
[Federal Register Volume 78, Number 250 (Monday, December 30, 2013)]
[Notices]
[Pages 79542-79559]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: 2013-31134]



[[Page 79542]]

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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-71179; File No. SR-FINRA-2013-025]


Self-Regulatory Organizations; Financial Industry Regulatory 
Authority, Inc.; Order Granting Approval of a Proposed Rule Change To 
Adopt Rules Regarding Supervision in the Consolidated FINRA Rulebook, 
as Modified by Amendment No. 1

December 23, 2013.

I. Introduction

    On June 21, 2013, the Financial Industry Regulatory Authority, Inc. 
(``FINRA'') filed with the Securities and Exchange Commission (``SEC'' 
or ``Commission''), pursuant to Section 19(b)(1) of the Securities 
Exchange Act of 1934 (``Exchange Act'' or ``Act'') \1\ and Rule 19b-4 
thereunder,\2\ a proposed rule change to adopt consolidated FINRA 
supervision rules.\3\ The proposed rule change was published for 
comment in the Federal Register on July 8, 2013.\4\ The Commission 
received seventeen (17) individual comment letters in response to the 
proposed rule change and five hundred sixty (560) comments using a form 
comment letter (``Letter Type A'').\5\ On October 2, 2013, FINRA 
responded to the comments \6\ and filed Amendment No. 1 to the proposed 
rule change. On October 4, 2013, the Commission published notice of 
Amendment No. 1 to solicit comment from interested persons and 
instituted proceedings pursuant to Section 19(b)(2)(B) of the Act to 
determine whether to approve or disapprove FINRA's proposal as modified 
by Amendment No. 1.\7\ The Commission received three comment letters in 
response to the Notice and Proceedings Order.\8\ On November 12, 2013, 
FINRA responded to comments to the proposed rule change, as modified by 
Amendment No. 1.\9\ The Commission is publishing this order (``Order'') 
to approve the proposed rule change, as modified by Amendment No. 1, on 
an accelerated basis.\10\
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ On June 10, 2011, FINRA filed with the SEC a proposed rule 
change to adopt the consolidated FINRA supervision rules (``2011 
Filing''), which addressed the comments received in response to 
FINRA's Regulatory Notice 08-24 (May 2008). See Exchange Act Release 
No. 64736 (June 23, 2011), 76 FR 38245 (June 29, 2011) (Notice of 
Filing No. SR-FINRA-2011-028). FINRA withdrew the 2011 Filing on 
September 27, 2011. See Exchange Act Release No. 65477 (October 4, 
2011), 76 FR 62890 (October 11, 2011) (Notice of Withdrawal of File 
No. SR-FINRA-2011-028).
    \4\ See Exchange Act Release No. 69902 (July 1, 2013), 78 FR 
40792 (July 8, 2013) (Notice of Filing of a Proposed Rule Change to 
Adopt Rules Regarding Supervision in the Consolidated FINRA 
Rulebook) (``Proposing Release''). The comment period closed on July 
29, 2013.
    \5\ See letters from Steven B. Caruso, Esq., Maddox Hargett 
Caruso, P.C., to Elizabeth M. Murphy, Secretary, SEC, dated July 12, 
2013 (``Caruso''); Norman B. Arnoff, Esq., to Elizabeth M. Murphy, 
Secretary, SEC, dated July 19, 2013 (``Arnoff''); J.S. 
Brandenburger, Registered Principal, FSC Securities Corporation, to 
Elizabeth M. Murphy, Secretary, SEC, dated July 25, 2013 
(``Brandenburger''); Steve Putnam, Financial Advisor, Raymond James 
Financial Services, to Elizabeth M. Murphy, Secretary, SEC, dated 
July 25, 2013 (``Putnam''); Nina Schloesser McKenna, General 
Counsel, Cetera Financial Group, Inc., to Elizabeth M. Murphy, 
Secretary, SEC, dated July 29, 2013 (``Cetera''); Scott Cook, Senior 
Vice President and Chief Compliance Officer, Charles Schwab & Co., 
Inc., to Elizabeth M. Murphy, Secretary, SEC, dated July 29, 2013 
(``Schwab''); Clifford Kirsch and Eric A. Arnold, Sutherland Asbill 
& Brennan LLP, on behalf of the Committee of Annuity Insurers, to 
Elizabeth M. Murphy, Secretary, SEC, dated July 29, 2013 (``CAI''); 
David T. Bellaire, Esq., Executive Vice President & General Counsel, 
Financial Services Institute, to Elizabeth M. Murphy, Secretary, 
SEC, dated July 29, 2013 (``FSI''); Howard Spindel, Senior Managing 
Director, and Cassondra E. Joseph, Managing Director, Integrated 
Management Solutions USA, LLC, to Elizabeth M. Murphy, Secretary, 
SEC, dated July 29, 2013 (``IMS''); Tamara K. Salmon, Senior 
Associate Counsel, Investment Company Institute, to Elizabeth M. 
Murphy, Secretary, SEC, dated July 29, 2013 (``ICI''); Susanne 
Denby, Chief Compliance Officer, NFP Securities, Inc., to Elizabeth 
M. Murphy, Secretary, SEC, dated July 29, 2013 (``NFP''); A. Heath 
Abshure, President and Arkansas Securities Commissioner on behalf of 
the North American Securities Administrators Association, Inc., to 
Elizabeth M. Murphy, Secretary, SEC, dated August 6, 2013 
(``NASAA''); Scott C. Ilgenfritz, President, Public Investors 
Arbitration Bar Association, to Elizabeth M. Murphy, Secretary, SEC, 
dated July 29, 2013 (``PIABA''); Ira D. Hammerman, Senior Managing 
Director and General Counsel, Securities Industry and Financial 
Markets Association, to Elizabeth M. Murphy, Secretary, SEC, dated 
July 29, 2013 (``SIFMA''); Pamela Albanese, Legal Intern, and 
Christine Lazaro, Esq., Acting Director, Securities Arbitration 
Clinic of St. John's University School of Law, to Elizabeth M. 
Murphy, Secretary, SEC, dated July 29, 2013 (``St. John's''); Brian 
P. Sweeney, Law Office of Brian P. Sweeney, to Elizabeth M. Murphy, 
Secretary, SEC, dated July 29, 2013 (``Sweeney''); Robert J. 
McCarthy, Director of Regulatory Policy, Wells Fargo Advisors, LLC, 
to Elizabeth M. Murphy, Secretary, SEC, dated July 29 2013 (``Wells 
Fargo''); see also Memorandum from the Division of Trading and 
Markets, SEC, dated August 29, 2013 (memorializing an August 5, 2013 
conference call between SEC staff and Gary Goldsholle and Michael 
Post of the Municipal Securities Rulemaking Board (``MSRB'') to 
discuss FINRA's recently proposed rule change to adopt the proposed 
consolidated supervision rules) (``MSRB Memo''). The Notice and 
Proceedings Order, as defined in footnote 7, identified 555 comments 
as having been received using Letter Type A. This number has been 
updated to reflect 560 total number of submissions using Letter Type 
A.
    \6\ See letter from Patricia Albrecht, Assistant General 
Counsel, FINRA, to Elizabeth M. Murphy, Secretary, SEC, dated 
October 2, 2013 (``October Response'').
    \7\ See Exchange Act Release No. 70612 (October 4, 2013), 78 FR 
62831 (October 22, 2013) (Notice of Filing of Amendment No. 1 and 
Order Instituting Proceedings 2013-SR-FINRA-025) (``Notice and 
Proceedings Order''). The comment period closed on October 28, 2013.
    \8\ See letters from Tamara K. Salmon, Senior Associate Counsel, 
Investment Company Institute, to Elizabeth M. Murphy, Secretary, 
SEC, dated October 17, 2013 (``ICI's October Letter''); David T. 
Bellaire, Esq., Executive Vice President & General Counsel, 
Financial Services Institute, to Elizabeth M. Murphy, Secretary, 
SEC, dated October 28, 2013 (``FSI's October Letter''); Andrea 
Seidt, President and Ohio Securities Commissioner on behalf of the 
North American Securities Administrators Association, Inc., to 
Elizabeth M. Murphy, Secretary, SEC, dated November 5, 2013 
(``NASAA's November Letter''); see also Memorandum from the Division 
of Trading and Markets, SEC, dated November 12, 2013 (memorializing 
a November 8, 2013 conference call between SEC staff and Tamara 
Salmon of the ICI to discuss FINRA's recently proposed rule change 
to adopt the proposed consolidated supervision rules (``ICI Memo'').
    \9\ See letter from Patricia Albrecht, Assistant General 
Counsel, FINRA, to Elizabeth M. Murphy, Secretary, SEC, dated 
November 12, 2013 (``November Response'').
    \10\ The text of the proposed rule change, as modified by 
Amendment No. 1, is available on FINRA's Web site at http://www.finra.org, at the principal office of FINRA, and at the 
Commission's Public Reference Room. The October Response and the 
November Response are available on the Commission's Web site at 
http://www.sec.gov.
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II. Description of Proposal
    As further described in the Proposing Release, FINRA proposes to 
adopt consolidated FINRA broker-dealer supervision rules.\11\ As part 
of the process of developing a new consolidated rulebook 
(``Consolidated FINRA Rulebook''),\12\ the proposed rule change would 
(1) adopt FINRA Rules 3110 (Supervision) and 3120 (Supervisory Control 
System) to largely replace NASD Rules 3010 (Supervision) and 3012 
(Supervisory Control System), respectively; (2) incorporate into FINRA 
Rule 3110 and its supplementary material the requirements of NASD IM-
1000-4 (Branch Offices and Offices of Supervisory Jurisdiction), NASD 
IM-3010-1 (Standards for Reasonable Review), Incorporated NYSE Rule 
401A (Customer Complaints), and Incorporated NYSE Rule 342.21 (Trade 
Review and Investigation); (3) replace NASD Rule 3010(b)(2) (often 
referred to as the ``Taping Rule'') with new FINRA Rule 3170 (Tape 
Recording of Registered

[[Page 79543]]

Persons by Certain Firms); (4) replace NASD Rule 3110(i) (Holding of 
Customer Mail) with new FINRA Rule 3150 (Holding of Customer Mail); and 
(5) delete the following Incorporated NYSE Rules and NYSE Rule 
Interpretations: (i) NYSE Rule 342 (Offices--Approval, Supervision and 
Control) and related NYSE Rule Interpretations; (ii) NYSE Rule 343 
(Offices--Sole Tenancy, and Hours) and related NYSE Rule 
Interpretations; (iii) NYSE Rule 351(e) (Reporting Requirements) and 
NYSE Rule Interpretation 351(e)/01 (Reports of Investigation); (iv) 
NYSE Rule 354 (Reports to Control Persons); and (v) NYSE Rule 401 
(Business Conduct). FINRA modified its proposal in certain respects 
through Amendment No. 1, as described in the Notice and Proceedings 
Order.\13\
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    \11\ See infra Section III, describing sections of the proposed 
rule change in the context of comments received.
    \12\ The current FINRA rulebook consists of: (1) FINRA Rules; 
(2) NASD Rules; and (3) rules incorporated from the New York Stock 
Exchange (``Incorporated NYSE Rules'') (together, the NASD Rules and 
Incorporated NYSE Rules are referred to as the ``Transitional 
Rulebook''). While the NASD Rules generally apply to all FINRA 
members, the Incorporated NYSE Rules apply only to those members of 
FINRA that are also members of the NYSE. The FINRA Rules apply to 
all FINRA members, unless such rules have a more limited application 
by their terms. For more information about the rulebook 
consolidation process, see Information Notice, March 12, 2008 
(Rulebook Consolidation Process).
    \13\ See supra note 7.
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    FINRA stated that it would announce the effective date of the 
proposed rule change in a Regulatory Notice to be published no later 
than 90 days following Commission approval. The effective date will be 
no later than 365 days following Commission approval.

III. Discussion of Comments and FINRA's Response

    On July 8, 2013, the Commission published in the Federal Register 
FINRA's proposed rule change to adopt consolidated FINRA supervision 
rules.\14\ The comment period ended on July 29, 2013 and the Commission 
received the 17 individual comment letters listed above as well as 560 
comments using a form comment letter.\15\ A few commenters generally 
supported the proposal, but many commenters raised specific concerns, 
including, among other things, references to MSRB rules; \16\ the scope 
of the definition of the term ``covered accounts;'' \17\ the 
application of a risk-based approach to supervision; \18\ the 
conditions for establishing a one person office of supervisory 
jurisdiction (``OSJ''); \19\ the requirements and presumptions relating 
to a single principal supervising multiple OSJs; \20\ the documentation 
requirements relating to written and oral complaints; \21\ and the lack 
of a cost benefit analysis. FINRA filed Amendment No. 1 to address 
commenter concerns and responded to comments in a letter dated October 
2, 2013.\22\
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    \14\ See supra note 4.
    \15\ See supra note 5.
    \16\ ICI. See also MSRB Memo.
    \17\ Brandenburger, CAI, FSI, ICI, IMS, Letter Type A, Putnam, 
SIFMA.
    \18\ Cetera, ICI, IMS, SIFMA.
    \19\ Brandenburger, Cetera, IMS, Letter Type A, Putnam.
    \20\ CAI, Cetera, FSI, IMS, Wells Fargo.
    \21\ Caruso, NASAA, PIABA, St John's.
    \22\ See supra note 6.
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    On October 22, 2013, the Commission published in the Federal 
Register the Notice and Proceedings Order.\23\ The comment period ended 
on October 28, 2013 and the Commission received the three comment 
letters listed above.\24\ One commenter fully supported the proposal 
and the other two commenters restated concerns raised in their original 
letters.\25\ One commenter raised an additional concern in response to 
Amendment No. 1.\26\ FINRA responded to comments in a letter dated 
November 12, 2013.\27\
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    \23\ See supra note 7.
    \24\ See supra note 8. Due to a temporary closure of the Federal 
Register, the Notice and Proceedings Order was not published in the 
Federal Register until October 22, 2013.
    \25\ See infra note 32 and accompanying text; see also supra 
note 8.
    \26\ See infra Section III(A)(6)(C).
    \27\ See supra note 9.
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    The sections below discuss: the comments received to the Proposing 
Release and the Notice and Proceedings Order; FINRA's October Response 
and November Response; and the Commission's findings.

