VIA MESSENGER December 27, 1996 Mr. Jonathan G. Katz Secretary Securities and Exchange Commission 450 Fifth Street, N.W. Mail Stop 6-9 Washington, D.C. 20549 Re: File Number S7-27-96: Books and Records Requirements for Broker-Dealers Dear Mr. Katz: PSA The Bond Market Trade Association (“PSA”)/1 welcomes the opportunity to comment on the Securities and Exchange Commission's proposed changes to Rules 17a-3 and 17a-4 under the Securities Exchange Act of 1934 (“Exchange Act”),2/ the books and records requirements for broker- dealers.3/ PSA supports the Commission's efforts to create a uniform federal scheme for the regulation of broker-dealer books and records that promotes investor protection and facilitates rigorous enforcement of the federal and state securities laws. PSA, however, strongly opposes the proposed amendments to Rules 17a-3 and 17a-4. As described below, PSA views the proposed amendments as a fundamentally flawed approach to books and records reform. Accordingly, PSA urges the Commission to withdraw the proposed amendments in their entirety. I. EXECUTIVE SUMMARY As described below, PSA objects to the proposed amendments because they: 1) impose excessive costs on broker-dealers and, ultimately, on investors; 2) impose substantive requirements, framed as procedural record keeping rules, with no analysis of their impact on broker-dealers and investors; 3) represent a radical and counter-productive change in the historical approach to regulation of the securities industry; 4) incorporate into the federal regulatory regime an inflexible micro-management of the compliance function that fails to account for the varying needs and concerns of different types of investors; and 5) raise serious due process concerns by making it difficult for broker-dealers to invoke the attorney-client privilege and other applicable privileges and protections, by creating interpretive ambiguities, and by mandating the creation of documents that will provide fodder for frivolous litigation; 6) create disincentives to effective self-regulation. PSA agrees with both the Commission and the North American Securities Administrators Association ("NASAA") that state regulators should be afforded reasonable access to the books and records maintained by broker-dealers. The proposed amendments, however, would go well beyond ensuring such access. They would mandate the creation of additional documents, prescribe new (and in many cases duplicative) retention requirements, and impose detailed, substantive requirements for the discharge of suitability and supervision obligations. The Commission's insistence on this level of specificity is both counter-productive and contrary to the regulatory trend of setting broader goals and objectives and allowing firms to achieve compliance with them in a manner best suited to their own organizational characteristics. While, for example, many broker-dealers already have taken it upon themselves to create the sorts of customer account forms and activity surveillance runs that the proposed amendments would require -- to mandate these firms revise their current business practices to comply with a federal statutory system would impose unnecessary costs that will be passed on to investors. Those firms that already generate such records have in place cost-effective systems that work well for them and their customers. PSA strongly believes, therefore, that it is in the best interests of market participants to allow each firm to determine the most effective means, tailored to its own structure, customer base and product mix, of creating and maintaining necessary records beyond those currently required by Rules 17a-3 and 17a-4.4/ Notwithstanding our concerns with the proposed amendments, in an effort to address the need for access to records by state securities regulators, PSA would support the uniform adoption of a modified version of the Model State Regulation Governing Access to Records Required to Be Kept by Broker-Dealers, attached as Exhibit A to the Proposing Release (“Uniform Access Regulation”). While PSA has concerns about some of the specific provisions of the Uniform Access Regulation,5/ PSA generally supports the adoption by state legislatures of uniform rules ensuring state regulators reasonable access to a broker-dealer's books and records. PSA therefore believes the Commission should allow the states the opportunity to adopt a uniform rule providing for such access, and propose amendments to the Exchange Act's rules and regulations only if state regulators thereafter can demonstrate a need for further rulemaking. II. INTRODUCTION Books and records requirements enacted to promote the administrative convenience of state securities regulators must be counterbalanced against the burdens they would impose upon broker-dealers and the attendant, increased costs of capital formation. Any reform efforts designed to facilitate the access of state securities regulators to documents and information maintained by broker-dealers must be cognizant of the burdens they impose. Contrary to the impression created by the Proposing Release, investor protection cannot be equated with bureaucratic convenience. The costs of such convenience are borne not only by broker-dealers, but also by other capital markets participants, including investors. Notably, the NSMIA is a mandate for a careful analysis of those costs. Its prohibition against state books and records requirements that are inconsistent with federal requirements was an attempt by Congress to ease the regulatory and administrative burdens on broker-dealers wherever possible -- not to add to them.6/ We disagree in this regard with the Proposing Release's suggestion that the proposed amendments are cost effective because the burdens imposed on broker-dealers would be even higher if each state were allowed to adopt its own books and records requirements. With the passage of the NSMIA, “individual, and possibly divergent, state regulations” is no longer an option. The Commission must assess the costs of the proposed amendments in relation to their benefit,7/ and not in relation to a hypothetical approach that has been foreclosed by Congress. After reviewing the proposed amendments, PSA strongly believes that the burdens involved in their implementation are too high in relation to the benefits that might be achieved. III. EXCESSIVE COSTS OF IMPLEMENTING THE PROPOSED AMENDMENTS The Commission