foreign markets is to be considered the same as if such contracts had been effected in a domestic market. (See (c) (11) below.) (ii) One and one-half percent of the market values of the greater of either the total long or total short future contracts in each commodity carried for all customers. Contracts in each customer's account representing purchases and sales of a like amount of the same commodity in the same market and in the same crop year may be eliminated. (See (c) (11) below.) Rule 325 (b) (4) (H) substitute the following: (H) Cash required to provide margin equal to (i) the amount required to restore the original margin required by the pertinent commodity exchange (or the clearinghouse requirement, per contract, if the commodity exchange has no original margin requirement) when the original margin has been depleted by 50 percent on all future commodity contracts in each customer's account. Cash required should be exclusive of liquidating deficits. (See (c) (9) and (11) below.) (ii) Twenty percent of the market value in each customer's account in equity containing spot commodity positions, evidenced by a warehouse receipt issued by a warehouse licensed by a commodity exchange, which are the result of future contracts tendered through an exchange within the past 90 days, but not hedged by future contracts in the same commodity. (See (c) (9) and (11); and (iii) Ten percent of the market value in each customer's combined account in equity when such account contains spot commodity positions, evidenced by a warehouse receipt issued by a warehouse licensed by a commodity exchange. which are the result of future contracts tendered through an exchange within the past 90 days, and hedged by future contracts in the same commodity. (See (c) (9) and (11) below.) (Whereupon, at 12:10 p.m., the committee recessed, subject to call of the Chair.) INVESTOR PROTECTION TUESDAY, FEBRUARY 18, 1964 HOUSE OF REPRESENTATIVES, SUBCOMMITTEE ON COMMERCE AND FINANCE OF THE COMMITTEE ON INTERSTATE AND FOREIGN COMMERCE, Washington, D.C. The subcommittee met at 10 a.m., pursuant to recess, in room 1334, Longworth Building, Hon. Harley O. Staggers (chairman of the subcommittee) presiding. Mr. STAGGERS. The committee will come to order for the continuation of hearings on H.R. 6789 and H.R. 6793. Chairman Cary, the subcommittee is pleased to have you back with us this morning to discuss with us the pending legislation and other aspects of your lengthy study into the adequacy, for the protection of investors, of the rules of the stock exchanges and of the National Association of Securities Dealers. It is our hope that with your testimony we shall be able to complete this phase of our hearings into the results of your study and your recommendations for legislation and for changes in the rules of these associations and of the Commission. It is my understanding that in your reappearance you wish to address yourself to a number of matters, questions, and problems which have come up during the course of the hearings these past weeks, such as the extension of your jurisdiction to require the registration of presently unlisted companies, including stock insurance companies: and the expansion of your authority over broker-dealers to periait you to compel their membership in a national association, to move against individuals in their firms, and to cover all their intrastate activities. You have been requested, in addition, to discuss several other topics including two major ones relating to the protection received by investors in the treatment of cash credit balances or securities left with broker-dealers, and in the combination of broker-dealer functions in the activities of the specialist. Since you were here 90 days ago, Mr. Cary, two very significant things occurred-the day you were here the New York Stock Exchange suspended two of its members for failure to meet the exchange's capital rule: 2 days later the President was assassinated. The effects of both events reach right to the fundamentals of the exchange and thus to the fundamentals of your regulatory responsibilities. The Haupt insolvency again brings into focus broker-dealer use of customer capital and the scope of the audits or examinations being made; the sharp drop in prices on the exchange on November 22 and rebound on November 26 again poses the question of the role of the specialist. 24-738-64-pt. 233 While I have mentioned these two events of 90 days ago, I am sure you appreciate that the committee is well aware that these, and other matters, were before you long before last November. Both subjects were part of your special study which was first proposed nearly 3 years ago. Indeed, it is now over 2 years since you issued your report on the specialist activities on the American Stock Exchange. Two weeks ago we heard from President Funston of the New York Stock Exchange on what that exchange has done, and partially what it currently is proposing to do about these two problems. In your reappearance here we wish to hear from you on what you and the Conmission intend to do about them. Before you proceed, however, I wish to include in the record at this point certain correspondence between the committee and the Commission, the exchanges, and the NASD, which relate to these subjects. Correspondence with the Commission with reference to the I Haupt & Co. case, as follows: 1. Chairman Harris' inquiry of December 10, concerning what is the scope of the Commission's audit of registered broker-dealers, in view of the fact that the New York Stock Exchange does not make a complete audit, and the Commission relies on the exchange. 