[Federal Register Volume 76, Number 125 (Wednesday, June 29, 2011)]
[Notices]
[Pages 38245-38262]
[FR Doc No: 2011-16232]

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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-64736; File No. SR-FINRA-2011-028]

Self-Regulatory Organizations; Financial Industry Regulatory
Authority, Inc.; Notice of Filing of Proposed Rule Change To Adopt
Rules Regarding Supervision in the Consolidated FINRA Rulebook

 June 23, 2011.
    Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934
(``Exchange Act'' or ``Act'') \1\ and Rule 19b-4 thereunder,\2\ notice
is hereby given that on June 10, 2011, Financial Industry Regulatory
Authority, Inc. (``FINRA'') (f/k/a National Association of Securities
Dealers, Inc. (``NASD'')) filed with the Securities and Exchange
Commission (``SEC'' or ``Commission'') the proposed rule change as
described in Items I, II, and III below, which Items have been prepared
by FINRA. The Commission is publishing this notice to solicit comments
on the proposed rule change from interested persons.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
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I. Self-Regulatory Organization's Statement of the Terms of Substance
of the Proposed Rule Change

    FINRA is proposing to adopt the consolidated FINRA supervision
rules. Specifically, the proposed rule change would: (1) Adopt FINRA
Rules 3110 (Supervision) and 3120 (Supervisory Control System) to
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 3010(e)
(Qualifications Investigated) with new FINRA Rule 1260 (Responsibility
of Member to Investigate Applicants for Registration); (5) replace NASD
Rule 3110(i) (Holding of Customer Mail) with new FINRA Rule 3150
(Holding of Customer Mail); and (6) delete the following NASD and
Incorporated NYSE Rules and NYSE Rule Interpretations: (i) NASD Rule
3010(f) (Applicant's Responsibility); (ii) NYSE Rule 342 (Offices--
Approval, Supervision and Control) and related NYSE Rule
Interpretations; (iii) NYSE Rule 343 (Offices--Sole Tenancy, and Hours)
and related NYSE Rule Interpretations; (iv) NYSE Rule 351(e) (Reporting
Requirements) and NYSE Rule Interpretation 351(e)/01 (Reports of
Investigation); (v) NYSE Rule 354 (Reports to Control Persons); and
(vi) NYSE Rule 401 (Business Conduct).
    The text of the proposed rule change is available on FINRA's Web
site at http://www.finra.org, at the principal office of FINRA and for
Web site viewing and printing at the Commission's Public Reference
Room.

II. Self-Regulatory Organization's Statement of the Purpose of, and
Statutory Basis for, the Proposed Rule Change

    In its filing with the Commission, FINRA included statements
concerning the purpose of and basis for the proposed rule change and
discussed any comments it received on the proposed rule change. The
text of these statements may be examined at the places specified in
Item IV below. FINRA has prepared summaries, set forth in sections A,
B, and C below, of the most significant aspects of such statements.

A. Self-Regulatory Organization's Statement of the Purpose of, and
Statutory Basis for, the Proposed Rule Change

1. Purpose
    As part of the process of developing a new consolidated rulebook
(``Consolidated FINRA Rulebook''),\3\

FINRA is proposing to adopt new FINRA Rules 3110 (Supervision) and 3120
(Supervisory Control System) and to delete NASD Rule 3010 (Supervision)
and NASD Rule 3012 (Supervisory Control System), on which they are
largely based. 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 do
not align with, the proposed supervision requirements. The proposed
rule change, however, does incorporate--on a tiered basis--certain
provisions from Incorporated NYSE Rule 342. The details of the proposed
rule change are described below.
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    \3\ The current FINRA rulebook consists of: (1) FINRA Rules; (2)
NASD Rules; and (3) rules incorporated from the NYSE (``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 (``Dual Members''). 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).
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(1) Proposed FINRA Rule 3110 (Supervision)
    Proposed FINRA Rule 3110 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. Proposed FINRA Rule
3110 also incorporates provisions in other NASD rules that pertain to
supervision, including NASD Rule 3012.
(A) Proposed FINRA Rule 3110(a) (Supervisory System) and Proposed
Supplementary Material .01 \4\
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    \4\ FINRA published the proposed rules for comment in Regulatory
Notice 08-24 (May 2008). In response to comments, FINRA, among other
things, has added new proposed Supplementary Material .01 (Business
Lines) to proposed FINRA Rule 3110; this amendment to the proposal
has resulted in a change in numbering of all subsequent
supplementary material to proposed FINRA Rule 3110. For ease of
reference, the proposed rule change employs the new proposed numbers
in all instances.
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    Proposed FINRA Rule 3110(a) requires a member to have a supervisory
system for the activities of its associated persons that is reasonably
designed to achieve compliance with the applicable securities laws and
regulations and FINRA and Municipal Securities Rulemaking Board
(``MSRB'') rules. The proposed rule provision is substantially similar
to NASD Rule 3010(a) except for two revisions. First, proposed FINRA
Rule 3110(a) refers only to associated persons instead of the current
reference in NASD Rule 3010(a) to each ``registered representative,
registered principal, and other associated person.'' Second, proposed
FINRA Rule 3110(a) requires a member's supervisory system to be
reasonably designed to achieve compliance with MSRB rules, which NASD
Rule 3010(a) does not explicitly reference.\5\
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    \5\ In this regard, SEC staff has confirmed FINRA staff's view
that a violation of the MSRB rules also would be a violation of the
Federal securities laws, as it would constitute a violation of
Exchange Act Section 15B(c)(1). See Letter from James L. Eastman,
Chief Counsel and Associate Director, Division of Trading and
Markets, SEC, to Patrice M. Gliniecki, Senior Vice President and
Deputy General Counsel, FINRA (March 17, 2009).
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    Proposed Supplementary Material .01 (Business Lines) provides that
for a member's supervisory system required by proposed FINRA Rule
3110(a) to be reasonably designed to achieve compliance with FINRA Rule
2010 (Standards of Commercial Honor and Principles of Trade), it must
include supervision for all of the member's business lines irrespective
of whether they require broker-dealer registration.
(i) Proposed FINRA Rule 3110(a)(1)
    Proposed FINRA Rule 3110(a)(1), which is identical to NASD Rule
3010(a)(1), requires a member's supervisory system to include the
establishment and maintenance of written procedures.
(ii) Proposed FINRA Rule 3110(a)(2): Designated Principal
    Proposed FINRA Rule 3110(a)(2), which is identical to NASD Rule
3010(a)(2), requires a member's supervisory system to include the
designation of an appropriately registered principal(s) with authority
to carry out the supervisory responsibilities for each type of business
in which the member engages for which registration as a broker-dealer
is required.
(iii) Proposed FINRA Rule 3110(a)(3) and Proposed Supplementary
Material .02-.03
    Proposed FINRA Rule 3110(a)(3) requires the registration and
designation as a branch office and/or an office of supervisory
jurisdiction (``OSJ'') of each location, including the main office, as
those terms are defined in the proposed rule. Proposed FINRA Rule
3110(a)(3) is based on similar provisions in NASD Rule 3010(a)(3). In
addition, the proposed rule provision and proposed Supplementary
Material .02 (Registration of Main Office) incorporate the requirement
in NASD IM-1000-4 (Branch Offices and Offices of Supervisory
Jurisdiction) that all branch offices and OSJs must be registered as
either a branch office or OSJ, respectively. FINRA is deleting NASD IM-
1000-4 as part of this proposed rule change.
    Additionally, the proposed rule change moves, with no substantive
changes, the provisions in NASD Rule 3010(a)(3) setting forth certain
factors a member should consider in designating additional locations as
OSJs into proposed Supplementary Material .03 (Designation of
Additional OSJs).
(iv) Proposed FINRA Rule 3110(a)(4) and Proposed Supplementary Material
.04-.05
    Proposed FINRA Rule 3110(a)(4) requires a member to designate one
or more appropriately registered principals in each OSJ and one or more
appropriately registered representatives or principals in each non-OSJ
branch office with authority to carry out the supervisory
responsibilities assigned to that office by the member. This proposed
provision replaces the nearly identical provision in NASD Rule
3010(a)(4) with a minor editorial change to delete the phrase
``including the main office,'' from the rule text.
    Supplementary Material .04 (One-Person OSJs) codifies existing
guidance on the supervision of one-person OSJs. Specifically, the
proposed supplementary material clarifies the core concept that the on-
site principal in a one-person OSJ location cannot supervise his or her
own activities if such principal is authorized to engage in business
activities other than the supervision of associated persons or other
offices as enumerated in proposed FINRA Rule 3110(e)(1)(D) through (G).
Proposed Supplementary Material .04 also provides that, in such
instances, the on-site principal must be under the close supervision
and control of another appropriately registered principal (``senior
principal''). The senior principal is responsible for supervising the
activities of the on-site principal at such office and must conduct on-
site supervision of such OSJ on a regular periodic schedule determined
by the member. The proposed supplementary material requires 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 on-site principal in determining this schedule.
    Proposed Supplementary Material .05 (Supervision of Multiple OSJs
by a Single Principal) clarifies the requirement in proposed Rule
3110(a)(4) to designate an on-site principal in each OSJ with authority
to carry out the supervisory responsibilities assigned to that office.
Such on-site principal must have a physical presence, on a regular and
routine basis, at the OSJ for which the principal has supervisory
responsibilities. The proposed

