and Exchange Commission). This letter is for information only. in original.]

[Emphasis

A. Examine with our lawyers what powers the Securities and Exchange Commission has to prevent our action and what recourse we have, if any. 4. Customers.-Inform customers in joint letter similar in form and content to the one of 1951.

This memorandum is written to provide a starting point for discussion among ourselves and with Carlisle. Proposed drafts of letters are attached.

The odd-lot differential has not been increased since 1951, and there has been no occasion to follow the "suggested procedure" outlined by Cobb. However, on February 20, 1958, representatives from the two major odd-lot firms and the presidents of the Midwest, Los Angeles, San Francisco, and Boston Stock Exchanges did attend a meeting described as a "purely exploratory examination of the possibility and the timing of lowering the breakpoint." The meeting was of a general nature and no specific action was agreed upon, but it was decided, in the words of Halsey's report, *** that if, as and when commissions are raised another meeting of the same group should be held to consider the situation as of then."

d. Services performed by the odd-lot dealers

Unlike the odd-lot differential which has been arrived at cooperatively, the services offered by the odd-lot firms do constitute a form of competition between them.

Mention has already been made of the extensive order service department maintained by each of the principal odd-lot firms, through which they compete for business. Competition here takes the form of supplying as much information as possible to meet requests of the commission firms, especially their heavy demand for last sale information.

Another competitive service is the liberal adjustment policy of the odd-lot firms,409 pursuant to which adjustments with commission firms are frequently made where the commission firm and not the odd-lot firm has made the error in the order. 410

The stock borrowing activities of the odd-lot firms are a third competitive service. Although the odd-lot firms assert that borrowing stock is necessary to enable them to meet their delivery commitments and to "make change," evidence suggests that competition in furnishing interest-free financing to their customers is at least an equally significant aspect of the practice. Thus, though the odd-lot firms claim that the borrowing results from pressure for prompt delivery, they opposed the establishment of a central depository which would have alleviated this problem. Furthermore, even after borrowing substantial quantities of stock, the odd-lot firms are responsible for a

409 The Midwest Stock Exchange minutes for October 1954 stated:

"The President reported to the Committee with regard to his recent visit to the odd-lot dealers of the New York Stock Exchange. He advised that New York odd-lot dealers break odd-lot transactions without exception upon the request of members. It was their opinion that the breaking of trades is good advertising, although in some cases it is expensive."

"Breaking" refers simply to canceling the transaction,

410 A partner of one of the odd-lot firms testified:

"On the basis of what we sent you in 1961, these are round figures, these are adjustments of over $100, the number [of errors] that the customers made was 1,200. The number that we made was 500, so that the majority were customer errors. Could correct that by saying they are not all errors. You see a tremendous amount, as I say, of money orders, but we couldn't accept the order that way. We did accept the order, but we accepted it on the number of shares, but it was adjusted later."

large number of fails-to-deliver. Moreover, while one of the three commission firms interviewed on this subject believed that borrowing was done to facilitate delivery, the other two explicitly discounted that explanation; one firm said that borrowing for that purpose would be too costly a practice.

The commission firms agreed that one would not choose between the odd-lot firms on the basis of their services, which one commission firm partner described as "exactly alike; like the soap you use a matter of personal preference." Except for a few small brokers, firms split their business between the two odd-lot houses equally, or, if unequally, the allocation rests on nonbusiness considerations such as favors, friendship, and family. The commission houses' switching is regular and integrated so that neither odd-lot firm will at any time be flooded or starved. However, Cobb did testify that DeCoppet & Doremus had obtained business by pointing out the advantages of lending stock. One of the small odd-lot dealers testified that though he did not engage in stock borrowing operations, he did not get complaints from customers about delivery; he borrowed only to meet actual needs and not "to do [the commission firms] a favor," and thus borrowed very infrequently and in very small amounts. Indeed, both firms acknowledge that stock is borrowed from member commission firms in direct proportion to the amount of business received from them.

Although the odd-lot firms use their services to compete, the chief competitive impact of such services lies in their deterrent effect upon firms which might otherwise enter the odd-lot business, and their effect on the business of the specialist odd-lot dealers on the New York Stock Exchange and the regional exchanges. All the services provided by the odd-lot firms entail considerable expense, and for order service and stock borrowing, a substantial capital investment or access to financing.

These services are only indirectly and partially provided for the public odd-lot customer, who, through the differential, bears their cost. Interest-free loans provided by the stock borrowing activities of the odd-lot firms result in no direct benefit to the public odd-lot customer. The liberal adjustment policy may on occasion benefit an individual public customer who places an erroneous order with the commission firm, but it is impossible to determine how frequently this occurs as compared to the frequency of errors made by members and employees of commission firms. Round-lot price information may benefit public odd-lot customers. However, the odd-lot houses widely advertise the availability of their order services to their commission firm customers, and they service such customers in all cases without regard to whether the service is directed toward an odd-lot or roundlot transaction. The fact that odd-lot transactions account for half of total public transactions indicates that the odd-lot customer receives only a portion of the services provided by the order service departments.

