Current Legal Issues Affecting Central Banks, Volume III.

Chapter 16 Government Securities Market Regulation: The Case of Salomon Brothers

Robert Effros
Published Date:
August 1995
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On May 20, 1992, the U.S. Securities and Exchange Commission (SEC) announced the filing and simultaneous settlement of charges against Salomon Inc. and its broker-dealer subsidiary, Salomon Brothers Inc., relating to securities law violations arising out of its trading activities in the U.S. government securities market.1 The settlement, which also encompassed charges that were or could have been asserted by the Department of Justice, requires the payment of civil sanctions of $290 million of which up to $100 million may be used to satisfy civil damage claims. This unprecedented action against a government securities broker-dealer followed less than a year after the public revelation of a broad government investigation into the firm’s government securities trading and irregularities in the government securities market. The firm’s disclosure in August 1991 of the government investigation and its admission of improprieties rocked the world’s financial community and resulted shortly thereafter in the resignation of the firm’s senior management.

This investigation, along with a related investigation into the activities of a large number of brokers and dealers engaged in the securities market for government-sponsored enterprises, touched off a significant public debate on the extent to which the government securities markets should be regulated. This paper discusses these regulatory issues against the backdrop of the Salomon case, reviewing, first, certain aspects of the Salomon case and related investigations and, second, specific regulatory and legislative proposals aimed at reforming the U.S. government securities market.

Need for Reform

The Salomon episode revealed significant deficiencies in the operation and integrity of the government securities market in the United States, the largest and most liquid securities market in the world. The discovery of these abuses evidenced a need to reconsider the regulatory objectives for that market and how best to accomplish them. The specific proposals that have been enacted or suggested in the United States may lack direct parallels in other countries.2 There is, however, a fundamental issue that cuts across the unique features of government securities markets in different countries. That is the need for fair, efficient, and transparent trading of government securities.

There is a tension between the views of government finance officials and securities regulators on this subject. Government finance officials, although not insensitive to the need for market regulation, generally emphasize funding concerns related to the important and specialized role played by government securities in national economic and financial policy. Securities regulators, on the other hand, while acutely aware of the important function served by the government securities market, tend to view the needs of the market from a securities market perspective. Notwithstanding these two positions, tension between government funding needs and securities regulation objectives is not as great as some have suggested: public confidence in market efficiency, integrity, and fairness complements rather than conflicts with government funding requirements.

In the Salomon case and the policy debate that ensued, a number of policy conclusions emerged, three of which should be mentioned at the outset. First, the Salomon case underscores the need to revisit the way the United States regulates its government securities market. The number and magnitude of Salomon’s violations, as well as the duration over which the misconduct occurred, when coupled with the difficulties encountered in investigating the case, indicate a fundamental need to reconsider the appropriate mechanisms for achieving cost-effective regulation in this market.

Second, an approach to market regulation that places excessive reliance on self-restraint, without adequate oversight by regulators or without adequate mechanisms to ensure market integrity and fairness to investors, may simply be too vulnerable to recurrent abuses, especially in an environment characterized by rapid financial innovation and increased investor participation. As former SEC Chairman Breeden indicated, “an honor code” is not a substitute for legal obligation in dynamic, sophisticated securities markets, such as the U.S. government securities market.3 Markets that are vulnerable to abuse, even when actual abuses are rare, suffer over the long term in the eyes of investors. The purpose of rethinking regulatory approaches in this area is not to exercise greater control over the government securities market but to enhance market efficiency, integrity, and fairness.

Third, the number of different government agencies whose regulatory purposes are implicated in the government securities market and the present allocation of regulatory responsibilities among those agencies require that careful thought be given to how these agencies interact. For example, some suggest that issues related primarily to market and trading practices have been assigned to agencies that regard the government securities market as essentially different from other securities markets. While there may be some justification for such a view with respect to the primary government securities market, the proposition seems questionable when applied to the secondary market. Although the secondary-market issues relating to efficiency, integrity, and fairness may differ in some respects from the corresponding concerns in corporate securities markets, there are common issues that call for fundamentally similar regulatory approaches.

