I M P O R T A N T
Officers * Partners * Proprietors
TO: All NASD Members
Last Voting Date Is September 19, 1983
Enclosed herewith is a proposed new rule under Article III of the Rules of Fair Practice. Proposed Section 38 was approved by the Association's Board of Governors and now requires the approval of the membership. 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 19, 1982 (Notice to Members 82-45).
BACKGROUND AND EXPLANATION OF THE PROPOSED RULE
The proposed rule provides the Association with authority to prescribe certain remedial courses of action which a member must follow during periods when the member is experiencing financial or operational difficulty. The rule is intended to address such problems in a timely fashion to protect the member, the investing public and other members.
As proposed, the rule addresses two levels of possible financial and/or operational difficulties. First, it restricts a member from expanding its business whenever certain early warning financial criteria relating to minimum net capital, ratio requirements and/or scheduled capital withdrawals are exceeded. Secondly, it covers a deteriorating situation in which another set of warning criteria with lower tolerances are exceeded. In such situations, the proposed rule requires a member to reduce or eliminate certain facets of its business.
In conjunction with adoption of the proposed rule, the Board has also adopted amendments to the Association's Code of Procedure to provide a special procedure to implement the provisions of the rule. Specifically, the procedures provide for the creation of a special Surveillance Committee of the Board and a special District Surveillance Committee to direct the implementation of the rule. The procedures also provide the member with an opportunity for an impartial hearing, an independent review by the Board of Governors and appeal to the Securities and Exchange Commission.
Additionally, the procedures permit a District Surveillance Committee to issue additional or supplemental notices to members whenever the Committee finds that the problems which gave rise to previous limitations are continuing or becoming more pronounced. Appropriate hearing procedures are also provided in such cases. Another provision specifies that action taken by the Association pursuant to the proposed rule would not preclude a District Committee from taking formal complaint action for violation of the Rules of Fair Practice.
Finally, the proposed rule is accompanied by an Explanation of the Board of Governors. The Explanation includes examples of conditions that might cause the Association to determine that a member is in or approaching financial and/or operational difficulties. Also included are examples of the types of remedial actions that might be selected to correct the problems. This list of possible problem situations and possible remedial actions is not intended to be, and is not, all inclusive. Rather, the list and the Explanation in general is intended to facilitate members' understanding of how the proposed rule would be administered and implemented by citing hypothetical problems and corrective actions as examples.
The Association received 15 comment letters on the proposed rule. Each letter was reviewed by the Association's Capital and Margin Committee and the full Board of Governors. The general concerns expressed in these letters and the Board's decisions regarding such are described below. General headings are used since similar points are made in more than one letter.
Applicability of the Rule — In response to the comments, the Board agreed that as to dual members (i.e., firms which are members of two or more self-regulatory organizations), the proposed rule would be limited solely to those members which have been designated to the NASD by the Securities and Exchange Commission pursuant to Rule 17d-l (the regulatory allocation rule for financial responsibility).
The question of whether the rule should include introducing firms as well as firms carrying customer accounts was also addressed by the Board. It noted that certain introducing firms, particularly those engaged in market making activities or those which hold positions for their own accounts, could potentially pose some risk and exposure as a result of such activities. However, it observed that those firms which introduced strictly agency business, the so-called "$5,000" firms under the net capital rule, posed no such problems. The Committee therefore concluded that the rule should only be applicable to firms required to maintain $25,000 in capital in accordance with the applicable provisions of the net capital rule irrespective of whether such firms carry customer accounts.
Rule Was Too Vague And/Or Placed Too Much Power With the Association's Staff — A number of commentators stated that because of the vagueness of Subsections (b)(2) and (c)(2) of the proposed rule, too much discretion would be left with the Association staff in interpreting these provisions.
It should be emphasized that under the rule, the staff's function is simply to obtain the necessary facts and make recommendations to the District Surveillance Committee. It has no decision-making authority as to implementation of the rule in any case. It would be the responsibility of the District Surveillance Committee, not the staff, to determine whether the provisions of the rule should be implemented. The proposed rule authorizes the District Surveillance Committee, not the staff, to prescribe the limitations by which the member would be obligated to abide.
Additionally, the procedure adopted by the Board makes available to a member ample opportunity for appeal of the District Surveillance Committee's decision to the Board of Governors and thereafter to the Securities and Exchange Commission.
The Committee therefore concluded that no changes should be made to the proposed rule based on these comments.
