Testimony Before a Hearing on Examination of Financial Institutions and Their Affiliated Broker-Dealers
Vice President, Member Regulation
I am Daniel M. Sibears, Vice President, Member Regulation of NASD Regulation, Inc. (NASDR). I appreciate the opportunity to appear before you today to give the views of the National Association of Securities Dealers, Inc. (NASD) on the examination of the securities activities of banks and other financial institutions.
Your invitation letter requested that we provide you with information on how the Securities and Exchange Commission (SEC) and securities industry Self-Regulatory Organizations (SROs) carry out their examination and supervision responsibilities, including review of internal controls; how the SEC supervises the examination process; and how the SROs coordinate their examinations of bank affiliated broker-dealers with the banking agencies.
NASD and NASDR
Established under authority granted by the 1938 Maloney Act Amendments to the Securities Exchange Act of 1934, the NASD is the largest self-regulatory organization for the securities industry in the world. Virtually every broker-dealer in the U.S. that conducts a securities business with the public is required by law to be a member of the NASD. The NASD has two operating subsidiaries, NASDR and The Nasdaq Stock Market. NASDR is charged with the responsibility of regulating the securities activities of broker-dealers and the surveillance, oversight, and enforcement of trading rules of The Nasdaq Stock Market.
The NASD has more than 5,500 broker-dealer members that operate in excess of 64,000 branch offices, employing more than 550,000 registered sales persons and principals. Virtually every broker-dealer doing business with the investing public is a member of the NASD. The scope of the NASD’s regulatory jurisdiction extends to all members and their associated persons. The 1,600 member staff of NASDR is devoted exclusively to carrying out the NASD’s regulatory and enforcement responsibilities.
NASDR carries out its examination, disciplinary, and other regulatory responsibilities through its Washington D.C. headquarters and 13 District Offices located in major cities throughout the country. A committee of the NASDR Board of Directors, the National Business Conduct Committee, serves as an appellate body over the organization’s disciplinary activities. Final NASD disciplinary actions can be appealed to the SEC and then to the United States Courts of Appeals.
As background, over the past five years, the NASD has initiated almost 1,000 formal disciplinary actions per year, with 1,045 issued in 1996. NASD monetary sanctions in enforcement actions have increased dramatically from about $10 million in fines in 1989 to almost $50 million in 1996. In addition to disciplinary fines, orders of restitution to harmed investors have increased from $1.5 million in 1990 to $21.8 million in 1996. Further, in 1996:
- 394 individuals were barred;
- 204 individuals were suspended;
- 7 firms were expelled from NASD membership; and
- 7 firms were suspended.
Currently, a twelve-member Board of Governors, a majority of whom are non-securities industry affiliated, governs the NASD and the NASDR is governed by a 24 member Board of Directors, balanced between securities industry and non-industry members. A proposal is pending with the SEC to restructure the NASD Board with 27 members, a majority of whom are non-securities industry affiliated, and create eight member subsidiary Boards for both NASDR and the Nasdaq Stock Market, balanced between securities industry and non-industry members. Board members are drawn from leaders of industry and academia and the public. Among many other responsibilities, the boards, through a series of standing and select committees, monitor trends in the industry and promulgate rules, guidelines, and policies to protect investors and ensure market integrity.
NASD rules — along with those of the New York Stock Exchange and other SROs —form a critical part of the securities regulation system. These rules address, among other things, customer suitability, best execution, unauthorized trading, markups and commissions, and requiring firms to supervise their associated persons to ensure they comply with these rules. The SROs promulgate and enforce the specific rules in these areas, subject to the general oversight of the SEC.
Through rulemaking, NASDR ensures that investors are afforded continuing protection even in this era of rapidly changing products, services, and practices and of fading distinctions among investment banking, commercial banking, and insurance. Increasingly, NASDR rulemaking and examination programs require close cooperation and coordination with other regulators. As we will discuss later, this cooperation with the banking regulators has worked well in NASDR’s efforts to develop rules governing securities activities on the premises of banks and other financial institutions and in coordinating examination efforts.
The Board creates standing committees to make policy recommendations to the Board relating to specific issues. The standing committees of the Board change to adapt to the changes in the regulatory environment. In January 1995, the NASD Board of Governors created a standing committee of the Board, the Bank Broker-Dealer Committee, to assist in developing proposed rules that would apply to the activities of NASD members providing broker-dealer services on the premises of a financial institution where retail deposits are taken. The Committee consists of 11 members representing a broad spectrum of types and sizes of institutions spread throughout the United States. The Committee has been very active in developing proposed rules and interpreting existing NASD rules as they apply to bank broker-dealers.
