RAY SUAREZ: When Richard Grasso quit seven weeks ago as chairman of the New York Stock Exchange, there was criticism not only of his $188 million pay package, but also of the exchange board that approved it. Board members, largely handpicked by Grasso, came under fire for being too cozy with the Wall Street firms they regulate.
Today the man who replaced Grasso, interim chairman and CEO John Reed, proposed reforms to the exchange's governing structure. The plan would do away with the current 27-member board of directors, and replace it with a smaller six to twelve member board. Today Reed nominated eight persons to that new board, mostly current and former CEO's, rather than Wall Street executives.
JOHN REED: The board will be independent. That's a requirement, in the sense that they don't have any ties to the exchange. But more importantly, which is somewhat unusual in corporate America, they will be independent from a regulatory point of view, i.e., none of these people have association with groups that we regulate.
RAY SUAREZ: Every day at the New York exchange, known as the Big Board, $20 billion changes hands. The exchange is self-regulating. The current board oversees the money-making operations and enforces day-to-day rules at the same time. John Reed's plan would separate those functions.
The board of directors would handle enforcement, while a separate board of Wall Street executives would oversee day-to-day operations. Reed acknowledged the exchange would continue to regulate itself. His plan needs to be approved by 1,366 members of the exchange, who pay for the right to trade on the big board. Reed, a retired chairman of Citibank, plans to re-retire once the new structure is in place.
JOHN REED: First of all, you have a totally independent board. On the board are four people who have had extensive experience running boards, so the whole issue of compensation and how it was handled for Mr. Grasso and so forth and so on, the conflicts that existed on the old board that certainly contributed to some of its dysfunction don't exist here. So that I think that the likelihood of this board getting carried away with what I would call irrational exuberance is very low.
RAY SUAREZ: Ultimately, the Securities and Exchange Commission must sign off as well. Today the SEC praised what it called a "critical first step," but said additional reforms will likely be considered.
Two views now of the new proposal: Joel Seligman is dean of the school of law at Washington University in St. Louis. He is also a nominee for the board of governors of the National Association of Securities Dealers. And John Coffee is director of corporate governance at Columbia law school. He recently testified before a House committee on this same subject. Professor Seligman, are John Reed's announced reforms this morning enough of an answer to the controversy that arose around the departure of Chairman Grasso?
JOEL SELIGMAN: There's certainly a good step. The notion of having eight individuals who are neither working for the exchange or subject to its regulation is a good move in the right direction. The transparency of reporting means there will never be salary arrangements like those for Mr. Grasso that go unnoticed for so long a period of time.
There's a major change in what was discussed over the last few weeks in the sense that the board will choose the chair rather than report to the chair. That's a very significant move. Whether it goes far enough though deals with a number of unresolved issues. We don't know who the new chair will be. We don't know how this board will perform. We have seen very disturbing news stories in the last few weeks or in the last few days especially with respect to oversight of specialists. And the concern you have is whether or not it would be wiser to have a fuller separation of the regulatory functions of the New York Stock Exchange from the floor so to greatly increase the likelihood that investors will have confidence that there will be a vigorous discipline, vigorous enforcement and vigorous oversight of the floor community.
RAY SUAREZ: We'll get to specialists, what they do and their role in this whole reform process in a little bit. Professor Coffee, what do you make of the Reed proposals this morning?
JOHN COFFEE: I think I agree with my colleague, Joel Seligman. This does adequately respond to the executive compensation excesses that prompted the current scandal. But it doesn't respond to the SEC's new concern about the regulatory independence and integrity of the enforcement system at the New York Stock Exchange. Here you've got a problem in that the new regulatory chief, that this new board will choose, will still be subject to influence, pressure, control, from the exchange's chief executive officer. There are two different conflicts of interest here.
First, no chief executive wants a series of scandals on his watch. That reflects poorly on him and it may cause the chief executive to signal or to reduce the budget to a regulatory staff that produces too much activism, too many scandals, too much enforcement.
Conversely, what all the other markets are concerned about is that the regulatory apparatus of the New York Stock Exchange might be used and they allege it has been used as a tool for retaliation. If a broker/dealer moves some of its order flow from the New York Stock Exchange to a competing market center, those other market centers allege that the exchange's regulatory staff will come in and put regulatory pressure on that broker/dealer until it brings its order flow back to the New York Stock Exchange. That is not proven, only an allegation. It's the sort of problem that gives rise to the need for very clear separation, very clearly, distinct lines of reporting so in no way do the business side of the Exchange have influence over the regulatory side.
