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U.S. Securities and Exchange Commission

Speech by SEC Commissioner:
Remarks at the ALI-ABA Course of Study, Broker Dealer Regulation


Commissioner Annette L. Nazareth

U.S. Securities and Exchange Commission

Washington, D.C.
January 11, 2007

Good afternoon. I have often told the story that the very first industry conference I attended when I entered the brokerage industry was this very ALI-ABA conference. It must have been about 1987, and I came at the encouragement of Tom Russo. So much has transpired since that time! I am delighted to be here today with Tom and so many other old friends from my many years in the securities industry and as a regulator. And speaking of regulation, today I would like to reflect on self-regulation of the securities markets, highlight both the benefits and conflicts inherent in an SRO model, and then discuss the proposed consolidation of the regulatory operations of the NYSE and NASD. Before I begin, I must remind you that my remarks represent my own views and not necessarily those of the Commission, my fellow Commissioners, or members of the staff.1

Few businesses are as dynamic or innovative as the securities business. In just the last few years we have witnessed significant structural shifts in our trading markets – from floor-based exchanges to more fully electronic markets, and now potentially from fragmented national markets to more consolidated international platforms. Perhaps even more relevant to our self-regulatory model, we recently have seen many of our markets move from private, mutual organizations to shareholder-owned, public companies. While the regulated members of these markets are the participants, or users, of the marketplace, they do not necessarily have an ownership stake in the exchange itself. The interests of members may diverge from the shareholders in a number of important ways, and, indeed, the members in many instances are now competitors of the very exchanges that also have regulatory authority over them. And of course the markets themselves might have a greater incentive than in the past to place profit motives over regulatory priorities. These ever changing practices and structures compel us, as regulators, to continually evaluate the effectiveness of our regulatory structure and programs and to marshal change when appropriate.

As you are all well aware, all broker-dealers are required to be members of a self-regulatory organization. The Exchange Act requires SROs to implement the federal securities laws as well as their own rules. SROs, among other things, set standards, conduct examinations, and enforce rules regarding their members. Self-regulation has a long tradition in the U.S. securities markets. In the early 1800s, not long after the historic Buttonwood Agreement, the NYSE and other exchanges began laying the foundations of the SRO model, which included adopting standards concerning the conduct of its members and listed companies – in particular, trading conventions, financial responsibility, listed company registration, and financial reporting. Federal regulation of exchanges, and their formal recognition as self-regulatory organizations, followed events including the stock market crash of 1929 and the NYSE investigatory failures related to market manipulation that were the subject of the 1934 Pecora Hearings.2 And ultimately, in 1938, the Maloney Act amended the Exchange Act by adding a new Section 15A which established the concept of a registered national securities association SRO.

Together, the Exchange Act, the Maloney Act, and the Exchange Act Amendments of 1975 (1975 Amendments) reflect Congress’ determination to rely on self-regulation as a fundamental component of U.S. securities market and broker-dealer regulation. By enacting these laws, Congress concluded that self-regulation of both the exchange and OTC markets was a mutually beneficial arrangement that balanced government and securities industry interests. Congress favored self-regulation for many reasons including the significant expertise and in-depth knowledge that the industry could bring to regulation. There were cost considerations as well. The cost of effectively regulating the securities industry solely through a federal agency was considered prohibitive and inefficient. With SROs, the Commission could leverage its resources by focusing on its oversight role. Another significant benefit of the SRO model was that SROs could set standards that exceeded those the Commission could impose. The Commission has anti-fraud authority, but the industry may set higher standards for business conduct and ethical behavior. For these and other reasons, Congress determined that the securities industry self-regulatory system would provide a workable balance between federal and industry regulation. I believe that the SRO model has served us very well. It has both contributed to the efficiency and dynamism of our markets, and has fostered high quality investor protection.

Congress adopted the self-regulatory model for the securities industry despite the obvious conflicts of interest that are present in such a structure. Ultimately, Congress believed that the SRO, with close SEC oversight, could successfully balance the tension between “self” and “regulation” by mitigating, or managing, the attendant conflicts. In delegating oversight authority to the SEC, Congress granted us the authority to approve or disapprove, when appropriate, SRO rules, including SRO bylaws and charters, which contain many of the provisions concerning governance of the SRO. Further, the Commission may affirmatively mandate change within an SRO through SEC rulemaking. The SEC’s oversight role has led to frequent communication and close interaction between the staffs of the Commission and the SROs over the substance of rule proposals. Having had direct experience with this dynamic, I can confidently say that the SEC’s ability to disapprove, and indeed affirmatively promulgate, SRO rules is a powerful tool in effecting change within an SRO.