A. General Comments

1. Support for Proposal
    Several commenters to the Proposing Release expressed overall 
support for the proposed rule change \28\ and specific changes FINRA 
made in response to comments on the 2011 Filing, including requiring 
that supervisory procedures and corresponding amendments be 
communicated to relevant associated persons rather than throughout the 
organization; eliminating the requirement that associated persons 
verify annually that they have reviewed their firm's written 
supervisory procedures; eliminating risk management from the additional 
content requirements under proposed FINRA Rule 3120; and clarifying 
that supplementary material is part of the rule and the location of 
language within the supplementary material does not affect the weight 
or significance of a provision.\29\ Commenters also expressed support 
for FINRA's efforts to consolidate the existing NASD and Incorporated 
NYSE rules into the FINRA rulebook.\30\
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    \28\ Cetera, NFP, Schwab, SIFMA, St. John's, Sweeney.
    \29\ Schwab, SIFMA.
    \30\ NASAA, PIABA, Wells Fargo.
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    In response to the Notice and Proceedings Order, one commenter 
expressed strong support for the proposed rule change, as modified by 
Amendment No. 1.\31\ The commenter stated that the proposed rule 
change, as amended, ``will ensure that investors are protected by the 
robust supervision programs implemented by firms, and that firms can 
continue to effectively utilize their supervisory structures and 
procedures under clear regulatory requirements.'' \32\
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    \31\ FSI's October Letter.
    \32\ Id.
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2. Opposition to Risk-Based Review Principles
    Two commenters to the Proposing Release opposed the proposed rules' 
flexibility permitting members to rely on risk-based or principles-
based review standards for specific obligations, such as the review of 
securities transactions and correspondence, arguing that such 
flexibility would result in reduced or diminished supervisory 
requirements that would not achieve the purpose of protecting the 
investing public.\33\
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    \33\ NASAA, PIABA.
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    FINRA responded by explaining that the proposed rules' risk-based 
approach for certain aspects of a member's supervisory procedures is 
intended to further strengthen, not diminish, investor protection by 
allowing firms the flexibility to establish their supervisory programs 
in a manner that reflects their business models, and based on those 
models, focus on areas where heightened concern may be warranted.\34\ 
FINRA also noted that the proposed rules further protect investors by 
retaining specific prescriptive requirements of NASD Rules 3010 and 
3012, such as mandatory inspection cycles, prohibitions on who can 
conduct location inspections, and procedures for the monitoring of 
enumerated activities. FINRA also pointed to additional prescriptive 
requirements in the proposed rules, including special supervision for 
supervisory personnel rather than just the existing special supervision 
for producing managers, specific procedures to detect and investigate 
potential insider trading violations, and additional content 
requirements for specific firms' annual reports. FINRA noted that it 
understands concerns that additional guidance may be needed and intends 
to provide such guidance as circumstances warrant.
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    \34\ October Response.
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3. Reconsider Previously Proposed Supplementary Material
    One commenter to the Proposing Release suggested that FINRA

[[Page 79544]]

reconsider its decision to delete supplementary material previously 
proposed in the 2011 Filing providing that for a member's supervisory 
system to be reasonably designed to achieve compliance with FINRA Rule 
2010 (Standards of Commercial Honor and Principles of Trade), it must 
include supervision of all of a member's business lines irrespective of 
whether they require broker-dealer registration.\35\ This commenter 
restated this concern in a second letter.\36\ FINRA responded that it 
continues to believe that it was the best course to eliminate the 
proposed supplementary material from the proposed rule because of 
potential differences with the supervision requirements otherwise 
applicable to those business lines.\37\ FINRA stated that it will 
continue to apply FINRA Rule 2010's standards to non-securities 
activities of members and their associated persons consistent with 
existing case law.
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    \35\ NASAA (referring to the 2011 Filing's proposed FINRA Rule 
3110.01 (Business Lines)).
    \36\ NASAA's November Letter.
    \37\ October Response. See also November Response, stating that 
FINRA continues to support its analysis of these issues as described 
above.
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4. Cost Benefit Analysis
    One commenter to the Proposing Release stated that the proposal's 
compliance costs would be minimal and outweighed by the benefits.\38\ 
Other commenters suggested that the proposal lacked a sufficient cost 
benefit analysis,\39\ with some commenters stating that FINRA had not 
provided any specific performance objectives or identified other 
metrics to which it may later refer to assess the effectiveness of the 
proposed changes.\40\ One commenter acknowledged that it was not 
possible for FINRA to perform a thorough cost benefit analysis when the 
proposal was filed, but suggested that FINRA revisit the proposed rules 
within five years of their adoption to ensure they are achieving their 
stated purpose while avoiding unnecessary costs.\41\
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    \38\ St. John's.
    \39\ Brandenburger, FSI, IMS, Letter Type A, Putnam.
    \40\ Brandenburger, FSI, IMS, Letter Type A.
    \41\ FSI.
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    FINRA responded that the proposed rule change, as amended, strives 
to minimize the membership's burden and cost of complying with the 
consolidated supervision rules, as consistent with their purposes.\42\ 
FINRA noted that the consolidated supervision rules transfer many of 
the existing requirements in NASD Rules 3010 and 3012 relating to, 
among other things, supervisory systems, written procedures, internal 
inspections, review of correspondence, and supervisory controls. Thus, 
FINRA believes that transferring existing requirements does not raise 
additional costs or burdens for firms because firms have already 
developed the necessary procedures and supporting systems to comply 
with those requirements. FINRA further noted that the proposed rule 
change also would delete Incorporated NYSE Rule 342 and much of its 
supplementary material and interpretations as they are, in main part, 
either duplicative of, or not in alignment with, the proposed 
supervision requirements, thereby reducing potential costs to firms 
that are members of both FINRA and the NYSE.
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    \42\ October Response.
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    In addition, FINRA noted that it has also applied a risk-based 
approach or similar flexibility for specified aspects of a member's 
supervisory procedures that is intended to allow firms the ability to 
establish their supervisory programs in a manner that reflects their 
business models, and based on those models, focus on areas where 
heightened concerns may be warranted. Those aspects include:
     Permitting risk-based review of all transactions relating 
to a member's investment banking or securities business; \43\
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    \43\ See proposed FINRA Rule 3110(b)(2) and FINRA Rule 3110.05, 
discussed further at infra Section III(E); see also Section E, page 
12 of FINRA's October Response and Section 2(C), page 5 of FINRA's 
November Response.
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     Permitting risk-based review of a member's correspondence 
and internal communications that fall outside of the subject matters 
listed in proposed FINRA Rule 3110(b)(4); \44\
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    \44\ See proposed FINRA Rule 3110(b)(4) and FINRA Rule 3110.06, 
discussed further at infra Section III(F); see also Section F, page 
14 of FINRA's October Response and Section 2(E)(i), page 6 of 
FINRA's November Response.
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     Providing exceptions, based on a member's size, resources, 
and business model, from proposed FINRA Rule 3110's provisions 
regarding the supervision of a member's supervisory personnel and the 
persons prohibited from conducting a location's inspections; \45\
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    \45\ See proposed FINRA Rule 3110(b)(6)(C)(ii) and FINRA Rule 
3110(c)(3)(C), discussed further at infra Section III(H); see also 
Section H, page 19 and Section K, page 24 of FINRA's October 
Response and Section 2(D), page 5-6 of FINRA's November Response.
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     Requiring that only members reporting $200 million or more 
in gross revenues in the preceding year (increased from the $150 
million threshold originally proposed in the 2011 Filing) include in 
the annual report required by FINRA Rule 3120 supplemental information 
from Incorporated NYSE Rule 342.30's annual report content 
requirements; \46\
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    \46\ See proposed FINRA Rule 3120(b), discussed further at infra 
Section III(M); see also Section N, page 34 of FINRA's October 
Response and Section 2(G), page 11 of FINRA's November Response.
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     Aligning proposed FINRA Rule 3110(d)'s definition of 
``covered account'' with respect to detecting and investigating 
potential insider trading violations with existing NYSE guidance in 
response to commenters' concerns regarding compliance costs and 
burdens; \47\
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    \47\ See proposed FINRA Rule 3110(d)(1)(A) through (D), 
discussed further at infra Section III(K); see also Section L, page 
29 of FINRA's October Response and Section 2(F)(ii), page 10 of 
FINRA's November Response.
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     Replacing NASD Rule 3110(i) (Holding of Customer Mail) and 
its strict time limits for holding customer mail with proposed FINRA 
Rule 3150 (Holding of Customer Mail), which generally allows a member 
to hold a customer's mail for a specific time period in accordance with 
the customer's written instructions if the member meets specified 
conditions; \48\ and
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    \48\ See proposed FINRA Rule 3150(a) and (b).
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     Deleting proposed supplementary material, in response to 
commenters' concerns regarding compliance costs and burdens that would 
have required a senior principal to have a physical presence on a 
regular periodic schedule at a one-person office of supervisory 
jurisdiction (``OSJ'') where the one-person OSJ principal was 
conducting sales-related activities.\49\
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    \49\ See Section C, page 8 of FINRA's October Response and 
Section 3, page 12 of FINRA's November Response.

FINRA stated that it agrees that the proposed consolidated supervision 
rules should be subject to a retrospective review process following an 
appropriate period after their implementation to determine whether they 
are achieving their intended purpose or have become overly burdensome 
\50\ and would seek to consult with the membership, the public, and 
other stakeholders in analyzing the economic impact of the rules.
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    \50\ On September 19, 2013, FINRA issued a public statement, 
``Framework Regarding FINRA's Approach to Economic Impact Assessment 
for Proposed Rulemaking,'' outlining the core principles defining 
FINRA's approach to conducting economic impact assessments for 
rulemaking. The framework applies specifically to significant new 
rule proposals, and therefore would not cover the current proposal. 
However, as noted in the framework, FINRA has historically taken 
into account the costs and burdens of its rulemaking, including the 
changes proposed in the proposed consolidated supervision rule 
filing.

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[[Page 79545]]

5. Include Other Supervisory-Related Requirements
    Some commenters to the Proposing Release requested that FINRA 
revise the proposal to include provisions addressing other supervisory-
related issues.\51\ These issues include, for example, establishing a 
minimum ratio of producing representatives to compliance officers,\52\ 
requiring heightened supervision for associated persons with a high 
volume of complaints,\53\ identifying and supervising suspicious 
withdrawal patterns,\54\ and requiring special supervisory procedures 
for senior investors and non-English speaking customers.\55\ FINRA 
responded that it believes that these matters should be considered as 
part of a member's establishment of a supervisory system and procedures 
reasonably designed to achieve compliance with the federal securities 
laws and FINRA rules, and the testing and verification of such 
procedures under FINRA Rule 3120.\56\ In this regard, FINRA noted that 
it has issued guidance addressing areas of concern, including 
supervision of associated persons with disciplinary history,\57\ 
verification of emailed instructions to transmit or withdraw 
assets,\58\ and obligations relating to senior investors.\59\
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    \51\ Sweeney, St. John's, PIABA. In addition, IMS suggested that 
FINRA include in the proposal a specific presumption that a member 
firm's supervisory procedures would be presumed acceptable to FINRA 
examiners if the firm's procedures are properly documented and 
reasonable in light of the scope of its business, the extent of its 
customer contact, and its disciplinary history. However, as FINRA 
has noted previously, members retain the responsibility to design 
and implement supervisory procedures that are appropriate for their 
specific businesses and structures. See Notice to Members 99-45 
(June 1999).
    \52\ Sweeney.
    \53\ PIABA.
    \54\ PIABA.
    \55\ St. John's.
    \56\ October Response.
    \57\ See, e.g., Notice to Members 97-19 (April 1997).
    \58\ See Regulatory Notice 12-05 (January 2012).
    \59\ See, e.g., Regulatory Notice 07-43 (September 2007).
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6. Additional General Comments
    One commenter to the Proposing Release suggested that proposed 
FINRA Rule 3110 would require firms to have compliance departments that 
operate independently from their sales activity.\60\ FINRA responded 
that it disagrees with this interpretation of proposed FINRA Rule 3110 
and stated that proposed FINRA Rule 3110, which is based primarily on 
existing requirements in NASD Rule 3010 and Incorporated NYSE Rule 342 
relating to, among other things, supervisory systems, written 
procedures, internal inspections, and review of correspondence, is 
intended to allow firms the flexibility to establish their supervisory 
programs in a manner that reflects their business, size, and 
organizational structure.\61\ FINRA further noted that proposed FINRA 
Rule 3110 would not require a member to have an independent compliance 
department.
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    \60\ Sweeney.
    \61\ October Response.
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    Another commenter to the Proposing Release suggested incorporating 
the proposed supplementary material into the body of the proposed 
rules.\62\ FINRA responded that supplementary material is part of the 
rule and a provision's location as supplementary material is intended 
to improve the readability of the rule without affecting the weight, 
significance, or enforceability of the provision.\63\
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    \62\ IMS.
    \63\ October Response.
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B. Comments on Proposed FINRA Rule 3110(a)

    As proposed, FINRA Rule 3110(a) (Supervisory System) would have 
required a member to have a supervisory system for the activities of 
its associated persons that is reasonably designed to achieve 
compliance with applicable securities laws and regulations and FINRA 
and the MSRB rules. One commenter to the Proposing Release requested 
that FINRA delete proposed FINRA Rule 3110(a)'s reference to the MSRB 
rules.\64\ FINRA responded that the proposed reference to the MSRB 
rules was intended to clarify that members' supervisory systems must 
extend to compliance with MSRB rules and also to align FINRA's 
supervisory system requirement with the existing requirement under MSRB 
Rule G-27 (Supervision) to have a supervisory system that is reasonably 
designed to achieve compliance with applicable securities laws and 
regulations and MSRB rules.\65\ In light of a member's separate 
obligation to comply with MSRB Rule G-27, however, FINRA deleted the 
proposal's references to the MSRB rules in Amendment No. 1.
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    \64\ ICI. See also MSRB Memo.
    \65\ See MSRB Rule G-27(b) (Supervisory System).
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C. Comments on Deleted Supplementary Material Regarding One-Person OSJs

    As proposed, FINRA Rule 3110 would have included supplementary 
material clarifying the conditions a firm must satisfy to establish a 
one-person OSJ consistent with proposed FINRA Rule 3110(a)(4)'s 
requirement to have one or more appropriately registered principals in 
each OSJ with authority to carry out the supervisory responsibilities 
assigned to that office. Specifically, proposed FINRA Rule 3110.03 
(One-Person OSJs) expressly provided that the registered principal at a 
one-person OSJ (each such person is referred to in this paragraph C as 
the ``on-site principal'') cannot supervise his or her own sales 
activities and must be under the effective supervision and control of 
another appropriately registered principal (``senior principal''). The 
proposed supplementary material would have required that the designated 
senior principal be responsible for supervising the activities of the 
on-site principal at the one-person OSJ and conduct on-site supervision 
of the one-person OSJ on a regular periodic schedule to be determined 
by the member. In determining the schedule, the proposed supplementary 
material would have required a member to consider, among other factors, 
the nature and complexity of the securities activities for which the 
location is responsible, the nature and extent of contact with 
customers, and the disciplinary history of the principal at the one-
person OSJ.
    One commenter to the Proposing Release supported the proposed 
supplementary material,\66\ while another commenter suggested that 
FINRA revise proposed FINRA Rule 3110.03 to specify that ``no 
Registered Principal shall supervise his or her own sales activity.'' 
\67\ Numerous commenters raised concerns regarding the negative impact 
and costs of implementing the proposed requirement.\68\ One commenter 
also stated that proposed FINRA Rule 3110.03 would create an 
inconsistency and serve little regulatory purpose by requiring the 
personal production of one-person OSJs to be supervised differently 
than an OSJ with multiple registered persons.\69\ Several other 
commenters suggested that proposed FINRA Rule 3110.03 was unnecessary 
to ensure effective supervision \70\ and could undermine many 
independent firms' overall supervisory structures \71\

