AIG Advisor Group, Inc.
December 30, 2002
Jonathan G. Katz
Re: Proposed Rule Change Pursuant to 17 CFR 240.19b-4
Dear Mr. Katz,
I am writing to you on behalf of the AIG Advisor Group, Inc. (AIG/AG). AIG/AG is the marketing designation for the wholly owned subsidiary broker dealer members of American International Group (AIG): Advantage Capital Corporation, FSC Securities Corporation, Royal Alliance Associates, Inc., Sentra Securities Corporation, Spelman & Co., Inc. and SunAmerica Securities, Inc. The AIG/AG broker/dealer member firms represent, in the aggregate, approximately 7500 independent contractor registered representatives.
The AIG/AG broker/dealers are also members of the Financial Planning Association (FPA) and its broker/dealer division. Although we are responding by using an FPA suggested template, we are adding additional commentary where appropriate.
As Chief Legal and Regulatory Counsel of AIG/AG, I appreciate the opportunity to submit comments on the issues raised in the above captioned proposed rule change by the National Association of Securities Dealers, Inc. (NASD). Efforts to enhance supervision should be commended. Effective supervision is a cornerstone of investor confidence and efficient markets. Indeed, the issue is of such import that further member consideration should be afforded the issues presented in this proposal. In that regard we respectfully request that additional time be allotted to the comment period so that all member firms may more diligently and intelligently review the proposal and its effect on their business. Alternatively, we would request that the proposal be sent back to the NASD with specific direction to seek input from all NASD members prior to Commission approval. Bypassing traditional channels to afford member comment and input ignores the benefits of self-regulation.
This proposed rule would have a dramatic impact on many small firms and all firms that are organized on an independent contractor basis. The NASD membership includes hundreds of members that are structured differently than the large wire houses and regional firms and would be substantially damaged by the proposed rule. The AIG/AG member firms and their industry counterparts in the FPA have a long and successful history of working proactively with the NASD to vet proposals that are deemed to have a dramatic effect on their supervisory and business models without requisite increase in consumer protection.
Quite frankly, we were also surprised that a significant new proposal such as NASD Conduct Rule 3012 (Rule 3012) would have been sent to the SEC without prior NASD member comment. As set forth in the FPA responses to this proposal, that process was completely skirted in this instance by denying both the NASD and SEC the valuable insights and experience of brokers/dealers most impacted by this proposal.
We also agree that it would be very unfair to implement Rule 3012 without adequate opportunities for those firms to provide feedback as to their experience complying with present NASD guidelines with respect to supervisory systems, which have been reasonably designed to detect and prevent sales practices abuses. AIG/AG also believes that full review and thorough analysis of all ramifications of Rule 3012 for NASD members would also assist the Commission in creating a fair, balanced and meaningful final rule. Please extend the comment period to at least ninety (90) days.
Effective enforcement of existing rules will promote investor protection more effectively than additional rules and regulations.
With respect to the proposal, AIG/AG is concerned that Rule 3012 changes submitted by the NASD are an overreaction to isolated failures by a small number of member firms. The Gruttaduaria case was not so much a failure of the current regulatory system as it was a single individual intent on defrauding customers. The firms affiliated with the Gruttaduaria case failed to comply with existing supervision rules and failed to apply existing firm policies. We are sure that such message will be driven home in subsequent legal and regulatory actions against such firms and their associated persons. The key point is that the existing rules were and are sufficient to prevent unlawful conduct. Certainly no set of rules can protect against every circumstance, and to expect that they should is unreasonable. Current regulations are reasonable and sufficient when effectively implemented and enforced. Thus, enforcement of existing rules will better serve the interests of investors. New rules simply add complexity and cost without additional guarantees against unlawful conduct.
If additional rules are required proposed Rule 3012 requires significant changes.
In the event that the NASD is committed to additional rule making, the proposal requires a cost/benefit analysis as to the merits of its results, in light of the impact to the business and supervisory models of so many NASD member firms. As written, the proposed rules are vague, needlessly burdensome, and will have a negative impact on AIG/AG's ability to supervise the sales activity of its registered representatives. Such rules will also delay implementation of recently adopted rules responding to the requirements of the USA PATRIOT Act, and will substantially increase costs to a significant percentage of member firms without providing a meaningful improvement in investor protection.
The proposal lacks definition of key operative terms.
