In the course of your testimony, I asked you for your opinion on whether stock insurance companies' securities should be included under the registration and disclosure provisions of this bill with other over-the-counter securities. I believe that your answer was in the affirmative. In connection with this question, I am enclosing a copy of the supplemental information form that was adopted by the National Association of Insurance Commissioners at their meeting in December. As you will note, the form relates to information supplied by insurance companies to their stockholders. I would appreciate it if you would look the form over and give me your opinion as to the adequacy of the reporting requirements and whether it would be a satisfactory substitute to the requirements imposed by the SEC.

I would like to take this opportunity to thank you for your very clear presentation before the subcommittee yesterday. I'm sure you can appreciate the fact that this is a very complex and controversial area; therefore, your answers to the above questions will be of great assistance to me in my consideration of this legislation.

Very sincerely yours,

Enclosures.

HASTINGS KEITH, Member of Congress.

INSURANCE SECURITIES INC.,

San Francisco, Calif., February 3, 1964.

Hon. HASTINGS KEITH,

Member of Congress,

House Office Building,
Washington, D.C.

DEAR MR. KEITH: This is in response to your letter of January 22, 1964, in which you asked certain additional questions relating to my testimony before your subcommittee. I will respond to these questions in the order in which they were presented in your letter.

(1) Section 7(a) (3) of S. 1642 would require a national securities association to specify appropriate standards with respect to training, experience, and such other qualifications as the association finds necessary or desirable. No broker or dealer could become a member unless qualified under these standards nor could he hire any person who did not qualify under the association's standards. The association would also be required to develop standards relating to the financial responsibility of the broker and dealer members. Related to this is section 7(a) (6) (e) of S. 1642 which would amend section 15A (k) (2) of the Exchange Act to give the Commission power to change the rules of an association in relation to "the qualifications required for members or natural persons associated with members or any class thereof."

First, let me say that we are in favor of upgrading the standards and performance of people who engage in the securities business and our firm, along with many others I am sure, is constantly trying to improve standards within our sales organization. We certainly do not oppose any assist in this regard which may come from the specification of minimum standards under an act of Congress. It should be pointed out, however, that the above-mentioned amendments give the association and the Commission complete discretion to decide who can and who cannot engage in the securities business, without any statutory guideposts whatsoever. It is recognized that it would be extremely difficult to provide definitive statutory guideposts relating to qualifications for entering the brokerage business. However, if nothing more were done than to add the word "reasonable" in front of the language which grants these powers to the Commission and the association, some statutory restraint would be imported into the bill.

It should also be pointed out that section 7(a)(3) does not contain the usual "grandfather" clause which would protect against the retroactive application of this bill to persons already validly engaged in business. I feel confident that neither the Commission nor the Congress would intend to apply section 7(a) (3) retroactivity to persons who have been earning their livelihood in the securities business under existing law.

Chairman Cary, in his testimony in the Senate did state: "In establishing criteria, the NASD could adopt appropriate 'grandfather' clauses exempting existing members and their employees, either permanently or for a transition period, from some or all of the qualifications requird of new entrants."

In our opinion, such grandfather provisions should apply to all brokers and dealers and to persons associated with them who are validly in business under existing law, whether they are currently members of NASD or not and whether they join NASD or another association. Unless they do so apply, no broker or dealer would know, if this bill becomes law, whether he or any of his associates will be permitted to continue in business until the association or the Commission makes the fateful decision whether he qualifies under standards yet to be developed. Chairman Cary's above-quoted comment would seem to indicate that section 7(a) (3) should be applied retroactively to some (who are not now members of NASD) but not to others (who are). This we believe would be inequitable and unnecessary. Also, you will note that his comment is permissive, leaving it to NASD to select those firms or persons to which the legislation would be applied retroactively. We would urge the Congress, if it should enact the compulsory membership features of section 6(a), which we sincerely believe it should not do, to further amend section 7(a) (3) to provide that its application shall be prospective only. In the alternative, the report of your committee could make it clear that section 7(a) (3) is not to be applied retroactively so as to exclude from the securities business those who are now validly engaged in it.

(2) In your second question you stated that Chairman Cary has indicated that some broker-dealer firms may be exempted from compulsory membership in a national securities association by Commission action. You asked whether, in my opinion, a firm which is engaged in the direct selling of securities should receive such exemption.

There are a number of sales organizations like our own which engage exclusively in the sale of the securities of open-end investment companies. I believe that in connection with their selling activities these firms are subject to more Federal laws and regulations than are firms which sell other forms of securities. This is so because, in addition to being subject to the provisions and regulations of the Securities Act of 1933 and the Exchange Act, the sales activities of such firms also are governed by the provisions of and regulations issued under the Investment Company Act of 1940. I presume that if Congress or the Commission were trying to determine which firms ought to be relieved of compulsory membership, a most logical starting point would be to exempt those firms which already are subject to the most stringent laws and regulations.

