Self-Regulatory Organizations; Notice of Filing of Proposed Rule Change by the National Association of Securities Dealers, Inc. Relating to Tape Recording of Conversations

SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-39361; File No. SR-NASD-97-69]

Self-Regulatory Organizations; Notice of Filing of Proposed Rule

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

to Tape Recording of Conversations

November 26, 1997.

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

(``Act''),\1\ notice is hereby given that on September 12, 1997, as

amended on November 17, 1997,\2\ 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. Sec. 78s(b)(1).

\2\ On November 17, 1997, NASD Regulation filed Amendment No. 1

with the Commission. In Amendment No. 1, the NASD clarified that

firms will be required to establish procedures required by the Rule

when either information supplied by NASD Regulation or the firm's

actual knowledge indicates that it is the subject of the Rule, and

added a new provision defining the term, ``registered person,'' and

moving the definition of a ``disciplined firm'' to a different

location in the Rule for ease of reference. See Letter from Mary N.

Revell, Associate General Counsel, NASD, to Katherine A. England,

Assistant Director, Office of Market Supervision, Division of Market

Regulation (November 17, 1997).

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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'') Rule 3010 to

require tape recording of conversations where members hire more than a

specified percentage of registered persons from certain firms that have

been expelled or

[[Page 64423]]

that have had their broker/dealer registrations revoked for egregious

violations of sales practice Rules. The proposed Rule change also

includes a conforming Rule change to Rule 9610. Below is the text of

the proposed Rule change. Proposed new language is in italics.

Conduct Rules

Rule 3010. Supervision

(a) No change

(b) Written Procedures

(1) Each member shall establish, maintain, and enforce written

procedures to supervise the types of business in which it engages and

to supervise the activities of registered representatives and

associated persons that are reasonably designed to achieve compliance

with applicable securities laws and regulations, and with the

applicable rules of this Association.

(2) Tape recording of conversations

(i) Each member that either is notified by NASD Regulation or

otherwise has actual knowledge that it meets one of the criteria in

paragraph (b)(2)(viii) relating to the employment history of its

registered persons at a Disciplined Firm as defined in paragraph

(b)(2)(x), shall establish, maintain, and enforce special written

procedures for supervising the telemarketing activities of all of its

registered representatives.

(ii) The member must establish the supervisory procedures required

by this paragraph within 30 days of receiving notice from NASD

Regulation or obtaining actual knowledge that it is subject to the

provisions of this paragraph.

(iii) The procedures required by this paragraph shall include tape-

recording all telephone conversations between the member's registered

representatives and both existing and potential customers.

(iv) The member shall establish reasonable procedures for reviewing

the tape recordings made pursuant to the requirements of this paragraph

to ensure compliance with applicable securities laws and regulations

and applicable rules of this Association. The procedures must be

appropriate for the member's business, size, structure, and customers.

(v) All tape recordings made pursuant to the requirements of this

paragraph shall be retained for a period of not less than three years

from the date the tape was created, the first two years in an easily

accessible place. Each member shall catalog the retained tapes by

registered representative and date.

(vi) Such procedures shall be maintained for a period of two years

from the date that the member establishes the procedures required by

the provisions of this paragraph.

(vii) By the 30th day of the month following the end of each

calendar quarter, each member firm subject to the requirements of this

paragraph shall submit to the Association a report on the member's

supervision of the telemarketing activities of its registered

representatives.

(viii) The following members shall be required to adopt special

supervisory procedures over the telemarketing activities of their

registered representatives:

* A firm with at least five but fewer than ten registered persons,

where 40% or more of its registered persons have been employed by one

or more Disciplined Firms within the last two years;

* A firm with at least ten but fewer then twenty registered

persons, where four or more of its registered persons have been

employed by one or more Disciplined Firms within the last two years;

* A firm with at least twenty registered persons, where 20% or more

of its registered persons have been employed by one or more Disciplined

Firms within the last two years.

(ix) For purposes of this Rule, the term ``registered person''

means any person registered with the Association as a representative,

principal, or assistant representative pursuant to Rule 1020, 1030,

1040, and 1110 Series.

(x) For purposes of this Rule, the term ``disciplined firm'' means

a member that, in connection with sales practices involving the

officer, purchase, or sale of any security, has been expelled from

membership or participation in any securities industry self-regulatory

organization or its subject to an order of the Securities and Exchange

Commission revoking its registration as a broker/dealer.

