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QUESTION 3 There are a number of statutory differences between the degree of oversight authority the Commission has regarding exchanges and the degree of oversight it has regarding the NASD, In some respects the Commission's authority is more comprehensive in the case of exchanges and in some ways it is broader in the case of national securities associations. The Commission has on a number of occasions in the recent past considered these differences but in each instance the conclusion has been reached that, while in general there is no longer any theoretical justification for them in most instances, legislative action was not essential. The Committee will recall that these issues were considered at great length in the Special Study of Securities Markets in 1963 and at that time similar conclusion were reached. The principal reason for not recommending legislative change again relates to the question of resources. As the Special Study pointed out, the Commission has considerable direct power to act where the self-regulators have not performed adequately and, in addition, the self-regulatory organizations have, in general, cooperated with the Commission in effecting desirable changes in their rules and practices. While some gaps in these regulatory powers have been found, the main problem has been that the Commission has not been adequately equipped in terms of personnel and budgets to fully implement these broad powers. We think that the same conclusions remain largely valid today. If legislative revisions are to be considered the statutory oversight provisions should be broadened and made more consistent. The pattern adopted in the recent SIPC legislation could serve as a starting point. For example, under the SIPC Act, the Commission may disapprove, alter or abrogate any by-law or rule proposed or adopted by SIPC.


The self-regulatory scheme adopted by Congress in 1934 contemplated a less formal rule-making process than is true with other industries where self-regulation doesn't exist. It was recognized that, with respect to the securities industry, a less formal and more flexible method of regulation was desirable. We have found that this process has worked fairly successfully.

It should be borne in mind, however, that this scheme of self-regulation also evidences a Congressional intent that those directly affected—the broker-dealer community-be afforded protection from arbitrary or otherwise inappropriate rule-making or other action through democratic processes within the self-regulatory bodies, i.e., the power to elect those who govern. (See, for example, Sec. 15A (b) (6) of the Act which requires that members of the NASD be fairly represented in the administration of the Assoication's affairs.)

The public interest is this self-regulatory scheme was to be protected by the designated public representative, the Securities and Exchange Commission. Nonetheless, where significant matters of direct public and non-member concern are involved, such as commission rates or market structure, the Commission has, especially in recent years, increasingly invited public participation through investigatory hearings and/or the opportunity to comment.

The essential question is one of balancing the Congressional purpose of flexibility with the advantages of greater public participation in the self-regulatory rule-making process. Several months ago the NASD, with the Commission's concurrence, began subjecting to comment its proposed rules of conduct and rule interpretations and policy releases. After a sufficient period of time has elapsed to gauge the results of this experiment and if we determine that it does not unduly impede our mutual regulatory efforts, we would be prepared to recommend that the exchanges similarly broaden their programs.

I want to emphasize, however, that the less formal rule-making process tradi. tionally employed by the Commission and the self-regulatory bodies has provided a degree of flexibility and efficiency that may be difficult to achieve under a more formal process, and I believe that this efficiency and flexibility has been very desirable and has generally worked quite well.


In this question the Committee has raised various possibilities for legislative action, all of which appear to be designed to give the Commission greater inde. pendence from Congress and/or the executive branch of the government. Of course, any modifications in this area are a matter of national legislative policy and we stand ready to be of assistance to the Congress in considering appropriate reforms. However, since all of the suggested possibilities are directed towar the question of greater independence, we do not think it would be practical for us to attempt to deal with them individually.

The Commission has had occasion to consider Legislative proposals' of a similar tenor in the recent past and has pointed out that the issue of where oversight authority should lie, as between the executive and legislative branches, was not within our expertise. We had no further comment on the proposals then and do not believe we are in a substantially better position today. At this stage, we cannot conclude, based on the Commission's own experience, that any of the changes suggested by the question are necessary.


