finra

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

NASD Fall Securities Conference
Sheraton San Diego Hotel & Marina

San Diego, California
October 22, 2002

 

Thank you very much for your welcome, and I, in turn, would like to welcome you to NASD's Fall Securities Conference.

 

I hope you will find that we have put together a program that is as topical and informative as possible, a daunting task in these times. I recognize that current events have made it difficult for you to catch your breath, and you'll have to take it on faith that we on the regulatory side find ourselves confronting the same challenges. The scope of recent events has been sweeping both in subject matter and effect. And the fallout from these matters makes this a particularly propitious moment for us to meet.

 

We view education, whether it is for the benefit of the industry through conferences such as this, or for the public, as a key avenue in the path of our regulatory mission. We also know that successful education begins with listening and learning before teaching and we try to use our time at these conferences to listen and learn from you and not just make pronouncements from on high (OK we'll make a few pronouncements from on high, but I promise we'll listen too!).

 

I want to take the opportunity of our gathering to discuss the current landscape. We have no choice but to accept and institute change in the delivery of financial services and I have no doubt that together we are up to the task. Let's discuss what we at NASD are doing are doing as a regulator and what we must do together so that self-regulation can rise to the demands of the moment in a manner that will ensure investor protection and financial integrity immediately and in the future.

 

Over the past several months, Bob Glauber and I have traveled throughout the country and held investor forums. In Scranton, Pennsylvania; Baton Rouge, Louisiana; and Las Vegas, Nevada, among other communities, investors recounted their personal and local stories of fortunes won and lost, retirements postponed, and a faith shaken by reports of conduct they cannot fathom. Each story told was a little different, but each investor conveyed a simple message: they had not been treated by public companies, the marketplace and the financial services industry with the simple respect and fairness they were owed. Trust me, these meetings crystallize the attention of a regulator. The entire financial services marketplace must take heed of the clear and simple message that investors are sending.

 

I don't think we can appreciate where we are now unless we spend a moment reviewing how we arrived at this place in time. In sum, public companies engaged in unprecedented earnings management that enriched managers and duped shareholders. There were those who treated public companies as a private fiefdom, forgot that they were the custodians of their shareholders interests and believed that the purchasing power of the corporations under their stewardship were assets that they could trade for their personal benefit and profit.

 

Some boardrooms became places where loans and cash were stealthily dispensed while the public trust of shareholders cast no shadow. The accounting industry, charged with auditing and certifying the financial results of public companies, compromised its standards and parsed the language of generally accepted principles, regulation and law to the point where they were rendered virtually meaningless.

 

The research product of some firms nurtured existing and prospective investment banking relationships, instead of informing the public about the investment prospects of the companies the research was meant to cover. And IPOs were allocated in a manner that at least invites allegations of impropriety and at worst implicates serious violations of the federal securities laws and the rules of the self-regulatory organizations.

 

Did this happen universally? No. Does that matter? Yes, but not as much as we might like. The malfeasance of a few has crippled particular companies and by association, has damaged the thousands of firms who were not at fault, it has vaporized thousands of jobs, dashed the financial security of the retired and the nearly-retired, shocked financial markets trying to climb out of a recession, invited massive federal and state attention and subjected a handful of financial services firms to a prospective measure of liability that one cannot be sanguine about their ability to absorb.

 

Some may be tempted to argue that investor anger and confusion in the wake of this market's retrenchment is the result of their own greed or unreasonable belief in markets that forever defy gravity. Even to the extent that observation may be true, it will not help us. Investors contend that the game was rigged, the rules were unknown to them, their interests were ignored and they harvested financial loss, while insiders reaped unimaginable riches.

 

Just and equitable principles of trade is not an empty slogan; it is an imperative that must be followed because the capital markets constitute a public trust and their health and integrity go to the very strength of our nation and the fabric of our society. On this there can be no discussion. NASD will regulate on that basis and with that understanding.

 

There are many lessons to be learned, but let me set out what I consider the BIG FOUR. And let me hasten to add that I fully understand that many of the problems we are grappling with today were not the making of the vast majority of our member firms. Nonetheless, I believe the lessons can be instructive for us all.

 

FIRST. Contemplate whether what you do today will be acceptable three, seven and ten years from now. If we have learned anything from recent events it is this: when the chickens come home to roost, questions will arise about why there was a henhouse in the first place. Claiming that hindsight is 20/20 will gain us neither sympathy nor understanding. Avoidance or control of the problem through foresight and action is the better strategy.

 

SECOND. The penalties from a court of law pale in comparison to those meted out by the court of public opinion. There is really no appeal from the judgment of the press and elected officials. Our industry is reaching a painful understanding of this fact.

