Remarks at the SIA Compliance & Legal Conference

Mary L. Schapiro

President, NASD Regulation, Inc.

Orlando, FL

March 18, 1997

Thanks, Jim (Tricarico, Executive Group Vice President, Conference Chairman).

It's always a pleasure to come to Orlando--even if the closest I get to Disney World is reading about it on the billboards on my ride from the airport. Still, even that's exciting when you're used to reading things like the blue line of our latest Notice to Members!

Seriously, our industry is changing almost as dramatically as the Orlando area. NASD Regulation is one manifestation of the changes that have swept through, and permanently altered, not just the structure of the industry's largest Self Regulatory Organization, the NASD...but the self-regulatory process itself.

Today that process benefits from unprecedented participation by members and non-members alike. It benefits from an atmosphere that today encourages openness, and that seeks out ways to give the investing public access to the policy-making process.

Through its new structure, with daylight between the market regulation and market operation functions of the organization, the NASD is free from many of the conflicts that hampered it in years past.

I've seen the face of self-regulation change dramatically in the twelve months I've been with the organization--and virtually all the issues that NASDR will face in the coming years will revolve around defining--or redefining--the concept of self-regulation.

As a result of the Rudman Committee recommendations and the SEC settlement, we now have a separate and clear focus on NASD's self-regulatory responsibilities, and substantial new resources have been allocated to regulatory activities within the past year. Non-industry representatives have a greater voice than ever in the decision-making process, in ways ranging from a balanced board of directors to solicitation of comment from the general public before rules are filed with the SEC. Many responsibilities are shifting from the industry to the staff. For example we will soon have a disciplinary system in which the determination whether to institute disciplinary action will be made by NASDR rather than a committee composed of industry representatives. Similarly, the first level disciplinary decision will no longer be made by a district business conduct committee, but rather by a panel composed of two industry members and chaired by a hearing officer who is an NASDR staff member. The SEC order also mandates a heightened and more autonomous staff role in many other areas, such as admission to membership.

Some have understandably argued that the "self" in self-regulation has been eliminated or at best, seriously diminished. Another concern is whether the enhanced role of "professional regulators," (i.e., NASDR staff) has negated the necessity for industry professionals to participate in the self-regulatory process.

Both concerns are legitimate and I'd like to address them. Self-regulation has worked well, if not perfectly for many decades. A major reason it has worked is that relying on the industry's own expertise, high ethical standards, and sense of fair play truly has generated rules that protect investors--and a high level of compliance with those rules. Investor protection, the true goal of self-regulation, has never been so important. And there has never been a time when the industry's role in the process--when keeping the SELF in self-regulation--was more essential than it is today.

Designing and implementing the process was a team effort, involving veteran managers and recent additions alike, and the new leadership likewise reflects that combination. Let me point out a couple of things about his new structure.

First, we've centralized the disciplinary policy functions and the legal and regulatory policy area so we can better shape and coordinate these policies. Of particular note is the creation of an enforcement department with responsibility at the national level for setting priorities, establishing uniformity and consistency in case development and pleadings, and assuring quality control. In addition, a centralized enforcement department under the management of a very senior person--Barry Goldsmith--gives us a focal point for coordination with the SEC and criminal authorities, including the FBI, U.S. Attorneys Offices and local district attorneys.

The concentration of the examination program and the membership admission process in one department is enabling us to apply uniform standards across the country and has given us the ability to better coordinate our examination schedules with the other SROs, which I will speak about a bit later. The next step is more effective cooperation and coordination among SROs on rule writing and interpretations. In some cases, that will mean advising each other of what we are anticipating in the way of pending or proposed rule changes. Effective regulation must be cooperative regulation, where firms are not subject to multiple sets of rules--and where SROs and firms alike know each other's priorities and ultimate objectives.

I won't take you through the details of every function you see here, since you will have presentations this week from virtually every department of NASDR. But, I would like to draw your attention to the Technology Services Department. It is on the same level as our core regulatory functions because technology is integral to fulfilling virtually every aspect of our regulatory mandate. It's not only essential to making us an effective's essential to making us a more efficient regulator.

I mentioned that one of the purposes of restructuring the organization last May was to ready ourselves for immediate response in the likely--and as it turned out, actual--event of an SEC settlement against the NASD.

Once it became official, responding to the terms of the settlement became an immediate priority. It is still the number one endeavor for this organization going forward.

Again, in the interest of time I won't expand on every individual undertaking , but I'd like to hit a couple of highlights. Generally speaking, the SEC order requires greater breadth of participation in the rulemaking process. That is being accomplished in a number of ways: I think the fact that we've achieved a balance of member and non-member representatives on all Boards and many Committees is already well known. What is less well known is that we're now using our web site to actively solicit input from all who are interested at early stages of rule proposals and we are specifically targeting investor groups for their comments.

