The second provision relevant to this subject is section 15 (c) (3) of the Securities Exchange Act, which was added by Public Law No. 719, 75th Congress (1938), and reads as follows: "No broker or dealer shall make use of the mails or of any means or instrumentality of interstate commerce to effect any transaction in, or to induce or attempt to induce the purchase or sale of, any security (other than an exempted security or commercial paper, bankers' acceptances, or commercial bills) otherwise than on a national securities exchange, in contravention of such rules and regulations as the Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors to provide safeguards with respect to the financial responsibility of brokers and dealers." It will be noted that section 8(b) is self-operating and does not require the exercise of any rulemaking power by the Commission. This section, however, has not been effective for the following principal reasons: 1. It is not applicable to over-the-counter broker-dealers other than those who transact a business in securities through the medium of an exchange member. 2. Its limitations are applicable only "in the ordinary course of business as a broker," thus apparently excluding indebtedness not incurred in the “ordinary course of business" and indebtedness incurred in the course of business as a dealer. Indebtedness in these excluded categories presents a hazard to customers equal to that presented by indebtedness incurred "in the ordinary course of business as a broker." For these reasons the Commission relies primarily on section 15(c)(3) and its rule thereunder (rule 15c3-1) for the establishment of capital requirements. HISTORY OF THE RULE Although section 15(c) (3) of the act became effective in 1938, the Commission did not immediately exercise the rulemaking power therein granted. In 1942 the National Association of Securities Dealers, Inc., which is registered as a national securities association pursuant to the provisions of section 15A of the Securities Exchange Act and includes in its membership most of the overthe-counter broker-dealers in the United States, proposed the adoption of an amendment to its bylaws which would require that all members dealing directly with customers have a minimum net capital of $5,000, and that all other members have a minimum net capital of $2,500. When this bylaw was submitted to the Commission, in accordance with the provisions of section 15A, the Commission, after hearing, disapproved the proposed bylaw, finding it inconsistent with the purposes of section 15A upon the ground that it would discriminate against small broker-dealers. In that connection it was conceded by the association that the adoption even of the relatively modest capital requirements provided in the proposed bylaw might result in expulsion of over a quarter of the membership of the association who apparently did not have sufficient capital to satisfy the proposed requirements. In its opinion (12 SEC 322, 326 (1942)) the Commission announced that it would adopt its own capital rule and that in doing so it proposed to utilize the ratio method employed in section 8(b), both in deference to the congressional policy there expressed and in order to provide a rule which would impose adequate safeguards in the case of broker-dealers having a substantial indebtedness without unnecessarily penalizing small broker-dealers. In that connection the Commission pointed out that any minimum dollar figure which would be reasonable as applied to the business of a small broker-dealer might be totally inadequate for a larger firm which had substantial indebtedness to customers. Thereafter, following extensive studies for the purpose of developing appropriate definitions of the terms "aggregate indebtedness" and "net capital" the Commission adopted its own rule 15c3-1 in 1944 (Securities Exchange Act Release No. 3602, Aug. 11, 1944; Securities Exchange Act Release No. 3617, Nov. 8, 1944). The rule was substantially revised in 1955 to clarify its provisions and to strengthen the safeguards which it provides for customers (Securities Exchange Act Release No. 5156, Apr. 11, 1955). A copy of this release is attached. The principal change made by this revision was to increase the deduction from the market value of securities owned by the broker-dealer described below, thus increasing the margin of safety provided. ANALYSIS OF THE RULE There is attached hereto a copy of the rule as presently in effect. As will be noted, paragraph (a) provides that no broker-dealer shall permit his aggregate indebtedness to all other persons to exceed 2,000 percent of his net capital. That is, his aggregate liquid assets, computed in accordance with the rule, must be 105 percent of his aggregate indebtedness. For example, if a brokerdealer has liabilities of $1,000, he must have assets computed in accordance with the rule of not less than $1,050. Thus the aggregate indebtedness ($1,000) is 2,000 percent of his net worth ($50), which figure is arrived at by subtracting his total liabilities from his total assets. A major portion of the rule consists of definitions of "aggregate indebtedness" (par. (c) (1) of the rule) and "net capital" (par. (c)(2) of the rule). The definition of net capital is particularly significant, since it defines net capital to mean the net worth of the broker-dealer, subject to seven specified adjustments. Subparagraph (c) (2) (B) of the rule requires that net capital be adjusted by deducting fixed assets