Overview of the U.S. Government Securities Market

The largest segment of the U.S. government securities market consists of Treasury securities issued to finance the U.S. national debt.4 As of December 31, 1991, $2.5 trillion in marketable Treasury securities were held by private investors.5 The size of the secondary market for government securities in the United States necessarily raises traditional regulatory concerns relating to market efficiency, integrity, and fairness. Daily secondary-market trading in U.S. Treasury securities dwarfs trading activity in secondary equity markets. Over $128 billion in net principal amount of Treasury securities changes hands each day,6 more than ten times the market value of daily secondary equity trading in the United States.7 However, the number of actively traded U.S. Treasury issues amounts to only about 300, whereas actively traded equity, municipal, and corporate debt issues number in the tens of thousands.

Before the revelations connected with the Salomon case, there were 38 so-called primary dealers who received special privileges in the auction process, including the ability to place bids on behalf of themselves and their customers as well as special payment privileges. In return for such privileges, primary dealers were obligated to be significant participants in each auction and in the secondary market. These dealers were responsible for the largest share of the new issue market.8 To ensure the broad distribution of Treasury securities, the Treasury limited the maximum amount of securities that may be awarded to a single bidder to 35 percent of the public offering and did not recognize amounts bid at any one yield from a single bidder in excess of 35 percent of the public offering.9 Smaller bidders were allowed to participate in the auction in a noncompetitive bidding process. In recent years, when-issued trading has been permitted prior to the auction, during the period between the announcement and the issuance of a new Treasury issue, usually about two weeks.10

Trading Abuses in the Government Securities Market

Salomon Case

In late May 1991, rumors began circulating in the government securities market of a short “squeeze” with respect to the May 22, 1991, auction for two-year Treasury notes. A squeeze arises when there is an inadequate supply of a particular issue of securities to meet demand. An inadequate supply of securities occurs when participants sell securities that they do not own and temporarily borrow securities to cover themselves. This is otherwise known as creating a “short position.” In a squeeze, the price of the particular security and the costs of borrowing it in the “repo” market may increase dramatically relative to other Treasury securities of similar coupon and maturity.11 Markets in which there is significant when-issued trading, such as exists in advance of a new Treasury auction issue, are vulnerable to squeezes because short-sellers must cover their positions after auction results are announced.

On May 30, 1991, two days after receiving notification from the Treasury of possible irregularities in connection with the May auction, the SEC’s Division of Enforcement opened an informal investigation and began to gather information. During the course of the investigation, Salomon began conducting its own internal investigation. On August 9, it issued a press release disclosing that the firm had “uncovered irregularities and rule violations in connection with its submission of bids” in three specific auctions of Treasury securities and that certain other irregularities had been discovered.12 The firm’s release noted that it had violated the Treasury Department’s 35 percent rule in connection with its unauthorized bids and announced that the firm was suspending two managing directors at its Government Trading Desk and two other employees.13 Within days, Salomon issued a second press release offering additional details regarding irregularities in other Treasury auctions.14 In addition, Salomon acknowledged for the first time that three of its senior officers had been notified in April of an unauthorized bid in an earlier Treasury auction. On August 18, Salomon’s board of directors accepted the resignations of the three senior officers.15

The SEC’s investigation of the government securities market continued. Over 400 subpoenas and document requests were issued, more than 200 witnesses gave testimony under oath, producing more than 30,000 pages of transcripts, and hundreds of thousands of pages of records and documentary evidence of various kinds were obtained. In its investigation, the SEC worked closely with officials from the Treasury, the Federal Reserve, the Department of Justice, and the U.S. Attorney’s Office.

The complaint, filed by the SEC on May 20, 1992, identified ten false bids made by Salomon in nine auctions of Treasury securities over a two-year period between August 1989 and May 1991.16 The false bids typically involved unauthorized bids in the names of customers for hundreds of millions of dollars in Treasury securities and in some cases billions of dollars, enabling the firm to circumvent the Treasury Department’s 35 percent limitation in acquiring over $9.5 billion worth of Treasury securities. In one case, Salomon induced another primary dealer to submit a bid as Salomon’s nominee, and the allocation of securities awarded pursuant to that bid was subsequently purchased from the primary dealer by Salomon at one basis point over cost.

According to the SEC’s complaint, Salomon’s violations were not limited to the Treasury securities market but also included violative conduct during the initial distribution of government-sponsored enterprise (GSE) debentures. Moreover, in connection with the transactions relating to the false bids, the firm committed numerous record-keeping violations under federal securities laws.17 The SEC complaint also alleged that Salomon had failed to supervise adequately the individual in charge of Salomon’s government trading activities. Although senior management learned of certain irregularities as early as late April, they failed to alert government authorities of these discoveries and take appropriate steps to prevent additional violations.

