracticality of a burgeoning bureaucracy" that would be "in danger of breaking down of its own weight and proving ineffective." (44) The front line responsibility of regulating the securities markets was assigned to "national securities associations," which were voluntary private associations of brokers and dealers tasked with controlling the OTC market in much the same way stock exchanges were expected to control the auction markets. (45) This system of regulation, in which regulatory responsibility for the capital markets that historically had been a direct governmental function was transferred to registered national securities exchanges and registered national securities associations, came to be known as "self-regulation." Each such private regulator was called a "self-regulatory organization." One of the core assumptions of securities self-regulation was that SROs would be representative of the securities industry. Members would be responsible for their own governance, rule-making, member discipline, and funding. (46) In most respects, SRO staffs were not intended to be independent of their members. Their role was to defer to the members' business judgment and to implement competently the strategy approved for the SROs by their members. (47)
Shortly atter the passage of the Maloney Act, the SEC authorized the NASD as a national securities association. (48) Pursuant to that authorization, the NASD was incorporated as a "nonstock" member organization in Delaware and registered with the SEC. (49) Membership in the NASD was voluntary. Unlike exchanges, members were not preselected and the total number of members was not limited. Membership in the NASD was attractive only to those securities firms for which the business benefit of complying with the NASD's rules and paying its dues outweighed the costs of complying with them. (50)
One of the inherent characteristics of securities self-regulation is the conflict of interest it creates between SROs' regulatory functions--which are intended to benefit public investors--and their inherent bias in favor of members business concerns. Congress was well aware of this conflict, but believed it could be successfully managed. Events were soon to prove them wrong.
In the 1950s, problems emerged with the self-regulatory model. Instances of investor speculation, accompanied by fraud and manipulation, occurred with disturbing frequency on the stock exchanges and OTC market, resulting in a loss of investor confidence. (51) Yet the SROs remained passive regulators in the face of their members' conduct, and the SROs' market regulation function took a back scat to the promotion of their members' commercial interest and the defense of their members' conduct from public criticism. In 1963, the SEC published a comprehensive study (Special Study) conducted by its staff and outside experts that examined the characteristics of the exchange and OTC markets and the abuses that occurred on these markets. (52) The Special Study identified significant lapses in the SROs' surveillance of these markets and the discipline of their members. (53) According to Joel Seligman, a well-regarded expert in securities regulation and the history of the SEC, the Special Study illustrated that "securities self-regulation consistently had been self-interested and self-protective, often failing to produce standards of conduct superior to those that existed before the enactment of the securities laws." (54)
From 1967 to 1970, the securities markets experienced a severe operational breakdown that came to be known as the "back-office crisis." As trading volume increased on the various securities markets, securities firms were unable to process their customers' securities transactions and lost control of their records. (55) Significant delays in transaction settlement and the delivery of cash or securities, coupled with recordkeeping failures, forced many firms into liquidation. (56) SROs failed to intervene directly to resolve these problems until the situation had reached crisis proportions. (57) The magnitude of the crisis damaged public confidence in the system of securities clearance and illustrated the limits of the self-regulatory system.
