of the central market. To the extent, however, that this is not possible, I believe that the current fragmentation of markets is less in the public interest than unequal regulation. We should not delay the rebuilding process until all regulatory problems have been resolved.

Equal regulation does not, however, mean that every rule of every sector of the market must be identical. There are legitimate reasons for some differences based on local characteristics such as trading hours, differences in the volume of orders flowing initially to a particular market sector or legitimate disagreements over how best to achieve common regulatory objectives. Some room for experimentation should be permitted. Coordination by some overall supervisory body, such as the Commission, will be necessary, however, to insure that varying rules conform to agreed regulatory objectives and to minimum standards of fairness and appropriateness.

V. CONCLUSION

At this moment, the American securities markets are the largest in the world and, very probably, the best. They have succeeded to a great degree in fulfilling the capital needs of our nation. They have also succeeded impressively in accommodating themselves to the very rapid increase in institutional stockholdings and the resultant increase in large transactions. But you have called these hearings because problems have arisen that threaten the continued success of our markets. Since any serious breakdown in their operation could do a very grave injury to the American economy, a continued effort to protect their integrity is essential.

I believe that competition, appropriately regulated to ensure fairness, is the answer to the present problems in the market. Therefore, I favor the elimination of fixed minimum commissions, at least on all orders of $100,000 or more. If this is done, I favor the elimination of barriers to potential competition in the securities business from non-financial institutions and some financial institutions. Once these steps have been taken, we can proceed to rebuild the central market. Equal regulation should be recognized as a necessary characteristic of this central market, but other progress should not wait upon the development of a complete regulatory structure for the system. A composite tape for reporting all transactions in listed securities and a composite quotation system for advertising the bids and offers of all market makers in those securities should be put into operation as soon as possible.

STATEMENT OF WILLIAM R. SALOMON, MANAGING PARTNER, SALOMON BROS., BEFORE THE SUBCOMMITTEE ON COMMERCE AND FINANCE, COMMITTEE ON INTERSTATE AND FOREIGN COMMERCE, U.S. HOUSE OF REPRESENTATIVES

My name is William R. Salomon. I appear before this Subcommittee as the Managing Partner of Salomon Brothers, a member firm of the New York Stock Exchange and other principal stock exchanges. I also am a member of the Board of Governors of the New York Stock Exchange and several of the Board's committees that have been considering issues relating to these hearings. My statements, both written and oral, do not reflect in any way the views of the Board of Governors of the New York Stock Exchange.

Salomon Brothers has been in business since 1910, and has been a member of the New York Stock Exchange since its inception. Our firm deals almost entirely with financial institutions-banks, insurance companies, investment advisors, mutual funds and with corporations, federal agencies, state and local governments. Our principal business is as market makers and investment bankers. We make secondary markets in a very broad range of institutional grade securities, including bonds of corporations, the U.S. Government, federal agencies, states and local governments, money market instruments and approximately 150 over-the-counter stocks. We also do a large volume of business as brokers in listed securities. Our firm does extensive underwriting business, both negotiated and competitive, in the same broad range of securities in which we make markets. Our main office is in New York. Nine regional offices are located in major U.S. financial centers and a tenth office is in London, England. We have 31 general partners and approximately 1,000 employees.

In addressing the questions raised by the Subcommittee, I would like to point out that Salomon Brothers has been active in the business of block trading of equity securities for only a few years. Our entry into this business resulted from the fact that our institutional customers greatly enlarged their activities in equities and we broadened the base of our services to meet their needs in this regard.

Despite public attention accorded large block stock transactions, trading in listed stocks is a relatively small part of our business. In our last fiscal year our average daily inventory in all securities was $2.2 billion. Our average overnight block positions in listed stocks during this time were about $35 million. The bulk of our inventory was in government bonds, federal agency securities, municipal bonds and corporate bonds.

Our firm's experience of more than 60 years of trading bonds in a highly competitive environment has convinced us that fair and open competition is the cornerstone of an efficient securities market. Every secondary market in which we are engaged involves free and open Price competition. Some of these also involve competition with financial institutions. Commercial banks are dealers in securities of the United States Government, federal agencies and state and local governments. They have been major competitors in these areas for many years. Broker-dealer subsidiaries of insurance companies and mutual fund managers are active in the over-the-counter market, including the third market. Despite this competition, independent securities firms have managed to remain among the largest dealers in each of these markets.