The primary reason advanced for creating a new self-regulatory entity is that it coulă coordinate the activities of the existing self-regulators, ameliorate differences between them and generally provide unified direction. In my opinion, bowever, the existing self-regulatory bodies, with direction from the SEC, can achieve as much cohesion and direction as presently organized as they could through the offices of a parent organization. Whatever differences exist between the various exchanges and between the exchanges and the NASD cannot be resolved any more easily by interposing a new entity between the Commission and the existing self-regulatory agencies. In fact, the creation of any such entity might well have undesirable results so far as the SEC's relationship with the industry is concerned. It would create another layer of insulation between the Commission and the broker-dealer community, which would only make our oversight responsibilities more difficult to carry out."

My remarks in this respect assume continuance of the current market structure. As this Committee is aware, however, one of the questions involved in the Commission's current hearings is how the securities markets of the future should be structured. Consequently, the views I have just expressed in this respect are at this time only tentative and subject to change depending upon the development and resolution of this question in our hearings.

QUESTION 7 In principle the Commission favors the concept of public representation on the goterning boards of the self-regulatory agencies. As this Committee is aware, William McChesney Martin, in his Report on the Securities Markets, recommended that ten of the twenty elected members of a reconstituted “Board of Directors" of the New York Stock Exchange be public representatives.


The Commission has recognized for some time its need for an on-going policy staff. Our Office of Policy Research currently gathers and publishes statistics on, and evaluates the impact of, various aspects of the securities markets. There are, however, large areas of Commission responsibility that this office is not presently able to handle, notably the long-range planning activities suggested in your letter.

Over the last eight years, the Commission has spent an aggregate of almost $4 million on several one shot studies. That kind of money could better be applied to a continuing policy research staff which would guide the Commission in its policy operations and interpret currently the valuable data which the Commission gathers. Such a staff would produce much more valuable results than Intermittent studies that are done on a crash basis and then filed away while the special staff gathered to produce them disperses. A planning group could give the Commission the ability to anticipate, rather than merely react to, events of significance to the capital markets around the Forld. It would consider such matters as the internationalization of securities

Sco, for example. H.R. 656, 928 Congress and A.R. 1068. 91st Congress relating to baietary seriew.

* At the time of the SIPC legislation consideration was given to making SIPC a type of iuent self-regulatory organization but the idea was rejected.

markets, new types of offshore funds and capital offerings, and potential dangers in trends in financing techniques and corporate capital structures. Around such a group, moreover, we could build the long-range forward thinking arm of the Commission, separating it from our day-to-day regulatory and enforcement functions.

Regarding your question as to financing and structuring of this policy group the Commission is unable to say at this time whether a separate Division would be needed. In general, for a policy research activity to be successful, its basic long-range analytic work must in the short-term be brought to bear on the decisions the Commission must make in resolving day-to-day problems, which sus. gests a planning section within the present divisional structure, composed at least partially of personnel familiar with Commission operations. On the other hand, & planning group must have the time to develop their basic analyses with the broad perspectives implicit in the terms "planning" and "policy" and without any divisional bias. In any event, such a group must certainly be financed through the normal Commission budget; too much independence might result in imprac. ticable decisions which the Commission would be forced to abnegate.


Washington, D.C., November 4, 1971.
Chairman, Securities and Exchange Commission,
Washington, D.C.

DEAR MR. CHAIRMAN: This is to confirm our invitation to you to serve as a panelist at a public hearing on Wednesday, November 17, 1971, to be held by the Subcommittee on Commerce and Finance of the Committee on Interstate and Foreign Commerce. It would be helpful to the Subcommittee if you were to be accompanied by Mr. Irving M. Pollack who will also serve as a panelist. This hearing is, of course, an open one and additional members of your staff are welcome to attend and supply you with such information as may be required. I understand that prior commitments may preclude your appearance before the Subcommittee on November 17, 1971. If so, the Subcommittee desires that Commissioner Philip A. Loomis comes in your place. We believe that Mr. Loomis' long experience on the Commission's staff, first as Director of the Division of Trading and Exchanges and subsequently as the Commission's General Counsel would make him a quite knowledgeable panelist on the topic of self-regulation.

