Notice To Members 88-84

SEC Approval of Amendments to NASD Rules of Fair Practice and Conforming Amendments to the By-Laws Re: Supervisory Practices and Definitions of Branch Office and Office of Supervisory Jurisdiction

Published Date:

November 01, 1988

SUGGESTED ROUTING*

Senior Management
Legal & Compliance
Operations
Registration
Trading
Training

*These are suggested departments only. Others may be appropriate for your firm.

EXECUTIVE SUMMARY

On October 13, 1988, the Securities and Exchange Commission approved amendments to Article III, Section 27 of the Rules of Fair Practice and conforming amendments to Article I of the By-Laws and Schedule C to the By-Laws. The amendments to Article III, Section 27 (1) prescribe specific supervisory practices and procedures for all member firms and (2) revise the definitions of branch office and office of supervisory jurisdiction.

The conforming amendment amends the present text in the By-Laws to delete the substantive definition and instead references the definition set forth in Article III, Section 27. In addition, Schedule C to the By-Laws is amended to delete from an Explanation of the Board of Governors certain text pertaining to the definitions of office of supervisory jurisdiction and branch office. The texts of the amendments are attached.

BACKGROUND

In recent years, the NASD has become increasingly concerned that many persons associated with NASD members are engaging in the offer and sale of securities to the public without adequate ongoing supervision. In particular, the potential for significant regulatory problems exists when registered representatives conduct business at locations that are not subject to regular examination by the member and operate without direct oversight of qualified supervisory personnel.

The NASD also has considered whether certain aspects of a firm's business should be subject to on-site supervision by a registered principal so that the member can properly discharge its regulatory obligations. Further, the NASD has from time to time considered whether the definition of "branch office" in the By-Laws should be revised.

In connection with its review, the NASD, on February 9, 1988, issued Notice to Members 88-11, which requested comments on proposed amendments to Article III, Section 27 of the Rules of Fair Practice that set forth specific minimum requirements for supervisory practices and procedures for NASD members. After reviewing the comment letters, the NASD then published Notice to Members 88-44, requesting a member vote on proposed amendments substantially similar to those set forth in Notice to Members 88-11. The membership voted to approve the proposed amendments, and they were filed with the Securities and Exchange Commission. The Commission approved the amendments on October 13, 1988.

EXPLANATION

Amendments to Supervision Rules

The amendments substantially expand the specificity of Article III, Section 27 of the NASD Rules of Fair Practice with respect to a member's supervisory obligations. The NASD believes the new provisions will assist members in ensuring compliance with applicable laws, regulations, and rules by requiring that firms review their businesses and construct and document a supervisory system that is reasonably designed to achieve compliance with the securities laws and regulations and NASD rules applicable to the various areas of business in which NASD members are engaged.

The amendments also contain certain minimum required supervisory procedures and practices that the NASD believes to be necessary in any firm, regardless of size or type, in order to supervise adequately an investment banking and/or securities business.

The amendments require each firm to establish and maintain supervisory procedures and practices that provide for, at a minimum, the following:

(1) Establishment and maintenance of written supervisory and review procedures as specified in the proposed amendments;

(2) Designation of appropriately registered principals for each type of business in which the firm engages to carry out the firm's supervisory obligations;

(3) Designation as an OSJ for each location that meets the OSJ definition and any other loca tions for which such designation is appropriate to enable the firm to supervise properly, viewed in light of certain factors enumerated in the proposed amendments;

(4) Designation of one or more appropriately registered principal(s) in each OSJ, including the main office, and one or more appropriately registered representative(s) or principal(s) in each branch office to carry out the supervisory responsibilities and activities assigned to that office by the member;

(5) Assignment of each registered person to a supervisor;

(6) Reasonable efforts to ensure that all super visory personnel are properly qualified;

(7) Participation of each registered repre sentative, individually or collectively and not less than annually, at an interview or meeting at which compliance matters relevant to the activities of such representative(s) are discussed;

(8) Designation and identification to the NASD of one or more principals who shall review the firm's supervisory practices and procedures and take or recommend to senior management ap propriate action reasonably designed to achieve the member's compliance with applicable securities laws and regulations and with the rules of the NASD; and

(9) Establishment of a schedule for examin ing the firm's branch offices that takes into account the nature of the activity, volume of busi ness, and number of persons at each office.