grossly understates the burdens the proposed amendments would impose on broker-dealers and ultimately on investors. In assessing the costs of compliance with the proposed new requirements, the Commission grossly underestimates the amount of time and the number of individuals that broker- dealers would be required to devote to such compliance. It focuses almost all of its attention on one requirement -- that broker-dealers maintain and update customer account forms annually -- and ignores the burdens that other requirements would impose. The Commission lumps all of the other proposed rules together and concludes, without any analysis or detail, that they would require almost no additional time or other resources. PSA has surveyed its members and is certain that the Commission's perfunctory assessment of the burdens imposed by the proposed amendments on broker-dealers and, therefore, on investors is completely unrealistic. The Proposing Release lacks the sort of "meaningful cost-benefit analysis" contemplated by the NSMIA. 8/ A. Annual Update of Customer Account Forms. The Commission has underestimated significantly the time and resources required to update customer account forms annually. The Commission asserts that only 10% of a broker- dealer's customer account forms would need updating in any given year. While that may be true, a broker-dealer likely would need to review all of its accounts annually and presumably would have to inquire of all its customers annually to determine which account forms needed to be updated, and then, for each account, either update the form or prepare and file a memorandum explaining why no update was needed. Moreover, the Commission's estimate of five minutes per account is much too low. This process would require, at a minimum, the involvement of a sales person, branch manager, and administrative support for each update.9/ B. Faulty Time Estimates. The Proposing Release estimates that all of the additional record-keeping tasks required by the amendments to Rules 17a-3 and 17a-4 should result in an expenditure of only 2.4 minutes a day. PSA's members, based on their extensive and long-standing experience, think it almost self-evident that the numerous tasks imposed by the amendments would require considerably more time to complete. Indeed, PSA's members believe it would take a broker-dealer more than 2.4 minutes a day merely to comply with the requirement that a principal approve all internal documents used in connection with the broker-dealer's selling efforts. When one considers that the amendments also require, among other things, that broker- dealers maintain duplicate records in each local office, maintain transaction-specific compensation information, conduct specific customer inquiries and draft written memoranda of oral complaints, it becomes clear that the Commission's estimate is completely unrealistic, and does not account for the expenditures of other resources -- e.g., additional personnel and systems adjustments -- required by these amendments. Furthermore, when the Commission attempts to assess the aggregate daily burden of these requirements, it compounds the inaccuracy of its estimate by multiplying 2.4 minutes (an underestimate to begin with) by the number of broker- dealers registered with the Commission rather than by the number of individual registered representatives employed by those broker-dealers. We presume that the Commission did not intend to suggest that all of the additional requirements would take only an additional 2.4 minutes per working day, per firm. As noted above, the Proposing Release fails to acknowledge the significant time and additional resources necessary to complete the tasks required by the following: (i) Maintenance of Duplicate Records at Local Offices and/or the Automation of Local Offices. The proposed amendments would require blotters and memoranda of orders,10/ associated person files, complaint files, correspondence files, compliance manuals and account forms to be maintained at local offices.11/ Currently, most firms retain complaint and correspondence files in a single location. Many broker-dealers, for example, have opted to supervise their written communications from a centralized location. To comply with this rule, therefore, most firms would have to copy large numbers of records and establish duplicate files at the local offices. These firms would also need to ensure that both sets of files were kept current. Moreover, contrary to the assumption of the Proposing Release, some records, such as correspondence and complaint files, are not easily susceptible to electronic maintenance, and not all broker-dealer local offices are automated. Particularly for those firms, this amendment would involve a massive adjustment in record-keeping policies and procedures. 12/ (ii) On-Site Storage of Records for Significantly Longer Periods of Time. The proposed amendments would require the retention of certain documents, including blotters, complaint files and activity reports for six years, and would require the retention of other documents, including communication files and advertisements, for three years. Employment- related documents would need to be retained for the entire tenure of an “associated person's” employment, plus three years beyond. All such records would have to be maintained in an “easily accessible place” for the entire retention period rather than for just the first two years. Despite the Commission's belief that most of the records required under Rule 17a-3 would be stored electronically, PSA anticipates that many of the records would be created in paper form. To satisfy the new requirements, therefore, broker-dealers would be required to develop additional on-site storage, or to implement electronic storage, at significant expense. (iii) Principal Approval of Internal Use Documents Used in Connection with Selling Efforts. Requiring a principal to approve every document used in connection with selling efforts, including those intended only for internal use, is tremendously time consuming.13/ In this day of instantaneous communication (e.g., via electronic mail), compliance with this requirement conceivably could require some number of principals to be devoted solely to review of internal communications.14/ (iv) Maintenance of all Internal Documents Used in Connection with Selling Efforts. The proposed amendments would require a broker-dealer