ing the lack of experience of certain of such regulators with depository procedures. This could require a depository to await findings of inadequacies in these areas while the safety of all participants in the depository would dictate immediate action by the depository.

BASIC urges that if there is any depository legislation it permit the application of reasonable standards concerning operations capability, financial condition and character in determining eligibility of all participants. The application of these standards by the depository would be subject to review by regulatory authorities and, probably, by the courts.

Financial condition. No matter what safeguards a depository sets up, it and its users will probably never be able completely to insulate themselves from all risk of loss if a participant becomes insolvent and cannot make good on its transactions with the depository. One risk pattern may be mentioned:

Securities are deposited and credit is given; the securities are redelivered to another upon instruction of the depositing participant; they are subsequently rejected by the transfer agent because the securities are in some way defective. If the depository participant is insolvent and unable to accept redelivery of the securities, the depository faces some risk of loss. It may also have a loss if such a participant is unable at the end of the day to pay the amount is owes the depository for the net of the day's transactions.

Therefore, the credit of a participant is important to the depository (and to the other participants who are, in essence, co-insurers against losses from such risks). As discussed below under "Character", the posting of a bond or making of a security deposit does not provide adequate protection since a single user can generate risks to the depository and the other participants that exceed the bond of that user. Depositories should be allowed to establish rules, subject to regulatory review, as to financial responsibility of participants to protect against undue credit risks. Depositories should have the power to reject (again, subject to regulatory review) persons with, for example, a record of financial instability.

Operations capability. Anticipated increases in trading volume require that depositories devise even more sophisticated techniques. Since these transactions involve up to hundreds of millions of dollars, they must be processed with great accuracy. Further, integrity of the system requires that participants detect and report the relatively few erroneous transactions included in the daily transaction reports submitted to each participant by the depository. Unless all these conditions obtain, depository or participant errors could accumulate to create havoc similar to that experienced during 1968 and 1969.

Before joining a depository, prospective participants must have sufficient back-office personnel and equipment, with adequate expertise and training. Otherwise, the few could cripple the system for the many. However, those without the required expertise and without a constant volume of business that would warrant developing it could still benefit from the depository book-entry delivery system indirectly through their own correspondents.

Character. Unrestricted access to a depository could facilitate disposition of stolen securities. One possible pattern is:

A participant deposits, for example, $2 million worth of stolen securities which on their face are in good order and receives credit for the deposit before the securities clear transfer. (Brokers' quick turnaround requirements are such that usually they cannot await transfer before they redeliver.) The participant then orders book-entry delivery of the securities he has just deposited against payment to another participant, receives the $2 million in cash by the end of the day, and leaves the country. Twenty-four hours thereafter, the transfer agent rejects the certificates as stolen.

Other patterns of illegal activity which would victimize a depository and its participants are confined only by the limits of the ingenuity of those whose character is so inclined.

The use of a reasonable bond or deposit simply cannot protect a depository fully. Under the formula currently being utilized by DTC-22%

of average daily cash debits plus cash credits-a participant could receive and deliver against payment $2 million in securities each way daily for a contribution to the protection fund of $100,000. If the formula percentage were much higher, it could work a hardship on many participants. Further, a bond or deposit based upon the scale of past transactions does not protect against sudden changes in volume of use; a participant who operated on a $2 million scale in the past could jump to $10 or $20 million, or more, the next day. Thus a participant could engage in reckless or illegal activities which would not be protected against by his deposit and bond alone and all other participants would in such event bear the loss.

Well-managed brokers and banks exposed to risks like these attempt to ascertain the character of those with whom they do business and reject those whose credentials are not satisfactory. Both brokers and banks should know their customers. While they all sometimes make mistakes-and depositories will, too-depositories should not by law be required to eliminate character as a consideration of eligibility.

