that these recommendations were even conveyed to the Exchange. The fourth and final inspection was conducted in 1970 and resulted in serious questions being raised as to the adequacy of the Exchange's surveillance procedures bearing directly on the specialists' capacity and willingness to maintain fair and orderly markets. As discussed in section III.C.2.a.i. above, based on this inspection the SEC recommended major changes in the NYSE's regulatory program which it stated should be "expeditiously" implemented. Despite the fact that the NYSE rejected all of the SEC's recommendations, the SEC not only did not press its recommendations but it has not conducted a follow-up inspection in the intervening two years to determine if the NYSE's surveillance program, which it stated caused it "grave concern" in 1971, is providing the "effective and systematic surveillance" required by the SEC's Rule 11b-1.110 The Commission's Annual Reports to the Congress for the past eight years have contained only a brief description of the SEC's inspection program. None of the Reports gives any intimation that the program is not operating effectively. At the Subcommittee's hearings, however, Commissioner Loomis acknowledged that "interruptions" had occurred in the program, and cited as reasons "a steady attrition of persons [on the SEC staff] with expertise" in the areas being inspected, "the series of crises which the securities markets have undergone," and "the studies of the markets undertaken in the last few years.' "112 Whatever the explanation for the "interruptions," the Commission does not at the present time have anything approaching want Chairman Cary described to the Congress in 1964 as a "broad and regular" program for the inspection of the regulatory operations of the exchanges. ii. Surveillance of the Allocation of Securities to Specialists The allocation of securities to specialists on stock exchanges involves both the award of an extremely valuable monopolistic franchise and a fundamental mechanism for controlling the quality of the market in individual securities. The Institutional Investor Study Report stated: The economic motivation of NYSE specialist units could be 110 Id. at 34 and 51. 111 [To be supplied.] 112 4 Study Hearings at 81-82. Commissioner Loomis was addressing himself specifically to inspections of specialist surveillance. The Subcommittee's investigations indicate that the SEC's inspection program in this area is typical of its inspection activities in other areas. The Commission's description of "a comprehensive inspection program" to the Subcommittee, appears to be more in the nature of a future plan than a present reality. 4 Study Hearings at 328. 113 SEC, Institutional Investor Study Report, II. R. Doc. 92-64, 92d Cong., 1st Sess., vol. 4 at 1926 and 1959 (1971). In its comments to the Subcommittee on the staff's study of specialist regulation, the Commission endorsed the Institutional Investor Study's conclusions and added: [T]he heart of specialist regulation is in the nature of the as- Apparently sharing this view, William McChesney Martin recently Authority with respect to the allocation of newly listed It is significant, however, that although the security allocation process is "the heart of specialist regulation" and Mr. Martin has called for a major change in its operation, the SEC has never inspected the standards and procedures used by the NYSE to allocate securities to specialists. iii. Conclusion and Recommendation The Subcommittee's recommendations in section III.C.2.a.v. that the Commission give more detailed information in its Annual Reports concerning the performance of its self-regulatory oversight activities will aid the Congress in determining whether important continuing regulatory functions are being carried out properly. The Commission's Annual Report for fiscal 1971, for example, devoted only one page to inspections of exchanges and one paragraph to inspection of the NASD, while 25 pages were devoted to describing the Commission's administrative, civil and criminal proceedings against individual defendants accused of violations of the securities laws. To the extent that this reflects the allocation of Commission personnel and attention between these two areas of activity, it is a graphic illustration of the inadequate attention paid by the Commission to its important oversight responsibility for the vast areas of regulatory responsibility delegated to the exchanges and the NASD by the Securities Exchange Act of 1934. 3. THE SEC'S PROCEDURES FOR REVIEWING PROPOSED SELF-REGULATORY RULES The SEC makes policy for the securities industry in essentially two ways: by promulgating its own rules, and by passing on the rules of the self-regulatory agencies. The Administrative Procedure Act (the "APA") requires the SEC, in the formulation of its own rules, to give notice and an opportunity for interested persons to participate in the rule-making process, and to issue in connection with the promulgation 114 4 Study Hearings at 66. 