- FINRA Submits Proposed Consolidated Supervision Rules to SEC
- July 20, 2011 | Authors: Gail Marshall; John R. Snyder
- Law Firms: Bingham McCutchen LLP - Washington Office ; Bingham McCutchen LLP - Boston Office
The Financial Industry Regulatory Authority (“FINRA”) submitted to the Securities and Exchange Commission (“SEC”) for its approval a set of proposed consolidated supervision rules. SR-FINRA 2011-028. This proposal seeks to consolidate NASD and NYSE supervision rules, codify previously issued guidance, and adopt some substantive changes, such as:
Requiring supervision, including the implementation of written supervisory procedures, for all of a member’s business lines, regardless of whether they require broker-dealer registration.
Requiring the review by a registered principal, evidenced in writing, of the member’s transactions relating to its investment banking and securities businesses.
Requiring that the designated principal of an Office of Supervisory Jurisdiction (“OSJ”) have a physical presence at the OSJ on a regular and routine basis, and stating a presumption that a principal will not be assigned as the on-site supervisor for more than one OSJ.
Permitting risk-based principles for the review of incoming, outgoing and internal communications, and permitting delegation of such review to unregistered persons.
Amending the provisions governing supervision of producing managers.
Requiring that the testing and verification conducted as part of annual office inspections include review of the policies regarding the supervision of supervisory personnel.
Requiring additional content in the annual reports to senior management regarding the testing of supervision and compliance for those firms with $150 million or more in gross revenue.
FINRA first proposed consolidated supervision rules in May 2008.1 This new proposal addresses some, but not all, of the concerns raised by the comments to the 2008 proposal.
This alert is not a comprehensive compendium of the proposed rules, but rather highlights some of the more noteworthy aspects of those rules, particularly those that represent changes from the existing NASD and NYSE rules.
New Rule 3110 (Supervision)
Proposed Rule 3110 would replace current NASD Rule 3010 and NYSE Rule 342, on which it is largely based.2 Rule 3110 concerns, among other things, supervisory systems, written procedures, internal inspections and review of correspondence.
Proposed Rule 3110(a) would require a member to have a supervisory system for the activities of its associated persons3 that is reasonably designed to achieve compliance with the applicable securities laws and regulations and FINRA and MSRB rules. The proposed rule is substantially similar to NASD Rule 3010(a), with some noteworthy revisions. First, the proposed rule requires a member’s supervisory system to be reasonably designed to achieve compliance with MSRB rules, which NASD Rule 3010(a) does not explicitly reference.4
Also, more significantly, proposed Supplementary Material .015 states that, for a member’s supervisory system to be reasonably designed to achieve compliance with FINRA Rule 2010 (Standards of Commercial Honor and Principles of Trade), it must include supervision for all the member’s business lines regardless of whether they require broker-dealer registration. One could argue this proves too much. Although FINRA has retreated from its earlier proposal to delete the “for which registration as a broker-dealer is required” language from what would be FINRA Rule 3110(a)(2),6 several broker-dealers have argued that FINRA is trying to act outside its jurisdiction and to intrude into areas that are the responsibility of other regulators (such as investment advisory, banking, insurance products, commodities and foreign exchange). FINRA states, in the commentary in its Notice of Filing, that it does not believe Supplementary Material .01 is limited in its application or scope by the language in proposed FINRA Rule 3110(a) and 3110(b)(1) (and language in current NASD Rule 3010(a) and 3010(b)(1)), which provides that supervisory systems and written procedures must be reasonably designed to achieve compliance with “applicable securities laws and regulations and. . .applicable FINRA and MSRB rules.” In other words, there is no acknowledgement that, if a business activity does not implicate securities laws and regulations that FINRA is empowered to enforce, then the language of Rule 3110(a) and 3110(b)(1) would not seem to require supervisory systems and procedures for that activity. Indeed, FINRA contends Supplementary Material .01 is consistent with NASD Rule 3010(b)(1). Broker-dealers are likely to argue that Supplementary Material .01 would be an impetus for creating additional, duplicative, unnecessary and potentially inconsistent regulatory burdens.
