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On May 2, 2003, the Securities and Exchange Commission imposed sweeping new record-keeping requirements on the securities industry by amending the Securities Exchange Act of 1934 Rules 17a-3 and 17a-4. [FOOTNOTE 1] Although opposed by the securities industry as onerous, the rules are seen as a major victory for state regulators who will now benefit from them by enjoying easier access to salient information maintained by broker-dealers. As a result, the rules will affect the securities industry because the new records will be used by the SEC, state regulators, the NASD Regulation Inc., and the New York Stock Exchange against securities industry members in investigations and prosecutions. State regulators spurred the commission to action on these rules since they complained that the previous rules were inadequate and states were precluded from enacting their own standards by federal statute. The commission unsuccessfully attempted to remake the rules in 1996, then re-proposed them in 1998, generally finding support from state regulators and securities industry opposition. The commission ultimately adopted the rules in November 2001, providing broker-dealers with 18 months to prepare for the changes. This article highlights certain key rules adopted to combat shoddy broker-dealer regulatory responses and record-keeping practices such as those relating to customers, associated persons, advertising, complaints, record maintenance and broker-dealer explanation requirements during regulatory examinations. BAD RECORD KEEPING Although these rules will not affect any current regulation, they provide regulators with additional means to monitor compliance with all securities regulations. For example, customer order tickets were restructured to include the identity of the account’s responsible associated person (only if the broker-dealer has such a policy or the order entered upon request) and certain transactional information. Broker-dealers must also prepare an associated person list where their offices are matched to identification and CRD numbers, so regulators may monitor associated person activity. [FOOTNOTE 2] Broker-dealers must also create new customer records containing various customer data, financial information and investment objectives. The record may include multiple documents or applications, and, for multiple owner accounts, one set of financial datum and investment objectives. Further, if the record is incomplete, the broker-dealer is protected, provided it made a good faith effort to collect such information and documented its efforts; or is exempt from determining suitability for certain accounts under prevailing regulations. For all accounts, the responsible associated person (if one is assigned to the account) must sign the account record, and a broker-dealer principal must approve or accept the particular account while discretionary accounts require both customer signatures and those natural persons with discretionary authority. [FOOTNOTE 3] CUSTOMER COMPLAINTS Additionally, over the last decade, the SEC and other regulators found a strong correlation between customer complaints and high associated person compensation levels. The SEC crafted the rules to assist regulators in quickly identifying such trends. For every written customer complaint received by a broker-dealer, a new record must be created, containing information such as customer and associated person names, a description of the complaint and the broker-dealer’s disposition of the complaint. No new record is required if the broker-dealer maintains the original written complaint, and records the complaint’s disposition under the associated person’s name. Customers must also be provided with a notice indicating the address and telephone number of the broker-dealer department where complaints may be sent. [FOOTNOTE 4] Associated person compensation information, essential to regulators’ sales practice abuse investigations, now requires a record listing each purchase or sale of securities; the compensation amount; whether the compensation is monetary or a description of non-monetary compensation (such as sales incentives, gifts, trips, expensive dinners or outings) and an estimate of its value. Further, written records of all agreements (including verbal) between the broker-dealer and its associated persons must be maintained, summarizing each associated person’s compensation arrangement, plan or remuneration basis (periodically revised commission schedules). [FOOTNOTE 5] The SEC also revamped its communication record maintenance rules, so there are now records indicating compliance with or adoption of policies and procedures requiring a broker-dealer’s principal’s approval of any advertisements or public communications (sales literature, marketing materials, sales scripts, audio or videotapes). The SEC expects NASD and NYSE public communications rules to serve as models for broker-dealer policies and procedures. Additionally, broker-dealers must now record each principal responsible for establishing policies and/or procedures requiring principal acceptance or approval of a record. Coupled with this record, the broker-dealer must also list the names or titles of all office personnel, who, without any delay, will be responsible for and explain the broker-dealer’s records and the information on those records maintained at that office. [FOOTNOTE 6] CUSTOMER INFORMATION Controversy erupted over proposals to require broker-dealers to periodically furnish customers with account record information at least once every 36 months. Broker-dealers argued against the proposal because of the financial burden, while the SEC and other regulators sought to reduce errors and mistakes with periodic customer review of account information that broker-dealers use to recommend investments or determine suitability. The broker-dealers lost this battle, and customers will receive this information every 36 months; when a new account opens; or when a customer changes its name, address or other information. Broker-dealers, however, may need or choose to update customer information more frequently, and provide it to coincide with other mailings or even place it on a customer’s account statement. [FOOTNOTE 7] For pre- May 2, 2003, accounts, broker-dealers will have 36 months to satisfy this rule, and future 36-month cycles for both pre- and post- May 2, 2003, customer accounts start when the broker-dealer obtains the new information. Further, the broker-dealer’s investment objective terms or categories must be described in a written document (no oral explanations) and provided to the customer with the account record and a copy of a written