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In 1964 Commission examiners reported that the Exchange was more lenient in assigning "haircuts” 37 to securities of questionable marketability where an increased "haircut” would create a capital violation. The Exchange stated that such a policy was unintentional, but agreed to investigate the matter.38
When the Commission's staff conducted its next capital inspection of the Exchange, it found that in at least two instances the Exchange had deviated from the standard interpretation of its net capital rule, apparently in order to keep a member firm in compliance.39 Thé, Exchange denies that the two firms in question had violated its rules as then interpreted.
After the crisis had subsided, the Commission stated in a letter to the Honorable Harley 0. Staggers, Chairman of the House Committee on Interstate and Foreign Commerce:
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 bave had the effect of weakening public confidence in such
firms and in the exchange member community.40 As stated, the Exchange denies the existence of such a relaxation of enforcement and interpretation. However, the case study detailed numerous statements of high Exchange officials to the effect that during the crisis the staff was under great pressure to interpret the rule as loosely as possible so that firms would not be deemed in violation of the rule. 4 Furthermore, a member of the Exchange's Board of Governors and Chairman of its Capital Committee testified before the Subcommittee on Commerce and Finance of the House Committee on Interstate and Foreign Commerce as follows:
It was the question of the exchange accepting a certain interpretation and treatment of this particular problem on the part of certain member firms, the alternative being that probably the strict application of the rule might at any par
ticular moment have put them out of business. 42 Based on this evidence, it appears that, for whatever reasons, some of which may have been entirely appropriate, in the late 1960s the Exchange did in some instances so interpret its net capital rule as to permit firms to stay in business which would otherwise have been in violation.
(2) The flexibility with which the NYSE interpreted its net capital rule made it difficult at times for the Commission and its staff to determine whether particular firms were in or out of compliance. In April of 1970, for example, the staff reported to the Commission, "We have found it difficult to gauge the extent of firms' financial problems because of the conflicting net capital computations made by the firms themselves and by the self-regulatory organizations.” And, in connec
37 See note 12 supra.
38 Hearings on Securities Industry Study Before the Subcomm. on Securities of the Senate Comm. on Banking, Housing and Urban Affairs, 92d Cong., 2d Sess., pt. 3 at 222 (1972) (hereinafter cited as "Study Hearings”).
39 Id. at 228.
tion with one member firm the Commission's staff reported in June of 1970, "The firm has apparently been in net capital violation since March. It is unclear, because of computational differences betwoon the firm and the Exchange just what the firm's ratio is, but the firm computed it as 2,596 percent as of March 26." 43
The SEC's difficulty in determining whether firms were in compliance with the NYSE net capital rules was compounded by the manner in which the rules were applied. Commission Rule 17a-8 requires national securities exchanges to file proposed amendments to their rules with the Commission at least three weeks before approval of the amendment. But "rules” of an exchange is defined in only general terms. Because the NYSE's treatment of its net capital rule took the form of "'interpretations” rather than “amendments”, the “changes” were not filed with the Commission. In one case the Commission did not even learn of the "interpretation” until seven months after implementation.44 Some of these interpretations” allowed firms to stay in business despite problems that, without the interpretation, would have resulted in a net capital violation.
(3) The Commission has not made adequate use of its powers to inspect exchange records or its powers over exchange record-keeping. Section 17(a) of the Act 45 empowers the Commission to make rules and regulations requiring maintenance of books and records by an exchange and empowers the Commission to make reasonable inspections of "such” books and records. The Commission has not promulgated such a general exchange record keeping rule and therefore cannot rely upon the express language of section 17(a) in inspecting Exchange files although the Commission takes the position that section 17(a) does by implication give it such power without a recordkeeping rule. The Commission has nevertheless chosen to rely upon its general investigatory power under section 21(a) of the Exchange Act when it has not received voluntary cooperation from an exchange.
In order to obtain access to the documents it desired, on March 4, 1970, the Commission issued an order directing a private investigation of the NYSE's administration of its net capital rule under section 21(a) of the Exchange Act. This investigation, which delegates to a member of the staff the power to issue subpoenas, has never been terminated by the Commission.46 Use of this procedure has allowed the Commission access to NYSE files without having proposed a record-keeping rule for public comment but leaves open the possibility that future problems might arise with other exchanges.
(4) From time to time during the financial crisis the Commission disagreed with actions or policies of the NYSE. Yet in some of these instances, the Commission seemed primarily concerned with creating a record and did not exhaust its statutory authority to bring the NYSE into compliance with its views.
