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would be excluded. This proposal, as the SEC testified at the same hearing, was "contrary to the stated position of the Commission both in its statement of the future structure of the securities markets and earlier in its transmittal of the Institutional Investor report.” 1
More recently, the Chairman of the NYSE has amplified his opposi tion to the SEC approach of competing marketmakers, calling for "amalgamation" of all existing stock exchanges and legislative prohibition of the third market.46 Since this opposition threatens to delay, or perhaps even prevent, the creation of a strong central market system, the Subcommittee believes that it is important to analyze the NYSE arguments to determine whether its opposition is well founded.
The NYSE opposition to inclusion of competing market-makers within the central market system appears to rest on three principal arguments:
(1) The issuer of a security has a right to decide where its securities will be traded, and to prevent them from being traded in any other market.47
(2) Inclusion of quotes of competing dealers in a compost ite quotations system "would eliminate the auction market at least on one side of each trade." 48
(3) Third-market dealers are not subject to the same obligations as specialists to maintain orderly and continuous
markets. 49 a. The Right to Decide Where a Security Will Be Traded
The proposition that the issuer of a security has a right to limit the markets in which investors can trade its securities finds no support either in past practice in the securities markets or in Congressional or SEC' policy. In fact, the consistent approach has been that trading in a security should be permitted in any market unless such trading would contravene some important policy laid down in the Exchange Act.
Before the imposition of federal regulation on the securities industry markets commenced trading in securities when participants in those markets desired, for economic reasons, to commence such trading. This is of course still the case in the OTC market, where trading in a security commences when there is adequate investor and dealer interest, without any action on the part of the issuer. All of the exchanges, including the NYSE, started in the same manner, trading those securities which their members wished to trade, regardless of the desire of the issuer. All of the exchanges, other than the NYSE and the AMEX, continue to follow that policy: 50
Since the imposition of federal regulation in 1934, the SEC has consistently taken a position in favor of the competitive trading of listed securities in multiple markets. One of its early decisions, in 1936, permitted the AMEX (then the New York Curb Exchange) to commence trading in the bonds of a company listed on the Boston Stock Ex
45 See Section A.2.a. above. 46 Address by James J. Needhani, Chairman, NYSE, at the Securities Industry Ass’n. Convention Boca Raton, Fla., Dec. 1, 1972, at 6, 9. 47 Id. at 9.
48 Memorandum, dated Sept. 25, 1972 from William C. Freund to Board of Directors, NYSE, accompanying letter, dated Sept. 25, 1972, from NYSE to SEC.
19 Remarks by James J. Needham, Chairman, NYSE, at a luncheon for corporate presidents, Chicago, III., Dec. 7, 1972, at 4. 36 See 2 Loss, Securities Regulation 1132-35 (1961).
change, in spite of the issuer's opposition.51 And under the provisions added in 1936 to deal with the question of unlisted trading privileges, 52 the Commission has consistently approved applications by regional exchanges for dual trading privileges in NYSÉ-listed securities.53 It has also resisted efforts by the NYSE to prevent its members from dealing in such dually-traded securities on those other exchanges.54
The Subcommittee believes that restriction of trading in securities to a single market is a drastic measure, to be legislated only when the public interest clearly requires it. It is not a prerogative of corporate management, which has no legitimate interest in restricting the trading opportunities of investors who have acquired a company's shares. b. "Elimination of the Auction Market
The NYSE has expressed the fear that inclusion of competing dealers in the new composite quotation system "would eliminate the auction market on at least one side of each trade.” 55 However, this fear rests on an assumption that the dealer quotes would supplant, rather than supplement, the public orders on the specialist "book”. As set forth above, however, the SEC approach, endorsed by the Subcommittee, contemplates that all dealers making markets in listed stocks would be required to give precedence to public orders before completing any transaction. Thus, with respect to preservation of the "auction system, all dealers would be subject to restrictions comparable to those which are now applicable to exchange members.
Because of the confusion of the terms "auction market" and "agency market”,56 however, it appears that the NYSE's concern may really center on the elimination of the broker and his commission) on one side of a transaction with a non-member. As noted above, there does not seem to be any persuasive reason to require the interpositioning of a broker between an institution and a market-maker (although an institution may choose to avail itself of the services of a broker in particular transactions). On the other hand, it has been suggested that "the protection of agency representation" may be important to individual investors and that consideration should be given to prohibiting securities firms from dealing with unsophisticated investors on a principal basis.” 57
At present, in contrast to the situation in the OTC markets, none of the market-makers in listed securities-specialists, block positioners, third market-makers-deal directly with individual investors as a regular matter in the stocks in which they make markets. It is quite possible that in a freely competitive market-making system, stock exchange members making markets in listed securities would decide to "integrate” their market-making and retail operations and deal directly with individual customers in the securities in which they were making markets. This would of course deprive the customer of the protection of an independent agent not involved in the marketmaking function.