to preserve “any information” in its possession relating to the basis for any recommendation of a security that is underwritten or traded as principal by the broker-dealer. This overbroad requirement requires the maintenance of all internal documents connected in any way to the firm's selling efforts, including educational materials. To comply with this amendment, broker-dealers would need to devote significant additional time and resources to the identification, compilation, organization, and filing of such materials as well as create additional on-site storage space at considerable expense. (v) Maintenance of Trade-Specific Compensation Information. To comply with the proposed amendment, broker- dealers would be required to maintain a significant amount of information for each salesperson that generally is not maintained on a transaction-by-transaction basis. For most broker-dealers, this would necessitate the introduction of new record-keeping procedures and significant systems adjustments at considerable expense.15/ (vi) Memorialization of Oral Complaints. The proposed amendments would require broker-dealers to draft memoranda of oral complaints. To ensure proper compliance, broker-dealers are likely to draft memoranda for every problem discussed with a customer. Aside from the additional time required to draft such memoranda, this requirement would be difficult (if not impossible) and time consuming for a broker-dealer to monitor. In addition, since the determination whether alleged conduct by a broker- dealer rises to the level of a “complaint” is essentially a legal judgment, this requirement would effectively mandate legal participation in every potential oral complaint situation.16/ IV. DUE PROCESS CONCERNS The proposed amendments raise serious due process concerns by making it difficult for broker-dealers to invoke the attorney-client privilege and other applicable privileges and protections, by creating interpretive ambiguities, and by mandating the creation of documents that will provide fodder for frivolous litigation. PSA strongly believes that the proposed amendments are fundamentally flawed because they raise serious due process concerns. For example, the proposed rules regarding complaint files and the immediate production of requested documents threaten to infringe on protections afforded to broker-dealers by the attorney-client and other privileges. In addition, the requirement that a broker-dealer provide on demand an individual to explain the firm's books and records is essentially a rule that compels testimony without first affording the broker-dealer (or such individual) any due process protections. The proposed rules are also replete with interpretive ambiguities that raise due process concerns. For example, the rules impose obligations on broker-dealers to record a customer's "high risk objectives," to memorialize in writing any oral “customer complaints,” and to create activity runs to track "frequent" trading and "unusually high" commissions and canceled transactions. These terms are difficult to define, yet the consequences to a broker-dealer of non- compliance are potentially severe. In addition, these subjective terms create standards that are impossible to review from a compliance standpoint, creating insurmountable supervisory problems.17/ A. Privilege/Work Product and Related Concerns. PSA believes that the proposed amendments regarding complaint files and the immediate (and even three-day) production of requested documents will infringe on a broker-dealer's ability to claim the attorney-client privilege, work product protection and other applicable privileges and protections. And PSA believes that the proposed amendment requiring a broker-dealer to make available a person to explain its records may infringe on a broker-dealer's due process rights. (i) Complaint Files. As currently written, the proposed rules regarding official complaint files contain no provisions for privileged or protected documents. PSA believes that broker-dealers should not be required to maintain or produce privileged or protected documents in their complaint files. (ii) Time for Production. The proposed rules require that records be produced “immediately” when they are located in the office where the request is made, and otherwise within three days. This requirement fails to account for the time necessary for a broker-dealer to review the requested records to ensure that their production will not result in the waiver of any attorney-client privilege or any other privilege or protection, or even for an administrative review to ensure that the records are in fact responsive to the information requested. (iii) Compelled Testimony. The proposed rules require a broker-dealer to make available on demand an individual to explain any requested books and records. By compelling a broker-dealer to provide such an individual, the proposed amendment effectively compels testimony. A securities regulatory authority can ask for or, pursuant to a validly issued subpoena, compel such testimony. Nevertheless, in the absence of a broker-dealer's desiring to provide such testimony, a securities regulatory authority ought not be able to compel it without the due process required for the issuance of a subpoena. B. Complaint Files. PSA believes that ambiguities in the proposed rule regarding complaint files raise serious due process concerns. In particular, the amendment requiring broker-dealers to draft written records of certain oral “customer complaints” creates an unworkable obligation because the term “customer complaint” cannot be defined. In addition, the amendment is problematic because it requires broker-dealers to create documents that customers could use against them, without affording broker-dealers any protection against such use. To the extent there is any usefulness to this requirement, PSA believes it is undermined by such a lack of protection which will cause broker-dealers to be guarded in their characterizations of oral complaints.18/ (i) Ambiguous Definition of Customer Complaints. The proposed rules require a broker-dealer to draft written memoranda of certain oral customer complaints except those that result from customer misunderstandings or misinterpretations that are quickly resolved to the customer's satisfaction. In reality, however, it is difficult, if not impossible, to determine when a customer inquiry has reached the