indicated that had this been an actual requirement during the period February through March 1971, a total of more than 1,000 non-exchange members of this Association would have had to establish cash reserves of approximately 75% of the total free credit balances they then held. This seemingly large reserve requirement is caused by the fact that these members do not carry margin accounts. Consequently, they do not carry the large customer's debit balances which, under the exchanges' proposal, can be applied against free credit balances in determining the amount of customers' funds held on deposit that must be reserved. For these members, such reserves would have amounted to approximately 35% of their combined net capital. Therefore, although we agree in principle with the proposal of the two exchanges, we do not believe that it would be in the public interest to subject these firms to a reserve requirement of this magnitude without first exploring alternative possibilities for a graduated implementation schedule. SEC Rules 8c-1 and 15c2-1 under the Securities Exchange Act of 1934 govern hypothecation, the pledging of customers' securities as collateral for loans by brokers and dealers. The rules apply to substantially all registered brokers and dealers and members of national securities exchanges. The rules, in effect, are identical in scope and context, so compliance with one will automatically constitute compliance with the other, and vice versa. Subject to certain exemptions, the the rules specify three general prohibitions which brokers and dealers must observe in regard to the hypothecation of their customers' securities. In effect, a broker or dealer may not hypothecate or pledge securities carried for the account of his customers in such a way as to permit the securities of one customer to be commingled with the securities of other customers unless he first obtains the written consent of each such customer. Therefore, if a broker-dealer wishes to commingle securities carried for the account of different customers under the lien of a single pledge, he must first obtain the written consent of each such customer to such commingling. If, however, a customer's purchase order is a bona fide cash transaction and not one which takes place in a margin account, a brokerdealer may avoid the necessity of securing prior consent to commingle if, at or before the completion of the transaction, he gives or sends to such customer a written notice disclosing the fact that the securities are or may be hypothecated under circumstances that will permit the commingling thereof with securities of other customers. This written notice is included on the confirmation furnished to the customer. Such notice is referred to as a hypothecation legend. In addition, these rules prohibit a broker or dealer from hypothecating or pledging securities carried for the account of his customers under a lien for a loan made to the broker or dealer in such a way as will permit such securities to be commingled with the securities of any person other than a bona fide customer. This provision is primarily designed to prevent a broker-dealer from pledging his customers' securities and his own securities to secure the same loan. There are two exemptions to this rule. One exempts any lien of a clearing corporation or similar department of a national securities exchange for a loan made and to be repaid on the same calendar day if it is incident to the clearing either of securities or of loans through the clearing house. The second exemption permits pledges, whether banks or others, to have what may be referred to as a "one way lien" against the broker-dealer's own securities as additional collateral for loans made against customers' securities. The rules further prohibit a broker-dealer from hypothecating securities carried for the account of his customers in such a way as to permit the liens or claims of pledges thereon to exceed the aggregate indebtedness of all such customers in respect of securities carried for their account. Therefore, a broker-dealer may not pledge customers' securities for a sum which, in the aggregate, is greater than the total amount that his customers owe him on securities carried for their accounts. The rule is not violated, however, by reason of an excess arising on any day through the reduction of the aggregate indebtedness of customers on such day, provided that, funds or securities in an amount sufficient to eliminate such excess are paid or placed in transfer to pledgees as promptly as possible by the broker-dealer toeliminate such temporary excess. In addition to the above described requirements of the Commission's hypothecation rules, NASD members are subject to the provisions of Section 19 of Article III of the Association's Rules of Fair Practice which also applies to the pledging. and the lending of customers' securities. Under this section a member or a person associated with a member is prohibited from making improper use of a customers' securities or funds. Furthermore, he is required to obtain a lending authorization in addition to a margin account agreement before lending either to himself or others securities carried for the account of any customer. This provision also sets limitations upon the amount of a customer's securities which may be loaned or pledged regardless of any agreement between the member and his customer. The rule also provides that no member shall lend or pledge more of a customer's securities than is fair and reasonable in view of the indebtedness of the customer, except that under a separate lending authorization from the customer designating the particular securities to be loaned, a member can lend a customer's securities which have been fully paid for or are in excess of his indebtedness. It should be noted, however, that there are no circumstances under which a broker-dealer can pledge a customer's fully paid or excess margin securities. The Association's rule also obligates a member to segregate and identify by customer both fully paid securities and securities held in margin accounts which are in excess of the amount which may be pledged under the "fair and reasonable" standard referred to above. An extract of Section 19 of Article III of the Association's Rules of Fair Practice is attached as Exhibit "D." We do not believe that either the escrowing of fully-paid or excess margin securities or the creation of new, more elaborate rules in this general area is necessary since the existing rules, which we have discussed, now provide the protection necessary for the investing public. Quite clearly, a broker-dealer cannot use customers' fully-paid or excess margin securities for any purpose, except such lending as described above, and still be in compliance with the present requirements. We, therefore, feel that the problems surrounding the improper use of customers' securities is not a question of deficiencies in the existing rules but rather a failure on the part of a number of broker-dealers to establish procedures and to maintain current and accurate records which properly account for the location and ownership of customers' securities. We firmly believe that the SEC's newly adopted rule 17a-11, which requires reports of financial and operational condition, proposed rule 17a-13, which will require quarterly security counts, and increased financial responsibility standards, as proposed in the NASD net capital rule, are the best means for improving the protection afforded customers' fund and securities. We fully recognize, too, that the surveillance activities of the Association and other regulatory agencies in these crucial areas must be stepped up to insure across-the-board compliance by firms in our industry. EXHIBIT A BERKELSHE & Co., INC.-COMPILATION OF NET CAPITAL UNDER SEC Mechanical method I: Total assets__ Less total liabilities. Capital___. Less total other assets_ Current capital (deficit).. 30 percent long and short position... Adjusted net capital (deficiency). Capital required to meet 20:1 ratio_ Total net capital (deficiency). Additional capital required for $5,000 minimum require ments.. Mechanical method II: Current assets.. Less total liabilities.... Current capital (deficit) _ _ _ 30 percent long and short position____ (32, 028. 75) (B) 3, 382. 50 (35, 411. 25) 37, 028. 75 32, 962. 50 Current capital (deficit)--- Less 30 percent long and short position--- Adjusted net capital (deficiency). Capital required to meet 20:1 ratio_ Total net capital (deficiency). Additional capital required for $5,000 minimum require 37, 950. 00 (4, 987. 50) (A) 27, 041. 25 32, 028. 75 (B) 3, 382. 50 (35, 411. 25) |