A fellow, yesterday, gave me a-I made a hundred dollars ***. He needed 400 shares of stock. I said, "I bought 400 shares of stock at 13." me. He said, "All right. Take a quarter of a point for yourself," which is fair to Q. It cost him how much? A. Thirteen and a quarter. A. If he gets it for a customer-that 134-he charges stock exchange commission above 13. * * Q. In that kind of a situation, which you have just described, could the stock exchange house, itself, have gone into the market and bought the stock at 13, if it had the time and wires to do it? A. Sure. In some instances when the interposed firm is not able to negotiate a price better than the best quoted, it will advise the retail firm to execute directly with the market maker. In others, the interposed firm will execute the transaction and charge a commission so that the customer pays more than the best price quoted in the market. Another firm which frequently performed the service of supplying quotations and of executing for other firms was asked why retail firms would ask it to execute for them. The principal of that firm replied that he might be able to check the wholesale market carefully and chase stock at, for example, nine three-eighths where without such careful checking the purchase would have been made at nine one-half: Q. Why couldn't they [the retail firms] get it at three-eighths? pur A. Because it is a question of time. These wire houses are so flooded with quotes and orders ✶ ✶✶ Q. Would we be interpreting you correctly, then, if we understood that this happened only in busy markets when they did not have the time? A. No; not primarily. As I said before, I might be given such good service to XYZ security firm down here that they might want to throw me an order. Maybe I can make a sixteenth or an eighth, which I would like. Q. Service by way of giving quotations? A. Sure. *** This particular firm executed only 2 transactions for its own account in the 200 stock sample of questionnaire OTC-3 on January 18, 1962. Those transactions occurred in Great American Life Underwriters stock. The firm, which was not making a market, purchased 10 shares from a market maker at 198 and sold these shares to a retail firm at 202 at a time when the prevailing wholesale asked price was 198. The principal of the firm stated that the transactions probably occurred as a result of a call on the TWX from the retail firm in which the retail firm said that it could pay 202. Aside from the purchase at 202 by that retail firm the highest price paid by any other brokerdealer firm, either as agent or dealing for its own account, on January 18, 1962, was 199. In this case the interpositioned firm apparently was used to execute the order simply as a result of a previously established course of doing business with the retail firm. The $4 per share charge by the interposed firm which was probably passed on to the customer should be compared with the usual 3 to 5 cents per share charge that same firm makes when executing orders for its correspondents, which are not passed on to the customer.219 219 See pt. C.1.b, above. The effect of interpositioning on the net price to the customer can be illustrated by the samples on the following page derived from transactions in the 200 stock sample: TABLE VII-d.-Prices paid in purchases by public customers as a result of interpositioning, Jan. 18, 1962 1 Number of shares purchased by public. A different firm is involved in each of the transactions set forth in the table. In each of the transactions shown in the accompanying table, public customers paid the cost of interpositioning. In transactions in which the retail firm acted as agent, the retail firm charged the customer a commission equivalent to the New York Stock Exchange rate based upon the cost to the retail firm. Had no firm been interposed, the commission charged would have been added to a lower base. In those three transactions in which the retail firm acted as principal, the markup of the retail firm was apparently based upon its cost, not the price charged by the wholesale dealer. In all three examples the markup charged to the customer as related to the interposed firm's cost (i.e., the price charged by the wholesale dealer) was more than the NASD's 5 percent markup policy. If based upon the retail firm's cost, the markup was within 5 percent.220 Retail firms sometimes justify interpositioning on the ground that the wholesale dealer may give the interposed firm a better quotation. It is argued that if the retail firm dealt directly with the wholesale dealer, the latter would know which side of the market the retail firm was on, particularly if the retail firm has a pattern of doing business with the wholesale dealer, and adjust its quotations accordingly. In addition, interpositioning has been claimed to be necessary where a retail firm outside a financial center seeks to execute an order and finds it unduly expensive to contact more than one firm. Neither argument seems a satisfactory justification for the practice in many situations in which it appears. The retail firm can minimize any adjustment of quotations by wholesale dealers by checking competing markets. When the retail firm. uses an interpositioned firm, the latter is often no better qualified to obtain quotations than the retail firm. For example, the retail firm in many cases is an integrated firm with a fully staffed trading department capable of checking competing markets. With the expansion and refinement of communication facilities, it appears that most retail firms have access to wholesale dealers either directly or through 220 See sec. 4, below, for a discussion