[Senate Hearing 110-915]
[From the U.S. Government Publishing Office]
S. Hrg. 110-915
CONSOLIDATION OF NASD AND THE REGULATORY FUNCTIONS OF THE NYSE: WORKING
TOWARDS IMPROVED REGULATION
=======================================================================
HEARING
before the
SUBCOMMITTEE ON
SECURITIES AND INSURANCE AND INVESTMENT
OF THE
COMMITTEE ON
BANKING,HOUSING,AND URBAN AFFAIRS
UNITED STATES SENATE
ONE HUNDRED TENTH CONGRESS
FIRST SESSION
ON THE OVERALL IMPACT AND OUTCOME OF THE CONSOLIDATION ON THE
REGULATORY SCHEME INCLUDING BUT NOT LIMITED TO THE AREAS OF RULES,
GOVERNANCE, ENFORCEMENT AND COMPLIANCE, ADVERTISING, ARBITRATION,
FUNDING, AND THE POTENTIAL IMPACT ON INVESTORS
__________
THURSDAY, MAY 17, 2007
__________
Printed for the use of the Committee on Banking, Housing, and Urban
Affairs
Available at: http: //www.access.gpo.gov /congress /senate /
senate05sh.html
----------
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COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS
CHRISTOPHER J. DODD, Connecticut, Chairman
TIM JOHNSON, South Dakota RICHARD C. SHELBY, Alabama
JACK REED, Rhode Island ROBERT F. BENNETT, Utah
CHARLES E. SCHUMER, New York WAYNE ALLARD, Colorado
EVAN BAYH, Indiana MICHAEL B. ENZI, Wyoming
THOMAS R. CARPER, Delaware CHUCK HAGEL, Nebraska
ROBERT MENENDEZ, New Jersey JIM BUNNING, Kentucky
DANIEL K. AKAKA, Hawaii MIKE CRAPO, Idaho
SHERROD BROWN, Ohio JOHN E. SUNUNU, New Hampshire
ROBERT P. CASEY, Pennsylvania ELIZABETH DOLE, North Carolina
JON TESTER, Montana MEL MARTINEZ, Florida
Shawn Maher, Staff Director
William D. Duhnke, Republican Staff Director and Counsel
Alex Sternhell, Professional Staff
Dean V. Shahinian, Counsel
Justin Daly, Republican Counsel
Joseph R. Kolinski, Chief Clerk and Computer Systems Administrator
George Whittle, Editor
------
Securities and Insurance and Investment
JACK REED, Rhode Island, Chairman
WAYNE ALLARD, Colorado, Ranking Member
ROBERT MENENDEZ, New Jersey MICHAEL B. ENZI, Wyoming
TIM JOHNSON, South Dakota JOHN E. SUNUNU, New Hampshire
CHARLES E. SCHUMER, New York ROBERT F. BENNETT, Utah
EVAN BAYH, Indiana CHUCK HAGEL, Nebraska
ROBERT P. CASEY, Pennsylvania JIM BUNNING, Kentucky
DANIEL K. AKAKA, Hawaii MIKE CRAPO, Idaho
JON TESTER, Montana
Didem Nisanci, Staff Director
Tewana Wilkerson, Republican Staff Director
C O N T E N T S
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THURSDAY, MAY 17, 2007
Page
Opening statement of Chairman Reed............................... 1
Opening statements, comments, or prepared statements of:
Senator Allard............................................... 2
Senator Tester............................................... 4
Senator Bunning.............................................. 4
WITNESSES
Erik Sirri, Director, Division of Market Regulation, Securities
and Exchange Commission........................................ 5
Prepared statement........................................... 40
Response to written questions of:
Senator Dodd............................................. 100
Senator Reed............................................. 105
Mary Schapiro, Chairman and Chief Executive Officer, NASD........ 8
Prepared statement........................................... 49
Response to written questions of:
Senator Dodd............................................. 108
Senator Reed............................................. 116
Richard Ketchum, Chief Executive Officer, NYSE Regulation, Inc... 9
Prepared statement........................................... 57
Response to written questions of:
Senator Dodd............................................. 121
Senator Reed............................................. 124
Joseph Borg, President, North American Securities Administrators
Association.................................................... 27
Prepared statement........................................... 66
Marc Lackritz, President, Securities Industry and Financial
Markets
Association.................................................... 29
Prepared statement........................................... 80
John Coffee, Adolf A. Berle Professor of Law, Columbia Law School 31
Prepared statement........................................... 89
CONSOLIDATION OF NASD AND THE REGULATORY FUNCTIONS OF THE NYSE: WORKING
TOWARDS IMPROVED REGULATION
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THURSDAY, MAY 17, 2007
U.S. Senate,
Subcommittee on Securities, Insurance,
and Investment,
Committee on Banking, Housing, and Urban Affairs,
Washington, DC.
The subcommittee met at 2:30 p.m., in room SD-538, Dirksen
Senate Office Building, Senator Jack Reed (Chairman of the
Subcommittee) presiding.
OPENING STATEMENT OF CHAIRMAN JACK REED
Chairman Reed. I will call the hearing to order now and
welcome you all this afternoon. We are holding a hearing on the
consolidation of the NASD and the regulatory functions of the
New York Stock Exchange. This merger will result in a new
single, self-regulatory organization for our capital markets,
and I thank the witnesses for joining us this afternoon.
In this increasingly globalized financial services market,
no institution can remain static. They must continually re-
evaluate themselves to cope with dynamic and rapid change. In
this context, this merger represented a very serious attempt to
modernize and streamline operations of these SROs.
What cannot be lost is the continued need to keep our
markets fair, transparent, and properly regulated. Indeed, in a
world of increased competition, confidence in the integrity of
our markets is essential to assuring their continued supremacy,
and this merger needs to strengthen that confidence.
In creating this new entity, there is an opportunity to
take stock of where we are now, and I further hope that this
hearing is the beginning of a dialog on ways to improve the
regulatory regime overall.
As Wall Street and Main Street intersect and millions of
individuals invest in our capital markets through retirement
plans and other tools, this is an issue that affects an
overwhelming number of Americans. It is critical that the
merger and the harmonization of the rule book results in better
regulation of the industry and not a race to the bottom.
The globalization of markets across product lines as well
as geographic boundaries through increasingly sophisticated
trading in multiple markets and multiple currencies and other
complex transactions significantly raises the potential to
obfuscate illegal activities and avoid timely detection.
Daunting challenges arise from the rapid change that allows for
a small group of individuals to exploit the system for gain,
jeopardizing the whole market. As such, reducing the
duplicative efforts of two regulators must result in the use of
the single SRO's increased resources and capacity to preclude
this behavior. The ability of regulators and regulations to
both anticipate and adapt to change while helping investors
understand new products and how they compare is essential. A
more holistic approach to regulation will surely produce
greater results for all stakeholders.
Finally, the role of the SEC in oversight capacity and
working with this new regulatory entity is vital to its
success. Balancing the authority of the SRO and the SEC cannot
be overlooked, and I look forward to hearing from the SEC
regarding the steps they have taken and will take in the future
to provide adequate oversight of both this new regulatory body
and the market as a whole.
The hearing this afternoon is an opportunity to understand
the structure of the regulatory regime with this new entity and
plans for moving forward to increase regulatory capacity both
in member regulation and market surveillance. To this end,
there are several key questions. What are the best regulatory
models for SROs? How will the new SRO be better equipped to
anticipate problems and ensure and enhance our markets'
integrity and investor protections? How will the single new SRO
be financed? And what is the role of the SEC in effectively
overseeing this new regulatory body?
This transaction is an important sign of the growing
integration of institutions and world capital markets. As
activities of capital markets become more seamless, the way
this merger is dealt with will shape the way we deal with
challenges arising in the future.
We all look forward, again, to the testimony of our
witnesses, but first I would like to recognize the Ranking
Member, my colleague, Senator Allard. Senator.
STATEMENT OF SENATOR WAYNE ALLARD
Senator Allard. Well, first, Mr. Chairman, I would like to
thank you for holding this hearing today of the Subcommittee on
Securities, Insurance, and Investment. I look forward to the
opportunity of hearing about the consolidation of the NASD, or
the National Association of Securities Dealers, and the
regulatory functions in the NYSE.
The United States' securities markets represent the richest
source of liquid capital in the world. Their sophisticated size
and credibility are what attract investors from all over the
world. Currently, the securities and financial markets in the
United States are thriving, and investors are enjoying the
longest bull run in over 80 years.
The Dow Jones Industrial Average has recorded 23 record
closes since the start of the year, and the S&P 500 is 14
points below its record close it set in March of 2000. The Dow
is no longer showing lingering effects of the 416-point drop it
suffered on February 27th, and the U.S. economy is continuing
to expand and is adding jobs. But as Securities and Exchange
Commission Chairman Chris Cox noted yesterday before the Senate
Financial Services Appropriations Subcommittee, ``Our savings
are dependent on healthy''--he is talking about customers'
savings--``are dependent on healthy, well-functioning
markets.'' Prudent regulation has been the key to developing
our capital markets. The SEC is obviously primary in that
regulation; however, self-regulatory organizations also play an
important regulatory role. Good regulations help foster
fairness, transparency, and confidence in the marketplace. Yet
we must also be cognizant of the burden of regulation. Too much
regulation can be costly and inhibit innovation and stifle
competition.
Because the SROs are also part of the industry, they can be
helpful in finding a proper balance. As with all regulators,
even SROs can be prone to bureaucracy, duplication, and excess
cost. This seems to be the case for the NASD and the NYSE
regulatory arm. Firms have to comply with two rule books, which
are often different in rules or interpretation. Even those
members who are not directly members of the NYSE also felt the
effects if they did business with NYSE members.
The merger of the NASD and NYSE regulatory function has the
potential to eliminate duplication, streamline regulations, and
lower costs. The consolidation is not without its challenges,
however. Small broker-dealers, in particular, are feeling
vulnerable as these changes happen. As part of the NASD, they
are living under a Senate model. Just as all States are equal
in the Senate, all firms are equal at the NASD. So although the
ten largest firms employ more than 25 percent of the registered
representatives, they still have the same vote as the thousands
of firms with less than ten employees.
The small firms, those with less than 150 registered
representatives, will be able to vote for three members on the
Board of Directors of the new consolidated regulator. This will
shift things to a model much closer to the House of
Representatives.
Now, having served in both the House and the Senate, as did
our Subcommittee Chairman, I have an appreciation for both
models. The House still addresses the needs of smaller or less
populated States. Similarly, the new regulator can support
small broker-dealers, but this will require deliberate effort
on the part of the company, and I would strongly exhort them to
maintain such a focus.
I firmly believe that the broker-dealers of all sizes can
flourish under consolidated regulation. That is the bottom
line.
I look forward to today's hearing as an opportunity to get
more information on the merger. The merger is incredibly
complex and will involve the integration of human capital,
physical capital, rule books, procedures, information,
technologies, and many other items. I think we can all agree
that, should it receive the necessary approvals, it will not be
completed quickly.
I am hopeful that you will keep in contact with this
Subcommittee as the process moves forward. I know that the
Chairman and I will be very interested in monitoring this
merger. We have an outstanding line-up of witnesses, Mr.
Chairman, and I appreciate their time and would like to welcome
them. This hearing will be very helpful to the Subcommittee,
and I look forward to their testimony.
Chairman Reed. Thank you very much, Senator Allard.
Senator Tester, do you have an opening statement?
STATEMENT OF SENATOR JON TESTER
Senator Tester. Yes, thank you, Mr. Chairman, and thank you
for holding this hearing. I also want to thank the panels for
being here today. I really appreciate their time, and I also
appreciate the fact that anytime we have regulating agencies
looking at ways to reduce duplication without risking consumer
confidence, I think that is a good thing. And I want to applaud
your efforts in this.
The Chairman's point about where the SEC plays an oversight
of this SRO is critically important, and I look forward to
hearing from you, Mr. Sirri, how that is going to happen, how
you envision that unfolding, and once it is all done, how
consumer protection can be achieved while still providing the
kind of flexibility for the private sector to be able to run
their business and do it well. This hearing is very important
to me to be able to understand this proposal, find out what its
implications are for investors and brokers and the dealers,
also.
Finally, I would just like to say in the end hopefully
somewhere in the panel's comments I would like to see what your
vision for this SRO is over the long term, what you hope to
accomplish, and how you see it operating over the long run.
With that, Mr. Chairman, once again I want to thank the
panelists for being here, and it is a pleasure to be a part of
the Subcommittee. Thank you.
Chairman Reed. Thank you, Senator Tester.
Senator Bunning, do you have an opening statement?
STATEMENT OF SENATOR JIM BUNNING
Senator Bunning. Very short. It is always good to meet the
people who regulated me for 25 years.
Chairman Reed. You wish baseball was here?
[Laughter.]
Senator Bunning. No, no. Broker-dealer for 25 years, and
the exams were horrible. I just want you to know that. The 8-
hour exams for the principals were horrible exams to take.
It is not a very glamorous topic we are talking about
today, but it is important to all investors, whether they know
it or not. The last time the Banking Committee heard about the
market regulation functions of the NASD and the New York Stock
Exchange was before the merger was announced in November, so it
is good to get an update today. I am interested to hear how the
merger is going and what benefits investors, brokers, and
companies are going to see. Duplication of regulations is
rarely a good thing, whether it is done by the Government or
whether it is done by the private sector. Whether regulations
can be simplified without undermining quality, it should be
done so that resources and people can be put to more useful
purposes.
I am looking forward to hearing more about the deal. Thank
you, Mr. Chairman.
Chairman Reed. Thank you very much, Senator Bunning.
We have two panels, and let me now introduce our first
panel. Mr. Erik Sirri is the Director of Market Regulation at
the Securities and Exchange Commission. In this role, he is
responsible at the Commission for the administration of all
matters relating to the regulation of stock and option
exchanges, national securities associations, brokers, dealers,
and clearing agencies. Mr. Sirri is currently on leave from
Babson College where he is a professor of finance. From 1996 to
1999, Mr. Sirri served as the chief economist of the Securities
and Exchange Commission. Before joining the SEC, he was an
assistant professor of finance at the Harvard Business School
from 1989 to 1995. Mr. Sirri began his career--and this might
be a very visionary start--receiving a B.S. in astronomy from
the California Institute of Technology, and so he is someone
who has a broad view of the world and the cosmos. He received
an MBA from the University of California at Irvine, a Ph.D. in
finance from the University of California at Los Angeles. Thank
you very much, Mr. Sirri.
We are also joined by Mary Schapiro, Chairman and CEO of
NASD, the world's largest private sector securities regulator.
She joined NASD in 1996 as President of NASD Regulation and was
named Vice Chairman in 2002. Before assuming her present
duties, Ms. Schapiro was Chairman of the Federal Commodity
Futures Trading Commission and, as Chairman, she participated
in the President's Working Group on Financial Markets with the
Secretary of the Treasury and the Chairman of the Federal
Reserve Board and the SEC. Prior to assuming the CFTC
chairmanship, Ms. Schapiro served 6 years as a Commissioner at
the Securities and Exchange Commission. She is a graduate of
Franklin & Marshall College in Lancaster, Pennsylvania, and
earned a law degree with honors from George Washington
University, and she was named the Financial Women's Association
Public Sector Woman of the Year in 2000. Welcome.
Finally on this panel, Mr. Richard Ketchum has been Chief
Executive Officer of New York Stock Exchange Regulation, Inc.,
since 2006. He is also a member of the New York Stock Exchange
Regulation Board of Directors. Mr. Ketchum had served as the
first chief regulatory officer of the New York Stock Exchange
since March 8, 2004. From June 2003 to March 2004, Mr. Ketchum
was General Counsel of the Corporate and Investment Bank of
Citigroup, Inc. Previously, he spent 12 years at NASD and
Nasdaq Stock Market, Inc., where he served as President of both
organizations. Mr. Ketchum earned his J.D. from the New York
University School of Law and a B.A. from Tufts University.
Welcome, Mr. Ketchum.
Thank you all, and, Mr. Sirri, we will try to aim for 5
minutes, so you can summarize your testimony. Your written
statements will be made part of the record, without objection.
Mr. Sirri.
STATEMENT OF ERIK SIRRI, DIRECTOR, DIVISION OF MARKET
REGULATION, SECURITIES AND EXCHANGE COMMISSION
Mr. Sirri. Thank you very much. Chairman Reed, Ranking
Member Allard, and Members of the Subcommittee, thank you for
inviting me here today to testify about the proposal by the
NASD and the New York Stock Exchange to consolidate their
member firm regulatory functions into a single SRO. I believe
the proposed consolidation represents a positive development in
the regulation of our securities markets.
Although there are a number of SROs that perform various
functions, only the NASD and the New York Stock Exchange are
responsible for member firm regulation. Currently, the NASD and
New York Stock Exchange together oversee more than 5,000 U.S.
broker-dealers doing business with the public. About 170 of
them are members of both organizations. As a result, there can
be at times inefficient, duplicative, and potentially
conflicting regulation of U.S. securities firms.
The proposed consolidation of the NASD and the NYSE member
firm regulation functions into a single SRO is designed to help
eliminate today's duplicative member rule books and the
possibility of conflicting interpretation of these rules. At
the same time, a single SRO structure would retain one of the
fundamental precepts that has characterized the SRO model: that
securities regulation works best when the front-line regulator
is close to the markets.
As you know, this past November the NASD and the NYSE
publicly announced their proposed consolidation. The combined
SRO, which would be given a new name, would be responsible for
all member firm regulation, arbitration, mediation, and other
functions that are currently performed by the NASD. This
consolidation would allow securities firms to operate under a
uniform set of rules, replacing the overlapping jurisdiction
and duplicative regulation that currently exists. Thus, all
firms would deal with only one group of SRO examiners and one
SRO enforcement staff for member firm regulation.
The NASD and the NYSE agreed to a governance structure for
the combined SRO that reflects a blend of the current models.
As the proposed governance structure requires amendments to the
NASD's bylaws, these proposed bylaw changes are subject to the
Commission's rule-filing process, which includes notice and
comment as well as Commission action. We also expect to receive
several additional filings from the NASD and the NYSE that are
primarily technical in nature but, nonetheless, are critical to
the closing of the proposed transaction.
On March 19th of this year, the NASD filed with the
Commission the proposed changes to the NASD bylaws as approved
by the NASD membership, and the Commission published these
changes for public comment on March 26th. To date, the
Commission has received 78 comment letters. Commenters
supporting the proposed changes to the bylaws, including
several securities firms, the SIFMA, the National Association
of Independent Broker-Dealers, the Financial Services
Institute, and the North American Securities Administrators
Association, have generally agreed that the consolidation
proposal would streamline regulation and simplify compliance
with the uniform set of regulation.
Those commenters who urged the Commission not to approve
the proposal, including a number of small NASD firms, the
Commonwealth of Massachusetts, and the Center for Corporate
Policy, generally argued that the proposed bylaw amendments
would not protect investors or provide enough representation
for industry members or smaller firms.
Currently, the SEC staff is reviewing all comments received
and is in the process of preparing a recommendation to the
Commission. I expect the staff will submit a recommendation to
the Commission on the proposed NASD bylaw changes within the
next few weeks.
I should note that the proposal currently before the
Commission is to consider amendments to the NASD bylaws, which
would be required to implement the governance changes necessary
to establish the structure of the combined SRO. While these
bylaw changes are a key component of the proposed
consolidation, work would continue to be done after the closing
of the consolidation, if approved, in order to integrate the
member firm regulatory functions of the SROs. The combined SRO
would need to complete the harmonization of member firm rules.
Because there are a substantial number of rules that would need
to be reconciled, the SRO is expected to have a transitional
period during which the NASD and the NYSE member firm
regulation rules would be retained within the combined SRO,
with the NYSE rules applying to NYSE members and the NASD rules
applying to its members.
During this transitional period, the combined SRO would
continue to review and harmonize the duplicative NASD and NYSE
rules governing member firm regulation and conflicting
interpretation of those rules. It is my expectation that in
developing a single rule set, the combined SRO intends to be
sensitive to the needs and circumstances of firms of various
sizes and business models.
I believe that the harmonized rules would help make self-
regulation more effective and more efficient by allowing
securities firms to operate under a uniform set of rules,
replacing overlapping jurisdiction and duplicative regulation
that currently exists for many firms. The harmonized rule book
would be subject to Commission approval.
