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95-84 Rudman Committee Releases Summary Of Conclusions And Recommendations

SUGGESTED ROUTING

Senior Management
Legal & Compliance
Registration
Systems
Trading

Below are the summary conclusions and recommendations that the Rudman Committee released on Tuesday, September 19, 1995.

Overall Conclusions

Based on its Review, the Select Committee concludes that the NASD® has discharged its self-regulatory responsibilities, not of course with perfection or without difficulty, but professionally and reasonably. The NASD's role as the primary regulator of the broker/dealer profession and the non-exchange securities markets, combined with its stewardship of the vast Nasdaq® market, is both difficult and unique. No other SRO is faced with such complex and challenging obligations.

The Committee's Review does not support the claims of those who assert that the NASD is controlled by and for the benefit of Nasdaq market makers. Nor does it support those who assert that the NASD cloaks in regulatory garb actions that are in fact designed solely to advance the commercial interests of certain segments of the NASD's membership.

The Select Committee does find, however, that the NASD's governance structure has failed to keep pace with the significant growth and continuing evolution of the Nasdaq market, and the concomitant expansion of the NASD's regulatory responsibilities. In some cases, the existing governance structure has led to ineffective rulemaking for the Nasdaq market. In others, it has required the NASD to mediate economic clashes among its members arising from their divergent interests in the Nasdaq market—a daunting role which the NASD, as a membership association and regulator of the entire broker/dealer profession, did not seek and was never designed to play. The current structure has also placed the NASD, as the owner of Nasdaq's trading systems, in the unenviable position of regulating the competing systems owned by NASD members.

The NASD's existing governance structure thus blurs the distinction between regulating the broker/dealer profession and overseeing the Nasdaq stock market. Both missions are thereby disserved.

The NASD's existing structure would also benefit from increasing public representation on the NASD's governing bodies. Not only would a full measure of public representation befit the NASD's current stature and importance, it should also bolster confidence in the NASD's policies. It would not be inconsistent with self-regulation, because NASD members would still be fairly represented in the Association's affairs and have ample opportunity to bring their expertise and viewpoint to bear.

Regarding NASD enforcement, the Committee believes that the core of the NASD's disciplinary process is sound. No doubt, mistakes have been made, and some judgments certainly can be questioned in retrospect, but the overall process is designed to be effective and fair. At the same time, however, NASD disciplinary proceedings have become more contentious, complex, and consequential than the existing system was designed to accommodate. New measures are required to address these developments.

This will entail certain changes significant in the conduct of most NASD disciplinary proceedings. It will also entail greater national oversight within the NASD itself, greater public participation, more frequent, formal coordination of enforcement efforts with the SEC, the states and the major securities exchanges, and prompt deployment of increased financial and human resources. The Committee believes that these measures can be implemented without compromising the principle of peer review.

Finally, the Committee believes that the critical internal review function (including regular district audits) has not been given the mandate, resources, or prominence necessary for effective oversight within the NASD itself. Significant improvement is required.

Principles Of Effective Governance

Based on its Review, the Committee believes that, to be fully effective, the NASD's governance structure should conform to the following principles:

  • The NASD and the Nasdaq market should not be divorced, but regulation of the broker/dealer profession should otherwise be separated from and performed independently of regulation of the Nasdaq and other OTC markets.

  • To this end, the governing Board charged with regulating the NASD's member firms should be separate and independent from the governing Board responsible for overseeing the Nasdaq market. So, too, should their respective professional staffs. Those two governing Boards and staffs, however, should remain associated within a single SRO structure. This will maintain the strength of the existing NASD organization in linking commercial and technical expertise to regulation so that each informs and enhances the other.

  • In all events, enforcement should be independent of responsibility for the Nasdaq and other OTC markets and should be the paramount task of the Board charged with regulating the broker/dealer profession.

  • The separate governing Boards responsible for regulating the broker/dealer profession and for regulating the Nasdaq market should each have 50 percent public membership. The parent (or equivalent) Board should have a majority of public members. Other governing bodies with substantial policymaking or oversight authority also should have strong public representation, as appropriate to their specific tasks.