and assets which cannot be readily converted into cash, including, among other things, real estate, furniture and fixtures, exchange memberships, prepaid rent, insurance and expenses, goodwill, organization expenses, unsecured advances and loans, and customers' unsecured notes and accounts. Subparagraph (c) (2) (C) requires the deduction of specified percentages of the market value of securities long and short in the accounts of the brokerdealer, and in the accounts of partners. Except in the case of certain debt securities and prior preferred stock, this deduction is 30 percent of the market value. Smaller deductions are provided for such debt securities and prior preferred stock in view of the fact that the market for these securities does not fluctuate to the same degree as that for common stock. These deductions provide a substantial margin of safety for customers against losses incurred by a broker-dealer as a result of market fluctuations. Similar deductions are provided for in the case of commodity futures contracts and securities which are the subject of open contractual commitments, that is, executory contracts to purchase or sell securities not yet performed. In addition to providing a margin of safety, these deductions tend to prevent a broker-dealer from overextending himself. Thus, if a broker-dealer invested $100,000 in cash from his capital in the purchase of stock for his own account, he would need to provide an additional $30,000 in cash capital in order to retain the same net capital position under the rule as he had before the purchase. Similarly, if he contracted to purchase $100,000 worth of stock, he would have to enter the full purchase price as a liability, but would value the stock to be acquired at only $70,000, so that $30,000 in cash would be required to carry the commitment. The purpose of all of these adjustments is to include among assets in the computation of net capital only liquid assets which can be immediately realized in cash for the satisfaction of indebtedness, so that the broker-dealer will be in an entirely liquid position at all times and able to discharge his obligations to his customers immediately. It is to be noted that this standard of liquidity is higher than that required of banks, which may invest a substantial portion of their deposits in loans upon which they may not be able to realize immediately. The operation of the rule may be illustrated by the following simplified example, representing the financial position of a relatively small broker-dealer. Assume the balance sheet of broker A is as follows: Cash____ ASSETS Stocks owned by firm__. Amounts due from customers secured by adequate collateral_ $10,000 15, 000 1,000 2,500 2,000 500 31, 000 1,500 5,000 4, 500 9, 000 11,000 31, 000 Applying the adjustments specified in the rule to this firm, the unsecured accounts receivable from customers, the furniture and fixtures and the prepaid expenses would be eliminated under the provisions of paragraph (c) (2) (B) of the rule reducing admissible assets by $5,000. From the market value of the stocks owned by the firm, which aggregate $15,000, there would be deducted 30 percent of this amount, or $4,500. Thus for purposes of the rule, the assets would be reduced by $9,500, thus leaving a balance of $21,500. Since the firm has liabilities of $20,000, its net capital computed under the rule would be $1,500. Its aggregate indebtedness is $20,000 and it is required by paragraph (a) of the rule to have a net capital not less than 5 percent of this sum, or $1,000. The firm, therefore, is in compliance with the rule, but only by a margin of $500. It could not assume additional commitments for the purchase of stock exceeding $1,667 without obtaining additional capital by reason of the 30 percent deduction in the rule. The Commission enforces the net capital rule vigorously. Compliance with this rule is checked on each broker-dealer inspection. If a broker-dealer is not in compliance, he is given a few days to put up the additional capital, and if he fails to do so, administrative or court action is ordinarily taken against him. If he again violates the rule, immediate action may be taken. During fiscal 1957 violations of the net capital rule were alleged in 34 injunctive actions and 20 revocation proceedings. During fiscal 1958 it was necessary to charge such violations in only 15 injunctive actions and 12 revocation proceedings, indicating the deterrent effect of the enforcement policy pursued. STAFF MEMORANDUM ON AMENDMENTS TO S. 1179, THE SECURITIES EXCHANGE ACT OF 1934 The Securities Exchange Act of 1934 deals with post-distribution trading. It has three basic purposes: to afford a measure of disclosure to people who buy and sell securities; to regulate the securities markets; and to control the amount of the Nation's credit which goes into these markets. All stock exchanges must register unless exempted by the SEC, which has certain supervisory functions with respect to their rules and has authority to suspend or expel exhange members who violate the act. The Commission also has certain authority with respect to various exchange practices such as short selling, the specialist system, floor trading and hypothecation by brokers of customers' securities. No security may be listed on an exchange unless its issuer files an application for registration with both the exchange and the SEC containing much the same information as is required for new issues by the 1933 act. This information must