finra

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

SIA Compliance & Legal Division Annual Conference
Westin Diplomat Hotel, Hollywood, FL
March 20, 2006  
   


Good morning, and thank you once again for inviting me to come and have our annual chat. I always look forward to the opportunity to come and speak with you and I hope you feel the same, although I have the feeling at times that many of you look at me with trepidation, waiting for the next big regulatory ball to drop. Today's talk promises no regulatory bombshells and I am not here to scold you or exhort you in any way. OK, so I am not quite up to singing "Don't Worry, Be Happy," but you can only ask so much of me.

 

What I would like to do today is offer some thoughts on the state of regulation and comment on some recent criticisms of the regulatory environment and the recommendations specifically aimed at us. And I hope to mention throughout our talk the efforts we are expending to make the landscape of the industry more cohesive, rational, and free of those un-navigable bends beyond the horizon.

 

There is no question but that after the market break of 2000 the pace and breadth of regulation has significantly expanded. I have, in past talks with you, spent considerable time discussing the reasons underlying such regulation and I won't repeat those reasons this morning. Clearly we—and all regulators and legislators—are seeing a reaction from various quarters and the subtext is—that regulation is becoming the problem rather than the solution. These criticisms come with the territory so we're not surprised, but that does not mean they need not be addressed. The key for us is to pay attention to what is being said and not to discount the rebounding criticism of the moment as necessarily self-interested, uninformed or irrelevant—we need to learn what is useful from the criticism and apply that in our work.

 

Later this year, I will succeed Bob Glauber as Chairman and CEO of NASD. The opportunity to lead an organization of the quality of NASD, in an industry that is essential to the success of our country, is a great honor and a privilege. I do not underestimate the impact NASD has on the business and the seriousness with which we must carry out our responsibilities to protect investors and the integrity of the markets, while allowing the business to innovate, grow and flourish.

 

And, it comes as no surprise to you that I believe regulation is a necessary component of commercial success. But as I get ready to serve in my new role, I am committed to viewing the regulatory landscape with the input of not just my colleagues at NASD, but from the eyes and vantage point of those from inside the industry.

 

So, I have embarked on a listening tour—one-on-one meetings with CEOs from firms around the country, representing every size and business model, to hear their perspectives on NASD and regulation, and their views on what are our best opportunities for together ensuring the highest levels of integrity in the industry. What I learn, I will share with the entire NASD staff who, in turn, will look for appropriate opportunities to integrate these lessons into our regulatory programs.

 

My listening tour is still in the early days, but I am hearing from some a concern that the "regulatory pendulum" has swung too far and the burden of regulation has become too great. While this overarching theme is certainly of no surprise to you or me, I am pleased to say that I am also hearing of the value of sound regulation and how to make regulation work for the industry and investors. The question is really one of calibration.

 

I believe that regulation can always be improved and I don't always associate "improvement" with the expansion of rules or requirements. We take action on many fronts because we have myriad responsibilities to meet, and we try to get things right by embracing the possibility that we may not always have the best answers. That is the reason we tap and encourage industry thinking on virtually every potential rule proposal. That is why we create Task Forces to tackle the most vexing industry-wide problems. That is why the senior management of NASD spends thousands of hours a year with our standing committees and at programs like this.

 

We are not flexible in our commitment to investor protection or market integrity, but I know that we are ever pliable in considering the best solution to a problem. Later, I will turn to our recent recommendations, to amend the research analyst rules. These efforts symbolize, in large part, the proposition that some rule restrictions can be reworked to a better construction with a better defined focus.

 

The SIA recently published a survey on the costs and burdens of compliance. I, of course, will much prefer the upcoming sequel—to be titled "The Gratification and Pleasure of Compliance, Volume 1." But until that much anticipated academic tome eclipses sales of the next, and sadly last, Harry Potter installment, let me note and comment on several aspects of the survey.

 

First, while we shouldn't delude ourselves into thinking that either strong compliance or needed regulation comes on the cheap, NASD is not an enemy of efficiency. We monitor our costs and budgets rigorously, and aim for greater efficiency.

 

For example, through our Next Generation examination program, we are developing solutions that use technology to increase our examination productivity and reduce the time and effort needed by regulated firms to respond to our requests and information requirements.

