The Structure of the Securities Market - Past and Future

Fordham Law Review, Dec 1972

By Thomas A. Russo and William K. S. Wang, Published on 01/01/72

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The Structure of the Securities Market - Past and Future

The S tructure of the Securities Market - Past and Future as A. Russo 0 William K . S. Wang 0 0 Thi s Article is brought to you for free and open access by FLASH: The F ordham Law Archive of Scholarship and History. It has been accepted for inclusion in Fordham Law Review by an authorized editor of FLASH: The F ordham Law Archive of Scholarship and History. For more information , please contact Recommended Citation Thom as A. Russo and William K. S. Wang, Th e Structure of the Securities Market - Past and Future, 41 Fordham L. Rev. 1 (1972). Available at: - Article 1 LAW 1972-1973 VOLUME XLI PATRICIA FARREN Articles Editor PAMELA CHEPIGA Case Notes Editor LAWRENcE J. LAFARO Comments Editor ROBERT MEADE Managing Editor Jonm M. HUNT JOSEPHI W. MuccmA EDITORIAL BOARD THEODORE H. LArry Editor-in-Chief FRANx DzAz Book Reviews Editor PAUL BocnsccMo Articles Editor JAmEs P. TRACY Case Notes Editor ROBERT J. RIED Comments Editor ASSOCIATE EDITORS JOHN E. OSNATO MEMBERS MARY J. HAMMER RAYMoN L. HERBERT RONALD S. HERzoo THoMAs R. JoNms RicHARD R. KALxow JAms B. KEANEY EroT LAuER JACOB LAuFER KAREN G. LInD MAsuEL R. LLORCA THEMODORE P. MANNo PAUL A. MROLLA MIcHAL J.MONAGHAN JoN M. O'CONNOR CHnARLs R. RAGAN CONSTANTINE RALLI ANN V. SULLIvAN Business Secretary EDWARD W. DOYLE Writing & Research Editor PAUL J. OsmrNo BARNET PHILLIPS, IV KEVIN C. REILLY JA Es RYAN JoHm G. RYAN PETR S. SAchS GEORGE A. SHANMiAN JEROME SUEINMAN JosEPH R. SimoNE JoHN W. SPoLLEN NEA R. ST LL JACOB S-USLOVIc ALOY TAmOSIIUNAS ROBERTA L. Toss McCles= E. Twowzy GLEN WALKER DAVID W. WILTENBURo D=E L. YAEGER EDITORIAL AND GENERAL OFFICES Lincoln Center, 140 West 62nd Street, New York, N.Y. 10023 Published four times a year-October, December, March and May. Member, National Conference of Law Reviews. Printed by the Heffernan Press Inc., Worcester, Massachusetts. Second class postage paid at New York, N.Y. and at additional mailing offices. SUBScRIPTON PUCK $10.00, SInoLE IsSm $3.50. Make checks payable to FORDI1AM LAW REVIEW. Subscription renewed automatically unless notified to contrary. TABLE OF LEADING ARTICLES-AUTHORS iv FORDHAM LAW REVIEW COMMENTS ABORTION See also Constitutional Law, Women's Rights Abortion at Common Law 70-121 Abortion on Demand 921-44 American Abortion Statutes 122-67 Fetus' Right to Life 439-49 Historical Views on Abortion 814-15, 921 Legal History 439-45, 446 Legal Personality of Unborn Fetuses 439-49 .New York Abortion Law 839-40 Physicians Consent 924 Right to Privacy 923 Restrictive Abortion Statutes 440, 444-46 Role of Legislature with Respect to Abortion 439-40, 447-49 Wade Decision 807-14 Women's Constitutional Right to Bear or Not to Bear Children 443 Women's Right to Abortion 439-49 ADMINISTRATIVE AGENCIES Divestiture as a Remedy 579-97 Dual-Rate Contract 423-31 Factors in Granting Private Divestiture Positive Effects 597-601 Negative Effects 601-04 Federal Maritime Commission 423-31 Indemnification Among Antitrust Coconspirators 68, 72-73, 75-84 Injunctive Relief Under Antitrust Laws 569-604 Monopolies 569-604 Private Divestiture 569-604 Right to Implead Antitrust Coconspirators 67-84 Shipping Act of 1916 423, 425-31 Standards for Antitrust Immunity 428 Standing of Private Party to Sue for Injunctive Relief Under Antitrust Laws 574-75, 577-78, 587 Steamship Conferences 423-31 History 424-26 CAPITAL PUNISHMENT See also Constitutional Law Arbitrariness of the Death Penalty 675, 680-83 Cruel and Unusual Punishment Clause 671-74 Historical Development 671-74 Equal Protection 675, 681 Goals Behind Capital Punishment 677-79 Mandatory Death Penalty 683-84 CIVIL PROCEDURE VOLUME XLI Congressional Power to Withdraw Existing Jurisdiction 877-79, 882-83 Constitutional Limitations on CourtMartial Jurisdiction Over Overseas, Non-Service Related Offenses 339 "Critical Stage" Test 150-51, 154, 156, 1064-65, 1068-69 Cruel & Unusual Punishment Clause 671-84 Due Process 115, 158-66, 345, 431, 439, 507-08, 513, 568, 608-09, 682, 684-95, 708, 711, 722-42, 1063-74 Equal Protection 128, 345, 431-32, 439, 605-38, 675, 681, 695-702, 703-12, 941 Establishment Clause 1015-24 Fetus' Right to Life 439-49, 807-62 Fourteenth Amendment Rights of the Fetus 840, 851-62 Freedom of the Press 1024-34 Free Exercise Clause 1020-22 Frisk Limited to Weapons 323-24 Fundamental Rights 929-30 Immunity Statutes 712-22 Jehovah's Witnesses 158-66 Lack of Absolute Right to Supreme Court Review 874-75 Mandatory Chapel Attendance for Service Academies 1020-24 Miranda Warnings 318, 322, 1067-68 National Court of Appeals 863-86 Necessary and Proper Clause 330, 333, 340, 354-55 Oath Requiring Belief in God 1018 Parens Patriae Test 162, 165, 708 Prayer in School 1018-19 Prisoners' Rights 505-12, 730-42 Privilege Against Self-Incrimination Privileges & Immunities Clause Probable Cause Requirement 307-08, 323 Rational Basis Test 606-14, 706-12 Reasonable Expectation of Privacy Test 1044-51 Reasonable Suspicion Standard 307-09 Reed-Guano Impact Test 614-38 "Release Time" Religious Instruction Usury Statutes and Their Relation to Credit Sales 375-82 CONTRACTS "Critical Stage" Test 150-51, 154, 156, 735 Burden of Proof That Evidence is Not Derived From Compelled Testimony 720-22 Emergency Requirement of Warrantless Search 1034-44 Habeas Corpus 877-78 Immunity Statutes 712-22 MirandaWarnings 1067-68 Motion to Dismiss an Indictment 540-45 Neutral Magistrate 1039 Probable Cause 1037-38 Right to Counsel 149-58, 722-30, 1063-74 Right to Hearing with Respect to Redeterminations of Sentences 736-37 Role of Grand Jury in Criminal Investigations 1050-51 Search of Chattel Consigned to Common Carrier 1037, 1041-43 Search & Seizure 1034-44 Types of Immunity 713, 716-22 Derivative Use 713, 717-22 Transactional 713, 716-22 Use 713, 717-22 Vehicular Searches 1035-39 Wade-Gilbert Rule 1063-74 Warrantless Searches 1034-44 DAMAGES See also Antitrust Law, Impleader, Negligence, Remedies, Torts Active-Passive Negligence Test 71, 167-71 Antitrust Treble Damage Action 67-84 Apportionment of Damages Among Antitrust Coconspirators 67-84 Among Joint Tortfeasors 71-73, 167-74 Comparative Negligence Doctrine 174 Contribution Among Antitrust Coconspirators 67-75, 83 Among Joint Tortfeasors 167-74 Indemnification Among Antitrust Coconspirators 68, 72-73, 75-84 Among joint Tortfeasors 167-74 Right of Actively Negligent Party to Implead a Co-Wrongdoer 167-74 DUE PROCESS See also Administrative Law, Civil Rights, Constitutional Law, Criminal Law, tional Court of Appeals, Right to Appeal Abandonment of the "Rule of Four" 867 Abolition of Three-Judge Federal District Courts 864 Congressional Power to Withdraw Existing Jurisdiction 877-79, 882-83 Creation of Federal Circuit Courts of Appeals 867-68 Enlarging Jurisdiction of Circuit Courts of Appeals 868 Elimination of Direct Appeal to Supreme Court 866 Increase in Supreme Court Membership 866 Increasing Term of Supreme Court 867 Jurisdiction over Executive Pardons 879-80 Lack of Absolute Right to Supreme Court Review 874-75 Initiation of Supreme Court Jurisdiction 866 Limiting Right to Appeal 868-69 National Court of Appeals 863-86 "One Supreme Court" Requirement 884-85 Requirement of Congressional Authorization for Appellate Review 880-81 Supreme Court Control of Lower Federal Courts 880 Workload Statistics of Supreme Court 864-66 FRISKING See also Constitutional Law, Search & Seizure Airport Frisk 293-324 Frisk Limited to Weapons 323-24 Reasonable Suspicion Standard 307-09 Stop and Frisk Rule 293, 307-23 Terry Doctrine 293, 307-23 GOVERNIENT See also Congress, Constitutional Law, Federal Courts, Immunity, National Court of Appeals Article I Courts 340, 348, 363-69 Congressional Control Over the Supreme Court's Appellate Jurisdiction 875-83 Congressional Power to Self-Discipline Members 43-66 Estoppel Test 148 Judicial Review of Immigration and Naturalization Service Determinations 141-43 IMPLEADER See also Civil Procedure, Damages Right of Actively Negligent Party to Implead a Co-Wrongdoer 167-74 Right to Implead Antitrust Coconspirators 67-84 IMMUNITY See also Criminal Procedure, Constitutional Law, Government Breadth of Immunity Statutes 712-22 Burden of Proof that Evidence is Not Derived from Compelled Testimony 720-22 History 713 Immunity Statutes 712-22 Power of Government to Compel Testamony 712-22 Privilege Against Self-Incrimination Permitted 256-65 The Kennedy Round in American Trade Policy (Book Review) 217-20 Treaty of Rome Article 85-86 229-92 Article 36 273-75 Vertical Agreements 265-73 JUDICIAL REVIEW MEDICAL TREATMENT (LEGAL MEDICINE) See also Constitutional Law Clear and Present Danger Test Compelling State Interest Test 161, 165 Jehovah's Witnesses 158-66 Medicaid 931-44 Medical Jurisprudence (Book Review) 487-92 Medical Views on Abortion 833-35 Parens Patriae Test 162, 165 Right to Free Abortion 931-44 State Action re Compulsory Medical Treatment 158-66 Transfusion Cases 158-66, 442-43 MENTAL ILLNESS Mental Disability and the Criminal Law (Book Review) 221-24 PAROL EVIDENCE RULE See also Contracts Application to Third Parties (Privy) 965-68 Applied to Third Parties (Strangers) 959-65 Estoppel 951 Exceptions 961-64 Integration 953-58 Material Excluded 947 Mutuality of Estoppel 964-65 Rationale for Rule 946-51 Releases 968-72 Statutory Recognition 958 PATENT LAW Combination Patents 458, 461-69 Doctrine of Contributory Infringement 462-63 History of the Patent 459-61 Patent Infringement 458-69 Sale of Components of Patented Device for Final Assambly 458-69 Test of Substantiality (Doctrine of Equivalents) 466-68 Test of Technicality 466-68 PHILOSOPHY OF LAW A Dialogue Between a Philosopher and a Student of the Common Laws of England (Book Review) 479-86 RIGHT TO APPEAL See also Civil