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these recapture methods as “mazes of blatant gimmickry. Con-
sequently, (1) sophisticated and substantial investors avoided the
fixed commission rates and (2) these investors took their business to
the market in which they could best reduce transaction costs.38 More
recently, Mr. Haack has elaborated upon this phenomenon and its
consequences:

I, for a long time, have held to the conviction that the fixed
minimum commission rate, because it is not truly fixed for
all investors, and traditionally and customarily and prac-
tically has not been a fixed rate, has in itself been the greatest
fragmenter of the market that we know by reason of the
fact that there was obviously some fat in the schedule, and
it was this excess that permitted a lot of fragmentation
whereby orders could profitably be taken away from the
central market to other marketplaces. The result has been
that the market is becoming more fragmented by reason
of the ability to take transactions to other marketplaces so
that the fixed commission rate can be violated.

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I think that with fully negotiated rates business will be done on the basis of depth, liquidity, and continuity of the marketplace, and if that is in Chicago rather than New York, so be it.

But it will not be done on the basis of where you can trade commission dollars with an excess profitability that

arises out of a fixed rate.39 The SEC, in its letter transmitting the Institutional Investor Study 40 to Congress, agreed:

[T]he Commission regards non-competitive, fixed minimum commission rates on transactions of institutional size as the source of a number of difficulties in the development of institutional investing and the trading markets for equity securities. The clear conclusion from the Study Report is that competitive brokerage rates should be required at least

on such transactions. Since the existence of fixed commissions has been the principal contributor to market distortion and fragmentation, it is evident that fixed commissions also will impede development of a true central market system. So long as the incentives which gave rise to the "mazes

37 Address by Robert W. Haack, before the Economic Club of New York, Nov. 17, 1970 quoted in The N. Y. Times, Nov. 18, 1970 p. 76 col. 8. Some of the methods by which sophisticated investors reduced their commission costs, known by such colorful terms as "four-way tickets," "step-outs” and “mirror trades”, are described in the testimony of Robert Loeffler, 1 Institutional Membership Hearings, supra note 32, at 99-115.

38 Commission Rate Hearings, supra note 7, at 39, 152, 204; SEC, Statement on the Future Structure of the Securities Markets reprinted in 1 Institutional Membership Hearings, supra note 32, at 149, 164.

39 7 House IIearings, supra note 12, at 3727-28. The view has been expressed that in the absence of distortion, all transactions in a particular security would flow to a single market. This "is simply an extension of the concept that traders in a homogeneous good can always reduce their costs by localization of transactions in a single market place due to inventory, search and information cost reductions." R. W. Doede, The Monopoly Power of the New York Stock Exchange (1967) in Commission Rate Hearings at 405, 429 40 Supra note 21. 411 Institutional Investor Study, supra note 21, at VII.

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of blatant gimmickry.” continue, the distortions will remain.42 In its recent statement on the Future Structure of the Securities Markets, the SEC said: "Fixed minimum commissions, at least on institutional size orders, may well make it very difficult, if not impossible, to create the central market system we envision." 43

2. THE ARGUMENTS AGAINST COMPETITION The arguments against moving to competitive rates in the securities industry, although to a certain extent overlapping, can be reduced to the following essentials for the purpose of analysis: (a) effect on the industry and its ability to mobilize capital; (b) effect on trading in listed securities; (c) effect on the availability of service to the individual investor; and (d) effect on the availability of institutional research. a. Effect on the Industry and Its Ability to Mobilize Capital

Concern has been expressed that further competition on securities commission business would have an adverse effect on the aggregate income of the brokerage community and that this loss of income would, in turn, have the following unfavorable consequences:

-Regional and smaller firms would be unable to compete with
larger national firms and would fail or be forced to merge, leaving
only a few giants in the industry.44 A companion argument is
that the largest firms in the industry would cut their rates below
cost to drive other firms out of the business and then, once they
had obtained a monopoly position, would raise rates exhorbi-
tantly.45
-As regional firms are driven out of business as a result of their
supposed inability to compete, smaller companies and local
governments dependent upon these firms for underwriting
assistance will find it increasingly difficult to raise capital.46
-The general loss of income throughout the industry would
result in reduced profitability, thereby making it more difficult
for the brokerage community, already capital poor, to attract

much-needed capital.47 42 Seymour Smidt, the Associate Director of the Institutional Investor Study, has described the consequences of fixed rates as follows:

Attempts to obtain either cash rebates or reciprocal services of some sort have led to considerable distortion in the pattern of trading. . . . In my opinion, all attempts to deal with this disease by rigorously attacking the symptoms are bound to fail. The simple and obvious remedy is to move

as rapidly as practicable to a system of competitively determined rates. 7 House Hearings, supra note 12, at 3165.

