finra

Remarks by Robert Glauber 

Chairman and CEO

(As Prepared for Delivery)

45th Annual Meeting of the National Association for Business Economics

Atlanta
September 16, 2003

 

Thank you, Tim [O'Neill, NABE President]. And thank you all for being here. The last time I had this many first-rate economists listening to me, there was a President named Bush in the White House, great changes were afoot in the Treasuries market, and the U.S. was emerging from a war in the Persian Gulf. However, those economists all worked for the Treasury Department, that President Bush was a much older one, and this Bob Glauber was a much younger one

.

So I'm very glad to know that this is not some kind of time warp -- and I still have the good fortune of drawing a most distinguished economic audience.

 

At the outset, let me say just a word about who we are and what we do at NASD. Because there is still some confusion in the public mind, for example, as between NASD and our former subsidiary, NASDAQ.

 

NASD has worked to bring integrity to the markets and confidence to investors for more than 60 years. Since our creation in 1938, we have become the largest private-sector regulator in the world. Under federal law, every securities firm doing business with the U.S. public is required to be a member of our private, not-for-profit organization. This brings more than 5,300 brokerage firms and over 650,000 stockbrokers and registered representatives under our jurisdiction.

 

NASD provides a critical layer of private-sector regulation between the SEC and the securities industry -- all at no cost to taxpayers. Our duties include registering member firms, writing rules to govern their behavior, examining them for compliance with both our own rules and the federal securities laws, and bringing enforcement -- with teeth -- to those who break the rules. On average, NASD brings well over 1,000 disciplinary actions and weeds out more than 700 unfit brokers and dealers from the securities industry every year.

 

One major enforcement goal for us has been to ensure that the market excesses and abuses of the 1990s bubble are never repeated. Toward this end, NASD has brought cases against some 40 firms and individuals to date for violations in analyst research and initial public offerings alone. 

  • More than a year before the $1.4 billion global settlement with 10 large investment houses, NASD brought a landmark IPO payback case against CS First Boston that resulted in shared sanctions of $100 million.

  • NASD was the only regulator to develop substantive spinning cases that became part of the global settlement. Spinning is doling out hot IPO shares to key executives so as to induce future business.
     
  • We also led the way in filing charges against Jack Grubman, as well as Salomon Smith Barney, for research analyst violations. The firm agreed to pay $5 million in sanctions; Grubman agreed to pay $15 million. And under the settlement, this former telecom mover and shaker will be barred from the securities industry for life.
     
  • NASD likewise brought the first charges against technology deal-maker Frank Quattrone, for failure to supervise his analysts and bankers and for spinning violations.
     
  • The individual charges against dot.com analyst Henry Blodget investigated by NASD and jointly brought with other federal regulators were wrapped into the global settlement. Blodget has agreed to pay $4 million in fines and to be barred for life as well.

And we are by no means done with our efforts. NASD is continuing to investigate and develop cases against those who have violated their supervisory or individual responsibilities to the investing public.

 

This kind of hard-nosed enforcement has been a big part of NASD's mission in recent years. And this approach is what I'd like to focus on with you this afternoon. Because some have wondered how NASD's tough enforcement philosophy squares with another fundamental value that we share - which is a deep understanding of the benefits of free markets.

 

The answer -- one that will be familiar to this audience -- is that classical economics teaches us time and again to prefer regimes with relatively few rules, rigorously enforced, over regimes having many rules, lackadaisically enforced.

 

This is far more than a matter of theory. To the contrary, it is one of the central reasons why self-regulation has contributed for more than 60 years to making the U.S. financial markets the most liquid, developed and emulated in the world. But self-regulation only redeems its promise if it helps maintain a regime of not more but better rules, better enforced.

 

This is precisely what NASD under my leadership has sought to do. For instance, when I say "better rules," I have in mind such major ongoing initiatives as our Rule Modernization Project, which employs an eminent group of economists to help us ensure that across the entire NASD rulebook, the benefits of all our rules fully justify their burdens. This allows us to reassess our rules rigorously and continually to see that they provide maximum benefit while minimizing regulatory costs.

 

But while intelligent self-regulation is mindful of the burdens it imposes, it is emphatically not about "taking it easy" on the industry being regulated. Far from it. Indeed, any such approach means the death-knell of true self-regulation -- as evidenced by the experience of the accounting industry.

