Remarks at the SIA Annual Meeting
Chairman and CEO
Thank you, Allen [Morgan]. And thank you all for being here this morning.
I say that, of course, without any illusions WHY you're here.
For between the attractions of Boca in November; the leadership insights of Rudy Giuliani; the wit of Mark Shields; and the sheer entertainment value of two guys in tights, with chain saws and a "Garden Weasel" -- I'm not making that up, you can check the program -- hearing from the likes of me is just frosting on the cake.
Seriously, this meeting could not be more timely. And I very much value the opportunity to address the challenges we all face at this most influential gathering in our industry.
At the outset, let me say a few words about the resignation of SEC Chairman Harvey Pitt. Harvey is a brilliant lawyer, and someone who cares deeply about restoring confidence in the U.S. securities markets. These kinds of situations are never easy on anyone involved, but no one should doubt Harvey's commitment to dealing with the many issues confronting our industry. The important thing now is to continue working together to find solutions and punish wrongdoers as we deal with the aftermath of the market bubble.
Speaking of which, you know better than anyone just how tough things are out there. Volumes are down; brokerage revenues have plunged; underwriting is a trickle.
Throughout the country, corporate America is held in the lowest repute we can remember. And beyond our shores, as I've seen in recent travels, the reputation of our markets also has taken a heavy beating.
Unlike the end of most bubbles, however, the blame this time has not fallen almost entirely on Wall Street. After Enron and the other scandals, most people seem to realize we got into this mess through a great deal of accounting that was unaccountable, and corporate governance that didn't govern, as well as the research and IPO problems that have gotten so much press.
Nonetheless, our industry can learn vital lessons from the reforms aimed at other parts of the financial sector.
The Sarbanes-Oxley Act was not drafted in a vacuum. In the wake of Enron and then WorldCom -- which themselves followed years of exploding earnings restatements and stonewalled reforms -- there was a growing sense in Washington that the accounting industry's policing of itself had become more a matter of self-protection than of self-regulation.
Under the system that long preceded Sarbanes-Oxley, no "Big Five" firm ever failed -- even once -- a "regulatory" review conducted by its peers.
By contrast, NASD last year expelled, suspended or barred more than 800 unfit participants from the U.S. brokerage industry. And this year, acting alone or jointly with the SEC, we have fined some of our largest member firms more than $105 million for IPO and analyst research abuses alone.
In Congress's eyes, the lesson was clear. Strong private sector regulation leads to credible efforts to keep an industry scrubbed clean. Weak private sector regulation leads to one hand washing the other.
Which leads directly to my point. I am convinced there is one mighty bulwark separating the securities industry from the risk we might one day follow in the footsteps of the accounting industry. And that is our willingness and ability -- when we ARE faced with practices that would harm investors and the reputation of our markets -- to take decisive action together to correct the wrongdoing, instead of coddling it.
All this should help us see Sarbanes-Oxley in its proper light. Which is not as a bullet dodged, but as a cautionary tale. For as I will explain a bit later, Congress probably is not done legislating.
In any case, let me turn now to the reforms affecting our industry most directly.
Regarding analysts, you already know that NASD has issued two tough, comprehensive sets of rules.
These rules obviously were crafted to strengthen analyst independence. But they also were intended to preserve a sufficient supply of honest, competent research to retail investors.
Some commentators criticized us for not going further. But we rejected the politically easy path of ignoring the economic realities and enormous diversity of our industry.
You are aware of the joint effort -- among federal, state and private-sector regulators -- to bring a prompt and coordinated conclusion to our many separate investigations.
At this delicate stage, let me make just three main points.
First, I have stressed repeatedly the need for a uniform, national solution. Consistent, national regulation has been a pillar of the U.S. securities markets' global success. We must not let the present effort weaken that pillar by becoming a vehicle for balkanized regulation.
Second, I have also stressed the need for cooperation between national officials and those of every state. Our markets will be better off if we all can work with our arms linked, not our elbows out.
