The SPEAKER OF THE HOUSE OF REPRESENTATIVES.

SIR: I have the honor to transmit the first segment of the Report of the Special Study of Securities Markets. The report is submitted pursuant to section 19 (d) of the Securties Exchange Act of 1934 (Public Law 87-196), which directs the Commission to make a broad study of the adequacy of investor protection in the securities markets.

I

At the outset we emphasize that, although many specific recommendations for improvements in rules and practices are made in the Report of the Special Study, the report demonstrates that neither the fundamental structure of the securities markets nor of the regulatory pattern of the securities acts requires dramatic reconstruction. The report should not impair public confidence in the securities markets, but should strengthen it as suggestions for raising standards are put into practice. Serious shortcomings are apparent and the report, of course, has concentrated on their examination and analysis. Yet it is not a picture of pervasive fraudulent activity and in this respect contrasts markedly with the hearings and findings of the early thirties preceding the enactment of the Federal securities laws. The study confirms the strength of those laws and the heightened sense of obligation of the financial community.

At the same time the report makes very clear that important problems do exist, grave abuses do occur, and additional controls and improvements are much needed. The tremendous growth in the securities markets over the past 25 years, and most particularly the increased public participation, imposed strains on the regulatory system and revealed structural weaknesses. Neither the securities acts, the Commission, nor the industry itself fully anticipated the problems arising from the entry of unqualified persons, the spectacular development of the over-the-counter market, the vast number of companies going public for the first time, or a variety of other striking changes. Some of these problems resulted from inadequacies in established enforcement machinery, both Government and industry. Others reflect patterns of conduct now tolerated, but which, upon exposure and analysis, appear incompatible with the public interest. Testimony to this effect has been given by many responsible members of the financial community in their comments and most vividly in their adoption of higher standards of conduct without compulsion of law. It is these

III

voluntary standards which regulation should reflect and make generally applicable.

The functions of this report and of any changes proposed are to strengthen the mechanisms facilitating the free flow of capital into the markets and to raise the standards of investor protection, thus preserving and enhancing the level of investor confidence. Raising capital from the general public is a marked feature of the American economic system. In this country there are now approximately 17 million shareholders. As the study attests, this phenomenon has been advanced and protected by the securities acts, a proven legislative achievement. Yet no regulation can be static in a dynamic society; unanticipated changes in the markets and the broader public participation should be accompanied by corresponding investor protection. The importance of the capital markets to our national economic progress does not permit anything less than the most fair and efficient operations. Government and industry regulation and the efforts of the financial community must continue to be directed against practices which undermine the integrity of the securities markets and which can only be harmful to the economic growth of this country and to the investors who furnish the funds for that growth.

While the report focuses upon shortcomings in the industry and in the self-regulatory authorities, in certain respects it is an express or implied critcism of the Commission as an institution. The Commission has not fully exercised its powers, nor coped effectively with all of the problems confronting it. There are undoubtedly several reasons for this. Important among these is the expansion of the securities markets, which renders exceedingly difficult the task of identifying and responding to a myriad of new problems while preoccupied with a heavy flow of administrative tasks. Furthermore, at times the Commission has been hampered by a lack of personnel or has concentrated its efforts on particular areas. Finally, in certain instances, statutory power has been lacking. But our job, like industry's, is not to rationalize inactivity but to initiate improvements. The Report of the Special Study will be a catalyst in this process.

As a final prefatory comment, we should like to emphasize that this report is not a commentary on the level of securities prices, nor upon the investment merits of any particular company mentioned. These types of economic analyses have traditionally been outside the scope of the Commission's responsibilities.

II

The complete Report of the Special Study of Securities Markets will be the most comprehensive of its kind in over 25 years. The examination of the securities markets and the writing of the report have been done by a separate group established in the Commission and designated the Special Study of Securities Markets, under the supervision of Milton H. Cohen, Director. The Special Study was given freedom to analyze and point out problems as they appeared to it; in this respect, the judgments, analyses, and recommendations. in the report are those of the Special Study and not the Commission. However, the Commission has worked very closely with the study throughout and has gone over every section of the report. We be

lieve that the report is a thoroughly responsible document. We do not embrace every recommendation as our own, but we do accept them as a sound point of departure for proposals to the Congress, for rulemaking by the Commission and by the self-regulatory agencies, and for discussions with the industry. Like the study, we at the same time recognize the complexities and subtleties of the problems presented. III

Transmitted here are chapters I through IV and chapter IX. The remainder of the report, while nearing completion, is not available at this time essentially because of the scope of the undertaking. The Congress repeatedly made clear that the report should be broad and thorough. The study, with the support of the Commission and its operating divisions, has made every effort to carry out this mandate. However, the breadth of the obligation was not evident at the outset and a proper fulfillment necessitates some delay.

The chapters submitted deal with important and basic areas and practices in the securities markets. In many respects they disclose problems calling for vigorous and prompt responses by the Commission and the industry. The Commission will very shortly recommend to the Congress certain legislative proposals (to be discussed below) where the present statutory scheme appears inadequate. An important part of these reflects our continuing belief in self-regulation as an ingredient in protection of the investor. Certain deficiencies can be treated through rulemaking by either the Commission or the self-regulatory agencies. Still others can be resolved only by a more uniform and voluntary adoption of improved procedures by the members of the industry.

