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Senator WILLIAMS. Perhaps, before you begin, Mr. Chairman, we should consider how we will present our inquiries.

It might be helpful to have some observations or questions presented during the testimony rather than waiting until the end.

Mr. CARY. We would welcome it.

Senator WILLIAMS. You would?

Mr. CARY. We would welcome that; yes, sir. I may not be able to answer them all, but I am sure with the help of my colleagues here that we will be able to provide reasons and answers as best we can. Senator WILLIAMS. I would like, also, to invite our subcommittee counsel, Mr. Otto Lowe, Jr., to take part in our deliberations. Mr. CARY. A pleasure.

Now, sir, we are here today to testify, as you have indicated, on S. 1642, a bill embodying the legislative recommendations of the Securities and Exchange Commission. The bill, which is primarily an amendment to the Securities Exchange Act of 1934 and in one respect, the Securities Act of 1933, is designed to deal with areas where the present statutory structure of the securities acts is inadequate and vitally in need of strengthening.

In the unanimous opinion of the Commission, the enactment of S. 1642 will represent a major achievement in securities regulation, will materially increase existing investor protection, and thus will maintain and enhance investor confidence.

This bill on which we are testifying today is in an important respect a report to the Congress on the present adequacy of investor protection, as authorized and directed by the Congress in Public Law 87-196.

That law, enacted almost 2 years ago, was a product of congressional belief that the scheme of securities regulation needed a thorough reevaluation after a 25-year period of tremendous growth in the size of the securities markets and important changes in market practices.

The first segment of the report of the Special Study, reflecting that examination, was delivered to Congress on April 3, as you have indicated in your opening statement. The proposed amendments of S. 1642 are in substantial part based upon, and supported by, that report. With your permission, Mr. Chairman, I have introduced Mr. Cohen. I do think that, in view of the fact that he is the Director of the Special Study, I would like to ask him to speak very briefly on the report and its relationship to the proposed legislation.

Senator WILLIAMS. Mr. Milton Cohen.

Mr. MILTON COHEN. Mr. Chairman, speaking as the Director of the Special Study, which assembled the data and provided the analyses showing the need for legislation in the areas covered by S. 1642, I believe that the legislative program reflected in the bill is a fine one, an important one, and, indeed, an essential one.

While differing in some details from the legislative recommendations in our report, S. 1642 generally carries out the kind of reforms that our filed report shows to be highly necessary and that require statutory change as distinguished from rule change.

Indeed it adds a few items, such as the requirement for reporting data called for by the proxy rules where proxies are not solicited, that are not specifically included in our recommendations but that are quite in accord with the tenor of our findings.

One or two legislative recommendations in the completed portion of our report are not included in S. 1642 but are readily separable from the matters covered in the bill, and I understand that these are reserved for possible inclusion in a later legislative program.

The unfinished part of our report may also contain recommendations that will require legislation for their implementation. Any such future recommendations, however, will also be quite separable from the matters covered in S. 1642, so that I can assure the committee that nothing in the future program will detract from the compelling and pressing need for the proposals now before you.

Moreover a very substantial part of our total recommendations will involve actions that we think can be taken by the Commission and the self-regulatory agencies under existing powers.

We now expect that the next four chapters of our report dealing with operations and interrelationships of the trading markets can be delivered in the next week or two and the remaining chapters soon thereafter.

I, personally, do not plan to attend these hearings after today simply because I consider it my first responsibility to Congress and the Commission to finish the report as rapidly as possible.

Needless to say, however, I will be available on call to answer any questions that the committee may wish to address to me concerning aspects of the study and report bearing on the legislative proposals. Thank you.

Senator WILLIAMS. Thank you.

Mr. CARY. May I say all of us in the Commission are extremely grateful to Mr. Cohen and the staff of the special study not only for their fine craftsmanship but for the responsible way in which it has been conducted throughout, as you already indicated.

Before getting on to my prepared statement, I would like to make one other outside comment. It is contained in our letter to the chairman of this committee of June 3 when we submitted this bill.

