PART II

7. LIMITATIONS AS TO TYPES OR SOURCES OF MEMBER FIRM'S BUSINESS

The Pacific Coast Stock Exchange (PCSE) believes that the requirement that member firms do at least 50% of their brokerage commission business for nonaffiliated customers serves an important regulatory purpose. Such a rule would insure that a firm performs a substantial public brokerage function if it is to obtain the benefits of commission savings by handling transactions for its own account and for the accounts of affiliated customers. The PCSE does not perceive a similar regulatory purpose being served by some of the other limitations that have been proposed as to the types or sources of business of member firms. The PCSE believes that a member firm should be primarily engaged in transacting business as a broker or market maker. It is difficult to enforce rules such as the net capital rule without requiring member firms to transact business through a firm primarily engaged in the securities business. However, the PCSE sees no reason for requiring that the primary purpose of a firm's parent be transacting business as a broker or market maker. So long as a firm performs a substantial brokerage business for public (i.e., non-affiliated) customers, the PCSE sees no reason for excluding that firm from membership because the "primary purpose" of its parent is something other than engaging in business as a broker-dealer.

The PCSE also sees no need to limit the percentage of an affiliate's portfolio business which a member firm may handle, apart from the indirect limitation that results from the requirement that 50% of a firm's brokerage business be conducted for non-affiliated customers. The problem posed by institutional membership is the erosion of the minimum commission structure. This is best dealt with by limiting the proportion of a firm's business which can be conducted for affiliated customers, rather than by limiting the proportion of an affiliate's business which can be handled by the member firm with which it is affiliated.

A requirement that some given percentage of a firm's "total securities business", as opposed to its brokerage commission business, be conducted for nonaffiliated customers, also seems unnecessary. The reason for limiting the proportion of a firm's business which can be conducted for affiliated customers is to prevent erosion of the minimum commission structure. Thus the PCSE sees no reason to limit the amount of non-commission, securities-related business which a member firm can conduct for an affiliate.

The PCSE believes that member firms should be limited to engaging in business "kindred to the securities business." Because of the difficulty of regulating members engaged in a non-securities business, member firms should be required to engage primarily in the securities business, while any other business activities should be related to the securities business. The PCSE sees no reason, however, for imposing a similar requirement on the parents of member firms. Diversification by the parents of member firms, if properly carried out, can strengthen their ability to perform their responsibilities in the securities industry. Some such opportunities for diversification may lie in industries "kindred to the securities business," while others may not be so closely related to the securities business. Antitrust considerations, should, however, be kept in mind in considering the extent of diversification which is permissible.

8. DESIGN OF RULES TO PREVENT RECIPROCAL ARRANGEMENTS WHICH CIRCUMVENT THE LIMITATIONS ON MEMBERSHIP RECOMMENDED BY THE PCSE

The PCSE believes that it is feasible to develop a system for enforcing the 50% test which we have recommended above. If firms evade the fifty percent test to any significant extent by developing patterns of reciprocal relationships with other firms, the trading patterns should not be particularly difficult to discover. Firms which are caught violating the fifty percent test through the use of reciprocal arrangements should be subject to substantial penalties. The PCSE believes that the vast majority of member firms would not try to evade such a rule. The few that might be tempted to evade this rule would be deterred by appropriate sanctions and by a program for monitoring the brokerage commission business handled by member firms.

An appropriate monitoring system might require periodic reports from member firms concerning the sources and placement of their securities business.

In these periodic reports, members might be required to list all customers for whom they transacted more than some specified percentage (perhaps 5%) of their commission business. Members might also be required to disclose all member firms through which more than some specified percentage (perhaps 5%) of their business was transacted. This data could be fed into computers and analyzed for patterns of reciprocal relationships.

The PCSE does not believe it is feasible for a single exchange to operate such a monitorying system. The system would need to be operated by a regulatory body with jurisdiction over all firms which are members of any exchange. The PCSE believes that the appropriate body to operate this monitoring system is the Securities and Exchange Commission.

