October 22, 1998
Jonathan G. Katz
Securities and Exchange Commission
450 Fifth Street, N.W.
Mail Stop 6-9
Washington, DC 20549
Books and Records Requirements for Brokers and Dealers
Under the Securities Exchange Act of 1934
Dear Mr. Katz:
Thank you for the opportunity to comment on the reproposed amendments to the broker-dealer books and records rules, 17a-3 and 17a-4 under the Securities Exchange Act of 1934. This Department commends the Commission on its response to concerns raised by the North American Securities Administrators Association by once again addressing the books and records requirements for brokers and dealers. As you may know, Illinois strongly supports the requirement of brokers and dealers to maintain certain books and records at local offices. However, the Department has grave concerns about utilizing the number of salespersons doing business from a location as the basis for the definition of a local office and requirement to maintain books and records. The proposed records retention period is also cause for concern for the Department's audit program.
DEFINITION OF LOCAL OFFICE
Small offices make up a substantial portion of the locations that have day to day contact with the general public. For several years, Illinois has required the reporting of ALL locations from which salespersons are physically working via a very broad definition of "branch office". Most firms are complying with that requirement, although violations of the rule are still found during the course of the Department's audits. According to NASDR records, Illinois had 3,441 dealer branch offices as of October 9, 1998. Under the broad Illinois definition, which includes one person offices, 6,399 dealer branch offices have been reported to the Department. Due to a lack of oversight in these small offices, Department experience of uncovering grave problems in these offices and in order to avoid a duplication of examination efforts of the NASDR and the SEC, Illinois has targeted its audit program towards these locations. A total of 460 audits were conducted during calendar year 1997, including dealers, investment advisers and unregistered persons which were visited or audited by the Audit Division. Illinois conducted 193 dealer branch office audits of which 155 locations (82%) were 1 person offices; 18 locations (9%) were 2 person offices; 4 locations (2%) were 3 person offices; 4 locations (2%) were 4 person offices; and only 9 (5%) were 5 or more person offices. A total of 402 audits have been conducted so far in calendar year 1998 through August 24, 1998, including dealers, investment advisers and unregistered persons which were visited or audited by the Audit Division. Illinois has conducted 257 dealer branch office audits of which 195 locations (76%) were 1 person offices; 39 locations (15%) were 2 person offices; 10 locations (3.9%) were 3 person offices; 6 locations (2.34%) were 4 person offices and 7 locations (2.73%) were 5 or more person offices.
Illinois believes it has done an effective job of removing unscrupulous salespersons from the securities business through audits of small offices. The fact is that in Illinois over the past eight years, the Department has had 29 enforcement cases involving one person offices that were operating Ponzi schemes, selling away, selling fake securities or otherwise converting customer funds to their own use. In the 22 cases involving Ponzi Schemes and other conversions of customer funds, investors lost $38.9 million. Illinois has been able to effectively discover and investigate these problems due to the establishment of an Audit Division. Prior to its establishment, Illinois did not recognize the benefits of knowing where each representative is physically located and being able to review the records maintained at the individual offices. Many states have only recently established audit programs and will soon be recognizing the benefits. Since those states may not have previously required the reporting of these "other offices" or conducted audits of them, insufficient data may be available to quantify the abuses perpetuated at these locations. However, as individual states establish their audit programs, they will find these abuses just as Illinois did. Had these proposed rule changes been adopted 8 years ago, it would have been more difficult, if not impossible, to detect the abuses in the 29 cases referred to previously. In fact, some firms have already advised the Department that once these rule changes are put in place, they believe Illinois will not be able to visit these "other office" locations because there will be no requirements to maintain records at these locations.
The public makes no distinction between one person operating a securities business from a particular location or 100 persons operating a securities business from a particular location. Public perception is that an office is an office. Many of the smaller offices currently get around the NASD definition of branch office by letting salespersons use a "DBA" name such as Joe Smith & Associates to bait customers into the office. Since the salesperson does not mention the actual name of the dealer or securities in the name of their firm, it is not considered a branch office within the NASDR's regulatory structure. To the general public, however, there is no difference. These numerous exceptions to the NASDRs rule creates a lax standard which only adds to the publics confusion. To add to the viability of these locations, the DBA name is listed in the yellow pages of telephone directories as non-paid for line listings under sections entitled "Investments", "Securities", "Mutual Funds", "Investment Advisory" or "Financial Planning". Since the salesperson does not pay for the advertisement and only the DBA name appears, the NASD definition of branch office is avoided, yet the salesperson enjoys the same benefits as other offices of the dealer. One result is that customers become confused and believe that they are buying their securities from Joe Smith & Associates rather than from the actual registered dealer. This leads to grave problems when the office has complaints against it. Namely, confusion on the part of the investor as to who to voice their complaints to. Another result is that customers are easily convinced to write a check payable to the DBA entity of unscrupulous salespersons because that is the name the customer believes they are conducting business through.
