the brokerage industry. Inefficient firms, either because
management is inept or because the firm is too large or too

small, will have to change in order to survive.14 Such observations have not been confined to academicians; members of the industry have also recognized the beneficial effect which competition has upon cost control:

Were it not for the concept of fixed commissions we might be further ahead in reduction of costs. The existence of a fixed amount of revenue for any given volume of business has placed primary emphasis on volume. A more flexible rate structure will require active and continuous attention to costs. It is almost incredible that it took the paperwork crunch of the late 1960's to stimulate any meaningful effort to attack the archaic methods of settling securities transactions. Meaningful achievements in this area will be greatly stimulated by rewards. Rewards can best be attained and

best regulated by competition.15 Although many firms in the industry have effective and efficient management, inefficiency and inability to control operations and costs have been unfortunate identifying characteristics of the securities industry as a whole. The inability of the industry to come to grips with the problems of clearing and settlement is described in the Subcommittee's Initial Report and elsewhere.16 Each examination of the crisis which the industry experienced in 1968–70 shows repeated instances of firms failing because their inadequate and obsolete procedures made it impossible for them to keep adequate records of their transactions.17 As one observer has described the situation, in facetious terms that should not obscure the gravity of the situation, the task of bookkeeping was left to "a gentleman in the back room, wearing

who would lick his pencil as he recorded the trade . . . ." 18

While the fixed commission rate system is of course not solely responsible for managerial shortcomings in the securities industry, its effects contributed substantially to the crisis. The fixed commission rate system caused the industry to focus its attention solely on increasing sales, rather than on controlling costs; uneconomic branch offices were opened; salesmen were hired without regard to whether they would contribute to profits or whether the back-office could process additional business.19* Insufficient managerial attention was devoted to costs, efficiency and modernization. 14 Id. at 283. 15 Testimony of Paul A. Conley, 8 House Hearings at 3982,

16 Initial Report, supra note 1, at 7–11; Securities Industry Study, Report of the Subcomm. on Commerce & Finance of the House Comm. on Interstate & Foreign Commerce, 92d Cong., 2d Sess. (Subcomm. Print 1972) at 3-13 (hereinafter_cited as "House Report"); letter from Commissioner Hugh F. Owens to Chairman Harley O. Staggers. Jan. 12, 1971, printed in 3 House Fearings at 1719-28.

17 See the detailed case studies of the ailures of forty-six broker-dealers in Staff of Specials ubcomm. on Investigations of House Comm. on Interstate & Foreign Commerce, Review of SEC Records of the Demise of Selected Broker-Dealers, 92d Cong., 1st Sess. (Subcomm. Print 1971); SEC, Study of Unsafe and Unsound Practices of Brokers and Dealers, H.R. Doc. 92-231, 92d Cong., 1st Sess. (1971); BARUCH, at 85–118. Of course, as described at Chapter I.A.1.f., supra, the recordkeeping failures of any one firm serve to impair the efficiency of all other firms which deal with that firm.

13 "ADAMS SMITH”, SUPERMONEY 52 (1972). 19 See, e.g., Unsafe and Unsound Practices Report, at 18, 45, 95. It has been suggested that too many executives in the industry did not know the difference between gross and net income. Welles, Where Win Wall Street's Profits Come From?, Institutional Investor, Sept. 1972, pp. 35-36.

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The failure of the SEC and the self-regulatory agencies to stem this tide was not entirely a regulatory failure. The events of these years clearly demonstrate that efficiency and good management can not be created by regulatory fiat. Regulation is not an effective substitute for competition.

Inefficiency in the securities industry, in addition to contributing to the financial debacle, has had other disadvantages for the public:

This industry has many members, some large, some small;
some do a public business, some not; some are well capital
ized, some not; some are well managed, some badly managed.
Not to make too fine a point on it, some deserve to stay in
business, and some do not.

The ones who are really doing the greatest disservice to the
individual are the ones who are least efficient and worst
managed. They have the highest costs, and can survive only

in the artificial climate of fixed prices o Where prices are fixed, firms cannot compete by offering lower prices to their customers. Therefore, firms compete by offering their customers additional services. These additional services often are expensive and add to fixed costs. In many cases, the value of these services to customers is not proportionate to the cost of providing them. Moreover, the steady growth of fixed costs resulting from this service competition creates continuous upward pressure on the commission rate schedule.

