Although the investigation centered on manipulation, it is apparent from the face of section 11 that Congress was also concerned with the specialist's trading advantages and the conflicts of interest inherent in the mingled broker-dealer functions.

Immediately after the organization of the Commission, and even prior to the segregation study required by the statute, the staff in 1935 proceeded to formulate rules governing the conduct of specialists and other exchange members. These rules, in the main, were general; they were not promulgated as Commission rules, but were recommended to all exchanges for them to adopt.

Many of these rules were aimed at curtailing manipulative conduct. Two were of a recordkeeping variety: Specialists were required to be registered as such with the exchanges 99 and to keep a record of all orders placed with them.100 Two rules were specifically aimed at pool activities: One prohibited specialists from participating in joint accounts with nonmembers,101 while another prohibited specialists from acquiring various kinds of options pertaining to issues in which they specialized.102 Finally, one rule merely repeated the statutory mandate limiting all specialist transactions as principal to those reasonably necessary to maintain a fair and orderly market.103

In its Segregation Report, the Commission did not recommend separation of the broker and dealer functions, although problems arising from the mingled functions were recognized and further study was suggested. The report discussed and analyzed the contentions in favor of and against the specialist system. Most important were

these conclusions:

Recognition must be given to the fact that the specialist in acting both as broker and dealer has an inherent conflict of interest. From the present evidence it is not possible to conclude whether that conflict can be eliminated in such a way as to enable him to function more adequately in the public interest. Further exploration of such a possibility *** should be continued.104

Finally, in 1937, the Commission set forth by means of an interpretation 105 its regulatory position with respect to specialists and their functions. This interpretation, which still embodies the Commission's policies with respect to specialists, came to be known as the Saperstein Interpretation (named for the Director of the Division of Trading and Exchanges who prepared it). It avoided hard-and-fast rules and defined permitted transactions under the statutory standard-"reasonably necessary to permit him to maintain a fair and orderly market". as those which enhanced price continuity and minimized the effects of imbalances between supply and demand. Also, it made clear that each specialist-dealer transaction, and not merely the total course of dealing, had to meet the test. Thereafter the NYSE added portions of the Saperstein Interpretation as interpretative material to its own rules.106 The regulatory pattern has remained unchanged since 1937 despite the increasing emphasis on the dealer function. The policy underlying

Now NYSE rule 103.

100 Now NYSE rule 121. This material must be kept for 1 year.

101 Now NYSE rule 94.

102 Now NYSE rule 105.

103 Now NYSE rule 104.

104 Segregation Report, p. 111. The report also suggested three specific rules to govern specialist trading. These rules are discussed in sec. 6.b, below.

105 Securities Exchange Act release No. 1117 (Mar. 30, 1937).

100 NYSE Guide, par. No. 2104. The interpretation and the NYSE rules are discussed in sec. 6.b, below.

the Saperstein Interpretation was to minimize specialist trading by testing each trade with a standard of market necessity in order to minimize the conflict-of-interest problem and the trading advantage of the specialist, but the criteria of the interpretation have apparently been flexible enough to justify increased specialist trading if market conditions dictate. Thus, the growth of the dealer function has tended to negate or at least obscure the original purpose of minimizing the problems of conflict of interest and trading advantage, even while the expressed criteria have been found applicable to new conditions. As is shown in the following sections, problems of specialist trading and conflict of interest are still fundamental ones.

4. STRUCTURE OF THE NYSE SPECIALIST SYSTEM

a. Size and form of specialist units

As noted above, 360 NYSE members are registered as specialists. They are organized into 110 specialist units of between 1 and 9 specialists (table VI-5). Each of these units may be composed of individuals or legal entities of various kinds. A few of these units are registered in the same stocks and compete with each other. As of May 1963 there was one individual specialist who was unaffiliated with another unit and had no partner off the floor. The internal composition of the specialist units and their variation from one another present a highly complex picture. The wide range of the organizational techniques employed is merely the background for the wide variations of size and also of capital and performance.

The components of specialist units include individuals, partnerships, corporations, joint accounts, and combined books. Partnerships and corporations take their conventional legal forms. A joint account would be described in legal terms as a joint venture, and may be made up of two or more individuals, partnerships or corporations. In joint accounts, the participants keep separate books for brokerage orders, but maintain a single trading account.107 The converse of the joint account is the combined book, in which the trading accounts of the participants (who again may be individuals, partnerships or corporations) are maintained separately, but the participants are partners for purposes of the brokerage aspects of the business. Thus, while there is a single book for purposes of accepting and executing brokerage orders, for trading purposes each participant acts according to his own judgment and profits or losses are not shared.

