broker-dealer and relates these factors to those affecting what he pays for an execution. A succeeding section considers the NASD-sponsored retail quotations system, which is now the primary source of information for a public customer (other than direct inquiries to a broker-dealer) concerning the trading markets for over-the-counter securities, and the role of the NASD markup policy and of Commission regulation in protecting investors in over-the-counter markets.

2. MANNER OF EXECUTION

a. Capacity Agent or principal

When a public customer purchases or sells securities over the counter, his broker-dealer may act either as agent as as principal. Where a firm acts as agent (or broker) for its customer, it does not take title to a particular security and it charges a commission for executing the transaction, the amount of which is revealed to the customer on his confirmation.196 When a firm acts as principal (or dealer), it buys from and sells to the customer for its own account and the customer pays or receives a net price. The customer is not advised of the cost to the firm of securities sold to him or of the current inside market price for the security.

A firm will act as principal when it is selling securities to public customers from an inventory position. In this case, the customer will usually pay the dealer's inside offer plus an undisclosed "markup." 197 On the other hand, a customer may purchase the security in a principal transaction from a broker-dealer with no inventory position. If the broker-dealer does not go short, it will purchase the security from a wholesale dealer after it receives the customer's order and not confirm the transaction to the customer until the security is purchased. In such a situation the broker-dealer usually buys the security at the market maker's inside offer and then resells it to the customer on a principal basis at a "markup" over its cost. This kind of principal transaction has been called a "riskless" transaction since the risks of ownership are absent.

It is important to recognize the difference between a broker-dealer executing as principal in a riskless transaction and the market maker who also acts as a principal. While both may execute on a principal basis, the function of the former is limited to execution of the order, and in essence performing the function of a broker for which his undisclosed markup is a service charge. The market maker, on the other hand, in addition to executing the transaction, provides marketability by assuming the risk of taking positions.

The decision whether the firm will act as principal or as agent in any transaction with a customer is a matter for agreement between the firm and its customer. Since the profit in retailing securities depends upon retaining customers, the firm will usually respect a customer's desire as to one form of execution as opposed to the other, unless the firm has so strong a preference for a particular mode of execution that it will decline to accept an order on any other basis. In practice, however,

196 See rule 15c1-4 under the Exchange Act and art. III, sec. 12, of the NASD Rules of Fair Practice which require disclosure on the confirmation of the amount of commission or other remuneration in agency transactions.

197 See the discussion of the pricing practices of the integregated firm in sec. 4, below.

a firm can decide unilaterally in what capacity it is going to act in dealing with an unsophisticated customer who is unaware of the difference between the two types of execution. Such a customer may not even understand the significance of the disclosure in the confirmation received by him that the firm is acting as "principal" or as "agent."

(1) Frequency of agency and principal transactions

The study sought to ascertain through questionnaire OTC-3 the frequency of agency and principal transactions on a typical trading day (January 18, 1962) in the over-the-counter markets for equity securities. The table below shows the manner in which broker-dealers classified the capacity in which they acted in all their transactions for that day:

TABLE VII-c.-Proportion of over-the-counter trading by individuals and by other public customers with firms as agent and as principal, Jan. 18, 1962

NOTE.-Percentages are based on figures shown in app. VII-A, table 9.

In terms of number of shares, 61 percent of the purchases and 75 percent of the sales by the public on January 18, 1962, were made through broker-dealers as agent. By dollar volume, broker-dealers acted as agent in slightly less than one-half of the purchases and 62 percent of the sales by the public.

(2) Factors affecting capacity

Based on an analysis of table VII-c and other data from questionnaire OTC-3, the following discussion summarizes some of the significant factors affecting the capacity in which a broker-dealer executes a transaction.

(a) Type of customer. The proportion of transactions by nonindividuals (principally institutions) made on an agency basis was considerably lower than for all public customers, amounting for nonindividuals to only 38 percent of their purchases and 58 percent of their sales. The high percentage of purchases on a principal basis by nonindividuals is partially due to the fact that institutional and

other large investors tend to deal directly with the primary market maker who usually acts as principal in purchase transactions.198

(b) Characteristic of the security.-The percentages in table VII-c for agency transactions are lower for dollar volume than for share volume because transactions in higher priced stocks are more likely to be on a principal basis. This is also indicated by the trading in the January 18, 1962, sample of 200 stocks (tables VII-11 and 11a). For each stock in which individuals purchased or sold shares, the proportion of their shares traded through broker-dealers as agent tended to decline as the price of the security increased.

