NASD SUPERVISORY CONTROL AMENDMENTS WORKSHOP TELEPHONE TRANSCRIPT DECEMBER 16, :00 P.M.

Transcription

1 1/11/05 NASD SUPERVISORY CONTROL AMENDMENTS WORKSHOP TELEPHONE TRANSCRIPT DECEMBER 16, :00 P.M. Patricia: Hello. Good afternoon and welcome to the workshop discussing NASD s Supervisory Control Amendments. My name is Patricia Albrecht. I am an assistant general counsel in NASD s Office of General Counsel, Regulatory Policy and Oversight. Our panelists for this workshop are Vicky Berberi-Doumar, a senior attorney in Member Regulation s Office of Regulation Policy, and Eileen Morris, a regulatory analyst in Member Regulation s Examination Program Group. Today s workshop is sponsored by the Office of General Counsel, Regulatory Policy and Oversight, and is intended to act as a forum to provide guidance on the Supervisory Control Amendments, which the SEC approved in final form on September 30, 2004, and which become effective on January 31, This last October, NASD issued Notice to Members 04-71, which provides general guidance regarding the rule changes and their application. However, because we have continued to receive questions regarding the Supervisory Control Amendments, we have decided to conduct this workshop to provide additional guidance. We are also going to discuss the relationship of the Supervisory Control Amendments to new Rule 3013, which, among other things, requires each member s chief executive officer (CEO) to certify annually that it has certain processes in place regarding its supervisory system.

2 2 The format for today s program will be a panel discussion with Vicky and Eileen, which will last approximately an hour. Although the workshop will not contain a question-andanswer period, we previously requested questions from members about today s topic and have attempted to incorporate responses to those questions into today s presentation. Additionally, a transcript of this call will be posted on NASD s Web site. As a word of caution, workshop participants should be aware that nothing in this program constitutes legal advice. This program was created for educational and informational purposes only, and the issues discussed today are NASD staff opinions and have not been reviewed or endorsed by NASD s Board. Members who require legal advice should consult a properly qualified attorney or other professional adviser regarding specific matters relating to their respective businesses. With that caveat, let s begin today s session with Vicky Berberi-Doumar. Vicky, thank you for being here today. I would like to start by providing a little background on the events that gave rise to the Supervisory Control Amendments. Can you tell us what occurred to prompt NASD to propose them? Vicky: Certainly. In 2002, the New York Stock Exchange, and later the SEC, brought disciplinary actions against Frank Gruttadauria, a former registered representative and branch office manager, for allegedly stealing approximately $40 million from his clients. This case brought tremendous attention to the ongoing problem of operational and sales practice abuses at firms and the importance of ensuring that they effectively monitor the

3 3 activities of their employees. In response, NASD proposed the Supervisory Control Amendments, which amended certain NASD rules and interpretive materials and created new Rule I should mention that the New York Stock Exchange also responded by proposing similar rules applicable to its members. Rule 3012 Patricia: Thank you, Vicky. Now that we understand the genesis of the Supervisory Control Amendments, I would like to discuss them in detail. Let s begin with new Rule 3012, which is entitled Supervisory Control System. Eileen, can you provide a brief summary of Rule 3012? Eileen: Certainly. Rule 3012 basically requires members to do two things. First, a member must test and verify that its supervisory procedures are sufficient and amend or create additional supervisory procedures where the testing and verification identify a need. Second, a member must have procedures that are reasonably designed to review and supervise on a day-to-day basis the customer account activity conducted by the member s producing managers. Testing and Verification Patricia: I would like to concentrate for a moment on Rule 3012 s testing and verification requirement. Eileen, can you tell me who is responsible for conducting that

4 4 activity? Eileen: Yes. Rule 3012 requires a member to designate and specifically identify to NASD one or more principals who will be responsible for that function. That person or persons is also responsible for creating or amending the member s supervisory procedures if the testing and verification demonstrates a need to do so. Patricia: Now, you mentioned that members must identify their designated principals to NASD. How should members do that? Eileen: Well previously, Rule 3010(a)(8) required members to identify to NASD the principals responsible for reviewing the members supervisory system. Although Rule 3012 s testing and verification requirement replaces Rule 3010(a)(8), the identification method is similar. Members previously identified the principals responsible for performing Rule 3010(a)(8)'s requirements in their supervisory system. Now, members will need to identify the designated principals in their written supervisory control procedures. Patricia: Do the designated principals have any reporting requirements once they have completed testing and verifying the member s supervisory procedures? Eileen: Yes, they do. Rule 3012 requires them to submit, no less than annually, a report to the member s senior management that details the firm s system of supervisory controls, the summary of the test results, and any additional or amended supervisory