Procedure, Constitutional Law, Federal Courts, Judicial Review Abandonment of the "Rule of Four" 867 Clearly Erroneous Test 568 Congressional Power to Withdraw Existing Jurisdiction 877-79, 882-83 Creation of Federal Circuit Courts of Appeals 867-68 Enlarging Jurisdiction of Circuit Courts of Appeals 868 Elimination of Direct Appeal to Supreme Court 866 In Forma Pauperis 864-65 Judicial Review 532 Lack of Absolute Right to Supreme Court Review 874-75 Limiting Right to Appeal 868-69 National Court of Appeals 863-86 Requirement of Congressional Authorization for Appellate Review 880-81 RIGHT TO COUNSEL See also Constitutional Law, Criminal Law, Criminal Procedure, Due Process "Accusatory-Investigatory" Test 1067, 1070-71 At Post-Arrest Photographic Line-Up 149-58 Burdensome Demands on the Legal Profession 728 Confessions 1066-68 "Critical Stage" Test 150-51, 154, 156, 1064-65, 1068-69 Historical Development 723-26 Imprisonment-in-Fact Standard 728 Lineups 1068-69 Miranda Warnings 1967-68 Pre-Indictment 1063-74 Right to Counsel in Non-Felony Prosecutions 722-30 Right to Counsel in Parole Release Proceedings 741 Right to Counsel Where the Punishment is Imprisonment 722-30 Right to Fair Trial 722-30 When Right Attaches (History) 1064-74 SEARCH AND SEIZURE See also Constitutional Law, Criminal Procedure, Frisking, Probable Cause, Skyjacking INDEX TO VOLUME 744-48 Purpose of Section 10(b) 743-44, 748 SEPARATION AND STATE OF CHURCH See also Constitutional Law, Aid to Non Public Schools Neutrality of Government Toward Religion 1016, 1019 Tests for Violations Secular Purposes 1016 Purpose and Effect 1018-19 SENTENCING AND CORRECTIONS See also Constitutional Law, Criminal Law, Due Process, Hearings STATE ACTION See also Civil Rights, Constitutional Law, Sentencing and Corrections, Medical Treatment, Women's Rights Clear and Present Danger Test 164 Community Patrol Groups 985-90 Compelling State Interest Test 161, 165 Equal Protection 695-702 Initial Sentence Determinations by Parole Boards 737-42 Issuance of State License 700-02 Parens Patriae Test 162, 165 Physicians Performing Abortion 926 Racial Discrimination 695-702 State Action re Compulsory Medical Treatment 158-66 State Control of Sexual Conduct 709-12 State Involvement (Entwinement) 699-700 697-702 Tests for State Action TABLE OF CASES Case names prefixed with an asterisk are the subjects of Case Notes 775 1015-24 Anonymous .......... 824, 827, 830-31 Apodaca v. Oregon .... 115, 129-32, 138 *Argersinger v. Hamlin .......... 722-30 1972] This approach clearly requires change in the minimum commission rate structure of the Exchange. 90 The Staff Report considered it the duty of the broker to obtain best execution. It noted that "[t] he basic rule is that a customer who engages a broker to execute an order on an exchange confers authority on the broker to conduct the transaction according to the established rules and customs of the exchange.9 However, if the rule or usage contradicts an expressed agreement between the customer and the broker, is unreasonaobfleth,eillebgraolk, ecroagnetrarreylattoiopnushbilpic, piotliicsynoort obtihnedriwnigseuaplotenrsththee cbuasstoicmienrt.e"n1t2 Thus, the Staff Report seemed to imply that where a NYSE broker knew or should have known that it could receive a better price for its customer elsewhere, Rule 394 could not, without causing a violation of the fiduciary duty of best execution, require the transaction to be executed on the New York Stock Exchange. In its February 2, 1972 Statement on the Future of the Securities Markets, the SEC considered the creation of a central market system. The Commission stated that in order to achieve a central market system there must be an "elimination of artificial impediments, created by exchange rules or otherwise, to dealing in a best available market."0 3 The Commission said that all qualified broker-dealers must be able to obtain access to all exchanges. This aspect of the Commission's statement appeared to be aimed directly at the elimination of NYSE Rule 394. In its Security Industry Study Report, the House Subcommittee on Commerce and Finance also criticized Rule 394, and called for its rescission: In a central market system whose objectives are that customers should receive the best possible execution of their orders in any market wherever situated and that such orders be transacted at the lowest possible cost, rule 394 has no justification. Accordingly, the New York Stock Exchange should immediately rescind the rule. If this is not done the Subcommittee will introduce legislation which will have the effect of abrogating the rule.94 FIXED VERSus NEGOTIATED COMMISSION RATES A. Introduction On April 1, 1968 the Justice Department surprised both the SEC and the New York Stock Exchange by filing a brief with the Commission 5 90. Id. at D-49. 91. Id. at D-21. "[Tlhe broker's duty to obtain best possible execution for his customer .is the very essence of the broker's agency duty." Id. D-19. 92. Id. at D-21 (footnote omitted). 93. SEC Statement, supra note 42, at 10. 94. Securities Industry Study, supra note 1, at 127. 95. Memorandum of the Dep't of Justice, Inquiry into Proposals to Modify the Coinarguing that fixed commission rates were neither required nor justified by the objectives of the Securities Exchange Act and consequently were a violation of the antitrust laws under Silver v. New York Stock Exchange. 6 Stimulated by this pressure, the SEC called for hearings on the commission rate structureY In August 1968, the NYSE submitted a reply economic brief to the Justice Department0. During the next year, the NYSE99 and the Justice Department'" exchanged even longer and more forceful economic briefs on the subject of commission rates. The debate between the NYSE and the Justice Department continued with the Antitrust Division filing critical comments about Exchange proposals to permit public ownership but prevent institutional membership 101 and with replies by both the Justice Department'0 2 and the Exchange'0 " to SEC Release No. 8791. B. The Exchange's Arguments In its economic briefs and testimony, the NYSE made a number of fundamental arguments. 1. The Viability of the Central Auction Market The first contention of the Exchange was that minimum commissions are necessary as an incentive for brokerage firms to retain membership 1972] on the NYSE. With the abolition of minimum commission rates, there would be such a leakage of trades that the Exchange would become "an association of floor brokers and specialists." Firms would withdraw as members and conduct the main part of their business by means of crosses in their own offices or in the third market. With splintered markets, the public investor might very well lose on poor executions what he might save on negotiated commissions. The reduced membership on the Exchange would also impair the NYSE's self-regulatory function. The Exchange's fragmentation argument could be rephrased as follows: Excessive public commission rates give brokerage firms the incentive to join the NYSE both to obtain the lower intra-member rate and to gain the monopolistic profits derived from the high public commissions set by the cartel. Once firms are members of the Exchange, they come under Rule 394 which prevents fragmentation of trading and maintains the liquidity and depth of the central auction market. In short, one of the Exchange's principal arguments in support of the fixed minimum commission rate depends on a belief in the necessity of Rule 394. Rule 394 can only be justified if it is more efficient to bring all trading in a security to one geographicallocation. However, the Central Market Place is no longer a geographical concept but a communications concept.104 Even if Rule 394 were justified, however, fixed minimum rates would be a highly inefficient way of inducing brokerage firms to come under its jurisdiction. As Professor Samuelson pointed out in his testimony in the SEC Rate Structure Hearings, the principal barrier to a broker-dealer's becoming a member of the Exchange is the high cost of purchasing a seat, which is due to the artificial scarcity of seats maintained by the NYSE itself. Professor Samuelson urged that all monopolistic restrictions barring access to the facilities of the exchange be made illegal.10 5 104. "[Wie believe that because of modern communications and data processing facilities it is possible to preserve geographically separate trading markets while at the same time tying them together on a national basis. We are also satisfied that the Commission and other regulatory authorities should endeavor to prevent the evolution of a market place from being distorted by unnecessary restraint on competition." SEC, Letter of Transmittal, Institutional Investors Study, supra note 3, at XXIII. Professor Paul Samuelson has also questioned the premise of Rule 394: "[T]he New York Stock Exchange, as it should operate, is not something which is located on the floor of the Exchange. It is as big as the American T & T telephone network. The securities markets are one live, interconnected whole and the important thing is that there be freedom for equitable and efficient competitive forces to operate throughout that network and not that we protect volume or appearances on one particular domicile of the securities business." SEC Rate Structure Investigation Hearings 3540-41 (Oct. 30, 1968). 105. Id. at 3536-42. Professor Baumol went even further than Professor Samuelson and commented: [I]t can also be appropriate to consider making membership on the exchange and adherence to its rules compulsory for any broker-dealer who trades on it more than some specified volume. This procedure as a means to preserve the centralized market and to support self-regulation derives its rationale from the elements of public utility in the function of the exchange which acts as the near-exclusive purveyor of its service (trading in listed securities, particularly in small quantities). 