The amendments require that each firm maintain written supervisory procedures that describe the supervisory system implemented according to the above requirements and that list the titles, registration status, and locations of the required supervisory personnel and the specific responsibilities assigned to each. A copy of the member's supervisory procedures, or the relevant parts thereof, will be required to be kept and maintained at each OSJ and at each other location where supervisory activities are conducted on behalf of the member. The member will be required to amend its written supervisory procedures, as appropriate, within a reasonable time after changes occur in applicable laws, regulations, and rules, and as changes occur in the firm's supervisory system, and to communicate these changes throughout its organization.

Members also will be required to conduct a review, at least annually, of the business in which it engages for purposes of detecting and preventing violations of, and to ensure compliance with, applicable laws, regulations, and rules. At a minimum, this will include the periodic examination of customer accounts to detect and prevent irregularities and abuses, an annual inspection of each OSJ, and the inspection of branch offices in accordance with a schedule to be set forth in the member's supervisory procedures. The member will be required to retain a written record of the dates upon which each inspection and review was conducted.

Amendments to Definitions of "Office of Supervisory Jurisdiction" and "Branch Office"

An "office of supervisory jurisdiction" (OSJ) is currently defined in Article III, Section 27 of the NASD Rules of Fair Practice as "... any office designated as directly responsible for the review of the activities of registered representatives or associated persons in such office and/or any other offices of the member." Under the amendments, an OSJ is any business location of a member firm at which one or more of the following functions take place:

(1) Order execution and/or market making;

(2) Structuring of public offerings or private placements;

(3) Maintaining custody of customers' funds and/or securities;

(4) Final acceptance (approval) of new ac counts on behalf of the member;

(5) Review and endorsement of customer or ders pursuant to the provisions of proposed Article III, Section 27(d);

(6) Final approval of advertising or sales literature for use by persons associated with the member, pursuant to Article III, Section 35(b)(l) of the Rules of Fair Practice; or

(7) Responsibility for supervising the ac tivities of persons associated with the member at one or more other offices of the member.

The term "branch office" is currently defined in Article I, Section (c) of the NASD By-Laws as "... an office which is owned or controlled by a member, and which is engaged in the investment banking or securities business." An Explanation of the Board of Governors in Schedule C to the NASD By-Laws reiterates this definition and also provides that a place of business of a person associated with a member is considered a branch office if the member (1) directly or indirectly contributes a substantial portion of the operating expenses of such place of business; and/or (2) authorizes a listing in any publication or other media, including a professional dealers digest or telephone directory, that designates a place as an office or if the member designates any such place as an office to another organization.

The amendment redefines "branch office" as any business location of the member identified to the public or customers by any means as a location at which the investment banking or securities business is conducted on behalf of the member, excluding any location identified solely in a telephone directory line listing or on a business card or letterhead, which listing, card, or letterhead also sets forth the address and telephone number of the office of the member responsible for supervising the activities of the identified location.

Conforming Amendment to By-Laws

Article I of the NASD By-Laws sets forth certain definitions applicable to terms used in the By-Laws and the Rules of Fair Practice. Section (c) defines branch office. Because branch office is now defined in Article III, Section 27(f)(2), the substantive definition is deleted from the By-Laws provisions, and a reference to Article III, Section 27 of the Rules is substituted.

Amendment to Schedule C to the By-Laws

An Explanation of the Board of Governors set forth at Schedule C to the By-Laws contains material pertaining to the distinction between an office of supervisory jurisdiction and a branch office and to the definition of a branch office. This material has been deleted because the text is inconsistent with the amended Article III, Section 27.

Effective Date

As stated in Notice to Members 88-44, the Board of Governors has determined that it is appropriate to provide members with a six-month period following SEC approval to bring their supervisory practices and procedures into compliance with the new rules. The amendments will therefore take effect April 13, 1989.

The texts of the new rule and of the By-Law and Schedule C amendments are attached. The existing provisions of Section 27, with the exception of paragraph (e), are deleted.

Questions concerning this notice can be directed to Dennis C. Hensley, NASD, Deputy General Counsel, at (202) 728-8245, or Jacqueline D. Whelan, Senior Attorney, Office of the General Counsel, at (202) 728-8270.

ARTICLE III, SECTION 27 - RULES OF FAIR PRACTICE

Sec. 27.

Supervisory System

(a) 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 the rules of this Association. Final responsibility for proper supervision shall rest with the member. A member's supervisory system shall provide, at a minimum, for the following:

(1) The establishment and maintenance of written procedures as required by paragraphs (b) and (c) of this Section.