5 5 procedures that have been created in response to those results. Patricia: Since Rule 3012 becomes effective on January 31, 2005, does this mean that members must have designated their principals, completed their testing, and compiled their report by then? Eileen: Firms will need to have designated their principals by January 31, Firms must then complete the testing requirement and resulting report within one year of that date, and at least annually thereafter. Patricia: So, when will NASD staff begin examining for compliance with the rule? Eileen: NASD staff will begin examining for compliance with Rule 3012 and the other rule changes made by the Supervisory Control Amendments as soon as they become effective on January 31 st. Patricia: Thank you. That is good to know. Now, I understand that some members have asked whether they can include certain processes as part of testing and verifying their supervisory procedures. For example, some firms conduct regular self-assessments to determine if they are complying with applicable laws, regulations, and rules. Would members be able to use those self-assessment processes to comply with Rule 3012 s testing and verification requirement?

6 6 Eileen: That is not a determination that NASD can make. Because the processes a member should use to test and verify its supervisory procedures are so dependent on what activities a member conducts, how the member is structured, and the member s existing supervisory procedures, the member s designated principal will need to determine what processes would be adequate testing vehicles. However, with that caveat in mind, if the designated principal decides to use a firm s self-assessment process as a testing mechanism, the principal will need to first determine the sufficiency of that process s methodology and conclusions. Also, if the principal uses the process as a testing mechanism, the report should indicate that the principal has considered the data from the self-assessment process and used it to reach the report s conclusion. Patricia: Would this be the same answer if the member were considering using its current internal audits and inspections to meet the testing and verification requirement? Eileen: Yes, basically, the same response applies to any question regarding the use of a specific testing mechanism. If the principal responsible for the report believes that current internal audits or inspections are helpful, a member may use those. But, again, the principal would need to determine that the internal audits and inspections were sufficient in their methodology and conclusions before using them. Supervision of Producing Managers Patricia: Now, besides the testing, verification, and amendment requirements, Rule

7 also requires that a member review and supervise on a day-to-day basis the customer account activity conducted by its producing managers. Eileen, who can conduct these reviews? Eileen: Only a person who is senior to or otherwise independent of the producing manager can perform the supervisory reviews. Patricia: Okay, but some members business structures may not clearly indicate those persons who are senior to the producing manager. How would they determine who would be senior to the producing manager for purposes of conducting his or her day-today reviews? Eileen: They will need to determine seniority based on a facts and circumstances test. For example, an associated person who does not report to the producing manager, whose compensation is not decided in whole or in part by the producing manager, and who is not subordinate to the producing manager, may be considered senior to the producing manager if that person has the authority to oversee, direct, and correct the manager s activities and take all necessary remedial actions, including termination, if and when necessary. Patricia: Thank you. Now, you also used the term otherwise independent to describe a person who could conduct a producing manager s supervisory reviews. What does that term mean?

8 8 Eileen: An otherwise independent person is someone who: (1) does not report either directly or indirectly to the producing manager under review; (2) is situated in office other than the producing manager; (3) does not otherwise have supervisory responsibility over the activity being reviewed this includes not being directly compensated, either in whole or in part from the revenues accruing from those activities; and (4) who alternates his or her review responsibility with another qualified person every two years or less. Patricia: Now, you just mentioned that an otherwise independent person cannot be compensated based in whole or in part on the revenues accruing from those activities. Does this mean the person s compensation must come from other revenues generated in the firm? Eileen: Well, to some extent we understand that revenues are fungible and that it may be impossible in all cases to tie a member s compensation expense to a particular activity. That noted, what the compensation restriction regarding otherwise independent means is that the person cannot expressly or implicitly have his or her compensation tied to the production or success of the person being supervised. The factors that define an otherwise independent person, especially the compensation restriction, are specifically designed to protect against the possibility that any conflicts of interest may exist that

9 9 might adversely affect the producing manager s supervisory reviews. That is why a firm that decides to use the otherwise independent person standard to conduct the supervisory reviews must be able to meet all of the restrictions outlined in Rule Meeting only some of those restrictions only provides partial protection against potential conflicts of interest. Patricia: But what if the member trying to comply with the senior to or otherwise independent review requirement is a smaller firm and the revenues that the producing manager contributes is a significant portion of the revenues that will fund the wages all of the firm s employees? Eileen: Again, it depends on whether the member considers the compensation of the producing manager s reviewer to be expressly or implicitly tied to the producing manager s revenue or success. If the member s response to this consideration would be yes, and if the member cannot find other persons within the firm who are either senior to or who meet all of the requirements of an otherwise independent person, then it may conclude that it must use Rule 3012 s limited size and resources exception to conduct the producing manager s supervisory reviews. Patricia: Which leads me to my next question how does this limited size and resources exception work? Eileen: The exception allows any member that is so limited in size and resources that it

