finra

Testimony of Robert R. Glauber,
Chairman and CEO

Before the Committee on Banking, Housing and Urban Affairs
Hearing on Accounting and Investor Protection Issues Raised by Enron and Other Public Companies

U.S. Senate

 

March 5, 2002

 

Introduction

 

Chairman Sarbanes, Ranking Member Gramm, members of the Senate Banking Committee, thank you for this opportunity to testify today on the vital, troubling and timely issues of investor protection and accounting highlighted by the collapse of Enron. It would be hard to overstate the human tragedy for Enron’s employees, pension-holders and investors caused by the failure of America’s seventh largest company.

 

Yet it is my firm hope that significant good can come of the collapse of Enron – in the form of better policies, oversight and regulatory structures to help restore the public’s trust in the fairness of our markets. That is the purpose of today’s hearing, and I am privileged to contribute my thoughts and the NASD’s experiences to this Committee’s thoughtful search for solutions.

 

Overview

 

Let me begin with a quick overview of the NASD – because who we are bears directly on both the substance of what I’ll be saying and on the usefulness of the private sector self-regulatory model that we embody.

 

The National Association of Securities Dealers is not a trade association, but rather, the world’s largest self-regulatory organization, or SRO. Under federal law, every one of the roughly 5,500 brokerage firms, nearly 90,000 branch offices and almost 700,000 registered representatives in the U.S. securities industry comes under our jurisdiction. To give you a sense of our scope and authority, it is vital to know that every brokerage firm in the United States that does business with the public must by law be a member of NASD. We have a staff of over 2000 employees in Washington, Rockville and district offices across the country and an annual budget exceeding $400 million.

 

For more than six decades, our mission and our mandate from Congress has been clear: to bring integrity to the markets and confidence to investors. We do this by licensing and setting qualification standards for industry participants, maintaining a massive registration database that includes qualification and disciplinary histories of all brokers and firms, writing rules to govern the conduct of brokerage firms and their employees, providing investor education and outreach, educating our members on legal and ethical standards, examining them for compliance with the federal securities laws and NASD and federal rules, investigating infractions, and disciplining those who fail to comply.

 

The NASD’s staffing and governance gives us independence from the industry, but we use industry expertise and resources extensively to accomplish our mission. And the standards we set are not mere "best practices," but enforceable regulatory rules; violations may result in significant fines or even expulsion from the securities industry.

 

History of Securities Self Regulation

 

The NASD’s history to a great degree is the history of securities self-regulation in our country. The stock exchanges, options and futures markets have self-regulatory responsibilities, but they are centered on the trading that takes place within their respective markets and relate only to the members of their markets.

 

Self-regulation of the securities markets has deep roots in the United States.

 

The Securities Exchange Act of 1934 (Exchange Act or 1934 Act) is the legal foundation for self-regulation of the exchange markets. In that Act, Congress set up a system under which the New York Stock Exchange, the American Stock Exchange and other securities exchanges, and through them their member seat holders, would form a regulatory front line for the newly created governmental regulator, the Securities and Exchange Commission (SEC).

 

Four years later, Congress felt that the market regulation focus of the 1934 Act was not sufficient and passed the Maloney Act of 1938. The Maloney Act authorized the formation and registration of national securities associations, which would supervise the conduct of their members subject to the oversight of the SEC.

 

In this way, Congress sought to "bring about self-discipline in conformity to law" and to foster "obedience to ethical standards" that went beyond the law. Senator Maloney intended that the securities industry "handle the problems of technical regulation," with the SEC "policing the submarginal fringe." The next year the National Association of Securities Dealers became the first-and still the only-registered national securities association.

 

From the creation in the 1930’s, to strengthened SEC oversight of self-regulation in the 1970’s, the industry and the government have worked together successfully. The concept of self-regulation is now so ingrained in our capital markets’ regulatory structure and the markets themselves are now so enormous in every sense of the word-numbers of investors, types of products, volume and dollar value of trading-that it has become almost impossible to imagine their success without self-regulation.

 

This evolution has not been without its false steps. In 1996 the SEC criticized the NASD in part for putting its interests as the operator of Nasdaq ahead of its responsibilities as the regulator of the entire industry. The NASD’s response was both decisive and instructive. It acted almost immediately to carve out NASD Regulation and The Nasdaq Stock Market (Nasdaq) as two distinct corporate entities, with separate Boards, management, and staff. And since then, we have taken this principle of independence even further, by spinning off Nasdaq entirely – with the sale of our last 27 percent of the company completed earlier this year.

 

While there were many other changes of less significance that resulted from the SEC’s report with respect to the NASD, the bottom line was a much-strengthened role for the NASD’s staff and a paring back of many roles traditionally played by the industry. Nonetheless, the active involvement of the industry in self-regulation has remained the mainstay of its success. And during the more than six decades since this system was established, investors worldwide have flocked to our markets.

