[Federal Register Volume 67, Number 229 (Wednesday, November 27, 2002)]
[Notices]
[Pages 70990-70993]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 02-30041]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-46859; File No. SR-NASD-2002-162]


Self-Regulatory Organizations; National Association of Securities 
Dealers, Inc.; Notice of Filing of Proposed Rule Change Relating to 
Supervisory Control Amendments

November 20, 2002.
    Pursuant to section 19(b)(1) of the Securities Exchange Act of 1934 
(``Act'') \1\ and Rule 19b-4 thereunder,\2\ notice is hereby given that 
on November 4, 2002, the National Association of Securities Dealers, 
Inc. (``NASD'') filed with the Securities and Exchange Commission 
(``SEC'' or ``Commission'') a proposed rule change. The proposed rule 
change is described in Items I, II, and III below, which Items have 
been prepared by the NASD. The Commission is publishing this notice to 
solicit comments on the proposed rule change from interested persons.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
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I. Self-Regulatory Organization's Statement of the Terms of Substance 
of the Proposed Rule Change

    The NASD is proposing to adopt new NASD Rule 3012 and amend other 
rules regarding the supervisory and supervisory control procedures of 
member firms. Specifically, new NASD Rule 3012 would require members to 
develop general and specific supervisory control procedures that 
independently test and verify and modify, where necessary, the members' 
supervisory procedures. In addition, proposed amendments to (1) NASD 
Rule 3010(c) would require that office inspections be conducted by 
independent persons and include, at a minimum, the testing and 
verification of certain supervisory procedures; (2) NASD Rule 3110 
would expand upon a member's supervisory and recordkeeping requirements 
with respect to changes in customer account name or designation in 
connection with order executions; (3) NASD IM-3110 would provide 
guidance as to when a member may hold mail for a customer who will be 
absent for a period of time; (4) NASD Rule 2510(d) would clarify the 
time limit on time-and-price discretionary authority; and (5) NASD Rule 
9610 would incorporate into NASD Procedural Rules the ability of 
members to request an exemption from amended NASD Rule 3010(c). Below 
is the text of the proposed rule change. Proposed new language is in 
italics; proposed deletions are in brackets.
* * * * *

2510. Discretionary Accounts

    (a) through (c) No Change.
    (d) Exceptions
    This Rule shall not apply to:
    (1) discretion as to the price at which or the time when an order 
given by a customer for the purchase or sale of a definite amount of a 
specified shall be executed, except that the authority to exercise time 
and price discretion will be considered to be in effect only until the 
end of the business day on which the customer granted such discretion, 
absent a specific, written, contrary indication signed and dated by the 
customer;
    (2) No Change.
    Any exercise of time and price discretion must be reflected on the 
customer order ticket.
* * * * *

3010. Supervision

    (a) through (b) No Change.
    (c) Internal Inspections
    (1) Each member shall conduct a review, at least annually, of the 
businesses in which it engages, which review shall be reasonably 
designed to assist in detecting and preventing violations of, and 
achieving compliance with, applicable securities laws and regulations, 
and with applicable NASD rules [the Rules of this Association]. Each 
member shall review the activities of each office, which shall include 
the periodic examination of customer accounts to detect and prevent 
irregularities or abuses and at least an annual inspection of each 
office of supervisory jurisdiction. Each branch office of the member 
shall be inspected according to a cycle which shall be set forth in the 
firm's written supervisory and inspection procedures. In establishing 
such cycle, the firm shall give consideration to the nature and 
complexity of the securities activities for which the location is 
responsible, the volume of business done, and the number of associated 
persons assigned to the location. Each member shall retain a written 
record of the dates upon which each review and inspection is conducted.
    (2) Office inspections by members pursuant to paragraph (c)(1) must 
be conducted by a person who is independent from the activities being 
performed at the office and those persons providing supervision to that 
office. The independence requirements in connection with office 
inspections may be satisfied by reasonable means based on the size and 
resources of the firm and the scope and nature of its activities. 
Written reports of these inspections are to be kept on file by the 
member for a minimum of three years.
    An office inspection and review must include, but is not limited 
to, testing and verification of the member's policies and procedures, 
including supervisory policies and procedures in the following areas:
    (A) Safeguarding of customer funds and securities;
    (B) Maintaining books and records;
    (C) Supervision of customer accounts serviced by branch office 
managers;
    (D) Transmittal of funds between customers and registered 
representatives and between customers and third parties;
    (E) Validation of customer address changes; and
    (F) Validation of changes in customer account information.
    (3) Pursuant to the Rule 9600 Series, NASD may exempt any member 
unconditionally or on specified terms and conditions from the 
independence requirement in the inspection of a member's offices as set 
forth in paragraph (c)(2) upon a satisfactory showing that complying 
with the requirements would be unduly burdensome on the member and that 
the member's internal inspection procedures are reasonably designed to 
achieve compliance with applicable securities laws and regulations and 
applicable NASD rules.
* * * * *

