finra

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

SIA C&L Annual Seminar

Lake Buena Vista, FL
April 9, 2003
(Final)

 

Good morning. I am pleased to have this opportunity to speak with you and I want to thank Conference Chairman Paul Merolla and Division President (and NASD Board member) Dave DeMuro for the invitation. This annual seminar brings together phenomenal legal and compliance expertise, and so I always wonder how I can add to the insight and information already provided by the other speakers. So, my words this morning take on a wider scope than in past years, but then this past year has been quite unlike any other.

 

We have been through extraordinary changes since last year's Legal and Compliance program. At that time would any of us have predicted the intensity of Congressional scrutiny, the passage of Sarbanes-Oxley, the unrelenting media attention, enforcement activity or rule writing? Some have said that you have to reach back to 1933 and 34 when the US federal securities laws were enacted to find a parallel level of regulatory activity.

 

Historically, investors have viewed our capital markets as the premier place to invest because of a reputation for integrity, thus ensuring a steady supply of capital to enable businesses to grow and finance their operations. The engine of our economy has been fueled by investments in the capital markets. And, indeed its importance goes beyond the economic power the capital markets engender. Our place in the world as a superpower is completely dependent on our economic power.

 

As a result, the health of our markets raise important and pervasive issues concerning the strength of our nation and the quality of life to be afforded our citizens. It is a matter about which every one of us in this room must be deeply concerned. I think it is fair to say that the scandals that have plagued corporate America and the financial industry over the past year and a half have cast a shadow upon the reputation enjoyed by both corporate America and the U.S. capital markets. While this is not the first time that the markets have suffered a downturn as a result of corporate malfeasance, a confluence of events have caused an unprecedented crisis of confidence.

 

First, the scandals have occurred in many segments of the economy, and are simply staggering in their magnitude. The markets were rocked when Enron announced that it had overstated its earnings by $600 million dollars, but only months later, that revelation was overshadowed when it was discovered that Worldcom had overstated its earnings by $9 billion dollars. More shocking still, was that these schemes appear to have been perpetuated by executives who were very richly compensated.

 

With the investor class far larger and more diverse than it has ever been, those scandals were felt in virtually every corner of American society. In my 20 years as a regulator, I have seen many scandals—insider trading, blind pools and blank check offerings, junk bonds, the collapse of Barings Bank, penny stock fraud and much more—but those were largely illegal activities perpetrated by certain players within our markets. Recent problems have a vastly different qualitative ring: they change the question from who is perpetrating the fraud to who is left to trust? When the shareholders of the nation's most highly capitalized and visible companies cannot trust their own management to give them the unvarnished truth about the asset they own, then a great deal has been lost.

 

The scandals coincided with the end of an incredible bull market; indeed, they fueled the bull market to some considerable degree. But even where the numbers weren't fraudulently overstated, we lost our grasp on reality when we dismissed earnings, cash flow, inventory, shareholder equity and other traditional benchmarks in valuing companies and set our sights—and hopes—on illusory measures of success.

 

The bursting of the bubble has led to an unprecedented loss of capital, which in turn led to loud cries for reform and even louder cries for retribution.

 

So, we meet here today in truly extraordinary times, facing the extraordinary challenge of restoring investor confidence. What I would like to talk about this morning is our shared responsibility for re-establishing that trust, by working to ensure that ethics play a central role in future business decisions.

 

Much has been written about the difficulty of ensuring ethical behavior. But what is worthwhile and necessary does not become less so because it is also hard.

 

A recent study by Vanderbilt University found that in the three days that followed the disclosure that Enron's auditor, Arthur Andersen, had shredded documents, the public companies audited by Andersen lost 2% of their market value, a staggering decline in market capitalization. According to the study, and I quote, "investors downgraded the quality of the audits, indicating a failure of trust." Many public companies replaced Andersen as their auditor to avoid having their financial statements questioned. In light of the reaction of the market, one must wonder whether Andersen could have survived the market's judgment about its role in the Enron debacle, even without the Justice Department prosecution for obstruction of justice.

 

The banks that assisted Enron in structuring the off balance sheet partnerships that contributed mightily to Enron's downfall have been sharply criticized, as well. The editorial pages of the Wall Street Journal attacked the banks as "Enron enablers," and concluded that they deserved the beating that they were getting in the press. FORTUNE magazine took a similarly unsympathetic position, and observed that the banks appeared to have lent money "without really caring whether their clients could pay it back," and to have leveraged their balance sheets to obtain investment banking business. The damage to the banks' reputation had tangible economic consequences; their share prices dropped and they face significant potential contingent liabilities in the form of both bad debts and civil lawsuits. In a lengthy decision, the District Court handling the Enron shareholder case concluded that Enron's shareholders could sue the banks for violations of the securities laws.

