April 13, 1970
Page 11435
NOTICE OF HEARINGS ON AMENDMENT TO S. 2348, A BILL TO ESTABLISH A FEDERAL BROKER-DEALER INSURANCE CORPORATION
Mr. MUSKIE. Mr. President, nearly 1 year ago, I introduced S. 2348, a bill to establish the Federal Broker-Dealer Insurance Corporation. This Corporation would protect 26 million direct investors from losing their savings through the financial failure of brokers. In so doing it would close a serious gap in our securities laws.
Under existing securities law there is no protection for the investor whose broker goes bankrupt.
The Securities Act of 1933 requires that investors have adequate information to exercise sound judgment concerning the securities he purchases. The Securities Exchange Act of 1934 insures that he will not be victimized by fraudulent, manipulative, or deceptive selling schemes, and that the market in which his broker transacts his order will be maintained in a fair and orderly fashion. But neither statute insures that this same investor who exercises sound judgment in his choice of stock, and places his order with a reputable broker, cannot lose his entire investment if that broker subsequently fails because of operational or financial difficulties.
The United States insures bank deposits under the Federal Deposit Insurance Corporation and the Federal Savings and Loan Insurance Corporation, which are the models for the Federal Broker-Dealer Insurance Corporation. The FBDIC would give the investor who leaves his savings with a broker, the same protection now afforded the depositor who places his money in a bank.
The broker does not act as a simple pass-through agent, whose liability to his customer ends at the close of each transaction. Customer accounts with brokerage firms are maintained on a continuing basis. Credit balances of cash and securities provide the investor with instant liquidity for future transactions. As is the case with banks, these balances are used by the broker to finance the operations of his business. Margin regulations governing the purchase of securities on credit currently require 80 per cent collateral in transactions involving public customers. This means that credit balances and positions must always run well in excess of debits in customer accounts.
Brokers' liabilities to their customers, measured as the net between credit and debit balances in customers’ margin accounts, is currently more than $14 billion according to a recent estimate that appeared in the Wall Street Journal This $14 billion of the public's money is only one part of investor assets that the FBDIC would insure. A still greater amount is held in customer cash accounts. In all, assets in brokers' custody exceed $50 billion.
The FBDIC, like the Federal corporations that insure savings deposits, would serve a dual purpose. It would protect investors and the national economy from serious hardship which can follow the failure of financial institutions, and it would increase the soundness of these institutions and public confidence in them.
Our securities markets are a national asset. They permit individuals to invest their savings in private industry and thereby contribute to the growth of capital investment. Without strong capital markets it would be difficult for our national economy to sustain continued growth.
Brokers support the proper function ing of these markets, by providing a constant flow of orders. The continued financial well-being of brokers and the economy depends, in part, on public willingness to entrust assets to brokers
Partly because of Government insurance, failures of banks are very rare. A run on banks is virtually impossible. The same principle dictates that we pass legislation to insure, at a premium fairly related to the risk, accounts of 26 million direct investors and approximately 100 million people with interests in securities through mutual funds, banks, pin-pointed for at least 24 firms and other institutions.
When S. 2348 was introduced, many brokers had serious operational or "back office" difficulties. Recently, the financial difficulties of several brokerage firms have compounded these problems. Some of these financial problems were originally triggered by operational problems.
Stockbrokers owe money to one another. The failure of one aggravates the problem and reduces the financial soundness of all other firms to which it is indebted. Since many firms invest their capital in securities, market declines may further aggravate brokers' financial problems and cause stockbrokers’ failures to pyramid. This can also force the sale of brokers' securities, intensifying a general decline in securities values. A combination of these events can erode investor confidence and cause securities values to plummet. One of the features of the insurance program proposed under S. 2348 is to guard against such a situation by protecting brokers from each others' failures.
Since June 9, 1969, the date I introduced this bill, liquidators or receivers have been appointed for at least seven firms. While total losses are not known, the New York Stock Exchange trust fund has committed more than $15 million to protect the customers of three of those firms.
