-------------------------- COVER PAGE ------------------------- REPORT ON THE STATUS OF THE RECOMMENDATIONS FROM THE LARGE FIRM PROJECT REPORT Division of Market Regulation Division of Enforcement United States Securities and Exchange Commission This is a report of the Division of Market Regulation and the Division of Enforcement. The Commission has expressed no view regarding the analysis, findings or conclusions herein. -------------------- BEGINNING OF PAGE #1 -------------------- I. INTRODUCTION On May 19, 1994, the Securities and Exchange Commission ("SEC" or "Commission") announced the findings of a review undertaken by the SEC, working in conjunction with the New York Stock Exchange, Inc. ("NYSE") and the National Association of Securities Dealers, Inc. ("NASD), of the hiring, retention and supervisory practices of nine of the largest broker-dealers in the United States. This review was commenced because of increased concerns on the part of the Commission and others regarding the frequency and severity of sales practice abuses perpetrated by some registered representatives, particularly those moving from firm to firm. As part of this review (referred to as the "Large Firm Project" or "Project"), Commission, NYSE, and NASD staff conducted 170 examinations covering home offices of the nine firms and 161 branch offices. The Project also focused on 268 registered representatives ("selected registered representatives") who had been the subject of sales practice-related customer complaints, named as defendants or respondents in customer-initiated litigation or arbitration proceedings, or otherwise had been the subject of an enforcement or disciplinary action by a state or federal governmental entity or self-regulatory organization ("SRO"). The Large Firm Project Report ("Report") contained the following six specific findings: 1. More than one-third of the selected registered representatives were no longer in the securities industry. 2. Approximately 25 % of the examinations resulted in enforcement referrals. [Although one-quarter of the examinations resulted in enforcement referrals, this was not surprising. The branch offices were selected on the basis of, among other things, large numbers of customer complaints as reported to the NYSE. The selections were made with the intention of following up with enforcement action, whenever appropriate.] 3. Three of the nine firms accounted for 88% of the enforcement referrals. 4. Some branch office managers were not enforcing supervisory and compliance systems. 5. Registered representatives were able to move when customer complaints existed. 6. The largest revenue producing registered representatives generally were not the subject of investor complaints. -------------------- BEGINNING OF PAGE #2 -------------------- These findings suggest, in our view, that there is a need to devote additional resources at the firm, SRO, and Commission level to the detection and prosecution of registered representatives who have a history of sales practice problems or who commit sales practice violations. In addition, based on the results of the Project, as well as the Commission's oversight examination program generally, a number of areas relating to the enforcement of sales practice rules and detection of violations need improvement. In particular, the Commission Staff ("Staff") found deficiencies with respect to: (a) compliance with SRO reporting requirements; (b) tracking systems for SRO handling of investigations relating to Form U-4 and U-5 filings; and (c) the level of disclosure by firms on Form U-5. -[1]- Moreover, based on the results of our overall sales practice examination efforts, the Staff is concerned that the present level of sanctions may not provide sufficient deterrence against sales practice misconduct by registered representatives, and that existing disclosure regarding SRO disciplinary actions is inadequate. II. RECOMMENDATIONS The Report proposed a series of recommendations that the Staff believes will strengthen broker-dealer compliance mechanisms, enhance SRO efforts in detecting sales practice abuses and enforcing compliance with applicable rules, and reinforce the Commission's principal mandate of investor protection. What follows is a plan for implementing those recommendations, as well as a summary of what has been accomplished already. Additionally, on August 4,1994, the Division of Market Regulation and Division of Enforcement sent a letter ("August Letter") to the SROs suggesting a number of changes and requesting a timetable for implementation of those recommendations directed to the SROs. - [2]- See Appendix A for a sample of the letters. The responses we have received thus far generally agree with and support the overall findings and recommendations of the Large Firm Project. We have addressed the recommendations sequentially, as set out in the Report, below. 1. Increased Examination Efforts and Sanctions in all Sales Practice Matters Over the past five years, the SROs have increased substantially their staff resources devoted to enforcement matters, have brought an increased number of sales practice and failure to supervise cases, and have increased sanctions for violative conduct. Nevertheless, based on the results of the Project, stepped up examination efforts are necessary, existing supervisory and compliance systems designed to detect problem registered representatives need improvement, and existing sanctions for sales practice violations at both the SRO and Commission level need to be strengthened. a. Examination Efforts The Staff has increased its focus, and has encouraged the SROs to do likewise, on registered representatives with large numbers of customer complaints, arbitration awards or settlements, or disciplinary actions, and we will continue to step up our oversight efforts with respect to sales practice examinations conducted by the SROs. Focusing our attention and increasing the visibility of our presence in this arena will convey a strong message that violative behavior will not be tolerated by the Commission or by the SROs. The Staff is exploring different methods of utilizing NYSE Rule 351 data in its regular examination program. -[3]- The Staff also is developing a program for the systematic review of allegations made in arbitration cases filed with the NASD and -------------------- BEGINNING OF PAGE #3 -------------------- other SROs. This will enable the Staff to review allegations of sales practice abuses on a more timely basis, and should aid in the earlier identification of problem registered representatives. We are continuing our efforts to bring to the SROs' attention those areas we feel need improvement. The Division of Market Regulation, in the past ten years, has increased its oversight of the SROs' sales practice compliance and enforcement programs. This oversight includes increased compliance inspections, and regular meetings with senior staff of the NYSE and NASD to discuss the importance of effective sales practice compliance and overall enforcement programs. It also has contributed to an increased SRO commitment to identifying and disciplining sales practice abuses. The August Letter requested that the NYSE, NASD, and other SROs work on developing better tools for identifying sales practice problems at an earlier stage. Specifically, we have asked the SROs to enhance their efforts in the review of sales practice allegations made in arbitration cases. By utilizing information concerning allegations of sales practice abuses in a more timely manner, the SROs will enhance their ability to detect patterns of fraud and supervisory deficiencies, and to identify problem registered representatives. We also requested that the NYSE make greater use of the complaint information available from NYSE Rule 351 data to detect trends and patterns of complaints. The NYSE already has taken steps to enhance and increase its examination efforts in sales practice matters. Specifically, the NYSE has increased the resources in its Sales Practice Review Unit ("SPRU") by hiring an additional five examiners. This will enable the NYSE to conduct full sales practice reviews of all NYSE firms on a more frequent basis. Those NYSE firms that are not subject to a yearly full sales practice review are still subject to a financial and operation examination ("FINOP"). The FINOP examination had previously included a limited sales practice review. The NYSE has revised the FINOP examination procedures to include more focused sales practice analysis in order to facilitate the review for abusive sales practices. Additionally, the NYSE has instituted a program to conduct a risk analysis using NYSE Rule 351 data to identify problem registered representatives and, where appropriate, follow up with a special cause examination. The NYSE also will utilize this information in connection with its routine examination program. The NASD has been developing a program using information from the Central Registration Depository ("CRD") database relating to registered representatives with frequent customer complaints, settled arbitrations, and frequent employment changes. The NASD will provide this information to the SEC, and will distribute the information to the 14 NASD District Offices to utilize in the NASD's regular examination programs. The NASD also has instructed its District staff to conduct examinations of broker-dealer main and branch offices, as well as individuals associated with those offices, in cases where the broker-dealers or individuals pose a regulatory concern because of past conduct. B. b. Sanctions In the August Letter, we asked the SROs to devote additional resources to prosecuting sales practice cases against problem registered representatives who have -------------------- BEGINNING OF PAGE #4 -------------------- violated SRO rules. We also asked the SROs to review and, if necessary, revise their policies concerning remedial sanctions for sales practice violations. We strongly believe that disciplinary sanctions against broker-dealers and registered representatives engaging in abusive sales and trading practices should be severe. We also intend to devote additional resources to prosecuting sales practice cases against problem registered representatives who have violated Commission rules, and to reviewing the policies regarding remedial sanctions for sales practice violations. One area that has been acted upon already deals with the Commission's policy on bar orders. The Division of Market Regulation and Division of Enforcement recently sent a letter to the SROs announcing Commission policy regarding the consequences of an unqualified bar (i.e., one that does not contain a proviso allowing for re-application after a specified time period). -[4]- The imposition of an unqualified bar evidences the Commission's conclusion that the public interest is served by permanently excluding the barred person from the securities industry. This is viewed as a particularly severe sanction and is reserved for egregious cases. -[5]- Accordingly, absent extraordinary circumstances, a person subject to an unqualified bar will be unable to establish that it is in the public interest to permit re- entry to the securities industry. See Appendix B for a copy of the letter. 