December 7, 1998
Jonathan G. Katz, Secretary
Securities and Exchange Commission
450 Fifth Street, N.W
Mail Stop 6-9
Washington, D.C. 20549
Re: File No. S7-26-98
Books and Records Requirements for Brokers and Dealers
Under the Securities and Exchange Act of 1934
Dear Secretary Katz:
The Division of Securities and Retail Franchising ("Division") of the Virginia State Corporation Commission is thankful for the opportunity to provide constructive input into the Securities and Exchange Commissions ("Commission") rule making process regarding books and records requirements for brokers and dealers. The new rules help to fill the gap created by the National Securities Market Improvement Act of 1996 ("NSMIA"). The Division commends the Commission and generally supports the re-proposed broker and dealer books and records requirements.
Books and Records Requirements are Needed and Appear Non-burdening
There is no doubt the Division and the broker-dealers it regulates have a vested interest in investor protection. The Commissions books and records rules are vital to this purpose, and were contemplated by NSMIA to be the core proponent of an effective national scheme of broker and dealer regulation in part based on periodic input from state regulators. The re-proposed books and records requirements evolved from proactive and preventative regulatory and industry compliance systems, which exist now, and have developed over a long period of time, as the best practices of broker-dealers and government to protect investors and the securities industry from illegal and unscrupulous securities activities by certain individuals and firms. Although the re-proposed rules allow for more flexibility (a good thing), they do not demand change, and almost universally allow for firms to operate in pre-NSMIA fashion, if so desired. In the Divisions experience (600 compliance audits), the books and records required by the re-proposed Commission rules are currently 99% maintained by broker-dealers. In fact, in most cases, firms keep more extensive records than those spelled out in the Commissions re-proposal. Most of the regulatory changes introduced by the re-proposal, which expand on the pre-NSMIA regulatory requirements, are merely regulatory catch-up to existing broker-dealers practices. The Divisions past experiences have shown that when compliance problems occur, broker-dealers defense has always been well organized, detailed and fully compliant books and records.
In the Divisions experience, securities professionals cannot legally conduct business from any location without a base set of records to utilize in investment and compliance decisions. From both a regulatory and internal compliance standpoint, the records laid out by the re-proposed Commission rules regarding local offices, constitute the minimal records which can effectively be used as a road map to detect illegal securities activities and protect the investing public. In fact, the Division has strong concerns regarding the reduction and omission of certain important pre-NSMIA records requirements.
The Division has found that firms with well organized, detailed and fully compliant books and records seldom experience problems with illegal and unscrupulous activities by their staff. Consequently, they do not have to endure the potentially catastrophic losses which result from serious securities violations and fraud. It has also been the Divisions experience, that firms with one man or otherwise small offices frequently are deficient in books and records and supervisory oversight. The correlation between poor record-keeping and regulatory problems is strong in Virginia. A prime example of this problem is illustrated by the internal record-keeping failures which have victimized a small regional Virginia firm. This firm was audited in the early 90s and at that time was found to be so deficient in meeting even the most basic books and records requirements that it elicited the Divisions first ever routine audit books and records enforcement action based solely on deficient records. A modest fine was accessed, and the Division required the firm to set up a reasonable supervisory and records system. Unfortunately the firm in a short time neglected its new system and once again operated with little supervisory oversight and grossly inadequate records. By the mid-90s their luck ran out and they were victimized by multiple agent violations involving misappropriation. Between Division penalties, customer losses, contingent liabilities resulting from prior poor record-keeping/supervision and an enforcement imposed first class CPA designed compliance system, the firm paid out millions of dollars more than it would have expended if it had kept well organized, detailed and fully compliant books and records.
