On March 16, 2000, the Securities and Exchange Commission approved amendments to rules G-8, on books and records, G-9, on preservation of records, and G-27, on supervision.[1] The amendments will become effective on September 19, 2000. The amendments will allow brokers, dealers and municipal securities dealers ("dealers") to develop flexible supervisory procedures for the review of correspondence with the public. This notice is being issued to provide guidance to dealers on how to implement these rules.

Background

Technology has greatly expanded how communications between dealers and their customers take place. These new means of communication (e.g., e-mail, Internet) will continue to significantly affect the manner in which dealers and their associated persons conduct their business. While these changes allow timely and efficient communication with customers, prospective customers, and others, the significant changes in communications media and capacity raise questions regarding supervision, review, and retention of correspondence with the public.

In May 1996, the SEC issued an Interpretive Release on the use of Electronic Media by Broker-Dealers, Transfer Agents, and Investment Advisors for Delivery of Information.[2] That release expressed the views of the SEC with respect to the delivery of information through electronic media in satisfaction of requirements in the federal securities laws, but did not address the applicability of any self-regulatory organization ("SRO") rules. In its release the SEC did, however, strongly encourage the SROs to work with broker/dealer firms to adapt SRO supervisory review requirements governing communications with customers to accommodate the use of electronic communications.[3]

On December 31, 1997, the SEC approved proposed rule changes filed by the National Association of Securities Dealers ("NASD")[4] and the New York Stock Exchange ("NYSE")[5] to update rules governing supervision of communication with the public. NASD Notice to Members 98-11 announced approval of the proposed rule change, provided guidance to firms on how to implement these rules and stated that the amendments to NASD Rules 3010 and 3110 would be effective on February 15, 1998. Over the next year, further amendments were made to NASD Rules 3010 and 3110. NASD Regulation received final SEC approval of amendments to Rule 3010 on November 30, 1998.[6] The rule amendments were effective on March 15, 1999.[7]

As amended, NASD Rule 3010(d)(1) provides that procedures for review of correspondence with the public relating to a member's investment banking or securities business be designed to provide reasonable supervision for each registered representative, be described in an organization's written supervisory procedures, and be evidenced in an appropriate manner. NASD Rule 3010(d)(2) requires each member to develop written policies and procedures for review of correspondence with the public relating to its investment banking or securities business tailored to its structure and the nature and size of its business and customers. These procedures must also include the review of incoming, written correspondence directed to registered representatives and related to the member's investment banking or securities business to properly identify and handle customer complaints and to ensure that customer funds and securities are handled in accordance with firm procedures.

The Board has determined to adopt substantially similar rule changes. The Board believes that conforming its rule language to the language in the NASD rules will help ensure a coordinated regulatory approach to the supervision of correspondence.

Amended Rules

Rule G-27(d)(i), as revised, provides that procedures for review of correspondence with the public relating to a dealer's municipal securities activities be designed to provide reasonable supervision for each municipal securities representative, be described in the dealer's written supervisory procedures, and be evidenced in an appropriate manner.

Rule G-27(d)(ii) requires each dealer to develop written policies and procedures for review of correspondence with the public relating to its municipal securities activities, tailored to its structure and the nature and size of its business and customers. The rule requires that any dealer that does not conduct either an electronic or manual pre-use review will be required to:

• develop appropriate supervisory procedures;

• monitor and test to ensure these policies and procedures are being implemented and complied with;

• provide education and training to all appropriate employees concerning the dealer's current policies and procedures governing correspondence, and update this training as policies and procedures are changed; and

• maintain records documenting how and when employees are educated and trained.

The rule change states that these procedures must also include the review of incoming, written correspondence directed to municipal securities representatives and related to the dealer's municipal securities activities to properly identify and handle customer complaints and to ensure that customer funds and securities are handled in accordance with the dealer's procedures.

