Remarks at the SIA Compliance & Legal Conference

Mary L. Schapiro

Vice Chairman, NASD President, Regulatory Policy and Oversight

JW Marriott Desert Ridge
Phoenix, AZ

March 22, 2004

Good morning and thank you so much for the opportunity to join you this morning. Of all the invitations I receive, speaking before the SIA Compliance and Legal Division annual conference ranks as among the most important. It is NASD's opportunity to address the industry's compliance and legal professionals en masse and that is never a moment I wish to waste.

You all have, to my way of thinking, the hardest and most important jobs in the financial services industry. While we continue to struggle through very difficult times, I shudder to think of where we might be if dedicated and hardworking compliance professionals were not a part of this industry. I hope you will take my comments this morning in that light and with the understanding that I know how hard you work to do what is right.

Those of you who know me or have heard me speak before know I can be pretty straightforward and the current state of markets and investor confidence are very serious topics. So I apologize at the outset if I leave you a bit troubled when I am done. But on the bright side, the matters we will discuss today bode well for the need to keep all of you-indeed more of you-fully employed, and productively occupied.

I think it is fair to say that these are days of intense scrutiny for the financial services industry and that these days are here to stay. More about that in a minute. Yes, the market has been headed determinedly in the right direction, investors have continued to pour money into funds, the IPO market is showing robust signs of life-but from where I sit, most of the news is not quite so good.

I have been a regulator for virtually all of my professional life-more than 20 years. And I have been genuinely saddened, and more than a little discouraged, by the drift in professional conduct in our industry and what I see as refusal to deal systemically with the root causes of the problems, and to put forth the effort to lay the foundation necessary for re-establishing trust with the investing public.

As someone who cares deeply about this industry, and understands what it means for millions of Americans, I've been focused on what needs to happen to lay that foundation and to begin to re-earn the public's confidence.

In fact, it was another time and another scandal that actually prompted me to become a regulator in the first place.

When I was getting ready to graduate from law school, on a date that it serves no purpose to mention, the Hunt Brothers of Texas were making front-page news because of their efforts to corner the silver market. Working with others, they managed to buy about half the world's deliverable silver supply. (As the daughter of an antiques dealer, I despair to think of all of the magnificent sterling candelabra that were melted down for sale….) But as you all know, the Hunt's ultimately failed at their market manipulation, declared personal bankruptcy and a New York jury found them guilty of conspiring to manipulate the price of silver.

It fascinated me that the Hunt's thought they could get away with this fantastic scheme, and it led me to apply for a job with the Commodity Futures Trading Commission, the federal agency that regulates commodity markets. That spring I was offered several jobs: one with the CFTC and others, paying more than twice as much, with law firms. Much to the initial dismay of my father, I joined the CFTC. And, while I could not have imagined it at the time, a life-long interest and career as a market regulator was born.

From the CFTC to the SEC, back to the CFTC and finally to NASD, I have moved between markets and organizations, but always as a regulator and occasionally in response to the kind of scandals that piqued my interest in the Hunt Brothers nearly 25 years ago.

I tell you this story not because it is particularly interesting, but because it is partly this background that leaves me so surprised and so saddened today, and so determined to bring about the changes necessary to rebuild market integrity.

This should be a good time for the industry, with markets rebounding and investors taking another look. Instead, the news continues to be dominated by new scandals and tales of individuals and firms that appear to have forgotten the investor interest altogether.

What else can one think, when just last week The New York Times reported allegations that three major bank/broker-dealers underwrote and sold to the public, billions of dollars of WorldCom debt at a time when their internal credit analysts had decided that WorldCom presented an untenable credit risk?

I consider myself pretty seasoned and hard to surprise and yet scenarios like this leave me shaking my head.

I don't need to tell you that the financial impact of the year 2000 market break and its aftermath resulted in losses of capitalization that were depression-era in magnitude. Yet, I believe those financial blows pale in comparison to the regulatory fallout and the industry tremors from laying bare the scope of investor protection compromises by many financial services institutions.

Indeed, recent problems have been so serious and so pervasive that they have informed the thinking of the popular culture. When Martha Stewart was found guilty, one juror remarked upon the verdict being a "victory for the little guy" an apparent reference to the stock trading losses of the masses while insiders became increasingly rich. What's interesting is that no charge that reached the jury dealt with any allegation of trading violations or securities fraud. To me, the comment reflects that average investors don't think they had a fair shot and that their anger still runs deep. That is a sad state of affairs for this industry specifically and I believe it presents a general threat to one of our nation's major strengths: a vibrant capital market structure with a point of entry through the many firms we at NASD regulate.

