September 1, 2001
Obligations of a Broker- Dealer to Supervise the Securities Activities of Its Affiliates
Investment Lawyer
The recent consolidation among financial institutions has resulted in many broker-dealers becoming subsidiaries or sister companies of domestic and foreign securities dealers, and other financial services firms (affiliates). To eliminate redundancies and leverage the expertise of its personnel, these broker-dealers also frequently share employees with their affiliates (dual employees).1 Most principals of broker-dealer firms might be surprised to learn that the NASD Regulation (NASDR) Staff interprets National Association of Securities Dealers (NASD) Conduct Rule 3040 to require them to supervise the securities activities of their affiliates when the broker-dealer shares any dual employees with the affiliate. 2
The plain language or the rule does not appear to present a significant supervisory burden. The NASDR Staff interpretations3 thereunder, however, suggest that the NASDR Staff will read certain terms more expansively than they are generally interpreted elsewhere in securities law. Compounding the problem, the NASDR Staff has suggested a resulting level of supervision of these activities that is neither required by the text of the rule nor sensible in light of other detailed regulatory programs under which some affiliates already are regulated, supervised, and examined. Word has filtered out into the industry that NASDR has begun to use Conduct Rule 3040 as a back door means to supervise the securities activities of broker-dealer affiliates with dual employees. Because most financial services organizations share some employees (certain state and federal regulations expressly permit such arrangements and, in some cases, effectively require them), 4 these interpretations may require a broker-dealer to maintain redundant systems of supervision and recordkeeping of the securities activities of their affiliates.
The NASDR Staff's interpretation of Conduct Rule 3040 also may limit the synergies that financial organizations can generate through affiliating with one another. With the passage of various legislative initiatives, such as the Gramm-Leach-Bliley Act of 1999 (GLBA), financial organizations most likely will accelerate the trend of consolidation among the insurance investment advisory, broker-dealers, and banking industries. 5 The Securities and Exchange Commission (SEC's) rulemaking implementing Section 201 and Section 202 of Title II of the GLBA (Push-Out Release) this summer has placed a spotlight on the NASDR's interpretation of Conduct Rule 3040 and resulted in the banking agencies roundly criticizing it in their recent comment letter on the Push-Out Release. 6 It will not be long before state insurance commissioners and foreign regulators also realize that through these notices to members (NTMs) and interpretive letters, the NASDR Staff effectively is asserting jurisdiction over domestic and foreign banks, insurance companies, and securities broker-dealers that come under their jurisdiction. Congress has begun to look into the issue.
The History and Purpose of Conduct Rule 3040
The NASD has had a "private securities transaction" 7 interpretation or rule on its books since at least the mid-1970s. 8 The NASD originally promulgated its private securities transactions interpretation because these types of transactions were viewed as potentially resulting in securities being sold to public investors without appropriate levels of supervision, 9 and might result in member firm liability for the actions of an associated person even though the firm was not aware of his or her participation in the transaction. 10
In 1985, the NASD modified its private securities transaction interpretation. 11 The NASD's private securities transactions interpretation previously had addressed only the responsibility of associated persons to notify their member firms of their private securities transactions, but did not address the supervisory and oversight responsibilities of member firms. 12 In order to more clearly delineate the responsibilities of member firms, the NASD replaced the interpretation with a rule that set forth specific responsibilities for associated persons and member firms regarding the handling of associated person's private securities transactions. 13 The private securities transactions interpretation and rule were adopted and largely interpreted during a period when the regulated entities for which associated persons may have performed securities related functions were not as highly regulated as they are today. 14 For example, during this time, investment advisers were not registered with or regulated by most states and were examined less than once every 40 years by the SEC. 15
The NASD's private securities transactions interpretation and rule, and the NTMs addressing that interpretation and rule, do not on their face differentiate between private securities transactions executed pursuant to an associated person's employment with a regulated entity (e.g., a bank or registered investment adviser) and an unregulated entity (e.g., a hedge fund or a private, unregulated investment adviser), 16 nor have they been modified to acknowledge the modern reality that many of these entities are well supervised and regulated under other statutory regimes that now govern them. The purposes underlying the NASD's private securities transactions interpretation and rule (to fill the regulatory gap created when as associated person engages in securities transactions away from his or her member firm employer and to limit the possible liability of member firm employer and to limit the possible liability of member firms for the private securities transactions of their associated persons) are now nonexistent or greatly diminished. 17
The Text of 3040 and What It Literally Requires
NASD Conduct Rule 3040 generally provides that any person associated with (note that the Rule is not limited to registered personnel of a member firm) a NASD member firm who participates in a "private securities transaction," as defined under the Rule, must provide prior written notice to the member firm describing the proposed transaction and stating whether he or she will receive "selling compensation." 18 The NASD member firm then must state in writing whether it approves or disapproves of the proposed transaction. If the member firm approves and the associated person is to receive "selling compensation," as defined under the Rule, the member firm must record the transaction on its books and records and supervise the transaction as though the transaction were its own.
"Private securities transaction" is broadly defined as any securities transaction outside the regular course or scope of an associated person's employment with a member, including, but not limited to, new offerings of securities that are not registered with the SEC. 19 Excluded from the definition are transactions subject to NASD Conduct Rule 3050, transactions among immediate family members (as defined in IM-2110-1, the free-riding and withholding interpretation), for which no associated person receives any selling compensation, and personal transactions in investment company and variable annuity securities.
"Selling compensation" is defined as any compensation paid directly or indirectly from whatever source in connection with, or as a result of, the purchase or sale of a security, including, but not limited to:
Neither the federal securities laws nor NASDR rules, however, mandate the supervisory system or structure that a member must use. 21 Rather, each member firm can develop and implement its own supervisory system that is reasonably designed to detect and prevent violations. In this regard, no single document, combination of documents, or particular supervisory system is specifically required or necessarily adequate to comply with the requirements of Rule 3040.
However, the required level of recordkeeping and supervision should be, as in all other internal compliance system determinations, predicated on a risk-based analysis. Therefore, for example, thoroughly supervised and regulated entities should not present the same supervisory issues, as a private one-person advisory firm, hedge fund, or private placement management service.
NASDR Interpretations of 3040 and What They Purport to Require
The NASDR Staff previously has provided interpretive advice regarding how Conduct Rule 3040 applies in different factual situations.In particular, the NASDR Staff has addressed how the Rule applies to associated persons who engage in securities investment advisory services outside of the scope of their employment with their member firm employer. 23 NASDR has taken the position that advisory activity not involving the associated person's participation in the execution of securities transactions is an outside business activity governed by Conduct Rule 3030- and not Conduct Rule 3040. 24 Associated persons' advisory activities that may be covered by Rule 3030 include, among other things, writing financial plans for an advisory client for a fee without making specific securities purchase recommendations or arranging for the execution of securities transactions, Rule 3030 also may cover an associated person's advisory services where a client independently executes any resulting securities transactions, such as by dealing directly with a mutual fund.