While delays in payment and total losses to public customers and other creditors are unknown, since mid-1968 liquidators or receivers have been appointed for at least 24 firms. These figures do not include those that have merged, closed quietly or narrowly escaped collapse. The actual delays in payment and total losses to the public are known only to liquidators or trustees in bankruptcy.
Ultimate loss to the customer is only part of the problem. The brokerage business is built on the concept of liquidity – the fact that an investor can get his money immediately and not have to await the outcome of a prolonged bankruptcy court proceeding. A compulsory trust fund or insurance system promotes such liquidity.
Hamer Budge, Chairman of the Securities and Exchange Commission, has warned of the dangerously high level of "fails" in the securities industry. In a speech reported in the Wall Street Journal on December 10, 1969, he said that recent market activity indicates that repeated continuous high volume could force "fails" and other operation problems to return to crisis levels. "Fails" are the nondelivery within the 5-day settlement period of securities owed by one broker to another. High levels of "fails" and operational problems make it difficult for a brokerage firm to know what its financial position is and what risks it may reasonably take.
In addition to these problems, there have been huge thefts on Wall Street. Newsweek magazine, on December 15, 1969, reported former U.S. Attorney Robert M. Morgenthau's estimate that organized crime is stealing $45 million of securities annually. The total losses are unknown and may be even larger. This obviously compounds brokers' financial problems.
In the 10 months since I introduced this bill, the securities industry has lost over $15 million through brokerage failures. Our latest information is that in October 1969, 62 firms were required by the New York Stock Exchange to file monthly reports because they needed "closer scrutiny."
Since then, two substantial member firms, Gregory & Sons and McDonnell & Co., have gone into liquidation, and the problems of the industry seem to have intensified.
One week ago Thursday, the Securities and Exchange Commission was forced to approve a temporary surcharge on brokerage commissions because of the industry's deteriorating financial condition. SEC Chairman Budge stated in an official letter to the New York Stock Exchange that the Commission was concerned with "the financial problems of the industry and the losses sustained in the past year and during the first quarter of 1970." The Chairman also stated that the commission acted on its understanding that the industry required "immediate financial relief".
After the 1963 bankruptcy of Ira I. Haupt and Co., a large member firm, the New York Stock Exchange required its members to repay the firm's public customers. Subsequently, the New York Stock Exchange also established a guarantee fund, with initial assets of $10 million and a line of credit of $15 million. According to the press, the New York Stock Exchange's guarantee fund now has less than $3 million remaining in uncommitted funds. Furthermore, its line of credit has been adjusted down to $10 million.
The guarantee fund of the New York Stock Exchange is in the interest of the public and of its member firms. However, it also has obvious weaknesses. The fund is small in comparison to the total dollar volume of trading, to the $2 billion to $4 billion of "fails" that have been outstanding at various times, to the annual losses of $45 million due to theft, or to the over $50 billion value of customer assets held by brokerage firms. The fund protects only members of the New York Stock Exchange. It is voluntary as to its application. By its terms, it need not be applied to protect investors unless the board of the New York Stock Exchange decides to act. The fund would be unable to reimburse customers if one or more large member firms suffered substantial losses and needed to liquidate.
S. 2348 would extend protection to customers of brokerage firms that are not members of stock exchanges with guarantee funds. In addition, the credit of the U.S. Government would strengthen the protection now available from guarantee funds. The mere availability of this Federal guarantee should benefit the brokerage community. It would encourage customers to leave securities in "street name" and would therefore reduce the difficulty of transferring securities. It would also encourage the development of new concepts of securities transfers. All these factors could possibly increase the profitability of the brokerage industry. It would also reduce the chance of a run on brokers, thus making it possible to set an insurance rate for brokers lower than any private plan being discussed.
The insurance plan would be entirely paid for by brokers. It would be cost free to taxpayers.
A study by the North American Rockwell Information Systems Co. for the American Stock Exchange recommends a similar insurance program. The study concluded that operations systems development would be advanced if customers trusted brokers sufficiently to leave securities with them. The report suggests a system such as a Federal Deposit Insurance Corporation which would provide investors with the necessary confidence. A study made by Lybrand, Ross Brothers and Montgomery, also recommends this system.
