finra

Thomas M. Selman
Executive Vice President, Regulatory Policy

IRI Government, Legal and Regulatory Conference

 

Washington, DC
Monday, June 25, 2012

Thank you, Pat [Kelly, Vice President and Chief Compliance Officer, Prudential Annuities] for that introduction, and thanks also to IRI for the invitation to speak here today.

 

One hundred years ago, the "Titanic" struck an iceberg and sank on her maiden voyage. During the night of April 15, 1912, more than fifteen hundred men, women and children perished in the lethally cold waters of the North Atlantic. Much has been written about the causes of this tragedy. The rivets installed in the shipyard were defective. The captain was reckless. The White Star Line—owner of the Titanic—was overconfident of the ship's sea-worthiness.

 

In a commemorative article in the Wall Street Journal, Chris Berg described another cause for the enormous loss of life. According to Mr. Berg, lifeboat regulations issued by the British Board of Trade were outdated. The Board of Trade had not updated its lifeboat regulations for almost 20 years. Those regulations were written at a time when most people could not have imagined a ship so large. Indeed, the Titanic had over 2,000 people onboard, but its lifeboats could only hold about 1,200 people.

 

According to Mr. Berg, the Board of Trade had become complacent about the danger and saw little reason to update its lifeboat regulations. Ships had become safer and the number of disasters had declined. The purpose of lifeboats was to ferry people to safety. They were not meant to hold passengers while a ship sank. Apparently the Board of Trade assumed that modern ships would sink at a slow rate, affording fewer lifeboats enough time to transport passengers to safety.

 

Even so, the shipyard manager had suggested to the White Star Line that they equip the Titanic with 48 lifeboats—28 more than it finally held. Those 48 lifeboats would have been sufficient to save all of the passengers. However, the White Star Line declined the shipyard manager's suggestion to increase the number of lifeboats. Instead, the company decided not to add more lifeboats until the Board of Trade required them. The Titanic's cruise line thus awaited orders from its regulator to increase the number of lifeboats onboard. No order came, so no lifeboats were added.

 

Mr. Berg's take on the disaster—that it's easy to put regulations in place but harder to keep them up to date—doesn't only apply to ocean liners. The Titanic is a case study for all of us here today. It provides at least three lessons for us as regulators and at least three lessons for you.

 

The first lesson is that a regulator must periodically review its rules, its interpretation of those rules and the ways in which it inspects firms for compliance with those rules. The lifeboat standards of the Board of Trade were outdated. The Board did not account for the growth in the size of ships. It assumed that what worked in the past would continue to work.

 

Regulation can't be static—it must evolve to reflect a world of constant change. If rules do not reflect reality, then how effective can they be?

 

But at the same time, the industry and the public need certainty and predictability. If regulators change rules too frequently, then we complicate your ability to comply. You need and deserve a system of regulation that provides predictability and consistency. As a matter of fact, the whole purpose of adopting a rule is to establish a standard that the industry must follow.

 

So dynamic regulation is important, but certainty is important too. In my view, a self-regulatory organization offers some distinct advantages in achieving a good balance between the two. Of course, we are not perfect. Some may argue that at times we move too quickly or too slowly to modify a rule. But as an SRO we are, I believe, uniquely equipped to strike a reasonable balance between dynamic and predictable regulation.

 

An SRO can tap industry expertise to ensure that rules are comprehensive, workable and effective. An SRO can set ethical standards that exceed legal requirements, and are broader and more flexible than government regulation. An SRO is not subject to government spending limits, and therefore can more rapidly respond and devote resources when an unanticipated problem develops. And an SRO can devote significant resources to education and training, which can be critical in helping both industry and investors understand how to adapt to changes in the markets.

 

A good example of our ability to modernize our rule interpretations is the regulation of social media. As most of you know, FINRA has issued two sets of guidance concerning the uses of social media, and was the first regulator to do so. We will continue to work with the industry to ensure that the rules governing social media are practical to apply and effective in their protection of investors.

 

While an SRO can devote more resources to respond to an unanticipated problem, the speed with which we can update our rules is sometimes limited by the complexity of our rulemaking process. The development of rules and rule amendments takes time. Here are the steps of a typical FINRA rulemaking: First, FINRA staff develops an outline for a possible rule. We discuss our idea with FINRA's advisory committees, composed of industry and public members. The committees will describe any significant burdens that the proposal might impose on the industry. We will revise the proposal to reflect those committee comments that are consistent with the goals of investor protection.