As noted above, Salomon settled the law enforcement action without admitting or denying the allegations set forth in the SEC’s complaint. The settlement also resolved other potential claims not set forth in the SEC’s complaint that could have been asserted by the Department of Justice in separate litigation. Salomon agreed to pay a total of $290 million in civil sanctions and forfeitures and to establish a claims fund to compensate those damaged by violations of the law. Salomon also consented to the entry of injunctive relief barring it from future violations of the securities laws, agreed to a censure, and agreed to maintain appropriate procedures to prevent similar violations in the future. The settlement did not resolve the legal liability of individuals employed at Salomon or other firms.

GSE Securities Investigation

Although the Salomon case received wide coverage in the press, there was another investigation relating to abuses in GSE securities that, arguably, is as significant.18 Whereas Salomon, by itself, might be dismissed as an isolated episode involving only a few participants in the government securities market, the results of the SEC’s GSE securities investigation revealed misconduct on the part of a wide spectrum of government securities brokers and dealers.

The GSE investigation grew directly out of the Salomon investigation. The primary distribution of GSE securities traditionally has been accomplished through methods that differ from those employed for Treasury securities.19 Many GSE issues are distributed through offerings in which selling groups, consisting of brokerage firms and banks, solicit customer interest in advance of the offering and provide the GSE with a preliminary indication of such interest. The issue is then preliminarily priced, and the selling group members proceed to seek out customer orders. Typically, reported demand outstrips supply. Accordingly, the GSE must allocate securities among the members of the selling group. In doing so, GSEs have placed chief reliance on historic allocation percentages of the selling group members over other factors. This led to a practice in which selling group members routinely inflated their customer orders in order to ensure a larger allocation of securities.20

In January 1992, the SEC brought charges of securities violations against 98 broker-dealers and financial institutions that were members of GSE selling groups. The SEC’s complaint additionally alleged that virtually every bank and securities firm participating in the GSE selling groups had violated the federal securities laws by creating false books and records in connection with primary distributions of GSE securities. The SEC imposed relief requiring these banks and securities firms to cease and desist from committing future violations and to adopt and implement policies or procedures designed to prevent future violations.21 In addition, each broker-dealer was required to pay civil penalties of up to $100,000 to the U.S. Treasury.

Observations on the Government Securities Cases

There are two key lessons for regulators that emerge from the particulars of the Salomon and GSE securities cases and that are related to the policy conclusions already mentioned.

Accessible Markets for Purposes of Investigation

The Salomon and GSE securities cases posed tremendous challenges to law enforcement officials. The cases involved insufficient record keeping and inadequate access to transactional information with respect to market activity in the government securities market. What records were maintained were frequently kept in nonstandardized formats. As a consequence, time-consuming and expensive efforts were needed to reconstruct and gather marketwide information. The lack of readily available information in an acceptable format creates the potential that certain violators may escape the scrutiny of law enforcement officials.

Essential Role of Firms in Policing the Market

One of the most dismaying aspects of the Salomon incident was not that traders at a prestigious investment banking firm committed egregious violations, but rather that the firm failed to take prompt corrective action once the violations became known. The integrity of the market depends vitally on the integrity of the participants. Large and sophisticated market participants must recognize their duty to supervise their employees and traders and should bear significant responsibility in policing the conduct of such personnel. Yet, notwithstanding Salomon’s failure to discharge its supervisory function prior to the uncovering and disclosure of the violations, Salomon has made an effort to restore its good standing. Such actions have included firing individuals whom the firm believed to be implicated in the violations, bringing in entirely new senior management, instituting new compliance procedures, communicating to employees these strict standards of conduct, and cooperating with the government’s various investigations. As former SEC Chairman Breeden has noted, these efforts were exemplary.22

Reform Proposals in the Wake of the Salomon Scandal

The Salomon case had another dimension that has only been touched on so far. Before any hint of trading abuses by Salomon had emerged, Congress was engaged in a limited review of Treasury’s rule-making authority with respect to the government securities market.23 The revelations regarding Salomon’s trading violations infused these legislative deliberations with far greater significance and prompted far closer scrutiny by legislators and regulators of the existing scheme of regulation over the government securities market.