If, however, an associated person participates in any manner in executing a private securities transaction (e.g., by placing a securities buy or sell order, or generally implementing a financial or asset allocation plan for an advisory client), NASD Conduct Rule 3040 will cover the transaction. 25
In NTM 94-44, the NASDR stated that Conduct Rule 3040 is triggered whenever an associated person participates in the execution of securities transactions such that his or her actions go beyond a mere recommendation. 26 For example, the conduct of an associated person who not only monitors an advisory client's account at another broker-dealer, but also calls the other firm to implement or execute trades, falls within the scope of Conduct Rule 3040. 27 In addition, Conduct Rule 3040 applies to an advisory person's discretionary purchase-and-sale transactions for advisory client accounts, even if the ultimate buy/sell order is sent to a common trading desk for routing to a broker-dealer for execution. In these circumstances, the Rule requires the associated person to give his or her employer member firm advance written notification and receive permission for each transaction. 28 If the associated person receives selling compensation for these activities, the member firm must satisfy the books and records and supervision requirements of Conduct Rule 3040.
The NASDR Staff defines "selling compensation" broadly to include the receipt of any item of value, whether to include the receipt of any item of value, whether directly or indirectly, from the execution of any securities transaction. 29 Specifically, in NTM 94-44, the NASD indicated that selling compensation includes any compensation that an associated person receives for participating in the execution of a securities transaction, including, but not limited to, ". . . asset-based management fees, wrap fees, hourly, yearly, or per plan fees." As interpreted by the NASD Staff, if an associated person participates in any manner in managing a discretionary advisory account and receives almost any form of payment, including an asset based fee or annual salary, the employer member firm will have to comply with the notice, approval, recordkeeping, and supervision requirements of Rule 3040.
NASDR has stated that the written notice and written approval required under Conduct Rule 3040 need not take any particular form. 30 In addition, NASDR has stated that an associated person of a member firm engaging in securities investment advisory services outside the scope of his or her employment with a member firm need not acquire the prior approval of his or her member firm employer for each securities transaction in which the associated person participates. The NASDR took this position because it was concerned that requiring prior written notice and permission for each such transaction would hinder the advice being provided. Instead, the associated person may give prior notice of the services to be performed for each customer and receive the member firm's permission, but need not give advance notice and receive permission for each transaction.
The NASDR also has addressed how the recordkeeping requirements of Conduct Rule 3040 apply to the outside investment advisory activities of associated persons of NASD member firms. In particular, the NASDR has stated that member firms may use any form of recordkeeping under Conduct Rule 3040 so long as the records permit the member firm to properly supervise the activities of its associated persons engaging in private securities transactions. The NASDR has, however, provided a rather detailed illustrative list of books and records a member firm may want to "consider" creating and keeping regarding the private securities transactions of its dual employees. 31
The NASDR Staff has orally indicated that in order for a member firm to meet its supervision and recordkeeping obligations under Conduct Rule 3040, the member firm must maintain its own system of books and records and policies and procedures regarding the private securities transactions of its associated persons. Generally, the NASDR Staff believes that it is not sufficient for a member firm to rely on the books and records of another entity, even a SEC-regulated investment adviser or banking institution regulated by a bank regulatory agency.
Conflict between NASDR Staff Interpretations of Definitions and Their Plain Meaning
The NASDR Staff's interpretation of the meaning of selling compensation (or transaction-based compensation) and execution has greatly expanded the reach and impact of Conduct Rule 3040. 32 It also conflicts (in many respects) with their well-settled meaning under the federal securities laws.
Transaction-based or selling compensation generally is understood to mean commissions or other fees that are based on the execution of securities transactions33 Transaction-based compensation generally is not understood to include advisory fees based on a percentage of assets under management. 34 This distinction in fee structure has historically differentiated broker-dealers from investment advisors. 35 The NASDR Staff's interpretation of selling compensation departs from the generally accepted principle that a fee, which is not based on the execution of a securities transaction (e.g., an asset-based fee), is not transaction-based compensation.
Equally unusual is the NASDR Staff's interpretation of what constitutes participation in the execution of a securities transaction. 36 As indicated previously, the NASDR Staff has stated that anything more than a mere recommendation may be interpreted by the Staff as participation in the execution of a securities transaction for purposes of Rule 3040. In most other contexts, however, participating in the execution of a securities transaction generally is understood to mean a more active participation in locating and negotiating with the counterparty to a securities transaction. 37 Providing investment advisory services-such as what securities to buy and sell and when to buy or sell them-generally is not considered to be "executing a securities transactions"-where the advisor places the client's trades through broker-dealer firms. Many investment advisers have trading desks to place orders for client accounts with broker-dealers, and yet these advisory firms have never been considered to be engaged in the business of effecting transactions in securities.
The NASDR Staff's interpretation that anything beyond providing a mere recommendation will constitute participating in the execution of a securities transaction conflicts with the NASDR's interpretation of its Series 55 registration category. NASD Membership and Registration Rule 1032(f) addresses the registration category for associated persons who execute equity securities transactions in the Nasdaq Stock Market and/or over-the counter (Series 55 registration category). In NTMs 00-46, the NASDR Staff indicated that persons that merely make trading decisions (i.e., decide what securities to buy or sell, when to buy or sell such securities, and how much to buy or sell) would not be subject to the Series 55 registration requirements because such persons are not involved in the execution of securities transactions. 38 Participating in the execution of securities transactions requires one to, at a minimum, locate the counterparty to a securities transaction and/or negotiate the terms of that transaction.
In one of the interpretive questions raised in NTMs 00-46, the NASDR Staff states that an investment adviser who determines what securities to buy and sell, including the quantity and price, and communicates that information to the traders on the firm's trading desk does not have to qualify as a Series 55 because he or she is not involved in executing a securities transaction. 39 Clearly, this interpretation appears to be at odds with the Staff's "mere recommendation" interpretation in the context of associated persons engaging in investment advisory services outside of their employment with their member firm employer. 40
Overlapping Jurisdiction and Conflict with Other Regulatory Regimes
The NASDR Staff's broad interpretation of Conduct Rule 3040 grants the SEC and the NASDR the power indirectly to regulate and supervise the securities activities of entities subject to other regulatory regimes. For example, this interpretation permits the NASDR to indirectly regulate the advisory business of investment advisers subject to regulation under the Investment Advisers Act of 1940 (Advisers Act) or the various state securities authorities. In addition, it permits the SEC and the NASDR to indirectly regulate the permissible securities activities of banks that meet the definition of bank under Section 3(a)(6) of the Securities Exchange Act of 1934 (Exchange Act).
This outcome has major repercussions for the division of supervisory and regulatory jurisdiction under the GLBA. Under the GLBA, insurance regulators are delegated the responsibility of regulating and supervising insurance companies and insurance agencies, banking regulators are supposed to regulate and supervise banks, and securities regulators are supposed to regulate and supervise broker-dealers and registered investment advisers. The NASDR Staff's broad interpretation of Conduct Rule 3040, however has the effect of making the SEC and the NASDR indirectly the "super-regulators" of the securities activities of all types of financial services firms, if they share dual employees with a broker-dealer.
In the GLBA, however, Congress preserved a bank's ability to engage in certain traditional bank securities activities under the supervision of the banking agencies-not under the supervision of the SEC or the NASDR. 41 The NASDR's broad interpretation of Conduct Rule 3040 purports to authorize the SEC and the NASDR to indirectly regulate these bank securities activities if a bank employs dually registered employees. Congress clearly did not intend for the SEC and the NASDR supervise bank permissible securities activities of dual bank employees through a NASDR rule. 42
Similarly, investment advisers are registered pursuant to and regulated under the Advisers Act and broker-dealers are registered pursuant to and regulated under the Exchange Act. This legislative mandate should not be transgressed by an interpretation of a self-regulatory organization (SRO) rule that overlays broker-dealer regulation on investment advisers when dual employees are used.
