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Regulate Thyself (Better)

In the wake of the Wall Street scandals of the past few years, it was inevitable that government regulators would take a look at how the self-regulatory organizations (SROs), such as the NYSE and the NASD, were doing their jobs. If the SROs were really on the ball, why did so many abuses occur? And, if SROs have failed to protect investors, how should they be reformed to make sure they do better in

In the wake of the Wall Street scandals of the past few years, it was inevitable that government regulators would take a look at how the self-regulatory organizations (SROs), such as the NYSE and the NASD, were doing their jobs. If the SROs were really on the ball, why did so many abuses occur? And, if SROs have failed to protect investors, how should they be reformed to make sure they do better in the future? Further complicating the debate over the SRO structure are the NYSE's planned demutalization and merger with Archipelago Holdings and Nasdaq's planned merger with Instinet Group. How will these moves affect their role as policemen of brokers?

Last November the SEC posted two “concept releases,” in which the agency proposed restructuring the SROs to clarify their enforcement roles. The idea, said SEC Chairman William Donaldson in his farewell speech in June, is “to minimize conflicts between the business interests and regulatory responsibilities of the SROs.” Donaldson allowed that the SRO model may not be completely broken, but said the reforms would lead to “a higher degree of independence for SRO boards and key committees and requires the SROs to report more information to the Commission about their governance, regulatory programs and financial condition.” He cited former NYSE chief Dick Grasso's “headline-grabbing CEO compensation” package and the front-running scandal by seven specialist firms on the floor of the NYSE as the impetus for rethinking SROs.

Of the SEC's many individual propositions for reform, there are three broad options on the table, all of which would seek to keep SRO boards independent from their member firms. Under an “independent” model, all SROs would create separate subsidiaries for regulatory and market operations, just like the NASD has done.

In addition, a “hybrid” model would designate a “market neutral single self-regulatory organization to regulate all SRO members.” A “competing hybrid” would permit the existence of multiple SROs. Under a “Universal Industry Self-Regulator” and “Universal Non-Industry Regulators,” current SROs' authority would be transferred to one organization. Most Draconian would be a termination of the current SRO structure to be replaced by direct SEC regulation.

The comment period ended March 8, but it is not known how quickly newly appointed SEC Chairman Christopher Cox will address this issue. “There's no timetable,” SEC spokesman John Heine says. Nevertheless, the SRO reform effort could completely redraw how brokers and their reps are policed. The outcome of the commission's reform initiative will determine to a large degree how much further regulatory reform will go — and how much additional burden will be placed on firms, branch managers and individual reps.

It Ain't Broke

The Securities Industry Association (SIA), the trade group representing brokerage houses, sees no need for radical change, says Ira Hammerman, general counsel. Its comment letter to the SEC called for “one hybrid SRO to regulate various member firm functions and separate market SROs to regulate individual markets.” Hammerman says that this approach would help relieve duplicity, or “multiple rules by multiple organizations,” which he says increases regulatory burdens and costs.

“If I am a branch manager in a busy office, a lot of my time is spent on compliance issues, and that is because I have duplicative regulatory systems,” says Hammerman. “If I had one rule and one compliance checklist, that would free up some of my time to spend with my registered reps.”

Bill Singer, a securities lawyer and partner at Gusrae Kaplan Bruno & Nusbaum, and a columnist for this magazine, disagrees. Singer argues that, as constituted today, the SROs are “a failure” and suggests that the SEC proposals do not go far enough. Singer would abolish the SROs in favor of a national independent private regulator “with a board composed of public advocates and registered reps.” At that point Singer says the NYSE and NASD should be able to merge arbitration forms, making it cheaper to run. An independent board could then rewrite arbitration rules so individual brokers and the public both get fairer hearings, Singer says.

