Financial Industry Regulatory Authority, Inc. Notice Posted in Federal Register
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Self-Regulatory Organizations;
A Notice by the
I. Introduction
On
II. Description of Proposal
As further described in the Proposing Release, FINRA proposes to adopt consolidated FINRA broker-dealer supervision rules. [11] As part of the process of developing a new consolidated rulebook ("Consolidated FINRA Rulebook"), [12] the proposed rule change would (1) adopt FINRA Rules 3110 (Supervision) and 3120 (Supervisory Control System) to largely replace NASD Rules 3010 (Supervision) and 3012 (Supervisory Control System), respectively; (2) incorporate into FINRA Rule 3110 and its supplementary material the requirements of NASD IM-1000-4 (Branch Offices and Offices of Supervisory Jurisdiction), NASD IM-3010-1 (Standards for Reasonable Review), Incorporated NYSE Rule 401A (Customer Complaints), and Incorporated NYSE Rule 342.21 (Trade Review and Investigation); (3) replace NASD Rule 3010(b)(2) (often referred to as the "Taping Rule") with new FINRA Rule 3170 (Tape Recording of Registered Persons by Certain Firms); (4) replace NASD Rule 3110(i) (Holding of Customer Mail) with new FINRA Rule 3150 (Holding of Customer Mail); and (5) delete the following Incorporated NYSE Rules and NYSE Rule Interpretations: (i) NYSE Rule 342 (Offices--Approval, Supervision and Control) and related NYSE Rule Interpretations; (ii) NYSE Rule 343 (Offices--Sole Tenancy, and Hours) and related NYSE Rule Interpretations; (iii) NYSE Rule 351(e) (Reporting Requirements) and NYSE Rule Interpretation 351(e)/01 (Reports of Investigation); (iv) NYSE Rule 354 (Reports to Control Persons); and (v) NYSE Rule 401 (Business Conduct). FINRA modified its proposal in certain respects through Amendment No. 1, as described in the Notice and Proceedings Order. [13]
FINRA stated that it would announce the effective date of the proposed rule change in a Regulatory Notice to be published no later than 90 days following Commission approval. The effective date will be no later than 365 days following Commission approval.
III. Discussion of Comments and FINRA's Response
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The sections below discuss: the comments received to the Proposing Release and the Notice and Proceedings Order; FINRA's October Response and November Response; and the Commission's findings.
A. General Comments
1. Support for Proposal
Several commenters to the Proposing Release expressed overall support for the proposed rule change [28] and specific changes FINRA made in response to comments on the 2011 Filing, including requiring that supervisory procedures and corresponding amendments be communicated to relevant associated persons rather than throughout the organization; eliminating the requirement that associated persons verify annually that they have reviewed their firm's written supervisory procedures; eliminating risk management from the additional content requirements under proposed FINRA Rule 3120; and clarifying that supplementary material is part of the rule and the location of language within the supplementary material does not affect the weight or significance of a provision. [29] Commenters also expressed support for FINRA's efforts to consolidate the existing
In response to the Notice and Proceedings Order, one commenter expressed strong support for the proposed rule change, as modified by Amendment No. 1. [31] The commenter stated that the proposed rule change, as amended, "will ensure that investors are protected by the robust supervision programs implemented by firms, and that firms can continue to effectively utilize their supervisory structures and procedures under clear regulatory requirements." [32]
2. Opposition to Risk-Based Review Principles
Two commenters to the Proposing Release opposed the proposed rules' flexibility permitting members to rely on risk-based or principles-based review standards for specific obligations, such as the review of securities transactions and correspondence, arguing that such flexibility would result in reduced or diminished supervisory requirements that would not achieve the purpose of protecting the investing public. [33]
FINRA responded by explaining that the proposed rules' risk-based approach for certain aspects of a member's supervisory procedures is intended to further strengthen, not diminish, investor protection by allowing firms the flexibility to establish their supervisory programs in a manner that reflects their business models, and based on those models, focus on areas where heightened concern may be warranted. [34] FINRA also noted that the proposed rules further protect investors by retaining specific prescriptive requirements of NASD Rules 3010 and 3012, such as mandatory inspection cycles, prohibitions on who can conduct location inspections, and procedures for the monitoring of enumerated activities. FINRA also pointed to additional prescriptive requirements in the proposed rules, including special supervision for supervisory personnel rather than just the existing special supervision for producing managers, specific procedures to detect and investigate potential insider trading violations, and additional content requirements for specific firms' annual reports. FINRA noted that it understands concerns that additional guidance may be needed and intends to provide such guidance as circumstances warrant.
3. Reconsider Previously Proposed Supplementary Material
One commenter to the Proposing Release suggested that FINRA reconsider its decision to delete supplementary material previously proposed in the 2011 Filing providing that for a member's supervisory system to be reasonably designed to achieve compliance with FINRA Rule 2010 (Standards of Commercial Honor and Principles of Trade), it must include supervision of all of a member's business lines irrespective of whether they require broker-dealer registration. [35] This commenter restated this concern in a second letter. [36] FINRA responded that it continues to believe that it was the best course to eliminate the proposed supplementary material from the proposed rule because of potential differences with the supervision requirements otherwise applicable to those business lines. [37] FINRA stated that it will continue to apply FINRA Rule 2010's standards to non-securities activities of members and their associated persons consistent with existing case law.
