[Federal Register Volume 69, Number 120 (Wednesday, June 23, 2004)]
[Notices]
[Pages 35092-35106]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 04-14232]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-49883; File No. SR-NASD-2002-162]


Self-Regulatory Organizations; Order Approving Proposed Rule 
Change and Amendments No. 1 and 2 by National Association of Securities 
Dealers, Inc. Relating to Internal Controls and Supervisory Control 
Amendments and Notice of Filing and Order Granting Accelerated Approval 
of Amendment No. 3.

June 17, 2004.

I. Introduction

    On November 4, 2002, the National Association of Securities 
Dealers, Inc. (``NASD'') filed with the Securities and Exchange 
Commission (``SEC'' or ``Commission''), pursuant to Section 19(b)(1) of 
the Securities Exchange Act of 1934 (``Act'')\1\ and Rule 19b-4 
thereunder,\2\ a proposed rule change relating to the establishment, 
maintenance, and testing of internal controls and supervision of NASD 
members. The proposed rule change was published for comment in the 
Federal Register on November 27, 2002.\3\ The Commission received 72 
comment letters in response to proposed

[[Page 35093]]

rule change.\4\ In response, on August 5, 2003, the NASD filed 
Amendment No. 1 to the proposed rule change. On August 7, 2003, the 
NASD filed Amendment No. 2 to the proposed rule

[[Page 35094]]

change. On August 13, 2003, Amendments No. 1 and 2 were published for 
comment in Federal Register.\5\ The Commission received 14 comments 
letters in response to these Amendments.\6\ On December 17, 2003, NASD 
submitted Amendment No. 3 to the proposed rule change.\7\ This Order 
approves the proposed rule, as amended, and accelerates approval of 
Amendment No. 3.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ See Securities Exchange Act Release No. 46859 (November 20, 
2002), 67 FR 70990 (November 27, 2002). On December 18, 2002, the 
Commission extended the 21-day comment period for an additional 30 
days. See Securities Exchange Act Release No. 47021, 67 FR 78840 
(December 26, 2002).
    \4\ See Letters from Robert J. Schoen, President, Quest 
Securities, Inc., to Jonathan G. Katz, Secretary, Commission, dated 
November 22, 2002 (``Quest Letter''); William L. Sabol, President, 
Mutual Securities, Inc., to Jonathan G. Katz, Secretary, Commission, 
dated November 26, 2002 (``Mutual Securities Letter''); Keo Sheng 
Lin, President, Kyson & Co., to Jonathan G. Katz, Secretary, 
Commission, dated November 25, 2002 (``Kyson Letter''); Hsiao-wen 
Kao, President, Monitor Capital Inc., to Jonathan G. Katz, 
Secretary, Commission, dated November 25, 2002 (``Monitor Letter''); 
M. Shawn Dreffin, President, National Planning Corporation, to 
Jonathan G. Katz, Secretary, Commission, dated December 2, 2002 
(``National Planning Letter''); William Partin, President, Duerr 
Financial Corporation, to Jonathan G. Katz, Secretary, Commission, 
dated November 27, 2002 (``Duerr Letter''); Stanley C. Brooks, 
President and Chief Executive Officer, Brookstreet Securities 
Corporation, to Jonathan G. Katz, Secretary, Commission, dated 
December 4, 2003 (``Brookstreet Letter''); Thomas H. Oliver, 
President and Chief Executive Officer, United Planners' Financial 
Services of America, to Jonathan G. Katz, Secretary, Commission, 
dated December 13, 2002 (``United Planners' Letter''); Kevin P. 
Maas, Vice President and Director of Compliance, PrimeVest Financial 
Services, Inc., to Jonathan G. Katz, Secretary, Commission, received 
December 18, 2002 (``PrimeVest Letter''); R. Jack Conley, President 
and Chief Executive Officer, Vestax Securities Corporation, to 
Jonathan G. Katz, Secretary, Commission, dated December 17, 2002 
(``Vestex Letter''); David R. Wickersham, President and Z. Jane 
Riley, Compliance Officer, The Leaders Group, Inc., to Jonathan G. 
Katz, Secretary, Commission, dated December 13, 2002 (``Leaders 
Letter''); Jacqueline C. Conley, Vice President, Compliance, Locust 
Street Securities, Inc., to Jonathan G. Katz, Secretary, Commission, 
dated December 13, 2002 (``Locust Letter''); John L. Dixon, 
President, Pacific Select Distributors, to Jonathan G. Katz, 
Secretary, Commission, dated December 13, 2002 (``Pacific Select 
Letter''); Paul M. Phalen, Assistant Vice President, Variable 
Product Services, Midland National Life Insurance Company, to 
Jonathan G. Katz, Secretary, Commission, dated December 17, 2002 
(``Midland Letter''); Peter T. Wheeler, President, Commonwealth 
Financial Network, to Jonathan G. Katz, Secretary, Commission, dated 
December 17, 2002 (``Commonwealth Letter''); Nina S. McKenna, 
Sonnenschein, to Jonathan G. Katz, Secretary, Commission, dated 
December 17, 2002 (``Sonnenschein Letter''); Robert Watts, John 
Hancock, Financial Services, Inc., to Jonathan G. Katz, Secretary, 
Commission, dated December 17, 2002 and January 16, 2003 (``John 
Hancock Letter''); Michael L. Kerley, Vice President and Chief Legal 
Officer, MML Investors Services, Inc., to Jonathan G. Katz, 
Secretary, Commission, dated December 17, 2002 (``MML Letter''); Tom 
K. Rippberger, Vice President and Chief Compliance Officer, 
Washington Square Securities, Inc., to Jonathan G. Katz, Secretary, 
Commission, received December 17, 2003 (``Washington Square 
Letter''); Patrick H. McEvoy, President and Chief Executive Officer, 
Multi-Financial Securities Corporation, to Jonathan G. Katz, 
Secretary, Commission, dated December 16, 2002 (``Multi-Financial 
Letter''); Bryan R. Hill, President, Securities America, to Jonathan 
G. Katz, Secretary, Commission, dated December 16, 2002 
(``Securities America Letter''); Neal E. Nakagiri, President and 
Chief Executive Officer, Associated Securities Corp., to Jonathan G. 
Katz, Secretary, Commission, dated December 19, 2002 (``ASC 
Letter''); R. Jack Conley, President and Chief Executive Officer, 
IFG Network Securities, Inc., to Jonathan G. Katz, Secretary, 
Commission, dated December 18, 2002 (``IFG Letter''); Michael D. 
Burns, Chief Compliance Officer, USAllianz Securities, Inc., to 
Jonathan G. Katz, Secretary, Commission, dated December 16, 2002 
(``USAllianz Letter''); Greg Gunderson, President, Investment 
Centers of America, Inc., to Jonathan G. Katz, Secretary, 
Commission, dated December 16, 2002 (``Investment Centers Letter''); 
Sandy Brown, President and Chief Operating Officer, TransAmerica 
Financial Advisors, to Jonathan G. Katz, Secretary, Commission, 
dated December 16, 2002 (``TransAmerica Letter''); Jack R. Handy, 
Jr., President, Financial Network Investment Corporation, to 
Jonathan G. Katz, Secretary, Commission, dated December 13, 2002 
(``Financial Network Letter''); Julius J. Anderson, Vice President, 
David M. Hoff, President and Zeonia Christy, Compliance Officer, 
First Heartland Capital, to Jonathan G. Katz, Secretary, Commission, 
dated December 27, 2002 (``First Heartland Letter''); David W. 
Schofield, Director of Operations and Compliance, FMN Capital 
Corporation, to Jonathan G. Katz, Secretary, Commission, dated 
December 18, 2002 (``FMN Letter''); Arthur F. Grant, President, 
Cadaret, Grant & Co., Inc., to Jonathan G. Katz, Secretary, 
Commission, dated December 17, 2002 (``Cadaret Grant Letter''); 
Charles Mazziotti, President, 21st Century Financial Services, Inc., 
to Jonathan G. Katz, Secretary, Commission, dated December 17, 2002 
(``21st Century Letter''); J. Kemp Richardson, President, J.K.R. & 
Co., Inc., to Jonathan G. Katz, Secretary, Commission, dated 
December 10, 2002 (``J.K.R. Letter''); Dominick Del Duca, Chief 
Compliance Officer, ING FNC, to Jonathan G. Katz, Secretary, 
Commission, dated December 12, 2002 (``ING Letter''); Robert L. 
Hamman, President, Iron Street Securities, Inc., to Jonathan G. 
Katz, Secretary, Commission, dated December 24, 2002 (``Iron Street 
Letter''); Christopher R. Franke, Chairman, Self-Regulation and 
Supervisory Practices Committee, Securities Industry Association, to 
Jonathan G. Katz, Secretary, Commission, dated December 18, 2002 
(``SIA Letter 1''); Lynn R. Niedermeier, President and Chief 
Executive Officer, INVEST Financial Corporation, to Jonathan G. 
Katz, Secretary, Commission, dated December 17, 2002 (``INVEST 
Letter''); Steven J. Svoboda, President, Eagle One Investments, LLC, 
to Jonathan G. Katz, Secretary, Commission, dated December 16, 2002 
(``Eagle One Letter''); Stephen Batman, Chief Executive Officer, 1st 
Global, Inc., to Jonathan G. Katz, Secretary, Commission, dated 
December 18, 2002 (``1st Global Letter''); Thomas A. Hopkins, 
Chairman, Waterstone Financial Group, Inc., to Jonathan G. Katz, 
Secretary, Commission, dated December 16, 2002 (``Waterstone 
Letter''); David L. Meckenstock, Vice President and Chief Compliance 
Officer, Main Street Securities, LLC, to Jonathan G. Katz, 
Secretary, Commission, dated December 13, 2002 (``Main Street 
Letter''); Leesa M. Easley, Chief Legal Officer, World Group 
Securities, Inc., to Jonathan G. Katz, Secretary, Commission, dated 
December 19, 2002 (``World Group Letter''); Andrew J. Powers, 
President and Chief Compliance Officer, Re-Direct Securities 
Corporation, to Jonathan G. Katz, Secretary, Commission, dated 
December 13, 2002 (``RDS''); Dennis S. Kaminisi, Executive Vice 
President and Chief Administrative Officer, Mutual Service 
Corporation, to Jonathan G. Katz, Secretary, Commission, dated 
December 18, 2002 (``MSC Letter''); Roger W. Raber, President and 
Chief Executive Officer, National Association of Corporate 
Directors, to Jonathan G. Katz, Secretary, Commission, dated 
December 4, 2002 (``NACD Letter''); Rod J. Michel, President, World 
Trade Financial Corporation, to Jonathan G. Katz, Secretary, 
Commission, dated December 31, 2002 (``WORL Letter''); Brian C. 
Underwood, Senior Vice President and Director of Compliance, A.G. 
Edwards & Sons, Inc., to Jonathan G. Katz, Secretary, Commission, 
dated December 18, 2002 (``A.G. Edwards Letter''); Joan Hinchman, 
Executive Director, President and Chief Executive Officer, National 
Society of Compliance Professionals Inc., to Jonathan G. Katz, 
Secretary, Commission, dated January 8, 2003 (``NSCP Letter''); 
Minoo Spellerberg, Compliance Officer, Princor Financial Services 
Corporation, to Jonathan G. Katz, Secretary, Commission, dated 
December 16, 2002 (``Princor Letter''); Philip A. Pizelo, President, 
Pacific West Securities, Inc., to Jonathan G. Katz, Secretary, 
Commission, dated January 14, 2003 (``Pacific West Letter''); Terry 
L. Lister, General Counsel, Cambridge Investment Research, Inc., to 
Jonathan G. Katz, Secretary, Commission, dated December 20, 2002 
(``Cambridge Letter''); Malcolm A. Morrison, President, Wharton 
Equity Corporation, to Jonathan G. Katz, Secretary, Commission, 
dated January 10, 2003 (``Wharton Letter''); John T. Treece, 
President, Liberty Life Securities LLC, to Jonathan G. Katz, 
Secretary, Commission, dated January 15, 2003 (``Liberty Life 
Letter''); Beth E. Weimer, Vice President and Chief Compliance 
Officer, American Express Financial Advisors Inc., to Jonathan G. 
Katz, Secretary, Commission, dated January 17, 2003 (``AEFA 
Letter''); James F. McGuire, Senior Vice President and Chief 
Compliance Officer, Linsco/Private Ledger, Corp, to Jonathan G. 
Katz, Secretary, Commission, dated January 16, 2003 (``LPL 
Letter''); Beverly A. Byrne, Secretary, BenefitsCorp Equities, Inc., 
to Jonathan G. Katz, Secretary, Commission, dated December 18, 2002 
(``BenefitsCorp Letter''); Michael G. Brennan, Associate Counsel and 
Assistant Secretary, Woodbury Financial Services, Inc., to Jonathan 
G. Katz, Secretary, Commission, dated December 18, 2002 (``Woodbury 
Letter''); Craig Junkins, President and Chief Executive Officer, FFP 
Securities, to Jonathan G. Katz, Secretary, Commission, dated 
December 24, 2002 (``FFP Letter''); John M. Lefferts, President, AXA 
Advisors, LLC, to Jonathan G. Katz, Secretary, Commission, dated 
December 18, 2002 (``AXA Letter''); Charles Lesko, Jr., President, 
Lesko Securities, Inc., to Jonathan G. Katz, Secretary, Commission, 
dated December 24, 2002 (``Lesko Letter''); Marcia L. Martin, 
President, CUNA Brokerage Services, Inc., to Jonathan G. Katz, 
Secretary, Commission, dated December 24, 2002 (``CUNA Letter''); 
Robert M. Roth, President, MWA Financial Services, Inc., to Jonathan 
G. Katz, Secretary, Commission, dated December 24, 2002 (``MWAFS 
Letter''); Gregory D. Teese, Vice President, Compliance, Equity 
Services, Inc., to Jonathan G. Katz, Secretary, Commission, dated 
December 18, 2002 (``Equity Services Letter''); Selwyn J. 
Notelovitz, Senior Vice President, Global Compliance, Charles Schwab 
& Co., Inc., to Jonathan G. Katz, Secretary, Commission, dated 
February 25, 2003 (``Schwab Letter''); Kevin Ballou, President, 
Clark/Bardes Financial Services, Inc., to Jonathan G. Katz, 
Secretary, Commission, dated March 17, 2003 (``CBFS Letter''); 
Victoria Bach-Fink, Executive Vice President, Wall Street Financial 
Group, to Jonathan G. Katz, Secretary, Commission, dated December 
18, 2002 (``Wall Street Letter''); Sandra T. Masek, Executive Vice 
President and Chief Compliance Officer, Rhodes Securities, Inc., to 
Jonathan G. Katz, Secretary, Commission, dated December 18, 2002 
(``Rhodes Securities Letter''); Bridget M. Gaughan, Executive Vice 
President, Chief Legal and Regulatory Counsel, AIG Advisory Group, 
Inc., to Jonathan G. Katz, Secretary, Commission, dated January 2, 
2003 (``AIG Letter''); Adam Antoniades, President and Chief 
Operating Officer, First Allied Securities, Inc. (``First Allied 
Letter'') to Jonathan G. Katz, Secretary, Commission, dated December 
19, 2002; Martin Cohen, President, Balanced Financial Securities, to 
Jonathan G. Katz, Secretary, Commission, dated June 14, 2003 
(``Balanced Financial Letter''); and Scott Lynn Fagin, Chief 
Operating Officer and Chief Financial Officer, The Jeffrey Matthews 
Financial Group, LLC, to Jonathan G. Katz, Secretary, Commission, 
dated July 31, 2003 (``Jeffrey Matthews Letter'').
    \5\ See Securities Exchange Act Release No. 48298 (August 7, 
2003), 68 FR 48421. On September 8, 2003, the Commission extended 
the 21-day comment period for an additional 30 days. See Securities 
Exchange Act Release No. 48460, 68 FR 54034 (September 15, 2003).
    \6\ See Letters from Carl B. Wilkerson, Chief Counsel, 
Securities and Litigation, American Counsel of Life Insurers, to 
Jonathan G. Katz, Secretary, Commission dated September 3, 2003 and 
October 3, 2003 (``ACLI Letters''); Neal E. Nakagiri, President and 
CEO, Associated Securities Corp., to Jonathan G. Katz, Secretary, 
Commission dated October 2, 2003 (``ASC Letter-2''); Pamela K. 
Cavness, Director of Compliance, Edward D. Jones and Co., LP, to 
Jonathan G. Katz, Secretary, Commission dated October 2, 2003 
(``Edward Jones Letter''); Robert S. Rosenthal, Second Vice 
President and Associate General Counsel, Mass Mutual Financial 
Group, to Jonathan G. Katz, Secretary, Commission dated August 29, 
2003 (``Mass Mutual Letter-2''); Dennis S. Kaminski, EVP/CAO, Mutual 
Service Corp., to Jonathan G. Katz, Secretary, Commission dated 
October 3, 2003 (``MSC Letter-2''); Barbara Black, Director, Pace 
University School of Law, to Jonathan G. Katz, Secretary, Commission 
dated October 2, 2003; S. Kendrick Dunn, Assistant Vice President, 
Pacific Select Distributors, to Jonathan G. Katz, Secretary, 
Commission dated October 3, 2003 (``Pacific Select Letter-2''); John 
Polanin, Jr., Chairman, Self-Regulation and Supervisory Practices 
Commission, Securities Industry Association, to Jonathan G. Katz, 
Secretary, Commission dated October 3, 2003 (``SIA Letter-2''); 
Terry Lister, Of Counsel, Sonnenschein, Nath & Rosenthal, LLP, to 
Jonathan G. Katz, Secretary, Commission dated September 30, 2003 
(``Sonnenschein Letter-2''); Julie Gebert, Vice President and 
Director of Compliance, United Planners Financial Services of 
America, to Jonathan G. Katz, Secretary, Commission dated October 3, 
2003 (``United Planners Letter-2''); Ralph A. Lambiase, President 
and Director, Connecticut Division of Securities, North American 
Securities Administrators Association, Inc., to Jonathan G. Katz, 
Secretary, Commission dated October 24, 2003 (``NASAA Letter''); 
Lisa Roth, President, Monahan & Roth, to Jonathan G. Katz, 
Secretary, Commission, dated October 30, 2003 (``M&R Letter''); and 
Donald Gloisten, President, GBS Financial Corporation, to Jonathan 
G. Katz, Secretary, Commission dated January 15, 2004. The 
Commission notes that the letter from Edward Jones primarily sought 
interpretative guidance on application of the proposed rule from the 
NASD. These requests are not reflected as part of the summary of 
comments.
    \7\ See letter from Patricia Albrecht, Assistant General 
Counsel, NASD to Katherine A. England, Assistant Director, Division 
of Market Regulation, Commission, dated December 16, 2003 
(``Amendment No. 3'').
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II. Description

