December 17, 2003
Jonathan G. Katz - Secretary
Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549
Re: Proposed Rule Change Pursuant to 17 CFR 240.19b-4
Dear Mr. Katz,
Rhodes Securities, Inc. (RSI) is a fully disclosed introducing retail broker-dealer registered to conduct business in all domestic jurisdictions except Puerto Rico, with 24 Registered Representatives offering securities services throughout the Dallas-Fort Worth, North Texas area.
As Executive Vice President and compliance officer of RSI, I appreciate the opportunity to submit comments on the issues raised in the above captioned proposed rule change by the National Association of Securities Dealers, Inc. Efforts to enhance supervision should be commended. Effective supervision is a cornerstone of investor confidence and efficient markets. Indeed, the issue is of such import that further member consideration should be afforded the issues presented in this proposal. In that regard I respectfully request that further time be allotted to the comment period so that all member firms may more diligently and intelligently review the proposal and its effect on their business. In the alternative we would request that the proposal be sent back to the NASD with specific direction to seek input from all NASD members prior to Commission approval. Bypassing traditional channels to afford member comment and input ignores the benefits of self-regulation.
This proposed rule would have a dramatic impact on many small firms and all firms that are organized on an independent contractor basis. The NASD membership includes hundreds of members that are structured differently than the large wire houses and regional firms and would be substantially damaged by the proposed rule. For the most part these firms are not part of the "inner circle" that are informed on a timely basis about the need to comment on proposed Rules. They depend on the NASD to notify them of proposals and ask for their input. That process was completely skirted in this instance and many of those firms are completely unaware of the impact this proposed rule will have on their business and cost structures. It would be very unfair to implement the rule without adequate opportunities for those firms to learn about it, thoroughly review it, and comment on it. Full review and thorough analysis of all ramifications of the rule on NASD members would also assist the Commission in creating a fair, balanced and meaningful final rule. Please extend the comment period to at least ninety (90) days.
Effective enforcement of existing rules will promote investor protection more effectively than additional rules and regulations.
With respect to the proposal, RSI is concerned that the rule changes submitted by the NASD are an overreaction to isolated failures by a small number of member firms. The Gruttaduaria case was not so much a failure of the current regulatory system as it was a single individual intent on defrauding customers. The firms affiliated with the Gruttaduaria case failed to comply with existing supervision rules. Had they done so it is likely that the violations in question would not have occurred. In any event the magnitude of customer loss would have been significantly less had regulations been adhered to. The key point is that the existing rules were and are sufficient to prevent unlawful conduct. Certainly no set of rules can protect against every circumstance, and to expect that they should is unreasonable. To be clear, current regulations are reasonable and sufficient when effectively implemented and enforced. Thus, enforcement of existing rules will better serve the interests of investors. New rules simply add complexity and cost without additional guarantees against unlawful conduct.
If additional rules are required the proposed rule change requires significant changes.
In the event that the membership is committed to additional rule making, the proposal requires refinement. As written the rules are too vague, are needlessly burdensome, will have a negative impact on RSI's ability to supervise the sales activity of its registered representatives, will delay implementation of recently proposed and adopted rules responding to the requirements of the USA PATRIOT Act, and will substantially increase the costs of a significant percentage of member firms without providing a meaningful improvement in investor protection.
The proposal lacks definition of key operative terms.
Key words in various provisions of the proposed rules lack sufficient clarity. First, the heart of proposed Rule 3012 and the revisions to Rule 3010(c) is "independence". Rule 3012 contemplates independence of those persons charged with verifying compliance with firm supervisory procedures. Likewise, Rule 3010(c) requires independence from those charged with conducting branch office inspections. Unfortunately, there is no definition or explanation of "independent" as it is used in either rule. To the extent that the term "independent" is the touchstone of these new rules it follows that defining this term is critical to a common and complete understanding of this rule. Failing to define such a key term leaves the rule open to inconsistent application within member firms and among the various NASD District Offices responsible for its enforcement. Similarly, changes to rule 3110 require record keeping with respect to the "essential facts" supporting an account name change. Again, no guidance is offered in the rule that illuminates the meaning of "essential facts." Such inarticulate rule making unnecessarily requires supervisors to make uninformed judgments about incomplete rules. In response, you should expect these supervisors to subject themselves and the customers of their firms to unduly rigid procedures that don't account for the specific needs of individual investors. Accordingly, the proposed amendments will not result in enhanced supervision of sales practices.
The proposed rules are unduly burdensome.
By requiring independence in the supervisory system the NASD has with a broad brush prohibited numerous supervisory systems and structures that function well. As a result, effective systems will be scuttled for a regulatory system that may not fit the geography, structure or function for a given firm. Worse, the system suggested in the rule is sure to require additional human resources without any evidence that investors will be better served. First, Rule 3012 requires an independent review of supervision. To what extent should that independent review be subject to review as well? The rationale of the rule results in an endless chain of supervisors supervising supervisors. In contrast, the existing regulatory scheme requires that firms adopt policies and procedures reasonably designed to prevent and detect violations. That standard provides firms the necessary guidance in establishing a supervision system with specific goals in mind. If independent testing facilitates that standard and achieves goals then that independent testing process may be employed by member firms. However, such procedures should not be the burden of those firms that have already demonstrated the ability to create supervisory policies and procedures that are effective. The NASD in its 19(b)(2) filing assured the SEC that this rule will have no impact on competition, and as you can see this is clearly not the case as costs of application of the rule will depend on existing policies and procedures and the internal structures of each firm.
Also of concern is the apparent incongruity within rule 3010. The existing 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. Proposed rule 3010(c) turns that presumption on its head stating that supervision through the examination process is only effective if done using independent parties.