level of a “customer complaint.” The exceptions provided by the Commission (for misunderstandings and misinterpretations) are too ambiguous to provide adequate guidance. For example, an assertion by a customer (irritated by a fall in the market value of his security) that the registered representative should not have sold him the security in the first place conceivably could be interpreted as a suitability complaint. The amendment therefore creates the risk that, depending on the customer's tone of voice and precise language, a customer inquiry will need to be recorded as a customer complaint, to the detriment of the broker-dealer and its employees. In addition, PSA believes the ambiguity of the term “customer complaint” would make it impossible to monitor compliance. (ii) Access by Customers. In addition, the proposed amendment essentially compels the creation of documents that are potentially harmful to a broker-dealer's interests, yet accessible by a broker-dealer's customers. Although the Commission states that the amendment will not create a reportable event for Form U-4 purposes, the Commission is powerless to prevent civil litigants from seeking discovery of these memoranda. PSA believes that in light of the potentially serious consequences to the broker- dealer and its employees, a broker-dealer should not be compelled to draft such documents without first being afforded additional protection. C. Definition of “High Risk Objective” and Allocation of Percentages. As with the proposed rule regarding complaint files, PSA believes the proposed rule regarding investment objectives contains ambiguities that raise due process concerns and create unworkable obligations. Specifically, the amendment requiring broker-dealers to list a customer's “high-risk objectives” creates an obligation without providing adequate guidance as to the meaning of the term “high-risk objective.” The Commission defines speculation or a similar “high-risk objective” as an investment that “involve[s] a high risk of loss that may exceed the losses in general market averages on any specific day or over a longer period of time.” According to this definition, however, a customer's expressed interest to purchase U.S. Treasury Securities or investment-grade debt could be deemed a “high-risk objective.” The definition, therefore, is too vague to provide any meaningful guidance, and too ambiguous to monitor for compliance. Furthermore, the proposed rule requires broker-dealers to designate the “approximate percentage” of investment capital that a customer wishes to dedicate to the “high-risk objective.” PSA believes this requirement will merely encourage undue reliance on an arbitrary figure. Finally, no matter what the Commission might say, it cannot stop private litigants, when proceeding with their own suitability claims, from using the information recorded by broker-dealers as the customer's “high-risk objectives.” The proposed “investment objective” requirement, therefore, is simply a recipe for more private litigation -- in direct opposition to Congress' recent efforts to the contrary.19/ D. Activity Reports. PSA also believes that the proposed rule regarding activity reports contains ambiguities that raise due process concerns and create unworkable obligations. The proposed amendment would require broker-dealers to create exception reports detailing "frequent trading in customer accounts, unusually high commissions, [and] unusually high number[s] of trade corrections or canceled transactions" The terms "frequent" and "unusually high" are not defined, however, and create too vague a standard for broker-dealers to effect compliance and rest assured that they will not be subject to an enforcement action for non-compliance. E. Access to Records in and Relating to Activities in Another State. The proposed amendments regarding access by state regulatory authorities also raise potential due process issues. State regulatory authorities should have access only to records that relate to activities within their own jurisdictions. The proposed amendments improperly provide a warrant for a regulator from State X to conduct an inspection of records maintained in State Y, relating to business conducted in State Y. V. SUBSTANTIVE REQUIREMENTS FRAMED AS RECORD KEEPING RULES The proposed amendments would impose substantive obligations on broker-dealers under the guise of procedural record keeping requirements. If the Commission wishes to impose such obligations, it ought to do so directly, with full consideration of their necessity, as well as their effect, on broker-dealers and, ultimately, on investors. Many of the proposed amendments would go well beyond books and records requirements, and would effectively create new substantive supervision and conduct standards for broker- dealers. The Commission should not impose such obligations on broker-dealers without first conducting a thorough review of their import and impact. A. Activity Reports. The proposed rule requiring the creation of “activity” runs is unprecedented in that it sets a new substantive standard of supervision. By requiring broker-dealers to create exception reports detailing “frequent trading in customer accounts, unusually high commissions, [and] unusually high number[s] of trade corrections or canceled transactions,” the Commission essentially defines a new substantive obligation.20/ If enacted, the rule represents the first time a regulator has mandated specific types of surveillance reports. While the amendment purports to be a mere record-keeping rule, in actuality, it creates a substantive obligation to monitor the activities of a broker-dealer's salespeople measured against a federally mandated baseline of appropriate conduct. B. Account Forms. Likewise, the proposed rule regarding customer account forms clearly articulates a substantive suitability standard. It is no longer sufficient for a broker-dealer simply to inquire about a customer's investment objectives. It must provide a list of defined objectives from which the customer may choose. If the customer designates a “high-risk objective,” the customer must assign a percentage to that objective.21/ It is startling that the SEC is seeking comment, in the context of supposedly minor changes to its books and records rules, on the manner in which the term “speculation” is to be defined. Although the Commission seeks to assure broker- dealers that the