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Q. When you have the specialist willing to make a sizable bid * * * does the necessity to call on the trader then pass out of the picture?

A. Yes.

Q. So in essence, the trader in these cases serves what one might call an auxiliary specialist role in special situations?

A. Yes.

This floor broker noted another condition that has to prevail before he would solicit floor trader assistance:

First of all, the stock has got to be a stock that is an active stock. Quite obviously, when I ask traders to help me out, I want them to make some money out of it.

On other occasions the assistance of the floor trader will be solicited by the specialist in the stock involved. Most of the specialists testified that participation in cleaning up large blocks is one of the specialist's obligations, but that on occasion floor trader assistance is necessary. Ordinarily the floor trader will participate only in the more active stocks, purchasing large blocks at a discount and then feeding the stock back into the market over a period of time. Usually a block purchase is followed by a flurry of buying, during which the floor trader may dispose of part of the block. Thus, one of the most prominent floor traders testified:

That really means after the block is purchased, approximately three-quarters of a point below the market, let's say, there is a flurry of activity, brokers run after the cleanup and try to buy.

When it [the block] comes on the tape, it could be interpreted as a cleanup, as the end of a large selling order, and individuals who might tend to favor that stock anyhow, will then feel, I want to buy it, it looks like the worst of the selling is over, or something like that. They will come in and buy.

One specialist testified that he tried to avoid calling on floor traders because of this trading pattern following such transactions:

Q. You said you usually don't ask the assistance of traders.

A. We usually don't need them.

Q. Is it because you feel if they can make a profit you can make a profit?

A. No, it is here is what I usually do and why we don't usually take much stock. I feel usually that if there is an order around that the seller is going to sell it and sell it better than if I make the bid for it-he will sell it at a better price than we make the bid for it.

So I don't see any reason to call in traders for often it causes unwarranted activity in a stock and I would just as soon avoid that.

Unquestionably the participation of these few well-capitalized floor traders in block transactions relieves somewhat the financial burden of the specialist. But if, as appears to be the case, the major need for floor trader participation stems from specialists' capital problems, a more direct approach to the situation is called for, such as increasing specialist capital requirements. In any event, to the extent that the floor trader functions as a quasi-specialist in such cases, he should be required to perform subject to rules similar to those governing specialist trading.

6. REGULATION OF FLOOR TRADING

One of the last amendments made by the 73d Congress to H.R. 8720 the bill that was to become the Securities Exchange Act of 1934 was an amendment deleting a provision prohibiting floor trading. Prior to amendment the bill contained the following mandatory provision:

The Commission shall prescribe rules and regulations (1) to prevent floor trading by members of national securities exchanges, directly or indirectly for their own account or for discretionary accounts, and (2) to prevent such excessive trading on the exchange, but off the floor by members, directly or indirectly, for their own accounts, as the Commission may deem detrimental to the maintenance of a fair and orderly market. [Emphasis added.]

Shortly before floor debate on the bill, however, a committee amendment substituted a discretionary power to abolish or regulate floor trading:

The Commission shall prescribe such rules and regulations as it deems necessary or appropriate in the public interest or for the protection of investors (1) to regulate or prevent floor trading by members *** (etc.). [Emphasis added.]

The reasons for this amendment were stated by Congressman Lea on the floor:

When we came to the question of the broker and the dealer, a good deal of controversy was involved as to what control should be established; whether or not these positions should be separated; whether or not we would permit a man to act in the capacity of both broker and dealer, whether or not we should permit floor trading or permit specialists to be on the floor; and other problems. In attempting to deal with these questions I am candid to admit that the committee proposed to confer a large regulatory power on the regulatory Commission.

There were two reasons for this: the first was that we recognized we are not experts and tried to act with a caution becoming our inexperience. Where in doubt as to what should be done, we thought it better to resolve the doubt in favor of maintaining the present business practices than to establish some fixed rule that might prove unfortunate. In the second place, where we gave the regulatory Commission the power, it would be a flexible power. If the Commission finds a mistake has been made, it can readily change its rules to more favorable ones and thus accomplish the purposes of Congress."

471

The committee amendment became section 11(a) of the act, and in section 11 (c) Congress directed the Commission "to make a study of the feasibility and advisability of the complete segregation of the functions of dealer and broker, and to report the results of its study and its recommendations to the Congress on or before January 3, 1936." This report ("Segregation Report") is discussed below. Although the Commission has promulgated no floor trading regulations under the power granted by section 11(a), it has on occasion encouraged the adoption of certain rules by the various exchanges. a. The "excessive trading" rule

Prior to the completion of the Segregation Report, the Commission requested every national securities exchange to adopt 16 rules formulated by the Commission. These rules dealt with trading activities in joint accounts, specialist trading, and various other aspects of the exchange mechanism. One rule, the first, was applicable to floor trading generally, although it was not limited in application to floor trading. Known as the "excessive trading" rule it provided that "No member *** shall effect on the exchange purchases or sales for any account in which such member *** is directly or indirectly interested, which purchases or sales are excessive in view of the financial resources of such member *** or in view of the market for such security." This rule, in essentially the same terms, is now rule 3 of the American Stock Exchange and rule 435(1) of the New York Stock Exchange.

