Remarks at the NASAA Enforcement Conference

Robert R. Glauber

Chairman and CEO

Miami Beach, Florida
January 9, 2006

Thank you, Patty, for a very kind introduction and for inviting me to be with you today. NASAA and NASD have some issues in common to work on in 2006, and I look forward to our addressing them together.

Two-thousand-five was, I think, a pretty good year for investors, whose protection is our mutual responsibility. The worst of the bubble-era excesses are behind us, the markets have been moving in mostly the right direction, and the economy is in fact moving forward quite well. And, I think that we, as regulators, have reason to feel good about what we've accomplished during the last year.  It is at least in part because of your diligence and ours that investors have regained some measure of confidence and gotten back into the game.

In the post-bubble era, NASD is placing a heavy emphasis on transparency and point-of-sale disclosure. We believe strongly that requiring better, more comprehensible disclosure is the ounce of prevention that prevents enforcement actions, which are the pound of cure.

In one way or another, we're applying this principle to a number of markets and products – mutual funds, exchange-traded funds, 529s, corporate bonds, 401(k)s, variable annuities.

Be they fixed, variable or equity-indexed, annuities are particularly troublesome from a regulatory standpoint. And that is, in part, what I want to focus on today. I also want to touch on some of NASD's accomplishments over the last five years, as I've recently observed my fifth anniversary as CEO, and on some goals we hope to realize in the near future.

But first, annuities. And I'll start with a few illustrative vignettes.

A couple of years ago, we came across an on-line advertisement placed by a Texas firm specializing in reverse mortgages. It showed an elderly couple standing on their front porch. Next to the photo was text that screamed: "Sell Annuities to Seniors Who Don't Have Money! Most Have Equity in their Homes! Help Your Agents Tap into It!" It added that people "up to age 99" were fair game. After the 800 number, it says: "Ask for Ralph."

Just last month, here in south Florida, an insurance agent was arrested for stealing roughly $300,000 from three fixed-annuity investors – a 58-year-old woman supporting a disabled daughter, an 82-year-old woman with no family and an 80-year-old man with Parkinson's disease. According to the state's Department of Financial Services, the agent used the same tactics in all three cases: he persuaded the clients to buy fixed annuities, then later advised them that their annuity investments weren't doing well and convinced them to cash them out and invest the proceeds in products offered through his own firm. When they agreed, he put the money in his pocket.

In another case, a broker operating from a banking location in Kentucky, persuaded eight banking customers to exchange fixed annuity contracts for variable annuity contracts.  Each of the customers was retired and expressed a need for income for day-to-day living expenses. The customers also told the broker they had moderate to low risk tolerance and wanted safe investments. They had safe investments with their fixed annuities, which provided a guaranteed monthly income, based on a 9.35 percent return for the first year and no less than 3 percent thereafter. But the return from the variable annuities, after an initial six-month introductory rate period, fluctuated with the market and could not ensure guaranteed monthly income. Thus, they did precisely the opposite of what the customers said they wanted. That broker is now doing something else for a living; we kicked her out of the industry.

I could go on, but I think you get the picture. All three of these cases involve, in different ways, fixed annuities. You – state securities regulators, the SEC and NASD have worked tirelessly over the last few years to clean up variable annuity sales practices. Working together, we've returned millions of dollars to investors who were the victims of these abuses. And, we recently proposed some stringent suitability rules for VAs. While they focus primarily on suitability, the proposals also include a requirement that the customer be informed of the product's more salient features, such as surrender fees and front-end sales commissions. In these efforts we have had the support and cooperation of our friends and partners in NASAA.

But fixed annuity investors generally don't enjoy this level of protection, and that fact will almost certainly lead to increased sales of fixed annuities. And that in turn will lead to more people like Ralph preying on investors. Unfortunately, when we clean up sales practices in one investment product, sales activity increases in similar products with less investor protection.

