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"unsolicited” in the permanent records of a broker-dealer; that all customer complaints be kept in a single file and available for inspection and examination by the Commission, the NASD, and the exchanges; and that customer account cards or similar records include such information as investment goals, occupation, and type of service desired.
4. Greater emphasis should be given by the Commission and the self-regulatory bodies to the concept of "suitability" of particular securities for particular customers. The NASD, which has taken leadership in this respect by adopting a general suitability rule, should provide further definition of content and more effective surveillance and enforcement. The NYSE, which has less clearly recognized suitability as a standard of conduct, should make greater efforts to define its content and undertake necessary surveillance and enforcement. This area would seem to be a particularly appropriate one to be dealt with through statements of policy (similar to that now applicable to investment company selling literature), which can provide the necessary balance between generality and specificity of standards. Such statements of policy should cover such matters as: possible guidelines as to categories or amounts of securities deemed clearly unsuitable in specified circumstances; practices deemed incompatible with standards of suitability, such as indiscriminate recommending or selling of specific securities to other than known customers; and approved and disapproved practices in the handling of discretionary accounts.
5. The importance of disclosure for the protection of investors has long been recognized in securities regulation, and it is of particular value in connection with selling practices. The present mandatory, officially filed disclosures by issuers (reports and proxy statements), extended and improved as recommended in chapter IX, should have wider and more prominent use in selling activities, and the obligations of broker-dealers in this regard should be appropriately defined by the self-regulatory agencies and the Commission. These obligations might include such matters as: actually consulting available officially filed data prior to recommending or selling specific securities; furnishing copies to customers in appropriate cases; and advising customers whether officially filed information is available with respect to any security recommended for purchase.
6. The almost universal industry practice of compensating salesmen in proportion to the volume of business produced may be assumed to be inherent in the nature of the business, but certain of its particular aspects may tend to introduce undue pressures or biases into the selling process. This would appear to be another appropriate area for continuing attention of the selfregulatory agencies, with the view to evolving rules and standards, in line with the best existing practices, that might eliminate or reduce the more extreme forms of pressure or bias in selling. Among possible measures in this direction that should be considered by broker-dealer firms and the self-regulatory agencies would be: making monthly compensation less specifically dependent on each month's production; eliminating a step-up of commission rates for transactions in a given month on reaching a stated volume for the month; discouraging undue compensation differentials for sales of different categories of securities where advisory bias may result from the compensation differential; and requiring disclosure of extra compensation in respect of particular types of transactions.
7. The sanctions now available to the Commission in respect of selling practice and similar violations-revocation of a firm's registration with the Commission, or expulsion from or suspension (for up to 12 months) of membership in an exchange or national securities association-are sometimes unsuitable to the needs of particular cases, especially where the disciplinary action relates to only one or few salesmen or only one of many branch offices of a firm. The Commission should have more flexible powers to deal with the latter type of situation, so that it may invoke measures appropriate for dealing with particular kinds and degrees of misconduct rather than being limited to the choice between no sanction or an excessive or inappropriate one.
PART C. RESEARCH AND INVESTMENT ADVICE
Recent years have seen a vast increase in the amount of published material directed by the financial community to the investing public and devoted to describing, advising, recommending and in some cases urging the purchase of particular securities. The greater part of this material is prepared by broker-dealer firms and sent without charge to their customers and to potential customers whose names may come from mailing lists or responses to advertisements. A smaller but still significant portion is prepared by firms not engaged in selling securities but registered with the Commission as investment advisers who, for a subscription fee, provide information and recommendations on specific securities through periodical publications, sometimes supplementing the recommendations in the periodical with some personal investment advice to the subscriber.
