How to Restore Credibility at the NYSEPublished: September 24, 2003 in Knowledge@Wharton
New York Stock Exchange chairman Richard A. Grasso’s controversial $140 million pay package was a flash point that illuminated other issues at the Big Board and could trigger major change, including the possibility of the exchange itself going public.
Conflict between the NYSE’s role as a regulator and trading exchange, flaws in the structure of its board, and concerns about whether its specialist-based trading system is fair to investors -- all these issues must be addressed before the 211-year-old exchange can regain its credibility, say Wharton faculty and other experts.
After Grasso’s resignation, the NYSE board moved swiftly to appoint John S. Reed, former co-head of Citigroup, as its interim leader. Reed, who will earn $1 for his efforts, says he is not interested in the job permanently and hopes a new chairman will be in place within months.
“The New York Stock Exchange is the major market in the world and it’s going to go through some gyrations,” says Wharton accounting professor David Larcker. “John Reed is a big name. He’s well-regarded and a very smart and structured person who will institute some pretty rigorous reforms.” The Exchange, which in some ways has been run “like a club,” he adds, has been “hammering away on companies to get their governance in order while they themselves have some pretty serious problems.”
Barbara Roper, director of investor protection at the Consumer Federation of America, says Grasso’s pay package is just the latest in a series of episodes that has led to investor frustration with the NYSE board. She cited the exchange’s failure to address problems with Wall Street analysts and its attempt to place Sandy Weill, chairman and chief executive of Citigroup, on the board as a “public member” this spring. Citigroup had agreed to pay a $400 million to settle allegations it allowed analysts to mislead investors.
“The board continues to present an image of an organization that does not take itself seriously as a regulator and thinks of itself as a business first and a regulator second – at best,” says Roper.
Credibility at Risk
Grasso’s resignation is not enough to satisfy many investors who see it as only a symptom of deeper problems at the exchange, which lists 2,800 stocks. “Up until now, the only thing that has happened at the NYSE was cutting the tops off the dandelions. We must travel down the stems and get to the root of the problem,” notes Sean Harrigan, president of CalPERS, the nation’s largest pension fund, who spoke at a press conference after Grasso stepped down. “Make no mistake. What is at risk here is the credibility of our entire capital system.”
The exchange’s role as a regulator and the pressure to please member companies and encourage new listings is an inherent conflict, says Robert Mittelstaedt, Wharton’s vice dean and director of executive education. “They are fundamentally different activities. You can’t be both a regulator and an organization that is trying to draw companies [as members] and make it attractive for them to function on the exchange.”
The SEC does not regulate exchanges directly. Under the Securities Exchange Act of 1934, the NYSE and other national exchanges –including Nasdaq and new electronic communication networks (ECNs) such as Instinet – operate as self-regulatory organizations (SROs). Mittelstaedt pointed to Nasdaq, which separated its regulatory and trading operations after damaging SEC investigations in the mid 1990s.
Roper, also, urges a separation of the exchange’s regulatory operations from its trading functions and suggests it be done by an independent organization with a clear funding source, using a model like that of the new Public Company Accounting Oversight Board.
Wharton finance professor Marshall Blume says that if the regulatory role is removed from the NYSE, it should be a clean break. “It has been suggested the spin-off should be done as a subsidiary of the NYSE but I don’t see how that gets rid of the conflict,” says Blume, who with fellow Wharton finance professor Jeremy Siegel wrote Revolution on Wall Street: The Rise and Decline of the New York Stock Exchange (1993).
Blume advocates caution about placing more regulatory power with the SEC, which now oversees disciplinary action and rules made by the exchanges themselves. “The question is, do you want a government bureaucracy to do it, or do you want people who are more responsive to the needs of industry?”
The exchange’s future is likely to be shaped in a debate over technology, adds Mittelstaedt. Many competing exchanges, including Nasdaq, make trades electronically, without a physical trading floor. “In today’s world where technology is so pervasive, the question becomes, ‘Is this the most efficient way to get this done or is it an anachronism supported by the people who make a ton of money operating it?’” he asks.
The Specialists’ Role
Even before the debate over Grasso’s pay package, critics of the exchange complained that the NYSE’s specialist firms – which populate the floor of the exchange with human traders who specialize in making markets for each company listed – use their market position to benefit at the expense of investors in a hurry to sell shares. The specialists form an intermediary market that, in theory, helps support the broader market because they can trade on their own account to stabilize prices. When shares are put on the market and there are not enough buyers at what the specialist believes to be a reasonable price, he or she can step in to make up the difference.
Siegel calls for a thorough, independent examination of the specialist system as part of any wider NYSE reform movement. “I’m concerned the specialist system does not always serve the individual investor best, but it might under some circumstances. I think a dispassionate look” is needed, he says.
