Testimony of Robert R. Glauber
Chairman and CEO
Before the Committee on Banking, Housing and Urban Affairs
United States Senate
May 7, 2003
In December of 2002, the Securities and Exchange Commission (SEC), New York Attorney General, the North American Securities Administrators Association (NASAA), the New York Stock Exchange (NYSE), and NASD reached an agreement in principle with ten of the nation's largest investment banks to resolve issues of conflicts of interest involving research analysis and initial public offerings (IPOs). On April 28, 2003, regulators announced that the agreement had been finalized. This "global settlement" concludes a joint investigation begun in April by regulators into the undue influence of investment banking interests on securities research at brokerage firms. NASD will continue to investigate and bring cases against individuals who have neglected their personal or supervisory responsibilities to the investing public. The settlement, along with new rules and enforcement cases that are in force or being developed, will go a long way toward ensuring that these problems are effectively addressed -- not only at the large investment houses that are party to this settlement, but throughout a diverse industry. NASD
This global settlement is only part of the full-court press that NASD has been pursuing to strengthen market integrity and rebuild investor confidence. We have been busier than ever in the area of enforcement -- punishing individuals, as well as firms, for breaking the rules. We have been working with the NYSE on writing and preparing new rules on analyst research and initial public offerings -- and carefully studying what additional measures are needed. We have stepped up our investor education efforts across the board. Our dispute resolution services have been more heavily used than ever -- with almost 75 percent of cases resulting in a monetary recovery for the investor. And we are devoting unprecedented attention to strengthening the securities industry's own compliance mechanisms and efforts -- both with a targeted new certification proposal and with new tools that will help brokerage firms meet their self-compliance responsibilities.
NASD, the world's largest securities self-regulatory organization, was established under authority granted by the 1938 Maloney Act Amendments to the Securities Exchange Act of 1934. Every broker/dealer in the U.S. that conducts a securities business with the public is required by law to be a member of NASD. NASD's jurisdiction covers nearly 5,400 securities firms that operate more than 92,000 branch offices and employ more than 665,000 registered securities representatives.
NASD writes rules that govern the behavior of securities firms, examines them for compliance with NASD rules and the federal securities laws, and disciplines those who fail to comply. Last year, for example, we filed a record number of new enforcement actions (1,271) and barred or suspended more individuals from the securities industry than ever before (814). Our market integrity responsibilities include regulation; professional training; licensing and registration; investigation and enforcement; dispute resolution; and investor education. We monitor all trading on The NASDAQ Stock Market -- more than 70 million orders, quotes, and trades per day. NASD has a nationwide staff of more than 2000 and is governed by a Board of Governors - at least half of whom are unaffiliated with the securities industry.
Tough enforcement is only part of the equation. To prevent these kinds of abuses in the future, it is necessary not only to punish those who violated existing NASD rules and securities laws, but also to lay down a comprehensive framework of rules and laws that will protect investors and the integrity of our markets. It is important to note that while the global settlement is limited both in time and the participants it covers, NASD rules are not limited - they cover the entire brokerage industry -- and will form the basic scaffolding for a national system of rules that protect investors, whether they live in Birmingham or Baltimore, Berkeley or Brooklyn.
NASD and the NYSE have written two sets of analyst rules toward exactly that end. Our rules use a combination of disclosure and outright prohibitions to assure that investors are more informed and analysts are more independent. These rules were the model for several global settlement provisions -- including those declaring that analyst compensation cannot be influenced by any input from investment bankers. NASD has already begun examining for compliance with these new rules.
NASD rule-writers have been active on the IPO front as well. Last year, NASD issued proposed rules to make even more explicit the prohibitions against such practices as "spinning," "laddering," and quid pro quo arrangements. These practices were the most common IPO abuses during the bubble of 1999 and 2000 -- and they are among the most likely to pose a temptation when the IPO market heats up again.
Spinning is when an investment bank parcels out oversubscribed IPO shares so as to induce future investment banking business. Laddering is when an IPO underwriter requires the commitment to purchase IPO shares in the aftermarket, in order to be allocated some shares of the initial offering. Quid pro quo arrangements are the kinds of dealings where investment banks work out kickbacks to share in the profits of hot IPOs with their favored customers.
The SEC has held these new IPO rules in abeyance for the time being. In the meantime, it asked NASD and the NYSE to convene a blue-ribbon panel to take an even more comprehensive look at the process by which IPOs are priced, brought to market, and purchased by investors. We have brought together a truly eminent panel of experts to do so, and its analysis has been penetrating. The panel's report is not yet public, but its recommendations are due soon. The SEC will then take those recommendations, as well as NASD's proposed rules, into account in deciding what rules to issue in this vital area of capital formation. The global settlement explicitly contemplates that its provisions limiting the distribution of hot IPOs will be superceded by more comprehensive SEC rules.
