Remarks from the SIA Small Firms Forum

Robert R. Glauber

Chairman and CEO

New York
April 4, 2006

Thank you, Bill,* for the generous introduction, and thanks to the SIA for inviting me to speak at this most important forum.  Small firms are nothing less than the backbone of the securities industry.  And they comprise between 80 and 90 percent of the firms NASD oversees.  So this audience is as important as any I will speak to this year, which, incidentally, is my last as CEO and Chairman of NASD.

One of the most satisfying aspects of my five-and-a-half years at the helm of that organization has been our very cordial and constructive relationship with the SIA.  Obviously, we haven't agreed on everything, but we have worked together amicably and collegially on our common mission of ensuring the integrity of the markets and doing the right thing for investors.  I'm very grateful for that.

I want to begin my talk today with a discussion of the current state of self-regulation in the securities industry.  As you know, the events of the last six years have called into question the effectiveness of the self-regulatory structure.  And, now, with the NYSE and NASDAQ becoming public, for-profit companies - and the American Stock Exchange making its initial moves in that direction - that structure is being further scrutinized.

Self-regulation in the securities industry has a long and effective history.  Congress designed the statutory scheme of self-regulation for the securities markets in the 1930s, envisioning that most of the day-to-day responsibilities for market and broker-dealer oversight would be performed by SROs under the SEC's direct oversight.  Of course, in those days all exchanges were private, mutual organizations owned by their seat-holders.

The SEC was charged with supervising SROs and compelling them to act where they failed to provide adequate investor protection.  Congress's preference for self-regulation over other forms of regulation was deliberate; Congress recognized that it was impractical for the government to provide the necessary resources to effectively regulate the securities industry.  For that reason, Congress opted to rely primarily on the resources and expertise of the industry itself, notwithstanding its awareness of the conflicting roles of SROs in the regulatory scheme.

This model of securities regulation has proven effective through nearly 70 years of regulatory experience.  Both Congress and the SEC have periodically examined the role of self-regulation in the securities industry, and while each has taken steps in certain instances to remedy shortcomings, the concept of self-regulation has been repeatedly reaffirmed and strengthened. 

The self-regulatory model has many important benefits to investors and the markets.  Self-regulation can and does extend past enforcing just legal standards to adopting and enforcing ethical standards - such as just and equitable principles of trade.  Government regulation is well-suited for policing civil or criminal offenses, but less so for ethical lapses, which, while not necessarily illegal, may be unfair or hinder the functioning of a free and open market.  Self-regulation is uniquely capable of protecting investors from those sorts of failures.

Regulators operating in the private sector don't have to rely on Congress for annual funding, can attract staff with competitive pay packages, can commit to long-term funding of large-scale systems for important regulatory matters like market surveillance, broker registration and trade reporting.  

Moreover, private-sector regulators are able to tap industry expertise in ways not readily available to the government and to use this expertise to better protect investors and ensure market integrity.  Among other things, this expertise helps to make certain that rules are practical, workable and effective.  And industry participants often are in the best position to identify potential problems, thus enabling regulators to stay ahead of the curve.

During this post-bubble period, NASD has developed a reputation for being a hard-nosed, aggressive regulator.  I confess that with my free markets bias, this has at times been something I've had to come to grips with.  That said, it's all too clear that our markets won't stay free if we don't police ourselves to root out those who would flout the rules that are in place to protect the integrity of the system and investors who supply the capital for the system.

For what it's worth, there is nothing new or unique about this increased regulatory intensity.  Throughout the history of the securities business, whenever a market bubble has inflated, abuses have ensued.  And when the bubble collapses, as it always does, there follows a period of close scrutiny and the pendulum swings back toward increased regulation and new legislation.

Along with intensified regulation and enforcement, public skepticism of regulators is a characteristic of all post-bubble periods.  This skepticism most easily attaches to private-sector regulators, which are an easy target to be characterized as "the fox guarding the hen-house."

Anything less than an aggressive response by NASD to the problems of the last five years would have had the effect of not only further damaging what was left of investor confidence, but also putting in peril the self-regulatory system.  As we saw with the accounting industry, if Washington feels there is a void in the way an industry regulates itself, a new government-managed structure is almost guaranteed to emerge. The creation of the PCAOB should be a cautionary tale.

But I think one other important audience - in addition to Washington - needs to better understand the role and position of NASD.  That audience is the firms we regulate.  I know there was a time 15, 20, 25 years ago when NASD may have operated more like a trade association than a regulator.  Those times are over.  That's what the SIA is for - and they do a very good job of advocating for the interests of the securities industry.