NASDR’s Broker-Dealer Examination Process
The NASD has examination responsibilities for all of its 5,500 members. It conducts two major types of examinations, cause and cycle.
Cause examinations address a particular problem or event identified through a variety of sources, such as customer complaints or terminations for cause of registered representatives by broker-dealers and FOCUS report reviews. Referrals from federal or state authorities may also trigger a cause examination. Cause examinations by Enforcement Department headquarters staff respond to complaints from the public or other members, new issue manipulation reviews, Market Regulation referrals, and referrals from the SEC, states, NASD District Offices, and other regulators. Many of our formal complaints arise from cause examinations. Our investigation of customer complaints represents the most significant interaction between our examining staff and the investing public.
Cycle Examination Scheduling
The NASD cycle examination program is carried out through a regulatory plan that focuses examination resources on the firms, individuals, issues, and practices that present the greatest regulatory challenges and concerns in terms of investor protection. In 1996, more than 2300 cycle examinations were begun by NASDR. Annual on-site inspections are conducted of firms engaged in high priority activities. In addition, NASDR has established an examination frequency cycle, currently one to six years, for all of its members. This schedule is based upon the type of business conducted by the member, the scope of that business, the extent of customer exposure, method of operation, past regulatory history, and other similar factors.
Areas Covered in Examinations
NASDR’s on-site examinations cover a broad scope of NASD rules and regulations, as well as those of the SEC and the Municipal Securities Rulemaking Board (MSRB). NASDR examiners conduct a review of a member's sales and trading practices that, among other things, includes review for compliance with suitability, unauthorized trading rules, churning, best execution, fair pricing, supervisory and markup requirements, and general fair dealing with customers. In addition, NASDR examines members for compliance with all rules and regulations governing members’ conduct in The Nasdaq Stock Market, including compliance with the firm quote rule, and rules relating to trade reporting, short sales, limit orders, and underwriting activities.
NASDR examiners require all members to submit monthly and quarterly financial information electronically for review and analysis. Where NASDR has been designated financial and operational examination responsibility for a member, NASDR staff also conduct on-site examinations for compliance with the SEC's net capital and customer protection rules.
NASDR reviews other activities in a wide range of products trading in the over the counter markets (OTC), including OTC trading of exchange-listed securities, corporate bonds, municipal securities, options, limited partnerships, variable contracts, and mutual fund shares.
Currently, SEC Rule 17a-5 requires that, as part of a broker-dealer’s annual certified audit report, the independent auditor must review the firm’s internal control systems and report on any weaknesses found to exist. Notwithstanding the Rule’s requirement, NASDR — in conjunction with the SEC and the New York Stock Exchange — is expanding its financial and operational examination procedures to encompass a pilot to review large member firm’s internal procedures. The goal of this review is to determine the scope, level, and frequency of future internal control examinations, as well as whether it appears any rule making may be necessary.
During the course of their examinations, NASDR examiners routinely review for compliance with the federal securities laws, including anti-fraud provisions, and the Federal Reserve System's Regulation T, which governs the extension of credit by broker-dealers.
Before an on-site examination, examiners conduct a review to focus the upcoming examination by determining the principal areas of business of the broker-dealer, including revenue and profit areas. They also review previous regulatory history, and determine if there have been significant changes in the broker’s business mix or personnel. Examiners also review NASD internal regulatory intelligence to spot any additional potential problem areas, such as a high incidence of customer complaints or arbitration claims.
Examinations are conducted through an Automated Examination Module Program (AEM), consisting of 13 Modules that the examiner completes, depending on the business conducted and the application of approved focusing practices. AEM Modules include: Background Interview/General Examination, Financial and Operational Examination, Options, Municipal Examination, Underwriting and Distribution, Direct Participation Programs, Investment Company Securities/Variable Contracts Examination, Trading and Market Making Examination, Sales Practice Examination, Special Branch Office Examination, Government Securities Examination, Insider Trading, and Continuing Education.
Examiners use portable computers to input their findings and also access regulatory and transaction information stored electronically to assist the on-site examination process. The modules include related procedures, references and questions, as well as embedded spreadsheets that assist in writing up the examination. The program compiles information during the conduct of the examination. Because it eliminates the previous need to rewrite the gathered information, the program has significantly reduced the time needed to complete the examination. The portable computers also give examiners online access to databases on securities-related products, which can be annotated. These databases have replaced print volumes that the examiner previously had to carry, composed of several thousand pages, which were frequently difficult to keep up to date. In addition, the computers provide reference information, including the NASD Manual, NASD Notices to Members, and rules of the SEC, all instantly searchable by word or concept.