43 SEC. Statement on the Future Structure of the Securities Markets, reprinted in 1 Institutional Membership Hearings, supra note 32, at 164. This reaffirms the SEC's conclusion in its Letter of Transmittal for the Institutional Investor Study that fixed commissions and the

devices developed to avoid them "impede the development of a central market system for securities trading." Summary Volume, Institutional Investor Study, supra note 21, at XXII. 4 .9. Testimony of John E. Leslie, Commission Rate Hearings, supra note 7, at 178; W. M. Martin, The Securities Markets, A Report with Recommendations, (1971) reprinted in 1 Institutional Membershi Hearings, supra note 32, at 340-341.

45 E.G., Testimony of Richard Westcott, 6 House Hearings, supra note 12, at 3005; Stock-Fee Plan Alarms Wall Street, The N. Y. Times, Aug. 25, 1972, p. 43; No Negotiation on Rates for the Small Investor, Washington Post, Sept. 18, 1972, p. D 10. 46 E.g. Testimony of Richard Westcott, 6 House Hearings at 3024-27. 47 E.g. Testimony of John Richter, Commission Rate Hearings, supra note 7, at 245.

i. The Competitive Posture of Large and Small Firms

At the root of the first two arguments is the assumption that the large national firms have inherent cost advantages over the smaller or regional firms.48 No factual evidence has been offered to support this assumption. In fact, the available evidence leads to the opposite conclusion.

Professors Friend and Blume, after strenuous analysis of the revenue and expense data for individual NYSE firms for the years 1965–1970, conclude:

The study gives no support to the view that it is the small and regional firms which would be mainly affected by any decline in brokerage profitability, [as a result of competition] with possibly disastrous consequences for these firms and for the sectors of the economy which they service. An analysis of the cost and profit structure of NYSE firms and of changes in the concentration of securities business over time leads to the conclusion that economies of scale in the brokerage business

do not seem to be very strong, especially for regional firms.“ Others who have considered the question analytically have reached the same conclusion. One study introduced at the SEC's Commission Rate Structure Hearings, based upon the analysis of data from 350 NYSE member organizations, showed that, for the year 1967 no fewer than 70 firms had higher profit margins than Merrill Lynch, the largest firm in the industry, and that 240 firms had higher profit margins than the average of the ten largest firms.50

The NYSE's own analysis of its members’ securities commission business for 1971 reinforces this conclusion. The NYSE divided the 330 member organizations doing business with the public into nine groups of clearing members and four groups of non-clearing members on the basis of the gross amount of security commission income of the firms. The results of that survey are shown in the following table. The 34 clearing member firms reporting security commission income in excess of $20,000,000 for the year earned an average net profit on security commission business (after taxes) of 5.3%. Each of the eight

! other groups of clearing firms had an average profit greater than that of the largest firms. The average of all firms was 6.2%, almost one-fifth i higher than the average for the 34 largest firms. And the average net profit margin of each group which had less than $5,000,000 of securities commission income was higher than the average net profit margin of each group which had more than that amount.

48 At one time the NYSE argued that the industry was subject to "destructive competition;" ie that in a competitive environment firms will tend to lower their prices below full costs in an attempt to cover some of the large fixed costs supposedly associated with the business. As a result, so this argument goes, many firms will fail. See, e.g., NYSE, Economic Effects of Negotiated Commission Rates 5-9 (1968). In testifying on the subject of commission rates before this Subcommittee and the House Subcommittee on Commerce and Finance over the past 18 months, the NYSE has not made this argument and has now, apparently, abandoned it. See Commission Rate Hearings, at 120-174; 7 House Hearings, a: 3687,

3746. A few persons in the industry persist in this argument, however. See Testimony

of Richard Westcott, 6 House Hearings at 3004. In any event, this argument is carefully refuted in the study conducted by professors Irwin Friend and Marshall Blume who concluded, after studying factual material on the nature of costs of the business, that it was based upon incorrect assumptions. Friend & Blume Study, supra note 13, in Commission Rate Hearings at 267-3i8. 49 Friend & Blume Study, supra note 13, reprinted in Commission Rate Hearings, su pra note 7, at 395. 60 Garil Exhibit I, SEC Commission Rate Structure Hearings, SEC File No. 4-144.

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51 Data obtained from NYSE, Security Commission Income Business Calendar Year 1971, Income and Expense Ratios - (Aug. 24, 1972).

