NASD Regulation Requests Comment On Proposed Amendments To The Taping Rule

ACTION REQUESTED

Taping Rule

Comment Period Expires: July 25, 2001

Executive Summary

NASD Regulation, Inc. (NASD Regulation) requests comment on proposed amendments to Rule 3010(b)(2), commonly referred to as the Taping Rule.

In 1998, NASD Regulation adopted the Taping Rule in response to the findings of the "Joint Regulatory Sales Practice Sweep Report" (the "Report"), which found sales practice abuses at selected firms. Based upon the staff's experience applying the Taping Rule over the past two and one-half years, and input from the National Adjudicatory Council (NAC) and National Association of Securities Dealers, Inc. (NASD^®) Committees, NASD Regulation believes that it is appropriate to amend the Taping Rule in certain respects. Generally, the proposed amendments are intended to refine the application of the Taping Rule and provide some additional flexibility to firms that trigger application of the Rule.

Specifically, NASD Regulation seeks comment on five proposed amendments to the Taping Rule that would: 1) add a provision to permit firms that become subject to the Rule 30 days to make a one-time downward adjustment to their roster of registered persons in order to fall below the prescribed Taping Rule threshold levels and thus avoid application of the Rule; 2) revise the criteria by which firms become subject to the Taping Rule by excluding short-term employees of disciplined firms from a firm's calculation of the threshold levels triggering application of the Rule; 3) expand the time period for implementation of the special supervisory procedures, including the installation of taping systems, required by the Rule from 30 days to 60 days; 4) narrow the NASD's authority to grant exemptions from the Rule pursuant to the Rule 9600 Series; and 5) extend the duration of special supervisory procedures, including taping requirements, from two years to three years.

In addition, NASD Regulation requests comment on whether the identity of firms subject to the Taping Rule should be publicly available.

Included with this Notice are Attachment A (the text of the proposed amendments) and Attachment B (a checklist that may supplement or be used in place of written comments).

Request For Comment

NASD Regulation solicits comment on the proposed amendments to the Taping Rule as described in this Notice. For your convenience, we have provided a checklist (see Attachment B) that offers a convenient method to participate in the comment process concerning the proposed amendments.

Comments must be received by July 25, 2001. Members and interested persons can submit their comments using the following methods:

• mailing in the checklist (Attachment B)



• mailing in written comments



• e-mailing written comments to [email protected]



• submitting comments online at the NASDR Web Site (www.nasdr.com)

If you decide to submit comments using both the checklist and one of the other methods listed above, please indicate that in your submissions.

The checklist and/or written comments should be mailed to:

Barbara Z. Sweeney
Office of the Corporate Secretary
NASD Regulation, Inc.
1735 K Street, NW
Washington, DC 20006-1500

The only comments that will be considered are those submitted in writing, either via e-mail or regular mail, or those submitted online through the NASD Regulation Web Site.

Questions/Further Information

Questions regarding this Notice may be directed to Greg Dean, Assistant General Counsel, Office of General Counsel, NASD Regulation, Inc., at (202) 728-8159.

Background

In 1995, the NASD participated in a "Joint Regulatory Sales Practice Sweep" (the "Sweep"), an initiative to review the sales practice activities of selected registered representatives and the hiring, retention, and supervisory practices of the brokerage firms employing them. The findings of the Sweep were detailed in the Report.¹ In response to these findings, NASD Regulation and the New York Stock Exchange (NYSE) issued a joint memorandum recommending heightened supervisory procedures for registered representatives with histories of customer complaints, disciplinary actions, or arbitrations.² Based upon the Report's findings of sales practice abuses, NASD Regulation also adopted Rule 3010(b)(2), the Taping Rule.³

The Taping Rule was designed to ensure that firms that hire a significant number of registered persons from "disciplined firms"—firms that have been expelled from membership or participation by any self-regulatory organization or have had their registrations revoked by the SEC for sales practice violations—have proper supervision and oversight of their sales force to prevent fraudulent and improper sales practices. Currently, firms that exceed the threshold levels of the Taping Rule (Rule 3010(b)(2)(viii)) must establish, maintain, and enforce special written procedures for supervising the telemarketing activities of all their registered persons. As part of these procedures, firms are required to install taping systems that record all conversations with customers, to review the tape recordings for questionable sales practices, and to file quarterly reports with NASD Regulation describing any sales practice violations discovered during the review of the recordings. All such procedures and systems must be maintained for a period of two years. The Taping Rule permits firms to petition NASD Regulation for exemptive relief pursuant to the Rule 9600 Series.

Discussion

Based upon the staff's experience applying the Taping Rule over the past two and one-half years,⁴ and input from the NAC and NASD Committees, NASD Regulation believes that the Rule should be amended to refine its application and to provide member firms that trigger application of the Rule with some additional flexibility.

