==========================================START OF PAGE 1====== REPORT ON THE JOINT REGULATORY SALES PRACTICE SWEEP A Review of the Sales Practice Activities of Selected Registered Representatives and the Hiring, Retention, and Supervisory Practices of the Brokerage Firms Employing Them Federal regulation of the securities industry rests on the principle of self-regulation. First and foremost, effective self-regulation begins with the broker-dealer, which must monitor the trading and sales activities of its associated persons and establish effective compliance and supervisory procedures to prevent and detect possible violations of firm policies and procedures, SRO rules, and federal and state securities laws. At the next level of the regulatory structure are the SROs, which are self-regulatory membership organizations overseen by the Commission. The SROs have established rules that govern the conduct of their member firms and enforce compliance with those rules and with the federal securities laws. Broker-dealers and their registered representatives are regulated by state law, as well. Each state has adopted securities laws and promulgated regulations thereunder to govern the conduct of registrants and their registered representatives within the state and to enforce compliance with those laws and regulations. To enforce compliance, both SROs and many state securities authorities examine firms and registered salespersons subject to their jurisdiction on a routine basis, and initiate disciplinary actions where firms or their associated persons violate SRO rules, or federal or state securities laws. In addition, the Commission has direct regulatory authority over the activities of broker-dealers and SROs. The Commission exercises this authority, consistent with its principal statutory mandates of investor protection and the public interest, through its rulemaking authority, its examinations of broker-dealers and inspections of SROs, and through enforcement actions against persons and entities that violate the securities laws. These statutory purposes are best served when broker-dealers establish effective compliance mechanisms, regulators routinely examine for and enforce compliance with the securities laws and their own rules, and the Commission implements effective and comprehensive SRO oversight and enforcement programs. I. PREDECESSOR LARGE FIRM REPORT Work on the Large Firm Report began in 1992, when staff of the SEC, the NYSE, and the NASD met to discuss concerns regarding the hiring, retention and supervisory practices of brokerage ==========================================START OF PAGE 2====== firms, and agreed to conduct a series of examinations focusing on the nine largest broker-dealers in the United States and individual registered representatives employed by those firms. The nine firms were selected for review because they accounted for approximately 49% of all public customer accounts in the United States. Examinations conducted pursuant to this joint examination effort commenced in early February 1993, and resulted in the issuance of the Large Firm Report in May 1994. Appendix A to this report discusses the recommendations made in the Large Firm Report and the status of those recommendations. Because the Large Firm Report revealed a number of supervisory weaknesses and areas where improvements were needed, this Sweep was commenced as a follow-up to the Large Firm Project. Like the Large Firm Project, the Sweep focused on problem registered representatives and the firms employing them, and involved a review of the sales practices of selected individuals and the hiring, retention, and supervisory practices of the firms employing those individuals. Unlike the Large Firm Project, the Sweep focused on registered representatives that met the specific criteria developed by the Working Group. These individuals were primarily employed by small- and medium-sized brokerage firms. As described in more detail below, the registered representatives selected for review were identified based on specific criteria formulated by the Working Group and, therefore, the findings of this project should not be viewed as representative of all small- and medium-sized brokerage firms. II. THE EXAMINATION PROCESS A. Selection of Registered Representatives At the end of 1994, approximately 485,000 registered representatives were associated with registered broker-dealers doing business with the public. Out of this population, the Working Group selected, based on the criteria described below, 347 registered representatives (the profiled registered representatives or "PRRs") for special examination. The Working Group attempted in the selection process to identify individuals who, based on their disciplinary, customer complaint, and employment histories, may engage in sales practice misconduct. The firms and branch offices selected for examination during the Sweep were identified because they employed at least two individuals who met the profile. The criteria for identifying PRRs was continuously refined and resulted in a combination of four different criteria being employed. Three out of the four criteria used a single measure to identify a PRR while the last criterion included a combination ==========================================START OF PAGE 3====== of four different criteria. Out of a universe of approximately 485,000 registered individuals, 50,000 individuals were initially selected because they had reportable incidents noted on their Form U-4. Applying the four criteria to the list of 50,000 individuals resulted in a total of 1,018 individuals that met one or more of the four criteria: 1. The person: a. had been the subject of two or more NASD cause examinations-[12]- between January 1, 1992 and August 15, 1994, or b. had been the subject of one or more selected reported CRD pending actions between February 15, 1994 and August 15, 1994 (see Appendix B), or c. had been the subject of one or more selected reported CRD final actions between January 1, 1992 and August 15, 1994 (see Appendix C), and d. had been employed by three or more firms since January 1992; or 2. The person had been involved in two or more pending disciplinary actions during the period of January 1, 1992 through August 15, 1994; or 3. The person had been the subject of five or more NYSE Rule 351(d)-[13]- customer complaints during the period from April 1, 1992 to March 31, 1994; or 4. The person had been identified by the SEC, the NASD, the NYSE, or any state securities commission as needing special attention. Then, in order to reduce the universe of registered representatives to a manageable size, the following factors were applied to extract registered representatives from the initially identified list of registered representatives. Extracted from the list were: 1. All registered representatives employed at one of the nine firms examined during the Large Firm Project: 294. ==========================================START OF PAGE 4====== 2. All registered representatives who were the only profiled registered representative identified at their firm: 227. 