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and there is also the administrative cost of initiating the inquiry in the first place, ie., salaries of bank personnel, telephone expense, and record keeping expense.

(d) The securities exchanges are reluctant to require their members to participate in a mandatory securities validation program for fear of creating a monopoly which would present serious anti-trust problems, and potential member liability under the Uniform Commercial Code (UCC); that is, failure of a member firm to obey a rule requiring the utilization of a computer validation system might deprive a member of the protection afforded to a holder in due course. Whether legal liability under the UCC, anti-trust, or some other concerns underlie the exchanges' reluctance to establish a rule requiring its members to utilize a validation system can only be speculated upon at the present time.

The exchanges may be concerned that either the Justice Department or some competitor of Sci-Tek would charge them with engaging in a boycott or illegal requirements contract that restrains the competitive opportunities of Sci-Tek's competitors. The anti-trust legality of such an exchange rule would depend upon an analysis of the economic effects of such a plan, and the alternatives available to accomplish legitimate objectives. (See Attachment II. for further development of the anti-trust aspects.)

Because there is no standard by which a comparison can be made, your query as to the completeness of both data banks cannot be answered. Also, neither NCIC nor SVC is willing to have its securities file run against the other for a reconciliation. Both the NCIC Securities file and the SVC data base contain similar types of data, although not necessarily identical. There are three major exceptions to this generalization, they are:

1. The NCIC Securities file includes reported stolen Government Savings bonds, whereas, SVC does not.

2. The SVC data bank includes all items reported missing to the Stock Clearing Corporation (SCC) (a subsidiary of the New York Stock Exchange), whereas, NCIC does not because the SCC is not a law enforcement agency and NCIC will not accept input from a non-law enforcement entity.

3. Counterfeit stocks and bonds are not routinely entered in NCIC, whereas, SVC enters counterfeits as a "flag" to alert its members of a series or denomination of a particular stock or bond which has been counterfeited. Both NCIC and SVC were requested to provide separate summaries, following a generally similar format, of the total data contained in their securities data bases. This information is reproduced in Attachment III. The significant variances in dollar value between the content of the NCIC file and the SVC data bank are summarized below:

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1 Average dollar values assigned to stock shares: (a) common-$30/share; (b) preferred-$44/share; (c) warrants, rights, etc.-$7/share.

2 Represents 478,218 certificates totaling 306,942,618 shares of preferred and common stock.

3 Represents 53,681 certificates totaling 7,067,056 shares of preferred and common stock.

• Represents 2,525 U.S. Government bonds, bills, notes, etc.

Represents 367,950 U.S. Government bonds, bills, notes, etc.

Based upon this summary and comparison, the following suppositions can be made:

1. It is obvious that the SVC data bank contains about nine times more items directly relating to stocks than does NCIC. We believe this difference is mainly composed of missing and misplaced stock which has not been reported as stolen or missing to law enforcement authorities. As pointed out earlier in our letter, banks and brokerage houses are reluctant to report

the disappearance of securities to either Federal or local law enforcement authorities. However, there is no hesitancy to notify SCC so that the items appear on SCC's Lost/Found Notices. If the items are not recovered by using the Lost/Found Notices, the losses are compensated for by filing loss claims with their insurance carriers. SVC is inputting data from both the SCC's Lost/Found Notices, and also the data from the insurance claims, and is thus able to capture that significant portion of activity which eludes law enforcement authorities, and consequently NCIC. This "float" of allegedly missing and misplaced stock is considerable when compared to the amount actually being reported as stolen.

2. It is also significant to note that the NCIC Securities file contains about 145 times more US Government obligations than does SVC but the dollar variance is only about two times greater. The reason for this disparity is that NCIC contains about 349,000 US Savings bonds of nominal value which comprise about 95% of the total file. Data on US Government obligations is being input by both the FBI on a case basis, and by the Secret Service both on a case basis and by claims received by the Treasury Department. By comparison, SVC's input sources of US Government obligations are limited to its subscribers, SCC, and the New York Regional Federal Reserve, none of which report US Savings bonds.

Lastly, in response to your question regarding the speed with which each data bank is made available to primary users, we must first define "primary users."

