Hon. WARREN G. MAGNUSON, SECURITIES AND EXCHANGE COMMISSION, Chairman, Subcommittee on Independent Offices Appropriations, U.S. Senate, Washington, D.C. DEAR MR. MAGNUSON: Attached is the 1965 budget estimate of the Securities and Exchange Commission in the amount of $15,225,000. It differs from the appropriation of $13,937,500 for this fiscal year in the following respects: For 1965, the Commission is requesting an increase of 60 additional positions in order to carry out effectively the administration of the Federal securities laws enacted by the Congress for the protection of the investing public. Our aim is to achieve a realistic manpower level, particularly in the inspection and enforcement areas. Of the 60 positions, 47 will be assigned to our regional offices and 13 to our central offices. Distribution of the additional positions by program, in priority sequence, is shown below: 1. Inspection of investment companies. We are requesting funds for an increase of 21 positions for our regional offices to achieve a 2-year inspection cycle (325 inspections) of investment companies in 1965 as compared with an estimated 42-year cycle (150 inspections) in this fiscal year. These companies must be examined thoroughly as they represent a very vital and sensitive area of the securities market. In 1940, when the Investment Company Act was enacted, the aggregate net asset value of all investment companies was $2.5 billion as compared with approximately $35 billion on June 30, 1963. For all practical purposes, the inspection program was initiated about 2 years ago. It is the very core of our regulatory responsibilities. The program has already proven invaluable, indeed indispensable for the protection of public shareholders. The inspections frequently disclose situations, which, if not corrected, would result in losses to shareholders and which form the basis for investigative and enforcement action. In fact, for every two inspections made in fiscal 1963, one investigation_relating to serious violations involving possible civil action was instituted. Examples of a few substantial irregularities follow: 1. Unlawful transactions between a fund and its affiliates. In one case where fund moneys were used to finance an enterprise in which directors and officers were interested, restitution of approximately $250,000 was obtained, the fund was liquidated without serious loss to stockholders, and the principals agreed to stay out of investment company activity for a period of 5 years. 2. Larceny of fund assets by its promoter. The larceny escaped detection prior to the inspection by a regional office because of laxness of the directors in performing their duties, negligent performance by the fund custodian and improper certifications by the independent accountant of the fund. It is the Commission's goal to place the inspection of investment companies on an 18-month cycle. Until that objective is met, the Commission cannot state that it is meeting its full regulatory responsibilities. The Commission has recently approved the need for an annual compliance report from each registered invest ment company for the purpose of supplementing the inspection program on the proposed 2-year cycle. The compliance reports will enable the Commission to take remedial action, where necessary, on a more current basis. 2. Inspection of investment advisers. We are requesting an increase of 8 positions for our regional offices so as to achieve a 4-year inspection cycle, which involves the inspection of 440 investment advisers. For the current fiscal year, we expect to achieve a 7-year cycle or 235 inspections. For all practical purposes, the present 7-year cycle is unrealistic. Any inspection program should represent preventive enforcement for the protection of the public investors by a regular and periodic examination of books and records of the registered investment advisers. We have derived an important lesson from our work in the field of investment company inspections, demonstrating the wisdom of providing a realistic examination program. In the case of investment companies, as in the case of investment advisers, we had not inspected most of the firms even once in their history. When we began to step up the investment company inspection program, we found violations of a serious nature leading to court injunctions, recoveries of substantial amounts and acts of gross abuse of trust. This experience has led us to the conviction that an adequate program of inspection in the field of investment advisers is long overdue. This Commission has been criticized for not uncovering fraudulent activity before it has seriously injured investors. The only way to avoid such situations is to make more inspections so as to identify problem firms, thus minimizing the potential monetary losses to the investing public. The inspections frequently disclose situations, which, if not corrected, would result in losses to customers and which form the basis for investigative and enforcement action. More and frequent inspections are less costly on a long-range basis in "nipping violations in the bud," thus reducing losses to investors, as compared with the more costly operation of conducting administrative, civil and/or criminal proceedings after the violations have occurred. 3. Investigation and enforcement program.