American Council of Life Insurers
October 3, 2003
Jonathan G. Katz
RE: Release No. 34-48298; File No. SR-NASD-2002-162; Proposed NASD Supervisory Control Procedures for Broker-Dealers
Dear Mr. Katz:
The American Council of Life Insurers respectfully offers comment on Release No. 34-48298, which highlighted new NASD Rule 3012 and amendments to NASD Conduct Rules 2510, 3010, 3110, and NASD Interpretive Memorandum 3110.1 This initiative would create new broker-dealer supervisory control procedures.
The American Council of Life Insurers ("Council") is a national trade association with 399 members representing 72 percent of all United States life insurance companies. Many of our member companies offer and distribute variable annuities, variable life insurance and mutual funds directly or through affiliated and independent broker-dealers. Over 50% of the NASD's 664,798 registered representatives work for broker-dealers affiliated with life insurance companies. The initiative would have a significant impact on our industry.
We have actively participated in a numerous NASD rule proposals. SEC oversight of SRO rules ensures balanced regulations in the public interest, and provides an important protection against SRO rules that may impede competition.
ACLI greatly appreciates the SEC's courtesy in extending the comment period on the proposal for an additional 30 days.2 The original 21-day comment period provided inadequate opportunity for meaningful analysis of the amended proposal, particularly since the initiative had been more thinly vetted than most SRO rule proposals and lacked scrutiny by NASD substantive committees or a membership vote.
Summary of Rule Changes
The NASD proposed new Rule 3012, requiring broker-dealers to develop general and specific supervisory control procedures that test and verify the broker-dealers' supervisory procedures, and where necessary, to modify them. In addition, the August release proposed amendments to:
(i) NASD Rule 3010(c) to require that office inspections include the testing and verification of certain supervisory procedures;
(ii) NASD Rule 3110 to expand upon broker-dealers' supervisory and recordkeeping requirements with respect to changes in customer account name or designation in connection with order executions;
(iii) NASD IM-3110 to provide guidance regarding when a broker-dealer may hold mail for a customer who will be absent for a period of time;
(iv) NASD Rule 2510(d) to clarify the time limit on time-and-price discretionary authority; and
Impetus for Change
The November 2002 release states that NASD Rule 3012 compliments and is substantially similar to NYSE Rule 3012. According to the November release, "the recent Gruttadauria case, which involved the misappropriation of customer funds, has brought tremendous attention to the ongoing problem of operational and sales practice abuses at firms and the importance of ensuring that firms effectively monitor the activities of their employees."
The background to the Gruttadauria case helps frame the NASD's objectives. From 1987 to January 2002, while employed at a series of five different registered broker-dealers, Frank Gruttadauria defrauded over 60 customers by lying about purchases and sales of securities, misappropriating funds and securities, and sending falsified account documents. By the time that Mr. Gruttadauria confessed generally to his fraudulent conduct in a letter to the Federal Bureau of Investigation on January 11, 2002, he had misappropriated over $115 million from customers over a period of 15 years - transferring most of the money to other customers to cover withdrawal requests - and overstated account values by more than $280 million. Mr. Gruttaduria's fraudulent activities thrived due to profound supervisory failures.
On August 14, 2003, the SEC imposed remedial sanctions and issued cease-and-desist orders against two full-service broker-dealers, Lehman Brothers and S.G. Cowan Corporation, for failure to supervise Mr. Gruttadauria, among other things.3 Several aspects of the NASD's proposal specifically target supervision and compliance deficiencies evidenced in Gruttadauria. For example, proposed amendments to Rule 3010(c)(2) requires written reports about branch office inspections, including testing and verification of supervisory procedures covering the: safeguarding of customer funds and securities; transmittal of funds between customers and third parties; validation of customer account changes; and, validation of changes in customer account information.
Summary of Position
The initial proposal elicited 72 letters of comment expressing a variety of practical and regulatory concerns. This volume of comments was a lightning rod of broad concern. In several important respects, the NASD sensibly revised the proposal in response to comments. In other significant areas, however, the NASD's revisions inadequately address regulatory and competitive issues.
The proposal may have an anticompetitive impact on limited purpose broker-dealers affiliated with life insurers. Notwithstanding the release's assertion that the NASD has considered the rule's impact on competition, some of the changes in the proposal could unreasonably burden competition. In several regards, the proposal would require broker-dealers to create supervisory and control procedures for circumstances that never occur in their operations. Some technical aspects of the proposal remain unclear, and should be further clarified.
The life insurance industry fully supports meaningful enhancements to NASD rules for investor protection. NASD rules can be carefully tailored to achieve this worthwhile goal without impairing competition.
