Jonathan G. Katz, Secretary
Securities and Exchange Commission
Mail Stop 6-9
450 Fifth Street, N.W.
Washington, D.C. 20549
Charles Schwab & Co., Inc. ("Schwab") appreciates the opportunity to comment on the Commission's proposed amendments to Rules 17a-3 and 17a-4 under the Securities Exchange Act of 1934 set forth in Release No. 34-37850 (October 22, 1996) (the "Release"). These rules deal with the books and records that the Commission requires registered broker-dealers to create and maintain.
Schwab provides a broad array of investment services for individual retail investors, institutional investors and financial advisors, with more than four million active customer accounts. In providing services to customers, Schwab uses diverse and complimentary delivery systems, including regional telephone service centers, a network of some 240 branch offices and electronic brokerage channels. Schwab has over 5000 registered representatives based in its various offices.
Schwab recognizes that the Commission's books and records requirements are critical to regulatory examinations of broker-dealers. The Commission is right to consider from time to time whether its books and records requirements continue to contribute to effective regulatory oversight. Schwab believes that the current rules work well and do not require dramatic change.
The proposed changes to the books and records requirements seek to promote ease of local inspections and timeliness of document production. The proposals, however, do not sufficiently balance these intended benefits with the significant costs they will impose. We are concerned that the proposals, while designed to apply uniformly to the broker-dealer community, do not adequately consider the variety of ways in which broker-dealers actually deliver services to customers. We are also concerned that the proposals do not adequately accommodate existing and planned technology for storing and retrieving information. Consequently, the proposed rules, while affecting broker-dealers differently, may in many cases require inefficient operational changes and record keeping at multiple locations, resulting in costs far greater than the Commission projects. Schwab estimates that its one-time costs could exceed $14 million with annual costs thereafter of over $24 million. We discuss these reasons in more detail next and then provide comments on some of the specific proposals. When all is said and done, we urge the Commission to withdraw the proposed rules for further study.
THE PROPOSALS DO NOT RECOGNIZE EXISTING DIFFERENCES IN HOW BROKER-DEALERS DELIVER SERVICES.
The proposals are flawed in that they present a "one size fits all" regulatory scheme based exclusively on a traditional broker-dealer model. The proposals contemplate that an individual representative in a designated branch office is specifically responsible for his or her own "book" of customers. The representative solicits and recommends trades and is paid commissions based on that trading. This model apparently gives rise to many of the regulatory concerns the proposals attempt to address and to the means of record storage and retrieval the proposals prescribe.
Broker-dealers today deliver services in a variety of ways that do not fit within this model. Many broker-dealers do not solicit or recommend trades and do not maintain discretionary accounts. Their representatives merely take customer orders while providing no advice and perhaps limited market information.
Some broker-dealers do not have an individual representative who is solely responsible for a "book" of customers. Instead, the broker-dealer may take customer calls in a central service center where any one of a number of representatives may handle any given customer call or transaction. In other instances, customers are increasingly using advanced technology to trade through electronic brokerage channels without any direct contact with a representative. These channels may include a touchtone telephone trading service, PC-based on-line services or Internet trading via a Web site. Customers at Schwab, for example, are now choosing to place as many as 40% of their trades through electronic brokerage channels.
To the extent that the proposals seek to protect customers where a broker-dealer provides services in a traditional manner, it would appear anomalous to apply them to broker-dealers who provide services in non-traditional ways. To do so would impose additional costs on these broker-dealers without a corresponding increase in investor protection. Schwab believes that Rules 17a-3 and 17a-4 in their current form, together with the rules of the self-regulatory organizations, including the New York Stock Exchange and the National Association of Securities Dealers, provide a high level of investor protection. There has been no demonstration of the need for the dramatic change reflected in the proposals.
THE PROPOSALS ENCOURAGE DUPLICATIVE PAPER STORAGE OF RECORDS, INCREASING COSTS AND REDUCING EFFICIENCY.
Advancing technology inevitably is leading to paperless storage and retrieval of information from a central location. The Commission has recently acknowledged that "[a]dvances in computers and electronic media technology are enabling companies to disseminate information to more people at a faster and more cost-effective rate than traditional distribution methods, which have been largely paper-based." 1
Particularly for larger broker-dealers with a number of offices, various paperless technologies, including newer technologies such as Computer Output on Laser Disk (COLD) and optical disk, as well as somewhat older technologies like microfilm or microfiche, can provide much more cost-effective information retrieval systems than paper-based storage. Schwab's experience has been that the proper mix of paperless technologies reduces costs while allowing timely access to information.