The Proposed Rule Imposes More Restrictive Criteria Than Rule 17a-11, the SEC's "Early Warning" Rule — Several commentators noted that SEC Rule 17a-11 already provided an "early warning" measure with respect to broker-dealers and that the early warning threshold was set at 120%, significantly less than the 150% prescribed in the proposed rule. In response, the Board noted that the purpose of the proposed rule differs from the Commission's rule in that the proposed rule is designed to have a remedial effect on a member. In other words, the rule's approach is to put the Association on notice well before a firm reaches the more "critical" stage of 17a-11 reporting in order that corrective measures may be taken early enough to ensure the continuing viability of the firm. In the Board's opinion, sufficient lead time is necessary in order to address a firm's difficulties before they become irreversible.
The Board therefore determined that the early warning financial criteria as contained in the proposed rule were appropriate and should be retained.
Examples Cited in the "Explanation of the Board of Governors" — Commentators also noted that some situations and remedies specified in the companion explanation to the rule were too narrow in scope, unduly harsh, or not truly indicative in some cases of a firm's true financial health.
The Board emphasizes that the instances cited in the "Explanation" are merely examples of problems and suggested remedies and are not intended to be "automatic" in their application. The language of the rule and the accompanying Explanation make it sufficiently clear that these situations are provided as further explanation and were simply illustrative of situations and corrective actions which could be imposed depending on the circumstances.
The Board therefore determined not to alter the "Explanation of the Board of Governors" as a result of these comments.
Other Areas — One letter noted that the proposed rule did not speak to how and when any restrictions imposed by the rule would be lifted. The Board agreed and revised the procedure to vest responsibility for lifting the imposed restrictions in the District Surveillance Committee. Thus, restrictions once imposed would remain in effect until lifted or modified by the District Surveillance Committee.
Another commentator suggested that the procedure be changed to provide that a hearing on an order issued by the District Surveillance Committee be requested within five (5) business days of the receipt of the notice rather than three (3) business days after the issuance of the notice.
The Board noted that, in most instances, these notices would be hand-delivered to the member and therefore agreed that receipt of notice would not be difficult to document. The Board therefore determined to amend the procedure retaining the specified time frames but changing the starting point from "issuance" to "receipt of." A request for a hearing would, therefore, have to be made within three business days of receipt of the notice.
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The text of the proposed rule and the Explanation of the Board of Governors is attached and merits your immediate attention. Also attached are amendments to the Code of Procedure which do not require a membership vote and are included for informational purposes. Please mark the ballot according to your convictions and return it in the enclosed stamped envelope to "The Corporation Trust Company." Ballots must be postmarked no later than September 19, 1983.
The Board of Governors believes the proposed rule is necessary and appropriate and recommends that members vote their approval.
Questions concerning this notice may be directed to James M. Cangiano at (202) 728-8273, or your District Director.
Gordon S. Macklin
PROPOSED RULE OF FAIR PRACTICE
Proposed Article III, Section 38
of the Rules of Fair Practice
(a) Application - For the purposes of this rule, the term "member" shall be limited to any member of the Association who is not designated to another self- regulatory organization by the Securities and Exchange Commission for financial responsibility pursuant to Section 17 of the Securites Exchange Act of 1934 and Rule 17d-l there under. Further, the term shall not be applicable to any member who is subject to paragraphs (a)(2) and (a)(3) of SEC Rule 15c3-l, or is otherwise exempt from the provisions of said rule.
(b) A member, when so directed by the Association, shall not expand its business during any period in which:
(1) Any of the following conditions continue to exist, or have existed, for more than 15 consecutive business days:
(A) A firm's net capital is less than 150 percent of its net capital minimum requirement or such greater percentage thereof as may from time to time be pre-scribed by the Association;
(B) If subject to the aggregate indebtedness requirement under SEC Rule 15c3-l, a firm's aggregate indebtedness is more than 1,000 per centum of its net capital;
(C) If, in lieu of subparagraph (b)(l)(B) above, the specified percentage of the aggregate debit items in the Formula for Determination of Reserve Requirements for Brokers and Dealers under SEC Rule 15c3-3 (the alternative net capital requirement) is applicable, a firm's net capital is less than 5 percent of the aggregate debit items there under; or,
(D) The deduction of capital withdrawals including maturities of subordinated debt scheduled during the next six months would result in any one of the conditions described in (A), (B) or (C) of this subparagraph (1).
(2) The Association restricts the member for any other financial or operational reason.