In addition to the proposed consolidation of the two rule
books, the two separate regulatory staffs, and two different
enforcement staffs, the proposal would consolidate the
arbitration and mediation programs of the NASD and the NYSE,
making arbitration subject to one set of rules. I believe that
consolidating these two arbitration programs would reduce
overhead significantly, thereby increasing efficiency,
especially in light of the fact that the NASD currently is the
arbitration forum for over 90 percent of securities
arbitrations.
Finally, I should note that the proposed consolidation may
very well have positive ancillary effects on investors and on
the Commission's work. Following the consolidation, Commission
staff would continue to conduct examinations of the combined
SRO's regulatory, investigatory, and enforcement activities.
However, instead of examining member firm regulation activities
of two SROs, the Commission staff would be able to focus its
efforts on ensuring that the single combined SRO effectively
regulates member firms.
Investors, too, may benefit from the consolidation since
the consolidated SRO would combine the strengths and the
talents of the experienced enforcement and regulatory staffs
from both SROs. As a result, the consolidated SRO staff would
be able to more effectively focus their efforts in areas that
are critical to investors, such as sales practices.
I am grateful for the opportunity to speak to you today
about the self-regulatory system and about the update on the
proposed consolidation of the NYSE and the NASD, and I am happy
to take any questions.
Chairman Reed. Thank you very much, Mr. Sirri.
Ms. Schapiro, please.
STATEMENT OF MARY SCHAPIRO, CHAIRMAN AND
CHIEF EXECUTIVE OFFICER, NASD
Ms. Schapiro. Good afternoon, Chairman Reed, Ranking Member
Allard, and distinguished Members of the Subcommittee. As a
self-regulatory organization devoted to investor protection and
market integrity, NASD is grateful for the invitation to
testify on the historic regulatory consolidation of NASD and
NYSE member regulation. I am especially pleased to be
testifying on the panel today with my former SEC and NASD
colleague, Rick Ketchum, and SEC Director of Market Regulation,
Erik Sirri.
Never before have we witnessed so much change happening so
quickly in the financial services industry. Consolidation,
globalization, international mergers, and lightning-fast
technology are leaving the landscape of the global capital
markets forever altered.
As someone who has been a regulator for 25 years, I believe
strong regulation, including the self-regulatory model, has
always been a source of strength for our markets. But as the
markets grow faster and the world grows smaller, if we expect
to keep up with all the changes taking place around us, we need
to bring regulation into the 21st century, making it more
effective and more efficient.
Over the last several months, there have been three major
reports warning that America risks losing its position as the
world's financial capital. Whether you agree with these reports
or not, they have raised important issues concerning the
complexity of the regulatory structure and the competitiveness
of U.S. markets and have spurred much discussion, as well they
should.
NASD and the NYSE have chosen to lead and help shape a
system of regulation that is better for investors and financial
services firms of all sizes. Last November, we announced a plan
to consolidate NASD and the member regulation operations of the
NYSE into a combined organization which will be the sole
private sector regulator for virtually all securities brokers
and dealers in the United States. This consolidation is good
for investors, U.S. markets, and the industry. It will bring
about more focused regulation, able to meet the needs of
today's investors as well as eliminate confusion and
unnecessary duplication for firms. We believe more competent
investors and more efficiently regulated firms will ultimately
make U.S. markets stronger and more competitive.
Once the consolidated SRO is fully integrated, duplicative
regulation and overlapping jurisdiction will become a thing of
the past. Inconsistent approaches in rule interpretations and
the potential for matters falling through the cracks between
two separate regulators will be historical footnotes.
With the new SRO, there will be a single set of rules that
can be adapted to firms in different sizes and business models.
There will be one set of examiners and one enforcement staff.
And the new SRO's board will host a diversity of
representation. While there will be robust and diverse industry
participation, the majority of the seats will be held by public
Governors.
Today, as we await final approval from the SEC, we are
focused on integrating 470 New York Stock Exchange and 2,500
NASD employees, merging technology platforms, and consolidating
two rule books, all the while continuing to be ever vigilant in
enforcing our rules and overseeing our regulatory needs. With a
staff of nearly 3,000 dedicated individuals and a budget
approaching $800 million, the new SRO will be able to
vigorously carry out its mission of protecting investors.
Though NASD will soon have a new name, one thing will not
change: our dedication to investor protection and market
integrity and our core responsibilities. These include member
examination, advertising review, registration and testing, and
enforcement, as well as our administration of the securities
arbitration forum. It also includes our vigorous market
surveillance that identifies and combats illegal trading, and I
can assure you that technology and enforcement departments of
the new SRO will remain ever vigilant against insider trading.
A critical component of investor education also includes a
steadfast commitment to investor education. The NASD Investor
Education Foundation, currently funded with $82 million, is the
largest foundation in the U.S. dedicated to investor education.
We are proud of our work in this area, and it will remain one
of our top priorities.
Mr. Chairman, the financial services industry is
fundamental to the success of our economy, our national
security, and the well-being of our citizens. It has the means
and the intellect to solve a wide range of social and economic
problems and the potential to create secure financial futures
for all Americans. The transformation taking place in capital
markets both here at home and across the globe is here to stay.
The only question is how regulators and the industry will
evolve to meet the challenge.
NASD looks forward to working closely with Congress as it
continues to review the changing regulatory landscape. Thank
you again for giving us this opportunity to testify today.
Chairman Reed. Thank you very much, Ms. Schapiro.
Mr. Ketchum.
STATEMENT OF RICHARD KETCHUM,
CHIEF EXECUTIVE OFFICER, NYSE REGULATION, INC.
Mr. Ketchum. Thank you. Good afternoon, Chairman Reed,
Ranking Member Allard, and distinguished Members of the
Subcommittee. I want to thank the Subcommittee for providing
this opportunity to address how the impending consolidation of
the NYSE Regulation's member regulation functions and NASD will
impact the securities industry and investors.
For decades, there have been multiple self-regulatory
organizations, or SROs, to oversee the largest broker-dealers
in the United States as well as other broker-dealers that have
chosen to be members of both organizations. To protect
investors and ensure confidence in our securities markets, the
SROs were, in effect, deputized to work in the front lines of
America's capital markets. Under the supervision of the SEC,
New York Stock Exchange Regulation has played a significant
role in the oversight of our Nation's largest brokerage firms
and policing our markets.
Three years ago, I accepted an offer to serve as the New
York Stock Exchange's first fully independent chief regulatory
officer. The creation of my position was part of sweeping
reforms that were launched after the independence of regulation
at the NYSE had been questioned.
Then, in April 2006, the merger of the New York Stock
Exchange and Archipelago Exchange was completed, and the NYSE
Group became a public company. To further ensure our
independence, NYSE regulation was organized as a separate, not-
for-profit corporation, wholly owned by the NYSE Group, but
with its own majority independent board of directors, which I
reported directly to.
I believe strongly in the value of self-regulation. In
simplest terms, self-regulation offers the benefit of greater
expertise in the capacity to leverage Government resources. But
self-regulation must be efficient for the benefit of all
parties, including the securities industry, capital markets,
and investors.
In the past 3 years, working with NASD, we have achieved
significant results in reducing duplicative regulation of
brokerage firms that are members of both of our respective
organizations. For more than a year, we have worked with the
NASD, working particularly with the leadership of Mary
Schapiro, and securities industry representatives on an
ambitious program to harmonize our rules. But it became
apparent that we could do even more.
That recognition led the New York Stock Exchange Regulation
and the NASD to announce last November that we would combine
our member-related regulatory functions into a new regulatory
organization--the first major reform of the self-regulatory
system in 73 years. Clearly, it is an idea whose time has come.
I will serve and am pleased to serve as the Chairman of the
Board of the new organization while also continuing on as the
CEO of New York Stock Exchange Regulation, and as you know,
Mary Schapiro, NASD's current Chairman and Chief Executive
Officer, will run the new organization as CEO.
A word about Mary. I have had the privilege of working off
and on with Mary Schapiro in numerous positions over a period
of almost 25 years. She is a superb professional, enormously
passionate about protecting investors, with tremendous
leadership capabilities. I cannot imagine anyone more qualified
to be the CEO of this new organization, nor anyone I will be
more pleased to lead the board in helping to work with.
Approximately 470 of NYSE Regulation staff and member
regulation, arbitration, risk assessment, and related
enforcement units will join the new organization. Going
forward, NYSE Regulation will be comprised of the Division of
Market Surveillance, related enforcement staff, as well as our
Division of Listed Company Compliance, ensuring that companies
listed on the NYSE and NYSE-Arca meet their financial and
corporate governance listing standards.
Our joint proposal with NASD is to create a single new
self-regulatory organization that will be the private sector
member regulator for all securities brokers and dealers that do
business with the public in the United States. Under the strong
oversight of the SEC, self-regulation will continue to play a
vital role in the U.S. capital markets. Ultimately, there will
be a single set of rules, one set of examiners, one set of
interpretations, and one enforcement staff. The combined staff
will have more time to ferret out wrongdoing when freed from
the task of coordination or interpretation of inconsistent
rules. Firms will no longer be able to take advantage of subtle
differences in rules and exploit different interpretations by
the staff of the two SROs. This provides not only a direct
benefit to the securities industry, but also directly to
investors.
Importantly, NYSE Regulation will continue to play a vital
role, both in overseeing the trading on NYSE markets and NYSE-
listed securities and ensuring the regulatory integrity of our
listing programs. These activities do not present the issue of
regulatory duplication that we confront in member firm
regulation. In addition, they are activities that are best
performed within NYSE Regulation so that regulatory systems and
processes can be developed and improved in real time and in
close coordination with changes in the trading systems or rules
or listing requirements.
I feel honored to have been part of the revitalized NYSE
Regulation at a time of incredible change, but this new SRO for
member firm regulation is an idea whose time has finally come.
By combining the enormously talented staffs of NYSE Regulation
and NASD, we will be able to meet the challenges of tomorrow.
Mr. Chairman, thank you for the opportunity to testify
today.
Chairman Reed. Thank you very much, Mr. Ketchum.
We will do 8-minute rounds of questioning, and we would be
happy to entertain a second round if there are additional
questions, and let me begin.
To both Ms. Schapiro and Mr. Ketchum, one of the obvious
points of the merger is streamlining, combining rules and
regulations, simplifying. All of that should result in cost
savings and should accrue to the members and to the stability
and the effectiveness of the market. But one other aspect, an
overarching aspect, is: How will this improve the overall
effectiveness of the organization? And, most particularly, how
does it better protect investors? And I wonder if you might
comment, Ms. Schapiro, and then Mr. Ketchum, on that point.
This merger might be very appropriate when it comes to the
savings to the industry and firms. We all collectively have to
ensure it protects the consumers.
Ms. Schapiro. I absolutely agree with you, Mr. Chairman. I
think that one of the major ways that this approach really
truly benefits investors is that it is an opportunity to
leverage resources. To the extent--and I can give you a very
specific example that both the New York Stock Exchange and NASD
spend millions and millions of dollars a year developing
technology to support our individual regulatory programs. Each
of us has over 100 software applications that support
regulation. Many of them do virtually the same thing. They just
do them for two different SROs.
We can merger our technology platforms and save significant
money there that can then be leveraged into other regulatory
initiatives, training for our examiners and our enforcement
staffs, or creating even more feature-rich technology to
support the regulatory program.
So the ability to eliminate duplicative costs gives us the
ability to leverage precious resources much more effectively in
the interest of investor protection.
Chairman Reed. Thank you.
Mr. Ketchum, your comments, please.
Mr. Ketchum. Well, first, I entirely agree with Mary
Schapiro. We live in a world of finite resources for
everything, including regulation. Those resources should be
focused as efficiently as they can be on investor protection
and ensuring market integrity, and this merger, for exactly the
reasons Mary indicated, does that.
I also want to assure you, Mr. Chairman, as you properly
raise--and to some degree, questions have been raised in the
variety of testimony submitted--that the focus in developing a
single set of rules, we will be tremendously attentive ensuring
that what we have is rules that are clear, can clearly be
followed by brokerage firms. Clear rules that can clearly be
followed consistently will result in better protection for
investors. But we will be very careful to ensure that what we
get continues to be the most effective supervisory environment
and rules that protect investors that exist in the world. And I
can say clearly that both from the standpoint of myself and
Mary that nothing is more important to us than maintaining that
level of investor protection.
Chairman Reed. Thank you very much.
Mr. Sirri, both myself and Senator Tester in our statements
basically raised an important question: the role of the SEC not
just in terms of the preliminary steps of the merger, but for
several years thereafter, supervising a new single SRO.
The first question: Do you have all the legislative
authority that you need to deal with this merged SRO?
Mr. Sirri. Yes, we believe we do. Our oversight of this
process will come in a variety of ways. For example, as the two
rule books come together, the new SRO will be required to file
their new rules with the SEC. Those rules will be published for
notice and comment. That means that the industry, investors,
and other members of the public will be able to comment on
those rules and that the Commission staff will evaluate those
rules in coming to their opinion about how well those rule
books are coming together.
Second, as that merged entity comes together and as it
operates in the ensuing years, as you point out, the Commission
has a staff in the Office of Compliance, Inspections, and
Examinations whose job it is to evaluate the effectiveness of
those rules, how well they are working, whether the staff of
the new SRO is adhering to their new policies, their new rules.
That is something we will take very seriously. I will work
with the director of that office, Laurie Richards, to make sure
that, from a policy perspective, the policy issues are actually
being examined effectively by that office.
Chairman Reed. Mr. Sirri, part of it is not only the
authority, which you indicate you feel comfortable with, but
also the resources. Particularly as these organizations come
together, I can imagine there will be some novel issues that
arise, or at least issues that are not routine.
Do you have adequate resources now? And do you have the
long-term commitment of the Commission to maintain those
resources?
Mr. Sirri. I think the pattern of resource use is going to
be unusual. I think there will be a relatively high use of
resources early on as we deal with the combined rule book and,
as you point out, some novel issues.
I believe in the long run that, as Mary Schapiro and Rick
Ketchum both said, the actual use of resources and the demand
on resources will be actually less because of the more
effectiveness--the greater efficiency and effectiveness of the
combined single SRO.
So, yes, I do believe we do have the resources. It may take
a little shuffling around and management, but I do not believe
there is any shortfall.
Chairman Reed. You indicated you have a certain degree of
leverage, for want of a better term, when the rules are
submitted, about the practices. Will you have the ability to
look at the budgets of this combined entity and make a
determination whether savings are, in fact, being reinvested
into consumer protections in any way, shape, or form?
Mr. Sirri. Well, as you know, we take our mission of
investor protection very, very seriously. From the budgeting
perspective, the main way we look at these issues is not so
much by looking at costs at the SRO, but by looking at the fees
that they file. There is a standard for fees that has to do
with an equitable allocation of reasonable dues, fees, and
other charges. That is something that we evaluate as a staff.
So when the new SRO, for example, asks for a change in fees, as
they may, then we would notice those, put those up for public
comment, and evaluate those fee changes in light of the needs
and the specific circumstances.
Chairman Reed. Thank you.
Mr. Ketchum, one of the points that you raised in your
testimony was the fact that this is a consolidation of most
functions, except you maintain market surveillance of the stock
exchange, although the new combined SRO will, as I understand
the transaction, maintain member regulation. Is that accurate?
And so the question I think is, obviously--and you suggested,
at least alluded to it--is why this residual separateness in
terms of regulation.
Mr. Ketchum. Well, not surprisingly, market integrity is
absolutely critical to the New York Stock Exchange. The
exchange, although it is a swiftly changing marketplace,
remains a hybrid and a sui generis marketplace as to how it
operates. The proper application and interpretation of its
rules, effective market surveillance to ensure absolute
investor confidence with respect to trading that occurs at the
exchange, is a critical part of what the exchange has offered
historically and cares greatly about today. And it is the area
of market surveillance and the ability to use the knowledge
that I think our staff uniquely has with respect to that
market, the ability to participate in the development of
technology, to ensure that the proper rule compliance is
considered as that technology is developed from a trading
standpoint, all that is very important in the exchange, and
those are all reasons why we feel that while it is time to
combine member regulation and ensure a single entity and
operating it with respect to markets, both the New York Stock
Exchange and the wide range of competing markets in the United
States, it makes sense for market surveillance to still reside
with those marketplaces.
Chairman Reed. Thank you very much.
Senator Allard.
Senator Allard. Mr. Chairman, thank you.
In my opening statement, I mentioned the small brokers and
dealers and the fact that they are concerned about the merger.
I wonder if you could share with the Committee here how you
plan on taking them into account as you plan the merger. And
how do you plan to address their needs in the rule book? And
then, finally, how are you going to do this without creating
basically two systems? And maybe Ms. Schapiro as well as Mr.
Ketchum can both talk about that.
Ms. Schapiro. I would be pleased to start, because most of
the small firms are NASD members and are not current New York
Stock Exchange members, so we have a long history of working
closely with smaller broker-dealers. I would like to mention
just a few things in that regard.
For example, we have a small firm advisory board that
advises the staff and the NASD board on issues that are of
importance to small firms so that we can understand that while
the regulatory burden has clearly ramped up over the last
several years and creates unique burdens on smaller firms,
exactly what those burdens are and how we can help ameliorate
them without compromising basic investor protections.
Earlier this year, or late last year after I became CEO, I
created an Office of Member Relations, which is staffed with
people, including a former CEO of a small broker-dealer, to
reach out to small firms, to travel to their offices, talk to
them about their issues, bring their concerns and issues back
to the NASD so that we can try to address them as proactively
as possible.
We are going through a process now where, with the
assistance of a small firm task force, we are reviewing all
NASD rules that are going through the harmonization process
with New York to have sort of a small firm lens applied to
those rules and to understand where exemptions might be
appropriate for small firms or other less burdensome ways to
implement rules would be appropriate.
Then, finally, two other points I would make. We have
produced many tools and compliance programs to assist small
firms in meeting their regulatory obligations, so that in the
area of anti-money laundering, for example, where a small firm
is really hard pressed to go out and hire a consultant to
develop a money-laundering prevention program, we have
developed a plan and a template for them to use and to provide
a basic structure for them. And we have done that in a number
of different areas. We host many educational programs,
including webcasts and podcasts on regulatory issues geared
toward a small firm audience.
And then the last thing I would say is that we have
explicitly in recent months taken into account when we are
levying sanctions against a small firm for rule violations, we
have required the adjudicators of those violations to take into
account a firm's size and revenues when assessing a fine so
that we do not put small firms out of business with big fines
where those are not appropriate.
As we go forward, we will remain incredibly focused on
small firm issues. I very much am of the belief that investors
need a choice in the kind of financial intermediary they go to,
and in many communities across this country, having a small
firm there and someone you can talk to face to face is very
important. And our goal is to maintain that wide diversity of
business size in our financial community.
Senator Allard. Now, I think you also talked in your
testimony about the savings mentioned in tens of millions of
dollars. Can you be more specific in how those savings are
achieved?
Ms. Schapiro. I would be happy to. Clearly, for the firms
that are dually regulated, that are members of both New York
and NASD, there will be many in-house, so to speak, savings
from not having to keep up with two sets of rules, two sets of
examinations, and so forth. I really could not quantify those
savings.
I believe a large amount of the savings for the
consolidated SRO will come from the combination of the
technologies that I spoke about earlier. We each are supporting
over 100 applications to support regulatory programs. The
number of applications the joint SRO will need--it may not be
100, but it is certainly not going to be over 200, and so by
being able to retire some applications and invest going forward
in a single set I think will amount to cost savings.
There will also be some attrition in staff, we would
expect, over the years, and right-sizing.
Senator Allard. I suspect probably the most sensitive issue
is the issue of fees, and give us some idea of how you are
going to apply fees to a smaller operation versus a bigger
operation.
Ms. Schapiro. I would be happy to talk about that, and as
Erik Sirri pointed out, fees are filed with the SEC.
As part of the consolidation agreement and in order that
all firms can share in the financial benefits and synergies
that we think the consolidation will realize, we actually
intend to grant a moratorium--not a moratorium, but a reduction
in the gross income assessment, which is the primary fee that
is paid by firms to the NASD of $1,200 a year.
What that means is that for the next 5 years, about 2,800
small broker-dealers will pay no annual membership fee to the
NASD for their services. When we do fee filings and when we
review them on a periodic basis, we do it with great
sensitivity to the burden that they create for small firms.
Senator Allard. Yesterday, the Senate Appropriations
Subcommittee on Financial Services and General Government held
a hearing with Chairman Cox. At that hearing I asked him about
the budgetary implications of the merger. He indicated that he
believed the agency had requested a sufficient budget to
oversee the merger.