It's a difficult balancing act to create independent regulatory systems that have enough industry smarts to handle complex issues and satisfy the SEC's request for greater transparency and public input. “The question becomes is it worth the risk of giving up the devil you know for a system that might be more bureaucratic,” says Brandon Becker, securities lawyer and partner at Wilmer Cutler Pickering Hale & Dorr. He says that in the wake of the Wall Street scandals there has already been a tilt to more bureaucracy, with less industry involvement. “The classic tradeoff is how do we maintain some level of industry involvement and expertise without industry involvement in inappropriate conduct?” he says.

Not surprisingly, retaining industry expertise (and influence) is a top priority for the SIA, says Hammerman. “We have a concern that the self is kept in self regulation,” he says. “Who knows the industry best, but the brokers, dealers, branch managers, investment bankers and CEOs who are involved day to day? Having their insight and judgment is important to self regulation.”

Other industry figures also question the need for a major overhaul. Thomas Caldwell, chairman of Caldwell Financial and subsidiaries Caldwell Securities, Caldwell Management and Caldwell Asset Management, which represents 13 seats on the NYSE, calls the problems that occurred at the NYSE “pretty small potatoes” given the “gargantuan” amount of money that changes hands everyday. “Yes, what happened in our industry was wrong and had to be dealt with but that doesn't mean the system is broken,” he says.

But no less an NYSE insider than chief regulatory officer Richard Ketchum acknowledges that the SROs did not respond in a timely or adequate way to the industry scandals, creating an opening for the SEC. “The abuses resulting from the industry's inability to manage conflicts arising from the interaction of their investment banking and research functions and mutual fund revenue-sharing and sales practices have led many to question the commitment and even the ability of major complex financial institutions to maintain an effective compliance culture,” Ketchum said during a keynote address before the Practising Law Institute last November.

Not that Ketchum is a fan of the whole SEC slate of reforms. He heads up NYSE Regulation, the exchange's recently upgraded regulatory arm, which is intended to put some distance between the exchange and its regulator. The operating division reports to its own independent board, not to CEO John Thain. While he supports reforms such as winding down the open outcry system and beefing up electronic trading, Thain says that creating a new organization overseeing existing SROs “is the wrong way to resolve problems.” Instead, the NYSE favors greater coordination among existing regulatory agencies such as NYSE Regulation and the NASD.

If SROs are placed into one gigantic agency or are too removed from the action, they could lose “regional or industry sensitivity,” says Caldwell. “The larger your regulatory organization becomes, the more distant it moves from those you are regulating.” He adds that as far as potential abuses, if a regulator is too large, too aloof and Draconian, “it instills the propensity to bury stuff — make it go away, as opposed to working with regulators, and that is not a good thing.”

The logistical and managerial challenges of creating an uber-SRO probably make that proposal unlikely to survive, says Harrell Smith, manager of the Securities & Investments Practice at Celent Communications, a Boston-based research and consulting firm. “The creation of an enormous agency trying to police every participant in every market is almost beyond perception and would be a very difficult task,” he notes.

Smith predicts a compromise under which the NYSE and Nasdaq would fall under one umbrella or a loose configuration of regulators, each geared towards its own market. “My opinion is there will be increased regulations and increased costs in respect to compliance,” he says. “I don't think it will be so severe as to have a material impact on broker/dealer organizations. However, in the next few years, you will see a requirement for greater headcount for internal compliance.”

Becker says he hopes the SEC proposals lead to “some rationalization of resources.” But he is also resigned to the inevitability of additional scrutiny of securities marketing practices. “There will be continued pressure to show that not only did you do well, but you can demonstrate you did the right thing,” he says. “My view is that makes for a much more burdensome environment.”

For now, reps and b/d management will have to sit tight until Cox has a chance to formulate his agenda. Still, a shake-up for SROs undoubtedly lurks just over the horizon.



Designates a single, market-neutral SRO to regulate all members

Competing Hybrid:

Allows multiple SROs to oversee members


Transfers current SROs' authority to one organization

SEC Regulation:

Terminates current SRO structure in favor of direct SEC oversight

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