nounced that it was going to make a public offering of its own securities even if this resulted in the firm's expulsion from the NYSE.39 The NYSE Board of Governors thereupon reversed its prior position and endorsed "in principle" the concept of public ownership. On July 27, 1969, the Board directed its Committee on Permissive Public Ownership to report to it at the September Policy Meeting with specific proposals for the public ownership of securities of member corporations.40 On September 5, 1969, the NYSE proposed amendments to its constitution to permit member firms to issue freely transferable voting stock, subject to twenty specific conditions. Three of these conditions had a direct bearing on the question of institutional membership: 1. No more than 49% of a member corporation's outstanding voting stock could be held by the public; 2. No member would be permitted to have as a customer any non-member who acquired a 5% or more participation in profits; of a member firm after the effective date of the amendment; and 3. "The primary purpose" of a member corporation and its parent, if any, would have to "be the transaction of business as a broker or dealer in securities." 42 These proposed restrictions in effect prevented any form of institutional membership. The first restriction would have prevented an institution from acquiring a controlling interest in a member firm or obtaining an exchange membership for an existing subsidiary. The second restriction would have prevented an institution from purchasing any substantial interest in the profits of a member firm in order to recapture commissions. The third restriction limited ownership of a substantial interest in a member firm to corporations who were already in the securities business. Of the three proposed conditions set forth above, only the "primary purpose" provision became effective. On February 26, 1970, the Commission advised the NYSE that the other two conditions have not been supported by a showing of self-regulatory purpose sufficient to outweigh their anti-competitive impact and should not be sanctioned under the Securities Exchange Act." 43 The NYSE accordingly dropped those two provisions. On March 26, 1970 the SEC advised the Exchange of its non-objection to the adoption of the proposed constitutional amendment as revised.44 NYSE Rule 318.12 explains what a member firm, and its parent, must do to comply with the "primary purpose" provision: For the purposes of this Rule, a member organization's, or its parent's activities shall be considered to be the "transac tion of business as a broker or dealer in securities" when such 39 BNA, SEC. REG. & L. REP. NO. 1, at A-1 (June 4, 1969). 40 BNA, SEC. REG. & L. REP. No. 131, at X-4. (Dec. 15, 1971). 41 A "parent" is any party that has "the power to exercise a controlling influence over the management or policies of a [NYSE] member corporation" unless such power is solely the result of holding office in such member. Ownership of more than 25% of the voting securities of a member organization creates a rebuttable presumption of control. Ownership of less than 25% of the voting securities of a member organization creates a rebuttable presumption of no control. NYSE Rule 318.12. 42 Memorandum from NYSE Committee on Permissive Public Ownership to NYSE Board of Governors 1-2 (Sept. 5, 1969). 43 Sec. Ex. Act Rel. No. 8831 (Feb. 26, 1970). 44 Sec. Ex. Act Rel. No. 8849 (March 26, 1970). member organization including its approved corporate It should be noted that this rule does not include income from investment advisory and investment company management activities as income which is of a type qualifying to meet the primary purpose test. However, brokerage income received by member firms in lieu of fees from advisory accounts managed by them is included. Under this rule, most institutions cannot themselves qualify for Exchange membership because 50% of their total gross income is not attributable to broker-dealer activities of the type described in Rule 318.12. This is true even if such institutions are registered as brokerdealers under the Exchange Act. As noted, income from investment advisory and investment company management activities is not considered broker-dealer revenue, even though such activities represent a substantial part of the business of many NYSE member firms. Furthermore, this rule precludes a broker-dealer subsidiary of an institution from membership, even if such subsidiary itself meets the primary purpose test, unless the "parent" institution can also meet the primary purpose test. Thus, institutions cannot obtain membership by organizing or acquiring a broker-dealer subsidiary. ii. Pacific Coast Stock Exchange 46 The Pacific Coast Stock Exchange was the first regional stock exchange to admit subsidiaries of institutional investors to membership. In 1965 it admitted Kansas City Securities, the brokerage affiliate of Waddell & Reed, Inc., a large mutual fund manager. At the time, the PCSE did not have any rule prohibiting member firms from being controlled by publicly held