3012. Supervisory Controls

(a) General Requirements

    (1) Each member shall establish and maintain a system of 
supervisory control policies and procedures that (A) test and verify 
that the member's supervisory procedures are reasonably designed with 
respect to the activities of the member and its registered 
representatives and associated persons, to achieve compliance with 
applicable securities laws and regulations, and with applicable NASD 
rules and (B) create additional or amend supervisory procedures where 
the need is identified by such testing and verification. The member's 
supervisory controls must be performed by persons who are

[[Page 70991]]

independent from those activities being tested and verified and the 
persons who directly supervise those activities. The independence 
requirements in connection with testing and verification may be 
satisfied by reasonable means based on the size and resources of the 
firm and the scope and nature of its activities. A report detailing 
each member's systems of supervisory controls, including a summary of 
the test results and significant identified exceptions, must be 
submitted no less than annually to the member's senior management.
    (2) The independence requirement in the verification and testing of 
the member's supervisory procedures shall not apply to members that do 
not conduct a public business, or that have a capital requirement of 
$5,000 or less, or that employ 10 or fewer registered representatives.

(b) Managers' Activities

    Each member shall establish, maintain, and enforce written policies 
and procedures to administer the supervisory controls established 
pursuant to paragraph (a) reasonably designed to independently review 
and monitor the servicing of customer accounts by the member's branch 
office managers, sales managers, regional or district sales managers, 
or any person performing a similar supervisory function.

(c) Customers' Activities

    Each member shall establish, maintain, and enforce written policies 
and procedures to administer the supervisory controls established 
pursuant to paragraph (a), specifically with respect to the following 
activities:
    (1) Transmittals of funds (e.g., wires or checks, etc.) or 
securities:
    (A) from customer accounts to third party accounts (i.e., a 
transmittal that would result in a change of beneficial ownership);
    (B) from customer accounts to outside entities (e.g., banks, 
investment companies, etc.);
    (C) from customer accounts to locations other than a customer's 
primary residence (e.g., post office, ``in care of'' accounts, 
alternate address, etc.); and
    (D) between customers and registered representatives, including the 
hand-delivery of checks.
    (2) Customer changes of address.
    (3) Customer changes of investment objectives.
    The policies and procedures established pursuant to paragraph (c) 
must include a means or method of customer confirmation, notification, 
or follow-up that can be documented.

(d) Dual Member

    Any member in compliance with substantially similar requirements of 
the New York Stock Exchange, Inc. shall be deemed to be in compliance 
with the provisions of this Rule.
* * * * *

3110. Books and Records

    (a) through (c) No change.
    (d) Changes in Account Name or Designation.
    Before any customer order is executed, there must be placed upon 
the memorandum for each transaction, the name or designation of the 
account (or accounts) for which such order is to be executed. No change 
in such account name(s) (including related accounts) or designation(s) 
(including error accounts) shall be made unless the change has been 
authorized by a member or a person(s) designated under the provisions 
of NASD rules. Such person must, prior to giving his or her approval of 
the account designation change, be personally informed of the essential 
facts relative thereto and indicate his or her approval of such change 
in writing on the order or other similar record of the member. The 
essential facts relied upon by the person approving the change must be 
documented in writing and maintained in a central location.
    For purposes of this paragraph (d), a person(s) designated under 
the provisions of NASD rules to approve account name or designation 
changes must pass a qualifying principal examination appropriate to the 
business of the firm.
* * * * *

