Who Watches The Watchdog At Nasdaq?

Joseph R. Hardiman, president of the NASDAQ stock market, had high expectations when he stepped up to the podium in late March to introduce a new trading system for small investors. But those expectations were soon dashed. Before an overflow crowd at New York's posh Inter-Continental Hotel, the press briefing quickly degenerated into a shouting match between the NASDAQ chief and dissident NASDAQ broker Sheldon Maschler.

Claiming he was representing a sports publication, Maschler demanded to ask a few questions. Hardiman refused and threatened to have the burly head trader of Brooklyn-based Datek Securities Corp. thrown out by hotel security. Undeterred, Maschler denounced NASDAQ's domination by the clubby big firms and blasted the organization's executives for using their regulatory powers to drive small firms out of business.

Hardiman now tries to put a positive spin on the embarrassing episode. While disputing Maschler's charges, the NASDAQ chief insists that one of the organization's biggest successes is treating all constituencies fairly. "Criticism by members is healthy," he says. "It shows us if we get out of balance."

STRUCTURAL FLAWS. The Maschler incident is symptomatic of increasingly serious management problems and bitter internal dissent at the rapidly growing market system. At the root of NASDAQ's troubles is its structure: Owned and operated by the National Association of Securities Dealers (NASD), NASDAQ is a group of nearly 500 market makers who trade with one another over the phone. They advertise offers to buy and sell stocks on thousands of electronic quote machines in brokerage offices nationwide. But a vocal group of small firms alleges that the market's rules are designed to boost the profits of the large NASDAQ firms that control the market--at small firms' and investors' expense.

These firms are aiding federal probes into possible illegalities on NASDAQ. The Justice Dept. is investigating alleged collusion to fix prices. The Securities & Exchange Commission is looking into allegations of endemic late reporting of trades and backing away from quoted stock prices by traders. Academics and investors have also questioned the fairness of the way market makers conduct business. Indeed, pressure is slowly building to transform NASDAQ into a true national electronic execution market, which could curb many of the alleged abuses--and wipe out much of the big market makers' edge over smaller firms.

The heightened scrutiny could also lead to historic changes in the relationship between NASDAQ and the NASD. Critics say the NASD may have a conflict of interest: It not only owns NASDAQ but also has a congressional mandate as a privately run regulator to police the market and its member firms. "Congress has created an entity that has more power than a king," says Robert C. Beers, a former NASD enforcement attorney now in private practice.

Managing the NASD's vast array of constituencies may be a nearly impossible job. In the past two decades, the market has ballooned from a backwater for the stocks of emerging companies to the world's second-largest stock market, trading 321 million shares of 4,900 listed companies daily. NASD oversees 5,429 firms and 489,000 brokers (chart, page 109). "The question is being raised if the governance structure has kept pace with the expanded responsibilities," Hardiman concedes.

To forestall government-imposed reforms, the NASD last November appointed an independent panel headed by former New Hampshire Senator Warren B. Rudman to study the market's organization and governance. Hardiman acknowledges that the committee is considering some radical proposals, including spinning the market off from the NASD. Rudman declined to discuss specifics but said the study should be completed this summer.

BIG LOSERS. To its critics, nothing better symbolizes the NASD's preoccupation with protecting big market makers than the events that led up to the development of the new system--dubbed Aqcess--which Hardiman introduced at the March press conference. It started with the 1987 market crash, which prompted the NASD to force market makers to conduct trading on the little-used Small Order Execution System (SOES). The system, which guaranteed electronic execution of trades up to 1,000 shares, was seen as a way to protect investors from devastating market failures such as the crash, when brokers refused to answer telephones.

While designed for small investors, savvy dealers at some smaller NASD firms figured out that they could make tidy profits by using SOES to trade shares when dealers failed to update their prices. The losers often were big market makers that weren't paying enough attention to price changes by rivals in the same stocks.

When the large firms woke up, they struck back at traders they derisively labeled "SOES bandits." The NASD passed a series of rules that hurt these SOES firms--and investors as well--by limiting market makers' obligation to fill orders on SOES. Swayed by the NASD's arguments that SOES firms disrupted the market overall, the SEC rubber-stamped many of the changes. Some SEC officials now regret its action. "We took a system that wasn't perfect and messed it up even more." concedes SEC Commissioner Richard Y. Roberts.

Over the next few years, the NASD fought a series of pitched battles with the SOES firms to restrict their trading on SOES. The courts and the SEC, which began to take a harder line, ruled in favor of the SOES firms. Hardiman staunchly defends the NASD's steps. Some firms "were taking advantage of a system," he says. "We thought it was inappropriate."

The new version of SOES, Aqcess, is supposed to satisfy everyone's complaints. The proposed system offers execution for orders of up to 3,000 shares and is being promoted as the first central electronic market dedicated to small investors. Hardiman says most NASD member firms support Aqcess. But it's already under fire for giving firms a loophole to not always make good on their quotations. "Aqcess is the strongest evidence that NASD is not trying hard to act in the public's interest," says Rutgers State University of New Jersey's finance professor David Whitcomb. "It's just trying to put forward a cleverly designed system with minimal change."

NO CHOIRBOY. The SOES fight is hardly the only contentious issue. Many smaller members claim the NASD's disciplinary mechanism is biased. Take the treatment of Maschler's Datek. Maschler admittedly is no choirboy. He made a fortune at notorious First Jersey Securities Inc. and has a disciplinary record dating back to 1977.