Unique Burdens and Competitive Impact
Proposed NASD Rule 3012 parallels NYSE Rule 3012.4 Other aspects of the proposal also track NYSE provisions "to promote consistency between NASD's and NYSE's supervisory control requirements."5 Although regulatory symmetry has cosmetic appeal, it can also foster ill-fitting regulation endangering competition. The NYSE principally regulates full-service broker-dealers. In contrast, the NASD regulates a significantly more diverse group of broker-dealers. Limited-purpose broker-dealers affiliated with life insurers have structures, operations, functions, and product lines different from full-service broker-dealers. Several aspects of NASD Rule 3012 have marginal, if any, connection to the activities of these broker-dealers.
Most of the factors enabling the Gruttadauria fraud do not exist with limited-purpose broker-dealers affiliated with life insurers. These broker-dealers generally do not hold customer assets or securities. They do not maintain cash management accounts, or hold free cash balances. Many broker-dealers affiliated with life insurers distribute only variable life insurance and variable annuities. These offices essentially operate as introducing brokers, and transmit insurance and annuity applications to life insurers for underwriting and acceptance of the contract. Unlike full-service broker-dealers, active transactional accounts are not typically maintained.
After the variable life or variable annuity contract is issued, the life insurance company manages the on-going customer relationship. For example, the life insurance company handles ministerial modifications, such as changes of address or beneficiaries, not the broker-dealer. Withdrawals, surrenders, and policy loans occur between the insurer and the customer, without the intervention of the broker-dealer. Life insurers transmit annuity payments and death benefits directly to the customer or benificiary, not to third parties. The life insurer, not the broker-dealer, prints and mails customer account statements. Life insurance and annuities are legal contracts between the insurer and the customer. These relationships are different from those at a full-service broker-dealer. The unique features of variable contracts and the limited activities of broker-dealers affiliated with life insurers, therefore, do not provide an environment similar to Gruttadauria.
Several elements in the NASD's proposal specifically address circumstances of Gruttadauria.6 Those same elements, however, are not germane to broker-dealers affiliated with life insurers. For example, amendments to Rule 3010(c)(2) requires written reports about testing and verification of supervisory procedures covering the safeguarding of customer funds and securities, transmittal of funds between customers and third parties, validation of customer account changes, and validation of changes in customer account information. These supervisory procedures have no relevance to broker-dealers that do not hold customer funds, transmit customer funds to third parties, or validate customer account changes.
We are troubled that the NASD will require all broker-dealers to test and verify for all of the procedures noted in Rule 3010(c)(2), even when the target activities do not exist. For example, Rule 3010(c)(2) requires "that the written inspection report must also include, without limitation, the testing and verification of procedures" regarding safeguarding of customer funds, funds transmitted to third parties, validation of customer account changes, and validation of customer address changes. How can a broker-dealer have a written inspection report, without limitation, about testing and verification of procedures for activities that do not occur or are not permitted at a broker-dealer? This NASD rule amendment leaves no room for rational variations at different types of broker-dealers.
Our concerns are not unfounded. The NASD has enforced its rules in a one-size-fits-all fashion without regard to the actual activities of the broker-dealer. For example, in its examination for USA PATRIOT Act compliance under Rule 3011, the NASD required all broker-dealers to have procedures for identifying cash transactions, for filing Currency Transaction Reports (CTRs), and for verifying customers that trigger a CTR filing.7
These categories of anti-money laundering("AML") procedures do not apply to broker-dealers that do not accept cash. Quite appropriately, these broker-dealers did not establish an AML procedure for cash transactions and CTRs, because these events are inapplicable to their operations. Nonetheless, in examinations the NASD identified this as a deficiency, even though the Treasury Department emphasized that AML procedures should be risk-based and unique to the activities of the broker-dealer. Although Treasury's PATRIOT Act releases have all stressed that AML compliance was not one-size-fits-all, the NASD has sought identical practices of all broker-dealers. Similar examples exist in other rule enforcement practices at the NASD.
The same regrettable experience could occur in NASD inspections for compliance with the proposed supervision and control standards. The NASD release states that the rules need greater flexibility to accommodate variations in business models.8 Given the track record, we are unwilling simply to rely on the NASD's good will concerning reasonable application of the proposed supervision and compliance requirements. In the past, the NASD has used an inflexible, check-box approach that treats all broker-dealers as full-service firms. While this may be appropriate for the NYSE, it should be jettisoned from the NASD's operations.
