finra

Mary L. Schapiro
President, NASD Regulation, Inc.

Remarks to the Society of American Business Editors and Writers (SABEW) Conference

Marriott Marina 

Ft. Lauderdale, Florida
November 17, 1998

 

Thank you. It’s a pleasure and an honor to be with you today.

 

I’d like to talk today about one of my greatest worries. Aside, obviously, from the fear that my children won’t be happy or healthy or that the District of Columbia, where I live, will never repair its withering infrastructure or that Ken Starr ... well, never mind about Ken Starr ….

 

What I worry about is that securities regulators and securities regulation could become irrelevant. Not because they don’t serve an important purpose, but because they might not be able to keep up with technology, globalization and the fantastic growth of markets and products.

 

To appreciate this as a genuine fear, some of you will first have to be sold on the idea that regulation, with all of its costs—and they can be substantial—provides value to the marketplace and the investing public. I won’t spend a lot of time trying to convince you of that—suffice it to say that I believe it deeply and have throughout my career.

 

The U.S. securities markets are the deepest, most liquid, transparent and fairest in the world; and regulation, in particular self-regulation, can claim no small amount of the credit for that. Markets are built on trust and confidence: confidence that material information has been disclosed, confidence that prices are fair, confidence that fiduciary obligations will be honored and confidence that those who abuse the public trust will be punished.

 

Regulation helps to ensure that these basic conditions are indeed present in our markets. The great strength of self-regulation is that it marries the best and the brightest in the business with professional regulators to generate regulation that clearly targets problems and addresses them in ways that work in the real world.

 

At NASD Regulation, with responsibility for 5,600 brokerage firms and nearly 600,000 registered representatives, we’re guided by the principle that what is good for the investor is good for the markets. In carrying out our investor protection mandate, we undertake sales practice examinations of our members, institute about 1,000 disciplinary actions each year, administer testing, licensing and continuing education programs, run the largest securities industry dispute resolution forum, review 50,000 pieces of mutual fund advertising each year, assess corporate financing compensation arrangements for fairness, oversee and surveil The Nasdaq Stock Market and write the many rules that largely govern the securities business.

But, back to my fear: technology is perhaps the greatest threat to regulators’ relevance, and of course, it also likely provides the response as well.

 

In light of the technology and investment revolution going on all around us today, how do we regulators:

  • protect investors?
  • ensure market integrity?
  • promote and police fair dealing?

and how do we, when appropriate, get out of the way so we don’t hinder legitimate market operations and evolution?

In exploring these questions, I’d like to focus on just one aspect of technology—electronic commerce—and one market segment—the retail investor. After all, it’s retail investors who truly provide the fuel that makes the engine run. Individuals, directly or through mutual funds, hold a $7 trillion stake in the stock market. Total assets in the market now exceed those in bank accounts and nearly half of American households own some stock, directly or indirectly—up from just 6% in 1980.

 

This is truly an historical shift. We have a new investor class in this country that numbers 125 million people—increasingly, they are middle-class people. Surveys show that during the 90s almost half of the new investors have been women and 38% are non-professional, salaried workers. The typical new stockholder earns less than $70,000 a year. As economist Lawrence Kudlow recently observed: Karl Marx is both dead and wrong. Through the stock market, the American work force owns the means of production.

 

And, no matter how much they may rely on intermediaries who are sophisticated, thanks in large part to technology, investors are presented with more decisions, and maybe more risk, than ever before—which broker or adviser to use, which of the thousands of mutual funds to pick, whether to experiment with on-line trading, how much reliance to place on fund ratings, loads or no-loads, how to use on-line research sources, which on-line sources to trust and on and on.

 

If technology poses new issues for average investors, it also provides tremendous opportunity. There’s no doubt that the Internet has been a boon to investors. You can go on-line today to free sites like Nasdaq.com and get a wealth of incredibly valuable information—charts, historical data and research that just a few years ago was available only to a select community on Wall Street. The Internet has provided the potential to democratize many kinds of human activity, and in the financial services area, it has given a lot of ordinary people access and choices that would have been unthinkable until recently. Ever since the 1930s, much of the regulatory scheme in the securities industry has been devoted to trying to prevent abuses that arise from unequal access to information, and the power that flows from access. We’ll probably never level the playing field entirely, but thanks to the computer age, the gap is narrowing fast.

 

With all these new choices it would seem logical that the role of broker as intermediary would become more important than ever.

 

Fundamentally, what brokerage firms are supposed to do is to weed and sort information and present it in a form that makes the most sense for each and every customer. Now, for the first time, large numbers of individual investors have the ability to trade for themselves on-line, with no one standing between their finger tips and a financial commitment, much the way institutions have long traded. This disintermediation creates potential hazards for those investors who may not have the knowledge or experience to adequately determine which information is worthwhile or to use it effectively.

 

Now, before you accuse me of shilling for full service broker-dealers, let me say that I seek only to raise the question of what, if anything, should replace the protections inherent in the traditional broker/client relationship.