The NASDR's interoperation of Conduct Rule 3040 also has implications for established business relationships between US and non-US broker-dealers. In particular, the SEC in Rule 15a-6 43 and the SEC Staff in various no-action letters44 permit non-US registered broker-dealers to, among other things, effect transactions for US institutions through a US broker-dealer. The SEC permits the use of dual employees in these types of arrangements. 45 Neither Rule 15a-6 nor the Staff's no-action letters in this area, however, require the US member firm employer of the dual employee to supervise and record the securities activities that the dual employee effects outside the United States for its non-US registered broker-dealer employer. Rule 15a-6 specifies the level of supervision and recordkeeping required when a US broker-dealer "chaperones" a foreign broker-dealer's contact with US persons. Supervision and recordkeeping are required in respect of the chaperoned transactions under Rule 15a-6, but not the other non-chaperoned transactions of the foreign securities dealer, such as with non-US customers or with other US securities broker-dealers. The NASDR's interpretation of Rule 3040 effectively extends its regulatory authority overseas to non-US registered broker-dealers and banks.
Conclusion
The SEC's pending rulemaking on the bank exemptions from the definitions of broker and dealer has drawn the attention of Congress, the regulators, and the banking industry to the NASDR Staff's expansive interpretations of Conduct Rule 3040. If common sense prevails (by no means a certainty) the interpretation of the Rule will be returned to its text and original purpose of providing supervision to broker-dealer employees' securities activities conducted outside a regulated and supervised entity. That purpose is not furthered by doubling up with NASDR supervision of registered investment advisers, registered investment companies, banks and insurance companies, and foreign securities dealers that are already thoroughly regulated, supervised and examined by their primary regulators.
1 "Dual employees" are employees of a particular financial institution (e.g., a bank) who also are employed by another affiliated or unaffiliated entity (e.g., a broker-dealer, insurance agency, insurance company, or investment advisor). The dual employee functions as the single corporate contact for a customer and assumes different roles (e.g., trust department officer, registered representative, or investment advisor) relative to the service or product a customer is purchasing.
2 NASD Conduct Rule 3030 requires associated persons of a member firm to provide "prompt written notice" to their member firm employer before they accept employment or compensation for any outside business activity. Rule 3030 generally covers outside business activities that do not involve the associated person participating in the execution of securities transactions. Outside business activities that may be covered by Rule 3030 include, among other things, tax-planning services and selling non-securities insurance products. "Private securities transactions" covered by NASD Conduct Rule 3040 are specifically exempted from the requirements of Rule 3030. This memorandum will focus on NASD Conduct Rule 3040. Also of note in this area is NASD Conduct Rule 3050. Rule 3050 generally requires an executing broker-dealer to notify an employing broker-dealer of the opening of an account for the benefit of the associated person or over which the associated person has investment discretion (for example, an inter vivos trust that the associated person is a beneficiary of and over which he or she has investment discretion). At the employing broker-dealer's request, the executing broker must supply duplicate copies of confirmations, statements, or other information regarding the subject account.
3 See NASD NTMs 91-32, 94-44, and 96-33. See also NASD Interp. Letter of Aug. 4, 1997 (addressing the application of Rule 3040 to registered representatives of a distributor who also are employed by investment advisers to mange the portfolios of investment companies) and NASD Interp. Letter of Dec. 16, 1996 (addressing the applicability of NASD Rule 3040 to registered representatives of subsidiary bank of member broker-dealer). Available on the NASDR's Web site at www.nasdr.com/2910/3040_04.htm.
4 See generally Letter In Re: Chubb Securities Corporation (Nov. 24, 1993) (discussing use of dual employees in broker-dealer/financial institution networking arrangements); Letter In Re: First of American Brokerage Service, Inc. (Sept. 28, 1995) (discussing use of dual employees in broker-dealer/insurance agent networking arrangements); and Letter In Re: Securities Activities of US Affiliated Foreign Dealers (April 9, 1997) (footnote 5) (discussing the application of Rule 15a-6 (17 C.F.R. § 240.15a-6) to associated persons of foreign broker-dealers that are also registered representatives of a US registered broker-dealer).
5 "What's New in the Land of Regulation?," remarks by Acting Chairman Laura S. Unger, US Securities & Exchange Commission at "The SEC Speaks in 2001," sponsored by The Practicing Law Institute, Washington, DC (March 2, 2001). The GLBA, among other things, repealed or significantly amended various sections of the Exchange Act (e.g., Section 3(a)(4) and Section 3(a)(5)), the Banking Act of 1933 (e.g., Section 20 and Section 32 (Glass Steagall Act)), and the Bank Holding Company Act of 1956 (e.g., Section 4(c)(8)) that had separated the securities, insurance, and banking industries for most of the latter part of the 20th century.
6 See "Definition of Terms in and Specific Exemptions for Banks, Savings Associations, and Savings Banks under Sections 3(a)(4) and 3(a)(5) of the Securities Exchange Act of 1934," Exchange Act Release No. 44291 (May 11, 2001) [66 Fed. Reg. 27760, 27786 through 27788 (May 18, 2001)]. See also Comment Letter on Interim Final Rules from Federal Reserve, OCC, and FDIC (June 29, 1002).
7 Other self-regulatory organizations also have rules addressing the outside business activities of associated persons of securities firms. See, e.g., NYSE Rule 346 and Rule 407.
8 See NASD NTM 85-84 (citing Article III, Section 27 of the NASD Rules-"Private Securities Transactions.") See also Securities Exchange Act Release No. 11897 (December 3, 1975) [40 Fed. Reg. 57735].
9 See NASD NTM 85-54.
10 Id. This concern may stem from a broker-dealer's statutory obligation to supervise its associated persons. See 15 U.S.C. § 78o(b) (2001). Section 78o(b) provides:
11 See NASD NTM 85-84 and Securities Exchange Act Release No. 22617 (Nov. 12, 1985).
12 See Private Securities Transactions Interpretation under Article III, Section 27 (attached as Exhibit 2 to NTM 85-54).
13 See NASD NTM 85-84 and Securities Exchange Act Release No. 22617 (Nov. 12, 1985).
14See generally, Securities Exchange Act Release No. 11897 (December 3, 1975) [40 Fed. Reg. 57735]. The NASD changed the interpretation to a rule in the mid-1980s (see e.g., NASD NTMs 85-21 and 85-84) and provided various forms of interpretive guidance during the mid-1990s (see, e.g., NASD NTMs 94-44 and 96-33).
15 See Testimony of Arthur Levitt, Chairman, SEC, Concerning S. 1815, the "Securities Investment Promotion Act of 1996." Hearing before the Senate Comm. on Banking, Housing, and Urban Affairs (June 5, 1996). See also National Securities Markets Improvement Act of 1996, Pub. L. No. 104-290, 110 Stat. 3416 (1996) (dividing the regulation of investment advisers between the SEC and state securities regulators).
16 See, e.g., NASD NTMs 85-21, 85-54, 85-84, 91-32, 94-44, and 96-33.
17See generally Susan Rogers Finneran, "Investment Advisory Regulatory Muddy Waters: Registration and Control Issues Are Confused with Issues of Disclosure and Anti-Fraud," 19 Campbell L. Rev. 349 (Spring 1997). This interpretation is bolstered by a review of the NASD enforcement actions brought under Conduct Rule 3040. The vast majority of such enforcement actions address associated persons who sell unauthorized securities products to the clients of the associated person's member firm employer, or address situations in which an associated person establishes an unregulated enterprise to engage in private securities transactions. See, e.g., Securities exchange Act Release No. 25467, In the Matter of Allen S. Klosowski (March 15, 1988); Securities Exchange Act Release No. 16597, In the Matter of Richard L. Robinson (Feb. 21, 19980); and Securities Exchange Act Release No. 17381, In the Matter of Eugene T. Ichinose, Jr. (Dec. 16, 1980).
