Reappraising Self-Regulation Part III:

By Bill Singer

Published in 2002

e-mail:  bsinger@rrbdlaw.com

http://www.securitiesindustrycommentator.com

In the two prior parts of this article we examined how self-regulatory organizations ("SROs") enjoy a chameleon-like existence; at times being deemed governmental in nature; at other times, being deemed a private entity; and, at other times, being deemed quasi-governmental. Such transmutation immunizes the SROs against lawsuits by the investing public and the securities industry, while denuding industry participants under investigation of constitutional and due process protections (most notably the Fifth Amendment right against self incrimination). Similarly, this sophisticated game of hide-and-seek frequently blurs the boundaries between civil and criminal enforcement of the securities laws and opens the door (or already widens the portal) to facile cooperation between, on the one hand, government prosecutors bound by strict grand jury secrecy and subject to due process requirements, and, on the other hand, SROs who deem themselves unfettered by the restraints of their governmental colleagues.

The strength of self-regulation is that it is often the quickest way to curtail serious securities industry misconduct. However, the cost of such aggressive prosecution is, at times, too dear, as was divulged in unsavory detail by the United States Department of Justice (Antitrust Division) and the Securities and Exchange Commission during their 1996 investigations of the NASDAQ stock market. In more recent times, we learn of other examples of improper regulatory conduct as alleged by the Department of Justice and the SEC in their investigations of the Oakford scandal at the New York Stock Exchange.

The SROs are inextricably tied to the stock markets they regulate and when promulgating and enforcing market regulations, those same organizations are routinely confronted with circumstances where one membership segment is advantaged when another is disadvantaged, or the public’s interests are furthered at the expense of the industry. This dynamic remains at the heart of all self-regulation. Can the regulator remain impartial? Can the regulator transcend its own parochial interests? How does a regulator fairly regulate a stock market so that public investors, industry member firms, industry employees, and public issuers are all protected? The New Testament warns that no man can serve two masters, how then can an SRO serve four?

SROs must never become partisan combatants. They must remain, at heart, referees consistently and impartially applying the rules. In the clash of ideas in the marketplace, misplaced SRO paternalism reduces innovation, inbreeds inefficiencies, and artificially limits free-market competition. Ultimately, the SROs’ mission is not amenable to any degree of compromise that affords lesser/greater protection to one of the four market participants at the expense of the others.

But what is the definition of the term "self" in self-regulation? Who its scope?" What constituencies are covered? At present, Congress and the SEC seem content to permit the SROs to define the term "self" as effectively limited to their member firms. Essentially, Wall Street is viewed as a business of member firms. And what precisely is a member firm? It is management/employer. Who then at the SROs speaks on behalf of labor/employee? A member firm frequently enables private companies to go public and provides for an aftermarket for such securities. Who then at the SROs speaks on behalf of the issuers? A member firm often recommends/trades securities with public investors. Who then at the SROs speaks on behalf of the public investor? Finally, member firms are not monolithic but vary among many fault lines: retail, institutional, regional, national, full-service, discount. Who then at the SROs speaks on behalf of each interest group?

As recent history has all too clearly demonstrated, SROs tend to favor their larger members over their smaller. Certainly, to the extent that regulatory agendas have become politicized as a result of special interest group lobbying, the bias has always been in the direction of the members providing more revenue to the SRO. Consequently, smaller interest groups (frequently so-called mavericks and bothersome innovators) tend to find themselves on the defensive --- unwelcome, subjected to added scrutiny, denied representation on committees and subcommittees. Similarly, the hundreds of thousands of registered individuals (who are not technically "members" of any SRO --- such distinction only permitted to an entity) are routinely subjected to regulation pursuant to rules on which they are denied a vote and are called before hearing panels whose members they cannot nominate nor elect. And keep in mind that many disciplinary/arbitration proceedings often divide along an employer/employee line in which management has adopted certain policies not necessarily favorable to labor’s concerns. Accordingly, it goes without saying that if the "self" in SROs is the member firm, that there are similar built-in conflicts with the best interests of issuers and public customers.

The simplest way to distill the nature of this debate is to merely look at the title of the NASD --- the National Association of Securities Dealers, Inc. Historically, NASD was an association of dealers --- The Securities Exchange Act of 1934 defines a "dealer" as any person "engaged in the business of buying and selling securities for such person’s own account through a broker or otherwise." However, Wall Street is far larger than those who function as securities dealers. Further, since for many broker-dealers and registered persons membership/registration with NASD is mandatory --- the so-called "only game in town." The culture they join does not always welcome them with open arms. One need only look back in recent time to recall the hostility of the old-guard dealers to discount commissions, online trading, decimalization, day trading and direct access platforms. While some of this antagonism is certainly understandable as protectionism of traditional "dealer" interests, it also served to set the stage for the NASD’s subsequent difficulties with the Department of Justice and SEC. In a sense, it is time for the NASD to shed its role as a regulator of the dealer community and for it to move on to the next stage in its evolution. The NASD’s culture needs to change to a more inclusive one.