4. Cost Benefit Analysis
One commenter to the Proposing Release stated that the proposal's compliance costs would be minimal and outweighed by the benefits. [38] Other commenters suggested that the proposal lacked a sufficient cost benefit analysis, [39] with some commenters stating that FINRA had not provided any specific performance objectives or identified other metrics to which it may later refer to assess the effectiveness of the proposed changes. [40] One commenter acknowledged that it was not possible for FINRA to perform a thorough cost benefit analysis when the proposal was filed, but suggested that FINRA revisit the proposed rules within five years of their adoption to ensure they are achieving their stated purpose while avoiding unnecessary costs. [41]
FINRA responded that the proposed rule change, as amended, strives to minimize the membership's burden and cost of complying with the consolidated supervision rules, as consistent with their purposes. [42] FINRA noted that the consolidated supervision rules transfer many of the existing requirements in NASD Rules 3010 and 3012 relating to, among other things, supervisory systems, written procedures, internal inspections, review of correspondence, and supervisory controls. Thus, FINRA believes that transferring existing requirements does not raise additional costs or burdens for firms because firms have already developed the necessary procedures and supporting systems to comply with those requirements. FINRA further noted that the proposed rule change also would delete Incorporated NYSE Rule 342 and much of its supplementary material and interpretations as they are, in main part, either duplicative of, or not in alignment with, the proposed supervision requirements, thereby reducing potential costs to firms that are members of both FINRA and the
In addition, FINRA noted that it has also applied a risk-based approach or similar flexibility for specified aspects of a member's supervisory procedures that is intended to allow firms the ability to establish their supervisory programs in a manner that reflects their business models, and based on those models, focus on areas where heightened concerns may be warranted. Those aspects include:
- Permitting risk-based review of all transactions relating to a member's investment banking or securities business; [43]
- Permitting risk-based review of a member's correspondence and internal communications that fall outside of the subject matters listed in proposed FINRA Rule 3110(b)(4); [44]
- Providing exceptions, based on a member's size, resources, and business model, from proposed FINRA Rule 3110's provisions regarding the supervision of a member's supervisory personnel and the persons prohibited from conducting a location's inspections; [45]
- Requiring that only members reporting
- Aligning proposed FINRA Rule 3110(d)'s definition of "covered account" with respect to detecting and investigating potential insider trading violations with existing
- Replacing NASD Rule 3110(i) (Holding of Customer Mail) and its strict time limits for holding customer mail with proposed FINRA Rule 3150 (Holding of Customer Mail), which generally allows a member to hold a customer's mail for a specific time period in accordance with the customer's written instructions if the member meets specified conditions; [48] and
- Deleting proposed supplementary material, in response to commenters' concerns regarding compliance costs and burdens that would have required a senior principal to have a physical presence on a regular periodic schedule at a one-person office of supervisory jurisdiction ("OSJ") where the one-person OSJ principal was conducting sales-related activities. [49]
FINRA stated that it agrees that the proposed consolidated supervision rules should be subject to a retrospective review process following an appropriate period after their implementation to determine whether they are achieving their intended purpose or have become overly burdensome [50] and would seek to consult with the membership, the public, and other stakeholders in analyzing the economic impact of the rules.
5. Include Other Supervisory-Related Requirements
Some commenters to the Proposing Release requested that FINRA revise the proposal to include provisions addressing other supervisory-related issues. [51] These issues include, for example, establishing a minimum ratio of producing representatives to compliance officers, [52] requiring heightened supervision for associated persons with a high volume of complaints, [53] identifying and supervising suspicious withdrawal patterns, [54] and requiring special supervisory procedures for senior investors and non-English speaking customers. [55] FINRA responded that it believes that these matters should be considered as part of a member's establishment of a supervisory system and procedures reasonably designed to achieve compliance with the federal securities laws and FINRA rules, and the testing and verification of such procedures under FINRA Rule 3120. [56] In this regard, FINRA noted that it has issued guidance addressing areas of concern, including supervision of associated persons with disciplinary history, [57] verification of emailed instructions to transmit or withdraw assets, [58] and obligations relating to senior investors. [59]
6. Additional General Comments
One commenter to the Proposing Release suggested that proposed FINRA Rule 3110 would require firms to have compliance departments that operate independently from their sales activity. [60] FINRA responded that it disagrees with this interpretation of proposed FINRA Rule 3110 and stated that proposed FINRA Rule 3110, which is based primarily on existing requirements in NASD Rule 3010 and Incorporated NYSE Rule 342 relating to, among other things, supervisory systems, written procedures, internal inspections, and review of correspondence, is intended to allow firms the flexibility to establish their supervisory programs in a manner that reflects their business, size, and organizational structure. [61] FINRA further noted that proposed FINRA Rule 3110 would not require a member to have an independent compliance department.
Another commenter to the Proposing Release suggested incorporating the proposed supplementary material into the body of the proposed rules. [62] FINRA responded that supplementary material is part of the rule and a provision's location as supplementary material is intended to improve the readability of the rule without affecting the weight, significance, or enforceability of the provision. [63]
B. Comments on Proposed FINRA Rule 3110(a)
As proposed, FINRA Rule 3110(a) (Supervisory System) would have required a member to have a supervisory system for the activities of its associated persons that is reasonably designed to achieve compliance with applicable securities laws and regulations and FINRA and the MSRB rules. One commenter to the Proposing Release requested that FINRA delete proposed FINRA Rule 3110(a)'s reference to the MSRB rules. [64] FINRA responded that the proposed reference to the MSRB rules was intended to clarify that members' supervisory systems must extend to compliance with MSRB rules and also to align FINRA's supervisory system requirement with the existing requirement under MSRB Rule G-27 (Supervision) to have a supervisory system that is reasonably designed to achieve compliance with applicable securities laws and regulations and MSRB rules. [65] In light of a member's separate obligation to comply with MSRB Rule G-27, however, FINRA deleted the proposal's references to the MSRB rules in Amendment No. 1.
