The press has recently reported on a number of high-profile criminal prosecutions and civil matters involving questionable sales practices and potentially fraudulent activity by certain introducing firms, and the handling of customer complaints about those firms by their clearing firms. Such scrutiny and its resulting pressure prompted the National Association of Securities Dealers Regulation (NASDR) and the New York Stock Exchange (NYSE) to propose amendments to their respective rules governing the relationship between clearing firms and their client introducing firms. The Securities and Exchange Commission (SEC) recently approved amendments to NYSE Rule 382 and NASD Rule 3230, which govern clearing agreements between members. The amendments will become effective July 19, 1999 (with some 90 day variances to initially comply) and generally address
(1) the handling of customer complaintsabout introducing firms that are received by their clearing firms;
(2) exception and other reportsclearing firms make available to their introducing firm clients to assist them in their supervisory obligations; and
(3) clearing firms granting their introducing firm clients check writingprivileges on the clearing firm’s account.

This article addresses the changes to the NASD's rules.

Clearing firms generally forward to their introducing firms customer complaints they receive relating to matters that are the responsibility of the introducing firm. Although NASD Rule 3070 required a member to report to the NASD any written customer complaint against it involving allegations of theft or misappropriation of funds or securities or of forgery, some confusion had arisen over whether a customer complaint sent only to the clearing firm was properly deemed "received" by the introducing firm (and whether such needed to be reported by the clearing firm to the NASD). Accordingly, the regulators saw a pattern of late or delayed reporting arising from clearing-firm-received complaints about introducing firms

Consequently, the NASD added new paragraph 3230(b)(1) requiring the clearing firm to forward the complaint to the introducing firm and send a copy of the complaint to the introducing firm’s Designated Examining Authority (DEA). In addition, new paragraph (b)(2) requires the clearing firm to notify the customer in writing that the complaint was received, and was forwarded to the introducing firm and to the introducing firm’s DEA.

New paragraph (c)(1) requires the clearing firm to initially and annually provide each introducing firm a list or description of all exception or other reports that it offers to the introducing firm to assist it in supervising its activities, monitoring its accounts, and carrying out its functions and responsibilities under the clearing agreement. Failure to provide notification would not only be a violation of Rule 3230, but also of Rule 3010, which requires that members establish and maintain proper supervisory systems.

Some clearing firms do not actually create supervisory reports, but instead provide data and data formatting software to their introducing clients that allow the introducing firms to prepare their own reports. New section (c)(2) provides for compliance under such circumstances by permitting the clearing firm to communicate the data and data formatting available. The clearing firm will be required to retain, as part of its books and records, copies of any reports requested or provided to the introducing firm. However, the clearing must be able either to recreate the report or provide the data and data formatting that was used to prepare the report.

New paragraph (c)(3) requires that each year, no later than July 31, the clearing member must notify the introducing member’s chief executive and compliance officers of the reports offered to the introducing member pursuant to paragraph (c)(1), and the reports requested by or supplied to the introducing firm as of such date. The clearing member must also provide a copy of the notice to the introducing firm’s DEA. Clearing firm members and their introducing firm clients will be expected to provide notice of the exception reports available, the reports they are requesting, and the notices specified under the provisions of paragraphs (c)(1) and (c)(3) 90 days after the effective date of these amendments, or October 18, 1999.

Under new paragraph (d), the clearing agreement may permit the introducing firm to issue checks to the introducing firm’s customers that are drawn on the clearing member’s account upon written representation from the introducing firm that it has established, and will maintain and enforce, supervisory procedures with respect to the issuance of negotiable instruments. Clearing firm members will be required to comply with the requirements of paragraph (d) with respect to all new agreements on the effective date of the amendments (July 19, 1999). With respect to all existing agreements, as of October 18, 1999, members will be required to revoke check writing privileges unless the requirements of paragraph (d) have been complied with.

3230. Clearing Agreements
(a) All clearing or carrying agreements entered into by a member, except where any party to the agreement is also subject to a comparable rule of a national securities exchange, shall specify the respective functions and responsibilities of each party to the agreement and shall, at a minimum, specify the responsibility of each party with respect to each of the following matters:
(1) opening, approving and monitoring customer accounts;
(2) extension of credit;
(3) maintenance of books and records;
(4) receipt and delivery of funds and securities;
(5) safeguarding of funds and securities;
(6) confirmations and statements;
(7) acceptance of orders and execution of transactions;
(8) whether, for purposes of the Commission’s financial responsibility rules adopted under the Act, and the Securities Investor Protection Act, as amended, and regulations adopted thereunder, customers are customers of the clearing member; and
(9) the requirement to provide customer notification under paragraph [(d)] {(g)} of this Rule.

{(b) (1) In order for the introducing member to carry out its functions and responsibilities under the agreement, each clearing member must forward promptly any written customer complaint received by the clearing member regarding the introducing member or its associated persons relating to functions and responsibilities allocated to the introducing member under the agreement directly to: (A) the introducing member; and (B) the introducing member’s examining authority designated under Section 17 of the Act ("DEA") (or, if none, to its appropriate regulatory agency or authority). The clearing or carrying agreement must specifically direct and authorize the clearing member to do so.} {(2) The clearing member must also notify the customer, in writing, that it has received the complaint, and that the complaint has been forwarded to the introducing member and to the introducing member’s DEA (or, if none, to its appropriate regulatory agency or authority).}
{(3) Pursuant to the 9600 Series, the Association may exempt a member or person associated with a member from the requirements of this paragraph for good cause shown in instances where the introducing organization is an affiliated entity of the carrying organization.}

{(c) (1) A clearing member, when it enters into a clearing agreement, must immediately, and annually thereafter, provide the introducing member a list or description of all reports (exception and other types of reports) which it offers to the introducing member to assist the introducing member in supervising its activities, monitoring its customer accounts, and carrying out its functions and responsibilities under the clearing agreement. The introducing member must notify promptly the clearing member, in writing, of those specific reports offered by the clearing member that the introducing member requires to supervise and monitor its customer accounts.}
{(2) The clearing member must retain as part of its books and records required to be maintained under the Act and the Association’s rules, copies of the reports requested by or provided to the introducing member. For purposes of this Rule, the clearing member will be in compliance with the requirements of this paragraph if it retains the data from which the original report was produced, provided, the clearing member can, at the request of the DEA (or, if none, to its appropriate regulatory agency or authority), either (A) recreate the report; or (B) provide the data and the data formatting that was used to prepare the report.}
{(3) Each year, no later than July 31, the clearing member must notify in writing the introducing member’s chief executive and compliance officers of the reports offered to the introducing member pursuant to paragraph (c)(1) and the reports requested by or supplied to the introducing member as of such date. The clearing member must also provide a copy of the notice to the introducing member’s DEA (or, if none, to its appropriate regulatory agency or authority).}
{(4) Pursuant to the 9600 Series, the Association may exempt a member or person associated with a member from the requirements of this paragraph for good cause shown in instances where the introducing organization is an affiliated entity of the carrying organization.}

{(d) The clearing or carrying agreement may permit the introducing member to issue negotiable instruments directly to the introducing member’s customers using instruments for which the clearing member is the maker or drawer. The clearing member may not grant the introducing member the authority to issue negotiable instruments until the introducing member has notified the clearing member in writing that it has established, and will maintain and enforce, supervisory procedures with respect to the issuance of such instruments that are satisfactory to the carrying organization.}