There have been some notable failures by SROs over the years that have required SEC intervention. We have intervened on numerous occasions to encourage governance changes to redress failings by SROs. One such notable example dates back to the mid-1990s when the Commission instituted administrative proceedings against the NASD with respect to OTC market maker pricing collusion. The Commission found that the NASD regulatory staff lacked independence from Nasdaq’s market operations, to the detriment of the regulatory program. Specifically, the NASD failed to conduct an appropriate inquiry into anti-competitive pricing conventions of Nasdaq market makers, even though they knew of evidence of problems for several years. Further, the NASD failed to enforce significant market rules, such as the firm quote rule and trade reporting rule, which undermined the integrity of the entire Nasdaq market and also harmed investors. The Commission also found market makers to have undue influence in the disciplinary and regulatory processes, which led to lax and unbalanced enforcement and rulemaking. You may recall that the Commission issued a 21(a) Report in which it discussed at length problems that eviscerate the effectiveness of the self-regulatory system and inherent conflicts. As part of the enforcement undertakings imposed by the SEC, the NASD’s governance was overhauled, creating more balanced boards and committees. For its part, the Commission adopted the Order Handling Rules to enhance transparency, reduce fragmentation, and increase competition in the Nasdaq market.

A second example of the SEC’s intervention in SRO governance was the Commission’s inquiry into the compensation of the NYSE’s former Chairman Richard Grasso. As you may recall, then SEC Chairman Donaldson sent a letter to the NYSE questioning the NYSE Board’s announcement days earlier that it approved a new contract with its Chairman and that it had distributed compensation from three benefit plans totaling $139.5 million. Chairman Donaldson urged the NYSE to apply to itself the same high governance standards that it required of its listed companies. He raised serious concerns about the efficacy of NYSE’s current governance structure. Chairman Donaldson went on to ask numerous questions about the operation of the Board and its compensation committee and Mr. Grasso’s total compensation package, and demanded a report on the NYSE’s review of its governance structure. It rather quickly became apparent that weaknesses in the governance structure significantly contributed to the problems at the NYSE. Working with Commission staff, the NYSE adopted a new governance model that created an independent board, mandated that regulatory staff report to independent board committees, and increased transparency of SRO operations and governance activities.

When you think about it, SROs have weighty and complex responsibilities. SROs must enforce the securities laws and their rules, and yet are membership organizations invested in the economic interest of their members. Further, SROs that are imbedded in marketplaces are also concerned with furthering their competitive position, sometimes in a manner that conflicts with their self-regulatory responsibilities.

In terms of carrying out their regulatory mandate, SROs must promulgate and enforce rules that govern all aspects of their members' securities business. When the conflicts in the dual role of regulating and serving their members go unchecked, the result is poorly targeted SRO rulemaking and under-zealous, or even lackadaisical, enforcement of SRO rules against its members. And even where an SRO structure may by all appearances seem sound, effective self-regulation requires vigilance and robust enforcement by the SRO. Thus, to be effective, an SRO must be structured so that regulatory staff is independent – particularly from inappropriate business pressure – and must be well-funded, diligent, and accountable.

SROs may fall short of effective regulation for a variety of reasons, including member domination of SRO funding, member control of SRO governance, and member influence over regulatory and enforcement staff. When certain SRO members, or a coalition of members, can dominate or unduly influence the SRO, it may create particularly acute conflicts. In this situation, SROs may favor these members by failing to enforce rules against them, but all the while enforce the SRO rules against other less influential or dominant members. Also, SROs may favor certain members by failing to develop rules that would disrupt the business practices of such important members. Finally, when members have historically controlled the boards and the key committees, conflicts arise concerning vigorous regulation of such members. And today there are new sources of conflict within an SRO that may eviscerate its effectiveness as a regulator. For instance, the for-profit motive of a demutualized SRO may detract from proper self-regulation to the extent that profit seeking takes precedence over funding or enforcing regulation. Also, the expectations of shareholders, who are seeking a return on their investment, may diverge from regulatory interests.

It is because of all of these concerns, as well as the continual changes in the marketplace, that the SEC has in several instances reexamined the SRO model of regulation – whether through a special study, through the Market 2000 Report, or via its concept release on SROs.