However, we do not believe that the exclusion of some and the inclusion of other firms provides an answer to the basic regulatory problem. Congress is seeking a regulatory method which will improve sales practices in the securities industry. In accomplishing this, it seems to us, Congress first consideration must be to find a regulatory method which will assure fair and disinterested treatment to those who would be regulated. We have yet to discover anyone who contends that such treatment can be assured in a regulatory framework which would require competitors to be the judges of one another's conduct. If we are right in this concept, then the compulsory aspects of section 6(a) of S. 1642 are basically unsound as a regulatory method and should not be enacted.

With your letter you also enclosed a form entitled "Stockholder Information Supplement" recently adopted by the National Association of Insurance Commissioners. The information called for by the questions in the form is in substance the same kind of information that would be required of insurance companies under this bill. We are in favor of the basic concept of S. 1642 to cause additional information to be placed in the hands of shareholders of companies whose securities are traded in the over-the-counter markets. It would appear that the National Association of Insurance Commissioners is taking steps to cause such information to be provided to shareholders of insurance companies. We are not informed as to the methods of implementation available to and planned by the insurance commissioners in the various States. It would seem, however, that if these basic purposes of S. 1642 can be effectively accomplished through State action, it would then be unnecessary to go to the expense and duplication involved in including insurance companies under this bill.

I hope these answers will be helpful to you in your further deliberations of this bill.

Sincerely,

ARTHUR V. TOUPIN.

(Whereupon, at 12:08 p.m., the committee recessed to reconvene at 2 p.m., the same day.)

AFTERNOON SESSION

(The subcommittee reconvened at 2:30 p.m., Hon. Gillis W. Long presiding.)

Mr. LONG. The hearing will come to order.

The next witness is Mr. Edward F. Galotti.

Mr. Galotti, will you come forward, please?

STATEMENT OF EDWARD F. GALOTTI, ARLINGTON, MASS.

Mr. LONG. Welcome to the committee. Would you please identify yourself for the record and proceed in your own way

Mr. GALOTTI. Mr. Chairman and members of the committee, my name is Edward F. Galotti. My residence is 76 Broadway, Arlington, Mass. I am a businessman, president and treasurer of Ambassador Aluminum Products, Inc.

I appreciate this opportunity to appear before your committee. I am here to testify this afternoon on S. 1642 and related bills which propose to amend the Securities Act of 1933 in order that disclosure requirements to the issuers of additional publicly traded securities may be extended and to provide for improved qualification and disciplinary procedures for registered brokers and dealers.

The philosophy underlying the passage of the 1933 act was a direct result of the debacle of 1929 which was caused, at least in part, by the unscrupulous activities of certain financial manipulators, who operating under the prevailing philosophy of caveat emptor, saw the public as only so many sheep ready for a fleecing.

It is my feeling that there has been no change which justifies a return to the old view that the investing public needs no more protection than his own good judgment. I think it is fair to say that the present view is that legislation is needed to protect the unwary from the unscrupulous.

I do not approach this subject in an academic way. Quite frankly, my acquaintance with the subject is direct and personal. Like the Scriptural man who rode down from Jerusalem to Jericho and fell among thieves, my experience has not been conducive toward a charitable view toward those who operate within a loophole in the law to fleece the public.

For this reason I am vitally concerned that the proposed legislation be amended in order that the investing public may be protected by legislation with teeth in it.

I would like to discuss loopholes in section 4 (1) and (2) of the Securities Act which in my opinion negate the purpose of the framers of this legislation who intended to replace the philosophy of let the buyer beware with a philosophy more suited to the modern marketplace, let the seller beware.

One

Specifically, let us consider a case where a corporation organized under the laws of one of the States issues two classes of stock. class meets the registration requirements of the Securities Act, and the other does not. This latter stock is referred to as unqualified stock which is defined as stock which is to be issued with transfer restrictions limiting its sale to insiders. Insiders being defined as controlling persons, officers, directors, and key employees of the corporation.

In order to comply with the State's security regulations the public issue alone is qualified under the "blue sky" law.

If the corporation is successful, or appears so, the price of the stock issued to the public will, quite naturally, rise as demand increases. Naturally there will be a demand on the part of the general public for shares of the corporation's stock.