 

In that industry, it's quite telling that never in the history of regulatory "peer review" by the major firms of one another's auditing work did they give anything but a passing grade to one another. Not once. In light of that experience -- and the swelling tide of scandals and earnings restatements in the 90s -- it's no coincidence that many of the most sweeping changes in Sarbanes-Oxley involve oversight of the accounting industry.

 

NASD understands very clearly that self-regulation would not long survive without our manifest willingness to enforce our rules and the federal securities laws vigorously -- regardless of whether we are disciplining a sole proprietor or one of the most powerful firms in the industry.

 

That is our mandate. That is a consequence of the authority we have to fine and even expel firms and individuals from the industry. And that is utterly consistent with my life-long belief in free financial markets as essential for spreading prosperity and opportunity throughout our country and across the globe.

 

Now more than ever, we must heed the advice of the British judge who said in 1923, "Justice should not only be done, but should manifestly and undoubtedly be seen to be done." After all, it is human nature to want proof that a bad situation has been set right, and to want to see that wrongdoers are in fact being punished for their transgressions. This is not a matter of investor vindictiveness, but of rebuilding investor confidence.

 

And that can not be done by punishing wrongdoers more lightly or more quietly than the rules and public interest both demand. For the confidence we seek to restore is not the mania of the bubble, but the justified confidence of a public that can see that the problems revealed during the bubble are in fact being corrected. And such confidence cannot be regained if the public believes that in a crunch, the industry's main self-regulatory bodies cannot be relied on to come down on their members as hard and as often as the facts and circumstances warrant.

 

This theme is explored with scholarly rigor in a fascinating book published this year by two University of Chicago economists and staunch free market adherents, Rajan and Zingales, entitled Saving Capitalism from the Capitalists: Unleashing the power of financial markets to create wealth and spread opportunity. The authors point out that one of the greatest threats to free markets is not only the plight of the economic losers that such markets inevitably produce, but also of the political and regulatory tendency to coddle the influential incumbents that occupy key positions in and harm the integrity of the markets.

Translated from the language of economics, the point for us boils down to this. If NASD were to investigate and punish market miscreants less than vigorously, we would be doing the securities industry no favor. Because we would be compromising the only truly priceless asset any of us can hope to build on in today's market climate. And that is investor confidence.

Moreover, if we don't provide tough and effective enforcement of existing rules, that would lead inevitably to the demand for more rules and an increase in the already heavy regulatory burden.

 

So you understand how much importance NASD places on tough and evenhanded enforcement. But as critical a role as enforcement plays today, it is but one means to an end. The broader end we seek is compliance. And "compliance" represents an entire continuum of actions -- from the earliest and most voluntary compliance steps taken by firms in-house, to the tardiest and most coerced steps to settle or litigate charges brought by NASD and other regulators.

 

Private-sector regulation also protects investors and serves market integrity by actively encouraging industry conduct that falls somewhere in the broad middle of this continuum I have described. That is to say, we do many other things, besides enforcement litigation, to spur the industry to live up to its compliance obligations.

 

A prime current example is NASD's work to get investors the volume discounts they deserve off of the front-end loads in their mutual fund investments. This widespread problem of "breakpoints," as it's called, was incidentally first discovered not in some dramatic way but simply as the result of the thorough, smart performance of routine examinations by NASD's Philadelphia District Office.

 

On the broader key subject of mutual funds, NASD also has done a great deal of investor education as well -- issuing some half a dozen Investor Alerts this year on A vs. B vs. C share classes and the like. We have introduced an innovative "Mutual Fund Analyzer" on our Web site, www.nasd.com. And we have worked with the industry to make changes in the way firms conduct business, to avoid a repetition of the problems we have found.

 

All of that is not to say enforcement has been unnecessary in this area. Far from it. On mutual fund issues, NASD has brought a large number of enforcement cases -- some 60 this year and 200 over the last 2-1/2 years. And this afternoon I can announce an important addition to this enforcement record.