A. Background

1. Purpose for and General Description of Proposal
    The NASD's proposed rule change is designed to address concerns 
regarding its members' supervisory systems. Many of these concerns were 
brought to light following an investigation by the Commission into the 
activities of a branch office manager, Frank Gruttadauria.\8\ Over a 
period of 15 years, Mr. Gruttadauria misappropriated over $100 million 
from more than 40 clients. Mr. Gruttadauria was able to cover up his 
fraud by, among other things, providing clients with falsified account 
statements, and by causing the actual brokerage statements for some 
clients to be mailed, without the knowledge or authorization of these 
clients, to entities or post offices boxes under his control.
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    \8\ See In the Matter of SG Cowen Securities Corporation, 80 SEC 
Docket 3154 (September 9, 2003), Securities Exchange Act Release No. 
48335 (August 14, 2003) Administrative Proceeding File No. 3-11216. 
See also In the Matter of Lehman Brothers, Inc., 80 SEC Docket 3173 
(September 9, 2003), Securities Exchange Act Release No. 48336 
(August 14, 2003) Administrative Proceeding File No. 3-11217.
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    In an effort to ensure that members are more effectively supervised 
going forward, the NASD has proposed a new rule and amendments to 
existing rules to strengthen members' supervisory procedures and 
internal controls. Proposed new NASD Rule 3012 sets forth detailed 
requirements for members' supervisory control systems, while amendments 
to certain other rules complement that effort.
2. General Comments on the Proposed Rule Change
    Several commenters stated that the effective enforcement of 
existing supervisory rules should be sufficient to protect 
investors.\9\ These commenters frequently added that they viewed the 
proposed rules as an overreaction to the Gruttadauria case. The 
commenters stated that the Gruttadauria case was not a result of 
inadequate supervisory systems but, instead, was a case of a single 
individual intent on defrauding customers.\10\
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    \9\ See 1st Global Letter; AIG Letter; Cambridge Letter; Schwab 
Letter; CBFS Letter; Commonwealth Letter; CUNA Letter; FFP Letter; 
First Allied Letter; INVEST Letter; Investment Centers Letter; Lesko 
Letter; MSC Letter; MWAFS Letter; Princor Letter; Rhodes Securities 
Letter; Securities America Letter; SIA Letter; TransAmerica Letter; 
United Planners' Letter; USAllianz Letter; Waterstone Letter; and 
World Group Letter.
    \10\ See 1st Global Letter; AIG Letter; Cambridge Letter; Schwab 
Letter; CBFS Letter; Commonwealth Letter; CUNA Letter; FFP Letter; 
First Allied Letter; INVEST Letter; Investment Centers Letter; Lesko 
Letter; MSC Letter; MWAFS Letter; Princor Letter; Rhodes Securities 
Letter; Securities America Letter; SIA Letter; TransAmerica Letter; 
United Planners' Letter; USAllianz Letter; Waterstone Letter; and 
World Group Letter; see also Associated Securities Letter; AXA 
Letter; Cadaret Grant Letter; Equity Services Letter; LPL Letter; 
NSCP Letter; and Pacific Select Letter.
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    In Amendment No. 1, NASD responded that it understood the concern 
that regulators not overreact to one case of violative conduct, but 
stated that it did not view the proposed rule change as a reaction to 
any particular legal or regulatory event. Rather, NASD stated that the 
proposed rule change is designed to enhance the current rules and 
examination efforts by specifically requiring members to establish 
adequate supervisory control systems.
    Many commenters also suggested that implementing the proposed rule 
change would require firms to hire a large number of additional 
personnel to conduct the supervisory activities required by the 
proposed rules, thereby placing a significant financial burden on 
firms.\11\ Some commenters believed that this cost could destroy the 
business model of independent contractors located in small branch 
offices.\12\ Two commenters suggested that the proposed rule change be 
adopted in the form of ``principles for effective supervision'' or 
``best practices'' that could be tailored to various business models 
rather than rules that would apply to all firms.\13\
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    \11\ See 1st Global Letter; AIG Letter; AEFA Letter; Cambridge 
Letter; CBFS Letter; CUNA Letter; Equity Services Letter; FFP 
Letter; Financial Network Letter; First Allied Letter; IFG Letter; 
INVEST Letter; Investment Centers Letter; John Hancock Letters; 
Lesko Letter; LPL Letter; Locust Letter; Multi-Financial Letter; MSC 
Letter; MWAFS Letter; PrimeVest Letter; Princor Letter; Rhodes 
Securities Letter; Securities America Letter; TransAmerica Letter; 
United Planners' Letter; USAllianz Letter; Vestax Letter; Washington 
Square Letter; and Waterstone Letter.
    \12\ See Associated Securities Letter; AXA Advisors Letter; MSC 
Letter; Pacific Select Letter; SIA Letter; and Woodbury Letter.
    \13\ See 1st Global Letter and SIA Letter.
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    In Amendment No. 1, NASD stated that it disagreed with the 
suggestion that the proposed rule change should be adopted in the form 
of ``principles'' or ``best practices.'' NASD stated that it believes 
that the degree of authority carried by the proposed rules is necessary 
to effectively induce appropriate conduct. However, as discussed in 
detail below, NASD amended its proposed rules to allow greater 
flexibility in certain respects, such as, to account for variations in 
members' business models.

