November 30, 1998
Jonathan G. Katz, Secretary
Securities and Exchange Commission
450 5th Street, NW
Mail Stop 6-9
Washington, DC 20549
Re: File No. S7-26-98
Release No. 34-40518
Books and Records Requirements for Brokers and Dealers
Under the Securities Exchange Act of 1934
Dear Mr. Katz:
The State of Kansas appreciates this opportunity to comment on the reproposed amendments to Rules 17a-3 and 17a-4. We strongly support the amendments as reproposed in Release No. 34-40518.
The need for the records contemplated by the reproposed amendments cannot be overstated. Detailed, accurate records are absolutely essential to enforce compliance with regulatory requirements and to detect sales practice violations and fraud. Early detection, by either the firm or regulators will mitigate the public harm and facilitate the timely recovery of losses by investors.
The records captured by the reproposed amendments to a large extent already exist. Complete order tickets, customer account and transaction records, and compensation records, are core records required for the orderly conduct of business. They are also critical to any effective and credible firm supervision of associated persons. The reproposed amendments merely codify the "best practices" of industry already in place. The requirement that these records be maintained in a format to provide ready access to state regulators is likely to add no extra costs or, at worst, marginal costs to firms. On the other hand, the benefits to the investing public are enormous. The amendments allow firms sufficient flexibility to store the records in the most cost effective manner. Small firms may wish to store hard copy documents in a file cabinet. Other firms who are automated may opt for electronic storage and retrieval, taking full advantage of state-of-the-art technological advances.
A uniform, nation-wide requirement as to books and records will benefit both the industry and regulators. Brokerage firms will have a clear understanding and expectation of what records are required. Regulators can tailor and streamline their exam procedures to be more efficient. This will facilitate thorough and quick examinations. Firms with no violations will experience less intrusion. Firms with violations will be promptly identified.
Information Required on Order Tickets - Rules 17a-3(a)(6) and (7):
We support the changes envisioned by reproposed 17a-3(a)(6) and (7) which require that order tickets include not only the associated person responsible for the account, but in addition, the identity of any person who has "accepted or entered the order." This information will make firms more accountable for unregistered activity and sales practice violations and allow detection of such violations in a more expedient manner. The reproposal provides firms sufficient flexibility to meet this requirement. Firms may comply by simply modifying their current format to contain an additional data field, or create a new, separate record in the unlikely event that the former presents insurmountable technical difficulties. In either event, any associated burdens are offset by the fact that this additional information will provide for more efficient examinations and reduce the time regulators spend on site at a firm.
Similarly, we support the reproposed requirement that the order ticket be time stamped to reflect when it is received and when it is executed. This requirement, as well as identity of all persons who accepted or entered the order, provide a more accurate, historical record of the transaction as it actually occurred. This enables regulators to detect certain prevalent practices in secondary markets in the over-the-counter arena. This includes trading ahead of customer orders and trading at a prearranged price giving priority to insiders, nominees, or other person with whom a firm has parked stock.
Additional Records Concerning Agreements Between the Firm and Its Agents, Customer Complaints, and Compensation Records - Rules 17a-3(a)(12), (17), and (18):
The reproposed requirements as to these referenced records are interrelated and extremely important to state regulators in detecting and preventing certain fraudulent and abusive sales practices. From 1991 through 1994, this agency prosecuted a major enforcement action involving Hibbard Brown, a registered broker-dealer. The resulting enforcement action involved in excess of 50 customer complaints and 12 licensed sales agents. The settlement ultimately obtained resulted in the recovery of in excess of $1.2 million by Kansas investors. It also resulted in the firm modifying its procedures and record keeping practices.
In prosecuting this action, this agency had great difficulty in obtaining accurate compensation records. This significantly delayed the investigation and prosecution of this case. The type of fraudulent activity ultimately uncovered in that investigation was driven by the ability of the principals to motivate its sales force by its compensation practices. These practices focused sales activities on specific securities during specific time periods. These records existed and were needed for operational purposes. However, the firm resisted disclosure of this information citing as a reason that these records were not required under Rules 17a-3 and 17a-4.
It should also be mentioned that in this case, the existence of firm-disseminated sales scripts were also critical to demonstrating firm-wide, systemic fraud and manipulation. We ultimately obtained these scripts through pains-taking, time- consuming investigation. Again, this significantly delayed the enforcement action and allowed the firm to continue its fraudulent practices unabated during the progress of the investigation. A clear, regulatory requirement that state regulators have immediate access to these records would have shortened the process and made our job a lot easier. More importantly, however, it would have prevented substantial, ongoing injury to Kansas investors.
Timely access to compensation records is not limited to enforcement actions involving "penny stocks" or micro-cap fraud. These records would also have enhanced this agency’s ability to deal with a number of cases related to the improper sale of limited partnerships in the 1980s. Compensation records demonstrated that the improper activity was not merely attributable to "rogue" employees, as many firms first argued, but rather were the result of concerted, firm-wide initiative to market these products, rather than other, more suitable investments.
Definition of Local Office - Rules 17a-3(g), 17a-4(k)(1) and (2):
It is anticipated that the definition of "local office" under 17a-3(g) and the retention requirements set forth in 17a-4(k)(1) and (2) will be one of the more controversial aspects of the reproposed amendments. Prior to the adoption of NSMIA, many states required all offices to maintain certain minimum books and records. The current reproposal to limit this requirement to locations where two or more persons regularly conduct business is already a significant compromise of the states’ examination and enforcement priorities.
A review of a small but significant portion of our agency’s enforcement activity over the last ten years is instructive. Attached as Exhibit A, is a list of criminal actions pursued by the State of Kansas against registered securities agents during this time period. All of these actions involved misappropriation of client funds or criminal fraud. A review of the table demonstrates that seventy percent (70%) of these actions involved agents located at one or two-person office locations and the loss of over $3.5 million dollars.
This supports the intuitive perception by many regulators that small office locations present a disproportionate risk of serious regulatory problems and require closer scrutiny. Historically, the states have fulfilled this regulatory role through the examination of branch offices, which has tended to focus on smaller offices. Changing the demarcation line of the local office definition to a higher number than two would further erode the effectiveness of these examinations. If the states are prevented from effectively monitoring these locations, who will?
The interests of "Main Street" investors will be well served by the current, reproposed amendments. Any further erosion of these requirements will put the interests of Kansas investors at risk. We strongly support the current release and urge its prompt adoption and implementation
Thank you for the opportunity to provide input on these very important investor protection issues.
Very truly yours,