(2) The designation, where applicable, of an appropriately registered principal(s) with authority to carry out the supervisory respon sibilities of the member for each type of busi ness in which it engages for which registration as a broker-dealer is required.

(3) The designation as an office of super visory jurisdiction (OSJ) of each location that meets the definition contained in paragraph (f) of this Section. Each member shall also designate such other OSJs as it determines to be necessary in order to supervise its regis tered representatives and associated persons in accordance with the standards set forth in this Section 27, taking into consideration the following factors:

(i) whether registered persons at the location engage in retail sales or other activities involving regular contact with public customers;

(ii) whether a substantial number of registered persons conduct securities activities at, or are otherwise supervised from, such location;

(iii) whether the location is geographically distant from another OSJ of the firm;

(iv) whether the member's registered persons are geographically dispersed; and

(v) whether the securities activities at such location are diverse and/or complex.

(4) The designation of one or more appropriately registered principals in each OSJ, including the main office, and one or more appropriately registered representatives or principals in each non-OSJ branch office with authority to carry out the supervisory responsibilities assigned to that office by the member.

(5) The assignment of each registered person to an appropriately registered representative(s) and/or principal(s) who shall be responsible for supervising that person's activities.

(6) Reasonable efforts to determine that all supervisory personnel are qualified by virtue of experience or training to carry out their as signed responsibilities.

(7) The participation of each registered repre sentative, either individually or collectively, no less than annually, in an interview or meet ing conducted by persons designated by the member at which compliance matters relevant to the activities of the repre- sentative(s) are discussed. Such interview or meeting may occur in conjunction with the discussion of other matters and may be con ducted at a central or regional location or at the representative's(') place of business.

(8) Each member shall designate and specifi cally identify to the Association one or more principals who shall review the supervisory system, procedures, and inspections imple mented by the member as required by this Section and take or recommend to senior management appropriate action reasonably designed to achieve the member's com pliance with applicable securities laws and regulations, and with the rules of this Asso ciation.

Written Procedures

(b)

(l) Each member shall establish, maintain, and enforce written procedures to supervise the types of business in which it engages and to supervise the activities of registered representatives and associated persons that are reasonably designed to achieve compliance with applicable securities laws and regulations, and with the applicable rules of this Association.

(b)

(2) The member's written supervisory procedures shall set forth the supervisory systemstablished by the member pursuant to Section 27(a) above, and shall include the titles, registration status and locations of the required supervisory personnel and the responsibilities of each supervisory person as these relate to the types of business engaged in, applicable securities laws and regulations, and the rules of this Association. The member shall maintain on an internal record the names of all persons who are designated as supervisory personnel and the dates for which such designation is or was effective. Such record shall be preserved by the member for a period of not less than three years, the first two years in an easily accessible place.

(b)

(3) A copy of a member's written supervisory procedures, or the relevant portions thereof, shall be kept and maintained in each OSJ and at each location where supervisory activities are conducted on behalf of the member. Each member shall amend its written supervisory procedures as appropriate within a reasonable time after changes occur in applicable securities laws and regulations, including the rules of this Association, and as changes occur in its supervisory system, and each member shall be responsible for communicating amendments through its organization.

Internal Inspections

(c) 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 the rules of this Association. Each member shall review the activities of each office, which shall include the periodic examination of customer accounts to detect and prevent irregularities or abuses and at least an annual inspection of each office of supervisory jurisdiction. Each branch office of the member shall be inspected according to a cycle which shall be set forth in the firm's written supervisory and inspection procedures. In establishing such cycle, the firm shall give consideration to the nature and complexity of the securities activities for which the location is responsible, the volume of business done, and the number of associated persons assigned to the location. Each member shall retain a written record of the dates upon which each review and inspection is conducted.

Written Approval

(d) Each member shall establish procedures for the review and endorsement by a registered prin cipal in writing, on an internal record, of alltran- sactions and all correspondence of its registered representatives pertaining to the solicitation or execution of any securities transaction.

Qualifications Investigated

(e) Each member shall have the responsibility and duty to ascertain by investigation the good character, business repute, qualifications, and experience of any person prior to making such a certification in the application of such person for registration with this Association.