B. Discretionary Accounts (NASD Rule 2510)

    1. Original Proposal and Comments Received

[[Page 35095]]

    As originally proposed, changes to existing NASD Rule 2510(d)(1) 
required that discretionary authority as to the time or price at which 
an order may be executed be limited to the day it is granted, absent 
written authorization to the contrary. Several commenters suggested 
that the one-day time and price discretionary authority should be 
limited only to retail accounts and that NASD should craft an exemption 
for institutional accounts.\14\ Commenters argued that large orders for 
institutional accounts are ``worked'' over one or more days pursuant to 
a Good-Till-Cancelled Order with instructions issued on a ``not held'' 
basis.
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    \14\ See A.G. Edwards Letter; Schwab Letter; NSCP Letter; and 
SIA Letter.
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    In Amendment No. 1, NASD responded that it believes that a general 
institutional exemption is inappropriate. However, in an effort to 
address commenters' concerns, NASD amended NASD Rule 2510 to clarify 
that written authorization need not be obtained for the exercise of 
time and price discretion beyond the day a customer grants such 
discretion for orders effected with or for an institutional account, as 
that term is defined in NASD Rule 3110(c)(4), that are exercised 
pursuant to valid Good-Till-Cancelled instructions issued on a ``not 
held'' basis. NASD also amended NASD Rule 2510 to require that any 
exercise of time and price discretion be reflected on the customer 
order ticket.
    Several commenters also argued that allowing time and price 
discretion only until the end of the business day on which the 
discretion was granted absent written authorization from the customer 
seemed unduly restrictive and would not work to advantage of customers 
in moving markets.\15\ Commenters also requested that NASD clarify that 
the requirement to obtain written instructions for the exercise of time 
and price discretion beyond the business day it was granted allows 
customers to issue general ``standing'' instructions, rather than 
issuing written instructions on an order-by-order basis.\16\ NASD 
declined to adopt this position. In Amendment No. 1, NASD pointed out 
that the current text of NASD Rule 2510(d) clearly limits the exercise 
of time and price discretion to ``the purchase or sale of a definite 
amount of a specified security * * *.'' NASD noted that any written 
authorization granting time and price discretion must comply with this 
established, trade-specific standard and that customers who wish to 
grant more extensive discretionary authority to their registered 
representatives may do so pursuant to a fully executed trading 
authorization.
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    \15\ See Prime Vest Letter; ING Letter; Financial Network 
Letter; IFG Letter; Washington Square Letter; Multi-Financial 
Letter; and Vestax Letter.
    \16\ See NSCP Letter and SIA Letter.
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2. NASD Proposed Amendment in Response to Commenters
    Thus, in Amendment No. 1, which the Commission noticed on August 7, 
2003, NASD proposed amending NASD Rule 2510 to provide 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. However, the limitation 
shall not apply to time and price discretion exercised for orders 
effected with or for an institutional account \17\ pursuant to valid 
Good-Till-Cancelled instructions issued on a ``not-held'' basis. 
Further, any exercise of time and price discretion must be reflected on 
the customer order ticket.
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    \17\ See NASD Rule 3110(c)(4).
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C. Supervision and Internal Inspections (NASD Rule 3010)

1. Original Proposal and Comments Received
    The NASD originally proposed to amend NASD Rule 3010 to require 
that office inspections be conducted by a person who is ``independent'' 
from the activities being performed at the office and the people 
providing supervision to that office. In addition, NASD proposed to 
require that office inspections include, without limitation, the 
testing and verification of the member's supervisory policies and 
procedures in the areas of: Safeguarding customer funds and securities; 
maintaining books and records; supervision of customer accounts 
serviced by branch office managers; transmittal of funds between 
customers and registered representatives and between customers and 
third parties; validation of customer address changes; and validation 
of changes in customer account information.
    Several commenters agreed that requiring inspections of Offices of 
Supervisory Jurisdiction (``OSJs'') by persons who are not supervised 
by the OSJ manager makes sense and is reasonable given the facts of the 
Gruttadauria case.\18\ However, these commenters questioned the 
necessity of requiring the use of ``independent'' persons to inspect 
branch offices.
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    \18\ See PrimeVest Letter; Financial Network Letter; Vestax 
Letter; and Washington Square Letter.
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    Many commenters requested clarification regarding who would be 
sufficiently ``independent'' to conduct the office inspections required 
in NASD Rule 3010.\19\ At least one commenter stated that the 
``independence'' requirement proposed in NASD Rule 3010 appeared to 
refer to someone within the firm who does not receive compensation 
based on sales.\20\ Commenters also stated that the ``independence'' 
requirement proposed in NASD Rule 3010(c) would severely reduce the 
number of principals eligible to conduct branch exams and would put 
enormous pressure on home office exam personnel to conduct more office 
inspections.\21\ Commenters suggested that if home office exam 
personnel had to conduct more office inspections, the audit cycle would 
have to be extended to multiple-year durations and the quality of the 
audits would decline.\22\
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    \19\ See 1st Global Letter; A.G. Edwards Letter; AIG Letter; 
Cambridge Letter; Schwab Letter; CBFS Letter; Commonwealth Letter; 
CUNA Letter; FFP Letter; First Allied Letter; INVEST Letter; 
Investment Centers Letter; Lesko Letter; Midland Letter; MML Letter; 
MSC Letter; MWAFS Letter; NSCP Letter; Princor Letter; Rhodes 
Securities Letter; Schwab Letter; Securities America Letter; SIA 
Letter; United Planners' Letter; USAllianz Letter; Waterstone 
Letter; and World Group Letter.
    \20\ See Woodbury Letter.
    \21\ See 1st Global Letter; AIG Letter; AEFA Letter; Cambridge 
Letter; CBFS Letter; CUNA Letter; Equity Services Letter; FFP 
Letter; Financial Network Letter; First Allied Letter; IFG Letter; 
INVEST Letter; Investment Centers Letter; John Hancock Letter; Lesko 
Letter; LPL Letter; Locust Letter; Multi-Financial Letter; MSC 
Letter; MWAFS Letter; PrimeVest Letter; Princor Letter; Rhodes 
Securities Letter; Securities America Letter; TransAmerica Letter; 
United Planners' Letter; USAllianz Letter; Vestax Letter; Washington 
Square Letter; and Waterstone Letter.
    \22\ See 21st Century Letter; AIG Letter; Brookstreet Letter; 
Cambridge Letter; CBFS Letter; CUNA Letter; Duerr Letter; Eagle One 
Letter; FFP Letter; Financial Network Letter; First Allied Letter; 
First Heartland Letter; FMN Letter; IFG Letter; INVEST Letter; 
Investment Centers Letter; Iron Street Letter; JKR Letter; Kyson 
Letter; Lesko Letter; Liberty Life Letter; Locust Letter; Main 
Street Letter; Monitor Letter; Multi-Financial Letter; Mutual 
Securities Letter; MSC Letter; MWAFS Letter; National Planning 
Letter; Pacific West Letter; PrimeVest Letter; Princor Letter; Quest 
Letter; Rhodes Securities Letter; Securities America Letter; Leaders 
Group Letter; TransAmerica Letter; United Planners' Letter; 
USAllianz Letter; Vestax Letter; Washington Square Letter; 
Waterstone Letter; Wharton Letter; World Group Letter; and WORL 
Letter.
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    Some commenters argued that the current supervisory system, which 
allows OSJ managers to conduct office inspections of branch and 
satellite offices, should be retained because it is both effective and 
cost efficient.\23\

[[Page 35096]]

Commenters noted that OSJ managers are the most familiar with 
registered representatives and activities located at particular 
offices, and therefore, are the most qualified to perform the periodic 
inspections. Another commenter suggested that firms should have the 
flexibility to design internal control systems that conform to the 
nature of the business conducted by the member.\24\ In addition, 
commenters asserted that OSJ managers' auditing of branch and satellite 
offices serves to reinforce their accountability for the registered 
representatives' actions.\25\
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    \23\ See 21st Century Letter; AIG Letter; Brookstreet Letter; 
Cambridge Letter; CBFS Letter; CUNA Letter; Duerr Letter; Eagle One 
Letter; FFP Letter; Financial Network Letter; First Allied Letter; 
First Heartland Letter; FMN Letter; IFG Letter; INVEST Letter; 
Investment Centers Letter; Iron Street Letter; JKR Letter; Kyson 
Letter; Lesko Letter; Liberty Life Letter; Locust Letter; Main 
Street Letter; Monitor Letter; Multi-Financial Letter; Mutual 
Securities Letter; MSC Letter; MWAFS Letter; National Planning 
Letter; Pacific West Letter; PrimeVest Letter; Princor Letter; Quest 
Letter; Rhodes Securities Letter; Securities America Letter; Leaders 
Group Letter; TransAmerica Letter; United Planners' Letter; 
USAllianz Letter; Vestax Letter; Washington Square Letter; 
Waterstone Letter; Wharton Letter; World Group Letter; and WORL 
Letter.
    \24\ See Schwab Letter.
    \25\ Id.
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2. NASD Proposed Amendments in Response to Commenters
    In Amendments No. 1 and 2, the NASD responded to commenters and 
amended NASD Rule 3010 to replace the proposed ``independence'' 
requirement with a provision that prohibits a branch office manager or 
any person within that office who has supervisory responsibilities or 
any individual who is supervised by such person(s) from conducting an 
office inspection.
    Specifically, in Amendments No. 1 and 2, which the Commission 
noticed on August 7, 2003, NASD proposed amending NASD Rule 3010 to 
provide that an office inspection cannot be conducted by a branch 
office manager or any person within that office who has supervisory 
responsibilities or by any individual who is supervised by such 
person(s). This means that someone outside the branch office's 
managerial structure must conduct the inspection, such as regional or 
district office personnel, another branch office manager, or someone 
within the branch office who does not report to the branch office 
manager or other supervisor within the office (e.g., an employee that 
reports to the regional or district home office).
    Also, in Amendment No. 1, NASD proposed amending NASD Rule 3010 to 
require that members establish heightened inspection procedures in 
situations where the person conducting the inspection either works in 
an office supervised by the branch office manager's supervisor or 
reports to the branch office manager's supervisor and the branch office 
manager generates 20% or more of the income of the branch office 
manager's supervisor. NASD explained that the term ``heightened 
inspection'' means those inspection procedures that are designed to 
avoid conflicts of interest that serve to undermine complete and 
effective inspection because of economic, commercial, or financial 
interests that the branch office manager's supervisor holds in the 
associated persons and businesses being inspected.
    In Amendment No. 2, NASD gave examples of heightened inspection 
procedures, stating that members should consider such elements as 
unannounced office inspections, increased frequency of inspections, a 
broaden scope of activities inspected, and/or having one or more 
principals review and approve the office's inspections. To allow 
members flexibility, NASD stated that these examples are meant to 
illustrate the type of procedures a member may want to include in its 
heightened inspection procedures and are not meant to be an exclusive 
or exhaustive list.
    The proposed rule requires that an office inspection and review by 
a member must be reduced to a written report and kept on file by the 
member for a minimum of three years, unless the regular periodic 
schedule for the inspection is longer than a three-year cycle, in which 
case the report must be kept on file at least until the next inspection 
report has been written. The written inspection report must also 
include, without limitation, the 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. 
NASD Rule 3010, however, does not limit member testing and verification 
of the members' policies and procedures during an inspection to these 
specific areas but requires testing and verification of all relevant 
policies and procedures.
    In addition, in Amendment No. 1, NASD amended NASD Rule 3010 to 
codify previous NASD guidance that non-supervisory branch offices must 
be inspected at least every three years based on the nature and 
complexity of the securities activities and that all non-branch 
locations must be inspected periodically, and to provide that OSJs must 
be inspected annually.
    Finally, in Amendment No. 1, NASD deleted the provision in NASD 
Rule 3010(c) that would have allowed members to seek an exemption from 
the independence requirement in NASD Rule 3010(c) subject to specified 
terms and conditions, because it had removed the ``independence'' 
requirement regarding inspections conducted pursuant to NASD Rule 
3010(c). NASD also removed its Rule 3010(c) from the list of rules in 
NASD Rule 9610(a) from which a member can seek an exemption.

