Remarks at the District 7 Compliance Seminar

Mary L. Schapiro

President, NASD Regulation, Inc.

Atlanta, GA
September 25, 1997

It is a pleasure to be here today. This seminar, and others like it, are vital to NASD Regulation’s preventive compliance program and the dialogue that must exist between NASD Regulation and our membership if we are all to succeed in protecting investors and ensuring the continued growth of the markets.

Forums such as this help to ensure that NASD members can do their jobs effectively and responsibly, within the confines of legal and regulatory requirements. I am glad to be a direct part of our efforts to bring information and education to our members so that problems are avoided in the first instance. I and all of the NASD Regulation staff want to help you serve as the most effective first line of defense with respect to investor protection; a goal that we all share.

I understand from Marilyn that you are most interested in our examination and enforcement programs, current initiatives, and the major changes that have recently occurred within NASD Regulation. The timing could not be better considering the significant new disciplinary rules that were just approved by the SEC on August 7 and the many new initiatives that NASD Regulation has recently unveiled.

Additionally, NASD Regulation held a Board meeting earlier this week so I can update you on the very latest developments.

But let’s begin with four topics that I view as critically important. These topics are penny stock/micro cap fraud, trading and market making, the NASD Regulation examination program (including the important issue of supervision), and the rules just adopted on August 7; rules which dramatically change our process at NASD Regulation. After addressing these areas I’d like to briefly cover a number of other emerging areas and issues.

I. Major Areas of Focus

A. Penny Stock/Micro Cap Fraud

As NASDR staff testified on Monday before a Senate committee, we have zero tolerance for penny stock and micro cap fraud. These low priced, infrequently traded, thinly capitalized securities characterize the non-Nasdaq, non-exchange listed over the counter market. Just a couple of years ago, following several years of enforcement actions focused on eradicating fraud in penny stocks, allegations of misconduct in this market segment have resurfaced.

This appears to be a result of a number of factors including, very favorable market conditions, and an influx of new and inexperienced investors. In addition, there is a lack of reliable, accurate and timely information about the business operations of many lesser known OTC companies.

Another factor that we believe contributes to the increasing fraud in this area is a perception by the public, frequently fostered by dishonest brokers, that the OTCBB is akin to a highly regulated market such as The Nasdaq Stock Market. It is not.

The OTC Bulletin Board is an electronic quotation service for subscribing members and there is no formal relationship between the OTC issuers whose shares are quoted there and Nasdaq, even though the Bulletin Board displays real-time quotes, last sale prices, and volume information in domestic securities.

We are committed to ensuring that penny stock or micro cap fraud does not resurface as a significant investor protection issue. We and The Nasdaq Stock Market will tackle these issues by simultaneously following a number of avenues leading to new rules, higher standards, targeted examination and enforcement initiatives, and cooperative programs with the SEC.

Earlier this week, the NASD Regulation Board backed the staff’s efforts to explore : (1) limiting the OTC Bulletin Board to Exchange Act reporting companies. Currently, more than half of the OTC Bulletin Board companies are non-reporting. (2) requiring members to review specific financial information of the issuer prior to recommending a transaction in an over-the-counter security, (3) prohibiting members from effecting a transaction in an OTC security unless the member has furnished the customer a disclosure statement explaining the differences between the OTC market and The Nasdaq Stock Market. This will help to eliminate customer confusion; and, (4) providing Nasdaq with quote halt authority in limited circumstances. Current authority to halt quoting resides only with the SEC.

We have also proposed the elimination of cold calling to prospective customers by unregistered persons. We believe that it is in the best interests of firms and investors to require the registration of all associated persons who communicate with prospective customers for the purpose of either soliciting the purchase of securities or related services or identifying prospective customers.

Further, the Board has supported our ongoing efforts to discuss with the SEC reforms to the Penny Stock Rules and Rule 15c2-11. These reforms may ultimately include better, more meaningful disclosure to investors regarding the risks of penny stock investing and the nature of the over-the-counter market.

We will continue to work with the SEC in examination, investigation and enforcement in the micro cap arena. Collectively, we are using our technology and human resources to identify aberrant price and volume movements in securities despite the absence of economic factors that would reasonable drive such activity.

Our recent coordinated approach with the SEC is actually a continuation of our own efforts to move against penny stock and micro cap fraud. For example, the Atlanta staff recently participated in an enforcement proceeding where NASD Regulation imposed a number of suspensions and fined a firm and several of its representatives $725,000 and ordered $1.4 million in restitution to investors.