115 Martin, The Securities Markets, A Report with Recommendations, submitted to The New York Stock Exchange 14 (Aug. 5, 1971). of a rule a statement setting forth the "basis and purpose" of the rule.116 These requirements are not, however, applicable to the SEC's consideration and "approval" of proposed self-regulatory rules. Thus, if a policy is established by means of a self-regulatory rule, regardless of the SEC's direct jurisdiction in the area or the impact of the proposed rule on the industry and the public, no one is entitled under the APA or any other statute to notice of that change, to the opportunity to participate in the Commission review and evaluation of it, to be told the SEC's basis and purpose in "approving" the rule, or possibly even to the right to obtain judicial review of the rule. The Subcommittee has referred elsewhere in this report to the major industry policies which are set or affected by exchange and NASD rules, examples have included the regulation of the non-securities activities of broker-dealers, inclusion of listed stocks on NASDAQ, the substance of specialist regulation, capital requirements for exchange members, the ability of exchange members to trade with non-members, and the commission rate structure for the industry. Under present procedures, policy formulation by self-regulatory rule making often means that persons with significant interests at stake in a determination which is the equivalent of a governmental action do not have the procedural rights to which they are entitled. The Subcommittee believes this is a situation which should be promptly changed. a. Notice and Opportunity to Participate in the Rule Review Process In recognition of the desirability of providing interested persons notice and an opportunity to comment on proposed self-regulatory rules, the SEC has recently taken steps away from its traditional practice of processing exchange and NASD rule changes on a nonpublic basis. For example, the SEC has in certain significant cases, including the NYSE's incorporation and that Exchange's proposed rule on institutional membership, issued a release setting forth the proposed rule and requesting public comments.117 The SEC has also established a policy of placing proposed self-regulatory rule changes in a public file.118 Despite these steps toward opening the rule review process to participation by interested persons, the SEC's procedures need to be further improved. Notice of proposed rule changes is not always made public in a timely manner, and the failure of the SEC to give notice of a proposed amendment in no way affects the validity of the rule once it is adopted. For example, the Midwest Stock Exchange recently proposed and the SEC indicated "no objection" to a rule change permitting a 40% discount from the non-member commission rate to members of the London Stock Exchange. Upon learning of this change, the NYSE wrote to the SEC. Within the last two weeks, we noted newspaper reports that the Midwest Stock Exchange had proposed to extend a 40% commission discount to members of foreign stock exchanges. Since reading these news reports, we have learned that the Midwest Stock Exchange filed a formal proposal with the Commission under SEC Rule 17a-8 on October 16, 1972 to so amend its rules. 116 5 U.S.C. § 553 (1970). 117 SEC, Sec. Ex. Act Rel. Nos. 9112 (Mar. 17, 1971) and 8717 (Oct. 8, 1969). 118 SEC, News Digest No. 72-52 (Mar. 20, 1972). In March of this year the Commission began placing SEC Rule 17a-8 filings submitted by the various exchanges in a public file at the Commission offices in Washington. We have found, however, that Rule 17a-8 submissions are not always placed in the public file on a timely basis and, in fact, our routine review of that file did not disclose the Midwest Stock Exchange filing of October 16, 1972 until a few days ago. What makes this situation of concern is that the Midwest Stock Exchange proposal is an extremely important one which affects all registered national stock exchanges and large segments of their membership . In addition, the November 20 issue of the PBW news indicated that on November 15 that Exchange had taken preliminary steps to grant a similar 40% discount to foreign broker-dealers. That article indicated that the proposed PBW rule had been filed with the SEC. Nevertheless, a check of the Commission's public files on November 29, 14! days after the adoption of the proposed rule, did not produce a copy of the PBW letter, thus reaffirming the fact that many 17a-8 submissions are not placed in the public file on a timely basis.119 Proposals have been made that the self-regulatory agencies themselves solicit public comments on proposed rules before filing them with the SEC. Steps have been taken by the NASD and the Amex in this direction and other self-regulatory organizations may well follow! their lead. 120 The Subcommittee does not believe, however, that it would be appropriate to impose such a requirement on all self-regulatory agencies by statute. One of the strengths of the self-regulatory agencies is their informal procedures, and each self-regulatory agency should be encouraged to develop procedures for formulating policies best suited