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it would limit the brokerage-money management combination to firms primarily engaged in performing brokerage services, its principal impact would fall on those relationships which do not give rise to conflicts of interest-namely those in which the affiliated broker does business only for the managed account and passes all its profits back to that account. Furthermore, Martin's failure to connect the issues of! competitive commissions and institutional membership also neglects the fact that most of the conflicts are aggravated by the existence of fixed commissions.

While the Martin proposals would eliminate the economic problems resulting from differing rules regarding membership, and the market distortion which this has created, they fail to deal with the broad competitive advantage exchange members have in competing for money management. Indeed, except with respect to investment companies, it seeks to perpetuate this competitive favoritism by governmental action. Exchange members would be free to realize profits from two sources- -a management fee and commission income-but money managers would be barred from earning commisson income.

In an attempt to eliminate the most obvious symptom of this competitive inequality, Martin would prohibit member firms "from crediting commissions against any fee charged for investment advice." 86 But Martin does not propose, nor has anyone else seriously suggested, that a fixed minimum advisory fee be established at a level which would make advisory business profitable in its own right. Therefore, exchange members in setting advisory fees may take into account expected commission income from the managed account or, in fact, may charge no advisory fee whatsoever. b. The SEC Approach

The SEC's analysis of the problem of institutional membership proceeds from premises quite different from those advanced by Martin. The SEC asserts that the problems created by the combination of money management and brokerage are: (1) the recapture of commissions which is made possible by the combination of money management and brokerage and (2) the possibility of the use of exchange membership for "private purposes."

In its Statement on the Future Structure of the Securities Markets the SEC described these two problems in the following terms:

Certain regulatory problems arise out of the relationships created by institutional membership. The first stems from the existence of a structure of fixed minimum commissions. So long as such a structure exists, large investors should not, by virtue of their economic power and size, be entitled to obtain rebates of commissions not available to other investors. While fixed minimum commissions exist, they should apply to all investors, and an exception should not i be given to a particular person. Institutional membership, however, provides a vehicle for obtaining rebates, either directly or indirectly.

Second, institutional membership may result, to a greater or lesser degree depending on the circumstances, in the use 86 Martin Report at 18.

of exchange membership for private purposes rather than
for the purpose of serving the public in an agency capacity
or otherwise performing a useful market function. In part,
this problem is similar to that discussed in the preceding
paragraph: the problem of using exchange membership as a
means of obtaining a reduced commission rate. But the
problem of using exchange facilities for private purposes is
broader in scope than the rate question. For we believe that
membership in the market system should be confined to
firms whose primary purpose is to serve the public as brokers
or market makers. Stock exchanges are affected with an
overriding national interest which demands that they act
to maintain and improve the public's confidence that the
exchange markets are operated fairly and openiy. The public
should have the assurance that a member of an exchange is
dedicated to serving the public, and membership by institu-
tions not predominantly serving non-affiliated customers

should not be permitted to cloud this objective. 87 The premise which appears to underlie the SEC's first point is that the combination of money management and brokerage is permissible unless it results in benefits for the managed account, in the form of reduced commission expense, in which case it must be prohibited.

The SEC found that there was no basis for denying exchange membership to a brokerage firm solely because it is a subsidiary or affiliate of a money manager, but that the relationship between the money manager and the broker should be limited to eliminate the practices it found undesirable. To do this the SEC proposed a "predominant purpose" test.88 This test would allow money managers to join exchanges and do the brokerage for institutional accounts which they manage only if a predominant portion of their brokerage business were done with inaffiliated customers.

While the Market Structure Statement did not contain a statement of what constituted a "predominant" portion, the SEC soon thereafter indicated that it thought 80% was appropriate.89

In its Market Structure Report the SEC defined non-affiliated accounts as including:

individual discretionary and non-discretionary accounts and
the accounts of non-affiliated institutions, but do not include
institutional parents or investment companies or other in-
stitutional funds which are managed under contracts or
arrangements which give the brokerage firm investment

discretion.90 This definition included pension funds in the class of affiliated accounts because they are customarily managed under arrangements which give the brokerage firm investment discretion. 91

The SEC first sought to implement its proposal through the voluntary cooperation of the securities exchanges. On February 15, 1972,

87 SEC Statement on the Future Structure of the Securities Markets 21 (1972) (hereinafter rited as “Market Statement”). 89 Letter from the SEC to all registered national securities exchanges, Feb. 15, 1972. 91 Letter from Donaldson, Lufkin & Jenrette, Inc. to SEC, Oct. 2, 1972.

