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admitted to unlisted trading on those exchanges, but in almost all cases are securities which are fully listed on the ŃYSE or AMEX.95
Federal regulation of "unlisted trading" on exchanges has been intimately related to the disclosure requirements applicable to publicly traded companies. The disclosure, proxy solicitation and insider trading provisions of the Securities Exchange Act of 1934, for the 30 years prior to the 1964 amendments, applied only to companies whose securities were traded on exchanges. The original bill in 1934 would have prohibited unlisted trading on exchanges, but in light of the strong opposition of the AMEX (then known as the New York Curb Exchange), issues which were then admitted to unlisted trading privileges were permitted to continue being traded, pending an SEO report to be submitted by January 1936.96 On the basis of that report, Section 12(f) of the Exchange Act was amended in 1936, to permit unlisted trading on exchanges in three classes of issues: (1) those which were admitted to such trading prior to 1934 (which accounts
the unlisted issues still traded on the AMEX); (2) subject to SEC approval, any issue fully listed on another exchange (which accounts for the bulk of the trading on the regional exchanges); and (3) subject to SEC approval, other issues which were either subject to disclosure and other requirements "substantially equivalent" to those imposed on listed companies by the Exchange Act, or as to which the SEC determined that "the public interest and the protection of investors would best be served by such extension of unlisted trading privileges.” 97
In view of the disparity between the requirements applicable to listed companies and those applicable to companies traded only in the OTC market, it proved virtually impossible for an exchange to obtain SEC approval for extending unlisted trading privileges to additional issues under section 12(f) (3). In 1945, the AMEX applied to the SEC to extend unlisted trading privileges to six common stock issues which it thought were most widely traded in the OTC market. This application was opposed by the NASD, the organization responsible for regulating the OTC market, as well as by 5 of the 6 issuers. The SEC staff prepared a report analyzing the advantages to the shareholders of exchange trading, and expressing the view that, in light of these advantages, the Commission was authorized under the statute to grant the application. The Commission, however, determined that the circumstances were not sufficiently exceptional to warrant a departure from the "substantially equivalent requirements,” test, and denied the application as to 5 of the 6 issues 93
In 1950, the Securities and Exchange Subcommittee of the Senate Committee on Banking and Currency held the first Congressional hearings on legislation to extend the disclosure and other requirements of the 1934 Act to companies whose securities were traded only in the OTC market. One of the consequences of this proposal, of course, was that a large group of unlisted companies would have become eligible for unlisted trading privileges under section 12(1)(3) by virtue of becoming subject to disclosure and other requirements "substantially equivalent” to those applicable to listed securities. 95 See Chapter II, A.1.c. above. 86 See 2 Loss, Securities Regulation 1133 (1961). 07 Id. at 1133-35. 98 Matter of New York Curb Exchange, 18 SEC 315 (1945). The issue as to which the application was (conditionally) granted was of a company which was subject to "substantially equivalent" requirements by virtue of being registered under the Public Utility Holding Company Act. See 2 Loss, Securities Regulation 1145–48 (1961):
The NASD saw this possibility as a serious threat to the OTC market and urged that if the bill
passed, section 13(1) (3) should be simultaneously repealed :
The over-the-counter market made up of thousands of small dealers in securities throughout the country and which has served as the market place for these issues over the years would be destroyed or very seriously damaged. Long established over-the-counter dealers would be put out of business, inferior exchange markets for securities not suitable for auction trading would follow with resultant loss to the public—and therein lies the greatest danger involved in the
proposed bill as now written.9 The AMEX found it "difficult to accept" the idea of repealing Section 12(f)(3), particularly in view of the Commission's 1936 report. The Commission had there addressed itself to the question whether unlisted trading should be permitted if some "mechanism” could be devised for subjecting unlisted companies to 1934 Act disclosure requirements, and had concluded:
However, if one assumed that under some mechanism as that urged above, registration of a class of securities not now listed on exchanges will be effected, investment information for these securities comparable to that in existence with reference to listed securities will be available. The objection to permitting exchanges to grant trading privileges for this class of securities must then rest upon the theory that management has the right to determine what is the proper market place for a security. This contention the Commission
has rejected earlier. 100 As recently as 1946, the SEC, in a second case involving an AMEX application to granted unlisted
trading privileges, had taken the position that:
The enactment of Section 12(f) (3) was based on the recognition that where adequate investment information, public distribution and trading activity, and the other investor safeguards described therein are present, the "public interest would be served by exchange trading despite the fact that the issuer himself may exhibit no inclination in that direction.” Given wide distribution and considerable trading activity, investors in a security might need a public auction market with its publicity of quotations and transaction prices, which could function beside, and supplement the over
the-counter market.101 And in its testimony on the 1950 legislation, the Commission reaffirmed its adherence to the 1936 approach:
We by no means intend to depart from the 1936 philosophy, which was this, as we understand it: The Congress decided in 1936 that the question whether a particular security should be traded on an exchange or in the over-the-counter market
should not be decided absolutely by either the management, 99 Hearings before a Subcommittee of the Senate Committee on Banking and Currency on S. 2408,[81st Cong., 2d Sess. at 58 (1950). 101 Matter of the New York Curb Exchange, 22 S.E.C. 159, 165 (1946).
