TESTIMONY OF ARTHUR LEVITT, CHAIRMAN U.S. SECURITIES AND EXCHANGE COMMISSION CONCERNING THE LARGE FIRM PROJECT BEFORE THE SUBCOMMITTEE ON TELECOMMUNICATIONS AND FINANCE COMMITTEE ON ENERGY AND COMMERCE U.S. HOUSE OF REPRESENTATIVES SEPTEMBER 14, 1994 U.S. Securities and Exchange Commission 450 Fifth Street, N.W. Washington, D.C. 20549 EXECUTIVE SUMMARY The Commission, working in conjunction with the New York Stock Exchange ("NYSE") and the National Association of Securities Dealers ("NASD"), recently completed a review of the hiring, retention, and supervisory practices of nine of the country's largest broker-dealers. As a result of this review, the Commission staff ("Staff") found that certain sales practice abuses existed, although the problems found are not indicative of a larger systemic breakdown. In response to its findings, and as part of the Commission's general sales practice initiative, the Staff made a number of recommendations to strengthen broker- dealer compliance systems, enhance self-regulatory organization ("SRO") efforts, and build public confidence in the integrity of the securities industry. The recommendations and initiatives include, among other things: * Enhanced SRO efforts in conducting additional examinations, imposing tougher sanctions for sales practice abuses, improving the Central Registration Depository System ("CRD"), developing a better system to coordinate and track investigations among the SROs, and disclosing information to investors regarding the disciplinary history of registered representatives. * Enhanced Commission efforts in increasing compliance inspections and continuing to focus examinations on registered representatives with large numbers of customer complaints, arbitration proceedings, or disciplinary actions. The Commission also is planning another joint regulatory examination sweep with the NASD, the NYSE, and the North American Securities Administrators Association. This sweep will focus on all firms, large and small, and will target problem brokers throughout the industry. * Increased broker-dealer efforts in identifying problem registered representatives and developing procedures to govern the hiring and supervision of problem registered representatives. The Commission is also exploring means to afford qualified immunity to firms for good faith disclosure on Form U-5. Finally, the Commission is considering means to curtail abusive cold-calling. * Developing continuing education requirements for registered representatives * Examining compensation practices in the brokerage industry to identify and eliminate practices that pose conflicts of interest. TESTIMONY OF ARTHUR LEVITT, CHAIRMAN U.S. SECURITIES AND EXCHANGE COMMISSION CONCERNING THE LARGE FIRM PROJECT BEFORE THE SUBCOMMITTEE ON TELECOMMUNICATIONS AND FINANCE COMMITTEE ON ENERGY AND COMMERCE U. S. HOUSE OF REPRESENTATIVES Chairman Markey and Members of the Subcommittee: I appreciate this opportunity to appear before the Subcommittee on Telecommunications and Finance ("Subcommittee"), on behalf of the Securities and Exchange Commission ("Commission"), to discuss the Commission's recent efforts to combat sales practice abuses in the securities industry. As the members of this Subcommittee are aware, the Commission, working in conjunction with the New York Stock Exchange ("NYSE") and the National Association of Securities Dealers ("NASD"), recently completed a review of the hiring, retention, and supervisory practices of nine of the country's largest broker-dealers. The Commission initiated this review, referred to as the "Large Firm Project" or "Project," in response to increased public concerns about the perceived proliferation of sales practice abuses. On May 19 of this year, the Commission Staff ("the Staff") publicly announced the findings of its Large Firm Project. Commission, NYSE, and NASD staff conducted 170 broker-dealer examinations of both home and branch offices of the nine firms and focused their review on 268 registered representatives who had been the subject of sales practice-related customer complaints, litigation, arbitration, or disciplinary actions. We found that: * Of the branch office examinations conducted, one quarter resulted in enforcement referrals. * More than a third of the registered representatives selected for review were no longer employed in the securities industry. * Of those that remained, the majority were able to change jobs at least once, indicating a willingness among firms to hire individuals with a history of customer complaints. * Some firms were much better than others in minimizing sales practice abuses. * Three of the nine firms accounted for 88% of the enforcement referrals. This indicated to us that certain branch office managers were not enforcing supervisory and compliance systems. * Finally, the largest revenue producing registered representatives generally were not the subject of investor complaints. The Staff found sales practice abuses, but the problems found are not indicative of a larger systemic breakdown. Although one quarter of our examinations resulted in enforcement referrals, this was not surprising. Our sampling was not random; we selected branch offices on the basis of, among other things, large numbers of customer complaints as reported to the NYSE. We fully intended to follow-up with enforcement actions. Another finding revealed by the report is that some firms were much better than others in minimizing sales practice abuses, demonstrating that the tone set at the top can make a real difference. Managers and supervisors can and do set standards that have an impact. In response to our findings, and as part of the Commission's general sales practice initiative, the Staff made a number of recommendations that I believe will strengthen