With occasional exceptions, the commission firms which benefit by but do not pay for the services provided by the odd-lot firms have not

4 As of June 1962, Carlisle & Jacquelin had $10 million worth of fails-to-deliver; the May market break meant, however, that conditions were abnormal. Normally, fails-todeliver run between $2 million and $4 million for DeCoppett and around $1 million for Carlisle. On fails-to-deliver as a general matter, see ch. III.E.

been concerned about their cost. Indeed, as seen above,412 in 1938 the seven commission firms which appeared before the Committee on Floor Procedure unanimously urged the committee to prohibit the charging of a smaller differential where services were not provided.

The New York Stock Exchange apparently has never taken a position in regard to the services furnished by the odd-lot houses, except in 1940 when those services competed with the Exchange's own quotation service and consequently threatened to impinge on Exchange revenues, and the Committee on Member Firms ruled that the odd-lot houses were to cease their quotation service.

e. Methods and problems of handling round-lot offsets

As already noted, the odd-lot firms offset their positions acquired in the course of taking or supplying stock for odd-lot executions by effecting round-lot transactions on the floor of the Exchange. During 1961, these offsetting round-lot purchases and sales constituted 3 percent of total round-lot purchases and sales on the Exchange and 12.4 percent of members' round-lot purchases and sales for their own accounts.413 The gross income of the odd-lot firms has remained fairly constant at about 90 percent of the total amount realized from the differential, which indicates that round-lot trading results in a loss to the odd-lot firms.414

In earlier years it was the policy of the odd-lot firms to maintain large long or short positions--sometimes amounting to 3,000 or more shares-but they now try to keep positions as small as possible. Nevertheless, positions in individual stocks frequently exceed 1,000 shares and individual round-lot transactions in lots of several hundred shares are common. For example, both odd-lot firms had long positions in excess of 1,000 shares of Sperry Rand Corp. on March 23, 1961, a situation which gave rise to a round-lot sale of 500 shares by DeCoppett & Doremus, and two 300-share round-lot sales and a 700-share round-lot sale by Carlisle & Jacquelin on that date. At various times in January 1961, DeCoppet & Doremus had a short position of up to 1,776 shares of National Theaters and 1,000 shares of Goebel Brewing, and a long position of up to 4,264 shares of Atlas Corp. Both of the odd-lot firms have established position limits for individual securities, but one of the firms has relaxed its policy within the last year or two. Moreover, associate brokers do not always follow a trading policy geared toward maintaining an even position, as illustrated by the testimony of one of them:

* I went on my own to play these things. Where I thought that they should be played closer I played them closer, and if I thought that we wanted to extend, if the market acted exceptionally well, and I was long on some stock, and they were still selling us more, I would get a partner and say "Here, Bill, this acts as though it may want to go higher. What is your wish?" He may go along with me or he may say no. That is just the picture there.

Any gains or losses resulting from trading activities accrue to the odd-lot firms rather than the brokers, but the firms keep records of the trading gains and losses of individual brokers and may use such rec

412 See sec. 3.b, above.

413 See table VI-51 for the relation of offsetting round-lot purchases and sales by odd-lot dealers on the New York Stock Exchange to total round-lot purchases and sales during the period 1936-61.

414 The 90-percent figure was arrived at by comparing the two firms' actual gross income with their "potential" gross income, a dollar amount calculated from the number of shares traded at the one-quarter differential and the number traded at the one-eighth differential.

ords as the basis for assigning stocks to them. Unlike the usual floor brokerage situation, the associate broker ordinarily has wide discretion as to whether, when, and how much to offset, within the established position limits. Thus an associate broker's interest in offsetting is not limited to earning a commission but also involves maximizing profits and minimizing losses. Accordingly, it appears that some of the elements of floor trading are present in some degree in the roundlot activities of the associate brokers.

Like the floor trader, the associate broker's round-lot trading has the advantage of continuous, intimate, and immediate contact with the stocks in which he is interested. This was graphically described in 1956 by DeCoppet & Doremus in the course of arguing for the necessity of maintaining associate brokers on the floor: 415

Under our present system of trading the broker develops an intangible quality called a "feel of the market." At the post his eyes and ears become attuned to the sights and sound of the marketplace. Here he picks up information regarding the stocks he is trading in. Here he can act with spilt-second speed and reflect in his own trading the action of the tape. Here he makes friends with the specialists and other brokers and traders who impart to him their combined thoughts and advice and who are helpful to him in the execution of his round-lot trades made for the purpose of offsetting his positions. [If] our broker would no longer be able to remain at the place of auction * * * [that] would, in our opinion, cost our firm many hundreds of thousands of dollars in the effectiveness of his round-lot trading. When you consider that last year our firm traded 20 million shares in round-lots, the importance of this factor becomes immediately apparent. Even the minimum variation of one-eighth poorer on these transactions would result in a loss of $2,500,000.

