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Third, even if the profits on institutional business could be made to subsidize services to individuals, the Subcommittee is not con vinced that such a subsidy could be justified upon public policy grounds. Institutional investors act as financial intermediaries on behalf of their beneficiaries-insurance policy holders, pensioners, mutual fund shareholders and the like. If there were to be a subsidy it is these beneficiaries who would be called upon to subsidize the transaction costs of those individuals who choose to invest directly As one witness before the Subcommittee noted:
One of the most absurd arguments I know is that the present structure is justified because it subsidizes the small investor by charging excessive fees to large ones. I never heard of anyone who has the effrontery to argue that an appropriate way to redistribute wealth is through the noneconomic pricing of brokerage services. And even if that were a con ceivable way to do it, there is no clear evidence that the wealth that would be redistributed would be from the rich to the poor, since many of those who invest in institutions
are the relatively poor. 91 üz. Research and Other Services
Another concern that has been expressed is that if fixed rates are eliminated, there would be a tendency for great numbers of individual investors to patronize the firms offering the least expensive executions regardless of the quality or breadth of their services and that, accordingly, the research available to the individual investor would at best be of poor quality and at worst nonexistent. 92 However, the assumption that people will chose their brokers solely on the basis of price ignores the experience in numerous other areas of the economy, where high and low cost businesses, offering different packages of services, successfully compete.
In any event, maintenance of fixed rates does not and cannot insure that individual customers will receive adequate research and other services. On the contrary, the existence of higher profit margins on institutional transactions results in channeling the best research to the institutions. An executive at one large firm has been quoted as saying that "giving (research] to everyone downgrades the quality of the work." 93 Another firm reportedly penalized registered representatives for distributing research to customers deemed insufficiently profitable.94 Competitively determined commissions will not deprive individual investors of necessary research. In fact, industry representatives testified before the Subcommittee that their firms would always make research available to the individual investor without separate charge. The relatively small amount which brokerage firms spend on research for individual investors makes it extremely doubtful that firms will attempt to achieve a competitive advantage by eliminating research.95 01 Testimony of James Lorie, Commission Rate Hearings, supra note 7, at 154. 82 E.g., Testimony of Chairman William Casey, id. at 25.
3 Welles, Flow the Street is Putting the Little Alan out of the Market, Institutional Investor, March, 1972, p. 1 37, 92-93.
95 The available evidence indicates that research costs account for less than 4% of the operating expenses of NYSE member firnis. See Casey Is Against Forectch Clcret-See Only Small Fee Cuts By Brokers is! Cost of the Service is "Unbundled", The N.Y. Times, No. 2, 1971, reprinted in Commission Rate Hearings, su pra note 7, at 236. See also, Testimony of Chairman William Ca:ey, id. at 12.
d. Effect on Institutional Research
The existence of the "fat" in the fixed commission rate schedule on institutional transactions gave rise to a new kind of currency—the "soft dollar”—which could be used to pay for services provided by brokers other than execution of transactions. A significant portion of these "soft dollars” have been used to pay for “research” provided to investment advisors. With the elimination of fixed rates and the concomitant elimination of scft dollars, many mutual fund advisors and other fiduciaries are concerned that they will not be able to pay for the investment research and advice which is essential for informed investment decisions.98 Similarly, those brokers who have competed on the basis of the quality of their research are concerned that the market for their services will disappear.97 This concern arises from the belief that, under competitive rates, investment advisors must always use the broker who charges the least for a particular transaction, without regard to other services which he may provide for the fund.
This fear is based largely upon a 1967 decision by the SEC in the Delaware Management Company case, 98 in which a fund manager caused the fund to sell 200,000 shares of stock for $13.50 to one broker when another broker was offering $14.00. This was a transaction in a listed security on which the broker also received the minimum fixed commission. The manager defended its action on the ground that the broker provided investment research for the funds. However, the SEC found that the manager was contractually required to provide investment research and that the fund's prospectus said that the fund always sought best execution. For this reason, the Commission concluded that the manager was guilty of a fraud upon the fund.
It may well develop that in the future all money managers will pay "hard dollars” for research out of the advisory fees they charge their clients. However, the system has not developed in that manner up to now and the present situation is unlikely to change immediately. Such change is also hindered by state laws and contractual arrangements which limit fiduciary compensation. These make it difficult for fund managers to buy the research they need, unless they pay for it with commissions from portfolio transactions, which has been the general practice to date.
