December 9, 1998
Jonathan Katz, Secretary
Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549
Re: File No. S7-26-98, Books and Records Requirements for Brokers and Dealers
Under the Securities Exchange Act of 1934
Dear Mr. Katz:
This letter is submitted on behalf of Charles Schwab & Co., Inc. ("Schwab") on the SECs proposal to impose additional books and records requirements on broker-dealers registered with the Commission. Schwab is the second-largest U.S. broker-dealer in terms of active customer accounts, and is the largest broker-dealer in the world in several important market segments, for example (as relevant to this letter) on-line brokerage.
Schwab appreciates the opportunity to comment on this important issue. We commend the Commission for reconsidering the excessively burdensome books and records proposal issued in October 1996, and for the staffs attempt to work with the securities industry to come up with a more workable approach. Of course, we share the Commissions goals of protecting investors and detecting and deterring fraudulent sales practices. However, we cannot support the Commissions current proposal, which we believe will impose enormous costs on Schwab (and therefore on our customers) without any appreciable benefit in terms of achieving the Commissions intended goals.
The Commissions regulation is designed to regulate the full-commission model of brokerage firms: branch offices with commission-paid sales agents, each of whom telephones a book of clients and makes individualized recommendations of securities transactions to those clients. Of course, because of the intractable conflicts of interest inherent in such a business model, we are confident that the vast majority of the sales practice problems which the Commission faces relate to these firms. But while this type of firm has been important in the history of the securities markets, in our view the future of those markets increasingly belongs to firms with different business models.
The SIA recently estimated that by the end of 1998, 30% of retail securities trades will occur on-line. In the three years since Schwab introduced trading over the Internet, on-line trading has grown to over 60% of our daily trading volume. When combined with telephone-based discount brokerage, fee-compensated investment advisers (for whom broker-dealers provide only trading and back-office support), and no-load mutual fund supermarkets, we believe that by the end of this year less than half of retail securities trading will occur in the traditional manner at the old-fashioned full-commission wire-houses. Moreover, the trend towards on-line investing and other types of brokerage that minimize conflicts of interest is only intensifying, and in our view the trend away from the old business models is likely to continue to accelerate.
Schwab is a good example of why the assumptions that guide the Commissions proposal are out-of-date. Schwab has over 280 branches across the country. However, as noted above, the majority of Schwabs customer trades occur not at a branch, but over the Internet. Of the trades placed with a live registered representative, the vast majority occur at one of Schwabs four national telephone service centers, not at a branch. (The branches serve primarily to help customers open accounts, to teach customers how to use services such as the Schwab.com Internet site, to help customers with specific advice requests, and to perform cashiering and other similar functions for customers.) Schwab retail customers are not assigned to a specific account representative. Schwab retail registered representatives receive a salary and bonus, and do not receive commissions. The overwhelming majority of Schwab customer trades are unsolicited. Viewed against the way in which Schwab does business, most of the Commissions proposals simply do not make sense, particularly in light of the titanic costs they would impose.
The Customer Account Information Requirements Should Only Apply If a Broker-Dealer Makes Recommendations to a Particular Customer Account.
The proposal would require broker-dealers to obtain extensive information from customers, including annual income, net worth, employment, marital status, dependents and investment objective, and would require broker-dealers to mail this information to customers upon account opening and every three years thereafter (and more frequently if the customers investment objectives change), for the purpose of allowing regulators to review accounts for suitability issues. Schwab has been expanding the amount of "Help and Advice" we offer to customers. However, the vast majority of Schwab customer trades are unsolicited trades in which Schwab does not make any individualized recommendation to the customer. In the absence of an individualized recommendation, brokerages do not have any obligation to second-guess the appropriateness of investors decisions. 1 In short, for the vast majority of Schwab customer orders (and a rapidly increasing number of orders in the securities markets generally), the Commissions expensive proposal will produce information of no regulatory value whatsoever. 2
A substantial minority of Schwab accounts are managed by independent investment advisers. For these accounts, Schwab has no contact with the underlying customers at all regarding trading decisions. As a result, Schwab can have no suitability obligation with respect to trades in these accounts. To require Schwab to obtain and update customer suitability information for these accounts (as opposed to requiring the investment adviser to obtain and update that information) makes no sense.
