5. Permitting stock exchange members to have institutional affiliates might very well increase the economic power of such entities because of the combination of the brokerage and advisory functions. However, we are not sure such membership arrangements would necessarily result in the creation of dangerous concentrations of economic power. What we are more concerned with is the danger created by the conflicts of interest which are inherent in this situation. 6. See answer to Questions #1. and #1(b).

7. It is our opinion that the conflicts of interest inherent in such membership arrangements cannot be adequately cured or controlled by the institution of any of the regulatory restrictions enumerated in Question 7. However, if institutional membership on exchanges were expressly approved, we would strongly recommend that serious consideration be given to the adoption of the following membership limitations:

(1) A requirement that the primary purpose of a member firm be to act as a broker and/or market maker.

(2) A requirement that no more than twenty percent of portfolio business of an affiliate of a member firm be handled by that firm.

(3) A requirement that at least eighty percent of a firm's total securities business be done with or for non-affiliated customers.

(4) Limitations be imposed on the types of businesses in which member firms may engage.

8. No. A general prohibition against institutional membership and the combination of money management and advisory functions coupled with the adoption of fully negotiated rates is the only answer.

9. We oppose such membership arrangements but feel that if they are allowed, institutional membership must be subject to the regulatory authority of the SEC and/or the exchanges. Accordingly, whenever money management and brokerage functions are co-mingled, the regulatory authorities should develop and implement strict controls over the activities of such entities. Generally, it would be our recommendation that the practice of crediting commissions against advisory fees should be prohibited. Broker-dealers managing money should be subject to more complete requirements regarding reporting to regulatory authorities and disclosure to clients. Rules should be adopted which mandate disclosure of specific and detailed information to clients whose funds are managed by broker-dealers, such as investment companies, pension funds, and discretionary accounts. It would also be advisable to require that information regarding transactions for managed funds and accounts be reported to the SEC and to the exchanges. Those who combine money management and brokerage should also be required to prepare a detailed statement of standards by which they fix the commissions charged by them on portfolio transactions executed by them for their clients. Under this regulation, broker-money managers would be obligated to state the way in which they intend to handle internal conflict of interests.

10. While the self-imposed limitation on the number of memberships on the New York Stock Exchange has, in the past, been partially justified by certain practical considerations, the technologicial advances of today, the creation of new markets, and growth of institutional businesses make the continuation of such an arbitrary and restrictive rule unacceptable and not in the best interests of the public. The rule has served to perpetuate and protect a closed institution and has discouraged the influx of new capital and deprived the market place of capable and responsible persons. Consequently, it would be our recommendation that the present structure of the exchange be modified so as to make it a more open and public-oriented body. With this objective in mind, the elimination of the membership number limitation would be an obvious first step, but such a change would have to be accompanied by making the requirements for membership more selective and the rules of operation and practice more consistent with the exchanges' purpose of providing their services to all segments of the investing public on a non-discriminatory basis. Hopefully. such steps will significantly raise the quality of professionalism and further insure the financial stability and integrity of the exchange.

11. Since we are not in the brokerage business, we lack the knowledge and understanding of on and off floor transactions necessary to adequately answer or comment upon Question #11.

(a). See answer to Questions #2, (a), (b), (c). (b). See answer to Questions #2, (a), (b), (c).

(c). See answers to Questions #1. (b), 2, (a), (b), (c).

(d). It would appear that there would be no substantial advantage except that the market of the primary market specialist is ordinarily more continuous. 12. Since we are not in the brokerage business, we lack the knowledge and understanding of on and off floor transactions necessary to adequately answer or comment upon Question #12 or any of the additional questions posed therein.

13. (a). The potential conflict of interest created by the combination of brokerage and money management justifies the separation of these functions. See answers to Questions 1., 1(b)., 2. and 6.

Since we are not in the brokerage business, we do not have a full appreciation or understanding of the problems created by the combination of brokerage and market making functions. However, it appears that the industry has traditionally been able to resolve the conflicts created by such combinations and, consequently, we would not be in favor of a separation of such functions.

