LETTERS ON CURRENT ISSUES
[Text only of letters sent from the Commerce Committee Democrats]

December 12, 1997

The Honorable James F. Hinchman
Acting Comptroller General
General Accounting Office
441 G Street, N.W.
Washington, D.C. 20548

Dear Mr. Hinchman:

I am transmitting a copy of my correspondence with federal and state regulators regarding the highly-publicized increase in fraud in micro-cap stocks. In light of the excellent work done by GAO on related issues in the past, I am writing to request that GAO conduct certain audits and provide us with a report of your findings and any recommendations you deem appropriate with respect to the following (and any other items you deem necessary and appropriate to assist us in fully understanding and addressing this serious problem):

Penny Stocks and Rogue Brokers. In 1993, you submitted to the House Committee on Energy and Commerce and to the Senate Banking Committee a report on the National Association of Securities Dealers' (NASD) efforts to reduce fraud and abuse in the penny stock market. The report discussed changes to the NASD's oversight procedures for broker-dealers who conduct business in penny stocks, and recommended improvements in the NASD's procedures for informing investors of broker-dealers' disciplinary histories and for examining branch offices. It also discussed listing and delisting practices of the NASD and stock exchanges. See, Penny Stocks: Regulatory Actions to Reduce Potential for Fraud and Abuse (GAO/GGD-93-59, February 1993). The following year, you submitted to this Committee's Subcommittee on Oversight and Investigations and Subcommittee on Telecommunications and Finance a report that reviewed the oversight and disciplinary actions of the Securities and Exchange Commission (SEC) and several of the securities industry's self-regulatory associations against rogue brokers. The report discussed (1) the extent to which rogue brokers are active in the securities industry and (2) regulatory and industry efforts to identify and discipline unscrupulous brokers, and recommended improvements in the detection and discipline of these brokers. See, Securities Markets: Actions Needed to Better Protect Investors Against Unscrupulous Brokers (GAO/GGD-94-208, September 1994).

As a starting point, please update these reports and advise us of the extent to which GAO's recommendations either have been properly implemented or remain undone, and assess the effectiveness of any changes that have been made. In conjunction with this work, please also review the findings and recommendations of the March 1996 NASD-NYSE-NASAA-SEC Joint Regulatory Sales Practice Sweep and report on the extent to which those recommendations have been implemented or remain unaddressed, and assess the effectiveness of any changes that have been made.

Key Issues. I respectfully request that your report include or address these points:

  1. The classes and characteristics of the stocks involved in these scams;

  2. The classes and characteristics of the perpetrators;

  3. The frauds and abuses and how they are carried out--

    On May 29, 1997, NASAA announced that 20 state securities agencies had filed 37 actions against 14 firms operating in the micro-cap market. In the course of their sweep, state examiners discovered four systemic abuses--

    Trading Abuses. State examiners found an army of unlicensed solicitors who are accused of falsifying records, conducting unauthorized trades, and failing to complete trades.

    Failure to Report Investor Complaints. Most of the offices audited failed to have centralized procedures for handling and reporting customer complaints, as required by law. Examiners found hundreds of unreported investor complaints.

    Evasion of Broker-Dealer Registration Requirements Through Use of Third-Party Franchise Agreements. In a February 24, 1997, article, "Beware the scalpers," Forbes warned about the rapidly increasing networks of broker-dealer branch offices, many of which are one-person branches operated by independent contractors, operating just beneath the regulatory radar screen and fleecing investors with abandon. State examiners found that these "franchises"operate independently, with no central compliance or supervisory procedures or oversight as is industry practice. However, they do not have independent capital and bonding upon which the investing public relies.

    Abusive Cold-Calling Practices. Most of the firms and branches examined relied on high-pressure, scripted telephone cold calling techniques that include falsifying experience and performance, among other outright lies.;

  4. The relationship between introducing brokers and clearing firms;

  5. The adequacy of the current legal and regulatory framework, including, among other things, licensing requirements and books and records requirements, at both the federal and state levels;

  6. The adequacy of enforcement tools and resources at both the federal and state levels (see, e.g., "Departure of Many Lawyers at SEC Stretches Its Resources, Delays Cases," Wall Street Journal, Wednesday, November 19, 1997 at B13) and the degree and effectiveness of coordinated efforts; and

  7. The ability of investors to recover their losses, through the efforts of federal and state regulators or private lawsuits. In 1992, you submitted a report to the Senate Banking Committee and to this Committee's Subcommittee on Oversight and Investigations on the operations of the Securities Investor Protection Corporation (SIPC) with recommendations to improve SEC and SIPC disclosures to customers and SEC's oversight of SIPC's operations. See, Securities Investor Protection: The Regulatory Framework Has Minimized SIPC's Losses (GAO/GGD-92-109, September 1992).

Please update that report. Have GAO's recommendations been implemented? Is this protection still sufficient for investors? With the increase in fraud, should action other than a firm's financial failure be cause to trigger the coverage?

Thank you for your cooperation and attention to this request.

Sincerely,

JOHN D. DINGELL
RANKING MEMBER

Enclosure

cc: The Honorable Tom Bliley
The Honorable Michael Oxley
The Honorable Thomas J. Manton


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