That case stemmed from the domination and control of the market in eight securities and the charging of excessive markups to over 1,000 customers across the country (GKN Securities case). The securities were all micro cap stocks (5 OTCBB and 3 Nasdaq) and this action is one example of our focused efforts to put an end to fraudulent practices in the micro cap market. The sanctions also underscore NASD Regulation’s commitment to obtain restitution for victimized investors.

Just two weeks ago, NASD Regulation announced the imposition of fines and restitution of more than $950,000 in another penny stock fraud case (La Jolla Capital). In that case, a west coast based broker-dealer was permanently barred from selling penny stocks and five of the firm’s senior officials were sanctioned for violating penny stock rules. Fifteen securities were involved in the case and the decision finds that the firm engaged in conduct designed to circumvent the SEC Penny Stock Rules. These rules ensure that investors receive candid information about risk disclosure and suitability issues before they invest. Instead, the firm had investors sign a misleading document that purported to exempt transactions from the Penny Stock Rule requirements. Not surprisingly, this case also involved misleading and deficient supervisory policies and procedures, an issue I will separately address in a moment. While this case is still not final in that it could be called for review by Association Boards or appealed by the respondents, it nevertheless points out the continuing sales practice abuses that are infrequently, but unfortunately, occurring, in today’s micro cap markets.

The significant disciplinary actions show that while we nearly had this particular problem under control a few years ago, it now seems that a very small percentage of unscrupulous firms and salespeople are taking advantage of the wonderful market conditions to defraud investors. We simply will not tolerate this and neither should you.

Join with us in wiping out this problem by carefully screening new hires. If reps have a past characterized by serious prior disciplinary problems don’t hire them. If you do not view the disciplinary history as particularly egregious and you hire the person, be sure to meet your duty of placing heightened supervisory procedures around that person to protect not only investors, but your firm as well.

And, when we or another regulator shut down a problem firm, do not just hire all or part of that firm’s sales force. First determine whether the culture and habits acquired at the closed firm are indications of problems waiting to happen, of frauds waiting to occur, and of investors waiting to be harmed. Remember that these people and their practices become your responsibility and liability once you make the choice to hire them.

An initiative related to the hiring of problem reps moved ahead just a few days ago when we filed with the SEC a proposed rule change to require firms that hire a specified number of individuals from shuttered firms to tape record telephone conversations between their registered representatives and existing and potential customers. NASD Regulation initiated this rule after identifying a trend where the reps of firms that had been shut down for sales fraud simply move en masse to another broker dealer.

We do not expend our examination and enforcement resources to chase our tail we do it to protect investors. We cannot have the remedial benefits of our disciplinary actions thwarted by the simple movement of reps among firms. In this regard, the proposed rule would bring heightened supervisory responsibilities to firms that hire reps that come from broker-dealers that have been the subject of certain serious sales practice disciplinary actions.

The concept is for the new firms to tape record brokers’ conversations with clients and monitor them to ensure that the federal securities laws and NASD Rules governing sales practices are not broken. The measures contained in the rule are designed to prevent a reoccurrence of the sales practice abuse or other customer harm that caused the disciplined firm to be expelled or have its registration revoked in the first instance. The proposal also responds to concerns expressed in the Joint Regulatory Sales Practice Sweep Report which found some firms willing to employ registered representatives with a history of disciplinary actions or customer complaints.

B. Trading and Market Making

Turning to trading and market making, late last year NASD Regulation sent letters to all market makers asking for detailed written procedures relating to the trading and market making conduct addressed in the SEC 21(a) Report. In its report, the SEC identified two troublesome trading conventions relating to the size and price of securities that prevented spreads from narrowing and increased costs to customers. The SEC also found that traders were trained in the use of the conventions and noted instances of harassment against traders that did not follow the conventions.

Firms need to ensure that a designated principal is identified as responsible for each area identified in the 21(a) Report. The date the principal assumed responsibility should also be captured in the procedures. Importantly, the procedures themselves must be more than a recitation of the rules. Procedures need to explain how the firm will monitor its operations to detect and prevent violations identified in the 21(a ) report.

During the approximately 400 examinations of market making activity that will be conducted in 1997, examiners will specifically focus on trading and market making procedures, analyze records used by firms to supervise this area, and consider the frequency of reviews and how reviews are evidenced.