100 Both Professor Samuelson's and Professor Baumol's proposals would increase the number of broker-dealers who were members of the NYSE. Presumably, these new members would tend to trade listed securities on the Exchange both because of Rule 394 and because of the availability of the low intra-member NYSE rate. A more direct means of increasing the trading of listed securities on the Exchange would be to introduce negotiated rates. It does not take much economic expertise to predict that lower rates would result in more rather than less business for the NYSE. As mentioned earlier, the elimination of fixed commissions would cause the major differences between Exchange members and non-members to disappear. The Exchange would gain back the customers and broker-dealers which presently bring their business to the regionals or the third market in order to grant or obtain rebates and lower commissions. The NYSE's argument is based on the assumption that if it were desirable to bring all securities trading to a central market place, the NYSE would be that market. This assumption is highly questionable. In 1967 the regional exchanges and the third market together accounted for just over ten percent of all trading in NYSE listed stocks. By 1970, the share of the regionals and the third market had just about doubled, with an estimated 35 to 45 percent of blocks of 10,000 or more shares traded away from the Exchange."' The third market is an especially serious threat to the New York Stock Exchange. On February 8, 1971, NASDAQ, the National Association of Securities Dealers Automated Quotations system, commenced operation. Under this system the bid-ask quotations of all participating OTC dealers are continuously inserted into a computer system which instantaneously makes the quotations available on the desk terminals of subscribers to the system. 08s In many respects the system is like a securities exchange with competing specialists. 1972] It might be argued that public policy dictates that the NYSE floor should be abolished and that all trades be brought to NASDAQ rather than vice versa. This question will be discussed in the section of this article on automation, but it is interesting to note that the Exchange's arguments in favor of one efficient central marketplace may eventually be turned against it. In summary, the Exchange's argument that minimum commission rates are necessary to preserve the central auction market fails for several reasons. First of all, the NYSE's argument depends on a belief in the necessity of Rule 394, and it is not clear that the premise on which Rule 394 is based is correct. Secondly, even if Rule 394 were justified, fixed minimum rates do not appear to be the most efficient or desirable means of inducing broker-dealers to join the NYSE. Giving out seats free or even requiring most broker-dealers to join the Exchange would be much more effective. Furthermore, the ultimate goal of Rule 394 is to increase trading on the NYSE, and negotiated rates would result in more trading for the NYSE, not less. Thirdly, even if it is desirable to bring all trades in a given security to one "exchange," the NYSE is probably not the place to which the orders should be brought. Even if it were decided that all trades in listed securities should be brought to the NYSE, and that the NYSE were a natural monopoly, it might be necessary to regulate the Exchange itself as a public utility, and the utility commission would set the fees which the Exchange would charge for the use of its services; but broker-dealers using the Exchange facilities would still charge competitively determined commissions for their services to the general public. 10 9 2. Destructive Competition Although the phrase "destructive competition" is frequently incanted to justify price-fixing, the New York Stock Exchange has gone to great pains to buttress its argument that competitive rates will lead to destructive competition in the securities industry. Its arguments are quite complex. First of all, the Exchange asserts that the average total cost per transaction incurred by a brokerage firm declines at a significant rate as a firm grows larger, partly because of high fixed costs, and partly because of economies of scale. Consequently, marginal cost is continuously below average total cost for a wide range of output. If rates were competitively set, the Exchange argues, prices would fall to marginal cost, which would be below average cost, and the firms in the industry would suffer losses. The less diversified and less well capitalized firms would go bankrupt and an equilibrium state would be reached with a few well-capitalized diversified firms surviving. Size and diversification rather than efficiency would be the key to survival. Presumably, the surviving firms would be profitable, either because they were operating at a level where there were no longer economies of scale, or because they were tacitly agreeing to keep their prices at average cost or above. In order to justify their arguments, the NYSE includes in its August 1968 economic brief a fair amount of quite unpersuasive econometric analysis. 10 In its 1968 and 1969 briefs, the Exchange also attempted to demonstrate that the brokerage industry was exceptionally prone to destructive competition due to the erratic nature of the demand for its services."1 110. For example, the Exchange sought to demonstrate, by including as "fixed costs" such items as clerical salaries, communication costs, occupancy and equipment costs, and "other expenses," including promotion, licenses, dues, and assessments, that for the year 1966, fixed costs for the average firm constituted 51% of total costs. NYSE Economic Brief, Aug. 1968, supra note 98, at 64. As the Justice Department pointed out, it was highly unrealistic for the NYSE to classify 75% of salaries of personnel as fixed costs. When volume or profits have declined In the past, brokerage firms have not hesitated to lay off employees. The brokerage Industry is primarily a service industry, and it should have lower fixed costs than manufacturing industries and much lower fixed costs than industries which are traditionally regulated as public utilities. Dep't of Justice Memorandum, Jan. 1969 , supra note 100, at 114-15. In its 1968 economic brief, the NYSE also attempted to derive the average cost curve of the brokerage industry through two techniques. First of all, the Exchange found an inverse correlation between the rate of growth of member firms during the period 196566 and the direction in which their average unit costs were changing. In other words, rapid growth was associated with reductions in average cost. NYSE Economic Brief, Aug. 1968, supra note 98, at 55-58. But, as Professor Baxter has pointed out, this correlation does not demonstrate that the brokerage industry has a declining cost curve. The data may simply suggest that efficient brokerage firms tend to grow. Alternatively, it may indicate that there are some economies of scale in the brokerage industry and that firms that had not yet fully achieved significant economies of scale were tending to realize them by growth. Baxter, supra note 103, at 697-98. In addition, the Exchange ran a regression on total costs of output, which showed that the long-run average cost curve is negatively sloped over the entire range of outputs covered by firms in the data b ase. NYSE Economic Brief, Aug. 1968 , supra note 97, at 58-63. Although the NYSE did not bother to calculate the steepness of the slope, Professor Baxter analyzed the Exchange's data and discovered that costs drop quite sharply for firms that execute fewer than 200,000 transactions per year, but at larger outputs the rate of decline was insignificant. Thus, Professor Baxter argues that on the basis of the Exchange's own data substantially more than 80 firms w6uld survive the introduction of negotiated rates, a number far in excess of that necessary for effective competition. Baxter, supra note 109, at 698-99. 111. "When demand reaches short-run peaks, the industry must have available adequate capacity to handle the load. This means that excess capacity must be tolerated during 1972] Perhaps the most devastating blow to the Exchange's argument is the lack of destructive competition in the over-the-counter market and third market where rates are negotiated. Also, the bargaining of institutional traders for give-ups and other rebates in effect results in negotiated commission rates for a large number of customers. Thus, the NYSE in its defense of the fixed rate commission system was in effect defending a rate system which was and is to a large extent negotiated. Past experience has not indicated any tendency toward destructive competition among brokerage firms catering to institutions, which are in general the most profitable in the industry. Ironically, when the SEC initially proposed to eliminate give-ups by check,112 the NYSE defended give-ups. The Exchange also emphasized the public interest in the financial solvency of brokerage firms and the possibility that bankruptcies might result in extensive loss of customer funds or securities held in "street name.""' At the end of 1970, Congress created the Securities Investor Protection Corporation" 4 which will insure each customer account up to $50,000, of which no more than $20,000 can be in cash. The SEC is also considering strict regulations which would require brokerage firms to carefully segregate their customers' money and securities from the rest of the firm's assets. If adopted, these regulations should ensure that customers will be fully protected in the event of a firm's insolvency. In summary, although the Exchange pressed its destructive competition theory with great earnestness, its arguments are not convincing. periods of low demand and in fact should be actively encouraged... . We are not speaking here of any commission rate policy designed to foster a permanently redundant excess of supply. But commission rate fluctuations should not be such as to precipitate a reduction in capacity during periods of below-average demand." NYSE Economic Brief, May 1969 , supra note 99, at 32. The Exchange then argued that competitive commissions would approximate short-run, rather than long-run, marginal cost and that "competition would have the tendency to eliminate excess capacity at times of declining demand--capacity which must be available during the subsequent phase of recovery in demand." Id. at 36. The Exchange's argument rests on the propositions that no queuing can be tolerated and the cost of excess capacity cannot be recovered through negotiated commirsion rates. However, queuing does occur and should occur to some extent Even now, on a high volume day, it may be difficult for a client to reach his broker. With competitive rates, firms would maintain different degrees of excess capacity and charge appropriately different commission rates. Additionally, it is unrealistic to assume that firms will constantly change their rates to reflect temporary variations in short-run marginal cost. See Baxter, supra note 109, at 702-03. 