-We are requesting an increase of 20 positions for this program-18 for regional offices and 2 clerical positions for the Division of Trading and Markets. Our full disclosure program is the beginning of our jurisdiction over the distribution of securities; it is not the termination of our responsibilities. We must be in a position to determine whether the registration or antifraud provisions of the acts are being violated not only during a public offering, but in the subsequent trading of a security. The additional positions are necessary in order to accelerate the disposition of investigations as well as administrative, civil and criminal proceedings pending before the Commission and courts. Our backlog of investigations has reached an unrealistic figure (1,095) on December 31, 1963 and must be reduced. Current investigations and enforcement actions are far more complex and difficult than those which the Commission faced in the past. It is our experience that our cases become more and more intricate as violators are forced to exercise greater ingenuity in order to avoid the impact of our investigations and enforcement actions. Thus, more manpower must be utilized to uncover violations. illustrate the increased complexity of enforcement actions, the number of defendants in broker-dealer proceedings has more than doubled in the past 5 years. To During the past 4 fiscal years (1960-63), 208 cases were referred to the Department of Justice as compared with the same number for the previous 10 years (1950-59). It is estimated that 55 criminal reference reports will be referred to that Department in both 1964 and 1965. Moreover, the number of charges, and of defendants and coconspirators in the past year has increased significantly. Such criminal work is far more demanding in both extent and depth than is required in most civil and administrative proceedings. 4. Regulation of exchanges and over-the-counter market, and economic and statistical research. For 1965, seven additional positions are requested for this program, distributed as follows: five for the Division of Trading and Markets and two for the Office of Program Planning. The report of the special study of securities markets recommended that the Division of Trading and Markets be strengthened and “so organized and staffed that it will be in a position to maintain more effective liaison with all of the selfregulatory agencies, examine their rules and rule changes, keep informed as to their enforcement activities, and generally oversee and evaluate their performance on a continuous basis and advise the Commission with respect thereto." The study recommended also that the Commission be more adequately staffed to enable it to give greater emphasis to the "compilation, analyses and, where appropriate, publication of data concerning important aspects and developments of the trading markets." Accordingly, the seven positions requested are required to provide more effective supervision over self-regulatory organizations and analyze economic and statisticsl data about the securities markets. I have indicated generally the programs for which we are requesting 47 additional positions in 1965 for the regional offices, 7 for the Division of Trading and Markets, and 2 for the Office of Program Planning. The remaining four positions are for the increased number of administrative hearings and additional workload pertaining to administrative services resulting from the Commission's accelerated enforcement and inspection programs. It should be noted that approximately $2.9 million in statutory fees and other revenue will be collected by the Commission in this fiscal year as compared with an estimate of $3.1 million in fiscal 1965. These funds are not available for expenditure but are deposited in the general fund of the Treasury. The amount requested in this estimate for 1965, in the unanimous opinion of the Commission, is required to enable it to conduct its operations in an efficient and adequate manner and in accordance with the expressed intent of the securities laws. Sincerely yours, WILLIAM L. CARY, Chairman. INTRODUCTION OF WITNESSES Mr. CARY. Commissioner Jack Whitney is right behind me at this end. At the very far end is my colleague, Commissioner Manual Cohen. We have here Ralph Saul, who is the Director of our Division of Trading and Markets, and Philip Loomis, our General Counsel is right behind me. William Becker, our management analyst is farther behind me, and Frank Donaty, who has been here very frequently. Senator MAGNUSON. He is the important man we want to talk to. Mr. CARY. He is the man who runs this show. Allan Conwill, Director of our Division of Corporate Regulation, who handles investment companies, corporate reorganizations and the like; and Ed Worthy who is the Director of our Division of Corporation Finance, largely the matter of registration statements, proxy statements, and the application of disclosure generally. ADDITIONAL AMOUNT AND POSITIONS REQUESTED Mr. Chairman, as you already indicated, the total amount of our request for next year is $15,225,000-an increase of $1,287,500 over our appropriation of $13,937,500 for this fiscal year. The increase of $1,287,500 represents the following items: 1. $385,000 for 60 additional positions; 2. $290,000 for pay increases; 3. $262,500 for within-grade increases; and 4. $350,000 for other expenses. Briefly, we are requesting funds for 60 additional positions, 47 will be assigned to our regional offices. I wish to point out that about 45 percent of our requested increase of $1.3 million represents mandatory pay increases. In addition to covering the additional positions, I will briefly cover our existing space deficiency and our need for a computer, which are factors going into that item of $350,000. 