As noted above, small offices, and particularly one man offices, are the most problematic in terms of record-keeping and securities violations. In Virginia, approximately 1,650 known broker-dealer sales offices exist. Of this group, at least 50% are one man offices. As a result of NSMIA, and also due to the NASDs omission of many broker-dealer business offices from its effective oversight, the Division has been unable, except by chance, to determine the locations of non-branch operating broker-dealer sales offices in the state. There are many small offices whose existence the Division is unaware of, and a trend appears to be in place, where the securities industry is decentralizing and forming more and more one man and small offices.
In the past, Virginia has pursued a policy of auditing each location in the state from which brokers and dealers conduct business with the general public, including many locations which are not defined as NASD branch offices, and many which will not rise to the re-proposed local office Commission definition. As noted before, almost all of these locations had books and records available for their own purposes and regulatory review. In most instances, their records exceeded the currently re-proposed local office requirements. As regulators, the Division finds it very difficult to understand how securities professionals could legally and practically recommend and consummate investment strategies without business office access to the following minimal books and records or their equivalent: order tickets, confirms, account statements, compliance and procedures manuals, complaint records, correspondence records (incoming and out going), audit reports, blotters (for trades, funds and securities), local office bank records, and a personnel listing with information about site agents. Accordingly, the Division can see no record-keeping burden which the re-proposed Commission rules place upon broker-dealers. Additionally, the rules flexibility allow firms to modify and/or retain existing record-keeping systems to fit their needs.
Reconstructing Transactions and Identifying Responsible Individuals
With respect to the Commissions re-proposed rules 17a-3(a)(6) and (7), the Division strongly supports these provisions. These requirements are crucial to reconstructing transactions and identifying players involved in micro-cap fraud, misrepresentation, unauthorized transactions, unregistered activity and a host of other problem areas. It is extremely important to know each persons involvement with each security transaction from both the regulatory and broker-dealers standpoints. It benefits the investing public, the broker-dealers and the regulators to track this type of information, thus highlighting problematic agents and associates. These requirements are particularly important if the Commission ultimately decides to exclude from its rules (as is currently re-proposed) the historic practice and requirement of marking trades solicited or unsolicited. Many enforcement cases in Virginia have shown the need for these provisions. Two cases in particular form good examples. In one case it was determined that an unregistered sales assistant of an unregistered agent transacted business under the name of another registered agent who received no commissions and was unaware of the transactions. Several of the transactions involved misrepresentations, and several were unauthorized. The firm veiled the illegal transactions in sloppy records. In a second case, it was determined that an unregistered agent transacted business under the name of a registered agent, and again the firms records were so confusing as to mask violations. Additionally, these transactions involved unregistered, unauthorized and unsuitable activities. Under the re-proposed Commission rules, this sort of activity would be clearly traceable and the firm could not hide behind the unclear records mask.
If the Commission is unwilling to require that securities transactions be noted as solicited, alternatively, the Division recommends that consideration be given to a narrower designation which captures the best of the past practices. The Division advises the Commission to strongly consider requiring firms to mark or categorize the following transactions as "recommended"; any purchase or sale of a security by a broker or dealer, for a customer, where the transaction was based on a personally directed recommendation of the transaction by a broker or dealer, through its sales representative and/or its sales assistant. The Division feels that this requirement hits at the very heart of a firms responsibility while addressing regulatory concerns and not miring down in the intricacies of defining the term solicited. The Division honestly feels that broker-dealers have a strong need to identify their legal liability in this area. It seems imperative that through records they capture and thus know what investment recommendations they have or have not made to clients. Without these records and tracking information, how do they monitor and defend related agent activities. As a regulator or internal compliance person, clearly this information is helpful in establishing efficient and effective compliance audits and processes. Without this captured information, it seems the only other source will be to question the client base directly. The Division feels that broker-dealers would agree that this is a highly ineffective, expensive and disruptive way of gathering information which has been gathered for years on the front end of transactions, and would clearly be no burden to broker-dealers as a status quo requirement. The bottom line is that the Division feels the broker-dealers have a legal need and responsibility for knowing if their agents recommended transactions, and therefore should gather this information. Based on this premise the above stated requirement should be added to the re-proposal.
