Capital Standards has developed the new net capital rule for our members which will be presented to our board of governors next week. There are a significant number of differences between proposed NASD rule and the Commission net capital rule, and for the benefit of the subcommittee, these are detailed in exhibit B which is an analysis of the proposed rule and compared with the current and proposed versions of rule 15c3-1 of the SEC.

In this summary, it is not possible to detail all of the differences, but I would like to make certain main points.

The NASD proposal would increase minimum net capital requirements from present $5,000 to $25,000 for that portion of our membership engaged in a general securities business. This is identical to the presently proposed SEC requirement. However, the NASD proposed rule would also increase from $2,500 to $5,000 the minimum net capital required for firms engaged exclusively in the retail distribution of investment company shares. There would also be a separate minimum net capital requirement for market-making firms.

In addition, under our proposal, a minimum equity requirement of 25 percent of total capital would be established. This concept is an attempt to add a degree of permanency to our membership capital structure. Many of the NASD proposals regarding the capital rule directly relate to questions of liquidity and permanence of capital and as such will be discussed later.

Our Committee on Capital Standards has reviewed the questions of exemption from the SEC capital rule for our members and has concluded that our members need not be exempted from the SEC rule despite the fact that our proposals are more comprehensive.

In cases of critical financial condition, the Commission could take action through the courts to enjoin further violations of the capital rule, a power which the NASD lacks.

The subcommittee expressed interest in the different forms of capital which serve as a foundation for broker-dealer indebtedness. Ample liquid and permanent capital has been one of the primary considerations of the association's capital committee. The committee found that improper capital structure and impermanence of both subordinate and equity capital were factors in bringing about the demise of many broker-dealers. As mentioned previously, our proposed rule includes the requirement that members have 25 percent of total capital in equity form. In addition, in an effort to tighten standards regarding subordinated capital, the committee has recommended. that a maximum of 25 percent of total capital may be contributed by outsiders of the firm such as member customers.

The effect of this requirement is to insure that at least 75 percent of total capital is provided by persons who are viewed as insiders under the association's rules. These would be associated persons of the firm and members of their immediate families.

Further, the committee has proposed rigid restrictions on withdrawal of such capital and has significantly increased the required. time period of subordinated loans. Insiders must commit such loans for 4 years and other persons for 2 years. Repayment is, of course, not permitted if such would reduce the net capital of a member below the amount required under the proposed rule.

The subcommittee questioned the effect on broker-dealer solvency on investment of capital in security positions. Under the present

SEC rule the net capital value of subordinated debt may fluctuate with price movements of the securities loaned under a subordination agreement. Our proposed rule would provide that all subordination agreements be drawn for a sum certain; and if securities are used to collateralize these loans the net capital value of such securities shall not be permitted to fall below the face amount of the agreements. The overall effect of this requirement should be to provide stabilization of this portion of a member's capital.

The liquidity of capital should be improved through deductions from net worth of certain percentages of Government obligations, and municipal bonds as well as additional deductions for disproprotionately large inventory positions in securities of a single issuer.

The purposes of these deductions is, of course, to provide capital cushion in the market value of these securities positions.

Regarding broker-dealer usage of customer funds, as Mr. Pollack mentioned, there are no present restrictions. There is, of course, the requirement under SEC rule 15c3-2, that unless a broker-dealer does segregate customers free credit balances, he must have established procedures whereby he will notify customers in writing, at least quarterly, the amount of the balance due, that the funds are not segregated and may be used by the firm in the operation of its business, and that the funds are payable on demand.

In addition, our section 19(a) of the Rules of Fair Practice does prohibit improper use of customers' funds and securities. However, it seems clear that these requirements are not adequate safeguards for the public investor and, therefore, additional restrictions are desirable and necessary.

Recently the New York and American Stock Exchanges prepared a joint proposal to the Commission outlining further restrictions upon the use of customers free credits. The association has reviewed the impact of this proposal upon our membership. More than 1,000 nonexchange members of the association would have had to establish cash reserves of approximately 75 percent of the total free credit balances that they held. This was based on a study of free credit balances during the months of February and March of this year. Because these members do not carry margin accounts, they do not have large customer debit balances which under the exchanges' proposal can be applied against the free credit balances in determining the amount of required reserves. While we certainly agree that additional restrictions are necessary in this respect, we question whether it would be in the public interest to subject these firms to a reserve requirement of 75 percent without first exploring alternative possibilities for graduated implementation of such requirements.

Mr. Pollack has already mentioned the SEC rules regarding hypothecation and has also referred to section 19 of article 3 of the Rules of Fair Practice which governs the lending and pledging of customers' securities by our members. I might say that the section 19 is comparable to New York Stock Exchange rule 402 in this area.

With regard to the question of the use of fully paid or excess margin securities, it would seem that neither escrowing of fully paid or excess margin securities is necessary. We are not convinced that the existing rules with respect to segregation, lending, and pledging of customers' securities, do not provide the basic protection necessary for the investing public. The problems surrounding the improper use of

customers' securities is not so much a question of deficiencies in the existing rules but to a great extent to failures on the part of some firms to maintain accurate records that properly account for the location and ownership of customers' securities.

