[Federal Register Volume 78, Number 250 (Monday, December 30, 2013)]
[Notices]
[Pages 79542-79559]
[FR Doc No: 2013-31134]

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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-71179; File No. SR-FINRA-2013-025]

Self-Regulatory Organizations; Financial Industry Regulatory
Authority, Inc.; Order Granting Approval of a Proposed Rule Change To
Adopt Rules Regarding Supervision in the Consolidated FINRA Rulebook,
as Modified by Amendment No. 1

December 23, 2013.

I. Introduction

    On June 21, 2013, the Financial Industry Regulatory Authority, Inc.
(``FINRA'') filed with the Securities and Exchange Commission (``SEC''
or ``Commission''), pursuant to Section 19(b)(1) of the Securities
Exchange Act of 1934 (``Exchange Act'' or ``Act'') \1\ and Rule 19b-4
thereunder,\2\ a proposed rule change to adopt consolidated FINRA
supervision rules.\3\ The proposed rule change was published for
comment in the Federal Register on July 8, 2013.\4\ The Commission
received seventeen (17) individual comment letters in response to the
proposed rule change and five hundred sixty (560) comments using a form
comment letter (``Letter Type A'').\5\ On October 2, 2013, FINRA
responded to the comments \6\ and filed Amendment No. 1 to the proposed
rule change. On October 4, 2013, the Commission published notice of
Amendment No. 1 to solicit comment from interested persons and
instituted proceedings pursuant to Section 19(b)(2)(B) of the Act to
determine whether to approve or disapprove FINRA's proposal as modified
by Amendment No. 1.\7\ The Commission received three comment letters in
response to the Notice and Proceedings Order.\8\ On November 12, 2013,
FINRA responded to comments to the proposed rule change, as modified by
Amendment No. 1.\9\ The Commission is publishing this order (``Order'')
to approve the proposed rule change, as modified by Amendment No. 1, on
an accelerated basis.\10\
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ On June 10, 2011, FINRA filed with the SEC a proposed rule
change to adopt the consolidated FINRA supervision rules (``2011
Filing''), which addressed the comments received in response to
FINRA's Regulatory Notice 08-24 (May 2008). See Exchange Act Release
No. 64736 (June 23, 2011), 76 FR 38245 (June 29, 2011) (Notice of
Filing No. SR-FINRA-2011-028). FINRA withdrew the 2011 Filing on
September 27, 2011. See Exchange Act Release No. 65477 (October 4,
2011), 76 FR 62890 (October 11, 2011) (Notice of Withdrawal of File
No. SR-FINRA-2011-028).
    \4\ See Exchange Act Release No. 69902 (July 1, 2013), 78 FR
40792 (July 8, 2013) (Notice of Filing of a Proposed Rule Change to
Adopt Rules Regarding Supervision in the Consolidated FINRA
Rulebook) (``Proposing Release''). The comment period closed on July
29, 2013.
    \5\ See letters from Steven B. Caruso, Esq., Maddox Hargett
Caruso, P.C., to Elizabeth M. Murphy, Secretary, SEC, dated July 12,
2013 (``Caruso''); Norman B. Arnoff, Esq., to Elizabeth M. Murphy,
Secretary, SEC, dated July 19, 2013 (``Arnoff''); J.S.
Brandenburger, Registered Principal, FSC Securities Corporation, to
Elizabeth M. Murphy, Secretary, SEC, dated July 25, 2013
(``Brandenburger''); Steve Putnam, Financial Advisor, Raymond James
Financial Services, to Elizabeth M. Murphy, Secretary, SEC, dated
July 25, 2013 (``Putnam''); Nina Schloesser McKenna, General
Counsel, Cetera Financial Group, Inc., to Elizabeth M. Murphy,
Secretary, SEC, dated July 29, 2013 (``Cetera''); Scott Cook, Senior
Vice President and Chief Compliance Officer, Charles Schwab & Co.,
Inc., to Elizabeth M. Murphy, Secretary, SEC, dated July 29, 2013
(``Schwab''); Clifford Kirsch and Eric A. Arnold, Sutherland Asbill
& Brennan LLP, on behalf of the Committee of Annuity Insurers, to
Elizabeth M. Murphy, Secretary, SEC, dated July 29, 2013 (``CAI'');
David T. Bellaire, Esq., Executive Vice President & General Counsel,
Financial Services Institute, to Elizabeth M. Murphy, Secretary,
SEC, dated July 29, 2013 (``FSI''); Howard Spindel, Senior Managing
Director, and Cassondra E. Joseph, Managing Director, Integrated
Management Solutions USA, LLC, to Elizabeth M. Murphy, Secretary,
SEC, dated July 29, 2013 (``IMS''); Tamara K. Salmon, Senior
Associate Counsel, Investment Company Institute, to Elizabeth M.
Murphy, Secretary, SEC, dated July 29, 2013 (``ICI''); Susanne
Denby, Chief Compliance Officer, NFP Securities, Inc., to Elizabeth
M. Murphy, Secretary, SEC, dated July 29, 2013 (``NFP''); A. Heath
Abshure, President and Arkansas Securities Commissioner on behalf of
the North American Securities Administrators Association, Inc., to
Elizabeth M. Murphy, Secretary, SEC, dated August 6, 2013
(``NASAA''); Scott C. Ilgenfritz, President, Public Investors
Arbitration Bar Association, to Elizabeth M. Murphy, Secretary, SEC,
dated July 29, 2013 (``PIABA''); Ira D. Hammerman, Senior Managing
Director and General Counsel, Securities Industry and Financial
Markets Association, to Elizabeth M. Murphy, Secretary, SEC, dated
July 29, 2013 (``SIFMA''); Pamela Albanese, Legal Intern, and
Christine Lazaro, Esq., Acting Director, Securities Arbitration
Clinic of St. John's University School of Law, to Elizabeth M.
Murphy, Secretary, SEC, dated July 29, 2013 (``St. John's''); Brian
P. Sweeney, Law Office of Brian P. Sweeney, to Elizabeth M. Murphy,
Secretary, SEC, dated July 29, 2013 (``Sweeney''); Robert J.
McCarthy, Director of Regulatory Policy, Wells Fargo Advisors, LLC,
to Elizabeth M. Murphy, Secretary, SEC, dated July 29 2013 (``Wells
Fargo''); see also Memorandum from the Division of Trading and
Markets, SEC, dated August 29, 2013 (memorializing an August 5, 2013
conference call between SEC staff and Gary Goldsholle and Michael
Post of the Municipal Securities Rulemaking Board (``MSRB'') to
discuss FINRA's recently proposed rule change to adopt the proposed
consolidated supervision rules) (``MSRB Memo''). The Notice and
Proceedings Order, as defined in footnote 7, identified 555 comments
as having been received using Letter Type A. This number has been
updated to reflect 560 total number of submissions using Letter Type
A.
    \6\ See letter from Patricia Albrecht, Assistant General
Counsel, FINRA, to Elizabeth M. Murphy, Secretary, SEC, dated
October 2, 2013 (``October Response'').
    \7\ See Exchange Act Release No. 70612 (October 4, 2013), 78 FR
62831 (October 22, 2013) (Notice of Filing of Amendment No. 1 and
Order Instituting Proceedings 2013-SR-FINRA-025) (``Notice and
Proceedings Order''). The comment period closed on October 28, 2013.
    \8\ See letters from Tamara K. Salmon, Senior Associate Counsel,
Investment Company Institute, to Elizabeth M. Murphy, Secretary,
SEC, dated October 17, 2013 (``ICI's October Letter''); David T.
Bellaire, Esq., Executive Vice President & General Counsel,
Financial Services Institute, to Elizabeth M. Murphy, Secretary,
SEC, dated October 28, 2013 (``FSI's October Letter''); Andrea
Seidt, President and Ohio Securities Commissioner on behalf of the
North American Securities Administrators Association, Inc., to
Elizabeth M. Murphy, Secretary, SEC, dated November 5, 2013
(``NASAA's November Letter''); see also Memorandum from the Division
of Trading and Markets, SEC, dated November 12, 2013 (memorializing
a November 8, 2013 conference call between SEC staff and Tamara
Salmon of the ICI to discuss FINRA's recently proposed rule change
to adopt the proposed consolidated supervision rules (``ICI Memo'').
    \9\ See letter from Patricia Albrecht, Assistant General
Counsel, FINRA, to Elizabeth M. Murphy, Secretary, SEC, dated
November 12, 2013 (``November Response'').
    \10\ The text of the proposed rule change, as modified by
Amendment No. 1, is available on FINRA's Web site at http://www.finra.org, at the principal office of FINRA, and at the
Commission's Public Reference Room. The October Response and the
November Response are available on the Commission's Web site at
http://www.sec.gov.
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II. Description of Proposal
    As further described in the Proposing Release, FINRA proposes to
adopt consolidated FINRA broker-dealer supervision rules.\11\ As part
of the process of developing a new consolidated rulebook
(``Consolidated FINRA Rulebook''),\12\ the proposed rule change would
(1) adopt FINRA Rules 3110 (Supervision) and 3120 (Supervisory Control
System) to largely replace NASD Rules 3010 (Supervision) and 3012
(Supervisory Control System), respectively; (2) incorporate into FINRA
Rule 3110 and its supplementary material the requirements of NASD IM-
1000-4 (Branch Offices and Offices of Supervisory Jurisdiction), NASD
IM-3010-1 (Standards for Reasonable Review), Incorporated NYSE Rule
401A (Customer Complaints), and Incorporated NYSE Rule 342.21 (Trade
Review and Investigation); (3) replace NASD Rule 3010(b)(2) (often
referred to as the ``Taping Rule'') with new FINRA Rule 3170 (Tape
Recording of Registered

Persons by Certain Firms); (4) replace NASD Rule 3110(i) (Holding of
Customer Mail) with new FINRA Rule 3150 (Holding of Customer Mail); and
(5) delete the following Incorporated NYSE Rules and NYSE Rule
Interpretations: (i) NYSE Rule 342 (Offices--Approval, Supervision and
Control) and related NYSE Rule Interpretations; (ii) NYSE Rule 343
(Offices--Sole Tenancy, and Hours) and related NYSE Rule
Interpretations; (iii) NYSE Rule 351(e) (Reporting Requirements) and
NYSE Rule Interpretation 351(e)/01 (Reports of Investigation); (iv)
NYSE Rule 354 (Reports to Control Persons); and (v) NYSE Rule 401
(Business Conduct). FINRA modified its proposal in certain respects
through Amendment No. 1, as described in the Notice and Proceedings
Order.\13\
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    \11\ See infra Section III, describing sections of the proposed
rule change in the context of comments received.
    \12\ The current FINRA rulebook consists of: (1) FINRA Rules;
(2) NASD Rules; and (3) rules incorporated from the New York Stock
Exchange (``Incorporated NYSE Rules'') (together, the NASD Rules and
Incorporated NYSE Rules are referred to as the ``Transitional
Rulebook''). While the NASD Rules generally apply to all FINRA
members, the Incorporated NYSE Rules apply only to those members of
FINRA that are also members of the NYSE. The FINRA Rules apply to
all FINRA members, unless such rules have a more limited application
by their terms. For more information about the rulebook
consolidation process, see Information Notice, March 12, 2008
(Rulebook Consolidation Process).
    \13\ See supra note 7.
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    FINRA stated that it would announce the effective date of the
proposed rule change in a Regulatory Notice to be published no later
than 90 days following Commission approval. The effective date will be
no later than 365 days following Commission approval.