Other than the change to Rule 3110(a)(2) noted above, there are no material changes in proposed Rule 3110(a) subsections (1)-(7) from the version proposed in 2008. However, the proposed Supplementary Material, in addition to incorporating existing NASD and NYSE rules and guidance, introduces some new obligations. For example:
Supplementary Material .04 clarifies that a principal at a one-person OSJ cannot supervise himself/herself; it imposes obligations to assign a “senior principal” to have “close supervision and control” over a one-person OSJ and to conduct “regular and periodic” on-site supervision if the one-person OSJ engages in business activities other than supervision
Supplementary Material .05 clarifies that the designated principal of each OSJ must have a physical presence on a regular and routine basis at each office for which the principal has supervisory responsibilities. Notably, FINRA stresses that there is a presumption that a principal will not be assigned as the on-site supervisor to more than one OSJ. Further, perhaps to discourage the assignment of an on-site principal to more than one OSJ, FINRA requires that a member consider a number of factors in determining to assign a principal to “two or more OSJs” and document in its supervisory and inspection procedures how the firm concluded the supervisory structure was reasonable. FINRA notes that there is a general presumption that a determination to assign a principal to more than two OSJs is unreasonable.7
Supplementary Material .06 clarifies that, while the annual compliance meeting does not have to be conducted in-person, a member that uses other methods must take steps to ensure that each registered person attends the entire meeting and is able to ask questions and receive answers in a timely fashion.
FINRA proposes to consolidate various rules that currently require written supervisory and review procedures into proposed Rule 3110(b). FINRA is retaining the provision currently found in NASD Rule 3010(d)(1) requiring principal review, evidenced in writing, of all transactions, and is proposing to amend the provision to clarify that such review must include all transactions relating to the member’s investment banking or securities business. Proposed Supplementary Material .07 permits a member to use a risk-based system to review those transactions.8
Review of communications. Proposed Rule 3110(b)(4) and related proposed supplementary material incorporate guidance in NTM 07-59 regarding the supervision and review of electronic communications. The rule as drafted would require review of all internal communications, not just e-mail. Proposed Supplementary Material .08 permits a member to use risk-based principles to review much of its incoming and outgoing correspondence with the public and its internal communications. The proposed rule also requires a member to identify, and handle in accordance with the firm’s procedures, customer complaints, instructions, funds and securities, and communications containing a subject matter that requires review under FINRA and MSRB rules or the federal securities laws.
Proposed Supplementary Material .10 allows a supervisor/principal to delegate review of communications functions (even to an unregistered person), provided that the supervisor/principal remains ultimately responsible for the performance of all necessary supervisory reviews.9 Proposed Supplementary Material .09 codifies the guidance in Regulatory Notice 07-59 that a member must identify what communication was reviewed, the identity of the reviewer, the date of review and the actions taken by the member as a result of any significant regulatory issues identified during the review. Finally, proposed Supplementary Material .11 requires a member to retain its internal communications and correspondence of associated persons relating to the member’s investment banking or securities business in accordance with SEC Exchange Act Rule 17a-4(b) (three years).
Proposed Rule 3110(b)(5) includes the requirement of Incorporated NYSE Rule 401A that firms acknowledge — in addition to subsequently responding substantively to — all written customer complaints. Thus, firms that are members of FINRA but not of the NYSE would now be required to send such acknowledgements. Although no deadline is stated, FINRA notes in its Notice of Filing that a member would be expected to explain the reasonableness of taking more than 30 days to acknowledge receipt of a customer’s written complaint.
Producing managers. Proposed Rule 3110(b)(6) requires members to have procedures prohibiting associated persons who perform a supervisory function from supervising their own activities and from reporting to, or having their compensation or continued employment determined by (that is, directly controlled by), someone they are supervising. The proposal provides an exception for a member that determines and documents that compliance with either of these conditions is not possible because of the member’s size or a supervisory person’s position within the firm. Proposed Supplementary Material .12 explains that a member generally will need to rely on this exception only because it is a sole proprietor in a single-person firm or where a supervisor holds a very senior executive position within the firm. Proposed Rule 3110(b)(6)(D) requires a member to have procedures to “prevent[ ] the standards of supervision. . .from being reduced in any manner due to any conflicts of interest that may be present with respect to the associated person being supervised,” such as the person’s position or the amount of revenue generated. There is no limited size or resources exception from this provision.