[[Page 79546]]

where home office principals supervise the sales activities of multiple 
field-OSJ principals to prevent conflicts of interest from self-
supervision, or use technology and annual inspections to augment their 
supervision.\72\ Commenters also suggested that the requirement to have 
``on-site supervision on a regular periodic schedule'' ignores firms' 
use of technology-based remote supervisory systems.\73\ One commenter 
raised concerns that proposed FINRA Rule 3110.03 would require all 
necessary supervisory reviews of the one-person OSJ to be conducted by 
the senior principal and sought clarification that the proposed 
supplementary material does not limit comprehensive regional 
supervisory structures, where regional principals perform annual and 
unannounced inspections and a separate centralized supervisory unit 
within the home office is dedicated to overseeing specific functions 
that require specialized knowledge and experience such as 
correspondence, advertising, or trade review.\74\
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    \66\ PIABA. PIABA also expressed overall support for proposed 
FINRA Rule 3110(a)(4) and the proposed supplementary material 
addressing the supervision of multiple OSJs by a single principal.
    \67\ FSI.
    \68\ Brandenburger, Cetera, FSI, IMS, Letter Type A, Putnam.
    \69\ Cetera.
    \70\ Brandenburger, IMS, Letter Type A, Putnam.
    \71\ Brandenburger, Cetera, IMS, Letter Type A.
    \72\ Cetera.
    \73\ Brandenburger, IMS, Letter Type A, Putnam.
    \74\ FSI.
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    FINRA responded that it believes that OSJs conduct critical 
functions and one-person OSJs present unique supervisory challenges. 
However, in light of commenters' continuing concerns regarding 
compliance costs and burdens, in Amendment No. 1, FINRA eliminated the 
proposed supplementary material from the proposed rule.\75\ FINRA noted 
that, importantly, it believes that one-person OSJ locations where the 
on-site principal engages in sales-related activities that trigger OSJ 
designation should be subject to scrutiny, and firms should conduct 
focused reviews of such locations.\76\ FINRA stated that such locations 
would be subject to the general provisions of proposed FINRA Rule 
3110(a)(5) (requiring all registered persons to be assigned to an 
appropriately registered representative(s) or principal(s) who will be 
responsible for supervising that person's activities) and proposed 
FINRA Rule 3110(b)(6) (requiring procedures prohibiting associated 
persons who perform a supervisory function from, among other things, 
supervising their own activities).\77\ In addition, FINRA noted that it 
would continue to monitor one-person OSJs for possible conflicts of 
interest or sales practice violations and may determine to address the 
matter further as part of a retrospective review process following an 
appropriate period after implementation of proposed FINRA Rule 3110.
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    \75\ The deletion of this proposed supplementary material has 
resulted in a change in numbering of the remaining supplementary 
material to proposed FINRA Rule 3110. For ease of reference, FINRA's 
responses to comments employ the new proposed numbers in all 
instances.
    \76\ See October Response (citing to SEC Division of Market 
Regulation, Staff Legal Bulletin No. 17: Remote Office Supervision 
(March 19, 2004) (reminding broker-dealers that small, remote 
offices require vigilant supervision and specifically noting that 
``[n]o individual can supervise themselves''); NASD Regulatory & 
Compliance Alert, Volume 11, Number 2 (June 1997) (cited by Staff 
Legal Bulletin No. 17 as support for statement that individuals 
cannot supervise themselves); see also In re Stuart K. Patrick, 51 
S.E.C. 419, 422 (May 17, 1993) (``[s]upervision, by its very nature, 
cannot be performed by the employee himself'') (SEC order sustaining 
application of the New York Stock Exchange's supervisory rule--also 
cited by Staff Legal Bulletin No. 17 as support for statement that 
individuals cannot supervise themselves)).
    \77\ October Response.
---------------------------------------------------------------------------

    One commenter to the Notice and Proceedings Order opposed the 
elimination of the previously proposed supplementary material that 
would have required a registered principal at a one-person OSJ to be 
under the effective supervision and control of another appropriately 
registered principal.\78\ However, the commenter stated that ``the harm 
that may have resulted from its removal is remediated by further 
changes designed to make it clear that self-supervision is 
inappropriate, and [they] encourage FINRA to continue to follow up on 
its commitment to continue to examine the unique challenges posed by 
One-Person OSJs.'' \79\ FINRA responded that, based on prior comments 
on and concerns with issues raised in the Proposing Release, it 
continues to believe that it was the best course to eliminate the 
proposed supplementary material from the proposed rule.\80\
---------------------------------------------------------------------------

    \78\ NASAA's November Letter.
    \79\ NASAA's November Letter at p. 4.
    \80\ November Response.
---------------------------------------------------------------------------

D. Comments on Proposed FINRA Rule 3110.03

    Proposed FINRA Rule 3110.03 (Supervision of Multiple OSJs by a 
Single Principal) would clarify the general requirement in proposed 
FINRA Rule 3110(a)(4) to have one or more appropriately registered 
principals in each OSJ with authority to carry out the supervisory 
responsibilities assigned to that office (an ``on-site principal''). 
Specifically, proposed FINRA Rule 3110.03 would clarify that the 
requirement to have an appropriately registered principal in each OSJ 
requires the designated on-site principal to have a physical presence, 
on a regular and routine basis, at the OSJ. FINRA stated that it 
strongly believes OSJs engage in critical functions, and the 
requirement to have on-site supervision by designating one or more on-
site principals in each OSJ has been a long standing cornerstone in 
establishing a reasonable supervisory structure. As a result, proposed 
FINRA Rule 3110.03 sets forth a general presumption that a principal 
will not be designated and assigned to be the on-site principal 
pursuant to proposed FINRA Rule 3110(a)(4) to supervise more than one 
OSJ.
    If a member determines it is necessary to assign one principal to 
be the designated on-site principal to supervise two or more OSJs, then 
the firm must consider, among other things, the following factors:
     Whether the on-site principal is qualified to supervise 
the activities and associated persons in each location;
     Whether the on-site principal has the capacity and time to 
supervise the activities and associated persons in each location;
     Whether the on-site principal is a producing registered 
representative;
     Whether the OSJ locations are in sufficiently close 
proximity to ensure that the on-site principal is physically present at 
each location on a regular and routine basis; and
     The nature of activities at each location, including size 
and number of associated persons, scope of business activities, nature 
and complexity of products and services offered, volume of business 
done, the disciplinary history of persons assigned to such locations, 
and any other indicators of irregularities or misconduct.

In the Proposing Release, the proposed supplementary material would 
have created a further general presumption that assigning a principal 
to be the on-site principal of more than two OSJs is unreasonable.
1. Clarification of Term ``On-Site Principal''
    As originally proposed, FINRA Rule 3110.03 used the terms ``on-site 
supervisor'' and ``designated principal'' interchangeably throughout 
the provision. Commenters requested that FINRA clarify in the rule text 
whether proposed FINRA Rule 3110.03's terms ``on-site supervisor'' and 
``designated principal'' refer to the same person.\81\ In response, 
FINRA revised in Amendment No. 1 proposed FINRA Rule 3110.03 to use the 
term ``on-site principal'' consistently throughout the provision.
---------------------------------------------------------------------------

    \81\ Cetera, FSI.

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[[Page 79547]]

2. Home Office Principals; Costly and Burdensome Implementation
    Two commenters to the Proposing Release raised concerns with 
proposed FINRA Rule 3110.03.\82\ One commenter requested that FINRA 
either ``exclude `up-the-chain' home office supervision of producing 
field OSJ principals'' or more clearly address how the ``physical 
presence'' requirement applies to home office employee supervisors. The 
commenter specifically raised concerns about whether a home office 
principal with supervisory responsibilities over a particular business 
line conducted in the OSJ becomes the ``on-site principal'' and 
therefore would be required to have a physical presence on a regular 
basis.\83\ The second commenter stated that proposed FINRA Rule 3110.03 
does not provide sufficient flexibility, is too costly and burdensome 
to implement, and fails to take into account firms' various business 
structures.\84\
---------------------------------------------------------------------------

    \82\ CAI, Cetera.
    \83\ Cetera.
    \84\ CAI.
---------------------------------------------------------------------------

    FINRA responded that proposed FINRA Rule 3110(a)(4), which would 
require a firm to have an appropriately registered principal in each 
OSJ with authority to carry out the supervisory responsibilities 
assigned to that office by the member, is being transferred unchanged 
from current NASD Rule 3010(a)(4).\85\ FINRA further stated that due to 
inquiries from firms asking if they could assign one principal to be 
the designated on-site principal to two or more OSJs consistent with 
the requirements of NASD Rule 3010(a)(4), FINRA staff developed 
informal guidance and interpretations under NASD Rule 3010(a)(4). FINRA 
stated that Proposed FINRA Rule 3110.03 reflects these interpretations 
and consolidates them in one rule.
---------------------------------------------------------------------------

    \85\ October Response.
---------------------------------------------------------------------------

    FINRA further responded that it believes the proposed rule would 
continue to provide firms with the flexibility to design supervisory 
systems suited for their business models, by allowing some flexibility 
in the presence of on-site supervisors if the firm can determine that 
the on-site principal has sufficient time and resources to engage in 
meaningful supervision of the critical functions that occur at another 
OSJ.\86\ FINRA noted that firms can designate more than one on-site 
principal at an OSJ to supervise activities at that OSJ based on 
particular business lines, and each such principal designated as an on-
site principal is required to have a physical presence on a regular 
basis. FINRA further noted that the on-site principal(s) is one part of 
a firm's comprehensive supervisory chain and not all ``up the chain'' 
supervisors must be designated as the on-site principal.
---------------------------------------------------------------------------

    \86\ October Response.
---------------------------------------------------------------------------

3. Elimination of Presumption That More Than Two OSJs Is Unreasonable
    In the proposal, FINRA expressly included two general presumptions 
in the rule: (1) one principal should be assigned to be the on-site 
principal at one OSJ; and (2) assigning one principal to be the on-site 
principal at more than two OSJs is unreasonable. Commenters to the 
Proposing Release expressed concern about the effect that the 
presumptions would have on smaller firms; and one commenter stated that 
the presumptions negated the flexibility that FINRA otherwise intends 
to provide.\87\ FINRA stated that the general presumptions were 
intended to provide firms with clarity. FINRA noted that the 
presumptions established guidelines, not rules, and firms could 
overcome the presumptions by demonstrating that assigning one principal 
to supervise more than two OSJs is reasonable based on the relevant 
factors set forth in proposed FINRA Rule 3110.03.\88\
---------------------------------------------------------------------------

    \87\ IMS, Wells Fargo.
    \88\ Cetera also stated that this presumption inappropriately 
shifts the burden of proof to the member and does not appear 
justified given the lower ``preponderance of the evidence'' standard 
of proof in FINRA disciplinary proceedings. FINRA stated that it 
disagrees with the commenter's statement. FINRA explained that 
Proposed FINRA Rule 3110(a) specifies the standard that a member's 
supervisory system be reasonably designed to achieve compliance with 
the applicable Federal securities laws and regulations and FINRA 
rules, and it is the member's responsibility to demonstrate that its 
supervisory system meets this standard. See October Response.
---------------------------------------------------------------------------

    In response to comments, FINRA proposed in Amendment No. 1 to 
replace the presumption in the Proposing Release that assigning one 
principal to be the on-site principal at more than two OSJs is 
unreasonable with a general statement that assigning a principal to 
more than one OSJ will be subject to scrutiny.

E. Comments on Proposed FINRA Rule 3110(b)(2) and FINRA Rule 3110.05

    Proposed FINRA Rule 3110(b)(2) (Review of a Member's Investment 
Banking and Securities Business) would require that a member have 
supervisory procedures for the review by a registered principal, 
evidenced in writing, of all transactions relating to the member's 
investment banking or securities business. Proposed FINRA Rule 3110.05 
(Risk-based Review of Member's Investment Banking and Securities 
Business) permits a member to use a risk-based system to review these 
transactions.
1. Additional Clarification Regarding ``Risk-Based Review System''
    Commenters to the Proposing Release requested additional 
clarification regarding how to comply with proposed FINRA Rule 
3110(b)(2)'s requirement to review all transactions related to a 
member's investment banking and securities business if using a risk-
based system to review transactions pursuant to proposed FINRA Rule 
3110.05. Specifically, two commenters sought clarification as to 
whether a member's supervisory system must take into account ``all'' 
transactions, considering that a principal only is required to review a 
sample of transactions under a ``risk-based review system.'' \89\ 
Similarly, another commenter asked whether a member firm determining 
parameters for a technological-based review system that would cause a 
trade to be flagged for more intensive review would be a ``risk-based'' 
approach that would conform to proposed FINRA Rule 3110(b)(2).\90\
---------------------------------------------------------------------------

    \89\ IMS, SIFMA.
    \90\ Cetera.
---------------------------------------------------------------------------

    FINRA responded that proposed FINRA Rule 3110(b)(2) would transfer 
to the FINRA Rulebook NASD Rule 3010(d)(1)'s provision requiring 
principal review, evidenced in writing, of all transactions and 
clarifies that such review include all transactions relating to the 
member's investment banking or securities business.\91\ FINRA stated 
that the term ``risk-based'' describes the type of methodology a member 
may use to identify and prioritize for review those areas that pose the 
greatest risk of potential securities laws and self-regulatory 
organization (``SRO'') rule violations. In response to commenters' 
requests for clarification on risk-based reviews, FINRA clarified in 
Amendment No. 1 that a member would not be required to conduct detailed 
reviews of each transaction if a member is using a reasonably designed 
risk-based review system that provides a member with sufficient 
information that permits the member to focus on the areas that pose the 
greatest numbers and risks of violation.
---------------------------------------------------------------------------

    \91\ October Response.
---------------------------------------------------------------------------

    FINRA further responded that it understands that a member's 
procedures for the review of its transactions by a registered principal 
may include the use of technology-based review systems with parameters 
designed to assess which transactions merit further

[[Page 79548]]

review.\92\ FINRA noted that the parameters would have to be reviewed 
by a principal and that review would have to be documented in writing. 
FINRA further noted, as is always the case with the exercise of 
supervision under FINRA rules, a principal's use of any automated 
supervisory system, aid, or tool for the discharge of supervisory 
duties represents a direct exercise of supervision by that principal, 
and the principal remains responsible for the discharge of supervisory 
responsibilities in compliance with the proposed rule. In addition, 
FINRA noted that a principal relying on a risk-based review system is 
responsible for any deficiency in the system's criteria that would 
result in the system not being reasonably designed.\93\
---------------------------------------------------------------------------

    \92\ Id.
    \93\ See also Regulatory Notice 07-53 (November 2007) (Deferred 
Variable Annuities) (discussing use of automated supervisory 
systems).
---------------------------------------------------------------------------

2. Exclude Specific Types of Broker-Dealers
    One commenter requested that FINRA either exclude ``mutual fund 
underwriters'' and other members that do not have or maintain customer 
relationships or effect transactions with or for retail investors from 
proposed FINRA Rule 3110(b)(2) or explain how those members are 
expected to document compliance.\94\ FINRA stated that the proposed 
rules would apply a risk-based approach or similar flexibility for 
specified aspects of a member's supervisory procedures to allow firms 
the ability to establish their supervisory programs in a manner that 
reflects their business models, such as members with limited broker-
dealer activities.\95\ As noted above, FINRA stated that proposed FINRA 
Rule 3110(b)(2) would transfer NASD Rule 3010(d)(1)'s provision and 
would require a principal to review and evidence in writing all 
transactions and that such review would include all transactions 
relating to the member's investment banking or securities business. 
Thus, members, regardless of their business activities, currently are 
required to have a principal review all of their transactions. FINRA 
noted that if mutual fund underwriters do not effect transactions, then 
the firms would have no review obligations pursuant to proposed FINRA 
Rule 3110(b)(2).\96\ FINRA stated that it understands that some 
underwriters do have customer relationships that could involve customer 
transactions, in which case such member firms would need to review 
those transactions pursuant to proposed FINRA Rule 3110(b)(2).\97\ 
FINRA further stated that proposed FINRA Rule 3110.05 would permit a 
mutual fund underwriter to use a risk-based approach to review its 
transactions.\98\
---------------------------------------------------------------------------

