we similarly oppose Senate Bill 900 which is currently being considered.

H.R. 10 as it stands now simply contains too many loopholes. While everyone is talking about preserving so-called functional regulation, functional regulation is made a mockery of by this proposal. Too many products are exempted from securities regulation. The scope of these loopholes, which are ambiguously drafted, creates even greater problems and uncertainties in the future.

For example, under H.R. 10, two investors, one in a bank and one in a brokerage firm, could buy the exact same security but receive two very different levels of protection. The bank investor would not be protected by the SEC's failure to supervise doctrine, securities licensing procedures; securities arbitration remedies; and, perhaps most importantly, the Commission's extremely effective enforcement program. The brokerage industry would. The brokerage investor would.

The bank investor might or might not be able to make claims against the bank for unsuitable investments. The brokerage investor would. The bank investor would probably not even know this state of affairs existed. At best, this is inconsistent. At worse, and I think a lot more likely, this is down right dangerous.

By repealing Glass-Steagell, while largely maintaining the bank's exemptions from Federal securities laws, H.R. 10 would expand the flawed system of bifurcated regulation that currently exists. The bank exemptions were in part premised on the very existence of the safeguards that Glass-Steagell had erected between commercial and investment banking. We should not contemplate removing that separation of activity without also removing outdated exceptions.

I have believed for a long, long time that if banks were to gain full access to the securities industry, they must also be prepared to assume the great responsibilities that come with that privilege. Working within a regulatory framework painstakingly developed over 65 years, the securities industry and the SEC have instilled nothing less than a culture, a culture that places the interests of investors above all others.

Banking regulation is not and cannot be a substitute for sound securities regulation. I don't have to tell you that our markets continue to be the envy of the world. We have moved from a Nation of savers to a Nation of investors. American families today put more of their savings in mutual funds than in insured bank accounts.

It is crucial to ensure that we have a framework that maintains the strength, discipline, and vitality of our securities markets. That framework must allow the Commission, as the Nation's primary securities regulator, to continue to fulfill its mission to protect investors and to safeguard our market's integrity.

The purpose of my testimony is not really to comment on each and every one of the provisions of H.R. 10. I probably couldn't do that if I wanted to. Our written testimony contains much greater detail regarding those parts of the bill that the Commission finds most troublesome. However, overall, the Commission has come to the conclusion that H.R. 10 runs the risk of dramatically undermining investor protection as well as the integrity of our capital markets.

I believe that America's investors deserve a single high standard of protection. The current version of H.R. 10, however, simply fails to meet that critical standard. In addition, I share the financial services industry's call for a need to rationalize a system that tends to favor banking entities over brokerages. Again, I believe this bill fails to meet that basic threshold of fairness.

There are more investors in our markets today than ever before. Every day they choose from an increasingly wider array of both products and providers, but they should not have to give up basic safeguards in the process.

I urge the subcommittee to work toward a regulatory framework that really fits today's marketplace without compromising our Nation's historic commitment to protecting investors and preserving market integrity. The Commission would look forward to working closely with the Commerce Committee to help craft legislation that would bring about these important goals. Thank you.

[The prepared statement of Arthur Levitt follows:]

PREPARED STATEMENT OF HON. ARTHUR LEVITT, CHAIRMAN, SECURITIES AND

EXCHANGE COMMISSION

Chairman Oxley, Congressman Towns, and Members of the Subcommittee: I appreciate the opportunity to testify on behalf of the Securities and Exchange Commission ("SEC" or "Commission") regarding H.R. 10. I am pleased to appear before this Subcommittee again to present the Commission's views on the important issue of modernizing the nation's financial services industries. We look forward to working closely again with this Subcommittee and with the full Commerce Committee to ensure that the best interests of the nation's investors and the integrity of our securities markets are protected.

I. OVERVIEW

The Commission has long supported the primary goal of H.R. 10-modernizing the legal framework governing financial services.

