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Are you ready to certify to the adequacy of your supervisory controls by December 1, 2005?

NASD Rules 3012 and 3013 were passed by the NASD last year in an attempt to ensure that member firms have adequate supervisory control processes in place. SCA has developed a program to assist NASD member firms in meeting the requirements of the rules. Our program is designed to be flexible in meeting the needs of firms of varying sizes and differing business models.

Please see a summary of the new rules and an overview of SCA’s program below. You may contact David McBride at 505.466.3555 for additional information.

NASD Rule 3013 requires CEO certification no later than December 1 of 2005 that your firm maintains a process to establish, maintain, review, test and modify written compliance and supervisory procedures.

Rule 3013 also requires that a written report be prepared and reviewed by the CEO, CCO and other appropriate officers prior to executing the certification. The report must also be provided to the firm’s board of directors and audit committee. The report should include the manner and frequency in which the processes are administered, as well as the identification of officers and supervisors who have responsibility for such administration. The CEO and CCO are required to have at least one meeting annually to discuss the findings of the report.

NASD Rule 3012 requires that that your firm identify one or more principals by January 31, 2005, who will establish, maintain and enforce a system of supervisory control policies and procedures that test and verify that the firm’s supervisory procedures are reasonably designed to comply with applicable securities laws and NASD rules and amend those procedures when necessary. The identified principal(s) must submit to senior management, no less than annually, a report detailing the firm’s system of supervisory controls, a summary of test results, significant identified exceptions and any additional or amended supervisory procedures created in response to the test results. Rule 3012 also contains specific requirements for supervision of producing managers and supervisory controls for transmittal of customer funds, change of address and changes in customer’s objectives.
SCA Recommended Approach
We believe that a firm’s implementation approach should cover the following:

• Determine whether your firm has compliance policies and procedures in place covering all of its business activities AND that such procedures are reasonably designed to meet all applicable securities laws and regulations.

• Implement procedures where existing procedures are lacking.

• Develop and implement verification, testing and reporting process that will meet the requirements of the rules and will provide a basis for the CEO attestation on the adequacy of the firm’s supervisory controls by December 1, 2005 and the compliance reports required by Rules 3012 and 3013.

• Create a sustainable model that may be used to support the CEO attestation and reporting requirements in future years.

Our program calls for creating a catalogue of all regulatory requirements for each business activity, assessing the current state of the firm’s supervisory and compliance procedures, identifying gaps, developing new procedures where gaps have been identified, developing a plan for the firm to meet the verification and testing requirement and conducting the actual testing of those procedures that require an audit type of review. We then prepare report templates designed to serve as the foundation for a sustainable model.

Our program may be modified to meet the needs of each client.
 

SEC Final Rule 202(a)(11)-(1)(b) (the “Rule”) became effective on April 15 of last year. The Rule addresses the application of the Investment Advisers Act of 1940 (the “Act”) to broker-dealers offering certain types of brokerage programs. A broker-dealer providing advice that is solely incidental to its brokerage services is excepted from the Act if it charges an asset-based or fixed fee (rather than a commission, mark-up, or mark-down) for its services, provided it makes certain disclosures about the nature of its services. The Rule, however, specifies three instances in which the provision of advisory services by a broker-dealer is not solely incidental to brokerage activities, and therefore such advisory services are ineligible for either the fee-based account exception or the exception from the definition of an investment adviser in the Act.

In the first instance, a broker-dealer that charges a separate fee or separately contracts with a customer for investment advisory services may not rely on the above exceptions. A separate contract that specifically provides for investment advisory services to a customer inherently reflects that the advisory services are provided independent of brokerage services and, therefore, cannot be considered solely incidental to the brokerage services. In addition, charging a separate fee for advisory services suggests that such services are provided independently of brokerage services and, therefore, cannot be considered to be solely incidental to brokerage services. Under these circumstances, a broker will be subject to the Act with respect to those accounts.

The second instance deals with a broker-dealer that advertises or otherwise presents itself to the public in general as a financial planner or as providing financial planning services. Such broker-dealers must usually register as investment advisers under the Act. A broker-dealer that represents to a customer that it is a financial planner, or provides the customer with a financial plan, financial planning services, or other financial planning advice, must also usually register under the Act and regard that customer as an advisory client. Financial planning services and financial plans generally address a client’s long-term economic needs and goals, taking into account the individual client’s situation and requirements. Financial planning is normally distinguished from other advisory services by the length and depth of the advisory services provided.