C. Comments on Deleted Supplementary Material Regarding One-Person OSJs
As proposed, FINRA Rule 3110 would have included supplementary material clarifying the conditions a firm must satisfy to establish a one-person OSJ consistent with proposed FINRA Rule 3110(a)(4)'s requirement to have one or more appropriately registered principals in each OSJ with authority to carry out the supervisory responsibilities assigned to that office. Specifically, proposed FINRA Rule 3110.03 (One-Person OSJs) expressly provided that the registered principal at a one-person OSJ (each such person is referred to in this paragraph C as the "on-site principal") cannot supervise his or her own sales activities and must be under the effective supervision and control of another appropriately registered principal ("senior principal"). The proposed supplementary material would have required that the designated senior principal be responsible for supervising the activities of the on-site principal at the one-person OSJ and conduct on-site supervision of the one-person OSJ on a regular periodic schedule to be determined by the member. In determining the schedule, the proposed supplementary material would have required a member to consider, among other factors, the nature and complexity of the securities activities for which the location is responsible, the nature and extent of contact with customers, and the disciplinary history of the principal at the one-person OSJ.
One commenter to the Proposing Release supported the proposed supplementary material, [66] while another commenter suggested that FINRA revise proposed FINRA Rule 3110.03 to specify that "no Registered Principal shall supervise his or her own sales activity." [67] Numerous commenters raised concerns regarding the negative impact and costs of implementing the proposed requirement. [68] One commenter also stated that proposed FINRA Rule 3110.03 would create an inconsistency and serve little regulatory purpose by requiring the personal production of one-person OSJs to be supervised differently than an OSJ with multiple registered persons. [69] Several other commenters suggested that proposed FINRA Rule 3110.03 was unnecessary to ensure effective supervision [70] and could undermine many independent firms' overall supervisory structures [71] where home office principals supervise the sales activities of multiple field-OSJ principals to prevent conflicts of interest from self-supervision, or use technology and annual inspections to augment their supervision. [72] Commenters also suggested that the requirement to have "on-site supervision on a regular periodic schedule" ignores firms' use of technology-based remote supervisory systems. [73] One commenter raised concerns that proposed FINRA Rule 3110.03 would require all necessary supervisory reviews of the one-person OSJ to be conducted by the senior principal and sought clarification that the proposed supplementary material does not limit comprehensive regional supervisory structures, where regional principals perform annual and unannounced inspections and a separate centralized supervisory unit within the home office is dedicated to overseeing specific functions that require specialized knowledge and experience such as correspondence, advertising, or trade review. [74]
FINRA responded that it believes that OSJs conduct critical functions and one-person OSJs present unique supervisory challenges. However, in light of commenters' continuing concerns regarding compliance costs and burdens, in Amendment No. 1, FINRA eliminated the proposed supplementary material from the proposed rule. [75] FINRA noted that, importantly, it believes that one-person OSJ locations where the on-site principal engages in sales-related activities that trigger OSJ designation should be subject to scrutiny, and firms should conduct focused reviews of such locations. [76] FINRA stated that such locations would be subject to the general provisions of proposed FINRA Rule 3110(a)(5) (requiring all registered persons to be assigned to an appropriately registered representative(s) or principal(s) who will be responsible for supervising that person's activities) and proposed FINRA Rule 3110(b)(6) (requiring procedures prohibiting associated persons who perform a supervisory function from, among other things, supervising their own activities). [77] In addition, FINRA noted that it would continue to monitor one-person OSJs for possible conflicts of interest or sales practice violations and may determine to address the matter further as part of a retrospective review process following an appropriate period after implementation of proposed FINRA Rule 3110.
One commenter to the Notice and Proceedings Order opposed the elimination of the previously proposed supplementary material that would have required a registered principal at a one-person OSJ to be under the effective supervision and control of another appropriately registered principal. [78] However, the commenter stated that "the harm that may have resulted from its removal is remediated by further changes designed to make it clear that self-supervision is inappropriate, and [they] encourage FINRA to continue to follow up on its commitment to continue to examine the unique challenges posed by One-Person OSJs." [79] FINRA responded that, based on prior comments on and concerns with issues raised in the Proposing Release, it continues to believe that it was the best course to eliminate the proposed supplementary material from the proposed rule. [80]
D. Comments on Proposed FINRA Rule 3110.03
Proposed FINRA Rule 3110.03 (Supervision of Multiple OSJs by a Single Principal) would clarify the general requirement in proposed FINRA Rule 3110(a)(4) to have one or more appropriately registered principals in each OSJ with authority to carry out the supervisory responsibilities assigned to that office (an "on-site principal"). Specifically, proposed FINRA Rule 3110.03 would clarify that the requirement to have an appropriately registered principal in each OSJ requires the designated on-site principal to have a physical presence, on a regular and routine basis, at the OSJ. FINRA stated that it strongly believes OSJs engage in critical functions, and the requirement to have on-site supervision by designating one or more on-site principals in each OSJ has been a long standing cornerstone in establishing a reasonable supervisory structure. As a result, proposed FINRA Rule 3110.03 sets forth a general presumption that a principal will not be designated and assigned to be the on-site principal pursuant to proposed FINRA Rule 3110(a)(4) to supervise more than one OSJ.
