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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;
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 1. 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 1. Harrey, 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 1. Harvey. This dual approach to the problem was finally resolved in 1924 when all the states adopted the l'niform 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 VIL'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;
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 bona fide 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 Yegotiable Instrument Law and the Code. Negligence by itself will not suffice but actual bad faith will have to be shoun. 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 0. 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 initial matter, by the competitive procurement process. Subscribing members could also be protected from subsequent monopoly pricing if the initial contract entered into between the Exchange and the selected data bank company was for a limited term of years, presumably of short duration. In this manner, firms that were not awarded the initial contract would be in a position to bid away the contract from the initial service provider by offering either lower rates or better services to the members of the Exchange. In this manner the salutory effects of price and technological competition could be retained even though the service would only be provided by a single firm at any given time.
The purpose of the discussion above is to indicate to you that there may be various methods of achieving the goal of lessening the missing securities problem without violating the anti-trust laws. The New York Stock Exchange is familiar with the Anti-Trust Division's business review procedures and if it desires to obtain a statement of this Division's anti-trust enforcement intentions with respect to any specific proposal it knows how to obtain our views. Normally, if the proposed conduct requires the approval of a regulatory agency, the Anti-Trust Division will not consider a request for a statement of its enforcement intentions until after the regulatory agency has approved the proposed course of action. However, the Exchange has frequently consulted informally with the Anti-Trust Division and the Securities and Exchange Commission at the same time when it determined that both agencies would have an interest in what the Exchange was proposing to do."
SUMMARIES FROM SECURITIES VALIDATION CORP.'S DATA BANK AND NATIONAL CRIME INFORMATION CENTER'S
SECURITY FILE-SECURITIES VALIDATION CORP. DATA DUMP AS OF FEB. 11, 1974
9, 186 45, 604 95, 513 10, 605
25 45, 604 14, 004 29, 075
2 306, 055, 330 13 $9, 181, 659, 900 887, 288 3 39, 040, 672
366, 212, 585
6, 199, 148 1, 285, 726 17,714, 356 21, 359
521, 359 366, 212, 585 57, 458, 425 225, 940, 640
24, 388, 800 158, 424,900
1 Common stock of 306,055,330 shares, averaging out to $9,181,659,900 represents 74.4 percent of the total SVC data base.
1 Average value of $30/share (New York Stock Exchange).
of the $58,424,900, $18,669,500 represents bonds, etc. which have expired maturity date, thus. leaving a net of $39,755,400 open. The total data base consists of 629,965 certificates, representing 308,249,703 shares, valued at $9,600,848,020.
OFFLINE SEARCH OF NATIONAL CRIME INFORMATION CENTER SECURITIES FILE AS OF JAN. 31, 1974
Type of security
1, 360 30, 277 2, 924
470 53, 151
530 12, 407 467, 709
$16, 693, 018 107,600,000 18, 253, 750
450, 174 31, 857, 080 21, 255, 202 176, 488, 080
15, 012, 215 71, 109, 631 1 192,043, 470 • 29, 286, 708 320, 118, 987 700, 168, 315
6, 401, 449
665, 607 2,874, 141
1 Average value of $30/share (New York Stock Exchange).
Average value of $44/share (New York Stock Exchange). 3 Average value of $7/share (New York Stock Exchange).
37-905 0—74- -2
COMMENTS The following should be considered before any conclusions are reached based on the information contained in this attachment :
1. The average dollar values assigned to shares of stocks, warrants, and rights are based upon New York Stock Exchange quotations as of February 1974 and do not reflect up to the minute stock fluctuations.
2. A number of securities are stolen in blank and can be completed for any number of shares or value the thief desires.
3. Some duplication of entries exist in the NCIC data since policy allows entries to be made by two or more agencies for the same security if the agencies have statutory interest in the theft.
4. Duplication of entries are eliminated in the SVC data base through its programming and analysis of routine printouts.
Senator GURNEY. A letter from New York City Police Commissioner Michael Codd indicating that the NCIC terminal at the New York City Police Department is not a suitable mechanism to permit validation of securities because of the tremendous number of shares traded daily. Moreover, according to Commissioner Codd. the department is not satisfied with the response of the securities industry in reporting securities thefts.
The letter referred to was marked "Exhibit No. 155" for reference and follows:]
EXHIBIT No. 155
New York, N.Y., June 24, 1974 Hon. EDWARD J. GURNEY, U.S. Senator, Committee on the Judiciary, Washington, D.C.
DEAR SENATOR GURNEY: Thank you for your letter of May 15, 1974 and your interest in the use of the N.C.I.C. terminal by the Securities and Banking Industry. I hope the following responses to your questions will aid you in your endeavors.
Question. Do the New York Clearing banks and members of the exchange have direct access to the N.C.I.C. terminal?
Answer. No, Under no conditions do New York clearing banks have direct access to the N.C.I.C. terminal, it is only accessible to law enforcement agencies.
Question. If the banks and brokerage industry are not permitted direct access to the terminal, how do they receive information, if at all?
Answer. Most banking and brokerage firms subscribe to the private service performed by Sci-Tek, a private computer system which maintains records of lost and stolen securities reported by the industry.
Question. Is it true that many of the brokerage firms and banks have their own security agents who are able to obtain such information through friends at the department?
Answer. There is no evidence at this time to confirm this allegation, however, an internal investigation is in progress to determine if this is a fact.
Question. Is the N.C.I.C. terminal at the New York City Police Department a suitable mechanism to permit the banks and brokerage industry to validate securities in their possession?
Answer. The N.C.I.C. terminal located in the New York City Police Department is not a suitable mechanism to permit validation of securities. Because of the tremendous number of shares or certificates traded daily, the volume demanded of the N.C.I.C. terminal would be extraordinary to the point where it would interface with the noraml duties and efficiency of this department.
Question. Is the New York City Police Department satisfied with the response of the securities industry, (including the banks), in reporting securities thefts?
Answer. No. The Bond and Forgery Squad of this department is dissatisfied with the respouse of the securities industry, including banks, in reporting securities thefts because of the time lag, that is, between the date discovered and the date reported. Many times a company will conduct an in-house inrestigation to ascertain if the securities were misplaced, lost or otherwise