[Federal Register Volume 62, Number 234 (Friday, December 5, 1997)]
[Notices]
[Pages 64422-64428]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 97-31846]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-39361; File No. SR-NASD-97-69]


Self-Regulatory Organizations; Notice of Filing of Proposed Rule 
Change by the National Association of Securities Dealers, Inc. Relating 
to Tape Recording of Conversations

November 26, 1997.
    Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 
(``Act''),\1\ notice is hereby given that on September 12, 1997, as 
amended on November 17, 1997,\2\ NASD Regulation, Inc. (``NASD 
Regulation'') filed with the Securities and Exchange Commission 
(``SEC'' or ``Commission'') the proposed Rule change as described in 
Items I, II, and III below, which Items have been prepared by NASD 
Regulation. The Commission is publishing this notice to solicit 
comments on the proposed Rule change from interested persons.
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    \1\ 15 U.S.C. Sec. 78s(b)(1).
    \2\ On November 17, 1997, NASD Regulation filed Amendment No. 1 
with the Commission. In Amendment No. 1, the NASD clarified that 
firms will be required to establish procedures required by the Rule 
when either information supplied by NASD Regulation or the firm's 
actual knowledge indicates that it is the subject of the Rule, and 
added a new provision defining the term, ``registered person,'' and 
moving the definition of a ``disciplined firm'' to a different 
location in the Rule for ease of reference. See Letter from Mary N. 
Revell, Associate General Counsel, NASD, to Katherine A. England, 
Assistant Director, Office of Market Supervision, Division of Market 
Regulation (November 17, 1997).
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I. Self-Regulatory Organization's Statement of the Terms of Substance 
of the Proposed Rule Change

    NASD Regulation is proposing to amend National Association of 
Securities Dealers, Inc. (``NASD'' or ``Association'') Rule 3010 to 
require tape recording of conversations where members hire more than a 
specified percentage of registered persons from certain firms that have 
been expelled or

[[Page 64423]]

that have had their broker/dealer registrations revoked for egregious 
violations of sales practice Rules. The proposed Rule change also 
includes a conforming Rule change to Rule 9610. Below is the text of 
the proposed Rule change. Proposed new language is in italics.

Conduct Rules

Rule 3010. Supervision

    (a) No change

(b) Written Procedures

    (1) Each member shall establish, maintain, and enforce written 
procedures to supervise the types of business in which it engages and 
to supervise the activities of registered representatives and 
associated persons that are reasonably designed to achieve compliance 
with applicable securities laws and regulations, and with the 
applicable rules of this Association.
    (2) Tape recording of conversations
    (i) Each member that either is notified by NASD Regulation or 
otherwise has actual knowledge that it meets one of the criteria in 
paragraph (b)(2)(viii) relating to the employment history of its 
registered persons at a Disciplined Firm as defined in paragraph 
(b)(2)(x), shall establish, maintain, and enforce special written 
procedures for supervising the telemarketing activities of all of its 
registered representatives.
    (ii) The member must establish the supervisory procedures required 
by this paragraph within 30 days of receiving notice from NASD 
Regulation or obtaining actual knowledge that it is subject to the 
provisions of this paragraph.
    (iii) The procedures required by this paragraph shall include tape-
recording all telephone conversations between the member's registered 
representatives and both existing and potential customers.
    (iv) The member shall establish reasonable procedures for reviewing 
the tape recordings made pursuant to the requirements of this paragraph 
to ensure compliance with applicable securities laws and regulations 
and applicable rules of this Association. The procedures must be 
appropriate for the member's business, size, structure, and customers.
    (v) All tape recordings made pursuant to the requirements of this 
paragraph shall be retained for a period of not less than three years 
from the date the tape was created, the first two years in an easily 
accessible place. Each member shall catalog the retained tapes by 
registered representative and date.
    (vi) Such procedures shall be maintained for a period of two years 
from the date that the member establishes the procedures required by 
the provisions of this paragraph.
    (vii) By the 30th day of the month following the end of each 
calendar quarter, each member firm subject to the requirements of this 
paragraph shall submit to the Association a report on the member's 
supervision of the telemarketing activities of its registered 
representatives.
    (viii) The following members shall be required to adopt special 
supervisory procedures over the telemarketing activities of their 
registered representatives:
    * A firm with at least five but fewer than ten registered persons, 
where 40% or more of its registered persons have been employed by one 
or more Disciplined Firms within the last two years;
    * A firm with at least ten but fewer then twenty registered 
persons, where four or more of its registered persons have been 
employed by one or more Disciplined Firms within the last two years;
    * A firm with at least twenty registered persons, where 20% or more 
of its registered persons have been employed by one or more Disciplined 
Firms within the last two years.
    (ix) For purposes of this Rule, the term ``registered person'' 
means any person registered with the Association as a representative, 
principal, or assistant representative pursuant to Rule 1020, 1030, 
1040, and 1110 Series.
    (x) For purposes of this Rule, the term ``disciplined firm'' means 
a member that, in connection with sales practices involving the 
officer, purchase, or sale of any security, has been expelled from 
membership or participation in any securities industry self-regulatory 
organization or its subject to an order of the Securities and Exchange 
Commission revoking its registration as a broker/dealer.
    (xi) Pursuant to the Rule 9600 Series, the Association may exempt 
any member from the requirements of this paragraph unconditionally or 
on specified terms and conditions upon a satisfactory showing that the 
member's supervisory procedures ensure compliance with applicable 
securities laws and regulations and applicable rules of the 
Association.
    (3) The member's written supervisory procedures shall set forth the 
supervisory system established by the member pursuant to Rule 3010(a) 
above, and shall include the titles, registration status and locations 
of the required supervisory personnel and the responsibilities of each 
supervisory person as these relate to the types of business engaged in, 
applicable securities laws and regulations, and the rules of this 
Association. The member shall maintain on an internal record the names 
of all persons who are designated as supervisory personnel and the 
dates for which such designation is or was effective. Such record shall 
be preserved by the member for a period of not less than three years, 
the first two years in an easily accessible place.
    (4) A copy of member's written supervisory procedures, or the 
relevant portions thereof, shall be kept and maintained in each OSJ and 
at each location where supervisory activities are conducted on behalf 
of the member. Each member shall amend its written supervisory 
procedures as appropriate within a reasonable time after changes occur 
in applicable securities laws and regulations including the rules of 
this Association, and as changes occur in its supervisory system, and 
each member shall be responsible for communicating amendments through 
its organization.
    (c) through (f) No change