It appears that many institutional managers, and legal advisors, have read too much into the SEC's decision in the Delaware Management case.99 That case can be distinguished from the normal situation by a number of aggravating factors, including the complete failure of the fund manager to disclose its practices in allocating brokerage commissions. The SEC has sought to clarify these distinctions in an interpretive release. 100 Unfortunately, however, this release has failed to provide sufficiently clear guidelines to put the matter to rest. Many conscientious investment advisors are uncertain about the legality of paying higher commissions to brokers who provide their funds with valuable research, even though the funds' prospectuses candidly describe these practices. Accordingly, some fear that the introduction of competitive rates across the board will greatly diminish the availability of research. In order to meet this concern, which should not be allowed to hinder the movement towards competitive rates, the Investment Company Act and Investment Advisers Act should be amended to make it more clear that institutional managers may incur additional commissions on portfolio transactions for the purpose of obtaining research which they determine to be of value to the institutions which they manage. Such payments should be fully disclosed to fund beneficiaries to insure that this legislation will not be used to mask reciprocal practices or otherwise divert fund assets.
96 E.., SEC Statement on the Future Structure of the Securities Markets, reprinted in 1 Institutional Membership Hearings, supra note 32 at 166; Testimony of Charles Shaeffer, Commission Rate Hearings at 96; Statement of the American Bankers Association, id. at 33.
97 E.g., Testimony of Donald Marron, House Hearings, supra note 12, at 3994; Statement of the Securities Industry Association, id. at 4186-90; Welles, Where Will Wall Street's Profits Come From, Instutitional Investor, Sept. 1972 pp. 33, 41, 84; Bleakley, Institutional Research: End of an Era?, Institutional Investor, Feb. 1972, p. 27 et seq. 99 SEC Sec. Ex. Act Rel. No. 8128 (July 19, 1967). 99 Remarks of Senator Harrison A. Williams, Jr., Annual Institutional Trader Conference, New York, New York, June 22, 1972; Arldress of Chairman William Casey, Financial Analysts Federation, New York, New York reported in BNA, Securities Regulation & Law Report No. 154, p. A-4 (May 31, 1972).
190 Applicability of the Commission's Policy Statement on the Future Structure of the Securities Markets to Selection of Brokers and Payment of Commission's by Institutional Managers, Sec. Act Rel. No. 5250, Sec. Ex. Act Rel. No. 9598, Inv. Co. Act Rel. No. 7170, Iny. Adv. Act Rel. No. 318 (May 9, 1972).
3. AGENDA FOR COMPETITION There is now general recognition that elimination of price fixing on stock exchange commissions is necessary and appropriate in the interests of both the public and the securities industry itself. However, there is still a question as to the best method of implementing this decision. While suggestions have been made for alternate techniques, 101 continuation of the method used to date, namely successive reductions of the break-point, appears to be the least disruptive manner of accomplishing this objective 102
In light of the testimony of the NYSE and Chairman Casey, the Subcommittee believes that current plans to eliminate fixed commissions on that portion of an order over $100,000 by the first quarter of 1974 should allow the industry ample time to plan intelligently for the new competitive environment. In light of the statements of many in the industry 103 that retention of fixed commissions only on transactions under $100,000 would not be desirable, the Subcommittee also anticipates that elimination of fixed commissions on large transactions may ultimately lead to their elimination on all orders.
The step-by-step method should not, however, be used as the basis for renewing resistance to competitive pricing.
At every move to lower the level for negotiated rates, we have been bombarded from many sides with the argument that time is needed to adjust to the change so that the impact of each downward move could be evaluated.
As yet (April 17, 1972] it has not been made clear what
adjustments are being made by the firms who oppose nego101 See Friend & Blume Study, supra note 13, reprinted in Commission Rate Hearings at 401. 102 This is the approach now being used to eliminate fixed commissions on commodity transactions on the Chicago Board of Trade. The United States Department of Justice sued the Board of Trade, alleging that its fixed commission schedule constituted unlawful price fixing. The Administrator of the Commodity Exchange Authority, at the request of the court, submitted a report in which he concluded that fixed commissions were not necessary to make the Commodity Exchange Act work. The defend'ınts have bffered to settle the case, agrering to phase out fixed commissions at set dates over a four and one-half year period, starting with the largest transactions and working down to the smallest. United States v. Board of Trade of the City of Chicago, Docket No. 71C 2875, U.S.D.C. N.D. III. (1971).
