5 percent of an equity security of another corporation. In addition, the antifraud provision of the Exchange Act, section 10(b) and rule 10b-5, as well as other antifraud provisions of the Federal securities laws, are of importance with respect to insurance companies since the business of insurance involves day-to-day trading in securities. In addition, of course, trading exists in securities issued by publicly held insurance companies.

Insurance companies, or more commonly their affiliates, are subject to registration as broker-dealers under the Exchange Act, when they act in that capacity. Most insurance company subsidiaries registered as broker-dealers are primarily in the business of selling variable annuity and variable life contracts and mutual funds.

The Investment Company Act of 1940, which regulates pooled investment media, specifically excludes insurers from its coverage. Certain "separate accounts" of life insurance companies used to fund variable annuity and variable life contracts are, however, registered under the Investment Company Act and are thus subject to its comprehensive regulation. In addition, since the 1960's, insurance companies have increasingly sponsored their own muture funds by acquisition or formation. By 1974 insurance companies predominantly through subsidiaries managed over 50 percent of all mutual fund assets. Insurance companies are not bound by Federal statutes, such as the GlassSteagall Act or the Bank Holding Company Act, which would regulate these and other noninsurance activities.

Finally, an insurance company or, more frequently, its affiliate, is subject to registration under the Investment Advisers Act of 1940 when it acts as an investment adviser, except when its only clients are insurance companies.

ENFORCEMENT ACTIONS

While, as the above discussion indicates, our jurisdiction over insurance companies is rather limited, we have recently brought several enforcement cases relating to insurance companies, which might be of interest to the committee, and we have several cases pending. These actions have included administrative proceedings, actions for injunctive and ancillary relief, and referrals and assistance rendered in criminal prosecutions conducted by the Justice Department. Today, I would like to talk about the five cases we have instituted in the past year. Of the five cases, four were actions in the district courts and the remaining case was an administrative proceeding under the Exchange Act. Final relief was obtained in each of these cases as a result of consents submitted by the defendants.

Two cases were interrelated and involved allegations of self-dealing. These are the American Commonwealth Financial Corporation case and the National Pacific Corporation case.

In May 1977, the Commission brought an action against American Commonwealth Financial Corp., a Texas-based publicly held insurance holding company, and nine other defendants, in the U.S. District Court for the Northern District of Texas. The Commission alleged that the defendants had engaged in a fraudulent course of conduct whereby they used the assets of American Commonwealth and other publicly held companies for their personal gain. These activities are

alleged to have begun in about February 1975 upon the assumption of control of American Commonwealth by a new management group. The allegations of self-dealing in the complaint related to, among other things, the use of the assets and credit of public companies for loans, and guarantees of loans, made directly and indirectly to certain of the defendants. In connection with personal bank loans, restrictions were imposed on American Commonwealth's ability to conduct certain businesses, issue stock, increase capital, or grant dividends. Also, personal loans were secured from the publicly held controlled companies though the pledge of assets of doubtful value. Sales and exchanges of such assets and securities and notes of similarly questionable value were made. Finally, there were alleged to be a variety of omitted, false, and deceptive disclosures.

In June 1976, American Commonwealth transferred control of one of its subsidiaries, National American Life Insurance Co., to National Pacific Corp., a private company owned principally by several west coast promoters. According to the Commission's complaint, filed in September 1976, the National Pacific group immediately set out to engage in a series of self-dealing transactions which resulted in the misappropriation of several million dollars. The principal method by which the National Pacific group operated was to obtain lucrative union group insurance contracts for National American from union health and welfare funds, using other companies to obtain these contracts. Once the insurance contracts were obtained by National American through reinsurance agreements with the other companies, the proceeds of the contracts were diverted to the personal use of the National Pacific group. In addition, cash was obtained through the transferring of notes of highly questionable value to National American in exchange for cash. One month before the Commission's complaint was filed, the control person of National American, without any board of directors authorization, and contrary to applicable State law, transferred $1.1 million in National American funds to a Swiss bank account which had just been opened by a newly formed Swiss company. Following the filing of the Commission's complaint, the Federal court, upon the Commission's motion, appointed an equity receiver over National American and the court ordered, pursuant to a consent decree, that the $1.1 million be returned to National American. About $835,000 has been returned, and the control person of National Pacific has been held in contempt of court for failure to return the remainder.