(g) Definitions

    (1) through (3) No change
* * * * *

Rule 9600. Procedures for Exemptions

Rule 9610. Application

    (a) File With General Counsel
    A member seeking an exemption from Rule 1021, 1022, 1070, 2210, 
2340, 2520, 2710, 2720, 2810, 2850, 2851, 2860, Interpretive Material 
2860-1, 3010, 3350, 11870, or 11900, Interpretive Material 2110-1, or 
Rule G-37 shall file a written application with the Office of General 
Counsel of NASD Regulation.
* * * * *

II. Self-Regulatory Organization's Statement of the Purpose of, and 
Statutory Basis for, the Proposed Rule Change

    In its filing with the Commission, NASD Regulation included 
statements concerning the purpose of, and basis for, the proposed Rule 
change and discussed any comments it received on the proposed Rule 
change. The text of these statements may be examined at the places 
specified in Item IV below. NASD Regulation has prepared summaries, set 
forth in Sections A, B, and C below, of the most significant aspects of 
such statements.

[[Page 64424]]

(A) Self-Regulatory Organization's Statement of the Purpose of, and the 
Statutory Basis for, the Proposed Rule Change

Background
    At its meeting in July 1996, the NASD Regulation Board of Directors 
authorized the staff to issue a Notice to Members soliciting comment on 
proposed changes to NASD supervisory Rule 3010 to require the tape-
recording of telephone conversations of registered representatives in 
certain circumstances. The original Rule was developed both to respond 
to concerns expressed in the Joint Regulatory Sales Practice Sweep 
(``Sweep'') Report \3\ regarding the need for heightened supervision of 
certain registered representatives with troubled regulatory and 
compliance records and also to address the particular problems that 
occur when a firm hires a large number of individuals who formerly 
worked at a firm that has been expelled or has had its registration 
revoked in connection with sales practice violations (a ``Disciplined 
Firm'') where they were inadequately supervised and trained.
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    \3\ Staffs of the NASD, New York Stock Exchange, North American 
Securities Administrators Association, and the Office of Compliance 
Inspections and Examinations, SEC, Joint Regulatory Sales Practice 
Sweep: A Review of the Sales Practice Activities of Selected 
Registered Representatives and the Hiring, Retention, and 
Supervisory Practices of the Brokerage Firms Employing Them (March 
1996).
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    The Sweep was an initiative involving the staffs of the NASD, the 
SEC, the New York Stock Exchange, and representatives of the North 
American Securities Administrators Association (collectively, the 
``Working Group'') to review the sales-practice activities of selected 
registered representatives and the hiring, retention, and supervisory 
practices of the brokerage firms employing them in order to identify 
possible problem registered representatives, review their sales 
practices, and assess whether adequate hiring, retention, and 
supervisory mechanisms are in place.\4\ The Sweep Report was released 
on March 18, 1996.
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    \4\ Id. at i.
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    One of the key findings of the Sweep Report was that some firms are 
willing to employ registered representatives with a history of 
disciplinary actions or customer complaints. Based on this finding, the 
Working Group collectively recommended that firms that hire registered 
representatives with a recent disciplinary history involving sales 
practice abuse or other customer harm should implement special 
supervisory procedures tailored to the individual registered 
representative, which include a heightened level of scrutiny of the 
registered representative's activities by his or her supervisor, for a 
period of time.\5\ The Sweep Report recommended that, if firms fail to 
establish such special supervisory procedures, the self-regulatory 
organizations (``SROs'') should consider revising their rules to 
specifically require that registered representatives with a recent 
history of disciplinary actions involving sales practice abuse or other 
customer harm be placed under special supervision by the firm for a 
period of time.
