Letter to Firms from Richard Brueckner, Presiding Governor, NASD Board of Governors - 8/9/06

August 10, 2006

During the week of April 10, 2006, NASD received a petition from member firms requesting certain amendments to the NASD By-Laws. Our records show that your firm has signed this petition, and, on behalf of NASD's Board of Governors, I am writing to respond to your concerns.

As you know, the petition made four By-Law amendment requests, asking that NASD:

  • delay the implementation of the recent revisions to the NASD Sanction Guidelines pending a full independent review of the impact that these new guidelines will have on smaller NASD broker-dealers;
  • delay the OATS Phase III effective date pending a study to determine the impact on the smaller NASD broker-dealers;
  • halt all TRACE investigations and enforcement actions until the time that the TRACE Reporting System "can be error free and/or a study can be done to determine the impact of TRACE reporting rules" on smaller NASD broker-dealers; and
  • investigate member allegations that NASD staff engaged in abusive conduct in the course of NASD's examination program.

The NASD Board of Governors reviewed the petition at our April meeting and recommended that further review and analysis be conducted by NASD's management team and the NASD Office of the Ombudsman. We also asked that NASD's Governance Committee review those analyses and make a recommendation.

While the Board concluded at its July meeting that none of the four requests were appropriate subjects of By-Law amendments, the Board also undertook to examine each of your concerns. Each request made in the petition has been reviewed extensively and, as a result, the Board, in accord with the Governance Committee's recommendations, has made certain determinations, which are summarized below.

  • Sanction Guidelines
    The petitions asked that NASD delay the implementation of the revised Sanction Guidelines, published in March 2006, pending a full, independent review of how these guidelines might impact smaller broker-dealers. Given the extensive review to which the revisions were subject, the NASD Board determined that staying the effectiveness of the Guidelines revisions was not warranted. In fact, the National Adjudicatory Council's (NAC) consideration and deliberation that yielded the revised guidelines in March 2006 (described on page 3) is the type of review sought by the petitions—an independent review of the need, fairness and efficacy of the Sanction Guidelines amendments.
  • OATS Phase III
    Petitioners expressed concerns about NASD's Order Audit Trail System (OATS) and the Rule 6950 Series (the OATS Rules). The petitions received requested that NASD delay the OATS Phase III effective date pending a study to determine the impact on the smaller NASD broker-dealers. Based on a review of the processes by which the OATS Rules were adopted, we determined that all necessary and appropriate processes were followed in approval and implementation of the rule changes that were the subject of the petition. As outlined on page 4, there was extensive industry involvement in the development of the OATS Rules through numerous requests for comments and through other avenues, and NASD carefully considered the impact of these rules on the industry. The Board thus determined delaying the implementation of OATS was not warranted./li>
  • TRACE Investigations and Enforcement
    Another request in the petitions was that NASD halt all TRACE investigations and enforcement actions until the time that TRACE "can be error free and/or a study can be done to determine the impact of TRACE reporting rules" on smaller NASD broker-dealers. Given the extensive industry input into the development of TRACE as described below, the Board determined that halting TRACE investigations and enforcement actions would not be appropriate.
  • Allegations that NASD Staff Engaged in Abusive Conduct
    Petitioners asked that the NASD Board investigate allegations that staff had engaged in abusive conduct in dealing with member firms. We asked NASD's Ombudsman, who reports directly to the Audit Committee of the NASD Board of Governors, to contact each petitioner to seek and explore information relating to any specific allegations of this nature. The Ombudsman has made an interim report to the Audit Committee, is continuing to conduct follow up with a number of Executive Representatives (ERs) and will report back to both the Audit and Governance Committees of the NASD Board of Governors. Given that these are individual allegations, they will be dealt with appropriately based on each specific situation.

The Board considered a number of factors in arriving at the conclusions listed above. The remainder of this letter provides the basis upon which the Board reached its conclusions.

