exchange's surveillance program." The data appear on the summary in the form of a frequency distribution showing the number of days that the overnight position in each stock fell into various categories, as follows: no position, 100 and 200 shares, 300 to 500 shares, 600 to 900 shares, and 1,000 and over. Thus, if a specialist has a 1,000share position in a long-term investment account and buys and sells 1,500 shares of the same issue each day, the summary sheet would only indicate that his position is "1,000 shares or over." Even more important than this inadequacy of the data is the fact that the exchange does not now ordinarily use the data underlying the summary to determine whether the specialist was engaged in daylight trading.214 In their testimony Exchange officials agreed that although it would be theoretically possible for a daylight trading pattern to have been dictated by the needs of the market, it would be highly unlikely. They agreed that the facts of such cases should give cause for investigation by the floor department. However, the files of the Exchange show no such investigations.

This failure to investigate for daylight trading has undoubtedly encouraged such activity. Accordingly, the surveillance policies of the Exchange should be extended to this area. Moreover, since capital ability now seems to serve as a factor limiting adequate participation and since the specialist capital requirement has been substantially unchanged since it was introduced 20 years ago despite changing market conditions, a need for a revision of capital requirements is indicated.215

e. The specialist and market stabilization

The NYSE intimates in many of its public statements that part of the specialist's function is to "stabilize" the market. The Exchange pamphlet entitled "Now About the Specialist," states:

Moreover, the vast majority of the specialist's transactions for his own account is made against [emphasis in original] the trend of the market. Because he has the responsibility of filling in gaps in supply and demand, the specialist usually finds himself buying when the market is falling and others want to sell, and supplying stock when the market is rising and others want to buy. Approximately 85 percent of the specialists' dealer transactions are stabilizing [emphasis supplied] in nature. Specialists thus play a vital role in keeping price changes between transactions narrow and in maintaining the broad liquidity of exchange markets."

218

The same publication refers to the activities of specialists on September 26, 1955, the first trading day after President Eisenhower's heart attack:

Key men on this day were the specialists who worked with deliberation, speed and efficiency to perform their major duty-maintaining an orderly market. Long before the opening bell, sell orders began to flood the Exchange floor-and throughout the day, specialists bought massive amounts of stock. In meeting their responsibility, the specialists piled up their inventories by 595,550 shaies to a total of 2,246,524. Their total investment at the day's end was $73.4 million-an increase from the close Friday of $23.5 million in their capital commitments.

213 This test has been described by a former chairman as the most important test of specialist dealer performance. The various tests are described in sec. 6.b, above.

214 At one time the test was used to help to determine whether specialist "participation indicates tendencies of trading rather than that of dealing." At that time the results of this test were summarized to show daily average and maximum carryover positions in each stock.

215 See also sec. 6.h, below.

216 At pp. 8-9.

The specialists' risks that day were great. Their performance was exemplary.

217

This function was further amplified in an exchange press release concerning the May 1962 market break:

Ninety-two percent of specialists' transactions in 50 key stocks were stabilizing in nature—that is, specialists bought when others wanted to sell, and supplied stock when others wanted to buy. This was substantially above the highly satisfactory average stabilizing rate of 85 percent for all stocks throughout 1961.

Mr. Funston noted that stabilization and price continuity are the critical tests of specialists' performance. They explain why thousands of orders, funneling into the central marketplace, day after day, are executed at minimum variations between sales.

The specialists' performance during May 28-31 was all the more noteworthy in view of the fact that they had already taken considerable risks as a result of the market activity in the weeks immediately preceding May 28th.

At that time, the Exchange also released aggregate figures on specialists' buy. ing and selling in the three-day period. These figures showed on-balance buying by specialists as the market declined, and on-balance selling as it rose (a statistic that can be an early indication of a high stabilization rate).18 Emphasis supplied.]

A perhaps even greater emphasis on stabilizing is contained in a letter from the floor department to a complaining investor:

By stabilizing, we mean, in general, dealing against the trend of the marketpurchasing stock as prices decline and selling as prices advance. [Emphasis supplied.]

And in the hearings which led to the enactment of Public Law 87-196, creating the Special Study, Funston described the Exchange's surveillance of specialists as follows:

One of the studies made is to see if he is participating in the market as much as he should to keep a close, orderly, active market. Another study is the percentage of stabilization. A specialist in making a market in the stock is supposed to have a great preponderance, and the rule of thumb is about 80 percent, of his trades to be so-called stabilizing trades. In other words, buying when the market is going down, selling when the market is going up, a stabilizing factor.219 [Emphasis supplied.]

