finra

Remarks by Robert R. Glauber

Chairman and CEO

NASD Spring Securities Conference

Baltimore, MD

May 12, 2004

 

Good morning and thank you all for coming to our annual Spring Securities Conference. Unfortunately, we had to schedule this for a week when the Orioles are on the road. But this lovely city has lots of other attractions and I hope you'll all find time to avail yourselves of them.

 

As Doug Shulman eloquently explained, we have a rich schedule of events over the next couple of days, including keynote addresses by two of the leading lights of our industry - SEC Chairman William Donaldson and Senator Paul Sarbanes. I look forward hearing them and to meeting and talking with many of you over the course of the conference.

 

It seems that anytime someone in our industry makes a speech nowadays, he or she unfurls a scroll listing all the scandals, crimes and transgressions of the past few years and reads from it. I'll spare you that today. Instead, I want to look ahead and talk abouwhat I see, and what I hope to see as issues on the horizon.

 

I'll start with the question of transparency, because I do foresee NASD and others in the regulatory community placing a heavy emphasis on that, now that we appear to be heading into a new environment for investors, industry professionals and regulators - an environment characterized, one hopes, by rising markets - forget the last week -- and a more robust economy.

If this is indeed the case, and investors are getting back into the game, they are likely doing so more warily and with a deeper suspicion than what we saw in the 1990s. Our challenge, then, is to win back the American investor's faith and confidence in the cleanliness and trustworthiness of our industry. We all know this will not happen easily or quickly. And I suspect it won't happen at all if we don't strive to make transparency a central guiding principle of our work.

 

What do I mean by transparency? I mean, among other things, crystal-clear, up-front disclosure of all the costs and risks associated with a given investment, not just the potential benefits. I mean getting corporate bond pricing out of the back office and into the light of day. I even mean more legible account statements. A member of my staff recently complained to me that he couldn't make head or tail of his monthly statements - and he works in the industry. What does this tell us about the less sophisticated investor trying to figure out how his IRA is doing?

 

I am far from alone in calling for greater transparency in the markets. In the aftermath of the bubble and various scandals in the mutual fund industry, investors, the media, Congress, federal and state regulators all are demanding that the industry turn away from opaque disclosure and toward unambiguous transparency.

 

At NASD, we are doing more than talking the talk. We have issued new analyst rules and proposed new IPO rules that focus on expanded disclosure so that relationships that may influence analyst independence or cause conflicts in the initial public offering process will be more transparent for all investors at all levels.

 

Increased transparency in the fixed income market is also badly needed, as the corporate bond market continues to grow in importance for all investors. During the last 10 years, the total amount of outstanding corporate bonds has reached an estimated $4.3 trillion - exceeding U.S. Treasury bonds outstanding by about 25 percent.

 

Moreover, we've learned that the fixed income market is more liquid and does more business with ordinary investors than most of us realized. Of the more than 23,000 trades reported on an average day, about 65 percent have par values of less than $100,000.

 

Household assets invested in corporate and foreign bonds have grown considerably over the last 10 years and have exceeded household municipal bond holdings since 1997. With the fixed income market's large size, diversity and success comes a corresponding responsibility, because non-institutional investors by and large don't understand the debt market as well as they do the equity markets.

 

So, NASD last month announced plans to expand public dissemination of corporate bond transactions through our Trade Reporting and Compliance Engine, or TRACE. Pending SEC approval, the proposal will provide investors with last sale information on all publicly traded corporate debt.

 

TRACE went on-line in July of 2002. Now, in a relatively short time period, it has evolved from providing trade information on 550 bonds to more than 23,000 under this new proposal. This affords investors unprecedented transparency and enhances market integrity and fairness.

 

An argument we often hear is that more and better corporate debt disclosure may be fine for individual investors, but the secondary corporate bond market is dominated by institutional investors who don't need the protection that additional transparency provides.

 

A potent rebuttal to this argument is that the number of institutional investors subscribing to TRACE now exceeds 4,100 and continues to grow. Granted, by industry standards, the $720 annual subscription fee is not a lot of money. But industry professionals would not be paying for this information if they didn't find it valuable. Also, many institutional investors manage pension funds, 401(k)s and other pooled resources of ordinary working people.

