the Commission's recommendations do not deal with the problem the Commission actually outlined in its own report: the fact that relaxation of the rules took the form of “interpretations” and not of "amendments.” The power to review and approve or disapprove "rule proposals” is illusory when the Commission so defined the term "rules” as to permit the self-regulatory bodies to make "substantive changes" without even notifying the Commission.

ii. Regulatory Improvements

Both the Commission and the NYSE have taken significant steps since the enactment of SIPC to strengthen their programs for assuring financial responsibility of brokers and dealers. On July 15, 1971 the Board of Governors of the NYSE adopted comprehensive amendments to Rule 325 and to other Exchange rules dealing with financial responsibility.59 Among other changes, these amendments lowered the maximum net capital ratio permitted for member organizations from 20 to 1 to 15 to 1, increased the minimum net capital required from $50,000 to $100,000 and contained provisions designed to improve the quality of member capital by placing limitations on its withdrawal and requiring that it be contributed for a longer period of time.

On June 14, 1972 the Commission also amended its net capital rule.60 The amendment increases the minimum net capital required for most brokers and dealers from $5,000 to $25,000 and imposes a maximum ratio of aggregate indebtedness to net capital of 8 to 1 for the first 12 months of the existence of any broker or dealer. Among the other improvements made by the Commission in the area of financial responsibility are the adoption of rules requiring brokers and dealers to give immediate notice to the Commission at both its principal and regional offices and to each self-regulatory agency of which it is a member upon the event of a failure of compliance with the applicable net capital rule.61 New rule 17a-5 requires those national securities exchanges whose members are exempt from the Commission's net capital rule to promptly report to the Commission upon taking any action which causes a member to cease to be a member in good standing or when they learn of any action by the member which causes it to cease to be a member in good standing 62 The combined effect of these two new rules is to help assure that all regulatory and self-regulatory bodies having jurisdiction over a broker or dealer will be informed as soon as possible when the broker or dealer ceases to be exempt from rule 15c3-1 or becomes the primary responsibility of a different self-regulatory agency,

On November 8, 1971 the Commission adopted new rule 17a-13 which requires once each quarter a box count of securities held by broker-dealers and verification of securities not in the broker-dealer's possession. And, on June 30, 1972 the Commission adopted rules providing for greater disclosure by broker-dealers to their customers with respect to their financial condition.6

On December 5, 1972, the Commission took the first step toward what may be one of the most significant events in the regulation of 59 4 Study Hearings 241. 60 SEC, Securities Exchange Act Release No. 9633 (June 14, 1972). 81 17 C.F.R. 240.17a-11. 62 17 C.F.R. 240.17a-5. 63 SEC Securities Exchange Act Release No. 9658 (June 30, 1972).

broker-dealer financial condition since 1944.64 In Release 9891 the Commission proposed a uniform and comprehensive net capital rule applicable to all brokers and dealers regardless of whether they are members of an exchange. The Subcommittee believes this is an important and constructive step and looks forward to early adoption of a definitive rule.

Finally, in November 1972, the Commission announced that rules requiring the maintenance of reserves with respect to customers' deposits or credit balances would go into effect on January 15, 1973.65 These rules, which the SEC was directed to adopt by Section 7(d) of the SIPC Act, were first proposed by the SEC in November 1971 66 and were modified substantially in May 1972 67 and again in September 1972 68 in response to industry criticisms. The Subcommittee will review their operation at appropriate intervals after they have gone into effect to assure that they are achieving the objectives set forth in the SIPC legislation. f. Subcommittee's Analysis.

In 1963 the Special Study, in addressing regulatory problems associated with an influx of persons into the securities business, .concluded:

It is the belief of the Study that the gateway to the industry is the point where government and industry should look first for the solution of some of these problems, and that adequate controls over entry into the industry are an alternative to be preferred over an abundance of regulations and

too many policemen.69 The Special Study's conclusion was based in part on its finding that a disproportionate number of rule violations and financial problems occurred among newly formed broker-dealers and those with limited capital.70 Based upon these findings, the Special Study recommended that a minimum net capital requirement (as distinguished from a net capital ratio rule) be accorded a high order of importance in assuring broker-dealer responsibility.?1