He also took that opportunity to say that he believed the
consolidation of the regulatory functions of NASD and NYSE will
make it easier to track fraud across markets. And he continued
on to note, ``We will be much more efficient in tracking down
fraud.''
As Chairman Cox described, it can be difficult to stop
fraud when the sheriff has to stop at the border, and this
merger will help eliminate that border. Do you agree with his
assessment that the merger will help eliminate fraud? Maybe I
would have the panel in general speak about that.
Mr. Ketchum. I think the Chairman is absolutely right.
Anytime you can have a single examination team focused on
ensuring that nothing drops between the cracks, you increase
the ability to detect and identify fraud by using your
resources more efficiently. And I think this merger, as Mary
indicated earlier, puts together a range of knowledge and
expertise as well as allowing us to identify the most effective
technology systems used by both self-regulatory organizations.
So by eliminating risk that things fall between the cracks,
providing a more efficient environment where we can spend more
of our time, more of our examiners' time looking and
identifying where there may be securities law violations, we do
place ourselves in the better position to identify serious
wrongdoing, and I think that is clearly one of the most
important things about the merger.
Ms. Schapiro. I agree completely with Rick. I think that
whenever we can take a fragmented regulatory approach and
fragmented data and consolidate it and bring it together and
have a better view of the marketplace as a whole, we will be
much more effective with respect to catching fraud.
Senator Allard. Mr. Sirri, anything you want to add?
Mr. Sirri. Yes. I would just like to say I agree as well.
Chairman Cox in another setting has observed that today a lot
of fraud occurs outside the United States--the perpetrators are
situated outside the United States, but, in fact, the
occurrence is inside the States, making it difficult to catch.
And I think that simple example carries over within the United
States.
Senator Allard. You will have to repeat that statement.
Mr. Sirri. Sure.
Senator Allard. Fraud occurs outside the United States, but
the victims are inside the United States? Is that what you were
saying?
Mr. Sirri. Exactly. And the point of the Chairman's
statement----
Senator Allard. That is easy to believe.
Mr. Sirri [continuing]. When he made it was that we as a
Nation have a hard time getting our arms around those people in
a rapid way. And I think that same point carries over here.
Individuals who engage in fraud do not often restrict
themselves to just exchange-traded markets or just the over-
the-counter market or just the options market. Often they will
engage in a transaction or a series of transactions that
encompass all those markets. One of the benefits of this
consolidation is that a single regulator, this new SRO, will
have oversight over listed markets, exchanges, over-the-counter
markets, broker-to-broker transactions, as well as, say,
options markets. All of that will be under one roof.
In addition, not only is that oversight under one roof, but
all that information is under one roof. Oftentimes you could
see a transaction here or a transaction there. You cannot hook
them together. By having that all in one place, you can put the
pieces of the puzzle together, making it more likely that you
uncover that fraud.
Senator Allard. I see my time has expired, Mr. Chairman.
Thank you.
Chairman Reed. Thank you very much, Senator Allard.
Senator Tester.
Senator Tester. Yes, thank you, Mr. Chairman.
Mr. Ketchum talked about dozens of SROs. Mr. Sirri--or Mr.
Ketchum, it does not matter--are NASD and New York Stock
Exchange the last two standing, or are there other SROs out
there?
Mr. Sirri. No, there are other SROs out there. Most
exchanges are SROs. Other entities such as clearing agencies
are also SROs, the Municipal Securities Rulemaking Board.
Senator Tester. Is there overlap with those with these two,
also?
Mr. Sirri. The key distinction here is that the combination
of these SROs involve member firm regulation.
Senator Tester. OK. Can you give me an idea how much
overlap--Ms. Schapiro or Mr. Ketchum, how much overlap
currently exists between the two SROs?
Mr. Ketchum. Well, perhaps I can start and Mary can add in.
The exchange has approximately 400 members; 170 of those
members are both members of the New York Stock Exchange and the
NASD. Those are, as a generalization, the largest firms in the
United States, and they account for well over 90 percent of the
total securities accounts, for example.
So of the total activity, there is a very significant
amount of the total activity in the securities market which we
are both looking at from the standpoint of sales practice
violations and the like. So while we do our best to harmonize,
there is a significant overlap.
Senator Tester. OK. Ms. Schapiro, you talked about
transition, but I did not catch how long. How long do you
anticipate this transition to take?
Ms. Schapiro. Well, we talk about transition in the context
of the initial board of directors for the new organization will
be in place for 3 years, and Rick as Chairman of the board, yet
still chief regulatory officer in the New York Stock Exchange
will be in that role for 3 years. After the initial board
elections and the 3-year period expires, the organization will
obviously be fully functioning and go through a normal
governance election process.
We think the combination of the rule books will take some
time, because it is a careful process and we want to make sure
we get it right. That will take, I would guess, about 18 months
for us, optimistically, to conclude.
Senator Tester. Can that go on during the 3-year period or
are you talking over and above the 3-year period?
Ms. Schapiro. Oh, no. Someone should call us up here and
take us to task if by the time the 3-year period is over we
have not concluded a dual rule book.
Senator Tester. OK. Mr. Sirri, do you have input into the
bylaw rewrites?
Mr. Sirri. The bylaws were up for a proxy vote. They were
noticed and commented, and then they will be approved by the
Commission. So the Commission itself has a say in the approval
of those bylaws.
Senator Tester. OK. Thank you.
Ms. Schapiro, I think it was Mr. Sirri that pointed out
that generally folks thought this was a good idea, but some of
the small firms, as Senator Allard pointed out, had some
problems with it, as well as the Commonwealth of Massachusetts.
With the education you are doing and with the reduction in fees
and elimination of fees in a lot of cases, what is really the
rub here?
Ms. Schapiro. We have worked very hard to structure a
consolidation and a governance system that we think will serve
firms of all sizes, and particularly serves well small firms.
The primary complaint that we have heard--and I should say that
we went out across the country. We met with firms in 28 cities
to explain the transaction, to receive their questions. We were
available during the entire voting period to explain it to them
and to work with them.
The primary concerns have been the governance structure.
Small firms currently only have one seat dedicated to them on
the NASD board, but they broadly elected the entire board. All
firms elected the entire board.
The new structure dedicates three seats to small firms, but
they only vote for the small firm representatives. Large firms
will vote for three large firm representatives. Intermediate
size firms will vote for their representative.
Senator Tester. Do you think it is a valid concern?
Ms. Schapiro. I understand the concern, but I think we have
worked very hard to structure an extremely fair governance
model.
Senator Tester. OK. And any of you three can answer this,
but it is directed at Ms. Schapiro. What is the downside of
doing this?
Ms. Schapiro. The downside of doing the consolidation?
Senator Tester. Yes.
Ms. Schapiro. I have to be very honest. As I said, I have
been a regulator for 25 years in the commodity side of
financial markets, the securities side at the SEC, the CFTC,
and the NASD, and I have seen every model of regulation, I
think, that exists, and I do not see a downside. With strong
SEC oversight and very committed and expert staffs, I really
only see upside.
Senator Tester. Mr. Ketchum, do you see it the same way?
Mr. Ketchum. I do not see a downside. I see challenges,
which I am fully confident that Mary and her staff will be up
to. This is putting together--this is a significant integration
that needs to ensure that we do truly put together the best of
both organizations and that we really develop a single rule
book that both addresses burdens, ensures protection of
investors, and recognizes where there are different firms and
different situations from the standpoint of small and large
firms. Those are challenges; this organization will be up to
them.
Senator Tester. OK. Mr. Sirri?
Mr. Sirri. This is a question that is out for comment for
us and that the Commission will be developing an opinion over
time.
Senator Tester. OK. The last question, and I want to thank
you folks for your concise answers. I really, really appreciate
that. The question, I guess, is directed to Mr. Sirri. When Mr.
Reed asked you about if you had the authority, you said yes.
Then he asked if you had adequate resources in the short term,
and you said yes. And then you potentially made the error--and
it is not, by the way--of saying that long term this may
require less work. Do you see, long term, a cost savings here?
And what would you anticipate on a percentage basis that cost
savings might be?
Mr. Sirri. Well, hopefully it was not a mistake. I was
serious----
Senator Tester. No. I agree, and I appreciate that. I
appreciate your candor.
Mr. Sirri. I think that is the sense in which there is real
efficiency here. I want to say I can always make good use of
those resources for the benefit of investors, though.
But, that said, I think those savings are going to come
from a reduction in--really an efficiency in the way we use our
people to oversee this group, this set of activities. For
example, when it comes to inspections, we had to inspect before
two different SROs, which would each engage in the same set of
functions. Now there will be one, and one team.
Senator Tester. So it will ultimately be a savings on a
couple different levels--the SRO level and your level.
Mr. Sirri. We are hopeful. If things work well, that is
what I would anticipate.
Senator Tester. OK. And I assume this is self-funded. I
assume the SEC is self-funded through--not through taxpayer
dollars.
Mr. Sirri. No, we are not a self-funded organization.
Senator Tester. All right. Well, I appreciate efficiency
for sure. I guess I fibbed. One last question. You do not have
to spend a lot of time on this, but it is always interesting to
me, in the worldwide economy that we live in, how you deal with
regulation on worldwide transactions. And if there is fraud
that deals with somebody in another country of a company in
your organization, is that let go and you only apply it to U.S.
citizens, U.S. companies? Or how is that handled?
Ms. Schapiro. For NASD and as I recall from my SEC
experience, it is dealt with through cooperative efforts with
the foreign regulators, wherever either the fraudulent conduct
took place or the person who perpetrated the fraud is resident.
And that is why it is so important for regulators to have basic
understanding of each other's regulatory regimes and close
working relationships around the world.
Senator Tester. Thank you very much. I appreciate the panel
today. Thank you.
Chairman Reed. Thank you very much, Senator Tester.
Senator Bunning.
Senator Bunning. Thank you.
Mr. Sirri, is there anything about this merger that has not
been resolved that causes you concern?
Mr. Sirri. Well, as I said, right now we have--the proxy
and the rules are out for comment, so we are collecting
comment. So it probably would not be appropriate for me to
comment right now as a staff member, but in the coming weeks,
we hope to come to a conclusion as a Commission and make some
statement on that.
Senator Bunning. When is the comment period over?
Mr. Sirri. The comment period has already concluded. There
have been almost 80 letters that have been received. We are
evaluating those letters now and coming to the conclusion.
Senator Bunning. The comment period is over, and then how
long do you have?
Mr. Sirri. My anticipation is that we would come to a
conclusion in about a month. As a staff, we would make a
recommendation up to the Commission in about a month.
Senator Bunning. I have looked at the numbers of people
involved in the NASD: 5,100 brokerage firms, 663,000 registered
representatives. That is the NASD. And the New York Stock
Exchange has--let me read this. Four hundred New York Stock
Exchange broker-dealer firms have been registered by the SEC,
and approximately 180 of those are both NASD members and New
York Stock Exchange members. Is that accurate?
It seems to me that the small, the little broker-dealer--
and I am talking about the guy out in Richmond, Kentucky, that
has a two-office shop or a two-person shop that is a member of
the NASD presently is going to have a devil of a time
understanding what the heck you are doing in New York. Ms.
Schapiro?
Ms. Schapiro. I would love to respond. You know, NASD has
been around for almost 70 years.
Senator Bunning. Yes.
Ms. Schapiro. And during that period of time, we have
learned and worked closely with many, many small firms around
the country because, as you correctly point out, many of our
members are, in fact, small firms. We have to work with the
largest financial institutions in the world on one end of the
spectrum and a couple of thousand very small broker-dealers who
may have less than ten employees.
Senator Bunning. My big concern is fitting that into one
playbook.
Ms. Schapiro. I actually believe that the playbook--it will
be easier to have a tiered regulatory structure when we have
one rule book in place rather than two potentially dueling rule
books. And we have made a commitment and actually have already
begun to effectuate the commitment of ensuring that rules that
impact small broker-dealers disproportionately--particularly
rules that do not go to core investor protections--we will find
a way to make them fit the smaller firm business model. We do
not believe in one-size-fits-all regulation. I guess that is
the distinct way----
Senator Bunning. That is my big concern.
Ms. Schapiro. We have understood that for a very long time,
and we clearly understand that in this new environment. We have
a small firm advisory board that works closely with the staff
to advise us on issues that impact small firms. We have a small
firm rules impact task force--again, made up of the CEOs of
small firms--that help us look at every rule and understand how
we might change it to make it less impactful to small firms
while not diminishing the investor protection that is at the
core of the rule.
Senator Bunning. Well, let us put it this way: I lived
through this from the early 1960's through the mid-1980's.
There were so many mergers and acquisitions going on in the big
firms, and the medium and regional firms were all eaten up by
the--I mean, most of them were eaten up by the larger and more
affluent firms, and instead of having a Cincinnati-based firm,
you would have a Cincinnati-based firm that was connected to a
New York Stock Exchange firm. And the same thing--we used to
have offices of--I worked for a company that had offices in two
cities--Cleveland and Cincinnati. That is it. And they were
members of the New York Stock Exchange. They did not have a
floor trader, but they used somebody to trade for them on the
floor. And I am concerned about those kinds of firms,
particularly if they do not deal in equities much, if they are
a specialty firm that deals in municipal bonds, for instance.
Ms. Schapiro. And we have many firms that are specialized
in municipal bonds. You know, it is a very fair point.
I should add that we have 14 offices around the country. We
are actually based here in Washington, and, of course, the New
York Stock Exchange is based in New York. But we have 14
offices around the country, and the major reason for that is so
that we could be close to the firms throughout the country and
be able to work with them, do the examinations, work with them
on preventive compliance programs, be closer to the customers
as well. And that basic structure will not change. We will
maintain a nationwide presence so that small firms have a face
at the NASD or at the new SRO that they can always associate
with and talk to in the form of our district office directors
and our district staff.
Senator Bunning. I can see UBS Warburg having a compliance
officer and someone who is in charge of making sure that we are
complying with your book. But I have a devil of a time
understanding how a firm that has five broker-dealers and two
offices has the same type of a compliance officer that would be
as good and make sure that all the regulations that the NASD
and/or the New York Stock Exchange, if they have a connection
with the New York Stock Exchange, would comply and have that
person on the site every day making sure that you as a broker-
dealer are complying and so that your customers are not getting
the short stick.
Ms. Schapiro. Well, you are right. Many of the smallest
broker-dealers do not have the resources to have a dedicated
full-time compliance officer onsite in their offices. They are
still responsible for ensuring that they have compliance with
the rules, and sometimes it is the CEO who takes on that
responsibility or the office manager. But we also work with
those firms to try to give them some of the tools to help them
stay in compliance, whether it is trade reporting or books and
records or supervisory controls. We really work with firms, our
theory being that if they can get it right in the firm, if they
can take care of their compliance and regulatory obligations,
at the end of the day the customers will be best served by
that.
Senator Bunning. You know, those same firms could be in a
selling group. They could be in a group that underwrites. And I
worry about the ability of them to control the leakage so that
we do not have insider traders and we do not have small firms
that have the same knowledge that UBS does or someone like
that, and the information is going out just to two people.
Ms. Schapiro. Well, with respect to insider trading--and
Rick can speak to this as well--both NASD and New York have
very sophisticated surveillance technologies that can actually
detect very small amounts of insider trading. And over the
years, we have each made several hundred referrals a year.
Senator Bunning. Well, we have missed some, haven't we?
Ms. Schapiro. Oh, without a doubt. Without a doubt. There
is no system that catches everything. But insider trading is
one of those areas where technology has really benefited the
program.
Senator Bunning. But, see, the least bit of insider trading
and the least bit of leakage like that, public confidence in
the markets is damaged constantly from that.
Ms. Schapiro. I would agree with that, and it is one reason
that this consolidation will actually benefit the regulatory
structure----
Senator Bunning. So you think you can do it better with
fewer people?
Ms. Schapiro. I do not know that we will be doing it better
with fewer people. We will be doing it better with less money
spent on duplicative technologies.
Senator Bunning. I understand that part.
Ms. Schapiro. And overlapping. I think we can do it better
with people who are expert, where we bring different expert
people together----
Senator Bunning. Are you going to be able to do the same
amount of going around and making sure that your 14 offices are
able to----
Ms. Schapiro. Oh, yes. Our examination program out in the
field will not change. We will continue to go into every
broker-dealer on a periodic basis, as we do now and as the SEC
closely over----
Senator Bunning. Yes, they used to come and sit in our
offices. I remember very clearly.
Ms. Schapiro. That program will not change with this. What
will change is those 170 or so firms that now host examiners
from both New York and NASD will get one.
Senator Bunning. Yes, will get one. But will they get a
good, thorough exam? That is what I----
Ms. Schapiro. Yes.
Senator Bunning. OK. Thank you very much, Mr. Chairman.
Chairman Reed. Thank you, Senator Bunning.
I have two questions, and then I will recognize Senator
Allard. Much has been made and Mr. Sirri referred to the
comments about the governance, and the comments seemed to be
coming from the industry. But there is the issue here of the
independence of the proposed board. In effect, the majority of
the members will be either elected by the industry or be the
Chair and the CEO and the non-executive chairman.
Professor Coffee notes in his testimony that the New York
Stock Exchange requires all of its directors to be independent,
an entirely independent board.
So, Mr. Ketchum and Ms. Schapiro, your comments on the
independence of the board, and then I would like Mr. Sirri to
comment and see if there are concerns that he has with respect
to the proposed board.
Mr. Ketchum. Well, thank you, Mr. Chairman. Let me start,
since I do have the experience of having worked for numerous
years at the NASD and now have been involved in the creation of
the requirements of the New York Stock Exchange as a fully
public board.
I think that the requirement that no member of the board of
the New York Stock Exchange, and certainly of New York Stock
Exchange Regulation, should have any affiliation with a
brokerage firm. Given the unique issues of the exchange
operating as a for-profit corporation and taking on, as it is
required by statute, serious regulatory responsibilities, both
from the standpoint of enforcing rules and also just operating
a marketplace that is absolutely critical to investors going
forward justifies a standard of having a fully public board.
That does not mean that the exchange both from the business
side and from my side and the regulation side does not work
very closely with the industry and ensure that they have an
advisory role to make sure that our regulations and the way we
design systems are sensitive to their needs. We do and we
should.
I would say my experience from working at the NASD and my
experience of what I expect in this new board is that this
balance will work. I do not think that Marc Lackritz, whom you
will hear in the next panel, or other people in the industry
will have much trouble distinguishing Mary and myself from
industry representatives, as they count, as to what majority of
the board is. I think the majority of the board is truly
representative of the public, and certainly from our
standpoint, we view ourselves as our representation is for good
governance and to protect investors.
I do believe there is, with respect to an organization that
is separate from a marketplace, a benefit in having direct
participation of the industry on the board as long as that
participation is not a control position. It allows the industry
to be able to identify issues from a regulatory standpoint. It
often allows the industry members to be able to cut through
excuses or suggestions that, because of their expertise, they
are more able to cut through.
So I believe the design as it exists that both represents
firms of all sizes and ensures that they all have a voice, but
absolutely make sure that this board is independent from a
decisionmaking standpoint and the majority of persons do have
as their sole responsibility the public and statutory
responsibility of the new SRO, it will give you exactly the
type of oversight and self-regulation that Congress
appropriately should expect.
Chairman Reed. Ms. Schapiro, do you have a comment?
Ms. Schapiro. I really agree completely with what Rick
said. I think what we have is a hybrid governance structure--
the old NASD such and the old New York Stock Exchange
Regulation structure--and we really combined it to create
something that will have diverse and robust industry
participation but will not be in control. There will be a
majority of public directors.
Between us, I think Rick and I have somewhere north of 50
years of regulatory experience, so I would agree that few
people would characterize us as ``industry'' or ``non-public''
members of this board.
Chairman Reed. Mr. Sirri, do you have a comment?
Mr. Sirri. Just let me make two points.
First, I have known Mary and Rick for a long time, and I
have a great deal of confidence in their work and their ability
to be serious about this. In our role as an overseer of the
SROs, we intend to take these issues very seriously and, as I
said, are monitoring even now what is going on.
I want to make one specific comment, though. The nature of
this board is one in which it is tiered and there are small,
medium, and large firms with separate representation. I think
that is at the heart of your question. I want to point out that
is not the first time something like this was done. In a
slightly different circumstance, for the ISC, one of our
options exchanges, the board structure was set not with an eye
toward firm size but with an eye toward the nature of the firm
and the nature of their business. There were various kinds of
brokers that brought business to that exchange, and so the
board was tiered where there was separate representation from
each category or type of broker on that exchange that were
members, the non-public members.
