December 7, 1998

Mr. Jonathan G. Katz, Secretary VIA E-MAIL:

Securities and Exchange Commission

450 Fifth Street, N.W.

Mail Stop 6-9

Washington, D.C. 20549

Re: Books and Records Requirements for Brokers and Dealers Under the Securities Exchange Act of 1934; Release No. 34-40518; File No. S7-26-98

Dear Secretary Katz:

Please accept this comment letter on behalf of the Commonwealth of Kentucky, Department of Financial Institutions, Division of Securities (the "Department"). The Department strongly supports the Securities and Exchange Commission’s (the "Commission’s") reproposed release of amendments to Rules 17a-3 and 17a-4 of the Securities Exchange Act of 1934 (the "Release").

To understand our support for the Release, and why we believe the amendments it proposes are essential to the protection of the investing public, we present our discussion in three parts. Part 1 describes the steps we have taken to modernize our regulation of securities activity in Kentucky and, in relation to that, illustrates Kentucky’s commitment to protect its citizens from investment fraud in light of the new realm of regulatory responsibilities enunciated in NSMIA. We believe the Release demonstrates the Commission’s recognition of the essential role of states in the post-NSMIA world to protect the public from securities law violations as well as evidences the Commission’s commitment to facilitating that role. Part 2 of this letter provides a brief overview of our examination and investigation programs. Both programs would be dramatically – and adversely – affected were the SEC not to promulgate the Release. Part 3 of our comment letter derives from our regulatory experience and provides our observations about the potential impact of select features of the Release on regulators, industry, and the investing public.


A. Legislative and Regulatory Modernization

The Department was pleased this year by the passage of House Bill 112,(FN 1) which dramatically modernizes the Kentucky Securities Act. A few months later, the Department promulgated corresponding and comprehensive regulatory changes (FN 2) to complete the modernizing work begun with House Bill 112. In combination, these revisions to the Kentucky blue sky law comply with both the spirit and letter of NSMIA and demonstrate Kentucky’s sensitivity to the issue of uniformity and cooperation among regulators – state, federal, and SRO.(FN 3) The changes to the Kentucky blue sky law were a conscious attempt by this agency to address the dual objectives outlined in NSMIA of increased regulatory efficiency and increased public protection at the state level in the area of policing securities fraud. You may find more information about these changes at

B. Reorganization of the Department to Enhance Securities Regulatory Function

Simultaneous with the revisions to the Kentucky Securities Act and Regulations, this agency underwent a substantial reorganization. As part of this reorganization, Department staff performed a thoughtful self-examination of where the Division of Securities’ focus and mission should be as we enter the next millenium. Among the many issues discussed by Department staff, was the best way to respond to the increasing incidence of fraud and other securities law violations that were harming the investing public of our state. We determined that the most effective way to address the problem would be to assume a more proactive regulatory posture, particularly with regard to oversight of broker-dealer activity. One key to enhancing our proactive regulatory posture, we concluded, was to implement a routine examination program of the securities professionals that work in our state. (FN 4)

As a consequence of this regulatory introspection and the resulting reorganization of our agency, we created and staffed a new branch in the Securities Division to routinely inspect on-site the offices of brokers and investment advisers in our state. The new securities examination program officially commenced January 1 of this year and, to date, the Department has performed over 200 examinations of offices of broker-dealers and investment advisers throughout the Commonwealth. (FN 5)

As I will discuss further at Part 2.B., the Department’s routine examination program has already achieved success on several levels. We are grateful to the Commission’s support, exemplified in the Release, of state examination and investigation efforts. We believe the Release will ensure the continued success of examination programs such as our own as well as our investigative efforts. In addition, the provisions of the Release will lead to less disruption and less cost to the industry members whose offices we visit.


The amendments proposed by the Release go to the heart of the state regulator’s ability to effectively oversee the brokerage industry and, more importantly, to provide the minimum level of proactive regulation and protection the investing public deserves from its regulators. A brief description of our programs to examine and investigate securities firms, and some of the recent and disturbing trends we have observed, will illustrate this point.

