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V. Proposed SRO Rules
Responding to perceived sales practice abuses that have received wide media and considerable regulatory attention, in September 1997, the New York Stock Exchange approved amendments to Rule 382. NASD Regulation, Inc. more or less contemporaneously approved substantially similar amendments to its counterpart Conduct Rule 3230. These proposed amendments are attached as Exhibits "A" and "B," respectively. As required by the rules of the U.S. Securities and Exchange Commission (the "SEC"), these proposed amendments have both been submitted to the SEC for approval. If these amendments are approved by the SEC, clearing firms will now be required to:
- Forward promptly, any written customer complaint received by a clearing firm regarding the introducing firm or its associated persons, to the introducing firm and the introducing firm's designated self-regulatory organization ("SRO"). The clearing firm would also be required to notify the customer in writing that it has received the complaint and that the complaint has been forwarded to the introducing firm and to the introducing firm's SRO. In addition, and perhaps the source of some controversy, the new rules would require that the written notice to customers also contain a statement that the client of the introducing firm has the right at his discretion to transfer his account to another broker-dealer of his choice.
- Furnish annually to the introducing firm, a list or description or reports which it offers to the introducing firm to assist the introducing firm in supervising its activities, monitoring its customer accounts and carrying out functions and responsibilities under the clearing agreement. Initially, introducing firms would be required to notify the carrying firm of the specific reports available that the introducing firm needs to monitor its customer accounts.
- Retain as a part of its books and records, copies of the reports requested by the introducing members described in the aforementioned paragraph. The firm will be in compliance with the requirements of this paragraph and retain the data from which the original report was produced provided the clearing member can, at the request of the SRO, (i) recreate the report, or (ii) provide the data in the data formatting that was used to prepare the report.
- Provide annual written notice to the introducing firm's compliance CEO of the list of reports offered to, requested by or supplied to the introducing firm during the previous year. The clearing member must also provide a copy of the notice to the introducing member's SRO.
- Where the introducing broker is permitted to issue negotiable instruments directly to its customers on the clearing firm's account, the introducing broker must represent in writing to the clearing broker that it maintains and will enforce supervisory procedures satisfactory to the clearing broker with respect to the issuance of such instruments.
These rule changes are designed to permit introducing firms to fulfill the responsibilities allocated to them in the clearing agreements and to enable the SROs of the introducing firms to more quickly address any potential or perceived problems at the introducing firms. As can be seen in some of the more recent court cases and arbitrations, plaintiffs have alleged that the clearing firms should be held responsible for, among other things, detecting and/or not timely disclosing alleged fraud and/or defalcations to the customers' and the SROs' attention so as to prevent the fraud or defalcation or to mitigate any resulting losses or damages.
In their rule proposals to the SEC, both the New York Stock Exchange and NASD Regulation, Inc. undertook to state with clarity and specificity that the proposed amendments were not intended to change or interpret the fundamental nature of the relationship between the introducing and clearing firms nor otherwise affect the firms' respective rights, responsibilities or liabilities under law or contract.
Securities industry members generally endorse these proposed amendments. However, the Securities Industry Association ("SIA"), which represents more than 780 securities firms headquartered throughout North America, and whose members account for approximately 90% of the securities industry's revenues in the United States, has commented to the SEC upon proposed amendment to New York Stock Exchange Rule 382:
That the requirement that the customer be notified by the clearing firm that he or she has the right to transfer his or her account to another firm may unfairly single out a particular category of complaints, create an unfair implication that each such complaint would warrant the customer's transferring his account or otherwise operate inappropriately to distinguish this class of complaint from others.
The SIA has strongly recommended that the statement regarding the right to transfer an account be deleted from the final amendments of both the New York Stock Exchange and NASD Regulation, Inc. The SIA has also commented for the need for clarification relating to the scope of "reports" which would be subject to notification record retention requirements under these amendments. The SIA has noted that given the wide array of reports routinely furnished or available to introducing brokers for their general purposes, record retention requirements should only apply to exception reports relating to the introducing broker's supervision of sales practices or similar compliance-related activities. It has also commented that with respect to customer complaints received by the clearing firm, the amendment should clarify that the reporting requirements apply only where the complaint is received from the customer or his agent, not from a regulatory or self-regulatory agency that is merely forwarding it on to the clearing broker. Regarding the authority of the introducing broker to issue negotiable instruments, the SIA has opined that this requirement should not be construed as placing a supervisory liability on the clearing broker for check issuance procedures. The SIA has noted that this may directly contradict the language of Rule 382(b)(4). The SIA has also pointed out that the NASD Regulation proposals have apparently recognized this contradiction and have deleted this language from its proposed parallel Rule 3230 amendments.
These proposals have also prompted comments from the plaintiffs' bar and other groups. Some commentators have argued that imposing any affirmative action requirements on clearing brokers--like the customer/SRO notification of written complaints and the New York Stock Exchange rule proposal as to check writing procedures--may lead to new and novel claims against clearing firms arising under Rule 10b-5, Section 20, failure to supervise and common law liability theories. For example, as arbitration and civil cases suggest, if a claimant were to establish that the clearing firm failed to promptly advise the customer that he could move his account, failed to timely disclose a written customer complaint or was deficient in implementing check issuance procedures of the introducing broker, the clearing firm might in certain situations, be exposed to material liability. Despite the points made in the proposed SEC rule submissions that the SROs do not intend to alter the existing legal framework of responsibilities, a judge, jury or arbitration panel armed with the "right" facts might make a discretionary determination of liability in the above contexts.
As proposed net capital requirements continue to increase, it is likely that the growth in the clearing industry will continue and expand significantly over time. All parties to this debate should be mindful that in seeking to address the perceived problems in the microcap market, any attempt to impose supervisory responsibility on clearing brokers, which contract only to perform operational services and which have little or no control over the hiring, training and sales practices of introducing firms, would have a chilling affect on the growth of the securities business. Recent regulatory initiatives have been directed at enhanced scrutiny of the registration process of registered representatives and broker-dealers; amendments to U-4 and U-5 disclosures; and more frequent and rigorous inspections, examinations and interviews of registered representatives and broker-dealers. Many commentators believe that these initiatives will have the greatest impact on preventing further abuse in the microcap markets.