The third instance covered under the Rule relates to accounts over which a broker-dealer exercises investment discretion. The Rule states that exercising investment discretion is not solely incidental to the business of a broker or dealer within the meaning of the Act or brokerage services within the meaning of the Rule. A broker-dealer with the authority to effect a trade without first consulting a client is providing an entirely different service than simply providing advice as part of a package of brokerage services. In this instance, a broker-dealer may not rely on the exceptions for any accounts over which it exercises investment discretion, regardless of the form of compensation the broker-dealer receives or how it handles other accounts.

Given the above circumstances addressed by the Rule, certain broker-dealers may be required to register under the Act and comply with all associated regulatory requirements. Broker-dealer firms should examine the services they provide and consult with appropriate counsel to determine if registration under the Act is necessary as dictated by the Rule.
 

On September 9, 2005, the SEC approved amendments to the NASD branch office definition and adopted guidelines on factors to be considered by a member in conducting internal inspections of offices. Amendments to NYSE Rule 342 (Offices-Approval, Supervision and Control) were approved at the same time. Further, on September 30, 2005, the SEC approved new Form BR, which will replace Schedule E of the Form BD, the current NYSE Branch Office Application Form and certain state branch office forms. See NASD Notice to Members 05-67.

The current definition of Branch Office will remain in effect until April 30, 2006.

The new definition of branch office is “any location where one or more associated persons of a member regularly conduct the business of effecting any transactions in, or inducing or attempting to induce the purchase or sale of, any security, or that is held out as such”.

The following are exempt from the new branch office definition if certain requirements are met:

1. Non-sales locations/back offices
2. Primary residences
3. Non-primary residences
4. Offices of convenience
5. Location used primarily to engage in non-securities transactions
6. Floor of a registered national securities exchange
7. Temporary location used as part of a business continuity plan

New IM 3010-1 (effective May 1, 2006) provides that each member must conduct an annual review of its businesses and establish and maintain supervisory procedures that take into consideration, among other things, the following factors:

1. Size,
2. Organizational structure,
3. Scope of business activities,
4. Number and location of offices,
5. Nature and complexity of products and services offered,
6.Volume of business done,
7. Number of associated person assigned to a location,
8. Whether a location has a principal on-site,
9. Whether the office is a non-branch location, and
10. The disciplinary history of the registered representative or associated persons.

The IM indicates that members must be particularly diligent in establishing procedures and reviews with respect to non-branch locations.
 

 

NASD amends Anti-Money Laundering (AML) Rule

The SEC has approved a proposed NASD amendment to Rule 3011 (“the AML Rule”). Amendments to the AML Rule provide guidance regarding: (i) the required frequency of independent testing of a broker/dealer’s AML program; and (ii) requirements regarding internal broker/dealer personnel that are allowed to conduct the testing. The amended AML Rule also requires each member firm to review and update, if necessary, its AML compliance person information within 17 business days after the end of each quarter.
The AML Rule requires all broker/dealers to develop and implement AML programs and provides minimum requirements for such programs. One of the requirements is that all broker/dealers conduct an independent test of their AML programs. The amended AML Rule will require most firms to test their AML programs at least annually (on a calendar-year basis). However, firms that do not execute transactions for customers or otherwise hold customer accounts or act as an introducing broker with respect to customer accounts will be required to conduct independent testing every two years rather than annually. Examples of these types of firms include firms that limit their activities to proprietary trading or conduct business only with other broker-dealers.

The current rule allows the independent testing to be conducted by either firm personnel or by a qualified outside party. The rule change will require the person conducting the independent testing to have a working knowledge of the applicable Bank Secrecy Act requirements and related implementing regulations. Furthermore, to ensure independence, the testing may not be conducted by AML compliance personnel designated in the AML Rule, persons who perform AML functions subject to testing or by any person who reports to any of these persons. However, the amended AML Rule does provide an exception for small firms that would allow a person who reports to the AML compliance person or persons performing AML functions to conduct the testing if the following conditions are met:

1. The firm has no other qualified personnel to conduct the test;
2. The firm establishes policies and procedures that address potential conflicts;
3. If possible, the test is reported t to someone senior to the person to whom the testing conductor reports; and
4. The firm documents the reasons why it does not have another alternative.
If the person conducting the test does not report the results to a person senior to the AML compliance person or persons performing AML functions, the firm must document the reasons for not doing so.

The effective date of the rule change will be announced in a NASD Notice to Members within 60 days following SEC approval.