  • The public members of the Boards and other governing bodies, though not affiliated with NASD member firms, should have sufficient knowledge, experience, and interest in the securities industry or markets to play a meaningful role in governance, and should represent a wide spectrum of skills and interests.

  • Apart from public representation, the composition of the separate governing Boards should be tailored to reflect the interests of their respective constituencies.

  • In addition, the composition of the Board responsible for regulating the broker/dealer profession should provide for balanced representation of the NASD's diverse membership, including small and large firms and firms involved in different business specialties.

  • The Nominating Committees for the principal governing bodies should be composed equally of NASD members and public representatives, and the selection process should provide an opportunity for all interested and qualified constituencies to participate.

  • The NASD's professional staff should take an active management role, and should ensure that all governing bodies are equipped to reach decisions in a fully informed and timely fashion and that the views of all relevant constituencies are taken into account.

  • NASD discipline and enforcement should be, in fact and appearance, fair, effective, and professional.

  • The NASD should have a strong, independent and well-equipped Office of Internal Review, with provision for regular district audits and an Ombudsman.

  • The NASD should at all times devote the financial and human resources necessary to meet its paramount regulatory obligations.

Specific Recommendations

Guided by the foregoing, and based on the Review, the Select Committee makes the following specific recommendations:

Corporate Restructuring

(a) The NASD should reconstitute and establish Nasdaq as a strong, independent operating subsidiary, not divorced from the NASD, but with as much autonomy and authority over the Nasdaq and OTC markets as the law will allow.
(b) The NASD should create a separate, strong and independent operating subsidiary, NASD Regulation, Inc. (NASDR), responsible for regulating the broker/dealer profession.
(c) The NASD should retain ultimate policymaking, oversight, and corporate authority as parent holding company and statutory SRO. However, to effectuate the purposes of this proposed restructuring, the NASD should grant substantial deference to its operating subsidiaries in the areas of their respective jurisdiction.
(d) The composition of the Boards of the NASD, Nasdaq, and NASDR should be tailored to meet their respective responsibilities and to reflect the interests of their respective constituencies.
(e) The governing Boards of Nasdaq and NASDR should each have 50 percent public membership, meaning directors drawn from outside the membership of the NASD and representing a broad spectrum of skills and interests. The Board of the NASD should have a majority of public members, also representing a broad spectrum of skills and interests.
(f) Board compositions that would satisfy the foregoing criteria are depicted in Exhibit D (see page 529).
(g) The members of the NASD Board of Governors should be selected as shown in Exhibit D. Although as there shown, certain NASD governors would be selected by the Nasdaq and NASDR Boards, those governors should not be directors of Nasdaq or NASDR at the time of their selection. The public governors on the NASD Board should be proposed by an NASD Nominating Committee and elected by the NASD Board, with provision for public governor candidates to be proposed as well by any NASD member, under rules to be established by the NASD Board.
(h) The District members of the NASDR Board should be proposed by District Nominating Committees and elected by the NASD Districts, under rules to be established by the NASDR Board (including rules for contested elections). The remaining members of the NASDR Board should be proposed by an NASDR Nominating Committee and elected by the NASDR Board. The NASDR Board should establish procedures permitting NASD members or the public also to propose candidates for non-District seats.
(i) The members of the Nasdaq Board should be proposed by a Nasdaq Nominating Committee and elected by the Nasdaq Board. The Nasdaq Board should establish procedures permitting NASD members or the public also to propose candidates.
(j) The Nominating Committees of the NASD, NASDR, and Nasdaq, respectively, should be composed equally of individuals affiliated with NASD member firms and individuals drawn from the public. The members of the Nominating Committees need not be present members of the respective Boards.
(k) The Nasdaq and NASDR Boards should select, respectively, the CEOs of each entity. The NASD Board should retain the authority to reject or dismiss the CEOs chosen by Nasdaq and NASDR, but should exercise such authority only in exceptional cases.
(l) The NASD Board should choose the CEO of NASD.
(m) The CEOs of the NASD, Nasdaq, and NASDR, respectively, need not be affiliated with an NASD member, but may be drawn from the public or from the professional staffs of NASD, NASDR, or Nasdaq.
(n) The principal functions of NASD, NASDR, and Nasdaq, respectively, should be as shown in Exhibit E (see pages 530 and 531).

