One specialist thought he knew why institutions may give orders to specialists:

Q. It doesn't make any difference to the institutional investor, as far as commissions are concerned? You have *** to charge them a full commission?

A. They tie your hands up. If you know that they have something to do, we can't do it against them. If they have a buy order, we wouldn't buy it. We can't. As soon as they open up to us, if they say they have some stock to buy, they are going to put in 10,000 shares through us or through some other firm, we wouldn't buy a position other than just to make a market in the thing. Q. You mean, it is the way of locking you in, by giving you the order? A. It does. I am sure they think of that.

The Special Study did not attempt to determine whether a specialist's personal customers received preferential price treatment in any of the foregoing kinds of situations. The judgments involved in the specialist's role are often too subtle to permit determining whether a particular customer has been preferred or discriminated against, without complete market data such as the state of the specialist's book at the relevant times. However, some of the institutions quoted above seemed to believe that dealing directly with a specialist does give them "better" executions. In such a case, the better price received by the specialist's own customer may be at the expense of another customer whose order was forwarded to the specialist by another broker.354

Where a specialist is receiving reciprocal business through the efforts of an issuer, it is equally difficult to determine whether better markets are made in that issuer's stock than in comparable issues.

The two most recent significant disciplinary actions involving NYSE specialists resulted from orders given specialists in their specialty stocks by public customers. In one case, decided by the Exchange on January 2, 1963, the customer involved was an official and director of the issuer. The specialist, in defending his conduct, noted:

It is my understanding that it is not uncommon for employees and officers of the companies whose stock is listed on the New York Stock Exchange to carry their own accounts with specialists, as in many cases they know no other broker. My firm has done this in connection with other companies whose stock we handle, and I know of no rule or regulation against such a practice.

The more serious cases in recent years involving Amex specialists also concerned investors dealing directly with the specialist."

355

The NYSE takes the position that "it is a perfectly proper practice" for specialists to carry, service, or introduce public accounts so long as the practice "is not abused." Apparently in recognition of the possibility of abuse, shortly after publication of the Amex report, the NYSE instituted a rule 356 requiring specialists periodically to report all transactions for public customers in their specialty stocks.

The specialists interviewed felt that their public customer business has a very small place in their total business. One experienced specialist testified as follows:

Q. Assume a rule was passed which said specialists could no longer have public customers, what would be the effect on your business of such a rule?

A. It would be rather insignificant as my transactions take place today but it would close the avenue for possible development of public business should I at some later date desire to enter into it actively.

354 This is not a matter of speculation. As discussed above, in many instances, especially in inactive stocks, the specialist actually "sets" prices in situations which may be quite complex and may call for a good deal of judgment in arriving at "fair" prices. See sec. 6.j. above.

355 Amex report, pp. 29-32.

350 NYSE rule 111; Amex rule 190 (c) contains similar provisions.

This answer applies even to those who now have a public business, since that business has no connection with the function of the specialist. As pointed out above, the specialist relies on the flow of orders in the market and the book to offset his positions; he does not use his own retail customers as an outlet. There would be no harmful impact on the functioning of the specialist system on the Exchange if specialists and their firms could not deal directly with the public. On the other hand, the practice involves the basic difficulty that the specialist handles orders for two kinds of customers-those with whom he or his firm have direct contact, and the anonymous mass of investors whose orders are forwarded to him in the normal course of business. The potential for discrimination and difficulties of surveillance are so great that the practice should not be permitted to continue.357 e. Contacts with corporate officials

Many of the problems discussed above involve possibilities of the specialist's unfairly preferring himself or particular customers through his crucial position in the market. A direct possibility of preference to the specialist himself or to favored customers arises when he has access to corporate information denied to the general public. Such information might be advance knowledge of increased earnings, stock splits, mergers, etc. In this connection, the Exchange has a rule which prohibits specialists from being directors of companies in whose stock they specialize.358 Furthermore, the Exchange expresses a policy 359 prohibiting specialists from acquiring "inside

information.

Several specialists have testified that inside information is of no benefit to them because they service the market as the needs arise.360 One specialist indicated that advance corporate information would be helpful to him in servicing the market.361 Another specialist testified that most contacts with corporate officials are of little use because corporate officials are always optimistic:

Q. On the basis of [a visit to the company's plant], would your trading in the stock be influenced?

A. I wouldn't think so. One of our partners just went out to [a company] and came back and said that they were very bullish, and he was very bullish, and, the next day, I think we sold 10,000 shares short, because that is the time you want to get out, when everybody else is bullish.