NASD can't and shouldn't play that role.  We were chartered by Congress to protect investors big and small and help ensure the integrity of markets.  That may very well, at times, put us at odds with the firms and brokers we regulate.  That tension is natural and healthy, and frankly, should exist.

That doesn't mean we don't value and seek input from the firms and individuals we regulate.  We do.  Nor does it mean that firms shouldn't have a place on our board.  They should - and they do.  It doesn't mean that we can't produce guidance, training and other tools to help firms comply with the regulations to which they are subject.  We can, we should and we do.  And, most importantly, it doesn't mean that NASD is not sensitive to the burdens we and other regulators place on you and your firms.  We are committed to working with the industry to keep the regulatory burden as controlled as possible without sacrificing investor protection.

What it does mean is that NASD and the community it regulates must have a realistic view of the relationship we share.  The NYSE decided to take firms entirely off its board.  We have not, and for good reason.  We believe that a board controlled by the public, but with the voice of the industry, makes better regulatory decisions.   But NASD's role can't be one of advocating instead of regulating. 

That brings me to what may be in store for the future of self-regulation.  As SIA members, you are no doubt aware of the debate that's been taking place in various precincts of your industry about the future of New York Stock Exchange member regulation.  The question is: should the exchange continue to regulate its member firms now that it is a for-profit, publicly-traded company?

About a month ago, the day after the NYSE went public, I testified on this subject at the Senate Banking Committee.  Joining me at the witness table were NYSE CEO John Thain, Marc Lackritz and three other leading experts on securities regulation.  Each of us discussed his or her view of the conflicts that inevitably occur when a shareholder-owned, for-profit exchange regulates the firms that trade on it, and how best to manage those conflicts.

The view I expressed was that the NYSE and NASD ought to form a partnership to manage the regulation of the roughly 200 firms that are now jointly-regulated by us and them.  This partnership would be similar to the "hybrid" model set forth by the SEC in its concept release last year.  The hybrid model would pull the regulation of all securities firms that do business with the public away from exchanges and unify that regulation under a single SRO, not part of any exchange.

There are two main concerns that drive my thinking on this: first, the conflict that exists, or is perceived to exist, when a for-profit exchange tries to regulate firms that are also its customers.  And second, easing the glaring inefficiency of these dually-regulated firms having to follow two sets of rules, submit to two examinations, deal with two enforcement divisions and pay two sets of fees.  And, after the NYSE's current restructuring, the number of dually-regulated firms may increase substantially, because the NYSE has chosen to require that every firm that wants a trading license must submit not only to NYSE market regulation, but also full NYSE member regulation.

Let me spend a moment on the conflict of interest point.  The concern is that for-profit, publicly-traded exchanges will be faced with the conflicting goals of having to maximize profits while not compromising regulation.  This is true of any exchange that has become owned by public shareholders. 

To best protect the interests of investors, any new regulatory structure would have to solve the conflict inherent in both managing a for-profit exchange and regulating the member firms that are, quite simply, its customers.  The regulator would have rule-writing and enforcement authority over firms trading on the exchanges for sales practices, financial operations and transaction routing decisions.  Thus, absent complete separation of a for-profit exchange and regulation of member conduct, there is the unavoidable inherent conflict that regulation of member conduct may be influenced by the commercial, financial and stock price impact of such regulation on the exchange doing the regulating.

Effectively solving this conflict issue is NASD's guiding principle as we move forward in any discussion about SRO consolidation.  I would add that Marc Lackritz and the SIA have endorsed this idea of a hybrid consolidation for the last six years. 

As we testified at the Senate hearing, Senator Paul Sarbanes asked each of us if we thought a new regulatory structure were necessary, given the conflicts inherent in a for-profit entity's regulation of its members.  Suffice it to say that there was very broad, if not unanimous, agreement that, yes, a new structure is necessary.

The New York Stock Exchange, in its filings with the SEC and in various public statements, has endorsed a different approach.  It favors harmonization of its rules with ours so as to reduce or eliminate regulatory overlap.  Harmonization is an important goal, and one we have supported and worked toward for years.  One only has to look at the Branch Office and Gift and Gratuities rules recently put forward to see a demonstration of our commitment to harmonization.

While NASD and the NYSE should continue to work toward harmonization, I think most of you would agree that it doesn't address the central issues in the debate about the need for the hybrid model.  For one thing, it does nothing to reduce the conflict inherent in firm regulation by an exchange that, at the same time, must respond to commercial, financial and stock price imperatives.  And harmonization fails to eliminate the wasted resources of dual regulation of member firms.  Even with a fully harmonized rulebook, which would take several years to accomplish, there will still be two examination staffs interpreting that rulebook and performing separate exams, and two groups of enforcement attorneys each bringing sanctions for violations of that rulebook.  Simply put, the rulebook will be harmonized only as the ink is drying.  Once competing examination and enforcement staffs get to work, the rulebook's application will be subject to the interpretation of the staff that's applying it.  The only effective way to harmonize rules is to consolidate those staffs.

