May 17, 2007
May 15, 2007
Re: NASD Rule 3060
To: SEC Staff
I appreciate this opportunity to be heard regarding business entertainment of customer representatives by member firms and associated persons.
The interpretation states that no member shall provide business entertainment to a customer representative, pursuant to the establishment of, or during the course of a business relationship with any customer, that is INTENDED or designed TO CAUSE or would be reasonably judged to have the likely effect of causing such customer representative TO ACT IN A MANNER INCONSISTENT WITH:
(1) THE BEST INTERESTS OF THE CUSTOMER, or
(2) the best interests of any person to whom the customer owes a fiduciary duty.
Customer representative is defined as 'an employee, officer, director or agent of a customer (excluding designated family members).
The intent of the rule is clear.
Enforcement of the rule is not at all clear.
Uncertainties surrounding future enforcement have prompted the following observations.
Registered Investment Advisors are not Members or Associated Persons. Both NASAA and Fed-covered IA registrants, in their pursuit of fee-based and financial planning business, provide business entertainment to those who have decision-making power or influence over another person's choice of which fee-based firm with whom to do business.
In light of the Court's recent reversal of SEC's B-D Exemption rule, and SEC's decision not to challenge the Court's ruling, this may have just become very significant.
This is particularly true where some of the previously-exempted ONE MILLION accounts representing
300 BILLION dollars in assets are going to be 'encouraged and induced' to stay put, or 'encouraged and induced' to move to a true IA status.
How much money is going to be spent to keep those clients from leaving a member firm entirely? Will any or all of those expenditures be viewed as INTENDED to cause a customer rep to act in a manner inconsistent with the best interests of the customer?
Who is going to decide, from a compliance and enforcement viewpoint, if it is in a given customer's best interest to leave the B/D and go elsewhere? Who will decide if an impropriety has been committed when competing firms go after that lucrative business which is now 'up for grabs.' What metric will be used to judge, and who will be the judge? How much of what is spent will fall under the heading of 'business entertainment' expenditures.
I see nothing in the current proposal designed to address this serious and very current issue.
In the section titled BACKGROUND (beginning at the bottom of page 8), the following statements appear:
"The proposed rule change is intended to replace this statement regarding business entertainment with an approach that permits each member to adopt specific policies and procedures tailored to its business needs."
"The proposed IM does not impose hard limits nor does it require that all members adopt the same limits or even treat all recipients equally. Rather, the proposed rule change requires that each member assess its use of business entertainment, determine what limitations are appropriate and meet the general guidelines set forth in the proposed rule change..."
Small and mid-sized broker/dealers focusing on the words
"tailored to its business needs"
"requires each member assess its use of business entertainment, determine what limitations are appropriate"
will conclude that these new parameters will enable them to increase their business entertainment budgets sufficiently to enable them to compete with the big firms for the business of the wealthiest and the big ticket clients - the most lucrative and most sought-after business.
The historical and existing bias of customer reps of the wealthy and big ticket clients is to give the business to the major firms. Small firms whose quality of customer service is equal to or better than the big firms have no way of reversing the bias without showing that they can compete.
It is unfortunate but inarguably true that business entertainment is EXPECTED by customer reps: it's how it's done in the world in which we operate. No regulation is going to undo that expectation by people who control billions of dollars of other people's money, the expectation that they will be 'entertained' as part of the pre-requisite 'dance' to get the business of the customer they represent.
It's hard enough to overcome the historical bias in favor of the largest firms. Putting the smaller firms at a further disadvantage is the financial burden these expenditures represent as a percentage of net capital and of overall operating expenses, which in turn may or will raise surveillance concerns at the Designated Examining Authority when it views FOCUS reports.
Business entertainment expenditures by the big firms are escalating and there is reason to believe the trend will continue, creating an even greater financial disadvantage to the smaller member firms.
How does the new SRO intend to address the issue of small and mid-sized firms spending disproportionately more in business entertainment expenditures, as described above?
