finra

Remarks by Mary Schapiro

President, NASD Regulation, Inc.

21st Annual AICPA Conference of Banks and Savings Institutions
General Session Three

Grand Hyatt Washington Hotel
Washington, D.C.
November 7, 1996
(11:15 am)

 

Thank you Carol [Carol Larson, Partner, Deloitte & Touche LLP,] …It's a pleasure to be here.

 

Like the securities industry, the banking industry is in the midst of unprecedented change—and the role of the accounting profession to make sense of it all is absolutely critical. As regulators, and securities regulators in particular, our reliance upon you is fundamental to our success and to the viability and preeminence of our capital markets.

 

I haven't been asked to address accounting issues—which would be a real challenge in front of this audience, especially for a lawyer. I also haven't been asked to speak to banking issues which also would put me beyond my depth as a securities regulator. Instead, I've been asked to comment on corporate governance and how it can be strengthened.

 

I'd like to speak about that in the context of my personal experience. First, as a regulator for more than 10 years who watched the successes and, unfortunately, the failures of corporate governance and internal controls. And, secondly—and I might add, with a great deal of optimism—my very direct experience in participating in the creation of a new corporate and governance structure for the National Association of Securities Dealers.

 

With the country having just chosen its president and its 105th Congress, the nation has been focused intensely on political governance. Corporate governance rarely makes front page news—I suppose unless you are Archer Daniels Midland. But it is as important to the success of a company or an organization and its customers, employees, and shareholders as political governance is to the well-being of the nation and its citizens.

 

Like everything else, the process is undergoing change.

 

Walk the halls leading to the boardroom of most long-lived corporations and you will see one aspect of this change told in the pictures on the walls. In years past, those pictures were almost exclusively of men, the majority of them white men.

 

The more recent photos show a positive evolution of Board composition through the inclusion of women and minorities. Diversity of race and sex represents a strengthening of the corporate board because it reflects the reality that good ideas and good governance come from diverse elements of the population.

 

Unseen in those photos, however, another equally important strengthening process is underway. It is strength derived from the new intellectual and ideological diversity of the corporate board.

 

The old-fashioned board was often a friendly group of industry professionals, mostly from within the company, sprinkled with several trusted service providers and a few retired politicians or diplomats to lend prestige.

 

The new corporate board, in contrast, is increasingly a multi-disciplined body. Where the boards of the past were rooted in the tradition of a given industry—and often were drawn exclusively from the ranks of that industry—the model for successful boards today is one that is EXTERNALLY focused, often globally focused…and composed of people integral to, but external from, the organization itself.

 

These new board members are like pilots. They may not know how to make airplanes, but they're experts in navigating through all kinds of weather.

 

Like the progressive boards in the banking industry, the NASD has taken its governance structure down the path of creating both what might be called an externally focused "knowledge board"—and a board that is more representative of the NASD's diverse constituency.

 

Let me talk about that constituency for just a minute because it's a unique mix of customers.

 

First, it includes a membership of 5,400 securities firms, among them many bank-affiliated broker dealers.

While the NASD's membership includes the largest full-service securities firms—household names like Merrill Lynch and Smith Barney—80 percent of the firms report gross revenues of less than four million dollars.

 

And less than 10 percent of our membership consists of firms that make markets in Nasdaq stocks. Furthermore, the interests of this minority of members often differs from that of the majority of member firms, who engaged in a general securities business. That is, they perform brokerage functions, but do not buy and sell Nasdaq securities for their own account.

 

In addition to a diverse member constituency, the NASD also serves two extremely important non-member constituencies. Those constituencies include thousands of public companies that trade on The Nasdaq Stock Market, which the NASD operates…and millions of investors, large and small, who depend upon NASDR to adequately protect them in their interactions with our broker/dealer members…and depend on the NASD to ensure the operation of efficient, fair and liquid securities markets, which investors are participating in as never before.