 

Then we submit the revised proposal to our Small Firm Advisory Board for further comments from the small firm perspective. We consider their comments and revise the proposal as necessary. Subsequently, we submit the proposal to our full Board of Governors for its approval with any changes the Board requests. Once the Board has approved a proposed rule, we normally issue the proposal for public comment and with those comments further refine the rule. We then file the proposal with the SEC, and the SEC staff may suggest changes to the rule. Before approving a FINRA rule, the SEC must issue the rule for public comment. It is not unusual for the SEC to request comment several times before it approves a rule.

 

Our rulemaking is an open, transparent process, affording the industry and the public many opportunities to comment about the merits of the proposal, the burdens it could impose on the industry and the benefits it might provide to investors. These are good and necessary steps. But they can be time consuming and complex and they sometimes delay our efforts to modernize our rules. By way of example, FINRA recently amended its advertising rules. This rule proposal went through five rounds of comment—once by FINRA and four by the SEC. But the positive outcome was the introduction of changes that simplify and modernize the advertising rules.

 

The need for certainty and the complicated nature of our rulemaking impedes our ability to review our rules for currency. Nevertheless, as the Titanic experience illustrates, every regulator, including FINRA, must be willing to reconsider its rules, its interpretation of the rules and its application of the rules to the industry.

 

Regulation must reflect the industry that we regulate. That is the second lesson from the Titanic disaster. Let us remind ourselves of how the British Board of Trade regulated lifeboats. Satisfied with the improved safety of cruise ships, with the introduction of the telegraph that enabled ships in distress to request assistance and the absence of any disasters, the Board of Trade continued to require only 16 lifeboats on a ship the size of the Titanic. The Board of Trade apparently neglected to consider how the shipping industry had changed. As Berg notes in his article, lifeboats were not designed to keep all the ship's passengers and crew afloat while the vessel sank. In one case from 1909, it took a ship almost 36 hours to go under. Lifeboats were intended to ferry passengers to nearby rescue ships during the supposedly lengthy period before a vessel submerged. But the Titanic sank in less than three hours. Sadly, it took the first rescue ship, the Carpathia, four hours to arrive, far too late for more than two-thirds of the Titanic's passengers.

 

A regulator must understand how the industry operates, how businesses have changed, and how, as a result of those changes, existing rules may have become anachronistic.

 

A self-regulatory organization like FINRA is particularly capable of understanding the businesses we regulate, and we always endeavor to frame our oversight according to this understanding of the business. We engage with the industry along many avenues, such as our advisory committees and in conferences like this.

 

Those of you who lived through our adoption of a variable annuity rule will appreciate that FINRA took great pains to understand how the variable annuity business is conducted, how the proposed rule might affect that business and how the rule could be adjusted to accommodate legitimate business practices while protecting investors. This commitment to understand the industry is one of the great strengths of the SRO model.

 

Our Office of Emerging Regulatory Issues analyzes new products and services offered by the industry, to ensure that we understand their possible impact on customers and the soundness of firms. The work of this department as well as our examiners in the field, our Office of Fraud Detection and Market Intelligence, and many other FINRA staff members, help us to understand better how business is being conducted today. Perhaps most important, we are revising our examination process. We want to ensure that our examinations are tailored to address the risks presented by various business models and practices.

 

The third lesson from the Titanic tragedy for a regulator is that while we should consider the burdens that our rules impose on the industry, we must anticipate the possibility that the worst event can happen. In the Titanic case, the record suggests that the Board of Trade was sensitive to the practical problems of requiring more lifeboats onboard ships, but the Board overlooked the potential for catastrophe.

 

A regulator should consider the burdens that a rule may impose upon the industry, but remain vigilant for the prospect of catastrophe. Maybe the probability of a catastrophe is small. But when the stakes are so high, even a small probability of disaster becomes relevant. Did the small probability of a disaster at sea justify outdated lifeboat regulations? This is the sort of question that every regulator will face, and it is a question that no cost-benefit analysis can adequately address.

