SEC Enforcement: Responses to GAO and SEC Recommendations Related to
Microcap Stock Fraud (Letter Report, 09/30/98, GAO/GGD-98-204).

Pursuant to a congressional request, GAO provided information on the
actions taken by the Securities and Exchange Commission (SEC) and the
self-regulatory organizations (SRO) in response to GAO's and SEC's
recommendations to reduce microcap fraud.

GAO noted that: (1) SEC and the SROs have taken, or reported taking,
actions that respond to many of the recommendations in GAO's and SEC
reports that address issues related to microcap stock fraud; (2) in
responding to these recommendations, actions have been taken to: (a)
expand the disclosure of and public access to broker disciplinary
information; (b) improve National Association of Securities Dealers
branch office examination selection; (c) provide more focused sales
practices examinations; (d) improve compliance with industry reporting
requirements; and (e) implement a continuing professional education
requirement for broker-dealers; (3) these actions should enhance
regulatory oversight of microcap stock firms and help provide investors
with additional protections against abusive practices by such firms; (4)
actions have not been completed that would respond to other
recommendations related to the: (a) migration of unscrupulous brokers
from the securities industry to other financial services industries; (b)
modernization of the central registration database to improve oversight
of problem brokers and public access to broker disciplinary histories;
(c) ability of SEC to identify, across firms, trends in violations found
during its broker-dealer examinations; and (d) provision of information
on the availability of broker disciplinary histories before activity
occurs in an account; and (5) completing actions on these
recommendations would further enhance regulatory oversight and investor
protection.

--------------------------- Indexing Terms -----------------------------

 REPORTNUM:  GGD-98-204
     TITLE:  SEC Enforcement: Responses to GAO and SEC Recommendations 
             Related to Microcap Stock Fraud
      DATE:  09/30/98
   SUBJECT:  Stocks (securities)
             Securities regulation
             Brokerage industry
             Securities fraud
             Self-regulatory organizations
             Reporting requirements
             Information disclosure
             Data bases
IDENTIFIER:  National Association of Securities Dealers Central 
             Registration Depository
             
******************************************************************
** This file contains an ASCII representation of the text of a  **
** GAO report.  Delineations within the text indicating chapter **
** titles, headings, and bullets are preserved.  Major          **
** divisions and subdivisions of the text, such as Chapters,    **
** Sections, and Appendixes, are identified by double and       **
** single lines.  The numbers on the right end of these lines   **
** indicate the position of each of the subsections in the      **
** document outline.  These numbers do NOT correspond with the  **
** page numbers of the printed product.                         **
**                                                              **
** No attempt has been made to display graphic images, although **
** figure captions are reproduced.  Tables are included, but    **
** may not resemble those in the printed version.               **
**                                                              **
** Please see the PDF (Portable Document Format) file, when     **
** available, for a complete electronic file of the printed     **
** document's contents.                                         **
**                                                              **
** A printed copy of this report may be obtained from the GAO   **
** Document Distribution Center.  For further details, please   **
** send an e-mail message to:                                   **
**                                                              **
**                                            **
**                                                              **
** with the message 'info' in the body.                         **
******************************************************************


Cover
================================================================ COVER


Report to Congressional Committees

September 1998

SEC ENFORCEMENT - RESPONSES TO
GAO AND SEC RECOMMENDATIONS
RELATED TO MICROCAP STOCK FRAUD

GAO/GGD-98-204

Microcap Stock Fraud

(233555)


Abbreviations
=============================================================== ABBREV

  CRD - central registration database
  EATS - Examination Activity Tracking System
  IB - introducing broker
  NASAA - North American Securities Administrators Association
  NASD - National Association of Securities Dealers
  NASDR - NASD Regulation
  NSCC - National Securities Clearing Corporation
  NYSE - New York Stock Exchange
  OTC - over the counter
  SEC - Securities and Exchange Commission
  SRO - self-regulatory organization
  STARS - Super Tracking and Reporting System

Letter
=============================================================== LETTER


B-279399

September 30, 1998

The Honorable Susan M.  Collins
Chairman
The Honorable John Glenn
Ranking Minority Member
Permanent Subcommittee on Investigations
Committee on Governmental Affairs
United States Senate

The Honorable John D.  Dingell
Ranking Minority Member
Committee on Commerce
House of Representatives

In separate letters, dated December 12, 1997, and February 23, 1998,
respectively, you expressed concern over reported increases in fraud
involving microcap stock--the stock of companies with low-priced
securities and minimal capital.  You also indicated interest in the
actions securities regulators have taken to combat such fraud.  As an
initial step, you requested that we inform you of the actions taken
in response to recommendations in our and Securities and Exchange
Commission (SEC) reports that address issues related to microcap
stock fraud.  This report summarizes the May 27, and 28, 1998,
briefings we provided your respective offices on the status of SEC
and self-regulatory organization (SRO)\1 actions on these report
recommendations. 


--------------------
\1 SROs are private membership organizations given authority and
responsibility under federal law and regulations to adopt and enforce
rules of member conduct.  Securities SROs include the stock
exchanges, National Association of Securities Dealers, and Municipal
Securities Rulemaking Board. 