I did say there that, in making these proposals, we have singled out those measures which both the Commission and the securities industry regard as constructive and vitally needed. In other words, this is a group on which we have worked most constructively and on numerous occasions with the leaders of the securities industry in hammering out something upon which both of us could agree as constructive.

I do think, for that reason, I should acknowledge at this time the effort that they have made in working with us and the carefulness and the responsibility with which they approached the project of trying to work out a satisfactory bill.

Now, in its broadest terms, S. 1642 has two major purposes. The first is to improve investor protection in the over-the-counter market, primarily by extending fundamental disclosure requirements. Disclosures now furnished by listed companies would be required also of companies whose securities are traded in the over-the-counter market and in which there is a substantial public interest.

The second major purpose is to strengthen qualification standards and controls over those in the securities business, again with emphasis on the over-the-counter market. We stress that these purposes are

interrelated and have a common goal-the raising of standards in the securities markets.

Improved standards in the securities markets are best assured by the combination of better information about securities, on the one hand, and better qualified persons to utilize and evaluate that information, on the other. Each proposal in S. 1642 would be an important advance, but it is the sum of all of them which will produce the maximum benefit in the public interest.

I would first like to discuss those sections of the bill dealing with improved and expanded disclosure for over-the-counter securities.

A. OUTLINE OF PROVISIONS WITH RESPECT TO THE EXTENSION OF
DISCLOSURE REQUIREMENTS TO OVER-THE-COUNTER COMPANIES

A most vital aspect of S. 1642 would be its extension to investors in over-the-counter securities of the fundamental protections now generally afforded by the Securities Exchange Act of 1934 only to investors in securities listed on an exchange. These protections of present law may be briefly described as follows:

(1) Pursuant to sections 12 and 13 of the Exchange Act a company which lists its securities on an exchange must file a registration statement containing material financial and business information concerning its operations. This information has to be kept current by periodic and annual reports.

(2) Pursuant to section 14 of the Exchange Act shareholders whose votes are solicited by corporate management, or its opposition, must be furnished with a proxy statement. This statement must contain adequate and accurate information so that the corporate franchise may be intelligently exercised.

(3) Under section 16 of the Exchange Act corporate insiders are restrained from using inside information for personal benefit. These insiders must report their securities transactions, the corporation may recover their trading profits made within a 6-month period, and they are not allowed to sell short.

Sections 3, 4, 5, and 8 of S. 1642 will make this grand design applicable to the over-the-counter market. Initially companies having $1 million in assets and a class of equity securities held of record by 750 or more persons would be required to register with the Commission and assume the obligations of listed companies. After 2 years, or a longer period if the Commission so determines, the stockholder requirement would drop to 500. These two standards would result in an estimated coverage of 3,100 and 3,900 companies, respectively.

In the case of bank stocks, all functions of the Commission must be delegated to the appropriate Federal banking regulatory agency upon the request of any such agency.

Senator WILLIAMS. In that connection, a request by the Comptroller has already been made, has it not? I think Senator Robertson referred to reports in yesterday's papers.

Mr. CARY. In a sense if you refer to the information based on the Wall Street Journal article and the New York Times article of yesterday indicating that the Comptroller has taken very substantial, I judge, additional steps moving directly toward fuller disclosure.

So in a sense, as you indicate, Mr. Chairman, although it has not been a formal request-the bill is not in-nevertheless, it is certainly moving in that direction.

Senator WILLIAMS. I see that S. 1642 is flexible in a number of respects. For example, there is no mandate to reduce the number of stockholders in covered companies to 500 at the end of 2 years. You can postpone the effective date.

Is there any feeling now what the future would bring in terms of the number of stockholders that would be the qualifying number?

Mr. CARY. Assume, for example, that the bill becomes operative in July of next year. For a 2-year period, of course, we would be dealing exclusively with companies having 750 shareholders. And dur ing this period we would be testing out the situation, Mr. Chairman, in this sense: We would be finding out exactly how many companies we have to deal with, and what the problems are in the area of the additional companies whose shareholders exceed 500 but are not as many

as 750.

