savings banks also showed large, if less dramatic, increases in their equity holdings.5

During the 1960's institutional trading grew both absolutely and as a percentage of total trading. In 1961, institutional trading accounted for 33.3% of public share volume on the NYSE. In 1971, it accounted for 59.7%.

The increase in institutional trading activity also caused a sharp increase in the size of the average NYSE stock exchange transaction, from 204 shares in 1962 to 428 shares in 1971.7

This growth in the average transaction size was primarily due to an increase in the number of large transactions, those of 10,000 shares or over. From 1965 to 1971, the number of such transactions executed on the NYSE increased more than twelve-fold, going from 2,171 per year to 26,941 per year. By 1971 transactions of 10,000 shares or more represented 17.8 percent of the volume of all shares traded on the exchange, as compared with only 3.1 percent in 1965.9

b. Effect on the Brokerage Business

The increase in the size and number of institutional transactions had a great effect upon the profitability of NYSE firms. Institutional business was markedly more profitable than the business of individuals. For example, in 1968 the median pre-tax return on capital for institutional firms was 37.5 percent, while the return for retail firms was 18.9 percent.10

The greater profitability of institutional firms is in part attributable to the larger average size of institutional transactions." For example, in 1971, the average institutional order on the NYSE was 713 shares (up from 205 shares in 1961) while the average individual order was 172 shares (up from 91 in 1961). Among institutions, the average order size in 1971 ranged from a high of 4,206 shares for mutual funds (up from 550 in 1960) to a low of 582 shares for commercial banks (up from 166 in 1960).12

Until December, 1968, the fixed commission schedule failed to take any account of the economies of scale on executing large transactions. Until then, the commission for a 10,000 share order was 100 times the commission for a 100 share order.13 Since the costs of the former were not 100 times those of the latter, institutional transactions were more profitable than smaller orders.

In December 1968, the NYSE altered its commission schedule to allow a volume discount on transactions in excess of 1,000 shares. However, the volume discount was not deep enough to fully reflect the economies of scale. Accordingly, larger transactions continued to be substantially more profitable than smaller ones.14

5 SEC, Sec. Ex. Act Rel. No. 2582 (April 6, 1972).

14

6 NYSE.. 1972 Fact Book, 53 (1972) (hereinafter cited as "1972 Fact Book").

7 Id. at 10.

s Id. at 12.

9 Ibid.

104 Institutional Investor Study, Report of the Securities and Exchange Commission, H. R. Doc. 92-64, 92d Cong., 1st Sess., 2170 (1972) (hereinafter cited at "Institutional Investor Study"). 11 Id. at 2171.

12 NYSE 1971 Public Transaction Study at 18.

13 See Securities Industry Study. Report of the Subcommittee on Securities of the Senate Committee on Banking, Housing and Urban Affairs, for the period ended Feb. 4, 1972, 92d Cong., 2d sess. at 53 (Comm. Print 1972).

14 On April 5, 1971, at the urging of the SEC, the commission on that portion of any order in excess of $500,000 became subject to negotiation. On April 24, 1972, a new commission rate schedule was implemented with a further reduction in the level of the competitively determined portion of a transaction to $300,000.

Because institutional commission business was more profitable than retail business, many brokers came to concentrate heavily on institutional business during the 1960s. At the same time, many institutional investors sought to make use of the "fat" in the commission schedule by using commission payments to purchase services other than execution. Investment research was one such service. Advisors to investment companies also made extensive use of commission business to reward brokers for mutual fund sales. In this manner the excess profits in the commission rate schedule were put to use for the benefit of the institutional accounts or the managers of those accounts. However, many institutional money managers, particularly insurance companies and some investment advisors, were not dependent upon the research, fund distribution or other services offered by brokers in exchange for commission business. Often these money managers had substantial in-house research staffs and their own network of salesmen. Those investors accordingly sought to reduce their transaction costs. One way to do this was to use the third market 15 where they could obtain execution of transactions in NYSE-listed issues on a net price basis, thereby avoiding the payment of the NYSE minimum commission. Another way was to obtain or establish a brokerdealer affiliate. Through such an affiliate the institution could recapture a substantial portion of commission payments through a variety of reciprocal practices.

Although such institutional affiliates were barred from NYSE membership by its rule 318, some of the regional exchanges did accept them as members. It should be noted, however, that the recapture practices employed by these affiliates on the regional exchanges often involved the direct and willing participation of NYSE member firms who were also regional exchange members.

As a result there was a steady growth in the percentage of NYSE issues traded away from that exchange. By 1971, more than 17% of the volume in NYSE listed common stock represented transactions in other markets, of which approximately 10% represented regional exchange transactions, and approximately 7% represented third market transactions.16

c. Types of Affiliations Between Institutions and Brokers-Dealers

i. Institutional Acquisition of Brokerage Affiliates.

