64422 Federal Register / Vol. 62, No. 234 / Friday, December 5, 1997 / Notices

12 Id.

13See NASD Manual, Conduct Rules, Rule 2830,

p. 4621.

14 ICI Letter, p. 3.

15 Id.

16Letter from Mary N. Revell, Associate General

Counsel, NASD Regulation, Inc., to Katherine

England, Assistant Director, SEC, dated November

13, 1997 (‘‘NASDR Letter’’), p. 2.

17 Id. at p. 2.

18 Id.

19 Id. at pp. 2–3.

20See supra note 10.

21 ICI Letter at p. 2.

22 Id.

23Section 15A(b)(6) requires the Commission to

determine that an Association’s rules are designed

to prevent fraudulent acts and practices, to promote

just and equitable principles of trade, and, in

general, to protect investors and the public interest.

24Pursuant to Section 3(f) of the Act, the

Commission has considered the proposed rule’s

impact on efficiency, competition, and capital

formation. 15 U.S.C. § 78c(f).

25See supra notes 6 and 7.

26 15 U.S.C. 78s(b)(2).

27 17 CFR 200.30–3(a)(12).

1 15 U.S.C. § 78s(b)(1).

2On 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).

electronic media.12 Rule 2830 applies to

the activities of members in connection

with investment company securities.13

ICI notes that Rules 2830(d), 2830(k)(7),

and 2830(l)(1)(C), which apply to sales

charges, execution of investment

company portfolio transactions, and

dealer concessions, respectively, should

be included in the NTM to confirm that

electronic disclosure meets the

requirements in these rules in the case

of a prospectus that is delivered

electronically.14 Concerning Rule

3010(g)(2), which defines the term

‘‘branch office,’’ ICI believes that the

NTM should clarify the requirements of

the rule may be satisfied through

electronic delivery of sales material.15

In its response, the NASDR does not

agree that these rules should be added

to the NTM.16 According to the NASDR,

‘‘the rules the ICI suggests adding to the

NTM do not specifically address the

delivery of information between broker/

dealers and customers, but instead

concern substantive obligations that

arise under NASD rules regardless of

whether information is submitted in

electronic or non-electronic form.’’ 17

Notwithstanding its decision to exclude

the rules from the NTM, the NASDR

agrees that the disclosure requirements

of Rules 2210(d), 2210(f), IM–2210–3,

and 3010(g)(2) may be satisfied using

electronic media where the

communication itself is made

electronically.18 The NASDR also agrees

that the disclosure requirements of

Rules 2830(d), 2830(d)(4), 2830(k)(7),

and 2830(l)(1)(C) may be met if the

prospectus is electronically delivered.19

In the notice, the Commission

requested comment on what types of

security measures broker-dealers

employ or will employ to reasonably

assure themselves that the responses

they receive electronically from

customers are authentic.20 According to

ICI, while no formal survey of its

membership was conducted, one

member has indicated that it requires

each customer who wishes to

communicate electronically regarding

his or her securities account, provide

his or her social security number,

customer account number, and personal

identification number before electronic

access to the account will be allowed.21

For certain institutional clients, another

member uses a security system which

includes encryption technology and a

password requirement.22

The Commission reiterates its concern

that adequate security measures must be

implemented by members to protect

customers’ personal financial

information and to prevent

unauthorized transactions when

‘‘receiving’’ or ‘‘obtaining’’ electronic

responses from their customers. The

Commission recognizes that the security

measures instituted will vary depending

on the computer’s hardware and

software capabilities, as well as, on the

information being sent or received.

However, an effort should be made to

secure customers’ information, as the

two ICI members have done, by

developing procedures and improving

technology, when feasible.

IV. Discussion

The Commission finds that the

proposed rule change is consistent with

the requirements of the Act and the

rules and regulations promulgated

thereunder. Specifically, the

Commission believes that approval of

the proposed rule change is consistent

with Section 15A(b)(6) 23 of the Act.24

Pursuant to Section 15A(b)(6), the

proposed rule change benefits the

public, because it not only allows

customers easy and efficient access to

account information, but also requires

an evaluation of systems and procedures

by members to ensure that the privacy

of personal information is maintained.