18 NASD Conduct Rule 3040.
19 NASD Conduct Rule 3040(e)(1). See also NASD NTM 91-32, 94-44, and 96-33.
20NASD Conduct Rule 3040(e)(2). See also NASD NTM 91-32 (compensation arrangements for activities of registered representatives).
21 See NASD Conduct Rule 3040. See also NASD NTM 96-33 (providing an illustrative list of the types of general documents a member firm should consider generating and retaining regarding the private securities transactions of its associated persons). See also infra n.31 (listing documents mentioned in NTM 96-33).
22 See, e.g., NASD Interp. Letter of Aug. 4, 1997 (addressing the application of Rule 3040 to registered representatives of a distributor who also are employed by investment advisers to manage the portfolios of investment companies) and NASD Interp. Letter or Dec. 16, 1996 (addressing the applicability of NASD Rules to registered representatives of subsidiary bank of member broker/dealer).
23 See generally NASD NTMs 91-32, 94-44, and 96-33.
24 See NASD NTM 94-44. See supra n.1 for discussion of NASD Conduct Rule 3030.
25 See generally NASD NTMs 91-32, 94-44, and 96-33.
26 According to NASD NTMs 94-44 and 96-33 arrangements under which an account is "handed off" to a third-party adviser who makes all investment decisions are excluded from the coverage of Conduct Rule 3040.
27 See NASD NTM 94-44.
28 The NASD, however, has stated that an associated person who engages in outside investment advisory services need not provide prior notice for each transaction; rather, he or she may provide a single notice covering each of his or her clients. See NASD NTMs 96-33. Question 1.
29 See NASD NTM 94-44.
30 See NASD NTM 96-33.
31 Id.. The list includes the following items: (1) dated notifications from the associated person detailing the services to be performed by the associated person and the identity of each associated person customer serviced at another firm in a private securities transaction; (2) dated response from the NASD member to the associated person acknowledging and approving or disapproving the associated person's intended activities; (3) a list of associated persons who also are investment advisers or investment adviser agents; (4) a list of associated persons approved to engage in private securities transactions; (5) a list of associated person customers, including those that are customers of both the member firm and the associated person, with a cross reference to the associated person; (6) copies of customer account opening cards to determine, among other things, suitability; (7) copies of discretionary account agreements; (8) duplicate confirmation statements; (9) duplicate customer account statements; (10) a correspondence file for associated person customers; (11) investment advisory agreements between the associated person's investment adviser employer and each advisory client; (12) advertising materials and sales literature used by the associated person's investment adviser employer to promote investment advisory services wherein the associated person holds himself or herself out as a broker-dealer, complemented by a process that shows whether proper filings have been made at the NASD and whether the associated person is using any electronic means, such as the Internet, to advertise services or correspond with customers; (13) exception reports, where feasible, based on various occurrences or patterns of specified activity, such as frequency of trading, high compensation arrangements, large numbers of trade corrections, and cancelled trades; and (14) supervisory procedures designed to meet the requirements of Conduct Rule 3040. The procedures may include such items as the identity of persons responsible for Conduct Rule 3040 compliance, the recordkeeping system to be used and followed, and memoranda or compliance manuals that notify associated persons of the member's procedural requirements for Conduct Rule 3040 compliance.
32 NASD NTMs 91-32 and 94-44.
33 See "Compliance Guide to the Registration of Brokers and Dealers," Division of Market Regulation, SEC at 3 (Oct. 1998) (available at www.sec.gov/division/marketreg/bdguide.htm). See generally Letter In Re: 1st Global, Inc. (May 7, 2001); Letter In Re: BondGlobe (Feb. 6, 2001); Letter In Re: MuniAction (March 13, 2000); Letter In Re: John Wirthlin (Jan. 19, 1999); Letter In Re: Charles Schwab & Co., Inc. (Sept. 18, 1997); John Polanin, "The 'Finder' Exception from Federal Broker-Dealer Registration," 40 Cath. U. L. Rev. 787 (Summer 1991); Steven Lofchi, "A Guide to Broker-Dealer Regulation" at 24 (Compliance Int'l 2000; and 15 David A. Lipton, Broker-Dealer Regulation § 1.04[3][a] West 2000).
34 See generally Letter In Re: Portico funds, Inc. (April 11, 1996). See also Securities Exchange Act Release No. 42099, "Certain Broker-Dealer deemed Not to Be Investment Advisers" (Nov. 4, 1999) and "Definition of Terms in and Specific Exemptions for Banks, Savings Associations, and Savings Banks under Section 3(a)(4) and 3(a)(5) of the Securities Exchange Act of 1934," Exchange Act Release No. 44291 (May 11, 2001). Indeed, the "fiduciary" exemption for banks from broker-dealer regulation incorporates the concept that asset-based advisory fees are not transaction-related compensation. See § 3(a)(4)(B)(ii) of the Exchange Act.
35 Speech by SEC Staff: "Remarks before the ABA Trust, Asset Management, and Marketing Conference" by Robert L.D. Colby Deputy Director, Division of Market Regulation US Securities & Exchange Commission January 31, 2001. Available on the SEC's Web site at www.sec.gov/news/speech/spch461.htm.
36 See NASD NTM 94-44.
37 See, e.g., NASD Membership and Registration Rule 1032(f) and NASD NTM 00-46.
38 NASD NTM 00-46.
39 Id. at Question 4.
40See NASD NTM 94-44.
41 See e.g., Senate Committee on Banking, Housing, and Urban Affairs Report on S. 900, Financial Services Modernization Act of 1999 (Rpt. No. 106-44).
42Congress' intent to not permit SRO rules to trump the push-out provisions of Title II of the GLBA is clearly illustrated by the Conference Committee Report, which states:
44 Letter In Re: Certain Securities Activities for US Affiliated Foreign Dealers (April 9, 1997).
45 Id. at n.5. David F. Freeman is a partner, and Kevin A. Zambrowicz is an associate, at Arnold & Porter in Washington, DC. Mr. Zambrowicz served as Special Counsel in the office of Chief Counsel, Division of Market Regulation of the US Securities and Exchange Commission from 1997 to November 2000. The views expressed in the article do not represent the views of the Commission or the Staff of the Commission.
The plain language or the rule does not appear to present a significant supervisory burden. The NASDR Staff interpretations3 thereunder, however, suggest that the NASDR Staff will read certain terms more expansively than they are generally interpreted elsewhere in securities law. Compounding the problem, the NASDR Staff has suggested a resulting level of supervision of these activities that is neither required by the text of the rule nor sensible in light of other detailed regulatory programs under which some affiliates already are regulated, supervised, and examined. Word has filtered out into the industry that NASDR has begun to use Conduct Rule 3040 as a back door means to supervise the securities activities of broker-dealer affiliates with dual employees. Because most financial services organizations share some employees (certain state and federal regulations expressly permit such arrangements and, in some cases, effectively require them), 4 these interpretations may require a broker-dealer to maintain redundant systems of supervision and recordkeeping of the securities activities of their affiliates.
