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(202) 755-4846

FUTURE SECURITIES MARKETS -- REFORM, NOT REVOLUTION

An Address ByRay Garrett, Jr., Chairman

Securities and Exchange Commission

SEPTEMBER 8, 1975NORTH AMERICAN SECURITIESADMINISTRATORS CONFERENCE58th ANNUAL CONFERENCEMACKINAC ISLAND, MICHIGAN

It is a pleasure for me at last to be able to attendthe Annual Conference of the North American SecuritiesAdministrators and to extend my personal greetings to allmembers of this Association and their guests. That this ismy first appearance as Chairman of the Securities and ExchangeCommission at your Annual Conference is certainly no faultof yours. I have been invited each of the last two years,but for one reason or another, have been unable to make it.

Last year was a particular disappointment, becauseuntil almost the last minute I had expected to be in Portlandand was much looking forward to it. As it turned out, however,the President's economic summit conference preempted myattention. I frequently have difficulty deciding betweenconflicting demands upon my time, but I have no difficultywhen I receive an invitation from the President, as you canunderstand.

I trust, nevertheless, that you have not feltneglected by the Securities and Exchange Commission. It isour conscious policy to cooperate in every way with yourAssociation and its members, and we know that it is yourpolicy to do the same with us. It is our impression that weare succeeding. Although there have been periods in the pastwhen our relationships were characterized by some disaffectionand estrangement, I think today we are doing the best we canto work harmoniously and constructively in view of our disparatejurisdictions and resources.

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Certainly you should feel that you are getting plentyof attention -- I hope not too much. It is essential thatthe spirit ot cooperation be developed and

nurtured at the staff level. That is where the daily workis done. And year after year that is where there tends to bemore continuity of personnel -- meaning that Commissioners andAdministrators are somewhat less likely to be around over anextended period.

There is so much to do that I have long believed amore practical division of statutory responsibility could bedevised and would be salutary. There are areas where you areforced, to a degree, to duplicate our work and responsibility.There are other areas where the federal government mightmore wisely defer to state jurisdiction. The federal

securities code proje~t. is laboring in this direction, and Iwish it success. In the meantime, however, we must do whatwe can to achieve a harmonious pattern of federal and Stateadministration within our respective statutory mandates.

The other day, at the Commission table, we had finishedconsideration of some enforcement matters, including somestaff recommendations for formal orders of investigation thatcame from one or more of our regional offices. You probablyknow, but some of you may not, that our appropriate staffoffices -- the Division of Enforcement, in Washington, and

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the several regional offices -- may, and do, make informalinquiries reg~rding possi~le violations of our laws withoutany specific authorization from us and without even tellingus about it. But the issuance of subpoenas and the compellingof testimony requires a formal order of investigation enteredby the Commission itself. The recommendations that we entersuch orders are supported by rather comprehensive memorandums,supplemented, where appropriate, by oral presentations.

As one would expect, these memorandums, while followinga more or less established form and always reflecting agreat deal of labor, vary considerably as vehicles ofcommunication. It was this variation that became the subjectof comment among the Commissioners and led to speculationwhether, at our forthcoming Regional Administrators Conference.we could do something to improve the situation. Among thecomments, I observed that some staff members seem to besingularly lacking in insight as to what is likely to bedecisive to a Commissioner. I have often read 20 or 30 pagesof more or less inconclusive narrative and legal exegesisbefore coming to the clincher. For example, we have, Ibelieve, never declined to enter a formal order when theinvestigative effort has been requested by a state administrator.Such a request is virtually dispositive and should be on thefirst page of a memorandum to us. The other Co~issionersreadily agreed.

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I am assured that a like spirit prevails generallyamong the state administrators, if we need help, and I amglad that this is so and urge its continuance.

As important as our mutual enforcement activitiesare, however, it is not likely that I can contribute anythingof a concrete nature in that area beyond the discussions youwill be having with others from our Commission, so I wouldlike to divert your attention for a few minutes to otheraspects of our securities markets and, in particular,developments in the securities markets with special referenceto the 1975 Amendments to the federal securities laws.