A. The Problem of Securities Fraud in Kentucky

Notwithstanding Kentucky’s success in modernizing its blue sky law and enhancing its regulatory presence – or perhaps because of it – this Department has observed a disturbing trend in the securities investigations it has opened in recent years. One trend has been, quite simply, an enormous increase in the volume of securities investigations we have had to open. For example, as of the end of calendar year 1997, the Department opened and performed almost triple the number of securities fraud investigations than it performed in calendar 1996; calendar 1996 had, to that point, been the highest year ever on record. The Department likewise tripled the number of investigations referred to other agencies and criminal prosecutors in calendar 1997. This trend has continued in calendar 1998 with the number of fraud investigations opened this year already far-surpassing the calendar 1997 number. Indeed, we estimate that by the end of calendar 1998, the number of new fraud cases opened will represent a 25% further increase in new cases over the calendar 1997 number.

Another disturbing trend we have observed relates directly to the subject matter of the Release in so far as we are finding, proportionately, many more cases of suspected law violations by registered representatives and their firms than we have in the past. While the majority of cases our Department investigates continue to involve unregistered persons or unregistered securities, an increasing number of the investigations we open involve registered professionals or the brokerage firms employing them or both.(FN 6) Without proper access to the books and records of these firms, we are unable to perform a proper investigation and resolve the securities law compliance issues raised by the investigation. The reproposed amendments contained in the Release are absolutely crucial to our ability to properly perform such investigations.

One last trend we have observed is the growing volume of securities law violations – and harm to the investing public – emanating from the small one- and two-person shops that are scattered throughout our state. As a relatively small state in terms of population, and a state that is predominantly rural or mountainous, the proliferation of such small offices is not surprising. Indeed, we support the presence of these firms, when they are responsibly managing their agents, given that many of our citizens might not otherwise have access to investment services but for the existence of such smaller shops.

Based on our investigative and examining experience, some of the firms we regulate – particularly those headquartered out-of-state and with small satellite offices in Kentucky – demonstrate a marked nonchalance toward their supervisory responsibilities. This cavalier attitude has led to the commission of frauds by agents of several of these firms, which frauds our agency has had to investigate in the last year. These frauds, in aggregate, caused harm in the tens of millions of dollars to our citizens and, interestingly, the frauds present almost identical facts. In each instance, we uncovered evidence that indicated the agent perpetrated a fraud against several, sometimes even dozens of Kentucky investors; the damages to the investors ran almost invariably into the hundreds of thousands, if not millions of dollars; the fraud occurred over a several year period; and, most troubling of all, during the course of the fraud, the firm employing the agent typically had not even once visited the agent’s Kentucky office – let alone performed any type of compliance examination – during the agent’s employment and perpetration of the fraud. (FN 7)

Based on these experiences, we firmly believe problems could have been prevented, or harm to investors substantially mitigated, had the firms involved provided a minimal degree of supervision and oversight of these agents through periodic on-site inspections. In several instances, the fraud involved selling away and information was rampant in the agent’s office files of the illegal activity. The absence of such oversight illustrates to us the crucial role of state regulators, through their investigative and examination functions, to inspect firms in order to ensure some degree of oversight of the agents’ activities. The state regulator’s work in this area can only occur with proper and timely access to the books and records of these shops, as will be facilitated by the Release.

B. Examination Of Broker-Dealers In Kentucky

The Department officially established its routine compliance examination program in January of 1998. The new program is a direct response to the increase in fraud we have observed in the last several years, the trends outlined in Part 2.A. above, and the mandates of NSMIA. Clearly, our primary intention in establishing this program was to proactively ferret out potential compliance and supervisory issues before they could become full-blown problems and harm our citizenry. However, we are also striving to assist firms in better serving their customers by providing informative post-examination reports to the firms. In addition to documenting the potential securities violations observed by our examiners, the reports often include recommendations to the firms on ways they might enhance their compliance and supervision. Most firms recognize and appreciate the benefits of routine state examinations and, in turn, we appreciate the responsiveness of these firms to our examinations because their cooperation is crucial to the effectiveness and success of our examination program. We are convinced that the responsible members of the industry share with us a common desire to ensure the investing public is responsibly provided investment services by all industry members.

