V APPENDIXES F. A Report on the Auditors of Wall Street__. G. Financial Statement and Annual Report of Keefe, Bryuette & Woods, H. Proposed Consolidated Monthly Report-New York Stock Exchange, I. New York Stock Exchange Special Operations Questionnaire (Current Page 1091 1109 1146 J. Special Operations Questionnaire (Original Version) 1266 1276 1282 1291 STUDY OF THE SECURITIES INDUSTRY TUESDAY, SEPTEMBER 14, 1971 HOUSE OF REPRESENTATIVES, SUBCOMMITTEE ON COMMERCE AND FINANCE, COMMITTEE ON INTERSTATE AND FOREIGN COMMERCE, Washington, D.C. The subcommittee met at 10 a.m., pursuant to call, in room 2123 Rayburn House Office Building, Hon. John E. Moss (chairman) presiding. Mr. Moss. The subcommittee will be in order. This morning the Subcommittee on Commerce and Finance of the House Committee on Interstate and Foreign Commerce opens the second in its series of hearings in its study of the securities industry. As you know, the subcommittee held hearings on August 2d and 3d of this year to explore problems of broker-dealers, the various selfregulatory organizations and the Securities and Exchange Commission during the period 1968 through 1970. That period was one of the most troublesome periods in the history of the securities markets in the United States. While the emphasis in that hearing was largely historical, focusing on the question of "what went wrong," the emphasis in this and future hearings will be on the future. In other words, we shall be asking the broad question, "What should we do about it?" Whether our findings will indicate the need for further legislation, further rulemaking, either by the SEC or the self-regulatory organizations, or, indeed, a restructuring of the entire market itself, only time will tell. As I believe I have said before, we have no preconceived opinions, and we are not at this point willing to accept without examination simplistic solutions. But we are very eager to listen to what you, our panelists, and any others having constructive suggestions are willing to provide by way of new ideas. This hearing will focus specifically on problems of broker-dealer financial stability and the safety of customers' funds and securities. Some of these matters were explored in the August hearing, but we are endeavoring here to achieve a more intensive scrutiny of these very complex and technical problems. This is in recognition of the paramount importance of broker-dealer stability to the investment community. Without sound and permanent capital structures, brokerage houses constitute a distinct consumer hazard. And, since broker-dealers are fiduciaries, they must at all times be aware of their fiduciary duties in safeguarding customers' funds and securities. We are pleased to have with us this morning as panelists: Mr. Irving M. Pollack, director of the division of trading and markets of the Securities and Exchange Commission; Mr. Edward R. Gilleran, vice president, regulation, of the National Association of Securities Dealers, Inc.; (745) Mr. Fred J. Stock, Jr., assistant vice president, New York Stock Exchange, Inc., member firms department; Mr. Solomon Litt of Asiel & Company, a member of the board of governors and chairman of the capital committee of the New York Stock Exchange, Inc.; Mr. Edwin P. Fisher of Arthur Andersen & Company, a member of the Committee on Stock Brokerage Accounting and Auditing of the American Institute of Certified Public Accountants; and Mr. Roger E. Birk, vice president and director of the operations. division of Merrill Lynch, Pierce, Fenner & Smith, Inc. As with our prior hearing we have determined that this hearing will take the form of a panel discussion rather than the usual formal presentation of statements. In this way, the subcommittee hopes it will be possible to achieve an interchange of views, both between this subcommittee and the panelists and between the panelists themselves. At the outset, each panelist has been asked to present a brief summary of his views. The written statements will, of course, be made a part of the record and the Chair, at this point, requests unanimous. consent to include such statements in the record as they are presented. Is there objection? Hearing none, the record will be held open to receive them. I appreciate the difficulties inherent in the next request, but I ask that you confine yourselves to 15-minute summaries. If there are points left uncovered, you may pick them up at a later stage in our discussion. To make the record clear and simplify the task of the reporter, please identify yourself before presenting your remarks and also later in the discussion, if this seems necessary. The schedule of the committee as originally announced called for a panel meeting today and another panel tomorrow morning at 10 a.m. The Wednesday meeting is shifted to Thursday the 16th, at 10 a.m., the