A primary user of NCIC is a law enforcement agency either with or without a terminal device.

A primary user of SVC includes both subscribing and participating members either with or without a terminal device. Thus, members include both private industry, law enforcement, and other Governmental agencies.

System participants of NCIC include local, state, and Federal agencies throughout the United States and Canada. Terminals utilized range from manually operated devices to computers which in turn service subsystems and thus enable subsystem participants to have immediate access to the NCIC. The NCIC computer responds to each transaction as it is received. That is, the line is held open until an acknowledgement or reply is sent in response to the incoming transaction. The NCIC equipment can interface with terminal equipment manufactured by any of the major firms in the field.

Members of SVC do not have direct access to the SVC computer base. All inquiries whether by terminal device or telephone are addressed to 56 Pine Street, New York City, where each inquiry is monitored and retransmitted to the computer at Wilmington, Delaware. This procedure provides SVC with the ability to monitor all inquiries and responses for follow-up if necessary, and ensures that the system is not being abused. According to SVC representatives, the delay incurred by this control intercept is not significant under the present work load.

The Department of Justice, keenly aware of the securities problem and actively seeking a solution, is often hampered in its efforts by having to deal with a multiplicity of Governmental and industry representatives. It would be far more effective to deal with one agency and one focal point in industry.

So long as stock certificates and other securities continue to circulate in negotiable form, there remains a definite need for systematic authentication of ownership to preclude their illegal use in commerce. As indicated, in our discussion of holder in due course in Attachment I., the probability of modifying the notice requirement in each of the fifty states' commercial code is extremely remote. Federal legislation under the commerce power appears to be the more expeditious route to either:

1. Redefine "notice" in favor of a "reasonableness" test of good faith (as opposed to the "actual knowledge" test now in vogue) where a security was transported, or moved as, of which was a part of, or which constituted interstate or foreign commerce: or

2. Require banks, exchanges, brokerages, and dealers to validate the ownership of securities with the transfer agent, or a computer validation system (private or Governmental) before securities are accepted for sale or collateral,

and to report all securities losses to NCIC. These goals can be accomplished by giving an appropriate Federal agency, eg., SEC, the necessary authority and funds to promulgate the enforcement and procedural regulations in this

area.

I trust this information will be of value to you in your Subcommittee investigation.

Sincerely,

HENRY E. PETERSEN, Assistant Attorney General.

HOLDER IN DUE COURSE AND THE BANKING AND SECURITIES INDUSTRY A "Holder" is a unique and important creature of the Law of Negotiable Instruments. A "Holder in due Course" has the distinction of taking an instrument free and clear of many defenses which would be available to the maker as against the payee. If the instrument is drawn in negotiable form, the maker had indicated in advance that he surrenders or gives up the right of making certain defenses after the instrument has passed on into circulation beyond the payee's hands. Generally, in order to qualify as a "holder in due course" an ordinary holder has to acquire:

1. Paper complete and regular on its face;

2. For value;

3. in good faith; and

4. Before the paper is overdue.

For banks and brokerage houses, the requirement that a holder acquire paper in "good faith without notice of any infirmity in the instrument, or defect in the title of the person negotiating it," is the key requirement.

At common law, the Doctrine of "good faith" was painstakingly developed. Miller v. Race, 1 Burr 452, established the doctrine of the free circulation of commercial paper in England in the early 1800's. A series of cases followed, culminating in the celebrated case of Gill v. Cubit, 3 B&C 466 (1824), where the Court of King's Bench laid down the rule that reasonable prudence and caution must be exercised by the purchaser and that if circumstances were such as ought to have excited the suspicion of a prudent man, and no inquiry made, then he did not stand in the legal position of a holder in due course. In other words, suspicious circumstances alone would let in equities and defenses against such a purchaser. In 1836, England rejected this rule in the case of Goodman v. Harvey, 4 A&E 870, holding that nothing short of actual knowledge of defects or infirmities would deprive a purchaser of the holder in due course status.