In light of the Salomon case, the Treasury, the SEC, and the Board of Governors of the Federal Reserve System prepared a report for Congress on the government securities market. That report, the Joint Report on the Government Securities Market, was issued at the beginning of 1992.24 It marked a significant effort to address the need for reform in the government securities market.

Several bills were before the Congress in 1992 relating to the government securities market. One that was particularly significant was House Bill 3927.25 This bill attempted to deal with deficiencies in the regulatory structure revealed by the Salomon case. The Senate also had passed legislation, but its principal bill was passed before the Salomon scandal and, consequently, did not respond to the significant regulatory issues that regulators or the House of Representatives sought to address.26 Accordingly, the 1992 House legislation developed a more suitable legislative approach to the regulatory issues.

Government Securities Regulation and the Government Securities Act of 1986

The Treasury has long exercised principal responsibility for regulating the distribution of Treasury securities. Until the relatively recent enactment of the Government Securities Act of 1986 (GSA),27 there were significant regulatory gaps with respect to the government securities markets.28 The GSA was enacted following the failure of two government securities broker-dealers, which caused several financial institutions to sustain significant losses. The GSA expands the degree of regulation to which government securities brokers and dealers are subjected. For example, the Act requires that previously unregistered government securities brokers and dealers register with the SEC and self-regulatory organizations (SROs).29 Further, the Act authorizes the Treasury to establish financial responsibility requirements, rules for the protection of investors’ securities and funds, and record-keeping regulations.30

At the time of the GSA’s enactment, the government securities market was perceived as an institutional market, and the focus of the legislation was therefore aimed at ensuring capital adequacy. As a result, the GSA is limited in scope. For example, the government securities market is exempt from securities law provisions that would permit the SEC or an SRO to require market surveillance systems, and government securities brokers and dealers are not subjected to the same sales practice requirements as other registered broker-dealers.31

Areas of Consensus Regarding Reform Proposals

The Joint Report reappraises the operations and regulatory scheme that exist for the government securities market. It reflects substantial agreement among the Treasury, the SEC, and the Federal Reserve regarding three measures aimed principally at reforming the primary distribution market and averting short squeezes. The agencies also agree with the reauthorization of Treasury’s rule-making authority.

Broadening Participation in Auctions

Since Salomon’s disclosures, the Treasury and the Federal Reserve have recommended broadening participation in government securities auctions. These recommendations do not require new legislation. Therefore, the Treasury has already begun to implement some of them. Reforms that have already been completed or are under way include cutting back on the special rights of primary dealers and depository institutions. In order to accomplish this objective, all registered government securities brokers and dealers are permitted to submit bids for customers in Treasury auctions, and cumbersome deposit and payment procedures have been streamlined. Also, to facilitate greater participation by small bidders, the noncompetitive award limitation for notes and bonds has been raised. Last, spot checks, written certification, and confirmation have been instituted to verify the identity of bidders and compliance with auction rules.

The Treasury will also establish a “reopening” policy to combat short squeezes, whereby it will provide additional quantities of a security to the market when it has determined that an acute, protracted shortage exists, regardless of the reason for the shortage.32 The Treasury also published, for comment, a uniform offering circular describing auction procedures (including those just described) that would, for the first time, put in one place all of the rules for Treasury auctions. Finally, the Treasury has announced it will accelerate the schedule for automating auctions.33

False or Misleading Written Statements to Issuers

There was substantial agreement regarding the need for legislation that would permit government agencies to police the auction process more effectively and protect against the clearest forms of abuse. Specifically, the SEC, Treasury, and the Federal Reserve all expressed support for legislation that would make it an explicit violation of the federal securities laws to submit a false or misleading written statement to any issuer of government securities in connection with the primary issuance of such securities.34

Large-Position Reporting

The SEC, the Treasury, and the Federal Reserve Bank of New York expressed support for legislation that would grant the Treasury the authority to require reports from holders of large positions, in particular Treasury securities.35 The purpose of such authority would be to enhance the ability of regulators to deter, detect, and prosecute a short squeeze and other forms of manipulative market practices.

Areas of Controversy Regarding Reform Proposals

The measures instituted by the Treasury to reform the auction process and the other legislative proposals described above, proposals on which the Treasury, the SEC, and the Federal Reserve Board basically agree, rely on important positive reforms to curb fraudulent and manipulative conduct.