It is understandable that brokerage firms might be apprehensive that this measure could lead to intensified Federal regulation. However, this bill provides insurance and permits a minimum of regulation. It recognizes a legitimate role for privately financed guarantee funds. I urge the investment community to join me in a cooperative effort to establish a Fedral broker insurance program in which the legitimate interests of brokers would be recognized. We can do that and at the same time provide the necessary protection for investors and for all Americans who depend on the well-being of the financial community.
Last Thursday, I introduced an amendment to my bill which does not alter its original purpose or reduce the protection provided for investors. In part, the amendment incorporates suggestions we have received from Government agencies, the industry, and concerned citizens. It also reflects my efforts to increase the fairness of the assessment provisions and to improve protection for all segments of the industry.
The principal change in amended S. 2348 is that premiums are based on the insured risk – a way for setting rates which conforms to widely accepted business and economic principles. This program should be less costly for brokers than the plan presently being considered by the industry.
The amended bill expands the insurance coverage for the industry. Brokers are now insured against failures resultng from transactions among themselves. Institutional investors and investment clubs are given increased protection.
If this bill is enacted, no American would lose his savings through a brokerage firm bankruptcy. Without the enactment of the bill, it is possible that we could experience a run on brokers that could cause a decline in securities values which would destroy confidence and fracture the economy.
Unfortunately, it took the panic of 1929 to pass the Federal securities laws, and a run on the barks to create the FDIC. Let us not wait for an emergency. Instead let us use our foresight to act now to reestablish public trust in our securities markets. There is still time to avert a crisis. We must not delay until we can no longer act but are forced to react.
Mr. President, the Securities Subcommittee of the Committee on Banking and Currency will hold hearings on this legislation on Thursday and Friday, April 16 and 17. The creation of the Federal Broker-Dealer Insurance Corporation is so essential that I urge my fellow Senators and Representatives to join with me in assuring the prompt enactment of the bill.
I ask unanimous consent that four articles which deal with the need for this legislation be printed in the RECORD.
There being no objection, the articles were ordered to be printed in the RECORD, as follows:
[From Newsweek, Apr. 6, 1970]
WHEN BROKERS GO BROKE
(By Clem Morgello)
The prime rate finally went down last week and, just as everyone expected, stock prices went up. The brisk rally put Wall Street in a decidely better mood – at least as far as the price trend is concerned.
Brokers sorely needed the lift, for the financial health of Wall Street itself is still a matter of mounting concern. A great number of brokerage firms are losing money, and no day passes without reports that one firm or another is about to fold. It is impossible to say which, if any, of the rumors is based on fact. But they reflect genuine worry.
That concern was shown last week when a New York Stock Exchange study recommended that the exchange lend as much as $30 million to its Special Trust Fund if the money is needed to compensate the customers of failing member firms. The trust fund, set up in 1964 and limited in size to $25 million, has been reduced to about $3 million in uncommitted cash and government securities plus $10 million in stand-by bank credit because of allocations to take care of four member-firm failures. The board plans to permanently enlarge the fund, and some Wall Street men believe that it should be as large as $100 million.
CALLING FOR STOCK
Because they are concerned about the health of Wall Street, some investors are asking their brokers to send them the stock certificates that they have until now left in the custody of their brokers. They are worried about recovering their stock if the firm folds. While these are still isolated cases, they raise questions about the safety of investments left in the custody of brokers.
To Wall Street's credit, no customers have lost money due to the failure of a member firm since World War II.. The Big Board's trust fund covers not only its own listed securities, but also issues traded on the American Stock Exchange and over-the-counter if they are being held in custody by a member firm. Amex, in addition, has its own $10 million trust fund, but none is maintained by over-the-counter dealers.
But what if an investor wants to sell a stock that is being held for him by a firm that goes under? Unfortunately, he is locked in for varying periods of time, and that is disconcerting in a falling market.
The investor can sell his stock as soon as his account is transferred out of his old firm to any new broker he designates. Under ideal conditions, the account can be transferred in two or three weeks. But because the records of the failing firm are usually in poor shape, it typically takes longer. It took three months, for example, to transfer out the accounts when Gregory & Sons folded last year.
