Notes from the Chicago Small Firm Conference

September 7, 2006

Introduction

Doug Shulman, Vice Chairman of NASD spoke about two initiatives within the NASD to improve its relationship and communications with Members. The first is the Liaison Program which has been implemented in an effort to provide firms with a dedicated point of contact at each District.  This person is a full time NASD Employee and is available to answer questions on NASD rules, filing deadlines and to act as an overall compliance resource.  This person will generally not be the examiner who will visit the firm. The NASD is committed to providing firms with accurate and prompt answers and believes that this program will assist in achieving that goal.  

The second is the Member Relations Department, to be located in Rockville. This department will assist members with questions and problems that arise in dealing with the NASD. The department is in the developmental stages now and should be operational in the near future.

Mr. Shulman also talked about a couple of task forces that the NASD has developed that are specifically related to small firms.  The first is the Small Firm Advisory Board Review task force which is reviewing the composition of the Small Firm Advisory Board (SFAB) to ensure that it has sufficient resources and representation for its constituents. The SFAB currently consists of 11-15 members who are all affiliated with firms employing no more than 150 registered representatives.  Their goal is to ensure that issues which are of particular importance to small firms are effectively communicated to and considered by the NASD Board of Governors. One of their primary functions is to review all major regulatory issues and rule changes and to make recommendations and comments regarding the impact on small firms.

The second task force is the Small Firm Rule Impact Task Force.  This group is being assembled to review current NASD by-laws and rules to try assess the impact/burden on small firms and to make recommendations on how to reduce them.

Mr. Shulman also reiterated that the NASD is trying to have the SEC approve a permanent the exemption for non-public firms for the requirement to use PCAOB member accountants for their annual audits. The current exemption expires for 2007 year end audits.

He also reminded the audience about the many tools the NASD now has available to firms such as Podcasts, Report Center, Mutual Funds Tools, Educational courses and various seminars.

Handling Regulatory Inquiries and Requests

The first session of the day was a discussion regarding handling regulatory inquiries and requests.  There are three different types of examinations that the NASD conducts; Cause Examinations, Routine Examinations and Sweep Examinations. 

• Cause Examinations are initiated through information that has been received by the NASD (ie: customer complaint, tip). 
• Routine Examinations are conducted on a one, two or four year cycle, based on the firm’s net capital requirements and risk. 
• Sweep Examinations are determined by the NASD based on subjects that appear to be an industry wide issue. 

The NASD, State and SEC all reminded audience members of the importance of communicating with the examiner and for establishing a single point of contact within the firm for the examination. This will help you provide the regulator with a clear understanding of your firm and its business and help you get clarity about requests. Both of which should help to make the examination process as smooth as possible.

The next topic of discussion was regarding customer complaints and how to handle them.  It is very important to understand what the complaint is and what filing requirements are triggered by a complaint.  For example, if a customer files a complaint about a sales practice issue, it may be necessary to amend the representative's Form U4 and/or Form BD as well as complete a 3070 filing. While if the complaint is about service, it may only be necessary to file the 3070 information.

If your firm is the recipient of a complaint, there are some steps you should take in order to address the situation adequately;

• Talk to the principal charged with supervision of the applicable party or area and gather information.
• Review account documents, look at all account and transaction related information and create a timeline.
• Contact the representative, get their side of the story, did he/she know the complaint was coming?
• Are there written supervisory procedures regarding the subject of the complaint?
• Be sure you report this in the appropriate manner. If you have questions on how or when to report a complaint or regulatory inquiry, review Rule 3070. If you still have questions, your NASD liaison may be able to assist you.

Verbal complaints are complaints and should be handled the same way as a written complaint, except that 3070 only applies to written complaints.

Keep in mind that you should consider complaints and regulatory inquiries when developing Continuing Education and Annual Compliance Meetings.  They can also be used as a tool to indicate gaps in supervision and the potential need for enhancement in doing your 3012 Testing & Verification.

Advertising Regulation Issues

During the second session of the day, a discussion regarding Advertising Regulation was conducted.  The Advertising Regulation Department exists to protect investors by ensuring that NASD member firms’ communications with the public are fair, balanced and not misleading.