(b). The development of stricter regulations governing the involvement of fiduciary obligations is not a practical alternative to requiring a separation of functions.

(c). The potential dangers from performing conflicting functions would be exacerbated by permitting firms to have institutional affiliates. See answers to Question 7.

RESPONSE OF THE INVESTMENT COUNSEL ASSOCIATION OF AMERICA

INTRODUCTION AND BACKGROUND

I am Charles W. Shaeffer, President of the Investment Counsel Association of America. The Investment Counsel Association of America was formed in 1937 by a group of investment counsel organizations. These firms were dedicated to the proposition that investment advice should be provided on a professional basis to clients and divorced from the bias which is inherent in the broker-customer relationship when the broker also provides investment advice to the customer.

The first investment counsel firms were founded some fifty years ago in order to work exclusively for the investor and not for the issuer or market maker, and thus to be customers rather than participants in the underwriting and securities markets. Since the founding of the Association, our principal objective has always been to build professional standards similar to those of a lawyer, a doctor or an accountant, and to do all within our power to avoid situations in which our interests are at variance with the interests of our clients.

Eligibility for membership in the Association is based on solid professional standards. The ICAA consists only of firms which are primarily engaged in rendering investment supervisory services on a continuous basis, are registered under the Investment Advisers Act of 1940, and are entitled to use the title "investment counsel" under that Act. The Association was developed prior to the promulgation of the Investment Advisers Act and long before the Congress granted the Securities and Exchange Commission the power to issue rules and regulations under the Act. The Association reflected principles of its member firms-which were described as the new profession—which the Congress and the Commission later established in the law, with help and guidance, incidentally, from the Association. The current Standards of Practice of the ICAA are attached as Exhibit A to this statement. Articles I and IV of these Standards indicate how the Association, in recognizing the complex nature of the securities business, has dealt with the possible inherent conflicts of interest by requiring that members and persons affiliated with our firms may not have any broker or dealer or lending ties. Moreover, member firms and their employees may not engage in personal securities transactions in which there is an actual or potential conflict of interest with a client.

PROPOSED LEGISLATION

We understand that the specific purpose of these hearings is to consider S. 3169, which would prohibit after December 31, 1973 fixed minimum commission rates with respect to any portion of a transaction in excess of $100,000

and also would permit brokers to unbundle the fees they charge for various services. The latter provision would apparently be effective upon the date of passage.

The background and principles of our Association impel us to favor both major proposals of this bill. Moreover, because of the nature of the services offered by our member firms, our Association is uniquely qualified to comment upon these two issues.

REDUCTION OF FIXED COMMISSION RATES TO $100,000 LEVEL

The report of your Subcommittee issued February 4, 1972 contains an excellent discussion of the recent history of the New York Stock Exchange commission rate structure. As the report indicates, the rapidly growing participation in the stock market by institutions in the 1960's and the resultant increase in large block trading began to provide stock exchange member firms with commissions substantially in excess of the prices at which they would have been willing to execute the transactions in a competitive market. In other words, commissions were just too high. This resulted in increasing pressure on the fixed rate system and ultimately in a flood of applications for stock exchange membership by various kinds of institutions. Our Association believes that commissions must be reduced for the protection of the investing public and to lower the cost of services to our clients. A policy of fully negotiated rates is the only effective way to bring this about. We also are opposed to institutional membership because it produces serious conflicts of interest which are against the best interests of the investing public. As a vital step toward fully regulated rates, lowering of fixed commission levels to $100,000 will reduce the incentive of institutions to join or otherwise affiliate with exchanges. We are very much in favor of this proposed further lowering of fixed commission rates.

We question, however, whether it is necessary to delay the effective date until the beginning of 1974. The brokerage community seems to have adjusted very well to the $500,000 level and already the Securities and Exchange Commission has ordered a reduction to the $300,000 level commencing April 24 of this year. We feel an earlier date for the $100,000 level such as July 1, 1973 would be perfectly feasible without disruption of the industry.