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    \5\ Id. at ii, iv.
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    The NASD and the NYSE have issued a memorandum discussing the Sweep 
Report and providing guidance on actions firms could take to provide 
heightened supervision of problem registered representatives.\6\ While 
the special procedures designed to provide a heightened level of 
supervision recommended by the Sweep Report and described in the NASD/
NYSE memorandum may provide adequate supervision of associated persons 
in most circumstances, NASD Regulation proposes to adopt specific 
procedures in certain situations in order to provide the level of 
supervision required by Rule 3010.
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    \6\ NASD Notice to Members 97-19 (April 1997); NYSE Information 
Memo 97-20 (April 15, 1997).
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    NASD Regulation proposes to amend NASD Rule 3010 to require firms 
that hire a specified number of individuals from Disciplined Firms to 
tape-record telephone conversations between their registered 
representatives and existing and potential customers. The proposed Rule 
would apply when a firm hires a substantial number of registered 
persons from a firm or firms that have been expelled or had their 
registrations revoked for sales practice abuse. The measures described 
by the rule are designed to prevent a reoccurrence of sales practice 
abuse or other customer harm that caused the Disciplined Firm to be 
expelled or have its registration revoked. The proposal is similar to 
an interpretation adopted by the National Futures Association (``NFA'') 
in 1993 to combat abusive cold calling.\7\ The NFA's interpretation is 
discussed below.
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    \7\ See Letter from Lynn K. Gilbert, Deputy Director, Commodity 
Futures Trading Commission, to Daniel J. Roth, General Counsel, NFA 
(January 19, 1993).
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Notice to Members 96-59 and Original Proposal
    Notice to Members 96-59 (``Notice to Members''), containing the 
original proposed Rule (``original proposal'' or ``original Rule''), 
was issued in September 1996. The requirements of the original Rule 
would have been triggered whenever a significant portion of a member's 
work force was comprised of associated persons who formerly were 
employed by a Disciplined Firm or firms or when the firm itself was a 
Disciplined Firm. The original proposal defined a Disciplined Firm, for 
purposes of the Rule, as one that had been disciplined (i.e., expelled, 
suspended, or enjoined) by a regulatory entity, an SRO, or a court 
within the previous five years for telemarketing or sales-practice 
abuses in connection with the solicitation, offer, or sale of 
securities.
    Under the original proposal as described in the Notice to Members, 
if more than 20 percent of a member's sales force of associated persons 
previously were employed by a Disciplined Firm, the member would have 
been required to adopt special written procedures to supervise the 
telemarketing activities of its associated persons. Firms that were 
themselves Disciplined Firms also would have been required to adopt 
these procedures. The procedures would have required, at a minimum, 
that the employer member tape record all telephone conversations 
between all of its associated persons and both existing and potential 
customers, and maintain these procedures for two years. For each firm 
that was itself a Disciplined Firm, at the end of the two-year period, 
the NASD would have conducted an evaluation to determine whether, and 
for how long, the firm would continue to be subject to the requirements 
of the Rule. The Rule also would have required firms subject to the 
taping requirement to review the tapes periodically to ensure 
compliance with securities laws and NASD rules, to submit reports to 
the NASD on their supervision of telemarketing activities, and to 
retain and index the tapes.
Comments and Response
    Comments on the proposed Rule were requested by October 31, 1996. 
Of the 42 comments received in response to the Notice to Members, 39 
were opposed to the proposal, including those filed by the Securities 
Industry Association, Lehman Brothers, Merrill Lynch, Morgan Stanley, 
and Smith Barney.\8\

[[Page 64425]]

