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so long as they did not endanger their customers. Since then, the Commission's rule has been tightened in interpretation and application, while those of most of the exchanges it now appears were relaxed, at least in the last several years. This appears to have resulted from a concern on the part of the exchanges with the difficulties which might be encountered in closing a large firm. The result has been to reverse the respective stringencies of the rules as interpreted from that obtaining originally, and today as interpreted and enforced by the Commission, the Commission's rule affords investors the most protection.
This reversal came about gradually, for the most part. Before the recent financial problems came to the fore, there was arguably little practical difference between the Commission's and the Exchange's rules. However, in 1969, as the result of the widespread financial difficulties of the member firms, the NYSE relaxed the interpretation and enforcement of its net capital rule in order to avoid placing a number of firms in violation, which might have had the effect of weakening the public confidence in such firms and in the Exchange community.
Because of its Special Trust Fund, the Exchange felt able to adopt a "workout” approach in a number of cases, whereby the firm was allowed to continue in ostensible compliance with the net capital rule while it attempted to bring its problems under control or until it reduced the size of its operations so that liquidation could be made more easily. In a Special Membership Bulletin dated October 1, 1970, copy enclosed, entitled “Report on Self-Regulation", the NYSE explained its policy in these terms:
"For example, in the case of three major member organizations, the Exchange found itself facing situations where normal application of rules could have meant possible loss for many thousands of customers and potential chaos in the industry. These firms, Dempsey-Tegeler & Co., Inc., McDonnell & Co., and Blair & Co., carried a combined total of some 165,000 customer accounts. Their paperwork and capital problems were critical.
"With each firm, the Exchange allowed continued operation under increased regulation, pending a scaling down of business and reduction of paperwork backlogs. The hope was a scaled-down firm would present a manageable liquidation situation."
Apart from the decision to follow this policy in the enforcement of its pital rule in at least certain instances, the NYSE as well as the other self-regulatory organizations did not have adequate and timely programs to detect and monitor either the operational or the financial problems of their members. Consequently, by the time the self-regulatory bodies became fully cognizant of the problems, they had spread to such an extent that they could not be brought under control without the adoption of innovative broad based programs. We also believe the self-regulatory organizations frequently accepted the most optimistic progress estimates from their members who because of their overriding self-interest to remain in business, failed to objectively assess their own difficulties. There also seems to have been a hope that conditions would immediately improve with a sustained market upturn. Of course, when market conditions did not improve, the problems intensified.
For these and other reasons, the NYSE the principal self-regulatory organization, did not foresee and plan the steps necessary to cause a number of firms to correct their problems until their condition had deteriorated substantially. In many instances the NYSE allowed and arranged mergers which brought troubled firms together or combined a firm in a critical state with an ostensibly healthy one. In some cases these combinations were successful; in others they exacerbated existing problems. Moreover, there was some lack of contingency planning and a number of failures were only averted through herculean efforts at the last minute. Nevertheless, the members of the New York Stock Exchange did voluntarily expend in excess of $55 million of trust funds to assist in the liquidation of troubled firms, in recognition of their obligation to protect the prstomers of such firms from losses. The Exchange has further agreed, at the urging of the Congress, to protect customers involved in certain pending member firm liquidations not presently covered by the Special Trust Fund. The Exchange bas also obtained authority to assess its members up to $30,000,000 to cover contingent liabilities which may arise from the Goodbody situation and we understand that it proposes to increase the size of the Trust Fund by $20,000,000. Members of other stock exchanges have also contributed to trust funds which are belping to meet customer losses and thus sustain investor confidence.
You further ask: "What has been the Commission's role in supervising the Kork of the self-regulatory groups?”. For the past three years, we have been
attempting to make the legislative patterns of self-regulation work in the securities industry through numerous actions. We believe it will be helpful to describe generally some of these activities.
From our analysis of complaints about broker-dealers made to the Commission in early 1967, we came to the conclusion that the operations problems were more serious than were generally realized by the industry. Accordingly, we wrote to the ten firms which caused the greatest number of customer complaints, asking them what corrective measures they were taking about their apparent operations problems and whether we or the self-regulatory bodies might be of assistance. In general, the firms indicated that their problems were of a “business" and tenporary nature, which they could handle. They not only opposed government intervention but expressed the view it would actually be harmful.
