6. Conflicts of Interest

When the same firm has investment discretion over an account and also does the brokerage for that account, there is a possibility that the firm will manage the account not with an unbiased interest in what is best for the account but with a view to how the firm can realize the greatest amount of brokerage income. In addition, when the same firm does brokerage for managed accounts and also for the general public, there are additional potential conflicts between the interests of the two different classes of customers. The specific abuses which may arise from these conflicts are described in the following subsections. i. "Churning"

"Churning' is a term used to describe the practice by which a broker induces an investor to engage in unnecessary or excessive portfolio transactions for the purpose of generating commission income. A brokerage firm which exercises investment discretion over an account is subject to a continuing temptation to engage in such transactions. The great profitability of brokerage commissions on institutionalsized transactions under the fixed rate system has made this conflict especially acute with respect to managed institutional accounts.68

In cases where the profits of the brokerage affiliate flow directly to the pooled accounts, this incentive to churn the account is of course eliminated. Thus, where a mutual insurance company organizes a brokerage subsidiary for the purpose of recapturing commissions on its portfolio transactions there is no incentive to churn because there is an identity of interest between the parent institution and the subsidiary broker.

When the manager of a mutual fund establishes a brokerage affiliate to do the brokerage for the managed funds, and turns all the profits back to the funds, either through a credit against the advisory fee or otherwise, this conflict is similarly eliminated. ii. Choice of Market

Because of the differences in the rules of the various exchanges, described above, a money manager may be able to join one exchange while being barred from another. The opportunities for the money manager/broker to earn or recapture commission income therefore are greater in some markets than in others. It may therefore seek to execute transactions for its managed accounts in the market where it can earn or recapture commissions on the transaction; the interests of the managed account, however, require that the transaction be taken to the market where the "best execution” is available, that is, the best price net of all commissions and other transaction These two interests do not always coincide.

68 The Institutional Investor Study found the portfolio turnover rate for accounts managed by brokerdealers to be slightly higher overall than the rate for accounts managed by others. In the case of registered investment companies, however, the turnover rate for funds managed by broker-dealers was considerably lower than for funds managed by non-broker-dealers. 2 Institutional Investor Study at 173, 191.

69 See testimony of Robert Loeffler, 1 Study Hearings at 162; testimony of J. Walter Sherman, 1 Institutional Membership IIearings at 60. The confiict is attenuated, but not eliminated, when only a portion of the profits of the manager's brokerage affiliate is returned to the managed account.

70 Testimony of William Salomon, 8 Study of the Securities Industry, Hearings Before the Subcomm. on Commerce & Finance of the House Comm. on Interstate & Foreign Commerce, 92d Cong., 2d Sess. (1972) at 4031 (hereinafter cited as “llouse 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.

iii. "Dumping

Other aspects of a brokerage firm's business may also influence it in making portfolio decisions for accounts over which it has investment discretion. For example, if it is also acting as a broker for non-managed institutions, it may be required to “position” a block of securities for its own account in order to complete a large transaction. In such a case, the money manager/broker may be tempted to dispose of this inventory by causing a managed account to acquire it without giving sufficient consideration to the desirability of the investment.71

Donald Farrar, former Director of the SEC's Institutional Investor Study,72 expressed particular concern about this problem:

The Institutional Investor Study found trades between block positioners and managed accounts to be common during the 1968–69 period studied, absorbing on average three percent of the passive side of all NYSE block trades in excess of $1 million. Other portions of positioned blocks occasionally may find their way into the positioning dealer's managed portfolio(s) via intermediate broker dealers. The potential for conflict of interest inherent in such practices is considerable and may be growing as some of the more active block positioners expand their management ac

tivities. 73 in. Discriminating - Igainst Other Customers

Whenever a broker has more than one customer, there is a possibility that one customer will be favored over another. A broker who does no money management business but who has both institutional and individual customers may favor the former because their business is more profitable. The conflict is more severe in the case of a broker who also manages institutional accounts, because of the constant pressure on it to show "good performance”, both to retain its existing accounts and to obtain additional money management business.