    \94\ ICI and ICI's October Letter.
    \95\ October Response.
    \96\ October Response and November Response.
    \97\ October Response.
    \98\ Id.
---------------------------------------------------------------------------

    In response to the Notice and Proceedings Order, the same commenter 
restated its recommendation that mutual fund underwriters be excluded 
from the provision in Rule 3110(b)(2) that would require principal 
underwriters to have supervisory procedures that require the review of 
all customer transactions and evidence such review in writing. The 
commenter acknowledged FINRA's response to its original comment that 
``if mutual fund underwriters do not effect transactions, then the 
firms would have no review obligations pursuant to proposed FINRA Rule 
3110(b)(2);'' however, the commenter remained concerned that mutual 
fund underwriters would be required to create, maintain, implement, and 
review on an ongoing basis a procedure for reviewing transactions since 
the requirement to have such procedures is imposed on all FINRA members 
without regard to whether the member effects customer transactions.\99\
---------------------------------------------------------------------------

    \99\ See ICI's October Letter, page 5.
---------------------------------------------------------------------------

    FINRA responded that, if a member does not engage in any 
transactions relating to its investment banking or securities business, 
it would be sufficient under proposed Rule 3110(b)(2) for the member to 
acknowledge in its supervisory procedures that it does not engage in 
any such transactions and that it must have supervisory policies and 
procedures in place before doing so.\100\
---------------------------------------------------------------------------

    \100\ November Response.
---------------------------------------------------------------------------

F. Comments on Proposed FINRA Rule 3110(b)(4) and Related Supplementary 
Materials

    Proposed FINRA Rule 3110(b)(4) (Review of Correspondence and 
Internal Communications) would require a member to have procedures to 
review incoming and outgoing written (including electronic) 
correspondence and internal communications relating to its investment 
banking or securities business.\101\ In particular, the supervisory 
procedures would require the member's review of: (1) incoming and 
outgoing written correspondence to properly identify and handle in 
accordance with firm procedures: customer complaints, instructions, 
funds and securities, and communications that are of a subject matter 
that require review under FINRA rules and federal securities laws; and 
(2) internal communications to properly identify communications that 
are of a subject matter that require review under FINRA rules and the 
federal securities laws.\102\
---------------------------------------------------------------------------

    \101\ In the Proposing Release, proposed FINRA Rule 3110(b)(4) 
transferred NASD Rule 3010(d)'s reference to ``correspondence with 
the public'' and used the term in related supplementary materials, 
proposed FINRA Rules 3110.06-.08. In Amendment No. 1, FINRA revised 
proposed FINRA Rule 3110(b)(4) and proposed FINRA Rules 3110.06-.08 
to refer to ``correspondence'' to be consistent with FINRA Rule 
2210's (Communications with the Public) definition and use of the 
term ``correspondence.'' See also FINRA Rule 2210(b)(2) (requiring 
that all correspondence be subject to the supervision and review 
requirements of existing NASD Rule 3010(d)).
    \102\ In Amendment No. 1, FINRA revised proposed FINRA Rule 
3110(b)(4) and FINRA Rule 3110.06 to delete references to the MSRB 
rules, consistent with the deletion of such reference in proposed 
FINRA Rule 3110(a) discussed above.
---------------------------------------------------------------------------

1. Risk-Based Review of Internal Communications
    Proposed FINRA Rule 3110.06 (Risk-based Review of Correspondence 
and Internal Communications) would require a member to decide, by 
employing risk-based principles, the extent to which additional 
policies and procedures for the review of incoming and outgoing written 
correspondence and internal communications that fall outside of the 
subject matters listed in proposed FINRA Rule 3110(b)(4) are necessary 
for its business and structure.
    Some commenters suggested that FINRA should further align proposed 
FINRA Rule 3110.06 with the guidance in Regulatory Notice 07-59.\103\ 
One commenter stated that the proposed rule could be interpreted as 
requiring a member to review all internal communications.\104\ Two 
commenters to the Proposing Release requested additional guidance on 
the appropriate scope of internal communications requiring review and 
methodology for identifying those communications.\105\ Commenters 
further suggested that any firm that does not engage in activities that 
are of a subject matter that require review should not be required to 
review its internal communications for references to those 
activities.\106\ One commenter stated that requiring such firms to 
review internal communications for reference to those activities would 
result in significant costs that are not justified by the limited 
additional investor protection

[[Page 79549]]

benefits.\107\ Other commenters urged FINRA to further revise proposed 
FINRA Rule 3110.06 to state that ``[t]hrough the use of risk-based 
principles, firms can determine the extent to which the review of their 
internal communications is necessary.'' \108\
---------------------------------------------------------------------------

    \103\ ICI, IMS, Schwab, SIFMA.
    \104\ ICI and ICI's October Letter.
    \105\ CAI, ICI.
    \106\ Brandenburger, FSI, IMS, Letter Type A, Putnam.
    \107\ FSI.
    \108\ IMS, SIFMA.
---------------------------------------------------------------------------

    FINRA responded that, with respect to the review of internal 
communications, Regulatory Notice 07-59 states that ``with the 
exception of the enumerated areas requiring review by a supervisor, 
members may decide, employing risk-based principles, the extent to 
which review of any internal communications is necessary in accordance 
with the supervision of their business.'' \109\ FINRA responded that it 
believes that proposed FINRA Rule 3110.06 would accurately reflect this 
guidance by stating that ``[b]y employing risk-based principles, a 
member must decide the extent to which additional policies and 
procedures for the review of . . . internal communications that are not 
of a subject matter that require review under FINRA rules and federal 
securities laws are necessary for its business and structure.'' FINRA 
stated that, consistent with this guidance, proposed FINRA Rule 3110.06 
would not require the review of every internal communication.\110\ For 
example, if a member does not engage in any activities that are of a 
subject matter that require review, the proposed rule would not require 
that the member review its internal communications for references to 
those activities, provided that its supervisory procedures acknowledge 
that factor as part of the member's determination that its procedures 
are reasonably designed to achieve compliance with applicable federal 
securities laws and FINRA rules. Accordingly, FINRA declined to amend 
the proposal in response to the comments.
---------------------------------------------------------------------------

    \109\ See Regulatory Notice 07-59 (December 2007), at 3, 9.
    \110\ See id. at 11 (specifically noting that the guidance 
neither created new supervisory requirements nor required the review 
of every communication, and that, ``[w]ith respect to the review of 
internal electronic communications, the guidance states that--with 
the exception of the enumerated areas requiring review by a 
supervisor--a firm may use risk-based principles, including an 
examination of existing review processes, to determine the extent to 
which review of any internal communications is necessary''); see 
also November Response (ICI raised the same issue in its October 
Letter and FINRA responded that it believes that its guidance set 
forth in Regulatory Notice 07-59, as codified in proposed FINRA Rule 
3110.06, addresses this concern).
---------------------------------------------------------------------------

2. Evidence of Review of Communications Using Lexicon-Based Screening 
Tools
    Proposed FINRA Rule 3110.07 (Evidence of Review of Correspondence 
and Internal Communications) would clarify that merely opening a 
communication is not a sufficient review. Rather, a member must 
identify what communication was reviewed, the identity of the reviewer, 
the date of the review, and the actions taken by the member as a result 
of any significant regulatory issues identified during the review.
    Commenters suggested that firms using lexicon-based screening tools 
as a risk-based means of reviewing communications should not need to 
maintain the documentation required by proposed FINRA Rule 3110.07 
evidencing review for those communications that do not generate review 
alerts/hits for further review.\111\ One commenter suggested that it 
should be sufficient for a member to demonstrate that it has reasonably 
designed controls in place to ensure that the screening tools are 
subject to review and are operating as intended,\112\ while other 
commenters suggested revising proposed FINRA Rule 3110.07 to provide 
that ``[f]or those communications subjected to electronic review, the 
member must maintain documentation reasonably sufficient to demonstrate 
the parameters of such review.'' \113\
---------------------------------------------------------------------------

    \111\ ICI, ICI's October Letter, IMS, SIFMA.
    \112\ ICI and ICI's October Letter.
    \113\ IMS, SIFMA.
---------------------------------------------------------------------------

    FINRA noted that it had previously declined to accept the 
suggestion that a member does not have to retain the specified 
information fields required by proposed FINRA Rule 3110.07 for 
communications reviewed through electronic review systems or lexicon-
based screening tools if those messages do not generate review 
alerts.\114\ FINRA stated that it believes that not only is the 
required documentation necessary to demonstrate that the communication 
was actually reviewed, but that failure to record and retain this 
information, such as the identity of the reviewer, could be 
inconsistent with a member's record retention obligations under FINRA 
and SEC rules.\115\ FINRA further noted that, although proposed FINRA 
Rule 3110.07 would permit the use of lexicon-based screening tools and 
other automated systems, as noted in Regulatory Notice 07-59, members 
utilizing automated tools or systems in the course of their supervisory 
review of electronic communications must have an understanding of the 
limitations of those tools or systems and should consider what, if any, 
further supervisory review is necessary in light of those limitations.
---------------------------------------------------------------------------

    \114\ October Response.
    \115\ Id., citing proposed FINRA Rule 3110.09 (Retention of 
Correspondence and Internal Communications) and Exchange Act of 1934 
Rule 17a-4(b)(4) (requiring, among other things, that a broker-
dealer's retained communications records include any approvals of 
communications sent).
---------------------------------------------------------------------------

    With respect to communications reviewed by electronic surveillance 
tools that are not selected for further review, FINRA stated that, it 
would be sufficient to demonstrate compliance with proposed FINRA Rule 
3110.07 if the electronic surveillance system has a means of 
electronically recording evidence that those communications have been 
reviewed by that system.\116\ FINRA further stated that it would be 
permissible to use an electronic surveillance or reviewing tool that, 
with respect to communications that do not generate alerts, only 
captures the specified information fields to the extent necessary to 
comply with applicable FINRA and SEC rules.\117\ Additionally, FINRA 
stated that, consistent with previous guidance discussing the use of 
any automated supervisory systems or tools to discharge supervisory 
duties, the use of electronic surveillance tools to review 
communications represents a direct exercise of supervision by the 
supervisor (including any use of such tools by the supervisor's 
delegate to review communications). FINRA noted that the supervisor 
remains responsible for the discharge of supervisory responsibilities 
in compliance with the rule and is responsible for any deficiency in 
the system's criteria that would result in the system not being 
reasonably designed.\118\
---------------------------------------------------------------------------

    \116\ October Response.
    \117\ November Response.
    \118\ November Response at page 8. See Regulatory Notice 07-53 
(November 2007) (Deferred Variable Annuities) (discussing use of 
automated supervisory systems).
---------------------------------------------------------------------------

3. Retention of Correspondence and Internal Communications
    Proposed FINRA Rule 3110.09 (Retention of Correspondence and 
Internal Communications) would require, among other things, that a 
member retain internal communications and correspondence of associated 
persons relating to the member's investment banking or securities 
business for the period of time and accessibility specified in Exchange 
Act Rule 17a-4(b) (not less than three years, the first two years in an 
easily accessible place).

[[Page 79550]]

    One commenter to the Proposing Release requested that FINRA expand 
the record retention period in proposed FINRA Rule 3110.09 to six years 
to match the record retention period in Exchange Act Rule 17a-4(c) 
(requiring broker-dealers to preserve for a period of not less than six 
years after the closing of any customer's account any account cards or 
records relating to the terms and conditions with respect to the 
opening and maintenance of the account) and to the eligibility 
provisions for customer arbitration disputes in FINRA Rule 12206 (Time 
Limits).\119\ A second commenter restated this concern in a second 
letter.\120\ FINRA responded that firms are already subject to very 
extensive record retention requirements regarding communications about 
firms' business as such.\121\ In FINRA's view, the cost of extending 
the record retention period from three years to six years would 
unnecessarily raise costs and create recordkeeping inconsistencies. 
FINRA stated that the proposed supplementary material purposefully 
aligns the record retention period for communications with the SEC's 
record retention period for the same types of communications to achieve 
consistent regulation in this area.
---------------------------------------------------------------------------

    \119\ PIABA.
    \120\ NASAA's November Letter.
    \121\ See October Response citing generally Exchange Act Rule 
17a-4(b)(4); see also November Response, stating that FINRA 
continues to support its analysis of these issues as described 
above.
---------------------------------------------------------------------------

G. Comments on Proposed FINRA Rule 3110(b)(5)

    Proposed FINRA Rule 3110(b)(5) (Review of Customer Complaints) 
would require members to have supervisory procedures to capture, 
acknowledge, and respond to all written (including electronic) customer 
complaints.
1. Exclusion of Oral Complaints
    Several commenters to the Proposing Release suggested that members 
should be required to reduce an oral complaint to writing or to provide 
the customer with a form.\122\ Commenters also suggested that oral 
complaints should not be too difficult to capture,\123\ with one 
commenter stating that NYSE members have been required to capture and 
assess oral complaints for a number of years.\124\ One commenter 
restated its concern with regard to the exclusion of oral complaints 
from proposed FINRA Rule 3110(b)(5).\125\ FINRA stated that it did not 
include oral complaints because they are difficult to capture and 
assess, whereas members can more readily capture and assess written 
complaints.\126\ FINRA further stated that it continues to believe that 
proposed FINRA Rule 3110(b)(5) should include only written customer 
complaints. FINRA noted that it encourages members to provide customers 
with a form or other format that will allow customers to communicate 
their complaints in writing. FINRA further noted that the failure to 
address a valid customer complaint, written or oral, may be a violation 
of FINRA Rule 2010.\127\
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    \122\ Caruso, NASAA, PIABA, St John's.
    \123\ Caruso, NASAA, PIABA.
    \124\ Caruso.
    \125\ NASAA's November Letter.
    \126\ October Response; see also November Response stating that 
FINRA continues to support its analysis of these issues as described 
above.
    \127\ FINRA also pointed to its investor education literature 
that advises customers to communicate any complaints to their 
broker-dealer in writing, especially if customers have lost money or 
there were any unauthorized trades made in the customers' accounts. 
See FINRA's pamphlet Investor Complaint Program: What to Do When 
Problems Arise; see also NASD Rule 2340(a) (Customer Account 
Statements) (requiring a customer account statement to, among other 
things, advise the customer that any oral communications should be 
re-confirmed in writing to further protect the customer's rights, 
including rights under the Securities Investor Protection Act 
(SIPA)).
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    FINRA further responded that this aspect of the proposed rules 
would not change existing rules, explaining that although Incorporated 
NYSE Rule 401A previously required firms to acknowledge and respond to 
specified customer complaints (both oral and written), to harmonize the 
NASD and NYSE rules in the interim period before completion of the 
Consolidated FINRA Rulebook, FINRA amended Incorporated NYSE Rule 
351(d) (Reporting Requirements) to limit the definition of ``customer 
complaint'' to include only written complaints, thereby making the 
definition substantially similar to that in NASD Rule 3070(c) 
(Reporting Requirements).\128\
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    \128\ See Exchange Act Release No. 58533 (September 12, 2008), 
73 FR 54652 (September 22, 2008) (Order Approving File No. SR-FINRA-
2008-036). FINRA adopted FINRA Rule 4530 to replace NASD Rule 3070 
and comparable provisions in Incorporated NYSE Rule 351. See 
Securities Exchange Act Release No. 63260 (November 5, 2010), 75 FR 
69508 (November 12, 2010) (Notice of Filing of Amendments No. 1 and 
2 and Order Granting Accelerated Approval of File No. SR-FINRA-2010-
034). FINRA Rule 4530 became effective on July 1, 2011. See 
Regulatory Notice 11-06 (February 2011).
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2. Require More Than Written Acknowledgement and Response
    One commenter to the Proposing Release suggested that proposed 
FINRA Rule 3110(b)(5)'s requirement to capture, acknowledge, and 
respond to customer complaints was insufficient and that firms should 
be required to conduct an adequate and objective review and ongoing 
monitoring of claims that include, where appropriate, ``bona fide'' 
offers of resolution, including trade reversal and cancellation, good 
faith pre-arbitration or litigation discussion, or negotiation.\129\
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    \129\ Arnoff. This commenter also requested that it be mandatory 
for broker-dealers to pay for the customer's litigation and 
arbitration expenses if good faith and objectively sound procedures 
of supervision, compliance, inspection, and claims handling are not 
followed. FINRA responded that it considers the comment to be 
outside the scope of the proposed rule change. The FINRA Dispute 
Resolution Arbitrator's Guide discusses when arbitration fees and 
expenses may be waived or awarded.
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    FINRA responded that it understands the commenter's concerns that 
members have procedures in place to take appropriate and meaningful 
action with respect to customer complaints and expects that a member's 
supervisory procedures will be reasonably designed to respond to 
customer complaints.\130\ In addition, FINRA noted that members have 
reporting and records preservation obligations for customer complaints 
that assist FINRA in monitoring whether a member's supervisory 
procedures for capturing, acknowledging, and responding to written 
customer complaints are reasonably designed.\131\
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    \130\ October Response.
    \131\ See FINRA Rule 4513 (Records of Written Customer 
Complaints) (requiring each member to keep and preserve in each OSJ 
either a separate file of all written customer complaints that 
relate to that office (including complaints that relate to 
activities supervised from that office) and action taken by the 
member, if any, or a separate record of such complaints and a clear 
reference to the files in that office containing the correspondence 
connected with such complaints); see also FINRA Rule 4530 (requiring 
each member to promptly report to FINRA, but in any event not later 
than 30 calendar days, after the member knows or should have known 
of whether the member or a member's associated person is the subject 
of any written customer complaint involving allegations of theft or 
misappropriation of funds or securities or of forgery, as well as 
report to FINRA statistical and summary information regarding 
written customer complaints in such detail as FINRA shall specify by 
the 15th day of the month following the calendar quarter in which 
customer complaints are received by the member).
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H. Comments on Proposed FINRA Rule 3110(b)(6) and FINRA Rule 3110.10