Problems in the self-regulatory system resulted in the passage of the Securities Act Amendments of 1975 (1975 Amendments). (58) The 1975 Amendments did not change the NASD's role as an SRO, but they strengthened the SEC's oversight role of SROs by, among other things, giving the SEC the power to initiate and approve rulemaking, (59) expanding the SEC's role in SRO enforcement and discipline, (60) and allowing the SEC to play an active role in structuring the trading markets. (61) In addition, the Exchange Act set forth requirements with respect to the composition of exchange and association boards, providing that the rules of such organization must "assure a fair representation of its members and provide that one or more directors shall be representative of issuers and investors and not be associated with a member of the [exchange or association], broker or dealer." (62)
Though well-intentioned, the 1975 Amendments did not ameliorate the basic conflict inherent in securities self-regulation. SROs, including the NASD, continued to accord greater priority to their members' collective financial interests than to their regulatory responsibilities. As noted earlier, the inherent conflict between the NASD's regulatory and member-centric functions was exacerbated by the NASD's launch in 1971 of a wholly-owned entity called NASDAQ. Initially, NASDAQ was an electronic trading system for a limited number of stocks. Over time, NASDAQ expanded in size and scope. (63) Two decades later, it had evolved into a major market center for OTC securities, offering continuously updated quotes on a real-time basis and sophisticated computerized trade executions for buyers and sellers around the world. With virtually no competition, it became commercially successful, producing substantial revenues both for the NASD's members (i e., the market makers on NASDAQ) and the NASD itself. Although the NASD was required by statute to regulate trading on NASDAQ, the NASD appeared to regard itself primarily as a business whose purpose was to create structural advantages that would enhance the trading system's profitability. This is not surprising. Since the NASD is organized in a mutual form, its members effectively owned NASDAQ. Owners of securities markets often operate as monopolists, seeking to maximize their profits at a cost to public traders. (64) They have little incentive to encourage enforcement of SRO rules or to spend money on effective market surveillance, even if advances in technology permit the development of such systems. (65) They typically favor control of customer order flow (rather than multiple trading venues) and the terms of marketplace trades, which in economic terms allow them to extract more rents from their nonmember customers. (66)
The danger of this combination of regulation and commerce came into sharp focus in 1996, when the SEC and Department of Justice revealed widespread price-fixing among market makers on NASDAQ. (67) The SEC found that market makers had colluded in order to limit market maker quotes to 1/4 point spreads despite the availability of 1/8 quotation increments. (68) Market makers had also prevented customers from narrowing quotations by refusing to publish their limit orders. (69) The SEC determined that the NASD had failed to use its surveillance and enforcement resources to investigate allegations of collusive trading by NASDAQ market makers and had discriminated against electronic traders that used NASDAQ's small order execution system to trade electronically against the quotes of NASDAQ market makers. (70) The NASD was censured. (71)
At the SEC's insistence, the NASD was completely reorganized. The NASD became a holding company and its regulatory and market operations were placed into two separate and independent subsidiaries. (72) Arrangements were put into place to ensure that the NASD could not use its regulatory authority to promote its pecuniary interest in NASDAQ. (73) Other changes were made to reduce substantially the power of its members. The Board and important policy-making committees were reconstituted to achieve "greater diversity of representation" and the NASD's members became a minority on the Board and these committees. (74) The members' role in the disciplinary process of members was sharply curtailed, (75) and the NASD agreed to provide for the autonomy and independence of its staff with respect to the rulemaking and disciplinary proccsses. (76)
The 1996 reorganization was a transformative event in the NASD's history. After almost five decades as an organization that put its members' collective financial interests ahead of its regulatory duties, the NASD's mission and primary focus shifted decidedly away from its members' business concerns to regulation of the OTC market and securities firms. Two other events have also significantly redefined the organization's identity. In 2007, the NASD completed the spin-off of NASDAQ into an independent, for-profit company. (77) Although the NASD received $419.8 million of untaxed dollars from this transaction, (78) it was left with virtually no commercial business. (79) That same year, the regulatory and enforcement operations of the NASD and the New York Stock Exchange (NYSE) were consolidated. (80) The resulting organization took the FINRA corporate name.
