PFGBest Update: The Place Where Logic Goes to Die

Not a day has passed since the PFGBest scandal hit that we haven’t received an email from someone asking about suing the NFA. We definitely get the sentiment. We are not lawyers and will not purport to be, but unfortunately, based on the research we’ve conducted, our response is likely to further your rage: no, you can’t.

The NFA, as a self-regulatory organization (SRO) and quasi-governmental actor, enjoys a wide breadth of immunity. The analogy frequently referenced to justify this immunity is that of a judge. If a judge could be sued based on rulings made, they could not effectively execute their responsibilities from the bench for fear of retribution. In some ways, we’ll agree with granting a limited amount of immunity to SROs for the same reasons. In an era where the budgets of regulatory bodies frequently amount to little more than a drop in the bucket compared to the resources available to major financial institutions in their legal department alone, the ability to sue in response to disciplinary action might cripple any regulator’s ability to do their job.

But there is a distinction, in our opinion, between the amount of immunity needed to facilitate regulators, and the amount that fosters apathy. If a regulatory organization cannot be held accountable for their failure to do their job – as is rapidly becoming the apparent case with the PFGBest fiasco – maybe there is no incentive to do your job to begin with, let alone do it well.

Some might argue that there are other forms of checks and balances that can be leveraged, but we’re left wondering what those are. The CFTC should be monitoring the NFA, but with a budget of only $200mm a year to handle all manner of derivatives across a colossal stretch of financial landscape, they don’t exactly have the resources to do so effectively. Congress could always revoke their charter, but such a high profile charter revocation would be unprecedented, and unlikely (though we won’t give up hope of an investigation). The President, theoretically, could intervene, but such a move would, again, be unprecedented. In many ways, the judiciary is the only real, appropriate avenue that could be used to seek recompense for regulatory shortcomings, but that door has been shut.

Unfortunately, these circumstances were exacerbated by Standard Investment Chartered, Inc. v. National Assoc. of Securities Dealers. In this case, it was alleged that the National Association of Securities Dealers, or NASD, had misstated material facts in the process of consolidating with FINRA, resulting in substantial gain for the NASD officers and limitation of voting rights for their members. The Cato Institute explains the folly and consequences of this decision better than we can:

Remarkably, the Second Circuit held that a lawsuit against NASD for the alleged fraud could not proceed because the defendants had sovereign immunity. Yes, SROs should be immune for their actions as quasi-government regulators. For example, immunity is appropriate for government actors like judges, who must have some protection from private suit to do their jobs properly. But judges are not immune for things they do in their private lives — they can be sued just like anyone else. The Second Circuit, however, held that SROs, which have expansive and varied powers, enjoy absolute immunity even for actions that are merely “incident to” their regulatory duties. That is, suits involving private corporate actions cannot proceed if they are incident to actions taken in a governmental capacity. In this case, the court found that the voting-rights changes were “incident to” FINRA’s regulatory activities because they were part of a plan to make a larger entity that would also have regulatory duties. This case raises serious constitutional issues about the role the judiciary plays in ensuring that SROs remain faithful to their delegated duties of protecting investors and the public. Because SROs are quasi-private actors, they have incentives to act in their own best interests — rather than in the public interest — and they do not have to be as transparent as fully public agencies. Further, the executive branch, including the SEC, has failed to hold SROs accountable for their self-serving behaviors. As we see from this case, the judiciary provides the sole opportunity for SRO accountability.

Yep, the courts determined that, not only can you not hold an SRO liable for failure to do their job – you can’t hold them accountable for decisions made in the private sphere, either. So, even in a world where some of the more outrageous allegations flying around about the NFA and possible internal fraud held water (we don’t think they do, but that might just be wishful thinking), theoretically, they may never have to face the music.

In a twisted way, we suppose it’s comforting that it’s not just the futures industry languishing under the thumb of their SRO. Truth be told, issues with the SRO model have been known for some time, particularly on the securities side, but little has been done to address the pitfalls. As of late, though, criticism of FINRA has been nearly deafening, especially with legislation being considered that would greatly expand their power. Many of the laments expressed in relation to the proposed expansion resonate on the futures side of finance, too. In June 6th testimony in front of the House Committee on Financial Services, David G. Tittsworth, Executive Director and Executive Vice President of the Investment Adviser Association, summed it up pretty well:

The self-regulatory organization model of regulation suffers from significant flaws.  SROs are not accountable to Congress or the public, and are not subject to requirements related to the Administrative Procedure Act (“APA”), the public records laws, due process, the Freedom of Information Act, cost-benefit analysis, and other critical protections.  Moreover, the  effectiveness of SROs has not been demonstrated.  These deficiencies in the SRO model have been identified in meaningful reports and studies, including those from the SEC staff, the Government Accountability Office (“GAO”), the U.S. Chamber of Commerce, and the Boston Consulting Group (“BCG”).

Actually, his testimony in general was pretty spot on – we recommend reading it, along with the amicus curiae brief filed by CATO in Standard Investment Chartered, Inc. v. NASD. But the general thrust of it is this:

Self-regulatory bodies are given the power to interpret and enforce rules at their sole discretion, all paid for by the governed, with no accountability for their actions.

More sound reasoning from the powers that be. Again, we’re not lawyers, so maybe we’re missing something here, but if we’re not, it doesn’t take a law degree to know this is just a bad approach to effective regulation. It’s not often that we find ourselves on the same side of a battle as stock guys, but this time around, we see what they see – a breakdown in logic and common sense when it comes to self-regulatory bodies.