Remarks at the SIA Securities Industry Institute—Wharton School

Mary L. Schapiro

President, NASD Regulation, Inc.

Philadelphia, PA
March 11, 1997

Thank you, Sam (Yates, Chairman of the Securities Industry Institute). From all the feedback I've heard, the Institute is a uniquely rewarding professional and educational experience—and I count it as a real privilege to be part of this year's agenda.

For this I would particularly like to thank Jack O'Neil, who has been the Institute's guiding spirit for many years. I know Jack is retiring from the SIA, after a mere thirty years of hard work.

I wanted to take the opportunity to wish him all the best, and to personally thank Jack on behalf of the NASD for the service he has provided not only to the securities industry…but through the stewardship of the Institute and other programs, to the investing public, as well.

As Jack can surely attest, the securities industry is in the midst of unprecedented change. My own organization, NASD Regulation—is one of the many manifestations of that change. We did not even exist as a corporate entity—or a distinct regulatory presence—until last year.

Today, NASD Regulation is very much a reality. It is very much a part of the contemporary investment landscape. And it plays a significant role in the way in which our members conduct virtually every aspect of their business.

Because you will lead this industry into the next century—and because NASDR intends to be around, as well—I think it's important to get to know the organization a bit better.

I hope to leave you with a more complete understanding of what we do—and more important, our mandate for doing so. I also want to address some of the major developments the organization has gone through in the year that I've been its lead manager.

Finally, I want to talk candidly about the priorities we've identified in 1997.

Let me begin by sketching the scope of NASDR s responsibilities:

The organization is fundamentally responsible for regulating the broker/dealer community. It carries out that responsibility in a myriad of ways including: on-site examination of our 5,500 member firms, to assess their compliance with NASD rules and regulations, as well as those of the SEC and the Municipal Securities Rulemaking Board, relating to sales practices, financial and operational integrity, broker qualification, testing and continuing education.

NASDR also reviews firms' advertising and the underwriting terms and arrangements in connection with public offerings.

Further, we have the power to initiate disciplinary actions—and initiated more than 1,200 such actions in response to various infractions in 1996.

We provide the largest securities industry dispute resolution forum. NASDR arbitration panels handled about 6,000 cases in 1996—86 percent of all securities arbitration cases.

We also maintain the central registration depository of employment and disciplinary histories of every firm and registered representative.

On top of all of these functions, NASDR also has the responsibility of surveillance, oversight, and enforcement of the rules of The Nasdaq Stock Market.

Our responsibilities derive from a far-reaching mandate of our parent organization, the NASD. That mandate includes adopting rules and policies designed to prevent fraudulent and manipulative actions…promoting just and equitable principles of trade…and removing impediments to, and perfecting the mechanism of, a free and open market.

We exist to further the NASD's fundamental mission, set down in the By-Laws of the NASD's charter, "to protect investors and the public interest."

While this ultimate mandate has remained unchanged for almost six decades—the way in which it is being carried out has changed significantly in recent months.

What has changed most overtly is that the NASD has directed much of this mandate to be fulfilled through a new corporate and governance structure, both of which were the result of recommendations made by an NASD Special Committee headed by former Senator Warren Rudman.

Distilled to its essence, there is now a separation of the market operations function from market oversight and the broader regulation of the broker/dealer community. And, we have in place boards of directors and a network of committees that are balanced between industry and non-industry members to more accurately reflect the breadth of participation in securities markets.

Two points should be made with respect to these changes. One is that they were sorely needed in the wake of seriously eroded public trust--not just in the NASD but in the process of self-regulation. Both the Justice Department and the SEC have concluded investigations and enforcement actions against the NASD and many of its members. Those investigations not only called in question the ability of investors to get a fair price in Nasdaq, but questioned the ability of the NASD to do the job it had been mandated to do.

The changes laid the foundation for repairing investor trust, for improving Nasdaq, and for more completely allowing the NASD to meet its investor protection mandate.

Second, the changes received strong and unified backing from the NASD's membership. These were not changes imposed against the will of the broker/dealer firms that comprise the NASD's membership. They received the overwhelming endorsement of the NASD's membership, which swiftly approved these and other changes.