account form requirements are not intended to create “an obligation to monitor all customer accounts for adherence to the designated speculative percentage,” as a practical matter, the requirement inevitably would create just such an obligation. It is difficult to comprehend what other purpose this information would serve. Indeed, the Commission itself recognizes that “the designated percentage will be useful in assessing the suitability of recommendations.” C. Principal Approval of All Internal Use Documents Used in Connection With Selling Efforts. The proposed rule requiring broker-dealers to maintain records documenting approval by a principal of all “advertisements, marketing materials, sales scripts, and other paper or electronic records,” including “documents and other records that are intended exclusively for internal use,” is another example of a substantive requirement hidden in this books and records rule. As a practical matter, the amendment tells broker-dealers how to supervise the selling efforts of its personnel. In addition, the amendment creates a new substantive obligation, by requiring broker-dealers to create and maintain records of such principal approval.22/ VI. MICRO-MANAGEMENT OF, AND ONE-SIZE-FITS-ALL APPROACH TO, THE COMPLIANCE FUNCTION. The proposed amendments federalize an inflexible micro- management of the compliance function, reflecting a misguided, one-size-fits-all approach to regulation that may mandate imprudent management practices. The Proposing Release represents a radical and unexplained change in the traditional approach to regulation of the securities industry. Recognizing the significant differences among broker- dealers and their customers, the Commission traditionally has provided broker-dealers the ability to tailor their compliance regimes to the particulars of their businesses. Contrary to this approach, the proposed amendments would impose uniform, inflexible standards on broker-dealers that fail to account adequately for differences between (1) retail and institutional customers; (2) firms that make recommendations and firms that take orders; (3) different securities products; and (4) objective documents and subjective selling materials. To date, the Commission and the self-regulatory organizations ("SROs") typically have set forth general standards for broker-dealer compliance and have allowed each broker-dealer to decide, given its own unique circumstances, the specific means to achieve such compliance. Section 15(f) of the Exchange Act, for example, obligates broker- dealers to adopt procedures reasonably designed to prevent the misuse of material, nonpublic information, but does not specify the particular procedures that a broker-dealer must adopt to discharge that obligation.23/ Similarly, NASD Rule 3010 requires each member to establish a supervisory system “reasonably designed to achieve compliance with applicable securities laws and regulations” and notes that “[f]inal responsibility for proper supervision shall rest with the member.” Most recently, the Commission itself called for a functional approach to the maintenance and supervisory review of correspondence -- particularly e-mail and electronic correspondence that are more in the nature of traditional oral communications than traditional hard copy correspondence.24/ In response, the NYSE and the NASD proposed, and PSA has supported,25/ rule changes that would allow each member to develop its own scheme for supervising communications with customers. Rather than a blanket rule, requiring prior approval of any communication with a customer, the NYSE and NASD have appropriately suggested that firms be allowed to tailor their supervision to the firm's structure and the nature and size of its business and customer base.26/ The proposed amendments requiring broker-dealers to record customer investment objectives, to mark all trades solicited or unsolicited, and to have a principal approve all external communications all reflect a misguided approach to books and records reform. A. Investment Objectives. A requirement that every broker-dealer record each of its customers' investment objectives fails to reflect critical differences between retail and institutional customers as well as differences between firms that make recommendations and firms that take orders. For some firms -- e.g., those with sophisticated, high net worth customers -- setting forth a defined list of objectives may not make as much sense as asking customers, in open-ended fashion, what their investment objectives are. And for others -- e.g., firms that do not make investment recommendations or deal only with institutional customers -- asking customers about their investment objectives may not make sense at all. Indeed, the NASD's requirement that its member firms make affirmative inquiries concerning a customer's objectives prior to the execution of a recommended transaction does not apply to institutional customers.27/ Thus, as the Proposing Release itself suggests, it would not make sense to apply this proposed requirement to all broker-dealers. B. Marking Orders Solicited or Unsolicited. The requirement in the proposed amendments that orders be marked solicited or unsolicited fails to account for differences among securities products and customers. Historically, firms generally noted which trades were solicited and which were unsolicited to demonstrate compliance with Blue Sky Law registration requirements. Today, however, particularly after passage of the NSMIA, most securities are exempt from state registration requirements. There is, therefore, no longer a need for broker-dealers to maintain records of whether trades in these securities are solicited or unsolicited. Despite this, the proposed amendment makes no distinction between securities and requires that all orders be marked solicited or unsolicited, regardless of whether the trades require registration. Consequently, to the extent that the purpose of this requirement is to assist state securities administrators in enforcing state registration laws, broker-dealers should not be required to maintain such information. Furthermore, assuming the purpose of this amendment is to assist regulators in evaluating the suitability of particular trades, the Commission has inaccurately equated a “solicitation” with a “recommendation.” It is the existence of a “recommendation,” and not a “solicitation,” that triggers