December 4, 1998
Jonathan G. Katz
Securities and Exchange Commission
450 5th Street, NW
Mail Stop 6-9
Washington, D.C. 20549
Subject: File No. S7-26-98
Dear Secretary Katz:
The Washington State Securities Division would like to take this opportunity to comment on the re-proposed amendments to Exchange Act Rules 17a-3 and 17a-4. As the Director of Securities for the Washington State Department of Financial Institutions, I oversee the division that conducts examinations at offices of broker-dealers registered in the State of Washington. The division currently has three field examiners who examine a total of more than 100 local broker-dealer offices in Washington each year. There are over 1800 broker-dealer locations in the State of Washington and approximately 6500 sales agents located within the state. Local access to broker-dealer records is crucial in order to carry out our mission to protect the investing public, especially when the examination is performed for cause.
We strongly support the general theme of the reproposal, which is to provide certainty for both industry and regulators about the records that are required to be maintained. Detailed, accurate records are absolutely essential to enforce compliance with regulatory requirements and to detect fraud and sales practice violations. Local access to records is essential to state securities regulators because we often examine small offices which tend to operate quite independently and pose the greatest risk to retail investors. Many times the smaller offices have never been visited by any other regulatory authority.
Before addressing specific questions in the release, I would like to address the issue that is most important to this office. We strongly support maintaining the threshold of two licensed persons to trigger the requirement that certain records be kept or made available on site. In the State of Washington, 50% of our local offices have one person and an additional 20% have two persons. If the threshold is increased, the Commission's rules would severely restrict the availability of records necessary to run an effective broker-dealer examination program at the state level. As stated above, these smaller offices pose a greater risk to investors because the supervision tends to be minimal at best. The State of Washington would prefer that all offices have the core records. We realize that many one person offices are only part time offices and the maintenance of the core records could be burdensome. In the past we have allowed this type of office to keep records appropriate to the level and type of sales conducted there. Because we have no way of knowing what offices only have one person, we could, for example, end up going all the way to Richland, Washington only to find out the records are maintained in Seattle, over two hundred miles away. This would represent a big waste of time and resources. To increase the threshold number beyond two would only add to this cost and waste resources that are already stretched too thin. It would also reduce the number of examinations we can perform per year and obviously impact the number of investors that we can protect. Catching violations early can save both the broker-dealer and the investor a lot of time and grief.
The reproposed amendments would require broker-dealers to make available at the respective local office certain records, including blotters of that office's activities, memoranda of brokerage orders and dealer transactions at that office, customer account records, customer complaints about transactions at that office, and that office's associated persons records. We support requiring each of these records. We believe that these records are essential for the orderly conduct of business at each local office. Each type of record has been the source of evidence in cases this office has brought against licensed broker-dealers and their sales agents. It has been our experience in performing routine examinations for over 12 years, that the records identified in this proposal are already kept by a vast majority of the local offices and therefore additional costs will not be incurred. Furthermore, we believe these records represent the minimum level of recordkeeping necessary for a manager to effectively supervise a local office.
With regard to the retention period of one year, we do not believe that is long enough. Our examination cycle will probably not be less than three years and we believe that at least three years of records is often required for a meaningful review.
We offer the following examples of cases we have instituted against firms and sales agents that support the maintenance of the "core" documents:
In the case of S.O., a registered representative at the Yakima, WA branch of a major wirehouse, items in the complaint file alerted our examiners to S.O.'s excessive trading, unauthorized transactions, and unsuitable recommendations. Review of monthly account statements and customer account information allowed us to narrow our investigation to S.O.'s transaction in about a dozen accounts. We suspended the license of S.O. based on his sales practices with regard to these accounts. His employing broker-dealer paid $50,000 to customers in settlement of our action.
In a branch office of a regional firm in Bremerton, WA, our examiners found mutual fund sales made to avoid breakpoints by examining the purchase and sales blotters at the branch. As a result of this discovery, the firm refunded $4,000 to its customers.
On an examination of a third tier brokerage firm in Vancouver, WA, our examiners found evidence of "selling away" by comparing the check receipts with the purchases and sales blotters. This comparison showed that a substantial amount of client money received by the branch was not accounted for in brokerage transactions. Upon further investigation, we found that the funds had gone into other entities controlled by the sales agent and her husband. Both were subsequently prosecuted criminally and received substantial prison terms for their fraudulent activities.
Our examiners discovered sales by unregistered cold callers at the Bellevue branch of a major wirehouse through comparison of employee registration information. The firm was sanctioned as a result of this discovery.
Our examiners discovered a pattern of excessive and unsuitable trading in customer accounts at a Bellevue branch of a major broker-dealer by reviewing the purchase and sales blotters, customer account information, and monthly statements. The firm was sanctioned as a result.
M.M, a sales agent at a Tacoma, WA branch of a major wirehouse traded excessively in customer accounts. His activities were discovered when our examiners reviewed the purchases and sales blotters and order tickets. Our interviews with customers showed that M.M. had falsely marked order tickets as "unsolicited" in order to avoid discovery of his fraudulent sales practices.
G.C., a sales agent with the Bellingham, WA branch of a regional firm, churned his customers' accounts. Our examiners found G.C.'s misdeeds by reviewing the monthly account statements, customer account information, and exception reports. G.C.'s license was suspended. Our examiners reviewed three years of internal audit reports. These reports showed that the manager had been warned of G.C.'s activities, but had failed to take action. When we alerted the firm to this, the firm replaced the manager.
J.B., a sales agent with an Ellensburg, WA branch of a third tier broker-dealer, controlled the account of a guardianship for an elderly person. After the Securities Division received a complaint about possible misappropriation of the guardianship funds, it sent an examiner to review the records at the branch. In the complaint file at the branch, the examiner found another complaint of misappropriation. J.B. was criminally prosecuted for his misappropriations.