III. Discussion of Comments and FINRA's Response

    On July 8, 2013, the Commission published in the Federal Register
FINRA's proposed rule change to adopt consolidated FINRA supervision
rules.\14\ The comment period ended on July 29, 2013 and the Commission
received the 17 individual comment letters listed above as well as 560
comments using a form comment letter.\15\ A few commenters generally
supported the proposal, but many commenters raised specific concerns,
including, among other things, references to MSRB rules; \16\ the scope
of the definition of the term ``covered accounts;'' \17\ the
application of a risk-based approach to supervision; \18\ the
conditions for establishing a one person office of supervisory
jurisdiction (``OSJ''); \19\ the requirements and presumptions relating
to a single principal supervising multiple OSJs; \20\ the documentation
requirements relating to written and oral complaints; \21\ and the lack
of a cost benefit analysis. FINRA filed Amendment No. 1 to address
commenter concerns and responded to comments in a letter dated October
2, 2013.\22\
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    \14\ See supra note 4.
    \15\ See supra note 5.
    \16\ ICI. See also MSRB Memo.
    \17\ Brandenburger, CAI, FSI, ICI, IMS, Letter Type A, Putnam,
SIFMA.
    \18\ Cetera, ICI, IMS, SIFMA.
    \19\ Brandenburger, Cetera, IMS, Letter Type A, Putnam.
    \20\ CAI, Cetera, FSI, IMS, Wells Fargo.
    \21\ Caruso, NASAA, PIABA, St John's.
    \22\ See supra note 6.
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    On October 22, 2013, the Commission published in the Federal
Register the Notice and Proceedings Order.\23\ The comment period ended
on October 28, 2013 and the Commission received the three comment
letters listed above.\24\ One commenter fully supported the proposal
and the other two commenters restated concerns raised in their original
letters.\25\ One commenter raised an additional concern in response to
Amendment No. 1.\26\ FINRA responded to comments in a letter dated
November 12, 2013.\27\
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    \23\ See supra note 7.
    \24\ See supra note 8. Due to a temporary closure of the Federal
Register, the Notice and Proceedings Order was not published in the
Federal Register until October 22, 2013.
    \25\ See infra note 32 and accompanying text; see also supra
note 8.
    \26\ See infra Section III(A)(6)(C).
    \27\ See supra note 9.
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    The sections below discuss: the comments received to the Proposing
Release and the Notice and Proceedings Order; FINRA's October Response
and November Response; and the Commission's findings.

A. General Comments

1. Support for Proposal
    Several commenters to the Proposing Release expressed overall
support for the proposed rule change \28\ and specific changes FINRA
made in response to comments on the 2011 Filing, including requiring
that supervisory procedures and corresponding amendments be
communicated to relevant associated persons rather than throughout the
organization; eliminating the requirement that associated persons
verify annually that they have reviewed their firm's written
supervisory procedures; eliminating risk management from the additional
content requirements under proposed FINRA Rule 3120; and clarifying
that supplementary material is part of the rule and the location of
language within the supplementary material does not affect the weight
or significance of a provision.\29\ Commenters also expressed support
for FINRA's efforts to consolidate the existing NASD and Incorporated
NYSE rules into the FINRA rulebook.\30\
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    \28\ Cetera, NFP, Schwab, SIFMA, St. John's, Sweeney.
    \29\ Schwab, SIFMA.
    \30\ NASAA, PIABA, Wells Fargo.
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    In response to the Notice and Proceedings Order, one commenter
expressed strong support for the proposed rule change, as modified by
Amendment No. 1.\31\ The commenter stated that the proposed rule
change, as amended, ``will ensure that investors are protected by the
robust supervision programs implemented by firms, and that firms can
continue to effectively utilize their supervisory structures and
procedures under clear regulatory requirements.'' \32\
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    \31\ FSI's October Letter.
    \32\ Id.
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2. Opposition to Risk-Based Review Principles
    Two commenters to the Proposing Release opposed the proposed rules'
flexibility permitting members to rely on risk-based or principles-
based review standards for specific obligations, such as the review of
securities transactions and correspondence, arguing that such
flexibility would result in reduced or diminished supervisory
requirements that would not achieve the purpose of protecting the
investing public.\33\
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    \33\ NASAA, PIABA.
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    FINRA responded by explaining that the proposed rules' risk-based
approach for certain aspects of a member's supervisory procedures is
intended to further strengthen, not diminish, investor protection by
allowing firms the flexibility to establish their supervisory programs
in a manner that reflects their business models, and based on those
models, focus on areas where heightened concern may be warranted.\34\
FINRA also noted that the proposed rules further protect investors by
retaining specific prescriptive requirements of NASD Rules 3010 and
3012, such as mandatory inspection cycles, prohibitions on who can
conduct location inspections, and procedures for the monitoring of
enumerated activities. FINRA also pointed to additional prescriptive
requirements in the proposed rules, including special supervision for
supervisory personnel rather than just the existing special supervision
for producing managers, specific procedures to detect and investigate
potential insider trading violations, and additional content
requirements for specific firms' annual reports. FINRA noted that it
understands concerns that additional guidance may be needed and intends
to provide such guidance as circumstances warrant.
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    \34\ October Response.
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3. Reconsider Previously Proposed Supplementary Material
    One commenter to the Proposing Release suggested that FINRA

reconsider its decision to delete supplementary material previously
proposed in the 2011 Filing providing that for a member's supervisory
system to be reasonably designed to achieve compliance with FINRA Rule
2010 (Standards of Commercial Honor and Principles of Trade), it must
include supervision of all of a member's business lines irrespective of
whether they require broker-dealer registration.\35\ This commenter
restated this concern in a second letter.\36\ FINRA responded that it
continues to believe that it was the best course to eliminate the
proposed supplementary material from the proposed rule because of
potential differences with the supervision requirements otherwise
applicable to those business lines.\37\ FINRA stated that it will
continue to apply FINRA Rule 2010's standards to non-securities
activities of members and their associated persons consistent with
existing case law.
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    \35\ NASAA (referring to the 2011 Filing's proposed FINRA Rule
3110.01 (Business Lines)).
    \36\ NASAA's November Letter.
    \37\ October Response. See also November Response, stating that
FINRA continues to support its analysis of these issues as described
above.
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4. Cost Benefit Analysis
    One commenter to the Proposing Release stated that the proposal's
compliance costs would be minimal and outweighed by the benefits.\38\
Other commenters suggested that the proposal lacked a sufficient cost
benefit analysis,\39\ with some commenters stating that FINRA had not
provided any specific performance objectives or identified other
metrics to which it may later refer to assess the effectiveness of the
proposed changes.\40\ One commenter acknowledged that it was not
possible for FINRA to perform a thorough cost benefit analysis when the
proposal was filed, but suggested that FINRA revisit the proposed rules
within five years of their adoption to ensure they are achieving their
stated purpose while avoiding unnecessary costs.\41\
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    \38\ St. John's.
    \39\ Brandenburger, FSI, IMS, Letter Type A, Putnam.
    \40\ Brandenburger, FSI, IMS, Letter Type A.
    \41\ FSI.
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    FINRA responded that the proposed rule change, as amended, strives
to minimize the membership's burden and cost of complying with the
consolidated supervision rules, as consistent with their purposes.\42\
FINRA noted that the consolidated supervision rules transfer many of
the existing requirements in NASD Rules 3010 and 3012 relating to,
among other things, supervisory systems, written procedures, internal
inspections, review of correspondence, and supervisory controls. Thus,
FINRA believes that transferring existing requirements does not raise
additional costs or burdens for firms because firms have already
developed the necessary procedures and supporting systems to comply
with those requirements. FINRA further noted that the proposed rule
change also would delete Incorporated NYSE Rule 342 and much of its
supplementary material and interpretations as they are, in main part,
either duplicative of, or not in alignment with, the proposed
supervision requirements, thereby reducing potential costs to firms
that are members of both FINRA and the NYSE.
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    \42\ October Response.
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    In addition, FINRA noted that it has also applied a risk-based
approach or similar flexibility for specified aspects of a member's
supervisory procedures that is intended to allow firms the ability to
establish their supervisory programs in a manner that reflects their
business models, and based on those models, focus on areas where
heightened concerns may be warranted. Those aspects include:
     Permitting risk-based review of all transactions relating
to a member's investment banking or securities business; \43\
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    \43\ See proposed FINRA Rule 3110(b)(2) and FINRA Rule 3110.05,
discussed further at infra Section III(E); see also Section E, page
12 of FINRA's October Response and Section 2(C), page 5 of FINRA's
November Response.
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     Permitting risk-based review of a member's correspondence
and internal communications that fall outside of the subject matters
listed in proposed FINRA Rule 3110(b)(4); \44\
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    \44\ See proposed FINRA Rule 3110(b)(4) and FINRA Rule 3110.06,
discussed further at infra Section III(F); see also Section F, page
14 of FINRA's October Response and Section 2(E)(i), page 6 of
FINRA's November Response.
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     Providing exceptions, based on a member's size, resources,
and business model, from proposed FINRA Rule 3110's provisions
regarding the supervision of a member's supervisory personnel and the
persons prohibited from conducting a location's inspections; \45\
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    \45\ See proposed FINRA Rule 3110(b)(6)(C)(ii) and FINRA Rule
3110(c)(3)(C), discussed further at infra Section III(H); see also
Section H, page 19 and Section K, page 24 of FINRA's October
Response and Section 2(D), page 5-6 of FINRA's November Response.
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     Requiring that only members reporting $200 million or more
in gross revenues in the preceding year (increased from the $150
million threshold originally proposed in the 2011 Filing) include in
the annual report required by FINRA Rule 3120 supplemental information
from Incorporated NYSE Rule 342.30's annual report content
requirements; \46\
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    \46\ See proposed FINRA Rule 3120(b), discussed further at infra
Section III(M); see also Section N, page 34 of FINRA's October
Response and Section 2(G), page 11 of FINRA's November Response.
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     Aligning proposed FINRA Rule 3110(d)'s definition of
``covered account'' with respect to detecting and investigating
potential insider trading violations with existing NYSE guidance in
response to commenters' concerns regarding compliance costs and
burdens; \47\
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    \47\ See proposed FINRA Rule 3110(d)(1)(A) through (D),
discussed further at infra Section III(K); see also Section L, page
29 of FINRA's October Response and Section 2(F)(ii), page 10 of
FINRA's November Response.
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     Replacing NASD Rule 3110(i) (Holding of Customer Mail) and
its strict time limits for holding customer mail with proposed FINRA
Rule 3150 (Holding of Customer Mail), which generally allows a member
to hold a customer's mail for a specific time period in accordance with
the customer's written instructions if the member meets specified
conditions; \48\ and
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    \48\ See proposed FINRA Rule 3150(a) and (b).
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     Deleting proposed supplementary material, in response to
commenters' concerns regarding compliance costs and burdens that would
have required a senior principal to have a physical presence on a
regular periodic schedule at a one-person office of supervisory
jurisdiction (``OSJ'') where the one-person OSJ principal was
conducting sales-related activities.\49\
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    \49\ See Section C, page 8 of FINRA's October Response and
Section 3, page 12 of FINRA's November Response.

FINRA stated that it agrees that the proposed consolidated supervision
rules should be subject to a retrospective review process following an
appropriate period after their implementation to determine whether they
are achieving their intended purpose or have become overly burdensome
\50\ and would seek to consult with the membership, the public, and
other stakeholders in analyzing the economic impact of the rules.
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    \50\ On September 19, 2013, FINRA issued a public statement,
``Framework Regarding FINRA's Approach to Economic Impact Assessment
for Proposed Rulemaking,'' outlining the core principles defining
FINRA's approach to conducting economic impact assessments for
rulemaking. The framework applies specifically to significant new
rule proposals, and therefore would not cover the current proposal.
However, as noted in the framework, FINRA has historically taken
into account the costs and burdens of its rulemaking, including the
changes proposed in the proposed consolidated supervision rule
filing.

