Pacific Select Distributors, Inc.
December 18, 2002
Jonathan G. Katz
Re: Proposed Rule Change Pursuant to 17 CFR 240.19b-4
Dear Mr. Katz,
Pacific Select Distributors, Inc. ("PSD") is a broker-dealer member firm of the National Association of Securities Dealers, Inc. ("NASD") and is a subsidiary of Pacific Life Insurance Company. PSD has an affiliate relationship with six retail NASD member firms through either direct or indirect ownership. Four of these firms are 100% owned by PSD and another is 45% owned by PSD. The remaining firm is 80% owned by an affiliate of PSD. It is with respect to these retail firms in which Pacific Life has an equity interest, that PSD comments on the NASD's proposal to adopt new NASD Rule 3012 and to amend other Rules relating to the supervisory and supervisory control procedures of member firms ("Proposal")
Comments and Input on the Proposal
We are very uncomfortable with the rapidity with which this Proposal has been created by the NASD, submitted to the Securities and Exchange Commission ("SEC") and published for public comment. First, we realize that the NASD has the authority to fast track changes in their rules of fair practice ("Rules"). However, historically any Rule changes that deal with supervision requirements have been submitted to NASD committees established for that purpose, then released to the entire NASD membership for comment, then brought back to the NASD committees for further discussion - all before submitting proposed Rule changes to the SEC for approval. The SEC then would publish for public comment -usually for a period of 30-90 days. Unfortunately, in the case of the Proposal all the steps that would have given the NASD input from its members in the process of shaping a Rule change were by-passed. In addition, the SEC published the proposal in record time and with the minimum amount of time for public comments.
This rushed approach to regulation is not in the best interest of the industry or the public. We strongly suggest that the SEC either extend the comment period to at least ninety (90) days or send back the Proposal to the NASD asking them to gain the input of their standing committees and their members before determining re-submitting to the SEC.
Summary of Concerns
PSD has many concerns about the negative impact of the Proposal on the broker-dealers in which we have an economic interest if implemented in its present form. The Proposal appears to have been drafted to fit the typical structure of national wire houses and large regional firms, which have employee staffed branch offices and whose registered representatives are employees of the firm. The genesis of the Proposal is apparently to mirror rule changes recently submitted by the New York Stock Exchange, and that may be the reason for the presumption that "one size fits all". Unfortunately, a majority of the members of the NASD do not fit this mold. These members are small firms without the human or financial resources to implement changes embodied in the Proposal and independent contractor and insurance affiliated broker dealers that would incur huge costs and cultural change to adapt their corporate structures, management and supervisory systems to meet the requirements of the Proposals. The Proposal includes the possibility of a firm requesting an exception to the amended Rules, but it is not practical to implement a rule change where a majority of members would make such a request.
Current Rules are Sufficient
The NASD cites a recent enforcement case as the basis for submitting the Proposal. The Gruttaduaria case involves a single representative alleged to have misappropriated substantial funds from various clients over a 15-year period while registered with several broker-dealers. While the case gained high visibility with the Congress, regulators and the press, it seems overreaching to draw a conclusion based on that case alone that current supervisory rules and systems of office inspections are inadequate. We do not understand how the Proposed rules would have been any more effective in avoiding the alleged misconduct in Gruttaduaria than would have been the case if existing supervisory rules were followed by all parties concerned. We understand that even a special investigation of Gruttaduaria's activities by regulators failed to discover sufficient abuses to warrant any action.
Certainly no set of rules (including those being proposed) can fully protect the public against an individual or firm determined to commit fraud. However, we believe that current regulations are reasonable and sufficient when effectively implemented and enforced. The Proposal adds significant cost and complexity without meaningful enhancement of a firm's ability to detect a pattern of misconduct such as that illustrated in the Gruttaduaria case.
Concerns with the Proposal
Even if the SEC determines that additional rule making is needed to assure adequate supervisory systems, this Rule change does not accomplish that need. The Rule change is imprecise and is needlessly burdensome. It will substantially increase costs for member firms without providing any meaningful improvement in investor protection. Further, the Rule change may delay implementation of recently released record keeping rules and rules responding to the requirements of the USA PATRIOT Act.
Proposal Lacks Clarity
"Independence" is a central theme of the Proposal, yet that term is not defined with any precision. This leaves the concept of independence open to inconsistent interpretations and applications. The Proposal also includes requirements for record keeping of "essential facts" supporting an account name change, without illuminating the meaning of that term. The Proposal suggests the availability of exemptions from the requirements that office examinations and oversight of the supervisory systems be in the hands of "independent" individuals, but fails to set out a process for obtaining such an exemption.