1. INSPECTION OF INVESTMENT COMPANIES I will now discuss our request of 60 additional positions. Of this total, we are requesting funds for 21 positions for our regional offices to achieve a 2-year inspection cycle of investment companies, which involves the inspection of 325 companies in 1965, as compared with an estimated 4-year cycle or 150 inspections in this fiscal year. In other words, there are about 650 active investment companies in total to be inspected. TYPES OF INVESTMENT COMPANIES Senator ALLOTT. Mr. Cary, for my information when you say investment companies will you tell me how wide that term is? Mr. CARY. What we are thinking of primarily, Senator Allott, are two. One, the so-called mutual fund which is the open end and the closed end. Those are the two areas that we are working on most. Senator ALLOTT. Essentially mutual funds? Mr. CARY. That is correct. I would say there is about $8 billion now Senator in closed ends and about $30 billion almost in open end. Senator MAGNUSON. You had better put in the record at this point a definition of open and closed ends. Mr. CARY. All right, sir. An investment company is a company in which many persons frequently of moderate means have pooled their resources for the purpose of investing, reinvesting, and trading in securities. Inherent in the mutual fund or open end company concept is the company's commitment to stand ready to redeem or repurchase its shares at their then net asset value. Most mutual funds or open end companies also engage in a continuous offering of their shares for sale to the public at their then net asset value plus a sales load or commission. These two features-redemption and continuous offering-distinguish the open end company from the closed end investment company. A closed end company neither redeems its shares nor engages in a continuous public offering of its shares. If the board of directors of a closed end company deems it advisable to increase the amount of its resources available for investment, it will make a single public offering of its shares or other securities in the conventional way-the same way an industrial, utility, or transportation company obtains public financing. Shares of closed end companies are readily available to the public investor at any time, however, for the shares of some 25 closed end companies are listed on the New York Stock Exchange and many closed end company shares are actively traded in the over-the-counter market. The price you pay or receive will bear some relation but will rarely be identical to the net asset value. Your price will be controlled by supply, demand and other forces at work in the auction market. DESIGNATION OF INVESTMENT COMPANIES IN MARKET REPORTS Senator MAGNUSON. The open end are the mutual funds, and the closed ends, how would they be designated say in market reports? Mr. CONWILL. You would find those normally under the stock exchange quotations. Senator MAGNUSON. They are bought and sold as such every day. Mr. CONWILL. That is right, at regular auction market. Senator MAGNUSON. And mutuals of course, there is a bid and an asked usually. Mr. CONWILL. That is right, and the difference between the two is the difference between the net asset value per share and the net asset value plus a sales load. That is the difference between the bid and asked price. Senator MAGNUSON. And then what is the division percentagewise between the two when you speak of investment companies? Are there more of the mutual funds or the open end or are there more of the closed end? Mr. CONWILL. Many more of the open end mutual funds than closed end. Senator MAGNUSON. And put the percentage in the record. Mr. CONWILL. The approximate percentage would be about 80 percent more in terms of assets of mutual funds or open-end companies and about 20 percent of closed end. FRONT END SALES LOAD Senator ALLOTT. I didn't intend to get off of the subject Mr. Chairman, but while we are on this, what became of your investigation which you started a year or more ago I guess and what is the status of it on the loading charges on these funds? Mr. CARY. Yes, sir. As you recall, we finished our Special Study of the Securities Markets about a year ago, and one chapter of that, I think that it was chapter 11, Senator Allott, related to the co-called question of front-end load. Now as you know, when they sell mutual funds, the normal load or the normal charge is roughly around 8 percent. It has maximum of 9. There is also a plan by which you enter into a contract to buy shares over an extended period of time that is called the contractual arrangement to buy shares. In that case you can have what they call a load or in other words a charge of 50 percent of the first year payments. Now it was in that area that we found a particular problem. For instance, if a person entered into a contract and he had to pay 50 percent in that first year, and then his contract lapsed, he would never get back 50 percent of what he put in, whereas if he had kept on throughout until the end of his contract, let's say 10 years, then the average load or charge would have been about 8 percent. Now it was in that area Senator MAGNUSON. You mean 8 percent is charged by the company to handle it? Mr. CARY. That is the selling charge. It is paid the people who sell and distribute the shares, but in general that is the amount that the buyer has to pay overall as an average if the contract were completely fulfilled, Senator, that is over say a 10-year time. Senator MAGNUSON. Yes. Mr. CARY. The arrangement is also that although it can only be 8 or 9 percent over a 10-year period let's say or an extended period, it may be 50 percent in the first year and then a smaller percent in later years. Do you see the point? Under those circumstances it poses a particular problem if a person buys one of these contracts, and then he is not able to pay in say the second year, the contract lapses, so he had to pay 50 percent in that first year and he never gets it back. CONTRACTUAL PLANS-MUTUAL FUNDS Senator MAGNUSON. Supposing I buy a $1,000 contract with a mutual fund. Mr. CARY. Right. Senator MAGNUSON. I give him $500 the first year, is that right? |