November 9, 1998
Secretary
Securities and Exchange Commission
450 Fifth Street NW, Mail Stop 6-9
Washington, D.C. 20549
RE: Books and Records Requirements for Brokers and Dealers Under the Securities
Exchange Act of 1934; Securities Exchange Act Release No 34-40518; File No. S7-26-98
Dear Mr. Katz:
We are responding to the Commission’s request for comments to its reproposed amendments to the broker-dealer books and records rules set forth in the Federal Register on October 9, 1998. USAA Investment Management Company ("IMCO") is a registered broker-dealer under the Securities Exchange Act of 1934 and a member of the National Association of Securities Dealers, Inc. IMCO’s activities as a broker-dealer generally consist of distributing 35 no-load mutual funds and offering its discount brokerage service. As such, IMCO takes great interest in the Commission’s reproposed amendments.
We commented on the original 1996 proposal to amend the books and records requirements for broker-dealers. We were disappointed to see that notwithstanding the strong opposition to the 1996 proposal from the broker-dealer community, the Commission has elected to repropose the amendments with relatively minor changes, and even some additional requirements. Because the substance of the proposal has not significantly changed, we will reiterate many of the same concerns as we had with the 1996 proposal.
IMCO opposes the entire substance of this proposal. As with the 1996 version, there is nothing in the proposal that suggests that a problem currently exists that would require such extensive, burdensome requirements to be placed on broker-dealers. The introduction to the proposal makes clear that these proposed amendments derived from a "wish list" provided by a NASAA records committee asserting these additional books and records requirements would be "valuable" to state regulators during examination and enforcement proceedings. Unfortunately, these laudable thoughts on the part of NASAA and its state regulators illustrate a lack of sensitivity for the anticipated costs the regulations would impose on those examined.
Our primary opposition to these amendments continues to be the extensive incremental cost that would be necessary to implement what appear to be very remote benefits to state
Mr. Jonathan G. Katz
November 9, 1998
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examiners, not investors. The proposal does not appear to address a need, either on the part of the SEC or the states, to obtain the additional records. Most importantly, we believe this proposal does not further the Commission’s stated goal of investor protection. Even the Commission, within its own language, seems to acknowledge and appreciate the fact that many of these records are records which broker-dealers may routinely keep in the course of operating their businesses, but perhaps not in the precise form and in a location desired by state regulators. Moreover, the Commission appears to recognize that many of the requirements set forth in these recordkeeping responsibilities are already mandated on an ongoing basis by other rules and regulations, either adopted by the SEC, the NASD, or the other self-regulatory organizations, such as those rules concerning suitability and requirements when recommendations are made.
While we oppose the entire proposal as being costly and totally unnecessary, our most specific opposition is with proposed Rule 17-a-3(a)(16)(i), requiring an "account record" for each natural person customer account containing certain information on the customer. The idea of obtaining these account records for both new and existing customers reflects a particularly serious lack of sensitivity to costs for the industry. Even the Commission in its proposal appears to acknowledge that this requirement will be costly and burdensome. The request to create these customer account records, particularly with respect to existing customers, as well as the 36 month updating requirement with respect to the investment objectives designated will impose an extreme cost with relatively little benefit. Neither the Commission nor the NASAA committee has provided any empirical evidence or compelling reasons for a need to go back to existing customers to build a "new and improved" customer account record to make the auditing process easier.
At IMCO, we estimate that adoption of the customer account record requirements alone would cost over $1 million to implement. IMCO has approximately 1,100,000 mutual fund accounts and approximately 125,000 brokerage accounts in its discount brokerage service. If one simply assumes the cost of postage and 10¢ per account for the confirmation itself, and assuming that on average, that cycle will occur about 1.25 times per year, IMCO will spend approximately $650,000 in materials and postage alone the first year. After adding the allocated cost of representative time, systems changes and maintenance, record storage and machinery, IMCO may easily exceed $1 million in incremental costs per year. In our view, the Commission has not demonstrated a regulatory concern sufficient to justify this enormous incremental cost to IMCO and other broker-dealers.
