[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

                              ----------                              

                         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

                              ----------                              


                         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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