(xi) Pursuant to the Rule 9600 Series, the Association may exempt

any member from the requirements of this paragraph unconditionally or

on specified terms and conditions upon a satisfactory showing that the

member's supervisory procedures ensure compliance with applicable

securities laws and regulations and applicable rules of the

Association.

(3) The member's written supervisory procedures shall set forth the

supervisory system established by the member pursuant to Rule 3010(a)

above, and shall include the titles, registration status and locations

of the required supervisory personnel and the responsibilities of each

supervisory person as these relate to the types of business engaged in,

applicable securities laws and regulations, and the rules of this

Association. The member shall maintain on an internal record the names

of all persons who are designated as supervisory personnel and the

dates for which such designation is or was effective. Such record shall

be preserved by the member for a period of not less than three years,

the first two years in an easily accessible place.

(4) A copy of member's written supervisory procedures, or the

relevant portions thereof, shall be kept and maintained in each OSJ and

at each location where supervisory activities are conducted on behalf

of the member. Each member shall amend its written supervisory

procedures as appropriate within a reasonable time after changes occur

in applicable securities laws and regulations including the rules of

this Association, and as changes occur in its supervisory system, and

each member shall be responsible for communicating amendments through

its organization.

(c) through (f) No change

(g) Definitions

(1) through (3) No change

* * * * *

Rule 9600. Procedures for Exemptions

Rule 9610. Application

(a) File With General Counsel

A member seeking an exemption from Rule 1021, 1022, 1070, 2210,

2340, 2520, 2710, 2720, 2810, 2850, 2851, 2860, Interpretive Material

2860-1, 3010, 3350, 11870, or 11900, Interpretive Material 2110-1, or

Rule G-37 shall file a written application with the Office of General

Counsel of NASD Regulation.

* * * * *

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.

[[Page 64424]]

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

Statutory Basis for, the Proposed Rule Change

Background

At its meeting in July 1996, the NASD Regulation Board of Directors

authorized the staff to issue a Notice to Members soliciting comment on

proposed changes to NASD supervisory Rule 3010 to require the tape-

recording of telephone conversations of registered representatives in

certain circumstances. The original Rule was developed both to respond

to concerns expressed in the Joint Regulatory Sales Practice Sweep

(``Sweep'') Report \3\ regarding the need for heightened supervision of

certain registered representatives with troubled regulatory and

compliance records and also to address the particular problems that

occur when a firm hires a large number of individuals who formerly

worked at a firm that has been expelled or has had its registration

revoked in connection with sales practice violations (a ``Disciplined

Firm'') where they were inadequately supervised and trained.

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\3\ Staffs of the NASD, New York Stock Exchange, North American

Securities Administrators Association, and the Office of Compliance

Inspections and Examinations, SEC, Joint Regulatory Sales Practice

Sweep: A Review of the Sales Practice Activities of Selected

Registered Representatives and the Hiring, Retention, and

Supervisory Practices of the Brokerage Firms Employing Them (March

1996).

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The Sweep was an initiative involving the staffs of the NASD, the

SEC, the New York Stock Exchange, and representatives of the North

American Securities Administrators Association (collectively, the

``Working Group'') to review the sales-practice activities of selected

registered representatives and the hiring, retention, and supervisory

practices of the brokerage firms employing them in order to identify

possible problem registered representatives, review their sales

practices, and assess whether adequate hiring, retention, and

supervisory mechanisms are in place.\4\ The Sweep Report was released

on March 18, 1996.

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\4\ Id. at i.

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One of the key findings of the Sweep Report was that some firms are

willing to employ registered representatives with a history of

disciplinary actions or customer complaints. Based on this finding, the

Working Group collectively recommended that firms that hire registered

representatives with a recent disciplinary history involving sales

practice abuse or other customer harm should implement special

supervisory procedures tailored to the individual registered

representative, which include a heightened level of scrutiny of the

registered representative's activities by his or her supervisor, for a

period of time.\5\ The Sweep Report recommended that, if firms fail to

establish such special supervisory procedures, the self-regulatory

organizations (``SROs'') should consider revising their rules to

specifically require that registered representatives with a recent

history of disciplinary actions involving sales practice abuse or other

customer harm be placed under special supervision by the firm for a

period of time.

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\5\ Id. at ii, iv.

