HISTORY OF REGULATION
Early Specialist Rules
The basic regulatory issues involving the specialist were delineated in the House Report accompanying the progenitor of the 1934 Act:
The importance of the actual workings of the exchanges themselves… should not be exaggerated. The stronger and more subtle economic forces affecting speculation come from without the exchanges. But as this speculation converges upon the exchanges, the control of the exchange mechanism is a necessary part of any effective regulation. It is for that reason that the bill gives the . . .[SEC] broad powers over the exchanges to insure their efficient and honest functioning …
No issue has been more disputed than that centering about the functions of the specialist. There are many who believe that the exchange mechanism would function better without the specialist [and] that the work done by the specialist could be done more effectively by a clerk . . . clearing the orders in a purely mechanical way. . . .Others. . .believe that a specialist should be obliged to act either as a dealer or as a broker and should not be permitted to combine the functions of dealer and broker. …. It is generally admitted that there are serious abuses in connection with the work of specialists …. There are inherent difficulties in the situation where under normal circumstances the available orders are known to the specialist only-and perhaps his favored friends-and not to everyone dealing in the security involved. Inasmuch as the stock exchanges objected to the laying down of any statutory rule governing specialists, their suggestion has been adopted of giving the Commission effective power to control the activities of specialists and to experiment with various devices of control.37
Section 11 (b) of the 1934 Act contains the governing provisions for specialists subject to that Act.38
In a report to Congress in 1936 on the feasibility and advisability of the complete segregation of the functions of dealers and brokers. Concluding that such a segregation was not advisable at that time, this Segregation Report”° also described the initial steps taken to eliminate some of the undesirable consequences resulting from certain dealer and specialist activities on exchanges including the formulation a year earlier of sixteen proposed exchange rules 1 which were implemented by all exchanges with minor modifications for the particular requirements of each exchange. 2 One rule was similar to section 11(b) and prohibited dealer trades by specialists unless “reasonably necessary to permit such specialist to maintain a fair and orderly market . . . .-3 The purpose of this rule was described as follows:
It represents an attempt to eliminate the dealer activities of specialists except insofar as such activities allegedly perform a useful service to the market. In view of the specialist’s fiduciary obligation to buyers and sellers whose orders he has accepted for execution; in view of his special knowledge and superior bargaining power in trading for his own account; in view of his peculiar opportunities and motives for attracting public interest to the stock in which he specializes; and in view of the undesirable effect which his trading may exert upon the market; it was deemed essential by the Commission that the dealer functions of the specialist be subjected to stringent control. The rule was intended to allow him only sufficient latitude in his personal trading to enable him to maintain a fair and orderly market in the securities in which he is registered.”
Finally, the Segregation Report recommended (i) increased emphasis on the observance of rules against trading by the specialist for his own account without affirmative justification and (ii) the development of appropriate restrictions on the specialist’s trading with his “book.”45 Although the need for rules to restrict unnecessary specialist dealer activities was emphasized, imposition of an affirmative obligation to maintain a fair and orderly market was not recommended. However, the Report recognized that specialists voluntarily assume this latter obligation as “a matter of business principle” since the specialist, by virtue of his combined broker and dealer functions and his commission business, has an important incentive to maintain a stable and orderly market.
In 1937 the Commission endeavored to implement these two recommendations of the Segregation Report in the form of an “interpretation” of the uniform specialist rule”5 adopted in 1935 by all exchanges having a specialist system!’ The importance of the interpretation, commonly called the Saperstein Interpretation ,5 warrants a brief summary. Compliance with the rule prohibiting a specialist from acting as dealer except to maintain a fair and orderly market was not to be evidenced by proof that a specialist dealer trade “had no undesirable effect or even no discernible effect, upon the market.”51 Rather, each transaction must be reasonably necessary to maintain a fair and orderly market. The “negative” test to be used in judging a lack of reasonable necessity is violated when the transaction “is not reasonably calculated to contribute to the maintenance of price continuity .. .[and to the] minimizing of the effects of temporary disparity between supply and demand. 512 In addition, the transaction must be considered in relation to the “immediate condition of the market” and “the specialist’s book.” 3 Finally, the adequacy of the specialist’s position in relation to the
“reasonably anticipated needs of the market”5 4 may be a consideration in particular instances. The need to lessen “temporary disparity between supply and demand” and the reference to “immediate condition of the market” emphasize that the specialist acting as a dealer is responsible only for short run market stability or orderliness rather than intermediate or long term price trends or volume. The adequacy of his position to the “reasonably anticipated needs of the market” refers to the specialist’s right to buy or sell in anticipation of future price trends. This permits him to build up a long
position by trading in anticipation of a market rise and concomitant increase in the number of buyers. As the market subsequently rose the specialist would supply stock purchased earlier. If he refused to do this, his long position could not be justified under the Saperstein doctrine. Thus, the negative restriction can imply an affirmative obligation to deal, creating a need for the specialist to enter the market as seller rather than to refrain from dealing.