But the point is that this approach they have taken, which
I think is reasonable, is not the first time it has been done.
The balance that was struck is one of representation and
closeness to the industry where you are balancing off what I
think you are citing as potential for lack of independence.
Chairman Reed. A final question. I will direct it at Mr.
Sirri, but Ms. Schapiro and Mr. Ketchum might want to comment.
The description you had of the process of SEC in some respects
could be interpreted as somewhat passive; i.e., the rules are
presented to you, comments are made, and you will talk to
people and sort of negotiate.
But there are probably areas where proactively and together
you might be able to forge better rules; rather than waiting to
be told, you might have some suggestions. One area is
arbitration, which always seems to be an area of debate, issue
of fairness, issue of representation. Here you have, as you
point out, 90 percent of the arbitration is already done by
NASD, but there was always that other option, et cetera.
I am just wondering. With that case, but a more general
way, are there areas that you want to see rule improvements
made and that you are going to work proactively with the merged
organization?
Mr. Sirri. Well, I think there is a distinction here. One
is the literal process we go through, which is one in which an
SRO files a rule with us, and we generally put it out for
notice and comment, and then it is approved. That probably
should not--and I take your point. You should not infer,
however, that we are passive in that. In fact, I am sure Mary
will have a view on whether we have always been passive over
time, and probably some folks in the audience, too.
I think we have a fairly activist, an appropriately
activist view of our role. We are encouraging when we think it
is appropriate to be encouraging of certain changes. That said,
there is a process that is in place with filing, notice, and
comment.
But, no, I do not think as a group we are shy as a staff
about indicating our preferences, but in the end, it is up to
the SRO to make that rule filing.
Chairman Reed. Ms. Schapiro. Mr. Ketchum.
Ms. Schapiro. The only thing I would add is that
arbitration is probably a great example of an area where, as we
bring the two rule books together, we will work very closely
with the Commission to address issues that are becoming more
prominent as the days go on.
Chairman Reed. Mr. Ketchum.
Mr. Ketchum. I would agree with that and would agree with
Erik's characterization of the SEC's relationship not being
passive. Exhausting, perhaps, but definitely not passive.
Self-regulation truly is a partnership with the SEC. On
good days we get along; other days maybe we do not. But on all
days, we have a tremendous respect and the SEC has great
commitment to ensure that the rules and the enforcement of
those rules are done right. The great thing about moving to
this single rule book for all persons involved, both industry
and investors, is the chance to dust off and take a hard look
at our regulatory structure and ask how it can be better, and
that is a process that I expect should involve not only these
two great organizations, also the SEC and also the key
constituents, both industry and investor, that exist with
respect to our marketplaces.
Chairman Reed. Thank you very much.
Senator Allard.
Senator Allard. I will just make a point. If you follow the
testimony in the Appropriations Committee with Chairman Cox of
the SEC, I would emphasize the importance of the PART program,
which is basically setting measurable goals and objectives and
following through to measure performance. And so I am one who
will follow that closely, so as you go through this
reorganization, you expect some follow-up from me in that
regard.
My question to you--and this is the only question I had,
Mr. Chairman. Mr. Sirri, you had mentioned that you had some 80
comments or so that you received in your office, and as a
result, because of that, you did not feel it appropriate to
make any comments at this point in time. But the board members
have made comments and indicated their strong support.
Is that appropriate for them to do that before you have
reviewed those comments?
Mr. Sirri. I am not sure there is any issue with the board
members making comments. I think my comment was strictly for
ourselves. As a staff we cannot--I am not sure----
Senator Allard. Their minds are already made up, and so are
the--the fog, I am sure, that comes across some people's minds,
if they have already made up their mind, why in the world are
we submitting comments?
Mr. Sirri. Well, I think broadly they have been very
supportive of this transaction. The differences, as I
understand what the board members have said, have been on some
of the details of it. The board members, as I have listened to
and read about what they have said, have been very broadly
supportive. Maybe Mary would have something to say about
whether it is appropriate or not.
Ms. Schapiro. For the Commission to speak to these issues?
Senator Allard. Yes.
Ms. Schapiro. I thought you might not have understood
exactly the question, but it is appropriate for the Commission,
I think, to speak--not on the specific rules that are pending
before them until it is the appropriate time to make decisions
after the staff recommendation and the comments have been
summarized and absorbed. But it is certainly not inappropriate
to speak in support of the transaction in the sense of a
streamlining of the regulatory effort. The Commission actually
spoke to this issue in some proposed rulemaking, and a concept,
or at least it did several years ago, on the structure of self-
regulatory organizations. I believe it spoke to it to some
extent in the Arca order.
So it has been a view I think shared by many members of the
SEC over a long period of time that rationalizing the
regulatory structure would be a benefit to U.S. markets and
U.S. investors.
Senator Allard. OK. So you are comfortable that nobody has
put themselves in a position where they cannot objectively look
at any evaluation that comes out of those comments because of
public statements.
Ms. Schapiro. I certainly do not think so, but I am not the
judge, really.
Mr. Sirri. Yes, I apologize. I misunderstood your question.
I was interpreting you as commenting on the NASD board.
Senator Allard. Well, any board out there, I guess.
Mr. Sirri. I do not think there is any problem with that.
The Commission maintains an open mind. They evaluate comments
as they come in. There has been an ongoing dialog about SRO
structure for some time. It began with a concept released by
the Commission. The SIFMA submitted a white paper. So there has
been an active dialog for a period of time, and so I think
those are just comments in the spirit of that ongoing dialog.
Senator Allard. Very good.
Thank you, Mr. Chairman.
Chairman Reed. Thank you, Senator Allard.
Thank you for your excellent testimony. Let me remind you
that Members of the Committee may have questions in writing
which we would submit to you and ask you to respond as promptly
as you could.
Let me call forward the second panel, and also we are
expecting a vote in about 15 or 20 minutes, so I think this
will give us an opportunity to get the testimony of the second
panel, and then we might have to recess for a moment while we
vote. But we will return for questions. But let me thank the
first panel for their excellent testimony.
Well, let me thank the second panel for joining us today.
Thank you very much, gentlemen. I will introduce the panel now,
recognize you for opening statements, and then we will wait on
the timing of the vote to see if we go right into questions.
First let me introduce Mr. John Coffee. Mr. Coffee is the
Adolf A. Berle Professor of Law at Columbia University and
Director of its Center on Corporate Governance. He is a fellow
of the American Academy of Arts and Sciences and has been
repeatedly listed by the National Law Journal as among its 100
most influential lawyers in America. He is an international
authority in terms of securities and has testified before
Congress. He worked closely with this Committee with the
drafting of Sarbanes-Oxley. We thank you for your work,
particularly Title V. Professor Coffee has been a member of the
Legal Advisory Board to the New York Stock Exchange, the Legal
Advisory Board to the NASD, the Market Regulation Committee of
the NASD, and the Economic Advisory Board to Nasdaq. So it is
quite an impressive and extensive participation. Before
entering his teaching career, he practiced corporate law as an
associate with the small firm of Cravath, Swain & Moore in New
York City, and he is a graduate of Yale Law School and Amherst
College. Thank you, Professor Coffee, for joining us today.
Mr. Marc Lackritz is President and CEO of the Securities
Industry and Financial Markets Association, the trade
association formed in 2006 by the merger of the Securities
Industry Association and the Bond Market Association. He was
President of SIA for 14 years and was its Executive President
and head of the Washington office for 2 years prior to that.
Before joining SIA, Mr. Lackritz was Executive Vice President
and head of the Washington office of the Public Securities
Association, later renamed the Bond Market Association. He has
extensive experience on Capitol Hill and was previously a
partner at the Washington-based law firm of Wald, Harkrader &
Ross, specializing in litigation, lobbying, and trade
regulation. He received his J.D. from Harvard University Law
School, a master's degree in economics at Oxford, and a
bachelor's degree in public policy from Princeton University.
Thank you, Mr. Lackritz.
Mr. Joseph Borg is the Director for the Alabama Securities
Commission and President of the North American Securities
Administrators Association, the NASAA, an international
securities regulatory association. His prior positions at NASAA
include membership on the board of directors, Chair of the
enforcement section, and treasurer. Mr. Borg is also a delegate
to the Intergovernmental Expert Group for the United Nations
Commission on International Trade Law to prepare a study on
international fraud and the criminal misuse and falsification
of identity. He has testified before various committees of
Congress and in various areas, and we thank you for joining us
today, Mr. Borg.
Let me begin with Mr. Borg, then Mr. Lackritz, then
Professor Coffee. Mr. Borg.
STATEMENT OF JOSEPH BORG, PRESIDENT, NORTH AMERICAN SECURITIES
ADMINISTRATORS ASSOCIATION
Mr. Borg. Thank you, Chairman Reed. On behalf of NASAA, I
appreciate the opportunity to testify on the merger, and I plan
to focus my comments on the element of this hearing's title,
that is, working toward improved regulation.
Today, 100 million Main Street Americans buy and sell
securities locally through their State-licensed brokers, but as
a whole, the financial service industry itself has become
increasingly more global in scope. A merger of certain self-
regulatory functions does make sense. We hear a great deal
about regulatory efficiency, including the recent three capital
markets reports. But we must remember that efficiency at the
expense of effective regulation is not in our national
interest. Our markets will remain strong if our shareholders
and investors are confident that, in cooperation with Federal
and State regulators, their brokers and the capital markets
will be adequately policed by the new SRO.
Scaling back a system of regulation that has vigorously
protected U.S. investors for decades could have profound and
costly consequences. So while streamlining current rules and
regulatory structures may create some savings and efficiency,
the needs of investors must come first. With one less regulator
dealing with the public, State securities regulators urge the
new SRO to demonstrate that any rule changes they propose will
protect investors from fraudulent and manipulative acts and
practices.
In review of the NYSE's harmonization proposal, we have
concerns that the new rules will favor the interests of member
firms over the adoption of provisions that protect investors.
My written testimony contains several examples which, taken as
a whole, appear to reflect a trend to weaken certain rule
provisions. This is of great concern to us. Rules harmonization
must offer the greatest investor protection, not the least.
This new SRO must be tough and effective and willing to make
hard decisions that, in all likelihood, will not be popular
with its members. In the past, the NASD has been under great
pressure not to embrace some initiatives that serve investors'
interests when its members raised objections.
For example, the NASD received pressure when it proposed
revisions to its public disclosure system that reveals the
disciplinary history of stockbrokers. Initially, its proposal
to the SEC included the enhanced disclosure of certain
disciplinary history on BrokerCheck. Various NASD members
opposed the disclosure of this information. Subsequently, the
NASD amended its proposal and removed the enhanced disclosure
that the industry found objectionable. The entire disciplinary
history is available from State regulators, and it is an
essential tool for investors when deciding who they are going
to trust with their life savings. The NASD should match State
regulators and make the complete history publicly available.
On another subject, NASAA has been at the forefront of
trying to make certain the securities arbitration system is
fair and transparent to all. The NASD and NYSE dispute
resolution forums, although similar, have different rules,
procedures, and administrative practices. The new SRO will be
the exclusive arbitration forum. That raises the stakes for
getting it right.
As long as arbitration panels include a mandatory industry
representative of the securities industry and include public
arbitrators who maintain significant ties to the industry, the
arbitration process will be both perceptively and fundamentally
unfair to investors. NASAA urges the removal of the mandatory
industry arbitrators from the process and for public
arbitrators to have no ties with the industry. This change will
bring greater fairness to securities arbitration and instill
greater confidence in retail investors that their complaints
will be heard in a fair and unbiased forum.
State securities regulators often hear directly from
investors, and it is important to allow NASAA to be an official
observer at the National Arbitration and Mediation Committee,
called the NAMC. These meetings is where it occurs that the new
SRO will address arbitration rules and procedures.
The merger of the two SROs will impact State securities
regulation, and there must be consultation between the entities
involved and NASAA before relevant rule proposals and notice to
members are announced.
As referenced in my written statement, there have been
instances of proposed rulemaking by NASD that would
significantly affect State regulation done without
consultation. We believe advanced discussion will generate
further efficiencies and streamlining in the development of the
new SRO rules.
Currently, the SROs each have surveillance and enforcement
programs. Consolidation may result in a less effective
enforcement regime if not handled carefully. The following
questions must be addressed if the merger is to serve the
public's need for strong enforcement:
Will the new entity embrace an aggressive enforcement
philosophy that protects the public as effectively as possible
from abuses in the securities markets, both in the short and
long term?
Will the new entity allocate sufficient monetary and staff
resources to ensure that its unified enforcement program is at
least as robust as the two current programs that the NASD and
NYSE currently operate?
And will the new entity work cooperatively with State
securities regulators on enforcement matters?
In conclusion, a strong and effective regulatory structure
requires preserving the authority of State securities
regulators, it requires a strong SEC, and it requires a tough
SRO for efficient compliance. It takes all three working in
equal partnership to maintain investor confidence in the
world's deepest and most transparent markets.
I believe investors deserve a regulatory system that
commands and deploys the resources, expertise, and philosophy
necessary to vigorously enforce securities laws and maintain
fair and transparent capital markets. State securities
regulators are committed to working with Congress, the SEC, and
the new SRO to ensure that our Nation's investors continue to
prosper in a regulatory environment that provides the strongest
of investor protections.
Thank you, Mr. Chairman.
Chairman Reed. Thank you very much, Mr. Borg. Thank you.
Mr. Lackritz, please.
STATEMENT OF MARC LACKRITZ, PRESIDENT, SECURITIES INDUSTRY AND
FINANCIAL MARKETS ASSOCIATION
Mr. Lackritz. Thank you, Mr. Chairman. First of all, thank
you very much for convening this hearing, and thank you also
for the opportunity to testify on the consolidation of the two
SROs. We have been strong supporters of this over the years,
and we are very pleased that this has come to fruition and
pleased that the Committee is taking an active interest in this
subject.
We have supported the single SRO because we believe it is a
win-win situation for both investors and market participants. A
single SRO will provide for far more effective investor
protection; at the same time it will ensure more efficient
regulation for market participants. It will also improve the
quality and vigor of regulatory oversight of the markets rather
than diminish it, as some of the critics have suggested.
As such, we believe the single SRO will be a significant
step forward toward improving the global competitiveness of our
U.S. capital markets as well. Nevertheless, we believe that the
single SRO can be strengthened even more. A comprehensive SRO
decisionmaking process which includes expert practitioners will
ensure that regulation deals effectively with practical
business considerations. In addition, the formation of a single
SRO provides a historic opportunity to reassess traditional
regulatory approaches so that the U.S. markets remain globally
competitive. Achieving this goal we believe will require a more
textured approach to regulation, a sound regulatory budget, and
continued SEC oversight.
We have long supported a more streamlined and effective
approach to self-regulation and are very pleased, as I
mentioned before, that this regulatory consolidation will bring
the hoped-for change in self-regulation to fruition.
With the single SRO, there will finally be one centrally
managed self-regulatory entity to oversee member firms. As
envisioned, it will become the largest private sector regulator
of our members and will have integrated technologies, a single
set of rules for broker-dealer members, one set of examiners,
and one examination strategy. It will also more effectively
focus existing resources on substantive investor protection at
both the SRO level and the broker-dealer level.
For this historic restructuring to reach its full
potential, the single SRO should engage in meaningful and
regular interaction with all stakeholders throughout the
rulemaking process. Consultation with industry participants on
the front lines of the marketplace is critical to developing an
understanding of the practical implications and the potential
burdens that rules may have on the firms to which they are
applicable. This model of regulator-industry partnership yields
smarter, more effective regulation. It also allows our
regulatory system to be dynamic, informed, and responsive to
our rapidly evolving and highly complex financial markets.
Of particular interest to our members is the regulatory
philosophy that will undergird the single rule book. The
question is whether the single SRO should adopt a principles-
based versus a rules-based approach to regulation. A
principles-based approach to regulation involves a regulator
moving away, where possible, from prescribing how a firm should
reach a desired regulatory outcome. This approach considers
first whether firms supplemented by guidance, as appropriate,
could assume the responsibility to achieve the desired outcomes
in the context of their business processes and existing
supervisory obligations. We suggest that a paradigm whose
foundation is more clearly based on principles and the
achievement of outcomes tied to those principles may better
serve investors and its constituent firms.
As part of this rules review, we also encourage the single
SRO to create a culture in which its surveillance,
examinations, and enforcement efforts take into account the
different purposes of the rules and address violations
accordingly. The examination and enforcement process should
incorporate some sense of proportionality. In a world of
limited resources, the goal of any regulatory budget must be to
ensure that each dollar is spent in the most effective manner.
At the same time, fees for regulation should be apportioned to
the industry on a fair and reasonable basis. We recommend that
the consolidated regulator be required to define the costs
necessary to meet its self-regulatory obligations, prepare and
make public a budget to meet those obligations, and then fairly
apportion those costs among members by making periodic filings
with the Commission subject to public notice and comment as
well as Commission approval. Regulatory funding for the
consolidated SRO should come from regulatory fees assessed on
market participants, including broker-dealers, issuers, and
other constituents of the trading markets.
One risk of the single SRO is that it concentrates
regulatory power and authority in one entity. Therefore, it
will function effectively only if the SEC provides attentive
oversight of its activities. We look to the SEC to develop
increased transparency requirements for the consolidated
regulator, particularly concerning funding and budgetary
issues. Making the regulator's operations transparent to both
members and the investing public will place appropriate checks
on the single SRO and will enhance accountability to its
constituents.
Our securities markets are strong, and our robust
regulatory system plays a critical role in our markets'
success. To retain that strength, we must remain vigilant about
removing unnecessary regulatory inefficiencies, particularly in
light of increasing global competition. We are here to work
with you, Mr. Chairman, the Congress, the SEC, the SROs, and
all other interested parties to ensure that our markets remain
transparent, liquid, and dynamic, with unparalleled levels of
investor protection.
Thank you very much.
Chairman Reed. Thank you very much, Mr. Lackritz.
They have just called the vote. Professor Coffee, the
timing is pretty good because your testimony, we will take it
now, and if you will indulge me, I will recess for a moment,
vote, and come back, and we will have the rare opportunity of
questioning three experts alone.
Professor Coffee.
STATEMENT OF JOHN COFFEE, ADOLF A. BERLE
PROFESSOR OF LAW, COLUMBIA LAW SCHOOL
Mr. Coffee. I will be as brief----
Chairman Reed. No, no. Take 5 minutes, at least.
Mr. Coffee. My basic message is that the idea of a sole
consolidated regulator is an idea whose time has come. It is
efficient. There will be economies. There will be a stronger
regulator.
Chairman Reed. Can I ask you to bring the microphone up
closer?
Mr. Coffee. I think there are numerous efficiencies, and I
think this idea of consolidation is inevitable. But there is
one remaining question, and that is the effect of this
consolidation on investor protection. I think here the outcomes
are uncertain, and I think that these problems can be corrected
with some fairly modest tinkering that does not jeopardize the
idea of a merger of these two regulators.
My concern is simply that this new consolidated SRO is
vulnerable to industry domination because 10 of its originally
23 and ultimately 22 members will come from the industry. This
is in sharp contrast to what has been done recently across the
board of exchange regulation.
You have already heard the example I will give you of the
New York Stock Exchange which has an entirely independent
board. Now, notice, the New York Stock Exchange is a business.
We are talking about this new regulator which is essentially
going to be a quasi-judicial body. What it is going to do is
bring prosecutions, hear cases, hear appeals. That is
essentially a judicial or prosecutorial kind of role, and
historically the standards of independence, integrity, lack of
conflict of interest have always been higher for judicial
officers than they have been for corporate directors or
businessmen generally. So I am suggesting the specialized
nature of this body requires a higher rather than lower
standard of independence and protection from industry
domination.
I fully recognize that the statute says that on the board
of an SRO there has to be fair representation being given to
the industry. The SEC has historically said that that level of
fair representation is satisfied by 20-percent representation.
Here we are talking about 10 out of 22. That is effectively 40
to 45 percent. I think giving representation but at a smaller
level, a smaller percentage, would do more to protect the
interests of investors, and I want to give you some examples.
I am going to be met with the argument, I know, that there
will be 11 public Governors as opposed to 10 industry
directors. I think there are three things to say in response to
that.
One is that the standards are wholly unspecified as to what
these public Governors have to be, what level of independence
they have to have. They may come from the public, but they
could have all kinds of conflict of interest, and we are not
told that they even have to meet the level of independence that
a New York Stock Exchange director has to meet.
