Remarks at the NASD Fall Securities Conference

Mary L. Schapiro

Chairman and CEO

<p>Hyatt Regency Century Plaza<br>
Los Angeles, CA</p>


November 16, 2006

Listen to the audio version of this speech.

Thank you, Elisse. Good morning and welcome. As Elisse mentioned, we have a rich agenda for you with plenty of opportunities to talk directly with our senior staff and get clear and concise answers to your compliance-related questions.

I'm also delighted that we have as our keynote speaker Patrick O'Brien, Assistant Secretary for Terrorist Financing at the Department of the Treasury.

As Elisse said, I took over as CEO of NASD on September 1. And in anticipation of that day, I went on a six-month listening tour and talked to the CEOs of dozens of firms, large and small, all across the country, to find out what was on their minds with regard to their relationship with us and regulation in general.

As you can imagine, the concern I heard voiced most frequently centered on the sheer growth in regulatory burdens over the last several years and the difficulty—especially for smaller firms—in simply keeping up. There were many important takeaways for me from this endeavor, and what I want to do today is tell you about some of those, how we have been responding and what we plan to do to make compliance with our rules easier, less burdensome and less expensive—a goal to which I am firmly committed—and to make our operations and industry oversight more transparent.

First, though, I want to review a little bit of recent history to give you a sense of how we got to where we are today.

I came to NASD 10 years ago, at a time when the organization was very troubled. NASDAQ, which we then owned and operated, was under investigation by the SEC and the Justice Department for allowing market makers to maintain artificially wide spreads through a trading convention of quoting only in even eighths.

At the same time, NASD was under SEC investigation for failing to fulfill its regulatory responsibility to adequately examine for and enforce member firms' compliance with the federal securities laws and NASD rules.

The outcome of all this was the SEC's 1996 21(a) report, whose terms still govern NASD's conduct today.

I devoted the first four years or so of my tenure rebuilding the regulatory function. We added staff and funded technology projects to bring NASD to a level of performance that would satisfy the SEC—and ourselves.

Then came the market break of 2000 and we began the long, hard pull through a wide assortment of regulatory and enforcement issues—research analyst/investment banking conflicts of interest, late trading and market-timing of mutual funds, and the spillover effects of corporate accounting scandals.

The two or three years that followed the deflation of the bubble were, I think, the most difficult period the securities industry has seen since the crash of 1929. And, yes, we and other regulators crafted and implemented multiple new rules designed to respond to the abuses taking place in the marketplace and, ideally, to prevent future misconduct.

But when I was named CEO-elect earlier this year, I was determined not to view my new role solely through the lens of the last few years. I thought it was critical that I step back and take a broad and dispassionate look at my organization and how it accomplishes its mission.

So, as I said, I embarked on a listening tour. I started by sending letters to about 30 CEOs asking them to meet with me one-on-one. They represented firms of all different sizes, business models and geographic regions. I met with the largest and smallest firms, independent contractors, insurance-affiliated, bank-affiliated, and e-brokerages to name a few. And, I have met with hundreds of additional firms in small groups.

I asked all these people to give me their perspective on NASD, their view of the regulatory and business environment and how we could best work together to ensure the highest levels of compliance in the industry. And I said I would share what I learned from them with all of NASD, so their input could help shape our agenda.

So, let me start with a topic that I am sure all of you have read about in the last few days—regulatory consolidation between NASD and the New York Stock Exchange. I heard from many firms on my listening tour that the current regulatory structure is redundant, costly and inefficient. I agree with that, and for those of you who were able to hear SEC Chairman Cox last week or read the speech he gave, you know he also feels strongly about this issue.

NASD has been in discussions with the NYSE for a while now about how to best consolidate the member regulation functions of both SROs. We are continuing to talk, and my hope is that we will come to an agreement in the near future. My expectation is these talks will result in the creation of a new, independent regulatory body that will oversee the regulation of all securities firms.

This new organization would operate under a single, uniform set of rules, replacing the overlapping jurisdiction and duplicative regulation that exists today for many firms. This consolidation would result in firms dealing with only one rulebook, one set of examiners and one enforcement staff. This would greatly reduce unnecessary regulatory costs on firms while increasing regulatory effectiveness. And this new organization will be committed to an ongoing program of reducing regulatory costs and reducing burdens for firms of all sizes.

As Chairman Cox said in his speech to SIFMA, "Without a doubt, our current system of two rulebooks, two separate SRO staffs, and two separate enforcement regimes is undermining the effectiveness of regulation and, by extension, the efficiency of our capital markets. Reducing unnecessary regulatory costs, while increasing regulatory effectiveness, will help the United States continue to attract the capital necessary for our nation's economic growth. And most important of all, ending unnecessary duplication and the dangerous lack of coordination in our regulation across markets will offer the best protection to investors."

