Nine months after the New York Stock Exchange executive-pay scandal erupted, two big questions hover over the institution: Has it dealt with its governance problems? Is it addressing critics who say its two-century-old “open outcry” system is obsolete?


Governance does appear much improved but concerns over the trading-system remain unresolved, according to several Wharton professors. “It appears they have separated the issue of [former chairman and chief executive Richard] Grasso and his compensation from the future of the exchange – what its business model ought to look like,” says Robert Mittelstaedt , vice dean and director of Wharton executive education. “That’s for the good. People are looking at these two matters as separate. By the same token, the exchange still has some serious challenges ahead.”


According to Wharton finance professor Jeremy Siegel, “It’s a nice, cozy system there, and they know someone is knocking at the door.” The exchange’s 1,366 member/owners are resisting the need to modernize the trading system, preferring the profitable status quo. “What I would like to see is someone up at the top say, ‘How can we transform this to a more efficient system?’”


While the governance and trading-system issues are quite different, governance problems had to be resolved before the others could be debated fairly, suggests Wharton accounting professor David F. Larcker. With the exchange’s credibility shaken by the compensation scandal, “the problem is you really start wondering about whether [the trading-system discussion is] a fair debate.”


The scandal erupted last August when the exchange disclosed a $139.5 million retirement and severance package for Grasso. Additional benefits pushed the figure to $197.2 million. Grasso was forced to resign in September and is now in a battle with the exchange over whether he should return the lion’s share of the package. The exchange wants $120 million back but disclosed on May 3 that it had set aside $36 million in case it has to pay him the more than the $50 million he’s still owed under contracts approved by previous directors. The Securities and Exchange Commission and New York Attorney General Eliot Spitzer are investigating whether Grasso manipulated the complex compensation process to conceal the full figures from board members. Grasso has insisted he did nothing wrong.


Since late last year, the exchange has revamped its board, cutting membership from 27 to 10, a figure that includes the chairman and president, and restricting eight seats to outsiders. Nearly all the directors under Grasso are gone. The chairman and chief executive positions, both held by Grasso, have been separated. The regulatory operation was separated from the trading operation, eliminating what critics said was a conflict of interest when the regulators were controlled by the same board that represented the member firms seeking maximum profits.


An interim chairman appointed late in 2003, John S. Reed, former head of Citigroup, has generally received high marks. In December the exchange named as chief executive John A. Thain, former president and chief operating officer of Goldman Sachs Group, Inc. In January the exchange named a highly regarded former SEC official, Richard G., Ketchum, as its new chief regulatory officer.


“Picking Reed to be the interim chairman was a smart move,” says Larker. “He’s a well-regarded guy, a smart guy with impeccable ethics.” Thain, too, was an excellent choice, he adds. Thain will receive $4 million this year, while Grasso had been paid $31 million in 2001 and $12 million in 2002. Other top positions are also paying less than they did under Grasso. Reed is working for $1 a year.


Can the exchange attract top executive talent without paying as much as the big securities firms? Larcker thinks it can, arguing there’s significant prestige in running the most prominent stock exchange in the world, one with vast powers for regulating the behavior of traders, securities firms and publicly traded companies. “You want these people to be paid a fair buck for what they do, but you hope these people are not driven to squeeze out the last dollar [for themselves], that they have a higher objective in mind … If you found somebody that was purely motivated by money, it’s probably the wrong person for this job.”


In the post-Grasso period, the exchange has worked to become more open. More information on executive compensation is disclosed, and the annual report issued May 3 included a management discussion of the exchange’s finances, always opaque under Grasso and his predecessors. The board even tried letting the public nominate directors. But after being swamped with 110 nominees, too many to evaluate before its annual meeting June 3, it said it would wait until next year to put any public nominees on the ballot. This year, all of the current directors nominated themselves for another term.


There have been bumps in the road. Some big pension funds criticized the delay in accepting outside nominees. At the end of March, five of the exchange’s seven specialist firms – the companies that conduct trading on the floor – agreed to pay more than $240 million in fines and paybacks to settle an improper trading case brought by the SEC. The specialists, which neither admitted nor denied guilt, had been accused of trading for their own accounts when they should have matched buyers with sellers  – in effect, making $155 million that should have been their customers.’


