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Commentary: A Gap in Regulation of the OTC Markets
Traders Magazine Online News, January 26, 2010
On Dec. 17, the SEC released a proposal by FINRA to clarify FINRA's authority to process corporate actions by issuers with securities traded in the over-the-counter markets. As rule changes go, this one is fairly obscure. It is therefore strange how many calls I have received from clients who are outraged about this proposal.
Maybe this is one more sign of the times we are living in. Everyone seems to be angry about something.
FINRA, as has been pointed out by the courts on any number of occasions, is the primary regulator of the OTC markets. It can be argued that this was the reason it was instituted in the first place. The fact is that FINRA exists to correct a Congressional oversight.
Congress created the Securities Exchange Act of 1934 to regulate the securities markets, which to the Congress of 1934 meant the exchanges, and most especially The New York Stock Exchange. That is why it was called the "Exchange Act," rather than the "Securities Markets Act" or some other more expansive title. The idea was that stock exchanges operating in the U.S. would become self-regulatory organizations of their members, as well as the markets represented by the exchanges. Among other things, this meant that the industry would pay for its own regulation, a theory of regulatory taxation that remains a recurring theme in 2010.
This theory of regulation, however, left to one side the vast OTC markets. In 1934, the OTC markets included most corporate and government bonds and all the securities derivatives markets. Many of the brokers and dealers who worked in these markets were not members of any exchange, and therefore not subject to self-regulatory organization, something Congress discovered to its horror when the Puts and Calls Association of New York showed up a few years later to lobby on behalf of the options markets.
To correct this oversight, Congress created Section 15A of the Exchange Act in 1938, which instituted something called a "national securities association." The National Association of Securities Dealers, Inc., FINRA's predecessor, was established in 1939. The NASD was the only one of its kind until the National Futures Association was created sixty years later.
FINRA regulates the OTC markets by supervising the conduct of its broker-dealer members, and indirectly, the customers of broker-dealers. This regulation is memorialized in FINRA's Rules of Fair Practice, and more importantly perhaps, through the Uniform Practice Code. The UPC, while little known outside the back office, regulates clearance and settlement of trades in OTC securities, as well as dividend and interest payments, including who is entitled to receive them.
Unfortunately, this regulatory design contains a flaw that raises its ugly head from time to time.
Securities cannot be traded on a national securities exchange unless their issuer has entered into a listing agreement with the stock exchange. Listing agreements enables an exchange to regulate the conduct of the issuers whose securities are traded there, which means that the stock exchange is also the self-regulator of its listed issuers. As is the case of the broker-dealer members of an exchange, the issuer of listed securities pays for the cost of its own regulation by the exchange.
In contrast, issuers of OTC securities are not regulated by FINRA. Since FINRA does not have any contractual relationship with any issuer, and Congress has not granted it the authority to regulate issuers, FINRA lacks any ability to discipline miscreant issuers.
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