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5. Include Other Supervisory-Related Requirements
    Some commenters to the Proposing Release requested that FINRA
revise the proposal to include provisions addressing other supervisory-
related issues.\51\ These issues include, for example, establishing a
minimum ratio of producing representatives to compliance officers,\52\
requiring heightened supervision for associated persons with a high
volume of complaints,\53\ identifying and supervising suspicious
withdrawal patterns,\54\ and requiring special supervisory procedures
for senior investors and non-English speaking customers.\55\ FINRA
responded that it believes that these matters should be considered as
part of a member's establishment of a supervisory system and procedures
reasonably designed to achieve compliance with the federal securities
laws and FINRA rules, and the testing and verification of such
procedures under FINRA Rule 3120.\56\ In this regard, FINRA noted that
it has issued guidance addressing areas of concern, including
supervision of associated persons with disciplinary history,\57\
verification of emailed instructions to transmit or withdraw
assets,\58\ and obligations relating to senior investors.\59\
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    \51\ Sweeney, St. John's, PIABA. In addition, IMS suggested that
FINRA include in the proposal a specific presumption that a member
firm's supervisory procedures would be presumed acceptable to FINRA
examiners if the firm's procedures are properly documented and
reasonable in light of the scope of its business, the extent of its
customer contact, and its disciplinary history. However, as FINRA
has noted previously, members retain the responsibility to design
and implement supervisory procedures that are appropriate for their
specific businesses and structures. See Notice to Members 99-45
(June 1999).
    \52\ Sweeney.
    \53\ PIABA.
    \54\ PIABA.
    \55\ St. John's.
    \56\ October Response.
    \57\ See, e.g., Notice to Members 97-19 (April 1997).
    \58\ See Regulatory Notice 12-05 (January 2012).
    \59\ See, e.g., Regulatory Notice 07-43 (September 2007).
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6. Additional General Comments
    One commenter to the Proposing Release suggested that proposed
FINRA Rule 3110 would require firms to have compliance departments that
operate independently from their sales activity.\60\ FINRA responded
that it disagrees with this interpretation of proposed FINRA Rule 3110
and stated that proposed FINRA Rule 3110, which is based primarily on
existing requirements in NASD Rule 3010 and Incorporated NYSE Rule 342
relating to, among other things, supervisory systems, written
procedures, internal inspections, and review of correspondence, is
intended to allow firms the flexibility to establish their supervisory
programs in a manner that reflects their business, size, and
organizational structure.\61\ FINRA further noted that proposed FINRA
Rule 3110 would not require a member to have an independent compliance
department.
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    \60\ Sweeney.
    \61\ October Response.
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    Another commenter to the Proposing Release suggested incorporating
the proposed supplementary material into the body of the proposed
rules.\62\ FINRA responded that supplementary material is part of the
rule and a provision's location as supplementary material is intended
to improve the readability of the rule without affecting the weight,
significance, or enforceability of the provision.\63\
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    \62\ IMS.
    \63\ October Response.
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B. Comments on Proposed FINRA Rule 3110(a)

    As proposed, FINRA Rule 3110(a) (Supervisory System) would have
required a member to have a supervisory system for the activities of
its associated persons that is reasonably designed to achieve
compliance with applicable securities laws and regulations and FINRA
and the MSRB rules. One commenter to the Proposing Release requested
that FINRA delete proposed FINRA Rule 3110(a)'s reference to the MSRB
rules.\64\ FINRA responded that the proposed reference to the MSRB
rules was intended to clarify that members' supervisory systems must
extend to compliance with MSRB rules and also to align FINRA's
supervisory system requirement with the existing requirement under MSRB
Rule G-27 (Supervision) to have a supervisory system that is reasonably
designed to achieve compliance with applicable securities laws and
regulations and MSRB rules.\65\ In light of a member's separate
obligation to comply with MSRB Rule G-27, however, FINRA deleted the
proposal's references to the MSRB rules in Amendment No. 1.
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    \64\ ICI. See also MSRB Memo.
    \65\ See MSRB Rule G-27(b) (Supervisory System).
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C. Comments on Deleted Supplementary Material Regarding One-Person OSJs

    As proposed, FINRA Rule 3110 would have included supplementary
material clarifying the conditions a firm must satisfy to establish a
one-person OSJ consistent with proposed FINRA Rule 3110(a)(4)'s
requirement to have one or more appropriately registered principals in
each OSJ with authority to carry out the supervisory responsibilities
assigned to that office. Specifically, proposed FINRA Rule 3110.03
(One-Person OSJs) expressly provided that the registered principal at a
one-person OSJ (each such person is referred to in this paragraph C as
the ``on-site principal'') cannot supervise his or her own sales
activities and must be under the effective supervision and control of
another appropriately registered principal (``senior principal''). The
proposed supplementary material would have required that the designated
senior principal be responsible for supervising the activities of the
on-site principal at the one-person OSJ and conduct on-site supervision
of the one-person OSJ on a regular periodic schedule to be determined
by the member. In determining the schedule, the proposed supplementary
material would have required a member to consider, among other factors,
the nature and complexity of the securities activities for which the
location is responsible, the nature and extent of contact with
customers, and the disciplinary history of the principal at the one-
person OSJ.
    One commenter to the Proposing Release supported the proposed
supplementary material,\66\ while another commenter suggested that
FINRA revise proposed FINRA Rule 3110.03 to specify that ``no
Registered Principal shall supervise his or her own sales activity.''
\67\ Numerous commenters raised concerns regarding the negative impact
and costs of implementing the proposed requirement.\68\ One commenter
also stated that proposed FINRA Rule 3110.03 would create an
inconsistency and serve little regulatory purpose by requiring the
personal production of one-person OSJs to be supervised differently
than an OSJ with multiple registered persons.\69\ Several other
commenters suggested that proposed FINRA Rule 3110.03 was unnecessary
to ensure effective supervision \70\ and could undermine many
independent firms' overall supervisory structures \71\

where home office principals supervise the sales activities of multiple
field-OSJ principals to prevent conflicts of interest from self-
supervision, or use technology and annual inspections to augment their
supervision.\72\ Commenters also suggested that the requirement to have
``on-site supervision on a regular periodic schedule'' ignores firms'
use of technology-based remote supervisory systems.\73\ One commenter
raised concerns that proposed FINRA Rule 3110.03 would require all
necessary supervisory reviews of the one-person OSJ to be conducted by
the senior principal and sought clarification that the proposed
supplementary material does not limit comprehensive regional
supervisory structures, where regional principals perform annual and
unannounced inspections and a separate centralized supervisory unit
within the home office is dedicated to overseeing specific functions
that require specialized knowledge and experience such as
correspondence, advertising, or trade review.\74\
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    \66\ PIABA. PIABA also expressed overall support for proposed
FINRA Rule 3110(a)(4) and the proposed supplementary material
addressing the supervision of multiple OSJs by a single principal.
    \67\ FSI.
    \68\ Brandenburger, Cetera, FSI, IMS, Letter Type A, Putnam.
    \69\ Cetera.
    \70\ Brandenburger, IMS, Letter Type A, Putnam.
    \71\ Brandenburger, Cetera, IMS, Letter Type A.
    \72\ Cetera.
    \73\ Brandenburger, IMS, Letter Type A, Putnam.
    \74\ FSI.
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    FINRA responded that it believes that OSJs conduct critical
functions and one-person OSJs present unique supervisory challenges.
However, in light of commenters' continuing concerns regarding
compliance costs and burdens, in Amendment No. 1, FINRA eliminated the
proposed supplementary material from the proposed rule.\75\ FINRA noted
that, importantly, it believes that one-person OSJ locations where the
on-site principal engages in sales-related activities that trigger OSJ
designation should be subject to scrutiny, and firms should conduct
focused reviews of such locations.\76\ FINRA stated that such locations
would be subject to the general provisions of proposed FINRA Rule
3110(a)(5) (requiring all registered persons to be assigned to an
appropriately registered representative(s) or principal(s) who will be
responsible for supervising that person's activities) and proposed
FINRA Rule 3110(b)(6) (requiring procedures prohibiting associated
persons who perform a supervisory function from, among other things,
supervising their own activities).\77\ In addition, FINRA noted that it
would continue to monitor one-person OSJs for possible conflicts of
interest or sales practice violations and may determine to address the
matter further as part of a retrospective review process following an
appropriate period after implementation of proposed FINRA Rule 3110.
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    \75\ The deletion of this proposed supplementary material has
resulted in a change in numbering of the remaining supplementary
material to proposed FINRA Rule 3110. For ease of reference, FINRA's
responses to comments employ the new proposed numbers in all
instances.
    \76\ See October Response (citing to SEC Division of Market
Regulation, Staff Legal Bulletin No. 17: Remote Office Supervision
(March 19, 2004) (reminding broker-dealers that small, remote
offices require vigilant supervision and specifically noting that
``[n]o individual can supervise themselves''); NASD Regulatory &
Compliance Alert, Volume 11, Number 2 (June 1997) (cited by Staff
Legal Bulletin No. 17 as support for statement that individuals
cannot supervise themselves); see also In re Stuart K. Patrick, 51
S.E.C. 419, 422 (May 17, 1993) (``[s]upervision, by its very nature,
cannot be performed by the employee himself'') (SEC order sustaining
application of the New York Stock Exchange's supervisory rule--also
cited by Staff Legal Bulletin No. 17 as support for statement that
individuals cannot supervise themselves)).
    \77\ October Response.
---------------------------------------------------------------------------

    One commenter to the Notice and Proceedings Order opposed the
elimination of the previously proposed supplementary material that
would have required a registered principal at a one-person OSJ to be
under the effective supervision and control of another appropriately
registered principal.\78\ However, the commenter stated that ``the harm
that may have resulted from its removal is remediated by further
changes designed to make it clear that self-supervision is
inappropriate, and [they] encourage FINRA to continue to follow up on
its commitment to continue to examine the unique challenges posed by
One-Person OSJs.'' \79\ FINRA responded that, based on prior comments
on and concerns with issues raised in the Proposing Release, it
continues to believe that it was the best course to eliminate the
proposed supplementary material from the proposed rule.\80\
---------------------------------------------------------------------------

    \78\ NASAA's November Letter.
    \79\ NASAA's November Letter at p. 4.
    \80\ November Response.
---------------------------------------------------------------------------

D. Comments on Proposed FINRA Rule 3110.03

    Proposed FINRA Rule 3110.03 (Supervision of Multiple OSJs by a
Single Principal) would clarify the general requirement in proposed
FINRA Rule 3110(a)(4) to have one or more appropriately registered
principals in each OSJ with authority to carry out the supervisory
responsibilities assigned to that office (an ``on-site principal'').
Specifically, proposed FINRA Rule 3110.03 would clarify that the
requirement to have an appropriately registered principal in each OSJ
requires the designated on-site principal to have a physical presence,
on a regular and routine basis, at the OSJ. FINRA stated that it
strongly believes OSJs engage in critical functions, and the
requirement to have on-site supervision by designating one or more on-
site principals in each OSJ has been a long standing cornerstone in
establishing a reasonable supervisory structure. As a result, proposed
FINRA Rule 3110.03 sets forth a general presumption that a principal
will not be designated and assigned to be the on-site principal
pursuant to proposed FINRA Rule 3110(a)(4) to supervise more than one
OSJ.
    If a member determines it is necessary to assign one principal to
be the designated on-site principal to supervise two or more OSJs, then
the firm must consider, among other things, the following factors:
     Whether the on-site principal is qualified to supervise
the activities and associated persons in each location;
     Whether the on-site principal has the capacity and time to
supervise the activities and associated persons in each location;
     Whether the on-site principal is a producing registered
representative;
     Whether the OSJ locations are in sufficiently close
proximity to ensure that the on-site principal is physically present at
each location on a regular and routine basis; and
     The nature of activities at each location, including size
and number of associated persons, scope of business activities, nature
and complexity of products and services offered, volume of business
done, the disciplinary history of persons assigned to such locations,
and any other indicators of irregularities or misconduct.

In the Proposing Release, the proposed supplementary material would
have created a further general presumption that assigning a principal
to be the on-site principal of more than two OSJs is unreasonable.
1. Clarification of Term ``On-Site Principal''
    As originally proposed, FINRA Rule 3110.03 used the terms ``on-site
supervisor'' and ``designated principal'' interchangeably throughout
the provision. Commenters requested that FINRA clarify in the rule text
whether proposed FINRA Rule 3110.03's terms ``on-site supervisor'' and
``designated principal'' refer to the same person.\81\ In response,
FINRA revised in Amendment No. 1 proposed FINRA Rule 3110.03 to use the
term ``on-site principal'' consistently throughout the provision.
---------------------------------------------------------------------------

    \81\ Cetera, FSI.