A Bellevue, WA sales agent working for a Gig Harbor, WA branch of a third tier firm was suspended and the branch manager sanctioned as a result of the sales agents unauthorized and unsuitable transactions in her clients accounts. The agents sales practice abuses were discovered through a review of the purchase and sales blotters at the branch.
D.S., a sales agent with a Mill Creek, WA branch of a third tier broker-dealer sold fraudulent and unregistered securities off the books of the broker-dealer. Our examiners were able to get the information from the customer account information at the branch to allow us to contact the customers of D.S. and find out if they had been offered or sold these securities. The license of D.S. was revoked as a result of his activities.
R.P., a Bellevue, WA sales agent put his customers on margin and executed numerous unsuitable day trades on behalf of those customers. Through the review of order tickets our examiner discovered his activities. R.P.s license was revoked.
At the Spokane, WA branch of a major wirehouse, our examiners found that G.S., a sales agent, was making unauthorized transactions, making misrepresentations to customers, and making unsuitable recommendations to customers. These activities were discovered through review of the complaint file. The license of G.S. was suspended based on the discovery of his activities.
G.C., a Yakima, WA sales agent of a third tier firm, falsified customer records. His activities were discovered through review of the complaint file and then confirmed through review of order tickets and monthly statements. G.C. was criminally prosecuted and sentenced to prison and payment of restitution.
R. R., a Spokane, WA sales agent, diverted customer moneys to an account he controlled through a confederate. He then converted the funds to his own use. Customer account records allowed our examiners to determine the ownership of the account and then to uncover R.R.s deception. R.R. was criminally prosecuted.
H.-J. S., a Seattle, WA sales agent, sold away from his firm. He obtained customer moneys by claiming to operate a trading fund. In fact, H.-J. S. converted most of the money to his own use. Because he had been barred from trading by his firm, he executed trades in a co-workers account. Our examiners reviewed the customer account records to get information to contact customers and used monthly statements to reconstruct his activities in the other representatives account. H.-J. S. was criminally prosecuted and sentenced to prison time and restitution.
We have the following comments with regard to specific issues in the release:
Order Tickets - The reproposal adds a requirement for order tickets or electronic memorandum to include not only the identity of the associated person who is responsible for the account but also the identity of any person who has accepted or entered the order on behalf of the customer. We support this part of the proposal as it will help regulators and industry supervisors discover registration violations.
We also support the reproposal requirement that the order ticket be time stamped to reflect when it is received and when it is executed. This provision will enable regulators to detect certain practices that are prevalent in the over the counter secondary market, like trading at a prearranged price or trading ahead of customer orders.
Order tickets are a very important source document for certain types of cases. Our examiners feel very strongly that order tickets should be marked as "solicited" or "unsolicited". Because unsolicited orders are not counted against the broker in determining turnover ratios in a churning analysis, it is necessary to have that information to effectively determine turnover. There is no significant cost to a firm to indicate whether an order is solicited or unsolicited. I understand that the concern is over the definition of "solicited". The Penny Stock Rule has an exemption for transactions that are "not recommended". Several commentors on that rule suggested that the rule would be clearer if the term "solicited" rather than "recommended" were used in that Rule. Clearly, brokers understand when transactions are solicited and when they are not.
Customer Account Records - Washington supports the requirement that a copy of the account information or like facsimile be provided to the customer within 30 days of the opening of the account and thereafter at least once every 36 months or when the account record is updated to reflect a change in the customer's objectives. We do have a concern about the customer's ability to verify his or her investment objectives. Because the industry has no real uniformity with regard to its designation or description of what a particular "investment objective" means, we recommend that the rule contain a provision requiring that the objectives be described in "plain English".
Washington recommends that an account record be kept for each individual listed on a joint account. Should the individual with trading authority die or become incapacitated, the joint owner may become the trading authority and could continue trading. That person is very likely to have different suitability requirements than the main account holder. Without that information, a field examiner would not be able to determine suitability for that account.
Customer Complaints - Under the reproposal, the firm is only required to maintain a record of complaints that describes the nature of the complaint, the name of the complainant and the disposition of the complaint. Although we support the maintenance of the log, we are very concerned about the accuracy and completeness of the entries. In our experience, the firm's characterization of the nature of a complaint can differ substantially from that of the client. Washington recommends that at least a copy of the actual complaint letter and the documents sent with it should be kept locally.
The reproposal requires all firms to create a record indicating that each customer has been notified of the the address and telephone number of the department of the broker-dealer to which any complaints may be directed. We support requiring that each customer's account statement contain the name, address and telephone number of a responsible individual who a customer can contact with inquiries and complaints regarding the customer's account. This office often has to direct customers to the firm's branch manager or compliance office in order to get their complaints resolved.
Exception reports - Under the reproposal the firms are required to retain exception reports that they create. We support this requirement as these records are extremely useful to allow our examiners to focus in on problem areas in the firm.
State Record Depositories - The State of Washington supports the requirement that records for one person offices be stored in a state record depository in the event that the definition of local office is not changed to include one person offices. Having access to records in this state is critical to state enforcement efforts. State waiver of this provision should not be allowed.
We believe that the proposal benefits broker-dealers, regulators and investors. Broker-dealers benefit by having a uniform books and records requirement for little or no additional cost. Regulators benefit by being able to carry out their regulatory surveillance in a more efficient and timely manner. Investors benefit by having records of their accounts kept locally where they and regulators can examine them to prevent securities violations.
Thank you for the opportunity to comment on this very important proposal. We hope that you will seriously consider our suggestions for changes.
Director of Securities