Sanction Guidelines

NASD developed and implemented the revised Sanction Guidelines through the following process:

  • As with all revisions to the Sanction Guidelines, these revisions were approved by the NAC, NASD's appellate adjudicatory body, which is balanced between industry and non-industry members. (The Chair of the NAC is a member of the NASD Board of Governors.) The NAC possesses ultimate authority with respect to the Sanction Guidelines, which are not rules, but instead provide guidance, and are not noticed for comment. The NAC's independence is an important feature of the self-regulatory process, which was significantly re-engineered as a result of the SEC's 21(a) report in the mid 1990s.

In 2005, the NAC established a subcommittee, with majority industry representation to review and consider proposed revisions to the quality of markets and pay-to-play Sanction Guidelines. The subcommittee met several times and presented the NAC with recommended revisions, which the NAC adopted in February 2006.

  • Several policy considerations factored into the NAC's determination to revise the Sanction Guidelines. With these revisions, the NAC aimed to increase the effectiveness of NASD's disciplinary program by focusing NASD's resources on, and bringing formal actions only for, those violations that warrant formal action. The NAC also sought to increase the level of flexibility built into individual guidelines—giving member firms and NASD the opportunity to resolve matters informally—and to provide additional guidance to adjudicators and settling parties as to mitigating and aggravating factors.

NASD has taken action to make sure that the new guidelines are as clear as possible, and that all member firms are aware of the changes. Notice to Members 06-10 was issued on March 7, 2006, to notify all member firms of new revisions to the Sanction Guidelines, and it included a list of the revisions and a link to the complete Sanction Guidelines document. In addition, NASD published a Sanction Guidelines Q&A in April 2006 to address questions and concerns about the revised guidelines for member firms.

Finally, it is important to reiterate that the Sanction Guidelines are not NASD rules. Rather, they recommend broad ranges for monetary and non-monetary sanctions and provide potential factors to consider in determining what is appropriate for each individual case. Indeed, there are cases where the Hearing Panel or the NAC have imposed a sanction lower than what is recommended by the Guidelines or have imposed no sanction beyond the decision serving as a letter of caution. Under the revised Sanction Guidelines, these adjudicatory bodies remain free to reach those independent conclusions.


NASD developed and implemented OATS, in three separate phases, through the following process:

  • OATS was originally mandated by the SEC in 1996 as part of a settlement of enforcement actions against NASD. As approved by the SEC in March 1998, the OATS Rules provided for three phases of implementation, the final phase of which was just recently implemented on July 10, 2006—more than eight years since their initial approval. During that time period, NASD filed with the SEC amendments to the OATS Rules directly relating to Phase III of OATS, which were subject to two separate notice and comment periods by the SEC. In addition, NASD filed with the SEC four rule filings to extend the compliance date of OATS Phase III, including the most recent filing in April 2006, which extended the compliance date from May 8, 2006, to July 10, 2006. The goals set out 10 years ago for the OATS system—to create a reliable, comprehensive audit trail—have been achieved.
  • The amendments approving Phase III of OATS included a provision granting NASD exemptive authority with respect to smaller firms meeting specified criteria. NASD exercised this exemptive authority, granted a six-month exemption period from the OATS Rules to all firms meeting the criteria for exemption, and is evaluating whether it is appropriate to extend the blanket exemption beyond the initial six months.

Throughout the OATS implementation, NASD staff has actively involved the industry in rule development and promptly responded to industry concerns and issues. Knowing that the rule filing would have significant impact on the membership, particularly smaller firms who report their trades manually, NASD staff conducted an extensive member outreach program to help educate the membership on their responsibilities and, perhaps more importantly, to answer their questions.

  • Starting in the fall of 2005, staff participated in a variety of industry group forums and NASD-sponsored conferences and meetings. NASD Market Regulation staff hosted three industry-wide conference calls, a clearing firm outreach program and an initial round of road shows in 13 cities.
  • NASD staff developed a Phase III-specific Web site, which includes all rule filings, frequently asked questions and other educational materials./li>
  • The staff estimates that approximately 4,000 individuals participated in the events listed above.
  • In response to concerns that smaller firms had limited options and resources available to them for reporting manual orders, NASD developed a Web-based reporting tool for members. This tool was designed to minimize the data entry required by reporting firms. NASD conducted a second round of road shows in five cities, as well as hosted an industry-wide conference call, to ensure firms had adequate training on the use of the new tool.
  • At the request of the Board and Governance Committee, the staff recently surveyed a sampling of Phase III member firms to provide further input on the OATS implementation process. The vast majority of firms surveyed felt that the OATS requirements were communicated effectively and in a timely manner. Phase III launched on July 10, 2006, and although the launch went very smoothly from a systems-rollout and firm-compliance standpoint, NASD staff intends to continue the outreach and education program, and remains committed to enhancing the utility of the Web-based reporting tool.