 

As many of you are aware, the NASD came under tremendous scrutiny in the wake of concerns about the fairness to investors of trading on Nasdaq. The NASD's response to allegations of market maker impropriety, which were first raised in an academic research paper published in 1994, was to take a hard look at its own corporate structure and system of corporate governance.

 

It appointed a Select Committee headed by Warren Rudman, which made numerous recommendations for improving the NASD's structure and governance.

 

The NASD acted on those recommendations, and the first of the improvements it made was to re-structure the organization to create a single parent—NASD, Inc.—and two subsidiaries, The Nasdaq Stock Market, Inc. and NASD, Regulation, Inc. In essence, it was to focus our energies along functional lines: regulation and market operation.

 

Furthermore, each entity embarked on the assembly of a true "knowledge board," people who understand the mission of each entity and are capable of developing policies that best serve the organization and its constituencies. A concerted effort was made to represent all of the various customers served by the organization.

 

In a move that sets a precedent for the rest of the securities industry, in April of this year a new NASD Board was created that drew a majority of its governors from outside the securities industry—from the ranks of individual investors, institutional investors, public companies, the non-profit sector and other talent pools.

 

The subsidiaries, Nasdaq and NASD Regulation, have also formed boards that are equally balanced between industry and non-industry members.

 

One of the first, and biggest, responsibilities I had when I joined NASD Regulation in February was to join in a process of seeking out the most experienced, qualified candidates for NASDR's Board. Because it's important that there be a good working relationship between the Board and the organization's staff, I took a very active role in the recruiting process.

The end result is a very large board—27 people—including 13 drawn from the securities industry and 13 drawn from non-industry ranks.

 

It is also an extremely talented and committed board. Its size, though large by comparison to virtually any corporate board—not so large when compared to many non-profits, has, thus far, not hindered its ability to respond to emerging issues or take quick and decisive action. Nonetheless, over time, the Board will shrink in size to a more manageable number.

 

NASD Regulation's purpose is to strengthen market integrity through vigorous and evenhanded self regulation. Given this focus, NASDR's Board is made up of candidates who understand the regulatory process—and to a person are capable of developing policies in tune with the increasingly complex environment in which we work.

 

Having a board that understands the latest trends, products and complexities of an industry is vital to creating policies that can not only help an organization prosper…but help it avoid a crisis. As a regulator for nearly all of my career, I have witnessed, with varying degrees of closeness, many crises which have destroyed or nearly destroyed fine organizations.

In retrospect, the recent financial missteps that occurred at Sumitomo and at Barings—a failure with which I had a lot of personal and nerve-wracking involvement—revealed a lack of understanding at the governance level of the risks that are being taken in financial markets and often a corresponding lack of internal controls to manage those risks. Either of these factors—lack of Board understanding or lack of adequate controls—is dangerous alone, and together they make a deadly combination.

It is not enough for a board to presume that the organization's management understands the risks—the board itself must understand them, and ensure adequate mechanisms are in place to monitor and control them.

 

But you can't create adequate controls if you don't know what you are controlling. I dare say there were many in management at Barings, for instance, that did not understand the risk involved in ineffective supervision of trading operations, and did not understand at a basic level the dynamics of the arbitrage trading strategy that had actually been approved.

 

If you can't recognize a friendly dog from a dangerous one, chances are you're going to get bitten. A fundamental failure, a common theme, in Barings, in Sumitomo, in Orange County, at Daiwa, is that management and/or Boards failed to ask the hard questions in the good years. How could Nick Leeson, year after year, report extraordinary profits in derivative markets? How could such risky strategies always be winners? Should all the investment decisions for Orange County—even though they were very profitable in the early ‘90s—have resided in one man?

 

Based on past history, the advice for banks is that as they move into the securities business, their boards should reflect expertise in the areas in which their organization is moving.

 

Next…It's not enough to make boards socially diverse, externally focused and highly experienced . They have to be given—and accept—real responsibility.