 

More fundamentally, in an era when retail and institutional investors alike have access to a wealth of information about equities and other alternatives to bonds, it is simply an anachronism to withhold the basic building blocks for convenient, confident price discovery in the secondary corporate debt market. And while I acknowledge there can be a tension between increased transparency and its impact on liquidity, particularly in the more speculative sectors of the corporate bond market, I suspect it will be hard even there ultimately to sustain the argument against full transparency.

 

Transparency is also a major focus today in the area of mutual funds. Looking at both the funds and the practices used to sell them, a major part of the solution to the appalling abuses of the public trust we've seen recently is increased transparency.

With that in mind, I am announcing today the formation of an NASD-led Mutual Fund Task Force, whose members will be drawn from brokers-dealers active in the sale of mutual funds and from the mutual fund industry. Transparency will be at the heart of its mission. The task force, a product of discussions between the SEC and NASD staffs, will proceed in two phases. In the first, it will consider mutual fund portfolio transaction costs, including directed brokerage arrangements, soft dollars and transaction cost measurement and disclosure. We envision that the task force will submit its views on these issues to the SEC in the fall.

 

In the second phase, the members will focus on distribution arrangements, including investor understanding of 12b-1 fees and other costs. Since this phase will include a comprehensive evaluation of mutual fund distribution, it will take longer than the first phase.

 

NASD of course doesn't regulate mutual funds but we do regulate brokers who sell them and the sales practices they use. And our focus has been on the suitability of the mutual fund share classes that brokers recommend; the disclosures they make to investors; and the compensation they receive from mutual funds, including so-called shelf space payments. We also have played a pivotal role in ensuring that brokers give customers the proper volume discounts - called breakpoints - off of front-end loads or commissions.

 

The bottom line for us is this: when a brokerage firm or its registered representative has a financial incentive to sell or recommend particular funds, investors should know about it. And investors should also know the costs -- all the costs - of buying a fund. Plain and simple.

 

Regulators need to cut through the fog and shine a light on investor costs and broker compensation. That's why NASD has recently proposed to the SEC a one-page chart to be given to an investor when he or she is considering purchase of a particular fund showing what the investor pays - load, commission, annual management fee, operating costs and 12b-1 fee - and what the brokerage firm receives - load, commission, 12b-1 fee, revenue sharing payments - on the fund transaction. Equally important, the same chart would be posted on the broker's website for all the funds it sells, so an investor could easily compare costs and broker compensation for all funds. It's time to give investors the information they need in a form simple enough to use.

 

I have a fundamental belief that more information is better than less. One of the bedrock principles of our free market system is that all participants have access to information about prices and costs that will influence their decisions. When this information is hidden or distorted, investors are not able to make the best-informed decisions about where to invest their money. With this information in hand, investors are in a better position to evaluate the recommendations of those who create and sell these investment products, and to act wisely.

 

It is not just investors who will be helped by this. I believe the mutual fund industry's own self-interest will be served by better disclosure of costs and fees and payments for distribution, as well as better governance of the funds themselves. These changes will help the industry retain its customers and attract new ones. In fact I read recently that one mutual fund is proposing these kinds of changes on its own initiative as part of an effort to send a positive message to current and prospective investors.

 

This is a valuable example of a member of the financial services industry taking its own initiative to help restore investor confidence. This kind of attitude needs to become the rule, not the exception.

 

Let me touch briefly on one more subject, then I'll stop beating the transparency drum. We're concerned about the sales practices of brokerage firms that offer 100 percent loan-to-value mortgages, also called pledged-asset mortgages. Last week, we published an Investor Alert warning consumers that there are inherent dangers in these loans and that some brokers may be less than fully forthcoming in explaining them. It may be appropriate to offer 100 percent mortgages to some investors, but it is never appropriate to obscure the risks they pose - such as that the securities the borrower pledges in lieu of a down payment may be liquidated without warning, and that the borrower may be hit with an unexpected collateral call if those securities fall below a set value.

 

One can easily foresee new rules coming out of the regulatory community to protect investors from being snared with one of these loans. Broker-dealers can avoid that by explaining the risks of pledged-asset mortgages as clearly and as prominently as they explain the benefits.

