Letter to Ms. Mary L. Schapiro Chairman & CEO National Association of Securities Dealers

Letter to Ms. Mary L. Schapiro Chairman & CEO National Association of Securities Dealers

Ms. Mary L. Schapiro
Chairman & CEO
National Association of Securities Dealers
1735 K Street, NW
Washington, DC 20006-1500

Dear Ms. Schapiro:

As a senior member of the United States Senate and as Chairman of the Committee on Finance (Committee), it is my duty under the Constitution to conduct oversight into the activities of executive branch agencies and entities that are regulated by
these government agencies. Over the past year, I have been conducting oversight into the Securities and Exchange Commission (SEC) and its role in protecting investors. Various questions have arisen from a number of sources, regarding the procedures and safeguards that exist to ensure the integrity of financial markets.

NASD is the largest regulator of the financial markets, overseeing every securities firm that does business in the country. As such, NASD has a responsibility to all investors, in addition to the brokerage firms and registered agents that are its members.
Moreover, as a 501(c)(6) not-for-profit organization, NASD has a duty to all investors, taxpayers, and Congress to ensure that its core mission of protecting market integrity merits its tax-exempt status.

One of the most important components of the SEC's oversight of financial marketplace is reliance on Self-Regulatory Organizations (SROs), such as the NASD, as the front line of defense against fraud and manipulation in the financial markets. This complex partnership between the SEC and the SROs creates a situation where the government agency tasked with regulating the market relies, in part, on third parties to enforce market integrity.

The current system of industry self-regulation via the SROs, with federal oversight, as opposed to federal regulation, was established at a time when only a small minority of Americans invested with brokerages. Today, the majority of American
households have at least one brokerage account. Industry self-regulation was designed to prevent excessive government involvement in market operations. However, for this system to work effectively, the SEC must vigilantly ensure that SROs continue to meet their responsibilities to regulate, among other things, member conduct, market activity, and trading practices. Additionally, the SEC must actively oversee SROs.

In order to address these concerns, I recently requested a review of all SROs to be conducted by the Government Accountability Office (GAO). The GAO will conduct this review over the course of the next year. Cooperation on the part of NASD will be critical in ensuring that the GAO obtains access to all necessary information leading to a complete and accurate final report. Accordingly, I request that NASD provide complete cooperation to GAO during the course of the review.

Additionally, and as an integral part of my oversight of both the SEC and SROs, I request that NASD provide detailed, written answers to the following questions. In the event that NASD has written information, including policies and procedures that are
responsive to any of the questions set forth below, please attach that material also. Finally, in responding to the questions below, please respond for the period of January 1, 2002 through November 1, 2006.

(1) Please describe in detail the mechanisms used by NASD to conduct oversight of the financial markets, including but not limited to, details regarding automated monitoring systems, such as the INSITE monitoring system, Advanced Detection System (ADS), SONAR, and any other market surveillance tools utilized by NASD.

(2) Please describe in detail the types of enforcement actions available to the NASD. Additionally, please provide statistical information regarding the frequency of enforcement actions, information regarding the utilization of various enforcement mechanisms, as well as information regarding the number of enforcement actions sought by NASD that are not accepted or
overruled by the SEC.

(3) Please describe the oversight conducted by the SEC to ensure that NASD remains in compliance with SEC rules and regulations for SROs. When preparing this material please identify specifically each effort including the date(s), finding(s) and current status.

(4) Please describe the requirements that NASD must meet to maintain its good standing with the SEC. Identify any and all audits, evaluations, and investigations or other reviews conducted by SEC where NASD was found to be deficient in any matter. More specifically, describe all instances where NASD has been found in violation of Section 19(g) of the Securities
Exchange Act and what actions, if any were taken to address the identified deficiencies.

(5) Please describe the mechanisms in place at NASD to ensure that NASD casts a wide net during market surveillance and oversight. For instance, how does NASD ensure that it provides equal coverage for both buy side and sell side transactions?

