NASD EXAMINATION PRIORITIES Thomas J. McGonigle* M. Elizabeth Parks*

I. INTRODUCTION

A. NASD Rule 3010(c) requires members to review the business activity in each of its offices. These reviews must be reasonably designed to assist in detecting and preventing violations of, and achieving compliance with, applicable securities laws and regulations.

B. Priority regulatory topics are identified by the NASD each year based on:

(1) The needs of members,

(2) A review of formal actions and Letters of Caution that show statistically significant levels of noncompliance,

(3) Recent trends, and

(4) Unclear areas of securities law.

C. Areas of Focus for 2001 include:

(1) Supervision and written supervisory procedures,

(2) Trade reporting and market making activities,

(3) Electronic trading,

(4) Mutual funds and variable annuity sales, and

(5) Taping Rule

II. CURRENT TRENDS IN EXAMINATIONS

A. Supervision and Written Supervisory Procedures

* * Thomas J. McGonigle is a partner and M. Elizabeth Parks is an associate in the Securities Compliance and Enforcement and Securities Litigation Practice Group at McGuireWoods, LLP.

1 There is a heightened emphasis on the firm’s supervisory structure. Each member is required to maintain a system for supervising its business activities and employees. The firm should periodically review its supervisory procedures to ensure that they are both adequate and up to date. Members should update their supervisory procedures within thirty days when changes occur in supervisory responsibilities, business activities, or securities rules and regulations. Members must maintain a copy of their written supervisory procedures at every location where supervisory activities are conducted. At a minimum, the firm’s written supervisory procedures should:

(1) Designate principals to supervise each facet of the member’s business;

(2) Require that the member make reasonable efforts to determine that all supervisory persons are qualified;

(3) Require written evidence that all registered persons attend an annual compliance meeting;

(4) Evidence the review and approval of transactions and correspondence by the Branch Manager; and

(5) Require the member to review the background of new employees.

B. Trade Reporting and Market Making Activity

Examination of member firms’ market making activities includes a review of the firm’s best execution practices, reporting requirements, and net capital adequacy. Member firms’ transaction data is subject to ongoing surveillance by NASD Regulation’s Market Regulation Department. Quality of market issues is assessed during most trading and market making examinations. As a general matter, examinations focus on the following items:

(1) Trade Reporting. Market Making firms should review their records to ensure that they have complied with NASD’s trade reporting requirements. Specifically, the NASD examinations will focus on compliance with the new Order Execution Disclosure Rules, Rule 11Ac1-5 and 11Ac1-6. Rule 11Ac1-5 requires market centers that trade national market system securities to make available to the public monthly electronic reports that include uniform statistical

2 measures of execution quality. Rule 11Ac1-6 requires broker-dealers that route customer orders in equity and option securities to make available to the public quarterly reports that identify the venues to which customer orders are routed for execution.

(2) Interpositioning. Interpositioning, or the placement of a third broker-dealer between a customer and a market maker is generally prohibited. A non-market maker executing a trade on behalf of a customer should always go to a market maker to ensure best execution.

(3) Adequate Written Supervisory Procedures. A member firm’s supervisory procedures should address market making compliance issues.

(4) Designation of a Principal Responsible for Trading and Market Making Compliance.

(5) Best Execution. Member firms should have documentation showing that the firm conducts best execution and related reviews on a regular basis.

C. Electronic Trading

The NASD performs a heightened review of member firms that engage in electronic trading activities. Specifically, the NASD examinations focus on:

(1) System Capacity. The member firms should maintain the systems capacity needed to handle increasing share and on- line traffic volume. Firms should alert customers to any system deficiencies or potential problems.

(2) Margin Lending Practices. Examiners are concerned that some day-trading firms, principals and employees arrange for credit to be extended by customers who have excess equity in their accounts to those customers who require funds to cover margin calls. Absent these infusions of capital, many of the recipients of the loans would be unable to continue to trade. Examinations are focussing on the role of the member firm in arranging these loans and what, if any, representations are made to the lending customers concerning the risks associated with making the loans. They are also investigating the nature

3 and amount of the fees and interest rates being charged to the borrowing customers.

(3) New Account Opening Procedures. Examiners review minimum opening deposits.

(4) Day Trading. Member firms are encouraged to alert day trading customers to the risks associated with this investment strategy. Examinations review numerous areas, including financial responsibility, advertising, supervision, short sales, and training.

(5) Disclosures. Member firms must accurately describe their services and avoid language that misleads customers about their trading capabilities. Member firms’ must not exaggerate customers’ access to markets in any communication. Members should balance discussions of speed, accessibility, or reliability of electronic trading services with disclosure that market volatility and volume may delay system access and trade execution.

D. Mutual Fund and Variable Annuity Sales

Some mutual fund companies are now offering several classes of shares. This practice raises compliance issues in sales practice, suitability, switching, and disclosure. Specifically, NASD examiners are currently focussing on:

(1) Whether customers are adequately informed of the characteristics and costs associated with the various classes of shares,

(2) Whether a particular class meets the investment objective of the customer, and

(3) Whether transfers between share classes, or funds themselves with similar objectives are in the customer’s best interest.

(4) A particular area of concern is the switching or moving funds from one customer’s account to another to generate commissions. This practice is a violation of federal securities laws. This practice can be difficult to detect or prove because the registered person may justify the switch by claiming that the original fund held by the customer was

4 decreasing in value. Member firms should carefully scrutinize trades involving switching between mutual funds.

E. The Taping Rule

Rule 3010(b)(2) requires member firms that employ a certain percentage of registered representatives from previously disciplined firms to adopt special procedures to supervise the telemarketing activities of its registered representatives. If a member firm is subject to the taping rule, the firm must tape record all telephone conversations between registered persons and existing or potential customers for a two-year period.

Member firms subject to the taping rule are required to ensure a proper supervisory environment that protects investors and prevents fraudulent and manipulative telemarketing acts and practices. Member firms’ supervisory procedures should:

(1) Specify minimum percentage of recordings reviewed and method of review,

(2) Identify one or more senior persons with training to review recordings,

(3) Determine how reviews are performed and documented,

(4) Document how and when tape recordings are reviewed; and

(5) Review procedures should reflect a consideration of the disciplinary history of the registered representative whose phone conversations are being recorded.

III. INSITE

In late 1998 the NASD launched an initiative, titled INSITE, to resolve the challenges posed by new and complex market structures and regulatory mandates. The NASD hopes that the better use of emerging technologies will allow the NASD to monitor activities and patterns on a more timely basis and to handle potential compliance problems at the earliest possible time.

A. Objectives: The implementation of INSITE is meant to:

(1) Simplify and streamline the examination process, (2) Provide greater investor protection,

5 (3) More effectively use staff resources, and

(4) Add more value for firms.

B. Approach: The NASD intends to meet these objectives through:

(1) Streamlined examination procedures by use of cutting edge technologies,

(2) Consolidated clearing firm and regulatory data,

(3) A Cost/benefit assessment of new rules against examination and enforcement requirements.

(4) Improved development of examination modules and examiner training programs

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