112. Proposed Rule 10(b)-10, SEC Securities Exchange Act Release No. 8239, (Jan. 26, 1968). 113. NYSE Economic Brief, Aug. 1968, supra note 98, at 108-13. 114. Securities Investor Protection Act of 1970, § 3, 15 U.S.C. § 78ccc (1970). Mr. William McChesney market stated that: Martin, Jr. in his report on the securities Fully negotiated rates may cause a substantial concentration of the securities business in a few large firms. Because of the strategic importance of the securities industry to the operation of the free enterprise-capitalistic system, control of this industry cannot be permitted to be concentrated in the hands of a few persons or firms. Such a concentration of power could not be tolerated even on the grounds of efficiency. Negotiated rates may not have this effect. They may only serve to eliminate the inefficient, poorly managed broker-dealers. No one knows the answer to this question, but an abrupt change to fully-negotiated rates would be prudent at a time when the industry needs continued earnings to accumulate and attract capital."n 3. Price Discrimination The NYSE also suggested that minimum commission rates protected small investors from price discrimination. If rates were negotiated, institutional investors would use their greater bargaining power to force rates for large orders down to variable costs. Brokers would be forced to shift overhead expenses to smaller investors with less bargaining power. 1 6 To this argument the Justice Department retorted: It must take a certain amount of fortitude to advance such an argument in the face of the "monopolistic discrimination" of the present rate system, which . . . requires the investor to pay substantially more than cost on all but the smaller trades .... In fact, competition is the great eliminator of price discrimination since, in the long run, it tends to force prices into line with' Since there are large numbers of firms in the brokerage industry, price discrimination could not persist because no broker-dealer would handle a transaction at less than long-run marginal cost, no matter how large the client, and no customer would have to pay much more than long-run marginal cost because there would always be a competitive broker ready to handle his order at marginal cost. The "price discrimination" argument assumes a certain homogeneity among broker-dealers. This, of course, is not the case. Therefore, negotiated rates on all orders should not lead to shifting of overhead expenses to the small investor. 4. Quality of Service The Exchange also pointed out that negotiated commission rates would lead to unbundling and argued that it is desirable to tie together in115. Martin Report, supra note 24, at 80,563. 116. NYSE Economic Brief, May 1969 , supra note 99, at 46-47; Id., Aug. 1968, supra note 98, at 83-88. 117. Justice Dep't Memorandum, Jan. 1969, supra note 84, at 184. 1972] formation, research, advice, promotional services, and execution. The NYSE insists that investment advice and research protects the small investor in the same way that consumer information protects the consumer. Investors should be allowed to obtain these services free, simply to encourage them to make more enlightened decisions, not only for their own protection but for the protection of the stock market and the economy from rampant speculation. Promotional activities should be encouraged to make more Americans aware of the benefits of stock ownership and also to increase individual participation in securities trading at a time when liquidity is threatened by increased institutionalization. These arguments are easily rebutted. Tie-ins inhibit the freedom of the consumer to choose the mix of services he desires. Furthermore, competition in the markets for the separate services is inhibited. If commission rates were negotiated and unbundled, research might actually improve because a thriving and highly competitive market advisory system might develop. Consumer protection is not an appropriate analogy, because a purchaser of a product such as an automobile is purchasing an item which is almost a necessity. Malfunctions in the product may severely inconvenience him or even endanger his life. An individual who purchases stock has deliberately chosen to play a game in which there is a danger of loss and the possibility of gain. It seems reasonable that the investor or speculator should be free to choose his own advisors in this game or even to have no advisors at all. Furthermore, the present bundled system encourages the stockbroker to exploit the unsophisticated investor. Because the stockbroker receives a fee for execution and not for research, he is tempted to encourage the customer to churn his account more frequently than is necessary. The best customer is the speculator who trades frequently, and registered representatives may well encourage their customers to speculate. In summary, unbundling would be an advantageous rather than a disadvantageous result of negotiated commission rates. In its Statement on the Future of the Securities Market, the SEC expressed concern about the issue of research as an element of the commission rate. The Commission stated: In our opinion, the providing of investment research is a fundamental element of the brokerage function for which the bona fide expenditures of the beneficiary's funds is completely appropriate, whether in the form of higher commissions or outright cash payments .... Concern has also been expressed that under an unbundled rate system many small investors would seek to obtain the lowest rates available and would lose the benefit of basic research now paid for by the minimum commission. In this regard, the Commission wishes to emphasize that a broker-dealer will not be relieved of his obligation to his customer with respect to the 'suitability' of a securities transaction. . . .Unarticulated but implicit in such rules is also the broker's obligation to obtain current basic information regarding the security and then to make an evaluation as to the suitability of a recommendation for a particular customer in view of both the information concerning the security and the customer's needs. Vigorous enforcement of the standards of suitability ...would thus mean that as competitive commission rates are introduced the basic execution charge which would evolve would include the provision of research services to the extent necessary to comply with these standards." 8 The Commission's statement places much emphasis on the need for research to satisfy the suitability rules. However, the Commission seems to be saying that when a recommendation is given by registered representatives it must be backed by reasonable research. The Commission goes further to say that where a customer wishes to buy securities and requests no recommendation from the registered representative, the customer is entitled to receive from the registered representative any information that the broker-dealer has available to it."0 However, the Commission does not require that where the broker-dealer has no information on the particular stock, it must do adequate research before executing the customer's order. This would mean that broker-dealers may be set up whose only function is to execute the transactions so long as the customers realize that no research will be forthcoming. This is the present method of doing business for many block positioners and third market-makers. It would seem that under a system of negotiated rates the basic execution charge need not include a provision for research. 118. SEC Statement, supra note 42, at 37-39. 119. Id. 120. See Silver v. NYSE, 373 U.S. 341, 357 (1963). 1972] ket. Fixed rates have made the SEC a rate fixing agency-a role for which it is ill-suited. In short, fixed rates are not only unnecessary in making the Exchange Act work but have severely hampered the workings of an efficient securities market. C. Practical Coiniderations 1. Unenforceability Much of the theoretical debate between the NYSE and the Justice Department had an air of unreality, because the Exchange was defending an abstraction called the fixed commission rate structure which did not exist in practice. Reciprocity, floor give-ups, institutional memberships on regionals, and block-positioning have severely eroded the fixed commission rate structure. The regional exchanges have been quite willing to act as conduits for rebates of NYSE commissions. Furthermore, as Professor Baumol has commented, it is highly questionable if the SEC could effectively stop reciprocal practices and rebates, even if it wished to do so.' The present system is inequitable because investors vary in their ability to take advantage of the loopholes and because the rebates have a tendency to flow into the wrong hands. Under such circumstances, the so-called fixed commission rate structure does not seem worth preserving. 