NASD Requests Comment On Proposed Amendments To Membership Rules

Comment Period Expires September 13, 1999

Executive Summary

NASD Regulation, Inc. (NASD Regulation^®) is proposing to amend the rules governing new member applications and applications for approval of a change in a member's ownership, control, or operations. The text of the proposed amendments is included with this Notice to Members—Request For Comment (see Attachment A). A detailed explanation of the proposed rules follows in Attachment B.

Request For Comment

NASD Regulation encourages all interested parties to comment on the proposal. Comments must be received by September 13, 1999. Comments should be mailed to:

Joan Conley
Office of the Corporate Secretary
NASD Regulation, Inc.
1735 K Street, NW
Washington, D.C. 20006-1500

or e-mailed to:
[email protected]

Important Note: The only comments that will be considered are those submitted via e-mail or in writing.

Before becoming effective, any rule change developed as a result of comments received must be adopted by the NASD Regulation Board of Directors, may be reviewed by the National Association of Securities Dealers, Inc. (NASD^®) Board of Governors, and must be approved by the Securities and Exchange Commission (SEC).

Questions/Further Information

As noted, written comments should be submitted to Joan Conley. Questions concerning this Notice to Members-Request For Comment may be directed to Mary M. Dunbar, Assistant General Counsel, Office of General Counsel, NASD Regulation, at (202) 728-8252; or to Jeffrey S. Holik, Director of Regulation Policy, Member Regulation, NASD Regulation, at (202) 728-8387.

Changes To Membership Rules

NASD Regulation invites members to comment on amendments to the Rule 1010 Series, which govern NASD membership. NASD Regulation staff and the Member Admission Review Committee (Committee),¹ an ad-hoc committee convened in August 1998, developed the proposed changes. NASD Regulation asked the Committee to suggest ways to streamline the rules and make them more efficient while preserving their investor protection function. The Board, as well as the Membership Committee, the National Adjudicatory Council (NAC), and the Small Firm Advisory Board, approved the proposed changes.

The most significant changes are as follows:

• reorganizing and consolidating some of the current rules to make them easier to use;



• clarifying the rules and policies that apply to business expansions by—



• adopting a policy of building expansion plans into membership agreements,



• defining in the rules what kinds of "material changes in business operations" require a member to file an application for approval with NASD Regulation, and



• providing a safe harbor for modest expansions that will not require an application,
which together are intended to provide more even-handed treatment among members for various business expansions, provide more certainty regarding which expansions require approval, and eliminate unnecessary applications;


• simplifying administrative procedures for submitting an application and calculating the various time limits that apply to the process;



• rescinding the NAC's authority to review membership decisions that are not appealed by an applicant;



• permitting the staff to stay membership applications if a firm or one of its principals is the subject of a disciplinary action; and



• permitting the staff to reject immediately applications that are not substantially complete.

Attachment A

Text Of Amendments

(Note: New text is underlined; deletions are in brackets.)

1010. Membership Proceedings

1011. Definitions

Unless otherwise provided, terms used in the Rule 1010 Series shall have the meaning as defined in Rule 0120.

IM-1011-1. Safe Harbors for Business Expansions

This interpretive material concerns the types of business expansions that will not require a member to submit a Rule 1017 application to obtain NASD Regulation's approval of the expansion. This safe harbor applies to: (1) firms that do not have a membership agreement, and (2) firms that have a membership agreement that does not contain a "restriction" on the factors listed below.

The safe harbor is not available to a member that has a membership agreement that contains a specific restriction as to one or more of the factors listed below. In that case, the agreement takes precedence because NASD Regulation has determined that a particular restriction should apply as to one or more of the factors, and NASD Regulation has issued a decision with a rationale for that restriction. Similarly, the safe harbor also does not apply if the member has a membership agreement that permits expansion beyond the limits set forth below (e.g., an Applicant requests and obtains approval for ten registered representatives in the first six months with an additional ten registered representatives in the next year); in such case, the Department has specifically considered the firm's expansion plans and approved them.

The safe harbor is not available to any member that has disciplinary history. For purposes of this Interpretation, "disciplinary history" means a finding of a violation in the past five years by the Securities and Exchange Commission, a selfregulatory organization, or a foreign financial regulatory authority of one or more of the following provisions (or a comparable foreign provision): Section 15(b)(4)(E) 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).

For those firms to which the safe harbor is available, the following types of expansions are presumed not to be a material change in business operations and therefore do not require a Rule 1017 application. For any expansion beyond these limits, a member is required to contact its district office prior to implementing the change to determine whether the proposed expansion requires an application under Rule 1017. Expansions in each area are measured on a rolling 12-month basis; members are required to keep records of increases in personnel, offices, and markets to determine whether they are within the safe harbor.