I came on board after this blueprint had been laid, and have been working on it now for just about one year. It's been a hectic but rewarding twelve months, full of challenges that seemed overwhelming at the time, but in some regards pale in comparison to the challenges ahead.

The face of self-regulation has changed rather dramatically in a single year and virtually all of the issues that NASDR will face in the next two years will revolve around a single theme: defining—or redefining—the concept of self-regulation.

As a result of the Rudman Committee recommendations and the SEC settlement, we now have a separate entity focused on the NASD's regulatory responsibilities, and substantial resources have been allocated to regulatory activities. Non-industry representatives have a much greater voice in the decision-making process, in ways ranging from a balanced board of directors to solicitation of comment from the general public before rules are filed with the SEC. Many responsibilities are shifting from the industry to the staff. For example, we will soon have a disciplinary system in which the determination whether to institute disciplinary action will be made by NASDR staff rather than a committee composed of industry representatives. Similarly, the first level disciplinary decision will no longer be made by the industry district business conduct committee but rather by a panel composed of two industry members and chaired by a hearing officer who is an NASDR staff member. The SEC order also mandates a heightened and more autonomous staff role in many other areas, such as admission to membership.

Some have understandably argued that the "self" in self-regulation has been eliminated or at best, seriously diminished. Another concern is whether the enhanced role of professional regulators, i.e. NASDR staff, has negated the necessity for industry professionals to participate in the self-regulatory process.

Both concerns are legitimate and I'd like to address them. Self-regulation has worked well, if not perfectly, for many decades. A major reason it has worked is that relying on the industry's own expertise and sense of fair play truly has generated rules that protect investors—and a high level of compliance with those rules. It is not a coincidence that we have the most liquid and efficient markets in the world AND the best regulated.

NASDR staff is capable of proposing rules WE THINK will work well in the real world. But, given the complexity of products, trading strategies, and technology, it has never been more important for us to incorporate the expertise of the businessman or woman into our thinking. Effective, responsible regulation involves writing rules that go to the heart of fulfilling our mandate to protect investors. But those rules must, at the same time, be reasonable and practical for the people who have to comply with them. Reaching those goals REQUIRES active industry participation.

Preserving the "self" in self-regulation is critical, but we have not yet completely convinced the industry itself of our commitment to that principle. Perhaps I haven't stated clearly enough or often enough to the NASD's membership that successful, useful regulations cannot be developed without their input into each and every NASDR proposal.

We must continue to successfully recruit the best talent the industry has to offer to take an active role in the self-regulatory process. You represent a significant talent pool and I would urge upon you that you have a responsibility to this industry, much as you have to your community, to serve as a volunteer in the self-regulatory process.

We will spend significant time for the foreseeable future ensuring that we can indeed keep the "self" in self-regulation while delivering the high quality regulation and disciplinary process that the investing public has a right to expect.

While the enhancement of self-regulation permeates our mission, there are some immediate issues that we must address. None is more critical than fulfilling all of the requirements of the SEC settlement.

Substantial progress has been made toward compliance with the SEC settlement undertakings, and I expect that we will be in full compliance by August, the deadline set for most of the undertakings.

Let me review briefly what we have accomplished since the settlement was put in place six months ago.

The directive to balance the corporate boards and committees that the SEC required us to balance has been complied with in full.

We are in the final editing stage for our new Code of Procedure—which, as I mentioned, will significantly change the disciplinary process at the NASD, as well as membership application procedures. When the new Code is approved, professional hearing officers will preside over disciplinary proceedings and District Committees will no longer perform a "grand jury" function. This changed role will allow District Committees to devote more time to providing policy advice to NASD Regulation.

We have filed a rule interpretation with the SEC that expressly makes coordination of quotes, trades, and trade reports unlawful and that prohibits retribution or retaliatory conduct by traders.

Solicitation of input into the regulatory process has been broadened through the publication of proposed rules on our Web site and specific solicitation of comment from targeted investor groups.

The Internal Audit function has been strengthened and an Ombudsman office created.