3. All registered representatives who were under investigation by the NASD, NYSE, or SEC at the time of the selection process: 104. 4. All registered representatives who were preliminarily screened and designated as inappropriate candidates by the Working Group (e.g., customer complaints did not relate to retail transactions): 46. After extracting these registered representatives from the initial universe of potential PRRs, 347 PRRs at 117 different firms remained. These 347 PRRs were assigned among the NASD, the NYSE, the SEC, and certain state securities regulators for examination.-[14]- Due to movements by PRRs and the unavailability of others to be interviewed,-[15]- Working Group examiners interviewed 230 PRRs during 179 branch examinations. The SEC, the NASD, the NYSE, and the states conducted 43, 58, 40, and 38 examinations, respectively. B. Scheduling, Objectives and Scope The examinations, which began in December 1994 and generally were completed by November 1995, were conducted at 101 different (primarily small- and medium-sized) firms. The Sweep involved both on-site examinations and a CRD review to ensure that the PRR was still employed by the broker-dealer. The objectives of the Sweep were to identify possible problem registered representatives, to review their sales practices, and to assess whether adequate hiring, retention, and supervisory mechanisms are in place. Where appropriate, the Sweep would result in enforcement action against these registered representatives and/or the firms employing them. The examination field work consisted of (1) branch office examinations where the PRRs were employed and, where necessary, follow-up examinations where a PRR moved to a new branch or firm, (2) PRR interviews, and (3) branch office manager (and sometimes other compliance personnel) interviews. In order to ensure uniformity in examination methodology and scope, all Sweep examiners were furnished with procedures designed to provide a standard minimum review of the activities of the branch office, with interview modules designed specifically for the branch office manager/compliance officer and PRR interviews, and with instructions and guidance on the format and contents of the examination reports. ==========================================START OF PAGE 5====== III. THE SWEEP FINDINGS A. Some Firms Are Willing to Employ Registered Representatives With a History of Disciplinary Actions or Customer Complaints The Working Group reviewed the employment patterns of the 347 PRRs from December 1994 to November 1995 to identify any possible trends. Of the 347 PRRs, 114 PRRs (33%) had moved to at least one new brokerage firm during that time period.-[16]- Twenty-two registered representatives (or 9% of the 347 PRRs) had changed firms between two and six times. These findings show that some firms are willing to employ individuals with a history of disciplinary actions involving sales practice abuse or customer complaints. B. Many of the Branches Examined Utilize Only Minimum Hiring Procedures A review of hiring procedures revealed that while many firms go beyond the minimum steps required by law, approximately 42 of the 179 branches examined (24%) appeared to conduct, before hiring, only the minimum review required by NASD and NYSE rules of a registered representative applicant's background, including those with a disciplinary history or history of customer complaints.-[17]- Such review is generally limited to examining the individual's Forms U-4 and U-5 (or reviewing the applicant's history on CRD), and contacting the applicant's previous employers for the past three years.-[18]- A small number of branches did not conduct even the minimum background checks required by NASD and NYSE rules. As discussed above, the significant movement of PRRs within the securities industry may be attributable, at least in part, to the less than effective hiring procedures in place at some brokerage firms. The Working Group believes that many firms need to consider adopting more stringent hiring procedures. C. One-Fifth of the Examinations Resulted in Enforcement Referrals and an Additional One-Fourth of the Examinations Resulted Primarily in the Issuance of Letters of Caution or Deficiency Letters The Sweep established that sales practice abuses by registered representatives continue to be a problem that requires attention. As mentioned above, 104 registered representatives were eliminated from the Sweep because they were already under ongoing investigation by the SEC or an SRO. Moreover, 38 of the Sweep's 179 examinations (21%) resulted in referrals for enforcement investigation. This figure is roughly equivalent to ==========================================START OF PAGE 6====== the findings in the Large Firm Report, in which approximately 25% of the examinations resulted in enforcement referrals.