Discipline And Enforcement

(a) The NASD should significantly augment its disciplinary procedures, and allocate the necessary financial resources and personnel at both the District and national levels, so as to ensure effective, fair, and professional enforcement.
(b) The NASD should establish an Office of Professional Hearing Officers within NASDR. The profession al hearing officers should be NASDR employees and should sit, along with two industry representatives, in every NASD disciplinary proceeding in which either the respondent or NASDR so elects, or the Board of the NASD or NASDR so determines.
(c) In all disciplinary proceedings, ex parte contacts between the disciplinary panels—including the District Business Conduct Committees and the Market Surveillance Committee and the parties or their representatives—including attorneys presenting the case for NASDR— should be prohibited.
(d) Before any proposed settlement of a disciplinary proceeding is approved by a panel sitting without a professional hearing officer, it should be reviewed by a designated NASDR staff attorney (other than the attorney presenting the case) to determine and advise the panel whether the proposed settlement conforms to NASD policy, including sanction guidelines.
(e) The documentary discovery rights of respondents in NASD disciplinary proceedings should be expanded to furnish respondents, at a reasonable time in advance of the initial hearing, with all non-privileged materials in the NASD's possession (including exculpatory evidence) directly relevant to the dispute. The precise rules should be established by NASDR. Also, NASDR should establish rules for a motions practice suitable for NASD disciplinary proceedings. Disciplinary panels, including NBCC panels, should be given the power to impose sanctions on either side for frivolous practice or contumacious behavior by the parties or their counsel.
(f) The workload of the NBCC should be reduced in order for it to address national enforcement policy issues and ensure uniformity in NASD membership application processing. To help achieve this goal, the professional staff assigned to the NBCC should be delegated the responsibility to review all settlements and non-appealed disciplinary cases, referring to the NBCC itself only such settlements and non-appealed cases, if any, as appear inconsistent with NASD enforcement policy or sanction guidelines. Public members should serve on the NBCC, but NASD member firms should be in the majority.

District Committees

(a) District Nominating Committees should be directed to consider diversity in the size and type of firms represented on the District Committees, especially in Districts that have larger-than-average Committees.
(b) In the event of a contested election for District Committee seats, the NASD and its staff should remain strictly neutral. To the extent that NASD or NASDR resources are employed in the election process, they should be made available on an equal basis to all candidates.

Office Of Internal Review

(a) The NASD should create a strong, independent, and responsive Office of Internal Review, to be housed in and administered by the NASD parent. This Office should conduct regular internal audits and reviews of the NASD's and its subsidiaries' operations, including the Districts. The Office should also be equipped with the necessary authority and resources to conduct special internal investigations on its own initiative or at the request of the NASD Board, the Nasdaq Board, the NASDR Board, or the CEOs of the NASD, Nasdaq, or NASDR.
(b) The Office should serve also as an "Ombudsman" for receiving and addressing concerns and complaints, whether anonymous or not, from any source (within or outside of the NASD), concerning the operations, policies, or activities of the NASD, Nasdaq, or NASDR, or any staff members.
(c) The hiring, firing, and compensation of the professional staff serving in the Office should be exclusively the province of the NASD's CEO and the NASD Board. The Office should have authority to raise issues directly with any operating entity, unit, or official within the NASD organization.

Coordination With Other Regulators

On at least a semi-annual basis, high-level NASD and NASDR officials should engage in formal consultations to coordinate national enforcement policy with the other principal securities industry regulators, i.e., the SEC, state regulators, and the New York and American Stock Exchanges.

Membership Voting

The Select Committee finds no reason to change the NASD's decision, approved by the SEC in 1994, to eliminate the requirement of membership voting on proposed rule changes except in those unusual cases in which the NASD Board or NASDR Board determines otherwise.