10 10 does not have associated persons who are either senior to or otherwise independent of its producing managers to use a principal who is sufficiently knowledgeable of the member s supervisory control procedures to conduct the reviews. Patricia: You just stated that the person conducting reviews under the limited size and resources exception must be a principal. But what about a senior to or otherwise independent person conducting reviews? Does that person also have to be a principal? Eileen: No. Only the person conducting reviews under the exception must be a principal. Patricia: But why doesn t the rule require a reviewer who is either senior to or otherwise independent to be a principal? Eileen: Because that requirement has sufficient controls to ensure that a suitably qualified person conducts the supervisory reviews and assumes responsibility for those reviews and their findings. The limited size and resources exception does not have those controls. That is why Rule 3012 mandates that someone conducting supervisory reviews under the exception be a knowledgeable principal. Patricia: So, when can a member use the limited size and resources exception? Eileen: Well, the answer to that question depends entirely on what resources a member

11 11 has to meet the general supervisory requirement. For example, a very small member that is a sole proprietor or has only one or two small offices may look at its resources and find that it does not have enough senior to or otherwise independent persons to conduct the supervisory reviews. The member would then conclude that its only option is to use the limited size and resources exception. But, I should add one additional point about limited size and resources: a firm that has insufficient human resources currently in place may well have the financial resources to bolster its supervisory ranks. Firms will have to take that into account in determining and documenting whether they can rely on this exception. Patricia: Does this mean then that only small firms with little income may use the limited size and resources exception? Eileen: No, Patricia, it does not. A member may have the size and resources to conduct most of the supervisory reviews, but may need to use the exception for certain producing managers because there is no one who is either senior to or otherwise independent of these persons who can conduct their reviews. Patricia: Can you give me any examples? Eileen: Yes, I can. One example would be a member that has senior persons, such as the CEO, who are producing managers. Even if the member has the size and resources to have a person senior to or otherwise independent conduct the reviews of all of its other

12 12 producing managers, it may not have anyone who is either senior to or otherwise independent of its most senior personnel. In that instance, the member may use the exception to conduct those supervisory reviews. Patricia: Okay, but what if that firm still wants to have an otherwise independent person conduct the CEO s day-to-day reviews, instead of using the limited size and resources exception? Could the firm hire a qualified outside person to perform the reviews? Eileen: Before I answer that question, I would just like to mention that the senior to or otherwise independent person requirement was designed with the idea that a member would not need to look outside the firm for persons to conduct its supervisory reviews where its size and resources constrain it from being able to have sufficient personnel who are senior to or otherwise independent from the producing manager. However, as I mentioned a moment ago, some firms may have the financial resources to hire the additional supervisory human resources that they presently do not have and those factors will need to be a part of their analysis. Now, in the case of a producing CEO, by virtue of hiring a registered person to perform the CEO s reviews, that person now becomes associated with the firm. Whether that associated person could be considered otherwise independent would be a facts and circumstances determination that the firm would need to make. However, because the ultimate decision to hire or fire the firm s personnel resides with the CEO, it is unlikely

13 13 that the person hired to conduct the CEO s reviews would be considered otherwise independent of the CEO. That is why NtM recognizes that a firm with a producing CEO can use the limited size and resources exception for the CEO s reviews. Patricia: So let s assume that the member has decided that it needs to use the exception. Does the firm need to document its use? Eileen: Yes. Each firm using the exception will need to document that fact in its supervisory control procedures and explain the factors it used to determine that it could not comply with the requirement to use senior to or otherwise independent persons to conduct its supervisory reviews. Patricia: Okay, so what factors would a firm document in its supervisory control procedures to demonstrate that it must use the exception? Eileen: Firms should include every factor they have considered in making their decision. Those factors may include a precise listing of the firm s size and resources and an explanation of how they cannot be configured to comply with the general supervisory requirement. The firm may also want to include facts like the firm s compensation structure, reporting arrangement, and chain of authority. Obviously, I haven t listed everything that a firm may need to consider and document. That will depend on the firm s business structure and activities.