It is the understanding and view of the Board that dealers possess the legal capacity to insist that mail addressed to their offices be deemed to be related to their businesses, even if marked to the attention of a particular associated person, if they advise associated persons that personal correspondence should not be received at their firms. Dealers, other than non-NASD member bank dealers, are reminded that SEC Rule 17a-4(b)(4) requires that "originals of all communications received . . . by such member, broker or dealer, relating to its business as such . . ." must be preserved for not less than three years.

The retention requirements of the amendments to rule G-27 cross reference rules G-8(a)(xx) and G-9(b)(viii) and (xiv) and state that the names of persons who prepared, reviewed and approved correspondence must be readily ascertainable from the retained records. The records must be made available, upon request, to the appropriate enforcement agency (i.e., NASD or federal bank regulatory agency).

Guidelines For Supervision And Review

In adopting review procedures pursuant to rule G-27(d)(i), dealers must:

• specify, in writing, the dealer's policies and procedures for reviewing different types of correspondence;

• identify how supervisory reviews will be conducted and documented;

• identify what types of correspondence will be pre- or post-reviewed;

• identify the organizational position(s) responsible for conducting review of the different types of correspondence;

• specify the minimum frequency of the reviews for each type of correspondence;

• monitor the implementation of and compliance with the dealer's procedures for reviewing public correspondence; and

• periodically re-evaluate the effectiveness of the dealer's procedures for reviewing public correspondence and consider any necessary revisions.

In conducting reviews, dealers may use reasonable sampling techniques. As an example of appropriate evidence of review, e-mail related to the dealer's municipal securities activities may be reviewed electronically and the evidence of review may be recorded electronically.

In developing supervisory procedures for the review of correspondence with the public pursuant to rule G-27(d)(ii), each dealer must consider its structure, the nature and size of its business, other pertinent characteristics, and the appropriateness of implementing uniform firm-wide procedures or tailored procedures (i.e., by specific function, office/location, individual, or group of persons).

In adopting review procedures pursuant to rule G-27(d)(ii), dealers must, at a minimum:

• specify procedures for reviewing municipal securities representatives' recommendations to customers;

• require supervisory review of some of each municipal securities representative's public correspondence, including recommendations to customers;

• consider the complaint and overall disciplinary history, if any, of municipal securities representatives and other employees (with particular emphasis on complaints regarding written or oral communications with clients); and

• consider the nature and extent of training provided municipal securities representatives and other employees, as well as their experience in using communications media (although a dealer's procedures may not eliminate or provide for minimal supervisory reviews based on an employee's training or level of experience in using communications media).

Although dealers may consider the number, size, and location of offices, as well as the volume of correspondence overall or in specific areas of the organization, dealers must nonetheless develop appropriate supervisory policies and procedures in light of their duty to supervise their associated persons. The factors listed above are not exclusive and dealers must consider all appropriate factors when developing their supervisory procedures and implementing their supervisory reviews.

Supervisory policy and procedures must also:

• provide that all customer complaints, whether received via e-mail or in written form from the customer, are kept and maintained;

• describe any dealer standards for the content of different types of correspondence; and

• prohibit municipal securities representatives' and other employees' use of electronic correspondence to the public unless such communications are subject to supervisory and review procedures developed by the dealer. For example, the Board would expect dealers to prohibit correspondence with customers from employees' home computers or through third party systems unless the dealer is capable of monitoring such communications.

The method used for conducting reviews of incoming, written correspondence to identify customer complaints and funds may vary depending on the dealer's office structure. Where the office structure permits review of all correspondence, dealers should designate a municipal securities representative or other appropriate person to open and review correspondence prior to use or distribution to identify customer complaints and funds. The designated person must not be supervised or under the control of the municipal securities representative whose correspondence is opened and reviewed. Unregistered persons who have received sufficient training to enable them to identify complaints and funds would be permitted to review correspondence.

