short sales which had a demoralizing effect on the market,
merely codified the existing stock exchange requirements
which had been in effect since 1931. After the market break of
1937, the Commission re-examined the Exchange's short-sell-
ing rule, and as a result the Commission, in February 1938,
promulgated its own rules on short selling. The rule was
relaxed somewhat in the following year as a result of extensive
discussion between the Commission and NYSE officials. On
several occasions since that time, the NYSE has requested the
Commission to make further modifications in the short sale
rules but the Commission has refused to do so.91

Professor Jennings adds:

This kind of direct action by the Commission seems to be precisely what the Congress envisaged under the reserve power "if the exchanges do not meet their responsibility." 9 The Subcommittee strongly concurs with this judgment.

The Commission must expand its view of its regulatory options and show an increased willingness to take limited direct actions to correct perceived self-regulatory weaknesses. The Commission's oversight responsibility with respect to the self-regulatory agencies is to insure that they exercise their delegated governmental power effectively to meet regulatory needs in the public interest and do not exercise that delegated power in a manner inimical to the public interest or unfair to private interests. The initial determination of the merits of a specific self-regulatory action is only part of the Commission's job. The Commission must also act on that determination if necessary. In other words, an inherent part of the Commission's oversight task is to take the necessary steps to assure that the self-regulatory agencies comply with the policies which the Commission believes necessary or appropriate for the protection of public investors or the public interest. The Commission's handling of the exculpatory clause in the NYSE's subordinated loan agreement is an example of a failure to fulfill this latter aspect of its regulatory responsibility. If the Commission believed that this clause was against public policy then it had a responsibility to make sure that it was not used. Strong words cannot. take the place of the straight-forward exercise of effective power.

Based on its case studies and other investigations the Subcommittee believes that the major regulatory need in the securities industry is a willingness on the part of the Commission to use the broad oversight powers available to it to assure that "... there is no gap between the regulatory need and the self-regulatory performance." The House Subcommittee on Commerce and Finance states in its recent report:

Since its enactment, the Securities Exchange Act of 1934 has
been amended in 16 different years. . . . Sixteen different
years of amendments make clear Congress' readiness to assure
the Commission the power to protect investors, but no
amount of legislative tinkering can build within the SEC the
commitment and vitality to make full use of the tools
Congress provides. 94

91 Jennings, Self-Regulation in the Securities Industry: The Role of the SEC, 29 Law & Contemp. Probl. 663, 683-84 (1964).

92 Id. at 684.

93 Special Study, pt. 4 at 698.

94 Subcomm. on Commerce and Finance of the House Comm. on Interstate and Foreign Commerce, 92d Cong., 2d Sess., Report of Securities Industry Study 108 (Subcomm. Print 1972).

Although the Congress cannot legislate a willingness on the Commission's part to take effective action, the Congress can take steps to improve its own ability to oversee the Commission's regulatory performance. The Subcommittee believes, therefore, that the Exchange Act should be amended to require the Commission's reports to the Congress and the public to describe more adequately the conduct of its oversight activities.

1. The SEC should be required to include in its annual reports to the Congress specific information as to its program for inspecting the self-regulatory agencies, the inspections it has conducted during the year, its conclusions and recommendations, the actions taken by the self-regulatory agencies in response to previous recommendations, and the Commission's action in all cases in which its recommendations have not been accepted.

2. The desirability of making public all proposed changes in selfregulatory rules is discussed in section III.C.3. below. In addition, the SEC's annual reports should contain a description of the most significant self-regulatory rule changes effected during the year, the modifications in the proposals made at the Commission's "suggestion," the Commission's "suggestions" which were rejected, and the Commission's appraisal of the regulatory significance of the changes.

3. The SEC's annual reports are presently uninformative as to the regulatory activities, development plans and general operational characteristics of the self-regulatory agencies. The Commission should be required to include information bearing on these matters in its annual reports, particularly insofar as they involve significant expenditures of self-regulatory funds. Although the Commission should not be placed in the position of a budget review board for the selfregulatory agencies, the Congress needs to receive from the Commission a general evaluation of the regulatory priorities to which it believes the self-regulatory agencies should be addressing themselves and the extent to which they are doing so within their economic capabilities. If the Commission is unable to obtain the information from the self-regulatory agencies which it requires to report to the Congress on these matters, the Exchange Act should be amende 1 to insure that the Commission has the power to obtain this information. b. The SEC's Reliance on Its Staff for the Performance of Over sight Functions