D. Supervisory Controls (NASD Rule 3012)

1. Original Proposal and Comments Received
    As originally proposed, NASD Rule 3012 required that each member 
establish supervisory control procedures that (a) test and verify that 
the member's supervisory procedures are reasonably designed to comply 
with the federal securities laws and regulations and NASD rules; and 
(b) amend the supervisory procedures where such testing and 
verification identifies the need to do so. NASD further proposed that 
the supervisory control procedures be performed by persons who are 
``independent'' from those activities being tested and verified and the 
persons who directly supervise those activities.
    One commenter stated that the proposed rule change would expand a 
member's existing supervisory procedures and place a more substantive 
emphasis on testing and verification of the member's examination 
processes.\26\ This commenter did not believe that the change would be 
overly burdensome compared to the benefit derived--tightened security. 
Another commenter recommended that the proposed rule be limited to 
retail accounts.\27\
---------------------------------------------------------------------------

    \26\ See John Hancock Letter.
    \27\ See NSCP Letter.
---------------------------------------------------------------------------

    Many commenters requested clarification regarding who would be 
sufficiently ``independent'' to perform the supervisory control 
procedures required under proposed NASD Rule 3012.\28\ A large number 
of commenters

[[Page 35097]]

thought that the proposal restricted the firms' senior supervisory 
personnel from performing and/or overseeing the review of a firm's 
supervisory control procedures, which could compromise the quality of 
the review. These commenters stated that the alternative approach of 
assigning someone from another division of the firm, such as Marketing 
or Operations, to perform the review could result in a supervisory 
review that is less sensitive to compliance requirements.\29\ At least 
one commenter stated that the ``independence'' requirement in NASD Rule 
3012 appears to refer to someone outside of the firm.\30\
---------------------------------------------------------------------------

    \28\ See 1st Global Letter; AIG Letter; Cambridge Letter; Schwab 
Letter; CBFS Letter; Commonwealth Letter; CUNA Letter; FFP Letter; 
First Allied Letter; INVEST Letter; Investment Centers Letter; Lesko 
Letter; Midland Letter; MML Letter; MSC Letter; MWAFS Letter; 
Princor Letter; Rhodes Securities Letter; Securities America Letter; 
SIA Letter; United Planners' Letter; USAllianz Letter; Waterstone 
Letter; and WORL Letter; see also Sonnenschein Letter.
    \29\ See 21st Century Letter; AIG Letter; Brookstreet Letter; 
Cambridge Letter; CUNA Letter; Duerr Letter; Eagle One Letter; 
Financial Network Letter; ING Letter; First Allied Letter; First 
Heartland Letter; FMN Letter; IFG Letter; INVEST Letter; Investment 
Centers Letter; Iron Street Letter; JKR Letter; John Hancock Letter; 
Kyson Letter; Lesko Letter; Liberty Life Letter; Locust Letter; Main 
Street Letter; Monitor Letter; Multi-Financial Letter; Mutual 
Securities Letter; MSC Letter; MWAFS Letter; National Planning 
Letter; Pacific West Letter; PrimeVest Letter; Princor Letter; Quest 
Letter; Rhodes Securities Letter; Securities America Letter; Leaders 
Group Letter; TransAmerica Letter; United Planners' Letter; 
USAllianz Letter; Vestax Letter; Washington Square Letter; 
Waterstone Letter; Wharton Letter; World Group Letter; and WORL 
Letter.
    \30\ See Woodbury Letter.
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    In response to these concerns, in Amendments No.1 and 2, NASD 
amended proposed NASD Rule 3012 to eliminate the requirement that 
persons establishing, maintaining, and enforcing supervisory control 
policies and procedures be ``independent.'' Instead, NASD amended NASD 
Rule 3012 to require firms to designate a person who is senior to the 
producing manager (at any level) to perform the supervisory reviews 
that will test and verify that members' supervisory procedures are 
sufficient. In Amendments No. 1 and 2, NASD stated that this individual 
must not report to the producing manager, his compensation must not be 
determined by the producing manager, and he may not be in the same 
chain of authority as the producing manager.
    Several commenters mentioned that the requirements originally 
proposed in NASD Rule 3012 to test and verify a member's supervisory 
procedures and make any changes identified through the testing and 
verification procedures appear to be substantially similar to NASD Rule 
3010(a)(8), which requires a member to review the supervisory system 
and make any appropriate changes. Commenters stated that it would be 
redundant to require a member to conduct two separate, yet very 
similar, reviews of the member's supervisory procedures to determine if 
changes need to be made.\31\ NASD agreed and in Amendment No. 1 
modified the proposed rule change to combine the two supervisory review 
requirements into proposed NASD Rule 3012 and eliminate NASD Rule 
3010(a)(8) altogether.
---------------------------------------------------------------------------

    \31\ See CBFS Letter; Financial Network Letter; ING Letter; IFG 
Letter; Locust Letter; MML Letter; Multi-Financial Letter; PrimeVest 
Letter; Vestax Letter; and Washington Square Letter; see also 
Sonnenschein Letter.
---------------------------------------------------------------------------

    Two commenters stated that the requirement that specific 
supervisory controls be in place to address the transmittal of funds 
between accounts, changes of customers' addresses, and changes in 
customers' investment objectives should apply only to retail customer 
activity and not to institutional customer activity.\32\ One commenter 
went on to explain that an institutional exemption was appropriate 
because much of that business is done on a delivery-versus-payment or 
receipt-versus-payment basis or via prime brokerage arrangements that 
involve systems and controls that are different from retail account 
servicing.\33\ NASD responded that it is reasonable and appropriate for 
regulatory oversight in the sensitive areas designated in proposed NASD 
Rule 3012 extend to institutional account activity.
---------------------------------------------------------------------------

    \32\ See 1st Global Letter and SIA Letter.
    \33\ See SIA Letter.
---------------------------------------------------------------------------

2. NASD Amendments in Response to Commenters
    As described above, in Amendments No. 1 and 2, NASD amended 
proposed NASD Rule 3012, in response to commenters' concerns regarding 
the ``complete independence'' standard, to require that a member 
designate and specifically identify to NASD one or more principals who 
will establish, maintain, and enforce supervisory control procedures 
that will test and verify the sufficiency of the member's supervisory 
procedures and that create additional or amend supervisory procedures 
where the need is identified by such testing and verification. NASD 
stated that it expects that the designated principals will test and 
verify the adequacy of the supervisory control procedures in a manner 
that is independent of a member's countervailing business 
considerations.
    Proposed NASD Rule 3012, as modified by Amendments No. 1 and 2, 
provides that these policies and procedures must include procedures 
that are reasonably designed to review and supervise the customer 
account activity conducted by the member's branch office managers, 
sales managers, regional or district sales managers, or any person 
performing a similar supervisory function. Proposed NASD Rule 3012 
further provides that a person who is senior to the producing manager 
must perform these supervisory reviews. A person who does not report to 
the producing manager, whose compensation is not determined in whole or 
part by the producing manager, and is not be in the same chain of 
authority may be senior for the purposes of such supervision if that 
person has the authority to oversee, direct and correct the activities 
of the producing manager and take all necessary remedial actions, 
including termination, if and when necessary.
    NASD proposed an exception to this requirement. In Amendment No. 1, 
NASD proposed that if a member (1) does not conduct a public business; 
or (2) has a capital requirement of $5,000 or less; or (3) employs ten 
or fewer representatives and its business is conducted in a manner 
necessitated by a limitation of resources that includes fewer than two 
layers of supervisory personnel, then a person in another office who is 
in the same or similar position to the producing manager may conduct 
the supervisory review. This exception may only be used if the person 
in the same or similar position to the producing manager does not have 
supervisory responsibility over the activity being reviewed; reports to 
his supervisor his supervision and review of the producing manager; and 
has not performed a review of the producing manager in the last two 
years.
    Proposed NASD Rule 3012 also requires that members adopt procedures 
that are reasonably designed to review and monitor activities such as 
transmittal of funds or securities from customers to outside entities 
or locations other than a customer's primary residence, customer 
changes of address and the validation of such changes, and customer 
changes of investment objectives and the validation of such changes. 
The proposed Rule further requires that these policies and procedures 
include a means or method of customer confirmation, notification, or 
follow-up that can be documented.
    In Amendments No. 1 and 2, NASD proposed that the supervisory 
policies and procedures required under proposed NASD Rule 3012 also 
include procedures reasonably designed to provide heightened 
supervision of the activities of each producing manager who is 
responsible for generating 20% or more of the revenue of the business 
units supervised by the branch office manager's supervisor. NASD 
explained that the term ``heightened supervision'' means those 
supervisory procedures

[[Page 35098]]

that evidence supervisory activities that are designed to avoid 
conflicts of interest that serve to undermine complete and effective 
inspection because of economic, commercial, or financial interests that 
the branch office manager's supervisor holds in the associated persons 
and businesses being supervised.
    In establishing such heightened supervisory procedures, NASD stated 
that members should consider such elements as unannounced supervisory 
reviews, an increased number of supervisory reviews by different 
reviewers within a certain period, a broader scope of activities 
reviewed, and/or having one or more principals approve the supervisory 
review of such producing managers. These examples are meant to 
illustrate the type of procedures a member may want to include in its 
heightened supervisory procedures. NASD believes that proposed NASD 
Rule 3012, as amended, should allow members sufficient flexibility to 
create the supervisory control procedures mandated by the rule without 
creating undue burdens and costs.
    Finally, proposed NASD Rule 3012 provides that a member that is in 
compliance with substantially similar requirements of the New York 
Stock Exchange shall be deemed to be in compliance with the supervisory 
control requirements set forth in NASD Rule 3012.

E. Books and Records (NASD Rule 3110)

1. Original Proposal and Comments Received
    As originally proposed, the amendments to NASD Rule 3110 required 
that, before a customer order is executed, the account name or 
designation be placed upon the memorandum for each transaction. In 
addition, the proposed rule provided that only a designated person may 
approve any changes in account names or designations. The designated 
person also must document the essential facts relied upon in approving 
the changes and maintain the record in a central location. The 
designated person must pass a qualifying principal examination 
appropriate to the business of the firm before he or she can approve 
these changes.
    One commenter to the original proposal stated that its clerical 
staff is responsible for making changes to account names or 
designations and that requiring a principal to authorize the changes 
and be informed of the surrounding facts would place undue burden and 
cost upon the firm.\34\
---------------------------------------------------------------------------

    \34\ See Midland Letter.
---------------------------------------------------------------------------

    In response, NASD acknowledged that the proposed amendments may 
place additional costs and burdens upon members; however, NASD stated 
that it believes that account names and designations are material 
information that must be protected from possible fraudulent activity 
and that requiring a principal to authorize the change and be aware of 
the surrounding facts for the change is a relatively low-cost method of 
protecting this information.
    The same commenter stated that the requirement that a name or 
account designation be placed on ``each transaction'' is impractical 
for the administration of a variable life or variable annuity policy 
because dozens of transactions involving expense and insurance charges 
automatically occur each month for the multitude of funds associated 
with each policy.\35\
---------------------------------------------------------------------------

    \35\ Id.
---------------------------------------------------------------------------

    In response, NASD noted that it proposed this rule change to 
promote consistency with the SEC's books and records rules. 
Specifically, SEC Rule 17a-3(a)(6) requires that a memorandum of each 
brokerage order identify, among other things, the account for which the 
order was entered.\36\ In Amendment No. 1, NASD stated that it expects 
that members, regardless of the type of securities business they engage 
in, will comply with this requirement in the same manner that they 
comply with the SEC's books and records requirements.
---------------------------------------------------------------------------