We also urge that the industry be required to go to fully negotiated rates at an early date. Until that point is reached, there are still substantial motivations for institutions to seek special privileges through reciprocal arrangements and to establish exchange affiliations in order to share in commission dollars directly or through services. Fully negotiated rates are entirely consistent with a free and competitive economy, as the Justice Department has pointed out. It is interesting to us to note that support for fully negotiated rates also has come from within the brokerage community itself, as witness public statements of Chairman Donald Regan of Merrill Lynch and President Robert Haack of the New York Stock Exchange.

INSTITUTIONAL MEMBERSHIPS

We note in your Subcommittee report at page 66 that you do not at this time wish to express a view as to the necessity or appropriateness of a requirement that exchange membership be confined to firms whose primary purpose is to serve the public as brokers or market makers. This, of course, is a detail but one of vast practical import. The report states at that point that you intend to hold hearings later this year on that subject and on the related matter of whether member firms should be permitted to engage in both money management and brokerage.

Many institutions or their affiliates are now members of an exchange. As a result, pressures are mounting for other institutions to establish such affiliations. Allowing these institutional investors direct access to the exchanges has caused many others to seek it or be subject to a possible charge of breach of fiduciary duty if they do not. This situation has resulted in a paradox, since it is the performance of fiduciary duty according to the most stringent of standards that has caused the members of our Association to avoid brokerage affiliations. Unless an effective way is found to eliminate the pressures for institutional membership, there will be an increasing influx of institutional members on the stock exchanges which could have the result of further weak

ening the fiber of the securities markets. To protect the investing public, this fiber should be strengthened through elimination of the dangerous conflicts of interest which are inherent in institutional membership.

Furthermore, forcing institutional money managers into the brokerage business is to require them to do a job for which, in most cases, they have neither the philosophical inclination, the talent, or perhaps even the capital funds. The most important consideration is that they will be diverted and compromised in their primary purpose of providing impartial, unbiased advice. For the client to get the benefit of the adviser's brokerage affiliation, an arrangement might be entered into whereby the client would benefit from a pro rata portion of the brokerage profits based on some formula for a specified period. Brokerage operations involve considerable capital expenditure and continuing costs of operation, so there would be three unavoidable temptations. 1. To load into the brokerage affiliate many of the expenses of operating the entire complex ;

2. To generate sufficient brokerage business among clients to recover all expenses; and

3. To generate sufficient profits so as to more than offset any reduction in clients' advisory fees.

The client might agree, as an alternative, to share in the losses on the one hand and the profits on the other. The adviser, however, would always feel the pressure to generate enough brokerage business to avoid losses and the embarrassment of seeking, and having to explain the basis for, reimbursement from the client.

Mr. William McChesney Martin in his report to the Board of Governors of the New York Stock Exchange recommended that brokerage firms be prohibited from crediting commissions against any fee charged for investment advice. We support this position as an initial proposition but we do not believe it goes far enough. Brokerage firms should be precluded from managing any investment capital for a separate fee. The temptation in those firms, where the brokerage and investment management businesses are combined, is to generate trades to increase the brokerage commissions paid by the account. This is not in the client's best interest. It appears from the 1969 records of one organization, where such an affiliation exists, that of the revenues attributable to investment management services those received from commissions were approximately 16 times those received from advisory fees.

There are other factors to be considered in the complex business of trading securities besides the possibility of an ethical lapse. When a fund or an investment counsel client of a firm has a large block of stock, it may be very important to conceal the fact that a trade is taking place in order to protect the market in that stock. At the presen time, such transactions are accomplished through a number of brokers and usually over a period of time, particularly if it is a thinly-traded security. If the manager of the fund or the investment counsellor were required to use a broker-affiliate of the firm for all or most transactions, it might be unable to carry out successfully such complex trades. Best execution of the trade might not be accomplished.

