NFA's Interpretive Notice to Compliance Rule 2-9 entitled "Compliance Rule 2-9: Enhanced Supervisory Requirements" ("Notice") requires a Member to adopt certain enhanced supervisory procedures ("Requirements") if its sales force includes a specified number of associated persons ("APs") who have worked at Disciplined Firms.1 NFA's Special Committee to Study Customer Protection Issues recently recommended changes to the Notice to resolve some emergent loopholes in the Requirements and further prevent abusive sales practices. The Board adopted the Special Committee's recommendations, which:
A. Reimposing the Requirements on Members that have previously satisfied an obligation to abide by those requirements and are subsequently charged in a CFTC or NFA enforcement action.
In 1996, NFA's Board amended the Notice to provide that, if a Member that is currently subject to the Requirements becomes subject to a CFTC or NFA enforcement proceeding, the Requirements will remain in place for two years or until after the disciplinary or enforcement proceeding is concluded, whichever is longer. This provision does not, however, apply to Members that have already served full two-year tenures under the Requirements when one of those firms is subsequently charged in an enforcement action by the CFTC or NFA.
The practical effect of the current system is that some Members, with a number of APs from Disciplined Firms, that are charged by the CFTC or NFA in actions alleging fraudulent sales practices have a significant window of time during the pendency of the action to continue soliciting the public without any requirement to adopt additional prophylactic measures such as taping. Of course, in appropriate cases, prophylactic measures may be imposed as part of the ultimate resolution of the CFTC's or NFA's action, but it can take many months, or even years in cases that go through multiple layers of appeals, to resolve such actions.
There are at least three current NFA Members that served full terms under the Requirements and were subsequently charged in enforcement proceedings. It is worth noting that each of those firms still retains a sales force with histories at Disciplined Firms such that they would require the adoption of the Requirements but for the fact that they have already served the term of their obligation under the Notice. In fact, at one time one of these firms actually featured its purported immunity from further taping requirements as an inducement in a recruitment advertisement contained in a South Florida newspaper.
A review of one firm's history illustrates the differences in the operations of the present system and the system being proposed. This firm has been an introducing broker ("IB") NFA Member since August 1994. It was required to adopt the Requirements from February 1995 through February 1997, when it was automatically discharged of the Requirements.
NFA issued a Complaint alleging deceptive sales practices against the firm in April 1998. A settled Decision was issued at that same time which, among other penalties, required the firm to tape all solicitations from April 1998 through April 2000. NFA issued a second deceptive sales practice Complaint against the firm in January 2002, which was resolved in March 2003.
Because the firm had already fulfilled its obligation under the Notice in the mid-1990s, it was not required under the current system to tape conversations with customers during the pendency of NFA's 2002 Complaint. This gave the firm a fourteen-month window to solicit the public without any obligation under the Notice to adopt the enhanced supervisory procedures - including taping. Incidentally, during this time, the firm continued to have a mix of APs that otherwise would have triggered the Requirements. The modification to the Notice would have required the firm to observe all of the Telemarketing Requirements, including taping all customer solicitations, from the time that the 2002 Complaint was initiated until that Complaint was completely resolved.
The guiding principal in creating and refining the Requirements has always been to improve the overall level of supervision at those few Member firms which are likely to cause sales practice problems. When a firm that has already operated under the Requirements for two years because of the questionable backgrounds of its APs subsequently becomes subject to an NFA or CFTC enforcement action for sales practice abuses, there is a clear indication that the firm is, indeed, part of the group that is likely to cause sales practice problems and that it is prudent to require the firm to improve its level of supervision.
The amendment to the Notice provides that any firm that has previously been required to abide by the Requirements but has fulfilled its obligation - either by abiding by the Requirements under the Notice as it currently stands or by successfully petitioning the Telemarketing Procedures Waiver Committee ("Waiver Committee") to have the Requirements lifted or modified - would again become subject to the Requirements during the pendency and through appeals of a new CFTC or NFA enforcement action.