The Commission took a strong position against the Exchange's permitting member organizations' principals to withdraw capital during the period in which the temporary commission surcharge was in effect. Yet the Commission did nothing when the Exchange dis
43 Id. at 243.
45 1 Study Hearings 250. The Commission has stated that the reason it has not promulgated a general exchange record-keeping rule is that
the Commission “has felt such a rule might suggest a lack of cooperation by the exchanges which did not exist." Id. at 331.
regarded what had apparently been imposed as a condition precedent to the surcharge. (See the discussion in Section III.C.21a.iii below.)
The Commission specifically disapproved of an amendment to Exchange rule 325 regarding Chaircuts” on Canadian Government bonds. Yet, the Commission permitted the amendment to become effective with no further action.
The Commission strenuously objected to the inclusion of a disclaimer of liability in standard form subordination agreements developed by the Exchange for use by its member organizations. Despite these repeated objections, the Commission took no action to compel the Exchange to strike the clause from the documents. (See the discussion in Section III.C.2.a.IV below.)
The case of F. I. duPont, Glore, Forgan & Co. presented a unique and precarious situation. The NYSE entered into a specific agreement with investors in the organization regarding future treatment of short stock record differences. Although the Exchange claims that the Commission gave its specific oral consent to the agreement, the Commission wrote letters stating that it did not acquiesce in the arrangement.
It therefore appears that in some instances during the crisis the Commission made statements designed to demonstrate its regulatory vigilance but did not take any action to implement its views in the face of the Exchange resistance. (See generally the discussion in Section III.c.2 below.) d. Securities Investor Protection Act of 1970
By 1970 it became apparent that mere enforcement of financial responsibility rules would not avert disaster. Some direct means of protecting brokerage customers was necessary. The Securities Investor Protection Act was enacted to fill this need.47 The Act dealt with financial problems in the securities industry in four ways. First, it created the Securities Investor Protection Corporation ("SIPC), which insures the accounts of customers in the event of brokerage failure. Customer claims up to a maximum of $50,000 are covered in the event of a firm's failure ($20,000 in the case of claims for cash). Second, section 7(d) instructed the Commission to promulgate rules and regulations which require the maintenance of reserves with respect to customers' deposits or credit balances.48 Third, section 11(h) instructed the Commission to compile a list of unsafe and unsound practices by members of SIPC and to report to Congress on the steps being taken to eliminate those practices, together with recommendations for additional legislation to eliminate them.49 Fourth, the Act empowers the Securities Investor Protection Corporation and the Commissiou to apportion responsibilities among the self-regulatory agencies in inspecting their members for compliance and empowers SĪPC to designate one such agency where a given broker-dealer is a member of more than one self-regulatory body.50 Section 9(f) Jof the Act empowers the Commission to adopt rules with respect to the frequency and scope of inspections relating to the financial condition of members of the self-regulatory organizations and to require reports relating to the financial condition of members of the self-regulatory bodies. e. Post-SIPC Developments
47 Pub. L. 91-598. 48 These rules have recently been adopted by the Commission. See SEC, Securities Exchange Act Release No. 9856 (Nov. 13, 1972).
49 See SEC, Study of Unsafe and Unsound Practices of Brokers and Dealers, H.R. Doc. 92-231, 92d Cong., 1st Sess. (1971) (hereinafter cited as "Unsafe and Unsound Practices Report").
50 For the time being SIPC has determined to rely upon the existing allocation of inspection responsibilities. Securities Investor Protection Corporation Annual Report for the period ended December 31, 1971,
Almost simultaneously with the enactment of the SIPC Act, the financial crisis in the securities industry began to ease. During calendar year 1971, for example, the 330 NYSE member organizations carrying public customer accounts recorded an aggregate net profit on security commission business whereas in 1970 they had recorded an aggregate net loss.51 The easing of the financial squeeze and the existence of SIPC made it possible for the NYSE, in 1971, to begin to phase out its customer assistance program, the ceiling of which had been raised to $140 million in order to help protect the customers of failing member organizations.52 Further, both the NYSE and the Commission have now adopted comprehensive revisions of their respective net capital rules designed to avoid future financial crises.53
i. Operation of SIPC
On April 28, 1972 the Securities Investor Protection Corporation submitted its first annual report to the Commission. The report detailed the first year of operations of SIPC in protecting public customers of brokers and dealers. At March 31, 1972 there were 39 firms in liquidation under SIPC. The trustees estimated that some $7.8 million of SIPC funds would be required to satisfy the claims of customers of those firms.
