December 9, 1998
Hon. 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 - Release No. 34-40518
Reproposed Books and Records Requirements for Brokers and Dealers
Dear Secretary Katz:
I would like to commend the Securities and Exchange Commission for working with state regulators to develop reasonable and necessary books and records requirements, as well as giving state regulators the opportunity to comment on the reproposed amendments.
The need for the records being reproposed cannot be over emphasized, and to a large extent are necessary for the firms= orderly conduct of business. Detailed, accurate records are essential, not only as enforcement tools to the regulators, but also as supervisory tools for the firms. The reproposed rules, in most cases, simply codify the Abest practices@ of industry already in place. Both industry and regulators will benefit from a uniform requirement for books and records by facilitating thorough and quick examinations, making the exam more complete, cost-effective and less intrusive for the firms.
Memoranda of Brokerage Orders and Dealer Transactions - Rules 17a-3(a)(6) and 17a-3(a)(7)
This Department supports the changes as reproposed which require that order tickets include the identity of any person accepting or entering the order. The reproposed rules provide flexibility for the firms to meet the new requirement by allowing firms to create a separate record for this information. There have been complaints filed in which a miscommunication has occurred and the order was incorrect, or not complied with. In one case, the name of the order-taker was known, and the problem was quickly corrected without the need for an in-depth investigation. In another case, the firm was one that only takes unsolicited orders and the customer calls were given to the first available consultant. The firm recorded all calls, but not having the name of the order-taker made locating the recording costly to the firm. The firm elected to put the customer in the position she would have been in had the designated trade taken place, resulting in a $6,000.00 cost to the firm.
This requirement would also be helpful in identifying any unlicensed sales activity. Recent penny stock exams have shown unlicensed individuals quoting stock prices and making recommendations. Having the name of the sales assistant or cold caller on the order ticket would be extremely helpful in monitoring this type of activity.
Similarly, this Department supports the requirement that the order ticket be time stamped when received and when executed. Recent investigations into penny stock firms have found hundreds of order tickets, from several different brokers, time stamped for receipt and entry at the same time, within a few minutes of opening of secondary trading. Such a practice points to prearranged trading, unauthorized trading, and giving priority to insiders and nominees.
Additional Records Concerning Associated Persons - Rule 17a-3(a)(12), (17) and (18)
These reproposed rules are extremely important to state regulators. Although CRD does make certain information available to regulators, the CRD system does not give the names of all associated persons located at a branch. A record of all associated persons of a broker-dealer is provided to state regulators on an annual basis, but that report quickly becomes inaccurate. Therefore, unless CRD is available at the exam, staff cannot research U-4 or U-5 amendments, current disciplinary records, licensing status or any other pertinent information.
It is a common practice for federal, SRO and state examiners to review the records of the largest producers and those with disciplinary history during both for cause and routine exams. Without these records available at the time of the exam, examiners might need to revisit the branch office to look at a particular associate=s transactions. This causes more hardship and more cost to the firm. Similarly, employment agreements, customer complaints, client trading information, and compensation records are vital to detecting sales practice violations, and in determining whether the violations are a firm-wide problem or merely the actions of a Arogue broker.@
In the past, such records pointed to the firm practice of splitting commissions between insurance-only licensed employees and securities licensed employees during the 1980's sales of limited partnership units. Compensation records also focused regulators= attention on the practice of providing higher compensation for limited partnership sales, as well as non-monetary compensation. Employment records indicated high pressure was put on the brokers to sell the limited partnerships, with failure to do so resulting in warnings being placed in employment records and brokers being put on probation. Another case in point involved the wide-spread sales of proprietary mutual funds. The compensation being offered for the sale of the proprietary products resulted in customers being Aswitched@ into the proprietary funds. Customer records indicated that many of the transactions involved junk bond funds and were not suitable for the safety-conscious investor.
Customer Account Records - Rule 17a-3(a)(16)
Customer account records are kept at virtually every firm, and are critical to both regulators and compliance personnel. The account record is what most supervisors use to review trading for suitability and account activity, whether the record is in hard copy form, or an electronic record. It is also the fastest way for regulators to review the accounts for the same purpose, again saving the firm time and money.