The Saperstein Interpretation further specified certain types of transactions commonly considered unjustifiable including: a purchase above the last sale price; the purchase of all or substantially all the stock offered on the book at the last sale price; and the supplying of all or substantially all the stock bid for on the book at the last sale price.
The Saperstein Interpretation, the last formal Commission pronouncement on permissible dealer activities of specialists until the Amex Report of 1962,56 evidently had little effect. In 1941 “statistical evidence [failed]. to show any substantial change in the trading habits of the specialist after the Commission’s interpretation was made public.” 57
In 1938 the Commission and the NYSE commenced an investigation of the financial status of Exchange specialists to determine whether specialists were financially able to maintain a fair and orderly market and whether an Exchange rule was necessary to require that specialists have adequate capital8 In 1939, the NYSE minimum capital requirements were set at $10,000 or the market value of 100 shares of each specialty stock, whichever figure was higher 9 This development implicitly recognized the specialist’s affirmative obligation to enter the market. If the specialist’s only obligation was the negative one described in the Saperstein Interpretation and the Segregation Report-no affirmative requirement to act as dealer but any such action must be in a prescribed manner-arguably no mandate of a special minimum capital requirement would be needed. The Exchange, by enacting a
minimum capital requirement under informal Commission prodding, seemed to be requiring the specialist to affirmatively deal to make a fair and orderly market, at least to the extent of his minimum capital!’
COMMISSION RULES REGULATING SPECIALISTS
Commission Rule Jib-1 Commission rule I lb-1 governing specialists, implemented in January, 1965, is principally based on section 1 (b) of the 1934 Act which states in part that withen not in contravention of such rules and regulations as the Commission may prescribe. . . the rules of a national securities exchange may permit… a member to be registered as a specialist. If. . .a specialist is permitted to act as a dealer . . . such rules and regulations [of.the Commission] shall restrict his dealings so far as practicable to those reasonably necessary to permit him to maintain a fair and orderly market. . .
The Commission’s specialist rule provides that national securities exchanges may permit a member to register as a specialist and to act as both dealer and broker if the applicable exchange rules meet certain criteria. The NYSE and Amex had permitted dual broker-dealer functions even before the enactment of the 1934 Act, but the specialist rule first embodied the Commission’s formal acknowledgment of the combined broker-dealer function performed by specialists.
- Rule 1 lb-I provides that the rules of the exchanges must include five basic provisions:
1. Adequate minimum capital requirements.
2. Affirmative requirements that a specialist engage in dealings for his own account to assist in the maintenance, insofar as practicable, of a fair and orderly market.. This is often described as the “affirmative” obligation of the specialist to deal. “Substantial” or “continued” failure by a specialist to engage in such a course of dealings should result in the suspension or cancellation by the exchange of the specialist’s registration in one or more of his specialty stocks.
3. Restrictions on his dealings so far as practicable to those reasonably necessary to maintain a fair and orderly market. This is often described as the “negative” restriction on specialists and incorporates the Saperstein Interpretation.
4. Provisions defining the responsibilities of specialists acting as brokers.
5. Procedures to provide for effective and systematic surveillance of specialists’
The rule also establishes a procedure for Commission review and, if necessary, disapproval of new exchange rules relating to specialists 3 The Commission is given power to order the exchange to cancel or suspend a specialist’s registration in one or more of his specialty stocks upon finding that the specialist has made dealer trades which are not part of a course of dealings reasonably necessary to maintain a fair and orderly market, not effected in a manner consistent with the rules adopted by such exchange, and thus a violation of his “negative” obligation. However, if the exchange has itself suspended or cancelled a specialist’s registration, no sanction shall be imposed by the Commission under this rule unless the Commission finds “substantial” or “continued” misconduct by the specialist. 4
Finally, the Release promulgating the new rule provided that only the New York and American Stock Exchanges are to be subject to the rule’s requirements. The exemption of all other exchanges was based upon their limited volume of transactions and “the fact that the Commission had not made any studies of the structure of the regional exchange specialist system.””
Original drafts of the Commission rule sent to the New York and * American Stock Exchanges apparently imposed an affirmative obligation on the specialist to deal where necessary to maintain an orderly market.6 6 However, the final version provides that the affirmative obligation be included in an exchange rule. 7 The Special Study had recommended that a Commission rule be adopted under section 11 (b) to state an affirmative obligation to participate but recognized that section 11 has no explicit provision requiring specialists to participate in the market as principal.6 Possibly the uncertainty concerning Commission authority9 and fear of increased risk of private law suits against both the specialists and the exchange based upon such a Commission rule70 led to the adoption of the affirmative obligation to deal provision as an exchange rather than a Commission rule.