14 14 Patricia: Thank you for that answer. Now, are there any other documentation requirements? Eileen: Yes, there are. The firm must also explain how its supervisory reviews will still comply, to the extent possible, with the general requirement that someone who is either senior to or otherwise independent of the producing manager conduct the reviews. Patricia: Would you have any examples of how a firm may do that? Eileen: Yes, I do. For instance, if a member firm with senior personnel who are also considered producing managers decides to use the exception to conduct those persons reviews, the firm would consider documenting factors, such as the lack of sufficiently senior personnel to conduct the supervisory reviews and how, to the extent practicable, the persons who are conducting the senior persons supervisory reviews meet the requirements of an otherwise independent person. For example, the persons chosen to conduct the reviews may be qualified principals who would be considered otherwise independent except for the fact that there is an insufficient number to meet the rotation requirement. But, then again, there may be cases where firms are so constrained in size and resources where the persons conducting the review are not otherwise independent to any degree. In those situations, the reasons for this should be documented, as well. Patricia: And what if the reviewers meet all of the otherwise independent factors,

15 15 except that there are not enough to meet the rotation requirement, would that mean it would be acceptable for the firm to use these people to conduct the reviews? Eileen: Yes, that is right. But again, this is true only if the firm is using the limited size and resources exception. Otherwise, the reviewer would have to meet all of the independent person factors. Patricia: Thank you, Eileen for that explanation. Now, I understand that there will be a future notification requirement for firms that elect to use the limited size and resources exception. Is that correct? Eileen: Yes, that is correct. Because the SEC is requiring NASD to notify it of any members that elect to use Rule 3012 s limited size and resources exception, NASD plans to file a rule change to require members to notify NASD if they use the exception. Patricia: How will NASD collect this information? Eileen: NASD will use a Web-based reporting system or other automated electronic platform to collect the information. Patricia: Do you know when the notification requirement will become effective? Eileen: At this point, NASD does not have a definitive effective date for the notification

16 16 requirement. I can tell you that the reporting requirement s effective date will coincide with the completion of the electronic reporting system that firms will need to use to inform NASD that they are using the exception. Initial technology estimates indicate that it should take no more than one year from the date of the SEC s Approval Order, which was September 30, 2004, to construct this system and bring it online. However, we hope to have everything completed well before then. Heightened Supervision Patricia: Thank you, Eileen. Now, let me move on to a discussion of Rule 3012 s heightened supervision requirements. Vicky, can you tell me what these requirements are? Vicky: I d be glad to, Patricia. Rule 3012 requires a member to have procedures that provide heightened supervision over the activities of its producing managers who are responsible for generating 20 percent or more of the revenue of the business units supervised by their supervisors over the course of a rolling, twelve-month period. Patricia: Thank you, Vicky. Now, one of the questions we have received about this requirement is whether a firm should use gross or net revenues in making the 20-percent calculation. Could you tell us which one firms should use? Vicky: I don t think the terms gross and net revenues are necessarily appropriate in

17 17 this context, as those terms can have different meanings in different industries. We used the term revenues to mean the total dollar payment for goods and services before any deductions or offsets. We specifically used that term because we did not want to get into analyses of cost allocations, margins and net income in determining the benchmarks for heightened supervision. Patricia: Thank you. Now, we have also received requests from members asking for a definition of the term business units. What can you tell us about that term? Vicky: Firms should understand that business units is not meant to be a limiting term with a restrictive definition that applies uniformly to all types of business structures. Rather, it is used in a manner that recognizes that members have different business models with potentially different meanings of the term business units. In this context, the term provides members with a general means of gathering all of the revenue sources that the producing manager s supervisor is responsible for supervising so that the firm may compare that figure to the portion of that amount that the producing manager is responsible for generating. Let me give you an example that is not intended to comport with how supervision is actually conducted, but rather, is designed to highlight meaning of what I have just said. A supervisor supervises one of three firm proprietary trading desks with $200,000 in revenues, a sub-unit of insurance sales with $300,000 in revenues, and a producing manager with $200,000 in revenues, for a total of $700,000 in revenue. Each one of

18 18 these revenue sources is part of a different business unit but none is a complete business unit by itself. However, because the term business unit is not intended as a limiting term, that fact is not relevant. In this example, the producing manager is responsible for $200,000 of the total $700,000 in revenue, in other words, just over 28 percent of the revenues his supervisor oversees. Accordingly, he would be subject to heightened supervision under Rule Patricia: Thank you, Vicky. A related question we have received is whether Rule 3012 requires a firm to include the producing manger s personal production when the firm is determining the total production of all of the business units supervised by the producing manager s supervisor. Vicky: Yes, it does. Rule 3012 specifically includes revenue generated by the producing manager as part of the revenue of the business units supervised by his or her supervisor. Patricia: Would someone who only manages a few accounts for family and friends be considered a producing manager for purposes of Rule 3012 s heightened supervision requirements? Vicky: Yes, that person would be included. There is no minimum amount of revenue an associated person must generate to be considered a producing manager. As stated in NtM 04-71, an associated person is considered a producing manager regardless of the amount of customer account activity the person conducts. Therefore, even if the person is only