2. Difficulties of Rate Regulation If the NYSE were to continue to set fixed commission rates, the SEC would be forced to regulate these rates like a public utility commission. Rate regulation is a difficult task at best, but there are special problems in the brokerage industry which make rational rate regulation virtually impossible. Unlike most regulated industries, the brokerage industry is characterized by a multitude of firms which have great variations in their costs and their kinds of business. There is no regulatory control over exit, entry, and many aspects of a firm's operation. Furthermore, the sources of income of brokerage firms include such bizarre and difficult to allocate 121. As Professor Baumol commented in the Rate Structure Investigation Hearings: "Where a large number of suppliers is involved, whatever the nature of the regulations, no matter how severe the penalties imposed on their violation, ways are inevitably found for their evasion. . .. I know of no exception to the general principle-attempts to enforce any artificial price in the presence of a multitude of sellers leads inevitably to a patchwork of regulations, each designed to fill the holes left by its predecessors.... [W]ith such sub rosa market arrangements funds tend to flow into the wrong hands. Instead of their going to those who supply the service or to the consumer, they frequently go into some other pockets." SEC Rate Structure Hearings 3634 (Oct. 30, 1968). items as margin interest, interest on free credit balances, and profits (or losses) from block positioning. Brokerage firms are multi-product firms. In addition to NYSE business, they engage in regional-exchange business, over-the-counter business, underwriting, mutual fund distribution, arbitrage, trading, money-management, and many other activities. It is extremely difficult, if not impossible, to allocate the costs and capital of a firm among these various activities. Research costs, for example, help to generate income from trading, money management, and securities commission business. The registered representative in a regional office will do NYSE commission business, regional business, over-the-counter business, new issues, secondary distributions, and mutual fund sales. Moreover, once expenses are somehow allocated to NYSE business, they must then be divided into costs related to the order, the number of trades to execute that order, the value of the transaction, and other variables, to arrive at the commission schedule, which gives the fee for securities transactions of various sizes and value. After the Justice Department challenged the legality of fixed commission rates in its April 1968 brief, the NYSE hired National Economic Research Associates to develop a rational cost-related commission schedule. NERA presented its report in 1970.122 Although NERA conscientiously attempted to perform its assignment, it was forced to make innumerable arbitrary decisions. For example, it appears that no attempt was made to determine whether or not partners' compensation might be excessive or might represent a return on capital.1 23 The classification of costs as order-related, trade-related, and value-related seemed highly arbitrary. Promotional costs, professional fees, dues and assessments, and research expenses were all classified as "value-related." Either no explanation or a circular one was offered for this allocation.12 4 The NERA study attempted to arrive at an appropriate rate of return on capital for the brokerage industry by looking at rates of return for other industries of comparable risk. On an extremely intuitive basis, the study decided an after-tax return of 15 percent was appropriate for the brokerage industry.12 5 The commission schedule finally proposed by NERA increased commissions on odd lots and trades of up to 200 shares and cut virtually all 122. NERA, Reasonable Public Rates for Brokerage Commissions (1970) [hereinafter cited by volume as NERA Report]; see Roth, A Dissenting Opinion on the NERA Report, The Institutional Investor, June 1970, at 42; Thackray, How NERA Developed a New Commission Schedule, id., Apr. 1970, at 48. 123. See NERA Report, vol. 1, pt. VI, at 2. 124. See id., pt. IX, at 3-8. 125. See id., pt. VIII. other commissions. The commission on 100 shares of $40 stock rose 68 percent, while it fell 30 percent on 1,000 share transactions.'2 Although the net increases were greater than the cuts and were supposed to add about half a billion dollars in additional revenue to the industry, the report was bitterly attacked on all sides. The large institutional firms whose commissions were about to be cut drastically immediately criticized the new proposed commission schedule. The press almost unanimously condemned the increases in commissions on small trades. There were also Congressional murmurs of disapproval about the increased costs to the small investor. Although some retail houses were pleased by the proposed changes, they kept quiet; and some retail firms complained that the increases on small trades were too high and would drive away business. " Many members of the investing public, as well as some journalists and politicians, seemed to want to redistribute income between classes of investors by lowering rates for one class and raising rates for another class. The problem, of course, is that the brokerage industry is highly fragmented with firms specializing in different types of customers. Any attempt to "tilt" the rate schedule in favor of the small investor would result in excess profits for the institutional houses and losses for the retail firms. After the initial brouhaha, the NERA Report quietly slipped into oblivion. On June 30, 1970 the NYSE, purporting to use the NTERA Report as a basis, submitted to the SEC a proposed rate schedule. The NYSE's Costs and Revenues Committee, among other things, (i) limited to 50% the increase on rates for orders up to $5,000; (ii) limited all rates to a maximum of $1.00 per share; and (iii) raised the N-ERA suggested rate on orders over $5,000 to make up for revenue lost by lowering rates on the smaller orders. The arbitrary alterations by the NYSE to the NERA proposal demonstrated the impossibility of attempting to devise and impose a reasonable commission rate. Since the NERA Report there has been no other attempt to rationally devise a set of reasonable cost-related commission rates for the industry. 3. NYSE President Haack's Speech In a speech before the Economic Club of New York on November 17, 1970, President Haack of the New York Stock Exchange dramatically and suddenly announced his support for negotiated commission rates. He indicated that practical considerations had forced him to reverse his former position. 126. Id., pt. II (c); vol. 2, Table XI, at 1-14. 127. See Thackray, supra note 122, at 49. Concerning fragmentation and reciprocity he stated: [F]ragmentation has been accelerated by the proliferation of reciprocal practices in the securities industry today which, in my judgment, are not only threatening the central marketplace but are tending to undermine the entire moral fabric of a significant industry as well.... Bluntly stated, the securities industry, more than any other industry in America, engages in mazes of blatant gimmickry, all of which have been disclosed under oath at commission rate hearings. Deals are frequently involved, complicated, and bizarre and do no credit to the donor or beneficiary of the reciprocation.128 I personally think [the industry] might well reconsider fully negotiated commissions as an ultimate objective. The initial emphasis might be put on larger transactions .... I have altered my own personal thinking as a result of the commission rate proceedings of the last two years and the fragmentation of markets that has simultaneously been increasing.... [I]n view of the increased emphasis that rates be reasonable, there is the concomitant responsibility to set standards by one method or another. . . . I believe the sseescsuersitineosneinodfustthrye icshabreaicntgerilsetdicsdoowfna thuetilpitayt.h120of utility-type regulation when it pos President Haack conceded that fixed rates had perhaps brought about the same kind of self-destruction that the industry had feared would result from regulated rates. "I inquire of myself," he said, "as to whether overly-zealous service-type competition and inept management has not been fostered by minimum commission rates."' 30 President Haack further acknowledged that putting an end to the fixed commission system could help solve the problem of institutional membership, because the incentive to seek rebates on large commissions would be greatly diminished.l"' Concerning unbundling, President Haack said that he questioned the propriety of one commission rate serving all customers without regard to their individual wishes, needs or requirements for varying degrees of service.'82 Finally, President Haack stated that the negotiation of rates on regional exchanges and the third market "make a mockery of the fixed minimum rate concept," and have brought about various reciprocal practices which mean that some customers pay only a fraction of the fixed schedule. He continued: I inquire as to whether the fixed rate concept, providing the basis for reciprocity and concurrently developing an incentive for institutions to recapture all or part of commissions paid, is not the single greatest reason for our market fragmentation. We can compete in only two areas, namely, service and charges, and I submit that no entity, 128. Address by President Haack, Economic Club of New York, Nov. 17, 1970, at 6. 129. Id. at 8. 130. Id. at 9. 131. Id. at 9-10. 