Equity Services, Inc.
December 18, 2002
VIA ELECTONIC MAIL ONLY
Mr. Jonathan G. Katz
Re: File No SR-NASD-2002-162
Dear Mr. Katz:
We are commenting on the NASD's recent proposal to amend their rules related to broker-dealer's supervisory controls.
Equity Services, Inc. ("ESI") is a wholly owned retail broker-dealer of National Life Insurance Company and has been in operation since 1968. The firm offers a wide range of financial products and services, including mutual funds, variable life insurance, variable annuities and general securities. ESI has approximately 1,200 registered representatives and is registered to conduct securities business in all fifty states.
Method of Proposal
First, we note that the NASD did not did submit this proposal to its membership for comment prior to it being submitted to the SEC. While the NASD is not required under their By-Laws to submit rule change proposals to their membership, it has been NASD's practice to submit proposals of wide ranging impact to the membership so that significant issues and concerns can be considered before the matter is formally submitted to the SEC1. Given the sweeping consequences of this proposal, we are surprised that they did not solicit comments from its members on this very significant rule change.
In their proposal, the NASD noted the contemplated rule changes are similar to those contained in a recent NYSE rule proposal. However, we note that NYSE members are materially different from many NASD members, e.g., full service wire house and clearing firms versus independent broker-dealers, fully disclosed introducing broker-dealers and insurance broker-dealers, respectively. In reviewing this proposal, we do not believe that NASD fully considered the impact on each type of firm in its membership.
Need for the Rule Change
Philosophically, we question the need to amend the NASD supervisory rules. While it is true that the Gruttadauria case highlighted the risk of lax supervision, it would seem that the NASD could take any necessary enforcement action against the firms under their current rules. That is, NASD Rule 3010(a) says, "[e]ach member shall establish and maintain a system to supervise the activities of each registered representative and associated person that is reasonably designed to achieve compliance with applicable securities laws and regulations, and with the Rules of this Association. Final responsibility for proper supervision shall rest with the member." (Emphasis added.) Both the NASD and SEC have demonstrated an ability to take needed action against firms who have not adopted reasonable and adequate supervision.
We question whether this proposal would enhance the real supervisory controls of broker-dealers. This proposal seems to micromanage firms by dictating who can conduct audits and the items to be reviewed in the audits. We believe that this proposal does not take into regard the associated costs and a belief that firms can design their own supervisory procedures designed to reasonably achieve compliance with regulatory requirements.
Unfortunately, there will always be a few bad apples in the securities industry. However, there must be some recognition that no matter how strict regulations and enforcement become, a creative criminal mind can find ways to avoid being immediately discovered. Firms and regulators need to take strong actions against those who commit serious violations of regulatory requirements, including any material supervisory lapses. However, the solution should not be one of regulatory overreaction. In other words, should all firms pay the price of one, albeit large and well-publicized, fraud case? New rules that do not consider impact to firms, and ultimately investors, will result in over-regulated, cost heavy and inefficient financial markets.
Rule 3010, Supervision - Internal Inspections
Currently, ESI has registered approximately sixty-five of its offices as branch offices with the NASD. A small number of these branch offices are also registered with the NASD as Offices of Supervisory Jurisdiction. Supervisors of registered field offices are primarily compensated on a percentage of their representatives' sales production. The firm's registered offices typically have from five to twenty on-site representatives, but also have a number of detached, non-branch offices reporting to them. The firm has approximately 450 representatives working from non-branch locations. Under the firm's written supervisory procedures, the supervisor of each registered office location is required to conduct annual inspections of his/her detached non-branch locations. The supervisors make a report of their inspections on a firm approved checklist to the main office. Compliance personnel individually review these checklists and make any necessary follow-up. Compliance personnel also periodically inspect selected non-branch locations.
Under this proposal, the NASD would require that the inspections of the non-branch locations be conducted by a person independent from the activities being performed at the office and those persons providing supervision to that office. Assuming that the firm was unable to obtain a waiver referenced under 3010(c)(3) of the proposal, the firm would no longer be able to rely upon its branch office supervisors to conduct inspections of its detached, non-branch offices as these supervisors would not be considered "independent" under the proposed rule as they receive remuneration from the sales activities of the registered representatives.
