NASD is issuing this Regulatory Alert as part of its continuing effort to remind members that their supervisory systems and written supervisory procedures must be periodically amended so that sales of new and complex products comply with all relevant NASD and SEC Rules. Failure to update supervisory systems and procedures and failure to supervise registered persons may place at risk the protection of investors and integrity of the public markets and can result in serious sanctions for the member and the supervisor, including fines, requalification requirements, and suspensions, bars, or expulsions.
Compliance guidelines generally set forth the applicable rules and policies that must be adhered to and describe specific practices that are prohibited. Supervisory procedures document the supervisory system that has been established to ensure that compliance guidelines are being followed and to prevent and detect prohibited practices. There is no "one-size-fits-all" supervisory system. Each member's supervisory system must be tailored to its particular needs and circumstances and reasonably designed to achieve compliance with applicable securities laws, rules, regulations, and NASD rules. Once a member has designed its supervisory system, it is required to memorialize this system in writing and implement and enforce those written procedures.
NASD has issued a series of Notices to Members (NtMs) that provide guidance on establishing appropriate supervisory systems and procedures. NTM 98-38 reminds members of their obligation to supervise associated persons located in Offices of Supervisory Jurisdiction (OSJs), branch offices, and all other offices, and to inspect these offices. NTM 99-45 provides guidance on establishing supervisory systems and written supervisory procedures. NTM 99-45 also explains the differences between compliance procedures and supervisory procedures. NTM 98-96 elaborates on member firms' responsibilities for supervision for trade reporting and market making activities.
Under Rule 3010(a)(8), at least one principal must be designated to review the firm's supervisory system to determine the effects of changes, such as hiring additional representatives (who may be inexperienced in selling the firm's products) and adding new business lines or new financial products, such as transactions in hedge funds and funds of hedge funds, security futures, and brokered certificates of deposit, so that a firm can adjust its supervisory procedures to ensure compliance with all relevant NASD and SEC rules.1 In addition to reviewing their supervisory systems and procedures to ensure that they are current and adequate, it is also important that members conduct inspections to determine whether the systems and procedures are being followed. Paragraph (c) of Rule 3010, therefore, requires members to annually review the businesses they conduct, and sets forth the standard for this review.
Further, the quality of a firm's internal investigations is a crucial element of an effective supervisory program. NTM 97-19 lays out the elements of a comprehensive supervisory program with special emphasis on the supervisory issues related to registered representatives requiring heightened supervision. Nevertheless, many of the precepts discussed in NTM 97-19 represent best supervisory practices for all member firms.
In particular, member firms should conduct a meaningful internal investigation of irregularities discovered through the supervisory process. If a member receives repeated sales practice complaints against a registered representative, those complaints may indicate a compliance problem. Whenever a member firm determines that a customer complaint is well founded, the firm should conduct a thorough review of selected customer accounts of the registered representative for conduct similar to the conduct described in the complaint. In addition, members should regularly adapt and amend their supervisory procedures in light of customer complaints, arbitrations, lawsuits, and regulatory inquiries and actions.
Member firms should apply those same principles when investigating other irregularities and potential compliance issues within the firm. It is prudent for firms to broaden their review of specific matters to determine whether the irregularities are isolated incidents or part of a pattern of noncompliance.
Following best supervisory practice provides essential safeguards for NASD members and their customers. NASD reminds members to take the time needed to review, update, and strengthen their current supervisory procedures.
Firms should direct their questions regarding the compliance with NASD supervisory requirements to the NASD Department of Member Regulation at (202) 728-8221.