The SEC supports three additional provisions contained in the 1992 House legislation that are specifically aimed at enhancing the efficiency and integrity of the secondary market but that have not been embraced by the other government agencies: (i) backup authority to compel enhanced public dissemination of transaction information in the secondary market for government securities; (ii) additional authority to mandate record keeping to facilitate future investigations; and (iii) new authority to impose sales practice rules in government securities markets.36 These recommendations are discussed below.

Public Access to Market Information

The SEC has long regarded market “transparency,” the availability to all market participants of real-time trade and quotation information and other market-related information, such as information about the depth of the market, as essential to fair and equitable securities markets.37 Transparency enhances pricing efficiency by eliminating asymmetries in information between market “insiders” and public investors on the outside. By eliminating such disparities, market participants are able to make valuation decisions with greater certainty. Transparency also promotes market integrity and fairness by enhancing the ability of customers to determine whether they are receiving a fair price and increasing the ability of regulators to detect and deter manipulative trading. Given the strong regulatory commitment to transparent securities markets, it would be incongruous not to foster transparency in America’s largest securities market absent strong countervailing reasons.

The private sector has been slow to develop methods that give the public access to information in the government securities market. Between 1986 and 1990, several private sector efforts with the potential to expand transparency were undertaken without success.38 Although public access to government trades and quotes has improved since 1990 with the development of several private information systems, accessibility still falls well short of the level of transparency attained in equity markets. For example, in 1991, a private sector initiative known as GOVPX, Inc. was created. GOVPX, a joint venture of several primary dealers and interdealer brokers, provides price and quotation information 24 hours a day. However, GOVPX fails to provide the size of the market associated with bids and offers or information on certain categories of Treasury and non-Treasury securities. Further, GOVPX was designed to cover “only trading volume effected through contributing interdealer brokers. It does not report trading volume among primary dealers or between a primary dealer and a customer … that is not effected through an interdealer broker.”39 Accordingly, “a substantial amount of market activity is not reflected in GOVPX reports.”40

Despite recent trends toward increased transparency, the SEC continues to believe that a governmental role is required to guarantee public dissemination of market data relating to government securities. The SEC’s views favoring increased transparency are reflected in the 1992 House bill. Two tiers of backup rule-making authority would be given to the SEC to foster price transparency for non-mortgaged backed government securities. The first tier would be triggered only after an affirmative finding by the SEC that, with respect to a particular class or category of securities, information reported through “broker screens,” or government securities information systems, was not available to investors in a timely manner and on a fair, reasonable, and nondiscriminatory basis, and that investors were not able to determine the prevailing market price of securities quoted on these systems. Upon such a finding, the SEC would be authorized to act to ensure that these objectives are achieved. The second tier is designed to ensure that, if existing systems fail to provide sufficient price information, the SEC could require dealers to report their trades to a “securities information processor” (acting as a replacement information dissemination system) and could mandate the development of adequate information systems. Significantly, in recognition of the vital interest of the Treasury in the government securities markets, this authority could be triggered only if the Treasury determined that price information reported through existing systems was inadequate.

Backup transparency authority is not meant to displace private sector initiatives to provide the information necessary for an efficient and fair market. Rather, the SEC would continue to give private sector efforts a chance to develop, and the SEC’s authority would become available only upon a finding that existing systems for providing information are inadequate in specific respects. Thus, rather than assuming that such regulation is necessary, the legislation would authorize regulatory action only if it is established that private sector alternatives are inadequate. In addition, market participants are far more likely to develop innovative systems providing access to market information when the alternative is a government-mandated system of access.

Record Keeping

The Joint Report notes the SEC’s support for legislation that would give it the authority to require audit trail systems, systems that would result in time-sequenced reporting of trades to an SRO or an appropriate regulatory agency in the government securities market.41 The SEC has had a long and successful experience with audit trails in equity markets and believes that they are a beneficial and cost-effective surveillance tool.42 Audit trail mechanisms are not unknown in foreign government securities markets. For example, the United Kingdom utilizes an audit trail system whereby market professionals submit to the London Stock Exchange electronic trade reports for all secondary-market transactions in U.K. government securities, or “gilts.” The Salomon and GSE securities investigations dramatically illustrated the difficulties of accurately assessing trading activity in the government securities market on an after-the-fact basis.43

Although the SEC has urged Congress to adopt legislation that would provide the SEC with audit trail authority, the 1992 House legislation, in its final Committee form, opted for a scaled-back regulatory approach with respect to record keeping: the SEC would be given rule-making authority to establish adequate uniform record-keeping requirements for government securities transactions and to require nonroutine reporting of trades for investigatory purposes, after consultation with other interested government agencies.44 The record-keeping provision is structured in such a way as to minimize the costs of compliance for firms.45 In some cases, record-keeping requirements would result only in changing the format of information already retained by broker-dealers in the ordinary course of their business.