If a member determines it is necessary to assign one principal to be the designated on-site principal to supervise two or more OSJs, then the firm must consider, among other things, the following factors:
- Whether the on-site principal is qualified to supervise the activities and associated persons in each location; - Whether the on-site principal has the capacity and time to supervise the activities and associated persons in each location; - Whether the on-site principal is a producing registered representative; - Whether the OSJ locations are in sufficiently close proximity to ensure that the on-site principal is physically present at each location on a regular and routine basis; and - The nature of activities at each location, including size and number of associated persons, scope of business activities, nature and complexity of products and services offered, volume of business done, the disciplinary history of persons assigned to such locations, and any other indicators of irregularities or misconduct.
In the Proposing Release, the proposed supplementary material would have created a further general presumption that assigning a principal to be the on-site principal of more than two OSJs is unreasonable.
1. Clarification of Term "On-Site Principal"
As originally proposed, FINRA Rule 3110.03 used the terms "on-site supervisor" and "designated principal" interchangeably throughout the provision. Commenters requested that FINRA clarify in the rule text whether proposed FINRA Rule 3110.03's terms "on-site supervisor" and "designated principal" refer to the same person. [81] In response, FINRA revised in Amendment No. 1 proposed FINRA Rule 3110.03 to use the term "on-site principal" consistently throughout the provision.
2. Home Office Principals; Costly and Burdensome Implementation
Two commenters to the Proposing Release raised concerns with proposed FINRA Rule 3110.03. [82] One commenter requested that FINRA either "exclude `up-the-chain' home office supervision of producing field OSJ principals" or more clearly address how the "physical presence" requirement applies to home office employee supervisors. The commenter specifically raised concerns about whether a home office principal with supervisory responsibilities over a particular business line conducted in the OSJ becomes the "on-site principal" and therefore would be required to have a physical presence on a regular basis. [83] The second commenter stated that proposed FINRA Rule 3110.03 does not provide sufficient flexibility, is too costly and burdensome to implement, and fails to take into account firms' various business structures. [84]
FINRA responded that proposed FINRA Rule 3110(a)(4), which would require a firm to have an appropriately registered principal in each OSJ with authority to carry out the supervisory responsibilities assigned to that office by the member, is being transferred unchanged from current NASD Rule 3010(a)(4). [85] FINRA further stated that due to inquiries from firms asking if they could assign one principal to be the designated on-site principal to two or more OSJs consistent with the requirements of NASD Rule 3010(a)(4), FINRA staff developed informal guidance and interpretations under NASD Rule 3010(a)(4). FINRA stated that Proposed FINRA Rule 3110.03 reflects these interpretations and consolidates them in one rule.
FINRA further responded that it believes the proposed rule would continue to provide firms with the flexibility to design supervisory systems suited for their business models, by allowing some flexibility in the presence of on-site supervisors if the firm can determine that the on-site principal has sufficient time and resources to engage in meaningful supervision of the critical functions that occur at another OSJ. [86] FINRA noted that firms can designate more than one on-site principal at an OSJ to supervise activities at that OSJ based on particular business lines, and each such principal designated as an on-site principal is required to have a physical presence on a regular basis. FINRA further noted that the on-site principal(s) is one part of a firm's comprehensive supervisory chain and not all "up the chain" supervisors must be designated as the on-site principal.
3. Elimination of Presumption That More Than Two OSJs Is Unreasonable
In the proposal, FINRA expressly included two general presumptions in the rule: (1) one principal should be assigned to be the on-site principal at one OSJ; and (2) assigning one principal to be the on-site principal at more than two OSJs is unreasonable. Commenters to the Proposing Release expressed concern about the effect that the presumptions would have on smaller firms; and one commenter stated that the presumptions negated the flexibility that FINRA otherwise intends to provide. [87] FINRA stated that the general presumptions were intended to provide firms with clarity. FINRA noted that the presumptions established guidelines, not rules, and firms could overcome the presumptions by demonstrating that assigning one principal to supervise more than two OSJs is reasonable based on the relevant factors set forth in proposed FINRA Rule 3110.03. [88]
In response to comments, FINRA proposed in Amendment No. 1 to replace the presumption in the Proposing Release that assigning one principal to be the on-site principal at more than two OSJs is unreasonable with a general statement that assigning a principal to more than one OSJ will be subject to scrutiny.
E. Comments on Proposed FINRA Rule 3110(b)(2) and FINRA Rule 3110.05
Proposed FINRA Rule 3110(b)(2) (Review of a Member's Investment Banking and Securities Business) would require that a member have supervisory procedures for the review by a registered principal, evidenced in writing, of all transactions relating to the member's investment banking or securities business. Proposed FINRA Rule 3110.05 (Risk-based Review of Member's Investment Banking and Securities Business) permits a member to use a risk-based system to review these transactions.
1. Additional Clarification Regarding "Risk-Based Review System"
Commenters to the Proposing Release requested additional clarification regarding how to comply with proposed FINRA Rule 3110(b)(2)'s requirement to review all transactions related to a member's investment banking and securities business if using a risk-based system to review transactions pursuant to proposed FINRA Rule 3110.05. Specifically, two commenters sought clarification as to whether a member's supervisory system must take into account "all" transactions, considering that a principal only is required to review a sample of transactions under a "risk-based review system." [89] Similarly, another commenter asked whether a member firm determining parameters for a technological-based review system that would cause a trade to be flagged for more intensive review would be a "risk-based" approach that would conform to proposed FINRA Rule 3110(b)(2). [90]
FINRA responded that proposed FINRA Rule 3110(b)(2) would transfer to the FINRA Rulebook NASD Rule 3010(d)(1)'s provision requiring principal review, evidenced in writing, of all transactions and clarifies that such review include all transactions relating to the member's investment banking or securities business. [91] FINRA stated that the term "risk-based" describes the type of methodology a member may use to identify and prioritize for review those areas that pose the greatest risk of potential securities laws and self-regulatory organization ("SRO") rule violations. In response to commenters' requests for clarification on risk-based reviews, FINRA clarified in Amendment No. 1 that a member would not be required to conduct detailed reviews of each transaction if a member is using a reasonably designed risk-based review system that provides a member with sufficient information that permits the member to focus on the areas that pose the greatest numbers and risks of violation.
