FINRA's Ketchum Testifies Before Subcommittee on Oversight and Investigations

On May 13, 2011, Richard Ketchum, Chairman and CEO of FINRA, testified before the House Subcommittee on Oversight and Investigations. Ketchum's testimony related to the changes made at FINRA as a result of the Special Review Committee, established in 2009 by the Board of Governors, which conducted a review of FINRA's examination program as it related to the detection of fraud and Ponzi schemes. Specifically, he focused on the Special Committee's findings relating to the Ponzi scheme perpetrated by R. Allen Stanford. Stanford was behind the orchestration of a fraudulent, multi-billion dollar investment scheme centering on an $8 billion CD program.

Ketchum testified that between 2003 and 2005, the National Association of Securities Dealers—FINRA's predecessor entity—received information from at least five sources claiming that the Stanford CDs were a potential fraud. Despite the existence of these red flags, FINRA did not launch an investigation of whether the Stanford CD program was a fraud until January 2008.

Ketchum testified that FINRA missed a number of opportunities to uncover the Stanford firm's role in the CD scheme. First, FINRA's Dallas office cut off an investigation because they were unsure of the full scope of FINRA's investigative authority and because they believed that the offshore CDs upon which the Ponzi scheme were based were not "securities" regulated under federal securities laws.

Second, FINRA procedures at the time did not set forth criteria for escalation of a matter to senior management or the use of specially trained investigators based on the gravity and substance of the fraud allegations.

Third, FINRA's Dallas staff did not adequately document communications with the SEC, or discussions within FINRA itself, regarding the CD program.

Finally, FINRA at the time did not have a centralized database that gave examiners direct, electronic access to all relevant complaints and referrals associated with a firm. Consequently, no individual FINRA staff member was ever aware of all of the "red flags" related to the Stanford firm.

Following the investigation, the Special Committee made recommendations which sought to remedy the weaknesses revealed at FINRA. Among the recommendations were the following strategic objectives:

(i) greater emphasis should be placed on the detection of fraud;
(ii) potential fraud situations and other situations presenting serious potential risk to investors should be escalated promptly and properly;
(iii) examination staff should be diligent in pursuing potentially serious issues, exercising an appropriate degree of skepticism;
(iv) all FINRA operating units should closely coordinate and communicate in carrying out the examination program; and
(v) FINRA should provide additional resources to strengthen its cause examination program.

As a result of these recommendations made by the Special Committee, Ketchum stated that FINRA made the following changes:

• FINRA created the Office of Fraud Detection and Market Intelligence in October 2009. This group houses the Central Review Group, Office of the Whistleblower and the Insider Trading and Fraud Surveillance teams, and is responsible for the centralized intake and triage of regulatory filings and investor complaints.
• FINRA enhanced its examination programs and procedures in a variety of ways intended to help FINRA better detect conduct that could be indicative of fraud. Some of the enhancements FINRA has made to its examination program are: 1) focusing resources on highest-priority matters; 2) enhanced expertise of regulatory staff; 3) enhanced use of third-party and other information; and 4) multi-year technology enhancement plan.
  
• FINRA has increased communication and coordination with the SEC relative to our respective programs. FINRA and SEC staffs meet routinely to share details about strategic design and tactical delivery of information to the respective regulatory programs of each organization.
  
• In late 2010 FINRA created a new Office of Risk to begin the process of strengthening its ability to identify high-risk firms, branch offices, brokers, activities and products through broader data collection and more comprehensive analysis.
  

Ketchum concluded by stating that these steps will cause FINRA to become a more effective regulator, especially in terms of enhancing its ability to quickly identify and investigate conduct that could indicate fraud or other serious customer harm. A complete copy of Ketchum's statements can be found here. The SEC's litigation release with regard to the Stanford Ponzi scheme can be found here.