supplementary material establishes a general presumption that a
principal will not be assigned to supervise more than one OSJ and sets
forth factors members should consider in making a determination
regarding whether a single principal can supervise more than one OSJ.
Where a member determines to assign one principal to supervise more
than one OSJ, the member must document the factors it considered. There
is a further general presumption that a determination by a member to
assign one principal to supervise more than two OSJs is unreasonable.
If a member determines to designate and assign one principal to
supervise more than two OSJs, the proposed supplementary material
provides that such determination will be subject to greater scrutiny,
and the member will have a greater burden to evidence the
reasonableness of such structure.
(v) Proposed FINRA Rule 3110(a)(5) through (7) and Proposed
Supplementary Material .06
    Proposed FINRA Rule 3110(a)(5) requires that each registered person
be assigned to an appropriately registered representative(s) and/or
principal(s) who is responsible for supervising that person's
activities. Proposed FINRA Rule 3110(a)(6) requires a member to use
reasonable efforts to determine that all supervisory personnel have the
necessary experience or training to be qualified to carry out their
assigned responsibilities. Proposed FINRA Rule 3110(a)(7) requires each
registered representative and registered principal to participate, at
least once each year, in an interview or meeting at which compliance
matters relevant to the particular representative or principal are
discussed. These proposed provisions replace the nearly identical
provisions in NASD Rule 3010(a)(5) through (7) with only minor
editorial changes.
    Proposed Supplementary Material .06 (Annual Compliance Meeting)
codifies existing guidance that a member is not required to conduct in-
person meetings with each registered person or groups of registered
persons to comply with the annual compliance meetings required by
proposed FINRA Rule 3110(a)(7).\6\ However, a member that chooses to
conduct meetings using other methods (e.g., on-demand Web cast, video
conference, interactive classroom setting, telephone, or other
electronic means) must ensure, at a minimum, that each registered
person attends the entire meeting (e.g., an on-demand annual compliance
Web cast would require each registered person to use a unique user ID
and password to gain access and use a technology platform to track the
time spent on the Web cast, provide click-as-you-go confirmation, and
have an attestation of completion at the end of a Web cast) and is able
to ask questions regarding the presentation and receive answers in a
timely fashion (e.g., an on-demand annual compliance Web cast that
allows registered persons to ask questions via an e-mail to a presenter
or a centralized address or via a telephone hotline and receive timely
responses directly or view such responses on the member's intranet
site).
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    \6\ See Notice to Members 99-45 (June 1999).
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(B) Proposed FINRA Rule 3110(b) (Written Procedures)
    FINRA proposes to consolidate various provisions and rules that
currently require written procedures into proposed FINRA Rule 3110(b),
including provisions from NASD Rule 3010(d)(1) relating to the
supervision of registered representatives and Incorporated NYSE Rule
401A (Customer Complaints) relating to the review of customer
complaints. In addition, proposed supplementary material, which is
discussed in detail below, codifies and expands guidance in these
areas.
(i) Proposed FINRA Rule 3110(b)(1) (General Requirements)
    Proposed FINRA Rule 3110(b)(1) requires a member to establish,
maintain, and enforce written procedures to supervise the types of
business in which it engages and the activities of its associated
persons that are reasonably designed to achieve compliance with
applicable securities laws and regulations, FINRA rules, and MSRB
rules. The proposed rule provision is substantially similar to NASD
Rule 3010(b)(1) except for two revisions that mirror changes in
proposed FINRA Rule 3110(a). First, proposed FINRA Rule 3110(b)(1)
refers only to associated persons instead of the current reference in
NASD Rule 3010(b)(1) to ``registered representatives, registered
principals, and other associated persons.'' Second, FINRA Rule
3110(b)(1) requires a member's written supervisory procedures to be
reasonably designed to achieve compliance with MSRB rules, which NASD
Rule 3010(b)(1) does not explicitly reference.\7\
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    \7\ See supra note 5.
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(ii) Proposed FINRA Rule 3110(b)(2) (Review of Member's Investment
Banking and Securities Business) and Proposed Supplementary Material
.07
    FINRA is retaining the provision in NASD Rule 3010(d)(1) requiring
principal review, evidenced in writing, of all transactions, but is
relocating the provision to proposed FINRA Rule 3110(b)(2). FINRA is
also proposing to amend the provision to clarify that such review
includes all transactions relating to the member's investment banking
or securities business. Proposed Supplementary Material .07 (Risk-based
Review of Member's Investment Banking and Securities Business) permits
a member to use a risk-based system to review these transactions.
(iii) Proposed FINRA Rule 3110(b)(3)
    FINRA is reserving this provision for future rulemaking.\8\
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    \8\ As noted in Regulatory Notice 08-24, FINRA proposed to
delete NASD Rule 3040 (Private Securities Transactions of an
Associated Person) and replace it with FINRA Rule 3110(b)(3)
(Supervision of Outside Securities Activities) and proposed
Supplementary Material .07 (Reliance on Bank or Affiliated Entity to
Supervise Dual Employees). FINRA, however, has determined to address
NASD Rule 3040 as a separate proposal.
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(iv) Proposed FINRA Rule 3110(b)(4) (Review of Correspondence and
Internal Communications) and Proposed Supplementary Material .08-.11
    Proposed FINRA Rule 3110(b)(4) generally incorporates the substance
of NASD Rule 3010(d) (Review of Transactions and Correspondence)
requiring members to have supervisory procedures for the review of
correspondence. In addition, the proposed provision and proposed
related supplementary material incorporate certain existing guidance
regarding the supervision of electronic communications in Regulatory
Notice 07-59 (December 2007).
    Specifically, proposed FINRA Rule 3110(b)(4) requires that a member
have supervisory procedures for the review of the member's incoming and
outgoing written (including electronic) correspondence with the public
and internal communications that relate to its investment banking or
securities business. Proposed Supplementary Material .08 (Risk-based
Review of Correspondence and Internal Communications), however, permits
a member to use risk-based review principles to review much of its
incoming and outgoing correspondence with the public and internal
communications.
    The proposed rule also requires a member to identify and handle in

accordance with the firm's procedures: Customer complaints,
instructions, and funds and securities, and communications that are of
a subject matter that require review under FINRA and MSRB rules and the
Federal securities laws. Those communications include (without
limitation):
     Communications between non-research and research
departments concerning a research report's contents (NASD Rule
2711(b)(3) and Incorporated NYSE Rule 472(b)(3));
     Certain communications with the public that require a
principal's pre-approval (NASD Rules 2210 and 2211);
     The identification and reporting to FINRA of customer
complaints (NASD Rule 3070(c) and Incorporated NYSE Rule 351(d)); \9\
and
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    \9\ FINRA adopted FINRA Rule 4530 to replace NASD Rule 3070 and
comparable provisions in Incorporated NYSE Rule 351 (Reporting
Requirements). See Exchange Act Release No. 63260 (November 5,
2010), 75 FR 69508 (November 12, 2010) (Order Approving File No. SR-
FINRA-2010-034). FINRA Rule 4530 becomes effective on July 1, 2011.
See Regulatory Notice 11-06 (February 2011). With respect to
customer complaints, as detailed further below, proposed FINRA Rule
3110(b)(5) also would affirmatively require members to capture,
acknowledge, and respond to all written (including electronic)
customer complaints.
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     The identification and prior written approval of every
order error and other account designation change (NASD Rule 3110(j) and
Incorporated NYSE Rule 410).\10\
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    \10\ On January 27, 2011, the SEC approved, among other things,
FINRA Rule 4515 (Approval and Documentation of Changes in Account
Name or Designation) to replace NASD Rule 3110(j), and the deletion
of Incorporated NYSE Rule 410. See Exchange Act Release No. 63784
(January 27, 2011), 76 FR 5850 (February 2, 2011) (Order Approving
File No. SR-FINRA-2010-052). This rule change becomes effective on
December 5, 2011. See Regulatory Notice 11-19 (April 2011).
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    Proposed FINRA Rule 3110(b)(4) also requires that a registered
principal review correspondence with the public and internal
communications and evidence those reviews in writing (either
electronically or on paper). However, proposed Supplementary Material
.10 (Delegation of Correspondence and Internal Communication Review
Functions) allows a supervisor/principal to delegate review functions
to an unregistered person; however, the supervisor/principal remains
ultimately responsible for the performance of all necessary supervisory
reviews.
    Proposed Supplementary Material .09 (Evidence of Review of
Correspondence and Internal Communications) codifies existing FINRA
guidance that merely opening a communication is not sufficient
review.\11\ Instead, a member must identify what communication was
reviewed, the identity of the reviewer, the date of review, and the
actions taken by the member as a result of any significant regulatory
issues identified during the review.
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    \11\ See Regulatory Notice 07-59 (December 2007).
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    Finally, proposed Supplementary Material .11 (Retention of
Correspondence and Internal Communications) requires a member to retain
its internal communications and correspondence of associated persons
relating to the member's investment banking or securities business in
accordance with Exchange Act Rule 17a-4(b) \12\ and make those records
available to FINRA upon request.
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    \12\ 17 CFR 240.17a-4(b).
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(v) Proposed FINRA Rule 3110(b)(5) (Review of Customer Complaints)
    Incorporated NYSE Rule 401A requires firms to acknowledge and
respond to all customer complaints subject to the reporting
requirements of Incorporated NYSE Rule 351(d) (Reporting Requirements).
Previously, this meant that firms had to acknowledge and respond to
both written and oral customer complaints. However, as part of the
effort to harmonize the NASD and NYSE rules in the interim period
before completion of the Consolidated FINRA Rulebook, Incorporated NYSE
Rule 351(d) was amended 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).\13\
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    \13\ See Exchange Act Release No. 58533 (September 12, 2008), 73
FR 54652 (September 22, 2008) (Order Approving File No. SR-FINRA-
2008-036). As noted previously, FINRA Rule 4530 will replace NASD
Rule 3070 and comparable provisions in Incorporated NYSE Rule 351,
effective July 1, 2011. See supra note 9.
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    Proposed FINRA Rule 3110(b)(5), which requires a member's
supervisory procedures to include procedures to capture, acknowledge,
and respond to all written (including electronic) customer complaints,
essentially incorporates the customer complaint requirement in
Incorporated NYSE Rule 401A, including the limitation on including only
written (including electronic) customer complaints. FINRA believes that
oral complaints are difficult to capture and assess, and they raise
competing views as to the substance of the complaint being alleged.
Consequently, oral complaints do not lend themselves as effectively to
a review program as written complaints, which are more readily
documented and retained. However, FINRA reminds members that the
failure to address any customer complaint, written or oral, may be a
violation of FINRA Rule 2010.
(vi) Proposed FINRA Rule 3110(b)(6) (Documentation and Supervision of
Supervisory Personnel) and Proposed Supplementary Material .12
    Proposed FINRA Rule 3110(b)(6) 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. The
proposed rule also includes a new provision, proposed FINRA Rule
3110(b)(6)(C), that would address potential abuses in connection with
the supervision of supervisors. This provision would replace NASD Rule
3012(a)(2) concerning the supervision of a producing manager's customer
account activity and the requirement to impose heightened supervision
when any producing manager's revenues rise above a specific threshold.
    Specifically, the proposed provision requires members to have
procedures prohibiting associated persons who perform a supervisory
function from:
     Supervising their own activities; and
     Reporting to, or having their compensation or continued
employment determined by, someone they are supervising.

The proposal, however, creates an exception for a member that
determines, with respect to any of its supervisory personnel, that
compliance with either of these conditions is not possible because of
the member's size or a supervisory personnel's position within the
firm. A member relying on this exception must document the factors the
member used to reach such determination and how the supervisory
arrangement with respect to such supervisory personnel otherwise
comports with proposed FINRA Rule 3110(a). Proposed Supplementary
Material .12 (Supervision of Supervisory Personnel) explains that a
member generally will need to rely on this exception only because it is
a sole proprietor in a single-person firm or where a supervisor holds a
very senior executive position within the firm. Members relying on this
exception would not be required to notify FINRA of their reliance.\14\
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    \14\ See NAIBD letter, infra note 21, requesting clarification
regarding potential notification requirements for members relying on
the proposed exception.

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    Proposed FINRA Rule 3110(b)(6)(D) requires 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 the revenue generated by such person, or any other factor
that would present a conflict. There is no exception from this
provision.
(vii) Proposed FINRA Rule 3110(b)(7) (Maintenance of Written
Supervisory Procedures) and Proposed Supplementary Material .13
    Proposed FINRA Rule 3110(b)(7), which replaces the nearly identical
provision in NASD Rule 3010(b)(4), requires 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. The member must also communicate any
amendments to its written supervisory procedures throughout its
organization. Proposed Supplementary Material .13 (Use of Electronic
Media to Communicate Written Supervisory Procedures) permits a member
to distribute and amend its written supervisory procedures using
electronic media, subject to certain conditions. Those conditions
include: (1) Quick and easy access to the written supervisory
procedures; (2) prompt posting of any written supervisory procedure
amendments; (3) notifying associated persons of such amendments; (4)
verifying, at least once each calendar year, that associated persons
have reviewed the written supervisory procedures; (5) having reasonable
security procedures to ensure that the written supervisory procedures
cannot be altered by unauthorized persons; and (6) retaining current
and prior versions of the written supervisory procedures in compliance
with the applicable record retention requirements of Exchange Act Rule
17a-4(e)(7).\15\
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    \15\ 17 CFR 240.17a-4(e)(7).
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(C) Proposed FINRA Rule 3110(c) (Internal Inspections) and Proposed
Supplementary Material .14-.16
    Proposed FINRA Rule 3110(c)(1), based largely on NASD Rule
3010(c)(1), retains 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. That inspection schedule
requires that OSJs and supervisory branch offices be inspected at least
annually, non-supervisory branch offices be inspected at least every
three years, and non-branch locations be inspected on a regular
periodic schedule. The proposed rule provision also clarifies that the
term ``annually,'' as used in proposed FINRA Rule 3110(c), means on a
calendar-year basis.
    Proposed Supplementary Material .15 (General Presumption of Three-
Year Limit for Periodic Inspection Schedules) provides a general
presumption that a non-branch location will be inspected at least every
three years, even in the absence of any indicators of irregularities or
misconduct (i.e., ``red flags''). If a member establishes a periodic
inspection schedule longer than three years, the member must document
in its written supervisory and inspection procedures the factors used
in determining that a longer periodic inspection cycle is appropriate.
As with NASD Rule 3010(c), proposed FINRA Rule 3110(c) requires a
member to retain a written record of each review and inspection, reduce
a location's inspection to a written report, and keep each inspection
report on file either for a minimum of three years or, if the
location's inspection schedule is longer than three years, until the
next inspection report has been written.
    The proposal revises NASD Rule 3010(c)(3)'s provisions prohibiting
certain persons from conducting office inspections to make the
provisions less prescriptive. To that end, the proposed rule eliminates
the heightened office inspection requirements members must implement if
the branch office manager and the person conducting the office
inspection report to the same person. The proposal replaces these
requirements with provisions requiring a member to:
     Prevent the inspection standards required pursuant to
proposed FINRA Rule 3110(c)(1) from being reduced in any manner due to
any conflicts of interest that may be present, including but not
limited to, economic, commercial, or financial interests in the
associated persons and businesses being inspected; and
     Ensure that the person conducting an inspection pursuant
to proposed FINRA Rule 3110(c)(1) is not an associated person assigned
to the location or is not directly or indirectly supervised by, or
otherwise reporting to, an associated person assigned to the location.