Where the office structure does not permit the review of correspondence prior to use or distribution, appropriate procedures that could be adopted include the following:

• forwarding opened incoming written correspondence related to the dealer's municipal securities activities to a designated office, or supervising branch office, for review on a weekly basis;

• maintenance of a separate log for all checks received and securities products sold, which is forwarded to the supervising branch office on a weekly basis;

• communication to clients that they can contact the dealer directly for any matter, including the filing of a complaint, and providing them with an address and telephone number of a central office of the dealer for this purpose; and

• branch examination verification that the procedures are being followed.

Regardless of the method used for initial review of incoming, written correspondence, as with other types of correspondence, rule G-27 would still require review by a designated principal of some of each municipal securities representative's correspondence with the public relating to the dealer's municipal securities activities. Given the complexity and cost of establishing appropriate systems for effectively reviewing electronic communications, some members may determine to conduct a pre-use or distribution review of all incoming and outgoing correspondence (written or electronic).

Dealers must continually assess the effectiveness of these supervisory systems. Education and training must be timely (prior to or concurrent with implementation of the policies and procedures) and must include all appropriate employees. Dealers may incorporate the required education and training on correspondence into their Continuing Education Firm Element Training Program (see rule G-3(h) on continuing education requirements). The requirement for training regarding correspondence may also apply to employees who are not included under the Continuing Education requirements.

The Municipal Securities Rulemaking Board has recently received inquiries concerning the application of the Board’s confirmation disclosure requirements, which are contained in Board rules G-12 and G-15, to municipal securities with variable or "floating" interest rates.

 

Rule G-12(c)(v)(E)[*] requires a municipal securities dealer to set forth on an inter-dealer confirmation a description of the securities which are the subject of the transaction, including the interest rate. Rule G-15(a)(i)(E)[*] imposes the same requirement with respect to customer confirmations. The Board is of the view that these provisions require that the security description appearing on customer and inter-dealer confirmations for securities with variable interest rates include a clear indication that the interest rates are variable or "floating."

The Board also notes that due to the variability of the interest rates on these securities, it is not possible to derive a yield to a future call or maturity date. Therefore, the Board has concluded that the provision of rule G-15 which requires that customer confirmations for transactions effected at a dollar price set forth the yield resulting from such dollar price is not applicable to transactions in variable-rate municipal securities.

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[*] [Currently codified at rule G-15(a)(1)(B)(4)]

Board rules G-12 on uniform practice and G-15 on customer confirmations set forth certain requirements concerning the computations of yields and dollar prices to premium call or par option features. Both rules currently require that, in the case of a transaction in callable securities effected on the basis of a yield price, the dollar price should be calculated to the lowest of the price to premium call, price to par option, or price to maturity. Further, confirmations of transactions on which the dollar price has been computed to a call or option feature must state the call date and price used in the computation. Amendments to rule G-15 which will become effective on October 1, 1981, generally require that confirmations of transactions in callable securities effected at a dollar price in excess of par must set forth the lowest of the yield to premium call, yield to par option, or yield to maturity resulting from such dollar price.[1]

Since the December 1977 effective dates of rule G-12 and G-15, the Board has received numerous inquiries concerning these provisions and their application to different issues of municipal securities. In view of the general interest in this subject, the Board is issuing this notice to provide guidance with respect to the general criteria to be used in selecting the appropriate call feature for yield or dollar price computations.

The requirement for the computation of dollar price to the lowest of price to premium call, par option, or maturity reflects the long-established practice of the industry in pricing transactions. This practice assures a customer that he or she will realize, at a minimum, the stated yield, even in the event that a call provision is exercised. The pending amendment to rule G-15, which requires the presentation of information concerning the lowest yield on confirmations of dollar price transactions, will provide investors with the equivalent information on these types of transactions.

In view of the variety of call provisions applicable to different kinds of municipal securities, there is often uncertainty concerning the selection of the appropriate call feature for use in the computation of yield or dollar price. Issues of municipal securities often have several different call features, ranging from calls associated with mandatory sinking fund requirements to optional calls from the proceeds of a refunding or funds in excess of debt service requirements. Certain issues have additional call provisions in the event that funds designated for specific purposes are not expended or obligations securing the issue are prepaid.[2] Most of the inquiries which the Board has received concerning the provisions of rules G-12 and G-15 focus on this question of selection of the call provisions to be used for computation purposes.