companies. Within a year of the admission of Kansas City Securities, the Exchange admitted the subsidiaries of three other mutual fund advisors: IDS Securities Corporation, a subsidiary of Investors Diversified Services, Inc.; Emmet A. Larkin Co., a subsidiary of Channing Co., Inc.; and Imperial Securities, Inc., a subsidiary of Imperial Financial Services, Inc. After the admission of these members, the exchange revised its criteria for membership to prevent subsidiaries of mutual fund advisors from becoming members unless the shares of the mutual fund were sold to the public through a captive sales force rather than through broker-dealers.47 This restriction was designed to prevent the brokerdistributed funds from recapturing the commissions which they might otherwise instruct the executing broker to "give up" to other exchange members who sold the fund's shares.48 Before the end of 1965, the Exchange further modified its rules to exclude any firms controlled by persons outside the securities business. However, a grandfather clause was included which prevented the expulsion of existing members who were so controlled.49 The present PCSE membership rules have moved closer to those of the NYSE. They state that, except with the approval of the Board of Governors, all active stockholders of a corporate member firm shall be active in the business and this requirement shall not be deemed to be met in any case where a voting Nevertheless, the PCSE still has eighteen institutional members.51 iii. Midwest Stock Exchange The rules of the Midwest Stock Exchange prior to 1970 explicitly barred institutions from membership.52 In 1970, the MSE revised its rules to permit its members to obtain public financing. The revised rules do not restrict the kind of institution which may own or control a member firm. The MSE does require, however, that the member firm conduct a "general" securities business primarily with the "public" and not with its parent. An organization can be a member only if at least 50 percent of all brokerage commissions earned by The MSE rules do contain provisions regarding parents. Like the NYSE, the MSE retains the right of disapproval of principal stockholders including parent firms-of member organizations.54 However, the MSE, unlike the NYSE, does not automatically disapprove any parent which is not primarily a broker-dealer. There must be "affirmative grounds" for such disapproval.55 iv. PBW Stock Exchange In 1967, the PBW (formerly the Philadelphia-Baltimore-Washington) Stock Exchange made the internal policy decision that its rules did not prohibit membership to institutional affiliates or impose 48 4 Institutional Investor Study, supra note 3, at 2309. 49 PCSE, rule IX, § 3 adopted July 1, 1965. 50 PCSF, rule IX, § 5(a). 51 4 Institutional Investor Study, supra note 3, at 2310. 52 MSE Rules, Art. XV, rule 7. This section was modified in 1970. 53 MSE Constitution, Art. I, rule 1(c)(1). 54 Letter from Michael E. Tobin to See Division of Trading and Markets, January 13, 1970 at 1. $5 MSE Constitution Art. XV, rule 6. requirements as to the type of business in which the parent organizations may engage. As a result, early in 1968 the PBW began admitting subsidiaries of financial institutions to membership. The PBW has continued ever since to accept and even to solicit such applicants. As a result the PBW now has a large number of members who are subsidiaries of institutional investors. Of a total of 295 member organizations, 38 (or approximately 16%) are brokerage affiliates of financial institutions.56 In its rules on membership, the PBW, like the MSE," does not concern itself with the business of the parent. However, unlike the MSE, it also does not limit the amount of business the member firm can do with its parent. The Exchange has extended certain of its regulatory controls over the parents of member firms by reserving the right to examine the books and records of the parent and any of its affiliates, as well as by reserving the power to compel a member firm to sever connections with its parent.58 And while the Exchange does not require that the "primary purpose" of the parent must be the transaction of business as a broker or dealer in securities, its constitution does apply a "primary purpose" test to the member firm itself.59 2. PROBLEMS RESULTING FROM COMBINATION OF MONEY The combination of money management and brokerage under the differing rules of the various stock exchanges has created a number of difficulties. These difficulties fall into three basic categories: (1) impediments to fair competition between money managers; (2) conflicts of interest; and (3) distortion in the evolution of the central market system. a. Barriers to Fair Competition Between Money Managers As noted above,60 different stock exchanges take different approaches toward the combination of money management and brokerage. In some cases these rules discriminate between firms which are in essentially similar businesses, admitting some and barring others solely upon the basis of differences in the percentage of the firm's income