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Specialist Investment Accounts

The ability of specialists to possess and to system is that it has erected structural
trade in their own investment accounts safeguards to blunt the natural tendency of
should be a source of great consternation to men to pursue their own self-interest in a
investors. It is very easy to understand this situation where it’s not appropriate.
phenomenon once one understands that a
revolving door exists between the Stock If the system has failed in the case of the
Exchange and the SEC. For example, just Stock Exchanges, it is because the SEC the
prior to the investigation of E.F. Hutton for agency that is supposed to regulate and
thousands of frauds in 1981, John Shad, make the laws governing the Exchanges,
the Vice Chairman of E.F. Hutton, was expressly provides for the securities
appointed Chairman of the SEC. Having left industry’s representatives to dominate its
the SEC, he is returned to the investment advisory boards and act as its chairman
business as Chairman of Drexel, Burnham. and commissioners. In effect, the
The revolving door is one reason why the Exchanges make the regulations to which
specialist system has been allowed to they are presumably subject to.
perfect its goals of profit maximization
rather than the goals appropriate to its Thus there exists within the Exchange
function as a fiduciary. establishment an institutional arrangement
which not only does not thwart the
Rather than serving in accordance with their tendencies to self-interest, but which
statutory requirements as fiduciaries encourages it. The result is an institution,
specialists are allowed by the SEC to act in which exists for the benefit of those who are
competition with investors. Their ability to able to manipulate its institutional privileges
trade and invest for themselves has given to their own advantage. To fully understand
them a stake in the direction in which they the problem, it’s important to recognize that
move stock prices. At the same time, the it begins with the individual known as the
mere existence of their trading and specialist. Specialists do not work for the
investment accounts leads to certain Exchange they are the Exchange.
predictable patterns of behavior by
specialists specifically, patterns of behavior They are the brokers on the floor of the
which tend to maximize their profits. This, in Stock Exchange given the responsibility “to
turn, gives the astute investor, who is willing maintain a fair and orderly market” for the
to make the effort to learn these behavior stocks assigned to them. There are several
patterns, an important key to unlock the hundred specialists on the floor of the
markets future. Exchange, divided into approximately 50
units. Each unit handles the buy and sell
Of course, the ultimate solution to the orders in as few as 10 issues to as many as
problem of the specialist system is to do 50 or more stocks. Since each specialist
what has been done in other institutional unit is located at one locale on the
frameworks where conflicts of interest Exchange floor “called the post”, all buy
would be detrimental. For hundreds of and sell orders for issues are handled at
years, it’s been the maxim of English one spot.
common law that no man should serve as
judge and jury in his own case. Everyone, The orders placed with one’s broker
even if he or she has never studied the law, eventually find their way to the specialist on
understands intuitively why this should be the floor of the Stock Exchange. One of his
so. Indeed, one of the triumphs of our legal functions is to then match as best he can
the public’s buy and sell orders. Because all allowed to maintain an investment account.
orders flow through him, the specialist is The existence of this account gives the
suppose to possess the best overview of specialist the same trading incentives as
the demand and supply factors that should any profit-seeking figure. He wants to buy
determine the price of the issues assigned low, to sell high and to do so with a
to him. He is, therefore, charged with the minimum of tax consequences. The only
uniquely sensitive task of setting an trouble is that he is not just any profit
appropriate or fair price for his stocks. seeking figure.

