LEHMAN BROTHERS INC. THREE WORLD FINANCIAL CENTER, 11TH FLOOR NEW YORK, NEW YORK 10285-0011 TELEPHONE 212 526 5711 FACSIMILE 212 528 6679 KATHRYN S. REIMANN SENIOR VICE PRESIDENT SENIOR COUNSEL CHIEF COMPLIANCE OFFICER December 27, 1996 Jonathan G. Katz, Secretary US Securities and Exchange Commission Mail Stop 6-9 450 Fifth Street, NW Washington, DC 20549 Re: Books and Records Requirements for Brokers and Dealers Under the Securities Exchange Act of 1934; Securities Exchange Act Release No. 34-37850; File No. S7-27-96 Dear Mr. Katz: Lehman Brothers Inc. ("Lehman Brothers") appreciates the opportunity to comment on the proposed amendments to Rules 17a-3 and 17a-4 promulgated under the Securities Exchange Act of 1934 (hereafter "the Proposal"). Lehman Brothers joins in and endorses the comment letter submitted this date by the Public Securities Association ("PSA"), of which we are a member. In addition, Lehman Brothers, on the basis of current drafts and the level of participation that we have maintained to date, expects to join in and endorse the comment letter which we understand the Securities Industry Association ("SIA") will submit early in 1997. Lehman Brothers is also part of an ad hoc group of firms which intends to provide the Commission with a detailed comment letter in the very near future. Notwithstanding our high level of support for and participation in these three efforts, we believe the Proposal to be of such potential significance to the industry that we feel compelled to express our concern on an individual basis as well. Rather than reiterating the detailed commentary contained in the three group comment letters, we would like to address the Commission's specific request for comment on the accuracy of the Commission's estimate of burden posed by the Proposal, both in terms of economic cost and anti-competitive effect. With all due deference to the Commission, we strongly dispute the Commission's preliminary conclusions regarding the insignificance of the compliance burden, the costs of implementation, and the anti-competitive effect of the Proposal Moreover, we are unable to discern a potential benefit to the public that would justify any additional burdens. We respectfully suggest, as discussed more fully below, that an adequate analysis of the costs and potential benefits of the Proposal leads squarely to the conclusion that it should be withdrawn. The economic costs of the Proposal manifest themselves in a variety of ways. First, the complete lack of any institutional exemption, even with respect to concepts and practices that the Self Regulatory Organizations ("SROs") have acknowledged to be without relevance or use in the institutional context, would create the need for firms with significant or solely institutional business to build systems and add infrastructure which does not exist today, and which has no justifiable regulatory, business or public protection function. Second, the annual cost of supervising, running and maintaining the very basic compliance systems that many firms engaged in retail business have voluntarily developed to aid them in fulfilling supervisory obligations is, in our estimation, a number to be measured in millions for a firm of any substantial size. The cost of initially establishing such systems, and of hiring the personnel to support them, will vary depending upon the existing infrastructure and systems resources of a firm. In any event, they can be quite significant. Third, provisions such as those requiring the earmarking of a percentage of an account for "speculative" or "high risk" investments, the review of internal marketing materials and the memorializing of oral complaints will add significant supervisory, legal and other personnel costs to a firm's budget on a permanent basis. We believe that it is unrealistic to expect that any of the aforementioned tasks can be accomplished without a significant level of compliance review and oversight. The potential risks are simply too great. We should state here that this conclusion is not intended to imply that these are areas in which we are failing to detect problems by current methods, and which thus should be more closely regulated. To the contrary, we believe that the risks will be caused by the creation of unnecessary documents that can be misinterpreted to create the illusion of a problem where none existed. Fourth, the Commission has seriously underestimated the time that must be devoted to any type of endeavor that requires customer participation. With respect to the annual updating of account documentation, the basic figure of five minutes per account which the Commission feels is appropriate for account updating is fatally flawed; it appears to assume that the public responds to such requests on the first try, and that no additional contact is necessary. It may also assume that customers have a high tolerance for what they regard as needless bureaucracy. Our experience is to the contrary. Further, as is the case with other aspects of the Proposal, no consideration has been given to the need to create surveillance and supervisory procedures that will reasonably confirm that the assigned task has been accomplished. Even putting aside these criticisms for the moment, if we use only the Commission's analysis of recordkeeping costs in Article IV, Part D of the Proposal, and do not consider storage or secondary costs, costs for legal and compliance time, or costs for planning, implementation and systems or storage modification, we have done