a suitability obligation under the NASD's suitability rule. As PSA noted in a recent letter regarding NASD Notice to Members 96-60, PSA believes that a recommendation “embodies an unconditional affirmative statement by one party urging another party to enter into a particular financial transaction.”28/ It is therefore irrelevant, from a suitability perspective, whether or not a trade was solicited. Despite this, the proposed amendments would require that all trades with all customers be recorded as solicited or unsolicited. Finally, the Commission has failed to recognize that when dealing with institutional customers, many trades are not easily categorized as either solicited or unsolicited, or as recommended. Indeed, in the institutional context there is no real need to create such distinctions. In the NASD's recently promulgated “institutional suitability” interpretation, the NASD expressly noted that “[t]he manner in which a member fulfills [its] suitability obligation will vary depending on the nature of the customer and specific transaction.”29/ Thus, the factors identified by the NASD as relevant in connection with a member's obligations were offered merely as “guidelines” and the absence or inclusion of any of these factors “was not intended to be dispositive of the suitability determination.”30/ The Commission's inflexible approach is counter-productive in that it requires broker-dealers to maintain records that they do not need and to categorize trades that do not lend themselves to categorization. C. Review of All External Communications. The proposed requirement that all external communications be reviewed by a principal also fails to account for differences in the types of materials sent to different types of customers. Documents containing nothing but inventory listings, price quotations and market analytics cannot, and need not, be reviewed in the same way as subjective selling materials. Likewise, documents that are being sent to sophisticated institutions may not need the same type of scrutiny as materials being sent to private individuals. Contrary to the Commission's most recent release on the subject, and the direction it gave to the SROs (see supra at 12), this proposed amendment would apply the same standards to all communications rather than recognize that different categories of communications raise different supervisory issues. D. Maintenance of Documents. The proposed rules regarding (i) the maintenance of sensitive documents at local offices and (ii) the retention of any information used in connection with selling efforts are examples of where the Commission's attempt to micro-manage will mandate imprudent business practices. The proposed rules, for example, would require that sensitive and often highly confidential documents such as employment agreements and complaint files be maintained at local offices. This would provide unnecessary (and potentially detrimental) access to confidential records. Prudent management dictates that such documents be maintained in a secure place such as a Human Resources or a Legal Department in a single location. In addition, the proposed rules would require that broker-dealers maintain any information relating to the basis for a recommendation of a security that is underwritten by the broker-dealer or that the broker-dealer trades as principal. As the Commission is well aware, many broker-dealers involved in underwritings based upon advice of counsel create “due diligence” memoranda rather than maintain all of the underlying documentation and information supporting each underwriting. VII. DISINCENTIVES TO EFFECTIVE SELF-REGULATION In addition to imposing inflexible and difficult-to- monitor standards, the proposed amendments create disincentives to effective self-regulation and honest, self- critical evaluation. PSA believes that the proposed rules regarding the maintenance of audit reports and the creation of activity reports in particular would discourage broker-dealers from engaging in the type of honest, self-critical evaluation that the Commission traditionally has encouraged. A. Audit or Examination Reports. PSA believes that the requirement that a member preserve and produce all audit or examination reports completed by a party other than the broker-dealer serves as a counter-productive disincentive to broker-dealers. A broker-dealer who otherwise would be prepared to bring in an outside auditor for an independent evaluation of its business will hesitate when it realizes that it will be compelled, if asked, to share the audit or examination report with the Commission and/or any other regulatory authority. The Commission ought to be encouraging rather than discouraging firms from engaging in this type of honest, self-critical evaluation.2 B. Activity Reports. PSA firmly supports proactive monitoring for effective supervision. It is precisely PSA's strong belief in such oversight, however, that causes us to be concerned about the potentially chilling effect of mandating such a requirement. PSA believes that the proposed rule requiring the creation and maintenance of “activity” runs would discourage broker-dealers from maintaining any self-critical activity run other than those the Commission would deem minimally acceptable. If, for example, a broker-dealer viewed as minimally acceptable (for purposes of determining whether an account was being “churned”) the maintenance of a report that identified all accounts in which there were more than 10 trades in a week, the broker-dealer would be loathe to create a report that identified all accounts in which there were more than five trades in a week -- even if it truly believed that the maintenance of such a report made good compliance sense -- lest it identify to the regulators potential problems that the regulator would not otherwise identify. VIII. CONCLUSION In conclusion, PSA urges the Commission to withdraw the Proposing Release in its entirety. As PSA has noted above, it is unnecessary and counterproductive for the Commission to institute such radical changes to the current books and records requirements. The proposed rules are excessively burdensome and will impose significant costs on broker- dealers and ultimately on investors. In addition, the proposed amendments represent an unprecedented effort by the Commission to micro-manage the securities industry in a way that promotes imprudent business practice and discourages