I have declined to engage in the game of decidingwhat has been the most important federal securities legislationsince 1934. In terms of its pervasive effect upon corporatelife and investor protection a strong case can bemade for that provision in the 1964 amendments that inserted

Section l2(g) in the Securities Exchange Act and thus subiectedunlisted companies, plus banks and insurance companies, to thereporting requirements, proxy regulations and short-swing tradinginhibitions of that Act. But, if those who struggled so longto produce the 1975 Amendments find satisfaction in thinkingthem to be more important -- perhaps because they have shortmemories and forget that Section l2(g) has not always been withus -- I will not quarrel with them. Surely the 1975 legislationis quite important enough to demand attention.

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Nevertheless, the legislation itself is but a formalphase in the overall metamorphosis of our securities marketsfrom the post-World War II pattern, that served so well theunprecedented burgeoning of the individual investor as thedominant feature in our equity markets, to the markets ot thefuture, that surely will, as they have been for some time,be dominated by institutional investors. This fundamentaltrend has not been the creation of the Congress, andcertainly not the SEC, but rather of other economic andsocial forces not, on the whole, planned or decreed by anyone,although Congress has from time-to-time stimulated the movetoward increased institutionalization of equity investmentthrough various income tax provisions, as it did just recentlywith the Employee Retirement Income Security Act of 1974 ("ERISA").

Of course, the most dramatic feature of the securitiesmarkets of the 50's and 60's was its ultimate inability tocope successfully with the volume of transactions whichdeveloped in the late 60's. The great back-office crunchled to four-day weeks on the New York Stock Exchange, widespreaddiscontent among investors who waited weeks and months fordelivery of securities, and ultimately to the financialcollapse of scores of broker-dealer firms, including some

of the largest and best known.

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It all revealed some glaring inadequacies in thesystem all aspects of the system, including the regulatory.The facilities for handling transactions were horse and buggyequipment trying to meet the needs of the jet age. Andthis, in part, was the consequence of the historic domination

of the industry and its components by salesmen and therelatively little attention paid to operations -- or tocompliance with the law in all too many cases. tfhen salesmenare permitted, indeed encouraged, to generate or acceptorders without regard to whether the customer can be properlyserviced, and the salemen are successful, disaster isinevitable, and it came.

As we contemplate the future, it is important toreflect on how far we have come since 1970. There has beenmuch more of a reformation, if not revolution, in thesecurities industry than may be readily apparent. In termsof operating facilities, we have moved into a new order ofmagnitude. In the late 60's, when daily volume l7as in theneighborhood of 20 million shares on the I~ew York StockExchange, the market was drowning in paper work. In recentmonths, 30 million share days have been taken in stride.Net capital requirements have been tightened and the self-regulatory, as well as regulatory surveillance systems,vastly improved. SIPC has been established and proved itself

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as a major source of investor protection. Tons of paper havebeen brought in off the street, so to speak, through theestablishment of securities depositories, by far the largestof which is Depository Trust Company in New York. Thefacilities for clearing transactions have likewise beenmodernized and will be further coordinated among the variousmarkets. Of a less obvious nature, but perhaps mostimportant of all, operations men have been let out of thecage and given dominant roles in firm management, as have thosewhose primary responsibility is compliance. l.Jeall realizethat the most efficient and lawful system in the world isuseless if you do not get any business, but a better balanceis being achieved.

All of this has already come to pass. And there ismore. Last May 1, as everyone knows, through Commissionaction, fixed minimum brokerage commissions for exchangetransactions were abolished. What this means for the futurewe are, I am sure, just beginning to learn, but a change soradical is certain to have a profound, long-range effect.The observations and expectations that have been expressed sofar have either been wrong, or superficial and transitory,or unproven one way or the other.