100 Id. at 106.
the issuer or the exchange, or the over-the-counter market, because all of them have a bias, a legitimate, selfish bias; that it should be decided, in principle, by a public body, and that
was the SEC.102 However, the Commission, without really giving any reason for its position, suggested that section 12(f) (3) be repealed, and that:
The Congress direct the Commission to make a special study of trading both on and off exchanges, and report back to the Congress within 2 years of the passage of this bill, with recommendations as to the feasibility and the advisability of adopting standards and procedures under which securities may or shall be admitted to exchange privileges or re
moved from exchange privileges. 103 It appears that the principal reason the SEC took this position was the "pragmatic” consideration that repeal of Section 12(f) (3) would remove one source of OTC opposition to the extension of disclosure requirements to unlisted companies.104
The 1950 legislation was never reported out of Committee, and disclosure requirements were not extended to unlisted securities until 1964. The SĒC's Special Study, which formed the basis for the 1964 amendments, recommended that section 12(f)(3) be repealed, on the ground that "there appears to be no reason of public policy why an issuer should not have freedom to decide, as at present, either to remain entirely in the over-the-counter sector or to seek an exchange listing.” 105 While this represented a complete reversal of the policy enunciated by the SEC in 1936 and reiterated in 1950, there was no explanation of the reason for the reversal.
The SEC's legislative proposals to implement the Special Study recommendations also included the repeal of section 127f)(3). In its statement to the Senate Securities Subcommittee in support of that proposal, however, the Commission shifted to a new ground, arguing that "repeal of Section 12(f) (3) will assure a desirable conformance by issuers with the listing requirements of an exchange as a prerequisite to enjoying the privileges of trading on that or other exchanges."
» 106 The Commission made no attempt, however, to balance this desirable conformance" against the benefits to shareholders which might flow from exchange trading without listing.
No opposition was offered to the repeal of section 12(f)(3)! The AMEX, on which 80 percent of the issues were by then fully listed, dropped its opposition, noting only that if "it would be in the best interest of a company and its shareholders to list on an exchange, there would be less chance [under the expanded disclosure requirements) that those advantages would be ignored by management on a permanent basis. 107
Since the passage of the 1964 amendments, the process of "natural adjustment” foreseen by the Special Study in making its recommendation for repeal of section 12(f)(3), has taken the form of competition between the NYSE and AMEX, on the one hand, and the NASD, 102 Hearings, note 99 above, at 40. 104 See 5 Loss, Securities Regulation 3108 (Supp. 1969). 105 2 Special Study 836; see 3 id. at 56-57. 106 Hearings Before a Subcommittee of the Senate Committee on Banking and Currency on S. 1642, 88th
Cong., 1st Sess., at 59 (1963):
107 Id. at 157:
on the other, to persuade company managements that it was better to list or better not to list. After the 1964 amendments took effect, a substantial number of large companies which had previously remained in the OTC market primarily to avoid the disclosure requirements of the 1934 Act, listed their securities on the NYSE. On the other hand, the improvement in the OTC market resulting from the introduction of NASDAQ has been used by the NASD as an argument for persuading companies to leave their stocks in the OTC market.108 c. "Auction" Markets for Unlisted Securities
With the development of a central market system which combines competing market-makers with priority for public agency orders, there will be little reason for company management to wish to deprive stockholders of the advantages of the best available combined market. This is therefore an appropriate time to begin considering methods by which these advantages could be extended to investors in companies whose managements have not chosen to "list" their shares. One method of accomplishing this would be by permitting exchanges to establish public order books,” administered by their specialists, in certain securities which have hitherto been traded only in the OTC markets. No exchange would be required to admit securities to trading on this basis, and exchanges would be free to set higher criteria for securities to be traded on this basis than they do for securities which are formally "listed".