At least 4,000 registered representatives (Series 6 or Series 7) and approximately 750 registered branches are located within the geographic borders of Kentucky. And, as members of this business know, many more offices exist than are documented as ‘registered branches’ and the number of actual office locations is difficult to quantify absent any branch registration for these offices. Indeed, our information indicates that the majority of representatives, particularly those employed by out-of-state headquartered firms, are in small shops scattered throughout the state and not in ‘registered branch’ offices. (FN 8)

The registered branch offices alone are sufficient in number to keep our examiners very busy. If specified records were not readily available at these locations or, alternatively, at a central depository in the state, our examination program would be severely hampered. In addition, if records are not available as listed in the Release, the time of disruption to firms, as well as the examination costs charged to them, as a result of our examinations, would significantly increase.

Notwithstanding the logistical difficulties inherent in examining on-site these small shops (in light of their great number and our modest staffing), we are ready for the challenge of providing regulatory oversight for these shops wherever they are located. We believe that the amendments proposed in the Release will assist us in our examinations by ensuring records for these shops will be available, either at the ‘local office’ or a central depository in the state. It is hard for us to imagine any firm that takes its supervisory responsibilities seriously, not wanting to maintain these records at either such location. Without these proposed amendments, the present SEC rules would be inadequate to insure state regulators a meaningful role in policing securities law compliance and, consequently, adequate public protection at the state level.


Based on our experience examining firms and investigating securities law violations in Kentucky, we believe the Commission has struck the right balance in crafting the Release. Although our perspective as regulators does not permit us to agree wholeheartedly with each and every provision of the Release – because it is quite rightfully a compromise in several instances of very divergent industry and regulator viewpoints – we applaud the hard work of the Commission in giving thoughtful consideration to these competing viewpoints. At the end of this long and difficult process, we believe the Commission has achieved, in the form of the Release, a fair and balanced resolution of the oft times conflicting interests of regulators and industry.

Notwithstanding our general and strong support for the Release, we would like to offer the following observations with respect to certain of its provisions:

A. Certainty As To Records-keeping Requirements

We strongly support the general theme of the Release, which is to provide more certainty for both industry and regulators about the manner in which firms maintain records. Detailed, accurate and readily available records are absolutely essential to the public protection. Records – or, more often, their absence – are often the primary indicator that improper activities are occurring and review of records is the single-most important element of our examination and enforcement work. As both a matter of regulatory efficiency and industry convenience, the Release clarifies what records firms should or should not keep at certain locations. This will, in turn, assist the regulator in performing the most efficient examination and, consequently, cause the least disruption to the firm being examined.

Contrastingly, without easy access to relevant records at local offices, state regulators would incur significant additional costs by being forced to conduct examinations at two separate locations (one, the physical office, and the other, where records are located). State regulators would also have to wait extended periods of time for access to records, in the process subjecting the records to potential alteration, manipulation, or destruction by the record-keepers (or at least a perception on the part of the regulator that such could occur). The consensus among our examiners in Kentucky is that waiting for firms to send records from another location (as opposed to coming to an office where records are already waiting) can result in a substantial increase in the amount of time spent on the examination and, consequently, a significant increase (estimated by our examiners to be several hundred dollars typically) in the cost we bill to the firm for the exam. (FN 9)

B. Definition of Local Office and Establishment of State Depository Requirement

We support the Release’s definition of "local office" establishing a threshold of two licensed persons to trigger the requirement that certain core records be kept or otherwise made available for review and production on site. As discussed at Part 3.A., our examiners are often hindered by the absence of key records in local offices and so we appreciate that the Release will clarify for members what records they will need to maintain. While we would prefer records be on-site at all office locations in our state, we recognize the need to strike a compromise on this point between regulators and industry. We are confident that, in so far as defined records will be kept on site at all offices with two or more agents, we will be able to improve our examination efficiency as to such offices.

With respect to offices that do not meet the definition of ‘local office’ (e.g., less than two agents work there) these offices shall maintain records at a designated depository located within the state. We believe the state depository is an adequate compromise for regulators and industry and appropriately provides for record keeping of the many small shops located in states such as our own. It will be more convenient for industry, we believe, and, in so far as we will be certain that such records are available in our state, we can structure our examination program accordingly.

We would note, however, our belief that a significant proportion of enforcement problems will continue to emanate from these smallest offices. We hope that industry members will not take as a signal from this Release, and its provision for maintenance of records off-site, that their supervisory responsibility as to these offices is, in any way, diminished in relation to the local or branch office requirements.