And let me reassure all of you here, because I know many of your firms are not members of both NASD and NYSE, this new entity will be committed to being more efficient and effective for all 5,100 firms in the securities industry, not just those that are dually regulated. For small firms, this would mean keeping fees contained or reduced and finding ways to pass along the economic efficiencies that a single SRO would create. And most importantly, you have a commitment from me that firms of all sizes will be represented on the Board of Governors. As you know, the New York Stock Exchange has taken securities firms off of its board, but I made it clear to them we would not do this transaction without diverse and substantial industry representation in governance. And I can tell you that small firms will be guaranteed more seats on the Board of this new entity than they currently are guaranteed at NASD.

I won't try to predict the ultimate outcome or timing on this transaction, but both sides are committed to the concept.

Let me move on now to some other themes I heard on my listening tour.

An oft-repeated plea was for NASD, whenever possible, to work with the industry to solve regulatory issues at their inception, rather than address them through the enforcement process. I couldn't agree more. This is, in fact, the way we prefer to operate, and I'll offer a few examples.

Recently, I convened a task force to find ways to bring down the unacceptably high rate of failures in effecting account transfers through the Automated Customer Account Transfer System, or ACATS, which processes the 17,000 full or partial account transfers that occur every day.

In the last two years, NASD has gotten about 700 customer complaints, and member firms have gotten some 6,000 complaints, about firms taking too long to move accounts from one firm to another, or not moving them at all.

The Task Force issued its report last month, and you can find it on our Web site. Briefly, we found that transfer delays and failures were mostly a matter of operational error. Many firms were failing to expedite transfers and promptly resolve exceptions as required by SRO rules.

For example, there were too many times where errors that could have been corrected—soft errors—resulted in the rejection of the transfer request, so that the process had to start all over again.

Based on the Task Force's findings, we'll be sending out a Notice to Members reminding firms of their obligations to cooperate on and expedite customer account transfers, and offering some specifics on how to do that.

We'll also continue to work closely with firms to address the industry-wide operational issues that are negatively affecting performance of this important function.

Another Notice to Members that we sent out last year dealt with best practices for developing new products. This was the result of individual conversations we had with member firms to find out NOT what they were doing wrong, but what they were doing right. We got great ideas from that process, and they were reflected in that Notice.

And, while I won't take you through the specifics, a series of task forces on mutual fund issues has led to the creation of the Mutual Fund Breakpoint Search Tool, common terminology for account linkage rules and the development of the Profile Plus, among other things.

I would much rather use these sorts of cooperative ventures to solve regulatory problems than to simply crack the enforcement whip and move on, and I expect you'll be seeing more of them in the future.

A third theme that was prevalent in my conversations with CEOs was that, where fines are concerned, the punishment doesn't always seem to fit the crime.

Several of the CEOs I spoke to suggested that we consider more closely whether customers have been harmed or whether the integrity of the system has been compromised before deciding how big a fine to impose. It was also suggested that we consider fines in relation to the size and resources of the firm being sanctioned.

We've done that. You may have seen our recent announcement in which we made clear, in amendments to the Sanction Guidelines, that a firm's size and resources should be considered when imposing monetary sanctions for misconduct, and, where appropriate, that fines below the minimum levels recommended in the guidelines may be imposed.

In the absence of egregious violations or those involving fraud, fines are meant to be remedial, not punitive. Our purpose in imposing them is to correct errant conduct, not to damage a firm's reputation or financial health.

A fourth theme that resonated quite a bit was that our education and training utilities for members were helpful, and that we should do more of them. Large firms, in particular, expressed a desire to have NASD take on the role of providing training programs on an industry-wide basis, so that each firm was not in the position of reinventing the educational wheel for its employees.

These comments were really an affirmation that the path NASD began to take several years ago, to leverage our expertise and financial strength to meet the needs of the industry broadly with training and compliance tools, was the right decision.

As a result, NASD has been placing a heavy emphasis on compliance-related education and training. We offer a wide range of educational programs from short webcasts and podcasts at one end of the scale, to an intensive three-year course of study at the University of Pennsylvania's Wharton School at the other. And, there are many resources in between, including conferences, phone-in workshops and a library of e-learning courses. Our menu of education and training will continue to expand to meet the needs of the industry.

Another theme that emerged from my conversations took me utterly by surprise. It was the extent to which many firms really didn't understand NASD's processes and why we do the things we do.

Perhaps we have become complacent—assuming that because we know why we do things, everyone else must understand, too. It is, in my view, essential that NASD be as transparent as possible in our approach to firms, and we need to communicate what we are doing to fulfill our obligations and how that will impact you.

We've already taken some steps in this direction. We have, for example, produced a "What to Expect" series of webcasts. There are two available now and we'll be offering more over the next few months. Future installments will address enforcement investigations, U4/U5 disclosures, written supervisory procedures, the handling of customer complaints and corporate finance filings.