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2. Home Office Principals; Costly and Burdensome Implementation
    Two commenters to the Proposing Release raised concerns with
proposed FINRA Rule 3110.03.\82\ One commenter requested that FINRA
either ``exclude `up-the-chain' home office supervision of producing
field OSJ principals'' or more clearly address how the ``physical
presence'' requirement applies to home office employee supervisors. The
commenter specifically raised concerns about whether a home office
principal with supervisory responsibilities over a particular business
line conducted in the OSJ becomes the ``on-site principal'' and
therefore would be required to have a physical presence on a regular
basis.\83\ The second commenter stated that proposed FINRA Rule 3110.03
does not provide sufficient flexibility, is too costly and burdensome
to implement, and fails to take into account firms' various business
structures.\84\
---------------------------------------------------------------------------

    \82\ CAI, Cetera.
    \83\ Cetera.
    \84\ CAI.
---------------------------------------------------------------------------

    FINRA responded that proposed FINRA Rule 3110(a)(4), which would
require a firm to have an appropriately registered principal in each
OSJ with authority to carry out the supervisory responsibilities
assigned to that office by the member, is being transferred unchanged
from current NASD Rule 3010(a)(4).\85\ FINRA further stated that due to
inquiries from firms asking if they could assign one principal to be
the designated on-site principal to two or more OSJs consistent with
the requirements of NASD Rule 3010(a)(4), FINRA staff developed
informal guidance and interpretations under NASD Rule 3010(a)(4). FINRA
stated that Proposed FINRA Rule 3110.03 reflects these interpretations
and consolidates them in one rule.
---------------------------------------------------------------------------

    \85\ October Response.
---------------------------------------------------------------------------

    FINRA further responded that it believes the proposed rule would
continue to provide firms with the flexibility to design supervisory
systems suited for their business models, by allowing some flexibility
in the presence of on-site supervisors if the firm can determine that
the on-site principal has sufficient time and resources to engage in
meaningful supervision of the critical functions that occur at another
OSJ.\86\ FINRA noted that firms can designate more than one on-site
principal at an OSJ to supervise activities at that OSJ based on
particular business lines, and each such principal designated as an on-
site principal is required to have a physical presence on a regular
basis. FINRA further noted that the on-site principal(s) is one part of
a firm's comprehensive supervisory chain and not all ``up the chain''
supervisors must be designated as the on-site principal.
---------------------------------------------------------------------------

    \86\ October Response.
---------------------------------------------------------------------------

3. Elimination of Presumption That More Than Two OSJs Is Unreasonable
    In the proposal, FINRA expressly included two general presumptions
in the rule: (1) one principal should be assigned to be the on-site
principal at one OSJ; and (2) assigning one principal to be the on-site
principal at more than two OSJs is unreasonable. Commenters to the
Proposing Release expressed concern about the effect that the
presumptions would have on smaller firms; and one commenter stated that
the presumptions negated the flexibility that FINRA otherwise intends
to provide.\87\ FINRA stated that the general presumptions were
intended to provide firms with clarity. FINRA noted that the
presumptions established guidelines, not rules, and firms could
overcome the presumptions by demonstrating that assigning one principal
to supervise more than two OSJs is reasonable based on the relevant
factors set forth in proposed FINRA Rule 3110.03.\88\
---------------------------------------------------------------------------

    \87\ IMS, Wells Fargo.
    \88\ Cetera also stated that this presumption inappropriately
shifts the burden of proof to the member and does not appear
justified given the lower ``preponderance of the evidence'' standard
of proof in FINRA disciplinary proceedings. FINRA stated that it
disagrees with the commenter's statement. FINRA explained that
Proposed FINRA Rule 3110(a) specifies the standard that a member's
supervisory system be reasonably designed to achieve compliance with
the applicable Federal securities laws and regulations and FINRA
rules, and it is the member's responsibility to demonstrate that its
supervisory system meets this standard. See October Response.
---------------------------------------------------------------------------

    In response to comments, FINRA proposed in Amendment No. 1 to
replace the presumption in the Proposing Release that assigning one
principal to be the on-site principal at more than two OSJs is
unreasonable with a general statement that assigning a principal to
more than one OSJ will be subject to scrutiny.

E. Comments on Proposed FINRA Rule 3110(b)(2) and FINRA Rule 3110.05

    Proposed FINRA Rule 3110(b)(2) (Review of a Member's Investment
Banking and Securities Business) would require that a member have
supervisory procedures for the review by a registered principal,
evidenced in writing, of all transactions relating to the member's
investment banking or securities business. Proposed FINRA Rule 3110.05
(Risk-based Review of Member's Investment Banking and Securities
Business) permits a member to use a risk-based system to review these
transactions.
1. Additional Clarification Regarding ``Risk-Based Review System''
    Commenters to the Proposing Release requested additional
clarification regarding how to comply with proposed FINRA Rule
3110(b)(2)'s requirement to review all transactions related to a
member's investment banking and securities business if using a risk-
based system to review transactions pursuant to proposed FINRA Rule
3110.05. Specifically, two commenters sought clarification as to
whether a member's supervisory system must take into account ``all''
transactions, considering that a principal only is required to review a
sample of transactions under a ``risk-based review system.'' \89\
Similarly, another commenter asked whether a member firm determining
parameters for a technological-based review system that would cause a
trade to be flagged for more intensive review would be a ``risk-based''
approach that would conform to proposed FINRA Rule 3110(b)(2).\90\
---------------------------------------------------------------------------

    \89\ IMS, SIFMA.
    \90\ Cetera.
---------------------------------------------------------------------------

    FINRA responded that proposed FINRA Rule 3110(b)(2) would transfer
to the FINRA Rulebook NASD Rule 3010(d)(1)'s provision requiring
principal review, evidenced in writing, of all transactions and
clarifies that such review include all transactions relating to the
member's investment banking or securities business.\91\ FINRA stated
that the term ``risk-based'' describes the type of methodology a member
may use to identify and prioritize for review those areas that pose the
greatest risk of potential securities laws and self-regulatory
organization (``SRO'') rule violations. In response to commenters'
requests for clarification on risk-based reviews, FINRA clarified in
Amendment No. 1 that a member would not be required to conduct detailed
reviews of each transaction if a member is using a reasonably designed
risk-based review system that provides a member with sufficient
information that permits the member to focus on the areas that pose the
greatest numbers and risks of violation.
---------------------------------------------------------------------------

    \91\ October Response.
---------------------------------------------------------------------------

    FINRA further responded that it understands that a member's
procedures for the review of its transactions by a registered principal
may include the use of technology-based review systems with parameters
designed to assess which transactions merit further

review.\92\ FINRA noted that the parameters would have to be reviewed
by a principal and that review would have to be documented in writing.
FINRA further noted, as is always the case with the exercise of
supervision under FINRA rules, a principal's use of any automated
supervisory system, aid, or tool for the discharge of supervisory
duties represents a direct exercise of supervision by that principal,
and the principal remains responsible for the discharge of supervisory
responsibilities in compliance with the proposed rule. In addition,
FINRA noted that a principal relying on a risk-based review system is
responsible for any deficiency in the system's criteria that would
result in the system not being reasonably designed.\93\
---------------------------------------------------------------------------

    \92\ Id.
    \93\ See also Regulatory Notice 07-53 (November 2007) (Deferred
Variable Annuities) (discussing use of automated supervisory
systems).
---------------------------------------------------------------------------

2. Exclude Specific Types of Broker-Dealers
    One commenter requested that FINRA either exclude ``mutual fund
underwriters'' and other members that do not have or maintain customer
relationships or effect transactions with or for retail investors from
proposed FINRA Rule 3110(b)(2) or explain how those members are
expected to document compliance.\94\ FINRA stated that the proposed
rules would apply a risk-based approach or similar flexibility for
specified aspects of a member's supervisory procedures to allow firms
the ability to establish their supervisory programs in a manner that
reflects their business models, such as members with limited broker-
dealer activities.\95\ As noted above, FINRA stated that proposed FINRA
Rule 3110(b)(2) would transfer NASD Rule 3010(d)(1)'s provision and
would require a principal to review and evidence in writing all
transactions and that such review would include all transactions
relating to the member's investment banking or securities business.
Thus, members, regardless of their business activities, currently are
required to have a principal review all of their transactions. FINRA
noted that if mutual fund underwriters do not effect transactions, then
the firms would have no review obligations pursuant to proposed FINRA
Rule 3110(b)(2).\96\ FINRA stated that it understands that some
underwriters do have customer relationships that could involve customer
transactions, in which case such member firms would need to review
those transactions pursuant to proposed FINRA Rule 3110(b)(2).\97\
FINRA further stated that proposed FINRA Rule 3110.05 would permit a
mutual fund underwriter to use a risk-based approach to review its
transactions.\98\
---------------------------------------------------------------------------

    \94\ ICI and ICI's October Letter.
    \95\ October Response.
    \96\ October Response and November Response.
    \97\ October Response.
    \98\ Id.
---------------------------------------------------------------------------

    In response to the Notice and Proceedings Order, the same commenter
restated its recommendation that mutual fund underwriters be excluded
from the provision in Rule 3110(b)(2) that would require principal
underwriters to have supervisory procedures that require the review of
all customer transactions and evidence such review in writing. The
commenter acknowledged FINRA's response to its original comment that
``if mutual fund underwriters do not effect transactions, then the
firms would have no review obligations pursuant to proposed FINRA Rule
3110(b)(2);'' however, the commenter remained concerned that mutual
fund underwriters would be required to create, maintain, implement, and
review on an ongoing basis a procedure for reviewing transactions since
the requirement to have such procedures is imposed on all FINRA members
without regard to whether the member effects customer transactions.\99\
---------------------------------------------------------------------------

    \99\ See ICI's October Letter, page 5.
---------------------------------------------------------------------------

    FINRA responded that, if a member does not engage in any
transactions relating to its investment banking or securities business,
it would be sufficient under proposed Rule 3110(b)(2) for the member to
acknowledge in its supervisory procedures that it does not engage in
any such transactions and that it must have supervisory policies and
procedures in place before doing so.\100\
---------------------------------------------------------------------------

    \100\ November Response.
---------------------------------------------------------------------------

F. Comments on Proposed FINRA Rule 3110(b)(4) and Related Supplementary
Materials

    Proposed FINRA Rule 3110(b)(4) (Review of Correspondence and
Internal Communications) would require a member to have procedures to
review incoming and outgoing written (including electronic)
correspondence and internal communications relating to its investment
banking or securities business.\101\ In particular, the supervisory
procedures would require the member's review of: (1) incoming and
outgoing written correspondence to properly identify and handle in
accordance with firm procedures: customer complaints, instructions,
funds and securities, and communications that are of a subject matter
that require review under FINRA rules and federal securities laws; and
(2) internal communications to properly identify communications that
are of a subject matter that require review under FINRA rules and the
federal securities laws.\102\
---------------------------------------------------------------------------

    \101\ In the Proposing Release, proposed FINRA Rule 3110(b)(4)
transferred NASD Rule 3010(d)'s reference to ``correspondence with
the public'' and used the term in related supplementary materials,
proposed FINRA Rules 3110.06-.08. In Amendment No. 1, FINRA revised
proposed FINRA Rule 3110(b)(4) and proposed FINRA Rules 3110.06-.08
to refer to ``correspondence'' to be consistent with FINRA Rule
2210's (Communications with the Public) definition and use of the
term ``correspondence.'' See also FINRA Rule 2210(b)(2) (requiring
that all correspondence be subject to the supervision and review
requirements of existing NASD Rule 3010(d)).
    \102\ In Amendment No. 1, FINRA revised proposed FINRA Rule
3110(b)(4) and FINRA Rule 3110.06 to delete references to the MSRB
rules, consistent with the deletion of such reference in proposed
FINRA Rule 3110(a) discussed above.
---------------------------------------------------------------------------

1. Risk-Based Review of Internal Communications
    Proposed FINRA Rule 3110.06 (Risk-based Review of Correspondence
and Internal Communications) would require a member to decide, by
employing risk-based principles, the extent to which additional
policies and procedures for the review of incoming and outgoing written
correspondence and internal communications that fall outside of the
subject matters listed in proposed FINRA Rule 3110(b)(4) are necessary
for its business and structure.
    Some commenters suggested that FINRA should further align proposed
FINRA Rule 3110.06 with the guidance in Regulatory Notice 07-59.\103\
One commenter stated that the proposed rule could be interpreted as
requiring a member to review all internal communications.\104\ Two
commenters to the Proposing Release requested additional guidance on
the appropriate scope of internal communications requiring review and
methodology for identifying those communications.\105\ Commenters
further suggested that any firm that does not engage in activities that
are of a subject matter that require review should not be required to
review its internal communications for references to those
activities.\106\ One commenter stated that requiring such firms to
review internal communications for reference to those activities would
result in significant costs that are not justified by the limited
additional investor protection

benefits.\107\ Other commenters urged FINRA to further revise proposed
FINRA Rule 3110.06 to state that ``[t]hrough the use of risk-based
principles, firms can determine the extent to which the review of their
internal communications is necessary.'' \108\
---------------------------------------------------------------------------

    \103\ ICI, IMS, Schwab, SIFMA.
    \104\ ICI and ICI's October Letter.
    \105\ CAI, ICI.
    \106\ Brandenburger, FSI, IMS, Letter Type A, Putnam.
    \107\ FSI.
    \108\ IMS, SIFMA.
---------------------------------------------------------------------------