The proposed amendments, however, appear to require that broker-dealers store some records in paper form, even though they are already storing the information using paperless technology. For example, the proposed rules requiring that specified records must be kept in local offices permit electronic storage only if there is the "capability of electronically displaying and immediately producing printed copies" (Release at 41; emphasis added). Immediate display capability requires that data be immediately accessible on-line and not archived. Unless the proposals go further to accommodate paperless technologies, broker-dealers may have to maintain duplicate paper copies of extensive records.
In addition, to the extent that other proposed rules require record storage in separate files for each customer or each registered representative, they may effectively eliminate the use of paperless storage as a way to comply with their requirements. All information regarding a specific customer or registered representative that is stored on COLD or optical disk may require extended searches involving multiple files. Similarly, information about a particular customer or a particular registered representative is not stored on separate microfiche or microfilm. Even if it were feasible to store that information separately, other costs could be prohibitive. For example, for Schwab to put microfilm and microfiche reader/printers in each of its branches would likely cost more than $8 million with some $2 million in additional expenses each year thereafter.
With respect to the benefits from the proposed rules, the Release discusses the concerns of the North American Securities Administrators Association ("NASAA") that state examinations "are frequently hindered" by a lack of records in local offices and by "long delays" in producing required records from a central location (Release at 4-5). We do not question the difficulties that state regulators may have experienced from time to time in conducting their examinations of some firms. We are not aware of the Commission or the federal self-regulatory organizations experiencing similar problems with such delays in their examinations. The Commissioner might want to determine the extent of any problem at the federal level before adopting a solution. In any event, the current proposals, by requiring that records be maintained in local offices, could actually cause delay and result in incomplete files. A large broker-dealer with central document processing centers could be compelled to make millions of paper copies of records, sort them, and ship them to one or more of perhaps hundreds of locations. There is no assurance that any given document will be "immediately" available in any particular local office.
With respect to NASAA's concerns over delays in document production, we believe that more feasible solutions may be available that focus on the timeliness of production in varying circumstances and on dealing with individual broker-dealers that may raise particular problems. It may be that waiting a short period for records that are several years old would not seriously diminish investor protection yet would allow the general broker-dealer community to use cost-effective storage technologies without a duplicate paper-based system.
We suggest that, instead of determining where broker-dealers must keep records, in what particular files, and in what storage media, the Commission specify that broker-dealers must produce requested records within a reasonable time. The Commission should let each broker-dealer decide how it will meet that requirement, whether by paper-based or other storage in a local office or by electronic or other storage at a central location. The Commission will not be either requiring or discouraging any particular system for storage and retrieval of information, thus permitting the development of new technology. A broker-dealer that relies heavily on a cost-effective central computer system and a centralized filing system to handle records for hundreds of branch offices should be permitted to use that system, as long as it can produce records to a regulator within a reasonable time. The Commission can sanction any broker-dealer that fails to produce such records in a timely manner.
As we have previously mentioned, we believe that the Commission should withdraw the current proposals for further study in light of the significant drawbacks we have discussed. Without addressing each proposal, we will comment on proposals that in particular merit more attention.
COMMENTS ON SOME SPECIFIC PROPOSALS
1. ACCOUNT FORMS - Rule 17a3-(a)(16)
a. Account Approvals
The proposed rule provides that broker-dealer approval of the account form shall be indicated by written initials or signature and date on the account form. Release at 27. With advances in technology, customers may be transmitting account forms electronically and broker-dealers may be storing the account information electronically as well. We suggest that any Commission rule on account form approvals provide flexibility so that approvals may be documented by an electronic authorization, provided adequate security safeguards are in place. Otherwise, broker-dealers may store records in some non-electronic form simply to evidence required approvals.
b. Specific Information Required
The proposed rule will require broker-dealers to obtain from customers a wide variety of information, including, for natural persons, number of dependents, educational level and annual income. Release at 28. The rule is broad, covering every type of customer opening any kind of account, and it leaves the individual broker-dealer no discretion in determining the information to gather. In these respects, the proposed rules differ greatly from self-regulatory organization ("SRO") rules on which they are based. The SRO rules require that broker-dealers gather information in specified general categories only when the customer maintains an option account or the broker-dealer recommends the transaction. 2 Otherwise, each broker-dealer can determine what information it needs to "know its customer" and to evaluate customer credit risks to the firm. 3 The SRO rules thus afford broker-dealers more flexibility than the proposed rules. We believe that any proposal the Commission might adopt should distinguish between, on the one hand, options accounts and transactions recommended by the broker-dealer and, on the other, transactions where the broker-dealer makes no recommendation. The Commission should more closely model any new rules on existing SRO rules.