132. Id. at 9. not even the New York Stock Exchange, can forever ward off competition from a noncompetitive stance so far as pricing is Although Mr. Haack's views were promptly attacked by many leaders of the financial community, his comments on the "fixed" commission rate were extremely perceptive. The controversy over the desirability of negotiated rates still rages within the industry. There are still a great many leaders of the Wall Street community who refuse to face reality and still support the fixed commission rate system. The fixed commission rate system is unenforceable, and even if it were enforceable, it would be impossible for the SEC to find standards by which to regulate rates in the industry. The Department of Justice stated in January, 1969 that "the system of fixed minimum commissions is not justified or needed 'to make the Securities Exchange Act work.' " In February, 1971, the SEC directed that the national securities exchanges eliminate fixed rates "on portions of orders above a level not higher than $500,000.'"1 The exchanges implemented the Commission's order in April, 1971. One year later, the breakpoint for competitively determined commissions was dropped to $300,000. When the SEC directed this reduction in its February, 1972 Statement on the FutureStructure of the Securities Market, it announced that it would "continue to observe the experience under the $300,000 level in considering the timing of subsequent steps."'3 0 Elements in Congress agree that commission rates should be competitively determined. On February 4, 1972, the Senate Committee on Banking, Housing and Urban Affairs released its report on the securities industry, in which it remarked that "the interests of the investing public, as well as the long-term health of the securities industry itself, require that stock exchange members be free to set their own commissions on transactions effected for their customers ...."1137 The Subcommittee on Commerce and Finance of the House Committee on Interstate and Foreign Commerce released its report on the securities industry on August 23, 1972. In its report the Subcommittee stated that 133. Id. at 10. 134. Dep't of Justice Memorandum, Jan. 1969 , supra note 100, at 13. 135. SEC Securities Exchange Act Release No. 9079 (Feb. 11, 1971). In October, 1970, the SEC had announced its conclusion that "fxed charges for portions of orders in excess of $100,000 are neither necessary nor appropriate." Id., No. 9007 (Oct. 22, 1970). 136. SEC Statement, supra note 42, at 33. 137. Senate Comm. on Banking, Housing and Urban Affairs, Securities Industry Study Report, 92d Cong., 2d Sess. 60 (Feb. 4, 1972). "fixed minimum commission rates are not in the public interest"'8 8 and recommended "that a competitive commission rate system should be phased in without excessive delay."' 39 The Subcommittee said that the competitive system "should apply to all transactions, regardless of size,' 40 and warned that "if reasonable progress toward the elimination of fixed minimum rates is not being made, we are prepared to take legislative action to achieve this end.'' VIII. AUTOMATION Perhaps the greatest threat to the continued existence of the New York Stock Exchange as presently constituted is automation. In the past several years a number of different automated securities trading systems have begun operation. Perhaps the most important of these systems has been the National Association of Securities Dealers Automated Quotation System (NASDAQ).142 On February 8, 1971, the entire over-the-counter market was dra138. Securities Industry Study, supra note 1, at 131. 139. Id. at 132, 143-44. 140. Id. at 132, 144-45. 141. Id. at 144 (footnote omitted). 142. AutEx, a privately owned system operating since August 1969, is designed to facilitate block transactions within the context of the existing exchange setup. Only broker-dealers may use the system to express indications of interest to all other subscribers. The indications give the size and side of the interest and the broker's name. The other subscribers may contact the broker-dealer named either directly or through one of their own brokers. The Block Automation System (BAS) is the New York Stock Exchange's answer to AutEx and operates in basically the same way. Instinet, another privately owned system, is also designed to aid block-trading but differs from the previously described systems in that it performs execution as well as communications and information retrieval. It thereby lets institutional subscribers by-pass brokers and the exchange entirely. The system began operation on July 31, 1970 and had 30 clients as of April 1971. All subscribers may enter indications of interest or firm orders into Instinct. The Information given (price, stock, number of shares, side of interest) may be broadcast to all or selected other subscribers, or it may be placed in the "book" maintained by the system. When two entries in the "book" match, the computer notifies the two parties. To preserve anonymity, a code is specified for each subscriber making an entry. If a subscriber is interested in contacting another firm, it can actually negotiate through the system by teletyping narrative messages or using pre-programmed messages. If the two parties finally agree on the price and size of the trade, the computer automatically closes the trade and prints out confirmations. Although Instinct is still relatively small, its radical approach may herald the beginnings of a sizeable "Fourth Market" in which institutions trade directly with each other. The systems described in this footnote are all designed to facilitate the trading of large blocks. matically revolutionized by the introduction of NASDAQ. Virtually every firm which deals in the over-the-counter market subscribes to the system. At its inception, NASDAQ supplied quotes on 2,400 leading OTC stocks, although it has the capacity to handle up to 20,000 stocks. NASDAQ permits dealers to display their quotes and eliminates the time consuming need to constantly telephone one another.143 In 1968 the by-laws of the NASD were specifically amended by vote of the full membership to include listed securities in the proposed NASDAQ system.'" On October 9, 1970, Ralph Saul, the then President of the American Stock Exchange, wrote the SEC to seek to prevent the inclusion of listed stocks on NASDAQ. On October 13, 1970, NYSE President Haack, a former head of NASD, wrote a similar letter. These two letters were followed by a third letter from Gordon S. Macklin, President of the NASD, making a similar request. SEC Chairman Budge wrote back to Mr. Macklin stating that the Commission would have no objection if the NASDAQ system did not include listed securities. President Macklin, with the approval of the NASD Executive Committee, then announced that NASDAQ would not carry listed stocks at its inception.1 45 All six members of the Executive Committee were partners or officers of NYSE firms, and 16 of the 23 members of the NASD Board of Governors were representatives of NYSE firms. 143. NASDAQ provides service on three levels. Level I supplies representative, or median, bid and ask quotations to the desk-top video terminals already on the desks of registered representatives ("customers' men") in retail branch offices of brokerage firms. The retail trading firm executing orders for public investors will subscribe to Level I. A subscribing dealer is able to enter the symbol for a stock and immediately view on his video screen the offers of the firms making a market in that stock. Next to each quotation is the symbol of a market-maker. The Level I subscriber is the market-maker himself, who is the only subscriber permitted to put data into the system. For those securities for which he has qualified as a market-maker, the Level III subscriber can enter, withdraw, and change bid and ask quotations, which are instantly made available to other Level II and Level 11 subscribers. On the basis of the quotations displayed on their video-terminals, retail firms will contact market-makers by telephone to arrange an execution. Each Level I subscriber, as a condition of registration as a market-maker, must agree to report at the end of the trading day the volume of shares he has traded in each of the securities in which he makes a market. His terminal device is equipped to accept this volume information. After each market-maker in a security has reported, the computer summarizes the reports by security and issues them to the news media along with the exact dosing bid and ask price of each security. During the day the computer also calculates a composite OTC market index and updates it hourly. 144. NASD By-Laws, art. XVI, CCH NASD Mlanual U 1651-54 (1972). 145. Bank Stock Quarterly, Feb. 1971, at 3-5; id., Dec. 1970, at 7-11. In December 1970, Shumate & Company, a small over-the-counter firm located in Dallas, Texas, filed an antitrust treble damage suit charging that the NASD, the NYSE member firm of Shearson, Hammill & Co., and other NASD members who belonged to national securities exchanges had conspired, combined and agreed to illegally restrain trade in the purchase and sale of third market securities by excluding NYSE listed securities from NASDAQ.140 Third market firms also protested the NASD Executive Committee decision."1 ' On March 14, 1971, about five weeks after NASDAQ commenced operations, the NASD Board of Governors voted unanimously to conduct a test-listing of listed securities for a period of 90 to 180 days commencing April 5, 1971. Thirty-six stocks, 32 from the NYSE and two each from the Amex and the Midwest, were included in the test. 4 ' On April 5, 1971 the number of NYSE stocks was reduced to 30 and the number of American Stock Exchange stocks to one; but the test was implemented. Seven weeks after the beginning of the experiment NASDAQ trading of listed securities was already putting serious pressure on the Exchange; because for the first time third market quotations were as accessible as floor quotes. 