broker-dealer compliance systems, enhance self-regulatory organization ("SRO") efforts, and build public confidence in the integrity of the securities industry. I have submitted a report to this Subcommittee regarding our recommendations and I would like to discuss the progress we have made in implementing these recommendations with you today. I. SRO EFFORTS On August 4, 1994, the Divisions of Market Regulation and Enforcement sent a letter to the SROs requesting that the SROs advise the Commission regarding the actions they have taken or plan to take to develop and implement the recommendations set forth in the Large Firm Project Report. The responses from the SROs generally agree with and support the overall findings and recommendations of the Large Firm Project Report. Because the NYSE and the NASD also will testify before this Subcommittee today regarding their efforts to prevent sales practice abuse, I will not dwell on the specifics of the SROs' responses and initiatives. I would, however, like to discuss our recommendations to the SROs. A key finding in our Large Firm Report was that we need to conduct more examinations and impose tougher sanctions when abuses are found. Accordingly, the Staff asked the SROs to devote additional resources to conducting examinations and to prosecuting sales practice cases. We also asked the SROs to develop better tools for identifying sales practice problems at an earlier stage. Specifically, we asked the SROs to review arbitration claims when they are filed rather than when they are completed. This will enable the SROs to detect patterns of fraud and supervisory negligence at an earlier stage. To further this goal, we asked the SROs to consider adopting a rule, comparable to NYSE Rule 351, requiring members to report customer complaint information on a quarterly basis. -[1]- The NASD is currently in the process of drafting such rules to file for approval with the Commission. In its letter, the Staff further requested that the SROs closely monitor the timeliness of Forms U-4, U-5 and RE-3 filings, which are used by firms to report, among other things, terminations for cause, customer complaints, disciplinary actions, and arbitration awards and settlements. These forms, which firms are required to file with the SROs, are a very productive source for identifying possible sales practice problems. We believe that in cases of untimely or non-reporting of required information, SROs should increase their sanctions against both firms and individuals. I also would like to see the SROs better coordinate their investigations to ensure that the SROs fully investigate all matters and not duplicate their efforts. To this end, the Staff has asked the SROs to review their existing procedures and, if necessary, develop and implement a tracking system that would identify clearly which SRO is investigating a particular matter. The SROs also were asked to review and, if necessary, enhance their sanctions against registered representatives and broker-dealers who commit sales practice violations. I strongly believe that disciplinary sanctions against such individuals and firms should be severe. The Commission itself will devote additional resources to prosecuting registered representatives who have violated federal securities laws and Commission rules, and we intend to review the adequacy of existing sanctions for sales practice violations. One area of particular concern for the Commission is the re- entry of individuals who have been barred by the Commission from the securities industry without any provision for reapplication after the expiration of some period. We refer to these bars as unqualified bars and they are one of the most severe sanctions available to the Commission, reserved for egregious cases. Unfortunately, some in the industry appear to have a perception that, absent any intervening misconduct, SROs will approve and the Commission will not object to applications for re-entry by such individuals after five years. Such an expectation is unwarranted. When the Commission imposes an unqualified bar against an individual it evidences the Commission's conclusion that the public interest is served by permanently excluding the barred individual from the securities industry. Accordingly, absent extraordinary circumstances, a person subject to an unqualified bar will be unable to establish that it is in the public interest to permit re-entry to the securities industry. The Staff has sent a letter to the NYSE and NASD clarifying Commission policy in this regard. I also would like to mention that the NASD has embarked on a multi-million dollar rewrite of its Central Registration Depository ("CRD") system which should greatly assist the SROs in their investigatory endeavors. I am sure that the NASD will discuss their proposed new system with you today. When fully completed in early 1996, this state-of-the-art, user-friendly system will provide regulators with the ability to search through hundreds of thousands of records to identify problem registered representatives and the individuals and firms charged with supervising them. The updated system also will provide firms and investors with easier access to disciplinary records. The Staff has been working closely with the NASD's CRD redesign team and expects the new CRD to be an important element in our efforts against problem registered representatives. Investor protection also entails helping investors protect themselves. To do so effectively, I believe that investors need information about their registered representative before they open an account. It is essential that an investor be able to choose a registered representative who is trustworthy and reliable. To better protect investors, firms should inform potential investors that