For NYSE Unit, It’s Get Tough or Get Out
As financial punishments go, the $10-million fine that the New York Stock Exchange slapped on Merrill Lynch & Co. last month hardly rates a mention.
The brokerage earns almost $400 million a month, and Wall Street firms have shelled out billions of dollars in penalties in the last few years alone. But for the NYSE, it was the second-largest fine it has ever levied, and marked a clear attempt to be seen as an effective Wall Street regulator.
The NYSE has been widely criticized for failing to police Wall Street as scandals engulfed the financial industry in recent years. The low point came in April, when the Securities and Exchange Commission rebuked the Big Board for poor oversight that allowed trading abuses to flourish on its floor from 1999 to 2003, costing investors more than $158 million.
“The NYSE has traditionally been slow to act and slow to investigate,” said Steve Westly, the California state controller and a board member of the California Public Employees’ Retirement System, which has filed suit claiming exchange officials knew of the trading but did nothing to stop it.
Under pressure to make reforms, the Big Board overhauled its regulatory operation as part of the changes that followed former Chairman Richard Grasso’s $187.5-million pay flap. It created a chief regulatory officer position, recruited Wall Street executives to key positions and boosted enforcement spending by 6% this year.
The goal is to be “more of a force to be reckoned with, to have that respect,” enforcement chief Susan Merrill said.
It’s too soon to know whether that will be achieved, but what is certain is that the stakes are high.
The Big Board is trying to mend its reputation after the Grasso saga and is seeking permission to merge with electronic rival Archipelago Holdings Inc.
If the SEC and the Justice Department think that regulation is too weak, they could order the policing unit to be broken off from the NYSE. One option would be to create a single regulator by combining it with the oversight staff of the rival NASD, formerly the National Assn. of Securities Dealers.
“The issue is whether the regulatory unit of the New York Stock Exchange will survive,” said Wall Street lawyer Bill Singer. “It’s not just fighting for recognition; it’s fighting for survival.”
Added James Angel, a Georgetown University associate finance professor, “They’re in the spotlight, and they know their jobs are on the line.”
Richard Ketchum, who became chief of the regulatory unit in March 2004, said his focus was simply on restoring the NYSE’s credibility.
“I would not be a good leader, and this would not be a good regulatory organization, if we made decisions based on our worries about what the SEC is going to do,” Ketchum said. “We make our decisions based on our passionate belief that the securities laws need to be obeyed and that investors need to be able to trust the quality of regulation at the New York Stock Exchange.”
Like other stock markets, the NYSE is required to monitor brokerage firms to ensure that traders and brokers don’t take advantage of investors. Screening brokers’ books and tracking their trades are a crucial duty because the markets are the primary line of defense protecting individual investors.
But many critics say the exchange took that duty lightly during Grasso’s eight-year tenure as NYSE chairman, saying the exchange focused on its heated competition with the Nasdaq Stock Market and other rivals.
Regulation was a “limited priority” in recent years, said former SEC Commissioner Harvey Goldschmid.
Grasso disputes that was the case. Even so, the recent specialist scandal exposed what the NYSE now concedes were major flaws in its oversight functions.
The exchange’s surveillance unit discovered that certain floor traders, known as specialists, appeared to be stepping in and trading for their own accounts when there were customer orders to be executed. That was giving the specialists a risk-free profit on the spread between the buy and sell prices and leaving customer orders to be traded at inferior prices.
But the NYSE botched the investigation and failed to realize that the abuses were brazen and widespread, according to the SEC. The NYSE’s surveillance operation “routinely ignored scores of likely violations,” and even when it found them, the Big Board imposed few if any sanctions against traders, the SEC said.
The NYSE’s seven major specialist firms, which handle the trading of individual stocks, agreed last year to pay $242 million to the SEC and the NYSE to resolve the probe, and federal prosecutors indicted 15 traders in April on criminal charges.
The SEC forced the exchange to make major reforms, including submitting to the videotaping of some NYSE floor trading and paying $20 million to have an outside auditor oversee its operations.
Critics assailed the NYSE long before the specialist scandal, pointing out that it rarely took the lead in uncovering major abuses.
To be fair, the SEC and NASD have drawn similar criticism. After all, the blockbuster reforms of stock analysts and mutual-fund trading practices came after probes spearheaded by New York Atty. Gen. Eliot Spitzer.
Even so, the NYSE was never ambitious, many agree.
“The cases they were bringing were not as high-profile, not as big, not as scary as cases being brought by the SEC,” said NYSE enforcement chief Merrill, who joined the organization in July 2004 from top New York law firm Davis Polk & Wardwell.
Beyond the future of the NYSE, the exchange’s problems have renewed a debate about the unique nature of Wall Street regulation.
