July 29, 2002

When Size Counts:
what's a small NASD member? 

By Bill Singer

Bill Singer is a securities-industry attorney who may be contacted at  917-520-2836 or by e-mail at bsinger@rrbdlaw.com .  

Following on the heels of our recent announcements that a dissident group of NASD member firms was forming to undertake a contested election for the upcoming Board of Governors, I received a number of calls from the press and curious industry participants.  Is this really a problem? Reporters wanted to know how we felt about the existing efforts of the NASD's Small Firm Advisory Committee or about the many public statements issuing forth from the SRO about increasing sensitivity to smaller firms.  The response of many of the dissidents is that too much energy is being expended on cosmetic, feel-good projects while the core concerns and problems remain unaddressed.

On July 26, 2002 the NASD issued Notice to Members 02-44:  NASD Requests Comment on Application of Rule  2711 to Small Firms; Comment Period Expires on  August 30, 2002.  More than anything, this NTM illustrates the chasm that remains between those in power at NASD and the majority of the organization's membership.  The NTM explains that nearly three months ago on May 10, 2002, the Securities and Exchange Commission (SEC) approved new NASD Rule 2711: Research Analysts and Research Reports,which NASD claims is intended to address potential conflicts of interest in the issuance of research reports by members, improve the objectivity of research, and provide investors with more useful and reliable information when making investment decisions. 

As I and others have warned, one of the great dangers with the recent regulatory and political efforts to reform several unsavory (if not illegal) practices is that Wall Street has become a deer caught in the headlights.  Essentially, those who normally speak up and urge caution are silenced by the profound and overwhelming nature of industry misconduct.  It is neither politic nor comfortable to come to the aid of this industry under attack, particularly when many of the criticisms are justified and substantiated.  Nonetheless, the critical balance of powers and interests is out of whack --- dangerously so.  Consequently, the body of Wall Street is under the knife and many of the attending physicians are amateurs, unskilled, and pursuing hidden agendas.

In my opinion the NASD's recent rush to promulgate Rule 2711 is a typical example of the dangers of the missing counterbalance.  In response to requests from some of its smaller members, on July 1, 2002, approximately three weeks afterthe SEC approved the very same Rule, NASD filed another proposed rule change seeking to delay the implementation for smaller members of sections (b) and (c)  to November 6, 2002. Rules 2711(b) and (c) prohibit a research analyst from being subject to the supervision or control of the member's investment banking department and require compliance personnel to intermediate certain communications between research, investment banking,  and the company that is the subject of the research report. These delaying amendments would apply to members that over the previous three years, on average each year, have: participated in 10 or fewer investment banking transactions as manager or co-manager; and generated no more than $5 million in gross investment banking revenues from those transactions.  

The NASD then poses four enumerated questions.

1. Conflicts of Interest
Are the research reports issued by smaller firms any more or less objective than those issued by larger firms? What factors account for any differences in objectivity? To what extent do the conflicts of interest faced by smaller firms differ from those faced by larger firms? 

2. Conflicts Procedures
If smaller firms have adopted procedures, other than those required by Rule 2711, to address these conflicts, how effective have any such procedures been? 

3. Burden
Does any provision of Rule 2711 impose a burden that is unique to smaller firms. Does any unique burden outweigh any potential benefit to the investing public, and thus justify an exemption for smaller firms? 

4. Definition of Small Firm
What would be the best method to differentiate between firms that should be eligible for the exemption and those that should not be eligible? Is the transactions and revenues test that was adopted for the delaying amendment appropriate? Are there factors other than the number of investment banking transactions or the amount of investment banking revenues that NASD should consider in determining which members are "small firms"? 

Okay, I'll ask the questions we're all wondering: Why hadn't' the NASD given adequate consideration to the unique needs of its so-called smaller firms before submitting the rule proposal to SEC?  Why did the NASD first reconsider its proposals in the face of complaints from smaller members?  Why does NASD continue to reject the implementation of an Office of the Members' Advocate, which would have specifically vetted the very concerns now belatedly under review?  Given all the alleged small firm representatives at NASD --- on the Board, Committees, and Subcommittees --- why do these missteps continue to occur over and over?  Clearly, if asked, the present dissident group would explain that NASD needs more activist smaller firm members involved in its deliberations.

