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mation to persons on the other side of the transactions. The rather distinct problems that may arise from directorships in connection with over-the-counter making of markets and retailing seem not to have received attention from the NASD, the agency with primary selfregulatory responsibility for over-the-counter markets.

The Special Study did not conduct any investigation, as such, of the effect of directorships on broker-dealer trading and retailing activities, although views and descriptions of practices were sought in interviews with several firms. It is clear from even this limited survey that broker-dealer directorships are far from being an unmixed blessing to those involved or those affected. In some circumstances the positive aspects may be so far outweighed by negative ones as to preclude the directorships; but even where this is not the case, vigilant concern for niceties of conduct is obviously called for.

Actually, the problem of directorships is part of a broader one. A striking phenomenon of the securities industry is the extent to which any one participant may engage in a variety of businesses or perform a variety of functions. A single firm with customers of many kinds and sizes, may, and often does, combine some or all of the functions of underwriter, commission house in listed securities, retailer of unlisted securties, wholesale market maker for unlisted securities, custodian of funds and securities, investment adviser to discretionary accounts, to others on a fee basis, and to one or more investment companies, and financial adviser to one or more corporations. Its principals may invest or trade for their own accounts in securities also dealt in for others. In addition, as more particularly discussed above, principals and employees of the firm may serve on boards of directors of issuers of securities which the firm has underwritten, in which it makes a wholesale market, which it recommends to its retail customers, or all three.

Since each of these functions involves its own set of obligations to particular persons or groups of persons and since the self-interest of the broker-dealer may be involved in one or more, there are multifarious possibilities of conflict of obligation or interest in matters large and small. The multitude and variety of possibilities of conflict in the securities business make it difficult, if not dangerous, to generalize as to the problems presented or possible remedies. Total elimination of all such possibilities is obviously quite out of the question; theoretically, it would involve complete segregation of functions—a remedy often invoked or suggested where conflicts are considered. But segregation as a specific remedy for all the multifarious possibilities for conflicts in the complex securities business could not be a simple segregation in any traditional sense but would have to involve fragmentation of the business to a point where (as facetiously pointed out in a recent magazine article) each investor would have his own broker who would not be permitted to act for any other customer or for himself.

In some limited sectors, combinations of functions involving clearly conflicting roles may be excluded as a matter of business policy or public policy because the conflicts are deemed so fundamental and pervasive as to require separation; in most sectors, multiple roles are not excluded as a matter of policy, but here the conduct of broker-dealers performing them may require increased regulatory and self-regulatory vigilance. Some kinds of conduct (as in Cady, Roberts, for example)

are so gross that they already have been, or may in the future need to become, the subject of specific decisions or regulations. For others, more capable of being handled in terms of ethics than of law, the selfregulatory agencies would seem to have an ideal milieu for performing their role of elevating and guiding conduct of their members above and beyond strictly legal requirements. The exchanges and the NASD should be charged with continuing responsibility for keeping abreast of changing forms and methods of doing business, identifying areas of frequent difficulty, and setting forth guides to the conduct of brokerdealers serving as directors and performing other roles containing potentialities of conflict.

The Special Study concludes and recommends:

1. The many facets of the securities business, including the typical combinations of broker and dealer functions, underwriting functions, quasi-banking functions, and advisory relationships with issuers of securities and with customers, involve potential conflicts of interest and obligation of many kinds and degrees. This would appear to be the kind of area in which the self-regulatory agencies, with support from governmental agencies where violations of legal duties are involved, can be instrumental in defining and effectuating higher ethical standards. With all credit to the limited efforts they had made, the self-regulatory agencies have left many important subjects virtually untouched; for example, although the NYSE has recently advised its members concerning conduct in connection with the holding of directorships, the NASD, which has special responsibilities in respect of over-thecounter markets, apparently has never addressed itself to the conflicts involved in the role of the broker-dealer who is a corporate director while engaging in interdealer and retail transactions in the corporation's securities. The self-regulatory agencies, no less than the Commission, should institute more positive, continuing programs for the study of important problems of conflict of interest in the securities business, with a view to speaking out on particular questions in the form of cautionary messages, policy statements, codes of ethics, or rules of fair practice, as circumstances may require.




[Part A (Introduction) presents statistical data concerning distributions of corporate securities during the postwar period, with particular emphasis on equity issues during the years 1959–61.]


The new-issue market, which gathered force in 1959, reached its peak in 1961, and subsided with the market decline of early 1962, can now be seen in perspective. The intensive and extensive examination made by the Special Study reveals a picture-which perhaps will not be surprising to the financial community or to investors—of a general climate of speculation which may rank with excesses of previous eras.

More than any single activity or incident, it is this climate of speculative fervor which provides a key to the new-issue phenomenon. Its causes need not be dwelt on here. It is sufficient to note that its roots are presumably deep in human nature, and its manifestations include a willingness by more and more of the public to purchase securities at prices less and less in line with experience and reasonably foreseeable earnings.

The "hot" issues which thrived in this climate, being the plainest evidence of the riches attainable through the purchase of stocks without regard to earnings or other fundamentals, also helped to nourish it. This kind of interaction between cause and effect appears throughout any analysis of the new-issue market. The interaction may make it more difficult to identify underlying causes of particular problems and excesses in individual cases, but it may also assist in the search for practical solutions: the vicious circle of cause and effect can perhaps be broken by relatively limited remedies applied at strategic places.