Next, they will be initially appointed by the boards of the
New York Stock Exchange and the boards of the NASD. Frankly, I
think these will be fine, excellent, competent people, but they
are not going to be industry activists, enforcers, people who
have a specialized interest in the world of enforcement. I
think they are going to be reasonable business people, but,
again, they will be not organized, not cohesive, and they will
have to face ten Governors coming from the industry, who will
be elected by constituencies, very small constituencies, that
will want loyal agents protecting their interests. And I think
they have some interests, they need to be protected, and they
will be against a somewhat diffuse, disorganized group of ten
public Governors, who will necessarily have divergent
perspectives because they are not a unified force.
Now, what are my specific concerns? Again, I am not
suggesting that somehow the industry Governors will intervene
to stop prosecutions or to reduce penalties. I am suggesting it
will be subtler kind of influence. Let me give you two
examples.
One is our system of securities arbitration. There are many
today who believe, including myself, that this system is
somewhat ineffectual, somewhat cumbersome. As you may be aware,
Senators Leahy and Feingold have recently written the SEC
asking that securities arbitration no longer be made mandatory
by the industry. I frankly do not see that happening. Even if
it did happen, we would still need to reform absolutely because
the average investor must rely on it and cannot find an
attorney that he can afford to hire in most securities
disputes.
That is a world where I cannot believe that the current
system of arbitration will be reformed if we have something
like 45 percent of the directors coming from the industry. The
No. 1 problem today in securities arbitration is the presence
of one industry representative on every panel. Gretchen
Morgenson of The New York Times wrote just 2 weeks ago that
having that industry representative on the panel is the
equivalent of having a police officer on every jury hearing a
police brutality case. It does affect the dynamics. It may well
be the other two override and outvote that industry member, but
they may compromise on the penalty or the damages and give a
lesser sanction.
This is an area where I think some serious attention has to
be given to securities arbitration because we are now
consolidating two systems into one, and I do not think in this
process we are going to get significant reform with the level
of industry control over the process. That is example one,
securities arbitration, where I think the industry will have
too much influence.
Example two is the harmonization of the two rule books. We
all understand that harmonization is a good idea and we want it
to happen, but the two rule books differ, and in some areas one
rule book gives more protection to investors than the other.
Anytime you harmonize, you can level up or you can level down.
Given the domination of industry members and the diffuse nature
of the public Governors, I think there is a significant danger
that the rule book will be leveled down rather than leveled up.
There are really significant differences, such things as
old as the ``know your customer'' rule of these two bodies, and
if we want the stronger one, I think we need to have some SEC
oversight.
So, in substance, I am suggesting to you that this merger
should be encouraged, but it would work better if we reduced
the level of industry representation from ten Governors to
something like five Governors, and I think that both this
Committee and the SEC has to exercise very close oversight over
the harmonization of these rules, and I would submit also that
this Committee should ask the SEC to conduct a long, overdue
study of the efficacy of securities arbitration. Can it be made
better? Is it fundamentally fair? We cannot expect that the
industry itself is going to change something that will be very
costly to the industry if it is significantly reformed.
Thank you.
Chairman Reed. Thank you very much, Mr. Coffee. And if you
would grant me the opportunity to go vote, which is part of my
job, we will recess for approximately 10 minutes, no more, and
I hope less. And I will return, and I look forward to an
opportunity to ask you questions. Thank you for your testimony.
We stand in recess for approximately 10 minutes.
[Recess.]
Chairman Reed. The hearing will resume, and again, thank
you, gentlemen, for your excellent testimony. I think you have
raised many issues--in fact, common themes I think in all the
testimony. But let me begin with one that Mr. Borg raised and
that also I think was echoed by both Mr. Lackritz and Mr.
Coffee.
We understand there is a savings in terms of streamlining
efficiencies, but when you go from two regulators to one
regulator, you lose what some people call ``regulatory
competition,'' where regulators will see things that the other
does not, and there will be a sharing of information.
So if you want to elaborate on this notion, Mr. Borg, and
elaborate further, Mr. Lackritz, then Mr. Coffee.
Mr. Borg. Thank you, Mr. Chairman. With regard to combining
regulators, you can streamline and you can add resources and
whatnot, but, you know, two eyes are usually better than one.
The old example of two folks watch a car accident; they see
things, one does not. Streamlining makes sense, especially if
you are at the 20,000-foot level, but from an investor on Main
Street, somebody has got to take care of that investor. We are
afraid, to some extent, that by raising the bar to 20,000 feet,
or whatever level it is going to be, there is going to be less
look-see at the lower level.
Now, we have looked at the testimony from Mary Schapiro and
Rick Ketchum, and they seem to indicate that that is not going
to happen. Our concern is, OK, let's make sure we understand
what these problems are and make sure that there is a way to
fix it. We are not against the consolidation. We think it has
merit. And like Professor Coffee said, it has just some
concerns we have got to work out.
With regard to the fees and structures that we heard, I
heard a little inconsistency, I thought, a little earlier in
that there will be a reduction in costs and yet they are going
to reduce fees. Nowhere did I hear but let's put it toward
investor protection and make sure we maintain or heighten that
ability. So I am a little concerned about that, and it is in
our written testimony.
Other areas about putting two regulators together, again,
has to do with big organizations have a tendency to go in one
direction. There is a format, there is a process, and sometimes
when you have multiple regulators, you come at it from
different directions. When we work with the SEC--or the NASD,
for that matter--we bring a different sort of focus than they
do. My office is not as technically savvy as market
surveillance in New York, but I understand investors and how
the frauds work on the ground probably better than most.
So we lose a little bit of that. That is why our testimony
is geared that as this process goes forward, there has got to
be terrific and great amount of interaction between NASAA
members and the new SRO as they form the rules. Let us make
sure we are covering all the bases. We can help them do that,
and I think that is the important factor here.
Chairman Reed. I would presume that as these rules are
promulgated for notice and comment that your organization would
participate very actively. Is that fair?
Mr. Borg. We will, but we think it is more efficient if we
act in concert with them on the front end before they propose
the rules. Then we have got to go through the process of
responding to the rules. Then they have got to pull them back
and start all over.
It makes sense that if NASAA is on the front end of any new
SRO rules that come out, we can avoid having to miss a few
things because we look at it from a different perspective.
There is an example of that in our written material
specifically to that point.
Chairman Reed. Thank you.
Mr. Lackritz, your comments on this notion of regulatory
competition, you know, going from two to one, and one set of
eyes rather than two.
Mr. Lackritz. Sure. One person's competition is somebody
else's duplication, and I think here we should be focusing on
effectiveness, not necessarily whether it is competition or
not.
Multiple pairs of eyes miss lots of things. Single pairs of
eyes that are well trained, well qualified, highly
professional, and have some experience and history in the
process are actually much more effective, I would think, longer
term.
If you look from the standpoint of how many different
layers of regulation securities firms are subject to, it is
extraordinary. We have not only the SEC and we have self-
regulatory organizations; we have State regulators as well. And
so by eliminating one extra duplicate layer of self-regulation,
what you are going to do with the single SRO is to improve the
quality of the examination. You are going to improve the
examination strategy and the technology that goes into it. And
we think actually that will improve the quality of investor
protection. It will not diminish it whatsoever.
So we think it becomes a question of duplication rather
than competition.
Chairman Reed. And this goes, I think, to the point you
made in your testimony about that these savings have to be
reinvested in investor protections in a public fashion. Is that
a fair point that you made in your----
Mr. Lackritz. Well, we think----
Chairman Reed. Somebody's statement, I should say.
Mr. Lackritz. We think, first of all, that there is some
significant savings, which are good for investors as well as
good for the industry, and as they go through this process--
they have already identified a big chunk of that, I think. It
is shown in the governing bylaws, the proxy statement. And as
it goes forward, I think it is important to make sure that the
SEC stays involved to assure that there is no diminution in
investor protection.
Chairman Reed. Professor Coffee, the same question, and
sort of the flip side of regulatory competition between
regulators with two sets of eyes as regulatory arbitrage or
someone----
Mr. Coffee. This is a unique moment because I agree with my
colleague Mr. Lackritz here. I do not think this is the normal
kind of regulatory competition where two is better than one.
The New York Stock Exchange does have a residual conflict of
interest. If it continued to run New York Stock Exchange
Regulation, it would often be regulating and overseeing its
competitors, and that is an unhealthy set of circumstances.
Thus, it is desirable that its regulatory enforcement arm gets
moved into a more independent body. The NASD, having sold off
its interest in Nasdaq, has no conflict, and I think we improve
the caliber and at least the perceived integrity of the
process.
Next, I also agree with the point that there is not going
to be just one regulator. There are going to be three levels of
regulation. There is going to be the SEC, which never steps
aside. In a big fraud, it is always there first. Then there is
going to be this coordinated SRO. Then there are going to be
the States, sometimes 50 of them. That is multiple layers of
regulation that still remain, so I do not think we are going to
have a monopolistic situation here at all.
Chairman Reed. One of the issues I want to ask all of you,
but start with you, Professor Coffee, because you raised it in
your testimony, is the issue of independence. It is
independence not only in terms of, as you suggest, the subtle
ways in which the Board might operate, but also NASD itself has
a large portfolio of over $2 billion in assets. They have to
make arrangements to have that independently regulated. So can
you comment on independence from several different
perspectives?
Mr. Coffee. Yes. I would look at what happened when the New
York Stock Exchange set up NYSE Regulation, and there at the
last moment, at the same last moment we are now at, the SEC
intervened and changed the balance slightly to make sure there
was more of a public influence and that the New York Stock
Exchange had less control over the directors of New York Stock
Exchange Regulation.
So I still think this merger can go forward without any
major hitch, but I think there can be an adjustment, reducing
the level of the industry representatives from the current 45
to a more realistic 25 percent or so, without this
fundamentally impairing the merger. If you do that, then I
think this process of integrating and harmonizing the rule book
will get done by a board that has a little bit more concern for
investor interest and a little bit less obsession with the
costs of regulation. I agree the costs have to get considered,
but I think that an organized group of ten members of a board
will make almost any CEO somewhat more cautious.
I have great respect for Mary Schapiro, but I know that
when our Founding Fathers drafted the Constitution--and we are
now drafting a Constitution for our market system--they had to
look beyond George Washington. They knew he was great, but they
had to see that there were future Presidents that might not be
quite as perfect, and there could be future heads of this new
coordinated regulator that might be less able or less committed
than Mary Schapiro, and we have to think about that. Therefore,
I want to make sure our Board is a little bit more independent
than they proposed.
Chairman Reed. Thank you very much.
Mr. Lackritz, this issue of independence, and then Mr.
Borg, because I think it is an important one.
Mr. Lackritz. Yes. First of all, Mr. Chairman, I think it
is a good question. This negotiation was a very carefully
negotiated deal between the NASD and the New York Stock
Exchange. It required the approval of our firms. I should
mention that our small firms committee endorsed this, our
regional firms committee endorsed this, and our board
aggressively endorsed this. That meant that there had to be
some representation from the industry that was part of the self
of self-regulation. Our concern in this process is to assure
that there is business expertise, background, and understanding
of what the business is about infused in this process.
And so from the standpoint of the different constituency
representations, that was very carefully negotiated in an
effort to assure that the industry could support moving away
from the previous structure. And so we think it is an important
component of the current structure. Clearly, ten people out of
23 are not going to dominate or control. They do not have the
votes. The two other members, as Rick Ketchum mentioned in the
earlier panel, we would hardly perceive of as being industry
representatives. They both have been regulators for 25 years in
their careers, and I think they bring a balanced perspective of
both industry understanding and regulatory perspective that
really does help to promote the public interest.
So we think this balance is a very good balance because it
provides a majority of the members coming from the public, ten
members from the industry. They cannot dominate that other
group. They come from different constituencies within the
industry that sometimes have different perspectives. And that
was a very fundamental part of actually getting this deal done
in the first place.
Chairman Reed. One other follow-up, Mr. Lackritz, and I
think it takes off on a comment that Professor Coffee made. The
term ``independent'' or ``public director'' is not particularly
defined. Do you think in the process of this merger going
forward that definition would help this issue of independence,
that clearly the individuals do not have any direct influence
with respect to member firms that they might regulate?
Mr. Lackritz. Well, you know, I actually take a bit of
umbrage at the notion that there is a zero sum game here and on
the one hand are investors and on the other hand is an
avaricious industry that somehow it is a zero sum game. It is
obviously not in our interest for firms, individuals, or
representatives to commit bad acts. We want to get bad actors
out of this business. Trust in our markets and trust in our
profession is the top goal of our association, and I think it
is the top goal of our industry and our industry leadership as
well.
So I would sort of reject the notion that it is a zero sum
game, that you are either an investor's advocate or you are an
industry shill, because I do not think that is accurate.
Chairman Reed. I do not think that is accurate either, but
again--and this might go to the point of what works now with
people that you know very well and respect extremely--Ms.
Schapiro and Mr. Ketchum--and I think that respect is shared by
everyone that I have spoken to.
Mr. Lackritz. Yes.
Chairman Reed. Over time those change, but also I think,
you know, maybe a clearer definition of the criteria for these
directors might help resolve this issue, or at least this
debate, and not such----
Mr. Lackritz. Sure. Absolutely. I think that having a clear
definition so that there are clear expectations certainly is
helpful. And from the standpoint of what ``public'' means, that
obviously is a fairly broad term, and so getting more
definition around that probably is a helpful thing.
Chairman Reed. Mr. Borg, your comments?
Mr. Borg. Thank you, Mr. Chairman. If the purpose of the
new SRO is investor protection, protection of the markets--
investors are the bedrock of the entire capital market of the
U.S.--I think Professor Coffee's comments with regard to
concerns about board makeup is correct and right on point.
With regard to the public Governors of the new board,
undefined as it is, it is hard for us to make a determination
whether it would be fair or not. Is this going to be CEOs of
the major firms who have an interest in stock options and
things of that nature? Or is this going to be members of the
100 million investing public who have maybe something to say
about this? Or is it going to be folks who have experience in
enforcement? Who are these public Governors?
I think that is what Professor Coffee was getting to, and I
think that is the concern we share. And, therefore, we pretty
much join in Professor Coffee's concerns.
Chairman Reed. Thank you very much.
There is another issue that was raised in the first panel,
and I think I would like your advice and opinion also. That is,
is there sufficient legislative authority for this new model of
regulation, a single SRO? Are there things that we should be
doing? Ultimately, I think the results of this Committee's
deliberations are suggesting if necessary--it may not be, but
if necessary, legislative changes would be appropriate.
Professor Coffee, let me start with you and then go down.
Any suggestions?
Mr. Coffee. I cannot say that there is clearly inadequate
authority. What I can say is that there is this very cloudy
decision in the D.C. Circuit, the Business Roundtable case,
that cut back on the New York Stock Exchange authority to adopt
a rule, a one-share/one-vote rule, because it interfered with
State corporate governance. I think there are areas where the
rules of the SRO will affect things like proxy contests,
director nominations, or broker votes. Broker votes is a very
important part in its regulation of industry members.
There will be arguments made by many law firms in this city
that anything that the SRO does that differs at all with State
law invades the province of State law. Maybe the courts will
agree, maybe they will not, but you would forestall future
litigation and future uncertainty if you added some clarifying
words, making it clear that there was the full power to create
investor remedies, to have control over arbitration, and to
otherwise structure a system that did achieve the purposes of
self-regulation.
Chairman Reed. Thank you.
Mr. Lackritz, your comments?
Mr. Lackritz. Yes, Mr. Chairman. I think we do not believe
at this point that you need additional legislative authority in
this area. You have oversight authority of the SEC. The SEC has
direct oversight authority of the SRO and the consolidation. So
from that perspective, we think you have ample authority and
would urge you to stay involved in the oversight of this
process to assure that the public interest is well served here.
Chairman Reed. Mr. Borg?
Mr. Borg. As the first panel mentioned, this is a new
model; it is a new hybrid. It is going to be a moving target.
The initial impression seemed to be that things are in
place to make it work if the criticisms and the comments that
have been aired today are taken seriously. I think what we are
going to find is that there may be some unforeseeable issues
that may require in the future another look-see. And I would
just say let us keep an open mind on that issue and let us see
what may be needed down the road, because if it is a new model
and it is a new car that needs to be tested, you never know
when you have to make a tweak to the power steering or the
brakes. So we will just have to see how it goes.
From NASAA's point of view, that is what we intend to do,
is to make sure that we keep an eye on things and bring to the
attention of yourself and those appropriately to let them know
when we see something that may be going awry. The key is let us
make sure we are all involved, and that would include Mr.
Lackritz at SIFMA, NASAA, you know, our good friends, like
Professor Coffee, who have great knowledge in this area. And
let us make sure we are all in the dialog together up front.
Chairman Reed. Well, thank you very much. I think that is a
good point at which to conclude the hearing.
I want to thank you all for excellent testimony and your
insights into a very important process. One area that we did
not get a chance really to go into in detail is that in this
globalized market, this could be a template for a lot of other
not only national approaches, but perhaps even international
approaches of self-regulation and dealing with a global
securities market.
I would for the record indicate that some of my colleagues
might have written questions that they might submit to you. I
would ask you to respond in a very appropriate time to these
requests. And I appreciate your time and your patience, and
thank you very much.
The hearing is adjourned.
[Whereupon, at 4:42 p.m., the hearing was adjourned.]
[Prepared statements and responses to written questions
supplied for the record follow:]
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
RESPONSE TO WRITTEN QUESTIONS OF SENATOR DODD FROM ERIK SIRRI
Q.1. Chairman Cox said on November 28, 2006 that the
combination of the NASD and NYSE Regulation ``done properly . .
. could make our self-regulatory system more efficient and more
robust from an investor protection standpoint.''
Mr. Mark Lackritz's testimony stated that the combined
regulator ``will function effectively only if the SEC provides
attentive oversight of its activities.'' SIFMA also called for
``the SEC to develop increased transparency requirements for
the consolidated regulator, particularly concerning funding and
budgetary issues.'' Professor John Coffee's testimony stated
that ``greater SEC . . . oversight seems desirable'' and the
SEC ``should be informed as to the SRO's planning, priorities,
and internal policies.''
A. Will the SEC staff formally review in advance the
proposed budgets of the combined SRO with a view to assessing
regulatory priorities, how monies are allocated to different
functions, compensation levels, and other matters on a periodic
basis?
B. What benefits could inure to the Commission, to
investors and to others from such oversight?
A.1. SROs that are national securities exchanges and national
securities associations are required to supplement their
registration forms by annually filing financial information
with the Commission. The combined SRO would be required to
file, as NASD does currently, an annual consolidated supplement
to the NASD's registration as a national securities
association. This supplement must contain annual financial
statements for the preceding year, including the balance sheet
and an income and expense statement. Commission staff currently
reviews the financial information that SROs file each year as a
supplement to their registration forms.
SROs are not required to submit their proposed budgets to
the Commission and, as a result, Commission staff does not
review the proposed budgets of SROs. However, as part of the
Commission's exercise of oversight responsibility over SROs,
Commission staff periodically meets with SROs and at that time
discusses the SROs' plans and priorities. During such meetings
with a SRO, Commission staff may inquire about the adequacy of
the resources devoted to the SRO's regulatory programs and the
SRO's capacity to carry out the purposes of the Exchange Act. I
expect that Commission staff would hold similar meetings with
the combined SRO, if the proposed By-Law changes are approved
by the Commission.
Benefits may inure to the Commission, to investors, and to
others as a result of the Commission's oversight of a combined
SRO. Investors may benefit to the extent that Commission
resources that have been used to examine the two SROs can be
redeployed to address other areas of concern. Member firms may
benefit because of the increased efficiencies, and lower
regulatory compliance costs, of a single member SRO. The
Commission may benefit because, instead of conducting separate
inspections of the NASD's and NYSE's examination, enforcement
and surveillance programs, the Commission staff would be able
to focus its resources on ensuring that the single, combined
SRO effectively regulates member firms. This, I believe, is a
more efficient use of the Commission's resources.
Q.2. Professor John Coffee testified that ``Greater
transparency also seems necessary, including with respect to
compensation of senior executives.'' Transparency in executive
compensation has been a significant regulatory focus recently
of the SEC, with its new rules that require registrants to
provide more extensive annual disclosure of executive
compensation.
While a self-regulatory organization is not a public
company, do you feel it would be appropriate for the combined
self-regulatory organization to publicly disclose executive
compensation for the benefit of its members and investors?
