sell Morrison, president of Standard & Poor's, this suggestion is made, also I think Mr. Lee Kendall's testimony was referred to yesterday-which also seems to see the need for a central organization. I also have a letter here from Leland Dill, of Peat, Marwick & Mitchell, to Chairman Casey of the SEC, where Mr. Dill also recommends the establishment of a centralized uniform authority. Mr. Chairman, I would like to ask at this point to have this letter received for the record. Mr. CARNEY (presiding). Without objection, it will be entered. (The letter referred to follows:) Mr. WILLIAM J. CASEY, PEAT, MARWICK, MITCHELL & Co., Chairman, Securities and Exchange Commission, New York, N.Y., June 21, 1971. DEAR MR. CASEY: The following is written in response to your invitation to submit material pertaining to various proposals for dealing with security certificates. BACKGROUND The processing problems associated with the handling of security certificates has been recognized for many years. Many informal discussions and formal studies have been undertaken but an agreed upon master plan has not been accepted. The actual calling of this meeting is indeed encouraging for the need for action becomes more acute with the passing of each day. In our opinion the problem relates to the incomplete definition of what the securities industry actually encompasses. Depending on which segment of the industry you are talking with, you will obtain a different opinion. For years Easterners stated the securities industry as being Wall Street, whereas Midwesterners would define it as LaSalle Street, and Westerners would call it Wilshire Boulevard. With the increasing importance of over-the-counter trading and the regional firm concept, this provincialism abated. However, few still think of the securities industry as encompassing certain functions of what is commonly thought of as part of the banking industry. Also, perhaps the securities industry is really composed of two industries; the selling or income producing functions, and the processing functions. It is the processing functions which closely interrelates with similar functions in the banking industry. Individuals concerned with the viability of the stock certificate, and the stock certificate processing problems, have all emerged from these individual groups. Their efforts have been fragmentary and their views biased by the self-interest of the particular segment that they represented. The possibility of creating an overall integrated approach is hampered by the divergent interest of the people in the industries' management positions. Those in the banking industry are not charged with a fundamental responsibility towards the solution of the stock certificate processing problem. Those in the securities industry may be more interested in the selling function and may not have obtained the best possible appreciation of the processing problem. We believe the processing problem, along with its bookkeeping, message switching and clearance has, through technology evolution, become a separate industry and may best be treated as such. RECENT EVOLUTION IN THE BROKERAGE INDUSTRY The Stock Exchanges and later the Clearing Corporations were established to meet the growing needs of this industry. Recently, during the late 1950's and early 1960's the computer became the panacea for the industries back office work volume. Other brokers turned more frequently to clearing brokers or banks to handle the "back office operation." Service Bureaus emerged to take many of the disenchanted computer owners away from their "panacea." However, the problem still remained because certain activities dealing with the transportation and movement of certificates are not susceptible to mechanization. Some of the Exchanges, through subsidiary operations, have made individual efforts to solve the movement problem. The search for a solution has manifested itself in two basic concepts, (1) the machine readable certificate, and (2) the immobilization of certificates. It is not the stock certificate itself which is the basic problem, but perhaps undue influence of individuals who either do not understand or have no real interest in obtaining a unified total systems approach to clearing certificates and the recordkeeping pertaining thereto. Several suggestions have been raised dealing with the stock certificate. We believe and we intend to show that each of these suggestions while having merit will not solve the problem without attendant alterations in other existing practices, all of which can best be accomplished through a central organization or authority which directs and prescribes procedures and operates facilities where necessary. The following paragraphs express our views concerning: Elimination of the Stock Certificates Machine Readable Certificates Central Service Bureau It is recognized that the various proposals dealing with stock certificates have relative strengths and weaknesses. The important thing at this time is to achieve a unified approach rather than to obtain the best possible answer. For instance, there is a group who advocates the complete elimination of the stock certificate. This group suggests that customer's equities or ownership of securities in U.S. corporations would be described solely by bookkeeping positions (book shares) in a manner similar to that used by non-certificated mutual funds. While this approach would certainly appear to be extremely helpful to the back office problem, it is questionable whether it is acceptable to all public customers. In an industry where bookkeeping procedures are notoriously poor, it deprives the small public investor of tangible evidence of his ownership. On the other hand, institutional investors may very well welcome such an innovation. It may significantly decrease their operational expenses if banking arrangements were included and the institutional investors were freed from custodial responsibilities. We are in favor of optional elimination of stock certificates. Those customers who demand the certificates may do so while those who have no real need for them will not use certificates. Since a large percentage (80% is the general belief) of present day customer transactions may be classified as institutional we believe the optional approach will eventually lead to a significant reduction certificate processing. However, there are still many problems which must be solved before such a procedure may be instituted. Mutual funds have the advantage of the