103 E.g., Testimony of Robert Gardiner, 8 House Hearings, supra note 12, at 4182; Testimony of Charles Morin, id at 4200; Summary of panel discussion by Harvey Rowen, id. at 4195; Farrar, Wall Street Reform, HARVARD Bi's. Rev. Sept.-Oct. 1972 at p. 114. Bleakley, A progress report on negotiated rates: Where do we go from here? INSTITUTIONAL INVESTOR Jan. 1973 p. 44 ("Surprising as it may seem, a large number of brokersrepresenting both retail as well as institutional houses-say they would rather see a move to fully competitive rates than have the ceiling stop at $100,000"').
tiated commission rates. The gradual stepping down process
it can be permanently stalled.104 Recently, some persons have expressed the view that in light of the current “low profitability” of the industry and what some call "low volume” further reductions in the breakpoint should be postponed.105
It is asserted that the industry is in a "valley” of the business cycle and that steps which might reduce in dustry revenues would, therefore, be inappropriate at this time.106 The fact is, however, that this is not a period of "low volume”, as the following table clearly shows. –
Average daily reported !
Average daily reported share volume-NYSE 107
share volume-NYSE 107 (in thousands)
(in thousands) 1962 3,818 | 1971..
15, 381 1963.
4, 567 1972: 1964.
First half 1963.
17, 151 6, 176 July
14, 450 1966.
15, 522 1967
12, 314 12, 971 October..
14, 427 1969.
20, 282 1970.
16, 351 The continual search for new reasons for delay should be abandoned. The efforts of the industry should be concentrated on adjusting to the future, rather than attempting to recreate the past. As James J. Needham, now Chairman of the NYSE, advised the industry when he was still a member of the SEC:
You've lost the battle for public opinion and you've lost the battle in Washington, particularly in Congress. .. You've lost the battle on fixed commissions; it's that simple.108
104 T'estimony of William Salomon, id. at 4033. 105 See.e.g., Address of James Needham, Informational Meeting of NYSE Men bership, Oct. 25, 1972. 108 Ibid. 107 NYSE, 1972 Fact Book 72 (1972). Data for 1972 was obtained from the NYSE. 108 Fixed Commissions on "Orer $100,000" Trades Doomed, Wall Street Journal, Mar. 3, 1972, p. 7, col. 1.
C. INSTITUTIONAL MEMBERSHIP
1. HISTORICAL DEVELOPMENTS
The pressures for stock exchange membership by financial institu-: tions and their affiliates have developed largely as a response to fixed commission rates on the Nation's stock exchanges which have failed to take adequate account of the economies of scale involved in executing large transactions. The brokerage commissions on such transactions have been uneconomically high for customers and extraordinarily profitable to brokers. Financial institutions and their money managers have therefore sought stock exchange membership for the purpose of recapturing excessive commissions. This has given rise to the question of "institutional membership"—whether financial institutions and their money managers should be permitted to join stock exchanges and, if so, whether they should be permitted to do brokerage for their managed accounts.
The several exchanges have responded differently to the attempts of institutions and money managers to gain membership. The NYSE has strongly resisted membership by institutions. Institutions have, however, become members of several regional exchanges and have used these memberships in a variety of ways to "recapture" commissions on NYSE-listed securities. This development in turn has given rise to proposals for uniform rules of membership on all exchanges, which have been advanced both as methods of equalizing the competition for the management of institutional accounts ? and as an essential element in the creation of a central securities market system. In order to evaluate these proposals in an informed manner, it is important to consider in some detail the developments over the last decade in the securities industry which have given rise to the present debate over institutional membership. a. The Growth of Institutional Investors and the Shift to Common Stock
During the 1960's, institutional investors showed dramatic growth. This growth was accompanied by a shift in institutional portfolio investment policy away from government and private debt securities and toward corporate equity holdings, particularly common stocks.
All types of financial institutions participated in this trend. For example, from 1960 to 1971, the common and preferred stock holdings of private non-insured pension funds increased from $16.5 billion to $86.8 billion, state and local retirement funds increased from $.4 billion to $11.3 billion, and open-end investment companies increased from $15.4 billion to $52.5 billion. Life insurance companies and mutual 1 See Chapter I.C.1.d infra. for a discussion of the responses of the different exchanges. 2 The present competitive inequities are described in Chapter I.C.2.a, infra. 3 1 HIearings on s. 1164 and s. 3347, Before Subcomm. on Securities of the Senate Comm. on Banking, Housing & Urban Affairs,
92d Cong., 2d sess. at 138. (Hereinafter cited as "Institutional Membership Hearings".) 4 The growth of institutional investors and the shift to common stock is described at greater length in Securities Industry Study, Report of the Subcomm. on Securities of the Senate Comm. on Banking, Housing & Urban Affairs for the Period Ended February 4, 1972, 92d Cong., 2d Sess. at 38-39 (Committee Print 1972).