It has become a standard practice for regulators to recite the litany of scandals of the past three years but I will spare you-I know that you know them well and appreciate the important lessons they teach us. And my greatest hope is that this learning has transformed the thinking of the industry in a lasting manner. I must however admit to a concern that, deep down, many on the business side cling to a belief that "this too shall pass," that at some point we will return to the normalcy of lessened regulatory scrutiny and demand, and that some sense of "business as usual" will be regained.

Such thinking, if it does exist, misperceives the lasting effect of recent events. A tipping point has occurred and this industry will, for the foreseeable future, face increased obligations and heightened scrutiny of regulators. There is no reason to pretend that this change is not permanent and dangerous consequences lie if we fail to recognize this and act accordingly.

Many of you know of the very tangible fallout from recent corporate and market scandals-the enactment of Sarbanes-Oxley, which has had a galvanizing impact on corporate boards and audit committees, the daily parade in the headlines of SEC and NASD enforcement actions and criminal cases for tainted research, market timing, late trading, illegal sales contests, promotion of unsuitable products and on and on, the activism of State Attorneys General, and the vast array of new rules and regulations-NASD alone has filed 95 new rules with the SEC in the last 2 years.

There has also been a less tangible, but nonetheless transforming impact of these scandals on the relationship of regulator to the regulated. If the bond of trust between investors and the industry has been significantly damaged, and it surely has, then in equal measure there has been damage to the bond of trust between regulators and the industry. This is a serious problem for all regulators, but most especially for NASD, as the largest private sector regulator in the world with a budget of half a billion dollars, our work is a combination of enforcement and the encouragement of self-compliance. If we at NASD fail in our regulatory mission, then self-regulation itself will fail and it will vanish. I have a sense that some in this room may not be driven to tears at that prospect.

Yes, we have burdened your regulatory load significantly over the years and inevitably more is to come. And, it is true that NASD often is not aligned with what the industry perceives as its self interest; nevertheless I believe that the ultimate self interest, indeed the survival of the industry, lies in the promotion of balanced and vigorous self-regulation. Let's review the role of self-regulation for just a moment.

NASD has significant independent authority that at first glance looks a lot like the SEC's. We bring enforcement cases-in fact, more of them every year than the SEC, and all other SROs combined-collecting many millions of dollars in fines and removing, through our enforcement efforts, more than 800 brokers a year from the business. We engage in rulemaking that covers the full range of activity within brokerage firms and promotes integrity and information transparency in markets. We also have authority to define our budget and collect it from the industry, something we do with care but for which we have complete authority nonetheless.

But we are not the SEC and one of our greatest strengths lies in our access to industry expertise.

Ultimately, this industry flourishes best on a promise of fidelity between the interests of the broker and the client. And the realization of that promise is best promoted by ethical standards that are the cardinal principles of self-regulation.

OK, I have described self-regulation, but what is it really? This is not just a rhetorical question and I pose it because I think its role is misperceived even within this room. Self-regulation is not regulation by proxy or referendum of the regulated firms. It is not regulation-light. We are not a trade association and we are not a club. I believe self-regulation is best described as regulation informed and illuminated, but not dictated, by interaction with the industry. Self-regulation is a privilege to be earned and to be cherished.

The benefit to the industry is that self-regulation attempts to incorporate the reality of market and industry practice and operations in rulemaking.

The benefit to investors is that our consultation with brokerage firms should ideally give us a better picture of the risks investors face and the protections they need. We are professional regulators, yet we and the regulatory process itself, benefit greatly from the input and active participation of hundreds of industry contributors. The value of SRO participation in the regulatory process is in realizing targeted responses to problems in industry practice and conduct. We don't just find a problem, make a rule and ignore operational capacities and market impact.

Even though self-regulation does not operate at the pleasure of regulated firms, this does not mean it can operate effectively in an environment in which it is divorced from firms. I said a moment ago that self-regulation is regulation informed and illuminated by the views of the industry. Unfortunately, however, when we see questionable practices, as widespread as those in the mutual fund operational and sales areas, we must question the value of input received from the industry. Anyone looking objectively at the recent-and continuing-reports would question whether even the basic and most fundamental provisions of the law and commercial honor are being observed within some firms and be left with real doubts about whether they are putting the interests of their clients above all others.

If we cannot assume basic compliance with the rules, what might that mean for self-regulation and for how the industry functions?

Here's one hypothetical. Today we have 600 examiners at the NASD, responsible for inspecting brokerage operations. Our approach to routine examinations, which are in addition to those we do "for cause," is to examine firms on a risk-based cycle-the most concerning each year, all the others every two or four years, resulting in about 2,600 routine exams a year. If instead we felt the need to inspect annually all 5,400 brokerage firms for compliance with every NASD and SEC rule, rather than approaching our task based on a risk assessment, we will need thousands-not hundreds-more examiners, in essence taking up permanent residence inside each firm. We can all recognize that the cost and disruption to business from such an approach would be immense.