We're also in the final editing stages of the new Code of Procedure which, when approved by the SEC, will usher in the new disciplinary processes and member admission procedures.

While the role of District Committees in enforcement will be dramatically changed, the changes will allow them to devote more time to providing policy advice to NASD Regulation.

The Internal Audit function has been strengthened and an Ombudsman office created.

Finally, we are working hard to fulfill those obligations designed to restore investor confidence to the integrity and fairness of the Nasdaq market.

We have filed a rule interpretation with the SEC that expressly makes the coordination of quotes, trades and trade reports unlawful and that prohibits retribution or retaliatory conduct by traders.

We have added a new registration category and qualifications exam for equity traders.

We are developing surveillance systems that will look for evidence of the existence of pricing conventions or other anti-competitive behavior and that are designed to detect violations of the trade reporting requirements, including the identification of late trades, patterns of late trading, late trade reporting of blocks and firm profiling. This is in addition to recently enacted procedures for handling backing away complaints and a real-time system for resolving these complaints.

With respect to our market surveillance generally, let me say that while it is one of our most critical functions, it is also one for which we have been much criticized. Already, we collect a substantial amount of audit trail information on a regular and as-needed basis, and we will be collecting substantially more through the new order audit trail that is mandated by the terms of our settlement with the SEC. In arriving at the final configuration of the system, we will be mindful not only of the regulatory benefits but also the costs that must be borne, by both large and small firms.

We have and will continue to work with SIA members and SEC staff in designing audit trail requirements that will give us the tools we need to identify violations and potential violations quickly. As an organization and as an industry, our ability to maintain public credibility and confidence depends on an absolute assurance that the markets are well and fairly policed. I hope and trust that you will join with me in making this effort a cooperative one.

I think you can see that for the near term, much of regulatory agenda must be driven by the SEC order, in particular, putting the new disciplinary process in place and developing and using technology to improve market surveillance.

Another ongoing priority--and one that also is ultimately dependent upon technology--is the CRD system redesign. CRD has been serving as the registration system for the industry since 1981--and it's been subject to considerable expansion and extensive modification over the years.

As you're aware, NASD began developing CRD replacement technology in 1992. Over that same period, we saw technology advancing so quickly that we have made the decision to reassess the technology of the system to ensure that the new system will be state of the art, simple to use, support and maintain, while delivering an expeditious licensing capability and the regulatory tools needed by the NASDR and the states.

The feedback of our members has also contributed to our decision to re-evaluate technologies. Members that participated in the redesign pilot program commented that interaction with the system should be tailored to meet the operational needs of high, medium, and low volume CRD users. Additionally, we've seen a virtual transformation of data delivery through the Internet, whose supporting technology just keeps improving and opening up more options.

We're committed to delivering a redesigned CRD that is more cost effective, more efficient, and ultimately more useful to the industry, the public, and the regulators than its predecessor. The re-evaluation period will extend through this month and we will return to our Board in April with a plan for going forward.

The final priority I want to discuss is our examination process. The bulk of NASDR's staff--and the majority of our time and energy--and much of YOUR energy, as well--is focused on the examination area. Our exam program arguably ranks as the single most important function we perform on behalf of the investing public. We undertook roughly 2,400 cycle exams last year--and conducted more than 10,000 cause exams, the majority in the area of suitability, conversion and misappropriation, and misrepresentation.

Given the importance of the examination program to our mandate--and its impact on our member firms--I wanted to outline for you a number of areas that we have targeted for special emphasis in 1997. These are areas beyond the mandatory components of review for EVERY exam. For the record, if applicable to a member's business, NASDR examinations cover, among other subjects: 

  • Sales practices with respect to all products offered and sold by the member;
  • Compliance with MSRB rules;
  • Suitability in government securities;
  • Extensive supervisory reviews;
  • An analysis of customer complaints and customer complaint reporting;
  • Trade reporting compliance;
  • Options activities where we are the designated options examining authority;
  • Financial and operational issues (that are not subject to similar reviews by the NYSE; and,
  • The use of advertising and sales literature.

All routine exams conducted in 1997 will place SPECIAL emphasis on specific areas of heightened regulatory concern. This is the part where I tell you exactly what's going to be on the test--and how to prepare for it.

First, we're taking a close look at sales practices with respect to SmallCap securities. We're on the lookout for potential manipulation, unauthorized trading, abusive short selling and excessive markups.

We will also be looking closely at whether members have adequately met their suitability obligations with respect to recommending speculative or low-priced securities.

NASDR and Nasdaq are working in partnership to substantially improve the quality of the Nasdaq market and reduce risks (other than legitimate market risk) to the public of investing in low priced securities. Our focus in the exam area is complimented by the substantial increase in listing standards recently approved by the Nasdaq Board. If approved by the SEC, the quantitative and qualitative standards--which are some 50 percent higher than previous standards--would impact over 700 stocks.

