Fidelity Investments
82 Devonshire Street, G12A
Boston, MA 02109
December 8, 1998
Mr. Jonathan G. Katz
Secretary
U.S. Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, DC 20549
Re: Books and Records Requirements for Brokers and Dealers Under the Securities Exchange Act of 1934; Securities Exchange Act Release No. 34-40518
Dear Mr. Katz:
Fidelity Investments appreciates this opportunity to comment on the Commission’s reproposed amendments ("Reproposal") to the books and records requirements to which brokers and dealers are subject under Rules 17a-3 and 17a-4 of the Securities Exchange Act of 1934 ("Exchange Act"). 1
Introduction
Fidelity recognizes that the Reproposal, as well as the original books and records amendments proposed in 1996 ("Original Proposal"), was made in response to concerns regarding the adequacy of current books and records rules to support regulators’ efforts to identify and investigate potential sales practice abuses. Fidelity would support such of the Commission’s efforts which are reasonably designed and likely to eliminate such abuses and promote the highest possible degree of investor protection, as well as investor trust and confidence in the securities industry. However, Fidelity opposes adoption of certain provisions of the Reproposal in their current form because they do not take into proper consideration large segments of the broker-dealer community, the type of business they do, or their customer base and will therefore not further the Commission’s objectives but will impose significant unnecessary hardship on many broker-dealers. For example, certain of the provisions are inapplicable and substantially burdensome to: (i) broker-dealers that conduct unsolicited "discount" brokerage business through salaried employees who are not assigned accounts, (ii) broker-dealers that underwrite mutual funds, (iii) broker-dealers engaged in sales to institutional intermediaries and other institutional customers 2 and (iv) clearing brokers.
In addition, adoption of the Reproposal would jeopardize recent efforts to secure greater protection of customer confidential information, would constitute a reversal of the industry-wide trend toward centralization and electronic storage of customer records and services, and would require expensive systems changes in the midst of critical Year 2000 systems conversions which are already straining the resources of the financial community.
Set forth below are Fidelity’s specific comments on a number of the reproposed amendments.
Account Record
The reproposed amendments would require the creation, for each customer account with a natural person as a beneficial owner, of a record of certain information including, but not limited to (i) marital status, (ii) number of dependents, (iii) annual income, (iv) net worth and (v) investment objectives. This requirement would be more than just a new "record-keeping" requirement – it could be interpreted to impose a new, substantive obligation on broker-dealers to monitor account activity against such information. Such an obligation is inappropriate for many types of broker-customer relationships. It would significantly add to current self regulatory organization ("SRO") requirements on this topic, and we are not aware of any evidence that existing account information requirements have been ineffective or that additional requirements would assist in preventing or investigating the sales practice abuses that the Reproposal is designed to prevent.
The Reproposal would require the collection for all brokerage accounts virtually the same information as NASDR Conduct Rule 2860-2, a rule pertaining to the required diligence in connection with options transactions. Similarly, the Reproposal would require the collection for all brokerage accounts of certain information – such as customer investment objectives – that is currently required to be collected pursuant to NASDR Conduct Rule 2310, a rule pertaining to the required diligence in connection with recommended transactions. While collecting such information may be justified for complex, higher risk or recommended transactions, Fidelity is unaware of any industry-wide problem of a magnitude which would justify a requirement that broker-dealers conduct the same information-gathering for accounts in which there are solely conservative or unsolicited securities transactions, as is required for options accounts or accounts in which there are recommended transactions.
The Proposing Release offers no explanation of what would be accomplished by going beyond what is now required by SRO rules. The Proposing Release purports to justify the reproposed amendments on the grounds that the amendments will allow regulators to detect sales practice abuses such as churning and unauthorized or unsuitable trading. But such sales practice abuses are extremely rare or nonexistent in many segments of the broker-dealer community. At discount broker-dealers such as Fidelity, registered representatives are primarily salaried employees, are not paid directly on transaction-generated commissions, and are not assigned specific customer accounts. Discretionary trading is not permitted. Moreover, a large portion of the discount brokerage business -- eighty percent at Fidelity -- is conducted through electronic channels such as web, computer software or touch-tone phone, in which customers are not dealing with any representative. Customers who choose to speak with a registered representative to make a trade are generally placed in a queue, and speak with the next available representative. As a result, the typical discount/electronic brokerage environment does not present the traditional risks of churning, unauthorized or unsuitable trading.
