« AnteriorContinuar »
issuers, and representations that such filed information has been examined, with specific identification of issuers for which no officially filed information is available; (e) prohibition of specific practices in connection with written or oral recommendations, such as predicting specific future price levels of particular securities, claiming “inside” information by reason of a directorship, and trading against recommendations or other self-dealing; and (f) required disclaimers in connection with salesmen's written or oral recommendations not emanating from a firm's research department or otherwise sponsored by the firm.
3. The market letter surveillance program of the New York Stock Exchange should be strengthened and redirected toward achieving greater responsibility and restraint in the use and contents of such letters. More effective market letter surveillance should also be undertaken by the NASD and the other exchanges, or a coordinated program of self-regulatory agencies should be evolved.
4. Reckless dissemination of written investment advice by broker-dealers, whether or not for a separate fee, or by registered investment advisers, should be expressly prohibited by statute or by rules of the Commission and the self-regulatory agencies and should be made expressly subject to civil liability in favor of customers reasonably relying thereon to their detriment. Without limiting the general principle, written investment advice which purports to analyze issuers but fails to consider most recently filed official disclosures of issuers should be one of the factors to be considered in determining whether such advice is recklessly disseminated.
5. As recommended in chapter II, registered investment advisers other than broker-dealers, should be organized into an official self-regulatory association or associations, which should then adopt and enforce substantive rules corresponding to those recommended above in respect of advisory activities by broker-dealers. Alternatively, the Commission should extend and strengthen its own direct regulation of advisers to accomplish the purposes indicated.
PART D. PROTECTION OF CUSTOMERS' FUNDS AND SECURITIES
Many broker-dealers perform banking and custodial functions in the course of which they have custody of, and use, customers' assets of enormous value. The degree of dominion and control over customers' cash and securities may vary considerably depending upon the type of account which the customer has with the broker-dealer and with the amount, if any, owed by the customer to the broker-dealer. While many firms give regular notice to customers as to the status of their accounts, it would appear that there are many others which do not do so.
Customers' free credit balances are among the foregoing assets and may form a substantial part of the working capital of many brokerdealers. They are rarely segregated from broker-dealers' own funds. On the basis of prior loss experience, there does not appear to be a need to require complete segregation at this time. It would seem, however, that broker-dealers may reasonably be required to maintain an adequate liquid reserve against free credit balances, much as banks are required to maintain such a reserve against deposits. Furthermore, broker-dealers should be required to inform customers at regular intervals as to the status of their accounts.
Customers' margin and fully paid securities likewise are held in large volume by broker-dealers. Under the rules of the Commission, some States, and certain exchanges, broker-dealers are restricted both in the use which may be made of those securities and in the manner in which they may be held. The rules presently existing are salutary to the extent of their coverage; the rules of the Commission and of some of the self-regulatory organizations should be extended, however, so that they provide the fuller protection now existing under the rules of certain exchanges with respect to segregation and hypothecation and lending of customers' securities.
The net capital ratio rules of the Commission and certain exchanges have been a valuable protection for investors in preventing insolvency of broker-dealers. The current rigid "haircut” provisions of these rules, however, do not distinguish among broker-dealers performing different functions in the securities markets (except that exchange specialists and other members having no public business are not subject to such provisions), nor do they take account of changing circumstances in the markets. One result is that broker-dealers, including those making primary markets, may not be adequately restricted in accumulating inventories of over-the-counter securities during periods of price rises, but may be compelled to reduce inventories rapidly during periods of falling prices, contrary to market nee ds.
Section 60(e) of the Bankruptcy Act is a notable advance in the administration of broker-dealer bankruptcies. Nevertheless there are within it certain ambiguities which should be resolved; furthermore, it is believed that customers whose securities or free credit balances are appropriately segregated should be entitled to greater protection than they are now accorded by section 60(e).