For this reason, the Commission and its staff worked closely during the last Congress with the Commerce Committee to help craft legislation that would modernize the legal structure for financial services while at the same time preserving principles that are fundamental to effective oversight of the U.S. securities markets. Our securities markets today are strong, vibrant, and healthy. They are relied on by both individual investors, who are increasingly putting their savings in stocks, bonds, and mutual funds, and by American businesses that need to raise capital.2 The success of our securities markets is based on the high level of public confidence inspired by a strong system of investor protection, and on the entrepreneurial and innovative efforts of securities firms. As the nation's primary securities regulator, it is critical that the Commission be able to continue to fulfill its mandate of investor protection and to safeguard the integrity, fairness, transparency, and liquidity of U.S. securities markets.

Although the Commission had reservations, it supported the version of H.R. 10 that was passed by the full House of Representatives in May 1998. However, I must firmly state that subsequent negotiations substantially eroded the basic principles that the Commission believes are critical to maintaining securities markets that are strong, vibrant, and healthy. This critical erosion of basic principles is continued in the version of H.R. 10 now before you. The Commission, therefore, is strongly opposed to the version of H.R. 10 that the House Banking Committee reported and that the Commerce Committee is now considering.

As the Commission has testified before, its support of a financial modernization bill was contingent on maintaining the "delicate balance inherent in [the House

As of December 1998, mutual fund assets totaled $5.5 trillion. Investment Company Institute, Trends in Mutual Fund Investing: December 1998 (Jan. 28, 1999).

2 In 1998, businesses raised a record $1.8 trillion from investors, $1.31 trillion in 1997, and $967 billion in 1996. (These figures include firm commitment public offerings and private placements and do not include best efforts underwritings.) Securities Data Corporation.

passed version of] H.R. 10."3 Unfortunately, the version of H.R. 10 currently before the Commerce Committee no longer represents that balance. H.R. 10 now creates too many loopholes in securities regulation-too many products are carved out, and too many activities are exempted. These loopholes would prevent the Commission from effectively monitoring and protecting U.S. markets and investors. Moreover, the scope of those loopholes, which are ambiguously drafted, may create even greater problems and uncertainties in the future. The Commission cannot ensure the integrity of U.S. markets if it is only able to supervise a portion of the participants in those markets. Neither can it ensure fair and orderly markets if market participants operate by different sets of rules and investors receive different levels of protection.

Although the Commission has a long list of concerns with the bill in its current form, we would like to limit ourselves at this times to pointing out a number of provisions contained in the House Banking Committee bill that are particularly troublesome for the Commission. These sections would severely impact the ability of the Commission to protect investors and the integrity of our markets. As discussed more fully in the Appendix to this testimony, the Commission is particularly concerned about issues that arise under the following sections of the bill:

• New/Hybrid Products-The current provision would permit any bank to automatically stay Commission action (potentially for years) if the Commission determined, through rulemaking, that a new product was a security and warranted the protections of securities regulation.

• Derivatives-The current provision exempting "any swap agreement" is so broadly drafted that it could include nearly all securities activities, including securitiesbased derivatives. It would also permit sales to any type of investor, regardless of the investor's financial sophistication, without securities sales practice regulation. • Trust Activities-While the Commission recognizes the importance of traditional bank trust activities, the current provision is so broadly drafted that bank trust departments could take a "salesman's stake" in securities transactions without complying with basic securities law protections.

• Private Placements The original private placement exception was designed for small banks without broker-dealer affiliates that conduct limited securities business. The current provision, however, would allow all but the very largest banks to conduct this business—which is a very significant portion of the securities market-outside of the Exchange Act regulatory scheme.

Perhaps it would be useful at this time to step back and outline the broader points the Commission feels should be addressed by any financial modernization bill. It is crucial that there be consistent regulation of securities activities engaged in by all types of entities. The Commission must retain supervisory and regulatory authority over the U.S. securities markets and continue to determine how securities activities are defined. Our markets are vibrant because they are fair, and because investors rely on the protections that are offered them under federal securities laws. With that goal in mind, the Commission would like to work with the Commerce Committee and the Congress to include the following critical safeguards in any financial modernization legislation:

• Maintain aggressive SEC policing and oversight of all securities activities;

• Safeguard customers and markets by enabling the SEC to set net capital rules for all securities businesses;

• Protect investors by applying the SEC sales practice rules to all securities activities;

• Protect mutual fund investors with uniform adviser regulations and conflict-of-interest rules; and

• Enhance global competitiveness through broker-dealer holding companies.