The exchange rule must also require that the specialist engage in a”course of dealings” to “assist” in the maintenance of a fair and orderly market “so far as practicable,” indicating that the specialist’s activities are not to be judged on the basis of one transaction and that the amount of stabilizing purchases or sales he must accomplish is within reasonable limits. The measure of his affirmative obligation to help maintain a fair and orderly market may be related to the minimum amount of capital required to be maintained by the exchange rule.’
The original draft of the rule sent to the NYSE and Amex apparently intended to directly impose the negative restrictions on specialist dealing,72 but the final rule, perhaps to lessen the fear of civil liability, required this restriction to be incorporated in the rules of the exchanges rather than as a direct rule of the Commission.73 A notable difference exists, however, in the treatment of failure to meet the affirmative rather than the negative obligation As noted above, the Commission has the power under the rule to order the exchange to suspend the specialist in the latter case. In the former case the Commission has no such explicit authority; rule 1 lb-I merely requires that exchange rules provide for the disciplining of a specialist who violates his affirmative obligations. In the case of an exchange neglecting to suspend or cancel the registration of a specialist for failing to engage affirmatively in a course of dealings to assist in the maintenance of a fair and orderly market, the Commission’s remedy, unless it were to promulgate a new rule under section 11 (b), would appear to be under section 19(a)(1) of the 1934 Act Which permits the suspension or withdrawal of the registration of a national securities exchange upon the finding that the exchange has violated the Act or any rule thereunder. 74 This is obviously a drastic and radical measure.
Prior to rule 1 lb-I there was no formal Commission rule on specialists. Arguably, however, section 1 (b) was self-executing, and the Saperstein Interpretation’s negative obligation was in effect as a Commission rule. Section 11(b) provides that “[i]f under the rules and regulations of the Commission a specialist is permitted to act as a dealer. . . such rules and regulations shall restrict his dealings so far as practicable to those reasonably necessary to permit him to maintain a fair and orderly market. . . .”75 Since the Commission in fact always permitted specialists to act as dealers from 1934 to the date of rule 1 lb-I, a possible inference is that specialists acting as dealers were required to comply with the negative restrictions of section 11(b). Accordingly, section 19(a)(3), providing that the Commission may suspend or expel from a national securities exchange any member thereof when the Commission finds that he has violated any provision of or rule under the 1934 Act, may have been applicable up to the passage of rule llb-1. However, since the Commission did not adopt a rule until 1 lb-l was promulgated in 1965, arguably section 1l( b.) was not operative in this regard absent such a formal rule.
Other Regulatory Provisions
The specialist is, of course, also liable for any violations of other federal securities laws including 1934 Act sections 9(a) and 10(b)70 and rules lOb-5 77 and lOb-675 thereunder which refer to manipulation. The Commission has stated that “Section 11 of the Exchange Act grants to the Commission broad and direct rulemaking power over the activities of specialists and adoption of proposed Rule 1 lb-I would in no way foreclose the Commission from exercising its residual power of direct regulation. ‘ 79 In United States v. Re,81 the court considered whether the defendant Amex specialists were acting “in the legitimate role of specialists, not as market manipulators.”‘” Rejecting the defendants’ contention that the anti-manipulative provisions “are irreconcilably inconsistent with the legitimate duty of the specialist,” the court concluded that “[i]nherent in the jury’s verdict of guilty… was the determination that the Res were not performing the function of specialists in their dealings …. ,,82 A specialist may possibly violate his duty to create a “fair” market without violating the anti-manipulative sections of the federal securities laws. The term “fair” would thereby have ethical connotations somewhat similar to NYSE rule 401 which places a standard of good business conduct upon NYSE members.83 Since “fair” is part of rule I1 b- I of the 1934 Act, this ethical connotation is incorporated in federal as well as exchange standards concerning specialists’ activities. The Commission has stated that the specialist also functions as a broker executing orders entrusted to him by other brokers on behalf of their customers in the securities in which he specializes. Thus, he is in a position of trust and confidence with his customers and obligated within the terms of his agency to the strict standards of loyalty, disclosure and fair dealing required of fiduciaries. It is arguable that a violation of a duty to keep a “fair” market could also lead to possible civil liability8 5
EXCHANGE RULES REGULATING SPECIALISTS
