By Mara Der Hovanesian
Last year, Morgan Stanley voluntarily fessed up to the New York Stock Exchange that its stock-trading program had suffered technical glitches. Because it was up front, Big Board regulators say the firm asked them to cut it some slack. Instead, in December the brokerage was fined $800,000.
The Wall Street firm got an even bigger shock in September. Not only had Morgan Stanley failed to fix the trading system but it also had hit new supervisory and operational snags. Among other things, it omitted to send out prospectuses to about 100,000 clients for some 3,000 different investments.
So NYSE regulators slapped it with a $19 million fine, breaking the record set when Drexel Burnham Lambert was hit up for $2.5 million in 1992. Morgan Stanley, which agreed to the penalty in principle, said it had reported the problems and fixed them.
BREAK WITH THE PAST.
Big Board regulators are on a tear. Their mission is to restore the credibility of the NYSE's enforcement efforts after the battering the 211-year-old exchange received under disgraced former Chairman and Chief Executive Richard A. Grasso. It's a crucial part of new Chairman John Reed's efforts to make a break with regulatory scandals and prepare the NYSE for a raft of challenges, including sharp competition from electronic exchanges. Reed wants to keep regulation in-house and not cede control to an outside regulator, as some critics want.
Leading the charge is Chief Regulatory Officer Richard G. Ketchum, who was hired in July. In an exclusive interview with BusinessWeek, Ketchum and his top lieutenants outlined for the first time how they aim to restore the NYSE's place as watchdog of the world's largest marketplace. Here's what his team has done in three months:
• Issued stiffer penalties more often.
• Dusted off old rules that will lock persistent offenders out of lucrative businesses, such as the initial public offering market, for a set time.
• Spent more on technology to modernize market surveillance and better monitor trading by member firms.
• Sent out enforcers with investigators for the first time to expedite cases and get restitution to investors faster.
• Created a Risk Assessment Team to scour for misdeeds before they turn into full-blown scandals, tapping new sources such as arbitration filings.
• Set up an e-mail task force to set standards for how Wall Street should monitor and preserve internal and external communications.
In a major change, repeat violators will be dealt with harshly. Ketchum hopes to influence the behavior of Wall Street firms by, for example, showing them that if they don't do the right thing, they face higher fines. "We've got to make sure the penalties are sufficient so members won't treat them as a cost of doing business," says Ketchum. NYSE Enforcement Chief Susan L. Merrill adds that she'll also impose sanctions if firms don't fully reimburse investors for bad advice or fraud. "The whole idea is to make customers whole," she says.
Ketchum is spreading the regulatory net into entirely new areas. For the first time, his team will scrutinize brokerages that trade big blocks of shares for mutual and pension funds. It will also look closely into whether brokers handle orders near the close of the market fairly. It is mulling a rule to force Wall Street firms to acknowledge receipt of a customers' complaint within 15 days. There's no such requirement now.
And if the NYSE has its way, all brokers, no matter how long they've been in the industry, will have to participate in ongoing education. Until now, veteran brokers were often exempt from annual certification. "We're moving faster. The stakes are rising," says Grace B. Vogel, the new head of member firm regulation who was recruited from Citigroup in June.
Under Ketchum, the NYSE is looking a lot less clubby. His top cops include two women -- Vogel, 48, and Merrill, 47 -- as well as an African American, Robert A. Marchman, 46, a former branch chief of the Securities & Exchange Commission who joined in September as head of market surveillance. Marchman led the recent investigation into seven specialists for alleged improper trading that resulted in $247 million in fines. "We want to deal with issues before they become widespread, and we've been empowered to do that," Marchman says. By Mara Der Hovanesian
The new mod squad has a much bigger staff than in Grasso's era. So far this year, they've hired 67 more investigators and lawyers, pushing the total regulatory staff to 700 -- 42% of the NYSE's workforce. The team is responsible for oversight of 160 specialist and floor broker firms and the nation's 230 biggest securities firms, which manage more than 90% of all investor brokerage accounts. "I can assure you that the enforcement staff is not cozy with the members," says Merrill, who was hired in July. "They have a real prosecutorial mentality."
Firms that obstruct the enforcers can expect tough justice. On Aug. 26, for example, Deutsche Bank was fined $7.5 million by the SEC, NYSE, and others for not producing e-mail records in a timely manner. That fine was more than four times those imposed on five other Wall Street firms that paid up for not having proper systems to keep e-mail in December, 2002. Deutsche Bank says it has solved the problem.
The Morgan Stanley case shows that nobody gets "extra credit" for admitting to mistakes when it's required by law to do so anyway, says Merrill. "The prospectus is a key document in securities law that lays out risk factors to investors. It's not a sales pitch," she says. "Morgan Stanley showed several operational breakdowns, and that concerns me greatly."
Since Ketchum, 53, was recruited in June, the enforcement and market surveillance budget is up by $50 million. Ketchum, previously the general counsel for Citigroup's (C ) corporate and investment bank, was also president of Nasdaq Stock Market Inc. and spent 14 years at the SEC, eight as the director of market regulation. "If self-regulation is going to work, it must show that our decisions are irrelevant to whether it helps or hurts the NYSE as a business," he says. "The proof is how quickly we react to red flags and go after the conflicts [of interest] that are undeniably there."
The early response to his efforts is favorable. Many specialists, former regulators, and industry mavens say they believe the new regime is moving in the right direction. "There's no question that in my practice we are seeing a more active NYSE both in the surveillance and particularly enforcement," says Neal Sullivan, partner at Bingham E. McCutchen in Washington, who often represents Wall Street in securities regulation cases. "They are just much more aggressive -- pushing issues, getting documents, trying to ferret out deficiencies."
But Ketchum's reforms don't placate everyone. Critics of the NYSE's status as a self-regulatory organization (SRO) say the old klatsch of members who own the exchange will always act in their own self-interest. American Enterprise Institute fellow James K. Glassman argues that the SEC should force the NYSE to have an independent regulator. "I am extremely skeptical that any institution can absorb a regulator within itself and truly self-regulate," he says.
Ketchum's critics point to the NASD, a private entity with an annual budget of $400 million and a staff of 2,000. It now regulates the Nasdaq Stock Market, of which it used to be a part, and more than 5,200 securities firms. The SEC imposed the separation as a remedy after serious trading improprieties emerged in 1996.
The SEC is expected to weigh in on the debate. So far, Washington sources say agency staffers have adopted a wait-and-see approach but are optimistic about Ketchum's progress. On Nov. 9, commissioners will vote on whether to propose a rule covering transparency and governance in self-regulated markets. It will issue a discussion paper to explore alternatives to the NYSE's SRO status soon after.
One possibility: Combine the NASD and NYSE regulation, saving as much as $100 million a year. NASD officials declined to comment. Ketchum is not keen on the idea. He says NYSE regulators understand the nuances and intricacies of NYSE trading better -- but he's all for sharing training expenses and rulemaking.
If Ketchum and his team succeed in restoring the NYSE's reputation, they'll face an even stiffer test. "The real question is what's the next problem that's going to crop up," says James J. Angel, associate professor of finance at Georgetown University. In short, Ketchum's job will be to make sure the next scandal never happens.
Der Hovanesian is Finance & Banking editor for BusinessWeek in New York