Some specialists said that they can obtain all the information they need from the financial press, but others felt that they cannot get enough information from other published sources and should visit the company and its officials.362

857 This applies only to the two major exchanges in New York. The specialist business on the regional exchanges is different for various reasons, including limited volume, which makes separate treatment appropriate for those exchanges.

358 Rule 460.

359 NYSE Company Manual A-22.

360 Compare the attitudes of primary market makers in the over-the-counter markets, discussed in ch. VII.C.

381 The floor department records disclose that one specialist had been critical of a corporate official for failing to inform him of a contemplated stock split. The file in this matter reflects that the chairman of the board told the specialist that he was to treat officials of companies with courtesy when they visit the floor. The file contains no indication that the specialist was cautioned regarding his attempt to obtain inside information. Vanderbeck testified that the specialist was told orally that his attempt to get such information from a company official was improper, and further testified that he did not know of any investigation to determine whether the specialist had attempted to acquire or had acquired similar information from other companies.

203 One specialist testified:

"Q. How much do you believe that a specialist should know about the company whose stock he trades in?

"A. I think he ought to go to see that the buildings are there. We happen to have been specialists for McKesson Robbins at one time."

The Exchange has a program of encouraging specialists to maintain liaison with the officials of companies in whose stocks they are registered. Its view is that a specialist must maintain such liaison in order to give the company and its stockholders a fair and orderly market.363 The Exchange also believes that company officials should be kept informed of unusual market problems and should be free to call the specialist for information if a question arises about the market in the stock.364 Pursuant to this policy the floor department has organized a specialist corporation liaison unit designed to foster such contacts between specialist and issuer. A specialist is expected to contact officials of the companies in whose securities he is registered at least once a year, and is required to report to the Exchange on the number of his contacts. The Exchange staff periodically asks specialists whether or not they have been maintaining the prescribed relationships with their companies, and also attempts to bring the specialist and corporate officials together at the Exchange whenever this is possible.

Various specialists, including two former chairmen, testified that they believed this program performed principally a public relations function on behalf of the Exchange and its specialists. They emphasized that listed companies are "clients" of the Exchange and that the Exchange should attempt to keep them informed. The following excerpt from a staff memorandum is indicative of the floor department's views in this respect:

I told [the specialist] that he should get together with [the president of an issuer] and establish a friendly relationship with him. I emphasized that this company is one of the Exchange's customers, and that it is the responsibility of the specialist to conduct himself in such a way as to please and satisfy the officials of the company-at the same time explaining any market problems and the specialist function.

Although the floor department administers the specialist corporate liaison program, the "Department of Stock List" has principal responsibility in the area of Exchange-issuer relationships, and has an elaborate system for maintaining contact between the Exchange and listed companies. Listing representatives from this department visit issuers periodically to discuss common problems, and issuers are encouraged to confide in the listing representative assigned to their companies about corporate developments. Phillip West, vice president of this department, testified that his department by itself could adequately handle the usual problems an issuer might have with respect to the trading of its stock; e.g., whether a stock should be split. However, Vanderbeck, the vice president in charge of the floor department, emphasized that there were some market problems that only specialists were qualified to discuss with corporate officials.385

In administering the specialist corporate liaison program, the Exchange sets standards concerning the scope of what specialists are permitted to discuss with corporate officials. Generally, specialists are not supposed to receive inside information. Company officials may discuss matters with the specialist much as they would with "bankers, stockholders, security analysts, or anyone having a legitimate

883 NYSE Company Manual A-22.

204 Ibid.

305 This view seems at odds with the testimony of the two former chairmen who felt that contacts between specialists and corporate officials serve primarily a public relations function.

interest in the company, "366 except, of course, that a specialist may have his discussion at a higher level than would an ordinary stockholder. The testimony of Phillip West points up the latter difference:

To put it another way, some companies are relatively large and have hundreds of thousands of stockholders. They set up a division that deals with stockholders for the reason that the president of the company just would not have time to talk to every stockholder if he should raise a question, or to sit down with him for 2 hours every day. On the other side of the picture, as far as the specialist discussing something with the president of the company because the stock was listed on the Exchange, I think that a specialist would discuss with the president, whereas the 10-share stockholder might discuss it with the stockholder relations department, or something like that, but they should be equally satisfied.