FINRA further responded that it understands that a member's procedures for the review of its transactions by a registered principal may include the use of technology-based review systems with parameters designed to assess which transactions merit further review. [92] FINRA noted that the parameters would have to be reviewed by a principal and that review would have to be documented in writing. FINRA further noted, as is always the case with the exercise of supervision under FINRA rules, a principal's use of any automated supervisory system, aid, or tool for the discharge of supervisory duties represents a direct exercise of supervision by that principal, and the principal remains responsible for the discharge of supervisory responsibilities in compliance with the proposed rule. In addition, FINRA noted that a principal relying on a risk-based review system is responsible for any deficiency in the system's criteria that would result in the system not being reasonably designed. [93]
2. Exclude Specific Types of Broker-Dealers
One commenter requested that FINRA either exclude "mutual fund underwriters" and other members that do not have or maintain customer relationships or effect transactions with or for retail investors from proposed FINRA Rule 3110(b)(2) or explain how those members are expected to document compliance. [94] FINRA stated that the proposed rules would apply a risk-based approach or similar flexibility for specified aspects of a member's supervisory procedures to allow firms the ability to establish their supervisory programs in a manner that reflects their business models, such as members with limited broker-dealer activities. [95] As noted above, FINRA stated that proposed FINRA Rule 3110(b)(2) would transfer NASD Rule 3010(d)(1)'s provision and would require a principal to review and evidence in writing all transactions and that such review would include all transactions relating to the member's investment banking or securities business. Thus, members, regardless of their business activities, currently are required to have a principal review all of their transactions. FINRA noted that if mutual fund underwriters do not effect transactions, then the firms would have no review obligations pursuant to proposed FINRA Rule 3110(b)(2). [96] FINRA stated that it understands that some underwriters do have customer relationships that could involve customer transactions, in which case such member firms would need to review those transactions pursuant to proposed FINRA Rule 3110(b)(2). [97] FINRA further stated that proposed FINRA Rule 3110.05 would permit a mutual fund underwriter to use a risk-based approach to review its transactions. [98]
In response to the Notice and Proceedings Order, the same commenter restated its recommendation that mutual fund underwriters be excluded from the provision in Rule 3110(b)(2) that would require principal underwriters to have supervisory procedures that require the review of all customer transactions and evidence such review in writing. The commenter acknowledged FINRA's response to its original comment that "if mutual fund underwriters do not effect transactions, then the firms would have no review obligations pursuant to proposed FINRA Rule 3110(b)(2);" however, the commenter remained concerned that mutual fund underwriters would be required to create, maintain, implement, and review on an ongoing basis a procedure for reviewing transactions since the requirement to have such procedures is imposed on all FINRA members without regard to whether the member effects customer transactions. [99]
FINRA responded that, if a member does not engage in any transactions relating to its investment banking or securities business, it would be sufficient under proposed Rule 3110(b)(2) for the member to acknowledge in its supervisory procedures that it does not engage in any such transactions and that it must have supervisory policies and procedures in place before doing so. [100]
F. Comments on Proposed FINRA Rule 3110(b)(4) and Related Supplementary Materials
Proposed FINRA Rule 3110(b)(4) (Review of
1. Risk-Based Review of
Proposed FINRA Rule 3110.06 (Risk-based Review of
Some commenters suggested that FINRA should further align proposed FINRA Rule 3110.06 with the guidance in Regulatory Notice 07-59. [103] One commenter stated that the proposed rule could be interpreted as requiring a member to review all internal communications. [104] Two commenters to the Proposing Release requested additional guidance on the appropriate scope of internal communications requiring review and methodology for identifying those communications. [105] Commenters further suggested that any firm that does not engage in activities that are of a subject matter that require review should not be required to review its internal communications for references to those activities. [106] One commenter stated that requiring such firms to review internal communications for reference to those activities would result in significant costs that are not justified by the limited additional investor protection benefits. [107] Other commenters urged FINRA to further revise proposed FINRA Rule 3110.06 to state that "[t]hrough the use of risk-based principles, firms can determine the extent to which the review of their internal communications is necessary." [108]
FINRA responded that, with respect to the review of internal communications, Regulatory Notice 07-59 states that "with the exception of the enumerated areas requiring review by a supervisor, members may decide, employing risk-based principles, the extent to which review of any internal communications is necessary in accordance with the supervision of their business." [109] FINRA responded that it believes that proposed FINRA Rule 3110.06 would accurately reflect this guidance by stating that "[b]y employing risk-based principles, a member must decide the extent to which additional policies and procedures for the review of . . . internal communications that are not of a subject matter that require review under FINRA rules and federal securities laws are necessary for its business and structure." FINRA stated that, consistent with this guidance, proposed FINRA Rule 3110.06 would not require the review of every internal communication. [110] For example, if a member does not engage in any activities that are of a subject matter that require review, the proposed rule would not require that the member review its internal communications for references to those activities, provided that its supervisory procedures acknowledge that factor as part of the member's determination that its procedures are reasonably designed to achieve compliance with applicable federal securities laws and FINRA rules. Accordingly, FINRA declined to amend the proposal in response to the comments.
