to the industry. Second, it is a more sensitive and effective means for reaching unethical as distinct from illegal conduct. While self-regulation has contributed to investor protection by the establishment of ethical standards, the report of the special study recommended-and the Commission strongly agrees that the responsibilities of the self-regulatory agencies should be substantially expanded and made more effective in various areas. These recommendations envisage a more important role for self-regulation in establishing standards for investor protection. To be truly effective, these standards must be observed uniformly throughout the industry or there will be a void which could be filled only by Commission action. This is sharply illustrated by the Commission's recommendation in S. 1642 for standards of qualification for those in the securities business, to be established and administered by the self-regulatory agencies. In a qualification system which contemplates the complementary efforts of Government and industry, all groups subject to Government controls should also be subject to industry controls, either through the NASD or through similar organizations. In the light of these considerations, it would not be in the public interest to permit any broker or dealer, at his option, to exempt himself from the structure of self-regulation and its corresponding controls simply by choosing not to join a self-regulatory agency. Accordingly, section 6(a) of the bill would require all brokers and dealers to join such an agency, subject to a power in the Commission to grant exemptions where necessary and appropriate.

At the present time membership in the NASD is primarily based on the economic inducements authorized by section 15A (i) of the Exchange Act that no member shall deal with a nonmember broker or dealer except at the same prices and upon the same terms as such member deals with the public. A practical effect of this provision, and the corresponding NASD bylaw, is that nonmembers cannot obtain underwriting discounts in distributions by members or other possible benefits in trading with them. Consequently, most over-the-counter brokers and dealers find it economically necessary to be members of the NASD. A limited number, however, restrict their operations to retailing directly to the public securities of companies with which they have some association-for example, as the sole underwriter. It is important that this group, which includes retailers of mutual fund shares and real estate securities, be brought within the self-regulatory scheme.

A special study analysis, as of February 28, 1962, indicated that 1,035 of the 5,785 registered brokers and dealers were not members of the NASD. Of these, approximately 40 percent were either new firms who had not yet commenced business or existing firms which had gone out of business but had not withdrawn their registrations. About 9 percent were exchange members who presumably do a very limited over-the-counter business. Approximately 20 percent were engaged primarily in real estate, oil royalties, savings and loan shares, insurance, and the like. Many in the above two categories would probably qualify for exemption under the Commission's rulemaking power. The remaining firms, about 300, would be the principal subjects of this amendment. Some of them, moreover, including certain foreign dealers and investment advisers, might also qualify for exemption.

C. STANDARDS OF QUALIFICATION FOR ENTRY INTO THE BUSINESS

The Exchange Act presently embodies the concept that entry into the securities business or the assumption of any role in that business should be the right of anyone except those guilty of recent securities violations-regardless of fitness, competence, or capability. The report of the special study confirms the Commission's belief that this concept is obsolete and no longer in the public interest. The steady growth in the number of investors, the complex nature of the securities markets, the reliance which the investing public necessarily places upon the competence and character of professionals in those markets: all of these factors militate against continuation of the existing ease of entry and of the lack of qualification standards. These conditions subject the public to undue hazards and unnecessarily complicate the task of regulations.

The hazards are illustrated in an analysis by the special study of violations committed by securities firms. Almost 28 percent of new firms registering with the Commission during the first 3 months of 1961 had no experienced persons among their principals (proprietors, partners, officers, and large stockholders), and over 50 percent of the firms were in the hands of persons with under 2 years of experience. Further examination disclosed that the newest member firms of the NASD, which are generally controlled by persons having less experience than

principals of older firms, were responsible for a heavy preponderance of the offenses drawing the most severe penalties in disciplinary actions. These offenses often appeared to be attributable to their principal's lack of familiarity with the technical and financial aspects of the business.

Certain of the self-regulatory agencies, particularly the New York Stock Exchange, have taken the initiative in this area and established standards of competence, experience, character, and capital. These, however, have only a restricted impact, because of the selective nature of exchange membership. The void in the over-the-counter market has only been partially filled by the NASD. The Commission believes that the self-regulatory agencies, under its supervision, are particularly equipped to develop and administer qualification standards for those in the securities business. Accordingly, it is recommended in section 7(a)(3) of the bill that responsibility be given to the NASD for the establishment of such standards, including those relating to training and experience for its members and their employees, and capital requirements for members. In this manner all persons dealing in over-the-counter securities would have to meet certain basic requirements, which could vary with the responsibilities of the job-thus, branch office managers would have to meet higher tests of experience than salesmen. In establishing criteria, the NASD could adopt appropriate "grandfather" clauses exempting existing members or their employees, either permanently or for a transition period, from some or all of the qualifications required of new entrants. The Commission would have to approve these standards and could change them if in the public interest. At the same time it should be emphasized that no national securities exchange which desires to set standards for its members higher than those prevailing in the over-the-counter market would be prevented or discouraged from doing so.