1. Establishment Of A 30-Day Staff Adjustment Period

NASD Regulation proposes to add a provision to the Rule to provide firms with a one-time only option of adjusting their roster of registered persons within 30 days after they become subject to the Rule for the first time in order to fall below the threshold levels contained in paragraph (b)(2)(viii) of the Rule. This proposed amendment would not allow firms to hire additional registered persons to get below the percentage thresholds, but would permit them to reduce their number of registered persons formerly employed by disciplined firms. Under this proposal, once a firm has made the adjustment, the firm would not be permitted to rehire the individuals terminated in the adjustment for a period of at least six months. If a firm chose not to make the adjustment, then it would be required to comply with the Taping Rule.

As noted, this proposed amendment is a one-time only opportunity, available only when a firm triggers application of the Taping Rule for the first time. If a firm subsequently triggers application of the Taping Rule, it would not be able to adjust its staffing levels to avoid imposition of the requirements of the Rule (whether or not it had elected to avail itself of the adjustment option when it first triggered the Rule).

The purpose of this proposed amendment is to provide an opportunity for relief to firms that may become subject to the Rule inadvertently or unintentionally due to sudden turnover among registered persons or other events beyond their control. The one-time adjustment would provide these firms relief from the Rule without detracting from one of the primary objectives of the Taping Rule, to prevent registered persons from disciplined firms from moving, en masse, to another firm. NASD Regulation seeks comment on whether the proposed adjustment option provides sufficient flexibility.

2. Revision Of The Criteria By Which Firms Become Subject To The Taping Rule

NASD Regulation proposes to amend the Rule to exclude individuals who were employed by disciplined firms for a short period of time from the required calculation used to determine whether a firm triggers application of the Taping Rule. Specifically, NASD Regulation proposes that registered persons⁵ who were associated for a total of not more than 90 days in the aggregate with one or more disciplined firms during the prior three years and who have no relevant disciplinary history⁶ may be excluded from a firm's Taping Rule calculations.

NASD Regulation believes that this proposed amendment is consistent with the purpose of the Taping Rule. The amendment recognizes that individuals employed by disciplined firms for a very short period of time may have left the firm voluntarily before engaging in any activities or were unlikely to have been affected by the lack of proper training and inadequate supervision that the Rule seeks to redress. As an added measure of protection, the proposal would require that these individuals have no relevant disciplinary history. Unless both conditions are met, a firm would be required to include these individuals in the firm's Taping Rule calculations. NASD Regulation invites comment on whether it is appropriate to exclude short-term employees in this manner. We also request comment on: 1) whether 90 days, or a shorter period, is an appropriate measure of "shortterm"; and 2) whether the use of the definition of disciplinary history contained in IM-1011-1 is appropriate for this proposed amendment to the Taping Rule.

3. Expansion Of The Compliance Deadline From 30 To 60 Days

NASD Regulation proposes to amend the Taping Rule to extend the time for firms to implement the special supervisory procedures, including the installation of a taping system, from 30 days to 60 days. Almost all of the firms that have become subject to the Rule to date requested extensions of time to locate a vendor, purchase a recording system, and complete the installation of the system. The Rule currently does not provide NASD Regulation with the authority to grant such extensions.

Based on the staff's experience, NASD Regulation believes that the proposed expansion of the compliance date from 30 days to 60 days should provide sufficient time for firms to install the taping systems and would eliminate the need for members to request extensions of time to achieve compliance with the Rule.

4. Narrowing Of The Exemptive Relief Authority

Based on experience gained to date,⁷ and with the adoption of the other measures as currently proposed, NASD Regulation believes that the current exemptive authority provisions in the Taping Rule should be narrowed. The proposal would amend paragraph (b)(2)(xi) of the Rule to allow for the NASD to grant exemptive relief in "exceptional" cases only.

Currently, the Rule permits member firms that become subject to the Rule to apply for exemptive relief under the Rule 9600 Series. The Taping Rule states that relief may be granted, "upon satisfactory showing that the member's supervisory procedures ensure compliance with applicable securities laws and regulations and applicable rules of the Association." In general, NASD Regulation has interpreted this standard to require firms seeking exemptive relief to establish that their supervisory procedures assure supervision at a level functionally equivalent to the protections afforded by a taping system. Substantial resources are devoted to evaluating and ruling on these requests, the overwhelming majority of which were denied.

NASD Regulation believes that the additional flexibility created by the proposed amendments (particularly the proposed one-time adjustment period and the exclusion of short-term employees from a firm's calculations under the Rule) should reduce the number of cases in which firms would need to consider requesting exemptive relief. NASD Regulation also believes, consistent with the underlying purpose of the Rule, that exemptive relief should be limited to truly exceptional cases.