RAY SUAREZ: Professor Coffee, John Reed very carefully said today that if his suggestions are put into place, the New York Stock Exchange can remain self-regulating, that there would be no need for further oversight, further establishment of boards looking over its shoulder. And then the SEC was very grudging in its praise. Good first step but it held out the possibility of more reforms. Is that a signal from Chairman William Donaldson?
JOHN COFFEE: I think it's a very clear signal that they think Mr. Reed is doing a good job, but he hasn't fully defined the problem in terms of the need for greater regulatory independence and assurance of the integrity of the process. Even though Mr. Reed thinks the system will work very well, we don't know five years from now whether another chief executive will want his regulatory staff to try to deter broker/dealers from moving order flow to competitor or whether he will want to have less scandals on his watch and thus will signal to the regulatory staff that he wants a little less activism. I think that's where you've got to have a greater separation. The SEC did this seven years ago when it reorganized NASDAQ and the NASD. I think they had a very good model there. I expect they'll want to apply some of it here again.
RAY SUAREZ: Professor Seligman, what do you make of your colleague's suggestion that, yes, while the exchange is under the spotlight now, people are going to be minding their p's and q's but this doesn't bind chairmen down the road from perhaps taking their eye off the ball when it comes to regulation?
JOEL SELIGMAN: There's certainly something to that but there's also real force in the point jack made with respect to the reorganization of the NASDAQ and the NASD during the 1990s. There you had a crisis by which overall oversight of the equivalent to their floor community was not as vigilant as it should have been. It was a price fixing scandal.
You got the Justice Department involved, the SEC. It's very striking how differently the SEC addressed it in that instance than they have so far. In that instance they worked with the NASD to have a blue ribbon committee chaired by former Sen. Warren Rudman deliver what was quite a public report articulating the problems they saw, the alternative solutions and then making recommendations.
Reed, I think, has done a very good start at starting a process, but the underlying whether with oversight of the specialists or even the full report on what went on with respect to Mr. Grasso's compensation has not become public yet. The sense of what the policy choices are will be developed much more when the New York Stock Exchange makes its proposals to the SEC and the SEC reviews it. There are a number of questions which aren't yet on the table.
During the 1990s, there was considerable thought as to whether or not the world would be better off if there was one self-regulatory organization for all market centers rather than each self-regulatory or each exchange having their own SRO functions in house. That's a very complex proposal. There are a lot of bells and whistles in it. But it deserves thoughtful consideration by the SEC, and I think that's the reason why the end of the SEC'S release today they explained that additional possible reforms will be considered.
RAY SUAREZ: Who are the specialists, Professor Seligman, and what do they do? What is unique about their role at the New York Exchange?
JOEL SELIGMAN: The specialists at the New York and other exchanges are the market makers. They're the people to whom all order flow potentially is funneled. They set the opening price. They're the buyers and sellers of last resort. They're the ones who maintain what's called the limit order book, that is, buy-and-sell orders that are not at the immediate market price. They're the most important actors on the exchange floor. They deserve a good deal of credit in the history of the New York Stock Exchange for keeping quotes very tight, which is a way of protecting investors for a good record with the execution. But they're quite strikingly different than the system in the NASDAQ market where you have competitive dealers. And the way of keeping prices appropriate for investors is through competition rather than funneling all orders to a single specialist post.
RAY SUAREZ: Professor Coffee, why are they in such a harsh spotlight right now, those specialists?
JOHN COFFEE: Well, the world has changed dramatically in the last year or two. Congressman dated something called decibelization that securities would trade in terms of pennies rather than eighths of point. When we had the significant reduction in the width of the spread, it reduced a lot of the profits to the specialist. They are now are in a world where securities trade on a two or three cent spread or less, and in that world they are making less of a profit.
They are therefore often willing to provide less liquidity. They're often jumping in front of the customer taking transactions for themselves where two public trades could instead cross. That's a world that doesn't look like the old world. And I think the relevance of the specialists and their ability to survive in a rapidly evolving marketplace is one of the serious questions that the SEC and the exchange will have to move to next after they solve their current governance problems.
RAY SUAREZ: And haven't computers made the world of the specialist, let's say, less necessary than they were 20, 30 years ago?
JOHN COFFEE: I certainly think that you could have electronic auction market. There is a difference between an auction market and a dealer market. And there's a lot to be said for the New York Stock Exchange system that doesn't put a financial intermediary in the center of every transaction, the so-called dealer or market maker, but allows public orders to meet public orders.
For the future I expect that that can be done by a computer and won't always need an individual. By the way, it's much easier to monitor and regulate a computer than an individual because down deep computers don't cheat, only humans do.
RAY SUAREZ: Professors, thank you both for being with us.