the NASD operates a toll free hot-line ("800 number") that discloses disciplinary information about firms and registered representatives. The Staff's letter to the SROs asked them to consider adopting rules that would require member firms to disclose to investors, before effecting any transactions in their accounts, that this 800 number exists and is available to provide investors with important disciplinary information. I would also like to note that in addition to the 800 number, the Commission and the SROs, as well as the North American Securities Administrators Association ("NASAA"), recently published a brochure for investors entitled "Invest Wisely." The brochure was created to provide investors with information concerning selecting a registered representative, making investment decisions, monitoring investments, and dealing with investment problems. I also believe that investors need more information about disciplinary proceedings. Specifically, the public should have access to information regarding not only completed disciplinary actions, but also initiated disciplinary actions when charges are filed by the SROs. The failure to disclose this information to investors is not consistent with the public interest. The NASD and NYSE already have instituted procedures to disclose initiated disciplinary actions to the public through the 800 number; in its recent letter, the Staff asked the remaining SROs to disclose this information as well. II. Commission Efforts The Commission is strengthening its efforts to identify and curtail sales practice abuses. For example, the Commission intends to continue its aggressive oversight of SRO examinations, as well as SRO sales practice examination and overall enforcement programs. Our oversight endeavors have included increased compliance inspections and regular meetings with senior staff of the NYSE and NASD to communicate the importance of effective sales practice examination and enforcement programs. The Commission's efforts have led to an increased SRO commitment to identifying and disciplining registered representatives who commit or engage in sales practice abuses. I also believe that an important means of maintaining an aggressive examination posture is for federal, state, and SRO staff to continue to work together. The Large Firm Project, as well as the recent Penny Stock Sweep, the largest cooperative examination effort ever undertaken by securities regulators, demonstrate that by coordinating our resources we can make significant progress to reduce fraud, abuse, and manipulation, and add to overall investor confidence in the securities markets. -[2]- To this end, the Commission, in coordination with the NASD, the NYSE, and NASAA, is in the process of planning another joint regulatory examination sweep. Rather than focus on specific large firms as we did during the Large Firm Project, during this sweep we will include large, small, and medium-sized firms in the industry and will target so-called "rogue" or problem registered representatives throughout the industry. We plan to use CRD information to target registered representatives who have been the subject of customer complaints, arbitration proceedings, or disciplinary actions, and who have changed employment frequently. We look forward to again working cooperatively with the NASD and the NYSE, as well as NASAA, in order to increase the level of protection afforded to investors from abusive, fraudulent, and manipulative activities. We also intend to re-emphasize our own general examination focus on registered representatives with large numbers of customer complaints, arbitration proceedings, or disciplinary actions. The Staff is exploring different methods of utilizing the NYSE Rule 351 data in its regular examination program. In addition, we are developing a program for the systematic review of the allegations made in arbitration cases filed with the NASD and other SROs. This will enable us to identify potential sales practice abuses at an earlier stage. III. Broker-Dealer Efforts The regulatory agencies alone cannot stem sales practice abuses. Rather, broker-dealer firms are also critical to deterring abusive sales practices. Firms need to improve their efforts in identifying problem registered representatives. In particular, firms should amend their procedures to identify registered representatives-with large numbers of sales practice- related customer complaints, arbitration awards, or settlements. Firms should use, to a greater extent, NYSE Rule 351 data to detect trends and patterns of customer complaints within particular branches. Furthermore, firms should improve their compliance systems and enhance their data processing and computer capabilities to assist branch office managers in performing supervisory functions. I would like to note that the industry recently has taken steps towards enhancing the reporting and disclosure of sales practice-related complaints and actions. On June 21, 1994, the Commission received a letter from the Securities Industry Association ("SIA") discussing the creation of an Ad Hoc Committee on Regulatory Reporting and Disclosure ("Ad Hoc Committee"). The Ad Hoc Committee plans to work towards resolving reporting and disclosure problems and creating effective and fair systems for reporting, retaining, and analyzing sales practice-related data. The Commission intends to work with the Ad Hoc Committee to enhance reporting and disclosure requirements, giving due regard to privacy and fairness issues. One area of disclosure that should be improved is the firms' discussion on Form U-5 of reasons for a registered representative's departure from the firm. Full and accurate disclosure is necessary to prevent registered representatives from committing similar sales practice