of directors structured generally along the lines of the present New York Stock Exchange board.28

The New York Stock Exchange's experience to date with the major reorganization accomplished a year ago has been extremely favorable. A board committee headed by Mr. Ralph Saul is currently reviewing the possibility of making further refinements in the board's procedures. However, we do not believe that Congress should legislate the precise terms of such a reorganization for all exchanges. There are a number of reasons for this, the first being that each board needs a degree of flexibility to adapt its procedures to its own style of doing business. Second, a number of the specific proposals in the bill were considered in connection with the New York Stock Exchange reorganization last year and were either rejected or revised by the board's reorganization committee, headed by public director Cornelius Owens. Some of the requirements imposed would require the restructuring of exchange organization in a manner quite inconsistent with well established standards of corporate democracy and accountability. For example, the bill would require that "the public representatives elect their own successors to the governing body of the exchange," while the industry directors would be elected by the exchange membership by cumulative voting.29 This would mean that half the board would be elected by cumulative voting of the exchange membership and the other half would elect their own successors.3 30

Several of the requirements imposed may conflict with applicable State corporation laws. Another provision would require that only the board could amend the rules of the exchange, which elsewhere in the bill are defined to include, among other things, the exchange's articles of incorporation and constitution." This requirement would clearly be in conflict with the New York State law under which the New York Stock Exchange is incorporated, and it may well be in conflict with the corporation laws under which other exchanges are organized. New York law provides, in accordance with the tradition of corporate democracy, that only the members of a not-for-profit corporation have the ultimate power to amend its certificate of incorporation and bylaws. Indeed, every corporation listed on the New York Stock Exchange must meet the basic requirement of submitting important actions to their shareholders for a vote. The bill, therefore, would single out the stock exchanges as probably the only corporations in the country whose owners would be denied there basic rights.33

28 Proposed sec. 6(b) (3), H.R. 5050, sec. 202, amending act sec. 78r.

29 Proposed secs. 6(b) (3) (B) and (C), H.R. 5050, sec. 202, amending act sec. 78f.

30 Under sec. 6(b) (3) (A) at least half of the governing body of the exchange must consist of "public representatives" who are not connected with the securities industry and who are not members of the exchange, and under subsection (B) these public representatives must elect their own successors.

Under the New York not-for-profit corporation law ("NPCL") the governing body of a corporation (in the case of the exchange, its board of directors) must, with exceptions not relevant for the purposes of the bill, be elected by its membership (NPCL secs. 603(b), 613(a)); accordingly, it would not be possible under the NPCL for the public representatives to elect their own successors to the board of directors of the exchange unless the public representatives were also members, within the meaning of the NPCL, of the exchange.

31 Proposed sec. 6(b) (3) (D), H.R. 5050, sec. 202, amending act sec. 78f.

32 New York not-for-profit corporation law sec. 602 (McKinney 1970).

33 Proposed secs. 6(a) (3) (D) and (F), H.R. 5050, sec. 202, amending act sec. 78f raise some questions.

Subsec. (F) provides that the voting power of members must be distributed "on a fair and equitable basis," but it may well be that the only area where members would have the right to vote would be to elect the 10 industry directors, since subsec. (D) requires that the board, not the members, have the authority to change the exchange constitution, rules,

In any case, it appears to be inconsistent to require exchanges to have publicly oriented boards of directors, on the one hand; and on the other hand, to make it unattractive for persons of standing to serve on such boards by reducing their authority and increasing their potential liability exposure. If a publicly oriented board is a good idea-and we certainly agree that it is then it should follow that such a board should be given a fair opportunity to prove its mettle.

LIABILITY OF EXCHANGES INCREASED

In other sections of the bill, seemingly simple drafting changes increase the potential liability of the stock exchanges. At the same. time, the ability of the exchanges to adequately carry out this broadended responsibility by effecting needed rule changes, disciplining its members and the like, is undermined, as we have shown, in other sections of the bill.

This apparently inconsistent result is reached by repealing present provisions of the law which limit the responsibility of an exchange to enforce "so far as is within its powers compliance by its members" with the provisions of the Securities Exchange Act of 1934.34 Instead, under H.R. 5050 this important qualifying clause is deleted. An exchange is required simply "to enforce compliance by its members," without qualification. Companion sections which presently allow the exchanges to adopt and enforce any rule not inconsistent with the 1934 act are also repealed.

