Remarks from the 2010 FINRA Annual Conference

Richard G. Ketchum

Chairman and CEO

Baltimore, MD
May 26, 2010

Note: An audio podcast of this speech is available for download at

Good morning, welcome to Baltimore, and thank you for attending the FINRA annual conference. It's nice to see so many familiar faces here today.

If you've been to this conference before, you know it's a terrific opportunity to hear from experts who work in and around the financial industry. It's also a chance, of course, to reconnect with friends and peers and talk about issues affecting your firms.

If this is the first time you're attending our conference, I think you'll find that we plan to cover a rich menu of topics—from fraud detection, risk management and ethics to AML and advertising issues.

And for all of you here, I think you will notice an underlying theme for most of this year's panels and sessions: the comprehensive change that's now underway throughout the industry and throughout the regulations governing the industry. The pace of this change is clearly affecting all of us—regardless of our roles as either regulators or firms. So much so, in fact, that registration for this conference was sold out weeks ago. This suggests to me that there is great interest among all of you to better understand the market changes, and a greater commitment to ensure that your firm continually enhances its culture of compliance.

Another new addition this year is that we will be making some of our speeches and discussions available online once the conference has concluded. Given the volume of information we will be offering you over the next few days—and the fact that some panels overlap—we thought you might welcome the opportunity to review the conference proceedings at a later time, or share them with a colleague.

I think that does it for my housekeeping issues, so let me now talk to you for a few minutes about what's on our minds at FINRA—and how we are responding to the issues that both the industry and investors are facing.

Amid the changes sweeping our economy and the markets, I sometimes find myself agreeing with Paul Volcker, who has observed that "about every 10 years, we have the biggest crisis in 50 years." Yet there's no denying the significance of what has unfolded in the financial sector since just 2008.

Our nation is still living with the severe economic impact of the downturn, which stretched from Wall Street to Main Street. But at the same time, the industry, and those of us who regulate it, are dealing with a severe erosion of trust among investors. That trust deficit highlights for all of us the critical work we have ahead, since trust is—and always will be—the cornerstone of a vibrant and dynamic financial industry.

At this moment, not far from here, Congress continues to debate, albeit now in more individual conversations, the right course for financial regulatory reform, from the treatment of large financial entities and their permissible activities, to consumer product oversight and the possible application of a fiduciary duty to broker-dealers.

But regardless of the outcome, one of the challenges ahead, for everyone working in the financial markets, is to master the lessons of what went wrong and work to ensure that the same mistakes are not repeated—and not to be frozen waiting for things to happen in Washington.

Indeed, the financial crisis provided a potent reminder of the need for FINRA, and all other regulators, to re-examine how we can more effectively protect investors. We have already taken a number of actions to close gaps in regulation, enhance market transparency and tackle fraud. The theme underpinning this work, and all of our work, is to promote investor protection and overall market integrity. I'll describe some of what we're doing in those areas, and then I'd be happy to try to answer any questions.

Market Regulation

Let's start with market regulation and the issues coming out of the so-called "flash crash" of May 6th—recognizing that many of you aren't overseeing or having compliance responsibility with trading functions, but looking at the basic reality of the impact on investor confidence across your customer and client base, and the need for firms and regulators to be focused on the response. Obviously there remains much work to be done, both in terms of diagnosing what led to the market drop and identifying additional proactive steps we may want to take to ensure that our markets are able to function more efficiently under highly volatile conditions.

But I think this is an important time for all of us in the securities industry to step back and recognize that with the huge changes in the market, we need to once again look at market structure and look at the responsibility of firms when dealing with a very different market environment. I give the SEC great credit from the standpoint of its concept release, but more than that, we need to reflect on how other markets and other countries deal with issues of thinness of books when high-volume trading is triggered—either as a result of panic or as a result of errors.

We need to do this in at least three ways. First, as we and the New York Stock Exchange have consistently said: you, as firms, need to understand your order routing handling issues and your ability to use screens and other tools to ensure that you don't continuously feed in orders once markets have experienced precipitous declines.

