The benefits which public investors would receive from the introduction of the principle of precedence for their orders in the presently unlisted securities which are suitable for an "auction" system may well outweigh any of the possible difficulties that might arise from its introduction. The Subcommittee intends, therefore, simultaneously with the implementation of the combined auction-dealer market in presently listed securities, to consider proposals for the establishment of procedures by which exchange trading could be commenced in presently unlisted securities without the necessity of formal action by the company management.

This should be an important step in the natural evolutionary process by which each security will come to be traded in the combination of markets most beneficial to public investors in light of its distinctive trading characteristics. This process may well result in some securities moving off exchanges, or from larger to smaller exchanges, as well as the other way. However, the Subcommittee believes that greater flexibility is more likely to assure to all investors the optimum benefits of a combination of "auction” and “dealer” markets.

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A. INTRODUCTION The securities industry's unique system of self-regulation has shown great strength in some areas and in general has served the industry well. It has also, however, displayed serious deficiencies and is not at the present time operating as effectively or fairly as it should be. In the following sections the weaknesses of the self-regulatory process are discussed and recommendations are made for its improvement. Specific defects aside, however, there is a common and serious misunderstanding of the nature and limits of the concept of selfregulation itself. All too frequently, self-regulation is thought of merely as an arrangement whereby the exchanges and the NASD, rather than the federal government, police members' conduct and strengthen professional standards. In other words, self-regulation is thought to mean that the securities industry regulates itself and therefore is not regulated by the government. Such a conception of selfregulation is seriously misleading in failing to acknowledge the essential and continuing role of the federal government. Industry regulation and government regulation are not alternatives for the securities industry, but complementary components of the selfregulatory process.

It is important that persons engaged in the securities business, as well as exchange and NASD employees and SEC officials, have a clear understanding of the Congress' purpose in establishing a system of self-regulation for the industry and of the manner in which the system is expected to operate. A review of the statutory history of the self-regulatory concept is an essential prerequisite to that understanding.


EXCHANGE ACT a. The Stock Exchanges

Before the adoption of the Exchange Act, stock exchanges, unless incorporated under certain state laws, were subject to regulation by no governmental authority and ..

... exercised unrestricted dominion over the activities of their members." 1 Most exchanges were voluntary unincorporated associations and, as such, regarded themselves and were regarded by the courts as private business clubs, entitled to establish their own rules for the admission, expulsion and discipline of members without judicial interference. The courts reasoned that the rules of an exchange, as contained in its constitution and by-laws, expressed a “contract by which each member had consented to be bound, and which measured his duties, rights and privileges.” 2 While an exchange incorporated by charter from the state could not exceed its statutory grant of corporate power, an unincorporated exchange 1 S. Rep. No. 1455, 73d Cong., 20 Sess. 77 (1934). 2 Belton v. Hatch, 109 N.Y. 593, 17 N.E. 225, 226 (1888).

88-033—73 -10

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existed solely by reason of the contractual agreement between its members, and no limitations were imposed on its rule making power, except by specific legal prohibitions and general notions of public policy.

For many years all attempts to subject the exchanges to state or federal regulation were vigorously opposed by the exchanges on the ground that the existing private self-regulatory system afforded sufficient investor protection. In 1932, however, the Senate Committee on Banking and Currency began a thorough investigation of stock exchanges. The Committee found that the exchanges had made minimal efforts to reappraise and upgrade their standards and that reforms had been effected only "during periods of popular agitation or when legislative action was threatened.” 5 The Committee summarized its findings as follows:

[First,] the view that internal regulation obviated the need
for governmental control was unsound for several reasons.
In the first place, the interests of exchanges and their mem-
bers frequently conflicted with the public interest. Thus, it
was amply demonstrated . . . that some of the methods
employed by stock-exchange members to stimulate active
trading were technically in conformity with stock-exchange
rules and yet worked incalculable harm to the public. Second,
the securities exchanges have broadened the scope of their
activities to the point where they are no longer isolated
institutions but have become so important an element in the
credit structure that their regulation, to be effective, must be
integrated with the protection of our entire financial system.
Third, stock-exchange authorities have taken the position
that they would regulate only their own members and that
they had no power to prevent abuses by operators who were
not members of the exchanges, but who used their facilities
to impose upon the public. Fourth, the attitude of exchange
authorities toward the nature and scope of the regulation
required was sharply at variance with the modern conception
of the extent to which the public welfare must be guarded in

financial matters.
The Senate investigation made it clear that because of the "evils
and abuses which flourished on the exchanges and their disastrous
effects upon the entire Nation ... Federal regulation was necessary
and desirable." ? Stock exchanges could no longer be regarded as
“private clubs to be conducted only in accordance with the interests
of their members”; they are rather