35

Similiarly, the historic concept of limited membership or "seats" on an exchange is abandoned and open membership is mandated for all broker-dealers who voluntarily choose to become members.36 In view of the disincentives for membership. there may be few, if any, broker-dealers who would choose to be members. Assuming, arguendo, that this is not the case, the exchanges are nevertheless placed in an impossible position, as they would be required by law to admit everyone to membership-even though membership, as we know it, would not exist and would then be held responsible for regulating every broker-dealer they are compelled to admit.

37

As a matter of fact, under the provisions of the bill, membership in a registered national securities association, such as the NASD, could be more restrictive than membership on an exchange. If so, this approach-which, hopefully, is a drafting oversight-is a complete reversal of the present market organization and statutory arrangement. However, the basic statutory economic incentive for broker-dealers to want to become members of the NASD is retained in the law 38. as it should be-while, as noted previously, the traditional economic incentives for broker-dealers to become members of an exchange are repealed.

This approach, coupled with the manifold disincentives to exchange membership, could make membership in the NASD more attractive to broker-dealers than becoming or continuing as members of an exchange.

34 Act sec. 78f (a) (1).

35 Proposed sec. 6, H.R. 5050, sec. 202 amending act. Sec. 79 (f).

38 See note 3 supra.

37 Compare proposed sec. 6(m), H.R. 5050, sec. 202, with proposed sec. 15A (b) (2), H.R. 5050, sec. 206.

COMPETITIVE COMMISSION RATES AND INSTITUTIONAL MEMBERSHIP

Title II of the bill also mandates fully competitive commission rates by February 1975,39 unless extended by the SEC, and restricts membership on exchanges to those organizations doing primarily a public business.40 As noted previously, the New York Stock Exchange's board of directors, on March 1, 1973, adopted a policy statement outlining a program for addressing these and related issues concurrently."1 Mr. Ralph Saul will discuss that policy statement in his remarks, so I will only stress here that if fixed commission rates are to be eliminated the exchanges' and the SEC's present responsibility for regulating commission rates should also be repealed.

However, title II saddles the exchanges with new responsibility for providing "safeguards against unreasonable profits or unreasonable rates of commissions or other charges." 42 This language implies that while the exchange and the SEC may no longer engage in "the fixing of reasonable rates of commission," as they may presently do under section 10(b)-9 of the 1934 act, the exchanges would have a new responsibility for keeping members from charging "unreasonable rates of commission.”

While this is another example of additional responsibility imposed on the exchanges, it is one whose ramifications merit further examination, since similar specific authority to prevent exchange members from charging unreasonable rates of commission is not conferred on the SEC as is presently the situation under section 19 (b)-9. This approach could, among other things, place the exchanges in an untenable position under the antitrust laws. The exchange believes that its actions are and should be exempt from and justified under the antitrust laws where the SEC has specific oversight authority, as is presently the case in the commission-rate area.43

Again, the result of these provisions of the bill seems to lead to greater uncertainty rather than to clarify the present situation. It is arguable that this section, which purports to mandate fully competitive commission rates, really does not do so. Rather, it gives the exchanges, not the SEC, the authority to establish rules defining what commissions, profits, and charges are not "unreasonable," without including any standards or definitions as to what is meant by these broad terms. Again, we would urge that if fixed commission rates are abolished, Section 19 (b)-9 should be repealed and no new responsibility such as proposed in the bill should be imposed on the exchanges or the SEC.

SUMMARY OF TITLE II

Mr. NEEDHAM. Obviously, the full package of legislative changes contemplated in title II of H.R. 5050 would create a very different kind of securities industry in the United States. The provisions of title II are not only very far-reaching, but-as we have tried to demonstrate they are, in many instances, inconsistent.

41 A copy of the NYSE Board of Directors Mar. 1, 1973, policy statement is attached.

42 Proposed sec. 6(a) (5), H.R. 5050, sec. 202, amending act sec. 78f.

43 Silver v. New York Stock Exchange, 373 U.S. 341 (1963); Kaplan v. Lehman Bros.,

5944

Further, the bill directs the SEC to take steps to create such a system within the next 19 months, but nowhere does it attempt to define precisely what is meant by a "national market system." Previous testimony before the subcommittee has indicated some uncertainty about whether a "national market system" refers, in fact, to a "central market system," or to some kind of "coordinated system," or to a federation of stock exchanges.

As you know, the New York and Pacific Stock Exchanges have announced the start of discussions which could lead to an affiliation between our two organizations. It may be that these discussions will provide valuable insights into the best approaches to a national market system.