The first installment in this series explains what you should expect the next time an NASD examiner comes calling and how to prepare for your examination. Since we have made so many changes to our exam program, it would be helpful for compliance staff to take a look at this webcast, particularly if their firms are on a four-year exam cycle.

Let me diverge here for a few minutes and tell you about some of those changes. One is the launch last year of our Examiner University, whose purpose is to produce highly knowledgeable examiners.

Examiner U., which has completed its first full year of operations and graduated its first class, provides an intensive one-year course of classroom and on-the-job training for all incoming NASD examiners. The goal is to make sure our exam program keeps up with a constantly evolving marketplace by turning out examiners who know as much about a firm and its products at the start of an exam as their forebears knew at the end of one.

This enables them to focus on the areas of real risk, and to get in and out of your offices faster, less obtrusively, and with less expense to us and less distraction to your firms. It also affords us greater certainty that we have consistent exam approaches across the country.

Another exam-related project we're working on is aimed at ensuring that our exam program is equipped with the latest and best surveillance technology. Using that technology, we've adopted a series of exam practices that are focused on risk, not on the calendar.

Today, every firm continues to get a compliance examination at least once every four years. The timing of these exams is determined by a firm's basic risk exposure.

Each year, our Member Regulation Department conducts a thorough review of data for every one of the 5,100 firms we regulate and, using multiple criteria, develops a risk profile for each firm. The firms with the highest risk earn a specifically-tailored examination during the current year.

Looking ahead, we see that not all exams will have to be conducted on site. In fact, we have already deployed a number of off-site, near real-time reviews. These generally take the form of industry outlier analyses. This means that we now routinely conduct off-site reviews to identify firms that are outliers in specified areas, such as late U4 and U5 filings and inaccurate customer complaint disclosures.

In this way, we can identify apparent violations at the firms exhibiting the most problems—the outliers—and address the problems in a more timely and consistent manner by handling firms with similar issues at the same time.

There is more we are doing to improve transparency and understanding of NASD within the industry. Every firm has an NASD examiner, and now every firm also has an NASD liaison. With our new firm Liaison Program, we designate a dedicated staff person for every one of our member firms.

The liaison for your firm, who is housed in your District Office and is not on your examination team, is responsible for taking your calls or emails and either answering your questions directly or promptly finding someone who can. Since we launched the program several months ago, the liaisons have logged more than 6,000 calls with firms.

To date, 97 percent of questions have been answered within 48 hours. We've done some polling to determine the program's effectiveness. Ninety-four percent of those who have used it said their liaison was helpful or very helpful. We're tracking the most common questions so we can provide training and educational materials related to those topics. This is a program that will likely expand in 2007.

Another important step we've taken to become more accessible to member firms is to create an Office of Member Relations. This is one of the first things I did when I became CEO.

Its mission is to ensure that we maintain open communication with member firms through industry meetings, NASD committees and individual firm outreach. The goal is to ensure that our senior management is aware of industry issues and concerns, and that the industry understands what we're doing.

Yet another new initiative is the Small Firm Rules Impact Task Force, which we introduced last month. This group will look for opportunities either to amend or modernize certain conduct rules that may be particularly burdensome for small firms. They have already generated very valuable comments on many NASD rules.

Let me emphasize here that we can't promise anything, except an open mind and a commitment to work with the industry in reviewing these rules. And, I should point out as well that we've taken stabs at paring down the rulebook before, with little success.

We hope that bringing the perspective of small firms to bear on this process will lead to its bearing more fruit this time around. And, we have a golden opportunity to do this following on the efforts of the NASD and NYSE staffs to harmonize our rulebooks.

There are some additional things I'd like to do—things I had in mind before embarking on my listening tour. And I want to close with one of those.

I would like NASD, in concert with the industry and the SEC, to consider the entire universe of investment product disclosure to determine whether investors are getting the information they need when they need it, and in a way they can understand. I think that we owe investors a far more streamlined and effective disclosure regime.

Adhering to the principle that it's best to accomplish a goal before announcing that it was your goal, I'll note that we've already started on this as part of our response to the SEC's point-of-sale disclosure rule proposals for mutual funds and variable annuities.

The disclosure for these two products are different in their details, but identical in their purpose—to give investors a clear, simple and brief explanation of what they're getting into before they buy mutual fund shares or variable annuities. They are entitled to that, and they don't get it with the current disclosure regime.

But, what about other products? We hope to find some answers through academic research. The NASD Investor Education Foundation has awarded grants to three universities and the National Bureau of Economic Research, each of which is researching a specific aspect of the point-of-sale disclosure question.

I don't know what will come of this research, but my hope is that it will better inform us in working toward a more rational and effective disclosure regime for investors. And as we do so, we'll be soliciting the industry's input and advice every step of the way.

With that, let me conclude. Thanks for coming to our conference. Now I'd be happy to answer any questions.