In addition to these public references to stabilization, apparently placing it on a parity with the goal of continuity, stabilization is occasionally referred to in the internal files of the Exchange, as in the few instances when specialists have been criticized for not acting to "retard a decline," or for not making "a determined stand."

Despite these indications of the importance attached to stabilization, on other occasions exchange officials have insisted that specialists have nothing to do with stabilization as that word is commonly understood, i.e., pegging or fixing prices.220 Thus, Willard K. Vanderbeck, vice president in charge of the floor department, testified that the

217 At p. 1.

218 NYSE press release, June 25, 1962.

219 "Hearings on H.J. Res. 438," at pp. 114-115.

220 Since the Exchange's pronouncements on stabilization are directed at the public, it is appropriate to look at a nontechnical definition of the word.

Webster's International Dictionary, 3d edition, defines the term as "to make or hold steady, prevent fluctuations of, maintain a constant level to establish a minimum price for (a security) by buying all offerings at that price."

A technical use of the word may be found in Commission rule 10b-7 (b) (c) which defines stabilizing as "pegging" or "fixing" a price and states (for the purpose of the rule) that stabilizing activity during a distribution of securities is permitted for the purpose of "preventing or retarding a decline in the open market price of a security."

comments made in floor department memoranda with respect to "retarding declines" are indicative of nothing but the duty to maintain price continuity. He explained the use of such language as a "matter of semantics." He further testified:

Q. Do you think the specialist has an affirmative duty to do the best that he can within the limitation of his capital ability to retard or halt the decline [in the price of a stock]?

A. I don't think the specialist has any duty to halt the decline. That is not possible. He is to do the best he can to maintain continuity on the way down within the realm of practicality.

I have already pointed out that under no condition is he expected to halt a decline, which would mean keeping the price at a particular level. I return to what I have said that he is expected simply to maintain the best price continuity possible under the conditions. That is my answer.

In the same vein, Funston stated in a letter to the New York Times: But is it the Exchange's responsibility to try to control changes in the value of stocks? In a free economy I question if the Times really believes that any individuals or organizations, governmental or private, should attempt to prevent the market from rising or falling, or interfere with the individual decisions of millions of investors.

What the Exchange should and does do, of course, is to labor strenuously to maintain "orderly" markets in which prices, if they rise or fall, do so gradually with the smallest possible variations between sales. This is also known as maintaining market liquidity, to pay or receive a price not far different from the last sale. This is a key test of a market's orderliness. ✶ ✶ ✶ 221

Specialists have diverse views on the subject. Fourteen specialists testified that they believe that within the limitations of their capital ability, they had an affirmative duty to retard declines. There was general agreement that in a market break such as occurred in May 1962 no specialist could conceivably attempt to stabilize the market, but each of the 14 believed there was some duty to retard the decline so far as practicable. One testified:

I think that we should make a stand, so to speak, at a particular level that would be constructive for not only the stock but for the general market and this, in my opinion is the true injection * * * of the dealer into [the] market. * **

On the other hand, five specialists testified that only the basic specialist duty to maintain continuity was required in a declining market. One of these said:

we have to inject ourselves much more, of course, in this type of [rapidly declining] market than we do in a normal market to try to hold some kind of continuity * * * we * * * sell and rebid and sell and rebid to try to keep continuity as best we could.

Undoubtedly, part of this difference in view stems from ambiguities in the word "stabilization." As a public relations matter the Exchange has sought to project the image of the specialist as a stabilizer, but the problems in this area are too deep for any confusion to exist in the public mind between maintaining continuity on the one hand and retarding a decline on the other. At bottom is the very real problem of whether specialist trading does in fact, in and of itself, contribute to price stability, and whether it can be expected to. This involves an analysis of both the meaning of "stabilization" and the methods used to measure it. Before discussing these problems in the

The New York Times, June 21, 1962, p. 30.

context of the present market some understanding of the historical background may be useful.

(1) History

The oldest view of the specialist's function was that his trading was speculative in nature. There are a few such references antedating the Pecora hearings. J. Edward Meeker, an economist employed by the Exchange, characterized specialists' activities in 1922 as follows:

The majority of specialists act as dealers in much the same way as the floor traders do, and speculate for small, quick profits. In this buying and selling of securities * * for their own account, the specialists perform many of the functions of the "jobbers" in the London Stock Exchange. Far from there being any reasonable ground to object to this speculation by specialists, in reality the practice constitutes one of his necessary functions in the Exchange and renders the same general economic service that the more scattered transactions of the floor traders do. For, if the specialist refused to engage in speculative dealings on his own account, there would not be sufficient orders for inactive stocks, either in his book or with other members of the crowd, to make a close market for them.222

In this view, the marketmaking function was a result of speculative trading and such activity was viewed as being qualitatively similar to that of floor traders. However, there were also implications that informed speculative trading had what might be thought of as a stabilizing tendency. Meeker stated:

As a matter of fact, the floor trader's best opportunity for a profit exists when prices are for the time being out of line with true value. Since as a rule he quickly sells out purchased stock, and quickly covers his short sales, his transactions are self-nullifying so far as any permanent effects on security prices are concerned. Nevertheless, his swift purchases and sales tend temporarily to restrain rising and to cushion falling prices and, since they are normally undertaken for only fractional profits, they help to create a close market." [Emphasis supplied.]