Meanwhile, according to The Wall Street Journal, the SEC has expanded a probe begun in April into whether five specialists firms abused investors by “trading ahead.” The practice, which is a violation of exchange rules, occurs when a specialist puts his or her firm’s interests ahead of investors’ by ignoring one investor order in the process of interacting with another.
According to Wharton operations and information management professor Eric Clemons, who has studied the role of specialists at the NYSE, they serve a valuable function. “The idea that the market allows specialists to abuse investors is not correct. The specialist prevents a naive and uninformed investor in a hurry from being ripped off by a market professional or other better informed investor, and in that sense represents a wealth transfer away from an opportunistic professional and to a retail investor,” he says.
Blume does not expect the specialists to disappear from the NYSE, at least not for the next five years: “I do believe they provide some catalyst to make the markets work a little better. Having said that, I would not be surprised if their role became smaller in the trading process and I would not be surprised if they made less money in the future.”
Change is also likely to come to the 27-member board of the exchange, which includes many members of Wall Street trading firms. Perhaps the most troubling aspect of the Grasso pay-package flap was that members of the board had no idea what their top executive was being paid, suggests Larcker. “That is pretty terrifying. The most obvious reform is to go through and say ‘What is it that the board is doing?’ You would think there would be a wholesale rollover of the board.”
Harrigan, of CalPERS, wants the Big Board to shrink the size of its board of directors. “We need a much smaller and more accountable board to govern … Half should be investors and I don’t mean [from] the securities industry.” He also suggests that the board establish an independent nominating committee and more transparency in compensation and financial disclosures.
Blume expects a restructuring of the board with a shift in balance away from the financial industry to the investing public: “If I were the NYSE I would do it myself before Congress did.”
Wharton management professor Michael Useem compares the NYSE board’s approval of Grasso’s salary to the same kind of “conscious indifference” that occurred in the boardrooms at companies caught up in the recent wave of corporate governance scandals.
In a Wall Street Journal article earlier this week, Useem wrote that “The SEC and investor drumbeat for independent directors, vigilant audits – and even board minutes – should be appreciated and supported for their underlying purpose: the creation of unbiased, thoughtful, hard-hitting, and timely decisions when the directors convene behind closed doors … The diverse reforms already underway – ranging from non-executive chairs to director performance reviews – are the testing ground for what it will take for directors to make vigilant decisions when nobody is watching.”
The prospect of the NYSE going public is also under study. Board members had been scheduled to review a report on governance issues, including the idea of taking the exchange public, at their next meeting on Oct. 2. That review, however, has been put off until Reed can have more time to evaluate the issues.
The NYSE is owned by its 1,336 members who pay for seats on the exchange, which is operated as a not-for-profit public institution. But many members of the exchange have conflicting agendas when it comes to rules and policies at the NYSE.
Siegel would support a move to take the exchange public because it would lead to more and better disclosure, which would benefit all investors and the overall economy. “It would be more profit-oriented and not oriented toward particular groups warring over the biggest slice of the pie. If the pie were owned by all, it might lead to a more harmonious development and improvement in the exchange.”
An obstacle to going public would be the possibility of reluctance by investors to buy shares in the exchange if they do not know how much freedom it would have in developing its own rules, Siegel adds. Blume suggests it would be difficult to place a value on the shares already owned by members, particularly the specialists who pay a premium for seats.
Larcker, too, says a publicly traded exchange would be more open although he notes that more openness is not always the answer to governance problems. “We have seen a lot of problems in publicly traded companies. That’s not a panacea. WorldCom and Enron were publicly traded.”
Searching for Long-term Strategy
According to Clemons, Grasso was highly skilled in managing the exchange’s complex rules and varied constituencies. “Yes it is embarrassing at a time when chief executive pay is such a scandal,” he says, referring to Grasso’s resignation. "It’s a severe error in judgment, but I don’t think it’s an outrage. Grasso did a marvelous job managing the exchange’s various constituencies and serving as the worldwide face of American capitalism. In this industry, talent is never cheap. But I don’t think this is going to destroy the NYSE.
“I think the issues that face the NYSE are the same that always face the NYSE and they have to do with ECNs and competition with other exchanges in the U.S. and outside the U.S.”
Grasso’s successor will face those same challenges and will be called on to develop a long-term strategic plan in an industry that is known for operating on short time horizons, Clemons adds.
According to Mittelstaedt, whatever change occurs, it should be weighed carefully. “Despite the criticism, the NYSE has been a key part of creating, arguably, the finest capital market in the world,” he says. “We should be careful about throwing the baby out with the bath water.”