There is one last point I want to make about SROs and the regulatory environment.  As I said earlier, NASD has been very active these last few years, and appropriately so. Having said that, I would also point out that NASD is deeply sensitive to the costs and burdens of our regulatory and enforcement regime - particularly as they affect small firms.  Finding the proper balance between overly zealous and laissez faire regulation is a puzzle we struggle with every day.

But I think it is fair that many factors are increasing our regulatory responsibilities.  As firms roll out new and ever more complicated investment products for retail customers, such as structured debt instruments and equity-indexed annuities, the firms themselves increase their compliance burdens because the suitability analysis and point-of-sale disclosure for these products are by nature more difficult and labor-intensive.

Frankly, the challenges of adequately disclosing to a potential customer the material features of an equity-indexed annuity are daunting.  Some of the brightest people in this industry have put these things under a microscope and couldn't make head or tail of them.

But if your firms want to sell them, our job is not to stand in your way.  In fact, you can structure almost any kind of product you want and load it down with more ornaments than there are on the White House Christmas tree.  But I cannot emphasize strongly enough that your responsibility is absolute and unchanging to ensure that product's suitability for its intended customers, and to ensure that customers fully understand the product's risks as well as its benefits.

Moreover, we think two products that look the same to investors ought to be subject to the same rules on disclosure and sales practices.  This is a question NASD has focused on rather emphatically lately.

Why should brokers have to follow one set of rules when they sell fixed annuities, another when they sell variable annuities and yet another when they sell equity-indexed annuities?  And why should investors receive one level of protection for one of these products and a different level for another?

Clearly, they shouldn't and we've set about to fix that.  On May 5 in Washington, NASD and the Minnesota Department of Commerce will host a roundtable discussion to examine the fragmented nature of annuities regulation, the differences in current regulatory approaches by federal, state and NASD regulators, and how regulators can align those approaches to better serve and protect investors.

I want to emphasize that this has nothing to do with protecting or commandeering turf.  We are not proposing any new rule-making or expansion of our jurisdiction.  We simply want to make life easier for investors in these sometimes complicated products and, by extension, the brokers and insurance agents who sell them.  We want to level the investor protection playing field across these similar-looking products.

We are also working with the SEC on a clearer and simpler method of disclosing material facts about mutual funds to investors at the point of sale.  Every time I look at a mutual fund prospectus, I'm reminded of a question that Nora Joyce once asked her husband, James Joyce, the author of Ulysses.  She said, "Why don't you write a book that people can read?"

What we are proposing is clearly in the interest of investors without being onerous or costly to firms.  It is simply that prospective mutual fund purchasers be presented, at the point of sale, with a two-page document that describes in plain English the real and potential costs of investing in a particular fund, the fund's performance and style, and any conflicts that may present themselves to the selling broker.  And we believe this document ought to be available on the Internet rather than on paper or read over the phone, for those customers who want it that way.  The huge advantage of on-line disclosure is that a broker or investor could simply type in the name of the fund that interests him and the document for that particular fund would pop up.  And comparisons among funds would be a snap.

We've been talking to the SEC about this proposal and we hope the SEC will come around to this idea.

I'll close by noting that we now seem to be in a period of more robust markets and that's great.  But it shouldn't and won't signal a more relaxed regulatory climate.  Regulators were, perhaps, not as vigilant as we should have been during the bubble and the consequence was an abrupt and dramatic increase in regulatory and enforcement activity after the bubble burst.  Such rollercoaster regulation does nobody any good - investors or securities firms.  It's a pattern that shouldn't be repeated.

With that in mind, let me also point out again that we have developed an  approach to regulation that includes committed efforts to help the people and firms we regulate understand our rules and to make compliance with those rules as easy and painless as possible.

One step in the direction of supporting your compliance efforts is NASD's recent rollout of its Firm Liaison Program.  We have designated a specific liaison person for each one of your firms.  That person is housed in the District Office that covers your region, and is responsible for taking your calls or e-mails, and either answering your questions or finding someone who can.

With that, I'll again thank Bill Pictor, Mark Lackritz and the SIA for inviting me to be with you.  I'd be happy now to answer your questions or listen to your comments.

* Bill Pictor, President of Trubee Collins & Co. in Buffalo, NY and Vice Chairman of the SIA Small Firms Committee.