"Associated Persons involved in sales" includes all Associated Persons, whether or not registered, who are involved in sales activities with public customers, including sales assistants and cold callers, but excludes clerical, back office, and trading personnel who are not involved in sales activities.

1012. General Provisions

1013. New Member Application [and Membership] and Interview

1014. Department Decision

1015. Review by National Adjudicatory Council

1016. Discretionary Review by NASD Board

1017. [Removal or Modification of Business Restriction] Application for Approval of Change in Ownership, Control, or Business Operations

[1018. Change in Ownership, Control, or Operations]

1018. Stay of Application During Pendency of Criminal or Other Proceeding

1019. Application to Commission for Review

A person aggrieved by final action of the Association under the Rule 1010 Series may apply for review by the Commission pursuant to Section 19(d)(2) of the Act. The filing of an application for review shall not stay the effectiveness of a decision constituting final action of the Association, unless the Commission otherwise orders.

Attachment B

Rule 1011
Associated Person

The definition of "Associated Person" is amended to clarify that it includes only natural persons.

Material Change In Business Operations

The term "material change in business operations" is defined for the first time. The definition is significant because it triggers a requirement for a member to apply to the district office for approval of the change under proposed Rule 1017.

NASD Regulation does not believe that it is possible to develop an exhaustive definition of the term "material change in business operations." If a change in a member's business falls outside of the definition, or the safe harbor described below (e.g., because it exceeded the safe harbor limits or the member has disciplinary history), then the member may contact the district office to determine if the district would deem the change to be material. A member is not required to contact the district office if the member believes the change is not material. Nonetheless, the staff ultimately has the authority to determine whether a change not specified in the definition is material. If the staff determines that a change is indeed material after it is made, then the member potentially could be subject to disciplinary action for failure to file an application under proposed Rule 1017.

Safe Harbor Limits

Proposed Interpretive Material 1011-1 (IM-1011-1) is added to create a safe harbor for certain changes that are presumed not to be material and therefore do not require a member to submit an application for approval of the change. NASD Regulation requests comment on whether the limitations in the Interpretive Material are set at appropriate levels.

The safe harbor would not be available to members that have "disciplinary history." "Disciplinary history" means a finding of a violation in the past five years by the SEC, a self-regulatory organization, or a foreign financial regulatory authority of one or more of the following provisions (or comparable foreign provisions):

• Section 15(b)(4)(E) of the Securities Exchange Act of 1934 (failure to supervise);



• Section 17(a) of the Securities Act of 1933 (fraudulent interstate transactions);



• SEC Rules—



• 10b-5 (fraud and manipulation), and



• 15g-1 through 15g-9 (penny stock rules);
• NASD Rules—



• 2110 (just and equitable principles of trade),



• 2120 (fraud and manipulation),



• 2310 (suitability),



• 2330 (protection of customer securities and funds),



• 2440 (fair prices and commissions),



• 3010 (failure to supervise requirements only),



• 3310 (manipulative and deceptive quotations), and



• 3330 (payments to influence market prices); and
• MSRB Rules—



• G-19 (suitability),



• G-30 (prices and commissions), and



• G-37(b) & (c) (political contributions).

NASD Regulation requests comment on whether this definition is appropriate, particularly the five-year limit. NASD Regulation also requests comment on whether the definition of disciplinary history should include violations by officers or principals of the member.

Principal Place Of Business

The term "principal place of business" is defined for the first time. An applicant's principal place of business determines which district office will process its application. "Principal place of business" means the location where the officers, partners, or managers direct and control the activities of the applicant, unless NASD Regulation staff designates a different location. That location may be where the largest number of associated persons are located or where the books and records are kept. This definition is designed to prevent an applicant from trying to select a particular district office to process its application through its designation of a principal place of business.

Sales Practice Event

NASD Regulation proposes to redefine "sales practice violations" as "sales practice event" because the definition includes not only proven violations, but also unproven allegations. The current definition has become obsolete; it tracks a definition that was once used on Form U-4. The proposed definition includes any customer complaint, arbitration, or civil litigation that has been or is required to be reported to the Central Registration Depository (CRDSM) or otherwise is required to be reported to the Association (e.g., via Rule 3070).