51 Edison Elec. Illuminating Co., 1 S.E.C. 909 (1936). 52 On the question of unlisted trading privileges in securities not listed on any exchange, see Section 6 53 2 Loss, Securities Regulation 1142–43 (1961). 54 The Rules of the NYSE, 10 S.E.C. 270 (1941). The competitive aspects of this decision, known as the "Multiple Trading Case”, are discussed in Chapter III. E. below.
55 See note 48, supra. 56 See note 1, supra. 57 2 Institutional Membership Hearings at 716 (statement of Donald M. Feuerstein); see also 6 House Hearings at 3088.
To meet this legitimate concern raised by the NYSE, the Subcommittee will consider the desirability of legislation to prohibit any market makers in listed securities from dealing directly with individual members of the public in those securities, or, alternatively, to assure that any such dealing is surrounded by appropriate safeguards to prevent overreaching. c. Regulatory vs. Competitive Controls on Market Making
The NYSE opposition to the SEC proposal for expansion of com petitive market making, and its call for legislative prohibition of the third market, reflect a consistent NYSE position in favor of regulation of a single market-maker rather than competition in the market making function.
In addition to opposing the development of additional marketmaking capacity in NYSE stocks outside the Exchange, the NYSE has also discouraged its own members from offering competition to the single specialist in each stock. The last competing specialist vanished from the Exchange in 1967.58 A recent application by one specialist firm to be permitted to compete with another firm in the 14 stocks in which the latter makes a market was rejected by the NYSE Board of Governors. The Board said that its action was "based on the fact that the exchange has just recently adopted a new program which is aimed at improving specialist performance” and that this program "should be given a trial period to see how effective it is before any alternative ways to achieve the same goals be adopted.”
While prohibiting competing specialists on the floor, the NYSE also prevents its members from quoting continuous markets in listed stocks through any other medium, such as NASDAQ, even though resulting transactions would be brought to the Exchange floor. While block positioning member firms have served an important market function by taking substantial positions to facilitate institutional transactions, NYSE Rule 438 bars them from publishing their current bid and asked prices, in effect preventing any competition by other member firms with the market being quoted by the specialist in between the public limit orders on his book.
The specialist system has been bitterly criticized—and strongly defended-for many years. At the time of adoption of the Exchange Act in 1934 and for many years thereafter, the criticism related mainly to the possibilities of abuse inherent in the specialist's dual roles as broker and dealer. Rather than separating these two functions, the Congress, the SEC and the NYSE have attempted to prevent abuses by a number of restrictive rules designed to prevent the specialist from giving preference to his own interests as dealer over the interests of public customers whose orders are left on his book.
More recently, as the volume of institutional trading and block transactions on the NYSE have steadily increased, criticism has tended to focus more on specialists' performance-their ability to maintain orderly markets. This criticism is particularly troublesome because, "individual investors are the main victims of inadequate marketmaking by specialists, since they have no effective alternatives.” 603 While institutions can turn to block positioners or third market-makers if the specialist is doing an inadequate job, the small investor cannot. 58 1 Institutional Membership Hearings at 379. 50 Wall St. J., Jan. 21, 1972, p. 4. R0 Bus. Week, Dec. 4, 1971, p. 74 (statement of Seymour Smidt).