Finally, I want to add this important thought. We must be extremely careful, in taking steps to deal with the conflicts that have been exposed in analyst research and investment banking, not to diminish the availability of quality, honest, affordable research to investors. And we must be mindful that this is what could happen, however benign our intentions, if a global settlement were to drive up excessively the cost of research.
All this raises the question, in the event we conclude a "structural" settlement of these research and investment banking matters, would that make NASD's new analyst rules irrelevant?
The answer is a very clear "No." These rules will be the mortar that holds any new structure together and makes it leak-proof. Whatever comes next, these rules are essential to protect investors and the integrity of our markets. For example, there will be no investment banking input into analyst compensation decisions -- regardless of the ultimate structure of the securities firm.
NASD's rules lay a sound foundation of protections that investors can rely upon whether they live in Brooklyn or Berkeley, Boca or Boston.
And they will round out a regulatory regime that can also be complied with by the more than five thousand brokerages in our diverse industry that don't have all the resources of a large, money center mega-firm.
We must remember that our industry is much more than just the largest dozen investment banking houses. It also includes not only small firms, but also an entire tier of regional underwriters. These regional firms are a critical part of the capital-formation process for a lot of growing companies that have created a lot of American jobs. And at the end of the day, whatever we do in this area, we must ensure that the economic consequences do not distort or diminish the competitive balance of our industry.
In a related development, NASD and the New York Stock Exchange announced last month a blue-ribbon panel convened by our two organizations to review issues in the allocation and pricing of initial public offerings.
As you've heard, NASD has proposed rules to prohibit -- more explicitly than ever -- such IPO abuses as "spinning," " laddering" and quid pro quo arrangements. No matter what happens in this area, our blue-ribbon review should help us better understand and regulate this influential market activity.
At its first meeting this week, the panel agreed to hear testimony from a range of investors, issuers, venture capitalists and underwriters. Several panelists emphasized that, in any changes it proposes, the group should bear in mind that whatever the excesses of the late 90s, the IPO process worked well for many years preceding the bubble.
I am pleased we have assembled a panel of industry and academic leaders that is as distinguished as its task is important. We look forward to receiving its report by next Spring.
These are just some of the ways NASD has strived to play a constructive role in shaping the regulatory and political response to the revelations about research analysts and IPOs. Obviously this is a complex process, involving a shifting array range of actors and agendas.
What may be less plain to see is that, in an environment like this one, the response to such revelations risks going both too far and not far enough. The history of reforms in such situations teaches us as much.
Consider just some of the prominent examples in which the reform pendulum has swung TOO FAR. After the Crash of 1929 and the Great Depression, the Glass-Steagall Act separated commercial and investment banking for over half a century.
After the South Sea Bubble of 1720, the formation of new corporations was banned in Britain for more than 100 years.
Thirteen years later, Sir John Barnard's Act outlawed all futures, options and short sales of stock -- and while mostly ignored in practice, remained on the books until 1860.
As I suggested earlier, in circumstances like these, experience teaches that Sarbanes-Oxley is not likely to be Congress's last word on the subject. For legislated responses take time; and the speed with which Sarbanes-Oxley became law is the historical exception, not the rule. Consider that after the '29 Crash, the federal securities laws were not enacted until 1933 and '34, Glass-Steagall not until 1934, the Maloney Act not until 1938, and the Investment Advisors Act not until 1940.
Nor is it difficult to understand why Congress might feel motivated to legislate further in such a situation. More than half of America's families participate in the stock markets. Trillions in shareholder value have been lost -- on top of all the retirement plans Enron has made politically ripe for reform. It may be true that, as one institutional strategist told Fortune magazine, "A stock market bubble requires the cooperation of everyone." But investors and voters are human -- and human nature is to blame someone other than oneself.
In sum, those of us in this room may differ from some politicians in how much of the current crisis of confidence among investors is the fault of the securities industry. But not even the most die-hard among us would claim this industry is SO blameless that its freedom from further reform efforts by Congress or anyone else is assured.
So history, logic and political common sense all tell us how and why reforms might go too far. But let's also consider why reforms -- however well-designed or deliberative -- may not go far enough to really take care of the problem.