Most of the commenters support what they see as NASD Regulation's 
objective in proposing the taping Rule and agree that something should 
be done to deter a firm from recruiting groups of registered persons of 
dubious ethics or training from a Disciplined Firm. They also agree 
that firms and registered persons who have engaged in sales practice 
abuses should be disciplined. However, they don't agree with the 
proposal contained in the Notice to Members and have raised a number of 
concerns. Many of the commenters object to the concept of taping as a 
regulatory requirement, and fear that requiring taping in the 
circumstances described in the proposed Rule is the beginning of a new 
regulatory regime that may require even more comprehensive taping.
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    \8\ NASD Regulation received the following comment letters: (1) 
Letter from Brian C. Underwood, A.G. Edwards & Sons, Inc. 
(``Edwards''), dated October 31, 1996; (2) Letter from Kevin P. 
Howe, American Express Financial Advisors (``AEFA''), dated October 
31, 1996; (3) Letter from G. Thomas Mitchell, Aurora Insurance and 
Securities, Inc. (``Aurora''), dated October 10, 1996; (4) Letter 
from Jerome Snyder, Barington Capital Group, L.P. (``Barington''), 
dated October 23, 1996; (5) Letter from Leslie D. Smith, Berthel 
Fisher Company (``Berthel''), dated October 25, 1996; (6) Letter 
from Walter I. Miller, Capital Growth Planning, Inc. (``Capital''), 
dated September 24, 1996; (7) Letter from Sanford D. Greenberg, 
Chatfield Dean & Co. (``Chatfield Dean''), dated October 31, 1996; 
(8) Letter from Neil Lawrence Lane, Citicorp Investment Services 
(``CIS''), dated October 31, 1996; (9) Letter from David J. Master, 
Coastal Securities (``Coastal''), dated October 31, 1996; (10) 
Letter from John Polanin, Jr., Cowen & Company (``Cowen''), dated 
November 7, 1996; (11) Letter from Richard L. Sandow, Cullum & 
Sandow Securities, Inc. (``Cullum''), dated October 17, 1996; (12) 
Letter from Gregg Thaler, Duke & Company, Inc. (``Duke I''), dated 
October 10, 1996; (13) Letter from William Rotholz, Duke & Company, 
Inc. (``Duke II''), dated October 29, 1996; (14) Letter from Shannon 
Braymen, Duncan-Smith Securities, Inc. (``Duncan-Smith''), dated 
October 22, 1996; (15) Letter from James H. Pyle et al., E.E. Powell 
& Company, Inc., dated October 21, 1996; (16) Letter from Nancy K. 
Port, Equity Services, Inc. (``ESI''), dated October 30, 1996; (17) 
Letter from Rick Fetterman, Fetterman Investments, Inc., dated 
October 1, 1996; (18) Letter from Herbert O. Sontz, GKN Securities 
(``GKN''), dated October 31, 1996; (19) Letter from Lawrence E. 
Wesneski, Hoak Breedlove Wesneski & Co. (``Hoak''), dated October 
21, 1996; (20) Letter from Cabell B. Birdsong, Investors Security 
Company, Inc. (``ISC''), dated October 22, 1996; (21) Letter from 
David A. Rich, Jefferies & Company, Inc., dated November 8, 1996; 
(22) Letter from Thomas P. Koutris, John Hancock Distributors, Inc., 
dated September 23, 1996; (23) Letter from A.E. Monahan, Keystone 
Capital Corporation (``Keystone''), dated October 7, 1996; (24) 
Letter from Paul B. Uhlenhop, Lawrence, Kamin, Saunders & Uhlenhop 
(``Lawrence, Kamin''), dated October 29, 1996; (25) Letter from 
Kathryn S. Reimann, Lehman Brothers Inc. (``Lehman''), dated October 
31, 1996; (26) Letter from Kenneth S. Spirer, Merrill Lynch, Pierce, 
Fenner & Smith (``Merrill Lynch''), dated November 14, 1996; (27) 
Letter from Jack G. Levin, Montgomery Securities (``Montgomery''), 
dated January 16, 1997; (28) Letter from Frederick W. Bogdan, Morgan 
Stanley & Co., Incorporated (``Morgan Stanley''), dated October 30, 
1996; (29) Letter from Dennis S. Kaminski, Mutual Service 
Corporation (``MSC''), dated October 29, 1996; (30) Letter from 
Richard Berenger, Nathan & Lewis Securities, Inc. (``Nathan & 
Lewis''), dated October 18, 1996; (31) Letter from Douglas L. 
Dunahay, Neidiger/Tucker/Bruner Inc. (``Neidiger''), dated October 
29, 1996; (32) Letter from Edward T. Borer, Philadelphia Corporation 
(``PC''), dated October 17, 1996; (33) Letter from Michael 
Flannigan, Protective Group Securities Corporation (``PGSC''), dated 
September 24, 1996; (34) Letter from Robert A. Fitzner, Jr., RAF 
Financial Corporation (``RAF''), dated October 29, 1996; (35) Letter 
from Glen F. Hackmann, Robert W. Baird & Co., Incorporated 
(``Baird''), dated October 31, 1996; (36) Letter from Douglas F. 
Schofield, Schofield Investments, Inc., dated September 18, 1996; 
(37) Letter from Richard O. Scribner, Allen B. Holeman, and C. Evan 
Stewart, Securities Industry Association (``SIA''), dated November 
4, 1996; (38) Letter from Dov S. Schecter, Smith Barney Inc. 
(``Smith Barney''), dated October 31, 1996; (39) Letter from Patrick 
G. Haayes, Stratton Oakmont, Inc. (``Stratton''), dated October 30, 
1996; (40) Letter from Walter H. Schlobohm, dated February 10, 1997; 
(41) Letter from John Maceranka, The Windmill Group, Inc., dated 
September 28, 1996; and (42) Letter from Stanley J. Allen Jr., Yee, 
Desmond, Schroeder & Allen, Inc. (``Yee''), dated October 28, 1996.