calculations that indicate that the purely recordkeeping aspects of the Proposal will result approximately $400,000. in increased labor costs alone per year. While we do not believe the suggested calculation methodology to be appropriate, even it yields a cost figure which, taken together with the run rates for systems, demands some real demonstration of a benefit before it is foisted upon us. Finally, the cost of the warehousing or on-site storage of duplicative or additional records, particularly in local branch offices often located in leased space, is also one which can become significant and which does not appear to have been considered. Indeed, one reason that many dealers have centralized records is to reduce costs and promote efficiency. There are other bona fide business reasons for centralizing many records retention and information or records management functions as well, including but not limited to confidentiality concerns, exposure and risk management, legal needs, ease of responding to SRO and Commission requests of a firmwide nature, management efficiency, even- handed application of policies and more effective supervisory control. These are goals that ultimately benefit public customers, as well as shareholders of publicly-traded entities with broker-dealer licenses. One of the more astonishing aspects of the Proposal is that it not only fails to reflect adequate consideration of implementation and maintenance costs to the industry, but that it appears to be predicated upon the assumption that the business and operations of broker-dealers should be organized and managed, first and foremost, in the manner that is most convenient to the state regulators, regardless of business needs and concerns, or the type of business being conducted. This approach to regulation runs counter to the traditional approach that requires broker-dealers to supervise and conduct their operations in a manner that is reasonably designed to promote regulatory compliance, but recognizes that what is reasonable may vary according to the institution and its business. The notion that what purports to be a "books and records" rule should cause a dealer to rethink or retract completely lawful, considered decisions that it has made about the actual organization of its business without a palpable public justification is insupportable. The proposal that broker-dealers stand ready to produce records of compensation on a transaction-by-transaction basis illustrates this point. A firm that has deliberately chosen to make its registered employees salaried, with, for example, the goal of avoiding issues relating to transaction- based compensation and promoting a more firm-focused, long- term employee outlook, should not be compelled to create documents that are inconsistent with its true method of compensation and are essentially fictions created to fit an inappropriately applied regulatory formula. This type of interference with the ability of a firm to make decisions and allocate resources in a way that will most effectively provide excellent customer service, reasonable supervision and compliance with substantive requirements can lead to anti-competitive effects. The impact on smaller firms, institutional and specialty firms, and firms that are less sophisticated from an electronic perspective will be far in excess of the impact on firms that have made different historical decisions regarding resource allocation due to the nature of their business. And, we wish again to emphasize, the Proposal would force an allocation of resources that is in no way related to improved or more efficient service to the public or, we believe, to public protection. The cost of obviously unnecessary or irrational regulation is immeasurable, as it affects not only economics and productivity, but the credibility and perception of the regulatory regime as a whole, both by the industry and the public. We believe that experience supports the notion that the most effective levels of self-regulation, and hence, public protection, are achieved when the Commission and SROs set broad standards, and allow firms to tailor implementation mechanisms to fit their unique business, product and client needs. This type of regime has worked well in the Chinese Wall arena; the SROs wisely have chosen this approach more recently in connection with both continuing education and customer communications, with the approval of the Commission. We are perplexed at the inconsistency between the Proposal and other recent regulatory initiatives, both in approach and, with respect to customer communications and suitability, in content. We have alluded to, and feel compelled to comment further upon what appears to be a complete lack of justification for the proposed changes to Rules 17a-3 and 17a-4. The SROs and the Commission have conducted both sales practice and financial/operations examinations utilizing the records that exist today, with what appears to be little or no problem. Further, there are existing substantive rules which address the public harms about which the state regulators seem to be concerned. As we understand it, the state regulators believe that an absence of actual documentation or electronically available information housed permanently within their jurisdictional boundaries impedes their ability to protect the public. In an age when information can be transferred form place to place within a day, even in hard copy format, we find this argument difficult to follow. Even assuming that there is a larger