

[Federal Register: April 27, 2006 (Volume 71, Number 81)]
[Notices]               
[Page 24881-24885]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr27ap06-86]                         

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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-53689; File No. SR-NYSE-2005-60]

 
Self-Regulatory Organizations; New York Stock Exchange, Inc. (n/
k/a New York Stock Exchange LLC); Notice of Filing of Proposed Rule 
Change and Amendment No. 2 Thereto Relating to Proposed New Rules 
342.24 (``Annual Branch Office Inspection'') and 342.25 (``Risk-Based 
Surveillance and Branch Office Identification'') to Permit Member 
Organizations to Classify Appropriate Branch Offices for Cyclical 
Inspections and Proposed New Rule 342.26 (``Criteria for Inspection 
Programs'')

April 20, 2006.
    Pursuant to section 19(b)(1) of the Securities Exchange Act of 1934 
(``Act''),\1\ and Rule 19b-4 thereunder,\2\ notice is hereby given that 
on August 15, 2005, the New York Stock Exchange, Inc.\3\ (n/k/a New 
York Stock Exchange LLC) (``Exchange'') 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 the Exchange. The Exchange filed Amendment No. 2 to 
the proposed rule change on April 7, 2006.\4\ The Commission is 
publishing this notice to solicit comments on the proposed rule change, 
as amended, from interested persons.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ The Exchange is now known as the New York Stock Exchange 
LLC. See Securities Exchange Act Release No. 53382 (February 27, 
2006), 71 FR 11251 (March 6, 2006).
    \4\ See Amendment No. 2.
    The Exchange filed Amendment No. 1 to the proposed rule change 
on October 31, 2005 and subsequently withdrew Amendment No. 1 on 
April 7, 2006.
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I. Self-Regulatory Organization's Statement of the Terms of Substance 
of the Proposed Rule Change

    The Exchange is filing with the Commission proposed new Exchange 
Rules 342.24 (``Annual Branch Office Inspection'') and 342.25 (``Risk-
Based Surveillance and Branch Office Identification'') to permit 
organizations to classify appropriate branch offices for cyclical 
inspections and 342.26 (``Criteria for Inspection Programs''). The text 
of the proposed rule change is available on the Exchange's Web site 
(http://www.nyse.com), at the Exchange's Office of the Secretary, and 

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, the Exchange 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. The Exchange 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
    The proposed amendments would permit member organizations, with the 
written approval of the Exchange, to exempt certain branch offices from 
the general annual branch office inspection requirement of Exchange 
Rule 342 (``Offices--Approval, Supervision and Control'') by utilizing 
an Exchange-approved risk-based surveillance system.\5\ In addition, 
the proposed amendments would re-position a portion of Exchange Rule 
342's Interpretation into the rule text.
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    \5\ Pursuant to discussions with Exchange staff, the Commission 
made clarifying changes to the purpose section of the proposed rule 
change. Telephone conversations between Stephen Kasprzak, Principal 
Counsel, Rule and Interpretative Standards, Exchange, and Cyndi N. 
Rodriguez, Special Counsel, and Kate Robbins, Attorney, Division of 
Market Regulation (``Division''), Commission, on April 18, 2006.
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    The purpose of the proposed amendments is to provide member 
organizations the flexibility to reduce

[[Page 24882]]