A.2. There currently is no requirement that SROs disclose the
compensation of their senior executives, unless they happen to
be public companies. However, several SROs (e.g., NYSE, Nasdaq,
and ISE) are subsidiaries of holding companies that are public
companies or are tax-exempt organizations (e.g., NASD), and
therefore the compensation of the highest paid executives of
the holding company or tax exempt organization would be
publicly available. Transparency by the combined SRO regarding
executive compensation could foster good governance, and broad
dissemination of this information could benefit investors.
Q.3. The SEC performs an analysis of the competitiveness impact
of its proposed rules pursuant to Section 23(a)(2) of the
Exchange Act. Professor John Coffee in his testimony
recommended that ``the new SRO, even if not legally required to
do so, should conduct a cost/benefit analysis of its rules.''
What would you see as the benefits and costs of requiring
the new self-regulatory organization to perform a cost-benefit
or competitiveness analysis of its proposed rules?
A.3. SROs currently are required to provide a statement on any
burden on competition a proposed SRO rule may impose when the
SRO files a proposed rule change with the Commission.
Specifically, when filing a proposed rule change with the
Commission, a SRO is required to state whether the proposed
rule change will have an impact on competition and, if so, (i)
state whether the proposed rule change will impose any burden
on competition or whether it will relieve any burden on, or
otherwise promote, competition and (ii) specify the particular
categories of persons and kinds of businesses on which any
burden will be imposed and the ways in which the proposed rule
change will affect them. The SRO also must explain why any
burden on competition is necessary or appropriate in
furtherance of the purposes of the Exchange Act.
In addition, any proposed rule change by the combined SRO
must provide a statement on the statutory basis for the
proposal, which must be sufficient to support a finding that
the proposed rule change is consistent with the Exchange Act
and the rules and regulations thereunder applicable to the SRO.
Furthermore, Section 3(f) of the Exchange Act requires the
Commission, in reviewing an SRO's proposed rule change, to
consider whether its action will promote efficiency,
competition, and capital formation. I believe that these
requirements are appropriate.
Q.4. The North American Securities Administrators Association
in its testimony warned that ``efficiency at the expense of
effective regulation is not in our national interest'' and
asked that the SEC ``to require the NASD and NYSE Regulation
[to] demonstrate that any rule changes they propose will
protect investors and the public interest, promote just and
equitable principles of trade, and prevent manipulative acts
and practices.''
How would you respond to the merits of this request?
A.4. The Exchange Act requires that the rules of a SRO be
designed, among other things, to prevent fraudulent and
manipulative acts and practices; to promote just and equitable
principles of trade; to remove impediments to and perfect the
mechanism of a free and open market and a national market
system; and, in general, to protect investors and the public
interest. In this regard, the Commission adopted rules that
require that an SRO's filing relating to proposed rule changes
be sufficiently detailed and specific to support a finding by
the Commission that the proposed rule change is consistent with
the requirements of the Exchange Act and the rules and
regulations thereunder applicable to the SRO.
I agree with the statement that ``efficiency at the expense
of effective regulation is not in our national interest.'' NASD
and NYSE Regulation have publicly stated that the proposed
regulatory merger would make self-regulation more effective and
efficient, while also reducing the risk that fraud occurring in
multiple markets would fall between the regulatory cracks. A
number of commenters believe that these benefits would help
strengthen investor protection and market integrity. Commission
staff currently is evaluating the proposed consolidation so I
cannot comment on how the Commission will act. However, I can
assure you that the Commission takes seriously its mission to
protect investors, maintain fair, orderly, and efficient
markets, and facilitate capital formation.
Q.5. The North American Securities Administrators Association
in a letter dated February 12, 2007 to SEC Chairman Cox, said,
``arbitration panels must be unquestionably neutral. As long as
arbitration panels remain comprised of a mandatory industry
representative and public arbitrator who maintain significant
ties to industry, the process is fundamentally unfair to
investors.''
NASAA recommended in its testimony ``the removal of
mandatory industry arbitrators from the arbitration process and
for public arbitrators to have no ties to the industry. This
change will bring greater fairness to securities arbitration
and instill greater confidence in retail investors that their
complaints will be heard in a fair and unbiased forum.''
How has the Commission responded to NASAA and its concerns
expressed in the February letter? How do you plan to address
the concerns raised by NASAA about arbitration?
A.5. The Commission is considering NASAA's letter to Chairman
Cox, along with the other comments it received, as it considers
whether to approve NASD's changes to its by-laws. By way of
background, currently, both NASD and NYSE arbitration panels
include one ``non-public'' and two ``public'' arbitrators, one
of which serves as the panel chair. Smaller cases are heard by
a single public arbitrator in both forums, although the
thresholds for what constitutes a small case differ. NASD has
stated that it is working with NYSE to harmonize their
definitions of ``public'' and ``non-public'' arbitrators. Any
resulting proposed rule changes would be filed with the
Commission and subject to public comment at that time.
Q.6. William Glavin, Secretary of the Commonwealth of
Massachusetts, in a letter published in the Wall Street Journal
on December 11, 2006, called for an examination of ``Whether
the boards of directors of self-regulatory organizations (like
the NASD and the stock exchanges) adequately represent small
investors.''
How would you respond to Secretary Galvin's concerns? Will
the combined self-regulatory organization's board adequately
represent small investors, even though no board member is
specifically designated to be drawn from or represent this
group?
A.6. The ``fair representation'' provision of the Exchange Act
requires that an SRO's board include one or more
representatives of issuers and investors. This statutory
provision, however, does not require that a representative of
small investors be on an SRO's board. Under NASD's proposed By-
Law changes, eleven of the 23 Governors of the combined SRO
would be required to be Public Governors. Because no Public
Governor could have a material relationship with a broker or
dealer or other SRO, NASD has stated that these Public
Governors would fulfill the role of representing investors and
issuers.
Q.7. Professor Coffee in his testimony discussed concerns about
the board structure of the combined regulator. He observed that
``Public Governors'' would not be required to ``satisfy the
same independence standards that the NYSE mandates for
directors of a publicly held corporation. Thus, persons
affiliated with law or consulting firms serving the securities
industry might populate even these minority positions.''
A. Please comment on Professor Coffee's observation about
``Public Governors.''
B. What standards will the SEC employ in reviewing the
proposed composition of the Board of the combined regulator?
A.7. The proposed board structure of the combined SRO is not
dissimilar to the governance structures approved by the
Commission for other SROs. Specifically, the combined SRO's
proposed definition of Public Governor is comparable to the
definition of Public Governor or Independent Director contained
in the governing documents of other SROs. In addition, the
definition proposed for the combined SRO is substantially the
same as the definition of Public Director that is in the NASD's
current By-Laws, in that the definition of a Public Governor
would preclude such a Governor from having a material
relationship with a broker-dealer or an SRO. In other words,
significant relationships, monetary or otherwise, would be
precluded.
In terms of the NYSE's definition of Independent Director,
NYSE has a more detailed independence policy than other SROs.
However, the Commission has not required every SRO to adopt the
NYSE's approach, which is modeled on the governance standards
that NYSE has in place for its own listed issuers. I expect
that there may be less concern about conflicts of interest for
the proposed combined SRO, which would be a not-for-profit
regulator, unlike other SROs that operate markets, such as the
NYSE.
Because the proposed By-Law changes are pending before the
Commission, I hesitate to offer views that may in any way
prejudge the Commission's action on this important matter.
However, I can say that, in reviewing the proposed
composition of the combined SRO's board, the Commission is
required to consider whether the changes are consistent with
the statutory requirements set forth in the Exchange Act,
particularly the fair representation requirements of Section
15A(b)(4). This statutory provision requires that the rules of
a national securities association assure the fair
representation of its members in the selection of its directors
and administration of its affairs, and provide that one or more
directors will represent issuers and investors and not be
associated with a member of the exchange, broker, or dealer.
The Commission also is required to consider whether the
combined SRO would be so organized and have the capacity to
carry out the purposes of the Exchange Act and to enforce
compliance by its members and persons associated with its
members with the provisions of the Exchange Act, including
those provisions relating to investor protection and the
prevention of fraudulent and manipulative acts and practices.
Q.8. The combination of the self-regulatory organizations will
result in the NYSE rules and NASD rules being transformed into,
as you testified, one ``uniform set of rules.'' The North
American Securities Administrators Association in its testimony
raised concerns ``that harmonization does not compromise
investor protection standards.'' NASAA raised a concern that
``the rule harmonization project will favor the interests of
members firms of the newly Consolidated SRO over the adoption
of provisions that protect investors.'' NASAA cited several
instances in which it said the New York Stock Exchange has a
stronger investor protection rule than the NASD but is
proposing that its ``rules will be amended to facilitate
harmonization with less stringent NASD requirements.''
Columbia University Law Professor John Coffee in oral
testimony pointed out that ``in some areas one rule book gives
more protection to investors than the other. Anytime you
harmonize, you can level up or you can level down. Given the
domination of industry members and the diffuse nature of the
public governors, I think there is a significant danger that
the rule book will be leveled down rather than leveled up.
There are really significant differences, such things as old as
the `know your customer' rule of these two bodies, and if we
want the stronger one, I think we need to have some SEC
oversight.''
A. How would you respond to NASAA's concerns?
B. How would you respond to Professor Coffee's concerns?
C. In connection with the harmonization of rules, what
standards would govern the Commission staff analysis and the
recommendations that the staff would make to the Commission
regarding self-regulatory organization rule proposals that
would reduce the protections that some investors currently
receive?
A.8. When the Commission considers proposed rule changes by
SROs, I believe that it is crucial that investor protection
standards not be compromised. Because no harmonized rules have
yet been submitted for Commission consideration with respect to
the combined SRO, I am unable to speak about specific rules. I
expect that it may take the combined SRO approximately one year
to complete the harmonization process. I can assure you,
however, that, as with all SRO rule changes, the Commission
will carefully review the proposed harmonized rules when they
are filed, including ascertaining how they compare to current
NASD and NYSE rules. The Commission also will consider comments
received from interested persons.
The Commission's analysis of the harmonized rules will be
governed by the requirements set forth in the Exchange Act.
These requirements provide that an SRO's rules be designed,
among other things, to prevent fraudulent and manipulative acts
and practices; to promote just and equitable principles of
trade; to remove impediments to and perfect the mechanism of a
free and open market and a national market system; and, in
general, to protect investors and the public interest.
------
RESPONSE TO WRITTEN QUESTIONS OF SENATOR REED
FROM ERIK SIRRI
Q.1. The SEC and others have noted that some rules cannot be
easily categorized as either a member or market rule. What
challenges do NASD and NYSE Regulation face in separating
member and market rules? How might such challenges hamper their
ability to effectively regulate members and markets separately?
A.1. I agree that some rules cannot easily be categorized as
either a ``member rule'' or a ``market rule.'' For example,
rules relating to order handling have components that are
related to member firm regulation and components that are
related to market surveillance. Similarly, in connection with
investigations of trading rule violations (a market
surveillance function), SROs may examine the quality of
supervision by the member firm (a member firm regulation
function).
During the process of categorizing rules as ``member
rules'' or ``market rules,'' the NASD and the NYSE may face
difficult judgment calls. However, I do not believe that there
are any insurmountable challenges. Indeed, my understanding is
that the NASD and the NYSE have completed a review of the
NYSE's rules to determine which rules should be ``member
rules'' and which should be ``market rules.'' The Commission
will review the NASD's filing that identifies the ``member
rules,'' including the judgment calls made by the NASD and the
NYSE.
If the Commission approves the NASD's filing that
identifies the member firm conduct rules, it will be clear as
to which SRO will have oversight responsibility for a
particular rule because such rules will be clearly enumerated
in the combined SRO's rules. Thus, I do not believe that the
NASD's and NYSE Regulation's ability to effectively regulate
members and markets will be hampered.
Q.2. In its concept release on self-regulation, SEC identified
several ways in which the current SRO structure could be
modified but recognized that each has its advantages and
disadvantages.
What do you view are the principal advantages and
disadvantages of the proposed regulatory merger in terms of
both regulatory efficiency and effectiveness?
How will you measure efficiencies gained and the SRO's
effectiveness in ensuring proper regulatory oversight?
What are the principal factors the SEC is weighing in
deciding whether to approve the NASD by-law changes required
for the merger? Furthermore, what factors will be considered
for reviewing and approving a single rule book while ensuring
market competitiveness and strong investor protections?
A.2. The principal advantages of the proposed regulatory
consolidation include the elimination of today's duplicate
member rulebooks and the possibility of conflicting
interpretations of those rules. The consolidation also would
result in firms dealing with only one group of examiners and
one enforcement staff for member firm regulation. In addition,
consolidation could reduce the risk that fraud occurring in
multiple markets could fall between the regulatory cracks. All
of this could reduce unnecessary regulatory costs while, at the
same time, increasing regulatory effectiveness.
I believe that the principal disadvantages of the
consolidation would be temporary. During the initial transition
period, there could be some increased costs and use of
resources as the combined SRO works to harmonize the NASD and
NYSE member firm rules. There also could be an adjustment
period as the combined SRO integrates the staffs.
As to the combined SRO's overall regulatory effectiveness,
the Commission would monitor closely whether the combined SRO
is effectively carrying out its regulatory oversight
responsibilities under the Exchange Act. In this regard, the
Commission would continue to conduct examinations of the
combined SRO's regulatory, investigatory, and enforcement
activities.
In reviewing the proposed harmonized rules, when received,
the Commission would consider whether they are consistent with
Section 15A(b)(6) of the Exchange Act, which requires such
rules to be designed, among other things, to prevent fraudulent
and manipulative acts and practices; to promote just and
equitable principles of trade; to remove impediments to and
perfect the mechanism of a free and open market and a national
market system; and, in general, to protect investors and the
public interest.
In reviewing the NASD's proposed By-Law changes, the
Commission must consider whether they are consistent with the
requirements of Section 15A(b)(6) of the Exchange Act described
above, as well as consider the effects of the proposed By-Law
changes on efficiency, competition, and capital formation. In
addition, the Commission will be required to consider whether
the changes are consistent with other Exchange Act provisions,
particularly the fair representation requirements of Section
15A(b)(4). This statutory provision requires that the rules of
a national securities association assure the fair
representation of its members in the selection of its directors
and administration of its affairs, and provide that one or more
directors will represent issuers and investors and not be
associated with a member of the exchange, broker, or dealer.
The Commission also will be required to consider whether the
combined SRO would be so organized and have the capacity to
carry out the purposes of the Exchange Act and to enforce
compliance by its members and persons associated with its
members with the provisions of the Exchange Act, as set forth
in Section 15A(b)(2) of the Exchange Act.
Q.3. In your testimony, you discuss arbitration merely in terms
of increased efficiency and do not address many of the concerns
regarding fairness and effectiveness that have been raised by
stakeholders. Will the Commission address these concerns as
they consider the by-laws of the new SRO?
A.3. The Commission will take into account all of the comments
it received on NASD's proposed changes to its by-laws, as well
as NASD's response to the comments. Section 19(b)(2) of the
Exchange Act requires the Commission to approve a self-
regulatory organization rule change if it finds the rule change
is consistent with the requirements of the Act. Section
15A(b)(6) of the Act requires the rules of a national
securities association to be designed, among other things, to
prevent fraudulent and manipulative acts and practices, to
promote just and equitable principles of trade, and, in
general, to protect investors and the public interest.
Q.4. It is my understanding that the NASD/NYSE regulatory
consolidation will fully harmonize the ``two rule books'' of
the NASD and NYSE. North American Securities Administrators
Association President Borg raised significant concerns on this
front in his testimony. Mr. Borg gives four examples of
proposed rule changes--related to supervisor registration,
registered representative training, customer complaints, and
office space sharing arrangements--where taken as a whole
``appear to reflect a trend to weaken certain rule provisions
designed to foster diligent supervision, to the detriment of
investors.'' How will you address concerns about investor
protections while harmonizing the rule books? Will investors
have a meaningful opportunity to participate in this process to
ensure that the harmonized rule book serves their needs?
A.4. As the governmental agency responsible for protecting
investors under the federal securities laws, the Commission
would give great weight to the impact of the harmonized rules
on investors. When considering the rules, the Commission is
required to consider the Exchange Act's requirement that an
SRO's rules must, among other things, be designed to prevent
fraudulent and manipulative acts and practices and to protect
investors and the public interest.
Investors would have a meaningful opportunity to
participate in the rule filing process. NASD would be required
to submit the proposed harmonized rules to the Commission for
consideration subject to Section 19(b)(2) of the Exchange Act.
The Commission would then publish the proposed changes for
public notice and comment. During the comment period, any
interested investors as well as other persons would be able to
submit comment letters for Commission consideration. As with
any proposed SRO rule change, the Commission would consider the
views and comments expressed by all interested persons.
Q.5. There has been a lot of discussion in recent years
regarding giving shareholders greater access to the proxy
statements companies produce. But companies are concerned that
it is not always transparent as to who is voting the shares, or
even who the shareholders are--such that they could identify
and communicate with them. What should the regulators be doing
to determine who actually owns shares and who is voting them?
A.5. In May 2007 the Commission held a series of roundtables
seeking input from a variety of industry participants and
investor groups, including issuers, institutional investor
groups, broker-dealers, clearing agencies, transfer agents, and
private-sector proxy processors. As the roundtables made clear,
processing proxies and votes for investors who hold in street
name involves numerous complex legal, regulatory, and
operational issues. For example, the rights and obligations of
stock ownership differ between record owners and beneficial
owners under state and federal law. Moreover, the manner in
which the U.S. trading and clearing systems operate creates a
number of challenges in determining the allocation of voting
entitlements. The Commission is currently considering the
comments of market participants to determine the appropriate
regulatory response and whether any such actions may be
implemented in part or whole in order to affect the 2008 proxy
season.
------
RESPONSE TO WRITTEN QUESTIONS OF SENATOR DODD FROM MARY
SCHAPIRO
Q.1. The State securities regulators have an important role in
protecting investors, as has been shown many times in the past
decade's securities frauds. The North American Securities
Administrators Association in its testimony stated ``To the
extent that the merger between the NASD and NYSE-R will impact
state securities regulation, there must be consultation between
the entities involved and state regulators before relevant rule
proposals and Notices to Members are announced.''
Will the operating procedures for the combined regulator
require that there be such consultation with State regulators?
Why or why not?
A.1. NASD has historically engaged in a comprehensive and
robust dialogue with state and other regulators about rule
proposals, as well as other regulatory and investor protection
initiatives. FINRA intends to continue those efforts.
Toward that end, FINRA (as NASD) coordinated with state
regulators to form working groups to address specific areas of
concern (e.g., the Variable Annuity Group and the Book and
Records Task Force). Moreover, FINRA, state regulators, and
representatives of NASAA have certain standing committees
(e.g., the CRD Steering Committee and the Licensing and
Registration Council) that meet on a regular basis. These
meetings provide opportunities to discuss rule proposals and
their potential impact on state regulators. In addition, all of
FINRA's proposed rules are published for notice and comment
from interested parties.
Finally, NASD established in 2001, the office of State
Liaison to provide states (and NASAA) with a dedicated
resource. In conjunction with the existing forums described
above, FINRA's State Liaison will continue to work closely with
state regulators to address current issues and developments,
including any potential impacts of FINRA rules on state
regulation. In sum, FINRA will continue these longstanding
communication and coordination efforts with state and other
regulators.
Q.2.a. Columbia University Law Professor John Coffee in his
testimony discussed concerns that have been raised about the
board structure of the combined regulator. He said that
``Public Governors'' would not be required to ``satisfy the
same independence standards that the NYSE mandates for
directors of a publicly held corporation. Thus, persons
affiliated with law or consulting firms serving the securities
industry might populate even these minority positions.''
Please explain in detail the standards of independence for
a Public Governor in the combined regulator.
A.2.a. FINRA rules have prohibitions against persons with
material affiliations to the securities industry from serving
as ``Public Governors.'' Specifically, any individual who (1)
is or has served during the prior year as an officer, director
(other than as an independent director), employee or
controlling person of a broker or dealer, (2) has a consulting
or employment relationship with or provides professional
services to a self regulatory organization (``SRO'') registered
under the Securities Exchange Act of 1934 (the ``Act''), or has
had any such relationship or provided any such services at any
time within the prior year, or (3) has a material business
relationship with a broker or dealer or an SRO registered under
the Act (other than serving as a public director of an SRO) is
prohibited from serving as a ``Public Governor'' of FINRA. The
definition of ``controlling person'' further restricts
individuals who possess, directly or indirectly, the power to
direct or cause the direction of the management and policies of
a broker or dealer, whether through the ownership of voting
stock, by contract or otherwise from serving as a ``Public
Governor.'' Individuals who own 20 percent or more of the
outstanding voting stock of a broker or dealer likewise will be
restricted from serving as a ``Public Governor.''
