December 9, 1998
Jonathan G. Katz, Secretary
U.S. Securities and Exchange Commission
450 5th Street N.W.
Washington, DC 20549
Re: Books and Records Requirements for Brokers and Dealers Under the
Securities and Exchange Act of 1934, Release No. 34-40518,
File No. S7-26-98
Dear Mr. Katz:
The New Jersey Bureau of Securities ("Bureau") welcomes the opportunity to comment on the reproposed amendments to the books and records rules Rule 17(a)-3 and 17(a)- 4, under the Securities Exchange Act of 1934. The Bureau recognizes the difficult task of balancing the need for additional regulation against the added costs and effect on competition to our nations securities industry. The Bureau believes that the reproposed amendments meet that test in that they represent a cost effective approach to accomplish the goals of enabling all securities regulators (not just state agencies) and prosecutors to conduct more efficient and effective investigations, examinations and, in instances where violations have been uncovered, hearings and trials. Accordingly, the Bureau strongly urges adoption of the proposed rules and offers the comments set forth below.
I. The Commission should consider societal costs in addition to industry costs
The Bureau believes that in addition to the actual or claimed expenses these rules may have on the industry, in assessing costs the Commission must take into consideration: a) the cost to the government of obtaining the same information and evidence that otherwise would be available by these rules from other methods, b) the inability to replace by any other means information that would not be available because that information was not required to be created or kept, c) the costs, in terms of money lost by the public resulting from the delay that investigation from other methods would incur and d) the cost to the industry in terms of possible erosion of its reputation and public confidence in the industry that would result from less efficient oversight and less effective enforcement of the securities laws.
II. Investigative delays and losses of essential information will result if records do not exist, are not kept or are not available
Most important securities enforcement cases brought by the government take years to investigate and prosecute. [The SECís record $75 million judgement against Robert Brennan and First Jersey Securities took well over a decade to investigate and prosecute.] The complex matters investigated by the Bureau often take years to complete because they are burdened by evidentiary delays and records either being unavailable because they never existed or because they have been lost. For example, in the past, commission records and sales scripts have routinely been concealed and discarded by some broker-dealer firms based upon, among other things, claims that there are no statutory or regulatory maintenance requirements for those records. When this information is essential to connect the principals of a firm to the activity of its agents, it has become necessary to reconstruct this information from other sources, including testimony, often taken in bits and pieces, from several witnesses. This is only one demonstration of the substantial delay and the loss of essential information that has occurred because of a lack of clear rules requiring maintenance of these records.
These delays work substantially against the public interest and our ability to effectively regulate the securities industry. For many securities violators the following fact is true. While the government is investigating one bad act, the same principals sometimes have gone on to hatch new schemes and the unsuspecting investors are falling prey to those schemes. More hard-earned investors money is being lost. Also, the longer the governments investigation is delayed or obstructed because records are not available or do not exist, the less likely money will be recovered from those who violate the law and returned to the investors. The proposed rules represent an important step for the government in making the investigative process more efficient and effective and consequently, will reduce the delay and loss of essential information that would inhibit bringing more effective enforcement actions.
III. Integrity of the Industry and Market
There is also substantial impact to industrys reputation and an erosion of investor confidence when investors are victimized by broker-dealer fraud and, in particular, sales practice and trading abuses. In the F.D. Roberts case brought by this agency, the funds contained in over thirty thousand accounts were completely wiped out when the firm ceased business. The victims of that scheme, interviewed by this office, were obviously upset at their outrageous treatment by that firm. Many victims assured the Bureau that as a result of their experience they did not trust stockbrokers and they would not be investing in the future.
The F.D. Roberts case is not an isolated example. Frequently, unscrupulous broker dealers similarly adversely affect the lives of tens of thousands of customers before they are shut down by regulators. For example, from September 1991 through October 1994, L.C. Wegard & Co. sold over $125 million of speculative over-the-counter securities to thousands of small investors. By the summer of 1995, the value of these securities diminished to less than $25 million despite a bull market which continually reached new highs. During much of this period, the activities of Wegard were under investigation by several government and regulatory agencies, including the Bureau. Several of the records required by the reproposed amendments (i.e., commission records, requirements as to scripts, and the additional information required to be recorded on the Memorandum of Order as required by proposed Rule 17(a) 3(a)(6) and (7)) would have unquestionably assisted in these investigations and thereby would have reduced the delay in bringing enforcement action against these firms.
Investors who are victimized by these abuses distrust the securities industry and they will tell their neighbors, friends and families about their bad experiences. They may also put pressure on their elected officials to correct these problems through legislation. Therefore, it is clearly in the best interest of the industrys reputation for the government and regulators to have the tools required to act quickly to stop abusive and unlawful conduct and to bring those who violate the law to justice.
IV. Records already exist and are essential for legitimate firms to conduct business As to the actual expense to industry which may result from compliance with the reproposed amendments, the Commission should consider a) that most of these books and records already exist in many firms which employ the best practices in the industry, b) most of these records are created because they are necessary for the orderly operation of the firm, and c) the records required will assist industry in better fulfilling its obligation to supervise the activity of its agents.
