The new rules would define an affiliated party as one who holds more than 5% of the voting stock, capital or profit participation in a member organization. To provide equal and uniform regulation, this definition would also cover member or member firm trading for own account-except for bona fide marketmaking transactions and noninventory principal transactions. Transactions by registered traders would qualify as bona fide marketmaking transactions provided that they are effected in conformity with the plan adopted by the Exchange and filed with the SEC, which plan the SEC in its Release No. 7330, dated June 2, 1964, declared to be effective August 3, 1964 pursuant to Section 11a-1 of the Securities Exchange Act of 1934. Rule 11a-1 provides that a plan filed with the Commission by a national securities exchange shall not become effective unless the Commission, having due regard for the maintenance of fair and orderly markets, for the public interest, and for the protection of investors, declares the plan to be effective.

Under the proposed new rules, an "affiliate" includes any institution which controls, is controlled by, or under common control with, the member organization, and any institution's securities account which is controlled by the member organization. In determining whether control exists, the Exchange would consider many factors such as the terms of the advisory contract, independence of directors, exercise of the right to designate brokers, advisory fees, etc.but no account would be deemed to be controlled by another party solely because that party has discretion over the account.

Another requirement would prohibit an officer or employee of any member organization from owning 5% of any outstanding class of securities issued by any parent of a member organization which is not itself a member organization. This is intended to strengthen existing Exchange Rule 318 which is designed to assure that the financial and kindred activities of all persons who are active in the business of member organizations remain under the Exchange's selfregulatory control. (The change here from prohibiting a financial interest exceeding 5% to prohibiting 5% ownership of any class of securities-is not intended to alter the thrust of the existing rule; the change will be couched in language which conforms to the language of the existing Rule 318.)

To assure that a fixed commission charge may not be reduced, the new rules package includes a prohibition against reducing advisory fees to the extent of commissions received. It is expected that this will eliminate any advantages which member organizations may have over nonmembers because of the member's ability to reduce advisory fees. In the absence of a schedule of minimum advisory fees, firms will have to determine whether or not to charge a fee which, then, will not be subject to reduction. (Firms which choose not to charge advisory fees may still be compensated with commission business to the extent earned by the investment advisory account.)

The new rules also provide that a member organization and any parent must be organized under United States law. The purpose of this is to assure that member organizations and controlling parties operate under the laws and business customs of this country. Otherwise, significant problems in supervising and regulating member organizations and enforcing compliance with Exchange rules could arise and this would work to the detriment of public customers. Liberalization might be considered in instances in which appropriate arrangements can be worked out with other countries.

All of the changes described above are designed, it should be noted, to provide equal treatment for existing members and proposed new members engaged in essentially the same activities. Since some existing members may not now meet the proposed new requirements, the rules package provides a fair and adequate period of time for such firms to adjust their business so as to come into compliance. We would expect members now in compliance to continue to comply, and non-members to make the necessary adjustments before applying for membership.

Question 7.-Apart from any requirement that may be established as to the percentage of brokerage commission business that must be done for nonaffiliated customers, what limitations, if any, should be imposed on the types or sources of business of member firms?

The Exchange has taken the position that all activities of member organizations should be subject to some degree of Exchange authority, since the various activities in which firms engage may involve substantially the same personnel and the same customers as their securities business. Thus, a member

organization seeking to engage in business kindred to the securities business may not do so without first obtaining permission from the Exchange.

For example, under rules adopted by the Exchange in April 1972, member organizations are permitted to sell life insurance. However, in order to engage in life insurance sales, a member firm must first comply with Exchange requirements with respect to personnel qualifications, supervision, surveillance and maintenance of records. A person selling life insurance for a member firm must, as a prerequisite, meet Exchange standards and qualifications for the sale of securities as a member, allied member or registered representative. including the requirement that he or she devote full business time to the member firm. All member firms must also comply with Exchange rules establishing their responsibilities for supervision and control of each department or business activity and for adherence to good business practices in each business activity. Beyond Exchange requirements, of course, any member firm selling life insurance is subject to the applicable rules, regulations and training requirements of the appropriate state insurance regulatory agencies.