5. Increase Duration Of The Special Supervisory Requirements

NASD Regulation proposes to increase the time during which firms must maintain the prescribed special supervisory procedures, including a taping system, to three years. Currently, the Rule requires firms to establish and maintain these procedures for a period of two years.

NASD Regulation believes that this proposed change is consistent with the underlying purpose of the Taping Rule and will reduce the potential for confusion about the thresholds for applying it. To determine whether application of the Rule has been triggered for any particular firm, Rule 3010(b)(2)(viii) considers the employment history of the firm's registered persons over a three-year period. The application of the two-year and three-year periods have caused some confusion. NASD Regulation believes that equalizing these two time periods (i.e., three years) would eliminate ambiguities in the calculation of the Taping Rule thresholds.

Additional Issue For Comment

Recently, NASD Regulation has received requests from a variety of sources, including members of the public, to make the identity of firms subject to the Taping Rule publicly available. To date, NASD Regulation has not publicly disclosed the identity of firms subject to the Rule in recognition of the fact that the Taping Rule is by its nature a supervisory provision, not a disciplinary event. After further consideration of the issue, NASD Regulation believes that public disclosure of the identity of firms subject to the Taping Rule would be consistent with the objectives of the Rule and, moreover, would serve as an appropriate investor education and information vehicle.

NASD Regulation plans to enable investors and the general public to obtain information concerning whether a particular firm is subject to the Rule through the Public Disclosure Program.⁸ NASD Regulation invites comment on this approach as well as on whether a list of firms subject to the Rule should be made available on the NASD Regulation Web Site.

Endnotes

¹ The Sweep and the Report were undertaken by the Securities and Exchange Commission (SEC), the NASD, the North American Securities Administrators Association, Inc., and the New York Stock Exchange.

²NASD Notice to Members 97-19, "NASD Regulation And New York Stock Exchange Memorandum Discusses Sweep Report And Provides Guidance On Heightened Supervision Recommendations" (April 1997).

³NASD Notice to Members 98-52, "SEC Approves Taping Rule; Effective August 17, 1998" (July 1998).

⁴ Since the Taping Rule became effective in August of 1998, 24 firms have triggered application of the Rule. Of those firms, 13 are currently active and subject to the Rule. One application for exemptive relief is pending.

⁵ To clarify that the Rule includes independent contractors as well as employees, NASD Regulation intends to make a technical amendment to the current rule language by substituting "associated with" for "employed by" in subparagraph (b)(2)(viii) of the Rule. For a discussion of the supervision of independent contractors, see Notice to Members 98-38, "NASD Reminds Members of Supervisory And Inspection Obligations" (May 1998).

⁶ For purposes of this provision, NASD Regulation proposes to use the definition of disciplinary history used in the NASD Membership Rules. Interpretive Material-1011-1 defines "disciplinary history" as, "a finding of a violation by the member or a principal of the member in the past five years by the Securities and Exchange Commission, a self-regulatory organization, or a foreign financial regulatory authority of one or more of the following provisions (or a comparable foreign provision) or rules or regulations thereunder: Sections 15(b)(4)(E) and 15(c) of the Securities Exchange Act of 1934; Section 17(a) of the Securities Act of 1933; SEC Rules 10b-5 and 15g-1 through 15g-9; NASD Rules 2110, 2120, 2310, 2330, 2440, 3010 (failure to supervise only), 3310, and 3330; and MSRB Rules G-19, G-30, and G-37(b) & (c)."

⁷ To date, there have been 17 petitions to NASD Regulation for exemptive relief. Fifteen were denied, one was granted, and one is pending.

⁸ A technical amendment to Interpretive Material-8310-2 is necessary to implement this change. Attachment A includes the proposed amendment to
IM-8310-2.

ATTACHMENT A

Proposed Rule Language

Note: New language is underlined; deletions are in brackets.

3010. Supervision

IM-8310-2. Release of Disciplinary [Information] and Other Information Through the Public Disclosure Program

ATTACHMENT B

Request For Comment Checklist

We have provided below a checklist that members and other interested parties may use in addition to or in lieu of written comments. This checklist is intended to offer a convenient way to participate in the comment process, but does not cover all aspects of the proposal described in the Notice. We therefore encourage members and other interested parties to review the entire Notice and provide written comments, as necessary.

Instructions

Comments must be received by July 25, 2001. Members and interested parties can submit their comments using the following methods:

• mailing in this checklist



• mailing in written comments



• e-mailing written comments to [email protected]



• submitting comments online at the NASDR Web Site (www.nasdr.com)

The checklist and/or written comments should be mailed to:

Barbara Z. Sweeney
Office of the Corporate Secretary
NASD Regulation, Inc.
1735 K Street, NW
Washington, DC 20006-1500

Proposed Amendments Concerning The Taping Rule

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