2. Improved Broker-Dealer Compliance Systems for Identifying Problem Registered Representatives While the Large Firm Project generally found adequate home office procedures and supervisory structures at most of the firms examined, the Staff believes that firms need to strengthen their procedures used to identify registered representatives generating large numbers of sales practice-related customer complaints, and arbitration awards and settlements. We recommend that firms utilize, to a greater extent, the information contained in the NYSE Rule 351 data in order to detect trends and patterns of complaints within their own branch offices. Additionally, we ask that firms improve compliance systems designed to oversee and review employee conduct, and review their data processing and computer capabilities to better assist branch office managers m performing their supervisory functions. On June 21,1994, the Commission received a letter from the SIA regarding the creation of an Ad Hoc Committee on Regulatory Reporting and Disclosure ("Ad Hoc Committee"). The SIA created the Ad Hoc Committee to work toward the resolution of issues relating to the reporting and disclosure of sales practice complaints and disciplinary actions. The SIA letter affirmed the need for effective and fair systems for the reporting, retention and analysis of data on regulatory actions, complaint resolutions and allegations of improper sales practices. While there are concerns regarding the current systems and requirements, as well as issues regarding questions of privacy and fairness, we intend to work with the Ad Hoc Committee toward a resolution of these concerns and issues. 3. Enhanced Compliance by Firms and Registered Representatives with all SRO Reporting Requirements Historically, a highly fruitful source for the identification of possible sales practice problems has been reports that broker- dealers and registered representatives are -------------------- BEGINNING OF PAGE #5 -------------------- required to file with SROs. -[6]- These required filings form the backbone of the SRO systems for the early detection of problem registered representatives. The August Letter requested that the SROs closely monitor the timeliness of required filings, such as the Forms U-4, U-5 and RE-3, through examinations and otherwise. The SROs also were asked to increase sanctions against both firms and individuals where instances of noncompliance with SRO reporting requirements are discovered. In this regard, the NASD responded that one possible approach would be the adoption of a minor rule violation plan to ensure that late and deficient filers are dealt with promptly. We have requested that all other SROs consider adopting a rule based on NYSE Rule 351 requiring members to report customer complaints on a quarterly basis. The NASD is currently in the process of drafting customer complaint reporting rules calling for the submission by members of quarterly summary information of customer complaints received, and hopes to propose the rules to its appropriate committees before the end of the year. 4. Qualified Immunity for Firms on Form U-5 The Staff is aware of the concerns of firms and supervisory personnel about civil liability for disclosing disciplinary problems on Form U-5. Such concerns may inhibit full and adequate disclosure of the facts and circumstances surrounding the reason for termination of registered representatives. The Staff is exploring with the SROs means of affording qualified immunity to firms that make good faith disclosure on Form U-5. Nevertheless, broker-dealers have an obligation to file Form U-5 in a timely manner, and to make complete and accurate disclosure on such forms in order to prevent recurrent sales practice abuses. Disciplinary action may be necessary in instances where it appears that a broker-dealer inadequately disclosed the reasons for the termination of a problem registered representative who subsequently commits additional sales practice abuses. 5. Enhanced Role for Legal and Compliance Departments A firm's compliance department is an important means for assuring adherence by its employees to the federal securities laws. -[7]- Firms should have procedures that enable compliance personnel to ensure that firm supervisory procedures are being properly implemented. These procedures should specifically address the role of compliance personnel in ensuring that salespersons who previously have been involved in abusive sales practices are subject to reasonable supervision. The Staff believes that the hiring procedures adopted by broker-dealers with respect to problem salespersons should include significant involvement by senior management, and firm compliance or legal personnel. In general, the Staff believes that the determination whether to hire problem salespersons is most appropriately made by a firm's legal or compliance personnel. Firm procedures should include a requirement that management provide written justification for a decision to hire or retain an individual that is taken in the absence of, or against the express recommendation of, legal or compliance staff. In some instances, the Commission has entered into settlements requiring broker-dealers to develop standards to identify problem sales personnel and require the written approval -------------------- BEGINNING OF PAGE #6 -------------------- by compliance personnel of the hiring of any associated person with a significant disciplinary history or who has been the subject of significant customer complaints. -[8]- The August letter asked the SROs to consider whether rules requiring broker-dealers to have specific procedures regarding the role of legal and compliance departments in hiring and supervisory decisions should be implemented. 6. Firm Responsibility for Recidivist Registered Representatives The Staff will consider whether additional regulatory action is needed to address the problem of registered representatives with a disciplinary history of sales practice abuses who become employed by a broker-dealer and subsequently commit a sales practice violation. Broker-dealers and supervisors that have not devoted increased attention with respect to the hiring and supervision of problem salespersons may be subject to sanctions where problem salespersons subsequently engage in additional instances of abusive sales practices. The Staff believes that broker-dealers and their supervisory personnel have an obligation to reasonably apprise themselves of the disciplinary and employment history of sales personnel, and that the existence of prior sales practice problems should serve as a red flag signaling the need for heightened scrutiny with respect to the hiring or supervision of a particular employee. The Staff has asked the SROs in the August letter to review their rules and consider increasing sanctions against firms for hiring problem registered representatives who continue to commit sales practice violations. 7. Continuing Education Another crucial method of improving registered representative compliance with sales practice rules and procedures is to enhance registered representative education. In April 1994, Chairman Levitt wrote to the Chief Executive Officers of approximately seventy NYSE and NASD member firms emphasizing that mandatory continuing education of securities industry professionals should be one of the industry's highest priorities. Following the issuance of the Chairman's letter, both the NYSE and the NASD issued information bulletins to their membership to inform them of a continuing education program being developed by the Council on Continuing Education ("Council"), an organization composed of a cross-section of broker-dealer firms, representatives of six SROs, and liaisons from the SEC and the North American Securities Administrators Association ("NASAA"). The program being developed by the Council has two principal elements: (a) a "Firm" element mandating that every broker-dealer provide annual continuing education on its products and services to all registered employees who engage in sales, trading and investment banking, and their first-line supervisors; and (b) a "Regulatory" element generally requiring registered personnel to receive training in compliance, regulatory, ethics, and sales practice issues, on a two, five and ten year cycle following their initial registration. The Council has organized two working committees to develop the Regulatory and Firm elements of the program. These committees have prepared proposed draft rules for adoption by the SROs. The Regulatory Element Committee has developed an initial listing of standardized subject matter for a computer-based training program. -------------------- BEGINNING OF PAGE #7 -------------------- The Firm Element Committee has developed standards that firms must adhere to in developing and implementing their training programs. The SROs anticipate submitting proposed rule changes to the Commission in November 1994 that would put into place a mandatory continuing education program for all registered securities professionals. See Appendix C. The Council is working towards a July 1995 implementation date of the SRO rules. Chairman Levitt supports the efforts of the Council and has emphasized his belief that a continuing education program must be one of the industry's highest priorities. 