An NASD examination module has been prepared for the examination of broker-dealer services on financial institution premises under NASD Proposed Rule 2350, "Broker-Dealer Conduct on the Premises of Financial Institutions," which is now pending at the SEC. That proposed rule is described more fully later in this testimony. This module, for example, will include review and examination of management structure, nature of the business on the bank premises, execution and clearing, compensation, training, supervision, physical setting, networking and brokerage affiliate agreements, customer disclosure and acknowledgements, notification of terminations, communications with the public, SIPC membership, and retail sales. This module will be used in addition to any other examination modules that are applicable, based on the nature of the business conducted on the bank premises.
The NASD in 1995 improved the training of its examination staff by using the most current technology and techniques. Before this new training system, called CornerStone, was implemented, training took two years to ensure that our examiners were able to reach high performance levels. The new system now allows examiners to reach those levels in one year.
CornerStone incorporates the knowledge and best practices of NASD experts nationwide into a system that uses computer-based training, self-paced training, performance support technology, and on-site mentors. New examiners are first assigned mentors, whose first job is developing a personalized training plan for the new examiner. Mentors themselves take a three-day training program to understand their role in the training of new examiners under the CornerStone approach. If the previous securities experience of the new examiner is limited, the mentor will assign print-based foundation courses that are presented in a number of self-paced manuals. These include introductory material on the NASD and the examiner’s role, the corporate desktop computer system, product lines and business activities, fundamentals of brokerage operations, SEC rules, and examinations. This introductory material, which is presented in coordination with on-the-job activities, will take about four to six months for the employee to complete.
Once the foundation course is completed, the examiner uses the CornerStone desktop, which incorporates computer-based training with online performance support systems. There are eight different computer based lessons. The first seven take about 20 hours to complete and cover financial, sales practice, and trade reporting issues that an examiner would encounter in conducting an examination. The eighth lesson is a case study, where the examiner conducts an examination online, using member firm information typically available to examiners. After reviewing that information, examiners must make decisions and explain their rationale. The case study ends with the examiner writing a report on the examination.
Only after the computer-based training is completed do the examiners enter an eight-day workshop at the NASD’s Rockville offices. While instructors lead these classes, the examiners work in small groups and are involved in exercises to simulate a real examination, with on-line access to related information, and with presentation of their findings to a peer review panel.
Our CornerStone training approach has received the 1996 Outstanding Human Performance Intervention Award from the Society of Performance and Technology. This award recognizes organizations for putting trainees into the best position to learn the required information by using the most appropriate methods — such as class room learning, self-paced text, computer based training or job aids for reference — depending on the type of information that must be conveyed. We are now planning to work in 1998 to provide the opportunities of CornerStone training to other organizations in securities and financial services regulation that would like to use it, such as the SEC, the states, other exchanges, and bank regulators.
In November of 1995, the NASD entered a Memorandum of Understanding with the SEC, the North American Securities Administrators Association, the New York and American Stock Exchanges, and the Chicago Board Options Exchange to coordinate examinations of joint members. This coordination includes pre-examination planning and focusing of examination efforts to avoid duplicating work during on-site cycle examinations. Coordinated examination was are also a part of the National Securities Markets Improvement Act of 1996.
The Memorandum includes annual planning summits and periodic regional meetings to coordinate examination schedules and review broker-dealer examination histories to minimize examination duplication. It also requires extensive coordinated tracking of examinations, and sets out a procedure for broker-dealers to request a coordinated examination and for the organizations to meet those requests. NASDR implements the Memorandum of Understanding on a national level through its Office of District Oversight and Coordination.
During 1996, the first full year during which the agreement was effective, the NASD coordinated with the NYSE 117 cycle examinations of our joint members. These examinations constituted over 90% of the firms that sought a coordinated examination. In 1997, the coordinated examination program was enhanced to serve the interests of joint members that wish to opt out of, as well as those that desire, coordinated examinations. Firms that do not want two SROs in their firms at the same time now can generally have the examinations spaced apart by at least two months. For 1997, 137 firms requested a coordinated examination between NASD Regulation and the NYSE and 74 of those examinations have started as of the end of last month. We anticipate that we will again achieve at least a 90% success rate for firms seeking a coordinated examination in 1997.
