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Third, in addition to the legal obstacles discussed below, such predatory competition in the securities industry would be largely fruitless and self-destructive. The relative ease of entry into the business would make it attractive for others to enter the business if rates were subsequently raised to a level which produced a high rate of return.
Fourth, the antitrust laws prohibit predatory pricing practices designed to harm competitors or foster monopoly,63 and the Antitrust Division of the Department of Justice has asserted its belief that it has adequate authority to deal with any such practices. 64
Because it does not appear that the smaller and regional firms will be driven out of business by competitive commissions, the argument that fixed commissions are necessary to keep these firms in business so as to preserve their role as underwriters of regional and smaller companies does not seem well founded. While there may be inefficient firms, large and small alike, which will be unable to survive a competitive regime, it is clear that many smaller and regional firms will survive to provide a full range of local services.
Nevertheless, even without regard to the ability of these firms to compete effectively for securities commission business on transactions in the secondary markets, the argument that commission business in some manner subsidizes underwriting business is not supported by those who have testified on the subject. While some firms may need the income from a mix of activities to be profitable, it appears that underwriting is generally much more profitable than securities commission business and may even subsidize the latter. 65
ii. Ability to Raise Capital
The argument has been made that competition will reduce profitability and therefore make it more difficult for the industry to raise capital. Since the ability to raise capital depends on profitability, this argument really is that under fixed rates firms have been earning an artificially high rate of return which has enabled them to raise capital at lower cost.86 There is serious question, however, whether it is in the public interest to subsidize the raising of capital by all securities firms, efficient and inefficient alike, through a fixed commission schedule. The result is to make it possible for inefficient firms to raise capital which will not be put to its most effective use, since inefficient firms use more capital than efficient firms to support a given volume of business. Because the evidence indicates that firms in all size categories will be able to survive and compete effectively, and therefore profitably, in a competitive environment, there is no reason to believe that efficient firms will have difficulties raising capital. This is particularly true in light of the finding by the Friend and Blume Study that "any decline in brokerage profitability would fall mainly on the less efficient
62 “[T]here is free entry in the securities industry because fixed costs are low.” Testimony of Donald Feuerstein, 6 House Hearings, at 3013.
63 See analysis in 1 Securities Industry Study, Hearings Before the Subcomm. on Securities of the Senate Comm. on Banking, Housing & Urban Affairs, 92d Cong. 1st Sess., (1971) at 77-79 (hereinafter cited as "Study Hearings”). Parts 1 and 2 of those hearings were held in the 1st Session of the 92d Congress; parts 3 and 4 were held in the 2d Session.
65 Statement of the Department of Justice, id. at 27; Testimony of William Salomon, 8 House Hearings, supra note 12, at 4037. Friend & Blume Study, supra note 13, reprinted in Commission Rate Hearings, supra note 7, at 397; Hayes, Investment Banking: Power Structure in Flux, Howard Bus. Rev. March-April 1971 at 136, 137-38. 66 See Friend & Blume Study, reprinted in Commission Rate Hearings, at 395.
64 Id, at 29.
firms in the industry. The more efficient firms might very well experience an increase in profitability."67
Thus, to the extent that the advent of competition would make it more difficult for marginal and inefficient firms to raise capital, the market would be operating in the manner in which our free enterprise system for allocating capital is supposed to operate. As Donald Regan testified:
Would the securities industry become so capital-poor that it could no longer carry out its important public function? In the last 9 months, a considerable number of securities firms have gone to the public for their capital. More plan to do so. When that process stops, if it does, the market will be telling us that no more allocation of public capital to this industry
should take place for a while.68 b. Effect on Trading Markets
Another argument which is made against competitive rates is that fixed commissions are essential to market liquidity-at least on institutional-sized transactions. To the extent that there has been any articulation of the rationale for this argument, this concern appears to rest on the premise that the "cushion" of commission rates which are substantially in excess of the costs of the services rendered is necessary to induce firms to position large blocks of securities. 69
Based upon the experience to date with negotiated rates, it appears that this fear is unfounded. The NYSE study of the effects of negotiated rates (on portions of transactions above $500,000) upon liquidity during the period April 1971 to September 1971 came to the following conclusion:
In seeking to measure whether market liquidity has deteriorated as a result of negotiated rates, two sample periods were selected covering time spans both before and after the introduction of negotiated rates on orders over $500,000. The "before" and "after" periods were chosen carefully so as to have comparable time periods in terms of stock price movements. The results indicate that for trades of $1,000,000 and over (the definition of blocks in this report), market liquidity did not seem to deteriorate in the period
following the implementation of negotiated rates.70 Indeed, this NYSE study indicates that if competitive rates have had any, effect on liquidity, the effect has been to enhance liquidity. 71 The NYSE's subsequent study of the effect of negotiated rates under different market conditions during the last quarter of 1971 led to the same conclusion: "[T]he liquidity of the market place in the last quarter of 1971 remained significantly better than that estimated for the period ... (prior to competitive rates).” 72
68 Id. at 203. See also the discussion by Alan Greenspan about the role securities prices play in allocating economic resources. Id. at 149-50.
