The current system does not adequately insure these two conditions, and the failure to alter the system will expose the customer to a repetition of the losses sustained in the market collapse in 1969.

EXISTING LIMITATIONS ON FREE CREDITS AND SECURITIES IN THE POSSESSION OF BROKERS

The basic provisions which control the use of customers' free, excess margin, and margin securities are § 8(c) of the Securities Exchange Act of 1934 and rule 402 of the New York Stock Exchange. Section 8(c)3 reads in part as follows: "It shall be unlawful for any member of a national securities exchange or any broker or dealer who transacts business through the medium of any such member, directly or indirectly—

(c) In contravention of such rules and regulations as the Commission shall prescribe for the protection of investors to hypothecate or arrange for the hypothecation of any securities carried for the account of any customer under circumstances (3) that will permit such securities to be hypothe

cated, or subjected to any lien or claim or the pledgee, for a sum in excess of the aggregate indebtedness of such customers for such securities." Under this provision and the Commission's implementing rules, the broker can pledge a customer's securities only if he has loaned the customer money on those specific securities; and the broker may only borrow from the pledgee of his customer's securities an amount which is no larger than the amount he lent his customer. A broker's bank loan which is collateralized by the pledged securities of his customers should never be larger than the amount the broker would receive from a 100 percent margin call on all his customers.

On its face section 8(c)(3) does not limit the amount of securities which can be pledged as long as the broker has extended some credit to the customer on them, but rule 402 limits the amount of stock which may be pledged:

"With respect to the segregation of customer's securities representing excess margin as required under rule 402(a), a member organization should segregate that portion of the stocks in the customer's account having a market value in excess of 140 percent of the debit balance therein." [New York Stock Exchange Rule 402.70.]

Thus, the broker may hypothecate only those securities on which he has lent money to the customer (§ 8) and of those securities may hypothecate only an amount whose value is no more than 140 percent of the amount of money the customer owes the broker (rule 402).

The remainder of the customer's securities are segregated from the hypothecated securities. However, from day to day the customer may increase or decrease his margin indebtedness by further transactions and at the same time his margin status may change because of the fluctuation of market prices. For example, if the value of a customer's hypothecated securities on Monday equals 140 percent of his indebtedness to the broker, the appropriate provisions are satisfied; if the securities double in market value by the close of business on Tuesday, they will equal 280 percent of the indebtedness. To handle this situation the broker must: (a) determine the indebtedness of the customer to the firm; (b) determine which securities are in bank loan for each customer;

(c) value the securities at the close of business;

(d) compare the value with the customer's indebtness; and

(e) withdraw from bank loan a sufficient amount of securities to reduce the value of hypothecated securities to 140 percent of the customer's debit balance.

All of this requires accurate books and records, an ability to handle vast quantities of specific data in a short period of time, and a staff to accomplish the results as soon as they are determined.3 For the broker with more than one branch

? The use of customers' securities for stock loan is governed by § 8(d) of the Securities Exchange Act of 1934, which requires the broker to have the written consent of the customer to loan his securities but which places no dollar or other limit on the amount of stock a broker can loan. Under the present system, the regulation of hypothecation in bank loan under § 8(e) and stock loan under § 8(d) is totally unrelated. To insure the continuing financial capacity of a broker these separate limitations could be combined to preclude the broker from obtaining a total amount of money through bank loan and stock loan combined in an amount greater than the margin debit of the broker's customers.

Rule 8e-1(3), which regulates hypothecation of customers' securities, recognizes that any adjustments of the securities in "bank loan," ie., pledged to secure amounts equal to customers' debit balances, cannot be made contemporaneously with the transaction which causes the need for adjustment. The proviso permits the adjustment of securities in bank loan on the next banking day after the events requiring the substitution. Contrary to recent charges against the industry the broker may not use customers' securities for his own business and his own borrowings if he does not have specific permission.

office or a large number of customers, this would be impossible if the tasks were performed separately for each account; and they are not done that way. In fact, the valuations necessary to satisfy the 140-percent requirement are made in the aggregate, for example, the broker determines that he has loaned a total amount of money on various securities to all his customers and then takes whatever steps are necessary to assure that the securities in bank loan are worth no more than 140 percent of the amount. He makes no effort to relate specific shares of ABC Corp. to specific customers and specific debits, the ownership of the securities of each issuer being treated as if it were fungible. This is only possible if the broker maintains his customers' free and excess margin securities in fungible condition by use of "bulk segregation" rather than "individual segregation."