    Proposed FINRA Rule 3110(b)(6) (Documentation and Supervision of 
Supervisory Personnel) is based largely on existing provisions in NASD 
Rule 3010(b)(3) requiring a member's supervisory procedures to set 
forth the member's supervisory system and to include a record of the 
member's supervisory personnel with such details as titles, 
registration status, locations, and responsibilities. In addition, the

[[Page 79551]]

proposed rule would include two new provisions as described in more 
detail in the Proposing Release:
     Proposed FINRA Rule 3110(b)(6)(C) would require a member 
to have procedures prohibiting its supervisory personnel from 
supervising their own activities and reporting to, or having their 
compensation or continued employment determined by, a person the 
supervisor is supervising (subject to a limited size and resources 
exception); and
     Proposed FINRA Rule 3110(b)(6)(D) would require a member 
to have procedures to prevent the standards of supervision required 
pursuant to proposed FINRA Rule 3110(a) from being reduced in any 
manner due to any conflicts of interest that may be present with 
respect to the associated person being supervised, such as the person's 
position, the amount of revenue such person generates for the firm, or 
any compensation that the supervisor may derive from the associated 
person being supervised.
    Proposed FINRA Rule 3110.11 (Supervision of Supervisory Personnel) 
would indicate that the exception provided in proposed FINRA Rule 
3110(b)(6)(C) is generally intended for a sole proprietor in a single-
person firm or where a supervisor holds a very senior executive 
position within the firm.
1. Support for New Provisions
    Several commenters to the Proposing Release supported proposed 
FINRA Rules 3110(b)(6)(C) and (D),\132\ with one commenter stating that 
the provisions ``should never be diluted.'' \133\ Specifically 
referring to conflict of interest proscriptions in proposed FINRA Rule 
3110(b)(6)(D), one commenter stated that the provision eliminates the 
opportunity for activities going unchecked or supervision being more 
lenient on the basis of self-interest,\134\ while another commenter 
agreed that conflicts of interest relating to the compensation of the 
supervisor and the person being supervised should not needlessly 
compromise the effectiveness of supervisory procedures.\135\ Referring 
to the prohibitions against supervisory personnel supervising their own 
activities in proposed FINRA Rule 3110(b)(C), one commenter concurred 
that self-supervision is inappropriate.\136\
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    \132\ Cetera, SIFMA, Sweeney, St. John's.
    \133\ Sweeney.
    \134\ St. John's.
    \135\ SIFMA.
    \136\ Cetera.
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2. Heightened Supervision
    As noted in the Proposing Release, proposed FINRA Rule 
3110(b)(6)(C) regarding the prohibition of supervisory personnel from 
supervising their own activities and reporting to, or having their 
compensation or continued employment determined by a person the 
supervisor is supervising, would replace NASD Rule 3012(a)(2)'s 
provisions concerning the supervision of a producing manager's customer 
account activity and the requirement to impose heightened supervision 
when any producing manager generates 20 percent or more of the revenue 
of the business units supervised by the producing manager's supervisor. 
One commenter to the Proposing Release suggested that FINRA retain the 
heightened supervisory requirement for producing managers that meet the 
20 percent threshold and apply FINRA Rule 3110(b)(6)(C) to producing 
managers that do not meet the 20 percent threshold.\137\ This commenter 
restated this concern in a second letter.\138\
---------------------------------------------------------------------------

    \137\ NASAA.
    \138\ NASAA's November Letter.
---------------------------------------------------------------------------

    FINRA responded that, although it understands the commenter's 
concerns regarding the need for effective supervision of producing 
managers, FINRA believes that proposed FINRA Rule 3110(b)(6)(C)'s 
provisions addressing the supervision of all supervisory personnel, 
rather than just producing managers, would be better designed to 
prevent supervisory situations that would not lead to effective 
supervision.\139\ In addition, FINRA noted that proposed FINRA Rule 
3110(b)(6)(D)'s conflicts of interest provisions would be designed to 
further ensure effective supervision of supervisory personnel.
---------------------------------------------------------------------------

    \139\ October Response; see also November Response, stating that 
FINRA continues to support its analysis of these issues as described 
above.
---------------------------------------------------------------------------

3. Review of Senior Executive's Activities
    One commenter to the Proposing Release stated that proposed FINRA 
Rule 3110(b)(6)(C) could prevent compliance professionals in the firm 
from reviewing the firm's most senior person's activities when that 
senior person occasionally produces revenue, and might force a firm to 
hire a ``senior principal'' if the senior person in the firm determines 
the compliance professionals' compensation or continued employment with 
the firm.\140\
---------------------------------------------------------------------------

    \140\ IMS.
---------------------------------------------------------------------------

    FINRA disagreed with the commenter's interpretation of proposed 
FINRA Rule 3110(b)(6)(C) and stated that although proposed FINRA Rule 
3110(b)(6)(C)(ii) generally would require a member to have procedures 
prohibiting its supervisory personnel from, among other things, 
reporting to, or having their compensation or continued employment 
determined by, a person the supervisor is overseeing, the same 
provision specifically provides an exception if a member determines 
that compliance with the prohibition is not possible because of a 
member's size or a supervisor's position within the firm. FINRA further 
stated that a member relying on the exception must document the factors 
it used to reach its determination that it can rely on the exception 
and how the supervisory arrangement otherwise complies with proposed 
FINRA Rule 3110(a). FINRA noted that proposed FINRA Rule 3110.10 would 
further provide non-exclusive examples of situations when the exception 
would generally apply, including when a registered person is a senior 
executive officer (or holds a similar position) and that proposed FINRA 
Rule 3110(b)(6)(C) and FINRA Rule 3110.10 do not require a member to 
hire additional personnel.\141\
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    \141\ October Letter.
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4. Limited Exception
    One commenter requested that FINRA either delete proposed FINRA 
Rule 3110.10 or revise it to expand the list of situations in which a 
firm may rely on the exception to include situations where a person 
supervises a senior person for only a limited purpose or function.\142\
---------------------------------------------------------------------------

    \142\ ICI and ICI's October Letter.
---------------------------------------------------------------------------

    FINRA declined to make any revisions to proposed FINRA Rule 
3110.10. FINRA explained that the exception in proposed FINRA Rule 
3110(b)(6)(C) is specifically based on a member's inability to comply 
with the general supervisory requirements because of the member's size 
or supervisor's position within the firm.\143\ FINRA stated that 
proposed FINRA Rule 3110.10 reflects its view that a member would 
generally rely on the exception for a sole proprietor in a single-
person firm or when a supervisor holds a very senior executive position 
within the firm. FINRA noted that a member may rely on the exception in 
other instances where it cannot comply because of its size or the 
supervisor's position within the firm, provided the member

[[Page 79552]]

documents the factors used to reach its determination and how the 
supervisory arrangement with respect to the supervisory personnel 
otherwise complies with proposed FINRA Rule 3110(a).\144\ To clarify 
that proposed FINRA Rule 3110.10 would provide non-exclusive examples 
of situations where the exception would generally apply, FINRA revised 
the provision in Amendment No. 1 to delete the term ``only'' prior to 
providing the examples.
---------------------------------------------------------------------------

    \143\ October Response Letter (noting that Proposed FINRA Rule 
3110(b)(6)(C)'s exception is based, in large part, on the exception 
in NASD Rule 3012 from the general supervisory requirement for a 
producing manager's customer account activity and citing to NASD 
Rule 3012(a)(2)(A)(ii) (``Limited Size and Resources'' Exception)).
    \144\ Id.
---------------------------------------------------------------------------

    The same commenter restated this recommendation in its comments to 
the Notice and Proceedings Order and stated that FINRA's response to 
its previous comment did not sufficiently address the concerns or 
examples raised in its comments to the Proposing Release.\145\ In 
response, FINRA re-emphasized that the revisions to proposed Rule 
3110.10's list of examples where a member would need to rely on the 
exception is non-exclusive.\146\ FINRA further stated that it continues 
to support the principle set forth in proposed Rule 3110(b)(6)(C) that 
supervisory personnel must not report to, or have their compensation or 
continued employment determined by, a person they are supervising 
unless the firm complies with the permitted exception.
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    \145\ ICI's October Letter.
    \146\ November Response Letter.
---------------------------------------------------------------------------

5. Conflicts of Interest
    Commenters to the Proposing Release expressed concern that 
requiring members to have procedures to prevent their supervision 
standards from being reduced in any manner due to any conflicts of 
interest that may be present was inconsistent with the existing 
``reasonably designed'' standard in proposed FINRA Rule 3110(a) (and 
current NASD Rule 3010(a)) and the proposed rules' risk-based 
supervision principles.\147\ One commenter questioned whether proposed 
FINRA Rule 3110(b)(6)(D) creates a strict liability standard with 
respect to eliminating conflicts of interest.\148\ Commenters requested 
that FINRA revise proposed FINRA Rule 3110(b)(6)(D) to clarify that 
firms must mitigate conflicts of interest as part of designing and 
establishing a reasonable supervisory system.\149\ Two commenters 
suggested that FINRA amend the proposed supplementary material to 
require a member to have `` . . . procedures reasonably designed to 
prevent the supervisory system required pursuant to paragraph (a) of 
this Rule from being reduced. . . .'' \150\
---------------------------------------------------------------------------

    \147\ Cetera, IMS, Schwab, SIFMA.
    \148\ Schwab. NASAA raised similar concerns, asking whether 
proposed FINRA Rule 3110(b)(6)(C) requires a member's supervisory 
procedures to be designed to limit all conflicts of interest or 
solely be reasonably designed to eliminate conflicts of interest.
    \149\ IMS, Schwab, SIFMA.
    \150\ IMS, SIFMA.
---------------------------------------------------------------------------

    In response, FINRA revised proposed FINRA Rule 3110(b)(6)(D) in 
Amendment No. 1 to clarify that the provision does not create a strict 
liability obligation requiring identification and elimination of all 
conflicts of interest. As revised, proposed FINRA Rule 3110(b)(6)(D) 
would require that a member have ``procedures reasonably designed to 
prevent the supervisory system required pursuant to paragraph (a) of 
this Rule from being compromised due to the conflicts of interest that 
may be present with respect to the associated person being supervised . 
. . .'' \151\
---------------------------------------------------------------------------

    \151\ See also Section H(5), page 23 of the October Response.
---------------------------------------------------------------------------

I. Comments on Proposed FINRA Rule 3110(b)(7) and FINRA Rule 3110.11

    Proposed FINRA Rule 3110(b)(7) (Maintenance of Written Supervisory 
Procedures) would require a member to retain and keep current a copy of 
the member's written supervisory procedures at each OSJ and at each 
location where supervisory activities are conducted on behalf of the 
member.
    Proposed FINRA Rule 3110.11 (Use of Electronic Media to Communicate 
Written Supervisory Procedures) would permit a member to satisfy its 
obligation to communicate its written supervisory procedures, and any 
amendments to those procedures, using electronic media, provided that 
the written supervisory procedures have been promptly communicated to, 
and are readily accessible by, all associated persons to whom the 
supervisory procedures apply based on their activities and 
responsibilities.
    Two commenters to the Proposing Release requested that FINRA permit 
firms the flexibility to determine who should receive which portions of 
their written supervisory procedures, if any, and not interpret 
proposed FINRA Rule 3110(b)(7) to require communication of written 
supervisory procedures and amendments to non-supervisory 
personnel.\152\ The commenters stated that, at many firms, written 
supervisory procedures are intended solely for supervisors while other 
documents (e.g., compliance policies) are intended for the broader 
audience of all associated persons. In addition, the commenters noted 
that there may be written supervisory procedures (e.g., how employee 
correspondence and trading are reviewed) that member firms do not want 
to be disseminated because the broad dissemination of those procedures 
may undermine their effectiveness.
---------------------------------------------------------------------------

    \152\ IMS, SIFMA.
---------------------------------------------------------------------------

    FINRA stated that it continues to believe that it is important that 
all associated persons have knowledge of the supervisory procedures 
relevant to their activities.\153\ FINRA notes that proposed FINRA Rule 
3110(b)(7) and related supplementary material would not prohibit a firm 
from providing only its supervisory personnel with the written 
supervisory procedures' parameters detailing how a firm monitors or 
reviews its associated persons' activities to detect and prevent 
potential violative conduct (e.g., details about how a firm reviews an 
associated person's correspondence or trading).
---------------------------------------------------------------------------

    \153\ October Response Letter, referring to Notice to Members 
99-45 (June 1999) (distinguishing between a member's compliance 
procedures and written supervisory procedures and specifying that 
``[i]t is crucial that all persons associated with a member be 
informed of any changes in the supervisory system and applicable 
written procedures. [NASD Rule 3010(b)(3)], therefore, requires 
members to inform all associated persons of such changes.'').
---------------------------------------------------------------------------