With public expectation of continuously rising stock prices, hundreds of nonpublic companies and their major stockholders found unprecedented opportunities in recent years to make public offerings of their stock that would not have been possible in a different climate. The number of companies making their first public offerings climbed steadily during the period from 1953 to 1961, reaching an historic high in the years 1957 to 1961 when the bull market attained its peak. The new-issue phenomenon provided many small companies with the opportunity to raise funds for legitimate corporate purposes. It also provided an opportunity, however, to sell stock in companies that in a different climate would not have been deemed ready or appropriate for public financing.

The underwriter played an important role in the new-issue phenomenon not only by originating and distributing stock in companies going public but also, in many cases, by encouraging the speculative


climate. Most of the older firms exercised careful investment banking judgment in determining which companies were suitable for public ownership, and in so doing still provided many small companies with access to the capital markets. Other firms, under pressure from customers and salesmen hungry for new issues, lowered their standards of quality and size of issuers whose securities they would underwrite. Broker-dealers whose principals had little experience or knowledge of the underwriting business and whose capital commitment was minimal were hastily organized in order to participate in the newissue boom. Professional finders, either self-employed or employed by broker-dealer firms, occupied themselves in bringing issuers and underwriters together.

It is against this background of excitement and expectation of profit that the details of the offering of new issues must be seen. In the pricing of new issues, underwriters could not help but be influenced by the knowledge that the prices of many issues would subsequently rise in the immediate after-market to prices hardly justified by traditional standards of value. A high" offering price might not be justified by these standards, yet a low offering price, which might seem to be called for by a sober regard for fundamentals, merely assured an initial premium that whetted the public's appetite for the next issue. For the careful underwriter, these conflicting considerations posed a difficult dilemma in the pricing of a new issue. Others set low offering prices in the expectation of withholding substantial portions of the issue in accounts of insiders to be sold out to the public at premium prices.

Some underwriters found opportunities with the strong public demand for new issues to obtain very high amounts of compensation from small speculative companies. Thus, the weakest companies financially had to carry the heaviest burden and the investor in these companies paid the highest cost to assume the greatest risk. Since many of these offerings were made by newer underwriters on a “best efforts” or agency basis, there was very little or no risk for the underwriters.

It also became increasingly common for underwriters of new issues to receive a substantial portion of their compensation in stock, options, or warrants of issuers. Instead of serving as a substitute for cash compensation, equity compensation tended to appear in those offerings with the highest rates of cash compensation. The practice of taking unreasonable amounts of noncash compensation, particularly among the smaller and more aggressive underwriters, not only diluted the equity in the company of the public purchasers of the stock in the public offering, but it also gave the underwriter holding the stock, options or warrants a special kind of interest in the after-market for the issue.

In general, some investment banking houses carefully investigated issuers whose offerings they brought to the public market and registration statements reflected the meticulous standards of these underwriters and the lawyers and accountants involved in preparing them. Other underwriters, anxious to merchandise stock in public demand, were lax in performing their responsibilities to investigate issuers whose securities they intended to offer to the public. Under these circumstances carelessly prepared registration statements, if they were not corrected by the Commission's staff, might contain serious misrepresentations about the issuer and its affairs.

If the general background outlined above as a sine qua non of the new-issue boom, the premium prices of particular stocks were the results of the mechanics of the market and in many cases of the techniques and activities employed by particular broker-dealers. In a typical "hot issue,” over-the-counter trading began simultaneously with effectiveness of the registration statement or clearance of the Regulation A filing. Stocks were being quoted at premium prices in the after-market before all customers knew of their allotments, before the closing at which the managing underwriter remitted the proceeds of the offering to the issuer, and before customers received their stock certificates. Thus, the trading markets for new issues tended to reflect a distorted picture of demand and supply. While potential buying interest in an issue was often communicated to trading firms prior to the offering date, potential selling interest in the aftermarket was more difficult to assess and was seldom adequately reflected.

It was of prime significance that a limited number of shares of new issues were available for trading in the immediate after-market. Many new issues involve a relatively small number of shares. Moreover, most distributors of new issues had a policy of confining their allotments to customers who would not immediately resell in the open market. They implemented this policy by such measures as: (a) allotting only to customers with a record of not reselling prior new issues; (b) allotting to discretionary accounts or to a relatively small number of customers who customarily relied on the advice of the distributor; (c) advising customers of a "requirement," "necessity," or "expectation" that they would not immediately resell, or that immediate resale would reduce their chances of being allotted future issues; (d) penalizing salesmen whose customers sold their allotments in the immediate after-market; or (e) simply refusing to execute sell orders of customers in the immediate post distribution period. Although a policy of selling new issues to "investors” rather than to “speculators" may be based on excellent motives, such as assuring a successful distribution and discharging responsibilities to the issuer or to codistributors, the effect of the policy was to reduce the shares available for immediate trading in the after-market.

Supply was also reduced by delays in notifying customers that shares had been allotted to them and in sending them their stock certificates. Whereas trading markets may commence immediately upon effectiveness, customers normally did not receive notice of their allotments for 24 to 48 hours and sometimes for several days or weeks. Delay in notifying customers of their allotments gave added importance to the initial premium since the decisions of customers whether to accept allotments could be made on the basis of prices quoted in the after-market, rather than on information provided in the prospectus. Some underwriters did not deliver stock certificates for weeks or even months after the effective date, thus discouraging customers from selling. Thus, in the critical hours and days immediately following effectiveness the potential supply (including potential selling by owners who might have sold had they known of their ownership) might be artifically limited; and for a considerable period thereafter selling was hampered by the difficulty of making delivery.

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