B. FINRA 's Regulatory and Governance Profile
As this article is written in mid-2011, FINRA has few commercial operations. (81) The large preponderance of its financial and human resources are dedicated to the regulation of the OTC market and the regulation of broker-dealers, (82) and most of its revenues stem from these activities. (83) As an incident to its regulatory functions, FINRA operates what it claims to be the world's largest arbitration and mediation facility for the resolution of customer disputes with FINRA members and disputes between members and/or their employees. (84) It also operates a foundation dedicated to investor educations. (85) As of December 31, 2010, FINRA oversaw nearly 4,600 brokerage firms, approximately 163,000 branch offices and approximately 631,000 registered representatives. (86) FINRA has approximately 3,000 employees and operates in Washington, D.C. and New York City, as well as from twenty district offices in the United States. (87)
FINRA does not simply adopt rules and make policy pronouncements. FINRA regularly examines member firms for compliance with its laws and the federal securities laws. Its examinations also monitor the firms' financial solvency, operational capabilities, and risk assessment practices, as well as various aspects of their sales practices. (88) FINRA's examination program has become more risk-based, focusing on the business lines engaged in by its members that pose the highest risk to investors, and how well these risks can be managed or mitigated. (89) FINRA's staff is in continuous contact with its members that are part of large, complex financial institutions and receives financial and risk management information from them on a regular basis. (90) FINRA also has an enforcement program that investigates members' potential violations of its rules and/or the federal securities laws, (91) and brings disciplinary proceedings against its members and/or their employees who are believed to have violated these rules and/or laws. (92) Some commentators have raised the question whether FINRA's quasi-governmental status converts it into a government entity. (93) Though FINRA's activities do not constitute "state action" under relevant Supreme Court precedent, (94) most federal courts have held that FINRA and its staff enjoy absolute immunity from civil liability for actions taken in connection with the performance of FINRA's regulatory responsibilities. (95)
The SEC's oversight and supervisory authority over FINRA is "extensive" and "pervasive" (96) and FINRA (along with other SROs) has "no authority to regulate independently of the SEC's control." (97) As noted earlier, FINRA's rulemaking activity is subject to the SEC's approval. (98) No member or employee of a member may be disciplined by FINRA over the SEC's objection, and the SEC has de novo authority to modify or overturn sanctions imposed by FINRA. (99) While FINRA conducts its examination, enforcement, and rulemaking functions with substantial discretion: (100) in critically important matters FINRA has often taken its cue from the SEC. Where the SEC perceives that FINRA acts too slowly (or not at all), it has not hesitated to force new initiatives upon FINRA or impose its own rules.
How effectively FINRA performs its self-regulatory mandate is open to debate. In 2010, FINRA filed 1310 new disciplinary actions, barred 288 individuals and suspended 428 others, expelled 14 firms, levied nearly $42.2 million in fines, and ordered firms and individuals to pay slightly more than $6 million in restitution to investors. (101) In the same year, FINRA also conducted approximately 2600 routine examinations and 6600 cause examinations in response to such events as customer complaints and regulatory tips. (102) In 2009, FINRA brought 993 disciplinary actions, barred 383 individuals and suspended 363 others, expelled 20 firms, levied nearly $50 million in fines, and ordered the payment to investors of more than $8 million in restitution. (103) It also conducted approximately 2500 routine examinations and about 7900 cause examinations. (104) In each year between 2004 and 2008, FINRA reported that it (and its predecessors, the NASD and NYSE) expelled an average of 21 firms and banned an average of 433 registered representatives from the securities industry. (105) In each of these years, FINRA also suspended 396 registered representatives, levied approximately $97.4 million in fines and obtained restitution averaging $105 million for customers of its members. (106) Each year, FINRA receives about 25,000 complaints, tips, and similar items, of which it processes 5,000. (107)
In spite of these impressive accomplishments, FINRA has a track record of missing many of the major scandals in the securities industry. Regulators have determined that in the 1990s, the NASD failed to enforce effectively analyst conflict of interest rules. This failure allowed research analysts employed by large member firms to make overly optimistic and often baseless recommendations about scores of companies in order to win investment banking business for their firms. (108) More recently, FINRA failed to detect and prevent a large "Ponzi scheme" perpetrated by a member firm associated with R. Allen Stanford in spite of "red flags" indicating the existence of the scheme. (109) It also failed to pursue "facts worthy of inquiry" associated with Bernard Madoff's massive and well-publicized "Ponzi scheme" fraud. (110) So significant were these failures and the resulting harm to investors that FINRA's Board appointed on its own initiative a special review committee (Review Committee) to investigate FINRA's examination program. The Review Committee acknowledged FINRA's failures in the Stanford and Madoff scandals and recommended extensive changes in the organization's examination procedures, particularly in FINRA's fraud detection capability." (111)