 

NASD today has censured and fined Morgan Stanley $2 million for conducting prohibited sales contests for its brokers and managers to push the sale of Morgan Stanley's own proprietary mutual funds, as well as a much smaller number of variable annuities. The estimated value of the NBA finals tickets, resort trips, coveted concert tickets and other non-cash prizes awarded in the contests totaled $1 million. We uncovered 29 such contests, conducted at the branch, regional and national level.

 

The obvious potential result of such contests is that they give firm personnel a powerful incentive to sell products that serve the broker's interest in receiving valuable prizes, rather than the investment needs of the customer. And one of the most troubling things about this case is Morgan Stanley's failure to have any systems or procedures in place that could detect or deter the misconduct, which clearly violated NASD's existing rules on non-cash compensation.

I'll return to this point in a few minutes.

 

The point about all the examples I have discussed is frankly not who took the initiative or should get the credit. Rather, it is the fact that investors' rights are being vindicated, their interests protected and the integrity of the markets strengthened. And smart, practical self-regulation is playing its part.

 

Before wrapping up, I'd like to explore with you the self-compliance part of the continuum. This is the earlier, more voluntary and internal behavior of firms to comply with the rules that NASD seeks to facilitate for reasons and in ways I'd like to share with you.

 

First, an admission. As the head of an organization that writes and enforces rules, I would love to stand here and tell you that regulation -- sound rules and tough enforcement -- is all we need to ensure high standards of investor protection and market integrity.

 

But the fact is, any rule has possible loopholes -- and as a former professor, I can assure you that the graduates of any leading school of business or law are well trained to reverse-engineer such loopholes.

 

Moreover, while enforcement can do wonders in keeping an industry clean, violations of behavior-based rules are inherently difficult, relatively slow and resource-intensive to uncover and prove.

 

So we arrive at the truth that self-policing is not only a nice thing, but an indispensable thing, for the health of the securities industry. Because brokerage firms really are the front line of compliance -- for they can provide early detection and a swift, cost-effective response.

 

That is why assisting our members with their self-compliance responsibilities is an integral part of NASD's responsibilities.

In an era when information flows instantly, the business climate changes quickly, and new products emerge daily, we as regulators will never detect or deter every problem. Rather, investors will be better protected -- and market integrity will be strengthened -- if we use our resources not only to find and punish violations, but if we also help our members find problems within their firms before they come to fruition.

 

NASD's "Ahead of the Curve" Initiative has us more focused than ever on peering around corners to nip problems in the bud before they do harm to investors and the markets. But no matter how successful such efforts, we regulators will catch most problems after the fact. Whereas the firms -- given the right tools -- can prevent many problems from arising in the first place. So if NASD's mission is investor protection and market integrity, it is our duty to assist firms with their self-compliance responsibilities.

 

This is a vital part of truly cost-effective, truly risk-based regulation. In the words of Sun Tzu, "An army that is everywhere is an army nowhere." By giving firms the tools, technology and data to detect and correct more of their own potential violations, earlier in the process, NASD will be in an even better position to focus on the kinds of big risks to market integrity that have so harmed investors and the standing of the industry in recent years.

 

Which brings me to the final focus of my prepared remarks. NASD has sought and received member comment on a proposal to require the Chief Executive Officer and chief compliance officer of every firm to jointly certify annually the adequacy of the firm's compliance and supervisory procedures. That's a signed, annual certification.

 

NASD has sought to make four points very clear to the industry. First, our interest is in fostering ongoing attention by firm senior management to their compliance and supervisory systems. We are not doing this to pin a bulls-eye on the back of the top compliance officer, the CEO or anyone else.

 

Second, a prime purpose of this proposal is to generate more high-level interaction between our member's senior business officers and compliance and legal officers. The 90s made it all too clear what happens when top management listens only to the siren songs of the top producers. We need to restore a balance between the voice and influence of compliance types, and the clear clout of the business types. This proposal seeks to do that.

 

Three, the certification will concern the adequacy of the compliance and supervisory system, but not necessarily the implementation of those policies and procedures in each instance. NASD won't stand for willful amnesia or know-nothing certifications. But the focus of this certification is whether the supervisory system is fully in place. Our other rules will deal with whether it is operating effectively.

 

Finally, as I said, no additional liability will accrue to the signatories, provided that when they sign they have a reasonable basis for doing so, and do so consistent with high standards of commercial honor and just and equitable principles of trade.