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    The definition of Disciplined Firm is too broad: Many of the 
commenters believe the definition of Disciplined Firm in the original 
Rule was too broad because it did not take into account the nature of 
the event that led to the disciplinary problem.\9\ For example, a firm 
could be included in the definition because of an injunction resulting 
from a technical or inadvertent violation of state law or as the result 
of a consensual injunction involving only a fraction of the firm's 
employees or business activities. One commenter believes that the 
definition should be limited to firms that have been permanently barred 
from the securities industry due to telemarketing or sales practice 
abuses.\10\
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    \9\ See, e.g., letters from Edwards, Coastal, Cullum, ESI, 
Keystone, Lehman, Montgomery, Morgan Stanley, and Baird.
    \10\ See letter from Smith, Barney.
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    In response, the definition has been revised to include only firms 
that have been expelled from membership in a securities industry SRO or 
that have had their registration as a broker/dealer revoked by the SEC 
in connection with sales practice violations.
    The Rule is too broad: Commenters believe the original Rule was too 
broad in several respects.\11\ First, they believe that the Rule would 
unfairly punish firms and individuals with good disciplinary and 
compliance records for actions of others of which they have no 
knowledge and over which they have no control.\12\ Second, they believe 
the Rule should apply only to persons who were employed by a 
Disciplined Firm at the time of the disciplinary event or within a 
specified time prior to the event.\13\ Finally, commenters believe that 
the Rule should apply only to personnel who have sales contact with 
customers (i.e., registered representatives) and that clerical and 
ministerial employees, who have no opportunity for sales practice 
abuse, should be excluded from both the 20% calculation and from the 
taping requirement.\14\
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    \11\ See, e.g., letters from Edwards, Aurora, Barington, 
Chatfield Dean, CIS, Coastal, Cullum, Duke II, ESI, ISC, Lehman, 
Morgan Stanley, Nathan & Lewis, PC, PGSC, RAF, Baird, Smith Barney, 
SIA, and Stratton.
    \12\ See, e.g., letters from Lehman and Morgan Stanley.
    \13\ See, e.g., letters from Edwards, Morgan Stanley, Nathan & 
Lewis, PC, SIA, and Stratton.
    \14\ See, e.g., letters from Edwards, Barington, Chatfield Dean, 
Cullum, Duke II, ESI, ISC, Morgan Stanley, Baird, and Stratton.
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    NASD Regulation has responded to these comments in two ways. First, 
the Rule has been revised to apply only to firms that hire a specified 
percentage of individuals who were employed at a Disciplined Firm 
within the last two years. Second, only registered persons, and not 
other employees, would be counted in determining whether the firm meets 
the percentage criterion for triggering the taping obligation. Third, 
only sales personnel would be subject to the taping requirement, since 
sales activities and contacts with customers or potential customers are 
the focus of this Rule. Thus, there is no reason to include back office 
personnel in either the percentage calculation or to require taping of 
their conversations.
    The Rule does not achieve the stated purpose: The Notice to Members 
soliciting comment on the original proposal states that the purpose of 
the original proposed Rule is to respond to the Sweep Report 
recommendation that firms should adopt heightened supervisory 
procedures tailored to individual registered representatives with 
troubled regulatory and compliance records. Some of the commenters 
believe that the original Rule goes beyond the scope of the Sweep 
Report, and that it will not be effective in achieving the Sweep Report 
goal difficulties a firm would encounter when attempting to obtain the 
information that would be required to comply with the Rule.
    NASD Regulation believes that the narrower focus of the Rule will 
result in lower compliance costs, at least for the industry as a whole. 
First, fewer firms will meet the criteria in the Rule and will be 
subject to the requirement, and costs, of tape recording conversations. 
Also, the Rule has been revised to utilize a tiered structure of 
determining whether a firm must comply with the Rule, with a higher 
permissible percentage of registered persons from Disciplined Firms 
being applied to smaller firms; this should result in a more equitable 
impact on small firms. Finally, with respect to the practical 
compliance difficulties raised by the Advisory Council, the NASD 
Regulation staff has spent a significant amount of time since the 
comment period closed in October responding to this issue and devising 
methods whereby NASD Regulation can reduce the difficulties and costs 
of compliance. As a result of

