Testimony of Mark J. Griffin
President, North American Securities Administrators Association
Director, Utah Division of Securities
Before the
HOUSE SUBCOMMITTEE ON FINANCE AND HAZARDOUS MATERIALS
U.S. HOUSE OF REPRESENTATIVES

July 17, 1997

Summary

• As the national voice of the state securities agencies responsible for investor protection and the efficient functioning of the capital markets on the local level, NASAA supports congressionally directed financial services reform that will continue to provide essential investor protection and faith in the integrity of our securities markets.
• Financial services reform must be congressionally directed, not dictated on an ad-hoc basis by federal regulators and agencies.
• NASAA strongly supports and upholds the ideals of functional regulation of securities, but it must be identical regulation, not comparable regulation. We welcome banks, as well as insurance companies, into the securities business under the same complementary state/federal securities oversight system.
• The Securities and Exchange Commission and state securities regulators should be the only primary regulators of securities activities regardless of the legal structure of the entity engaging in such activities.
• Financial services modernization is a matter of permitting all financial service providers to compete on the same terms and not be impacted by regulatory advantage or disadvantage. Permitting securities activities to take place outside the complementary state/federal regulatory system would have an untoward effect on the securities markets, and on investor protection.
• Section 203 of H.R. 10 must be clarified to require that employees of a bank or bank affiliate that engage in the offer and sale of securities to the retail public not only are subject to NASD provisions, but are also state licensed with the appropriate state securities agency.
• The 1000 securities transaction de minimis exemption in Section 201 creates a worst of both worlds scenario with banks less knowledgeable in securities serving inexperienced investors. Couple that with unlicensed sales force selling the products and a huge investor protection loophole is created.
• As a participant on the National Council on Financial Services, NASAA will provide the insight as to how regulatory policies affect local markets and individual investors. NASAA supports a coordinating body, but is concerned with the Council’s enhanced regulatory oversight authority.

Mr. Chairman and Members of the Committee:

Introduction
I am Tom Geyer, Commissioner of Securities for the State of Ohio, and I sincerely appreciate the invitation to discuss several important issues associated with financial services modernization on behalf of the North American Securities Administrators Association (“NASAA”). NASAA was organized in 1919. Our membership consists of the 65 state, provincial and territorial securities administrators in the 50 states, the District of Columbia, Canada, Mexico and Puerto Rico. We administer the state securities laws that are the substantive and jurisdictional complement to federal securities laws.

As the national voice of the state securities agencies responsible for investor protection and the efficient functioning of the capital markets on the local level, we commend Chairman Oxley and the Subcommittee for your efforts to evaluate the existing structure of our financial service providers and reconcile conflicting views in order to bring about comprehensive financial services reform. We further applaud your determination in exploring all of the critical issues and your commitment to moving a reform measure forward in this congressional session.

The general theme of this testimony is NASAA’s wholehearted support for financial services modernization, provided that appropriate safeguards are put in place to provide investor protection and maintain the integrity of the securities marketplace. Specifically, this testimony will address four issues pertaining to the financial services modernization effort. First, NASAA will express its concern regarding the ad hoc activities of federal banking regulators in extending the scope of activities in which banks may engage. Second, we will advocate the need to ensure a level playing field for all financial service providers. Third, NASAA will express full support for the concept of true functional regulation. Finally, we will comment on the formation of the National Council on Financial Services.

1. REGULATORY EXTENSION OF PERMISSIBLE BANK ACTIVITIES
NASAA believes it is the responsibility of Congress to direct any comprehensive financial services reform. To that end, NASAA has appeared before the Congress on a number of occasions to reiterate our strong support for Congressionally directed financial services reform that will continue to provide essential investor protection and faith in the integrity of our securities markets. Investor protection, which is the basis for investor confidence in the securities markets, should be a top priority as Congress explores ways to modernize the financial system. We hope that our expertise and experience as state securities regulators will be useful to you.

