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Does The SEC Have It Out For Small Firms?

There is a feeling among employees of small broker/dealers that regulators have it out for them. Some small b/ds (defined as fewer than 100 reps) won't go so far as to say regulators want to drive them out of business on purpose, but agree that the net effect of their recent new rules is creating burdens that only bigger firms can handle.

There is a feeling among employees of small broker/dealers that regulators have it out for them. Some small b/ds (defined as fewer than 100 reps) won't go so far as to say regulators want to drive them out of business on purpose, but agree that the net effect of their recent new rules is creating burdens that only bigger firms can handle.

At issue is the so-called "Gruttadauria Rule," which took effect almost exactly one year ago. It's formally called NASD Rule 3012, and it stipulates that any producing branch managers be "actively" supervised by independent employees of the firm (i.e. independent as in not reporting to the BOM). Rule 3012 takes its name from the notorious story of Frank Gruttadauria -- a former producing manager in Cleveland who scammed his clients out of $125 million, spending the money on Lear jets and a New York City apartment, among other lavish items. Gruttadauria seemed to be such a money machine, authorities said, that he was not properly supervised, and, in fact, no one ever uncovered his fraud until Gruttadauria himself left a letter of explanation before disappearing. (He later turned himself in and in 2002 was sentenced seven years in jail.)
The rule, while seemingly simple, has been plagued by difficulties since it went into effect in January of 2005. The SEC recently approved amendments to Rule 3012, which will take effect on February 14. It will then require members who rely on its "limited size and resource exception" when conducting their producing managers' supervisory reviews to electronically report to the NASD.

What does all of this mean for small firms looking for help with the demands of 3012? Possibly just more confusion. "The rule wasn't written in plain English," says Bill Singer, partner at the New York-based securities law firm Gusrae, Kaplan & Bruno. "That's led to endless confusion about its actual requirements." Indeed, several BOMs contacted about this piece -- as well as their firms' spokespeople, couldn't recall the ruling offhand -- even despite two follow-up guidance memos issued by the NASD in April and October of 2005. Most firms contacted declined comment.

Nevertheless, the rule remains and is, in Singer's opinion, "the NASD's way of saying that it doesn't like producing managers. And, if a firm insists on having them, it had better make certain that an independent person is there to supervise them.

"This rule may be great for a wirehouse," he continues, "but it's not taking into account the reality that there are a lot of smaller firms out there that need producing BOMs to survive." Rule 3012 takes something of a one-size-fits-all approach to overseeing producing branch managers, which is making life much harder for the smaller firms, he says.

And there are many: A 2005 survey based on findings of the SEC by the National Registry Service and the Investment Counsel Association of America found that 67 percent of investment advisor firms registered with the SEC have 10 or fewer employees.

And, small and independent firms -- which need producing managers to remain economically viable -- typically lack the manpower and/or resources to have these managers independently supervised.

The aforementioned exception for "small" branches grew out of this problem and was approved in an earlier SEC rule in June 2004, Singer says while 3012 was still being drafted. Unfortunately, no actual criteria for "limited size and resources" were -- or have since been -- spelled out. "It was open to interpretation," Singer notes. "Many branch offices which assumed they fit the category were told, under later inspection, that they didn't."
But Patricia Albrecht, assistant general counsel of the NASD's Office of General Counsel, Regulatory Policy and Oversight, says, "We fought with the SEC to get this exception approved to help brokerage firms -- and, not just small ones, but firms of any size which do not have a qualified principal to conduct reviews." She continues, "After 3012 went into effect, we found many firms couldn't comply without either hiring extra resources or developing separate compliance departments. This exception was our way of enabling them to not have to do that."

Lisa Roth, president of the National Association of Independent Broker/Dealers, says that 3012 has had an enormously difficult impact on small firms. "When it was implemented, the response from small firms was so pronounced that the NASD had to hold many conferences to try and help them out. On behalf of the NAIBD, we're doing what we can to educate our 200 members on how they can comply. But, they face incredible challenges because they lack the adequate resources"

Roth doesn't see 3012 as a deliberate attempt by the NASD to drive small firms out of business. "I think it was just a knee-jerk response to the Gruttadauria case," she says. "But, nevertheless, it's devastating to them and may succeed in driving them out. This rule was based on the actions of one man, and he wasn't even with a small firm. That's the sad irony of this."

David Bellaire, general counsel for the Financial Services Institute, an Atlanta-based trade association for independent-contractor broker/dealers, says complying with 3012 is too expensive. The FSI's average member firm is bigger than the average NAIBD firm, averaging 95 home office and/or regional personnel. So, one can argue that they have sufficient resources to find extra supervision. "But," Bellaire stresses, " there's a lot of time and cost involved in that. And, without the business generated by branch managers, many independent offices would not be able to survive."

Singer sees this as a regulatory move to close down small firms. "I see this [3012] as a form of social engineering, an attempt by the NASD to weed out smaller firms," Singer says. "3012 was drafted with large national firms in mind. Small firms were not taken into consideration as either an oversight -- or as part of an agenda to raise the barrier for small firms to survive. I believe the latter is true. The large firms have more influence in Congress, higher-priced attorneys, more power. I believe the NASD is very accommodating to their needs, and very hostile to the needs of small firms."

The bottom line, he feels: "If regulators worked more closely with the industry to draft the rules, we'd have more rules that make sense at the outset, eliminating the need for guidance -- and especially -- amendments."

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