4 9 One early survey of the thirty Big Board stocks on NASDAQ showed that third market prices were superior to Exchange prices in about a third of the comparisons, and equal to floor prices in about one fourth of the cases. A small but growing number of member firms, including Merrill Lynch, were actively making comparisons between the Exchange and NASDAQ and using the third market via regional exchanges when the price was right. In late May 1971, Weeden & Co., the leading third market firm, reported that its business with member firms had risen ten percent as a result of the new access to its quotations through NASDAQ.' Since Weeden & Co. is a member of several regional exchanges, NYSE member firms that are members of one of these two exchanges can negotiate a transaction with Weeden & Co. and then cross it on a regional exchange without being forced to charge Weeden a NYSE commission and without violating Rule 394. 1 146. Shumate & Co. v. NYSE, Civil No. CA-3-4663 (N.D. Tex. Apr. 7, 1971); [1970-1971 Transfer Binder] CCH Fed. Sec. L. Rep. ff 93,037 (Apr. 7, 1971). 147. See Bank Stock Quarterly, Feb. 1971, at 8; id., Dec. 1970, at 13-14. 148. N.Y. Times, Mar. 15, 1971, at 55, col. 3. 149. Wall St. J., May 25, 1971, at 7, col. 1. 150. Id. 151. As mentioned in the earlier discussion of Rule 394, even if a third market-maker Is not a member of a regional, he can still deal with a dual member by interpositlonlng a If Rule 394 were eliminated, NASDAQ might gradually supplant the New York Stock Exchange. If it were to survive, the Exchange would certainly be forced to adopt technological innovations it should have implemented long ago. A fully automated, and possibly merged, NYSE and American Stock Exchange with negotiated rates would be almost identical to NASDAQ, except that the organized exchanges would have only one market-maker in each security, and these specialists would have certain public responsibilities. If there is more than one market-maker, it becomes impossible to determine which one has the obligation to dampen market fluctuations. On the other hand, if there are competing market-makers, regulation may not be necessary. 112 The large number of market-makers might maintain a reasonably stable market simply by going against the public to the extent that they feel this is profitable in the long run. Bid-ask spreads would remain narrow as each market-maker attempted to give higher bid and lower ask quotations than his competitors. Furthermore, both the SEC Special Study Report'm and the Institutional Investor Study 5" raised questions about the efficacy of NYSE and SEC regulation of specialists, as opposed to the control induced by competition. In its transmittal letter accompanying the InstitutionalInvestor Study the SEC stated: The participation of competing dealers in the central market will also reduce the element of monopoly power which has accompanied past efforts to establish a central market and will make it possible for potential abuses of such monopoly power to be controlled not only by regulation but to an increasing degree by competition.... In summary, our objective is to see a strong central market system created to which all investors have access, in which all qualified broker-dealers and existing market institutions may participate in accordance with their respective capabilities, and which is controlled not only by appropriate regulation but also by the forces of competition.155 The SEC's Statement on the FutureStructure of the Securities Market addressed itself to competing market-makers. It stated: The Commission believes that the liquidity needs of individual and institutional investors can best be provided by policies fostering the development of competition among dealers who are specialists, market-makers and block positioners. Such competition will mitigate the very difficult problem which now exists of developing and regional-only member between the dual member and himself. See text accompanying notes 87-88 supra. 152. See Wolfson and Russo, The Stock Exchange Specialist, 1971 Rev. of Sec. Reg. 891. 153. See note 11 supra, pt. 2, at 78-161. See also Wolfson and Russo, The Stock Exchange Specialist: An Economic and Legal Analysis, 1970 Duke L.J. 707. 154. See note 3 supra. 155. SEC, Letter of Transmittal, Institutional Investor Study, supra note 3, pt. 8, at XXIV-V. enforcing rules designed not only to prevent specialists from abusing their privileged position, but also to motivate them to perform satisfactorily under widely differing circumstances and in the light of varying risks and pressures.150 Thus it is clear that the Commission's emphasis is on competition among market-makers. Such competition is found on NASDAQ and not on the floor of the NYSE. The advent of NASDAQ has raised anew the question concerning the fiduciary obligation of the broker to obtain best execution. In the 1936 Segregation Report of the Securities and Exchange Commission, it was stated that "the relationship between broker and customer is fiduciary in nature. The legal incidents of that relationship are well-established in existing law .... [H]e is required to exercise the utmost fidelity and integrity."' 57 As noted earlier 58 the 1965 Staff Report of the Securities and Exchange Commission on Rule 394 also placed considerable emphasis on this fiduciary duty. If there was an argument at the time of the 1965 Staff Report on Rule 394 that the broker had an obligation to check to see if it could receive a better price for its customer, it seems clear that NASDAQ has added a new dimension to that conclusion. With the press of a button on NASDAQ a NYSE broker could find out if a better price could be received in the third market. In those cases where the third marketmaker is not a member of any regional exchange, Rule 394 would lead to a violation of the principle of best execution. The basic intent of the brokerage relationship is that the broker fulfill his obligation of best execution to the customer. It therefore seems apparent that to the extent rules such as NYSE Rule 394 prevent a broker from obtaining the best execution for its customer, they are clearly unreasonable and against public policy. In answer to this problem it has been argued that by executing trades in the third market fragmentation will result. Fragmentation, it is claimed, defeats the concept of a central market system. The fact is that real fragmentation results by not checking NASDAQ because a full picture is not seen. As more volume leaves the NYSE, the specialist's dealer function of maintaining continuity with depth becomes increasingly difficult. Al156. SEC Statement, supra note 42, at 16; See Wolfson and Russo, Let the Specialist Compete-Regulation Won't Solve Exchanges' Problems, N.Y. Times, Oct. 3, 1971, § 3, at 14, col. 3. 157. SEC, Report on the Feasibility and Advisability of the Complete Segregation of the Functions of Dealer and Broker (1936). 158. See text accompanying note 92 supra. though this is unfortunate, it should not be used as justification for keeping volume on the New York Stock Exchange. Instead, the Exchange should facilitate market-making competition and, in so doing, achieve narrower spreads between bid and ask and bring about continuity with depth in the entire market. Competition will also pressure all marketmakers to assume larger positions. NASDAQ, together with the third market, has been the single most powerful threat to the New York Stock Exchange's dominance since its founding in 1792. Recently, the Philadelphia-Baltimore-Washington Stock Exchange has requested that its specialists be placed on the NASDAQ system. If this is done other regional exchanges will, no doubt, follow. This would be another major step towards the growth and dominance of the NASDAQ system. There can be little doubt that NASDAQ has caused a basic restructuring of the market. It has set up the mechanism for a truly competitive central market system where all broker dealers may participate. 1 NASDAQ, however, does not have provision for the "book" in which all public orders may be represented. Once such a book is placed in the NASDAQ system the system will have the benefits of the auction market together with the advantages of competitive market-makers. At present NASDAQ is a communications and information retrieval system only. In the future it should also be possible for negotiations, executions, clearance, and confirmations to take place through the system. This would mean a truly efficient and competitive securities market. IX. CONCLUSION Institutional dominance of securities trading has shifted the balance of bargaining power to the customers and away from brokerage firms. Furthermore, the antitrust immunity of the Exchange is being severely questioned by both the Justice Department and Congress. The SEC has also become increasingly aware of the benefits competition can bring to the forming of an efficient securities market. This article has discussed a number of the monopolistic practices of the New York Stock Exchange, including limitations on the number of 159. In its August, 1972 Securities Industry Study Report the House Subcommittee on Commerce and Finance stated: "Although the actual details of developing a consolidated tape and composite quotation system should be left to the Commission, the overall characteristics of such a system should be delineated by appropriate legislative guidelines. The duty to make timely reports of transactions within the central market system should be imposed by statute; the precise contents of such reports and the method of their dissemination to the public could be provided by rule or regulation." Securities Industry Study, supra note 1, at 125. "seats," prohibition of institutional membership, Rule 394, and fixed minimum commission rates. Many of the problems regarding the structure of the securities industry are centered around the fixed commission rate. The fixed rate has led to numerous inefficiencies, to the issue of institutional membership, and the Byzantine reciprocity practices in the industry. The fixed rate together with other monopolistic practices has subverted the goal of best execution to the economic self-interest of the New York Stock Exchange. It shelters inefficiency while at the same time giving the wellmanaged firms excess profits. The New York Stock Exchange has taken every opportunity to fight competition. It sought to prevent listed securities from being included on NASDAQ. It has recently refused to have competition in the specialist function. It has instituted Rule 394 to prevent competition from the third market. It has, in short, made every attempt to insulate its monopoly status. Fixed commission rates and other monopolistic practices of the NYSE endanger the efficiency of the securities market. These practices are certainly not "necessary to make the exchange work," and should be declared violations of the antitrust laws. The sweep of technological innovation may resolve many of these problems. The New York Stock Exchange, unless it changes its philosophy, could well be replaced by a vigorously competitive computerized over-the-counter market with negotiated commission rates and virtually no limitations on membership or access. Stephen F. Downs ......................................................... 