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The early predictions of immediate catastrophe have,fortunately, proved mistaken. One thing regulators can useas well as anyone else is a little bit of luck, and in thiscase we had it, as the stock market took a sharp upturn inprice level and volume last spring. I have facetiously hintedthat we planned it that way, but that would be like Chanticleerclaiming that his crowing brought the sun up every morning,or that we had a frightening faculty of forecast not ordinarilyaccorded to mortals. In fact, of course, we eschew claimingcredit for the ups lest we be blamed-for the downs, and,incidentally, because we do not deserve either.

Nevertheless, if May Day had to come, as we believe itdid, the timing was fortuitous. The securities industry, onthe whole, has had good earnings to cushion the shock of theinitial shakedown period. I wish that Congress would seefit to provide the firms with a tax sheltered reserve, sothat more of these earnings could be set aside against lessprofitable periods in the future, but even without this,things are currently good in this area despite the discountsin commission rates.

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So far, most of the attention in the press and thetrade services has naturally been directed to the daily orweekly changes in cocrmission rates, usually expressed in termsof discounts from the prevailing fixed minimum rates as theywere on April 30. In this regard, what has happened has beenmore or less what one should have expected, although I confessthat I experienced some surprises, emphasizing the wisdom of ourdeclining to make any detailed predictions. In particular,so much had been made of the prospect that the large, strongfirms would price the little fellows out of the business --something that I did not expect, at least initially -- that I

was surprised when the deep discounts began withthe smaller, less strong firms. But that is the way it was.Of course, the strong firms responded and, after a period ofrather wild and irresponsible discounting, things appear tohave stabilized a bit.

Has all this been good? Its value cannot, in my opinion,be measured entirely, or even primarily, by the commissionrate level. Our objective in eliminating fixed minimums wasnot to cause rates to go down or up or reach any particular level.If we had thought we knew what rates ought to be, we couldmore simply have used our statutory authority to assurethat result. Rather, after years of studies and debates,

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we concluded that competitive forces could determine the"proper" rates better than any rate-making theory that hadbeen presented to us or that we had 'been able to contrive.It is still possible that this could prove not to be thecase and that we could be forced back into commission rateregulation on some formula or other, but Ido not expect thatto happen. In the meantime, absent any conspiracy or otherartificial restraint, whatever the rates are is what theyought to be.

There is much more to all of this, however, than ratelevel. Fixed minimum rates supported a whole host of servicesand practices beyond the simple brokerage functions for whichthe rate was ostensibly charged. Of these, research, as itis called, is the most obvious and possibly the most important.Many thoughtful persons predicted that the lack of a fixedminimum would drive rates do~~ to a level at which they wouldno longer cover the cost of research, that investors,particularly institutional investors, would not pay harddollars for research, and street research would inevitablywither and die. This has not happened yet, but it would behasty to conclude that it will not happen to some degree. Thereis already evidence that the so-called research "boutique,"

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the small firm. of limited capacity to execute orders butwith extensive research capability, may be in trouble. Somefirms that were in that category saw what was coming anddeveloped trading and execution facilities in time to ease theminto the new world. Others dOd t J1 no ana appear to be suffering.

There is great cynicism about the value of much thatpasses as research on the street. and no doubt some of it iR notworth a great deal. But sone of it clearly is. Furthermor~. whileone cannot know what may be the optimum number of the sourcesof investment opinion, there is a need for diversity to preserveliquidity, if nothing else. A seller needs a buyer. It wouldbe bad for our markets and our economy, :Eor a.ll, or even i:l.ost,of street research to disappear .//VJnet1'ier there is anyaanger

is, from the brok~~ of view, is a complexqUestion.~concept of the execution-only commission rate -- providing I

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\ no increment to cover the cost of research -- unrelated to ///\ volume is easier to imagine than to see in practice. __------/

The problems presented by unfixed commissions relatedto research are not by any means limited to the brokers' sideof the business. Institutional investors, including mutualfunds and their advisers, are equally involved. Heretofore,investment managers of all kinds have been able to rely on thecommission throw-off of portfolio activity to produceresearch and other services at no extra charge. The systemwas not without its potential for abuses, but it clearly had

