There have been only 76 purchases under rule 107(a) in the 102 years of its existence, or an average of about 8 per year (table VI-43). In the case of inactive issues, the additional spread received by the specialist apparently is not enough of a hedge, if it is to result in a realistic price to the seller, to induce specialists to make such purchases frequently. A former chairman testified that the plan has not been a

success.

The average size of blocks purchased under the rule was 10,200 shares, while the average size of blocks over 2,000 shares purchased by specialists within the market in the 3-week study was 3,800 shares. The two studies were also compared for time of distribution. During the 3-week study, one-half of the blocks over 2,000 shares were distributed within the next 5 trading days; one-third of the purchases under the block purchase plan were distributed in a similar period.

The discounts at which the blocks were purchased under the rule from 1953 to 1962, were: 1/4 to 1/2 in 27 cases, 5% to % in 20 cases, 1 to 13% in 17 cases, and 12 and over in 12 cases. These discounts appear to be greater than those for block purchases in the regular auction market, described above.

A weighted average price of successive long sales by the specialist up to the amount of the block purchase was calculated in 75 of the rule 107(a) purchases. The following is a distribution of the profit per share among these 75 cases:

TABLE VI-k.-Distribution of profit per share of specialists' off-board block purchases under NYSE rule 107(a)

Profit per share:

Loss---.

0 to $0.24-.

$0.25 to $0.49_

$0.50 to $0.74_

$0.75 to $0.99_.

$1.00 and over.

Total___

Number of cases

7

6

13

8

9

32

75

Thus, the profits under the specialist block purchase plan on the whole seem substantially larger than those on blocks taken in the regular auction market.

When specialists are unwilling to commit too much of their capital to a purchase they will often ask floor traders to help them. However, some specialists have expressed various reasons against calling on floor traders. One stated that he believed that floor traders add unwarranted activity, another preferred not to share any potential profits, while still others are guided by the wishes of the broker involved.294

Aside from purchasing blocks, either alone or as a part of a group, a specialist may act as "finder," bringing together the buyer and seller. The specialist's central position in the market place provides him with considerable knowledge of the brokerage firms which represent consistent buying or selling interest in the issue, which may be the issue's underwriter. When specialists act successfully as "finders," they are often given part of the floor brokerage when the transaction is effected. Both the buying broker and the selling broker let the spe

294 See pt. F of this chapter for a discussion of the trading patterns of floor traders.

cialist "write out" portions of the order, depending upon how useful to each his services were in making the trade."

295

In addition to the techniques just described,296 special distribution plans not involving the specialist are available. Since these distributions are permitted only on the assumption that the regular auction market is unable to absorb the block, their number is in part determined by the willingness of the specialist unit to bid, either alone or as part of a group, for a block. One specialist, whose unit is known. for its willingness to buy substantial blocks, testified that there are fewer special distributions in his specialty stocks because his unit. makes substantial bids.

297

Certain of the techniques employed in the execution of blocks may involve fiduciary problems. When a block is purchased by a specialist in the regular auction market at a discount, the buy limit orders on his book are usually filled at their limits and the specialist buys whatever amount he is prepared to take at a lower price." For example, a specialist may be asked to make a bid for 5,000 shares in a stock when the last sale was 35 and the book contains the following orders to buy: 3434, 500 shares; 342, 1,000 shares. The specialist might inform the seller that he could sell 500 at 3434; 1,000 at 342; and 3,500 at 34, the bid at 34 being the specialist's own, as principal. This is a normal method of operation in "cleaning up" blocks, but it would seem to involve a compromise of the specialist's fiduciary relationship with the buyers on his book, in that he has purchased stock for himself at a lower price than he obtained for his principal. This appeared to be recognized by one specialist who testified:

*** [I]f I know that there is a large order coming in and I am bidding for my own account at one price, I attempt to get it for everybody on my book at the same price.

Under the specialist block purchase plan the fiduciary problem is magnified, since the specialist may purchase the stock for his own account at a better price than a customer's limit and yet not fill the customer's order at all. One specialist testified that he did not like to make block purchases under the plan because of this conflict of interest.298

In 1955, as part of the Exchange-appointed Vilas Committee study of the operations of the Exchange, block transactions were given considerable attention. A subcommittee, whose report was in substance adopted by the full committee, concluded that the regular auction market, as supplemented by the special distribution plans, was wholly adequate to handle blocks. Its only recommendation, later adopted, was for the undertaking of an educational program to inform institutional investors of the methods available to dispose of or to acquire blocks.299

295 The "finding" function is considered a brokerage service so that the split of floor brokerage is not treated as prohibited by art. XV of the Exchange constitution. The use of specialists as finders has apparently developed within the past 20 years.