   RESULTS IN BRIEF
------------------------------------------------------------ Letter :1

SEC and the SROs have taken, or reported taking, actions that respond
to many of the recommendations in our and SEC reports that address
issues related to microcap stock fraud.  In responding to these
recommendations, actions have been taken to (1) expand the disclosure
of and public access to broker disciplinary information, (2) improve
National Association of Securities Dealers (NASD)\2 branch office
examination selection, (3) provide more focused sales practices
examinations, (4) improve compliance with industry reporting
requirements, and (5) implement a continuing professional education
requirement for broker-dealers.\3 These actions should enhance
regulatory oversight of microcap stock firms and help provide
investors with additional protections against abusive practices by
such firms. 

Actions have not been completed that would respond to other
recommendations related to the (1) migration of unscrupulous brokers
from the securities industry to other financial services industries;
(2) modernization of the central registration database (CRD) to
improve oversight of problem brokers and public access to broker
disciplinary histories; (3) ability of SEC to identify, across firms,
trends in violations found during its broker-dealer examinations; and
(4) provision of information on the availability of broker
disciplinary histories before activity occurs in an account. 
Completing actions on these recommendations would further enhance
regulatory oversight and investor protection. 


--------------------
\2 NASD operates the Nasdaq Stock Market, Inc., and, through its
independent subsidiary NASD Regulation, Inc., establishes and
enforces standards of industry conduct. 

\3 A broker-dealer is a registered firm that buys and sells
securities for its customers and itself. 


   BACKGROUND
------------------------------------------------------------ Letter :2

The term microcap security is not defined in the federal securities
laws.  Microcap securities include penny stocks\4 and generally
describe the low-priced securities of companies with market
capitalizations of less than $300 million.  Prices of microcap
securities may be quoted on the NASD over-the-counter (OTC) Bulletin
Board,\5 in the National Quotation Bureau's Pink Sheets,\6 or on the
Nasdaq Small Cap Market.\7

Public information on microcap securities is limited; often a small
number of broker-dealers dominate trading, making the securities more
susceptible to fraud.  Microcap fraud is typically associated with
"pump and dump" schemes involving high pressure sales tactics
designed to induce investors to purchase relatively worthless stocks
in which the firm or other insiders hold a large inventory.  When
successful, these high pressure sales tactics result in an increase
in the price of the targeted stock (pump).  Insiders then sell (dump)
their shares, sometimes realizing large profits at the expense of
public investors.  A variety of other fraudulent practices are also
used as part of these schemes, including "bait and switch" tactics,
unauthorized trading, failure to execute sell orders, and excessive
markups or price increases.  Firms investigated for microcap fraud
have typically been owned or controlled by individuals with ties to
other firms with a history of stock fraud. 

The securities markets, of which microcap securities are a part, are
regulated by SEC, industry SROs, and state securities regulators. 
The SROs monitor members, including individuals and firms, for
compliance with federal and SRO requirements.  Among its
responsibilities, SEC inspects SRO compliance programs for adequacy
and conducts examinations of broker-dealers, including microcap
firms.  The states license firms and individuals to operate in their
jurisdictions.  Many states also conduct on-site examinations of
broker-dealers. 

To centralize broker licensing and registration, NASD and the North
American Securities Administrators Association (NASAA)\8 established
CRD in 1981.  The database was designed to provide a more efficient
licensing and registration process by eliminating redundant state
reporting requirements.  Operated by NASD Regulation Inc.  (NASDR),
CRD's centralized computer system has allowed individual brokers and
firms to satisfy both state and NASD reporting requirements.  Over
the years, however, CRD's role has expanded to serve several other
regulatory functions, such as gathering information for federal,
state, and SRO enforcement and examination purposes, including
identifying problem brokers or firms.  CRD has also become the
primary source of information for NASD's public disclosure program. 
Among other things, this program provides investors with information
on the professional background, business practices, and conduct of
NASD member firms and their brokers.  The information is available
via NASDR's toll-free telephone information service (hotline) or its
Internet web site. 


--------------------
\4 Penny stocks are generally defined by SEC rules as stocks having
an offer price of less than $5. 

\5 NASD's OTC Bulletin Board is a quotation service that displays
real-time quotes, last-sale prices, and volume information on OTC
securities.  OTC securities are not listed or traded on a national
securities exchange. 

\6 The National Quotation Bureau's Pink Sheets are daily printed
listings containing quotations for thousands of OTC stocks that are
not listed on a major stock market. 

\7 The Nasdaq Small Cap Market includes the securities of more than
1,300 smaller, less-capitalized companies that do not qualify for
inclusion in the Nasdaq National Market. 

\8 NASAA is a voluntary association of state, provincial, and
territorial securities administrators in the United States, Canada,
and Mexico that is devoted to investor protection and efficient
capital formation. 


   SCOPE AND METHODOLOGY
------------------------------------------------------------ Letter :3

To determine the status of SEC and SRO actions on recommendations in
our and SEC reports that address issues related to microcap stock
fraud, we reviewed SEC, NASD, and New York Stock Exchange (NYSE)
documents that report on their respective actions.  We also
interviewed officials of the SEC Divisions of Enforcement and Market
Regulation, SEC Office of Compliance Inspections and Examinations,
the Department of Justice, NASDR, NYSE, NASAA, and Securities
Industry Association.\9

In addition, we analyzed SEC and SRO data on examinations completed,
customer complaints, and disciplinary actions taken from 1992 through
1997. 

We did our fieldwork between February and July 1998 in accordance
with generally accepted government auditing standards.  We obtained
written comments on a draft of this report from SEC.  These comments
are discussed at the end of this letter and are reprinted in appendix
II. 