PROTECTIVE BOND
The Big Board and Amex trust funds guarantee only the accounts of customers in failing firms. They do not cover theft, fraud or the loss of a client's securities. But both exchanges require members to take out what is known as a "broker's blanket bond" as protection. These actually insure the brokers themselves against loss or theft, but they protect the customer indirectly because an uninsured loss could place a firm in serious financial jeopardy.
But the big concern at the moment is customer losses due to failure. And some legislators believe that the trust fund is not adequate to protect investors. Identical bills submitted in the House and Senate call for a Broker-Dealer Insurance Corp. similar to the Federal-Deposit Insurance Corp. that insures bank depositers. Each account would be insured up to a maximum of $50,000. The money for this insurance fund would come from an annual fee levied against brokers and amounting to one-half of 1 per cent of their net capital.
Most Wall Streeters oppose the legislation. They say that it would be costly – amounting to about $25 million a year in fees for Big Board members. A more fundamental objection is that it would set up another regulatory body with broad powers (to liquidate or merge firms, for example) – striking another blow at self-regulation.
Late last week, the Big Board took a step that may ease its problems. It formally adopted specific rules allowing its members to go public – including provisions that prevent mutual funds, pension funds and other institutions from taking over member firms. Capital raised in public offerings will strengthen brokerage houses and lessen the danger that they may fail.
[From Time Magazine, Mar. 30, 1970]
LOOKING FOR MORE MONEY
For more than a year, savvy Wall Street insiders have feared that the back-office paper-work tangle in brokerage houses might lead to a major scandal. Now those fears have been heightened.
Several firms have failed, some others are in obvious financial trouble and the top officers of the New York Stock Exchange are desperately asking Washington for emergency help. Nobody expects a repeat of the classic 19th century panics, when brokerage houses went under in domino fashion, trading was suspended on the Exchange and Wall Street was crowded with frantic depositors trying to get their money from failing banks. But if the situation gets much worse, it could hurt some investors, scare others and provoke selling that would drive stock prices still lower.
Taking a Beating.
Two weeks ago, McDonnell & Co. announced that it would close because of insufficient capital. Three smaller houses have liquidated in the past two years, but McDonnell is the best-known one to have shut down since 1963. One problem was that McDonnell has invested some of its capital in the sagging stock market. Investing capital reserves in stocks is a common though risky practice on Wall Street. Many of the larger firms, including Merrill Lynch, refuses to change it. But McDonnell did, and so does Francis I. du Pont, among others.
Last week's news was also disconcerting. Bache & Co., the second largest brokerage house, announced an $8.7 million pretax loss for last year. Goodbody & Co. reportedly had a $1.5 million operating loss in the first two months of this year. Hayden, Stone took a $17.5 million loan from a group of investors in Oklahoma. And Kleiner, Bell & Co. announced that it was getting out of the brokerage business, but will continue as an investment banker.
No Profit in Trades.
The trouble with Wall Street is that the securities business, which fattens on the managerial prowess and high technical competence of others, is itself poorly managed and technically backward. Though the Stock Exchange has started a centralized certificate clearing service, millions of dollars worth of stock certificates are still moved back and forth each day by aged messengers. Office automation came to the brokerage business relatively recently, and only because the Street was strangling in its own paper work. In 1968, brokers stepped up hiring expensive new talent and adding office equipment. All of this added greatly to the brokers' costs.
At the same time, their income was reduced because of a cut in commission rates on large trades and the shortening of trading hours, a change imposed to give back offices time to catch up. On top of that, the market started its long decline in December of 1968, and volume tumbled. Costs could not be cut enough to prevent last year from being a disaster.
According to the Exchange, half of its member firms that serve the public lost money on their stock-trading business last year and continue to do so. Even Merrill Lynch, the largest and most efficient brokerage house, made most of its 1969 profit from underwriting and from its commodity and bond-trading activities. Institutional houses – which deal with mutual funds, insurance companies and pension plans – do well by comparison. Such institutions account for more than 40% of the current 11-million-share daily volume. That leaves the retail arms to scramble for the remaining 6,000,000 shares per day, the level of trading that prevailed in the mid-1960s before the recent spurt of expensive expansion took place. One good index of the malaise in the market: the price of a seat on the Exchange dropped from $515,000 last May to $300,000 this month.