    FINRA responded that, with respect to the review of internal
communications, Regulatory Notice 07-59 states that ``with the
exception of the enumerated areas requiring review by a supervisor,
members may decide, employing risk-based principles, the extent to
which review of any internal communications is necessary in accordance
with the supervision of their business.'' \109\ FINRA responded that it
believes that proposed FINRA Rule 3110.06 would accurately reflect this
guidance by stating that ``[b]y employing risk-based principles, a
member must decide the extent to which additional policies and
procedures for the review of . . . internal communications that are not
of a subject matter that require review under FINRA rules and federal
securities laws are necessary for its business and structure.'' FINRA
stated that, consistent with this guidance, proposed FINRA Rule 3110.06
would not require the review of every internal communication.\110\ For
example, if a member does not engage in any activities that are of a
subject matter that require review, the proposed rule would not require
that the member review its internal communications for references to
those activities, provided that its supervisory procedures acknowledge
that factor as part of the member's determination that its procedures
are reasonably designed to achieve compliance with applicable federal
securities laws and FINRA rules. Accordingly, FINRA declined to amend
the proposal in response to the comments.
---------------------------------------------------------------------------

    \109\ See Regulatory Notice 07-59 (December 2007), at 3, 9.
    \110\ See id. at 11 (specifically noting that the guidance
neither created new supervisory requirements nor required the review
of every communication, and that, ``[w]ith respect to the review of
internal electronic communications, the guidance states that--with
the exception of the enumerated areas requiring review by a
supervisor--a firm may use risk-based principles, including an
examination of existing review processes, to determine the extent to
which review of any internal communications is necessary''); see
also November Response (ICI raised the same issue in its October
Letter and FINRA responded that it believes that its guidance set
forth in Regulatory Notice 07-59, as codified in proposed FINRA Rule
3110.06, addresses this concern).
---------------------------------------------------------------------------

2. Evidence of Review of Communications Using Lexicon-Based Screening
Tools
    Proposed FINRA Rule 3110.07 (Evidence of Review of Correspondence
and Internal Communications) would clarify that merely opening a
communication is not a sufficient review. Rather, a member must
identify what communication was reviewed, the identity of the reviewer,
the date of the review, and the actions taken by the member as a result
of any significant regulatory issues identified during the review.
    Commenters suggested that firms using lexicon-based screening tools
as a risk-based means of reviewing communications should not need to
maintain the documentation required by proposed FINRA Rule 3110.07
evidencing review for those communications that do not generate review
alerts/hits for further review.\111\ One commenter suggested that it
should be sufficient for a member to demonstrate that it has reasonably
designed controls in place to ensure that the screening tools are
subject to review and are operating as intended,\112\ while other
commenters suggested revising proposed FINRA Rule 3110.07 to provide
that ``[f]or those communications subjected to electronic review, the
member must maintain documentation reasonably sufficient to demonstrate
the parameters of such review.'' \113\
---------------------------------------------------------------------------

    \111\ ICI, ICI's October Letter, IMS, SIFMA.
    \112\ ICI and ICI's October Letter.
    \113\ IMS, SIFMA.
---------------------------------------------------------------------------

    FINRA noted that it had previously declined to accept the
suggestion that a member does not have to retain the specified
information fields required by proposed FINRA Rule 3110.07 for
communications reviewed through electronic review systems or lexicon-
based screening tools if those messages do not generate review
alerts.\114\ FINRA stated that it believes that not only is the
required documentation necessary to demonstrate that the communication
was actually reviewed, but that failure to record and retain this
information, such as the identity of the reviewer, could be
inconsistent with a member's record retention obligations under FINRA
and SEC rules.\115\ FINRA further noted that, although proposed FINRA
Rule 3110.07 would permit the use of lexicon-based screening tools and
other automated systems, as noted in Regulatory Notice 07-59, members
utilizing automated tools or systems in the course of their supervisory
review of electronic communications must have an understanding of the
limitations of those tools or systems and should consider what, if any,
further supervisory review is necessary in light of those limitations.
---------------------------------------------------------------------------

    \114\ October Response.
    \115\ Id., citing proposed FINRA Rule 3110.09 (Retention of
Correspondence and Internal Communications) and Exchange Act of 1934
Rule 17a-4(b)(4) (requiring, among other things, that a broker-
dealer's retained communications records include any approvals of
communications sent).
---------------------------------------------------------------------------

    With respect to communications reviewed by electronic surveillance
tools that are not selected for further review, FINRA stated that, it
would be sufficient to demonstrate compliance with proposed FINRA Rule
3110.07 if the electronic surveillance system has a means of
electronically recording evidence that those communications have been
reviewed by that system.\116\ FINRA further stated that it would be
permissible to use an electronic surveillance or reviewing tool that,
with respect to communications that do not generate alerts, only
captures the specified information fields to the extent necessary to
comply with applicable FINRA and SEC rules.\117\ Additionally, FINRA
stated that, consistent with previous guidance discussing the use of
any automated supervisory systems or tools to discharge supervisory
duties, the use of electronic surveillance tools to review
communications represents a direct exercise of supervision by the
supervisor (including any use of such tools by the supervisor's
delegate to review communications). FINRA noted that the supervisor
remains responsible for the discharge of supervisory responsibilities
in compliance with the rule and is responsible for any deficiency in
the system's criteria that would result in the system not being
reasonably designed.\118\
---------------------------------------------------------------------------

    \116\ October Response.
    \117\ November Response.
    \118\ November Response at page 8. See Regulatory Notice 07-53
(November 2007) (Deferred Variable Annuities) (discussing use of
automated supervisory systems).
---------------------------------------------------------------------------

3. Retention of Correspondence and Internal Communications
    Proposed FINRA Rule 3110.09 (Retention of Correspondence and
Internal Communications) would require, among other things, that a
member retain internal communications and correspondence of associated
persons relating to the member's investment banking or securities
business for the period of time and accessibility specified in Exchange
Act Rule 17a-4(b) (not less than three years, the first two years in an
easily accessible place).

    One commenter to the Proposing Release requested that FINRA expand
the record retention period in proposed FINRA Rule 3110.09 to six years
to match the record retention period in Exchange Act Rule 17a-4(c)
(requiring broker-dealers to preserve for a period of not less than six
years after the closing of any customer's account any account cards or
records relating to the terms and conditions with respect to the
opening and maintenance of the account) and to the eligibility
provisions for customer arbitration disputes in FINRA Rule 12206 (Time
Limits).\119\ A second commenter restated this concern in a second
letter.\120\ FINRA responded that firms are already subject to very
extensive record retention requirements regarding communications about
firms' business as such.\121\ In FINRA's view, the cost of extending
the record retention period from three years to six years would
unnecessarily raise costs and create recordkeeping inconsistencies.
FINRA stated that the proposed supplementary material purposefully
aligns the record retention period for communications with the SEC's
record retention period for the same types of communications to achieve
consistent regulation in this area.
---------------------------------------------------------------------------

    \119\ PIABA.
    \120\ NASAA's November Letter.
    \121\ See October Response citing generally Exchange Act Rule
17a-4(b)(4); see also November Response, stating that FINRA
continues to support its analysis of these issues as described
above.
---------------------------------------------------------------------------

G. Comments on Proposed FINRA Rule 3110(b)(5)

    Proposed FINRA Rule 3110(b)(5) (Review of Customer Complaints)
would require members to have supervisory procedures to capture,
acknowledge, and respond to all written (including electronic) customer
complaints.
1. Exclusion of Oral Complaints
    Several commenters to the Proposing Release suggested that members
should be required to reduce an oral complaint to writing or to provide
the customer with a form.\122\ Commenters also suggested that oral
complaints should not be too difficult to capture,\123\ with one
commenter stating that NYSE members have been required to capture and
assess oral complaints for a number of years.\124\ One commenter
restated its concern with regard to the exclusion of oral complaints
from proposed FINRA Rule 3110(b)(5).\125\ FINRA stated that it did not
include oral complaints because they are difficult to capture and
assess, whereas members can more readily capture and assess written
complaints.\126\ FINRA further stated that it continues to believe that
proposed FINRA Rule 3110(b)(5) should include only written customer
complaints. FINRA noted that it encourages members to provide customers
with a form or other format that will allow customers to communicate
their complaints in writing. FINRA further noted that the failure to
address a valid customer complaint, written or oral, may be a violation
of FINRA Rule 2010.\127\
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    \122\ Caruso, NASAA, PIABA, St John's.
    \123\ Caruso, NASAA, PIABA.
    \124\ Caruso.
    \125\ NASAA's November Letter.
    \126\ October Response; see also November Response stating that
FINRA continues to support its analysis of these issues as described
above.
    \127\ FINRA also pointed to its investor education literature
that advises customers to communicate any complaints to their
broker-dealer in writing, especially if customers have lost money or
there were any unauthorized trades made in the customers' accounts.
See FINRA's pamphlet Investor Complaint Program: What to Do When
Problems Arise; see also NASD Rule 2340(a) (Customer Account
Statements) (requiring a customer account statement to, among other
things, advise the customer that any oral communications should be
re-confirmed in writing to further protect the customer's rights,
including rights under the Securities Investor Protection Act
(SIPA)).
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    FINRA further responded that this aspect of the proposed rules
would not change existing rules, explaining that although Incorporated
NYSE Rule 401A previously required firms to acknowledge and respond to
specified customer complaints (both oral and written), to harmonize the
NASD and NYSE rules in the interim period before completion of the
Consolidated FINRA Rulebook, FINRA amended Incorporated NYSE Rule
351(d) (Reporting Requirements) to limit the definition of ``customer
complaint'' to include only written complaints, thereby making the
definition substantially similar to that in NASD Rule 3070(c)
(Reporting Requirements).\128\
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    \128\ See Exchange Act Release No. 58533 (September 12, 2008),
73 FR 54652 (September 22, 2008) (Order Approving File No. SR-FINRA-
2008-036). FINRA adopted FINRA Rule 4530 to replace NASD Rule 3070
and comparable provisions in Incorporated NYSE Rule 351. See
Securities Exchange Act Release No. 63260 (November 5, 2010), 75 FR
69508 (November 12, 2010) (Notice of Filing of Amendments No. 1 and
2 and Order Granting Accelerated Approval of File No. SR-FINRA-2010-
034). FINRA Rule 4530 became effective on July 1, 2011. See
Regulatory Notice 11-06 (February 2011).
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2. Require More Than Written Acknowledgement and Response
    One commenter to the Proposing Release suggested that proposed
FINRA Rule 3110(b)(5)'s requirement to capture, acknowledge, and
respond to customer complaints was insufficient and that firms should
be required to conduct an adequate and objective review and ongoing
monitoring of claims that include, where appropriate, ``bona fide''
offers of resolution, including trade reversal and cancellation, good
faith pre-arbitration or litigation discussion, or negotiation.\129\
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    \129\ Arnoff. This commenter also requested that it be mandatory
for broker-dealers to pay for the customer's litigation and
arbitration expenses if good faith and objectively sound procedures
of supervision, compliance, inspection, and claims handling are not
followed. FINRA responded that it considers the comment to be
outside the scope of the proposed rule change. The FINRA Dispute
Resolution Arbitrator's Guide discusses when arbitration fees and
expenses may be waived or awarded.
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    FINRA responded that it understands the commenter's concerns that
members have procedures in place to take appropriate and meaningful
action with respect to customer complaints and expects that a member's
supervisory procedures will be reasonably designed to respond to
customer complaints.\130\ In addition, FINRA noted that members have
reporting and records preservation obligations for customer complaints
that assist FINRA in monitoring whether a member's supervisory
procedures for capturing, acknowledging, and responding to written
customer complaints are reasonably designed.\131\
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    \130\ October Response.
    \131\ See FINRA Rule 4513 (Records of Written Customer
Complaints) (requiring each member to keep and preserve in each OSJ
either a separate file of all written customer complaints that
relate to that office (including complaints that relate to
activities supervised from that office) and action taken by the
member, if any, or a separate record of such complaints and a clear
reference to the files in that office containing the correspondence
connected with such complaints); see also FINRA Rule 4530 (requiring
each member to promptly report to FINRA, but in any event not later
than 30 calendar days, after the member knows or should have known
of whether the member or a member's associated person is the subject
of any written customer complaint involving allegations of theft or
misappropriation of funds or securities or of forgery, as well as
report to FINRA statistical and summary information regarding
written customer complaints in such detail as FINRA shall specify by
the 15th day of the month following the calendar quarter in which
customer complaints are received by the member).
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H. Comments on Proposed FINRA Rule 3110(b)(6) and FINRA Rule 3110.10