These objectives are not novel; they have been central themes to all of the Commission's testimony to date. The Commission is eager to work with the Congress and the Commerce Committee to again achieve an appropriate balance in H.R. 10, without compromising these important principles.

II. BACKGROUND ON THE SECURITIES ACTIVITIES OF THE BANKING INDUSTRY

Before discussing the Commission's objectives in detail, I would like to summarize the key points that the Commission has consistently raised in considering GlassSteagall reform.

3 Testimony of Arthur Levitt, Chairman, U.S. Securities and Exchange Commission, Concerning H.R. 10, the "Financial Services Act of 1998," Before the Senate Comm. on Banking, Housing, and Urban Affairs (June 25, 1998), at 2.

The Commission has been the nation's primary securities regulator for 65 years. As such, it is the most experienced and best equipped to regulate securities activities, regardless of who conducts those activities. The Commission's statutory mandate focuses on investor protection, the maintenance of fair and orderly markets, and full disclosure. Moreover, securities regulation encourages innovation on the part of securities firms, subject to securities capital requirements that are tailored to support risk-taking activities. Significantly, securities regulation—unlike banking regulation does not protect broker-dealers from failure. It relies on market discipline, rather than a federal safety net, with an additional capital cushion and customer segregation requirements to insulate customers and the markets from the losses of broker-dealer firms. Moreover, protection of customer funds has been further assured by the Securities Investor Protection Corporation (“SIPC").4

The Commerce Committee is well aware of the many securities activities in which the banking industry now engages. While these market developments have provided banks with greater flexibility and new areas for innovation, they have also left U.S. markets and investors potentially at risk. Because banks continue to have a blanket exemption from most federal securities laws, their securities activities have been governed in a hodge-podge manner by banking statutes and regulations that have not kept pace with market practices or needs for investor protection. As you know, banking regulation properly focuses on preserving the safety and soundness of banking institutions and their deposits, and preventing the failure of banks. But, because market integrity and investor protection are not principal concerns of banking regulation, the Commission believes that banking regulation is not an adequate substitute for securities regulation.

In order for banks to be fully liberated from the outdated Glass-Steagall Act restrictions on their ability to conduct securities activities, banks must be willing to take on the responsibility for full compliance with U.S. securities laws, with which all other securities market participants must comply. In terms of sound public policy, Congress should impose such full responsibility on banks.

III. COMMISSION OBJECTIVES FOR FINANCIAL MODERNIZATION

I will now turn to a more detailed discussion of the fundamental securities principles that the Commission believes are necessary elements of a truly effective financial modernization bill.

A. Aggressive SEC Policing and Oversight of All Securities Activities

Public confidence in our securities markets hinges on their integrity. As the Supreme Court recently stated: "an animating purpose of the Exchange Act... [is] to insure honest securities markets and thereby promote investor confidence." The Commission has an active enforcement division, whose first priority is to investigate and prosecute securities fraud. The banking regulators, on the other hand, are required to focus their efforts on protecting the safety and soundness of banks, not considering the interests of defrauded investors. As a former Commission Chairman said in recent Congressional testimony, detecting securities fraud is a full-time job, and it is a far cry from formulating monetary policy."

To continue its effective policing and oversight of the markets, the Commission must be able to monitor all securities activities through regular examinations and inspections, which includes access to all books and records involving securities activities. This is currently not the case. For example, during recent examinations of bank mutual funds, Commission examiners have had difficulty gaining access to key documents concerning the securities advisory activities of banks. The Commission

4 SIPC is a non-profit membership corporation created by the Securities Investor Protection Act of 1970. SIPC membership is required of nearly all registered broker-dealers, and SIPC is funded by annual assessments on its members. If a broker-dealer were to fail and have insufficient assets to satisfy the claims of its customers, SIPC funds would be used to pay the brokerdealer's customers (up to $100,000 in cash, and $500,000 in total claims, per customer). 5 United States v. O'Hagan, 521 U.S. 642, 117 S.Ct. 2199, 2210 (1997). "See Testimony of Richard C. Breeden, President, Richard C. Breeden & Co., Before the Subcomm. on Finance and Hazardous Materials, House Comm. on Commerce (May 14, 1997). 7 The Commission and the federal bank regulatory agencies have worked to enhance coordination of their examination and inspection programs. See Testimony of Lori Richards, Director, Office of Compliance Inspections and Examinations, U.S. Securities and Exchange Commission, Concerning the Securities and Exchange Commission's Examination Oversight of Securities Firms Affiliated with Banks, Before the Subcomm. on Financial Institutions and Consumer Credit, House Comm. on Banking and Financial Services (Oct. 8, 1997). Despite these initiatives, however, the Commission continues to have difficulty obtaining access to all appropriate books and records.

cannot vigorously protect the integrity of U.S. markets and adequately protect investors with one hand tied behind its back.