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The NASD and the NYSE have issued a memorandum discussing the Sweep

Report and providing guidance on actions firms could take to provide

heightened supervision of problem registered representatives.\6\ While

the special procedures designed to provide a heightened level of

supervision recommended by the Sweep Report and described in the NASD/

NYSE memorandum may provide adequate supervision of associated persons

in most circumstances, NASD Regulation proposes to adopt specific

procedures in certain situations in order to provide the level of

supervision required by Rule 3010.

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\6\ NASD Notice to Members 97-19 (April 1997); NYSE Information

Memo 97-20 (April 15, 1997).

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NASD Regulation proposes to amend NASD Rule 3010 to require firms

that hire a specified number of individuals from Disciplined Firms to

tape-record telephone conversations between their registered

representatives and existing and potential customers. The proposed Rule

would apply when a firm hires a substantial number of registered

persons from a firm or firms that have been expelled or had their

registrations revoked for sales practice abuse. The measures described

by the rule are designed to prevent a reoccurrence of sales practice

abuse or other customer harm that caused the Disciplined Firm to be

expelled or have its registration revoked. The proposal is similar to

an interpretation adopted by the National Futures Association (``NFA'')

in 1993 to combat abusive cold calling.\7\ The NFA's interpretation is

discussed below.

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\7\ See Letter from Lynn K. Gilbert, Deputy Director, Commodity

Futures Trading Commission, to Daniel J. Roth, General Counsel, NFA

(January 19, 1993).

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Notice to Members 96-59 and Original Proposal

Notice to Members 96-59 (``Notice to Members''), containing the

original proposed Rule (``original proposal'' or ``original Rule''),

was issued in September 1996. The requirements of the original Rule

would have been triggered whenever a significant portion of a member's

work force was comprised of associated persons who formerly were

employed by a Disciplined Firm or firms or when the firm itself was a

Disciplined Firm. The original proposal defined a Disciplined Firm, for

purposes of the Rule, as one that had been disciplined (i.e., expelled,

suspended, or enjoined) by a regulatory entity, an SRO, or a court

within the previous five years for telemarketing or sales-practice

abuses in connection with the solicitation, offer, or sale of

securities.

Under the original proposal as described in the Notice to Members,

if more than 20 percent of a member's sales force of associated persons

previously were employed by a Disciplined Firm, the member would have

been required to adopt special written procedures to supervise the

telemarketing activities of its associated persons. Firms that were

themselves Disciplined Firms also would have been required to adopt

these procedures. The procedures would have required, at a minimum,

that the employer member tape record all telephone conversations

between all of its associated persons and both existing and potential

customers, and maintain these procedures for two years. For each firm

that was itself a Disciplined Firm, at the end of the two-year period,

the NASD would have conducted an evaluation to determine whether, and

for how long, the firm would continue to be subject to the requirements

of the Rule. The Rule also would have required firms subject to the

taping requirement to review the tapes periodically to ensure

compliance with securities laws and NASD rules, to submit reports to

the NASD on their supervision of telemarketing activities, and to

retain and index the tapes.

Comments and Response

Comments on the proposed Rule were requested by October 31, 1996.

Of the 42 comments received in response to the Notice to Members, 39

were opposed to the proposal, including those filed by the Securities

Industry Association, Lehman Brothers, Merrill Lynch, Morgan Stanley,

and Smith Barney.\8\

[[Page 64425]]

Most of the commenters support what they see as NASD Regulation's

objective in proposing the taping Rule and agree that something should

be done to deter a firm from recruiting groups of registered persons of

dubious ethics or training from a Disciplined Firm. They also agree

that firms and registered persons who have engaged in sales practice

abuses should be disciplined. However, they don't agree with the

proposal contained in the Notice to Members and have raised a number of

concerns. Many of the commenters object to the concept of taping as a

regulatory requirement, and fear that requiring taping in the

circumstances described in the proposed Rule is the beginning of a new

regulatory regime that may require even more comprehensive taping.

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\8\ NASD Regulation received the following comment letters: (1)

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

(``Edwards''), dated October 31, 1996; (2) Letter from Kevin P.