Our concern was also discussed with the self-regulatory bodies, and in August of 1967, the exchanges curtailed trading hours for a short period. In the fall of 1967 we received the first concrete indication that the operational situation was not improving. We were unable to obtain certain records from Pickard & Co., a NYSE member firm, and we notified the Exchange about our difficulty and our concern at the way the firm was being run. Several months later, when the Exchange examined the condition of the firm, our concern was confirmed and the Exchange commenced to liquidate this firm with the aid of trust fund monies.
In January 1968, the Commission wrote to the New York and American Stock Exchanges and the NASD, expressing concern about "accounting, recordkeeping and back office problems and their effect on prompt transfer and delivery of securities." We asked them exactly what steps they and their members were taking to deal with the problem, and what measures they were considering. The responses, at least in our view, underestimated the full seriousness of the overall situation and the need for steps in addition to just closing the exchanges early—a step which was taken early in 1968.
After numerous conferences between the Commission and the self-regulatory bodies, we instituted our own inquiry into operational conditions in the industry. We also solicited and obtained the NASD's participation in this activity. The purpose of this program was twofold: first, to obtain the necessary information on the conditions at all major firms and second, to inspect the major firms to evaluate operational problems in a firsthand manner.
In the summer of 1968, we recognized the necessity for a shorter trading week (in addition to shorter hours) when the NYSE had at first sought only to limit over-the-counter trading where fails were larger than in listed trading; but about 80% of such trading is conducted by member firms. We also insisted that the self-regulatory agencies require that their members keep their offices staffed during the one day the market was closed each week. That same month, we called a meeting with Presidents of the exchanges and the NASD, at which they were asked to consider the following measures :
Establishment of a specific period of time within which broker-dealers must accomplish deliveries of funds and securities to customers on trades
Establishment of an appropriate charge to capital for aged fails-to-deliver.
Establishment of requirements covering accounting and bookkeeping systems, and the number of back office personnel to be maintained by firms. At the time of the meeting the Commission published a release (Securities Exchange Act Release No. 8335, copy enclosed) which expressed the Commission's concern and expressly cautioned all brokers about their responsibilities related to books and records, financial responsibility, and the prompt delivers of securities and settlement of transactions.
Where inquiries showed that adequate corrective action was not being taken. the Commission instituted both injunctive and administrative actions against spen cific broker-dealers for violation of Commission rules. The Commission also included as a matter of decision in administrative proceedings against firms with back office problems the issue of suspending the firm's registration pending completion of the proceeding. The possibility of suspending a broker-dealer's regis tration was a strong measure. However, this was made necessary because the Commission believed it appropriate to consider whether a firm's operational pentru lems were so substantial that its doors should be closed promptly. In one partie ularly egregious case, the firm had lost control of its books and stock record differences reached the enormous totals of $473 million long (securities whose ownership could not be determined) and $220 million short (securities which could not be located). It continued to accept business as usual, and planned a clean-up program (to research and reduce fails and differences) that displayed no sense of urgency. Although the firm was put under certain operational restrictions by the responsible self-regulatory organization, the restrictions were inadequate to deal with its problems. Accordingly the Commission instituted an administrative proceeding and thereby caused the firm immediately to employ the necessary accounting help to clean up its records promptly, which it did.
In July, 1968 we issued a release as a forceful reminder of the responsibilities of broker-dealers to their customers with respect-to delivering securities and money promptly and maintaining accurate and current records of their transactions. This release (Securities Exchange Act Release No. 8363, copy enclosed) still expresses the Commission's policy on this subject :
“The Commission also warns broker-dealers that it is a violation of applicable antifraud provisions for a broker-dealer to accept or execute any order for the purchase or sale of a security or to induce or attempt to induce such purchase or sale, if he does not have the personnel and facilities to enable him to promptly execute and consummate all of his securities transactions."
In addition, after issuing the release, we wrote to the Presidents of the New York and American Stock Exchanges and of the NASD, suggesting consideration of other measures that could be adopted to reduce volume and minimize fails, including prohibiting for an indefinite period of time all promotional activities and advertising designed to induce customers to engage in securities transactions, and the opening of any new offices or the employment of any new salesmen.
At the Commission's urging, the NASD announced that it was continuing a special examination of its members. Mandatory buy-in rules, urged by the Commission, were adopted by the NYSE and AMEX. We suggested to the NASD the adoption of a rule barring a broker from trading a security where he had aged fails-to-deliver. This rule was made effective by the NASD. We also proposed and adopted an amendment to our own rules whereby a percentage of aged failsto-deliver were charged to capital. Similar rules were adopted by the major exchanges at our request.
