Self-Regulatory Organizations; Notice of Filing of Proposed Rule Change by the National Association of Securities Dealers, Inc. Relating to Supervision and Record Retention Rules

SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-38548; File No. SR-NASD-97-24]

Self-Regulatory Organizations; Notice of Filing of Proposed Rule

Change by the National Association of Securities Dealers, Inc. Relating

to Supervision and Record Retention Rules

April 25, 1997.

Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934

(``Act''),\1\ and Rule 19b-4 thereunder,\2\ notice is hereby given that

on April 11, 1997, NASD Regulation, Inc. (``NASD Regulation'') filed

with the Securities and Exchange Commission (``SEC'' or ``Commission'')

the proposed rule change as described in Items I, II, and III below,

which Items have been prepared by NASD Regulation. The Commission is

publishing this notice to solicit comments on the proposed rule change

from interested persons.

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\1\ 15 U.S.C. 78s(b)(1).

\2\ 17 CFR 240.19b-4.

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I. Self-Regulatory Organization's Statement of the Terms of Substance

of the Proposed Rule Change

NASD Regulation is proposing to amend National Association of

Securities Dealers, Inc. (``NASD'' or ``Association'') Rules 3010,

``Supervision,'' and 3110, ``Books and Records,'' to revise the NASD's

supervision and record retention rules to provide firms with

flexibility in developing reasonable procedures for the review of

correspondence with the public. Below is the text of the proposed rule

change. Proposed new language is in italics; proposed deletions are in

brackets.

Rule 3010. Supervision

(a) through (c) No change

(d) [Written Approval] Review of Transactions and Correspondence

(1) Supervision of Registered Representatives. Each member shall

establish procedures for the review and endorsement by a registered

principal in writing, on an internal record, of all transactions and

for the review by a registered principal of [all] incoming and outgoing

written and electronic correspondence of its registered representatives

with the public relating to the investment banking or securities

business of such member [pertaining to the solicitation or execution of

any securities transactions]. Such procedures should be in writing and

be designed to provide reasonable supervision of each registered

representative.\3\ Evidence that these supervisory procedures have been

implemented and carried out must be maintained and made available to

the Association upon request.

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\3\ Pursuant to a telephone conversation between Mary Revell,

Assistant General Counsel, NASD Regulation, Inc. and Katherine

England, Assistant Director, Division of Market Regulation, SEC, on

April 25, 1997, Commission staff has replaced the phrase

``reasonably supervise'' with the phrase ``provide reasonable

supervision of.''

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(2) Review of correspondence. Each member shall develop written

procedures that are appropriate to its business, size, structure, and

customers for the review of incoming and outgoing written and

electronic correspondence with the public relating to its investment

banking or securities business. Where such procedures for the review of

correspondence do not require pre-use review of all correspondence,

they must include provision for the education and training of

associated persons as to the firm's procedures governing

correspondence; documentation of such education and training; and

surveillance and follow-up to ensure that such procedures are

implemented and adhered to.

(3) Retention of correspondence. Each member shall retain

correspondence of registered representatives relating to its investment

banking or securities business in accordance with Rule 3110 (``Books

and Records''). The names of the persons who prepared outgoing

correspondence and who reviewed the correspondence shall be

ascertainable from the retained records and the retained records shall

be readily available to the Association, upon request.

(e) through (g) No change

Rule 3110. Books and Records

(a) Requirements

Each member shall make [keep] and preserve books, accounts,

records, memoranda, and correspondence in conformity with all

applicable laws, rules, regulations, and statements of policy

promulgated thereunder and with the Rules of this Association and as

prescribed by Rule 17a-3. The record keeping format, medium, and

retention period shall comply with Rule 17a-4 under the Securities

Exchange Act of 1934.

(b) through (g) No change

II. Self-Regulatory Organization's Statement of the Purpose of, and

Statutory basis For, the Proposed Rule Change

In its filing with the Commission, NASD Regulation included

statements concerning the purpose of and basis for the proposed rule

change and discussed any comments it received on the proposed rule

change. The text of these statements may be examined at the places

specified in Item IV below. NASD Regulation has prepared summaries, set

forth in Sections A, B, and C below, of the most significant aspects of

such statements.