An interesting aspect of the National Pacific case is that, just prior to National Pacific's acquisition of National American, a Louisiana insurance company, the State of New Jersey had turned down National Pacific's application to acquire a New Jersey-based insurer, on grounds of unsuitability of the applicant. In Louisiana, however, State approval of such an application is not required, so National Pacific acquired a Louisiana corporation, using, as the source of funds for the acquisition, the proceeds of a dividend from an Arizona insurance company that the State of Arizona had declared illegal, but which National Pacific failed to return to that company.

Two other cases involved failures to prepare adequate financial statements, principally relating to loss reserves. The first culminated

in administrative proceedings under section 15 (c) (4) of the Exchange Act against Government Employees Insurance Co., commonly referred to as "GEICO". In these proceedings, the Commission found that GEICO, after April 1975, failed to make necessary disclosures of changes in its manner of computing loss reserves, causing liabilities to be understated. In addition, the Commission found that GEICO capitalized the carrying value of acquisition costs on its balance sheet which raised questions. The changes discussed above had the effect of substantially decreasing the net loss which GEICO reported in various filings with the Commission and in reports made to its shareholders and the press.

The changes made by GEICO in the manner of computing its loss reserves were inconsistent with that firm's prior practice and were not supported by available data or by the findings of GEICO's outside auditors and certain consultants. Also, GEICO's method of valuing acquisition costs raised questions. GEICO historically deferred certain costs incurred in acquiring insurance businesses, thus avoiding the negative impact such costs would otherwise have had on current earnings. Recoverability of these costs through future underwriting profits is, however, a necessary prerequisite to deferral, and, of course, the asset must be reduced as portions are deemed non-recoverable. We found that GEICO failed to make downward adjustments in the valuation of its acquisition costs. We also found in this case that an officer of GEICO sold GEICO securities while in possession of material nonpublic information concerning these matters.

Our fourth and most recent enforcement action against an insurance company, SEC v. Fisco, an action for injunctive and ancillary relief, was filed and consented to on August 18 of this year. While the Commission's complaint alleged other areas of fraud, the principal fraud alleged in Fisco was the understatement of reserves for losses. As a result of the understatement, over a 3-year period, Fisco, a casualty insurance company, was able to report increasing earnings, when in fact, we alleged, it was incurring substantial losses.

According to the complaint, numerous methods were used by Fisco to understate its loss reserves, including:

1. Direct orders from management to "freeze" reserve increases even where a Fisco claims adjuster had indicated that the previously set reserve was substantially understated.

2. The adoption of a computer program designed to "freeze" reserve increases. The program operated in such a way as to negate all attempts to increase reserves for particular classes of claims.

3. The use of so-called GI parties. These were reviews, by claims personnel, of all claims files. The sole purpose was to find reserves which could be reduced or deleted in their entirety.

4. The so-called Black Friday incident. In February 1972 a physical inventory of the claims files in Fisco's Philadelphia office was taken, involving a comparison of a computer printout of existing files with the files themselves. Claims files reflecting approximately $1,000,000 in reserves were not located and management ordered that the reserves for those claims be deleted as of December 31, 1972. A few weeks later it was found that the missing files were in transit to Fisco's New

Jersey office; notwithstanding discovery of the missing files Fisco failed to reverse the entry deleting the reserves for these claims.

After having reported doubled earnings for the record 1970 through June 1973, Fisco reported in early 1974 an operating loss of approximately $39,000,000 which completely eliminated all prior reported earnings of the company. This revision principally resulted from its policy of understanding loss reserves.