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its benefits. Customary rates for investment managementhave in fact been based on the assumption, conscious or not,that the managers would be getting a lot of "free" research.70 the degree that this should be denied to rhp.m now and in thefuture, what does this mean? For thp. same fee, is the manager nowto provide an in-house substitute? Or should he be perflittedto use the portfolio's funds to pay up for research -- fleaningpay a hiEher commission to a firm that furnishes research thancould be obtained from an execution-only firm, or from thesame firm without research? If so, how much more? If hemanages more than one portfolio, must he be' sure that thepaying up is done by the portfolio that benefited from theresearch? Finally, can he use the portfolio's cash to pay

spend out of his own pocket, whatever is necessary to enableHe must do, andmanagement for the agreed fee, and that's it.

hard~~_~_la-=s for research ~ __ ------------------\: It is easy -- too easy -- to dispose of the matter by ,

/ saying that the investment manager, whether trustee, investment\II adviser or whatever, accepted the responsibility of portfolio

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him to perform his duties properly, while keeping expenses ,/

I agree, but it is too simplistic to accord with practicalrealities.

I charged to his beneficiaries as low as possible.

IIt is easy, ;'

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While the problem is most complex with respect to thetrust departments of banks with their great variety of invest-ment management functions, it also arises with respect to theinvestment advisers of mutual funds and other investmentcompanies, which are of more immediate concern to the membersof this association. Does a fund investment adviser have aduty to seek the lowest available commission rates eventhough so doing denies it access to street research -- assumingthat such a choice becomes q practical reality, and assumingthat brokerage commissions are charged to the fund as theynormally are?

In considering this question, I believe everyone agreesthat there is no duty to seek the lowest rate where the qualityof services is not adequate. Clearly the adviser can causethe fund to pay whatever is reasonably necessary to obtainbest execution. This becomes easy to demonstrate and justifyfor large and difficult orders requiring special knowledge bythe broker with respect to the other side of the trade, orskill in handling market transactions so as to minimize marketdisruption, or possibly positioning by the broker. But smallorders can also be mishandled, and there are many littlethings that contribute to the overall quality of brokers'services, just as there are for other services. Surely,absent any conflict of interest or other contaminating factor,the adviser is justified in using a broker, or a list ofbrokers, who he believes generally provide the best service

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without regard to whether, on each trade, a lower commissionmight have been obtained from someone else.

The fund benefits most from best execution and overallquality of service. This must not be neglected simplybecause commission rates are so obvious and easy to compare.

But the research question goes beyond this. Itassumes, in its simplest form, a circumstance like this.Brokerage Firm A and Firm B offer equal execution capabilityand quality of service, but A's rates are X percent higherthan B's. However, A offers good research regularly, andB offers poor research or none at all. Can the fund adviseruse A instead of B?

This question was much debated prior to the adoptionof the 1975 Amendments, and the result was new Section28(e)(1) of the Exchange Act, which provides that no personhaving investment discretion shall be deemed to have actedunlawfully or to have breached his fiduciary duty

solely by reason of his having caused theaccount to pay a ... broker ... an amountof commission for effecting a securitiestransaction in excess of the amount ofcommission another ... broker ... wouldhave charged for effecting that trans-action, if such person determined in goodfaith that such amount of commission wasreasonable in relation to the value of thebrokerage and research services provided bysuch ... broker ... , viewed in terms of eitherthat particular transaction or his overallresponsibilities with respect to the accountsas to which he exercises investment discretion.

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Clearly Congress has answered our question, yes. Of course,this presents a subject for disclosure and possible negotia-tion of advisory agreements, and you may have noticed thisbeing done in current prospectuses and proxy material.