 

Perhaps the financial crisis was our Titanic hour. In September 2008 all of us witnessed a breakdown in our financial system that had catastrophic consequences. Whether one agrees or disagrees with all of the provisions of the Dodd-Frank Act, almost everybody assumed in 2008 that Congress would enact sweeping legislation that could not have been enacted before the crisis. As Alex Pollock of the American Enterprise Institute has said:

 

"Here's as close to an empirical law of government behavior as you'll ever get: When government financial officers—like Treasury secretaries, finance ministers and central-bank chairmen—stand at the edge of the cliff of market panic and stare down into the abyss of potential financial chaos, they always decide upon government intervention. This is true of all governments in all countries in all times."

 

Mr. Pollock may have been speaking about government intervention like the TARP programs, but the corollary to his law of government behavior is that after a catastrophe the legislators will step in. There are some decisions, whether to put enough lifeboats on the Titanic, whether to protect the financial system, that no cost-benefit analysis can resolve.

 

I have said that the Titanic disaster provides three lessons for us, and three lessons for you. The first lesson for you is to identify the risks that arise from developments in your business. Don't become too dependent upon us, or the SEC, when you manage your risks. The managing director of the shipyard where the Titanic was built testified that he did not install extra lifeboats, but he did put the plans together in case the Board of Trade required more. But the Board never required more. Chris Berg makes the case that, the enormous loss of life was partially due to inertia and complacency. You must work every day to resist the common temptation of regulated firms—to allow an innovative program of risk management to deteriorate into a rote exercise. This temptation is understandable. We examine you, we issue rules and interpretations and guidance. It is easy to fall into complacency. But your approach should be one that focuses on the greatest risks to your customers. You should not wait for our detailed instructions to decide how to protect your customers. I assume that the active compliance that I suggest already exists in most of your firms. However, as the experience of the White Star Line in 1912 demonstrates, you must take it upon yourself to engage in independent, thoughtful analysis of how best to protect your customers.

 

The second, related lesson is that you should review your procedures regularly to ensure that they reflect existing business practices. In 1912, the fact that the Titanic might sink quickly should have caused the White Star Line to consider that more lifeboats would be necessary. Indeed, other ship lines had taken it upon themselves to increase the number of lifeboats. A financial services firm also must ensure that its compliance and supervisory systems reflect the products that it offers, the businesses in which it engages, and the types of customers that it serves. In our Notice on complex products, we emphasized the importance of ensuring that compliance takes into account the types of products that the firm is selling.

 

Reps need to be trained on the products that they offer. If they do not understand the features of the products that they sell—no matter how complex those products may be—then they may violate the suitability rule. Many firms have established a committee to vet new products. Part of the committee's function may be to recommend compliance measures with respect to the products that they approve. Some firms also monitor the performance of complex products that they have approved for sale, to determine whether the products behaved as anticipated under different market conditions. This approach helps to ensure that your compliance programs will reflect your new products and services.

 

The third lesson is that you should keep in mind not merely the black letter law that applies to your business, but the purpose of the rules to which you are subject. Often when FINRA or the SEC proposes a new rule, the industry will ask for more specificity concerning the application of the rule. Even after the rule has been adopted, the industry will often seek additional guidance. A case in point is our amended suitability rule. For the most part, the amendments codified longstanding interpretations of our suitability rule. However, we have received many questions from firms that we have answered in the form of extensive guidance. I sympathize with the industry's request for guidance concerning our rules, and we try to provide as much direction as possible. Compliance with the specific provisions of the law and our rules is, of course, critical.

 

But we need to remember that laws and rules can never cover every possible scenario. In every business decision, firms must conduct their business with integrity, provide honest service and act in the customers' best interests. That is the purpose of our just and equitable principles of trade and our support of a fiduciary standard for the broker-dealer industry. These principles must be the bedrock of each firm.

 

The purpose of the fiduciary standard would be to ensure that at all times broker-dealers and their reps act in their customers' best interest even as they comply with the more specific requirements that FINRA or the SEC lays down.

 

Three lessons for us and three lessons for you. But they are interrelated. As a regulator, we should review our rules to ensure that they remain relevant. And you should review your procedures to ensure that they reflect your business today. We need to understand your business, and you need to appreciate the fundamental purpose of our rules. This comes through a dialogue, which I believe an SRO model best provides. Finally, regulators must contemplate the possibility of a catastrophe, and so must you. Take the initiative in identifying concerns before they become major problems. We, and you, must be prepared for the worst. We need not turn to ancient history for that lesson.

 

Thank you.