In addition, we believe that the Commission should make clear in any such proposal that, in recommended trades, the broker-dealer need not gather the information until it makes a recommendation. In this way, the information will be current.
c. "Speculation" As an Investment Objective
The proposed rule would require that the prescribed account form contain a section on investment objectives. The rule would compel broker-dealers to define a "speculative" investment and state that such an investment involves a high risk of loss that may exceed the losses in general market averages on any specific day or over a longer period of time. In addition, the proposed rule would require that the customer designate the approximate percentage of investment capital dedicated to speculation. Release at 29. Schwab believes that the Commission should reconsider whether this proposal is workable.
First and foremost, by requiring that customers specify the percentage of capital to be dedicated to "speculation," the proposal as a practical matter will lead broker-dealers to monitor continuously every account to see whether any customer has exceeded the given percentage. Changes in the market and the fortunes of individual securities mean that the percentage of capital invested in "speculative" securities can vary dramatically from day to day and, indeed, from hour to hour. By disclaiming any intent to impose a monitoring requirement, the proposal provides no guidance on how frequently the broker-dealer must look at each account to protect itself against a claim that it improperly permitted an unsuitable customer trade.
In addition, the proposed rule must itself define "speculation." If the five thousand broker-dealers covered by the proposed rule were to fashion their own definitions, they likely would produce many different definitions. Investors who have accounts with more than one broker-dealer could become confused if one of their brokers did not consider an investment "speculative" while another did.
Any definition must be one that broker-dealers and investors alike can easily apply to a given security. The suggested definition that a speculative investment "may exceed losses in general market averages on any specific day" (Release at 29) is inadequate. It could cover almost any investment, other than perhaps a money market fund, on any given day.
The requirement that all brokers gather information on speculative investments is overbroad when applied to broker-dealers who, like Schwab, make no recommendations on individual equity securities. The proposal acknowledges this point when it states that the information "will be useful in assessing the suitability of recommendations made by a broker-dealer." Release at 10; emphasis added. In addition, because of the monitoring of customer accounts that the proposal will generate, broker-dealers who otherwise make no recommendations may have to make recommendations because of the changing percentage of capital a customer is devoting to "speculative" investments.
d. Annual Updates
The proposal that information on customer investment objectives be updated annually is among the most burdensome amendments in the Release. The proposal does not explain the basis for the estimate that only 10% of accounts need be updated annually. That figure suggests that any given account need be updated only once every 10 years. We see no meaningful way, short of contacting each customer, to identify which accounts will need updating in any given year. As a practical matter, broker-dealers will be compelled to update all accounts every year.
The proposal likewise does not articulate why the update will take only 5 minutes per account. Release at 21. Schwab's experience suggests that it is likely to take between 8 and 20 minutes per account, depending on the method of contact (phone call or mailing) and the acceptable number of customer responses. For example, Schwab estimates that an initial mailing will generate a response from approximately 40% of customers and that it will take three mailings to achieve a 90% customer response rate. To update its existing four million active accounts given the 8 to 20 minute range per account, Schwab will need at least 325 and up to 800 full-time employees. Depending on the number of employees and other factors, Schwab's costs would be at least $14 million annually and could rise to $60 million each year.
2. CUSTOMER COMPLAINT FILES - Rule 17a-3(a)(17)
In keeping with its centralization of other aspects of its activities, Schwab has centralized its handling of customer complaints. Schwab maintains a hard copy of all customer complaints in a centralized location, can easily identify where a particular complaint may be found and can use various criteria to sort the records. In the states that require local offices to maintain customer complaint files, Schwab also keeps a copy of customer complaints in its local office. The proposed rule, however, would compel Schwab to maintain additional and multiple copies of each record in one or more of its 240 branch offices and 5 regional service centers: one copy by customer account and the remaining copies by associated person for each associated person who may happen to be mentioned in a customer complaint. The proposal may also require Schwab to transfer files from one office to another to the extent that its thousands of registered representatives change offices. This proliferation of copies and records increases costs and reduces efficiency. And there is no assurance that the proposed rule will increase investor protection more than a requirement that a broker-dealer make these records available within a specified reasonable time.