be kept current by the filing of annual and other reports with the exchange and the SEC. The solicitation of proxies in respect of listed and registered securities is subject to SEC control, and there are certain provisions governing the trading in such securities by the issuer's officers, directors, and principal stockholders. Securities which are not listed on an exchange are not subject to the registration, reporting, proxy, or insider trader provisions. However, over-thecounter brokers and dealers must themselves register with the SEC; they must maintain appropriate records and file statements of financial condition; they are subject to inspection at any time by the SEC, and to denial or revocation of registration in certain contingencies; and there is also provision, under a 1938 amendment of the act, for the registration with the SEC of "national securities associations" of over-the-counter brokers and dealers who thus regulate their own business practices under the general supervision of the Commission. There are general provisions outlawing fraud and manipulation in both the exchange and over-the-counter markets, and the SEC has a considerable amount of rulemaking authority. The credit provisions of the act give the Board of Governors of the Federal Reserve System authority to promulgate margin rules and the SEC the task of enforcing them. AMENDMENTS TO THE SECURITIES EXCHANGE ACT OF 1934, S. 1179 The amendments in S. 1179 are recommended by SEC. A substantial number of the amendments were designed to make SEC's enforcement activities more effective by providing additional remedies and eliminating or minimizing various problems which have come to light in the course of SEC enforcement over recent years. Some of the proposed amendments were intended to reflect changes that have taken place since 1934. This memorandum covers the principal substantive amendments. Technical or codifying amendments have been omitted. The principal amendments, which are discussed in the following order, would (1) extend regulations over registered brokers' and dealers' margin, extension of credit, and proxy practices directly instead of indirectly; S. 1179, sections 4, 5, 11, and 12; discussed on page 356 of this memorandum; (2) expand the power to make rules over financial responsibility of brokers and dealers, and over the lending of customers' securities by brokers and dealers, section 6, page 357; section 7, page 358; (3) increase the power over denial or revocation of brokerdealer registration, including the withdrawal of an application for registration, section 13, page 360; page 360; page 361; page 361; page 362; (4) expand the power to suspend trading in any registered security on an exchange, suspend trading in all stocks on any exchange, section 19, page 363; section 20, page 364; create the power to suspend trading in the over-the-counter market, section 15, page 365; create the power to make rules in "when issued" trading in the overthe-counter market, section 14, page 365; (5) define more widely "matched orders" and a "series of transactions," to discourage manipulation, section 8, page 366; section 9, page 367; (6) add a $100-a-day fine for late filing of any report, section 30, page 368; (7) add a prohibition against larceny and embezzlement, section 31, page 369; (8) create the power to have a broker adjudged a bankrupt, section 25, page 369; (9) create the power to grant an injunction for a past violation of the act, section 24, page 370; (10) add prohibitions against "aiders and abettors," section 22, page 370; (11) create jurisdiction to decide who was a "cause" of broker-dealer revocation, section 16, page 371; and (12) expand the SEC's authority to suspend or withdraw the registration of a national exchange, section 18, page 372. SECTION-BY-SECTION TABLE OF CONTENTS The substantive sections of S. 1179 are discussed in this memorandum on the following pages: Section 1. "Member" of a stock exchange redefined. 3. Registration of a stock exchange 4. Jurisdiction over extension of credit to customers by brokers and dealers 5. Jurisdiction on borrowing by brokers and dealers. 6. Expansion of rulemaking power over financial responsibility of brokers and dealers. 7. Creation of rule making power over lending of customers' securities by brokers and dealers. 8. Wider definition of "matched orders". 9. Wider definition of "series of transactions". 10. Extension of general antifraud provision. 11. Jurisdiction over extension of credit during an underwriting; prohibition extended to brokers or dealers 12. Jurisdiction over broker or dealer proxy practices. 13. Increase of power over denial or revocation of broker-dealer registration generally. Disqualification for criminal conviction Creation of power to suspend registration of broker Extension of power to post pone effectiveness of registration pending denial. Creation of power to deny withdrawal of application for broker-dealer registration. 14. Creation of rule making power over "when issued" trading in over-the-counter market. 15. Creation of power to suspend trading in over-the-counter market 16. Creation of jurisdiction to decide who was a "cause" of broker-dealer revocation.. 17. SEC review of action against rezistered representative. Page 372 371 356 356 352 352 366 367 367 356, 359 356 360 360 360 361 361 361 362 365 365 371 371 372 363 364,365 370 370 369 368 369 18. Suspension or withdrawal of registration of national exchange. 