Howe, American Express Financial Advisors (``AEFA''), dated October

31, 1996; (3) Letter from G. Thomas Mitchell, Aurora Insurance and

Securities, Inc. (``Aurora''), dated October 10, 1996; (4) Letter

from Jerome Snyder, Barington Capital Group, L.P. (``Barington''),

dated October 23, 1996; (5) Letter from Leslie D. Smith, Berthel

Fisher Company (``Berthel''), dated October 25, 1996; (6) Letter

from Walter I. Miller, Capital Growth Planning, Inc. (``Capital''),

dated September 24, 1996; (7) Letter from Sanford D. Greenberg,

Chatfield Dean & Co. (``Chatfield Dean''), dated October 31, 1996;

(8) Letter from Neil Lawrence Lane, Citicorp Investment Services

(``CIS''), dated October 31, 1996; (9) Letter from David J. Master,

Coastal Securities (``Coastal''), dated October 31, 1996; (10)

Letter from John Polanin, Jr., Cowen & Company (``Cowen''), dated

November 7, 1996; (11) Letter from Richard L. Sandow, Cullum &

Sandow Securities, Inc. (``Cullum''), dated October 17, 1996; (12)

Letter from Gregg Thaler, Duke & Company, Inc. (``Duke I''), dated

October 10, 1996; (13) Letter from William Rotholz, Duke & Company,

Inc. (``Duke II''), dated October 29, 1996; (14) Letter from Shannon

Braymen, Duncan-Smith Securities, Inc. (``Duncan-Smith''), dated

October 22, 1996; (15) Letter from James H. Pyle et al., E.E. Powell

& Company, Inc., dated October 21, 1996; (16) Letter from Nancy K.

Port, Equity Services, Inc. (``ESI''), dated October 30, 1996; (17)

Letter from Rick Fetterman, Fetterman Investments, Inc., dated

October 1, 1996; (18) Letter from Herbert O. Sontz, GKN Securities

(``GKN''), dated October 31, 1996; (19) Letter from Lawrence E.

Wesneski, Hoak Breedlove Wesneski & Co. (``Hoak''), dated October

21, 1996; (20) Letter from Cabell B. Birdsong, Investors Security

Company, Inc. (``ISC''), dated October 22, 1996; (21) Letter from

David A. Rich, Jefferies & Company, Inc., dated November 8, 1996;

(22) Letter from Thomas P. Koutris, John Hancock Distributors, Inc.,

dated September 23, 1996; (23) Letter from A.E. Monahan, Keystone

Capital Corporation (``Keystone''), dated October 7, 1996; (24)

Letter from Paul B. Uhlenhop, Lawrence, Kamin, Saunders & Uhlenhop

(``Lawrence, Kamin''), dated October 29, 1996; (25) Letter from

Kathryn S. Reimann, Lehman Brothers Inc. (``Lehman''), dated October

31, 1996; (26) Letter from Kenneth S. Spirer, Merrill Lynch, Pierce,

Fenner & Smith (``Merrill Lynch''), dated November 14, 1996; (27)

Letter from Jack G. Levin, Montgomery Securities (``Montgomery''),

dated January 16, 1997; (28) Letter from Frederick W. Bogdan, Morgan

Stanley & Co., Incorporated (``Morgan Stanley''), dated October 30,

1996; (29) Letter from Dennis S. Kaminski, Mutual Service

Corporation (``MSC''), dated October 29, 1996; (30) Letter from

Richard Berenger, Nathan & Lewis Securities, Inc. (``Nathan &

Lewis''), dated October 18, 1996; (31) Letter from Douglas L.

Dunahay, Neidiger/Tucker/Bruner Inc. (``Neidiger''), dated October

29, 1996; (32) Letter from Edward T. Borer, Philadelphia Corporation

(``PC''), dated October 17, 1996; (33) Letter from Michael

Flannigan, Protective Group Securities Corporation (``PGSC''), dated

September 24, 1996; (34) Letter from Robert A. Fitzner, Jr., RAF

Financial Corporation (``RAF''), dated October 29, 1996; (35) Letter

from Glen F. Hackmann, Robert W. Baird & Co., Incorporated

(``Baird''), dated October 31, 1996; (36) Letter from Douglas F.

Schofield, Schofield Investments, Inc., dated September 18, 1996;

(37) Letter from Richard O. Scribner, Allen B. Holeman, and C. Evan

Stewart, Securities Industry Association (``SIA''), dated November

4, 1996; (38) Letter from Dov S. Schecter, Smith Barney Inc.

(``Smith Barney''), dated October 31, 1996; (39) Letter from Patrick

G. Haayes, Stratton Oakmont, Inc. (``Stratton''), dated October 30,

1996; (40) Letter from Walter H. Schlobohm, dated February 10, 1997;

(41) Letter from John Maceranka, The Windmill Group, Inc., dated

September 28, 1996; and (42) Letter from Stanley J. Allen Jr., Yee,

Desmond, Schroeder & Allen, Inc. (``Yee''), dated October 28, 1996.