--------------------
\9 The Securities Industry Association is a trade group that
represents broker-dealers. 


   THE ACTIONS TAKEN RESPOND TO
   MANY OF OUR RECOMMENDATIONS
------------------------------------------------------------ Letter :4

SEC and the SROs have taken actions that respond to many of the
recommendations in our reports that address issues related to
microcap stock fraud.\10 The reports with recommendations that were
acted on focused on penny stock fraud;\11 unscrupulous brokers
(brokers who have committed a significant breach of sales practice
rules or have a history of repeated sales practice violations); \12
and NASD's toll-free telephone hotline.\13


--------------------
\10 Some of the actions taken on our recommendations involved changes
to industry rules.  See appendix I for a list of new, amended, and
proposed SEC and SRO rules addressing our and SEC report
recommendations and/or microcap stock fraud. 

\11 See Penny Stocks:  Regulatory Actions to Reduce Potential for
Fraud and Abuse (GGD-93-59, Feb.  3, 1993), which addresses NASD's
efforts to reduce fraud and abuse in the penny stock market. 

\12 See Securities Markets:  Actions Needed to Better Protect
Investors Against Unscrupulous Brokers (GGD-94-208, Sept.  14, 1994),
which addresses the extent to which unscrupulous brokers were active
in the securities industry, regulatory and industry efforts to
discipline unscrupulous brokers, and the industry's ability to
identify unscrupulous brokers through CRD. 

\13 See NASD Telephone Hotline:  Enhancements Could Help Investors Be
Better Informed About Brokers' Disciplinary Records (GGD-96-171, Aug. 
19, 1996), which addresses the accessibility of the NASD hotline to
investors, including how investors were informed about the hotline;
what perceptions users had about the usefulness and appropriateness
of the types of information provided by the hotline; and whether the
information provided by the hotline met NASD disclosure policies. 


      PENNY STOCK REPORT
---------------------------------------------------------- Letter :4.1

Our 1993 report on penny stock fraud recommended that SEC require
NASD to (1) provide callers using its toll-free telephone hotline
with information on final arbitration awards and (2) identify and
examine high-risk branch offices of penny stock broker-dealers. 
NASD's public disclosure program, which includes its toll-free
telephone hotline, now provides information on, among other things,
all consumer-initiated arbitrations that are pending or have been
settled (for $10,000 or more) and final arbitration decisions that
resulted in an award to the customer.  NASD district offices also
target branch offices for review based on complaints of customers,
termination of registered representatives for cause, and transactions
in microcap stocks.  In addition, NASD is developing an automated
risk-based approach to examination scheduling to identify
broker-dealers and branch offices for examination. 


      UNSCRUPULOUS BROKER REPORT
---------------------------------------------------------- Letter :4.2

Our 1994 report on unscrupulous brokers recommended that SEC impose a
permanent industry bar, with no opportunity for reentry, on certain
problem brokers and ensure that CRD includes SRO formal disciplinary
actions as well as information on customer complaints and their
dispositions.  SEC clarified in September 1994 that, absent
extraordinary circumstances, persons subject to bars with no
provision for readmission to the securities industry would be unable
to establish that the public interest was served by allowing their
reentry.  Also, SEC officials said that they have begun an inspection
of NASDR that will review actions taken on reentry applications.  In
addition, the NASD public disclosure program now discloses SRO formal
regulatory actions as well as customer complaints and their
disposition. 


      NASD HOTLINE REPORT
---------------------------------------------------------- Letter :4.3

Our 1996 report on the NASD hotline recommended that SEC encourage
NASDR to (1) publicize its hotline number to more investors, such as
by including the number on account-opening documents; (2) provide
hotline callers with all relevant CRD disciplinary-related
information or, at a minimum, inform them that the information is
available from most state regulators; (3) make disciplinary-related
information directly available to investors through the Internet; and
(4) ensure that the CRD information provided to callers is
disclosable and complete. 

Addressing these recommendations, SEC approved an NASD rule on
September 10, 1997, that requires members to provide customers, at
least annually, with written information on the NASDR hotline
telephone number, its Internet address, and the availability of a
brochure describing NASD's public disclosure program.  In addition to
informing investors of the availability of information from state
regulators, as of March 16, 1998, NASD reports information related to
pending and final disciplinary actions, civil judgments, arbitration
decisions, pending customer complaints, criminal convictions,
settlements of $10,000 or more, and bankruptcies.  On the same date,
CRD information also became available to the public over the
Internet, with disciplinary information available via electronic mail
(discussed below).  To better ensure the quality of the CRD data
disclosed, NASD now requires an additional review prior to data
input, has instituted a statistical quality-control process to
measure the accuracy of disclosures, and has added a requirement for
periodic examination of data by data quality professionals. 


   THE ACTIONS REPORTED RESPOND TO
   MANY SEC RECOMMENDATIONS
------------------------------------------------------------ Letter :5

SEC and the SROs have reported taking actions that respond to many
recommendations in two SEC reports that address issues related to
microcap stock fraud.\14 The first report addressed the sales
practice oversight of nine large broker-dealers (the large firm
project report).\15 The second report followed up on the first and
focused on firms with problem brokers (the sales practice sweep
report).\16


--------------------
\14 Some of the actions taken on SEC recommendations involved changes
to industry rules.  See appendix I for a list of new, amended, and
proposed SEC and SRO rules addressing our and SEC report
recommendations and/or microcap stock fraud. 

