The minimum dollar capital requirement for its member firms which carry customer accounts has been raised from $50,000 to $100,000 and for those that do customer business on a fully disclosed basis it has been raised from $25,000 to $50,000.

Member firms are also prohibited from expanding if their capital ratio exceeds 10 to 1. Moreover, they must reduce their business when their capital ratio exceeds 12 to 1. Many of the exchange's amendments have delayed effective dates depending upon receipt of a favorable tax ruling from the IRS.

The Commission rules currently provide for a minimum capital requirement of $5,000 except in certain cases and a capital ratio of 20 to 1. The Commission, as I mentioned previously, has recently proposed an amendment which would raise the requirement to $25,000 and require a capital ratio of 8 to 1 for the first year of a broker-dealer's existence. These new minimums would apply to all firms including stock exchange firms.

It might be wise to mention the rule 17a-11 under the Exchange Act which we anticipate will result in far better detection and monitoring of firms with capital problems. This rule in essence requires an immediate report from any firm in capital violation and in addition requires detailed monthly reports from firms whose net capital ratio exceeds 1,200 percent and firms whose books and records are not

current.

The question has been raised as to the exemption from the Commission's net capital rule of the New York Stock Exchange and other specified national securities exchanges. This question has been under consideration for a considerable period of time. In keeping with the concept of self-regulation, mandated by Congress, and in recognition of the special trust funds of the New York Stock Exchange, the Commission's primary efforts were directed toward strengthening the net capital rule of the New York Stock Exchange.

As previously mentioned, substantial progress has been made in recent months by the exchange in revising its net capital rule and the Commission's consideration of the question of removing the exemption has been further affected by consideration of the impact of proposed rules regarding the use of customers' funds and securities. and by the enactment of the SIPC legislation.

Regarding the relationship of debt to equity in broker-dealer capital, it should be noted that brokerage firms until recently have. taken the partnership or closed corporation form of organization. As such, they have been rather severely restricted in their sources of financing and have relied to a great extent upon customers' funds and securities for working capital. Until March of 1970, New York Stock Exchange members were prohibited from selling their securities to the public. Since their actual cash needs were minimal due to the availability of customers free credit balances, they secured the limited. moneys they needed primarily by other means.

Due to excessive use of leverage limited only by the tax regulations which penalized "thin" capitalization, firms frequently had a topheavy debt structure which hurt them at a time when profits fell.

According to the terms of many subordinated account agreements, firms were precluded from using the securities in a subordinated account except in the event of insolvency or similar catastrophe.

Similarly, secured demand notes could not be presented for payment but, rather, only the collateral could be realized upon. Recent changes provide that securities in subordinated accounts will have to be subject to utilization by the firm commencing in August 1972, although there is no personal liability on this secured demand note.

Under the New York Stock Exchange net capital rule, a member corporation, but not partnerships, has to have at least 25 percent of its total capital in the form of equity. During the crisis period, this requirement was not strictly adhered to. Where the corporation is publicly owned, at least 50 percent of total capital must be in the form of equity.

The question next in order is the effect on broker-dealer solvency of the investment of capital in securities, particularly speculative

securities.

To the extent that broker-dealers invest working capital in securities positions, they become more heavily dependent upon the use of customer assets in carrying on the brokerage business. Furthermore, capital invested in such positions may suffer significant impairment due to market fluctuations in individual securities or due to a general decline in stock prices.

Although to some extent the danger from market fluctuations is minimized by the policy of haircutting securities positions in computing net capital, it is only prudent that a firm refrain from utilizing any customers' assets for its own speculative purposes.

There are at present no restrictions upon the use by brokers of their customers' free credit balances or other cash equities; that is, credit balances which customers cannot freely withdraw other than a requirement that customers be informed if their funds are not segregated and that they may be used in the business of the broker-dealer.

As the committee is aware, until the SIPC legislation was adopted, there was a question as to the Commission's authority to adopt rules with respect to free credit balances.

In order to protect the investing public, as Congress mandated in the Securities Investor Protection Act of 1970, some means must be found to limit the use which brokers make of customers' credit balances. The most severe limitation would be a 100-percent reserve against, or complete escrow of, all credit balances, just as credit balances of commodity customers are escrowed under the Commodity Exchange Act of 1934. Because of the economic effects which such a requirement would have upon the securities industry, it would have to be phased in gradually if it were to be imposed, and there is some question as to whether it is essential for the protection of investors.

One means of partially protecting the public, while not disrupting the industry's financial practices, would be to establish partial reserves against free credit balances. These reserves could be either a flat percentage of total free credits or could be designed to take into consideration various factors such as a firm's financial condition.

