Remarks at the NASD Fall Conference

Mary L. Schapiro

Vice Chairman, NASD President, Regulatory Policy and Oversight

Westin Mission Hills Resort
Rancho Mirage, CA

October 14, 2004


Thank you, Doug. Good Morning. It is a pleasure for me to be here. We have a rich agenda for you today, culminating in an opportunity for you to meet—and even argue with—NASD Senior staff this afternoon.

It is a special pleasure to be outside of Washington, DC for a couple of days. And to talk to real people with real customers, who run real businesses—as opposed to life in the Nation's Capital which, in this political season, is a very surreal place.

I recognize—all of us at NASD recognize-that the intensity of regulatory initiatives over the past several years has been nothing short of overwhelming, especially for smaller firms. What I hope to do this morning is leave you with a better understanding of how we are approaching our task as regulators, so that—even when you do not agree with us—you can understand what propels us forward.

Problem Avoidance

There are two very high priority areas of focus for us right now, and for the coming months, and they both fall under the heading "PROBLEM AVOIDANCE." We often hear that an ounce of prevention is worth a pound of cure. But in the securities markets, which rely so heavily on investor trust to operate, grow, and fund the capital needs of our economy, I think the saying should be an "ounce of prevention is worth a ton of cure."

Our industry has paid an enormous price in lost investor confidence for the transgressions of the past few years—research analyst conflicts, accounting problems, late trading and market timing, breakpoints—exacerbated of course, by the huge market decline. If those issues had been spotted early and dealt with decisively, imagine what heights investor confidence might now reach….

We all know of grandparents or their friends who were heavily invested in the stock market in the 1920s. Most lost their money in 1929. Many never bought a stock, bond, or fund again.

Our markets in 2000 did not fall as far as that—thanks in part to the securities and banking protections erected in the 1930s—and today's investors certainly have not left in the droves that they did during those earlier years. But with substantial numbers of our citizens relying on the markets to grow the 401(k)s that are their primary retirement reserves, and so much of our economy depending on the operation of orderly and trustworthy markets to generate capital, the stakes are higher now.

So we are putting a great deal of thought into spotting problems as early as possible, dealing with them decisively, and warning investors to steer clear.

Two of the primary components of problem avoidance for us are the undertaking we call "Ahead of the Curve" and Investor Education. You may have heard me talk about both before, in general terms, but I'd like to drill down a bit more and discuss how I think both of these initiatives can help us all avoid problems in the future and serve investors more faithfully.

Ahead of the Curve

I believe NASD's Ahead of the Curve Initiative—established nearly three years ago—was the first organized effort by any regulator to set up and fund a cross-organizational program designed specifically to target industry-wide regulatory problems early and address them quickly.

To remind you, through ATC (as we call it) we mine data from CRD, FOCUS reports, advertising filings, customer complaints, sweeps, examination findings, and arbitration claims; talk to our committees; meet regularly with top securities industry analysts; and read research reports on broker-dealers, ECNs and the financial services industry more generally. ATC uses all the internal data we have—a huge collection—but also goes outside to investigate any source that can give us the clues to spot important regulatory issues before they mature into real problems.

Once ATC identifies and issue, we collect all relevant data to understand and size the issue, and then develop an array of responses and implement them quickly. Those responses can include such traditional approaches as examination sweeps—and I want to speak in detail about those in a moment—enforcement investigations and disciplinary actions, and writing rules and interpretations. But Ahead of the Curve also expands those approaches to include surveying the membership, investigating best practices, coordinating with other regulators, educating members, providing compliance tools for firms—including templates, web tools, and checklists—and writing Investor Alerts.

Since its inception in 2002, Ahead of the Curve has evolved from a task force to an NASD-wide anticipatory business approach. A Director of Emerging Regulatory Issues coordinates and manages the efforts of the operational departments, as well as a variety of NASD task forces.

Ahead of the Curve has identified and taken responsibility for managing and tracking more than 30 major areas of regulatory concern, including, for example, delivering mutual fund breakpoints, pricing in municipal bond transactions, hedge fund sales practices and front running, and real estate related issues including TICs and using mortgage refinancing proceeds to invest in securities. We consider ourselves successful if we catch the important potential problems and respond to them before investor harm occurs and most certainly, we hope to detect and head off issues before they ever become stories on C-1 of the Journal.