Regulation of Bank Securities Activities
Over the course of the last decade, financial institutions, primarily banks, have increased the levels of their affiliates’ and networkers’ securities activities, which began with retail customer discount brokerage and have extended to debt underwriting, equity underwriting, and expanded activities in mutual funds. For retail investors, banks engage in the sale of most investment products but mutual funds currently are by far the predominant securities product sold through banks.
There are three primary ways in which securities are sold by or through banks and their affiliates:
- Direct sales by employees of a bank, which are subject to oversight by the banking regulators but are exempt from regulation by the SEC and the SROs.
- Sales through a broker-dealer that is affiliated with a bank, which are regulated by the SEC and each SRO of which the broker-dealer is a member.
- Sales through a non-affiliated broker-dealer, under a third party networking arrangement. These programs are regulated by the SEC and each SRO of which the broker-dealer is a member.
The NASD has 228 members that are affiliates of banks, and approximately 100 members engaged in networking arrangements with banks across the country, where broker-dealers contract to establish an office on a bank site to sell securities, predominantly mutual funds. According to the GAO’s September 1995 study, Banks’ Securities Activities, 88% of all investment product sales made on the premises of banks are conducted by NASD member broker-dealers and thus are subject to all of the rules, regulations, and examinations of the SEC and NASD. The remaining 12% of securities sales are made directly by banks themselves and neither the SEC nor the NASD has any authority to review the bank’s policies, practices, and procedures for consistency with SRO rules and federal securities laws.
The bank regulators – the Federal Reserve Board (FRB), the Federal Deposit Insurance Corporation (FDIC), the Office of the Comptroller of the Currency (OCC), and the Office of Thrift Supervision (OTS) – adopted guidelines on bank securities activities in 1993. While these guidelines referred to NASD Rules of Fair Practice as an appropriate reference for direct bank securities sales, the NASD’s rules do not directly apply to these transactions, or to the conduct and practices of the individuals involved.
The four bank regulatory agencies issued on February 15, 1994 an Interagency Statement on Retail Sales of Nondeposit Investment Products (Interagency Statement) that consolidated and made uniform the guidance contained in the 1993 statements issued by the banking regulators. The Interagency Statement, which contains guidelines for sales of securities on bank premises, was designed to enhance investor protection and reduce the potential for confusing securities with insured products. The Interagency Statement’s guidelines apply to sales of securities by bank employees as well as by employees of affiliated or unaffiliated third parties located on bank premises. The guidelines state that financial institutions should insure that customers are informed that securities products:
- are not insured by the FDIC;
- are not deposits or other obligations of the institution and are not guaranteed by the institution; and
- are subject to investment risks, including possible loss of the principal invested.
The Interagency Statement also states that banks should adopt policies and procedures for the sales of securities products. These procedures should address, among other things, disclosures and advertising; the setting in which securities products are sold; the qualifications and training of personnel selling securities products; sales practices applicable to securities sales, including suitability; and compensation of personnel involved in securities sales. The Interagency Statement also recommends that banks establish procedures for ensuring that securities sales activities are conducted in compliance with applicable laws and regulations. However, as with the 1993 guidelines discussed above, neither the NASD’s rules nor the securities laws directly apply to bank direct securities transactions or to the conduct and practices of bank employees selling securities directly for the bank.
The NASD’s Proposed Rules
The NASD has been concerned that the activities of member firms operating on the premises of financial institutions, and related customer protection issues, are not adequately addressed by existing NASD rules. The Interagency Statement and other policies and guidelines established by bank regulators do not apply directly to NASD members. Therefore, the NASD believes that it is important to adopt a set of NASD enforceable rules that establish clear, consistent standards of conduct governing the practices of all NASD member firms (affiliates and networkers alike) operating on the premises of financial institutions. These proposals would apply exclusively to the activities of NASD members that are providing broker-dealer services on the premises of a financial institution where retail deposits are taken. The focus of the proposed rules is to enhance investor protection by minimizing confusion by retail customers.
The NASD proposed these rules in December 1994 when it issued Notice to Members 94-94 to request comment on the proposals. NASD staff and the NASDR Bank Broker-Dealer Committee reviewed the 284 comment letters filed on the proposed rule. As described earlier in this testimony, the Committee was created in 1995 to recommend rules and procedures to govern securities activities of members firms operating on bank premises. The Committee made significant changes to the proposal to take account of the concerns of the many commentors, including banks and bank regulators. These changes were intended to eliminate provisions that duplicated existing NASD rules, to clarify the NASD’s intent to regulate only its members and not financial institutions, to make the rules more consistent with the Interagency Statement, and to reduce the regulatory burden on members and financial institutions to the extent possible.