We simply must be able to rely on the existence of a basic level of compliance within every firm. But I will tell you that even that statement is probably met with skepticism by some number of investors, media and policymakers. Indeed, based on recent events, I sometimes have my doubts, as well.

So, where does that lead us as we try to find a way forward in this environment of shattered trust? The regulators doubt the commitment of firms to operating at the highest ethical standards. The industry thinks the regulators have gone off the deep end and become competitors in a contest to see who can be toughest. And investors think neither the industry nor the regulators deserve their trust.

Speaking as a regulator, I think you will see us staying in the deep end for quite awhile. That means, above all else, aggressive enforcement of the rules and pushing enforcement of our bedrock ethical rule, that firms must observe high standards of commercial honor and just and equitable principles of trade. This means, among other things, that even where there isn't a specific rule tailored to address a specific situation, a firm and its officers should be committed to do the right thing.

It also suggests to me more creative sanctions in our enforcement cases, including taking a firm out of an entire line of business for a period of time when there have been repeated or particularly egregious violations. It is foreseeable that a full-service firm with multiple violations over a period of time in the mutual fund sales practice arena could be prohibited from opening any new mutual fund accounts for a period of time. The impact of such a sanction would be far greater than a fine of many millions of dollars and we have recently amended the NASD Sanction Guidelines to make clearer the capacity to have such sanctions considered.

Similarly, we will consider in the appropriate case, asking Board Compensation Committees of publicly owned broker-dealers to address how major regulatory failures were factored into their compensation decisions.

And, you will continue to see enforcement actions go up the chain of command and hold increasingly senior members of management responsible for the firm's transgressions as we did in September when we charged the national head of retail sales at a major firm for failure to supervise when regional and branch offices of the firm were holding illegal sales contests. Our decision in that case also talked extensively of the failure of the firm's Compliance Department to have any procedures to ensure compliance with the long-standing NASD rule prohibiting this type of sales contest.

This sort of lack of compliance and supervisory procedures has led me to ask our staff to step up the analysis of regulatory data which points to firms that are exhibiting red flags that enhanced compliance or supervision could address BEFORE there is a need for disciplinary action. We will be discussing our findings at face-to-face regulatory conferences with compliance officers and CEOs of firms, where we will also explore what remedial action is expected.

In a similar vein, this week, letters will be going out to firms that employ brokers with multiple customer complaints or other disclosures, reminding each firm of its responsibility to pursue heightened supervision with respect to the activities of these reps.

Recent events will probably control the tempo and tenor of future rulemaking for some time, as well. Most firms, and I would venture to say this is true in most industries, would prefer principle-based regulation in which the detail of policies and procedures is left to the firm to determine. And in principle, I agree this is a good goal for regulation wherever possible. But this approach becomes increasingly less possible when even a few firms demonstrate behavior that not only ignores the animating purpose of our rules but also flouts their express borders.

I think you can also expect to see the regulators demand more self-reporting from firms about their compliance weaknesses. And, as you know we are moving forward with certification from broker-dealers about the state of their compliance processes, not unlike the Sarbanes-Oxley certifications that require sign-off on financial statements and on the effectiveness of internal controls for financial reporting.

I can't predict for you what will happen in Congress, but I don't think anyone should yet count out mutual fund legislation this year, despite the many new requirements already proposed or enacted-and there will be more to come-concerning fund governance, and disclosure surrounding fees, soft dollars, and breakpoints, to name just a few.

On a more specific level, our focus on distribution and compensation issues related to mutual funds will continue through enforcement and rulemaking.

Our focus historically has been on the suitability of the mutual fund share classes that brokers recommend; the sales practices they employ; the disclosures they make to investors; and the compensation they receive from mutual funds. We also have played the lead role in policing whether brokers give customers the proper volume discounts-or breakpoints -off of the front-end "loads" that many funds levy, and we have lead the Task Force charged with developing the operational and regulatory changes necessary to prevent these problems in the future.

We will continue to monitor implementation of the Task Force recommendations and we have now expanded this line of inquiry into "discounts owed but not given," to UIT products and Net Asset Value Transfer programs.

Besides breakpoints, NASD has been highly active in mutual fund enforcement more broadly. Last year alone, we brought some 70 mutual fund cases-and more than 200 over the last three years covering inappropriate share class sales, suitability and the use of directed brokerage commissions to pay for shelf space. There are nearly 200 ongoing, active investigations at NASD covering these fund-related issues, as well as market timing and late trading.