I'd like to share with you two recent examples to give you an idea of how this has been working. One of the issues concerns the way 529 college savings plans are being sold to investors. I'm a fan of 529s and I have them for my daughters. They are good vehicles for saving for higher education—good not just for families who have them, but for society as a whole, because the degree to which Americans save for college has a profound effect on our country's future. 529's are hugely popular. Every state offers them; there are about 80 available and there are upwards of $54 billion invested in them.

We started looking closely at 529s after hearing investor complaints about inappropriate recommendations from brokers. We initially focused on six firms that had high volumes of 529 sales or had significant investor complaints. We reviewed their sales practices with a particular focus on the suitability of recommendations their brokers were giving to customers and on the firms' supervisory procedures, sales and advertising material. Based on what we learned, we later added 12 more firms to that review.

What we found surprised us. In many cases, firms were placing most of their customers in 529s sponsored by states where the customers didn't live. There isn't anything inherently wrong with that. In fact, it may be that the investment company that manages a particular state's 529 plan has had poor performance or offers a too-narrow range of investment options. Or, it could be that the in-state plan has high fees that outweigh any in-state tax advantage. So, recommending that a resident of one state buy a 529 offered by another state might be perfectly suitable.

What got our attention, though, is that several firms' out-of-state 529 sales exceeded 90 percent of their totals. One firm was at 100 percent, another at 99 percent. Given that half the states offer tax deductions to their residents, we were curious about why so many investors were being steered into other states' plans. Have brokers been doing thorough suitability analyses before advising their clients on what plans to buy? Have they been giving clients all the information they need, such as the possible tax implications of investing in one state's plan as opposed to another's?

You're no doubt breathlessly awaiting my answers to those questions. Well, I'm sorry, but I don't have them yet. These reviews are still underway and are several months away from completion.

Whatever the outcome of our reviews, it helps neither broker nor client that there is no uniform disclosure regime for 529 plans. Every state offers at least one 529 and every state has its own way of disclosing the plans' benefits and risks. If there is any uniformity at all, it's that the state issuers of 529s do a better job of promoting the benefits than disclosing the risks.

We think standardized disclosure across all 529 plans should be required and we made this point to Congress a couple of weeks ago when I testified at a Senate hearing on 529 plans.

A second issue that's shown up on our radar screen is broker-dealer securities self-offerings. As you know, firms sometimes sell their own or an affiliate's securities to raise capital. These offerings can either be registered public offerings or private placements. Our concerns here are simple: the offer may be in violation of the law—registration or antifraud, or the broker-dealer making the offer may have an undisclosed conflict of interest.

We are looking at a number of situations where broker-dealers are raising capital through the sale of equity to shore up weak balance sheets. Again, in these situations it is essential that material facts be disclosed and that investors understand the conflicts of interest and the risk of loss. Those who invest in broker-dealers also need to understand that a direct investment is not covered by SIPC since the investor is not a traditional "customer" of the firm.

I bring this to your attention simply to let you know that we're concerned about this—as is the SEC, which, like NASD, has brought several recent enforcement cases involving private self-offerings. We will issue a Notice to Members later this fall outlining our concerns in this area, but for now, I can only encourage you to be scrupulously careful in selling your own securities or those of any affiliate—all sorts of warning bells are set off for regulators.

You can divide our ATC issues broadly into two groups: products and process/structural issues. Products are pretty obvious, and include items such as variable annuities, hedge funds, 529 plans, as I have just described, and mutual fund B shares. Process/structural issues can be a little more occult, and include areas such as directed brokerage, the variety of conflicts of interest within broker dealers, or distribution chain issues like breakpoints.


For product related sales issues, we know that we need to resist the temptation to write special suitability, disclosure and supervision rules for each product, even though we have done that in a couple of instances. To fail to resist that temptation will deliver us into the regulatory evils of thick volumes of disclosure given to clients, covering all potential products, with mind numbing similarities in the disclosures for different products, and an even higher probability that investors will neither read nor comprehend those volumes. We will have done little for investors. The more generic approach that we favor, however, requires that the firms' and reps' suitability analyses be stringent and tightly tailored to the specifics of the products they are recommending. And we will do more to alert you to what we believe are the special suitability issues surrounding particular products.


