maximum 20:1 ratio between "aggregate indebtedness" and "net capital" upon all broker-dealers subject to the rule.10 The term "aggregate indebtedness" includes (with certain exceptions) the total money liabilities of a broker or dealer arising in connection with any transaction whatsoever." And, in computing "net capital" the broker's or dealer's net worth In addition to the financial responsibility rules promulgated directly by the Commission, the Exchange Act permits the self-regulatory agencies (the exchanges and the National Association of Securities Dealers, Inc.) to adopt additional standards for their members. Section 15A of the Exchange Act requires that the rules of a registered national securities association limit membership to persons who meet "specified and appropriate standards with respect to ... financial responsibility.. 13 Section 6(c) of the Exchange Act 14 permits national securities exchanges to adopt any rules which are not inconsistent with the Exchange Act and rules thereunder (or applicable state law) and section 19 (b) authorizes the Commission, upon following certain procedures, to alter exchange rules "in respect of such matters as (1) safeguards in respect of the financial responsibility of members.. 9 15 Although the National Association of Securities Dealers, Inc. ("NASD") did on December 10, 1971 propose a net capital rule for its members, the rule has not been adopted and the NASD relies primarily upon Commission rule 15c3-1 in assuring the financial responsibility 10 17 C.F.R. 240. 15c3-1(a). Recent amendments impose an 8:1 ratio upon broker dealers commencing business during the first 12 months of their existence. SEC Securities Exchange Act Release No. 9633 (June 14, 1972). A pending proposal would reduce the maximum permissible ratio to 15:1 and require that at least 30% of the firm's capital be in the form of equity. The proposed rule, if adopted, will apply to all brokers and dealers, regardless of exchange membership. SEC Securities Exchange Act Release No. 9891 (Dec. 5, 1972). 11 17 C.F.R. 240.15c3-1 (c) (1). 12 2 L. Loss, supra note 6, at 1354 (Citations omitted). The adjustments required in computing net capital under the Commission's rule reflect its philosophy that Congress intended financial responsibility rules for brokers and dealers to result in "instant" liquidity. (See, e.g. Guy D. Marianette, 11 S.E.C. 967 (1942); Stock Exchange Regulation, Hearings Before the House Comm. on Interstate & Foreign Commerce, 73d Cong., 2d Sess. at 87 (1934).) Application of the "haircut" provisions in computing net capital is illustrated by the present rules 15c3-1 (SEC) and 325 (NYSE) which, for example, require the following deductions from market value of securities, long and short (except exempted securities) in the capital, proprietary and other accounts of brokers and dealers: Most common stocks... Future commodity contracts.. Securities failed to deliver: 40-49 days old.. 50-59 days old.. 60 days or over. 13 15 U.S.C. § 780-3 (1970). Percent 30 30 10 20 30 88-033-733 of its members rather than upon separate rules promulgated under section 15A of the Exchange Act. The major national securities exchanges, on the other hand, have all adopted their own financial responsibility rules. These rules utilize the basic principle of a maximum net capital ratio rule but may also incorporate other features designed to assure solvency and liquidity of members. For example, the rules of the New York Stock Exchange ("NYSE") differ from present Commission rule 15c3-1 in the following particulars, among others: 16 When the Commission adopted rule 15c3-1 in 1942, several of the stock exchanges already had their own rules of financial responsibility in operation. The forerunner of NYSE rule 325, for example, was established in 1939. At the time Commission rule 15c3-1 became effective, eight of the exchanges had rules and practices which the Commission felt were more "comprehensive." 17 In view of this fact, on November 8, 1944 (the day before rule 15c3-1 became effective) the Commission announced that it was exempting from the rule members in good standing of eight named securities exchanges "whose rules, settled practices and applicable regulatory procedures are deemed by the Commission to impose requirements more comprehensive than the requirements... of the Commission's rule.18 Members of the following exchanges are now exempt from rule 15c3-1 under this provision: American Stock Exchange The present exemption from Commission rule 15c3-1, which is terminable upon ten days written notice by the Commission, has two primary effects. First, it means that most of the largest brokersdealers in the nation and those which account for the great majority of the securities business in the country are not subject to rule 15c3-1.19 Second, the exemption serves to insulate members in good standing of the named exchanges from Commission enforcement of any net. capital rule. 16 Compare 17 C.F. R. 240.15c3-1 with NYSE rule 325. This tabular comparison has been greatly simplified for convenience. Moreover, the Commission proposed further amendments in its rule on December 5, 1972. SEC, Securities Exchange Act Release No. 9891 (Dec. 5, 1972). The proposed amendment would, among other features, lower the maximum permissible ratio of aggregate indebtedness to net capital from 20:1 to 15:1 and would impose a requirement that at least 30% of the firm's capital take the form of equity. 