November 6, 1998
Jonathan G. Katz, Secretary
Securities and Exchange Commission
450 Fifth Street, NW
Mail Stop 6-9
Washington, DC 20549
Re: File No. S7-26-98
Dear Secretary Katz:
I would first like to commend the Securities and Exchange Commission for working with the state regulators to develop uniform books and records requirements as required by the National Securities Markets Improvement Act of 1996 ("NSMIA"). This rule proposal is vital for investor protection as well as implementation of NSMIA.
In general, the Division of Securities supports the reproposed rule. In some ways it is more difficult for South Dakota to comment in line with other states since we have so little direct or local influence by broker-dealers. South Dakota has one active broker with an in-state home office. All other broker-dealer firms maintain their home offices and branch offices out-of-state. Out-of-state branch or home office supervises the majority of resident agents. Most offices in South Dakota are one or two person offices. Based upon the small size of the firms located in South Dakota and the lack of home offices, the Division does not expect that all books and records be kept at every office. The critical records for a rural state are those records that relate to sales practices and help prevent and detect abusive sales practices.
The Division supports the idea that certain core records should be kept at the broker-dealer and the local office. In our state, the broker-dealer may have to have a state depository, since many "satellite" offices only have one licensed person. However, in an effort to support uniform books and records, we will do our best to operate within the reproposed rules. Uniform books and records requirements will create the same record keeping throughout the industry. Both regulators and brokers will know what records are required at specific locations and prepare for examinations accordingly.
It is rare for South Dakota to do "for cause" examinations. We probably conduct one or two per year. Due to our situation, the Division asks in advance for records from the broker-dealer and
schedule examinations, giving the broker-dealer and agents time to prepare the records. Our examination program has been in effect for approximately two years and we feel more prepared to require surprise examinations and cooperative examinations of firms in other jurisdictions. Those types of examinations will likely be "for-cause" examinations. Uniform books and records requirements will assure regulators and the securities industry that adequate records will be maintained and accessible.
The Division particularly supports the notion that broker-dealers should keep records in the format best suited for their firm. South Dakota will be proposing legislation to support the acceptance of electronic records, digital signatures, etc. Electronic records are coming less and less expensive and are a good tool for complying with the reproposed rules. The broker-dealer can save money if the appropriate records can be located at the office of inspection. In addition, regulators spend less time on examinations when the appropriate records are located on site. Therefore, we encourage electronic records when possible. We just need to be assured that the records are readily accessible, either in their electronic format or printed-down hard copy.
Keeping the records at the local level, in whatever format, is another reason to support this proposal. When there is abusive sales practices occurring at a local office, it is easier to discover at the earliest stages, protecting investors and subjecting the broker-dealer to less liability.
Information Contained on Order Tickets for Agency and Principal Transactions, 17a-3(a)(6) and (7):
Order tickets are crucial for determining who was involved in a particular transaction. Persons responsible for trades, either solicited or unsolicited should be traceable. The names of those responsible should appear on the trade tickets. Further, it is extremely important that the trade ticket name the person who accepted and/or entered the order on behalf of the customer. It is not uncommon for an unregistered cold caller to solicit residents of South Dakota and then run the sale under a registered agents account. If the regulators required the firms to disclose the name of the person who took the order, it will be much easier to determine compliance with securities laws and rules both for state and federal law. This is particularly true now that the proposed rules dropped the requirement for the firm to mark trade tickets as "solicited" or "unsolicited."
South Dakota would like to the Commission consider marking the trade ticket for cold calling. While cold calling is a critical tool for business expansion, it is also one of the most abusive sales practices used by brokers. My enforcement attorney receives at least one abusive cold call, particularly offering Regulation D, Rule 506 offering documents, each week. The microcap firms and many of the latest boilerroom scams have abused regulation D, Rule 506, since NSMIA. Regulators should be able to examine trade tickets and determine the amount of cold calling that exists at any given time in any firm or local office. If most of the brokers business is generated by cold calls, there is a likelihood that the firm has an abusive sales force, or at the very least, an abusive agent.
Exception for Electronic Trading Without the Services of a Natural Person:
The following persons names should appear on the order tickets, whether the order is solicited or unsolicited and whether the order is on paper or in an electronic format:
1. The licensed person assigned to the account; and
2. The person who accepts or enters an order, whether or not that person is registered.
Time Stamping of all Order Tickets:
All orders should be time-stamped at the time the order was received from the customer. Time stamping is important to determine real-time trading. Time-stamping orders would prevent time-delayed abuses, such as front running and failure to place the "best execution."
Additional Records Concerning "Associated Persons": Agreements between BD and Associated Person, Customer Complaint Information, Trading Information/Commission Runs, 17a(12), (17) and (18).
Commission runs are an important part of an examination. The runs should contain the date, some identification of the account for which the commission was paid, the name or number (even if internal) of the Associated Person, the amount of shares or units and the dollar amount of the trade. The old saying "Follow the money and you will find the crime" is true. Knowing exactly what commissions were paid, to whom and for what, helps detect and prevent abusive sales practices. The Division has been able to show abusive sales practices in limited partnership cases and the sale of promissory notes by showing the amount of commissions generated by specific agents.