Rule 1012

NASD Regulation proposes to amend the service and filing provisions to permit additional methods of delivery and to use consistent terminology for calculating deadlines. The term "commercial courier" is replaced with "overnight courier" to clarify that applicants and NASD Regulation staff may use the overnight delivery service offered by the United States Postal Service. NASD Regulation intends the term "overnight courier" to refer to any entity that regularly provides such overnight delivery services, such as Federal Express, DHL, or the United States Postal Service. Use of the term "overnight courier" is not intended to imply that only actual overnight delivery may be used under the Rule. Overnight delivery should be used if it is available. However, if overnight delivery is not available for a particular location, the applicant or NASD Regulation staff may use the most rapid delivery option available (e.g., two day service) from the overnight courier and still be in compliance with the Rule.

The lapse of application provisions are consolidated and moved from Rules 1013(b), 1017(c), and 1018(d) to proposed Rule 1012(b) for ease of reference. The lapse rule, which is discussed in greater detail in the next section, permits the staff to discontinue processing an application if an applicant does not timely provide requested information or documents. The only changes to the lapse rule are to:

• permit the staff and the Applicant to agree on a submission date for the membership agreement, rather than requiring that all agreements be submitted within 25 days, and



• clarify that fees are not refunded for lapsed applications.

Rule 1013

One of the major changes to this Rule is to simplify application submission procedures. Currently, this Rule requires applicants to submit their applications in two parts. Part One, which includes primarily forms and fees (e.g., the Forms BD and U-4), is sent directly to CRD in Rockville, Maryland, for processing. Part Two, which includes all remaining documents required for member admission, is sent to the district office that will review the application. At the time the rule was adopted, the staff thought it would be more efficient to send each part to the location where it would be processed. In practice, this has created problems when both parts of the application are not submitted at the same time, or one or both parts are incomplete, making it difficult to determine when the application should be treated as filed and when the staff should begin reviewing it. The application filing date is critical because the 180-day limitation placed on the staff for rendering a decision on the application is measured from this date.

To alleviate these problems, NASD Regulation recommends one point of entry for the entire application - the district office. District staff will review the entire application to determine if it is substantially complete. If so, they will forward any documents that need to go to CRD and continue processing the application.

NASD Regulation proposes a new rule for dealing with applications that are not substantially complete at the time of submission. Currently, the staff does not have any authority to refuse to begin processing an inadequately prepared application. Instead, they attempt to begin processing such an application by sending a request for further information to the applicant. If the applicant does not timely provide the requested information, then the rules permit the staff to "lapse" the application. The staff then notifies the applicant that the application has lapsed, all fees are forfeited, and the applicant is required to start over with the application process if it still wants to become an NASD member. These procedures can consume as much as 90 days and a considerable amount of staff and applicant resources, but still result in a rejected application.

Under the proposed rule, if an application is so deficient upon initial submission that the staff cannot begin processing it (e.g., it is missing major components of the application, such as written supervisory procedures or a business plan), then the staff may reject the application. The staff would have no more than 30 days after submission to do this, and would be required to provide reasons for its action in writing. NASD Regulation proposes a $350 processing fee for the rejection of an application that is not substantially complete.² NASD Regulation considered but rejected defining the term "substantially complete" because the determination will vary depending on the type and complexity of the proposed business, among other things. The lapse rules will still apply to those situations where an applicant stops providing information in the middle of the application process.

Rule 1013 also is simplified by removing requirements for applicants to submit information that has already been submitted to CRD. The district staff has full access to CRD and can obtain the information they need directly from it. This change will make the application process simpler for applicants by eliminating duplicative submissions to NASD Regulation. The proposed rule adds new requirements for applicants to submit information concerning their ability to ensure business continuity, including information about the capacity of their communications and operational systems, contingency plans, disaster recovery plans, and the like. NASD Regulation also proposes a new standard for admission that requires that such systems, plans, and procedures be adequate. The staff would not be required to investigate the adequacy themselves; rather, the applicant would certify that the systems, plans, and procedures are adequate for the applicant's business. The applicant may rely on a third party (e.g., a vendor of such a system) to provide the certification if the applicant so chooses. NASD Regulation requests comment on what sort of certification would be appropriate, who may prepare it, and what it should contain.

NASD Regulation also wishes to clarify that under Rule 1013(b)(4), the applicant and the staff may agree to hold the membership interview at the applicant's place of business.

Rule 1013 is amended by adding new subparagraph (b)(5) to require applicants to provide updated financial information at the time of their membership interview.

Rule 1014

NASD Regulation proposes few changes with respect to the standards for admission. NASD Regulation proposes a new standard with respect to business continuity, as described above. NASD Regulation also proposes that the applicant's supervisory procedures specifically must include procedures to ensure proper registrations are obtained by the firm. All other changes to the standards for admission are conforming changes.