effective self-regulation. Finally, the proposed rules are replete with ambiguities that raise due process and could provide fodder for frivolous litigation. If the Commission sees a need for rules that will assist state regulators in gaining access to documents and information maintained by broker-dealers, the Commission should encourage state governments to adopt a modified version of the Model Regulations. PSA would be pleased to assist in developing such regulations. PSA would also welcome the opportunity to meet with representatives of the Commission to further discuss the Proposing Release and the Model Regulations. Should you desire additional information or any clarification of the matters discussed in this letter, please contact the undersigned at (212) 440-9459, or George Miller, PSA Vice President and Deputy General Counsel, at (212) 440-9403; or our special outside counsel on this matter, Stephen M. Cutler at Wilmer, Cutler & Pickering at (202) 663-6278. Sincerely, Paul Saltzman Senior Vice President and General Counsel cc: The Honorable Arthur Levitt, Chairman, Securities and Exchange Commission The Honorable Steven M.H. Wallman, Commissioner, Securities and Exchange Commission The Honorable Norman S. Johnson, Commissioner, Securities and Exchange Commission The Honorable Isaac Hunt, Jr., Commissioner, Securities and Exchange Commission Richard R. Lindsey, Director, Division of Market Regulation, Securities and Exchange Commission Robert L. Colby, Deputy Director, Division of Market Regulation, Securities and Exchange Commission Michael A. Macchiaroli, Associate Director, Division of Market Regulation, Securities and Exchange Commission Catherine McGuire, Chief Counsel, Division of Market Regulation, Securities and Exchange Commission Edward A. Kwalwasser, Executive Vice President, New York Stock Exchange, Inc. Mary L. Schapiro, President, NASD Regulation, Inc. John E. Pinto, Executive Vice President, NASD Regulation, Inc. T. Grant Callery, Vice President and General Counsel National Association of Securities Dealers, Inc. Elisse B. Walter, Executive Vice President, Law and Regulatory Policy, NASD Regulation, Inc. Alden S. Adkins, Vice President and General Counsel, NASD Regulation, Inc. ps/Bkrecltr.doc/12/30/96 _______________________________ 1/ PSA represents approximately 220 securities firms and banks that underwrite, trade and sell debt securities, both domestically and internationally. PSA's member firms account for in excess of 95% of all primary issuance and secondary trading activity in the domestic debt capital markets. More information about PSA can be obtained from our website at http://www.psa.com. This letter was prepared by PSA staff in conjunction with special outside counsel, and has been circulated among, and reviewed by, numerous PSA committees and working groups, including the Fixed Income Practices and Procedures Working Group, PSA's Books and Records Task Force and Regional Advisory Committee, that collectively represent in excess of 50 member firms. 2/ 17 C.F.R. 240.17a-3 and 240.17a-4. 3/ See SEC Release No. 34-37850 (Oct. 28, 1996) ("Books and Records Requirements for Brokers and Dealers Under the Securities Exchange Act of 1934") (hereinafter, "Proposing Release"). 4/ While NASAA may have spoken to a number of broker- dealers in connection with the draft of its model Rule 203(A)-2 relating to record-keeping requirements for broker- dealers ("NASAA Model"), PSA did not support the NASAA Model and does not believe that either its members or the rest of the broker-dealer community supported the NASAA Model. Moreover, this letter marks the first opportunity PSA and its members have had to comment on supplemental books and records requirements since the October 11, 1996 enactment of the National Securities Markets Improvement Act of 1996 ("NSMIA"), which prohibits the adoption of such requirements by the states. 5/ For example, PSA does not believe it either practicable or fair for a broker-dealer to have to produce “immediately” documents located on site and to produce within three days documents located elsewhere. PSA would support a uniform rule requiring requested documents to be produced within a reasonable period of time. PSA does not provide a detailed critique of the Uniform Access Regulation here, however, as we hope to work with the SEC and NASAA to develop an acceptable uniform rule. 6/ See 142 Cong. Rec. H12046 (daily ed. Sept. 28, 1996) (Joint Explanatory Statement of the Committee of Conference) (the purpose of the legislation is to “promote efficiency . . . and provide . . . less burdensome regulation”). 7/ As Chairman Levitt noted recently, the Commission should “constantly reappraise [its] regulation and discard what doesn't work, either because the burden outweighs the benefits or because it has become outdated and no longer meets our needs and the needs of our investors.” See Remarks by Chairman Arthur Levitt, United States Securities and Exchange Commission, at the International Organization of Securities Commissions, Montreal, Canada, September 18, 1996. 8/ 142 Cong. Rec. H12047 (Conference Report on H.R. 3005) (remarks of Congressman Bliley); see also id. ("Under this new provision, the SEC must weight the cost of every rule they propose against the burden those rules would impose on the engine of our economy."). Moreover, PSA questions the Proposing Release’s compliance with the Paperwork Reduction Act, 44 U.S.C. § 3507, which, when it requires an "estimate of the burden that will result from the collection of information," presumably means an estimate that is well founded. Similarly, the Proposing Release may fail to comply with the Regulatory Flexibility Act, 5 U.S.C. § 603, which requires an agency's initial regulatory flexibility analysis ("IRFA") to contain a description of "significant alternatives to the proposed rule which accomplish the stated objectives of applicable statutes and which minimize any significant economic impact of the proposed rule on small entities." The Commission's summary of its IRFA contains no such description. Instead, the Commission simply states, without elaboration, that it does not believe any less burdensome alternatives are available. 