U.S. Securities and Exchange Commission
450 Fifth Street NW
Mail Stop 6-9
Washington DC 20549
Re: Reproposed Books and Records Requirements for Broker-Dealers
Under the Securities Exchange Act of 1934 (File No. S7-26-98)
Dear Mr. Katz:
The Division appreciates this opportunity to comment on the Commissions reproposed rules establishing books and records requirements for securities broker-dealers, and commends the Commission for working with state securities regulators to develop uniform requirements as mandated by the National Securities Markets Improvement Act of 1996 ("NSMIA"). Prior to commenting on several specific issues set forth in separately numbered paragraphs below, we would like to comment generally on two aspects of the reproposed rules that are of overriding significance.
"LOCAL OFFICE" DEFINITION
I . The first aspect is the Commissions reproposed definition of "local office" which was changed to apply to locations where two or more associated persons conduct business. (As originally proposed in 1996, the definition included single-person locations). The elimination of single-person offices will have a major impact--and, we believe, a major negative impact--on the Divisions ability to conduct its regulatory oversight of broker-dealer licensees. That is because our periodic, on-site inspections of one-person offices in Wisconsin will largely cease because under the reproposed rules, the critical records that are necessary to facilitate an effective inspection will no longer be required to be kept on-site at single person offices.
An important part of the Divisions investor protection efforts for decades has been the implementation of an extensive program of conducting pre-announced, as well as unannounced, inspections of Wisconsin branch office (and Wisconsin home office) locations of broker-dealer licensees. A number of the Divisions investigations and enforcement actions involving Wisconsin broker-dealer and agent licensees results from branch office inspections.
As an example of the impact the Commissions rule change will have on the Divisions branch office inspection program, of the total of 1521 broker-dealer branch office locations in Wisconsin, 790 are one-person locations, comprising some 52% of all office locations in the state. (There are 224 two-person branch offices in Wisconsin.) In the two preceding fiscal years, the Division conducted 112 and 76 branch office inspections, respectively. One-person offices comprised 46 (41%) and 27 (35%) of those inspections. Consequently, over half of Wisconsin office locations that currently are on the Divisions periodic inspection list will no longer be getting regular Division oversight. Therefore, because the Commissions change in the definition of "branch office" to eliminate one-person office locations will already adversely affect the Divisions ability to conduct our regulatory oversight of a substantial proportion of broker-dealer office locations in Wisconsin, it is critical that the definition not be further weakened by adopting a 3-person (or higher) test.
With regard to the Commissions records requirement for single-person offices that they be maintained at a single, central repository in the state, the Division has the concern that certain key categories of records that would reflect problems at a particular branch--such as copies of customer complaints--could be "lost in the shuffle" (unintentionally or even intentionally) of forwarding them to the central repository.
An additional concern with the central repository provision is that it will not enable the Divisions examination staff to identify certain problem business practices that only are evident from on-site inspections where evidence relating to those practices is uncovered (such as unsafe cashiering practices, agents doing business "off the books", and situations involving agent promissory notes payable to customers). As an example of this concern, a recent examination (within the past week) of a two-person office revealed deficient recordkeeping of securities received and delivered. A customer delivered certificates (in connection with a sale transaction) to the branch office, which forwarded them to the home office. However, no record was made of the receipt or transmittal of the certificates, and no receipt was given to the customer. The home office acknowledged it received an envelope, but not that it contained any certificates, and no record exists of what was in the envelope. The firm then threatened that it would "buy in" the customer to satisfy the "failure" to deliver the certificates for the sales. The specific recordkeeping requirements that are now being implemented by the branch as a result of the Divisions on-site inspection which identified this deficient cashiering practice, will avoid similar problems for customers in the future. Because the Division no longer will be conducting routine inspections of one-person branch offices, we will no longer be able to identify these types of problem practices at such branches and alert firms to take remedial action.
SCOPE AND CONTENT OF THE REPROPOSED RULES
II . The second aspect is the scope and content of the reproposed books and records rules. The Division urges that the rules be expanded in several respects as set forth in some of the numbered paragraphs below.
A broker-dealers books and records provide the informational basis to demonstrate either violations of, or compliance with, the Wisconsin Uniform Securities Law, whether the Division is conducting a for-cause examination as a result of a specific complaint matter, or is conducting a "standard" periodic branch office (or home office) examination. Particularly now that NSMIA prohibits states from establishing books and records rules that differ from, or are in addition to, the Commissions rules, it is crucial that the Commissions rules require the creation and maintenance of the types of records--especially at local offices--to enable states such as Wisconsin to continue to provide effective regulatory oversight.
Importantly also, the records required by the Commission to be created and maintained must be comprehensive enough to enable the broker-dealer to provide adequate supervision of the activities of those local Wisconsin offices. In that regard, the scope of this Divisions books and recordkeeping rules--which have been in place for decades--encompasses all of the records that would be required under the Commissions reproposed rules, and in several instances (discussed with more particularity below), go beyond the scope of the Commissions reproposed rules. Consequently, most all of the records required to be maintained under the Commissions reproposed rules have been required records for Wisconsin branch offices for years. Therefore, such records required under the reproposal would not involve new types of records to be prepared and retained by broker-dealers. Additionally, because broker-dealers already need to maintain the kinds of books and records required under the reproposed rules to enable supervision of the firms activities and operations, broker-dealers currently already have such records.