The NYSE adopted a number of significant changes in its specialist rules as a result of the Commission’s promulgation of rule 1 lb-1. The current framework of rules is described in this section with reference to any changes made as a result of rule I lb-I and the recommendations of the Special Study. 6 The central provisions governing specialists are set forth in NYSE rule 104 and the supplementary material thereto 8 7 The first paragraph of rule 104 is almost identical to the rule in effect at the time of the Saperstein Interpretation in 1937. The initial provisions of rule 104.10 setting forth the specialist’s affirmative obligation generally were, with certain differences, effective for many years’prior to the Special Study and are now required to be included pursuant to SEC rule llb-l(a)(2)(ii). Moreover, as a result of recommendations of the Special Study, the phrases related to “depth” were added. In this regard, the Commission stated that a related finding [of the Study] was [that] there was too much emphasis upon transaction by transaction price continuity, as distinguished from the concept of depth, i.e., the ability of the market to supply and absorb reasonable quantities of stock before significant price changes occur. . . .[The] problem has been met by an amendment to existing rules which specifically adds the concept of market depth to the obligations of specialists as dealers.p In announcing this amendment, the NYSE asserted that the term “reasonable” in rule 104.10(l)(2) and (3) “implies that the appropriate degree of participation will vary with conditions in each stock-price range, volume, etc.-and with over-all market conditions.” 9 The general statements in paragraphs 1, 2, and 3 of rule 104.10 provide only the most general guidelines. For example, no one expects a specialist to become insolvent to stem a long-run market downswing. On the other hand, the specialist is required to buy within reasonable limits to meet temporary disparities in public supply and demand. The difficulty arises in actually measuring the limit and scope of his obligation. Suppose that the exchange delays the opening of a stock due to a sudden influx of public sellers. Assume further that (a) the specialist must expend $50,000 of his own capital to meet the sell orders, without a significant drop in price; or (b) the specialist would have to expend $6 million to meet the sell orders at a price which is reasonably close to the last sale. What is the specialist’s obligation in each case? What standards should the exchange use in measuring the specialist’s precise dollar obligation under rule 104? A paradox may exist: If the specialist has a legal obligation to buy or sell only in cases of relatively non-serious imbalances, then the economic value of the specialist is somewhat lessened. In such nonserious cases, the public imbalance of buy and sell orders is relatively small and price gyrations may not be great even without the specialist. On the other hand, imposition of liability on the specialist to stem great imbalances of demand would call for greater capital resources than most specialists can command by themselvesY0 Paragraphs (5)(B) and (C) of rule 104.10, prohibiting what is commonly called “cleaning up the book,” were amended in 1965 to include a specific statement regarding the 50 percent limitation on specialists’ transactions in connection with establishing or increasing positions in specialty stocks. The first clause of paragraph (5)(B) prohibits the purchase of all or substantially all the stock offered on the book at a price equal to the last sale when the stock so offered represents all or substantially all of the stock offered in the market. Hence, if 2,000 shares were offered on the book and 4,000 offered in the crowd, this clause standing alone would appear to permit the specialist to buy the full 2,000 on the book for his own account, plus perhaps all or part of the stock offered in the market. However, the second clause limits the specialist to 50 percent of all the stock offered, subject to the general restrictions against unnecessary dealing. These prohibitions against cleaning up the book are refinements of prohibitions dating back to the Saperstein Interpretation and apply to transactions which “establish” or “increase” a position-long purchases or short sales.
Paragraph (6), added in 1965, provides limitations on the specialist’s transactions in connection with liquidating or decreasing a position and applies to long sales and purchases to cover a short position. Without prior approval of a Floor Official, the specialist must avoid liquidation of all or substantially all of a position by selling stock at prices below the last different price or by purchasing stock at prices above the last different price. The specialist must also maintain a fair and orderly market during liquidation. The Commission announced that these changes were made in response to the Special Study’s conclusion that NYSE rules did not adequately “inhibit potential disruptive market effects that could follow from an extensive liquidation or reduction of a specialist’s position.” 1 Rule 104 was also modified in 1965 to state that a specialist should avoid participating as a dealer in opening or reopening a stock in such a manner as to upset the public balance of supply and demand, unless the conditions of the general market or the specialist’s position make it advisable to do so in light of the reasonably anticipated needs of the market.12 This change complied with the Special Study recommendation that specialists be prohibited from changing prices at openings against the direction indicated by public supply and demand?
NYSE rule 103 contains the requirement that no individual may act as a specialist without being registered with the Exchange. In 1965, the rule was modified to provide that if the Exchange finds a substantial or continued failure to engage in a course of dealings directed toward the maintenance of a fair and orderly market, the specialist’s registration in one or more of his specialty stocks shall be subject to suspension or cancellation by the Exchange. This amendment had the effect of implementing paragraph (a)(2)(ii) of SEC rule 1 lb-1.