As the following table indicates, partnerships are the predominant form of organization: 108

TABLE VI-C-Components of the 110 units

107 The participants in the joint account divide the profit or loss from the trading account as they agree. For orders that a participant may execute for the joint account, he charges the account floor brokerage.

Brokerage income cannot be divided between the joint account participants, since Exchange rules require that the minimum brokerage fees can go only to the member who executes the transaction. If the participants of a joint account decide to split brokerage income according to a predetermined ratio, the book must be transferred between them so that each participant is able to execute his share of orders. See sec. 5, below.

108 As of February 1963.

The unit of average size has three specialists. However, the largest units those comprising the top 10 percent of all units-have an average of seven members and represent 22 percent of all specialists (table VI-6).

The average number of common stocks assigned to specialist units is 12. Most units handled between 6 and 15 common stocks, but there are 2 handling between 36 and 40. The 11 units constituting the top 10 percent handle 269 stocks, for an average of 24 stocks per unit. These 269 stocks represent 21.2 percent of all common stocks; the 10 units constituting the bottom 10 percent had 31 stocks, representing 2.4 percent of all common stocks or 3 common stocks (per unit (tables VI-7 and VI-8).109

Total annual share volume of stocks handled by the units show a similar pattern, ranging between 1 and 40 million shares; average annual volume for all units was 10,428,000 shares. The 11 largest units had three times the average volume, while the smallest units. had about one-fifth of the average (tables VI-10 and VI-11). As is shown in this and succeeding sections, differences in size of units and concentration of issues have a direct impact on the kinds of markets maintained by specialists.

b. Specialist income

Specialist income comes from two sources, floor brokerage and trading profits. The gross income of all NYSE specialist units in 1959 and 1960 was computed from questionnaire EX-1 as follows: TABLE VI-d.-Gross income of NYSE specialists

While the aggregate figures show that both brokerage income and trading profits are major sources of income, there is extremely wide diversity among the units. Some units realize all their income from brokerage, while others earn as much as 80 percent from trading profits (table VI-12). This may simply reflect the fact that dif ferent units have different kinds of securities-some securities are primarily commission stocks (referred to by specialists as "bread and butter issues"), while others generate trading profits. On the other hand, certain specialists are more aggressive traders. Whatever may be the cause of this range in the composition of income, it is but one example of the diversity among NYSE specialist units.

109 Between 1957 and 1961, although volume on the Exchange almost doubled, the number of specialists and the number of issues per specialist moved within a narrow range. In fact, despite extremely differing market conditions over the past 25 years, the number of specialists has varied only from a low of 312 in 1945 to a high of 382 in 1939 (table VI-9).

At the upper end of the scale of income distribution, there is even more concentration than in the distribution of stocks. In 1960 the top 10 percent of all units earned 38 percent of total income, 26 percent of all commission income, and 52 percent of all trading profits. The figures were similar for 1959: the top 10 percent accounted for 38 percent of total income, 24 percent of all commission income, and 50 percent of all trading profits. It is noteworthy that the top 10 percent of units had greater trading profits than commission income. At the other end of the income scale, the lowest 10 percent of the units accounted for 0.4 percent of all income in 1960 and 1.1 percent in 1959 (tables VI-13 to VI-17).110

Expenses of specialist units seem fairly standard, and, in relation to expenses in other areas of the securities business, fairly low."11 Many specialists run their business "out of their hat" with the assistance of a few clerks. They have no offices of their own; such office space as they may require is provided for them as an accommodation by their clearing agents. Firms which clear for themselves, or engage in other activities of course have their own staffed offices. The specialist's ability to run a large volume business at relatively modest costs as compared to other areas of the securities business illustrates the fact that the specialist is a middleman-wholesaler. c. Specialist capital

Exchange policy requires that each specialist unit must be able to assume a position of at least 400 shares of each 100-share-unit stock, and 100 shares of each 10-share-unit stock in which it is registered.112 The Exchange interprets the rules as placing a continuing capital obligation on specialists and routinely determines the amount of capital required of each unit. In fact, this capital requirement is now thought of as nominal, most specialists having more capital than the required amount.113 As will be seen, this low requirement permits extremely wide diversity among the units.

