I want to begin my talk today with a look at the state of self-regulation in the securities industry. That might sound like a mundane topic, but with the two major stock exchanges having made the transition from essentially private clubs to public corporations, and with the SEC now taking a fresh look at the SRO model that Congress created in the 1930s, this seems a particularly appropriate time for this discussion.
As you know, the events of the last few years have called into question the effectiveness of the self-regulation concept. And now, with the de-mutualization of the New York Stock Exchange and NASDAQ, and with the American Stock Exchange having made its initial moves in that direction, that structure is being scrutinized even more intensely. That is a good and healthy thing. Such scrutiny should and does occur from time to time.
Self-regulation in this industry has a long and effective history. Congress fashioned and codified self-regulation for the securities markets in the 1930s, determining 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 when they failed to adequately protect investors. Congress based its preference for self-regulation on a recognition that it was unreasonable to expect government to provide the necessary resources to effectively regulate the securities industry. For that reason, Congress chose 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 beyond 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 compromise the freedom and openness of markets. Self-regulation is uniquely capable of protecting investors from those sorts of failures.
Private sector regulators don't have to rely on Congress for funding, can attract top-notch 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 much better able to tap industry expertise than government is, and to use that expertise to protect investors and ensure market integrity. Among other things, expertise derived from the industry itself helps to make certain that rules are practical, workable and effective. And industry professionals are often the best situated 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 market 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 we've put 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 they all do, there follows a period of 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 for "fox guarding the hen-house" accusations.
However, 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 certain to emerge. The creation of the PCAOB should be a cautionary tale for the broker-dealer industry.
And frankly, I think the securities industry needs to better understand the role and position of NASD. 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 days are over. That's what the SIA and others are for - and they do a very good job of advocating for the interests of the securities industry.
NASD cannot and should not play that role. We were chartered by Congress to protect investors big and small and to help ensure the integrity of markets. That may, at times, put us at odds with the firms and brokers we regulate. That tension is natural, healthy and desirable.
However, that doesn't mean we don't seek or value 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 that apply to them. 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.
What it does mean is that NASD and the community it regulates must have a realistic view of the relationship we share. The New York Stock Exchange decided to take firms off its board. We did 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 rather than regulating.
That brings me to what may be in store for the future of self-regulation. You are no doubt aware of the debate that's been taking place in various precincts of the 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?
At NASD, we've been watching with interest as Nasdaq and the New York Stock Exchange have been courting the London Stock Exchange - with some success in Nasdaq's case. At the same time, we've been trying to affect some changes in our relationship with the NYSE.
NASD and the New York Stock Exchange are still commonly referred to as SROs, although in our case that term no longer applies so neatly, because we no longer have any ownership stake in any of the entities we regulate.
Now with NASDAQ and the NYSE having become for-profit, publicly traded companies, a debate has taken shape in our industry about what the future of self-regulation should be. For example, is it proper for a for-profit, shareholder-owned exchange to regulate the firms permitted to trade on it? We believe it is not. In our view, such an arrangement creates a conflict that is simply unmanageable - the conflict of an exchange regulating the behavior of firms that are, in fact, its paying customers.
Secondly, the 200-odd firms that answer to both the NYSE and NASD have to follow two sets of rules, submit to two examination and enforcement staffs and pay fees and assessments to both regulators. And even if the rulebooks are harmonized, as both institutions are working to accomplish, the duplicate examination and enforcement staffs and the duplicate fees and assessments will still unnecessarily burden these firms.
I believe the best solution to these problems would be the creation of a wholly new regulator to handle the oversight of securities firms, while the exchange would retain responsibility for regulating trading of its securities. This arrangement would erase the potential for conflicts and would get the regulated firms out from under the weight of dual regulation. We estimate this would save them, collectively, more than $100 million a year in regulatory fees and assessments. The SIA has proposed a hybrid regulatory structure that would accomplish these goals very effectively.
We look forward to a continuation of this debate with the NYSE and other interested parties and, I hope, finding a solution to this conflict.
One last point about SROs and the regulatory environment. As I said earlier, NASD has been very active in regulation and enforcement these last few years, and appropriately so. Having said that, I would also point out that NASD is deeply sensitive to the costs and hardships of our regulatory 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's fair to say that there are many factors 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, to put it mildly. 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 reps want to sell them, it is not our job to stand in their way. In fact, you can create almost any kind of product you want and structure it like a Rube Goldberg device. But I cannot emphasize strongly enough that your responsibility to ensure that product's suitability for its intended customers, and to ensure that those customers fully understand the product's risks as well as its benefits, is absolute and unchanging.
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 with vigor 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 out to fix that. On May 5 in Washington, NASD and the Minnesota Department of Commerce co-hosted 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.
Participants in the roundtable primarily included senior people from the insurance and brokerage industries, and their respective regulators. And I think I can safely say that every one of them agreed that the regulatory schemes for the three annuity types ought to be distilled down to one, to the extent possible. How to go about it was a matter of some debate, however, so I recommended that the participants form working groups to examine the obstacles that stand in the way of our achieving this goal. I have no reason to believe that, with a little ingenuity, we can't fix this problem.
I want to emphasize that, for NASD, 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 safer and more understandable for investors by leveling the regulatory playing field.
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. And I'm sorry, but the prospectus and SAI just don't cut it. I'd rather read War and Peace than the typical mutual fund prospectus, which is dense, in small type and without pictures.
What we have proposed 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.
We believe this document ought to be available on the Internet, rather than on paper or read over the phone, for 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.
This idea originated at the SEC, although its proposal calls for a little less information than ours, and doesn't emphasize Internet disclosure to the extent that ours does. We've been talking with commissioners and staff about these differences, and I hope we'll sort it out soon and make this tool available to investors.
At Chairman Cox's request, the SEC has proposed a series of public roundtable discussions on how to improve the Internet's utility for providing investors with financial and market-related information. I hope and expect that participants will consider this question of Internet delivery of mutual fund disclosure information, and I want to commend Chairman Cox for having the idea.
I'll close by noting that we now seem to be in a period of strong economic growth and 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 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 the recent debut of NASD's Firm Liaison Program. This will consist of a specific liaison person for each one of your firms. That person will be responsible for taking your calls or e-mails, and either answering your questions or finding someone who can. I can assure you that you won't have to spend 30 minutes on hold listening to a recorded voice telling you how important your call is, and the person who takes your call won't be in India. He or she will be in your NASD district office. We've been testing this project with a pilot program in five of our 15 districts. Since January, the program has logged about 2,000 calls and e-mails from 900 firms. We plan to have full, nationwide coverage of our 5,100 regulated firms by the end of September.
If you have a question that can't wait that long, you can put it to me right now and I'll do my best to answer it. Thank you all for being here.
("Copyright 2006 National Association of Securities Dealers, Inc.")
