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STATEMENT OF WILLIAM L. CARY, CHAIRMAN, SECURITIES AND
EXCHANGE COMMISSION; ACCOMPANIED BY MANUEL F. COHEN, COMMISSIONER; PHILIP A. LOOMIS, DIRECTOR, DIVISION OF TRADING AND EXCHANGES; ARTHUR FLEISCHER, LEGAL ASSISTANT TO THE CHAIRMAN; ALEXANDER J. BROWN, JR., ACTING REGIONAL ADMINISTRATOR, WASHINGTON REGIONAL OFFICE; AND STUART LAW, AN ATTORNEY IN THE DIVISION OF TRADING AND EXCHANGES
Mr. CARY. Mr. Chairman and members of the committee, I am William L. Cary, Chairman of the Securities and Exchange Commission.
I have with me my colleague, Commissioner Manuel F. Cohen, also Philip Loomis, the Director of the Division of Trading and Exchanges; my legal assistant, Arthur Fleischer; our Acting Regional Administrator of the Washington district, Alex Brown, and Stuart Law, an attorney in the Division of Trading and Exchanges.
I am here to testify on the problems of securities regulations in the District of Columbia. I have a prepared statement, which I believe you have copies of. I will expect to proceed through that with minor deviations.
The Commission believes that a serious problem existed in the Metropolitan Washington area with respect to the conduct, business methods, ethics, and qualifications of numerous broker-dealers engaged in the securities business.
This situation has been graphically and thoroughly discussed in a series of articles by Miriam Ottenberg in the Washington Star.
It has been reflected in the great number of enforcement actions brought by the Commission and the National Association of Securities Dealers against local firms; by the crescendo of illegal and unethical practices; by the number of local brokerage firms that have gone out of business; and by the substantial number of new firms managed by inexperienced personnel.
Apparently vigorous enforcement action has measurably reduced the present gravity of the situation, although we have no illusions it is entirely cured. We cannot be assured there will be no recurrence unless additional corrective action is undertaken. It is my understanding that a main purpose of these hearings is to assist in the determination of what such action might be.
I wish to point out that the problems of securities regulation in the District of Columbia are not unique. As the committee knows, the Commission is presently engaged in a broad study of the securities markets pursuant to Public Law 87–196, a bill introduced by Congressman Mack.
One of the important reasons for this study was evidence of a general breakdown of controls and lowering of standards in various sectors of the securities markets. The situation in the District of Columbia appears to represent a particularly intensified and extreme example of a national problem.
Why has there been an acute problem in the District ?
I do not have any scientifically developed correlations. But I do believe that there are certain factors peculiar to the Metropolitan Washington area which aggravate problems normally present in securities regulation.
In the first place, the District of Columbia has no local securities regulation--no "blue sky” law. There are only two States without this type of legislation. Its absence in the District appears to have been a substantial inducement in encouraging both the formation of substandard new brokerage firms and the movement of undesirable persons from other areas to here. Convincing evidence is seen in the fact that nearly all new brokerage firms have located within the boundaries of the District, rather than in Maryland or Virginia.
Moveover, principals and salesmen from outside the District with so-called boilerroom backgrounds became participants in local firms. The District had become a haven for a developing breed--the migratory broker-dealer who flocks to the place of minimum interference with his operation.
I might say in that connection, there have been quite a few homegrown ones, too.
Secondly, the metropolitan area would generally be attractive to broker-dealers. Its comparatively high-income military and Government population, largely transient and allegedly somewhat unsophisticated in investing, and its large number of retired people, interested in supplementing fixed income, obviously present a prime target for unscrupulous brokers and their salesmen.
While this potential appears not to have been fully appreciated until recently, the phenomenal sprouting of local brokerage houses in the past few years attests to the fact that the possibilities offered by the market here have become well known. The new firms, some of which enjoyed rapid apparent growth for a time, in turn, trained new salesmen. Then the salesmen, upon exposure to the prospects offered, frequently opened up firms of their own.