The specific terms of rule 402 prescribe a system for individual segregation of securities by customer, that is, each customer's securities are held separately from the securities of all other customers. No efficient brokers use this system. Instead, they rely on the following part of rule 402:

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. [New York Stock Exchange rule 402.90.j" +

In a bulk segregation system used under this provision, the broker holds all securities of a particular issuer in one location and in his records indicates the right of each separate customer to a specific number of shares of the total amount. Certain of the securities shown on the brokers records for a bulk segregation location may not even be physically on hand.

For example, after satisfying all of his substitution requirements for hypothecation of customer's securities, the broker has 10 customers who each own 100 shares of ABC Corp. Two of the customers have recently purchased and paid for their shares but the selling broker has not yet delivered them. These 200 shares are in "fail to receive." The broker has also recently received 200 shares in negotiable form but not in the broker's street name, and these shares have been sent to the transfer agent. In his books and records the broker will show each of the 10 customers by name and account with a holding of 100 shares of ABC Corp. The broker will also show other entries on his books for free and excess margin securities: "

One customer then orders the sale of 100 shares and another instructs the broker to transfer 100 shares to his own name and ship them to him. Under a system of individual segregation the broker could do this only if the shares belonging to each of these two customers were on hand in the customer's folder and were not in "fail to receive" or "transfer." Under the bulk segregation system the broker first determines from his customers' records whether each of the customers has a claim for 100 shares of ABC Corp., and then complies with both instructions

If the customer desires, he can always leave his securities in the possession of his broker for "safekeeping," the broker holding the securities in the name of the customer rather than in street name. These securities are specifically identifiable within the meaning of the Bankruptey Act and the Securities Investor Protective Act. The customer always has the right to require this. The broker carries a customer's securities in street name in bulk segregation only if the customer has not given him other instructions.

Bulk segregation has two parts: a bookkeeping location and a physical location. The total figure shown for bulk segregation is a bookkeeping location which assists the broker in accounting for all securities against which his customers have claims. The physical bulk segregation location permits the broker to make immediate deliveries and take other operational actions in compliance with his customer's instructions.

The bookkeeping entries in bulk segregation vary from firm to firm and are limited only by "generally accepted accounting principles." In these entries some firms include "customer shorts," e.g., securities which the customer has instructed the broker to sell but has not yet delivered to the broker. A number of the bulk segregation locations are shown in the answer to question 6G on the required financial questionnaire. The Securities and Exchange Commission has apparently treated this part of the financial questionnaire as if its content were required by a precise rule, but its content reflects the bookkeeping entries and is only limited by "generally accepted accounting principles." It, too, varies from firm to firm.

Securities delivered to the firm from Stock Clearing Corp. provide the best example of the impossibility of using specific identification. At the end of each day SCC determines the firm's total purchases and sales on that day in each security. It then nets these two figures for each security. If the firm had more purchases than Sales, SCC will direct another firm with a balance of sales to deliver the securities to the first firm. The delivering firm may not have been a party to any of the first firm's transactions on the floor of the exchange. These securities are then placed in bulk segregation. Any allocation of them to the account of particular customers would be purely arbitrary.

67-228-71-pt. 2-16

immediately by using 200 of the 600 shares in the box. He will adjust his records as follows:

This system gives the broker maximum flexibility to meet his daily obligations to his customers and to other brokers, while the limitation on hypothecation keeps his bank loans to a minimum, but permits him to assist the customer in financing margin transactions. At the same time all of this requires a significant amount of recordkeeping and securities movement. For the customers' free and excess margin securities, the broker using bulk segregation has the maximum flexibility with the least amount of recordkeeping and specific handling of securities. The fungibility concept, both in hypothecation and in securities on hand (in the box), permits the least physical movement of securities consistent with the current regulatory requirements, a goal being sought by everyone in the industry.

BUSINESS REQUIREMENTS OF THE BROKER

The present securities markets require that the broker be able to locate and deliver free credits and free securities immediately upon the direction of his customer. To do this the broker must identify the specific transaction which was performed on behalf of those customers and which resulted in the credits and securities due the customer. This will permit the broker to determine that he has an obligation to perform the customer's instruction. The broker must then locate the cash or securities necessary to comply with the instruction and dispose of them as the customer directs.

A broker whose business is limited to institutional clients or at least to few members of the public can perform all of these acts separately for each customer and can have separate depositories for each customer's securities. For the larger firm this would be unfeasible at best and impossible at worst.

