Mr. DINGELL. In the less well regulated segment of the market. Am I correct?

Mr. CARY. Before this bill. Now it will be regulated in very much the same way.

Mr. DINGELL. Still less regulated, though, than the others.

Mr. CARY. Certainly probably than exchange-regulated securities, that is correct.

Mr. DINGELL. I thank the chairman and I am very grateful to my good colleague from Maine.

Mr. STAGGERS. The committee will stand adjourned because there is one bill on the floor that requires some of us to be there. We will stand adjourned until tomorrow at 10 o'clock.

(Whereupon, at 12 noon, the committee adjourned to reconvene at 10 a.m., February 19, 1964.)

INVESTOR PROTECTION

WEDNESDAY, FEBRUARY 19, 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.

We will resume the hearings where we left off yesterday when Chairman Cary was our witness on H.R. 6789 and H.R. 6793.

Mr. Cary, again the subcommittee is pleased to have you with us and we certainly will try to bear with you in trying to keep your engagement at noontime, and we will recess in time. We will proceed from here with the understanding that you will come back this afternoon, if needed.

STATEMENT OF CHAIRMAN WILLIAM L. CARY, ACCOMPANIED BY COMMISSIONER BYRON D. WOODSIDE; COMMISSIONER MANUEL F. COHEN; COMMISSIONER JACK M. WHITNEY II; ANDREW BARR, CHIEF ACCOUNTANT; PHILIP A. LOOMIS, GENERAL COUNSEL; RALPH S. SAUL, DIRECTOR, DIVISION OF TRADING AND MARKETS; EDMUND H. WORTHY, DIRECTOR, DIVISION OF CORPORATION FINANCE; AND ARTHUR FLEISCHER, JR., EXECUTIVE ASSISTANT TO THE CHAIRMAN, SECURITIES AND EXCHANGE COMMISSION-Resumed

Mr. CARY. Yes, sir.

Mr. STAGGERS. About what time?

Mr. CARY. I could be back at 3 o'clock for sure.

Mr. STAGGERS. If we do not finish this morning we will set the hearings again to resume at 3 o'clock.

Mr. CARY. Thank you, sir, very much.

Mr. STAGGERS. Of course, that depends upon the procedures on the House floor as to whether we can, and if we cannot we will get word to you and the committee as to what takes place. We may be voting or we may be in the amendment stage or something and then we cannot sit at that time.

At this time I believe that we will forgo any further questioning by any member of the committee until you have presented your statement in full that you intend to present to the committee and then we will resume questioning.

You may proceed, if you will.

Mr. CARY. Yes, sir. In that case, as you may recall, yesterday I said I had two additional statements to make, one on the Haupt case and the other on specialists. I had not known exactly how you wanted to proceed. I thought of going to the specialists first, but in view of the fact that I take it you want me to read both of those other statements perhaps I might just as well proceed in the normal page way in which the statement is prepared. That would bring me, therefore, really to page 2 of my statement which bears on the Ira Haupt case. Mr. STAGGERS. Page 2.

Mr. CARY. Page 2. As you may recall, Mr. Chairman, I started really at page 22 yesterday.

First of all, with respect to the Haupt case, an event of major significance since the prior hearings on H.R. 6789 has been the insolvency of Ira Haupt & Co. By way of background, on November 20, 1963, Ira Haupt & Co. and J. R. Williston & Beane, Inc., members of the New York Stock Exchange, were suspended by the exchange for failure to comply with the exchange's minimum net capital rule. These firms were in serious financial difficulties arising out of their relationship as broker and creditor for a single commodities customer. Currently Haupt is undergoing liquidation pursuant to an agreement among the general partners of the firm, the New York Stock Exchange and various creditors of the firm under which the exchange has made available $12 million for payment to the firm's securities customers. This commendable action permitted investors to secure their funds and securities without undue delay and saved them from suffering losses which might otherwise have been insured.

J. R. Williston & Beane, Inc., after being reinstated by the exchange, was absorbed by another exchange member firm and I understand that its customers suffered no losses as a result of the firm's financial difficulties.

The Commission has been investigating the facts of the Haupt affair and the regulatory problems which it raises within the jurisdiction of the Commission. The New York Stock Exchange has also been active and we have kept in contact with the exchange.

The Haupt situation is a matter of importance to us for several reasons. First, the funds and securities which customers of Haupt left with the firm were placed in jeopardy. Second, the insolvency of a brokerage firm carries with it the risk of affecting the general confidence of investors. Third, the combination of securities and commodities business, although apparently limited primarily to New York Stock Exchange member firms, occurs with some frequency in those firms.

Thus, many important New York Stock Exchange firms are also members of the major commodities exchanges. Commodity income of some of these firms is quite substantial. In 1962, for example, of a reporting group of almost 346 exchange firms, 26 had gross commodity commissions of over $100,000 and 12 had commodity commissions of over $1 million.

We have not completed our analysis nor has the New York Stock Exchange submitted their views on the problems arising from the

Haupt case. However, I can outline the conclusions we have so far reached, which are presented in more detail subsequently:

1. Additional safeguards for securities customers must be adpoted by firms also engaged in the commodity business. These firms appear to be primarily New York Stock Exchange members.