Capital requirements of NYSE specialists require each unit to have the ability to assume a position of 20 trading units-2,000 shares in a 100 share unit stock-in each common stock in which it is registered 5 The requirement was 400 shares prior to 1964 and was raised to 1,200 shares by the Exchange concurrently with the enactment of rule llb-1 6 This capital requirement is not to be confused with a net capital requirement, since the specialist himself is not required to have net capital sufficient to assume a position of 20 trading units. The specialist may fulfill this capital requirement either with his own funds or by borrowing from a bank or another member organization?7 The NYSE also adopted a rule in 1965 requiring that it be informed immediately by telephone of any intention to terminate or change existing financial arrangements or to issue margin calls to specialists. Both the Amex and NYSE agreed to inform the Conimission immediately by telephone if a specialist would apparently not be able to meet promptly a margin call or to continue in business because of his inability to obtain new financing. These provisions enable the exchanges to enforce the restrictions on specialist’ liquidations where margin calls might cause the specialist to start liquidating his position and in general to police the financial responsibility of specialists.
A number of rules deal with the agency or brokerage functions of specialists. The Special Study recommended that the NYSE and Amex should adopt rules prohibiting specialists from servicing the accounts of their own public customers9 to eliminate the potential for discrimination. 00 The Amex argued that the effect of this recommendation would be to diminish the capital resources of many specialists, since firms forced to split into two or more firms-one handling public customers, the other acting solely as specialist-would be smaller and weaker. The Amex also argued that such a ban would prevent it from interesting firms now engaged in a public business in specializing. 1 The NYSE, asserting that specialists had not given preferential treatment to their own public customers, contended that it would be undesirable to have a “blanket prohibition against specialists’ handling public accounts.”‘0 2 As a compromise, the NYSE adopted a rule prohibiting specialists from accepting an order for his specialty stock directly from the issuer, any officer, director, or 10 percent stockholder of the issuer, pension or profitsharing funds, or institutions such as banks, insurance companies, and mutual funds 0 Supplementary material to,&te rule provides that “popularize” any security in which he is registered. The Special Study has recommended that all securities owned by a specialist and in which he is registered should be kept in one trading account rather than segregated in long-term investment accounts for tax or other purposes. 04 The existence of such accounts was considered inconsistent with the Saperstein Interpretation in that the specialist was made a long-term investor regardless of his obligation to buy and sell stock only when reasonably necessary to maintain a fair and orderly market.”5 The final determination was that under certain circumstances a specialist may have an investment account. NYSE rule 104.12106 provides in part that purchases for the investment account must be reasonably necessary to permit the maintenance of a fair and orderly market. Moreover, no stock which was purchased on destabilizing ticks may be placed in the account.
These requirements are designed to reconcile the existence of the investment account with the negative and affirmative obligations of the specialist under NYSE rule 104 and Commission rule lIb-1. In addition, the specialist’s income data reported to the NYSE must “reflect, by speciality stock, any gain or loss occurring within an investment account.’ ” 07
The practice of stopping stock was criticized by the Special Study.”‘ If a floor broker is dissatisfied with the then quoted market, he may utilize this device by asking the specialist for a “stop.” If granted, the broker is assured a price for his customer no worse than the current market. If a better price is available at a later time, the order will be executed, and the “stop” is null and void. The Special Study noted that usually the “stop” would be filled from the book and only rarely by the specialist as dealer.”9 In 1965 NYSE rule 116 was modified to provide that with certain limited exceptions, a specialist may not stop stock against the book or for his own account if he” holds an order capable of execution at the “stopped” price. In those limited cases when a stop may be granted, the guarantee must result in narrowing quotations on the exchanges.”‘ The Special Study noted that the NYSE permitted “stopped” stock transactions to be omitted from the tape;”‘ rule 126112 was amended to eliminate this practice.
Several other exchange rules directly regulate the dealings of the
specialist. In certain circumstances he is permitted to execute “off the
floor” transactions for his own account without satisfying orders
from his book,”3 but he may not accept “not held” orders which
permit discretion as to time and price of execution.”‘ Dealings toadjust LIFO inventory in a specialty stock are prohibited.” ‘ Also a
specialist may not pay a better price for a block for his own account
than his brokerage customers pay for other pieces of the same
block.”‘ In successive dealer transactions with his customers’ orders a
specialist must charge all of them the best price which any of them
receive.”7 No member, including a specialist, may fill buy or sell
orders accepted by his organization as principal, except under
certain exceptions.”18
There are also several additional general proscriptions on a
specialist’s conduct. He is prohibited from participating in “pool
dealing” in his specialty stock’19 and may not hold any interest in a
joint account for specialty stock, except with another member
organization. 20 Proxy contest activity, directorships, and other
business dealings with companies in whose stock he is registered are
also forbidden.’ 2′ The specialist is subject to certain other rules of the
exchange involving record keeping for “own account” transactions, 22
auction market rules,’2 and responsibility for loss if an order which
should have been executed is not reported. 24
One of the most important rules regulating the specialist, as well
as other members, is the requirement that members and member
organizations shall follow the principles of good business practice.’2
This rule is potentially one of the most important rules regulating the
specialist. It might be applicable where there would be a violation of
principles of good business without another rule to directly fit the
particular facts.