Salomon Brothers has long endorsed the position that commission rates on transactions in excess of $100,000 should be negotiable. We believe that the SEC action in prompting the reduction of the minimum for negotiated rates from $500,000 to $300,000 is highly commendable. We also are pleased to note Chairman Casey's announcement of plans to reduce this amount to $200,000 in April, 1973 and to $100,000 in April, 1974.

However, we feel strongly that it would be preferable to lower the floor to $100,000 immediately rather than wait two years. Only in this way, in our opinion, will the industry be able to resolve the problems of institutional membership and move forward to establish a central market system.

At every move to lower the level for negotiated rates, we have been bombarded from many sides with the argument that time is needed to adjust to the change so that the impact of each downward move could be evaluated. As yet, it hasn't been made clear just what adjustments are being made by the firms who oppose negotiated commission rates. The gradual stepping down process presently under way just seems to invite the same opposition at every further downward adjustment. They say, "move slowly". There haven't been any plans for adjustment brought forward. Their only aim seems to be to delay the downward movement as long as possible in the hope that it can be permanently stalled.

Since negotiated commission rates above the $500,000 level were introduced a year ago, we haven't witnessed any of the calamities which the proponents of fixed commissions have forecast.

There haven't been any harmful effects. There haven't been wider gyrations in the market. There haven't been greater price discounts. There hasn't been any substantially increased concentration of business in the large block trading firms. Diversified houses in the middle range have lost some ground, but the smaller firms have gained business. The regional firms which are so vital to the distribution of new securities haven't suffered. We haven't seen any firms going out of business.

Entry into the block business has been made easier. We are seeing a great many more new names on one or both sides of a large block. The handful of firms which did the bulk of block trading a year ago has now expanded into a much larger group including small and medium-sized firms, regional firms and wire houses as well as the institutionals concerns.

There has been much discussion re the "unbundling" of commission rates. It seems to us that when commission rates are negotiated, for all practical purposes, they are "unbundled". The rate is based primarily on execution and the broker has the option of offering additional services, depending upon his negotiation with his customer. We concur, however, with the SEC in its position that a broker should not be permitted to execute a transaction for an individual investor without providing certain minimum basic information about

the particular security. Within this frame of reference, it seems reasonable for a charge for this basic research component to remain "bundled" for regulatory reasons.

Our firm does not do any business with the general consumer public. Consequently, we are not in a position to comment on commission rates for small investors. It would seem, however, that if fixed rates are retained for small transactions, the only substantial cost element in addition to the execution is the salesman's compensation. For individual investors, it clearly would not be practical to "unbundle" the sales component, since this is not a separate "service". Many institutional customers, however, are house accounts and there is no salesman's compensation to pay on their small orders.

The question of research relates directly to the previous expression that certain minimum information should be required to be made available to individual investors by their brokers before executing transactions for them. In the securities industry, research consists of fundamental information about the economy as a whole, a particular industry or a particular company that serves as the basis for an investment decision. It also involves so-called technical information about individual security. This information may be obtained by retail firms either through their own research departments or through purchases from others. Special research above the minimum for individuals mentioned previously and institutional research should be provided without charge or paid for in cash. We oppose the use of brokerage dollars to pay for research because it creates a potential conflict of interest. Cash payments for research, particularly from independent research firms, would seem to be more objective. An independent research firm would not have the same incentive as a broker to make only recommendations that would generate brokerage business that the broker is capable of handling. I understand, however, that there are some legal restrictions against paying cash for research. Not being a lawyer, I am not qualified to comment on this matter.

I believe the whole matter of institutional membership on national securities exchanges is tied to the question of fixed commission rates. Institutional membership for recapture of commissions should not be allowed. If recapture is appropriate, there must be something wrong with the fixed rates. And if there is something wrong with them they can hardly meet the test of regulatory necessity. At the $100,000 level, the incentive to recapture commissions would be greatly reduced.

