(5) The States

94

The 33 States 91 imposing capital and/or bonding requirements for broker-dealers follow varying patterns. Some require a minimum net worth or net capital as a condition to registration. One such State is New Hampshire, which requires that broker-dealers have a net worth of not less than $25,000.92 Other States required a surety bond 93 regardless of a firm's capital; Iowa, for example, has no minimum capital rule but requires a surety bond of $5,000. A third group uses a "combination" principle (which is also recommended in the Uniform Securities Act) 95 requiring a surety bond but only in the event that a firm's capital, as defined in the statute or by appropriate regulation, is less than a given amount. Section 202(e) of the Uniform Securities Act authorizes the administrator to require brokerdealers, agents, and investment advisers to post surety bonds in amounts up to $10,000, but no bond may be required for any registrant whose net capital, as defined, is more than $25,000. New Jersey's requirements are more elaborate than those of most jurisdictions and exemplify this third approach, taking into account the varying degrees of risk attached to various functions which broker-dealers perform.96 Another variant of the "combination" principle conditions the size of the required surety bond on the number of agents employed by the broker-dealer.97

Most States requiring surety bonds permit an "appropriate deposit" of cash or securities as an alternative. A State statute that did not contain such an alternative was once declared unconstitutional on the ground that the statute constituted a deprivation of liberty without due process of law under the 14th amendment.98 Surety bonds are not always readily available. When available, on the other hand, surety bonds cost only $15 to $25 per thousand dollars of coverage per year, and thus represent no assurance that a broker-dealer has any commitment to the business, nor that it has sufficient capital to meet the various needs noted at the outset.

b. The need for a generally applicable minimum capital requirement In 1942, at the Commission's hearing on the NASD proposal of a minimum capital requirement as a condition for the NASD membership, the association's chairman said:

[T]he Board found that too often meager capital or no capital at all and the abuse of public trust and the rules of the association were inclined to go

91 Alabama, Alaska, Arizona, Arkansas, California, Colorado, Florida, Georgia, Hawaii, Indiana, Iowa, Kansas, Kentucky, Maine, Maryland, Michigan, Minnesota, Mississippi, Missouri, Nebraska, New Hampshire, New Jersey, New Mexico, North Dakota, Ohio, Oklahoma, Oregon, Pennsylvania, South Carolina, South Dakota, Utah, Vermont, and Virginia. Additionally, Montana requires that each salesman be covered by a surety bond for $5,000. Montana Rev. Code, title 15, sec. 2006 (2). Illinois and Wisconsin impose a net capital ratio rule like that of the SEC on any broker-dealer not subject to the Commission's rule or that of an exchange. Illinois Regulations, Secretary of State, rule D, rule 1; Wisconsin: Regulations, Department of Securities, sec. 1.01.

B2 N.H. State Insurance Commission Reg. No. 2.

83 A surety bond typically permits an aggrieved person to sue directly on the bond for violations, by the bonded broker-dealer or his agents, of the applicable blue-sky law. The range of coverage is broader than that of brokers blanket bonds and partnership bonds, which do not cover violations of Federal or State securities laws and under which there is no direct right of action by a member of the public. See, e.g., Uniform Securities Act, sec. 202 (e).

94 Iowa Code, ch. 502, sec. 18.

6 Uniform Securities Act, sec. 202 (d), (e).

8 N.J. Rev. Stat. sec. 49:3-10; Regulations, N.J. Bureau of Securities, pt. I, rules 2 and 3; pt. II, rules 2 and 3.

See, e.g., New Mexico Statutes, 1953, secs. 48-18-20.2 and 20.3; Regulations, Commissioner Securities, No. 59-101.

98 Riley v. Sweat, 111 Fla. 362, 149 So. 48 (1933).

96746-638

together. I believe it is obvious that an organization whose capital has been vanishing or an organization that is in the red would find it difficult to avoid the temptation of taking inordinate profits on transactions with customers since such profits would help to restore a balance on the financial statement. We would like to dissipate some of the temptation. We don't say that these capital requirements will do away with all abuses, but we do believe that they will be helpful.

Our examination and enforcement program, during the course of which we reviewed financial and business practices of over 2,200 members, convincingly showed that in those areas where capital was a requisite to securing the State license, violations of association rules were proportionately less and much easier surveillance was possible. We had this experience, for example: Two States adjoin each other, in one of which there is a statutory capital requirement and in the other there is none. Our examinations of members in the latter resulted in complaints having to be filed against one-third of the membership in the State; whereas in the State having a capital requirement statute, only one case of insolvency presented itself and in relation to total number of members involved in this instance, the ratio was infinitesimal. Our experience in other States where capital requirements are included in the statute or enforced by administrative action was gratifyingly comparable * * ***

It is apparent that the association's experience in the intervening period has not changed its position. The NASD submitted to the study a memorandum which placed at the head of a list of additional powers needed by the NASD to fulfill its regulatory responsibilities the power to impose an "initial capital before becoming members***" It was further suggested that there might be separate requirements for those selling mutual funds and that there might be bonding, in addition to capital, requirements. Avery Rockefeller, Jr., the 1962 chairman of the board of governors of the NASD, testified during the study's public hearings that the board "strongly favors" a minimum capital requirement. And Wallace H. Fulton, executive director of the NASD, has stated on numerous occasions his support of a minimum capital requirement.