Second, without singling out any particular firm or particular transactions, the "flash crash" demonstrates again the wisdom of the SEC's proposal from the standpoint of direct access. We have always said and will always say that firms that provide their name and sponsoring transaction have a responsibility to ensure the proper screens are in place. The supervisory responsibility is yours as long, as that activity can occur from a co-location standpoint around large numbers of entities and both broker-dealers and non-broker-dealer firms. But the SEC's approach is right. There needs to be some assurance that people are being looked at and examined regularly by some regulatory entity if they have the ability to directly and profoundly impact the market in a matter of instances.

Third, we ought to take a look from the standpoint of other markets abroad and learn from their wisdom and recognize the simple fact that when liquidity disappears in markets today—with electronic trading—it disappears absolutely. It almost doesn't matter whether we're talking about error transactions or coordinated mass panic from the standpoint of algorithmic trading; the basic reality of our markets and how they have changed is pretty simple. We now have highly fragmented markets—books that are effectively pulled together electronically in good times, but pulled together without the same type of market-maker obligations that existed in the past. We have regulatory requirements that require two-sided quotes which leave stub quotes at trivial prices when those thin books are pierced, and simply create more problems. We also need to recognize that there are cliffs with respect to electronic books and there simply is not a level of expectation on how market-making operates to ensure any modulation once you reach those cliff moments.

Taking note of that last point, FINRA was pleased to have participated in a series of discussions with the U.S. equities and options exchanges, under the oversight of the SEC, to establish a framework for market-wide, stock-by-stock circuit-breaker or "pause" rules and protocols. The result of this coordinated effort was the rule changes filed last week by each of the exchanges and FINRA to implement the following stock-by-stock circuit-breaker protocols on a pilot basis for all securities included in the S&P 500:

  • If the price of a security changes by 10 percent within a rolling five-minute period, trading in that security will be halted for five minutes—a period of time sufficient to allow people to identify error trades and to stop them, and for buy-side liquidity to determine that there isn't a huge information dysfunction and move back into the market.
  • A message will be sent simultaneously to all the markets and FINRA.
  • The primary market for the security will employ its standard auction process to determine the opening print after the five-minute halt period.
  • The authority will apply from 9:45 a.m. to 3:35 p.m., Eastern Time.

This pause in trading will allow market participants to better evaluate the trading that has occurred to correct any erroneous "fat finger" orders, and to allow a more transparent, organized opportunity to offset the order imbalances that have caused the volatility. The regulatory response should reduce the negative impacts of sudden, unanticipated and otherwise unexplained dramatic price movements in individual securities. This is far preferable to the markets having to be in the position of going back after the fact to determine what trades should be broken when markets go close to zero.

There are many additional implementation and technological issues that will be discussed and resolved by the relevant markets in the coming weeks, with the goal of implementing the new circuit-breaker authority within 30 days of the Commission approval. In addition, there will be efforts to quickly expand that pilot, both with respect to ETFs and a far-wider range of securities. Once implemented, the markets and FINRA will be monitoring continuously the application and effectiveness of the rule's framework and protocols to determine the most efficient and effective permanent approach.

Fraud Detection

Let me now shift and spend some time discussing our program at FINRA. I will shortly be discussing the compliance challenges facing your firms and each of you, but, we and other regulators have also taken a step back and reassessed how we could do a better job at both detecting—and preventing—fraud. At FINRA, we have focused intently on strengthening how we go about looking for fraud at firms, and how we process tips and allegations of fraud when they come our way. We have also worked hard to arm our examiners with new training and education on fraud detection.

Last October, we created an Office of Fraud Detection and Market Intelligence. This unit provides a heightened review of allegations of serious frauds, a centralized point of contact internally and externally on fraud issues, and consolidates recognized expertise in expedited fraud detection and investigation. The office combines several departments, including departments investigating insider trading and manipulation and the Central Review group, which is responsible for preliminary review of filings from firms. It also includes the Office of the Whistleblower, which we established in March 2009. And while both of these offices are new, I feel that already, they have had a tremendous impact on our ability to focus and respond quickly to areas where there are fraud concerns.

We have also enhanced our examination programs and improved our ability to detect and investigate conduct indicative of fraud.