Aside from the erroneous logic in 3010(c), this requirement severely reduces the number of principals eligible to conduct branch exams. Members can respond to this burden in one of two ways, hire additional staff or stretch reduced auditing resources over a larger sample of branches (don't forget that the proposed branch definition rule will increase the number of registered branch locations). While some firms may make the difficult choice to increase staff other firms simply won't have the economic capacity to do so. If those firms are faced with sending compliance employees to audit hundreds of additional locations, then the duration and the quality of the audits may decline. Furthermore, the audit cycle will lengthen, increasing the period of time between inspections. Accordingly, the proposal may have the unintended consequence of forcing firms into economic dilemmas that erode supervisory resources without any evidence that examiner independence will improve supervision outcomes.
Furthermore, with respect to the burdens associated with this rule change, many firms have actively sought to make supervision more timely, more hands on and as close to the point of sale as possible. The theory being that the closer you are to sales practices the more effective you can be at identifying problems quickly and taking prompt remedial action. To support these efforts, RSI has invested substantial resources in training and firm element continuing education materials that instruct managers on "just in time" supervision. This model can be an effective one that serves client interests. Unfortunately this model is under attack from the proposed rule.
Finally, the obligations of these new rules forces my firm to seriously assess the expenses associated with some of our more remote locations. If I and my colleagues choose to withdraw from various rural communities as a result of this rule there can be no guarantee that the void left behind will be filled. Customers in these under served areas will have to travel farther and farther to meet with someone that can help them with financial decisions. Thus, reducing the competitive capabilities of my firm and firms like mine comes at the detriment to our clients and others in their communities.
Attempting to separate supervision and auditing reduces the effectiveness of both functions and results in a waste of compliance resources.
RSI is particularly concerned over the requirement that the office audit function be independent of the supervisory function. Along with the majority of NASD Member Firms, we employ a hierarchical system of supervision. Our Representatives work from non-OSJ Branch offices and unregistered locations ("satellite offices"), assigned to a Branch or OSJ Manager for supervision. The supervising Manager is also responsible for an annual inspection of each office under his/her supervision. In addition, the OSJ is supervised and inspected by the Principals of the firm from the head office in Fort Worth.
To divorce the inspection of Branch and satellite offices from the supervision of the Representatives assigned to those locations is to introduce an artificial distinction between the two activities. We believe that our supervising Managers, who are most familiar with the Representatives and activities associated with those locations, are the most qualified to perform the periodic inspection. The increased understanding gained from the inspections enhances the effectiveness of the Managers' supervision and the supervision activities provide additional information regarding the types of activities that should be more closely monitored in the inspection. In addition, when OSJ Managers audit the Branch and satellite offices, it serves to reinforce the OSJ Managers' accountability for their Representatives' actions. By appointing an outside party (such as the firm's Compliance Department or unrelated contractors as many small firms will be required to do) to audit the Branch and satellite offices, OSJ Managers will have a decreased sense of responsibility with regard to the activities conducted at the offices.
Currently, our supervising Managers understand that in the event of wrongdoing by a Representative, the Manager will be held accountable by the firm and its regulators unless he/she is able to demonstrate effective supervision over the Representative. The NASD's proposal may lead some Managers to feel that their supervision is less important, as they begin to rely on the firm's Compliance Department to detect problems during the periodic office inspections. In essence, the overall level and quality of supervision over the Representatives may decline.
The proposal may result in implementation delays for other key rule changes.
As stated above, these rules changes add significant costs to our Compliance Department, not simply in terms of money, but time, as well. Our firm is awaiting guidance from the Treasury Department on customer identity verification. In addition, the firm continues to work on the implementation of the Commission's revised requirements for the maintenance of books and records. Even with increased funding for supervision, there is a limit to the amount of change that may be implemented to our systems at any one time. Because the office examination process is a core component of our supervisory structure, changes in this area will impact the timeline for completing changes in these other key areas.
Therefore, we strongly suggest that by barring the firm from making appropriate use of its supervising Managers, the proposal will result in decreased supervision of our representatives and a waste of the resources allocated to supervisory and compliance functions.
The proposed requirement regarding supervisory controls is flawed.
At our firm, similar to many of our peers, the Chief Compliance Officer ("CCO") is responsible for the design, implementation and oversight of the firm's system of supervisory controls. Restricting the CCO from performing and/or overseeing such a review would compromise the quality and thoroughness of each review. An alternative to fulfill the new independence requirements would be to assign someone from Marketing or Operations to perform the review. We believe that such an alternative would likely result in a supervisory review that is less sensitive to securities compliance issues.
Finally, given the relatively small number of serious cases, as compared to the universe of firms and representatives, it appears that the majority of firms clearly strive to conduct business in a manner that is compliant with industry rules and regulations. Members realize that if the public loses faith in the investment community, then we all lose.
I am confident that the current regulatory environment already provides the necessary tools and resources for firms to properly oversee their Representatives, and I strongly believe that the proposed changes will actually have a negative impact on the effectiveness of our overall supervision as well as place a significant and inefficient financial burden on NASD members.
If strictly construed, the proposals would establish new requirements that could be extremely burdensome for firms, particularly small firms, to implement. The proposed rule changes present a huge burden for independent contractor firms and firms with far-reaching branch networks and that will result in an inappropriate burden on competition. For the reasons cited above, the proposal as it relates to independent inspections of branch offices would have been more appropriate as a recommended guideline for effective supervision rather than a hard and fast rule that applies to firms across the board. RSI urges the Commission to consider the real world ramifications and costs of this proposal and to consider alternatives that would allow firms to meet their obligations with internal resources and minimal disruptions to existing supervisory structures.
Again, we thank the Commission for the opportunity to comment on these important issues.
Rhodes Securities, Inc.
Sandra T. Masek