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Mr. Jonathan G. Katz
U.S. Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549-0609
Re: File No. SR-NASD-2002-99; Revisions to NASD Bylaws Regarding Gross Income Assessments
Dear Mr. Katz:
National Futures Association (NFA) is a registered futures association under the Commodity Exchange Act (CEA) and a limited purpose national securities association under the Securities Exchange Act of 1934 (Exchange Act). We appreciate this opportunity to comment on NASD's proposed changes to the way it calculates the gross income assessment (GIA) it imposes on its members.
NFA believes that funding for regulatory services (and all other services) should be transparent and the costs should be borne by the people who benefit from those services. We also believe that funding should be dynamic in that it should be responsive to changing conditions. For example, significant increases in trading volume on U.S. futures exchanges, coupled with increased efficiencies, have allowed NFA to reduce its assessment fee four times since July 1, 2001.
NASD currently charges its members a gross income assessment (GIA) equal to the greater of $1,200 or .125% of the member's annual gross revenue from securities transactions, except that revenue from exchange-traded securities is excluded unless NASD is the member's designated examining authority (DEA). Revenue from futures transactions, other income unrelated to the securities business, and some types of securities-related income are excluded.1 The NASD proposal would change the way GIA is calculated so that it would include revenue from transactions that have no regulatory nexus to NASD, including futures transactions that are not securities.
The NASD proposal violates the standard of fairness imposed by Section 15A(b)(5) of the Exchange Act and is inconsistent with past SEC statements regarding NYSE revenue proposals. The NASD proposal also violates Section 15A(b)(9) of the Exchange Act by imposing undue competitive burdens on NASD members who predominantly engage in activities that are not regulated by NASD.2
I. NASD's Proposed GIA Violates the Standards in the Exchange Act Section 15A(b)(5) of the Exchange Act provides that the rules of a registered securities association must "provide for the equitable allocation of reasonable dues, fees, and other charges among members...." Section 15A(b)(9) of the Exchange Act prohibits those rules from imposing any burden on competition that is not necessary or appropriate to further the purposes of the securities laws.3
The SEC has recognized that self-regulatory organization (SRO) fees must have a nexus to the regulatory activities they fund. In 1983, the NYSE proposed establishing a regulatory fee based on its members' gross FOCUS income, including income unrelated to a firm's securities business. See Exchange Act Release 34-20107 (August 23, 1983). A number of commenters, including NFA and NASD, opposed the assessment on the grounds that it included income from transactions that the NYSE did not regulate. NFA opposed the fee because it included income from futures transactions, and NASD opposed the fee because it included income from over-the-counter (OTC) securities transactions – transactions that NFA and NASD, respectively, regulate and impose fees on.
After considering the comments, the SEC approved the NYSE rule, noting that the NYSE had narrowed its proposed rule by filing an amendment so that the regulatory fee assessment only applied to those members for which it was the DEA. The SEC expressly stated that the assessment on all FOCUS income was appropriate for those firms because NYSE, as DEA, was required to conduct financial and operational (FINOP) examinations that covered all reported income. The SEC noted, however, that:
- The Commission's determination that the proposed fee is consistent with the Act is directly based on the universal nature of the FINOP examination. SRO fees calculated on members' gross revenues intended to support services directly related to that marketplace or for examinations (such as sales practice examinations) which do not focus on all aspects of a member's business would not appear to be appropriate.
In 1984, the NYSE proposed raising its regulatory fee, and NASD filed a comment letter reaffirming the position it took in 1983. The SEC noted that "a fee imposed on a member's gross FOCUS revenues is justified only insofar as the fee compensates the Exchange for expenses incurred as a result of the Exchange's performance of its FINOP responsibilities as designated examining authority under Rule 17d-1 of the Act." The SEC went on to state that:
- [A]ny future NYSE proposals to increase its regulatory oversight services fee based on gross revenues must be accompanied by data that specifies for each FINOP-related cost center those expenses related exclusively to the NYSE's responsibilities as designated examining authority under Rule 17d-1. Such data should make clear that such revenues are not used to defray expenses related solely to member firms' listed activities or other similarly limited activities.
NASD attempts to capitalize on the SEC's approval of the NYSE regulatory fee by stating in its rule filing that the proposed fee is similar to that employed by the NYSE. This statement is clearly disingenuous. Like the NYSE fee, NASD's proposed GIA would apply to all income reflected on the FOCUS report. Unlike the NYSE fee, however, NASD's proposed GIA would apply to all NASD members regardless of whether NASD is the firm's DEA. This was a critical distinction in the SEC's approval of the NYSE fee, and one that NASD conveniently ignores.
The FOCUS report's definition of revenue sweeps up income that is unrelated to securities, such as revenue from OTC derivatives, cash commodities, futures, and foreign exchange. NASD has no regulatory responsibility for these transactions and does not conduct sales practice examinations, trade practice surveillance, or market surveillance services involving them. Therefore, NASD proposes to collect fees for transactions that have no nexus to the regulatory activities they would fund and, where it is not the firm's DEA, which it does not even have to review as part of its FINOP responsilities. This approach is inconsistent with the position NASD took in 1983 and 1984 and with the statements the SEC made at that time.
NASD states its belief that the majority of small member firms would not be impacted by this proposal since over half of NASD's member firms currently have gross FOCUS revenue of less than $960,000, which means that they would continue to pay the $1,200 minimum fee. NASD's statement assumes that what is fair for most is fair for all, but fairness is not simply a matter of "majority rules." NASD's position simply ignores the fact that this approach has a significant effect on larger firms that obtain revenue from transactions with no regulatory nexus to NASD. For example, as of June 30, 2002, one joint NFA/NASD member had total annualized gross FOCUS revenue of $350 million, of which $335 million, or 95%, was from commodities and other revenue unrelated to its securities activities. The remaining revenue was primarily from exchange-traded securities, and the firm's GIA under the current calculation would have been the $1,200 minimum. Under the proposed calculation, however, the firm's GIA would be approximately $200,000, for an increase of over 16,000%.