Key words in various provisions of the proposed rules lack sufficient clarity. First, the heart of proposed Rule 3012 and the revisions to Rule 3010(c) is "independence". Rule 3012 contemplates independence of those persons charged with verifying compliance with firm supervisory procedures. Likewise, Rule 3010(c) requires independence from those charged with conducting branch office inspections. Unfortunately, there is no definition or explanation of "independent" as it is used in either rule. To the extent that the term "independent" is the touchstone of these new rules, it follows that defining this term is critical to a common and complete understanding of Rule 3012. Failing to define such a key term leaves Rule 3012 open to inconsistent application within member firms and among the various NASD District Offices responsible for its enforcement. In addition, if such firms are required, in mass, to rely on third parties to achieve such "independence", what is to be gained when such firm's institutional and operational history and knowledge is diluted by the contracting of so many "outsiders"? Surely, room for error in the auditing process exists equally for both in house auditors and "independent" auditors.
Similarly, changes to Rule 3110 require record keeping with respect to the "essential facts" supporting an account name change. Again, no guidance is offered in the rule that illuminates the meaning of "essential facts." Such inarticulate rule making requires supervisors to make uninformed judgments about incomplete rules. In response, supervisors will subject themselves and the customers of their firms to unduly rigid procedures that do not account for the specific needs of individual investors. Accordingly, the proposed amendments will not result in enhanced supervision of sales practices.
The proposed rules are unduly burdensome.
By requiring independence in the supervisory system, the NASD has with a broad brush prohibited numerous supervisory systems and structures that function well. As a result, effective systems will be scuttled for a regulatory system that may not fit the geography, structure or function for a given firm. Worse, the system suggested in Rule 3012 is sure to require additional human resources without any evidence that investors will be better served. First, Rule 3012 requires an independent review of supervision. To what extent should that independent review be subject to review as well? The rationale of Rule 3012 results in an endless chain of supervisors supervising supervisors. In contrast, the existing regulatory scheme requires that firms adopt policies and procedures reasonably designed to prevent and detect violations. That standard provides firms the necessary guidance in establishing a supervision system with specific goals in mind. If independent testing facilitates a standard and achieves goals, then that independent testing process may be employed by member firms. However, such procedures should not be the burden of those firms that have already demonstrated the ability to create supervisory policies and procedures that are effective. The NASD in its 19(b)(2) filing assured the SEC that Rule 3012 will have no impact on competition; as you can see, this is clearly not the case as costs of the application of Rule 3012 will depend on existing policies and procedures and the internal structures of each firm.
Also of concern is the apparent incongruity within Rule 3010. The existing Rule 3010(g) establishes Offices of Supervisory Jurisdiction (OSJ) as those locations in which supervisory functions are performed. Obviously, Rule 3010 presumes that those OSJ branches are to be staffed with managers and other registered persons with the responsibility and the expertise to effect supervision. Proposed Rule 3010(c) turns that presumption on its head, stating that supervision through the examination process is effective only if done using independent parties.
Aside from the erroneous logic in Rule 3010(c), this requirement severely reduces the number of principals eligible to conduct branch exams. Members can respond to this burden in one of two ways: hire additional staff, or stretch reduced auditing resources over a larger sample of branches. (Do not forget that the proposed branch definition rule will increase the number of registered branch locations.) While some firms may make the difficult choice to increase staff, other firms simply will not have the economic capacity to do so. If those firms are faced with sending compliance employees to audit hundreds of additional locations, then the duration and the quality of the audits may decline. Furthermore, the audit cycle will lengthen, increasing the period of time between inspections. Accordingly, the proposal may have the unintended consequence of forcing firms into economic dilemmas that erode supervisory resources without any evidence that examiner independence will improve supervision outcomes.
Furthermore, with respect to the burdens associated with this rule change, many firms have actively sought to make supervision more timely, more hands on and as close to the point of sale as possible. The theory is that the closer you are to sales practices the more effective you can be at identifying problems quickly and taking prompt remedial action. To support these efforts, AIG/AG has invested substantial resources in training and firm element continuing education materials that instruct managers on "just in time" supervision. This model can be an effective one that serves client interests. Unfortunately, this model is under attack from the proposed Rule 3012.
Finally, the obligations of these new rules force our firms to seriously assess the expenses associated with some of our more remote locations. If we and our colleagues choose to withdraw from various rural communities as a result of Rule 3012, there can be no guarantee that the void left behind will be filled. Customers in these under-served areas will have to travel farther and farther to meet with someone that can help them with financial decisions. Thus, reducing the competitive capabilities of my firm and firms like mine comes at the detriment to our clients and others in their communities.
Attempting to separate supervision and auditing reduces the effectiveness of both functions and results in a waste of compliance resources.