Sales Practice Rules

Broker-dealers are typically subject to rules governing their sales practices, such as excessive markups and customer suitability requirements. The Securities Exchange Act of 1934, however, prevents the National Association of Securities Dealers (NASD) from applying sales practice rules to government securities transactions.46 The SEC believes that the application of such rules to government securities brokers and dealers is essential to protect investors and that the NASD should be given the authority to adopt such rules applicable to transactions in government securities.47 Recent developments in the government securities market, increased participation by less sophisticated investors, the introduction of derivative products, and other innovations underscore the need for sales practice rules in this market. The 1992 House bill would have provided the NASD and other appropriate regulatory agencies with the authority to adopt sales practice rules applicable to transactions in the government securities market.48

Balanced and Cost-Effective Regulation: Competing Policy Considerations

The Treasury and the Federal Reserve voiced opposition to the 1992 House bill and, as noted above, did not join in the SEC recommendations regarding transparency and audit trails. These agencies also had some differences with respect to sales practice rules. The policy differences between the SEC and other government agencies stem, as suggested earlier, from the different regulatory perspectives of the various agencies and each agency’s own assessment of how best to reconcile the needs of government financing and the demands of market efficiency, integrity, and fairness. Some of the differences concern matters of design and implementation that are not especially relevant since the specific sources of the differences lack clear parallels in other countries. However, there are four themes that may be of general policy significance.

Comparison of Secondary Market for Government Securities with Other Securities Markets

At the core of the policy debate in the United States is the notion that the government securities market is different from other types of securities markets and, therefore, that many of the premises favoring particular forms of regulation in corporate securities markets are not applicable in the government securities market. There is some validity to this view. For example, no one contends that Treasury securities should be subject to the same registration requirements that corporate issuers face.

The key policy consideration, however, is to what extent the “uniqueness” of the government securities market actually eliminates the need for other customary forms of securities regulation, especially in the secondary market. Some have suggested that, as a general principle, regulation aimed at targeted abuses in the government securities market should not be adopted, absent affirmative evidence that such abuses are actually a significant problem. For example, the Federal Reserve contends that the need for sales practice regulation by the NASD of NASD-regulated government securities brokers and dealers has not been affirmatively shown, even though such regulation is applied to brokers and dealers that are members of the New York Stock Exchange.

Such reasoning, however, does not rest on a firm regulatory premise. If it can be argued that differences between types of securities markets dispense with the need for certain forms of regulation, it seems equally valid to argue that similarities in secondary trading between corporate securities markets and the government securities market may compel similar types of regulation, absent reasons for taking a different approach. As former SEC Chairman Breeden stated: “Issues of manipulation, transparency, or sales practices do not turn on the identity of the primary issuer. Rather, they turn on the conduct of the secondary market participants.”49

The government securities market is subject to abusive conduct in secondary trading by brokers and dealers of the same type that exists in corporate securities markets. The increasing diversity of derivative products and the increased participation by retail investors and unsophisticated institutional investors indicate, for example, that the government securities market is vulnerable to sales practices abuse. It would seem that those who oppose provisions directed at sales practices, transparency, and record keeping should offer reasons why the same brokers and dealers should be subjected to wholly different regulatory approaches based solely on the type of securities traded.

Indirect Costs of Regulation in Financing Public Debt

Cost is a major concern to the Treasury and industry participants. The U.S. government securities market enables the government to meet its large financing needs in a cost-effective manner. According to one frequently cited estimate, an increase of only one basis point in government securities financing costs would cost U.S. taxpayers over $200 million annually.50 Such a statistic indicates the need for considerable care in fashioning an appropriate regulatory response to ensure that the national debt is financed at the lowest possible cost. It does not, however, establish that increased regulatory authority with respect to the secondary market will increase those costs. Cost-effective regulation is likely to have overall beneficial effects on the government securities market that would outweigh additional minor costs. For example, increased transparency would increase public confidence in secondary-market efficiency and foster increased investor participation. Moreover, cost is primarily affected by primary-market mechanisms, which would not be affected by provisions of the kind included in the 1992 House bill. Although considerations of regulatory cost are not irrelevant to the debate, enhanced mechanisms for secondary-market regulation would not likely translate into higher offering costs for the government.