The Exchange's program appears unrealistic. It brings together individuals each of whom may have confidential information of value to the other on the one side corporate information and on the other technical information concerning the book and possible short-range price movements and yet it forbids the exchange of such information. Various situations coming to the attention of the Special Study illustrate the difficulties presented.

In a period of several weeks after a "liaison" trip to the Universal Leaf Tobacco plant, various personal friends and relatives of the specialist purchased 4,400 shares of the stock through his firm; on 1 day 1,400 shares were purchased for such customers this was 58 percent of the reported volume. The stock was then selling in the middle 30's. The specialist testified that he mentioned the stock to friends as one he was buying for himself although he denied having access to inside information. The stock rose as high as 5534 during 1961, which he attributed to higher earnings and the recommendations of certain brokerage houses. Although it is not possible to state whether the specialist did have confidential information in this situation, such trading by his firm's public customers creates substantial questions as to whether the information acquired by the specialist was readily available to the public in general.

In the case of two listed companies, it appears that the specialists were advised by the company official of merger possibilities before they were publicly announced. In another case a leading specialist testified that in a visit to the floor by the largest stockholder of a company in which he specialized, the stockholder and the specialist discussed the splitting of that company's stock. The stock was actually split 6 to 8 months later, although the specialist stated this conversation had no effect on his trading 367 Again, although there may not have been any impropriety on the part of the specialists in any of these situations, they illustrate the problems involved in encouraging contacts between specialist and issuer but prohibiting the exchange of information.

The Amex report illustrates that relationships between specialists and issuers were crucial factors in the problems involving Amex specialists. Indeed, two of the three major disciplinary cases in the past several years involving NYSE specialists concerned corporate insiders in one way or another.368 In one of these cases the specialist had ac

366 NYSE Company Manual A-22.

367 The Exchange considers it improper for an issuer to give advance information about stock splits. NYSE Company Manual A-22.

388 Problems involving the corporate insider public customer are often linked in these

cases.

quired options from a corporate official, and in the second, various questionable trading activity took place in accounts introduced by a director through the specialist.369 It is perhaps ironic that the specialist in the latter case urged this in his defense:

It has been my understanding that it is the policy of the New York Stock Exchange to encourage a close relationship between the specialist or members of the specialist firm and the officers of the companies whose stock they make markets in. I recall a few occasions when I was requested by my floor partners to fill out questionnaire cards of the Exchange indicating which of our companies we had been in contact with, what the names and titles of the officers were, and when did we last visit them. As a result of this, my firm encouraged me to become more closely acquainted with the officers of those firms in whose stock we specialized.

Accordingly, when the director involved], whom I had met on several occasions and who had met with my father and with various officials of the Exchange, introduced these accounts *** whom I identified either as employees of the issuer] or of his accounting firm, I felt that a proper introduction had been made. * * *

In view of the Exchange's strong belief, which the Special Study shares, that specialists should not receive "inside" corporate information, encouraging contacts between issuers and specialists would not seem to be an appropriate or necessary way to maintain liaison with listed companies.

f. The need for increased surveillance

In the area of the conflicts of interest which arise from the specialist's unique role as both broker and market maker, the Exchange's regulatory and surveillance program has been inadequate. Until recently, almost its entire effort has been directed to expanding and regulating the dealer function without regard to the fact that high level of specialist dealer activity more often puts the specialists in situations where his customers' interests conflict with his own. There was no routine procedure to disclose conflict-of-interest problems and few standards governing specialists' fiduciary conduct. With respect to the latter, the Exchange has been content with the technical auction market rules, such as the "crossing" rule and the rule prohibiting direct competition at the same price between a member and his customer. Even when possible problems of conflicts have been discovered, the Exchange, with limited exceptions, has not enforced high standards in the handling of the cases. This is exemplified in two of the cases discussed in the text. In the instance where it appeared that the specialist gave preferential treatment to certain orders over others and in the case where the specialist deliberately lowered the price of the stock to touch off his customer's stop-loss order, the Exchange's investigation of the cases turned on poor market-making activities rather than conflict of interest and no disciplinary action was taken against the specialists.

The point is further illustrated by the length of time which passed before the Exchange discovered that many specialists had ignored the 1952 ruling against not-held orders, with the attendant fiduciary problems caused by such orders. The rule against the acquisition of inside information has also had only casual enforcement. When such problems have been uncovered, the Exchange on one occasion was more concerned with discourtesy to a corporate official and in other cases

369 In January 1963, the specialist was fined $5,000 for violating the "know your customer" rule (rule 405).