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1973

LETTER OF TRANSMITTAL

February 1973.
Hon. John SPARKMAN,
Chairman, Committee on Banking, Housing and Urban Affairs,
U.S. Senate, Washington, D.C.

DEAR MR. CHAIRMAN: Transmitted herewith is the final report of the Subcommittee on Securities in connection with its study of the securities industry.

Senate Resolution 109, agreed to June 21, 1971, authorized expenditures and employment of personnel by the Committee on Banking, Housing and Urban Affairs "to examine, investigate and make a complete study of any and all matters pertaining to the securities industry and securities markets of the United States." Senate Resolution 244, agreed to March 6, 1972, authorized additional expenditures for this purpose and directed the Committee to “report its findings, together with such recommendations for legislation as it deems advisable . . . to the Senate at the earliest practicable date, but not later than February 28, 1973."

Pursuant to this authorization, the Subcommittee on Securities has obtained information by means of letters, interviews, questionnaires, and public hearings. The Subcommittee's analysis of this information, together with recommendations for legislation, is set forth in this report.

The Chairman of the Subcommittee wishes to thank the members and staff of the Securities and Exchange Commission, the officers and staff of the national securities exchanges and the National Association of Securities Dealers, and representatives of industry groups and individual firms for their cooperation and assistance in making information available to the Subcommittee. Sincerely,

HARRISON A. WILLIAMS, Jr., Chairman, Subcommittee on Securities.

(III)

CONTENTS

Page
iii
1
4

Letter of transmittal...

Introduction ----

Summary of conclusions and recommendations-

CHAPTER I. THE STRUCTURE OF THE INDUSTRY

A. Regulation of Financial and Operational Aspects of the Securities

Business

1. Financial Responsibility of Brokers and Dealers

a. The Legal Framework--

b. Financial and Operational Crisis.

C. Case Study of NYSE Net Capital Rule-

d. Securities Investor Protection Act of 1970.

e. Post-SIPC Developments.

i. Operation of SIPC.

ii. Unsafe and Unsound Practices Report_

iii. Regulatory Improvements..

f. Subcommittee's Analysis --

g. Subcommittee's Recommendations.

2. Processing of Securities Transfers..

B. Commission Rates -

1. The Benefits of Competitive Commission Rates.

a. Efficiency --

b. Difficulty of Ascertaining Appropriate Rates.

i. T'he Absence of Standards

ii. Impediment to Industry Adjustment...

c. Fixed Commissions as a Cause of Market Distortions.-

2. The Arguments Against Competition.--

a. Effect on the Industry and its Ability to Mobilize

Capital ---

i. The Competitive Posture of Large and Small

Firms.

ii. Ability to Raise Capital.

b. Effect on Trading Markets -

i. Liquidity

ii. “Fragmentation'

c. Effect on Individual Investors.

i. The “Subsidy” Argument-

ii. Research and Other Services

d. Effect on Institutional Research.

3. Agenda for Competition.-

C. Institutional Membership)--

1. Historical Development,

a. The Growth of Institutional Investors and the Shift to

Common Stock --

b. Effect on the Brokerage Business-

c. Types of Affiliations Between Institutions and Broker-

Dealers.

i. Institutional Acquisition of Brokerage Affiliates.-

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ii. Brokers' Expansion into Money Management.--

d. Exchange Reaction to Institutional Membership-

i. New York and American Stock Exchanges

ii. Pacific Coast Stock Exchange..

iii. Midwest Stock Exchange.--

iv. PBW Stock Exchange-

66

67

68

69

71

72

72

C. Institutional Membership-Continued

2. Problems Resulting from Combination of Money Management Page

and Brokerage---

a. Barriers to Fair Competition Between Money Managers. 73

b. Conflicts of Interest.

75;

i. “Churning”

ii. Choice of Market.

75

iii. “Dumping”

76

iv. Discriminating Against Other Customers.

76

v. Determining Appropriate Commissions.

76

c. Interference with the Evolution of the Securities

Markets.

77

3. Proposed Remedies

77

a. The Martin Approach.

b. The SEC Approach..

80

4. The Subcommittee's Approach-Prohibiting Self-Dealing -

a. Eliminating the Combination of the Brokerage and

Money Management Functions

8.3

b. Implementation

87

CHAPTER II. THE STRUCTURE OF THE SECURITIES

MARKETS

A. The Development of a Central Market System.

89

1. The Current Situation...

89

a. The OTC Market.

89

b. The Exchange Market.

90

c. Growth of Competing Markets in NYSE-Listed

Securities.--

91

d. Consequences of Use of Other Markets..

