In our own review of the position and the problems of the industry; we have emphasized the requirement of service and safety to the investor and of strengthening the firms to serve the investor, and also the coherence and understanding of equality in the relationship between the investor and the industry, and between different segments of the industry; and we believe this calls for very careful review, and perhaps some restructuring. Objectives such as the sufficiency of the securities transfer process, which caused much of the trouble in the period under consideration, the adequacy of disclosure of price and volume in all markets, and the fairness of the marketplace must be sought and attained because, certainly, as we look ahead and see the large capital needs that our country will require and the probability of a growing internationalization of the investment process, there is a need for increasingly broad public participation: That rests on public confidence, and that must be the center of our efforts.

Now, as you know, and as I indicated, my knowledge of the experience in the period under discussion was derived from reading the newspapers during that period of time, and from consultations with my colleagues and the reading of reports since assuming the chairmanship of the Commission some 4 months ago. Mr. Pollack and Mr. Rappaport have submitted a statement which is a very admirable review from our standpoint of the Commission's handling of the problems that were encountered during that period. Perhaps the best contribution I can make would be to indicate very briefly the broad approaches that we are developing and working on to prevent a recurrence of this experience. So I will focus just a few remarks on your question No. 5: "Could the problems such as those that arose during the period 1968 to 1970 be dealt with more successfully today?" And, while not wanting to appear over-sanguine, I have no hesitation in saying that I believe that if these problems were to recur—and our effort must be to prevent their recurring they could be dealt with more successfully today and they are much less likely to recur.

My main reasons for taking this somewhat optimistic outlook are. first, that we have made a significant stride forward in improving the capital position of the industry. The New York Stock Exchange has adopted a new net capital rule which does provide assurance of more adequate capital, more permanent capital, more liquid capital, and less concentration of the available capital in particular issues or particular types of securities While this improved net capital rule is not to be considered the ultimate, it does represent a very significant stride forward and is perhaps as large a stride as could practically be taken in one step.

Second, we are in the process of developing rules requiring reserves for customer cash balances and segregation of customers' securities, which we believe will represent a significant step forward in providing or assuring investors of the safety of their securities.

Third, we are in the process of reviewing and coming up with improved, higher standards for entry into the business, requiring more capital, perhaps a bonding of broker-dealer firms that handle customer accounts, customer securities, and cash; a closer scrutiny of experience and a more rigorous testing; and a showing of greater operational knowledge and operational plans which will give greater assurance

that broker-dealers who serve the public will be competent and organized to provide service on a sound and secure basis.

Lastly, we are also working on a requirement that broker-dealer firms more adequately report to customers their financial standing, their operational needs, perhaps their income, and their standing with the regulatory authorities. We have over the period of 18 months, provided for better reports from broker-dealer firms to the Commission and to other regulatory agencies. This has been a process in which the self-regulatory agencies have collaborated with the Commission in a very impressive series of reports showing operational status and financial status. I will not go into detail on those reports at this point. Mr. Pollack and Mr. Rappaport are more familiar with the details of the reports and that reporting system than I am, but I will say that on September 15, we expect to have effective a new Rule 17a–11 under the Exchange Act, which will require firms in trouble to report by telegram and fill out a very detailed questionnaire on a new form, X-17A-11. This will be a quantum jump in the kind of information that comes into the Commission about the exact status of firms in trouble.

This more detailed reporting and greater frequency of reporting calls for a review of these reports on the part of the Commission; and as these reports are reviewed, occasions for inspections for cause will increase. Part of the continuing program to provide greater protection for the public, in my opinion, has to be a more intensive and a more frequent inspection program. The Commission only has about 30 fulltime inspectors; and in order to carry out a minimal inspection program of inspecting every NASD member every 2 years and every SECO firm-firms regulated only by the Commission-once a year, we would require about another 100 to 110 inspectors. However, an additional, more detailed, more frequent inspection program will almost certainly result in additional requirements of personnel for investigatory work and enforcement activities.