 

The NASD’s Responsibilities

 

The NASD has a comprehensive regime of regulatory duties. We writes rules to govern the conduct of our member firms, examine them for compliance with these rules, and discipline members if they fail to comply. Our market integrity services include professional testing and training, licensing and registration; examination of our member firms; investigation and enforcement; dispute resolution; and investor education. We also monitor all trading on Nasdaq, the largest volume market in the world, and other select securities and derivative markets.

 

Our rulemaking process. After an initial NASD staff determination that a rule or rule change is necessary to protect the public or strengthen market integrity, we begin a rigorous process to vet the rule and solicit industry and public input. The proposed rules or rule modifications are the result of input from our Board, industry, the SEC, consumer groups, the public, Congress, as well as arising from our own experience tracking markets and regulatory trends.

 

The NASD’s rules must be approved by the SEC prior to becoming effective. Once a rule is finalized, our members are required to comply and put into place supervisory systems designed to achieve compliance with the new rule. NASD examiners, through routine cycle exams, surveillance monitoring and examinations for cause, evaluate firm compliance and recommend remedial actions by the firm, or disciplinary action by the NASD where compliance does not meet our standards.

 

Enforcement. Tough and even-handed enforcement is a fundamental part of NASD’s mission. It not only ensures compliance and punishes wrongdoing, but also benefits the vast majority of our members who obey the rules and place investors first. For investors feel more confident using the markets when they know a tough cop is patrolling the beat. This is a fundamental aspect of our value to both the public and the industry.

 

On average, the NASD files more than 1,000 new disciplinary actions annually, with sanctions ranging from censures to fines and suspensions to expulsion from the securities industry. We supplement our enforcement efforts with referrals to criminal authorities and the SEC. In one important settlement alone this year, reached jointly with the SEC, the NASD and the SEC each imposed sanctions of $50 million against a major investment bank for violating SRO rules by extracting illegal paybacks from favored customers to whom it allocated "hot" IPOs.

 

While this role as writer and enforcer of rules is familiar territory for this Committee, I’d like to highlight some of the aspects of the NASD with which you may not be as familiar and some of the ways we carry out our regulatory functions.

For instance, we have created and we maintain a vast database of well over one million current and former registered representatives that enables us to provide the public with information on securities firms and professionals. This Central Registration Depository (CRD) is the largest such vehicle on the Internet. In 2001 we responded to over 2 million public disclosure inquiries. Using this same technology, we developed and operate through a contract with the SEC and state securities regulators the Investment Adviser Registration Depository (IARD). We have registered some 10,000 investment advisers through IARD.

 

It is also important to note that NASD Dispute Resolution is the largest dispute-resolution forum in the securities industry, with a docket that contains more than 90 percent of the cases in the industry.

 

And a point of particular importance to this Committee, considering its focus on financial literacy, is that we have an active office of Individual Investor Education that brings increased attention and focus to this area of burgeoning importance.

 

Why NASD Works: Some "First Principles" for Private Sector Regulation

 

Private sector regulators bring to bear a keen practical understanding of the industry. They can tap industry expertise and resources that are not readily available to governments. They foster investor protection and industry involvement. And they foster higher standards that go beyond simply complying with the law.

 

Self-regulation works because the brokerage industry understands that market integrity leads to investor confidence, which is good for business. The overwhelming majority of the NASD’s members comply willingly with the rules and the law. They view their own reputation for fair dealing and high standards as a competitive asset in a competitive industry.

 

Private sector regulators are uniquely qualified to identify and respond to emerging regulatory issues and keep their members appropriately informed. The NASD has developed a proactive program to ensure that members are timely apprised of emerging industry regulatory issues. Private sector regulators also are uniquely qualified to alert the general public to emerging regulatory issues. In this regard, the NASD has taken steps to reach out to the public through investor alerts and a host of written in-person and Internet-based investor education offerings.

 

All this explains how private sector regulation can work. But why specifically does it work well in the securities industry?

The first essential ingredient of the NASD’s success is independence. At least half our Board of Governors are a non-industry representative. And our large, experienced professional staff is not beholden to the industry.

 

Our governance structure relies on parties that have the right incentives to insist upon market integrity and investor confidence. Specifically, our Board includes representatives of the public, corporate issuers, and institutional investors, as well as the brokerage firms that make up our membership. The beauty of our system is that all these interests want markets that are fair, efficient and safe. And no one stands to benefit from this more than the brokerage industry – which knows well that market integrity leads to investor confidence, which is good for business.

 

This leads to our next key attribute, which is assured funding from that part of the private sector having the greatest interest in our effectiveness. The right people pay for the NASD’s services: namely, the brokerage firms that profit from the investor confidence that stems from market integrity.

 

We are funded three ways: (1) through a gross assessment on firms based on their revenue; (2) a regulatory fee on every transaction that occurs on Nasdaq and on the InterMarket as our cost of regulating those trades generally; and (3) user fees, including various application costs and test fees, continuing education courses, and so forth. Every registered representative must also pay a small assessment when he or she registers.