duplicate record maintained for them both by their clearing banks and transfer agents. Even here there have been examples where the record maintenance has been done very poorly. However, the banking institutions involved have a great ability both to pay for the errors and to finance the development involved have a great ability both to pay the errors and to finance the development of more sophisticated bookkeeping systems. Brokers continually must be concerned about their capital ratio with respect to their investment in back office activities. The elimination of stock certificates without greatly strengthened or centralized bookkeeping operations may be extremely dangerous. Furthermore, it is not completely valid to compare mutual fund procedures to that of the securities business. The mutual fund customers' interest is not constantly traded, therefore, his bookkeeping requirements are relatively simple by comparison. Customers of stockbrokerage firms, in their desire for protection, should be allowed to insist upon certificates the same as some mutual fund investors do. The mutual fund investor can, if he wishes, insist upon certificated shares, if not in the particular fund in which he is originally interested, or some other fund that has the same investment objectives. It is unfair to force someone who wishes to invest in a particular U.S. Corporation to do so strictly on a bookkeeping basis. He should be provided an alternative. In summary, the retail investor must be provided guaranteed accuracy of his account and the account must be universally available to him for loan collateral. The institutional investor and the brokerage industry would benefit by the elimination of certificates. We suggest an optional approach which provides for the requirements of all these groups, but this implies a strong centralized bookkeeping system. Perhaps elimination of the stock certificate is possible in the distant future, but it is of questionable short-range value. MACHINE READABLE CERTIFICATES Yor years a number of people have advocated machine readable certificates. At first, discussions centered around the use of punched cards being used in place of paper documents. More recent technological advances have allowed considerations of encoding and optically scanning paper certificates. (a) Punched Card Certificates Many of the people who advocate the punched card certificate fully recognize the disadvantages and problems of this approach but believe that it would be an improvement over present practices. Punched cards have consistently proven their limited life when used for long periods of time by non-EDP people in a non-controlled environment. Notwithstanding the now familiar, "Do Not Spindle or Mutilate," legend on many cards, the public still is not sufficiently gentle with this form of document. Also, where these documents are maintained in large files which must be manually manipulated, they readily become dog-eared and no longer susceptible to machine processing. When they are no longer susceptible to machine processing they are traditionally duplicated. However, this is a probJem in the case of the stock certificate in that the authentications would be destroyed in the reproducing process. Under todays procedures, large portfolios of punched cards would have to be transported much in the same fashion as #tock certificates are today. The net benefit may not be as helpful as the proponents of this method believe. Certainly centralized depositories would still be a necessary prerequisite to control the environment in which they would be used. (b) Encoded Certificates Encoded certificates provide the best possibility for modern document control In a highly mechanized environment. The problem here is that the smaller brokernge houses would not be able to take advantage of the mechanized aspects because the equipment necessary for this approach is relatively expensive. This, of course, may be overcome by using several depository and clearing agencies, but due to the individual financial requirements that would be imposed upon each broker, the enforcement of this type of immobilization without the complete participation of the banking community and a real-time communications system, may spell the end of the small and medium size broker. Therefore, again we come to the realization that the problem is not so much the form of the certificate as it is the procedure and the organization of the whole processing function. IMMOBILIZATION OF CERTIFICATES The net-by-net method and Central Certificate Service both provide means of reducing the quantity of security movements, but neither is really completely compatible with each other: perhaps they are even competitive. Each operates on entirely different basic concepts and each is limited by the extent of its influence and broker participation. The net-by-net method is popular and successful on the West Coast. but is used by relatively few brokers. Central Certificate Service is hampered by incomplete bank participation, no truly effective communication system with its members and non-uniform member recordkeeping system. CENTRAL SERVICE BUREAU The basic prerequisite to solve the securities processing problem is to provide an industry or a capability of specialists in this area who operate for the profit motive but without the interference of the brokerage industry's sales-oriented decision makers. The processes that these people use must be basically uniform. Differences between the various clearing methods must be eliminated. New York Stock Exchange Clearing Commission must be carefully examined. A central service bureau concept would include clearing all markets, bookkeeping data processing services for customer firms, message switching, custody of securities and barking functions, such as lending money and securities. It can be seen epick's that this conglomerate list of functions are presently handled br Exchange members, Indeperdent service bureaus and certain elements of the banking ovmity Pich of these separate entities presently have the problem of entering informarion into fre computer systems about security movements which in many Instances are predictable and are part of what can be looked upon as a total system. Therefore, multiple entries are made about a single transaction which if looked at from a larger viewpoint could be made less frequently, thereby minimizing the propensity for input errors and allowing more flexible staffing of manual work stations associated with the system. We believe this is the only way costs can be minimized and that the already readily visible trend toward few giant brokerage houses can be turned to allow the type of competitive development of smaller firms that traditionally has provided innovative and specialized customer services. CONCLUSION In conclusion, we believe many of the new approaches presently under development are contributory to the solution of the securities problem, but without a master plan and strong direction from a higher authority they will not provide maximum benefits. Duplicate solution to the same problems are wasteful. We suggest the following priorities: 1. Establish a centralized uniform approach with service bureau type facilities where required for standard clearing depository transfer and bookkeeping procedures. 