2. Chairman Cary's reply of December 19 to the effect that the Haupt case is leading the Commission to reassess both its audit procedures as well as the adequacy of existing rules and regulations governing the financial responsibility of broker-dealers. 3. Chairman Cary's letter of January 3, enclosing copy of memorandum prepared by the Division of Trading and Exchanges relating to the scope of the SEC examinations of broker-dealers. 4. Chairman Harris' letter of January 20 expressing the desire that when the hearings were reconvened, Chairman Cary might indicate exactly the Commission's intentions with respect to the protec tion of customers of a broker-dealer. 5. Chairman Cary's acknowledgment of this request. This is the first insertion in the record. (The material referred to follows:) HOUSE OF REPRESENTATIVES, COMMITTEE ON INTERSTATE AND FOREIGN COMMERCE, Hon. WILLIAM L. CARY, Chairman, Securities and Exchange Commission, DEAR MR. CHAIRMAN: As you know, for some time I have been interested in the activities of the Commission in carrying out the special study that the Congress directed it to make relating to the adequacy, for the protection of investors. of the rules of national stock exchanges and national securities associations. and during the past few weeks of hearings upon the Commission's recommenda tions for legislation growing out of this study, I have followed with close atten tion your testimony both as to the legislative recommendations and as to other matters which the Commission has taken up or intends to effectuate through its rulemaking powers. In the midst of these hearings has occurred the most unfortunate insolvency of a member of the stock exchange, stemming apparently from an overextension of the member's position in commodities rather than in securities. I am informed that it is the practice of the New York Stock Exchange in making the financial audits of its members to confine such audit only to its mem bers' activities in the securities fields and does not cover the members' activities in the commodities or other fields. This is most amazing and I hardly can be lieve that I am accurately informed inasmuch as it has appeared over the years and appears now in connection with the current Commission's special study that there is very limited protection to the securities customer through any rules requiring the segregation or trusteeing of customers' accounts in the securities and of the business. I am aware that during the past years we have had several occasions to discuss the Commission's audit activities and on those occasions have made inquiry into the frequency of the Commission's audit and how often the Commission covered all of the members of the exchange as well as the Commission's reliance upon the audit of the exchange. It appears that our questioning at that time properly should have concerned itself also with the question of the scope of the Commission's audit as well as its frequency, and accordingly I now am writing to determine just what is the scope of the Commission's audit of its registered broker-dealers. Sincerely yours, OREN HARRIS, Chairman. Hon. OREN HARRIS, SECURITIES AND EXCHANGE COMMISSION, Chairman, Committee on Interstate and Foreign Commerce, House of Representatives, Washington, D.C. DEAR MR. CHAIRMAN: Thank you for your letter of December 10, 1963, in which yon request information concerning the scope of the Commission's audit of registered broker-dealers in light of the recent insolvency of a New York Stock Exchange member firm; namely, Ira Haupt & Co. I have requested the Commission's Division of Trading and Markets to prepare a detailed memorandum on existing audit and inspection procedures which will be forwarded to you shortly. As you know, the Commission's program of routine inspection of broker-dealer firms generally excludes member firms of the New York Stock Exchange. The Commission does, however, require most registered broker-dealers, including all exchange member firms who do business with the public, to file annual financial reports, certified by an independent public accountant who must state that he performed an audit in accordance with generally accepted accounting principles. Financial reports filed by broker-dealers with the Commission contain information about customers' and firm commodity accounts for the purpose of evaluating the financial condition of the filing broker-dealer. The Commission has exempted member firms of the New York Stock Exchange and certain other exchanges from the provisions of its net capital rule on the ground that the rules and procedures of these exchanges impose requirements more comprehensive than the requirements of the Commission's net capital rule. Similarly, the exclusion of member firms from the Commission's routine brokerlealer inspection program has been based upon the apparent adequacy of the exhange's examination of its own members which, among other things, covers the Commodity activities of member firms. Recently, the exchange has appointed a special committee of its members to study the adequacy of its own rules and procedures, in order to give greater protection to the securities customers of member firms carrying commodity accounts. In view of the existing exclusion of member firms from the Commission's brokerlealer inspection program and its net capital rule and our own residual responsibility over exchange rules and procedures, we intend to review carefully