Such an approach would be an important step toward the goal of a market system in which investors in any particular security obtain the optimum benefits of both the “auction” and “dealer” systems which are feasible in a security having its particular trading characteristics. In weighing the merits of this proposal, however, attention must be given to its potential impact on the OTĆ market and on the present system by which securities are "listed” on exchanges.
At present, when an OTC stock is admitted to trading on an exchange, existing patterns of dealing are completely disrupted because of the restrictions, described above, against exchange (particularly NYSE) members dealing with non-members in listed securities. The disruptive effect is just as great, of course, when a security is "listed” on the basis of a decision by the company management as it would be if the security were admitted to "unlisted” trading privileges by unilateral action of the exchange. In fact, it was the sisting of a large number of bank stocks on the NYSE after 1964, with concomitant disruption of existing relationships between NYSE members and nonmembers in those securities, that has led to the most bitter attacks on NYSE Rule 394.109
However, in the central market system envisioned above, in which all market makers and brokers will be permitted to deal with one another in any security, these relationships would not be severed. In fact, the NASD does not appear to be opposed to establishment of exchange trading in the most active OTC issues. The Chairman of its NASDAQ committee testified recently that "possibly many of the NASDAQ stocks should be listed stocks. They have the volume and the interest to be on some national marketplace."'110 108 See, e.g., Galle, NASDAQ's Impact on the Listing Decision, Inv. Dealer's Digest, July 25, 1972; 108 See, e.g., 6 House Hearings at 2989 (statement of Morris A. Schapiro).
110 7 House Hearings 3562.
The Subcommittee's recommendations earlier in this section, however, envision a requirement, for the benefit of public investors, that public orders on the "book" be given precedence over any transaction by a dealer in an exchange-traded security. The admission of a previously "unlisted” security to trading on an exchange would therefore automatically subject all dealers making markets in that stock to an obligation to check the "book” before executing their trades. For that reason, admission of a security to trading on a particular exchange should be subject to SEC approval, upon a finding that the exchange's facilities were adequate to interface with the existing dealer market in that security. Notice of the filing of an application by an exchange for such approval would also enable the management of the issuer to apply for listing on another exchange which, because of its broader membership or other factors, might be expected to offer access to a broader public market.
With respect to the effect of such a change on the present system of "listing”, the SEC in 1964 expressed the concern that availability of unlisted trading privileges on a broad scale would discourage companies from “desirable conformance” with listing requirements. It is not at all clear that any such result would follow under today's circumstances. In the first place, there would be no requirement that any exchange grant unlisted trading privileges on its facilities. The two larger exchanges in New York might well decide to retain the formalities of listing. The fact that another exchange might grant unlisted trading privileges to a security eligible for listing on the NYSE or AMEX would not necessarily reduce the incentives to listing on those exchanges; in fact, it might well increase them as companies decided that, if their stock was to be traded on any exchange, they wanted it traded on the one which would provide the greatest benefits in terms of exposure to public orders.
In any event, the burdens and benefits of formal listing have become much less significant in light of the 1964 amendments. In fact, the AMEX expects companies admitted to unlisted trading privileges to comply with all of the disclosure obligations applicable to fully listed companies, and in 1969 imposed on them the obligation to pay the continuing annual fee.111 As a result, the only difference between listed and unlisted companies on that exchange is the absence of a formal agreement requiring the company to pay an initial fee for listing and to obtain a vote of shareholders (even if not required by state law) for certain types of actions which result in the listing of additional shares. The AMEX's success in securing compliance with these obligations indicates that the threat of removal of a security from trading is as effective a sanction as the existence of a formal signed agreement. In that connection, it is also noteworthy that the NAŠD, which of course has no formal "listing” procedure for its NASDAQ system, imposes, as a condition to continued quotation of a company's securities in the system, requirement, comparable to that imposed by exchanges, that the company "promptly disclose to the public through the press any material
information which may affect the value of its securities. 112 111 See letter, dated June 12, 1969, from the President of the AMEX to companies admitted to unlisted trading privileges. Fourteen of the 62 companies whose issues were then admitted to unlisted trading privileges failed to pay the continuing annual fee, and their securities were removed from the AMEX. Letter, dated Dec. 19, 1972, from AMEX
to Subcommittee staff. 112 CCH, NASD Manual (1653A (p. 1137-3).