NASD Regulation also considered the requirement of Rule 1014(a)(9)(C) that prospective supervisors have at least one year of direct experience or at least two years of related experience in the subject area to be supervised. NASD Regulation believes that this requirement should continue to be imposed and has published interpretive guidance on this subject in How To Become A Member, which is available online at www.nasdr.com/4700_appendix_b.htm. NASD Regulation does not believe that supervisory experience requirements should be increased.

Rule 1014(c), which concerns the submission of membership agreements, is amended by deleting the requirement that any member with a membership agreement obtain approval from NASD Regulation of any change in business outside the terms of the agreement. NASD Regulation believes that this provision is too restrictive, particularly for firms with no disciplinary history. The provision also puts members with a membership agreement at a disadvantage vis-à-vis members that do not have a membership agreement.³ Therefore, this provision is deleted.

When the proposed rules become effective, to ensure that members are treated equally, NASD Regulation will permit members that are eligible for the safe harbor to use it, even if their membership agreement includes a requirement to obtain approval from NASD Regulation of any change in business outside the terms of the agreement. When NASD Regulation examines a member, it will update the membership agreement to reflect the new rule.

NASD Regulation also requests comment on whether restrictions in a membership agreement should automatically sunset after a fixed period (e.g., five years) if the applicant does not have any disciplinary history.

In addition, upon adoption of the proposed rules, NASD Regulation will begin including business expansion plans in membership agreements to the extent practicable.

Rule 1015

NASD Regulation proposes to delete the NAC's call for review authority. Under current Rule 1015, the NAC or the Review Subcommittee may call for review a district decision on a membership application, even if the applicant does not appeal the decision. NASD Regulation considered at length whether a procedure or policy could be developed to implement this provision effectively, but ultimately determined that it is unworkable.

Member admission decisions do not lend themselves to calls for review. This is especially true for decisions that grant a membership application without restriction because they do not contain a rationale. (Only decisions that deny an application or grant it with a restriction contain a rationale. Decisions that grant an application without restriction simply state that the applicant has met all relevant standards.) Just reading the districts' decisions, without looking at the rest of the record, would not be particularly useful. Unlike a call for review of a regular disciplinary decision, there is no hearing panel vote that might indicate a close or difficult issue. NASD Regulation believes that it would be duplicative of district staff work and inefficient to review every record in its entirety to determine if it supports the decision. NASD Regulation also considered whether certain categories of decisions could be reviewed, but was concerned that such a procedure might be perceived as biased against those firms that fell within the selected category.

Therefore, NASD Regulation has temporarily suspended calls for review of membership decisions, and proposes to delete this provision altogether. NASD Regulation headquarters staff will continue to exercise oversight of the district decision-making process.

NASD Regulation also proposes a new provision for dismissing appeals that are abandoned by an applicant.

Rule 1017

Current Rule 1017, which addresses applications for removal or modification of a business restriction, and Rule 1018, which addresses applications for approval of changes in ownership, control, or operations, are consolidated in proposed Rule 1017. Sometimes a member initiates business changes that involve both rules, which creates confusion as to which rule should be used. Therefore, NASD Regulation proposes to consolidate these rules to make them easier for staff and applicants to use and to eliminate any confusion that may arise from overlapping provisions.

This consolidation is achieved in part by defining the term "material change in business operations" in proposed Rule 1011(i) to include the removal or modification of a business restriction. All material changes in business operations would trigger a review under proposed Rule 1017.

Members should note that a "restriction" is specifically labeled as such in the membership agreement, and NASD Regulation issues a decision that states the rationale for the restriction. A restriction is distinct from other limitations that a member may set forth in its business plan that may be recited as part of the "Business Activities" section of a membership agreement.

For example, an applicant may indicate in its business plan that it intends to have 10 to 20 registered representatives and make markets in no more than 10 stocks. If the NASD approves the application, these self-imposed limitations, which have been considered as part of the application, may be included in the "Business Activities" section of the membership agreement. These types of limitations are not considered "restrictions" under the Rules because they are not imposed by NASD Regulation, and therefore NASD Regulation does not have to include a rationale for them in the decision in the application. Under the proposed Rules, a member that has such limitations in its membership agreement may expand beyond those limitations without prior review and approval by NASD Regulation to the extent permitted in the safe harbor in IM-1011-1.

Another type of change that triggers an application under proposed Rule 1017 is a direct or indirect change in the ownership or control of the member. NASD Regulation wishes to clarify that a group of individuals acting in concert to obtain control of 25 percent or more of the equity or partnership capital of a member will be deemed to be an "entity" under the Rule, and as such, trigger the requirement to submit an application to obtain approval of the ownership/control change.