Within the regulatory structure it is plausible to have different books and records requirements for different types of offices based upon the number of salespersons which are present. However, by not recognizing the existence of these "other office" locations, a system is created in which customers who choose to transact business with these smaller offices are not afforded the same protection as those who transact business with larger offices. These smaller offices are also problematic because most are never visited by the dealer after the salesperson becomes affiliated with that dealer. In several instances, the firm never visited the location prior to agreeing to let the salesperson become associated with their firm. The whole arrangement to establish an office was done over the telephone, fax machine or some special delivery service. This Department has found that some dealers are not even aware of the physical locations from which their salespersons are working. The Department questions the ability of firms to exercise oversight of salespersons when they are not aware of the location they are physically working from. The Department has been told by some dealers that adequate oversight of these salespersons can be accomplished by having the salesperson: complete a questionnaire; bring a sample of their records to the OSJ to be reviewed; attend quarterly meetings at the supervisor's office or some off-site location; or attend the dealer's annual meeting.
The reality is that small offices, especially those with only one person, tend to be the most problematic, especially with regard to off-book activity. Although there is no guarantee that off-book activity will be discovered during an audit, there is a greater chance when visiting the location that person is physically working from. It is unrealistic to believe that an unscrupulous salesperson will send copies of a Ponzi Scheme or evidence of other unscrupulous conduct to their home office, OSJ, or supervisor. Nor will they supply this information to some record depository established by the firm. Since there is no oversight of these locations, it is easy for the salesperson to conduct scams. The states are the local cop on the beat and should be providing the oversight of these "mom and pop" offices. The rule changes, as proposed, appear to allow firms and unscrupulous salespersons the opportunity to forego an on-site examination by stating that the required records are at the OSJ, main office, or record depository. This would greatly hinder the states ability to monitor these offices through an audit program. To this Departments knowledge, neither the SEC nor the NASDR audit these offices and therefore it is the efforts of the various states which will be most effected by this rule change.
Every salesperson maintains certain records in order to conduct business. Recently, a member of the SEC's staff stated to an individual of this Department that the SEC also believed that certain minimum records (ie: suitability information, customer account activity records and customer correspondence), needed to be maintained by salespersons in order to comply with the "Know Your Customer" requirements. This Department concurs with this position, however, the current proposed rule does not reflect that requirement. The Department proposes the rule be amended to state minimum books and records requirements for all locations regardless of the number of salespersons. This would set a minimum standard for all salespersons in order for them to properly service each customers account by having adequate information to assist them in complying with the "Know Your Customer" requirement. In a recent SEC decision, the SEC cited a firm for failure to supervise in a case where two salespersons of the firm misappropriated $4.5 million from their customers by convincing them to make checks payable to their DBA entities for their securities purchases. One of these offices was a one person off-site office, which under this rule change would probably not be recognized as an office. The SEC said that the firm should have reviewed the customer files located at these brokers' offices, which contained copies of the fraudulent statements sent to customers. That is exactly what the Illinois Audit Program has attempted to do, yet this proposed rule does not outline that records are even required to be maintained by salespersons at these "other office" locations.
LOCAL OFFICE RECORD RETENTION PERIOD
A record retention period at the local office of one year is not adequate for a review of the salespersons activity. For example, a mutual fund is a long term product and therefore should be held for a minimum of 3-5 years. However, a sales practice review of mutual fund transactions could not be conducted at the local office under this rule because records covering only a one year period would be required to be maintained. This is not a sufficient time period for a salesperson either in regards to complying with the "Know Your Customer" requirement. In regards to customer account records, (statements, suitability information, correspondence), the Department believes a minimum of 5 years of records should be maintained at the office.
Thank you again for the opportunity to voice our concerns regarding these matters. The Department appreciates the Commission's willingness to take them into consideration.
Very truly yours,
Robert H. Newtson