. . . public institutions which the public is invited to use

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for the purchase and sale of securities listed thereon . . 3 C. Meyer, The Law of Stockbrokers and Stock Exchanges 38, 79-85 (1931). 4 In 1909 New York Governor Charles Evans Hughes appointed a commission to investigate the NYSE. The Hughes Commission rejected the recommendation that the NYSE be regulated by the state in the expectation that the Exchange . . . will be active in preventing wrong doing such as has occurred in the past.” Jennings, Self-Regulation in the Securities Industry: The Role of the SEC, 29 Law & Contemp. Probs. 668 (1964).

In 1912 and 1913 the Pujo Committee, a subcommittee of the House Banking and Currency Committee, conducted the first federal investigation of stock exchange practices.

The Committee found that the NYSE had condoned improper conduct by Exchange members and recommended that the NYSE be fedeally regulated. However, the Committee's recommendations never got out of committee. Id. at 668-669. S. Rep. No. 1455, 73d Cong., 2d Sess. 81 (1934).

old. 7 Id.

The great exchanges of this country upon which millions of
dollars of securities are sold are affected with a public in-

terest in the same degree as any other great utility. 8 Despite the general agreement that it was necessary to create a system of federal oversight of stock exchange practices, considerable disagreement remained over the extent to which governmental control should supersede the existing system of exchange self-regulation. In 1933 President Roosevelt directed Secretary of Commerce Daniel Roper to appoint a Federal Interdepartmental Committee on Stock Exchanges (the "Roper Committee"). In January 1934 this Committee recommended the adoption of "... a method of stock exchange regulation by broad discretionary authority vested in an administrative agency rather than through detailed and specific statutory prohibition and requirement of particular practices." 10 "It is not proposed that the Government so dominate exchanges as to deprive these organizations of initiative and responsibility, but it is proposed to provide authority to move quickly and to the point when the necessity arises.” 11

Assistant Secretary of Commerce and Roper Committee Chairman John Dickinson later explained:

No doubt the exchanges will frequently fail to do a good job
of regulating their members, but even so, it seemed . . that
Government regulation was likely to be more effective and
less unwieldy it [sic] it was applied to the exchanges in an
effort to make them do their own job and to come down on
them like a ton of bricks if they did not do their job, rather
than for the Government itself to take over from them that
job of direct regulation and attempt to perform it from the
very beginning and in the first instance by governmental

policing methods.12 According to Dickinson, the Roper Committee sought to achieve a balance between the clear need for some governmental regulation and the impracticality of a burgeoning bureaucracy. If the government attempted too much direct regulation of the securities industry, the Roper Committee feared it would be "in danger of breaking down under its own weight and proving ineffective.” Therefore, the Roper Committee recommended that governmental regulation be used only "to supplement and supervise what in the first instance was selfregulation of the exchanges." 13

The initial legislative proposal to control stock exchange activities, the so-called Fletcher-Rayburn bill,14 provided for far more direct governmental regulation of the exchanges and the industry than the Roper Committee had recommended. This Committee thought it appropriate to continue to rely on the exchanges for regulatory initiatives but to give government the authority to discipline the exchanges if they did not fulfill their responsibility. The Fletcher-Rayburn bill, & H.R. Rep. No. 1383, 73d Cong., 2d Sess. 15 (1931).

The Roper Committee was comprised of Chairman John Dickinson, A. A. Berle, Arthur H. Dean, Henry J. Richardson and J. M. Landis.

10 staff of Senate Comm. on Banking and Currency, 73d Cong., 2d Sess. Stock Exchange Regulation, Letter from President to Chairman of Comm. on Banking and Currency with an Accompanying Report Relative to Stock Exchange Regulations 13 (Comm. Print 1934).

11 Id. at 6 (emphasis added). 12 Hearing on H.R. 7852 and H.R. 8720 Before the House Comm. on Interstate and Foreign Commerce, 73d Cong., 1st Sess. at 514 (1934). 14 H.R. 7852 and S. 2693, 73d Cong., 2d Sess. (1934).

13 Id. at 513.

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