The Division would like to strongly support time-stamping of order tickets or an electronic equivalent. This practice is important in tracing such illegal activities as front running and other time-delayed abuses frequently used by unscrupulous penny stock firms, micro-cap manipulators, and their agents.
Tracking Securities Professionals Activities and Pay
With respect to the re-proposed Commission rules 17a-3(a)(12) agreements between associated person and broker-dealer, (17) consumer complaint information, and (18) commission runs/trading information, the Division strongly supports these provisions. This set of records truly provides regulators and broker-dealers with the big picture regarding each sales associate and other registered personnel. This set of records allows compliance reviews to accurately focus on the high problem areas and also facilitates efficient and effective regulatory audits. The Division would like to stress the importance of consumer complaint information. This type of information, in Virginia, has historically led to more enforcement actions than any other regulatory tool. Effectively monitoring consumer complaints is at the very heart of investor protection. The Division would also like to suggest certain information be captured in connection with commission runs/trading information. This information should include date information, identification of account charged, and unit amount and dollar amount of each commission transaction.
Tracking Customer Information
With respect to the re-proposed Commission rule 17a-3(a)(16) customer account information, the Division strongly supports these provisions. This type of information is currently captured and has been captured for years. The re-proposals additional regulation of consumer confirmation of this important information is an excellent idea that is long overdue. This provision will provide a level of clarity on all confirmed account information in the future, which will greatly reduce broker-dealers liability and regulatory expense regarding the age-old he said/she said accusations. The Division can only guess at the number of cases it could have dismissed as frivolous, or focused on as important, if this provision had historically been in place. The cost to achieve this accurate and reliable account information should be no more than the extra paper that is required to be sent out in the already required quarterly account statements. At that price, its a bargain. Lets face it, this is a great idea!
The Division would like to suggest two other improvements to the accuracy of account information which protects the interest of both investors and legitimate broker-dealers. The Commission should strongly consider requiring account information to include separately, both investment objectives and risk tolerance of clients. Without both, firms cannot truthfully say they know their customer. Certain firms have historically utilized nebulous investment objectives to mask unsuitable trading activity. It seems silly to craft these very important rules in a fashion that perpetuates these illegal activities. Clearly, legitimate broker-dealers firms must know their customers, so the Division strongly supports adding this provision to facilitate their endeavor. Similarly, in order for a legitimate broker-dealer to know its customer, it must determine each clients investment experience. A customers past investment experience is a key determinant of their suitability for related investment strategies. Any recommended strategy which fails to consider this would be flawed and difficult to defend. The Division feels that legitimate broker-dealers have a strong need to capture and rely on the types of information these suggested provisions produce. As a regulator, the Division always supports clarity. These suggested modifications to the Commissions re-proposal are a win win proposal for broker-dealers, investors and regulators.
Local Office Issues
Last but not least, the Division would like to address issues related to the re-proposed definition of a local office. As noted before, Virginia has at least 800 one man offices. The Division is very concerned that the re-proposed Commission rules will weaken their own stated desire that supervision of satellite offices be thorough and complete. The Division has historically noted many instances where decentralized broker-dealers with many one man offices, tended to perform inadequate supervision and record-keeping. There have been many small securities shop frauds in Virginia, and it would be an injustice to select one example. Typically, cases involve theft, selling away, misrepresentation, forgery, and sales of highly unsuitable securities. Very frequently the evidence of fraud is easily found in the on-site files while obscured in the home office records. The Division believes the Commission would agree that this is currently a problem. The Division fears the re-proposed local office records retention loophole (one man offices) will further exacerbate an already large and growing problem. If there are no records at business locations of one man shops, then who will visit these shops to review the shop version records, which have historically contained the dirt of fraud in many Virginia enforcement experiences.
