STATE OF CALIFORNIA -- BUSINESS, TRANSPORTATION AND HOUSING AGENCY PETE WILSON, Governor
DEPARTMENT OF CORPORATIONS
Los Angeles, California
December 4, 1998
IN REPLY REFER TO:
FILE NO: Alpha
Mr. 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 Mr. Katz:
The State of California appreciates the opportunity to comment on the Securities and Exchange Commissions ("SEC") proposed books and records rules. I would also like to commend the SEC for diligently working with the states to develop uniform requirements for broker-dealer books and records. It is our opinion that this rulemaking project is critical for the overall protection of the investing public in this state and the maintenance of investor confidence. Furthermore, this rule will enable states to augment the Federal securities regulatory scheme, by allocating more resources to the area of branch office examinations and by focusing more on the state-related issues.
California is in the process of implementing a routine branch office examination program. The objective of the program is to gather information concerning the activities and sales practice in broker-dealer and, in the near future, investment adviser branch offices domiciled in California.
There are more than 9,000 reported broker dealer branch offices in California. Neither the Securities and Exchange Commission ("SEC") nor the National Association of Securities Dealers, Regulation, Inc. ("NASDR") have programs to routinely examine branch office locations. The SEC and NASDR only examine branch offices on a "For Cause" basis, resulting from complaints or formal inquiries. Consequently, the states have taken primary oversight responsibility over branches located within their respective jurisdictions. Most states aggressively register and examine branch offices.
The adoption of the National Securities Markets Improvement Act ("NSMIA") has created a major impediment in the implementation of the branch office inspection program in California. Title I, Section 103 of NSMIA limits the states ability to adopt any law, rule, etc. that, inter alia, would require a broker-dealer to make or keep records that are different from or in addition to, those required by the SEC under the 34 Act. The 34 Act does not require broker-dealers to maintain books and records in branches. Therefore, states are precluded from requiring broker-dealers to make or keep books and records in branches or local offices. This has hindered California and other states ability to bridge the regulatory gap by conducting routine regulatory examinations of branch offices.
Enforcement cases brought by the Department show that most violations of law and related fraudulent activity originate and are carried out from branch office locations. Recent enforcement action against SunAmerica Securities, Royal Alliance and Consolidated
Investment Services, for failure to supervise are the most notable cases that demonstrate the supervisory problems in branch offices. California presently has pending actions against broker-dealer that hedge on branch office inspections and the records maintained in those branch offices. The branch office is where broker-dealers make first contact with the public. A brokers principal sales force is located in its branch offices. Rogue agents often practice aggressive and abusive sales practices out of those branches. Brokers with a large number of branches often have insufficient compliance staff to supervise those branches. As a result, these branches operate anonymously and without supervision by the broker-dealer.
It is necessary and appropriate for states to readily identify where securities activity is being conducted within its borders. This includes one or two person branch locations. One of the most glaring examples of the need to identify smaller branch locations was recently illustrated in an action brought by the SEC in the State of Massachusetts; (NYLIFE Securities, Inc., Admin. Proc. File No. 3-9712; Rel. No. 40459; 9/23/98). The case involved agents in two states, New York and Massachusetts. The SEC brought an administrative proceeding against a broker-dealer for allegedly failing to supervise two registered representatives.
One of the agents involved was assigned to a one-person branch office located in Massachusetts; the other agent was assigned to a branch in New York. Over a seven-year period, the two agents allegedly misappropriated approximately $4.5 million from customers by convincing them to purchase securities and make check payable to their own entities, and finally depositing the checks into their personal accounts.
Among other things, the SEC alleged that the broker-dealer lacked adequate supervisory and compliance procedures. It failed to conduct unannounced inspections of its branches and its agent working at remote branch locations. The broker-dealer also failed to adequately review agents customer files, and lacked adequate procedures to insure that the responsibility delegated to the managing partner in New York was being diligently executed. The broker-dealer was charged with failing to reasonably supervise its agents. These cases and others illuminate the need for expanded regulatory surveillance of off-site and/or branch office locations.
Approximately 25% of all broker-dealers licensed in California are domiciled outside the state but maintain branch office locations within the state. Many of these broker-dealers maintain networks of reported and non-reported branch office locations within California. Therefore, it is imperative in the public interest that California has the ability to effective review records related to securities activity generated from within the state. Examinations are conducted on an unannounced basis. To preserve the integrity of unannounced examinations, immediate and untainted access to books and records that relate to the activity within each branch is critical. The records must be readily available in the location being examined. One or two agents occupy many of the branch locations. Accordingly, it is imperative that what constitutes a branch or local office within the definition in the proposed rule does not exceed two agents. Furthermore, due to the size of the state having records maintained at a centralized location or depository will jeopardize the integrity of our examinations. The prefect world would be to
have certain core records at all business locations. Nonetheless, California supports the establishment of a threshold of limit of two licensed persons to actuate the core record maintenance and depository requirements. California is an expansive state. Increasing to the number licensed person that will actuate the record keeping requirements will only serve to increase the cost of the regulatory program, by inhibiting examiners from securing and having ready access to books and records in a large number branch locations within the state. According, exceeding the two-person threshold will negatively effect our ability to administer an efficient regulatory program.
The re-proposed rule would require records to be maintained at the "local office" for a one-year period. Due to resources and other limitations, examinations of these offices will be conducted on a two or three year cycle. During examinations records are reviewed from the date of the prior examination, therefore, record pertinent to the examination coincides with the examination cycle. Therefore, records should be retained for third years, two-years in the local office and the third year in a designated depository within the state.
Finally, the re-proposed books and records requirements allow records to be retained at state record depositories for those offices that do not qualify as local offices. Our concern is access to the records, and the availability of someone at the depositories to interpret the information. The rule does not delineate what constitutes a depository. Can the depository be a third party? If so, is the third party obligated to provide regulators access to the books and records in their possession? If not, records would not be readily accessible. Also, since examinations are conducted on an unannounced basis, denial of access to the records located at the independent depository could compromise the examinations.
Industry, the investing public and the regulatory committee will benefit from uniform record keeping requirements. Uniformity of these records will empower examining authorities to better focus on activities specific to a branch office location. Maintenance of certain cored records and an extended retention period for those record within branches or local offices will preserve the integrity of unannounced examinations, promote more efficient and effective examinations and expedite enforcement or other remedial actions by the states.
Maurice O. Cox
Securities Regulation Division