In the United States, the several jurisdictions followed a dual line of development. Some followed the former rule of Gill v. Cubit and others followed the rule of Goodman v. Harvey. This dual approach to the problem was finally resolved in 1924 when all the states adopted the Uniform Negotiable Instruments Law (NIL) and this was the law until the adoption of the present Uniform Commercial Code by the states. Under the NIL, to constitute notice of an infirmity, the person to whom the instrument is negotiated "must have actual knowledge of the infirmity or defect, or knowledge of such facts that his action in taking the instrument amounts to bad faith."

In the 1952 official draft of the Uniform Commercial Code (UCC), the NIL'S "actual knowledge" test of good faith was dropped in favor of a "reasonableness" test of good faith, ie., "Good faith" means the observance of the reasonable commercial standards of any business in which the holder may be engaged." The Code's comment intimated that a bare showing of "honesty-in-fact" was not enough, when a purchaser's actions failed to meet accepted standards.

The banking community strongly objected to this language in the UCC, asserting that it was an attempt to revive the "reasonableness test" of Gill v. Cubit. They felt that such a revival would hamper the free flow of commercial paper and add considerably to their operating costs because of the time and expense necessary in conducting a credit investigation to determine whether or not any infirmities exist in relation to the instrument being negotiated. So much opposition arose that the editorial board of the UCC voted to delete the controversial language from Article 3. Parenthetically, it might be noted that prior to the advent of modern communications systems and the perfection

of central computerized data banks, ironclad negotiability was a basic necessity for the free flow of commercial paper. This, however, is not the case today. Modern, speedy equipment is available at nominal cost for each transaction and a surcharge borne by the borrower would support such a validation system. The 1962 official UCC text now defines "notice" as follows:

Section 1-201: (25) a person has "notice" of a fact when (a) he has actual knowledge of it; or (b) he has received notification of it; or (c) from all of the facts and circumstances known to him at the time in question he has reason to know that it exists.

Section 8-301(2) confers full negotiability upon investment securities and by virtue of § 8-301, a bonafide purchaser acquires not only all the rights of his transfer, but also takes free from all adverse claims. It is the creation of that status that is so coveted by the industry. For a bonafide purchaser to be able to take advantage of this provision, the transfer to him must comply with the requirements of Article 8. Section 8-302 requires a bonafide purchaser to have given value for a security, and to have taken delivery of the security in bearer form, or to have received a security which is registrable while he is still in good faith and without notice of adverse claims. Compared to the Negotiable Instruments Law, with reference to a holder in due course, a transferee must take an instrument:

1. Which appears to be complete and regular:

2. Before it is overdue without knowledge of having been dishonored; 3. In good faith and for value; and

4. Without notice of any infirmity in the instrument or defect in the title or the transfer.

Under NIL, a failure to comply with any of the foregoing requirements would have prevented the transferee from becoming a holder in due course. Thus, comparing a "bonafide purchaser" under Article 8 of the UCC with a holder in due course under the NIL, it is apparent that completeness and regularity are no longer required under UCC. In fact, even though the instrument has been incorrectly completed, the issuer cannot raise this incompleteness or incorrect completion as a defense against the purchased for value without notice. Also, the UCC recognizes the practice that securities are often dealt with after they have become due. The fact that securities are overdue will not effect nor deprive the purchaser of the advantageous position of a bonafide purchaser although it will bring into play Section 8-305 (Staleness as Notice of Adverse Claims) and may raise a presumption of knowledge of adverse claims. This Section, however, refers to a principle obligation having become due and, thus will not apply where interest charges have not been met, unless the failure to do so will immediately result in the principle obligation becoming due. The requirement of good faith, (ie., honesty in the fact) in the conduct or transaction concerned, is required under both the Negotiable Instrument Law and the Code. Negligence by itself will not suffice but actual bad faith will have to be shown. Under the provisions of Section 8-305 there must be actual notice of the existence of adverse claims. This apparently applies only to staleness as notice and does not alter the proposition that "notice" may be established by all of the circumstances surrounding a transaction. A security issued to a bearer cannot be altered by an endorsement. However, if the security contains "an unambiguous statement" it will convey sufficient notice to the existence of an adverse claim. There is no need for a purchaser to inquire to the extent of the adverse claim, but if the instrument carries an endorsement of the existence of such adverse claim the purchaser by ignoring this will take the security with knowledge of such facts that his action in taking the instrument amounted to bad faith.