unnecessary inspections of low-risk branch offices with good compliance 
records and to more fully concentrate surveillance and compliance 
resources on those branch offices that would most likely benefit from 
more frequent or more thorough on-site inspections. This would be 
accomplished through the ongoing monitoring of prescribed branch office 
criteria that would serve as effective indicators to distinguish those 
offices that warrant annual inspection from those that might not. 
Further, use of the prescribed criteria would enable member 
organizations to more effectively direct attention to those regulatory 
risk areas most likely in need of closer scrutiny during the course of 
an on-site inspection. The proposed amendments would require that every 
branch office, without exception, be inspected at least once every 
three calendar years.
Background
    Exchange Rule 342 and its Interpretation currently require that 
branch office inspections be conducted at least annually by member 
organizations, unless it has been demonstrated to the satisfaction of 
the Exchange that because of proximity, special reporting or 
supervisory practice, other arrangements may satisfy the Rule's 
requirements.\6\ Under this Interpretation, exemptions from the general 
annual inspection requirement have been determined on case-by-case 
basis, one branch office at a time. Recent years have brought to the 
securities industry an increase in the number of smaller, so-called 
``limited purpose offices,'' \7\ as well as many life-style changes 
(such as increasing use of home offices). These business/demographic 
changes, coupled with advances in the use of surveillance technology, 
strongly suggest that it may be no longer practicable or necessary that 
all branch offices warrant on-site annual inspections.
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    \6\ Interpretation Handbook Rule 342(a),(b)[sol]03 (``Annual 
Branch Office Inspection'').
    \7\ See Securities Exchange Act Release No. 52640 (October 19, 
2005), 70 FR 61672 (October 25, 2005) (SR-NYSE-2004-51).
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    The provision, noted above, allowing for a case-by-case exemption 
from the annual inspection requirement is being retained. However, in 
order to provide a more uniform standard to determine such exemptions, 
and in recognition of available surveillance capabilities, proposed 
Exchange Rule 342.24 would permit member organizations to submit to the 
Exchange, for approval, policies and procedures outlining the use of a 
risk-based surveillance system that the firm would utilize to identify 
branch offices requiring less frequent than annual inspections. The 
proposed amendments would require that all branch offices, without 
exception, be inspected at least once every three calendar years.
Policies and Procedures
    Under the proposed amendments, a member organization seeking an 
exemption from the standard annual inspection requirement would be 
required to submit to the Exchange policies and procedures that reflect 
their business models and product mix. In addition to the incorporation 
of prescribed criteria to identify branch offices eligible for 
exemption from an annual inspection cycle (discussed in detail below), 
proposed Exchange Rule 342.25 would outline the policy and procedure 
requirements that member organizations would be required to include in 
any risk-based surveillance system acceptable to the Exchange pursuant 
to the proposed amendments. Specifically, such policies and procedures 
would be required to provide, at a minimum, for: (1) Flexibility to 
initiate ``for-cause'' inspections, when circumstances warrant, of any 
branch office that has been exempted from the standard annual 
inspection cycle; (2) inspection on an unannounced basis of no less 
than half of the branch offices inspected each year; and (3) a system 
to allow employees to report compliance issues on a confidential basis 
outside of the branch office chain of command.
    The Exchange believes that establishment of these policy and 
procedure requirements would engender an environment conducive to 
effective supervision and oversight by member organizations of both 
branch offices subject to an annual inspection cycle as well as those 
exempted from the standard cycle. For instance, the requirement that 
``for-cause'' inspections be conducted when warranted makes clear that 
branch offices that have been deemed exempt from the standard annual 
inspection cycle are not exempt from ongoing surveillance and 
supervision.\8\ Further, if the profile of an exempted office 
subsequently changes (with respect to the size or scope of its business 
activities or significant changes in other risk-based criteria), the 
firm could reconsider the exemption. In instances where a firm rescinds 
an exemption from annual branch office inspection due to regulatory 
``red flags'' (e.g., registered representatives under special 
supervision, receipt of multiple customer complaints, etc.), the 
rescission should remain in effect until the factors or conditions that 
prompted it have been thoroughly resolved.
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    \8\ But see also section 15(b)(4)(E) of the Act, 15 U.S.C. 
78o(b)(4)(E).
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    The use of unannounced branch office inspections is an effective 
means of enhancing the integrity of the annual inspection process in 
that it encourages branch office personnel to properly view regulatory 
compliance as an ongoing, day-to-day process.\9\
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    \9\ The Division's Staff Legal Bulletin No. 17 (Remote Office 
Supervision) noted that unannounced inspections may form part of an 
effective supervisory system.
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    The ability of employees located in branch offices to report 
compliance issues on a confidential basis outside of the branch office 
chain of command should foster an atmosphere conducive to reporting 
issues of regulatory concern that may arise at the branch level, but 
might not be reflected in the prescribed risk criteria. Knowledge of 
such compliance issues would further assist firm personnel in making 
``for-cause'' branch office inspection determinations.
Prescribed Criteria
    Certain prescribed criteria, applied to each branch office, would 
be required of any acceptable risk-based surveillance system used to 
determine which branch offices could be exempted from annual 
inspection. The criteria, selected after extensive review by Exchange 
staff and consultation with industry representatives, are effective 
indicators to distinguish those offices that warrant annual inspection 
from those that might not. Further, their inclusion directs attention 
to the risks that most need to be addressed via on-site inspection. The 
risk-based factors to be considered should include, but not necessarily 
be limited to, the following:
    (1) Number of registered representatives;
    (2) A significant increase in the number of registered 
representatives;
    (3) Number of customers and volume of transactions;
    (4) A significant increase in branch office revenues;
    (5) Incidence of concentrated securities positions in customers' 
accounts;
    (6) Aggregate customer assets held;
    (7) Nature of the business conducted and the sales practice risk to 
investors associated with the products sold, and product mix (e.g., 
options, equities, mutual funds, annuities, etc.);
    (8) Numbers of accounts serviced on a discretionary basis;
    (9) Compliance and regulatory history of the branch, including:

[[Page 24883]]

    (a) Registered representatives subject to special supervision by 
the member organization, self-regulatory authorities, state regulatory 
authorities or the SEC in years other than the previous or current 
year;
    (b) Complaints, arbitrations, internal discipline, or prior 
inspection findings; and
    (c) Persons subject to recent disciplinary actions by self-
regulatory authorities, state regulatory authorities or the SEC.
    (10) Operational factors, such as the number of errors and account 
designation changes per registered representative;
    (11) Incidence of accommodation mailing addresses (e.g., post 
office boxes and ``care of'' accounts);
    (12) Whether the branch office permits checks to be picked up by 
customers or hand delivery of checks to customers;
    (13) Experience, function (producing or non-producing) and 
compensation structure of branch office manager;
    (14) Branch offices recently opened or acquired; and
    (15) Changes in branch location, status or management personnel.
    The size of the office (as represented by the number of registered 
representatives, the number of customers, the volume of transactions 
and the aggregate customer assets held), as well as any significant 
increase in the number of registered representatives or revenues, are 
quantitative considerations that a firm should carefully assess before 
granting an exemption from the annual inspection. Either individually 
or in aggregate, these factors could indicate that the office's 
activity is so extensive that, as a matter of good practice, it should 
be inspected annually, even in the absence of any disciplinary or 
operational ``red flags.'' In fact, as discussed below, certain 
quantitative thresholds would, in and of themselves, disqualify offices 
from an annual inspection exemption.
    The incidence of concentrated securities positions in customers' 
accounts is included since highly concentrated positions, particularly 
in securities not recommended by the firm, could be indicative of 
unsuitable or highly leveraged activity. The nature of the business 
conducted and the sales practice risk to investors associated with the 
products sold and product mix of the branch office would be factors to 
consider, as would the prevalence of certain types of investment 
strategies. For example, a high level of low-priced equities (e.g., 
penny stocks) might be indicative of potential sales practices 
problems. The numbers of accounts serviced on a discretionary basis 
would be a factor given the heightened potential for abuse (e.g., 
churning or excessive trading) in such accounts.
    As with all risk-based criteria, the factors noted above should not 
be viewed strictly in quantitative terms but should also be subjected 
to qualitative analysis when determining whether to exempt a branch 
from the annual inspection requirement. For example, while a branch 
office's increase in revenue may simply be attributable to an increase 
in the number of registered representatives it employs, it may also be 
attributable to increased sales volume from existing customers of 
registered representatives, which could be indicative of an 
inappropriately aggressive sales effort.
    Also to be considered when conducting a branch office risk analysis 
is the compliance and regulatory history of the branch office. Such 
factors include:
    (1) Registered representatives subject to special supervision \10\ 
by the member organization, self-regulatory authorities, state 
regulatory authorities or the SEC in years other than the previous or 
current year;
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    \10\ Indicia of special or heightened supervision include, but 
are not limited to, limitation on the types of products (e.g., low 
price or small cap) a broker is permitted to sell, restrictions or 
elimination in a broker's discretion, restricting the broker to 