In using the Commission’s releases as a

guide,25 the Association has established

a uniform policy concerning electronic

delivery of information which should

allow members and member

organizations to satisfy their delivery

obligations under the federal securities

laws and the Association’s rules. This

uniform policy should simplify

compliance by members and member

organizations and aid the Association in

monitoring the same.

For the above reasons, the

Commission believes that the proposed

rule change is consistent with the

provisions of the Act, and in particular

with Section 15A(b)(6).

It is therefore ordered, pursuant to

Section 19(b)(2) of the Act,26 that the

proposed rule change (SR–NASD–97–

57) be, and hereby is approved.

For the Commission, by the Division of

Market Regulation, pursuant to delegated

authority.27

Margaret H. McFarland,

Deputy Secretary.

[FR Doc. 97–31844 Filed 12–4–97; 8:45 am]

BILLING CODE 8010–01–M

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.

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
Federal Register / Vol. 62, No. 234 / Friday, December 5, 1997 / Notices 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.
64424 Federal Register / Vol. 62, No. 234 / Friday, December 5, 1997 / Notices

3Staffs 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).

4 Id. at i.

5 Id. at ii, iv.

6NASD Notice to Members 97–19 (April 1997);

NYSE Information Memo 97–20 (April 15, 1997).

7See Letter from Lynn K. Gilbert, Deputy

Director, Commodity Futures Trading Commission,

to Daniel J. Roth, General Counsel, NFA (January

19, 1993).

8NASD 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

(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.

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.

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 selfregulatory 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.

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.

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.

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 twoyear 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
Federal Register / Vol. 62, No. 234 / Friday, December 5, 1997 / Notices 64425

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.

9See, e.g., letters from Edwards, Coastal, Cullum,

ESI, Keystone, Lehman, Montgomery, Morgan

Stanley, and Baird.

10See letter from Smith, Barney.

11See, 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.

12See, e.g., letters from Lehman and Morgan

Stanley.

13See, e.g., letters from Edwards, Morgan Stanley,

Nathan & Lewis, PC, SIA, and Stratton.

14See, e.g., letters from Edwards, Barington,

Chatfield Dean, Cullum, Duke II, ESI, ISC, Morgan

Stanley, Baird, and Stratton.

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.

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

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

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
64426 Federal Register / Vol. 62, No. 234 / Friday, December 5, 1997 / Notices

15See, e.g., letters from CIS, Duke II, ESI, Lehman,

Merrill Lynch, MSC, Nathan & Lewis, and SIA.

16See, e.g., letters from Berthel, CIS, Coastal,

Duke II, ESI, GKN, Keystone, Lehman, Morgan

Stanley, Nathan & Lewis, Baird, and Smith Barney.

17See, e.g., letters from Capital, Cowen, DuncanSmith, Hoak, SIA, and Yee.

18See, e.g., letters from AEFA, Duke II, Lawrence,

Kamin, Lehman, Morgan Stanley, MSC, Neidiger,

Montgomery, SIA, and Smith Barney.

19See Interpretive Notice to NFA Compliance

Rule 2–9, Supervision of Telemarketing Activity,

9021 (February 18, 1997).

20 18 U.S.C. §§ 2519 et seq.

21The 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.

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

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

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

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 (‘‘twoparty 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 twoparty state.

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 oneparty 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.

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
Federal Register / Vol. 62, No. 234 / Friday, December 5, 1997 / Notices 64427

22For 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.

23See Interpretive Notice to NFA Compliance

Rule 2–9, Supervision of Telemarketing Activity,

¶ 9021 (February 18, 1997).

24NASDR 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 taperecord 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, ¶ 9021 (February 18, 1997).

26Telephone conversation between Mary N.

Revell, Associate General Counsel, NASD, and

Daniel Driscoll, Vice President, Compliance, NASD

(February 26, 1997).

27See, e.g., letters from Edwards, Barington,

Cullum, Duke I, Duke II, Duncan-Smith, GKN,

Hoak, Morgan Stanley, Baird, and Montgomery.

28 15 U.S.C. § 78o–3(b)(6).