A different approach to the question of the use of customers' funds, and customers' margin securities as well, would be to segregate customers' funds and securities. This separation could be accomplished by running all customers' transactions through a special escrow account. Another suggested approach has been to accomplish this

without an escrow by restricting the use of customers' funds to particular purposes, for example, supporting margin debits. These approaches would be based upon the premise that it is reasonable to allow firms to finance customer activities, such as margin loans, but not firm activities, such as underwriting and operating expenses, with customers' funds and margin securities.

Any reserve or free credit escrow approach assumes that cash paid in on account of fully paid or excess margin securities which are not segregated by the broker is protected under a securities segregation program as mentioned in my response to the next question.

Since cash is fungible, it would be unreasonable to restrict the use of free credit balances, or moneys gained by hypothecating or lending margin securities, while at the same time allowing brokers to use freely moneys received on account of fully paid transactions which did not settle on settlement date.

Does the protection of the investing public require that brokerdealers escrow customers' fully paid and excess margin securities?

Under the Bankruptcy Act and the Securities Investor Protection Act of 1970, the extent to which a customer can reclaim fully paid and excess margin securities in the event of his firm's insolvency depends upon his ability to identify them specifically. Unless certificates are held for him in safekeeping in his name, or are properly segregated for him in street name, he will be unable to identify and reclaim them. An exception is made for securities held by a securities depository: As long as the depositing firm maintains records showing which securities belong to a customer he can identify and reclaim them. Where a customers' securities holdings on deposit amount to more than $50,000, or more than $30,000 in addition to a cash balance of $20,000, proper segregation is essential if a loss is to be avoided in the event of insolvency. The SIPC legislation confers upon the Commission new authority to establish rules to specify that a particular manner of holding cash customers' property is sufficiently identifiable to permit the trustee to return such property to the cash customers upon a liquidation.

The current restrictions on the use of customer's securities are primarily threefold: Sections 8(b), 8(c), and 15(c) of the Exchange Act and SEC Rules 8c-1 and 15c2-1 thereunder; New York Stock Exchange Rule 402; and section 19 of the NASD's Rules of Fair Practice. The restrictions in the Exchange Act on hypothecating customers' securities were designed to prevent brokers from overextending themselves by pledging customers' securities for bank loans. The chief effect of the prohibition in the Exchange Act and accompanying rules is to preclude a broker from pledging his customers' securities for a loan in excess of what the customers owe him. This is buttressed by prohibitions against commingling customers' securities with a firm's securities under the same lien, and against commingling one customer's securities with those of another under the same lien, without their consent. There is also a restriction in the Exchange Act, prohibiting a broker from lending his customers' securities without their written

consent.

Under New York Stock Exchange rules previously mentioned and NASD rule, section 19 of the Rules of Fair Practice, firms are prohibited from pledging or lending more of any customer's securities than is "reasonable" in view of his individual indebtedness to the firm.

This means that securities with a market value of up to 140 percent of the customer's debit balance may be hypothecated and/or loaned. Segregation is required for securities in excess of the 140-percent amount; that is, excess margin securities, and for securities which are fully paid.

The final question is in the light of recent problems of the securities industry, are the current restrictions adequate to protect public. investors?

In the light of recent problems in the securities industry, the current restrictions are not adequate to protect investors. As was recognized by Congress in enacting the Securities Investor Protection Act of 1970, there is a clear need for more effective securities segregation provisions. To protect customers whose fully paid or excess margin securities are not deemed segregated by their broker, such a rule might require the escrowing of cash held in lieu of the appropriate certificates. For example, where securities had been fully paid for but had not yet been received by the buyer's broker, the purchase price might be held in an escrow account. The possibility of holding, for a brief period, either cash or certificates in segregation would ease the operational strains which a strict certificate segregation rule might entail.

In addition to a segregation rule, consideration might be given to a specific rule limiting the amount of money which a broker could obtain through the use of a particular customer's securities, to the customer's net debit balance in a fully secured margin account. Permissible uses of margin securities would be hypothecation, lending, and delivery out on sales transactions of other customers. The effect of such a rule would be to prevent a broker from overexposing any particular margin customer.

Mr. Moss. Thank you, Mr. Pollack.

Let the record indicate that I am making a charge to your net capital of some 7 minutes in excess of the 15. [Laughter.] (The prepared statement referred to follows:)

PREPARED STATEMENT OF IRVING M. POLLACK OF THE DIVISION OF TRADING AND MARKETS, SECURITIES AND EXCHANGE COMMISSION, BEFORE THE HOUSE SUBCOMMITTEE ON COMMERCE AND FINANCE OF THE HOUSE OF REPRESENTATIVES, COMMITTEE ON INTERSTATE AND FOREIGN COMMERCE

(a) The purpose of the net capital rule

ITEM I

The net capital rules of the national securities exchanges and the Commission are viewed as measures to ensure the liquidity of broker-dealers. As the Commission has stated: "Customers do not open accounts with a 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." Under the Commission's net capital rule, a broker can be forced to suspend operations at a point prior to insolvency or bankruptcy, when it still has sufficient assets to repay customers' funds and securities.