to its individual needs and characteristics. Nevertheless, it is important to provide a meaningful opportunity for interested persons to obtain accurate information as to proposed changes in self-regulatory rules and to comment on the need or justification for the changes before a decision is made. The most appropriate way to accomplish this is to require the SEC to follow an APAtype procedure of giving notice and providing an opportunity to participate in the rule-review process when proposed self-regulatory rules are filed with it.121 The Subcommittee believes that by imposing these APA requirements on the SEC, the goals of protecting the rights of persons affected by self-regulatory rule changes and providing the Commission with a complete picture of all opinions on an issue will be adequately served. In order to insure that persons interested in a proposed rule change have accurate information about the substance of the rule and its possible implications, the Subcommittee recommends that the statute clearly require that all comments and all correspondence between the SEC and the self-regulatory agency concerning the proposal should be publicly available. 119 Letter from James J. Needham to William J. Casey, Nov. 30, 1972. 120 See 3 Study Hearings at 257-258. 121 Although the Commission will be engaged in determining whether to approve or disapprove a proposed rule rather than promulgating rules directly, with appropriate modifications the Subcommittee believes the APA requirements for rule-making in section 4 can be made to apply in a straightforward manner to the SEC's procedures. Under an APA-type procedure, the SEC will have sufficient flexibility to fashion the type of proceeding appropriate to each particular proposed self-regulatory rule. In many, perhaps most, situations, notice and an opportunity for comment will be sufficient and there will undoubtedly be few if any comments. In some cases, however, where fundamental policy issues are involved, public hearings or publicly announced conferences might be most appropriate. In still other cases, the proposed rule will involve a significant anticompetitive impact on members of the industry. The NYSE's Rule 394 and that Exchange's "parent test" are examples of this type of a rule. In such situations the SEC should consider reviewing the proposal "on the record" by placing the burden of justification on the self-regulatory agency proposing the anti-competitive rule and affording to those persons significantly affected by the proposal the rights of cross examination and the opportunity to submit rebuttal evidence. b. Approval of Self-Regulatory Rules Under section 15A(j) the Commission is required to disapprove a proposed NASD rule "unless such change or addition appears to the Commission to be consistent" with the requirements of the Exchange Act. There is no similar provision concerning proposed exchange rules. The Commission's practice is to review proposed amendments to exchange rules and either make suggestions for changes or to indicate it has no objection to the adoption of the amendments. However, the Commission does not view a statement of "no objection" as "a 'definitive' determination 'dealing with the merits' of the Exchange's rule amendments." 122 The Commission has recommended that the Exchange Act be amended to conform its power over proposed exchange rules to that over NASD rules.123 As Chairman Casey has stated, the Commission should have the authority"... to approve or disapprove of any new [self-regulatory] rule proposal. 124 The Subcommittee concurs in this recommendation. The Exchange Act should expressly provide that the Commission has the authority and responsibility to assure that no self-regulatory rule is adopted which is inconsistent with the objectives of the Exchange Act, inimical to the public interest or "nfair to private interests. The manner in which the Commission expresses its approval of a self-regulatory rule change is significant for assuring adequate public scrutiny and judicial review of Commission action.125 The Commission's present practice is to indicate "approval" of both exchange and NASD rules by merely stating that it has "no objection" to their adoption. In the absence of an articulated explanation of the proposal from the self-regulatory agency, 126 this practice often results in a total lack of public justification for significant shifts in regulatory policy. The decision to include listed securities on NASDAQ and to permit exchange members to sell life insurance provide examples of this type of situation. 122 SEC, Memorandum in Support of the Respondent's Motion to Dismiss Petition for Review, Independent Investor Protective League v. SEC, Docket No. 71-1924 (2d Cir.; filed Sept. 28; 1971); see 3 Study Hearings at 182-183. 123 See Letter from William J. Casey to Senator Harrison A. Williams, Jr., May 8, 1972. 124 Unsafe and Unsound Report at 6 (Letter of Transmittal from William J. Casey); but see 3 Study Hearings at 182-183 (statement of Commissioner Philip A. Loomis, Jr.). 125 See Section III.D.1 infra. 126 See Section III.B.1.b. supra. |