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The definition of Disciplined Firm is too broad: Many of the

commenters believe the definition of Disciplined Firm in the original

Rule was too broad because it did not take into account the nature of

the event that led to the disciplinary problem.\9\ For example, a firm

could be included in the definition because of an injunction resulting

from a technical or inadvertent violation of state law or as the result

of a consensual injunction involving only a fraction of the firm's

employees or business activities. One commenter believes that the

definition should be limited to firms that have been permanently barred

from the securities industry due to telemarketing or sales practice

abuses.\10\

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\9\ See, e.g., letters from Edwards, Coastal, Cullum, ESI,

Keystone, Lehman, Montgomery, Morgan Stanley, and Baird.

\10\ See letter from Smith, Barney.

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In response, the definition has been revised to include only firms

that have been expelled from membership in a securities industry SRO or

that have had their registration as a broker/dealer revoked by the SEC

in connection with sales practice violations.

The Rule is too broad: Commenters believe the original Rule was too

broad in several respects.\11\ First, they believe that the Rule would

unfairly punish firms and individuals with good disciplinary and

compliance records for actions of others of which they have no

knowledge and over which they have no control.\12\ Second, they believe

the Rule should apply only to persons who were employed by a

Disciplined Firm at the time of the disciplinary event or within a

specified time prior to the event.\13\ Finally, commenters believe that

the Rule should apply only to personnel who have sales contact with

customers (i.e., registered representatives) and that clerical and

ministerial employees, who have no opportunity for sales practice

abuse, should be excluded from both the 20% calculation and from the

taping requirement.\14\

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\11\ See, e.g., letters from Edwards, Aurora, Barington,

Chatfield Dean, CIS, Coastal, Cullum, Duke II, ESI, ISC, Lehman,

Morgan Stanley, Nathan & Lewis, PC, PGSC, RAF, Baird, Smith Barney,

SIA, and Stratton.

\12\ See, e.g., letters from Lehman and Morgan Stanley.

\13\ See, e.g., letters from Edwards, Morgan Stanley, Nathan &

Lewis, PC, SIA, and Stratton.

\14\ See, e.g., letters from Edwards, Barington, Chatfield Dean,

Cullum, Duke II, ESI, ISC, Morgan Stanley, Baird, and Stratton.

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NASD Regulation has responded to these comments in two ways. First,

the Rule has been revised to apply only to firms that hire a specified

percentage of individuals who were employed at a Disciplined Firm

within the last two years. Second, only registered persons, and not

other employees, would be counted in determining whether the firm meets

the percentage criterion for triggering the taping obligation. Third,

only sales personnel would be subject to the taping requirement, since

sales activities and contacts with customers or potential customers are

the focus of this Rule. Thus, there is no reason to include back office

personnel in either the percentage calculation or to require taping of

their conversations.

The Rule does not achieve the stated purpose: The Notice to Members

soliciting comment on the original proposal states that the purpose of

the original proposed Rule is to respond to the Sweep Report

recommendation that firms should adopt heightened supervisory

procedures tailored to individual registered representatives with

troubled regulatory and compliance records. Some of the commenters

believe that the original Rule goes beyond the scope of the Sweep

Report, and that it will not be effective in achieving the Sweep Report

goal difficulties a firm would encounter when attempting to obtain the

information that would be required to comply with the Rule.

NASD Regulation believes that the narrower focus of the Rule will

result in lower compliance costs, at least for the industry as a whole.

First, fewer firms will meet the criteria in the Rule and will be

subject to the requirement, and costs, of tape recording conversations.

Also, the Rule has been revised to utilize a tiered structure of

determining whether a firm must comply with the Rule, with a higher

permissible percentage of registered persons from Disciplined Firms

being applied to smaller firms; this should result in a more equitable

impact on small firms. Finally, with respect to the practical

compliance difficulties raised by the Advisory Council, the NASD

Regulation staff has spent a significant amount of time since the

comment period closed in October responding to this issue and devising

methods whereby NASD Regulation can reduce the difficulties and costs

of compliance. As a result of

[[Page 64426]]

research, NASD Regulation staff believes that it can assist firms by

providing them with all the relevant information they require to

determine whether they are in compliance with the Rule. However,

comment is specifically requested on the cost of compliance with the

Rule.