88 Id. at 23.

90 Market Statement at 23.

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the SEC sent a letter to all of the registered exchanges calling upon them to adopt rules:

1. Prohibiting membership for firms whose primary function

is to rebate, recapture, or redirect commissions.
2. Eliminating any parent test that presently exists.
3. Restricting membership to firms doing the predominant

portion of their brokerage business on registered national

securities exchanges for nonaffiliated customers. 92 The NYSE promptly indicated its agreement in principle with the SEC's proposals. 93 The regional exchanges, however, raised objections. The reluctance of the Pacific Coast Stock Exchange and the Midwest Stock Exchange seemed to stem at least in part from the fear of antitrust liability which might result in the event they took voluntary action to expel one class of members without a binding SEC directive.94 The PBW Stock Exchange, which has been a leader in permitting unrestricted institutional membership, refused to acquiesce on broader grounds, asserting that the proposals were both unnecessary and beyond the SEC's authority. 95

On March 10, the SEC indicated its intention to proceed and requested all exchanges to send it “all data, views and drafts of rules which you would like to have us consider.'í 96

On May 26, 1972 the SEC formally requested the exchanges to adopt as their own a rule promulgated by the SEC concerning institutional membership. 97 While the SEC's proposal generally followed the position taken in its Market Structure Statement it differed from the earlier position in one significant respect. Originally, the SEC suggested that pension funds be included in affiliated business. 98 However, the May 26 proposal defined affiliation in a manner which made pension funds unaffiliated if managed under the arrangements most commonly used by brokers, but affiliated if managed pursuant to the arrangements most commonly used by insurance companies. 99

Although the suggestion for this change came from the NYSE,100 the SEC has not explained why it accepted the NYSE position in preference to the position it had expressed in its Market Structure Statement. Because of the fact that pension funds are the largest and fastest growing category of institutional business, this change of position has a substantial impact on the competition between NYSE members and non-members for the management of pension fund accounts.101

In the face of continued opposition, the SEC moved to impose its rule upon the exchanges by using its power under section 19(b) of the 02 Letter from the SEC to the President of all registered national securities exchanges, Feb. 15, 1072 93 Letter from the NYSE to the SEC, Feb. 17, 1972. 94 Letter from the Midwest Stock Exchange to the SEC, Feb. 24, 1972; letter from the Pacific Coast Stock Exchange to the SEC, Feb. 25, 1972.

95 Letter from the PBW Stock Exchange to the SEC, Mar. 2, 1972. 06 Letter from the SEC to all registered national securities exchanges, Mar. 10, 1972. 97 SEC, Sec. Ex. Act Rel. No. 9623 (May 30, 1972). 99 Testimony of Jerome Grossman. 8 House Hearings at 4152–53. This is so because stock exchange firms typically manage pension funds under arrangements that give them only investment discretion whereas insurance companies usually manage pension funds pursuant to a contractual arrangement. The ultimate consequences of these two modes are the same: The money manager has the de facto authority to make the day-to-day investment decisions for the managed account. However, Rule 19b-2 would apparently treat these two situations differently by relying heavily on the existence of a contractual arrangement to determine "affiliation", thus disregarding the realities of the situation. See generally 8 House Ilearings 4029-4203. 100 See NYSE Special Membership Bull., April 20, 1972. 101 See Chapter İ.C.1.c. ii, supra and sources cited therein.

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93 Market Statement at 23. See text at notes 90-91, supra.

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test. 103

Securities Exchange Act.102 Attempting to avert the delay inherent in an adversary proceeding-in which factual questions are developed and resolved through evidentiary hearings with interested parties afforded the right of cross-examination--the SEC sought to act through a rulemaking procedure. On August 3, 1972, it proposed to adopt a new Rule 19b-2 which would, in effect, require all registered securities exchanges to adopt rules implementing the SEC's predominant purpose

The legality of the procedure which the SEC is using to attempt to reach its goals has been called into question, as has the SEC's statutory authority to deal with the question of membership at all.104

In the fall of 1972 the SEC held public hearings upon its proposed Rule 19b-2.105 At these hearings, interested persons were invited to comment on the rule proposal but were not permitted to crossexamine proponents of the rule or of the view point. On January 16, 1973 the SEC promulgated Rule 19b-2 substantially in the form proposed in August except that a three-year phase-in period was allowed for firms which were exchange members on January 16.106 Rule 196–2 requires all registered national exchanges to adopt, by March 15, 1973, rules following the exact language of SEC Rule 19b-2.

The Antitrust Division of the Department of Justice, among others, has taken the position that the type of hearing held in connection with the promulgation of Rule 19b-2 did not satisfy the hearing requirements of section 19(b) of the Exchange Act or of the Administrative Procedure Act.107 While the SEC may succeed in forcing the exchanges to adopt rules consistent with its proposals, the possibility exists that its attempt will be resisted by one exchange or another.108 Moreover, even if the exchanges acquiesce, affected members may yet attack the rules in court. In short, the SEC's proposals and action may well be subjected to court test and protracted litigation.109 Chairman Casey has estimated that it may take two years for the SEC to put its rule into effect, assuming that both its procedure and the substance of the rule can withstand judicial scrutiny. 110

In addition to the procedural questions raised by the manner in which Rule 19b-2 was adopted, there are a number of problems with the Rule itself.

