The examination function began as both a continuation of the 1933 Act’s disclosure approach and an initiation of the 1934 Act’s regulatory approach, with a short-lived “Examination Division” intended to conduct one-time inspections of exchanges and broker-dealers in addition to registration of corporate issuers.(2) Section 17(a) of the Exchange Act, however, made an ongoing inspection program possible by allowing the SEC to require exchange members and over-the-counter (OTC) broker-dealers to keep certain books and records and allow for “reasonable periodic, special or other examinations by examiners or other representatives of the Commission.”
Oversight of the Exchanges
Although legislators had considered implementing a scheme of regular inspection on par with bank examination, they soon abandoned the idea as impractical and expensive. The SEC spent years trying to figure out what was practical and affordable. Staff in Washington and the regional offices learned how to conduct inspections in part by registering the securities exchanges and developing reports to be filed by the exchanges and their member firms. By mid-1936, examiners were reviewing 380 of these reports per week. The incoming information was critical to the SEC’s Congressionally required segregation study—the first example of inspections informing policy.
At first, the Commission’s exchange exam program was hampered by poor administration and weak governance at the nation’s largest exchange. In late 1937, the SEC required the NYSE to reorganize, a process helped along when NYSE president Richard Whitney was convicted of theft from exchange accounts. Reforms followed, including Exchange Act Rule 17a-5, establishing a supervision program by requiring uniform statements from all exchange member firms.
Aware that it would not be possible for the SEC to directly regulate all market participants, legislators provided for “national securities exchanges” required to demonstrate both their own compliance with the Federal statutes and SEC rules and that of their members as well. Section 7 of the Exchange Act, however, directed the SEC itself to ascertain the adequacy of broker-dealer margin accounts (through which money was loaned to investors) as per Federal Reserve Regulation T. During the Commission’s first year, members of a designated unit examined 197 exchange member firms. By 1938 inspectors were looking at OTC broker-dealers as well.
Broker-Dealer Inspection
The OTC market presented investors with all the risks of exchanges and a few more as well. One problem was price discovery. Newspaper listings were always stale, and quotation service “pink sheets” were not much better, allowing well-connected broker-dealers to take advantage of investors. A second risk was that customers could not know whose interest financial professionals were serving—whether they were acting as a broker or a dealer. Finally, OTC broker-dealers tended to be thinly capitalized, meaning customer money could easily disappear in a down market. Chair William O. Douglas made it a priority to “obtain some real regulation of over-the-counter brokers and dealers.”(3)
The work had begun in late 1934 with a study of the OTC market approved by Section 15 of the Exchange Act. By June 1936, 5,740 OTC broker-dealers had registered with the SEC. Preliminary rules for conduct of the OTC market, adopted in 1937, required participants to disclose whether they were acting as broker or dealer and prohibited transactions “excessive in size or frequency†given the nature of the investor.(4) The SEC launched a pilot inspection project that same year and a formal program by the fall of 1939.
The Division of Trading and Exchanges supervised both the exchange and OTC inspection programs. But while the former were conducted mostly in New York and Chicago, the latter were undertaken mostly by personnel attached to the Commission’s ten regional offices. In fiscal year 1940, the SEC conducted 560 surprise inspections. Some of these were “routine”in which regulators checked all industry participants on a cyclical basis. Others were cause inspections, meaning regulators had reason to examine the books.
Meanwhile, the 1938 Maloney Act enabled OTC broker-dealers to convert their trade organization into an SRO. During its first few years, the National Association of Securities Dealers (NASD) stuck to upholding member qualifications through examinations, conducting cause inspections, and fielding SEC referrals.
During the early 1940s, the SEC conducted about 1,000 inspections per year. On occasion, inspectors conducted narrowly targeted exams, but the convention was to perform a full-scale inspection, checking compliance, detecting fraud, gauging financial risk, and providing the broker-dealer with a deficiency report afterward.
The Essentials of the Exam
Although regulators considered both inspections and investigations to be elements of enforcement, the Commission was usually careful to distinguish between the two, explaining that inspections are “based on examination of books and records only and are designed to test compliance.”(5)
Broker-dealers could be out of compliance for reasons ranging from carelessness, such as lax bookkeeping, to fraudulence, such as improper use of customer funds. During the early years of the program, OTC inspectors emphasized uniform bookkeeping. More concerned with promoting compliance than punishing minor violations, inspectors allowed broker-dealers ample time to conform.
Defining wrongdoing rested on case law, with two decisions paramount to inspectors. The 1943 Charles E. Hughes v SEC decision confirmed the Commission’s assertion, as Trading and Exchange Division Chief Counsel Louis Loss put it, “that even the dealer at arm’s length impliedly represents that when he hangs out his shingle that he will fairly deal with the public.”(6) The 1949 Arleen Hughes v SEC decision upheld the SEC’ss insistence that investment advisers had a fiduciary duty to their clients.
Regulation T had brought the first inspectors into broker-dealers’ doors and established risk monitoring as one of the chief objectives of the SEC’s inspection program. Section 15(c)3 of the 1934 Act allowed the SEC to fix the ratio of aggregate indebtedness to net capital for OTC broker-dealers. The Net Capital Rule, Rule 15c3-1, became one of the primary concerns of OTC inspectors after its adoption in 1944.