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CHAPTER I

INTRODUCTION

[This chapter describes the background of the Special Study and sets forth statistical data concerning the securities industry.]

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CHAPTER II

QUALIFICATIONS OF PERSONS IN THE SECURITIES

INDUSTRY

The large numbers of new investors and new broker-dealer firms and salesmen attracted to the securities industry in recent years have combined to create a problem of major dimensions. Among the new investors have been the naive, the unsophisticated, and those with slender resources, while the new broker-dealers and salesmen have included persons who were inept, ignorant, or rapacious. The protection of the former from the errors and depredations of the latter has imposed a heavy burden on the governmental and self-regulatory agencies charged with the protection of the public interest in the area of securities and securities markets.

More than a generation of experience with the Federal securities laws has demonstrated, moreover, that it is impossible to regulate effectively the conduct of those in the securities industry, unless would-be members are adequately screened at the point of entry. Neither the industry nor the Government nor the investing public can afford the burden of a policeman on every corner. The steady growth in the very numbers of investors and participants has made obsolete the concept that entry into the industry should be the right of anyone, regardless of fitness or capability, except those guilty of recent securities violations. The right to carry on those functions of the industry which involve the public investor should be available only to those who shall have demonstrated their ability to meet at least minimal standards of integrity, competence, and financial responsibility.

1. THE REGULATORY STRUCTURE

The agencies with jurisdiction over members of the securities industry, and which are therefore in a position to determine who may enter, include the Commission, the National Association of Securities Dealers, Inc., the various stock exchanges, and the securities administrators of the several States. The present restrictions upon entry into the business that are established by this polycentric system of controls form, as might be expected, an unfortunately irregular and erratic pattern, involving both considerable overlapping of effort and serious deficiencies in total result. No national securities exchange that may wish to set higher standards for its membership should be discouraged from doing so, but there should be a rise in the minimum level of standards applicable to all firms and persons in the securities business.

The Commission's controls which affect the largest number of persons in the industry—though even its jurisdiction does not embrace all elements constitute the lowest barrier, excluding only those individuals whose previous unreliability in matters of securities has been evidenced by judicial or Commission decision. All other persons are admitted upon their firm's registration, without regard to their character, competence, or original capital' commitment. The NASD also has jurisdiction over a wide segment of the securities industry. It has until recently required little more than the Commission. While banning from membership or employment by members roughly the same categories for which the Commission denies registration, the NASD delegates questions of prospective registered representatives' character to the discretion of member firm employers and until 1962 gave a spurious accreditation of competence through a now-discarded examination. The examination which it adopted, and a more recent extension of its examination program

to include proprietors, reveals an effort to raise standards in the area of competence. Yet it remains true that the authorities exerting controls over the broadest range of the diverse activities of the securities business—the Commission and the NASD-accomplish little toward excluding undesirable and unqualified persons. Higher standards of character, competence, and capital requirements are imposed by the major exchanges, and particularly the New York Stock Exchange, but the selective nature of exchange membership limits the number of industry members under their control. The States vary widely in the scope of their statutes and regulations and in the vigor with which these provisions are enforced; at best they are handicapped by geographic limitations in dealing with what is essentially a national problem.

Since NASD membership is based on specific economic inducements, there are gaps in its coverage which leave important categories of securities firms—certain mutual fund distributors, and real estate syndication broker-dealers, put-and-call dealers and registered investment advisers, for example subject only to Commission controls over the qualifications of their principals and employees. In a qualification system which envisages the complementary efforts of governmental and industry regulatory agencies, all groups subject to governmental controls ought also to be subject to industry controls, either through the existing NASD or through other self-regulatory organizations with similar functions and status.

Customers of any firm subject to Federal jurisdiction should be able to assume that the firm's principals, the salesmen with whom they deal, the salesmen's supervisors, and the persons responsible for the investment advice upon which they rely, have met at least minimal standards of competence and integrity and have at least a minimal commitment to their business. In the light of the findings of the Special Study, such an assumption has less validity than should be the case. National securities exchanges should not be discouraged from erecting higher standards for any categories of persons they deem appropriate, but it is up to the concerted efforts of the Commission and the NASD to determine, establish and administer the minimum standards for all firms and persons.

In establishing minimum standards, the various lists of so-called statutory disqualifications, which now apply only to misbehavior relating to securities, should be expanded and made uniformly applicable to all categories of principals and employees. Not every activity which results in the imposition of penal sanctions should disqualify a person from the securities business, but the public is no less concerned with records of theft, fraud, embezzlement, or similar crimes on the part of the salesmen or broker-dealers with whom they deal simply because they involve property other than securities. Particularly important in implementing the establishment of minimum standards, as well as for other regulatory purposes, is the revision of broker-dealer registration forms to require the filing of further information concerning the nature and scope of a firm's business and concerning some categories of its personnel for whom minimum standards must be established, but about whom the regulatory agencies now have no readily accessible information.

2. BROKER-DEALERS

The ease with which almost anyone can start his own securities firm and deal with the public has permitted many an amateur to embark on the deep waters of broker-dealer entrepreneurship. The statistics and cases reviewed in this chapter indicate a surprisingly high incidence of inexperience in the securities business on the part of principals of new firms, and concurrently a lack of awareness of and respect for a broker-dealer's obligations to the investing public. They suggest also that the initial capital commitment of a large number of the new firms is nominal or at best unduly modest. Many of these firms quickly become sources of concern to the Commission and the NASD; the Special Study's analyses and observations revealed a distinct tendency on the part of newcomers to become involved in the more serious securities violations more often than experienced firms. New firms often have particular difficulty in maintaining adequate records and complying with the Commission's net capital ratio requirement. Many new firms include among their salesmen “boiler-room" veterans or totally inexperienced newcomers, or both. The training which such firms give their inexperienced salesmen rarely goes beyond a modicum of orientation to the firm and a brief introduction to its merchandise.

The potential of harm to the public from a firm whose principals are unqualified is intensified when, as so often happens, the firm engages in underwriting. This activity generally calls for skills and involves responsibilities beyond those required for an ordinary brokerage business. The study's review of underwriting practices reveals a disquieting tendency for firms with the least experience and least capital to engage in underwriting the most speculative and questionable new issues.

A minimum net capital requirement for broker-dealers, with appropriate flexibility to meet the variety of functions from the underwriter to the very small mutual fund distributor-although not foolproof or sufficient in itself, would substantially add to both responsibility and commitment without imposing an incommensurate burden. The securities business involves dealing in other people's funds and liquid assets; the regulatory scheme is based to a significant extent on the sanction of legal liability to customers for improper conduct; the smooth and speedy functioning of market mechanisms depends on mutual confidence among members of the financial com

1 In addition to the discussion in ch. II.B, see also ch. IV.B (pt. 1).

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