Below is information on the evolution of TRACE:

  • The Trade Reporting and Compliance Engine (TRACE) system and rules were first proposed in 1999 with input from the Bond Market Transparency Committee (BMTC). The industry was well represented on the BMTC, holding 11 of the 15 seats on the committee.
  • The initial TRACE proposal was presented to the NASD Board of Governors in July of 1999. It has since been amended several times, and those amendments that required rule filings have been presented to and acted upon by the Board of Governors. Many of these amendments addressed member concerns, including slowing the implementation to provide time to determine the effect of transparency on liquidity, capping the size of trades so the actual size of a large transaction was not displayed and extending the Phase I length of time required for reporting to 75 minutes to accommodate small firms. In fact, it was due to member concerns, and NASD's consideration of and response to such concerns, that NASD implemented TRACE in a phased approach.
  • NASD staff who support TRACE regularly visit and hold conference calls with firms to gather feedback and respond to questions about the system. For example, during the last 12 months alone, of the approximately 1,700 firms that reported a trade to TRACE, 200 firms were visited or contacted via conference call. In addition, the most recent in a long series of industry-wide conference calls was held with more than 500 firms to discuss TRACE and municipal bond market issues.
  • In addition, although no system can be guaranteed to be "error free," TRACE has only had four outages that affected members' ability to submit trades, and just one that lasted more than an hour, during its four years of operation.
  • With respect to TRACE, NASD designed the system and implemented its use with specific input from a working committee that included significant representation by bond market dealers.
  • At the request of the Board and Governance Committee, NASD staff recently surveyed a sampling of both large and small member firms who participate in TRACE to provide further input regarding its reporting rules and operations. The vast majority of firms surveyed felt that TRACE rules were appropriately communicated and that the system operated effectively. A limited number of firms—in particular, small firms—indicated some reporting challenges when coordinating across private-sector service providers, clearing firms and TRACE. As in the past, NASD staff will continue to work with member firms to try and resolve these issues, although many of these issues reside outside of NASD's jurisdiction.

Allegations that NASD Staff Engaged in Abusive Conduct

NASD's Office of Ombudsman, which reports to the NASD Audit Committee, is charged with providing a confidential forum for public investors, member firms and their associated persons in order for them to voice concerns of unfair practices or disparate treatment by NASD staff.

Below is an overview, to date, of the investigation into allegations that NASD staff engaged in abusive conduct:

  • Following receipt of the petitions, the Board directed the Office of the Ombudsman to commence a confidential investigation. The Ombudsman initiated telephone calls to each of the ERs who filed petitions. The purpose of the calls was to gather any information regarding situations the ER might have experienced as described in the petition.
  • The Office of the Ombudsman was able to successfully reach a substantial majority of the ERs who filed petitions. For the remaining ERs, the Office of the Ombudsman left phone messages on a minimum of two occasions. The messages fully explained the reason the office was attempting to contact the ER.
  • In each instance where successful contact was established, the Office of the Ombudsman provided the ER with an overview of the independence of the Ombudsman Office and the office's function and responsibility, and asked the ER to provide specific information about instances of abusive conduct.

As previously mentioned, the Ombudsman is continuing to conduct follow up with a number of ERs and will report back to both the Audit and Governance Committees of the NASD Board of Governors.

In closing, please know that NASD is committed to getting the balance right, and will continue to work very hard to offer education, services and support to help member firms comply more easily.

We encourage you to contact NASD senior staff if you have any questions regarding the issues outlined in this letter. You may also contact the NASD Ombudsman's Office at (888) 700-0028. Finally, you may contact me through NASD's General Counsel, Grant Callery, at (202) 728-8285.


Richard Brueckner
Presiding Governor
NASD Board of Governors