When I became Chairman of the Commission, one of the first things I did was to ask the Office of Management and Budget to collaborate with us in a review of the way the Commission is using its existing personnel-use of its manpower and allocation of that use-and we had a task force of about six men from OMB who worked with the Commission for about 6 to 8 weeks. I am hopeful that during this month we will be able to define our personnel and our money needs so that we will know more surely and be able to ask for the personnel and the budget to perform more adequately our oversight and regulatory function.

And that, Mr. Chairman, is the extent of my introductory statement. Thank you very much.

Mr. Moss. Thank you very much, Mr. Chairman.

The first statement will be that of the panelists from the New York Stock Exchange, and gentlemen, I do not know which one of you is going to act as spokesman in presenting the joint statement.

STATEMENT OF LEE ARNING, SENIOR VICE PRESIDENT, NEW YORK STOCK EXCHANGE; ACCOMPANIED BY DONALD L. CALVIN, VICE PRESIDENT; AND ROBERT BISHOP, DIRECTOR, MEMBER FIRMS DEPARTMENT

Mr. ARNING. Mr. Chairman, I am Lee Arning, and I am accompanied by Mr. Robert Bishop, who is director of the Member Firms Department, and Mr. Donald L. Calvin, a vice president of the New York Stock Exchange, on my left. And we do have a short statement to make to the committee.

Mr. Moss. You may proceed, Mr. Arning.

Mr. ARNING. We appreciate the opportunity to appear as panelists in these opening hearings in the subcommittee's study of securities industry practices. As always, the exchange is pleased to cooperate with the subcommittee.

As we understand it, these hearings will deal with the background of the problems faced by broker-dealers during the 1967 to 1970 period. These 4 years comprised one of the most difficult periods in the history of the securities industry. It was characterized by a crushing burden of paperwork followed by a severe cost-income squeeze that brought financial disaster to many brokerage firms.

It was a period crowded with developments and crises. To help set the stage for the subsequent discussion, we would take a few minutes to present a brief overview of the events of the 4 past years.

The problem began in 1967 with a sudden and unexpected upsurge in securities trading early in the year. The continued record pace of trading began to take its toll as the months passed in the form of a growing backlog of paperwork and delayed securities deliveries.

The securities industry is unique in that it must process business as it is received, as the service it sells cannot be stockpiled. Therefore, the industry is subject to unpredictable changes in volume.

By early 1968 it was clear that the flood of business that had initially created the industry's paperwork problems were causing major difficulties-both operational and financial-for many securities firms, and a year of substantial difficulty ensued.

The following year was much the same, but by the end of 1969 the worst of the paperwork problems had been surmounted. However, a new crisis was beginning to emerge. By early 1970 the problem had changed dramatically, having shifted from one of overloaded capacity to one of insufficient business and shrinking profitability. Brokerage firms, which had made huge financial commitments for personnel, automation and other operations improvements, found their profit margins dwindling and then turning into losses. The sustained decline in both stock volume and prices in early 1970 eroded brokerdealer capital, brought heavy losses in trading inventory, and equally heavy operating losses. As a result, many broker-dealers were forced out of business.

In summary, the cycle of the 4 years-1967 to 1970-was one of an unprecedented and unexpected surge in activity that necessitated substantial increases in operating and capital expenditures to increase capacity, followed by a substantial decline in activity and income. Throughout this period, however, the New York Stock Exchange marketplace itself continued to function very effectively-almost

impervious both to the furor taking place in hundreds of back and front offices throughout the securities industry, and to the sharp rise and then decline in stock prices and volume.

Mr. Haack, president of the exchange, testified before this subcommittee on February 26, 1969, on the background of the paperwork problem. His testimony also detailed the steps then taken by the securities industry to improve the operational situation.

The action taken by the securities industry at that time had its desired effect-the paperwork problem was largely under control by the end of 1969. While these efforts continued in 1970, the major exchange effort was then directed to dealing with the financial problems created for member organizations as a result of the depression in the securities industry. As had been the case in the paperwork or operational crisis, the exchange moved rapidly to deal with the financial crisis.