The Subcommittee's question recognizes the so-called 80-20 test proposed to be included in the Exchange's rules, as described earlier. It is important to note again that in both this test and the parallel "20-80" test, which would apply a similar standard to the business of each affiliate, that the 20% is a measurement of the total value of all purchases and sales rather than a measurement only of brokerage commissions.1 We believe that this provides a fairer measure, in accordance with the Exchange's anti-rebate policies than would be the case if the requirement were limited to 20% of the value of brokerage commissions alone.

The Exchange's proposed new rules would continue the requirement that the primary purpose of every member organization must be the transaction of business as a broker or dealer in securities. The primary purpose requirement is basically a regulatory device predicated on the Exchange's responsibility— set forth in Section 6 of the Securities Exchange Act of 1934-to regulate its member broker-dealers.

We believe that Exchange regulations covering situations in which member organizations may engage in any other financial or related activity are consistent and appropriate within the Exchange's existing statutory self-regulatory obligations.

Question 8.-Can workable rules be designed to prevent reciprocal and other arrangements intended to circumvent the membership requirements you have indicated to be appropriate in your responses to questions 4 and 7?

As we noted in our response to question 3, the Exchange is aware of the possibility that brokerage firms and institutions may be capable of devising arrangements which could circumvent the intended thrust of new Exchange rules in this area, and we have recognized this in developing the proposed new rules package.

Thus, so-called "sweetheart arrangements" between affiliated parties would be permissible only to the extent that purchases and sales made pursuant to them would be counted as purchases and sales for affiliated parties for purposes of the proposed predominance of public business test, which would limit a member firm's business for affiliated parties to 20% of its total securities business (and the parallel requirement that an affiliated party may give only 20% of its securities business to its affiliated member firm.)

We believe the proposed rules are workable and we anticipate a high degree of voluntary compliance. At the same time, nevertheless, we are exploring what changes and additions may be appropriate with respect to reporting requirements and monitoring systems to enable the Exchange to enforce the new rules effectively. At the present time, we doubt the likelihood that there would be any need for any new level of regulatory authority.

Question 9.-Apart from any requirement that may be established as to the percentage of brokerage commission business that must be done for nonaffiliated customers, what types of regulatory authority should the SEC and/or the exchanges have over institutions which control member firms?

1 Exemptions from this total would include purchases and sales of "exempted securities," as defined in Section 3(a) (12) of the Securities Exchange Act of 1934; "shortterm paper." as defined in Section 2 (a) (38) of the Investment Company Act of 1940; and securities with respect to which a member firm acts as an "underwriter," as that term is defined in Section 2 (11) of the Securities Act of 1933.

The Exchange's rules presently require that any beneficial owner of 5% or more of the outstanding voting stock of a member corporation must file an application-designed to enable the Exchange to assess his integrity and general reputation-and be approved by the Exchange's Board of Governors as an "Approved Person." Each applicant, before being approved, must also agree to notify the Exchange of any acquisition or disposition of any security of the member corporation, and to abide by the Exchange's rules and regulations dealing with Approved Persons. The Exchange's Constitution further empowers the Exchange to withdraw approval of any Approved Person found guilty of fraudulent acts, misstatements to the Exchange or violations of Exchange rules.

The proposed package of new rules dealing with institutional membership would add a requirement that each Approved Person and each parent of any such Approved Person must agree to comply with the predominant portion test, both for itself and on behalf of its subsidiaries.

In the past, the Exchange has not permitted membership for broker-dealers whose parents were not also registered broker-dealers. Thus, we have no experience with regulatory problems which might arise if any institution were permitted to become a parent of a member broker-dealer. The proposed revision of membership requirements, together with existing relevant rules, we believe, give the Exchange adequate regulatory authority. We recognize, however, that as we gain experience in regulating controlling institutions, additional regulatory provisions may prove necessary.

Question 10.—Should the number of exchange memberships continue to be limited?