Low priced stocks AND the way they are often sold have given the market so many black eyes over the years, and have hurt so many investors, that both the market side and the regulatory side agreed that significant measures were needed. Investors must feel confident that if they buy a low-priced security, that stock is competitively priced, properly traded, and its risks accurately and fully disclosed by a sales rep.

Turning back to our exam focus...another area of heightened scrutiny is how our members use electronic communications, including the Internet and the attendant supervisory procedures. Your study guide for this one is Notice 96-50, issued in July and which addresses supervisory and other obligations related to the use of electronic media.

Next, a member's variable annuity sales practices, particularly with respect to suitability, and potential improper switching will be a source of heightened focus for our examiners. The study guide here, among others, is Notice 96-86, which reviews obligations with respect to the sale and supervision of variable contracts.

We are also focusing squarely on the issue of problem Registered Representatives and the heightened supervision of individuals with a history of complaints, disciplinary actions or abusive sales practices.

We know from the results of the Joint Sweeps conducted in 1994 and '95 that some firms hire problem reps without adequately checking on their past history. Then, once they're hired, they don't institute the required higher level of supervision that these individuals would seem to warrant. In fact, the most recently published Sweep Report made clear that ordinary supervisory procedures are often INSUFFICIENT to ensure compliance with federal securities laws and SRO rules by newly hired reps with a history of repeated customer complaints, disciplinary actions, or arbitrations.

We want to drive this point home to our members, and to do so we're in the process of issuing a Notice on the issue. The Notice will contain a joint memorandum developed and issued by NASDR and the NYSE alerting our members to their responsibilities with respect to problem reps.

The Notice will also give guidance to firms that have made a decision to hire problem reps in developing and implementing heightened supervisory procedures. We expect full compliance with all supervisory obligations--and our examiners will carefully assess that compliance. We also expect our members to provide adequate training and supervision of all telemarketers and reps engaging in cold calling, and full compliance with the FCC provisions and SRO rules with respect to cold calling.

In this regard, our 1997 cycle examinations will thoroughly evaluate each member's compliance with the continuing education rules. Those rules have now been effective since July 1, 1995, and there is no excuse for any firm not to have conducted a training needs analysis, and prepared and implemented a written training plan.

Firms must also be aware that they are responsible for recognizing whether or not a rep has a history of problems, and if that rep engages in FURTHER sales practice violations, we will closely evaluate whether the firm itself should be subject to disciplinary action for failing to supervise the problem rep.

Finally, our members should operate on the assumption that the past is prologue: a rep with a history of abusing rules will probably continue to do so, unless supervision is not only heightened, but specifically tailored to control or limit the risk of future problems and violations.

I've just spoken about hiring...but let me comment on the other side of the employment coin. I know that the SIA's members are seriously concerned, as am I, with the costs and uncertainties that are posed by litigation with terminated employees. You must continue to fully and fairly report the circumstances surrounding the terminations of employees for cause. The public interest demands access to that information. At the same time, while we impose that obligation, we understand the need to try to ensure that members are not exposed to needless and excessive lawsuits because they tried to fulfill it. In cooperation with NASAA, SEC staff, and SROs, we are working on a plan to try to resolve questions of immunity. We welcome any and all ideas that will help to resolve this problem, and we hope that the SIA will become a constructive force in trying to do so.

That should give you a pretty clear picture of what our examiners will be looking for. Let me say finally that we're very much aware of the disruption that examinations cause to business operations. We have adopted a memorandum of understanding with the SEC and SROs that reflects our commitment to coordinate and eliminate unnecessary duplication when conducting exams, and we mean to make every effort to conduct coordinated examinations for every firm that requests it. In 1996, 93% of the firms that requested a joint or coordinated exam by SROs received one. (A total of 142 exams were conducted jointly, at our members' request.)

We will continue to look for ways to make compliance less burdensome while making regulatory reviews more meaningful--and we want you as a partner in that process. We are also partners in building investor confidence in our markets. Putting the investor first is the cornerstone of success and has kept our financial markets the envy of the world. Recall for a moment the fact that 43% of Americans own securities and they are increasingly relying on stock investments to fund their retirements. Also recall that a majority of investors are young--under 50 years old--and a full 10% have gotten into the market in the past two years. That means they (and many of the registered reps on whom investors rely) have no experience with bear markets, or even with unsustained, sharp drops in the market. In addition, 63% expect the market to continue to rise over the next twelve months. This may be great news for brokers, but for all of us in this room it is sobering. These numbers mandate abiding by the very highest standards of business and ethical conduct and all of our jobs in ensuring that will be enormously challenging over the next few years.

Thank you.