During this period the exchange intervened directly in the affairs of nearly 200-member organizations more than half of the total number of firms dealing with the public. The most important result of this intervention was that the cash and securities of the customers of these firms were saved from loss that might well have been incurred. During the 2-year period-1969 and 1970-a total of 129-member organizations went out of business, merged, or were otherwise acquired by other firms.

Most importantly, the exchange, through its customer assistance program, has voluntarily committed $75 million to protect the customers of those firms which have encountered the most severe financial problems and were forced to liquidate.

An additional $15 million is specifically earmarked for possible use in connection with the duPont Glore Forgan indemnification agreement. Beyond this, up to $30 million may be made available to Merrill Lynch, Pierce, Fenner & Smith, Inc., under a separate indemnification agreement in connection with that member firm's acquisition of Goodbody & Co. Last week the board of governors sent a proposal to the exchange membership asking approval to increase the ceiling on the Special Trust Fund by an additional $20 million.

Thus the total cost of the exchange's voluntary customer assistance program could exceed $130 million, and if all authorized funds were to be used, reach $140 million.

A table showing the current status of the exchange's customer assistance program is attached to this statement. Also attached are three charts which demonstrate graphically the crucial developments of the past 4 years.

Chart I shows the average daily trading volume on the exchange monthly for the last 5%1⁄2 years and the level of total "fails" and fails aged over 30 days old from April 1968, through June 1971.

Chart II shows the number of sales and nonsales personnel and number of member firm branch offices from yearend 1965 to yearend 1970.

Chart III shows member firm capital and profits in member firms from 1965 through 1970.

During these crucial years, literally dozens of separate actions were taken by the exchange and the securities industry. We have prepared for the subcommittee a detailed chronology of the developments during

this period, up to the present. This white paper is attached to our

statement.

What have we, as a self-regulatory organization, learned from all this?

While it is not easy to generalize in the face of so many developments, it became apparent that:

(1) The broker-dealer capital rules must be revised and strengthened;

(2) The exchange's Central Certificate Service, which eliminates the physical delivery of securities by immobilizing stock certificates within a central system, must be expanded; and,

(3) Broker-dealer financial and operations reporting must be on a more frequent and more comprehensive basis to detect weaknesses at an early stage.

Substantial progress has been made in all three areas.

The exchange adopted a new capital rule on July 15, after months of study and consultation with the Securities and Exchange Commission. The Central Certificate Service has been expanded to include New York Clearing House banks as participants, as well as adding American Stock Exchange stocks. Currently we are adding over-thecounter securities. Plans are underway to significantly broaden the scope and nature of the Central Certificate Service.

Reporting by NYSE member organizations has been expanded so that firms are reporting by way of a special questionnaire on their financial and operational status at least quarterly, or more frequently, as required. This may be on a monthly, weekly or even daily basis.

The changes in the capital rules aim at increasing the quality and permanence of the capital required of firms that deal with the public. While adjustments and fine tuning may be required as the new rules are applied in the coming months, the exchange is confident that the rules will provide a significant strengthening of the capital structure of a major part of the securities industry.

A summary of the new capital rules is included in the attached white paper.

When Mr. Haack testified before the subcommittee in February of 1969, the exchange's central certificate service had not been fully activated. Basically, CCS is a computerized system for immobilizing stock certificates. Brokerage firms deposit certificates in their CCS accounts. Deliveries among these brokers are effected by computer debits and credits. The certificates remain in the CCS vault. More than 900 million shares are now on deposit, aggregating more than $50 billion.

Although use of CCS by participating brokers is voluntary, more than 75 percent of eligible deliveries are being made each day between our member organizations by bookkeeping entry, rather than by physical delivery of a stock certificate.

CCS is expanding in other directions, as well. Ten of the 11 New York clearinghouse banks now are direct CCS participants for computerized delivery to, and receipt from, participating brokers, in addition to the banks' participation in a collateral loan program through CCS.

Efforts are being made to broaden CCS further-to include other major investing institutions such as mutual funds, pension funds, insurance companies, as depositors, and to enable out-of-State banks