The once quaint view that the Wall Street is a famous street with a graveyard at one end and a river at the other is simply outdated. The Stock Market’s gyrations no longer send rumbles to the blocks adjoining Wall Street, but now set off convulsions and aftershocks throughout America and the world. Wall Street has become so much more than a mere local business; it is the heartbeat of the world’s capitalist system. Clearly, the "self" in self-regulation is not a provincial issue to be left to a few powerful member firms.

In the midst of the unfolding Enron scandal, SEC Chairman Harvey Pitt recently conceded that there was much public debate concerning "whether there should be private regulation of the accounting profession with vigorous SEC oversight or direct SEC regulation." In considering the merits of the proposition, Pitt expressed his strong belief that

Chairman Pitt further opined that direct government regulation of the accounting profession would likely not work and the cost of government involvement in the audit and oversight processes could prove prohibitive. He concluded that the accounting profession could be best regulated by the private sector, subject to SEC oversight, with the costs spread among all effected private parties.

All in all, a well-reasoned analysis, but one that subsequently took an odd turn. Where one would have anticipated that Chairman Pitt would ultimately urge adoption of the securities industry’s self-regulatory model, he states that

Chairman Pitt raises an interesting distinction between "self" regulation and "private sector" regulation. Self-regulation in his lexicon apparently means exactly that --- a given industry/profession regulates itself. Private sector regulation as he uses the term, seems to have a very different meaning: one where all those mutually benefiting from ethical conduct of a profession undertake the task of regulation and share the cost. In Chairman Pitt’s worldview the accounting profession ought not regulate itself; rather, it should be a partner in the process with other private sector participants.

As I see it, the best way to ensure more ethical and effective self- regulation is to adopt Chairman Pitt’s perspective of private sector regulation. Ultimately, Wall Street ought not be a game preserve for a few major broker-dealers. It’s time to set a larger table. The SROs need to transform themselves beyond the regulation of Wall Street by Wall Street. It’s time that the entire private sector stepped in: member firms, registered person, issuers, and public customers. And it’s also time that the costs of such regulation were apportioned fairly among those who will share in the benefits.

On January 15, 2002, the NASD posted a Special Notice to Members 02-09, seeking comment on changing the NASD’s regulatory transaction fee.—The NTM candidly concedes that

Why the need to modernize fees? Perhaps the answer is found in a recent NASD announcement that its Board of Directors had approved the sale of its remaining 33.7 million shares of NASDAQ common stock to the NASDAQ Stock Market. According to NASD Chairman and CEO Robert Glauber, this divestiture of NASDAQ enables NASD to

Can the NASD really be considered independent if it relies upon transactional fees from NASDAQ and OTC transactions? Doesn’t such a revenue stream to a self-regulator create irreconcilable conflicts of interest? How can a regulator not be sensitive to any reduction in trading volume--- which must obviously result in a decrease in revenues? And now that the NASD no longer owns NASDAQ (but merely generates revenues from the transactions occurring in that market), isn’t there even more pressure to regulate in a manner that ensures higher levels of trading? And won’t that give larger members generating higher transaction levels even more influence? It’s sort of the difference between not earning revenue from the sale of cigarettes but, rather, from each puff.

Additionally, it would seem that NASD has only a few sources of revenue: transaction fees, membership fees, and regulatory fines. Transaction fees will likely prove resistant to arbitrary increases; in fact, in this present economy with more competition for less business, one should expect to see pressure to maintain (if not lower) existing fees. Similarly, these are tough times and membership fees cannot be arbitrarily raised to close budget gaps or fund new ventures.

We seem left with the inescapable conclusion that self-regulators may put their cross-hairs on regulatory fines as a way to enhance revenues. Of course, the dirty little secret with such agendas is that one frequently notices a discomforting increase in the number of enforcement actions. During such blitzes the practice is to ticket for a whole host of minor violations --- hoping for the quick payment to settle the nuisance. Such a practice is all too reminiscent of a speed trap behind some billboard on a quiet rural highway. The small town paying the motorcycle cop loves to raise the costs of the ticket and the frequency of pulling over the unsuspecting out-of-towner. And should you be foolish enough to demand a jury trial, good luck with the panel of taxpayers whose assessments are kept low by the revenues from the tickets.