When the investor hears that GM has The specialists access to the most sensitive
closed up ½ or that IBM has moved down 2 market data, the universe of demand and
¼, he should understand that this literally supply orders, as well as his ability to set
means the specialist-set price in IBM was 2 the price of his issue, puts him in a situation
¼ points lower on the second day than the where it is impossible for him to fulfill his
first. We shall see, however, that more than duty as a fiduciary. The equivalent situation
public supply and demand factors impinge in the legal world would be to let one act as
upon the specialist’s decision-making a judge in his own case.
process of what price to set for his issue.
A special investigators team of the
To understand the source of these other Securities and Exchange Commission
factors, it is necessary to explore a bit recognized the inherent conflict of interests
further the nature of the specialist’s in 1963 when it studied the market crash of
operations. Those few individuals who know 1962. In its report, the commission wrote,
anything about the specialist probably have “purchases made on the Exchange for the
heard that he is supposed to maintain a fair purpose of segregation into long term
and orderly market. One way he is investment accounts raised problems which go
supposed to accomplish this is to act as a to the heart of the specialists system”. The
source of market liquidity. specialist is permitted to trade for his own
account only when such trades affirmatively
Every stock that is traded on the New York contribute to the maintenance of a fair and
Stock Exchange is assigned to a specialist, orderly market. Where the specialist goes
and every specialist stands as a miniature into the market with the intention of
warehousing operation for the stocks he’s segregating the securities purchased and
been assigned. Theoretically, any “excess” not with the purpose of creating a fair and
public demand for an issue would be met by orderly market, the trading is clearly
selling distribution from the specialist’s contrary to the statutory and regulatory
principle warehouse, better known as his standards. “Beyond this, the specialist with
trading account. On the other hand, when a long-term position now has a stake in
there is “to much” public supply or public seeing that the security rises in price - - he
selling, the specialist is supposed to open has become an “investor” as well as a
his warehouse (trading account) to mop up dealer.”
or accumulate these excess quantities of “A further problem arises when the specialist
who maintains such long-term accounts is
stock. required to sell stock to maintain a fair and
Whatever legitimacy specialists trading orderly market and he has no stock in his
accounts might have because of there role specialist trading account. (If) the 12 month
in maintaining market liquidity, they more period of the tax statute is almost over, the
than lose once one discovers that in specialist may well be tempted to keep his stock
in the long-term account and neglect the needs
addition to a trading account maintained for
of the market”.
warehousing purposes, the specialist is also
Of course, the last point, about the 12 markets are the occasional misdeeds of
month statute, was written at a time when these so-called insiders. Nothing could be
there were special tax incentives to hold an further from the truth. This country’s
issue for a period of time. The period has regulatory agencies, such as the SEC, are
and continues to be as long as a year. concentrating their energies on the wrong
“insiders”. Thus, the investing public has
Since specialists are investors and are just developed a false sense of security in the
as anxious to minimize the tax integrity of the financial markets.
consequences of their trading as you and I,
we also believe that bullish phases of the If one begins, using the premise that the
market in the future will tend to match market’s true insiders are Stock Exchange
whatever period of time is deemed specialists, and that they will do anything
necessary to obtain favorable tax treatment. they can to profit from their position at the
Not surprisingly, the Chairman and center of the market, then certain points of
Commissioners of the SEC chose to ignore departure begin to emerge from other sorts
the reforms recommended by the staff they of market analysis. The most important of
had gathered to carry out Congress’s those is our focus on the specialist as a
mandate for an investigation of the Stock merchant seeking to buy low and to sell
Exchange practices. high for his investment account.

Human nature being what it is, one should If the specialist has for the most part been
not be surprised to see the specialist use accumulating in his investment accounts,
his unique position to further his own he can be expected to use his control over
interests - - which he does every minute of price to rally his issue. If the specialist has
every day. It is no exaggeration to state sold stock from his investment account and,
that by the very nature of the situation in furthermore, if he has sold short, then the
which they have placed themselves, specialist can be expected to use his
specialists conduct insider trading from control over price to drop the price of his
the moment the opening bell rings until stocks.
the moment the market closes!
Since I believe one can do no better than
There has, of course, been a stream of to piggyback the actions which specialists
troubling news flowing from Wall Street as are taking for their investment accounts, my
the improprieties of figures such as David approach centers on determining whether
Levine, Roger Winans, Ivan Beosky, Boyd specialist have been accumulating,
Jeffries, Mike Milken, and others have been distributing, selling short or covering earlier
disclosed. The direct harm caused to short sales in these accounts. I then
individuals and corporations by the illegal conform my strategies as closely as
actions of these men cannot be possible to those specialists.
underestimated. It is ironic, however, that
the fact of the discovery of their misdeeds Of course, the question which logically
has had an unrecognized consequence. It arises is whether there is some way to
has reassured the small investor that the identify which of these specialist
financial establishment’s regulatory merchandising operations is underway - - a
agencies are actively and productively specialist fingerprint that would enable you
working on his behalf. More than ever, he or I to identify such specialist transactions. I
probably believes that the system works - - noticed on the ticker tape that time after
that all which stands between him and the time big blocks of stock were traded both at
operation of squeaky clean securities the top and the bottom of the stock’s price
pattern. These blocks seemed to herald a
forthcoming reversal, but at first I did not
understand why they appeared. I learned
subsequently that at the top such blocks
signify a specialist sale, a specialist short
sale or a combination of the two; while at
the bottom these blocks reflected
transactions in which the specialist covered
his short position and went long before
rallying his stock.

Of course, over time, the size of the blocks


that show that important specialist activity is
underway has grown considerably.
Nevertheless, it is just as true as it was 25
years ago that when big block activity
occurs in an issue a turning point will have
been reached in the price history of that
stock. Furthermore, in the market as a
whole, when a large majority of specialists
are conducting the same type of big block
activity, bull and bear markets are sure to
follow.

It was enormous specialist accumulation at


the lows of late 1986 and early 1987 that
fueled the rise of the market to historic
highs in the spring and summer of 1987. It
was the massive specialist selling and short
selling which was then responsible for the
crash, which specialists launched in August,
and which ended with the 508-point decline
of October 1987.

Despite the evidence to the contrary, the


Stock Exchanges will seek to persuade you
that its specialists are passive instruments
subordinate to market forces. The argument
is deeply at odds with common sense.

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