200 Another brokerage technique, which was utilized until October 1961, was for the specialist to accept a discretionary order for the purchase or sale of a block. The problems with this form of order, known as a "not held" order, are discussed in sec. 7.b, below. 207 In other cases, the specialist may mingle his bids with those on the book at successively lower prices.

298 The Commission expressly approved the provisions of rule 107(a).

299 See Exchange pamphlets, "Now About the Specialist," pp. 9-10, and "Marketing Methods." The committee did not recommend an increase in specialist capital requirements though, as mentioned earlier, another Exchange committce had done so (unsuccessfully) 2 years before,

In its findings, the subcommittee recognized the specialist's importance in handling blocks. At one point it stated that the specialist could satisfactorily "organize his own capital and the capital of others to make a volume market when necessary," but no discussion or recommendation was directed to the underlying problem of the inability or unwillingness of some specialists to make substantial bids, a problem which seemingly existed then but perhaps more clearly exists today. An increase in specialist financial requirements generally might well prove helpful in dealing with the problem of the block transaction, but only if coupled with more affirmative definition of specialist obligations and surveillance adequate to assure that reluctant specialists would use their capital to an appropriate degree. However, even this will not wholly solve the problem in cases where the risks are too great for one unit to bear alone. At some point it becomes unreasonable to expect specialists to take certain very large blocks even in active stocks or even more modest-sized blocks in less active stocks.

The key here may be found in the testimony of a prominent former chairman. He stated that an argument used to persuade institutional investors to give their business to the Exchange rather than to competing markets is that the Exchange undertakes to make markets in some 1,400 stocks, many of which are difficult to handle, while the competing over-the-counter dealers can restrict themselves to "easy" dealer stocks. In fact, however, the total floor resources of the Exchange are not utilized to service particular stocks, and specialist units by themselves are often financially unable to allocate a sufficient portion of their capital to engage in a large transaction in one of their stocks.

To be better able to cope with the problems of blocks the Exchange should increase the specialist capital requirement and explore the possibilities of a capital fund, from which specialists could borrow to enable them to handle blocks beyond their economic capacity or which may also be used to partially insure specialists against possible losses when they purchase a block of stock. The adoption of such a plan may in fact, give substance to the Exchange's representation that the resources of its members are available for its entire list of stocks. i. Long-term investment accounts

Specialists' dealings may be motivated by considerations of tax planning rather than by the needs of the market. In the Amex report, certain observations were made with respects to the practice of some specialists on that exchange of segregating securities in which they were registered as specialists in long-term investment accounts:

The primary motive behind the creation of these accounts is to turn profits which would otherwise be taxed as ordinary income into long-term capital gains. Section 1236 of the Internal Revenue Code is the key provision. It provides that a gain by a dealer in securities from the sale of a security shall not be considered as a capital gain unless : (a) the security was identified within 30 days of the acquisition as a security held for investment; and (b) "the security was not, at any time after the expiration of such thirtieth day, held by such dealer primarily for sale to customers in the ordinary course of his trade or business."

However, purchases made on the Exchange for the purpose of segregation into long-term investment accounts raise problems which go to the heart of the specialist system. The specialist is permitted to trade for his own account only when such trades affirmatively contribute to the maintenance of a fair and orderly market. *** Where the specialist goes into the market with the intention of segregating the securities purchased and not with the purpose

96-746-63-pt. 2—10

of creating a fair and orderly market, the trading is clearly contrary to the statutory and regulatory standards. Beyond this, the specialist with a longterm position now has a stake in seeing that the security rises in price he has become an "investor" as well as a dealer.

A further problem arises when the specialist who maintains such long-term accounts is required to sell stock to maintain a fair and orderly market and he has no stock in his specialist trading account. *** [If] the 6-month period of the tax statute is almost over, the specialist may well be tempted to keep his stock in the long-term account and neglect the needs of the market.00

That this practice and attendant problems also relate to the NYSE is indicated by the fact that as of June 16, 1961, when total specialist inventory was 3,229,556 shares, 890,733 shares or 28 percent of the total inventory were segregated into long-term investment accounts. In response to an inquiry by the Special Study, the NYSE stated its position on long-term investment accounts as follows:

The Exchange also believes that it is perfectly proper for a specialist unit to carry stock in a Long-Term Investment Account. This is based on the following considerations:

1. The specialist acquires the position through transactions made to maintain a fair and orderly market;

2. The stock in the Long-Term Investment Account of the specialist unit must be made available to the market if necessary, or the specialist must sell short in an amount at least equal to the amount in the investment account;

3. The specialist does not cause price trends since these are the results of public supply and demand; and

4. The Exchange policies its specialists to see that fair and orderly markets are maintained by them.

The Exchange's position raises questions of consistency with the Saperstein Interpretation, Exchange rules, and the Internal Revenue Code. The Saperstein Interpretation was made flexible expressly because the myriad of trading situations in which specialists found themselves were not though amenable to a rigid regulatory structure, and the Exchange has always taken the position that justification of specialist trading often turned on questions of judgment and degree. In view of this regulatory background, the points numbered 1, 3, and 4 in the NYSE statement seem somewhat disingenuous. Since specialist trading is and to a considerable degree must remain a matter of judgment, it begs the question to say that the investment position is acquired "through transactions made to maintain a fair and orderly market." Although many specialists testified that these positions were acquired through such transactions, two specialists whose long-term investment positions accounted for 22 percent of the total would only state that these positions were "usually acquired" in the ordinary course of business.

The NYSE's point 2 is of a somewhat different character from the others. Its rationale is that the segregation of inventory into longterm investment accounts has no effect on the specialist's market-making abilities since the stock must be made available to the market if necessary, or the specialist must be prepared to sell short against the long-term account. The question inevitably arises whether the first part of the argument is consistent with one of the requirements of section 1236 of the Internal Revenue Code, that the security not be held primarily for sale to customers in the ordinary course of business: it is difficult to see how securities can be held both for investment

300 Amex report, pp. 34-35.

and for servicing the market at one and the same time. The other point, that the specialist must be prepared alternatively to sell short in an amount equal to the investment account, is equally unsatisfactory. It may sometimes be necessary for a specialist to sell out his position and go short, to some reasonable extent, to service the market, but to preserve the long-term investment position the specialist is required to cover such a short position within 20 days," 301 whether or not the needs of the market indicate that he should cover. Again it would require means of surveillance more subtle than any which have been developed to probe the motivation of a specialist in such a situation.

The Saperstein Interpretation which permits positioning (even though temporary destabilizing transactions may occasionally result) presumably did not contemplate that specialists would be permitted to acquire and retain positions for long-term gains where there would be a tendency to further destabilize the market. Exactly this might happen if a specialist withheld his position in a time of rising prices in hope of a further increase.

There is another point with respect to these long-term accounts not mentioned in the Amex Report. In 1940, at the time of the NYSE's unsuccessful attempt, and again in 1949 in its successful endeavor, to have specialists exempted from the margin requirements of regulations T and U,302 the Exchanges strongly argued that the needs of the market made such an exemption a proper and wise one. In 1940 it argued that the exemption was necessary because declining markets could tie up "all or a substantial part of the capital available to many specialists." In 1949 it was urged by specialists that an exemption from regulations T and U would make available "such financing [that] would permit specialists to deal in their stock more frequently, enabling them to narrow the spread between bids and offers, and generally to improve the liquidity and continuity of the market." If, as the Exchange asserts, most specialists have acquired the positions carried in long-term investment accounts through the normal course of their business, they are utilizing credit made available by their exemption from current Federal Reserve Board requirements, not to maintain continuity and liquidity but to realize an investor's gain. This also raises a question of fairness. In 1949, the Director of the Trading and Exchanges Division opposed the proposed exemption on the ground that specialists "should not be given an advantage over members of the public generally"; i.e., an ability to speculate with less equity than the public.

Thus it seems clear that the segregation of specialty securities into long-term investment accounts is subject to strong possibilities of abuse without any corresponding public benefit or means of effective regulation, and in addition represents an unfair use of the specialist exemption from margin requirements. On both grounds the practice should be prohibited.3

303

301 Internal Revenue Code of 1954, sec. 1233 (e) (4). 302 See sec. 4.c, above.

303 Another area where the specialist dealer activities are biased by tax considerations is the method of costing their inventory. When specialists use the "last in, first out" method (LIFO) of inventory valuation it is to their benefit to have the same number of shares in inventory at the end of the year as they had at the beginning of the year. Specialists testified that they would purchase stock near the end of the year to be sure that they had the proper inventory position to get the tax benefit. Such purchasing would seem to be clearly inconsistent with a standard of affirmative market necessity for each specialist transaction.