19 19 managing a few accounts for family and friends, the person is considered a producing manager for purposes of Rule Obviously, this would mean the person is subject to all of Rule 3012 s provisions, including the heightened supervision requirements, if that person meets the 20-percent threshold. Patricia: Does this mean then that, even if the producing manager s personal production is not a large amount of revenue, a firm will have to have heightened supervision for that producing manager if the amount of his personal production plus the revenue generated by his office meets the 20-percent threshold? Vicky: Yes, it does. As I mentioned, Rule 3012 specifically requires a firm to take into account all of the revenue generated by or credited to the producing manager or his office. Rule 3012 does not place more emphasis on a producing manager s personal production than it does on the production that person oversees. A producing manager may be able to exert control over, or otherwise be critical to, either type of revenue. Patricia: Thank you for that explanation. Now, would an otherwise independent person who is conducting a producing manager s review be considered a producing manager s supervisor for purposes of the heightened supervision requirement? Vicky: No, an otherwise independent person is not considered to be the producing manager s supervisor for purposes of determining if heightened supervision is required. As Eileen mentioned earlier, the factors that define an otherwise independent person

20 20 already protect against the possibility that any conflicts of interest may exist that might adversely affect the producing manager s supervisory reviews. Patricia: So, now that we understand the mechanics of the heightened supervision calculation, let s discuss what Rule 3012 means when it refers to heightened supervision. Does Rule 3012 have a specific definition of that term? Vicky: Yes, Patricia, it does. Rule 3012 defines the term heightened supervision as those supervisory procedures that are designed to avoid conflicts of interest that serve to undermine complete and effective supervision because of the economic, commercial, or financial interests that the supervisor holds in the associated persons and businesses being supervised. Patricia: That is a good definition, but do we know what type of heightened supervisory procedures the definition is actually describing? Vicky: The answer to that question depends entirely on the type of business activities a firm is engaged in and its business structure. However, depending on a member s circumstances, heightened supervisory procedures may include such elements as unannounced supervisory reviews, more complete sampling sizes, an increased number of supervisory reviews by different reviewers within a certain period, a broader scope of activities reviewed, and/or having one or more principals approve the supervisory review of those producing managers. I would like to mention that these examples only serve to

21 21 illustrate the kinds of procedures a member might want to include. They are not meant to be an exclusive or exhaustive list. Activities that Require Individualized Policies and Procedures Patricia: Thank you, Vicky. Now, in addition to the testing and verification and the supervisory review requirements, Rule 3012 also requires that a firm have procedures that are reasonably designed to review and monitor certain activities. I would like to discuss these for a moment. Vicky, can you tell me what these activities are? Vicky: Certainly. Rule 3012 requires procedures that will review and monitor all transmittals of funds or securities: 1. from customers to third-party accounts -- for example, a transmittal that would result in a change of beneficial ownership; 2. from customer accounts to outside entities, such as banks and investment companies; 3. from customer accounts to locations other than a customer s primary residence, such as a post office box, in care of accounts, or alternate address; and 4. between customers and registered representatives, including the hand delivery of checks. Patricia: Now, one of the questions we have received on this topic is whether the transmittal of funds by a customer to purchase shares directly from the mutual fund

22 22 company would need to be monitored under Rule Vicky: If those funds are coming from the customer s account, then the answer is yes. As I just mentioned, the transactions to be monitored include any transmittals of funds or securities from a customer s account to outside entities. This would include transmittals to a mutual fund company. Patricia: Thank you, Vicky. Are there any other things Rule 3012 expressly requires firms to monitor? Vicky: Yes, Rule 3012 also requires members to monitor and validate any customer changes of address or investment objectives. I would just like to mention, that for all of the activities and changes I have mentioned, Rule 3012 requires members to have a method of customer confirmation, notification, or follow-up that can be documented. Patricia: What if a member does not engage in all of these activities? Is the member still required to have procedures for those activities? Vicky: No. NASD does not expect a member to have supervisory policies and procedures for activities in which it does not engage. However, a member must identify those activities it doesn t engage in and document that it will need additional supervisory policies and procedures before it ever engages in them.