C. Order Tickets

We are pleased by changes relating to order tickets that require identifying not only the associated person responsible for the account but any person who has accepted or entered the order on behalf of the person. However, we do wonder why the Commission does not require firms to mark trades as solicited versus unsolicited given this has a bearing on suitability as well as, potentially, the registration status of the order taker.

D. Review of U4 and U5 Forms

We are mildly disappointed by the provision of the Release that firms do not need to maintain U-4s, U-5s, and amendments at a local office. Notwithstanding the statements of commenters referenced by the Commission in the Release, in our experience, the efficiency of the examination that can be conducted will be diminished if this information is not readily available during the regulator’s on-site visit. The problem for our examiners is that it is impossible to know what agents are in an office until the examiners actually visit the site to perform the examination. Therefore, it is impossible to run the CRD checks on the agents (and obtain their disciplinary and employment information) until after the examiners have returned from the examination to our offices. In our opinion, if an agent is terminated for cause, or has been subject to a disciplinary action, we need to know this while on-site in order to ask questions and determine if there is cause for concern.

E. Joint Account Information

We strongly believe that firms should maintain suitability information on each joint account customer. For example, should the individual with trading authorization die or become incapacitated, the joint account holder would have a right to the assets and continuing trading. Similarly, joint holders might have divergent financial interests or the joint holder could be a child that, upon majority, would be able to make his or her own investment choices. We also believe that the Release should expressly phrase the 36-month updating requirement as a floor only and, conversely, not permit it to be construed as a safe harbor for updating account information. As a practical matter, for firms truly committed to the notion of ‘knowing their customer’, it would seem unlikely they could, indeed, know such customers (or their investment objectives) sufficiently if they are waiting three years to contact them. In our view, at a minimum, the period should be 24 months.

F. Customer Complaints

We are somewhat dismayed by the Release’s elimination of any requirements on firms to maintain verbal complaint information. We believe it appropriate, at a minimum, for brokers to maintain a log of verbal complaints in order to spot potential trends involving representatives and how they deal with their customers. One would think, too, that a firm would be better served by maintaining this oral complaint information as a means of proactively (rather than reactively) addressing potential problem behavior by agents.

As to the Release’s requirement respecting written complaints, we are concerned that the Release does not go far enough if, in a log format, it only requires the maintenance of a record as to the nature of the complaint, the name of the complainant, and the disposition. We feel that the firm should maintain at least a copy of the actual complaint letter and related correspondence at the local office. In our experience, the firm’s characterization of the nature of the complaint may in actuality be very different from, or more understated than, the customer’s. Subsequent correspondence is also crucial to demonstrate how the firm resolves the complaint. Our examiners have observed some rather sarcastic response letters from a firm to a complainant that suggest this rule may be subject to abuse.

G. Exception Reports

We are disappointed by the Release’s failure to require firms to make exception reports. While most of the larger firms automatically make and retain these reports, our examiners have found that most smaller firms do not and often it appears that these reports would be extremely important to such firms in their supervision of their agents. We believe that broker-dealers that truly desire to meet their supervisory obligations can only begin to do so if they produce an exception report. The report should detail, at a minimum, excessive trading, unusually high commissions, high number of trades, switching, and agents making trades in states in which such agents are not registered.

H. Sales Scripts

We are unclear from the current working of the rules if firms will maintain sales scripts at a local office level, assuming a firm uses such scripts. We would respectfully request the Commission to clarify that the firm using such scripts must maintain them in local offices. In a recent for-cause examination of a firm in Kentucky engaged in cold-calling sales practices, we found scripts used by the firm very helpful to our examination. In our experience, the scripts can document if the firm routinely gives potential investors misleading, misrepresented, exaggerated, flamboyant or untruthful information. In addition, comparing scripts to information in the prospectus can also be enlightening about the possible sales practice abuses of a firm.

* * *

In conclusion, I would like to emphasize our support for the Release. The Release fairly balances the interests of state regulators and the industry in light of our common objective of better service and protection to investors. In our view, the Release imposes no ‘new’ requirements on firms to create or keep records. Indeed, in our experience, the records enumerated in this Release are exactly those records a conscientious firm – that is, a firm committed to meeting its supervisory and suitability responsibilities – will maintain. In so far as firms are now permitted with respect to their smallest shops to keep the records at one central location in the state, the firms will benefit from the Release in terms of both cost and convenience.

