IMPORTANT RECENT DEVELOPMENTS Special Study of Securities Markets and its Implementation Fiscal year 1964, which marked the 30th year of the Commission's existence, and the months that followed was a period of extraordinary, even historic, significance for the Commission, the parts of the nation's economy which are concerned with the issuance and trading of securities, and, of course, public investors. Shortly after the beginning of the year, the final two portions of the Report of the Special Study of Securities Markets were transmitted to Congress.1 The Special Study and the Report, constituting the most thorough examination of the securities markets since the early 1930's, have already had far-reaching consequences. Even while the study was still in progress, it stimulated an extensive self-examination by various segments of the securities industry, most notably the self-regulatory agencies, which resulted in a number of improvements in the rules and practices of those agencies. Secondly, the Report provided a foundation for the far-reaching legislative proposals submitted by the Commission to Congress in June 1963, which, with certain modifications, were enacted into law in August 1964. This legislation (the "Securities Acts Amendments of 1964") is summarized in Part II of this Report and referred to at appropriate points elsewhere in the Report.2 The 1964 Amendments represent the most significant statutory advance in Federal securities regulation and investor protection since 1940. In the main, they eliminate the differences in reporting requirements between issuers of securities listed on the exchanges and the larger issuers whose securities are traded over the counter, allow the self-regulatory agencies and the Commission to raise standards for 1 For a summary of the contents of the Report, see the 29th Annual Report, pp. 1-3. The Report is available from the Superintendent of Documents, Government Printing Office, Washington, D.C., 20402, as H. Doc. No. 95 of the 88th Cong., 1st Sess. Pt. I: $2.25, Pt. II: $3.50, Pt. III: 50 cents, Pt. IV: $3.75. The letters of transmittal and the Study's conclusions and specific recommendations are set forth in a summary volume, Pt. V: 55 cents. A more extended summary and discussion of the legislation is contained in Securities Act Release No. 4725 (September 15, 1964). 757-903-65- -2 1 entry into the securities business, and strengthen the Commission in dealing with broker-dealers and their employees. The legislation. was strongly supported in principle by representatives of the securities industry and by others affected by it, and it benefited from extensive hearings by the Congress which permitted a thorough consideration of all of the issues involved. In signing the measure, the President stated: "The law signed today should further strengthen the securities markets and public confidence in them. Industry and government have worked together in the writing of these laws. Industry and government will work together in making these measures succeed." A number of changes in the Commission's rules have already been effected or proposed to implement the new legislation or to conform the rules to it. One important area still to be implemented relates to the Commission's new authority to prescribe qualification standards and standards of conduct for those registered broker-dealers who are not members of a registered securities association. The Commission is now gathering more precise and fuller information as to the persons and firms affected and assessing the regulatory needs and problems which may be anticipated. Significant progress has been made in the way of administrative action by the Commission and the self-regulatory agencies in implementing the recommendations of the Special Study Report. This is, of course, a continuing process, and what is referred to herein as prospective action may well be accomplished fact by the time this Report appears in print. In one of the principal areas also dealt with in the Amendments, qualification standards applicable to members and their employees have been tightened by the self-regulatory agencies. Proposed amendments to the Commission's net capital rule establishing for the first time a minimum net capital for broker-dealers were submitted to the industry on an informal basis for comments; comments have now been received and the proposal will be considered by the Commission before it is officially published for comment. The Commission's staff has devoted considerable effort to assisting the self-regulatory groups in the formulation of effective rules governing selling practices. Primary emphasis was placed on supervision of salesmen by the principals of broker-dealer firms. The New York Stock Exchange (NYSE) adopted a new supervision rule in the spring of 1964. The Board of Governors of the National Association of Securities Dealers, Inc. (NASD) has approved a package of rules which set out in detail members' responsibilities for supervision, maintenance of certain records and handling of discretionary accounts. As of October 1964, these rules were submitted to the NASD membership for adoption. At the same time increased attention is being paid by the self-regulatory agencies to inspections of brokerage firms and enforcement of selling practice rules. The NYSE, American, and several regional exchanges have adopted new rules and interpretations with respect to advertising and investment advice. The NASD Board of Governors has adopted a comprehensive interpretation with respect to these matters. And the Commission's staff has drafted comparable rules applicable to investment advisers which will be submitted informally to the industry for comment in the very near future. Two of the areas which were studied in great depth by the Special Study and were subjects in its Report of recommendations for extensive changes were the activities and responsibilities of floor traders and specialists on the exchanges. These recommendations in turn gave rise to extended discussions between members of the staff and of the New York and American stock exchanges, culminating in the adoption, on June 2, 1964, of Rule 11a-1 under the Exchange Act,3 the first Commission rule ever adopted relating to floor trading, and the announcement, on September 24, 1964, of proposed Rule 11b-1 relating to specialists. Briefly, the purpose of Rule 11a-1 is to eliminate the abuses which the Commission found in floor trading on the two major exchanges. The new provisions require that traders must have substantial capital and they are subjected to high performance standards, various conditions designed to eliminate or