In the first two of the three cases I just mentioned, total jurisdiction belonged to the states of Texas and Florida, respectively. In the third, the Commonwealth of Kentucky and NASD shared jurisdiction, because the victims were taken out of fixed annuities – Kentucky's jurisdiction – and put into variable annuities – which also fall within NASD's jurisdiction.

And therein lies the problem: NASD, and you as state securities regulators, have jurisdiction over sales of variable annuities, because of their underlying securities portfolios. Your colleagues, the state insurance commissioners, have jurisdiction over sales of fixed annuities, owing to their lack of a securities component. And jurisdiction over equity-indexed annuity sales is essentially a jump ball, because it isn't clear whether they're securities, insurance products or something in between. 

Importantly, I should point out here that we're committed to making sure investors get a fair shake when they buy EIAs, despite our limited jurisdiction. Last August, we advised our 5,200 member firms that they would do well to treat EIAs as securities, even though it's not clear that they are. And we're investigating some situations where brokers switched older investors from variable annuities into EIAs with high costs and long surrender periods.

What the three annuity types do have in common is that they are arguably among the most complicated retail investment products out there. And they are frequently marketed to senior citizens, to whom they all look very much the same. And why shouldn't they? Annuities really are one product that's been carved in thirds for regulatory purposes. That may be OK for regulators, but it's a bum deal for investors, who have every right to expect the same degree of protection when they buy what they think is the same product. An investor shouldn't get one level of disclosure and protection if he's looking at a fixed annuity, another level if he's looking at a variable annuity, and yet another if he's looking at an EIA. It is simply not fair to investors that the level of disclosure and protection should vary depending on what agency regulates the product.

So what we're proposing is this: a concerted effort by all interested parties to harmonize the rules governing sales of these three versions of the same product. And we propose to get the process started with a summit conference, where regulators and senior representatives of the securities and insurance industries can meet to discuss the best ways to level the investor protection playing field among and between these products. 

I want to emphasize that we are not proposing any new rule-making on our part or any expansion of our jurisdiction. This is not about turf. It is about leveling the regulatory playing field in the interest of investor protection. It is simply an effort at harmonizing and clarifying disparate rules and regulations that apply to not-so-disparate products.

Minnesota Commerce Commissioner Glenn Wilson has been working with us on this idea. We reached out to Minnesota because it already has a suitability requirement for insurance products that is very similar to NASD's. Minnesota's requirement is significant in that it goes much further than the NAIC's so-called model suitability standard, which applies only to investors over 65. I'm not sure why the NAIC thinks such a lax suitability requirement provides adequate investor protection, but that's a topic for discussion at the summit, which we hope to schedule for sometime in the next few months. We're looking forward to a constructive dialogue among the interested participants.

What we're proposing here is similar to an initiative we've been working on with the MSRB. We and they have been working together on harmonizing NASD's mutual fund sales rules and the MSRB's 529 college savings plan sales rules. A 529 is, for all intents and purposes, a mutual fund, so there is no compelling reason why they should be covered by different regulatory rules and protections.

Initiatives like this, aimed at taking the mystery and confusion out of retail investing, are a large part of what NASD has been all about over the last five years. After the tech bubble burst in 2000 – the year I became CEO – we and other regulators discovered a parade of transgressions that ranged from marginally unethical to downright felonious.

At the same time, the so-called mutual fund scandal rose to the surface and brought with it a litany of fund-related abuses that had little or nothing to with the marquis issues of market-timing and late trading. Here I'm talking about improper sales contests, directed brokerage, breakpoint discount and share class violations and other problems.

So, there followed a period of intensive enforcement and disciplinary action. Between 2002 and 2004, we fined, suspended and expelled registered reps and firms in unprecedented numbers. We wrote lots of new regulations aimed at making sure the abuses we discovered would not happen again.

For example, we've tightened up our rules on directed brokerage to ban it altogether rather that to allow it in some instances, as had been the case.

