at least one year, whereas there was no minimum contribution period under the Exchange's rule and capital was furnished for very short periods, in many instances for three- or six-month periods.

(2) Short stock record differences.-During the operational breakdown of 1967-1968 in the securities industry, many firms lost physical control over securities and bookkeeping accountability for the securities. The result was appreciable discrepancies between securities actually on hand and those which the firms' records indicate should be on hand. Where the firm wound up with securities whose ownership could not be traced, it had "long stock record differences." Where it wound up with fewer certificates than it should have had, it had "short stock record differences." In some cases, these amounted to millions of dollars, in each direction. The long difference securities were not in any sense an offset to the shorts, for their ownership might be determined at a later date when customers demanded delivery of securities. Short differences might or might not prove to be a liability, depending upon whether research confirmed that the securities were still owing and had not previously been delivered out (without having been recorded).

Under the Commission's net capital rule, in view of the potential exposure to a firm from its short stock record differences, a charge (i.e., a deduction) in the full amount is made against the firm's net capital. Until May of 1969, the NYSE too followed the practice of making a full deduction in computing member firms' net capital. However, at that time, the deductions were so large that the Exchange, in order to keep firms in ostensible compliance with its rule, adopted the policy of charging only the amount of the reserve set up by a firm against its exposure from short stock record differences. This provided firms with an incentive not to establish any reserve, or to establish only a minimal one. The result was that firms did not charge net capital with the full amount of the short stock record differences, and under the 20:1 test, they were thus able to carry millions of dollars of additional indebtedness.

(3) Unsecured receivables.-Under the Commission's net capital rule, unsecured receivables of all kinds are excluded from a firm's net capital in making the net capital computation. The chief receivables thus disallowed are unsecured and partly secured debits in margin accounts, dividends and bond interest receivable, accounts receivable from other brokers, tax refund claims and insurance claims. The Exchange, throughout the period in question, allowed full credit for all receivables up to thirty days old and, in various cases, allowed full credit for receivables due for an even longer period of time. Once again, under the 20:1 ratio test, by permitting firms to claim millions of dollars more in good capital on account of unsecured receivables, the Exchange was allowing them to carry substantial amounts of indebtedness.

(4) Credit for unmarketable securities.-Under both the Commission's net capital rule and the Exchange's, firms are supposed to exclude from their net capital the value of securities which are not readily marketable. A lack of ready marketability may be due either to legal or contractual restrictions upon resale, or to the size of the position in comparison to the depth of the market. At certain firms, however, credit was given for such non-liquid securities positions. This was particularly the case where the securities stood as collateral for demand notes contributed by lenders. Unfortunately, the notes were so worded as to preclude the firms from realizing upon them in cash, and when they went to sell the securities, they found that their value had shrunk or that the securities were unsaleable.

There were a number of other differences between the two principal net capital rules. At some firms, these differences amounted to millions of dollars, which was significant under the 20:1 test. Among the items were: Clearinghouse deposits the Exchange allowed firms to take full credit for monies on deposits with securities clearinghouses, which the firms could withdraw only if they ceased doing business; commercial paper-the Exchange did not require its member to "haircut" positions of commercial; short security positions-where a firm's trading or investment account was a short security, the Commission required that a 30% haircut be applied (the same as to a long position) but the Exchange did not in effect require any haircuts on shorts; equity in subsidiary corporations the Exchange allowed credit for net capital of certain subsidiaries, whereas the Commission did not.

Because of the above noted differences the Commission made various recommendations for changes in the NYSE net capital rule. In July 1971, following conferences between representatives of the Exchange and the Commission the NYSE as an initial step adopted major changes in its net capital rule.

Among the more significant changes were the following:

(1) Temporary Capital.-The NYSE net capital rule now requires both debt and proprietary capital to be locked-in for a minimum of one 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 12:1 or violation of the Exchange's net capital dollar requirements.

(2) Short Stock Record Differences.-The Exchange will now charge in full short stock record differences after 45 days. Thus, it has returned to its earlier practice previous to May 1969 of making full deductions of short stock record differences when computing net capital.

