finra

Rick Ketchum  

Chairman & CEO, FINRA

ALI-ABA Conference

New York, NY

 

October 8, 2009

As prepared for delivery

 

This conference comes at an important time, in the aftermath of a very difficult period. If we look back to the summer and fall of 2008, every time we thought conditions in the financial sector couldn't get worse, they did, and we ultimately came to the brink of a global market meltdown. Even with the enactment of stabilization measures in October, the market turmoil continued into March, at which time the S&P 500 reached a 12-year low.

 

When combined with the terrible harm to investors resulting from the Madoff and Stanford scandals, there is no question that we need to step back and take stock of the values driving our most important financial organizations, and the effectiveness of our regulatory oversight.

 

Part of the learning process involves making sense of precisely what caused the financial crisis. The volatility spawned an array of theories, and the research arm of the U.S. Congress issued a report earlier this year that cited 26 different possible causes—spanning from excessive leverage and deregulation to bad computer models and so-called "Black Swans."

 

I'm not here this morning to wade into any of those debates. But whatever we believe to be the biggest contributors to the financial crisis, we can hopefully agree that underpinning much of the turmoil were decisions made by market participants that were, at best, short sighted and ill advised, and in many cases reckless, if not illegal. At the most basic level, many market participants abdicated their professional responsibility—selling products or pursuing deals that may have offered short-term gains but which they had to know were inappropriate for the marketplace.

 

The risks associated with such behavior have been a concern of regulators for decades. In 1938, just a few years after the Securities and Exchange Commission was founded, the Commission's chairman, William Douglas, spoke to the importance of trust in the markets. He said,

 

To satisfy the demands of investors there must be in this great marketplace not only efficient service but also fair play and simple honesty. For none of us can afford to forget that this great market can survive and flourish only by the grace of investors.

 

Accordingly, I would like to explore three issues with you today—the financial reform process, then hopefully an honest look, coming out of the implosion, of what both firms and regulators should be focusing their energy on.

 

Regulatory Reform

 

Turning to the current debate about comprehensive changes to financial regulation, the Obama administration has identified five key priorities:

  • Controlling systemic risks
  • Tightening regulation of non-bank activities
  • Enhancing protections for consumers
  • Establishing a mechanism for the resolution of systemically important financial holding companies
  • Improving regulation throughout the world.

Each of these priorities are getting a thorough vetting in Congress at the moment, and regardless of what reforms are ultimately agreed to and enacted, policymakers and regulators must not lose sight of a key lesson from the past: financial regulatory systems tend to stand still, while the financial industry is in a state of perpetual motion—constantly offering new products to new customers.

 

This poses a fundamental challenge for regulators and policymakers. The immediate task is to reform the regulatory architecture to address the many vulnerabilities in the financial system and help restore investor confidence. But part of the long-term objective must be to create an architecture in which regulations can evolve to adapt to changing circumstances in the financial sector. If we simply look backward, we will be, in some sense, "fighting the last war." The real test will be whether the regulatory system can evolve along with the financial system, and help to prevent the excesses that are destined to develop.

 

As we look ahead in the longer term, I would like to see an effort to identify a set of common investor-protection principles. In simplest terms, it should not matter whether you are buying stock, futures, insurance or banking product, your protection should be the same. Regulatory organizations should be required to develop rules that implement each of these principles and also to actively work with the other relevant regulatory organizations to harmonize their rules. This will help to ensure that all investors receive the same level of protection.

 

Without suggesting an exclusive list, I would recommend these principles should include the following:

  • Every person who provides financial advice and sells a financial product is tested, qualified and licensed;
  • Advertising for financial products and services is not misleading;
  • Every product marketed to them is appropriate for recommendation to that investor;
  • A full and comprehensive disclosure for the services and products being marketed that address, in plain English, the risks, including the worst-case risks, of the product; and
  • Every person who is in the business of regularly providing financial advice is subject to a federally crafted fiduciary standard.

Most of this won't be solved in this legislation, but there is a meaningful chance to address the disparities of regulation between BD and IA sales activity

 

Fiduciary Duty

 

I testified before the House Financial Services Committee on Tuesday, and I told the Committee that FINRA whole-heartedly embraces the Administration's goal of harmonizing the regulation of broker-dealers and investment advisers. We believe that in order to accomplish that goal, two steps are necessary. The first is establishing a consistent fiduciary standard for investment advisers and broker-dealers providing investment advice. The second is harmonizing the oversight and enforcement of that standard and the other rules relevant to each channel to better ensure that participants in that industry actually comply with those obligations.