Burdens Created would Outweigh the Benefits
Independent contractor and insurance affiliated broker-dealers would have to make substantial organizational and process changes if the Proposal were adopted. In many cases this would result in wholesale changes from supervisory systems that have proven quite effective to new systems that will not fit the structure or functions of the firms.
By introducing the concept of "independence" in the supervisory system the Rule change would, with a broad brush, scuttle proven effective supervisory systems for a new system that may not fit the geography, structure or function of a given firm. Worse, the system suggested in the Rule change is sure to require significant additional financial and human resources without any evidence that investors will be better served. This is especially true for independent contractor firms. Typically, Principals who oversee OSJ offices in such firms are owners of their own business including the Offices that report to them. Under the proposed rule those Principals would not be able to conduct, or supervise those who conduct, branch office examinations because they have an economic interest due to their ownership. These Principals are better supervisors when they are involved personally in the branch examination process. They also have the most thorough understanding of the business and operations of the branch Offices reporting to them. In our opinion, the Proposal, if implemented, would reduce the training and knowledge of field supervisors and would reduce the effectiveness of the supervisory process for most independent contractor broker-dealers.
The cost of implementing the Proposal for small firms and independent contractor firms would be prohibitive and far outweigh any perceived benefits. The Proposal mirrors a similar rule change forwarded by the New York Stock Exchange ("NYSE"). Most NYSE members are structured very differently than the typical independent contractor firm. For example, the NYSE firm typically has larger offices with a full time employee designated as Branch Manager. Thus, these firms have in place a sales supervisory department, often made up of non-producer employees and that department is distinct from the compliance department. Direct sales supervision is placed in the hands of a local Branch Manager who both reviews transactions and also promotes proprietary products, IPO's and, in some cases, lists of individual stocks or bonds the firms internal research staff recommend be sold, bought or held. In contrast, most independent contractor firms do not have a research department, do not participate in IPO's, and do not promote proprietary products or advisory services. In addition, these firms do not have a sales supervisory staff employed by the firm that reviews trades and promotes sales. Rather, the home office and compliance Principals often are assigned the responsibility of overseeing both the Principal review of transactions and the Office examination process. In addition, field Principals do both functions under the oversight of the home office compliance staff. Most independent contractor firms would incur enormous expense as they make major changes in systems, reorganize their firms and add a lot more personnel to implement the Proposal. Hundreds of Office examinations currently handled by field Principals would have to be undertaken by home office compliance staff. As a result firms would be put under additional financial stress during a difficult economy, examination cycles would be extended and other compliance tasks would be delayed or deferred. Small firms just do not have the breadth of staff to accommodate a complete separation of sales supervision and compliance duties. Again, in our opinion implementation of the Proposal would result in prohibitive increases in the cost of doing business for small broker dealers and for all sizes of independent contractor broker-dealers without any significant benefit. In fact, we believe the Proposal taken as a whole may reduce, rather than enhance, the effectiveness of supervision for these firms.
Conflicts with Existing Rules
The Proposal appears to create conflicts within existing rules. Rule 3010(g) establishes Offices of Supervisory Jurisdiction as those locations in which supervisory functions are performed. Obviously the rule presumes that those OSJ branches are to be staffed with managers and other registered persons with the responsibility and the expertise to effect supervision. The Proposal turns that presumption on its head by indicating that supervision through the examination process is only effective if done using independent parties.
Proposal may Conflict with Implementation of Other Key Rule Changes
We are worried about the confluence of several major issues that all broker dealers face. First the current tepid economy and sustained negative markets combine to create significant duress on broker-dealers. Lay-offs are commonplace and profits have eroded or, in come cases, been replaced by losses. At the same time several regulatory initiatives are at an implementation stage for these firms. They are awaiting guidance from the Treasury department on customer identity verification rules. They are implementing the new requirements for creation and maintenance of books and records and the requirements under the USA PATRIOT Act. This Proposal, if approved, would further extend the human and financial resources of the broker-dealer community at a very difficult time.
Timelines are Too Tight
If the Proposal is approved, the NASD will announce the Rule within 60 days and make the rule changes effective 30 days later. Most independent contractor firms would have to make major changes in business structural, technology and other systems and would have to add considerable staff. It is essential that the effective dates be deferred for 6-9 months to give firms time to implement the changes necessary to comply with the Proposal.
We recognize that if the public loses faith in the investment community, then we all lose. We are confident that the current regulatory environment already provides the necessary tools and resources for firms to properly oversee their Representatives, and we believe that the Proposal, if approved, is likely to have a negative impact on the effectiveness of supervision at most small broker-dealers and at all independent contractor firms.
We appreciate the opportunity to comment on these important issues and request that the time allowed for comment be extended to at least ninety (90) days to accommodate many firms that have not received timely notice of the Rule changes and have not the opportunity and/or the time to respond.