The NASD performs routine examinations of member firms on one, two, and four year cycles. In the past, areas of interest to the NASD have included supervision, anti-money laundering, the NASD Contact System, sales of new products, use of electronic systems, use of email, branch offices, business continuity planning and municipal securities transaction reporting. However, the next examination for some firms will be broader in scope because this year it will include certain regulatory changes. Highlighted below are some of the new regulations, as well as existing regulations, that could be of significance to the NASD and additional areas of potential examination focus in 2007. We’ve also included some new developments that member firms should consider when reviewing their supervisory and compliance programs.

Data Integrity

In 2007, Examiners will be focusing on both the timeliness of information submitted to the NASD as well as the accuracy of the information submitted. Firms can expect to see data integrity reviews of CRD filings (Forms U4, U5, BD and BR), the 3070 reporting system and data reported pursuant to NASD Rule 3150. Therefore, it is essential that the data available to NASD is accurate.

NASD Report Center

The NASD Report Center provides member firms with secure access to data and reports that aid in the early detection of reporting problems, and helps to identify areas that need improvement. New features include a 3070 Disclosure Timeliness Report Card to help firms identify late 3070 disclosure filings as well as four new risk monitoring reports, which are designed to enable firms to examine trends that may indicate potential areas of risk.

Electronic Filing Requirements

Starting on January 1, 2007, the following notices must be filed with NASD

electronically:  Withdrawals of equity capital, Special Reserve Bank Account, Electronic storage media, Replacement of accountant, Net capital deficiency, Aggregate indebtedness is in excess of 1200 percent of net capital, Net capital is less than 5 percent of aggregate debit items, Net capital is less than 120 percent of required minimum dollar amount, Failure to make and keep current books and records and Material inadequacy in accounting systems, internal controls, or practices and procedures. NASD members can access the templates for these regulatory notices on NASD's Web site. 2

Protection of Customer Information

Regulation S-P addresses the protection of customer information and records. It is Important that member firms protect customer information effectively in order to ensure that it cannot be accessed by a third-party and used to harm or inconvenience any customer. In order to ensure compliance with Regulation S-P, member firms should maintain policies and procedures that address the protection of customer information and records and consider whether testing or training in this area is adequate.

Hedge Funds

Many investors, especially retail investors, may not understand the risks associated with hedge funds and funds of hedge funds. Since they are complex investment vehicles and are often risky and lacking in transparency, the NASD has reminded member firms that it is essential to determine suitability prior to recommending such funds.

TRACE Reporting

Pursuant to NASD Rule 6230, firms are required to report transactions in corporate bonds to NASD’s Trade Reporting and Compliance Engine (TRACE) system within 15 minutes of order execution. Member firms now have access to inter-dealer trade report alerts that are designed to assist members in their trade reporting compliance. These alerts include information on unreported trades, erroneously reported trades and duplicate reported trades.

Order Audit Trail System

OATS Phase III became effective on July 10, 2006. The OATS Phase III amendments: (1) require members to report to OATS manual orders in NASDAQ-listed securities; (2) require members to capture and report both the time the order is received by the member from the customer and the time the order is received by the member’s trading desk or trading department, if different; (3) exclude certain members from the definition of “Reporting Member”; and (4) permit NASD to grant exemptive relief from the OATS reporting requirements in certain circumstances. In April 2006, NASD issued Notices to Members 06-15 and 06-17 to discuss, respectively, NASD’s exemptive authority and the implementation date. On October 10, 2006, the SEC approved amendments to the OATS rules to expand the OATS reporting requirements to over-the-counter (OTC) equity securities. Under the amendments, members will be required to record and report order information relating to “OTC equity securities” beginning on June 11, 2007. In December 2006, NASD issued Notice to Members 06-70 to discuss the amendments and the effective date.

Fixed Income Research

SEC Regulation AC and NASD Rule 3010 apply to both fixed income and equity research. SEC Regulation AC requires certifications to be made by analysts who issue research reports and NASD Rule 3010 requires that member firms establish adequate supervisory procedures and systems in areas where they conduct a business. In addition, while NASD Rule 2711 does not apply to fixed income research, SIFMA (in its former capacity as the Bond Market Association) has issued a best practices document that members who issue fixed income research are advised to review. NASD and the NYSE issued joint guidance on a review of fixed income research compliance, published in Notice to Members 06-36.

Gifts and Gratuities

NASD Rule 3060 (the “gift rule”) was designed to protect against potential conflicts of interest. The rule prohibits any member or person associated with a member from giving or receiving anything of value, including gratuities, in excess of $100 per individual per year, where such payment or gratuity is in relation to the business of the recipient’s employer.

Anti-Money Laundering

The requirement to have an AML program is a federal requirement, and there are no exceptions. All member firms, regardless of business type or customer interactions, are subject to the requirements of NASD Rule 3011 and the requirements of the Bank Secrecy Act. Effective March 6, 2006, NASD Rule 3011 was amended to require each member firm to conduct an annual independent test of its AML compliance program. There is a limited exception that allows some firms to test every two years, but this exception is generally limited to firms that do not deal with customers and do not execute customer transactions. The exception is not based upon the amount or type of business conducted by the firm. Regardless of which category a firm falls into, a firm must test its AML program more frequently if circumstances warrant.

Business Continuity Planning

Member firms are required to create and maintain a business continuity plan and update it as needed. In addition to developing business continuity plans, firms are encouraged to periodically test such plans.

New Developments:

Advance Notice of Examinations

For most firms, the NASD is doubling the amount of notice in advance of a routine examination. The notice period is now 30 days rather than 14 days. This change will provide firms with adequate time to respond to the WebIR and to gather the records and information requested prior to the on-site portion of the examination. It will also provide the examiners with more time to review materials and conduct a more efficient examination.

Examination Webcast

To help member firms better prepare for an examination, the NASD has produced a webcast that briefly explains the examination process. To view the webcast, go to www.nasd.com/webcasts/whattoexpect.

WebIR

The NASD is gathering input on the WebIR to help them streamline its contents and ensure effective pre-examination preparation by NASD staff. Their goal is to make submission of the WebIR as easy as possible so that examiners can collect a sufficient amount of relevant information to prepare for an on-site examination.

Best Execution

NASD amended its Best Execution Rule (Rule 2320(a)), effective November 8, 2006, to expand to the scope of the member’s duty of best execution to customers of another broker-dealer. The purpose of this rule change was to better ensure that customer orders receive equivalent best execution protections, irrespective of whether a customer order is executed by the originating broker-dealer or routed to a recipient member for handling and execution.

If you utilize Regulatory Compliance or another outside FINOP, you must notify your FINOP as soon as the NASD contacts you regarding an examination since they may be required to provide information necessary for the examination.

The key to a successful examination is preparation. Regulatory Compliance can help you prepare for your examination by offering consulting in preparing WebIR questionnaires, through an onsite books & records examination or with an onsite examination preparation visit. For more information on our services, please contact our Sales staff by calling 603-434-3594.

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