8. Development and Implementation of Tracking Systems for SRO Handling of Investigations Relating to Form U-4 and U-5 Filings The August Letter asks the SROs to review their existing coordination protocols and, if necessary, implement a system for tracking which SRO is investigating a registered representative's termination for cause or amendment to Form U-4 and U-5, and the current status of such investigations. An important element of the SROs responsibility to govern the conduct of their member firms is the ability to ensure that matters are fully investigated and that there is no duplication of effort. The NASD currently is embarked on a multi-million dollar rewrite of the CRD system. The first phase of the new CRD system, which is scheduled to be operational as a pilot program in the fall of 1995, focuses on member filing functions in the new CRD environment relating to individuals and organizations, and encompasses full electronic filings by the membership. When completed in 1996, the state-of-the-art, user-friendly system should provide regulators with the ability to search through hundreds of thousands of records to identify problem registered representatives, to flag problem registered representatives who have left the industry so that they can be reviewed should they try to return to the business, and to target firms and branches for examination in a more effective way. The updated system will continue to provide firms and investors, through the toll free hot- line operated by the NASD ("800 number"), with easier access to disciplinary records. The Staff has been working closely with the NASD redesign team and views the new CRD system as an important means of identifying problem registered representatives. 9. Disclosures When Opening New Accounts Providing investors with information concerning the disciplinary history of registered representatives is another means of protecting investors from abusive sales practices. The Staff believes that information concerning a registered representative's disciplinary history is particularly important to investors at the time they open an account or establish a relationship with a registered representative. The selection of a reliable registered representative is a critically important decision. To better protect the interests of investors, customers should be made aware of the availability of disciplinary history information regarding the firm and the registered representative through the 800 number. Accordingly, the August Letter asked the SROs to consider the submission of rules requiring member firms to disclose to investors, prior to effecting any transaction in a new account, information relating to the availability of the 800 number. -------------------- BEGINNING OF PAGE #8 -------------------- 10. Public Disclosure by All SROs of Initiated Disciplinary Actions The final recommendation of the Large Firm Project involved the issue of public disclosure, by the SROs, of the filing of charges against member firms or registered representatives when actions are initiated. The Staff believes that the lack of disclosure with respect to SRO disciplinary proceedings is inconsistent with the public interest. While the NASD and the NYSE already have instituted procedures to disclose initiated disciplinary actions, the August Letter asked the remaining SROs to make public disciplinary actions against member firms and individuals when the SRO initiates the disciplinary action by filing formal charges. III. OTHER INITIATIVES In addition to the recommendations noted in the Large Firm Project, there are several other initiatives underway to address and curb abusive sales practices. 1. Joint Regulatory Examination Effort A joint regulatory examination effort is currently in the planning stages and will be conducted with the NASD, NYSE, and NASAA. The Large Firm Project focused on nine of the largest broker-dealers in the United States and on registered representatives who were or had been employed at one of the firms. This joint effort will focus on so-called "rogue brokers" employed throughout the industry. The NASD has developed a program designed to profile and analyze the current registered representative population using, among other things, the regulatory information that resides in the CRD. The planning process includes coordinating the selection of registered representatives using information from the CRD, including customer complaints, arbitrations, patterns of frequent employment changes and disciplinary actions previously taken by a regulatory entity. By working with the SROs and NASAA in this cooperative venture, we are increasing the level of protection afforded to investors from abusive, fraudulent and manipulative activities. 2. Cold-Calling A practice that is widely used in the industry, yet holds the potential for abuse, is cold-calling. Some securities firms have procedures in place to govern the cold-calling practices of their registered representatives, and are able to use cold-calling as a legitimate method to develop customer relationships. However, when a registered representative uses abusive cold-calling to convince a customer to make inappropriate or excessive securities trades, the standards of conduct expected of a securities professional are wholly violated. Broker-dealers, like all firms engaged in telemarketing, are subject to the Telephone Consumer Protection Act of 1991 ("TCPA") and a Federal Communications Commission ("FCC") rule promulgated thereunder. -[9]- Pursuant to the FCC rule, firms must: adhere to time-of-day restrictions; establish "do-not-call" lists; and establish training requirements, supervisory procedures and identification requirements for cold-callers. -------------------- BEGINNING OF PAGE #9 -------------------- The Commission intends to take action to adopt a cold-calling rule. Last month, Congress passed and the President signed new cold-calling legislation, entitled the Telemarketing and Consumer Fraud and Abuse Prevention Act. -[10]- The Act directs the Commission to promulgate rules to prohibit deceptive and other abusive telemarketing practices. The Act requires, however, that the Federal Trade Commission ("FTC") adopt cold-calling rules within a year of the legislation and that the SEC adopt substantially similar rules within six months of the FTC rule. The Commission intends to work in cooperation with the FTC to coordinate the rulemaking efforts. 3. Compensation Practices The public's trust and confidence in the securities industry are strongly affected by registered representative compensation. Investors develop confidence in a registered representative based on their interactions with that individual. When a registered representative recommends a security, the investor should not have to wonder whether the investment is in his or her interest or whether the registered representative is simply trying to make a quick buck. Investors should feel that their registered representatives are looking out for their best interest. The Chairman has asked a committee of distinguished individuals to examine compensation practices in the brokerage industry ("the Committee"). The Committee is chaired by Dan Tully, Chairman and CEO of Merrill Lynch, and includes: Warren Buffett, Chairman and CEO of Berkshire Hathaway, and former Chairman of Salomon Brothers; Jack Welch, Chairman and CEO of General Electric; Raymond Mason, Chairman and CEO of Legg Mason; Sam Hayes, a noted Harvard Business School professor; and Tom O'Hara, President of the National Association of Investors Corp. and a member of the SEC's Consumer Affairs Advisory Committee. The Committee's mission is to identify industry practices that raise significant conflicts of interest between a registered representative and his or her customers, and to suggest ways to eliminate or reduce these conflicts. The Committee will focus specifically on the factors that influence a registered representative when he is attempting to make a sale. In August, the Committee released an open letter to the financial services industry asking for widespread comment from all parts of the industry and public. See Appendix D. Over the next few months, the Committee plans to draft a discussion paper that will address industry compensation practices, identify actual and perceived conflicts of interest, and identify the "best practices" in the industry -- those compensation practices that pose the least conflict between investors and registered representatives. IV. CONCLUSION The Staff believes that the cooperative working partnership between the Commission, the SROs and the securities industry should increase the early detection and prosecution of problem registered representatives. The Commission, the SROs, and most firms are committed to removing problem registered representatives. Together, we have implemented or are in the process of implementing a variety of recommendations and programs. Our highest aim is to protect the investing public and improve investor confidence in the integrity of this nation's capital markets. --------------------------- ENDNOTES ------------------------- -[1]- See Article IV, Section 3 of the NASD By-Laws and NYSE Rule 345. These rules require the registration of representatives and associated persons. The rules require that specific relevant information be disclosed during the registration and termination process. This information is disclosed on Form U-4 ("Uniform Application for Securities Industry