\15 See The Large Firm Project:  A Review of Hiring, Retention and
Supervision Practices (May 1994), which responded to concerns about
the increased frequency and severity of sales practice abuses.  SEC,
NYSE, and NASD staff conducted 170 examinations of 9 firms and their
161 branch offices in 32 states in completing the project. 

\16 See Joint Regulatory Sales Practice Sweep:  A Review of the Sales
Practice Activities of Selected Registered Representatives and the
Hiring, Retention, and Supervisory Practices of the Brokerage Firms
Employing Them (Mar.  1996), in which examiners interviewed 230
problem brokers during 179 branch examinations at 101 small-to-medium
size firms. 


      LARGE FIRM PROJECT REPORT
---------------------------------------------------------- Letter :5.1

The 1994 large firm project recommended that SEC and the SROs devote
additional resources to sales practice examinations and to
identifying and prosecuting problem brokers.  The large firm report
also recommended that (1) the SROs disclose all pending disciplinary
actions, (2) NASD require its members to report customer complaints
quarterly, (3) SROs enhance their tracking of regulatory filings
related to disciplinary actions and terminations and sanction firms
for failing to promptly and accurately file required forms, (4) SEC
take action to implement uniform policies governing liability for
information provided in regulatory filings, and (5) the securities
industry adopt a mandatory continuing education requirement. 

In response to the large firm report recommendations, federal, state,
and self regulators undertook the sales practice sweep.\17 As part of
the sweep, 101 small- to medium-size broker-dealers were examined,
focusing on the sales practices of selected problem brokers and the
hiring and supervisory practices of the firms employing them
(discussed further below).  As a result of the sweep, 28 firms and 23
brokers were referred for enforcement action.  In response to both
the large firm project and sweep report recommendations, SEC and the
SROs reported increasing their examination focus on sales practices
and hiring and supervisory practices.  In addition, SEC drafted
several new examination modules to further address microcap and penny
stock fraud, sales practices, and hiring and supervising problem
brokers.  SEC consolidated its SRO inspection and broker-dealer
examination programs and created a separate office of broker-dealer
examination oversight to expand and give greater focus to the
broker-dealer examination program.  As discussed above, NASD is
developing an automated risk-based examination system.  Furthermore,
NYSE added questions and procedures to its examinations and
implemented a surveillance system to track brokers with disciplinary
histories. 

Also in response to the large firm report recommendations, SROs are
now required to report all formal investigations as well as pending
and final disciplinary actions to CRD for public disclosure.  In
addition, NASD members are required to report certain customer
complaints within 10 business days and summary data on written
customer complaints each quarter.  In August 1994, SEC requested that
the SROs closely monitor the timeliness of required filings and
increase sanctions when noncompliance is discovered.  In April 1998,
NASD proposed a rule that would provide members with qualified
immunity for statements made in good faith in filings related to
disciplinary actions and terminations.  In 1995, SEC approved a
uniform industry continuing education program that requires periodic
training in regulatory matters and ongoing programs by firms to keep
brokers up to date.  A permanent continuing education council was
created to recommend the specific content of the curriculum and to
monitor the program. 


--------------------
\17 The sweep was conducted by SEC, NASD, NYSE, and the following
state securities regulators:  Alaska, Arizona, California, Colorado,
Connecticut, District of Columbia, Florida, Idaho, Illinois, Iowa,
Kansas, Maine, Maryland, Michigan, Montana, New Jersey, New Mexico,
Nevada, North Carolina, North Dakota, Oklahoma, Oregon, Pennsylvania,
Puerto Rico, Texas, Utah, Virginia, Washington, and Wisconsin. 


      SALES PRACTICE SWEEP REPORT
---------------------------------------------------------- Letter :5.2

The 1996 SEC sales practice sweep report recommended various
voluntary best practices for hiring and supervising problem brokers
and follow-up examinations for problem firms.  As previously
discussed, SEC and the SROs have reported increasing their
examination focus on firms with problem brokers, improving the
selection of firms for examination, and drafting new examination
modules.  The new modules should provide SEC a means of gauging
adherence to the best practices.  Also, in April 1997, NASD and NYSE
issued a joint notice to members that encouraged the adoption of the
best practices.  Although adoption of these practices was voluntary,
the notice provided guidance on heightened hiring and supervisory
procedures for brokers with prior disciplinary histories, customer
complaints, or arbitrations and detailed overall member supervisory
responsibility under existing rules.  The Securities Industry
Association adopted a similar set of best practices. 


   ACTIONS HAVE NOT BEEN COMPLETED
   ON SOME RECOMMENDATIONS
------------------------------------------------------------ Letter :6

Although the actions taken have responded to many of our and SEC
report recommendations, for some other recommendations, actions have
not been completed.  Actions have not been completed on our
recommendations related to the migration of unscrupulous brokers from
the securities industry; modernization of CRD to allow regulators to
more easily monitor brokers with disciplinary histories; and ability
of SEC to identify, across firms, trends in violations found during
its broker-dealer examinations.\18 Also, SEC's recommendation that
would require disclosures to customers on the availability of broker
disciplinary information prior to account activity has not been
implemented. 


--------------------
\18 See Securities Industry:  Strengthening Sales Practice Oversight
(GGD-91-52, Apr.  25, 1991), which addresses SEC oversight of SRO
monitoring and enforcement of sales practice compliance among
broker-dealers. 