2. Evidence of Review of Communications Using Lexicon-Based Screening Tools
Proposed FINRA Rule 3110.07 (Evidence of Review of
Commenters suggested that firms using lexicon-based screening tools as a risk-based means of reviewing communications should not need to maintain the documentation required by proposed FINRA Rule 3110.07 evidencing review for those communications that do not generate review alerts/hits for further review. [111] One commenter suggested that it should be sufficient for a member to demonstrate that it has reasonably designed controls in place to ensure that the screening tools are subject to review and are operating as intended, [112] while other commenters suggested revising proposed FINRA Rule 3110.07 to provide that "[f]or those communications subjected to electronic review, the member must maintain documentation reasonably sufficient to demonstrate the parameters of such review." [113]
FINRA noted that it had previously declined to accept the suggestion that a member does not have to retain the specified information fields required by proposed FINRA Rule 3110.07 for communications reviewed through electronic review systems or lexicon-based screening tools if those messages do not generate review alerts. [114] FINRA stated that it believes that not only is the required documentation necessary to demonstrate that the communication was actually reviewed, but that failure to record and retain this information, such as the identity of the reviewer, could be inconsistent with a member's record retention obligations under FINRA and
With respect to communications reviewed by electronic surveillance tools that are not selected for further review, FINRA stated that, it would be sufficient to demonstrate compliance with proposed FINRA Rule 3110.07 if the electronic surveillance system has a means of electronically recording evidence that those communications have been reviewed by that system. [116] FINRA further stated that it would be permissible to use an electronic surveillance or reviewing tool that, with respect to communications that do not generate alerts, only captures the specified information fields to the extent necessary to comply with applicable FINRA and
Proposed FINRA Rule 3110.09 (Retention of
One commenter to the Proposing Release requested that FINRA expand the record retention period in proposed FINRA Rule 3110.09 to six years to match the record retention period in Exchange Act Rule 17a-4(c) (requiring broker-dealers to preserve for a period of not less than six years after the closing of any customer's account any account cards or records relating to the terms and conditions with respect to the opening and maintenance of the account) and to the eligibility provisions for customer arbitration disputes in FINRA Rule 12206 (Time Limits). [119] A second commenter restated this concern in a second letter. [120] FINRA responded that firms are already subject to very extensive record retention requirements regarding communications about firms' business as such. [121] In FINRA's view, the cost of extending the record retention period from three years to six years would unnecessarily raise costs and create recordkeeping inconsistencies. FINRA stated that the proposed supplementary material purposefully aligns the record retention period for communications with the
G. Comments on Proposed FINRA Rule 3110(b)(5)
Proposed FINRA Rule 3110(b)(5) (Review of Customer Complaints) would require members to have supervisory procedures to capture, acknowledge, and respond to all written (including electronic) customer complaints.
1. Exclusion of Oral Complaints
Several commenters to the Proposing Release suggested that members should be required to reduce an oral complaint to writing or to provide the customer with a form. [122] Commenters also suggested that oral complaints should not be too difficult to capture, [123] with one commenter stating that
FINRA further responded that this aspect of the proposed rules would not change existing rules, explaining that although Incorporated NYSE Rule 401A previously required firms to acknowledge and respond to specified customer complaints (both oral and written), to harmonize the
2. Require More Than Written Acknowledgement and Response
One commenter to the Proposing Release suggested that proposed FINRA Rule 3110(b)(5)'s requirement to capture, acknowledge, and respond to customer complaints was insufficient and that firms should be required to conduct an adequate and objective review and ongoing monitoring of claims that include, where appropriate, "bona fide" offers of resolution, including trade reversal and cancellation, good faithpre-arbitration or litigation discussion, or negotiation. [129]
FINRA responded that it understands the commenter's concerns that members have procedures in place to take appropriate and meaningful action with respect to customer complaints and expects that a member's supervisory procedures will be reasonably designed to respond to customer complaints. [130] In addition, FINRA noted that members have reporting and records preservation obligations for customer complaints that assist FINRA in monitoring whether a member's supervisory procedures for capturing, acknowledging, and responding to written customer complaints are reasonably designed. [131]
H. Comments on Proposed FINRA Rule 3110(b)(6) and FINRA Rule 3110.10
Proposed FINRA Rule 3110(b)(6) (Documentation and Supervision of Supervisory Personnel) is based largely on existing provisions in NASD Rule 3010(b)(3) requiring a member's supervisory procedures to set forth the member's supervisory system and to include a record of the member's supervisory personnel with such details as titles, registration status, locations, and responsibilities. In addition, the proposed rule would include two new provisions as described in more detail in the Proposing Release:
- Proposed FINRA Rule 3110(b)(6)(C) would require a member to have procedures prohibiting its supervisory personnel from supervising their own activities and reporting to, or having their compensation or continued employment determined by, a person the supervisor is supervising (subject to a limited size and resources exception); and - Proposed FINRA Rule 3110(b)(6)(D) would require a member to have procedures to prevent the standards of supervision required pursuant to proposed FINRA Rule 3110(a) from being reduced in any manner due to any conflicts of interest that may be present with respect to the associated person being supervised, such as the person's position, the amount of revenue such person generates for the firm, or any compensation that the supervisor may derive from the associated person being supervised.
Proposed FINRA Rule 3110.11 (Supervision of Supervisory Personnel) would indicate that the exception provided in proposed FINRA Rule 3110(b)(6)(C) is generally intended for a sole proprietor in a single-person firm or where a supervisor holds a very senior executive position within the firm.