For our part, we moved ahead with an interpretation that was responsive to the SEC 21(a) Report and on July 17, 1997, the SEC approved a new interpretation under Rule 2110 regarding anti-intimidation and coordination activities of member firms and their associated persons. This interpretation defines certain conduct by and among members as conduct inconsistent with just and equitable principles of trade, and sets forth specific exclusions for bona fide commercial activities. The interpretation identifies three general areas of conduct that are prohibited, including coordinating activities by member firms involving quotations, prices, trades, and trade reporting. Conduct covered by this prohibition includes agreements to report trades late or inaccurately, or agreements to maintain certain minimum spreads or quote sizes above the legal minimums.

The second part of the interpretation prohibits "directing or requesting" another member to alter prices or quotations. This includes situations in which one market maker requests another market maker to move or adjust its displayed quotations to accommodate the requesting market maker.

The third part of the interpretation relates to conduct that threatens, harasses, coerces, intimidates, or otherwise attempts improperly to influence another member in a manner that interferes with or impedes the forces of competition among member firms operating in Nasdaq. This prohibition reaches conduct that goes beyond legitimate bargaining among member firms and includes refusals to trade, improper systems messages, trading in odd lots, and other conduct intended to influence a member to engage in improper market activity or refrain from legitimate market activity.

We issued this interpretation to codify a long-standing policy and to address certain criticisms contained in the 21(a) report pertaining to the anti-competitive behavior of Nasdaq market makers. The interpretation expressly reaffirms that anti-competitive behavior and intimidation and harassment of other members is prohibited. In addition, the interpretation clearly delineates the type of behavior that is antithetical to a free and open market while preserving the ability of members to engage in legitimate market activity.

C. Examination Programs

As for our examination programs, we continue to be extremely busy. To put this in perspective, in 1997 NASD Regulation will conduct approximately 2500 cycle examinations and 10,000 cause examinations arising principally from customer complaints and Form U-5 termination for cause filings. I know that you are particularly interested in what we are doing to coordinate these many examinations with other regulators so that you are not subjected to unnecessary regulatory overlap.

In 1995 we entered into an agreement with the SEC, NASAA, and several other securities self-regulators to coordinate examinations of joint members; meaning that pre-examination planning and focusing would ensure that multiple regulators do not duplicate work during on site cycle examinations. This Memorandum of Understanding followed and was in response to a movement by the industry to do away with unnecessary regulatory duplication and to permit firms so requesting to consolidate multiple on-site examinations. This agreement extensively impacted NASD Regulation and the NYSE considering our individual front line examination responsibilities.

During 1996, the first full year during which the agreement was effective, we coordinated with the NYSE over 100 cycle examinations of our joint members, meaning that over 90% of the firms that sought a coordinated examination received one.

In 1997, we enhanced the coordinated examination program so that firms that do not want two SROs in their firms at the same time can have the examinations spaced apart by at least two months. For 1997, 137 firms requested a coordinated examination between NASD Regulation and the NYSE and 74 of those examinations have started. Based on the early returns, I anticipate that we will again achieve at least a 90% success rate with respect to firms seeking a coordinated examination in 1997.

Keep in mind that the coordinated examination program does not apply to cause examinations. These are special examinations precipitated by a specific event, such as a customer complaint, that requires an immediate response by the appropriate regulatory or self-regulatory authority.

Beyond the coordinated examinations, I am sure that you want to know what our examiners look for when they conduct examinations of your firms. While there are a number of key priorities that our examiners focus on, there is likely not a single issue that cuts across virtually every examination to the extent that supervision does. This is a topic that is important to all of us who are concerned with preserving the integrity and vitality of the U.S. securities markets.

Overall, our examinations show that firms do their jobs well in the face of complex and changing conditions. Nevertheless, no matter how much attention is devoted to developing good compliance procedures there often are deficiencies or changes in the business that require that every firm review its supervisory procedures on an ongoing basis to ensure that: 

  1. compliance procedures are in place and operating,
  2. compliance systems are working as designed,
  3. exceptions are identified and problems solved promptly,
  4. procedures are in writing and available to all appropriate personnel,
  5. managers are trained to carry out designated procedures, and
  6. remedial action is swift, appropriate, and documented.