 

THIRD. The road to damaging the trust and interests of investors is paved with rationalized intentions. Every time a firm decides to bury a disclosure in small print or bundled mailings, argues why it really is in the best interest of their customer not to be told about certain charges, commissions or fees, or talks itself into believing that it can simultaneously serve different clients with competing interests without meaningful disclosure, a step is taken down this road.

 

FOURTH. Defending commercial behavior on the basis that it was standard operating procedure that occurred industry-wide and was well known is a fool's defense. Bad acts repeated and publicized are still bad acts. This may seem to be an obvious statement, but you can't imagine how often regulators hear the excuse that a course of conduct is acceptable because "that's the way everyone does it" and "everyone knows that that's the way everyone does it."

 

We have much to do - regulators and the industry - to regain and repair that most precious of commodities - trust and confidence. Business as usual is, in no uncertain terms, not an option. Fidelity to the interests of investors - your clients - must dictate every large and small decision made. "Putting investors first" can't be just a tag line; it must be the prism through which all actions and potential actions are viewed.

 

We at NASD think the most important ways to meet these challenges are through (1) understanding and anticipating the problems, (2) responsive rule making and interpretation, (3) active enforcement, and (4) accessible education. But, let's be clear: there has never been a time when self-regulation was needed more. And self-regulation works best when the industry works cooperatively with its regulator.

 

Recognizing and anticipating problems is not always a simple feat. Current events teach us that miscalculations as to acceptable norms of commercial conduct can have disastrous consequences. In our industry, it impacts the protection of investors, market integrity and structure, the financial health of our members and the American economy. Timing is crucial.

 

In appreciation of the criticality of timing we have launched an "ahead of the curve" initiative to anticipate problems as early as possible and develop ways to contain them before they can do harm. We aim for a vision of problems before their footings are in place. If our efforts through cutting edge computer assisted examination programs such as ADS and INSITE can be characterized as regulation conducted in real time, then getting ahead of the curve should be thought of as regulation ahead of time.

 

We aren't kidding ourselves. This is an extremely difficult thing to do, and is akin to clairvoyance. But we think that its potential for averting investor misery and shattered dreams is well worth it.

 

To get ahead of the curve, we are marshaling all of our resources, both within and outside of NASD. NASD resources include our most thoughtful experts, our powerful computer systems, our corps of examiners, and the terabytes of data that we gather, all coordinated and evaluated in new ways. Outside NASD, we are engaging the services of other regulators and experts, but our most important partner in this is you.

 

In the past, your most frequent help has been commenting on our rule proposals. Those comments help shape our rules with greater precision, but these tumultuous times call for you to be more than just our critic, even a constructive one. You need to provide us with information that we can use to stay ahead of the curve. I am willing to wager that the major problems that we are struggling with today were discussed first within your firms. How much better off would we be today if the regulators had been included in those discussions, so that an early response to growing problems could have been implemented?

 

I know we are proposing an incredibly counter-intuitive interaction when we ask you to discuss tricky, delicate potential problems with your regulator. But that is exactly what I am asking of you. A new era of transparency and discourse with regulators is the best way for us to get ahead of the curve.

 

The second way we at NASD meet our challenges is responsive rulemaking and interpretation. You have no doubt been following our recent flurry of rulemaking and probably think that our rule writers have been making too many visits to Starbucks. But to be honest, the volume of our rulemaking is driven by the anthology of problems we are all reading about every day.

 

I would like to highlight three of our initiatives, each resulting from recent events: anti-money laundering, research analyst conflicts of interest, and IPO allocation procedures.

 

Anti-money laundering was something in which we had only a limited role before the events of September 11. The PATRIOT Act that followed moved concerns about money laundering from being a criminal justice and economic fraud problem to the front line of national defense.

 

We quickly responded to the PATRIOT Act with NASD Rule 3011, which requires firms to set up an anti-money laundering compliance program. We didn't just write the rule and walk away. We recognized the enormous responsibilities - particularly for small firms - of these new rules and have sought in every possible way to ease the burdens. We have published a great deal of guidance in four Notices to Members. We prepared a template to help small firms navigate the maze of regulatory requirements in setting up their programs. We have run well-attended phone-in workshops, and provided information and online training on our web site. We even built a revved up engine to speed your searches of the official list of money laundering bad actors. Because clearly, a part of our job is and must always be helping you to achieve full compliance.

 

Perhaps no issue has been as pervasive in the marketplace as the conflicts of interests facing analysts. It has been hard to find a day in the last year without a research analyst story on the front page of the Wall Street Journal or the New York Times.