 

In a similar vein, at NASD, I have directed organization-wide coordination of our sweep efforts across firms. Many of you will have experienced a vast reduction of sweep requests from NASD and the elimination of duplicative sweep requests from within NASD because of the centralization of control and authorization of all sweeps. And we have made it known to the industry, and I happily repeat it here, that if you get a sweep request from NASD that is duplicative of a request from another regulator, then let us know and we will work with the other regulator to eliminate any overlap.

 

And one last thought for the moment on efficiency. Our recent efforts toward more focused rulemaking and examination are limiting the burden on firms and make us more efficient in getting up to speed on issues. But, sweeps are sometimes a blunt method for simply gathering enough information and education on an area of regulatory concern. While they are an important tool, sweeps are not interactive exercises lending themselves to the next iterative question to be asked. Regulated firms rarely see sweeps as a beneficial exercise for them and that is understandable. In contrast, our efforts to be proactive through initiatives such as the Ahead of the Curve Task Force have fundamentally changed the way we access information.

 

In the context of Ahead of the Curve initiatives, we bring firms into the loop as part of a cooperative exercise in gathering information. Firms seem to relish the opportunity to teach us their business, make their points, both commercial and substantive, and have an interaction with NASD outside the context of an examination. I'll talk a little later about a few current initiatives, but I wanted to note the marriage of benefits—firms having an opportunity to share their unvarnished thoughts, concerns and interests with NASD in a constructive setting—and the reduction of burden—the need for fewer sweeps because of alternative and better avenues for information discovery.

 

The SIA survey makes several key findings and I won't attempt to discuss all of them but several jump out for comment and reflection.

 

First, of the regulatory rule-based initiatives cited in the report as presenting undue burden, the vast majority are either statutory-based law or federal administrative agency rules such as Sarbanes-Oxley, Patriot Act, SEC Books and Records and Investment Advisory Regulations. I do not make this differentiation for the purpose of saying "blame them, not us." Rather, I think some perspective needs to be maintained about the degree to which SROs create incremental burden and cost. It is fallacious, in my view, to believe that, if SROs were not on the scene, the subject matter we address would disappear. It would not. Rather, I believe it would be refashioned but in a manner more distant from the voice of those regulated and less fine-tuned to burden and cost. This is not a slander on federal regulation, it is an advantage of self-regulation that Congress understood in codifying the role of SROs.

 

There is the potential for real harm to the industry, investors and markets in failing to recognize the wisdom of a regulatory scheme that truly has at its core self-regulation. Can there be better coordination among regulators? I am sure the answer to that question is always yes. You might ask what has been our call to action in the face of that answer. Well, let me remind you that, whether it came to Regulations NMS, SHO, the Patriot Act or Sarbanes-Oxley, NASD has been on the forefront of trying to intercede for greater clarity of the mandated obligations and better calibration of those requirements where reasonable. And we have sought change successfully.

 

The provisions of Sarbanes-Oxley required all broker-dealers, whether or not publicly-held, to have their annual financial reports certified by PCAOB-registered public accounting firms. The vast majority of NASD's members are not publicly-held and the costs of a PCAOB-registered accounting firm are for them either materially financially burdensome or untenable, but most importantly did not seem to NASD to be consistent with the other audit requirements of the Act.

 

I cannot say with authority how this matter will eventually be resolved, but I do know that the series of temporary exemptions given to date to such firms by the SEC were largely the result of the efforts of NASD in working with the SEC.

 

As for examination coordination, this has long been an area of focus for us. It is important because examination coordination (or the lack of it) impacts virtually every firm. Until ten years ago, regulators pretty much planned and executed their own examination programs. That autonomous approach has dramatically changed. Since then, NASD, together with the SEC, the NYSE and other self-regulators, have operated under a formal Memorandum of Understanding through which we share information, coordinate examinations, and identify regulatory priorities. Common areas of review are allocated, such as AML, Research Analyst Conflicts of Interest, Regulation SP, Business Continuity Plans; Regulation SHO; Continuing Education; Supervisory Controls; and Electronic Communications, so that only one regulator examines the topic.