223

Thus, prior to 1934 the dealer activities of specialists had no formal rationale other than that markets were made in inactive stocks, that narrowing the spread in all stocks increased liquidity, and that informed speculative trading had a stabilizing effect as a byproduct.

At the hearings which led to the passage of the Exchange Act, the subject of specialists was discussed extensively. The system was vigorously defended against the criticism of the Senate committee, the burden of the defense being carried by the president of the Exchange and several prominent specialists. Certain NYSE specialists also submitted a "petition" justifying their work.

The defenses advanced for the dealer function were generally no different from those mentioned in previous works on the subject, i.e., specialists narrowed the spread and made markets in inactive stocks. In all of the testimony there are only a few scattered references to stabilization (in any sense). Two specialists testified that in the

222 Meeker, "The Work of the Stock Exchange," p. 108 (1922).

Another early writer states merely that the economic usefulness of the specialist consists chiefly in his willingness to take chances as a speculator "and that [specialists] through their speculation help to create a continuous market. Without them fluctuations between sales of certain stocks would be much greater and many stocks would at times have no markets whatsoever." Huebner, "The Stock Exchange," p. 147 (1922).

23Meeker, p. 89, note 222, above. This, of course, does not imply any purposeful activity to peg prices or to retard advances or declines but suggests merely a side-effect of informed speculation.

worst days during 1929, their activities went beyond the maintenance of a continuous market:

Mr. PECORA. Doesn't the specialist as a rule, even in the case of an active stock, run away from the support of the market when he thinks he is going to be hurt by standing by?

Mr. SPRAGUE. No, sir ***. I will say that I have seen many cases where men did not run away but stood there and took it and we had to do it in 1929.

Mr. PECORA. To what extent in 1929?

Mr. SPRAGUE. To a great extent.

Mr. PECORA. To what extent, if any?

Mr. SPRAGUE. I can cite my own instance, where I stood by and took blocks of stock with no bids on my books, and stabilized my market.

Mr. PECORA. How long did you stand by?

Mr. SPRAGUE. It was plenty long enough in one particular day.

Mr. PECORA. How long did you stand by?

Mr. SPRAGUE. One day at the very height of it.

*

Mr. ADLER. Let me explain to you one thing that happened, as I remember it very distinctly. In the last day of the panic in 1929, which is one of the proud moments of our career as specialists.* * * My partner is sitting here, and I said to him at that time, I said "I am not going to let this stock sell down par." And we sent a message to each of the brokers that had given us this order, that had entrusted this order to us, that we would guarantee them the bid price. Now frankly, I do not do that every minute of the time. But one of my duties as a specialist is, if possible, to maintain a fair market for my customers, because if I do not, I am going to have competition the next week and he is going to get the business. That is one of the ways I have to trade to keep my business together.224

However, in the formal petition submitted by specialists there is no reference to stabilizing activities. Other than the quoted testimony, neither the witnesses nor the committee itself considered the general effects of specialist trading.

It was not until the study conducted by the 20th Century Fund in 1935 that the actual impact of specialist's trading was analyzed. This study reached certain conclusions on the general character of specialist trading:

In view of the fact that their trading is largely of the short-run, intraday variety, it may be seriously doubted whether they contribute much toward making an accurate reflection of fundamental values. Such positions as they assume are as a rule quickly liquidated and therefore their influence upon the broad price structure is likely to be small. *** 225

The study concluded that the main contribution of specialist trading "is in giving the market a more continuous, liquid character." 226

The Commission's Segregation Report in 1936, considering the same question, found that specialists traded "against the daily trend more often than with it. *** 227 It was also noted that in the course of the study "some specialists however, profess to be willing to trade * * * in order to maintain a stable and continuous price level which in turn stimulates the good will of commission brokers who dislike a widely fluctuating market." 228 Background documents in the Commission's files antedating the Segregation Study would seem to indicate that the specialists' argument that they traded for the purpose of maintaining stable prices was a response to the staff's concern that special

224 "Hearings on Stock Exchange Practices," pp. 6810, 6814-6815.

225 "The Securities Markets," p. 426.

220 Ibid.