9. REGULATORY AUTHORITY THAT IS NEEDED OVER INSTITUTIONS WHICH
CONTROL MEMBER FIRMS

Institutions which control member firms must be subject to appropriate regulation by exchanges and ultimately by the Securities and Exchange Commission. Such regulatory authority should be exercised in the first instance by the exchanges, but should be subject to Commission review and rule-making.

The content of such regulation should be concerned with the potential abuses that could result from institutional control over member firms. These abuses may be little different from the abuses that can result from individual control of member firms, except for the fact that few individuals have the resources available to institutions.

One area of possible concern is that the parent should not be allowed to deplete the capital of a member firm. Thus all intercorporate dividends and other intercorporate transactions should be disclosed to the appropriate regulatory authority. A parent's interest in a member firm should be limited to stock and subordinated debt, so that the parent would not be able to come before customers and general creditors in any distributions resulting from a liquidation of the member firm. Care should be taken to prevent member firms from engaging in any manipulative practices in relation to securities in which the firm's parent has a substantial position.

The PCSE does not believe that these, and other regulatory problems which are raised by allowing institutions to have subsidiaries which are exchange members, are particularly serious. The experience of the PCSE has been that it has not encountered unusual problems in the regulation of brokerdealers whose parents are financial institutions. The PCSE does believe, however, that as membership by institutional subsidiaries becomes more common in the nation's securities exchanges, it is important for all exchanges to establish the principle that the parent of a member firm is subject to regulation by appropriate securities exchanges in connection with its dealings with its broker-dealer subsidiary.

10. LIMITATIONS ON THE NUMBER OF EXCHANGE MEMBERSHIPS

The PCSE believes that, given the present structure of the nation's securities markets and the present technology that is used for securities trading, the number of exchange memberships should continue to be limited. There are limitations on the number of firms which can effectively be represented on a trading floor. Moreover, limitation of the number of exchange memberships is very closely related to the system of minimum commission rates. A limited number of members and fixed commission rates enable members to earn sufficient revenues to provide research and other services to small investors. Maintaining limitations on exchange memberships in order to promote the financial integrity of member firms is in conformity both with the policies of the Exchange Act and the public interest.

The PCSE also sees no reason, given the present structure of the securities industry, for creating a category of exchange members with no right to be present on the floor.

The PCSE, however, believes that fundamental changes should be made in the structure of the nation's securities industry, and that these changes may well affect the concept of exchange membership. We have recommended that all exchanges should be electronically linked to form a national system of securities exchanges. Membership in such a system might be limited only by

financial responsibility, ability to effect clearance, and satisfaction of other performance criteria. In such a system, an absolute limit on the number of exchange members might no longer make sense. The PCSE does not believe that compensation of existing seat holders should be allowed to serve as an obstacle to development of such a market system. Existing exchange members have long benefited from the franchises which they hold. In most cases, original capital investments have been recovered many times over. Thus the PCSE believes that, depending on the way in which a national market system is organized, compensation to existing exchange members may not be required.

11. TRADING ADVANTAGES OF EXCHANGE MEMBERS WITH RESPECT TO
OFF-BOARD TRANSACTIONS

The principal trading advantage possessed by exchange members with respect to off-board transactions is that positions created in off-board trading can be liquidated on an exchange without the necessity of paying a commission. The exchange member who trades off-board has commission-free access to an additional market maker, the exchange specialist. Apart from lower commission costs, the PCSE does not believe that exchange members possess any significant advantages. The PCSE believes that any manipulative problems which may result from members trading for their own accounts can be dealt with by appropriate regulatory measures. Additionally, trading on inside information which is not made available generally to a firm's customers and to the public can be prevented by established regulatory techniques. Because this is true, the PCSE does not believe that permitting member firms to trade for their own account or for the account of individual stockholders or partners is injurious to public confidence.