There are 4 Main Units within the NASD’s Advertising Department:

1.  Filings Review Unit

• Member firms file sales material with this unit for review
• This is a fee based process and is the largest unit in the department

2.  Investigations Unit

• When a complaint or inquiry from a third party is submitted (such as a competitor or district office) the staff reviews the complaint and if a violation is found an informal disciplinary action may be taken or for formal action it is referred to the department of enforcement

3.  Spot-Checks Unit

• This unit reviews material that is not normally subject to filing.  The department will periodically request material from member firms to determine that applicable rules are being followed

4.  Member Education Unit

• The department sponsors an annual conference on advertising and investment company issues for NASD member firms
• Senior staff of the Advertising Regulation Department regularly speak at industry conferences

Recently, there has been a focus on communications with the public on Variable Insurance Products.  The panelists provided the audience with some helpful information which is outlined below:

Do:

• Identify the product as a variable annuity or variable life insurance policy.
• Disclose risks of the variable account, such as potential loss of principal invested.
• Balance claims and about the benefits (i.e. the guaranteed death benefit, minimum rate for fixed account, principal protection, etc.) with disclosure about the terms, limitations and restrictions.
• Balance discussions concerning liquidity features with disclosure of the negative impact of early withdrawals (i.e. surrender charges, tax penalties etc.).
• Disclose fees and charges and their impact on investment returns.
• Thoroughly explain the mechanics and limitations of any “dollar cost averaging” programs or riders.
• Ensure that internal use only and broker dealer use only communication is clearly labeled and distributed only to that audience.
• Disclose that variable annuity investments in a tax-qualified account do not provide any additional tax benefits beyond what is provided by the tax-qualified plan itself.

Do Not:

• State or imply that the contract or underlying accounts are mutual funds.
• Imply that these products are short term, liquid investments.
• Overemphasize the issuing insurance company’s ratings or strength.
• Overemphasize or misrepresent a rider.
• Overemphasize the fixed accounts current interest rate.
• Promote fixed rates that are unattainable under a “dollar cost averaging” program.
• Promote or encourage inappropriate annuity switching.

The next topic of discussion involved 529 College Savings Plans Municipal Funds Securities and a recent amendment.  The MSRB amended Rule G-21 which establishes specific requirements with respect to advertisements relating to municipal fund securities:

• Required Disclosures – must advise investor to consider investment objectives, risks,  charges and expenses before investing; that more information is in the issuer’s official statement; that the official statement should be read carefully and disclose that the dealer is an underwriter
• Conditional Disclosures – each advertisement that refers by name to a specific 529 Plan, its issuer/sponsor, or its underlying fund assets must disclose the source of the official statement; that the investors should consider whether their home state offers any state tax or other benefits only available in their own state’s 529 plan; and include a money market legend as applicable

A discussion regarding Electronic Communications was next on the agenda.  To follow are key areas to focus on regarding Electronic Communications:

• Web Sites
• Registered principal must approve in writing and prior to use
• NASD member firm name is required on the site
• Remember to keep the site current
• E-mail and Instant Messages

a.     When distributed to 25 or more prospects within a 30 calendar day period, it is deemed to be sales literature

• Requires approval in writing prior to use
• Must comply with all standards that apply to sales literature

b.     When distributed to less than 25 prospects within a 30 day period or to existing retail customers it constitutes correspondence

• Correspondence to 25 or more existing retail customers must be approved in writing prior to use 
• All other correspondence can be approved according to your firms’ procedures.
• Blogs  (web pages expressing opinions of a specific person on a specific topic)

1. Constitute advertisements
2. Require principal approval and recordkeeping and possible filing requirements
3. Subject to advertising contents and standards

New disclosure requirements are forthcoming for mutual fund advertising and sales materials. More information will be made available once the rule changes are approved. (Note – These changes were published in NtM 06-48 and will be effective April 1, 2007)

A question was raised regarding advertising review for Investment Advisors.  At this point in time, neither the SEC nor most states have a department where advertising can be filed for review.  However, the panel reminded the audience that if an RIA is also a registered BD or if Advisory Representatives are affiliated with a broker/dealer, they are subject to NASD review, approval and filing requirements on all of their advertising or sales literature.

Fixed Income Small Firm Issues

The third session of the day focused on Fixed Income issues with regard to Small Firms. 

Since the BD is responsible for ensuring that trade reporting is done correctly, even if you are relying on your clearing firm to do this reporting, it is important that you have the tools to monitor their activities. Some questions you might want to ask your clearing firm, if they report municipal or other transactions on your behalf

• What tools do they provide to monitor reporting?  Such as logs or reports
• Who is the contact person at the clearing firm for reporting issues?
• If there is a power outage –
• How will the firm be notified?
• When will the firm be notified?
• Who will notify the applicable regulator?