customer agreement, on or after May 2, 2003. [FOOTNOTE 8] OFFICE RECORDS The SEC and, in particular, state regulators found that broker-dealers who operated from various locations lacked certain records at these locations, making investigations difficult. Thus, in a direct effort to mollify state regulators, the SEC made a controversial decision to require certain records be kept at the office where those records were created. These new rules were extremely important to state regulators since their examinations are limited by state boundaries, but will have almost no impact on the SEC with its national jurisdiction, and the NASD and NYSE, which have nearly unlimited access to their members’ offices. Although the term “office” applies to the creation and maintenance of records and to any location where the associated person regularly conducts business, it is broader and more inclusive than the definition of “branch.” An office, however, is not a customer’s office or home even if regularly used, but an associated person’s residence may be an office, and a broker-dealer may choose an office to maintain required records for an associated person, who works at multiple locations. Irrespective of the office location, broker-dealers must now make and keep, for one to two years, each office’s books and records as outlined in Exchange Act Rule 17a-3. [FOOTNOTE 9] In determining the record maintenance location, the SEC balanced competing interest. State regulators sought to require broker-dealers to maintain duplicate records (in paper or electronic form) at each of their local offices to decrease examination delays and expenses experienced in the past by these regulators. The broker-dealer community opposed this proposal because it was burdensome and costly to maintain two sets of records or upgrade inadequate computer systems for electronic storage, and it would decentralize record keeping systems, compromising record keeping and supervisory internal controls. The SEC found a middle course, permitting required records created at one office to be maintained at another office if the broker-dealer promptly produced such records upon request either at the office where those records were created or at another location with regulator consent. Additionally, although broker-dealers must satisfy a regulator’s request “promptly,” the SEC did not define the word “promptly,” only suggesting same-day compliance for onsite records and regulator and broker-dealer discussions for large or complex requests. Further, records need not be produced at an associated person’s non-public residence-office if certain conditions are met, or at a foreign office. [FOOTNOTE 10] INTERNAL CORPORATE RECORDS The commission also required broker-dealers to maintain certain internal documents so their operations would be laid bare to regulatory scrutiny. For example, advertising and marketing communications (not drafts), including sales scripts used to communicate with but not delivered to the public, must be maintained so state regulators may enforce peculiar state regulations on form and use. The SEC also reiterated that the communication’s content and audience determines whether a copy of the communication must be preserved irrespective of its paper or electronic form. Broker-dealer organizational records (broadly defined since states use different terms), Form BDs, actual Form BD amendments and broker-dealer related entities’ records not covered by the current regulatory scheme also must be maintained. Further, customer account record information retention is now six years from the time said account is closed or the information is replaced or updated. [FOOTNOTE 11] Similarly, copies of special or exception reports that identify suspicious activity, such as churning and unauthorized trading, must be maintained for three years, if either required or requested by regulators in an order or settlement, or any exception report designed to record unusual customer account activity. However, no such reports must be created, only maintained if created. Many broker-dealers commented that the SEC’s new rules might force broker-dealers to curtail the creation of these reports, but the agency claimed broker-dealers will continue to create these exception reports when necessary to fulfill their supervisory obligations, and suggested broker-dealers may create exception reports to aid securities regulators and possibly reduce the examination burden on their firms. [FOOTNOTE 12] Finally, copies for all versions of the compliance and supervisory procedures manuals must also be maintained for a minimum of three years, to permit regulators historical information on a broker-dealer’s policies and procedures without any delay. [FOOTNOTE 13] CONCLUSION The new SEC Books and Records Rules require securities industry members to undertake significant efforts to comply with these mandates. Time will tell if these new measures will be effective tools for securities regulators in their pursuit of bad actors or an unwieldy yoke around the necks of the broker-dealer community. Ernest E. Badway, a former SEC enforcement attorney, practices securities law at Saiber Schlesinger Satz & Goldstein (www.saiber.com) in Newark, N.J. He is also an adjunct assistant professor of law at Brooklyn Law School, where he co-teaches a course on securities enforcement law and co-chairs the New York County Lawyers’ Association’s Committee on Securities and Exchanges. If you are interested in submitting an article to law.com, please click here for our submission guidelines. ::::FOOTNOTES:::: FN 1 See Books and Records Requirements for Brokers and Dealers. Under the Securities Exchange Act of 1934, Exchange Act Release No. 34-44992 (Oct. 26, 2001), 66 FR 55818 (Nov. 2, 2001) (File No. S7-26-98). FN 2 See 17 CFR ��240.17a-3(a)(6), (7) and (12)(ii). FN 3 See 17 CFR ��240.17a-3(a)(17)(i)(A)-(D). For existing accounts, the broker-dealer is required to create a record indicating delivery of the customer information within three years of May 2, 2003, not 30 days. FN 4 See 17 CFR ��240.17a-3(a)(18)(i)-(ii). FN 5 See 17 CFR ��240.17a-3(a)(19)(i)-(ii). Only employment or contractual relationships must be included in this record, personal relationships unrelated to the broker-dealer’s business are not covered. FN 6 See 17 CFR ��240.17a-3(a)(20)-(22). FN 7 See 17 CFR �240.17a-3(a)(17)(i). FN 8 See 17 CFR ��240.17a-3(a)(17)(i) and (iii). FN 9 See 17 CFR ��240.17a-3(g) and 240.17a-4(k). FN 10 See 17 CFR ��24017a-3(g) and 240.17a-4(k). FN 11 See 17 CFR ��240.17a-4(b)(4) and (10), (d), and (e)(5). FN 12 See 17 CFR ��240.17a-4(e)(6) and (8)(ii). FN 13 See 17 CFR ��240.17a-4(e)(7).

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