These issues are not new and are not being raised for the first time as part of some divisive agenda to destabilize NASD.  If you don't believe the roots of these historic disagreements, I would ask interested readers to visit Order Granting Approval to Proposed Rule Changes and Notice of Filing and Order Granting Accelerated Approval to Amendment No. 2, Relating to the Combination of the American Stock Exchange, Inc. and the National Association of Securities Dealers, Inc. (Securities And Exchange Commission, Release No. 34-40622; File Nos. SR-Amex-98-32; SR-NASD 98-56; SR-NASD 98-67, October 30, 1998)at http://www.sec.gov/rules/sro/nd9867o.htm .  At this link you will read the rationale for the SEC's approval of the 1998 merger of the American Stock Exchange, Inc. and the National Association of Securities Dealers, Inc., and may surprisingly learn that only one comment in opposition was received --- from the author of this article.  As it now appears that many of my concerns in 1998 were valid, I have reprinted substantially all of the  written comment submitted to the SEC for your consideration.  You can find that text at http://rrbdlaw.com/RegulatoryLinks/1998AMEXopp.htm

Below please find a portion of the now a four-year old analysis of the very same issue that NASD once again raises:  what is the proper definition of "small firm."  It is frustrating to see that the SRO is once again raising this question, as it has so meticulously avoided dealing with it year-in and year-out.  You be the judge!

WHY A GUARANTEED 2.9% OF THE VOTE IS UNFAIR

NASD's meaningless gesture of offering one Governor's seat out of 35 (2.9%) to member firms of 150 or less registered representatives is unfair and serves to further the needs of its minority major NASDAQ market makers. Typically, NASD handpicks so-called advisory panels; those advisors then convene in a sanitized vacuum free of critics and dissenters, create artificial guidelines and standards, and then impose these concoctions by fiat.

The Securities Industry Yearbook 1997-1998

The Securities Industry Yearbook 1997-1998, pages 6-33, discloses as of January 1, 1997 a membership roster of 479 firms with 12,695 offices and 120,169 total registered representatives.  By simple arithmetic, that’s an average of 27 offices per firm, 251 RRs per member, and 9.5 RRs per office.

The SIA is a formidable and respected trade group, perhaps the securities industry's most effective. However, industry insiders do not view the SIA as representing the breadth of the business; quite clearly it represents 479 securities firms, less than 10% of the NASD's membership. Further, its policies are heavily influenced by major NASDAQ market makers. Consequently, when the interests of major NASDAQ market makers and independent/regional firms collide, the SIA usually advocates on behalf of the former. Unfortunately, at times SIA's influence is detrimental to independent/regional firms. By SIA's own admission its "Office of General Counsel (OGC) leads the securities industry in shaping legal and regulatory policy. OGC attorneys, many of whom are former regulators, maximize the industry's participation during every stage of the rulemaking process . . .Several OGC attorneys have worked as committee counsel on Capitol Hill . . ." See, SIA website, http://www.sia.com/about_sia/http://www.rrbdlaw.com/index.html.

 

Statistics are malleable. When considering the supposed relevancy of a 150 RR threshold, it is important to keep in mind how easily numbers can be manipulated. Take a fairly simple example: according to The Securities Industry Yearbook 1997-1998, Edward Jones has the largest number of offices among SIA members with 3,400. More impressively, not only is Edward Jones the number-one ranked SIA member by number of offices, but it is also the 9th ranked SIA member by number of RRs with 3,580. So these dual top-ten rankings give the impression of a dynamo.  But when we perform the simple arithmetic, we learn that this huge firm has only 1.05 RRs per office, approximately one-ninth the SIA average.  Consequently, depending upon the measuring stick, Edward Jones could be viewed as a larger or smaller firm. 

81% OF THE SIA'S MEMBERS HAVE FEWER THAN 150 RRS

 

Using The Securities Industry Yearbook 1997-1998's disclosure of 479 members, the mathematical median (the actual midpoint member rather than a hypothetical average/mean) would be the 240th member, which based upon capital is First Investors Corporation. First Investors Corporation employs 159 RRs, but this presents an anomaly because this firm is the 88th highest ranking SIA member if measured by its 159 RRs member (in contradistinction to its 240^th median by capital). The Securities Industry Yearbook 1997-1998 does not disclose the mathematical median member by total number of RRs, but it does disclose that its 92nd ranked member by capital has 145 RRs and its 91st ranked member has 154 RRs.  By deduction we can place the 150 RRs threshold between the 91st and 92nd SIA members. Consequently, only 91 out of 479 SIA members - -19% -- have in excess of 150 RRs. Put in a more IBDA-favorable posture: 81% of the SIA has less than 150 RRs.  As a result, a minority of SIA firms has more than 150 RRs. 