In the realm of cases FINRA has actually brought, there is some reason to suspect the quality of its performance. A well-known law firm has studied disciplinary hearings conducted by the NASD/FINRA staff in 2006 and 2007 that were not settled and required a hearing. The study revealed that charges against members were dismissed in a significant percentage of cases. For those respondents that were found after a hearing to have violated FINRA or SEC rules, the sanctions imposed upon them were on many occasions narrower in scope than the sanctions sought by the NASD/FINRA staff prosecuting the cases. (112) Even in the area of surveillance, a function to which FINRA has given a great deal of attention, (113) the aftermath of the "flash crash" that occurred in May, 2010 (114) indicated that neither FINRA nor the SEC has an adequate consolidated audit trail that would allow them to track buy and sell orders across different trading markets on a real-time basis. (115)
Admittedly, FINRA's examination and enforcement efforts are hobbled by its lack of jurisdiction over entities that are not broker-dealers registered with the SEC and persons that are not current or former employees of such firms. This is especially true with respect to non-securities firms that are part of a financial holding company structure that contains a securities firm regulated by the SEC and FINRA. (116) Nonetheless, Congress was sufficiently concerned about FINRA's examination and enforcement efforts that it inserted into the Reform Act a provision that directs the U.S. Comptroller General to evaluate these efforts in the context of an overall review of the SEC's oversight of FINRA. (117)
Self-regulation is based upon members governing, regulating, and disciplining themselves and upon members' voluntary compliance with ethical standards. Industry knowledge and expertise among the members is intended to enhance the quality, efficiency, and effectiveness of the SRO's rules and its overall performance. Consistent with these characteristics, the Maloney Act principles that applied to national securities associations (i.e., the NASD) were democratic organization, staff deference to the members' business judgment, and local autonomy. Today's FINRA is a stark departure from its Maloney Act roots. Structurally, FINRA continues to be a membership organization. As a practical matter, members no longer play any meaningful role in (or exert any meaningful impact upon) the organization's governance, rulemaking, enforcement or member discipline. Specific examples of how FINRA's members have fallen from grace in these areas are presented below.
The NASD's 1996 reorganization was the beginning of the decline of membership's influence in the NASD's governance process. Subsequent events have exacerbated this decline and indicated concretely the members' diminished role in FINRA's governance. The first event was the establishment of class voting, which had the effect of diluting the members' voting power and relegating them to a minority status on the Board. (118) Historically, the NASD met its statutory duty to "assure a fair representation of its members in the selection of directors" (119) by following a policy by which all members were entitled to vote on 15 of the 17 positions on the Board (120) As part of the reorganization, the size of the Board was expanded to 23 governors, which were divided into classes for voting purposes. (121) Eleven seats were set aside for public governors (i.e, governors who were unaffiliated with any FINRA member), and two seats were allocated to the staff Of the Board seats apportioned to the members, three were given to "small" firms, (122) three were allocated to "large" firms (123) and one seat each was given to "mid-size" firms, (124) NYSE floor brokers, independent dealer/insurance affiliates, and investment companies.
In 2009, PUNKA received permission from the NEC to increase member dues and assessments substantially in order to offset a loss in 2008 of $568 million in its investment portfolio and a projected decline in regulatory fees. (125) Many members (primarily "small" securities firms) objected that the fee proposal was unreasonable in light of the difficult economic climate for the securities industry, but FINRA asserted (with obvious success) that its members' economic difficulties could not stand in the way of providing FINRA with the necessary financial resources to fund its regulatory activities. (126) In 2010, the Board rejected a proposal to give members the right to cast a non-binding "say-on-pay" vote in connection with FINRA's executive compensation, (127) in spite of the fact that the proposal received overall membership support, especially among FINRA's "small" members. According to Richard Ketchum, FINRA's CEO, the Board believed the proposal "raised serious problems for FINRA because of its potential to create the perception that regulated entities had the power to improperly intimidate regulatory staff." (128) This explanation mischaracterizes the relationship between the staff and FINRA's members (129) and runs contrary to the SEC's philosophy of corporate governance. (130) Moreover, in view of the public scandal created by the NYSE's payment of nearly $200 million in compensation to its CEO, Richard Grasso, over a multi-year period, (131) the unwillingness of FINRA's Board to be flexible about discussing its executive officers' compensation packages is impolitic and threatens to erode whatever goodwill and political support it has accumulated since its reorganization in 1996.