[[Page 64426]]

research, NASD Regulation staff believes that it can assist firms by 
providing them with all the relevant information they require to 
determine whether they are in compliance with the Rule. However, 
comment is specifically requested on the cost of compliance with the 
Rule.
    Privacy concerns: Many commenters stated that the Rule would result 
in an invasion of the privacy of both a firm's customers as well as the 
firm's associated persons, which would be especially unfair both to 
firms and associated persons that do not have disciplinary histories. 
Commenters also believe that the Rule would conflict with federal and 
state wiretapping laws. Finally, they are concerned that the Rule does 
not restrict the accessibility and appropriate use of heightened 
supervision because taping is not an effective means to supervise sales 
personnel.\15\
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    \15\ See, e.g., letters from CIS, Duke II, ESI, Lehman, Merrill 
Lynch, MSC, Nathan & Lewis, and SIA.
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    In response, NASD Regulation believes that restricting application 
of the Rule to only the most egregious situations, i.e., employees who 
formerly were employed at firms that were expelled from the industry, 
addresses some of these concerns. Also, NASD Regulation believes that 
the in terrorem effect of tape recording all telephone conversations 
may be useful in deterring sales practice abuses. In addition, NASD 
Regulation notes that the Rule is designed to go beyond the problems 
raised by hiring individual problem registered representatives and is 
meant to address the concerns raised when a firm hires a large number 
of individuals who formerly were employed by a Disciplined Firm where 
they were inadequately trained and supervised.
    The costs of the Rule are too great: Some commenters believe that 
the costs of the original Rule will be too high, particularly 
considering the limited benefits that will be achieved. The commenters 
state that the costs for purchasing tape-recording equipment, hiring 
personnel to review the tapes, and record retention would be 
enormous.\16\ Also, some commenters state that the Rule would have a 
disproportionate effect on small firms both in terms of the costs and 
because small firms are more likely to become subject to the 20% 
threshold.\17\ Finally, while not discussed in a formal comment letter, 
the Advisory Council raised as an issue the practical effect of the 
tapes.\18\
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    \16\ See, e.g., letters from Berthel, CIS, Coastal, Duke II, 
ESI, GKN, Keystone, Lehman, Morgan Stanley, Nathan & Lewis, Baird, 
and Smith Barney.
    \17\ See, e.g., letters from Capital, Cowen, Duncan-Smith, Hoak, 
SIA, and Yee.
    \18\ See, e.g., letters from AEFA, Duke II, Lawrence, Kamin, 
Lehman, Morgan Stanley, MSC, Neidiger, Montgomery, SIA, and Smith 
Barney.
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    As stated above, because the Rule has been revised to address only 
the most egregious situations, the impact on privacy will be minimized. 
Also, if the Rule is adopted, NASD Regulation will inform NASD members 
that, in complying with this Rule, they must also comply with federal 
and state civil and criminal statutes governing the tape recording of 
conversations. This is the same approach the NFA has taken with respect 
to this issue.\19\
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    \19\ See Interpretive Notice to NFA Compliance Rule 2-9, 
Supervision of Telemarketing Activity, 9021 (February 18, 1997).
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    Each state has a statute governing wiretapping; there also is a 
federal statute governing wiretapping and electronic surveillance.\20\ 
The federal statute and the majority of the state statutes permit 
taping of telephone conversations with the consent of one party (``one-
party statutes''); a minority of state statutes require the consent of 
all parties to the conversation (``two-party statutes''). Three issues 
arise from the proposed Rule: what is necessary to comply with one-
party statutes; what is necessary to comply with two-party statutes; 
and how to comply where a conversation occurs between a person in a 
one-party state and a person in a two-party state.
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    \20\ 18 U.S.C. Secs. 2519 et seq.
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    In one-party statute states, the only issue is whether the 
registered representative knows of and consents to the tape recording. 
Since the recording requirement would run to the firm, and the 
equipment would be the firm's, it might be argued that the firm, and 
not the representative, is doing the recording. Therefore, it would be 
necessary for the firm to insure that the representative has notice and 
consents to the tape recording of his or her telephone conversations. 
This could be accomplished through a clause in an employment agreement 
or employee handbook or other written notice to the representative.
    In two-party statute states, it would be necessary to insert on the 
firm's telephone line a recording stating that all telephone 
conversations are being taped, similar to customer service lines in 
other industries. Some states require a system of beeps or buzzers that 
sound throughout the conversation. Another possibility is to insert a 
clause into the customer agreement notifying customers that their calls 
will be tape recorded. Some states also have a ``business use 
exception'' to the two-party statute consent requirement, but it is 
worded and applied differently in each state.
    The issue of choice of law for conversations between persons in 
one-party statute and two-party statute states is an open issue that 
depends on the individual laws of each state and the individual facts. 
Firms would be required to independently determine that state laws are 
satisfied. The safest course of action in each case would be to notify 
their representatives and customers that their telephone calls are 
being tape recorded. If all parties know of the tape recording, then 
there is no violation of any statute.
Proposed Rule
    As revised, the proposed Rule would apply whenever a specified 
percentage of a member firm's sales force is comprised of registered 
persons who were employed within the last two years by a firm that has 
been expelled from membership in a securities industry SRO or has had 
its registration as a broker/dealer revoked by the SEC.\21\ The 
requisite percentage varies depending on the size of the firm, from 40 
percent for a small firm to 20 percent for a larger firm. The firm must 
establish the required supervisory procedures within 30 days of 
receiving notice from NASD Regulation or obtaining actual knowledge 
that it is subject to the provisions of the Rule.
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    \21\ The revised definition of Disciplined Firm includes only 
expelled and revoked firms in order to focus, at least initially, on 
the most egregious cases with the greatest supervisory and 
disciplinary problems. This approach is similar to the one taken by 
the NFA, and will allow us to gain experience with the 
implementation of the Rule before we consider expanding the 
definition of Disciplined Firm to include firms that have been 
suspended from SRO membership or from SEC registration.
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    Under the proposed Rule, if a significant portion of a member's 
sales force previously was employed by a Disciplined Firm, the member 
would be required to adopt special written procedures to supervise the 
telemarketing activities of its registered representatives. The 
procedures would require, at a minimum, that the member tape-record all 
telephone conversations between all of its registered representatives 
and both existing and potential customers, and maintain these 
procedures for two years. The Rule would require firms to ensure that 
they tape record all regularly used means of telecommunications, 
including cellular phones. The Rule also would require firms subject to 
the taping requirement to establish reasonable procedures for reviewing 
the tape recordings to ensure compliance with securities laws and NASD 
rules, to submit reports to the NASD on their supervision of