      ACTION ON THE MIGRATION OF
      UNSCRUPULOUS BROKERS IS NOT
      COMPLETE
---------------------------------------------------------- Letter :6.1

Our report on unscrupulous brokers discussed the potential for
brokers barred from the securities industry to migrate to other
financial services industries, such as banking and insurance.  As a
result, we recommended that the Secretary of the Treasury work with
SEC and other financial regulators to (1) increase disclosure of CRD
information so that regulators can consider a broker's disciplinary
history in allocating examination resources and employers can use the
information in making hiring decisions and (2) determine whether
legislation or additional reciprocal agreements between SEC and other
financial regulators are necessary to prevent the migration of
unscrupulous brokers to other financial services industries. 

In 1996, the Office of the Comptroller of the Currency, Board of
Governors of the Federal Reserve System, and Federal Deposit
Insurance Corporation proposed a rule that would have required banks
to report the hiring of brokers to CRD and for brokers hired by banks
to take NASD qualification examinations.\19 Among other things, the
filings required by the proposed rule would have allowed bank
regulators to consider a broker's disciplinary history in allocating
examination resources, thereby, helping address the migration of
unscrupulous brokers to the banking industry.\20 To date, the
proposed rule has not been finalized.  In June 1998, NASD expressed
concern to the banking regulators over bank employees taking the NASD
examination.  NASD communicated that the use of its examinations
would not test for knowledge of bank rules and regulations.  NASD
recommended that new bank-specific examinations be developed and
offered to assist in developing them.  No further agreements on this
point have been reached. 

In the absence of a rule change, no reporting has occurred and thus
no record exists of the movement of unscrupulous securities brokers
to banks or unregistered affiliates of banks.  Completion of CRD's
modernization (discussed further below) will not ensure effective
surveillance of the migration of these brokers to banks because banks
are not required to report to CRD. 


--------------------
\19 61 Fed.  Reg.  68,824 (1996). 

\20 The agreement did not address the migration of unscrupulous
brokers to the insurance industry. 


      THE CRD MODERNIZATION NEARS
      COMPLETION
---------------------------------------------------------- Letter :6.2

Recommendations in our unscrupulous broker and hotline reports
addressed the need to modernize CRD to allow regulators to more
easily monitor brokers with disciplinary histories and to improve
public access to broker disciplinary information, including Internet
access.  Although many actions have been taken on these
recommendations, including limited Internet access, the CRD
modernization is not yet complete. 

As previously discussed, CRD's original role as the securities
industry's centralized licensing and registration system has expanded
and now includes numerous other regulatory and disclosure functions. 
CRD's original technology, however, was not able to accommodate this
expansion.  As a result, NASD began a redesign of CRD in 1992.  This
redesign has taken longer than expected, partly because of a switch
in 1997 to technology that would allow Internet access.  When
completed, regulatory components of the new system will provide (1)
automatic reports to regulators when certain predefined events occur,
such as multiple customer complaints against a broker; (2) greater
detection of late, deficient, or missed report filings; and (3)
customized analytical capabilities to help regulators identify
industry compliance trends, including those associated with specific
problem brokers and firms.  Also when completed, investors will be
able to view broker and firm disciplinary information while on line. 
Currently, this information can be requested on line, but the
response is provided via electronic mail.  Full implementation of all
system improvements, including enhanced regulatory functions and full
Internet access, is scheduled for late 1999. 


      SEC PLANS A NEW EXAMINATION
      TRACKING SYSTEM
---------------------------------------------------------- Letter :6.3

Our 1991 report on SEC oversight of industry sales practices
recommended that the agency explore ways to record and maintain
information on the number of each type of violation found during
on-site examinations of broker-dealers and, as one option, include
this information in its examination tracking system, called the
Examination Activity Tracking System (EATS).  The intent of our
recommendation was to address SEC's inability to identify, across
firms, trends in violations found during examinations that could
warrant greater regulatory attention.  Having such a capability would
enhance the agency's ability to more efficiently and effectively
target its resources.  According to SEC, its planned replacement of
EATS with the Super Tracking and Reporting System (STARS) will allow
headquarters and regional office staff to identify and analyze trends
in violations.  For example, SEC staff said they will be able to
query the system to determine the number of firms within a state or
across the United States that have been cited for specific
violations, such as those related to books and records violations or
specific types of fraudulent conduct.  Also, according to SEC, in
order to gather more information about the significance and extent of
violations found in examinations, the full text of all reports will
be stored on a computerized system, called Zyindex, that will enable
staff to search all reports using key words and to compile an
analysis of the information.  SEC staff told us that implementation
of STARS and Zyindex is scheduled to begin in the fall of 1998.  If
implemented as described, taken together, these enhanced capabilities
would be consistent with our recommendation that SEC be able to
analyze, across firms, trends in violations found during its
examinations of broker-dealers. 


      DISCLOSURES ARE NOT REQUIRED
      BEFORE ACTIVITY OCCURS IN AN
      ACCOUNT
---------------------------------------------------------- Letter :6.4

SEC's 1994 large firm report recommended that information on the
availability of a broker's disciplinary history via NASD's toll-free
hotline be disclosed to investors before any activity occurs in their
accounts.  Our hotline report suggested this information could be
included on account-opening documents or account statements. 
Investors could use such information to protect themselves against
unscrupulous brokers. 