It is noteworthy that options and recommended transactions are a small fraction of the overall securities business. For example, at Fidelity greater than ninety percent of the retail brokerage business involves neither solicited nor options trades. It is simply unnecessary to cast the account record requirement over all accounts and transactions in order to capture and properly analyze a relatively small percentage of the transactions.
Adoption of this proposed rule amendment would be inconsistent with Exchange Act Release 34-40048 (May 29, 1998) in which the Commission approved an amendment to the NASDR’s "Books and Records" rule, NASDR Conduct Rule 3110. Pursuant to the amendment, certain customer account information is no longer required with respect to accounts in which investments are limited to transactions in open-end investment company shares that are not recommended by the member. The explanation in the Adopting Release included the following language:
The (Investment Companies) Committee concurred with the NASD Regulation staff’s conclusion that the requirement to obtain Retail Customer Information is burdensome and largely unnecessary as it applies to members who distribute directly marketed mutual funds and other unsolicited accounts that are limited to mutual fund shares and for which no recommendations are made. A primary purpose of obtaining Retail Customer Information is to help a member evaluate the suitability of a recommendation. Consequently, the same regulatory requirement does not apply with respect to accounts that are limited to mutual funds and for which no recommendations are made.
Fidelity urges the Commission to take a consistent approach with respect to the rule amendment at issue.
In addition, requesting all customers to furnish investment objectives, as well as routine updates (discussed further below), is likely to mislead customers into believing that broker-dealers are monitoring their unsolicited transactions to ensure consistency with account information. In most cases, the broker-dealer has not undertaken such a function. In addition to potentially misleading customers, such a requirement would impose on broker-dealers an inappropriate litigation risk by exposing them to claims that they are on constructive notice that certain clients are engaging in unsuitable, albeit unsolicited and self-directed, transactions. Expanding the universe of accounts that require the additional information may even have the effect of diluting industry focus on certain transactions -- such as recommended transactions -- that warrant additional and careful scrutiny.
The reproposed amendment is likely to stifle the legitimate goal of encouraging diverse consumer-driven needs for brokerage services. Discount brokers are able to offer reduced commission rates and other savings because they do not have investment research staff and dedicated financial consultants who make recommendations to customers who are willing to pay a premium for such services. The proposed changes will impose additional costs on many discount brokerage customers with no countervailing benefit to customers or regulatory agencies. For example, many discount brokers will be forced to pass on the costs to customers incurred because of expensive systems changes and the millions of communications necessary to routinely update the account record information. At Fidelity, there are 2.2 million discount brokerage accounts that will require additional, costly maintenance if the reproposed amendment is adopted as written.
Not only does the reproposed account record requirement not further its stated objective in the discount brokerage context, but it does not properly consider the brokerage business conducted by firms that act as underwriters of mutual funds or other investment company securities and that make no recommendations with respect to such securities. Mutual fund underwriters do not currently collect and maintain this information because it is neither required nor necessary for their business. Mutual fund underwriters typically distribute fund shares either directly to the public through customer response to general advertising, or through financial intermediaries. Moreover, at Fidelity much of the customer response is made by written application or electronic channels in which there is no interaction with a Fidelity representative. Mutual fund accounts at Fidelity contain the securities of only one issuer, and are not established on the basis of a recommendation. As Exchange Act Release 34-40048 appeared to generally recognize, there is simply no opportunity or motive for the underwriter of mutual fund securities to engage in churning and unauthorized and unsuitable trading and other sales practice abuses that the reproposed amendment at issue is purportedly designed to prevent.
In addition, there is no material risk of churning or unsuitable and unauthorized trading by clearing brokers that carry customer accounts. Therefore, there is little or no added protection afforded by such a requirement with respect to customer accounts carried at a clearing broker on either a fully-disclosed or omnibus basis for introducing firms. In a fully-disclosed clearing relationship, responsibility for customer account documentation, sales practice-related activities, account supervision and suitability obligations is typically delegated to the introducing firm pursuant to New York Stock Exchange Rule 382. Clearing firms generally do not have direct contact with customers of introducing firms with respect to account establishment and maintenance matters and do not have access to, or a need for, the type of information required by the reproposed amendment. In an omnibus clearing relationship, even in the unusual circumstances where the clearing firm may know the identity of the customers of the introducing firm, the customers of the introducing firm are not considered customers of the clearing firm.
In summary, if the Commission adopts a books and records rule requiring customer investment objectives or similar information, the rule should be limited to what is required by existing SRO rules. If, however, the Commission goes beyond this, it should make it clear that, absent a defined set of circumstances (e.g., recommended transactions) collecting such information does not impose any monitoring obligation on the broker-dealer.