A. Self-Regulatory Organization's Statement of the Purpose of, and

Statutory Basis for, the Proposed Rule Change

1. Purpose

In May 1996, the SEC issued an Interpretive Release on the Use of

Electronic Media by Broker-Dealers, Transfer Agents., and Investment

Advisers for Delivery of Information.\4\ That release expressed the

views of the SEC with respect to the delivery of information through

electronic media in satisfaction of requirements in the

[[Page 24148]]

federal securities laws, but did not address the applicability of any

self-regulatory organization (``SRO'') rules. In the release the SEC

did, however, strongly encourage the SROs to work with broker/dealer

firms to adapt SRO supervisory review requirements governing

communications with customers to accommodate the use of electronic

communications.\5\

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\4\ See Release Nos. 33-7288; 34-37182; IC-21945; IA-1562 (May

9, 1996); 61 FR 24644 (May 15, 1996) (File No. S7-13-96).

\5\ Id., note 5.

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On September 12, 1996, the New York Stock Exchange, Inc.

(``NYSE'') filed with the SEC a proposal to update its rules governing

supervision of its member firms' communications with the public.\6\ The

NYSE's proposal is designed to recognize the growing use of new

technology and new means of communication such as ``e-mail'' and the

Internet while still providing for appropriate supervision and review.

The NYSE's proposal currently is pending at the SEC.

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\6\ See securities Exchange Act Release No. 37941 (November 13,

1996), 61 FR 58919 (November 19, 1996) (File No. SR-NYSE-96-26)

(soliciting comment on the NYSE's proposed rule change).

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The NYSE's current rules require firms to review all

communications with the public relating to their business prior to use.

For example, a registered representative's correspondence to a customer

must be reviewed prior to being sent, and all incoming correspondence

must be reviewed by the firm before it is given to the representative.

Under the NYSE's proposal, prior review of all outgoing correspondence

and review of all incoming corrrespondence would no longer be required.

Instead, firms would be allowed flexibility in developing procedures

for review of such correspondence tailored to the nature and size of a

firm' busineess and customers. Other communications with the public,

such as advertisements, sales literature, and research reports, loud

continue to be subject to prior approval.

The NYSE's proposal would require firms to develop written

procedures for review of communications with the public that are

designed to provide reasonable supervision of each registered

representative. In addition, any firm that does not conduct pre-use

review of correspondence (whether electronic or manual) would be

required to regularly educate and train employees about the

organization's policies and procedures governing review of

communications, document such education and training, and conduct

surveillance to ensure compliance with such procedures.

The proposed rule change filed by the NYSE responds to the SEC's

request to adapt supervision rules to accommodate the use of electronic

communications. The proposed amendments to NASD rules governing

supervision of correspondence similarly would respond to this request

and would provide firms with flexibility in developing reasonable

procedures for the review of correspondence. The NASD's proposed

approach is designed to be consistent with the one proposed by the NYSE

and thereby help to ensure a coordinated regulatory framework for

supervision of manual and electronic correspondence.

Supervision of Registered Representatives. NASD Rule 3010(d)(1), as

revised to reflect comments received and recommendations from the

NASD's Membership Committee, \7\ provides, among other things, that a

firm must establish procedures for the review by a registered principal

of each registered representative's outgoing and incoming manual and

electronic correspondence with the public relating to the member's

investment banking or securities business. The procedures must be

designed to provide reasonable supervision of each registered

representative, must be described in the firm's written supervisory

procedures, and implementation and execution of these procedures must

be clearly evidenced. In developing these procedures, members should

specify, among other things, what types of correspondence will be pre-

or post-reviewed; where the reviews will be conducted; the position and

qualifications of persons who will conduct the reviews; the frequency

of reviews; the nature of type of review to be conducted; and how the

reviews will be documented.

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\7\ For a discussion of comment received on the proposed

changes and the recommendations of NASD's Membership Committee, see

infra notes 9-20 and accompanying test.

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Under the proposal , review of each item of correspondence no

longer will be required. Instead, firms could use reasonable sampling

techniques, such as random spot-checking of e-mail logs. In order for

this method to be effective, NASD Regulation expects that members

should require review of some portion of the electronic mail sent and

received by each registered representative, with special emphasis on

messags delivered to or received from customers of the members.