V. Industry compliance costs may be exaggerated
The Commission should be wary of exaggerated claims made by industry as to the expense they will incur from compliance with the proposed rules. Predictably, the industry will eventually discover some economical means to accomplish this task once the rules are adopted. For example, notice to clients of the information required on the new account form can accompany the first customer statement sent to that client. We may also see required information added as additional fields on the periodic statements sent to clients with notice to the clients to contact the firm if any of that information is incorrect, or if there are any problems with the handling of the account.
VI. Costs of maintaining records at local offices are not overly burdensome
The Bureau strongly favors the retention of records in branch offices whether the offices are large or small. However, the Bureau is especially in favor of records retention in small local offices and that those records will be made available to regulators. With respect to the burdens imposed on industry from the requirement that certain records be maintained at the local offices of a broker-dealer, staff of the Bureau has conducted interviews to assess the claims that it would be costly to require small offices to maintain these records. A regional compliance director of a national firm having eight small local offices in this state advised the Bureau that he was aware of the proposal and was already prepared to comply with these requirements. The compliance director claimed these records were already used for supervision of his firms branch offices and that he believed that it was good for the industry to have the level playing field which will result from all firms having the same requirements for records at the local office level.
The manager of a small local office of another broker-dealer firm which has two full-time and one part-time registered agents advised the Bureau that he believed his local office was already in compliance with the proposed rules. He acknowledged that the local office has always maintained blotters, copies of correspondence relating to its business, copies of customer account forms, client holding pages and certain of the other records required by the reproposed amendments. This managers office conducts $10 million to $15 million of new mutual fund business each year. Due to the relatively small amount of business that small local offices execute, and because most of the records are necessary for the operation of the office and proper supervision, there is no meaningful extra burden imposed by the new rules on small offices.
VII. Regulatory value in having records available at local offices is very high.
Misappropriation of clients funds and selling away from the firm are common problems which, in the Bureaus experience, periodically surface in small offices. This conduct often results in irreparable injury to investors. Many of the operators of these offices view themselves as "independent" from the broker-dealers with whom they are registered and many of these offices are geographically dispersed, making regular on-site supervision by the broker-dealer costly. Competition between broker-dealers to expand their network of offices causes them to open more and more of these "autonomous" small offices with arrangements where the small branch office receives a pay out of 85%, 90% and in some instances even 100% of the gross commissions earned on trades. The broker-dealer home office makes very little money on each transaction in this example, but instead derives income from the large volume of transactions among all of its many small local branch offices. The broker-dealer home office also benefits from having a larger network of retail outlets. In turn, the small local office receives, at best, minimal supervision and operates virtually independently of its home office.. The "independent" operators of these local offices have also become prime targets for promoters of unusual exotic investment schemes such as viatical settlements, because the promoters of such schemes offer much higher commissions than the 4% commission these offices can earn on mutual funds, and because local offices do not have regular on-site supervision.
VIII. The Bureau supports adoption of the reproposal
In summary, the Bureau urges the Commission to adopt this reproposal. The Bureau especially urges the Commission to retain the "two man" definition of local office to ensure that these small local offices maintain minimum core records which will make them more accountable and more amenable to supervision through meaningful regulatory inspections (i.e., inspections that involve the review of meaningful records as opposed to no records). These inspections will help to prevent and deter harmful conduct.
New Jersey has a very strong economic interest in encouraging the Commission to adopt this reproposal due to the high level of securities industry activity in the State. More than 135,000 securities agents nationwide apply with the Bureau of Securities to do business in New Jersey. Two out of every five broker-dealer firms nationwide are registered to do business here.
New Jersey also has a very strong investor protection interest in encouraging the Commission to adopt this reproposal. In fact, New Jersey is home for a large population of investors, ranking in the top ten among states with the largest senior citizen population, including more than 800,000 senior citizens who rely on earnings from investments for 25% or more of their monthly income in their retirement years. These elderly investors are prime targets for dishonest and fraudulent activity.
Some in the securities industry may view piles of new account forms, order tickets and commission runs merely as the paper residue of conducting a business and secondary to the business itself. The Bureau, in carrying out its mandate to protect the States investors, takes a different view. Commission runs can mask the transactions of the unlicensed cold caller under the name of his supervisor, who agrees to "settle up" on the side. A senior citizens account contains multiple purchases of risky stocks, because the investment objective on the new account form is noted as "speculative." Unauthorized customer trades are put through with order tickets that are marked as "unsolicited."
These violations of books and records rules are found all too often by Bureau investigators, and they hurt small investors who do not understand how much bad record keeping can reveal about bad business practices.
The Bureau commends the efforts of the Commission in working with the states to develop effective rules and recommends the adoption of these rules.
Very truly yours,
Franklin L. Widmann
Chief, Bureau of Securities