A member that determines it cannot comply with this last condition due
to its size or business model must document in the inspection report
both the factors the member used to make its determination and how the
inspection otherwise comports with proposed FINRA Rule 3110(c)(1).
Proposed Supplementary Material .16 (Exception to Persons Prohibited
from Conducting Inspections) explains that such a determination
generally will arise only in instances where the member has only one
office or the member 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. The proposal also retains as
Supplementary Material .14 (Standards for Reasonable Review) the
content of NASD IM-3010-1 (Standards for Reasonable Review) relating to
standards for the reasonable review of offices, which has already been
harmonized with the review requirements in analogous Incorporated NYSE
Rule 342.10.
    In addition, the proposal relocates into proposed FINRA Rule
3110(c)(2) certain provisions in NASD Rule 3012 regarding the review
and monitoring of certain specific activities, such as transmittals of
funds and securities and customer changes of address and investment
objectives. Specifically, proposed FINRA Rule 3110(c)(2)(A) requires a
member to test and verify a location's procedures for the safeguarding
of customer funds and securities, maintenance of books and records,
supervision of supervisory personnel, transmittals of funds or
securities, and changes of customer account information, including
address and investment objective changes and validation of such
changes.
    Proposed FINRA Rule 3110(c)(2)(B) requires a means or method of
customer confirmation regarding transmittals of funds and securities
but makes clear that members may use risk-based methods to determine
the authenticity of the transmittal instructions. Proposed FINRA Rule
3110(c)(2)(C) also requires a means or method of customer confirmation
for changes of customer account information. Finally, proposed FINRA
Rule 3110(c)(2)(D) makes clear that if a location being inspected does
not engage in all of the activities listed above, the member must
identify those activities in the location's written inspection report
and document in the report that supervisory policies and procedures
must be in place at that location before the location can engage in
them.

(D) Proposed FINRA Rule 3110(d) (Transaction Review and Investigation)
    Section 15(g) of the Act,\16\ adopted as part of the Insider
Trading and Securities Fraud Enforcement Act of 1988 (``ITSFEA''),\17\
requires every registered broker or dealer to establish, maintain, and
enforce written policies and procedures reasonably designed to prevent
the misuse of material, non-public information by the broker or dealer
or any associated person of the broker or dealer. Incorporated NYSE
Rule 342.21 sets forth specific supervisory procedures for compliance
with ITSFEA by requiring firms to review trades in NYSE-listed
securities and related financial instruments that are effected for the
member's account or for the accounts of the member's employees and
family members. Incorporated NYSE Rule 342.21 also requires members to
promptly conduct an internal investigation into any trade the firm
identifies that may have violated insider trading laws or rules.
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    \16\ 15 U.S.C. 78o(g).
    \17\ See Insider Trading and Securities Fraud Enforcement Act of
1988, Pub. L. No. 100-704, 102 Stat. 4677.
---------------------------------------------------------------------------

    FINRA is proposing FINRA Rule 3110(d) to incorporate into the
Consolidated FINRA Rulebook the provisions of Incorporated NYSE Rule
342.21, with some modifications, and extend the requirement beyond
NYSE-listed securities and related financial instruments to cover all
securities. Specifically, proposed FINRA Rule 3110(d)(1) requires a
member to have supervisory procedures for the review of securities
transactions that are effected for the account(s) of the member and/or
associated persons of the member as well as any other ``covered
account'' \18\ to identify trades that may violate the provisions of
the Act, the rules thereunder, or FINRA rules prohibiting insider
trading and manipulative and deceptive devices. The proposed rule
change also requires members to promptly conduct an internal
investigation into any identified trades to determine whether a
violation of those laws or rules has occurred.
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    \18\ Proposed FINRA Rule 3110(d)(3)(A) defines the term
``covered account'' to include (i) any account held by the spouse,
child, son-in-law, or daughter-in-law of a person associated with
the member where such account is introduced or carried by the
member; (ii) any account in which a person associated with the
member has a beneficial interest; and (iii) any account over which a
person associated with the member has the authority to make
investment decisions.
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    Proposed FINRA Rule 3110(d)(2) requires any member that engages in
``investment banking services,'' \19\ to provide reports to FINRA
regarding such investigations. These members would be required to make
reports to FINRA within ten business days of the initiation of an
investigation, each quarter to update the status of all ongoing
investigations, and within five business days of the conclusion of an
investigation.
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    \19\ Proposed FINRA Rule 3110(d)(3)(B) defines 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; 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. This
proposed definition is the same definition as in proposed FINRA Rule
2240(a)(4) (Research Analysts and Research Reports). See Regulatory
Notice 08-55 (October 2008).
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(E) Proposed FINRA Rule 3110(e) (Definitions)
    Proposed FINRA Rule 3110(e) retains the definitions of ``branch
office,'' ``office of supervisory jurisdiction,'' and ``business day''
in NASD Rule 3010(g). The branch office definition already has been
harmonized with the definition of ``branch office'' in Incorporated
NYSE Rule 342.10.
(2) Proposed FINRA Rule 3120 (Supervisory Control System)
    FINRA is proposing to replace NASD Rule 3012 (Supervisory Control
System) with FINRA Rule 3120. Proposed FINRA Rule 3120(a) retains NASD
Rule 3012(a)(1)'s testing and verification requirements for the
member's supervisory procedures, including the requirement to prepare
and submit to the member's senior management a report at least annually
summarizing the test results and any necessary amendments to those
procedures.
    Proposed FINRA Rule 3120(b) requires a member that reported $150
million or more in gross revenue (total revenue less, if applicable,
commodities revenue) on its FOCUS reports in the prior calendar year to
include in the report it submits to senior management:
     A tabulation of the reports pertaining to customer
complaints and internal investigations made to FINRA during the
preceding year; and
     A discussion of the preceding year's compliance efforts,
including procedures and educational programs, in each of the following
areas:
    [cir] Trading and market activities;
    [cir] Investment banking activities;
    [cir] Antifraud and sales practices;
    [cir] Finance and operations;
    [cir] Supervision;
    [cir] Anti-money laundering; and
    [cir] Risk management.
    With the exception of risk management, the categories listed above
are incorporated from the annual report content requirements of
Incorporated NYSE Rule 342.30 (Annual Report and Certification). The
requirement to adequately manage the risks of a member's business is an
inherent part of the member's obligations under FINRA's supervision and
supervisory control rules. Accordingly, FINRA believes that a
discussion of the member's compliance efforts in the area of risk
management should be included in proposed FINRA Rule 3120's additional
annual report content requirements.
(3) Proposed FINRA Rule 3150 (Holding of Customer Mail)
    The proposed rule change replaces NASD Rule 3110(i) (Holding of
Customer Mail) with proposed FINRA Rule 3150, a more general rule that
eliminates the strict time limits in NASD Rule 3110(i) and 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
certain conditions. Specifically, proposed FINRA Rule 3150(a) provides
that a member may hold mail for a customer who will not be receiving
mail at his or her usual address, provided that the member:
     Receives written instructions from the customer that
include the time period during which the member is requested to hold
the customer's mail. If the time period included in the customer's
instructions is longer than three consecutive months (including any
aggregation of time periods from prior requests), the customer's
instructions must include an acceptable reason for the request (e.g.,
safety or security concerns). Convenience is not an acceptable reason
for holding mail longer than three months;
     Informs the customer in writing of any alternate methods,
such as e-mail or access through the member's Web site, that the
customer may use to receive or monitor account activity and information
and obtains the customer's confirmation of the receipt of such
information; and
     Verifies at reasonable intervals that the instructions
still apply.
    In addition, proposed FINRA Rule 3150(b) requires that the member
be able to communicate, as necessary, with the customer in a timely
manner during the time the member is holding the customer's mail to
provide important account information (e.g., privacy notices, the SIPC
information disclosures required by FINRA Rule 2266).
    Finally, proposed FINRA Rule 3150(c) requires a member holding a
customer's mail to take actions reasonably designed

to ensure that the customer's mail is not tampered with, held without
the customer's consent, or used by an associated person of the member
in any manner that would violate FINRA rules, MSRB rules, or the
Federal securities laws.
(4) Proposed FINRA Rule 3170 (Tape Recording of Registered Persons by
Certain Firms)
    FINRA proposes to reconstitute NASD Rule 3010(b)(2) (Tape Recording
of Conversations) without any substantive changes as new FINRA Rule
3170 (Tape Recording of Registered Persons by Certain Firms). The only
proposed changes to the rule text are minor editorial changes to assist
with readability, changes to the definition of disciplinary history to
reflect the adoption of certain enumerated NASD rules as FINRA rules,
and a definition clarifying that the term ``tape recording'' includes
without limitation, any electronic or digital recording that meets the
requirements of proposed FINRA Rule 3170.
(5) Proposed FINRA Rule 1260 (Responsibility of Member To Investigate
Applicants for Registration)
    FINRA is proposing to relocate the requirements in NASD Rule
3010(e) (Qualifications Investigated) concerning a member's
responsibilities during the pendency of a person's application for
registration as a representative or principal to a standalone new
registration rule, FINRA Rule 1260 (Responsibility of Member to
Investigate Applicants for Registration). In addition, the proposed
rule change deletes NASD Rule 3010(f) (Applicant's Responsibility)
requiring an applicant for registration to provide, upon a member's
request, a copy of his or her Form U5. The provision is no longer
necessary because members now have electronic access to an applicant's
Form U5 through the Central Registration Depository.
(6) Proposal To Eliminate Certain NYSE Rules
    As mentioned previously, the proposed rule change deletes
corresponding provisions in the Incorporated NYSE Rules and
Interpretations that are, in main part, either duplicative of, or do
not align with, the proposed supervision requirements discussed above.
Specifically, the proposed deleted rule provisions are:
     Incorporated NYSE Rule 342;
     NYSE Rule Interpretations 342(a)(b)/01 through 342(a)(b)/
03, 342(b)/01 through 342(b)/02, 342(c)/02, 342(e)/01, 342.10/01,
342.13/01, 342.15/01 through 342.15/05, 342.16/01 through 342.16/03;
     Incorporated NYSE Rules 343, 343.10 and NYSE Rule
Interpretation 343(a)/01;
     Incorporated NYSE Rule 351(e) and NYSE Rule Interpretation
351(e)/01;
     Incorporated NYSE Rule 354; and
     Incorporated NYSE Rule 401.
    FINRA will announce the implementation date of the proposed rule
change in a Regulatory Notice to be published no later than 90 days
following Commission approval. The implementation date will be no later
than 365 days following Commission approval.
2. Statutory Basis
    FINRA believes that the proposed rule change is consistent with the
provisions of Section 15A(b)(6) of the Act,\20\ which requires, among
other things, that FINRA rules must be designed to prevent fraudulent
and manipulative acts and practices, to promote just and equitable
principles of trade, and, in general, to protect investors and the
public interest. FINRA also believes that the proposed rule change will
clarify and streamline the supervision and supervisory rules for
adoption as FINRA Rules in the Consolidated FINRA Rulebook.
---------------------------------------------------------------------------

    \20\ 15 U.S.C. 78o-3(b)(6).
---------------------------------------------------------------------------

B. Self-Regulatory Organization's Statement on Burden on Competition

    FINRA does not believe that the proposed rule change will result in
any burden on competition that is not necessary or appropriate in
furtherance of the purposes of the Act.