Registration or Transfer Form") and Form U-5 ("Uniform Termination Notice for Securities Industry Registration"). -[2]- The August letter was sent to the NYSE, NASD, American Stock Exchange ("AMEX"), Boston Stock Exchange ("BSE"), Chicago Board Options Exchange ("CBOE"), Chicago Stock Exchange ("CHX"), Cincinnati Stock Exchange ("CSE"), Pacific Stock Exchange ("PSE") and the Philadelphia Stock Exchange ("PHLX"). -[3]- NYSE Rule 351, among other things, requires a member firm to submit to the NYSE, on a quarterly basis, summary information concerning all written customer complaints the member firm received during the quarter. -[4]- Individuals subject to an unqualified bar are subject to a statutory disqualification under Section 3(a) (39) of the Securities Exchange Act of 1934 ("Exchange Act") and, as such, are required to undergo a special review process before becoming associated with a member of a SRO in addition to obtaining the Commission's consent. -[5]- See e.g. Lester Kuznetz, Securities Exchange Act Release No. 23525 (Aug. 12, 1986), 36 SEC Docket 466, 470; Stephanie J. Hibler, Securities Exchange Act Release No. 22067 (May 23, 1985), 33 SEC Docket 205, 208. -[6]- Forms U-4 and U-5, which are the uniform forms for registering and terminating salespersons respectively, require, among other things, disclosure of criminal charges and convictions, disciplinary actions brought by domestic and foreign regulators, customer complaints that exceed certain thresholds, and investigations by the firm, an SRO or a foreign or domestic entity. Separately, the NYSE requires the filing of Form RE-3, which discloses, among other things, disciplinary actions taken by the member firm against any of its associated persons, judgements, awards or settlements involving customer- initiated litigation and arbitration, and written customer complaints involving allegations of theft, misappropriation of funds or securities, or forgery. -[7]- See Prudential Bache Securities. Inc., Exchange Act Release No. 22755 (January 2, 1966)(noting that, for purposes of supervision, a broker-dealer should not rely solely on its branch managers). -[8]- Prudential Securities Incorporated, Exchange Act Release No. 33082 (October 21,1993). -[9]- Telemarketers are subject to the Telephone Consumer Protection Act of 1991 and the FCC rule promulgated thereunder. See Pub. L. No. 102-243, 105 Stat. 2394 (1991)(codified at 47 U.S.C.  227 (1992)); 47 C.F.R.  64.1200 (1992). It should be noted that one federal district court held that the TCPA, by prohibiting the use of artificial or pre-recorded voice devices to deliver commercial messages to residential telephones without consent of the called party, places an unconstitutional restriction upon protected commercial speech in violation of the First Amendment. Moser vs. Federal Communications Commission, 826 F.Supp. 360 (D. Or. 1993). There are presently no federal court of appeals or Supreme Court cases dealing with this issue. -[10]- See H.R. Rep. No. 868, 103rd Cong., 1st Sess. (1994). -------------------------- APPENDIX A -------------------------- August 4, 1994 Richard A. Grasso President New York Stock Exchange, Inc. 11 Wall Street New York, New York 10005 Re: Large Firm Report Recommendations Dear Mr. Grasso: In May 1994, the Divisions of Market Regulation and Enforcement ("Divisions") jointly issued The Large Firm Project Report ("Large Firm Report" or "Report"). The Report announced the findings of a review undertaken by the Securities and Exchange Commission ("SEC" or "commission"), working in conjunction with the New York Stock Exchange ("NYSE") and the National Association of Securities Dealers ("NASD"), regarding the hiring, retention and supervisory practices of nine of the largest broker-dealers in the United States. It recommended several actions to be taken or considered by self-regulatory organizations ("SROs") in order to improve the detection of sales practice violations and enforcement efforts in this area. Since the issuance of the Large Firm Report, the Divisions and the SROs have been working together to develop and implement the Report's recommendations, as well as other proposals to reduce sales practice problems. At this time, we would like you to review and report to us the actions your organization has taken, or plans to take, to address the issues discussed below. 1. Increased Examination Efforts and Sanction in all Sales Practice Matters The Large Firm Project concluded that SROs need to increase examination efforts to ensure that member firms have adequate supervisory and compliance systems designed to detect problem registered representatives. It also concluded that sanctions for sales practice violations should be strengthened at both the SRO and Commission levels. a. Examination Efforts In order to address these findings, we encourage you to devote additional resources to conducting examinations. In addition to expanding your examination efforts, we believe that you should focus additional attention on the review of sales practice allegations made in arbitration cases. This is an important resource for identifying sales abuses at an early stage. By reviewing allegations of sales practice abuses made in arbitration filings in a timely manner, we believe that you will --------------- APPENDIX A: BEGINNING OF PAGE #2 --------------- Richard A. Grasso Page 2 enhance your ability to detect patterns of fraud and inadequate supervision and increase your ability to identify problem registered representatives. We request that you advise us of the steps you have taken to achieve this objective. In this regard, we also request that the NYSE make greater use of Rule 351 information to detect trends and patterns of complaints. We would appreciate any recommendations you may have in this regard. b. Sanctions We urge you to review and, if necessary, enhance sanctions against registered representatives and broker dealers who commit sales practice violations. The Report specifically recommended that SROs review their rules and by-laws with a view towards increased sanctions against firms for hiring registered representatives with a history of sales practice abuses who continue to commit sales practice violations. Broker-dealers should have procedures governing the hiring of individuals having disciplinary or employment histories involving abusive sales practices that are more stringent than its general hiring procedures. These procedures should identify the personnel responsible for making the decision to hire a problem salesperson. They also should set forth factors relevant to this hiring decision, and provide for heightened supervision of any prospective employee with prior disciplinary or employment history involving sales practice abuses. We believe that these procedures should also include a requirement that broker dealer management provide written justification for a decision to hire or retain an individual that is made in the absence of, or against the express recommendation of, legal or compliance staff. We request that you inform us of the status of your review of your rules and by-laws with regard to ensuring the existence of adequate broker-dealer hiring procedures and sanctions for hiring registered representatives with a history of sales practice abuses. Additionally, we ask that you inform us about what steps you have taken or intend to take to devote additional resources to prosecuting sales practice cases against problem registered representatives who have violated your rules. 2. Enhanced Compliance by Firms and Registered Representatives with all SRO Reporting Requirements Historically, Forms U-4, U-5 and NYSE Form RE-3 have been a fruitful source for identifying possible sales practice problems. These required filings form the backbone of the SRO systems for identifying problem registered representatives. The Report recommended that the SROs monitor the timeliness of these required filings. In cases of untimely or non-reporting of required information, SROs should increase their sanctions against both firms and individuals. --------------- APPENDIX A: BEGINNING OF PAGE #3 -------------- Richard A. Grasso Page 3 3. Tracking Systems When conducting investigations of member firms, SROs must ensure that matters are fully investigated, without duplication of effort between the SROs. The Large Firm Report revealed deficiencies in regulators' existing capability to identify and track problem registered representatives. The staff identified instances where investigations by SROs were duplicated, and cases where the SROs were uncertain as to the status of certain investigations. The Report recommended that the SROs develop and implement a system for tracking which SRO is investigating a particular matter, as well as the current status of the investigation. We request that you review your existing procedures for coordinating information between SROs and if necessary, develop and implement a joint system for tracking which SRO Is investigating a case in connection with information contained in a Form U-4 or U-5 or any amendments thereto, and the current status of the investigation. Please inform us of the results of your review and any possible recommendations you may have to improve tracking systems. 