Privacy concerns: Many commenters stated that the Rule would result

in an invasion of the privacy of both a firm's customers as well as the

firm's associated persons, which would be especially unfair both to

firms and associated persons that do not have disciplinary histories.

Commenters also believe that the Rule would conflict with federal and

state wiretapping laws. Finally, they are concerned that the Rule does

not restrict the accessibility and appropriate use of heightened

supervision because taping is not an effective means to supervise sales

personnel.\15\

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\15\ See, e.g., letters from CIS, Duke II, ESI, Lehman, Merrill

Lynch, MSC, Nathan & Lewis, and SIA.

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In response, NASD Regulation believes that restricting application

of the Rule to only the most egregious situations, i.e., employees who

formerly were employed at firms that were expelled from the industry,

addresses some of these concerns. Also, NASD Regulation believes that

the in terrorem effect of tape recording all telephone conversations

may be useful in deterring sales practice abuses. In addition, NASD

Regulation notes that the Rule is designed to go beyond the problems

raised by hiring individual problem registered representatives and is

meant to address the concerns raised when a firm hires a large number

of individuals who formerly were employed by a Disciplined Firm where

they were inadequately trained and supervised.

The costs of the Rule are too great: Some commenters believe that

the costs of the original Rule will be too high, particularly

considering the limited benefits that will be achieved. The commenters

state that the costs for purchasing tape-recording equipment, hiring

personnel to review the tapes, and record retention would be

enormous.\16\ Also, some commenters state that the Rule would have a

disproportionate effect on small firms both in terms of the costs and

because small firms are more likely to become subject to the 20%

threshold.\17\ Finally, while not discussed in a formal comment letter,

the Advisory Council raised as an issue the practical effect of the

tapes.\18\

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\16\ See, e.g., letters from Berthel, CIS, Coastal, Duke II,

ESI, GKN, Keystone, Lehman, Morgan Stanley, Nathan & Lewis, Baird,

and Smith Barney.

\17\ See, e.g., letters from Capital, Cowen, Duncan-Smith, Hoak,

SIA, and Yee.

\18\ See, e.g., letters from AEFA, Duke II, Lawrence, Kamin,

Lehman, Morgan Stanley, MSC, Neidiger, Montgomery, SIA, and Smith

Barney.

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As stated above, because the Rule has been revised to address only

the most egregious situations, the impact on privacy will be minimized.

Also, if the Rule is adopted, NASD Regulation will inform NASD members

that, in complying with this Rule, they must also comply with federal

and state civil and criminal statutes governing the tape recording of

conversations. This is the same approach the NFA has taken with respect

to this issue.\19\

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\19\ See Interpretive Notice to NFA Compliance Rule 2-9,

Supervision of Telemarketing Activity, 9021 (February 18, 1997).

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Each state has a statute governing wiretapping; there also is a

federal statute governing wiretapping and electronic surveillance.\20\

The federal statute and the majority of the state statutes permit

taping of telephone conversations with the consent of one party (``one-

party statutes''); a minority of state statutes require the consent of

all parties to the conversation (``two-party statutes''). Three issues

arise from the proposed Rule: what is necessary to comply with one-

party statutes; what is necessary to comply with two-party statutes;

and how to comply where a conversation occurs between a person in a

one-party state and a person in a two-party state.

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\20\ 18 U.S.C. Secs. 2519 et seq.

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In one-party statute states, the only issue is whether the

registered representative knows of and consents to the tape recording.

Since the recording requirement would run to the firm, and the

equipment would be the firm's, it might be argued that the firm, and

not the representative, is doing the recording. Therefore, it would be

necessary for the firm to insure that the representative has notice and

consents to the tape recording of his or her telephone conversations.

This could be accomplished through a clause in an employment agreement

or employee handbook or other written notice to the representative.

In two-party statute states, it would be necessary to insert on the

firm's telephone line a recording stating that all telephone

conversations are being taped, similar to customer service lines in

other industries. Some states require a system of beeps or buzzers that

sound throughout the conversation. Another possibility is to insert a

clause into the customer agreement notifying customers that their calls

will be tape recorded. Some states also have a ``business use

exception'' to the two-party statute consent requirement, but it is

worded and applied differently in each state.

The issue of choice of law for conversations between persons in

one-party statute and two-party statute states is an open issue that

depends on the individual laws of each state and the individual facts.

