Broker-dealers (“BDs”) are subject to a variety of recordkeeping requirements that are promulgated and enforced by both the Securities and Exchange Commission (the “SEC”) and self-regulatory agencies, such as the Financial Industry Regulatory Authority (“FINRA”). These requirements are considered vital to customer protection, fraud-prevention, and general regulatory activities. To that end, recordkeeping requirements are among the most potent enforcement tools used by securities regulators because much of the information that is required to be maintained portends fraudulent activity. As a result, recordkeeping regulations are subject to change with shifts in enforcement priorities and the political climate of the day.
Indeed, the recordkeeping regulations came under renewed focus in the wake of the 2008 financial collapse, which exposed numerous financial frauds that victimized millions of investors. In response, President Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”). Pursuant to the Dodd-Frank Act, the BD recordkeeping regime expanded essentially across the board, and now reaches new types of trading activities and markets (i.e. security-based swaps). Since its enactment, critics have argued that the cost of complying with the Dodd-Frank Act far outweighs its benefits. As a result, President Trump has indicated that he intends to roll back much of the Dodd-Frank Act. History teaches us that recordkeeping regulations will be used to effectuate whatever “roll back” does occur.
Below, we focus on the touchstone of the recordkeeping rules, which is found in Section 17(a) of the Securities Exchange Act of 1934, as amended, (“the Exchange Act”), 15 U.S.C. § 78q(a) – and its corresponding regulations, 17 C.F.R. § 24017a, et. seq. (“Rule 17a”). Among these regulations, Rules 17a-3 and 17a-4 stand out as particularly noteworthy. Together, they identify the records that a firm must create and preserve in addition to the format, medium, and time-period for doing so.
Exchange Act Rule 17a-3
Rule 17a-3 sets forth the various books and records that BDs must create. A review of Rule 17a-3 reveals a broad assortment of records, including purchase and sale documents, source documents, long/short position documents, business records, associated person records, and customer account information. Importantly, there is an inherent duty to create and maintain all records “accurately.”
Like many SEC rules, Rule 17a-3 is geared towards curbing fraud. For example, Rule 17a-3 contains a detailed list of information that must be contained in documents relating to sales transactions. Included within this list is the requirement that transaction orders contain the time the order was received and executed. This information, in turn, enables regulators to thwart fraudulent schemes such as late trading.
It follows that prosecutors often cite Rule 17a-3 in conjunction with other regulations, such as those pertaining to fraud. While fraud violations generally only stand if a defendant acts with scienter, recordkeeping requirements have no such requirement. Thus, Rule 17a-3 provides regulators with a fallback option when there is evidence that fraud has occurred, but evidence of scienter is lacking.
Recently, there have been a spate of fraudulent schemes aimed at elderly investors. To thwart such activity, FINRA created additional recordkeeping requirements. For example, BDs must update their records with a “Trusted Contact Person” who can address suspected financial exploitation. As we noted above, recordkeeping regulations such as these are a tried and true way to quickly address hot button issues.
Exchange Act Rule 17a-4
Rule 17a-4 specifies the length of time and manner that the records set forth in Rule 17a-3 must be preserved. This Rule also requires additional records to be preserved even though they are not listed in Rule 17a-3. These additional records are predominantly created in a BD’s natural course of business.
Rule 17a-4 sets forth the time period and method that records must be retained. Retention periods vary according to the type of record at issue. Notably, Rule 17a-4 does not preempt other non-securities related requirements. Therefore, it is paramount that BDs ensure that there are no other legal requirements that require record retention once the Rule 17a-4 period lapses.
Method of Preservation
The “method of preservation” component requires that any records named in Rule 17a-3 be kept in an “accessible place.” This has been interpreted to mean that the records must be kept in a “readily accessible location,” such as on the premises or at a nearby location. Additionally, the records must be filed in such a way that they can be easily identified or retrieved. As to the records required by Rule 17a-3, the “accessible place” requirement lasts for two years, although such records will need to be preserved for longer periods to comply with their applicable retention periods.