4. EXCEPTIONAL NUMERICAL OCCURRENCES - Rule 17a-3(a)(19)
Schwab currently uses activity reports of the general type described in the proposed rule. To the extent that the proposed rule would require tracking of specific activities not currently being tracked, Schwab would be compelled to spend hundreds of thousands of dollars to modify existing reports or create new ones.
On the other hand, the proposals do not demonstrate the need for all broker-dealers to track many of the activities mentioned. For example, a rule concerned with the need to monitor registered representatives who may be churning customer accounts should not be applicable to broker-dealers that do not compensate their representatives on a per-trade basis and do not recommend individual equity securities or solicit transactions in these and other securities. In addition, we believe that any rule should allow individual broker-dealers flexibility in determining the best method of supervision given individual methods of doing business.
5. ASSOCIATED PERSON RECORDS - Rule 17a-3(a)(20)
The proposed amendments would require broker-dealers to keep in local offices sensitive personnel information of their associated persons. Release at 33. Schwab currently maintains these files in a central location. Under the proposal, Schwab would need to duplicate the specified records for more than 5000 registered representatives and maintain these duplicative files in over 240 locations. This risk to confidentiality and expense does not appear to us to be justified when Schwab can make the records available from a central location within a few days.
In addition, as noted above, the proposed rule will require Schwab to maintain in these 240 locations multiple copies of customer complaints so that they are accessible not only by account number but by associated person as well. This proposal is costly, inefficient and counter-productive in achieving its intended purposes, as we earlier explained.
The proposed rule requires that broker-dealers keep for each associated person a client trading record listing all trades in chronological order for all customers of each associated person. Release at 34. If applied to certain broker-dealers, including Schwab, the proposed rule may not produce records organized in a way helpful to regulators. As noted above, some broker-dealers do not necessarily have a particular registered representative who "owns" any individual retail customer account. Any such customer may place a trade with any number of the broker-dealer's registered representatives or, if the customer chooses, through electronic or other channels without speaking with a registered representative. Client trading records kept by associated person will necessarily be incomplete since no client will usually place orders with any one representative exclusively. If a customer places trades with five different representatives, for example, a regulator would have to look at the files of all five representatives to view the customer's complete trading record. Some of the representatives may be in different states. Consequently, to require that a broker-dealer like Schwab keep client trading records by associated person, and that it do so in hundreds of offices in different states, will make it harder, not easier, for regulators in individual states to obtain information.
Where a broker-dealer does not pay its representatives on a transaction basis, there seems to be no purpose in requiring the broker-dealer to produce and retain such client trading records. Schwab estimates that to reprogram its system to produce such a report will cost over $60,000. To retain these records in hard copy for over 5000 representatives in over 240 locations will cost Schwab over $100,000 annually.
The proposals also require that broker-dealers produce associated person documents, such as Forms U-4 and U-5, "immediately." Regulators have at least some of these documents available to them on the CRD system. To that extent, we see no reason to compel broker-dealers to change methods of storing and retrieving these documents. In addition, planned changes to the CRD system will enable most broker-dealers to store information electronically in one place, eliminating most paper copies of information relating to registration of firms and representatives.
6. STORAGE IN AN "EASILY ACCESSIBLE PLACE" - Rule 17a-4(a) and (b)
The proposed rule does not define "easily accessible." The rule should state that "easily accessible" means that broker-dealers are capable of producing the required records within a reasonable time. The rule would then permit each broker-dealer to select the most cost-effective means for that broker-dealer to comply with the rule. And the Commission will neither be dictating nor discouraging the use of specific storage and retrieval systems.
7. RECORDS OF COMMUNICATIONS - Rule 17a-4(b)(4)
The proposed rule requires that the broker-dealer maintain a file for each customer at each local office involved in communications with the customer and that all communications with the customer involving that local office be placed in that one file. This proposal is ambiguous in at least two respects.
First, the proposal does not clearly state that it excludes central locations. (This section appears to distinguish between a local office and a central location, but the definition of a local office could include a central location since a local office is "any location where an associated person regularly conducts the business of handling funds or securities or effecting transactions in . . . the purchase or sale of any security.") Second, the proposal is also unclear regarding whether the "communications" it covers would include every contact with a customer, including, for example, the delivery of a monthly statement.
If broadly construed, the proposal would be unworkable. For example, Schwab does not organize all its documents by customer and does not store them in one file per customer at any of its locations. The proposal would require that Schwab make at least one extra copy of tens of millions of documents; open at least four million new files arranged by customer (Schwab will need to open more than one file per customer if communications relating to a particular customer involve more than one location); and, on an ongoing basis, maintain this ever-expanding number of files and records. The cost could exceed $6 million annually.
