10-70 Report 193 Rules of Board-Conduct of Accounts Administered by Department of Member Firms. 3699 The "summary card" will enable brokers to determine from day to day the total number of shares segregated. Although the "summary card" illustrated on the previous page provides space for recording the shares to be segregated on the basis of outstanding and unaccomplished instructions such column may be eliminated if the member organization's system does not necessarily require a "To be Segregated" column. The daily entries of amounts will be initialed by the security clerk or a supervisory employee. The "requisition," "removal" and "summary" cards must be kept for a period running back to the date of last answer to the Stock Exchange Financial Questionnaire but at least six months in any event. (See also S. E. C. Regulation § 240.17a-4 [¶ 4584].) IV .60 Securities registered in customers' names not to be put in segregated box. If the above described method of segregation is used, all securities segregated must be registered either in the broker's name, the name of one of its nominees, or "street" names. No securities registered in the names of customers may be put into the segregated box. Each customer whose securities are to be transferred out of his name for the purpose of making such securities usable in the bulk segregation, should be given prompt notice of the transfer of his free or excess margin securities, or his consent in writing to do so obtained. In case a customer refuses to give such consent, or objects to the transfer, such of his securities shall be identified and segregated separately. Note: The above plan would not apply to securities not of a "fungible" nature, such, for example, as callable bonds. Such securities would require separate identification and segregation, as heretofore. (See "Callable Bonds" at .80, below.) .70 Segregation of excess margin securities.-With respect to the segregation of customers' securities representing excess margin as required under Rule 402(a) [¶ 2402], a member organization should segregate that portion of the stocks in a customer's account having a market value in excess of 140% of the debit balance therein. The foregoing applies solely to a customer's account which contains only stocks. When a customer's account contains bonds, the basis upon which the organization is borrowing or can borrow on such bonds should be taken into consideration in determining the amount of securities to be segregated. .80 Callable bonds.-Member organizations which have in their possession or under their control bonds of issues which are callable in part, whether held in safekeeping or otherwise, shall so identify each such bond that their records shall clearly show for whose account it is held. However, this ruling need not be followed in the case of bonds, interest upon which has not been paid for at least two interest periods. In addition, Euro-Dollar bonds deposited in a central clearing facility for Euro-Dollar bonds are exempt from this ruling provided : (a) customers are notified before deposit that their bonds may be deposited in the facility, and (b) customers have the right to withdraw uncalled bonds from the facility at any time. In the event there is any call, in part, of such bonds no so identified, the member organization shall not allocate any such called bonds to any account in which it or its partners or stockholders have an interest until all customers' positions in such bonds have been satisfied. Amended. December 19, 1968. .90 Approval.-Any proposed system devised by a member organization for the segregation of customers' securities in bulk which does not follow the exact procedure above described should be presented to the Department of Member Firms for approval. (By order entered November 16, 1971, the following material was directed to be inserted in the record at this point:) BOARD OF Governors, FEDERAL RESERVE SYSTEM, Washington, D.C., November 2, 1971. Mr. HARVEY A. ROWEN, DEAR MR. ROWEN: Please accept my apologies for having had to delay so long in responding to your letter of September 15, in which you asked for my comments on portions of a statement filed with the Subcommittee on Commerce and Finance by the New York Stock Exchange. Recalling our subsequent telephone conversation, I have particularly directed my attention to the parallels these materials draw between customer credit balances at brokers and demand deposits at commercial banks. It is true that the claim a customer has in the form of a credit balance with a broker/dealer is similar to the claim a depositor has in the form of a demand deposit with a bank. That is, funds are withdrawable without notice and are noninterest-bearing. But this similarity does not, in my view, imply that the brokerage business is analogous to the banking business or that customers' credit balances should be regulated or protected in the same way as demand deposits. The major distinguishing feature, of course, is that broker/dealers are in business to buy and sell securities, not to accept deposits against which loans and investments are made. Equally important, a bank's portfolio is much less susceptible to dramatic swings in value than are the marketable assets of a broker/ dealer. For banks, a substantial proportion of total investments are in the form of Government, Federal agency and State and local marketable obligations, while loans are generally well diversified among the various consumer and business categories and are subject to individual scrutiny (on a sample basis) by examination authorities. For brokers, in contrast, investments are likely to be concentrated in common stocks-often of a speculative and volatile characterand are not subjected to individual