In 1992, SEC's penny stock rules had been amended to require that
information on the availability of a broker's disciplinary history
via NASD's toll-free hotline be provided to a customer before
effecting any penny stock transaction with the customer.  However,
this rule did not cover nonpenny stock transactions (i.e., securities
priced at $5 or more).  On September 10, 1997, SEC approved NASD Rule
2280, which required NASD members to provide information on the
availability of broker disciplinary information to customers in
writing at least annually, along with the Internet web site address
of the NASD public disclosure program and a statement regarding the
availability of an investor brochure describing the program. 
However, the NASD rule does not require that the information be
provided before activity occurs in an account or at account opening. 

Since the issuance of the SEC report, numerous additional efforts
have been made to educate the public on the availability of
information on a broker's disciplinary history through NASD's
toll-free hotline and web site as well as through other information
on how to invest safely.  These efforts have included information
made available through federal, state, and SRO Internet web sites,
free publications on investing, and SEC town meetings for investors. 
NASD also stated that it includes the toll-free hotline number and
web-site address on every disciplinary action press release and has
publicized them in a multilingual radio and television public service
announcement campaign, in investor fairs and seminars, and in
conjunction with investor and other associations.  As a result,
access to this information is now more readily available and widely
disseminated.  Nonetheless, we believe SEC's initial rationale for
recommending that information on a broker's disciplinary history be
available to investors before any activity occurs in their accounts
remains valid. 


   CONCLUSIONS
------------------------------------------------------------ Letter :7

SEC and the SROs have taken actions that respond to many of our and
SEC report recommendations.  These actions have improved the
availability of registration and disciplinary information on brokers
and firms, branch office audit selection, and availability and
analysis of customer complaints, which should enhance regulatory
oversight and investor protection.  We continue to support the need
to implement prior recommendations related to the migration of
unscrupulous brokers, completion of CRD modernization, ability of SEC
to identify trends in violations across firms, and disclosure of the
availability of broker disciplinary information before account
activity.  Full implementation of these recommendations should
further enhance regulatory oversight and investor protection. 


   AGENCY COMMENTS AND OUR
   EVALUATION
------------------------------------------------------------ Letter :8

Written comments from SEC on a draft of this report are contained in
appendix II.  SEC and NASD also provided technical comments on the
draft report, which were incorporated as appropriate. 

SEC said that most of SEC and our recommendations have been
implemented and focused its comments on the four recommendations
where actions have not been completed.  SEC commented that it expects
to continue working with NASD to complete the CRD upgrade.  It also
commented that planned enhancements to its examination tracking
capabilities will enable it to identify trends in violations.  If
implemented as described, these enhanced capabilities would be
consistent with the intent of our recommendation that SEC be able to
analyze, across firms, trends in violations found during its
broker-dealer examinations that could warrant greater regulatory
attention.  In addition, SEC explained NASD's concerns about the
banking regulators' proposed rule on the migration of unscrupulous
brokers. 

Finally, regarding SEC's recommendation to disclose the availability
of broker disciplinary information prior to any account activity, the
agency commented that the availability of this information is now
widely publicized to investors for their use before opening an
account and committing to buy or sell securities.  Although we agree
that this publicity is valuable, we also believe that SEC's original
recommendation to require the disclosure of the availability of this
information directly to individual investors when they are about to
open an account would provide the information to the investor when it
is of immediate use. 


---------------------------------------------------------- Letter :8.1

As agreed with your offices, unless you publicly announce its
contents earlier, we plan no further distribution of this report
until 5 days after the date of issuance.  At that time, we will send
copies of this report to the Chairman, SEC and other interested
parties.  We will also make copies available to others upon request. 
Please contact me at (202) 512-8678 or Cecile O.  Trop, Assistant
Director, at (312) 220-7600 if you or your staff have any questions. 
Major contributors to this report are listed in
appendix III. 

Richard J.  Hillman
Associate Director, Financial Institutions
 and Markets Issues


NEW, AMENDED, AND PROPOSED SEC,
NASD, AND NYSE RULES RELATED TO
MICROCAP FRAUD
=========================================================== Appendix I


   SEC AMENDED RULE
--------------------------------------------------------- Appendix I:1


      AMENDMENTS TO
      REGULATION S
------------------------------------------------------- Appendix I:1.1

On February 17, 1998, the Securities and Exchange Commission (SEC)
adopted amendments to Regulation S that are designed to prevent
abuses related to offshore offerings of equity securities of domestic
issuers.  Regulation S provides a safe harbor from the registration
requirements of the Securities Act of 1933 for offers and sales of
securities by both foreign and domestic issuers that are made outside
the United States.  In abusing this safe harbor, issuers have
illegally distributed securities in the United States and, in doing
so, have denied investors the protections provided by registration
under the Securities Act.  Under the amendments, equity securities of
U.S.  issuers that are sold offshore under Regulation S would be
classified as "restricted securities" within the meaning of Rule 144
under the Securities Act, and the period during which these
securities cannot be distributed in the United States would be
lengthened from 40 days to 1 year.  SEC also adopted amendments that
would affect applicable reporting requirements along with other
amendments intended to prevent further abuses of Regulation S. 


