Mr. CAVANAUGH. Well, we did make recommendations with respect to broadening the deliverable supply in the Treasury note area. Originally the proposal was to have only 4-year notes. Senator STEWART. Did they accept those recommendations? Mr. CAVANAUGH. We made recommendations that the deliverable supply be broadened by having a market basket approach. They went, I think, a great deal of the distance, toward our recommendation in settling that. Senator STEWART. That was a recommendation as to a modification. Now my question was, did you ever object to the designation of a contact, and, if so, did they issue the contract? Mr. CAVANAUGH. I don't think there is any one specific contract that we recommended against that was later designated. it? Senator STEWART. Then your answer to my question is no, isn't Mr. CAVANAUGH. With the one qualification, Senator, that as I say, in the report, we urged a go-slow policy which the CFTC felt they could not completely embrace. Senator STEWART. But basically you approved the contracts designated by CFTC? Mr. CAVANAUGH. With regard to these specifics. Now, there are some we recommended against that they did not approve. They were not designated. Senator STEWART. By the CFTC? Mr. CAVANAUGH. That is correct, sir. Senator STEWART. So that consultation process has worked, is that correct? Mr. CAVANAUGH. I think it has largely worked. EXTENSIONS OF CREDIT Senator STEWART. Largely worked. All right. Now, Secretary Carswell, do you agree with the observation that if there were no considerable extensions of credit involved in silver speculation, that is, direct and indirect loans by banks and brokerage houses, that the mentality that followed the events of March 27 would have not occurred? Mr. CARSWELL. I really don't know. Senator STEWART. What caused you to have a concern? Mr. CARSWELL. What caused us a concern was that we had a major brokerage house that was in danger of being closed down. Senator STEWART. Why was it in danger of being closed down? Mr. CARSWELL. That is what we were trying to find out. Senator STEWART. Could extention of credit have had anything to do with it? Mr. CARSWELL. It could have. That is why one of the first things we did was try to find out how much credit had been extended by whom under what circumstances. Senator STEWART. Isn't that the reason you were concerned about the possible failure of the brokerage house, extension of credit and collateralizing of that particular item by silver? Mr. CARSWELL. That was part of the reason. Senator STEWART. What was the other reason? Mr. CARSWELL. The kind of thing Chairman Williams was discussing. If a major brokerage house shuts down, what does that do? Because if you close down retail operations all around the country, that means that people who trade with those, have outstanding transactions, they, in turn- Senator STEWART. Chairman Williams, let me see if I understand the SEC's responsibility. Do you all have responsibility for that brokerage house breaching that rule as far as capital requirements are concerned? Mr. WILLIAMS. The net capital rule is a rule we established. Senator STEWART. Do you monitor them in any way at all to determine whether they do or do not breach that rule? Mr. WILLIAMS. Of course, we do. Senator STEWART. At any point in time did you get concerned about this particular matter prior to March 27, or did this concern of yours develop after March 27? Mr. WILLIAMS. I don't remember the specific date, but I think it's March 27. It developed on that day. Yes, sir. Senator STEWART. Why would you get concerned if you were monitoring this particular situation? What is the reason for monitoring? Mr. WILLIAMS. We didn't monitor this specific situation. We went through this line of questioning once before. Senator STEWART. Well, this is a new forum. Mr. WILLIAMS. You don't want to refer to the other record. All right. Senator STEWART. You might offer something new today. Mr. WILLIAMS. The net capital rule requires daily computation on the part of the brokerage house. In the event that certain thresholds are pierced, they notify us. Senator STEWART. Will you wait until those thresholds are pierced and let them tell you whether or not they have done it, or do you raise those questions prior to that time? Mr. WILLIAMS. There is no way that we can monitor-raise those questions in advance-with 3,600 brokerage firms around the country. Senator STEWART. What you would do then is wait until one fails- Mr. WILLIAMS. No, sir, we don't wait until one fails. There are a number of thresholds in the net capital rule. There are different levels of significance, and they call for different consequences-Senator STEWART. I see. Where did this particular brokerage house get to that