-[19]- These enforcement referrals involved 28 of the 101 firms examined, and 23 of the 230 PRRs interviewed. The potentially violative activity identified during the examinations included, among other things, excessive trading, unauthorized trading, failure to supervise, and improper registered representative registration or failure to update registration forms. In addition, 52 of the Sweep's 179 examinations (29%) resulted in the issuance of a letter of caution or a deficiency letter. The letters noted violations or deficiencies not rising to the level of seriousness warranting enforcement investigation. These letters noted a significant number of minor or less serious violations and deficiencies including, among other things, inadequate supervision, deficient written supervisory procedures, books and records deficiencies, problems with the filing or completion of registration forms, and advertising issues. Together with the enforcement referrals, almost half of the examinations resulted in either an enforcement referral, a letter of caution, or a deficiency letter. Inadequate supervision and deficient written supervisory procedures accounted for many of the apparent violations and deficiencies found. There appeared to be deficient supervision in various respects and in varying degrees of seriousness in 51 of the 179 examinations (28%), and deficient written supervisory procedures in 24 (13%) of the 179 examinations. Inadequate supervision and deficient written supervisory procedures were also the most common apparent violations underlying the enforcement referrals. Only nine of the 179 examinations (5%), however, revealed very poor supervision or particularly deficient written supervisory procedures. Nonetheless, these findings suggest that many firms' supervisory and compliance systems should be strengthened. D. Supervisors in Many of the Branches Examined Conduct Inadequate or No Routine Review of Registered Representatives' Customer Securities Transactions to Detect Sales Practice Abuses It appeared from the examinations conducted that at 47 of the 179 branches examined (26%), supervisors conduct inadequate or no routine review of customer securities transactions effected by registered representatives employed at the branch. Supervisors should review registered representatives' securities transactions in order to detect, among other things, sales practice abuses.-[20]- Trading reviews were generally determined to be inadequate if supervisors within the branch reviewed too ==========================================START OF PAGE 7====== few reports or other documents over a period of time that appeared to be insufficient to detect a pattern of trading abuses vis-a-vis the size and business mix of the firm.-[21]- In addition, some branch office manager interviews disclosed practices that present significant concerns. For example, one branch was found to employ two PRRs who are co-managers (and also husband and wife) who approve each other's trades. Another branch employs only one PRR (who was also the branch manager) but whose activities did not appear to be supervised. Of particular concern is a statement by yet another branch manager that the registered representatives in the branch supervise their own activities. Although these types of findings were isolated, they require that supervision of sales practice activity be improved to aid in the detection and prevention of sales practice abuses. E. Almost One-Half of the Branches That Engage in Some Type of Cold Calling Evidenced Cold-Calling Violations or Deficiencies The examination interviews revealed that 103 of the 179 branches examined (representing 71, or 70%, of the 101 firms examined) engage in some type of cold-calling activity. Of the 103 branches that engage in cold calling, 46 (45%) did not fully comply with the Telephone Consumer Protection Act.-[22]- For example, the Sweep revealed that 12 of the 103 branches that engage in cold calling (12%) do not maintain a "do-not-call" list. In 17 of the 103 branches (17%), registered representatives who engage in cold calling indicated that they had not received training regarding the provisions of applicable cold-calling rules although the firms represented that they provide such training.-[23]- Finally, sixteen of the 103 branches that engage in cold calling (16%) provide no training regarding cold-calling requirements. IV. RECOMMENDATIONS The Working Group believes that the examination findings demonstrate a need to continue to devote additional attention and resources to the prevention and detection of sales practice and supervisory problems. Consequently, the Working Group proposes the recommendations discussed below. These recommendations have been developed to place the responsibility on broker-dealers to strengthen the compliance mechanisms in place within firms and to enhance the efforts of the Commission, the SROs, and the state securities regulators in the prevention and detection of sales practice abuses. ==========================================START OF PAGE 8====== A. More Stringent Hiring Procedures for Registered Representatives The Working Group believes that more effective pre-hiring screening of all registered representatives will aid in efforts to eliminate problem registered representatives from the securities industry. To this end, firms and their branch offices should adopt stringent hiring procedures when considering all registered representative applicants for employment. In addition to reviewing an applicant's Form U-4 and Form U-5, reviewing CRD, and contacting the applicant's previous employers, as is now required under SRO rules, the Working Group strongly recommends as a "best hiring practice" that firms (or branches) also (1) discuss with the applicant the nature of the applicant's prior customers, business mix, and investment philosophy; (2) conduct a credit and financial check of the applicant; and (3) obtain from the applicant, orally or in writing, explanations regarding any customer complaints and regulatory actions to determine the merit, to the extent practicable, of each prior to hiring. Firms also should consider asking applicants about the existence and nature of any pending proceedings, customer complaints, or arbitrations not listed in CRD. The firm's specific hiring policies and procedures should be adopted by the firm in writing. Consistent with the recommendations made in the Large Firm Report and the "Best Compliance Practices" endorsed by the Securities Industry Association ("SIA"),-[24]- the Working Group also recommends that broker-dealers involve compliance and legal staff in the hiring process and designate (above the branch office manager level) an individual or committee to approve the hiring of any registered representative with a history of compliance problems. The Sweep disclosed that almost 25% of the branches examined follow such a practice, by requiring that senior management (above the branch office manager level), compliance staff, outside counsel, or a special committee review registered representative applicants before hiring. In addition, SROs and state securities regulators should remind firms about their existing responsibilities under SRO rules and regulations and applicable state securities laws to investigate adequately each applicant's character, business repute, qualifications, and experience before hiring and to maintain documentation of the hiring steps taken (including the "best practices" discussed above). Firms' documentation of the steps taken in the hiring process should then be subject to regulatory review during examinations. B. Special Supervision for Registered Representatives With a Disciplinary History The Working Group strongly believes that it is important for firms to exercise close supervision over registered ==========================================START OF PAGE 9====== representatives who have engaged in misconduct in the past. If a firm hires a registered representative with a recent disciplinary history involving sales practice abuse or other customer harm, the firm should place the newly hired registered representative under special supervision. This special supervision should include a heightened level of scrutiny of the registered representative's activities by the registered representative's supervisor. "Normal" supervision is simply not enough; firms must craft special supervisory procedures tailored to the individual representative. If firms fail to establish such special supervisory procedures, SROs will consider revising their rules to specifically require that registered representatives with a recent history of disciplinary actions involving sales practice abuse or other customer harm be placed under special supervision by the firm for a period of time.-[25]- While the firm should be responsible for monitoring such a registered representative's special supervision, the SROs should evaluate the firm's special supervision of problem registered representatives during their routine examinations. Moreover, if such an employee commits a sales practice violation during the period of special supervision, firms should recognize that securities regulators do and will continue to closely evaluate whether the firm itself should be subject to disciplinary action for failure to supervise the registered representative. In addition, the Working Group recommends that firms' compliance or legal personnel immediately perform a thorough review of a registered representative's customer account activity when the registered representative is named, during a one-year period, in three customer complaints alleging sales practice abuse. The customer account activity of persons with fewer customer complaints or customer complaints over a longer period of time also should be reviewed as a matter of course. C. Branch Manager Compensation The Working Group is concerned that some branch office managers are neither devoting sufficient time nor employing adequate supervisory tools in overseeing the sales activities of registered representatives. With now over 505,000 registered representatives and approximately 60,000 branch offices, it is critical that supervision be effective at every level. As the first line supervisor, however, the role performed by the branch office manager, or other first-line supervisor, is critical in preventing, detecting, reporting, and correcting problems. In order to encourage and enhance supervisory vigilance, the Working Group recommends that firms consider adopting a policy of tying a component of the branch office manager's compensation to the manager's effective supervision of registered representatives.-[26]- The Working Group believes that it ==========================================START OF PAGE 10====== would be a good practice for managers to be compensated, at least in part, for effective supervision and compliance efforts based on preventing, detecting, reporting, and correcting sales practice abuses and other customer harm. These efforts may be evidenced by, for example, internal audit review of the branch, external regulatory review, and an assessment of arbitrations and customer complaints within the branch. Firms implementing this recommendation should also provide branch office managers with adequate support (both in terms of technical assistance and support) to enable them to conduct their supervisory responsibilities adequately. D. Firm Supervisory Obligations In light of the deficiencies and weaknesses found in firms' supervision and written supervisory procedures, the Working Group believes that firms must ensure that they are fulfilling their supervisory obligations under SRO rules. It is firms themselves that are responsible for deterring, detecting, and correcting weaknesses, deficiencies, and apparent violations of relevant laws, rules, and regulations. In order to focus firms on this endeavor, the SROs should remind members of their supervisory obligations under SRO rules through the use of notices to members or information memoranda to members. For example: 1. The NASD will remind its members of the following obligations: a. Firms must designate one or more appropriately registered principals in each office of supervisory jurisdiction ("OSJ"), including the main office, and one or more appropriately registered representatives or principals in each non-OSJ branch office with authority to carry out the supervisory responsibilities assigned to each office.-[27]- b. At least annually, firms must conduct a review of the businesses in which they engage, which review must be reasonably designed to assist in detecting and preventing violations of and achieving compliance with applicable securities laws and regulations and with the rules of the NASD. c. Firms must conduct an annual inspection of their OSJs. ==========================================START OF PAGE 11====== d. Firms must conduct inspections of non-OSJs according to the schedule set forth in the firm's written supervisory procedures. e. Firms must retain a written record of the dates upon which each review and inspection was conducted.