1. Support for New Provisions
Several commenters to the Proposing Release supported proposed FINRA Rules 3110(b)(6)(C) and (D), [132] with one commenter stating that the provisions "should never be diluted." [133] Specifically referring to conflict of interest proscriptions in proposed FINRA Rule 3110(b)(6)(D), one commenter stated that the provision eliminates the opportunity for activities going unchecked or supervision being more lenient on the basis of self-interest, [134] while another commenter agreed that conflicts of interest relating to the compensation of the supervisor and the person being supervised should not needlessly compromise the effectiveness of supervisory procedures. [135] Referring to the prohibitions against supervisory personnel supervising their own activities in proposed FINRA Rule 3110(b)(C), one commenter concurred that self-supervision is inappropriate. [136]
2. Heightened Supervision
As noted in the Proposing Release, proposed FINRA Rule 3110(b)(6)(C) regarding the prohibition of supervisory personnel from supervising their own activities and reporting to, or having their compensation or continued employment determined by a person the supervisor is supervising, would replace NASD Rule 3012(a)(2)'s provisions concerning the supervision of a producing manager's customer account activity and the requirement to impose heightened supervision when any producing manager generates 20 percent or more of the revenue of the business units supervised by the producing manager's supervisor. One commenter to the Proposing Release suggested that FINRA retain the heightened supervisory requirement for producing managers that meet the 20 percent threshold and apply FINRA Rule 3110(b)(6)(C) to producing managers that do not meet the 20 percent threshold. [137] This commenter restated this concern in a second letter. [138]
FINRA responded that, although it understands the commenter's concerns regarding the need for effective supervision of producing managers, FINRA believes that proposed FINRA Rule 3110(b)(6)(C)'s provisions addressing the supervision of all supervisory personnel, rather than just producing managers, would be better designed to prevent supervisory situations that would not lead to effective supervision. [139] In addition, FINRA noted that proposed FINRA Rule 3110(b)(6)(D)'s conflicts of interest provisions would be designed to further ensure effective supervision of supervisory personnel.
3. Review of Senior Executive's Activities
One commenter to the Proposing Release stated that proposed FINRA Rule 3110(b)(6)(C) could prevent compliance professionals in the firm from reviewing the firm's most senior person's activities when that senior person occasionally produces revenue, and might force a firm to hire a "senior principal" if the senior person in the firm determines the compliance professionals' compensation or continued employment with the firm. [140]
FINRA disagreed with the commenter's interpretation of proposed FINRA Rule 3110(b)(6)(C) and stated that although proposed FINRA Rule 3110(b)(6)(C)(ii) generally would require a member to have procedures prohibiting its supervisory personnel from, among other things, reporting to, or having their compensation or continued employment determined by, a person the supervisor is overseeing, the same provision specifically provides an exception if a member determines that compliance with the prohibition is not possible because of a member's size or a supervisor's position within the firm. FINRA further stated that a member relying on the exception must document the factors it used to reach its determination that it can rely on the exception and how the supervisory arrangement otherwise complies with proposed FINRA Rule 3110(a). FINRA noted that proposed FINRA Rule 3110.10 would further providenon-exclusive examples of situations when the exception would generally apply, including when a registered person is a senior executive officer (or holds a similar position) and that proposed FINRA Rule 3110(b)(6)(C) and FINRA Rule 3110.10 do not require a member to hire additional personnel. [141]
4. Limited Exception
One commenter requested that FINRA either delete proposed FINRA Rule 3110.10 or revise it to expand the list of situations in which a firm may rely on the exception to include situations where a person supervises a senior person for only a limited purpose or function. [142]
FINRA declined to make any revisions to proposed FINRA Rule 3110.10. FINRA explained that the exception in proposed FINRA Rule 3110(b)(6)(C) is specifically based on a member's inability to comply with the general supervisory requirements because of the member's size or supervisor's position within the firm. [143] FINRA stated that proposed FINRA Rule 3110.10 reflects its view that a member would generally rely on the exception for a sole proprietor in a single-person firm or when a supervisor holds a very senior executive position within the firm. FINRA noted that a member may rely on the exception in other instances where it cannot comply because of its size or the supervisor's position within the firm, provided the member documents the factors used to reach its determination and how the supervisory arrangement with respect to the supervisory personnel otherwise complies with proposed FINRA Rule 3110(a). [144] To clarify that proposed FINRA Rule 3110.10 would provide non-exclusive examples of situations where the exception would generally apply, FINRA revised the provision in Amendment No. 1 to delete the term "only" prior to providing the examples.
The same commenter restated this recommendation in its comments to the Notice and Proceedings Order and stated that FINRA's response to its previous comment did not sufficiently address the concerns or examples raised in its comments to the Proposing Release. [145] In response, FINRA re-emphasized that the revisions to proposed Rule 3110.10's list of examples where a member would need to rely on the exception is non-exclusive. [146] FINRA further stated that it continues to support the principle set forth in proposed Rule 3110(b)(6)(C) that supervisory personnel must not report to, or have their compensation or continued employment determined by, a person they are supervising unless the firm complies with the permitted exception.