23 23 Patricia: Thank you. This may now be a good time to break from discussing Rule 3012 s specific requirements and discuss a few general questions about the rule that we have received. The first question is whether Rule 3012 s requirements apply to members institutional business activities, as well as their retail business activities. Vicky: Yes, it does. In fact the Supervisory Control Amendments, in their entirety, apply to all members securities activities, including any institutional securities activities they conduct. NASD is aware that members have questioned how to apply certain aspects of the Supervisory Control Amendments to their institutional business and is hoping to issue additional guidance on that subject in coordination with the New York Stock Exchange in the near future. Patricia: Thank you, Vicky. Another general question we have received is whether NASD plans to provide templates for firms to use to help them create the written supervisory control policies and procedures required by Rule Vicky: There are currently no plans to provide templates. Given the fact that firms will need to write their supervisory control procedures based on their business models and lines of business, which vary widely among NASD members, it would not be possible to provide workable templates that all firms could use. Dual Members Compliance with Substantially Similar NYSE Requirements

24 24 Patricia: Now, that we have answered those questions, I would like to discuss an issue that applies only to our dual members. I understand that Rule 3012 provides that NASD members that are also New York Stock Exchange members may comply with Rule 3012 s requirements if they comply with substantially similar New York Stock Exchange requirements. Is that correct? Vicky: Yes, that is correct. This means that if a dual member decides to comply with similar New York Stock Exchange Rule , instead of the provisions of Rule 3012, that member will be considered to be in compliance with Rule 3012, as long as the dual member complies with New York Stock Exchange Rule in its entirety. [This text has been amended to clarify information provided during the call-in workshop.] Rule Supervision Patricia: Thank you, Vicky and Eileen for explaining new Rule I would now like to turn to the changes that the Supervisory Control Amendments have made to Rule 3010 s provisions regarding members office inspection requirements. Mandatory Inspection Cycles Patricia: One of those changes is the codification of minimum office inspection cycles. Vicky, what does Rule 3010 now require members to do?

25 25 Vicky: Well, one of the first things amended Rule 3010 now requires is that members inspect each supervisory branch office at least annually. This is in addition to Rule 3010 s existing requirement that members inspect, at least annually, each office of supervisory jurisdiction (OSJ). Patricia: Vicky, what is a supervisory branch office? Vicky: A supervisory branch office is any location that is responsible for supervising the activities of persons associated with a member at one or more of a member s non-branch office locations. Patricia: Great. Now that brings me to the subject of non-supervisory branch offices. How often does Rule 3010 require members to inspect those locations? Vicky: Rule 3010 requires a member to inspect all non-supervisory branch offices, at a minimum, every three years. Patricia: Are there any factors a member must consider when establishing how often to inspect its non-supervisory branch offices? Vicky: Yes, there are. A member must consider whether the nature and complexity of a branch office s securities activities, the branch office s volume of business, and the number of associated persons assigned to the branch office require inspections more

26 26 frequently than once every three years. Also, a member must document in its written supervisory and inspection procedures the examination cycle and an explanation of the factors used in determining the frequency of the cycle. Patricia: What if a member inspects its non-supervisory branch offices more frequently than once every three years, but only inspects certain activities of those offices during each visit. Would the member still be in compliance with Rule 3010? Vicky: NASD understands that a general practice exists where a member may inspect non-supervisory branch offices on a more frequent cycle than once every three years but target only certain areas of the offices activities during a particular examination. However, a member following this practice must inspect all of the areas Rule 3010 requires to be examined within the three-year cycle, regardless of the number of times within that cycle the office is inspected. Also, a member must document in its written supervisory and inspection procedures how it will inspect those areas within the threeyear cycle. Patricia: So, now that we have covered branch offices, can you tell us how often members must inspect their non-branch offices? Vicky: Rule 3010 requires a member to inspect every non-branch location on a regular periodic schedule.

27 27 Patricia: What exactly is a non-branch location or office? Vicky: A non-branch location or office is any location that does not conform to Rule 3010 s branch office definition or is specifically excluded by the definition from being a branch office. Patricia: That is good to know. So, what factors must a member consider in establishing a regular periodic schedule of its non-branch locations? Vicky: A member must consider the nature and complexity of the non-branch location s securities activities and the nature and extent of contact with customers and, again, must set forth in its written supervisory and inspection procedures an explanation regarding how the member determined the frequency of the examination schedule selected. Patricia: Thank you, Vicky, for that overview of the mandatory inspection cycles. I would now like to ask a question on this subject that a number of members have asked, which is how does a firm inspect a site that is considered a location of convenience? But before answering that question, could you please tell us what a location of convenience is? Vicky: Certainly. Rule 3010 s branch office definition describes a location of convenience as any location where a person conducts business on behalf of the member occasionally and exclusively by appointment for the customer s convenience. Now,