It is not surprising, therefore, that the Commission is keenly interested in the latest approach to addressing the SRO model – the proposed merger of NASD and NYSE Regulation. Much has happened to bring us to this point. First, as you know, there has been much discussion over the past several years on the optimal model for self-regulation, beginning with then Chairman Levitt’s 1999 Market Structure Speech at Columbia. Chairman Levitt raised concerns as to whether for-profit, shareholder-owned exchanges qualitatively increased the conflicts so as to warrant a separation of member regulation from market regulation, with member regulation ideally put in a single SRO for all members – the so-called “hybrid” model of self-regulation. The speech was followed by the SIA (SIFMA) White Paper, which analyzed several alternative SRO models, in light of changes in the marketplace. The hybrid model favored by Chairman Levitt was ultimately embraced by the SIA White Paper drafters as well.

When you think about it, the NASD/NYSE Regulation proposal is an industry-driven solution that largely achieves the goals of the hybrid proposal. The new SRO would be responsible for member compliance for virtually all broker-dealer firms. It will also have enforcement and mediation functions, as well as rulewriting, professional training, and licensing areas. The NYSE would continue to oversee the NYSE market through its own market surveillance, enforcement, and listed company compliance groups. Thus, member regulation would be separated from the NYSE market under this proposal.

In addition to more effectively managing conflicts of interest, an NASD/NYSE Regulation combination potentially could achieve greater efficiencies and cost effectiveness than the current model. This consolidation should eliminate costly overlapping regulation and establish uniform rule sets within a single regulatory organization. Further, a single rule set and enforcement of such rules should reduce complexity and eliminate potential conflicts arising from multiple SROs. It is well worth noting that as market competition becomes even more aggressive as it moves beyond our own borders, we must be even more focused on providing the most effective regulatory oversight in the most cost effective manner.

The governance structure of the new combined NASD/NYSE Regulation SRO is expected to be balanced and independent. In the initial three-year period, of the 23-person board, 11 seats will be held by public governors, to be initially appointed by the boards of both the NASD and NYSE. The remaining ten seats will be from the securities industry – specifically, large and small firms shall each be guaranteed three seats; medium-sized firms, NYSE floor members, independent dealers/insurance affiliates, and investment companies will each have one seat. The current CEOs of the NASD and NYSE Regulation will also serve on the interim board. Beyond the interim period, the board will elect the public members through a nominating committee process.

I believe the proposed governance structure for the new SRO is well suited to achieve its mission. It both incorporates a long tradition of industry representation on the board while providing balance through a fair electoral process and a significant presence of independent governors that will be from outside the industry. Self-regulatory organizations must be independent from undue influence that interferes with the organization’s regulatory mandate. Whether this influence derives from domination of a particular member or class of members, or more generally through underfunding of regulation or control of regulation by a particular constituency, the SEC must and will address these regulatory issues. We will not approve any governance changes, or permit any governance structures to stand, that are not designed to achieve the goals of self-regulation.

It is interesting to note that when Congress most recently addressed industry regulation – that of public accountants – they created the PCAOB under the Sarbanes-Oxley Act of 2002. The PCAOB is a private-sector, non-profit corporation formed to oversee the auditors of public companies. SOX also specifically delegated oversight of the PCAOB to the SEC and authorized the SEC to approve the Board’s rules and professional standards, appoint the Board members, and conduct periodic or special exams of the Board’s records. Pursuant to the Act, the PCAOB must have a five-person board of directors which, interestingly, can only have two members who have been CPAs. To me this is a strong indication that independence of Boards and of regulatory oversight is now paramount to Congress and, commensurately, the role of industry and industry representatives has been diminished under the PCAOB model. In sum, much of the “self” in self-regulation has been removed in this latest formulation by Congress of industry oversight.

Notwithstanding Congress’ determination not to adopt the securities SRO model for the accounting industry, I remain optimistic that our self-regulatory model, as refined and recalibrated from time to time to address conflicts of interest and with watchful SEC oversight, can continue to work well for the securities industry and investors. Our focus should be on boards that have at least a majority of independent directors and that are balanced – that is, boards that incorporate fair, inclusive, and transparent processes, and appropriately provide for representation of all constituencies in the industry. We have a unique opportunity to confirm that securities self-regulation is an effective means of preserving the integrity of our markets. The NASD/NYSE Regulation merger represents a very positive step in securities member regulation of our evolving securities markets.

Thank you.



Modified: 01/12/2007