02-10579. Self-Regulatory Organization; Notice of Filing of a Proposed Rule Change by the National Futures Association Relating to Interpretive Notice Regarding NFA Compliance Rule 2-9, Supervision of the Use of Automated Order-Routing Systems

April 24, 2002.

Pursuant to section 19(b)(7) of the Securities Exchange Act of 1934 (“Act”) ^[1] and Rule 19b-7 under the Act,^[2] notice is hereby given that on March 5, 2002, the National Futures Association (“NFA”) filed with the Securities and Exchange Commission (“SEC” or “Commission”) the proposed rule change described in Items I, II, and III below, which Items have been prepared by the NFA. The Commission is publishing this notice to solicit comments on the proposed rule change from interested persons. The NFA has also filed the proposed rule change with the Commodity Futures Trading Commission (“CFTC”).

The NFA, on March 1, 2002, submitted the proposed rule change to the CFTC for approval. On March 21, 2002, the CFTC issued a notice and request for comment regarding the proposed rule change.^[3] Under Section 19(b)(7)(B) of the Act, the proposed rule change may take effect upon approval by the CFTC.

I. Self-Regulatory Organization's Description of the Proposed Rule Change

Section 15A(k) of the Act ^[4] makes the NFA a national securities association for the limited purpose of regulating the activities of NFA members who are registered as brokers or dealers in security futures products under Section 15(b)(11) of the Act.^[5] The proposed Interpretive Notice to NFA Compliance Rule 2-9 Regarding the Supervision of the Use of Automated Order-Routing Systems (“AORSs”) applies to all NFA members who accept orders for futures accounts, regardless of the underlying product and, therefore, will apply to NFA members registered as broker-dealers under Section 15(b)(11) of the Act with regard to their security futures activities.

In November 2000, NFA's Board of Directors—responding to a letter from then CFTC Chairman Rainer—asked its Special Committee to Review Technology (“Special Committee”) to develop standards relating to security, capacity, and controls for AORSs that route orders through a futures commission merchant (“FCM”). The Board also directed the Special Committee to find a middle ground between one-size-fits-all requirements that mandate specific technology and guidelines that are so general as to be meaningless. The proposed Interpretive Notice addresses AORS issues by providing interpretive guidance to NFA members on their supervisory responsibilities over orders entered through those systems.

II. Self-Regulatory Organization's Statement of the Purpose of, and Statutory Basis for, the Proposed Rule Change

NFA has prepared statements concerning the purpose of, and basis for, the proposed rule change, burdens on competition, and comments received from members, participants, and others. The text of these statements may be examined at the places specified in Item IV below. These statements are set forth in Sections A, B, and C below.

A. Self-Regulatory Organization's Statement of the Purpose of, and Statutory Basis for, the Proposed Rule Change

1. Purpose

The proposed interpretive notice recognizes that NFA members have a supervisory responsibility to process orders in a reliable and timely manner and to impose credit and risk-management controls on trading done by any particular customer. The notice also recognizes that supervisory standards do not change with the medium used but that how those standards are applied may be affected by technology. Therefore, as the Board directed, the notice tries to achieve a middle ground between one-size-fits-all requirements that mandate specific technology and guidelines that are so general as to be meaningless.

Regarding security, the notice states that NFA members who accept orders must adopt and enforce written procedures reasonably designed to protect the reliability and confidentiality of orders and account information at all points during the order-routing process. To that end, the notice states that NFA members should have procedures regarding authentication of users, encryption of information, firewalls, authorization of users, periodic testing of the AORS's security systems, and who will administer system security.

On the subject of capacity, the notice provides that NFA members who accept orders must adopt and enforce written procedures reasonably designed to maintain adequate personnel and facilities for the timely and efficient delivery of customer orders and reporting of executions. In this regard, the procedures should cover capacity reviews, disaster recovery and redundancies, and advance disclosure to customers of both potential systems problems and alternative procedures for customers to use if problems occur.

In connection with credit and risk-management controls, the notice states that NFA members who accept orders must adopt and enforce written procedures reasonably designed to prevent customers from entering into trades that create undue financial risks for the NFA member or the NFA member's other customers. In particular, the procedures should address pre-execution and post-execution controls and how to determine which controls apply to a particular customer, special considerations for authorizing use of direct access systems, and on going review of the controls imposed.

