Cambridge Investment Research, Inc.
December 20, 2002
VIA OVERNIGHT DELIVERY AND E-MAIL
Mr. Jonathan G. Katz
Re: File No. SR-NASD-2002-162 Filed Pursuant to 17 CFR 240.19b-4
Dear Mr. Katz,
Cambridge Investment Research, Inc. ("CIR") became registered with the SEC as a broker-dealer in 1995. CIR presently has approximately 550 independent registered representatives located in remote locations throughout the United States. CIR clears its securities business on a fully disclosed basis through Pershing and National Financial Services. Approximately 40% of CIR's revenues come from RIA fees, with the remaining 60% generated primarily from the sale of mutual funds and variable insurance products. Subsequent to the publication of NASD NTM 99-45 CIR developed a system of supervision of its remote offices that delegates the primary responsibility for the day-to-day supervision of securities and RIA activities to the OSJ managers located in the remote office. The personal business of each OSJ manager is supervised from the home office. Since it's founding CIR has not been the subject of any regulatory enforcement action. We believe strongly in the concept of self-regulation and we work very hard to maintain a compliant environment throughout our system.
We 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 and strengthen the system of self-regulation should be commended. Effective supervision is a cornerstone of investor confidence and efficient markets. This why it was so troubling to read the NASD's comments in their Rule 19b-4 filing that "written comments were neither solicited nor received" from the membership and that the "NASD does not consent at this time to an extension of the
time period for Commission action". Bypassing traditional channels to afford member comment and input on such a complex issue ignores the benefits of self-regulation.
A general reading of the proposed rule changes indicates that the drafters have little or no real understanding of the supervisory systems in place in most NASD members. Therefore, we believe it is imperative for the membership of the NASD, particularly those of us who have not experienced extreme lapses in our supervisory systems, to have substantial input into the construction of these proposed rule changes. Only through effective and meaningful dialogue between the membership and the NASD staff can we ensure that we don't throw out the baby with the bathwater.
Effective enforcement of existing rules will promote investor protection
The rule changes submitted by the NASD are an overreaction to one isolated supervisory failure. The Gruttaduaria case was not so much a failure of the current regulatory system as it was the failure of a specific supervisory system to detect what appears to have been an open and obvious fraud on customers. The firms affiliated with the Gruttaduaria case clearly failed to implement a system of supervision that would have met any of the applicable regulatory standards in force at the time. The key point is that the existing rules were and are sufficient to prevent the unlawful conduct in the Guttadauria case. The NASD and SEC have codified the fact that a system of supervision does not have to be perfect. It merely has to be reasonable under the circumstances to detect and deter the improper activities in question. In the Guttadauria case the systems in place did not meet this standard. This should not lead to an assumption that the entire system of supervision throughout the industry is broken. We believe that current regulations are reasonable and sufficient when effectively implemented and enforced. Enforcement of existing rules concerning supervision will better serve the interests of investors. The NASD simply has shown no credible evidence that the amended and new rules they propose provide additional, meaningful safeguards for investors.
The proposal lacks definition of key operative terms.
Key words in various provisions of proposed Rule 3012 and the amendments to Rule 3010(c) are vague and lack sufficient clarity to enable members to be certain that their compliance efforts will be deemed reasonable by the NASD. 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. Failing to define such a key term leaves the rule open to inconsistent application among member firms and among the various NASD District Offices responsible for enforcement. 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 as to how the NASD will interpret "essential facts." Although it is not entirely clear, it appears that the only way for a member to ensure that the persons engaged to conduct audits and oversee the firm's supervisory system is to retain outside attorneys or accountants at costs that most firms will be unable to bear. Accordingly, the proposed rule and amendments will not result in enhanced supervision of sales practices but will create a further unlevel playing field in which large firms will be granted by the NASD another substantial competitive advantage over smaller firms.
The NASD has not shown that the current system is broken.
By forcing firms to retain outside attorneys or accountants to conduct audits and evaluate the firm's supervisory system the NASD has for no valid reason chosen to prohibit numerous supervisory systems and structures that function well. Worse, the system suggested in Rule 3012 is sure to require additional human resources without any evidence that investors will be better served. Member firms are already obligated under SEC and NASD rules and regulations to establish effective written supervisory procedures and systems. Rule 3012 merely duplicates these existing requirements at substantial additional cost. In the current regulatory environment it is unlikely that a firm will be able to obtain an independent review of and report on its supervisory system at a cost less than the firm currently pays for its annual financial audit. Certainly, the NASD has no credible evidence that firms will not have to incur such costs.
Attempting to separate supervision and auditing reduces the effectiveness of both functions and results in a waste of compliance resources.
We are particularly concerned about the requirement in Rule 3010(c) that the office audit function be independent of the supervisory function. Along with the majority of NASD members, we employ a hierarchical system of supervision. Our registered representatives work in OSJ branch offices, non-OSJ branch offices and unregistered locations ("satellite offices"). Each non-OSJ branch and satellite office is assigned to an OSJ Manager. The OSJ Manager is responsible for the day-to-day sales supervision of the registered representatives assigned to the OSJ Manager and for an annual audit of each office under their supervision. The OSJ Manager's office is audited by an auditor who is a salaried employee of the firm and who reports to the Compliance Department, not the OSJ Manager. We believe that this system is consistent with the spirit and letter of NASD NTM 99-45.
We believe that our OSJ Managers, who are most familiar with the registered representatives who work under them and activities associated with those locations they oversee, are the most qualified to perform the periodic inspection. We also believe that the increased understanding gained from these inspections enhances the effectiveness of the OSJ Managers' supervision of each registered representative's business activities. In addition, when OSJ Managers audit the non-OSJ branch and satellite offices, it serves to reinforce the OSJ Managers' accountability for the actions of the registered representatives they supervise. By appointing an outside party (such as the firm's Compliance Department or outside contractors) to audit the non-OSJ branch and satellite offices, OSJ Managers will have a decreased sense of responsibility in connection with their other supervisory responsibilities.
Currently, our OSJ Managers understand that in the event of wrongdoing by a registered representative, the OSJ Manager will be held accountable by the firm and its regulators unless they are able to demonstrate that they effectively carried out the firm's supervisory procedures. In this situation, the overall level and quality of supervision carried out by OSJ Managers may decline.
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. Contrary to the NASD's blanket statement, we are convinced that this initiative will result in an inappropriate burden on competition. The rule proposal goes well beyond the realities of the Guttadauria case and poses unduly burdensome and negative effects on a system of supervision that has worked well for decades. Therefore, we urge the Commission to consider the real world ramifications and costs of this proposal.
It would be very unfair to implement the rule proposal without adequate opportunities for all firms to learn about it, thoroughly review it, and comment on it. Full review and thorough analysis of all ramifications of the rule proposal would also assist the Commission in creating a fair, balanced and meaningful final rule. Therefore, we urge the Commission to extend the comment period to at least ninety (90) days from year-end.
Again, we thank the Commission for the opportunity to comment on these important issues.