Section (e) permits the enforcement of the uniform accounting rules by requiring by order that the company may make specific entries in specific books. Otherwise the only remedy would be the institution of punitive or injunctive proceedings for violation of the uniform accounting rules.

Section (f) is a technical qualification of the paragraphs that I have described. It permits the companies to maintain supplementary records, provided they do not impair the integrity of the accounts classified.

Section 32 is somewhat along the same line and deals with accountants and auditors. I will describe it very briefly and in very general

terms.

Subdivision (a) requires that except in emergencies any independent public accountant retained by an investment company shall be selected by the company's stockholders.

I think that the benefits that may come from that are largely psychological, but it will help to bring home to the independent public accountant that he is not any longer retained merely to find out if somebody in the office force is stealing the petty cash or merely to inform the directors as to what has happened in their company, but that under the existing statutes and existing practice that independent public accountant is really acting for the security holders rather than for the management.

Senator HUGHES. The security holders have selected him?

Mr. HEALY. If this bill is passed the stockholders are to select the independent accountant.

Senator HUGHES. I thought I saw something in the bill about the voting securities.

Mr. HEALY. That is true. I did not realize you were making a distinction between voting securities and other securities.

Senator HUGHES. I wondered whether other securities had an interest.

Mr. HEALY. Under the terms of this bill all the holders of stock in the future will have voting rights, if the bill is passed.

There are of course some difficulties about getting the names and properties of other types of security holders, such as debenture holders. It did not seem wise to carry it that far.

Under subsection (b) the comptroller or other principal accounting officer of an investment company is to be selected by the company's voting security holders or by the board of directors, but not by the president.

Under subsection (c) the commission is authorized to prescribe the minimum scope of the procedure to be followed in audits and to require accountants and auditors to keep accounts, reports, and work sheets, and so one, and have them available for inspection.

We have had some talk with representatives of accounting societies and, as I understand it, the one objection they make relates to subsection (c) of section 32. They have some difficulty with the proposal that the commission be authorized to prescribe the scope of procedure to be followed in audits. I am very hopeful that we can work out some substitute language for that.

The difficulty arises, according to my point of view, at least, from the fact that no two accountants ever seem to agree on what an audit is. Every one that you meet has a different definition of audit.

When I picked up the certificate that was made by the auditors and attached to the McKesson & Robbins statement, and held it up alongside of a copy of the engagement or contract between the McKesson & Robbins Co. and the auditors, taking that in one hand and their certificate in the other, I was extremely surprised. I did not see anything in the certificate that gave a security holder fair warning as to what things the auditor was responsible for and what things he was not responsible for.

It may be that there is some other way of approaching this. I despair of ever coming to an agreement as to a definition of audit. It may be that if the Commission is authorized to set some minimum standards, or if the Commission is authorized to require an auditor to disclose in some general way what he does or does not do, that will meet the problem.

If the committee is agreeable, we will continue our discussions with the accounting societies with the hope that we can bring back something that will be acceptable to them and to the proponents of this bill. Senator HUGHES (presiding). We will take a recess at this time. until 2:30 this afternoon.

(Whereupon, at 12:45 p. m., a recess was taken until 2:30 p. m., the same day.)

AFTER RECESS

The subcommittee resumed at 3 p. m.

of

Senator WAGNER (chairman of the subcommittee). The subcommittee will resume. I have no doubt other members of the subcommittee will be here in a few minutes.

Mr. HEALY. Mr. Chairman, might I make a brief statement at this time?

Senator WAGNER. Yes.

ADDITIONAL STATEMENT OF ROBERT E. HEALY, COMMISSIONER SECURITIES AND EXCHANGE COMMISSION, WASHINGTON, D. C.

Mr. HEALY. Before Mr. Schenker resumes his discussion of the bill I would like to offer for the record a memorandum showing the cost of the study and a description of the work completed by the investmenttrust study of the Commission. This is the expense item that Senator Townsend asked for a few days ago. If he or anyone else desires a further break-down of it we will be glad to get it.

In that connection I would like to say that each year, when the Commission has been before committees of Congress dealing with appropriations, the status of the investment-trust study has been reported, and each year additional funds have been appropriated by Congress for carrying on the investigation.

Senator WAGNER (chairman of the subcommittee). That will be made a part of the record at this point.

(The memorandum referred to, dated April 10, 1940, is made a part of the record, as follows:)

[Memorandum]

To: Senate Committee on Banking and Currency.
From: Securities and Exchange Commission.

APRIL 10, 1940.

Re: Cost of study and description of work completed by the Investment Trust Study.

I. Description of work completed by Study:

A. Public examinations:

250 companies subject of public examination.

33,000 pages of testimony taken in connection with public examina

tions.

4,800 exhibits introduced in connection with public examinations. 100 companies subject of field investigation.

B. Reports submitted to Congress:

1 Includes 8 lawyers, 3 accountants, and balance includes statistical and stenographic staff.

Mr. HEALY. Next, this morning when I was testifying I expressed the idea, possibly with some reservations, that the Federal Communications Commission had the same power, to approve or disapprove reorganizations in court which is given to the Interstate Commerce Commission under the Transportation Act, and given to the Securities and Exchange Commission under the Holding Company Act. I was mistaken. I understand they do not have any such power, although they are given power to appear and be heard in 77B or the Chandler Act cases as we should call them now, involving companies subject to their jurisdiction.