4. Additional Disclosures Information concerning final disciplinary history of registered representatives is now available to the public through the NASD'S toll-free hotline (1-800-289-9999). Customers can obtain information regarding final disciplinary actions against registered representatives taken by federal, state and foreign regulators, as well as criminal indictments and convictions. The Report recommended that SROs adopt a rule requiring member firms to disclose to investors opening new accounts, prior to effecting any transaction in that account, the availability of information through the NASD's Central Registration Depository ("CRD") system concerning disciplinary actions against registered representatives, and the availability of the hotline. The Staff believes that the information in the CRD database should be expanded to include notification at the time a regulator initiates a disciplinary action rather than at the time the action is completed. Once an SRO has made a determination that there is probable cause for believing that securities laws have been violated and has actually initiated a disciplinary action, this information should be publicly available on the NASD's CRD system. Making this information available at an earlier stage of the proceeding will enhance the SROs' ability to detect patterns of fraud and supervisory negligence. It also will aid in the detection of problem registered representatives and remove existing benefits firms receive from dilatory tactics that delay resolution of the disciplinary proceeding. ----------------- APPENDIX A: BEGINNING OF PAGE #4 ------------- Richard A. Grasso Page 4 It is the staff's understanding that the NYSE and the NASD have already initiated procedures to disclose initiated disciplinary actions to the public. The staff supports this action and believes that it will aid investors in obtaining the information they need to know regarding their registered representatives. Presently, we request that you inform us regarding the status of your review of these recommendations. We appreciate your cooperation and assistance in this matter. We believe that by coordinating our efforts we can make significant progress to reduce fraud and abuse and improve overall investor confidence in the securities markets. Please respond in writing on or before August 29, 1994, outlining the actions you have taken or intend to take to address the issues discussed above. If you have any questions, please call Mark Fitterman at (xxx) xxx-xxxx or Joseph Goldstein at (xxx) xxx-xxxx. sincerely, sincerely, /s/ /s/ Brandon Becker William McLucas Director Director Division of Market Regulation Division of Enforcement cc: Edward Kwalwasser Sal Pallante ------------------------ APPENDIX B ------------------------ Richard A. Grasso President New York Stock Exchange, Inc. 11 Wall Street New York, New York 10005 Re: Unqualified Bar Orders Dear Mr. Grasso: In connection with the Commission's initiatives to address abusive sales practices, we are writing to discuss the Commission's policy on the reentry into the securities industry of persons who have been barred by the Commission from association in any capacity with registered entities, and whose bar orders do not contain any proviso for re-application for such association after the expiration of a specified period (i.e., unqualified bars). -[1]- There apparently has been some confusion about the consequences of an unqualified bar. Some believe that an unqualified bar implicitly provides an opportunity for reentry after five years absent any misconduct during that period. Others do not share that view. The purpose of a bar is "to protect the public interest by preventing [problem sales representatives] from again engaging in . . fraudulent activity." -[2]- It also "serves the purpose of general deterrence and should act as a warning to any other participant in the securities industry who might be tempted to engage in similar misconduct." -[3]- An unqualified bar is a particularly severe sanction and is reserved for egregious cases. -[4]- Henceforth, the imposition of an unqualified bar evidences the Commission's conclusion that the public interest is served by PERMANENTLY excluding the barred person from the securities industry. Accordingly, absent extraordinary circumstances, a person subject to an unqualified -------- FOOTNOTES -------- -[1]- Such persons are subject to a statutory disqualification under Section 3(a)(39) of the Securities Exchange Act of 1934 ("Exchange Act") and, as such, are required to undergo a special review process before becoming associated with a member of the New York Stock Exchange, Inc., in addition to obtaining the Commission's consent. -[2]- Lester Kuznetz, Securities Exchange Act Release No. 23525 (August 12, 1986), 36 SEC Docket 466, 470. -[3]- Id. at 470-71. See also Arthur Lipper Corporation v. SEC, 547 F.2d 171, 184 (2nd Cir. 1976) ("The purpose of such severe sanctions must be to demonstrate not only to petitioners but to others that the Commission will deal harshly with egregious cases.") -[4]- See, e.g., Lester Kuznetz, supra n.2; Stephanie J. Hibler, Securities Exchange Act Release No. 22067 (May 23, 1985), 33 SEC Docket 205, 208. ---------------- APPENDIX B: BEGINNING OF PAGE #2 -------------- Richard A. Grasso, President New York Stock Exchange, Inc. bar will be unable to establish that it is in the public interest to permit reentry to the securities industry. Sincerely, Brandon Becker, Director William McLucas, Director Division of Market Regulation Division of Enforcement cc: Joseph R. Hardiman, President National Association of Securities Dealers, Inc. Richard F. Syron, Chairman and Chief Executive Officer American Stock Exchange [Heads of all SROs] -------------------------- APPENDIX C -------------------------- STATUS REPORT ON THE CONTINUING EDUCATION PROGRAM The Industry Regulatory Council On Continuing Education August, 1994 BACKGROUND In March 1993, six self-regulatory organizations (SROs) -[1]- announced the formation of an industry task force to consider whether the industry should develop a uniform continuing education program for registered persons. The task force was composed of experienced individuals with diverse backgrounds from a broad range of firms, thus ensuring consideration of the interests and needs of a wide cross section of the industry. The SROs noted that the increasing complexity of the securities industry demands that professionals who deal with the public or are in supervisory positions maintain minimum standards of competence and professionalism. The SROs also said that a formal industry-wide continuing education program to keep professionals up to date on products, markets, and rules might be needed. By initiating a broad-based industry effort, the SROs hoped to provide a unified industry-wide approach acceptable to all segments of the industry. In September 1993, the industry task force issued a report calling for a formal two-part continuing education program for securities professionals that would require uniform periodic training in regulatory matters (Regulatory Element) and ongoing programs by firms to keep employees up to date on job and product- related subjects (Firm Element). The report also recommended the creation of a permanent Industry/Regulatory Council on Continuing Education (the Council) -[2]- to recommend to the SROs the specific content of the uniform Regulatory Element and the minimum core curriculum for ongoing firm training programs undertaken to satisfy the requirements of the Firm Element. The task force recommended further that computer-based training be used as a primary delivery vehicle for the uniform Regulatory Element of the program. In November 1993, the SROs endorsed in concept the recommendations of the industry task force. Since November 1993, the Council has met monthly and has formed separate committees to work on the Regulatory and Firm Elements. The Regulatory and Firm Element committees have prepared proposed draft rules that would implement the program when approved by the SROs. The Regulatory Element Committee has also developed an initial listing of standardized subject matter for the computer- based training program. The Firm Element Committee has developed standards that firms must adhere to in developing and implementing their training programs. The Council has now submitted these proposed rules to the various SROs for review with an aggressive schedule to develop and implement the continuing education program. The current target is to have the final rules adopted by the SROs by November 1994 and for the SROs to immediately thereafter file the rules for approval with the SEC. It is anticipated that the rules will be formally approved by the SEC in January 1995. The continuing education program would then be implemented on July 1, 1995. PROPOSED PROGRAM HIGHLIGHTS The Regulatory Element proposal requires all registered persons to participate in a prescribed computer-based training session on their second, fifth and tenth registration anniversary -------- FOOTNOTES -------- -[1]- The SROs include the American Stock Exchange (AMEX), the Chicago Board Options Exchange (CBOE), the Municipal Securities Rulemaking Board (MSRB), the National Association of Securities Dealers, Inc. (NASD), the New York Stock Exchange (NYSE), and the Philadelphia Stock Exchange (PHLX). -[2]- The Council includes representatives from 13 broker/dealers and the six SROs. In addition, the Securities and Exchange Commission (SEC) and the North American Securities Administrators Association (NASAA) have each assigned a liaison to the Council. Members of the Council are listed at the end of this report (appendix). ---------------- APPENDIX C: BEGINNING OF PAGE #2 ------------- dates. Persons who have been registered for more than 10 years and have not been subject of a serious disciplinary action (as more fully described below) during the most recent 10 years are exempt from the Regulatory Element. Failure to complete the required Regulatory Element computer- based training session during the prescribed period would result in a person's registration becoming inactive. A person whose registration becomes inactive cannot conduct a securities business or perform any of the functions of a registered person until such person meets the requirement. Any person who would otherwise be exempt from the Regulatory Element would be required to re-enter the program for another 10 years upon becoming subject to certain disciplinary actions or as otherwise required by a securities regulatory or self-regulatory organization. Such re-entry would be occasioned by a person becoming subject to a statutory disqualification pursuant to the Securities Exchange Act of 1934; if an individual's registration is