"***nothing herein contained shall be construed to prohibit any member, allied member or member firm from, or to penalize any such firm for, acting as an oddlot dealer or specialist or otherwise publicly dealing for his or its own account (directly or indirectly through a joint account or other arrangement) on another exchange located outside the City of New York (of which such member, allied member or member firm is a member) in securities listed or traded on such other exchange."

No appeal was taken by the Exchange from the order of the Commission. Many of the smaller exchanges had protested vigorously against the rule as it stood and was interpreted by the Exchange prior to the ordered amendment.

Exchanges Registered and Exempted from Registration

During the past fiscal year there was no change in the number of exchanges registered with the Commission as national securities exchanges, nor did any change occur in the num-ber of exchanges exempted from such registration.

OVER-THE-COUNTER MARKETS

Commission Supervision of Over-The-Counter Brokers and Dealers

In the year ended June 30, 1942 the Commission received from its regional offices, 1,054 reports of inspections of registered brokers and dealers. These inspections are based on examination of books and records only and are designed to test compliance with the statutes aand rules and regulations thereunder. Prominent points covered are best illustrated by a brief summary of the findings of these inspections. In 368 inspections there were found irregularities which may be classified as follows: 112 instances of unsatisfactory or precarious financial condition; 65 instances of improper use of customers' funds or securities (only 18 of which involved firms whose financial condition was not unsatisfactory); 161 instances of transactions at prices which tended to indicate that sales had been made to customers at prices not reasonably related to the current market; and 28 instances of secret profits, involving misrepresentations as to the prices at which customers' orders had been executed. In many other cases involving the sale of oil royalty interests it was found that sales to customers were at prices grossly in excess of the cost to the dealer.

Administrative Remedies

Public interest and protection of customers are factors which the Commission must weigh and consider prior to the application of a statutory remedy upon consideration of irregularities of the sort described above. In the course of our examination of the books of registered brokers and dealers cases are frequently encountered involving unsatisfactory financial condition or improper hypothecation of customers' securities. cases, circumstances suggest that the violations are unintentional. The inspection program being, in part, educational, it has been the Commission's policy, before considering statutory remedies, to give opportunity to firms to correct such conditions. In one case a firm had improperly pledged customers' fully paid for securities but officers who were also principal stockholders disclaimed knowledge of the situation and promptly contributed more than $40,000 to the corporation, discharged responsible employees and reorganized the business. Subsequent surveillance failed to disclose further irregularities by the firm.

In the case of Ver Hulst & Co., Inc. of Denver, Colorado, 6/ the Commission, on information tending to show insolvency and improper use of customers' securities,

6/ Securities Exchange Act Release No. 3204.

instituted proceedings in February, 1942 to determine whether the firm's registration should be revoked and whether it should be suspended or expelled from membership in the N.A.S.D. Subsequently the firm requested withdrawal of its registration, representing that it had paid or arranged to pay $55,000 satisfying all creditors and protecting customers from the possibility of loss, that it was in the process of going out of business and contemplated dissolution, that it had resigned from the N.A.S.D., and that the registrant's President, George M. Ver Hulst, would not again enter the securities business. Under these circumstances, the Commission found that withdrawal would not be inconsistent with the public interest and the protection of investors and ordered, on April 22, 1942, that the withdrawal application be permitted to become effective.

In the case of Morrison Bond Co., Ltd., of Long Beach, California, 7/ a similar proceeding was instituted by the Commission on information that the company had filed a petition under Chapter XI of the Bankruptcy Act to effect an arrangement with unsecured creditors. The company proposed to continue its broker-dealer business. On April 8 registration was revoked and the firm was expelled from the N.A.S.D. on findings of misleading representations and fraudulent omissions of material facts in the sale of securities, wilful violations of the hypothecation rules and alterations and false entries in its books and records. It was stated in the Commission's opinion that the Commission was convinced that the false entries had been made "to avoid discovery of the fact that it (the firm) has violated the Commission's hypothecation rule."

As a result of information obtained in some inspections, civil suits were filed and permanent injunctions obtained, the defendants consenting, against Kimball, Ware & Co., Portland, Maine, Seybolt & Seybolt, Inc., Springfield, Mass., John M. Wyatt & Co., El Paso, Texas, and Hartmann Inc., Wheeling, W. Va. In twelve instances facts relating to serious financial condition were referred to the Attorney General of the State of New York who, after independent inquiry, obtained injunctions against nine of the firms involved. One injunction was later vacated. The capital position of each of the three remaining firms was adjusted and no action against them was taken.