C. Self-Regulatory Organization's Statement on Comments on the Proposed
Rule Change Received From Members, Participants, or Others

    FINRA published the proposed rules in Regulatory Notice 08-24 (May
2008) requesting comment from interested parties. A copy of the
Regulatory Notice is attached as Exhibit 2a. FINRA received 47 comment
letters. A list of the commenters and copies of the comment letters
received are attached as Exhibits 2b and 2c, respectively.\21\ The
comments and FINRA's responses are discussed below.
---------------------------------------------------------------------------

    \21\ All references to commenters in this rule filing are to the
commenters as listed in Exhibit 2b.
---------------------------------------------------------------------------

(a) General Comments
    Many of the commenters expressed general support for the proposed
rules. Commenters especially commended FINRA for proposing rules that
give members the flexibility to design supervisory procedures that
reflect their individual business models, as well as eliminating
obsolete and/or duplicative requirements.\22\
---------------------------------------------------------------------------

    \22\ ProEquities, ICBA Financial, WealthTrust, LPL, Nationwide
Financial, NAIBD, Northwestern Mutual, ING, Prudential, Comerica,
WilmerHale, Charles Schwab, CCS.
---------------------------------------------------------------------------

    One commenter, PIABA, opposed the flexibility within the proposed
rules, including the proposed risk-based review standards for the
approval of securities transactions and the review of certain
correspondence, arguing that such flexibility appears to reduce the
supervision requirements, thereby diminishing the protection of the
investing public. FINRA disagrees. The proposed rules include
prescriptive provisions where necessary, while also providing firms
with additional flexibility to establish their supervisory programs in
a manner that reflects their business models, where consistent with the
principles of investor protection and market integrity. In this regard,
the proposal retains certain specific 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
certain enumerated activities, while providing additional prescriptive
requirements where necessary, including special supervision for
supervisory personnel rather than just the existing special supervision
for producing branch managers, specific procedures to detect and
investigate potential insider trading violations, and additional
content requirements for certain firms' annual reports. Additionally,
with respect to the risk-based review of correspondence, as explained
further below, the proposed rules would codify certain existing
guidance.
    One commenter requested that all supplementary material be moved
into the ``body'' of the proposed rules.\23\ FINRA notes that
supplementary material is considered part of the rule and carries the
same force of regulation. Supplementary material provisions provide
additional detail regarding a requirement that either appears elsewhere
in the rule or is of special significance.
---------------------------------------------------------------------------

    \23\ National Planning.
---------------------------------------------------------------------------

(b) Comments on Proposed FINRA Rule 3110(a) (Supervisory System)
(1) Use of ``Associated Person''
    Several commenters objected to the use of the term ``associated
person'' in the preamble of proposed FINRA Rule 3110(a), arguing that
FINRA could

effectively expand its jurisdiction over non-broker-dealer entities by
broadly interpreting this term to include a member's affiliates and the
affiliates' employees.\24\ To avoid this result, the commenters
suggested retaining the reference in NASD Rule 3010(a) to ``registered
representative, registered principal, and other associated person.''
---------------------------------------------------------------------------

    \24\ National Planning, Cornerstone Financial, Nationwide
Financial, Great American Advisors, FSI.
---------------------------------------------------------------------------

    These concerns are unfounded as the FINRA By-Laws specifically
define who is an ``associated person of a member.'' \25\ Included in
that definition are all persons who are registered (or have applied for
registration) with FINRA. Accordingly, in drafting proposed FINRA Rule
3110(a), FINRA omitted the references to registered representatives and
principals as duplicative and unnecessary. The elimination of the terms
``registered representative'' and ``registered principal'' does not
alter the reach of the provision or expand FINRA's jurisdiction in any
way. FINRA's jurisdiction continues to extend to all persons,
regardless of affiliation, that meet the associated person definition.
---------------------------------------------------------------------------

    \25\ See FINRA By-Laws Art. 1(rr); see also Notice to Members
98-38 n.5 (May 1998) (citing the same By-Laws definition to clarify
the term ``associated person'').
---------------------------------------------------------------------------

(2) Permissive Licenses
    Commenters also suggested that proposed FINRA Rule 3110(a) should
acknowledge that associated persons holding permissive licenses who do
not engage in securities activities can have a different level of
supervision than registered persons actively engaged in securities
activities.\26\ To that end, certain commenters even suggested that
FINRA rewrite proposed FINRA Rule 3110(a) to refer only to associated
persons who are ``actively engaged in the securities business of the
firm.'' \27\ In response, FINRA notes that it has separately issued for
comment the proposed consolidated FINRA rules governing registration
and qualification requirements.\28\ Among other things, those proposed
rules address permissive registration categories and members'
differentiated supervisory obligations with respect to persons
registered pursuant to such categories.
---------------------------------------------------------------------------

    \26\ FSI, Cornerstone Financial.
    \27\ Great American Advisors, National Planning, M Holdings.
    \28\ See Regulatory Notice 09-70 (December 2009).
---------------------------------------------------------------------------

(3) MSRB Rules
    One commenter questioned the proposed requirement to have a
supervisory system that is reasonably designed to achieve compliance
with MSRB rules, arguing that members affiliated with banks that have
opted to conduct their municipal securities business within a bank
should not be required to supervise in-bank municipal securities
activities.\29\ Any member that falls within the Act's definitions of
``municipal securities broker'' or ``municipal securities dealer'' must
comply with all applicable obligations, including the obligation to
supervise the municipal securities activities of its associated persons
and the conduct of its municipal securities business, set forth in the
Federal securities law and MSRB rules. Proposed FINRA Rule 3110(a) does
not alter this basic premise. Rather, it supports the premise by
expressly requiring members to have supervisory procedures that are
reasonably designed to achieve compliance with the applicable Federal
securities laws and regulations, FINRA rules, and MSRB rules.
---------------------------------------------------------------------------

    \29\ ABA.
---------------------------------------------------------------------------

    Additionally, although FINRA enforces and examines its members for
compliance with MSRB rules, current NASD Rule 3010(a) does not
expressly require members to design supervisory systems to achieve
compliance with the MSRB rules. The proposed rule change clarifies that
supervisory systems must extend to compliance with MSRB rules and also
aligns FINRA's supervisory system requirement with the existing
requirement under MSRB rules to have a supervisory system that is
reasonably designed to achieve compliance with applicable securities
laws and regulations and MSRB rules.\30\
---------------------------------------------------------------------------

    \30\ See MSRB Rule G-27(b).
---------------------------------------------------------------------------

    FINRA is not making any changes to the preamble in proposed FINRA
Rule 3110(a) in response to the comments above.
(c) Comments on Proposed FINRA Rule 3110(a)(2): Designated Principal
(1) A Designated Principal for All Business Lines
    As proposed in Regulatory Notice 08-24, FINRA Rule 3110(a)(2)
required a member to designate an appropriately registered principal(s)
with authority to carry out the member's supervisory responsibilities
for all of a member's business lines, regardless of whether a business
line required broker-dealer registration. Commenters had several
reactions to this proposed change. Some commenters asked whether the
proposed change would expand FINRA's jurisdiction and rules into non-
securities activities, such as insurance and investment advisory
services that are already regulated by other regulators.\31\ Other
commenters asked about the appropriate principal registration license
for persons responsible for non-broker-dealer business lines.\32\ One
commenter asked how a firm would comply with the provision without
violating the prohibition in NASD Rule 1021(a) (All Principals Must Be
Registered) prohibiting principal registration of associated persons
who are not currently engaging in a member's investment banking or
securities business.\33\
---------------------------------------------------------------------------

    \31\ Cornerstone Financial, National Planning, Comerica, LPL,
Nationwide Financial, Great American Advisors, Janney, FSI, NAIBD,
WilmerHale, CAI, Charles Schwab, CCS, NSCP, SIFMA, Wachovia
Securities, FPA, ING, NFA.
    \32\ Janney, Charles Schwab, SIFMA, Wachovia Securities, FPA,
NFA.
    \33\ SIFMA. NASD Rule 1021(a) permits a member to maintain a
principal license for an associated person who performs legal,
compliance, internal audit, back office operations, or similar
responsibilities for the member or a person engaged in the
investment banking or securities business of a foreign securities
affiliate or subsidiary of the member.
---------------------------------------------------------------------------

    The proposed rule change was intended to explicitly address the
fact that a member is responsible for having a supervisory system that
encompasses all of its business lines. Thus, if a member chooses to
engage in a business that does not require registration as a broker-
dealer, the member is nonetheless responsible for supervising that
business. To avoid further confusion, FINRA has proposed to retain the
language in NASD Rule 3010(a) and adopt supplementary material
explaining this requirement. Consequently, proposed Supplementary
Material .01 (Business Lines) provides that for a member's supervisory
system required by proposed FINRA Rule 3110(a) to be reasonably
designed to achieve compliance with FINRA Rule 2010, it must include
supervision for all of the member's business lines irrespective of
whether they require broker-dealer registration.
    As FINRA noted in Regulatory Notice 08-24, the requirement that a
member supervise all of its business lines is consistent with NASD Rule
3010(b)(1) (and proposed FINRA Rule 3110(b)(1)), which currently
requires a member to have supervisory procedures for all business
activities in which it engages. Additionally, a member's responsibility
for appropriate supervision for all of its business activities is
consistent with a member's obligation under FINRA Rule 2010 to observe
high standards of commercial honor and just and equitable principles of
trade in the conduct of its business.\34\ These general

ethical standards protect investors and the securities industry from
dishonest practices that are unfair to investors or hinder the
functioning of a free and open market, regardless of whether those
practices occur in business lines that do not require broker-dealer
registration or are not illegal or violate a specific rule, law, or
regulation.\35\ The proposal merely codifies, under proposed FINRA Rule
3110, a member's duty required by FINRA Rule 2010 to supervise all
business activities, irrespective of whether they are part of a
member's investment banking or securities business.\36\
---------------------------------------------------------------------------

    \34\ FINRA is required under the Act to have rules that, among
other things, are designed to prevent fraudulent and manipulative
acts and practices and to promote just and equitable principles of
trade. 15 U.S.C. 78o-3(b)(6).
    \35\ See Ialeggio v. SEC, No. 98-70854, 1999 U.S. App. LEXIS
10362, at *4-5 (9th Cir. May 20, 1999) (``NASD's disciplinary
authority is broad enough to encompass business-related conduct that
is inconsistent with just and equitable principles of trade, even if
that activity does not involve a security.'') (citations omitted).
    \36\ A number of other FINRA rules apply to conduct irrespective
of whether securities transactions are directly involved. For
instance, NASD Rule 2210 (Communications with the Public) requires
that all member communications with the public be based on
principles of fair dealing and good faith and prohibits the
distribution to the public of exaggerated, unwarranted, or
misleading advertisements and sales literature. See Robert L.
Wallace, 53 S.E.C. 989, 995 (1998) (Rule 2210 is ``not limited to
advertisements for securities, but provide[s] standards applicable
to all NASD member communications with the public''). See also
Daniel C. Adams, 47 S.E.C. 919, 920-21 (1983) (finding that it was
within NASD's authority pursuant to NASD Rule 8210 (now FINRA Rule
8210) to investigate and seek information about a product that the
broker was selling even assuming that the product was not a
security).
---------------------------------------------------------------------------

(d) Comments on Proposed Supplementary Material .03 (Designation of
Additional OSJs)
    Several commenters raised questions regarding the factors set forth
in proposed Supplementary Material .03 that a member should consider in
designating additional OSJs.\37\ One commenter requested that FINRA
delete the factor regarding whether registered persons at the location
engage in retail sales or other activities involving regular customer
contact with the public as it was not a previously articulated
factor.\38\ Two other commenters asked that FINRA clarify the terms
``diverse'' and ``complex'' as used in the factors.\39\ FINRA notes
that proposed Supplementary Material .03 transfers NASD Rule 3010(a)(3)
unchanged into the Consolidated FINRA Rulebook without adding any new
requirements or language. No single factor is dispositive, but members
must use these factors, as necessary, to supervise their associated
persons and activities in accordance with proposed FINRA Rule 3110.
---------------------------------------------------------------------------