In addition, while written approval of correspondence no longer

would be mandated, firms should specify the means for evidencing

review. For example, firms could electronically review e-mail

correspondence relating to the firm's investment banking or securities

business and could electronically record evidence of the review.

Procedures for Review of Correspondence: As revised to reflect

comments received and recommendations from the NASD's Membership

Committee, NASD Rule 3010(d)(2) would require each member to develop

written procedures for review of incoming and outgoing correspondence

with the public relating to its investment banking or securities

business tailored to its structure and the nature and size of its

business and customer base. In developing supervisory procedures for

the review of correspondence with the public, members should consider

the following suggestions. For example, members should determine

whether it is more appropriate to implement uniform procedures or

procedures tailored to specific functions, offices or locations,

individuals, groups of persons, or specific registration categories. In

this regard, members may consider such factors as the number, size and

location of offices; the volume of communications overall and in

specific areas of the organization; the types of activities conducted

by registered representatives and other applicable persons; the nature

and extent of training provided; the complaint and overall disciplinary

record, if any, of registered representatives and other applicable

persons (with particular emphasis on complaints regarding written or

oral communications with clients); and the overall experience levels of

registered representatives and other applicable persons using

communications media.

In addition, reasonable procedures in some cases might require

review of all correspondence of particular individuals. The supervisory

system should provide specific processes for the receipt and handling

of incoming checks and customer complaints as well as standards for

correspondence indicating permitted and prohibited activities and any

restrictions imposed by the member upon such correspondence. The

procedures also should address communications with customers from

outside of the workplace.

While the proposed rule does not require review of all

correspondence, any member that does not conduct electronic or manual

pre-use review of each item of correspondence will be required to:

regularly educate and train its associated persons as to the firm's

procedures governing review of correspondence; document such

[[Page 24149]]

education and training; and monitor to ensure implementation and

compliance with such procedures. This provision is a departure from the

NASD's current rule, which requires members to review and endorse in

writing all correspondence, but allows such review and endorsement to

occur after use. However, the NASD's proposed rule is consistent with

the rule proposed by the NYSE. Also, the NASD's proposed rule provides

sufficient flexibility such that members that do not wish to conduct

prior review of correspondence have the option of conducting education

and training as to the firm's procedures instead. Accordingly, the

proposed rule would create a ``default'' standard that is more

stringent than the current rule in requiring pre-use review. The Notice

to Members announcing adoption of this rule will provide guidance to

members on how the education and training provisions should be

implemented.

Firms may incorporate the required education and training on

correspondence procedures into their Continuing Education Firm Element

training program.\8\ However, education and training must be timely and

must apply to all appropriate employees, including employees who may

not be included under the Continuing Education requirements.

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\8\ See NASD Rule 1120, ``Continuing Education Requirements.''

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Retention of Correspondence: Under amended NASD Rule 3010(D)(3),

each member must retain correspondence in accordance with amended NASD

Rule 3110. NASD Rule 3010(d)(3) also requires that the names of the

persons who prepared and reviewed correspondence must be ascertainable

from the retained records and the records must be made available to the

NASD upon request.

Books and Records: NASD Rule 3110(a) has been amended to recognize

that records must be made and preserved as prescribed by all applicable

rules, regulations and NASD rules and with Rule 17a-3 under the Act.

The record keeping format, medium, and retention period must comply

with Rule 17a-4 under the Act.\9\

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\9\ The SEC recently proposed for comment amendments to its

broker/dealer books and records rules. See Securities Exchange Act

Release No. 37850 (October 22, 1996), 61 FR 55593 (October 28, 1996)

(File No. S7-27-96).

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2. Statutory Basis

NASD Regulation believes that the proposed rule change is

consistent with the provisions of Section 15A(b)(6) of the Act,\10\

which requires, among other things, that the Association's rules be

designed to prevent fraudulent and manipulative acts and practices, to

promote just and equitable principles of trade, remove impediments to

and perfect the mechanism of a free and open market, and, in general,

to protect investors and the public interest and not be designed to

permit unfair discrimination between brokers or dealers. The NASD

believes that allowing broker/dealer firms to use new technology and

new means of communication, such as e-mail and the Internet, while

still providing for appropriate supervision and review, will further

these requirements.