-[28]- 2. The NYSE will remind its members of the following obligations: a. Firms must supervise each office, department, or business activity.-[29]- b. Firms must delegate to qualified principals or employees responsibility and authority for the supervision and control of each office, department, or business activity, and provide for appropriate procedures of supervision and control.-[30]- c. Firms must establish a separate system of follow-up and review to determine that the delegated authority and responsibility is being properly exercised.-[31]- 3. In addition, the other SROs and the state securities regulators should remind firms about their respective responsibilities to supervise branch offices and the importance of designating appropriately registered principals to carry out supervisory responsibilities.-[32]- Moreover, as part of the increased regulatory emphasis on evaluating the adequacy of supervision and supervisory procedures, the Working Group believes that regulators should place increased emphasis during regulatory examinations on whether firms have met these requirements. E. Cold-Calling Training and Supervision and Increased Regulatory Review and Enforcement Cold calling plays an important role in many firms' efforts to generate revenue. Because of the abuses that can be, and have been, perpetrated by cold callers, both Congress and regulatory authorities have prescribed restrictions to protect the public from unwanted solicitations and fraudulent conduct by salespersons and telemarketers.-[33]- The Working Group believes that many cold-calling violations can be prevented (at least to a significant degree) through training and more effective supervision. However, the examinations revealed that a ==========================================START OF PAGE 12====== significant number of firms that engage in cold calling of some type are unaware of all of their responsibilities, particularly those under the Telephone Consumer Protection Act.-[34]- Accordingly, firms must ensure that they adequately train and supervise all telemarketers and registered representatives who engage in cold calling on the provisions of FCC rules and SRO rules on cold calling. Firms that employ cold callers or whose registered representatives engage in cold calling must ensure that the Firm Element of the newly implemented continuing education program incorporates a cold-calling component and that employees are trained appropriately. In addition, firms must ensure that they maintain a "do-not-call" list, establish procedures to add names to the list upon request, and provide a "do-not-call" list to all persons who engage in cold calling (or ensure that such persons have access to a copy of the list). Moreover, in order to ensure that firms fulfill their obligations under applicable laws and rules, the Commission and the regulators that conduct examinations will increase their focus on their regulatory review of cold-calling practices during sales practice examinations and on bringing appropriate disciplinary actions for violations in this area. To this end, the Commission and SROs and state securities regulators that do not already have a cold-calling component in their modules to incorporate such a review. SROs should also consider whether it is appropriate to add to their minor rule violation plans minor violations of the cold-calling rules.-[35]- F. Increased Review During Examinations for Inadequate Supervision and Deficient Written Supervisory Procedures Effective supervision and sound written supervisory procedures are the first line of defense in guarding against sales practice abuses, detecting those problems that do arise and taking prompt corrective action. However, the Sweep examinations found supervisory breakdowns at a number of branches. Accordingly, members must take steps to improve their performance in these important areas. The Working Group recommends that during regulatory examinations, the Commission, the SROs, and those state securities regulators that conduct examinations increase their emphasis on evaluating firms' supervision of registered representatives. In particular, where a weakness, deficiency, or apparent violation is detected by examiners, examiners should determine whether supervisors reasonably carried out their responsibilities; whether such weakness, deficiency, or apparent violation is indicative of a defect in the firm's system of supervision, including its written supervisory procedures; and whether remedial measures are required. This recommendation is a corollary to the recommendation in the Large Firm Report that ==========================================START OF PAGE 13====== examination staff increase the emphasis during examinations on sales practice abuses. The Working Group believes that an increased focus during examinations on supervision and supervisory procedures applicable to sales practices would improve firms' efforts to prevent and detect sales practice abuses by helping to identify weaknesses in the firms' systems of supervision. G. Follow-Up Review of Firms That Were the Subject of Enforcement Actions Firms that have engaged in sales practice abuse and have been the subject of disciplinary action must take necessary steps to remedy the problems within the firm. To ensure that firms that have had sales practice problems do not repeat the offense and to quickly detect those that do, the Working Group recommends that the SEC and the appropriate SROs include in their annual examination priorities follow-up examinations of firms that have been the subject (or whose management have been the subject) of SEC or SRO enforcement actions involving serious sales practice abuses, supervisory breakdowns, or other egregious activity that harms customers within one year of the enforcement action. The Working Group also recommends that, as part of the overall sanctions imposed in enforcement actions, firms be required to prepare and submit to