To avoid conflicts of interest, as long as any fixed rates remain, a member firm's listed stock business should be limited to transactions for unaffiliated customers or, for its own account, to transactions that contribute to the market function, such as market making, block positioning and arbitrage. If self-dealing is adjudged to contravene the public interest, it should be prohibited entirely not just up to an 80 percent level. If fixed rates are eliminated entirely, however, then I see nothing wrong with institutions executing their own transactions as long as the institutional manager is not allowed to profit from those transactions.

Penetration of the securities industry by commercial banks and widespread entry by insurance companies pose serious problems of increasing concentration of economic power and should certainly not be encouraged. This same problem would not apply necessarily in the case of most non-financial institutions. In fact, their participation could greatly strengthen the securities industry through a new infusion of permanent capital. We would welcome their entry into the general securities business. Thus, we are in favor of institutional membership even if fixed commissions are maintained at the $100,000 level but we would require complete prohibition of self-dealing.

This brings up the question of how to treat institutions presently owning seats if institutional membership for recapture purposes is to be restricted or prohibited. To allow those institutions to retain membership under grandfather clauses would afford them an unfair competitive advantage over non-member institutions of a similar type. I don't believe compensation for the disposition of the seats in question would pose a major problem, since memberships on the regional exchanges for recapture purposes do not entail any great investment. From an objective and idealistic viewpoint, money management and brokerage should be separated. The prohibition of profiteering from self-dealing, as previously suggested, would eliminate most of the conflict of interest inherent in the combination of these functions under one roof. It would be difficult to

break up all of the combinations that already exist. Moreover, the stable income from money management does balance the cyclical nature of brokerage income. I would rely upon a prohibition of self-dealing and not actually require separation. It would not be equitable, however, to allow broker member firms to manage mutual funds and other pooled investments while prohibiting institutional membersnip. Uniform standards should be applied to all firms-brokers and institutions.

As I have indicated our firm has a few reservations about the SEC's recent statement on market structure. In most respects, however, we wholeheartedly support the recommendations in that statement. In our view they can serve as the foundation for the new central market system that we all so earnestly desire. I hope that this Subcommittee will do what it can to help implement these recommendations.

STATEMENT OF DONALD M. FEUERSTEIN, FORMERLY CHIEF COUNSEL-MARKETS, INSTITUTIONAL INVESTOR STUDY,* AT HEARINGS CONDUCTED BY THE SECURITIES AND EXCHANGE COMMISSION

I appreciate Chairman Casey's invitation to appear here today with my former colleagues from the Institutional Investor Study. Although the Commission's transmittal letter for the Study's report expresses our views about general principles that should govern market structure, it does not contain specific recommendations for effectuating them. In this statement I shall attempt to make such recommendations. Most of them were originally formulated during the course of my work on the Study. Although my subsequent practical experience with a major securities firm dealing with institutions has resulted in some minor modifications in those original recommendations, in the main it has only served to strengthen them. Nevertheless, I speak only for myself today. The views of my present firm will be presented later in these hearings by its managing partner, and I shall appear with him again in that capacity. I plan to address myself in order to each of the six matters specified in Securities Exchange Act Release No. 9315. Before I do so, there is one additional matter that must be mentioned. The Institutional Investor Study found that the application of fixed minimum commission rates to institutional orders is the prime motivating force behind most of the major structural changes that have taken place in the securities markets and are continuing to take place today. I do not advert to fixed rates to argue the merits of this issue, which have been extensively discussed in the Commission's Rate Structure Investigations of National Securities Exchanges. Rather, I do so because most interested people agree that fully negotiated rates for institutions are inevitable. Moreover, as I shall point out in my discussion of the specified matters, the appropriate solution to many of them is impracticable in a fixed rate environment. A discussion of the problems in our secondary markets must begin where the problems began.