During the 1960's many financial institutions and brokerage firms began to diversify and expand into related fields. As part of this trend, financial institutions, particularly insurance companies and investment advisors, acquired broker-dealer affiliates. Some acquisitions of brokerage affiliates were made primarily as investments for the parent advisor, rather than as a means of recapturing commissions on the parent's transactions. For example, Investors Diversified Services, a large investment advisor and underwriter of mutual funds, acquired John Nuveen & Co., a bond firm, and Jefferies & Company, Inc., an institutional brokerage firm. After the acquisitions, both firms continued to do a general business with the public, and neither did any business

17

15 The third market and its growth is discussed in chapter II, A.1.e., below.

16 1972 Fact Book at 15, 16. This subject is also discussed in Chapter I.B.l.c., supra, and Chapter II.A.1.c., infra. 17 4 Institutional Investor Study, supra note 10, at 2299.

with the funds managed by Investors Diversified Services.18 The result of this kind of affiliation is simply to diversify the business of the institutional investor in the financial area while supplying additional sources of capital to the broker-dealer.

Other affiliations, however, were established for the purpose of reducing the cost of brokerage for accounts managed by the institutional advisor.19 Such affiliations can take a number of forms. The affiliated broker may or may not actually execute transactions for the accounts of its parent and may or may not conduct a general securities business with others.20

One type of affiliation involves the creation of a so-called "shell broker" which has no execution capability and transacts no brokerage business with the general public. Its sole function is to become a member of a regional exchange in order to recapture a portion of the brokerage commissions paid by its parent to other brokers. Often it does not even participate in the stock transactions of its parent institution. It may simply refer its parent's order to a member of the NYSE which is also a member of the particular regional exchange ("a dual member"). The dual member executes the transaction on the NYSE and then, using a variety of techniques available on regional exchanges, pays over a predetermined amount of commissions on unrelated transactions to the institutional subsidiary.21 The subsidiary then rebates all or part of these commissions to its parent.

In other cases an institutional investor may organize or acquire an affiliate which will join a regional exchange for the purpose of actually executing trades for its parent in dually-listed stocks.22 As a result, the institution realizes direct commission cost savings, paying only the floor brokerage costs on such transactions.23

ii. Brokers' Expansion into Money Management

While institutional investors have been going into the brokerage business, brokers have been expanding their activities in the money management field, particularly in the management of pooled accounts. There are two primary reasons for this diversification. First, money management fees provide a steady source of income to supplement cyclical brokerage income. Second, in the usual case, a broker can expect to receive a substantial portion of the commissions generated by an account which it manages.

The extent and significance of this trend is demonstrated by the substantial growth in the profits earned by exchange members from investment management. In 1962, exchange members earned profits from investment advisory services of all kinds of $11.2 million. In 1969, profits from this line of business had grown to $43.6 million.24

18 Statement of Investors Diversified Services, Inc. and Jefferies & Company, Inc., SEC Public Investigatory Hearing on the Structure of the Securities Markets, SEC. File No. 4-147 (Oct. 19, 1971) at 2-5. 19 Id. at 2296.

20 4 Institutional Investor Study id. at 2296-99.

21 For a particularly lucid explanation of the evolution and mechanics of commission recapture through the use of regional exchange affiliates; see Testimony of Robert Loeffler, 1 Institutional Membership Hearings supra note 3, at 99-106.

22 Dually-listed stocks are stocks listed on the NYSE and on one or more regional exchanges.

25 See Testimony of E. Wetherill, SEC Market Structure Hearings, File No. 4-147, tr at 600-03 (Oct. 18, 1971).

24 4 Institutional Investor Study, supra note 10, at 2297. These figures are net of any credit for brokerage against advisory fees.

One important area of expansion has been mutual funds. Many brokers have organized investment companies which are then managed by the broker or an affiliate. As of June, 1972, NYSE member firms managed $4.8 billion in mutual fund assets, approximately 7 percent of 1 all such assets.25 In addition members have begun to compete more aggressively for the management of pension fund accounts.26 Estimates of private pension fund assets under management by NYSE firms vary. One witness at recent hearings in the House estimated that NYSE member firms manage $16 billion in pension funds, and that the rate! of growth in this field has been "fantastic" 27 Other less current estimates indicate that the figure could be somewhat lower The Institutional Investor Study found that as of June 30, 1969, all investment advisors, including those performing brokerage services, managed no more than about $4.3 billion.28 As of the end of 1971, the SEC's Office of Policy Research estimated that non-insured pension fund assets aggregated $106.4 billion, of which $12.4 billion, or approximately 8.5%, was managed by both broker and non-broker investment advisors.29

An October 1972 study released by the Federal Reserve Bank of New York showed that between 1965 and 1970 the percentage of pension funds using banks as managers had declined from 75 to 68 percent, and those using insurance companies had declined from 38 to 35 percent. Over the same period, the number of companies using independent investment counselors as fund managers had increased from 5 percent to 22 percent; those using brokerage houses, from 1 to 8 percent; and those using open-end investment companies from 1 to 3 percent.30 While brokers still have a much smaller percentage of the total pension accounts under management than do. banks, insurance companies and investment advisors, they have! exhibited the most rapid recent growth.