In a firm using bulk segregation the transactions which result in a securities and cash position for the customer can always be specifically identified, thus permitting the broker to recognize his obligations to the customer. But the proceeds of the transactions and the securities involved in them are not specifically identified to a customer after the transaction has been recorded within the firm. Both cash and securities become fungible; and the broker uses them to meet the obligations he has incurred for all of his customers, the cash becoming part of the firm's "float" and the securities going into the "one box system." This is a delicately balanced system whose complexity the industry constantly tries to reduce. To avoid unbalancing this mechanism any measures intended to insure the safety of customers' free credits and securities must not unduly impinge on:

(a) The ability of the firm to meet its financial obligations by making payments to customers and other brokers; or

(b) the ability of the firm to meet its operational requirements by properly recording the customers' transactions and by delivering, handling, and receiving securities on a current basis.

The safety imposed on customers' securities by any revision of the regulatory scheme must be balanced against the effect of the proposed system on the operational viability of the broker. For example, recent restrictions on the withdrawal of subordinated capital will deter many former and potential subordinated lenders from participating in the securities industry, thus diminishing the supply of money available to brokers for capital. If free credits are withdrawn from the broker's cash "float," the money available to the broker for performance of his customers' instructions will be further reduced and would have to be replaced through borrowings, which would generally increase the broker's cost of doing business and the price to the public. This added cost should be weighed against any system which requires the broker to replace this cash.

A revision must select between a system which directly inhibits the use of free credits and securities while generally ignoring the condition of the broker or a system which generally ignores the use of securities and free credits but assures the viability of the entity which handles them.

THE PRINCIPAL CAUSES OF THE COLLAPSES

The recent collapses stemmned in large measure from the inability of brokers to meet their obligations while the market was suffering extraordinary increases in volume and wide price fluctuations. The large increases in volume impaired the operational fitness of many firms while the radical price fluctuations impaired their ability to meet financial obligations. As a result they became unable to satisfy their daily commitments to customers and to other brokers for both cash and securities. Changes in market condition will specifically affect the ability of a broker to function as follows:

(a) Volume fluctuations-a change in volume will require the broker to handle a larger number of orders, record a larger number of transactions, make more and more complicated valuations for credit relations with customers, make larger and more complicated substitutions of securities in bank loan, and generally assume much larger bookkeeping and physical handling burdens. As the bookkeeping burdens increase, the time consumed in directing the movement of securities increases; and as the volume of deliveries increases, the physical movement is slowed even more.

(b) Price fluctuations-failure of the broker to satisfy his operational commitments places each uncompleted transaction at the risk of the market. In a stable market this is inconsequential, but in a fluctuating market this impairs the financial stability of the broker. As the operational capacity of the firm declines and the market level moves away from the unfulfilled commitments, the broker is exposed to increasing financial losses on transactions which it is physically unable to consummate.

However, the collapse of a particular broker cannot be foreseen by analyzing volume and price changes of the market. At any time that the broker has business burdens which strain his financial and operational capabilities to the limit, a slight change in volume or price will topple him. His ability to withstand a change in the market condition will depend on the relationship between the market change and his capacity to absorb the change. Because changes in price and volume will affect some firms but have no effect on others, any evaluation of the condition of a specific firm must determine the ability of that particular firm to perform under the existing conditions. The adverse effect caused by changed market conditions can only be detected by a subjective analysis of the internal capacity of the specific firm based on current figures produced by that firm.

The best system for the protection of customers' free credits and securities will (1) insure the operational and financial fitness of the firm and (2) place the customers' accounts with another entity when the firm shows signs of operational or financial failure. To do this the system should require specified tests which would permit an objective examiner to determine whether or not a firm is approaching operational or financial inability to meet commitments.

THE CURRENT REGULATORY METHODS FOR DETECTING A BROKER'S COLLAPSE The current regulatory scheme requires various periodic reports, periodic inspections, surprise audits, and minimum standards for books and records. These make detection of incipient weakness possible but not probable. In addition, these requirements are not the same for members of national securities exchanges and nonmembers; and they receive different levels of attention.

To determine whether or not a broker is operationally and financially fit, the criteria under the present system require the exercise of judgment followed by the exercise of authority. An objective analysis of the documents and other information produced under these requirements was probably sufficient to detect at an early stage the failure of many of the firms which later collapsed in hopeless confusion, but the persons and institutions with the power to prevent these events were not prepared for the drastic steps which were necessary.

• Recent changes in rules governing fails to receive require buy-ins within a limited time, i.e., a new transaction in which the security is purchased from a different broker in order to cover the fail to receive; but it places no dollar limit on the fail to receive. Losses sustained from buy-ins will undoubtedly be lessened by the limitation on the period of time that a fail to receive may remain open; but the rule changes do not eliminate the direct loss of capital sustained by a firm which is forced to buy in a security at a higher price or the loss sustained by the firm charged with a buy-in on a security which it has failed to deliver.