Will the Department of Enforcement file charges against these firms for violating Rule 3060 for spending 'too much,'
alleging that DOE applied an internal 'reasonably judged' standard, and ascertained that it was 'likely' that the business entertainment 'caused' a customer rep to 'act in a manner inconsistent with the best interests of the customer?'
When an accused member firm defends its expenditures as being an absolute business necessity, designed to encourage customer reps to 'give our small-firm services a chance, give us a try,' will a Disciplinary Panel appointed by the Office of Hearing Officers turn a deaf ear?
It's only a matter of time before the test cases begin, and an adverse ruling could amount to a corporate 'death penalty' for a small member firm. This is particularly true because this kind of violation would constitute conduct deemed morally and ethically reprehensible, even egregious - the kind of violation that commands special attention when the sanctions are determined, i.e. expulsions and bars.
Quoting from the GENERAL REQUIREMENTS (pg. 2)
"No member....shall provide any business entertainment to a customer representative.....that is intended or designed to cause...such customer representative to act in a manner inconsistent with the best interests of the customer..."
Who at the new SRO is in a position to judge that a customer rep's decision to give a small firm a 'shot' at the customer's investment business is not in the best interests of that customer?
If it requires a significant increase in the entertainment budget to 'break through' the bias against dealing with anyone but the big firms, who at the SRO is going to judge that this is inherently unethical, or suggestive of impropriety.
Are the SROs building in an assumption that members are guilty of coercive conduct unless they can PROVE that their services are at least equal to, if not better than, the big firms' services? What metric will provide a 'safe harbor' from being held in violation of 3060?
Precisely what does 'best interests of the customer' mean, in the 3060 context?
Rule 3060 avoids setting hard limits - this is commendable. Small firms are counting on the new SRO to give all due consideration to the unique needs of the smaller firms who are trying to compete for business in a world in which the number of member firms is shrinking, and the most lucrative business is largely given to the major firms, not necessarily because they have provably 'better service.'
In anticipation of the future filings of charges against small and mid-sized member firms for 3060 violations alleging the business entertainment expenditures were INTENDED to cause a customer rep to act in contravention of the customer's best interests, I ask the NASD and the NYSE to go on record that as SROs, they do not intend to enforce 3060 in a such a way as to draw an automatic connection between disproportionately higher business entertainment expenditures by the smaller firms, and an INTENT to cause inappropriate behavior by customer reps: the member's goal is solely to get 'the foot in the door,' to demonstrate the member's excellent customer services, services which are intended to be IN THE BEST INTERESTS OF THE CUSTOMER.
Absent assurances that the DOE is going to be directed to take a reasonable, well-conceived approach, some Members will be put in an untenable position, and may conclude they have no choice but to inform customer reps whom they are soliciting for business that 'business as usual' is history.
Consider this possible future scenario:
Customer representatives are being bombarded with unsolicited communications from all sorts of sources, including the media, attorney groups, and a wide range of consultants, informing them that their 'continued' receipt of 'business entertainment' from any NASD or NYSE member firm, whether such entertainment is direct or indirect, current or future, front end or back end, tangible or intangible, hard dollar or soft, solicited or unsolicited, declared, under-declared or completely undeclared, will be the subject of intense regulatory scrutiny as never before.
Customer reps will be notified that they should prepare to be asked or compelled to prove a negative that the business entertainment they have received played NO part in their decision to give business to one firm over another. They may become subject to lawsuits as a result of their testimony.
Customer reps will be informed that they should expect to be subpoenaed to appear and testify under oath at NASD Arbitration Hearings, and possibly in State or Federal Court, to disclose FULLY and CLEARLY how their decisions to whom to give customer business were made - that their decisions were NOT influenced by business entertainment, not even 1% influenced.
The mere prospect of this sort of intense scrutiny will mark the end of TRANSPARENT DISCLOSURE of business entertainment expenditures in the securities-related arena.
Of course, it's a given that business entertainment will never stop - it will become opaque or invisible, which defeats the entire purpose of Rule 3060 as well as 2110.
Such are the potential unintended consequences of unwise and ill-conceived enforcement of this otherwise well-intended rule.