Remarks at the NASD Regulation Fall Securities Conference

Mary L. Schapiro

President, NASD Regulation, Inc.

San Francisco, CA
November 5, 1998

Opening Remarks

Good morning. It’s my pleasure to welcome you to NASDR’s annual Fall Securities Conference. We’re very glad you could join us. Out of curiosity, could I see a show of hands from those of you who are attending your first NASD Securities Conference? How many of you work in compliance departments?

We’ve tried to put together a program that will give you an overview of our recent progress at NASD Regulation and an update on a number of critical initiatives.

The prevailing market uncertainty underscores the importance of market integrity and investor protection and confidence in the successful operation of these markets. They are the ethical foundation for our industry’s continuing health and vitality.

I would like to briefly highlight for you some of the key initiatives ongoing at NASDR. I wanted to focus specifically in the areas of:

  • Microcap Regulation;
  • CRD modernization;
  • Order Audit Trail or OATS;
  • Risk-based examination;
  • Mutual Fund Fee Disclosure; and
  • Arbitration and Mediation.

What I hope to give you is a bit of a "tour," or an overview of things you will be hearing about in much greater detail over the next two days. I’d like to conclude with my view of the "state of regulation" today and where I think we are headed.

Microcap Rule Proposals

We have had many concerns with the microcap end of the market over the past two years, stemming in large part from the rapid increase in investor participation, especially by first-time investors, and the use of the Internet to aggressively promote and sadly, often misrepresent the prospects of some microcap issuers.

The chances of finding the next industry leader in the field of microcap stocks is, of course, next to impossible. And yet advertisers and touts on the Internet—including information readily available in chat rooms and forced upon us by anonymous e-mail—feed these wayward hopes with near endless recommendations.

With these abuses in mind, NASDR proposed three new rules: 

  • First, an OTC Bulletin Board Eligibility Rule—which permits only those companies that report their current financial information to the SEC, banking, or insurance regulators to be quoted on the OTC Bulletin Board. Companies whose securities are quoted on the OTC Bulletin Board, when the rule becomes effective, will have 6-12 months to comply with the new requirements;
  • Second, a Recommendation Rule—which requires brokerage firms to review current financial statements before they recommend a transaction in any OTC security (a security that is not listed on Nasdaq® or any registered national securities exchange); and
  • Third, a Disclosure Rule—which requires brokerage firms to provide investors with written disclosure of the differences between OTC securities and those that trade on a listed market. We have some outstanding issues with the SEC with regard to this proposed rule and you may see it evolve over the coming months.

We believe that these proposed rule changes would go a long way toward curbing microcap abuses.

Though several committees explored these proposed rules and expressed the view that the problems in this market reflect poorly on small brokerage firms, some worried that the proposed eligibility rule will cause a loss in quote transparency in the marketplace. Both views are legitimate, but the prevailing opinion is that the benefits of the new rules to investors outweigh the concerns. So, I’m hopeful for prompt SEC action.

An additional new rule proposal was approved by the Board and sent to the SEC last week which would give NASDR Temporary Cease and Desist Authority – the first really effective remedy we’ve had to prevent continuing, egregious violations of a limited class of NASD rules. We have seen too many instances of firms like Stratton Oakmont continuing to devastate investors while disciplinary proceedings take their course. You’ll hear a lot about the proposed rule in the panel sessions but I want to stress that it is closely tailored with a lot of built in protections for use only in the most egregious instances.

Regular disciplinary actions and criminal referrals will continue to be emphasized in this end of the market as we believe that at the end of the day, those that choose with deliberation to cheat customers will only be impacted in a meaningful way by enforcement action.

CRD Modernization

A second area of major focus for NASDR, as you know, is modernizing the CRD, so that brokers and investors have easier access to the information they need.

We have several goals in mind:

  • First, to make the CRD faster and more efficient for registration processing, including Web-based filing and relicensing;
  • Second, to respond to industry registration needs, through the CRD Industry/Regulatory Council and the Association of Registration Management; and
  • Third, to make CRD into a modern relational database so that it meets your registration and regulatory needs—enabling firms, for example, to easily download data, as it’s needed.

As you know, we operate under a statutory requirement to make information available to investors through a Public Disclosure Program. Our Call Center for the Public Disclosure Program receives 850,000 calls a year. We already are using the technology of the Internet to make much of the data available more quickly and easily.

Full deployment of the modernized CRD system is scheduled for the third quarter 1999 and will incorporate form filing via a Web-based application. We have already accepted our first electronic filings in a pilot program.

We are also moving ahead with deployment of the state/regulator network, and conversion of disclosure information in a modernized format.

To be sure, CRD modernization has been more time-consuming than we had anticipated; nevertheless, we fully expect that the results in terms of expedited service to our member firms and to investors will be worth the trouble—once the new system is in place next year.

In the meantime, we made the painful choice that many of you have made in your firms to make Year 2000 compliant a system that you intend to retire before year 2000 - just in case ...