For our part, NASD Regulation examiners integrate your compliance procedures into their examination. It is critical, therefore, that you view your firm’s procedures as living documents that change with business operations, personnel movement, new regulations, and new internal compliance approaches. If you do this, and you identify and correct problems on your own that would otherwise result in disciplinary action, it is highly likely, although not guaranteed, that NASD Regulation will defer taking enforcement action grounded on deficient supervision.

D. New Disciplinary Structure

Last April (the 18th) the NASD proposed dramatic changes to its rules relating to disciplinary proceedings, membership application procedures, and procedures used to determine eligibility questions, impose limitations on the operations of members, impose summary and non-summary suspensions, cancellations, bars and denials of access. The Commission approved these sweeping changes and the effectiveness of the new rules on August 7, 1997. The new and amended rules follow both the Rudman report, which offered recommendations after an in depth review of regulatory programs and corporate governance standards at the NASD, and the 21 (a) Report issued by the SEC in August of 1996.

I will briefly highlight some of the key changes relating to disciplinary proceedings and member applications.

The disciplinary process is substantially changed and now provides for the staff rather than committees to authorize complaints. To ensure a fair process and accountability now that the staff is vested with authority to authorize complaints, I have established a process within NASD Regulation whereby the Enforcement Department and the new Office of Disciplinary Policy will approve staff recommended enforcement actions. Specifically, a case authorization unit within the Enforcement Department will review investigations to ensure that all necessary evidence is gathered and that a prima facie case exists prior to the issuance of a formal complaint. Furthermore, prior to the issuance of a complaint, potential respondents will generally have an opportunity to submit a written statement, referred to as a Wells Submission, explaining why anticipated charges should not be brought.

Professional hearing officers will chair and preside over proceedings bringing a high level of standardization to evidentiary and procedural issues no matter where the hearing takes place.

Decisions following a disciplinary proceeding will be issued by the hearing panels presiding over the case rather than by District Committees.

With respect to new members, the decision to admit applicants shifts from subcommittees and committees to the District Office staff. The new membership rules are much more specific then their predecessors and set forth detailed information on the standards for admission and contain specific time frames and guidelines under which admission decisions must be made. Additionally, the rules greatly expand the responsibilities of the staff and applicants with respect to restriction agreement modifications and changes in ownership, control or operations. (1010 Series.)

For the details regarding all of the new rules I direct you to NTM 97-55 and the NASD Regulation web site at

Leaving these 4 major areas, let me now turn to a couple of key items, in addition to those I’ve already discussed, arising from this week’s Board meeting.

September Board Results

Arbitration: The Board voted to require member firms who are government securities only members to arbitrate claims involving exempted securities. In the past, NASD Regulation had limited regulatory jurisdiction over member firm activities in connection with government securities and no jurisdiction over firms that engaged only in exempted securities activities. This jurisdiction changed as a result of the Government Securities Act of 1993 as well as the recent adoption of amendments to the NASD’s rules in recognition of the broader jurisdiction. We intend to issue a Notice to Members to obtain industry and public comment on the proposal.

DPP Compensation: Acting on a recommendation from the Corporate Financing Committee, the Board determined to publish for comment proposed amendments to Rule 2810 governing the underwriting terms and arrangements of public offerings of direct participation program securities and REITs. Under the proposal the current compensation structure would be modified to lower maximum permissible front-end compensation, permit members to receive a service fee and a trail commission, and revise the guideline for organization and offering expenses. If adopted, these modifications will better align the interests of the investor, the salesperson, and the member as recommended by the Trully Report on compensation practices.

Qualified Immunity: For quite some time the issue of qualified immunity with respect to Forms U-4 and U-5 disclosures has been a hot industry and regulatory topic. In an effort to bring some closure to this issue, NASD Regulation staff believes that a rule should be adopted requiring member firms to provide registered persons advance notice of the contents of Form U-5 prior to filing, and that members be afforded qualified immunity for statements made in good faith on Forms U-4 and U-5. The NASD Regulation Board agreed that the initiative should move ahead and additional internal work will be completed shortly in anticipation of a Notice to Members regarding the proposal. We expect a lot of widely divergent comment on it.

Clearing/Introducing Firms: There has been a lot of recent interest in the relationship between clearing and introducing firms and the handling of customer complaints. The NASDR Board approved a proposal for filing with the SEC, which would require a clearing firm that receives a customer complaint about one of its introducing firms to forward the complaint to the introducing firm and send a copy to the introducing firm’s Designated Examining Authority (DEA). The clearing firm would also be required to acknowledge to the complaining customer that the complaint was received and forwarded to the introducing firm and the DEA. If approved, the new requirement will provide an early warning to the appropriate self-regulator of potential deficiencies at the introducing firm.