In the past, exchange surveillance of the specialist has been
criticized as inadequate,’26 although a number of exchange rules are
-directed toward this function. For example, the specialist is required
to keep a record of purchases and sales initiated on the floor “in stock
in which he is registered, for an account in which he has an
interest.”‘1 The recorded information must include the price, number
of shares, time of transaction, and an indication if the sale is either a
short sale or an opening sale and must be reported as requested by the
Exchange. A designation indicates whether each transaction was on
a plus tick, minus tick, zero plus tick, or zero minus tick.12
1 The
specialist is also required to prepare a monthly report of his long
position in his investment account. 30
The exchange evaluates the specialist’s activities through the
information provided in these reports. One of the tests used is the
“tick test” which has been discussed above; 3′ however, no objective
criteria are established by the exchange rules to judge the results of the
tick test, although the specialist is restricted from assigning specialty
stock to an investment account unless he has maintained “a
stabilization rate of at least 75%, measured by the Tick Test . .. for
the day of purchase, and for the entire calendar week encompassing
that day.’ 32 Both exchanges have assigned additional personnel for
floor surveillance and have taken other steps to comply with the
recommendations of the Special Study.-1′ However, N YS E specialists
have recently been criticized for their performance and for their weak
capital position.
CIVIL LIABILITY
The extent of civil liability for violations of exchange rules is a
matter of considerable controversy’ and was litigated in Colonial
Realty Corp. v. Bache & Co.13
1 Judge Friendly stated that
[a] .particular stock exchange rule could . . . play an integral part in SEC
regulation . . . . The court must look to the nature of the particular rule and
-its place in the regulatory scheme, with the party urging the implication of a
federal liability carrying a considerably heavier burden of persuasion than
when the violation is of the statute or an SEC regulation. The case for
implication would be strongest when the rule imposes an explicit duty unknown
to the Common Law.1Y
The Colonial case was followed by Buttrey v. Merrill Lynch,
Pierce, Fenner& Smith, Inc.3″ where the issue was whether a violation
of NYSE rule 405, the,”know your customer” rule, gave rise to civil
liability. The defendant argued that section 27 of the 1934 Act 3 ‘
granted jurisdiction to the federal court only for violations of either
the Act itself or its rules and regulations and not rules of the NYSE.
The court answered that “[t]here is nothing inconsistent with this
section in holding that violations of Rule 405 may be actionable as a
‘duty created by this chapter’ inasmuch as Rule 405 was promulgated
in accordance with Sections 6 and 19 of the Act, even if Rule 405 is
not in itself to be considered a rule ‘thereunder.’ “4 The Court then
articulated a test to be used in determining whether there is implied
civil liability:
The touchstone for determination whether or not the violation of a particular
rule is actionable should properly depend upon its design “for the direct
protection of investors.”…
Such a breach of fair practice undermines the protection of investors and
surely “play(s) an integral part in SEC regulation” of Exchanges and their
members.’
Another case after Buttrey is Aetna Casualty & Surety Co. v.
Paine, Webber, Jackson & Curtis’ which involved stock certificates
endorsed by the owners in blank with signatures guaranteed by a
broker. An employee of the broker allegedly stole the certificates and,
after several unsuccessful attempts to sell them, finally sold them
through the defendants. The plaintiff based his suit in part on NYSE
rule 405. The court determined that rule 405 did not impose an
obligation, based in part upon the conclusion that under the Uniform
Commercial Code the securities were fully negotiable. In dictum
the court stated that even if rule 405 did impose an obligation of care,
“4mere negligence” cannot be a ground for imposing civil liability
under an exchange rule. Buttrey was distinguished on the grounds that
its facts were “tantamount to fraud.” However, the court’s
interpretation is open to doubt; although the court in Buttrey did state
that the facts involved fraud, the standard articulated for civil liability
did not require such a finding.