review with regard to quality, so far as I know, in the course of brokerage examinations. For this and other reasons, it seems reasonable to me to presume that there is a considerable difference between banks and brokers in the risk exposure of their deposit customers, aside from Federal insurance coverage. Bank capital to protect against that risk, though a small proportion of total liabilities, is long-term and nonwithdrawable, whereas a substantial part of the capital coverage of many broker/dealers may be temporary or withdrawable on fairly short notice. The deposit customers of banks are also a much more diverse group than those of the brokers-where there is a mutuality of interest in security investmentso that the banks are less exposed to a broad and sustained outflow of deposit funds. And if such an outflow does develop, the liquidity position of banks may be bolstered by the conventional practice of borrowing from other banks, and, in the case of member banks, from the Federal Reserve System. Banks, unlike brokers, in sort, have access to a lender of last resort. In view of these differences and considering the serious financial difficulties that have beset a substantial number of brokerage firms in the past few years, I believe that the insulation of customers' funds from brokers' general operation would represent a constructive reform. That insulation could be achieved through 100 per cent reserves and segregation of customers' securities. At the same time, however, the impact of such a change on the capital needs of the brokerage business deserves careful attention. Presumably, the new requirement would need to be phased in over a sufficiently long period to avoid undue pressure on the industry. Also, I would deem it entirely acceptable for reserve funds to be invested in assets other than cash or government securities to the extent that the safety of such assets is assured. The use of customer credit balances to finance secured debit balances of margin customers seems to me quite acceptable as a reserve asset on that score. I want to emphasize that these issues have not been brought to the attention of the Board of Governors. Accordingly, this letter should be taken as representing my own personal views and not those of the Board. Sincerely yours, J. CHARLES PARTEE, Adviser to the Board. Mr. Moss. Now, Mr. Solomon Litt. STATEMENT OF SOLOMON LITT, PARTNER, ASIEL & CO. Mr. LITT. Chairman Moss and gentlemen. I am going to address myself very, very briefly to the first two questions in Mr. Moss' letter of August 18 and that is the net capital rule and ample, liquid and permanent capital. I think the statement of the New York Stock Exchange as presented to you gentlemen through Mr. Stock states very thoroughly the case as it exists today. I thought you might be interested in some of the thinking of the Capital Committee which I chair, on how some of these rules came about. We addressed ourselves to the liquidity of member firms and let me say at the outset that more than a substantial majority of our member firms were never in any danger of any capital problem all through the trying periods of 1969 and 1970. Also, that the rules try to address themselves certainly not fully, certainly need more work, and the committee's report and its adoption by the New York Stock Exchange in my opinion and the opinion of the committee is not the last word and I agree with Mr. Pollack on that, but I think we have taken a giant step in the direction of providing more permanency, more adequacy, and more liquidity and I will touch briefly on those three points. More permanency, in that even before the report was filed with the board of governors for action on their part, we recommended to the administration, and they followed our recommendation, and put through an administrative change about a year ago, which made any new capital contribution subject to 1 year's deposit with 6-month withdrawal. That was done even before the rule was adopted by the board and subsequently was adopted by the board. Adequacy, we tried to answer and I hope we did by a much more realistic ratio, 15 to 1, rather than 20 to 1; there is no magic in these numbers. This ratio is a measure of the liquidity of a member firm. Obviously, 15 to 1 is better than 20 to 1. But with the tremendous increase in members' overhead trying to plan for a business which in its very nature is the most cyclical business in the world since we don't know what our volume is going to be and what our market is going to be like, and we felt members should have a cushion in their capital structures to provide against any surprises. That was the philosophy behind 15 to 1 and you may be interested to know that the exchange ratio was 15 to 1 up to 1953. It was raised at that time from 15 to 1 to 20 to 1. We learned from the experience of those firms that were not able to solve their problems, and many firms were able to solve their problems with the help of the staff of the exchange and some of the members of the surveillance committee of the exchange, that time was a very important criteria. Did we have enough time to help them solve their problem? This was the philosophy behind what I call the accordian provision of our rule. You can't expand if you go above 10 to 1. If you get up to 12 to 1 in the ratio and you are there for 15 days or more, we make you go back to 10 to 1. What was our thinking behind that? If a firm was going to expand, we wanted them to have an adequate capital base. If they expanded without an adequate capital base, we wanted a strong rule that would force them to go down to an adequate capital base. If their problems were so complex and they were losing money, which so many firms unfortunately did, that