A

The report begins where regulations must begin-the point of entry into the business. It is self-evident that the standards of conduct of the securities industry are vitally dependent on the integrity and competency of its personnel. Obviously, no system can be devised which eliminates all potential wrongdoers. But the Report of the Special Study concludes that the minimal controls furnished by existing regulation are inadequate. Notable ease of entry is apparent under both Federal law and the rules of the National Association of Securities Dealers, Inc., the self-regulatory agency for the over-thecounter market. With the exception of the major exchanges, significant standards of character, competence, and minimum capital have not been generally imposed. Nor has attention been sufficiently directed to the unique problems of supervisors, such as branch managers, and research analysts. Furthermore, certain sectors of the industry, including most importantly certain distributors of mutual fund and real estate securities and also investment advisers, are not subject to the discipline of self-regulation. In addition, the present legislative scheme, in revolving around the firm as the regulated unit, provides an artificial and unsatisfactory means of focusing on the individual in the many instances where he is the appropriate object of disciplinary action. Finally, useful and needed intermediate sanctions, short of revoking the registration of a broker-dealer, are not available to the Commission.

We shall, therefore, recommend to the Congress legislative pr posals in the following direction:

1. Authorizing standards of character, competence, and fina cial responsibility as conditions for entry into the business, to b established and administered by the national securities associa tions, notably the NASD, which will complement similar regula tion by the exchanges of their members;

2. Requiring all firms and individuals to be subject to the au thority of one of the self-regulatory agencies;

3. Granting the Commission direct disciplinary controls ove individuals and perfecting NASD controls in this area; and 4. Providing the Commission with intermediate sanctions ove firms and individuals.

B

A basic factor underlying the enactment of the Federal securitie acts was recognition of the intricate nature and high liquidity of secu rities and of the corresponding duties necessarily assumed by those wh deal in them. The heightened public participation in the securitie markets severely tested the adequacy of controls, external and self imposed, particularly in the area of selling practices and investmen advice. The examples of sales techniques cited by the study show striking spectrum: from the illegal operations of boiler rooms to the disciplined patterns of the responsible, reflecting elaborate supervisory procedures and voluntary codes of conduct. Even in the latter, which represent high standards of achievement, serious lapses have occurred Yet it is their best formulae which, if universally followed, would result in increased investor protection. Certain excesses also appear to have developed in the investment advisory materials of both broker dealers and investment advisers, as evidenced by fanciful recommenda tions based on little more than mere rumor. Here again uniform application of the best industry practices would seem to be in order In this area, legislation is not presently recommended. Powers exist in the self-regulatory institutions and the Commission to advance selling and investment advisory practices.

с

The mechanism, practices and rules for distributions in the securities markets are examined in the report with particular emphasis on the so-called "hot issue" phenomenon that accompanied the active and rising markets of the late 1950's and the early 1960's and involved primarily companies going to the public for the first time. A record flow of these new issues was another critical trial for both the regulatory pattern and industry practices; the findings of the report do not invalidate the general thrust of this pattern or those practices. At the same time particular weaknesses have developed; their elimination should strengthen the distribution mechanism without impairing access to the capital markets. Most of these can be remedied by rules of the Commission and the NASD, with one important exception.

At present a prospectus containing business and financial information about a company must be delivered to the purchasers of the company's stock during a period of 40 days after a registered public offering of that stock. The findings of the Report of the Special Study demonstrate that, particularly in the case of new issues, dramatic price

movements may result from uninformed investor action and that maximum exposures of financial and public information is crucial to securing knowledgeable evaluation of these securities. The Commission will, therefore, recommend to the Congress that, in the case of new issues, the 40-day period be extended to 90 days or such shorter period as the Commission may prescribe by rule or order.

D

Much of the material submitted evidences the fundamental importance of adequate disclosure by issuers as a most vital means of investor protection. The report points out the broad range of problems and abuses in the securities markets, including improper selling practices, misleading public relations, irresponsible investment advice, and erratic "after markets" for new issues, which can be greatly mitigated by the more complete availability and dissemination of financial information. The report further demonstrates, as have prior studies, that the longstanding contrast in the disclosure-oriented protections afforded investors owning securities listed on national exchanges and investors owning securities traded in the over-the-counter market is not warranted. Issuers of over-the-counter securities, unlike their listed counterparts, are under no obligation to comply with the Commission's proxy rules or, except in certain cases, to furnish annual and periodic financial reports. Another void in investor protection in the over-the-counter market relates to insider trading. An insider of a listed company must report his transactions in the company's stock; his short-swing trading profits in the stock are recoverable by the company; and he is prohibited from selling the stock short. The policies expressed in these sections should also be applicable in the over-the-counter market. The so-called sponsorship problem, where an underwriter makes an after-market in a stock he has underwritten and at the same time is represented on the board of directors of the issuing company, has been carefully analyzed by the study. Its findings indicate that the application of the insider trading provisions will not disrupt trading markets in over-the-counter securities, except perhaps in very limited instances which could be handled through exemptions on a case-by-case basis.

Accordingly, the Commission will recommend extension of those sections of the Securities Exchange Act of 1934 which provide for the filing of annual and periodic reports, compliance with the proxy rules, and protections against insider trading to certain companies whose securities are traded in the over-the-counter market. A phased program of coverage would gradually include all those companies with 300 or more stockholders. In the case of bank stocks, which appear to account for about 20 percent of the issues of the over-the-counter market, if Congress so desires, disclosure requirements could be administered by the appropriate Federal bank regulatory authorities in order to integrate these controls with the existing patterns of bank regulation.

E

An analysis of the over-the-counter market will be submitted in our complete report. At this time, however, we wish to inform the Congress that we shall propose a legislative recommendation essentially directed to the wholesale quotations systems of that market.