NASD STATISTICS QUESTION THE 150 RR STANDARD

 

The NASD discloses on its own website a five-year statistical review for 1994-1998, http://www.nasd.com/mr_section7.html. As of June 1998, the NASD discloses 5,576 member firms with 68,771 branches and 579,671 RRs. Again the simple mathematical averages: 12 branches per member (SIA: 27), 104 RRs per average firm (SIA: 251), and 8.4 RRs per branch (SIA: 9.5).   

So what has NASD-NTM-98-64 offered? One seat on a board of 35 is guaranteed to firms with no more than 150 RRs. However, the average NASD member has only 104 RRs.  The implications are disturbing.  

Let us consider this example. First, the NASD determines that its typical/average member is 5' 8" in height (104 RRs). Second, the NASD then says it needs to ensure the fair representation members of average height and shorter, so it reserves one seat for individuals of no more than 8' 3" in height (150 RRs)! Mathematically, this is the actual foolishness the NASD has perpetrated. The NASD knows that its typical/average member has 104 RRs (69% of the 150 RR threshold).  Nonetheless, the NASD defines a small firm as having nearly 45% more RRs (150 RRs) than its typical/average member (104 RRs)! And if the SIA's data is indicative of reality, at least 81% of the NASD's members (in excess of 4,500 member firms) have fewer than 150 RRs, yet are only guaranteed 2.9% of the vote through one seat on the Board.   

More unsettling is why a majority of NASD's members must depend upon the benevolent intercession of their own organization to ensure at least a 2.9% vote. The answer seems clear: the powerful minority of major NASDAQ market makers has co-opted the organization. The even more cynical question is why did the NASD wait until a pending merger with the AMEX to even float this initiative? It is from this misguided path that IBDA must rescue NASD.

By way of updating some of the four-year old data referenced in the excerpt above, I note the following statistical data from http://www.nasdr.com/2380.asp:

Doing the simple math we can determine the following facts:

Consequently, the average NASD member firm has 124 registered persons.  As explained above, I suspect that the mathematical median is lower.  Nonetheless, after more than 4 years, NASD still doesn't get it. The "average" sized member is not a "small" member.  To the contrary, it is typical --- neither small nor large.  

Distressingly, the NASD's Small Firm homepage states that "NASD has created this Web Page to provide information for the small firm community—those firms with 150 or fewer registered representatives." http://www.nasd.com/member_info/sf_index.asp  So clearly, the SRO refuses to do the basic math.  As in the past, 150 RRs is still some 20% more RRs that the average member firm.  Someone in Washington needs to sit down, quietly, and seek an epiphany on this matter.  Assuming you divide your membership according to an accepted parabolic graph, perhaps the top 25% or so would generally be deemed "large" members and the bottom 25% or so would be deemed "small" members --- but the 50% of your membership that falls within the center of the bell curve is "average".  

NASD continues to consider its average-sized member as a small firm.  That's misguided.  While the SRO may be disappointed that it's typical member isn't a New York Stock Exchange behemoth, it's membership is what it is.  Accordingly, you don't go out and propose new rules based upon the assumption that all member firms with 150 or fewer RRs are "small" firms.  Why isn't that acceptable?  Because it wrongly bifurcates the SRO into regulating the top percentile members as if they constituted 75% of the membership, and they don't!

A tempest in a teapot?  I think not because the recent retracing of steps with the Rule 2711 proposal indicates that once again NASD member firms are not getting the best service from their SRO.  Someone needed to have been more attentive to the realities of the membership's size and needs.  You don't propose such critical representation, then realize you didn't fully think the impact upon your membership through, and then go back to the drawing board.  With Wall Street under attack, you've simply got to get the damn thing right the first time --- the public, the politicians, and the press are not giving us second chances.  And we're not helping our image with such inept tinkering.