The Commission only recently approved an NASD amendment to its Rule 3110 that allows broker-dealers which distribute direct-marketed mutual funds not to obtain customer suitability information at all. See Exchange Act Rel. No. 34-40048 (May 29, 1998). The NASD and the Commission recognized that although those broker-dealers provide generalized marketing information about their mutual funds (both in advertisements and on their web-sites), this activity does not constitute the type of individualized recommendation that triggers suitability requirements, and in the absence of individualized recommendations, there is no regulatory benefit which would justify the cost of requiring broker-dealers to obtain suitability information. The premise of the Commissions action on the NASDs rule contradicts the premise of its proposal here.
The proposed account information requirements would be extraordinarily expensive to implement and operate. Schwab estimates that the up-front costs of building an automated system which would generate and mail account information for every Schwab account whenever one of the specified events (account opening, change in objective or passage of three years) and which would track responses, would be at least $4.7 million dollars. For the first three years, in which Schwab would have to re-survey each of its existing 6.5 million open accounts (5.5 million of which have had activity in the past nine months), Schwab estimates that to process information relating to these existing accounts it would take a minimum of 174 new line-level employees, plus 18 supervisors, for a total of 192 new employees, costing over $10 million per year. Schwab would also incur postage and printing costs of approximately $1.15 million per year for these existing accounts. These minimum estimates are based on Schwabs burden estimate of eight minutes per account, which we believe is more realistic than the Commissions estimate of five minutes per account. In our view, these estimates are very conservative: with a higher customer response rate (and corresponding burden estimate of twenty minutes per account), the costs for servicing the existing customer accounts would exceed $27 million per year. Moreover, the costs of mailing to and inputting information for new accounts (assuming Schwabs historical rate of account growth) will add over $1 million per year to these figures. In sum, Schwab estimates an up-front cost of nearly $5 million dollars and an on-going cost (for the first three years) of between $12 million and $29 million per year, just to comply with the customer information requirements of the new rules. 3
Of course, if we thought there was some tangible benefit to customers from the proposed account information rules, Schwab might support them despite their tremendous cost (just as Schwab supported the rules which have tightened spreads and increased visibility of customer orders in the Nasdaq market, even though these rules significantly depressed the profitability of our capital markets unit). However, as set forth above, the large majority of Schwab customers never receive an investment recommendation from Schwab, and the overwhelming majority of Schwab orders are unsolicited. For these customers and orders, the account information requirement will generate information that is of absolutely no legal or regulatory significance. In other words, the rules impose enormous costs, without providing any corresponding benefit to anyone. Of course, these costs will have to be passed on to customers, resulting in higher commissions and fees. We note that the Commission has not even attempted to quantify any benefit from this or any other of the proposed rules. In this case, there simply is no such benefit. NSMIA requires the Commission to consider "efficiency" along with "capital formation" and "competition" when adopting new rule requirements: we respectfully suggest that a rule such as this one that has a large cost and no associated benefit for a significant number of accounts at a significant number of firms fails any "efficiency" test (as well as imposing an unwarranted burden on capital formation).
Schwab urges the Commission not to adopt the account information requirement. In the alternative, Schwab suggests triggering the requirement as to a particular customer account only if the customer executes a solicited transaction in that account as a result of an individualized recommendation from the broker-dealer. Similarly, the updating requirement should only be triggered if, more than three years after the information is first obtained, the broker-dealer executes another solicited transaction for that customer. In this way, the requirement would only apply in situations where it potentially could generate information with regulatory significance.
The Requirement to Retain Customer Trading Information and Complaints in Branches Should Be Modified.
The proposed rules would require broker-dealers to keep information about customer trading and customer complaints in the firms branch offices (or for that information to be retrievable there on a same-day basis), to assist regulators in examining branch offices. Schwab customers conduct the vast majority of their trading over the Internet or through national telephone service centers. To the extent that Schwab customers have complaints, the vast majority are submitted and handled centrally and have nothing to do with the operations of the branches. Having this information available in branch offices will provide regulators with virtually no assistance in evaluating branch offices. While the Commissions proposal to allow electronic delivery of customer trading information to branches limits the cost of this requirement, once again the benefit of the requirement, in the context of a firm such as Schwab, appears almost entirely lacking.
The customer complaint requirement should be clarified to require that only complaints that relate specifically to branch operations be maintained in the branch. It would be nonsensical to require that a complaint from a customer be maintained in a branch (simply because it is the branch nearest the customer) when the customer never dealt with that branch but instead only dealt with the firm through the Internet or through national telephone service centers. Similarly, the proposed requirement that firms keep a record of the identity of the associated person who receives a customers order makes no sense in the context of orders received and executed electronically (as is true for the large majority of Schwabs customer orders) without the assistance of any individual at Schwab. Finally, all of the branch office record retention requirements should be modified to require that records be retrievable at the branch within one business day: it will not always be workable to require "same day" retrieval if, for example, a regulator makes his or her demand at 3:30 PM.