suspended by a securities regulatory or self-regulatory organization; or if a securities regulatory or self-regulatory authority imposes a fine of $5,000 or more for a violation of any securities law, rule or regulation, which is the threshold level for determining a serious disciplinary action. The Regulatory Element computer-based training program will be designed to transmit information broadly applicable to all registered persons. The content will be recommended by a group of industry representatives, subject to Council review and SRO approval. The content will focus on compliance, regulatory, ethical and sales-practice standards. Because of the general and broadly applicable nature of this material, the Council determined to recommend that the Regulatory Element should be initiated with a "one size fits all" approach to the material transmitted in the computer-based training program, regardless of the job functions or registration status, such as Series 6 or Series 7. While there will be no grading of individual performance on the Regulatory Element, information feedback will be provided to individuals and their firms regarding areas of apparent strength or weakness as indicated by the individual's interaction with the computer-based training program. In addition, aggregated information will be provided to their firms on all their covered registered persons who take the computer-based training program in a given period. Firms will be expected to consider this information when formulating their training plans for the Firm Element, as more fully described below. Unlike the Regulatory Element, where only those persons registered for 10 years or less are covered, the Firm Element has no time limitations. It is applicable to all persons who conduct business with retail, institutional or investment banking customers of the firm. The immediate supervisors of such persons are also covered by the Firm Element. The Firm Element requires each member to establish a training process and identifies certain minimum requirements associated with that process. The firm must prepare a training plan after an analysis of its training needs. Firms must consider certain factors when developing their analyses and in developing their training plans, such as the firm's size, organizational structures, and scope of business activities, as well as regulatory developments and the performance of covered registered persons in the Regulatory Element. The program requires a training plan to be implemented by a member and requires the member to maintain records that clearly demonstrate the content of its training programs and the completion of the programs by the persons identified in the firm's training plan. Persons who are subject to the training plan would have an affirmative obligation to participate in the programs identified by the member. The Firm Element also establishes certain minimum standards for the training programs that are used in a member's plan. For example, such programs, when dealing with investment products and services, must identify their investment features and associated risk factors, their suitability in various investment situations and applicable regulatory requirements that affect the products or services. The SROs would have the ability to require members, individually or as part of a group, to provide specific training to covered registered persons in any area the SROs deem necessary. Depending on the issue of concern, these requirements could be directed at specific individuals or portions of a firm, a specific firm or group of firms, or across the entire industry. IMPLEMENTATION The SROs propose to fully implement the Regulatory Element on July 1, 1995. The Central Registration Depository (CRD) system will track persons subject to the requirement and notify members in advance of those individuals approaching their second, fifth and tenth anniversary dates who are required to participate in a computer-based training session. Follow-up notices will also be sent as persons subject to the Regulatory Element requirement approach the end of the 120 days during which the requirement must be satisfied. In addition, the CRD system will generate monthly reports to members identifying those persons approaching or subject to the Regulatory Element requirement as well as those persons whose registration have become inactive due to failure to complete the requirement within the specified time. The Regulatory Element requirements will apply to all registered persons whose second, fifth and tenth registration anniversary dates occur on or after July 1, 1995. Persons who have completed 10 years of registration before July 1, 1995 will be exempt. A person's registration anniversary dates will be measured from his or her first registration with the CRD, regardless of any subsequent firm changes or changes in registration category. Persons who have incurred a disciplinary event during the 10-year period before July 1, 1995, that would require them to re-enter the program will have the initial registration date that coincides with the effective date of the final decision in a disciplinary action. The NASD PROCTOR system will be modified to handle the delivery of the computer-based training program in the 55-center PROCTOR network. Future expansion of the network is also being investigated, including the use of temporary centers that would operate periodically in areas located at a considerable distance from a full-time network center. In addition, the Council and the SROs will in the future consider the feasibility of permitting members to deliver the computer-based training in their internal computer systems in certain technical, administrative and regulatory concerns can be adequately resolved. The Firm Element of the continuing education program will be implemented in two stages. By July 1, 1995, members would be required to complete their training needs analyses and to develop written training plans that would be available for review upon request by the SROs, the SEC, and state regulators. Members would be expected to begin implementing their plans as soon as practicable but, in any event, no later than January 1, 1996. The SROs are committed to developing a consistent approach to examination and enforcement of the Firm Element requirements. Additionally, the SROs will coordinate their field inspection efforts to avoid any unnecessary regulatory overlap in the inspection process for firms that are joint members of two or more SROs. The Firm Element provides great flexibility to firms in designing training programs appropriate to their needs and consistent with their resources, subject to broad standards defined in the Firm Element. The Firm Element framework is intended to be flexible enough to accommodate differences in the size, scope, and complexity of firm operations. Therefore, the Council and the SROs believe that the training plan requirements of the proposal are within the capabilities of all organizations, regardless of size. The Firm Element also proposes that a member would be responsible for assuring that training programs for investment products and services used in its training plan appropriately cover the investment characteristics and associated risk factors of the product or service, their suitability for different investment situations and any regulatory requirements that affect the product or service. The Council and the SROs realize that a great deal of the training material and programs will be provided by a variety of training and education providers. Nevertheless, the proposed rules place the responsibility on each member to assure that such training meets the broad content standards included in the rule as they relate to that particular firm. The SROs do not intend to pre-approve training materials and programs developed by members or providers. They will, however, communicate regularly with members regarding the expectations for the content of training programs. As the program evolves, it is expected some curricula content standards will be defined by the SROs for products and services where heightened regulatory concerns exist. The Council intends to develop more extensive guidelines to assist firms in carrying out their responsibilities under the Firm Element and will recommend to the SROs that these guidelines be provided to firms when the final continuing education rules are adopted by the SROs and approved by the SEC. Industry/Regulatory Council on Continuing Education William R. Simmons Council Chairman Executive Vice President & Director Dean Witter Reynolds, Inc. New York, NY Industry Representatives Judith Belash Vice President & Associate General Counsel Goldman Sachs New York, NY Mary Alice Brophy First Vice President & Director of Compliance Dain Bosworth Inc. Minneapolis, MN Ronald E. Buesinger Corporate Secretary & Senior Vice President A.G. Edwards & Sons, Inc. St. Louis, MO Elena Dasaro Compliance Official H.C. Wainright & Co., Inc. Boston, MA David A. DeMuro Senior Vice President Associate General Counsel Lehman Brothers, Inc. New York, NY ---------------- APPENDIX C: BEGINNING OF PAGE #4 -------------- John P. Gualtieri Vice President & Insurance Counsel Prudential Insurance Co. of America Newark, NJ Therese M. Haberle Associate General Counsel Charles Schwab & Co., Inc. San Francisco, CA James Harrod General Principal Investment Representative Edward D. Jones & Co., Inc. Maryland Heights, MO Todd A. Robinson Chairman & CEO Linsco/Private Ledger Corp. Boston, MA Richard C. Romano President Romano Brothers & Co. Evanston, IL Lois Towers Director Institutional Compliance Fidelity Securities Boston, MA O. Ray Vass First Vice PResident Merrill Lynch, Pierce, Fenner & Smith, Inc. New York, NY SRO Representatives Diane Anderson Vice President of Examinations Philadelphia Stock Exchange Philadelphia, PA Howard Baker Senior Vice President American Stock Exchange New York, NY Darrell Dragoo Vice President of Compliance Chicago Board Options Exchange Chicago, IL Frank J. McAuliffe Vice President NASD Rockville, MD Loretta Rollins Professional Qualifications Administrator MSRB Alexandria, VA Donald Van Weezel Managing Director NYSE New York, NY Questions & Answers Regarding The Securities Industry Continuing Education Proposals 1. What is the Industry/Regulatory Council on Continued Education (the Council) and what role does it play? The Council is comprised of 13 representatives of the securities industry (primarily the former members of the Securities Industry Task Force on Continuing Education) and representatives of six self-regulatory organizations (SROs). 