the appropriate regulator a report of the steps taken by the firm to address the abusive practices, including a follow-up review by the firm regarding its supervisory improvements following such actions. The improvements contained in this report will then be closely reviewed during follow-up regulatory examinations. Enhanced regulatory oversight of firms with a history of serious deficiencies or violations through increased SRO examinations should cause such firms to take remedial actions in a more timely fashion, and should allow SROs to detect and halt sales practice abuse at the earliest point. V. CONCLUSION The protection of customers from sales practice abuses or other financial harm is critical to maintaining a healthy securities industry. As such, it is an objective shared by the Commission, the SROs, state securities regulators, and the securities industry. Like the Large Firm Project, the Sweep disclosed that the efforts to prevent and combat sales practice abuses can be improved and strengthened by both regulators and the securities industry. The Sweep involved a sampling of registered representatives with histories of disciplinary actions and customer complaints ==========================================START OF PAGE 14====== and the firms employing such individuals. As a result, it is not possible to draw general conclusions regarding the securities industry as a whole with respect to its hiring, retention and supervisory practices. However, in the small sample selected for examination, the Sweep's findings suggest that existing supervisory and compliance systems at many firms could and should be improved. The Working Group believes that the Commission, the SROs, the state securities regulators, and the securities industry should work together to identify problem registered representatives at an early stage. Once identified, steps should be taken to reduce the potential for future sales practice abuse through examination oversight and, where appropriate, aggressive enforcement action. Even more important, however, is the need to prevent sales practice abuses through the establishment and implementation of firm policies and procedures designed to prevent and detect such abuses, and through effective supervision. In addition, firms must improve substantially their pre-screening of registered representative applicants in order to preclude problem registered representatives from re-entering the securities industry or remaining in the industry by moving from firm to firm. Reducing the number problem registered representatives in the securities industry is a pivotal step in effectively reducing potential harm to the investing public. The Working Group recommends that the Commission, the SROs, the state securities regulators, and the securities industry consider prompt implementation of the recommendations contained in this report, which are designed to build on and improve existing supervisory and regulatory systems, and most importantly, to protect the integrity of the U.S. securities markets and the well-being of public investors. ==========================================START OF PAGE 15====== =========ENDNOTES========= -[1]- The term "Working Group" refers to the staffs of the SEC, the NASD, the NYSE, and NASAA. -[2]- The firms examined include both clearing and introducing firms (mostly introducing firms), employ anywhere from approximately 10 to several thousand registered representatives, are located throughout the United States, and generally offer a wide variety of securities products. -[3]- For purposes of this report, the main and branch offices of firms examined during the Sweep are collectively referred to as branches. -[4]- The review also revealed that almost one-fourth of the 347 PRRs were not working in the securities industry at the conclusion of the Sweep in November 1995. -[5]- An applicant for registration with an NASD member firm must complete a Uniform Application for Securities Industry Registration or Transfer Form (Form U-4), pursuant to Article IV, Section 2 of the NASD's By-Laws. Similarly, NYSE Rule 345.12 requires persons preparing to become associated with NYSE firms to file and keep current Form U-4. Form U-4 requires that firms and individuals report personal data, residential history, employment, and personal history for the past ten years, as well as findings and adjudications by domestic and foreign courts, the SEC, the Commodity Futures Trading Commission ("CFTC"), federal, state, and foreign regulatory agencies, self-regulatory organizations ("SROs"), and commodities exchanges involving felony convictions, certain misdemeanors, false statements and omissions and violations of applicable rules. Applicants must also report customer-initiated complaints involving allegations of fraud or wrongful taking of property, allegations of compensatory damages of $10,000 or more, awards of damages of $5,000 or more, or settlements of $5,000 or more. Form U-4 also requires disclosure of unsatisfied judgments or liens, petitions in bankruptcy and any discharges or resignations from employment resulting from accusations involving investment- related rules, regulations or statutes, wrongful ==========================================START OF PAGE 16===== taking of property or failure to supervise in an investment context. -[6]- Under Article IV, Section 3 of the NASD By-Laws and NYSE Rule 345.17, members must provide the NASD and NYSE, respectively, with written notice of termination of any registered person. In addition to notifying the SROs of the termination of association between the broker-dealer and registered representative, the Uniform Termination Notice for Securities Industry Registration (Form U-5) requires that firms report any disciplinary action, investigation, or proceeding by a domestic or foreign governmental body or SRO with jurisdiction over investment-related business; convictions or guilty pleas in a foreign or domestic court involving felonies or certain misdemeanors; internal investigations involving fraud or wrongful taking of property or violations of investment-related statutes or regulations; and investment-related consumer initiated complaints that allege compensatory