Historically, all exchanges have been characterized by limited membership; and it may be observed that a "membership" organization is, inherently, one from which non-qualified persons are excluded. We can find no indication in the Securities Exchange Act of 1934 that Congress had any intent to challenge or alter the status of exchanges as organizations having a "limited" membership; indeed, the provisions and language of the Act would seem to express, inferentially, the Congress' belief that exchanges should be membership organizations.

At the same time, it may be acknowledged that the character and public orientation of the securities business has changed substantially since the enactment of the 1934 Act. The NYSE has recognized this in a number of ways which are reflected in the present membership structure: for example, permissive incorporation and public ownership of member organizations; accessthrough commission discounts-to non-member broker-dealers; the newly proposed package of Constitution and rules changes which would permit institutional membership consistent with the public interest; and the re-organization of the governing structure of the Exchange so as to provide for greater public participation in the Exchange's policy-making activities.

To eliminate the limitation on membership could involve a great many considerations, not the least of which would be the feasibility of providing a regulatory umbrella and apparatus for insuring the smooth functioning of exchange markets in which participation would not be circumscribed by membership requirements. Eliminating, increasing or decreasing the number of memberships would also inevitably involve complex problems with respect to the valuable property rights and substantial financial investments of existing members.

It is true that member firm capital represented by the value of an Exchange seat is not included in computation of net capital. However, it should be recognized that this provides an additional safeguard to public customers of a seatholder since in any extenuating circumstances, the proceeds of the sale of a seat would be available to satisfy the claims of customers.

Question 11.-With respect to off-floor transactions, what, if any, trading advantages do exchange members enjoy over nonmembers?

An Exchange member who is not required to pay non-member commission rates when an order for his account is entered off the floor obviously has a cost advantage over a non-member. However, a number of NYSE member organizations, as a matter of policy, permit their Exchange members to trade for their own accounts off the floor only if they do pay the full non-member commission-and all allied members must also pay the full non-member commission. None of these people have any cost advantage over public investors.

It may also be acknowledged that an off-floor trader may acquire unique insight into the market over a period of years; i.e., his long experience with trading may give him a "feel" for the market that the occasional public investor would not have. This same advantage would be available to most large institutional investors which have departments specializing in trading, and to any public trader willing to devote the time necessary to acquire such expertise.

As recently as 1955, reports of transactions on the floor often were not published on the Exchange's ticker tape until several minutes after the trade. Between the time when a large trade was effceted and printed on the tape, off-floor traders could learn of the cleanup price, and react by entering orders in the stock. With advancements in computer technology and improvements in capturing transaction data on the floor, trade reports are put on the tape within 20-40 seconds after the trade.

In addition, steps were taken in 1967 to equalize the respective positions of the off-floor traders and the members of the public. Two requirements were adopted. The first provides that all off-floor orders, for an account in which a member or allied member has an interest, must be sent to the floor through the same facilities used for public orders. The second provides that, after an off-floor trader learns of any trade involving 5,000 shares or more, the transmission of an order for an account of a member, allied member, or a member organization to the floor is prohibited for a period of two minutes following the printing of the transaction on the tape. These requirements also apply to all discretionary accounts.

Additional Exchange rates place other restrictions on off-floor trading to further reduce possible advantages of off-floor trading over trades by nonmembers. These restrictions include: locking in for 24 hours any transaction effected at a price higher than the last different price; and prohibiting a Floor partner of a member firm from handling an order for his firm's account which is "not held" to the sales which occur. (Public orders, on the other hand, may be executed at the discretion of the broker with respect to the time and price of execution.)

It should be pointed out that off-Floor trading by members contributes a measure of liquidity, continuity, depth and fluidity to the market which is beneficial to investors generally and far outweighs any supposed advantages to the members.

Question 12.-Should member firms with institutional affiliates be prohibited from having their own man on the floor of an exchange?

The Exchange sees no justification for prohibiting firms with institutional affiliates or any other member firms-from having their own broker on the Floor of the Exchange. Here again, if we correctly interpret the thrust of the question, the predominance of public business test will adequately speak to the interest of public customers in this area.