For the ATC structural issues, we have an obligation to call to your attention the industry-wide concerns we have and work with you to address them. An example of an ATC process or structural issue is our initiative on new product review. We have been exploring with larger firms the internal processes they use to vet and ultimately offer new products to their customers. And, we are now expanding our discussions to smaller firms to learn what procedures work for them.

While we started out with the idea of a Notice To Members on suitability, due diligence and the other regulatory prescriptions, we have effectively tilled most of that ground in prior product specific Notices, and so we are shifting to a different furrow in hopes of cultivating something better.

We are working with firms that have strong new product review systems, to extract and distill from their proprietary processes generic ideas on how best to evaluate a new product for sale. Such ideas involve how the firm designs and prices the product, what risk it carries for the firm and how those risks will be controlled, how it will be regulated, what customers it will be appropriate for, how the reps selling it will be trained and supervised, and how the firm will assess the investor experience with the product over time.

Our goal is to collect the best practices and publish a white paper that can help to inform the entire industry in this critically important area. An early suggestion I would have is to insure that both business and compliance personnel are involved early in the process, so that supervision and potential regulatory pitfalls can be considered from the beginning.

Another example of an ATC structural issue comes from the underworld of conflicts of interest, and involves recommending the use of home equity to buy securities. This conflict can arise most easily where a member firm is affiliated with a mortgage lender. The rapid increase in home prices over the past several years, in combination with refinancing activity, has lead to increasing investment activity by homeowners using equity from their homes.

The recommendation for a homeowner to liquefy home equity for investments poses some unique risks for investors. For example, a decrease in the value of the investments made with liquefied home equity may result in the loss of the investor's home, particularly if the ability to repay the mortgage is tied to the performance of the investments. We issued two Investor Alerts and brought three enforcement cases on this earlier this year, and we are now in the process of drafting suitability and other guidance for members in this high-risk area.


I mentioned sweeps earlier as important tools in the Ahead of the Curve intelligence arsenal. First, let's get on the same page regarding sweeps. Sweeps define a method we use to gather information, and conduct examinations and investigations, about systemic issues that cut across all or a defined portion of the industry. They are, in short, an organized, targeted set of examinations.

I know there is a good deal of concern in the industry about the use of sweeps and I want to address that.

Sweeps are not new—for example, they were done more than a decade ago in the penny stock arena and they have been regular fare in the market regulation context for a long time—but we are employing them with more frequency in sales practice and related areas than we have historically. They are extremely powerful tools for us to understand what is happening in the industry. Ideally, we can use sweep information to focus our examinations and pinpoint our regulatory response to the real problems at hand, and get much more refined investor protection.

The number of firms included in sweeps varies dramatically and those firms that are included are carefully chosen—in some cases only a few firms are included and others, dozens. We currently are running a variety of sweeps, including fee based accounts, 529 plans, B shares, structured products, broker-dealer self-offerings, failures to delivery, and variable annuities. If you have been part of a sweep, you probably wondered "Why this?" —how did NASD arrive at the subject of our inquiry and, more personally, "Why me?" —how did NASD select the firms in our sweep.

The process used by our Member Regulation Department to conduct a sweep will give you an idea of the strategy and effort involved. After a sweep topic is identified, our staff prepares an action plan for senior management review. When approved, we deliver specialized training for the examiners conducting the sweep, as well as develop any special tools, templates and information request letters.

Firms are selected based on a variety of factors, including level and nature of business activity in a particular area, customer complaints and regulatory history, and prior examination findings. We try to include a variety of firms both in terms of size and operational model so that we understand the issue from the perspective of our diverse membership.

Initial sweep exams are conducted and what we learn from those first few exams is incorporated into the final plan. Examiners are deployed to conduct the sweeps and report back to a sweep leadership team. That team manages the sweep and collects and reports on the findings. The findings then inform the regulatory response required, such as Notices to Members and Regulatory Alerts.

From NASD's perspective, sweeps can be resource and management intensive, but the findings that they provide are invaluable. They are critical, too, in our ongoing effort to get ahead of issues before they swell into more pervasive industry problems.