Instead of being overseen by a government entity that is free of conflicts, the financial industry monitors itself through “self-regulatory organizations” such as the NYSE and the NASD, the founder of the Nasdaq Stock Market. The structure evolved in part to save the government the considerable expense of doing it.
Self-regulatory organizations are overseen by the SEC, but the markets handle much of the ground-level digging.
The core problem, critics say, is that organizations that regulate themselves tend to go lightly on their industry. At the NYSE, Singer said, “regulation became a handmaiden to the business side.”
Some outsiders say the regulatory unit should be broken off from the NYSE and combined with the NASD into a new organization that is unaffiliated with the markets.
Ketchum maintains that linking the two functions gives regulators a better vantage point to spot infractions. Ketchum also argues against melding the NYSE and NASD regulatory teams.
“A little healthy rivalry and two sets of eyes probably isn’t a bad thing,” he said.
After Grasso was ousted in September 2003, the exchange embarked on a major restructuring.
In one of the biggest reforms, oversight of the regulatory unit was transferred from the exchange’s chief executive to a new three-member committee of the board. The goal was to insulate regulation from the business side.
Ketchum, a former SEC and NASD official, is well-regarded among other regulators.
“He’s very committed to making the exchange a regulator without fear,” said Stephen Cutler, former SEC enforcement chief.
Critics note, however, that Ketchum was the second-ranking official at the NASD in the mid-1990s during a major scandal involving price fixing by market makers. The Justice Department, rather than the NASD, uncovered the abuses, and the NASD was forced into its own restructuring as a result.
“I certainly accept responsibility that we didn’t find [the wrongdoing], and we didn’t understand the unlawful activity that was going on,” Ketchum said. “That was unacceptable and I learned a lot from that.”
At the NYSE, Ketchum appointed new heads of the unit’s three main divisions: enforcement, member-firm regulation and market surveillance. He also boosted the regulatory budget and staff.
A key goal is to be a player in major cases.
The NYSE’s main focus historically has been on individuals, such as stockbrokers who push risky securities to senior citizens. But it wants to bolster that with higher-profile cases against bigger targets that lead to broader reforms and wider acclaim.
“The challenge is how to continue to bring those cases that are the backbone of our program and that are very important, but to still be a player in the bigger cases involving industrywide or firm-wide problems,” Merrill said.
Merrill assigns routine cases to junior lawyers to free up veteran investigators for larger issues. She also created two units to focus solely on improper trading and Wall Street sales practices, two frequent areas of abuse.
Examples of greater ambition, she said, were the $10-million Merrill Lynch settlement and a similar one late last year with Morgan Stanley. Both cases centered on the firms’ failure to deliver prospectuses to customers. Morgan’s $13-million penalty was half of the $26 million the NYSE collected in fines last year.
The way the NYSE pursued the investigation was perhaps as telling as the fines themselves. After discovering problems at one firm, the NYSE probed to see whether they existed industrywide. It turned up infractions at other brokerages, and more cases are expected.
Another area receiving scrutiny is whether brokerages are making improper payments to middlemen who assemble blocks of stock for bearish trades known as short sales, in which the traders bet the shares will lose value. The NYSE is concerned that some payments may be kickbacks.
A byproduct of the focus on bigger cases, however, has been a drop in the number of enforcement actions, which have tumbled from 231 in 2003 to 195 last year. This year, through Aug. 31, the unit has brought 94 cases.
Exchange officials attribute the drop-off in part to the time-consuming investigation of floor specialists. They say that several big investigations are in the works and that total enforcement cases will near last year’s 195.
Nevertheless, critics say, such numbers prove that the NYSE has a long way to go.
Howard Wachtel, an American University economics professor who wrote a 2003 book about the history of the Big Board, thinks that the NYSE is stepping up enforcement now only because “the spotlight is on them.”
“Then as memories fade and the pressure is off, it’ll resort to form,” he said.
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Policing Wall Street
The number of enforcement actions has slipped at the NYSE, but has remained steady at the NASD. NYSE officials attribute the drop-off to a major deployment of resources for the floor-trading scandal.
NYSE’s regulatory arm
*--* Budget Fines Enforcement Employees (In millions) (In millions) actions 2003 598 NA $13 231 2004 656 $258 26 195 2005 680 273 13 94 (Through August)
*--*
NASD’s regulatory arm
*--* Budget Fines Enforcement Employees (In millions) (In millions) actions 2003 2,100 $518.2 $33.3 1,410 2004 2,384 564.0 103.9 1,396 2005 2,391 NA 80.0 749 (Through July)
*--*
NA=Not available
Sources: NYSE, NASD