17 The NYSE rule, for example, established a 15:1 capital test for brokers and provided for greater "haircuts" against the market value of securities carried in the accounts of the firm and its partners than did the Commission's rule. 2 L. Loss, supra note 6, at 1353 n. 246. See also H. BARUCH, WALL STREET: SECURITY RISK 171-176 (1971). 18 SEC, Securities Exchange Act Release No. 3617 (Nov. 8, 1944). 19 See, e.g., Securities Industry Study, Report of the Subcomm. on Securities of the Senate Comm. on Banking, Housing & Urban Affairs for the Period Ended February 4, 1972, 92d Cong., 2d Sess. at 75 (1972). The Commission does not have the power to directly enforce exchange rules (viz. NYSE rule 325).20 And it is not entirely clear that the Commission can compel national securities exchanges to enforce their own rules. Former Commissioner Ganson Purcell testified in 1942, for example: Curiously enough, the act does not, however, contain any Thus, while the exemption from Commission rule 15c3-1 applies to members in good standing of certain stock exchanges "whose rules, settled practices and applicable regulatory procedures are deemed by the Commission to impose [more comprehensive]__ requirements...", there is little in the express language of the Exchange Act which compels the exchanges to enforce or apply those rules, practices and procedures. To summarize the legal pattern of regulation as it applies to the financial responsibility of brokers and dealers, registered brokers and dealers who are not members of one of the exempted exchanges or of the NASD must comply with the Commission's net capital rule. NASD members who are not members of an exchange must also comply with Commission rule 15c3-1. But, brokers and dealers who are members of one or more of the named, exempted exchanges need not at present comply with rule 15c3-1. Instead, they must comply with the capital rules of the exchanges of which they are members.22 Inspection of brokers and dealers for compliance with these several rules is informally apportioned among self-regulatory agencies on a similar basis except that the NASD bears the primary burden of inspection of those of its members who are not members of a named, exempted exchange. On December 5, 1972, the Commission formally proposed a uniform net capital rule, applicable to all firms in the securities industry, regardless of their exchange membership.23 For the first time ever, this rule 20 E.g. SEC, Study of Unsafe & Unsound Practices of Brokers & Dealers, 92d Cong., 1st Sess., H.R Doc. 92-231, pp. 6-7 (1971). 21 Four Proposed Amendments to the Securities Act of 1933 & to the Securities Exchange Act of 1934, Hearings Before the House Comm. on Interstate & Foreign Commerce, 77th Cong., 1st Sess. at 1265 (1942). Of course, the rules of the exchanges do provide for sanctions against members adjudged guilty of violations. See, e.g., Constitution, New York Stock Exchange, Inc., Art. IV, § 6. It has been widely assumed in the area of civil liability, that national securities exchanges do have a statutory duty to enforce their own rules. E.g. Baird v. Franklin, 141 F.2d 238 (2d Cir. 1944), cert. denied 323 U.S. 737 (1944). See also L. Loss, supra note 6 at 5177-1178; N. Wolfson & T. Russo, The Stock Exchange Member: Liability for Violation of Stock Exchange Rules, 58 CALIF. L. REV. 1120 (1970); L. Lowenfels, Implied Liabilities Based Upon Stock Exchange Rules, 66 COLUM. L. REV. 12, 19-30 (1966): Note, Private Actions as a Remedy for Violations of Stock Exchange Rules, 83 HARV. L. REV. 825, 828-830 (1970). 22 As a practical matter, the NYSE assumes primary responsibility for its members. The AMEX assumes primary responsibility for those of its members who are not NYSE members. As to brokers and dealer who maintain membership only on regional exchanges, the largest regional exchange to which the member belongs will normally assume primary responsibility. See, e.g., 3 Study of the Securities Industry, Hearings Before the Subcomm. on Commerce & Finance of the House Comm. on Interstate & Foreign Commerce, 92d Cong. 1st Sess. at 1713 (1971) [hereinafter cited as "House Hearings"]. 23 SEC, Securities Exchange Act Release No. 9891 (Dec. 5, 1972). will, if adopted, directly impose a Commission net capital rule on For many years after the great crash of 1929 the remedial steps! taken by the Congress, the Commission, the Exchanges and the NASD were relatively successful in avoiding massive brokerage failures. In 1963 the Commission's Special Study of the Securities Markets 24 found that the exchanges and the NASD had, by and large, done an effective job in enforcing applicable regulations, particularly in the financial responsibility and books and records areas.25 Beginning about 1968, however, the financial condition of many brokers and dealers deteriorated rapidly. Strangely enough, the industry's financial problems were in large measure attributable to a significant increase in trading volume. In 1960, average daily share volume on the NYSE was three million. By 1967 the average volume had reached 10 million shares. The following year the daily average spurted to an unprecedented 13 million shares, with a record 21.3 million being traded on June 13, 1968.26 Volume continued almost as high in 1969 and it has since become clear that, with occasional exceptions, the markets of the present will consistently handle many times the volume known a decade ago. Twenty-million-share-days, though infrequent, are no longer remarkable and as many as 31.4 million shares have been traded on the NYSE in a single day. Expectations are that the markets of the future will handle even more shares and more transactions on a daily basis. 