The decision as to whether listed securities would be quoted on NASDAQ carried major consequences for the character and operation of this country's securities markets.127 The NASD had the responsibility to make the decision in the first instance, but any rule change reflecting the decision had to be filed with the SEC under section 15A. and could not become effective if the Commission disapproved it. The NASD took varying positions, deciding first to exclude listed securities from NASDAQ, then to include them, then to exclude them, and finally to include them. With regard to the NASD's initial two decisions, the Commission made no public statement at all; with regard to the latter two decisions the Commission merely stated it had " no objection”. 128

At no point during the entire three-year period of debate over whether to allow the quoting of listed stocks on NASDAQ did the Commission make a public statement as to the merits of the issue. Its public role was entirely passive and, therefore, there was no effective way for the public, the courts or the Congress to evaluate the justification for the final result.

The basic facts discussed in the Subcommittee's case study of the decisions involved in permitting members of the NYSE and the MSE to sell life insurance are summarized in section III.B.2.a. above 129 The expansion of member firms into this new area of activity has major ramifications for the marketing of financial services and the diversification of the securities industry. 130 Yet when the MSE and then the NYSE proposed to change their rules to permit their members to sell life insurance, the Commission raised no questions concerning the basic policy changes, and issued no statement as to the possible effects of life insurance sales by member firms on the protection of investors or the public interest. The Commission merely stated it had “no objection to ... members undertaking this new activity.131

At the Subcommittee's hearing on the insurance case study, Senator Williams asked whether the SEC had “any basic policy . . . as to what types of activities members should be permitted to engage in.” Commissioner Loomis replied:

All I would say on that was that ... the exchanges, particularly the major ones, have tended to limit their member firms to activities which you might say are related or “kindred,” or however you wish to put it, to the securities industry and the securities brokerage function, or the securities market function, and we have not found it necessary to develop for ourselves an independent overall policy as to activities that member firms should be allowed to engage in, and there is a question as to whether they should be more restricted in diversification than nonmember firms who sometimes get even more diversified.

But in view of the tendency toward diversification in the financial community, which has been going on very rapidly, and which is probably the stimulus for the New York Stock Exchange's decision here, I think it is a matter that the

Commission should take another look at 127 See generally 3 Study Hearings at 1-17. 128 See 3 Study Hearings at 6-10. 129 See generally 3 Study Hearings at 80-93. 130 See 3 Study Hearings at 185-190. 131 3 Study Hearings at 86 and 91. 132 3 Study Hearings at 159 (emphasis added).


In order to avoid the lack of public justification for major selfregulatory policies illustrated by the NASDAQ and insurance cases, the Subcommittee believes that the Commission should be required, in connection with the approval of every self-regulatory rule change, to issue a concise statement of the rule's basis and purpose. In most situations this will be purely perfunctory and the Commission will be able simply to endorse the justification provided by the selfregulatory agencies. 133 With regard to rule changes which have significant policy implications, however, the Commission should issue its own statement as to the regulatory need for and appropriateness of the changes. As the MSE pointed out to the Subcommittee:

In performing its oversight role, the Commission should attempt to speak as unambiguously as possible as to what it is requiring, approving, accepting, or not passing on. Further, to the extent possible, the Commission should acknowledge changes and refinements in its policies and procedures as they are in the process of development. In our judgment, greater certainty on the part of self-regulators with respect to the position of the Commission in those areas in which it exercises jurisdiction cannot but be helpful in

achieving common regulatory objectives." The Subcommittee believes that the discipline imposed by the need to give public reasons for regulatory actions, together with the review afforded by public, congressional and judicial scrutiny of regulatory justifications, should be valuable aids to the Commission in the performance of its oversight functions.




The Subcommittee's case studies and other investigations reveal that a substantial part of the formulation of regulatory policy for the securities industry is carried on by means of private consultation between the SEC or its staff and one or more self-regulatory agencies. As a recent article notes, many significant regulatory decisions have been "hammered out in closed door bargaining sessions where vast discretion rests with the (SEC).” 135 In an industry which is dependent on investor confidence, it is important that the way in which policy is made, as well as the substance of policy, inspires such confidence. The Subcommittee is convinced that this has not always been the case.

The history of SEC Rule 11b-1 illustrates the problem of private negotiation between the exchanges and the SEC over the standards by which those exchanges will be regulated.136 Prior to 1964, the SEC had never adopted a rule under section 11(b) of the Exchange Act, which section gives it the authority to limit specialists' dealer transactions to those necessary to maintain a fair and orderly market and otherwise to regulate specialists' activities in such manner as it deems appropriate. Following a recommendation of the Special Study, in February 1964 the SEC drafted a proposed Rule ilb-1 defining the dealer obligations of specialists and requiring each exchange to adopt a "plan" for the "regulation and surveillance” of specialists which would be required to be "declared effective” by the Commission. This draft rule was sent to the NYSE and the AMEX, but it was not distributed to anyone else outside the SEC.137

133 See recommendations in section III.B.1.b supra 134 3 Study Hearings at 206. 135 Informal Bargaining Process: An Analysis of the SEC's Regulation of the New York Stock Exchange, 80 Yale L.J. 811, 812 (1971) (hereinafter cited as “Regulation of the NYSE"]. 138 See generally 4 Study Hearings at 7-21.