At the end of SIPC's first year of operation, certain technical problems were apparent and discussed in the SIPC annual report. These primarily involved delays in paying out funds to customers of insolvent brokers and the fact that the SIPC legislation does not cover changes in the value of securities during the period of receivership.54 However, the Subcommittee feels that it would be premature at this time to consider amendments to the SIPC Act for several reasons.55 First, as stated in SIPC's annual report, many of the difficulties currently being encountered are attributable to broker/dealer failure to establish and maintain current and reliable records. This matter is already covered by existing laws and regulations. What is needed is enforcement, not new laws. Second, SIPC was created at the end of 1970. It began its corporate life without staff, funds, or even an office of its own. Many of the difficulties so far encountered can be expected to be reduced as the corporation's procedures become more routine. Third, some of the delays appear to have been attributable to the unfamiliarity of practitioners with expedited procedures which are available in some instances to speed up payments to customers.55 Finally, until the Subcommittee has a better idea of the extent of delays which will be experienced now that SIPC is established, it is impossible to accurately determine the need, if there is one, to extend coverage to changes in value which occur after commencement of judicial proceedings but before distribution to customers. 61 New York Stock Exchange, Inc., Security Commission Business, Calendar Year 1971, p. 2 (1972). 52 4 Study Hearings 241. 53 Moreover,
on December 5, 1972, the Commission proposed an overall net capital rule which, if adopted, will apply to all brokers and dealers, regardless of membership. See text supra at note 23. 54 See L. Gapay, Little Guy's Friend?
Snags Develop in Fund Set Up To Aid Investors in Brokerage Col56 See also SIPC, Annual Report for the period ended December 31, 1971, p. 10.
lapses, The Wall Street Journal, May 12, 1972, at 1. col. 1.
The Subcommittee intends to continue observing the operation of SIPC. When sufficient experience is gained to allow informed consideration of amendments, the Subcommittee intends to act promptly.
ii. Unsafe and Unsound Practices Report
On December 28, 1971, as mandated in the SIPC Act, the Commis- ; sion transmitted to Congress its Study of Unsafe and Unsound Prac- ! tices of Brokers and Dealers containing its analysis of the financial and operational crisis of the late 1960s and the Commission's recommendations for legislation to avoid a recurrence.56 The findings and legislative recommendations relevant to the financial responsibility of brokers and dealers were the following:
2. ... The Commission believes that the public interest would be better served if it had plenary authority with respect to the rules of the self-regulatory bodies. ... The specific authority sought would be that to approve or disapprove of any new rule proposal or any proposed amendment, supplement or repeal of an existing rule, as well as the authority to require rule amendments and supplements, and the authority to abrogate rules. Action pursuant to such authority should be preceded by appropriate notice and afford an opportunity for hearing.
3. . . . A limitation of the Commission's oversight power over the self-regulatory bodies is that it cannot directly enforce their rules against their members.
4. . . . it would be appropriate for the Commission to have the right to review all disciplinary proceedings of a selfregulatory body upon appeal or on the Commission's own motion, and that such right to review include the power to affirm, disaffirm or modify in any way deemed to be required in the public interest, the findings of and penalties imposed
by the self-regulatory body.57 A comparison of the Commission's recommendations with the $ubcommittee's findings from its case study of the NYSE's net capital rule, and with the facts set out in the Unsafe and Unsound Practices Report, however, raises questions concerning the need for the requested legislation. For example, the Commission recommends that it be given the specific authority to approve or disapprove any new rule proposal or proposed amendment, supplement or repeal of an existing rule of a self-regulatory body and to directly enforce self-regulatory rules against members. A fuller discussion of this recommendation appears elsewhere in this report.58 But, whether the Commission should have the requested powers or not, their absence was clearly not a cause of the financial crisis. First, the case shows that at all times during the crisis the Commission had the power to adopt rules directly applicable to all brokers and dealers regarding financial responsibility. Second, in several instances the Commission disapproved of either an existing Exchange policy or of a proposed amendment. Yet, it failed to exhaust its existing statutory powers to enforce its position. Finally, 56 H.R. Doc. 92–231, 92d Cong., 1st Sess. (1971). 57 Unsafe & Cnsound Practices Report at 6. The Commission's specific legislative proposals
are contained: in H.R. 15303, 92d Cong., 2d Sess. For a fuller discussion of these proposals, see Section III. C.1. infra. 58 See Chapter III. C.1.