Using futures and other income to fund regulatory services that have no nexus to that income is inequitable. NASD's proposal puts the onus on firms with a diverse business to pay a disproportionate share of the regulatory expenses for firms that principally specialize in OTC securities, and it does so without providing any corresponding benefit to the firms it places the onus on, to investors, or to the securities markets.
NFA recognizes that the mere fact that a fee has a disproportionate effect on some firms does not make the fee inequitable or anti-competitive. Certainly, there is nothing inequitable or anti-competitive about requiring firms that take more regulatory resources to pay more in regulatory fees. With the proposed NASD GIA, however, the amount of the fee seems to actually have an inverse relationship to the resources that NASD must expend on those firms. The smaller the portion of the firm's business that is regulated by NASD, the greater the fee's financial impact on the firm. And, unlike the NYSE fee, the NASD fee would apply to firms for which NASD has no FINOP responsibilities.
The proposed NASD fee is also inequitable as applied to firms for which NASD is the DEA. NFA continues to believe that a charge based on income from transactions an SRO does not regulate is inequitable regardless of the use to which it is put. Even given the SEC's 1984 position, however, the proposed NASD fee is inequitable as applied to firms for which NASD is the DEA when those firms are engaged primarily in activities outside of the securities markets because they must pay proportionally more for the cost of NASD's FINOP services. NASD's costs related to auditing commodities revenues and expenses of firms for which it is the DEA are not significant since NFA and other futures SROs coordinate their FINOP examinations of these firms with NASD. For those examinations, NFA or another futures SRO meets with NASD in advance to determine who will have responsibility for testing particular line items on the FOCUS report, with the futures SRO accepting responsibility to test the line items relating to commodities.5
Furthermore, as noted above, when the SEC approved the NYSE's regulatory fees in 1983 and 1984 it declared that a fee on non-regulated revenue can only be used to pay for an SRO's FINOP responsibilities as a DEA and is not justified if it exceeds the cost of those services. We realize that the SEC's statement referred to an SRO's overall FINOP costs rather than the costs that apply to individual firms. Nonetheless, where a firm is primarily engaged in activities unrelated to the securities markets, assessing a fee that encompasses all revenue from those activities does not have a reasonable relationship to the cost of the firm's FINOP examination and related responsibilities as the firm's DEA.6
NFA also recognizes that the mere fact that the same transactions are assessed by more than one SRO does not make those fees inequitable or anti-competitive if both SROs provide services, regulatory or otherwise, in connection with those transactions. However, NASD's proposed changes tax revenue for which it provides no services whatsoever and, where NASD does provide FINOP services, taxes revenue far in excess of the costs for providing those services.
Moreover, the proposed GIA favors firms that specialize in activities regulated by NASD. NASD claims that its fees are designed to be market neutral, but that is not the case. For firms for which NASD is not the DEA, the change makes it more expensive to trade on an exchange or an ECN by increasing the amount the firm has to pay for those transactions overall. Although NASD may not itself run a market, it still has ties with Nasdaq, both as a partial owner and through its regulatory services agreement, where Nasdaq is its largest client. Any type of fee that makes it more expensive to do business in other markets, including the futures markets, should be inherently suspect.7
NASD's proposed changes to its GIA calculation are inequitable to and impose undue competitive burdens on firms that predominantly engage in activities not regulated by NASD. Therefore, the SEC should not approve the NASD proposal.
If you have any questions concerning this letter, please contact me by telephone at 312-781-1413 or by e-mail at firstname.lastname@example.org.
Thomas W. Sexton
Vice President and General Counsel
1. NASD is also proposing to increase the current personnel assessment and to extend the transaction fee to include exchange-traded securities. NASD claims that its entire proposal would be revenue neutral, but it does not provide any figures to support that claim.
2. We recognize that some NASD members for which NASD is not the DEA may have concerns about extending the GIA to income from exchange-traded securities and may otherwise question the reasonableness of the assessment based on NASD's failure to provide figures relating the assessment to relevant NASD expenses. Our particular concern, however, is with the inclusion of revenue from futures transactions, and we will limit our arguments to that issue.
3. These are the same standards that apply to national securities exchanges under Sections 6(b)(4) and 6(b)(8) of the Exchange Act. 4.In 1992, the NYSE filed a rule proposal to charge the regulatory fee to all NYSE members, even if the NYSE was not the member's DEA. See SEC Release 34-31668 (December 29, 1992). We understand that proposal was subsequently withdrawn.
5. An SRO's FINOP responsibilities also include review of the firm's financial statement filings. However, financial statement reviews take significanly less resources than the annual FINOP audit.
6. Although we are not privy to NASD's non-public communications with the SEC, we have no reason to believe that NASD has made this showing even on a macro basis.
7. We also note that the proposed calculation could have an anti-competitive effect on NFA if NASD follows through on its announced intention to become a registered futures association. NASD is currently the only national securities association authorized to regulate most securities activities. If joint NFA/NASD members are already paying a fee to NASD based on their futures activities, NASD might find it easier to use its monopoly position as a national securities association to fund those activities from the futures portion of the GIA – which its members would be required to pay regardless of which registered futures association they belonged to – and charge lower assessment fees than NFA would be able to charge, thereby giving NASD an unfair advantage when competing for members as a registered futures association.