    \37\ Thornburg, NAIBD, Cornerstone Financial, FSI.
    \38\ NAIBD.
    \39\ Cornerstone Financial, FSI.
---------------------------------------------------------------------------

(e) Comments on Proposed FINRA Rule 3110(a)(4) and Supplementary
Material .04 and .05
    Commenters requested clarification regarding several aspects of the
requirement in proposed Rule 3110(a)(4) for a member to designate an
appropriately registered principal in each OSJ to carry out supervisory
responsibilities assigned to that location and the proposed
Supplementary Material .04 (One-Person OSJs) and .05 (Supervision of
Multiple OSJs by a Single Principal).\40\ In main part, the commenters'
concerns are centered on their belief that the proposed provisions do
not take into account the business and supervisory structure of
independent dealer firms and appear to be more tailored to
``wirehouses.'' Specifically, one commenter objected to the requirement
in proposed Supplementary Material .04 to designate a senior principal
to supervise the activities of a producing on-site principal at a one-
person OSJ.\41\ The commenter believed that a producing manager at one-
person OSJs should be able to supervise his or her own activities. The
commenter noted that its firm employs a ``field OSJ'' supervisory
structure that permits field OSJ staff to conduct supervisory functions
and also be producing managers. The commenter stated that requiring an
on-site principal to supervise one-person OSJs would result in the firm
needing over 3,300 new staff in the field.
---------------------------------------------------------------------------

    \40\ LPL, Cornerstone Financial, FSI.
    \41\ LPL.
---------------------------------------------------------------------------

    Proposed Supplementary Material .04 codifies existing FINRA
guidance on the designation and supervision of one-person OSJs. The
provision makes clear that a member may establish a one-person OSJ and
also clarifies how a member can establish reasonable on-site
supervision on a regular periodic schedule determined by the member at
a one-person OSJ in light of the core concept that a principal cannot
supervise his or her own activities. A one-person office that is
designated an OSJ because it engages in final approval of new accounts
or sales literature presents an inherently different supervisory
challenge than a one-person OSJ location where the single on-site
principal engages in structuring public offerings and/or is a producer.
In the latter instance, the proposed supplementary material makes clear
that the principal cannot supervise his or her own sales activities due
to the conflict of interest such situation presents. Accordingly, FINRA
believes that the requirement to have a senior principal regularly
supervise the activities of an on-site producing principal is necessary
to ensure that the on-site principal's activities are appropriately
supervised.
    With respect to concerns regarding the need for additional
personnel to meet the proposed requirements, FINRA believes that the
proposed supplementary material provides members with flexibility in
designing a supervisory scheme for these locations by not mandating a
specific schedule, but rather, permitting the member to establish the
schedule after considering certain factors (e.g., 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 on-site principal). Consequently, FINRA has
not revised the proposed supplementary material as requested by the
commenters.
    Several commenters requested that FINRA revise the presumption in
proposed Supplementary Material .05 that a principal cannot supervise
more than one OSJ to allow a registered principal to supervise
additional OSJs.\42\ In addition, at least one commenter stated that
firms and their registered principals should be allowed to determine
the appropriate number of offices assigned to each OSJ manager and the
rules ``should clearly reflect that firms have this freedom in
designing their supervisory system.'' \43\ Commenters further stated
that the requirement of a ``physical presence'' on a regular and
routine basis is overly burdensome and biased against independent
broker-dealer firms.\44\
---------------------------------------------------------------------------

    \42\ LPL, Cornerstone Financial, FSI.
    \43\ Cornerstone Financial.
    \44\ Thornburg, Cornerstone Financial, FSI, NAIBD, SIFMA.
---------------------------------------------------------------------------

    FINRA does not agree that the proposed supplementary material is
biased against independent dealer firms. Members are currently required
under NASD Rule 3010(a)(4) to designate an appropriately registered
principal in each OSJ and an appropriately registered representative or
principal in each non-OSJ branch office with authority to carry out
supervisory responsibilities. Proposed FINRA Rule 3110(a)(4) transfers
that provision unchanged into the Consolidated FINRA Rulebook. The one-
principal-per-OSJ presumption in proposed Supplementary Material .05
explains the meaning of the term ``in each OSJ'' in proposed FINRA Rule
3110(a)(4). This presumption does not limit a

member's ability to have more than one principal in the supervisory
chain for an OSJ. Rather, FINRA believes that the presumption is
consistent with the long-standing requirement in NASD Rule 3010(a)(4)
for members to have an on-site principal in each OSJ location, which is
a cornerstone of a member's supervisory structure. Moreover, FINRA
believes that physical presence, on a regular and routine basis, by a
supervisor at a location that engages in significant activities is
necessary for effective oversight. The presumption ensures that such
on-site principal has sufficient time and resources to engage in
meaningful supervision. However, in response to the comments, FINRA has
modified proposed Supplementary Material .05 to make it clear that the
presumption applies only to the designation of the on-site principal
supervisor required for FINRA Rule 3110(a)(4) purposes in each OSJ
location.
(f) Comments on Proposed Supplementary Material .06 (Annual Compliance
Meeting)
    Several commenters supported proposed Supplementary Material .06,
which allows a member to conduct annual compliance meetings through
electronic means rather than holding in-person meetings.\45\ Two
commenters, however, asked that the text be simplified or
clarified.\46\ One of the commenters also asked that the term
``presenter'' be deleted, as ``many webcasts have audio recordings and
screens, rather than presenters, and employees with questions may be
directed to an email address or group of individuals, rather than to a
single presenter.'' \47\ FINRA believes that the proposed rule text
provides significant flexibility as to the methods members may choose
to conduct their annual compliance meetings; however, in response to
commenters' concerns, FINRA has revised the proposed rule to eliminate
the term ``presenter,'' thereby further recognizing that members may
employ methods that may not necessarily involve a specific presenter.
The proposed rule would continue to require that registered persons
attending the meeting be able to ask questions regarding the
presentation and receive answers in a timely fashion (e.g., an on-
demand annual compliance Web cast that allows registered persons to ask
questions via an e-mail to a presenter or a centralized address or via
a telephone hotline and receive timely responses directly or view such
responses on the member's intranet site). FINRA also reminds members
that the proposed supplementary material requires a member to ensure,
at a minimum, that each registered person attends the entire meeting.
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    \45\ NAIBD, ING, SIFMA.
    \46\ ING, SIFMA.
    \47\ SIFMA.
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(g) Comments on Proposed FINRA Rule 3110(b)(1) (General Requirements)
(1) Use of ``Associated Person''
    Several commenters objected to the use of the term ``associated
person'' by itself in proposed FINRA Rule 3110(b)(1), arguing that its
use could effectively expand FINRA's jurisdiction to include a member's
affiliates.\48\ This argument is similar to those raised by commenters
objecting to the same proposed change in FINRA Rule 3110(a). As noted
in FINRA's response to that argument, the use of ``associated person''
by itself does not effectively expand FINRA's jurisdiction as the FINRA
By-Laws specifically define who is considered an ``associated person of
a member.'' \49\ Included in the definition are persons who are
registered (or have applied for registration) with FINRA, which
includes registered representatives and registered principals.
Accordingly, FINRA drafted proposed FINRA Rule 3110(b)(1) without the
references to registered representatives and principals because such
persons are already included in the term ``associated person.''
---------------------------------------------------------------------------

    \48\ National Planning, Cornerstone Financial, Nationwide
Financial, Great American Advisors.
    \49\ See FINRA By-Laws, Art. 1(rr); see also Notice to Members
98-38 n.5 (May 1998) (citing the same By-Laws definition to clarify
the term ``associated person'').
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(2) Scope of Supervisory Procedures
    Some commenters suggested narrowing the scope of FINRA Rule
3110(b)(1) by having a member's written supervisory procedures address
only those types of business for which broker-dealer registration is
required.\50\ FINRA declines to adopt this suggestion for several
reasons. First, NASD Rule 3010(b)(1) currently requires a member to
have supervisory procedures to supervise all types of business in which
it engages. Proposed FINRA Rule 3010(b)(1) merely retains this existing
requirement. Second, as explained above, a member's supervisory system
must include appropriate supervision for all of its business activities
in order to comply with its obligations under FINRA Rule 2010 to
protect investors and the securities industry from dishonest practices
that are unfair to investors or hinder the functioning of a free and
open market.
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    \50\ National Planning, Cornerstone Financial, FSI.
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(h) Comments on Proposed FINRA Rule 3110(b)(2) (Review of a Member's
Investment Banking and Securities Business)
(1) ``One Size Fits All''
    Two commenters objected to the proposed provision requiring a
member to review its investment banking and securities business on the
basis that a firm's investment banking business and its securities
business are inherently different and that any supervisory review for
these businesses should not be subject to a ``one-size-fits-all
approach.'' \51\ The commenters build on their objection with the
arguments that since members adopt specific supervisory structures and
supervisory procedures specific to their investment banking businesses,
implementing this proposed requirement would be ``unnecessary'' and
``duplicative.'' \52\ These objections do not take into account the
fact that a member's supervisory procedures should be tailored to a
member's business. As long as a member has supervisory procedures that
meet the requirements of the proposed rule, a member may design
procedures specific to its individual business lines.
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    \51\ Janney, SIFMA.
    \52\ Id.
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(2) Use of Risk-Based Principles
    Several commenters requested that the risk-based provision in
proposed Supplementary Material .07 be inserted into the body of the
rule.\53\ As noted previously, supplementary material is part of the
rule. FINRA believes that locating the risk-based discussion as
supplementary material improves the readability of the rule without
affecting the weight or significance of the provision. Finally, one
commenter requested that FINRA clarify the meaning of the term ``risk-
based.'' \54\ The term ``risk-based,'' which the proposed rule uses in
several places, 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. FINRA acknowledges that members may need to
prioritize their review processes due to the volume of information that
must be reviewed by using a review methodology based on a reasonable
sampling of information in

which the sample is designed to discern the degree of overall
compliance, the areas that pose the greatest numbers and risks of
violation, and any possibly needed changes to firm policies and
procedures. In addition, FINRA believes that allowing risk-based review
in limited circumstances improves investor protection by ensuring that
those areas that pose the greatest potential for investor harm are
reviewed more quickly to uncover potential violations.
---------------------------------------------------------------------------

    \53\ Cornerstone Financial, FSI, LPL, Nationwide Financial,
Great American Advisors, Janney, NSCP, SIFMA, ING.
    \54\ PIABA.
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(i) Comments on Proposed FINRA Rule 3110(b)(3) (Supervision of Outside
Securities Activities)
    As noted above, proposed FINRA Rule 3110(b)(3) is reserved for
future rule making. Accordingly, FINRA is not addressing any comments
received on proposed FINRA Rule 3110(b)(3) and related Supplementary
Material .07 as such comments are outside of the scope of this proposed
rule change.
(j) Comments on Proposed FINRA Rule 3110(b)(4) (Review of
Correspondence and Internal Communications) and Supplementary Material
.08-.11
    One commenter suggested that proposed FINRA Rule 3110(b)(4) and
proposed Supplementary Material .08 (Risk-based Review of
Correspondence and Internal Communications) could be read to create a
new affirmative obligation to supervise all written and electronic
internal communications relating to investment banking and securities
activities.\55\ This conclusion appears to be a misreading of the
proposed rule change. As explained in the Purpose section, although
there are certain communications that members must review, members may
use risk-based review principles to determine the extent to which
additional communications should be reviewed.\56\
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    \55\ Charles Schwab.
    \56\ In a related comment, several commenters requested that
FINRA move the proposed supplementary material regarding the use of
risk-based review and delegation of review into the body of proposed
FINRA Rule 3110(b)(4). SIFMA, Janney, Baum, Cornerstone Financial,
Nationwide Financial, Great American Advisors, FSI. As previously
explained, the proposed supplementary material is part of the
proposed rule.
---------------------------------------------------------------------------

