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85-43 Proposed New Rule of Fair Practice Relating to Permission for Members to Alter Their Methods of Operation Under SEC Rule 15C3-3 (the "Customer Protection Rule")
IMPORTANT MAIL VOTE
OFFICERS, PARTNERS AND PROPRIETORS
TO: All NASD Members
LAST VOTING DATE IS JULY 12, 1985
Enclosed is a proposed new rule under Article III of the NASD Rules of Fair Practice. Proposed Section 39 was approved by the NASD'S Board of Governors and now requires the membership's approval. If approved, it must then be filed with and approved by the Securities and Exchange Commission. As discussed below, the proposed rule was published for member comment on August 22, 1983 (Notice to Members 83-48).
BACKGROUND AND EXPLANATION OF THE PROPOSED RULE
The proposed rule provides the NASD with an additional regulatory tool in monitoring the financial and operational condition of members that are not designated to another self-regulatory organization for financial responsibility pursuant to SEC Rule 17d-l. The proposed rule is intended to provide the NASD with the authority to evaluate, in advance and on a case-by-case basis, a firm's capacity to alter the nature of its business by virtue of a change in its exempt status under SEC Rule 15c3-3 (the "Customer Protection Rule") in such a manner that increases customer financial exposure. Such a change could involve, for example, a member converting its business operation from clearing on a fully disclosed basis through another member to processing and clearing its own transactions and/or holding customers' funds or securities. The proposed rule is designed to ensure that a member has the necessary capabilities, including adequate net capital and qualified personnel, to conduct the type of business it plans.
The proposed rule would require an existing member to obtain the NASD's prior written approval before altering its method of operation by changing its exempt status under SEC Rule 15c3-3. Currently, a member could alter its status under SEC Rule 15c3-3 at any time without prior approval, provided it has the minimum amount of net capital prescribed by SEC Rule 15c3-l (the "Net Capital Rule") and complies with other minimum qualifications standards. It is the Board's view that the requirements put forth in this proposed rule are necessary to provide appropriate regulatory oversight for an orderly transition of a member's business at a time when there would be an increase in overall financial exposure, thereby providing further protection for the public and other members.
NATURE OF EXEMPTIONS PROVIDED BY SEC RULE 15c3-3
All broker-dealers, regardless of the nature of their businesses, are obligated to comply with SEC Rule 15c3-3. However, depending on their types of business and methods of operation, broker-dealers may avail themselves of various exemptions contained in this Customer Protection Rule.
The exemptions provided in subparagraph (k)(2)(b) of the Customer Protection Rule are self-operative and, heretofore, no formal notification was required of a broker-dealer operating pursuant to such an exemption that determined to alter its status under the rule. For instance, currently a broker-dealer that introduces transactions for customers on a fully disclosed basis as provided for in paragraph k(2)(b) of the rule, could begin clearing for itself, carrying customer accounts, and holding customer funds and securities without any prior notification to the NASD even though the NASD has responsibility for monitoring the financial and operational condition of that member. The Board believes that such major changes to the method in which a member conducts its business are substantial events which should be subject to notification and prior approval by the NASD through its local District Offices, given the potential risks involved for the public and other members. The Board further believes that the NASD needs this authority if it is to continue to carry out its regulatory responsibilities in an effective and efficient manner.
Under the proposed rule, any member planning to change its exemptive status under subparagraph (k) of SEC Rule 15c3-3 to enable it to begin carrying customer accounts and/or to maintain customer free-credit balances or hold customer securities, or to operate in some other manner so that the member no longer qualifies for continued exemptive status under the Customer Protection Rule must obtain the prior written approval of the District in which the member's main office is located before effectuating such change. This would be accomplished by submitting a written request to the District, which, among other things, fully describes the procedures the member has established to effect an orderly transition of its business. In turn, under an amendment to the NASD's Code of Procedure, the District staff is required to notify the member in writing of its decision to approve or disapprove the change within 15 business days.
The proposed rule also cites several factors to be considered by a District in determining whether to approve or disapprove any proposed change in a member's operations. Finally, if approval is denied by the District staff, or approval is granted with modifications, procedures are provided for a member to appeal that decision to the District Business Conduct Committee and thereafter to the NASD Board of Governors.
In conjunction with adoption of the proposed rule, the Board has also adopted amendments to the NASD's Code of Procedure which provide a special procedure to implement the provisions of the proposed rule. The procedures provide the member with an opportunity for an impartial hearing, an independent review by the Board of Governors and an appeal to the Securities and Exchange Commission.
The NASD received 19 comment letters on the proposed rule. Each letter was reviewed by the NASD's Capital and Margin Committee and the Board of Governors. Five letters were in favor of adopting the proposed rule, eight expressed opposition and six asked for further explanation or clarification of the proposed rule's provisions or applicability. The general concerns expressed in these letters and the Board's decisions regarding such are described below.
Opposition to the Proposed Rule
While each letter was reviewed individually, the letters that were opposed to the adoption of the proposed rule generally expressed the belief that the proposed rule was unwarranted and represented an additional regulatory burden on members. The commentators also believed that ample requirements already exist for broker-dealers who decide to change their mode of business, and pointed to the protections offered by the Customer Protection Rule, the Net Capital Rule and the applicable qualification standards for financial and operations principals.
The Board concluded, however, and the NASD's experience has shown, that the proposed rule is necessary to ensure that members adequately demonstrate, in advance of start-up, their ability and capacity to clear their own transactions and/or carry customer accounts. The Board further believes that if any added regulatory burden is attached to this new rule, it is far outweighed by the additional protections afforded customers and other members.