abuses at a new firm after they have been terminated by their old firm. Firms and supervisory personnel are concerned, however, that, in certain instances, if they accurately and fully disclose their reasons for terminating an individual, that individual may bring a defamation action against the firm and supervisory personnel. The Staff is exploring with the SROs means of affording qualified immunity to firms for good faith disclosure on Form U-5. Even without this immunity, however, broker-dealers presently have an obligation to file accurate and complete Form U-5s. Broker-dealer legal and compliance departments also have an important role in preventing sales practice abuses. Firms should have procedures governing the hiring of individuals having disciplinary or employment histories involving abusive sales practices that are more stringent than their general hiring procedures. These procedures should identify the personnel responsible for making the decision to hire a problem salesperson. The procedures also should set forth factors relevant to this hiring decision, and provide for heightened supervision of prospective employees having a prior problem. We believe these procedures should include a requirement that firm management provide written justification for a decision to hire or retain an individual that is taken in the absence of, or against the express recommendation of, legal or compliance staff. I have asked the Staff to consider whether there should be greater regulatory sanctions against firms and supervisors who hire problem registered representatives who subsequently commit additional sales practice violations at their new firms. I believe that broker-dealers and their supervisory personnel have an obligation to apprise themselves of the disciplinary and employment history of their sales personnel. Firms need to take a harder look at a registered representative's disciplinary record before hiring that individual. If a firm takes the risk of hiring a registered representative with a bad record, the firm must be especially vigilant in its supervision. If a particular individual has had prior sales practice problems, this fact should serve as a red flag to a firm that either the firm should not hire the individual or the individual should be subject to greater oversight by the firm and its supervisory personnel. Supervisory deficiencies combined with lax hiring standards for problem registered representatives gives rise to repeated sales practice abuses. We will, accordingly, hold firms and supervisors responsible for their employees' sales practice abuses if they have ignored the warning signs while hiring a problem registered representative. The recent Staff letter to the SROs asked them to review their rules and consider increasing sanctions against firms who hire a problem registered representative who continues to commit sales practice violations. Finally, in addition to the areas I have just discussed, there is another area that I believe warrants our attention. A practice that is widely used in our industry, yet holds the potential for abuse, is cold-calling. We receive complaints from angry consumers who receive unsolicited calls and high pressure sales pitches from securities firms, and continue to receive these calls even after telling the salesperson never to call again. This is harassment. Moreover, these high pressure sales tactics may result in customers making inappropriate and risky investments. Some securities firms have procedures in place to govern the cold-calling practices of their registered representatives, and represent that they are able to use cold-calling as a legitimate canvassing tool. There are others, however, that give the entire industry a bad name. These persistent and abusive few affect investors across the nation, making the problem seem pervasive. There must be a stop to the practice of abusive cold- calling. Broker-dealers, like all firms engaged in telemarketing, are subject to the Telephone Consumer Protection Act of 1991 and a Federal Communications Commission ("FCC") rule promulgated thereunder. -[3]- Pursuant to the FCC rule, firms must: adhere to time-of-day restrictions; establish "do-not- call" lists; and establish training requirements, supervisory procedures and identification requirements for cold-callers. The Commission also intends to take action to adopt a cold- calling rule. Last month, Congress passed and the President signed new cold-calling legislation, entitled the Telemarketing and Consumer Fraud and Abuse Prevention Act. -[4]- The Act requires the Federal Trade Commission ("FTC") to enact cold- calling rules within a year of the legislation and directs that the SEC adopt substantially similar rules within six months of the FTC rules. The Commission intends to work in cooperation with the FTC to coordinate the rulemaking efforts. IV. Continuing Education Another crucial method of improving registered representative compliance with sales practice rules and procedures is to enhance registered representative education. Enhancing education in the profession so that registered representatives are always informed and knowledgeable about the markets, about the products they sell, about the rules, and about new developments in the industry will help protect investors and build public trust. I have personally emphasized to NYSE and NASD member firms that mandatory continuing education for securities industry professionals should be one of the industry's top priorities. In addition, an Industry/Regulatory Council on Continuing Education ("Council"), composed of representatives from the SROs, a cross-section of firms, and liaisons from NASAA and the SEC, is developing a continuing education curriculum to improve practices throughout the industry. Under