In view of the situation, we were concerned when suggestions were made for resumption of full 5 day trading, and after consultation with the exchanges, this was postponed and then only allowed with shortened hours. We also continued to meet with the heads of the self-regulatory bodies in an effort to discuss additional measures which would bring operational problems under better control.
During 1969, the industry's financial problems emerged as its operational ones were receding. As was the case during the back office crunch the year before, the Commission spent a considerable amount of time working with the self-regulatory bodies in an effort to be kept informed of the steps being taken and to encourage them to take necessary and appropriate regulatory and enPorcement measures with respect to their members. One area of continual conifra to us was the detection of financial difficulties at a firm in time for them o be controlled and overcome: in the summer of 1969, we asked the New York Stock Exchange for a report on its program for checking on the financial condition of member firms.
Throughout the summer, the situation appeared to deteriorate with the general market decline, and it became apparent to us that the programs of the selfregulatory bodies were not fully adequate to detect or deal with the problems. We again invited the major national and regional exchanges and the NASD to 2 meeting early in October, at which time we discussed such topics as:
Existing programs for obtaining information about financial and operational conditions on an overall industry as well as specific broker-dealer basis.
The review and evaluation being made of such information and its utilization to project individual and industry-wide conditions.
The sufficiency of the criteria currently used to evaluate the condition of the industry and the adequacy of the flow and interchange of information among all regulatory groups.
Programs for dealing with situations where serious financial or operational inadequacies are disclosed. Seitber that meeting, nor a following one later in the month, produced agreesent as to an appropriate course of action. For example, our proposal for new financial reporting requirements, and the adoption of a financial questionnaire which would be used by the exchanges, was met with opposition. Among the objections raised were the following: the existing self-regulatory reporting programs were adequate; the Commission was already receiving enough data about exchange members; the report would be burdensome to firms.
Because we were convinced of the need for action in this area, we called a meeting for November 1969, at which time we again met with resistance with respect to our proposals for augmented timely industry-wide financial reporting. However, the NASD agreed that it would develop with us an appropriate financial questionnaire and implement a reporting system applicable to all of its members, exchange and non-exchange alike. We also pursued individual programs with each of the major self-regulatory bodies and stepped up our own monitoring of individual firms.
In the course of reviewing the financial problems of specific firms, in the fall of 1969 we discovered that the New York Stock Exchange was interpreting its net capital rule in a way which appeared inconsistent with the liquidity concept underlying the rule. Since the effect of these interpretations was to weaken the protection to customers, early in 1970 we understook a major inspection of the Exchange's administration of its net capital rule. Both prior and subsequent to the formal inspection we had numerous discussions with the Exchange about the application of its rule, and we succeeded in reversing the Exchange's treatment of such items as insurance claims, restricted stock, reserves for stock differences, and aged dividends receivable. In each case, the effect of our continuing oversight was to strengthen the efficacy of the rule by decreasing or eliminating the capital credit given for such illiquid items.
Because of the Commission's view that the financial condition of certain New York Stock Exchange member firms was critical, in April 1970 the Commission called the Chairman and Vice Chairman of the New York Exchange (together with its top staff personnel) to meet with the Commission and to review in de tail the current condition of its members and the need for further measures. Subsequent to this meeting, the Chairman of the Commission met with the Board of Governors at the Exchange to reiterate the Commission's concern.
The Board of Governors established a special committee both to monitor the financial condition of member firms and to determine what steps should be taken. The members of this committee, which included the Chairman and Vice Chairman of the Board, gave their fullest energies to preventing the collapse of ser. eral major firms which were in serious financial trouble, most notably Hayden, Stone, Incorporated and Goodbody & Co. They constantly reviewed the firins brought to their attention by the Exchange's monitoring program and they met with the management of such firms to recommend or direct measures to reduce operating losses and the exposure to customers. Without such attention, the situation would have been immeasurably worse.
In July 1970, the Commission again met with Exchange officials to discuss the Exchange's responsibility to customers of failing firms, the adequacy of the Special Trust Fund, and the urgent need for broker-dealer insurance legislation.