of markups. correspondents.221 Even assuming that communication costs are a factor, many firms outside of financial centers have found it possible to execute on a give-up basis with a charge that is nominal compared to the cost of interpositioning. In fact, several large wholesale dealers indicate that they check markets and execute transactions for outof-town firms without any charge in securities in which they do not make markets.222 (5) Standards with respect to diligence of execution A broker-dealer acting as an agent for a customer in the execution of a transaction assumes the obligations of a fiduciary. As the Commission has stated the common law principle: A corollary of the fiduciary's duty of loyalty to his principal is his duty to obtain or dispose of property for his principal at the best price discoverable in the exercise of reasonable diligence." 223 Actual operating standards to assure execution of transactions in accordance with this principle have been largely left to individual firms. While some firms apparently have established specific standards for their own personnel,224 many others leave the execution of retail orders to the personal habits and work patterns of individual order clerks and traders or to the demands of reciprocal obligations and understandings. The NASD has broadly recognized the principle of best execution but specific guidelines or standards have not been prescribed.225 The most specific recognition of the principle has been made in several NASD disciplinary proceedings involving interpositioning but there appears to be no consistent policy with respect to the propriety of that practice. In three cases in Boston, an NASD District Business Conduct Committee found that, for purposes of determining the current market from which to compute a retail markup to a customer, it was improper to include the service charge paid to an intermediate brokerdealer interposed between the initiating firm and the wholesale market. The cost of the initiating dealer was held not to be a fair gage of the market because of the interposing of the intermediate firm.226 In another proceeding in New York in 1952, an NASD District Business Conduct Committee found that the practice of interposing 221 See pt. C.1.b, above. 222 It is recognized that these wholesale dealers may be indirectly compensated for such services by reciprocal business. 223 Arleen W. Hughes, 27 S.E.C. 629, 636 (1948), aff'd. 174 F. 2d 969 (D.C. Cir. 1949). See also "Restatement of Agency, 2d," sec. 424. 224 For example, a number of firms have a rule that a quotation be obtained from at least three competing wholesale dealers before any commission order is executed. 225 The NASD has recently been considering an amendment to its Rules of Fair Practice not yet submitted to its members, which would require that a member selling or buying a security "as agent for a customer shall exercise due diligence to find the best available market for such security; and to execute the transaction in such market." With respect to the proposed rule, the NASD states that it is intended to cover the "problem of failure to seek the best market which is presently dealt with under the general terms of rule 1." The latter rule is a general rule requiring members to "observe high standards of commercial honor and just and equitable principles of trade." In the hearings on the legislation authorizing this study, the then chairman of the NASD board of governors stated: "One of your functions in executing [an] order for your customer is to seek out the best market, and then to execute to his best advantage." Hearings on H.J. Res. 438 (1961) before a subcommittee of the House Committee on Interstate and Foreign Commerce, 87th Cong., 1st sess. (1961), p. 79. 228 It should be noted that recently the Boston District Committee has dealt with the practice of interpositioning by a letter of caution rather than proceeding by formal complaint. See the discussion of interpositioning in relation to the markup policy in sec. 4, below. other broker-dealers between the executing firm and the best market was a violation of the Rules of Fair Practice when done without justification, without regard to whether the resulting price to the customer violated the markup policy. The district committee held that the initiating firm has an obligation to obtain the best market for its customer and noted that the interposed dealers were in effect executing riskless transactions for the initiating firm.227 In this case, the NASD stated: The integrity of the industry can be maintained only if the fundamental principle that a customer should at all times get the best available price which can reasonably be obtained for him is followed. As previously indicated, while the common law principle of best execution has been recognized by the NASD, there has been little or no delineation of what it is supposed to mean in practice-for example, in respect of checking of markets or use of interpositioned firms in various circumstances and little or no enforcement effort with respect to it. The absence of explicit standards and of enforcement effort is reflected in an uneven quality of executions for customers in the over-the-counter markets. 3. COSTS OF EXECUTION The size of markups (or markdowns) in principal transactions and commissions in agency transactions is not governed by a fixed schedule in the over-the-counter markets. 