There are many ways in which favoritism can be shown to managed accounts. For example, the money manager/broker can favor them by providing them with research information before disseminating the information to the firm's customers, or by executing their transactions ahead of transactions in the same securities for public customers. 4

r. Determining Appropriate Commissions

The existence of the fixed commission rate schedule has created for aggravated some of the conflicts described above. To a certain extent, however, it has eliminated the problem of determining the appropriate commission charges on a transaction executed by a broker for a managed account. As the industry moves into an era of competitive commission rates, however, a new conflict of interest will arise as money manager/brokers have to determine, without the benefit of arm's length bargaining, what constitutes a fair commission charge for transactions executed for their managed accounts. William Salomon, the managing partner of one of the largest institutional brokerage firms, il See, e..., Testimony of Donald Farrar, 1 Institutional Membership Hearings at 412; Response to Questionnaire hy Robert Loeffler, 2 Institutional Membership Hearings at 578-80; Testimony of Donald Feuerstein, 6 House Ilearings at 2978-9. 72 Institutional Investor Study supra note 20. 73 Testimony of Donald Farrar, 1 Institutional Membership Hearings at 412. 14 See Testimony of Harold E. Bigler, Jr., 8 House Ilearings at 4080-1; 2 Institutional Investors Study

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at 318-52.

has described this as the greatest potential problem presented by the combination of money management and brokerage." c. Interference with the Evolution of the Securities Markets

As noted above, the nature of the trading on the Nation's securities exchanges has undergone extraordinary changes over the past decade, particularly as institutional transactions have come to account for well over half of the volume of trading. Veeting the particular needs of institutions, while continuing to serve the needs of individual investors, has demanded, and will continue to demand, a high degree of flexibility on the part of the industry. One example of flexible adjustment to the trading needs of institutions has been growth of the “block positioners.” As discussed in Chapter II.B. below, it may well be that future evolution of the market will see institutions normally dealing directly with market makers, without the intermediation of a broker.76

At present, however, the fixed commission rate provides artificial incentives for the combination of money management and brokerage. If this combination becomes more widespread because of these artificial inducements, its existence could distort the natural evolution of the market. While functions are separated, institutions are customers for securities market services. As such, they will seek the most efficient and flexible market relationships, and thus help to sharpen price and service competition in the securities business. If the institutional money managers are also the brokers, however, they will lose a good deal of their incentive to bargain with the brokers on behalf of their beneficiaries, thus sacrificing an important instrument of protection for the millions of Americans whose securities investments are made through the medium of institutions.


While there is no evidence that the conflicts of interest described above have led to widespread breaches of fiduciary duty, the existence of these conflicts is troublesome. The distortion in market trading patterns resulting from the combination of money management and brokerage, as well as the competitive unfairness between stock exchange members and non-members are also sources of concern. In addition, concern has been expressed that the securities industry will lose significant revenues if the combination of money management and brokerage become more widespread.” On the other hand, institutional investors continue to advocate unrestricted member


Accentuating the pressure for resolution of the "institutional membership” question is the widespread belief that the current situation, in which different exchanges have different rules governing the combination of brokerage and money management, cannot continue indefinitely. This current situation of uncertainty and tension has been likened to "a coin standing on edge.” In the absence of uniform action by the exchanges to eliminate the combination of functions, competition between the exchanges may well cause all 75 2 Institutional Membership Fearings, su pra note 3, at 705. 76 See Chapter II.B.4.c., infra. 77 See, e.g., Testimony of William Casey, 1 Institutional Membership Hearings, at 132. 78 See, e.g., Testimony of T. Lawrence Jones, id, at 14.

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of them to eliminate any restrictions on this combination. The
antitrust laws prohibit any joint action by the exchanges to deal with
the problem.80 Accordingly, governmental action is required. A num-
ber of legislative or regulatory proposals have been advanced to deal
with the problem.
a. The Martin Approach

William McChesney Martin, in a report prepared for the NYSE, came first to the conclusion that the question of the combination of money management and brokerage was a separate question from the question of appropriate commission charges on institutional orders. 81 Considering the matter apart from commission rates, Mr. Martin concluded:

[I]t is recommended that the primary purpose of every mem-
ber organization and any parent of any member corporation
should continue to be the transaction of business as a broker
or dealer in securities” as presently provided in New York
Stock Exchange Rule 318. This rule, in effect, prohibits mem-
bership by banks, trust companies, insurance companies,
mutual funds and other institutions. It should be noted that
the purchase of 25% or less of the voting securities of a mem-

ber corporation by an institution is not prohibited. 82
In effect, Mr. Martin suggests that the NYSE's parent and pri-
mary purpose tests 83 be imposed on all exchanges by governmental
authority so as to deny membership to financial institutions and money
managers. Martin recognizes the anomaly of barring institutions and
money managers from the securities commission business while per-1
mitting exchange members to manage institutional accounts. There-
fore he advocates that exchange members be barred from managing
investment companies. Exchange members or their affiliates would,
however, be permitted to manage pension funds, endowments and
other institutional accounts and do brokerage for these managed
accounts. It is, of course, these latter accounts, not investment com-
panies, which constitute the great bulk of the institutional money
management done by exchange members. 84

The asserted basis for the distinction between the two kinds of financial institutions is that there is a "personal relationship" between a money manager and all types of financial institutions except in vestment companies. Martin argues that this personal relationship allows all financial institutions except investment companies to protect themselves in their dealings with the money manager/broker. He describes the basis for this distinction as follow's:

It is a tenuous distinction but I have looked at it this way:
I visited and talked with quite a few registered representa-

tives. I came to the conclusion they were investment coun79 In January 1971 a NYSE Committee commissioned to study the matter came to the conclusion that institutional membership on the NYSE was desirable. 1 Study Hearings at 123. Action upon this recommendation was held up pending receipt of the results of the study then being conducted for the NYSE by William McChesney Martin.

*80 Joint action by the exchanges to exclude financial institutions from membership might well constitute an unlawful refusal to deal. See Chapter III.E., infra.

81 Martin, The Securities Markets, A Report with Recommendations 16 (1971) (here:nafter cited as ! "Martin Report"). 82 Id. at 17. 83 Those "tests'' are described supra in Chapter I.C.1.d. 81 See Chapter I.C.1.c. ii, supra and sources cited therein.

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selors, they certainly were not just taking orders. So I saw no way of conflict of interest being separated there. Then I went one step further to the discretionary account. I never took a discretionary account when I was in the business and I looked askance at it but in this period of affluence there are a lot of people who will come up and say, "I have x amount of money and I want to give it to Joe Blow and I don't care what he does with it.” It is awfully hard to say to a firm or an individual that they can't do that and to draw a flat prohibition on it.

Then you get the pension fund. The pension funds of course are operated for the employees of the firm concerned but the relationship is with the member firm and can be changed not by the individuals in the pension fund but by the relationship between, let's say, a corporation and the broker or investment counselor, or whoever it is that he has decided to have administer this fund. Now when you come to the mutual fund it is sold through salesmen through [sic] hundreds of individuals, and those individuals have no direct contact with the parent firm and in fairness I thought that the New York Stock Exchange firms ought to be divested from that type of operation and that that was about as far as we could go.

This was the rationale on which I was operating here, and I realize that there are some weaknesses in it but I look at it as a practical problem at this juncture and I think that this is a step in the right direction, and I think that just flatly to start separating brokerage, as some of the people advocate, brokerage and investment management at this juncture

without having any lines would be a mistake.85 The factual situation regarding the different sales methods may be as described. However, this analysis ignores a number of important considerations which indicate that, at best, the risks of overreaching in the case of investment companies are not sufficiently greater than those with other institutions to justify different governmental treatment. First, investment companies are intensively regulated under the Investment Company Act of 1940. A particular focus of that Act is protection of the investment company in its dealings with its investment advisor. The Act imposes both broad regulatory control over the relationship between the fund and manager and extensive disclosure requirements. There is no comparable body of regulation protecting the interests of beneficiaries of other types of managed accounts. Second, it has been well established that mutual fund shareholders have a derivative right of action to sue the fund managers for breaches of their fiduciary duties. No comparable right of action has yet been recognized for the beneficiaries of other kinds of institutions.

By limiting the separation of functions to investment companies the Martin approach would permit the continued existence of all of the conflicts of interest described above with respect to pension funds and other types of managed institutional accounts. Indeed, because 85 6 House Hearings at 3121.

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