At page 61 of the Subcommittee report is an explicit example concerning the inherent unfairness in the present asymmetry of the rules of the New York Stock Exchange, e.g., permitting existing members to manage institutional portfolios while at the same time prohibiting membership to those similarly engaged. We support Senator Proxmire's position as expressed in his "Additional Views" contained at the end of the Subcommittee report:

"I believe it is wrong to expand the scope of an unwise policy simply to achieve equal treatment. Unlike the report's conclusions, I would prefer to shift the burden of proof to the institutions seeking exchange access. Until a final national policy is established and in the absence of a clear showing that institutional control of exchange members is beneficial to the public interest, the burden of persuasion must be on the institutions seeking to acquire member firms. Likewise, the burden of persuasion should be on those member firms managing institutional funds to justify their continued management of these funds and [their continued membership] on the New York Stock Exchange which now permits it."

UNBUNDLING OF CHARGES FOR SERVICES PROVIDED BY BROKERS

The Association is in favor of the bill's proposal for an unbundling of charges for many of the same reasons that we support the reduction of fixed

commission levels. Indeed, the two issues in many respects go hand in hand. An unbundling of charges will aid substantially in the arrival by the industry at fully negotiated, competitive rates. If separate charges are made for execution of trades, for research, and for other services, it will force more competition and lower rates. Rates are more likely to go lower for all investors with published fee schedules and with separation of charges than they would with fully negotiated rates alone. In any event the motivation for institutions to join exchanges will be reduced further if they can pay for execution only and then go elsewhere and pay for research or do it themselves.

It is obvious to all and not just the Association's member firms that there are many conflicts in the securities business. In his report to the New York Stock Exchange, Mr. Martin has taken the position that one of these should be eliminated-that between broker and adviser-but only if the advisee is a registered investment company. However, the discretionary pension trust or welfare fund is actually more vulnerable to the broker-adviser conflict than the registered investment company, which is subject to intensive scrutiny by federal and state regulators and by stockholders. Our Association's position is rather simple: any conflict between a firm's self-interest and a client's interest should be eliminatedt o the maximum extent possible.

In this connection we applaud the sentiments contained in the following excerpt from page 68 of the Subcommittee report:

"Second, if for reasons of inherent conflicts of interest, there is to be an absolute prohibition on member firms doing business with particular classes of affiliated accounts, the prohibition should extend to all similarly situated accounts. For example, if member firms are prohibited from doing business with accounts controlled by their parents, the firms should also be prohibited from doing business with accounts they control directly.

"Similarly, if member firms are prohibited from doing commission business with controlled mutual funds, they should also be prohibited from doing business with pension funds over which they exercise investment discretion. A restriction on the sources of a member firm's business because of the inherent conflict of interest in the relationship with that account must be applied across the board. If money management and brokerage cannot be allowed in combination without substantial dangers to the public, then any prohibition should be general and even-handed."

We do not believe that the conflict inherent in these dual relationships can be resolved by full disclosure and self-administration. The clearest such conflict is the case of the broker who receives brokerage commissions whenever he executes a discretionary trade pursuant to his own recommendation. It is confusing the issues to contend that equity and symmetry require institutional membership on the exchanges. If doctors were permitted to own drug stores on the pretense that they could provide a better price for the drugs they prescribe for their patients, we would think it improper. If the druggist were allowed to have a doctor on his payroll, we would consider it even worse. This latter situation closely parallels the case of the brokerage firm acting as the investment manager which is responsible for recommending portfolio changes. If a druggist were to hire a doctor, all druggists, simply in order to achieve symmetry, would not be permitted to have doctors on their payrolls-the druggist and doctor in question would be required to terminate their private arrangement. Similarly, the Association feels constrained to speak out against any combination of the advisory and brokerage functions.

The argument has been advanced by member firms that a further lowering of fixed commission levels and an unbundling of charges will affect the quality of research. We do not believe this to be so for a number of reasons. First of all, we have the very direct example of the members of our own Association. The large research effort of the investment counsel fraternity is supported by cash fees paid for the management of accounts. We do not believe that the quality of this effort would materially suffer if the research assistance provided by brokerage firms and paid for by commissions business were shut off or were paid for in hard dollars. Nor do we believe that the quality of research effort would suffer if charges were unbundled and the true costs of research as against execution were known. As for the effect of further reduced fixed commission levels upon research, this would release funds that could then be devoted directly to research efforts, either by the institution itself or by the brokerage community.