The public, however, is not as likely to understand the distinctions between the two classes of stock. The same is not true of the insiders, however. The insiders the controlling persons, both officers and direactors are permitted, through exemption, to sell their stock to broker-dealers. The insiders continue to exercise their options, thereby receiving additional nonregistered, nonexempt, so-called restricted stock. If they should decide that they wish to cash in their profits they must merely tell the corporation counsel that their circumstances have changed since they originally agreed to the restrictions. Counsel will then notify the transfer agent to honor the transfer if it has not already done so before any notification.

Broker-dealers may legally use instrumentalities of interstate commerce in publicly distributing the restricted shares. The restrictions vanish at some point amid the original issuant, the corporation counsel, and the transfer agent. If the public should, by accident, learn that it has been sold and delivered a class of stock which is not qualified for public distribution, it has merely learned something new, but that is all. The public has no available remedy even though section (5) states that it is illegal or unlawful to sell securities unless a registration statement is filed or in effect.

The brokerage fraternity can take advantage of the situation in a unique fashion. The broker calls the underwriter for instructions as to what to do. The broker-dealers claim that they do not contact the SEC or the particular office which oversees the "blue sky" law, but that the underwriter is the more logical source. The underwriter then becomes the scapegoat.

At some point, some broker makes a mistake by inserting a quotation on the pink sheets specifying a particular class. At this point, the erring broker is advised not to be specific. It is suggested that less attention will be attracted if this stock is traded on an unspecified basis. In addition, the nonqualified class will not have to be sold at a lower price than the qualified class. Hence, the insiders, the brokerdealers, and the sophisticated, will be able to make more money.

Incidentally, the nonqualified stock sells for a lower price then the qualified.

The stock now is traded from broker to broker on an "unspecified" basis. This indicates to the broker that more than one class is outstanding. Incidentally, the public does not know this terminology and is not to be told same orally or by confirmation slips. If a typist should make an error and show "unspecified" on the customer's copy, and if the customer should question the brokerage house, he is told that this does not belong on his copy-disregard it.

Now to further confuse the customer, the broker will send him a delivery slip stating that the securities delivered are of the class which may be sold to the public. The certificates will, however, be of the other class. The brokers employ the exemption under existing section 4(2) of the Securities Act. This will prevent the public from

rescinding the transaction and getting his money returned. That is, should the public ever discover that the class of securities which it never ordered but was delivered is not qualified for public sale.

A sophisticated broker will never solicit an order from the public in an unregistered stock. He may stimulate the demand, then direct the person to another broker for execution of the order. This will prevent liability under the act of 1933.

If a member of the public should bring suit to recover under the "blue sky" statute against the selling broker and/or the agent broker, a unique defense will be presented. The selling broker will admit he was the principal but will allege he did not sell to the plaintiff, rather he sold to agent broker, not as agent but as principal. The alleged agent will uphold the selling broker's position. Both, then, will testify that: (1) this becomes an exempt broker's transaction; (2) "custom and practice" preempt any statute and an agent at the time of sale never discloses that he is acting as agent; (3) neither are concerned as to whether the stock is qualified under either law. This protects the selling principal. Subsequently, the buying broker will issue to the seller a confirmation slip stating that the purchase was for a third party—hence, an agency transaction. The selling broker simply disregards this because it is a postsale development.

The buying broker will testify that this will stimulate the market price. The customer is issued a confirmation slip stating it was an agency transaction. Some brokers will execute a transaction in a security having two classes on a temporary unspecified basis. If qualified stock is delivered, the broker, now not in need of exemption 4(2), will then issue a correction reading that the transaction should read "Specified." He will not respond to a customer's inquiry on this subject matter. To do so might expose this unique loophole which is detrimental to the public.

It is conceded that a shipping clerk who acquired a few shares of restricted stock through stock options should not be expected to spend thousands of dollars to register his stock after his employment has been terminated. He should be permitted to sell his stock to a brokerdealer, who purchases it for investment purposes only. The restrictions should not simply vanish. This loophole should be outlawed. The broker should not be allowed to publicly sell and distribute these shares, as is now done.

Brokerage people will move into dominating corporate positions as either or both directors and officers to augment the original group of high repute. They will take advantage of the loophole, and in so doing, will show the other officers, directors, and employees how to realize actual cash profits. Through skillful application of: changes in accounting procedures; dissemination of false and misleading information, both orally and otherwise; artificial market price stimulation; unique application of investment letters; issuance of the publicly held class at less than 50 percent of market value and not through stock options; cooperation of the registrar and transfer agent banks, both in improper dilution of stockholder equity and refinancing; officers and directors forming a brokerage firm and later issuing or causing to be issued market letters containing factually inaccurate and misleading statements for public distribution and consumption; causing other brokerage houses and investment advisers to aid in the