Same with our rule covering sales contests. Today it applies only to non-cash prizes for sales of certain products, such as mutual funds and variable annuities. Cash prizes are not covered. We think a broader prohibition may be needed, so we have asked for comment on a proposed rule amendment to ban all sales contests – cash or non-cash – that are geared to any type of investment.
I know there are those among our regulated firms who think we've gone off the deep end, but then I don't think there is a regulated industry that doesn't think it's over-regulated.

Wherever you come down on this question, the fact is that some of the abuses that came to light in the aftermath of the bubble were disgraceful. And they hurt investors, both financially and in terms of their faith and confidence in the securities industry. The fact is, too, that we have enforced our rules vigorously but fairly. And we have enforced them as they are, not as we might wish they were. We have avoided using enforcement actions as a rule-making mechanism.

I believe the worst of it is behind us now, as the industry seems to have gotten the message. However, that does not mean we're ratcheting back our regulatory and enforcement operations. We're not. In fact, 2005 was a record year for us in terms of fines – $125 million – and disciplinary actions – just over 1,400.  

Still, we're at a place now where we can devote more of our time and resources to initiatives that make markets more transparent and investment products more intelligible to investors.

The squeaky wheel gets the grease, so we've focused heavily on mutual funds. In addition to the cooperative venture with the MSRB I just mentioned, we have in the last couple of years, convened three mutual fund task forces – one to make recommendations on point-of-sale disclosure and portfolio transaction costs, the second to consider ways to ensure that fund investors who are eligible for volume discounts on front-end loads actually get them, and the third related to omnibus accounts and redemption fees.

Thanks to their good work, and to the SEC for proposing the idea in the first place, we hope that mutual fund purchasers will eventually receive a brief point-of-sale disclosure document explaining in plain English the material features of the fund they're considering – investment strategies, risks, costs and conflicts of interest – information that is either buried in a prospectus or SAI, or not provided at all. And, we hope, this information will be available on-line as well as by more traditional means for quick access and easy comparison of different funds. Some of these ideas – on-line delivery, information on investment strategies and risks, as well as costs and conflicts – build upon the original SEC proposals. We have been working with SEC commissioners and staff to win approval of these important measures for investors.

If the SEC does indeed mandate that this information be available on-line, NASD has committed to construct and maintain, at our expense, the on-line database containing these point-of-sale documents for all mutual funds. We are prepared to put our money where our mouth is.

Brokers and mutual fund investors now have at their disposal an electronic database that simplifies the process of determining eligibility for A share volume discounts – a process that until now has been arcane and complicated. This, too, is a product of one of the task forces we set up. And again, NASD has taken the lead in building and maintaining this database.

Mutual funds obviously are the most popular products sold to mainstream investors. There are nearly 8,000 funds with more than $8 trillion invested. Half of all American households own equities either directly or through mutual funds, and 90 percent of equity-owning households own mutual fund shares. Mutual funds are so successful because they are a very good product for investors.

So, it is entirely in keeping with our investor protection mandate that we would scrutinize them as intensely as we have. And that we would put so much time and money into increasing the level of effective product disclosure.

For the same reasons, we've targeted the corporate bond market, which dwarfs the equities market in terms of capitalization – $23 trillion in the former versus about $15 trillion in the latter. Moreover, to a surprising degree, this is a retail market. Roughly two-thirds of corporate bond transactions reported to NASD are trades of 100 bonds or fewer. 

Yet, until recently the corporate bond market has been about as transparent as a sheet of plywood. At the direction of the SEC, we set out in 2002 to change that by creating and deploying our Trade Reporting and Compliance Engine, or TRACE. TRACE has taken the world of corporate bond investing out of the darkness and into the light of day. In fact, as of today, after three years of incremental growth, trade and price information on the entire universe of corporate bonds is instantly accessible on-line to investors and professionals, and all within 15 minutes of any trade. That's about 29,000 bonds, from investment-grade to high-yield.