The most difficult current problem arising out of regulation of over-the-counter brokers and dealers stems from the practice of selling securities at prices which bear no reasonable relationship to current market. 8/ In such cases extensive investigations beyond the limits of books and records must be made. These investigations tax to the utmost the limited staff of the Commission now available for such work. They require the compilation of voluminous price schedules and the reconstruction of market prices at the time the transactions took place. Customers must be interviewed to determine what representations were made to induce the transactions and whether material facts were concealed from them. In a number of investigations made during the past year the evidence disclosed a pattern of fraudulent conduct which resulted in the formal proceedings. The chief remedy employed in such cases is the revocation of the firm's registration, coupled with expulsion from the N.A.S.D. where the firm is a member of that Association.

7/Securities Exchange Act Release No. 3189.

8/ In July 1942 the Trading and Exchange Division offered to the industry for comment a proposed rule which would require the disclosure to the customer of the best available market for a security before the completion of a transaction in that security.

In ten of the cases decided during the year 9/ revocation of registration was ordered because of fraudulent over-reaching of the character just described. Seven of these firms were also expelled from membership in the N.A.S.D. Of the ten cases referred to above, two 10/ involved not only the sales of securities at prices inconsistent with prevailing market prices but also gross abuse of a relationship of trust and confidence which the firms had established with their customers. Both cases are of importance on the question of agency.

In its findings and opinion in the Allender case, the Commission discussed the legal principle that words alone on a "confirmation" to a customer do not establish the relationship between the parties and held that "the words 'we have this day sold to you' and 'bought from you' do not of themselves contravene the existence of an agency relationship between the respondent and its customers and do not justify respondent's failure to disclose its secret profits." The complete reliance of the customers on the firm's advise, the unequal circumstances of the parties in the transaction, and complete trust and confidence in the firm were held to impose upon it the duty to make full and complete disclosure of all material facts.

In the Stelmack case the evidence showed that the firm obtained lists of holdings from certain customers and then sent to these customers analyses of their securities with recommendations listing securities to be retained, to be disposed of, and to be acquired. The firm's order blanks, which customers signed, stated "I hereby authorize you as my agent, for my account and risk... to sell. buy," but also contained language which authorized the firm, as principal, to "buy from or sell to me. at prices to be fixed by you and I hereby ratify and confirm any transaction effected by you pursuant hereto." The Commission held that the conduct of the customers in soliciting the advice of the firm, their obvious expectation that it would act in their best interests, their reliance on its recommendations, and the conduct of the firm in making its advice and services available to them and in soliciting their confidence, pointed strongly to an agency relationship and that the very function of furnishing investment counsel constitutes a fiduciary function. As to the order form, the Commission held that where the language of a document or a course of conduct thereunder create an agency, other provisions in the document explicitly negating the existence of an agency are of no effect.

The Stelmack case in important in another respect. One of the admitted charges which the Commission found to be in violation of the fraud provisions of the Securities Act and the Securities Exchange Act was that, while the corporation was engaged in selling its own preferred stock, it failed to disclose to the purchasers thereof that it had submitted false and misleading financial reports to the Office of the Attorney General in that State which in effect permitted the registrant to remain in business only at the peril of discovery by the Attorney General.

Rules

To facilitate sales of federal stamps and bonds and tax saving notes, registered brokers and dealers and members of exchanges were no longer required to keep records or send written confirmations thereon by amendments to Rules X-17A-3 and X-15C1-4 effective January 21, 1942.

In one case, In the Matter of W. K. Archer & Co., the Commission's order was appealed. The Circuit Court of Appeals (8th Circuit) affirmed the Commission's findings and order, 133 Fed. (2) 795 (C.C.A.8), 1943.

10/ In the Matter of Allendar Co., Inc. and In the Matter of William J. Stelmack Corporation, respectively, Securities Exchange Act Releases 2992 and 3254.