(3) Security Haircuts; Unmarketable Securities.-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.

An extra haircut on portions of undue securities concentrations also was added to the rule. An undue concentration under the Exchange rule exists when the market value of securities of a single issuer in the proprietary account of the firm exceeds 15% of "tentative net capital," i.e., net capital before reduction for haircuts.

Also under the new rule haircuts as high as 100% (instead of the prior 30%) are imposed on certain stocks not meeting specified standards. In the past the Exchange applied no haircut on commercial paper. The new proposal now calls for haircuts ranging from a standard %% to 30% in certain cases where the commercial paper is not covered by the ratings of recognized financial services. (4) Net Capital Ratio Changes.-The Exchange has decreased the maximum permissible capital ratio from 2,000% to 1,500%. The minimum dollar capital requirement for member firms which carry customer accounts has been raised from $50,000 to $100,000. The minimum dollar capital requirement for member firms which introduced customer accounts on a fully disclosed basis has been raised from $25,000 to $50,000.

Member firms also are 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 changes have delayed effective dates depending upon the receipt of a favorable tax ruling of the IRS.

The Commission's rule currently provides for a minimum capital requirement of $5,000, except in certain cases, and a capital ratio of 20 to 1. The Commission 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 also be mentioned that the recently promulgated Rule 17a-11 under the Exchange Act will result in far better detection and monitoring of firms with capital problems. This rule requires an immediate report from any firm in capital violation and also requires detailed monthly reports from firms whose net capital ratio exceeds 1,200% and firms whose books and records are not current. (d) The question of exemption from the Commission's net capital rule

The question of removing the exemption of members of national securities exchanges from the Commission's net capital rule 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 Fund of the NYSE, the Commission's primary efforts were directed to strengthening the net capital rule of the NYSE. As noted, 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 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.

ITEM 2

(a) The relationship of debt to equity in broker-dealer capital

Brokerage firms until recently have taken the partnership or close corporation form of organization. As such, they have been severely restricted in their sources of financing and have relied to a great extent upon customers' funds and securities for working capital. The trend to incorporation was the result of the Ira Haupt collapse in 1963, which demonstrated the personal vulnerability of partners to their firm's problems. Still, incorporation did not bring with it better capitalization. Until March 1970, NYSE 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 monies they needed by other means.

Due to an excessive use of leverage, limited only by the tax regulations, which penalize "thin" capitalization, firms frequently had a top heavy debt structure which hurt them at a time when profits fell. What was especially unfortunate was that much of the debt capital was in a form that did not furnish the firms with actual cash working capital. Instead of the debt taking the form of subordinated debentures, it took the form of subordinated accounts or secured demand notes. 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, the secured demand notes could not be presented for payment, but rather only the collateral could be realized upon.

Firms were willing to pay interest on subordinated accounts and secured demand notes, even though they provided no working capital, because full credit was given for such "capital" under the Exchange's net capital rule. Recent revisions in the Exchange's net capital rule 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 the secured demand note.

Under the net capital rule of the NYSE, a member corporation (but not partnerships) has to have a least 25% of its total capital in the form of equity. During the crisis period, this requirement was not strictly enforced. Where the corporation is publicly owned, at least 50% of total capital must be in the form of equity.

(b) The effect on broker-dealer solvency of the investment of capital in securitiesparticularly speculative securities

To the extent that broker-dealers invest working capital in securities positions, they become more heavily dependent upon the use of customers' 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. At the same time that prices are falling, liquidity may decline, so that large positions which previously could have been sold within a short period of time become unsaleable at anything like their apparent market value. Where the monies used in firm investing have been supplied by customers via free credit balances, there is an obvious danger that the firm will become illiquid and unable to repay customers' cash and/or redeem customers' securities from liens.