From annuities to mutual funds to 529s to corporate bonds, a major part of our mission during my tenure as CEO has been to open doors and turn on lights so that investors can see where they're going rather than stumbling around in the dark and relying on someone else to guide them. The better job investors can do for themselves, the less often regulators will have to take action to clean up problems after the fact.

A big part of this effort is the NASD Investor Education Foundation, which we launched in December 2003 with initial funding of $10 million, all of it derived from disciplinary fines we had imposed. The foundation has received several cash infusions since then, bringing it up to $31 million, and has awarded more than $5 million in grants in 2004 and 2005. Grant recipients are universities and non-profits that develop programs aimed at helping mainstream investors understand the capital markets and devise investment strategies.

These efforts at making the science of investing more comprehensible and less intimidating form a part of my legacy I'll be particularly proud of beyond my term at NASD, which runs to the end of this year.

There is one other goal we've been working toward, but remains unmet. That is the complete separation from NASDAQ, which will happen only when the SEC grants it exchange status.

As you know, NASD created NASDAQ in 1971 and was its sole owner, operator and regulator for close to 30 years. After being stung by the SEC in 1996 for doing a poor job of regulating NASDAQ, we set up an internal wall between NASDAQ operations and our regulatory activities. Then, in 1999, when NASDAQ decided to become a for-profit entity, we determined that a partial separation wasn't enough. We decided to move away from NASDAQ altogether and made it operate as a wholly separate company with its own management and own board. Since then, we've been gradually selling our interest in NASDAQ and our ownership stake today is less than 20 percent.

We'll reduce our interest to zero after the SEC designates NASDAQ as a stock exchange. Given recent statements and activities by the commission, we're optimistic that that will occur very soon. And when it does, we will regulate NASDAQ under contract.

This is an important goal for reasons other than avoiding the obvious conflict of simultaneously owning and regulating a for-profit, shareholder-owned exchange. The complexion of the capital markets is changing rapidly and we, as regulators, have to be willing and able to change and adapt if we are to remain relevant and maintain public confidence.

The NASDAQ separation is a large part of a fundamental realignment NASD has undertaken in the last few years. Where once we were an SRO in the traditional sense – owning and regulating a market – we are today something different: a private-sector regulator of the securities industry and, by contract, other exchanges. This new alignment may serve as a template for other SROs wrestling with the same circumstances.

Obviously, I'm thinking primarily of the New York Stock Exchange, which is also going public and will compete head-to-head with NASDAQ as a for-profit, shareholder-owned entity. John Thain has properly recognized that the traditional SRO structure may not be the best means of operating and regulating the NYSE under those circumstances. There is a lot to be said for the idea of streamlining the regulation of joint NASD/NYSE members, from both efficiency and policy perspectives. Such an arrangement poses clear and tangible efficiency benefits to firms that now have to devote time, money and manpower to complying with rules imposed by two regulators, and have to pay fees and assessments to both. And from a policy viewpoint, if structured correctly, it would reduce the inherent conflicts of interest that inevitably arise when a for-profit, shareholder-owned exchange regulates itself. The arrangement we seek to achieve would end that.

This structure is very much in line with the hybrid SRO proposal that the SIA put forward a few years ago and has recently again endorsed.

Time will tell whether some sort of combination of our regulatory activities is possible. NASD and the NYSE are continuing to talk about this and I hope we can work something out.

I think I've given you a pretty good look at what we've been doing and what we're planning in the realm of annuities, and of how those initiatives mesh with our larger efforts at improving disclosure and transparency across the board. In this regard, we're looking at other products as well, including hedge funds and their derivatives, and I'd be happy to talk about those in response to your questions, if that interests you.

With that, let me again thank Patty Struck and Conference Chair David Massey for inviting me to be with you today, thank you all for listening and wish you a happy and prosperous 2006. Now I'd be happy to answer any questions.