NASD Regulation proposes to discontinue its review of certain ownership or control changes. Under proposed Rule 1017, NASD Regulation would discontinue review of member mergers and acquisitions that are reviewed by the New York Stock Exchange, thereby eliminating duplication by self-regulatory organizations.

Proposed Rule 1017 also sets forth for the first time what type of information should be included in an application and the content of the staff's decision on an application under this rule. The Rule also clarifies when the application should be filed and what changes can be effected prior to obtaining NASD Regulation's approval.

NASD Regulation requests comment on whether a new provision should be added to proposed Rule 1017 to clarify what happens if a change in ownership is denied. For example, the Rule could provide that if the ownership change is denied, then the member cannot engage in the securities or investment banking business, and that the firm has a fixed period of time to find new owners or file a Form BDW. Of course, as under the current rules, a member could continue to operate with the approved owners if the transaction has not closed or otherwise could be unwound.

As part of its review of the Rule 1010 Series, NASD Regulation considered whether the time frames in proposed Rule 1017 could be shortened so that the overall process would be completed in 90 days. NASD Regulation determined not to shorten the time frames at this time because other rule revisions (e.g., defining material change in operations and listing the documents required for the application) should speed up processing of applications. NASD Regulation is working on additional guidance to members on what types of documents and information the staff will require if a member requests approval to engage in certain specialized areas of the securities or investment banking business. This guidance will be posted on the Web Site in the future. NASD Regulation believes that these changes should be given a chance to work before any time frames are shortened. NASD Regulation will reconsider the issue one year after the rule revisions have become effective and more information is available about the processing time for applications.

Rule 1018

NASD Regulation proposes to adopt a new Rule 1018, which would permit the staff to stay a membership application under Rule 1013 or 1017 if:

• a state or federal authority files criminal charges against the applicant or a principal or proposed principal of the applicant;



• the SEC files a complaint or a request for injunctive relief against the applicant or a principal or proposed principal of the applicant; or



• the NASD, another self-regulatory organization, or a state files a complaint alleging a violation of one of the laws or rules listed in proposed IM-1011-1 (or a comparable state provision).

Under the proposed rule, the stay would be lifted automatically if the applicant prevailed in the disciplinary action. The staff also would be authorized to lift the stay if circumstances changed. If the staff denied the request to lift the stay, the applicant could appeal to the National Adjudicatory Council.

Summary of Requests for Specific Comments

NASD Regulation encourages members and other interested parties to comment on all aspects of the proposed rules discussed in this Notice. We also specifically solicit comment on the following issues:

• the definition of material changes in business operations in proposed Rule 1011(i);



• the safe harbor numbers set forth in proposed IM-1011-1;



• the definition of disciplinary history in proposed IM-1011-1;



• whether the definition of disciplinary history should include violations by officers or principals of the member;



• how an applicant should demonstrate that it can ensure business continuity under proposed Rule 1014(a)(6);



• whether restrictions in a membership agreement should automatically sunset after a fixed period (e.g., five years) if the applicant does not have any disciplinary history; and



• whether a provision should be added to proposed Rule 1017 that clarifies what happens if a change in ownership is denied, e.g., whether the Rule specifically should provide that if the ownership change is denied, then the member cannot engage in the securities or investment banking business, and that the firm has a fixed period of time to find new owners or file a Form BDW.

Endnotes

¹ Members of the Committee are: Faith Colish, New York, New York; Linda Lerner, All-Tech Investment Group, Inc., Montvale, New Jersey; Brian T. Shea, Pershing, Jersey City, New Jersey; Theodore W. Urban, Ferris, Baker Watts, Incorporated, Washington, D.C.; and Richard P. Woltman, Spelman & Co., Inc., San Diego, California. Mr. Urban chairs the Committee.

² NASD Regulation also proposes to charge a $350 processing fee for Rule 1017 applications that are not substantially complete. Currently, NASD Regulation does not charge a fee for Rule 1017 applications, but anticipates doing so in the future.

³ In 1984, the SEC approved a codification of the NASD's member admission procedures, which included a requirement that any restriction on a member's business be included in a membership agreement executed by the member. See Exchange Act. Rel. No. 21159, 49 FR 30268 (Jul. 27. 1984) (File No. SR-NASD-82-24). Thus, a member admitted before 1984 or a member admitted without any restriction from 1984 to 1997 may not have a membership agreement. In 1997, NASD Regulation began requiring all new members to execute a membership agreement, regardless of whether NASD Regulation imposed any restriction. See NASD Rule 1014(c); Exchange Act Rel. No. 38908 (Aug. 7, 1997); 62 FR 43385 (Aug. 13, 1997) (File No. SR-NASD-97-28).