(1) One of the SEC's acknowledged purposes is to prohibit the use of exchange membership to reduce the commissions levied on insti102 The so-called 19(b) power is described infra in Chapter III.C. 103 SEC, Sec. Ex. Act. Rel. No. 9716 (Aug. 3, 1972). 104 See Letter from Wolf, Block, Schorr & Solis-Cohen to SEC, Sept. 8, 1972; Comment of the United States Department of Justice in response to SEC Release 9716 (Oct. 3, 1972). 105 Matter of Proposed Securities Exchange

Act Rule 19b-2, SEC File No. 57-452 (1972) (hereinafter cited as "19h-2 Tearings"). 106 SEC Sec. Ex. Act Rel. No. 9950 (Jan. 16, 1973). 107 Comment of the l'nited States Department of Justice, supra note 104. 108 On November 28, 1972 the PBW indicated that it would not challenge the SEC's proposed Rule 19h-2 in the courts if a phase-in-period were allowed. Testimony of E. Wetherill, 19 b-2 Hearings (Nov. 29, 1972). While the rule as adopted contains a phase-in-period, it is unclear as to whether the conditions governing it meet the PBW's objections. Press reports indicate that the possibility still exists of one exchange or another challenging Rule 19h-2 in the courts. See Stock Exchange ordered to Admit Institution Firms, The N.Y. Times, Jan. 17, 1973, p. 1 col.

4. 109 The Treasurer of the state of Connecticut among others has indicated his displeasure with Rule 196-2 in the strongest

terms and suggested the possibility of legal action. Testimony of R. Berdon, 19b-2 IIearings (Dec. 1, 1972).

110 Testimony of William Casey, 1 Institutional Membership IIearings at 146. Since the time of this testimony, the PBW Stock Exchange has stated that it will not contest Rule 19b-2 in the courts if certain conditions are met. See note 108, supra.

tutional transactions under the fixed commission rate schedule.111 The SEC recognizes that the question of institutional membership is inseparable from the question of commissions on institutional transactions and that the pressures for such membership will decline under à competitive system.:12 Fixed commissions on institutional-sized transactions are now being phased out.113 Currently, it appears that the phase-out will be finished in little more than a year. When it is, there will be no more excess commission charges to recapture. The SEC is, thus, devoting enormous amounts of energy to eliminating a problem which will shortly be eliminated by other methods. Therefore, if Rule 19b-2 is designed to shore up the fixed commission rate structure, it not only contradicts the SEC's own policy in favor of price competition on institutional transactions, but also overlooks the fact that this aspect of the institutional membership question really has relatively little long-term importance.

(2) The SEC's approach does nothing to reduce the conflicts of interest which exist by virtue of the combination of money management and brokerage.14 Indeed, the SEC's approach can only exacerbate and make more widespread the conflicts which already exist: by requiring all money managers who execute transactions for affiliated accounts to do business with unaffiliated accounts as well, Rule 196-2 makes universal the opportunity for a money manager to favor one type of customer over another. Moreover, in order to meet the 80% requirement, a broker might well be tempted to churn his unaffiliated accounts or, conversely, to artificially limit transactions by affiliated accounts in order to keep the trading for affiliated accounts below 20%.

(3) Rule 196–2 fails to come to grips with the fundamental unfairness in the current situation which permits brokers to combine money management with their brokerage business but prohibits money managers from combining brokerage with their money management business. Gustave Levy, a former NYSE Chairman, has expressed this unfairness succinctly:

Our Achilles' heel has always been that we have been in the
money managing business and the money managers could

not get into ours.115
Under the SEC's proposal, a firm which does mostly money manage-
ment will be barred from doing brokerage for managed accounts, but
a firm which does mostly brokerage can also do brokerage for man-
aged accounts. There is no justification for this anti-competitive
discrimination.

(4) The predominant purpose test, the percentage formula and the definition of affiliation proposed by the SEC will cause firms to structure their relationships with their managed accounts artificially

111 This represents an unexplained alteration of the position taken by the SEC in several court cases involving the failure of mutual fund advisors to make use of membership to reduce commission charges paid by the funds they manage. See, e.g., Memorandum of the SEC as Amicus Curiae, Gross v. Moses, 67 Civ. 4186 U.S.D.C. S.D.N.Y. (August 1971). The SEC took the position that where recapture of commissions is available

through regional exchange membership, mutual fund managers must at least, make a bona fide judgment as to whether to establish a brokerage affiliate to recupture commissions for the fund.

112 Testimony of William Casey, 1 Study lleurings at 109. Chairman Casey stated that the question of fixed commissions and institutional membership were "completely, but not utterly" entwined. 113 See Chapter I.B., supra. 114 The SEC takes the position that conflicts are inevitable in the combination of money management and brokerage. Without analyzing the effect its own proposals will have on these conflicts, the SEC takes the position that if these conflicts are to be dealt with, Congress should do it. Market Statenent at 23.

115 The New York Times, Jan. 27, 1971.

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