36 Month Updates of Account Record
The Reproposal would further require that broker-dealers update the information in the customer account record every 36 months. We oppose this requirement for accounts in which there have been exclusively unsolicited transactions, and for directly-marketed mutual fund accounts. There is nothing in the Proposing Release that justifies the routine collection of such information beyond the general assertion that such a requirement will help regulators detect certain sales practice abuses which, as described above, are simply not a material risk with respect to many brokerage accounts outside the "full-service" brokerage context. Such routine proactive solicitations of updates would likely lull customers into a false sense of security that broker-dealers are monitoring their unsolicited transactions for suitability or consistency with the updated account information. They would also require expensive systems changes and millions of costly hard copy mailings, with no corresponding benefit to the customer or regulatory agencies.
The reproposed amendment also represents a random update standard that may or may not reflect the actual frequency of account information changes. If adopted as written, the potential would exist for firms to use the standard as a safe harbor and be less diligent with updating customer information. Information such as investment objectives, net worth and number of dependents is subject to frequent and substantial change at unique intervals for each customer. Far more reliable and beneficial results would be obtained by requiring proactive notices in a prominent place, for example, on monthly account statements, reminding customers to provide updated personal information to their broker-dealer, the content of which should be determined by the nature of the customer’s relationship with the broker.
The reproposed amendment requiring 36 month updates could jeopardize recent efforts to secure greater protection of customer confidential information. At the precise time when customers are demanding more confidential alternatives to hard copy communication, the Commission is proposing massive hard copy mailings that will inevitably involve misplaced or misappropriated mail, resulting in the risk of inadvertent, but nonetheless inappropriate, disclosure of confidential information. This risk is increased by the fact that the mail requirement – with all the customer’s confidential information (including net worth, annual income, social security number and investment objectives) -- would be triggered every time there is an address change (or any other change to the account record). This type of requirement would not only be an unnecessary and expensive overhaul of an already existing industry-wide procedure in which firms send hard copy notices of address changes to both the old and new address, it is also inconsistent with the trend toward privacy-oriented initiatives not only in the United States, but abroad. For example, a recently-enacted European Union Directive prohibits members of the European Union from participating in business with companies that do not adequately address customer privacy issues in the way they do business with European and other customers. The proposal seems particularly inappropriate in this regard because there is a reasonable alternative – the Commission could require firms to send out routine, proactive reminders to customers to update their personal information and could provide the customer’s current information to them upon request for verification. In any event, the application of any such updating requirement should be limited to accounts for which the information is currently required to be requested by SRO rules.
In its Proposing Release, the Commission requests comment on whether broker-dealers should include a customer’s social security number when sending an updated account record. Fidelity opposes inclusion of the social security number in any such update because unauthorized access to such information could facilitate the perpetration of fraud against the customer.
Order Tickets
The Reproposal contains at least one other provision which is overly broad in its application and overlooks the potential consequences to many broker-dealers that do not conduct their business in the same manner as traditional full service firms -- the requirement that order tickets reflect the identity of any person(s) entering an order and the person responsible for the account in which the order was entered.
The Proposing Release explains the order ticket requirement by stating that it will allow regulators to determine "whether particular persons are engaged in sales practice violations." For many of the reasons discussed above, the sales practices that the Reproposal is designed to prevent are not a material risk at discount and electronic brokerage firms because such firms primarily accept unsolicited orders, and their registered representatives are salaried employees, are not paid transaction-based commissions, and are not assigned specific customer accounts. As also mentioned, a large portion of the discount brokerage business is conducted electronically, in which case there is no contact with any representative whatsoever. Additionally, the sales practice concerns at issue do not pose a material risk with respect to broker-dealer sales to institutional intermediaries and other institutional customers that neither expect nor receive investment recommendations. The proposed requirement should be narrowed to require the information only with respect to accounts that have an assigned representative, and should exempt accounts in which there are no unsolicited transactions.
Pursuant to the Reproposal, order tickets would be required to reflect the identity of multiple persons, including the representatives who accepted the order, who enter the order, and who are assigned to the account. The Proposing Release explains the provision by stating that the requirement would "help reveal that a broker-dealer was engaging in boiler room activities in situations in which numerous associated persons were accepting and entering orders under one associated person’s name." We must question whether boiler room employees who flagrantly and deliberately falsify records in plain violation of current books and records rules, would suddenly stop doing so because this provision was adopted. In any event, the requirement of marking the order ticket with the identity of the representative assigned to the account, in addition to the individual(s) entering the order, would result at most firms in the unnecessary duplication of an already existing record (i.e., most firms maintain a separate record of account assignments) and the creation of a possibly confusing record. At a minimum, there should be an exemption from that requirement if a similar record is otherwise maintained.
