Supervisory Systems - Written Supervisory Procedures

NASD (now known as FINRA) Rule 3010 requires that member firms maintain a supervisory system for their registered representatives. Written procedures must be created to ensure oversight of the representatives' activities in handling customer accounts. These procedures must be kept and maintained in each Office of Supervisory Jurisdiction (OSJ) and at each location where supervisory activities are conducted on behalf of the member. Furthermore, each registered representative must be assigned to a specific principal for supervision.

The OSJ: Definition
An OSJ is any office location of a member where the following activities occur:

  • Approval of new accounts
  • Approval of advertising
  • Order execution
  • Custody of customer funds or securities
  • Review of customer orders

Supervision of registered representatives includes the following issues:

  • Investigating qualifications: Members must investigate the good character, business repute, qualifications, and experience of any person prior to making such a certification in the application of such person for registration.

  • Notice of outside employment: The representative must provide written notice to the member firm before taking on any outside employment or business activity in order to ensure no conflict of interest arises from such activity.

  • Regulation of securities transactions: The member firm must be notified of any account opened for the representative at another securities firm, and may request duplicate account statements. Also, the representative must not participate in any private securities transactions without prior written notice to the employer. An exception to this rule exists for mutual fund accounts and variable contracts registered under the Investment Company Act of 1940.

In addition to these activities, the OSJ principal has the following responsibilities:

  • Approve customer correspondence
  • Review and approve new accounts
  • Maintain records of customer complaints and what actions were taken to resolve the issue
  • Review and endorse securities order tickets
  • Approve advertising and sales literature prior to use
  • Enforce the broker-dealer's written supervisory procedures
  • Periodic inspection of branch offices
  • Annual compliance review

Branch Office: Definition
A branch office includes an office where the representative advertises the location as a branch office and directly or indirectly contributes a substantial portion of the office's operating expenses. Branch offices must have a registered principal designated to supervise representatives, but a principal is not required to be located at the branch.

In a 2005 notice numbered 05-67, the SEC approved an important amendment to the definition of branch office, effective May 1, 2006. The amendment was devised in an effort "to provide reasonable exceptions from branch office registration", without compromising investor protection. These exceptions, as stated in notice 05-67, include:

  • a location that operates as a non-sales location/back office;

  • a representative's primary residence provided it is not held out to the public and certain other conditions are satisfied;

  • a location, other than the primary residence, that is used for less than 30 business days annually for securities business, is not held out to the public as an office, and which satisfies certain of the conditions set forth in the primary residence exception;

  • a location of convenience used occasionally and by appointment;

  • a location used primarily for non-securities business and from which less than 25 securities transactions are effected annually;

  • the floor of an exchange; and

  • a temporary location used as part of a business continuity plan.

Look Out!
Remember that a branch office does not have the same responsibilities as an OSJ. Also, having a principal located at a branch office does not convert the branch to an OSJ.

Annual Inspections and Compliance Meetings
Registered principals must conduct internal inspections at least once a year to ensure compliance with securities laws. These inspections must include a review of customer account records to detect irregularities and ensure compliance.

Members must conduct these inspections at least annually for OSJs and branch offices that have supervisory responsibility over one or more non-branch offices. Branch offices that don't supervise any non-branch offices must be inspected at least once every three years.

A further requirement is that each registered representative must participate in an annual meeting with a designated supervisory person to discuss compliance matters. These meetings may be held individually or in a group setting and must discuss compliance issues that are relevant to registered persons' business activities.

Outsourcing Activities to Third-Party Service Providers
In a July 2005 NASD (now know nas FINRA) Notice to Members (05-48), there was a reminder to members of a few important rules regarding outsourcing.

Even though certain firm functions may be performed by a third-party, the member firm is still responsible for ensuring the third party is complying with federal securities rules and regulations, and FINRA and MSRB rules. This includes conducting a due diligence analysis.

The following functions and activities cannot be outsourced:

  • Activities and Functions Requiring Registration and Qualification
    • Exception: where the third-party is a registered broker-dealer and the arrangement follows federal, FINRA, and MSRB rules. Ie. NASD (now known as FINRA) Rule 3230

  • Supervisory and Compliance Activities
    • Exception: Although a firm cannot contract a third party to supervise their activities, they can implement a system designed by a third party that detects rule violations. However, the firm is responsible for ensuring the software is up to date and functions in compliance with rules and regulations.
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