For purposes of evaluating whether a ``Public Governor''
has a ``material business relationship'' with a broker or
dealer or an SRO, the term ``material business relationship''
will be defined as a ``relationship, whether compensatory or
otherwise, that reasonably could affect the independent
judgment or decision making of the director.'' In evaluating
whether a Board candidate has a material business relationship
with a broker or dealer or an SRO, the Office of the Corporate
Secretary and the Nominating Committee (aka the Nominating and
Governance Committee) will consider various factors, which
capture the types of professional and business relationships
that may be considered to be material and pose significant
conflicts of interests, including, but not limited to:
1. Employment or service as an officer, director, board
committee member, or general partner with a Covered Entity \1\
---------------------------------------------------------------------------
\1\ For purposes of the assessment, the term ``Covered Entity''
shall include any SRO, broker-dealer, insurance company, investment
company, investment adviser, or an affiliate of any such entity.
---------------------------------------------------------------------------
2. Whether the Board candidate and/or the candidate's firm
or partnership provided consulting or professional services to
a Covered Entity or the director, officer or employee of a
Covered Entity and the amount of fees collected from such
services
3. Whether the Board candidate ever has appeared as an
expert witness or consultant in an SRO hearing or SRO
arbitration proceeding on behalf of any party, other than him-
or herself or the registered firm with which the candidate is
associated
4. Whether the Board candidate ever had any other type of
business relationship with or received any other types of
payments or benefits from a Covered Entity including, for
example, but not limited to, benefits under a tax-qualified
retirement plan, pensions, deferred compensation for prior or
continued service, non-discretionary compensation, insurance
benefits, post-employment office-space and/or administrative
support, or other benefits
5. Whether the Board candidate possesses, directly or
indirectly, the power to direct or cause the direction of the
management and policies of a Covered Entity, through the
ownership of voting stock, by contract or otherwise
6. Whether the Board candidate has a stock or another
ownership interest in a Covered Entity
7. Whether the Board candidate's investment portfolio is
concentrated in the securities industry
8. Whether the Board candidate has made or accepted any
loan or any other form of indebtedness to a Covered Entity
9. Whether the Board candidate has an immediate family
member with and employment or investment relationship with a
Covered Entity
Each of these factors has been incorporated in the form of
a question in the Board of Governors' questionnaire, which is
the means by which FINRA collects information that is necessary
for a determination of the prospective committee member's
classification as an ``Industry Governor'' or ``Public
Governor.''
Q.2.b. Is Professor Coffee's comment accurate, that it would be
permissible for ``Public Governors'' to include ``persons
affiliated with law or consulting firms serving the securities
industry''?
A.2.b. Under most circumstances, attorneys, consultants or
other professionals whose practice area or expertise involves
the securities industry would be prohibited from serving as a
``Public Governor,'' based simply on the definitions of
``Industry Governor'' and ``Public Governor.'' First, any
individual who currently has, or had during the previous year,
a consulting or employment relationship with or currently
provides, or provided during the previous year, professional
services to an SRO may not serve as a ``Public Governor.'' This
restriction is all-inclusive regardless of the amount of work
performed for, time dedicated to, or fees charged to the SRO.
Although this restriction allows any individual who provided
legal, consulting or other professional services to an SRO more
than a year ago to serve as a ``Public Governor,'' the minimum
one-year look-back period removes the individual from any
direct or immediate ties to the industry.
Second, although the By-Laws expressly prohibit persons
affiliated with law or consulting firms who work with or on
behalf of SROs from serving as a ``Public Governor,'' it does
not expressly prohibit such persons if they provide similar
services to a broker or dealer. However, any lawyer or
consultant who provides professional services to brokers or
dealers will be prevented from serving as a ``Public Governor''
if such services amount to a ``material business
relationship.'' This will restrict a large number of
individuals with the appropriate experience and knowledge of
the securities industry from serving on the Board in the
capacity as a ``Public Governor.''
Q.2.c. If this observation is accurate, do you feel that
individual investors would have concerns about the composition
of the Board and, if so, how would you respond to these
concerns.
A.2.c. FINRA does not believe Professor Coffee's observation is
accurate for several reasons. First, as explained above, most
``persons affiliated with law or consulting firms serving the
securities industry'' will be ineligible to serve as a ``Public
Governor.''
Second, Professor Coffee inaccurately described the
``Public Governors'' as ``minority positions.'' FINRA's By-Laws
expressly provide that the number of ``Public Governors'' must
exceed the number of ``Industry Governors.''
Third, ``Public Governors'' historically have represented a
cross-section of representatives with varied backgrounds,
including the public sector, and academia. The ``Public
Governors'' of FINRA will continue to bring wide-ranging
experiences to the Board and will continue, in their public
capacity, to represent the needs of investors, industry and the
marketplace with an independent point of view.
Q.3. William Galvin, Secretary of the Commonwealth of
Massachusetts, in a letter published in The Wall Street Journal
on December 11, 2006, called for an examination of ``Whether
the boards of directors of self-regulatory organizations (like
the NASD and the stock exchanges) adequately represent small
investors.''
How would you respond to Secretary Galvin's concern? Is the
resulting organization's board designed to adequately represent
small investors, since no board member is specifically
designated to be drawn from or to represent the concerns of
this group?
A.3. We believe the FINRA's board is more than adequately
designed to represent small investors and that the interests of
all investors will be well represented in the new organization.
To begin, FINRA's By-Laws expressly provide that the number of
``Public Governors'' must exceed the number of ``Industry
Governors.'' As described above in response to Question Number
2, the Board's eleven ``Public Governors'' will not include
anyone who (1) is or has served during the prior year as an
officer, director (other than as an independent director),
employee or controlling person of a broker or dealer, (2) has a
consulting or employment relationship with or provides
professional services to an SRO, or has had any such
relationship or provided any such services at any time within
the prior year, or (3) has a material business relationship
with a broker or dealer or an SRO registered under the Act
(other than serving as a public director of an SRO). Those
serving as Public Governors share FINRA's commitment to
investor protection. Among others, FINRA's inaugural Board of
Governors includes a former SEC Commissioner, a former state
securities commissioner, two university presidents, a former
Comptroller General of the U.S., and an expert in individual
investor rights.
Under strong leadership selected by the Board, FINRA will
fulfill its mission of investor protection and market integrity
through surveillance, rulemaking, and working directly with the
industry to ensure that members comply with regulations,
ensuring investor choice, offering investor education tools.
With nearly 3,000 staff, FINRA will be committed to providing
more effective protection for the tens of millions of people
who invest for their future in the U.S. capital markets.
Furthermore, FINRA will continue NASD's longstanding
commitment to investor protection and education, which is the
most effective way to protect investors and ease their
interaction with the marketplace. Over the past decade, NASD
has taken a number of steps to reach as many investors as
possible with education and tools to inform their investment
decision-making. These have included developing and publishing
Investor Alerts, brochures and online resource guides on such
critical topics as mutual fund class shares, retirement
accounts, college savings plans, and bond investing. FINRA
holds investor forums around the country to directly reach
investors and answer their questions. FINRA also offers
multiple tools on its web site that can help investors manage
their money with confidence, including mutual fund fee and
expense calculators. Online tools such as BrokerCheck allow
investors to search a database to find out their broker's
qualifications and determine whether any regulator has ever
taken disciplinary action against the broker.
FINRA regularly examines all firms to determine compliance
with the rules of the SEC, FINRA, the Department of Treasury
and the Municipal Securities Rulemaking Board (MSRB).
Examinations are conducted by FINRA's 15 District Offices, with
oversight from its offices in Washington, DC, and New York
City. Sales practices are analyzed to determine whether the
firm has dealt fairly with customers when making
recommendations, executing orders and charging commissions or
markups and markdowns; and anti-money laundering, business
continuity plans, financial integrity and internal control
programs are scrutinized. In addition to routine examinations,
FINRA conducts thousands of investigations each year stemming
from investor complaints, terminations of registered persons
for cause, financial problems, arbitrations, referrals from
other regulators and FINRA surveillance system alerts.
FINRA's disciplinary procedures promote investor protection
and market integrity by providing a process to appropriately
sanction firms or associated persons who violate FINRA rules
(currently NASD Rules and incorporated NYSE Rules, for dual
members), the federal securities laws, or other regulations.
These procedures provide for progressive discipline for repeat
offenders and can result, for those who have been found to have
engaged in the most serious forms of misconduct and harm to
investors, in expulsion from the industry. Where feasible,
FINRA orders violators to make restitution to customers
identified as having been harmed by their actions. Over the
past decade, FINRA has filed over 14,000 disciplinary actions,
and expelled close to 200 firms from the industry. We have
barred over 4,900 individuals and suspended another 3,600 from
the industry.
Finally, NASD established its Investor Education Foundation
in 2003. Now renamed the FINRA Investor Education Foundation,
it currently is funded with $82 million, making it the largest
foundation in the U.S. dedicated to investor education. The
Foundation's mission is to provide investors with high quality,
easily accessible information and tools to better understand
the markets and the basic principles of saving and investing.
As demonstrated by all these programs, FINRA and the thousands
of people who work for the organization will continue to
maintain a fierce commitment to protecting the interests of the
individual investing community.
Q.4.a. Some have raised questions about advertisements by
broker-dealers. For example, some have said that advertisements
for registered representative sometimes suggest that they have
a fiduciary relationship with their clients.
How would the NASD respond to such concerns?
A.4.a. FINRA's advertising rules prohibit any misrepresentation
by a broker-dealer of its regulatory responsibilities. In
addition, all communications with the public must provide a
sound basis for evaluating the facts with regard to the broker-
dealer's services. Of course, any determination of whether a
violation of the advertising rules has occurred depends upon
the facts and circumstances surrounding the sales piece at
issue, including the context in which it is used and the
accuracy of its representations.
Q.4.b. Please describe the role of the NASD in overseeing
member advertisements.
A.4.b. FINRA's advertising rules require that any communication
with the public by a broker-dealer comply with high standards.
Every communication must be fair, balanced and not misleading,
and must comply with the specific requirements of the FINRA,
SEC, MSRB and SIPC advertising rules. Some types of sales
material must be filed with FINRA's Advertising Regulation
Department. Most of the sales material that is subject to the
filing requirement consists of variable product and mutual fund
sales material produced or used by broker-dealers. The
Department reviews over 93,000 pieces of sales material every
year to determine whether they meet the standards of our
advertising rules. We require that members correct any material
that violates our rules. Material that is not filed is subject
to review by our District Office staff through the examination
process. In addition, FINRA conducts periodic sweeps to
identify practices and violations not found through the filing
program or examination process. Depending upon the severity of
the violations, we may pursue disciplinary action through our
Department of Enforcement.
Q.5. The North American Securities Administrator Association
and Professor Coffee cited several concerns about the
arbitration process in their testimony.
A. The North American Securities Administrators
Association testified that as ``long arbitration panels include
a mandatory industry representative of the securities industry
and include public arbitrators who maintain significant ties to
the industry, the arbitration process will be perceptively and
fundamentally unfair to investors.'' How would you respond to
NASAA's observation? What would be the costs and benefits of
adopting NASAA's suggestion: ``the removal of mandatory
industry arbitrators from the arbitration process, and for
public arbitrators to have no ties to the industry''?
B. A recent column published in The New York Times, ``When
Winning Feels a Lot Like Losing,'' discussed concerns about an
arbitration and said: ``One explanation for why awards may not
reflect the facts of the cases . . . is arbitrators, who are
often retired, want to be chosen to serve on future panels.
Those known for giving big awards to plaintiffs are more likely
to be stricken by brokerage firms from lists of potential
arbitrators.''
Do you feel this is a significant problem in the
arbitration process? If so, what is the NASD doing to address
it?
A.5. FINRA's arbitration program and rules are consistent with
landmark United States Supreme Court decisions, are highly
regulated and investor friendly. Our program is regulated by
the SEC, which must approve any rule changes or fee increases
and which inspects our program on a regular basis. FINRA serves
the arbitration claims on industry parties; arbitrations are
held in the location where the investor lived when the event
occurred that gave rise to the arbitration; FINRA has hearing
locations in all 50 states, Puerto Rico and London; and FINRA
suspends from the business any industry parties that do not pay
arbitration awards within 30 days. Whether or not an arbitrator
is classified as public or non-public, all arbitrators serving
in FINRA's arbitration forum are expected to be fair and
neutral. Arbitrators do not represent a part or interest in the
arbitration matter to which they are assigned. All
arbitrators--public and non-public--execute an oath when they
accept appointment to an arbitration, and swear to serve in an
impartial manner, in accordance with the FINRA Code of
Arbitration Procedure and the AAA/ABA Code of Ethics for
Arbitrators. All arbitrators--public and non-public--must
disclose any business or personal relationships they have with
any of the parties, their counsel and representatives, or their
witnesses.
We would like to provide some background on the current
composition of arbitration panels. (This discussion relates to
NASD arbitration rules, which apply to new cases filed after
the consolidation.) The NASD Code of Arbitration Procedure
classifies arbitrators as either public or on-public. Under
both NASD and NYSE Regulation current arbitration rules,
customer arbitrations are decided either by a single public
arbitrator or by a panel of three arbitrators, two of whom are
public and one of whom is non-public. Under the revised rules,
non-public arbitrators are not necessarily from the industry;
they could be persons who derive some income from the industry.
For example, an attorney who represents investors 80% of the
time but also represents industry clients 20% of the time would
be a non-public arbitrator. Many non-public arbitrators have,
however, worked in the industry at some point.
Both NASD and NYSE Regulation--now FINRA--have taken
significant steps to ensure that public arbitrators do not have
ties to the industry. Working with investor representatives,
arbitrators and the securities industry, we amended the
arbitration rules--after publication in the Federal Register,
public comments and SEC approval--to eliminate from the pool of
public arbitrators those with any ties to the securities
industry. Individuals employed at a company that controls, is
controlled by, or is under common control with, a securities
firm are not eligible nor are spouses and immediate family
members of such individuals allowed to serve as public
arbitrators. This prevents individuals with even indirect ties
to the securities industry from serving as public arbitrators
in the FINRA forum. In order to enforce this rule, FINRA
requires arbitrators to disclose relevant information about
their education, employment history and any potential conflicts
of interest.
It is helpful to have at least one arbitrator on a three-
person panel (three-person panels are used in larger cases--
those with damages claims over $50,000) who is knowledgeable
about industry practices. Knowledge about industry rules and
procedures, documentation practices, and other regulatory
requirements prevents counsel from having to educate each
arbitrator about these issues. This expedites hearings, saving
time and costs for the parties. Our forum handles increasingly
complex issues, such as variable annuities, breakpoints, and
mutual fund switching. Industry knowledge about rules and
procedures in this area helps hold firms and individuals
accountable. If a party prefers to introduce expert witnesses
to inform the panel on a particular issue, however, then of
course the party may do so.
We understand from our discussions with arbitrators that
they work together to uphold their oath to decide each case
fairly and to render a just award. Deliberations are
collaborative efforts to analyze evidence and testimony, not
adversarial debates between the public and non-public
arbitrators. A review of the awards database provided free of
charge on the FINRA Web site will show that an overwhelming
percentage of all awards are unanimous.
We note also that other systems involving technical matters
often have one arbitrator who is from the field in question,
such as arbitration systems used in state medical malpractice,
attorney malpractice, residential real estate, and
construction.
We have no indication that arbitrators are issuing small
awards or attempting to curry favor with one side in order to
assure future appointments. Because of the time commitment
necessary to serve as an arbitrator, many of our arbitrators
are retired; however, others are working full-time or part-time
and do not rely on arbitrator honorarium as an important source
of income. Currently, an arbitrator receives an honorarium of
$400 for an eight-hour day of hearings, with $75 extra for the
chairperson.
In addition, it is important to note that both the
claimants' bar (largely through the Public Investors
Arbitration Bar Association, or PIABA) and the defense bar
(largely through the Securities Industry and Financial Markets
Association, or SIFMA) are well organized. We understand that
they both maintain historical information on arbitrators, which
they share with their colleagues through email lists, member-
only Web sites, seminars, or other sources. Other investors may
be represented by one of the several securities arbitration
clinics operated by law schools. Thus, it is in the best
interests of arbitrators to act in a fair and judicious manner.
Also, FINRA maintains a free, online awards database that
parties and counsel may search for prior awards by the
arbitrators on the lists of proposed arbitrators that FINRA
sends to them on each case. In researching their arbitrators,
parties and counsel also must be aware that only about a
quarter of arbitration cases go to an award. Significantly more
arbitration matters are resolved by settlements, which
generally are confidential but almost certainly include
compensation to the investor, in that experienced industry
attorneys tend to settle the strongest cases filed against them
by investors.
------
RESPONSE TO WRITTEN QUESTIONS OF SENATOR REED
FROM MARY SCHAPIRO
Q.1. In a March 8, 2005, letter commenting on an SEC concept
release on self-regulation, NYSE opposed a proposal to
consolidate member regulation under a single SRO, stating that
the existing SRO structure, ``preserves one of the key
advantages of a competitive regulatory structure, namely
multiple watchdogs reviewing trading activity.'' Is it still a
concern? What internal mechanisms or external factors will
serve to prevent this potential unintended consequence?
A.1. As indicated in our 2005 comment letter in response to the
SEC Concept Release, NASD did not share the NYSE view on
consolidation of member regulation. Our view then as now was
that the benefits of consolidation in terms of regulatory
effectiveness, elimination of regulatory fragmentation and
efficiency more than offset the elimination of an additional
overseer. Importantly, the consolidation in fact combines all
the complementary abilities and resources of both NYSE
Regulation and NASD, while seeking to eliminate inconsistent
regulatory requirements, and redundant infrastructures and
technology applications.
Member and market regulation had always been spread among
the various competing self-regulatory organizations and the
result was redundant, or sometimes competing, regulation, with
firms having to ferret through the minor and major distinctions
by each SRO and build a compliance program around those
distinctions.
But then came the opportunity that accompanied the change
in the business structure of exchanges. When the non-profit
exchange model gave way under competitive pressures to public
ownership of markets, the opportunity to support a change in
self regulation in the interests of elimination of conflicts
and efficiency was presented.
Q.2.a. According to the NASD, it will make a one-time payment
of $35,000 to its members once the merger is approved in
anticipation to cost savings achieved by the new SRO. NASD also
will reduce each firm's annual dues by $1,200 each year for
five years and pay NYSE Group $103 million. At the same time,
NASD announced that it does not plan to close any of its
offices or lay off any of its staff as a result of the
consolidation.
What additional revenues will the new SRO receive from
taking over NYSE Regulation's Member regulation, and how does
NASD expect to achieve its anticipated cost savings?
A.2.a. The revenue streams that accompany the regulatory
expenses of NYSE are similar to revenue streams at NASD.
Regulatory Fees such as Gross Income Assessment, Personnel
Assessments, and Branch Office Fees fund the Member Regulation
functions. These revenues have effectively allowed NYSE
Regulation's member regulation to operate on a break-even
basis.
The anticipated costs savings are expected to be achieved
through the retirement of duplicative technology platforms, the
ability to leverage existing back office functions.
Q.2.b. How did NASD calculate the $35,000 payment, and why
isn't NASD waiting to first achieve cost savings before making
such a payment to its members?
A.2.b. The $35,000 payment represents the incremental value
derived from this transaction and NASD wanted to ensure that
the whole industry was able to share in these savings, not just
the dually regulated firms. These savings were based upon an
independent valuation. NASD was confident in its ability to
meet these savings and therefore determined to pass them onto
its members up-front so all members can begin realizing the
benefits immediately.
Q.2.c. What, if any, special funding sources or powers will the
new SRO have if regulatory fees prove insufficient for a given
year if its anticipated cost savings are not realized?
A.2.c. FINRA does not have special funding powers; however, the
core regulatory revenue stream (Gross Income Assessment--
``GIA'') is based on the industry's prior year revenue
performance. That said, FINRA can use quarterly FOCUS filings
to project future regulatory revenues and in the event that
industry revenues declined significantly, FINRA would adjust
the GIA rates to ensure adequate funding of the regulatory
program.