I would like to thank you for this opportunity to provide input on the subject of the Release.



/s/ Marion H. Lewis

Marion H. Lewis

Director, Division of Securities

Kentucky Department of Financial Institutions 

Copy: Karen O’Brien, NASAA


(1) H.B. 112, 1998 Ky. Leg. Sess. (enacted), codified at KRS 292 et seq. Equally pleasing to the Department, notwithstanding a few minor technical amendments, the Bill passed into law received unanimous support in both legislative chambers and was virtually identical to the draft prepared by the Department with the assistance of a Legislative Advisory Committee. The Committee included leading securities professionals, scholars, and attorneys from around the Commonwealth and the nation.

  1. See the new and amended regulations promulgated on June 25, 1998, at 808 KAR 10:010, et seq.

(3) Among other things, the revisions also streamlined regulations on small businesses raising capital in the state, enhanced the Department’s enforcement powers (including among other things, assumption of enforcement authority over variable annuities), and provided for implementation of the Department’s routine examination program of securities professionals in the Commonwealth. A comprehensive summary of the revisions to the Kentucky blue sky law can be reviewed on the Internet at

(4) The fruit of this self-examination is found in the revised statutory policy for the Department at KRS 292.530: The Department’s statutory mission is to (1) enforce the laws in order to best protect the public, (2) increase educational awareness of fraud on the part of the public, and (3) facilitate small business capital raising.

(5) This number includes a couple dozen exams performed in calendar 1997 while we were beginning to implement the program. Based on our current staffing levels we estimate we will perform around 200 exams this year; however, because we are continuing to increase our staffing in this area we anticipate increasing the rate of exams performed annually in the future.

(6) The percentage of investigations we have opened involving registered representatives or firms doubled in calendar year 1997 over the calendar 1996 number. It appears likely the number of such cases opened in calendar 1998 will be equal to the calendar 1997 number as well.

(7) There is also a disturbing trend in that many of these frauds appear to be coming from insurance affiliated broker-dealer subsidiaries. Of the several significant fraud cases we have opened in last year, in almost every one of the cases, the agents investigated were contractors through an insurance broker-dealer subsidiary. The cases present chillingly similar facts and the harm to the investors we estimate to be in the aggregate in excess of ten million dollars. In the most recently concluded investigation of this type, the Department’s investigation indicated that the brokerage firm in question (a subsidiary of a large, multi-national insurance conglomerate) had not once performed an on-site inspection (announced or unannounced) of the subject agent in a several year period. The agent ultimately was convicted of defrauding 59 Kentuckians of close to $4 million and was given a 20-year prison sentence. Upon the conclusion of our investigation of the firm’s supervisory practices, the firm agreed to make full rescission of the investments of several dozen investors. More relevant for purposes of the Release, the firm agreed to significantly enhance its supervisory procedures including performing several annual announced and unannounced on-site inspections of its Kentucky agents.

(8) And, as stated earlier, it has been our experience that a number of these offices are not subject to adequate supervision by the out-of-state headquartered broker-dealers employing them. Because firms are not required to report to us information as to any non-branch offices they may have in the state, we do not have precise numbers for these locations. However, as part of our creation of a database to track these non-branch locations, we have determined that, at a minimum, there are several hundred additional such offices located throughout the state. We would also observe that the explosion in the number of bank affiliated broker-dealer offices, that are almost invariably manned by one person (or less) has presented added challenges to our examination program. In our experience, many of these outfits are less cognizant of their supervisory and suitability obligations than their peers in the ‘traditional’ brokerage industry. And, simply as a logistical matter, many of these offices are set up in a ‘circuit’ fashion with one bank brokerage employee responsible for providing the brokerage services at several separate bank branch office locations, making it difficult to schedule examinations, particularly those which are unannounced.

(9) 75% of the offices we examine have 90 to 95% of the needed information available when the examiners arrive. 25% of the firms examined do not have a substantial portion of the necessary documents available. The documents often unavailable—and which cause delay and added costs until provided—include the following: exception reports, internal audits, U-4 and U-5 information, customer listings (all), margin and option account listings, commission runs, confirmations, CRD numbers of agents, and employee/employee-related accounts.

(10) In the Release, the Commission states that it was persuaded by industry comments that this ‘information is . . . available through the Central Registration Depository.’