Beyond the cost-benefit issues, the proposed account records are unnecessary. The "know your customer" practice and suitability requirements in the brokerage industry already require that brokers obtain information that is relevant to the opening of a customer’s account and relevant to certain transactions that the broker makes on behalf of the customer. The account opening process and the transaction process are not stale processes. Each process is unique to the business capabilities of the broker in tandem with the desires of the customer. As such,
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requiring that brokers obtain and update a static list of information at least once every 36 months and, much worse, requiring that the customer provide the static list of information is an assembly line approach to an individual process.
The proposal requires that the account records be obtained not only from new customers but also from existing ones and that brokers will have 36 months to obtain the account information from existing customers. While we restate our objection to the account records as a concept, we particularly object to obtaining this information from existing customers. There is simply no benefit to going back to existing customers to obtain any additional information unless the customer is going to do business with the broker in the future. It is at such a time that a broker should, consistent with the current regulatory environment, obtain any information necessary to the transaction in question. Therefore, we believe that this proposed requirement should particularly not apply for existing customers.
In this regard, the Commission states that it wants to ensure that the required account records have enduring value as an indicator of customer choices as some sort of justification for requiring creation of the account records and that the investment objective be updated at least once every 36 months. This misses the point. Any information provided by a customer to a broker is only relevant if the customer is making a request that requires the broker to assess the customer information in relation to the customer request. It is only upon such request by the customer that the factual information, (i.e., objective,) obtained from the customer has any meaning.
The proposal may have intended that updating the customer’s objective would increase the customer’s confidence in the broker’s knowledge of the customer’s account. However, as the Commission correctly suggests, it is quite possible that the customer’s objectives may change over a period of time less than 36 months. Or, perhaps the investor may have multiple objectives at the same time, i.e., trying to build an emergency fund while at the same time looking to retirement. The broker cannot force customers to commit their resources to one objective or the other or even to a single objective. As such, putting a specific update requirement in the proposal for this information might actually be a disservice to customers. The best method of providing brokers and regulators with a reasonably current indication of each customer’s would be to require that the broker obtain the customer’s objectives each time the broker opens a customer account and review that objective as appropriate, which may be more frequent than annually. Current regulation already satisfies this approach.
The proposal ignores the reality of the process for certain broker-dealers where such a system of obtaining and updating information would be impractical. At IMCO, (as well as at other direct marketed fund complexes) when a USAA mutual fund shareholder calls into IMCO more than once, the shareholder may or may not reach the same account representative as before to handle their business. In other words, no specific representative is generally assigned to a mutual fund customer. There is no ongoing proactive relationship between the customer and a single representative. This is the case whether that call involves purchasing additional shares of
Mr. Jonathan G. Katz
a USAA mutual fund or rebalancing the shareholder’s portfolio of USAA mutual funds because the shareholder’s investment objectives have changed. Among other actions, the account representative may respond to the shareholder’s request by making a specific recommendation of USAA funds. At that point, the representative obtains the appropriate records in accordance with existing regulation. This process is generally shareholder-driven, and the proposed requirement mandating the broker-dealer to take affirmative steps to obtain and update informations make no sense in our operations, would be very costly, and would not further any goal of investor protection.
Should the Commission adopt the account records proposal, we would urge the Commission, at a minimum, to adopt an exemption for all broker-dealers to the extent their activity as a broker-dealer involves the underwriting and distribution of affiliated no-load mutual funds. In many respects, the investor protection goals which are to be achieved through the adoption of this proposal are currently being accomplished with respect to investors of mutual funds. In such instances, the customer protections currently in place are twofold, foregoing the need for additional rules.