The NASDR Staff's interpretation of Conduct Rule 3040 also may limit the synergies that financial organizations can generate through affiliating with one another. With the passage of various legislative initiatives, such as the Gramm-Leach-Bliley Act of 1999 (GLBA), financial organizations most likely will accelerate the trend of consolidation among the insurance investment advisory, broker-dealers, and banking industries. 5 The Securities and Exchange Commission (SEC's) rulemaking implementing Section 201 and Section 202 of Title II of the GLBA (Push-Out Release) this summer has placed a spotlight on the NASDR's interpretation of Conduct Rule 3040 and resulted in the banking agencies roundly criticizing it in their recent comment letter on the Push-Out Release. 6 It will not be long before state insurance commissioners and foreign regulators also realize that through these notices to members (NTMs) and interpretive letters, the NASDR Staff effectively is asserting jurisdiction over domestic and foreign banks, insurance companies, and securities broker-dealers that come under their jurisdiction. Congress has begun to look into the issue.
The History and Purpose of Conduct Rule 3040
The NASD has had a "private securities transaction" 7 interpretation or rule on its books since at least the mid-1970s. 8 The NASD originally promulgated its private securities transactions interpretation because these types of transactions were viewed as potentially resulting in securities being sold to public investors without appropriate levels of supervision, 9 and might result in member firm liability for the actions of an associated person even though the firm was not aware of his or her participation in the transaction. 10
In 1985, the NASD modified its private securities transaction interpretation. 11 The NASD's private securities transactions interpretation previously had addressed only the responsibility of associated persons to notify their member firms of their private securities transactions, but did not address the supervisory and oversight responsibilities of member firms. 12 In order to more clearly delineate the responsibilities of member firms, the NASD replaced the interpretation with a rule that set forth specific responsibilities for associated persons and member firms regarding the handling of associated person's private securities transactions. 13 The private securities transactions interpretation and rule were adopted and largely interpreted during a period when the regulated entities for which associated persons may have performed securities related functions were not as highly regulated as they are today. 14 For example, during this time, investment advisers were not registered with or regulated by most states and were examined less than once every 40 years by the SEC. 15
The NASD's private securities transactions interpretation and rule, and the NTMs addressing that interpretation and rule, do not on their face differentiate between private securities transactions executed pursuant to an associated person's employment with a regulated entity (e.g., a bank or registered investment adviser) and an unregulated entity (e.g., a hedge fund or a private, unregulated investment adviser), 16 nor have they been modified to acknowledge the modern reality that many of these entities are well supervised and regulated under other statutory regimes that now govern them. The purposes underlying the NASD's private securities transactions interpretation and rule (to fill the regulatory gap created when as associated person engages in securities transactions away from his or her member firm employer and to limit the possible liability of member firm employer and to limit the possible liability of member firms for the private securities transactions of their associated persons) are now nonexistent or greatly diminished. 17
The Text of 3040 and What It Literally Requires
NASD Conduct Rule 3040 generally provides that any person associated with (note that the Rule is not limited to registered personnel of a member firm) a NASD member firm who participates in a "private securities transaction," as defined under the Rule, must provide prior written notice to the member firm describing the proposed transaction and stating whether he or she will receive "selling compensation." 18 The NASD member firm then must state in writing whether it approves or disapproves of the proposed transaction. If the member firm approves and the associated person is to receive "selling compensation," as defined under the Rule, the member firm must record the transaction on its books and records and supervise the transaction as though the transaction were its own.
"Private securities transaction" is broadly defined as any securities transaction outside the regular course or scope of an associated person's employment with a member, including, but not limited to, new offerings of securities that are not registered with the SEC. 19 Excluded from the definition are transactions subject to NASD Conduct Rule 3050, transactions among immediate family members (as defined in IM-2110-1, the free-riding and withholding interpretation), for which no associated person receives any selling compensation, and personal transactions in investment company and variable annuity securities.
"Selling compensation" is defined as any compensation paid directly or indirectly from whatever source in connection with, or as a result of, the purchase or sale of a security, including, but not limited to:
- Commissions; ·
- Finder's fees; ·
- Securities or rights to acquire securities; ·
- Rights of participation in profits, tax benefits, or dissolution proceeds, as a general partner or otherwise; or ·
- Expense reimbursements. 20
Neither the federal securities laws nor NASDR rules, however, mandate the supervisory system or structure that a member must use. 21 Rather, each member firm can develop and implement its own supervisory system that is reasonably designed to detect and prevent violations. In this regard, no single document, combination of documents, or particular supervisory system is specifically required or necessarily adequate to comply with the requirements of Rule 3040.
However, the required level of recordkeeping and supervision should be, as in all other internal compliance system determinations, predicated on a risk-based analysis. Therefore, for example, thoroughly supervised and regulated entities should not present the same supervisory issues, as a private one-person advisory firm, hedge fund, or private placement management service.
NASDR Interpretations of 3040 and What They Purport to Require
The NASDR Staff previously has provided interpretive advice regarding how Conduct Rule 3040 applies in different factual situations.
If, however, an associated person participates in any manner in executing a private securities transaction (e.g., by placing a securities buy or sell order, or generally implementing a financial or asset allocation plan for an advisory client), NASD Conduct Rule 3040 will cover the transaction. 25
In NTM 94-44, the NASDR stated that Conduct Rule 3040 is triggered whenever an associated person participates in the execution of securities transactions such that his or her actions go beyond a mere recommendation. 26 For example, the conduct of an associated person who not only monitors an advisory client's account at another broker-dealer, but also calls the other firm to implement or execute trades, falls within the scope of Conduct Rule 3040. 27 In addition, Conduct Rule 3040 applies to an advisory person's discretionary purchase-and-sale transactions for advisory client accounts, even if the ultimate buy/sell order is sent to a common trading desk for routing to a broker-dealer for execution. In these circumstances, the Rule requires the associated person to give his or her employer member firm advance written notification and receive permission for each transaction. 28 If the associated person receives selling compensation for these activities, the member firm must satisfy the books and records and supervision requirements of Conduct Rule 3040.
The NASDR Staff defines "selling compensation" broadly to include the receipt of any item of value, whether to include the receipt of any item of value, whether directly or indirectly, from the execution of any securities transaction. 29 Specifically, in NTM 94-44, the NASD indicated that selling compensation includes any compensation that an associated person receives for participating in the execution of a securities transaction, including, but not limited to, ". . . asset-based management fees, wrap fees, hourly, yearly, or per plan fees." As interpreted by the NASD Staff, if an associated person participates in any manner in managing a discretionary advisory account and receives almost any form of payment, including an asset based fee or annual salary, the employer member firm will have to comply with the notice, approval, recordkeeping, and supervision requirements of Rule 3040.
NASDR has stated that the written notice and written approval required under Conduct Rule 3040 need not take any particular form. 30 In addition, NASDR has stated that an associated person of a member firm engaging in securities investment advisory services outside the scope of his or her employment with a member firm need not acquire the prior approval of his or her member firm employer for each securities transaction in which the associated person participates. The NASDR took this position because it was concerned that requiring prior written notice and permission for each such transaction would hinder the advice being provided. Instead, the associated person may give prior notice of the services to be performed for each customer and receive the member firm's permission, but need not give advance notice and receive permission for each transaction.