A number of other members and representatives of the securities industry have recommended to the Special Study that a Federal minimum capital requirement be created to complement the Commission's present net capital ratio rule. Active and responsible members of the industry have almost invariably given prime emphasis to a minimum capital requirement in expressing their views as to needed improvements in existing rules. James E. Day, president of the Midwest Stock Exchange, expressed his views as follows:

I think you need to have a line drawn so that there are some definite financial requirements rather than to be more or less wide open as is the case today *

I think you have to measure [additional restrictions] in relation to the good of the whole or on balance.

By their actions even more than any mere expressions, the Midwest and other exchanges have, of course, made clear their views as to the significance of capital requirements.

The principal objection to a minimum net capital rule-in a sense the other side of the point that a minimum net capital rule cannot by itself assure financial or other responsibility-is that worthy individuals without capital may be excluded from the business. The exclusion, at most, would not be from the securities business, but from the right to set up a separate broker-dealer entity without a modicum of capital. It is true that most of the learned professions do not require

Transcript, pp. 32–33, In the Matter of National Association of Securities Dealers, Ino. (Aug. 13, 1942).

a newcomer to have capital, but they do require serious commitment in the form of extended education. Most merchandising businesses do require a starting fund of capital commensurate with the kind and size of business undertaken, at least if there is to be any assurance of continuity and success. The securities business is intermediate, involving more intricate merchandise and higher levels of obligation than the ordinary business. The question is whether a modest capital requirement is an appropriate element in the recommended general tightening of standards for entry into the securities business-in the words just quoted-"in relation to the good of the whole or on balance." Information available to the study from Commission records indicates that a disproportionate number of violations of Commission rules occurs among broker-dealers with limited capital, and thus gives objective support to the views expressed above. An analysis was made of the first financial reports 100 filed with the Commission by 215 broker-dealers whose applications for registration were filed between July 1 and December 31, 1956. On August 1, 1962, 95 were still in business, the registrations of 26 had been revoked by Commission action, and the registrations of 94 had been withdrawn voluntarily. In table II-4, broker-dealers in the sample are classified by net capital and ratio of aggregate indebtedness to net capital as of the date of their first financial reports to the Commission. It can be seen that half of the revocations are concentrated among the 58 firms (or 27 percent) in the sample which reported net capital of less than $1,000 at the time of their first reports. The 130 firms (or 60 percent) in the sample having net capital of less than $5,000 accounted for 73 percent of the revocations. It may be, of course, that low capital was not the cause of these violations, and that lack of experience or aptitude for business played a part. Nonetheless, the fact remains that firms with low capital were involved in a high proportion of revocation actions by the Commission.

The figures available to the study tend to indicate also that firms with net capital smaller than $5,000 may have a significantly higher chance of falling into net capital difficulties under the Commission's ratio rule than those with a greater amount. In table II-5, registered broker-dealers, other than New York and American Stock Exchange members, are classified by net capital and by ratio of aggregate indebtedness to net capital, according to the latest financial reports submitted to the Commission as of December 31, 1961. The table indicates that 210 out of 220 broker-dealers whose reports indicated violations of the Commission's capital ratio rule had net capital of less than $5,000. These 210 represented 11.5 percent of the 1,804 brokerdealers having net capital of less than $5,000, and 4.1 percent of the 5,123 broker-dealers whose reports were analyzed. The 10 brokerdealers with net capital of more than $5,000 who were in violation of the capital ratio rule, in contrast, represented only 0.3 percent of all firms with more than $5,000 and 0.1 percent of the total of 5,123 broker-dealers.

A study of the latest financial report of each of the 503 brokerdealers engaged in underwriting "unseasoned" issues in 1961 101

100 These reports, under Commission rules, must be filed not less than 1 nor more than 5 months after a firm has become registered; all firms in the sample became registered within 30 days following their applications.

101 This study is described in detail in ch. IV.B.

showed that 104 had a net capital of less than $10,000; the reports of 34 indicated net capital of less than $1,000, including 21 with net capital deficits. Underwriters with capital of $1,000 or less, or even $10,000,102 hardly can be said to have such commitment to the business of such financial stake as to engender a sense of the especially high responsibilities entailed in underwriting, or to make the statutory provisions for civil liability an effective deterrent to fraudulent or responsible activities.