 

If the industry as a whole is seen as fully supporting - and better, leading - the effort to increase transparency, it will send a powerful and positive message to investors.

 

And increasing transparency is also, frankly, a good message to send to policymakers, legislators, and regulators. Absent effective disclosure, there will be rising pressure for new rules that mandate certain kinds of broker behavior and prohibit others - rules that may be unnecessary and worse still, impose needless costs on investors.

 

That is what I see on the horizon. With the markets now apparently back on the right track, there are also some things I hope to see. They include a culture of avoiding temptations. There are some old tricks that some may find hard to resist in an up-market, and I hope they won't succumb to them.

 

One of those I find particularly offensive is the practice of persuading homeowners - particularly elderly ones - to refinance their mortgages, take cash out and invest it in stocks or variable annuities. In March, we took enforcement actions against three brokers for inappropriately recommending this strategy to retail customers. We suspended two of them for six months and ordered one to repay his customers $15,000 before he re-enters the securities business.

 

I'm not going to say this strategy is inappropriate 100 percent of the time, but I'd guess that 99.9 percent is pretty close. If the homeowner has no other means of raising cash to invest in the market, then it's absolutely the wrong strategy for him. This is an area that our Enforcement Division will be keeping a particularly close eye on.

 

I also hope to see our industry get its house in order with respect to breakpoint discounts on front-end loads. The question of when they apply is not always simple or straight-forward, so brokers need to develop a better understanding of when breakpoints may be owed. There are several applicable situations aside from a simple purchase of $50,000 worth of Class A shares. A modicum of self-enlightenment on this will go a long way toward keeping mutual fund sellers in the good graces of the regulators.

 

Let me close with a theme many of you have heard from me before: the importance of firms taking the lead as the first line of regulation in this industry. The greatest challenge now facing this industry is not technical or technological, but cultural. Only by strengthening the ethical culture of compliance throughout our industry will investors have the confidence on which the success of our capital markets depends.

 

In a recent interview with Money magazine, the chairman of Vanguard described the message given to new employees in stark terms: "The difference between right and wrong is black and white. If you think there's any gray area, you won't last long here." When it comes to matters of compliance, he declared, "The most important defense is cultural."

 

Other influential voices have also noted that the abuses we see today do not turn on rocket science or fine shades of gray. For example, commenting on the mutual fund scandals, former SEC Chairman Richard Breeden said, "If someone comes to you and asks for the right to engage in trading that is blatantly illegal, it should not take longer than a nanosecond to say No."

Put differently, we regulators can issue a thousand rules and they still won't cover explicitly every loophole. By contrast, if firms build a strong culture of compliance and integrity throughout the industry, that culture will take care of a thousand specific situations that no regulator can ever fully foresee. NASD wants to help in building this culture.

 

Regulators will indeed continue to do our part. But it is your firms that must do the truly heavy lifting to win back and hold on to the trust of their customers.

 

That is because enforcement -- forced compliance, if you will -- comes after the damage is done; after investors have lost money they should not have lost; and after investor confidence has been harmed.

 

By contrast, improved self-compliance by the firms can prevent investors from being harmed in the first place. That's why we are working with the SEC to put the finishing touches on the rule to require certification, involving a firm's CEO and Chief Compliance Officer, that a process is in place to assure compliance with NASD and SEC rules.

 

So self-policing is not only helpful, but indispensable, for the health of the capital markets. Because brokerage firms really are the front lines of compliance. It is they who can provide the earliest detection, and the swiftest, most cost-effective response.

Do any of you remember the line from the car repair ad, "You can pay me now or you can pay me later"? You might think of improved self-compliance by firms as paying now. And of enforcement by regulators as paying later.

 

At the largest firms, the costs of solid compliance and supervisory systems are counted in the millions of dollars. The scandals of the past two years, by contrast, have shown that the costs of lax compliance -- in terms of both lost market value and lost business at some of our nation's largest investment houses -- are counted in the billions. You can do the math to see which approach makes better business sense.

 

Which makes improved self-compliance not only the right thing for the industry, but also the smart thing.

I didn't come here just to talk. I also came to listen and to learn. And I think it's time now to desist from the former and proceed to the latter. So, thank you all very much for being here. I'll be happy to answer any questions you may have.