which is derived from one line of business or another. A firm which receives 49% of its gross income from money management and 51% from brokerage and related activities 61 is eligible for NYSE membership. A firm which receives only 49% of its income from brokerage is not eligible for membership. This discrimination gives exchange members who want to enter the money management business a competitive advantage over money managers who are unable to join exchanges. This competitive ad 56 2 Securities Industry Study Hearings Before the Subcomm. on Securities of the Senate Comm. on Banking, Housing & Urban Affairs, 92d Cong.. 1st Sess. (1971) at 215 (hereinafter cited as "Study Hearings"). Parts 1-2 of these hearings were held in the 1st Session of the 92d Congress, parts 3-4 were held in the 2d session. 57 See text at fns. 52- 55 su pra. 5 Statement of the PBW Stock Exchange, SEC. Market Structure Hearings, supra note 23, at 3 (October 1971). 59 PBW Constitution, Art. XIV, § 2. 60 See & C.1.d., supra. 61 Fees received for money management services are not considered to be income from the transaction of business as a broker or dealer in securities although brokerage commissions received in lieu of such fees are. NYSE Rule 318.12. SS-033-73-6 vantage is enhanced by the existence of a fixed minimum commission rate schedule which establishes uneconomically high commission rates on institutional-sized transactions. The New York Stock Exchange's rules allow its member firms to act as investment advisors and managers for institutional (and individual) accounts, and to do the brokerage for those managed accounts without restriction. When a NYSE firm manages such an account, it customarily does a substantial portion of the brokerage for that account. With this additional source of revenue, the broker can, in theory, undertake to manage an account for a lower fee than it would have to charge if it did not also receive related brokerage income. Indeed, NYSE member firms often agree to reduce this management fee by a fixed percentage of the brokerage income they receive from the managed account,62 or even undertake to manage accounts without charging any separate management fee at all.63 Money managers who are barred from NYSE membership cannot earn brokerage income on NYSE transactions for the accounts which they manage. As a consequence, they may be at a disadvantage in competing with NYSE member firms for money management business, since they cannot reduce their management fees in consideration of brokerage received. Under a competitive rate system, this disadvantage would not be as significant since there would not be excessive profits on brokerage transactions to subsidize the costs of providing money management services. However, under the fixed rate schedule, commissions on institutional-sized transactions are sufficiently profitable that brokerage firms are often willing to manage institutional accounts for a nominal fee, or no fee at all, solely in order to obtain the brokerage business of the managed account. In order to reduce their competitive disadvantage, money managers excluded from membership in the NYSE have joined regional stock exchanges. Through such membership these money managers have been able to earn income from portfolio brokerage for their managed accounts or to reduce the commission expenses incurred by the accounts which they manage. However, while regional exchange membership has reduced the advantage enjoyed by the NYSE member firms, it has not entirely eliminated it, since the methods utilized to recapture commissions via regional exchange membership are often intricate and costly.65 One witness testified before the Subcommittee that his firm incurred costs of $7 million to recapture $24 million in commissions.66 While regional exchange membership has thus helped to reduce excessive commissions levied on the beneficiaries of institutional accounts, as well as the competitive advantages enjoyed by NYSE member firms, it is essentially a response to artificially created economic pressures. Most money managers assert that they would have no interest in stock exchange membership in the absence of fixed minimum commissions.67 62 4 Institutional Investor Study, supra note 10, at 2296-97. 63 1 Institutional Membership Hearings, supra note 3, at 96. 64 Id. at 89-90. 65 See Testimony of Robert Loeffler, 1 Institutional Membership Hearings, supra note 3, at 109. 66 See Testimony of Robert Loeffler, 1 Study Hearings at 162. 67 See, e.g., Testimony of Charles T. Bauer, Senior Vice President, American General Insurance Co., 1 Institutional Membership Hearings at 17; Testimony of Donald H. Whitney, Senior Vice President, Commercial Union Insurance Co. of Boston, Mass., Ibid. Testimony of Gustave L. Levy, Goldman Sachs & Co., id. at 26; Testimony of Andrew G. L. Sage, II, President, Lehman Bros., Inc., id. at 39; Testimony of Robert L. Loeffler, Senior Vice President, Investors Diversified Services, Inc., id. at 112; Testimony of Robert W. Haack, Président, New York Stock Exchange, Inc. id. at 360. " |