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\10\ 15 U.S.C. 78o-3(b)(6).

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B. Self-Regulatory Organization's Statement on Burden on Competition

NASD Regulation does not believe that the proposed rule change will

result in any burden on competition that is not necessary or

appropriate in furtherance of the purposes of the Act, as amended.

C. Self-Regulatory Organization's Statement on Comments on the Proposed

Rule Change Received From Members, Participants, or Others

The proposed rule change was published for comment in Notice to

Members 96-82 (December 1996) (``NTM 96-82''). The comment period

closed on January 30, 1997. Nineteen comment letters were filed on the

proposed rule.\11\

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\11\ NASD Regulation received the following comment letters: (1)

Letter from Brian C. Underwood, A.G. Edwards & Sons, Inc., to Joan

Conley, NASD Regulation, dated January 28, 1997 (``A.G. Edwards'');

(2) Letter from Rockell Metcalf, American Express Financial Advisors

Inc., to Joan Conley, NASD Regulation, dated January 30, 1997

(``AEFA''); (3) Letter from Neal E. Nakagiri, Associated Securities

Corp., to Joan Conley, NASD Regulation, dated January 20, 1997

(``Associated Securities''); (4) Letter from Rita Adler, CoreStates

Securities Corp., to Joan Conley, NASD Regulation, dated January 30,

1997 (``CSC''); (5) Letter from Brad Sutherland, D.A. Davidson &

Co., to Joan Conley, NASD Regulation, dated January 11, 1997 (``D.A.

Davidson''); (6) Letter (e-mail message) from David Fry dated

January 3, 1997 (``David Fry''); (7) Letter from R. Gerald Baker,

Everen Securities, to Joan Conley, NASD Regulation, dated January

30, 1997 (``Everen''); (8) Letter from Michael L. Michael, Fidelity

Investments, to Joan Conley, NASD Regulation, dated January 29, 1997

(``Fidelity''); (9) Letter from Adam N. Antoniades, First Allied

Securities Inc., to Joan Conley, NASD Regulation, dated January 29,

1997 (``First Allied''); (10) Letter from Alexander C. Gavis,

Investment Company Institute, to Joan Conley, NASD Regulation, dated

January 30, 1997 (``ICI''); (11) Letter from Thomas P. Koutris, John

Hancock Mutual Life Insurance Co., to Joan Conley, NASD Regulation,

dated January 31, 1997 (``John Hancock''); (12) Letter from Kenneth

S. Spirer, Merrill Lynch, to Joan Conley, NASD Regulation, dated

January 27, 1997 (``Merrill Lynch''); (13) Letter from Michael L.

Kerley, MML Investors Services, Inc., to Joan Conley, NASD

Regulation, dated January 27, 1997 (``MML''); (14) Letter from Peter

J. Bernota to Joan Conley, NASD Regulation, dated January 22, 1997

(``Peter J. Bernota''); (15) Letter from George P. Miller, PSA The

Bond Market Trade Association, to Joan Conley, NASD Regulation,

dated January 24, 1997 (requesting an extension of time to file

comments); (16) Letter from William P. Hayes and R. May Lee, PSA The

Bond Market Trade Association, to Joan Conley, NASD Regulation,

dated February 7, 1997 (``PSA''); (17) Letter from Stephen Putnam,

Robert Thomas Securities, to R. Clark Hooper, NASD Regulation, dated

January 9, 1997 (``Robert Thomas Securities''); (18) Letter from

Kenneth S. Spirer, R. Gerald Baker, C. Evan Stewart, and Robert C.

Errico, Securities Industry Association, to Joan Conley, NASD

Regulation, dated February 7, 1997 (``SIA''); and (19) Letter from

Henry H. Hopkins and David Roscum, T. Rowe Price, to Joan Conley,

NASD Regulation, dated February 11, 1997 (``T. Rowe Price'').

Copies of the Comment Letter received by NASD Regulation in

response to NTM 96-82 are available for inspection and copying at

NASD Regulation or at the Commission's Public Reference Room.