you were so concerned about on March 27. What threshold had it reached? Mr. WILLIAMS. It was approaching the first threshold under the net capital rule. Senator STEWART. Was that the first threshold? Mr. WILLIAMS. The first threshold. I will have to submit more detailed information in the record if I can. It gets very technical. Senator STEWART. Why don't you submit that? Please, for the use of the committee, because I think it's important. What you think we need to do to change the law in regard to your supervision of brokerage houses. It gets to the point where you-I think that precipitated the panic mentality of March 27. Then I would like to know what particular requirements you feel like we need to add to your regulatory activities and give you the capability that you apparently didn't have to discover that. Mr. WILLIAMS. I don't believe there is anything needed. Senator STEWART. You don't need anything at all. Mr. WILLIAMS. No, sir, I don't think so. [The following was received for the record:] Hon. WILLIAM PROXMIRE, SECURITIES AND Exchange COMMISSION, Washington, D.C., July 17, 1980. Chairman, Senate Committee on Banking, Housing, and Urban Affairs, DEAR MR. CHAIRMAN: On May 29, 1980, I appeared before the Committee on Banking, Housing and Urban Affairs to testify at the hearing on recent events in the silver futures markets and possible legislative and regulatory responses. At that time the Committee asked that the Commission submit supplemental informaition for inclusion in the record. I am happy to enclose the information requested. Sincerely, HAROLD M. WILLIAMS, Chairman. Question 1. What are the powers of the Securities Investor Protection Corporation ("SIPC") and trustees appointed under the Securities Investor Protection Act of 1970 ("SIPA") and are they adequate to deal with broker-dealers, particularly those the size of Bache Halsey Stuart Shields Inc., that violate the net capital rule? Answer. Failure of a broker-dealer to comply with applicable financial responsibility requirements set by the Commission (such as Rule 15c3-1, the net capital rule) is a ground for SIPC to apply for and the court to issue a protective decree. 2 The stated purpose of the SIPA proceeding is to satisfy customer claims and to liquidate the broker-dealer's business. To date, SIPC has instituted 141 customer protection proceedings. The largest of the liquidations has been Weis Securities, Inc., initiated in 1973 and involving 32,000 customers. In 1978, SIPA was amended to provide more flexibility than was originally permitted in winding up the business of failed firms. Since that time, twelve proceedings have begun. One of the innovations included in the 1978 amendments is the transfer of customer accounts from the broker-dealer being liquidated to other SIPC_members. SIPC is currently undergoing its first experience with this procedure. It recently approved the transfer of customer accounts in the liquidation of Mister Discount Stock Brokers, Inc. Nevertheless, a trustee appointed under SIPA does not appear to be authorized to operate the firm's business, at least under normal circumstances. Under SIPA, the firm may not continue to engage in business as a broker-dealer once a protective decree is issued and a trustee appointed, unless the Commission determines otherwise in the public interest. Even if the Commission permitted the broker-dealer to remain in business under such circumstances, the firm, or rather the trustee, could not conduct the business for purposes other than liquidation. Recent situations such as that involving Bache have raised questions regarding the need to afford SIPC and SIPA trustees greater flexibility in handling failing broker-dealers, short of straight liquidation. The Commission and its staff are in the process of consulting with SIPC as well as other appropriate or interested persons about developing alternative approaches. At present the Commission is prepared neither to advocate nor even to suggest any proposals to amend SIPA to authorize the availability of alternative approaches. Question 2. What are the early warning thresholds established by the Commission to give the agency the means to monitor the financial condition of brokerage firms? Answer. To explain the Commission's early warning thresholds, it is necessary to give a brief description of Rule 15c3-1, the Commission's net capital rule. Rule 15c3I establishes the financial benchmarks that trigger the early warning system. The net capital rule is a comprehensive regulation with a simply stated goal: that broker-dealers have sufficient liquid assests on hand to pay all customer claims 1 SIPC must also determine that the member has failed or is in danger of failing to meet its obligations to customers. 