The last case which I will discuss this morning, involving Vanguard Security Funding Corp., a holding company, also relates to misleading financial statements. It is of particular note that the direct object of the alleged fraud there was a State regulatory agency, rather than the trading market in securities. The Commission alleged that in 1974 Vanguard's operating subsidiary, which is engaged in underwriting individual and group life and health insurance and group disability insurance risks, entered into sham transactions in which it acquired real estate in exchange for surplus notes. The alleged purpose of these transactions was to increase Vanguard's statutory surplus, removing an impairment of capital for State regulatory purposes. In a financial statement filed by Vangard with the Commission, Vanguard valued the newly acquired real estate at the stated value of the surplus notes. The surplus notes, a form of debt apparently unique to the insurance industry, provided for payment only if and when the statutory surplus of Vanguard exceeded a certain predetermined amount. It was alleged that the value of real estate and debt were substantially overstated and that the reported net loss and retained earnings deficit were substantially understated in those financial statements. The Commission also alleged that Vanguard failed to disclose that it filed false and misleading statutory surplus reports with the Alabama State insurance department, including false and misleading appraisals of certain of the real estate. The operating subsidiary of Vanguard was placed in receivership by the State insurance department.

The limited number of these cases makes it difficult to generalize about abuses since the cases themselves reveal a variety of misconduct. A few observations may, however, be made regarding these cases, which, with few exceptions, involve smaller insurance companies. Insurance companies represent large pools of liquid assets, which lend themselves to a variety of intricate techniques designed to enrich controlling persons through looting or use of assets to gain control of other companies or otherwise to mislead regulatory authorities or defraud the public. The American Financial and National Pacific cases. indicate the rather amazing speed at which determined persons appear to be able to utilize the assets of insurance companies for their personal gain. In addition, more than one of our enforcement cases has involved fraudulent usage of reinsurance agreements either to conceal under-reserved deficiencies or to transfer overvalued assets from company to company.

Other areas of abuse which have surfaced in our investigations are inadequate loan loss reserves and irregularities with respect to valuation of assets. These latter abuses appear to grow out of the desire of insurance companies to inflate earnings and to protect or increase surplus which determines the amount of insurance they can write.

GENERAL OBSERVATIONS

The above description of our enforcement activities with respect to insurance companies also indicates both the growing complexity of possible misconduct in this area, and the difficulties faced by State regulators, with their limited jursidiction and resources, in attempting to deal with the varieties of problems presented by multistate insurance companies. S. 1710 recognizes that there is at least some question as to the adequacy of State regulation and proposes to supplement it by a voluntary Federal Insurance Guaranty Fund and voluntary Federal chartering of insurance companies. I recognize that, in its present form, the bill does not directly affect the nature of our jurisdiction in this area. However, drawing from our enforcement actions and our experience with regulatory matters dealing with other financial institutions, as well as from my own personal observations, I would like to make some comments about S. 1710 and raise some questions which I think the committee may wish to consider.

First, both titles of the proposed bill provide for voluntary participation by insurance companies. While the freedom from State rate regulation has been articulated as an attraction of Federal chartering, I wonder whether this is enough of an incentive to attract participation. I am also concerned with respect to whether the types of insurance companies we have brought enforcement actions against would voluntarily come into a Federal system of regulation. In addition, the voluntary nature of the Federal Insurance Guaranty Fund may provide problems of adverse selection against the Federal fund or State funds, as some 46 States have enacted legislation establishing guaranty funds to protect policyholders against loss in the event of the insolvency of their property and liability insurers.

My next observation relates to an aspect of the regulatory structure reflected in the proposed bill. The proposed legislation does not appear to provide authority explicitly-except perhaps for federally chartered insurance companies for direct regulation of insider misconduct. Some States appear to have such statutes, and there are similar Federal statutes dealing with other financial intermediaries.

Finally, I would like to make some general observations concerning legislation of the nature presently before this committee. In dealing with major regulatory proposals regarding any financial intermediary, and in particular a proposal to establish another specialized Federal agency, one must consider the growing diversity of financial services such companies are beginning to offer. No longer are banks, brokers, or insurance companies content to remain within traditionally defined areas as to which their differing regulatory structures have been established. Accordingly, any comprehensive legislation should seek both to create effective regulatory mechanisms which recognize this diversity and to avoid overlapping jurisdiction.

I hope that my testimony here today, while rather limited, will be of assistance. I would be happy to respond to any questions the members of the committee might have.

The CHAIRMAN. Well, Chairman Williams, I want to thank you for a masterful summary of your testimony. I thought it was going to take about half an hour and you took about 10 minutes. You did a beautiful job.