The Special Study concludes and recommends:
1. The net capital rules of the Commission and the self-regulatory agencies should be amended to require broker-dealers to maintain a reserve of, say, 15 percent of the aggregate amount of free credit balances in the form of cash or short-term U.S. Government securities; or in the alternative, if a lesser reserve is maintained, to charge the difference to net capital. In addition, broker-dealers holding free credit balances should be required to give customers at least quarterly notice of the amounts of such balances. Such notice should include information to the effect that their free credit balances may be withdrawn at any time; that while held by the firm they are not segregated and may be lent to other customers or otherwise used in the business of the firm; that interest is not paid on such balances (or the circumstances in which interest is paid); and that financial statements of the broker-dealer firm are available for inspection.
2. The Commission should be empowered to adopt rules requiring that excess margin and fully paid securities be segregated and marked in a manner which clearly identifies the interest of each individual customer.
3. The Commission should be empowered to adopt rules requiring that there be a "reasonable relationship" between the amount of each customer's securities that can be hypothecated or lent by the broker-dealer and the amount of indebtedness of such customer; and also requiring that broker-dealers obtain the specific, prior written consent of a customer before borrowing or lending his excess margin or fully paid securities.
4. Consideration should be given to the feasibility of providing greater flexibility in the so-called “haircut” provisions of the net capital ratio rules and in their administration, in order to take account of different functions, market circumstances, and needs. Additionally or alternatively, consideration should be given to exempting specified quantities (perhaps 500 shares) of securities in the inventory of a "primary market maker" as defined in chapter VII.
5. Section 60(e) of the Bankruptcy Act should be amended to provide (a) that customers' securities that have been appropriately segregated within 4 days after receipt so that their ownership can be ascertained, whether or not specifically identified (e.g., the bulk segregation system), and customers' free credit balances if similarly segregated, will be considered to be “identified specifically” within the meaning of section 60(e)(4) notwithstanding that such segregation may have occurred less than 4 months prior to bankruptcy or during insolvency; (b) that the term "stockbroker” clearly include "dealers” as well as "brokers"; and (c) that the term "customers” includes persons depositing cash for the purchase of securities. In addition, the Bankruptcy Act should be amended to empower the Commission to petition that an insolvent broker-dealer be adjudicated a bankrupt, so as to assure equitable treatment of claimants under section 60(e).
PART E. DELIVERY OF SECURITIES
The importance of encouraging prompt delivery of securities is clear. Late delivery to customers may render it difficult for them to sell when they so desire and may cause a loss of public confidence in the industry. Excessive "fails to deliver” may result in actual danger to the financial position of broker-dealers. Furthermore, the rise in fails to deliver in periods of heightened market activity suggests the danger that present securities handling, clearing, and delivery methods would prove inadequate to meet any sustained increase in volume. A "fails” situation such as that which arose in the spring of 1961 should not again be allowed to occur.
The volume of fails to deliver at any given time may well be reduced by revision
of the present rules of the self-regulatory organizations or their affiliated clearing organizations to encourage prompt delivery. It is apparent, however, that these organizations should give increased attention to basic changes in present methods of handling, clearing, and delivery of securities and also to centralization of bookkeeping systems, in order to prepare for the expected increase in volume. A number of ideas have been advanced in this area for many years; their implementation is desirable.
The establishment of over-the-counter clearing facilities and the New York Stock Exchange pilot project for handling securities are promising developments. The Midwest Stock Exchange's centralized bookkeeping service, while not performing custodial functions, gives
promising indication that centralized handling systems may be able to perform these functions.
The Special Study concludes and recommends:
1. The NASD should reconsider the adoption of rules under the Uniform Practice Code permitting marking to the market on a greater range of contracts than is now permitted. The experience of the Pacific Coast Stock Exchange with respect to mandatory marking to the market appears to have been highly satisfactory and the self-regulatory organizations should consider the desirability of the adoption by them or their affiliated clearinghouses of rules requiring marking to the market for all clearinghouse transactions.
2. A requirement for mandatory buy-ins might be of material assistance in reducing the volume of fails to deliver. It is recognized, however, that the adoption of such a system might raise certain problems such as the unavailability of securities which could be bought in at a fair price. The self-regulatory organizations and the Commission should give further study to the feasibility and utility of such a requirement for various types of markets or categories of securities.