soliciting only firm recommendations, and approval of all or certain 
transactions prior to execution.
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    (2) Complaints, arbitrations, internal discipline, or prior 
inspection findings; and
    (3) Persons subject to recent disciplinary actions by self-
regulatory authorities, state regulatory authorities or the SEC.
    In analyzing the compliance and regulatory history of branch 
offices, firms should, among other things, review the previous 12 
months for investigations by any self-regulatory organization or the 
SEC, customer complaints or complaint summaries, arbitrations and 
lawsuits closed or pending, Form RE-3 filings submitted to the Exchange 
pursuant to Exchange Rule 351(a), and internal investigation reports 
filed pursuant to Exchange Rule 351(e).\11\
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    \11\ See Exchange Information Memo No. 06-6, dated February 17, 
2006. See also note 5, supra.
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    It is expected that the review and analysis of recent branch office 
regulatory history would have a considerable effect on exemption 
determinations. For example, a significant disciplinary action at a 
given branch office location would strongly suggest against a firm 
granting an exception from an annual branch office inspection. 
Moreover, an overall increase in the number of disciplinary actions 
firm-wide should require the firm to review its overall inspection 
cycle, particularly regarding inspections on less than an annual basis.
    As discussed further below, in instances where a branch office has 
one or more registered representatives subject to special supervision, 
it should subject that branch office to the annual inspection until 
such time as the registered representatives are no longer subject to 
such supervision. In instances where the conduct of a particular 
registered representative or that of the office generally has been 
egregious, the firm should take immediate and appropriate action and 
consider administering on-site inspections on a more frequent than 
annual basis.
    In addition, the proposed amendments prescribe certain key 
operational factors to be considered when making determinations 
regarding the frequency of branch office inspections. Specific 
indicators include:
    (1) The number of errors and account designation changes per 
registered representative (which can be indicative of unauthorized 
trading);
    (2) The presence of ``accommodation'' mailing addresses (e.g., post 
office boxes and ``care of'' accounts), which can be indicative of a 
registered representative directing confirms, statements, and other 
account-related materials to other than the customer; and
    (3) Whether the branch office permits checks to be picked up by 
customers or hand delivers checks to customers (a practice that could 
facilitate misappropriation practices).
    These criteria reflect the focus of recent amendments to Exchange 
Rule 342 that subject certain sensitive regulatory functions to 
internal control procedures in order to address potential lapses in 
supervision at member organizations.\12\ The referenced operational 
functions have been included due to their notable misuse, both by 
registered representatives and branch office managers (BOMs), to the 
disadvantage of customers. Accordingly, consistent with the general 
supervision requirements of Exchange Rule 342, a firm should carefully 
review such criteria, quantitatively and qualitatively, before granting 
an exemption from an annual inspection.
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    \12\ See Exchange Information Memo 04-38, dated July 26, 2004. 
See also Securities Exchange Act Release No. 49882 (June 17, 2004), 
69 FR 35108 (June 23, 2004) (SR-NYSE-2002-36).
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    The prescribed criteria further include indicia relative to the 
BOM, such as his

