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 exaluations 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 broker-dealer 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, the 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 circulated

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 circulation 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 brokerdealer's failure to disclose its position or its marketmaking 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 employees "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 sales-promotion 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 mar

ketmaking activities; preferential treatment of different categories of clients; responsibility for following recommendations-the selfregulatory 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-regulatory institutions, both to clarify the ethical responsibilities of its members and to promote the establishment of reasonable standards which the disseminators 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 member 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 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 brokerdealers. Alternatively, the Commission should extend and strengthen its own direct regulation of advisers to accomplish the purposes indicated.

D. PROTECTION OF CUSTOMERS' FUNDS AND SECURITIES

1. CONDUCT OF CUSTOMERS' ACCOUNTS

a. Purpose of study

The purpose of this part is to continue the study of the brokerdealer financial responsibility rules begun in chapter II.B. There, bonding and minimum capital rules that have an impact at the point of entry into the business were examined; here certain rules governing the conduct of broker-dealer business operations are reviewed. The rules discussed relate to custody and use of customers' assets, and to net capital ratios. It is appropriate to consider whether they provide adequate protection to investors by reducing the probability of brokerdealer insolvency and by correlating adequately with the provisions

of Federal bankruptcy law in the event that such an insolvency occurs. The rules treated include those embodied in certain State and Federal statutes and those of the Commission, national securities exchanges, and the NASD. Their adequacy, in substance and enforcement, is fundamental to the health of the securities business because the broker-dealer community regularly has custody of and uses customers' funds and securities of enormous value. Substantial unprotected losses to the public resulting from misuse of customers' assets or other practices which the rules are intended to protect against, would cause, in addition to injury to the public, serious harm to the industry's reputation.

b. Method of study

The study of financial responsibility rules was carried out through interviews with officials of certain exchanges, the NASD, partners and officers of various types of broker-dealers, stock brokerage accountants, and certain other informed persons; through review of currently applicable laws and rules and regulations; and through analysis of answers to questionnaire FR-1,314 distributed to 245 selected broker-dealers throughout the country. The questionnaire requested information with respect to transmission of statements to customers; practices relating to custody and use of, as well as protection for, customers' cash balances and customers' securities; hypothecation and lending of customers' securities; handling of margin accounts and nonpurpose loans (see ch. X); and bonding (see ch. II.B). Distribution of the questionnaire was limited to 245 brokerdealers conducting a general retail securities business with the public, since it was believed that specialized operations, e.g., mutual fund retailing and nonpublic business, would not present certain of the problems on which interest centered. Usable responses were obtained from 228,315 including 50 members of the NYSE, 15 regular or associate members of the Amex, 44 regional-only exchange members, and 119 broker-dealers not exchange members. The responses are believed to present a representative sampling of the practices and procedures of the full spectrum of general retail broker-dealers.

c. Types of accounts

As a preliminary to consideration of the financial responsibility rules, the nature of the principal relationships that normally exist between broker-dealers and their customers should be briefly delineated. The technical characteristics of various types of accounts are discussed in chapter X; here only general attributes are noted.

The principal types of brokerage accounts are "cash" and "margin" accounts, technically designated as, respectively, "special cash" and "general" accounts. Numerous other types of accounts are also prescribed under the applicable regulations and the rules of the various exchanges. Cash and margin accounts, however, are the basis for such

814 See app. III-J.

$15 17 of the original 245 broker-dealers in the sample were not included for the following

reasons:

(a) 12 did not reply (at least 4 of these are no longer in business and 2 are insolvent); (b) 2 were merged with other firms and no longer operate independently;

(c) 2 had no public business;

(d) The principal of one firm is recently deceased and the firm is winding up its business.