Q.3. NASD has a $2 billion plus investment portfolio. Given
that members of NASD's Finance Committee--an advisory committee
that provides investment recommendation to the board--include
money managers for large, well known financial firms, what
safeguards and protections are in place to ensure that NASD
remains independent and free of conflicts? With the merger of
the two SROs, what, if any, changes are expected to be made in
the future to NASD's investment process?
A.3. The FINRA Investments Office (formerly the NASD
Investments Office) is charged with sourcing and managing
investments. The Investments Office is composed entirely of
FINRA staff which makes all investment recommendations. Some of
these recommendations are subject to Investment Committee
approval, as dictated by the Investment Policy Statement.
Duties and responsibilities for members of the Investment
Committee and Investments Office staff are reflected in the
Investment Policy Statement. The Investment Committee's duties
and responsibilities are also reflected in the Charter of the
Investment Committee. This process remains the same as it was
prior to the merger of the two SROs.
FINRA subscribes to high standards of ethics and
professional conduct, consistent with its mission of investor
protection and market integrity, and requires annual
certification by all FINRA staff of compliance with the FINRA
Code of Conduct. FINRA similarly holds its investment managers
and investment consultants to the highest ethical business
practices.
FINRA may retain investment managers, custodians, brokers,
or other advisors, provided that members of the Investment
Committee fully disclose if they are an employee or contractor
of the firm and recuse themselves from discussion and voting.
FINRA may retain investment managers in which a member of the
Investment Committee is also invested, provided that the member
makes full disclosure of the member's interest.
Q.4. There have been reports of many concerns raised about the
arbitration process involving arbiters' conflicts of interest,
failure of brokers to provide documents, unfairness to
investors, and so on. The New York Times and witnesses who
appeared on our second panel have highlighted these
deficiencies in the arbitration process. With the merger of the
two SROs what changes should be made to enhance the arbitration
process?
A.4.
Arbitrator Neutrality and Conflict of Interest
FINRA provides to both sides in arbitration disputes
identical lists of proposed arbitrators, along with detailed
reports on each arbitrator's background. We also provide a list
of cases in which each arbitrator has issued a final decision,
or award. Parties may also find a record of past awards online
and free of charge on FINRA's website.
Arbitrators work on a case-by-case basis as independent
contractors. They must apply with FINRA to be arbitrators, and
we verify through an independent vendor their education,
licenses, employment and disciplinary history. Prior to serving
on panels, arbitrators are required to take training courses
and pass related exams.
In each case to which they are appointed, arbitrators take
a written oath to remain neutral. Arbitrators are further
required to complete an Arbitrator Disclosure Checklist, as
well as to make decisions on the facts and merits of the cases
they hear. FINRA constantly monitors arbitrators to ensure they
meet necessary standards. If an arbitrator fails to meet those
standards, he or she is removed from FINRA's roster of eligible
arbitrators.
Impact of the NASD-NYSE Regulatory Consolidation
There was a steady migration by investors to NASD's
arbitration forum before the consolidation was proposed; the
result is that, prior to the merger, NASD already administered
over 94 percent of the investor-broker disputes filed every
year. Also, over the past decade, the SEC has approved the
consolidation of arbitration programs at several SROs with NASD
with no adverse effects.
FINRA's dispute resolution program is subject to extensive
regulatory oversight and must operate in a fair manner. As
noted above, the SEC must approve all arbitration and mediation
rules. FINRA must file with the SEC proposed changes to the
rules, as well as significant changes to our processes. After
publication in the Federal Register, there follows an extensive
period for comments by the public, and FINRA must address the
issues raised by the commenters. We often amend rule filings in
response to comments from the public. SEC's Office of
Compliance Inspections and Examinations (OCIE) conducts
periodic inspections of our dispute resolution program. The GAO
also conducts reviews of our program from time to time.
The consolidation of the NASD and NYSE dispute resolution
forums continues to serve the interests of the investing
public. The combined entity continues to be subject to full SEC
oversight and inspections, and its rules subject to approval by
the Commission as at present. The economics of scale will make
it more efficient to recruit, train, and maintain a unified
roster of neutrals; there will be better coordination on
disciplinary referrals arising out of arbitrations, and on
suspending or terminating firms for non-payment of awards; and
the single set of rules will reduce confusion for investors.
Q.5. It is my understanding that the NASD/NYSE regulatory
consolidation will fully harmonize the ``two rule books'' of
the NASD and NYSE. North American Securities Administrators
Association President Borg raised significant concerns on this
front in his testimony. Mr. Borg gives four examples of
proposed rule changes--related to supervisor registration,
registered representative training, customer complains, and
office space sharing arrangements--where taken as a whole
``appear to reflect a trend to weaken certain rule provisions
designed to foster diligent supervision, to the detriment of
investors.'' How will you address concerns about investor
protections while harmonizing the rule book? Will investors
have a meaningful opportunity to participate in this process to
ensure that the harmonized rule book serves their needs?
A.5. The rule harmonization effort, which will now be concluded
in the rule consolidation process, will do nothing to undermine
investor protection. To the contrary, a coordinated and
harmonized system of member conduct regulation should allow
firms to more efficiently meet their regulatory requirements
and thereby move them towards a more perfect execution of their
responsibilities. NASD and the NYSE have consistently
emphasized the primacy of registered representative and
supervisory education as well as supervision as core concepts
of its regulatory scheme. As recently as its joint guidance on
Electronic Communications, both SROs emphasized education and
supervision as a bulwark towards avoiding the failure to comply
with firm conduct requirements. Neither harmonization nor
consolidation will undermine investor protection and all new
rules of the combined SRO, FINRA, that materially change the
rules of either SRO will be filed with the SEC and subject to
public comment by all members of the public.
Q.6.a. In your speech before the Chamber of Commerce you talked
about regulatory agencies having ``overlapping jurisdiction''
and the need to deploy regulatory resources thoughtfully. In
addressing the issue about limited regulatory resources, a
number of agencies have revised their examination procedures to
take a risk focused regulatory approach.
What changes have the SROs made recently to ensure limited
resources are deployed in the high risk areas?
A.6.a. Prior to becoming FINRA, NASD had a long evolutionary
history in terms of assessing risk as an important driver into
the decision of where to apply its resources. There is a
tremendous amount of diversity in the securities industry. The
business lines are far-ranging, from making markets in over-
the-counter securities, to real estate syndication, to retail
sales of equities, mutual funds and fixed income products. Firm
structures include partnerships, sole proprietors,
corporations, subsidiaries of holding companies, independent
contractors, and other models. While some firms operate from a
single location, others do business throughout the world,
managing trillions of dollars in customer assets from dozens of
domestic and foreign venues.
As a result of this diversity across the industry, the
examination program has evolved to meet the demands of the
increasing complexity in products and trading systems, the
growing use of sophisticated technology by firms, the new
requirements introduced by Congress, the SEC and SROs, and the
shifting mix of business activities and models. Further, as a
result of the merger with NYSE Regulation's member regulatory
program, the examination program at FINRA has expanded its
scope of responsibilities, most notably in the area of
financial and operational regulation of large firms.
We have launched specific initiatives to design and
implement a more risk-based approach to our work. An initial
step in this direction was the enhancement of our approaches
and the development of risk models to assess sales practice and
financial risks based on the footprint, or impact, of firms
regulated by FINRA. The ability to assess risk and impact
allows us to focus our limited regulatory resources on those
firms that present the most risk, those firms that represent a
significant part of overall industry activity, and those areas
that reflect our current regulatory priorities. This new
approach allows us to better hone our sales practice risk focus
and conduct more frequent and thorough financial and
operational examinations.
A significant number of firms are examined annually. From
an impact perspective, this group of firms includes the largest
broker-dealers with significant retail, investment banking
operations, or highly complex financial operations, as well as
all firms that clear or carry for themselves or other firms.
From a risk perspective, this group of firms includes broker-
dealers with a history of sales practice problems and may
present other significant risks to investors. The firms with
the highest risk earn a special, specifically-tailored
examination during the current year. Moreover, we will refresh
our risk view of regulated firms periodically throughout the
year to make certain that resources are properly allocated.
Among the remaining firms, riskier firms and higher impact
firms are placed on a two-year examination cycle. Firms that
appear less risky and are smaller in scale of operations will
default to a four-year cycle. We are developing offsite
approaches to enhance the monitoring of these four-year cycle
firms in the intervening years.
While we tailor the scope of our cycle examinations, there
are certain priority areas that our examination staff reviews
during every examination, when applicable. These priority areas
include items such as Anti-Money Laundering and Protection of
Customer Information.
Sweep examinations are another method of performing a
focused review of emerging regulatory issues. Rather than
directly incorporate these reviews into our on-site
examinations, we have used sweeps to inform our thinking on
current issues. As sweeps have progressed, we have enhanced our
examination techniques to make the job more efficient for our
staff and less intrusive for firms. In this regard, we have
successfully experimented with on-line surveys, questionnaires,
and self-assessments to collect and analyze data. This approach
leverages our regulatory resources and permits us to conduct a
global assessment of potentially systemic problems.
Q.6.b. Also, what changes do you expect to make to the new SRO
to ensure that regulatory resources are deployed appropriately?
A.6.b. FINRA will continue to have a risk-based examination
program. FINRA staff is currently engaged in a process of
developing the framework for our risk based examination program
for 2008 and beyond. While cycle examinations will continue to
exist, much as they do today, we will look to further develop
our approach to be sure that higher risk member firms and
activities are subject to more frequent examinations.
We are also leveraging the synergies between legacy
strategic NASD risk-based initiatives and strategic NYSE Member
Firm Regulation initiatives. The successful integration of
these concepts will blend advanced analytics with additional
and rich data for better quality risk identification.
------
RESPONSE TO WRITTEN QUESTIONS OF SENATOR DODD FROM RICHARD
KETCHUM
Q.1. The State securities regulators have an important role in
protecting investors, as has been shown many times in the past
decade's securities frauds. The North American Securities
Administrators Association in its testimony stated ``To the
extent that the merger between the NASD and NYSE-R will impact
state securities regulation, there must be consultation between
the entities involved and state regulators before relevant rule
proposals and Notices to Members are announced.''
Will the operating procedures for the combined regulator
require that there be such consultation with State regulators?
Why or why not?
A.1. Both NYSE Regulation and the NASD have been committed to a
close working relationship with NASAA, and we have every
expectation that the staff of FINRA will continue that
commitment. We are confident that the rule harmonization
proposals that are put forth by FINRA will reflect a careful
weighing of the relative merits of the existing rules, with
absolute commitment to ensuring that the new rules effectively
protect investors and the integrity of the market. To the
extent anyone, whether a state regulator, a representative of
the industry or of the public, has a concern with any proposal,
it can be raised in the public comment period, and will be
considered and weighed in the balance by the SEC, as the final
arbiter of whether a rule proposal is consistent with the
statute and the public interest.
Q.2.a. Professor Coffee in his testimony discussed concerns
that have been raised about the board structure of the combined
regulator. He said that ``Public Governors'' would not be
required to ``satisfy the same independence standards that the
NYSE mandates for directors of a publicly held corporation.
Thus, persons affiliated with law or consulting firms serving
the securities industry might populate even these minority
positions.''
Please describe the standards of independence for the
directors of a NYSE-listed company and the reasons the Exchange
has adopted such standards.
A.2.a. The Exchange's listing standards (Section 303A of the
NYSE Listed Company Manual) require generally that listed
companies have a majority independent board. To be independent
a director must be determined by the company's board to have no
``material business relationship'' with the company, and the
rules also note that the focus in this regard is on
independence from the company's management. This basic test is
supplemented by a series of ``bright line'' standards, which
specify certain relationships that preclude independence. To
paraphrase, these are specified business relationships with the
company, the company's independent auditor, or another company
with specified relationships with the listed company. (See
section 303A.02(b)(i) through (v).)
The Exchange adopted these standards in the 2002-2003
timeframe to shore up investor confidence in the wake of the
Enron and Worldcom scandals. The purpose was to provide
confidence that listed companies had appropriately independent
boards in place to safeguard the interests of investors who
owned stock in the listed companies. These standards
represented an evolution in historical NYSE standards that
already required at least a certain number of independent
directors on the board and that required an audit committee
composed entirely of independent directors.
Q.2.b. Please compare the standards of independence for the
directors of a NYSE-listed company with the standards of
independence for a Public Governor in the combined regulator.
A.2.b. The basic standard is the same as our general
independence requirement for listed companies, in that it
precludes having a material business relationship with FINRA.
The FINRA policy adds the requirement that the public governor
not have a business relationship with a broker dealer or any
other SRO.
Q.2.c. and Q.2.d.
C. Do you agree with Professor Coffee's statement that it
would be permissible for Public Governors to include ``persons
affiliated with law or consulting firms serving the securities
industry''?
D. If this observation is accurate, and persons affiliated
with law or consulting firms serving the securities industry
are seated as Public Governors of the board of the combined
regulators, do you feel that individual investors may have
concerns about the composition of the Board and, if so, how
would you respond to these concerns?
A.2.c. and A.2.d.
The following is an answer to both of the above questions.
The FINRA standard would not preclude a person from public
governor status simply because they are with a law or
consulting firm that spent part of its time serving the
securities industry. Rather, such an affiliation would be
considered in determining whether the individual had a material
business relationship with a broker-dealer. We believe this to
be an appropriate standard for an organization such as FINRA.
FINRA requires public governors who are knowledgeable regarding
the financial services business and the needs of investors. Law
firms and consulting firms garner their expertise by serving
all parts of the business spectrum. Clearly individuals have to
be evaluated individually, and we believe that the FINRA
standard will allow that to happen.
Q.3.a. and Q.3.b.
The combination of the self-regulatory organizations will
result in the NYSE rules and NASD rules being transformed into
one uniform set of rules. The North American Securities
Administrators Association in its testimony raised concerns
``that harmonization does not compromise investor protection
standards.'' NASAA raised a concern that ``the rule
harmonization project will favor the interests of member firms
of the newly Consolidated SRO over the adoption of provisions
that protect investors.'' NASAA cited several instances in
which it said the New York Stock Exchange has a stronger
investor protection rule than the NASD but is proposing that
its ``rules will be amended to facilitate harmonization with
less stringent NASD requirements.''
Columbia University Law Professor John Coffee in oral
testimony pointed out that ``in some areas one rule book gives
more protection to investors than the other. Anytime you
harmonize, you can level up or you can level down. Given the
domination of industry members and the diffuse nature of the
public governors, I think there is a significant danger that
the rule book will be leveled down rather than leveled up.
There are really significant differences, such things as old as
the `know your customer' rule of these two bodies, and if we
want the stronger one, I think we need to have some SEC
oversight.''
A. How do you respond to these concerns that the combined
regulator will have rules that are the weaker of the current
NYSE or NASD rules to the detriment of investors?
B. How will the combined regulator address the perception
that it is reducing the protections that are currently afforded
for the benefit of some investors as it proceeds with rule
harmonization?
A.3.a. and A.3.b.
The following is an answer to both of the above questions.
As a registered national securities association, FINRA is
required to have rules that, among other requirements, prevent
fraudulent and manipulative acts and practices, promote just
and equitable principles of trade, and in general, protect
investors and the public interest. The SEC will have to be
satisfied that FINRA's proposed rule changes satisfy these
requirements, and the SEC will reach such conclusion only after
public notice and opportunity for comment. The entire process
is one that should satisfy the public that FINRA has made
appropriate choices as it promotes efficient regulation through
the rule harmonization project.
------
RESPONSE TO WRITTEN QUESTIONS OF SENATOR REED
FROM RICHARD KETCHUM
Q.1. In a March 8, 2005, letter commenting on an SEC concept
release on self-regulation, NYSE wrote, ``because member firm
regulation and market surveillance functions frequently
intertwine, it would substantially degrade the quality of both
functions to split them into two or more SROs.'' The letter
went on to reference the implementation of Regulation SHO in
this context, saying, ``because the short sale restrictions
involved aspects of both member firm and market regulation, the
situation required a degree of fluid and ongoing collaboration
between employees of the NYSE's member firm regulation and
market surveillance divisions that would have been difficult to
achieve if the two groups had been located within separate
regulatory entities.''
Will the quality of member firm regulation and/or market
surveillance be degraded as a result of their separation? What
changed your position on this matter?
What steps is NYSE Regulation taking to ensure that market
surveillance not only remains robust, but continues to improve,
given the evolving nature of our capital markets?
A.1. The following is an answer to both of the above questions.
NYSE Regulation did indeed have the concern expressed in the
March 8, 2005 comment letter, and we focused on structuring the
transaction with the NASD in a way that addressed that concern.
In negotiating and planning with the NASD and the SEC for
the structure of the new combined regulator--FINRA--we were
very attentive to the need to ensure good communication and
cooperation between FINRA and NYSE Regulation. Important in
this regard are several elements--(1) the three year transition
with an integrated board at FINRA comprised of appointees from
both NYSE and NASD, (2) providing for senior NYSE staff to have
senior positions in FINRA, and (3) the time and attention we
have paid and will continue to pay to integrating NYSE staff
and procedures with those of FINRA. These are all part and
parcel of ensuring that NYSE Regulation and FINRA remain
committed to and capable of efficient and effective cooperation
so as to provide continued high quality regulation for the
industry and investors.
Q.2. In a March 8, 2005, letter commenting on an SEC concept
release on self-regulation, NYSE opposed a proposal to
consolidate member regulation under a single SRO, stating that
the existing SRO structure, ``preserves one of the key
advantages of a competitive regulatory structure, namely
multiple watchdogs reviewing trading activity.''
Is this still a concern? What internal mechanisms or
external factors will serve to prevent this potential
unintended consequence?
A.2. As indicated above, the opinion expressed in the March 8th
letter about the importance of keeping surveillance of our
market at the NYSE led to our decision to structure the
consolidation with FINRA in a way that kept the market
surveillance function at NYSE Regulation. In fact, we have been
working with the NASD and the other securities self-regulatory
organizations, with the knowledge and cooperation of the SEC
staff, to rationalize and optimize the way our industry
surveils for insider trading in listed securities--further
evidence of NYSE's continued commitment to the support and
improvement of the market surveillance function.
Q.3. There have been reports of many concerns raised about the
arbitration process involving arbiters' conflicts of interest,
failure of brokers to provide documents, unfairness to
investors, and so on. The New York Times and witnesses who
appeared on our second panel have highlighted these
deficiencies in the arbitration process. With the merger of the
two SROs, what changes should be made to enhance the
arbitration process?
A.3. Over many years, the investors who are users of securities
industry arbitration have shown a clear preference for the NASD
program, to where it now comprises over 90% of all arbitrations
nationwide. It will be up to FINRA, the industry and the SEC to
decide the future fate of securities industry arbitration,
including whatever evolutionary changes are shown to be
appropriate as time goes on.
Q.4. It is my understanding that the NASD/NYSE regulatory
consolidation will fully harmonize the ``two rule books'' of
the NASD and NYSE. North American Securities Administrators
Association President Borg raised significant concerns on this
front in his testimony. Mr. Borg gives four examples of
proposed rule changes--related to supervisor registration,
registered representative training, customer complaints, and
office space sharing arrangements--where taken as a whole
``appear to reflect a trend to weaken certain rule provisions
designed to foster diligent supervision, to the detriment of
investors.'' How will you address concerns about investor
protections while harmonizing the rule books? Will investors
have a meaningful opportunity to participate in this process to
ensure that the harmonized rule book serves their needs?
A.4. The proposed changes in the harmonization filings were
made only after a lengthy and careful examination allowed us to
be satisfied that they did not degrade investor protection. As
a general matter, we have proposed to eliminate what we found
to be overly prescriptive regulations that imposed excessive
burdens and delay, while retaining key requirements necessary
to protect investors. In place of specific prescriptions we
have provided that it will be each member firm's responsibility
to develop policies and procedures to effectively comply with
the rules. FINRA examiners will still have to be satisfied that
the firms have taken the appropriate measures to comply and are
not compromising the protection of investors.
We are likewise confident that the additional rule
harmonization proposals that are put forth by FINRA will
reflect a careful weighing of the relative merits of the
existing rules of NYSE and NASD. Nonetheless, to the extent
anyone, whether a state regulator, a representative of the
industry or of the public, has a concern about a proposal,
whether one already filed by NYSE or one that is filed in the
future by FINRA, that concern can be raised in the public
comment period, and it will be considered and weighed in the
balance by the SEC, as the final arbiter of whether a rule
proposal is consistent with the statute and the public
interest.
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