3. The NASD should promptly reconsider the adoption of appropriate rules which would permit the NASD Board of Governors to establish hours of trading for all members or for specified classes.
4. The industry, with the cooperation of the Commission, should give continuing attention to possibilities for modernizing and improving existing securities handling, clearing, and delivery systems, with the goal of evolving institutions and procedures which would permit the reduction of physical transfers of securities and centralization of functions now performed by broker-dealer back offices insofar as possible.
PART F. THE BROKER-DEALER AS CORPORATE DIRECTOR
For purposes of the present discussion, there is no occasion to question the merits of broker-dealer representation on boards of directors of publicly held companies. Undoubtedly the managements of many corporations who seek individuals in the securities business as directors value their judgment and experience, as investment bankers and otherwise. Many broker-dealers assert that the need for this kind of judgment and experience is especially great in the case of corporations which have recently made a first public offering and whose managements are inexperienced in financial matters and in fulfilling obligations to public stockholders. From the broker-dealer's point of view, representation on a corporate board can aid it in discharging what it considers its responsibilities as underwriter and at the same time may be of tangible or intangible value to the firm in other ways.
The problems here considered arise from broker-dealer representation on company boards in conjunction with other relationships and activities of the broker-dealer that may involve other obligations or interests, and therefore potential conflicts of obligation or interest. For example, if the broker-dealer represented on the board has been a managing underwriter in the flotation of a company's securities, obligations to customers in the original allotment and to fellow underwriters and their customers may be important. If the same brokerdealer is now making a market, or recommending or selling the securities to retail customers, or has investment advisory clients, additional motivations and obligations may arise and the potentiality, for conflict with the director's obligation to his corporation and its stockholders inevitably widens.
The nub of the difficulty is the use of inside information. It is well established that a director is a fiduciary who may not use inside information for his private benefit, and enforcement of such fiduciary obligation of directors (and officers and controlling stockholders) of listed companies is the central purpose of section 16 of the Exchange Act. The most obvious misuse of inside information for the director's own benefit would be in transactions for the broker-dealer's own account as principal, a subject which is further considered in chapter IX.
The most subtle questions of conflict arise where transactions of customers are involved. Where a broker-dealer has inside information through a directorship, there may be a violation of obligation to the corporation and its stockholders if the information is used, and, at least in some circumstances, there may be violation of obligations to customers if it is not used, especially if the customers have been led to rely on the protection flowing from his close affiliation with the corporation. But the problem is even more complex than this, because the use of inside information for the benefit of customers may amount to fraudulent activity in respect of members of the public on the other side of customers' transactions.
Broker-dealer firms have a great variety of views and practices in this area. Some firms take the position that inside corporate information is available for their benefit and that of their customers; others attempt to maintain a wall of insulation between the individual when serving as director and the same individual in relation to his firm, its trading department and its retail customers. In the former instance, apparently no obligation to the corporation or its stockholders is recognized, or else an obligation to customers is considered dominant. In the latter, the emphasis is on obligations as director notwithstanding any obligations to the public customer. Just how sharply and consistently these theoretical distinctions are maintained in practice is not easy to determine. Other firms avoid or prefer to avoid directorships entirely, because of the conflicts problem or for other reasons.
The regulatory and self-regulatory treatment of this subject is of rather recent origin. The New York Stock Exchange recently issued two educational circulars to its members, pointing out the many pitfalls in this area. The Commission's staff, while making no general pronouncement on the subject, has advised individual broker-dealers that the duty to disclose material information to customers may be overriding in some circumstances, so that many broker-dealers may prefer not to place themselves in a position where there is a conflict between this duty and any obligation as director of a corporation not to disclose the information. In the 1961 case of Cady, Roberts, the Commission held that the antifraud provisions of the securities laws had been violated where inside information as to reduction in a company's regular dividend became the basis for transactions of a partner of a broker-dealer firm for his wife's account and discretionary accounts of customers, in the absence of disclosure of the inside infor