(c) A member, when so directed by the Association, shall forthwith reduce its business:
(1) To a point enabling its available capital to comply with the standards set forth in subparagraphs (b)(1)(A), (B) or (C) of this rule if any of the following conditions continue to exist, or have existed, for more than fifteen (15) consecutive business days:
(A) A firm's net capital is less than 125 percent of its net capital minimum requirement or such greater percentage thereof as may from time to time be prescribed by the Association;
(B) If subject to the aggregate indebtedness requirement under SEC Rule 15c3-l, a firm's aggregate indebtedness is more than 1,200 per centum of its net capital;
(C) If, in lieu of subparagraph (c)(l)(B) above, the specified percentage of the aggregate debit items in the Formula for Determination of Reserve Requirements for Brokers and Dealers, under SEC Rule 15c3-3 (the alternative net capital requirement) is applicable, a firm's net capital is less than 4 percent of the aggregate debit items there under; or,
(D) If the deduction of capital withdrawals including maturities of subordinated debt scheduled during the next six months would result in any one of the conditions described in subparagraph (c)(l)(A), (B) or (C) of this rule.
(2) As required by the Association when it restricts a member for any other financial or operational reason.
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EXPLANATION OF THE BOARD OF GOVERNORS
Restrictions On A Member's Activity
This explanation outlines and discusses some of the financial and operational deficiencies which could initiate action under the rule. Subparagraphs (b)(2) and (c)(2) of the rule recognizes that there are various unstated financial and operational reasons for which the Association may impose restrictions on a member so as to prohibit its expansion or require a reduction in overall level of business. These provisions are deemed necessary in order to provide for the variety of situations and practices which do arise and, which if allowed to persist, could result in increased exposure to customers and to broker-dealers.
In the opinion of the Board of Governors, it would be impractical and unwise to attempt to identify and list all of the situations and practices which might lead to the imposition of restrictions or the types of remedial actions the Corporation may direct be taken because they are numerous and cannot be totally identified or specified with any degree of precision. The Board believes, however, that it would be helpful to members' understanding to list some of the other bases upon which the Corporation may conclude that a member is in or approaching financial difficulty.
(a) For purposes of subparagraphs (b)(2) and (c)(2) of the rule, a member may be considered to be in or approaching financial or operational difficulty in con ducting its operations and therefore subject to restrictions if it is determined by the Corporation that any of the parameters specified therein are exceeded or one or more of the following conditions exist:
(1) The member has experienced a reduction in excess net capital of 25% in the preceding two months or 30% or more in the three-month period immediately preceding such computation.
(2) The member has experienced a substantial change in the manner in which it processes its business which, in the view of the Corporation, increases the potential risk of loss to customers and members.
(3) The member's books and records are not maintained in accordance with the provisions of SEC Rules 17a-3 and 17a-4.
(4) The member is not in compliance, or is unable to demonstrate compliance, with applicable net capital requirements.
(5) The member is not in compliance, or is unable to demonstrate compliance, with SEC Rule 15c3-3 (Customer Protection Reserves and Custody of Securities).
(6) The member is unable to clear and settle transactions promptly.
(7) The member's overall business operations are in such a condition, given the nature and kind of its business that, notwithstanding the absence of any of the conditions enumerated in subparagraphs (1) through (5), a determination of financial or operational difficulty should be made, or
(8) The member is registered as a Futures Commission Merchant and its net capital is less than 7% of the funds required to be segregated pursuant to the Commodity Exchange Act and the regulations there under.
(b) If the Corporation determines that any of the conditions specified in subparagraph (a) of this Explanation exist, it may require that the member take appropriate action by effecting one or more of the following actions until such time as the Corporation determines they are no longer required:
(1) Promptly pay all free credit balances to customers.
(2) Promptly effect delivery to customers of all fully-paid securities in the member's possession or control.
(3) Introduce all or a portion of its business to another member on a fully- disclosed basis.
(4) Reduce the size or modify the composition of its inventory.
(5) Postpone the opening of new branch offices or require the closing of one or more existing branch offices.
(6) Promptly cease making unsecured loans, advances or other similar receivables, and, as necessary, collect all such loans, advances or receivables where practicable.
(7) Accept no new customer accounts.
(8) Undertake an immediate audit by an independent public accountant at the member's expense.
(9) Restrict the payment of salaries or other sums to partners, officers, directors, shareholders, or associated persons of the member.
(10) Effect liquidating transactions only.
(11) Accept unsolicited customer orders only.
(12) File special financial and operating reports and/or
(13) Be subject to such other restrictions or take such other action as the Corporation deems appropriate under the circumstances in the public interest and for the protection of members.