Assuming that a rule of an exchange may give rise to civil liability
there is at the outset the issue whether any of the exchange standards
applicable to specialists are “rules” at all. In this connection many of
the provisions regulating specialists on both the NYSE and Amex are
found in the supplementary material or commentary to the rules
themselves. For example, much of the material concerning a
specialist’s transactions with the book or liquidating his position is
found in the “Commentary” to Amex rule 170 while the analogous
NYSE provisions are found in the rules themselves. In this regard the
issue appears to be whether “commentary” or “supplementary
material” is a rule. In DeRenzis v. Levy’1 3 Judge Frankel stated in
dicta that the test to be used is “at a minimum, [whether] the
propositions in question were promulgated, recorded, and known as
rules-or, at least, something closely approximating rules.” ’44
Clearly, any material which rule I lb-1 requires to be an exchange rule
would be considered as such whether or not labeled as a rule.
Once the barrier is crossed concerning the existence of a “rule,”
the issue becomes whether the rule plays an “integral part” in
Commission regulation and is designed “for the direct protection of
the investor.” At the time of the promulgation of rule I lb-1 it might
‘have been assumed that requiring the exchanges, as opposed to the
Commission itself, to make the specialist’s rule an exchange rule
would shield the specialist from civil liability. However, with the
Colonial and Buttrey cases this proposition appears to be incorrect.
The different treatment of the negative Saperstein and positive
obligation of the specialist under rule 1 lb-I further complicates
matters. Since both section 11(b) of the 1934 Act and rule I lb-1 seem
to give greater emphasis-at least by way of Commission
enforcement-to the Saperstein approach it might seem that if there is
the possibility of any liability under the Colonial and Buttrey tests
then the stronger implication might result when the specialist disrupts
the market.’ However, in view of the importance of the affirmative
obligation to maintain an orderly market, this implication seems to
be incorrect.
RECENT DEVELOPMENTS
The increasing percentage of institutional trades on the New York
Stock Exchange has placed an unprecedented strain on the specialist
system. More than 50 percent of public transactions on the exchange
are currently represented by institutional orders,’ and the total of
purchases and sales by such financial institutions was $80 billion for
1969 and $65 billion for 1968, a great increase over the 1967 total of
$49 billion.’47 Accompanying this growth, large block transactions
have continued to increase in number. Indeed, in 1968 block trades of
10,000 shares represented 10 percent, of the total reported volume on
the NYSE; for 1969 this ratio increased to over 14 percent.”8
Paralleling this development is an increase in the average number of
shares per sale printed on the NYSE tape. The average number of
shares pef sale was 257 in 1967, 302 in 1968,141 and 356 for 1969.1’1
The tremendous growth of institutional participation in the
markets places an increasing burden on the specialist’s capacity as
dealer to meet the demands created by such large transactions. The
specialist must stand ready within reasonable limits to purchase or
sell from or to the public investor where temporary disparities occur
in the public demand or supply and is expected to add depth to the
markets. The task is obviously easier when he is dealing with the
relatively small purchase and sales orders of the ordinary public
investor. When large institutions attempt to purchase or sell blocks
amounting to millions of dollars, a new magnitude of economic stress
is placed upon the specialist. The former Chairman of the
Commission, Manuel Cohen, stated that “[t]he specialist was
developed to provide liquidity and correct temporary imbalances in
the supply and demand for particular stocks, and no longer can,
alone, meet the large needs of the institutions.”” s Ralph Saul,
President of the American Stock Exchange, has expressed similar
doubts about the capabilities of the existing specialist system to
handle current market conditions.152
Growth of so-called block positioning member firms of the NYSE
in recent years has resulted from the new needs of the institutional
markets. Such firms have the capital, experience, and willingness to
purchase large blocks from institutional sellers and sell positions so
acquired in small pieces on the floor of the exchange. In the past year,’
a number of such firms have joined specialist units on the Amex and
the NYSE.15 3 Such mergers or associations by the specialists and
block positioning firms will increase the capital resources of
specialists and perhaps better enable them to handle the increasing
demands of institutional investors. If additional block positioning
firms join specialist units, specially tailored exchange specialist rules
may be required to facilitate the handling of block transactions in
addition to whatever regulatory provisions are deemed necessary by
the Commission.’
One of the issues raised by the growth of block transactions is
whether block transactions fall within the scope of an auction market
involving ordinary specialist activity. The Commission recently
invited responses to certain questions resulting from the public
investigatory hearings on the exchange commission rates.’ One of
the questions asked was whether block transactions should be
“excluded from the scope of any exchange rules which . . . fix
commission rates. . -“.”I” It was pointed out that the
question assumed the definition of a “block” transaction to be a transaction in
which a member firm, by reason of the size of the order in relation to
conditions in the exchange auction market, reasonably concludes that it is in
the interest of the customer to search and negotiate for a matching interest on
the other side of the market (including negotiating as principal with the
customer) rather than to accept or submit a bid or offer in the ordinary course
of the auction market. 57
The question raised the basic issue of whether block trades are
negotiated trades falling outside the scope of the auction market and
therefore outside the scope of exchange rules on fixed commissions.