AIG/AG is particularly concerned by the requirement that the office audit function be independent of the supervisory function. Along with the majority of NASD Member Firms, we employ a hierarchical system of supervision. Our representatives work from non-OSJ Branch offices and unregistered locations ("satellite offices"), while each branch and satellite office is assigned to an OSJ for supervision. The OSJ Manager is also responsible for an annual inspection of each office under his/her supervision. In addition, the OSJ is supervised and inspected by a salaried employee of the firm or independent consultants. To divorce the inspection of branch and satellite offices from the supervision of the representatives assigned to those locations is to introduce an artificial distinction between the two activities. We believe that our OSJ Managers, who are most familiar with the representatives and activities associated with those locations, are the most qualified to perform the periodic inspection. The increased understanding gained from the inspections enhances the effectiveness of the OSJ Managers' supervision, and the supervision activities provide additional information regarding the types of activities that should be more closely monitored in the inspection. In addition, when OSJ Managers audit the branch and satellite offices, it serves to reinforce the OSJ Managers' accountability for their representatives' actions. By appointing an outside party (such as the firm's Compliance Department or unrelated contractors, as many small firms will be required to do) to audit the branch and satellite offices, OSJ Managers will have a decreased sense of responsibility with regard to the activities conducted at the offices. In response to prior NASD actions against independent contractor firms for failing to develop and maintain dynamic supervisory systems, AIG/AG has strived to make ownership of local supervisory responsibilities "Top-Of-Mind" with our OSJ Managers.
Currently, our OSJ Managers understand that in the event of wrongdoing by a representative, the OSJ Manager will be held accountable by the firm and its regulators unless he/she is able to demonstrate effective supervision over the representative. The NASD's proposal may lead some OSJ Managers to feel that their supervision is less important, as they begin to rely on the firm's Compliance Department to detect problems during the periodic office inspections. Reverting supervision back to Compliance personnel - regardless of our ability to economically support it - flies in the face of prior NASD efforts to drive supervision down to the local level. In essence, the overall level and quality of supervision over the representatives may decline. Although it may be argued that a qualified, disinterested third party may be more motivated and qualified to conduct superior oversight, we must realize that such "qualified" oversight is limited to a snapshot arrived at once during each audit cycle--as opposed to the expectation of ongoing supervision by our OSJ Managers.
The proposal may result in implementation delays for other key rule changes.
As stated above, these rule changes add significant costs to our Compliance Department, not simply in terms of money, but time as well. Our firms are awaiting guidance from the Treasury Department on customer identity verification. In addition, we continue to work on the implementation of the Commission's revised requirements for the maintenance of books and records. Even with increased funding for supervision, there is a limit to the amount of change that may be implemented to our systems at any one time. Because the office examination process is a core component of our supervisory structure, changes in this area will impact the timeline for completing changes in these other key areas. Therefore, we strongly suggest that barring the firm from making appropriate use of its OSJ Managers will result in decreased supervision of our representatives and a waste of the resources allocated to supervisory and compliance functions.
The proposed requirement regarding supervisory controls is flawed.
At our firms, similar to many of our peers, the Chief Compliance Officer ("CCO") is responsible for the design, implementation and oversight of the firms' system of supervisory controls. Restricting the CCO from performing and/or overseeing such a review would compromise the quality and thoroughness of each review. An alternative to fulfill the new independence requirements would be to assign someone from Marketing or Operations to perform the review. We believe that such an alternative would likely result in a supervisory review that is less sensitive to securities compliance issues.
Finally, given the relatively small number of serious cases, as compared to the universe of firms and representatives, it appears that the majority of firms clearly strive to conduct business in a manner that is compliant with industry rules and regulations. Members realize that if the public loses faith in the investment community, then we all lose.
I am confident that the current regulatory environment already provides the necessary tools and resources for firms to properly oversee their representatives, and I strongly believe that the proposed changes will actually have a negative impact on the effectiveness of our overall supervision, as well as place a significant and inefficient financial burden on NASD members.
If strictly construed, the proposals would establish new requirements that could be extremely burdensome for firms, particularly small firms, to implement. The proposed rule changes present a huge burden for independent contractor firms and firms with far-reaching branch networks and will result in an inappropriate burden on competition. For the reasons cited above, the proposal as it relates to independent inspections of branch offices would have been more appropriate as a recommended guideline for effective supervision rather than a hard and fast rule that applies to firms across the board. AIG/AG urges the Commission to consider the real world ramifications and costs of this proposal and to consider alternatives that would allow firms to meet their obligations with internal resources and minimal disruptions to existing supervisory structures.
We respectfully request that the NASD reconsider both its current rulemaking process, as it relates to this proposal, as well as certain of its underlying tenants and assumptions. We have witnessed that even the best wire house supervisory systems are only as good as the firm's intent to support them.
AIG/AG and its industry colleagues would be happy to work with the NASD to consider new ways to refine such a proposal. We believe that this can be accomplished by increased
emphasis on placing the ownership of supervisory responsibility on OSJ Managers through additional advisories and educational programs directed at them.
The AIG Advisor Group broker/dealers thank the Commission for the opportunity to comment on these important issues.
c: Robert Neill - Financial Planning Association