finra

Mary L. Schapiro
Vice Chairman, President NASD, Regulatory Policy and Oversight

NASD Spring Securities Conference

Hollywood, FL
May 1, 2003

 

Good afternoon, I want to add my warmest welcome to all of you to the welcomes you've received from Bob, Doug and Ann.

I know that I am not hitting you at the best time. After a full morning standing between you and finishing your lunch. But I hope that I can give you some food for thought, to take home and chew on, about what we need to do together to rebuild trust in our markets and our industry.

 

In the next few minutes I have with you I want to update you on our new approach to finding and fixing problems earlier and more comprehensively, to walk you through an example or two, and to hint at some of the areas we will be probing.

 

I feel like we have all lived through about five business cycles in the last two years. We are always slow to understand the ground truth, that what is happening to us in the markets today is really not that different from what happened to our parents' markets before us. Even though today's markets may be trading the hottest products that the fertile and fevered imaginations of the mathematicians and the marketers can dream up, the fundamental basis for the markets' success hasn't changed since they began.

 

This basis is so simple a concept that you would think we would all seek it, get it, prize it, and live by it. When we have it, we prosper. When we lose it, we struggle. You know, of course, that I can only be referring to trust.

Simply put, if people don't trust our markets, they will not trade and the greatest engine of capital formation in the world will not function.

 

Our jobs, our investments and investors, our economy, and even our international role as a superpower - none of it can endure unless investors trust the markets.

 

That is why you and I have an absolutely critical job, and why we have to remain fast partners in self-regulation if we are to do it as well as it can be done. If the securities industry stumbles because investors won't play a game they think is rigged, we can complain that they don't know how the real world works, or accuse them of fear. Or greed.

 

But it also means that we haven't done our part to maintain the trust that fuels capitalism. And if we can't make capitalism work, what hope is there for young market economies throughout the world that look to us as the model?

 

Who can restore this trust? While all of us have a role to play, I think that the major impact has always - and will always - come from the way that you do your job. We regulators and self regulators write rules, examine firms, and bring cases, but it is you, in the firms, on the ground, who carry the lion's share of the actual regulation of the securities industry, on a daily basis, and in the details.

 

I don't think that I can overemphasize the role you play in assuring honest securities markets. I believe that there is no higher calling, and we all thank you for all that you do.

 

When we at NASD were thinking through our vision and mission recently, we agreed that "NASD will protect investors, ensure market integrity, facilitate market efficiency, and support member's commitment to honest and fair markets."

 

While all of these goals are important, the most important is first on the list - protecting investors. It is most clearly supported by the last goal on the list - supporting member's commitment to honest and fair markets. And that is why we are all gathered here together today - to ensure that you can get all the information and advice about best practices and emerging regulatory issues that you need to support your firm's commitment to honest and fair markets.

 

I wake up in the middle of the night - probably like many of you in the room - worried that we may not be anticipating new problems as early as possible. If we aren't quick to identify and resolve a problem, it can touch and rob more investors than it has to. And that means ultimately that firms will have to pay more dearly in dollars and reputation.

 

To help me sleep through the night, we have come up with a new approach to regulatory problems that I can sum up in four words: "find fast, hit hard." Under this approach we scan for problem trends earlier and with greater intelligence, and we attack the problems quickly and with as many weapons as we need to get the job done.

 

How do we find problems faster? For the past several years, probably unbeknownst to many of you in the industry, we have been working to spot problem trends as those weed's first tender shoots break the surface, and to warn investors before they invest.

 

An important part of that spotting and alerting is done by our TIP Group. TIP stands for Targeted Investor Protection and it is unique among securities regulators. It is made up of experts from across NASD divisions, in headquarters and the field, who meet biweekly to compare notes about what they are seeing in their own areas, in the press, in complaints collected from all NASD systems, from other employees, and from NASD committee members.

 

Problems that our Advertising Department might see only once or twice become more ominous when examiners and Dispute Resolution also each see the same problems once or twice. The TIP Group helps us see the big picture faster. And that allows us to respond faster.