Distinguishable from our federal counterparts who tend to focus upon the oversight of large corporate offerings and the internationalization of the marketplace, state securities regulators are concerned with small investors who are saving to pay for their retirement, their children’s college education or a variety of other needs. Many of these individuals are first-time investors who may purchase securities through a bank. Because banks may be the only financial institution that investor has ever dealt with, the investor will probably not be aware that in selling securities, the bank is not subject to most federal and state securities laws and regulations. As a result, the investor protections mandated by the state and federal securities laws are not in place.

That such protections are not in place results in part from unchecked regulatory expansion. NASAA is concerned with the trend toward federal banking regulators and agencies dictating policy that impacts existing law without Congressional oversight. This ad hoc manner of restructuring the financial services industry without coordination or statutory change needs examination. State securities regulators view Congressional analysis of the current system and Congressional action to modernize regulation as the key to meaningful reform.

Consequently, we have apprehensions regarding Section 112 of H.R. 10, which appears to further sanction agency treatment of important issues surrounding financial services modernization. Specifically, it seems that Section 112 would amend the Federal Deposit Insurance Act to create a new quasi-securities regulatory scheme for securities activities of banks, distinct from the established complementary state-federal securities oversight system. A core principle of financial services modernization must be that all financial service providers are subject to the same laws and regulations; it appears that Section 112 is adverse to this principle.

As you are well aware, until recently the Glass-Steagall Act prohibited banks from engaging in most securities activities. That no longer holds true in today’s marketplace, primarily as a result of the Federal Reserve Board’s amendments to Section 20 of the Glass-Steagall Act to permit a nonbank subsidiary of a bank holding company to underwrite and deal in securities. These amendments have cleared the way for Bankers Trust to acquire Alex. Brown and NationsBank Corp. to purchase Montgomery Securities. Today, banks engage in a broad range of broker-dealer and investment advisory activities that are parallel to and competitive with the services of “traditional” brokers and registered investment advisers.

NASAA welcomes banks, as well as insurance companies, into the securities business under the complementary state-federal securities oversight system. It is our hope that over the long term, increased competition will inure to the benefit of the investing public, particularly small investors who will reap the benefits of one-stop shopping. However, the competition must not be impacted by regulatory advantage or disadvantage. Therefore, it is essential that all financial service providers be subject to the same regulatory standards.

2. ENSURING A LEVEL PLAYING FIELD
NASAA is alarmed by a number of instances in H.R. 10 that appear to create an unlevel playing field by suggesting that certain securities activities, when conducted through a bank, will not be subject to the well established complementary state-federal securities regulatory
framework.

First, it seems that Sections 112 and 201 of the bill appear to work at cross purposes with each other. Section 201 properly recognizes that because of the erosion of the Glass-Steagall barriers, it is no longer appropriate to give banks a blanket exemption from the definition of “broker” under the Securities Exchange Act of 1934. Thus, subject to enumerated exemptions, a bank that publicly solicits securities transactions and is compensated for effecting transactions in securities is considered a “broker,” subject to the same laws and regulations as “traditional” brokers like Merrill Lynch and Dean Witter. However, Section 112 would permit federal banking regulators to erect new barriers by creating a new quasi-securities regulatory scheme for securities activities of banks, separate from the established system of state-federal oversight.

Second, proposed new Section 3(a)(4)(c)(viii) of the Securities Exchange Act of 1934, set out in Section 201 of the bill, tilts the field by creating a “de minimis” exemption that virtually subsumes the definitional section itself. This exemption would permit a bank to engage in over 1,000 securities transactions annually outside the established state-federal securities regulatory system.

Third, while NASAA applauds the direction in which Section 203 of the bill is headed in terms of qualification of individuals who sell securities, this provision does not go far enough. Like their counterparts at “traditional” brokers, bank employees who sell securities must be subject to the state securities licensing system as well as self-regulatory rules. Demonstrating the importance of state licensing, NASAA recently submitted a report to the Securities and Exchange Commission (“SEC”) to assist them as they prepare a study mandated by the National Securities Markets Improvement Act of 1996 (“NSMIA”) on the uniformity of state licensing requirements of associated persons of registered brokers and dealers. A copy of our letter is attached to this testimony and copies of the entire submission are available through the NASAA office. (see note)

In addition, NASAA is concerned about the implications of including equity swaps in the definition of “banking products” contained in Section 152 of the bill. Designation as a banking product means that a bank may effect a transaction in the product without falling into the definition of “broker” or “dealer.” We are concerned that so designating equity swaps could circumvent the ability of the SEC to determine whether these products are securities, and if they are, how they should be regulated regardless of who sells them.