III. Other Key Initiatives

In addition to these events that just took place at the Board meeting, NASD Regulation in just the last couple of months has made substantial progress on a number of other key initiatives that you should be aware of:

Municipal Securities Issues

There has been a lot of press lately about our efforts to enforce the rules of the MSRB, particularly Rule G-36. You need to know that this is an examination and enforcement priority for us. As you know, Rule G-36 requires underwriters to file municipal disclosure documents with the MSRB no longer than 10 days after bonds are sold. These documents and filings are fundamental to full and adequate disclosure and we are, together with the SEC, vigorously conducting examinations for compliance with the rule.

Violations have been and will continue to be viewed as serious breaches of regulatory responsibilities and will generally be answered with a formal disciplinary proceeding. I urge all of you involved in this segment of the business to review the rule and your written supervisory procedures directed at compliance with this and other MSRB rules.

Be sure that your procedures are adequately designed to achieve compliance and that if not prevented, that infractions will be quickly detected and properly dealt with. Importantly, be sure that your sales people, managers, and compliance staff understand all the MSRB rules applicable to your firms and make municipal education available under the Firm Element of your continuing education plans. These types of measures with help us work together at protecting investors in the nearly $1.5 trillion municipal market.

Arbitration of Statutory Discrimination Claims

I understand that you are particularly interested in our current initiatives regarding arbitration of discrimination claims. Our posture is to eliminate mandatory arbitration of statutory discrimination claims for registered brokers. Currently, the NASD requires all registered representatives and principals, as a condition of employment in the securities industry, to agree to arbitrate all employment and investor claims.

The new NASD policy will permit employees to choose between entering into private arbitration agreements with their employers, or reserving the right to file a case in federal or state court for statutory discrimination claims. The NASD's proposed new rule will require enhanced disclosure to employees and will also require any brokerage firm that uses private arbitration agreements with its employees to specify an SRO or other arbitration forum that meets certain standards.

We did not arrive at this decision lightly. To help formulate this policy, NASD and NASD Regulation senior management formed an Advisory Committee on Employment Discrimination Claims. The Advisory Committee conducted a meeting in June at which it heard from five panels of speakers invited from civil rights groups and the Equal Employment Opportunity Commission, member firms, attorneys who represent employees, attorneys who represent broker/dealers, and employee organizations. Following the work of The Advisory Committee, the Boards considered the issue and decided to amend the NASD’s rules to remove from the mandatory arbitration requirement all employment discrimination and sexual harassment claims made under federal or state statutes. The Boards also decided to make the rule change effective one year after approval by the SEC to allow the NASD time to enhance the arbitration forum, making it more attractive to employees, and to produce explanatory material for employees and firms.

These changes will affect very few matters considering that of the 5,631 cases filed in the NASD's arbitration forum last year, only 109 alleged employment discrimination of some kind.

Year 2K: The year 2000 will be upon us in less than two and a half years, and all NASD member firms will have to ensure that their automated systems will continue to operate successfully. The NASD has instituted a Year 2000 Program to address the unique challenges this coming century poses for our date-sensitive systems. I urge all members to initiate a Y2K project as well. Computer failures related to Y2K problems generally will be considered neither a defense to violations of a firm’s regulatory or compliance responsibilities nor a mitigation of sanctions for such violations. For those of you who may not already have done so, I suggest that you review Notice to Members 97-16 that describes the NASD’s efforts, responsibilities of the member firms, and advice on implementing their own Y2K programs. There is also a Y2K Web page on the NASD Web Site to ensure that members have ready and current access to the NASD’s Y2K efforts.


As we continue to lay a foundation for improved self-regulation and better communications between us, we at NASD Regulation have an obligation to prove that we can be effective without limiting the creativity or the competitiveness of our members. In virtually all instances, creativity and competition provide greater services and benefits to investors. The industry, like the markets themselves, runs on investor trust and confidence. Where we can extend a helping hand to our members in the form of compliance tools, improved communication and disclosure, we will do so. Our partnership will work if we—NASD Regulation and our members—are both committed to doing whatever it takes to succeed. You have my word that NASD Regulation will work with you on issues and will provide an open dialogue with the industry so that you, investors, and self-regulation all flourish in an atmosphere of trust and confidence.

Thank you.