For the firm whose difficulties are detected very early, the reduction of business might produce manageable conditions. Reductions could be accomplished, for example, by transferring all accounts of several branches to the control of a sound entity.

In sum, the current methods, personnel, and institutions will only detect a firm whose financial and operational capacity has declined so far that continuous operation of its customers' accounts is no longer possible, thus placing the accounts at the risk of the market until the records can be deciphered.

THE PRESENT REMEDIES AVAILABLE AT THE COLLAPSE OF A BROKER

Under the present conditions, the firm whose financial and operational condition has deteriorated to the extent that it should not continue has two choices: continuation in a new form through merger, sale of assets, or infusion of new capital; and termination of the existence through liquidation, receivership, bankruptcy under section 60(e), or dissolution in the hands of the Securities Investor Protection Corp. (SIPC).

Continuation in business: If the firm elects to continue in business in another form through merger, it must find a willing partner, but no solvent firm will assume the burdens and liabilities of a firm in a state of operational and financial decrepitude unless the assumption is protected by external guarantees.10 This will impose additional burdens and obligations on other brokers or securities exchanges. Sale of assets will also usually be unsuccessful unless the firm is a going concern; but if the broker is still operational, it will usually not voluntarily end its independent existence unless compelled by external factors." If the firm elects to continue by infusion of new capital, obligations will again be imposed on external entities as a condition by the parties producing the new capital.12

Liquidation is the best alternative if the firm is to be terminated, but requires a decision to liquidate at a sufficiently early stage to allow a satisfactory payment to all creditors. If the liquidation begins too late in the collapse, creditors who will take less in liquidation than they would under another procedure will force distribution of the assets under another procedure.14

Receivership, whether State or Federal, must be established by court order, although the broker entering receivership can consent to the order. The conduct of the receiver is governed by the law under which he was appointed. Because he usually does not prefer one group of creditors over others, he does nothing which particularly protects the customer, who shares in distributions along with other noncustomer creditors and whose account continues at the risk of the market while the receiver marshals the debtor's assets and deciphers his books. In addition, receivers are personally liable for wrongful acts during their receivership, an exposure which induces the slowest and most methodical handling of the broker's accounts and obligations.

10 The recent merger of Goodbody & Co. and Merrill Lynch, Pierce, Fenner & Smith, Inc. provides an excellent example of the burdens imposed on the industry by the acquiring firm as a condition for the merger.

Most firms will not voluntarily cease doing business even when their operational and financial capability has been impaired beyond reconstruction; but those firms which have successfully sold their assets to other firms have been more or less operational at the time of the sale; for example, the sale of assets by Winslow, Cohu & Stetson, Inc., to Weis, Voisin, Cannon, Inc.

12 The recent infusion of new capital into duPont Glore Forgan Inc. by a group of private investors headed by H. Ross Perot required substantial commitments by the remainder of the industry as a condition for the Perot group's financial commitment to the firm. In addition, permission for this transaction required exemption of the Perot group from certain of the New York Stock Exchange rules.

13 Winslow, Cohu & Stetson, Inc. sold its assets to Weis, Voisin, Cannon, Inc., and began liquidation of its affairs at a very early stage in its operational difficulties. As a consequence, this firm is being liquidated without financial assistance from any outside sources whatsoever. However, the liquidation was required by an external event which forced the firm to leave the securities industry before it collapsed. The insurer on the firm's fidelity bond terminated its coverage, and the firm was unable to obtain a new fidelity bond from any other carrier. New York Stock Exchange rule 319 requires all member firms to carry a fidelity bond. Winslow, Cohu's inability to replace its canceled coverage forced it to terminate its business and sell its assets. Because this external event occurred early in Winslow, Cohu's operational decline, the firms is being successfully liquidated on its own.

14 In a number of recent instances, firms have entered liquidation, but the proposed plan of liquidation has been unsatisfactory to one or more groups of creditors, most often the subordinated lenders. As a result, the liquidation procedure has been successfully attacked by a particular creditor, and the firm has been thrown into bankruptcy. For example, subordinated lenders were responsible for the ultimate formal bankruptcy of Blair & Co., Inc. In certain other cases, subordinated lenders determined that they would receive more favorable treatment under section 60(e) of the Bankruptcy Act than they would under equity receiverships, and they initiated successful litigations to force the brokers into bankruptcy; for example, In the Matter of Naftalin & Company, Inc., Fed. Sec. L. Rep. ¶ 92, 752 (D. Minn. 1970). The status of these litigations would not be the same under the SIPC legislation, but the motivation of different groups of creditors to seek the procedure most favorable to their interest will remain. It could be avoided if the broker were liquidated early as a going concern.