The SEC's newly adopted rule 17a-11, which requires reports regarding financial and recordkeeping conditions, and proposed SEC rule 17a-13, which would require quarterly security accounts, along with higher capital standards, should provide the bases for improved protection for customers, in this area.

We thank the subcommittee for the opportunity to express our views, and we will be glad to answer any questions.

(The prepared statement follows:)

STATEMENT OF THE NATIONAL ASSOCIATION OF SECURITIES DEALERS, INC., BEFORE THE SUBCOMMITTEE ON COMMERCE AND FINANCE OF THE HOUSE OF REPRESENTATIVES, COMMITTEE ON INTERSTATE AND FOREIGN COMMERCE, SEPTEMBER 1, 1971

In response to the Subcommittee's request that the Association present its views on a series of questions pertaining to net capital requirements, the adequacy, liquidity and performance of capital and the use of customers' funds and securities, we submit the following.

As the Subcommittee is aware, the Association's Committee on Capital Standards is in the final stages of developing a new net capital rule for Association members. The Committee's proposed rule will be submitted to our Board of Governors at their September 1971 meeting. In this connection, it should be noted that certain of the provisions of this new rule are tentative in nature since they must be considered by the Board and thus are subject to possible revision. However, until such time as the Association has its own rule, we shall continue to vigorously enforce the Commission's Net Capital Rule through our field inspection programs and examinations of members quarterly and annual reports of financial condition. We believe that our procedures for determining membership compliance with capital requirements do not differ in any material respect from those of the SEC since the net capital requirements enforced by the Association are those contained in Rule 240.15c3-1 under the Securities Exchange Act of 1934 and because we rely largely upon SEC interpretations of the rule.

We believe that the answer to your question, "What is the purpose of the (net capital) rule?" is best expressed in the SEC's Securities Exchange Act of 1934 Release No. 8024, dated January 18, 1967, "Net Capital Requirements for Brokers and Dealers-Interpretation and Guide," which states that, "Rule 15c3-1 was adopted to provide safeguards for public investors by setting standards of financial responsibility to be met by brokers and dealers. The basic concept of the rule is liquidity, its object being to require a broker or dealer to have at all times sufficient liquid assets to cover his current indebtedness." The Association's proposed rule, which is also founded on a concept of liquidity, has been designed to improve the financial health and stability of the industry through increased broker-dealer financial responsibility standards.

In order to assist the subcommittee in its understanding of how aggregate indebtedness and net capital are computed, we have attached as Exhibit A, an example of a computation of "net capital" pursuant to Rule 15c3-1 as prepared by a hypothetical broker-dealer, "Berkelshe & Co., Inc." This exhibit, which we have used for a number of years in our Examiner Training Course, includes the hypothetical member's trial balance, supporting schedules, worksheets, balance sheet and computation of net capital.

In order to illustrate the basic differences in the Commission's net capital requirements as contrasted with those proposed by the Association, we have prepared the attached comparison between the two rules (Exhibit B). Although the

NASD rule has been constructed with the SEC rule as its foundation, there are a significant number of differences in terms of proposed NASD requirements for which there exists no equivalent counterpart in the Commission rule. As described in Exhibit B, these new areas of financial responsibility include the following: 1. Increased minimum net capital requirements, from $2,500 to $5,000 for firms exclusively engaged in the retail distribution of mutual funds shares and from $5,000 to $25,000 for firms engaged in a general securities business;

2. A separate minimum net capital requirement for market makers of $5,000 or in an amount equal to the cost of one trading unit, whichever is greater, for each security in which a member makes a market, but in no event shall such member have less than $25,000 or be required to maintain more than $100,000;

3. A minimum equity requirement of 25% of total capital;

4. An initial net capital requirement for new members of 120% of the required amount;

5. Additional percentage deductions from net worth of the market value of disproportionately large inventory positions in securities of a single issuer;

6. Percentage deductions from net worth of the market value of both municipal bonds and government obligations;

7. A totally new satisfactory subordination agreement provision which requires that such loans be drawn for a fixed amount in cash;

8. A limitation on the amount of subordinated capital that may be furnished by persons not associated with a member; and

9. Restrictions on the withdrawal of subordinated capital of four years for lenders defined as insiders, and two years for all other persons.

You have also raised the question of exemptions from the Commission's rule. In this connection, it is the view of the Association's Committee on Capital Standards that NASD members should not be exempted from the SEC capital rule despite the fact that the proposed NASD rule is more comprehensive. The reason for this view is that in cases of critical financial condition the SEC can take action through the courts to enjoin further violations of the rule, a capacity which the NASD lacks.