No matter how often or how quickly a customer=s investment objectives change, a broker cannot make recommendations without knowing the customer=s objectives, and the compliance supervisor must have the same information in order to review the trades for suitability. It is imperative to both firms and regulators that account information be accurate and up to date, including information regarding investment objectives and risk tolerance.
Examinations of customer records have found many instances in which customer records indicate a customer=s objectives are a mix of safety, growth, income and speculation. Without asking a customer what percentage of assets should be placed in each category, and recording that information, an account can easily be improperly diversified. Allowing the firms to use their own formulation will result in a lack of uniformity, conflicting with the stated purpose of making records more uniform. The firms can also change their own formulations at any given time, supporting the sale of what may be unsuitable proprietary products. This is clearly a conflict of interest.
Customer Complaints - Rule 17a-3(a)17
A written record of customer complaints and how they should be stored is of utmost importance. Customer complaints are often the first indication regulators and compliance personnel have of sales practice violations. Without customer complaints, regulators may not have been aware of the sales practice violations in the limited partnerships, CMOs, or junk bonds. When performing an examination, whether the examiner is a regulator or an in-house auditor, the examination cannot be complete without reviewing customer complaint files for problem brokers or products. The customer complaint file is not complete without a record of the resolution of each complaint.
The Department has received customer complaints that were first brought to the attention of the firm through an oral complaint. In our experience, many investors are not aware that a verbal complaint is treated differently by the firm than a written complaint, or who at the firm they should address a complaint to. For this reason, the books and records requirements should also have provision for memorializing and storing oral complaints.
Other records - Rule 17a-4
Many brokerage firms regularly produce reports which monitor common sales practice violations, such as churning, switching, break point sales, unlicensed sales, etc. as a supervisory tool. The rules as reproposed, do not require the firms to produce these reports, but to retain them and make them available if they do. In the Department=s experience, it is only the smaller introducing firms that do not have the technology available who do not produce these kinds of reports. In most cases, the clearing firms do have the technology available, and some provide their introducing firms with such reports. There is some added expense, but the liability for failing to identify and prevent sales practice violations far outweigh the costs of these reports.
Definition of a Local Office - Rules 17a-3(g), 17a-4(k)(1) and (2)
Prior to the adoption of NSMIA, many states required all offices to maintain certain minimum books and records. The current reproposal to limit this requirement to locations of two or more persons significantly compromises the states= ability to conduct unannounced examinations and to finalize an examination in a relatively short time frame. It could also result in examiners having to make a second visit to the office for further interviews.
In the last few years the number of one and two person offices has significantly increased. The smaller offices have been the subject of many egregious sales practice violations. A significant number of complaints alleging Aselling away@ and conversion of customer funds has been from the smaller offices. The majority of cases involve firms that define their associates as independent contractors. Many of the firms do not perform internal audits of these locations. Some firms allow brokers to place mutual fund orders directly with the funds, rather than through the firm. Lack of supervision is a serious problem with many of these firms. If the firms are not going to provide surveillance and supervision, regulators must. Due to a lack of resources, the SROs and the Securities and Exchange Commission very seldom examine the smaller offices, therefore it is left to the local Acop on the beat@ to perform these examinations. Without the same records available on-site, there may be a delay in finalizing the examinations, and the records are many times misplaced. In states like Montana, which take up a large geographical area, the state securities office, the local office and the central office can be hundreds of miles apart, resulting in expensive travel costs and man-hours being charged to the firm, and fewer examinations by the state regulators, as well as causing a costly delay in preventing further violations. I cannot express strongly enough that exempting one-person offices from storing the required books and records on-site will be a serious detriment to the early detection of securities law violations and is not in the interest of the public we serve.
In conclusion, I fully support strong, enforceable books and records rules. I hope my comments are helpful in demonstrating the need for the reproposed rules. Any further softening of these requirements will put the best interests of investors at significant risk.
Thank you for the opportunity to comment on this all important issue.
David L. Hunter
Deputy State Auditor
cc: Karen O=Brien, NASAA