I say that fully negotiated rates for institutions are inevitable because of the inexorable economic forces that fixed minimum rates create. History supports this proposition. The Institutional Investor Study only confirms the point already made obvious by the Rate Structure Investigations: Stock exchange commissions for institutions have always been open to negotiation. The subjects of such negotiation have been various-direct rebates, reciprocal business, special services, etc. But, because the negotiations have taken place under the guise of fixed rates, they have resulted in varying degrees of benefit to the institutional manager itself and/or the ultimate investors whose money it manages:

(1) Direct benefits to the manager only. The Rate Structure Investigations disclosed flagrant examples of cash payments to fund managers, as well as free or underpriced goods and services-for example, rent-not even arguably related to the investment process. The Commission swiftly and forcibly dealt with such deplorable practices through enforcement proceedings. Brokerage commissions earned by the institutional manager or by its broker-dealer affiliate also involve a direct benefit to the manager. The institutional manager is either compensated for brokerage services not already required under its man

*Presently counsel, Salomon Bros.

agement contract, or it receives reciprocal brokerage commissions on independent accounts. In such cases, involving both New York Stock Exchange members and nonmembers, only the institutional manager benefits from the brokerage commissions unless any profit is offset against the management fee. The Institutional Investor Study documents reciprocal practices of similar effect by banks with regard to demand deposits and brokers' loans and, to a much lesser extent, by insurance companies with regard to policies.1 Although Section 17 (e) (2) of the Investment Company Act is said to authorize such practices by mutual fund managers when they perform work to justify the payment of brokerage commissions, there is no similar provision of law with respect to banks and insurance companies. It is true that each of these forms of negotiation could conceivably benefit the investors indirectly if they resulted in lower management fees. I know of no persuasive evidence that this has in fact occurred, however, in the absence of a formal offset arrangement.

(2) Direct benefits to the manager and arguable direct benefits to the investors. The use of mutual fund portfolio brokerage as additional compensation to mutual fund sellers is generally disclosed in fund prospectuses, was described in detail in the Rate Structure Investigations and has been confirmed by the Institutional Investor Study.2 It is clear that the fund manager whose fee is based on the size of assets under management benefits directly from fund sales. Although the fund industry has long claimed that sales efforts also enhance performance by providing a steady net flow of new money, this relationship has never been proved.3

(3) Direct benefits both to the manager and to the investors. Questions may appropriately be raised about the anticompetitive effects inherent in bundling together execution-clearance and research and whether research is an appropriate expense of management rather than a charge against the investors' portfolio. In the latter respect it is clear that payment for outside research services with brokerage commissions benefits the manager by reducing its own research expenses. Nevertheless, these outside research services also directly benefit the investors, although not ncessarily to the same extent as a reduction in the brokerage commissions through recapture techniques or lower negotiated rates. Other services in this category described by the Institutional Investor Study are portfolio valuation and communication facilities.4 Arrangements by which part of the profits of an affiliated broker-dealer are retained by the manager and part are offset against the management fee also clearly benefit both parties in a direct fashion.

(4) Direct benefits to the investors only. The Study contains the first comprehensive data on the economics of block positioning, and it is apparent that the additional execution service of assuming an institution's market risks in liquidation or accumulation is an expensive one for the block positioner.5 If the block positioner did not assume these market risks, the institution would presumably have executions that are inferior by roughly the same magnitude as the block positioner's trading losses. Although it has also been claimed that institutions are allocated new issues on the basis of brokerage commissions paid to the underwriters, the Study was not able to develop evidence to substantiate this claim. Services such as block positioning and allocation of new issues clearly benefit only the investors, although not necessarily in the same ratio as brokerage commissions are paid by multiple accounts under the same management. Arrangements by which the entire profits of an affiliated broker-dealer are credited against the advisory fee also fall in this category, and appropriate allocation of the benefits to the pertinent account is more practicable.

Although the recipients of these various benefits vary, each type of benefit has a common economic impact: additional expense for the broker-dealer that furnishes it and negotiation between the broker-dealer and the recipient institution about the extent of the benefit to be furnished. The Institutional Investor Study confirmed that, prior to any changes in commission rates, there was vigorous competition among broker-dealers concerning the extent of the extra

1 Vol. 4, pp. 2278-83, 2285-86.

2 Vol. 4, pp. 2283-85.

3 The study found a statistical relationship between growth and performance, but it was not able to determine the direction of any causal effect. Vol. 2, p. 331.

Vol. 4, pp. 2273-74.

5 Vol. 4, pp. 2938-40.

6 Vol. 5, pp. 2373-81.