 

When we spot an issue that is becoming serious, the TIP Group prepares an Investor Alert to let investors know of problems best avoided. You may have seen these on NASD.com or announced in our weekly emails. In the past year they have addressed issues including mutual fund classes and breakpoints, variable annuities, principal protected funds, and hedge funds. We get a great response to them from investors, they are often picked up by the press, and many members also use them to educate customers on problems to avoid.

 

The TIP Group is just one part of our earlier warning systems, though. Our Ahead of the Curve initiative focuses on identifying major problems fast and responding comprehensively - I should say exhaustively - to them. I like to think of this as our regulatory version of shock and awe.

 

Once an issue makes the Ahead of the Curve list, we brainstorm on the best ways to learn all we can about it. We collect all of the data and then we quickly develop the regulatory responses we think it merits and put each of them in force. Responses can include such traditional approaches as bringing cases and writing rules and interpretations, but they can also include surveying the membership, publishing best practices, coordinating with other regulators, educating members, providing compliance tools for our members to use, including templates, web tools, and checklists, and writing Investor Alerts if none already exists on the topic.

 

In addition to the TIP Group to spot problems and warn investors and Ahead of the Curve to profile and manage large initiatives, we are also about to add a third approach to finding problems fast. This approach will include several components.

First, it will rely on tracking multiple customer complaints against individual brokers to help identify recidivists. When identified, we will sift complaint and related information in fine detail to see if an onsite examination of the firm and its supervisory procedures is indicated.

 

This unit will also track, on an ongoing, full time basis, arbitration claims and criminal and civil complaints. It will also monitor the concentration of products solicited and sales practices employed to ensure that our conduct rules are current.

Finally, it will supplement our examination process with new review procedures to make sure that firms provide heightened supervision of their brokers who have patterns of customer complaints and regulatory actions.

 

The best way that I can think to start showing you our "Find Fast, Hit Hard" approach is to give you a few examples of it in action. I'll start with hedge funds.

 

Hedge funds have been available to sophisticated investors for years. Their unexciting sisters, mutual funds, were meant for the masses. They are regulated rigorously. Hedge funds, which employ riskier strategies and charge higher fees, were limited to the truly wealthy, who could afford to take significant risks. Hedge funds, as we all know, are regulated very lightly.

But things have changed since the market turned and the marketers turned to new customers for an old product. After the bubble burst investors were looking to return to the heady 20% returns they were getting each year, and mutual funds were returning a tiny - and decreasing - fraction of that. Old definitions of who was wealthy no longer filtered out many average investors. For those who couldn't afford hedge funds, funds of hedge funds were developed to spread the risk among several funds and had much lower minimum investment requirements.

 

We spotted this increasing "retailization" of hedge funds more than a year ago and began pursuing it. Our Investor Alert on hedge funds was posted in August of last year. At the same time, the issue was incorporated into the Ahead of the Curve watch list, which put it on our examining table and under bright lights.

 

We surveyed more than 200 members offering the funds and found that some members' sales practices were inadequate for the complex nature and structure of the funds.

 

Based on that survey, we issued Notice to Members 03-07 this February, which requires that members must balance their sales material with the risks of these funds, and must do heightened due diligence before offering them, as well as customer-specific suitability.

 

In addition to our Investor Alert, firm survey, and Notice to Members, we wanted to make sure that we understood how members market hedge funds. So we conducted an advertising sweep. We found, first, some firms were using misleading historical related performance data, substituting current adviser or related fund data for the fund's actual performance. Second, we found inadequate risk disclosure and touting, such as how the fund can beat the market with less volatility and promises about expected returns.

 

Based on our advertising sweep findings, we continue to monitor hedge fund issues to see if rulemaking might also be needed in the future.

 

And of course, last week, we brought our first case against a broker dealer for hedge fund advertising violations - censuring and fining the firm $175,000 for failing to disclose the risks of investing in hedge funds adequately.

 

Are we going overboard on hedge funds and funds of funds? Let me put it to you this way. What would have happened if regulators had used the same approach to limited partnerships? The industry would have foregone some sales, but it would have also avoided regulatory action, investor lawsuits, bad publicity, huge payments and, worst of all, the loss of that basic ingredient of markets - trust.