B. Requiring Telemarketing Firms to abide by the Telemarketing Requirements until they are granted a complete or partial waiver by the Telemarketing Procedures Waiver Committee.
Currently, the obligation to abide by the enhanced procedures runs for two years, at which time it terminates automatically in most circumstances. The current amendment makes it more likely that firms that continue to pose problems would remain subject to the Requirements for longer than the current two-year tenure provided for in the Notice. The modification puts the burden on Member Firms triggering the criteria to demonstrate that a waiver from the Requirements is warranted after two years rather than automatically discharging the obligation to abide by the Requirements once the two years has passed.
The amendments also provide that a Member firm has 30 days to seek a waiver from the Waiver Committee after it first employs an AP mix that triggers the Requirements.2 If the Waiver Committee denies the initial petition or no petition is filed, the firm would not be eligible to petition for a waiver again until it had served a full two years under the Requirements. Any waiver would be subject to conditions that, if violated, could subject the firm to revocation of the waiver by the Waiver Committee.3 This additional component gives the Waiver Committee the flexibility to revisit the issue of whether a waiver is still warranted when there is a material change in the firm's organization or regulatory status.
C. Combating sham transactions and including principals who have worked at Disciplined Firms in calculating whether a Member firm has qualified under the Requirements.
The principals of several firms that have triggered the Requirements have avoided them by simply closing their firms and opening other firms that have a mix of APs that do not trigger an obligation to abide by the Requirements. The new firms typically have APs from the closed firm who have worked at Disciplined Firms, but their ratios to the overall AP population of the new firms are below the triggering point for imposing the Requirements.
For example, one firm, which had been an NFA Member IB since 1987, qualified under the Requirements in March 2004. One particular individual had been the firm's principal and an AP of the firm since May 1987. The firm petitioned the Waiver Committee for a complete waiver from any obligation to abide by the Requirements. Although that Committee gave the firm a partial waiver by reducing the firm's required minimum adjusted net capital from $250,000 to $100,000, it did not waive the taping or other obligations.
Rather than having the firm abide by the Requirements, the individual simply withdrew the firm from NFA membership and created two new firms. Neither of those firms triggered the Requirements because the individual kept their AP populations below the triggering points by judiciously splitting APs from Disciplined Firms between the two firms. In addition, while the individual is a principal of both firms, he did not register as an AP of either of them. By so doing, he was able to avoid being personally counted as an AP from a Disciplined Firm for purposes of determining whether either firm had an AP population that triggered the Requirements.
The firm's use of a sham reorganization to avoid triggering the Requirements is not unique. NFA is aware of several other firms that have used similar tactics to avoid the Requirements.
NFA has developed a twofold approach to combat sham reorganizations and transfers designed to avoid the Requirements. First, once a firm has triggered the Requirements, then any other firms of which the principals of the qualifying firm are also principals would become subject to the Requirements.
Second, individuals who are listed principals, but who are not APs of the firm, will be included in the calculation for purposes of determining whether a firm has triggered the Requirements if such individuals have previously worked as an AP at a Disciplined Firm. Principals who have not previously worked at a Disciplined Firm will not be included in the calculation. Otherwise, a firm could name "straw man" principals, thereby increasing the firm's overall calculation population and diluting the impact of the number of individuals who have worked at Disciplined Firms.
Counting non-AP principals who have been APs at Disciplined Firms in the past will cause eight current Member firms to trigger the Requirements. Collectively those firms have twelve individuals who are listed as principals but are not currently registered as APs of their respective firms. Those non-AP principals have worked as APs at fourteen different Disciplined Firms in the past, and several of them have been personally named in CFTC and NFA actions. At least three other former Members would have been added over the past few years under this proposed modification, except that the CFTC took injunctive actions against them for sales practice violations and their NFA memberships were withdrawn.