    Proposed FINRA Rule 3110(b)(6) (Documentation and Supervision of
Supervisory Personnel) is based largely on existing provisions in NASD
Rule 3010(b)(3) requiring a member's supervisory procedures to set
forth the member's supervisory system and to include a record of the
member's supervisory personnel with such details as titles,
registration status, locations, and responsibilities. In addition, the

proposed rule would include two new provisions as described in more
detail in the Proposing Release:
     Proposed FINRA Rule 3110(b)(6)(C) would require a member
to have procedures prohibiting its supervisory personnel from
supervising their own activities and reporting to, or having their
compensation or continued employment determined by, a person the
supervisor is supervising (subject to a limited size and resources
exception); and
     Proposed FINRA Rule 3110(b)(6)(D) would require a member
to have procedures to prevent the standards of supervision required
pursuant to proposed FINRA Rule 3110(a) from being reduced in any
manner due to any conflicts of interest that may be present with
respect to the associated person being supervised, such as the person's
position, the amount of revenue such person generates for the firm, or
any compensation that the supervisor may derive from the associated
person being supervised.
    Proposed FINRA Rule 3110.11 (Supervision of Supervisory Personnel)
would indicate that the exception provided in proposed FINRA Rule
3110(b)(6)(C) is generally intended for a sole proprietor in a single-
person firm or where a supervisor holds a very senior executive
position within the firm.
1. Support for New Provisions
    Several commenters to the Proposing Release supported proposed
FINRA Rules 3110(b)(6)(C) and (D),\132\ with one commenter stating that
the provisions ``should never be diluted.'' \133\ Specifically
referring to conflict of interest proscriptions in proposed FINRA Rule
3110(b)(6)(D), one commenter stated that the provision eliminates the
opportunity for activities going unchecked or supervision being more
lenient on the basis of self-interest,\134\ while another commenter
agreed that conflicts of interest relating to the compensation of the
supervisor and the person being supervised should not needlessly
compromise the effectiveness of supervisory procedures.\135\ Referring
to the prohibitions against supervisory personnel supervising their own
activities in proposed FINRA Rule 3110(b)(C), one commenter concurred
that self-supervision is inappropriate.\136\
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    \132\ Cetera, SIFMA, Sweeney, St. John's.
    \133\ Sweeney.
    \134\ St. John's.
    \135\ SIFMA.
    \136\ Cetera.
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2. Heightened Supervision
    As noted in the Proposing Release, proposed FINRA Rule
3110(b)(6)(C) regarding the prohibition of supervisory personnel from
supervising their own activities and reporting to, or having their
compensation or continued employment determined by a person the
supervisor is supervising, would replace NASD Rule 3012(a)(2)'s
provisions concerning the supervision of a producing manager's customer
account activity and the requirement to impose heightened supervision
when any producing manager generates 20 percent or more of the revenue
of the business units supervised by the producing manager's supervisor.
One commenter to the Proposing Release suggested that FINRA retain the
heightened supervisory requirement for producing managers that meet the
20 percent threshold and apply FINRA Rule 3110(b)(6)(C) to producing
managers that do not meet the 20 percent threshold.\137\ This commenter
restated this concern in a second letter.\138\
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    \137\ NASAA.
    \138\ NASAA's November Letter.
---------------------------------------------------------------------------

    FINRA responded that, although it understands the commenter's
concerns regarding the need for effective supervision of producing
managers, FINRA believes that proposed FINRA Rule 3110(b)(6)(C)'s
provisions addressing the supervision of all supervisory personnel,
rather than just producing managers, would be better designed to
prevent supervisory situations that would not lead to effective
supervision.\139\ In addition, FINRA noted that proposed FINRA Rule
3110(b)(6)(D)'s conflicts of interest provisions would be designed to
further ensure effective supervision of supervisory personnel.
---------------------------------------------------------------------------

    \139\ October Response; see also November Response, stating that
FINRA continues to support its analysis of these issues as described
above.
---------------------------------------------------------------------------

3. Review of Senior Executive's Activities
    One commenter to the Proposing Release stated that proposed FINRA
Rule 3110(b)(6)(C) could prevent compliance professionals in the firm
from reviewing the firm's most senior person's activities when that
senior person occasionally produces revenue, and might force a firm to
hire a ``senior principal'' if the senior person in the firm determines
the compliance professionals' compensation or continued employment with
the firm.\140\
---------------------------------------------------------------------------

    \140\ IMS.
---------------------------------------------------------------------------

    FINRA disagreed with the commenter's interpretation of proposed
FINRA Rule 3110(b)(6)(C) and stated that although proposed FINRA Rule
3110(b)(6)(C)(ii) generally would require a member to have procedures
prohibiting its supervisory personnel from, among other things,
reporting to, or having their compensation or continued employment
determined by, a person the supervisor is overseeing, the same
provision specifically provides an exception if a member determines
that compliance with the prohibition is not possible because of a
member's size or a supervisor's position within the firm. FINRA further
stated that a member relying on the exception must document the factors
it used to reach its determination that it can rely on the exception
and how the supervisory arrangement otherwise complies with proposed
FINRA Rule 3110(a). FINRA noted that proposed FINRA Rule 3110.10 would
further provide non-exclusive examples of situations when the exception
would generally apply, including when a registered person is a senior
executive officer (or holds a similar position) and that proposed FINRA
Rule 3110(b)(6)(C) and FINRA Rule 3110.10 do not require a member to
hire additional personnel.\141\
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    \141\ October Letter.
---------------------------------------------------------------------------

4. Limited Exception
    One commenter requested that FINRA either delete proposed FINRA
Rule 3110.10 or revise it to expand the list of situations in which a
firm may rely on the exception to include situations where a person
supervises a senior person for only a limited purpose or function.\142\
---------------------------------------------------------------------------

    \142\ ICI and ICI's October Letter.
---------------------------------------------------------------------------

    FINRA declined to make any revisions to proposed FINRA Rule
3110.10. FINRA explained that the exception in proposed FINRA Rule
3110(b)(6)(C) is specifically based on a member's inability to comply
with the general supervisory requirements because of the member's size
or supervisor's position within the firm.\143\ FINRA stated that
proposed FINRA Rule 3110.10 reflects its view that a member would
generally rely on the exception for a sole proprietor in a single-
person firm or when a supervisor holds a very senior executive position
within the firm. FINRA noted that a member may rely on the exception in
other instances where it cannot comply because of its size or the
supervisor's position within the firm, provided the member

documents the factors used to reach its determination and how the
supervisory arrangement with respect to the supervisory personnel
otherwise complies with proposed FINRA Rule 3110(a).\144\ To clarify
that proposed FINRA Rule 3110.10 would provide non-exclusive examples
of situations where the exception would generally apply, FINRA revised
the provision in Amendment No. 1 to delete the term ``only'' prior to
providing the examples.
---------------------------------------------------------------------------

    \143\ October Response Letter (noting that Proposed FINRA Rule
3110(b)(6)(C)'s exception is based, in large part, on the exception
in NASD Rule 3012 from the general supervisory requirement for a
producing manager's customer account activity and citing to NASD
Rule 3012(a)(2)(A)(ii) (``Limited Size and Resources'' Exception)).
    \144\ Id.
---------------------------------------------------------------------------

    The same commenter restated this recommendation in its comments to
the Notice and Proceedings Order and stated that FINRA's response to
its previous comment did not sufficiently address the concerns or
examples raised in its comments to the Proposing Release.\145\ In
response, FINRA re-emphasized that the revisions to proposed Rule
3110.10's list of examples where a member would need to rely on the
exception is non-exclusive.\146\ FINRA further stated that it continues
to support the principle set forth in proposed Rule 3110(b)(6)(C) that
supervisory personnel must not report to, or have their compensation or
continued employment determined by, a person they are supervising
unless the firm complies with the permitted exception.
---------------------------------------------------------------------------

    \145\ ICI's October Letter.
    \146\ November Response Letter.
---------------------------------------------------------------------------

5. Conflicts of Interest
    Commenters to the Proposing Release expressed concern that
requiring members to have procedures to prevent their supervision
standards from being reduced in any manner due to any conflicts of
interest that may be present was inconsistent with the existing
``reasonably designed'' standard in proposed FINRA Rule 3110(a) (and
current NASD Rule 3010(a)) and the proposed rules' risk-based
supervision principles.\147\ One commenter questioned whether proposed
FINRA Rule 3110(b)(6)(D) creates a strict liability standard with
respect to eliminating conflicts of interest.\148\ Commenters requested
that FINRA revise proposed FINRA Rule 3110(b)(6)(D) to clarify that
firms must mitigate conflicts of interest as part of designing and
establishing a reasonable supervisory system.\149\ Two commenters
suggested that FINRA amend the proposed supplementary material to
require a member to have `` . . . procedures reasonably designed to
prevent the supervisory system required pursuant to paragraph (a) of
this Rule from being reduced. . . .'' \150\
---------------------------------------------------------------------------

    \147\ Cetera, IMS, Schwab, SIFMA.
    \148\ Schwab. NASAA raised similar concerns, asking whether
proposed FINRA Rule 3110(b)(6)(C) requires a member's supervisory
procedures to be designed to limit all conflicts of interest or
solely be reasonably designed to eliminate conflicts of interest.
    \149\ IMS, Schwab, SIFMA.
    \150\ IMS, SIFMA.
---------------------------------------------------------------------------

    In response, FINRA revised proposed FINRA Rule 3110(b)(6)(D) in
Amendment No. 1 to clarify that the provision does not create a strict
liability obligation requiring identification and elimination of all
conflicts of interest. As revised, proposed FINRA Rule 3110(b)(6)(D)
would require that a member have ``procedures reasonably designed to
prevent the supervisory system required pursuant to paragraph (a) of
this Rule from being compromised due to the conflicts of interest that
may be present with respect to the associated person being supervised .
. . .'' \151\
---------------------------------------------------------------------------

    \151\ See also Section H(5), page 23 of the October Response.
---------------------------------------------------------------------------

I. Comments on Proposed FINRA Rule 3110(b)(7) and FINRA Rule 3110.11

    Proposed FINRA Rule 3110(b)(7) (Maintenance of Written Supervisory
Procedures) would require a member to retain and keep current a copy of
the member's written supervisory procedures at each OSJ and at each
location where supervisory activities are conducted on behalf of the
member.
    Proposed FINRA Rule 3110.11 (Use of Electronic Media to Communicate
Written Supervisory Procedures) would permit a member to satisfy its
obligation to communicate its written supervisory procedures, and any
amendments to those procedures, using electronic media, provided that
the written supervisory procedures have been promptly communicated to,
and are readily accessible by, all associated persons to whom the
supervisory procedures apply based on their activities and
responsibilities.
    Two commenters to the Proposing Release requested that FINRA permit
firms the flexibility to determine who should receive which portions of
their written supervisory procedures, if any, and not interpret
proposed FINRA Rule 3110(b)(7) to require communication of written
supervisory procedures and amendments to non-supervisory
personnel.\152\ The commenters stated that, at many firms, written
supervisory procedures are intended solely for supervisors while other
documents (e.g., compliance policies) are intended for the broader
audience of all associated persons. In addition, the commenters noted
that there may be written supervisory procedures (e.g., how employee
correspondence and trading are reviewed) that member firms do not want
to be disseminated because the broad dissemination of those procedures
may undermine their effectiveness.
---------------------------------------------------------------------------

    \152\ IMS, SIFMA.
---------------------------------------------------------------------------

    FINRA stated that it continues to believe that it is important that
all associated persons have knowledge of the supervisory procedures
relevant to their activities.\153\ FINRA notes that proposed FINRA Rule
3110(b)(7) and related supplementary material would not prohibit a firm
from providing only its supervisory personnel with the written
supervisory procedures' parameters detailing how a firm monitors or
reviews its associated persons' activities to detect and prevent
potential violative conduct (e.g., details about how a firm reviews an
associated person's correspondence or trading).
---------------------------------------------------------------------------

    \153\ October Response Letter, referring to Notice to Members
99-45 (June 1999) (distinguishing between a member's compliance
procedures and written supervisory procedures and specifying that
``[i]t is crucial that all persons associated with a member be
informed of any changes in the supervisory system and applicable
written procedures. [NASD Rule 3010(b)(3)], therefore, requires
members to inform all associated persons of such changes.'').
---------------------------------------------------------------------------

J. Comments on Proposed FINRA Rule 3110(c) and Proposed FINRA Rules
3110.13 and 3110.14

    Proposed FINRA Rule 3110(c)(1) (Internal Inspections), based
largely on NASD Rule 3010(c)(1), would retain the existing requirements
for each member to review, at least annually, the businesses in which
it engages and inspect each office on a specified schedule. The
provision would also retain the existing requirement that the member's
annual review must be reasonably designed to assist the member in
detecting and preventing violations of, and achieving compliance with,
applicable securities laws and regulations and FINRA rules.\154\
---------------------------------------------------------------------------