shift being made necessary because of a change in the rules. of the Democratic caucus which called upon committee chairmen to schedule no business during such caucuses and such a caucus is scheduled for tomorrow morning at 10 a.m. I am very pleased to recognize the first member of the panel, Mr. Pollack. STATEMENT OF IRVING M. POLLACK, DIRECTOR, DIVISION OF TRADING AND MARKETS, SECURITIES AND EXCHANGE COMMISSION Mr. POLLACK. I am Irving M. Pollack, director of the division of trading and markets of the Securities and Exchange Commission. My statement will follow the questions that were posed in the letter that Chairman Moss sent to all panelist participants. First, the purpose of a net capital rule. The net capital rules of both the national securities exchanges and the Commission are viewed as measures to insure the liquidity of broker-dealers. The Commission very early stated that "customers do not open accounts with the broker relying on suit, judgment, and execution to collect their claims. They are opened in the belief that a customer can, on reasonable demand, liquidate his cash or securities position." The two essential elements of the net capital rule are aggregate indebtedness and net capital, and in a very general way, they are computed as follows: A broker's aggregate indebtedness is his total money liabilities with certain specified exceptions. A broker's net capital is essentially its net worth, that is, the excess of total assets over total liabilities, not the lesser figure for aggregate indebtedness, adjusted to take into account unrealized profits or losses of the firm and deductions for the value of assets which are not readily convertible into cash, and a percentage of the market value of certain liquid assets to take into account the fact that their value might be less at the time they had to be sold. These are commonly referred to as haircuts. The final net capital computation is made us follows: First, the firm's liabilities are adjusted to get to the aggregate indebtedness figure mentioned previously. Second, the firm's net worth is adjusted to get to the net capital figure also mentioned previously. The net capital ratio is a comparison of the aggregate indebtedness against the net capital. As long as the former under the Commission rule is no more than 20 times the latter, the firm would be in compliance with the Commission rule, assuming that it also met the absolute minimum net capital requirement for the particular broker-dealer. The next item is the differences between the Commission net capital rule including the proposal recently made by the Commission for increasing minimum capital for new entrance into the business and the New York Stock Exchange's net capital rule. Until its recent revisions, the net capital rule of the New York Stock Exchange as interpreted and administered differed from that of the Commission in certain key respects. These differences, among others, were: (1) The allowance of credit for temporary debt capital; (2) failure to deduct for short stock record differences; (3) the allowance of credit for unsecured receivables; and (4) the allowance of credit for nonmarketable securities. The details of these items are set forth in the full statement. Because of these differences, the Commission made various recommendations for changes in the New York Stock Exchange net capital rule. In July 1971, following conferences between exchange and Commission representatives, the New York Stock Exchange as an initial step adopted major changes in its net capital rule. The more significant changes included the following: New York Stock Exchange net capital rules now requires both debt and proprietary capital to be locked in for a minimum of 1 year, with the exception of special capital furnished for underwritings. Moreover, the capital must be locked in indefinitely if withdrawal would result in a net capital ratio in excess of 12 to 1 or violation of the exchange's net capital dollar requirements. As for stock record differences, the exchange will now charge them in full after 45 days. On security haircuts, the previous exchange practice had permitted capital credit for stock which was otherwise unmarketable where the brokerage firm could arrange for a "put." The new rule will eliminate such use of puts commencing in August 1972. The extra haircut on portions of undue securities concentrations also was added to the rule. In addition, new rule haircuts as high as 100 percent instead of the prior 30 percent are imposed on certain stocks not meeting specified standards and specified haircuts are now imposed on commercial paper ranging from one-eighth percent to 30 percent in cases where there are no ratings by recognized financial services. The exchange has decreased the maximum permissible capital ratio from 2,000 percent to 1,500 percent. |