J. Comments on Proposed FINRA Rule 3110(c) and Proposed FINRA Rules 
3110.13 and 3110.14

    Proposed FINRA Rule 3110(c)(1) (Internal Inspections), based 
largely on NASD Rule 3010(c)(1), would retain the existing requirements 
for each member to review, at least annually, the businesses in which 
it engages and inspect each office on a specified schedule. The 
provision would also retain the existing requirement that the member's 
annual review must be reasonably designed to assist the member in 
detecting and preventing violations of, and achieving compliance with, 
applicable securities laws and regulations and FINRA rules.\154\
---------------------------------------------------------------------------

    \154\ FINRA is revising proposed FINRA Rule 3110(c)(1) to delete 
references to the MSRB rules, consistent with the deletion of such 
reference in proposed FINRA Rule 3110(a) discussed above.
---------------------------------------------------------------------------

1. Impose Additional Inspection Safeguards
    Although one commenter to the Proposing Release supported proposed 
FINRA Rule 3110(c)(1),\155\ another commenter suggested that firms 
should be required to conduct more frequent inspections to ensure that 
risks created by a firm's size, location, and resources are 
addressed.\156\ The commenter also suggested requiring firms to hire 
third-party vendors to monitor their activities and conduct independent 
compliance

[[Page 79553]]

audits, as well as to have a registered principal or compliance 
professional sign off on all compliance, supervisory, and inspection 
reports representing that to their knowledge and good faith belief, the 
report is true and correct.
---------------------------------------------------------------------------

    \155\ St. John's.
    \156\ Arnoff.
---------------------------------------------------------------------------

    FINRA responded that the proposed rule change would generally 
provide members with flexibility to conduct their inspections using 
only firm personnel.\157\ This flexibility, in turn, would assist firms 
in managing compliance costs. FINRA stated that, with respect to 
addressing potential risk gaps, proposed FINRA Rule 3120 would require 
that firms test and verify, at least annually, that the member's 
supervisory procedures are reasonably designed to achieve compliance 
with applicable securities laws and regulations and with applicable 
FINRA rules and, if necessary, create any additional or amended 
supervisory procedures in response to those test results. FINRA noted 
that this testing and verification would necessarily include any 
supervisory procedures regarding a member's inspections to ensure that 
inspections have not been compromised by any potential risks inherent 
to a member's size, location, or resources. Therefore, FINRA declined 
to make changes to proposed FINRA Rule 3110(c)(1) in response to 
comments.
---------------------------------------------------------------------------

    \157\ October Response.
---------------------------------------------------------------------------

2. Exclude Residences From Inspections
    Two commenters to the Proposing Release requested that FINRA 
exclude residences from proposed FINRA Rule 3110(c)(1)'s required 
inspections of a firm's locations.\158\ One of these commenters 
suggested that other types of review, such as review of a registered 
person's email would be a more effective way of identifying potential 
red flags.\159\ One commenter repeated its request that FINRA not 
subject home offices to the inspection requirements for supervisory 
branch offices and non-branch locations.\160\
---------------------------------------------------------------------------

    \158\ ICI, IMS.
    \159\ IMS.
    \160\ ICI October Letter.
---------------------------------------------------------------------------

    FINRA declined to adopt the commenters' suggestions to exclude 
residences from proposed FINRA Rule 3110(c)'s inspection requirements. 
FINRA stated that inspections are a crucial component of detecting and 
preventing regulatory and compliance problems of associated persons 
working at unregistered offices.\161\ Some unregistered offices also 
operate as separate business entities under names other than those of 
the members. FINRA noted that while FINRA does not encourage or 
discourage such arrangements, a large number of geographically separate 
offices present the potential that sales practice problems will not be 
as quickly identified as would be the case for larger, centralized 
branch offices.\162\ FINRA stated that remote supervision, such as 
reviewing email for ``red flags,'' would not be a sufficient 
substitution for an actual inspection, although red flags identified 
through such means could be helpful in determining whether to conduct 
unannounced location inspections.
---------------------------------------------------------------------------

    \161\ October Response; see also November Response, stating that 
it continues to support proposed FINRA Rule 3110's inspection 
requirements and believes that the proposed annual inspection cycle 
in FINRA Rule 3110(c)(1)(A) remains appropriate for home offices of 
regional distributors where supervisory activities are occurring.
    \162\ See Notice to Members 98-38 (May 1998).
---------------------------------------------------------------------------

3. Remove Presumption for Periodic Inspection Schedules
    One commenter to the Proposing Release requested that FINRA delete 
proposed FINRA Rule 3110.13 (Presumption of Three-Year Limit for 
Periodic Inspection Schedules), which sets forth a general presumption 
of a three-year limit for periodic non-branch location inspection 
schedules, and allow each member to determine what would be an 
appropriate inspection period for their non-branch locations.\163\ One 
commenter restated the same concerns and questioned the regulatory or 
public purpose to be served by FINRA presuming that all members should 
conduct an inspection of each home of a regional distributor or 
wholesaler at least every three years in accordance with proposed FINRA 
Rule 3110.13 (General Presumption of Three-Year Limit for Periodic 
Inspection Schedules) relating to non-branch locations.\164\
---------------------------------------------------------------------------

    \163\ ICI.
    \164\ ICI's October Letter.
---------------------------------------------------------------------------

    FINRA responded that it believes that the proposed annual 
inspection cycle in FINRA Rule 3110(c)(1)(A) remains appropriate for 
home offices of regional distributors where supervisory activities are 
occurring.\165\ FINRA stated that it believes that home offices of 
regional distributors or wholesalers that are not registered branch 
office locations and from which no supervision is occurring, should 
remain subject to the proposed periodic inspection cycle in FINRA Rule 
3110(c)(1)(C). FINRA noted that proposed FINRA Rule 3110.13 would 
provide members with the flexibility to use an inspection schedule 
period that is either shorter or longer than three years.\166\ FINRA 
also noted that if a member chooses to use a periodic inspection 
schedule longer than three years, the proposed supplementary material 
would require the member to properly document in its written 
supervisory and inspection procedures the factors used in determining 
why a longer periodic inspection cycle is appropriate for that 
location.\167\ Therefore, FINRA declined to make the changes suggested 
by the commenter.
---------------------------------------------------------------------------

    \165\ October Response and November Response.
    \166\ October Response and November Response.
    \167\ October Response and November Response.
---------------------------------------------------------------------------

4. Test and Verify Policies and Procedures Regarding Specified 
Activities
    Proposed FINRA Rule 3110(c)(2)(A) would relocate provisions in NASD 
Rule 3012 regarding the review and monitoring of specified activities, 
such as transmittals of funds and securities and customer changes of 
address and investment objectives. Specifically, proposed FINRA Rule 
3110(c)(2)(A) would require a member to test and verify a location's 
procedures for:
     Safeguarding of customer funds and securities;
     Maintaining books and records;
     Supervision of supervisory personnel;
     Transmittals of funds or securities from customers to 
third party accounts, from customer accounts to outside entities, from 
customer accounts to locations other than a customer's primary 
residence, and between customers and registered representatives, 
including the hand-delivery of checks; and
     Changes of customer account information, including address 
and investment objective changes and validation of such changes.
    With respect to the transmittal of funds or securities from 
customers to third party accounts, the proposal would eliminate NASD 
Rule 3012's parenthetical text (``i.e., a transmittal that would result 
in a change in beneficial ownership'') to clarify that all transmittals 
to an account where a customer on the original account is not a named 
account holder are included. One commenter to the Proposing Release 
objected to the deletion of the parenthetical, stating that it could 
expand application of the rule to transfers not currently captured by 
existing rule text, such as transfers from a joint account to an 
account of one of the joint account holders. The commenter suggested 
that the proposed change is inconsistent with contractual agreements 
involving joint account holders and member firms, potentially

[[Page 79554]]

conflicts with applicable state and federal laws, and impacts member 
firms' operations.\168\
---------------------------------------------------------------------------

    \168\ Schwab.
---------------------------------------------------------------------------

    FINRA responded that the deletion of the reference to beneficial 
ownership would aid in preventing conflict of law issues, as the 
meaning of that term may vary depending on the context in which it is 
used and the law applying to that situation.\169\ FINRA noted that the 
provision would not prohibit transfers to third-party accounts, but 
only requires a firm to have procedures for the monitoring of such 
transfers and a means of customer confirmation, notification, or 
follow-up that can be documented. FINRA stated that it believes that 
such follow-up procedures would provide an important investor 
protection function by verifying that the customer was aware of the 
transfer.
---------------------------------------------------------------------------

    \169\ October Response.
---------------------------------------------------------------------------

    Another commenter to the Proposing Release asked whether proposed 
FINRA Rule 3110(c)(2)(A)'s requirement to review changes of customer 
account information, including address and investment objective 
changes, requires a member to review all changes of customer account 
information.\170\ FINRA responded that, consistent with existing 
requirements,\171\ a member must review all changes of customer account 
information and not only address and investment objective changes.\172\ 
Examples of other changes to customer account information would 
include, without limitation, changes to a customer's name, marital 
status, telephone, email, or other contact information. FINRA noted 
that a firm may delegate reviews of such changes to an appropriately 
qualified person who is not a principal, unless another FINRA or SEC 
rule would require principal review (e.g., FINRA Rule 4515 (Approval 
and Documentation of Changes in Account Name or Designation) 
prohibiting an account name or designation change unless authorized by 
a qualified and registered principal designated by the member).
---------------------------------------------------------------------------

    \170\ ICI.
    \171\ See, e.g., NASD Rule 3010(c)(2)(F).
    \172\ October Response.
---------------------------------------------------------------------------

    Two commenters also requested that FINRA permit member firms to 
identify in their written supervisory or compliance procedures or other 
field manuals the activities enumerated in FINRA Rule 3110(c)(2)(A) 
that they do not engage in rather than requiring them to be documented 
in a location's written inspection report.\173\ FINRA noted that it had 
originally proposed, in Regulatory Notice 08-24, that a member must 
document the enumerated activities in which it did not engage in its 
written supervisory procedures, and that, it had revised the proposed 
rule change in response to commenters' concerns to retain the 
requirement that a member identify in a location's written inspection 
report any enumerated activities the member does not engage in at that 
location and document in that location's report that the member must 
have in place at that location supervisory policies and procedures for 
those activities before the location can engage in them.\174\
---------------------------------------------------------------------------

    \173\ FSI, ICI.
    \174\ October Response.
---------------------------------------------------------------------------

    In light of the continued comments, FINRA revised proposed Rule 
3110(c)(2)(D), in Amendment No. 1, to require members to identify in 
their written supervisory procedures or in the location's written 
inspection report the activities enumerated in FINRA Rule 3110(c)(2)(A) 
the member does not engage in at a particular location and document in 
their written supervisory procedures or that location's written 
inspection report that supervisory policies and procedures must be in 
place for those activities at that location before the member can 
engage in them. In FINRA's view, this would provide firms with 
additional flexibility in meeting the requirement, while still allowing 
an examiner to readily determine what enumerated activities a location 
does not engage in by referencing the firm's written supervisory 
procedures or the location's most recent inspection report.\175\
---------------------------------------------------------------------------

    \175\ October Response Letter.
---------------------------------------------------------------------------

5. Conflicts of Interest
    Commenters to the Proposing Release expressed concern that proposed 
FINRA Rule 3110(c)(3)(A) could be interpreted to create a new strict 
liability standard that would require members to eliminate all 
conflicts of interest with respect to a location's inspections \176\ 
and suggested revising the provision to provide more flexibility.\177\ 
FINRA responded by revising proposed FINRA Rule 3110(c)(3)(A) in 
Amendment No. 1 to require that a member have ``procedures reasonably 
designed to prevent the effectiveness of the inspections required 
pursuant to paragraph (c)(1) of this Rule from being compromised due to 
the conflicts of interest that may be present with respect to the 
location being inspected, including but not limited to, economic, 
commercial, or financial interests in the associated persons and 
businesses being inspected.'' \178\
---------------------------------------------------------------------------

    \176\ Cetera, IMS, SIFMA.
    \177\ CAI, IMS, SIFMA.
    \178\ October Response.
---------------------------------------------------------------------------

    One commenter to the Proposing Release also asked whether the 
requirement to consider the ``economic, commercial, or financial 
interests in the associated persons and businesses being inspected'' 
when determining if conflicts of interest have reduced inspection 
standards is intended to prohibit an OSJ principal from conducting 
inspections of branch and non-branch offices designated to that OSJ 
principal if he receives overrides from business conducted at that 
location.\179\ In Amendment No. 1, FINRA clarified that a member's 
procedures must take into consideration factors such as economic, 
commercial, or financial interests in the associated persons and 
businesses being inspected, when determining if members have procedures 
reasonably designed to reduce conflicts of interest that may be present 
with respect to a location being inspected.\180\ FINRA stated that the 
provision is not intended to address directly who a member may 
designate to inspect a location. FINRA further noted that a member 
assigning an OSJ principal to inspect a branch or non-branch office 
designated to that OSJ principal would need to ensure that it complies 
with proposed FINRA Rules 3110(c)(3)(B) (prohibitions regarding who may 
conduct inspections) and 3110(c)(3)(C) (limited exception from these 
prohibitions), which are discussed further below.
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    \179\ Cetera.
    \180\ October Response.
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6. Associated Persons Conducting Inspections
    Proposed FINRA Rule 3110(c)(3)(B) would generally prohibit an 
associated person from conducting a location's inspection if the person 
is either assigned to that location or is directly or indirectly 
supervised by someone assigned to that location. One commenter to the 
Proposing Release asked whether compliance personnel who operate 
independently from the branch office or OSJ to which they are assigned 
(and are supervised by the compliance manager and not by the branch 
office or OSJ manager) would be permitted to inspect such branch or 
OSJ.\181\ FINRA noted that the proposed provision would not prohibit 
compliance personnel assigned to a member's separate compliance 
department and supervised solely by the compliance department from

[[Page 79555]]

conducting a location's inspections.\182\ In FINRA's view, such an 
arrangement helps to protect against the potential conflicts of 
interest the provision is designed to address.
---------------------------------------------------------------------------

    \181\ ICI.
    \182\ October Response.
---------------------------------------------------------------------------

7. Reliance on the Limited Size and Resources Exception
    Proposed FINRA Rule 3110(c)(3)(C) would provide an exception for 
those members that cannot comply with proposed FINRA Rule 
3110(c)(3)(B)'s restrictions prohibiting certain associated persons 
from conducting a location's inspection, either because of a member's 
size or its business model. Proposed FINRA Rule 3110.14 (Exception to 
Persons Prohibited from Conducting Inspections) would set forth the 
general view that a member with only one office or an independent 
contractor business model will need to rely upon the exception.
    One commenter to the Proposing Release requested that FINRA amend 
proposed FINRA Rule 3110.14 to include home or administrative office 
personnel conducting home or administrative office inspections as one 
of the enumerated situations covered by proposed FINRA Rule 
3110.14.\183\ FINRA responded that proposed FINRA Rule 3110.14 would 
reflect FINRA's belief that a member will generally rely on the 
exception in instances where the member has only one office or has a 
business model where small or single-person offices report directly to 
an OSJ manager who is also considered the offices' branch office 
manager.\184\ FINRA noted that a member may still rely on the exception 
in proposed FINRA Rule 3110(c)(3)(c) in other instances provided it 
documents the factors the member used in making its determination that 
it needs to rely on the exception.\185\
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    \183\ CAI.
    \184\ October Response.
    \185\ In Amendment No. 1, FINRA sought to clarify that proposed 
FINRA Rule 3110.14 provides non-exclusive examples of situations 
where the exception would generally apply, by revising the provision 
to delete the term ``only'' prior to providing the examples.
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K. Comments on Proposed FINRA Rule 3110(d)