Even more important, it could have a deleterious effect on the ability of the SEC to meaningfully apply the antifraud provisions of the securities laws to equity swaps in which banks are participants. NASAA previously expressed this position to the House Agriculture Committee regarding the Commodity Exchange Act Amendments of 1997.

These are several examples of how H.R. 10 would create an unlevel playing field in the sale of securities. Permitting securities to be sold under two different regulatory systems directly and detrimentally impacts market integrity and investor protection. For example, standard market conduct requirements, such as the T+3 delivery rule and rules governing clearing arrangements would not apply, impairing the integrity and uniformity of the securities market place. On the investor protection side, disregard of state licensing standards is the disregard of a vital consumer safeguard.

The notion of separate regulatory systems also raises notable disclosure issues. Because disclosure is a bulwark principle of the securities laws, both misrepresentations and omissions of material facts are prohibited. Query whether a bank employee selling securities under the lesser standard would be guilty of an omission for not disclosing that the sale of securities was not subject to the normal protections of the state and federal securities laws, including, for example, the lack of SIPC insurance.

Mr. Chairman, NASAA urges you and the committee to keep in mind that securities activities are subject to a balanced, complementary state-federal regulatory system. Permitting securities activities to take place outside this system would have an untoward effect on the securities markets, and of course, on investor protection. While H.R. 10 has regard for protecting the integrity of FDIC insurance, equal regard must be given to protecting the integrity of the securities marketplace. The United States has the most successful capital markets in the world because of the reasonable securities regulatory system that is in place, not in spite of it.

3. TRUE FUNCTIONAL REGULATION
For the same reasons that we advocate a level playing field, namely ensuring investor protection and maintaining the integrity of the securities marketplace, NASAA strongly supports and upholds the ideals of true functional regulation. NASAA would define true functional regulation as a system where all providers, regardless of corporate form are subject to the same securities, banking, insurance and other commercial laws, and where the banking regulators oversee banking functions, state and federal securities regulators oversee securities functions, state insurance regulators oversee insurance functions, and so on. For example, if Section 112 of the bill were to be consistent will true functional regulation, it would simply provide that all securities activities by banks be subject to the existing state-federal regulatory framework, not that parts of the system will be “taken into account” by federal banking authorities who are permitted to craft a new securities regulatory regime.

Most important is the consideration that a person investing in securities must receive the same disclosures and have the same investor protections whether he or she deals with a “traditional” broker, a bank, an insurance company or a mutual fund. Employees who sell securities must be subject to the same licensing qualifications whether their employer is a bank, an insurance company or a securities firm. These qualifications include state licensing. Among other possible unintended results of establishing a lesser standard for bank employees who sell securities is the creation of a conduit for bad brokers to migrate to banks in order to evade state securities licensing review directed at discovering and punishing fraudulent and abusive practices.

Another important consideration is the registration or exemption of the actual securities sold. While NSMIA did create the “covered security” that is not subject to state registration or exemption requirements, NSMIA left state registration and exemption in place in a number of other areas. Federal and state securities laws incorporate exemptions for the registration and review of certain securities, including securities sold by banks. However, H.R. 10 creates a completely unregulated transaction environment by exempting out the salespersons based upon the already exempted product. Securities registration and exemption provisions are based upon the premise that all salesperson are subject to federal and state licensing and registration. The exemptions rely on the fact that the salespersons are licensed and otherwise qualified. To adopt the H.R. 10 approach is to weaken the enormously successful investor protection network in the United States.