The problems of securities regulation in the District of Columbia may be illustrated in numerous ways. The growth of the brokerdealer community in itself is exceptional.
At the end of 1958, there were 71 District firms who were members of the NASD. At the end of 1961, this number had increased over 47 percent to 104.
In this connection, it should be borne in mind that in the interim a large number of firms had failed-23 in 1961 alone. By contrast, the net gain in NASD membership for the Nation as a whole was only 22 percent-and the failures were correspondingly lower.
The genesis—and subsequent history-of many new firms reflects what has caused our anxiety and resulted in our actions. A staff study of the past 5 years shows that many local brokerage firms have been formed by persons formerly associated with houses that the Commission had closed.
Approximately one-third of the 67 that went out of business in the past 5 years had an officer, director, or owner who had previously worked for a firm against which the Commission had brought proceedings. Half of this group had two such persons.
As a dramatic instance of how substandard firms have grown, hydra-like, from the pieces of revoked firms, let me give the following example: A large District broker-dealer recently was put out of business by the Commission's Washington regional office. Investigation of possible fraud in the operations of this firm had barely begun when a number of salesmen and others connected with it opened new offices of their own.
Indeed, even before the firm closed, its salesmen were setting up firms. Altogether, at least 16 new houses were started by alumni of the original alma mater. Of this
Of this group, nine have either gone bankrupt, been forced to sell out, become dormant, or been put out of business.
Proceedings have been brought against several of this group of nine, and investigation is in progress with respect to others.
A barometer of what the District securities problem was may be seen in the great number of enforcement actions brought by the Commission and complaints filed by the NASD against District broker-dealers.
During the 4-year period up to June 30, 1959, a total of 12 administrative proceedings were brought by the Commission against District firms.
From July 1, 1959, to May 7, 1962, a period of less than 3 years, a total of 20 such proceedings were brought, nearly twice that of the previous period. Similarly, from July 1, 1955, to June 30, 1959, only two injunctive proceedings were brought against local firms.
From July Î, 1959, to May 7, 1962, 18 such actions have been brought, an increase of 900 percent. The Commission's Washington regional office has brought more of these actions against District brokerage firms than firms in all other States for which this particular regional office is responsible (Maryland, Virginia, West Virginia, Delaware, and Pennsylvania).
Data furnished to the Commission by the NASD is likewise illuminating. The NASD has indicated that, over the past 5 years, the number of complaints filed against District broker-dealers increased 650 percent, over three times the national increase of 215 percent.
Further, in 1960, the NASD filed complaints against 8 percent of its members nationally, whereas, for the District, the figure was 25 percent.
Thus, one out of four District firms was the subject of an NASD complaint involving some infraction of its rules. In 1961, possibly because of the increase in the number of local firms that went out of business, the District's percentage dropped to 18 percent, but this was still twice the number of complaints per member as the national percentage.
The number of local broker-dealer firms that have gone out of business is an additional measure of what has been the poor health of the broker-dealer community here. Nationally, in 1961, approximately 8 percent of the firms admitted
8 to the NASD failed. In the District, 18 percent of NASD member firms failed.
This rate of failure has presented a grave danger to the investing public and has resulted in substantial losses by many investors. One recent District broker-dealer, which is now in bankruptcy, has debts of well over $1 million, and few assets.
Hundreds of individual public investors dealing with this firm failed to receive certificates for which they paid, or proceeds from stock which they sold. It is doubtful whether they will receive anything on their claims filed in the bankruptcy proceedings.
There is evidence to demonstrate that these failing firms were characterized by management which had little or no prior experience. Such experience as existed was too frequently with a firm that had been involved in Commission proceedings.
Nearly half of the firms which commenced business in the past 5 years and failed had no executive with any previous experience except in a firm involved in revocation proceedings or injunctive action.
The consequences attendant upon minimal standards of qualification for the securities business—so graphic here—are the subject of
— major concern in the special study now being conducted by the Commission.