The right to have a broker on the Floor of the Exchange has historically been a prerogative of Exchange membership-although some firms have not chosen to exercise it. To abridge that prerogative would be tantamount to creating a form of second-class membership in which a firm would have to comply with Exchange regulations without having equal access to the advantages traditionally associated with such compliance. Presumably, the major difference between such a second-class firm and a nonmember broker-dealer would center on commission charges for floor brokerage; and we question whether firms would be willing to submit to the full range of compliance with NYSE requirements if they could remain outside the self-regulatory umbrella and still receive the 40% commission discount now available to qualified nonmember broker-dealers.

The Exchange's new institutional membership rules proposals do not contemplate placing any limitation on institutionally affiliated member firms' having their own brokers on the Floor.

Question 13.-Does the potential conflict of interest created by (i) the combination of brokerage and money management or (ii) the combination of brokerage and market making justify the separation of these functions?

Both William McChesney Martin, Jr., in his report on The Securitics Markets (August 5, 1971) and the SEC, in its Policy Statement of February 2. 1972, recognized that there are potential conflicts of interest in these areas

Significantly, neither Mr. Martin nor the Commission recommended separation. Mr. Martin commented, in part:

"Unavoidable conflicts of interest arise when money management and brokerage functions are combined within a single profit-making firm, regardless of whether a fee is paid for investment advice. It is believed, however, that these conflicts of interest have been reasonably well handled by [NYSE] member firms.

"Serious consideration has been given to the frequent suggestion that the clearest solution to the whole problem of money management would be to separate all management and brokerage. However, giving investment advice, historically, has been an inherent and logical part of the brokerage business."

Mr. Martin recommended, subject to specified qualifications in the event institutional membership on the NYSE were to be prohibited, that member firms should be permitted to engage in all customary forms of money management, but that they should not be permitted to credit commissions against any fee charged for investment advice.

The SEC Policy Statement noted that:

". . . If it were to be concluded that it is improper for a member firm to execute transactions for accounts which it manages, it would logically follow that it could not execute transactions for its own account (except in the performance of market functions, such as those of a specialist, block trader or arbitrageur). But it has also long been the practice in the securities industry for member firms to execute transactions for their own account. In view of the long-standing nature of these relationships and practices, we believe that a prohibition against a member firm of an exchange executing transactions, either for accounts which it manages or for its own account, would be a precipitate measure, the full consequences of which might not be foreseeable at this time. We also believe that those members of the investing public who invest directly rather than through institutions are in need of additional money management services and that the experience member firms have accumulated in the area of money management can be valuable in meeting this need. Finally, we think it important that a portion of broker-dealer income be based on a more stable source than commission business. [Emphasis added.]

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In enacting the Investment Company Act, Congress apparently did not find it necessary that the brokerage and investment company functions be completely separated. There are potential conflicts of interest in these relationships, as well as in the broker-underwriter relationships, as well as in the broker-underwriter relationship and the dealer-money manager relationship. If all of these functions were to be separated, the capital-raising capability of the industry and its ability to serve the public could be significantly weakened. "[Emphasis added.]

The SEC Policy Statement nevertheless acknowledged that it was Congress' prerogative to decide whether potential conflicts in these areas are being satisfactorily dealt with, but it seems to us that there is a clear implication in the Policy Statement that the SEC does not find cause for serious concern.

As indicated earlier, the Exchange's rules package on institutional membership would, as Mr. Martin recommended, bar member firms from crediting commission charges against investment advisory fees. Beyond this, it is the Exchange's position that, in the absence of evidence that potential conflicts of interest are not being handled satisfactorily, it is not now necessary—and could be damaging to both the industry and the investing public-to forcibly separate the brokerage and money management functions or the brokerage and market-making functions.

We believe that, to date, Exchange regulations covering the research activities of member organizations-qualifications of analysts, form and content of research reports, etc.-has been effective. Since we have no experience in regulating institutional affiliates, we are not able to suggest at this time what additional problems, if any, in this area, may require additional self-regulatory measures in the future. In this, as in other areas involved in permitting a limited form of institutional membership on the New York Stock Exchange, we wish to assure the Subcommittee that the Exchange will be vigilant in seeking out and attempting to remedy any special problems which may become apparent.