Activity of the stock also is related to the frequency of principal and agency transactions. There appears to be some tendency for broker-dealers to act as agent in both purchases and sales to a greater extent in inactive stocks than in active ones measured both by share value and dealer interest (tables VII-12 and 12a, 13, and 13a).

(c) Type of firm.-Some firms may as a matter of firm policy act as agent for retail customers in all over-the-counter transactions. Many firms act as agent in unsolicited transactions or in transactions involving securities not on a recommended list and as principal in all other transactions. Still other firms act as principal in all over-the-counter transactions whether or not they inventory the security involved in a transaction.

From the reports received of trading in the January 18, 1962, sample of 200 stocks, it was observed that certain firms consistently traded as principal in stocks in which they made markets but acted as agent in all others. In all stocks on January 18, 1962, 740 broker-dealers, or 40 percent of the 1,839 who had purchases or sales for public customers (individuals and institutions), effected all of their transactions with the public on an agency basis. On the other hand, 290 brokerdealers, or 16 percent, effected all of their transactions with the public on a principal basis.199 About two-thirds of the broker-dealers in the former group were small firms which had less than $10,000 of transactions for the public during the day.

On January 18, 1962, individuals purchased over-the-counter stocks from or through a total of 1,398 broker-dealers. Of these firms, 517 always acted as agent for the customer and 407 dealt exclusively on a principal basis; these 924 firms that dealt exclusively on one basis or the other tended to be firms with small public business so that 1 or 2 transactions may have represented their total volume of individuals' purchases that day. Apart from this, however, there was no readily apparent distinction between firms with smaller or larger volume as to the handling of public business on a principal or agency basis. A distribution of broker-dealer firms by size of individual customers' purchases and by proportion of such purchases made on an agency basis indicates that there is no tendency for firms with small volume to act more frequently on a principal basis than firms with larger volumes (table VII-13b).

198 See pt. C.2.d, above; sec. 3.c, below; and ch. VIII.C. Both broker-dealers and institutions may prefer to deal on a principal basis in order to avoid negotiating a commission rate different from the NYSE rate which is used for the vast majority of over-thecounter transactions on an agency basis. See sec. 3, below. As indicated in ch. VI.D, many institutions are critical of the NYSE rate in its application to large block transactions.

199 Some of the firms which had only agency trades stated that this was not the usual day's training in that respect, but this was offset by other respondents who had only principal trades but stated that this was unusual for them.

96-746-63-pt. 240

Members of the New York and American Stock Exchanges effected a larger proportion of their public transactions in over-the-counter stocks as agent than did other broker-dealers (table VII-14). NYSE members acted as agent in 58 percent of their purchases and 71 percent of the sales, in terms of dollar volume of public transactions.200 In contrast, the corresponding percentages for broker-dealers who were not members of any exchange were 27 percent for purchases and 37 percent for sales.

Generally, firms with an inventory in a particular security deal on a principal basis with the public in that security; few transactions are on an agency basis. There is a higher incidence of agency executions for such firms when customers are sellers than when customers are purchasers (table VII-16). Stated another way, when a customer sells, there is a greater chance that the integrated firm making a market in the security will execute the order on an agency basis than if the customer is a buyer.

In many principal transactions, a firm may not have an inventory at the time of the order. Of the shares purchased on a principal basis by individuals for the sample day of January 18, 1962, 54 percent were purchases from firms with no inventory who executed the transactions on a riskless basis.201 Riskless transactions constituted approximately 24 percent of all individuals' purchase transactions (both principal and agency) by share volume for the same sample day.

