Commentary: Can The Big Board Police Itself?

As the debate over public stock offerings by the stock exchanges heats up, one issue has come to the forefront: If the New York Stock Exchange and the Nasdaq stock market go public, can they still properly regulate themselves? The Securities & Exchange Commission is seriously considering one possible solution--combining the exchanges' regulatory arms into one separate and distinct "super-self-regulator."

This intriguing idea is gaining support on Wall Street. But Big Board Chairman Richard A. Grasso feels that such a move would "do irreparable harm to the NYSE brand." Grasso has told the Senate Banking Committee that "self-regulatory duties literally permeate every part of the exchange" and that "involvement of regulatory personnel who understand the workings of the exchange from the inside" has ensured the market's integrity.

SEC CHARGES. But just how thoroughly have "self-regulatory duties" permeated the NYSE? To be sure, the exchange's reputation for regulatory acumen is far better than that of Nasdaq, which has struggled with microcap fraud and price-fixing charges through much of the 1990s. But the Big Board has had difficulties of its own when it comes to overseeing the brokers who work on the exchange floor. In June, the NYSE settled SEC charges that it had systematically failed to curb or detect illegal trading by many of its 500 floor brokers. The SEC charges stemmed from a continuing federal investigation that, back in February, 1998, resulted in charges that were brought against floor brokers and executives at the now-defunct Oakford Corp. Most of the defendants in the Oakford case have pleaded guilty and are awaiting sentencing.

The NYSE has promised to clean up its act. But the Oakford case has continued to raise troubling questions about the regulatory climate at the NYSE--questions that deserve to be addressed in the debate over the single-self-regulator proposal.

A good example of the continuing fallout for the exchange from Oakford came to light on Oct. 20-21 at a little-noticed federal court hearing in lower Manhattan. A parade of witnesses--ranging from floor brokers to a top NYSE official--depicted an exchange that for years failed to stop illegal trading by floor brokers. The hearing also brought forth the intriguing news that much of the trading carried out by the Oakford brokers---activity for which they are now facing up to 10 years in jail--actually may have been legal in the eyes of the NYSE.

At issue in the hearing before U.S. District Court Judge Jed S. Rakoff were the sentences that are to be imposed on six of the Oakford defendants. The accused, mainly former floor brokers, have admitted that they traded for their own profit. Such "discretionary" trading is verboten because floor brokers have access to nonpublic information by just being on the trading floor. They are supposed to simply execute trades given them by others.

Some of the most startling testimony came from former floor broker Michael A. Frayler, who has pleaded guilty to charges of illegal trading. Frayler testified that one time in 1996, he netted a handsome profit by a swift day trade in AT&T stock. He testified that the specialist, William Johnston, complimented him on the trade and that Frayler said: "I get 70% of that"--a reference to his profit-sharing scheme, which prosecutors contend was illegal. Frayler said a bystander told him to be quiet because Johnston was the NYSE's vice-chairman. Frayler said Johnston "turned around and said: `I didn't hear that."' Johnston is now president of the exchange. Through a spokesman, he declined to comment.

Also troubling was testimony indicating that there is, it seems, a fine line between legal conduct by floor brokers and trading that can lead to a federal court indictment against them. The exchange's chief regulator, Edward A. Kwalwasser, testified that until October, 1998, the NYSE felt it was not necessarily improper for a floor broker to share in the profits of someone else's trading account. (The Oakford indictment had charged that such profit-sharing arrangements were grave violations of the securities laws.) Kwalwasser also testified that the Big Board regulators did not look for such profit-sharing arrangements and that "we had no knowledge during that time that there were such [profit-sharing] arrangements."

"EXTRAORDINARY" OPINION. The hearing also shed light on the NYSE's current, apparently narrow view of what constitutes illegal discretionary trading by floor brokers. Judge Rakoff posed to Kwalwasser a hypothetical example in which a trading firm tells a floor broker that he can "trade anything you [the floor broker] want in any amount and at any time, and all you have to do is call me [the trading firm] through my clerk, who will have a standing order from me to clock the order." Kwalwasser said that that would not be an illegal discretionary trade by a floor broker.

Rakoff seemed surprised and disturbed by Kwalwasser's testimony. The judge said that he found that to be "an extraordinary interpretation" of the securities laws and said that he believed that Kwalwasser's testimony appeared to conflict even with the "dictionary definition of discretion." The judge, formerly a prominent securities lawyer, was also disconcerted by the NYSE's stance toward profit-sharing schemes until 1998. Rakoff said that he would take into account such testimony, which might impact favorably on the sentences the defendants may receive. The SEC was also troubled by the Big Board's stance, saying in its June, 1999, complaint that "the NYSE's failure to police for performance-based compensation arrangements of independent floor brokers was a material inadequacy of its regulatory program."

Rakoff's concerns are justified. If Grasso is correct that the NYSE regulators are "cops on the beat," with an intimate knowledge of exchange operations, why did they let improper trading go on for so long? Why do they continue to allow floor brokers to engage in trades that appear, to a federal judge at least, to be improper discretionary trading? There can be one self-regulator or two or three. The issue is not the number but the degree of vigilance. The Oakford case is continuing to show that regulators--be they the NYSE or a "super-self-regulator"--need to keep a close watch over the activities of NYSE floor personnel and promptly act against any practice that takes unfair advantage of the brokers' position at the heart of the nation's leading stock exchange.

Before it's here, it's on the Bloomberg Terminal.