The NASDR also has addressed how the recordkeeping requirements of Conduct Rule 3040 apply to the outside investment advisory activities of associated persons of NASD member firms. In particular, the NASDR has stated that member firms may use any form of recordkeeping under Conduct Rule 3040 so long as the records permit the member firm to properly supervise the activities of its associated persons engaging in private securities transactions. The NASDR has, however, provided a rather detailed illustrative list of books and records a member firm may want to "consider" creating and keeping regarding the private securities transactions of its dual employees. 31
The NASDR Staff has orally indicated that in order for a member firm to meet its supervision and recordkeeping obligations under Conduct Rule 3040, the member firm must maintain its own system of books and records and policies and procedures regarding the private securities transactions of its associated persons. Generally, the NASDR Staff believes that it is not sufficient for a member firm to rely on the books and records of another entity, even a SEC-regulated investment adviser or banking institution regulated by a bank regulatory agency.
Conflict between NASDR Staff Interpretations of Definitions and Their Plain Meaning
The NASDR Staff's interpretation of the meaning of selling compensation (or transaction-based compensation) and execution has greatly expanded the reach and impact of Conduct Rule 3040. 32 It also conflicts (in many respects) with their well-settled meaning under the federal securities laws.
Transaction-based or selling compensation generally is understood to mean commissions or other fees that are based on the execution of securities transactions33 Transaction-based compensation generally is not understood to include advisory fees based on a percentage of assets under management. 34 This distinction in fee structure has historically differentiated broker-dealers from investment advisors. 35 The NASDR Staff's interpretation of selling compensation departs from the generally accepted principle that a fee, which is not based on the execution of a securities transaction (e.g., an asset-based fee), is not transaction-based compensation.
Equally unusual is the NASDR Staff's interpretation of what constitutes participation in the execution of a securities transaction. 36 As indicated previously, the NASDR Staff has stated that anything more than a mere recommendation may be interpreted by the Staff as participation in the execution of a securities transaction for purposes of Rule 3040. In most other contexts, however, participating in the execution of a securities transaction generally is understood to mean a more active participation in locating and negotiating with the counterparty to a securities transaction. 37 Providing investment advisory services-such as what securities to buy and sell and when to buy or sell them-generally is not considered to be "executing a securities transactions"-where the advisor places the client's trades through broker-dealer firms. Many investment advisers have trading desks to place orders for client accounts with broker-dealers, and yet these advisory firms have never been considered to be engaged in the business of effecting transactions in securities.
The NASDR Staff's interpretation that anything beyond providing a mere recommendation will constitute participating in the execution of a securities transaction conflicts with the NASDR's interpretation of its Series 55 registration category. NASD Membership and Registration Rule 1032(f) addresses the registration category for associated persons who execute equity securities transactions in the Nasdaq Stock Market and/or over-the counter (Series 55 registration category). In NTMs 00-46, the NASDR Staff indicated that persons that merely make trading decisions (i.e., decide what securities to buy or sell, when to buy or sell such securities, and how much to buy or sell) would not be subject to the Series 55 registration requirements because such persons are not involved in the execution of securities transactions. 38 Participating in the execution of securities transactions requires one to, at a minimum, locate the counterparty to a securities transaction and/or negotiate the terms of that transaction.
In one of the interpretive questions raised in NTMs 00-46, the NASDR Staff states that an investment adviser who determines what securities to buy and sell, including the quantity and price, and communicates that information to the traders on the firm's trading desk does not have to qualify as a Series 55 because he or she is not involved in executing a securities transaction. 39 Clearly, this interpretation appears to be at odds with the Staff's "mere recommendation" interpretation in the context of associated persons engaging in investment advisory services outside of their employment with their member firm employer. 40
Overlapping Jurisdiction and Conflict with Other Regulatory Regimes
The NASDR Staff's broad interpretation of Conduct Rule 3040 grants the SEC and the NASDR the power indirectly to regulate and supervise the securities activities of entities subject to other regulatory regimes. For example, this interpretation permits the NASDR to indirectly regulate the advisory business of investment advisers subject to regulation under the Investment Advisers Act of 1940 (Advisers Act) or the various state securities authorities. In addition, it permits the SEC and the NASDR to indirectly regulate the permissible securities activities of banks that meet the definition of bank under Section 3(a)(6) of the Securities Exchange Act of 1934 (Exchange Act).
This outcome has major repercussions for the division of supervisory and regulatory jurisdiction under the GLBA. Under the GLBA, insurance regulators are delegated the responsibility of regulating and supervising insurance companies and insurance agencies, banking regulators are supposed to regulate and supervise banks, and securities regulators are supposed to regulate and supervise broker-dealers and registered investment advisers. The NASDR Staff's broad interpretation of Conduct Rule 3040, however has the effect of making the SEC and the NASDR indirectly the "super-regulators" of the securities activities of all types of financial services firms, if they share dual employees with a broker-dealer.
In the GLBA, however, Congress preserved a bank's ability to engage in certain traditional bank securities activities under the supervision of the banking agencies-not under the supervision of the SEC or the NASDR. 41 The NASDR's broad interpretation of Conduct Rule 3040 purports to authorize the SEC and the NASDR to indirectly regulate these bank securities activities if a bank employs dually registered employees. Congress clearly did not intend for the SEC and the NASDR supervise bank permissible securities activities of dual bank employees through a NASDR rule. 42
Similarly, investment advisers are registered pursuant to and regulated under the Advisers Act and broker-dealers are registered pursuant to and regulated under the Exchange Act. This legislative mandate should not be transgressed by an interpretation of a self-regulatory organization (SRO) rule that overlays broker-dealer regulation on investment advisers when dual employees are used.
The NASDR's interoperation of Conduct Rule 3040 also has implications for established business relationships between US and non-US broker-dealers. In particular, the SEC in Rule 15a-6 43 and the SEC Staff in various no-action letters44 permit non-US registered broker-dealers to, among other things, effect transactions for US institutions through a US broker-dealer. The SEC permits the use of dual employees in these types of arrangements. 45 Neither Rule 15a-6 nor the Staff's no-action letters in this area, however, require the US member firm employer of the dual employee to supervise and record the securities activities that the dual employee effects outside the United States for its non-US registered broker-dealer employer. Rule 15a-6 specifies the level of supervision and recordkeeping required when a US broker-dealer "chaperones" a foreign broker-dealer's contact with US persons. Supervision and recordkeeping are required in respect of the chaperoned transactions under Rule 15a-6, but not the other non-chaperoned transactions of the foreign securities dealer, such as with non-US customers or with other US securities broker-dealers. The NASDR's interpretation of Rule 3040 effectively extends its regulatory authority overseas to non-US registered broker-dealers and banks.
Conclusion
The SEC's pending rulemaking on the bank exemptions from the definitions of broker and dealer has drawn the attention of Congress, the regulators, and the banking industry to the NASDR Staff's expansive interpretations of Conduct Rule 3040. If common sense prevails (by no means a certainty) the interpretation of the Rule will be returned to its text and original purpose of providing supervision to broker-dealer employees' securities activities conducted outside a regulated and supervised entity. That purpose is not furthered by doubling up with NASDR supervision of registered investment advisers, registered investment companies, banks and insurance companies, and foreign securities dealers that are already thoroughly regulated, supervised and examined by their primary regulators.
1 "Dual employees" are employees of a particular financial institution (e.g., a bank) who also are employed by another affiliated or unaffiliated entity (e.g., a broker-dealer, insurance agency, insurance company, or investment advisor). The dual employee functions as the single corporate contact for a customer and assumes different roles (e.g., trust department officer, registered representative, or investment advisor) relative to the service or product a customer is purchasing.
