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A) Explanation of Proposed Amendments to NFA Compliance
NFA Compliance Rule 3-17 provides, in part, that a hearing panel shall include "at least one member who represents a membership category . . . other than the Respondent's membership category. . . ." NFA adopted Compliance Rule 3-17 to comply with CFTC Regulation 1.64 and, when doing so, simply copied the language of that regulation.
Recently, the meaning of Compliance Rule 3-17 was questioned in an NFA disciplinary case. In that case, one of the panelists was an IB, one was a retired employee of an FCM, and one was a former employee of an FCM who now works for an affiliate of that FCM. The IB respondent argued that the panel was improperly constituted under Rule 3-17 because none of the panelists was directly employed by a Member firm that was not an IB. The hearing panel ruled that the requirements of Compliance Rule 3-17 were satisfied because two of the panelists represented the FCM category since they had been long-time employees of FCMs and were never employed by an IB. The respondent then petitioned the Appeals Committee to review that ruling. The Appeals Committee dismissed the petition because the hearing was still going on, and the case eventually settled.
Although we do not agree with the respondent's argument, if it prevailed, it would be difficult to appoint qualified hearing panelists in some cases. It can be difficult to find three panelists who can commit the time to cases with multiple hearing days, but it would be even more complicated if one of them has to be employed by a Member in a membership category other than the one the respondent belongs to. And if the respondent is dually registered or there are two or more respondents from different membership categories, it would be almost impossible. It would also mean that NFA could not put together a panel of two individuals who are not affiliated with any membership category and one who is affiliated with the respondent's category or a panel of three individuals who are not affiliated with any membership category - even though this composition would arguably be more neutral than a panel of two individuals with the same affiliation as the respondent and one who has a different affiliation.
The proposed amendment to Compliance Rule 3-17 provides that no more than one panelist can come from the same category as any one respondent. This allows NFA to make the restriction less subject to interpretation by changing it from panelists who "represent" a Member in the category to panelists who are "employed by" a Member in the category.
B) Explanation of Proposed Amendments to NFA Interpretive Notice to Compliance Rule 2-9: Supervision of Telemarketing Activity
During the last seven years, 127 Member firms have been subject to Compliance Rule 2-9(b)'s enhanced supervisory requirements, which are embodied in the rule's interpretive notice ("Telemarketing Rule"). Of these firms, 35 have been required to adopt the enhanced requirements in whole or in part and NFA's Waiver Committee has granted two a complete waiver from adopting the requirements. The remaining firms either met the Telemarketing Rule's criteria and subsequently altered their personnel to fall outside the Telemarketing Rule's criteria or went out of business. Staff, along with the Waiver Committee, have allowed firms to alter their personnel in this manner after many firms claimed that they inadvertently met the criteria for the first time. Since firms are not allowed to alter their personnel a second time upon meeting the criteria, firms on the borderline of the criteria appear to pay more attention to their hiring practices.
While relatively few Members have met the Telemarketing Rule's criteria and fewer have actually been required to adopt the enhanced supervisory requirements, the regulatory impact of the Telemarketing Rule has been quite significant. For example, 23 of the 35 firms that adopted the enhanced supervisory requirements have been subject to one or more NFA disciplinary actions, with seven of those firms joining the Disciplined Firm list after being expelled for sales practice problems. Moreover, since the adoption of the Telemarketing Rule, NFA has noticed a dramatic drop off in the number of both customer complaints filed at NFA and of registered APs in the industry who had previously worked at Disciplined Firms.
In a 1999 report issued by the CFTC's Division of Trading & Markets on NFA's telemarketing supervision program, the Division noted that some firms appear to circumvent the Telemarketing Rule by transferring APs to firms that are only nominally separate and do not trigger the criteria themselves. When the Telemarketing Rule was initially adopted in 1993, the firms meeting the criteria were generally large (e.g., with 20 to 40 APs). Today, firms meeting the criteria are generally much smaller with five to 10 APs. Additionally, the current Telemarketing Rule does not apply to firms with less than five APs. NFA has continually monitored an evolution whereby Member firms with large concentrations of APs who have been employed at Disciplined Firms restructure to avoid the Telemarketing Rule's impact. The most common form of restructuring involves the formation of FCMs with principals who were previously employed by a Disciplined Firm. This handful of FCMs then guarantees numerous small IBs with less than five APs who previously were employed at Disciplined Firms. In some instances, these GIBs are formed and operate from the same offices as the FCM itself. However, none of these GIBs must adopt the enhanced supervisory procedures because they remain outside the triggering threshold by having less than five APs.