Primary- Versus Secondary-Market Regulation

The Treasury proposed a number of important reforms to the auction process. In opposing the 1992 House bill, the Treasury, the Federal Reserve Board, and the Federal Reserve Bank of New York expressed the view that these primary-market reforms alone are sufficient to deal with the specific abuses identified in connection with the Salomon scandal. However, the significance of the Salomon episode extends beyond the particular abuses uncovered; it reveals that the risk of abuses in the secondary market is greater than had previously been appreciated. As noted above, reform of the auction process alone does not address these concerns in any significant respect, except insofar as it minimizes the risk of a squeeze with respect to when-issued trading of government securities.

Cost-Effective Regulation and Facilitating Competition

All government agencies agree that increased market access, uniformity in record keeping, and observance of sales practice standards are laudable regulatory objectives. Opponents of the 1992 House bill suggested that the costs of regulation to foster these objectives would outweigh the benefits. Both the SEC recommendations and the 1992 House bill, however, took special efforts to avoid needless regulation. For example, the proposed legislation would have expressly rejected authority to create a consolidated trading system for government securities.51 Furthermore, the backup nature of the transparency authority meant that it would be employed only if circumstances warrant.


The Salomon case revealed the existence of trading abuses in government securities markets, even though those markets were previously thought by some to be immune from such misconduct. If nothing else, the Salomon case should be regarded as a warning to those who believe that meaningful regulation of government securities markets is not necessary. Although unique in some respects, government securities markets share common features with other types of securities markets that make cost-effective regulatory standards regarding transparency, record keeping, and sales practices not only appropriate but essential. Such standards are the cornerstone of investor confidence in corporate securities markets and cannot be ignored in the government securities market. Legislative initiatives, such as those proposed in the 1992 House bill, would move in this direction. These initiatives, taken together with the reforms of the auction process that are being implemented by the Treasury, should define a workable balance between the needs of governments in financing their public debt and the goal of making government securities markets fair and efficient.


In December 1992, the SEC instituted public administrative proceedings against the former Salomon officers for their failure to supervise a former managing director of Salomon.52 The SEC’s objective was to prevent violations of the federal securities laws in connection with the submission of the false auction bids. The SEC agreed to settle these actions in return for the payment of monetary penalties and imposition of employment-based restrictions with respect to each of the three former officers.53 In response to the conduct of Salomon’s former chief legal officer in this matter, the SEC also issued a report with respect to the supervisory responsibilities of brokerage firm employees.54 The SEC also filed a complaint against two former Salomon managing directors, alleging violations and the aiding and abetting of violations of the Securities Exchange Act’s antifraud and record-keeping provisions.55 One of the former managing directors was eventually fined $300,000 and permanently barred from participating in Treasury auction bids.56 The other was barred from the securities industry for life and fined $1.1 million.57

In February 1993, the SEC instituted public administrative proceedings against the brokerage firm Daiwa Securities America, Inc. and an officer of Daiwa, in connection with Daiwa’s submission of a false auction bid on behalf of Salomon.58 The SEC agreed to settlement offers from both parties that included disgorgement and a requirement that each party cease and desist from future violations. In addition, Daiwa was censured for its actions and its officer was suspended for three months.59

On the regulatory and legislative fronts, the Treasury published in January 1993 a uniform offering circular that put in one place all of the rules for Treasury auctions.60 Meanwhile, none of the proposed government securities bills discussed above was adopted into law in 1992. However, in 1993, a bill was introduced in the House, the proposed Government Securities Reform Act of 1993,61 that was virtually identical to the 1992 House bill.62 In the Senate, the Government Securities Act Amendments of 199363 were introduced, which encompassed the provisions set forth in both Senate Bill 124764 and Senate Bill 1699.65 The Senate bill was subsequently adopted into law.66

[Author’s note: This article was delivered while the author was General Counsel of the SEC. At the time, the agency was explicating its position on proposed legislation that was eventually embodied in the Government Securities Act of 1993.]

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