Section 28(e)(1) was not without opposition. Itshocks and frightens some persons -- including some withinthe ranks of the SEC -- to have the law relax to any degreethe strictures imposed upon fiduciaries who manage otherpeople's money to use that money solely for the others'benefit. But this assumes that it is the obligation of theadviser to provide all research at its own expense. If thiswere its obligation, then such paying-up as Section 28(e)(1)permits would arguably constitute using the fund shareholders'money to benefit the adviser by relieving it of an expensethat it would otherwise have to bear. However, as I said

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earlier, this is simply not the practical fact in man~, _ifnot~uations ./The;r~c~~~al f~~~., t~a~ a-dViSOry \.

~eements andfue;/ were negotiated in contemplation of the ""I

( availability of street research from brokerage commissions.\If research can no longer be obtained in this way, something"-\has to change.

~s quite unrealistic and unfair to expect everyadviser, for the same fee, now to provide full in-house

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research capability or, to purchase. research with its ownmoney. The matter must, b~ renegotiated.

I have gone .into thip subject at some length pecauseof its abiding importance. ,As advisory agreements and patternsare readjusted to reflect the consequences of unfixed commis-sion rates, some readjustment may be appropriate in regulatorypatterns. A major purpose and intended effect of unfixingrates is to break out the various services traditionallyprovided by many brokers and paid for, if at all, only throughcommissions. Ideally, these services should be unbundled tothe extent that research is paid for by hard dollars. Butthis cannot occur widely in the institutional area withoutsubstantial changes in the contracts, laws and customsgoverning investment management of all kinds. Section 28(e)(1)is intended to ease the transition. I supported it, and Ihope it does the job to the extent required ~y practicaldevelopments. But it cannot do the job unless it is properlyunderstood and applied by regulatory authorities.

As we observe the securities industry, and those who

do business with the securities industry, learning to livewithout fixed commission rates, we are also engaged in arestructuring of our securities markets looking toward theestablishment of what the Commission has referred to as a"central market system" but which the 1975 Amendments prefer

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to call a "national market system."same concept.

Both phrases allude to the

It is commonplace for those industry spokesmen whoprefer things the way they are, or, more properly, the waythey were, to say that everybody talks about a national marketsystem but nobody knows what it is. In ultimate detail, thisobservation has a degree of accuracy, but that is simply tosay that much remains to be worked out. In any event, thetime for fundamental debate is passed, and the time forimplementation is upon us.

Section llA(a) of the Exchange Act, inserted by the1975 Amendments, directs the Commission --

having due regard for the public interest,the protection of investors, and themaintenance of fair and orderly markets,to use its authority under this title tofacilitate the establishment of a nationalmarket system for securities ... in accor-dance with the findings and to carry outthe objectives set forth in paragraph (1)

Paragraph (1) reads in its entirety(1) The Congress finds that

(A) The securities markets are an importantnational asset which must be preserved andstrengthened.

(B) New data processing and communicationtechniques create the opportunity for moreefficient and effective market operation.

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(C) It is in the public interest and appro-priate for the protection of investors andthe maintenance of fair and orderly marketsto assure

(i) economically efficient executionof securities transactions;

(ii)dealers,exchangeexchange

fair competition among brokers andamong exchange markets, and betweenmarkets and markets other thanmarkets;

(iii) the availability to brokers,dealers, and investors of informationwith respect to quotations for and trans-actions in securities;

(iv) the practability of brokers executinginvestors' orders in the best market; and

(v) an opportunity, consistent withthe provisions of clauses (i) and (iv) ofthis subparagraph, for investors' ordersto be executed without the participationof a dealer.(D) The linking of all markets for qualifiedsecurities through communication and dataprocessing facilities will foster efficiency,enhance competition, increase the informationavailable to brokers, dealers, and investors,facilitate the offsetting of investors' orders,and contribute to best execution of such orders.

That is our goal, or those are our goals. The powers that wehave been given to use toward that end include not only moredirect authority over the content of the rules of securitiesexchanges, but also, for the first time, regulatory authorityover transfer agents, clearing agencies, and, a new classification,"securities information processors" -- those who collect anddisseminate information with respect to transactions in orquotations for any security.