Firms would be required to independently determine that state laws are

satisfied. The safest course of action in each case would be to notify

their representatives and customers that their telephone calls are

being tape recorded. If all parties know of the tape recording, then

there is no violation of any statute.

Proposed Rule

As revised, the proposed Rule would apply whenever a specified

percentage of a member firm's sales force is comprised of registered

persons who were employed within the last two years by a firm that has

been expelled from membership in a securities industry SRO or has had

its registration as a broker/dealer revoked by the SEC.\21\ The

requisite percentage varies depending on the size of the firm, from 40

percent for a small firm to 20 percent for a larger firm. The firm must

establish the required supervisory procedures within 30 days of

receiving notice from NASD Regulation or obtaining actual knowledge

that it is subject to the provisions of the Rule.

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\21\ The revised definition of Disciplined Firm includes only

expelled and revoked firms in order to focus, at least initially, on

the most egregious cases with the greatest supervisory and

disciplinary problems. This approach is similar to the one taken by

the NFA, and will allow us to gain experience with the

implementation of the Rule before we consider expanding the

definition of Disciplined Firm to include firms that have been

suspended from SRO membership or from SEC registration.

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Under the proposed Rule, if a significant portion of a member's

sales force previously was employed by a Disciplined Firm, the member

would be required to adopt special written procedures to supervise the

telemarketing activities of its registered representatives. The

procedures would require, at a minimum, that the member tape-record all

telephone conversations between all of its registered representatives

and both existing and potential customers, and maintain these

procedures for two years. The Rule would require firms to ensure that

they tape record all regularly used means of telecommunications,

including cellular phones. The Rule also would require firms subject to

the taping requirement to establish reasonable procedures for reviewing

the tape recordings to ensure compliance with securities laws and NASD

rules, to submit reports to the NASD on their supervision of

[[Page 64427]]

telemarketing, and to retain and catalog the tapes.

While each firm will be responsible for meeting its own obligations

under the Rule, NASD Regulation will provide firms with all of the

information that they need to determine if they are subject to the

requirements of the Rule. NASD Regulation believes that firms should be

able to rely on the accuracy of the information provided to them, and

that a firm should be disciplined for failure to comply with the Rule

only if it has actual knowledge of information that would make the firm

subject to the Rule that is inconsistent with information provided by

NASD Regulation to the firm that indicated that the firm was not

subject to the Rule.

NASD Regulation will compile and maintain several lists that firms

will be able to review on a quarterly basis to assist them to determine

if they are in compliance with the Rule. The primary list that will be

prepared will be a list of firms that meet the definition of

Disciplined Firm.\22\ Two additional lists will be prepared that should

be helpful. One list will contain an alphabetical listing of all

registered persons who had worked for Disciplined Firms within the last

two years. Another list will be complied containing the same list of

people grouped according to the firm for which they currently work. In

order to alert firms that they are approaching the percentage that

would make them subject to the requirements of the Rule, the second

list will contain a computation of the percentage of all registered

persons at the firm represented by registered persons who had been

employed at a Disciplined Firm within the last two years.

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\22\ For the two-year period 1995-1996, 14 firms met the

definition of Disciplined Firm: 4 firms were expelled from SRO

membership and 10 had their registration revoked.

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The Rule is thus very similar to an NFA interpretation concerning

supervision of telemarketing activity.\23\ NFA member firms subject to

the requirements of the interpretation must tape record all sales

solicitations.\24\ The NFA interpretation applies to firms that meet

criteria relating to the percentage of the firm's associated persons

who formerly were employed at a firm that was closed down and barred

from the industry through enforcement actions for deceptive

telemarketing practices.\25\ These firms are required by the NFA

interpretation to tape record sales solicitations. An NFA member

subject to these procedures may seek a waiver of the taping requirement

upon a satisfactory showing that its current supervisory procedures

provide effective supervision over its employees, including enabling

the member to identify potential problem areas before customer abuse

occurs. The NFA has rarely granted such waivers. In one instance, a

waiver was granted to a firm that did not engage in telemarketing and

had only institutional customers. In two other instances, partial

waivers were granted to firms that hired outside consultants. NFA

informed NASD Regulation that they were not satisfied with the work

performed by the outside consultants and would not grant such waivers

in the future.\26\ In response to commenter requests, NASD Regulation

has included a waiver provision in the proposed Rule, and also has

proposed a conforming change to the Rule 9600 Series.\27\

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\23\ See Interpretive Notice to NFA Compliance Rule 2-9,

Supervision of Telemarketing Activity, para. 9021 (February 18,

1997).