228 The service charge that a customer pays for an execution of an over-the-counter transaction is related to a diversity of factors including the firm with which he deals, the capacity in which the firm executes the transaction, i.e., on a principal or agency basis, whether the transaction is a purchase or sale, the size of the transaction, and the general relationship of the customer to the firm. This section examines some of these factors affecting the costs of execution paid by the public. There is a significant range in the size of markups in principal transactions.229 On the other hand, in agency transactions there tends to be a uniformity in the level of commission rates. Approximately 95 percent of the agency transactions on January 18, 1962, in the stock sample were executed at the applicable NYSE commission rate. The importance of NYSE member firms in handling the public business in the over-the-counter markets and the tendency of such firms to handle over-the-counter transactions on an agency basis points up the fact that the NYSE minimum commission rate schedule has a substantial effect upon pricing in the over-the-counter markets.230 Indeed its 227 In the New York case and in two of the three Boston cases the NASD committees found that the occurrence of the practice was attributable in part to a lack of proper supervision of the activities of the traders in the firm. 228 Sec. 15A (b) (7) of the Exchange Act prohibits the NASD from imposing "any schedule of prices, or to impose any schedule or fix minimum rates of commission." In the exchange markets commisison rates are fixed by exchange rule. See ch. VI.I. Investment company shares are offered pursuant to selling agreements at fixed public offering prices less selling commissions or loads fixed in such agreements. See ch. XI. 229 See table VII-25 which shows the ranges of retail and wholesale prices in certain stocks. The variations in prices charged to customers cannot be ascribed to changes in market price. This is more fully discussed in sec. 3.d, below, where it is pointed out that wholesale variations were negligible in the same securities in which retail variations were substantial. See also sec. 4.b, below, and the range of prices in transactions between dealers in chart VII-b, 230 See ch. VI.I. For a discussion of the importance of NYSE member firms in the overthe-counter markets see pt. B.3, and app. VII-A. effect also extends to the pricing practices of nonmember firms, since it was found that nonmember firms tended to use the NYSE schedule in agency transactions. a. Purchases by retail customers Purchases by customers executed on an agency basis were consistently effected at lower total costs (including commissions) than purchases on a principal basis. In 82 percent of the stocks in the sample traded on January 18, 1962, in which comparisons could be made, the average cost to individual customers of purchases from dealers acting as principal was higher than the cost of purchases on an agency basis.231 Moreover, agency transactions usually result in a lower cost of execution to a customer than a principal purchase on a net basis, whether the firm sells to the customer out of its inventory or purchases the stock and then sells it to the customer in a riskless transaction. In 80 percent of the securities studied, when an individual public customer purchased shares from a dealer with an inventory which existed prior to the order, the customer paid more on the average than when he purchased through a broker on an agency basis (including commissions).232 Similarly, the net price to individual customers in principal purchases from firms which had no positions were also more costly than purchases on an agency basis. Of the stocks in the samplei n which both of these types of executions occurred on January 18, 1962, the average price of purchases on a principal basis was higher in 87 percent of the stocks. In the category of principal transactions, the cost of execution are related to whether the firm does or does not have an inventory in the particular security at the time of the transaction. Principal purchases from firms which had no positions were more costly than principal purchases from firms with inventories. In 69 percent of the securities in which both types of execution for individuals occurred on January 18, 1962, the average cost in principal riskless transactions was higher than in principal purchases from firms with inventories. Of the riskless transactions in the stocks in the 200 stock sample for which comparisons could be made, 10 percent of the markups over contemporaneous cost exceeded 5 percent and one-half were in excess of 4 percent of contemporaneous cost (table VII-20). Although the higher markups appear to have occurred in the smaller dollar transactions, there was a significant percentage of large transactions in which markups of over 4 percent were charged though the dealer was without risk. There appeared to be some tendency for markups to be proportionately higher in riskless transactions for lower priced stocks than for higher priced ones (table VII-21). Moreover, if the riskless transactions had been effected on an agency basis, they would most likely have resulted in net prices to the customer which would have been lower than the net prices actually paid, since it was found that, in almost all of the 325 riskless transactions for which data were available, the public customer paid more than the applicable NYSE commission, in many instances by 2 to 3 times (table VII-22). As 231 See app. VII-E. These findings are corroborated by tables VII-19 and 32, which illustrate the lower costs of agency over principal executions for public purchases. Also see table VII-25a. 232 See app. VII-F. The material in the text comparing prices of execution for firms with and without positions is derived from this appendix. |