The Commission believes that the establishment of qualification standards, in conjunction with the requirement of membership in a self-regulatory body, will measurably simplify regulation and improve investor protection. Enactment of these provisions will result in better qualified persons, rather than more policemen. It will most importantly result in a general raising of standards in the over-the-counter market.

As a supplement to strengthening entrance requirements through the medium of the self-regulatory agencies, the Federal bases for disqualification of brokers and dealers would be expanded to a limited extent by section 6(b) of the bill, so as to conform with the provisions recently approved by the Congress in the 1960 amendments to the Investment Advisers Act of 1940. These new disabilities would include not only offenses and injunctions involving securities transactions or the securities business, but would also cover other types of financial offenses which equally reflect upon a person's suitability to handle other people's money. In addition, the bill would make a failure reasonably to supervise employees a basis for disciplinary action against a broker or dealer or supervisor. The Commission has consistently held that brokerage firms have a duty to supervise and on numerous occasions has stressed the necessity for adequte supervision as an essential key to maintaining proper standards. The report of the special study documented the damage that can result to investors from its absence, particularly in the case of a large firm with branch offices scattered throughout the country. The proposed amendment will make this important supervisory responsibility explicit on the face of the statute and set express guidelines for its fulfillment.

D. COMMISSION DISCIPLINARY CONTROLS OVER BROKERS AND DEALERS

The report of the special study pointed out the rigidity and artificiality of the present statutory scheme for disciplining violators, in neither providing for direct action against individual wrongdoers, nor expressly authorizing_useful intermediate sanctions against a firm short of revoking registration. Section 6(b) of the bill would add needed flexibility to the Commission's disciplinary powers to overcome these limitations.

At the present time, if an individual connected with a securities firm violates the law without the approval-or the knowledge of his employer, the Commission can take disciplinary action only by a proceeding against the entire firm. This approach, possibly involving many persons wholly innocent of the violations in question, is awkward and may be unfair. For this reason, individuals may sometimes not be properly disciplined. Accordingly, section 6(b) would permit

the Commission to act directly against offending individuals, where that course is appropriate, in lieu of proceeding against the entire firm. The power of the NASD so to act would also be clarified. Of course, this section would not in any way reduce the responsibility of a firm to supervise its employees-an obligation expressly recognized, as already discussed, in the bill.

Section 6(b) would also provide needed flexibility by authorizing the Commission to impose sanctions intermediate to putting a firm out of business. Short of such revocation, the Commission could temporarily suspend or censure. At present the Commission has only three alteratives: it may revoke registration and expel a firm from any exchange or association of which it is a member; it may, at the other extreme, impose no sanction at all; the only intermediate sanction is a suspension of membership in the NASD or an exchange if the firm happens to be a member. The effectiveness of a suspension from an exchange or the NASD as a meaningful sanction varies considerably in accordance with a firm's business and its reliance for profits upon professional price concessions from members of an exchange or securities association.

Another aspect of present law which dilutes the effectivness of Commission regulation is the exemption from registration for brokers and dealers doing an exclusively intrastate business, even though they use the mails and instrumentalities of interstate commerce to effect purchases and sales. This narrow exemption from registration would be eliminated. It creates a gap in the regulatory pattern for investor protection which would become more striking if all other brokers and dealers are required to become members of self-regulatory bodies. Since these intrastate brokers or dealers are presently subject to the antifraud and financial responsibility sections of the Exchange Act, the Congress has already placed a responsibility upon the Commission to assure that their operations are carried out in compliance with those sections. Registration will provide the Commission with means adequate to discharge that responsibility. Moreover, if the Commission suspends registration for a limited period, a firm should not be able to minimize the impact of this suspension by conducting an exclusively intrastate business during the period specified.

Finally, section 6(b) would dispense with proof of the use of the mails or jurisdictional facilities in the case of Exchange Act violations by federally registered brokers or dealers. This would avoid instances where fraud or other offenses by such firms go unpunished simply because use of these facilities in the particular transaction cannot be shown. It would also obviate the necessity of spending a substantial amount of time and effort in collecting evidence that the mails or facilities of interstate commerce were used in a transaction-an unnecessary waste of taxpayers' money and diversion of the Commission's enforcement resources from more productive tasks in protecting the investing public.