19. Expansion of power to suspend trading in any registered security on an exchange 20. Expansion of power to suspend trading in any registered security on an exchange, continued; in all trading on any exchange 22. Addition of prohibition against aiders and abettors. 24. Creation of power to grant an injunction for past violation of the act. 25. Creation of power to have broker adjudged a bankrupt.. Section 4, 5, 11, and 12. Margin requirements, extension of credit, and proxy practices; jurisdiction over brokers and dealers The Securities Exchange Act of 1934, as originally written, was based upon Federal jurisdiction over stock exchanges and their members. It restricted the activities of exchanges and their members and also other brokers and dealers who transacted business in securities through members of stock exchanges. Among the requirements imposed on members, and on brokers and dealers transacting business through them, were specific restrictions on extension of credit to customers (sec. 7(c)), indebtedness incurred by brokers (sec. 8(b)), extension of credit during an underwriting (sec. 11(d)), and proxies (sec. 14(b)). In 1936, section 15 of the act was added, in order to provide for control of over-the-counter markets. Section 15 required registration of all brokers and dealers who used the mails or any means of interstate commerce to effect transactions in securities. SEC was authorized to issue rules relating to fraudulent practices by, and financial responsibility of, brokers and dealers and to require reports by certain companies (sec. 15 (c) and 15(d)). Because of the specific nature of the provisions of sections 7, 8, 11, and 14 relating to extension of credit and proxies, SEC has felt that it should proceed through those sections in regulating brokers and dealers, instead of through the more general provisions of section 15. This means that in those cases SEC must show that the broker or dealer transacted business through an exchange member, instead of merely showing use of the mails or other means of interstate commerce. Most registered over-the-counter brokers and dealers transact business through exchange members and can therefore be controlled through sections 7, 8, 11, and 14. However, SEC considers the additional step of showing the transaction of business by a broker or dealer through a member of a stock exchange unnecessary and undesirable. In order to correct this situation, various sections of S. 1179 amend (i) section 7(c) dealing with extension of credit to customers (sec. 4 of S. 1179); (ii) section 8(b) dealing with indebtedness incurred by brokers (sec. 5 of S. 1179); (iii) section 11(d) dealing with credit extended by underwriters (sec. 11 of S. 1179); and (iv) section 14 (b) dealing with proxies (sec. 12 of S. 1179). These changes are effected by making the sections applicable to registered brokers and dealers. Other amendments are made to these sections of the act by S. 1179 and are dealt with later. This section is intended to cover only the jurisdictional aspects of these amendments. Section 6. Expansion of regulation over financial responsibility of brokers and dealers Section 8(b) is designed to protect customers against the risk of a broker's insolvency by restricting the amount of obligations he may incur. The statute fixes a top limit on the obligations a broker may incur in the normal course of his brokerage business, at 20 times his net capital, and authorizes the Commission by rule to fix a smaller ratio. The section does not apply to dealers who do no brokerage business, even though they hold customers' funds and securities, and it applies to brokerdealers only with respect to their brokerage business. It is difficult to segregate the indebtedness incurred by a broker-dealer in the course of his brokerage business from that incurred in his business as a dealer. In addition, obligations incurred by a broker outside of his brokerage business, whether in his business as a dealer or in a business outside the securities field, may subject his customers to the same kinds of risks as the obligations he incurs as a broker. These limitations render the section so ineffective that SEC has not considered it worthwhile to exercise its rulemaking power. Section 15 (c) (3), added in 1936, grants SEC general rulemaking power over the financial responsibility of both brokers and dealers in the over-the-counter market. It permits SEC to issue any rules it thinks proper in the public interest or for the protection of investors. But it cannot be applied when a broker or a dealer effects a transaction on a national stock exchange. Under section 15 (c) (3), SEC has issued rules comparable to section 8(b) which apply to all brokers and dealers in the over-the-counter market, whether or not registered. These rules prescribe a maximum 20-to-1 ratio between aggregate indebtedness and net capital, and define these terms in detail. (SEC considered but rejected the possibility of establishing a fixed minimum capital rule.) An exception is made for members of eight specified national exchanges whole rules and settled practices are more comprehensive (SEC rule 15c3-1). Under section 15(3) (c), SEC has wide discretion with respect to the rules it may prescribe. This very flexibility, and the scope it gave to SEC, were in part responsible for the fact that these rules were not issued until 1944. SEC, in section 6 of S. 1179, requests a general power to issue rules respecting the financial requirements of all brokers and dealers. The effect of the amended |