The unhealthy state of the securities business here in the District is also illustrated by the types of securities broker-dealers have been selling. In many cases, for example, the insiders and underwriters have taken for themselves what might appear to be an unconscionable amount of the proceeds of a public offering of securities and have left little for the benefit of the company and its public shareholders.
Thus, in one case, a company which had an operating deficit of over $12,000 was underwritten by a local broker. The total issue was for 150,000 shares at $2 per share. The underwriting group received 10 cents per share as commission and expenses and 30,000 shares of stock at a penny and a half a share, a total compensation of approximately $120,000 or 50 percent of the net proceeds received by the issuer.
Seven months after the stock was issued, the price had risen over 500 percent to more than $11 per share. The issuer is now the subject of bankruptcy proceedings.
In another case, the public paid nearly $175,000 for what eventually was a 30-percent interest in a company which had less than $3,000 in the bank, less than $200 worth of office furniture, and a net loss for the 6 months in which it had been in business of over $6,000. The insiders received the other 70 percent of the company for less than $500. The issuer is now bankrupt.
Securities problems in the District are perhaps most acutely demonstrated by the allegations, and evidence, of widespread fraudulent conduct on the part of certain local broker-dealers. Because of the Commission's quasi-judicial functions, it is not appropriate for me to comment on any pending cases or active investigations.
But, speaking generally, the erosion of standards which has occurred to some extent on a national level appears to have been magnified in the District. Just as the broker-dealers seem to have found a center of operations in the District, so have all of the unsavory practices which the Commission is constantly trying to extinguish.
The aforementioned conditions lead to the question of whether some type of legislative action is called for.
The District of Columbia, unlike virtually all of the States, is without legislation of its own, and must rely on the Federal securities laws for protection.
In this connection, it should be emphasized that, as a practical matter, investors in the Maryland and Virginia suburbs are affected by the situation in the District, inasmuch as the “blue sky” laws of these States do not effectively reach District brokers.
The Commission has attempted to meet the challenge of the problem without any new legislation. We have taken concentrated enforcement action in this area, which I believe has been at least temporarily productive in diminishing the unhealthy practices and creating a new environment.
Some of the specific steps that we have taken include the following:
(1) The assignment of personnel to the Washington regional office from the national office and other regional offices.
(2) The institution, since January 1, 1961, of 23 administrative and injunctive proceedings against District broker-dealers, involving a total of 79 persons from the local area, and 23 parties from other
Indicative of the complexity of these administrative cases is one pending broker-dealer proceeding involving some eight firms, including four local ones, and some 20 salesmen and principals, of whom 9 are from the Washington area. Another case new pending took over 9 months to investigate.
(3) Various investigations are in the final stages. It is anticipated that a number may result in reference for criminal prosecution to the U.S. attorney, Mr. David C. Acheson, who is giving us his full cooperation.
However, despite the important steps we have taken and the apparent general improvement in the conduct of local broker-dealers, the situation still presents many difficulties—which can be expected to increase to the extent that the market for over-the counter securities moves up.
Vigorous enforcement can never be a permanent substitute for high regulatory standards. If there is a relaxation of our present efforts, and our national enforcement responsibilities might make this necessary, there could be a renaissance of past unsavory practices, hopefully now substantially curtailed.
The Federal securities acts do not presently appear to be a full answer. The legislative history and the language of the Federal statutes make clear that they are not, and were not intended as, complete instruments for local regulation.
They contemplate concurrent jurisdiction by the Securities Commission of any State or the District of Columbia. Although specifically designed to supplement, rather than supplant, local securities legislation, the Federal acts have been forced to function in the District of Columbia as a local “blue sky” law without the provisions which “blue sky” laws normally have.
Under the Federal acts, the Commission's power is largely punitive or remedial, not preventive. There are only limited controls over entrance into the securities business.
Usually, we cannot act until violations have taken place, and investors have suffered—until the fraud has been committed, or the firm's net capital depleted beyond the limit allowed by law.