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50–317 2009

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 

jlentini on DSKJ8SOYB1PROD with HROC

(II) 

COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS 

CHRISTOPHER J. DODD, Connecticut, Chairman 

TIM JOHNSON, South Dakota 

JACK REED, Rhode Island 

CHARLES E. SCHUMER, New York 

EVAN BAYH, Indiana 

THOMAS R. CARPER, Delaware 

ROBERT MENENDEZ, New Jersey 

DANIEL K. AKAKA, Hawaii 

SHERROD BROWN, Ohio 

ROBERT P. CASEY, Pennsylvania 

JON TESTER, Montana 

RICHARD C. SHELBY, Alabama 

ROBERT F. BENNETT, Utah 

WAYNE ALLARD, Colorado 

MICHAEL B. ENZI, Wyoming 

CHUCK HAGEL, Nebraska 

JIM BUNNING, Kentucky 

MIKE CRAPO, Idaho 

JOHN E. SUNUNU, New Hampshire 

ELIZABETH DOLE, North Carolina 

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 

TIM JOHNSON, South Dakota 

CHARLES E. SCHUMER, New York 

EVAN BAYH, Indiana 

ROBERT P. CASEY, Pennsylvania 

DANIEL K. AKAKA, Hawaii 

JON TESTER, Montana 

MICHAEL B. ENZI, Wyoming 

JOHN E. SUNUNU, New Hampshire 

ROBERT F. BENNETT, Utah 

CHUCK HAGEL, Nebraska 

JIM BUNNING, Kentucky 

MIKE CRAPO, Idaho 

DIDEM NISANCI, Staff Director 

TEWANA WILKERSON, Republican Staff Director 

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(III) 

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 

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(1) 

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, selfregulatory 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 transjlentini on DSKJ8SOYB1PROD with HROC

2 

actions 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 Appropriajlentini on DSKJ8SOYB1PROD with HROC

3 

tions 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? 

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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 asjlentini on DSKJ8SOYB1PROD with HROC

5 

sociations, 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 rejlentini on DSKJ8SOYB1PROD with HROC

6 

sponsible 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. 

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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. 

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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 

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9 

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 wellbeing 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 

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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 NYSEArca 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 

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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. 

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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 longterm 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. 

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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. 

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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 

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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 

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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-thecounter 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? 

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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 

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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. 

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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 approxijlentini on DSKJ8SOYB1PROD with HROC

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mately 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 twooffice 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-fitsall 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. 

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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 brokerdealers 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—— 

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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 forprofit 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 

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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 representajlentini on DSKJ8SOYB1PROD with HROC

24 

tion 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 

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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 

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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. 

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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 

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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? 

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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. 

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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 fundjlentini on DSKJ8SOYB1PROD with HROC

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ing 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. 

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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. 

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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 

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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. 

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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? 

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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 memjlentini on DSKJ8SOYB1PROD with HROC

37 

bers 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. 

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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, 

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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:] 

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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 

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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. 

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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 conjlentini on DSKJ8SOYB1PROD with HROC

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stitutes 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 projlentini on DSKJ8SOYB1PROD with HROC

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posed 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? 

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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. 

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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 assojlentini on DSKJ8SOYB1PROD with HROC

107 

ciated 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. 

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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, brokerdealers, 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 conjuncjlentini on DSKJ8SOYB1PROD with HROC

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tion 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: 

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1For purposes of the assessment, the term ‘‘Covered Entity’’ shall include any SRO, brokerdealer, insurance company, investment company, investment adviser, or an affiliate of any such 

entity. 

1. Employment or service as an officer, director, board committee 

member, or general partner with a Covered Entity 1

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. 

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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 crosssection 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 

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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 projlentini on DSKJ8SOYB1PROD with HROC

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vide 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 brokerdealers. 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. 

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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 

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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, 

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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 

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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 Investjlentini on DSKJ8SOYB1PROD with HROC

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ments 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. 

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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 

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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 brokerdealers 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 

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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 

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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 

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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 prinjlentini on DSKJ8SOYB1PROD with HROC

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ciples 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? 

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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 

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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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