2. Although our examination reveals certain deficiencies in the rules and procedures of the New York Stock Exchange and the practice of its member firms respecting commodity activities and the safekeeping of customers' securities, we fully expect these deficiencies will be remedied and we shall continue to rely on the efforts of the exchange in this area, although under more intensive Commission oversight. 3. In addition the commodities question, the Haupt case has accelerated our consideration of the recommendations of the report of the special study relating to the protection of customers' funds and securities also problems which appear to concern primarily members of the New York Stock Exchange. The thrust of several of these recommendations is that the rules of the various self-regulatory agencies should be amended to afford financial responsibility protections similar to those which the New York Stock Exchange's rules are presently designed to provide.

4. With the exception of certain amendments to the Bankruptcy Act, the recommendations of the special study report relating to the protection of customers' funds and securities can be implemented by the self-regulatory agencies under existing authority. We have written these agencies about the problems disclosed by the Haupt case and discussed in the special study report. If they do not adopt rules adequate to meet the revealed shortcomings, we shall operate under our own rulemaking powers or ask Congress for legislation, where needed.

5. We hope to submit to the Congress amendments to the Bankruptcy Act following further analysis of the complex problems presented by the bankruptcy of securities firms.

I would now like to give a brief and somewhat simplified factual description of the Ira Haupt case.

In May 1963, Ira Haupt & Co., opened a commodities account for Allied Crude Vegetable Oil Refining Corp., a large processor and dealer in cottonseed and soybean oils. As a condition for opening the Allied account at Haupt, DeAngelis, the principal of Allied, required that Haupt arrange for a $2.5 million financing of Allied's commercial operations.

Pursuant to the terms of a written agreement, Allied received the loan of $2.5 million, collateralized by warehouse receipts and forward sales contracts for cottonseed and soybean oils. Haupt in term pledged the warehouse receipts with a bank and borrowed the $2.5 million. During the ensuing months, the loans by Haupt to Allied increased in amount until, by November 1963, totaled $10 million; Haupt in turn was indebted to various banks for the same amount. In the autumn of 1963, Allied began purchasing, through the Haupt firm, a very large number of contracts for future delivery of cottonseed and soybean oil. By November, Allied held 15,000 contracts and thereby exposed Haupt to a risk whose dimensions must be understood in light of the rules applicable to trading in futures contracts. First, the broker is liable for any drop in the market to the clearing

association which clears transactions for the particular commodities exchange. If the broker's customer cannot meet a daily margin call (which is equal to the decline in the market multiplied by the num ber of futures contracts held), the broker must tender immediate payment to the clearing association. The clearing association looks to the broker and the broker looks to the customer. If the customer holds a substantial number of contracts, even a slight decline can seriously tax a broker's resources.

Just going out of the statement for a moment, I figured if there are 60,000 pounds per contract and if the market dropped a cent a a pound that would mean $600 per contract, and if there were 1,500 contracts it would mean roughly $9 million, so you can see the magnitude of a drop of a cent a pound with that many contracts held.

Second, because of the low initial margins which apply to the purchase of futures contracts, a customer of a brokerage firm can, with a relatively small cash outlay, purchase a very sizable number of contracts and thus create significant exposure for the firm. The difference between the margin put up by the customer and the price of the contract is the total exposure of a firm in the event that the customer cannot pay for and take delivery of the commodity called for by the contracts perhaps months later.

It should be pointed out that, although the customer may liquidate the contract at some point prior to delivery day, thereby relieving the broker of its obligation, liquidation could drive the price down because of the selling pressure. This could require the broker to meet additional margin requirements and thus absorb, on a current basis, the full impact of a market decline in commodity prices.

The New York Produce Exchange Clearing Association rules did not require that Allied, Haupt's customer, put up any margin upon the purchase of cottonseed futures contracts. Haupt, as the broker, however, was required to put up $400 with the Clearing Association, or approximately 5 percent of the cost of a contract.

In the beginning, Haupt required for its own protection that Allied pay it the $400 of initial margin in cash; after October 1963, Haupt began to accept warehouse receipts, instead of cash, for a portion of the $400 payment-many of these receipts later apparently turned out to be forged or worthless.

By the middle of November, Haupt had loaned Allied $3.1 million collateralized by warehouse receipts, which was used to finance the initial margin payments. Haupt also pledged these warehouse receipts with banks. This $3.1 million was in addition to the $10 million in loans to Allied referred to above.

On November 15, 1963, after a month's prior notice, the New York Produce Exchange required an increase in the initial margin which had to be deposited by members on cottonseed oil contracts. The combination of this margin increase, which applied retroactively to existing contracts, and a drop in prices for both cottonseed and soybean oils resulted in a call by Haupt upon Allied for $51 million. When Allied failed to put up the money, Haupt was immediately liable to the Clearing Association for the full amount and paid it.

On November 18, the next trading day, an additional $9 million in margin was called for from Allied because of a substantial marke decline. Once again Allied did not meet its call from Haupt. Once