In addition, in June 1970, in an effort to obtain more consistency in the preparation of the required annual financial reports and the treatment of items in computing a firm's capital, we brought together at the Commission's offices repre sentatives of the American Institute of Certified Public Accountants, the New York State Society of Certified Public Accountants together with representatives of the examiners offices of the major national securities exchanges. At this meet. ing we reviewed the theory underlying the net capital concept pointing out that its principal objective was to test a brokerage firm's liquidity. We expressed our concern with respect to recent departures from this concept in connection with the treatment of a number of items including various error accounts and unse cured receivables. We urged all present to make every effort to attain uniformity in this area consistent with the basic objective underlying the capital rule.
Moreover, during the summer and fall of 1970, we made a number of concrete proposals for changes in the Exchange's net capital rule which would restore some of its potency and make it comparable in stringency to the Commission's rule.
To bring out analysis of the Exchange's interpretation and administration of Its financial responsibility rules up to date, in October 1970, we again conducted a broad inspection, at the Exchange. These two inspections have involved hun. dreds of man hours of work in combing through and evaluating financial and
operational reports, correspondence, minutes of meetings, and other documents, in an effort to pinpoint any weaknesses in the Exchange's rules and procedures. In addition, during the entire period we were briefed on a weekly, and at times a daily, basis by Exchange officials.
Although we have focused our attention primarily on NYSE member firms because of their size and consequent importance to the industry, we have made strenuous efforts to keep ourselves informed on a current basis as to the financial condition of brokerage firms throughout the industry. We have had our staff inspect hundreds of non-exchange member-firms, using a financial/operational questionnaire devised to identify quickly the firm's key problems. These inspections were coordinated with those by the NASD, which has also made surveys periodically at our request to ascertain the condition of its member firms. We have also been in touch with all of the major exchanges on a frequent basis to exchange information and discuss specific problems of mutual concern.
When we have identified a major firm as having severe financial problems, we have worked with the New York Exchange and, in many cases, with the firm itself, in an effort to have the problems brought under control pursuant to a deliberate program. Where customers' funds and securities were endangered, we had ready the necessary court pleadings where major firms were involved so that we could go into court promptly if the Exchange did not take adequate action to protect customers' funds and securities. On occasion we pressed the Exchange to commit its Special Trust Fund in various situations, and we went into court to protect the investors in those cases (First Devonshire, Robinson, and Plohn) where the Exchange did not do so. Where the firm was a member of another stock exchange, we have rendered such assistance as was desired. For example, we worked closely with the Pacific Coast Stock Exchange in two different brokerage failures, to get the POSE itself appointed as the liquidator, with excellent results for the firms' customers.
We should also mention the unusually large volume of complaints which our staff has processed during the past three years. With extremely limited resources we have helped tens of thousands of customers straighten out their accounts, obtain delivery of certificates, recover unpaid dividends and interest, etc. Unfortunately, we were unable to be as helpful as we would have liked to be to complainants who were customers of firms now in liquidation, where the delivery out of credit balances and securities were governed by court rules.
Finally, we have rendered assistance to various Federal and state governmental bodies, and to court or Exchange appointed liquidators, in an effort to resolve problems at troubled firms. As you know, we have also worked closely with Congress this past year in the drafting of the SIPC legislation and in trying to ensure that the members of your Committee were kept informed as to the gravity of the situation confronting the securities industry and its customers. When hearings commenced on the insurance legislation in April 1970, we strongly urged adoption of an insurance program for the protection of customers of securities firms.
Finally, I will turn to your last question: Is it time to consider whether the existing system of self-regulation is adequate for the purposes intended?" Selfregulation has come under severe stress in the last three years or so, particularly in the area of financial and operational regulation. In these areas substantial problems and shortcomings have manifested themselves as indicated in the earlier paragraphs of this letter. Some of these may have become more serious in the light of hindsight than they appeared to the self-regulators at the time. While there were deficiencies in addressing itself to the problems in a timely and strict enough manner, it must also be recognized that self-regulation was inhibited in this area by a natural reluctance to force the liquidation of firms, particularly large firms, with the unpalatable alternatives of serious losses to customers or a heavy drain on industry funds. This problem was most acute among New York Stock Exchange member firms because of the high proportion of the business they handle and the sheer magnitude of some of the firms themselves.
Enactment of the SIPC legislation, which we strongly urged, authorizes and calls for a major change in the existing situation. We foresee two principal consequences. In the first place, it will be possible for regulatory and selfregulatory authorities to become more vigorous in the enforcement of financial and operational regulations, because they need not hold their hand out of conru for existing customers of firms, thereby perpetuating situations which create