 

The Administration has proposed that the SEC write rules establishing consistent fiduciary standards of care for investment advisers and brokers providing investment advice. FINRA stands in agreement with numerous interested parties that the standard of care in both channels should be a fiduciary standard for the provision of advice.

 

We need to step away from the nonsense of diminishing present standards. We should start with a commitment that the standard is "business model neutral" and focus on the basic shift that each recommendation must be in the "best interest of the customer."

 

Harmonization of the standard of care is an important first step. However, given the number of recently revealed frauds perpetrated by investment advisers bound by the fiduciary standard, it is clear that the existence of the fiduciary standard of care alone is not a guarantee against misconduct. Compliance with that standard must be regularly and vigorously examined and enforced to ensure the protection of investors.

 

FINRA believes that authorizing the SEC to designate an independent regulatory organization to augment the agency's efforts in examining investment advisers would create a structure that would better protect investors regardless of how their financial professional is registered.

 

To put this in real terms, there are nearly 5,000 broker-dealer firms registered with the SEC, and between the SEC and FINRA, approximately 55 percent of those firms are examined on an annual basis. By contrast, there are over 11,000 investment adviser firms registered with the SEC, and the agency expects only 9 percent to be examined in fiscal years 2009 and 2010.

 

In our view, we should pursue an oversight system that can reach significantly beyond 9 percent a year. Allowing the SEC to designate an independent regulator to augment its efforts would help raise that number in a meaningful way.

 

Especially today, when so many firms and individuals are dually registered as both broker-dealers and investment advisers, or have affiliated businesses that work closely together, it is vital that both sides of those businesses be examined on a regular basis and that regulators can see the full picture of both sides of the business.

 

Firms

 

So, in the new world of fiduciary standards (or in the present world) where should the brokerage firms redouble their attention? The answer, though not novel, is clear: a renewed focus on conflicts of interest. About a decade ago, in the midst of the technology bubble, a research analyst remarked that there was nothing problematic with his role in helping to sell investment-banking services because, and I quote, "What used to be a conflict is now a synergy."

 

As we know, the "synergy" that he spoke of really was a conflict, and the research analyst settlement of 2003 now prohibits analysts from selling investment banking services. But it's still the case that conflicts of interest permeate the financial sector. These conflicts are embedded in the system so deeply that they are never going to be completely eliminated. So the goal should be for institutions and the individuals who work for them to manage these conflicts, and be fully transparent about them.

 

In 2003, in the midst of charges that mutual funds had engaged in late trading and market timing, the SEC's director of enforcement, Steve Cutler, gave an important speech. He called on every financial services firm to undertake a top-to-bottom review of their business operations, aimed at addressing all of their conflicts of interest. And, he encouraged each firm to identify business practices that could pit the interests of one set of customers over another, or could put the firm's interests ahead of its customers' interests.

 

The need to address conflicts of interest is just as important today as it was six years ago. While the profile of the financial sector has been transformed over the past two years, conflicts are still rampant—and they demand greater disclosure. Failing to disclose conflicts frequently results in exposure of conflicts. And that brings even greater scrutiny from the press, the public and regulators; it heightens reputational risk, and it contributes to an erosion of investor confidence. More fundamentally, disclosure is the right thing to do—customers should know when a firm's interests may not be aligned with their interests.

 

So first, institutions should be reviewing their conflicts, and disclosing them, and then they should be ensuring these reviews become part of their standard operating procedure. It is not enough to do a conflict review once every few years and put it in the drawer; it should be a continuous, evolving process, just as real-time as the changes in a firm's business and the financial products it manufactures and sells. For employees, this process will help to underscore the seriousness with which their respective employers treat conflicts of interest.

 

Quarterly earnings pressures


A related issue that must be confronted is the compliance and risk management issues associated with public companies and their reporting of earnings.

 

As you know, companies report the earnings every quarter, and while this provides only a snapshot of corporate performance, the impact of earnings on a company's stock price can be considerable. And there have been many examples through the years of companies manipulating their numbers to show uninterrupted quarter-to-quarter growth. A few years ago, a study found that from 1999-2004 nearly half of the companies in the Dow Jones Industrial Average always met consensus earnings estimates, or beat them by a penny. Meeting short-term earnings estimates can have short-term advantages, but it can be a poor approach to creating long-term growth, and it can lead senior officials to resort to practices that are unethical and often illegal. We should remember the words of W. Edwards Deming, the celebrated business thinker, who once wrote that, "People with targets, and jobs dependent on meeting them, will probably meet the targets—even if they have to destroy the enterprise to do it."

 

Earning pressure will not go away. What's needed is a set of responses that can help to minimize the pressures that come from this reporting process. Let me suggest what some of those responses should be.