The testimony of industry representatives supports the conclusicns which follow from analysis of the data: smaller and regional firms appear to be perfectly capable of competing successfully with the larger firms. Thus, Robert W. Fischer, President of Dain, Kalman & Quail, Inc., a regional firm with headquarters in Minneapolis, testified before the Subcommittee in support of competitive rates. When asked whether competition would mean the demise of regional firms he responded: Small, poorly managed, under-capitalized firms in the

ies industry will be badly hurt, if not killed, by competitive rates. A lot of small, under-capitalized, badly managed firms are located around the country. If you use that as a description of regional firms, then regional firms will be

hurt.52 Mr. Fischer then went on to state that he thought Merrill Lynch could not successfully compete for investment banking business in his firm's territory and that he thought his firm had a better profit margin than Merrill Lynch.53 Donald T. Regan, Chairman of Merrill Lynch, agreed:

Anyway, from my point of view, I think the well-managed, efficient, regional firm will always be a part of the financial industry. Nothing can drive him out. Competition from the

large national wirehouses can never offset the local flavor, 52 Commission Rate Hearings at 209. 63 Ibid.

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the local trust that there is in knowing a firm in your own
area. These firms, as long, as I said, as they are well-managed,
will do very well and will make profits, probably exceeding

on a ratio those of the large wirehouses. 54 Even the representative of a Philadelphia firm who expressed concern about the survival of regional firms, said that he did not think his firm would be unable to survive.55 And the representative of a number of regional firms who also subscribed to these concerns indicated that an unspecified number of the firms he represented thought they would easily survive under any competitive rate structure" but "would be severely damaged." 56 As Commissioner Loomis observed in the course of the SEC's Market Structure Hear

! ings, “We have other people come in and say that regional firms cannot survive, but no regional firm has.” 5* Robert W. Haack, former President of the NYSE, wh) spent 25 years with a Milwaukeebased regional firm, noted that competition:

would not necessarily put the so-called small dealer out of
business. I think I can speak with some expertise about the
smaller firms because I spent 25 years with one and they do all
right and as Mr. Tobin [President of the Midwest Stock

Exchange) says, they will continue.58 A related argument, as noted above, is that the largest firms in the industry might attempt to drive other firms out of business by cutting prices below costs, and then, having obtained a monopoly position, raise prices to exploit the monopoly. This argument fails to give heed to the structure of the industry. First, as discussed above, many small | and medium sized firms in the industry have higher profit margins than the largest firms, and thus do not appear to be in a particularly vulnerable position should the large firms embark on a campaign to drive them out of business.

Second, the lack of concentration in the security commission busi- ! ness as a whole makes it unlikely that such a predatory attempt would have any significant success. Currently, the largest firm in the industry accounts for only 11% of all round lot volume on the NYSE.59 The ten largest firms account for an aggregate of only 29.9% of NYSE security commission income. The twenty largest account for 43.9% and the fifty largest for 62.2%.60 In light of this relatively low level of concentration it does not seem reasonable to assume that the larger firms will succeed in driving the smaller firms, many of which have significantly higher profit margins, out of business. 61

54 Id. at 207.
55 Testimony of John Richter, id. at 244.
58 Testimony of Charles Morin, id. at 245.
57 SEC File 4-147 tr. at 2942 (1971). Donald Farrar has noted:

Those firms who would be hurt most seriously [by competitive rates)--and who claim most vocifer-
ously that small efficient regional firms would be hurt-are in fact a relatively small number of

very large New York houses. 6 House Hearings, supra note 12, at 3016.

68 House Hearings, at 3735. See Regional Brokerage Houses Thrive, The N.Y. Times, Oct. 15, 1972 $ 6 p. 16 col. 3. "A number of regional brokerage houses have stolen some of the thunder from New York by establishing strong research departments in their own trading areas and using them to build up trading and underwriting." A shakeout hits Wall Street Analysts, BUSINESS WEEK, Nov. 11, 1972, p. 140.

69 Merrill Lynch Pierce Fenner & Smith, Inc., 1971 Annual Report 4 (1972). Merrill Lynch does, lowever, account for almost one-fourth of all odd-lot business on the NYSE. Ibid. The use of NYŠE volume figures in the example cited overstates the degree of concentration in the industry as a whole by failing to include O-T-C volume and business. 60 Letter from NYSE to Subcommittee Staff, Jan. 9, 1973. These figures are based upon 1971 data 61 See Testimony of George Reycraft, 3 House Hearings, supra note 12, at 1664.

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