2. Rulemaking, Enforcement and Member Discipline
The diminution of members' influence is also evident in the context of FINRA's rulemaking and its member discipline. Members have no authority to approve or disapprove FINRA rulemaking proposals or rule interpretations. (132) FINRA's Regulation Policy Committee, which was established as part of the reorganization, is composed of a majority of non-industry members. (133) In fact, "FINRA staff can and does present proposed rules and interpretations to the Board that are opposed by [member] firms." (134) In the case of enforcement proceedings, the staff has sole discretion to decide which matters to investigate and prosecute. (135) FINRA's disciplinary process, once driven primarily by member firm representatives, is now almost entirely driven by FINRA's staff. (136) Disciplinary hearings that were conducted for many years by the members in an informal "business-like" manner have given way to proceedings conducted by professional hearing officers in quasi-judicial settings. (137) Appeals of disciplinary sanctions are now heard by the National Adjudicatory Council (NAC), which is equally balanced between individuals who are in the securities business and non-industry representatives. (138)
C. A Brief Profile of FINRA's Finances
FINRA is funded in large part by member dues (which depend for each member upon its annual gross revenues) and separate member assessments (which are based upon the number of registered representatives it employs). (139) It also earns fees from several other sources, including user fees (e.g., fees for qualification exams and charges to review members' advertisements and corporate finance filings); fees collected in connection with FINRA's dispute resolution services; transparency services fees (which represent charges for its TRACE reporting system and its quotation display facility); and contract service fees (which represent surveillance, monitoring, technology development, and other services performed on a contract basis for various stock and options exchanges). (140) It also earns interest, dividends, and capital gains (if any) from its sizeable investment portfolio, receives fines resulting from disciplinary actions it brings against members and/or their registered employees, and collects transaction charges that it remits to the SEC pursuant to Section 31 of the Exchange Act. (141)
FINRA has a considerable amount of financial resources As of December 31, 2010, its total assets were approximately $2.2 billion, an increase of about $159 million from the comparable period in 2009. (142) Its operating revenues in 2010 (excluding transaction charges and fines collected in disciplinary proceedings) were almost $808 million, compared to $708 million in 2009 and $779 million in 2008. (143) Consolidated net income in 2010 was $54.6 million. (144) In 2009, it was $48.6 million, as opposed to a loss of $693.6 million in 2008 that was attributable largely to investment losses. (145) FINRA had $50.1 million in net investment gains in 2010. (146) The total return of FINRA's investment portfolio from December 31, 2003 to December, 31, 2009 (net of the $568 million loss in 2008) was $252 million. (147) FINRA also generates substantial cash flow from its Operations. (148)
D. Measuring the Value of Membership in FINRA
When the NASD registered with the SEC in 1939 as a national securities association, membership was voluntary. The securities firms that initially joined the NASD did so because the financial advantage to them of membership outweighed their costs of complying with the NASD's rules and the restrictions on their business activities contained in these rules. (149) For large securities firms that regularly underwrote fixed price public stock offerings, membership was attractive because the NASD permitted its members to establish a "firm price" in connection with their underwritings. (150) Underwriting syndicates could therefore be formed without regard to the anti-trust laws that might otherwise have required syndicate participants to sell in price competition with each other. (151)
For smaller firms, an NASD membership "was more a matter of indifference." (152) Many firms did not join the NASD, either because they were opposed to compulsory membership in a trade association or believed the cost of membership (including the cost and inconvenience of complying with the NASD's rules) outweighed any advantage of membership for them. (153) When Congress became frustrated that many firms were avoiding self-regulation by not joining the NASD, it amended the Exchange Act by adding a provision that subjected non-NASD member broker-dealers to an "NASD-like" SEC rule administered by the SEC in a program that came to be known as "SEC Only," or "SECO." (154) A large number of broker-dealers thereafter declined to become an NASD member and became subject instead to SECO. From the SEC's perspective, this alternative arrangement did not work out well. In 1983, Congress responded by making NASD membership mandatory for virtually all brokers and dealers that conduct a securities business in the United States. (155)