The proposal impairs competition in several respects. The NASD inflicts disparate operational costs when limited purpose broker-dealers must fulfill procedures relevant only to full-service firms. Scarce resources are better used to combat compliance issues likely to occur. NASD citation of inapplicable deficiencies causes unwarranted commercial and reputational damage in a competitive marketplace. Unlike NYSE broker-dealers, NASD broker-dealers are not all full-service firms. Jamming broker-dealers affiliated with life insurers into inapplicable full-service compliance thwarts competition.
In other respects, the NASD proposal falls short. The NASD's request for SRO rule approval lacks any meaningful analysis of the initiative's burden on competition. Without any apparent substantiation, the NASD request simply asserts that the proposal would not impair competition.9 No attempt appears to have been made to evaluate the disparate impact of the initiative on different categories of broker-dealers. Most SEC rulemaking makes a serious effort to evaluate and quantify the economic and competitive impact of rule changes. There is no reason that the NASD cannot fulfill the same high standards to fairly protect marketplace competition.
Moreover, nothing in the NASD request indicates that the initiative's competitive impact was evaluated with pending rule changes in mind. For example, the NASD has filed a request for SEC approval of an amended definition of "branch office." The rule would substantially revise the status of non-branch locations. Unlike full service firms, broker-dealers affiliated with life insurers tend to have many small, geographically dispersed non-branch locations. This reflects the insurance distribution systems through which variable products are marketed.
Several aspects of the proposal have a significant impact on branch and non-branch locations. As a result, the initiative could have a disproportionate impact on limited purpose broker-dealers affiliated with life insurers that operate many non-branch locations. Nothing in the NASD application for approval reveals whether the NASD thoroughly considered this issue of competition. The 1934 Act demands more. Without better analysis, the NASD rule request is not ripe for approval.
When it amended the Exchange Act in 1975, Congress specifically charged the SEC with the responsibility to evaluate competitive burdens of SRO rules and rule changes. The Senate report on the legislation stated that:
Sections 6(b)(8), 19(b) and 19(c) of the Exchange Act would obligate the Commission to review existing and proposed rules of the self-regulatory organizations and to abrogate any present rule, or to disapprove any proposed rule, having the effect of a competitive restraint it finds to be neither necessary nor appropriate in furtherance of a legitimate regulatory objective.10
Section 23(a) of the Exchange Act was also added in 1975, and requires the SEC to consider the anti-competitive effects of rule changes, and to balance any impact against the regulatory benefit to be obtained.11 Similarly, Sections 15A(b)(6) and (9) of the 1934 Act require the SEC to evaluate carefully the competitive impact of proposed SRO rules and amendments.
The Securities Act Amendments of 1975 significantly expanded the SEC's oversight and regulatory powers concerning SRO rules, and specifically directed the SEC to carefully evaluate competitive factors in exercising its SRO oversight. Importantly, Congress did not intend to confer general antitrust immunity on SRO rulemaking that was subject to the SEC's oversight review.12
The antitrust immunity created by Congress contemplates active oversight by the SEC in executing its responsibilities to ensure consistency with the securities laws, and to blunt the anticompetitive behavior inherent in self-regulatory conduct. Otherwise, a Congressional grant of substantial regulatory authority to private organizations without federal regulatory oversight would violate the constitutional prohibition against the delegation of legislative powers.
In order for SEC review to provide immunity for self-regulatory conduct, the review must be active, and must result in a ruling by the SEC that is judicially reviewable.13 Section 25 of the 1934 Act states that the SEC's actual findings are conclusive if supported by substantial evidence, and that its decisions should be overturned only if "arbitrary, capricious, an abuse of discretion, or otherwise not in accordance with the law, the excess of statutory jurisdiction, authority, or limitations, or short of statutory right, or without observance of procedures required by law." The proposed rule amendments fail the statutory safeguards to competition set forth above.
In a different context, former SEC Chairman Levitt emphasized the importance of reviewing the impact of rulemaking on competition when he stated:
In response to the National Securities Markets Improvement Act of 1996 (NSMIA), the Commission has rededicated itself to considering how rules affect competition, efficiency, and capital formation as part of its public interest determination. Accordingly, the Commission intends to focus increased attention on these issues when it considers rulemaking initiatives. In addition, the Commission measures the benefits of proposed rules against possible anti-competitive effects, as required by the Exchange Act.14
The NASD's rule request for SRO rule approval does not fulfill the important SEC and statutory goals to protect both competition and investors. The SEC should not approve the NASD initiative without modifications to remedy the rules' anticompetitive impact.