 

First, compliance officers need to have direct access to senior management and they must be an active participant in the process of formulating and implementing risk management strategies. The artificial border between risk management and compliance must end. The instincts of risk management officers need to be integrated into firms' everyday operations.

 

Beyond just access to senior leaders, there needs to be a genuine demonstration of compliance's importance in the way senior leaders respond to potential problems, invest in technology solutions and, most important, provide adequate staffing in the area of compliance.

 

Second, employees must not fear the decision to question a company's financial reporting, or to escalate an internal dispute. Indeed, questioning should be encouraged, and even rewarded in certain instances. We have to confront the reality that both managers and general counsel still perceive that acting as a squeaky wheel is career-limiting, if not career-ending.

 

Third, at senior management meetings, there should always be time allocated to risk and compliance issues. Theoretical access means little if there isn't a continuous message of the importance senior management attaches to these issues.

 

Corporate boards have an important role to play in helping to ensure that the implementation of these and other steps is rigorous. As pointed out recently by my predecessor at FINRA, Mary Schapiro, who is now Chairman of the SEC, in the period leading up to the financial crisis, boards of directors failed to thoroughly question the decisions of senior management to take on risks. And it seemed they often did not understand the risks being taken. No, board members will not be able to fully evaluate all of the risk analysis presented to them. But board members becoming more engaged in integrating compliance into company operations would be a step to help prevent these mistakes from being repeated.

 

Products


Next, I'd like to turn to how financial services firms should think about the products they offer. Today, firms typically maintain product review committees, to review what the firm is selling, how popular and profitable their products are, and to explore additional products that could potentially be offered. Having a formal committee pass judgment on financial products is a good step, but more is needed.

 

Like the reviews of conflicts of interest, product committees need to be institutionalized. And the committees need to broaden their focus to look at not just whether a product is acceptable, but also how products have evolved, who they have been sold to, and whether they have become riskier over time. That requires an in-depth understanding of the components of the products. It also demands a sophisticated analysis of which external forces could influence their behavior, and how. Firms have made some real progress in the new products process over the last few years through the creation of review committees and the incorporation of compliance earlier in the product creation process. But too often the analysis ends when the product is pushed out for the first time. This is less than optimal given that macro forces can fundamentally change how a product performs and who should be buying it.

 

The recent experience with auction rate securities highlights the need to understand the risk-reward quotient of products. That understanding must extend from the product originator to any firm marketing the product. Product review cannot be a static process and firms must understand when market forces render a change in the risks of a product at the earliest reasonable time.

 

Executive compensation 

 

I would also like to say a few words about executive compensation. It is fairly well established that certain compensation schemes contribute to a dangerous short-termism—encouraging executives to pursue measures, some of them unethical, which drive up the company's stock price but do nothing for the long-term health of the company, and often undermine it. We saw this during the dot-com and technology boom, with its stock option culture. More recently, we saw it with financial institutions taking on excessive leverage, and making high-risk bets tied to the expectation of a continued rise in housing prices.

 

My view on executive compensation is fairly simple: I favor rewarding people in accordance with their ability to create true, long-term value for their company. But as we know, much executive compensation has been structured thoughtlessly, and without the kind of controls that will encourage long-term thinking. Compensation is often tied to annual performance, even though bad decisions may only show up years later. So performance measures need to change. I support so-called clawback provisions, whereby executives would forfeit a portion of their compensation if it is determined that they were rewarded for taking risks that proved to be reckless. Along the same lines, I favor compensation in deferred equity, and—for senior managers in particular—companies should consider requiring them to hold on to a large portion of their equity until they retire, or at least for a number of years.

 

I have no illusion that there are simple, one-size-fits-all solutions to improper incentives imposed by today's compensation programs. But a board that cannot demonstrate that it has wrestled with these issues and sent the right messages "from the top" has not done its job.

 

I see the need for public-policy reforms focused on executive compensation. But I am not of the view such reforms will be a cure-all. We know from experience that limiting one form of compensation often just leads companies to devise another form of compensation to evade the rules. So more important than public-policy reforms is for executives and their boards to exercise greater discretion in how they structure compensation—and to be able to articulate why it is in the long-term interests of the firm and their customers.

 

Regulators

 

I'd like to turn now to the role of regulators in promoting an ethical marketplace.

 

Regulators play a critical role in policing our markets and striving to ensure that regulation evolves to keep pace with market dynamics. But regulations are only as good as the people vested with the authority to enforce them. And one of the lessons from the past two years is that regulators—and I include FINRA here—need to rethink how to respond to issues of fraud, but also how to more effectively prevent it.