Several of FINRA's regulatory initiatives have imposed (or threaten to impose) significant compliance costs on its members (especially smaller firms that lack the financial resources of large firms). For example, in 2002, the NASD began to require its members to report real-time price data for all secondary market transactions in corporate bonds through FINRA's "TRACE" Reporting System. (156) On March 1, 2010, FINRA expanded TRACE to include debt issued by Federal Government agencies and Government-sponsored enterprises, as well as primary market transactions in eligible debt issues. (157) The "Manning Rule" has been extended to every NASD member, regardless of whether the firm is trading as a market maker. This rule expansion in all likelihood requires costly operational enhancements by firms whose trading activities require compliance with the rule. (158) In addition, FINRA has received the SEC's permission to extend the reporting requirement of its OATS audit trail system to all National Market System securities on all national securities exchanges. (159) The average one time initial cost per member is estimated to be approximately $1.5 million. Ongoing maintenance will add to these costs. Finally, FINRA has recently proposed to establish a registration category for certain "back office" operations personnel, with its own qualification exam and continuing education requirements. (160) If the SEC approves the proposal, FINRA members (particularly small members) can be expected to face significant administrative challenges implementing such a registration regime.161 Whatever overall regulatory benefits accrue from the initiatives described in this paragraph, they impose (or are likely to impose) onerous economic burdens on a significant number of FINRA's members, particularly small members that lack the financial resources of FINRA's large members. if membership in FINRA were optional, these firms would in all likelihood elect not to join FINRA and thereby avoid the costs of these initiatives.
FINRA has often been criticized as a "private club," an elite group of securities firms that voluntarily come together with the primary purpose of protecting, promoting, and enhancing their collective economic interests. (162) This label, though once accurate, no longer applies to FINRA. There is no genuine community of interest among FINRA's members. FINRA's membership is large and geographically diverse, with different business models, client bases, and amounts of capital. (163) Since FINRA must accept as a member any securities firm that satisfies basic legal standards, there is no exclusivity to being a FINRA member. (164) With the separation of the NASD and NASDAQ, there is no cachet, privilege, or overall economic benefit associated with FINRA membership. (165) While FINRA would likely assert that membership in its organization fulfills the statutory objective of ensuring that broker-dealers are collectively subject to financial responsibility and business conduct oversight (which prevents one member from undercutting another member by engaging in unethical practices or behaving in a financially irresponsible manner), the SEC could fulfill this objective just as effectively. From the perspective of most broker-dealers, the inability of FINRA's members to control the organization's governance and participate meaningfully in its regulatory activities hardly makes FINRA the type of organization they would want to join if membership in FINRA were voluntary.
E. Assessing the Cost of FINRA's Tax Exemption to American Taxpayers
Richard Ketchum, FINRA's Chairman and CEO, claims that FINRA is not financially dependent upon American taxpayers because its funding comes primarily from membership dues and assessments. (166) In a 2008 Treasury report advocating a modernized financial regulatory structure, former Treasury Secretary Henry Paulsen asserted that SRO self-funding "results in significant savings to taxpayers." (167) Since SROs obtain most of their revenue from members, Paulsen regarded SRO funding as "even ... more flexible than that of government regulators, which typically depend upon Congress and an annual appropriations process." (168) It is surprising that neither Ketchum nor Paulsen alluded to FINRA's federal tax exemption, which constitutes a substantial burden on American taxpayers.