Still, the NASD's treatment of his firm raises questions. In 1992, it suspended Datek from trading for six months after finding that Maschler violated some of the rules designed to curb SOES firms. But the SEC found that two of the three members of the disciplinary panel worked at firms--Smith Barney, Harris Upham and Shearson Lehman Brothers--that were involved as market makers in 20% of the transactions at issue. The conflict of interest led the commission to overturn the sanction. Maschler now is suing the NASD and a half dozen major Wall Street firms, seeking $24.6 million in damages. Maschler's background "doesn't give license to the NASD to act improperly," says Beers, the former NASD attorney. Hardiman declines comment because of the litigation.

A less visible tool wielded by the NASD against dissidents and associates of SOES firms is the "restriction letter"--a document that dictates terms of operation for new and expanding firms. Typically, a firm with $125,000 in capital is allowed to make markets in the stocks of 50 companies. But the rules seem to change for mavericks. Take Big Board member Domestic Securities Inc. It has a nine-year track record and a healthy $1 million in capital, but its affiliate company, All-Tech Investment Group Inc., fought the NASD's efforts to rein in SOES's use. When Domestic's new NASD membership became effective in mid-1994, the firm was approved for making markets in only 50 stocks. A month later, Domestic applied to increase that number and hasn't gotten an answer yet. "This is clearly retribution because of All-Tech's criticism of NASD," says Harvey I. Houtkin, head of both firms.

Hardiman says the association has to be careful in admitting new firms to make sure they have enough capital and experience. "We use those restrictions to protect the public," he says.

Some dissidents are trying to force change from within. Alan L. Davidson, president of tiny Zeus Securities Inc. of Jericho, N.Y., tried in 1993 to get elected to the NASD's board of governors from New York District 10. His platform was to break up the big market makers' domination of the association's leadership. Among other things, Davidson questioned a March, 1993, bylaw amendment that let the board, rather than members, approve key rule changes. The NASD says the amendment brought it in line with other markets such as the New York Stock Exchange. But Davidson fumes that "the power is being concentrated even more in the board."

The 30-year Wall Street veteran ruffled the NASD's feathers when he challenged its handpicked candidate, Dennis C. Hensley, a managing director at J.P. Morgan Securities Inc. and a former NASD deputy general counsel. The five-member District 10 nominating committee, including executives from Merrill Lynch & Co. and First Manhattan Co., sent out a letter on a NASD letterhead slamming Davidson and urging members to vote for the committee's nominee. But Davidson still ended up with 40% of the vote. "The entire NASD process has mutated into a special agenda of a few large firms," says Davidson.

Unfazed, Davidson launched the Independent Broker-Dealer Assn. He expects to double the group's membership of 100 by yearend. Growth would be faster, he says, but for the fear of small firms that they would face retribution from the NASD or other firms. "Small firms feel the NASD will retaliate. They retaliate in ways that are never put in writing," says Joseph Mays, a former NASD examiner and now a consultant.

Pressures from inside and outside are beginning to force the NASD to make changes. Earlier this year, the NASDAQ board increased the number of outsiders from two to five. More than a third of the NASD's 29-member board is from outside the securities business.

But these moves aren't enough to forestall further pressure for change, especially on the NASD's tight linkages with NASDAQ. NASD supporters point out that the New York Stock Exchange and other exchanges have a similar combined organization. "But the legitimacy of those markets isn't being investigated by the Justice Dept. and SEC," says Junius W. Peake, a former NASD vice-chairman and professor at the University of Northern Colorado.

CHINESE WALL? Some academics advocate separating NASDAQ from the NASD. That would allow the NASD to perform its regulatory function without having to serve the interests of NASDAQ's membership. "There should be a separation," says Dale A. Oesterle, a professor at the University of Colorado School of Law. "Otherwise it's hard to get a market operating in the best interest of customers." Hardiman disputes the proposal, saying the system would lose synergies.

The Rudman committee likely won't recommend anything as radical as a spin-off but it might suggest a Chinese Wall between the NASD and NASDAQ members--particularly the influential major firms. One option under study is to separate management of the two organizations, which currently are both run by the same senior executives. Another is to move NASDAQ's headquarters from Washington to New York. But given the number of Rudman committee members with close ties to the association, many skeptics doubt the panel will propose much more than increasing independent board membership to 50%.

More pressure is likely to come from the SEC. It was embarrassed when Justice launched its price-fixing probe. And the commission's recent aggressiveness suggests it no longer rubber-stamps proposals the NASD sends over for approval--especially those that could hurt smaller firms or investors. The SEC might even become sufficiently fired up to force the ultimate reform: transforming NASDAQ into a fully electronic system with automatic execution to all investors. Market makers would no longer do trades aver the phone and make money by keeping spreads suspiciously wide. NASDAQ would at last become what it has always claimed it already was: the stock market of the future.


Critics, especially some small NASDAQ firms, say the NASD, which owns NASDAQ, abuses its power. The NASD says it runs its market fairly.


The NASD and NASDAQ boards are controlled by major firms, which sway policy to suit their own interests.

Some small firms are targets of unfair disciplinary actions, and their rights of due process are violated.

The NASD retaliates against new firms set up by dissidents by restricting their activities.

The NASD, along with major NASDAQ market makers, has tried to limit trading by some small firms on the Small Order Execution System (SOES).

The NASD should be split off from

NASDAQ. That would end the conflict of interest between the NASD's role as both NASDAQ's owner and its regulator.


The NASD balances the interests of all constituents. The boards have been adding nonindustry members.

The system is not unfair. Cases are evaluated by a panel of peers. Decisions can be appealed to the SEC and federal courts.

Care must be taken in letting new firms into the business to make sure they have enough capital and experience.

Some small firms trading on SOES take unfair advantage of a system designed for individual investors and create unnecessary volatility in stocks.

The benefits of synergies in combining NASD and NASDAQ make any separation an unwise strategy. The Big Board and other exchanges have similar structures.


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