Technical and Interpretive Issues
Several items in the proposal need technical clarification. Rule 3012(A)(2)(C) references "heightened supervision" for "each producing manager who is responsible for generating 20% or more of the income of the producing manager's supervisor." Similarly, Rule 3010 (c)(3) mandates "heightened office inspections" if the person conducting the inspection "works in an office supervised by the branch manager's supervisor and the branch office manager generates 20% or more of the income of the branch office manager's supervisor."
These formulations raise mechanical, timing and cost questions. Some of our members have asked what income the 20% is intended to measure. Does it include insurance, investment advisory, group variable annuities, or just securities sales? Are limited purpose broker-dealers expected to develop an automated system to measure the 20% figure, or can it be calculated manually? How often is the system (whether automated or manual) to be tested? Should it be tested once a year, every quarter, or on a continuous basis? These issues are even more complex for the calculation in Rule 3012 because it would require an automated system to log every manager making 20% of their supervisor's income. Before the rule changes are approved and adopted, these issues need to be clarified.
The terms "heightened office inspections" and "heightened supervision" provide conceptual outlines elusive to practical application. The release defines "heightened office inspection" to mean those inspection procedures that are designed to avoid conflicts of interest that serve to undermine complete and effective inspection because of the economic, commercial, or financial interests that the branch manager's supervisor holds in the associated persons and businesses being inspected.
The release defines "heightened supervision" to mean those supervisory procedures that evidence supervisory activities that are designed to avoid conflicts of interest that serve to undermine complete and effective supervision because of the economic, commercial, or financial interests that the supervisor holds in the associated persons and businesses being supervised.
Although the NASD endeavored to clarify the scope and intent of these terms, it failed in its mission. The definitions give broad conceptual borders needing further clarification. Broker-dealers will be uncertain whether their "heightened" procedures will pass the NASD's muster. NASD examiners will be hard pressed to apply these standards in a uniform fashion. Flexibility to accommodate different business models is commendable. The imprecision in these definitions, however, thwarts conscientious interpretation.
Some broker-dealers have noted that the scope or meaning of the term "supervising" may present interpretive difficulty when applied in Rule 3010(g)(2)(B). Under this provision, any location "supervising" activities at a non-branch location is now considered a branch office. The NASD needs to clarify that the scope covers supervision of securities activities, rather than supervision in generic sense. Otherwise, supervision of non-securities activities could incorrectly elevate a location to a branch for purposes of the rule.
Some have observed that the requirement in Rule 3012 (a)(1) to specifically link significant identified exceptions to additional or amended supervisory procedures created in response to test results may create an unnecessary exposure to litigation. It should satisfy the rule's purpose to simply list the new or amended procedures without linking it to a specific exception.
Several things can be done to balance the NASD proposal appropriately and to cure its anticompetitive impact. First, the NASD should restore Rule 3010(c) to the list of rules in NASD Rule 9610(a) from which a broker-dealer can seek an exemption. This would allow for reasonable accommodation for broker-dealers that do not need to adopt, examine and report on artificial factors that do not exist in their operations. The NASD should be encouraged to grant the exemption requests in an even-handed manner giving full force to the purpose of the exemption mechanism.
Second, the NASD needs to conduct an objective, quantifiable examination of the economic and competitive impact of the rule proposal. This should be done with an eye to upcoming NASD rule changes that have been filed with the SEC for approval, such as the amendments to the "branch office" definition. As a general matter, the SEC should not accept the NASD's unsubstantiated assertion that rule changes will not have an adverse impact on competition. Clear evidence of substantive analysis should be shown in all NASD requests for rule approval.
Third, the release should emphasize that supervision and control procedures do not need to be created, reported upon, or examined when activities are outside the scope of the broker-dealers' operation. For example, the release should state that no special supervisory or control procedures are necessary for the safeguarding of customer funds and securities, transmittal of funds between customers and third parties, validation of customer account changes, and validation of changes in customer addresses when these activities do not occur in the broker-dealer's operation.
Fourth, the SEC should strongly discourage the NASD from filing rules for approval without first vetting them internally through the committee process, and subjecting them to membership vote. Circumventing this worthwhile process increases the probability that NASD rules will be developed without the benefit of constructive balance that can retard anticompetitive activity early in the process. All relevant NASD committees should have the opportunity to offer input on rule initiatives.
Fifth, the NASD should systemically ensure that its rules are applied fairly to reasonably address different business models. With these recommended changes, the rule proposals can properly accommodate all broker-dealers, and not just full-service firms.
We also recommend that the NASD clarify the technical issues noted above. In this way, the rule will be more fully and equitably useful.
We greatly appreciate your attention to our concerns. If any questions develop, please call.
cc: William H. Donaldson, Chairman