minimize possible conflicts with public customers, and other restrictions intended to channel their trading for beneficial purposes. Upon the effectiveness of the rule, about 30 traders became registered on the NYSE, as compared with an estimated 300 persons who engaged in floor trading in recent years. The proposed specialist rule, which also applies only to the two large New York exchanges, forms an integrated regulatory program together with rules which have been adopted by those exchanges and which will take effect concurrently with the effectiveness of Rule 11b-1. It contains three major parts. The first part would require the exchanges to have adequate rules in certain areas. Thus, for the first time the exchange rules would have to impose an affirmative obligation on specialists to utilize their capital as dealers to assist in the maintenance of a fair and orderly market, and the proposed exchange rules so provide. Additionally each exchange would have to establish adequate minimum capital amounts for specialists and provide effective methods of surveillance of specialist activities. Finally, the ex • Securities Exchange Act Release No. 7330. Securities Exchange Act Release No. 7432. For further discussion of this rule, see p. 13, infra. changes would be required to have rules on the brokerage responsibilities of specialists. Among the changes adopted by the exchanges are rules designed to assure that specialists' brokerage customers receive the best possible prices available and that the specialist does not give himself preferential treatment over his own customers. The second part of Rule 11b-1 would establish a procedure by which the Commission can review and disapprove new exchange rules relating to specialists if the Commission finds that they are inadequate to achieve the purposes described in the rule or are inconsistent with the public interest or the protection of investors. The Commission, of course, would retain the authority contained in Section 11 of the Exchange Act to adopt its own rules regulating the conduct of specialists if that becomes necessary. The third part of Rule 11b-1 would permit the Commission to commence proceedings directly against a specialist in certain cases where an exchange has failed to do so or its action has been inadequate. Turning to the over-the-counter markets, a new Rule 15c2-7 requires dealers entering quotations in a system such as the "sheets" of the National Quotation Bureau to disclose whether they are acting as correspondents, or have entered into some other financial arrangements with other dealers, and the identity of the latter. This information is to be revealed in the published quotations by symbol, number or otherwise. The rule should improve significantly the reliability of the wholesale quotations system and make it more informative." Extensive consideration is also being given by the Commission and the NASD to revisions of the retail quotations system. During the 1964 fiscal year, the Commission established an Office of Regulation within its Division of Trading and Markets, one of whose primary responsibilities is to oversee the operations of the self-regulatory agencies. In pursuit of that goal, the Office has conducted continuing inspections of various operations of the exchanges and the NASD. Furthermore, the new Rule 17a-8, requiring the exchanges to file with the Commission reports of newly proposed rules, enables the Commission to be aware, on a continuing basis, of developments in an exchange's policies and to offer the exchange, at an early point, the benefit of its views. Important steps have also been taken by the self-regulatory agencies, particularly the NASD, to effect organizational changes in line with the views expressed in the Special Study Report. The above are only some of the many steps already taken or under active consideration as a result of the Special Study and its Report. For further discussion of this rule, see p. 16, infra. This rule is discussed on p. 19, infra. Enforcement Activity: Proposed Revision of Annual Report Form for Investment Companies Although the Commission's attention during the 1964 fiscal year was focused to a considerable extent on the implementation of the Special Study's recommendations, its day-to-day enforcement activities, designed to combat fraudulent and other illegal practices in securities transactions, continued at a vigorous level. Details regarding the various aspects of these activities will be found in the appropriate parts of this Report. Among other things, 50 cases were referred to the Department of Justice for criminal prosecution during the year. On the civil side, 84 injunctive and related enforcement proceedings were instituted by the Commission in the Federal courts. And 458 investigations of securities transactions involving possible violations of the anti-fraud or other provisions of the securities acts were instituted. A substantial number of formal administrative proceedings were instituted with respect to broker-dealers and investment advisers-119 broker-dealer proceedings and 9 investment adviser proceedings. The Commission's inspection program under the Investment Company Act of 1940, which has proceeded at a steadily accelerating pace since its inception in 1957, resulted in a record total of 146 inspections during the 1964 fiscal year. Even at that rate, however, each of the 617 so-called "active" registered investment companies would be inspected only once every 4.2 years. To place the inspection program even on a 3-year cycle would require additional personnel and entail other related expenses. It also takes time and expense to train inspectors, many of whom must necessarily be new recruits, to achieve a high degree of proficiency. The Commission has proposed expansion of its inspection program because of its proven value. Even under an expanded inspection program, certain investment companies inevitably require closer or prompter scrutiny. Because of this and the continued growth in the number and size of investment companies, the Commission considered that the public interest and the protection of investors would be served by strengthening the annual report filed by investment companies, and accordingly it published a proposal, shortly after the end of the fiscal year, to revise the present Form N-30A-1, which is the current annual reporting form for all registered management investment companies except those which issue periodic payment plan certificates and small business investment companies licensed as such under the Small Business Investment Act of 1958.8 * Investment Company Act Release No. 4026 (August 4, 1964). |