28 28 often a location of convenience will be an office in a bank affiliated with the member firm. But sometimes, because the meeting is being arranged for the customer s convenience, the meeting place could be, for example, a hotel conference center or other area that is close to the customer. Patricia: I understand that Rule 3010 s branch office definition excludes locations of convenience from being branch offices. I assume that means that they are considered non-branch locations that must be examined on a regular periodic schedule. Is that correct? Vicky: Yes, that is correct. Patricia: Yet, I also understand that because these locations are often not readily suited to keeping records, any records of the business conducted there are usually not kept at the site. How then does a member inspect a location, if there are no records at the location to be examined? Vicky: Well, the first thing a member may want to consider is whether an associated person using a location of convenience would have a certain amount of control over that place that would make it possible for the person to keep records of any business conducted there. If so, a member should consider whether to physically visit the site of the location of convenience. For instance, it is unlikely that an associated person would have sufficient control over a hotel conference center to be able to maintain

29 29 records at that facility, but if an associated person goes to a company on a once-a-month basis to conduct business and is provided an office for that purpose, the associated person may have enough control over that location to be able to maintain records there. In any event, a member may still want to visit the address of any locations of convenience to ensure that they actually exist and are accurately represented in the member s records. Just because a member s records list the address of a location of convenience as a local restaurant does not mean that the member should just rely upon that information without checking to make sure that the restaurant is really there. The firm may also want to ensure that it has records of any business conducted at a location of convenience, even if they are kept at another location. For example, a member firm may want to require each associated person to record when a customer requests to meet at a location of convenience, where the location of convenience is situated, how often the associated person uses any location of convenience, and what kind of business is conducted at these locations of convenience. Patricia: Thank you, Vicky, for that explanation. Now, I understand that members must make a written report of their office inspections. How long do they have to keep these reports on file? Vicky: Members have to keep them on file for a minimum of three years, unless the offices are being inspected on a cycle that is longer than that. If they are, then members must keep the reports on file at least until the next reports for those offices have been

30 30 written. Required Content and Recordkeeping Requirements for Inspection Reports Patricia: Thank you, Vicky. I would now like to turn to Eileen and ask if she would explain what a written inspection report must include. Eileen: I would be happy to. Rule 3010 requires that a written inspection report include, without limitation, the testing and verification of the member s policies and procedures, including supervisory policies and procedures in the following areas: 1. Safeguarding customer funds and securities; 2. Maintaining books and records; 3. Supervising customer accounts serviced by branch office managers; 4. Transmitting funds between customers and registered representatives and between customers and third parties; 5. Validating customer address changes; and 6. Validating changes in customer account information. Patricia: But what if a member does not conduct all of the activities you just mentioned. Does the member still need to have supervisory policies and procedures for those areas? Eileen: No. NASD does not expect a member to have in place procedures for activities in which it does not engage. However, Rule 3010 does require that a member identify in

31 31 the written inspection report the activities it does not engage in and also document that supervisory policies and procedures for those activities must be in place before the member can engage in them. Limited Size and Resources Exception Patricia: Thank you, Eileen, for that information. I understand that Rule 3010 also prohibits certain persons from conducting office inspections, is that correct? Eileen: Yes, that is correct. Rule 3010 prohibits a branch office manager or any person within that office who has supervisory responsibilities or any individual who is directly or indirectly supervised by such persons from conducting office inspections. Patricia: Now, what if a member has someone managing a branch office, but does not specifically call that person a branch office manager? Would that person still be considered a branch office manager for purposes of Rule 3010? Eileen: The term branch office manager is not meant to be a restrictive term. Rather, it refers to anyone, regardless of his or her official title, who performs the same or similar supervisory function a branch office manager generally performs. Patricia: Is there any exception to the prohibition on who can conduct office inspections?

32 32 Eileen: Yes, Patricia, there is. Because NASD understands that members have different business models or may be so limited in size and resources that they are not able to comply fully with the restrictions on who may conduct an office inspection, Rule 3010 provides a limited size and resources exception. Under the exception, a member firm can use any principals that have the requisite knowledge to conduct those inspections. Patricia: Now, you just mentioned that the persons conducting the inspections under the exception have to be principals. But what about the people who can conduct inspections under the general requirement? Do they also have to be principals? Eileen: No, they do not. Only the people who conduct the inspections under the exception have to be principals. Patricia: Is there a reason for this requirement? Eileen: The reason is similar to Rule 3012 s requirement that the people conducting supervisory reviews under that rule s limited size and resources exception be principals. Basically, the requirement that a principal conduct the inspections performed under the exception is designed to ensure that, in the absence of a firm s ability to meet the general restrictions on who may conduct office inspections, a suitably qualified person will conduct the office inspections and assume responsibility for the inspections and the reports generated by them.