   SEC PROPOSED RULES
--------------------------------------------------------- Appendix I:2


      AMENDMENTS TO RULE 504 OF
      REGULATION D
------------------------------------------------------- Appendix I:2.1

On May 21, 1998, SEC proposed amendments to Rule 504 of Regulation D
that would require all securities issued under the rule to be
"restricted securities" and would allow their resale only after
certain criteria were met.  Rule 504 allows companies to raise up to
$1 million per year in "seed capital" without complying with
Securities Act registration requirements.  SEC is concerned that the
freely tradable nature of securities issued in Rule 504 offerings may
have facilitated a number of fraudulent market manipulations through
the over-the-counter (OTC) Bulletin Board and National Quotation
Bureau's Pink Sheets.  The comment period on these amendments expired
on July 27, 1998. 


      AMENDMENTS TO RULE 15C2-11
------------------------------------------------------- Appendix I:2.2

On February 17, 1998, SEC proposed amendments to Rule 15c2-11 that
would require all broker-dealers to review issuer information before
publishing quotations on non-Nasdaq OTC securities and require
broker-dealers quoting a price to annually review updated issuer
information.  Rule 15c2-11 currently operates so that just the first
market maker\21 in these stocks is required to review basic issuer
information before publishing quotations for that issuer's
securities.  Other market makers may "piggyback" on the first market
maker's quotes and publish quotes after 30 days without reviewing
issuer information.  Retail brokers "hyping" a microcap security may
refer to a market maker's quotation when marketing a security to a
potential customer.  SEC is concerned that most market makers for
unlisted securities publish quotations without reviewing current
financial and other information on the issuer.  The comment period
for these amendments expired on April 27, 1998. 


--------------------
\21 Market makers are dealers who, with respect to a security, hold
themselves out as being willing to buy and sell the security for
their own accounts on a regular or continuous basis. 


      AMENDMENTS TO FORM S-8 AND
      RELATED RULES
------------------------------------------------------- Appendix I:2.3

On February 17, 1998, SEC proposed amendments to Form S-8 and related
rules that would restrict the use of the form for the sale of
securities to consultants and advisors.  Form S-8 is the short-form
registration statement for offers and sales of a company's securities
to its employees, including consultants and advisors.  The amendments
are designed to deter misuse of this form either by avoiding the
Securities Act requirements that apply to securities sales to
nonemployees or by issuing securities as compensation to stock
promoters.  Other proposed amendments would permit Form S-8 to be
used by employees' family members for the exercise of stock options
that employees give as gifts to their families.  The comment period
for these amendments expired on April 27, 1998. 


   AMENDMENTS OR PLANS BEING
   CONSIDERED BY SEC
--------------------------------------------------------- Appendix I:3


      AMENDMENTS TO PENNY STOCK
      RULES
------------------------------------------------------- Appendix I:3.1

Currently, the definition of "penny stock" excludes securities that,
among other things, are priced at $5 or more per share.  However, SEC
believes that some broker-dealers have circumvented the rules by
pricing securities above the $5 threshold.  The SEC Chairman has
testified that SEC is considering whether to recommend changing the
penny stock rules to raise the price threshold to cover the types of
securities that might be involved in microcap stock fraud. 


      PLAN FOR NATIONAL SECURITIES
      CLEARING CORPORATION
      REPORTING ON SUSPICIOUS
      TRANSACTIONS BY INTRODUCING
      BROKERS
------------------------------------------------------- Appendix I:3.2

Under a plan being discussed by the securities industry and SEC, the
National Securities Clearing Corporation (NSCC)\22 would consolidate
a variety of data received from clearing firms, SROs, and other
sources.  NSCC would use these data to identify suspicious activity
by broker-dealers (introducing brokers (IB) and others), and this
information would be made available to regulators. 


--------------------
\22 NSCC, owned jointly by the New York Stock Exchange (NYSE), the
National Association of Securities Dealers (NASD), and the American
Stock Exchange, clears 98 percent of all stock and bond transactions
in the United States. 


   NASD NEW AND AMENDED RULES
--------------------------------------------------------- Appendix I:4


      NEW RULE 2280
------------------------------------------------------- Appendix I:4.1

On September 10, 1997, SEC approved NASD Rule 2280, effective January
1, 1998, which requires NASD members that carry customer accounts to
provide customers in writing, at least once each calendar year, the
NASD public disclosure program hotline number and web site address as
well as a statement regarding the availability of an investor
brochure describing the public disclosure program. 


      NEW RULE 2211
------------------------------------------------------- Appendix I:4.2

On December 2, 1996, SEC approved NASD Rule 2211, effective December
2, 1996, that imposes time restrictions and disclosure requirements
on telephone calls to customers by NASD members and their associated
persons. 


      NEW RULE 3070
------------------------------------------------------- Appendix I:4.3

On September 8, 1995, SEC approved NASD Rule 3070 for reporting
customer complaint information and other specified events to NASDR. 
The rule, which became effective on October 15, 1995, requires that
NASD members report to NASDR if any of 10 specified events occur and
that they provide quarterly summary statistical information on
written customer complaints. 


      NEW RULE 3110(G)
------------------------------------------------------- Appendix I:4.4

On June 9, 1995, SEC approved NASD Rule 3110(g), or "cold calling"
rule, effective June 9, 1995, consistent with rules of the Federal
Communication Commission promulgated under the Telephone Consumer
Protection Act, which require telemarketers to establish and maintain
a list of persons who have requested that they not be contacted by
the telemarketer (do-not-call list). 


      NEW RULE 1120
------------------------------------------------------- Appendix I:4.5

On February 8, 1995, SEC approved NASD's membership and registration
Rule 1120 to implement the Securities Industry Continuing Education
Program, which became effective July 1, 1995.  The rule required all
registered persons to take computer-based training within 120 days of
their second, fifth, and tenth registration anniversaries.  Effective
July 1, 1998, this training is required every 3 years. 