 

Similarly, options examinations are coordinated through the Options Self Regulatory Council and the result is a designated options examining authority for each firm. A final example that I will cite, and there are many more, relates to branch office examinations. To coordinate these types of exams, NASD took the lead in developing a web based Report Center that is shared among NASD, SEC, and NYSE staff. The Report Center contains the information necessary for the regulators to choose high risk branches for examination and to coordinate those examinations.

 

The SIA survey notes that compliance mandates have had a material impact, increasing overall compliance spending levels significantly. This is a point well worth examining, in fact it should be one of perpetual consideration. I don't want to quibble about the fact that the cost of compliance has gone up and probably to a material extent and we are committed, as I have said, to realizing greater efficiency and less cost where possible and amending rules to reduce burden where advisable.

 

But some further observations are in order. Prior to the 2000 market break there were firms with compliance efforts that simply did not measure up. For those firms playing catch-up, it would be a mistake to ascribe increased costs as attributable to incremental regulatory burden from and following year 2000. Similarly, it is not quite honest to point to regulatory burden when firms manufacture and sell complex products, such as structured debt instruments and variable insurance products, that require the building of sophisticated computer models and systems with attendant IT support and specialized personnel costs to meet, in part, existing regulatory obligations.

 

In fact, some firms have seen fit, based on good business judgment and not regulatory concerns, to develop and implement entirely new infrastructures to manage the risks that surround new products. When you build the bigger, better thing in financial services that is structurally ever more complicated, it costs a lot just because you still have the old, old—and absolutely critical—duties to customers.

 

The other aspect of compliance costs that must be understood is that they must be incurred, at least to some extent, to realize benefits to the industry you don't want to eliminate. In his recent book "The Wisdom of Crowds," New Yorker financial columnist James Surowiecki notes that in 18th and early 19th century Britain a large portion of that nation's economy, including the vital transatlantic trade with America, was run by the Quakers. The reason for the Quakers' success was their notoriety for absolute honesty and meticulous record keeping. I can sum it up with a phrase well-known to this industry, "their word was their bond." And the Quakers went on to build some of the great British banking institutions such as Lloyds and Barclays.

 

You can dismiss this as a quaint story about markets and economies from another age, but that is not the case as far as we can tell. NASD's Office of Economic Analysis has recently surveyed the economic literature in the area of the effect of regulation on trading markets. The evidence is compelling that the viability of any trading market rests on strong regulation, the cost of equity capital decreases with more rigorous regulation because there are wider shareholder bases, and regulatory-mandated transparency reduces transaction costs providing incentives for further participation and therefore liquidity in the marketplace.

 

I recognize that some of the pushback on regulation is coming at a time when people believe that the recent conflagration of industry, and broader corporate, problems and scandals have either been extinguished or vastly reduced. I hope that factual premise is correct. But in a fairly recent Forbes article about the year 2005 being a record one on Wall Street, measured by the earnings and bonuses of the larger proprietary trading and investment banking houses, the article asked the pointed question: "record year on Wall Street during a sub-par year for the averages and investors, what gives?"

 

But, if financial history has taught us anything, it is that the cracks threatening trust and confidence always reside just under the thin veneer of better times. The threats to trust and confidence are always present irrespective of the fact that their causes may not always be predictable or rational. I urge the industry to think beyond quarterly results and consider these observations when judging the magnitude of compliance cost.

 

And I assure you that I understand there is the other side of the street to this equation: that we, as regulators cannot allow the clarion call that the sky may fall at any moment to mask our obligation to be judicious, cost conscious and efficient in the implementation of regulation. I understand there is a feeling by some that to date we have not gotten the balance exactly right. I can say that we at NASD have always struggled with these considerations of cost and burden even if the evidence of that struggle has not always been detectable in the outcome of our efforts.

 

The survey makes certain recommendations worth addressing. I'll start with my personal favorite; the call for greater clarity in rulemaking to eliminate guesswork. One must observe that on this issue the industry has spoken out of both sides of its mouth. I understand that the industry is honestly not monolithic in its views or interests. I understand that these differentiations come from variance in businesses, business models, capital, size of operations and segment of the investment market being served.

 

Nonetheless, when we attempt to be specific and bright line in our approach, as was the case in our proposal concerning policies and procedures for heightened supervision of registered persons with regulatory, compliance, complaint and litigation histories, the uniform cry from the industry was that we were being unduly prescriptive and mechanistic. When we opt for principle-based regulation, as is the case in our proposed entertainment rules, many—including some in this room—complained that they wanted specific dollar amounts.