Should regulators be in the "business" of collecting fines? I continue to believe that one of the failures of Wall Street’s regulatory community is that far too many defrauded public customers win litigation/arbitration verdicts against disreputable firms and individuals, only to be unable to collect their awards. Wall Street would certainly be taking the moral high ground if it allocated all collected regulatory fines to a fund for the exclusive benefit of defrauded public customers unable to collect their awards. Similarly, by crediting collected fines to their operating accounts, the SROs create a troublesome conflict by generating revenue through enforcement activities. This only fuels the legitimate concern that SROs give higher performance evaluations (and hence larger bonuses and better promotion consideration) to regulatory employees who do a superb investigative job and recommend an enforcement action, but somehow deem those employees who do not recommend an enforcement action as not so entitled.

SROs cannot act effectively when they lack first-hand familiarity with the practices of Wall Street. There must be some sensitivity for the professionals and the industry being regulated. Consequently, it is critical that an appropriate number of regulators have actually worked on the Street. If SROs merely hire from the ranks of the SEC and state prosecutors, one must ask whether the system is nothing more than a redundancy rubber-stamping governmental agendas. Accordingly, SROs must be more than a dummy in an SEC or NASAA ventriloquist act. Wall Street should not be saddled with self-regulators who only parrot the SEC or unquestioningly bow in deference to the states. For self-regulation to properly function, its regulators must be prepared to advocate the industry’s best interests when appropriate. This means that those involved in self-regulation must reaffirm each SRO’s proper role as a full-fledged partner in the regulatory process, and not merely as a proxy for the SEC or states.

The markets will become publicly owned and the dominance of the NASD and NYSE are daily being challenged by expanding alternative trading systems and growing international competition. The public markets’ success will not be determined by the NASDAQ or NYSE composite index, which measures the profitability of the listed companies. To the contrary, after demutualization, success will be determined by the profitability of the market itself. And woe be it if the NASDAQ or NYSE cannot turn a profit or begins losing market share to some upstart. One only needs to look as far as NASDAQ’s most recent 10-Q for the period ended September 30, 2001 (http://www.sec.gov/Archives/edgar/data/1120193/000095017201501137/0000950172-01-501137.txt) to see what the future may hold:

Daily share volume is down. All primary revenue streams are suffering. Transaction services revenues are declining. Perhaps more ominously, in addition to the general economic downturn, NASDAQ’s market information services and transaction services revenues face a competitive threat from other stock exchanges that trade its listed stocks and there is certainly a potential for significant erosion NASDAQ’s market share of trading activity and the related market information services and transaction services revenues as new exchanges arise or existing exchanges increase their market share.

It is time for us to put to rest the concept of "self" regulation and move forward with the more dynamic alternative of "private sector" regulation. SRO boards must be opened up to wider representation from the private sector. Board seats should be allocated for the President of the Public Investors’ Arbitration Bar Association (or another similarly credible investors’ organization) and for a representative of the more than half-million registered persons in the industry. Individual registered persons must be enfranchised and permitted to vote on the rule proposals relating to their profession. And of course, it’s high time that we provide industry employees and member firms with a bill of rights regarding the conduct of SRO investigations.

SRO management must find more creative ways to finance their operations and any resort to fines as stopgap financing must be abandoned. It is simply unacceptable that the critical job of privately policing Wall Street should be handled by individuals whose best hopes of compensation is not comparable to their industry counterparts. Private regulation is not supposed to be amateur hour; nor, should the rolls of SRO employees be filled with rejects from the private and public sector. Similarly, there must be a financial commitment to maintain a veteran complement of regulators and to stop the damaging revolving door. True, in these difficult times SROs will find it easier to hire and retain experienced staff --- but this recession will not last forever and good times will once again deplete the ranks of skilled regulators. Consequently, I call for the creation of a salary/bonus system for regulatory employees that is more competitive with the compensation structure of the same industry being regulated. Similarly, longevity should not entitle any regulator to promotion. We already have enough SRO managers who are not up to the task but simply obtain promotions by staying on the job long after the Street hired their more qualified colleagues. Ultimately, Wall Street is better served when regulated by well-compensated professionals.

Finally, I believe that the time has now come to merge all the existing SROs into one, national SRO. The funding for that organization should be derived from a fee on each securities transaction in the markets, from a fee on each public offering, and from reasonable membership/registration fees. By developing such a pool of funding, the national SRO will be largely freed from conflicts caused by reliance upon the one market each present SRO regulates. All regulatory fines should be deposited into a fund to be administered for the purpose of compensating defrauded public investors who can demonstrate an inability to collect awards rendered against member firms and registered persons.

[a version of this article previously appeared in eSecurities (Vol.4, No.6 Feb.2002)