In addressing itself to the question of exemption from the NASD Net Capital Rule, the Committee has further determined to track the Commission's rule by exempting any member who is currently exempted from the provisions of 15c3-1. As you are probably aware, the provisions of the SEC rule do not apply to any member in good standing and subject to the rules of the American, Boston, Midwest, New York, Pacific Coast, Philadelphia-Baltimore-Washington or Pittsburgh Stock Exchanges, on the basis that their rules, settled practices, and regulatory procedures have been determined by the Commission to impose requirements more comprehensive than those under 15c3-1.

In regard to your questions concerning the adequacy, liquidity and permanence of broker-dealer capital, we have attached as Exhibit C the Association's Committee on Capital Standards proposed NASD Net Capital Rule. It should be noted that this new rule deals directly with these questions. During the course of its study of the adequacy of existing financial requirements, the Committee found among other things, that improper capital structure and the impermanence of both subordinated and equity capital were major factors in bringing about the eventual demise of many brokerage firms. Furthermore, the committee found that the current method of computing net capital must be improved in order to insure that such computations will result in a more accurate measure of a firm's true liquidity.

In dealing with the problem of improper capital structure, the Committee has, in the proposed rule, included a wholly new requirement that a member have, as a minimum, 25% of his total capital in the form of equity, as opposed to debt such as subordinated loans, for example. Consequently, at least 25% of a member's capital will be permanent and not withdrawable.

In the area of subordinated capital, the Committee has recommended a maximum of 25% of total capital as an amount that may be contributed by outsiders such as a member's customers. The effect of this requirement is to insure that at least 75% of the total capital of a brokerage firm is provided by persons the

proposed rule defines as insiders. Of the 75% contribution by insiders, at least 3 must be in the form of equity as a result of the aforementioned minimum equity requirement. In order to make subordinated capital more permanent, the Committee has further proposed extremely rigid restrictions on the withdrawal of such capital and has significantly increased the term periods of such loans to four years for insiders and two years for all other persons and longer if the effect of repayment of any such loan would be to reduce the net capital of a member below the amount required under the NASD rule.

Under the present SEC rule, the net capital value of subordinated capital fluctuates in direct relationship to price movement of securities loaned under a "satisfactory subordination agreement." The NASD rule, however, will provide that all subordination agreements be drawn for a sum certain and, if securities are used to collateralize these loans, that the net capital value of such securities (market value less appropriate haircuts) shall not fall below the face amount of the agreements. If such value should fall below the face amount, further deposits or sales of the collateral are required. The overall effect of this requirement is to provide for a stabilization of this portion of a member's capital.

The proposed rule further attempts to improve the liquidity requirements of members through deductions from net worth (total assets minus total liabilities) for Government Obligations, Municipal Bonds and disproportionately large inventory positions in securities of a single issuer. The basis for these deductions from net worth (or haircuts) is an awareness that a member will frequently invest a large portion of his capital in securities. Quite clearly, to be a dealer by definition requires a member to carry inventory positions. The purpose of "haircut" deductions therefore, is to provide a capital cushion for market fluctuations in the value of liquid securities positions carried by a broker-dealer. In the case of securities for which there is no independent market and for securities which cannot be publicly offered and sold because of contractual arrangements or other restrictions, the member receives no value for net capital purposes. Although the proposed NASD rule does not directly classify or differentiate between investment merits or speculative characteristics of securities, we believe that the proposed haircut deduction schedule provides the necessary cushion required to meet problems arising from market fluctuations.

The current restrictions upon the use of customers' funds by broker-dealers are set forth under Rule 240.15c3-2 of the Securities Exchange Act of 1934 and Section 19(a) of the Association's Rules of Fair Practice. Specifically, these rules regulate the use of customer free credit balances. The Commission has defined free credit balances as funds which the customer has an unrestricted right to withdraw. Essentially, Rule 15c3-2 requires a broker-dealer carrying customers' free balances to segregate such balances so as to preclude their use, directly or indirectly, in his business unless he has established procedures whereby he will notify the customer in writing at least quarterly: (1) The amount of the balance due, (2) that the funds are not segregated and may be used by the firm in the operation of its business, and (3) that the funds are payable on demand. If a free credit balance has been carried but is eliminated within any quarter, the notice must still be sent at the end of that quarter, showing that no free credit balance exists as of the statement date. This requirement entails both the maintenance of customer records on a basis which accurately reflects the free credit balances due, and the inclusion of an appropriate legend on customers' statements of account or on a separate form to accompany these statements.

In addition to this Commission Rule, Section 19(a) of the NASD's Rules of Fair Practice requires that "No member or person associated with a member shall make improper use of a customer's securities or funds. An extract of this rule is attached as Exhibit "D."

It is our view that the above mentioned requirements do not provide what we consider to be adequate safeguards for the protection of public investors who maintain funds on deposit with brokers and dealers. We believe that additional restrictions on the use of customers' funds are not only desirable but are indeed necessary. We further believe that the joint proposal of the New York and American Stock Exchanges on "Free Credit Balances and Reserves," which would restrict firms from using customers' funds for such purposes as investment, trading, underwriting, block positioning, etc., represents a major step toward achieving this much needed increased investor protection. It should be noted, however, that a recently completed study of the impact of this proposal on our membership