[[Page 64427]]

telemarketing, and to retain and catalog the tapes.
    While each firm will be responsible for meeting its own obligations 
under the Rule, NASD Regulation will provide firms with all of the 
information that they need to determine if they are subject to the 
requirements of the Rule. NASD Regulation believes that firms should be 
able to rely on the accuracy of the information provided to them, and 
that a firm should be disciplined for failure to comply with the Rule 
only if it has actual knowledge of information that would make the firm 
subject to the Rule that is inconsistent with information provided by 
NASD Regulation to the firm that indicated that the firm was not 
subject to the Rule.
    NASD Regulation will compile and maintain several lists that firms 
will be able to review on a quarterly basis to assist them to determine 
if they are in compliance with the Rule. The primary list that will be 
prepared will be a list of firms that meet the definition of 
Disciplined Firm.\22\ Two additional lists will be prepared that should 
be helpful. One list will contain an alphabetical listing of all 
registered persons who had worked for Disciplined Firms within the last 
two years. Another list will be complied containing the same list of 
people grouped according to the firm for which they currently work. In 
order to alert firms that they are approaching the percentage that 
would make them subject to the requirements of the Rule, the second 
list will contain a computation of the percentage of all registered 
persons at the firm represented by registered persons who had been 
employed at a Disciplined Firm within the last two years.
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    \22\ For the two-year period 1995-1996, 14 firms met the 
definition of Disciplined Firm: 4 firms were expelled from SRO 
membership and 10 had their registration revoked.
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    The Rule is thus very similar to an NFA interpretation concerning 
supervision of telemarketing activity.\23\ NFA member firms subject to 
the requirements of the interpretation must tape record all sales 
solicitations.\24\ The NFA interpretation applies to firms that meet 
criteria relating to the percentage of the firm's associated persons 
who formerly were employed at a firm that was closed down and barred 
from the industry through enforcement actions for deceptive 
telemarketing practices.\25\ These firms are required by the NFA 
interpretation to tape record sales solicitations. An NFA member 
subject to these procedures may seek a waiver of the taping requirement 
upon a satisfactory showing that its current supervisory procedures 
provide effective supervision over its employees, including enabling 
the member to identify potential problem areas before customer abuse 
occurs. The NFA has rarely granted such waivers. In one instance, a 
waiver was granted to a firm that did not engage in telemarketing and 
had only institutional customers. In two other instances, partial 
waivers were granted to firms that hired outside consultants. NFA 
informed NASD Regulation that they were not satisfied with the work 
performed by the outside consultants and would not grant such waivers 
in the future.\26\ In response to commenter requests, NASD Regulation 
has included a waiver provision in the proposed Rule, and also has 
proposed a conforming change to the Rule 9600 Series.\27\
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    \23\ See Interpretive Notice to NFA Compliance Rule 2-9, 
Supervision of Telemarketing Activity, para. 9021 (February 18, 
1997).
    \24\ NASDR states that no NFA member firm is currently taping 
sales solicitations. Due to recent changes to the NFA interpretation 
that were approved by the Commodity Futures Trading Commission in 
December, 1996, seven new firms became subject to the requirements 
of the interpretation, but all are in the process of seeking waivers 
from the taping requirement. If these firms do not obtain waivers 
from the NFA, or adjust their personnel numbers, they will be 
required to tape-record conversations.
    \25\ In early 1997, 44 firms met the NFA definition of 
Disciplined Firm. See Interpretive Notice to NFA Compliance Rule 2-
9, Supervision of Telemarketing Activity, para. 9021 (February 18, 
1997).
    \26\ Telephone conversation between Mary N. Revell, Associate 
General Counsel, NASD, and Daniel Driscoll, Vice President, 
Compliance, NASD (February 26, 1997).
    \27\ See, e.g., letters from Edwards, Barington, Cullum, Duke I, 
Duke II, Duncan-Smith, GKN, Hoak, Morgan Stanley, Baird, and 
Montgomery.
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Statutory Basis
    NASD Regulation believes that the proposed Rule change is 
consistent with Section 15A(b)(6) of the Act,\28\ which requires, among 
other things, that the Association's rules must be designed to prevent 
fraudulent and manipulative acts and practices, to promote just and 
equitable principles of trade, and, in general, to protect investors 
and the public interest. The NASD believes that requiring members that 
hire more than a certain percentage of registered representatives who 
formerly were employed by a Disciplined Firm will further these 
requirements.
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    \28\ 15 U.S.C. Sec. 78o-3(b)(6).
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(B) Self-Regulatory Organization's Statement on Burden on Competition