access and enforcement problem, the answer to such a problem is to enact an access rule which will require broker-dealers to produce information responsive to reasonable requests in a reasonable amount of time upon the pain of sanction. Instead, the Commission has put forth a proposal that seeks to create new records with no business value, and to duplicate others at substantial cost and legal risk to broker-dealers -- including those who are not in businesses that are generally impacted by state regulatory activities. Further, the Proposal couches new substantive requirements and burden-shifting devices for the state regulators in the guise of books and records requirements. Some of these requirements, such as what is in effect the ability to compel immediate testimony on the substance of any document, are unjustifiable in their reach. Others, such as the requirement which suggests that investment objectives can be established and maintained on a percentage basis, suggest either a lack of practical understanding of, or a complete disregard for, the dynamic nature of a securities portfolio, the nature and limits of suitability analyses and obligations, the unfair and unnecessary legal risks that the existence of such records will present, and the necessity--regardless of assurances to the contrary--of building a surveillance and maintenance structure to manage these new legal risks. The only apparent benefit of such a requirement would flow to regulators, who would be able to have minimally trained personnel conduct a superficial audit without making subjective determinations about customer or account circumstances, and would then be in a position to shift the burden to the firms to demonstrate why the superficial findings were wrong. The other beneficiaries would be plaintiffs' attorneys who would hope to find an incongruity between percentage objectives stated on an annual update form, and assets actually held in an account at a given point in time, each time a client desired to be reimbursed for a legitimate market loss. The public, which will eventually share the passed-on costs of needless recordkeeping, inefficient regulatory activity and windfall litigation awards, will not benefit from the above requirement. In the event, will a customer whose bonds are unexpectedly downgraded and became arguably speculative overnight really be better served if he or she is told to ignore any prognosis for market recovery, sell the bonds immediately and take the loss because his or her circumstances do not permit the appropriate percentage of speculation as an objective? Or are the firms expected to permit the customer to hold the position in disregard of stated objectives at their own risk, and wait for the regulatory action or arbitration claim to be filed? And, for a firm like Lehman Brothers, which does a full spectrum business primarily with institutions, and on a more limited basis with high net worth individuals, the requirement that assets and investment objectives be rigidly classified will be neither welcomed by nor helpful to our customer base, if there is a reasonable way to implement it at all. How does a firm reasonably and efficiently monitor a system in which a product that is bought for speculation in one account may function as a relatively conservative hedge in another? As noted above, despite the Commission's assurances to the contrary, the enactment of such a proposal would give the firms no choice but to monitor trading for consistency with objectives. If the answer is that monitoring must be done on an account-by account basis by the registered representative and responsible manager, with periodic oversight by an audit staff, then we have expended substantial resources and created needless, potentially problematic new records, risks and systems only to arrive back at exactly the same place that we find ourselves under current rules. Finally, still other features of the Proposal would seem to require the review of and retention of internal marketing materials, and the designation of a firmwide "books and records" principal. These provisions are inconsistent with other parts of the Proposal that call for decentralization, and in that respect seemingly fail to serve even the articulated goal of state access. Such innovations would call for a change in business practices and a dedication of resources that seem not to have been taken into account in any of the Commission's analysis. More important, we perceive no public benefit arising from these innovations. In sum, we believe that an analysis of the costs and benefits of the Proposal is decidedly weighted against its adoption. As is cogently demonstrated in both the PSA and SIA comment letters, the current provisions of Rules 17a-3 and 17a-4, together with the existing SRO rules satisfy the need to protect the public from unsuitable recommendations and unsupervised sales efforts. A simple access rule would satisfy the need to provide state regulators with sufficient information to make their own assessments and perform their own examinations. To the extent that Commission believes that this is not the case, a more clear articulation of the books and records issues to be addressed, and a proposal that addresses those particular issues in a reasonable manner without requiring wholesale changes in sales and other business practices might well be appropriate. The current Proposal does not fit this category; we therefore respectfully suggest that it be withdrawn. Sincerely, Kathryn S. Reimann