IM-3110. Customer Account Information

    (a) through (h) No Change.
    (i) Holding of Customer Mail
    Upon the written instructions of a customer, a member may hold mail 
for a customer who will not be at his or her usual address for the 
period of his or her absence, but (A) not to exceed two months if the 
member is advised that such customer will be on vacation or traveling 
or (B) not to exceed three months if the customer is going abroad.
* * * * *

9610. Application

    (a) Where to File
    A member seeking an exemption from Rule 1021, 1022, 1070, 2210, 
2320, 2340, 2520, 2710, 2720, 2810, 2850, 2851, 2860, Interpretive 
Material 2860-1, 3010(b)(2), 3010(c), 3020, 3210, 3230, 3350, 8211, 
8212, 8213, 11870, or 11900, Interpretive Material 2110-1, or Municipal 
Securities Rulemaking Board Rule G-37 shall file a written application 
with the appropriate department or staff of NASD [the Association] and 
provide a copy of the application to the Office of General Counsel of 
NASD [Regulation], Regulatory Policy and Oversight.
    (b) through (c) No Change.
* * * * *

II. Self-Regulatory Organization's Statement of the Purpose of, and 
Statutory Basis for, the Proposed Rule Change

    In its filing with the Commission, the NASD included statements 
concerning the purpose of and basis for the proposed rule change and 
discussed any comments it received on the proposed rule change. The 
text of these statements may be examined at the places specified in 
Item IV below. The NASD has prepared summaries, set forth in Sections 
A, B, and C below, of the most significant aspects of such statements.

A. Self-Regulatory Organization's Statement of the Purpose of, and 
Statutory Basis for, the Proposed Rule Change

1. Purpose
    Adequate supervisory systems play an important role in assuring 
investor protection and the integrity of the markets. Operational and 
sales practice abuses can stem from ineffective supervisory and 
supervisory control procedures. The recent Gruttadauria case, which 
involved the misappropriation of customer funds, has brought tremendous 
attention to the ongoing problem of operational and sales practice 
abuses at firms and the importance of ensuring that firms effectively 
monitor the activities of their employees.
    NASD rules contain extensive supervisory requirements. NASD Rule 
3010 generally requires each member to establish and maintain a 
supervisory system, including the development of written procedures. 
Beyond this broad general requirement, NASD Rule 2110 requires members 
to observe high standards of commercial honor and just and equitable 
principles of trade, and NASD Rule 3110 sets forth extensive books and 
records obligations. In addition, the NASD recently established 
comprehensive examination procedures for supervisory controls. The 
examination procedures focus on supervisory controls as they relate to 
several areas of a firm, including senior

[[Page 70992]]

management, internal audit and trading risk controls.
    In light of the concerns raised by the Guttadauria case with 
respect to inadequate supervisory systems, the NASD is proposing a new 
rule and amendments to existing rules to enhance the NASD's current 
rules and examination efforts by specifically requiring members to 
establish adequate supervisory control systems. In general, proposed 
new NASD Rule 3012 sets forth general and specific supervisory control 
requirements while amendments to certain other rules complement NASD's 
efforts with new NASD Rule 3012. The New York Stock Exchange, Inc. 
(``NYSE'') also recently filed with the SEC a series of amendments 
aimed at improving a firm's supervisory and internal (or supervisory) 
control systems.\3\ The NASD states that its proposed rule change is 
substantially similar to the NYSE's proposed amendments.
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    \3\ See Securities Exchange Act Release No. 46858 (November 20, 
2002) (SR-NYSE-2002-36).
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    The obligation to establish supervisory and supervisory control 
procedures is not a ``one-size-fits-all'' requirement. The NASD 
recognizes that there is no single set of procedures that will be 
appropriate for all firms and each firm must tailor such procedures to 
fit its business. In developing appropriate supervisory and supervisory 
control procedures, each firm must consider factors such as its size, 
location, and nature of business activities.

