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Who Watches the Watchers? As Professor Loss put it, the "recurrent theme" of federal securities regulation is "disclosure, again disclosure, and still more disclosure. The principle of disclosure, however, does not apply with equal force to the regulation of the broker-customer relationship. For example, "disclosure" does not require securities firms to inform investors of the value of a broadly diversified, low turnover strategy requiring relatively little firm-specific data. Nor does it require securities firms to divulge that their investment advice generally yields returns no better than random stock picking.
This last piece of neglected information is especially important. Securities firms not only recommend and sell securities, they also control the securities that investors own. When an investor purchases securities, they are generally not held in the name of that investor sometimes referred to as the "beneficial owner" , but rather in the name of an intermediary.
Thus, "[u]nlike property claimants such as lessors and secured creditors, the sui generis claims of customers of a securities intermediary are marked by a lack of control and knowledge and an almost exclusive reliance on the integrity and solvency of the intermediary. This Article focuses on the Securities Investor Protection Act SIPA , one aspect of the securities regulation structure with the potential to improve the safety and reliability of the custodial relationship between broker and customer.
SIPA could accomplish this goal by deterring broker misconduct and making customers more aware of the risks posed by it. In response to a wave of failures of securities broker-dealer.
SIPC administers a fund to protect the accounts of securities investors somewhat analogous to the protection the Federal Deposit Insurance Corporation FDIC provides for the accounts of bank depositors.
Although over a quarter century has passed since the enactment of SIPA, its basic, underlying concepts remain the same.
Its approach to protection is principally to reimburse customers for certain types of losses. This Article argues that SIPA improperly distributes costs and thereby fails to realize its potential to prevent failures.
Furthermore, allocating the risk of losses due to failure to the parties best able to avoid such loss is a more efficient means to the long-term protection of customers, as well as the long-term health of the industry.
To justify allowing the industry to retain its self-regulation, the industry should take action to prevent failures and pay for the consequences of its regulatory shortcomings.
This Article does not mean to suggest that misconduct is currently creating an epidemic of failures, as the current failure rate of SIPC members is quite low. SIPA was created for the avowed dual purposes of protecting investors and instilling public confidence in brokerage firms and, by extension, the securities markets. There is no indication that the latter goal is still worthy of concern, if indeed it ever was.
In fact, given the prolonged bull market of the s, quite the opposite may be true. It argues that SIPA fails to directly address the problems that caused broker-dealer failures at that time or today. It does little to reduce the likelihood broker-dealers will fail.
The upshot is that the cost of protecting investors from loss due to broker insolvency is not currently borne by those most able to avoid such insolvencies. Finally, Part IV suggests ways in which Congress should reform SIPA to create incentives in the structure of self-regulatory organizations SROs and in the ownership structure of individual firms to monitor financial distress and avoid failures.
The immediate impetus for the passage of SIPA was the protracted "back office crisis" that plagued the securities industry in the late s and early s. Between and , "brokerage firms [found] themselves in the paradox of being forced out of business by having too much business"  as the total volume of securities transactions grew explosively during the s.
Average daily trading volume on the NYSE increased from 3,, shares in to 12,, in Unfortunately, the brokerage industry failed to make the infrastructural improvements required to handle increased demand. Brokerage firms were slow to automate their back office procedures and continued to rely on outdated methods. The continued increases in the number of transactions eventually overwhelmed the resources of securities firms.
Errors were rampant and chaos ensued as a result of the failure of record-keeping procedures. Pickard, "a habitual violator of SEC and Exchange regulations," confessed to numerous "egregious violations" of securities laws. In response to the crisis, the NYSE and other exchanges, after discussions with the SEC, implemented temporary reductions in trading hours and even instituted a four-day trading week during Hurd Baruch, special counsel to the SEC during this period, has argued that brokerage firms did not merely respond to increased demand, but had fanned the flames of excessive speculation.
Ironically, as brokerage firms slowly and painfully implemented the automation, personnel expansion and other expensive back office improvements demanded by increased trading volume, the stock market entered a prolonged slump in Against this background, it came time for firms to resolve the accounting problems that had built up during the back office crisis.
Many firms had accumulated substantial short differences in their securities positions. Over NYSE member firms and probably even more nonmember firms went out of business. Promotion of "Investor Confidence". Muskie stated that an insurance program would "restore investor confidence and help the securities market to flourish.
This will reinforce the confidence that investors have in U. It is, rather, a tactic to boost investor confidence in the securities market which will, presumably, facilitate capital formation. The economic function of the securities markets is to channel individual institutional savings to 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 ; indeed, the state of U. Securities brokers support the proper functioning of these markets by maintaining a constant flow of debt and equity instruments.
The continued financial well-being of the economy thus depends, in part, on public willingness to entrust assets to the securities industry. Ironically, although SIPA was designed to protect broker-dealers by promoting investor confidence, the loss of investor confidence was not the cause of the failures that inspired SIPA. Rather, the reverse was the case: Congress feared the failures attributed to the back office crisis were causing a loss of confidence.