2Ă "protective decree" is a decree that customers of a SIPC member are in need of the protection afforded by SIPA. Appointment of a trustee follows the issuance of the protective decree. 3 In that connection, the receiving broker-dealer may be indemnified against shortages of cash or securities in a transferred account up to the limits of SIPA protection. For each separate customer, the maximum SIPC may advance is $100,000, of which $40,000 may be for claims for cash. A bill to increase the limits to $500,000/$100,000, H.R. 6831, is pending in the House of Representatives. promptly and to protect customer funds and securities from broker-dealer insolvency. Basically, the net capital rule provides a liquidity test for broker-dealers. The rule requires that the broker-dealer determine his net capital by comparing the amount of his liquid assets, as they are defined in the rule, against virtually all his liabilities. Such liquid assets must exceed all specified liabilities and the excess is known as the broker-dealer's "net capital." The rule sets out in detail the kinds of assets which are excluded in computing net capital. Assets which cannot be readily converted into cash, such as furniture and fixtures, are deducted from the asset side of the balance sheet. In addition, specified percentages are deducted from the current market value of securities owned by the broker. Higher deductions are required if the securites are traded in a limited market or are subject to an unusual delay in delivery. The net capital rule also details the deductions which are required by the rule when broker-dealers undertake transactions in commodities. Specifically applicable in the Bache situation, the rule requires that broker-dealers deduct the amount of funds required to meet margin maintenance requirements of applicable boards of trade when the margin maintenance calls are outstanding over five business days. Had the outstanding margin call not been met by the Hunts within this time frame, Bache might not have had enough net capital to meet the test under the rule. However, the margin call was obviated when Bache sold sufficient collateral to meet the call. With the above outline of the net capital rule in mind, it is possible to describe the Commission's early warning reporting provisions. The early warning rules were developed by the Commission following the paperwork and financial crisis which seriously disrupted the brokerage industry in the late 1960's and early 1970's. The rules were adopted to give the Commission and other self-regulatory bodies the ability to identify firms that are encountering difficulties and monitor their financial condition. Under Rule 15c3-1(f) of the Commission's net capital rule, broker-dealers are required to maintain net capiital equal to the greater of $100,000 or 4 percent of aggregate debit items, as computed in accordance with the rule. Although this is the required minimum amount of net capital, below which the broker-dealer cannot operate his business, the Commission has provided in the net capital rule and related regulations for advance warning of a broker-dealer's impending net capital deficiency. One such early warning provision is contained in Rule 17a-11. Rule 17a-11(a) requires of every broker-dealer subject to the net capital rule that, if net capital falls below the minimum required, he shall give immediate telegraphic notice to the Commission that his capital has been impaired. Within 24 hours, the brokerdealer must also file Part II of Form X-17A-5, which sets forth basic financial information from which the staff of the Commission can attempt to determine the seriousness of the problem and follow up on it. If at any time during the month, a broker-dealer's net capital, even though not in violation of Rule 15c3-1, declines to the point where the excess of such capital over the minimum required is only 120 percent, Part II of Form X-17A-5 must be filed pursuant to Rule 17a-11(b) within 15 calendar days after the end of each month until three successive months have elapsed where the broker-dealer's net capital is more than 120 percent of the minimum. Furthermore, the rule states that if a broker-dealer computing net capital according to Rule 15c3-1(f) finds that his net capital is less than 6 percent of aggregate debit items computed in accordance with the formulas provided by the rule, or that his total net capital is less than 120 percent of the minimum capital required, he must file Form X-17A-5 to provide the Commission with detailed financial information on the firm. Rule 15c3-1(e) limits the withdrawal of equity capital of a broker-dealer, subsidiary or affiliate when such a withdrawal would cause the broker-dealer's net