NASD Enforcement Efforts
The U.S. capital markets are not only the most liquid and developed, but overall the best run in the world. In the past decade, more than 5,600 domestic and foreign enterprises have raised a total of over $500 billion through initial public offerings in U.S. markets. For companies seeking to raise capital, go public, or find a partner, the U.S. capital-formation environment remains the most attractive anywhere. Healthy capital markets are an engine of the U.S. economy -- and as such, nothing less than a national security asset. That is another reason why we take our responsibility to police IPO practices so seriously.
When the high-tech bubble burst and stock prices began to fall dramatically in the second half of 2000, many people began to wonder why the analyst recommendations sounded strangely the same as during the bull market. In fact, during the excruciating slide from the top of the market in 2000 to the low after 9/11, "strong buy" or "buy" recommendations outnumbered "sells" by a ratio of more than 50 to 1.
Beginning in 2000, NASD began aggressively investigating IPO practices and research analyst conflicts. To date, NASD has investigated and brought charges in more than a dozen important analyst and IPO allocation cases against individuals as well as firms. For example:
In all these enforcement efforts NASD has underscored several important principles:
And we are by no means done with our efforts. NASD is continuing to investigate and develop cases against those in the securities industry who have violated their supervisory or individual responsibilities to the investing public.
Global Settlement Terms
The "global settlement" concludes a joint investigation begun in April 2002 by regulators into the undue influence of investment banking interests on securities research at brokerage firms. The settlement will bring about balanced reform in the industry and bolster confidence in the integrity of equity research.
Terms of the agreement include:
To ensure that individual investors get access to objective investment advice, the firms will be obligated to furnish independent research. For a five-year period, each of the firms will be required to contract with no fewer than three independent research firms that will make available independent research to the firm's customers. An independent consultant for each firm will have final authority to procure independent research.
The ten firms against which enforcement actions were taken as part of the global settlements include:
Penalties, Disgorgement and Funds for Independent Research and Investor Education
Pursuant to the enforcement actions, the ten firms will pay a total of $875 million in penalties and disgorgement, consisting of $387.5 million in disgorgement and $487.5 million in penalties (which includes Merrill Lynch's previous payment of $100 million in connection with its prior settlement with the states relating to research analyst conflicts of interest). Under the settlement agreements, half of the $775 million payment by the firms other than Merrill Lynch will be paid in resolution of actions brought by the SEC, NYSE, and NASD, and will be put into a fund to benefit customers of the firms. The remainder of the funds will be paid to the states. In addition, the firms will make payments totaling $432.5 million to fund independent research, and payments of $80 million from seven of the firms will fund and promote investor education. The total of all payments is roughly $1.4 billion.
An issue that has been under close scrutiny by members of the Senate and that this Committee is especially interesting in includes a provision that the firms will not seek reimbursement or indemnification for any penalties that they pay. In addition, the firms will not seek a tax deduction or tax credit with regard to any federal, state, or local tax for any penalty amounts that they pay under the settlement.
The individual penalties include some of the highest ever imposed in civil enforcement actions under the securities laws.
The enforcement actions allege that, from approximately mid-1999 through mid-2001 or later, all of the firms engaged in acts and practices that created or maintained inappropriate influence by investment banking over research analysts, thereby imposing conflicts of interest on research analysts that the firms failed to manage in an adequate or appropriate manner. In addition, the regulators found supervisory deficiencies at every firm. The enforcement actions, the allegations of which were neither admitted nor denied by the firms, also included additional charges:
Under the terms of the settlement, an injunction will be entered against each of the firms, enjoining it from violating the statutes and rules that it is alleged to have violated.
Further, seven of the firms will collectively pay $80 million for investor education. The SEC, NYSE, and NASD have authorized that $52.5 million of these funds be put into an Investor Education Fund that will develop and support programs designed to equip investors with the knowledge and skills necessary to make informed decisions. The remaining $27.5 million will be paid to state securities regulators and will be used by them for investor education purposes.
In addition to the other restrictions and requirements imposed by the enforcement actions, the ten firms have collectively entered into a voluntary agreement restricting allocations of securities in hot IPOs -- offerings that begin trading in the aftermarket at a premium -- to certain company executive officers and directors, a practice known as "spinning." This will promote fairness in the allocation of IPO shares and prevent investment banking firms from steering these shares to executive's personal accounts to attract investment banking business.
The global settlement will strengthen the industry's own business practices and ethical standards. And it will be enforced by NASD and the other regulators with a full range of disciplinary options - which include stiff fines and the potential for expulsion from the industry. While the settlement does not solve all the problems revealed in recent months, it is an important step in restoring investor confidence in the markets.
The work of your Committee and the Congress will be vital in addressing the myriad other issues that will arise in the wake of the settlement. I look forward to working with you as Congress examines the range of suitable remedies to address these issues.
View video of Senate Hearing on SEC / Wall Street Investment Firms Settlement from C-Span.org.