The PCSE sees no significant difference in allowing a firm to trade for its own account and in allowing a firm to trade for the account of such affiliates as institutional parents.

There are some advantages to being able to trade with a primary market specialist which do not exist in trading with a third market dealer. The primary market specialist is responsible for maintaining an orderly market. The specialist may see greater inquiry and may thus be able to make a tighter market. Of course, some third-market dealers may be superior to primary market specialists. The ideal situation is to be able to trade directly with primary market specialists, specialists on other exchanges, and third market dealers. Competition between these market makers should result in tighter, more liquid markets. Under proposals which the PCSE has made for establishing a national market system, all broker-dealers meeting certain qualifications would be able to trade directly with all market makers in listed stocks.

12. ACCESS TO THE FLOOR FOR FIRMS WITH INSTITUTIONAL AFFILIATES

The PCSE sees no reason for preventing firms with institutional affiliates from having their own man on the floor of an exchange. Depending on the volume of transactions, it may prove more economical for a firm to have its own man on the floor than to pay floor brokerage to someone else. Additionally, having one's own man on the floor may allow a firm to achieve better executions. We see no reason for denying these advantages to a firm simply because it has institutional affiliates.

The PCSE sees no substantial regulatory problems in allowing firms to use their own man on the floor to handle trades for the firm's own account of its partners or stockholders.

13. POTENTIAL CONFLICTS OF INTEREST CREATED BY COMBINATION OF THE BROKERAGE FUNCTION WITH MONEY MANAGEMENT AND MARKET MAKING FUNCTIONS The PCSE believes that the potential conflicts of interest created by combination of the brokerage function with the functions of money management and market making are manageable and do not justify separation of these functions. The regulatory techniques traditionally applied in this area have been generally adequate in preventing the potential conflicts from becoming actual abuses. No doubt there have been isolated instances of abuse, but we believe any such harm to the public is greatly outweighed by the benefits that

are derived from the combination of brokerage with money management and market making. By engaging in money management and market making, a brokerage firm can diversify its sources of revenue and thus strengthen its ability to serve the public as a broker.

The PCSE does not believe that the potential dangers involved in this area are sufficient to justify prohibiting firms from having institutional affiliates. We do believe, however, that as firms increasingly develop institutional affiliates, regulatory authorities need to become increasingly conscious of enforcing standards such as those relating to churning of portfolios.

CONCLUSION

The PCSE hopes that the above answers will aid the Subcommittee in its consideration of the issues posed by institutional membership.

Respectfully submitted,

THOMAS P. PHELAN.

RESPONSE OF PARKER/HUNTER INC.

PART I

1. We do not believe brokers should be allowed to be members of the stock exchanges for the sole purpose of handling transactions for institutional affiliates. 1a. The primary purpose of exchange membership under the Exchange Act is to serve the public and not primarily to conduct business for their corporate affiliates.

1b. Such membership arrangements could well result in an erosion of the public's confidence in the Exchange due to the public's concern that they would distinctly be in a position of disadvantage in relation to institutions. In part the public would feel that institutions have access to more information and more timely market information among other things.

1c. Regulatory problems could well arise but the principal relationships of responsibility would not necessarily be as strong a deterrent as it is under the present circumstances of customer and broker relations.

1d. The various affiliate relations as outlined would allow us to make no distinction among them.

1e. No comment.

2. We do not consider it proper to use an exchange membership for "private" purposes. We strongly feel, generally speaking, that a firm's activity should be the servicing of the public including individuals as well as institutions.

2a. (i) Private.

2a. (ii) Private.

2a. (iii) This is definitely a gray area.

2a. (iv) This is definitely a gray area.

2a. (v) The likelihood is that under the list below it would be "private" but certain circumstances indicating the amount of business being done for such an institution in relation to the total amount of business being done by the member firm would be a factor.