471 78 Congressional Record 7862 (1934).

Although the Segregation Report noted that the competitive advantage of members trading on the floor had been "in some measure diminished" by this rule,472 the 1945 Report of the Division of Trading and Exchanges, made public by the Commission, said of this and of other rules subsequently adopted by the exchanges, that "* ** [a] review of the exchanges' enforcement of these rules over the past 10 years demonstrates that neither these nor any similar rules administered by the exchanges serve to restrain floor trading in the slightest measurable degree." 473

The Segregation Report recommended that the following steps be taken with respect to floor trading:

The complete suppression of floor trading does not, for the time being, appear to be demanded. But the immediate aim should be the restriction of floor trading as a whole in stocks. The suggested means for the accomplishment of this end

are:

(1) The requirement that commitments by all persons trading on the floor for their own accounts should be "fully margined" at all times. Such a requirement, by eliminating the "shoestring" trader and by discouraging excessive trading, would serve to reduce floor trading, particularly of the unduly speculative type.

(2) Functional segregation of all members on the floor of the exchange, with the exception of the specialist in stocks in which he specializes. Under such a requirement floor traders could not act as brokers, and floor brokers and commission brokers could not, while on the floor, initiate orders for their own account or the account of their firms. From this requirement some recasting of the existing alignment among commission brokers, floor brokers, and floor traders is to be expected, with some shift in the direction of the floor trader. But, especially if some control over that movement should be exercised, a substantial reduction in the aggregate of floor trading would take place.

This requirement, apart from its effect upon floor trading as a whole, possesses the virtue implicit in segregation; that is, insistence upon a singleness of allegiance on the part of the broker on the floor. As such, it has the added significance of tending to insure the better performance of the broker's fiduciary obligations to his client.474

The segregation recommendation of the report was not carried out: "Instead, the Commission adopted a policy of watchfulness, investigating market breaks and rises in order to determine, among other things, what role floor trading played in the movement." 475 The NYSE did adopt a rule, at the Commission's request, relating to trading on margin.

b. The "daylight margin" rule

The so-called "daylight margin" or "daylight trading" rule, adopted in 1937, required each member to have on deposit each night an amount equal to the margin required to carry the maximum position assumed during the day, even if such position was quickly abandoned. Studies conducted by the Commission in 1944 revealed that floor trading volume as a percentage of twice total volume on the NYSE dropped from 6.8 percent in 1936 to 4.1 percent, in 1942, and recovered to 5.3 percent in 1944. The 1945 report, based on these studies, therefore concluded that "*** the 'daylight trading' rule's restrictive effects on floor trading volume were not particularly great." 476 The rule was rescinded by the exchange as of September 21, 1953.

472 Segregation Report at p. 16.

473 1945 report at p. 43.

474 Segregation Report at p. 110.

475 1945 report at p. 4.

476 Id. at p. 12, footnote 32.

c. The attempt to abolish floor trading

The major portion of the 1945 report by the Division of Trading and Exchanges was addressed to the issues of the floor trader and (1) his competitive advantage, (2) his conflict of interest if a broker, and (3) his effect on price movements. The findings of the report were vigorously stated on each issue:

(1) Floor traders "beyond a doubt" enjoy "formidable" trading advantages over the general public."

(2) "Floor trading cannot fail to divert and distract brokers from their duties to the public. Nor does the floor trader help in the filling of public orders. By and large, floor traders compete with the public in their buying and selling. When public demand exceeds public supply at a given price, the floor trader is likely to step in to increase the disequalibrium; he is more likely to augment the demand and compete with the public for the available supply than to do the opposite." 478

(3) "Floor trading engenders excessive trading and excessive fluctuations in price. The floor trader typically 'trades with the trend.' If there are times when he tends to reestablish equilibrium in prices, such trading is very likely the aftermath of a course of action which threw prices off balance in the first instance. Cases other than these may sometimes exist when floor trading acts as a stabilizing influence but, if so, the voluminous data which we have accumulated shows that they are certainly not common, let alone typical."

99 479

The report then considered the following possible approaches to the problems: (1) segregation of broker-dealer functions and the registration of floor traders, (2) restraint of floor trading by either flexible or inflexible rules, and (3) prohibition of floor trading.