Hints, Tips, Help

• Use the free reports on line as self-compliance tools.  These tools allow firms’ to identify problems sooner rather than later and to monitor the reporting that is being done. 
• If you rely on another firm to report on your behalf, be sure you have procedures in place to demonstrate that you are checking the process and document that you do so.  It is ultimately the firm’s responsibility to ensure that the reporting is being done in accordance with applicable rules.
• Test the reporting systems – before, during and after implementation
• If you have failures and reporting problems, be sure you understand the scope of the problem and notify the applicable regulator as soon as possible
• If you have continued violations, expect that you will be cited and that disciplinary actions will escalate for ongoing issues
• Invest in technology and personnel to effectively monitor reporting compliance

Ask the Regulators

During this session the attendees were able to ask the panel questions related to the industry. 

Question:            Does the SEC have a department where someone can report fraudulent advertising by an Investment Advisor?

Answer:              The SEC does not have a department to review advertising but false or misleading communication can be sent to the SEC District or Regional offices. They will evaluate the content and determine if further investigation is warranted.

Question:            How can Small Firms meet the requirements for independent testing of their AML programs, if they have nobody internally that qualifies?

Answer:              Firms have used the following methods in complying with this requirement:

• Have their accountant do the review during the annual audit
• Partner with another firm in your area where they do yours and you do theirs
• Contract with an outside company

Question:            Why are state securities rules different from state to state?

Answer:              Each state has the ability to set their own rules and regulations. The NASAA has been working on making some regulation, such as registration requirements, as uniform as possible.

Question:            How often can a firm expect to receive an exam from the SEC?

Answer:              The SEC does not have a set cycle in which exams are performed.  The determination is dependent upon the type of business that your firm engages in and of course if they have received a complaint regarding your firm or its associated people.

Question:            If the NASD or another regulator calls to schedule an exam and the dates are not convenient for us, can we request an extension?

Answer:              Yes, but be reasonable. The examiners must complete a certain number of examinations each year and will try to accommodate requests where there is a good reason for the extension.

Question:            Why don’t states have a uniform de minimus exemption from registration for BDs?

Response:           Each state sets its own requirements for registration. The NASD and SEC do not control these requirements. The NASAA has been working with states to try to make these regulations as uniform as possible.

Question:            How many reps can one person supervise?

Response:           There is no regulation for a specific number. The number of reps one person could supervise is dependent on a number of factors including:

• The history and experience of the reps
• The experience of the supervisor
• The products being offered
• The geographic distance between the reps and the supervisor
• Whether the supervisor is also a selling rep.

Best Practices of Very Small Firms

During the final session, one regulator and two small firm CEO’s were asked to offer suggestions on best practices. 

Business Continuity Plan (BCP)

• Be sure to create and maintain a plan.
• Review the plan at least annually –think about things like power outages, flooding, etc

Anti-Money Laundering

• In addition to having a plan, firms must independently test AML programs

NASD Rule3013:

• CEO Certification that the firm has a process to adopt adequate procedures and policies. 
• Must be performed annually

NASD Rule 3010:

• Must establish a supervisory system and adopt adequate written supervisory procedures

NASD Rule 3012:

• Must test and verify written supervisory procedures and if necessary make amendments
• Must do so annually

OATS:

• Phase III effective July 10, 2006
• Requires members to capture and report the time an order is received by the firm from the customer for all orders
• Excludes certain firms from the definition of reporting member
• Provide 1-2 year exemptions from reporting for certain firms

529 Plans:

• Make sure you are providing disclosures to customers investing in out of state plans
• Undertake active suitability analyses for recommended transactions in 529 plans

NASD Resources for Small Firms:

• Small Firm page on NASD website, provides tools, links, checklists, templates and educational information
• Issue Center on NASD website provides a central location to access the most current compliance topics
• NASD Report Center allows firms to access compliance related reports such as equity report cards, TRACE report card, Web CRD late filing fee report etc.
• NASD Podcasts are short audio recordings which offer access to information in compliance topics, news and regulation updates
• NASD Webcasts are an online tool which provide brief tutorials that can be used for training and also to remain current on key compliance issues

Outsourcing – NtM 06-23 reminds members and offsite FINOPs of their duties and responsibilities under Rule 1022:

• On Site visits must be done once per calendar year
• Some or all of the visits should be done on a surprise basis.
• Review contracts; ongoing liabilities (including settlements and arbitration awards); contingent liabilities; nature and timing of capital contributions and withdrawals; expense sharing agreements; firms business activities to assess proper net cap requirement

Material Changes in Business:

• When a firm plans on making a material change to its business, it must file an application for approval with the NASD , not just change its Form BD
• Material changes include changing lines of business, modifying or removing restrictions, changing the ownership structure of the firm and adding branches or reps outside the number allowed in the firm’s membership agreement or outside the safe harbor.