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93-50 Mail Vote — Proposed New Section to the Rules of Fair Practice Relating to the Respective Obligations And Supervisory Responsibilities of Introducing and Clearing Firms;

Last Voting Date: September 27, 1993

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Executive Summary

The NASD invites members to vote on a proposed new section to the Rules of Fair Practice that would require 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 proposed rule follows this Notice.

Background and Description of Proposal

The NASD is proposing to amend the Rules of Fair Practice to require that all clearing or carrying agreements entered into by a member specify the respective functions and responsibilities of each party to the agreement. The proposed rule clarifies the obligations and supervisory responsibilities of clearing and introducing firms. The Board of Governors believes it is important for the NASD to adopt a standard for such agreements that is similar to New York Stock Exchange (NYSE) Rule 382.

Further, when the Securities and Exchange Commission (SEC) considered the NYSE's Rule 382, 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 perform those functions adequately. The NASD urged that firms should not be permitted to avoid obligations or responsibilities that would otherwise be theirs under the securities laws. In approving NYSE Rule 382, the SEC recognized the NASD's concerns and stated "no contractual arrangement for the allocation of functions between an introducing and carrying organization can operate to relieve either organization from their respective responsibilities under federal securities laws and applicable SRO [self-regulatory organization] rules." The Board believes that the rule proposed herein reflects the principles previously asserted by the NASD and noted by the SEC.

Subsection (a) of the rule as originally proposed for member comment required 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, receipt and delivery of funds and securities, safeguarding funds and securities, preparing confirmations and statements, and accepting orders and executing transactions.

Subsection (a) of the rule as currently proposed retains these seven requirements and adds two new ones. Proposed 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, then 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 will treat the introducing member as a firm in possession of customer funds or securities subject to the higher net capital requirements of such a designation. Proposed Subsection (a)(9) requires the agreement to address the customer notification requirement of Subsection (d) of the proposed rule, discussed below. Finally, Subsection (a) does not apply to the content of the agreement if either party is also subject to a comparable rule of a national securities exchange.

Subsections (b) and (c) impose filing requirements for new agreements or amendments to agreements. Subsection (b) requires any clearing member designated to the NASD for compliance oversight to file with the NASD for review and approval any new clearing or carrying agreement entered into with an introducing member and any amended clearing or carrying agreement that revises any item enumerated in Subsections (a)(1) through (a)(9).

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 any new clearing or carrying agreement entered into with a clearing member and any amended clearing or carrying agreement, entered into with a clearing member designated to another self-regulatory organization (SRO) for oversight, that revises any item enumerated in Subsections (a)(1) through (a)(9). Unlike agreements for approval, agreements submitted for review are effective when executed.

Subsection (d) requires members to notify each customer, whose account is introduced on a fully disclosed basis, of the existence of the clearing agreement when the account is opened.

Member Comments

The NASD published the proposed rule change for comment in Notice to Members 92-32 (December 1991). In response to the comments received, the Board amended the original proposal.

Subsection (d) of the rule change as originally proposed for member comment required more specific disclosure than its analogous subsection in NYSE Rule 382(c). The Board modified Subsection (d) to make its meaning consistent with the text of NYSE Rule 382(c) to respond to commenters who argued that the disparity in disclosure requirements could lead to different disclosure standards and practices among SROs.

Other commenters argued that the proposed rule's informational and filing requirements would create necessarily duplicative filing requirements and add administrative and compliance burdens to member firms. The Board recognized the burden and amended the rule to provide that only new clearing agreements would have to be filed with the NASD by both the introducing and clearing member if the clearing member were not designated to another SRO for oversight. However, if the clearing member is designated to another SRO for oversight, an amended agreement submitted by an introducing member to the NASD will have already been submitted by the clearing firm for review and approval by the SRO, thus obviating the need for the clearing firm to submit the same agreement to the NASD. In addition, an amended agreement that does not change any of the enumerated functions in Subsection (a) of the proposed rule need not be filed. Finally, the filing by the introducing member is a submission for review only and does not require approval by the NASD before becoming effective.

Request for Vote

The Board believes that it is appropriate to add a new rule 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. In addition to creating consistency and uniformity in the regulation of clearing arrangements by all SROs on an industry-wide basis, the proposal would reduce customer confusion regarding the identity of the responsible party when questions or concerns arise. The Board considers the proposed provision necessary and appropriate and recommends that members vote their approval.

The text of the proposed new rule that requires member vote is below. Please mark the attached ballot according to your convictions and mail it in the enclosed, stamped envelope to the Corporation Trust Company. Ballots must be postmarked by no later than September 27, 1993. If approved by the members, the amendment will not be effective until it is filed with and approved by the SEC.

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 Proposed Rule

(Note: New language is underlined.)

Clearing Agreements

(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 thereunder, 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 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 upon the opening of his account of the existence of the clearing or carrying agreement.

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