To address this problem, an amendment to the Telemarketing Rule applies the rule to firms with less than five APs. Under this proposal, firms with less than five APs will be required to adopt the enhanced supervisory procedures or seek a waiver if two or more APs have been employed by one or more Disciplined Firms. Preliminary data shows that 30 additional firms will meet the Telemarketing Rule's criteria. Of this number, 26 have a principal who was previously employed at a Disciplined Firm and many of these 30 firms have been the subject of NFA arbitration or CFTC reparations actions. Additionally, 21 of the firms are GIBs with seven of the 21 being GIBs of FCMs that have principals themselves who were previously employed at a Disciplined Firm.
Although compelling based upon the profile of these 30 firms, this change alone is not sufficient for several reasons. First, these small GIBs could easily manipulate their AP count to a level just outside the criteria. For example, firms with four APs with two from Disciplined Firms could simply add one with no experience in the industry and not meet the Telemarketing Rule's criteria. Second, data shows that a number of GIBs that are guaranteed by the small universe of FCMs that have principals previously employed by Disciplined firms are not picked up by merely changing the criteria.
Therefore, an additional amendment to the Rule focuses upon the handful of these FCMs and their GIBs. Specifically, the amendment provides that these FCMs and their GIBs shall be counted as one "firm" for purposes of determining whether the Telemarketing Rule's criteria apply. The data collected to show the impact of this change illustrates that this solution would target only the handful of FCMs that appear to be evading the current Telemarketing Rule by placing their sales force into GIBs that fall under the Rule's criteria. Specifically, 37 NFA Member FCMs currently guarantee IBs. Under the aggregation proposal, the impact would be felt by only four of these 37 FCMs because these four then have at least 20 APs, with more than 20 percent previously employed at Disciplined Firms. Additionally, each one of the four FCMs has principals from Disciplined Firms, most of these FCMs' GIBs have principals from Disciplined Firms, and several have been the subject of customer complaints and NFA arbitration or CFTC reparations actions.
If this "firm" meets the criteria, then the FCM and all its GIBs will be required to adopt the enhanced supervisory requirements or seek a waiver. Of course, even if an FCM does not meet the aggregation requirements, individual GIBs will be required to adopt the enhanced supervisory procedures provided the GIB itself meets the requirements.
The Telemarketing Rule currently defines a Disciplined Firm as one that has been closed down or permanently barred from the industry by either NFA or the CFTC for deceptive sales practices. The list of Disciplined Firms has grown from 37 in 1993 to 56 today. The CFTC's Report encouraged NFA to expand this definition to include firms or branches that are found to have engaged in deceptive telemarketing practices, even if the sanction imposed is less than a permanent bar. The CFTC then identified 11 firms that could be added to the Disciplined Firm list because they had actions against them during the period 1993-1998 and were found to have engaged in deceptive telemarketing practices. In reviewing this list of 11 firms, we note that eight were subject at one time to the Telemarketing Requirements themselves. Moreover, most of the 11 firms were named in an NFA BCC Complaint, which alleged deceptive sales practices. However, in almost all these cases, no findings were made because the firm settled the case without admitting or denying the Complaint's allegations.
In acknowledging the importance of the CFTC's recommendation's general spirit, the proposed amendments make one material change that expands the definition of a Disciplined Firm to tighten the Rule's impact. Over the years, the Telemarketing Rule has undergone many changes. Today, the Telemarketing Rule has enhanced supervisory requirements relating to telemarketing, promotional material and financial capital. Therefore, an amendment renames the Telemarketing Rule from "Supervision of Telemarketing Activities" to "Enhanced Supervisory Requirements". To coincide with the broader focus of the Telemarketing Rule, an amendment provides that firms expelled or closed down for only promotional material violations will be added to the Disciplined Firm list. In 1995, the Board approved the requirement that firms meeting the Telemarketing Rule's criteria file all promotional material with NFA at least 10 days prior to use. At that time, prior NFA disciplinary cases indicated that Member firms that have lax supervisory requirements relating to telemarketing had similar lax requirements relating to the use of promotional material. For example, most of the firms on the Disciplined Firm list had both fraudulent telemarketing practices and promotional material. Since promotional material and sales practice deficiencies often go hand-in-hand, a likelihood exists that APs of firms closed for only promotional material violations also received inadequate training and supervision and, therefore, these firms should constitute Disciplined Firms.
If firms expelled for only promotional material violations are added to the Disciplined Firm list, preliminary data shows that 15 additional firms would meet the Telemarketing Rule's criteria. Of this number, 12 have a principal who was previously employed at a Disciplined Firm and several firms have been the subject of NFA arbitration or CFTC reparation actions.
As mentioned earlier, NFA intends to make the proposed amendments to NFA Compliance Rule 3-17 and the Interpretive Notice to NFA Compliance Rule 2-9 effective 10 days after receipt of this submission by the Commission unless the Commission notifies NFA within the 10-day period that the Commission has determined to review the amendments for approval.