Electronic distribution of supervisory procedures. Proposed Supplementary Material .13 to Rule 3110(b)(7) permits a member to use electronic media to distribute its written supervisory procedures, including any amendments and updates, to each location where supervisory activities are conducted. This alternative is subject to half a dozen conditions, including verification at least once a year that associated persons have reviewed the written supervisory procedures and retention of prior versions of the procedures in compliance with the applicable record retention requirements of Exchange Act Rule 17a-4(e)(7).
FINRA retains the current requirements for office inspections in Rule 3110(c), with some notable additions. The proposal clarifies that the term “annually” means on a calendar-year basis and not a rolling 12-month basis. Also, FINRA proposes to expand the requirement that the inspection include testing and verification of the policies relating to the “supervision of customer accounts serviced by producing managers” to a broader requirement that includes testing and verification of the policies relating generally to the “supervision of supervisory personnel.”
FINRA identifies several examples of types of fund transmittals that should be reviewed. FINRA also adds, with respect to the transmittal of funds between customers and third parties or registered representatives, a requirement that the policies and procedures include a means or method of customer confirmation, notification or follow-up that can be documented. Likewise, FINRA proposes to add a requirement that the policies and procedures include, for each change in customer account information processed, a means or method of customer confirmation, notification or follow-up that can be documented.
Supplementary Material .14 contains the content of NASD IM-3010-1 providing the standards for the reasonable review of office inspections, which had already been harmonized with the review requirements in Incorporated NYSE Rule 342.10. However, because, as noted above, FINRA has now specifically provided in proposed Supplementary Material .01 that a member’s supervisory system include supervision for “all of the member’s business lines, irrespective of whether they require broker-dealer registration,” the scope and impact of this provision will be much broader.
Despite the rule provision that non-branch locations shall be inspected on a “regular periodic schedule,” Supplementary Material .15 provides that there is a general presumption that a non-branch office will be inspected at least once every three years like other non-supervisory offices. Members may rebut this presumption if they document in their written supervisory and inspection procedures the factors used in determining that a longer periodic inspection cycle is appropriate.
FINRA also proposes to replace the heightened office inspection requirements with provisions more generally prohibiting “the inspection standards . . . from being reduced in any manner due to any conflicts of interest.” In Supplementary Material .16, FINRA concedes that, in very limited circumstances, a member may not be able to comply with Rule 3110(c)(3)(A) with respect to who is allowed to conduct an examination.
Proposed Rule 3110(d) incorporates and expands upon the general premise of Incorporated NYSE Rule 342.21. Members are required to have a supervisory process — designed to prevent insider trading and other manipulative conduct — for reviewing transactions in “all securities” (not just NYSE-listed securities and related financial instruments) that are effected for the account(s) of the member and/or the member's associated persons and any other covered account.10 The proposal requires a member promptly to conduct an internal investigation into any identified trade to determine whether a violation has occurred. Further, proposed Rule 3110(d)(2) provides that members that engage in investment banking services must file written reports with FINRA, signed by a senior officer, relating to any internal investigations that result from that business.
New Rule 3120 (Supervisory Control System)
Proposed Rule 3120 would replace NASD Rule 3012. FINRA is retaining the requirements for the testing and verification of a member’s supervisory procedures found in NASD Rule 3012(a)(1). FINRA is also proposing, for certain members, additional content requirements for the annual reports submitted to senior management. The additional content requirements include the annual report content requirements of Incorporated NYSE Rule 342.30 as well as the requirement to report on the compliance efforts in the area of risk management. Recognizing that the additional content requirement imposes a burden on firms, FINRA proposes to have the additional content requirements apply only to members that report $150 million or more in gross revenue on their FOCUS reports in the prior calendar year.