Assessing the cost of FINRA's tax exemption is not a straightforward process. The Congressional Joint Committee on Taxation and many tax practitioners use the concept of "tax expenditures" to measure the budgetary cost of particular tax preferences. Tax expenditures are provisions in the Code (and certain state tax laws) such as exclusions, deductions, exemptions, and credits that are designed to encourage certain types of activities to help taxpayers. (169) These provisions effectively reduce the amount of tax revenues to the Federal Government (and to state governments) and are deviations from the basic structure of taxation. (170) For example, the base of the sales tax includes all retail sales to consumers. If an exemption is enacted for sales of energy conservation equipment, it is an exemption from the sales tax base. The sales tax is not collected because the exemption is regarded as a tax expenditure. (171)
Very little about tax law is uncomplicated, so it should come as no surprise that certain tax exemptions and deductions that appear on their face to be tax expenditures are not. Thus, certain income of for-profit passthrough entities is exempt from corporate income tax. (172) The income of sole proprietorships, S corporations, and partnerships is taxed at the individual level, not the entity level. (173) Certain other entities are entitled to deduct dividends paid to shareholders and do not pay tax on the amount of the deduction. (174) Since any entity can organize itself as a pass-through vehicle and thereby benefit from the transfer of income tax liability to the individuals that in actuality constitute the entity, the tax reduction benefits to the pass-through entity are not considered to be tax expenditures. (175) For the same reason, the exemption under Section 501(c)(6) of the Code is not regarded as a tax expenditure. (176) Moreover, despite mutual benefit organization members' right to deduct their dues and assessments as ordinary business expenses under Code Section 162, this deduction is not regarded as a tax expenditure because it is a normative element in the base of our income tax system. (177)
Professor Daniel Halperin has proposed a different analytical tool by which the cost of a business mutual's tax exemption can be determined. Halperin begins by observing that member contributions to an association (in the form of dues and assessments) are generally deductible as a business expense. He then postulates that some portion of these deductible contributions may not be spent by the association until some future time period. (178) Halperin observes that if the member itself performed an activity covered by its dues and expenses instead of having the association perform it, a portion of the deduction amount would be deferred until the point of expenditure. If, however, dues are regarded as the member's current expense irrespective of when the association spends it, he notes that deferral occurs at the association level. (179) Since dues and assessments might not be taxable until a future tax period, Halperin reasons that the failure to tax such income when received results in a tax deferral benefit for the association. (180) Because our tax system must "impose the same tax burden on group activities that would apply if similar activities were conducted by the association's members individually," (181) Halperin believes that there is no reason to allow a deferral benefit simply because member contributions are used for future expenses. (182)
Effective January 1, 2010, a large increase in FINRA members' dues and assessments went into effect. FINRA estimated that it would collect an additional $73 million as a result of this increase, so that the amount collected from dues and assessments in 2010 would be $283 million rather than the $210 million collected in 2009. (183) FINRA's actual total 2010 revenues from member dues and assessments increased only by $67.7 million. (184) Applying a 35 percent federal corporate income tax rate to the actual amount collected in 2010 from dues and assessments (i.e., a before-tax income of $278 million), the resulting annual cost to taxpayers of the deferral benefit is approximately $97 million. (185) This amount is magnified by FINRA's exemption from Delaware's corporate income tax. As the securities industry returns to profitability and sustained growth, the cost of the deferral benefit is likely to increase substantially.
At a more practical level, FINRA's 501(c)(6) exemption expands its own financial resources by allowing FINRA to keep most of the revenues it collects from its various income-producing activities (including income from interest, dividends, and capital gains). As noted earlier in this article, from 2003 to 2009, FINRA's investment portfolio was used to support $293 million in regulatory expenses and to provide $326 million in discretionary cash rebates to FINRA's members. (186) These amounts would have been substantially reduced had Federal corporate tax and Delaware corporate tax been payable on FINRA's investment earnings.
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|Title Annotation:||part 1; Financial Industry Regulatory Authority|
|Author:||Orenbach, Kenneth B.|
|Publication:||Virginia Tax Review|
|Date:||Jun 22, 2011|
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