One other item: This bill does not have a provision covering the matter of notice and hearing in advance of orders to be issued by the Commission. That was not an oversight. It was omitted with the

deliberate intention of supplying it at a later date when the phraseology of it could be worked out in a satisfactory manner.

To be entirely frank about it, I think there is no harm in saying that one point as to which there was some doubt related to the question whether it was necessary to have notice and hearing in those instances where the decision was favorable to the applicant; or whether it should be merely confined to the cases where the question was open to doubt and there might be a difference of opinion as to what the result would be after hearing the parties.

Now, that provision will be compiled and submitted to the subcommittee.

Senator WAGNER. All right. Is that all, Judge Healy?

Mr. HEALY. Yes, Mr. Chairman.

Senator WAGNER (chairman of the subcommittee). You may proceed with your statement, Mr. Schenker.

STATEMENT OF DAVID SCHENKER, CHIEF COUNSEL, SECURITIES AND EXCHANGE COMMISSION, INVESTMENT TRUST STUDY, WASHINGTON, D. C.-Resumed

Mr. SCHENKER. Section 33 deals with settlement of civil actions in which investment companies are involved.

Senator WAGNER. What page of the bill are you on now?

Mr. SCHENKER. Page 74. During the course of our investigation we found that investment companies, for one reason or another, appeared to be particularly susceptible to representative stockholders, actions. Whether that is because of the nature of the activities of investment companies in that they may make investments and take losses and thereby may get disappointed stockholders, or whether it is attributable to the fact that there has been some prevalence of abuses in connection with that type of company, or whether misfeasance or nonfeasance is more prevalent in that institution, I would not attempt to say. I think the fact is that investment companies. probably have been subjected to representative stockholder actions much more than industrial corporations, for instance.

Now, you have this problem: As Mr. Smith indicated, a management being in power and not wanting to have its activities aired in court, is in position to settle with the stockholder by buying his stock.

In a great many instances the investment company is really a nominal defendant because the officers and directors would not institute the action on behalf of the corporation. Under the rules of pleading and practice of many jurisdictions in such an instance the corporation has to be made a nominal defendant. You get the situation that in many cases the settlement is made, and instead of the officers and directors paying the settlement, or even the judgment, you may get the situation where the entire burden is borne. by the investment company. The investment company may not have benefited from the misfeasance of the officers and directors; or even in the worst case, the officers or directors may have benefited from their wrongful conduct.

Senator WAGNER. Is that usually an action against the directors? Mr. SCHENKER. It is usually a representative stockholders action. You may get a situation where one investment trust controls another and there is the claim that that investment company cleaned out the

controlling investment trust. The officers and directors of the investment trust are made party defendants.

Now, in such a situation the controlling investment company may be only a nominal defendant because the rules of practice require that it be made defendant where the officers and directors themselves refuse to institute the suit.

In that type of situation, although the persons who may have been guilty of the wrongful conduct, are the officers and directors-and in a more extreme case, they may have been the ones that benefited by their conduct-you may find that the damages, if any, are borne by the investment company.

Senator WAGNER. And there are some cases where, if prosecuted to the end, the corporations may not be found liable but the directors

may.

Mr. SCHENKER. That is right.

Senator WAGNER. And in the settlement, of course, they absolve themselves in that way.

Mr. SCHENKER. Yes. That is the situation we are talking about. You may also get the situation, and I think there are cases like that, where there was a representative stockholder's action brought, and the investment company was not guilty of wrongful conduct but the officers and directors were. The case was settled, but instead of the officers and directors paying the settlement, they had the investment company settle it.

Fortunately in that case as I understand it the person who instituted the representative stockholders action was also a stockholder of the company which was being sued. Then he had to institute an action against the officers and directors for waste, for using the company's money to pay their own liability.

You also get cases, such as the extreme case of United Founders, where they pay a million dollars in settlement of a claim, and the only piece of paper that was served in that connection was a letter to the effect: Please take notice we have a claim against you. If you want to settle it we will be pleased to talk to you.

Well, the attorney had lunch with the officers of the company, and over the lunch table that case was settled for a million dollars without even the service of a summons or complaint.

Now, there the corporation itself is a fiction. If there was any wrongful conduct it must have been that of those persons who controlled the company. Yet the entire million dollars was paid by the investment company, and never at any time was there any disclosure in any report to stockholders, that a million dollars was paid in settlement of a claim which was asserted only in a written letter.

Now, what is the approach in this connection? We say in that type of case-a representative stockholder's action, or action predicated on wrongful conduct of officers and directors-that you cannot settle the case unless an action is instituted so that it is brought to the attention of a court.

Then we say if it is in a Federal court-under the new Federal rules you cannot settle the representative stockholder's action unless the settlement is submitted for the approval of the court. And we say in that type of instance the Commission should be authorized merely to file an advisory opinion in connection with the settlement, so that the court may receive what assistance the Commission can give the court.