We wish to make it clear that by espousing this position as to "access" the intent is not to restrict the number of responsible depository participants. Quite the contrary is the case. As stated earlier, DTC plans to increase substantially the number of participants. The success of DTC and other depositories in further immobilizing the physical movement of securities hinges on their abilities to attract and hold a greater number of participants and securities rather than a lesser number, to increase its volume of bookentry transactions and so lessen the number of securities transactions settled by physical delivery of securities.

Our concern is that if depositories cannot restrict access on the basis of financial ability, operational ability and character, the number of participants will not increase due to the fear of potential participants that there is inadequate protection against participation by those who would create significant risks for all. Thus the success of the depository system depends upon the existence of adequate standards for access, not on the elimination of such standards.

Disciplinary Relationships

Section 17A(d)(7) of H. R. 5050 requires a depository to discipline not only participants, but also persons associated with participants. While a depository should consider whether a broker, dealer, bank, insurance company or mutual fund is to be or continue as a participant, a depository should not be placed in the position of effecting the dismissal of an employee, officer, director or partner of a participant. The primary responsibility for firing should remain with the participant.

A better procedure would be to limit a depository to remedial action directed to the participant and to provide, if regulatory intervention is desired, that a participant's regulatory authority prescribe sanctions for offending persons associated with the participant. This would permit a depository to suspend a participant due to the activities of persons associated with it and leave to the participant the responsibility of dealing with such persons in order for the participant to gain readmission.

Management Participation

Section 17A(d)(3) of H.R. 5050 gives participants who are not shareholders of the depository authority over important corporate actions by requiring their "fair representation" in the adoption and amendment of rules, the selection of officers and directors and in all other phases of administration.

This would conflict with a basic principle of corporate law, and depositories, as corporate entities, are established under such laws. The basic principle is that shareholders shall elect directors who shall manage the business. In the case of the New York depository, the New York Banking Law provides that "the stockholders shall elect directors" at their annual meeting (Section 7003 (1)), that the directors shall elect officers (Section 7013) and that "[t]he affairs of every [banking] corporation shall be managed by a board of directors..." (Section 7001(1)). Moreover, every director of a bank or trust company in New York must be a "stockholder" of the bank or trust company (Section 7001 (4)) or have made an equivalent

investment in the bank or trust company (Section 14(1)(b) and New York Banking Board General Regulation 27.3). In addition to conflict with statutory provisions, Section 17A(d)(3) would raise questions as to the ability of directors to carry out their fiduciary responsibilities.

Non-shareholder participants are separately protected by the regulatory authority's review of a depository's rules and procedures in Section 17A(d)(6). The proposed rules of DTC also provide that all participants be advised of any proposed amendment to the rules, so that participants may comment on them to DTC and its regulatory agencies.

BASIC has met the objective of user participation in management by recommending that each participant, or the securities exchange or association of which he is a member, be entitled (though not required) to purchase voting stock in the trust company in proportion to his use of the depository's services. The use of services could be measured by a combination of the fees paid to the depository for transaction services and the value of securities left in its custody. Together with cumulative voting for directors, this procedure assures minorities of shareholding participants of a voice at the Board of Directors level. For example, if the depository has 15 directors, as planned by DTC, holders of less than 7% of the depository's stock, acting together, can assure the election of a director of their choice.

The availability of ownership rights to users, whether they be brokers, dealers, investment companies, securities exchanges or associations, banks or insurance companies,* adequately ensures a depository's responsiveness to the needs of users.

At an appropriate point in the proceedings we might like to submit additional comments of a more limited, technical nature.

* The Uniform Commercial Code currently requires that all the capital stock of a depository be held by a national securities exchange or association. The pending revision would require that 90 per cent or more of the stock of a depository be held by or for (i) national securities exchanges or associations registered under federal law, (ii) registered brokers, dealers or investment companies, and (iii) institutions which are themselves subject to either state or federal supervision or regulation under banking or insurance laws. Any remaining stock may be held only by individuals who purchased it only in such amounts as are necessary for qualification as directors of the depository.