Maintenance of Branch Office Records
The Reproposal would require that a multitude of branch office related books and records, which at many firms are now maintained at a central or other location, be stored on-site for one year at the branch office, or, alternatively, be produced to regulators the same day they are requested. The Proposing Release justifies the requirement on the grounds that it will: (i) allow regulators to conduct a focused localized examination of a particular office and identify abusive activities that may be isolated to that office, (ii) allow regulators to conduct more effective and thorough examinations because the examiners will be able to conduct the examinations on-site where they can review the pertinent records and interview various employees regarding the contents of those records, (iii) reduce the potential for alteration or fabrication of requested records and (iv) facilitate examinations by state securities regulators because the records would be located within that regulator’s jurisdiction.
First, and most important, Fidelity is not aware of a pattern or trend of industry-wide books and records related problems that have prevented or hindered regulators from conducting "on-site," "focused, localized exam(s)," or interviews. Neither is Fidelity aware of a pattern or trend of industry-wide problems with respect to the alteration and fabrication of requested documents. The reported occurrences of any such problems suggest that they are infrequent and isolated, and are appropriately resolved through enforcement of already-existing rules requiring storage, and timely production to requesting regulatory examiners. Where effective remedies already exist for non-compliance with current regulations, we believe it is inappropriate to impose expensive and burdensome local records requirements on the majority of broker-dealers that cooperate with local authorities.
Second, many firms, including Fidelity, produce records, typically via overnight delivery, from centralized, off-site storage facilities, within twenty-four hours of a request from a regulator. Fidelity is unaware of any occurrence with any of its broker-dealers or any other firm, in which such a delay or the fact that off-site storage was utilized, inhibited a regulator’s ability to conduct "focused localized exam(s)" and interviews of branch office employees. Moreover, the Commission has not provided any evidence which suggests that off-site storage or allowing a reasonable time, e.g., twenty-four hours, for delivery of requested documents has resulted in requested records being altered.
Pursuant to the Reproposal, broker-dealers may satisfy the local office maintenance requirement if they produce documents requested by a regulator on the day of the request. This alternative to on-site storage was included in recognition of technological advances in the industry with respect to electronic storage. While this is a laudable amendment to the Commission’s Original Proposal, it is clearly an alternative "before its time." Very few firms currently have the capability to electronically retrieve the required records at the branch office, and it will be years before that type of capability will be commonplace. By default, most firms will be forced to resort to on-site storage. This will be extremely expensive. Not only will firms be required to rent extra space to store the records -- assuming that such space is even available -- but they will have to incur the cost of duplicating many of the documents, which most firms, in order to maintain adequate supervision and internal controls, will want to continue to maintain at a centralized location.
Adoption of this reproposed amendment would represent a reversal of the industry-wide trend toward centralization of customer records and services. Fidelity, and presumably many other large financial services firms, has spent millions of dollars to automate and centralize records management. Fidelity has done so in order to attain the highest level of supervision, maximize internal controls, reduce costs to customers, ensure confidentiality of records, protect the integrity of the information contained in the records, and deliver outstanding service to customers. Dismantling centralized storage and migrating it to hundreds of different locations and hundreds of different records custodians, would imperil all those objectives. Indeed, in a recent Order Instituting Cease-and-Desist Proceedings against a major broker-dealer, the Commission based its failure to supervise charges on, among others things, the decentralized nature of the firm’s infrastructure. 3
The Commission should eliminate any local office maintenance requirement from its revisions of Rules 17a-3 and 17a-4 of the Exchange Act. Moreover, firms should be allowed at least 24 hours to produce requested records for the most recent one year period, and at least 48 hours for all other records.
Record of Compliance with Account Opening Rules
The Reproposal would require that broker-dealers create and maintain a record that evidences compliance with account opening requirements in connection with at least seven different SRO rules. If this provision is adopted, it will likely result in a waste of time, money and resources, not only to broker-dealers, but to regulators reviewing such records. Certainly such a record, without the supporting underlying documentation, will not provide any meaningful information to an examining regulator. The account opening documents themselves are the evidence of compliance with the SRO rules.
The Commission should eliminate any such requirement from its revisions of Rules 17a-3 and 17a-4 of the Exchange Act.
