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COMPLIANCE RULE 2-9:
ENHANCED SUPERVISORY REQUIREMENTS
Over the years, NFA's Board of Directors has adopted strict and effective rules to prohibit deceptive sales practices, and those rules have been vigorously enforced by NFA's Business Conduct Committees. The Board notes, however, that by their very nature, enforcement actions occur after the customer abuse has taken place. The Board recognizes that NFA's goal must be not only to punish such deception of customers through enforcement actions but to prevent it, or minimize its likelihood, through fair and effective regulation.
One NFA rule designed to prevent abusive sales practices is NFA Compliance Rule 2-9. This rule places a continuing responsibility on every Member to supervise diligently its employees and agents in all aspects of their futures activities, including sales practices. Although NFA has not attempted to prescribe a set of supervisory procedures to be followed by all NFA Members, NFA's Board of Directors believes that Member firms which are identified as having a sales force that has received questionable training in sales practices should be required to adopt specific supervisory procedures designed to prevent sales practice abuse. Rule 2-9 authorizes the Board of Directors to require Members, which meet certain criteria established by the Board, to adopt specific supervisory procedures designed to prevent abusive sales practices.
The Board believes that in order for the criteria used to identify firms subject to the enhanced supervisory requirements to be useful, those criteria must be specific, objective and readily measurable. The Board also believes that any supervisory requirements imposed on a Member must be designed to quickly identify potential problem areas so that the Member will be able to take corrective action before any customer abuse occurs. The purpose of this Interpretive Notice is to set forth the criteria established by the Board and the enhanced supervisory procedures which are required of firms meeting these criteria.
In developing the criteria, the Board concluded that it would be helpful to review Member firms which had been closed through enforcement actions taken by the CFTC or NFA for deceptive sales practices. The Board's purpose was to identify factors common to these Member firms and probative of their sales practice problems, which could be used to identify other Member firms with potential sales practice problems.
One factor identified by the Board as common to these firms and directly related to their sales practice problems is the employment history and training of their sales forces. For many of these Members, a significant portion of their sales force was previously employed and trained by one or more of the other Member firms closed for fraud. The Board believes that the employment history of a Member's sales force is a relevant factor to consider in identifying firms with potential sales practice problems. If a Member firm is closed by NFA or the CFTC for fraud related to
either widespread telemarketing or promotional material problems or a firm is closed by NASD or the SEC for fraud related to its sales practices regarding security futures products as defined in Section 1a (32) of the Commodity Exchange Act ("Act"), it is reasonable to conclude that the Member's training and supervision of its sales force was wholly inadequate or inappropriate. It is also reasonable to conclude that an AP who received inadequate or inappropriate training and supervision may have learned improper sales tactics, which he will carry with him to his next job. Therefore, the Board believes that a Member firm employing such a sales force must have stringent supervision procedures in place in order to ensure that the improper training its APs have previously received does not taint their sales efforts on behalf of the Member.
The Board has determined that a Member will be required to adopt the specific supervisory procedures over its sales practice activities if:
- For firms with less than five APs, 2 or more of its APs have been employed by one or more Member firms which have been disciplined by NFA or the CFTC (or one or more firms disciplined by any securities industry self-regulatory organization or the SEC in matters involving security futures products) for sales practice fraud ("Disciplined Firms");
- For firms with at least 5 but less than 10 APs, 40 percent or more of its APs have been employed by one or more Disciplined Firms;
- For firms with at least 10 but less than 20 APs, four or more of its APs have been employed by one or more Disciplined Firms; or
- For firms with at least 20 APs, 20 percent or more of its APs have been employed by one or more Disciplined Firms.
Additionally, for purposes of determining whether a futures commission merchant ("FCM") Member firm meets this requirement, an FCM and its guaranteed introducing brokers ("GIBs") will be considered a single firm. Therefore, for FCMs with GIBs, the APs of its GIBs will be treated as APs of the FCM for determining whether the FCM meets the requirements. If the FCM Member firm meets the requirements, then the FCM and all its GIBs shall be required to adopt the supervisory procedures specified herein. Of course, individual FCMs or GIBs will be required to adopt the enhanced supervisory procedures provided the FCM or GIB meets the requirements on its own.
The Board recognizes that there is a group of APs who worked at Disciplined Firms for only a short period of time many years ago and who have not worked at any Disciplined Firm since. The Board's review of the employment and disciplinary histories of such individuals suggests that APs who served a very brief tenure with Disciplined Firms more than ten years in the past do not raise the same concerns regarding their previous supervision and training that are raised by APs who have worked at Disciplined Firms for longer periods or at a more recent point in time. Therefore, the Board has determined that APs who have been previously employed by Disciplined Firms for a cumulative total of less than 60 days and who, in addition, have not been employed by any Disciplined Firm during the 10 years preceding the determination of whether a Member firm is required to employ the enhanced supervisory procedures established in this Interpretive Notice shall not be counted for purposes of calculating whether the composition of a firm's sales force triggers enhanced supervisory requirements.