In September 1995, the NASD Board of Governors authorized filing the revised rules with the SEC. The proposed rules were filed with the SEC in December 1995. The SEC published them for comment in March 1996. The SEC received almost 100 comments.
The NASDR Board of Directors and the NASD Board of Governors approved revisions responsive to the comments in January 1997. In April 1997, Amendment No. 4 containing the revised proposal was published for comment, generating ten comment letters. Amendment No. 5, proposing several technical, non-substantive revisions to the proposed rule in response to the comments, was filed with the SEC in July 1997. The SEC is now reviewing the proposal.
As a result of this process, these proposals were substantially changed in response to the many comments that were made on them. Many of the original proposals have been converted into generic proposed rules of uniform application to all of the brokerage industry from proposals originally focused on bank securities activities. The remaining proposals address areas unique to the bank securities context that present special potential for abuses.
As published by the SEC, the proposed rules contain the following principal provisions regarding the operation of broker-dealers on bank premises:
Setting - Wherever practical, broker-dealer services must be conducted in an area physically distinct from the retail deposit taking area. In all situations, broker-dealer services must be clearly distinguished from retail deposit-taking activities, with the name of the securities firm clearly displayed.
Networking and brokerage affiliate agreements - The agreement between the bank and the broker-dealer must be in writing and describe the responsibilities and compensation arrangements of the parties, and allow the SEC and NASD access to the premises to inspect member books and records.
Customer disclosure and written acknowledgment - Broker-dealers must, when opening an account for a customer, disclose that the products sold are not insured by the FDIC; are not deposits of, or insured by, the bank; and are subject to investment risk, including loss of principal. Broker-dealers also must make reasonable efforts to obtain from customers a written acknowledgement that the disclosures were provided.
Communications with the public - Broker-dealers must clearly inform customers which services the broker-dealer – as opposed to the bank – is providing, and must provide the same information in communications with the customer that it must provide upon opening an account (e.g., products are not FDIC insured, not obligations of the bank, and subject to investment risk). Broker-dealers may provide shortened disclosures in visual media and in written advertisements and may omit the disclosure in limited circumstances.
Notification of terminations – Broker-dealers must promptly notify the bank if the broker-dealer terminates a dually employed person for cause.
NASD and Bank Affiliate Securities Activities
NASD Bank Broker-Dealer Inspections
As part of its national examination program, NASDR conducts examinations of all of its members on a regular basis, including the 228 members that are affiliated with banks and the approximately 100 members that have third-party networking arrangements. During 1996, the NASD conducted 55 routine examinations of bank-affiliated broker-dealers as well as 338 cause examinations. One of the routine examinations and 25 of the cause examinations resulted in formal actions.
In addition to these examinations, as part of its national regulatory program for 1995, the NASD examined the mutual fund sales practices of all broker-dealers and specifically conducted on-site examinations of broker-dealers involved in the sale of securities on financial institution premises. The on-site examinations encompassed a special review of 58 different locations of bank offices from which broker-dealer services were provided – 21 main offices and 37 branch offices. Examiners found general compliance with existing NASD and SEC rules and regulations, although 18 examinations resulted in minor informal disciplinary actions involving cautionary letters and a compliance conference.
Coordination with Bank Regulators
The banking agencies and the NASD share a common interest in the supervision of broker-dealers selling non-deposit investment products on depository institution premises. To ensure that this common interest is addressed with a minimum of duplication, to promote regulatory consistency, and to reduce unnecessary burdens, the banking agencies and the NASD have agreed to cooperate to facilitate the coordination, and enhance the effectiveness, of examination efforts by the banking agencies and the NASD.
In January 1995, the NASD signed an Agreement in Principle with the banking regulators. With regard to bank-affiliated broker-dealers, the agreement included: sharing of examination schedules and examination information, bank regulator access to NASD examination findings, bank agency referrals to the NASD of apparent securities violations, and NASD referrals to banking agencies of apparent violations that fall within their jurisdiction. The Agreement also calls for communications between the banking agencies and the NASD on non-affiliated networker broker-dealers who sell securities on bank premises, as well as coordination of education and policy initiatives, and maintaining the confidentiality of shared information.
The NASD thanks the Subcommittee for the opportunity to provide information on the examination of securities firms and especially securities activities on bank premises, and would be pleased to provide the Committee with any assistance it may need as it studies further the important issues of bank securities regulation.