Emergency Fund.
In a semicrisis atmosphere last month, Robert Haack, Bernard Lasker and Ralph DeNunzio, the three top officers of the New York Stock Exchange, went to Washington to ask the Securities and Exchange Commission for an increase of 17% in brokerage commissions, the first raise since 1958. At the time, the plan was criticized because the heaviest burden would fall on small investors, and the public would be asked to support some sloppily managed firms. Last week, with a real crisis on their hands, the Exchange's trio went back to Washington to ask permission to impose an interim surcharge on all trades up to 1,000 shares. The surcharge would be $15 or 50% of the regular commission, whichever is lower. That would help keep some brokers solvent while the SEC studies the February proposal.
The Exchange maintains a trust fund to cover customers against losses if their broker fails. It has committed $6,000,000 to the orderly liquidation of McDonnell. The money will enable McDonnell to repay bank loans and reclaim customers' stock that had been pledged as collateral to secure the loans. Investors who buy stock on margin must agree to let the brokerage firm use the stock as collateral. McDonnell's clients stand to get their cash or stock, though margin customers may have to wait some time for the paper work to be unscrambled. One result of the McDonnell failure could be a decline in margin speculation because there is always the chance that the stock could be tied up indefinitely if more brokerages fail.
The Exchange has also committed $6,000,000 from its trust fund to the liquidation of two firms that failed last year. It has only $3.3 million left to handle other emergencies, though it does have a $15 million line of credit from banks. If several big houses should go under, the Exchange would assess the membership, and some institutional firms might well decide to leave the Big Board rather than pay up.
The latest tremors show that share-holders need more protection than the Exchange's trust fund provides. Maine's Senator Edmund Muskie has introduced a bill that would set up a Broker- Dealer Insurance Corp. similar to the Federal Deposit Insurance Corp., which protects bank depositors. Congress might be wise not to wait for the kind of disaster that brought FDIC to fruition before acting on the proposal.
[From the New York Times, Mar. 23, 1970]
MORE FAILURES PORTENDED AS WALL STREET WOES RISE
(By Terry Robards)
Shrinking volume in the stock market, the continually rising cost of doing business and the unlikelihood of immediate commission-rate increases are once again creating a crisis atmosphere on Wall Street. The securities industry, in fact, is rife with rumors that another major brokerage house will follow the lead of McDonnell & Co., which announced 10 days ago that it would go out of business because it had been unable to stem a rising tide of heavy losses.
Informed sources report that at least two major securities firms with known financial difficulties are foundering.
At least three other firms are mentioned frequently as having major operating difficulties. Still others are said to be losing money at rates that cannot be sustained for long.
The New York Stock Exchange reported to the Securities and Exchange Commission last week that preliminary data for all its member houses doing a public business indicated that more than half had lost money on their securities commission business in 1969.
"SEVERE" LOSSES LISTED
Recent data covering almost 20 per cent of the business done suggested that "important firms" sustained severe losses in both the third and fourth quarters of 1969, both on their brokerage business and on an overall basis, the exchange continued.
It added that there were indications the losses had continued into early 1970. Industry experts say it is probable that losses not only have continued, but have mounted, namely because most of the same adverse conditions prevailing last year have continued into the present year.
Stock market volume, a direct indicator of the level of commission income available to meet costs, has not only remained relatively low but actually has declined.
Turnover on the New York exchange averaged 11.4 million shares daily last year. Fourth-quarter volume averaged 12.4 million shares a day and it is known that several of the industry's largest firms operated at a loss during that period.
Activity has continued to diminish this year, reflecting the slowing of the economy, the discouraging duration of the bear market and little in the way of optimistic news.
DAILY AVERAGE FALLS
The Big Board's daily trading average in January fell to 11.6 million shares and moved sharply lower in February, to 9.4 million. In the first three weeks of March it was running at less than a 10 million rate again.