In May the SEC approved our new rules governing research analysts and reports to improve the objectivity of research and give investors more reliable information to make their investment decisions. Since then we, the NYSE, the SEC and Congress have worked on additional ways to prevent research analyst conflicts of interest. The Sarbanes-Oxley Act specifies even more SEC or SRO rule actions that we are now drafting. And, further changes are coming in a second round of NASD-NYSE rulemaking pending approval at the SEC. These changes would require further separation of analyst compensation from investment banking influence, prohibit research intended to bolster the price of secondary offerings known as "booster shots", restrict the analyst covering a company from taking part in the investment banking pitch meeting known as the "bake off", require notice when firms terminate analyst coverage, and create a new registration category and examination for analysts.

 

We have also seen far too many articles recently about investment banks misusing the IPO allocation process - in summary it is alleged that customer interests were sacrificed in allocating IPOs in an effort to garner further investment banking business. In August we proposed rules that explicitly prohibit spinning, laddering, quid pro quo agreements and unfair penalty bids.

 

In response to Chairman Pitt's request, we and the NYSE have gone beyond making rule proposals and convened a blue ribbon IPO Advisory Committee to review the IPO pricing and allocation process, evaluate existing rules and statutes, and recommend improvements. The two self-regulatory organizations will use the Committee's findings to formulate further rule proposals or other recommendations to the SEC.

 

The third way that we at NASD meet our challenges is active enforcement. Enforcement is an area that I won't dwell on in the time that I have remaining, since it will be covered in great detail during the conference. Spotting problems correctly and early, and writing responsive and surgical rules will be hollow efforts if we do not have an active enforcement presence to help stiffen everyone's resolve to do the right thing.

 

Our commitment to effective enforcement is unwavering and growing; this summer we bolstered enforcement staffing by more than a third to try to keep pace with our workload.

 

And the fourth way we meet our challenges is through education. Accessible education is essential for the investing public to become intelligent and discerning consumers of financial services. We have beefed up our investor education efforts by holding investor forums around the country, increasing and updating educational content on our web site to the point that it receives 25,000 visits a month, translating our advice into Spanish, and issuing Investor Alerts and unbiased new product descriptions that investors can use to avoid problems.

 

And we plan to do more. We will be explaining single stock futures to investors, making available Anti-Money Laundering customer notices for firms to use, supplying a major - and needed - piece on 401Ks, and fielding an "Ask NASD" frequently asked questions database that uses artificial intelligence to either respond to investor questions with relevant information, or automatically refer the question to the right NASD staff person for response.

 

You can help us raise the level of investor awareness by pointing your customers to our Web Site for the variety of educational material that can be accessed there. We encourage you to contact us with ideas for additional content that can be provided to customers so that they can become better-educated consumers.

 

Your helping NASD with the job of regulation is part of our critical path to success. But that isn't your main job. The center of your focus must be the compliance function within your firms. 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 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 regulation of the industry.

 

You see what goes on day-to-day and can spot small problems before they become large ones. You develop specific practices and policies from our general guidance, to make regulation work in concert with your business, not against it. You are there to make sure that losses that investors suffer come from the vagaries of the market, and not from dishonest practices or unfair dealing. You are the ever-present reminder that if a broker's conscience flexes too readily, the consequences will be swift and formidable.

 

You do all these things all day, and every day, and it would be hard to overemphasize the role you play in ensuring fair securities markets. I believe that there is no higher calling than your profession, and we all thank you for what you do to protect investors.

 

So what do we have to do to survive the tumult of today? The industry has been seriously harmed because damage to investors' interests did not result solely from market gyrations. For certain, industry practices must and will change. But we need to do more. We need a sea change in the culture of our member firms. A culture of compliance must prevail. Firms must cease parsing the regulatory language and start endorsing the spirit of the securities laws. In connecting the dots of behavior, we must understand that it is of no utility or refuge when each dot is technically correct but the whole pattern of connected dots suggests a problem.

 

The leadership of our member firms has to understand that compliance is not just a cost; it is an integral part of a successful business. Compliance can't be something that product is maneuvered around; it has to be at the core of product design.

Times are turbulent, the damage has been extensive and the immediate economic future is uncertain. But the American capital markets have been counted out before and the pundits were wrong then. It is up to us to make sure that those betting against us are wrong now. This industry has the resolve, the resources and the intellectual capital to make the changes needed to restore the confidence of the investor and the integrity of the marketplace. We know we can count on all of you in this effort. Thank you for attending this conference and thank you for your continuing efforts in guarding the interests of investors, our industry and the capital markets.