Complaints
Fidelity supports the Commission’s elimination of the amendment in its Original Proposal which would have required the creation of memoranda for oral complaints. This type of provision requires that each of the thousands of sales, service and operations personnel of large national firms such as Fidelity make an immediate judgment whether a conversation with a customer constitutes a routine inquiry, "misunderstanding," "misinterpretation" or "complaint" (quoted terms from Original Proposing Release). However, the industry is now faced with inconsistent and conflicting regulatory schemes as a result a New York Stock Exchange ("NYSE") interpretation issued subsequent to the Original Proposal, that essentially requires members to create memoranda of "oral complaints." 4 In the interests of achieving uniformity between the regulatory schemes, Fidelity urges the Commission to review with the NYSE the considerations that were the basis for the Commission’s decision to exclude the provision from the Reproposal. Fidelity would not be opposed to a requirement that broker-dealers periodically remind customers to submit their complaints in writing. 5
Maintenance of Reports of Unusual Trading Activity
The Reproposal would require that broker-dealers maintain copies of reports produced to review "unusual" trading activity in customer accounts, including "exceptional" numerical occurrences and "frequent" trading. The Commission did not define those terms, and Fidelity is unaware of any generally recognized criteria for what constitutes "unusual," "exceptional" or "frequent" trading. Indeed Fidelity produces a number of different trading-related reports that do not necessarily evidence "unusual," "exceptional" or "frequent" trading. This type of requirement may have a chilling effect on firms to produce these reports in the first place. For the reasons discussed above, the requirement would also be inappropriate for discount brokerage and other firms that do not have the same issues of churning and other sales practice abuses that such reports are designed to prevent.
The Commission should eliminate any such requirement from its revisions of Rules 17a-3 and 17a-4 of the Exchange Act.
Maintenance of Examination Reports
The Reproposal would require that broker-dealers maintain all reports requested, required, or produced by a securities regulatory authority. Fidelity strongly opposes this requirement. Although the Commission and SROs have rules that protect the confidentiality of such records when such records are retained by them, many states do not. The liberal application of many state information access laws (sunshine laws) would inevitably lead to the unfair and inappropriate disclosure of confidential broker-dealer and customer information.
The Commission should eliminate any such requirement from its revisions of Rules 17a-3 and 17a-4 of the Exchange Act.
Conflict with Year 2000 Systems Conversions
Fidelity notes that the Reproposal would require extensive systems changes requiring (i) modifications to order tickets, (ii) the creation of an account record and (iii) routine updates of the account record. In addition, extensive systems changes would be required to enable firms to electronically produce records at their branch offices. These systems changes would have to be implemented in the midst of critical Year 2000 systems conversions that are already straining the resources of the financial community. Implementation of such rules would be inconsistent with the Commission’s August 27, 1998 issuance of the Regulatory Moratorium to Facilitate the Year 2000 Conversion.
Conclusion
In conclusion, Fidelity opposes certain provisions of the Reproposal because they do not apply to broker-dealers such as discount broker-dealers and broker-dealers that distribute directly marketed mutual funds and/or they impose a substantial burden and expense on broker-dealers with little or no countervailing benefit. In particular, Fidelity opposes the reproposed amendments that would impose a requirement:
(i) to create and update an "account record" for all brokerage accounts, even for accounts which accept exclusively unsolicited transactions,
(ii) that all order tickets reflect the identity of the associated person who enters the order and the person responsible for the account in which the order was entered, even if the account is not assigned to any specific individual,
(iii) of on-site storage at branch offices of certain branch-related records, and
(iv) to maintain records of compliance with account opening rules, "unusual" trading activity reports, and reports requested, required, or produced by a securities regulatory authority.
We thank you for your consideration of our comments. If you have any questions or comments regarding the issues addressed in this letter, do not hesitate to contact us at (617) 563-3651.
Sincerely yours,
Michael L. Michael
Vice President
Chief Compliance Officer
cc: The Honorable Arthur Levitt, Chairman
The Honorable Norman S. Johnson, Commissioner
The Honorable Isaac C. Hunt, Jr., Commissioner
The Honorable Paul R. Carey, Commissioner
The Honorable Laura S. Unger, Commissioner
Richard R. Lindsey, Director, Division of Market Regulation
Robert L. Colby, Deputy Director, Division of Market Regulation
Michael A. Macchiaroli, Associate Director, Division of Market Regulation
Thomas K. McGowan, Assistant Director, Division of Market Regulation
Deana A. LaBarbera, Attorney, Division of Market Regulation