Donald Farrar, the Director of the SEC's Institutional Investor Study, 21 has described this phenomenon as follows:

The dynamics of service competition in the securities industry guarantees that costs will build up rapidly until they exhaust whatever revenues are produced by a given rate structure—thus any rate schedule becomes self-justifying on

a cost basis over time. 22 The President's Commission on Financial Structure and Regulation recently made the same point about another area of the economy: "non-price competition in convenience and services (where the customer would prefer price competition) leads to uneconomic increases in operating costs and ... therefore, causes resources to be misallocated.” 23

The lesson of the past few years seems plain: lack of competition fosters inefficiency and tends to cause prices to rise without justifica tion in terms of public benefit.

The detrimental impact of fixed rates upon efficiency and costs is of current as well as historical importance. Recently, concern has been expressed anew about the profitability of the industry.24

This concern about profitability at a time when volume is at historically high levels 25 illustrates the fact that costs have been allowed to rise to the point where constantly increasing volume is necessary in order to enable the industry to break even. 20 Testimony of Donald Regan, Commission Rate IIearings, supra note 7, at 202. 21 Institutional Investor Study Report of the SEC, H.R. Doc. No. 92-64, 92d Cong., is: Sess. (1971) (hereinafter cited as "Institutional Investor Study'). 23 The Report of the President's Commission on Financial Structure & Regulation at 28 (1971). 24 E.g., Address of James Needham and William C. Freund, Informational Meeting of NYSE Membership, Oct. 25, 1972: The Market 18 Tough on Brokers, Too. NEWSWEEK, Nov. 6, 1972, p. 87; Wall Street, Profities Prosperity. TIME, Nov. 6, 1972, p. 94. 26 See Table in text at footnote 107, infra.

22 6 House Hearings at 2947.

The standard excuse for the present difficulties is low volume.
In reality, trading on the New York Stock Exchange, the
nation's dominant market, has been running ahead of a
year ago .:. : Explanation: The brokerages have not
themselves been instituting the vigorous cost-cutting pro-
grams they acclaim for companies whose stocks they recom-
mend to clients for purchase. Many firms last year opened
new branch offices and expanded their sales staffs. As a result,
officials of the New York Stock Exchange estimate member
brokers break even only when daily volume averages a high
14 million to 15 million shares v. 12 million only two years

ago.28 Price competition is the best stimulus to managerial efficiency and the securities industry is in need of a strong and prompt dose of this remedy.27 b. Difficulty of Ascertaining Appropriate Rates į. The Absence of Standards

The inability of the SEC to fulfill the normal role of a rate regulator was described at length in the Initial Report.28 Without reviewing here at great length the history of the SEC's three and one-half year commission rate hearings, it is important to note the circumstances under which the rate schedule was reviewed: (1) the SEC was unable to establish objective standards of reasonableness against which to measure the rate schedule; and (2) the SEC did not have, and could not obtain from the NYSE, appropriate cost information to use in evaluating this rate schedule.

The SEC has been candid in recognizing its inability to apply public utility standards in viewing commission rates. In response to an inquiry from the Subcommittee's Chairman concerning the SEC's review of the NYSE's most recent change in the commission rate schedule,29 Chairman Casey stated:

As you know, the securities industry is diverse. A public utility type rate is impractical for application to all exchange member firms because of the different businesses in which they engage. Thus, the exercise of the Commission's review function necessarily involves a large degree of practical judgment based upon all available information. The review of the current New York Stock Exchange proposed rates was, we believe, thorough and included an extensive public investigatory hearing at which relevent testimony and data were presented. ..

It appears to us at this time that, largely because the public utility approach to rate setting is not appropriate here, we 28 Wall Street, Profitless Prosperity, TIME, Nov. 6, 1972, p. 94. 27 Rep. Emanuel Celler, former Chairman of the House Judiciary Committee, put the matter as follows: "If the near collapse of 1968–70, when over 100 member firms failed, or got into difficulties, demonstrates anything, it tells us that Wall Street needs the invigorating effects of real competition, not

more protective regulation." 3 House Hearings at 1646. 28 Initial Report, supra note 1, at 56-60.

29 Letter from Senator Harrison A. Williams, Jr., to Chairman William J. Casey, Nov. 2, 1971 in Commission Rate Hearings, supra note 7, at 29-30.

should rely on broad judgment applied to many elements,
shifting in their relative importance, rather than tending to

formulate an abstract set of standards.30 In other words, the SEC has not been able to determine an appropriate rate of return for the securities commission business. Moreover, it has specifically noted that it had to review the most recent commission rate schedule in a vacuum resulting from the NYSE's inability to allocate costs to the business for which the rates were being fixed.