93

2. Steps Toward the Creation of a Central Market System.

94

a. Alternative Approaches.-

94

b). Barriers to Communication and Competition.

96

c. Central Communications Systems.

96

i. Composite Transaction Reporting System.

97

ii. Composite Quotation System.

101

d. Elimination of Regulatory Barriers.

104

B. What Kind of Central Varket System?

106

1. “Auction" and "Dealer” Markets.

106

2. Goals of a Central Market System.

106

3. Characteristics of Present Markets.

107

4. Implementation of a Central Market System.

110

a. Priority for Public Orders-

111

b. Handling of Institutional Transactions.

112

i. Restrictions on Institutional Trading -

ii. Separation of Individual and Institutional

114

iii. Improved Market-Making Capacity.

115

c. Regulation of the Activities of Market Makers -

i 116

5. Opposition to the Central Market System.

119

a. The Right to Decide where a Security Will Be Traded..

120

b. “Elimination of the Auction Market”.

121

c. Regulatory Competitive Controls Market

Making-

122

6. Which Securities should be Traded on Exchanges?

126

a. Characteristics of Listed and Unlisted Issues-

126

b. History of “Unlisted Trading Privileges”.

129

Auction” Markets for Unlisted Securities..

133

CHAPTER III. THE STRUCTURE OF THE REGULATORY

SYSTEM

A. Introduction -

1. Statutory History of the Self-Regulatory Concept in the

Exchange Act--

137

a. The Stock Exchanges -

137

b. National Securities Associations-

| 143

2. Evaluation of Self-Regulation.-

145

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Page 149 150 150 151 1.53 154 1.35 157 160

164 170

170

172 172 174

175 177

179 180

180

180 183 184

B. The Operations of the self-Regulatory Agencies.
1. Procedural Standards for Self-Regulatory Action...
a. Actions Directed Against Particular Persons-

i. Disciplinary Actions..
ii. Denial of Membership

iii. Actions Affecting Non-Members -
b. Policy Formulation..
2. Jurisdiction of the Self-Regulatory Agencies..

a. Relation to the SEC Jurisdiction..
b. Allocation of Jurisdiction Among Self-Regulatory

Agencies
C. The Authority and Procedures of the SEC.

1. The SEC's Request for Additional Authority to Oversee the

Self-Regulatory Agencies...
a. The SEC's Authority over the Content of Self-Regula-

tory Rules...

i. Power to Disapprove Proposed Rules
ii. Power to Alter Existing Rules-
iii. Procedures Employed in Disapproving or Alter-

ing Rules..
b. The SEC's Authority to Enforce Self-Regulatory Rules.
c. The SEC's Authority to Review Disciplinary Proceed-

ings Conducted by Self-Regulatory Agencies.---
2. The SEC's I'se of Its Existing Oversight Powers.--

a. The SEC's Implementation of Its Regulatory Recom

mendations.
i. The 1970 Inspection of the NYSE's Specialist

Surveillance Program.
ii. Automation of Specialist Surveillance-
iii. The $15 Commission Surcharge-
iv. The Exculpatory Clause in the NYSE's Subordi-

nated Loan Agreement.

V. Conclusions and Recommendations..
b. The SEC's Reliance on Its Staff for the Performance of

Oversight Functions.
i. The Decisions concerning Listed Securities on

186 188

191

NASDAQ-
ii. Criticism of the NYSE's Net Capital Rule ..
iii. Evaluation of Self-Regulatory Surveillance AC-

tivities.
iv. Conclusions and Recommendations..
c. Performance of Continuing Oversight Responsibilities--

i. Inspections of Stock Exchanges.
ii. Surveillance of the Allocation of Securities to

Specialists..

iii. Conclusions and Recommendations..
3. Procedures for Reviewing Proposed Self-Regulatory Rules -

a. Notice and Opportunity to Participate in the Rule Re

view Process

h. Approval of Self-Regulatory Rules.
4. Private Contact Between the SEC and the Self-Regulatory

Agencies.
D. Role of the Courts..

1. Judicial Review of Commission and Self-Regulatory Action.
a. Present Law; Availability of Judicial Review -

i. Commission Action -
ii. NASD Action.--.
iii. Action of National Securities Exchanges..
iv. Summary: Availability of Direct Judicial Re-

view.

V. Collateral Attack on Self-Regulatory Action.-
b. Conclusions and Recommendations; Availability of Ju-

dicial Review----
c. The Importance of Reasons, Findings and Conclusions..

192 192

193 193 194 194

195 196 196

197 199

201 205 205 207 208 210 211

211 212

213 215

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