69 E.g., Testimony of Chairman William J. Casey, id. at 16; Testimony of Macrae Sykes, 8 House Hearings, supra note 12, at 4025-26.
10 NYSE Economists Office, Negotiated Rates and Market Liquidity, reprinted in Commission Rate Hearings, supra note 7, at 135.
71 Id. at 137.
72 NYSE Economists Office, Negotiated Rates and Market Liquidity During the Fourth Quarter 1971, reprinted in Commission Rate Hearings at 139–141. This report noted that the two periods considered were not entirely comparable.
The results of this study were corroborated by the testimony of representatives of financial institutions in the course of the Subcommittee's hearings. These witnesses testified that, in trading the portfolios of their companies, they had not experienced any reduction in liquidity in the period after the advent of competitive commissions at the $500,000 level.73 The position of these institutional representatives, who have, of course, the most direct concern with the question of liquidity because it is their portfolios which most require a liquid market, was unanimously in favor of competitive rates.
While the experience to date with competitive rates for the largest exchange transactions (those over $500,000) does not "prove” that there will be no adverse effect upon liquidity with further reductions in the break point, it does cast doubt on the hypothesis that competitive rates will have a deleterious effect on market liquidity. It is, after all, the largest blocks (on which rates are now partially negotiated) which put the greatest strain on the markets.
The success of the third market, in which institutions deal net with market-makers, reinforces this conclusion:
The third market is sort of reassuring also, Mr. Chairman. There are no fixed commissions or rates or anything else in the third market. It has been extraordinarily successful in attracting block trading in competition with the New York Stock Exchange, primarily because of the increased liquidity
which it provides.74 This view has been endorsed by William Salomon, the managing partner of one of the leading block positioning firms, who strongly endorsed competitive rates:
Our firm's experience of more than 60 years of trading bonds in a highly competitive environment has convinced us that fair and open competition is the cornerstone of an efficient securities market. Every secondary market in which we are engaged involves free and open price competition.
Since negotiated commission rates above the $500,000 level were introduced . . : [in April, 1971] we haven't witnessed any of the calamities which the proponents of fixed commissions have forecast.
There haven't been any harmful effects. There haven't been wider gyrations in the market. There haven't been
greater price discounts.75 ii. "Fragmentation"
Another argument made against competitive rates is that, absent the incentive of the profit generated by the difference between fixed commissions and the presumably lower level which would prevail in a competitive system, brokers will have no incentive to bring their orders to a central market, thus causing a "fragmentation" of the market.76 Insofar as the proposed “central market system” described
73 Statement of the American Bankers Association, id. at 33; Statement of American Life Convention and Life Insurance Association of America, id. at 39.
74 Testimony of James Lorie, id. at 160. 75 8 House Hearings, supra note 12, at 4032-33. 78 E.9., NYSE, Economic Effects of Negotiated Commission Rates, 20 (1968); Statement of the American Stock Exchange, 7 House Hearings at 3811.
in Chapter II becomes a reality, this problem will be eliminated by putting all transactions through a central nationwide communications system, with competing market-makers in which brokers will have a duty to seek best execution for their customers.
In any event, this argument is rebutted by virtually unanimous testimony that fixed commission rates, rather than unifying the markets, have been the single most important factor contributing to market fragmentation." c. Effect on Individual Investors
Another source of opposition to competition in commission rates is concern that, in a competitive system, the so-called "small investor” will be hurt. This concern appears to have two primary aspects: (i) that the individual investor will be required to pay more under a competitive system and (ii) that services which the individual investor needs, particularly research, will no longer be available to him.78
i. The “Subsidy” Argument
The argument that the individual investor will have to pay more for executions seems to be based primarily on the assumption that profits on large institutional transactions subsidize services provided to the individual investor. This subsidization is justified on the public policy ground that individual investors are "small investors" and institutions represent large investors. This subsidy argument, however, does not withstand close analysis, for a number of reasons.