Next, let me tell you about our work on the Order Audit Trail System (OATS), which will allow the NASDR for the first time to capture and maintain specific details about the life cycle of orders received by our members in Nasdaq securities. This system records order information reported by members via OATS and combines it with trade and quote details.

The system will yield a time-sequenced integrated audit trail of market activity.

The ability to combine the order information with the trade information from ACT and quote information will give us a complete picture of the market at any instant, allowing us to more quickly and effectively respond to investor issues. This information will significantly enhance the ability of the NASDR to oversee the market.

OATS is being implemented in phases. ECNs and market makers that receive electronic orders at the trading desk will begin transmitting order data to the NASD by March 1, 1999. In June of 1999 all other electronic orders in Nasdaq securities must be reported and by the Year 2000, all other orders (manual order or non-electronic orders) must be reported, completing the OATS implementation schedule.

Five firms are currently participating in the OATS pilot: four NASD member firms  and one financial service bureau. The pilot process has allowed us to improve our OATS software and communication and feedback mechanisms between the NASD and our reporting firms.

All market makers, ECNs and service bureaus that will report for member firms by March 1, 1999, should have already registered with the NASD (September 14, 1998 was the deadline). Through the registration process, member firms will receive information on obtaining the private network, over which OATS data should be submitted to the NASD. They will also receive instructions on submitting OATS data via the Web and gaining access to information they have submitted to OATS.

Member firms that are scheduled to begin OATS reporting by March 1, 1999 will be able to begin testing their OATS interfaces with the NASD next month.

Member Preparedness for the OATS Initiative

Member preparedness for OATS remains a major concern. NASDR has dedicated a number of resources in this area. NASDR’s Web Site includes OATS Web pages, in addition our Notices to Members and Regulatory and Compliance Alerts provide the most up-to-date information on OATS issues.

We know that many of our members are depending upon a third party to report OATS data to the NASD on their behalf. We have, therefore, established a Financial Service Bureau OATS Focus Group. The goal of the Focus Group is to ensure that these organizations understand the OATS reporting requirements and to provide us with feedback and suggestions on ways to improve our OATS software.

We continue to reach out to the smaller broker-dealers that are less automated and may not have to report OATS information until the Year 2000. We want to ensure that these member firms have the information needed in order to comply with OATS.

We want to hear from you on issues that you believe need further clarification, or that will make the OATS implementation process easier.

Mutual Fund Fee Disclosure and Advertising

Mutual Fund Fee Disclosure is another area I want to touch on today. I believe that a customer who understands the risks of an investment decision today will not panic if the market weakens tomorrow. On the other hand, a customer who has developed unrealistic expectations about future returns may be more likely to bail out at the first market decline.

During the past few months, global market volatility has exceeded that of any other period in recent memory. All of your firms have customers who are unfamiliar with such market volatility and unlikely to understand it unless you have prepared these customers for the long term. Therefore, it is truly in all of our interests - firms, reps, customers and regulators to have informed investors.

As those of you who attended the Advertising Regulation Seminar yesterday, heard, the issue of mutual fund fees and expenses has gotten a lot of press lately. Congress recently held hearings on mutual fund fees. Most of these discussions focus on the level of fees. Frankly, we are more concerned about the disclosure of those fees in sales material.

Should we require that certain sales material separately disclose a mutual fund's fees and expenses? One can summon arguments on either side of this issue. Nevertheless, NASDR is concerned that some mutual fund sales material may emphasize certain fees, without presenting a fair and balanced discussion of all fees and expenses.

We are concerned that an incomplete picture may confuse investors about the fees and expenses that a mutual fund imposes. For that reason, we are considering whether to require separate fee disclosure in certain types of mutual fund sales material. Whether or not we do require fee disclosure, we strongly urge you to educate your customers about the effect that fees can have upon their investments.

NASDR is also very concerned about the aggressive promotion of new facilities to trade through the Internet or to engage in electronic day trading. As with any marketing campaign, the promotion of Internet trading or electronic day trading should not offer promises that cannot be kept, or raise the expectation of investors to a level that cannot be maintained.

We are not "Luddites." We embrace new technology and we encourage our members and their customers to do so, too. Nevertheless, the promotion of any new technology must be as fair, balanced and complete as the promotion of traditional brokerage services. Members should avoid promoting the use of new technologies in a manner that encourages reckless speculation by retail investors or that attempts to turn the securities market into a lottery. Those that suggest that day trading is the "best entertainment since television" are forgetting that we are talking about people’s savings, their retirement funds, or their children’s education.

Your sales material must describe your products and services accurately and disclose the risks clearly. Clear language leads to a clear message. But no matter how clearly the rules are written or how many of the specific issues they address, they are only the starting points in the creation of compliant sales material.

On their own, the rules will never provide the entire solution. Decisions about which risks to disclose and how to disclose them require more than knowledge of our rules. They require an exercise of good judgment.

For this reason, NASD Regulation has commenced the most comprehensive review and overhaul of the advertising rules ever undertaken. We already have begun to submit potential amendments to our committees, and we hope to submit them to the board of directors in the near future.

