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94-7 SEC Approves New NASD Rule Relating To The Obligations And Responsibilities Of Introducing And Clearing Firms

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Executive Summary

On January 24, 1994, the Securities and Exchange Commission (SEC) approved new Section 47, Article III, of the Rules of Fair Practice that requires members entering into clearing or carrying agreements to specify the obligations and supervisory responsibilities of both the introducing and clearing firm. The text of the amendment, which takes effect April 15, 1994, follows the discussion below.

Background And Description Of The Amendment

On January 24, 1994, the SEC approved an amendment adding a new section to Article III of the Rules of Fair Practice that requires members entering into clearing or carrying agreements to specify the obligations and supervisory responsibilities of both the introducing and clearing firm.

The NASD does not currently require its members who enter into clearing or carrying agreements to specify the respective functions and responsibilities of each party. New York Stock Exchange (NYSE) Rule 382 and American Stock Exchange (Amex) Rule 400, which are identical, require respective exchange members to submit carrying agreements to the exchange for approval before becoming effective and to identify the party responsible for certain enumerated functions.

At the time of SEC consideration of the NYSE proposed rule relating to the respective obligations of introducing and clearing firms, the NASD commented to the SEC that permitting certain functions to be allocated to the introducing firm may result in compliance failures and violations resulting from the inability of the introducing member to adequately perform such functions. The NASD urged, and the SEC noted in its approval of NYSE Rule 382, that firms should not be permitted to avoid obligations or responsibilities that would otherwise be theirs under the securities laws. The NASD believes that the new rule reflects those principles.

Allocation Of Functions

The first seven provisions of new Subsection (a) of new Section 47, Article III, of the Rules of Fair Practice mirror the provisions of NYSE Rule 382(b) and require that all clearing or carrying agreements entered into by any member specify, at a minimum, the respective functions and responsibilities of the parties to the agreement with regard to: opening and approving customer accounts, extending credit, keeping books and records, receiving and delivering funds and securities, safeguarding funds and securities, preparing confirmations and statements, and accepting orders and executing transactions.

Subsection (a)(8) requires the agreement to address whether, for purposes of the Securities Investor Protection Act and the financial responsibility rules adopted under the Securities Exchange Act of 1934, customers are customers of the clearing member. If an introducing member intends to qualify for lower net capital, the clearing or carrying agreement must clearly state that the customers are customers of the clearing member. Absent such a provision, the SEC net capital rule classifies the introducing member as a firm in possession of customer funds or securities subject to higher net capital requirements. Subsection (a)(9) requires designation of who notifies the customer of the agreement as required under Subsection (d) of the rule, discussed below. Finally, Subsection (a) provides that its requirements do not apply to clearing or carrying agreements if either party to the agreement is also subject to a comparable rule of a national securities exchange.

Regardless of the procedural requirements concerning submission of the clearing agreement to the NASD (discussed below), as of the effective date of the new rule, all clearing agreements to which an NASD member is a party must comply with the substantive provisions of Subsection (a). Thus, any agreement not currently in compliance with Subsection (a) must either be amended or terminated on or before the effective date of the new rule.

Filing Requirements

Subsections (b) and (c) impose filing requirements for new agreements and amendments to agreements. Subsection (b) requires any clearing member designated to the NASD for compliance oversight to file with the NASD Compliance Department, 1735 K Street, NW, Washington, DC 20006–1500 for review and approval (1) any new clearing or carrying agreement entered into with an introducing member, and (2) any amended clearing or carrying agreement where any item enumerated in Subsections (a)(1) through (a)(9) has been revised.

Subsection (c) requires any introducing member designated to the NASD for compliance oversight to file with the introducing member's local NASD district office for review only (1) any new clearing or carrying agreement entered into with a clearing member, and (2) any amended clearing or carrying agreement entered into with a clearing member designated to another self-regulatory organization for oversight where any item enumerated in Subsections (a)(1) through (a)(9) has been revised. The submission by the introducing firm to its NASD district office either a new or amended agreement for review presumes that such agreement has already been submitted to the NASD or a national securities exchange by the clearing firm and approved.

Customer Notification

Subsection (d) requires each customer whose account is introduced on a fully disclosed basis to be notified of the existence of the clearing agreement at the time the account is opened. As set forth above, Subsection (d)(9) requires that the agreement specify whether the clearing or introducing member will be responsible for compliance with this provision.

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The amendment takes effect April 15, 1994. Questions regarding this Notice should be directed to Elliott R. Curzon, Senior Attorney, (202) 728-8451, and Robert J. Smith, Attorney, (202) 728-8176, at the Office of General Counsel.

Text Of New Section 47, Article III, Of The Rules Of Fair Practice Regarding Obligations And Responsibilities Of Clearing And Introducing Firms

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(Note: New language is underlined.)

Clearing Agreements

Sec. 47.

(a) All clearing or carrying agreements entered into by a member. except where any party to the agreement is also subject to a comparable rule of a national securities exchange, shall specify the respective functions and responsibilities of each party to the agreement and shall, at a minimum, specify the responsibility of each party with respect to each of the following matters:
(1) opening, approving and monitoring customer accounts:
(2) extension of credit:
(3) maintenance of books and records:
(4) receipt and delivery of funds and securities:
(5) safeguarding of funds and securities:
(6) confirmations and statements:
(7) acceptance of orders and execution of transactions:
(8) whether, for purposes of the Securities and Exchange Commission's financial responsibility rules adopted under the Securities Exchange Act of 1934. as amended, and the Securities Investor Protection Act, as amended, and regulations adopted there under, customers are customers of the clearing member: and
(9) the requirement to provide customer notification under Subsection (d) of this Section.
(b) Whenever a clearing member designated to the NASD for oversight pursuant to Section 17 of the Securities Exchange Act of 1934, as amended, or a rule of the Securities and Exchange Commission adopted thereunder, amends any of its clearing or carrying agreements with respect to any item enumerated in Subsections (a)(1) through (a)(9) of this Section or enters into a new clearing or carrying agreement with an introducing member, the clearing member shall submit the agreement to the NASD for review and approval.
(c) Whenever an introducing member designated to the NASD for oversight pursuant to Section 17 of the Securities Exchange Act of 1934, as amended, or a rule of the Securities and Exchange Commission adopted thereunder. amends its clearing or carrying agreement with a clearing member designated to another self-regulatory organization for oversight with upon the opening of his account of respect to any item enumerated in Subsections (a)(1) through (a)(9) of this Section or enters into a new clearing agreement with another clearing member, the introducing member shall submit the agreement to its local NASD district office for review
(d) Each customer whose account is introduced on a fully disclosed basis shall be notified in writing the existence of the clearing or carrying agreement.

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