There are two organizations primarily responsible for promulgation of the UCC and any changes and amendments to the Code. They are the American Law Institute, 133 South 36th Street, Philadelphia, Pennsylvania, and the National Conference of Commissioners on Uniform State Laws, 1155 East 60th Street, Chicago, Illinois. Any recommended modification of the Code requires the approval of these organizations prior to proposing changes for ratification by the various states. Even if their support could be acquired. it may possibly take several years before all the state legislatures could enact the amendments. Heavy financial institution lobbying against such modification could be expected depending upon their particular interests.

ANTITRUST ASPECTS

For the benefit of those interested in this problem, we have consulted with the Anti-Trust Division as to the possible anti-trust ramifications of various types of securities exchange action designed to deal with the problem of missing or stolen securities. It is the position of the Anti-Trust Division that under the Supreme Court's decision in Silver v. New York Stock Exchange, 373 U.S. 341 (1963), exchange practices or rules which unreasonably restrain competition and are more restrictive than necessary to effectuate the purposes of the Exchange Act of 1934 are in violation of the anti-trust laws. The Anti-Trust Division is not aware of any specific proposal of any stock exchange to take action relating to missing or stolen securities. Since any judgment as to the anti-trust legality of securities exchange practices or rules requires an examination of specific facts, the Anti-Trust Division cannot offer a definitive legal judgment on the basis of hypothetical cases. The following, however, constitutes a general expression of views of the AntiTrust Division which may assist you in understanding the possible anti-trust considerations relevant to exchange efforts to deal with the problem of stolen or missing securities.

"We shall assume that preventing the theft of securities and facilitating the location of missing securities are desirable public goals and legitimate business objectives of the New York Stock Exchange and its member firms. On those assumptions, an attempt by the New York Stock Exchange to require its members to make serious efforts, on an individual basis, to utilize the best means of solving these problems would not seem to raise serious anti-trust problems. For example, the Exchange could establish a rule requiring its members to utilize the best available means of determining whether securities in their possession have been stolen. (We take no position on whether existing rules of the Exchange already impose such a duty upon Exchange members.) Under such a rule, members of the Exchange could chose, on an individual basis, whether to utilize Sci-Tek's services, similar services offered by other companies, or some other means of meeting the general obligation imposed by the Exchange's rule. Under such a rule, parties other than Sci-Tek could compete with it in an attempt to pursuade individual members of the Exchange to use their services. In that case, no anti-trust problems would arise since competition would exist between various providers of computer services and the success of any such provider would be based upon its ability to convince individual members of the Exchange of the superiority of its services. Under such a scheme, the New York Stock Exchange would play no role in influencing the success of any provider of service to its members.

It may be. . . that the goal of tracing missing securities and deterring the theft of such securities can best be achieved if all members report missing securities to a single data bank which would be available for subsequent accessing by all members. If provision of such data bank services is in fact a natural monopoly, ie., one where a single provider of services can perform the task more efficiently than a number of providers, and we intimate no view on this question at the present time, the competitive concerns could be dealt with in a number of manners. One could allow Sci-Tek and other companies to compete for the business of individual members firms, knowing that the firm which is most successful during the initial stages of competition will eventually acquire all of the business. Under such a policy the determination of whether this business is in fact a natural monopoly would be left to free market forces.

Alternatively, the New York Stock Exchange could attempt to set up its own data bank company and provide the services for its members. Under such an arrangement the Exchange would presumably provide the service to its members on a cost basis. A decision by the Exchange to offer the services to its members could raise anti-trust questions due to the potential foreclosure of opportunities to other potential providers of such services. In addition, Exchange ownership of the data bank might raise anti-trust questions with respect to the Exchange's duty to allow non-members to have access on reasonable terms to its data bank.

Another alternative would be to allow the New York Stock Exchange to solicit bids from various would-be providers of the data bank service and to award the monopoly contract to the firm which proposes the best service. Under such a procedure, the problem of exposing the members of the Exchange to monopoly pricing for the subscription service would be lessened as an

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