With regard to various specific provisions of the Commissions reproposed rules, the Division has the following comments:
1. Reproposed Rules 17a-3(a) (6)and(7) relating to order tickets were modified to delete the requirement to specify whether the order was solicited or unsolicited. The Division believes that deleting such requirement is counter-productive because it deprives both regulators, as well as the supervisory personnel of broker-dealers, of the key information that would enable at-a-glance verification of the basis for relying on the "unsolicited order" registration exemption for secondary trading purposes that is present in most states (based on the Uniform Securities Act language in sec. 402(b)(3)). Most of the Uniform Act states with that exemption, including Wisconsin, require that in order to claim use of the exemption, a broker-dealers records --such as an order ticket--must confirm that the order was unsolicited. We therefore urge the Commission to restore the requirement that an order ticket verify whether the order was solicited or unsolicited.
2. With regard to certain additional records under Rule17a-3(a)(12) concerning "associated persons", the Division supports the Commissions interpretation of the term "associated person" to include any "independent contractor" (that provides broker-dealer services), and the corresponding reproposed rule requiring broker-dealers to keep the records described in Rule 17a-3(a)(12) regarding such "independent contractors."
3. With respect to customer account records and reproposed rule 17a-3(a)(16) that would limit applicability to accounts with "natural persons" as the beneficial owners, the Division would comment that the Commission needs to clarify applicability of that rule. Because in a tenants-with-rights-of-survivorship account, as well as a tenants-in-common account, each of the tenants would have authority to direct transactions in the account, regardless of their financial contribution to the account, account information should be maintained for all participants in such joint accounts.
4. Also with respect to reproposed rule 17a-3(a)(16) and the requirement that the records be updated once every 36 months or if there is a change in the customers name, address or investment objectives, the Division believes that the Commission should consider requiring updating of the customer account record for certain types of "material events". For instance, if the customer retires or loses his/her job and so notifies the agent, such should trigger the requirement to update the customers account record data.
5. A final comment regarding the reproposed customer account record rules relates to Rule 17a-3(a)(16)(C) which provides that the refusal, neglect, or inability of a customer to provide account data excuses the broker-dealer from obtaining the account information. The Division would recommend that the rule add express language to provide that such customer refusal/neglect does not exempt the broker-dealer from making a general suitability determination with respect to each transaction the broker-dealer recommends for such customer.
Illustrative of this issue is a recent Division case where a broker-dealer argued that although no financial information was contained on a customers new account form to demonstrate suitability of a high-net-worth required investment, the broker-dealer contended that because the firm "knew" "other information" about the customer that purportedly supported the suitability claim, the Division could not discipline the firm just because the "other information" was not written down.
6. Reproposed Rule 17a-4(b)(11) deleted a provision contained in the original 1996 proposing release that would have required broker-dealers to "produce reports to monitor unusual occurrences in customer accounts such as frequent trading, unusually high commissions, or unusually high numbers of trade corrections or cancellations." To a supervisor properly doing his or her job, each of those types of agent practices demonstrates that the agent is engaging in practices that adversely impact customers. The reproposed rule requires broker-dealers to retain the reports only if reports are created (or must be able to create them upon request). Such an exception that would allow broker-dealers not to create reports, even when a pattern of potential or actual problem trading practices might have been identified, seriously undercuts a firms obligation and responsibility to supervise. It sends exactly the wrong message to supervisors (and firms)--namely, under the reproposed rule, broker-dealers no longer have to create the kind of report that under current rules presumably would be used to document the problem to management of the firm. Thus, by not having to create the report, the supervisor and management are insulated from the risk of ignoring the problem and not taking any corrective action because there is no "smoking gun" report that would have evidenced a failure to supervise. The exception provided in this reproposed rule thus deprives federal and state regulators of basic documentation evidencing whether the firm had and implemented proper supervisory systems and practices--namely, reports chronicling problem agent conduct that supervisors have identified. Such exception puts regulators in the position of having to establish after-the-fact both the pattern of agent conduct and who in the firm knew what (and when did they know it ) about such practices. This exception will nullify regulators "get tough" policy on both supervisors and on management where there are serious supervisory lapses by a firm.
7. Reproposed Rule 17a-3(f) listing the specific records required to be retained at each "local office" fails to include monthly statements. The Division regards monthly statements as critical records because they indicate overall account activity and show patterns of trading at-a-glance which otherwise would take a lot of effort to construct from other customer account records (for instance, in contrast to a branchs daily blotter which is useful only as a "transaction verifier"). A branch offices monthly customer statement records currently are one of the key records used by this Divisions staff when investigating customer complaints and would deprive the Division of an at-a-glance indicator of overall activity in not only that customers account, but in comparing activity with a particular agents other customer accounts (which otherwise would take substantial effort to reconstruct).
8. The Division both: (i) supports the requirement that a broker-dealer retain any written approvals of outgoing communications and (ii) strongly supports the Commissions reproposed Rule 17a-4(b)(10) that broker-dealers maintain a record of any written procedures for reviewing marketing materials because the rule requirements will allow easier examination for sales practice abuses such as unauthorized trading, non-suitability, and churning.
9. In response to the Commissions request for comments on various subjects contained in Section IV, the Division has the following comment on whether the Commission rules need to provide for state regulator "access" to Commission-required books and records. The Division notes an apparent language inconsistency between sections 17a-4(f)(3)(vii)(1)and (2) (relating to electronic records) and section 17a-4(j) (relating to all records generally). Specifically, the reproposed rule language in 17a-4(f)(3)(vii)(1)and(2) expressly provides for access to those electronic records by "any state securities regulator having jurisdiction over the broker-dealer"; however, section 17a-4(j) does not contain equivalent language. Accordingly, it appears that the same language contained in sections 17a-4(f)(3)(vii)(1)and(2) should be added to section 17a-4(j) to expressly provide for access to those records by state securities regulators.
My staff and I would be pleased to respond to any questions regarding the Divisions comments. My direct dial telephone number is (608) 266-3432.
Patricia D. Struck