The Requirement to Retain Registered Representative Compensation Information in Branches Should Be Limited to Representatives Who Receive Transaction-Based Compensation.
The proposal also would require broker-dealers to keep information about the compensation of registered representatives in the firms branch offices, primarily to help regulators detect possible unsuitable recommendations or churning. Schwab retail registered representatives are paid on the basis of a salary and bonus and not on the basis of commissions; as a result, they have no incentive to make unsuitable recommendations or churn accounts. (Schwab retail bonuses depend on the firms financial results and factors such as customer asset acquisition and customer satisfaction, but not trading revenues.) Moreover, as discussed above, branch representatives do very little trading for customers. Once again, the benefit of such a requirement, in the context of a firm such as Schwab, appears entirely lacking. The Commission should limit this proposal to registered representatives who receive transaction-based compensation.
The Commission Should Not Make any Proposals Effective Until After the End of its Year 2000 Regulatory Moratorium
Schwab notes that the Commission has adopted a Year 2000 moratorium on regulatory changes that require significant systems modifications. Schwab commends this far-sighted recognition that some regulatory priorities must take a back seat to adequate preparation for this major technical challenge. For a firm the size of Schwab, the only reasonable way to address all of the Commissions books and records proposals is through automation (most notably for the totally new requirement to send account information repeatedly to customers for their review). Schwab joins the SIA in strongly urging the Commission to postpone the effectiveness of any new books and records rule until after the end of the Year 2000 regulatory moratorium, so that broker-dealers may have adequate time to design and implement new systems for these rules without thereby compromising their Year 2000 compliance efforts.
The Commission Should Conduct Meaningful Cost-Benefit Analysis.
Schwab has commented above on the burdens and benefits of the proposal in connection with particular aspects of the Commissions proposal. However, we would like to make a more general point. Nowhere does the Commission make any serious effort to compare the costs of the proposed rules (individually or in the aggregate) with the benefits of those rules. The Commission fails even to attempt to quantify any benefit from the rules. Rather, the Commission simply makes the conclusory, unsupported, and we believe erroneous statement that the multi-million dollar burdens of the rules appear slight in light of their benefits. Schwab does not believe that this is the type of analysis which Congress intended when it passed NSMIA, the Regulatory Flexibility Act, and the Paperwork Reduction Act. Congress has repeatedly directed the Commission, when considering rule proposals of this magnitude, to perform meaningful cost-benefit analysis. Congress recently removed a statutory cap on salaries for Commission economists to better allow the Commission to conduct this analysis. We urge the Commission not to dismiss so cavalierly Congress direction in this area. We believe a searching and meaningful cost-benefit analysis would demonstrate that, as we have suggested above, the rules could be modified to reduce or eliminate most of the costs they impose without any material reduction in whatever benefits they may provide.
The Proposals Are Inconsistent with NSMIA and the Paperwork Reduction Act.
In 1995, as part of the National Securities Markets Improvement Act (NSMIA), Congress enacted Section 15(h) of the Exchange Act, which preempts states from imposing books and records requirements on federally registered broker-dealers. Congress took this step because several states were contemplating books and records requirements very similar to those proposed by the Commission here. Schwab believes the Commissions proposal is contrary to Congress intent expressed in NSMIA. To be sure, we prefer a uniform federal approach (even an expensive and burdensome one) to fifty or more overlapping and inconsistent state approaches. However, we do not believe that in NSMIA Congress was concerned solely with uniformity. Rather, Congress believed that in the books and records area, broker-dealers were adequately regulated (if not already over-regulated), and that a significant speed-bump was necessary before imposing new regulation. This is why NSMIA requires the Commission to consider the effects of proposed rules of efficiency, competition and capital formation before adopting new rules. We do not believe Congress intended for the Commission to adopt sweeping new broker-dealer books and records rules, particularly without the type of detailed, proposal-by-proposal cost-benefit analysis contemplated in NSMIA.