Moreover, the requirement that "all" communications for a customer account be consolidated in one customer file is inconsistent with the Commission's previous instructions that customer complaints are to be filed separately from other correspondence.
8. BROKER AGREEMENTS - Rule 17a-4(b)(7)
The proposal requires that the customer receive a copy of every written agreement between the customer and the broker-dealer. Release at 37. Schwab currently provides each customer with a written copy of the terms and conditions governing the customer's account with Schwab. These terms and conditions are separate from the customer's signed account application, a copy of which Schwab does not currently send the customer. (Schwab instead sends each customer a computer-generated document with account opening information as maintained in Schwab's computer.) It is not clear whether this proposal would require that Schwab send each customer a copy of the completed account application form. 4 If the proposal were to do so, Schwab estimates that to retrieve a copy of the completed application for each of its four million active accounts and send the form to each customer would cost over $10 million. To implement an ongoing system so that new customers will receive a copy of their completed account applications would likely cost Schwab over $1.5 million annually.
9. PRODUCTION TO REGULATORS - Rule 17a - 4(j)(1)
The proposed rule requires that a broker-dealer produce, upon request, any records maintained under Rule 17a-4 to any state securities regulator. As far as we are aware, this is the first time that the Commission will be requiring that state regulators be accorded access to books and records maintained under federal securities laws. Giving a state regulator access to documents of activities outside the state of the regulator's jurisdiction in this fashion could raise jurisdictional issues that merit the Commission's consideration, particularly since the National Securities Markets Improvement Act of 1996 seems to have resolved similar issues in favor of federal preemption.
In terms of actual implementation, the requirement that the records produced "be organized in a systematic and easily recognizable order, such as chronologically or alphabetically" may pose difficulties where the records are not produced in paper form. Data stored electronically or on microfiche or microfilm may not necessarily be organized either chronologically or alphabetically. Accessing records stored on a non-paper-based system may be faster than accessing untold boxes of stored paper and a broker-dealer may want to produce records on non-paper media. To require that broker-dealers produce paper copies of records stored on non-paper media would increase costs without increasing investor protection.
Production within three business days may not be feasible when a regulator seeks a large volume of documents. The proposed rule needs to incorporate additional flexibility, as acknowledged in the NASAA proposed rule on access.
10. LOCAL OFFICE RECORDS - Rule 17a-4(1)
For the reasons discussed above, to maintain in its 240 local offices the mass of records called for in the proposed rules, Schwab would need to hire dozens of additional employees and expand its physical locations to facilitate additional filing space, which means additional leaseholds or relocation for a large number of branches that have no space for the storage required. This will cost Schwab over $4 million in one-time costs and over $3 million annually.
CONCLUSION
We again thank you for the opportunity to comment on the Commission's proposed amendments to its books and records requirements. We believe that the existing rules of the Commission and the self-regulatory organizations provide adequate investor protection while allowing individual broker-dealers needed flexibility to determine the best method for compliance. Any changes should preserve this flexibility. They also should clearly strengthen investor protection without unduly increasing broker-dealer compliance costs.
If we can be of further assistance or if you have any questions, please call me at (415) or Brian Bellardo at (415) 636-1080.
cc: Chairman Arthur Levitt
Commissioner Steven M. H. Wallman
Commissioner Isaac C. Hunt Jr.
Commissioner Norman S. Johnson
Richard R. Lindsey, Director, Division of Market Regulation
Michael Macchiaroli, Associate Director, Division of Market Regulation
Peter Geraghty, Assistant Director, Division of Market Regulation
| 1 | SEC Release 33-7233 (October 6, 1995) at 2, 60 F.R. 53458 (October 13, 1996). The Commission also stated that it "believes that the use of electronic media should be at least an equal alternative to the use of paper-based media." SEC Release 33-7233 at 8. See also SEC Release 33-7288 (May 6, 1996) at 7. |
| 2 |
Rule 9.7 of the Chicago Board Options Exchange; Rule G-19 of the Municipal Securities Rulemaking Board; Conduct Rule 2310 of the National Association of Securities Dealers ("NASD").
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| 3 | Rule 405 of the New York Stock Exchange; see also NASD Conduct Rule 3110. |
| 4 | Proposed Rule 17a-3(a)(16) provides that a broker-dealer is not required to send a completed copy of the account form if the broker-dealer sends an alternative document that contains all required information set forth on the account form. |