The exchange appears to be having trouble finding a permanent chairman, prompting Reed, who came out of retirement to take the interim post, to stay on for another year.


Getting the governance issues behind it clears the way for the more important debate over the trading system. The purpose of any exchange is to allow investors to quickly buy and sell as many shares as they want at prices that most accurately reflect supply and demand. The heart of the NYSE’s system is the floor specialist assigned to a specific stock. Trades are conducted through an “open outcry” system that works much like an auction.


The NYSE says this is the most efficient way for supply and demand to interact. Additionally, in cases where there is no buyer present to accept an offer from a seller (or vice versa), the specialist steps in to act as buyer (or seller), using his firm’s account to facilitate the trade.


Most other trading operations, such as the Nasdaq and Instinet, use computerized systems to match buyers and sellers electronically. They have no floor; it all happens inside black boxes. The difference between the two systems is often characterized as the NYSE’s best prices versus the electronic systems’ speed.


This spring the debate over which system serves traders best has come to a head over a proposal by the Securities and Exchange Commission to modify the so-called trade-through rule. The NYSE, Nasdaq and other exchanges and electronic markets are linked through the National Market System. The trade-through rule says any offer to buy or sell a NYSE-listed stock must be filled at the best price available anywhere in the system. Thus, an NYSE stock may be bought or sold on Nasdaq or any other market that offers a price better than that available on the NYSE. For a buyer, the best price is the lowest anyone on the system is willing to offer; for a seller, it’s the highest.


The NYSE likes the rule because it steers business to the exchange offering the best prices – usually the NYSE. The NYSE offers the best prices about 93% of the time, it claims.


The SEC is considering changing the rule in a variety of ways, allowing some big investors, for instance, to opt out and steer their trades to the exchange offering the fastest transactions or the greatest certainty of completing a trade at a specific price, even if it’s not the best price. Many institutional traders, such as pension funds and mutual fund companies, prefer the speed and certainty they can get in electronic markets to the very slight price benefits they may get from the NYSE.


This proposed rule change threatens to cut into the NYSE’s market share, and Thain has opposed it. But he has enhanced competition by relaxing a rule that had made it difficult for listed companies to switch from one specialist firm to another. He has been enthusiastic about bringing more electronic trading to the exchange. And he has said he will develop methods to evaluate the specialists’ claim that they improve prices. He contends the open outcry system deals more effectively than electronic markets with crises and imbalances between supply and demand. The electronic markets believe the trade-through rule gives the NYSE an unfair advantage, and they support the rule change.


At the heart of the issue, says Mittelstaedt, is the question of whose interests are coming first and “whether or not the interests of the [NYSE’s] owners are consistent with serving the public and those who trade. There are just massive amounts of money being made [by the specialists]. The question: How much of that is for value they bring to the process and how much is sapped from the profits that rightly belong to traders? The open outcry system has served traders and listing companies well in the past.” But, he adds, the specialist firms have “managed to insulate themselves from market forces” with rules, such as the trade-through rule, that give them a leg up on the competition.


“Every company resists change,” Mittelstaedt notes. But the NYSE is a quasi-public entity, and the issue is whether the public interest should supercede its members’ desire to maximize profits.


“My feeling is the [open outcry] system is doomed,” says Siegel, arguing the specialists have a de-facto monopoly in the trading of NYSE-listed stocks that can legally be traded on other exchanges.


Spreads – the difference between bid and asked prices – are wider on the NYSE than on Nasdaq, indicating traders are not actually getting the best possible prices, he argues. The NYSE says spreads are deceptive, since specialists make it possible for trades to take place at prices between the bid and asked. But there’s no definitive data to support this claim, Siegel says. The electronic trading systems say that while the NYSE may appear at one moment to offer the best prices, its slower system often leaves traders with worse prices by the time trades are executed.


While the exchange itself is a non-profit organization, its owners are not. “The question is how do you buy out the specialists?” Siegel asks. “They’re making a lot of money. If you’ve got to change to another system, you’ve got to offer them enough to stop fighting it.”