33 33 Patricia: So, exactly how would a member determine if it can use the exception? Eileen: There is no set answer for this question. Whether a firm is so limited in its size and resources that it cannot comply with the general requirement is a facts and circumstances analysis that only the individual firm can make. However, I should mention that this exception, similar to the limited size and resources exception in Rule 3012, should be narrowly construed. For instance, although Rule 3010 provides as an example of limited size and resources, a member with only one office, this does not mean that any member with one physical location may use the limited size and resources exception. The example in the rule text is meant to illustrate a small member, such as a member with a single-person office. A member that has one physical location that includes a single production office, yet is so big that there are other departments, such as corporate offices, technology offices, etc., could be of sufficient size and resources such that there would be someone within the firm outside the production office that could conduct the inspection. In addition, as we mentioned in the context of Rule 3012, a member may have insufficient human resources to conduct office inspections under the general requirement but has sufficient financial resources to bolster its ranks to be able to meet the general requirement. The firm will have to take that into account in determining and documenting whether it can rely on the exception.

34 34 Patricia: Okay. If members determine they need to use the exception, do they need to document that use? Eileen: Yes, they do. Members must document in their office inspection reports that their size and resources are such that they have no other alternative than to use the exception. Patricia: How would they do that? Eileen: It is up to the individual members to determine how best they should document that their situation requires that they use the exception. However, one method of documentation would be to include in the inspection report a precise listing of the firm s size and resources and how they cannot be configured to comply with the general inspection requirement. Patricia: Many NASD members use an independent dealer or independent contractor model that generally consists of a number of small or single-person offices that report directly to an OSJ manager who is also considered the branch office manager of all of these offices. Would these members be eligible to use the limited size and resources exception in Rule 3010? Eileen: Yes, in that instance, a member firm may use Rule 3010 s exception regardless of its size and resources to inspect its small or single-person offices. However, the

35 35 member cannot use the exception for its OSJ inspection unless it has determined that it is so limited in size and resources that it cannot comply with the general inspection requirement for that location. Patricia: Eileen, do you have any other information for firms that may be considering using this exception? Eileen: Yes, I do. I would like firms to be aware that, other than those firms using the exception as a result of their independent dealer or independent contractor business model, members should understand that the limited size and resources exception is designed for those firms that genuinely need relief from the general inspection requirement. Firms should not construct their business models specifically to take advantage of the exception. If they do, they will be considered to be violating Rule Heightened Inspection Requirements Patricia: Thank you, Eileen. Now, Vicky, I understand that Rule 3010 has heightened inspection requirements. Can you tell me what they are? Vicky: Certainly. Rule 3010 requires a member to have in place heightened inspection procedures if two conditions are met: (1) the person conducting the inspection reports to the branch office manager s supervisor or works in an office supervised by the branch manager s supervisor; and (2) the branch office manager generates 20 percent or more of

36 36 the revenue of the business units supervised by his or her supervisor over the course of a rolling twelve-month period. Patricia: So, what exactly does the term heightened inspection mean? Vicky: Rule 3010 s term heightened inspection means those inspection procedures that are designed to avoid conflicts of interest that serve to undermine complete and effective inspection because of the economic, commercial, or financial interests that the branch manger s supervisor holds in the associated persons and businesses being inspected. Patricia: I notice that Rule 3010 s heightened inspection definition is very similar to Rule 3012 s heightened supervision definition. Is Rule 3010 s 20-percent threshold that triggers the heightened inspection requirement also similar to Rule 3012 s 20-percent threshold trigger? Vicky: They are very similar. Both 20-percent thresholds are a trigger for determining when a member must put in place additional procedures, either heightened supervisory procedures under Rule 3012, or heightened inspection procedures under Rule And similar to the calculation required in Rule 3012, to calculate Rule 3010 s 20-percent threshold, a member must attribute all of the revenue generated by or credited to the branch manager or his or her office as part of the overall revenues of the business units

37 37 supervised by the branch manager s supervisor irrespective of a member s internal allocation of revenues. Patricia: But how should firms calculate Rule 3010 s 20-percent threshold if the branch manager is supervised by the member s compliance department rather than having an individual supervisor? Vicky: In that situation, the member would attribute the branch office manager s revenue to a business unit supervised by the compliance department. If that revenue constitutes 20 percent or more of all of the supervised revenue attributable to the compliance department, then the member must have in place heightened inspection procedures. Patricia: What types of heightened inspection procedures should members have in place if they trigger the 20-percent threshold? Vicky: Just like the answer to the question regarding the type of heightened supervisory procedures Rule 3012 would require, the answer depends entirely on the type of business activities a firm is engaged in and its business structure. Depending on a member s circumstances, heightened inspection procedures may include such elements as unannounced office inspections, increased frequency of inspections, broader sampling of sizes, a broader scope of activities inspected, and/or having one or more principals review and approve the office inspections. I am mentioning these examples only to illustrate the