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these rules, the rules of the NASD and the principal stock exchanges are being carefully considered. Revision of Retail Quotations System
One of the most significant recent developments in the regulation of trading in the over-the-counter markets occurred during the past year when the NASD adopted a revision of its retail quotations system. The Special Study had recommended that the existing system of providing the public with quotations be improved to reflect more accurately the best prevailing inter-dealer bid and asked quotations. In the 1964 amendments Congress added a new provision to the Exchange Act (Section 15A (b) (12)) which requires national securities associations to promulgate rules designed to produce fair and informative quotations.
Under the revised NASD system, which was adopted in response to the Congressional mandate and the Study recommendations, newspaper quotations for securities on the “National List” are now published on the basis of prevailing inter-dealer quotations as of a particular time and the masthead accompanying such published quotes states that the prices shown are subject to markups, markdowns or commissions in retail transactions. “Local List” securities are quoted as before but the masthead has been revised to provide a more accurate description of what the quotations purport to be. The NASD has engaged an outside management consulting firm to study the effects of the revised system and to determine the appropriateness of further changes in this and various related areas of the over-the-counter markets. Summary Suspension of Over-the-Counter Trading
The 1964 amendments provide the Commission in new Section 15(c)(5) with authority to summarily suspend over-the-counter trading in any security (except an exempted security) for periods of 10 days if, in its opinion, the public interest and protection of investors so require. Broker-dealers are prohibited from trading in any such security during the period of suspension. This provision is a counterpart to Section 19(a)(4), which provides for summary suspension of trading in securities listed on a national securities exchange.
During the 1965 fiscal year the Commission used this new authority in two instances. Trading in the stock of Empire Petroleum Company was suspended for a 5-day period to permit adequate dissemination of the company's annual report which contained adverse information, so that brokers and dealers as well as investors would be apprised of the facts before engaging in any further transactions in such stock. Trading in Idamont Oil and Mining Co. securities was suspended following the institution by the Commission of court action to enjoin violations of the Federal securities acts in the offer and sale of such
securities. The suspension was later terminated following entry of a court order preliminarily enjoining the further offer and sale of such securities in violation of the Securities Act registration and anti-fraud provisions.
IMPLEMENTATION OF SPECIAL STUDY RECOMMENDATIONS Aside from the enactment of the 1964 amendments and the implementation of that legislation as described above, further significant progress was made during the 1965 fiscal year in the implementation of recommendations of the Special Study Report. Minimum Net Capital
The Special Study recommended the adoption of a minimum net capital requirement as one of several different approaches to assuring a broker-dealer community of principals and firms “reasonably qualified in terms of responsibility and commitment.” Its Report commented that such requirement need not and should not be a uniform one for all firms but should be appropriately scaled to reflect the type and size of business engaged in.
Following extensive discussions with a number of industry groups and several statistical studies conducted by the Commission in an effort to arrive at a meaningful and workable proposal which would carry out the recommendation of the Special Study, the Commission adopted amendments to Rule 15c3–1 under the Exchange Act which provide for a minimum net capital requirement of $5,000 for firms engaged in a general securities business and $2,500 for firms solely engaged in transactions in shares of registered investment companies.26 These requirements are minimum figures and broker-dealers subject to the rule must also comply with the requirement that their ratio of aggregate indebtedness to net capital not exceed 2000 percent.
The Commission postponed the effectiveness of the minimum capital provisions until December 1, 1965, in order to provide broker-dealers with sufficient time to bring themselves into compliance. It stated that after the minimum net capital requirements had been in effect for a reasonable period the adequacy of such requirements would be given further study to determine whether it is necessary for the protection of investors to modify such requirements and if so, to what extent.
In order to permit the Commission to exempt particular brokers or dealers from the provisions of the rule in unusual circumstances, a new paragraph (b)(3) provides that the Commission may, upon written application, exempt from the rule either unconditionally or on specified terms and conditions, a broker or dealer who satisfies the Commission that because of the special nature of his business, his financial position, and the safeguards he has established for the pro
Securities Exchange Act Release No. 7611 (May 26, 1965).
tection of customers' funds and securities it is not necessary in the public interest or for the protection of investors to subject him to the provisions of the rule. The Commission also adopted an amendment to paragraph (b) (1) of the rule which limits the scope of the exemption previously provided by that paragraph. The amended exemptive provision now applies only to a broker who is also licensed as an insurance agent, whose securities business is limited to selling variable annuity contracts as agent for the issuer, who promptly transmits all funds and delivers all variable annuity contracts, and who does not otherwise hold funds or securities for or owe money or securities to customers, and only if the issuer files with the Commission a satisfactory undertaking that it assumes responsibility for all valid claims arising out of the activities of the agent. Supervision of Selling Practices
The Special Study pointed out serious inadequacies in the supervisory controls utilized by broker-dealers in their surveillance of the selling activities of salesmen and other employees and recommended the strengthening of such procedures and the adoption by the selfregulatory agencies of clearer standards and stronger enforcement procedures to assure more effective supervision by their member firms. In the 1964 amendments, Congress clearly recognized the importance of proper supervision by providing in new Section 15(b)(5) (E) of the Exchange Act that failure to supervise properly which results in the violation of the securities acts or rules thereunder is a ground for disqualification from broker-dealer registration or from being a person associated with a broker-dealer.
