The mechanics of regulatory bodies only occasionally attracts the interests of rank-and-file advisors, like back in 1996 when the Nasdaq market was nailed for price fixing. It wasn't just investors that were paying too much for a trade: Small broker/dealers were also getting ripped off by big Nasdaq market makers who were colluding to set spreads.
Among other reforms, this scandal eventually led to the creation of the Small Firms Advisory Board, a committee to help represent the needs of small b/ds — those that employ 150 representatives and under — to NASD regulators.
But, nearly 10 years later, many small firms say they are still getting pushed around by bigger firms — and this time the NASD is taking the side of the bullies.
The NASD and member firms deny the accusation, stating that regulators are agnostic about the size or business model of any individual member firm. But a handful of small firm executives, fed up with what they call the ineffectiveness of the Small Firms Advisory Board, are taking their fight directly to the NASD: Three “NASD dissidents,” as they are called, won seats on one of the NASD's regional committees in December 2005, and two others won seats in prior regional elections. The small firm insurgency continues to gather speed, with three small firm representatives running for election to the NASD Board of Governors in early February.
The NASD dissidents want to change everything from how disciplinary actions are meted out to how firms are investigated. Small firms, they argue, suffer disproportionately from regulatory policies that larger firms can easily afford to absorb. What small b/ds need is a voice at the NASD table, the dissenters say, so that regulators and others can better understand the consequences of the NASD's regulatory policies on the small firm constituency. This dust-up would have a direct affect on the rank-and-file rep, since, the dissidents claim, the NASD punishes brokers for violations that do not directly hurt their clients.
John Busacca, president of North American Clearing, in Longwood, Fla., was one of the “dissidents” who managed to get on the District 7 Committee ballot in December; he won. He says, “Nothing has changed in the past five years. Working with NASD Regulation hasn't gotten any better” — Small Firms Advisory Board notwithstanding.
While the NASD is supposed to protect the investing public, Busacca argues that it is also supposed to advise b/d management about rep supervision in a way that won't automatically bring down heavy penalties; in short, Busacca and his allies want NASD staffers to show more discretion in dealing with a b/d who has honest questions about compliance issues.
“Firms can't get help anymore with resolving issues,” Busacca grouses. “They're more likely to get dragged into a fine-and-penalty situation that may ruin careers and companies before trying to resolve what are often minor or accidental infractions.”
The Dissident Slate
Now Busacca is helping Richard Goble, his partner at North American Clearing, and two others, make a run for the NASD National Board of Governors election on Feb. 3. Running with Goble are Brian Kovack, president of Kovack Securities, of Fort Lauderdale, Fla., and Tyler Dedman, a retired Naval officer from Lake Mary, Fla. To get on the ballot, Goble, Kovack and Dedman had to collect more than 10 percent of the NASD membership's signatures, a feat they managed in about 10 days. (In order to win seats on the National Board, they must get a majority of the voting membership's support.) Normally, the NASD Nominating Committee nominates one candidate for each available seat for both the Board of Governors and the 11 NASD district committees. (The official nominating procedure prompts Busacca to compare the NASD's election process to “Saddam-era Iraq.”)
Serving with Busacca in District 7 are Marc Ellis, chief compliance officer for GunnAllen Financial, and Ronald Kovack, chairman of Kovack Securities and father of Brian Kovack, the National Board candidate.
In the NASD structure, District Committees serve as advocates for the constituents they serve. In Busacca's case, District 7 encompasses the Carolinas, Georgia and Florida, as well as Puerto Rico, the Panama Canal Zone and the Virgin Islands. District Committees also approve who joins the NASD in their district. The committees also participate in enforcement hearings, which are required if a member firm contests an NASD charge. Two members, who are selected based on their expertise in relation to the charge, serve on the panel with an independent hearing officer hired by the NASD. They decide what punishment, if any, a member will receive.
Busacca and his compatriots say too often the NASD fines instead of issuing warnings and directives. They would like to see other changes at the NASD, including: making the regulators' investigative process more transparent (today regulators do not declare why they are investigating); notifying members of potential compliance problems and offering sufficient time to fix them before being fined; lessening penalties for violations with no customer harm (like late-reported bond trades); reducing the time it takes to become an NASD member or for an existing member to add a line of business; and a reduction in investigative “sweeps” and rule 8210 requests, the NASD's broad requests for information. Lastly, the slate would like the NASD to operate under the “presumption of innocence at all times.”
Busacca particularly dislikes the NASD's use of “sweeps.” He calls them an “underhanded way to make money,” invariably catching a few otherwise good firms — along with the bad — that haven't complied with some reporting requirement, he says. Reporting requirements are another point of contention, such as the Order Audit Trail System (OATS) and the Trade Reporting and Compliance Engine (TRACE). All of this, Busacca and Goble say, forces firms to add expensive archiving, staffing and legal costs that large firms can more easily absorb.