There are substantial advantages in the combination of the money management and brokerage functions. Investment advisors not affiliated with brokers receive only management fees for their services. Their accounts must pay commissions to a separate broker for their portfolio transactions. On the other hand, the integrated brokermanager receives both a management fee and, if he executes brokerage transactions for a managed account, a commission on each portfolio transaction as well. Other advantages result from his ability to use the managed account's portfolio to facilitate his other business as a broker.31

d. Exchange Reaction to Institutional Membership

Faced with increased competition from exchange member firms for institutional money management business, as well as pressure

252 Institutional Membership Hearings, supra note 3, at 858-862; 37 SEC Ann. Rep. 142 (1971).

26 By the end of 1971, total private non-insured pension funds represented a pool of assets with a market value of $125 billion, a growth of $20 billion over the preceding year. Banks hold about four-fifths of the total (pension funds probably accounted for approximately $84 billion of the trust assets held by banks in 1970), but an increasing number of corporations are choosing non-bank managers.

27 Testimony of Bernard H. Garil, 8 Study of the Securities Industry, Hearings before the Subcomm on Commerce & Finance of the House Committee on Interstate and Foreign Commerce, 92d Cor.g. 2d $ess, at 4282 (hereinafter cited as "House Hearings"). Parts 1-5 of these hearings were held in the 1st Session of the 92d Congress; parts 6-9 were held in the 2d Session.

282 Institutional Investor Study, supra note 10, at 150.

29 Based on figures at book value at year-end 1971 provided to this Subcommittee by the Office of Policy Research, Securities and Exchange Commission.

30 Ehrlich, The Functions and Investment Policies of Personal Trust Departments; 54 MONTHLY REVIEW, Fed. Reserve Bank of New York at 265 (Oct. 1972). Figures add to more than 100 percent because many pension funds have more than one manager.

31 The advantages involved, and the problems which they present, are discussed below.

32

com

from shareholders and from the SEC 22 to take steps to reduce mission costs, an increasing number of financial institutions have sought exchange memberships. The various exchanges responded in different ways.33 Some regional exchanges sought to attract increased volume by making membership available to brokerage affiliates of institutions. On the other hand, the NYSE and AMEX have barred financial institutions and their affiliates from membership, without, however prohibiting their own members from diversifying into the money management business.

The rules of the various exchanges concerning the combination of money management and brokerage can be summarized as follows: i. New York and American Stock Exchanges 34

The rules of the NYSE on institutional membership are of the greatest importance because it is the principal market place for the shares of more than 1400 of the largest corporations in the country, representing an estimated 96% of the common stock holdings of institutional investors.35 From the early part of the eighteenth century until recently, member organizations of the NYSE were required to be partnerships or sole proprietorships. Member firms were not permitted to incorporate, for fear that corporate provisions for limited liability would enable their owners to evade their financial responsibilities and jeopardize the interests of the investing public.

In 1953, the NYSE amended its Constitution to allow member firms to incorporate.36 The purpose of this change was to facilitate the retention of capital by member firms and to enable them to take advantage of certain tax benefits not available to partnerships or proprietorships.

The constitutional amendment, however, did not permit public ownership of member firms. The NYSE required that every holder of voting stock in a member firm be approved by the NYSE Board of Governors and become a member or allied member of the NYSE.37 These restrictions prevented member firms from going public and precluded publicly-held corporations or their affiliates from joining the exchange. The NYSE justified these restrictions on the ground that they were necessary to enable the NYSE to regulate and control its members, and to prohibit "undesirable or unqualified persons" from obtaining control of a member firm.38

By 1969, changes in the nature of the securities business, combined with adverse market conditions, had placed additional pressure on the capital structure of the industry. The industry's need for new capital could no longer be met without resorting to public financing.

The issue was brought to a head on May 23, 1969, when Donaldson, Lufkin and Jenrette, Inc., a substantial NYSE member firm, an

32 See footnote 109; infra.

33 Under the Exchange Act, the qualifications for membership are, in the first instance, if not exclusively, within the province of the exchange. The Exchange Act does not establish standards for exchange membership nor does it bar financial institutions from the brokerage business. Section 6(c) provides that an exchange may adopt and enforce "any rule not inconsistent with this title and the rules and regulations thereunder and the applicable laws of the State in which it is located." The Commission's power over the rules of national securities exchanges is contained in Section 19(b), in accordance with which the Commission may require alterations in exchange rules but only in so far as they related to enumerated (or "similar") matters. Membership is not an enumerated subject.

34 AMEX membership policies are not separately discussed since they have tended to follow NYSE policies in most relevant respects.

35 3 Institutional Investor Study, supra note 3, at 1323.

38 See NYSE Constitution, Art. IX, sec. 7.

37 NYSE Constitution, Art. IX, secs. 7(a) (2) and (b)(2).

38 See, e.a., Letter from Robert W. Haack to the Director of the SEC Division of Trading and Markets, Jan. 27, 1970, commenting on proposed public ownership rules of the Midwest Stock Exchange.