The Exchange Act delegates "broad discretionary powers" 95 to the Commission to oversee the self-regulatory agencies. Under Public Law 87-592, passed in 1962, the Commission may in turn delegate "any of its functions" to its staff, subject to certain important exceptions. Two of these exceptions relate directly to the Commission's oversight responsibilities, i.e., its general rulemaking authority and its authority to order changes in exchange rules under section 19 (b).97 As noted elsewhere in this Report, the Commission seldom relies on its formal rule-making or section 19(b) powers in dealing with the self-regulatory agencies, preferring, as Commissioner Loomis informed the Subcommittee, to follow an "informal approach... designed to help the self-regulatory bodies do their part of the job more effec

95 H. R. Rep. No. 1383, 73d Cong., 2d Sess. 7 (1937).

96 Pub. L. 85-592.

Stat.

$7 [Njothing herein contained shall be deemed to authorize the delegation of the function of rule making as defined in the Administrative Procedure Act of 1946, as amended... or of the making of any rule, regulation, or order pursuant to section 19(b) of the Securities Exchange Act of 1934." Id.

tively in the public interest, rather than confronting them as adversaries in an arena." 98 This lack of formality is accentuated, in many cases, by casting communications from the Commission to the selfregulatory agencies in the form of "staff" communications, even where they reflect positions which the Commission itself has agreed on at a formal meeting. The following examples, drawn primarily from the Subcommittee's case studies, illustrate this process.

i. The Decisions Concerning Listed Securities on NASDAQ

The Subcommittee's study of the decisions involved in the inclusion oflisted securities on NASDAQ describes the ways in which the formal position of the NASD's Board of Governors varied in accordance with the pressures brought to bear on it.99 Its initial policy against inclusion of listed securities in September 1968 was modified in November 1968 and completely reversed by May 1970 as a result of repeated indications from the staff that the Commission would disapprove the exclusion of listed securities. The communications from the SEC to the NASD concerning this matter were always from the staff, but the Commission reviewed all staff positions, including a specific recommendation conveyed to the NASD in 1968 that the prohibition in the Association's rules against quotation of listed securities on NASDAQ should be deleted.

In 1970, shortly before NASDAQ was to become operational, renewed pressure was placed on the NASD to exclude listed securities from the system. The NASD approached the Commission, which by then had a new Chairman, and this time obtained from the Commis sion itself a "non-disapproval" of such an exclusion at the start-up of the system. According to one person involved in the discussions, the Chairman of the SEC explained that the Commission's decision not to object to the exclusion of listed stocks "... was not a reversal of position by the Commission since the comments previously expressed to the NASD against any boycott by NASDAQ of third market securities were those of the staff of the Commission and not the Commission's." 100

ii. Criticism of the NYSE's Net Capital Rule

The net capital rule for broker-dealers is not only the most important protection for public securities customers against broker-dealer insolvency but it is also one of the primary standards for access to the exchange market.101 On October 1, 1970 the NYSE forwarded a proposed broad scale revision of its net capital rule to the SEO for! comment.102 In response the SEC's Division of Trading and Market prepared a detailed letter to be sent to the NYSE over the signature of the Commission. The letter was extremely critical of the proposed rule changes because they would further relax standards which were, in light of the financial crisis, proving too loose already. The letter asserted:

As you are aware, the exemption which your members were
granted three decades ago from the net capital test ad-
ministered by the Commission was based on the premise that
the Exchange's net capital test was the more stringent one.

98 3 Study Hearings at 20.

99 The case study is contained in 3 Study Hearings at 3-17.

100 3 Study Hearings at 11 (Letter from Donald E. Weeden to the NASD Board of Governors, Oct. 30, 1968). 101 See Section I.A.1.a. supra.

102 For a full discussion of the decisions involved in the NYSE's revision of its net capital rule, see 4 Study Hearings at 239.

