Woodbury Financial Services, Inc.
December 18, 2002
Mr. Jonathan G. Katz
Dear Mr. Katz:
Thank you for the opportunity to provide comment on the Proposed Rulemaking set forth in SEC Release No. 34-46859 and File No. SR-NASD-2002-162. While we share the NASD's aspiration to continually enhance investor protection, we believe the proposed rulemaking involves significant cost and burden to certain types of broker-dealers, while providing very little enhancement to the supervisory protections already in place at our firm, Woodbury Financial Services, Inc. ("Woodbury").
BACKGROUND REGARDING THE EFFECTIVENESS AND UTILITY OF WOODBURY'S SYSTEM OF COMPLIANCE
The proposed rulemaking would severely and negatively impact the compliance structure of broker-dealers, like Woodbury, which function through the use of registered representatives who are independent contractors. Woodbury, an insurance-affiliated broker-dealer owned by The Hartford, currently engages in the sale of securities through licensed representatives, who are often licensed with the insurance agencies of the states in which they sell insurance products. Most of our representatives are independent contractors who work from small, remote offices throughout the country. The offices usually consist of one or two representatives.
Woodbury's business model parallels the independent contractor model commonly accepted in the insurance industry, where an agent is easily able to meet, advise, and ultimately sell to customers in either the agent's office or the client's home. The advantages of the model lie in the ability of a registered representative to personally service his/her customers, and, in some instances, to reach into areas of the country where large wire houses are not present. In these instances, market demand simply may not support offices with more than one representative.
From a compliance perspective, it is invaluable for representatives to have close contact with their customers, because close contact significantly enhances the likelihood that the representatives will truly know their customers. Of course, this is not to say that Woodbury relies on its representatives to make judgments regarding the suitability of a particular investment or to otherwise observe high standards of commercial honor and just and equitable principles of trade. Over the course of many years, Woodbury has developed and refined a sophisticated compliance structure, which has repeatedly withstood routine examination by both federal and state regulators.
As required under NASD Rule 3010(a), Woodbury's current compliance structure is reasonably designed to achieve compliance with applicable securities laws and regulations and with the rules of the NASD. Woodbury's current supervisory structure is bifurcated between principals in Woodbury's home office and Woodbury's Regional Principals ("RSPs"). At the home office level, the Brokerage Operations Division reviews all sales for suitability and monitors trading activity for other violations such as churning, selling away, etc. The Compliance Department also functions out of the home office. The staff of the Compliance Department regularly visits remote locations to audit registered representatives, fields questions from representatives and customers, works with regulators, and performs innumerable other duties. In addition to acting as a sales resource, the RSPs perform annual audits of all representatives in their regions and generally supervise their activities.
Not only has this supervisory system been reasonably designed to achieve compliance with applicable laws and regulations, but also, in light of Woodbury's past performance, the system has been successful in this regard. Before guessing at the enhancement of investor protection through the proposed rules, the NASD should take a hard look at our past performance.
THREE SIGNIFICANT PROBLEMS WITH PROPOSED RULES 3010(c) AND 3012
The proposed rules have several deficiencies, but we would like to focus your attention on three specific issues.
First and foremost, proposed Rule 3012's requirement that there be an "independent" review of the member firm's supervisory structure is both unduly burdensome and highly unrealistic. Woodbury's Compliance Department provides significant supervision of our registered representatives and is an essential facet of our supervisory structure. Compliance staff members already demonstrate impeccable integrity and thorough independence. Requiring an independent review of their work begs the question, "Who is going to perform it?" Given the fact that Brokerage Operations and the RSPs play a role in our supervisory structure as well, the only remaining department of the firm that could perform the "independent" review would be Sales & Marketing, Finance, or another equally inexperienced department.
For all practical purposes, the proposed rule would require Woodbury to contract with an outside vendor and incur the significant cost associated with such a requirement. There is no reason to believe an outside contractor would do a better or more "independent" job than the current Compliance staff. Woodbury staffs its Compliance Department with professionals who are not offered compensation or other incentives based on the production of registered representatives. Like so many other businesses, the Compliance Department assures accountability through a hierarchical structure that rewards quality and integrity.
Although our RSPs do receive a portion of their income based on the sales of the registered representatives they supervise, they also receive a salary for performing audit functions. We have no evidence that shows they are not able to exercise independent supervisory judgment. Furthermore, the risk that they might be more lenient in their supervision is mitigated by the fact that the Compliance Department supervises the activities of the RSPs.
Secondly, if the NASD adopts the proposed requirement that "independent" parties must perform all office audits, the future would become very uncertain for our current compliance structure. While we believe that we could continue to use RSPs to perform office audits even if the rule were adopted, it seems clear that the NASD would be moving toward extinguishing such a system.
It is our position that RSPs could continue to perform office audits for three reasons. First, they are compensated as employees for performing this function. Second, the "Office Inspection" section of Part II of Release No. 34-46859 does not specifically define "independence" regarding office audits to include persons whose compensation is based on the activities of the office. Third, RSPs, unlike Branch Managers, do not work out of the office that they supervise, so they are able to function independently of the work that is performed in the office. Furthermore, if RSPs were unable to perform office audits, our compliance system would be so devastated that there would be no doubt about our right to avail ourselves of the Rule 9600 exemption contemplated in proposed Rule 3010(c)(3).
In evaluating our use of RSPs to perform a portion of the office audits, it is crucial to keep in mind that the office audit is not the only means by which to detect violations of applicable laws and regulations. Both the Compliance Department and the Brokerage Operations Department play key roles in our system. Importantly, the Compliance Department is committed to performing office audits for all representatives, but on a somewhat less expedient audit schedule than annually.
It is also imperative to recognize that technological advances have significantly enhanced the effectiveness of remote supervision by "independent" people. For example, the Brokerage Operations Department can perform its suitability analysis by reviewing a scanned customer account form on-line. Furthermore, Compliance staff can electronically review the trading blotter for a particular customer to ensure a representative is not churning the account. There are numerous similar examples and new developments and improvements are regularly being made. Prohibiting office audits by people whose compensation is based in part on sales ignores the fact that new technologies are constantly improving the effectiveness of Compliance staff.
In addition to the RSP office audit, our system of compliance involves significant additional checks upon the activities of registered representatives. If RSPs were strictly prohibited from playing a role in the compliance system, our system of compliance, like that of many other broker-dealers, would be decimated. Decimating our system of compliance based on the threat that RSP independence may not be entirely thorough is a fundamentally disproportionate response to the risk. While the proposed rule does not change the regulatory landscape so drastically as to render our compliance system obsolete, the NASD should not be permitted to move in this direction with the hope of extinguishing the system in the future.
The first two points that have been raised clearly illustrate the third. Specifically, there is no uniform definition of "independent." With regard to proposed Rule 3012, "independent" suggests someone outside the firm, but with regard to proposed Rule 3010(c) "independent" permits someone within the firm who does not receive compensation based on sales. The rules rely heavily on the term "independence," but they fail to define the crucial, operative term. Failing to define this term will result in inconsistent application by both member firms and NASD District Offices. It also leaves open the very real possibility that firms will implement expensive and fundamental remedial changes to their compliance systems only to later find that the changes were either unnecessary or insufficient.
Thank you very much for your attention to this matter. We very much appreciate your consideration. Please do not hesitate to contact me directly at (651) 738-4000, or via e-mail at Michael.Brennan@Woodburyfinancial.com, if you have any comments or questions.