Supervisory Controls--General Requirement

    Under NASD Rule 3010, a member's supervisory system is required to 
encompass the activities in which the member engages as well as the 
activities of the member's registered representatives and associated 
persons in order to achieve compliance with applicable securities laws 
and regulations and NASD rules. Not only must supervisory procedures be 
established, but such procedures must also be independently tested and 
verified through a system of supervisory control procedures to ensure 
appropriate application and effectiveness. The proposed rule change 
would require firms to develop and maintain a system of adequate 
supervisory control procedures that (1) test and verify that the 
member's supervisory procedures are reasonably designed, with respect 
to the activities of the member and its registered representatives and 
associated persons, to achieve compliance with the applicable 
securities laws and regulations, and with the applicable NASD rules and 
(2) create additional or amend supervisory procedures where the need is 
identified by such testing and verification.
    The proposed rule change would require that a member's control 
procedures be performed by persons who are independent of the 
activities being tested and verified and the persons who directly 
supervise those activities. The independence requirement may be 
achieved by reasonable means in light of the member firm's size and 
resources and nature and scope of its activities. In practice, the NASD 
would expect that, unless a member could establish it was impractical, 
the system of supervisory controls will be deployed by persons who (1) 
are not connected in function to, or receive direct remuneration from, 
the activities which are the subject of the supervisory control 
procedures and (2) do not report to persons who supervise those 
activities. In the situation where the size and resources of the firm 
and the scope and nature of its activities make it impracticable for 
the firm to achieve independence in this fashion, the firm may satisfy 
the independence requirement by alternative means such as establishing 
additional policies and procedures to create a sufficient level of 
separation. Members would be required to report the testing and 
verification results to the firm's senior management annually.
    Recognizing that the independence requirement in connection with 
testing and verification may not be practical for smaller members, the 
proposed rule change would allow an exemption from this independence 
requirement for firms that do not conduct a public business, or have a 
capital requirement of $5,000 or less, or employ 10 or fewer registered 
representatives.

Supervisory Controls--Customers' Activities

    The NASD believes that certain customer activities, such as the 
transmittal of customer funds or changes in customer address or 
investment objectives, require additional monitoring to help prevent 
fraud and theft of customer funds. Changes in customer investor 
objectives would require additional protections because of the 
importance of maintaining accurate books and records in the course of 
the member's business and potential for sales practice abuse in 
connection with the recording of inaccurate investment objectives for 
customers. The monitoring of customer address changes would guard 
against the improper delivery of customer-related documentation. As 
such, the proposed rule change would require firms to establish written 
supervisory control procedures specifically with respect to the 
transmittal of customer funds and changes in customer address and 
investment objectives. Members would be required to follow-up with 
customers after the occurrence of any of these activities and to 
document the method of follow-up.

Supervisory Controls--Sales Managers' Activities

    The proposed amendments would require firms to develop and 
implement written policies to independently review and monitor the 
servicing of customer accounts by branch office managers, sales 
managers, regional/district sales managers, and other supervisory 
personnel. The NASD expects that all sales-related activities will be 
reviewed. The NASD believes that the sales activities of branch 
managers and other sales managers should be subject to independent 
oversight to ensure that supervisors do not perform the final review of 
their own sales activity.

Dual Members

    Proposed NASD Rule 3012 provides that a member that is in 
compliance with substantially similar requirements of the NYSE shall be 
deemed to be in compliance with the supervisory control requirements 
set forth in NASD Rule 3012.

Office Inspection

    NASD Rule 3010(c) requires members to inspect and review the 
activities of each office.\4\ To ensure that the inspections are 
objective and not subject to conflicts of interests, the proposed rule 
change would require that office inspections be conducted, by a person 
who is independent from the activities being performed at the office 
and the persons providing supervision to the office. Similar to the 
general supervisory controls amendments discussed earlier, the 
independence requirements may be satisfied by reasonable means based on 
the size and resources of the firm and the scope and nature of its 
activities. Office inspection programs would be required to include, at 
a minimum, testing and verification of a member's

[[Page 70993]]

policies and procedures with respect to: (1) Safeguarding of customer 
funds and securities; (2) maintaining books and records; (3) 
supervision of customer accounts serviced by branch office managers; 
(4) transmittal of customer funds; (5) validation of customer address 
changes; and (6) validation of changes in customer account information.
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    \4\ NASD Rule 3010(c) requires an inspection at least annually 
of each office of supervisory jurisdiction and cycle examinations of 
branch offices. Although the rule does not specify the frequency of 
inspections for unregistered offices, NASD, Notice to Members 98-38 
(May 1998) states that in order to fulfill the general obligation to 
supervise, such inspections should be conducted according to a 
regular schedule.
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    The NASD recognizes that it may not be practical for members with 
small offices to conduct an independent inspection. In this regard, the 
proposed rule change would allow the NASD to exempt members pursuant to 
the NASD Rule 9600 Series from the independence requirement in the 
inspection of a member's office.