 

Let me turn to another example of our focus, mutual funds, the less glamorous sister of hedge funds.

 

Born in Boston in 1924, mutual funds were quickly mired in scandal as insiders took advantage of fund investors. However, the 1940 Investment Company Act's regulatory regime - one of the most stringent of all of the federal securities acts - resurrected their reputation. Investment in them now tops $6 trillion, in about 250 million accounts that invest in more than 8,000 funds. Not a bad recovery, over sixty years, from a problem childhood. And a pretty strong testament to the power of regulation benefiting both investors and the industry.

 

But even a long history of effective regulation and investor trust does not guarantee that problems won't happen. Witness our recent breakpoints initiative.

 

As a result of several routine examinations, NASD discovered that broker-dealers selling front-end load mutual funds were not properly delivering breakpoint discounts to investors. We placed this on the Ahead of the Curve list and started moving in on the problem.

 

In November and December the SEC and NYSE joined us for an examination sweep of 43 firms selling front-end load mutual funds. We found that most of those firms didn't give investors all the breakpoint discounts they should have.

 

Failures to give the discounts stemmed from a variety of different problems, including a failure to link share classes and holdings in other funds in the same fund family and a failure to link accounts of family members.

 

The good news is that the failures do not appear to have been intentional. Rather, they reflect misunderstandings about the availability of discounts and systemic deficiencies.

 

We are tackling this issue in two distinct ways. One is looking ahead to find solutions on a going forward basis. In January, the SEC asked us to lead an industry working group to find break point solutions. The task force has 24 members, including representatives from broker-dealers, mutual funds, transfer agents, clearing facilities, academia, and trade associations.

Based on its work to date, a solution will likely require better tools for bringing information about breakpoint opportunities to brokers and investors, greater attention to gathering information at the point of sale in order to link accounts and transactions, and improving the transparency and linking capabilities in the processing systems for mutual fund sales.

 

We issued a Notice To Members in December reminding firms to explain and deliver breakpoints. And we issued in January an Investor Alert to tell customers of breakpoint opportunities.

 

Our second approach to tackling the breakpoint issue is to deal with the past - the transactions that should have received discounts, but didn't. We have directed all firms with more than 100 automated mutual fund purchases in either of the last two years to perform a self-assessment of their own of breakpoint discounts delivery. When the assessments are complete, we will determine what other steps will be taken - including restitution to customers who failed to receive the discounts that they were offered.

 

I wish I could tell you that scrutiny of the problems of mutual funds started and ended with breakpoints. But we have brought several cases for inappropriate share class sales where the particular class sold was not in the investor's best interest, but did generate larger commissions. And, in line with those actions, our second Investor Alert ever posted, was on mutual fund share classes. The issue is now a major concern of the SEC's as well.

 

Not only did the scrutiny of mutual funds not precisely start with the current breakpoint issue, the powerful combination of a down market and the loss of trust from a tarnished reputation is now keeping the fund industry in the regulatory spotlight for other concerns beyond breakpoints.

 

Mutual fund fees have now become an item of focus in Congress, where GAO reported stock fund fees going up as returns head down.

 

Also being questioned are soft dollar arrangements, costs for placement in fund supermarkets, fund manager salaries, and fund governance, particularly the independence of the board and its chairman.

 

Where will it stop? I don't know. But I suspect that the result will mean a lot of work but ultimately will improve the long-term health of the industry, as regulation did in 1940.

 

Time won't permit me to cover in any depth other issues that we see on the regulatory horizon, but let me list a few so that you can be on the lookout for them, too. This list would include variable annuity sales, especially to seniors; high yield debt sales to retail investors; 529 plan advertising; municipal bond pricing; and yes, oil and gas partnerships, just like in the old days.

 

I am glad that I have had an opportunity to describe today our new regulatory approach of "find fast, hit hard" and show how we are implementing it. I am also happy to share with you my views that it is our joint role to restore investor trust, and to restore healthy markets - because that means we are both playing our parts in restoring a healthy economy and a strong nation.

 

Thank you.