It is not every day that a company bungles something so badly that it has to turn to a regulator for help to clean up its mess. But that is what the Nasdaq stock market has done with the Financial Industry Regulatory Authority following its blunders in Facebook's $16-billion initial public offering.
The move is causing raised eyebrows because of the long and intertwined relationship between the exchange and Wall Street's industry-funded regulator.
Market makers say Nasdaq OMX Group Inc owes them at least $115-million and probably much more because of costly delays in processing orders when Facebook Inc made its debut on the exchange on May 18. Nasdaq has only offered $40-million in compensation for the losses, and most of that is in rebates on trading rather than in cash.
Nasdaq, which says software glitches caused the delays, has asked FINRA to review the client transactions and claims. But some industry lawyers and compliance experts on Wall Street disapprove.
Conflicts of interest are inevitable and could lead to questions of fairness, say observers and people familiar with both entities.
For its part, FINRA sees the review and subsequent report as a "natural extension of the services we provide to Nasdaq under our regulatory agreement," spokeswoman Nancy Condon said in response to Reuters' questions about possible conflicts. "We make decisions every day that could have an impact on Nasdaq."
A Nasdaq spokesman declined to comment.
FINRA's involvement in the process is "a mistake," said a person familiar with the regulator's operations.
Despite a longstanding reputation for integrity, Richard Ketchum, the Wall Street watchdog's chairman and chief executive officer, "should have said no" to Nasdaq's request for FINRA's services, the source said, because the relationship is "heavily conflicted."
Among those conflicts that experts cited: The exchange pays FINRA fees to be – regulated. FINRA's role as a regulator includes monitoring the exchange's trading activity and providing surveillance for insider trading – services that are remnants from when Nasdaq was owned by FINRA's predecessor, the National Association of Securities Dealers, or NASD.
In 2000, Nasdaq members voted to spin off the exchange after a widespread and historic price-fixing scandal that led to industry reforms. FINRA continued to have an ownership interest in Nasdaq until 2006, according to regulatory filings.
FINRA is also a Nasdaq customer, relying on the exchange's technology to operate a unit that provides various trade and quote data to brokerages so they can comply with reporting rules. And Nasdaq's annual report says the company subleases roughly 115,000 square feet of its downtown New York headquarters space from FINRA.
Mr. Ketchum spent a total of 12 years with NASD and Nasdaq. He left his post as Nasdaq's president a month after current CEO Robert Greifeld arrived in 2003.
Mr. Ketchum is not the only top financial regulator who has longstanding ties with Nasdaq. U.S Securities and Exchange Commission Chairman Mary Schapiro is a previous head of NASD and FINRA.
Neither FINRA nor Nasdaq would disclose how much money changes hands between them. But Nasdaq's bill for regulatory services could be in the tens of millions of dollars, based on a review of recent FINRA annual reports.
FINRA's role in the Facebook IPO will include determining the total value of all valid claims against Nasdaq. The exchange's compensation program is subject to approval by the SEC, which is also taking a broad look at Nasdaq's handling of the IPO. It is unclear how long the SEC will take to decide if Nasdaq's compensation proposal is adequate.
Recent Nasdaq notices to traders say FINRA has agreed to review the Facebook claims and "related data," using criteria the exchange has already laid out. FINRA will base its evaluation on information from Nasdaq and other details the regulator may request from claimants, according to the alerts.
The process will also include input from International Business Machines Corp, which Nasdaq has brought in to conduct a review of its market systems following the Facebook problem.
Other details are not yet clear.
Deciding who gets what compensation after this analysis could easily put FINRA in the legal crosshairs if aggrieved parties ultimately challenge the outcome in court, lawyers say.
The market makers, which facilitate trades for brokers, say their orders were not executed in a timely fashion and that they were in the dark for hours about how many Facebook shares they owned. They ended up holding stock for clients when they thought they had already sold it, and took losses as the price of Facebook shares fell after initial gains on the first day of trading.
Four market makers – UBS AG, Citigroup Inc., Knight Capital Group Inc. and Citadel Securities – have collectively lost at least $115-million, according to company announcements and industry sources. CNBC has reported that UBS alone may have lost as much as $350-million, although the company has not confirmed that figure.
The concern is not so much that FINRA would intentionally skew its findings, but that allegations of bias by others on Wall Street could undermine the regulator's conclusions, industry observers say.
Questions of fairness are already cropping up on other points. Rival exchanges are concerned about Nasdaq's offer of rebates, which would be an incentive to move business from them.
Moreover, the exchanges have agreements in place to restrict compensation to certain sums, and the Nasdaq offer has already exceeded its own limit of $3-million a month. Some exchanges, whose liability is typically limited to $500,000 a month, are concerned that Nasdaq will set a precedent.
But even critics say FINRA will probably go to great lengths to make the review fair in an effort to avoid risking its reputation. Still, that might not be enough.
"It doesn't pass the smell test," said George Brunelle, a New York-based lawyer who advises brokerages. Even the appearance of conflict could worsen the negative perception of Wall Street among investors, he said.
FINRA should not conduct the review, nor even know about its progress as it occurs, said Mr. Brunelle, former legal head of a surveillance unit of the New York Stock Exchange. The potential for even minimal interaction among Nasdaq and FINRA employees about information either may learn during the process is problematic, he said.
"The SEC is fully qualified to handle this thing on its own, and it should," Mr. Brunelle said.
The SEC, whose mission includes maintaining "fair, orderly and efficient markets," has broad oversight over U.S. exchanges and listed companies. Nasdaq falls into both categories.
An SEC spokesman declined to comment.
Keeping FINRA out of the process entirely would be difficult, though, given the regulatory functions it provides not just to brokerages and Nasdaq, but also for equities and options traded on a host of other U.S. exchanges, including the New York Stock Exchange, NYSE Amex and BATS, an acronym for "Better Alternative Trading System."
"FINRA is such a major player in the industry, it would be very hard for them not to be involved," said James Angel, associate professor of finance at Georgetown University.
The SEC's involvement and the fact that nearly "every law firm in the industry is gearing up for litigation" should at least alleviate concerns that there will be too little investigation into Nasdaq's liability, Mr. Angel said.
FINRA could take some precautions that could make its conclusions more palatable, said former SEC Chairman Harvey Pitt. It could, for example, set up a virtual firewall to prevent people sorting through the Facebook claims from interacting with other officials who may be looking at where Nasdaq's processes or systems may have gone wrong, said Mr. Pitt, who now heads Washington-based consultancy Kalorama Partners.
The SEC's involvement "ought to allay concerns," Mr. Pitt added.
Still, appointing a special master, such as an accountant or academic, to adjudicate the claims may be better, said Lawrence Harris, a finance and business economics professor at the University of Southern California.
The SEC uses a similar process when distributing funds to harmed investors, Harris said.
"It would potentially give at least the perception of more objectivity," said a financial services company's lawyer who requested anonymity because of the issue's sensitivity.