    \36\ 17 CFR 240.17a-3(a)(6).
---------------------------------------------------------------------------

    At least one commenter requested clarification regarding whether a 
firm may avoid duplicate records by maintaining the ``Account 
Designation Change'' documentation ``in the location whether the 
determination and approval occurs,'' rather than in the central 
location of the ``Home Office.'' \37\
---------------------------------------------------------------------------

    \37\ See A.G. Edwards Letter.
---------------------------------------------------------------------------

    In response to this comment, in Amendment No. 1, NASD amended the 
proposed rule change to require members to preserve these records in a 
manner substantially similar to the record retention requirements of 
SEC Rule 17a-4.\38\
---------------------------------------------------------------------------

    \38\ 17 CFR 240.17a-4.
---------------------------------------------------------------------------

2. NASD Amendment in Response to Comments
    Thus, NASD proposed to amend NASD Rule 3110 to require that, before 
a customer order is executed, the account name or designation must be 
placed upon the memorandum for each transaction. In addition, only a 
designated person may approve any changes in account names or 
designations. The designated person must pass a qualifying principal 
examination appropriate to the business of the firm before he or she 
can approve these changes. The designated person also must document the 
essential facts relied upon in approving the changes and maintain the 
record in a central location. Members must preserve account designation 
change documentation for a period of not less than three years, with 
the documentation preserved for the first two years in an easily 
accessible place, as the term ``easily accessible place'' is used in 
Rule 17a-4 under the Act

F. Customer Account Information (NASD Rule IM-3110)

1. Original Proposal and Comments Received
    Proposed changes to NASD IM-3110 would permit a member, upon a 
customer's written instructions, to hold mail for a customer who will 
not be at his or her usual address for the period of his or her 
absence, but not to exceed (A) two months if the member is advised that 
the customer will be on vacation or traveling or (B) three months if 
the customer is going abroad.
    At least one commenter stated that a member would have to impose 
additional recordkeeping and administrative controls to avoid lost or 
misplaced mail in situations where a customer that travels frequently 
looks to a member to provide custody of his or her mail.\39\ Another 
commenter expressed concerns about the rule's application to foreign 
customers.\40\
---------------------------------------------------------------------------

    \39\ See John Hancock Letter.
    \40\ See NSCP Letter.
---------------------------------------------------------------------------

2. NASD Amendment in Response to Comments
    In response to these comments, in Amendment No. 2, NASD 
acknowledged that members that agree to hold mail for customers may 
have to implement additional procedures to comply with the limitations 
set forth in this rule. However, NASD stated that the rule will help to 
ensure that members that do hold mail for customers who are away from 
their usual addresses, do so only pursuant to the customers' written 
instructions and for a specified, relatively short period of time, thus 
reducing the likelihood that customers would not receive account 
statements or other account documentation at their usual addresses.

[[Page 35099]]

G. Comments on the Effective Date of the Rule Change

    Several commenters stated the proposed rule change may tax member 
resources that were already under pressure due to requirements imposed 
by other new rules, such as the U.S.A. Patriot Act and the Commission's 
books and records rules.\41\ At least one commenter requested that the 
effective date of any new requirements be delayed for six to nine 
months after the approval date. \42\ In response, NASD is proposing to 
establish an effective date of six months from SEC approval of the 
proposed rule change to allow members sufficient time to address any 
necessary procedural or system changes.
---------------------------------------------------------------------------

    \41\ See Quest Letter; Mutual Securities Letter; Kyson Letter; 
Monitor Letter; Duerr Letter; Brookstreet Letter; United Planners 
Letter; PrimeVest Letter; Vestax Letter; Leaders Group Letter; 
Locust Letter; Commonwealth Letter; Washington Square Letter; Multi-
Financial Letter; Securities America Letter; IFG Letter; 
TransAmerica Letter; Financial Network Letter; First Heartland 
Letter; FMN Letter; 21st Century Letter; JKR Letter; Iron Street 
Letter; SIA Letter; INVEST Letter; Eagle One Letter; 1st Global 
Letter; Waterstone Letter; Main Street Letter; World Group Letter; 
RDS Letter; MSC Letter; WORL Letter; A.G. Edwards Letter; Princor 
Letter; Pacific West Letter; Wharton Letter; Liberty Mutual Letter; 
AEFA Letter; FFP Letter; Lesko Letter; CUNA Letter; Rhodes 
Securities Letter; AIG Letter; and First Allied Letter.
    \42\ See Pacific Select Letter.
---------------------------------------------------------------------------

III. Summary of Comments on Proposal as Amended by Amendments No. 1 and 
2 and Description of Amendment No. 3

    After the publishing for comment the original proposal in the 
Federal Register on November 27, 2002, the Commission again noticed for 
comment the proposal, as amended by Amendments No. 1 and 2, in the 
Federal Register on August 13, 2003.\43\ In response to the proposed 
rule, as amended, the Commission received 14 comment letters.\44\ These 
letters and the NASD's response in Amendment No. 3 are summarized 
below.
---------------------------------------------------------------------------

    \43\ See Securities Exchange Act Release No. 48298 (August 7, 
2003), 68 FR 48421.
    \44\ See note 6, supra.
---------------------------------------------------------------------------

A. Discretionary Accounts (NASD Rule 2510)

    One commenter stated that NASD Rule 2510(d) should contain a 
requirement that firms notify their clients of the one-day limit on 
time and price discretionary authority. The commenter believed that 
informing customers would better protect them.\45\
---------------------------------------------------------------------------

    \45\ See Pace Letter.
---------------------------------------------------------------------------

    In Amendment No. 3, NASD responded that it believes that the 
commenter may have misperceived the purpose of the amendment to NASD 
Rule 2510(d)(1). NASD explained that the intent of the amendment is to 
provide greater investor protection by clarifying the terms of an order 
given pursuant to price and time discretion pertaining to the time such 
an order remains pending, and NASD believes that the amendment achieves 
its stated purpose.

B. Internal Inspections (NASD Rule 3010)

    One commenter suggested that NASD's codification of a minimum 
three-year inspection period for ``certain non-registered and/or non-
supervisory branch offices'' was inappropriate and could have a 
detrimental effect on the overall supervisory systems for firms with 
remote office locations.\46\ This commenter stated that the 
codification was contrary to previous NASD guidance regarding how often 
offices should be inspected. Another commenter stated that members 
often conduct examinations of non-supervisory branch offices more than 
once every three years to ensure that supervisors maintain regular and 
frequent professional contact but that these examinations did not 
always cover every area required under the amendments to proposed NASD 
Rule 3010.\47\ The commenter requested assurance that these more 
frequent inspections do not violate proposed NASD Rule 3010, even if 
they are not designed to comply strictly with NASD Rule 3010's 
requirements.
---------------------------------------------------------------------------

    \46\ See M&R Letter.
    \47\ See Mass Mutual Letter-2.
---------------------------------------------------------------------------

    In response to these comments, in Amendment No. 3, NASD explained 
that proposed NASD Rule 3010 requires a member to examine non-
supervisory branch offices at least once every three years, and that a 
member may choose to examine these offices on a more frequent schedule. 
NASD went on to state that more frequent inspections are not equivalent 
to complying with the requirements of NASD Rule 3010, however, if all 
of the express constituent areas of supervision are not covered during 
the course of those examinations. NASD explained that members must 
consider whether the nature and complexity of a branch office's 
securities activities, the branch office's volume of business, and the 
number of associated persons assigned to the branch office require 
inspections more frequently than every three years. In this regard, 
NASD explained that members must set forth in their written supervisory 
and inspection procedures the examination cycle and an explanation of 
the factors used in determining the frequency of the cycle.
    To further address the commenters' concerns, NASD also proposed a 
clarification to the rule text which states that if a member 
establishes a more frequent inspection cycle than every three years, 
the member must ensure that at least every three years, all the 
inspection requirements provided for in the rule have been met and 
describe in the member's written supervisory and inspection procedures, 
the manner in which this will be accomplished.
    Two commenters suggested that NASD either eliminate, or provide 
greater detail on, the requirement in proposed NASD Rule 3010(c) to 
inspect non-branch locations on a regular periodic schedule.\48\ In 
response NASD noted that the provision requiring members to inspect 
non-branch locations on a regular periodic schedule codifies previous 
and consistent NASD guidance on this issue.\49\ NASD stated that 
members should already be familiar with the requirement to inspect non-
branch locations and should be currently conducting such inspections.
---------------------------------------------------------------------------

    \48\ See Pacific Select Letter-2; and United Planners Letter-2.
    \49\ See NASD Notice to Members 98-38 (May 1998); NASD Notice to 
Members 99-45 (June 1999).
---------------------------------------------------------------------------

    One commenter suggested that the NASD should require chief 
executive officers and chief compliance officers to certify that firms 
have adequate compliance and supervisory policies and procedures.\50\ 
In response to this comment, NASD stated it believes that the proposed 
amendments put in place appropriate measures to ensure a member's 
responsibilities for its supervisory control policies and procedures. 
NASD noted that proposed NASD Rule 3012 already requires each member to 
designate and identify one or more principals who will establish, 
maintain, and enforce a system of supervisory control policies that 
test and verify that the supervisory procedures are reasonably designed 
to achieve compliance with applicable securities laws and regulations 
and with applicable NASD rules. Further, NASD explained that it 
recently filed with the Commission a proposed rule change to require 
each member to designate a chief compliance officer and require the 
member's chief compliance officer and chief executive officer to 
certify annually that the member has in place process to establish, 
maintain, review, modify and test policies and procedures reasonably 
designed to achieve compliance with applicable NASD rules, Municipal 
Securities Rulemaking

[[Page 35100]]

Board rules, and the federal securities laws.\51\
---------------------------------------------------------------------------

    \50\ See Mass Mutual Letter-2.
    \51\ See Securities Exchange Act Release No. 48981 (December 23, 
2003), 68 FR 75704 (December 31, 2003) (NASD-2003-176).
---------------------------------------------------------------------------

    One commenter stated that NASD should assure the integrity of 
office inspections by restricting persons responsible for office 
inspections from reporting directly or indirectly to the branch 
office's sales manager, and that NASD should also require members to 
send inspection reports directly to the compliance department.\52\ In 
response to these comments, NASD noted that as proposed, the amendments 
to NASD Rule 3010 restrict the branch office manager or any person 
within that office who has supervisory responsibilities or any 
individual who is supervised by such persons from conducting 
inspections. NASD stated that it does not believe that additional 
restrictions on the persons appropriate to conduct office inspections 
would necessarily increase the integrity of office inspections.
---------------------------------------------------------------------------

    \52\ See NASAA Letter.
---------------------------------------------------------------------------

    One commenter asked whether the written reports of office 
inspections required by proposed NASD Rule 3010(c)(2) to be kept on 
file are subject to direct review by NASD examiners during the course 
of an examination or whether they can be made available upon 
request.\53\ In response, the NASD explained that it expects a member 
to produce the office inspection reports during an examination by any 
self-regulatory organization if the information contained in the 
reports is relevant to the subject matter of the examination and if it 
is requested for production by a self-regulatory organization.
---------------------------------------------------------------------------

    \53\ See ASC Letter-2.
---------------------------------------------------------------------------

    Finally, several commenters requested more clarification regarding 
who can conduct an office inspection.\54\ Specifically, the commenters 
asked who could conduct an office inspection if a firm has small or 
single-person satellite offices that report to an OSJ, rather than to a 
separate branch office. The commenters asked whether the OSJ manager, 
who may also be considered the branch office manager of the small 
offices under some business models, could conduct the office 
inspection.
---------------------------------------------------------------------------

    \54\ See Mass Mutual Letter-2; and Sonnenschein, Letter-2.
---------------------------------------------------------------------------