We now gather more information before each examination about a firm's ownership and affiliate relationships. This includes understanding the nature of any investment advisory business conducted through the firm or any affiliate, or by associated persons. Our exam teams use expanded internal and external information about firms to identify potential conflicts of interest or other evidence of problems before the examination. And, when apparent conflicts of interest are identified, examiners are looking for appropriate internal controls and segregation of duties.

When a firm acts as both adviser and broker to customers, and these functions are not segregated, firms have a higher level of control over customer assets. FINRA has enhanced custody and customer protection procedures to review for such activity.

We are also examining the relationship between broker-dealers and/or their affiliates with feeder funds, or master funds that utilize feeder funds.

We are looking more closely for material misstatements in financial reports, unusual money movement, and any apparent red flags involving a firm's auditor or exceptional off-balance sheet items.

And, since much of the information used for examination is self-reported, to mitigate the risk that inaccurate information provided by firms may affect the focus of examinations and conceal violations, FINRA is independently verifying information, including custody information with DTCC or other outside custodians. We are also verifying customer account activity and balances directly with customers.

To ensure that serious matters get escalated quickly, FINRA has focused on the speed and efficiency with which we bring enforcement actions. Quicker action means more investors escape harm. We need to be out of the business of sweeping up bodies, and into the business of getting in there before too many investors are hurt. And we are doing everything we can to ensure that we have a more laser-like focus on fraud detection. This includes working with states and with other regulators to pursue and prosecute allegations of fraud.

In the next year or two, I think you'll see that we'll be making even more changes to our exam program to be far more risk-based and far more informed with respect to the different types of firm business models. If there's one thing I've found traveling around the country in my first year at FINRA, it's that many things about the way FINRA operates and the way our districts operate are working well. But I also recognize that there is a continuing frustration among firms that there's not enough understanding of your business or enough appreciation of where some of the most serious risks reside.

Through our expanded coordinator program, we want to have more continued, ongoing conversations with you about what's happening with your firm and where and how your firm is changing, both from the standpoint of your business model and elsewhere. The same thinking applies to our examiners—we want them to understand what's happening to your firm and focus on areas of heightened risk.

It's our goal that the days of one-size-fits-all regulation become a thing of the past. Using risk-based analysis, we are focused on understanding the composition of each firm's business as we walk in the door. Rather than a check-the-box approach, you should see our exam teams more focused on those areas that pose a real risk to investors.

All of these things, of course, require continued communication with the SEC since we are also regulated, just like you. And with new leadership at the SEC, we're seeing that staff is truly open to rethinking how to develop an effective exam program. Hopefully, what you'll see in the next few years is a FINRA exam program that continues to be more knowledgeable about what makes your firm tick and wiser about where we choose to spend most of our time.

This is especially true for smaller firms. By revising our exam program to no longer mandate certain areas of review—when they don't apply to your business—we have the flexibility to spend more time looking at higher-risk activities. Some of the common findings in small firm exams include those relating to financial and operational issues, books and records, supervision and anti-money laundering.

The best advice I can give to small firms is to continue to focus on these areas, as this is where we are seeing the most issues.

Product Review

As I mentioned at the outset, rebuilding investor trust is an essential element of restoring the vitality of financial markets. One way to help rebuild trust is for firms to ensure that all of the products they offer are appropriate for individual customers, in light of their needs, goals and current financial situation. Easy things to say; far harder things to ensure.

If we've learned anything from the last two years, it's that senior management at firms must be involved in compliance. Compliance officers need to have access to senior leaders and there needs to be a genuine demonstration in responding to potential problems, investing in technology solutions and, most important, providing adequate staffing in the area of compliance.

What about now, after the issues of the last two years? I know every firm is under pressure today, but a firm's obligation to compliance has not changed.

This is especially true now as investors may be looking to recoup the losses they've been hit with over the past year or so. Some investors are going to be tempted to overreach in their search for higher returns. They may be less cautious at a time when they should be extremely cautious.