    \154\ FINRA is revising proposed FINRA Rule 3110(c)(1) to delete
references to the MSRB rules, consistent with the deletion of such
reference in proposed FINRA Rule 3110(a) discussed above.
---------------------------------------------------------------------------

1. Impose Additional Inspection Safeguards
    Although one commenter to the Proposing Release supported proposed
FINRA Rule 3110(c)(1),\155\ another commenter suggested that firms
should be required to conduct more frequent inspections to ensure that
risks created by a firm's size, location, and resources are
addressed.\156\ The commenter also suggested requiring firms to hire
third-party vendors to monitor their activities and conduct independent
compliance

audits, as well as to have a registered principal or compliance
professional sign off on all compliance, supervisory, and inspection
reports representing that to their knowledge and good faith belief, the
report is true and correct.
---------------------------------------------------------------------------

    \155\ St. John's.
    \156\ Arnoff.
---------------------------------------------------------------------------

    FINRA responded that the proposed rule change would generally
provide members with flexibility to conduct their inspections using
only firm personnel.\157\ This flexibility, in turn, would assist firms
in managing compliance costs. FINRA stated that, with respect to
addressing potential risk gaps, proposed FINRA Rule 3120 would require
that firms test and verify, at least annually, that the member's
supervisory procedures are reasonably designed to achieve compliance
with applicable securities laws and regulations and with applicable
FINRA rules and, if necessary, create any additional or amended
supervisory procedures in response to those test results. FINRA noted
that this testing and verification would necessarily include any
supervisory procedures regarding a member's inspections to ensure that
inspections have not been compromised by any potential risks inherent
to a member's size, location, or resources. Therefore, FINRA declined
to make changes to proposed FINRA Rule 3110(c)(1) in response to
comments.
---------------------------------------------------------------------------

    \157\ October Response.
---------------------------------------------------------------------------

2. Exclude Residences From Inspections
    Two commenters to the Proposing Release requested that FINRA
exclude residences from proposed FINRA Rule 3110(c)(1)'s required
inspections of a firm's locations.\158\ One of these commenters
suggested that other types of review, such as review of a registered
person's email would be a more effective way of identifying potential
red flags.\159\ One commenter repeated its request that FINRA not
subject home offices to the inspection requirements for supervisory
branch offices and non-branch locations.\160\
---------------------------------------------------------------------------

    \158\ ICI, IMS.
    \159\ IMS.
    \160\ ICI October Letter.
---------------------------------------------------------------------------

    FINRA declined to adopt the commenters' suggestions to exclude
residences from proposed FINRA Rule 3110(c)'s inspection requirements.
FINRA stated that inspections are a crucial component of detecting and
preventing regulatory and compliance problems of associated persons
working at unregistered offices.\161\ Some unregistered offices also
operate as separate business entities under names other than those of
the members. FINRA noted that while FINRA does not encourage or
discourage such arrangements, a large number of geographically separate
offices present the potential that sales practice problems will not be
as quickly identified as would be the case for larger, centralized
branch offices.\162\ FINRA stated that remote supervision, such as
reviewing email for ``red flags,'' would not be a sufficient
substitution for an actual inspection, although red flags identified
through such means could be helpful in determining whether to conduct
unannounced location inspections.
---------------------------------------------------------------------------

    \161\ October Response; see also November Response, stating that
it continues to support proposed FINRA Rule 3110's inspection
requirements and believes that the proposed annual inspection cycle
in FINRA Rule 3110(c)(1)(A) remains appropriate for home offices of
regional distributors where supervisory activities are occurring.
    \162\ See Notice to Members 98-38 (May 1998).
---------------------------------------------------------------------------

3. Remove Presumption for Periodic Inspection Schedules
    One commenter to the Proposing Release requested that FINRA delete
proposed FINRA Rule 3110.13 (Presumption of Three-Year Limit for
Periodic Inspection Schedules), which sets forth a general presumption
of a three-year limit for periodic non-branch location inspection
schedules, and allow each member to determine what would be an
appropriate inspection period for their non-branch locations.\163\ One
commenter restated the same concerns and questioned the regulatory or
public purpose to be served by FINRA presuming that all members should
conduct an inspection of each home of a regional distributor or
wholesaler at least every three years in accordance with proposed FINRA
Rule 3110.13 (General Presumption of Three-Year Limit for Periodic
Inspection Schedules) relating to non-branch locations.\164\
---------------------------------------------------------------------------

    \163\ ICI.
    \164\ ICI's October Letter.
---------------------------------------------------------------------------

    FINRA responded that it believes that the proposed annual
inspection cycle in FINRA Rule 3110(c)(1)(A) remains appropriate for
home offices of regional distributors where supervisory activities are
occurring.\165\ FINRA stated that it believes that home offices of
regional distributors or wholesalers that are not registered branch
office locations and from which no supervision is occurring, should
remain subject to the proposed periodic inspection cycle in FINRA Rule
3110(c)(1)(C). FINRA noted that proposed FINRA Rule 3110.13 would
provide members with the flexibility to use an inspection schedule
period that is either shorter or longer than three years.\166\ FINRA
also noted that if a member chooses to use a periodic inspection
schedule longer than three years, the proposed supplementary material
would require the member to properly document in its written
supervisory and inspection procedures the factors used in determining
why a longer periodic inspection cycle is appropriate for that
location.\167\ Therefore, FINRA declined to make the changes suggested
by the commenter.
---------------------------------------------------------------------------

    \165\ October Response and November Response.
    \166\ October Response and November Response.
    \167\ October Response and November Response.
---------------------------------------------------------------------------

4. Test and Verify Policies and Procedures Regarding Specified
Activities
    Proposed FINRA Rule 3110(c)(2)(A) would relocate provisions in NASD
Rule 3012 regarding the review and monitoring of specified activities,
such as transmittals of funds and securities and customer changes of
address and investment objectives. Specifically, proposed FINRA Rule
3110(c)(2)(A) would require a member to test and verify a location's
procedures for:
     Safeguarding of customer funds and securities;
     Maintaining books and records;
     Supervision of supervisory personnel;
     Transmittals of funds or securities from customers to
third party accounts, from customer accounts to outside entities, from
customer accounts to locations other than a customer's primary
residence, and between customers and registered representatives,
including the hand-delivery of checks; and
     Changes of customer account information, including address
and investment objective changes and validation of such changes.
    With respect to the transmittal of funds or securities from
customers to third party accounts, the proposal would eliminate NASD
Rule 3012's parenthetical text (``i.e., a transmittal that would result
in a change in beneficial ownership'') to clarify that all transmittals
to an account where a customer on the original account is not a named
account holder are included. One commenter to the Proposing Release
objected to the deletion of the parenthetical, stating that it could
expand application of the rule to transfers not currently captured by
existing rule text, such as transfers from a joint account to an
account of one of the joint account holders. The commenter suggested
that the proposed change is inconsistent with contractual agreements
involving joint account holders and member firms, potentially

conflicts with applicable state and federal laws, and impacts member
firms' operations.\168\
---------------------------------------------------------------------------

    \168\ Schwab.
---------------------------------------------------------------------------

    FINRA responded that the deletion of the reference to beneficial
ownership would aid in preventing conflict of law issues, as the
meaning of that term may vary depending on the context in which it is
used and the law applying to that situation.\169\ FINRA noted that the
provision would not prohibit transfers to third-party accounts, but
only requires a firm to have procedures for the monitoring of such
transfers and a means of customer confirmation, notification, or
follow-up that can be documented. FINRA stated that it believes that
such follow-up procedures would provide an important investor
protection function by verifying that the customer was aware of the
transfer.
---------------------------------------------------------------------------

    \169\ October Response.
---------------------------------------------------------------------------

    Another commenter to the Proposing Release asked whether proposed
FINRA Rule 3110(c)(2)(A)'s requirement to review changes of customer
account information, including address and investment objective
changes, requires a member to review all changes of customer account
information.\170\ FINRA responded that, consistent with existing
requirements,\171\ a member must review all changes of customer account
information and not only address and investment objective changes.\172\
Examples of other changes to customer account information would
include, without limitation, changes to a customer's name, marital
status, telephone, email, or other contact information. FINRA noted
that a firm may delegate reviews of such changes to an appropriately
qualified person who is not a principal, unless another FINRA or SEC
rule would require principal review (e.g., FINRA Rule 4515 (Approval
and Documentation of Changes in Account Name or Designation)
prohibiting an account name or designation change unless authorized by
a qualified and registered principal designated by the member).
---------------------------------------------------------------------------

    \170\ ICI.
    \171\ See, e.g., NASD Rule 3010(c)(2)(F).
    \172\ October Response.
---------------------------------------------------------------------------

    Two commenters also requested that FINRA permit member firms to
identify in their written supervisory or compliance procedures or other
field manuals the activities enumerated in FINRA Rule 3110(c)(2)(A)
that they do not engage in rather than requiring them to be documented
in a location's written inspection report.\173\ FINRA noted that it had
originally proposed, in Regulatory Notice 08-24, that a member must
document the enumerated activities in which it did not engage in its
written supervisory procedures, and that, it had revised the proposed
rule change in response to commenters' concerns to retain the
requirement that a member identify in a location's written inspection
report any enumerated activities the member does not engage in at that
location and document in that location's report that the member must
have in place at that location supervisory policies and procedures for
those activities before the location can engage in them.\174\
---------------------------------------------------------------------------

    \173\ FSI, ICI.
    \174\ October Response.
---------------------------------------------------------------------------

    In light of the continued comments, FINRA revised proposed Rule
3110(c)(2)(D), in Amendment No. 1, to require members to identify in
their written supervisory procedures or in the location's written
inspection report the activities enumerated in FINRA Rule 3110(c)(2)(A)
the member does not engage in at a particular location and document in
their written supervisory procedures or that location's written
inspection report that supervisory policies and procedures must be in
place for those activities at that location before the member can
engage in them. In FINRA's view, this would provide firms with
additional flexibility in meeting the requirement, while still allowing
an examiner to readily determine what enumerated activities a location
does not engage in by referencing the firm's written supervisory
procedures or the location's most recent inspection report.\175\
---------------------------------------------------------------------------

    \175\ October Response Letter.
---------------------------------------------------------------------------

5. Conflicts of Interest
    Commenters to the Proposing Release expressed concern that proposed
FINRA Rule 3110(c)(3)(A) could be interpreted to create a new strict
liability standard that would require members to eliminate all
conflicts of interest with respect to a location's inspections \176\
and suggested revising the provision to provide more flexibility.\177\
FINRA responded by revising proposed FINRA Rule 3110(c)(3)(A) in
Amendment No. 1 to require that a member have ``procedures reasonably
designed to prevent the effectiveness of the inspections required
pursuant to paragraph (c)(1) of this Rule from being compromised due to
the conflicts of interest that may be present with respect to the
location being inspected, including but not limited to, economic,
commercial, or financial interests in the associated persons and
businesses being inspected.'' \178\
---------------------------------------------------------------------------

    \176\ Cetera, IMS, SIFMA.
    \177\ CAI, IMS, SIFMA.
    \178\ October Response.
---------------------------------------------------------------------------