 

In addition, our own industry has been battered by the revelations that analysts issued unduly optimistic research reports to attract investment banking clients and that shares of hot IPOs were allocated to the executives of banking clients. I don't need to detail the specifics for you—soon enough, the global settlement, with a price tag of $1.4 billion, will be public. The settlement brings meaningful structural reform and significant dollar liability in the form of payments to regulators and private plaintiffs. But the far greater cost lies in battered reputations and the shattered confidence of investors in the integrity of our markets.

 

The consequences of these lapses in judgment and ethics have rippled throughout corporate America and the capital markets. Stock prices tumbled. There were massive redemptions of mutual funds. And some of the largest firms in our industry have lost billions of dollars in market capital. In short, there is compelling empiric evidence that reputation counts, and that damage to reputation has real, sometimes staggering, economic costs.

 

In economic terms, there is also an insidious "moral hazard" created by these acts of malfeasance. Obviously, I don't mean that the government has bailed out investors affected by recent corporate events. But as a matter of investor psychology, recent corporate behavior HAS become fodder for the view that investors should not be held responsible for their own investment decisions. After all, irrespective of whether investors did their homework or allocated capital wisely, they can, rightly or wrongly, point to tainted research and fraudulent financial statements as the real causes for their losses.

Now maybe that is true in a few cases; maybe it is true in more than a few cases; but clearly it is not true in ALL cases. So to the extent that tainted research and cooked books provide an avenue for investors to lay the blame for their decisions at someone else's feet, we have threatened one of the foundations of the market's ability to efficiently allocate capital—which is the investor's need to take responsibility for his or her own decisions.

 

All of which leads us back to today's question: how do we restore investor confidence? The courts and the media will play their part in assigning blame for these events, but going forward, how do we prevent future breakdowns?

 

Not surprisingly, I think self-regulation is a huge part of the answer. As a regulator, I believe that both effective regulation and successful compliance programs promote a balanced business culture that recognizes the tension between the desire to maximize profits and the absolute obligation to always put the investor first. Self-regulation has many distinct advantages in striking this balance because by giving the securities industry the opportunity to participate in regulation, we ensure that while we will indeed create and continuously bolster the regulatory scheme, we will not do so in a way that either ignores the practical constraints of the securities industry or unduly limits opportunities for building wealth.

 

However, those who operate in self-regulated industries need to take special care to ensure adherence to their self-imposed standards. The opportunity to participate in the regulatory process and indeed to be entrusted with regulation and compliance in the first instance as you are, brings significant burdens as well as benefits. You all know better than I the many responsibilities that have been added to your portfolios in just this past year—extensive anti-money laundering requirements, comprehensive research/investment banking conflicts rules and procedures, supervisory controls, IPO allocation practices, new fixed income reporting requirements and more. Effective compliance and supervisory programs will have policies and procedures that address all of these. But firms must be committed to more than having a good—or even great—compliance department. Throughout the organization, there must be an understanding of the rules and the expectations of management that breaching the rules will not be tolerated.

 

I think there are five things that must be done to build a culture that will allow us to begin to reclaim investor faith. First, management, not just compliance officers who give meaning to these words every day, must seek to instill a culture that takes the obligation to observe high standards of commercial honor and just and equitable principles of trade seriously. We must get beyond the temptation to ask the narrow question "is what I am doing permissible under the rules?" Instead we must ask "is this in the best interest of my client?" The latter is not, strictly speaking, a matter of regulation—it is a matter of building a culture of trust.

 

Second, firms must operate in an environment that encourages openness and raising of issues so that they can be addressed and not buried.

 

We expect a firm to discover issues of potential concern from within and take appropriate corrective action; BEFORE a big problem develops. If we have learned anything in the past year, let it be that knowing you have a problem and taking comfort in the fact that the rest of the Street has the same problem, is no protection from the wrath of regulators, the press and investors.

 

Third, management must be ready to confront and combat problematic behavior or situations by taking appropriate action. What action will be appropriate will depend, of course, upon the situation.

 

But when deciding how to respond to problems, it is important to resist the temptation to consider as serious only those infractions with a big price tag. Improper conduct is a signal that a breakdown has occurred; a small price tag doesn't necessarily mean it isn't a big problem; instead it may mean that the problem was caught before its expense became apparent. Likewise, no one should excuse problematic conduct by big producers. I had thought the days of having a master of the universe operate within a firm as an untouchable were over 20 years ago. The last two years have shown that this is still an issue in some firms and it must be confronted.

 

Fourth, we cannot engage in rationalizations to excuse improper behavior. I read an article recently about a highly paid corporate executive who has been accused of raiding the corporation's coffers to finance a lavish lifestyle. In the article, this executive explained his rationale for his actions: To afford the things he wanted to buy, he would need to sell some of his stock in the company, and such sales might hurt investor confidence. As I read his rationalizations, I wondered, did he really think selling his stock would hurt investor confidence more than using the corporate treasury as a personal piggy bank? I doubt it.

