April 20, 1998
BY OVERNIGHT AND
Jonathan G. Katz, Secretary
Securities and Exchange Commission
450 Fifth Street, NW
Washington, D.C. 20549
(via e-mail to: email@example.com)
Re: Securities Exchange Act Release Number 34-39724
File No. S7-7-98
Securities Exchange Act Release Number 34-39726
File No. S7-8-98
Dear Mr. Katz:
Merrill Lynch is pleased to respond to the Commission's request for comments on the above-captioned releases. The Securities and Exchange Commission (the "SEC" or "Commission") has proposed temporary rule amendments under the Securities Exchange Act of 1934 (the "Exchange Act") that would require certain broker-dealers and transfer agents to file reports with the Commission regarding their preparation for the Year 2000 computer problem.
Merrill Lynch has played an active leadership role in securities industry efforts to assure that all participants have taken adequate steps in preparation for the potential computer and systems problems that may arise in the Year 2000. We have also devoted significant resources to addressing this issue within our own firm. We applaud the Commission in its efforts to raise the attention level of all entities subject to its regulation through the vehicle of required reports to the Commission. While we generally support the approach advanced by the Commission, we would like to offer our comments on certain specific provisions of each proposal.
A temporary paragraph (5) would be added to subparagraph (e) of Exchange Act Rule 17a-5 that would require any broker-dealer with a minimum net capital of $100,000 or more as of the end of 1997 to file with the SEC, and with its Designated Examining Authority ("DEA"), a report describing the broker-dealer's preparation for the Year 2000 and the steps the broker-dealer is taking to avoid Year 2000 problems. This report would be dated as of December 31, 1997 and would be required to be filed no later than 45 days after the Commission adopts the rule amendment proposed by the subject release.
A second report (the "Second Report") would be required to be filed with the Commission and the broker-dealer's DEA, as of the date of the broker-dealer's fiscal year 1998 financial statements, describing the broker-dealer's progress in addressing Year 2000 problems. The Second Report would be due within 90 days after the date of the broker-dealer's 1998 fiscal year-end financial statements. In addition, broker-dealers would have to file with the Second Report an attestation from an independent public accountant that would take the form of a letter giving the opinion of the independent public accountant whether there is a reasonable basis for the broker-dealer's assertions in the Second Report.
Registered Transfer Agents
The Commission has proposed similar requirements for non-bank transfer agents. Proposed paragraph (a) of Exchange Act Rule 17Ad-18 will require each registered non-bank transfer agent to file with the Commission a report describing the transfer agent's preparation for the Year 2000 and the steps the transfer agent is taking to avoid Year 2000 problems. This report (the "Initial Report") would contain the transfer agent's evaluation of its Year 2000 actions as of December 31, 1997. It would also describe the transfer agent's future plans and preparations for the Year 2000. The Initial Report would be due no later than 45 days after the Commission adopts the rule.
Registered transfer agents that do not qualify for an exemption under existing Rule 17Ad-13(d) (a transfer agent that performs transfer agency functions solely for its own securities, or securities of certain affiliated issuers, or a bank or financial institution) will be required to file reports with the Commission describing their progress in addressing Year 2000 problems ("Follow-Up Reports"). These reports would be due on or before August 31, 1998 and on or before August 31, 1999, as of June 30, 1998 and June 30, 1999, respectively.
Transfer agents would also be required to file an attestation from an independent public accountant giving the accountant's opinion whether there is a reasonable basis for certain of the transfer agents' assertions in the Follow-Up Reports. The attestation would be required to be filed with each Follow-Up Report.
(i) affiliated entities
We note that some registered broker-dealers and transfer agents may be part of a group of registered broker-dealers and transfer agents affiliated under one corporate structure. For example, although Merrill Lynch, Pierce, Fenner & Smith Incorporated is the largest registered broker-dealer in the Merrill Lynch corporate family, there are ten other registered broker-dealers and transfer agents affiliated, either directly or indirectly, with Merrill Lynch, Pierce, Fenner & Smith Incorporated. In order to minimize the burdens on such regulated entities, we suggest that the Commission permit them to consolidate their reports under the proposed temporary rules. The reports would, of course, specifically address any issues or problems that are unique to each individual registrant.
Merrill Lynch is not objecting to the need for these reports and recognizes that there will be costs associated with their preparation. Our recommendations are directed at reducing some of the unnecessary costs that would otherwise be incurred by broker-dealers and transfer agents at a time when Year 2000 costs are already extremely high.
(ii) accountants' attestation
We also recommend that the Commission not adopt a rule amendment that would require a separate attestation by an independent public accountant. Such a separate audit letter can be very costly and is unnecessary in our view. Instead, we recommend that the Commission require that the scope of the auditor's already required "material inadequacies" letter be expanded to include the issues that would be addressed in the proposed separate accountant's attestation. We suggest that a separate accountant's letter, addressing the topics raised in proposed Rule 17a-5(e)5(v)(A) through (G) and proposed Rule 17Ad-18(d)(1) through (7). The Commission could make this information public while preserving the confidentiality of the remainder of the accountant's "material inadequacies" letter.
We understand that the Commodities Futures Trading Commission is taking an approach similar to the one we are suggesting. We have seen a draft of a CFTC Division of Trading and Markets advisory that states the position that prompt reporting of any apparent problem relating to Year 2000 compliance issues should be reported as a material inadequacy in the accounting system of the regulated entity. According to the CFTC staff document, "A Year 2000 problem is an MI within the meaning of (CFTC rules), because there can be no doubt that a failure to effectively remedy Year 2000-related problems in any significant system of the (Futures Commission Merchant) may prevent the FCM from completing transactions, may inhibit the discharge of the FCM's obligations to customers and creditors, and could result in material financial loss to the FCM and its customers."