To some extent, the danger from market fluctuations is minimized by the policy of "haircutting" securities positions in computing net capital. However, firms show a marked reluctance to sell out firm positions at a loss, so they may resort to increased use of customers' funds at a time when they should be cutting back on their own investments. Further, the "haircut" may not be sufficient to compensate for market decline, as where a security is suspended from trading by an exchange or the Commission. In such cases a security which previously was given 70% credit may become worthless overnight. It is only prudent that a firm refrain from utilizing any customers' assets for its own speculative purposes.

ITEM 3

(a) What are the current restrictions in the use of customers' funds?

There are at present no restrictions upon the use by brokers of their customers free credit balances or other "cash equities," i.e., credit balances which customers cannot freely withdraw, other than a requirement that customers be informed that their funds are not segregated and may be used in the business. 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. (b) and (c) Does the protection of the investing public require that broker-dealers segregate customers' credit balances and cash equities? If segregation is not required in the public interest, are the maintenace of reserves, as required by the SIPC amendments to the Securities Exchange Act, sufficient protection for public investors?

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% reserve against, or complete escrow of, all credit balances, just

67-228-71-pt. 2-2

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 (e.g., 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.

One formula which we have been considering for the establishment of a reserve lumps together in a pool customers' free credit balances, monies gained by hypothecating customers' margin securities, and monies gained by lending customers' margin securities to other brokers (a 100% cash deposit is required of the borrowing broker). From this pool, monies could be deducted to finance the net debit balances (i.e., monies owed the broker) in customers' fully secured margin accounts, and to finance borrowings of securities necessary to complete customers' short sales. Any excess monies would have to be escrowed in bank deposits or U.S. Government securities. Various other items could be worked into the formula, but at least those previously mentioned must be taken into account. A minimum percentage reserve also might be considered, for firms which would not have to escrow funds under the formula approach. In the event this approach were followed, consideration would have to be given to minimizing exposure by preventing undue concentrations in particular securities in customers' margin accounts. It should be mentioned that this approach, or indeed 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 outlined in response to the next question). Since cash is fungible, it would be unreasonable to restrict the use of free credit balances, or monies gained by hypothecating or lending margin securities, while at the same time allowing brokers to use freely monies received on account of fully paid transactions which did not settle on settlement date.

ITEM 4

(a) Does the protection of the investing public require that broker-dealers 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 relaim 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 customer's 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 with respect to cash customers determining that a particular manner of holding such customers' property is sufficiently identifiable to permit the Trustee to return such property to the cash customers upon a liquidation.

(b) What are the current restrictions in this area?

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; NYSE Rule 402; and Section 19 of the NASD's Rules of Fair Practice. The restrictions in the Exchange Act of hypothecating customers' securities were designed to prevent brokers from overextending themselves by pledging customers' securities for bank loans. The chief effect of the

prohibitions 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 NYSE Rule 402 and Section 19 of the NASD's 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% of the customer's debit balance may be hypothecated and/or loaned. Segregation is required for securities in excess of the 140% amount, i.e., excess margin securities, and for securities which are fully paid.

(c) 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 fullypaid 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. Mr. Gilleran?

Mr. GILLERAN. Thank you, Mr. Chairman. I hope I am solvent after this effort.

Mr. POLLACK. I hope that will reduce my deficit by that amount. STATEMENT OF EDWARD R. GILLERAN, VICE PRESIDENT, REGULATION, NATIONAL ASSOCIATION OF SECURITIES DEALERS, INC.

Mr. GILLERAN. This is a capsule summary of the association's written response to the questions posed by the subcommittee. The written response was forwarded under date of September 1, 1971. To begin with, we view the purpose of the net capital rule as providing standards of financial responsibility for broker-dealer in order that public investors might be safeguarded.

The basic concept of such a rule is liquidity, its object being to require broker or dealer to have at all times sufficient liquid assets to cover indebtedness.

We supplied the subcommittee with various methods by which net capital is computed. This was identified as exhibit A and included a simple trial balance supporting schedules, worksheets, and a balance sheet.

I might add here that under the proposed NASD capital rule, the basic approach of computation would be very much the same. Some of the specific items would be different, of course.

The capital structure of our member firms has been of great concern to the association and, accordingly, the association's Committee on