The negotiating is often done in the member firm’s office and not on
the floor of the Exchange, although the actual executing after a
successful negotiation will take place on the floor of the exchange.
Some observers feel that block trading and block positioning have no
significant relationship to the auction market and belong rather to the
negotiated over-the-counter market.15
1 The NYSE, on the other hand,
believes that block transactions do belong to the auction market.’
Certain observers claim that the specialist could not be expected to
continuously quote a bid and ask which is valid for huge blocks of
stock. Moreover, to the extent a specialist positions a large block, he
creates a conflict of interest, since he may be pressured to sell his
block regardless of his obligation to sell only in a rising market.
Furthermore, the large position may lessen his ability to enter the
market as a purchaser pursuant to his obligation as a specialist.
The impact of institutionalization of the markets is beyond the
scope of this article, but the subject is currently being researched by
the Institutional Investors Study of the SEC.”‘0 The pressures on the
specialist structure are recognized to be enormous by representatives
of the industry, and the future of the specialist system in its present
form will depend upon methods developed to handle these
pressures.
Another recent innovation is the growth of so-called computerized
markets. One such market is the Institutional Networks Corporation
or Instinet, a computerized system whereby institutions are able to
trade with each other without the intervention of an exchange, a
specialist, or a block positioning firm.’ Direct sales between
institutions have commonly been designated as the Fourth Market-a
158. market where institution meets institution directly without the assistance of an exchange or a broker. This market, previously
handled exclusively by telephone communications between
institutions, can now also be handled via the I nstinet computer.’ The
risk to the specialist is that the success and proliferation of such
computerized markets may minimize the role of exchanges and
specialists in this insitutional trading. Moreover, the possibility of
complete computerization of the specialist function also exists.,”
CONCLUSION
The specialist is a key figure in the operations of the New York
and American Stock Exchanges. In his role as dealer, which is the
most important and most controversial of his two functions, he is
expected to add depth and continuity to the auction market. The
consensus of the exchanges and many economists has been that the
specialist, acting as dealer, is vital to the maintenance of an orderly
market. An orderly market, a term admittedly difficult to define,
manifests several characteristics over the short-run: prices move in
small and continuous gradations; such minute price changes occur
with respect to relatively large transactions as well as small–the
market has depth; and the specialist is able and willing to step in as a
significant buyer in falling markets and as a seller in rising markets.
Moreover, the specialist is expected to solve the time discontinuity
problem by virtue of his willingness to buy when no public buyer
appears and to sell when no public seller appears. The underlying
rationale is that the successful performance of the foregoing functions
will improve the auction market, enhance public confidence in the
operations of the market, and enable investors, at least in the shortrun,
to buy or sell stocks promptly and at prices which are very close
to that of the previous transaction. The rules of the exchanges and the
Commission are designed to require specialists to fulfill the foregoing
purposes.
Of crucial importance in any consideration of the specialist is the
continuous exchange surveillance over his performance. The failure of
specialists to enter a declining market, or the actions of specialists in
selling long or short in bear markets, could, if not prevented or
curtailed by proper surveillance, contribute to the public’s lack of
confidence. In a bear market, such derilictions would unnecessarily
contribute to the cumulative build-up of investor concern. The
important items to monitor in a surveillance program include, in
addition to the continual review of specialists’ performance in
particular stocks on particular days, sufficiency of capital, profit and
loss information, continuance of proper financing arrangements with
banks and member firm creditors, and review of margin calls from
creditors of specialists. The exchanges must obtain data on a current
basis, and the Commission must be promptly informed of significant
developments in these areas.
The specialist system is facing unique challenges. Various
representatives of the securities industry representing different
interests have attempted to predict future developments of
varying kinds. The developers of Instinet hopefully anticipate a
market in which institutions trade with each other without the use of
specialists or exchanges. Third market makers criticize the ability of
exchanges to handle blocks, predict the accelerated growth of their
market, and call for liberalization of exchange rules which restrict
members from dealing in the third market. The NYSE and Amex, on
the other hand, believe that institutional trading belongs on the floor
of the exchange and will continue to contribute to the depth and
liquidity of the auction market in which specialists play a pivotal role.
In this connection, they are considering an increased role for block
positioning firms with specialists. In that case, the specialist rules
which evolved to fit the needs of individuals may have to undergo
profound changes to satisfy the new situation and the increasing role
of block positioners. Even if the exchanges succeed in their efforts to
bring and keep blocks on the floor of the exchange, the changes in
structure due to the growth of blocks may result in the growth of a
situation which many feel currently exists-that is, two de facto
separate markets, a negotiated market for blocks and the traditional
specialist auction market for individuals.
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