 

We seem, on this front always to face the refrain when it comes to our rules "heads I win, tales you lose." We believe that some rules should be prescriptive, while others should be principle-based; it is a case-by-case public policy determination. But the debate around the clarity of regulation is not furthered when the "too prescriptive"/"too vague" response is really code for not wanting any regulation at all. We can deal with the view that there should be no regulation at all on a particular topic, indeed presented clearly with well-thought-through reasons born in good faith, such views are not only helpful but frequently change the outcome.

 

Combining certain other recommendations of the survey, we are urged to understand how rules will impact the industry both as a whole and as they pertain to the constituent participants as distinguished by business model and channel. I leap to respond that there is no other SRO that has the breadth of participation, through the standing committee process, that NASD has fostered.

 

We have standing committees such as Market Regulation, Fixed Income, Corporate Finance and Operations that consider all proposals that come within their subject matter expertise. We have standing committees for the independent dealer and insurance affiliate channel and the small firm advisory board, that consider rule proposals and other policies on a business model basis—and let me note that every proposal is reviewed by the small firm advisory board. If a proposal has aspects that implicate the remit of more than one committee, then it simply goes to multiple committees. We argue our views to be sure but we do not cajole our committee members and they are not co-opted by their participation. More than one proposal has died in a committee. But committee review is just one piece of a larger mosaic.

 

Virtually every rule proposal goes through a notice and comment twice, once by a Notice to Members and once after publication by the SEC in the Federal Register. Some claim that by the time of the comment process the result is cast in stone. Nothing could be farther from the truth. To the contrary, we depend on the hurdles imposed by this vigorous systemic vetting to help shape our product to a better result.

 

We are amenable to further suggestions as to how this extensive and wide-ranging process can be improved. So we are admittedly left scratching our heads at the observation that there must be a better opportunity and process for industry and public consultation and evaluation of rules before implementation.

 

Lastly, I will comment on the survey's recommendation that we reduce the pace and volume of regulation. We do not operate on a quota system. In fact, the pace of regulation in 2005 and so far in 2006 has been vastly reduced. But that has been and will always be dictated by need and circumstance, and not other artificial considerations.

 

I want to shift my focus now to several substantive areas in which we are engaged to demonstrate that our greatest contribution as an SRO is not necessarily defined by either new rulemaking or enforcement, but, rather through our commitment to shaping better investor protection and market conduct by fine tuning of existing rules, providing guidance on better practices, engaging in the early detection of looming potential problems, and embracing the mission of educating the public in the hope of greater financial literacy.

 

Let me turn first to the fine tuning of existing rules. Regarding the research analyst conflict of interest rules, NASD and the NYSE have submitted to the SEC, at its request, a joint report on the operation and effectiveness of these rules. Included in this report are recommendations we developed that in many cases argue for the relaxation of certain restrictions in order to strike a better balance between the original purpose of the rule and the greater utility that arises from the reduction of those restrictions. And we have made these recommendations notwithstanding that it may mean in certain instances urging the SEC to grant an exemption from applicable provisions of Sarbanes-Oxley.

 

Some of examples of these recommendations are to: (1) permit web-based disclosure of conflicts of interest instead of publication in the research report itself, (2) amend the definition of "research report" to exclude mutual fund and direct participation program sales material, since NASD already has other rules in place pertaining to communications related to these products and we believe the regulatory overlap is unneeded, (3) eliminate quiet periods before and after the expiration, termination or waiver of a lock-up agreement because we believe that Regulation AC certification now protects against research recommendations intended to act as a "booster shot" in connection with selling shareholder secondary offerings—I would note here that the NYSE supports a reduction of the quiet period but not its complete elimination and (4) create a limited exemption from the registration requirements for "research reports" produced by individuals whose primary job is something other than research, for example, registered representative newsletters or trader commentary.

 

In the area of forward thinking, our Ahead of the Curve Task Force continues to confront issues at a constant pace. Before discussing some of these issues let me point something out about the work product of Ahead of the Curve. Seldom is the outcome rulemaking or enforcement. We don't preclude those as an action plan, but it truly is the last place to which we jump. At the time I was preparing this talk, there were 23 substantive items in our pipeline but none contemplate enforcement activities at this time and few have a rulemaking component.