During fiscal 1965, new rules establishing or clarifying standards of supervision were adopted in response to the Special Study recommendations by the American, Midwest, New York, and Pacific Coast Stock Exchanges. In addition, the New York Stock Exchange and the NASD continued the expansion and improvement of their existing branch office inspection programs. These inspection programs have as a primary function the surveillance of supervisory procedures executed at the branch office level.
A major step taken during the past year in this area was the adoption by the NASD of new rules which incorporate required standards of supervision by its members. These rules require the establishment and enforcement of written supervisory procedures and designation of a partner or officer as responsible for their execution. The internal procedures must include periodic review of customer accounts and at least an annual inspection of each branch office. The rule governing discretionary accounts has also been amended to require written customer authorization and supervisory review and approval of activity in such accounts. The NASD also adopted a revised statement for
inclusion in its Manual which enumerates many of the selling practices which violate members' responsibility for fair dealing. To aid in the implementation of these rules the Association has prepared and distributed to its members a comprehensive supervision manual which contains detailed guidelines and suggestions for effective supervisory procedures. Research and Investment Advice
Significant progress has been made since the publication of the Special Study Report with respect to the upgrading of standards applicable to the research and investment advice disseminated by brokerdealers and investment advisers. The major self-regulatory agencies have amended their rules to include interpretations and statements of policy designed to meet important deficiencies. These rules now generally provide that recommendations must have a basis that can be substantiated as reasonable; firms must accurately describe their research facilities and staffs; and existing proprietary positions or other interests must be disclosed. With respect to the activities of investment advisers who are not subject to rules of a self-regulatory body, the Commission staff has prepared a draft rule under the Investment Advisers Act incorporating similar requirements. This rule is presently being circulated to affected industry groups for informal comment and discussions. Financial Responsibility
In the area of financial responsibility and the protection of customers' funds and securities there have been several significant developments since the publication of the Special Study Report. As discussed in last year's annual report, the adoption of Rule 15c3-2 provides investors with meaningful information regarding the status and nature of free credit balances left with broker-dealers. Several of the selfregulatory organizations have revised their rules on the hypothecation and lending of securities to require that there be a "reasonable relationship” between the amount of each customer's securities that can by hypothecated or lent by a member broker-dealer and the amount of the customer's indebtedness. In addition, the NASD has revised its Rules of Fair Practice to require the segregation and identification of customers' free and excess margin securities.
As a result of the Ira Haupt & Co. insolvency, the New York Stock Exchange established a Special Trust Fund of $25 million which can be utilized to satisfy the claims of customers in the event of the insolvency of any member organization of that Exchange. Furthermore, the NYSE and the other major exchanges have amended their rules to provide special adjustments and “haircuts” in the computation of members' net capital to reflect the commodities activities of their members. In the recent amendments to Rule 15c3–1 the Commission
also provided that in computing net capital there should be deducted from net worth an amount equal to 112 percent of the greater of customers' long or short commodities positions in each commodity. Specialists and Floor Traders
Two of the areas which were studied in great depth by the Special Study were the activities and responsibilities of floor traders and specialists on the exchanges. The recommendations of the Special Study in these areas 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,27 regarding floor trading, and the adoption on November 23, 1964, of Rule 11b-1 28 respecting specialists. These rules were discussed at pages 3 and 4 of the Commission's 30th Annual Report and the plans filed by the New York and American Stock Exchanges pursuant to Rule 11a-1 were discussed at pages 13 and 14. Both exchanges have also adopted the necessary rule changes and additions required for compliance with Rule 11b-1. The “Third Market”
The Special Study described a sharp increase in recent years in the volume of off-board trading in common stocks traded on the New York Stock Exchange and other national securities exchanges. To correct the deficiency of information concerning this growing market, which it described as the “third market," the Study recommended establishment of a system for identification of market makers and for reporting of trading activity. The adoption of Rule 17a-9 and related reporting forms X-17A-9(1), X-17A-9(2), and X-17A-9(3) 29 implements this recommendation by providing a system for the identification of broker-dealers making off-board markets in common stocks traded on national securities exchanges and for the reporting of summaries of over-the-counter trading in common stocks traded on those national securities exchanges whose annual sales volume exceeds $20 million.
Under the rule and the forms, brokers and dealers are required to report their trading over the counter and on exchanges in common stocks in which they are market makers, and to report certain offboard trading in common stocks traded on exchanges in which they do not make a market. Broker-dealers who are not market makers are also required to report certain third market transactions. It is expected that the Commission will regularly publish summaries of third market trading, as compiled from the reports filed under the rule.
Securities Exchange Act Release No. 7330. * Securities Exchange Act Release No. 7465.
Securities Exchange Act Release No. 7474 (December 1, 1964).