damages of $10,000 or more, allege fraud or the wrongful taking of property, were settled or decided against the individual for $5,000 or more, or where the broker-dealer found fraud in the wrongful taking of property. Members must file an amended Form U- 5 in the event that the member learns of facts or circumstances causing information in the Form U-5 termination notice to be inaccurate or incomplete. One purpose of the timely filing of the termination notice is to provide the SROs with a mechanism for reviewing past conduct of terminated registered representatives before the SROs lose jurisdiction over the registered representatives that may have violated federal, state, or SRO rules and regulations. -[7]- Developed jointly by NASAA and the NASD in 1981, the CRD, which the NASD operates, is an on-line database containing information pertaining to broker-dealers and their associated persons. Information contained in the CRD is provided by the NASD, SEC, some exchanges, the CFTC, the National Futures Association, state securities regulators and the Federal Bureau of Investigation. Information is also provided to the NASD for input into CRD by broker-dealers through their submissions of amendments to Form BD (the firm's registration form) and Forms U-4 and ==========================================START OF PAGE 17====== U-5. The CRD database includes information on approximately 5,500 broker-dealers and 505,000 active registered persons. -[8]- An enforcement referral occurs when findings discovered during an examination are deemed by the staff to be of sufficient concern to warrant further investigation and possible enforcement action. The fact that an examination has been referred to enforcement staff does not necessarily mean that a violation of the sales practice rules or the antifraud provisions of the securities laws has occurred, or that an enforcement case will be brought involving the branch or registered representative whose conduct is the subject of the referral. Some of these examinations also resulted in other actions, such as a letter of caution or a deficiency letter. See infra note 9 (definitions of letter of caution and deficiency letter). -[9]- A letter of caution is a letter sent to a broker- dealer by an SRO or state securities regulator describing a violation by the broker-dealer or its associated persons of one or more securities laws, rules or regulations. A letter of caution is typically issued for violations that are less serious than those warranting an enforcement referral. If further similar violations occur, the broker-dealer may be subject to more formal disciplinary action, such as a disciplinary proceeding seeking a fine or bar. A deficiency or exception letter is issued to a broker-dealer by an SRO, state securities regulator, or Commission staff describing deficiencies and sometimes violations in the broker-dealer's operations found during a broker-dealer examination. A deficiency letter is not viewed as a disciplinary action; it apprises the broker-dealer of areas that need improvement, requests that corrective steps be taken to rectify the problems specified, and generally requires the broker-dealer to provide within a specified time a response identifying any remedial actions taken or proposed to be taken. -[10]- Broker-dealers, like all firms engaged in telemarketing, are subject to the Telephone Consumer Protection Act and a Federal Communications Commission ("FCC") rule promulgated thereunder. See Pub. L. No. 102-243, 105 Stat. ==========================================START OF PAGE 18====== 2394 (1991) (codified at 47 U.S.C.  227(1992)); 47 CFR  64.1200 (1992). Pursuant to the FCC's cold-calling rule, telemarketers must abide by specified time-of-day restrictions, maintain "do- not-call" lists and add names to such lists upon request, train personnel and adopt a written policy with respect thereto, and follow certain identification requirements. In August 1994, Congress passed and the President signed new cold- calling legislation, entitled the Telemarketing and Consumer Fraud and Abuse Prevention Act. See H.R. Rep. 686, 103rd Cong., 1st Sess. (1994). This Act required the Federal Trade Commission ("FTC") to enact cold-calling rules with respect to most telemarketers, except those regulated by the SEC, within a year of the legislation, and directed that the SEC adopt, or cause SROs to adopt, substantially similar rules for broker- dealers and other SEC-regulated entities within six months of the effective date of the FTC rules, unless the Commission determines that such rules are unnecessary or inappropriate. See infra note 34. The FTC approved rules under the Act in August 1995, which rules became effective on December 31, 1995. See 60 Fed. Reg. 43842 (Aug. 23, 1995). -[11]- The Securities Industry/Regulatory Council on Continuing Education, composed of representatives from SROs, a cross-section of firms, and liaisons from NASAA and the SEC, has developed a continuing education curriculum to improve practices throughout the securities industry. Under the program, every broker-dealer is required to provide its registered representatives and first- line supervisors with annual continuing education relating to its products and services. In addition, all registered representatives who have been registered less than ten years or who have been the subject of serious disciplinary action must receive compliance, ethics and sales practice training. -[12]- NASD cause examinations generally are conducted as a result of a customer complaint alleging violation of the NASD rules and/or federal securities laws or disclosure of certain information on Form U-5 regarding the termination for cause of a registered representative. ==========================================START OF PAGE 19====== -[13]- NYSE Rule 351(d) requires that member firms submit to the NYSE, on a quarterly basis, summary information concerning all customer complaints the member firm received during that quarter. In addition, NYSE Rule 351(a) specifically identifies ten different circumstances where broker-dealers must file a report with the NYSE. See Appendix D (text of Rule 351(a)). -[14]- The following state securities