2b. This certainly does not lend itself to a generalization and only specific circumstances would determine first, whether or not it is "private" or "public" and second, whether or not the public interest is violated.

2c. As long as the public interest is protected an occasional use for "private" purposes is certainly innocuous.

3. Rebate of commissions should be prohibited.

3a. It is hardly necessary to define "rebate" but it is assumed that one receiving rebate would be paying a lesser commission than one not receiving rebate. 3a. (i) Should pay the going commission.

3a. (ii) Should pay the going commission.

3a. (iii) Query: Does it matter whether member firm pays itself on business done for its own investment account?

3a. (iv) We would consider this a rebate.

3a. (v) We would consider this a rebate.

3a. (vi) This is not a rebate-just good business.

3b. Answered above.

3c. Answered above.

3d. We do not favor making discounts available to a certain class of customers as distinguished from others.

3e. As stated above we are opposed to making rebates available.

4. Exchange memberships should be limited to firms doing general brokerage business with the public or exercising a market making function, or conducting kindred financial services to satisfy the public need.

4a. The purpose of such a limitation is to maintain the "reason to be" a stock exchange association or corporation exists.

4b. Allow more effective regulatory controls to be exercised.

4c. The absence of such limitations affects the public's confidence in the market place.

4d. This is where an arbitrary percentage has to be established in the hopes of resolving a complicated problem. The 80% limitation as suggested by the SEC is not an unreasonable compromise percentage figure.

4e. It is rather difficult to see the relevancy between the commission structure and such a limitation. This is so whether we have fixed commissions or not. 4f. Again the relevancy is difficult to measure. If the limitation on the number of exchange memberships is removed, we have a new "ball game."

4g. Should such a limitation be removed an adequate time period of several years should be allowed for the working out of necessary adjustments.

4h. We are opposed to inactive memberships.

4i. It is incumbent upon the broker to perform whatever functions are necessary in the execution of the order on behalf of the customer.

5. We are of the opinion that permitting members to have institutional affiliates creates a definite potential problem because of the vast sums of money that well could come under their control and in turn could lead to the exercise of a tremendous, unreasonable amount of economic influence on various parts of the economy. This could conceivably be very serious in its impact.

5a. As briefly noted above.

5b. Yes.

5c. Theoretically the antitrust laws would be adequate to deal with such dangers. The grave concern is that smaller firms, regional firms in the investment business as well as the public generally could have suffered irreparable damage before the processes instituted by the Justice Department would have a restraining effect.

6. We are of the opinion that permitting institutions to trade through controlled members could well be disruptive of the orderliness of securities markets. 6a. Such developments certainly might occur, how likely it is is another question. The only steps, short of prohibiting institutional control of members is the requirement that, as mentioned heretofore, 80% of the business be done with others.

6b. Very likely any problems created would be very similar in either case. 6c. This leads to the "conflict of interest" question.

PART II

7a. Brokerage firms should be permitted to afford customers a broad range of financial services. A primary purpose is to act as a broker, market maker, and/or investment banker.

7b. The SEC suggested 80% figure.

7c. This leads into unknown areas.

7d. Generally as set forth above. Also allowing for the development of broad financial services to satisfy the needs of the public.

8. We are not opposed to reciprocal arrangements that are predicated on a sound, fully disclosed basis. We are opposed to rebates. Setting workable rules can be designed to enforce the elimination of rebates. These rules must be carefully drawn so as not to impose an unnecessarily vast amount of paper work. Reporting and monitoring could be made effective.

8b. It is impractical for exchanges other than the NYSE to make workable such a control system.

9. Primary control by the SEC and Exchanges should be limited to their mem bers. To go beyond this, say for example, to controlling institutions, would be cumbersome, ineffective, and unacceptably expensive.

10. We are of the opinion that the number of exchange memberships continue to be limited. This opinion would be maintained until it is demonstrated beyond