2. Provide for optional elimination of certificates within the framework of item 1. 3. Last, provide for the future encoding of certificates still remaining in the system after items 1 and 2 are operational. Thank you for inviting us to the meeting on June 29, at 10:00 AM, to discuss various proposals dealing with security certificates. I certainly plan to attend and will bring with me Mr. William H. Brakman, Jr., a Principal of our firm, who is in charge of our consulting activity to the brokerage industry. He also has been in charge of several banking engagements where these pertain to security movement and control. Very truly yours, Mr. ROWEN. Thank you, Mr. Chairman. S. LELAND DILL, Partner. In these interviews we were conducting with the back office people, and these are the people who actually have to do the clearing, there seemed to be unanimous agreement, although reluctantly, that the standardization was not going to be achieved on a voluntary basis, that there was need for some type of a regulatory action-although, of course, I think most of the people said they did not want any further Federal intervention into their affairs. I noted a strange dichotomy between the suppliers of services-the exchanges and the clearance corporations--and the users of the services, with the suppliers saying no legislation is needed in this area, and the users saying there is legislation needed. The position of the suppliers seems to be that we should wait and that voluntary cooperation will solve the problem. 1 I notice in the Special Study of the Securities Markets 1 it is stated: "A central depository system has been considered at least since 1929." That was 41 years ago. The Special Study, itself, in 1963, recognized the "back office" problem. It discussed it in detail. I would like to read the special study's recommendation, which appears in part 1 at page 428: The industry, with the cooperation of the Commission, should give continuing attention to possibilities for modernizing and improving existing securities handling, clearing, and delivery systems, with the goal of evolving institutions and procedures which would permit the reduction of physical transfers of securities and centralization of functions now performed by broker-dealer back offices, insofar as possible. 1 See Report of Special Study of Securities Markets of the Securities and Exchange Commission, H. Doc. No. 95, 88th Cong., 1st sess., pt. 1 (1963). That was in 1963, of course. Five years later, the street had what might be described as a catastrophe, precipitated by its inability to handle its back office problems. And, indeed, Robert Haack, in his testimony before Senator McClellan's subcommittee on June 23 of this year, said that the industry was out of control in the 1968-69 period. Now, following that, of course, is the new round of studies, the Rand study and the Rockwell study and so forth. But I am informed in interviews with operations people that today the street is still unable, or would be unable if volume approached the 1968 level, to handle the securities transactions, and if we went back to the 1968 level of transactions, we would have the same crunch that we had then. Now, I would like to base my discussion, as Mr. Painter said, on the assumption that Congress has decided that there is a national problem here and a national solution is needed, and that Congress has determined hypothetically to establish this central organization to provide the standardization that apparently is needed. I would like to use your proposal, Mr. Peake, as a vehicle for discussion of this area. I have noticed, that with all the people who have suggested a central organization, nobody has suggested that the SEC do this, or perform this task. I notice that you don't bring the SEC into this, and I would like to find out your reason for not assigning this task to the Securities and Exchange Commission. Mr. PEAKE. Mr. Rowen, I believe the primary reason for not suggesting the Securities and Exchange Commission is that this is an interindustry problem. It does include the banking industry as well as the securities industry. The Congress in the early 1930's decided that a separation of those two functions was essential for the economy of the country, and it seems only reasonable to me to assume that, given that assumption, it would not be proper to have a regulatory agency over one-half of the industry being in a position to make rules over a totally different industry, namely, the banking industry. Mr. ROWEN. I see. You propose that we establish a new organization. Now, this organization could take one of three forms. You could have a Federal agency, much like the Securities and Exchange Commission: you could have a federally chartered agency like SIPC; or you could have a quasi-public agency like Comsat. You recommend that the agency be profitmaking rather than nonprofit. I would like to find out why you feel that an SIPC-like agency would be the best, and why you think it should be profitmaking. Mr. PEAKE. The composition of the board which I suggested was designed to try to counterbalance all of the interests involved in the function. I do consider it a service corporation. I didn't realize I was designing it like SIPC. I was trying to fulfill the particular needs that I felt were required to be filled. The reason I believe it should be a profitmaking organization much as the Federal Reserve System is a profitmaking entity, is that this will tend to attract and keep the interest of those who are depositors and users of it. I do not mean to suggest that it should be an unlimited profit organization, by any means, but that there be an incentive for good |