The very process of shipping records to depositories described in the re-proposal will most likely initiate a knee-jerk cleansing of records, which before now, was only performed by the shrewdest of operators. Securities criminals currently paying fines, in jail or removed from the business might have avoided prosecution if they had systematically cleansed, processed and shipped their records to depositories, and then successfully claimed that no other records existed. The Division believes strongly in the old saying "while the cats away the mice will play". Because of that belief, the Division supports the idea that a minimum core set of books and records must be available to securities professionals and regulators at every office from which broker-dealers operate. The Division also believes that legitimate broker-dealers and securities professionals cannot practically and legally conduct business without business site access to these minimal records. The Division suggests at least the following records, or their equivalent, be available or accessible at every office from which broker-dealers operate: order tickets, confirms, account statements, compliance and procedures manuals, complaint records, correspondence records (incoming and out going), audit reports, blotters (for trades, funds and securities), local office bank records, and a personnel listing with information about site agents.
As stated above, the Division believes legitimate broker-dealers and securities professionals have a responsibility and need to have separate business site access to at least the above noted core set of records. The Division cannot understand how broker-dealers and regulators can practically conduct compliance audits and supervision without clear and open access to the on-site records that all one man shops should have access to in order to function practically and legally. With the currently re-proposed option to eliminate one man office on site books and records availability to compliance supervisors and regulators, it is quite likely that investor protection will diminish accordingly. With this in mind, the Division would like to restate its opposition to the local office loophole.
If it is assumed that all records will be shipped to a depository, or will otherwise be available, there are still two problematic and costly issues. First, compliance audits and supervision involve having records and having someone who can explain those records. It has been the Divisions experience, that no one knows a set of records like the people who made them. The depository re-proposal would defeat the normal interaction which occurs between compliance professionals and record makers. In the Divisions opinion, this will substantially increase relative compliance effort and aggravation. Second, auditors will have to do both site reviews and depository audits if this form of record-keeping is chosen. Clearly, this will cost additional time and money, representing at least a 50% increase in both for each unit compliance audit.
The Division would also like to stress the importance of having records available on site at audit locations, wherever that may be. Experience has shown that when records are not readily available, the compliance audit process becomes much more time intensive and costly. It also causes reduced investor protection as regulators response times are extended. This can be particularly catastrophic if a securities criminal is spending ill-gotten gains at a high rate, as is frequently the case in the real world.
For reasons previously stated, the Division strongly supports the one year record retention requirements for local office records. In addition, the Division strongly recommends lengthening, to the normal two years, the retention requirements regarding consumer complaint information. Monitoring consumer complaints is at the very heart of consumer protection and a one year requirement is simply to short for trend analysis. The Division would also like the re-proposal to clarify the requirement that sales scripts be maintained in local offices. Sales scripts can be very revealing and Virginia has relied on local office access to this information to build enforcement cases in the past. Some of our largest cases have relied heavily on these types of records.
The Division strongly recommends adding the following two local office record requirements to the re-proposal. First, each office should maintain records of incoming correspondence. In Virginia, undocumented complaints and other regulatory problems are frequently found in these records. The Commission will be losing a very effective regulatory tool by excluding this record from local office records. Second, local offices should also maintain phone logs or tape recordings of client conversations if these records exist. Frequently, these records provide clarity to an otherwise compliance jungle.
The above comments regarding one man offices, when applicable, are equally directed toward whatever office size ultimately falls under the local office Commission definition. The Division hopes the Commission will consider its comments thoroughly and not be too quick to cast aside regulatory practices which have proven effective through time, or those new ideas, which for the most part, represent current and non-burdening legitimate broker-dealers practices. Thank you again for the opportunity to provide constructive input regarding these matters. The Division appreciates your willingness to consider our thoughts.
If you have any questions about these comments, don't hesitate to contact me.
Very truly your,
Garland H. Sharp, III, Chief Examiner
Division of Securities and Retail Franchising
Virginia State Corporation Commission