Functional regulation also touches on oversight and examination philosophy. As you know, traditional bank examinations focus on the financial viability, or so-called “safety and soundness,” of the financial institution. This form of examination concentrates on the oversight and review of the health of the institution. NASAA does not object to “risk assessment ” supervisory principles. However, with respect to broker-dealer activities, a risk assessment must consist of the traditional securities oversight, which focuses on discreet operational functions such as supervision, suitability, sales practices and record-keeping. Such oversight assesses risk, but on a much more specific level. Thus, sales practices that contribute substantially to the broker-dealer’s overall financial health, or safety and soundness, may nonetheless violate the securities laws because they diminish investor protection or impair the capital markets. This type of oversight is essential if investors, especially small investors, are to have the degree of confidence in our capital markets to encourage and sustain their participation. Securities regulators have found this to be the only way to effectively monitor broker-dealer activities.

There are several exemptions in the legislation to ensure that certain bank activities do not trigger broker-dealer regulation which NASAA believes deserve further review. We believe it is necessary for the Committee to clarify that Section 201, which amends Section 3(a)(4) of the Securities Exchange Act of 1934, could not allow a bank to act as an unregistered clearing broker for its affiliate, the introducing broker/bank. Clearing agencies are required to be registered with the SEC and comply with essential reporting and disclosure requirements. We believe that brokers who clear for banks must be subject to the same regulation as other clearing firms that contract with non-bank entities. If not, significant investor protection issues, market integrity concerns and anti-competitive issues to those entities registered as a broker-dealer would be raised.

As noted previously, because of the complementary state-federal system, NASAA believes that the SEC and state securities regulators should be the sole primary regulators of securities activities. However, H.R. 10 appears to ignore state securities regulators when establishing the securities oversight for the new financial services system. Mr. Chairman, we respectfully urge you and the Committee to consider the vital role of the state securities administrator. It is the state securities administrator that is the closest to the investing public, that serves as the local cop on the beat. It is the state securities administrator that performs essential licensing functions. It is the state securities administrator who reviews the local securities offerings and oversees the integrity of the local securities marketplace. It is the state securities administrator that is the necessary jurisdictional and substantive complement to the SEC. These issues were thoroughly debated during consideration of NSMIA and the overall importance of state securities regulation was upheld by this Subcommittee.

To disregard state securities regulation in connection with the modernization of the financial services system is to ignore the concept of true functional regulation and is to upset the delicate and well-reasoned regulatory balance that has resulted in the unprecedented success of the United State’s securities markets. Further, if state securities law is disregarded, to what extent may other state laws, such as state insurance, corporate and commercial codes, be disregarded to the detriment of market integrity and consumer protection?

NASAA whole-heatedly supports financial services modernization, but only to the extent that financial service providers compete on a level playing field. There must be true functional regulation. NASAA would urge that the existing state and federal securities regulatory system, including this system of specific securities examination and oversight, be applicable to all financial service providers. To hold otherwise would create an unlevel playing field, impair market integrity and investor protection, and skew competition based on regulatory advantages and disadvantages.

4. NATIONAL COUNCIL ON FINANCIAL SERVICES
Section 121 of H.R. 10 would create The National Council on Financial Services (“Council) composed of the Secretary of the Treasury, the Chairman of the Board of Governors of the Federal Reserve System, the Chairman of the Federal Deposit Insurance Corporation, the Comptroller of the Currency, the Chairman of the Securities and Exchange Commission, the Chairperson of the Commodity Futures Trading Commission, an individual with current or prior experience in securities regulation at the State level who shall be appointed by the President; two individuals with current or prior experience in state insurance regulation who shall be appointed by the President; and one individual with current or prior experience in State banking supervision who shall be appointed by the President.

NASAA is very pleased that the structure of the Council was expanded to include an individual with current or prior experience in securities regulation at the State level. Both U.S. federal and state securities regulation provide oversight of the richest, most liquid and successful capital marketplace in the world. We each possess great experience and expertise that is complementary in nature.

Although representation of the SEC provides valuable insight into the national and international issues facing our financial markets, it would not provide specific insight as to how regulatory policies affect local markets and individual investors. According to the Wall Street Journal (January 29, 1997), the SEC closed or solved 345 cases in 1996. State securities regulators solved or closed over 6,740 cases during that period. These statistics reflect the differing enforcement emphasis of the state and federal securities regulators. State securities regulators handle the majority of individual investor complaints and are thus in a much better position to observe the effects of regulatory policies on the individual investor, especially as such investors become an increasingly larger portion of the investing public. In a recent speech, SEC Chairman Arthur Levitt stated, “state regulators are closer to the scene and can uncover problems that are hard for us to see all the way from Washington.”