      AMENDMENT TO RULE 3010
------------------------------------------------------- Appendix I:4.6

On April 17, 1998, SEC approved an NASD amendment to Rule 3010 that
requires an NASD member firm to tape record conversations between
customers and registered representatives if it hired a significant
percentage of individuals (dependent on firm size) from disciplined
firms. 


      AMENDMENT TO RULE 8310
------------------------------------------------------- Appendix I:4.7

On January 20, 1998, SEC approved an amendment to Interpretive Memo
8310-2 (Release of Disciplinary Information), which allowed for the
release of additional disciplinary information that is required to be
disclosed pursuant to amended forms U-4, U-5, and BD, including, but
not limited to (1) customer-initiated arbitrations that are pending
or settled (for $10,000 or more), (2) civil proceedings and written
customer complaints (within certain dollar limits), (3) current
investigations involving criminal or regulatory matters, and (4)
bankruptcies less than 10 years old.  The rule also was amended to
allow NASDR to respond to electronic requests for information. 
Amendments in 1993 allowed for the release of pending formal SRO
disciplinary actions, criminal indictments, civil judgments, and
final judgments in arbitration decisions. 


   NASD PROPOSED RULES
--------------------------------------------------------- Appendix I:5


      RULES 2315 AND 2360
------------------------------------------------------- Appendix I:5.1

In July 1998, NASD filed proposed Rules 2315 and 2360, which would,
respectively, require NASD members to (1) review current issuer
financial statements prior to recommending a transaction to a
customer in an unlisted equity security and (2) provide a disclosure
statement to a customer on each customer's confirmation following any
trade of an unlisted equity security.  SEC has not yet published the
proposals for public comment. 


      AMENDMENTS TO RULES 6530 AND
      6540
------------------------------------------------------- Appendix I:5.2

In July 1998, NASD filed an amendment to Rule 6530 to limit
quotations on the OTC Bulletin Board to the securities of issuers
that are current in reports to be filed with SEC or other regulatory
authorities and a companion Rule 6540 that would prohibit an NASD
member from quoting a security on the OTC Bulletin Board unless the
issuer's filings are current.  SEC has not yet published the
proposals for public comment. 


      INTERPRETATION OF RULE 3010
      AND AMENDMENT TO RULE 1060
------------------------------------------------------- Appendix I:5.3

In July 1998, NASD filed a proposed interpretation to Rule 3010 and
an amendment to Rule 1060 that would limit the kinds of cold calls
that may be made by unregistered persons and impose obligations on
member firms to supervise these employees.  However, in its
description of the proposal, NASD states that "the proposed rule
change would permit members to use third-party telemarketing firms"
to make cold calls on behalf of the member firm.  SEC has not yet
published the proposal for public comment. 


      RULE 1150
------------------------------------------------------- Appendix I:5.4

On April 21, 1998, NASD filed proposed Rule 1150 with SEC to provide
NASD members with qualified immunity in arbitration proceedings for
statements made in good faith in certain required disclosures filed
with NASD on forms U-4 and U-5, the uniform registration and
termination notices for registered persons, respectively.  The
comment period expired on June 19, 1998. 


      RULE 3230
------------------------------------------------------- Appendix I:5.5

On November 21, 1997, SEC published for comment a proposed change to
NASD Rule 3230 that would require clearing firms to (1) forward
customer complaints about an IB to the IB and the IB's designated
examining authority, (2) notify complaining customers that they have
the right to transfer their accounts to another broker-dealer, (3)
provide IBs with a list of exception reports to help them supervise
their activities, and (4) assume liability for any mistakes or fraud
made by an IB that issues checks drawn on the clearing firm's
account.  The comment period expired on December 22, 1997. 


   NYSE PROPOSED RULE
--------------------------------------------------------- Appendix I:6


      AMENDMENT TO RULE 382
------------------------------------------------------- Appendix I:6.1

NYSE proposed an amendment to Rule 382 on September 16, 1997, that is
similar to proposed NASD Rule 3230.  The comment period has expired. 




(See figure in printed edition.)Appendix II
COMMENTS FROM SEC
=========================================================== Appendix I

those in the report text appears at the end of this appendix. 



(See figure in printed edition.)



(See figure in printed edition.)


The following is GAO's comment on the August 28, 1998, letter from
the Securities and Exchange Commission. 

GAO COMMENT

Based on discussions with SEC staff to further clarify the intent of
our recommendation and the capabilities of SEC's planned system
enhancements, we revised the text of the report.  The report now
recognizes that, if implemented as described, SEC's planned
enhancements to its systems capabilities would be consistent with the
intent of our recommendation.  The intent of our recommendation was
that SEC be capable of identifying, across firms, trends in
violations found during its broker-dealer examinations that could
warrant greater regulatory attention. 


MAJOR CONTRIBUTORS TO THIS REPORT
========================================================= Appendix III

CHICAGO FIELD OFFICE

Cecile O.  Trop, Assistant Director
Roger E.  Kolar, Evaluator-in-Charge

GENERAL GOVERNMENT DIVISION,
WASHINGTON, D.C. 

James R.  Black, Senior Evaluator

OFFICE OF GENERAL COUNSEL,
WASHINGTON, D.C. 

Rosemary Healy, Senior Attorney


*** End of document. ***