As the head of an organization that writes and enforces rules, I would love to stand here and tell you that good rules are all we need to root out the kinds of abuses we've seen with analysts and IPOs.
But to use a technical term from my previous life as a professor, that would be a crock.
For the truth is, any rule has loopholes, and the graduates of Harvard Business School -- along with their minions from the Law School -- are exquisitely well-trained to reverse-engineer such loopholes. For all the other MBAs and JDs here, please don't have hurt feelings; I just don't know your schools quite as well as Harvard.
Moreover -- as I noted earlier -- while enforcement can do wonders in keeping an industry clean, the fact is, violations of behavior-based rules are inherently difficult to uncover and prove.
So we arrive at the truth that self-policing is not only a nice thing, but an indispensable thing, for the health of the securities industry.
Your firms really are the front line of compliance.
And that is why self-compliance must also be a vital part of truly cost-effective, truly risk-based regulation. In the words of Sun Tzu, "An army that is everywhere is an army nowhere." By giving you the tools, technology and data to detect and correct more of your own potential violations, NASD will be better able to focus on the kinds of big risks to market integrity that are so harming the reputation and profitability of our industry today.
But even with close attention to the letter of the law and rules, self-policing and self-compliance are NOT enough. For as I said, rules and laws have loopholes. And to guide us in all the places that no explicit set of rules can hope to cover, what we need is a greatly strengthened CULTURE of ethical behavior.
Now wait. It is true you just heard "the E-word" -- but please let me explain before eyes roll, minds click off and BlackBerries click on.
With markets way down and IPOs often seeming like a fond memory, this may seem like a strange time to be talking about not only rebuilding Chinese Walls, but rebuilding an entire culture of ethical behavior.
Yet that is precisely what our industry -- along with the rest of corporate America -- needs to do.
Because we don't just need such a culture when times are especially good or bad. We need it all the time.
John Kenneth Galbraith's classic work, The Great Crash 1929, helps us understand why. There, he identifies an intriguing measure of the undiscovered embezzlement that has been taken from the country's businesses and banks at any given time. He calls this measure the "bezzle" -- and points out that in good times, the bezzle grows, because everyone's making money; while in bad times, the bezzle shrinks, because money becomes tight and so do attitudes.
Galbraith's concept of the "bezzle" clearly extends to the kinds of misappropriations of lucrative opportunities by corporate insiders that have been so much in the news since Enron first burst the dam. And his key point about how it ebbs and flows applies remarkably well to the boom markets of the 90s and the suspicious markets of today.
As we're now seeing, once the "bezzle" of undiscovered wrongdoing in corporate America is allowed to grow large, there is only one way it gets cut back down to size. That is through scandals and bad publicity; less investor confidence; more shareholder and investor lawsuits; and the pendulum of reform swinging to potentially onerous levels.
For the securities industry -- which always has to live with depressed investor confidence, even when we're not the ones who depressed it -- the alternative is clear. And that is to keep our industry as far beyond reproach as humanly possible -- both in good times and bad.
To do that, we need a full complement of good rules and enforcement; self-policing and self-compliance; and an ethical culture so firmly rooted that every person in every firm has a good idea -- even in the gray areas between the rules -- of what is the right thing to do.
Let me illustrate with a classic real-life case study: the Tylenol recall of 1982.
On September 30 of that year, three people died from Cyanide-laced Tylenol in the Chicago area. A total of seven eventually would die.
Tylenol was Johnson & Johnson's largest single brand, accounting for nearly a fifth of the company's income. The decision whether to recall all 31 million bottles on the shelves -- or just those mostly likely to be contaminated -- was of potentially "bet the company" magnitude.
Nonetheless, J&J's decision was swift and simple. It pulled ALL bottles from the shelves, and developed an industry-leading tamper-proof bottle.
Lore even has it that at the time of the crisis, the CEO was on a long plane flight -- and this was before the advent of in-flight telephones.
