Financial regulation often seems complicated, and the public tends not to care because we may lack context to grasp all of the issues at stake. Still, there is one issue that the public understands: Financial regulators should not take money from the firms under their supervision.

This clear governance principle has not been important for public representatives at the quasi-governmental Financial Industry Regulatory Authority (FINRA). Some of these individuals now have incentive compensation plans from financial services firms.

ADVERTISEMENT

FINRA, an association of Wall Street firms, plays an essential role in regulating brokerage firms and exercises power granted by Congress. Although the promise of Securities and Exchange Commission (SEC) oversight lends theoretical legitimacy to this arrangement, reports from Government Accountability Office encourage the SEC to pay closer attention to FINRA’s governance.

Sadly, the SEC has not vigorously policed conflicts of interest on FINRA’s governing board. FINRA’s structure already cedes significant influence to Wall Street firms because securities industry members elect 10 members to FINRA’s governing board.

To counterbalance industry influence, FINRA itself appoints another 13 persons as public governors — presumably to represent the public. In a report we recently released, we reviewed FINRA’s choices for public governors. Often, few differences separate industry and public representatives.

Several public governors now take money from financial services firms. For example, Rochelle B. Lazarus, a public governor, now holds over $1 million of Blackstone stock. She received it as incentive compensation for her service on Blackstone’s board.

Other public governors serve on the boards of firms with FINRA members as subsidiaries. Others rely on FINRA members to distribute their financial products. These entanglements and incentive compensation plans do not create confidence.

FINRA’s choices for public governors appear puzzling for an organization ostensibly devoted to investor protection. Our current public governors now include the co-president of the world’s largest hedge fund, the chief investment officer (CIO) for The Travelers Companies, Inc. and directors from Blackstone and Legg Mason. These conflicts matter.

Wall Street generally prefers high transaction costs for investors because the transaction costs investors pay create revenues for financial firms. Public governors occupying these dual roles may balk at investor protections that make it harder for asset management firms to bilk investors with high fees.

If new FINRA protections caused investors to pay Wall Street less, FINRA’s member firms would book lower profits. This economic reality now causes many to doubt whether FINRA can lead on investor protection.

But these conflicts may create more dangers than just high fees for investors. They also mean that conflicted public governors will be at their worst when we need them at their best. Consider the issues that William Heyman will face in the next financial crisis:

As FINRA’s chairman, Heyman bears significant responsibility for overseeing FINRA’s response to a financial crisis — a time when the largest losses usually land on Main Street. Despite this heavy load, he also has to worry about his day job as the CIO at Travelers.

In a financial crisis, his attention may skew toward managing risks for Travelers’ $70 billion in investable assets. It also seems unlikely that the co-president of the world’s largest hedge fund will have the time to think much about ordinary investors during next market crash. She will have her hands full with her humongous hedge fund.

These conflicts likely do more than merely undercut confidence — they generate risks for the entire financial system.

To be sure, FINRA faces a difficult task in selecting qualified public governors. Financial regulators need to understand the securities industry, and persons with industry backgrounds will often have a strong grasp of the industry’s workings.

This, of course, does not mean that FINRA now makes the best choices from the pool of knowledgeable persons. To help FINRA improve its governance, we also provided it a list of qualified candidates without the same sorts of conflicts.

If FINRA truly cares about its investor protection mission, it should appoint investor advocates to its board. Surely, someone like Phyllis Borzi, a public servant who led the Department of Labor’s fiduciary rule efforts, would be a more credible investor representative.

If FINRA does not reform itself, the SEC, Congress or courts should step in. One option is to change the process for appointing or removing FINRA’s public governors — giving that power to the SEC.

Hester Peirce, a recent SEC nominee, also has concerns about FINRA. She recently speculated that the Supreme Court might “find FINRA to be unconstitutional because of the SEC’s inability to remove FINRA’s board members.”

On the legislative front, Sen. Cortez Masto (D-Nev.) has also raised questions about conflicts of interest on FINRA’s governing board. In a recent hearing, she questioned whether Randal Quarles was the right choice for the Federal Reserve's vice chairman of supervision role.

The senator had doubts about Quarles because he simultaneously served as one of FINRA’s public governors and on the board of the U.S. Chamber of Commerce, a Wall-Street-funded lobbying organization.

Closer public attention might motivate FINRA to clean up these unsightly conflicts. If we do nothing now, things will be even worse for ordinary investors when the next financial crisis arrives.

Benjamin Edwards is an associate professor of law at the University of Nevada Las Vegas, specializing in business and securities law, corporate governance and consumer protection.

Andrew Stoltmann is the president of the Public Investors Arbitration Bar Association, which aims to promote investor education by providing the public with information about abuses in the financial services industry and the securities dispute resolution process.