Now, if we found, for example, that administratively we had not really fully digested the group of companies having 750 shareholders, we would postpone either in whole or in part, or by classes, the effective operative date on which companies having shareholders below the 750 level down to 500 would be subject to these disclosure require

ments.

So this section gives us that needed flexibility to see what our problems are, and what the situation actually is, and thus tailor these additional companies into our program as it is working out.

Senator WILLIAMS. Mr. Chairman, in fixing responsibility on the basis of shareholders, do you feel that there might be an inhibiting effect on some companies in their desire to broaden their equity base? Would there be an inhibition to stay short of the qualifying number?

Mr. CARY. We do not believe that there is a very great likelihood, Mr. Chairman. I think that most companies, if they are going out obtaining financing, will decide on whether, for example, it is the kind of a situation that would lend itself to a private type of placement or, in the alternative, whether they are going public.

At the point that they are going public, it seems to me that they have made a decision to disclose to the public-particularly when they go public to the point of having roughly 500 or 750 shareholders that is quite a lot of people. I would assume that the application of this bill would have very little effect on the market to which they would go for money.

Senator WILLIAMS. Well, I think that would be true. Certainly growing companies have had no inhibitions toward petitioning the exchanges for listing.

Mr. CARY. That is correct.

Senator WILLIAMS. If they list on an exchange, of course, they are under full authority of the SEC.

Mr. CARY. And not only that but under the authority of the exchanges themselves.

Senator WILLIAMS. Yes.

Mr. CARY. Which, of course, have additional regulations. Perhaps one of my colleagues would add something to that.

20-286 4.2

Mr. WOODSIDE. No.

Mr. CARY. These provisions would not apply to foreign companies, unless the Commission finds any such company, or class of companies, should be included because of an active trading market in the United States.

Moreover, dealers who make markets in over-the-counter securities would be exempted from the insider-trading sections to the extent of their marketmaking activities, but subject to terms and conditions to be prescribed by Commission rules.

Finally, the Commission would have broad powers to exempt issuers, affected persons, and securities.

The policy supporting this expansion of the basic disclosure philosophy of the securities acts into the over-the-counter market has long been recognized; so has the need. Both have been strongly confirmed by the report of the special study. To these I now turn.

B. THE BASIC DISCLOSURE PHILOSOPHY OF THE SECURITIES ACTS

The keystone of the entire structure of Federal securities legislation is disclosure. Making available to investors adequate financial and other information about securities is the best means of enabling them to make intelligent investment decisions and of protecting them against securities frauds.

The Senate Committee on Banking and Currency in its 1934 report on stock exchange practices expressed this philosophy as follows:

It is universally conceded that adequate information as to the financial structure and condition of a corporation is indispensable to an intelligent determination of the quality of its securities. The concept of a free and open market for securities necessarily implies that the buyer and seller are acting in the exercise of enlightened judgment as to what constitutes a fair price. Insofar as the judgment is warped by false, inaccurate, or incomplete information regarding the corporation, the market price fails to reflect the normal operation of supply and demand. One of the prime concerns of the exchanges should be to make available to the public honest, complete, and accurate information regarding the securities listed.

Although the quoted statement singles out the exchanges, it applies and was intended to apply to all securities, listed or unlisted. Because too little was known about the over-the-counter market in 1934 to enable Congress feasibly to devise provisions as specific as those relating to listed securities, the original section 15 of the exchange act granted the Commission rulemaking power in relation to the over-thecounter market. In doing so the expressed purpose of Congress was "to insure" investors in over-the-counter securities "protection comparable" to that provided investors in listed securities. The sanctions made available, however, proved inadequate because of their focus upon brokers and dealers, rather than companies, and the provision was repealed.

There is no convincing reason why the comprehensive scheme of disclosure that benefits the exchange markets should not apply also in the over-the-counter market. Nothing in the nature of the securities traded in that market or in its mechanisms make any less necessary the disclosure of basic information about its companies.

On the contrary, because the over-the-counter market includes not only widely known and seasoned companies, but also relatively unknown and insubstantial ones, the need of investors for accurate in

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