Professional Staff

The NASD, NASDR, and Nasdaq professional staffs should take an active role in management and in identifying and pursuing issues and recommending proposed solutions, policies, and rules.

Individual Investors

The Committee notes that, in accordance with the principles of effective governance endorsed by this Committee, the NASD is creating an Office dedicated to representing the interests of individual investors and making certain that those interests are taken into account in policy and rulemaking.

Allocation Of Financial Resources

The NASD should allocate the necessary financial resources and personnel to achieve the foregoing goals as soon as practicable. In particular, the NASD should significantly increase the resources it currently allocates to enforcement and discipline and to internal audit and review.

Exhibit D

Current and Proposed Makeup of NASD and Subsidiary Boards

NASD, Inc., Board of Governors
Current Proposed

President of NASD

13–15 Governors elected by NASD members in the various NASD Districts

11–13 Governors elected by the Board (the "at-large" Governors)

CEO of NASD

1 industry representative selected by the Nasdaq Board

1 industry representative from the NASD Districts

selected by the NASDR Board

1 at-large industry representative selected by the

NASDR Board

5 public members representing a broad spectrum of skills and interests
The Nasdaq Stock Market, Inc., Board of Directors
Current Proposed
President of NASD/Nasdaq

4 public representatives (including 2 issuer representatives)

10 industry representatives (including 1 current NASD Governor)
CEO of Nasdaq

8 public members representing a broad spectrum of skills and interests

4 "market maker" representatives

4 industry representatives from firms that are not primarily "market makers"

CEO of NASD (ex officio, non-voting)
Proposed Makeup of the NASD Regulation, Inc., Board of Directors

CEO of NASDR

11 representatives of member firms elected by the NASD Districts

3 at-large industry representatives

14 public members representing a broad spectrum of skills and interests

CEO of NASD (ex-officio, non-voting)

Exhibit E

Recommended Role and Composition of NASD and Subsidiary Boards

NASD, Inc.

Makes ultimate policy decisions and exercises ultimate review authority over the decisions of the two operating subsidiaries, including NASDR disciplinary decisions (but with substantial deference to each subsidiary's expertise in the areas of its jurisdiction)

Resolves jurisdictional or other disputes between Nasdaq and NASDR

Administers the Office of Internal Review

Administers common overhead and technology of Nasdaq and NASDR

Establishes a consolidated corporate budget

Manages external relations on major policy issues, including relations with Congress, the SEC, state regulators, other SROs, business groups and the public at large

Retains overall responsibility for ensuring that the NASD's statutory obligations and functions are fulfilled

Board of Governors

CEO of NASD

1 industry representative selected by the Nasdaq Board

1 industry representative from the NASD Districts selected by the NASDR Board

1 at-large industry representative selected by the NASDR Board

5 public members representing a broad spectrum of skills and interests
The Nasdaq Stock Market, Inc.

Oversees and operates the Nasdaq market

Designs and operates Nasdaq trading systems, and promulgates rules for those trading systems and for the other OTC markets

Conducts market surveillance, including trading halts

Establishes fees for market services

Prepares the annual budget and strategic plan for the Nasdaq subsidiary

Board of Directors

CEO of Nasdaq

8 public members representing a broad spectrum of skills and interests

4 "market maker" representatives

4 industry representatives from firms that are not primarily "market makers"

CEO of NASD (ex officio, non-voting)
NASD Regulation, Inc.

Establishes rules and regulations for the broker/dealer profession generally (including Rules of Fair Practice and membership requirements)

Administers the enforcement and disciplinary systems, including investigation and adjudication of all cases referred by the NASD or Nasdaq, or initiated by NASDR itself

Administers the Office of Professional Hearing Officers

Conducts arbitrations

Conducts qualification examinations and operates the CRD system

Oversees all District Offices and compliance activities (including review of underwriting agreements, advertising, and enforcement of MSRB rules)

Establishes the annual budget and strategic plan for the NASDR subsidiary

Board of Directors

CEO of NASDR

11 representatives of member firms elected by the NASD Districts

3 at-large industry representatives

14 public members representing a broad spectrum of skills 2nd interests

CEO of NASD (ex officio, non-voting)

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