The general format of the hearing will be that of a panel discussion, similar to the discussions in open hearings which the Subcommittee has recently been holding. We will inform you of the specific time and location of the hearing once it has been confirmed.

For your convenience and guidance in preparing testimony, we are attaching a brief outline of the principal areas which are to be covered at the hearing. It would be appreciated if you would prepare a written statement presenting your views on these areas, as well as any other areas which you believe are important in the context of this hearing, and submit 100 copies to the Subcommittee by 10 later than November 11, 1971. However, in order to conserve the time of the Subcommittee and of the other panelists, it will be necessary to avoid reading written statements, and you will be asked to present a capsule summary of your views at the start of the hearing. In this manner panelists will have an oppor tunity to exchange views and reply to questions by members of the Subcommittee. It would be especially helpful for our staff if you would see that fifteen copies of your statement are punched along the left-hand margin for insertion in a three-ring binder. The holes should be four and one-quarter inches apart, mens uring from the center of each hole. These fifteen copies should not be stapled but should be bound together by rubber band, paper clip or some other similar method.

If you have any questions concerning the hearing, please contact Mr. William H. Painter, Special Counsel to the Subcommittee, who will be happy to assist you. All statements should be mailed or delivered to Mr. Painter at the following address: Securities Markets Study, Subcommittee on Commerce and Finance Room B331, Rayburn House Office Building, Washington, D.C. 20515.

We appreciate your efforts and the contribution which you will make to the hearing. Sincerely,

JOHN E. Moss, Chairman, Subcommittee on Commerce and Finance. Enclosure.


(Hearing: November 17, 1971, Self-Regulation) 1. Describe briefly the way in which the various self-regulatory organizations bave divided the industry for regulatory purposes, i.e., who regulates brokerdealers that are (1) members of more than one exchange; (2) members of an tichange and the NASD; and (3) neither members of an exchange nor the NASD. What role does the Commission play in this regulatory scheme?

2. Has self-regulation worked and should it be continued, abandoned or modified? If you believe that modification is necessary, what specific changes would you recommend ?

3. Should the Securities Exchange Act of 1934 be amended to provide the Commission with the same degree of oversight of national securities exchanges that it now has over the National Association of Securities Dealers, Inc.?

4. How can the method by which the rules of national securities exchanges are adopted be made more public? [See, Note: Informal Bargaining Process: An Analysis of the SEC's Regulation of the New York Stock Exchange, 80 Yale Law Journal 811 (1971).] 5. In order to insure the Commission's independence, should :

(a) the Commission be made a self-funding organization?

(b) the Commission be prohibited from clearing proposed legislation and and legislative comments with the executive branch?

(c) the Commission be authorized to conduct Supreme Court litigation independently of the executive branch?

(d) the reappointment of Commissioners filling unexpired portions of predecessors' terms be ma automatic? 6. Should a new self-regulatory organization be established to act as a parent organization, to be placed between the SEO and the existing self regulatory organizations? [See, W. Cary and W. Werner, "Outlook for Securities Markets,” Harvard Business Review (July-August, 1971).]

7. If the present regulatory scheme is continued, what should be the composition of the self-regulatory bodies ? Should there be public members and representatives of corporate issuers and in what number? (See the Martin Report at pages 6–12.]

& Should a Division of the Commission be established to act as a planning organization, which would view the industry as an industry, instead of reacting to specific problems as they arise? If so, how should such a Division be structured, staffed and financed ? (See Transmittal Letters of the Special Study and the Institutional Investor Study, and the speech of Abe Fortas in Colorado Springs in May, 1971, at page 12, proposition number 7.)


Washington, D.C., January 12, 1971. Hon. Harley O. Staggers, Chairman, Committee on Interstate and Foreign Commerce, House of Repre

sentatives, Washington, D.O. DEAR MR. CHAIRMAN : It is generally recognized that the securities industry bas been faced with unprecedented problems during the past three years. More than a dozen New York Stock Exchange member firms failed during the last Eighteen months alone, and perhaps another seventy merged into or were acquired by other firms, ceased carrying customer accounts, or gradually liquidated themmetres. Failures also have occurred among the smaller brokers, who are members of a regional exchange or the NASD. We are, of course, deeply concerned by these events, as we know you are, and we are pleased to present our views on the quesdons raised in your letter. Both the facts and the issues are highly complex, but at the risk of over-simplifying, we shall try to be brief.