It seems clear that the bill gives broker-dealers incentives to handle customers' orders not in an orderly auction process on a stock exchange, but as dealers setting prices at which they are willing to trade listed securities with customers in their offices. But it does not seem to contemplate just where listed securities will be listed in the absence of viable stock exchanges.

If there are no advantages to listing on a stock exchange, issuing companies are unlikely to accept the costs and responsibilities of listing and continued listing. This would obviously deprive the exchanges of listing fees which are a primary source of exchange revenues- -at the same time that the exchanges would be required to withstand other new burdens and liabilities imposed by H.R. 5050. The compound aggravation of the already fragile financial condition of the exchanges, and, I might add, the NASD, would be intensified by further encouraging over-the-counter trading in listed issues.

As of the first quarter of this year, the over-the-counter market in listed securities the third market-accounted for 5.8 percent of all trading in stocks listed on the New York Stock Exchange. One third-market firm is said to account for about one-third of the total. The New York Stock Exchange itself accounts for 81.7 percent of trading in NYSE-listed issues, while the remaining 12.5 percent is spread among the various regional exchanges on which NYSE-listed issues are also traded.

There is a long series of very cogent reasons why the third market has not succeeded in garnering a larger share of transactions in listed securities. But perhaps the principal reasons are that third-market dealers lack any responsibility, comparable to that of NYSE specialists, to provide continuous markets in the issues they trade, to report their transactions to the public, or to submit to effective regulatory or self-regulatory procedures. What makes the third market attractive to dealers and to their large institutional clients are precisely the features which tend to exclude the public from participating in the third market.

We hear a great deal from the supporters of the NASDAQ system about how NASDAQ is changing all that. But to date, certainly NASDAQ has clearly promised infinitely more than it has delivered.

One objective appraisal of NASDAQ was offered in an article in the July 1971 issue of the Institutional Investor magazine, which-with the subcommittee's permission, Mr. Chairman-I would like to sub

mit for the hearing record. [See appendix, p. 1102.] In one key paragraph, this article points out:

*** lest NASDAQ too early be hailed as a panacea, it must be pointed out that it is only a communications system--and a rather primitive one at that, by current electronic standards. There is no way as yet to input orders or to lock in a trade. And most important, no new rules have been created to contend with some traditional OTC abuses that instant communication exacerbates. Before NASDAQ. many dealers' success depended upon the art of bluffing over a telephone; now *** these same dealers lie awake at night devising ways of treating the NASDAQ machine as a similar extension of themselves.*5

Noting that NASDAQ's prices are not always reliable, the article goes on:

46

The spread of the system and the visibility of its prices mean market makers can put one price on the machine to attract orders or tempt competitors to follow suit and then quote a different price verbally when a customer calls. I think it is important to recognize NASDAQ for what it is-an automated quotation system. Before NASDAQ, dealers displayed their quotations daily in pink-colored lists obtainable, for a price, by anyone who wanted them. NASDAQ began as-and remains today-an automated version of those lists. It is not a stock market, as some have claimed. It is not any kind of market. NASDAQ does not display transactions; it simply indicates the prices at which a dealer says he would be willing to buy or sell at least 100 shares of particular stocks. However, it becomes obvious from watching the NASDAQ screen that many quotations have little or no significance even with respect to 100-share round lots. Market makers often will not change their quotes in an exchange-listed stock for a full day or longer, even when that issue is continuously trading on the New York Stock Exchange. When, over long periods, some third market makers change their quotes and others do not, we find the anomalous situations known as "locks" and "reverses"-where the highest bid is equal to or greater than the lowest offer among all the market makers.

A lock or a reverse usually indicates that trades are not going to the dealer with the highest bid or the lowest offer. As far as we are aware, that happens because it is generally realized that those particular quotes are meaningless and will not be honored. The explanation may simply be that the dealer has carelessly neglected to adjust his quotes in line with those of other dealers. But whatever the underlying reason, the point is that the NASDAQ quotes may not be at all reliable and that there is a clear potential for confusing or even misleading investors who may have access to them.

It is disturbing that provisions in title II of this bill, instead of achieving the intended goal of stimulating better service to the investing public, may further alienate the public from the U.S. securities markets.

It's no secret that individual investors have been disenchanted with the market for some time--and everyone seems to have a favorite set of explanations for why this is so. To get a clearer picture, the exchange recently completed-and has published the results of a broad, in-depth survey. Our report provides some significant-if not exactly

45 July 1971 Institutional Investor magazine. See Bleakley, "Is NASDAQ Really the Answer" Institutional Investor; July 1971; at p. 21 (p. 1102; this hearing).