Most specialists have purchasing power significantly above their actual invested capital, as the result of 25 percent margin maintenance agreements with their clearing agents. Exchange Rule 431, which generally prescribes a 25-percent maintenance requirement,114 is the only restriction on the specialist's ability to margin his position. The Federal Reserve Board in 1949 exempted specialists from the margin requirements of regulations T and U, and this exemp

110 In 1959 one unit had a loss from trading which exceeded its commission income; in 1960, two units had such losses.

111 Each member registered as a specialist is required to pay annually a registration fee of $300 and a post space rental ranging between $1,000 for the smallest specialist units to over $6,000 for the larger units. Each unit employs specialist clerks on the floor: larger units will have up to eight or nine clerks. Generally speaking, these clerks' earnings are in the $5,000 to $8,500 per year range. There is also a $120 annual registration fee for each specialist clerk. Clearing expenses are similar to those incurred by all Exchange members. In addition, 32 specialists rent telephone booth spaces; the rents range from $320 to $1,100 per annum.

112 The specialist at Post 30, the inactive post, must at all times have net liquid assets of $50,000. NYSE Guide, par. No. 2104.20.

Specialists on the Amex, under a recently instituted change in the capital requirement. must have a cash liquid asset position enabling them to assume a position of 10 round lots in every security in which they are registered, or $50,000, whichever is greater. However, the Amex rule may still require less capital than the NYSE counterpart because of the generally lower prices of Amex securities. (See ch. VIII.B.)

113 The rule says nothing as to the form in which capital must be carried. A prior rule in effect in 1949 expressly required that such capital be in "the liquid form of either cash or readily marketable securities."

114 The rule permits the specialists and their clearing agents to agree that the specialists' equity may fall below 25 percent, but if this occurs, the deficit is charged as a debit against the clearing firm's net capital.

96-746-63—pt. 2—6

tion has been characterized as the real foundation of the specialist's ability to trade and assume positions.

The accounts of specialists who do not clear for themselves are usually carried by their clearing agents, as margin accounts. Certain of these clearing firms, who may be specialists themselves, carry margin accounts for a significant number of specialist units. An example is one leading specialist firm which carries accounts for eight units. Such arrangements give a relatively few member firms considerable authority over the activities of many specialists, whom they may direct to reduce positions or commitments when the accounts approach the 25-percent limit.115

One of the questions in questionnaire EX-1 concerned specialists' capital.116 Computations from the figures submitted show the net capital employed by each unit in the conduct of its specialist business for the first and last days of 1959 and the last day of 1960. The capital, as computed, included cash available for the unit, the value of specialty securities held by the unit (at their cost), and any credit balance, less the market value of specialty stocks in which the unit may have been short and any debit balance. The resultant figure was the specialist's liquid capital actually used to assume positions in specialty securities at these three times. This figure did not include other assets that specialists had available but did not employ in their specialist business.

NYSE specialists employed $69,099,000 in 1959 and $76,285,000 in 1960 of such capital in their business. This would be an average of $628,200 per specialist unit in 1959 and $693,500 per unit in 1960, although for both years about one-half of the units had less than $300,000. The variation among the units is significant: most units were clustered at the lower end of the scale, while those in the upper 10 percent of the scale had over 50 percent of all specialist liquid capital (tables VI-18 and VI-19).

The data also indicate a relationship between the number of common stocks per unit and the capital. Thus, the top 10 percent of units with the most capital used in carrying positions (during 1960) had 218 common stocks assigned to them (in 1961), averaging $193,080 of capital per common stock. Those units comprising the bottom 10 percent of units in the amount of capital had 80 common stocks assigned to them and averaged $6,370 per common stock.

This does not seem to be an accidental result. The extent to which specialists are willing and able to employ substantial capital in their business has an important effect on their dealer activities.117 As noted above, NYSE policy has favored so-called "dealer" specialists in the allocation of important issues and, since specialists tend not to take large positions in less active stocks,118 a pattern develops in which the well-capitalized specialist receives the lion's share of important, active issues; this leads in turn to a greater employment of capital by the more heavily capitalized units.

Another analysis sought to determine the specialists' gross rate of return on the liquid capital employed in their business plus the value

115 This power has been used and is discussed more fully in sec. 6.f, below.

116 See app. VI-B. Because of the complexities in this area, this question was supplemented by further communications with specialists and their clearing agents. 117 See sec. 6.d on problems arising from specialist participation and sec. 6.h on specialists' ability to bid for blocks.

118 See sec. 6.c, below.