2 NASD Conduct Rule 3030 requires associated persons of a member firm to provide "prompt written notice" to their member firm employer before they accept employment or compensation for any outside business activity. Rule 3030 generally covers outside business activities that do not involve the associated person participating in the execution of securities transactions. Outside business activities that may be covered by Rule 3030 include, among other things, tax-planning services and selling non-securities insurance products. "Private securities transactions" covered by NASD Conduct Rule 3040 are specifically exempted from the requirements of Rule 3030. This memorandum will focus on NASD Conduct Rule 3040. Also of note in this area is NASD Conduct Rule 3050. Rule 3050 generally requires an executing broker-dealer to notify an employing broker-dealer of the opening of an account for the benefit of the associated person or over which the associated person has investment discretion (for example, an inter vivos trust that the associated person is a beneficiary of and over which he or she has investment discretion). At the employing broker-dealer's request, the executing broker must supply duplicate copies of confirmations, statements, or other information regarding the subject account.
3 See NASD NTMs 91-32, 94-44, and 96-33. See also NASD Interp. Letter of Aug. 4, 1997 (addressing the application of Rule 3040 to registered representatives of a distributor who also are employed by investment advisers to mange the portfolios of investment companies) and NASD Interp. Letter of Dec. 16, 1996 (addressing the applicability of NASD Rule 3040 to registered representatives of subsidiary bank of member broker-dealer). Available on the NASDR's Web site at www.nasdr.com/2910/3040_04.htm.
4 See generally Letter In Re: Chubb Securities Corporation (Nov. 24, 1993) (discussing use of dual employees in broker-dealer/financial institution networking arrangements); Letter In Re: First of American Brokerage Service, Inc. (Sept. 28, 1995) (discussing use of dual employees in broker-dealer/insurance agent networking arrangements); and Letter In Re: Securities Activities of US Affiliated Foreign Dealers (April 9, 1997) (footnote 5) (discussing the application of Rule 15a-6 (17 C.F.R. § 240.15a-6) to associated persons of foreign broker-dealers that are also registered representatives of a US registered broker-dealer).
5 "What's New in the Land of Regulation?," remarks by Acting Chairman Laura S. Unger, US Securities & Exchange Commission at "The SEC Speaks in 2001," sponsored by The Practicing Law Institute, Washington, DC (March 2, 2001). The GLBA, among other things, repealed or significantly amended various sections of the Exchange Act (e.g., Section 3(a)(4) and Section 3(a)(5)), the Banking Act of 1933 (e.g., Section 20 and Section 32 (Glass Steagall Act)), and the Bank Holding Company Act of 1956 (e.g., Section 4(c)(8)) that had separated the securities, insurance, and banking industries for most of the latter part of the 20th century.
6 See "Definition of Terms in and Specific Exemptions for Banks, Savings Associations, and Savings Banks under Sections 3(a)(4) and 3(a)(5) of the Securities Exchange Act of 1934," Exchange Act Release No. 44291 (May 11, 2001) [66 Fed. Reg. 27760, 27786 through 27788 (May 18, 2001)]. See also Comment Letter on Interim Final Rules from Federal Reserve, OCC, and FDIC (June 29, 1002).
7 Other self-regulatory organizations also have rules addressing the outside business activities of associated persons of securities firms. See, e.g., NYSE Rule 346 and Rule 407.
8 See NASD NTM 85-84 (citing Article III, Section 27 of the NASD Rules-"Private Securities Transactions.") See also Securities Exchange Act Release No. 11897 (December 3, 1975) [40 Fed. Reg. 57735].
9 See NASD NTM 85-54.
10 Id. This concern may stem from a broker-dealer's statutory obligation to supervise its associated persons. See 15 U.S.C. § 78o(b) (2001). Section 78o(b) provides:
(4) The Commission, by order, shall censure, place limitations on the activities, functions, or operations of, suspend for a period not exceeding twelve months, or evoke the registration of any broker or dealer if it finds . . . that such broker or dealer . . . (E) has willfully aided, abetted, counseled, commanded, induced, or procured the violation by any other person or any provision of the Securities Act of 1933, the Investment Advisers Act of 1940 . . . this title the rules or regulations under any of such statutes . . . or has failed reasonably to supervise, with a view to preventing violations of the provisions of such statutes, rules, and regulations, another person who commits such a violation, if such other person is subject to his supervision. (Emphasis added.). . . .15 U.S.C. § 78o(b)(6) incorporates 15 U.S.C. § 78o(b)(4)(E) by reference and authorizes the SEC to impose similar sanctions against individuals for failure reasonably to supervise individuals associated with broker-dealers. Unfortunately, Congress did not specify what it meant by the phrase "subject to the supervision." The statutory language by its terms is not limited to supervising an associated person's activities done on behalf of, or for the benefit of, the broker-dealer. id. See generally John H. Walsh, "Right the First Time: Regulation, Quality, and Preventive Compliance in the Securities Industry," 1997 Colum. Bus. L. Rev. 165 (generally discussing the evolution of the duty to supervise). Of course, registered investment advisers and banks are also subject to various forms of regulatory oversight, including a duty to supervise their employees. See, e.g., Investment Advisers Act of 1940 §§ 203(e)(5) and 204A and In the Matter of Justin Federman Stone, 41 S.E.C. 717, 721-722 (1963) (adjudicated opinion of the SEC). See generally David B. Fischer, Comment, "Bank Director Liability under FIRREA: A New Defense for Directors and Officers of Insolvent Depository Institutions-or a Tighter Noose?," 39 UCLA L. Rev. 1703, 1712-1740 (1992); 12 C.F.R. § 12.7(a)(1) (2001). In addition, common law agency principals, such as respondeat superior, may have been the genesis of this concern. Generally, however, principals are not liable for the actions of their agents when done outside of the scope of their employment. See, e.g., Shell Petroleum Corporation v. Magnolia Pipe Line Co., 85 S.W.2d 829, 832 (July 10, 1935).
11 See NASD NTM 85-84 and Securities Exchange Act Release No. 22617 (Nov. 12, 1985).
12 See Private Securities Transactions Interpretation under Article III, Section 27 (attached as Exhibit 2 to NTM 85-54).
13 See NASD NTM 85-84 and Securities Exchange Act Release No. 22617 (Nov. 12, 1985).
14See generally, Securities Exchange Act Release No. 11897 (December 3, 1975) [40 Fed. Reg. 57735]. The NASD changed the interpretation to a rule in the mid-1980s (see e.g., NASD NTMs 85-21 and 85-84) and provided various forms of interpretive guidance during the mid-1990s (see, e.g., NASD NTMs 94-44 and 96-33).
15 See Testimony of Arthur Levitt, Chairman, SEC, Concerning S. 1815, the "Securities Investment Promotion Act of 1996." Hearing before the Senate Comm. on Banking, Housing, and Urban Affairs (June 5, 1996). See also National Securities Markets Improvement Act of 1996, Pub. L. No. 104-290, 110 Stat. 3416 (1996) (dividing the regulation of investment advisers between the SEC and state securities regulators).