Medium of Storage
The permissible medium of storage has evolved with technology, and today BDs may preserve records on “electronic storage media.” Consistent with its fraud-prevention motives, the Rule requires any “electronic storage media” to preserve records exclusively in a non-rewriteable and non-erasable format. In this regard, Rule 17a-4 sets forth a standard that electronic storage media must satisfy, rather than the type of technology (i.e. CD-roms) that must be used. Systems that only preserve records or mitigate (rather than eliminate) the risk of a record being overwritten are unacceptable.
As noted above, Rule 17a-4 also requires BDs to preserve additional records that are not set forth in Rule 17a-3. Perhaps most notable is the requirement to preserve “originals of all communications received and copies of all communications sent” relating to the BDs’ “business as such.” In light of the rapid advancements in communication platforms, this provision has proved to be particularly troublesome. BDs must remain cognizant that Rule 17a-4 is a standard-based rule meant to evolve with technology. Indeed, the Rule has been expanded to cover evolving communication mediums such as e-mail and social media.
Rule 17a-5: The Basic Reporting Rule for BDs
Whereas Rule 17a-3 and Rule 17a-4 provide for the creation and preservation of records, Rule 17a-5 imposes affirmative reporting obligations on BDs. The reporting requirement is used by the SEC to ensure compliance with a host of other rules. For example, the Net Capital Rule is designed to ensure the financial health of BDs by requiring them to maintain a minimum amount of net liquid capital. Rule 17a-5 adds teeth to this rule by requiring scheduled reporting of such information, thereby giving the SEC an early warning sign of a potential BD collapse. The numerous different reports that BDs must make cover a wide range of information. Unsurprisingly, the reporting requirements have only grown in importance since the Madoff scandal and the enactment of the Dodd-Frank Act. Naturally, the cost of compliance has skyrocketed, and critics often cite Rule 17a-5 as a primary example of the hardships imposed by the Dodd-Frank Act.
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Adding to the complex maze of recordkeeping requirements, self-regulatory organizations such as FINRA have also enacted numerous recordkeeping rules. See, e.g., FINRA Rules 2210, 3110, 4511, 4513, and 4530. In fact, the SEC and FINRA often use these rules to advance their present-day priorities, instead of seeking broad amendments to the Federal Statutes and Regulations. Thus, while Rules 17a-3, a-4, and a-5 provide a useful starting point, full compliance with the BD recordkeeping regime can only be achieved through a detailed review and understanding of all applicable rules.
Benjamin McCoy (LAW ’12) is an associate at Fox Rothschild where his experience as a trial and appellate litigator is used to assist clients in a broad commercial practice that includes an emphasis on international, business, class action, and white-collar litigation.
Ernest Badway is a partner at Fox Rothschild and co-chairs the firms Securities Industry Practice. He is a former United States Securities and Exchange Commission Enforcement Attorney and currently advises clients on a broad range of business matters including securities, corporate governance, and partnership disputes, as well as providing counseling services for hedge funds and investment advisors.
Joshua Horn is a partner at Fox Rothschild where he co-chairs the firm’s Securities Industry Practice. His practice includes representing major financial services companies; representing financial advisory companies, individual advisors, and counselors in FINRA examinations, enforcement and arbitrations; and representing individual brokers on disciplinary matters before FINRA and state securities commissions, and companies and individuals in SEC investigations.
The foregoing is based on an article written by Mr. Badway, Mr. Horn, and Mr. McCoy for Lexis Practice Advisor®, a comprehensive practical guidance resource providing insight from leading practitioners, and is reproduced with the permission of LexisNexis. For a more detailed discussion of recordkeeping requirements, please consult the following: http://www.foxrothschild.com/content/uploads/2017/04/Broker-Dealer-Recordkeeping-Requirements.pdf
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