Rules X-15B-8 promulgated and effective June 9, 1942 provides that withdrawal of registration of a broker or dealer becomes effective on the thirtieth day after the filing of a notice, unless prior to its effective date the Commission has instituted a proceeding to revoke or suspend registration or to impose terms and conditions on such withdrawal. If the Commission institutes such proceeding, or if a notice of withdrawal is filed after the Commission has ordered proceedings to revoke or suspend registration, the withdrawal, during the pendency of such proceedings, becomes effective only at such time and on such conditions as the Commission may appropriately order.

The following table contains statistics relating to administrative proceedings under Section 15 (b) of the Securities Exchange Act, which Section governs registration of brokers and dealers:

The Commission's experience during the year ended June 30, 1942 with broker-dealer registrations is shown in the tabulations accompanying this report. Briefly, there was a net decline of 508 registrants to 5,557 as of the end of the period. It is clear that the war effort is a basic cause of at least part of this shrinkage.

The National Association of Securities Dealers, Inc.

The Commission's efforts in regulating the over-the-counter industry have been aided by the cooperation of National Association of Securities Dealers, Inc. (N.A.S.D) pursuant to Section 15A of the Securities Exchange Act of 1934, otherwise known as the Maloney Act. During the year under review N.A.S.D. continued as the only national securities association registered as such with the Commission.

Due largely to diversion of personnel of its membership into war activities, membership in that Association suffered a 12.8% decline from 2,974 members as of July 1, 1941 to 2,593 as of June 30, 1942.

Examination program

As of June 30, 1942 the Association had completed, largely through questionnaires, its initial examination of more than 2,200 members. Less than 700 members then remained uninspected. These examinations, conducted by each of the fourteen District Business Conduct Committees, under the general supervision of the main office of the Association,

delve into the business practices of members with emphasis upon the compliance with the Rules of Fair Practice. Reports of examination which indicate violations of the Association's rules result in the filing of either formal or informal complaints by the appropriate District Business Conduct Committee. The scope and results of these disciplinary actions are discussed subsequently.

Cases referred by the Commission to the NASD

The Association's examination program outlined above is not the only source of disciplinary action against members. The Commission, as a matter of policy, frequently refers to the Association information uncovered in its own inspection which appears to concern either unfair prices or other violations of the Association's rules.

On July 1, 1941 there were before the Association 11 cases which had previously been referred to it by the Commission and, in the ensuing year, 46 other cases were referred. In that time the Association disposed of 46 cases and it held pending 11 cases on June 30, 1942. Of the cases disposed of 23 were handled informally and in the remaining cases 23 formal complaints were filed which resulted in five expulsions, two suspensions, three fines and censures, six fines, four censures, and no action or penalty in three instances.

Disciplinary proceedings by NASD

In disciplinary matters, minor or technical infractions of the Association's rules are generally handled informally and usually result in no more than a formal censure, but in more serious matters formal complaints are filed by the Association which may have as their consequence expulsion, suspension, fine or censure or any combination of those penalties.

On July 1, 1941 there were pending before the Association 19 formal complaints and 132 additional complaints were filed in the following year. Of these 151 cases, 130 were disposed of in the year and 21 remained in process on June 30, 1942.

Formal complaints were withdrawn or dismissed without penalty in 25 instances; 32 respondents were censured; 47 were fined, in amounts ranging from $25 to $2000; 12 were suspended for periods of from thirty days to one year; and 24 respondents were expelled. Cases referred by the Commission are included in this summary.

In 20 cases decisions of District Business Conduct Committees came before the Board of Governors for review. The Board affirmed three decisions; dismissed one complaint in which a Business Conduct Committee had censured and imposed a $250 fine; modified a decision of suspension, censure and $1500 fine to censure and $300 fine; and modified a decision of "strong censure" and $100 fine to eliminate the censure. appeal for review was withdrawn and 12 cases were pending June 30, 1942.

One

A District Business Conduct Committee decision of censure and $250 fine, affirmed by the Board of Governors was brought by the respondent to the Commission for review but by June 30, 1942 no action had been taken.

Amendments to Rules

Uniform Practice Code. The Commission not disapproving, a Uniform Practice Code covering "Settlement of Contracts and Trading Practice in Over-the-Counter Transactions in Securities" became effective August 1, 1941 after membership approval. This code is technical in substance and codifies on a national scale what was generally recognized as sound practice in the securities business.