Let me begin with the second question: "How have the broker-dealer firms which have recently gone into liquidation and bankruptcy gotten into such difficulties?” While various factors, particularly the quality of management, differed from firm to firm, in most cases the trouble was traceable to the paperwork tie-up of 1967–1968. The industry as a whole had not modernized and automated its procedures and equipment during the 1950's and early 1960's. This was due in part to the fact that trading was forecasted to increase gradually, and in part to the widely prevalent partnership form of doing business with partners withdrawing profits as they were made, rather than reinvesting them as industrial corporations do. When the unexpected surge of trading volume came, brokers were unprepared to handle orders in a timely and accurate manner. Record keeping broke down and firms lost physical control over the stock certificates themselves. In the course of the hearings conducted last year by the Subcommittee on Commerce and Finance of your Committee (House Report Serial No. 91–9 "Securities Market Agencies”) the Commission presented a picture of this situation in some detail.

At some firms the operational crisis was so grave as to require liquidation. In most cases, however, back office problems did not prove fatal until they were combined with the unforeseen financial pressures which arose during the 1969– 1970 bear market. This decline in market prices and volume, while not as sudden as that of 1962, for example, was the most prolonged and persistent bear market since the nineteen thirties. At the beginning of 1969, both stock prices and volume started a gradual but sustained slide, which often created new difficulties for brokerage firms. A number of them had just expanded their plant-branch offices and transaction processing facilities—and were committed to a high level of overhead expenses. Commission income dropped significantly, as did income from underwriting and other securities activities. At the same time, firms were forced to expend additional sums to resolve errors remaining from the operations crisis, such as old fail-to-receive items, and stock record differences. Moreover, the finan. cial condition of most firms was further adversely affected by the market value decline in firm trading and investment accounts and by the withdrawal of capital contributed by partners and subordinated lenders. Firms also lost working capital by the reduction in customers' free credit balances and by the increased reliance on non-monetary items to bolster their capital (e.g., subordinated demand notes and subordinated accounts.)

Next, I would like to deal with your first and third questions together: "Hare the rules of the self-regulatory groups been effective in preventing and correcting the difficulties?," and "Why have some broker-dealer firms apparently been permitted to operate after they have gotten into such difficult financial condition!". Self-regulation should be strongest in the area of financial responsibility, because firms trading with each other are highly interdependent and all have a direct self-interest in ensuring that a troubled firm does not pull the rest of them down with it. The industry generally has also been conscious of the need to prevent the financial difficulties of a broker from causing losses to its customers. thereby undermining the public confidence upon which the markets rest. However well the self-regulatory mechanism might be able to cope with the individual firms in difficulty, it did not prove to be designed to handle industry-wide opera tional and financial problems of the magnitude experienced during the past three years.

Although the ordinary business can continue to operate despite financial problems, until it becomes insolvent or its liabilities exceed its assets, it has long been recognized that the customers of brokerage firms need to be protected hy the application of higher fiscal standards. Pursuant to Congressional authority the Commission in 1944 made effective à net capital ratio rule the purpose of which was to ensure that a broker had enough liquid capital to meet the ordinary needs of his business, and that he would be shut down, if in trouble, at a time when he would still have enough assets to cover the claims of his customers.

At the time the Commission's net capital rule was put into effect, the rules of the exchanges were more stringent that the Commission's (for example, thi NYSE's maximum permissible liabilities to capital ratio was then 15:1 rathe than 20:1 as under the Commission's rule), and so the Commission exempter members of the specified exchanges from the applicability of the Commission rule. Exchange members were usually fairly large firms, but the Commission' rule had to be so framed as to permit small firms to enter and remain in busines

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