27 The increase in market activity had a very natural effect on the broker-dealer community. In order to take maximum advantage of the exceptional growth and volume during this period of prosperity, sales facilities were quickly expanded and sales personnel greatly increased.2 28 Unfortunately there was no corresponding increase in trained or experienced "back-office" employees or the development of operating procedures adequate for the expanded volume.29 Once the paper crisis hit, there were simply not enough qualified operational personnel to go around.30 Desperate for skilled help, firms "raided" one another, compounding the problem.31 At the same time, firms which were belatedly recognizing the need for data processing services and equipment too often paid premium prices for services poorly suited to the needs of business.32 Installation and programming difficulties arose at the most inopportune time.33 24 Special Study of the Securities Market, H. R. Doc. No. 95, 88th Cong., 1st Sess. (1963). 25 See 1 House Hearings 48. 26 N.Y. Stock Exch., 1970 Fact Book 72; 1969 Fact Book 70. 27 On Aug. 16, 1971, a total of 31.4 million shares were traded on the NYSE, establishing a new record high volume for a single day and surpassing the previous record of 21.351 million shares traded on the Exchange on June 13, 1968. 28 S. Robbins, W. Werner, C. Johnson, A. Greenwald, Paper Crisis in Securities Industry: Causes Cures 18 (1969). 29 Id. at 53. 30 Id. at 55-56. 31 Id. at 36. 32 Id. at 54. 33 Id. at 55. In 1969 the tide of trading profits began to recede. Share volume on all exchanges declined 7.01 percent from 1968 levels and the dollar value of shares traded declined 11 percent.34 The result was a precipitous decline in revenue from retail brokerage activities. For example,. the average New York Stock Exchange member firm reported a loss. of 2.9 percent from security commission business in 1969 compared to a profit of 9.9 percent in 1968.35 Overhead expenses, which had ballooned during the boom, became grossly disproportionate to the newly reduced revenues.36 The downtrend continued well into 1970. About this time the consequences of the paperwork logjam began to have a significant effect on firms' financial position. For many firms (both NYSE members and nonmembers) retail losses and paperwork problems meant insufficient capital to meet day-do-day operating requirements. For some, the losses of this period spelled disaster. Many were required to liquidate or merge. When the dust cleared in 1971 over 100 member organizations had vanished from the NYSE's roster and an unknown number of nonmember firms had also disappeared. c. Case Study of NYSE Net Capital Rule During this period of crisis the principal weapons used by the Commission and the self-regulatory bodies in attempting to protect the investing public (and other brokers and dealers) from brokerage failures were the net capital rules of the Commission and the exchanges. Because its members were the largest brokers in the industry, the NYSE experienced some of the most difficult net capital enforcement problems. For these reasons the Subcommittee instructed its staff to prepare a "case study" of the interpretation and enforcement of the NYSE's net capital rule during the crisis with an eye toward prevention of a recurrence and with the hope of gaining more general insights into the operation of the self-regulatory structure. In preparing the case study, the staff relied primarily upon published materials and upon the files of the Commission. The Commission cooperated in every respect with the staff in making its files available. Before completion of the case study, a draft was provided to the Commission and the NYSE for review in order to assure complete accuracy. When this review had been completed, copies of the final version of the case study were given to the Commission, the Securities Investor Protection Corporation ("SIPC") and the NYSE together with a series of questions raised by the case study. The case study, questions, responses and additional comments of these bodies are included as an appendix to the Subcommittee's hearings on the self-regulatory structure of the securities industry. A review of the case study of the interpretation and enforcement of the net capital rule of the NYSE and of the statements of the Commission, SIPC, and the NYSE leads to the following conclusions: (1) Dating back perhaps as far as 1964, the NYSE at times "interpreted" its net capital rule in such a way as to permit member organizations to remain in business despite what would otherwise be considered violations of the rule. The Exchange takes the position that it did not follow this practice. However, the evidence is compelling. 34 N.Y. Stock Exch., Inc., 1971 Fact Book 75 (1971). 35 Staff of Special Subcomm. on Investigations of House Comm. on Interstate & Foreign Commerce, 92d Cong., 1st Sess., Review of SEC records of the Demise of Selected Brokers-Dealers 3 (Subcomm. Print 1971). |