That's why I am left unpersuaded by many of the comments from the industry complaining about the proposal as just one more onerous rule. Because this proposal is not really a new rule, it is a mechanism to increase compliance with existing rules. And it will be an excellent tool to focus the minds of CEOs and their top compliance people.

 

The truth is, in just a couple of years, the reality in which our member firms operate has been fundamentally transformed. The economic environment is different; the legal and regulatory environment is different; the attitude of investors, the media and Congress is different. Reputational and compliance risks that once seemed able to take a back seat are now front-burner issues -- and they are not going away.

 

Many firms have gotten the message and gotten with it in terms of adapting to these fundamental changes. But some firms have not.

 

Do any of you remember the classic line from the ad, "You can pay me now or you can pay me later"? You might think of certification as paying now. And of enforcement as paying later.

 

The costs of solid compliance and supervisory systems should be counted as the costs of doing business in the securities industry. But they may also be thought of as an investment in reputational capital that produces and preserves future revenues. At the largest firms, such expenditures are counted in the millions of dollars. The scandals of the past two years, by contrast, have showed that the regulatory, monetary and reputational costs -- in terms of both diminished market value and lost business at our nation's largest investment houses -- are counted in the billions. You of all people can do the math to see which approach makes better business sense.

 

That's another reason this is the right proposal at the right time. And why I mean to see it succeed.

 

The Morgan Stanley case I announced earlier supports the argument for certification. For it is a prime example of policies and procedures NOT being in place that were adequate to comply with existing rules against such contests. I believe that if the firm's CEO and chief compliance officer had to join together annually to make the kind of certification NASD has proposed, the odds are good that due diligence would have revealed the lack of adequate policies and procedures. And the CEO and CCO would have instituted such policies and procedures, so they could make the required certification.

 

So as I indicated, this is not about a lack of existing rules to prohibit bad practices. This is about a mechanism to focus the minds of top industry officials that compliance with such rules is serious business.

 

The last several years have reminded us all starkly that bubbles bring out the worst in the free market system. The literature on the subject is ample. Recall John Kenneth Galbraith's witty discussion of the ebb and flow of "the bezzle," as he dubbed it, in his classic, The Great Crash 1929. And David Chancellor's Devil Take the Hindmost is only one of several fine works to explore how the aftermath of a major bubble spawns loud cries for reform and tendencies to over regulate for many years thereafter.

 

Consider just some of the prominent examples in which the pendulum of reform has swung too far. After the Crash of 1929 and the Great Depression, the Glass-Steagall Act separated commercial and investment banking for over half a century.

After the South Sea Bubble of 1720, the formation of new corporations was banned in Britain for more than 100 years.

Thirteen years later, Sir John Barnard's Act outlawed all futures, options and short sales of stock -- and while mostly ignored in practice, it remained on the books until 1860.

 

The Public Utility Holding Company Act, first enacted in 1935, continued to require SEC oversight of utility industry mergers more than 60 years later -- even after the SEC declared in 1982 that the law had outlived its purpose.

 

After the 1929 Crash, the federal securities laws were not enacted until 1933 and '34, Glass-Steagall not until 1934, the Maloney Act not until 1938, and the Investment Advisors Act not until 1940.

 

So in circumstances like these, experience teaches that Sarbanes-Oxley is very unlikely to be Congress's last word on the subject. And the risks of overreaction today are by no means limited to Washington.

 

I have sought to illustrate for you this afternoon NASD's philosophy that what we need now is not more pervasive regulation, but better regulation, better enforcement and above all better compliance. Such compliance can be relatively coerced or relatively voluntary. We prefer that it be voluntary but will not shrink from compelling it through tough enforcement.

 

This is how NASD is doing what a private sector regulator ought to do. Which is not to issue the most rules, or the most reflexively restrictive, but to help administer and enforce a regime of both rules and more voluntary encouragements that will yield the greatest achievable investor protection and market integrity, while imposing the least practical burdens and restrictions on the freedom of market participants.

 

And now there's one last thing this private-sector regulator should do. That is to stop taking up all the oxygen in this room and get to the best part. Which for me, particularly with this audience, is answering your questions.

 

Thank you very much.