Both of the successor firms resulting from the sham reorganization described above would trigger the Requirements under either of NFA's proposed modifications. Since the principal of the original firm is also a principal of the two successor firms, that fact would automatically trigger the Requirements for those two firms. In addition, since the individual previously worked at a Disciplined Firm and is a non-AP principal of both successor firms, he would be included in the calculation of whether the AP mix at these two firms triggered the Requirements, which, in this case, would result in a ratio that would trigger the Requirements for both successor firms.
D. Individuals who had brief tenures at a Disciplined Firm a number of years ago.
In 2003, the Board amended the calculation to exclude APs who had worked at Disciplined Firms for less than sixty days more than ten years ago. The current amendment decreases the required time away from Disciplined Firms to five years while retaining the requirement that the individual must have worked a total of less than sixty days at Disciplined Firms.
Although their impact has been limited in terms of numbers, the 2003 modifications have had the desired effect of allowing a few firms that hire APs who worked at Disciplined Firms for a short period of time more than ten years ago to avoid triggering the Requirements. In fact, only two firms would have triggered the Requirements under the former method but were not so classified because of the 2003 modification, and neither has been the subject of any regulatory action.
In its latest review of the Requirements, NFA revisited the question of whether further modifications can be prudently made to decrease the potential burden on NFA's membership and the Waiver Committee. NFA studied data to examine the effect of keeping the less than sixty days at a Disciplined Firm requirement while reducing the time away from Disciplined Firms from ten to five years.
NFA's analysis showed that reducing the required period away from any Disciplined Firm from ten years to five years while maintaining the less than sixty day cumulative tenure at Disciplined Firms requirement yielded a population that is of no more cause for concern than the present system. Approximately 1,280 individuals are exempted from being counted under the current system. Reducing the required length of time away from a Disciplined Firm to five years would add approximately 275 brokers who would not have to be counted in determining if a firm triggered the Requirements. As was the case with the group that has been exempted under the current ten-year test, the number of additional APs who would be exempted under the proposed modification who have been subject to any kind of regulatory action is small.4
Based upon this data, NFA believes that the triggering criteria as currently set out in the Notice can be further refined to reduce the burden on the membership while still imposing supervisory enhancements on firms that pose a concern given the background of their APs and principals at Disciplined Firms. Not including APs and principals who served less than sixty cumulative days with Disciplined Firms more than five years ago in calculating whether a Member is subject to enhanced supervision would also serve the efficiency and fairness of the Waiver Committee's function by removing a few non-problematic firms from the waiver process.
NFA respectfully requests that the Commission review and approve the proposed amendments to the Interpretive Notice regarding Compliance Rule 2-9: Enhanced Supervisory Requirements.
2 The Notice provides that some of the factors that the Waiver Committee may consider in evaluating a Member's waiver request include: the number of APs; the number of branch offices and GIBs; the experience and background of supervisory personnel; the number of APs who received training at Disciplined Firms, the time those APs worked for those firms and the amount of time which has passed since they worked for Disciplined Firms; the results of previous NFA examinations; and the cost effectiveness of taping.
3 The conditions include requirements that the firm: notify NFA of any action charging the firm with a violation of CFTC or SRO regulations or rules; notify NFA of any customer complaint involving sales practices or promotional material; not change ownership; not have any material deficiencies noted during any SRO examination; not hire additional APs from Disciplined Firms; and execute a written acknowledgement that the firm understands the conditions of the waiver.
4 Ten individuals who have been subject to actions by NFA or the CFTC are exempted from being included in the calculation of whether a Member has become a Telemarketing Firm under the Notice's current ten-year provision. The proposed modification to reduce the required time away from a Disciplined Firm to more than five years would exempt six additional individuals who have been subject to actions by NFA or the CFTC. All charges against those individuals have been resolved. None of the individuals has been permanently barred from the industry and none of them are currently registered.