    Proposed FINRA Rule 3110(b)(4) requires each member to have
supervisory procedures to review its incoming and outgoing (including
electronic) correspondence with the public and internal communications
relating to the member's investment banking or securities business to
ensure that the member properly identifies and handles in accordance
with firm procedures, among other things, customer complaints,
instructions, and funds and securities. Two commenters noted that this
requirement conflicted with the guidance in Regulatory Notice 07-59,
which the commenters contend does not instruct members to review
internal communications for these topics (outside of those relating to
the identifying and reporting of customer complaints).\57\ FINRA
believes that proposed FINRA Rule 3110(b)(4) and the guidance in
Regulatory Notice 07-59 do not conflict. Regulatory Notice 07-59
specifically notes that a member must have procedures for the review of
its associated persons' incoming, outgoing, and internal electronic
communications that are of a subject matter that require review under
FINRA rules and the Federal securities laws. It is FINRA's view that
the categories at issue are of a subject matter that would require
review under the Federal securities laws and FINRA rules, including
current NASD Rule 3010(d)(2).
---------------------------------------------------------------------------

    \57\ SIFMA, Janney.
---------------------------------------------------------------------------

    Several commenters also requested that FINRA replace the phrase
``to ensure'' in proposed FINRA Rule 3110(b)(4) with ``reasonably
designed to ensure.'' \58\ FINRA declines to make this requested
change. Proposed FINRA Rule 3010(b)(1) already requires a member to
have reasonably designed written procedures. The term ``to ensure'' is
the standard around which those supervisory procedures must be
designed. Altering the standard to read ``reasonably designed to
ensure'' is a redundancy and would only serve to weaken the standard.
---------------------------------------------------------------------------

    \58\ Cornerstone Financial, Nationwide Financial, Great American
Advisors, FSI, NAIBD, ING.
---------------------------------------------------------------------------

    SIFMA and Janney requested that FINRA delete the provision in
proposed Supplementary Material .09 (Evidence of Review of
Correspondence and Internal Communications) stating that merely opening
a communication is not sufficient review. NAIBD also supported deleting
this provision, noting that electronic review systems could become more
sophisticated and thus, render the sentence obsolete. FINRA declines to
delete this provision as it codifies existing guidance that FINRA
believes remains appropriate.\59\ Whether technological advances would
render this provision obsolete in the future is an issue that FINRA
will address when, and if, such technology exists.
---------------------------------------------------------------------------

    \59\ See Regulatory Notice 07-59 (December 2007).
---------------------------------------------------------------------------

    NAIBD requested that FINRA acknowledge that a reviewer can be an
electronic system. A reviewer may decide to use an electronic review
system to assist with his or her review functions but the assigned
supervisor/principal remains responsible for the adequacy of the
review.
    SIFMA and Janney requested that FINRA clarify what reasonable and
appropriate standards would be sufficient to demonstrate overall
supervisory control of delegated functions pursuant to proposed
Supplementary Material .10 (Delegation of Correspondence and Internal
Communication Review Functions). What may be reasonable and appropriate
for each firm will depend on the firm's size, business, structure, etc.
Members should look to these factors to determine how they should
structure their procedures to demonstrate adequate supervision of
delegated functions.
    Finally, PIABA requested that FINRA expand the record retention
period in proposed Supplementary Material .11 (Retention of
Correspondence and Internal Communications) to six years to match the
eligibility provisions for customer arbitration disputes in FINRA Rule
12206 (Time Limits). The proposed rule 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. Accordingly, FINRA declines to extend the
record retention period beyond the three-year period stipulated in Rule
17a-4(b) of the Act.\60\
---------------------------------------------------------------------------

    \60\ 17 CFR 240.17a-4(b).
---------------------------------------------------------------------------

(k) Comments on Proposed FINRA Rule 3110(b)(5)
    One commenter questioned the necessity of proposed FINRA Rule
3110(b)(5) as proposed FINRA Rule 3110(b)(4) would require members to
review communications to ensure that customer complaints are identified
and handled in accordance with a member's supervisory procedures.\61\
Proposed FINRA Rule 3110(b)(5) makes clear that members have an
affirmative obligation to capture, acknowledge, and respond to every
written customer complaint. The review requirement in proposed FINRA
Rule 3110(b)(4) supplements this affirmative responsibility.
---------------------------------------------------------------------------

    \61\ ING.
---------------------------------------------------------------------------

    Another commenter, SIFMA, supported proposed FINRA Rule 3110(b)(5),
including the decision to include only written customer complaints.
PIABA, on the other hand, argued that members should be required to
reduce an oral complaint to writing or to provide the customer with a
form. As stated previously, the proposed rule change does not include
oral complaints because they are difficult to capture and assess,
whereas members can more

readily capture and assess written complaints. FINRA encourages members
to provide customers with a form or other format that will allow
customers to detail their complaints in writing. However, as noted
above, FINRA reminds members that the failure to address any customer
complaint, written or oral, may be a violation of FINRA Rule 2010.
    A couple of commenters were concerned with the requirement that
members ``acknowledge'' customer complaints. One commenter argued that
this would be a new requirement for firms currently required to comply
only with NASD rules.\62\ Another commenter questioned the relevancy of
requiring firms to acknowledge complaints when the proposed rule does
not include the Incorporated NYSE Rule 401A requirement to do so within
15 days.\63\ While FINRA acknowledges that this would be a new
requirement for many FINRA members, the investor protection that this
provision would provide outweighs any potential compliance burdens.
Finally, the absence in the proposed rule of a specific time period in
which members must acknowledge their receipt of customer complaints
provides members a certain amount of flexibility in designing their
supervisory procedures. Members, however, would be expected to explain
the reasonableness of a period in excess of 30 days.
---------------------------------------------------------------------------

    \62\ Charles Schwab.
    \63\ ING.
---------------------------------------------------------------------------

(l) Comments on Proposed FINRA Rule 3110(b)(6)
    Commenters generally supported FINRA's proposal to eliminate NASD
Rule 3012's producing manager supervision requirements.\64\
Nevertheless, some commenters requested clarification and guidance
regarding certain aspects of the proposed supervisory requirements that
would replace the current producing manager supervision provisions.
---------------------------------------------------------------------------

    \64\ ProEquities, NAIBD, Charles Schwab, SIFMA.
---------------------------------------------------------------------------

    One commenter, concerned about the meaning of the term
``supervisory function,'' asked FINRA whether an associated person
performing a supervisory function needed to be a principal.\65\ The
proposed rule language does not impose a registration requirement.
Whether an associated person performing a supervisory function should
be licensed as a principal depends on whether the person is acting in a
capacity that requires principal registration.\66\ Furthermore, the
term ``supervisory function'' does not have a static definition.
Whether an associated person is performing a supervisory function
depends on the member's supervisory structure and the associated
person's assigned duties. Members may delegate supervisory functions to
associated persons who are not registered principals. However, FINRA
expects members to supervise those persons in accordance with proposed
FINRA Rule 3110(b)(6).
---------------------------------------------------------------------------

    \65\ CCS.
    \66\ See NASD Rule 1021.
---------------------------------------------------------------------------

    One commenter asked why a member's written supervisory procedures
should prohibit a supervisor from engaging in conduct (supervising
one's own activities and reporting to, or having compensation
determined by, a person being supervised) when such conduct is not
expressly prohibited by any other FINRA rule.\67\ The same commenter
also questioned how a member should apply the prohibitions to certain
supervisory personnel, such as finance, continuing education, and
registration supervisors, who supervise people who could ``affect'' the
supervisors' compensation. Other commenters requested, without
explanation, that ``home office personnel'' be exempted from the
prohibitions.\68\
---------------------------------------------------------------------------

    \67\ ING.
    \68\ Cornerstone Financial, Nationwide Financial, FSI.
---------------------------------------------------------------------------

    The proposed supervisory requirements are designed to prevent
supervisory situations from occurring that regulators previously have
found do not lead to effective supervision.\69\ Additionally, the
requirement to have supervisory procedures prohibiting a supervisor
from supervising one's own activities and reporting to, or having
compensation determined by, a person being supervised also serves as
the general substantive prohibition against that conduct.\70\ However,
FINRA understands, and has provided a limited exception for, certain
situations and member business models (i.e., senior executive
management and/or sole proprietors) where, for example, it is not
possible to avoid having someone supervise his or her own activities or
supervise someone who determines (not merely ``affects'') his or her
compensation. FINRA believes that this exception provides sufficient
flexibility for a member to design an appropriate supervisory system
for all of its supervisory personnel, irrespective of their place in
the member's organizational structure.
---------------------------------------------------------------------------

    \69\ See SEC v. Frank D. Gruttadauria, Civil Action No.
1:02CV324 (N.D. Ohio Apr. 23, 2004), SEC Litigation Release No.
17369 (Feb. 21, 2002).
    \70\ FINRA also notes that the SEC has consistently recognized
that FINRA rules do not generally permit someone to supervise his or
her own activities. See, e.g., Bradford John Titus, 52 S.E.C. 1154,
1158 (1996) (compliance director held liable, under FINRA (then
NASD) rules, for supervisory failure based on finding that
salesperson, who was operating as independent contractor out of two-
person ``non-branch'' office, could not supervise himself).
---------------------------------------------------------------------------

    Two commenters also requested that FINRA add rule language
explaining that a supervisor receiving commission overrides does not
equate to having ``compensation determined by'' a person who is
supervised.\71\ FINRA does not believe that additional rule language is
necessary. Although a supervised person may affect his or her
supervisor's compensation (through overrides or in other ways),
proposed FINRA Rule 3110(b)(6)(C) concerns only those situations where
a supervised person directly controls a supervisor's compensation or
continued employment. In this context, however, the member would still
need to address this conflict in its procedures pursuant to proposed
FINRA Rule 3110(b)(6)(D).
---------------------------------------------------------------------------

    \71\ Cornerstone Financial, FSI.
---------------------------------------------------------------------------

    Several commenters questioned the necessity of proposed FINRA Rule
3110(b)(6) given the requirement that a member's supervisory system and
written procedures be reasonably designed to achieve compliance with
applicable securities laws and regulations and SRO rules.\72\ As noted
above, proposed FINRA Rule 3110(b)(6), among other things, requires
members to address conflicts of interest that may reduce the standards
of supervision applicable to an associated person. Serious conflicts of
interest have, in the past, caused diminished supervision standards
that, in turn, have resulted in inadequate supervision. Accordingly,
FINRA believes that supervisory procedures to address potential
conflicts of interest are necessary.
---------------------------------------------------------------------------

    \72\ Janney, Charles Schwab, SIFMA.
---------------------------------------------------------------------------

    Several commenters suggested that the standards within FINRA Rule
3110(b)(6) (e.g., procedures ``to prohibit'' supervisory personnel from
supervising their own activities and to prevent supervision from being
``lessened in any manner'' due to conflicts of interest) should be
changed to ``a reasonably designed'' standard. As noted previously,
proposed FINRA Rule 3110(b) already requires that members have
procedures that are reasonably designed to achieve compliance with the
applicable laws, regulations, and SRO rules. To alter the standards
within the rule that describe the outcome the procedures should try to
achieve suggest an impermissible relaxation of the standard around
which the rule is

designed. FINRA, however, has revised proposed FINRA Rule 3110(b)(6) to
clarify that a member must 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.
(m) Comments on Proposed FINRA Rule 3110(b)(7) and Proposed
Supplementary Material .13
    Commenters requested clarification regarding several aspects of
proposed FINRA Rule 3110(b)(7), which requires each member to keep and
maintain a copy of its written supervisory procedures at each OSJ and
at each location where supervisory activities are conducted.
Specifically, several commenters requested that FINRA clarify whether
members can electronically maintain their written supervisory
procedures and also electronically communicate to their associated
persons any amendments or updates to the written supervisory
procedures.\73\ One commenter also suggested that it would be
inappropriate to communicate a written supervisory procedures amendment
throughout the firm if the amendment was relevant only to a limited
business line or set of associated persons.\74\
---------------------------------------------------------------------------