480

The first alternative was dismissed as merely postponing "the solution of the most pressing question of all *** the effects of floor trading on market prices." so Control of floor trading by flexible rules was also rejected, on the ground that enforcement of existing rules had proved ineffective:

For all practical purposes *** [this method] is already in effect and has been for many years. For a long time, the exchanges have had adequate power under existing rules to restrain undesirable floor trading. As we have already noted, rule 613 of the board of governors of the New York Stock Exchange prohibits transactions by a member which are excessive "in view of the financial resources of such member" or "in view of the market for such security." Section 4 of article XIV of the New York Stock Echange constitution provides for the suspension or expulsion of a member guilty of making any purchases or sales for the purpose of upsetting the equilibrium of the market and bringing about a condition of demoralization. Section 10 of the same article provides for the punishment of a member guilty of any act which may be detrimental to the welfare of the Exchange. Exchange officials always have been in a position to enforce these rules since they always have exercised a degree of surveillance over their respective floors and could not fail to have observed the incursions of floor traders. But a review of the exchanges' enforcement of these rules over the past 10 years demonstrates that neither these nor any similar rules administered by the exchanges serve to restrain floor trading in the slightest measurable degree.481

Control of floor trading by inflexible rules was also rejected on the ground that avoidance by floor traders would be easy:

The Commission's one effort in this direction-the short-selling rulehas met with limited success at best, insofar as floor traders are concerned, for it has not adequately prevented heavy short selling from this source at critical junctures in the market. It did not prevent floor traders on the New York Stock

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Exchange, for example, from selling 15,100 shares short in the week ended February 15, 1941, as the Dow Jones Industrial Average dropped 6 points, nor from selling 2,600 shares short in U.S. Steel common stock, on December 8, 1941, as the stock fell 15% points. The fact is that the floor trader's proximity to the marketplace affords him frequent enough opportunities so that he can legally avoid much of the impact of restraints of this kind, however restrictive they may appear to be.

482

With these alternatives eliminated, prohibition of floor trading was recommended as the only effective remedy of floor-trading abuses, and a rule was proposed-designated X-11A1-1-to effect this abolition. The advantages of such prohibition were noted as (1) removing the competitive cost advantage of on-floor trading, (2) equalizing all traders' access to market developments, (3) elimination of the trader's privilege of representing himself in transactions, thus placing him on a par with off-floor traders, and (4) circumscription of the opportunity for concerted action (intentional or otherwise) among floor traders.483

Release of the 1945 report in January set off an intensive series of conferences and correspondence between the Commission, the two New York exchanges and others interested in the problem. It was at this time that the NYSE submitted the Cole-Hoisington report, referred to above, to the Commission. The conclusions and recommendations of that report were as follows:

It is therefore our conclusion that if floor trading is to be judged solely on the basis of the manner in which it has affected liquidity, continuity and orderliness in trading, then the record justifies a continuation of this practice. From an objective point of view, the evidence does not seem to us to be heavily one-sided in respect to price stability, although insofar as price continuity, and, particularly, liquidity are concerned, it seems obvious to us that floor trading makes a definite and unmistakable contribution.

A certain proportion of the traders' activities, as discussed above, tends to be directly nonstabilizing and therefore presumably initiates or accentuates price trends; the indirect effect on price stability of a large number of their transactions has yet to be satisfactorily measured, and, in certain specific instances presented in the Trading and Exchange Division's report of January 15, 1945, some of the effects of floor trader activity do not appear to have been in the public interest. It would therefore seem that every effort should be made to explore the possibilities of modifying floor trading practices as they now exist to the end that specific deleterious effects may be eliminated and, on an overall basis, the net favorable influence of floor trading may represent a larger proportion of all floor trading than currently seems to be the case.

As a preliminary to any discussions of the general directions in which such modifications in floor trading practices might be made, the question arises as to why floor traders as a class, or floor trading as a special type of activity, should be subject to specific regulations or restrictions to which the public generally, and all other trading, are not subject. The logical reason for restrictions or regulations applicable to floor traders is that these individuals possess certain prerogatives and enjoy certain advantages not held by the public at large. If a continuation of these prerogatives and advantages is to be justified, then it seems to us that such continuation must rest upon these premises:

1. The salutory effects of floor trading in terms of public interest are demonstrably greater than their cost; and

2. Floor trading activity could not be conducted at all if it did not enjoy these advantages.

The opinion has been previously expressed that the effects of floor trading as it is now conducted are on the whole salutory, but that the margin is rather moderate. It therefore seems proper to examine the nature and extent of the special advantages enjoyed by floor traders, and to attempt to assess their cost in terms

482 Id. at p. 44.

483 Ibid.

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