Alternatively, we direct the Commission's attention to the proposal articulated by the American Institute of Certified Public Accountants in its comment letter that proposed Rule 17a-5(e)(5)(v) be revised to eliminate the attestation requirement by an independent auditor and instead permit a report on agreed-upon procedures that are the result of a clear understanding between the accountant and the registered entity.
(iii) capital threshold
We note that the Commission is proposing to establish a $100,000 minimum net capital threshold for the rules. Because broker-dealers below this minimum net capital level have substantial financial exposure to the market and to customers, we believe this would be unwise. We are concerned about the cascading effect that would result from small broker-dealers' inadequate preparation for the Year 2000 problem and suggest that it would be more appropriate if the Commission excluded all broker-dealers that clear all of their brokerage transactions through other registered broker-dealers or outsource all of their securities transaction processing to third party service bureaus. (We trust that the Commission will be carefully scrutinizing and monitoring the Year 2000 capabilities of industry utilities since broker-dealers have substantial dependency on such entities.) We think this is a more meaningful approach for differentiating between those firms whose failures could affect the capabilities of the securities industry and those whose difficulties may not create systemic problems.
(iv) content of reports
As proposed, temporary Rule 17a-5(e)(5) would require that the First and Second reports of a registrant discuss whether the registrant's board of directors has approved and "funded" plans for purposes of Year 2000 remediation and compliance. We recommend that the funding requirement be deleted since the segregation of funds is not a substantive guarantee that these funds will be utilized for Year 2000 purposes. The thrust of the proposals, which we support, is that senior management attention should be given to this extremely important problem and that adequate funding should be made available to address the issues presented.
The proposals would also require that the reports indicate a broker-dealer's current progress to "avoid" Year 2000 problems. It is unrealistic to expect that the Board of Directors of any registered entity will with certainty "avoid" any Year 2000 problem from occurring, particularly in view of the complex inter-relationships that exist with external sources. What can be done is for high level management attention and resources to be directed at identifying and resolving Year 2000 problems and demonstrating a commitment to do so. We suggest that the word "avoid" be changed to "address."
(v) number of reports
We recommend that the Commission eliminate the requirement that registered transfer agents file their first Follow-Up Report on August 31, 1998. Assuming an expedited review by the SEC staff and the Commission of the public comments (which are due by April 27, 1998), it does not seem likely that the Commission could adopt the rule amendments before the end of May, at the earliest. Thus, a transfer agent's Initial Report would be due in mid-July, 1998 (45 days after adoption of the rule amendments). Requiring an Initial Report immediately followed by a Follow-Up Report at the end of August would create an unnecessary burden and would not provide any meaningful additional information. Accordingly, we recommend that registered transfer agents not be required to file an Initial Report.
Indeed, we believe that the Commission should provide in the final rules that if the due date of any report would fall within reasonably close proximity to the date of a required follow-up report (for example, 90 days), duplicate reports should not be required. This would avoid unnecessary "bunching" of reports which would serve no public purpose.
(vi) contingency plans
In the two releases, the Commission asks that a broker-dealer's reports discuss, among other things, whether the broker-dealer has written contingency plans in the event that, after December 31, 1999, it has Year 2000 computer problems. Because of the nature of Year 2000 planning, submitting contingency plans in the first report would be premature since, by necessity, such plans would be somewhat vague until the nature and the source of any problems can be ascertained. In addition, there are numerous external events that are outside the control of registered broker-dealers and transfer agents which make contingency planning less than perfect for any one firm. Thus, while taking note of the need for contingency planning, broker-dealers should not be expected to have detailed contingency plans, especially at the time of the first report.
(vii) materiality standard
Under the proposed new reporting requirements, a broker-dealer or transfer agent might be found to have violated the technical reporting requirements of Rules 17a-5 and 17Ad-18 under the Exchange Act even though it is making satisfactory progress with respect to Year 2000 compliance. We urge the Commission to make it clear that a registered broker-dealer or transfer agent that satisfies its good faith reporting requirements under the proposed temporary rules will not be found to have a separate reporting violation if there is a reporting error.
(viii) selection of accountant
The Commission has asked whether the accountant's report related to the Second Report should be prepared by the same independent public accountant who prepares the annual audit of the broker-dealer's 1998 fiscal year-end financial statements. In our view the same independent auditor should be permitted to perform the services required under the Rule. This would avoid the unnecessary expense and difficulty of introducing an accountant who is unfamiliar with the broker-dealer systems to perform the follow-up engagement.
The comments contained in this letter are intended to fine tune the proposals and avoid any unnecessary expenditure of resources to provide meaningful information to the Commission. We have frequently stated that without proper attention, the consequences of the Year 2000 problem will be costly and disruptive. Thousands of computers, running everything from telephone networks to financial markets, are threatened with failure. Even institutions that have fixed their own internal problem will feel the ripple effects from problems occurring externally. It is for this reason that Merrill Lynch supports the Commission's proposals to require reports on Year 2000 readiness from broker-dealers and transfer agents. The preparation and filing of these reports will help keep our industry focused on the significant Year 2000 issues before us.
Very truly yours,
Michael J. Castellano