16 See, e.g., NASD NTMs 85-21, 85-54, 85-84, 91-32, 94-44, and 96-33.
17See generally Susan Rogers Finneran, "Investment Advisory Regulatory Muddy Waters: Registration and Control Issues Are Confused with Issues of Disclosure and Anti-Fraud," 19 Campbell L. Rev. 349 (Spring 1997). This interpretation is bolstered by a review of the NASD enforcement actions brought under Conduct Rule 3040. The vast majority of such enforcement actions address associated persons who sell unauthorized securities products to the clients of the associated person's member firm employer, or address situations in which an associated person establishes an unregulated enterprise to engage in private securities transactions. See, e.g., Securities exchange Act Release No. 25467, In the Matter of Allen S. Klosowski (March 15, 1988); Securities Exchange Act Release No. 16597, In the Matter of Richard L. Robinson (Feb. 21, 19980); and Securities Exchange Act Release No. 17381, In the Matter of Eugene T. Ichinose, Jr. (Dec. 16, 1980).
18 NASD Conduct Rule 3040.
19 NASD Conduct Rule 3040(e)(1). See also NASD NTM 91-32, 94-44, and 96-33.
20NASD Conduct Rule 3040(e)(2). See also NASD NTM 91-32 (compensation arrangements for activities of registered representatives).
21 See NASD Conduct Rule 3040. See also NASD NTM 96-33 (providing an illustrative list of the types of general documents a member firm should consider generating and retaining regarding the private securities transactions of its associated persons). See also infra n.31 (listing documents mentioned in NTM 96-33).
22 See, e.g., NASD Interp. Letter of Aug. 4, 1997 (addressing the application of Rule 3040 to registered representatives of a distributor who also are employed by investment advisers to manage the portfolios of investment companies) and NASD Interp. Letter or Dec. 16, 1996 (addressing the applicability of NASD Rules to registered representatives of subsidiary bank of member broker/dealer).
23 See generally NASD NTMs 91-32, 94-44, and 96-33.
24 See NASD NTM 94-44. See supra n.1 for discussion of NASD Conduct Rule 3030.
25 See generally NASD NTMs 91-32, 94-44, and 96-33.
26 According to NASD NTMs 94-44 and 96-33 arrangements under which an account is "handed off" to a third-party adviser who makes all investment decisions are excluded from the coverage of Conduct Rule 3040.
27 See NASD NTM 94-44.
28 The NASD, however, has stated that an associated person who engages in outside investment advisory services need not provide prior notice for each transaction; rather, he or she may provide a single notice covering each of his or her clients. See NASD NTMs 96-33. Question 1.
29 See NASD NTM 94-44.
30 See NASD NTM 96-33.
31 Id.. The list includes the following items: (1) dated notifications from the associated person detailing the services to be performed by the associated person and the identity of each associated person customer serviced at another firm in a private securities transaction; (2) dated response from the NASD member to the associated person acknowledging and approving or disapproving the associated person's intended activities; (3) a list of associated persons who also are investment advisers or investment adviser agents; (4) a list of associated persons approved to engage in private securities transactions; (5) a list of associated person customers, including those that are customers of both the member firm and the associated person, with a cross reference to the associated person; (6) copies of customer account opening cards to determine, among other things, suitability; (7) copies of discretionary account agreements; (8) duplicate confirmation statements; (9) duplicate customer account statements; (10) a correspondence file for associated person customers; (11) investment advisory agreements between the associated person's investment adviser employer and each advisory client; (12) advertising materials and sales literature used by the associated person's investment adviser employer to promote investment advisory services wherein the associated person holds himself or herself out as a broker-dealer, complemented by a process that shows whether proper filings have been made at the NASD and whether the associated person is using any electronic means, such as the Internet, to advertise services or correspond with customers; (13) exception reports, where feasible, based on various occurrences or patterns of specified activity, such as frequency of trading, high compensation arrangements, large numbers of trade corrections, and cancelled trades; and (14) supervisory procedures designed to meet the requirements of Conduct Rule 3040. The procedures may include such items as the identity of persons responsible for Conduct Rule 3040 compliance, the recordkeeping system to be used and followed, and memoranda or compliance manuals that notify associated persons of the member's procedural requirements for Conduct Rule 3040 compliance.
32 NASD NTMs 91-32 and 94-44.
33 See "Compliance Guide to the Registration of Brokers and Dealers," Division of Market Regulation, SEC at 3 (Oct. 1998) (available at www.sec.gov/division/marketreg/bdguide.htm). See generally Letter In Re: 1st Global, Inc. (May 7, 2001); Letter In Re: BondGlobe (Feb. 6, 2001); Letter In Re: MuniAction (March 13, 2000); Letter In Re: John Wirthlin (Jan. 19, 1999); Letter In Re: Charles Schwab & Co., Inc. (Sept. 18, 1997); John Polanin, "The 'Finder' Exception from Federal Broker-Dealer Registration," 40 Cath. U. L. Rev. 787 (Summer 1991); Steven Lofchi, "A Guide to Broker-Dealer Regulation" at 24 (Compliance Int'l 2000; and 15 David A. Lipton, Broker-Dealer Regulation § 1.04[3][a] West 2000).
34 See generally Letter In Re: Portico funds, Inc. (April 11, 1996). See also Securities Exchange Act Release No. 42099, "Certain Broker-Dealer deemed Not to Be Investment Advisers" (Nov. 4, 1999) and "Definition of Terms in and Specific Exemptions for Banks, Savings Associations, and Savings Banks under Section 3(a)(4) and 3(a)(5) of the Securities Exchange Act of 1934," Exchange Act Release No. 44291 (May 11, 2001). Indeed, the "fiduciary" exemption for banks from broker-dealer regulation incorporates the concept that asset-based advisory fees are not transaction-related compensation. See § 3(a)(4)(B)(ii) of the Exchange Act.
35 Speech by SEC Staff: "Remarks before the ABA Trust, Asset Management, and Marketing Conference" by Robert L.D. Colby Deputy Director, Division of Market Regulation US Securities & Exchange Commission January 31, 2001. Available on the SEC's Web site at www.sec.gov/news/speech/spch461.htm.
36 See NASD NTM 94-44.
37 See, e.g., NASD Membership and Registration Rule 1032(f) and NASD NTM 00-46.
38 NASD NTM 00-46.
39 Id. at Question 4.
40See NASD NTM 94-44.
41 See e.g., Senate Committee on Banking, Housing, and Urban Affairs Report on S. 900, Financial Services Modernization Act of 1999 (Rpt. No. 106-44).
42Congress' intent to not permit SRO rules to trump the push-out provisions of Title II of the GLBA is clearly illustrated by the Conference Committee Report, which states:
The Conferees provided for an exemption for networking arrangements between banks and brokers. Revisions to Rule 1060 recently approved by the national Association of Securities Dealers (NASD) are in conflict with this provision. As a consequence, revisions to the rule should be made to exempt banks and their employees from the provisions' coverage.43 17 C.F.R. § 240.15a-6 (2001). See also Registration Requirements for Foreign Broker-Dealers, Exchange Act Release No. 27017 (July 11, 1989).
44 Letter In Re: Certain Securities Activities for US Affiliated Foreign Dealers (April 9, 1997).
45 Id. at n.5. David F. Freeman is a partner, and Kevin A. Zambrowicz is an associate, at Arnold & Porter in Washington, DC. Mr. Zambrowicz served as Special Counsel in the office of Chief Counsel, Division of Market Regulation of the US Securities and Exchange Commission from 1997 to November 2000. The views expressed in the article do not represent the views of the Commission or the Staff of the Commission.