State securities administrators are particularly well suited to protect older Americans and unsophisticated citizens. For example, the Ohio Supreme Court has noted that a “central objective [of state securities law is] providing protection for those unfamiliar with market conditions from the dishonesty of those who do.”

NASAA notes that the regulatory rulemaking functions of the Council have broadened significantly since the proposal was originally discussed in the Banking Committee. Under the current version of H.R. 10, the Council would be granted the authority to issue regulations regarding the types of activities that may be financial in nature for the purposes of the Financial Services Holding Company Act, and to determine whether an activity or product is insurance or banking for purposes of the limitations on insurance underwriting by national banks.

NASAA supports this type of coordinating body, but is concerned with the Council’s enhanced regulatory oversight authority. This Council’s coordinating structure might be broadened, so that any perceived need for an umbrella regulator would be eliminated.

The heavy representation of federal banking regulators compared to all other financial services regulators would tend to skew the Committee’s policies towards the banking “safety and soundness” style of regulation. While this type of regulation is entirely appropriate for traditional banking activities where the FDIC and the government have assumed the risk for insured deposits, it is not appropriate for other financial services regulation. Securities regulation recognizes that the customer assumes most of the risk in a securities transaction, and the style of regulation reflects this different emphasis. This is why securities regulation stresses accurate disclosure of risks, suitability of investment recommendations and appropriate sales practices.

NASAA believes that regulation of each financial entity should be focused on the specific functions being performed, not solely on the corporate structure. This approach would help assure the proper balance between the twin goals of expanded opportunities related to the provision of banking, securities and insurance services and the provision of important institutional and individual protections. Clearly, great care must be taken to avoid duplicative regulations and oversight that waste resources.

NASAA takes no position on how best to structure financial service entities; however, we would urge Congress to require banks, securities firms and insurance companies to organize in a manner that will protect investors, protect the securities markets and protect the FDIC. NASAA believes this would be accomplished through true functional regulation where financial service components are overseen by the corresponding expert regulators. We are concerned that the expanded powers of the Council may cut against true functional regulation.

If banks believe that the regulation of certain existing entities is too restrictive, Congress
should seek to eliminate the overly restrictive rules and regulations for all participants, rather
than encourage banks to organize in a way that produces more risk to the bank and the investor.
While ease of entry and increased competition are important goals, financial services reform
efforts should not ignore the goals of maintaining protection of investors and the federal
deposit insurance fund. If investors lose faith in the system, it will not matter how easy it is to
enter.

Conclusion
Mr. Chairman, NASAA commends you and the Committee for tackling the daunting task of financial services modernization. We welcome such modernization, provided that investor protection and market integrity are maintained. We believe that this can be accomplished through congressionally directed reform that establishes a level playing field marked by true functional regulation. This will permit securities, banking, and insurance providers to operate efficiently under existing regulatory expertise, while eliminating the disparities caused by regulators with differing objectives reviewing identical services being provided in different financial institutions. This coordinated approach, most importantly, will provide continued protections for both investors and the securities marketplace by recognizing roles for both federal and state securities regulators in the financial institution’s securities activities, while allowing banking and insurance regulators to carry out their respective mandates.

The division of labor among securities, insurance and banking regulators has served the public well for many decades. This division of labor should continue after the abolition of the barriers the Glass-Steagall Act imposed on bank activities. If banks or their affiliates venture into the securities arena, they must embrace the realities of investor protection and market integrity and be subject to the same oversight system, administered by the same regulators, as the “traditional” brokers.

Thank you again for the opportunity to provide our views on these important matters. Please do not hesitate to contact me or anyone at NASAA if we can provide additional information or be of other assistance as you continue in your efforts to achieve meaningful financial services modernization.

*Copies of the NASAA Uniformity Study referenced above can be obtained by calling NASAA
at 202-737-0900, and will be available soon on this site.

July 17, 1997