To summarize: Though there are exceptions in individual securities and among individual firms, data with respect to the frequency of agency and principal transactions indicate that (1) in a majority of transactions broker-dealers deal with individual customers on an agency basis and with institutions and other nonindividual investors on a principal basis; (2) the likelihood of a broker-dealer acting on a principal basis tends to be greater if the security is higher priced, if it is active, and if a large number of dealers are quoting markets; (3) some brokerdealers, particularly members of the New York Stock Exchange and American Stock Exchange, will as a matter of policy usually act as agent in all transactions, except those involving inventory securities; (4) broker-dealers which inventory securities usually execute transactions on a principal basis though there is a tendency to act as agent in securities held in inventory more frequently on customers' sales than purchases; and (5) in many principal purchase transactions (i.e., over one-half of such transactions on the sample day), the executing brokerdealer does not have an inventory in the security.

(3) Standards with respect to capacity

Neither the Commission nor the NASD has prescribed standards with respect to the capacity in which a retail firm executing an overthe-counter transaction must act. As described below, there may be circumstances under which the broker-dealer is required to disclose the nature and extent of his adverse interest in the transaction despite

200 Member firms of the New York Stock Exchange handle a substantial part of the public's business in the over-the-counter markets. On Jan. 18, 1962, New York Stock Exchange firms effected 54 percent of the public share volume and 62 percent of their dollar volume (table VII-15). If public trading in over-the-counter stocks only (as distinguished from over-the-counter trading in exchange-listed stocks) is considered, NYSE members participated to an even larger extent, effecting 69 percent of the total value of public transactions in such stocks. See app. VII-A.

201 This computation was based on the sample of 200 stocks studied in questionnaire OTC-3 for Jan. 18, 1962.

the nominal capacity in which he acts.202 However, in most situations the election of the broker-dealer to act as agent or principal controls the extent of disclosures to customers.

Some firms have rigorous standards concerning the capacity in which they will act in over-the-counter transactions. Many others may leave the choice of capacity to their salesmen, who are compensated in most firms by a percentage of the gross commission or profit involved in the transaction.203 Since the salesman's gross is ordinarily greater in principal transactions, this factor may dominate his choice of capacity. The manner in which salesmen's compensation can affect the type of execution is illustrated by this testimony of a representative of a retail firm:

Q. Would you explain those circumstances in which a salesman would decide *** to be principal and in which he would decide to be agent?

A. How he would make that decision?

Q. Yes. Is there a firm policy on this?

A. No; there is no firm policy on it.

Q. Well, is there a firm standard operating procedure?

A. It is dictated somewhat by the salesman.

principal.

Q. Would he make more money out of it?
A. In most cases, as a principal; yes.

In other words, he acts as

The firm may be influenced by the fact that, if it acts on a principal basis, it need not disclose either its cost in a riskless transaction or the inside market where it sells from inventory. No rule requires these disclosures in a principal transaction, although rules of the Commission and of the NASD do require disclosure of any commissions or other remuneration received in an agency transaction. Thus, in connection with a "riskless" transaction, the firm need not disclose the inside price though the transaction cannot, in function, be distinguished in any way from an agency execution. If the firm executes the transaction from an inventory position, it can only act as principal, but in most instances no facts are disclosed to the customer to enable him to determine whether the net price which he pays is reasonably related to the inside price quoted by the selling firm or by others or to the commissions of firms executing on an agency basis. b. Diligence of execution

(1) Firms executing retail transactions

Of the large variety of firms handling over-the-counter transactions for retail customers, it is estimated that more than two-thirds do not make markets in over-the-counter securities.204 It is estimated, based on transactions for a sample day in the over-the-counter markets, that 80 percent of individuals' purchase transactions and 89 percent of individuals' sale transactions by share volume were executed by firms having no inventory in the particular security at the time of the transaction.205 Retail business with both individuals and institutions

1202 See sec. 4.c, below.

203 See ch. III.B (pt. 1).

204 See pt. B.3, above.

205 This is based on the 130 stocks in the sample of 200 stocks which individuals purchased or sold on Jan. 18, 1962. In these stocks, 56 percent of individuals' purchases were on an agency basis, 24 percent were dealers' riskless principal trades, and 20 percent were on a principal basis at dealers' risk. In individuals' sales, 78 percent were on an agency basis, 11 percent were riskless, and 11 percent were on a principal basis and taken into inventory.