Because of the way in which the Exchange floor is physically constructed, an associate broker is assigned stocks which are traded at a particular post. This coincides with the manner in which stocks are allocated to specialists, with the result that an individual odd-lot broker will have the "book" in many of the same stocks as an individual specialist, and various mutual accommodations develop. Frequently the odd-lot brokers hold back offsets to accommodate the specialists,116 or turnover orders to the specialist. And the specialist

415 See sec. 3.f, below, on modernization of facilities.

416 An associate broker testified:

"Q. What I mean is, if you see that a specialist is having to absorb a good deal of stock would you, as an accommodation to the specialist, hold back stock that you might otherwise have sold?

"A. Yes, we have done that on occasions too, on many occasions.

"Q. Are you generally aware of the specialist book or situation? "A. No, we are not permitted access to the specialist books.

"Q. So neither of you ever knows what the other's situation is? "A. That is true.

"Q. But on the other hand, in order for you to accommodate the specialist in the kind of situation which we were just discussing, wouldn't the specialist tell you what his situation is?

"A. Then he would have opened up and said, well, here, for the love of something or other, I am getting murdered here.

"I will say, all right. So am I, but we will step aside, but remember that I need stock, you need stock.

"Or we have to sell stock or you have to sell stock. "Let's work together on it and let it be for the best.

"Q. In that situation, he is really showing you his book.

"A. He is not showing me his book actually. He is telling me that he is over long or over short and he has no book.

Just his own trading position?

"Q. What is it that he shows you? "A. It is just what he tells me. He just tells me he doesn't show me anything. He said, 'Oh, please, I am up to here in this,' or 'I am over short' or something like that, and, there is no offer in the book. He could tell me that—which has happened on many occasions."

will frequently stop stock 17 for the associate broker, and on occasion give up brokerage commissions to the associate broker on orders executed by the specialist for the associate broker.

In less active stocks, especially, a number of odd-lot orders may accumulate between round-lot transactions. An associate broker who has accumulated orders on one side in excess of 100 shares might find it profitable for his firm to buy or sell a round lot at a price less favorable than he otherwise might obtain, to "trigger" execution of the oddlot buy orders to be met from his firm's account. For example, if he has orders to buy 345 shares in odd lots, a high triggering price is to his interest, though not to his customers'. Rather than waiting for a round-lot transaction that may occur between the bid and asked, he could himself buy 100 shares at the asked, then sell the 345 shares at that price (plus the differential). To prevent this, the odd-lot firms have ruled that whenever the broker gives a round-lot order and has on the same side of his books a greater number of shares to be triggered by that round lot, he must give the round-lot order to the specialist rather than buying or selling for his firm.418 (Under the rules of the Exchange, the specialist is obligated to execute the round lot at the best price obtainable.) Thus the transaction that triggers the odd-lot customers' orders will be executed by a party presumably in no conflict of interest with those customers. However, if the specialist wants to meet the round-lot order from his own account, he and the odd-lot broker have a mutual interest that conflicts with that of the odd-lot customers' buy orders: for example, the specialist's interest is to sell the round lot high, the broker's, to have a high triggering price. In such cases, the specialist must advise the broker that he is dealing for himself, and the approval of a governor must be secured.419

The Exchange, taking the position that the round-lot trading of the odd-lot firms is not analogous to floor trading, has provided no special rules for such round-lot trading, and does not receive reports of the round-lot transactions or exercise direct supervision of any of the matters discussed above.

f. Modernization of facilities

In order to study and improve its floor operations, the NYSE in early 1956 retained Ebasco Services, Inc., an engineering consultant firm. At the same time the Exchange appointed a special committee of members (the "Piper Committee"), on which representatives of both odd-lot firms served, to work with Ebasco. Ebasco's studies were divided between the round-lot market and the odd-lot market. The history of that segment of the Ebasco survey dealing with odd lots is treated here.

Ebasco began work in the early part of 1956 by studying the existing methods of operation of the odd-lot dealers. This study entailed numerous meetings with members of the odd-lot firms as well as

417 See pt. D.7.c, above

418 "Odd-Lot Trading Rules of the Odd-Lot Dealers on the New York Stock Exchange," p. 52 (1951).

410 Id. at 53. When asked about this problem of offsetting round-lot transactions, Exchange Vice President Willard K. Vanderbeck, in charge of the floor department and responsible for oversight of specialists even if not of odd-lot brokers, said: "I have from time to time had occasion to read the booklets which prescribe the methods that are used by the odd-lot firms in executing odd-lot orders. As to this particular part of it. I can't honestly say that I have been conscious of that particular part of their own regulations." He also said, speaking generally, "We have no particular system for observing or enforcing any rules as we have none concerning the activities of odd-lot dealers."