Definitions

(f)

(l) "Office of Supervisory Jurisdiction" means any office of a member at which any one or more of the following functions take place:

(i) order execution and/or market making;

(ii) structuring of public offerings or private placements;

(iii) maintaining custody of customers' funds and/or securities;

(iv) final acceptance (approval) of new accounts on behalf of the member;

(v) review and endorsement of customer orders, pursuant to paragraph (d) above;

(vi) final approval of advertising or sales literature for use by persons associated with the member, pursuant to Article III, Section 35(b)(l) of the Rules of Fair Practice; or

(vii) responsibility for supervising the activities of persons associated with the member at one or more other branch offices of the member.

(f)

(2) "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 any location identified solely in a telephone directory line listing or on a business card or letterhead, which listing, card, or letterhead also sets forth the address and telephone number of the branch office or OSJ of the firm from which the person(s) conducting business at the non-branch location are directly supervised.

AMENDMENTS TO ARTICLE I— NASD BY-LAWS

(Note: Deleted language is in brackets; new language is underlined.)

When used in these By-Laws, and any rules of the Corporation, unless the context otherwise requires, the term:

(a) - (b) No change;

(c) "branch office" means an office [located in the United States which is owned or controlled by a member, and which is engaged in the invest ment banking or securities business;] defined as a branch office in Article III, Section 27 of the Rules of Fair Practice;

(d) - (o) No change.

AMENDMENTS TO SCHEDULE C TO THE NASD BY-LAWS

Explanation of the Board of Governors.

[Distinction Between Branch Office and Office of Supervisory Jurisdiction;] Appointment of Executive Representative; [Standards for Determining Branch Offices].

[The term "office of supervisory jurisdiction" defined in Section 27 of Article HI of the Rules of Fair Practice means any office designated by the member in its memorandum of supervisory procedures, established pursuant to Article III, Section 27 of the Rules. Such office shall be directly responsible for the review of the activities of Registered Representatives and persons associated with the member in that office and/or in other offices of the member.]

The term "executive representative" as found in Section 3 of Article III of the By-Laws means that person designated by the member to represent, vote and act for the member in all the affairs of the Corporation. Pursuant to the provisions of Section 8 of Article III of the By-Laws, every member who maintains a registered branch office in a district of the Corporation other than the one in which its main office is located, is entitled to one vote on all matters pertaining solely to the district in which such registered branch office is located, including the election of members of the Board of Governors from such district. Should a member maintain more than one branch office in a district, it is entitled to only one vote in that district. Therefore, each member shall designate one executive representative and shall designate one "district executive representative" for each district other than the one in which the main office is located in which the member maintains a registered branch office.

[The term "branch office" defined in Article I of the By-Laws means any office, including a corporate subsidiary of a member, located in the United States and other than the main office which is owned or controlled by a member and engaged in the investment banking or securities business.]

Each member is under a duty to insure that its membership application with the Corporation is kept current at all times by supplementary amendments to its original application and that any offices other than the main office are properly designated and registered, if required, with the Corporation. [Each member must also determine in light of the requirements of Article III, Section 27 of the Rules of Fair Practice, the form of its written supervisory procedures, and, accordingly, which offices are to be designated as offices of supervisory jurisdiction responsible for carrying out the written procedures.]

Each member must designate to the Association those offices of supervisory jurisdiction, including the main office, and must register those offices which are deemed to be branch offices in accordance with the standards [found hereafter] set forth in Article HI, Section 27 of the Rules of Fair Practice. [A branch office would be considered an office of supervisory jurisdiction only if designated as such and only if specified supervisory activities are assigned to it under the member's written procedures. Members should note that the term "branch office" of itself does not carry any implication that the branch office personnel are required to perform any supervisory function. The term "branch office" is merely to designate and identify for registration purposes the various offices of a member other than the main office and as such are required to be registered and as to which a registration fee should be paid. If an office falls within the definition of both an office of supervisory jursidiction and a branch office, it must be designated to the Corporation in each category, and it must be registered as a branch office, and the applicable registration fee for a branch office must be paid.

In determining whether an office or the activities of a person associated with a member in an area constitutes a branch office of a member, the following standards shall be used:

1. It shall be considered a branch office if the member directly or indirectly contributes a substantial portion of the operating expenses of any place used by a person associated with a member who is engaged in the investment banking or securities business, whether it be commercial office space or a residence. Operating expenses, for the purposes of the standard, shall include items normally associated with the cost of operating the business such as rent and taxes.

2. It shall be considered a branch office if the member authorizes a listing in any publication or any other media, including a professional dealer's digest or a telephone directory, which listing designates a place as an office or if the member designates any such place with an organization as an office.]