    \73\ Cornerstone Financial, Great American Advisors, FSI, SIFMA,
Baum, ING.
    \74\ Charles Schwab.
---------------------------------------------------------------------------

    Written supervisory procedures are records subject to the
recordkeeping requirements of Exchange Act Rule 17a-4,\75\ which
permits a member to store records electronically so long as they are
accessible. However, in response to commenters' concerns regarding the
use of electronic means to communicate written supervisory procedures
amendments to their associated person, FINRA has added proposed
Supplementary Material .13 (Use of Electronic Media to Communicate
Written Supervisory Procedures), which clarifies that a member may
electronically amend and distribute its written supervisory procedures
as long as the member meets certain conditions (e.g., providing easy
access to the written supervisory procedures, promptly posting written
supervisory procedures amendments, and notifying associated persons of
the amendments).
---------------------------------------------------------------------------

    \75\ 17 CFR 240.17a-4.
---------------------------------------------------------------------------

(n) Comments on Proposed FINRA Rule 3110(c)
(1) Flexibility To Conduct Location Inspections
    Several commenters raised concerns regarding the flexibility
members have in conducting location inspections.\76\ In particular,
four commenters expressed concern regarding the three-year presumption
in proposed Supplementary Material .15 (General Presumption of Three-
Year Limit for Periodic Inspection Schedules) for inspecting non-branch
locations (also referred to as ``unregistered locations'').\77\ While
one commenter expressed concern that the presumption would be
interpreted as a ``three-year pass,'' \78\ two other commenters viewed
the presumption as becoming a de facto three-year requirement.\79\
These same two commenters suggested that the proposed rule include a
risk-based inspection scheme similar to that in Incorporated NYSE Rules
342.24 and 342.25, arguing that, otherwise, Dual Members will be forced
to change inspection programs previously approved by the NYSE
permitting firms to conduct branch office examinations less frequently
than once each calendar year.
---------------------------------------------------------------------------

    \76\ Janney, SIFMA.
    \77\ Janney, SIFMA, CAI, Nekvasil.
    \78\ Nekvasil.
    \79\ Janney, SIFMA.
---------------------------------------------------------------------------

    FINRA believes the timing requirements for location inspections in
proposed FINRA Rule 3110(c)(1), which are carried over from the
existing NASD requirements, are appropriate and provide all members
with sufficient flexibility to meet their inspection requirements. In
addition, irrespective of any annual branch office inspection
exemptions that may have been granted by the NYSE pursuant to NYSE Rule
342.24, Dual Members have always been required to comply with the
annual inspection requirements for supervisory branch offices pursuant
to NASD Rule 3010(c)(1)(A).
    Regarding the periodic inspection of non-branch locations, proposed
Supplementary Material .15 does not set forth either a three-year
requirement or a three-year gap between inspections. The proposed
supplementary material merely establishes a three-year presumption and
provides members with the flexibility to use a periodic inspection
schedule that is either shorter or longer than three years. Members may
choose to examine non-branch locations more frequently than every three
years if the member determines such examinations are necessary to
detect and prevent violations of, and achieve compliance with,
applicable securities laws and regulations and with applicable FINRA
and MSRB rules. Conversely, if a member chooses to use a periodic
inspection schedule that is longer than three years, then the proposed
supplementary material requires the member to properly document the
factors used in determining the appropriateness of the longer
schedule.\80\
---------------------------------------------------------------------------

    \80\ National Planning requested that this documentation appear
in a member's written supervisory procedures. However, FINRA
believes that such documentation is more appropriate in an
inspection report for a particular location because it explains why
a member established a longer periodic inspection schedule for a
particular location.
---------------------------------------------------------------------------

(2) Reliance on Existing Guidance Regarding Unannounced Inspections
    One commenter asked that FINRA clarify the continued viability of
those sections of Notices to Members 99-45 (June 1999) and 98-38 (May
1998) alerting members to specific SEC cases where the SEC found one
pre-announced annual inspection of unregistered locations to be an
inadequate discharge of a firm's supervisory obligations for those
locations.\81\ As indicated by the commenter, these portions of the
referenced Notices alerted members to SEC decisions regarding the
failure to adequately supervise unregistered locations. Although this
is not FINRA guidance, these SEC decisions continue to provide valuable
information that firms may wish to consider when establishing
inspection cycles for unregistered locations. The actual guidance in
the referenced Notices is applicable unless overridden by the content
of proposed rules.
---------------------------------------------------------------------------

    \81\ NAIBD.
---------------------------------------------------------------------------

    FINRA is not making any changes to proposed FINRA Rule 3110(c)(1)
in response to the comments received.
(3) Minimum Content Requirements of Inspection Reports
    Several commenters argued that a location's written inspection
report should not have to include the testing and verification of a
member's policies and procedures for all of the activities enumerated
in proposed FINRA Rule 3110(c)(2)(A)(i) through (v) (e.g., transmittals
of funds and securities, changes of customer account information,
safeguarding of customer funds and securities, supervision of
supervisory personnel, maintaining books and records) if that location
did

not conduct all of those activities.\82\ In response to these concerns,
FINRA has amended the proposed rule language to make clear that a
location's inspection report has to include the testing and
verification of only those enumerated activities conducted by the
location.
---------------------------------------------------------------------------

    \82\ Cornerstone Financial, Great American Advisors, FSI, ING
(referring to activities in proposed FINRA Rule 3110(c)(2)(A)(i)
through (v)).
---------------------------------------------------------------------------

    One commenter suggested that the proposed customer confirmation
requirements for transmittals of funds and securities and changes of
customer account information be moved to another section of the
proposed rule as they did not pertain to the internal inspection
requirements.\83\ FINRA disagrees. It is clear from the proposed rule
text that the customer confirmation requirements must be included in
the policies and procedures for the transmittals of funds and
securities and changes of customer account information that a member
must test and verify during its inspection of any location at which
those activities are performed.
---------------------------------------------------------------------------

    \83\ Charles Schwab.
---------------------------------------------------------------------------

    This commenter also objected as ``unnecessarily broad'' the
proposed requirement to test and verify the policies and procedures
regarding a location's supervision of its supervisory personnel and
argued that this language could potentially include off-site
supervisory personnel who supervise a branch office manager's
activities. FINRA, however, does not view this requirement as overly
broad. Rather, the provision is intended to further ensure that the
activities of supervisory personnel are subject to supervision, and
FINRA would expect, for example, an inspection report to address, as
applicable, off-site supervision of the branch office manager's
activities.
    One commenter asked whether anything other than an account
statement would be appropriate to comply with the requirement in
proposed FINRA Rule 3110(c)(2)(B) to provide a means or method of
customer confirmation for transmittals of customer funds and
securities.\84\ Additionally, the commenter requested guidance on how
to comply with the proposed requirement that members test and verify
procedures for the transmittal of funds, especially the hand-delivery
of checks. The proposed requirements are already existing requirements
of NASD Rule 3012 that FINRA is moving into proposed FINRA Rule 3110.
As such, members should already be aware of how to comply with these
requirements. Additionally, FINRA has previously provided guidance in
Notice to Members 05-08 (January 2005) regarding the appropriate means
or method of customer confirmation, notification, or follow-up that
members should use to comply with this requirement. That guidance
remains applicable to the relocated provisions. FINRA does not believe
additional guidance is necessary.
---------------------------------------------------------------------------

    \84\ ING.
---------------------------------------------------------------------------

    Commenters also objected to the rule requirement, as originally
proposed in the Notice, requiring a member to identify in its written
supervisory procedures the activities in which it does not engage.\85\
In response to these concerns and the proposed changes made above,
FINRA has amended the proposed rule change 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.
---------------------------------------------------------------------------

    \85\ Thornburg, Charles Schwab.
---------------------------------------------------------------------------

(4) Associated Persons Who May Conduct Inspections
    Several commenters questioned whether the proposed requirement that
a location be inspected by someone who is not an associated person
assigned to that location or is not supervised by an associated person
assigned to that location would require members to hire outside
consultants to conduct inspections.\86\ FINRA believes that the
proposed rule change, similar to existing NASD Rule 3010(c), provides
members with sufficient flexibility to conduct their inspections using
only firm personnel.\87\ Pursuant to the proposed rule, a member that
determines it cannot comply with the restriction, either because of its
size or business model, must document in the inspection report the
factors the member used to make its determination and how the
inspection otherwise comports with proposed FINRA Rule 3110(c)(1).
---------------------------------------------------------------------------

    \86\ Nationwide Financial, Cornerstone Financial, Great American
Advisors, FSI.
    \87\ Charles Schwab also argued that the proposed restriction
would prevent personnel based in the same location from inspecting
other business units at the same location. To the extent that this
comment refers to business departments within a location, the
proposed restriction pertains only to office (both registered and
unregistered) location inspections. If the comment is referring to
multiple locations within one geographical place, a member may use
personnel from one location in a particular setting to inspect
another location in that same setting.
---------------------------------------------------------------------------

    One commenter requested that FINRA permit members to rely on the
exception described above for home office personnel conducting home
office inspections.\88\ As noted in proposed Supplementary Material .16
(Exception to Persons Prohibited from Conducting Inspections), a
member's determination that it cannot meet the requirement on who can
conduct a location's inspection will generally arise only in instances
where a member has only one office or has an independent contractor
business model. However, this general presumption does not prohibit a
member from relying on the exception in other instances provided it
complies with the conditions in proposed FINRA Rule 3110(c)(3)(C).
---------------------------------------------------------------------------

    \88\ ING.
---------------------------------------------------------------------------

(5) Preventing Conflicts of Interest from Lessening an Inspection
    Some commenters have argued that the proposed rule's requirement
that members prevent conflicts of interest from lessening an inspection
in any manner is vague and overly broad and should be altered to a
``reasonably designed'' standard.\89\ One commenter also suggested that
firms be permitted to design their own procedures to safeguard against
conflicts of interest. The proposed requirement does not pertain to a
member's supervisory procedures, which a member must ``reasonably
design'' to achieve compliance with applicable Federal laws and
regulations and SRO rules. Instead, it defines a standard around which
inspections must be conducted. The proposed requirement does not
prohibit conflicts of interest. Additionally, FINRA has revised the
proposed rule text to make clear that a member, for each inspection,
must prevent the inspection standards required pursuant to proposed
FINRA Rule 3110(c)(1) from being reduced in any manner due to any
conflicts of interest that may be present.
---------------------------------------------------------------------------

    \89\ LPL, Cornerstone Financial, Great American Advisors,
Janney, FSI, Charles Schwab, NSCP, SIFMA.
---------------------------------------------------------------------------