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The comments filed on the proposed rules were overwhelmingly

positive. The commenters praised NASD Regulation for proposing rule

amendments that will allow each firm the flexibility to develop

procedures for the review of correspondence tailored to the nature and

size of its business and customers. The commenters also commended NASD

Regulation for harmonizing its supervision requirements with those of

the NYSE. Commenters did, however, make some suggestions about how the

rule could be clarified or amended.

Correspondence with the public: NASD's current supervision rule

requires firms to establish procedures for the review of all of its

registered representatives' correspondence pertaining to the

solicitation or execution of any securities transactions. The rule

proposed in NTM 96-82 would require the review of registered

representatives' correspondence relating to the business of the member.

NASD Regulation received 12 comments on this change.\12\ Many of

the commenters requested a clarification that only correspondence with

the public must be reviewed. Otherwise, they stated, the rule could be

construed to apply to internal communications or to correspondence

between members and third parties other than customers. Also, this

would conform the rule to the intention stated in the text of NTM 96-

82. This clarification has been made by adding the words ``with the

public'' to paragraphs 3010 (d)(1) and (d)(2).

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\12\ See letters from A.G. Edwards, AEFA, Associated Securities,

D.A. Davidson, Everen, Fidelity, ICI, John Hancock, MML, Peter J.

Bernota, PSA, and T. Rowe Price.

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Three commenters believe the rule change is overly expansive,

burdensome, and unjustified.\13\ They urge NASD Regulation to retain

the language in the current rule. Notwithstanding these comments,

[[Page 24150]]

NASD Regulation has determined to retain the language as proposed, for

several reasons. First, conforming the rule language to the language in

the NYSE rule will help to ensure a coordinated regulatory approach to

the supervision of correspondence. Second, the amended language is

consistent with language in SEC Rule 17a-4, which requires a broker/

dealer to preserve records of all communications relating to its

business. Also, limiting the review requirement to correspondence

pertaining to securities transactions may be too narrow to capture

information important to an effective supervision program. Finally,

limiting the review requirement to correspondence with the public, as

described above, will significantly address the concerns raised by

these commenters.

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\13\ See letters from John Hancock, MML, and T. Rowe Price.

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One commenter asked if certain electronic communications, depending

on their content, could be treated as oral ``conversations'' rather

than correspondence, such that the content requirements of the NASD's

advertising rules would apply, rather than the supervision and record

retention rules.\14\ In response, NASD Regulation notes that the SEC in

its recent release on Reporting Requirements for Brokers or Dealers

under the Act on record retention requirements applicable to electronic

communications,\15\ has stated:

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\14\ See letter from A.G. Edwards.

\15\ See Securities Exchange Act Release No. 38245 (February 5,

1997), 62 FR 6469 (February 12, 1997) (File No. S7-21-93).

for record retention purposes under Rule 17a-4, the content of the

electronic communication is determinative, and therefore broker-

dealers must retain those e-mail and Internet communications

(including inter-office communications) which relate to the broker-

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dealer's ``business as such.''

Similarly, the proposed rule focuses on the content of electronic (and

manual) correspondence by requiring each member to develop supervisory

procedures for the review of written and electronic correspondence with

the public relating to its investment banking or securities business.

This obligation to review correspondence is not obviated by a firm's

classification of e-mail correspondence as equivalent to an oral

``conversation.''

Incoming correspondence: Three commenters discussed the proposed

requirement that both incoming and outgoing correspondence must be

reviewed.\16\ One commenter asked NASD Regulation to clarify that

incoming correspondence would be subject to review.\17\ NASD Regulation

has made this clarification by adding the words ``incoming and

outgoing'' to paragraphs 3010 (d)(1) and (d)(2).

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\16\ See letters from AEFA, John Hancock, and MML.

\17\ See letter from John Hancock.

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Two of the commenters are insurance-affiliated broker/dealers.\18\

They stated that it would be extremely difficult for an insurance-

affiliated broker/dealer to comply with the requirement to review

incoming correspondence. Most of their registered representatives are

primarily life insurance salespersons who conduct business in non-

branch locations (e.g., in their homes or at insurance company

offices). Also, virtually all correspondence is addressed to the

insurance company or to the agents personally, and most correspondence

pertains to the life insurance business. Both because of the location

where these agents/registered representatives conduct business and

because most of their correspondence is addressed to a non-broker/

dealer entity, these commenters maintain that it would be improper,

illegal, and impossible for a principal to open and review it.