    In response to these comments, in Amendment No. 3, NASD 
acknowledged that members have different business models and that some 
members may be so limited in both size and resources that their 
business models do not make it possible to comply fully with the 
restrictions regarding who can conduct an office inspection. Therefore, 
in Amendment No. 3 NASD proposed an exception to proposed NASD Rule 
3010 that provides that if a member is so limited in size and resources 
that it cannot comply with the prohibition against office inspections 
being conducted by the branch office manager or any person within that 
office who has supervisory responsibilities or by any person who is 
supervised by such person, then the member may have a principal who has 
the requisite knowledge to conduct an office inspection perform the 
inspections. NASD stated that examples of such situations would include 
a member that has only one office or has a business model where small 
or single-person offices report directly to an OSJ manager who is also 
considered the offices' branch office manager. NASD proposed to require 
that a member must document in its office inspection reports the 
factors relied upon in determining that it is so limited in size and 
resources that it has no other alternative than to comply in the manner 
described above.\55\
---------------------------------------------------------------------------

    \55\ NASD notes, however, that the ``heightened inspection'' 
procedures in proposed NASD Rule 3010(c)(3) would be applicable to a 
member availing itself of the ``limited size and resources'' 
exception to the prohibition against office inspections being 
conducted by the branch office manager or any person within that 
office who has supervisory responsibilities or by any person who is 
supervised by such person. Telephone conversation between Patricia 
Albrecht, Assistant General Counsel, NASD and Florence Harmon, 
Senior Special Counsel Division, Commission on April 15, 2004.
---------------------------------------------------------------------------

    Finally, one commenter raised a concern with respect to the 
requirement in proposed NASD Rule 3010 that a member's written 
inspection report include, without limitation, the testing and 
verification of the member's policies and procedures, including 
supervisory policies and procedures in the areas of safeguarding of 
customer funds and securities; maintaining books and records; 
supervision of customer accounts serviced by branch office managers; 
transmittal of funds between customers and registered representatives 
and between customers and third parties; validation of customer address 
changes; and validation of changes in customer account information.\56\ 
Specifically, this commenter asked whether broker-dealers that did not 
engage in any or all of these activities would nonetheless be required 
to test and verify procedures governing such activities.
---------------------------------------------------------------------------

    \56\ See ACLI Letters.
---------------------------------------------------------------------------

    In response to this comment, in Amendment No. 3, NASD proposed an 
amendment to NASD Rule 3010 that provides that if a member does not 
engage in all the activities identified in the proposed rule, the 
member must identify those activities in which it does not engage in 
its written inspection report and document in the report that 
supervisory policies and procedures for such activities must be in 
place before the member can engage in them.

C. Supervisory Controls (NASD Rule 3012)

    One commenter stated that NASD should not limit the scope of 
persons qualified to conduct a producing manager's review under NASD 
Rule 3012 only to those individuals who are ``senior'' to the producing 
manager.\57\ The commenter argued that other persons within a branch 
office or within a firm who are not senior to the producing branch 
office manager should be allowed to review the producing manager, as 
long as that person is of an equal level of ``seniority'' and has the 
requisite knowledge to conduct a meaningful review.
---------------------------------------------------------------------------

    \57\ See SIA Letter-2.
---------------------------------------------------------------------------

    In Amendment No. 3, NASD responded that it understands the concern 
that members may have to make changes to their supervisory review 
procedures to comply with this seniority requirement. NASD believes, 
however, that requiring the producing manager's reviewer to be senior 
to the producing manager is essential to protecting investors and 
helping to ensure that events, such as those that led to the 
Gruttadauria case, do not occur again. NASD noted that the 
determination of seniority is a facts and circumstances test, and that 
for the purposes of supervision, a person who does not report to the 
producing manager, whose compensation is not determined in whole or 
part by the producing manager and who is not in the same line of 
authority, may be senior for the purposes of supervision if that person 
has the authority to oversee, direct, and correct the activities of the 
producing manager and take all necessary remedial actions, including 
termination, if and when necessary.
    NASD also pointed out that the rule as currently proposed provides 
for an exception to the ``seniority'' requirement. Specifically, the 
proposed rule states that for members who (1) do not conduct a public 
business; or (2) have a capital requirement of $5,000 or less; or (3) 
employ 10 or fewer employees and in the case of (1) through (3), have 
fewer than two layers of supervisory personnel, a person in another 
office who is in the same or similar position to the producing

[[Page 35101]]

manager may conduct the supervisory reviews, provided that the person 
does not have supervisory authority over the activity being reviewed, 
reports to his supervisor his supervision and review, and has not 
performed a review of the producing manager in the last two years.
    Nevertheless, NASD stated in response to commenters that it 
understands that some members may be so limited in both size and 
resources that their business models do not make it possible to meet 
all of the exception's above-mentioned prerequisites. Therefore, in 
Amendment No. 3, the NASD proposed an additional exception from the 
``seniority'' requirement.
    The exception would provide that if a member is so limited in size 
and resources that it cannot avail itself of the above-described 
exception (i.e., the member has only one office or has two offices, but 
an insufficient number of qualified personnel who can conduct reviews 
on a two-year rotation), the member may have a principal who is 
sufficiently knowledgeable of the member's supervisory control 
procedures conduct the reviews. NASD further proposed to require that 
the member document in its supervisory control procedures the factors 
it relied upon in determining that its size and the resources available 
to it are so limited that the member has no other alternative than to 
comply in this manner.\58\
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    \58\ NASD notes, however, that the ``heightened supervision'' 
procedures in proposed NASD Rule 3012(a)(2)(C) would be applicable 
to a member availing itself of the ``limited size and resources'' 
exception from the requirement that a person senior to the producing 
manager perform supervisory reviews. Telephone conversation between 
Patricia Albrecht, Assistant General Counsel, NASD and Florence 
Harmon, Senior Special Counsel, Division, Commission on April 15, 
2004.
---------------------------------------------------------------------------

    One commenter requested clarification regarding whether a member 
could comply with NASD Rule 3012, with respect to changes of customer 
address and investment objectives and validation of such changes if the 
member follows the procedures set forth in SEC Rule 17a-
3(a)(17)(i).\59\ In response, NASD explained that proposed NASD Rule 
3012(a)(2)(B) requires members to have in place supervisory control 
policies and procedures that include procedures that are reasonably 
designed to review and monitor all transmittals of customer funds and 
securities, and customer address and investment objectives changes, and 
the validation of such changes. NASD stated that proposed NASD Rule 
3012(a)(2)(B) was not designed to address the specific measures a 
member should adopt regarding the supervision of changes in a 
customer's address or investment objectives. Further, NASD noted 
compliance with SEC Rule 17a-3(a)(17)(i)'s recordkeeping provisions may 
not be sufficient under all facts and circumstances to discharge a 
firm's supervisory requirements under proposed NASD Rule 3012(a)(2)(B) 
and that to avoid potential problems, members should ensure that they 
comply with both proposed NASD Rule 3012(a)(2)(B) and Rule 17a-3(17)(i) 
under the Act.
---------------------------------------------------------------------------

    \59\ See Sonnenschein Letter-2.
---------------------------------------------------------------------------

    Another commenter requested that NASD delete proposed NASD Rule 
3012's provision allowing a ``dual'' NASD/NYSE member to satisfy Rule 
3012's requirements if the member satisfies substantially similar 
requirements promulgated by the NYSE.\60\ The commenter argued that 
proposed NASD Rule 3012 is more specific and detailed than comparable 
supervisory control requirements proposed by the NYSE.
---------------------------------------------------------------------------

    \60\ See Securities Exchange Act Release No. 48299 (August 7, 
2003), 68 FR 48431 (August 13, 2003); See Securities Exchange Act 
Release No. 46858 (November 20, 2002), 67 FR 70994 (November 27, 
2002).
---------------------------------------------------------------------------

    NASD responded that it is retaining proposed NASD Rule 3012's 
originally proposed provision that any member in compliance with 
substantially similar requirements of the NYSE shall be deemed to be in 
compliance with NASD Rule 3012. As NASD stated in its response to 
comments to the original rule filing, NASD believes that this provision 
helps promote consistency between NASD's and the NYSE's supervisory 
control requirements.
    Several commenters requested clarification regarding the 20% 
threshold contained in proposed NASD Rules 3010 and 3012.\61\ 
Specifically, commenters identified three concerns regarding the 
threshold: (1) How to structure compensation; (2) what time period to 
use to calculate the 20% threshold; and (3) whether the 20% threshold 
can be viewed as a ``safe harbor.'' In addition, at least one commenter 
asked for clarification regarding who is considered to be the producing 
manager's supervisor if the producing manager is supervised directly by 
the member's compliance department.\62\
---------------------------------------------------------------------------

    \61\ See ASC Letter-2; Pacific Select Letter-2; SIA Letter-2; 
Sonnenschein Letter-2; and United Planners Letter-2.
    \62\ See Sonnenschein Letter-2.
---------------------------------------------------------------------------

    In Amendment No. 3, NASD amended NASD Rules 3010 and 3012 to 
address the commenters' concerns regarding compensation structure and 
time periods for calculation. NASD proposed to replace the 20% 
threshold of income of the producing manager's supervisor with a 
threshold of 20% of the revenue of the business units supervised by the 
producing manager's supervisor. For purposes of determining the 20% 
revenue threshold, under the proposed rule, all revenue generated by or 
credited to the branch office or the branch office manager would be 
attributed as revenue generated by the business unit or units 
supervised by the branch office manager's supervisor irrespective of 
the internal allocation of such revenue by the member. NASD also 
clarified that a member must calculate the 20% threshold on a rolling, 
twelve-month basis.
    NASD explained that if a producing manager does not have an 
individual assigned to supervise him, but rather, is supervised 
directly by the member's compliance department, then the revenue 
produced would be attributable to a business unit supervised by the 
compliance department, and if such revenue constituted 20% or more of 
all the supervised revenue attributable to the compliance department, 
then the member must have in place heightened inspection and 
supervisory procedures. Finally, NASD explained that it does not view 
the 20% threshold as a ``safe harbor,'' but rather, as a trigger for 
determining when a member clearly must put in place heightened 
inspection and/or supervisory procedures.
    Finally, one commenter raised a concern with respect to the 
requirement in proposed NASD Rule 3012 that members establish, 
maintain, and enforce written supervisory control policies and 
procedures, including procedures that are reasonably designed to review 
and monitor the transmittals of funds from customer accounts to 
locations other than a customer's primary residence and between 
customers and registered representatives; customer changes of address 
and validation of such changes of address; and customer changes of 
investment objectives and the validation of such changes of investment 
objectives.\63\ Specifically, this commenter asked whether broker-
dealers that did not engage in all of these activities would 
nonetheless be required to institute policies governing such 
activities.
---------------------------------------------------------------------------

    \63\ See ACLI Letters.
---------------------------------------------------------------------------

    In response to this comment, in Amendment No. 3, NASD proposed an 
amendment to NASD Rule 3012 that provides that if a member does not 
engage in all the activities identified in the proposed rule, the 
member must identify those activities in which it does

[[Page 35102]]

not engage in its written supervisory control policies and procedures 
and document in those policies and procedures that additional 
supervisory policies and procedures for such activities must be in 
place before the member can engage in them.

D. Holding of Customer Mail (NASD IM-3110)

    One commenter stated that NASD should provide a limited exception 
that would allow a firm, when necessary, to receive and hold a 
customer's mail for a longer time than the two-month and three-month 
limits proposed in IM-3110(i).\64\
---------------------------------------------------------------------------

    \64\ See ASC Letter-2.
---------------------------------------------------------------------------

    NASD responded that it continues to believe that the time periods 
mentioned in the rules are appropriate. As NASD stated in the response 
to comments to the original rule filing, it believes that the 
amendments to NASD IM-3110(i) will help to ensure that members that do 
hold mail for customers who are away from their usual addresses, do so 
only pursuant to the customers' written instructions and for a 
specified, relatively short, period of time.