This would be a costly result to the firm. The firm believes that at least four new compliance officers would minimally be required to comply with this aspect of the proposal.2 Assuming annual salaries and benefits of $60,000, plus annual travel expenses of $15,000 per year per person, the firm would incur at least $300,000 in new overhead expenses. Alternatively, the firm could hire an outside compliance consultants to conduct such inspections. However, these firms generally charge $1,500 per day, plus expenses, which would result in a cost of at least $675,000 per year.
We note that under the proposal, the independence requirements may be satisfied "by reasonable means based on the size and resources of the firm and scope and nature of its activities". More specifically, firms seeking an exemption from the independent requirement would need to make a written application to the NASD, pursuant to NASD Rule 9610. However, we believe that this process could be highly subjective and that there could be a wide disparity between firms that are granted an exception and those that are not. For those firms not granted an exception, it would appear that the NASD would be subjecting those firms to a higher overhead cost structure and placing those firms at a competitive disadvantage with its peers.
In addition, we believe this proposal may have an unintended consequence of transferring supervisory responsibility. Specifically, under the firm's current supervisory procedures, each of the firm's supervisors understands their responsibility to directly supervise their agents, including ensuring proper records and procedures at non-branch locations and upturning violations of firm and/or securities regulations by conducting audits. If these supervisors are no longer permitted to conduct inspections, it would seem that the responsibility (and liability) for supervising these offices transfers to the compliance personnel. Compliance personnel would be placed in the untenable situation of not being responsible for the hiring and terminations of representatives and their day-to-day supervision, while having ultimate personal liability. In fact, it would seem that the local supervisors would have a less vested interest in the supervision of non-branch locations under the proposal.
Rule 3012 Supervisory Controls - General Requirements
The proposal would require firms to have "independent" persons conduct annual inspections of the firm's supervisory procedures and controls. In their narrative discussion of the proposal, the NASD acknowledges that they currently require that firms annually inspect the activities of each office. Of course, this existing rule requires an annual inspection of the firm's main OSJ as well. Therefore, it seems that proposed Rule 3012 is somewhat duplicative of existing NASD rules, other than requiring independent persons to conduct the examination.
For our firm, the Compliance Department is responsible to establish and maintain a system of supervisory control. Personnel in this department would not be "independent" and could not conduct the inspection of the firm's supervisory controls, as required under this proposed rule.
This leaves the firm with two options: 1) Have its parent insurance company's internal audit department conduct the inspection. However, the internal audit department is not involved in the securities business, does not have NASD registered personnel, and without significant training, would be unlikely to provide an insightful examination of the firm's supervisory procedures. 2) Hire an outside compliance consultant-this proposal would seem to be a boon for consultants. However, as noted previously, the expense to the firm would be high.
In their proposal, its seems that the NASD is postulating that those who are not independent of the supervisory process cannot conduct a complete and thorough job. On the contrary, given personal regulatory liability, we believe that the compliance personnel are highly and personally motivated to ensure reasonable and adequate supervisory systems. In recent years, there has been a number of well-publicized enforcement cases made against compliance personnel for failure to supervise. These cases have a profound effect on compliance officers and their desire to ensure adherence to sound supervisory procedures by the firm and its personnel. It is our opinion that the internal compliance personnel are in a position to best understand the firm's business, the necessary procedures to have in place and controls to monitor the firm's compliance. We believe that the proposal is unnecessary given existing NASD Rules and would add expense with results which are, arguably, no better than under the current rules.
The proposal would require that firms establish supervisory control over:
This proposal does not make any differentiation between clearing broker-dealers holding customer accounts and broker-dealers which do not. For example, while ESI acts a fully disclosed introducing broker-dealer, it also processes a significant amount of mutual fund, variable annuity and variable life business on an application-way basis.
If one of our customers establishes a checkwriting account with ABC mutual fund, and directs a check to a third party, how is ESI supposed to know about this activity as the transaction is directly between the customer and the fund transfer agent? Similarly, if ESI does not hold the account of a mutual fund customer, customers do not always notify the firm of residential address changes. Instead, the customers directly notify the fund transfer agent. How is the firm supposed to assert supervisory controls over this type of activity if the firm does not have electronic access to this type of information? As noted above, it would seem that in mirroring the NYSE rule proposal, the NASD did not fully consider the impacts of these proposed rule changes on different types of broker-dealers.
Unfortunately, given the relatively short comment period, we have not been able to fully evaluate the impact of this proposal on the firm's operations. However, we are hopeful that we have raised enough issues and questions so that the Commission may deny the proposal and request the NASD more fully consider the necessity and impact of the changes.
Thank you for your consideration.