\24\ NASDR states that no NFA member firm is currently taping

sales solicitations. Due to recent changes to the NFA interpretation

that were approved by the Commodity Futures Trading Commission in

December, 1996, seven new firms became subject to the requirements

of the interpretation, but all are in the process of seeking waivers

from the taping requirement. If these firms do not obtain waivers

from the NFA, or adjust their personnel numbers, they will be

required to tape-record conversations.

\25\ In early 1997, 44 firms met the NFA definition of

Disciplined Firm. See Interpretive Notice to NFA Compliance Rule 2-

9, Supervision of Telemarketing Activity, para. 9021 (February 18,

1997).

\26\ Telephone conversation between Mary N. Revell, Associate

General Counsel, NASD, and Daniel Driscoll, Vice President,

Compliance, NASD (February 26, 1997).

\27\ See, e.g., letters from Edwards, Barington, Cullum, Duke I,

Duke II, Duncan-Smith, GKN, Hoak, Morgan Stanley, Baird, and

Montgomery.

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Statutory Basis

NASD Regulation believes that the proposed Rule change is

consistent with Section 15A(b)(6) of the Act,\28\ which requires, among

other things, that the Association's rules must be designed to prevent

fraudulent and manipulative acts and practices, to promote just and

equitable principles of trade, and, in general, to protect investors

and the public interest. The NASD believes that requiring members that

hire more than a certain percentage of registered representatives who

formerly were employed by a Disciplined Firm will further these

requirements.

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\28\ 15 U.S.C. Sec. 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 NASD Notice

to Members 96-59 (September 1996). Forty-two comments were received in

response to the Notice.\29\

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\29\ See discussion supra Section II(A) Comments and Response.

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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

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. The Commission requests comments on

all aspects of the proposal as well as the following specific items.

1. Should customers be notified by firms that their calls are being

taped? Should firms be required to obtain their customers' written

consent to be taped? Why or why not?

2. Should registered representatives subject to the Rule be

notified by the firms that their calls are being taped? Why or why not?

3. In light of the information already available on the Central

Registration Depository, is a list of all registered persons who have

worked for a Disciplined Firm within the last two years necessary to

ensure compliance with the Rule? Would such a publicly available list

be used in other ways (for example, as a screening device for

applicants for registered representative positions)?

The Commission also is soliciting comments concerning whether the

Rule captures the appropriate registered persons in the percentage

calculation that triggers the taping requirement. The Rule would apply

whenever a specified percentage of a member firm is comprised of

registered persons who were employed within the last two years by a

firm that has been expelled from

[[Page 64428]]

membership in an SRO or has had its registration as a broker-dealer

revoked by the SEC. The requisite percentage varies from 40 to 20

percent, depending on the size of the firm.

4. As proposed, the Rule captures registered persons who have

worked at a Disciplined Firm within the past two years. Is the proposed

time frame appropriate?

5. Should the percentage of registered persons counted in the

calculation exclude registered persons who have worked at a Disciplined

Firm within the past two years, but who themselves have no disciplinary

history or customer complaints?

6. Should the percentage of registered persons counted in the

calculation include registered persons who may not have worked at a

Disciplined Firm, but who have, as individuals, been barred by the

Commission from association with any broker, dealer, investment

adviser, investment company, or municipal securities dealer?

7. Should firms with fewer than five registered persons be excepted

from the Rule?

8. As proposed, the Rule limits the taping requirement to

registered representatives in conversation with existing or potential

customers. Should the taping requirement apply to registered principals

in conversation with existing or potential customers? Should it apply

to any other associated person of a member firm?

9. What are the estimated costs to comply with the Rule? Please

comment generally on the benefits and costs of the Rule, as well as

ways to reduce the costs while preserving the benefits of the Rule.

Persons making written submissions should file six copies thereof

with 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. Sec. 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 File No. SR-NASD-97-69 in the caption above and

should be submitted by December 29, 1997.

For the Commission, by the Division of the Market Regulation,

pursuant to delegated authority.\30\

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\30\ 17 CFR 200.30-3(a)(12).

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Margaret H. McFarland,

Deputy Secretary.

[FR Doc. 97-31846 Filed 12-4-97; 8:45 am]

BILLING CODE 8010-01-M