[[Page 24884]]

or her experience (whether it is sufficient for the nature and volume 
of business required to be supervised), whether or not the BOM services 
customer accounts (which could take time away or otherwise detract from 
supervisory duties), and the BOM's compensation structure (e.g., 
whether he or she receives a substantial override from registered 
representatives' revenue that could lead to a conflict of interest) or 
whether the BOM's compensation is determined in part by the branch's 
compliance record.
    Finally, the proposed amendments require member organizations to 
consider potential problems associated with branch offices that have 
been recently opened or acquired, as well as changes in branch office 
location, status or management personnel. Where firms have acquired 
branch offices through merger or acquisition, and where such branch 
offices have had regulatory problems, firms should consider initially 
subjecting such offices to annual inspections absent compelling reasons 
to the contrary. Moreover changes in personnel (e.g., the resignation 
or termination of a BOM) may warrant more diligent review before 
exempting such branch office from the annual inspection cycle.
Branch Offices Not Eligible for Exemption
    Certain branch offices--given their size, the scope of supervisory 
activities, or other factors--would not be deemed appropriate for an 
exemption under the proposed amendments. For instance, offices 
exercising supervision over other branch offices, those with 25 or more 
registered individuals, and offices in the top 20% of production or 
customer assets at the member organization would not be eligible for 
exemption from the annual inspection requirement, nor would any branch 
office with a registered representative subject to special supervision 
in the current or immediately preceding year. Further, the proposed 
amendments require that every branch office, without exception, be 
inspected at least once every three calendar years.
Repositioning of Interpretation Text
    The proposed amendments would delete current Interpretation 342(a), 
(b)[sol]03 in its entirety. However, the Interpretation text is largely 
being repositioned into the Rule itself. For instance, the proposed 
amendments retain: (1) The ability of a member organization to request, 
on an office-by-office basis, an alternate arrangement to an annual 
inspection; (2) the requirement that branch office inspections be 
carried out by a person independent of the branch office in question 
(i.e., not the Branch Office Manager, or any person who directly or 
indirectly reports to such Manager, or any person to whom such Manager 
directly reports); and (3) the requirement that internal controls over 
certain prescribed areas be subject to independent testing and 
verification.\13\ The amendments would also require that written 
reports reflecting the results of the inspections must be maintained 
for the longer of three years or until the next branch inspection.\14\
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    \13\ See proposed Exchange Rule 342.26.
    \14\ See proposed Exchange Rule 342.24.
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2. Statutory Basis
    The Exchange believes that the proposed rule change is consistent 
with the provisions of section 6(b)(5) under the Act \15\ because it is 
designed to prevent fraudulent and manipulative acts and practices, to 
promote just and equitable principles of trade, to foster cooperation 
and coordination with persons engaged in regulating, clearing, 
settling, processing information with respect to, and facilitating 
transactions in securities, to remove impediments to and perfect the 
mechanism of a free and open market and a national market system, and, 
in general, to protect investors and the public interest. The Exchange 
believes that the proposed rule change is consistent with the Section 
in that it should enable member organizations to better allocate and 
focus their regulatory resources on their branches requiring annual 
inspections.
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    \15\ 15 U.S.C. 78f(b)(5).
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B. Self-Regulatory Organization's Statement on Burden on Competition

    The Exchange believes that the proposed rule change will not impose 
any burden on competition 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

    Comments were neither solicited nor received.

III. Date of Effectiveness of the Proposed Rule Change and Timing for 
Commission Action

    Within 35 days of the date of publication of this notice in the 
Federal Register or within such longer period (i) as the Commission may 
designate up to 90 days of such date if it finds such longer period to 
be appropriate and publishes its reasons for so finding or (ii) as to 
which the Exchange consents, the Commission will:
    (A) By order approve such proposed rule change, as amended; or
    (B) Institute proceedings to determine whether the proposed rule 
change, as amended, should be disapproved.

IV. Solicitation of Comments

    Interested persons are invited to submit written data, views and 
arguments concerning the foregoing, including whether the proposed rule 
change, as amended, is consistent with the Act. Comments may be 
submitted by any of the following methods:

Electronic Comments

     Use the Commission's Internet comment form (http://www.sec.gov/rules/sro.shtml.
); or     Send an e-mail to rule-comments@sec.gov. Please include 

File Number SR-NYSE-2005-60 on the subject line.

Paper Comments

     Send paper comments in triplicate to Nancy M. Morris, 
Secretary, Securities and Exchange Commission, 100 F Street, NE., 
Washington, DC 20549-1090.
    All submissions should refer to File Number SR-NYSE-2005-60. This 
file number should be included on the subject line if e-mail is used. 
To help the Commission process and review your comments more 
efficiently, please use only one method. The Commission will post all 
comments on the Commission's Internet Web site (http://www.sec.gov/rules/sro.shtml
). Copies of the submission, all subsequent amendments, 

all written statements with respect to the proposed rule change that 
are filed with the Commission, and all written communications relating 
to the proposed rule change between the Commission and any person, 
other than those that may be withheld from the public in accordance 
with the provisions of 5 U.S.C. 552, will be available for inspection 
and copying in the Commission's Public Reference Room. Copies of such 
filing also will be available for inspection and copying at the 
principal office of the Exchange. All comments received will be posted 
without change; the Commission does not edit personal identifying 
information from submissions. You should submit only information that 
you wish to make available publicly. All submissions should refer to 
File Number SR-NYSE-2005-60 and should be submitted on or before May 
18, 2006.


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    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\16\
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    \16\ 17 CFR 200.30-3(a)(12).
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J. Lynn Taylor,
Assistant Secretary.
 [FR Doc. E6-6321 Filed 4-26-06; 8:45 am]

BILLING CODE 8010-01-P