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\18\ See letters from John Hancock and MML.

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NASD Regulation has determined to amend the rule as proposed in NTM

96-82 explicitly to require the review of incoming correspondence. The

proposed rule provides a firm with flexibility to develop procedures

for the review of correspondence tailored to its structure and the

nature of its business. Also, the proposed changes lessen the

regulatory burden by eliminating the requirement to review and endorse

each piece of correspondence. Supervisory review of incoming

correspondence in many circumstances may be particularly valuable in

detecting potential problems with a registered representative's conduct

or a customer complaint. NASD Regulation believes that a review of

incoming correspondence is a valuable method for early detection of

problems and believes that rule provides insurance-affiliated members

with the needed flexibility to devise appropriate procedures for

reviewing correspondence. Therefore, the proposed language has been

retained.

Education and training: Four commenters addressed this provision of

the proposed rule.\19\ Two of the commenters requested that firms be

allowed flexibility in developing appropriate education and training as

to the firm's procedures governing correspondence.\20\ Since the rule

already allows this flexibility by permitting firms to develop

procedures tailored to the nature and size of their business and

customers, NASD Regulation does not believe an amendment is necessary

to respond to this comment.

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\19\ See letters from D.A. Davidson, First Allied, ICI, and John

Hancock.

\20\ See letters from First Allied and John Hancock.

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In response to a request from one commenter,\21\ the staff wishes

to clarify that a member may fulfill its education and training

requirements in conjunction with compliance with NASD Continuing

Education requirements. This is consistent with the position the NYSE

has taken on this issue, as stated in its draft Information Memo,

submitted in conjunction with the NYSE's proposal.\22\

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\21\ See letter from ICI.

\22\ See supra note 4.

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Finally, at its meeting on February 19, 1997, the NASD's Membership

Committee discussed the proposed rule, the comments that have been

received on the proposal, and the changes the staff proposed to make to

respond to the comments. The NASD's Membership Committee was supportive

of all of the changes the staff recommended. However, the NASD's

Membership Committee asked staff to also consider revising the proposed

rule to require members to supervise and review only correspondence

relating to their investment banking or securities business instead of

correspondence relating to their business. NASD's Membership Committee

members stated that member firms may conduct a business in capacities

other than as broker/dealers and suggested that language be added to

clarify the rule so that it could not be interpreted to apply to areas

beyond the securities business of the member. Although this is a minor

department from the NYSE rule, which requires members to review

communications relating to the firm's business, NASD Regulation has

limited application of the rule to correspondence related to the

securities or investment banking business of a member.

III. Date of Effectiveness of the Proposed Rule Change and Timing for

Commission Action

Within 35 days of the date of publication of this notice in the

Federal Register or within such longer period (i) as the Commission may

designate up to 90 days of such date if it finds such longer period to

be appropriate and publishes its reasons for so finding or (ii) as to

which the self-regulatory organization consents, the Commission will:

A. by order approve such proposed rule change, or

[[Page 24151]]

B. institute proceedings to determine whether the proposed rule

change should be disapproved.

IV. Solicitation of Comments

Interested persons are invited to submit written data, views, and

arguments concerning the foregoing. Persons making written submissions

should file six copies thereof with the Secretary, Securities and

Exchange Commission, 450 Fifth Street, N.W., Washington, D.C. 20549.

Copies of the submission, all subsequent amendments, all written

statements with respect to the proposed rule change that are filed with

the Commission, and all written communications relating to the proposed

rule change between the Commission and any person, other than those

that may be withheld from the public in accordance with the provisions

of 5 U.S.C. 552, will be available for inspection and copying in the

Commission's Public Reference Room. Copies of such filing will also be

available for inspection and copying at the principal office of the

NASD. All submissions should refer to File No. SR-NASD-97-24 and should

be submitted by [insert date 21 days from the date of publication].

For the Commission, by the Division of Market Regulation,

pursuant to delegated authority.\23\

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\23\ 17 CFR 200.30-3(a)(12).

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Margaret H. McFarland,

Deputy Secretary.

[FR Doc. 97-11454 Filed 5-23-97; 8:45 am]

BILLING CODE 8010-01-M