    NASD Regulation does not believe that the proposed Rule change will 
result in any burden on competition that is not necessary or 
appropriate in furtherance of the purposes of the Act, as amended.

(C) Self-Regulatory Organization's Statement on Comments on the 
Proposed Rule Change Received From Members, Participants, or Others

    The proposed Rule change was published for comment in NASD Notice 
to Members 96-59 (September 1996). Forty-two comments were received in 
response to the Notice.\29\
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    \29\ See discussion supra Section II(A) Comments and Response.
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III. Date of Effectiveness of the Proposed Rule Change and Timing for 
Commission Action

    Within 35 days of the date of publication of this notice in the 
Federal Register or within such longer period (i) as the Commission may 
designate up to 90 days of such date if it finds such longer period to 
be appropriate and publishes its reasons for so finding or (ii) as to 
which the self-regulatory organization consents, the Commission will:
    A. By order approve such proposed rule change, or
    B. Institute proceedings to determine whether the proposed rule 
change should be disapproved.

IV. Solicitation of Comments

    Interested persons are invited to submit written data, views, and 
arguments concerning the foregoing. The Commission requests comments on 
all aspects of the proposal as well as the following specific items.
    1. Should customers be notified by firms that their calls are being 
taped? Should firms be required to obtain their customers' written 
consent to be taped? Why or why not?
    2. Should registered representatives subject to the Rule be 
notified by the firms that their calls are being taped? Why or why not?
    3. In light of the information already available on the Central 
Registration Depository, is a list of all registered persons who have 
worked for a Disciplined Firm within the last two years necessary to 
ensure compliance with the Rule? Would such a publicly available list 
be used in other ways (for example, as a screening device for 
applicants for registered representative positions)?
    The Commission also is soliciting comments concerning whether the 
Rule captures the appropriate registered persons in the percentage 
calculation that triggers the taping requirement. The Rule would apply 
whenever a specified percentage of a member firm is comprised of 
registered persons who were employed within the last two years by a 
firm that has been expelled from

[[Page 64428]]

membership in an SRO or has had its registration as a broker-dealer 
revoked by the SEC. The requisite percentage varies from 40 to 20 
percent, depending on the size of the firm.
    4. As proposed, the Rule captures registered persons who have 
worked at a Disciplined Firm within the past two years. Is the proposed 
time frame appropriate?
    5. Should the percentage of registered persons counted in the 
calculation exclude registered persons who have worked at a Disciplined 
Firm within the past two years, but who themselves have no disciplinary 
history or customer complaints?
    6. Should the percentage of registered persons counted in the 
calculation include registered persons who may not have worked at a 
Disciplined Firm, but who have, as individuals, been barred by the 
Commission from association with any broker, dealer, investment 
adviser, investment company, or municipal securities dealer?
    7. Should firms with fewer than five registered persons be excepted 
from the Rule?
    8. As proposed, the Rule limits the taping requirement to 
registered representatives in conversation with existing or potential 
customers. Should the taping requirement apply to registered principals 
in conversation with existing or potential customers? Should it apply 
to any other associated person of a member firm?
    9. What are the estimated costs to comply with the Rule? Please 
comment generally on the benefits and costs of the Rule, as well as 
ways to reduce the costs while preserving the benefits of the Rule.
    Persons making written submissions should file six copies thereof 
with Secretary, Securities and Exchange Commission, 450 Fifth Street, 
N.W., Washington, D.C. 20549. Copies of the submission, all subsequent 
amendments, all written statements with respect to the proposed rule 
change that are filed with the Commission, and all written 
communications relating to the proposed rule change between the 
Commission and any person, other than those that may be withheld from 
the public in accordance with the provisions of 5 U.S.C. Sec. 552, will 
be available for inspection and copying in the Commission's Public 
Reference Room. Copies of such filing will also be available for 
inspection and copying at the principal office of the NASD. All 
submissions should File No. SR-NASD-97-69 in the caption above and 
should be submitted by December 29, 1997.

    For the Commission, by the Division of the Market Regulation, 
pursuant to delegated authority.\30\
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    \30\ 17 CFR 200.30-3(a)(12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 97-31846 Filed 12-4-97; 8:45 am]
BILLING CODE 8010-01-M