(b) How aggregate indebtedness and net capital are computed

The net capital rule of the Commission establishes a maximum permissible 20:1 ratio between a firm's aggregate indebtedness and its "net capital." In Exchange Act Release No. 8024, dated January 18, 1967, the Commission set forth the basic definitions of the ratio's two components, and it also set forth a hypothetical example of a broker's balance sheet and the adjustments thereto which would be made for the purposes of a net capital computation.

A broker's "aggregate indebtedness" is his total money liabilities, with certain specified exceptions. These exceptions are principally fourfold. First is indebted

ness which is adequately collateralized by securities or spot commodities owned by a broker-dealer. For example, a bank loan adequately collateralized by a bank certificate of deposit would be excluded. Similarly, the indebtedness pertaining to an asset which had been excluded from "net capital"—such as a mortgage on a building would also be excluded. The second category of liability excluded from aggregate indebtedness from under the Commission's rule is indebtedness on account of securities loaned by the broker-but only where the securities are owned by the firm itself; security deposits on customers' securities loaned are included in aggregate indebtedness. Similarly, amounts due on securities which the broker has failed to receive from other brokers are excluded where the securities were purchased for the broker-dealer's own account and were not subsequently resold. Third, liabilities on certain open underwriting contracts are excluded. And, fourth, indebtedness is excluded if it is subordinated to the claims of the firm's general creditors pursuant to a "satisfactory subordination agreement." The Commission's net capital rule lays down strict standards for subordination agreements, and indebtedness which is not contributed in accordance with such standards will be included in aggregate indebtedness.

A broker's "net capital" is essentially its net worth, i.e., 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. Two other adjustments are also made. The first deducts the value of assets which are not readily convertible into cash, while the second deducts 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. Assets which are deemed not readily convertible into cash, and hence are excluded from a broker's assets and net capital for the purpose of the computation, include furniture and fixtures, land and buildings, stock exchange memberships, and securities which cannot be sold freely without being registered with the Commission. Unsecured accounts receivables, whether from customers or other brokers, are also excluded, as are dividends and bond interest receivable, insurance claims, tax refund claims, etc. In computing the value of securities in a firm's portfolio, a deduction is made to serve as a cushion against market fluctuation. This deduction, known as a "haircut," ranges from zero in the case of U.S. Government securities to 30% in the case of common stocks. Net worth is further adjusted by augmenting net worth through the elimination of liabilities which are the subject of satisfactory subordination agreements.

The net capital computation is made as follows. First, the firm's liabilities are adjusted to get to the "aggregate indebtedness" figure discussed previously. Second, the firm's net worth is adjusted to get to the "net capital" figure discussed previously. The net capital ratio is a comparison of the aggregate indebtedness against the net capital. As long as the former is no more than twenty times the latter, the firm would be in compliance with the Commission's rule (assuming that it also met the absolute minimum net capital requirement). When a firm has net capital, but it is less than required under the 20:1 test, it is said to have a "net capital deficiency." Where a firm has no net capital at all (because of large deductions from its net worth), the amount of capital which would be required to bring it up to zero net capital is called the "net capital deficit." In such a case, the "net capital deficiency" would include the "net capital deficit." (c) The differences between the Commission's net capital rule (including the revision recently proposed by the Commission) and the New York Stock Exchange's net capital rule

Until its recent revisions the net capital rule of the NYSE as interpreted and administered differed from that of the Commission in certain key respects. These differences were as follows: (1) Allowance of credit for temporary debt capital; (2) failure to deduct for short stock record differences; (3) allowance of credit for unsecured receivables; and (4) allowance of credit for nonmarketable securities. (1) Temporary debt capital.--One of the major problems during the 1969-1970 financial crisis on Wall Street was the ability of lenders to withdraw their subordinated accounts and loans despite the actual or impending financial collapse of their brokerage firms. There were no restrictions, either under NYSE rules or the subordination agreements themselves which required firms to lock in debt capital even when the firm had a net capital deficiency. This contrasted with the situation with respect to firms governed by the Commission's net capital rule. Under that rule, for subordinated indebtedness to be given full capital credit, the debt must be subordinated pursuant to an agreement which prohibits repayment at a time when the firm is, or thereby would be placed, in net capital violation. Further, the agreement required a minimum contribution period of