 

Under the scheme that exists now, securities firms have an obligation—and we strictly enforce it—to make sure that every recommendation they make to every customer is right for that particular customer. But the new on-line firms are not recommending anything other than the use of their services. So when a customer sends a trade through this kind of system, the question is, what information or advice is he or she reacting to? Unfortunately, in a lot of cases, it may be nothing more than the kind of garbage that fraudsters used to peddle to one investor at a time through a cold call from a boiler room but can now send via the Internet to thousands in literally seconds. This junk e-mail, or "spam," promises fantastic returns, inside information and special deals. I have yet to see one—and I get lots of them—that’s worth the time it takes to read it.

 

My favorite example—because I am a conservationist at heart—involves a company called Alliance Industries. Via e-mails sent to thousands of investors, Alliance claimed that it was going to corner the lumber market and make a fortune by growing the "Pauwlonia tree," which it said would grow to 80 feet in three years. The company’s Internet site invited the public to buy the stock or buy a tree. I don’t know how many trees they sold, but the stock went from 25 cents to $25 in less than six months—far exceeding the touted growth of the tree—in the same period.

 

Investors are also reacting to the information they read on Internet Bulletin Boards and in chat rooms. These venues are rife with anonymous tips, intentionally misleading information and hype.

 

The popularity of chat rooms, bulletin boards and e-mail has helped to fuel a bull market in microcap stock fraud. The Internet has provided the securities crooks with another distribution channel in addition to the old reliable telephone. This is so much more efficient and economical than the old fashioned boiler room operation, where you have to rent phones, lease office space, hire and train sales people, write them scripts and then make a hundred calls to find one victim.

 

But what about on-line trading activity itself, the great bulk of which is conducted honestly, fairly and efficiently, uninfluenced by spam or chat rooms? There are issues here as well that we should be concerned about. For example, I’m very troubled by the aggressive promotion of new facilities to trade through the Internet or to engage in electronic day-trading where that promotion makes promises that can’t possibly be kept or raises the expectations of investors to unrealistic levels. On-line trading is easy—investing is not—and we should not be confusing the mechanics of entering an order, which is quick and easy, with making thoughtful investment decisions, which is not.

 

We are not Luddites. At NASD Regulation, we embrace new technology and we encourage our members and their customers to do so too. Nevertheless, the promotion of any new technology must be as fair and balanced and complete as the promotion of traditional brokerage services. Firms should avoid promoting the use of new technologies in a manner that encourages reckless speculation by retail investors or that attempts to turn the securities market into a lottery. Those that suggest that day trading "is the best entertainment since television"—as I heard one day trading entrepreneur describe it on NPR recently—are forgetting that we are talking about people’s savings, their retirement funds, or their children’s education.

 

There are other Internet-related issues we’re wrestling with. Even when dealing with the most honest and compliance-oriented of firms, there are more subtle yet equally perplexing issues as well: if a broker-dealer operates a chat room with a moderator to ensure nothing untoward is said, are they, by implication, vouching for the quality of information displayed on the site?

 

What constitutes a "recommendation" for suitability purposes? Is there ever any obligation to stop a customer from trading a particular security? What if the firm believes the security may be the subject of a manipulation? Under current law, when brokers don't themselves spread bad information, there’s no clear obligation on the part of the firm to turn on a warning light, even if it knows, for example, that a stock is being manipulated. I don't know that we ought to impose new obligations, but I know that many firms are reviewing their policies to find the right approach, and I think we should try to work with them to achieve a consensus on ways to protect both the customers and the firms.

 

Perhaps by now some of you share my concerns about whether regulators can remain relevant in the era of the Internet, which by its very nature—its speed, reach and anonymity—calls into question the value of our existing tools for regulating. How do we make sure that new technology doesn’t become a more effective tool for those whose first and only interest is not fast service but a fast buck?

 

To do that, we regulators need to become far more technologically adept.

 

At NASD Regulation, we use the Net aggressively to educate investors, to communicate with our members and to ferret out fraud where we can. We accept customer complaints directly on our web site and through the Motley Fool site on AOL. We participate in Internet Surf Days with our fellow regulators, and refer unregistered offerings and other apparently fraudulent conduct to the SEC. It’s a routine part of our market surveillance to look at Internet postings when a stock has begun to behave peculiarly. And, we’ve developed an on-line surveillance tool that will help us in extracting Internet content from pre-determined sites, index that information, sorting by individuals and issuer names, key financial terms and issuer symbols, and prepare notifications or "alerts" of high Internet activity for specific securities. But let’s be clear, neither we nor any other regulator will ever "cover" the activity that is occurring on the Internet in a comprehensive way

 

There’s no rule we can write to change the darker side of the Internet—at least not without doing unacceptable harm to all that is good about it. So it is critical that we—YOU in the media and the regulators—do all we can to educate the public. I’ve tried to make investor education a central and visible part of the mission at NASD Regulation. We aggressively use our web sites for educational purposes and we work with the SEC, the states and the industry to teach intelligent investing. We’ve used the Internet to put at investor’s fingertips information about every registered broker—from the states where they’re licensed to do business—to their regulatory and disciplinary history.

 

Closing

 

Regulators will always struggle to muster the resources and talent to keep up with change. Most particularly, electronic commerce provides us with an extraordinary range of challenges and issues. And while I periodically fall prey to my fear that we’re falling behind, the reality is not so grim as that. When it comes to change, we’ll almost certainly always be reactive, but react we must and react we will—hopefully more often than not with intelligence and common sense.

I’d be happy to try to answer your questions.