IV. Discussion

    After careful review, the Commission finds that the proposed rule 
change, as amended is consistent with the requirements of the Act and 
the rules and regulations thereunder applicable to a national 
securities association.\65\ In particular, the Commission finds that 
the proposal, as amended, is consistent with the provisions of Section 
15A(b)(6) of the Act,\66\ which requires, among other things, that a 
national securities association's rules 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 Commission finds that NASD's proposal, as 
amended, is designed to accomplish these ends by requiring members to 
establish more extensive supervisory and supervisory control procedures 
to monitor customer account activities of their employees and thereby 
reduce the potential for customer fraud and theft.
---------------------------------------------------------------------------

    \65\ In approving this proposal, the Commission has considered 
the proposed rule's impact on efficiency, competition, and capital 
formation. 15 U.S.C. 78c(f).
    \66\ 15 U.S.C. 78o-3(b)(6).
---------------------------------------------------------------------------

A. Discretionary Accounts (NASD Rule 2510)

    Currently, 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 and prior written approval by the member, but does not 
specify the duration of such discretionary authority. The Commission 
believes that NASD's proposal to limit the time for such discretion to 
the end of the business day on which it was granted, absent a signed 
authorization from the customer providing otherwise, is appropriate. 
Such a control should limit the opportunity for misapplication of 
discretionary authority, thus furthering investor protection. The 
Commission also believes that this change will clarify for members and 
customers the length of time for which discretionary authority is 
granted in the ordinary course.
    Commenters argued that the limited duration for the exercise of 
time and price discretion should be applied only retail accounts, not 
institutional accounts. NASD chose not to include a general 
institutional exemption, but instead amended NASD Rule 2510 to provide 
a limited exception from the requirement to obtain written 
authorization for good-til-cancel orders for institutional accounts 
where discretion is exercised on a ``not held'' basis. The Commission 
believes that this exception from the general rule will provide members 
handling institutional accounts the flexibility they require while 
still providing adequate protection over client accounts.

B. Supervision and Internal Inspections (NASD Rule 3010)

    The Commission believes that NASD's proposal with respect to 
internal inspections should increase the likelihood that fraudulent 
activity with respect to handling customer accounts will be detected in 
a timely manner. To this end, proposed NASD Rule 3010 requires each 
member to inspect every office of supervisory jurisdiction and any 
branch office that supervises one or more non-branch locations at least 
annually. Branch offices that do not supervise one or more branch 
locations must be inspected at least every three years, and members 
must inspect non-branch locations on a regular, periodic schedule 
depending on the nature and complexity of the securities activities for 
which the location is responsible and the nature and extent of customer 
contact.
    As part of the inspection, members must test and verify the 
policies and procedures in several key areas, including the supervision 
policies and procedures governing: Safeguarding customer funds and 
securities; maintaining books and records; supervision of accounts 
serviced by branch office managers; transmittal of funds between 
customers and registered representatives or other third parties; 
validation of customer change of address; and validation of customer 
account information. The findings of the inspection must be reduced to 
a written report and kept on file for a minimum of three years, unless 
the next inspection is not due for more than three years, in which case 
the report must be kept on file until the next inspection report has 
been written.
    The Commission believes that the areas identified in particular by 
NASD as subject to testing and verification effectively reduce the 
possibility of fraudulent activity in important aspects of customer 
account handling, but are not so broad that members will be overly 
burdened by inspections. Further, the Commission believes that it is 
appropriate for member firms to retain a written record of the findings 
of the inspection to help ensure that necessary modifications to 
policies and procedures are made promptly and in accordance with the 
findings of the inspection.
    Proposed NASD Rule 3010 also dictates who is ineligible to conduct 
an inspection. Specifically, the proposed rule provides that office 
inspections may not be conducted by the branch office manager or any 
person within that office who has supervisory responsibilities or by 
any individual who is supervised by such a person. After careful 
consideration of the comments, the Commission believes that these are 
appropriate limitations on who may conduct office inspections. The 
Commission believes that these limitations should reduce conflicts of 
interest and lead to more objective and vigorous inspections because 
persons who have a significant financial interest in the success of a 
branch office would be precluded from inspecting it.
    In Rule 3010, NASD proposed an exception from the above requirement 
for firms that are so limited in size and resources that they cannot 
comply with this limitation. The Commission finds reasonable the NASD's 
examples of such situations as a member that has only one office or has 
a business model where small or single-person offices report directly 
to an OSJ manager who is considered the offices' branch manager. In 
such cases, a member may have a principal who has the requisite 
knowledge to conduct an office inspection perform the inspection. NASD, 
however, proposes to require that any member utilizing this exception 
document in its office inspection report the factors it has relied upon 
in

[[Page 35103]]

determining that it is so limited in size and resources that it has no 
alternative other than to comply in this manner.
    The Commission believes that this exception is warranted for those 
firms that can demonstrate and document that, as a result of their size 
and structure, they cannot comply with the proposed rule's limitation 
on who may conduct office inspections. The Commission, however, expects 
NASD to closely monitor the use of this exception to be certain that 
only members for whom the exception is intended take advantage of it 
and that this exception is not abused.
    In NASD Rule 3010, NASD also included a provision requiring 
heightened office inspection procedures if the person conducting the 
inspection either works in an office supervised by the branch office 
manager's supervisor or reports to the branch office manager's 
supervisor and the branch office manager generates 20 percent or more 
of the revenue of the business units supervised by the branch office 
manager's supervisor. The Commission expects that this provision will 
reduce potential conflicts of interest in situations when the 
individual conducting the inspection, though not reporting to the 
branch office manager or any individual with supervisory 
responsibilities in the office being inspected, works in an office that 
receives substantial revenues from the branch office being inspected. 
The Commission notes that these ``heightened inspection'' procedures 
also apply to a member availing itself of the above ``limited size and 
resources'' exception in proposed NASD Rule 3010(c)(3). The Commission 
believes that such heightened inspection procedures should help address 
conflicts of interest with sufficient flexibility so as not to create 
undue burdens and costs on members. However, the Commission expects 
NASD to carefully monitor member compliance with such procedures to 
ensure that members are, in fact, adequately addressing such conflicts.

C. Supervisory Controls (NASD Rule 3012)

    The Commission notes that NASD proposed new procedures for ensuring 
that adequate supervisory control policies are in place. NASD has 
proposed to require that each member designate one or more principals 
who would be responsible for establishing, maintaining, and enforcing a 
system of supervisory controls that, in general, test and verify that 
the member's supervisory procedures are reasonably designed to achieve 
compliance with applicable securities laws and regulations and NASD 
rules. The designated principal or principals must submit to the 
member's senior management no less than annually, a report detailing 
each member's system of supervisory controls, the summary of the test 
results and significant identified exceptions, and any additional or 
amended supervisory procedures created in response to the test results.
    More specifically, the designated principal must establish, 
maintain, and enforce procedures that are reasonably designed to review 
and supervise the customer account activity conducted by branch office 
managers, sales managers, regional or district sales managers, or any 
person performing a similar supervisory function. NASD proposed that a 
person who is senior to the producing manager must conduct such 
supervision, unless the member meets certain criteria \67\ and its 
business is conducted in a manner necessitated by a limitation of 
resources that includes fewer than two layers of supervisory personnel. 
In such a case, a person in another office in a position similar to the 
producing manager may conduct supervisory reviews provided that such 
person does not have supervisory responsibility over the activity being 
reviewed, reports to his supervisor his supervision and review of the 
producing manager, and has not performed a review of the producing 
manager in the last two years. The Commission believes that these 
limitations should help assure that supervision of customer account 
activity is objective and not subject to conflicts of interest, while 
at the same time accommodating legitimate limitations of small firms.
---------------------------------------------------------------------------

    \67\ The proposed rule text provides that these criteria are 
that the member does not conduct a public business, has a capital 
requirement of $5,000 or less, or employs 10 or fewer 
representatives.
---------------------------------------------------------------------------

    NASD proposed an additional exception from the requirement that a 
person who is senior to the producing manager must conduct the 
supervisory reviews for a member whose size and resources are so 
limited that it cannot avail itself of the exception. In such 
situations, a member may have a principal who is sufficiently 
knowledgeable of the member's supervisory control procedures conduct 
the reviews required by NASD Rule 3012.\68\ The Commission finds 
reasonable the NASD's examples of such situations as a member with only 
one office or a member with two offices and an insufficient number of 
qualified personnel who can conduct reviews on a two-year rotation. 
However, any such member must document in its supervisory control 
procedures the factors it relied upon in determining that its size and 
the resources available to it are so limited that it has no alternative 
than to comply in this manner. The Commission expects NASD to carefully 
monitor use of this exception to be certain that only members for whom 
the exception is intended take advantage of it and that this exception 
is not abused.
---------------------------------------------------------------------------

    \68\ See Staff Legal Bulletin No. 17: Remote Office Supervision, 
Division, Commission, fn 39 (March 19, 2004).
---------------------------------------------------------------------------

    In addition, as with NASD Rule 3010, NASD has included in proposed 
Rule 3012 a provision requiring heightened supervision over activities 
of each producing manager who is responsible for generating 20% or more 
of the revenue of the business units supervised by the producing 
manager's supervisor. The Commission expects this provision will reduce 
potential conflicts of interest in situations where the producing 
branch manager is responsible for generating substantial revenues for 
the benefit of his supervisor. The Commission believes that such 
heightened supervisory procedures should help address the potential 
conflicts of interest with sufficient flexibility so as not to create 
undue burdens and costs on members. However, the Commission expects 
NASD to carefully monitor member compliance with such procedures to 
ensure that members are, in fact, adequately addressing such conflicts.
    In sum, the Commission believes that specifically requiring review 
and supervision of customer account activity conducted by branch office 
managers, sales managers, regional/district managers or any other 
supervisory personnel by a person senior to the producing manager, 
except in limited circumstances, is appropriate so that supervisors do 
not perform the final review of their own sales activity, nor are they 
able to put undue or even unintentional pressure on subordinates who 
might otherwise be responsible for conducting a review.
    Further, the Commission believes that the two exceptions delineated 
by NASD for when a member need not require supervision by someone 
senior to the producing manager are appropriate to give relief to 
members whose size and/or structure would make application of the 
general rule impractical. The Commission, however, expects the NASD to 
closely monitor the use of these two exceptions to be certain that only 
members for whom they are intended, in fact, use these exceptions, and 
that these exceptions are not abused.

[[Page 35104]]

D. Books and Records (NASD Rule 3110)

    The Commission believes that NASD's proposal to require that a 
qualified, designated person approve and document the basis for any 
change in account name or designation is appropriate. The Commission 
recognizes that changes in account names and designations in connection 
with order executions can be subject to abuse and believes that 
requiring that a designated person authorize changes to account names 
or designations before they may be made, as well as requiring that the 
designated person document the essential facts relied upon, should help 
to protect against such abuse.
    The Commission further believes that NASD's proposed requirement 
that members preserve the documentation of the essential facts relied 
upon in approving changes for a period of not less than three years, 
the first two in an easily accessible place, as that term is used in 
SEC Rule 17a-4, is appropriate. This requirement should enable members 
to use existing recordkeeping systems, as the proposed requirement is 
substantially similar to the record retention requirements of Rule 17a-
4 under the Act.

E. Customer Account Information (IM-3110)

    The Commission believes that NASD's proposal to permit members to 
hold customer mail only upon the written instructions of a customer, 
and only for two months if the member is advised that the customer will 
be on vacation or traveling, and only for three months if the customer 
is going abroad, is appropriate. The Commission believes that limiting 
the period of time during which members may hold mail for customers 
will reduce the risk of customers not receiving account statements or 
other account documentation for their review at their usual addresses. 
The Commission believes that the proposed rule change will assist 
customers in ensuring that the information contained in their account 
statements or other account documentation is accurate and in accordance 
with their stated goals.

F. Effective Date of Proposed Rule Change

    The Commission notes that NASD has proposed an effective date for 
the proposed rule change of six months from the date of Commission 
approval. The Commission recognizes that the proposed rule change may 
require members to make procedural or systems changes, and therefore 
believes that it is appropriate to delay the effective date of this 
proposed rule change for six months. Accordingly, the effective date of 
the proposed rule change shall be December 17, 2004.

