FINRA Chairman & CEO Rick Ketchum told Congress what lessons FINRA learned from the Allen Stanford Ponzi Case.  Mr. Ketchum began his testimony before a House Subcommittee that was dealing with Financial Services Oversight and Investigations, with these words: 

Unfortunately, we are here today because of a massive fraud that has had tragic results for many investors.  No regulator can feel good about its performance regarding Stanford.  ... FINRA clearly could have done better and we deeply regret we did not.  In the wake of Stanford, FINRA ... searched for ways to more effectively uncover misconduct, especially fraud, and enhance our programs to better protect investors.

    The Stanford Case, and FINRA's Missed Opportunities.   Between 2003 and 2005, NASD received information from at least 5 sources claiming that the Stanford CDs were a potential fraud.  The most significant was a July 2005 5-page referral letter from the SEC's Fort Worth office that explained in detail why the purported investment strategy of the offshore bank could not have produced the consistently high returns being paid by the CDs.  According to this letter, "as of October 2004, [the Stanford firm's] customers held approximately $1.5 billion of CDs."  Despite the existence of this "red flag" and others, NASD, then FINRA, did not launch an investigation of whether the Stanford CD program was a fraud until January 2008. 

Missed Opportunity 1.   Dallas office staff curtailed a 2005 investigation prompted by the SEC referral letter because of a concern that the offshore CDs were not "securities" regulated under federal securities laws. Facts surrounding the decision not to pursue the fraud investigation indicated that certain of FINRA's examination staff at the time were unsure of the full scope of the organization's investigative authority, were reluctant to pursue investigations where jurisdictional questions arose and were not adequately trained to identify alternate bases of jurisdiction.

Missed Opportunity 2.   FINRA procedures at the time didn't 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.  Additionally, the Dallas staff did not provide the SEC referral letter to FINRA senior management in Washington, D.C., until December 2008.  As Mr. Ketchum highlighted later in his testimony, FINRA has since implemented a comprehensive prioritization system that ensures such matters will be immediately brought to the attention of senior staff and investigators.

Missed Opportunity 3.   FINRA's Dallas staff did not adequately document communications with the SEC, or discussions within FINRA itself, regarding the CD program.  

Missed Opportunity 4.   During this period, FINRA did not have a centralized database that gave examiners direct, electronic access to all relevant complaints and referrals associated with a firm.  As a result, no single FINRA staff member was ever aware of all of the "red flags" related to the Stanford firm that are discussed in the report. 

    Examination Program Enhancements.   A  Special Review Committee analyzed the entire Stanford Case and, among other things, offered recommendations on how FINRA could enhance its examination programs and procedures - so as to help staffers better detect conduct that could be indicative of fraud.  It is our goal that exam teams focus most on those areas at firms that pose a real risk to investors. Here are highlights of the enhancements that FINRA made to its examination program. 

1.  Focusing Resources on Highest-Priority Matters.  

• Prioritization of regulatory resources. In response to those concerns, FINRA staff created an "Urgent" designation for those regulatory matters posing the greatest potential for substantial risk to the investing public. Urgent matters are expedited, and then reviewed to make certain that the right level of resources and expertise are assigned to them, as well as to ensure there is coordination and information sharing across departments at FINRA.
• The Special Committee identified that the lack of a formal mechanism for the escalation of policy issues created risk within the organization. FINRA issued a new policy designed to enhance the process for the escalation and documentation of complex legal and policy issues. This enhancement ensures that senior management is apprised of significant, complex and novel legal issues arising in the course of examinations and investigations; expediting the formulation of an organizational position on such issues; ensuring issues and decisions are appropriately documented by staff; and allowing regulatory staff access to these decisions through a company-wide, centralized searchable database.

2.  Enhanced Expertise of Regulatory Staff.

• FINRA has increased the number of staff in its district offices who are tasked with in-depth and ongoing understanding of specific firms, including increased real-time monitoring of business and financial changes occurring at a firm. This expansion has enhanced our staff's ability to evaluate available regulatory information and to target examinations based on that information.  We have added 35 new positions specifically dedicated to this surveillance function.
• We have also redesigned an existing program to identify FINRA staff with expertise in specific subject matters who will lend their expertise to examinations, investigations and litigation, and assist with the training and development of staff. In addition, these individuals may be called upon to participate in the risk assessment process for individual firms with an active business in their area of expertise.
• In addition, FINRA designed and conducted training for examination staff focused on fraud detection and established a framework for regulatory operations staff to complete continuing education instruction in selected topics. The continuing education requirement is part of the broader regulatory operations training program, and is intended to complement existing programs and serve as a mechanism by which we can ensure that staff is kept current on topics that are core to our regulatory programs and relevant in the current regulatory landscape.  

3.  Enhanced Use of Third-Party and Other Information.

• FINRA has enhanced its use of third-party and other external information to inform our regulatory programs. We have established procedures for third-party verification of firm-provided information, particularly as it relates to customer assets. FINRA passed a rule to ensure that it can independently verify assets maintained by a FINRA-regulated firm at a non-FINRA-regulated institution. The rule provides that a FINRA-regulated firm may not custody assets at a non-FINRA-regulated institution that fails promptly to provide FINRA with written verification of assets. We are also working with third parties to test available data sources that may be incorporated into our programs. 
• FINRA also now requires high-risk firms to submit financial data on a more frequent basis. As part of our effort to obtain more timely regulatory information, FINRA now requires all firms assessed as high risk to submit financial data, including income statements, on a monthly, as opposed to a quarterly, basis. 
• In addition, in 2009, FINRA instituted a process to review all employer-employee related statements of claim filed with FINRA Dispute Resolution, in addition to customer-related statements of claim that FINRA had previously reviewed and continues to review. FINRA then expanded that process to include review of all amended claims and additional claims related to arbitration matters. These include counter claims, cross claims, answers to employer-employee related matters and third-party claims.

4.  Multi-Year Technology Enhancement Plan.

• A number of the initiatives FINRA is undertaking to strengthen its programs and make them more investigative are technology-based. One of those initiatives was the development of an enterprise search tool, which allows FINRA staff to access internal regulatory intelligence by conducting searches for information and documents regarding firms, individuals, products or other significant regulatory topics from across FINRA's regulatory areas.
• Longer term, we are in the midst of an initiative that will overhaul existing applications and tools used to conduct examinations and reviews by FINRA regulatory staff. The project will create a new integrated examination platform, and introduce new and expanded tools and services that will provide FINRA regulatory staff greater capability and flexibility to collect, access and share data, information and regulatory intelligence across the organization.

5.  Coordination With the SEC.

• In addition to the initiatives listed above, 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 our respective regulatory programs. FINRA and the SEC also meet periodically to discuss risk assessment, including models to measure characteristics of risk of broker-dealers, branch offices and registered representatives. 

6.  Risk-Focused and Risk-Defined Exams.

• FINRA continues to reshape its exam program, and I would like to highlight a few of the ways we will be transforming our program in the months ahead. In late 2010 we created a new Office of Risk to begin the process of strengthening our ability to identify high-risk firms, branch offices, brokers, activities and products through broader data collection and more comprehensive analysis. FINRA will require more information to help us better understand firms' business models, including information about business activities, product mix and customer base. This information will be used to better understand the risks that exist for individual firms and to tailor regulatory responses to those risks. 

For the complete testimony, go to:   [FINRA Speeches, Ketchum, 5/13/11]