Commentary: Clearing Firm, Clear Thyself

He is a high official of a major brokerage that handles trades for smaller firms around the country. Small brokerages can't afford their own back offices, so they turn to this man's firm and other leading Wall Street firms--notably Bear Stearns and the Pershing division of Donaldson, Lufkin & Jenrette. "Correspondent clearing" is a humdrum, if lucrative, corner of Wall Street. But there is nothing at all routine about this man's job. He keeps his firm from working with brokers who manipulate stocks and rip off customers.

This exec, who insists on anonymity, has done his job well. He keeps voluminous files on stock promoters and rogue brokers, and tracks them from firm to firm--to keep away from them. So you won't read about his firm in the papers. But other big clearing firms are not so fortunate. The role of Bear Stearns, in particular, as clearing firm for A.R. Baron, Stratton Oakmont, and other firms with troubled regulatory histories has alarmed regulators and led to an examination of the rules governing clearing firms, which are not liable for the actions of firms clearing through them. "The Securities & Exchange Commission has expressed concern, and so have the state regulators," notes Salvatore Pallante, senior vice-president for member firm regulation at the New York Stock Exchange. Bear Stearns maintains that it has fully abided by the law and is working with regulators evaluating the clearing business.

NO COMFORT. The relationship between large Wall Street firms and small, sometimes shady ones is symbiotic. For large brokerages, the clearing business is a cash cow. And part of what they are selling to the smallest firms is prestige. Regulators note that cold-callers from small-stock firms often cite their links with prestigious clearing firms as a selling point in pushing stocks on the public. Bear Stearns General Counsel Mark I. Lehman asserts that his firm would act swiftly to stop "improper use" of Bear's name. He acknowledges, however, that a relationship with Bear Stearns, by dint of its repute and financial standing, "is one of the ways firms derive comfort for their customers."

In fact, the customers have no reason to feel comfort. Although clearing firms know intimately their client firms' trading patterns, as well as the sometimes excessive markups and commissions charged to the public, clearing firms have no legal obligation to pass on such information to the regulators. "I think they know perfectly well the caliber of firm they are dealing with," says Mark Griffin, president of the North American Securities Administrators Assn.

What's the solution? The clearing firms, not surprisingly, oppose any move to hold them liable for the actions of their clients. But sharing information with regulators might be more palatable. Lehman says regulators might want to require clearing firms to report improper trading, plus excess commissions and markups--if they remain liability-free.

Sharing information would help--but it isn't enough. Clearing firms must be goaded into more vigorous self-policing. They must cease lending their names to unsavory firms. How do smart firms do that? Pallente notes that many clearing firms demand to see the disciplinary and employment records of both principals and brokers of small firms before taking them on as clients. Otherwise, "you're asking for trouble," says Pallente. Checking managers alone is clearly not enough. "These brokers tend to all come from the same firms, and if I see that they are I won't take their firms on as clients," says the publicity-shy clearing firm exec.

NO DATA. By contrast, Bear Stearns has checked the disciplinary and employment records of small-firm principals--but has not checked brokers' records. Why not? Until March, Lehman says, the firm was legally barred from getting such info from the computer database of the National Association of Securities Dealers. But Pallente says other firms simply get broker info directly from prospective clients--which Bear has never done. Lehman, after first telling BUSINESS WEEK that Bear now gets broker data from the NASD database, later withdrew the remark. "I am not sure we are accessing such information," he says.

Such a lack of curiosity is legal, but shortsighted. If clearing firms continue to knowingly work with rotten brokers, regulators should expose them to liability for the actions of their clients. If they insist on lying down with Wall Street's dogs, they should not be protected from getting up with fleas.

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