5. Conflicts of Interest
Commenters to the Proposing Release expressed concern that requiring members to have procedures to prevent their supervision standards from being reduced in any manner due to any conflicts of interest that may be present was inconsistent with the existing "reasonably designed" standard in proposed FINRA Rule 3110(a) (and current NASD Rule 3010(a)) and the proposed rules' risk-based supervision principles. [147] One commenter questioned whether proposed FINRA Rule 3110(b)(6)(D) creates a strict liability standard with respect to eliminating conflicts of interest. [148] Commenters requested that FINRA revise proposed FINRA Rule 3110(b)(6)(D) to clarify that firms must mitigate conflicts of interest as part of designing and establishing a reasonable supervisory system. [149] Two commenters suggested that FINRA amend the proposed supplementary material to require a member to have " . . . procedures reasonably designed to prevent the supervisory system required pursuant to paragraph (a) of this Rule from being reduced. . . ." [150]
In response, FINRA revised proposed FINRA Rule 3110(b)(6)(D) in Amendment No. 1 to clarify that the provision does not create a strict liability obligation requiring identification and elimination of all conflicts of interest. As revised, proposed FINRA Rule 3110(b)(6)(D) would require that a member have "procedures reasonably designed to prevent the supervisory system required pursuant to paragraph (a) of this Rule from being compromised due to the conflicts of interest that may be present with respect to the associated person being supervised . . . ." [151]
I. Comments on Proposed FINRA Rule 3110(b)(7) and FINRA Rule 3110.11
Proposed FINRA Rule 3110(b)(7) (Maintenance of Written Supervisory Procedures) would require a member to retain and keep current a copy of the member's written supervisory procedures at each OSJ and at each location where supervisory activities are conducted on behalf of the member.
Proposed FINRA Rule 3110.11 (Use of Electronic Media to Communicate Written Supervisory Procedures) would permit a member to satisfy its obligation to communicate its written supervisory procedures, and any amendments to those procedures, using electronic media, provided that the written supervisory procedures have been promptly communicated to, and are readily accessible by, all associated persons to whom the supervisory procedures apply based on their activities and responsibilities.
Two commenters to the Proposing Release requested that FINRA permit firms the flexibility to determine who should receive which portions of their written supervisory procedures, if any, and not interpret proposed FINRA Rule 3110(b)(7) to require communication of written supervisory procedures and amendments to non-supervisory personnel. [152] The commenters stated that, at many firms, written supervisory procedures are intended solely for supervisors while other documents (e.g., compliance policies) are intended for the broader audience of all associated persons. In addition, the commenters noted that there may be written supervisory procedures (e.g., how employee correspondence and trading are reviewed) that member firms do not want to be disseminated because the broad dissemination of those procedures may undermine their effectiveness.
FINRA stated that it continues to believe that it is important that all associated persons have knowledge of the supervisory procedures relevant to their activities. [153] FINRA notes that proposed FINRA Rule 3110(b)(7) and related supplementary material would not prohibit a firm from providing only its supervisory personnel with the written supervisory procedures' parameters detailing how a firm monitors or reviews its associated persons' activities to detect and prevent potential violative conduct (e.g., details about how a firm reviews an associated person's correspondence or trading).
J. Comments on Proposed FINRA Rule 3110(c) and Proposed FINRA Rules 3110.13 and 3110.14
Proposed FINRA Rule 3110(c)(1) (Internal Inspections), based largely on NASD Rule 3010(c)(1), would retain the existing requirements for each member to review, at least annually, the businesses in which it engages and inspect each office on a specified schedule. The provision would also retain the existing requirement that the member's annual review must be reasonably designed to assist the member in detecting and preventing violations of, and achieving compliance with, applicable securities laws and regulations and FINRA rules. [154]
1. Impose Additional Inspection Safeguards
Although one commenter to the Proposing Release supported proposed FINRA Rule 3110(c)(1), [155] another commenter suggested that firms should be required to conduct more frequent inspections to ensure that risks created by a firm's size, location, and resources are addressed. [156] The commenter also suggested requiring firms to hire third-party vendors to monitor their activities and conduct independent compliance audits, as well as to have a registered principal or compliance professional sign off on all compliance, supervisory, and inspection reports representing that to their knowledge and good faith belief, the report is true and correct.
FINRA responded that the proposed rule change would generally provide members with flexibility to conduct their inspections using only firm personnel. [157] This flexibility, in turn, would assist firms in managing compliance costs. FINRA stated that, with respect to addressing potential risk gaps, proposed FINRA Rule 3120 would require that firms test and verify, at least annually, that the member's supervisory procedures are reasonably designed to achieve compliance with applicable securities laws and regulations and with applicable FINRA rules and, if necessary, create any additional or amended supervisory procedures in response to those test results. FINRA noted that this testing and verification would necessarily include any supervisory procedures regarding a member's inspections to ensure that inspections have not been compromised by any potential risks inherent to a member's size, location, or resources. Therefore, FINRA declined to make changes to proposed FINRA Rule 3110(c)(1) in response to comments.
2. Exclude Residences From Inspections
Two commenters to the Proposing Release requested that FINRA exclude residences from proposed FINRA Rule 3110(c)(1)'s required inspections of a firm's locations. [158] One of these commenters suggested that other types of review, such as review of a registered person's email would be a more effective way of identifying potential red flags. [159] One commenter repeated its request that FINRA not subject home offices to the inspection requirements for supervisory branch offices and non-branch locations. [160]
FINRA declined to adopt the commenters' suggestions to exclude residences from proposed FINRA Rule 3110(c)'s inspection requirements. FINRA stated that inspections are a crucial component of detecting and preventing regulatory and compliance problems of associated persons working at unregistered offices. [161] Some unregistered offices also operate as separate business entities under names other than those of the members. FINRA noted that while FINRA does not encourage or discourage such arrangements, a large number of geographically separate offices present the potential that sales practice problems will not be as quickly identified as would be the case for larger, centralized branch offices. [162] FINRA stated that remote supervision, such as reviewing email for "red flags," would not be a sufficient substitution for an actual inspection, although red flags identified through such means could be helpful in determining whether to conduct unannounced location inspections.
3. Remove Presumption for Periodic Inspection Schedules
One commenter to the Proposing Release requested that FINRA delete proposed FINRA Rule 3110.13 (Presumption of Three-Year Limit for Periodic Inspection Sched
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