2. Statutory Basis

The rule change is authorized by, and consistent with, Section 15A(k) of the Act.^[6]

B. Self-Regulatory Organization's Statement on Burden on Competition

The rule change will not impose any burden on competition that is not necessary or appropriate in furtherance of the purposes of the Act and the Commodity Exchange Act (“CEA”). The Special Committee considered the economic burdens the rule change could impose on smaller entities and attempted to minimize those burdens. In any event, any burdens imposed are necessary and appropriate in order to ensure that customer orders are handled properly.

C. Self-Regulatory Organization's Statement on Comments on the Proposed Rule Change Received From Members, Participants, or Others

NFA sent a notice to all NFA members requesting comments on the proposed interpretive notice. NFA received nine comment letters. NFA's FCM, introducing broker (“IB”), commodity pool operators' (“CPO”) and commodity trading advisors' (“CTA”) Advisory Committees also provided comments. In general:

• All of the commenters except the FCM Advisory Committee supported NFA's efforts to provide guidance to NFA members on their supervisory responsibilities for orders entered through an AORS;
• Several of the commenters questioned the specific approach taken by the proposed interpretive notice, which they interpreted as being overly prescriptive rather than simply providing guidance; and
• Some commenters believed that NFA should not mandate that the supervisory procedures be in writing. Some commenters also felt that it is unnecessary to have procedures covering protections that are already written into an automated system.
• In contrast to the other commenters, NFA's FCM Advisory Committee felt that NFA should not issue interpretive guidance on the use of AORSs. The FCM Advisory Committee believes that decisions regarding AORSs should be a matter of business judgment, not regulation.

Special Committee's Response to Comments

The Special Committee considered all of the comments that it received. Although it recognizes the FCM Advisory Committee's concerns, the Special Committee continues to believe that its mandate from the Board requires it to propose interpretive guidance. The Special Committee also believes, however, that the industry needs guidance and that it is appropriate for NFA to issue it. The Special Committee believes that the interpretive notice provides that guidance by clarifying existing requirements.

As noted above, some of the commenters felt the interpretive notice was too prescriptive. As a general matter, the Special Committee believes that the standards must be clear enough to provide meaningful guidance and ensure that firms can be audited for compliance. The Special Committee did, however, agree with a number of the specific comments that were made and revised the interpretive notice accordingly.

Finally, despite some comments, the Special Committee believes that the supervisory procedures should be in writing. It did, however, add a footnote to clarify that the procedures do not have to contain technical specifications or duplicate procedures that are documented elsewhere.

The Board agreed with the Special Committee's conclusions and adopted the Interpretive Notice as recommended.

III. Date of Effectiveness of the Proposed Rule Change and Timing for Commission Action

The proposed rule change will become effective upon approval by the CFTC. Within 60 days of the date of effectiveness of the proposed rule change, the Commission, after consultation with the CFTC, may summarily abrogate the proposed rule change and require that the proposed rule change be refiled in accordance with the provisions of Section 19(b)(1) of the Act.^[7]

IV. Solicitation of Comments

Interested persons are invited to submit written data, views and arguments concerning the foregoing, including whether the proposed rule change conflicts with the Act. Persons making written submissions should file nine copies of the submission with the Secretary, Securities and Exchange Commission, 450 Fifth Street, NW, Washington, DC 20549-0609. Comments also may be submitted electronically to the following e-mail address: [e-mail]. Copies of the submission, all subsequent amendments, all written statements with respect to the proposed rule change that are filed with the Commission, and all written communications relating to the proposed rule change between the Commission and any person, other than those that may be withheld from the public in accordance with the provisions of 5 U.S.C. 552, will be available for inspection and copying in the Commission's Public Reference Room. Copies of these filings also will be available for inspection and copying at the principal office of NFA. Electronically submitted comments will be posted on the Commission's Internet website (http://www.sec.gov). All submissions should refer to File No. SR-NFA-2002-01 and should be submitted by May 21, 2002.

For the Commission, by the Division of Market Regulation, pursuant to delegated authority.^[8]

Margaret H. McFarland,

Deputy Secretary.

Footnotes

1.  15 U.S.C. 78s(b)(7).

2.  17 C.F.R. 240.19b-7.

3.  67 FR 14701 (March 27, 2002).

4.  15 U.S.C. 78o-3(k).

5.  15 U.S.C. 78o(b)(11).

6.  15 U.S.C. 78o-3(k).

7.  15 U.S.C. 78s(b)(1).

8.  17 C.F.R. 200.30-3(a)(75).