A number of persons have suggested that a Federal fidelity or surety bond requirement be imposed in addition to or in lieu of a capital requirement. It would seem, however, that such a requirement would present a number of practical difficulties and that more significant protection to the public can be assured through a Federal net capital requirement. No recommendation as to bonding, therefore, will be made at this time.

c. The variety of needs

While it is believed that all entepreneurs in the securities business should be subject to some kind of capital requirements, the amount required to provide minimum operating resources and minimum protection for the public may vary considerably for differing types of broker-dealers.

At one end of the scale is the small mutual fund distributor with no employees and minimal fixed expenses. Ordinarily he does not handle the securities he sells, maintain an inventory of securities, or receive customers' funds except in the form of a check payable to the fund or its custodian bank. Occasionally, however, he may be paid in cash or may receive other securities to be sold in order to purchase mutual fund shares, and thus come into possession of a customer's funds or securities for a short period of time.

The broker-dealer selling a larger variety of securities will have greater need for operating capital, even though his volume of business may not be larger. He may regularly handle customers' funds and securities. He may also receive, and be required to pay for, securities for which he has not yet received payment from his customer. 108 Often he holds securities in custody for his customers; the recordkeeping and custodial expenses may be considerable and he is accountable for these securities.

The larger firm will have larger needs; these may, of course, range over a considerable gamut. One obvious measure is the size of a firm's selling organization and another is the number of its separate offices with their separate demands of overhead. The practices of a few States 104 take account of at least the former criterion. Both would seem to be appropriate, workable guides in establishing minimum capital requirements adjusted for differing needs.

Other variations may exist in terms of the type of business conducted, apart from size. This is already suggested above with reference to underwriting firms, and similar considerations may apply,

102 An underwriter with net capital which is $10,000 more than that required to support his aggregate indebtedness can "take down" not more than about $33,000 of a firm commitment underwriting of common stock. (See ch. III.D.3.d.) In the event that the underwriting is on a "best efforts" basis, however, there is no limit as to the amount which he may undertake to sell with even less capital.

103 This is not necessarily a violation of the Federal regulations governing extension of credit. See ch. X.

for example, to firms making markets in over-the-counter securities or to other special activities or differences in customer relationships. The NASD, in its 1942 attempt to adopt a minimum net capital rule, recognized the principle that capital needs of broker-dealers and risks to the public might be greater where firms were holding customers' funds and securities. The New York Stock Exchange and certain other exchanges similarly differentiate among specialists, floor traders, "introducing" firms not holding customers' funds, and securities and other member firms. The minimum capital or bonding requirements of some States also take into account the activities of the firms affected. No single net capital standard at a reasonable level can take care of all these variables. Exceptions and refinements for different types of business and different relations with customers may have to be worked out, but the general pattern should at least take account of size, with all firms being subject to some "minimum minimum" and larger firms in terms of numbers of salesmen and branch offices-being subject to an appropriately scaled up minimum.

a. His duties

C. QUALIFICATIONS OF SALESMEN

1. THE SALESMAN'S ROLE IN THE INDUSTRY

Securities salesmen represent their firms to the public. They often serve investors as investment advisers, and sometimes even enter the field of "financial" or "estate" planning, which involves counseling the investor on his entire financial situation, including, at times, such elements as life insurance, real estate, savings accounts, and trust arrangements.

Industry representatives speak of the work of the securities salesman as a "profession," either as a present status or as one to be aspired to, depending on the position and outlook of the speaker. "Professionalism," for most persons who use the term in connection with the securities industry, implies, first, the meeting of certain initial qualification standards of competence and integrity-salesmen must be "knowledgeable and ethical," in the words of the NYSE 105—and, second, the continued adherence to certain fiduciary or ethical standards subsequent to becoming a salesman. While problems of compliance with ethical and legal standards by securities salesmen in their day-to-day conduct is discussed in part B of chapter III, the manner in which salesmen are selected and prepared for the performance of their duties in the securities business is analyzed here.

What are the duties for which a salesman is selected and trained? A recent advertisement of Merrill Lynch, Pierce, Fenner & Smith, entitled "Hat Trick," explained the virtues of its salesmen (or "account executives," as it refers to them) in this manner:

Every day of his working life, he [the Merrill Lynch salesman] is called on to wear a variety of hats. *** For his customers, he answers questions, gets quotations, obtains information, and executes orders in listed and unlisted securities, government and municipal bonds, and commodities. He opens monthly investment plans and arranges for gifts to minors.

106 NYSE Department of Member Firms Liaison, "Ethical Conduct, a Study Guide for Registered Representative Trainees of New York Stock Exchange Member Firms," p. 1 (1962).