their net capital was in danger, the difference between 12 to 1 and 15 to 1 gives us time to work out some of these problems. I hope all of that and the experience of the surveillance committee and staff of the New York Stock Exchange justified the bringing in of this recommendation to the Board. Now, the panel is so much more able than I am and I studied accounting many, many years ago, but I don't remember much about it any more, but liquidity can only be just that-liquidity. That sounds a little silly, but it is a fact. What we call liquidity, the Stock Exchange says an asset is a liquid asset if it can be turned into cash within 30 days. This is the hard-core rule we tried to follow in our thinking in our committee, whether it was dividends receivable, commissions receivable, security differences; we recognize that there is an operational problem and we wrote a rule that they should be charged in full after 44 days of their discovery and we also wrote into the rule that they must be for the first time actually posted into the records of the member firms so that they can be kept track of and marked to the market. You can't put them on a sheet of paper and put them in a drawer and lose track of them. Unfortunately, that is one of the things that did happen but we have gotten away from that. We have outlawed the use of letter stock. We have outlawed the use of stock that is not liquid in the figuring of liquidity. We have outlawed the use of "puts" to establish capital value on restricted securities. We have recognized that some firms may want to take large investment positions or large speculative positions in one group of securities or one company. We have said you can do that but you are going to pay capital penalties for that and that is our excess. concentration rule. One thing we wanted to be careful of was that we did not hurt the legitimate marketmaking functions of the market. The specialists, block positioners, marketmakers, the underwriters, and we were particularly careful of that so our rule says that anybody in that category, if they value their inventory on first-in and first-out basis are subject only to the 30-percent haircut rule. I don't want to take up the time of the committee to discuss many of the details. I will be delighted to answer any questions that may come up in respect to this. I am not going to comment on the question of cash segregation and security segregation because there are experts far more qualified than I am to handle that. Thank you, Mr. Chairman. Mr. Moss. Thank you very much. Mr. Edwin P. Fisher, of Arthur Andersen & Co. STATEMENT OF EDWIN P. FISHER, ARTHUR ANDERSEN & CO., MEMBER, COMMITTEE ON STOCK BROKERAGE ACCOUNTING AND AUDITING, AMERICAN INSTITUTE OF CERTIFIFED PUBLIC ACCOUNTANTS Mr. FISHER. Thank you, Mr. Chairman. Five minutes is all I will need for my remarks. I am a partner in the firm of Arthur Andersen & Co., a certified public accounting firm. As such, I have responsibility for my firm's technical competence in auditing in the brokerage industry. I am also a member of the American Institute of Certified Public Accountants, Committee on Stock Brokerage Accounting and Auditing. It was in that capacity that I was invited to appear before this subcommittee. It is my pleasure to do so and I hope that I can make a worthwhile contribution to the proceedings. While the statements in the paper submitted by me were discussed with certain members of the AICPA committee, I think it is only fair to state that the views expressed are largely my own. I think enough has been said already about the purpose of the net capital rules. I don't think any of us would have any basic differing viewpoints on that question. I would just like to state, however, that while the rules are very simple in theory, they can be extremely complex in application. The formal paper which I submitted to the subcommittee illustrates the principles that are involved in a very simple way. I would be. pleased to run through that with you later if you so desire. A few of the differences between the capital rules of the SEC and the New York Stock Exchange were also mentioned in my paper. A plea was made-and I would like to emphasize this-a plea was made for uniformity and consistency of interpretation of the capital rules. If these rules were uniform, clear as to meaning and consistently interpreted, it would not appear to be particularly significant as to who had responsibility for the policing of the rules. That is whether it be the exchange's, NASD, or SEC. The amount and the quality of broker's capital has been a serious issue for quite some time and the weaknesses in certain types of capital structures are well known. Some of these weaknesses pertain to subordinated borrowings which are admissable as capital under the capital rules and which frequently consist of securities which, of course, are subject to market fluctuation. Typically in the past, these agreements could be terminated by the lender on very short notice. Further weaknesses were evidenced in partnership agreements which permitted capital withdrawals and, in the case of corporations, in what I have called the "put option" contained in many corporate charters. These provisions stipulate that stockholders may put their stock to the corporation. That is, require purchase of the stock with, of course, the resulting loss in capital. While recent changes in the capital rules should be very beneficial, there remains in my view, a need for stronger capital structures of a more permanent nature. As has been said, the brokers presently have unrestricted use of the customers' free credit balances. However, since these funds do constitute aggregate indebtedness in the capital computation, they |