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AMENDMENTS TO CODE OF PROCEDURE FOR HANDLING TRADE PRACTICE COMPLAINTS
Limitation Procedures Under Article III, Section 38 of the Rules of Fair Practice
Board of Governors Surveillance Committee
(1) The Board of Governors shall appoint a standing Committee of the Board to be known as the Board of Governors Surveillance Committee which is composed of such members as are from time to time determined by the Board.
District Surveillance Committee
(2) As required to implement the provisions of this rule, each District Committee shall create a District Surveillance Committee composed of two current or former District Business Conduct Committee members; two members of the Board of Governors Surveillance Committee, and one former member of the Board of Governors.
(3) If the District Surveillance Committee has reason to believe that a member has not complied with any of the conditions contained in sub- sections (b) or (c) of Section 38, it may exercise the authority conferred by Section 38 by issuing a notice directing the member to limit its business. Such notice shall contain a statement of the specific grounds on which such action is being taken, specify in reasonable detail the nature of the limitations being imposed and inform the member that he has an opportunity to be heard, if such request is made within three business days of receipt of the notice. The District Surveillance Committee shall also provide a similar notice in writing to a member of any revision or modification of restrictions or limitations previously imposed.
(4) If an opportunity to be heard is requested, it shall be provided by the District Surveillance Committee within five business days of the receipt of the notice. A member requesting the opportunity to be heard shall present its reasons why the notice should be withdrawn or modified and shall be entitled to be represented by counsel. A record shall be kept of the proceeding before the District Surveillance Committee.
Decision and Effective Date
(A) The District Surveillance Committee shall within five business days of a hearing issue a written decision approving or modifying the limitations specified in the notice. The decision shall also provide for an appropriate sanction to be immediately imposed for failure to comply with any limitations imposed.
(B) When an opportunity to be heard is not requested, the limitations contained in the notice shall become effective three days following receipt of the notice without any written decision unless the District Surveillance Committee decides upon a later effective date or unless the matter is reviewed by the Board of Governors, subject to the provisions of subsections (6), (7), and (8) hereof, and they shall remain in effect until such time as they are removed, revised or modified by the District Surveillance Committee.
Review by Board
(6) The written decision issued pursuant to subsection (5) shall be subject to review by the Board of Governors upon application by the member aggrieved thereby filed within five business days of the date of the decision. The decision, or the notice where no opportunity to be heard was requested before the District Surveillance Committee, shall also be subject to review by the Board of Governors on its own motion within 30 calendar days of the decision or notice. Where two members of the District Surveillance Committee disagree with the determination of the Committee, the matter will automatically be reviewed by the Board of Governors. In the case of an appeal, the member shall be given an opportunity to be heard before a subcommittee of the Board within 10 business days of the written decision. If called for review, the matter shall be heard within 30 days of such action In any hearing before the Board, a member shall be entitled to be represented by counsel. The institution of review, whether by application or on the initiative of the Board, shall operate as a stay of the action by the District Surveillance Committee unless otherwise ordered by the Board.
Composition of Board of Governors Hearing Subcommittee
(7) The Board of Governors' hearing subcommittee shall be composed of two members of the Board of Governors' Surveillance Committee and one current member of the Board.
(8) Upon consideration of the record, the Board of Governors shall in writing affirm, modify, reverse or dismiss the decision of the District Surveillance Committee or remand the matter for further proceedings consistent with its instructions. The Board shall set forth specific grounds upon which its determination is based and shall provide for an appropriate sanction to be immediately imposed for failure to comply with any limitations imposed. If a hearing is held, a decision shall issue within five business days of the hearing and the decision shall be the final action of the Board. If no hearing is requested, the matter shall be considered on the record and a decision shall be issued promptly. Any limitation imposed as a result of Board action shall become effective immediately upon issuance of its decision and shall remain in effect until such time as removed or modified by the District Surveillance Committee.
Application to Commission for Review
(9) In any case where a member feels aggrieved by any 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.
(10) If it appears at any time to the District Surveillance Committee that, notwithstanding an effective notice or decision under subsections (3), (5) and (8) hereof, the member is still approaching financial or operational difficulty, the District Surveillance Committee may prescribe additional limitations of a member's business in which case all of the procedures specified above shall be followed prior to the implementation thereof.
Complaint by District Committee
(11) Action by the Corporation under this Article is not intended to foreclose complaint action by the District Business Conduct Committee under the Code of Procedure for Handling Trade Practice Complaints where a violation of the Rules of Fair Practice may be involved.
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