“It's definitely a big-firm/little-firm thing — the big firms are gaining more and more market share from this regulatory environment,” says Goble. “You can see it in the decreasing number of firms overall alongside the exploding number of branches.” Indeed, according to the NASD, the number of member firms has decreased by 161 firms, to 5,111 in 2005 from 5,272 in 2003. Meanwhile, during the same period, the total number of branches grew by 13,994, up to 106,855 in 2005 from 92,861 branches.
Life After Spitzer
Certainly, the NASD and other regulators have become more aggressive — and rightly so, given some of the abuses uncovered during the bear market, from research and other conflicts of interest that were not properly disclosed to the investing public. In 2003, the number of disciplinary cases jumped to 1,410 from 1,271 in 2002. From 2003 to 2005, the total number of cases stayed around an annual level of 1,400, but the fines almost quadrupled, to $125 million in 2005 from $33 million in 2003.
No one disputes the importance of regulation, it's just harder — i.e., more expensive — for smaller firms. One wirehouse counsel with a regulatory background agreed it's a longstanding perception that the NASD picks on small firms and that favor is given to the large firms. But, “It's dead wrong,” he says. Young attorneys bucking for a promotion, more power and influence don't get there by fragging the little firms, he says. “The guy looking to move up doesn't get to stand next to the Schapiros, Goldsmiths and Cutlers at a press conference in front of the SEC office building for nailing Joe Broker Securities,” he says. “That comes if it's a Merrill Lynch or a Smith Barney.”
NASD spokespersons did not return phone calls requesting comment, but Mary Schapiro, the NASD's soon-to-be-chairwoman, addressed the issue of suspected favoritism within the organization, as well as seven other “myths” at the SIA's Compliance and Legal Division Conference in April. “The independent contractor firms are sure we prefer the traditional national or regional wirehouse model. Small firms think that we only care about big firms and big firms are sure that we enforce the rules only against them and allow small firms to do whatever they please,” said Schapiro. “I will state it simply:We are agnostic as to business model, but we believe that business model is not an excuse for the ability to be in compliance.”
In 1996 the SEC found NASD market makers were colluding with other large market makers to inflate spreads on the Nasdaq. The subsequent “21a Report” laid out the problems, remedial measures and enforcement actions against the market makers for their trading abuses. It was a black eye for self-regulation, but numerous improvements came out of the SEC's report, including changing the composition of the NASD Board of Governors to include more non-industry representatives.
The report also led to the creation of the Small Firms Advisory Board, a council of between 11 and 15 members made up of executives from firms with less than 150 reps, in 1998. It's the Small Firms Advisory Board's job to communicate the concerns of the small firm community to the NASD. The Small Firms Advisory Board vice Chairman Lou Denton, part owner of Borer Denton & Associates, a Blue Bell, Pa.-based b/d with only seven reps, is sympathetic to the challenges of running a small b/d. But Denton disagrees with the “dissidents” complaints.
Denton agrees that OATS and TRACE and “sweeps” are burdensome, especially for small firms. But, he says, they're also part of the new order of things after Sept. 11, Enron and conflicts-of-interest scandals. Most importantly, they're also designed to protect investors: OATS ensures best execution on trades by auditing the order flow; TRACE keeps bond pricing transparent and timely by requiring transactions to be reported within 15 minutes. As for sweeps, Denton says it was a sweep that uncovered mutual fund breakpoint infractions. “It's the NASD's way of taking the pulse of a situation,” he says.
The 8210 rule requests, which give the NASD power to request information during a sweep, are “the lifeline for the NASD's regulatory authority,” he says, since, without subpoena power, the NASD wouldn't be able to obtain information from firms that weren't willing to give it over. Additionally, he says, “You did something wrong if you got one of those babies.”
The bottom line: It's a different era, Denton says. “Congress beats on the SEC and they beat on the NASD,” he says. “The days of the one-bite rule are long gone,” says Denton of the idea that regulators could show discretion when addressing some b/d infractions in the past.
That said, his job is to advocate for the small firms and raise his hand if he doesn't like what he sees while sifting through NASD rule proposals in Washington, D.C. “We argue tooth and nail,” he says. “And we're working for inches here, not yards.” Denton says, ultimately, the rule proposals that come out are a long way from what they were originally.
Even if the slate wins all three seats on the National Board, their power will be very limited, given the NASD's bylaws on required diversity of the board. For Denton, the worry is that dissidents' agitation may capsize their shared goal: greater sensitivity and understanding for small firms. But there is more at stake. “The biggest issue here is not whether you have dissidents on the board,” he says, “it's if the SEC decides the organization isn't working together, lacks unification and ultimately decides it wants one single regulator that doesn't involve those it regulates. If you end up with Big Brother, you're going to have no input from the people and a lot more hurt.”