We, of course, are not alone in our use of sweeps, and I am sure that is a big part of the burden for firms. The SEC, for example, has announced that it is conducting more than 80 mini-sweeps at the moment, and the New York Stock Exchange is also active. And, of course, state securities regulators can be active participants in these types of activities. For our part, we have 30 active sweeps ongoing, a number of them jointly with the SEC, the NYSE, or both.

There is no doubt that for the firms subject to one or multiple sweeps, there can be a burden in responding to our information requests. We understand this burden—we really do listen attentively when you talk—and so I make these commitments to you:

  • We will track and approve all of our sweeps centrally—we will not have different offices of the NASD conducting the same or competing sweeps.
  • We will pay close attention to the firms that we choose to include in the sweep with a view to minimizing the impact of multiple sweeps on any single firm.
  • We also promise to work hard to coordinate with the SEC, NYSE and other regulators to eliminate duplication and regulatory burden.
  • Finally, we will work constructively with you to make sure that we are not asking for information that we really don't need, to establish reasonable and fair dates for production, and to use our respective technology capabilities to make the production of information as easy as possible.

While I am firm in these commitments, they are made with the unequivocal understanding that investor protection and market integrity are the ultimate drivers of our decisions.

Investor Education

While we are working hard to get Ahead of the Curve, I want you to know that we are also working hard to get behind investor education, which is the second part of Problem Avoidance I want to talk about today.

Education has become an increasingly important program at NASD— and by education, I am referring to education of both investors and industry. Your attendance here speaks with crystal clarity of your commitment to industry education: the need for it, and the power of it. And I applaud you for that.

A survey we sponsored last year showed that there is a lot of work to be done to increase investor literacy. Only about 21 percent of people who identified themselves as at least occasional investors could define a no-load mutual fund. Only 38 percent knew that they weren't insured against losses in the stock market. And less than 40 percent understood that bond prices fall as interest rates rise.

I believe that investor education can be a powerful tool and I want to touch quickly on three areas of investor education that we are pretty excited about.

First, investor tools. We have deployed a number of excellent investor aids on our web site. These include research tools to allow investors to learn about their broker through BrokerCheck, analyze mutual fund fees, and 529 plan expenses, and financial calculators for retirement and college savings. I encourage you to look at our two training series, Smart Saving for College and Smart 401(k) Investing, and refer your clients to these tools.

The second area is our Investor Education Foundation—with a mission to deliver high quality, objective information and tools to investors by providing grants to non-profit organizations and researchers for investor education projects and research.

We are targeting a number of areas. Because our Investor Survey found that women and younger investors had a less developed understanding of basic financial issues, and older Americans need real help handling their finances during retirement, they will receive special attention. It is amazing to me, for example, that a third of all women over 85 without a husband are classified as poor, even though half of them were not poor when they entered retirement.

In addition, we will expand the body of general investment knowledge, get current investor education materials out to wider audiences, and develop new tools for those reaching retirement age, since few exist now.

The Foundation Board met earlier this month to select its first round of grants from the 127 proposals we received. We hope to announce the awards by year-end. The proposals have been thoughtful, stimulating and very wide ranging, including topics such as understanding why the elderly are victimized by investment fraud, and the impact of fund assortment in 401(k)s on the quality of investor decisions.

The third and final investor education area is one that is near and dear to my heart. It is a directed request for grant proposals on disclosure. If we can understand what information investors really believe is important to their decision making and in what form and at what time is it optimal for them to receive it, we can truly make a difference. We will fund a grant early next year to help us answer these questions and it is my hope that the results can direct us to a more rational point of sale disclosure regime.


In closing, I hope that some of things I have talked about will make plainer why we regulate the way we do. We understand the burden we create and we balance that as carefully as we can with our responsibility to protect investors and promote market integrity. It is a difficult balance (the President would say "its hard work, its really hard work"). With your continued commitment to compliance and supervision and the rebuilding of investor confidence in our industry, getting that balance right will be easier and easier.

Thank you for your attention and I would be happy to answer questions that you have. I understand that question cards have been distributed for you to use, but I believe that we will have open mikes available as well for the more courageous ones among you.