2. Why does the program consist of two elements? The Regulatory Element is applicable to all persons registered with an SRO within their first 10 years in the business. Because the Regulatory Element is intended to enhance education and training in broad-based regulatory, compliance and ethical issues, a "one-size fits all" approach is initially contemplated for persons engaged in limited or full- service aspects of the securities business and in a variety of jobs. The Firm Element is designed to ensure that firms provide ongoing education --------------- APPENDIX C: BEGINNING OF PAGE #5 -------------- and training to persons who deal directly with individual, institutional and investment banking customers. This element will focus on topics tailored specifically to the job functions and products handled by those people. Accordingly, the Firm Element has sufficient flexibility to meet the needs of all firms irrespective of their size or product mix. 3. Who will be covered by the program? Every person registered for 10 years or less will be covered by the Regulatory Element and will be required to take the regulatory portions within 120 days after their second, fifth and ten anniversaries. The Firm Element requirements shall apply to all "covered registered persons (salespeople, traders, investment bankers, and others who conduct a securities business with customers, and their first-line immediate supervisors) for as long as they are considered "covered registered persons." The term "customer" applies to retail, institutional, and investment banking customers, but does not include other broker/dealers. 4. Will registered personnel located outside the United States be covered? Yes and the Council is considering what special accommodations may be necessary to deliver the program to such individuals. 5. Will anyone be grandfathered or exempted? Grandfathering applies to the Regulatory Element only. Those who have been registered more than 10 years and who have not been subject of a serious disciplinary action (suspension, bar, fine of $5,000 or more, or a statutory disqualification) during the most recent 10 years will be grandfathered from the Regulatory Element. 6. Are the branch managers "covered registered persons" within the Firm Element? Yes. Branch are covered registered persons because they directly supervise salespeople in the branch. If a branch manager also has customer accounts, then his/her supervisor is a "covered registered person" as well. 7. Are research analysts "covered registered persons" within the Firm Element? Yes, if they communicate directly with or engage in sales presentations to customers. 8. Will either element contain pass/fail tests? No. The Council recommended that the program should focus on increased education and training rather than on periodic examinations. 9. How will the program be administered? The Regulatory Element will be delivered through computer- based training, in which participants will work through problems and/or scenarios at computer terminals located in an NASD PROCTOR center or other specified location. The Firm Element will be delivered by firms and may include written material, videos, audio tapes, classroom training, direct broadcasts or other media. 10. What is the rational behind discontinuing the Regulatory Element after 10 years? Because information to be transmitted through the Regulatory Element is primarily of a compliance, regulatory and ethical nature, it was perceived that individuals registered for more than 10 years without a significant disciplinary action would have adequately absorbed this material and that this would be reflect in their manner of doing business. In addition, all registered individuals who are "covered registered persons" will continue to be subject to the requirements of the Firm Element throughout their careers. 11. In the Regulatory Element, will there be a way to verify that individuals have completed the computer-based training? Yes. The CRD system will track and communicate anniversary dates and evidence of completion for the Regulatory Element. The computer-based training systems used to transmit the training information can also capture, store and analyze data as to who took the training, when, where and other information - in a manner similar to that of the industry qualification testing now conducted through the NASD PROCTOR system. 12. What is the expected fee for each Regulatory Element session at an NASD PROCTOR center? --------------- APPENDIX C: BEGINNING OF PAGE #6 -------------- The current estimate is about $75; however, the ultimate fee will depend on the overall costs of the program, which will operate on a revenue-neutral basis and be subject to periodic independent audits. 13. For those firms with internal computer systems and the capability to interface with the NASD PROCTOR system, will there be an opportunity to deliver the Regulatory Element material through these systems? Initial delivery of the Regulatory Element will be on the PROCTOR system; however, the potential for internal delivery on firm computer systems is under discussion. Obviously, arrangements to permit internal delivery depend on the development of appropriate safeguards to ensure the integrity of the program and the ability to capture the necessary information on feedback. 14. Is the content of the Firm Element left entirely up to the individual firms? No. The firms will be required to update training plans annually to demonstrate that they meet certain prescribed minimum standards with respect to subject material to be disseminated to their "covered registered persons" based on their needs, products, and line of business. 15. Will "covered registered persons" need to participate in formal Firm Element training programs every year? Not necessarily. There are no set schedules or required numbers of hours for the Firm Element, but coverage must be sufficient to meet the criteria established by SRO rules. For example, it may not be necessary to include every "covered registered person" within each calendar year if the firm is engaged exclusively in limited lines of business. 16. Is the annual compliance meeting required under Section 27 of the NASD Rules of Fair Practice adequate to demonstrate compliance with the requirements of the Firm Element? Not in and of itself. It can certainly be used as an occasion on which to transmit information or conduct training. However, firms must address their own needs with regards to sales practices and product training and carry out effective programs. In most instances, a significant expansion of material covered at the annual compliance meeting will probably be necessary. Also, it may be appropriate to transmit some material in a more timely manner than waiting for scheduled annual compliance meetings. 17. Can the requirements of the Firm Element be met through continuation of the significant internal training and education programs already at place in some firms? Possibly. For firms with comprehensive ongoing training programs in place, the requirements may result primarily in expanded record keeping, more formalized planning, and the incorporation of any minimum criteria specified by the SROs. It is likely, however, that most firms will need to substantially increase their education and training efforts to meet or exceed these requirements. 18. Will it be necessary for each "covered registered person" to meet personally with his/her supervisor annually to determine the training requirement for that person? No. However, some firms may elect to conduct such meetings to ascertain individual needs or to do so during regular performance reviews. 19. Can firms use training materials or presentations prepared or delivered by outside entities to satisfy the requirements of the Firm Element? Yes, provided that they meet the same standards established for firms. 20. If firms use materials or presentations prepared or delivered by outside entities to satisfy the requirements of the Firm Element, who is responsible for the content? Individual firms have the ultimate responsibility for the content and adequacy of material or presentations, regardless of who prepares or presents the material. 21. How can firms obtain guidance on designing and implementing internal training programs adequate to meet the requirements of the Firm Element? The Council anticipates producing a compilation of guidelines taking into account comments and questions received while rule enactment is pending. These guidelines would not be rules but would offer suggestions intended to help firms devise appropriate and reasonable programs consistent with their own unique characteristics and businesses. --------------- APPENDIX C: BEGINNING OF PAGE #7 --------------- 22. Will sessions devoted exclusively to selling skills or prospecting fulfill the requirements of the Firm Element? No. 23. How will materials or presentations used by firms to satisfy the Firm Element be checked or evaluated? Training plans, materials, outlines, and other required documentation must be retained for regulatory examination (upon request or during routine sales practices examinations) for conformance with standards prescribed by SRO rules. In addition, firms will be required to maintain evidence of participation and completion by their "covered registered persons." 