    Proposed FINRA Rule 3110(d)(1) (Transaction Review and 
Investigation) would require a member to have supervisory procedures to 
review securities transactions that are effected for a member's or its 
associated persons' accounts, as well as any other ``covered account,'' 
to identify trades that may violate the provisions of the Act, its 
regulations, or FINRA rules prohibiting insider trading and 
manipulative and deceptive devices. The proposed rule would also 
require members to promptly conduct an internal investigation into any 
such trade to determine whether a violation has occurred, and would 
require firms engaged in ``investment banking services'' to report 
information regarding these investigations to FINRA.
    Commenters to the Proposing Release expressed concerns related to 
the scope of the proposed definition of ``covered account'' and the 
extension of the reporting requirements to certain types of investment 
banking services that commenters asserted pose less risk of insider 
trading.
1. Definition of ``Covered Account''
    As proposed, FINRA Rule 3110(d)(3)(A) would have defined ``covered 
account'' as: (i) the accounts of parents, siblings, fathers-in-law, 
mothers-in-law, and domestic partners if the account is held at or 
introduced by the member and (ii) accounts that are reported to the 
member pursuant to NASD Rule 3050 (Transactions for or by Associated 
Persons) or Incorporated NYSE Rule 407 (Transactions--Employees of 
Members, Member Organizations and the Exchange), as applicable.\186\ 
Multiple commenters expressed concern about the breadth of the 
definition of ``covered account,'' and in particular the extension of 
the term to include more remote family members.\187\ Several commenters 
noted that the proposed definition went beyond the terms of existing 
NYSE rules and guidance, on which proposed Rule 3110(d) is based, and 
would create unnecessary difficulty for firms in monitoring trading in 
the accounts of more distant relatives, with whom an associated person 
may not have regular contact. Multiple commenters suggested that FINRA 
harmonize the scope of the term ``covered account'' with existing NYSE 
guidance and with SEC rules addressing similar types of concerns (e.g., 
the scope of the SEC's Code of Ethics rules for investment 
advisers).\188\
---------------------------------------------------------------------------

    \186\ One commenter sought to confirm that the proposed rule 
would not modify obligations imposed by NASD Rule 3050. See CAI. 
FINRA responded that nothing in proposed Rule 3110(d) would alter 
reporting obligations pursuant to other FINRA rules, including NASD 
Rule 3050.
    \187\ Brandenburger, CAI, FSI, ICI, IMS, Letter Type A, Putnam, 
SIFMA. Several commenters also expressed the view that the term 
``domestic partner'' was vague. See Brandenburger, CAI, FSI, IMS, 
Letter Type A. Because FINRA is proposing to narrow the scope of the 
term, including removing the reference to domestic partners, FINRA 
did not address this comment.
    \188\ CAI, ICI, IMS, Schwab, SIFMA, Wells Fargo. Some commenters 
also expressed concerns that expanding the scope of the definition 
could raise potential privacy issues relating to personal financial 
information. See CAI, FSI, ICI, IMS, Schwab, SIFMA, Wells Fargo. 
FINRA stated that it believes that these concerns were addressed in 
Amendment No. 1; however, FINRA does not believe the initial 
definitions implicated privacy concerns since the accounts covered 
by the rule must be introduced or carried by the firm.
---------------------------------------------------------------------------

    In response, FINRA revised the proposed rule in Amendment No. 1 to 
align the definition of ``covered account'' with existing NYSE 
guidance, which it noted has been in place since 1989.\189\ FINRA 
specified that under the revised definition, the term ``covered 
account'' would include any account introduced or carried by the member 
that is held by: (1) The spouse of a person associated with the member; 
(2) a child of the person associated with the member or such person's 
spouse, provided that the child resides in the same household as or is 
financially dependent upon the person associated with the member; (3) 
any other related individual over whose account the person associated 
with the member has control; or (4) any other individual over whose 
account the associated person of the member has control and to whose 
financial support such person materially contributes.\190\ In FINRA's 
view, the amended definition strikes an appropriate balance between 
ensuring that trading activity in the accounts that present the 
greatest risk of insider trading are reviewed while not imposing undue 
compliance burdens on firms.
---------------------------------------------------------------------------

    \189\ See NYSE Information Memo 89-17 (April 4, 1989).
    \190\ In addition to ``covered accounts,'' the proposed rule 
also applies to accounts of the member, accounts introduced or 
carried by the member in which a person associated with the member 
has a beneficial interest or the authority to make investment 
decisions, and accounts of a person associated with the member that 
are disclosed to the member pursuant to NASD Rule 3050 or 
Incorporated NYSE Rule 407, as applicable.
---------------------------------------------------------------------------

2. Internal Investigation Reporting
a. Definition of ``Investment Banking Services''
    As proposed, FINRA Rule 3110(d)(2) would impose reporting 
requirements for internal investigations undertaken by members that 
engage in ``investment banking services.'' Proposed FINRA Rule 
3110(d)(3)(B) would define the term ``investment banking services'' to 
include, without limitation, acting as an underwriter, participating in 
a selling group in an offering for the issuer, or otherwise acting in 
furtherance of a public offering of the issuer; acting as a financial 
adviser in a merger or acquisition; and providing venture capital or 
equity lines of credit or serving as placement agent for the issuer or 
otherwise acting in furtherance of a private offering of the issuer. 
Two

[[Page 79556]]

commenters to the Proposing Release questioned the definition of 
``investment banking services,'' noting that the term includes 
underwriting products that present less risk of insider trading, such 
as mutual funds and variable insurance products.\191\
---------------------------------------------------------------------------

    \191\ CAI, ICI.
---------------------------------------------------------------------------

    FINRA acknowledged that both commenters repeated objections to 
which FINRA responded in the Proposing Release. FINRA further noted 
that it does not believe that any of the categories of activities 
identified by the commenters should be categorically excluded from the 
definition of ``investment banking services'' given its limited use for 
the purposes of proposed FINRA Rule 3110.\192\
---------------------------------------------------------------------------

    \192\ October Response. Although one commenter asserted that 
``the proposed rule would require any member that engages in 
`investment banking services' to file with FINRA each quarter, a 
written report that is signed by a senior officer of the member,'' 
FINRA responded that, ``if a member did not have an open internal 
investigation or either initiate or complete an internal 
investigation during a particular calendar quarter, the member would 
not be required to submit a report for that quarter.'' See October 
Response; see also ICI.
---------------------------------------------------------------------------

    FINRA disagreed with the commenters' assertions that FINRA failed 
to take into account the potential costs and burdens to firms 
associated with adopting policies and procedures and systems to ensure 
compliance with the rule. FINRA noted that these entities are already 
subject to Section 15(g) of the Act, which requires all broker-dealers 
to ``establish, maintain, and enforce written policies and procedures 
reasonably designed . . . to prevent the misuse . . . of material, 
nonpublic information by such broker or dealer or any person associated 
with such broker or dealer.'' \193\ FINRA stated that firms are 
permitted to use a risk-based approach to monitoring transactions that 
takes into account a firm's specific business model, which would 
include the type of underwriting activity performed by the firm. In 
fulfilling their obligations, FINRA noted that firms may determine that 
certain departments or employees pose a greater risk and examine 
trading in those accounts accordingly. FINRA further noted that there 
is no implied obligation on firms as to how best to conduct the 
reviews. Thus, FINRA responded that it would expect that firms with 
underwriting activity limited to mutual funds may adopt significantly 
different review procedures than a firm engaged in more traditional 
investment banking activity. FINRA proposed to amend the rule in 
Amendment No. 1 to include the phrase ``reasonably designed'' to 
acknowledge more clearly that firms with different business models may 
adopt different procedures and practices.\194\ As amended, the proposed 
rule would require each member to include in its supervisory procedures 
a process for the review of securities transactions reasonably designed 
to identify trades that may violate the provisions of the Exchange Act, 
the rules thereunder, or FINRA rules prohibiting insider trading and 
manipulative and deceptive devices.\195\
---------------------------------------------------------------------------

    \193\ See Section L(2), page 31 of the October Response.
    \194\ FINRA noted that the ``reasonably designed'' standard 
already applied to the transaction review procedures required by the 
provision pursuant to the overarching language applicable to all of 
a member's procedures in paragraph (b)(1) of the proposed rule 
change. FINRA is proposing to repeat the phrase in paragraph (d) to 
avoid an implication that it did not already apply to the procedures 
governing transaction review.
    \195\ See Section L(2), page 32 of the October Response.
---------------------------------------------------------------------------

    In response to the Notice and Proceedings Order, one commenter 
restated its concern that mutual fund underwriters should be excluded 
from the definition of ``investment banking services.'' The commenter 
stated that FINRA disregarded or failed to consider ``the costs and 
burdens associated with members being required to establish, maintain, 
implement, and review on an ongoing basis policies and procedures to 
comply with each rule FINRA adopts, even those rules that do not apply 
to the member's business.\196\ FINRA stated that it continues to 
believe that the primary costs and burdens associated with the proposed 
rule change would arise in developing and implementing policies and 
procedures for reviewing transactions and conducting investigations, 
not in reporting those investigations to FINRA. FINRA also noted that 
it believes that the type of ``investment banking services'' in which a 
firm engages, and the relative level of risk of insider trading those 
activities present, may be a factor in assessing the reasonableness of 
such a firm's procedures; however, FINRA stated that it does not 
believe that it should affect the analysis of whether a firm engaged in 
``investment banking services'' has a reporting obligation once 
potentially violative trades have already been identified and internal 
investigations have begun.
---------------------------------------------------------------------------

    \196\ ICI's October Letter.
---------------------------------------------------------------------------

b. Required Investigation Reports
    One commenter to the Proposing Release stated that, in defining 
``investment banking services'' broadly, FINRA disregarded the 
cumulative effect a ``misapplied'' rule can have on a firm's compliance 
obligations and has substantially underestimated ``the unnecessary 
questions and confusion surrounding the rule's implementation that the 
firm is likely to face.'' \197\ FINRA noted that the commenter did not 
include examples of the types of questions or confusion that are likely 
to arise. FINRA responded that the reporting obligation is triggered 
only after an investigation has been initiated and that it believes 
that the primary costs and burdens associated with the proposed rule 
change would arise in developing and implementing policies and 
procedures and in conducting investigations, not in reporting those 
investigations to FINRA.\198\ FINRA noted that that certain types of 
``investment banking services'' may present less risk of insider 
trading than others, and firms are permitted to take these risks into 
account when developing their policies and procedures; however, FINRA 
stated that neither commenter offered an explanation as to why 
investigations should not be reported when the reports are only 
required after a firm has identified trades that may violate applicable 
laws or rules other than to note that these firms may pose less risk to 
begin with.\199\
---------------------------------------------------------------------------

    \197\ SIFMA.
    \198\ October Response.
    \199\ One commenter questioned the need for the rule at all in 
light of FINRA Rule 4530. See ICI. FINRA pointed to its previous 
statement that proposed FINRA Rule 3110(d) would require more 
targeted and detailed reporting than FINRA Rule 4530(b), which 
requires reporting only where a member concludes or reasonably 
should have concluded a securities-related law or rule was violated. 
Moreover, FINRA noted that Rule 4530 does not require firms to 
report every instance of noncompliant conduct. See Regulatory Notice 
11-06 (February 2011) (discussing scope of requirement to report 
internal conclusions of violation).
---------------------------------------------------------------------------

    FINRA maintained that it continues to believe that firms engaged in 
investment banking services should be required to report the results of 
their investigations to FINRA when these investigations are only 
required after a firm has already identified and begun investigating a 
trade that may violate the provisions of the Exchange Act, the rules 
thereunder, or FINRA rules prohibiting insider trading and manipulative 
and deceptive devices.\200\ FINRA further noted that, although the fact 
that certain firms may present a lower risk of insider trading may be a 
factor in assessing the reasonableness of a firm's procedures, FINRA 
does not believe it should affect the analysis of whether a firm has a 
reporting obligation once potentially violative trades have already 
been identified and investigated.
---------------------------------------------------------------------------

    \200\ October Response.
---------------------------------------------------------------------------

    One commenter to the Proposing Release stated that by not including 
any

[[Page 79557]]

materiality or reasonableness standard, the reporting requirement seems 
unduly broad and likely to result in reports on activity that 
ultimately is determined to be lawful.\201\ FINRA amended the proposed 
rule language in Amendment No. 1 to include the phrase ``reasonably 
designed'' to acknowledge more clearly that firms with different 
business models may adopt different procedures and practices. The same 
commenter restated its recommendation in a second letter requesting 
that FINRA more formally incorporate guidance from NYSE Information 
Memo 06-06 into the rule's supplementary material to address the scope 
of the rule's investigation and reporting requirements.\202\ FINRA 
responded that it does not believe that it is necessary to adopt the 
guidance from NYSE IM 06-06 as supplementary material.\203\
---------------------------------------------------------------------------

    \201\ ICI.
    \202\ ICI's October Letter.
    \203\ November Response.
---------------------------------------------------------------------------

    FINRA noted that it agrees with the guidance from NYSE IM 06-06 
that not all reviews will result in an internal investigation. FINRA 
further noted that it also agrees that, as part of implementing a 
firm's risk-based approach to these requirements, a firm's procedures 
should include establishing guidelines or criteria for taking 
reasonable follow-up steps to determine which trades are potentially 
violative trades and, therefore, merit further review through an 
internal investigation. Similar to the guidance set forth in NYSE IM 
06-06, FINRA stated that it does not expect that every trade 
highlighted in an exception or other report would require a firm to 
conduct an internal investigation and FINRA would expect that ``firms 
that utilize such reports will maintain additional written procedures 
that set forth guidelines or criteria for reasonable follow-up steps 
for determining which trades initially highlighted merit further 
review.'' \204\
---------------------------------------------------------------------------

    \204\ See Section 2(F), page 11 of November Response.
---------------------------------------------------------------------------

L. Comments on Proposed FINRA Rule 3110(e)

    Proposed FINRA Rule 3110(e) (Definitions) retains, without change, 
the definition of ``branch office'' in NASD Rule 3010(g) (Definitions). 
The definition specifically excludes some locations from being 
considered a branch office, including an associated person's primary 
residence, if certain conditions are met. However, if any excluded 
location, including an associated person's residence, is responsible 
for supervising the activities of a member's associated persons at one 
or more non-branch locations, the location is considered a branch 
office.
    Commenters to the Proposing Release suggested that FINRA either 
revise the branch office definition to exclude mutual fund regional 
distributors and wholesalers who operate out of their homes but conduct 
no retail business or have any interaction with retail customers at 
such locations \205\ or eliminate the distinctions among OSJs, branch 
offices, and a registered person's home office and require annual 
audits for all offices other than the main office that are over a 
certain minimum business threshold (e.g., $300,000 in annual 
sales).\206\
---------------------------------------------------------------------------

    \205\ ICI.
    \206\ Sweeney.
---------------------------------------------------------------------------