IV. Amendment No. 3

    The Commission finds good cause for approving Amendment No. 3 prior 
to the thirtieth day after the date of publication of notice thereof in 
the Federal Register. In Amendment No. 3, NASD made clarifying changes 
to proposed NASD Rules 3010 and 3012 in response to concerns raised by 
commenters.\69\ Further, the Commission believes these change do not 
significantly alter the original proposal, which was subject to a full 
notice and comment period.
---------------------------------------------------------------------------

    \69\ See Sections III.B. and C., supra.
---------------------------------------------------------------------------

    In addition, in Amendment No. 3, NASD responded to concerns raised 
by commenters that because of their limited size and resources, they 
would not be able to comply with the requirements regarding who is 
eligible to conduct inspections and supervisory reviews. In response to 
these concerns, NASD proposed alternative means of compliance for 
members whose size and resources are so limited that they could not 
comply with the requirements of proposed NASD Rules 3010 and 3012 as 
proposed in Amendments No. 1 and 2. The Commission believes that NASD's 
proposed changes in Amendment No. 3 adequately address commenters' 
concerns and provide a reasonable alternative for members that could 
otherwise comply with the proposed rules.
    Therefore, for all the foregoing reasons and the overall importance 
of the proposed rules, the Commission finds good cause for granting 
accelerated approval to Amendment No. 3, and believes that it is 
consistent with Section 19(b)(2) of the Act.\70\
---------------------------------------------------------------------------

    \70\ 15 U.S.C. 78s(b)(2).
---------------------------------------------------------------------------

V. Text of Amendment No. 3

    In Amendment No. 3, NASD proposed further amendments to NASD Rules 
3010 and 3012. The base text is that proposed in Amendment Nos. 1 and 2 
(i.e., how the rule would appear if only Amendment Nos. 1 and 2 were 
approved by the Commission). Changes made by Amendment No. 3 are in 
italics; deletions are in brackets.
* * * * *

3010. Supervision

(a) Supervisory System
    Each member shall establish and maintain a system to supervise the 
activities of each registered representative and associated person that 
is reasonably designed to achieve compliance with applicable securities 
laws and regulations, and with applicable NASD Rules. Final 
responsibility for proper supervision shall rest with the member. A 
member's supervisory system shall provide, at a minimum, for the 
following:
    (1) through (7) No change.
    (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. 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.
    (A) Each member shall inspect at least annually every office of 
supervisory jurisdiction and any branch office that supervises one or 
more non-branch locations.
    (B) Each member shall inspect at least every three years every 
branch office that does not supervise one or more non-branch locations. 
In establishing how often to inspect each non-supervisory branch 
office, the firm shall consider whether 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 require the non-supervisory branch office to be 
inspected more frequently than every three years. If a member 
establishes a more frequent inspection cycle, the member must ensure 
that at least every three years, the inspection requirements enumerated 
in paragraph (c)(2) have been met. The non-supervisory branch office 
examination cycle[ and], an explanation of the factors the member used 
in determining the frequency of the examinations in the cycle, and the 
manner in which a member will comply with paragraph (c)(2) if using 
more frequent inspections than every three years shall be set forth in 
the member's written supervisory and inspection procedures.
    (C) Each member shall inspect on a regular periodic schedule every 
non-branch location. In establishing such schedule, the firm shall 
consider the nature and complexity of the securities activities for 
which the location is responsible and the nature and extent of

[[Page 35105]]

contact with customers. The schedule and an explanation regarding how 
the member determined the frequency of the examination schedule shall 
be set forth in the member's written supervisory and inspection 
procedures.
    Each member shall retain a written record of the dates upon which 
each review and inspection is conducted.
    (2) An office inspection and review by a member pursuant to 
paragraph (c)(1) must be reduced to a written report and kept on file 
by the member for a minimum of three years, unless the inspection is 
being conducted pursuant to paragraph (c)(1)(C) and the regular 
periodic schedule is longer than a three-year cycle, in which case the 
report must be kept on file at least until the next inspection report 
has been written. The written inspection report must also include, 
without limitation, the 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.
    If a member does not engage in all of the activities enumerated 
above, the member must identify those activities in which it does not 
engage in the written inspection report and document in the report that 
supervisory policies and procedures for such activities must be in 
place before the member can engage in them.
    (3) An office inspection by a member pursuant to paragraph (c)(1) 
may not be conducted by the branch office manager or any person within 
that office who has supervisory responsibilities or by any individual 
who is supervised by such person(s). However, if a member is so limited 
in size and resources that it cannot comply with this limitation (e.g., 
a member with only one office or a member with a business model where 
small or single-person offices report directly to an office of 
supervisory jurisdiction manager who is also considered the offices' 
branch office manager), the member may have a principal who has the 
requisite knowledge to conduct an office inspection perform the 
inspections. The member, however, must document in the office 
inspection reports the factors it has relied upon in determining that 
it is so limited in size and resources that it has no other alternative 
than to comply in this manner.
    A member must have in place procedures that are reasonably designed 
to provide heightened office inspections if the person conducting the 
inspection reports to the branch office manager's supervisor or works 
in an office supervised by the branch manager's supervisor and the 
branch office manager generates 20% or more of the revenue [income] of 
the business units supervised by the branch office manager's 
supervisor. For the purposes of this subsection only, the term 
``heightened inspection'' shall mean those inspection procedures that 
are designed to avoid conflicts of interest that serve to undermine 
complete and effective inspection because of the economic, commercial, 
or financial interests that the branch manager's supervisor holds in 
the associated persons and businesses being inspected. In addition, for 
the purpose of this section only, when calculating the 20% threshold, 
all of the revenue generated by or credited to the branch office or 
branch office manager shall be attributed as revenue generated by the 
business units supervised by the branch office manager's supervisor 
irrespective of a member's internal allocation of such revenue. A 
member must calculate the 20% threshold on a rolling, twelve-month 
basis.
* * * * *
(g) Definitions
    (1) No change.
    (2) (A) ``Branch Office'' means any location identified by any 
means to the public or customers as a location at which the member 
conducts an investment banking or securities business, excluding:
    (A) through (D) renumbered as (i) through (iv).
    (B) Notwithstanding the exclusions provided in paragraph (2)(A), 
any location that is responsible for supervising the activities of 
persons associated with the member at one or more non-branch locations 
of the member is considered to be a branch office.
    (3) No change.

3012. Supervisory Control System

(a) General Requirements
    (1) Each member shall designate and specifically identify to NASD 
one or more principals who shall establish, maintain, and enforce 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 designated 
principal or principals must submit to the member's senior management 
no less than annually, a report detailing each member's system of 
supervisory controls, the summary of the test results and significant 
identified exceptions, and any additional or amended supervisory 
procedures created in response to the test results.
    (2) The establishment, maintenance, and enforcement of written 
supervisory control policies and procedures pursuant to paragraph (a) 
shall include:
    (A) Procedures that are reasonably designed to review and supervise 
the customer account activity conducted by the member's branch office 
managers, sales managers, regional or district sales managers, or any 
person performing a similar supervisory function. A person who is 
senior to the producing manager must perform such supervisory reviews. 
However, if a member (i) does not conduct a public business, (ii) or 
has a capital requirement of $5,000 or less, or (iii) employs 10 or 
fewer representatives, and, in the case of (i) through (iii), its 
business is conducted in a manner necessitated by a limitation of 
resources that includes fewer than two layers of supervisory personnel, 
a person in another office of the member who is in the same or similar 
position to the producing manager may conduct the supervisory reviews, 
provided that the person in the same or similar position does not have 
supervisory responsibility over the activity being reviewed, reports to 
his supervisor his supervision and review of the producing manager, and 
has not performed a review of the producing manager in the last two 
years. If a member is so limited in size and resources that it cannot 
avail itself of this exception (e.g., a member with only one office or 
a member with two offices and an insufficient number of qualified 
personnel who can conduct reviews on a two-year rotation), a member may 
have a principal who is sufficiently knowledgeable of the member's 
supervisory control procedures conduct these reviews. The member, 
however, must document in its supervisory control procedures the 
factors it has relied upon in determining that its size and resources 
available to it are so limited that the member has no

[[Page 35106]]

other alternative than to comply in this manner;
    (B) Procedures that are reasonably designed to review and monitor 
the following activities:
    (i) All transmittals of funds (e.g., wires or checks, etc.) or 
securities from customers and third party accounts (i.e., a transmittal 
that would result in a change of beneficial ownership); from customer 
accounts to outside entities (e.g., banks, investment companies, etc.); 
from customer accounts to locations other than a customer's primary 
residence (e.g., post office, ``in care of'' accounts, alternate 
address, etc.); and between customers and registered representatives, 
including the hand-delivery of checks;
    (ii) Customer changes of address and the validation of such changes 
of address; and
    (iii) Customer changes of investment objectives and the validation 
of such changes of investment objectives.
    The policies and procedures established pursuant to paragraph 
(a)(2)(B) must include a means or method of customer confirmation, 
notification, or follow-up that can be documented. If a member does not 
engage in all of the activities enumerated above, the member must 
identify those activities in which it does not engage in its written 
supervisory control policies and procedures and document in those 
policies and procedures that additional supervisory policies and 
procedures for such activities must be in place before the member can 
engage in them; and
    (C) Procedures that are reasonably designed to provide heightened 
supervision over the activities of each producing manager who is 
responsible for generating 20% or more of the [income] revenue of the 
business units supervised by the producing manager's supervisor. For 
the purposes of this subsection only, the term ``heightened 
supervision'' shall mean those supervisory procedures that evidence 
supervisory activities that are designed to avoid conflicts of interest 
that serve to undermine complete and effective supervision because of 
the economic, commercial, or financial interests that the supervisor 
holds in the associated persons and businesses being supervised. In 
addition, for the purpose of this section only, when calculating the 
20% threshold, all of the revenue generated by or credited to the 
branch office or branch office manager shall be attributed as revenue 
generated by the business units supervised by the branch office 
manager's supervisor irrespective of a member's internal allocation of 
such revenue. A member must calculate the 20% threshold on a rolling, 
twelve-month basis.
(b) 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.
* * * * *

VI. Solicitation of Comments

    Interested persons are invited to submit written data, views, and 
arguments concerning the foregoing, including whether Amendment No. 3 
is consistent with the Act. Comments may be submitted by any of the 
following methods:

Electronic Comments

     Use the Commission's Internet comment form (http://www.sec.gov/rules/sro.shtml); or
    Send an e-mail to [email protected]. Please include File Number 
SR-NASD-2002-162 on the subject line.

Paper Comments

     Send paper comments in triplicate to Jonathan G. Katz, 
Secretary, Securities and Exchange Commission, 450 Fifth Street, NW., 
Washington, DC 20549-0609.
    All submissions should refer to File Number SR-NASD-2002-162. This 
file number should be included on the subject line if e-mail is used. 
To help the Commission process and review your comments more 
efficiently, please use only one method. The Commission will post all 
comments on the Commission's Internet Web site (http://www.sec.gov/rules/sro.shtml). 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 Section, 450 Fifth 
Street, NW., Washington, DC 20549. Copies of such filing also will be 
available for inspection and copying at the principal offices of the 
NASD. All comments received will be posted without change; the 
Commission does not edit personal identifying information from 
submissions. You should submit only information that you wish to make 
available publicly. All submissions should refer to File Number SR-
NASD-2002-162 and should be submitted on or before July 14, 2004.

VII. Conclusion

    It is therefore ordered, pursuant to section 19(b)(2) of the 
Act,\71\ that the proposed rule change (SR-NASD-2002-162), as amended, 
be, and it hereby is, approved.
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    \71\ 15 U.S.C. 78s(b)(2).

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\72\
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    \72\ 17 CFR 200.30-3(a)(12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 04-14232 Filed 6-22-04; 8:45 am]
BILLING CODE 8010-01-P