What I'm suggesting—and have been emphasizing again and again—is the need to ensure an ongoing new products process. Firms need to look at their list of products and make fairly difficult assessments as to whether they are still right for their customers. That requires an in-depth understanding of the components of the products. It demands a sophisticated analysis of which external forces could influence their behavior, and how—and it requires an effective tracking process to ensure you understand what your reps are selling, and what new reps coming into the firm already have their customers invested in.

The need to understand how products and services change over time has never been more pressing. Firms have made some real progress in the new products process over the last few years through the creation of review committees and the incorporation of compliance earlier in the product creation process. But too often the analysis ends when the product is pushed out for the first time. This is less than optimal given that macro forces can fundamentally change how a product performs and who should be buying it.

As investors find what are perceived to be safer places to put their money, firms need to be able to communicate to them not just the risks of those products now, but anticipate and communicate the risks if conditions change. And the concerns don't always focus on the most complex and newest structured products.

For example, we will see even greater retail participation in the muni market, and given the increased financial exposure of some state and local governments, what bonds remain appropriate and what changes in disclosure are necessary to reflect new risks? What controls do you have in place to identify municipalities entering into financial distress and to make sure that information flows to your retail customers? Beyond munis, how about the ETF market and the increasing number of leveraged trading vehicles in that sphere? Certainly not all munis and ETFs are created equally, certainly not in a world of higher volatility and a world where solvency and liquidity are constant concerns.

Similar issues are raised by annuity products. Today, a cornerstone of our regulation of variable annuities is FINRA Rule 2330, formerly NASD Rule 2821, which governs variable annuity sales practices. Although this rule certainly took some time to complete, the final product resulted in a workable approach that strengthens our protection of investors in variable annuities.

With the rule having been in effect, at least partially, since mid-2008, we now have some experience with the types of problems we are seeing at firms. For example, we have uncovered inadequate compliance policies and procedures. We also have found that some firms failed to obtain customer information, such as information about customers' liquidity needs and tolerance for risk.

Unfortunately, we have also encountered unsuitable recommendations to purchase or exchange variable annuities, although failures to document a suitability analysis were a more frequent finding than actual unsuitable recommendations. Some of the things you should be looking for with your compliance reviews are a justification for numerous switches by the same broker. You should also look for patterns like sales to seniors, same riders for many customers and policy lapses. In our examinations, we have also seen inadequate training and supervision, and failures to document transaction approvals.

Another area of continuing and greater concern for us involves Reg D offerings. This is an area where I'm really pleased with the FINRA program—the effort to identify a serious problem, create a national program and respond on multiple levels. We are responding to firms that aren't represented in this room that have generated a variety of cookie-cutter operations often affiliated with the issuers of the securities they're selling, creating the risk of the type of penny stock markets and fraudulent markets that we dealt with in the 1980s. In addition to all of you who operate very careful compliance operations, we've also tried to reemphasize the need and importance of careful compliance efforts and careful diligence with regard to Reg D offerings. Again, not all Reg D offerings are the same. We recognize you have to rely to some substantial degree on the efforts of firms that are operating effectively in an underwriting function, where they're not affiliated with the issuers. We recognize that you have to rely upon the disclosure that issuers provide—but not with your eyes closed. This is an environment that creates the risk of the type of problems that we've seen before and will have a serious impact from the standpoint of investor confidence.

We've put out a Notice that identifies the number of legal requirements that firms have, so they can be aware of red flags—and where things don't go right, or where they haven't been properly explained, to push harder for the quality of disclosure. It's not okay to just go to a prefab sales meeting and check off that you understand what's going on with the issuer. These are concerns that I really want to underline as critical. The Reg D market is an increasingly important market from the standpoint of capital formation, and it has an important place in the U.S. capital markets. But the responsibility and the commitment—whether it is from a legal or reputational standpoint—to know what you're selling, is more important than ever.

In the past, I've talked about what I call "wealth events." These are events that happen once or twice in a family's or individual's lifetime.

It could be the death of a parent or spouse or simply entering retirement these days. The one thing all "wealth events" have in common is they involve large amounts of money being turned over and they fundamentally change the way investors interact with their broker or financial adviser.