Criticism of specialist performance tends to be selective, rather than general. The Institutional Investor Study found “persistent and consistent differences in behavior (among the NYSE specialist units] that seem to reflect characteristics of the specialist unit as a firm.” 61 The head of one major institutional brokerage firm has stated that our experience with specialists is that some are almost always good, and some are almost always bad,” 62 while the former vice chairman of the NYSE Board of Governors, himself a specialist, admits that "what is wrong is that some specialists don't do a good job. We've got to make them do better." 63
The problem has been finding an effective method, in the absence of competition, for improving performance. An obvious incentive would exist if greater economic rewards came to those specialists who utilized their capital more actively in providing “continuity with depth” to the market. Unfortunately, the opposite appears to be the case. The Institutional Investor Study found that the average gross return on investment in high dollar volume stocks was 88 percent per year for high inventory activity NYSE specialist units--those who risked more of their capital in maintaining orderly markets—while it was 191 percent per year for low inventory activity specialists—those who took a more passive role.64
In the absence of direct economic incentives for better performance by specialists, the only alternative is for the NYSE to use its regulatory power to reward the more active specialists (by favoring them in the allocation of new stocks) or impose sanctions on those who perform inadequately (by reassigning their specialty stocks). This has not been done. Since 1965, the VYSE has revoked only one specialist registration.65 The Institutional Investor Study, on reviewing allocations of new listings by the NYSE during the period 1967–70, found that the proportions of issues by dollar volume assigned to high and low inventory activity specialists did not change, and concluded that “the NYSE does not appear to be using the stock allocation process to allocate a higher proportion of its volume to specialist units that provide greater liquidity in depth.” 66 In his 1971 report to the NYSE William McChesney Vartin said:
Allocating specific securities to specialists and maintaining effective markets in them are the direct responsibility of the Exchange. The allocation procedure must, at all times, reflect the ability to provide effective markets in the public interest. Allocations of securities, which are valuable franchises, should be governed by clearly defined performance criteria against which all specialists should be judged. Once such criteria are established, specialists would have the incentive to meet them, and as a result, effective regulation of the specialist system would become an easier task. Authority with respect to the allocation of newly listed securities and the reallocation of presently listed securities should ultimately
be vested in the staff of the Exchange, subject to review by 61 4 Institutional Investor Study at 1956. 62 Bus. Week, Dec. 4, 1971, p. 73 (William H. Donaldson). 63 Id. (Stephen M. Peck). 64 4 Institutional Investor Study at 1959. 65 Subcommittee Staff Study of Regulation of Specialists on the New York and American Stock Exchanges (hereinafter cited as “Specialist Study”) A Study Hearings at 28. During the same period, the AMEX revoked 35 registrations and reallocated the securities to other specialists. Id.
66 4 Institutional Investor Study at 1959. The influence of the desire to give each specialist unit a mixture of "desirable" and "undesirable” securities is discussed in Section B.6.a. below.
the Board of Directors. Effective regulation of the specialist
the Exchange.67 The NYSE has not taken any action on Martin's recommendations with respect to transferring to the staff the authority to allocate and reallocate specialty securities. Prior to the reorganization of the NYSE Board of Governors in July 1972, the Committee on Floor Affairs, which decides on the assignment of specialty stocks, consisted of the 11 Floor Governors, 3 Office Governors, the Chairman and Vice Chairman of the Board, and the President of the Exchange.68 When the new Board of Directors was established, with only three directors! coming from the floor, the Committee on Floor Affairs was modified, on an interim” basis, to include the 3 new Floor Directors, plus 10 of the 11 members who had been the last Floor Governors under the old: system, plus 4 other floor members and the Chairman of the Exchange.69* The result is that the committee responsible for assigning specialty stocks consists, at least for the present, of the Chairman of the Exchange and 17 floor members (8 specialists and 9 commission brokers). This eliminates even the small influence that the office members, the "customer" for the specialists' product, had under the old system.70
Not only has the NYSE been unable to find a regulatory substitute for competition as a means of improving specialist performance, but it has not even been able to develop criteria for determining whether a given specialist is doing a good or a bad job. The Subcommittee's case study of the regulation of specialist performance show that the Exchange has consistently opposed suggestions by the SEC for more precise definition of specialist obligations. In response to an inquiry from the Subcommittee as to whether there is currently any standard by which an impartial observer could ascertain whether a sperialist is meeting his market obligations, the Exchange responded:
It is impossible to define with mathematical certainty, the boundaries of the specialist's obligation because of the many variables in the day to day market in each stock, the market in general, and the dealing activities of a specialist. Each situation must be considered in the light of the particular circumstances at the time. In this connection, consideration must be given to the fact that the specialist is required by the nature of his function to make rapid decisions based upon the relevant facts as he knows them at the time of the desion. He may be unaware of other facts—such as corporate decisions, important news events, changes in public senti- ! ment—which may subsequently be incorrectly construed i by an aggrieved party as having been relevant to a particular decision.
If an "impartial observer” is willing to examine all of the facts and circumstances in a specific situation, he will be 67 Martin Report at 13-14. 88 4 Study Hearings at 43 fn. 192. 69 Letter from NYSE to Subcommittee Staff, Jan. 8, 1973. 70 The three Office Governors had been added to the Floor Committee in response to the findings and recommendations of the SEC's Special Study concerning the disproportionate influence of floor professionals in the government of the Exchange." See 4 Special Study
at 512-13, 544-59, 576-77. 71 4 Study Hearings at 10-21, 99-110.