The inextricably intertwined, heterogeneous nature of the brokerage, underwriting, margin, investment advisory and other services provided by broker-dealers creates immense difficulties in allocating costs, capital and revenues among these functions. Although the Commission and the Exchange are attempting to devise a uniform system of reporting, the joint use by brokerage firms of personnel and facilities in various securities business activities makes allocations of cost and capital extremely difficult and may dictate that all such activities be considered in determining reasonable

rates. 31 William McChesney Martin, who is generally favorable toward fixed rates, has also noted:

Setting commissions has been one of the most difficult problems in the industry, and it has caused constant differences between member and non-member brokers and the exchanges. The difficulties of determining a fixed commission

schedule are major.. .. In short, despite the serious efforts of all concerned, the setting of reasonable fixed rates in the securities industry still proceeds without an adequate rationale or sufficient benchmarks, producing enormous profits for some firms and bare subsistence for others. The forces of competition working in a free market-place are better suited to the task of pricing brokerage services.

ii. Impediment to Industry Adjustment

Even were it possible to devise appropriate rate-setting criteria and to obtain financial data to enable those criteria to be applied, the process of setting and reviewing rates will always have a built-in timelag. This lag prevents firms from promptly adjusting the prices at which they will do business to reflect changing conditions. Under a freely competitive system, firms will have the necessary flexibility to change their prices as conditions change. As Robert Fischer, president of

30 Letter from Chairman William J. Casey to Senator Harrison A. Williams, Jr., Dec. 3, 1971 in Commission Rate Hearings, at 31. Commissioner Loomis has also acknowledged that it is impossible to determine "a cost-related public utility type rate to suit all of the firms which are in different businesses." 3 House Hearings, supra note 12, at 1794.

In another context, the regulation of margin requirements, the SEC has suggested that it does not have the staff, facilities or requisite knowledge for acting in areas of economic regulation. Unsafe and Unsound Practices Report, supra note 17, at 21.

31 Letter from Chairman William J. Casey to Senator Harrison A. Williams, Jr., supra note 30

32 W. Martin, The Securities Markets: A Report, With Recommendations (1971) reprinted in | Hearings on S. 1164 and S. 3347 Before the Subcomm. on Securities of the Senate Comm. on Banking, Housing

& Urban Affairs, 92d Cong., 2d Sess. at 321, 340 (hereinafter cited as "Institutional Membership Hearings").

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Dain, Kalman & Quail, Inc., a Minneapolis-based securities firm, testified:

It may be theoretically true that prices in any economic
activity can be fixed for a period of time during which con-
ditions remain relatively unchanged. The history of fixed
prices in almost any economic activity, however, is that they
are not changed when the conditions under which they were
developed change. The result is simple and predictable.
When conditions change, various practices are built up to
avoid the effects of fixed prices that are out of tune with
with the economics of the activity for which they are charged.

That has happened in the securities industry ... 33 Flexibility to adjust prices becomes even more important because of the cyclical nature of the securities commission business. Volume and revenues fluctuate widely in relatively short periods of time.34 Firms must be free to adjust to meet changes. An officer of a selfregulatory organization has stated that the lack of this flexibility results in customers receiving "an unsatisfactory level of servces. ... c. Fixed Commissions as a Cause of Market Distortions

The available evidence clearly indicates that the fixed commission rate structure has also been the primary cause of the market distortions and fragmentation which have taken place concurrently with the growth of institutional market activity. According to Donald Farrar:

The great majority of economic and regulatory problems
currently surrounding the nation's securities markets can
be traced in whole or in part to attempts by the major
exchanges and some types of institutional investors to
protect noncompetitively determined fixed minimum com-
mission rates, and by other markets and institutional types
to exploit competitive opportunities to avoid such rates.
The growth of off-board trading in listed securities, reciprocal
practices that are properly described as Byzantine, pressures
for institutional membership on both regional and major
exchanges, as well as innumerable exchange rules designed
to preserve fixed rates-most of which are circumvented by
exchange members through an unending variety of loop-
holes—all testify far more eloquently than I can to the
enormous pressures that have built up under this pricing

structure during recent years.” In order to avoid paying the fixed minimum commission rates, sophisticated investors made use of the third market and commission recapture methods available on regional exchanges. More than two years ago Robert W. Haack, former President of the NYSE, described

33 Commission Rate Hearings, supra note 7 at 211. Some in the industry, not giving sufficient recognition to the inevitability of delay in rate-making proceedings, suggest that the problem could be alleviated by more prompt rate review. See e.g. Testimony of Richard A. Westcott, 6 House Hearings, supra note 12, at 3006.

34 See Tables in text at footnotes 90 and 107, infra.
35 Testimony of John Weithers, 7 House Hearings, at 3715.

38 6 House tearings at 2947. See also Testimony of Seymour Smidt, former Associate Director of the Institutional Investor Study, 7 House Hearings, at 3465.


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