 

This steady and sufficient funding means we can afford the sophisticated technology, techniques and infrastructure it takes to regulate a fast-changing, technology-intensive industry. NASD’s technology budget exceeds $150 million per year. No private sector regulator can succeed without sufficient ways and means.

 

Another key to our success is that we have the combined ability to write rules, examine for enforcement of these rules and enforce the rules with teeth all under one roof. This consolidation of central regulatory functions reinforces our authority, competence and credibility.

 

As discussed in detail in the preceding section, the NASD is empowered to discipline our members with sanctions tough enough to punish violations and deter future misconduct. Last year we brought more than 1200 disciplinary actions, resulting in over 800 expulsions or suspensions from the industry. That’s a powerful sanction – the ability to bar someone from earning a livelihood in his or her chosen field. In an average year we levy well in excess of $10 million in monetary sanctions.

Of course, with authority comes responsibility. Just as our members are accountable to the NASD, so we are accountable to the SEC. Strong oversight by government regulators protects investors by ensuring that someone is watching the industry watchdog.

 

What Desirable Features Congress Should Consider in Fashioning an Oversight System For the Accounting Industry

 

There are strong policy reasons to move in the direction of private sector regulator with strong SEC oversight for accounting. The advantages of such a solution over a purely governmental solution include the fact that when industry is involved, the regulator is able to tap private expertise in a way the government cannot. And with industry assessed for the cost, the regulator can be better funded. This way the professional staff of lawyers, examiners, administrators, technologists, and analysts remain top notch and able to keep pace with industry. This model provides the best of both worlds: tough SEC oversight of a well-funded, well-staffed front-line private sector regulator.

 

While we would never presume to prescribe in detail what a new private sector regulator for the accounting industry should look like, we can, based on our analysis of what has been successful in the securities industry, illuminate the implications for such a body in the accounting industry, should Congress decide to move in this direction.

 

First, the private sector regulator should be an independent organization, with a sizable, professional staff, and sufficient technology and infrastructure to stay apace of the accounting profession. It should seek maximum industry input consistent with maximum industry accountability. And it should consolidate as many of the industry’s central regulatory functions - especially in the areas of licensing, registration, examination and strong enforcement - under one roof as is feasible. This will reinforce its authority, competence and credibility all at once.

 

Second, it should have a strong mandate from the government that sets its structure and empowers its enforcement arm with full authority to discipline the industry. Any form of private-sector regulation must be empowered to effectively enforce the rules: the ability to levy meaningful fines, place conditions on continued participation in the industry, suspend, and where appropriate, banish those who misbehave from the industry. This "ultimate sanction" is both a powerful deterrent for would-be violators and an important investor protection.

 

Third, it should have a governance structure based on enlightened self-interest – namely, the need for effective auditing to produce numbers that investors can rely on and markets they can trust. This means a Board with interested parties much the same as the NASD’s: solid public companies that want investors to have confidence in their financial statements; institutional investors; broker/dealers; and the public – with accountants being a small minority.

 

Self-regulation does not mean that industry is left to its own devices. Public participation on an SRO Board is important not only to prevent any conflicts of interest, but also the appearance of such conflicts.

 

Fourth, it should have assured funding from some of these same self-interested parties, especially those with the biggest stake in the success of the system that have the most to gain from thorough, fair and transparent accounting practices. The best candidates might be issuers (with a small fee on new share registrations, 10K or 10Q filings) and broker/dealers. And since they, of course, also have a major stake in the credibility of their audits, another source of funding could be examination fees charged to the accounting firms themselves.

 

An effective private regulatory system requires infrastructure, technology and processes to provide quality, timely services. As we all know, monitoring compliance with accounting standards and principles in today’s global economy is a complex and technology-intensive process. The regulator for the accounting profession must be equally up-to-date and technology-intensive.

 

And finally, it should be subject to strong, appropriate oversight from the SEC to institutionalize accountability. Oversight by government regulators is essential to ensure the integrity of the process. It also provides an appropriate appellate forum for disciplinary actions.

 

Conclusion

 

Self-regulation in the securities industry has helped make the U.S. capital markets the most successful and respected in the world. This system was the legislative embodiment of the belief that additional protections were needed to "protect the investor and the honest dealer from dishonest and unfair practices by the submarginal element in the industry." These words are really the roots of the NASD’s central rule: "A member, in the conduct of his business, shall observe high standards of commercial honor and just and equitable principles of trade."

 

No one is under the illusion that the systemic flaws revealed by Enron can be set right without significant government involvement. Even in the accounting industry, where self-regulation has suffered a bad name, there is a vital role to be played by private sector regulation which fully understands the industry but is not co-opted by it; which commands respect with accountants and credibility with investors; and which allows the SEC to focus its scarce resources where they are most needed to police the honesty of the financial reporting that underpins the success of the U.S. capital markets.