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To assist the Commission in this enormous task, the 1975Amendments also provided for the establishment of a 15 memberNational Market Advisory Board, which we have already appointed,with John Leslie, the chief executive officer of Bache and Co.,as Chairman. The Board will study and make recommendations asto steps appropriate to facilitate the establishment of anational market system. It is also directed to study "thepossible need for modifications of the scheme of self-regulationprovided for in this title so as to adapt it to a nationalmarket system, including the need for the establishment of anew self-regulatory organization ...to administer the nationalmarket system."

Needless to say, neither we nor the industry had towait for the final act of Congress to tell which way the windwas blowing. In fact, the basic elements of the nationalmarket system grew out of Commission and Congressionalstudies over the last half-dozen years or so and were set forthin the Commission report on the central market system publishedin March, 1973. Since then, there has already been establisheda consolidated tape for reporting transactions on all exchangesas well as the third market. Exchanges and third marketmakers must now make their quotations generally available,and we look forward to the early availability of consolidated,or composite, quotations. And, as I mentioned earlier, much hasbeen done to make more efficient the processing of transactions.

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As you observe the progress from hereto the full nationalmarket system, you will doubtless hear some thunder and smellsome smoke, more than once. It is already beginning.

While we have the duty, under the 1975 Amendments, toreview all rules of the national securities exchanges, Congress,in its wisdom, not ours, required that we immediately review"any and all rules of national securities exchanges which limitor condition the ability of members to effect transactions insecurities otherwise than on such exchanges." The most obvioussuch rule is Rule 394 of the New York Stock Exchange requiringits members to execute all trades in listed securities on theexchange, or some other exchange, unless certain inhibitingconditions are met.

We filed a report of our review of Rule 394 and similarrules on September 2, when it was due, and we said that the rulesobviously had some anti-competitive effect but that we wereunable to determine whether the rules were neverthelessjustifiable under the new statutory standards without a hearing,which we said would commence October 1. Although we strovefor objectivity in the report, the press editorialized to theeffect that we had really already made up our minds to abolishRule 394, and the thunder has begun to roll. I am frequentlypuzzled at how the press presumes to know better than we dowhat we think. The truth of it is that we meant what we said.Collectively, we have not yet concl~ded whether, and to what

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extent, such restrictive rules are appropriate during theperiod while the full national market system is beingdeveloped. Our own advisory committee on the implementationof the central market system, headed by Alexander Yearley, ofAtlanta, has recommended retention of Rule 394, and thatnaturally carries some weight.

I realize that you are not directly involved in thisprocess and may have limited interest in what must seem likeinterminable intramural bickerings. So I will resist anytemptation to get further bogged down in details. My purposehas been to bring you up to date on some current developmentsin the securities markets that we all participate inregulating. The movements now underway, and those mandatedby the 1975 Amendments will be occupying the attention ofthe Commission and industry leaders for months and years tocome, and it is important that you understand what is going on.

It is, and will continue to be, an exciting process.It is also one which requires as many cool heads and clearminds as can be brought to the task. Most reform movementsstart from a different base one of collapse and disgrace.In this case, such collapse and disgrace as there were havealready been largely overcome by the developments that Ioutlined early in my remarks. We have now what all of usrecognize as the best capital markets in the world. Congress

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and the Commission and those industry spokesmen who supportedthe 1975 Amendments have concluded that our markets can bemade even better and should be. But in the process of furtherimprovement we must be careful not to destroy that which wehave that is good until we can replace it with something better.

It is not, as far as we are concerned, a punitiveexpedition, and, through the Advisory Board and otherwise, wehope to draw as much as possible on industry initiative andcooperation.

Thank you again for inviting me. These annual conferencesare a major institution and represent government at itsbest -- where representatives of federal, state and provincialgovernment can meet with representatives of the industry andthe bar to consider matters of common concern. We should allbe proud of this institution and strive to keep these conferencesproductive as well as pleasant.

I wish you great success in both regards.