(o) Comments on Proposed Supplementary Material .14 (Standards for
Reasonable Review)
    Several commenters suggested that proposed Supplementary Material
.14 be amended to adopt a ``reasonably designed to ensure''
standard.\90\ Another commenter suggested that the experience of a
representative and/or length of service of a representative with the
firm be added as a factor to be considered in determining the
reasonableness of review for one-person

or small remote locations.\91\ Proposed Supplementary Material .14
transfers NASD IM-3010-1 with minor changes into the Consolidated FINRA
Rulebook. NASD IM-3010-1 was adopted in connection with the uniform
branch office definition in 2005 after several years of discussions
with the NYSE, NASAA, and NASD. As such, FINRA does not believe that
this provision should be further modified at this time. Additionally,
FINRA notes the factors listed are not exhaustive, and no single factor
is dispositive. Members can and should consider additional factors that
are relevant to their business model.
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    \90\ Cornerstone Financial, Great American Advisors, FSI.
    \91\ Nekvasil.
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(p) Comments on Proposed FINRA Rule 3110(d)
    FINRA received numerous comments on the proposal to require members
to include in their supervisory procedures a process for the review of
securities transactions that are effected for the accounts of the
member and certain accounts of associated persons of the member and
their family members to identify trades that may violate the Federal
securities laws, rules thereunder, or FINRA rules. The provision was
originally proposed in Regulatory Notice 08-24 as supplementary
material to proposed FINRA Rule 3110; however, as reflected above,
FINRA has amended the proposed rule change so that the provision is now
contained in the rule as proposed FINRA Rule 3110(d) (Transaction
Review and Investigation) rather than as supplementary material. As
described below, FINRA made several other changes to the rule in
response to comments.
(1) Scope of Provision
    Several commenters expressed concern that the proposed provision
was too broad in that it failed to recognize different types of
business models or to account for transactions in securities such as
mutual funds or variable contracts that do not raise the types of
concerns addressed by the rule.\92\ Other commenters believed the
provision was overly broad, vague, or inconsistent with existing FINRA
Rules, such as NASD Rule 3050.\93\
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    \92\ CAI, Liberty Life, NSCP, PFS, Thornburgh.
    \93\ FSI, ING.
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    As noted above, proposed FINRA Rule 3110(d) is intended to help
members comply with their existing obligations under Section 15(g) of
the Act,\94\ which requires all registered brokers or dealers to
``establish, maintain, and enforce written policies and procedures
reasonably designed, taking into consideration the nature of such
broker's or dealer's business, to prevent the misuse in violation of
[the Act] * * * or regulations thereunder, of material, nonpublic
information by such broker or dealer or any person associated with such
broker or dealer.'' FINRA recognizes that not all members will have the
same procedures and that not all transactions present the same risks.
Consistent with the requirements of Section 15(g) of the Act and
proposed FINRA Rule 3110(b), the procedures adopted by the member would
need to be reasonably designed to prevent violations of the Act, the
rules thereunder, and FINRA rules prohibiting insider trading and
manipulative and deceptive devices. Accordingly, each member's
procedures should take into consideration the nature of the member's
business, which includes an assessment of the risks presented by
different transactions and different departments within a firm. Thus,
while some members may need to develop restricted lists and/or watch
lists, other members may only need to periodically review employee and
proprietary trading. Like the incorporated NYSE rule on which the
proposal is based, there is no requirement that a member examine every
trade of every employee or every proprietary trade.
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    \94\ 15 U.S.C. 78o(g).
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(2) Family Member and Other Accounts
    One commenter stated that, as proposed in Regulatory Notice 08-24,
the proposal would require family members of persons associated with a
member to hold their accounts at the associated person's firm.\95\
Other commenters suggested changes to the rule to include those
accounts in which the associated person of the member had a beneficial
interest or accounts over which an associated person of the member had
control.\96\ In response to these comments, FINRA has revised the text
in the proposed rule change regarding a member's responsibility to
monitor trading in certain accounts of an associated person of a member
and his or her family members. As revised, the proposed rule change
would require a member to review the account activity of any account
held by the spouse, child, son-in-law, or daughter-in-law of a person
associated with the member where such account is introduced or carried
by the member, not every family member of a person associated with the
member. In addition, the revised proposed rule change would require
members to review any account in which a person associated with the
member has a beneficial interest and any account over which a person
associated with the member has the authority to make investment
decisions. This revised language is based, in large part, on the
obligations established by the NYSE in Information Memo 88-21 (July 28,
1988) regarding the accounts of certain family members of persons
associated with a member and accounts in which the associated person
has an interest or has the power, directly or indirectly, to make
investment decisions. Finally, proposed FINRA Rule 3110(d) does not
require family members of persons associated with a member to hold
their accounts at the associated person's firm.
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    \95\ ING. Another commenter requested that FINRA clarify the
term ``family member'' if the provision was not removed. Charles
Schwab.
    \96\ FSI, Northwestern Mutual.
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(3) Required Reports
    Several commenters expressed concern with the provision in the
proposed rule change requiring that members that engage in investment
banking activities report to FINRA the status of internal
investigations.\97\ Although some commenters supported the quarterly
report requirement, but not the additional reporting requirements,\98\
another commenter believed the reports were unnecessary in light of
information reported to FINRA pursuant to NASD Rule 3070 \99\ (to be
replaced by FINRA Rule 4530 (Reporting Requirements, effective July 1,
2011)).\100\
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    \97\ Janney, NSCP, Charles Schwab, SIFMA,
    \98\ Janney, SIFMA.
    \99\ Charles Schwab.
    \100\ See supra note 9.
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    FINRA believes that the proposed rule change strikes the
appropriate balance by only requiring certain members to report
information (i.e., those members that conduct investment banking
activities). Additionally, unlike FINRA Rule 4530,\101\ the proposed
rule change would require more targeted and detailed reporting,
following a review of whether a securities transaction effected for the
account(s) of the member, the member's associated person, or other
covered account may have violated the Exchange Act or FINRA rules
prohibiting insider trading and manipulative and deceptive devices.

Such information would include reporting the initiation of an
investigation (including such information as the identity of the
member, the date the internal investigation commenced, and the identity
of the security, trades, accounts, associated persons, or associated
person's family members holding a covered account, under review), a
quarterly report providing progress of any open investigation, and a
written report detailing the completion of an investigation, including
the investigation's results. Providing such detailed information, even
if a member's investigation does not uncover violations in association
with the suspected securities transactions, could prove vital to FINRA
in connecting the underlying conduct to other conduct about which the
member may not know. Thus, FINRA believes that the reporting
obligations pursuant to the proposed rule change are necessary to help
protect investors and market integrity.
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    \101\ FINRA Rule 4530 is based in large part on NASD Rule 3070
and takes into account requirements under NYSE Rule 351, including
the requirement that the firm report whenever the firm has concluded
on its own that an associated person of the firm or the firm itself
has violated any securities, insurance, commodities, financial or
investment-related laws, rules, regulations or standards of conduct
of any domestic or foreign regulatory body or SRO. See FINRA Rules
4530(b) and 4530.01.
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(q) Comments on Proposed FINRA Rule 3110(e)
    Two commenters requested that FINRA make several amendments to the
definition of the term ``branch office'' in proposed FINRA Rule
3110(e).\102\ Both commenters stated that additional exemptions from
branch office registration need to be established for certain
categories of activities. Specifically, one of the commenters asked
that FINRA add an exemption from branch office registration for
wholesalers of mutual funds who use their primary residences for
business purposes but do not meet with customers at such
locations.\103\ The other commenter asked that FINRA add an exemption
from branch office registration for certain non-U.S. locations because
registration can create potentially adverse consequences for the member
in the local jurisdiction.\104\ FINRA notes that the definition of
branch office is being transferred unchanged from current NASD Rule
3010(g)(2). The uniform branch office definition was developed in 2005
after several years of discussions with the NYSE, NASAA, and NASD. As
such, FINRA believes the current definition provides appropriate
exemptions from registration, and such exemptions should not be
expanded at this time.
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    \102\ Nationwide Financial, SIFMA.
    \103\ Nationwide Financial.
    \104\ SIFMA.
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(r) Comments on Proposed FINRA Rule 3120
    All of the comments FINRA received regarding proposed FINRA Rule
3120 addressed the new provisions concerning the report requirements in
paragraph (b). As noted above, these requirements are based on
provisions that had previously been adopted by the NYSE; however, FINRA
determined to apply the requirements only to members that reported $150
million or more in gross revenue on their FOCUS reports for the
previous year.
    Several commenters noted that the requirements would impose new
burdens on certain FINRA members that had previously been members of
only NASD and would continue to impose a burden for certain firms that
had previously created the report under the Incorporated NYSE
Rule.\105\ Commenters also questioned the need for the report,\106\ and
several commenters suggested that the report was duplicative of
existing requirements.\107\ Finally, several commenters suggested that
the $150 million revenue threshold was inappropriate.\108\ One
commenter suggested that all members be required to include the
supplemental information in the report, not merely those members
reporting more than $150 million in revenue.\109\
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    \105\ Cornerstone Financial, FSI, Great American Advisors,
Janney, SIFMA.
    \106\ Charles Schwab, ING, SIFMA.
    \107\ FSI, Northwestern Mutual, Charles Schwab, ING, Wachovia
Securities.
    \108\ Cornerstone Financial, GAA, FSI, CAI, ING, Charles Schwab.
    \109\ PIABA.
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    As FINRA stated in Regulatory Notice 08-24, FINRA believes that the
additional information required of members with more than $150 million
in gross revenue will prove to be valuable information for FINRA's
regulatory program, in addition to being valuable compliance
information for the senior management of the firm. FINRA recognizes the
burden the additional content requirements may place on some members
and, as a result, proposed only requiring certain members to include
the specific information listed in paragraph (b) of the proposed rule
in their reports. Although FINRA considered several alternative metrics
(e.g., number of registered persons), FINRA attempted to balance the
value of the information with the burden and determined that using a
gross revenue threshold of $150 million struck the appropriate balance.
The metric also is easily determined by reference to the member's most
recent annual FOCUS report.
    With respect to the specific supplemental information required in
the report, for members reporting more than $150 million in gross
revenue, the proposed rule requires that those reports include the
preceding year's compliance effort in seven areas: Trading and market
activity, investment banking activities, antifraud and sales practices,
finance and operations, supervision, anti-money laundering, and risk
management. In addition, the report is required to include a tabulation
of the reports made to FINRA in the previous year regarding customer
complaints and internal investigations. As noted above, several
commenters stated that some of the information (such as the tabulation
of customer complaints) was duplicative of existing requirements while
other information was too broad or could be outside the scope of a
member's compliance structure (such as risk management or finance). The
proposed requirements to include a tabulation of information provided
to FINRA regarding complaints and internal investigations are not
duplicative of existing requirements. Whereas FINRA Rule 4530 requires
reporting certain information to FINRA, the requirement in proposed
FINRA Rule 3120(b) covers information required to be provided to a
firm's senior management. Thus, each rule serves a distinct purpose.
    Several commenters also suggested that the provisions in proposed
FINRA Rule 3120 are duplicative of requirements in NASD Rule 3013 and
IM-3013.\110\ FINRA disagrees. Paragraph (b) of proposed FINRA Rule
3120 does not create a new report requirement; it merely specifies
several specific topics that the report (already required under NASD
Rule 3012) must address for firms reporting $150 million or more in
gross revenue. Since the adoption of NASD Rules 3012 and 3013, FINRA
has addressed the issue regarding the interplay between the
requirements of NASD Rules 3012 and 3013, noting that the requirements
are complementary, not duplicative. For example, in Notice to Members
04-71 (October 2004), FINRA stated that the supervisory system required
under NASD Rule 3010 results from the processes that are the subject of
certification under FINRA Rule 3130.

NASD Rule 3012 (proposed FINRA Rule 3120) requires members to have
supervisory control procedures to test and verify that the member's
supervisory procedures are reasonably designed to achieve compliance
with applicable securities laws and regulations and FINRA rules, as
well as to, where necessary, amend or create new supervisory
procedures. This same relationship between the rules (proposed FINRA
Rules 3110 and FINRA Rule 3120) remains present.
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    \110\ The SEC approved the adoption of NASD Rule 3013 and IM-
3013 into the Consolidated FINRA Rulebook as FINRA Rule 3130. See
Exchange Act Release No. 58661 (September 26, 2008), 73 FR 57395
(October 2, 2008) (Order Approving File No. SR-FINRA-2008-030). The
rule became effective on December 15, 2008. See Regulatory Notice
08-57 (October 2008).
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    With respect to the specific topics covered by the rule, although
most were taken from the existing provisions of Incorporated NYSE Rule
342.30, FINRA determined to add risk management as a required area of
discussion in the report. For those firms that did not have compliance
efforts in that area (or in any of the enumerated areas) during the
year covered by the report, the report should so state.
    Finally, one commenter stated that ``it should be clear that such
`testing and verification' also may be risk-based in light of the
member's particular business and circumstances.'' \111\ The commenter
also suggested that the language in the proposed rule be changed from
``test and verify'' to ``regularly test or otherwise monitor.'' FINRA
has previously provided guidance in Notice to Members 05-29 (April
2005) regarding a member's ability to use risk-based methodologies and
sampling to test a subset of policies and procedures annually when
conducing the testing and verification required by NASD Rule 3012. That
guidance remains applicable to proposed FINRA Rule 3120. FINRA does not
believe additional guidance or rule text is necessary.