Meanwhile, fixed costs have remained high, reflecting the costly new operating capacity which many brokerage houses were forced to install last year and the year before in crash programs to cope with the paperwork problems brought on by heavy volume.
"I don't think I'd like to bet that McDonnell will be the last," a well known securities industry figure said last week. "You know the ones in trouble as well as I do," he added. "We all hear the same stories."
Confirmation of brokerage-house difficulties is difficult to obtain. The senior officers of troubled firms are understandably wary of making their losses public, lest the disclosure itself cause customers to panic and losses to be aggravated.
The urgency of the situation last Tuesday, when representatives of the New York exchange proposed to the Securities and Exchange Commission that a "minimum service charge" be imposed on all transactions to provide interim commission rate relief.
The $15 charge would be only a temporary measure, designed to raise revenues while the commission conducts its study of the more comprehensive rate package proposed Feb. 13. This study is expected to take months.
In a letter to the exchange membership Thursday, Robert W. Haack, president, said, "Allowing for the normal three-week waiting period of S. E. C. comments, if the commission interposes no objection, the new charge could be given final approval by our board on April 12 and take effect shortly thereafter."
SPEEDY ACTION ASKED
Mr. Haack noted that the S. E. C. had been asked to expedite its review of the service-charge proposal, but some industry leaders wondered if quick action by the S. E. C. would be forthcoming under any circumstances and whether certain firms could continue in business much longer.
Of special concern is the crisis of public confidence that could ensue if one or more of the securities industry's giant houses were to become insolvent. Such a crisis could cause a run on other houses, according to one theory, and the result could be a major catastrophe.
WALL STREET TREMORS
The bear market in Wall Street and the climb in operating costs are producing serious financial problems for stock brokers. McDonnell & Co. is to be gradually liquidated and its accounts transferred to other houses. Kleiner, Bell & Co., a California firm, has decided to end its public brokerage business. Bache & Co., the second largest broker in the country, has announced that it lost $8.7 million last year, although its chairman states that the deficit did not seriously impair the firm's financial position.
These events appear on the surface to lend support to the New York Stock Exchange's proposal for a boost in the level and change in the structure of commission charges. Rates to small investors would be drastically increased and rates to big institutional investors steeply cut. The new rates are designed to increase the earnings of the securities industry by more than 10 per cent; the aim is to assure what the "big board" describes as a normal after-tax return of 15 per cent on invested capital from securities commissions and the interest on margin accounts.
In effect the New York Stock Exchange wants to be treated as a kind of public utility, with the privilege of determining its own rate structure. The Justice Department objects to this arrangement on antitrust grounds and says that rates should not be collusive.
There are better ways of dealing with the problems of setting proper commission charges than through monopoly pricing by the New York Stock Exchange. There is no reason why big institutional investors cannot be permitted to work out commissions with the brokers who handle their accounts. It is only fear of potential conflicts between the managers of two types of institutions, mutual funds and banks, that inhibits the S.E.C. from endorsing free-market pricing at the upper end of the scale.
At the lower end of the trading scale, the market might also do a better job of setting commissions than a rate-making authority. A study done for the Stock Exchange has tried to calculate the costs of securities trades objectively, but its results are open to criticism on several grounds: that they have focused on the individual transaction rather than the customer, that the study is based on an unrepresentative period, and that the report does not record all stockbrokers' income.
Instead of moving at once to a full free market solution, the S.E.C. could require the Stock Exchange to deregulate commissions at the upper end of the scale. Initially, rates on transactions of $100,000 or higher could be left to the parties involved. If a free market system for commissions on big trades were found to work well, it might gradually be extended to apply to trading at the lower levels. But changes should be made carefully, especially given the present degree of illiquidity of some brokers.
The job of protecting the public from losses that might result from the failure of stock brokers should be separated from the problem of setting commission rates. The way to protect customers should be through a Broker-Dealer Insurance Corporation, similar to the Federal Deposit Insurance Corporation which protects bank depositors. Representative John E. Moss of California and Senator Edmund Muskie of Maine have introduced just such a bill. The signals of danger on Wall Street call for urgent Congressional attention and action on legislation to protect the investing public.