 

A critical ingredient in those preventative efforts is ensuring regulatory organizations are staffed by the right people, with the right backgrounds. At FINRA and other organizations with which I've been involved, I've had the privilege of working with a select corps of professionals—people with a commitment to strengthening investor protections and promoting greater market transparencies. But as markets have evolved, I have seen a need for more regulators with different skill sets, and with a refined understanding of some of the complex financial instruments that get deployed in the never-ending search for comparative advantage. We need regulators to know where to go for information, and to know how to collect it, so they have a comprehensive picture of market developments. We also need regulators to network outside their regulatory organizations—and to be able to hear the concerns of industry representatives.

 

Of course, as part of this outreach process, regulators need to be able to separate the wheat from the chaff, and make the crucial determinations about necessary reforms. Regulators must take care not to stifle what Alexis de Tocqueville called "the boldness of enterprise" that he said was the "foremost cause of [America's] rapid progress, its strength, and its greatness." By the same token, for markets to function as efficient allocators of capital, they need rules, and need these rules to be firmly enforced.

 

Examination Program

 

For this reason examination programs are a key ingredient in advancing investor protections and, already this year, FINRA has enhanced our programs, procedures and training in a variety of ways intended to help us better detect conduct that could be indicative of fraud including:

  • Gathering more information—prior to each exam—regarding a firm's ownership and affiliate relationships.
  • Identifying indications of problematic behavior concerning the opening of investment advisory accounts at a broker-dealer.
  • Examining the relationship between broker-dealers and/or their affiliates with feeder funds, or master funds that utilize feeder funds.
  • Identifying potentially fraudulent activity by examining for material misstatements in financial reporting, unusual money movement, and apparent red flags involving a firm's auditor and off balance sheet items.

Of course, these types of procedures and inquires have been part of the FINRA examination program for some time. Our enhancements are based on what we have learned from the many recently exposed frauds; including many that involve non-registered entities. For this latter group, we are not looking to extend our jurisdiction, but we are more focused on relationships that broker-dealers have with affiliated and other third parties so that we can assess the impact on the broker-dealer and thus on investor protection.

 

In addition, shortly after I arrived in March, we established an Office of the Whistleblower to handle high-risk tips. And last week, we announced the creation of FINRA's Office of Fraud Detection and Market Intelligence. This new office provides a heightened review of incoming allegations of serious frauds, a centralized point of contact internally and externally on fraud issues and consolidates recognized expertise in expedited fraud detection and investigation.

 

It's also critically important for regulators to continue the process of identifying gaps in regulation and then work to close them. The disparate treatment of investment advisers and broker-dealers is an example of a gap that needs to be addressed.

 

One way of thinking about regulatory gaps is to consider the law of fluid dynamics. I won't pretend to fully understand the many nuances of this law, but I know the basic principle underpinning it is that water will always flow toward the point where it encounters the least resistance. This is not so different from the financial system. Capital, like water, will flow to where it seems most welcome, which is to say, where it is least regulated.

 

But the effect of regulatory gaps is to create an unlevel playing field, diverting capital to instruments or industries not because they offer the most attractive risk-adjusted returns but because they face the least regulation.

 

The market-distorting examples of regulatory gaps are plain to see. The inevitable result of mutual fund regulation has been the growth of hedge funds. The inevitable result of broker-dealer regulation has been unregistered high-frequency traders. The inevitable result of futures and options regulation has been the creation of the OTC swaps market. And the inevitable result of securities offering regulation has been the growth of private offerings and private capital.

 

This is meant in no way to question the validity of any of these regulatory structures that are fundamental to efficient markets and investor protection, but only to note the reality that in today's global environment, products and intermediaries will change to fill specific needs and avoid, wherever possible, the costs of regulation. We could, of course, control this tendency by shifting to a more command and control economy, but few would recommend it and, moreover, it would be self-defeating, unless embraced across all major global markets. The Obama administration's plan probably does the best it can to address this gap by filling regulatory voids in the OTC derivatives and hedge funds, and giving the Fed cross-market systemic authority. But I predict that the next serious crisis will not come from Citibank or Bank of America, but from entities that today we would not recognize.

 

In the same vein, there is a need for companies to exercise more responsibility in determining precisely how they will submit to regulation. Because America's financial regulatory infrastructure is a web of overlapping—and sometimes conflicting—jurisdictions, companies frequently look for opportunities to abide by the least demanding regulation, or to exploit gaps in regulation. We saw this dynamic at work in the case of Bernard Madoff. And while he is an extreme case, as he was determined to evade all regulatory statutes, the larger point is that regulatory gaps and inconsistencies create temptations for honest people to make bad decisions. Regulatory reforms are needed that close these gaps. But even more important is for companies to avoid the temptation to play the regulatory arbitrage game in a cynical effort to boost their short-term profits.