 

We live in an era of mergers, acquisitions, spin-offs, downsizing, right sizing, and the need for financial and organizational re-structuring—all of which require board participation, decisions, and ultimate approval. As Ronald Berenbeim, who studies corporate governance issues for the Conference Board noted: Boards have little choice "but to begin acting like the powerful institutions that they [are] supposed to be."

 

The strong, successful boards I've known spend time and effort debating and hammering out policies that determine the course of an organization. They do so because they have the responsibility for doing so.

 

One of the most important functions of the new NASDR Board is that of policy making.

 

Because of the complexities of the issues we face, our boards meet not the traditional four times a year…but six. The busier schedule is a nightmare for our Corporate Secretary—who has a total of eighteen board meetings to keep straight—but it keeps us on top of fast-breaking issues and allows us to react to fast-changing environmental and market conditions.

It also allows for periodic Board meetings devoted primarily to review of company strategies. Despite the overwhelming pressure we all feel in dealing with day-to-day crises (a phenomenon we at the NASD are intimately familiar with), Boards can help force management to take a longer term view.

 

Strengthening corporate governance also requires the presence of an adequate support system to boards at both the stage of policy development and policy implementation.

 

This support can come from committees that lend another tier of expertise to the primary governing body. We make extensive use of committees, which advise the Board on a variety of issues and serve as yet another way to give important segments both from the industry and outside it a voice in the policy making process.

 

But the process of giving non-governing voices a chance to be heard does not need to be as formalized as we're often used to making it.

 

Another important group that is obviously essential to supporting corporate governance is an organization's staff. Board members should have direct access to management, And, because staff are ultimately responsible for implementing Board actions, they should be closely involved in the policy making process. They should also be held to the highest standards in communicating to the Board ALL information necessary to informed decision-making. Achieving the balance between too much and not enough information is a tricky one. But as both a Board member and a staff member, I would argue strongly for erring on the side of too much. Nonetheless, it is critical to be conscious of the demands on Board members time and to be discerning and concise in the transmission of information to them.

 

At the NASD, staff have traditionally played a role in developing rule proposals and with the advent of the SEC settlement, that role is being expanded, especially with respect to the writing of regulatory, compliance and enforcement rules and policies.

The important thing is for Boards and staff to respect each other—and the share the responsibility for achieving an organization's vision. Boards that treat staff like servants and staff that expect Boards to rubber stamp everything they suggest are equally misguided—and equally out of sync with what it takes of succeed in today's world.

 

There is one final element that I feel can strengthen corporate governance, and it's still in its infancy. That process is self-examination—a board taking stock of its own actions, submitting itself to peer review.

 

Until a few years ago the idea of anyone—investor analyst, media or manager evaluating a board's performance—was out of the question. When things went right, or wrong, the CEO and not the Board got the credit or blame. Today, boards are subject to all sorts of external scrutiny—and I think for the most part this scrutiny has been beneficial.

 

But the best form of strengthening ultimately comes from within.

 

We are beginning to see a trend toward boards themselves setting performance standards and determining on a regular basis whether or not they have been met. Companies like GM and Westinghouse have promulgated guidelines for the process. Westinghouse issues a report annually by its Nominating and Governance Committee to the full board that assesses the Board's performance and where improvements can be made.

 

Whether or not a formal self review is undertaken, I think it's important for boards to look critically from time to time at their own performance and even, as the NASD has done, its own structure. In time the process may become routine, as it is now routine for companies to review employee performance.

 

Those are my thoughts on strengthening corporate governance. Strength resides in diverse representation…varied professional expertise…the possession of real not artificial responsibility…support from staff and outside experts…and a willingness to submit to self review.

 

This is the direction governance is taking in many organizations across the country. It's a healthy process. It's keeping corporate governance accountable and functional and meaningful—and in doing so it's bringing tangible benefits to a multitude of shareholders and constituencies.

 

Thank you and I'd be happy to take your questions.