B. SEC Financial Responsibility Rules for All Securities Businesses

Securities positions can be highly volatile. The Commission's capital requirements recognize this fact and are, with respect to protection from market risk, more rigorous than those imposed by bank regulators. Market exposures and volatility are risks that the net capital rule was designed to address, unlike bank capital requirements, which focus more on credit exposure. Thus, the Commission's net capital rule better protects the liquidity of any entity engaging in often volatile securities transactions.

In addition to promoting firm liquidity, the Commission's net capital rule is a critical tool to protect investors and securities markets because the Commission also uses the net capital rule to address abusive or problematic practices in the market. For example, with respect to penny stock market makers, the Commission can limit their activity by raising capital requirements for market-making activities. In addition, the Commission can expand on the margin rules with respect to particularly risky stocks by increasing capital charges. Finally, the net capital rule's 100-percent capital charge for illiquid securities serves to constrain the market for securities that have no liquidity or transparency. Without the ability to uniformly apply its net capital rule, the Commission's ability to oversee and influence U.S. securities markets is severely inhibited.

In addition to detailed net capital requirements that require broker-dealers to set aside additional capital for their securities positions, the Commission's customer segregation rule prohibits the commingling of customer assets with firm assets. Thus, customer funds and securities are segregated from firm assets and are wellinsulated from any potential losses that may occur due to a broker-dealer's proprietary activities. Furthermore, federal securities law, unlike federal banking law, requires intermediaries to maintain a detailed stock record that tracks the location and status of any securities held on behalf of customers. For example, broker-dealers must "close for inventory" every quarter and count and verify the location of all securities positions. Because banks are not subject to such explicit requirements, the interests of customers in their securities positions may not be fully protected.

Because the Commission's financial responsibility requirements are so effective at insulating customers from the risk-taking activities of broker-dealers, the back-up protection provided by SIPC is seldomly used. Although there have been brokerdealer failures, there have been no significant draws on SIPC, and there have been no draws on public funds. In fact, because of the few number of draws on SIPC funds, SIPC has been able to satisfy the claims of broker-dealer customers solely from its interest earnings and has never had to use its member firm assessments to protect customers. This is in sharp contrast to the many, often extensive, draws on the bank insurance funds to protect depositors in failed banks.

We must continue to protect our markets from systemic risk by ensuring that there is enough capital to support the market risk that is inherent in securities transactions. In addition, we must ensure that customer funds and securities are fully protected by enforceable requirements to segregate customer assets from firm assets. To satisfy its quest for effective financial modernization, Congress should permit the Commission to set financial responsibility requirements for all securities activities, in order to better protect investors and U.S. markets.

C. SEC Sales Practice Rules Applied to All Securities Activities

All investors deserve the same protections regardless of where they choose to purchase their securities. Unfortunately, gaps in the current bifurcated regulatory scheme leave investors at risk. For example, broker-dealers are subject to a number of key enforceable requirements to which banks are not, including requirements to: • recommend only suitable investments;

• arbitrate disputes with customers;

• ensure that only fully licensed and qualified personnel sell securities to customers; • disclose to investors, through the ÑASD, the disciplinary history of employees; and

adequately supervise all employees.8

8 The federal bank_regulatory agencies have issued guidelines that address some bank sales practice issues. See Board of Governors of the Federal Reserve System, Federal Deposit Insurance Corporation, Office of the Comptroller of the Currency, and Office of Thrift Supervision, "Interagency Statement on Retail Sales of Nondeposit Investment Products" (Feb. 15, 1994). These guidelines are advisory and therefore not legally binding, and they may not be legally enforceable by bank regulators.

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