29See discussion supra Section II(A) Comments

and Response.

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.

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

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.

(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

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
64428 Federal Register / Vol. 62, No. 234 / Friday, December 5, 1997 / Notices

30 17 CFR 200.30–3(a)(12).

1The NASD filed Amendment Nos. 1 and 2 to the

proposed rule filing on October 17, 1997 and

November 14, 1997, respectively, the substance of

which is incorporated into the notice. See letters

from Joan C. Conley, Corporate Secretary, NASD

Regulation, to Katherine A. England, Assistant

Director, Market Regulation, Commission, dated

October 17, 1997 (‘‘Amendment No. 1’’) and

November 14, 1997 (‘‘Amendment No. 2’’)

respectively.

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. § 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

Margaret H. McFarland,

Deputy Secretary.

[FR Doc. 97–31846 Filed 12–4–97; 8:45 am]

BILLING CODE 8010–01–M

SECURITIES AND EXCHANGE

COMMISSION

[Release No. 34–39371; File No. SR–NASD–

97–47]

Self-Regulatory Organizations; Notice

of Filing of Proposed Rule Change by

the National Association of Securities

Dealers, Inc. Relating to Punitive

Damages in Arbitration

November 26, 1997.

Pursuant to Section 19(b)(1) of the

Securities Exchange Act of 1934

(‘‘Act’’), 15 U.S.C. 78s(b)(1), notice is

hereby given that on July 8, 1997,1 the

National Association of Securities

Dealers, Inc. (‘‘NASD’’ or ‘‘Association’’)

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 the selfregulatory organization. The

Commission is publishing this notice to

solicit comments on the proposed rule

change from interested persons.

I. Self-Regulatory Organization’s

Statement of the Terms of Substance of

the Proposed Rule Change

NASD Regulation is proposing to

amend the NASD’s Code of Arbitration

Procedure to add a new rule relating to

the award of punitive damages. Below is

the text of the proposed rule change.

Proposed new language is in italics;

proposed deletions are in brackets.

Rules of the Association

10000. Code of Arbitration Procedure

10300. Uniform Code of Arbitration

10336. Punitive Damages

This Rule explains when a party may

seek punitive damages, what standards

and limitations apply to the claim, and

what the arbitration award must state.

(a) The Availability of Punitive Damages

(1) This Rule applies to any claim that

must be arbitrated under Rule 10301

between a public customer and a

member, or between a public customer

and an associated person.

(2) A party may request punitive

damages if, at the time the party files a

claim, the party is a citizen of a state

that allows its courts to award punitive

damages for the same type of claim.

(3) A member or an associated person

may request punitive damages from a

public customer only if the public

customer is a citizen of a state that

allows its courts to award punitive

damages for one or more of the public

customer’s claims.

(4) A party seeking punitive damages

must state the amount in its claim.

(5) For purposes of this Rule, the term

‘‘claim’’ means any dispute or

controversy described in the Statement

of Claim (including Counterclaims,

Third-Party Claims, and Cross-Claims)

for which the claimant is seeking any

form of remedy.

(b) Arbitrators to Apply State Standard

(1) When arbitrators decide whether

to award punitive damages, they will

apply the same standard of conduct

applied by courts in the state where the

requesting party is a citizen at the time

a claim is filed.

(2) Arbitrators will apply this

standard even if the parties signed a

choice of law agreement that specifies a

different state.

(c) Limitations on the Amount and

Availability of Punitive Damages

(1) Punitive damages may be awarded

in an amount up to two times

compensatory damages or $750,000,

whichever is less.

(2) For purposes of this paragraph

only, compensatory damages do not

include attorneys’ fees, costs of

arbitration, or post-award interest.

(3) Arbitrators cannot award punitive

damages if they have already awarded

multiple damages for the same claim

under:

(A) the Racketeer Influenced and

Corrupt Organizations Act (RICO), or

(B) any other federal or state statute

that provides for multiple damages

awards.

(4) The limitations in this Rule apply

even if state laws differ.

(d) Statement in Award

If the arbitrators award compensatory

and punitive damages, they must state

separately the amount they awarded for

each.