Congress rushed to restore investor confidence without stopping to consider whether a loss of confidence, if it were indeed occurring, might administer a healthy dose of market discipline to the industry. This section discusses the causes of the original back office crisis as well as contemporary conditions contributing to the risk of customer loss and broker-dealer failure today.
Rather, it is generally accepted that the principal cause of the back office crisis was "incompetent broker-dealer firm management during the securities volume surge. I know of no other business where this could happen. Although correcting the trade processing system was an important step in addressing the issue of brokerage failures, limited processing capacity did not by itself cause firms to fail.
In this sense, the term "back office crisis" is a misnomer. Limited capacity translated into back office failure only for firms that had voluntarily overburdened their processing machinery by accepting orders they were unable to process. Firms that did not wish to expand processing capacity had the option of refusing to accept orders in excess of capacity; such restraint would have cost firms increased immediate profits, but would not have led to failure.
In any industry, accepting orders that cannot be filled violates basic principles of contract. Moreover, in the view of the SEC, such conduct constituted securities fraud. As the SEC informed broker-dealers during the crisis:. The Commission also warns broker-dealers that it is a violation of applicable anti-fraud provisions for a broker-dealer to accept or execute any order for the purchase or sale of a security or to induce or attempt to induce such purchase or sale, if he does not have the personnel and facilities to enable him to promptly execute and consummate all of his securities transactions.
Because acceptance of excessive orders occurred on so great a scale, it cannot be dismissed as the work of a few rogue brokers. Firms failed to control their employees, at least in part because the firms enjoyed the short-term benefits of commissions earned from increased orders. Furthermore, although accidentally accepting some degree of excess orders might be understandable, the continued, widespread, and large-scale nature of this conduct indicates that firms must have been aware they were violating the law.
Put bluntly, the immediate cause of the swamping of back offices was not technological backwardness, but rampant securities fraud. The chaos caused by back office failure also created the opportunity for other forms of securities fraud, including misappropriation.
Thus, although it is true that mismanagement caused the back office crisis, mismanagement was not confined to the failure to upgrade processing capacity. It also included the greedy acceptance of excess orders and the failure—or refusal—to control the misconduct of employees. The failure of oversight was not limited to the firm level.
Given the unusually important role of SROs in regulation of the securities industry,  all the failures of supervision attributable to firm management are in some measure also attributable to SROs. The Exchange had placed some restrictions on Pickard because of its misconduct, but failed to enforce them. The Exchange never even recommended that its members take direct steps to reduce volume, such as halting the opening of new branches, hiring new salespeople, advertising, or trading for their own accounts.
Although SROs are regulatory bodies, at the same time they are business groups representing broker-dealer firms, as well as businesses themselves. The Exchange refused to protect the customers of three small member firms that failed in August The Exchange also failed to carry out its duty to ensure that brokers maintain capital cushions sufficient to protect their customers in the event of insolvency. In , an SEC study argued that "those entering the securities business as entrepreneurs should have such sense of commitment to their business as is likely to produce responsible, reliable operations.
However, the Exchange retained its exemption even when it subsequently relaxed its capital rules. Furthermore, as the SEC concluded in , the Exchange had failed to enforce its minimum capital requirements during the back office crisis. Today, technological advances and the advent of centralized trade-clearing facilities have all but eliminated back office failures. Misconduct, however, continues to play a central part in broker-dealer failure.
The role of misconduct in failures, however, suggests that industry stability requires the elimination of misconduct, not merely the allocation of its costs to the firm. The persistence of misconduct indicates that the existing vicarious liability regime is not providing firms sufficient incentive to deter misconduct. Moreover, there is evidence that the vicarious liability regime, as administered by the industry-dominated arbitration system, does not adequately protect customers.
The nature of the broker-dealer business makes insider fraud and theft especially easy. Broker-dealers, like other financial intermediaries, conduct "transactions that are 1 numerous, 2 in highly liquid form, 3 easily forgeable, and 4 involve large amounts of money which 5 often cross jurisdictional boundaries.
In fact, misconduct is the leading cause of the insolvencies administered by SIPC. SIPC officials have estimated that over half of the broker-dealer failures it had administered as of were due to some type of fraudulent conduct. The significance of misconduct as a cause of failures is underscored by the fact that SIPC liquidations often involve introducing firms that handled customer property without legal authority to do so. Introducing firms have retail relationships with customers, but may not hold cash and securities for customer accounts.
Nonetheless, twenty-six of the thirty-nine firms SIPC liquidated from to , or sixty-seven percent, were introducing firms. A study by the General Accounting Office found "shortcomings in the detection and discipline of unscrupulous [broker-dealer firms]. Although originally designed for broker registration purposes, the CRD is the only centralized source of information about broker-dealer disciplinary proceedings and terminations.
It was designed to provide information about individual brokers and not as a tool to monitor regulatory compliance. Second, the CRD is incomplete in that it does not include information on informal disciplinary actions.
Rather, CRD personnel had to research and compile data from public records. The public does not have direct access to the CRD. While it may be tempting to suggest reallocation of substantial regulatory and disciplinary powers from the SEC and SROs to SIPC, such a drastic change is unrealistic on both the political and logistical levels.