the Council's proposed program, every broker-dealer will be required to provide its registered representatives and first-line supervisors with annual continuing education relating to products and services. In addition, and perhaps more importantly, the Council proposes that all personnel who have been registered less than ten years or who have been the subject of serious disciplinary violations receive compliance, ethics, and sales practice training. The idea behind this continuing education program is simple: any registered person having direct personal contact with customers will be subject to ongoing education and training requirements. A registered representative must participate or his registration will become inactive. The Council has organized two working committees to develop the elements of the continuing education program. The committees have drafted enabling rules and designed the program structure, content, and delivery mechanisms. The Council has submitted the proposed rules to the various SROs for review and adoption. The Council has an ambitious time frame for completing its work and expects to have SEC approval for its rules in January 1995 and to implement its program in July 1995. I wholeheartedly support the mission and efforts of the Council. In addition to continuing education, I believe that there is a place for higher education of registered representatives. Industry leaders have expressed support for a voluntary higher education program, similar to the "Certified Life Underwriter" degree for insurance brokers with several years of experience. I have offered my support for industry efforts to develop this concept further with our nation's top business schools. I believe many registered representatives may wish to take advantage of such a program, to distinguish themselves and offer their clients even better service. V. Compensation In addition to education, I want to touch on the subject of compensation. The public's trust and confidence in the securities industry are strongly affected by registered representative compensation. Investors develop trust and confidence in a registered representative based on their interactions with that individual. When a registered representative recommends a security, the investor should not have to wonder whether the investment is in his or her interest or whether the registered representative is simply trying to make a quick buck. Investors should feel that their registered representatives are looking out for their best interest. In order to focus industry attention on compensation practices, I have asked a committee of distinguished individuals ("Committee") to examine compensation practices in the brokerage industry. The Committee is chaired by Dan Tully, Chairman and CEO of Merrill Lynch, and includes: Warren Buffett, Chairman and CEO of Berkshire Hathaway, and former Chairman of Salomon Brothers; Jack Welch, Chairman and CEO of General Electric; Raymond Mason, Chairman and CEO of Legg Mason; Sam Hayes, a noted Harvard Business School professor; and Tom O'Hara, Chairman of the National Association of Investors Corp. The Committee's mission is to identify industry compensation practices that raise significant conflicts of interest between registered representatives and customers, and suggest ways to eliminate or reduce these conflicts. The Committee will focus specifically on the factors that influence a registered representative when the registered representative is attempting to make a sale. Last month, the Committee released an open letter to the financial services industry asking for comment from all parts of the industry and public. My hope is that this Committee will increase firm, registered representative, and the public's awareness about compensation issues. Over the next few months, the Committee plans to draft a paper that will discuss industry compensation practices, identify actual and perceived conflicts of interest, and identify the "best practices" in the industry - - those compensation practices that minimize to the greatest extent possible conflicts of interest between investors and registered representatives. VI. Conclusion As the members of the Subcommittee can see, we have made progress in addressing sales practice abuses in the securities industry. The Commission, the SROs, and most firms are committed to removing problem registered representatives. We have implemented or are in the process of implementing the variety of recommendations and programs that I have discussed with you today to eliminate sales practice abuse. In all these actions, our highest aim is to protect the investing public and improve investor confidence in the integrity of this nation's capital markets. END NOTES -[1]- NYSE Rule 351 requires that member firms report customer complaint information to the Exchange on a quarterly basis. In addition, the rule requires that member firms report certain occurrences or events to the Exchange on NYSE Form RE-3. These events include, among other things, certain customer complaints, arbitration awards and settlements, and disciplinary actions. -[2]- The Penny Stock Sweep was a joint examination sweep by federal and state regulators, as well as the SROs. The Sweep was designed to measure broker-dealer compliance with penny stock legislation and SEC rules and determine the extent of penny stock activity in the United States. The joint examination team released its 1993 Penny Stock Examination Sweep report on June 28, 1994. -[3]- Telemarketers are subject to the Telephone Consumer Protection Act of 1991 and the FCC rule promulgated thereunder. See Pub. L. No. 102-243, 105 Stat. 2394 (1991) (codified at 47 U.S.C.  227 (1992)); 47 C.F.R.  64.1200 (1992) -[4]- See H.R. Rep. No. 868, 103rd Cong., 1st Sess. (1994).