Through this modernization effort, we hope to produce advertising rules that establish broad principles that will govern the conduct of every member, rather than impose detailed standards that obscure the rules’ essential purpose. We also hope to eliminate redundant provisions and ensure that rule language is as clear and concise as possible. One issue that we are considering is whether to add a definition of "Institutional Sales Material," which would provide more flexibility concerning communications that are limited to institutional customers.

NASDR is committed to ensuring that our advertising rules are clear and complete, and that our members comply with those rules. Our Advertising/Investment Companies Regulation Department reviews all sales materials for compliance with our advertising rules. We expect to review almost 65,000 filings this year alone.

This past summer, we recognized the need to dedicate significantly more staff to this area and authorized an increase in resources for the advertising review program. We hope that the dedication of more staff will allow the Department to keep pace with the increase in volume while providing timely and effective review of the sales material that you file.

Dispute Resolution

Another area where there has been activity recently is in our Arbitration and Mediation forum. Some of you may be aware that on October 14th of this year, the SEC approved the adoption of a list selection method of choosing arbitrators for claims filed in NASDR’s arbitration forum.

Once it is in place, the parties involved in a dispute will exercise significant influence in determining which arbitrators will hear their case. The revamped, computer-based method will completely change the manner in which arbitration panels are formed.

The nationwide system will be in place for both investor and intra-industry cases the third week of November.

Arbitration of Employment Discrimination Claims

You might also be interested to learn that the NASD Regulation Board approved several enhancements to the dispute resolution process for employment discrimination claims within the securities industry. These enhancements to NASD’s arbitration forum include:

  • The development of a specialized case roster of arbitrators with training and experience in discrimination law;
  • The requirement that panels hearing employment discrimination claims be composed of arbitrators who, do not primarily represent employers or employees; and
  • The coordination of claims filed in both court and arbitration to minimize bifurcation.

In addition, the Board announced that the NASD will propose a rule to provide enhanced disclosure to all employees concerning the nature and effect of the arbitration clause contained in the Form U-4, the document that all registered representatives must complete to enter the securities industry or change firms.

Looking to the future, Elisse Walter, NASD Regulation’s Chief Operating Officer, is heading an initiative to study the role that technology plays in member firms’ compliance systems and procedures. The study is designed to permit the NASD to take advantage of the technological advances that member firms have made in their operations.

In the short term, the project will provide the NASD with a fuller understanding of the regulatory and compliance technology used by member firms. Longer term, this initiative will advance newly designed "risk-based" examination program by using firm compliance technology as a key component of the examination process.

Overall, the project has four distinct components focusing on: examination processes, leveraging member firm technology, best practices, and shaping NASD Regulation’s future surveillance approaches.

Let me touch briefly on each of these areas.

  • In the examination process, NASD Regulation plans to integrate firm technology-generated reports into its assessment of the proper scope and depth of its on-site examinations, and also will use such reports to determine if routine, accelerated cycle, or cause examinations should be performed.
  • In the future, we foresee the ability to leverage firm technology into NASD Regulation and Nasdaq Surveillance programs. Surveillance activities rely on automated systems to review market-related activity. It is likely that greater familiarity with the operation of member firm compliance technology will result in more efficient, effective, and targeted use of NASD Regulation and Nasdaq resources in oversight of firms’ market activities.
  • After obtaining information on how firms use technology for compliance and other business purposes, we will have a clearer picture of what current "best practices" might be. As part of its overall preventive compliance initiatives, the NASD will be positioned to serve as a clearinghouse for disseminating innovative uses of technology.
  • Through this initiative NASD Regulation will enhance our overall readiness to adapt our regulatory approach to address the many technology-driven and other changes in the securities industry. This will include developing solutions to new scenarios, products and services, and reinterpreting existing regulation and approaches so that they are relevant to the changed business environment.

To make this future vision a reality, NASD Regulation this summer launched a National Examination Program Analysis to identify a new business model and business processes to execute the examination program.

The scope of the project includes the development of methodologies to maximize the use of technology to identify the highest areas of regulatory risk to investors. In this regard, the project will leverage the findings of the Regulatory Technology Compliance initiative I just talked about into the design of the new business model.

The anticipated results include streamlined examination procedures, value-added examinations for members, and enhanced investor protection.

This virtual re-engineering of our examination program will only succeed through a partnership between NASD Regulation and its members. In this regard, we will invite you into the process and seek the participation of the SEC staff.

In concluding, let me mention a word or two about where we headed more generally. I worry - on a daily basis that our ability as regulators to keep up with the industry is being taxed to the limit. If we are to be successful, then we must work in partnership. We need you to help us to craft rules that are effective and that you in the first instance enforce. We need to leverage each other’s resources, talents and the confidence of investors.

We must become truly risk-focused in our approach to examinations and the use of our resources generally and that is the reason for our major initiatives to reinvent the examination process and to modernize the advertising rules. We must use technology to aid us, but not as a substitute for common sense and creative thinking.

NASD Regulation is not even two years old – it has never had and never will have the luxury of sitting back and watching as the industry changes. We know we have to change and evolve with you.