New Rule 3150 (Holding Customer Mail)
Rule 3150 would replace NASD Rule 3110(i) with a more general rule that eliminates the strict time limits in NASD Rule 3110(i). The new rule would generally allow (but not require) a member to hold a customer’s mail for a specific time period in accordance with the customer’s written instructions if the customer will not be receiving mail at his or her usual address, and if the member meets certain conditions, including:
receipt of written instructions from the customer that include the time period during which the member is requested to hold the customer’s mail. If that time period is longer than three consecutive months (including any aggregation of time periods from prior requests), the customer’s instructions must include an acceptable reason for the request (e.g., safety or security concerns). The proposed rule specifies that convenience is not an acceptable reason for holding mail longer than three months.
informing the customer in writing — with confirmation of receipt from the customer — of any alternate methods, such as email or access through the member’s website, that the customer may use to receive or monitor account activity and information
verification at reasonable intervals that the customer’s instructions still apply
In addition, the proposed rule requires that the member be able to communicate, as necessary, with the customer in a timely manner during the time the member is holding the customer’s mail to provide important account information (e.g., privacy notices, the SIPC information disclosures required by FINRA Rule 2266).
If and when these requirements go into effect, members should consider whether, in light of the burden imposed, they will accept such customer instructions, particularly for longer than a short period of time.
NASD Rule 3010(b)(2) will now be FINRA Rule 3170 (tape recording of registered persons), without substantive change.
NASD Rule 3010(e) will now be FINRA Rule 1260 (responsibility of member to investigate applicants for registration), without significant substantive change.11
In light of various concerns raised by these proposed rules, some of which are noted above, and the additional costs that could result, member firms may wish to consider submitting comments to the SEC. Comments are due by July 20, 2011.
1 Regulatory Notice 08-24.
2 The FINRA rulebook consists of FINRA Rules, NASD Rules and rules incorporated from the NYSE. While the NASD Rules generally apply to all FINRA members, the incorporated NYSE Rules apply only to those members of FINRA that are also members of the NYSE.
3 As defined in FINRA By-Laws Art. 1(rr).
4 But see FINRA Rule 3130, which requires a member’s CEO to certify annually that senior executive management has in place processes to establish, maintain, review and test policies and procedures reasonably designed to achieve compliance with, inter alia, MSRB rules (as evidenced in a report submitted to the board of directors).
5 FINRA’s Notice of Filing states that “supplementary material is considered part of the rule and carries the same force of regulation.”
6 Rule 3110(a)(2) as now proposed reads “A member’s supervisory system shall provide, at a minimum, for the following: . . . (2) The designation, where applicable, of an appropriately registered principal(s) with authority to carry out the supervisory responsibilities of the member for each type of business in which it engages for which registration as a broker-dealer is required” (same as current NASD Rule 3010(a)(2)).
7 FINRA notes in its Notice of Filing that, in response to comments, it modified Supplementary Material .05 “to make clear that the presumption applies only to the designation of the on-site principal supervisor required for FINRA Rule 3110(a)(4) purposes in each OSJ location.” Unfortunately, the language of Supplementary Material .05 is not that precise.
8 FINRA’s Notice of Filing explains that “risk based”
describes the type of methodology a member may use to identify and prioritize for review those areas that
pose the greatest risk of potential securities laws and self-regulatory organization (“SRO”) rule violations. . . .
[A] review methodology based on a reasonable sampling of information in which the sample is designed to
discern the degree of overall compliance, the areas that pose the greatest numbers and risks of violation, and
any possibly needed changes to firm policies and procedures. . . . [R]isk-based review . . . ensur[es] that those
areas that pose the greatest potential for investor harm are reviewed more quickly to uncover potential violations.
9 With respect to supervision of such delegated review, FINRA’s Notice of Filing states, “What may be reasonable and appropriate for each firm will depend on the firm’s size, business, structure, etc. Members should look to these factors to determine how they should structure their procedures to demonstrate adequate supervision of delegated functions.
10 Proposed Rule 3110(d)(3)(A) defines the term “covered account” to include “(i) any account held by the spouse, child, son-in-law, or daughter-in-law of a person associated with the member where such account is introduced or carried by the member; (ii) any account in which a person associated with the member has a beneficial interest; and (iii) any account over which a person associated with the member has the authority to make investment decisions.”
11 FINRA had proposed to revise and relocate NASD Rule 3040 (Private Securities Transactions of an Associated Person) as part of this rule promulgation process, but has now decided to address Rule 3040 in a separate proposal.