regulators participated in the Sweep examinations discussed in this Report: Alaska, Arizona, California, Colorado, Connecticut, District of Columbia, Florida, Idaho, Illinois, Iowa, Kansas, Maine, Maryland, Michigan, Montana, New Jersey, New Mexico, Nevada, North Carolina, North Dakota, Oklahoma, Oregon, Pennsylvania, Puerto Rico, Texas, Utah, Virginia, Washington, and Wisconsin. -[15]- One hundred and seventeen PRRs were not interviewed because, among other things, they were either out of the industry at the time of the examination, determined (on-site or immediately prior to the scheduled examination) to be inappropriate interview candidates because they did not conduct retail securities business or conducted an insignificant number of trades per month, or were subject to an enforcement investigation that began after the examinations occurred. -[16]- The review of the 347 PRRs revealed that 75 of the 347 PRRs (22%) were not working in the securities industry at the conclusion of the Sweep in November 1995. Of these PRRs, four (5%) have been the subject of a disciplinary action involving sales practice abuse during the Sweep and 11 PRRs (15%) were, as of January 1996, the subject of an ongoing, non-public investigation involving sales practice abuse. -[17]- See Article III, Section 27(e) of the NASD's Rules of Fair Practice and NYSE Rule 345.11. Some state securities regulatory authorities have adopted similar requirements. ==========================================START OF PAGE 20====== -[18]- An applicant is frequently offered a position before the broker-dealer contacts the person's employers for the past three years as required by Form U-4. However, that person is not permitted to act as a registered representative until the Form U-4 has been filed with and received by the NASD (or other SRO as required). -[19]- The number of Sweep examinations that resulted in enforcement referrals was roughly consistent with the number of referrals typically resulting from the SEC's examination program. In fiscal year 1995, approximately 21% of the SEC's examinations (excluding those related to the Sweep) resulted in referrals for possible enforcement investigation. -[20]- The types of reviews conducted vary from firm to firm, or branch to branch, based on the size of the firm or branch, and the business mix. Reviews include the examination of, among other things, order tickets and customer accounts. In addition, some firms or branches may utilize exception reports (i.e., computerized reports designed to highlight activities that trigger certain parameter breaks), while others (usually smaller firms or branches) may rely primarily on manually generated reports. -[21]- For a branch with few registered representatives, for example, a daily check of order tickets and a review of monthly statements by the branch office manager may be adequate because the branch manager should be familiar with all of the accounts. For a larger firm with many registered representatives, such a trading review should include the use of exception reports, which enable a firm to tailor reports to detect specific types of sales practice abuses based on parameter breaks. -[22]- See supra note 10. -[23]- Two branch managers believed that training is not required or given if the salesperson is a registered representative. -[24]- See Appendix A, Section A.5. (discussion of SIA endorsement of best compliance practices). ==========================================START OF PAGE 21====== -[25]- Registered representatives who are subject to a statutory disqualification and seek to become associated with a registered broker-dealer typically are required by the SRO to be placed under enhanced supervision as a condition of such person's employment at the broker-dealer. Generally, a person is subject to a statutory disqualification if that person has been convicted of any felony or certain enumerated misdemeanors within the last ten years; is enjoined temporarily or permanently from violating the securities laws by a court of competent jurisdiction; or has been and is barred from associating with a broker- dealer by the SEC, the CFTC, an SRO, or the foreign equivalent thereof. See Section 3(a)(39) of the Securities Exchange Act of 1934 ("Exchange Act"). The recommendation to place registered representatives with a history of disciplinary actions under special supervision is not limited to statutorily disqualified persons. -[26]- Compensating a branch office manager based on, among other things, the compliance record of the branch was reflected as a "best practice" in an April 1995 report by the Committee on Compensation Practices. See Report of the Committee on Compensation Practices (April 10, 1995) (also discussed in Section B.1. of Appendix A). -[27]- See Article III, Section 27(a)(4) of the NASD's Rules of Fair Practice. -[28]- See Article III, Section 27(c) of the NASD's Rules of Fair Practice. -[29]- See NYSE Rule 342(a). -[30]- See NYSE Rule 342(b)(1). -[31]- See NYSE Rule 342(b)(2). -[32]- See Section III.D. for examples of highly questionable supervisory practices by principals. -[33]- The permitted activities of telemarketers who are not registered representatives are extremely limited. See generally Article II, Section 2 and Article IV, Section 1 of the NASD's By-Laws. ==========================================START OF PAGE 22====== -[34]- See supra note 10 and accompanying text (discussion of cold-calling requirements and examination findings). To date, several SROs have promulgated cold-calling rules that require members that engage in telephone solicitations to offer and sell securities to create and maintain a centralized do-not-call list. Exch. Act Rel. No. 35821 (June 7, 1995) (NYSE rule); Exch. Act Rel. No. 35831 (June 9, 1995) (NASD rule); Exch. Act Rel. No. 36588 (Dec. 13, 1995) (CBOE rule); and Exch. Act Rel. No. 36748 (Jan. 19, 1996) (Amex rule). -[35]- Many SROs have minor rule violation plans that enable them to discipline members and registered representatives for minor violations without having to follow the more formal procedures required for enforcement actions (see, e.g., Art. II, Sec. 10 of the NASD's Code of Procedure, NYSE Rule 476A).