But the company's other senior executives were able to make this decision without hesitation. Because doing the right thing by the consumer was so thoroughly ingrained in the company culture, even a decision this momentous came naturally.
I want every firm in the securities industry to be capable of making these kinds of tough choices, for the right reasons, however high the stakes. Because as the current environment has brought into sharp focus, keeping your firm clean is not only good policy, it is good business.
That's why I want your most ambitious analysts to be able to say "No" to any pressures, from within or outside your firms, to let any illegitimate factor influence their rating or research on a stock.
I want the allocation of IPOs by our industry to leave no room for anyone to make any kind of argument that we have taken the "public" out of "initial public offerings" -- and substituted instead a sophisticated exercise in commercial bribery.
And I want your hiring officials and senior executives to heed the research heads in your firms when they say, "I'm sorry, Boss, I don't care HOW much we covet that star biotech analyst, I've checked and she is hopelessly conflicted."
In fact, this last change needs to be broader than that.
I would like to see a culture in our industry in which it becomes standard operating procedure, for you as CEOs and top business people, to give the same access and attention to your top compliance people, and their advice about the reputational risks your firms face, as you give to the siren songs from your most aggressive top producers.
Because it is painfully clear that both parts of the equation matter. And pretending they don't is like driving around the city wearing special sunglasses that filter out the red and yellow lights and only let a driver see the green. For a few blocks, the driver may think he's beating traffic. But if he lets his vision remain distorted that way, he's going to get into a lot of bad accidents.
Now I won't pretend it will be easy to rebuild such a culture of ethical behavior -- or to construct key parts of it anew. Nor is this something that can be left solely to the firms.
Rather, I believe that NASD must lead the way in making ethical requirements an integral part of both our industry's Continuing Education programs and its qualifications tests.
Already NASD, working with our regulatory partners, has proposed amendments to the Continuing Education rules to require ethics training for research analysts. But we are not stopping there.
NASD will work to require firms to include ethics training in your Continuing Education programs in such areas as initial public offerings and financial reporting.
As for qualifications exams, it is difficult in something like the Series 6 or Series 7 to test for abstract concepts. But once precepts of ethical behavior have been codified in rules -- as is happening with NASD's new rules on research analysts and IPOs -- then we can and do test on them all the time. And everything I've said today illustrates why we ought to do so in these areas.
Simply put, I believe that ethics should be an integral part of our industry's Continuing Education and qualifications testing programs. Period.
I am convinced that by working together to get this done, NASD and its members can help to protect investors; safeguard your firms' valuable reputations; and remind every investor in every state and nation how America's markets became the most liquid, transparent and trusted in the world.
Look, I know that anyone who talks about ethics takes a risk. The audience often feels the vague sensation that you're about to be asked to join hands and sing "Kumbaya."
But you don't even have to go beyond the headlines to know that, here and now, we are talking about intensely practical stuff.
Some of the largest firms in our industry have lost billions of dollars in market capitalization due to reputational risks relating closely to matters of ethics.
Just a couple of years ago, the most successful firms were still vying for the flashiest technology analysts.
Today, it's a coup to hire someone who appears on a magazine cover as, quote, "The Last Honest Analyst."
Will it be easy to build the kind of culture of ethical behavior that I've been talking about? No it won't. Will it take an investment of time and resources? Absolutely. Most business assets do.
And that's exactly what we are talking about. A reputation for playing it straight and doing things right is a competitive asset in a competitive industry. And in the age of the Internet and round-the-clock financial cable coverage, you can't just buy such a reputation with slick advertising. You have to earn it the old-fashioned way.
So yes, it's fair to describe the culture I'm describing as a big challenge. But fairness also demands that we call it essential -- and treat it as such -- if we want to see our industry regain profitability and public standing and the trust of investors worldwide.
Now it's possible, just possible, that I'm misjudging this audience.
But I don't think so. I see a lot of smart, tough, savvy business people in this room.
You did not become leaders in your firms -- and major players in our industry -- by walking away from a challenge. Especially one that calls for you to act in your own interests.
And I don't believe for a second that you will walk away from this one.
Thank you very much.