Published advisory materials have been produced by both sources in large and increasing volume. As might be expected, they have had an influence on investors and the security markets. When responsibly prepared, these materials play a useful part in the flow of reliable information about securities which is so important to sound investment decisions. When irresponsibly or recklessly prepared, or when too casually based on unfounded statements of unreliable company managements, they can start a chain reaction which may end in disaster for many investors. Such a chain reaction and its effect on the public was illustrated in the eager recommendations of the stock of Dunn Engineering Co. by publications of broker-dealers and subscription publishers alike shortly before the company's bankruptcy.
The preparation and dissemination of printed advisory matter has become an ordinary part of conducting a successful retail securities business today and plays an important part in sales promotion. The most common forms taken by broker-dealer published material are the market letter, sent daily or weekly, the research report, devoted to recommending a specific company or group of companies and sent regularly or occasionally, a monthly report and special securities reports, often in finished magazine form. Some of this material contains detailed and extensive evaluations of the merits, risks, and prospects of the securities considered. Far more of it does not purport to make any detailed analysis to support the recommendations. It generally classifies the securities in terms of investment goals, but omits any consideration of adverse data or uncertainties. Overwhelmingly the recommendations are to purchase; recommendations to sell securities are few, and for the most part deliberately avoided, even with respect to securities previously recommended whose prospects may have changed. The core of the recommendation is generally a projection, which often is in the form of an estimate of future earnings but which sometimes involves an outright prediction of a future market price well in excess of the present market. Ordinarily little information is given concerning the extent or method of research and about the person responsible for the recommendation. Moreover, usually there is no indication of any interest in or intentions as to the securities recommended on the part of the distributing broker-dealer firm, since few disclosures of these facts go further than an unrevealing boilerplate hedge clause.
While the material produced by subscription publishers is not principally designed as sales promotion material, and reflects on its face a greater diversity in research approaches than the material of broker-dealers, it is nevertheless similar in many respects. As in broker-dealer material, recommendations to buy securities are overwhelmingly predominant, although recommendations to sell are not as scarce. Also, like broker-dealer material, subscription publications are almost uniformly silent on the subject of their publishers' positions and intentions with respect to recommended stocks.
Common to printed material of broker-dealers and subscription publishers alike is the suggestion, express or implied, that their recommendations are the product of research. The study's survey of the research practices followed by firms in each category revealed wide variations in the practices followed and the adequacy of research staffs to perform the functions they were called on to perform, as well as a frequently broad gap between the practices followed and the standards professed. At the upper end of the scale, firms in each group followed practices which were meticulous, painstaking, and time consuming. At the other extreme were investment adviser firms with limited staffs and what can at best be described as a casual approach to research, and broker-dealer firms with obviously overburdened research departments. In the research departments of brokerdealer firms, which publish regular market letters and other selling material, answer a steady stream of questions from salesmen and their customers, review portfolios for customers and potential customers, and often prepare special reports for institutional customers, thé study also found wide variations in the standards applicable to differing research functions. As a general policy, the highest quality research efforts are directed to institutions and substantial customers, and the most casual efforts are generally directed to review of portfolios submitted in response to newspaper advertisements.
Reliance on outside sources for research services also occurs in both broker-dealer and investment adviser firms. Some firms circulate material prepared by the research departments of larger correspondent firms or independent research organizations, with or without disclosure of the source. On the other hand, the occasional circula
tion by broker-dealers under their own names of material prepared by public relations counsel of the company whose stock is recommended, or by advertising firms or others, represents an abdication of responsibility.
Both broker-dealers and investment advisers almost inevitably find themselves on some occasions in situations where the nature of the advice they give to the public may be affected by consideration of their own interests. The most common situations involve the broker-dealer's failure to disclose its position or its market-making activities in a stock it recommends. Whatever the motives, which may be good or bad, the legal and ethical responsibilities in such situations are not clearly defined. A wide variety of views exists even on the propriety of using market letters to recommend a security in which the firm has a position which it has decided to liquidate. Diversity of opinion similarly exists concerning the propriety of making recommendations available in advance of publication to certain favored classes of customers. The study found evidence of some practices, however, which go to the basic question of good faith: in both broker-dealer and investment adviser firms the study found cases of proprietors and em. ployees "scalping," or buying securities which they were about to recommend, in anticipation of the market impact of the recommendation, and selling immediately thereafter.