When investors find themselves in such an event, an adviser's first reaction may be to recommend selling everything and starting over, which of course, generates a lot of commission fees—but hardly ever is the best course of action.

That's why I believe these "wealth events" need to be proactively supervised more closely. They need to be on senior management's radar screen, not simply as a revenue opportunity, but as a crossroads moment with a client. Similarly, these events need to be a particular focus of your compliance reviews. Where there is greater risk and incentives, there has to be greater attention.

Compliance Assistance

The complexity of securities products today also stands as a reminder of the importance of staying up-to-date with regulatory requirements, particularly given that your focus is to serve your customers. And while you absolutely cannot ignore your regulatory obligations, we recognize we have a responsibility to help enhance your compliance and make that compliance less of a burden.

Over the last several years, we have done our best to provide tools and resources to help firms—particularly smaller firms—comply with our rules. Earlier this year, we updated our AML and BCP templates, which provide example language and walk through a process for creating your own procedures. Similarly, last year, we worked with the FTC to develop a template to help firms comply with the Red Flags Rule of the FACT Act.

Another example of a resource we developed to help firms are the rulebook conversion charts. These were developed to help with the transition to a consolidated rulebook. They map former NASD and NYSE rules to the new FINRA rules and vice versa.

And, we've also increased the frequency and number of online programs for compliance professionals. We know your travel budgets are limited and for many of you being out of the office means being further away from your customers. So, in addition to our weekly podcast series, we have ramped up our webinar program to give you easier access to compliance information.

BrokerCheck Expansion

Another area where FINRA is actively looking to increase transparency is through BrokerCheck. As you know, BrokerCheck was expanded last November to make records of final regulatory actions against brokers permanently available to the public, regardless of whether they continue to be employed in the securities industry.

More recently, we filed a rule proposal with the SEC that would further expand BrokerCheck and provide additional information to investors. The proposed enhancements, which must be approved by the SEC, would expand the number of historic complaints displayed for individuals who are currently registered with FINRA or who were previously registered with FINRA.

The comment period for the BrokerCheck rule filing has closed and as of May 19th, the SEC had received a number of comment letters. We are currently drafting our response, but I wanted to take a minute to discuss a few high-level concerns we've heard around our proposed release of historic customer complaints and how we plan to address them.

In response to the concerns raised about how historic complaints would be displayed in BrokerCheck, we plan to include text in the BrokerCheck report that clearly describes that customer complaints are based upon allegations. We also plan to organize complaints by the nature of their disposition—that is pending, settled and closed with no action, withdrawn, dismissed or denied. And, when a complaint was closed with no action, was withdrawn, dismissed or denied, we will clearly identify it as such.

Other feedback we heard relates to comments that a rep may have responded to a complaint that had previously been archived. Beginning in June, firms, on behalf of a rep, will be able to easily update or provide additional context in the comment section on these filings.

I recognize that, even with these responses, increased disclosure through BrokerCheck will not be painless, but it is an important step to take to regain investor trust.


Each of the efforts that I've outlined today contributes to the broader mission I discussed at the outset: rebuilding trust in the financial industry and in those of us who regulate it. There are many issues on the landscape that present an opportunity for enlightened action—including enhanced disclosure of conflicts, creation of a more vibrant compliance culture in firms of all sizes, and closing the regulatory gaps that leave markets vulnerable to manipulation. But regardless of the specific issues, what's critically important will be the actions of all of you in this room today. Regulators need to have a deep and nuanced understanding of markets as they continually evolve, so we can recognize the vulnerabilities and move to address them. And firms need to focus on complying not only with the letter of the laws, but also the spirit underpinning them.

The next three days and beyond are an opportunity for all of us to maintain open lines of communication, share information and work together. Because by cooperating, we can rebuild—and restore—trust in America's markets, and see to it that they are once again an engine of growth for the United States and nations throughout the world.

So while there is a lot of work ahead, your attendance at this conference is evidence to me that you're invested in this process. Indeed, I can't think of a group of people I feel more confident in that have the ability to react and respond, and move the industry in the right direction. I hope you find the next few days to be a productive use of your time and that you leave with valuable information.

I want to thank you again for your commitment to be here.