capital to fall below 7 percent of aggregate debit items. This capital lock-in provision prevents untimely reduction of available net capital when a broker-dealer may be approaching financial difficulty by precluding its withdrawal by firm management or owner. Other situations trigger early warning requirements as well. Paragraphs (c) and (d) of Rule 17a-11 require that broker-dealers giver telegraphic notice to the Commission when their books or records fail to be currrent or when they are notified by their accountant of a material inadequacy in their accounting controls. Similarly, Rule 17a-5(h)(2) requires that if during the course of an audit an independent accountant determines that material inadequacies exist in the brokerdealer's accounting system, the broker-dealer must notify the Commission telegraphically within 24 hours. A copy of the notice must be submitted to the account 4 See Rule 15c3-1(b)(a)(3)(xii). 5 This test is an alternative to the basic test set forth at Rule 15c3-1(a) and is used by many larger broker-dealers. ant that discovered the inadequacies. If the accountant disagrees with the statements contained in the notice, he must inform the Commission or the designated examining authority within 24 hours. Rule 17a-5(b)(1) also performs an early warning function by requiring that if any broker-dealer holding a membership interest in a national securities exchange or a registered national securities association ceases to be a member in good standing, he must file with the Commission Part II of Form X-17A-5 within two days thereafter. In addition to its own early warning efforts, the Commission works in close cooperation with the self-regulatory organizations, of which most broker-dealers are members, to achieve advance warning of potential net capital deficiencies. Under the auspices of the Securities Exchange Act of 1934, the New York Stock Exchange, for example, maintains its own requirements for membership and trading on the Exchange, including early warning thresholds. Rule 325 sets the Exchange's net capital requirements. In general, the rule requires members to notify the Exchange if, among other criteria, the member's net capital as computed pursuant to the Commission's net capital rule falls below 7 percent of its aggregate debit computations. New York Stock Exchange Rule 326 sets forth certain consequences of the failure of the broker-dealer member to maintain his capital at the exchange minimum. Among the possible consequences of a member's failure to maintain a sufficiently high net capital level are a required reduction or non-expansion of business of the capital deficient firm as well as heightened surveillance of its financial situation. Finally, along with procedures required by the early warning rules, there are the normal surveillance tools of the Commission and the self-regulatory organizations, including periodic inspections of firms, which may uncover financial or operational difficulties. Furthermore, every firm is required by Rule 17a-5 to file an annual financial statement which has been audited by an independent accountant. This required filing may also identify firms in financial difficulty. Senator STEWART. I am having difficulty following you. Are you saying that the silver futures positions taken by the Hunts and others perhaps is what precipitated this particular situation? Mr. WILLIAMS. Yes, sir. Senator STEWART. Are you saying that because of the lack of regulatory activity on the part of the CFTC that that took place? Mr. WILLIAMS. I think it's because of the condition in the marketplace. Senator STEWART. Extension of credit by brokerage houses didn't have anything to do with it, did it? Mr. WILLIAMS. It affected it, yes, sir, but it would not- Senator STEWART. What rules and regulations do you all have in mind for that kind of thing? Mr. WILLIAMS. I have just explained-the net capital rule. Senator STEWART. That is all you have with regard to that? Mr. WILLIAMS. In this area, yes. Yes, sir. Senator STEWART. Mr. Heimann, when did you find out about these loans that were collateralized by silver by the financing institutions? Did they call you each time they made one? Mr. HEIMANN. Heavens no. Senator STEWART. They didn't indicate to you? When did you find out? Mr. HEIMANN. Well, the specific information which has been developed, which has been presented by the Federal Reserve, and we could operate with them- Senator STEWART. They said they didn't know about it until March 27? Mr. HEIMANN. We didn't know about it until after March 27. Senator STEWART. You mean you didn't know anything about over a billion dollars in loans connected with the taking of positions in the futures market that were collateralized by silver at a |