293 A AiurcA- TRAGEDY: THE SuPRnm CouRT ON ABORnON. Robert M. Byrn ........ 807 ANmTRUST 3w nm EEC-Hm FIRST DECADF. Barry E. Haw .................. 229 CONGRESSIONAL SELr-Dscmsp : Tim PowER TO E3XEL, TO EXCLuDE AND TO PuNISH. Gerald T. McLaughlin ..................................................... 43 Co'Rm TioN AND IzvEmmcAT ON Amo0NG ANTITRUST COCONsPiRATORS REVSTE. Robert D. Paul ........................................................... 67 COpyIm=xr Po 'mooFOR COiu ER-PRODUCED DnmC-opuEs . Michael S. Oberman .. 767 THE Gissel DocT NE: WHEN A BARGAINING ORDER WVILr IssuE. Daniel M. Carson ... 85 nir's NOoN-SERVICE RELATED CRItES Coi nmo ABROAD . ChristopherH. Mills .. 325 cHANGES To DiscipijNE MEiBERs. DonaldJ. Dawidoff ..................... 549 PpisoN: THE JuDGE's DI-NUTA. Irving R. Kaufman .............................. 495 Willianm K.S. Wang ......................................................... 1 AN L ,ATryOF ExcUTivE ORDER No. 55 . Robert M. Pitier ................ 517 BtRw , ROBERT M. , An American Tragedy: The Supreme Court on Abortion ........ 807 CARsoN , DAmsm M. , The Gissel Doctrine: When a BargainingOrder Will Issue ...... 85 Require Stock Exchanges To Discipline Members ............................ 549 HAwK , BARRY E., Antitrust in the EEC-The FirstDecade ........................ 229 KAuF AN , IRVIG R., Prison: The Judge's Dilemma .............................. 495 Reasonable Approach ...................................................... 293 McLAUGHL3N , GERALD T. , Congressional Self-Discipline: The Power To Expel, To Exclude and To Punish .................................................... 43 diction over Servicemen's Non-service Related Crimes Committed Abroad ....... 325 OxcaxAN , MIcHAEL S., Copyright Protection for Computer-ProducedDirectories .... 767 Revisited ................................................................. 67 stitutionality and Legality of Executive Order No. 55 . ........................ AxELROD, BERGER AND JOHNSTONE : LAND TRArSER AND FINANCE: CASES AND MATERIALS. John L. Peschel ........................................................... 199 BLUVMOSEN: BL c EMPLOYMENT AND THE LAW . Sarah Collins Carey .............. 206 OF ENGLAND BY THOMEAS HOBBES. Joseph H. Smith ............................ 479 DoWNIE: JusTIcE DENIED : THE CASE FOR RE'ORM OF THE COURTS . Joseph D. Grano 756 EvANS: THE KENNEDY Rom IN AamUCAN TRADE PoLIcY-TUE TWILIGUT OF TU1E GATT ?. Leslie Alan Glick ................................................. 217 MATTHEWS: MENTAL DISABIITY AND TUE CRmMAL LAW. Donald J. Hall ........... 221 AriTY Ami NEGLECT. Walter W. Steele , Jr................................... 760 D. H ayton ............................................................... 1085 WALTZ AND INBAu: MEDICAL J ImPuDExCE. Ralph Slovenko ...................... 487 Aid to Parochial Schools 1015-16 , 1018 Airport Frisk 293-324 Balancing of Interest Test 686-91 Bill of Rights 347 Border Searches 322-23 Classification 615 , 617 , 620 , 622 - 23 Capital Punishment 671-84 Constitutionality Per Se 674-77 , 679 - 80 Clear and Present Danger Test 164 Civil Rights 431-39 Compelling State Interest Test 161 , 165 , Court's Appellate Jurisdiction 875-83 Members 43-66 New York Stock Exchange 1-42 NYSE Rule 394 16 - 21 , 23 - 25 , 40 , 42 Section 16(b )) 471 - 74 Pragmatic Interpretation of Section 16 (b) (Speculative Abuse Test ) 472 , 475 selves 561-64 change Rules 559-61 Private Offering Exemption 887-920 Proxy Rules 1074- 84 Purpose of the Securities Act of 1933 Reciprodty Among Brokers 13-15 Registration of Exchanges 553-54 , 556 Rule 146 ( Proposed ) 887 , 906 - 20 SEC 1- 42 , 549 - 68 , 887 - 920 Securities Control 469-78 tion 16(b ) 477 - 78 Theory Behind Section 16 ( b ) 470 - 71 , 475 Third Market 4 , 17 - 19 , 23 - 24 , 36 - 42 Unbundling 16 , 29 - 30 of Private Offering Exemption 887-920 Section 10(b ) and Rule 10b-5 478 , 742 - 55 Disclosure Under Section 10 (b) and Rule 10b-5 742 - 55 tion 10(b) or Rule 10b- 5 742 - 55 Extension of Section 10(b ) and Rule 10b-5 Application 748-52 Fraud Under Section 10 ( b ) 744 - 48 Interpretations of Section 10 (b) Aaron Brothers Co .............. 89 Adams v. Williams ............ 315 - 16 Publishers ("ASCAP") ....... 593 - 94 Arts , Inc ...................... 771 Allied Stores v. Bowers .......... 617 Almenares v. Wyman ............ 1002 Altz v. Liebermon ............. 451 - 52 American Crystal Sugar Co. v. Cuban-American Sugar Co. .. 595 - 96 ing v. McAnnulty ............. 1006 ible Top Replacement Co ........ 462 Arthur v. Hellstrom ......... 192 , 194 , A.T. Brod & Co. v. Perlow ..... 747 - 48 (The Netherlands v . Venezuela) 410 Babbitz v. McCann ............ 443 .45 Baidach v. Togut .............. 173 - 74 Bailey v . Poindexter's Executor .... 837 Bailey v . Richardson .... 1007-08 , 1010 Baird v. Franklin .............. 561 - 64 Baker v. Carr .................... 611 Barbier v. Connolly .............. 606 Co. Case ...... 395 , 408 , 413 , 414 - 22 Bass v . City of New York .... 976 , 978 Baxtrom v. Herold ........ 623 - 24 , 626 Beale v. Beale ................... 820 *Beatty v. Bright ............. 1074 - 84 Beete v. Bidgood .............. 376 - 77 B6guelin Import Co . v. G.L. Import Export Co................. 247 , 267 Bell v . Clark ..... 342-44 , 350 , 357 , 360 Bell v. Liberty Drug Co ....... 959 - 60 Benn Meyer & Co. v. Miller ...... 404 Betts v. Brady ............ 149 , 724 - 25 Birnbaum v . Newport Steel Corp . 744 - 45 , Blade-Tribune Publishing Co.... 102 Blau v. Lehman .................. 477 Board of Education v . Allen ..... 1018 *Board of Regents v . Roth ...... 684 - 95 , Boddie v . Connecticut .. 630-33 , 927 - 28 Bogardus v . Commissioner .... 189 - 90 , Bond v. Floyd .................... 51 Buttone v. Lindsley ............... 433 Boyd v. United States ........... 1043 Bradwell v. Illinois ............ 706 - 07 Brandt v. Hickel ................. 148 *Branzburg v. Hayes .......... 1024 - 34 trict 742 ....................... 617 Washington Stock Exchange .... 567 Brown v . Board of Education ...... 611 Pacific R.R. .................. 1078 Brown v. Duchesne ............... 461 Brown v . Southall Realty Co.... 452-56 Brown v. Walker ............. 715 - 17 Buck v. Bell ................ 809 , 858 facturing Co ................... 461 Burkhead v . Phillips Petroleum Co . 596 - 97 Sarony ........................ 776 Authority .................. 699 - 702 Hospitals Corp .............. 439 - 49 C. & S. Industries , Inc. ........ 179 - 80 Cafeteria Workers Local 473 v. McElroy ........... 686 - 87 , 688 , 690 Cahill v. Regan ............... 970 - 71 Caldwell v. United States ........ 1027 mission Rate Structure of the New York Stock Exchange (April 1 , 1967 ) (filed with the SEC in response to SEC Securities Exchange Act Release No. 8239) . 96 . 373 U.S. 341 , 357 ( 1963 ). 97. SEC Securities Exchange Act Release No. 8324 ( May 28, 1968 ). 98. NYSE, Economic Effects of Negotiated Commission Rates on the Brokerage Indus- try, the Market for Corporate Securities and the Investing Public ( 1968 ) [hereinafter cited as NYSE Economic Brief , Aug. 19681 . In addition, Chairman of the NYSE Board Gustave Investigation Hearings 2540-3002 (Aug. 19 - 21 , 1968 ). The Justice Department Invited a Mann . Id. at 3523-901 . 99 . Brief of NYSE, In the Matter of SEC Rate Structure Investigation of National Securities Exchanges , SEC File No. 4 - 144 ( May 1 , 1969 ) (filed in reply to Memorandum of the Antitrust Div. of the Dep't of Justice , Jan. 17 , 1969 ) [hereinafter cited as NYSE Economic Brief , May 19691 . 100. Memorandum of the Dep't of Justice, In the Matter of Commission Rate Struc- ture of Registered National Securities Exchanges, SEC File No. 4-144 (Jan. 17 , 1969 ) [ here - inafter cited as Dep't of Justice Memorandum , Jan. 19691 . 101. Memorandum of the Dep't of Justice , Inquiry into New York Stock Exchange Proposals to permit Public Ownership of Member Corporations (Feb. 6 , 1970 ) (filed with the SEC in response to SEC Securities Exchange Act Release No. 8717) . 102. Justice Dep't Brief , supra note 73. 103. NYSE Memorandum, supra note 74. 106. Id. at 3639 . 107. Address by Robert W. Haack , President of the NYSE , Economic Club of New York , Nov. 17 , 1970 . See Securities Industry Study, supra note 1 , at 117. 108. See Wolfson , Rosenblum and Russo, The Securities Markets: An Overview , 16 How . L.J. 791 , 821 - 23 ( 1971 ). 109 . See generally Baxter, NYSE Fixed Commission Rates: A Private Cartel Goes Pub- lic , 22 Stan. L. Rev. 675 , 704 - 05 , 711 ( 1970 ) [hereinafter cited as Baxter] .

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Thomas A. Russo, William K. S. Wang. The Structure of the Securities Market - Past and Future, Fordham Law Review, 1972,