The investing public gets only modest protection from existing Government and industry controls over the form and content of investment advice and the manner in which it is produced and disseminated. Printed investment advice of broker-dealers, which is essentially salespromotion material, is subject to Federal control through the application of the Federal antifraud statutes, and both the NYSE and the NASD have promulgated broad general standards applicable to it. However, the Commission has concentrated its efforts on the selling literature of boiler-room-type broker-dealers, and makes no concerted effort generally to police the mass of sales-promotion material of all broker-dealers subject to its jurisdiction. While the NYSE has established "guideposts” for the preparation of sales material, a number of firms appear to pay little attention to them, and although the Exchange has recently devoted more effort to a program of reviewing this material, its activities still fall considerably short of vigorous self-regulation. Similarly the general standards articulated by the NASD suffer from largely ineffective enforcement. The self-regulatory agencies have been slow to accept their
responsibilities in this area. Only at the urging of the Commission did the exchanges and the NASD establish even the modest controls now afforded by their programs for review of selling literature. The New York Stock Exchange still encourages its members to advertise their research and advisory activities without concerning itself with their ability to perform the services which they purport to perform. The Exchange's inquiries into trading against market letters came only after the disclosure of such activity by the study. In areas of other ethical questions—disclosure in advisory material, other than by meaningless hedge clauses, of positions, trading intentions, and marketmaking activities; preferential treatment of different categories of clients; responsibility for following recommendations—the self-regulatory agencies have not provided leadership.
Unfortunately, the registered investment advisers operate largely in an area which lacks any guiding self-regulatory organization. The emergence of such an organization, which could formulate standards and educate its industry to a higher ethical plane, is highly desirable. Absent such an organization it will remain for the Government to take further steps for the protection of investors in respect of the problems which have come to light.
The responsible dissemination of sound investment advice, even as a method of sales promotion, is clearly beneficial to the investment community at large. It can be assisted by governmental measures which may clarify some cloudy areas of legal responsibility, and encourage the dissemination of reliable information, officially and unofficially, by issuers. Irresponsible dissemination of advice, however, has been responsible for injury to the public investor and to the reputation of the entire investment community. It behooves the responsible leaders of that community, and particularly its self-regutory institutions, both to clarify the ethical responsibilities of its members and to promote the establishment of reasonable standards which the dissemination of investment advice may be expected to meet.
The Special Study concludes and recommends:
1. Investment advice furnished by broker-dealers, though an integral part of their business of merchandising securities, is incidental to that business and, for the small investor particularly, their facilities for providing advice are quite varied in quantity and quality. This being the case, a minimum protection for such investors is that firms should not be permitted to represent that they perform research or advisory services which they are not reasonably equipped to perform. The New York Stock Exchange, instead of indiscriminately encouraging its members to advertise their research and advisory facilities, should adopt standards governing the representations its members may make in this regard, and the NASD should provide similarly for its membership.
2. Specific practices with respect to investment advice, whether expressed in market letters, advertisements or otherwise, should receive more positive and effective attention from the self-regulatory agencies. Such agencies obviously cannot assume responsibility for the staffing of their member firms or the quality or validity of specific recommendations, but they should assume responsibility for eliminating irresponsible or deceptive practices by their members firms. This area also lends itself to establishment of standards through Statements of Policy, covering such matters as (a) required disclosures in printed material of sources of information, research techniques used, and/or other bases of recommendation, rather than general disclaimers as to sources and reliability of data in market letters; (b) required disclosures in written advice of existing positions, intended dispositions, and market-making activities, rather than general "hedge" clauses as to possible present conflicting positions or transactions; (c) required indication of the name of the person responsible for the preparation of market letters, and dating of such material; (d) in printed investment advice which purports to analyze issuers, required references to most recently filed official disclosures by