First, most of the "subsidy” arising from institutional transactions does not go to firms which serve retail customers, but rather to firms which deal primarily or exclusively with institutional investors. Chairman Casey testified before the Subcommittee that "different firms tend to serve different types of investors” 79 and Dr. William Freund, the NYSE's economist, has noted that it would be very difficult to transfer funds from institutional firms to retail firms." šo Retail firms (defined by the SEC as firms whose average orders are for less than 300 shares) receive less than 8% of their security commission income from commissions on portions of orders over $100-, 000.81 Only about one-third of the commissions on portions of orders over $100,000 goes to retail firms.82 Many of the firms which receive the greater portion of this subsidy do not and will not do business with individual investors. 83 Therefore, in the absence of a public-utility type regulation requiring all firms to do business with public customers, there is no way to make this "subsidy” work effectively. 77 E.g., Testimony of Harold Bigler, Jr., Commission Rate Hearings, supra note 7 at 36; Testimony of James Lorie, id. at 152; Testimony of Donald Regan, id. at 204. 78 E.g. Testimony of Chairman William Casey, id. at 12, 20. 70 Id. at 25. 80 SEC, Commission Rate Structure Hearings, File No. 4-114, tr. at 5468. In an advertisement in the Wall Street Journal the NYSE asserted: It is not realistic to say, as some people
insist, that profits on the big trades should cover the losses on, the small...
There is no fair way that the profits of firms concentrating on institutional business can subsidize the losses that other firms in doing a general retail business suffer on small transactior s. Wall Street Journal,
Apr. 21, 1970, p. 23. 81 Subcommittee Exhibit 1A, Commission Rate Hearings, supra note 7, at 22. 82 Subcommittee Exhibit 1B, id. at 22. 63 According to testimony at the House hearings, five firms currently account for about half of the total commissions received by NYSE
members from trades over $500,000. 7 House Hearings at 3716. Only one of these five firms is included in the NYSE's Investors' Service Bureau Directory list of member firms serving individual investors.” The other four firms apparently do not
serve individual investors.
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There is also substantial doubt as to whether any such "subsidy” is required to support brokerage services for small investors. Donald T. Regan, Chairman of Merrill Lynch, indicated that his firm, which accounts for about one fourth of all odd-lot business, 84 would be able to offer a straight execution service to individual investor for substantially less than the rate presently fixed by the NYSE fixed commission schedule. 85 There are also firms that do not belong to the NYSE which are willing to execute transactions for individual investors in the third market, even on odd lots, at a substantial discount from the NYSE commission rate schedule. 86 Finally, the Friend and Blume Study suggests that commissions on transactions in excess of about $500 would probably decline under a competitive system. 87
Second, in relation to industry security commission revenues, the amount of the so-called subsidy does appear particularly material, Security commission income currently accounts for about one-half of the gross income of the NYSE's member firms.88 In 1971 security commission income for NYSE member firms totalled $2.9 billion. Recent NYSE figures concluded that the imposition of competitive rates on transactions over $300,000 reduced the annual income of member firms by $80 million 89 and that income would be reduced by an additional $50 million by lowering the break point from the current $300,000 to $100,000. Thus, the total "loss" would be around $130 million. Such a reduction in gross income of less than 5% in an area accounting for about one-half of the income of the NYSE's member firms' aggregate income does not seem particularly significant, particularly when compared to the relatively enormous year-to-year fluctuations occasioned by the cyclical nature of the industry. Over the past five years, the smallest fluctuation from one year to the next has been $588 million and the greatest has been $978 million. The following table shows the extent of these fluctuations:
NYSE MEMBERS' SECURITY COMMISSION INCOME. 90
Change from previous
90 Data obtained from NYSE. The 1972 first half figures slightly overstates income by comparison to prior years because non-clearing firms, excluded from prior years data, are included.
84 Sce note 59, supra. 85 2 Study Hearings, supra note 64, at 25. Mr. Regan also noted that in such circumstances his firm might charge separately for some services, such as custodial services, which are now included in the fixed rate. As noted in the text at footnotes 49–50 su pra many firms in the industry are more efficient than Merrill Lynch.
86 Statement of Odd Lot Securities Ltd., SEC Market Structure Flearings, File No. 4-147 (1971). See also Bargain Brokers: Many Investors Turn to Firms That Discount Their Fees on Stocks, Wall St. Jour., Jan. 9, 1973, p. 1, col. 8.
87 Friend & Blume Study, su pra note 13, reprinted in Commission Rate Hearings, at 323-24; see also Testimony of James Lorie, id. at 163. 88 NYSE, 1972 Fact Book 4 (1972). 89 Address by William Freund, Informational Meeting of NYSE Membership, Oct. 25, 1972.