First, the customer, as a mutual fund investor, has the disclosure protections of the Securities Act of 1933 and the Investment Company Act of 1940 regarding prospectuses, reports and advertising/sales literature. Moreover, recent initiatives in the mutual fund industry with the fund profile and Plain English prospectus emphasize the need to clearly illustrate through the use of graphs and explanations the risks of a particular security and the suitability of that investment for particular investors. The Commission’s recent amendments to Form N-1A, the registration form for mutual funds, formally address improved risk disclosure designed to improve an investor’s understanding of risk for that particular investment. Second, the customer, as an account holder, has the "know your customer" and suitability requirements protection as established by the Securities Exchange Act of 1934, NASD regulation, and industry practice.
The case for the exemption for mutual funds is strongest in the no-load category. All the protections noted above currently exist in a no-load mutual fund environment where the profit margins are already narrow. The 36 month mandatory updating and written confirmation of any objective changes would severely impact the no-load sector of the mutual fund industry financially, which prides itself on low expenses. Unless broker-dealers serving as underwriters of mutual funds are exempted from the account records proposal, the associated costs may preclude such firms from providing any additional services, including recommendations to their customers.
We understand from discussion with representatives of the Investment Company Institute ("ICI") that the ICI will submit a comment letter that will propose an exemption from the account records requirement for broker-dealers who serve as underwriters of mutual funds and who do not recommend securities to the investing public. We believe the ICI proposed exemption is too narrow and does not adequately represent the concerns of the entire industry.
November 9, 1998
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While we concur that certainly broker-dealers who do not recommend securities should be excluded from the rule, to create an exemption limited only to broker-dealers that do not provide recommendations would unfairly exclude broker-dealers like IMCO for whom these recordkeeping requirements simply do not fit. For the reasons discussed above, when broker-dealers are engaged in the activity of distributing their own mutual funds, investors receive appropriate disclosure concerning the suitability of that investment for them. And for those investors receiving a recommendation, existing regulation already mandates adequate recordkeeping. And finally, there is no ongoing proactive relationship between the customer and a single representative. As such, we believe the appropriate exemptions would be for broker-dealers who do not recommend securities to customers and for fund underwriters and distributors in connection with the sale of affiliated no-load mutual funds.
Associated Person Records
The reproposed amendments also would require a broker-dealer to create additional records on their associated persons. The Proposing Release notes that these requirements would assist examiners in reviewing sales practices of individual associated persons. This proposed amendment again ignores the reality within the no-load sector of the mutual fund industry. Concerns such as frontrunning and best execution simply are not present with respect to sales of mutual funds. As such, to the extent the Commission adopts this requirement, it clearly should exempt associated persons of broker-dealers who sell mutual funds.
Separate Records of Compliance with Securities Regulatory Rules
The reproposed amendments would require a broker-dealer to create a record indicating whether it has complied with applicable securities regulatory authorities governing the information required when opening or updating a customer account. To require such a record simply adds regulatory burden with no benefit. Examiners should be able to determine compliance with existing regulations without mandating the creation of a separate record.
Communication Retention Requirements
The reproposed amendments would require a broker-dealer to retain any written approvals of outgoing communications sent and any written procedures it uses for reviewing outgoing communications. To the extent the Commission adopts this portion of the reproposed amendments, we would encourage it to ensure consistency between the provision and those recently approved by the NASD with respect to the review of customer correspondence. Broker-dealers should retain the flexibility to establish reasonable procedures for reviewing a registered representative’s communications with the public.
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In summary, as with the 1996 proposal, we believe that the Commission should not adopt any part of this proposal due to the extensive incremental costs to broker-dealers with virtually no added protection for investors. Of most concern, are the proposed customer account records,
which would impose an enormous cost to the broker-dealer industry, most particularly those broker-dealers who not recommend securities and those distributing affiliated no-load mutual funds. In the event, however, the Commission believes the proposals have merit and chooses to adopt the proposals, we believe that, at a minimum, the Commission should exempt broker-dealers from the customer account records requirement of proposed rule 17a-3(a)(16)(i) for: (1) those activities relating to underwriting and distributing no-load mutual funds and (2) those activities not relating to the recommendation of securities.
Sincerely,
Michael J.C. Roth
President
MR/MH/smg.65845