The two Exchanges "violently” objected to the SEC's draft rule, and there ensued over the following six months a series of meetings and discussions between the SEC and a "negotiating team” from the exchanges. As a result of these negotiations, the rule underwent five substantial rewritings, each designed to meet specific exchange objections. 38 In August, the SEC finally prepared a draft rule which met "all objections of the exchanges. This version of the rule was released for public comment in September and was adopted without change as SEC Rule 11b-1 in November 1964.139

Although the precise provisions of Rule 11b-1 are not important for purposes of the present discussion, it is significant that the final version accomplished none of the objectives of the Special Study's original recommendation. Unlike the draft rule which was privately discussed with the exchanges, the rule which was proposed for public comment, and subsequently adopted, (1) did not provide a means for the SEC to take direct disciplinary action against a specialist, (2) substantially eliminated a specialist's exposure to civil liability for failing to fulfill his dealer obligations and (3) severely restricted the SEC's control over stock exchange rules concerning specialists.140 Because the changes between the original draft and the final rule were worked out in the course of private negotiations between the SEC and the exchanges before the proposal was even released for public comments, interested persons-other than the exchanges themselves-did not have a meaningful "opportunity to participate in the rulemaking” as required by the Administrative Procedure Act.

The Subcommittee's investigations indicate that the procedure followed by the SEC in connection with Rule 11b-1 is by no means atypical. The SEC's common practice of working out "acceptable" policy positions with the self-regulatory agencies before publishing a proposal for public comment has drawn the following criticisms from Professor Schotland:

The legally required process designed to assure public
participation in rule making has degenerated into an empty
form, with anyone outside the ... industry leadership
relegated to sending in letters about proposals which in
reality are almost always adopted as “proposed” for the very
excellent reason that they are only proposed” when they
are the final result of industry-Commission negotiation.141
I am not objecting to ex parte contracts in informal rules
making, for I believe them necessary and I approve the
current state of the law about them. I do object to the
practice of putting "all the action” into secret consultations,
with the public uninformed and unwelcome if they sought to

join the consultations. This was legal practice before the 137 See 4 Study Hearings at 7-11. 138 Id. at 11-14. 139 Id. at 15. 140 Id, at 18-21. 141 BNA Sec. Rev. L. & Rep. No. 137 at A-11 (Feb. 4, 1972).

APA. It would have continued to be legal under earlier
versions of the bills which became the APĂ. But those bills
were changed, and minimal requirements were written into
law, calling for timely announcement of the proposed rules
and opportunity for public as well as private interest par-
ticipation. In addition to being illegal, allowing "all the
action" to occur in secret, closed consultations with the

industry weakens the regulators' bargaining power. 142 Another author concludes:

[R]ather than describing a desired modus operandi for the
ŠEC, the statutory provisions [of the Exchange Act) are
merely being used as an arsenal of weapons through which
the SEC has bargaining leverage at the informal level. Sec-
tion 11 rule-making authority has been used not as a pro-
cedure for the SEC to find the best regulators for foor
trading and specialist surveillance) but as a bargaining
threat, and then, as a formal means of announcing a closed-
door bargaining outcome. Section 19(b) authority is not a
procedure which the SEC has used to update and reform
Exchange rules after notice and hearings, but a threat which
the SEČ brandishes to push Exchange reform, or a formal
announcement procedure which is used by the Exchange
to shift pressure from itself to the SEC by making it appear

that the SEC is forcing Exchange reform. 143 The SEC takes a somewhat different view of this process of negotiation with the self-regulatory agencies. During the Subcommittee's hearings Commissioner Loomis stated:

When we discuss particular regulatory problems with the
self-regulatory body, both we and they have an input of
factual information and insight, and a result which reflects
both their input and ours is not, as some have suggested,
necessarily the product either of bargaining or of
compromise. 144
The process is not one of "bargaining,” but of preliminary
exploration of the issues in order for the agency to arrive
at an informed decision. Points made by persons consulted
are evaluated upon their merits. Of course, when a proposal
requires other persons to take voluntary cooperative action, it

is desirable to find out whether they are willing to do so.145 However, Commissioner Loomis also remarked:

Oversight should not only insure but also appear to insure that
regulatory decisions are not made for other than regulatory
purposes. Procedures for Commission oversight of self-
regulatory action require a balancing between the oppor-
tunity for frank and uninhibited discussion of policy issues
and the need to give all persons, whether members or not,
who may be affected by the action, a chance to make their

views known.146 142 Schotland, After 25 Years: We Come to Praise the APA and Not to Bury It, Ad. L.R. 261, 267 (1972). 143 Regulation of the NYSE, supra note 135, at 819. 145 4 Study Hearings at 75 (emphasis added). For the Subcommittee's views on the position represented by the italicized portion the quotation, see Section III, C.2.a.v., supra. 146 Id. at 40.

144 3 Study Hearings at 20.

The Commission's private contacts with the self-regulatory agencies concerning the substance of future regulatory policy, whether these contacts are characterized as “negotiations" or "bargaining" or preliminary explorations of the issues”, and whether or not they are permissible under the APA, have raised questions as to the fairness of SEC procedures for formulating policy in the oversight area and the openness of these procedures to public participation. While it is neither feasible nor desirable to inhibit informal discussion between the SEO and the self-regulatory agencies on policy questions, the Subcommittee believes that the Commission should take steps promptly to guarantee the appearance as well as the substance of fairness and openness in the process by which policy is actually made.

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