Applicability of the Proposed Rule
Certain commentators believed that, in order to avoid duplicative regulation, the proposed rule should be clarified to limit its applicability to members that are not designated for financial responsibility to another self-regulatory organization by the Securities and Exchange Commission, pursuant to SEC Rule 17d-l (the regulatory allocation rule for financial responsibility matters).
The Board concurred with these comments and approved the recommendation to limit the applicability of the new rule to such firms.
Clarification of the Term "Carrying Customer Accounts"
When originally published for comment, the proposed rule dealt solely with members requesting permission to "carry customer accounts." Some commentators felt that clarification of the proposed rule's language was needed to define what was meant by "carrying customer accounts" since it was unclear as to exactly what situations would trigger the provisions of this new rule.
The Board therefore determined to clarify the proposed rule by applying it only in those instances where a member was changing its status from exempt under subparagraph (k)(l) or (k)(2)(b) to exempt under subparagraph (k)(2)(a); or from exempt under subparagraph (k)(l), (k)(2)(a) or (k)(2)(b) to a fully computing firm that is subject to all provisions of SEC Rule 15c3-3; or to commence operation in some other manner so that the member no longer qualifies for continued exemptive status under SEC Rule 15c3-3. Not only does this define the proposed rule's applicability, but it also provides the regulatory coverage desired by the Board and certainty as to when the proposed rule's provisions will be applicable.
Expansion of the Review Period
Finally, one commentator suggested that the originally proposed five-business day review period within which a District Office must advise a member of its decision to approve or disapprove the member's change in exemptive status be expanded to give the NASD staff sufficient time to evaluate the member's plan of operation and to conduct an on-site inspection of the firm, if it was deemed necessary.
The Board concurred with this recommendation, and the proposed rule now provides for a period of 15 business days within which the District Office must inform a member of its decision to approve, deny or modify the member's request.
* * * *
The text of the proposed rule is attached and merits your immediate attention. Also attached are amendments to the NASD Code of Procedure, which do not require a membership vote and are included for informational purposes only. Please mark the ballot and return it in the enclosed, stamped envelope to "The Corporation Trust Company." Ballots must be postmarked no later than July 12, 1985.
The Board of Governors believes that the proposed rule is necessary and appropriate and recommends that members vote their approval.
Questions concerning this notice may be directed to Thomas R. Cassella, Director, Financial Responsibility, at (202) 728-8237.
James M. Cangiano
PROPOSED RULE OF FAIR PRACTICE
Proposed Article III, Section 39 of the Rules of Fair Practice
PROPOSED ADDITION TO THE CODE OF PROCEDURE
Procedures Under Article III, Section 39 of the Rules of Fair Practice
Applications for approval of a change in exemptive status under SEC Rule 15c3-3, required pursuant to Article III, Section 39 of the Rules of Fair Practice, shall be made by filing a written request with the District Office in which the member's principal place of business is located. Such request shall address the criteria set forth in Section 39(c) of Article III of the Rules of Fair Practice. Within fifteen (15) business days of the receipt of such application, the District staff shall make a determination and inform the member, in writing, of its decision to approve, deny or amend the member's request as submitted. If the decision is to deny or amend the member's request in any way, the written decision shall set forth the reasons for such action.
Whenever a request under subparagraph (b) of Article III, Section 39 of the Rules of Fair Practice is denied in whole or in part by the District staff, the member may, within five (5) business days of receipt of the District's determination letter, petition the District Business Conduct Committee ("DBCC" or "District Committee") for review of such decision. The member will have the opportunity to be heard and to present the reasons why it believes that the decision by the staff should be set aside or modified. Such hearing shall be held before the DBCC or a designated subcommittee thereof within seven (7) business days of receipt of the petition for review. The member shall be entitled to be represented by counsel and a record shall be kept of the proceeding. Thereafter, the District Committee shall, within five (5) business days of the hearing or within five (5) business days of receipt of the member's petition for review if the member waives a hearing and elects to proceed by written petition, issue a written decision affirming, modifying or setting aside the District staff decision and setting forth the reasons for such action. This written decision shall also provide for an appropriate sanction to be immediately imposed for failure to comply with the Committee's determination.
The written decision issued by the District Committee pursuant to subsection (b) shall be subject to review by the Board of Governors upon application by the member filed within five (5) business days of the date of the decision, or the matter may be called for review by the Board on its own motion within thirty (30) calendar days of the District Committee's decision. In the case of an appeal, the member shall be entitled to a hearing before a subcommittee of the Board within fifteen (15) business days. If called for review by the Board on its own motion, the member shall be entitled to a hearing within thirty (30) business days of such call for review. The member shall be entitled to be represented by counsel. Instituting a review, whether by application or on the action of the Board, shall not act as a stay of the action taken by the DBCC unless otherwise ordered by the Board.
Upon consideration of the record, the Board of Governors shall, in writing, affirm, modify, reverse or dismiss the decision of the DBCC or remand the matter to the District for further proceedings consistent with its instructions. If a hearing is held, a decision, which shall be the final action of the Board, shall be issued within five (5) business days of the hearing. If no hearing is requested, the matter shall be considered based on the record and a decision shall be issued promptly. In its decision, the Board shall set forth the specific grounds upon which its determination is based and shall provide for an appropriate sanction to be immediately imposed for failure to comply with its directives. Board action restricting the member's activity shall become effective immediately upon issuance of its decision and shall remain in effect until the limitation is removed or modified by the DBCC.
In any case where a member is aggrieved by an action taken or approved by the Board of Governors, such member may make application for review to the Securities and Exchange Commission in accordance with Section 19 of the Securities Exchange Act of 1934, as amended. There shall be no stay of the Board's action upon appeal to the Commission unless the Commission determines otherwise.