Let me just mention a couple of other areas where we will be highly focused this year.

I have long had concerns about how variable annuities are marketed to investors. We brought three important cases in the past month alone related to the sale of these products. We ordered Prudential to pay customers $9.5 million and a $2 million fine for variable annuity sales and switches that violated NY State Insurance Department regulations.

We filed a case earlier this year against Waddell & Reed and two of its senior executives charging them with recommending 6,700 variable annuity exchanges to its customers without determining the suitability of the transactions, generating $37 million in commissions and costing their customers $10 million in surrender fees.

The same week, we permanently barred from the industry, a Louisiana broker for unsuitable variable annuity sales.

While we have brought some 75 annuity-related disciplinary actions in the last three years, given the increasing complexity of these products and the impact of tax law changes, we will intensify our scrutiny. We are considering rulemaking in this area that could require pre-approval by a principal of the appropriateness of variable annuities in a manner akin to the process of approval for options trading, and we will consider whether firms must have their customers sign a specific risk disclosure document when considering an exchange of one variable annuity product for another.

Coming out of the Metropolitan case that we filed late last year, we are currently analyzing all securities offerings done over the past two years where a broker/dealer sold its own securities or those of an affiliate. Our examinations cover both registered offerings and private placements and include equity and debt. In case you missed the Metropolitan case, it involved fraud in the sale of debentures, investment certificates and preferred stock issued by two affiliated companies of an NASD member. The BD's sales force made unbalanced presentations to investors and downplayed important investment risk factors, including the risk of loss due to the companies' insufficient earnings, subordination of the securities to other obligations and the absence of an established market for the preferred stock.

We also have a growing concern about the intersection within broker-dealers of mortgage lending and securities investing. As investors have watched the tempting combination of a rising stock market, record low mortgage interest rates and tremendous growth in the equity they have in their homes, they have been tempted by sales pitches to unlock that equity, by refinancing their homes-perhaps through a non-registered affiliate of the broker/dealer-and investing the proceeds in the stock market.

So, I will go out on a limb here and say that 99% of the time, a recommendation that an investor mortgage his or her home in order to speculate in the securities market-IS UNSUITABLE-and subject to potential enforcement action.

We brought three enforcement cases last week against individual brokers for making unsuitable recommendations that included convincing clients to mortgage their houses.

Additional areas of interest that I can forecast for this year include debt and municipal security pricing and markups, retail sales of non-conventional products and an extensive effort, coordinated with the SEC and the NYSE to deal with abusive short-selling, to name just a few.

Before I finish, I'd like to go back to where I began: the role of the industry.

NASD will continue to be extraordinarily busy this year, as we have been for the last several years, but the harder task remains with the industry. I've outlined some of NASD's priorities and approach but in order to restore investor trust, what's truly critical is for brokerage firms to recommit to the principle of putting the investor first.

Brokers need to truly understand, accept and act on the fact that pursuing short-term profits, at the expense of treating your customers fairly will never be a successful strategy over the long run. Truthfully, I do not understand the failure to grasp and live this dynamic, particularly in the face of a thousand examples where it has been true.

The U.S. capital markets are the most efficient and resilient in the world because we operate in a market economy in which risk-taking that culminates in innovation, efficiency and consumer satisfaction is richly rewarded with profits. Regulators are not at war with profit seeking. But, profit seeking must not prevent any in this industry from honoring the responsibilities that arise from the trust placed in them by investors.

All commercial regulation reflects, at least in part, the understanding that unbridled capitalism can lead to excesses of behavior and harm, that we as a society find unacceptable. This is not a remarkable proposition. I believe I can presume to say that there is not a person in this room who does not believe that in the long term, you do better on the balance sheet by doing better for your customers.

I think that if the industry wants to preserve the privilege of self-regulation and to regain investor confidence and the confidence of regulators, then a cultural change is necessary at many firms.

There is a tendency in life to believe that the way things are is the way they will always be. This is why the end of bull markets are rarely seen. The way things were is not the way things can continue to be. I urge all of you to come to that realization. I believe it is as simple as this: if the industry wishes to be in control of its future it must control its conduct, it must act in the interests of its clients in deeds as well as words, and it must dispense with the notion that what is ethical can be informed by the formula of profit and loss.

This audience is composed of the best and the brightest, all of whom are committed to seeing fair markets thrive, investor interests served and healthy capitalism flourish. I urge you to redouble your efforts today and tomorrow in creating a strong, proactive culture of compliance within your firm that demonstrates that commitment to investors and regulators. There aren't any better uses of your time.