 

I can't commit that the course of potential Ahead of the Curve initiatives will not change, but I can say that our proclivity in this area has been the issuance of a Notice to Members, Member Alert, Investor Alert or holding one of our educational forums in which we bring together distinguished practitioners, businesspersons and academicians to foster interaction, debate and action and to agitate for industry-led change.

 

Let me give you an example of a current Ahead of the Curve initiative. We are concerned that a recent study noted that 45% of all employees take cash distributions from their 401(k) plans when they leave their company as opposed to rolling the money into another qualified plan or account. This is a trend that we are worried will increase as people begin to exhaust their home equity lines of credit.

 

We are issuing an Investor Alert to highlight the immense opportunity cost of failing to keep retirement assets in tax-sheltered retirement plans and accounts. We are promoting conduct that is a win for investors and responsible investment service professionals who want to see those funds growing for retirement instead of being placed in consumer-oriented wasting assets.

 

We have become concerned about emerging secondary markets in variable life contracts because of the fact that the seller is often in a position of economic distress and feels forced to sell what may be an asset of substantial value below its true discounted value price. So, we are working on a Notice to Members that we hope will offer balanced guidance on how to participate in such transactions from a member perspective.

 

We realize that the ability to sell these assets can be of vital importance to their owners and that in many, if not all cases, the price of the secondary market transaction exceeds the redemption price that would be paid by the contract's issuer, but we believe there are other considerations worth noting, such as alternative sources for income or alternative premium payment sources that might be considered before recommending such a sale.

 

Turning to an unpleasant topic, we are actively engaged in the possible avian-flu pandemic planning dialogue. At a human level, I have to tell you that never have I wished more fervently that a news story was more the product of hype than fact. It is difficult for regulators and industry to attend these meetings and not be depressed by the projections of what a pandemic might do. Reports indicate that, consistent with prior experience with SARS in Asia, worker absentee rates could be between 40% and 50%. Indeed, your firms will need to plan to take the counter-intuitive action of encouraging ill employees not to come to work.

 

NASD is leveraging its post 9/11 and Hurricane Katrina experience and learning to undertake planning for what we hope will never occur. And we are trying to plan for that for which no known plan can seemingly work. We understand that at a certain magnitude of absenteeism, common carrier communication lines could become so overwhelmed by people trying to log-in from home that they will slow down to a level where performance becomes virtually impossible. Yet we are trying to think through answers to that and other scenarios, not because we will necessarily be successful but because it may enhance our reaction to scenarios that are less dire. We will share our learning in this area with the industry.

 

In the area of guidance on better practices, our Notice to Members on the critical review of new products has been mentioned by many of you as highly beneficial in informing your own processes. We sat down in one-on-one meetings with many firms and immersed ourselves in their vetting process for new products. From that experience we gleaned and published the best practices we could ascertain. Interestingly, even firms at the vanguard of practice in this area found the Notice to be very useful because those firms welcomed the confirmation of their approach.

 

Last, let me bring to your attention our efforts to harmonize requirements across other financial products that compete with securities. Variable annuity sales compete with equity-indexed and plain vanilla annuities. Variable annuities are securities, equity-indexed annuities may not be securities, yes the subject of another long and tortuous story, and plain vanilla annuities are not securities. These are complex products in pricing, operation and structure that may be purchased for similar purposes but are subject to disparate levels of regulation and offer dissimilar levels of protection to investors. NASD will be hosting a roundtable on this subject in May to discuss with other regulators ways to harmonize regulation to comparable levels of disclosure, suitability and other customer protection requirements associated with the recommendation and sales of securities products.

 

I'm starting to feel like I'm in the Sound of Music and I should start singing "these are a few of my favorite things" except I am occasionally compelled to watch American Idol and I know the level of humiliation my singing would bring on for, frankly, all of us in the room. I have attempted this morning to offer a view of regulation not based solely on rulemaking and enforcement, but which also includes adding value and strengthening the necessary foundation of trust, integrity and confidence.

 

Thank you for indulging me and listening this morning and I wish for all of you a great conference.