E. AMENDMENTS WITH RESPECT TO REGISTERED SECURITIES ASSOCIATIONS

In addition to those fundamental amendments already discussed which concern the NASD-required membership in a self-regulatory agency and the establishment of qualification standards-the Commission is also recommending a series of proposals designed in a few respects to clarify or strengthen present law with respect to self-regulatory associations.

First, an increasing scope for responsibility by the NASD is reflected in section 7(a) (6) requiring its adoption of rules designed to produce fair and informative quotations of over-the counter securities. The section is intended to clarify the NASD's authority in this area and further to impose upon it a responsibility to act. It is not a resolution of the problems affecting over-the-counter quotations, but a means for dealing with some of these problems.

Second, section 7 (c) would shorten from 60 to 30 days the time for appealing to the Commission from disciplinary action taken by the NASD or its denial of membership. This reduction will expedite Commission review proceedings and still allow ample time for appeals. This section also provides that the Commission may order, after a hearing, that an appeal from an NASD disciplinary action will not stay the judgment of the NASD pending final decision on review by the Commission. At present, an appeal automatically operates as a stay. It is contemplated that this new power to lift the stay would be sparingly employed; however, its use would be proper where an appeal is clearly taken for delay and injury to the public should be prevented pending Commission action.

Finally, under section 7(a) (1), the NASD would be authorized to adopt rules, subject to Commission approval, which would permit exclusion from its membership of persons who have been suspended or expelled from an exchange for violation of any of the exchange's rules. It is anticipated that only serious misconduct of a nature affecting the protection of investors would be grounds for exclusion and any such action would be subject to Commission review. This section would resolve a problem existing primarily between the NASD and the New York Stock Exchange with regard to the collateral effects of the latter's disciplinary proceedings.

In concluding I would again note that S. 1642 is in response to a congressional directive to the Commission to evaluate the adequacies of present investor protection. That directive has produced a searching and intensive inquiry by the Commission's special study of securities markets. It also resulted in a firm conviction on the part of the Commission that the present statutory structure of the securities acts requires improvement in significant respects. The provisions of S. 1642 represents such a strengthening and the Commission strongly recommends its enactment.

(Whereupon, at 2:50 p.m., the hearing was recessed, to reconvene at 10 a.m., Wednesday, June 19, 1963.)

SEC LEGISLATION, 1963

WEDNESDAY, JUNE 19, 1963

U.S. SENATE,

COMMITTEE ON BANKING AND CURRENCY,

SUBCOMMITTEE ON SECURITIES,

Washington, D.C.

The subcommittee met, pursuant to recess, at 10: 12 a.m., Senator Harrison A. Williams, Jr. (chairman of the subcommittee) presiding. Present: Senators Williams and McIntyre. Also present: Senator Dominick.

Senator WILLIAMS. We will call the subcommittee to order and again consider the bill S. 1642. We began our hearings yesterday with the statement of Chairman Cary of the SEC.

We are honored this morning to have as our first witness Mr. Hudson Lemkau of the National Association of Securities Dealers. STATEMENT OF HUDSON B. LEMKAU, VICE CHAIRMAN, BOARD OF GOVERNORS, NATIONAL ASSOCIATION OF SECURITIES DEALERS, INC.; ACCOMPANIED BY AVERY ROCKEFELLER, JR., CHAIRMAN OF THE ADVISORY COMMITTEE TO THE BOARD OF GOVERNORS AND PAST CHAIRMAN OF THE BOARD OF GOVERNORS; A. JACKSON GOODWIN, JR., MEMBER OF BOARD OF GOVERNORS AND CHAIRMAN OF LEGISLATION COMMITTEE; ROBERT W. HAACK, MEMBER OF BOARD OF GOVERNORS AND CHAIRMAN OF NATIONAL BUSINESS CONDUCT COMMITTEE; WALLACE H. FULTON, EXECUTIVE DIRECTOR; AND MARC A. WHITE, GENERAL COUNSEL

Mr. LEMKAU. Mr. Chairman and members of the subcommittee, I am Hudson B. Lemkau of New York City. I am serving as a vice chairman of the Board of Governors of the National Association of Securities Dealers, Inc. The chairman of the board of governors, Merrill M. Cohen of Minneapolis, could not be present as he is hospitalized following a heart attack.

Here with me are Avery Rockefeller, Jr., of New York City, chairman of the advisory committee to the board of governors and past chairman of the board of govermnors; A. Jackson Goodwin, Jr., of Chicago, on the far right, a member of the board of governors and chairman of the association's legislation committee; Robert W. Haack of Milwaukee, on the far left, a member of the board of governors and chairman of the national business conduct committee; Wallace H. Fulton, executive director of the association next to Mr. Goodwin; and on my right, Marc A. White, general counsel.