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COMMISSION REVIEW OF SELF-REGULATORY ORGANIZATION RULES
Audit Report No. 272
July 14, 1998
The Securities and Exchange Commission's Office of Inspector General conducted an audit of the Commission's process for reviewing Self-Regulatory Organization (SRO) rule filings. Overall, we found that the review process was efficient and effective and adhered to statutory requirements. Additionally, SRO officials were complimentary toward Commission staff and felt that it had improved on review timeliness.
We identified potential enhancements that could improve the efficiency and effectiveness of the review process. Specifically, we are making recommendations on the control of rule filing documentation, automated tracking of rule filing information, flow of rule filing information, SRO guidance, rule filing policies and procedures, training program for new staff, techniques for handling turnover and performance elements.
The Commission has statutory authority to review and approve (or disapprove) SRO-proposed rule changes based on consistency with the Securities Exchange Act of 1934 (the Act) requirements. The Commission must also comply with specific procedural requirements of the Act, such as providing public comment and a timely review of rule proposals.
The Division of Market Regulation's (the Division) Office of Market Supervision reviews about 400 SRO rule proposals per year. The review function includes a Senior Associate Director, a Deputy Associate Director, three Assistant Directors, each assigned to specific subject areas (e.g., trading rules, new product rules, etc.), a staff of about 40 attorneys, and several administrative personnel. Staff attorneys are assigned to any Assistant Director depending on the nature of a proposal. Prior to 1997, the review structure consisted of hierarchies. Each hierarchy included an Assistant Director, two Branch Chiefs (assigned to particular SRO's), and 2-4 staff attorneys assigned to a Branch Chief. The structure was changed in 1997 due to National Performance Review recommendations.
Proposed rule changes range from routine to complex, with some having political controversies associated with them. Proposals may cover organization and administration, membership and listing requirements, trading rules, financial products traded, business conduct and disclipinary procedures. The main types of rule filings are described below.
- 19(b)(2) - routine - This filing is submitted for "routine" review. The Commission must provide for public comment and must either 1) approve the proposal within 35 days following its publication for comment, absent extenuating circumstances1 or 2) institute and conclude a proceeding to determine whether the proposed rule change should be disapproved within 180 days following publication for comment, again absent extenuating circumstances.2
- 19(b)(2) - accelerated - This filing is submitted for "accelerated" approval and is typically approved quicker than those under "routine" review -- within 30 days following publication for comment. This filing is generally approved without a notice and comment period.
- 19(b)(3)(A) - This filing, effective upon filing, must: 1) constitute a stated policy, practice, or interpretation with respect to the meaning, administration, or enforcement of an existing rule; 2) establish or change a due, fee, or other charge; or 3) apply solely to SRO administration or other matters that the Commission, by rule, may specify. The SEC has 60 days to abrogate the rule.
Once an SRO proposal is received it is sent to an Assistant Director and assigned to a staff attorney. Information is then entered into the Q&A tracking system, a DOS-based database application used to track filings. Additionally, several files are set up, the most critical of which is the Division file, serving as the Commission's official and "permanent" record of a proposed rule change.
If a preliminary review is satisfactory, the Commission will publish (i.e., notices) the proposal in the Federal Register and SEC Docket (a weekly Commission publication) to solicit public comment. The Division's internal goal is to notice a filing in 30 days or less of receipt provided that sufficient information is submitted by the SRO and there are no subsequent amendments. The Division analyzes the public comments, reviews supporting information, and attempts to resolve outstanding issues. The process may require continuous dialogue between Division and SRO staff, negotiating necessary modifications, since each has differing organizational objectives.
An approval order, explaining why the filing is consistent with statutory requirements, will be prepared once all concerns have been addressed. However, if a proposal raises significant policy issues, Division staff may submit the matter for Commission consideration. Though not frequent, an SRO may withdraw a filing or the Commission may disapprove a proposal.
SCOPE AND OBJECTIVES
We reviewed the Commission's process for reviewing SRO (NASD and stock exchange) rule filings. We did not review the Commission's process for reviewing clearing agency or Municipal Securities Rulemaking Board rules, nor did we review the legal conclusions by Commission or SRO staff related to any rule filing.
The primary audit objective was to determine the effectiveness and efficiency of the Commission's review process and verify compliance with the Act. The audit was performed from November 1997 through May 1998. Due to a Division request, no field work was performed from January 23 through March 23, 1998. Our audit was performed in accordance with generally accepted government auditing standards.
We reviewed a random sample of 17 rule filings closed out during September and October of 1997. We also reviewed a listing of all open rule filings on December 16, 1997. From these filings, we: 1) verified compliance with statutory requirements and Division policies and procedures, 2) assessed controls over rule filing documentation and the Division's ability to track rule filing information, 3) identified timeliness issues, and 4) identified possible improvements.
We reviewed relevant sections of the Act, Division policies and procedures, and past GAO audit reports on the Commission's review process. Additionally, we interviewed selected Division and SRO officials.