The Board is of the view that a distinction should be drawn between "in whole" call provisions, (i.e., those under which all outstanding securities of a particular issue may be called) and "in part" call provisions (i.e., those under which part of an issue, usually selected by lot or in inverse maturity or numerical order, may be called for redemption). The Board is of the view that for computation purposes only "in whole" calls should be used; sinking fund calls and other "in part" calls should not be used in making the computations required by rules G-12 and G-15.

Several inquiries have raised the question of which "in whole" call should be used in the case of issues which have more than one such call. The earlier call features of such issues are often subject to restrictions on the proceeds which may be used to redeem securities (e.g., a restriction that only unexpended funds from the original issue may be used for redemption purposes). Since such call features operate as a practical matter as "in part" calls, the Board is of the view that the "in whole" call feature which would be exercised in the event of a refunding is the call feature which should generally be used for purposes of the computation of yields and dollar prices.

Other concerned persons have inquired regarding the application of the "pricing to call" requirements in the case of an issue with a sequence of call dates at gradually declining premiums. The Board believes that, as a general matter, a trial computation to the first date on which a security is callable "in whole" at a premium will be sufficient to determine whether the price to the premium call is the lowest dollar price. However, in the rare instance where the price to an intermediate premium call (i.e., a call in the "middle" of a sequence of calls at declining premiums) is the lowest dollar price, such price should be used. The Board notes that, in such cases, the structure of the call schedule is sufficiently unusual (e.g., with sharp declines in the premium amount over a very short period of time) that dealers should be alerted to the need to take the intermediate calls into consideration.

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[1] Effective December 1, 1980, customer confirmations of transactions in callable securities effected at a dollar price less than par must set forth the yield to maturity resulting from such dollar price. Confirmations of dollar-price transactions in non-callable securities, or securities which have been called or prerefunded, must set forth the resulting yield to maturity (or to the date for redemption of the securities, in the case of called or prerefunded securities).

[2] Other issues are also callable in the event that the financed project is damaged or destroyed, or the tax exempt status of the issue is revoked. Since the possibility of such a call being exercised is extremely remote, and beyond the control of the issuer of the securities, the Board does not believe that these "catastrophe" calls need be considered for computation purposes.

Rule G-12(c)(v)(E) requires a municipal securities dealer to set forth on an inter-dealer confirmation a description of the securities which are the subject of the transaction, including "…in the case of revenue bonds the type of revenue, if necessary for a materially complete description of the securities…."

 

Rule G-15(a)(v) [*] imposes the identical requirement with respect to customer confirmations. The Board has recently received an inquiry regarding whether these provisions require confirmations of transactions in Los Angeles Department of Water and Power bonds to distinguish between bonds secured by revenues of the electric power system and bonds secured by revenues of the waterworks system.

The Board is of the view that, if securities of a particular issuer are secured by separate sources of revenue, the source of revenue of the securities involved in a transaction is a material element of the description of the securities which should be set forth on customer and inter-dealer confirmations. Confirmations of transactions in Los Angeles Department of Water and Power bonds must therefore indicate whether the securities are "electric revenue" or "water revenue" bonds.

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[*] [Currently codified at rule G-15 (a)(i)(C)(1)(a)]

"Person." Your letter regarding rule G-20 has been referred to me. Rule G-20 prohibits a municipal securities professional from giving gifts or providing services to a person in relation to the municipal securities activities of such person's employer, in excess of a specified amount.

In your letter, you inquire whether the term "person" in rule G-20 is intended to include "a ‘corporate’ person as well as a ‘real’ person."As used in the rule, the term "person" refers only to a natural person. The rule is intended to discourage municipal securities professionals from attempting to induce individual employees from acting in a manner inconsistent with their obligations to, or contrary to the interests of, their employers. MSRB interpretation of March 19, 1980.