We are developing surveillance systems that will look for evidence of the existence of pricing conventions or other anti-competitive behavior. Also in development, are surveillance systems designed to detect violations of the trade reporting requirements, including the identification of late trades, patterns of late trading, late trade reporting of blocks and firm profiling.

We have created a new registration category and qualification exam for equity traders and are incorporating material relating to market maker anti-competitive behavior into the Firm Element of our continuing education requirements.

We've put in place new procedures for handling backing away complaints, and have created a real-time system for resolving these complaints that provides an opportunity for a complaining party to receive a timely trade execution.

We have recently put in place a Firm Quote Compliance System that, among other things, allows for the automated tracking and reporting of backing away complaints and resolutions.

Finally, a longer term project is the development of our Order Audit Trail System. This new system will receive and archive data with respect to orders and create an enhanced audit trail by integrating order, quote and trade data. While the requirements for the system are not final, significant work is in progress.

We feel these initiatives—in conjunction with the SEC's recently adopted order handling rules, which the NASD strongly supported—will go a long way toward restoring investor confidence in the Nasdaq market. They should also bring renewed credibility to the way in which orders are handled and pricing determined.

Challenges Ahead

A great deal has been accomplished in the wake of the SEC investigation and settlement—but a lot remains to be done. While we will need to always be vigilant with regard to the failings identified by the SEC in the 21(a) report, and implementing the undertakings is the number one priority, we do have an independent agenda that we are beginning to develop.

Let me comment on a number of areas in which we are currently focusing:

The first is the broad arena of cyberspace. If you've seen our Web site, you know we're using the Internet to provide members and investors with an array of valuable information. Members can access compliance information like Notices to Members and exam schedules. Investors can log complaints and enter a request to receive CRD information about a firm.

We're also using the Internet to allow both members and non-members the ability to comment, early on, about a given rule or policy, and all comments are taken under advisement when the Board makes its final determinations.

Finally, we're patrolling the Internet for on-line investment scams. The net is an ideal medium to transmit and receive information. Unfortunately, some of that information is either fraudulent, or fabricated solely in the hope of inflating or deflating the price of a stock. We are developing a range of Internet search capabilities, one of which will, for example, alert us anytime a Nasdaq company creates a home page.

Second, we believe there is a limited but disturbing presence of organized crime in the securities industry. We're working with the FBI and other federal agencies to determine the extent of the connection—and to sever any and all connections that might exist.

We have formed a joint task force of personnel from NASD Regulation and Nasdaq to coordinate our response to this issue. The team's primary responsibility will be to assist federal agencies and prosecutors with information with respect to companies, broker-dealers, and registered personnel that we suspect to have connections to organized crime. The message the NASD—and I'm certain every reputable broker/dealer—is anxious to send to organized crime is: stay away from the investor…stay away from the securities industry.

I promised to be candid, and I believe I can say with both candor and confidence that enforcement will remain one of our highest priorities. We will continue to spearhead high-profile enforcement efforts—such as expelling firms like Stratton Oakmont and Hibbard Brown, firms that have given the whole industry a black eye for years. We as an industry have tolerated the presence of rogue firms for far too long. We will also continue to work with the SEC and other enforcement agencies to build criminal cases when warranted.

Third, we're going to continue to focus on sales practices. The bull market remains in high gear. Investors are becoming accustomed to lofty returns, and sales people may be reluctant to promote a lower-risk product that may not be in step with current bull market returns, even though the low-risk product might be better suited to the client. Whether suitability requirements are being met, and whether sales practices adequately protect investors in today's environment will remain a key focus of our examinations.

Finally, we're focusing very specifically on how we can support and work with the internal compliance departments of our members. I spent much of 1996 sitting down with the SEC—finding out what its expectations of NASDR were, and how we can meet those expectations.

In 1997, I intend to spend a good deal more time with our firms—understanding more completely how you do business, and how we can work together to ensure compliance at the firm level.

Investor confidence is our common goal. Maximizing this confidence—and doing so cooperatively, proactively and efficiently—is something we can work toward accomplishing together in 1997.

Thank you.