 

Finally, in these economically challenging times, an ethical business culture will resist the temptation to cut compliance programs to improve the bottom line. Compliance programs are not luxury items to be pursued only when things are flush. To the contrary, they are a critical way of developing and maintaining investor trust and confidence—and protecting the firms' bottom line.

 

A system that relies entirely upon regulation to promote the development of an ethical business culture invites failure. The best example I can think of to support this statement comes again, from the analyst conflict arena. Traditionally, research analysts did not base their recommendations on the commercial interests of investment bankers at the same firm; indeed there was a time when such an idea would have been unthinkable. This philosophy was not mandated by any regulatory rule, although NASD rules always required there to be a reasonable basis for all research recommendations. Rather this was simply the ethic of the industry.

 

The reasons for the changes in research recommendations and the role of the research analyst are many. Firms contend that research cannot pay for itself through commissions or that some public companies came to view analysts over time as trusted advisors.

 

Whatever the reasons for such changes, their effect was tainted research by certain analysts in their coverage of companies. Not surprisingly, when reports about these conflicts surfaced in the media, many investors lost confidence in the research reports—and not only the reports of the analysts who were conflicted. Simply put, the regulatory backdrop said the research had to be honest, but the business ethic allowed other considerations to trump honesty.

 

I think the path ahead for our industry is pretty clear—not easy to achieve, especially in these challenging economic times—but nonetheless, pretty straightforward: a renewed and pervasive commitment to operating with the highest standards and a robust compliance and supervisory system to ensure that that commitment is met everyday.

 

And what about the regulators? What is our role in rebuilding investor confidence? Clearly we have to continue to enforce existing requirements across the broad range of rules for which we have responsibility. We must support you in your compliance efforts. And we have to anticipate the problems not yet manifest.

 

To address this latter question, NASD organized an "Ahead of the Curve Task Force," with the goal of tackling issues before they become full-fledged problems.

 

This is not the traditional way of approaching regulatory issues. Historically, commercial activity has not been regulated prospectively. Rather, legislation or regulations governing commercial conduct are often the result of prior transgressions. I think there are many reasons for this; it is often difficult to anticipate problems, and the truth is, there are usually enough extant problems that require attention, that pre-emptive attempts to proscribe conduct that has not yet occurred may appear unimportant. But the truth is, markets today move much too fast for regulators to wait until harm has occurred before taking action. For if we do, the damage to investor trust may already be mounting and hard to repair.

 

The renewed commitment to catch problems before they surface has led us to examine several important issues. For example, we asked ourselves what products members might turn to, when both equity and debt investments appear unattractive. This question prompted us to examine hedge fund sales to retail investors. Because hedge funds are often risky and lacking in transparency, and have traditionally been reserved for the ultra high net worth investor and institutions, NASD asked whether they are appropriate products for the retail investor. Accordingly, we have done special examinations, an advertising and sales material sweep and issued a Notice to Members, which summarizes the broker-dealer's obligation to perform suitability determinations when selling hedge funds, and to provide appropriate training and supervision to associated persons engaged in selling. The Notice to Members also raised the further question of whether the fact that a product has been available only to institutions and high net worth investors raises a red flag that casts doubt upon the suitability of the asset for retail investors.

 

We are also looking at and mapping conflicts of interest throughout investment banks, the possibility of coercive tying of commercial and investment banking activity, compensation practices and a number of others.

 

Additionally, we are engaged in two industry-wide task forces. The first, with the New York Stock Exchange, is examining allocation, pricing and other practices in connection with Initial Public Offerings. Specifically, we are investigating how new issues are priced, how the distribution process works, and whether further rule making may be warranted.

 

The second task force is examining the delivery of front-end load discounts during the sale of mutual fund shares. NASD examinations have revealed that investors do not always receive the load discounts to which they are entitled. However, we are mindful that the variations in the systems used to process and settle mutual fund sales can make the process of determining and delivering the correct discount extremely difficult. We are therefore working with members and the fund industry to develop a solution to this issue, and are considering either harmonizing the settlement process or setting standards for the different settlement processes that are currently used by industry. Our goal is to find a practical solution that protects investors. Again, we have invited industry to participate in this task force to ensure that we, as regulators, understand the challenges and costs of processing so that whatever solution is adopted achieves the greatest overall economic benefit.

 

I am happy to report that the industry has been very supportive our efforts on these task forces and I am confident that, together, we can find solutions to the challenges ahead. NASD will do its part to meet the twin goals of investor protection and market integrity by engaging in timely and effective regulatory activity and taking appropriate enforcement action, when necessary. But NASD cannot restore investor confidence and market integrity through regulation. Industry itself plays a critical role in achieving these twin goals by creating a corporate culture that emphasizes value and loyalty to the investor, and does not tolerate transgressions. As we work together to ensure adherence to high standards of commercial honor, we will rebuild and increase investor confidence, and ensure that the U.S. capital markets embody the principles of integrity for which they have always been known.

 

Thank you.