9/ PSA is also concerned that a one-year phase-in period for updating account forms is not feasible with respect to existing customers. As the Commission notes, there are currently 46,000,000 customer accounts. Certainly, broker-dealers should not be required in the next year to obtain for all of them -- including those that have been inactive or limited in their activities -- the detailed information set forth in the proposed amendment. 10/ With respect to the proposed requirement that each memorandum of order indicate the name of the associated person who entered the order, PSA understands that, in the case of an order placed by a customer, the associated person who entered the order ordinarily would be the associated person to whom the customer communicated the order for execution rather than an "upstairs" trader or trading desk. 11/ PSA understands the term “local office” to include only offices within the U.S. We note, in this regard, that the impetus behind the "local office" requirements was to facilitate access by state securities regulators to information about securities activities in their jurisdictions. The extension of the blotter requirement to foreign offices would do nothing to promote the interests of the state securities regulators. Moreover, while the Commission creates an exception for "single-agent offices," it does not do so for branch offices that are not designated "offices of supervisory jurisdiction (“OSJs”) under the Rules of the National Association of Securities Dealers, Inc. (“NASD”). Much of the supervision of those offices is effected from other offices. Accordingly, it does not make sense to preclude off-site retention of records for non-OSJ branch offices. 12/ Electronic storage is not only costly, but also raises a host of ancillary issues such as increased access to confidential documents, which we discuss infra at 14. 13/ PSA does not read the rule to require retention or "approval" of those audio tapes a broker-dealer might make of its salespeople or traders. While the tapes might constitute records of the broker-dealer's efforts to sell securities, they would most certainly not constitute records used by the broker-dealer in making those efforts. 14/ The supervision of external documents, such as correspondence, is discussed infra at 14. 15/ In addition, the proposed requirement that a broker-dealer maintain "a summary of each person's compensation agreement" is also unduly burdensome. Compensation arrangements between a broker-dealer and its associated persons are constantly changing. Where salespeople are concerned, compensation may be determined by inventory levels, product type and other variables in constant flux. 16/ The proposed memorialization of oral complaints is discussed in further detail infra at 8-9 17/ Similarly, the requirement that a broker-dealer maintain "other records [aside from contracts] pertaining to the relationship" between itself and its associated persons is either so vague as to lack any specific meaning or is so over broad as to require the maintenance of an almost unlimited universe of documents. 18/ PSA is also concerned that a requirement that broker-dealers memorialize oral complaints may remove an incentive that broker-dealers currently have to resolve such complaints promptly: the hope that they can avoid any record-keeping or reporting requirements in connection with such complaints. Currently, the distinction between oral and written complaints, and the seriousness with which written complaints are treated, encourages broker-dealers to act preemptively and to resolve minor complaints promptly before they develop into serious, written grievances. By requiring that all oral complaints be memorialized in writing, the proposed rules will likely destroy this incentive. 19/ See Private Securities Litigation Reform Act of 1995, 15 U.S.C. § 77k et seq. 20/ The vague terms included in the Commission's description of activity runs are described supra at 10. 21/ PSA also believes it would be unduly burdensome to require that broker-dealers maintain a written memorandum of a customer's refusal, neglect or inability to provide information relating to his or her investment objectives. 22/ In contrast, and as discussed below, the New York Stock Exchange ("NYSE") and NASD recently have proposed rule changes that would eliminate the requirement of prior review for “any” communication distributed to the public, instead limiting such review to “advertisements, market letters, sales literature and other similar types of communications.” 23/ 15 U.S.C. § 78o(f). 24/ See SEC Release No. 33-7288 (May 9, 1996) (“Use of Electronic Media by Broker-Dealers, Transfer Agents, and Investment Advisers for Delivery of Information . . .”) at 5, n.5. 25/ See PSA Comment Letter re: File Number SR-NYSE-96- 26: Proposed Rule Changes Relating to NYSE Rules 342, 440 and 472 (Dec. 10, 1996). 26/ See SEC Release No. 34-37941 (Nov. 13, 1996) (“Self-Regulatory Organizations; Notice of Filing of Proposed Rule Change . . . .”) and NASD Notice to Members 96- 82 (Dec. 1996). 27/ See NASD Rule 2310. 28/ See Letter from Paul Saltzman, Senior Vice President and General Counsel, PSA, to John E. Pinto, Executive President, NASD, re: Notice to Members 96-60 (November 25, 1996). 29/ See SEC Release No. 34-37588 (Aug. 20, 1996) (“Self-Regulatory Organizations; National Association of Securities Dealers, Inc.; Order Granting Approval to Proposed Rule Change . . . .”) at 17. 30/ Id at 45. 31/ Congress expressed a similar concern when it enacted the NSMIA, which expanded the Commission’s authority to obtain copies of an investment company’s records without first obtaining a formal order. Congress recognized that “voluntary compliance efforts by investment companies . . . should be strongly encouraged” and that “internal control systems . . .function most effectively when they operate in an atmosphere of openness and candor, which is best fostered when internal audit reports are utilized by, and maintained within, the investment company organization, and are not routinely made public to third parties or requested by regulatory authorities.” See H.R. Rep. 104-622 at 49. To address this concern, Congress included a clause in the NSMIA requiring the Commission to exercise their inspection authority “with due regard for the benefits of internal compliance policies and procedures and the effective implementation and operations thereof.” 15 U.S.C. 80a- 31(b)(3). PSA believes the Commission’s proposed rules regarding audit reports would have the same chilling effect on broker-dealers that Congress aimed to prevent in the NSMIA.