24. What authority does the Council have to require firms to transmit specific information or carry out training in specific areas? None directly. Explicit authority for the requirements and enforcement of the continuing education program will be established in rules promulgated by the SROs. 25. If a "covered registered person" has an insurance license and fulfills insurance continuing education obligations, can that serve as a substitute for the Firm Element? Perhaps it may comprise a portion of the Firm Element requirements relating to insurance-related securities products, but it is unlikely that most insurance programs will meet all minimum standards prescribed under this program. 26. Will study materials be available? A content outline will be prepared for the Regulatory Element. Guidelines will be published for the Firm Element and it is anticipated that additional study materials will be developed and made available by individual firms, product originators, and other outside entities. 27. When will the Continuing Education rules be enacted? It is expected that the rules will receive SEC approval in January of 1995. 28. When will the Regulatory Element actually go into effect? The Regulatory Element is slated to begin on July 1, 1995. Thus, persons with two, five, and 10-year registration anniversaries on or after July 1, 1995 will be required to participate in accordance with those dates. 29. When and how will the Firm Element become effective? The Firm Element will also begin on July 1, 1995, and, for most firms, will necessitate a two-tier implementation process. Firms will be required to have completed their written training plans by July 1, 1995. The Council and the SROs recognize that firms will likely require additional time to develop and prepare materials, plan budgeting needs, and arrange scheduling; however, the actual implementation of the plan must begin no later than January 1, 1996. It is anticipated that regulatory examination of the Firm Element will also proceed in accordance with the preceding schedule. For example, written training plans are subject to inspection by July 1, 1995, and firm records should demonstrate programs in progress as of January 1, 1996. 30. How will people be phased into the program initially? Individuals will be phased into the Regulatory Element based on their registration date or, if applicable, based on the date of the most recent disciplinary action against them. For example, persons who became registered in October 1990 would enter the program having been registered for more than four years and would be required to participate in the Regulatory Element around October 1995 (within 120 calendar days after their fifth anniversary of continuous registration). In October 2000 they would have to participate to complete their 10-year cycle. Thereafter, they will be exempted from the Regulatory Element, provided they have no serious disciplinary action within the most recent 10 year period. The Firm Element will begin for all "covered registered persons" no later than January 1, 1996, in accordance with their firms' written plans. 31. How does a serious disciplinary action affect one's status in the Regulatory Element? A serious disciplinary action would effectively pre-empt one's original registration date as a trigger for entry into the full 10-year cycle of the Regulatory --------------- APPENDIX C: BEGINNING OF PAGE #8 --------------- Element. Within 120 days of imposition of the disciplinary action, that individual will be required to participate in a Regulatory Element session, followed by additional sessions at the second, fifth and tenth anniversaries of the date of the disciplinary action. 32. Is a serious disciplinary action the only factor that might mandate re-entry into the Regulatory Element? No. A federal or state regulatory authority or self- regulatory organization may require re-entry into the Regulatory Element as part of the sanction in a disciplinary matter. 33. How will the registration date be calculated for individuals who have acquired multiple registrations (for example: the series 6 in 1988 plus the series 7 in 1991)? The original registration date (1988 in the above example) will be used, provided that the person has remained continuously registered since that time. 34. How will temporary lapses in registration be handled? These will be treated similar to the way in which qualification testing is handled. If individuals become unregistered for less than two years, they will maintain their original registration date, but will first be required to participate in any Regulatory Element program that may have been missed during the period in which they were unregistered. For example, an individual whose registration lapses at four and a half years who wishes to reactivate at what would be his/her six-year anniversary must complete the fifth year Regulatory Element before reactivation of registration. 35. What will be the status of a person who becomes unregistered for a two-year period or more? This person would begin the entire registration process anew. He or she would be required to take the appropriate qualification examination(s) and would enter the Regulatory Element at the beginning of its 10-year cycle. 36. What regulatory consequences will result when an individual does not complete the required continuing education? Non-compliance with Regulatory Element requirements will result in an individual's registration being deemed inactive until he/she fulfills all applicable elements. Firms must ensure that those deemed inactive are not permitted to engage in activities requiring registration. Failure to comply with Firm or Regulatory Element requirements may be subject the firm and individuals to disciplinary action. 37. Will firms that are members of two or more SROs be subject to redundant inspections for compliance with the continuing education requirements? The SROs will coordinate their field inspection efforts to avoid any unnecessary regulatory overlap for joint members. The SROs are especially committed to developing a consistent approach to examining for and enforcing the Firm Element Requirements. -------------- APPENDIX D: BEGINNING OF PAGE #1 ---------------- An Open Letter To Members of the Financial Services Industry Regarding Compensation of Retail Brokers And Their Supervisors From The Committee On Compensation Practices August 29, 1994 As you may be aware, Securities and Exchange Commission Chairman Arthur Levitt asked us to serve on a committee to examine the securities industry's compensation practices and to highlight areas of potential conflicts of interest as well as examples of particularly effective procedures for managing the broker-investor relationship. The Committee is seeking to identify practices that most effectively eliminate, reduce or mitigate these conflicts of interest. Specifically, the Committee's mission is to: * Review industry compensation practices * Identify actual and perceived conflicts of interest for both brokers and managers. * Identify the "best practices" used in the industry to eliminate, reduce or mitigate such conflicts. The Committee is particularly interested in any conflicts that exist at the time of sale. Simply stated: when a responsible broker can choose among a large number of reasonable investments, what influences his/her recommendation? Does the broker place the investor's interest first? To what extent do compensation practices influence a broker's recommendation? We hope that this Committee's work will initiate a dialogue within the industry about the best compensation practices and encourage firms to compete on the basis of how they manage these real and perceived conflicts. As part of the Committee's process, we would like your help and your views on these issues. We are not seeking information about any specific compensation program at any particular firm. Rather, we are seeking examples of how current compensation practices affect sales behavior, as well as examples of practices that eliminate or reduce conflicts. The Committee would like your thoughts on what impact, if any, the following compensation practices have on sales behavior: differentiating compensation by product; flat fees versus transactional commissions; recruitment practices (e.g., up-front payments and increased payouts); compensation for fixed income products (e.g., credits); sales contests or other incentive programs; and supervisor compensation. Similarly, many in the industry have developed practices designed to align closely the broker's interest with that of the client. The Committee is interested in your observations regarding such practices, including supervision and other management techniques, compliance and training programs, and disclosure. -------------- APPENDIX D: BEGINNING OF PAGE #2 ---------------- We want to emphasize that the above are only examples of the kinds of practices that we are interested in examining; they are in no way intended to limit any observations or comments you may have on this subject. The Committee welcomes any insights you may with to provide, including those based on your experiences with experimental or pilot programs. We hope you will take the time to respond and share your views with us. Please forward your comments to: Professor Samuel L. Hayes III Jacob H. Schiff Professor of Investment Banking Harvard Business School, Morgan 375 Soldiers Field Road Boston, MA 02163 Fax: (617) 496-6592 Please respond by October 14, 1994. Thank you in advance for your assistance. Sincerely, Daniel P. Tully Chairman, Committee on Compensation Practices Chairman and Chief Executive Officer Merrill Lynch & Co., Inc. Warren Buffett Chairman and Chief Executive Officer Berkshire Hathaway Inc. Samuel L. Hayes III Jacob H. Schiff Professor of Investment Banking Harvard University, Graduate School of Business Administration Raymond A. Mason Chairman and Chief Executive Officer Legg Mason, Inc. Thomas O'Hara Chairman of the Board National Association of Investors Corp. John F. Welch, Jr. Chairman and Chief Executive Officer General Electric Company # # #