Over the course of the years, changes in the interpretation of
our respective rules, and differences in enforcement practices,
have resulted in a reversal of the stringency of the two rules
to the point where the question must be raised whether the
exemption previously accorded is still justified. We regret to
report that our analysis of the proposed changes to the Ex-
change's net capital rule does not indicate a sufficient
strengthening to obviate that question. The regressive char-
acter of the proposals is not due to specific language which
could be altered easily, but rather is due to their fundamental
premise that the net capital test should be geared to a firm's
"operating cycle" or "credit worthiness." On the basis of
recent experience, however, we can see no justification for
departing from the liquidity concept which previously under-
lay both the Commission's and the Exchange's net capital
rules, 103

The Commission discussed the draft letter on October 9 and approved it as written, subject only to its being sent as a letter from the staff rather than from the Commission. No explanation for this change appears in the Commission's minutes.

iii. Evaluation of Self-Regulatory Surveillance Activities

The Commission's description of its program for inspection of the exchanges in the Annual Report to the Congress for fiscal year 1970 contains the following sentence:

These inspections are a means of insuring exchange perform-
ance of regulatory responsibilities and enable the Commission
to recommend, where appropriate, improvements and refine-
ments designed to increase the effectiveness of self-
regulation. 104

In the Annual Report for the fiscal year 1971, this sentence was revised to read:

These inspections enable the Commission to recommend,
where appropriate, improvements designed to increase the
effectiveness of self-regulation. In cases when it appears that
revisions in internal policies are desirable, the Commission's
staff communicates its views to the particular exchange and
discusses the matters with exchange personnel in an effort
to arrive at appropriate solutions.105

iv. Conclusions and Recommendations

The Commission's reliance on "staff" communications in the performance of its oversight role often makes it difficult, as the NASDAQ case study shows, to determine whether a particular statement represents the position of the Commission or the staff and whether the Commission has actually made a decision on a question. It may also run counter to the spirit of the statutory restrictions which have been placed on the Commission's ability to delegate functions to its staff. Further, it is contrary to sound administrative procedure. Regulatory responsibility and accountability rest with the Commission; the Commission must openly and vigorously assume both.

103 Letter from Irving M. Pollack to Robert W. Haack, Oct. 9, 1970, quoted in 4 Study Hearings at 240. 104 36 SEC Ann. Rep. 68 (1970).

105 37 SEC Ann. Rept. 76 (1971) (emphasis added).

Commissioner Loomis has informed the Subcommittee that the SEC's present practice for reviewing self-regulatory rules involves the investigation of the proposal by the staff and then "when the staff has formulated a position with respect to the proposed rule, this is submitted to the Commission and discussed, after which the reaction of the Commission to the proposal and any suggested changes in it are communicated to the [self-regulatory agency]." 106 So long as the communication to the self-regulatory agency is clearly identified as representing the Commission's position on the matter, the Subcommittee believes that this pattern is an appropriate one for the Commission to follow in carrying out all of its oversight responsibilities. Although it is not feasible nor desirable for the Congress to impose limitations on the Commission's ability to "delegate" informal oversight functions to its staff, the recommendations in section C.3 below regarding Commission review of self-regulatory rules should help to assure adequate participation by the Commission itself in the oversight process.

c. Performance of Continuing Oversight Responsibilities

In addition to situations in which the SEC failed to maintain its position in the face of resistance by the self-regulatory organizations, the Subcommittee's studies uncovered weaknesses in the Commission's program of continuing oversight of self-regulatory activities through regular inspections and other surveillance techniques.

i. Inspections of Stock Exchanges

Following the Special Study's warning that if the SEC did not .. re-examine and strengthen its total concept and program for surveillance and oversight..." of the exchanges there might well be a serious breakdown of surveillance in the securities industry, the SEC established, in late 1963, a program for the inspection of the NYSE and the other exchanges.107 The plan was to inspect each of nine major areas of the NYSE's regulatory activity at least once every six months. A staff report with recommendations was to be prepared and the conclusions discussed with the exchange. In March of 1964, SEC Chairman William Cary reported to the Congress: "In line with the recommendations of the Special Study, we have instituted a broad and regular inspection program of all national securities exchanges." 108

In practice, the SEC's program for exchange inspection has not been as "broad and regular" as anticipated. The formal 1963 program was relaxed in 1966 and appears to have been generally discontinued in 1967 or 1968. For example, with regard to exchange surveillance of the performance of specialists, the SEC has conducted only four inspections since the Special Study.109 The first inspection, in 1964, ended with a conclusion that no conclusions were possible because of pending rule changes. The second, in 1965, produced a lengthy series of recommendations which were not forwarded to the NYSE until more than 14 months after the inspection. The third inspection, in 1968, was thorough and produced numerous recommendations for major changes in the NYSE's surveillance procedures, but the SEC has no record

106 3 Study Hearings at 182.

107 The SEC's inspection program is discussed in the case study of specialist regulation, see 4 Study Hearings at 30-36.

108 Letter from William L. Cary to Harley O. Staggers, March 3, 1964; quoted in 4 Study Hearings at 31. 109 See 4 Study Hearings at 31-35.