Discretionary Authority

    NASD Rule 2510(d)(1) allows members to exercise time-and-price 
discretion on orders for the purchase or sale of a definite amount of a 
specified security without prior written authorization from the 
customer or prior written approval by the member, but does not specify 
the duration of such discretionary authority. The proposed rule change 
would clarify that a firm's authority to exercise time and price 
discretion terminates at the end of the business day on which the 
customer granted such discretion, unless a signed authorization from 
the customer shows otherwise. The proposed rule change would further 
require any exercise of time or price discretion to be reflected on the 
order ticket.

Changes in Customer Account Name or Designation

    Because changes in account names or designations in connection with 
order executions can be subject to abuse, the NASD believes that such 
changes should be approved by a qualified person and the basis for the 
change should be adequately documented. The proposed rule change would 
specify that no changes to the account name(s) or designation(s), 
including related accounts or error accounts may be made unless 
previously authorized by the person designated to approve such changes. 
Such designated person would be required to pass a qualifying principal 
examination appropriate to the business of the firm, such as the 
General Securities Sales Supervisor (Series 9/10) or General Securities 
Principal (Series 24). The designated person must document the 
essential facts relied upon in approving the changes and maintain the 
record in a central location.

Customer Mail

    To prevent improper mail delivery if a customer is away from his or 
her regular address for an extended period of time, the proposed rule 
change would allow members to hold mail for a customer upon receiving 
written instructions from the customer, not to exceed two months if the 
customer is on vacation or traveling or three months if the customer is 
going abroad.
2. Statutory Basis
    The NASD believes that the proposed rule change is consistent with 
the provisions of section 15A(b)(6) of the Act,\5\ which requires, 
among other things, that NASD's rules must be designed 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. The NASD believes that the proposed rule 
change is designed to accomplish these ends by requiring members to 
establish more extensive supervisory and supervisory control procedures 
to monitor customer account activities of its employees and thereby 
reduce the potential for customer fraud and theft.
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    \5\ 15 U.S.C. 78o-1(b)(6).
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B. Self-Regulatory Organization's Statement on Burden on Competition

    The NASD does not believe that the proposed rule change will result 
in any burden on competition that is not necessary or appropriate in 
furtherance of the purposes of the Act, as amended.

C. Self-Regulatory Organization's Statement on Comments on the Proposed 
Rule Change Received from Members, Participants, or Others

    Written comments were neither solicited nor received.

III. Date of Effectiveness of the Proposed Rule Change and Timing for 
Commission Action

    Within 35 days of the date of publication of this notice in the 
Federal Register or within such longer period (i) as the Commission may 
designate up to 90 days of such date if it finds such longer period to 
be appropriate and publishes its reasons for so finding or (ii) as to 
which the self-regulatory organization consents, the Commission will:
    (A) by order approve such proposed rule change, or
    (B) institute proceedings to determine whether the proposed rule 
change should be disapproved.

IV. Solicitation of Comments

    Interested persons are invited to submit written data, views, and 
arguments concerning the foregoing, including whether the proposed rule 
is consistent with the Act. Persons making written submissions should 
file six copies thereof with the Secretary, Securities and Exchange 
Commission, 450 Fifth Street, NW., Washington, DC 20549-0609. Copies of 
the submission, all subsequent amendments, all written statements with 
respect to the proposed rule change that are filed with the Commission, 
and all written communications relating to the proposed rule change 
between the Commission and any person other than those that may be 
withheld from the public in accordance with the provisions of 5 U.S.C. 
552, will be available for inspection and copying in the Commission's 
Public Reference Room. Copies of such filing will also be available for 
inspection and copying at the principal office of the NASD. All 
submissions should refer to the File No. SR-NASD-2002-162 and should be 
submitted by December 18, 2002.

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\6\
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    \6\ 17 CFR 200.30-3(a)(12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 02-30041 Filed 11-26-02; 8:45 am]
BILLING CODE 8010-01-P