(6) Please describe NASD's sampling patterns for capturing "aberrational" or "serendipitous" trades preceding or following a "material" event. (E.g. Does NASD focus on specific timeframes in the weeks immediately preceding material announcements, or does it take a more holistic snapshot? How rigorous are NASD's surveillance systems in catching aberrational trading that far predates a "material" announcement?).

(7) Does NASD limit referrals to SEC based upon the size of the referral? If so, what is the determining factor? (E.g. Dollar value involved? Size of the trade compared to daily volume of a particular security? Size of the broker/dealer involved?).

(8) What types of statistical information does NASD retain regarding referrals made to SEC? Provide any statistical analysis or reports that outline the types of referrals made to SEC from NASD.

(9) How vigorous is NASD in identifying and tracking potential repeat offenders? What safeguards are in place at NASD for determining if a past referral to SEC corresponds with a current unusual activity file (UAF)?

(10) What level of coordination exists between NASD and other SROs for monitoring insider trading and market manipulation? Are regular channels of communication available to discuss unusual activity? To what extent are the computer systems between various SROs compatible to exchange information regarding suspect activity?

(11) How secure is information at NASD? What internal safeguards are in place to ensure that sensitive information is secure from contacts with entities and individuals that are regulated by NASD? Has NASD ever had a security breach and/or situation where non-public information was left vulnerable? If so, please describe each instance in detail.

(12) What procedures are in place to detect and prevent internal conflicts of interest at the NASD? Does NASD have a system designed to recuse individuals who have a conflict of interest that is direct or indirect? If so, what are the procedures and how often are they implemented?

(13) Discuss the delegation of any regulatory responsibilities to subsidiaries that operate under the umbrella of NASD, such as NASDR. Please describe the relationship between NASD and NASDR, as well as any other subsidiaries, including but not limited to, the tax status of the subsidiary, board structure, governance, fire walls between the two organizations, and any shared board members between NASD and a subsidiary thereof.

(14) How does NASD conduct oversight over any subsidiary entities that are responsible for regulatory matters? What mechanisms are in place to ensure that any delegation is done in a manner consistent with federal law? What rules or procedures are in place to ensure the integrity and fairness of any delegated regulatory authority? What, if any, role does SEC play in approving such delegation of authority?

(15) What tools does NASD, or any delegated subsidiary thereof, have in place to detect and investigate "wash trades"? Does NASD have any tools designed to identify "wash trades" conducted by institutional investors?

(16) Has NASD conducted any internal reviews of its regulatory responsibilities? Please provide copies of all final reports including those prepared by third party contractors or other outside entities or individuals.

(17) Please describe any protections that may exist for any registered member, or employee thereof, who brings forth allegations of wrongdoing, waste, fraud, and/or abuse of laws, rules, or regulations. Does the NASD have any internal whistleblower protections for its own employees who are aware of potential wrongdoing? How does NASD handle any internal complaints regarding its oversight activities?

(18) What procedures are in place with NASD to prevent employer retaliation against registered analysts, brokers, or dealers that are regulated by NASD? For example, does NASD have an appeal process to investigate negative reports filed by an employer in an employee's U-4, U-5, and/or other similar registration forms? If not, why not?

(19) What procedures does the NASD have in place to ensure that the information it provides to the public regarding the disciplinary records of its member firms and their registered representatives through its Brokercheck program are accurate? What efforts has the NASD made to upgrade this program in light of technological advances? What has the NASD's response
been to private sector initiatives aimed at improving investor awareness of brokerage wrongdoing? Is the NASD of the opinion that it is the sole party entitled to deliver such information to the investing public?

(20) Provide a specific list of all funds received by NASD, or any subsidiary thereof, from the United States federal government or any affiliated agency or organization of the federal government and for each, specify the amount(s), date(s) or such funds, the source of the funds, and the stated purpose of those funds.

Thank you in advance for your prompt attention to this matter. Please provide your written response by December 18, 2006. Additionally, I request that you provide an in-depth briefing to the Committee staff following the submission of your written
response. Should you have any questions regarding this matter, please contact Nick Podsiadly or Jason Foster of my staff at (202) 224-4515.

Sincerely,

Charles E. Grassley
Chairman
Attachment

http://finance.senate.gov/sitepages/grassley.htm