    In response, FINRA noted that the branch office definition is being 
transferred unchanged from current NASD Rule 3010(g). FINRA explained 
that the uniform branch office definition was developed in 2005 after 
several years of discussions with the NYSE, NASAA, and NASD. In FINRA's 
view, the current definition provides appropriate exemptions from 
registration, and that those exemptions should not be expanded at this 
time. FINRA further explained that the OSJ definition, which industry 
members have relied upon for many years in designing their supervisory 
systems, is also being transferred unchanged from NASD Rule 3010(g). 
FINRA also noted that adopting a location audit requirement based 
solely on a specified sales threshold could exclude many offices 
engaging in activities enumerated in the OSJ definition from being 
inspected.
    In response to the Notice and Proceedings Order, a commenter 
restated its request that FINRA revise proposed FINRA Rule 
3110(e)(2)(B) to exclude from the definition of ``branch office'' the 
homes of regional distributors and wholesalers of mutual fund 
underwriters. The commenter suggested that FINRA revise the provision 
to include the statement that ``[t]he provisions of this subparagraph 
(2)(b) shall not apply to any location that qualifies for the exclusion 
in subparagraph (2)(a) if such location is used exclusively by an 
associated person of a member whose business qualifies for the 
exemption in SEA Rule 15c3-3(k)(1).'' \207\ The commenter further 
suggested that FINRA not subject such home offices to the inspection 
requirements for supervisory branch offices and non-branch locations. 
In its comments to the Proposing Release, the commenter questioned the 
regulatory or public purpose to be served by FINRA presuming that all 
members should conduct an inspection of each home of a regional 
distributor or wholesaler at least every three years in accordance with 
proposed FINRA Rule 3110.13 (General Presumption of Three-Year Limit 
for Periodic Inspection Schedules) relating to non-branch 
locations.\208\ The commenter indicated that FINRA's previous response 
did not sufficiently address its concerns regarding the treatment as 
branch offices of such personal residences that are not held out to the 
public and do not conduct a public securities business.
---------------------------------------------------------------------------

    \207\ ICI's October Letter.
    \208\ Id.
---------------------------------------------------------------------------

    FINRA declined to amend proposed FINRA Rule 3110's branch office 
definition.\209\ FINRA noted that the commenter's request to exclude 
from the branch office definition the homes of regional distributors 
and wholesalers of mutual fund underwriters based on the exemption 
provided in Rule 15c3-3(k)(1) of the Exchange Act would be over-broad 
as that exemption would extend beyond mutual fund underwriters. FINRA 
stated that when supervisory activities occur at such locations, it 
does not believe that an exclusion from the branch office definition is 
appropriate for regional distributors working from home offices and 
that such an exclusion would undermine the core principle underlying 
the registration of branch offices and OSJs that recognizes the 
critical nature of locations where supervision is occurring.
---------------------------------------------------------------------------

    \209\ November Response.
---------------------------------------------------------------------------

M. Comments on Proposed FINRA Rule 3120

    Proposed FINRA Rule 3120 (Supervisory Control System) requires a 
member to test and verify its supervisory procedures and prepare and 
submit to its senior management a report at least annually summarizing 
the test results and any necessary amendments to those procedures. The 
proposed rule also requires a member that reported $200 million or more 
in gross revenue (total revenue less, if applicable, commodities 
revenue) on its FOCUS reports in the prior calendar year to include 
additional content in the report it submits to senior management. The 
required additional content includes a tabulation of the reports 
pertaining to the previous year's customer complaints and internal 
investigations made to FINRA. Also, the report must include a 
discussion of the preceding year's compliance efforts, including 
procedures and educational

[[Page 79558]]

programs, in each of the following areas: (1) Trading and marketing 
activities; (2) investment banking activities; (3) antifraud and sales 
practices; (4) finance and operations; (5) supervision; and (6) anti-
money laundering.
    One commenter requested that FINRA exclude mutual fund underwriters 
from the additional content requirements because those firms, which may 
meet the $200 million threshold solely through receipt of 12b-1 fees, 
are not the type of ``complex'' firms FINRA intended to address when 
proposing the additional content requirements.\210\ FINRA responded 
that the additional content requirements are incorporated from the 
annual report content requirements of Incorporated NYSE Rule 342.30 
(Annual Report and Certification) that provide valuable information for 
FINRA's regulatory program.\211\ FINRA also stated that this 
information will be valuable compliance information for the senior 
management of the firm. FINRA noted that some content requirements 
relate to regulatory obligations, such as supervision and anti-money 
laundering, that apply to all member firms, regardless of their 
business activities. Because all the content requirements are not 
relevant to every firm, FINRA revised proposed FINRA Rule 3120, in 
Amendment No.1, to clarify that a member's report must include the 
additional content, to the extent applicable to the member's 
business.\212\
---------------------------------------------------------------------------

    \210\ ICI. ICI alternatively suggested that FINRA exclude from 
proposed FINRA Rule 3120's ``gross revenue'' definition any 12b-1 
revenues a mutual fund underwriter receives.
    \211\ See October Response; see also Regulatory Notice 08-24 
(noting that the supplemental information in Incorporated NYSE Rule 
342.30's annual report was a valuable tool for the NYSE regulatory 
program and would also be valuable information for FINRA's 
regulatory program going forward).
    \212\ In addition, FINRA is revising proposed FINRA Rule 3120 to 
delete references to the MSRB rules, consistent with the deletion of 
such reference in proposed FINRA Rule 3110(a) discussed above.
---------------------------------------------------------------------------

    The same commenter restated its request for FINRA to revise 
proposed FINRA Rule 3120 to exclude mutual fund underwriters from the 
proposed rule's additional content requirement.\213\ The commenter 
suggested that FINRA revise proposed FINRA Rule 3120 to avoid having 
12b-1 fees (characterized by the commenter as pass-through revenues) 
counted as the member's gross revenue for purposes of calculating the 
additional content requirements' $200 million threshold. FINRA noted 
that the commenter did not indicate how a mutual fund underwriter's 
gross revenue calculation, which may vary depending on the amount of 
12b-1 fees, is different from other members with gross revenue 
calculations that may vary significantly depending on the amount and 
nature of revenue received.\214\ For these reasons, FINRA responded 
that it continues to believe the rule should require each member 
meeting the specified threshold to provide the additional content, to 
the extent applicable to its business.
---------------------------------------------------------------------------

    \213\ ICI October Letter.
    \214\ November Response.
---------------------------------------------------------------------------

N. Comments Outside the Scope of the Proposal

    One commenter, while recognizing the statutory framework applicable 
to proposed SRO rulemaking, nonetheless requested additional time to 
review, analyze, and develop comment letters for more comprehensive 
FINRA rule changes.\215\ Another commenter suggested that firms should 
make available to the ``public investor education facilities'' 
regarding their products, activities, and services.\216\ One commenter 
suggested that a firm's compliance and ongoing oversight of its 
associated persons' outside business activities (``OBA'') could be 
further enhanced through updates of OBA information captured by FINRA's 
Central Registration Depository.\217\ Another commenter suggested that, 
in addition to FINRA Rule 3270's (Outside Business Activities of 
Registered Persons) requirement that a registered person provide a firm 
with written notice prior to engaging in any OBA, that FINRA should 
require firms to supervise OBAs.\218\ The same commenter also suggested 
that FINRA require firms to prevent the ``spoilation of evidence'' once 
it is reasonably foreseeable that an arbitration might be filed. One 
commenter suggested that FINRA draft standard, pro forma, baseline 
written supervisory procedures that firms can adapt to their 
businesses.\219\ FINRA responded that it appreciates the commenters' 
input on these matters, but it considers these comments to be outside 
the scope of the current proposal.
---------------------------------------------------------------------------

    \215\ CAI. See Exchange Act Section 19(b) for the statutory 
framework for SRO rulemaking.
    \216\ Arnoff. This commenter also suggested that the proposed 
consolidated supervision rules be tested for efficacy based on risk-
based considerations in specified topical areas (e.g., supervisory 
depth, avoidance of supervisory conflicts, suitability, best 
execution, prevention of unauthorized trading, systemic problems, 
defined responsibility and non-delegable duties, customer 
complaints). FINRA responded that it also considers this comment to 
be outside of the scope of the proposal, but that it would expect 
these matters to be considered as part of a member's establishment 
of a supervisory system and procedures reasonably designed to 
achieve compliance with the federal securities laws and FINRA rules, 
and the testing and verification of such procedures under FINRA Rule 
3120.
    \217\ NFP.
    \218\ PIABA. FINRA Rule 3270.01 also requires that, upon receipt 
of a written notice, a firm must consider whether the proposed 
activity will: (1) interfere with or otherwise compromise the 
registered person's responsibilities to the firm and/or the firm's 
customers or (2) be viewed by customers or the public as part of the 
firm's business based upon, among other factors, the nature of the 
proposed activity and the manner in which it will be offered. In 
addition, based on the firm's review of such factors, the firm must 
evaluate the advisability of imposing specific conditions or 
limitations on a registered person's outside business activity, 
including where circumstances warrant, prohibiting the activity. A 
firm also must evaluate the proposed activity to determine whether 
the activity properly is characterized as an outside business 
activity or whether it should be treated as an outside securities 
activity subject to the requirements of NASD Rule 3040 (Private 
Securities Transactions of an Associated Person).
    \219\ IMS. FINRA noted that although it considers IMS's comment 
to be outside the scope of the proposal, FINRA's Tools Web page 
includes a ``WSP Checklist'' that members may consult when drafting 
or revising their written supervisory procedures.
---------------------------------------------------------------------------

IV. Commission Findings

    The Commission has carefully reviewed the proposed rule change, the 
comments received, and FINRA's responses to comments, and finds that 
the proposed rule change, as modified by Amendment No. 1, is consistent 
with the requirements of the Act and the rules and regulations 
thereunder applicable to a national securities association. In 
particular, the Commission finds that the proposed rule change is 
consistent with Section 15A(b)(6) of the Act,\220\ which, among other 
things, requires that FINRA rules be designed to prevent fraudulent and 
manipulative acts and practices, to promote just and equitable 
principles of trade, and, in general, to protect investors and the 
public interest. In addition, the Commission finds that the proposed 
rule change is consistent with Section 15A(b)(9) of the Act,\221\ in 
that the proposed rules do not impose any unnecessary or inappropriate 
burden on competition.
---------------------------------------------------------------------------

    \220\ 15 U.S.C. 78o-3(b)(6).
    \221\ 15 U.S.C. 78o-3(b)(9).
---------------------------------------------------------------------------

    The Commission believes that FINRA, through its responses and 
through proposed changes in Amendment No. 1, has addressed commenters' 
concerns, other than those that it determined are outside the scope of 
the current proposal. The proposed rule change was informed by FINRA's 
consideration of, and the incorporation of many suggestions made in 
comments on the 2011 Filing, the Proposing Release, and the Notice and 
Proceeding Order. Proposed Amendment No. 1 reflects FINRA's efforts to 
further address

[[Page 79559]]

commenter concerns and minimize burdens resulting from the proposed 
rule's requirements. Additionally, many of the amendments are designed 
to revert to existing requirements in the NASD and NYSE rules. For 
example, in Amendment No. 1, FINRA proposed to respond to commenter 
concerns by, among other things:
     Deleting references to MSRB rules, noting that members are 
separately obligated to comply with MSRB Rule G-27;
     Deleting proposed FINRA Rule 3110.03 (One-Person OSJs), in 
light of comments concerning the negative impact and costs of the 
proposed requirement, especially for independent firms; \222\
---------------------------------------------------------------------------

    \222\ The Commission notes that FINRA urges firms to conduct 
focused reviews of one-person OSJs that conduct sales-related 
activity.
---------------------------------------------------------------------------

     Replacing the presumption in proposed FINRA Rule 3110.03 
(Supervision of Multiple OSJs by a Single Principal) that assigning one 
principal to be the on-site principal at more than two OSJs is 
unreasonable with a general statement that assigning a principal to 
more than one OSJ will be subject to scrutiny;
     Modifying proposed Rule 3310.05 to incorporate additional 
clarification regarding a member's risk-based review system;
     Clarifying in proposed FINRA Rules 3110(b)(6)(D) and 
3110(c)(3)(A) that the provisions do not create a strict liability 
obligation requiring identification and elimination of all conflicts of 
interest;
     Revising the definition of ``covered account'' in proposed 
FINRA Rule 3110(d) to align the definition with existing NYSE guidance; 
and
     Clarifying in proposed FINRA Rule 3120(b) that a firm must 
only comply with the requirement to include certain additional content 
in its report to senior management only to the extent applicable to the 
member's business, noting that not all the content requirements are 
relevant to every firm.
    Additionally, in its responses, FINRA provided guidance and 
clarifications concerning the provisions noted above and other 
provisions, as well as general matters, about which commenters raised 
concerns. For example, FINRA responded to comments concerning 
costs,\223\ the application of a risk-based approach,\224\ review of 
correspondence and internal communications,\225\ review of 
transactions,\226\ review of customer complaints,\227\ and maintenance 
and communication of written supervisory procedures,\228\ among others.
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    \223\ See supra Sections III(D)(2), III(F)(1), and III(K)(2).
    \224\ See supra Sections III(E)(1), III(F)(1), and III(F)(2).
    \225\ See supra Section III(F).
    \226\ See supra Section III(E).
    \227\ See supra Section III(G).
    \228\ See supra Section III(I).
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    In approving this proposed rule change, the Commission has 
considered the proposed rule's impact on efficiency, competition, and 
capital formation.\229\ As discussed above, the Commission believes 
that the proposed rule change, as amended by Amendment No. 1, is 
consistent with Sections 15A(b)(6) and 15A(b)(9) of the Act. The 
Commission ``has long emphasized that the responsibility of broker-
dealers to supervise their employees is a critical component of the 
federal regulatory scheme.'' \230\ By harmonizing current NASD and NYSE 
supervisory rules into one consolidated FINRA rulebook, the proposed 
rule will protect investors and the public interest while also 
enhancing efficiency. Among other things, the proposed rule would 
incorporate additional flexibility in some instances by permitting 
firms to implement risk-based principles consistent with a firm's 
business model. The proposed rule also takes into account potential 
inefficiencies that firms could experience if FINRA adopted the 
expanded definition of ``covered accounts.'' As a result, FINRA amended 
the definition in Amendment No. 1 to align it with current guidance.
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    \229\ See 15 U.S.C. 78c(f).
    \230\ SEC, Division of Market Regulation (now known as, Division 
of Trading and Markets), Staff Legal Bulletin No. 17: Remote Office 
Supervision (March 19, 2004).
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    The Commission also believes that the proposed rule takes into 
account competitive concerns that could arise from different 
supervisory approaches for different product lines, business models, 
business size, and resources. Moreover, by permitting a risk-based 
principles approach when applying certain supervisory standards, the 
proposed rule is designed to allow firms to implement supervisory 
policies and procedures and programs in a manner consistent with their 
business models.
    The Commission has reviewed the record for the proposed rule change 
and notes that the record does not contain any information to indicate 
that the proposed rule would have a significant effect on capital 
formation. The Commission believes that the effect of the proposed rule 
is beneficial and that the changes will enhance investor confidence by 
promoting robust supervisory policies and procedures, programs, and 
controls that can be flexibly applied to account for member firms' 
business models.

V. Conclusion

    It is therefore ordered, pursuant to Section 19(b)(2) of the 
Act,\231\ that the proposed rule change (SR-FINRA-2013-025), as 
modified by Amendment No. 1 be, and hereby is, approved.

    For the Commission, by the Division of Trading and Markets, 
pursuant to delegated authority.\232\
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    \232\ 17 CFR 200.30-3(a)(12).
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Kevin M. O'Neill,
Deputy Secretary.
[FR Doc. 2013-31134 Filed 12-27-13; 8:45 am]
BILLING CODE 8011-01-P