existing exchange rules and procedures in light of the events which transpired in the Ira Haupt case and any findings and recommendations of the exchange committee. The circumstances surrounding the insolvency of Ira Haupt & Co. also call for a reassessment of the Commission's broker-dealer inspection procedures to insure that we are aware of situations involving substantial exposure risks, such as an overextension of credit, which may imperil customers' funds and securities. Such a reassessment is now underway. In addition, we have instituted a formal investigation of those aspects of the Ira Haupt situation relating to activities within the jurisdiction of this Commission to determine, among other things, the adequacy of existing rules and regulations governing the financial responsibility of broker-dealers. This inquiry, together with the report of the special study, should provide a basis for making an informed evaluation of the adequacy of such rules and regulations. If we can be of further assistance in connection with this or any other matter, please let me know. Sincerely yours, WILLIAM L. CARY, Chairman. Hon. OREN HARRIS, SECURITIES AND EXCHANGE COMMISSION, Chairman, Committee on Interstate and Foreign Commerce, House of Representstives, Washington, D.C. DEAR MR. CHAIRMAN: In accordance with my letter of December 19, 1963, I am enclosing a memorandum prepared by the Commission's Division of Trading and Markets on the scope of the Commission's audit of registered broker-dealers. You had requested information on this matter in a letter dated December 10, 1963. If we can be of any further assistance in connection with this or any other matter, please let me know. Sincerely yours, WILLIAM L. CARY, Chairman. MEMORANDUM PREPARED BY THE DIVISION OF TRADING AND MARKETS OF THE SECURITIES AND EXCHANGE COMMISSION IN RESPONSE TO A LETTER DATED DECEMBER 10, 1963, FROM HON. OREN HARRIS In this letter of December 10 to the chairman, the Honorable Oren Harris made inquiry as to the scope of the Commission's audit of registered broker-dealers. This memorandum has been prepared in response to that request. Section 17 (a) of the Securities Exchange Act of 1934 ("Exchange Act") authorizes the Commission to conduct periodic, special, and other examinations of the books and records of registered broker-dealers. These examinations include the physical examination of the books and records, business practices, and activities of registered broker-dealers for the purpose of determining whether there have been any violations of the Federal securities laws. These examinations are not audits in the sense that that term is used in accounting parlance. In lieu of a Commission audit procedure, registered broker-dealers are required to file annual reports of financial condition certified by an independent certified public accountant, who must state that he performed an audit in accordance with generally accepted accounting principles. The Commission generally does not examine the books and records of members of the New York Stock Exchange. The exclusion of member firms from the Commission's routine broker-dealer inspection program has been based upon the apparent adequacy of the exchange's examinations of its own members as well as the workload and budgetary considerations involved in a Commission program of inspection of such firms. Member firms of the New York Stock Exchange are also exempt from the Commission's net capital rule-rule 15c3-1-under the Exchange Act-because that exchange's "rules and settled practices are deemed by the Commission to impose requirements more comprehensive” than the requirements of the Commission's net capital rule. In making an examination, Commission examiners seek to determine the general financial condition of the broker-dealer, his pricing and selling practices. the nature of safeguards employed in handling customers' funds and securities, whether adequate and accurate disclosures are made to customers, whether his books and records are maintained in accordance with the Exchange Act and rules thereunder, whether regulation T of the Federal Reserve Board has been complied with, and whether he has engaged in unlawful selling practices such as excessive trading or switching of customers' accounts. Broker-dealers are also examined with respect to underwritings, distributions, and dealer transactions. A major purpose of Commisison examination is to ascertain compliance with rule 15c3-1, which is designed to safeguard customers' funds and securities by limiting the amount of indebtedness that may be incurred by a broker-dealer in relation to its capital or-stated in another way-by insuring that broker-dealers maintain a margin of liquid assets in relation to their indebtedness. Under the rule, "aggregate indebtedness" may not exceed 20 times the amount of "net capital." 1 Analysis is made of the items and accounts which comprise the firm's 1 "Aggregate indebtedness" means the total money liabilities (arising in connection with any transactions), including debts not the subject of satisfactory subordination agreements of the broker-dealer, which are not adequately collateralized by its own assets and which are not segregated in accordance with the provisions of the Commodity Exchange Act 7 U.S.C. 1-17a; "net capital" is essentially the net worth of the broker-dealer, reduced by certain percentages of the market value of most securities and certain commodities futures contracts, carried by the firm or partners, but including appropriately subordinated debt. |