Overall, we found that the Commission's review of SRO rules is efficient and effective and adhered to statutory requirements set forth in the Act. Additionally, SRO officials were complimentary toward Division staff and felt they had improved on review timeliness. We identified several potential enhancements that could improve the efficiency and effectiveness of the review process, such as improved controls over rule filing documentation, automated tracking of information, and the flow of rule filing information.
CONTROL OF RULE FILING DOCUMENTATION
From our sample of 17 closed rule filings, four files were found in the "open" file area (making timely location difficult), none documented Assistant Director approval, most did not indicate which attorney(s) worked on the filing, several lacked key documents (original proposal, comment letters, close-out checklist, significant non-public information) and five took longer than the statutory time required, yet had no written justifications. Although the Division already has a file close-out checklist, officials advised that their goals included developing a revised file close-out checklist. Periodic spot checks would also help ensure that documentation is available when needed.
Division officials have begun to scan older files, including SRO rule filings, onto optical discs. The goal is to create a library of extracted rule filing information. We believe that this is an innovative and proactive idea because such technology will create a permanent record of documentation and allow Division staff to conduct timely searches of historical rule filing information. However, the Division needs a long-range plan for implementing this project. In addition to cost and time line estimates, such a plan should document key decisions, such as specific action steps, off-site storage, and other quality control procedures.
The Division of Market Regulation should revise the file close-out checklist.
The Division of Market Regulation should perform periodic spot checks of the Division's official files to verify accuracy.
In coordination with the Office of Information Technology (OIT), The Division of Market Regulation should prepare a long-range plan for transferring file documentation to optical discs and developing a library of extracted rule filing information.
AUTOMATED TRACKING OF RULE FILING INFORMATION
From our sample of 17 closed rule filings, we identified four instances where amendments were not recorded in the Q&A system, four instances where dates were inaccurate or unrecorded, and one instance where the rule filing type was not in the system. Additionally, we selected a judgment sample of 10 rule files (eight closed and two open) and traced information back to the Q&A system. We found one amendment not recorded in the system and one incorrect date. Division officials aggressively sought to correct inaccuracies identified during these tests.
During the review, the Division created a detailed control checklist to record rule filing information, such as applicable dates and the filing status. We reviewed this document, offered suggestions for improvement and verified that it was being used. After identifying errors in the Q&A system, the Division recently instituted limited read-only access for staff attorneys using the Q&A system. We believe that these actions will reduce the frequency of data input errors because there will be a control over data entered and only two support staff will have unlimited data entry access to the system.
The Division is planning to transfer existing Q&A data to a new ACCESS system. We believe this will aid in managing current rule filing workload since this system will provide improved capabilities (expanded comment fields and enhanced search features). The Division needs a detailed plan for implementing the new system. Such a plan should include: 1) establishing time lines; 2) surveying staff to identify system requirements; and 3) developing controls over converting data (security, accuracy). <3>Recommendation D
The Division of Market Regulation should identify and correct inaccuracies in the Q&A system for 1997 and 1998 (to date). Additionally, spot checks should be performed on data prior to 1997, as appropriate.
The Division of Market Regulation should perform periodic spot checks of Q&A information (and ACCESS information, once this system is implemented) to verify accuracy.
In coordination with OIT, the Division of Market Regulation should prepare a detailed plan for implementing the new ACCESS database system.
flow of RULE FILING INFORMATION
Closed Rule Filings
From our sample of 17 closed rule filings, the average time between receipt and notice was 25 days and between notice and final action was 72 days, for a total time from receipt to final action of 97 days. In addition, 21 of 69 items noticed (or 30%) took more than 30 days to notice. Division officials advised that their goals include developing a 30-day log that Assistant Directors will use to identify filings nearing the 30 day internal goal to notice. Finally, not considering the filing type, 36 of 69 items noticed (or 52%) took more than 35 days (the statutory requirement) for final action to be taken. These calculations did not consider whether the SRO amended the filing, which can delay approval.
Open Rule Filings
As of April 27, 1998, the five oldest filings that had been noticed had been open 635 to 1,290 days. Additionally, the oldest filing that had not been noticed had been open for 325 days. Of these six filings, Division officials were waiting for SRO action on three, the SRO was waiting for Commission action on two, and the Commission and the SRO were waiting for discussion in a third party forum on one of the filings.
These six open filings were complex and/or controversial, lending themselves to a longer review period. In these cases, additional amendments and frequent debates between the Commission, SRO's, and third parties were necessary. Division officials advised that when there are complex issues involved, SRO's must frequently obtain approvals from their boards and/or committees. Accordingly, some factors are not in the Division's control. However, we believe that older filings should be reviewed to determine what action, if any, can be taken.
Other potential areas identified for improving the flow of rule filing information include:
- Rule filing documentation is often faxed by the SRO to varying Division staff depending on who the SRO knows is working on the filing, with paper copies also being sent. However, Division officials advised that, when an employee is absent, the review process can sometimes be temporarily held up because others do not receive the faxed documentation. Additionally, the Division has only one fax machine used for rule filings and it is not used exclusively for this purpose.