    One commenter to the Proposing Release also asked whether the
requirement to consider the ``economic, commercial, or financial
interests in the associated persons and businesses being inspected''
when determining if conflicts of interest have reduced inspection
standards is intended to prohibit an OSJ principal from conducting
inspections of branch and non-branch offices designated to that OSJ
principal if he receives overrides from business conducted at that
location.\179\ In Amendment No. 1, FINRA clarified that a member's
procedures must take into consideration factors such as economic,
commercial, or financial interests in the associated persons and
businesses being inspected, when determining if members have procedures
reasonably designed to reduce conflicts of interest that may be present
with respect to a location being inspected.\180\ FINRA stated that the
provision is not intended to address directly who a member may
designate to inspect a location. FINRA further noted that a member
assigning an OSJ principal to inspect a branch or non-branch office
designated to that OSJ principal would need to ensure that it complies
with proposed FINRA Rules 3110(c)(3)(B) (prohibitions regarding who may
conduct inspections) and 3110(c)(3)(C) (limited exception from these
prohibitions), which are discussed further below.
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    \179\ Cetera.
    \180\ October Response.
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6. Associated Persons Conducting Inspections
    Proposed FINRA Rule 3110(c)(3)(B) would generally prohibit an
associated person from conducting a location's inspection if the person
is either assigned to that location or is directly or indirectly
supervised by someone assigned to that location. One commenter to the
Proposing Release asked whether compliance personnel who operate
independently from the branch office or OSJ to which they are assigned
(and are supervised by the compliance manager and not by the branch
office or OSJ manager) would be permitted to inspect such branch or
OSJ.\181\ FINRA noted that the proposed provision would not prohibit
compliance personnel assigned to a member's separate compliance
department and supervised solely by the compliance department from

conducting a location's inspections.\182\ In FINRA's view, such an
arrangement helps to protect against the potential conflicts of
interest the provision is designed to address.
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    \181\ ICI.
    \182\ October Response.
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7. Reliance on the Limited Size and Resources Exception
    Proposed FINRA Rule 3110(c)(3)(C) would provide an exception for
those members that cannot comply with proposed FINRA Rule
3110(c)(3)(B)'s restrictions prohibiting certain associated persons
from conducting a location's inspection, either because of a member's
size or its business model. Proposed FINRA Rule 3110.14 (Exception to
Persons Prohibited from Conducting Inspections) would set forth the
general view that a member with only one office or an independent
contractor business model will need to rely upon the exception.
    One commenter to the Proposing Release requested that FINRA amend
proposed FINRA Rule 3110.14 to include home or administrative office
personnel conducting home or administrative office inspections as one
of the enumerated situations covered by proposed FINRA Rule
3110.14.\183\ FINRA responded that proposed FINRA Rule 3110.14 would
reflect FINRA's belief that a member will generally rely on the
exception in instances where the member has only one office or has a
business model where small or single-person offices report directly to
an OSJ manager who is also considered the offices' branch office
manager.\184\ FINRA noted that a member may still rely on the exception
in proposed FINRA Rule 3110(c)(3)(c) in other instances provided it
documents the factors the member used in making its determination that
it needs to rely on the exception.\185\
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    \183\ CAI.
    \184\ October Response.
    \185\ In Amendment No. 1, FINRA sought to clarify that proposed
FINRA Rule 3110.14 provides non-exclusive examples of situations
where the exception would generally apply, by revising the provision
to delete the term ``only'' prior to providing the examples.
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K. Comments on Proposed FINRA Rule 3110(d)

    Proposed FINRA Rule 3110(d)(1) (Transaction Review and
Investigation) would require a member to have supervisory procedures to
review securities transactions that are effected for a member's or its
associated persons' accounts, as well as any other ``covered account,''
to identify trades that may violate the provisions of the Act, its
regulations, or FINRA rules prohibiting insider trading and
manipulative and deceptive devices. The proposed rule would also
require members to promptly conduct an internal investigation into any
such trade to determine whether a violation has occurred, and would
require firms engaged in ``investment banking services'' to report
information regarding these investigations to FINRA.
    Commenters to the Proposing Release expressed concerns related to
the scope of the proposed definition of ``covered account'' and the
extension of the reporting requirements to certain types of investment
banking services that commenters asserted pose less risk of insider
trading.
1. Definition of ``Covered Account''
    As proposed, FINRA Rule 3110(d)(3)(A) would have defined ``covered
account'' as: (i) the accounts of parents, siblings, fathers-in-law,
mothers-in-law, and domestic partners if the account is held at or
introduced by the member and (ii) accounts that are reported to the
member pursuant to NASD Rule 3050 (Transactions for or by Associated
Persons) or Incorporated NYSE Rule 407 (Transactions--Employees of
Members, Member Organizations and the Exchange), as applicable.\186\
Multiple commenters expressed concern about the breadth of the
definition of ``covered account,'' and in particular the extension of
the term to include more remote family members.\187\ Several commenters
noted that the proposed definition went beyond the terms of existing
NYSE rules and guidance, on which proposed Rule 3110(d) is based, and
would create unnecessary difficulty for firms in monitoring trading in
the accounts of more distant relatives, with whom an associated person
may not have regular contact. Multiple commenters suggested that FINRA
harmonize the scope of the term ``covered account'' with existing NYSE
guidance and with SEC rules addressing similar types of concerns (e.g.,
the scope of the SEC's Code of Ethics rules for investment
advisers).\188\
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    \186\ One commenter sought to confirm that the proposed rule
would not modify obligations imposed by NASD Rule 3050. See CAI.
FINRA responded that nothing in proposed Rule 3110(d) would alter
reporting obligations pursuant to other FINRA rules, including NASD
Rule 3050.
    \187\ Brandenburger, CAI, FSI, ICI, IMS, Letter Type A, Putnam,
SIFMA. Several commenters also expressed the view that the term
``domestic partner'' was vague. See Brandenburger, CAI, FSI, IMS,
Letter Type A. Because FINRA is proposing to narrow the scope of the
term, including removing the reference to domestic partners, FINRA
did not address this comment.
    \188\ CAI, ICI, IMS, Schwab, SIFMA, Wells Fargo. Some commenters
also expressed concerns that expanding the scope of the definition
could raise potential privacy issues relating to personal financial
information. See CAI, FSI, ICI, IMS, Schwab, SIFMA, Wells Fargo.
FINRA stated that it believes that these concerns were addressed in
Amendment No. 1; however, FINRA does not believe the initial
definitions implicated privacy concerns since the accounts covered
by the rule must be introduced or carried by the firm.
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    In response, FINRA revised the proposed rule in Amendment No. 1 to
align the definition of ``covered account'' with existing NYSE
guidance, which it noted has been in place since 1989.\189\ FINRA
specified that under the revised definition, the term ``covered
account'' would include any account introduced or carried by the member
that is held by: (1) The spouse of a person associated with the member;
(2) a child of the person associated with the member or such person's
spouse, provided that the child resides in the same household as or is
financially dependent upon the person associated with the member; (3)
any other related individual over whose account the person associated
with the member has control; or (4) any other individual over whose
account the associated person of the member has control and to whose
financial support such person materially contributes.\190\ In FINRA's
view, the amended definition strikes an appropriate balance between
ensuring that trading activity in the accounts that present the
greatest risk of insider trading are reviewed while not imposing undue
compliance burdens on firms.
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    \189\ See NYSE Information Memo 89-17 (April 4, 1989).
    \190\ In addition to ``covered accounts,'' the proposed rule
also applies to accounts of the member, accounts introduced or
carried by the member in which a person associated with the member
has a beneficial interest or the authority to make investment
decisions, and accounts of a person associated with the member that
are disclosed to the member pursuant to NASD Rule 3050 or
Incorporated NYSE Rule 407, as applicable.
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2. Internal Investigation Reporting
a. Definition of ``Investment Banking Services''
    As proposed, FINRA Rule 3110(d)(2) would impose reporting
requirements for internal investigations undertaken by members that
engage in ``investment banking services.'' Proposed FINRA Rule
3110(d)(3)(B) would define the term ``investment banking services'' to
include, without limitation, acting as an underwriter, participating in
a selling group in an offering for the issuer, or otherwise acting in
furtherance of a public offering of the issuer; acting as a financial
adviser in a merger or acquisition; and providing venture capital or
equity lines of credit or serving as placement agent for the issuer or
otherwise acting in furtherance of a private offering of the issuer.
Two

commenters to the Proposing Release questioned the definition of
``investment banking services,'' noting that the term includes
underwriting products that present less risk of insider trading, such
as mutual funds and variable insurance products.\191\
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    \191\ CAI, ICI.
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    FINRA acknowledged that both commenters repeated objections to
which FINRA responded in the Proposing Release. FINRA further noted
that it does not believe that any of the categories of activities
identified by the commenters should be categorically excluded from the
definition of ``investment banking services'' given its limited use for
the purposes of proposed FINRA Rule 3110.\192\
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    \192\ October Response. Although one commenter asserted that
``the proposed rule would require any member that engages in
`investment banking services' to file with FINRA each quarter, a
written report that is signed by a senior officer of the member,''
FINRA responded that, ``if a member did not have an open internal
investigation or either initiate or complete an internal
investigation during a particular calendar quarter, the member would
not be required to submit a report for that quarter.'' See October
Response; see also ICI.
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    FINRA disagreed with the commenters' assertions that FINRA failed
to take into account the potential costs and burdens to firms
associated with adopting policies and procedures and systems to ensure
compliance with the rule. FINRA noted that these entities are already
subject to Section 15(g) of the Act, which requires all broker-dealers
to ``establish, maintain, and enforce written policies and procedures
reasonably designed . . . to prevent the misuse . . . of material,
nonpublic information by such broker or dealer or any person associated
with such broker or dealer.'' \193\ FINRA stated that firms are
permitted to use a risk-based approach to monitoring transactions that
takes into account a firm's specific business model, which would
include the type of underwriting activity performed by the firm. In
fulfilling their obligations, FINRA noted that firms may determine that
certain departments or employees pose a greater risk and examine
trading in those accounts accordingly. FINRA further noted that there
is no implied obligation on firms as to how best to conduct the
reviews. Thus, FINRA responded that it would expect that firms with
underwriting activity limited to mutual funds may adopt significantly
different review procedures than a firm engaged in more traditional
investment banking activity. FINRA proposed to amend the rule in
Amendment No. 1 to include the phrase ``reasonably designed'' to
acknowledge more clearly that firms with different business models may
adopt different procedures and practices.\194\ As amended, the proposed
rule would require each member to include in its supervisory procedures
a process for the review of securities transactions reasonably designed
to identify trades that may violate the provisions of the Exchange Act,
the rules thereunder, or FINRA rules prohibiting insider trading and
manipulative and deceptive devices.\195\
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    \193\ See Section L(2), page 31 of the October Response.
    \194\ FINRA noted that the ``reasonably designed'' standard
already applied to the transaction review procedures required by the
provision pursuant to the overarching language applicable to all of
a member's procedures in paragraph (b)(1) of the proposed rule
change. FINRA is proposing to repeat the phrase in paragraph (d) to
avoid an implication that it did not already apply to the procedures
governing transaction review.
    \195\ See Section L(2), page 32 of the October Response.
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    In response to the Notice and Proceedings Order, one commenter
restated its concern that mutual fund underwriters should be excluded
from the definition of ``investment banking services.'' The commenter
stated that FINRA disregarded or failed to consider ``the costs and
burdens associated with members being required to establish, maintain,
implement, and review on an ongoing basis policies and procedures to
comply with each rule FINRA adopts, even those rules that do not apply
to the member's business.\196\ FINRA stated that it continues to
believe that the primary costs and burdens associated with the proposed
rule change would arise in developing and implementing policies and
procedures for reviewing transactions and conducting investigations,
not in reporting those investigations to FINRA. FINRA also noted that
it believes that the type of ``investment banking services'' in which a
firm engages, and the relative level of risk of insider trading those
activities present, may be a factor in assessing the reasonableness of
such a firm's procedures; however, FINRA stated that it does not
believe that it should affect the analysis of whether a firm engaged in
``investment banking services'' has a reporting obligation once
potentially violative trades have already been identified and internal
investigations have begun.
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    \196\ ICI's October Letter.
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b. Required Investigation Reports
    One commenter to the Proposing Release stated that, in defining
``investment banking services'' broadly, FINRA disregarded the
cumulative effect a ``misapplied'' rule can have on a firm's compliance
obligations and has substantially underestimated ``the unnecessary
questions and confusion surrounding the rule's implementation that the
firm is likely to face.'' \197\ FINRA noted that the commenter did not
include examples of the types of questions or confusion that are likely
to arise. FINRA responded that the reporting obligation is triggered
only after an investigation has been initiated and that it believes
that the primary costs and burdens associated with the proposed rule
change would arise in developing and implementing policies and
procedures and in conducting investigations, not in reporting those
investigations to FINRA.\198\ FINRA noted that that certain types of
``investment banking services'' may present less risk of insider
trading than others, and firms are permitted to take these risks into
account when developing their policies and procedures; however, FINRA
stated that neither commenter offered an explanation as to why
investigations should not be reported when the reports are only
required after a firm has identified trades that may violate applicable
laws or rules other than to note that these firms may pose less risk to
begin with.\199\
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    \197\ SIFMA.
    \198\ October Response.
    \199\ One commenter questioned the need for the rule at all in
light of FINRA Rule 4530. See ICI. FINRA pointed to its previous
statement that proposed FINRA Rule 3110(d) would require more
targeted and detailed reporting than FINRA Rule 4530(b), which
requires reporting only where a member concludes or reasonably
should have concluded a securities-related law or rule was violated.
Moreover, FINRA noted that Rule 4530 does not require firms to
report every instance of noncompliant conduct. See Regulatory Notice
11-06 (February 2011) (discussing scope of requirement to report
internal conclusions of violation).