Similarly, Congress passed the Paperwork Reduction Act to prevent the adoption of expensive and burdensome new recordkeeping requirements which do not further any regulatory purpose. As discussed above, we believe the Commissions estimates significantly understate the burdens of the proposed rules, and, at least in the context of Schwab, there simply are no benefits from these rules. We are providing a copy of this letter to the Office of Management and Budget with a request that they refuse to approve these rules unless they are modified to bring the burdens and benefits into balance.
The Commission Should Review the Existing Books and Records Rules for Unnecessary or Counterproductive Requirements, Especially in the Area of Electronic Books and Records.
When considering the addition of new books and records requirements, Schwab urges the Commission to review its existing books and records rules for provisions that could be clarified, limited or deleted. Schwab has two suggestions:
"Business as Such". Most of the existing SEC books and records requirements are fairly specific and the need for the requirements are clear. However, Rule 17a-4 currently contains a catch-all requiring broker-dealers to retain and store all communications (including interoffice communications) relating to their "business as such." As Schwab has previously commented to the Commission, the scope of this requirement is quite unclear; the Commission has provided virtually no guidance on its interpretation; and the result is a significant imposition of costs on broker-dealers, which must be over-inclusive in their record retention for fear of violating this requirement. Moreover, we do not understand the regulatory need for such a broad catch-all. (Why should the Commission care about Schwabs correspondence, for example, with computer hardware or office supply vendors, or its interoffice memoranda regarding holiday parties?) Schwab urges the Commission to delete the "business as such" provision. To the extent there are specific categories of documents that the Commission wishes broker-dealers to retain, such as those identified in this rule proposal, the Commission should simply identify those specific categories, and it can eliminate the "business as such" provision.
Electronic Records. In a February 1997 release concerning a completely different issue (the permissible storage media for retention), the Commission announced a radical new requirement: henceforth the records covered by the books and records rules would be deemed to include electronic documents. The Commission had never sought comment on this proposal nor given any indication that it was under consideration (nor did it codify this requirement in its actual published rules). Despite the clear mandate of the Paperwork Reduction Act, the Commission did not obtain an OMB control number for this vast expansion of its collection of information requirements, nor did it seek comment on the burdens and benefits of this requirement. The Commission did not assess the effects of this requirement on efficiency, capital formation or competition, nor did it perform a Regulatory Flexibility Act analysis of its effect on small businesses (or any other businesses). Because the Commission short-circuited the APA notice and comment process, the Commission did not obtain information about the tremendous technical obstacles involved in storing internal electronic documents at broker-dealers in a way that comports with its record retention rules, and the Commission left a great deal of unnecessary ambiguity (for example, must one retain non-final drafts of letters and memos?). In short, the Commissions 1997 statement on this issue was fatally flawed. If the Commission wishes to be able to enforce its dictum on electronic records, it should propose and justify such a rule through the traditional APA process and obtain the input of the broker-dealer community and other interested parties.
Schwab thanks the Commission for the opportunity to comment on this important set of proposals. While we commend the Commission for abandoning some of the ideas in its October 1996 broker-dealer books and records proposal, we believe the Commission should continue to work with the industry to refine its current proposals. As set forth above, we believe the Commissions current proposals are ill-suited to Schwab and many other similar broker-dealers: they require the collection and retention of information that, in the context of the fastest growing segments of the broker-dealer industry, is of no legal or regulatory significance to anyone. Schwab urges the Commission to delete or substantially modify the customer account information provisions of the proposed rules. Schwab believes a more tailored set of proposals could substantially reduce the cost of the current proposals without any sacrifice of benefits to customers.
David S. Pottruck
-- Even the Commissionís penny stock rules impose suitability review requirements only if the broker-dealer recommends the transaction to the customer. See Rule 15g-1(e). The same applies under Rule 10b-5. SRO suitability rules also only apply if the broker-dealer recommends the transaction to the customer. See e.g., NASD Rule 2310.
-- Similarly, in connection with the proposal to retain account surveillance and other compliance reports, we urge the Commission to recognize explicitly that firms can and should tailor those reports to their particular methods of doing business. For example, it would make no sense to require the surveillance of frequent trading in customer accounts if those customer orders were unsolicited, nor would it make sense to surveil for unusually high commissions at a firm without transaction-based compensation. We concur with the SIAís observation that the Commissionís exception report proposal creates potential disincentives toward creative and aggressive compliance monitoring and reporting.
-- For comparison, the entire Charles Schwab Corporation had annual net income of $270 million in 1997: the proposed customer account requirement would, in its first year, cost at least five and possibly more than ten percent of the companyís total net income.