For example, the Division did a scheduled, routine examination of a bank that has a securities subsidiary and an insurance agency. When we examined the commission runs during our examination we found that, while all of the securities agents were licensed to sell securities and all of the insurance agents were licensed to sell insurance, that the securities agents were not licensed to sell insurance, but were receiving a portion of the commissions for the sale of insurance products for those agents who "referred" their clients. This is a violation of South Dakota insurance law. The firm handled the problem and there is clear compliance for all agents.
Customer Account Records 17a-3(a)(16)
The new account form or "record of each account of a customer" is a critical document for regulators. Regulators use this information to determine whether the broker made transactions that are in the best interest of the customer. Brokers should use the new account form to make certain that purchases and sales match customer suitability and investor goals.
We want to emphasize that properly used, new account forms can also help brokers defend against allegations of improper sales lodged by their customers. We strongly encourage the firms we examine to have as much information as possible on their clients and document all of their conversations and correspondence. It is the best way for a broker to stay on top of his clients needs and have a record for the regulator to follow when a complaint is filed. Also, since the Commission does not require the broker-dealer to keep records of oral complaints, the Division recommends that the Commission require the firm to provide disclosure to the investor about filing complaints.
We have had cases where the broker fabricated all in the information on the new account form. The investor had not met the broker in person and had never received a copy of the new account form that the broker filled out in his name. The broker had marked "accredited investor" when the investor was retired, never had invested in the stock market, had a $200,000 inheritance and $25,000 yearly income. It is tough for a regulator to believe the brokers defense (which in this case didnt help the brokers case) when he had no records to back up his story, except a new account form obviously signed by the broker.
The investor should verify the information within 30 days. If the investor does not sign the new account form within that period of time, the broker and/or firm has done its duty and can note as such on the record in order to comply with the rule. We would prefer that the broker-dealer gets the investors signature as "verification", but verification may be determined by further rule or by each firm. However, we still recommend that verification be by signature and that a firm reject new accounts that fail to verify. Further, we would prefer that the information be updated and verified every 12 months, but we are glad that the Commission is willing to require verified, updated information at least every 36 months.
The Division would prefer to develop our own waivers for record retention. In general, the record requirements would not be waived. However, due to our very small broker-dealer community, I could foresee a time where, to encourage a local broker-dealer, we would want to grant certain relief from the records retention requirements. It would be difficult for the SEC to craft waivers given each states particular problems and concerns. Exemption or waivers should be left to the states.
Definition of a Local Office 17a-39g), Local Office Records and Retention Requirements 17a-4(k)(1) and (2):
The definition of local office for access and retention of books and records is extremely important to rural states such as South Dakota. The reproposed amendment defines "Local Office" as an office having two or more licensed persons that "regularly" conduct activities that the SEC describes as relating to securities sales activities. These offices are required to maintain the minimum generally described records at that location for a one-year period. One-person offices would be required to maintain the same core records, but they could be stored at another location within South Dakota. The majority of offices in South Dakota are one-person offices, typically supervised by a broker or principal with an out-of-state address.
Since "Local Office" refers to two or more licensed person offices, many South Dakota offices will not be required to keep certain core documents such as customer complaint. The Division would prefer the definition of local office to include one-person offices for retention of core documents in
order to expedite our examination program. It is one area where having uniform records standards is a road block to the "local cop on the beat." As a practical matter, many one-person offices are more than likely the only office in the state (sometime even in the case of a prominent national or regional firm) and therefore the records would likely reside in that office.
However, examinations have revealed that one-person offices seldom have the same kind of broker-dealer support that larger offices provide. Typically, an out-of-state broker-dealer of "independent brokers" or "insurance agents" will have five or six compliance officers overseeing hundreds of agents located throughout the United States in one-person offices. Our office has experienced extensive selling away, unauthorized, outside business activities and suitability problems in one-person offices.
While the Division would prefer records requirements for one-person offices, at the very least local office should be defined as a two-person office. It should be noted that South Dakota has the statutory authority to charge the broker-dealer for the cost of the examination, including time and salary for the examiner. Any action that delays that process is more costly to the broker-dealer. Any needed document that is not held at the local office increases the amount of time spent on the examination, resulting in increased costs.
Sales scripts should be retained at the local office. Sales scripts are frequently a road map to abusive sales practices. It is also a way to determine if the broker is using firm scripts (and complying with the law) or developing his own. The local office should also retain correspondence. Not only is it a help during an examination, but it is also a record that can support the brokers defense against customer complaints.
Thank you for the opportunity to comment about the reproposed rules on books and records. We appreciate the efforts of the Commission to address state regulator needs along with the needs of the federal regulators.
If you have any questions about these comments, please do not hesitate to contact me.
Very truly yours,
Debra M. Bollinger, Director
Division of Securities