For purposes of this requirement, a Disciplined Firm is defined very narrowly to include
only those firms that meet the following three criteria:
- the firm has been formally charged by either the CFTC or NFA with deceptive telemarketing practices or promotional material;
- those charges have been resolved; and
- the firm has been permanently barred from the industry as a result of those charges;
In addition, a Disciplined Firm shall be defined to include any broker-dealer that, in connection with sales practices involving the offer, purchase, or sale of any security futures product as defined in Section 1a (32)of the Act has been expelled from membership or participation in any securities industry self-regulatory organization or is subject to an order of the SEC revoking its registration as a broker-dealer.
Attached is a list of firms currently meeting the definition of a Disciplined Firm. Although this list is current as of the date of this Interpretive Notice, NFA will provide Members with updated lists as necessary.
Any Member firm meeting these criteria will be required either to operate pursuant to a guarantee agreement or maintain an adjusted net capital of at least $250,000 for the entire period during which the Member is required to tape record its sales solicitations. Any Member opting to maintain the higher level of adjusted net capital would also be subject to the financial record-keeping and reporting requirements applicable to FCMs. Eligible guarantor futures commission merchants are those that meet the eligibility requirements for executing a Supplemental Guarantor Certification Statement pursuant to NFA Registration Rule 504(a)(2)(B). The Board believes that requiring these Members to operate pursuant to a guarantee agreement will likely improve the overall level of supervision at these firms.
Those Member firms meeting the criteria will be required to tape record all telephone conversations that occur between their APs and both existing and potential customers. The Board believes that tape recording these conversations provides these Members with the best opportunity to monitor closely the activities of their APs and also provides these Members with complete and immediate feedback on each AP's method of soliciting customers. Members meeting the criteria must tape record these conversations for a period of two years and must retain such tapes for a period of five years from the date each tape is created and the tapes shall be readily accessible during the first two years of the five-year period. In retaining the tape recorded conversations, Member firms must catalog the tapes by AP and date. Additionally, any Member firm meeting the criteria must require all its APs to maintain a daily log for sales solicitations which reflects at a minimum the identity of each customer or prospective customer the AP spoke with on each day. A Member firm must be able to promptly produce, upon request from NFA or the CFTC, all conversations relating to a specific AP, and only that AP, for a given date.
In addition, for a period of two years, those Member firms meeting the criteria will be required to file all promotional material, as defined in NFA Compliance Rule 2-29(g), with NFA at least 10 days prior to its first use.
Those Members meeting the criteria shall have written supervisory procedures that include the titles, registration status and locations of the firm's supervisory personnel as these relate to the firm's commodity futures business, and applicable securities laws and regulations for the trading of security futures products. Member firms shall also maintain on an internal record the names of all persons who are designated as supervisory personnel and the dates for which the designation is or was effective. Additionally, a Member meeting the criteria shall by the 30th day of the month following the end of each calendar quarter file with NFA's Compliance Department a report relating to the Member firm's compliance with the supervisory requirements contained herein. Member firms shall retain the internal record and report(s) for a period of five years, the first two years in an easily accessible place.
If an NFA Business Conduct Committee disciplinary proceeding or Commodity Futures Trading Commission enforcement proceeding has been filed against a Member firm required to adopt these enhanced supervisory procedures, then the enhanced supervisory procedures will remain in effect for the applicable time period specified or until after the disciplinary or enforcement proceeding is closed and all appeals are completed or the time for appeal has passed without an appeal being filed or perfected, whichever occurs latest. Member firms shall be required to retain tapes for the five-year period as specified above.
Any Member required to adopt these enhanced procedures may seek a waiver of the enhanced supervisory requirements. NFA may grant such a waiver upon a satisfactory showing that the Member's current supervisory procedures provide effective supervision over its employees, including enabling the Member to identify potential problem areas before customer abuse occurs. Additionally, if a Member meets the criteria and trades security futures products, then the Member firm must also make a satisfactory showing that the Member's supervisory procedures ensure compliance with all applicable securities laws and regulations.
Some of the factors that the three-member Waiver Committee may con-sider in evaluating a waiver request include:
- the total number of APs sponsored by the Member;
- number of branch offices and GIBs operated by the Member;
- the experience and background of the Member's supervisory personnel;
- the number of the Member's APs who had received training from firms which have been closed for fraud, the length of time those APs worked for those firms and the amount of time which has elapsed since those APs worked for the disciplined firms;
- the results of any previous NFA examinations; and
- the cost effectiveness of the taping requirement in light of the firm's net worth, operating income and related telemarketing expenses.
A Member firm that does not comply with this Interpretive Notice will violate NFA Compliance Rule 2-9 and will be subject to disciplinary action.