Securities and Exchange Commission Historical Society

The Bright Image: The SEC, 1961-1973

An Economic Theory of Regulation Emerges

Rule 394

In December 1964, over-the-counter securities dealer Morris Schapiro threatened an anti-trust lawsuit challenging New York Stock Exchange Rule 394, causing the SEC to make its first detailed examination of the rule.

Rule 394 required members to obtain NYSE permission before trading in a listed stock off the NYSE. In effect, the rule prevented a NYSE member from buying or selling nearly all of NYSE-listed stocks in any over-the-counter market.(19)

Schapiro contended that this rule violated the anti-trust law because it stifled free and competitive markets. Faced with the likelihood of a court challenge, Cohen ordered a full staff investigation of the rule. Eugene Rotberg, chief counsel of the SEC's Office of Policy Planning, headed the investigation that took six months and produced over two thousand pages of witness and documentary testimony from the NYSE and other exchanges. In September 1965, the final report, which had been endorsed by SEC General Counsel Philip Loomis and SEC Division of Trading and Markets Director Irving Pollack, was circulated within the Commission.

The final report was a clear assessment of the economic implications of Rule 394. It concluded that the rule was most probably illegal under anti-trust principles and proposed alternatives that involved changes to the stock-commission rate structure that would put all NYSE member transactions in over-the-counter stock subject to NYSE reporting and fair-dealing rules. In addition, the SEC report proposed an increase in dealer capital available to handle large-block trades that would benefit customers by offering them the advantage of the over-the-counter competitive prices.

NYSE President G. Keith Funston strongly objected to the report's conclusions and proposals. "Rule 394 is one of the pillars of the Exchange," he said, "and we cannot, and will not, budge on this issue."(20) Although Pollack suggested publication of the report, the full SEC Commission refused. Cohen and Funston eventually reached a compromise, but the resulting proposal was a weak palliative that only minimally increased over-the-counter competition in NYSE-listed securities. This experience proved instructive as pressure mounted on the SEC to initiate a comprehensive review of NYSE stock commission rates and membership rules.

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(19) Seligman, Transformation., 386.

(20) "The SEC Has a Little List," Fortune, January 1967, 113.

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