Recent experience has indicated that the Special Study was correct in finding that newly formed firms and those with limited capital are most likely to experience financial difficulties. In its quarterly report for the period ended September 30, 1972 the Securities Investor Protection Corporation summarized the longevity and initial capital of the 51 firms in liquidation at that date as follows:

64 On November 8, 1944, the Commission exempted from rule 15e3–1 members in good standing of certain named national securities exchanges. Such members, as a group, constitute most of the largest broker-dealers in the nation and account for the great majority of the securities business in the country. 65 SEC Securities Exchange Act Release No. 9856 (Nov. 13, 1972). 68 SEC Securities Exchange Act Release No. 9376 (Nov. 8, 1971). 67 SEC Securities Exchange Act Release No. 9622 (May 31, 1972). 68 SEC Securities Exchange Act Release No. 9775 (Sept. 14, 1972).

69 i Special Study 47. At the same time, the Special Study recognized that the basic policy of the Exchange Act is to permit relatively free entry into the securities business. Id. at 48.

70 Id. at 91, 152. 71 Id. at 161. This recommendation has largely been implemented as rule 15c3-1 which now requires most brokers and dealers to maintain

net capital of at least $25,000. Moreover, present rule 15c3-1 (a) (1) imposes a maximum net capital ratio of 800 percent during the first 12 months of existence as a broker or dealer.

Percentage of the 51 firms which

were in liquidation at Sept. 30, 1972

6 35 65 75

Years of operation
Less than 1.
Less than 2
Less than 3.
Less than 4.

Initial capital
Less than $10,000.-
Less than $25,000.
Less than $50,000.
Less than $100,000.

18 52

While the probability of failure is higher among newly formed firms with limited capital, the Subcommittee's net capital case study points out that in 1968–76 it was the failure of large, established firms which posed the greatest threat to customers and the industry. At September 30, 1972, total SI PC advances paid and accrued with: respect to a total of 35 firms aggregated $5.5 million and the number of customers involved was 4,177. By way of comparison, the NYSE's. liability with respect to the single firm of Goodbody & Co. is expected to amount to $30 million. At the time of its acquisition by Merrill Lynch, Goodbody had 225,000 customer accounts. The firm was. founded in 1885.

Nevertheless, the Subcommittee is cognizant of the need for meaningful entry requirements for brokers and dealers. The steps taken recently by the Commission to strengthen its capital rules regarding the minimum amounts of capital which must be maintained by and maximum permissible ratios during the first year cf operation for brokers and dealers are certainly constructive. However, in considering future legislation the Subcommittee must also weigh the sound policy of the Exchange Act in avoiding unreasonable restraints upon entry into the securities business. New entry into the brokerage business benefits customers by increasing the number of alternative sources of brokerage services and provides a healthy injection of competition into the industry. Indeed, as in other areas of this report, the Subcommittee has concluded from its investigation that, subject to compliance with applicable regulatory requirements, competition is likely to be the best and most effective regulator of brokers and dealers. The fact that a given number of brokers or dealers fail during a certain period does not necessarily lead to the conclusion that regulatory problems exist. While no one derives pleasure from the misfortunes of brokerage firms, we must not lose sight of the fact that the securities business, like other businesses, involves an entrepreneurial risk. Not everyone who engages in the business is destined to succeed.

Balancing these various considerations, the Subcommittee's basic conclusion is that the economic advantages to the investor of relatively open entry into the brokerage business are such that only the minimum necessary entry requirements should be imposed by federal statutes. The fact that one or more brokerage firms fail does not in and of itself suggest a need for higher entry standards.

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There are, however, important considerations which necessitate imposing some financial requirements upon members of the industry.

First, the investing public must be protected against the consequences of brokerage failure. The Subcommittee believes that the SIPC legislation is a significant step in this direction. There may be some imperfections in the SIPC legislation, however, and the Subcommittee will address them as soon as sufficient experience has been gained under the statute.