- SRO's submit filings in Word 7.0 and the Commission uses Word 6.0. The Commission plans to move to Windows NT, which should have Word 7.0. Currently, a Division ADP liaison has a converter package (obtained free off of the Internet) that is used to convert documents received from SRO's. While some attorneys use this package, others are not aware of it or request that the SRO's convert the information prior to submitting it.
- Form 19(b)(4), used by SRO's to submit rule change proposals, contains about 80% duplicative information. The first part of the form is the actual proposal language, while the second part is the notice, which is virtually identical in many respects to the first part. Although updating the form is not considered a Division priority, it should be something that the Division should work toward.
The Division of Market Regulation should develop a 30-day log for Assistant Directors.
The Division of Market Regulation should review and consider what action (e.g., approve, disapprove, or encourage withdrawal), if any, should be taken on all rule filings open for more than 365 days.
The Division of Market Regulation should instruct SRO's to copy all pertinent Division staff on rule filing documentation. Additionally, the Division should purchase an additional fax machine and/or desk-top faxing for selected staff.
The Division of Market Regulation should provide a word processing converter package (and instructions) to all staff attorneys.
The Division of Market Regulation should consider updating/revising Form 19(b)(4).
Division officials advised that periodic meetings used to be held with NASD and NYSE officials from 1988-1996 to identify recurring glitches in the review process, changes in statutes, and to provide information on problems with existing filings. However, these meetings ceased after the Division reorganized in 1997 and the Assistant Directors no longer specialized in certain SRO's. Division and SRO staff felt that these meetings helped develop and improve working relationships.
SRO officials indicated that they would like clarification of the process their filings go through, as well as which individuals are working on them. Due to Commission turnover and organizational changes, keeping SRO's informed seems critical to the efficiency of the review process.
One suggestion is to create a Division home page on the Commission's Internet site, such as the Division of Enforcement's site. A home page could include a current organization chart (with names, titles and phone numbers). Division staff advised that they were working internally to create such a site. However, since resource constraints in OIT have limited the development of new home pages, the Division will need to coordinate with OIT. Division management should also instruct staff attorneys to immediately notify the SRO once a filing assignment is made.
The Division of Market Regulation should institute periodic face-to-face meetings with SRO's, as appropriate, to discuss rule filings and related topics.
In coordination with OIT, the Division of Market Regulation should create its own home page on the Commission's Internet site.
The Division of Market Regulation should instruct staff attorneys to immediately notify the SRO about the process and individuals assigned once a filing assignment is made.
POLICIES AND PROCEDURES
During the review, Division officials updated the policies and procedures for secretaries under the review process. We reviewed these procedures and believe that they clarify and improve secretarial roles and responsibilities. Division officials also advised that they planned to update the staff handbook for rule filings, create document control procedures, and prepare a procedural manual for the new ACCESS tracking system (e.g., entering/retrieving data, operating the system).
The Division of Market Regulation should implement their plans to update the staff handbook for rule filings to include document control procedures.
The Division of Market Regulation should implement their plans to prepare and issue a procedural manual for the ACCESS system to all staff.
TRAINING PROGRAM FOR NEW STAFF
Division officials advised that new staff are given a brief overview of the rule filing process. In addition, management regularly arranges for outside groups to lecture staff on securities law topics. Finally, trips are periodically scheduled for new staff attorneys to visit exchanges.
Division officials stated that, once the Office of Compliance Inspections and Examinations became a separate entity in May 1995, training for new staff became less formalized. Additionally, weekly meetings used to be held with staff to present and discuss securities law issues. However, these meetings were discontinued because of time constraints.
We believe that a formalized training program for new staff attorneys would benefit the entire review process. Besides the topics mentioned above, such a program should include subjects, such as dealing with SRO staff, using the automated tracking system, and emphasizing only substantive changes (in lieu of format or editorial changes) when reviewing filings.
The Division of Market Regulation should institute a formalized training program, as described above, for new staff attorneys.
TECHNIQUES FOR HANDLING TURNOVER
Staff turnover is a hindrance to the review process. Division officials advised that each manager handles turnover differently. Some have an exit interview/briefing with the departing attorney, while others have the attorney train the person taking over. Furthermore, some managers ask the departing attorney to prepare a work summary.
The Division of Market Regulation should encourage its managers to use a variety (or combination) of techniques, as appropriate, in handling turnover.
We reviewed performance plans for selected Division staff. We felt that the plans were sufficient to evaluate staff performance in the rule filing process, but that enhancements could be made to make them more useful.
The performance plan for Attorney-Advisors did not include timely, accurate, and complete maintenance of file documentation and review of information entered into the automated tracking system. Additionally, the performance plans for support staff did not include timely and accurate data entry into the automated tracking system.
The Division of Market Regulation should modify the performance plans for Attorney-Advisors and support staff as described above.
1 The Commission may designate up to 90 days to take action on a proposed rule change if it finds it necessary and publishes its reasons; or the SRO may consent to a time extension.
2 The Commission may extend the time for conclusions of such proceedings up to 60 days if it finds good cause and publishes its reasons; or the SRO may consent to a time extension.