Second, the consequences of brokerage failure should be confined as nearly as possible to the individual firm and not be allowed to ? permeate the entire brokerage industry or to have a significant detrimental effect upon the nation's economy. As Robert W. Haack, former President of the New York Stock Exchange, said in a letter of May 25, 1970 to the Director of the Commission's Division of Trading and Markets:

there is a high degree of interdependence among members of the Exchange community which results from the contractual relationship among the Exchange, Stock Clearing Corporation and Members and Member Organizations. Not only must the Exchange be concerned with the solvency and liquidity of individual members but it must also be concerned with the overall liquidity of the marketplace. Reasonable administration of rule 325 demands due consideration of the impact of remedial action with respect to one member organization upon the wider circle of other

brokers and their customers, etc.72 Without accepting or rejecting the conclusions stated in Mr. Haack's letter, his observation of a possible domino effect of the failure of one or more brokerage houses is noteworthy. For, in the ordinary course of their business, brokers and dealers become debtors or creditors of, and deposit funds and securities with, one another and with various clearing corporations and securities depositories. When one broker's account with another firm is placed in jeopardy due to insolvency, it is entirely possible that both firms will fail. The possibility of cumulative effects in such a situation is a matter of serious concern.

Third, the SIPC fund should be protected against unnecessary claims. The SIPC fund constitutes a public trust and is subject to supplementation from the United States Treasury. It should not be subject to the fortuities of fiscal impropriety in the brokerage industry. g. Subcommittee's Recommendations. Based upon the above analysis, the Subcommittee makes the fol

! lowing recommendations with regard to the financial responsibility of brokers and dealers.

First, the Subcommittee stands ready to consider amendments to the SIPC legislation as soon as it is feasible to draw meaningful conclusions about the experience of SIPC thus far. Among the amendments which may merit consideration would be the possibility of expanding the coverage of SIPC with respect to accounts of stock clearing corporations and other brokers and dealers. Such a provision 72 4 Study Hearings 233.

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might provide additional protection against a "domino” effect in the

event of future financial crises,

Second, the SEC should promptly implement its recent proposal to .terminate the present exemption from rule 15c3–1 for stock exchange members and subject all broker-dealers to the SEC's own net capital rules.73 It is not necessary for the Congress to resolve the question of whether the exchanges' net capital rules are more or less "comprehensive" than Commission rule 15c3-1. The fact that a dispute was allowed to exist between the New York Stock Exchange and the Commission concerning interpretation of that Exchange's rule 325 is proof enough, if any is required, that the exemption from rule 15c3–1 should never have been promulgated. The Commission must accept its responsibility to dictate minimum standards of financial responsibility for brokers and dealers. The exchanges should be and are free to adopt more rigorous standards for their own members so long as all of such members remain subject at all times to a Commission adopted rule.

Rigid enforcement of a uniform net capital rule for the entire securities industry will help protect the SIPC fund from unnecessary claims and protect public customers from any imperfections in the SIPC legislation as now in effect. In view of the SÈC's apparent determination to end the exemption of exchange members from the SEC's net capital rule, the Subcommittee does not propose or recommend additional legislation in this area.

Third, as pointed out in the case study, it is not entirely clear that the Commission has power under the present Exchange Act to compel national securities exchanges to enforce their own rules.74 To erase any doubt on this subject, section 6(a)(1) of the Exchange Act should be amended to make it clear that every registered national securities exchange is obligated to enforce not only the provisions of the Exchange Act and the rules thereunder but also its own rules.

Fourth, the importance of public disclosure of information regarding the financial condition of brokers and dealers should not be underestimated. Although disclosure does not form an appropriate substitute for vigorous enforcement of applicable rules, the Subcommittee does believe that the Commission's recent action imposing upon brokers and dealers the obligation to furnish their customers with information regarding their financial condition is a constructive step.


A major contributing factor to the financial crisis which engulfed the securities industry in 1969 and 1970 was the tremendous backlog of paperwork associated with processing securities transactions. In its report for the period ended February 4, 1972, the Subcommittee detailed the severe financial pressures created by cumulative failures to deliver and receive securities among brokers. The so-called "paperwork crisis” resulted not only in financial stress for professionals in the securities business but in poor service, late deliveries, misdirected shareholder communications and sometimes financial loss for the investing public. Operational problems in the

73 See text supra at notes 23 and 64. 74 See text supra at notes 20 and 21.

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