<DOC>
[108 Senate Hearings]
[From the U.S. Government Printing Office via GPO Access]
[DOCID: f:25149.wais]
S. Hrg. 108-881
IMPROVING THE CORPORATE GOVERNANCE
OF THE NEW YORK STOCK EXCHANGE
=======================================================================
HEARING
before the
COMMITTEE ON
BANKING,HOUSING,AND URBAN AFFAIRS
UNITED STATES SENATE
ONE HUNDRED EIGHTH CONGRESS
FIRST SESSION
ON
BROKER-DEALER SELF-REGULATION AND REGULATORY AUTONOMY WITH MARKET
SENSITIVITY
__________
NOVEMBER 20, 2003
__________
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COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS
RICHARD C. SHELBY, Alabama, Chairman
ROBERT F. BENNETT, Utah PAUL S. SARBANES, Maryland
WAYNE ALLARD, Colorado CHRISTOPHER J. DODD, Connecticut
MICHAEL B. ENZI, Wyoming TIM JOHNSON, South Dakota
CHUCK HAGEL, Nebraska JACK REED, Rhode Island
RICK SANTORUM, Pennsylvania CHARLES E. SCHUMER, New York
JIM BUNNING, Kentucky EVAN BAYH, Indiana
MIKE CRAPO, Idaho ZELL MILLER, Georgia
JOHN E. SUNUNU, New Hampshire THOMAS R. CARPER, Delaware
ELIZABETH DOLE, North Carolina DEBBIE STABENOW, Michigan
LINCOLN D. CHAFEE, Rhode Island JON S. CORZINE, New Jersey
Kathleen L. Casey, Staff Director and Counsel
Steven B. Harris, Democratic Staff Director and Chief Counsel
Douglas R. Nappi, Chief Counsel
Bryan N. Corbett, Counsel
Dean V. Shahinian, Democratic Counsel
Joseph R. Kolinski, Chief Clerk and Computer Systems Administrator
George E. Whittle, Editor
(ii)
?
C O N T E N T S
----------
THURSDAY, NOVEMBER 20, 2003
Page
Opening statement of Chairman Shelby............................. 1
Opening statements, comments, or prepared statements of:
Senator Sarbanes............................................. 3
Senator Bunning.............................................. 4
Senator Schumer.............................................. 5
Senator Crapo................................................ 7
Senator Allard............................................... 8
Senator Chafee............................................... 8
Senator Corzine.............................................. 18
Senator Sununu............................................... 19
WITNESSES
William H. Donaldson, Chairman, U.S. Securities and Exchange
Commission..................................................... 9
John S. Reed, Interim Chairman and CEO, New York Stock Exchange.. 31
Prepared statement........................................... 45
(iii)
IMPROVING THE CORPORATE GOVERNANCE
OF THE NEW YORK STOCK EXCHANGE
----------
THURSDAY, NOVEMBER 20, 2003
U.S. Senate,
Committee on Banking, Housing, and Urban Affairs,
Washington, DC.
The Committee met at 10:06 a.m., in room SD-538, Dirksen
Senate Office Building, Senator Richard C. Shelby (Chairman of
the Committee) presiding.
OPENING STATEMENT OF CHAIRMAN RICHARD C. SHELBY
Chairman Shelby. The hearing shall come to order.
This hearing is part of the Committee's ongoing oversight
of our national market system and the role of self-regulatory
organizations. As a result of the controversy surrounding Dick
Grasso's compensation, investors have questioned the New York
Stock Exchange corporate governance standards and its
effectiveness as a regulator.
Many have criticized the current structure of the
Exchange's board of directors for being dominated by directors
representing specialists and member firms and lacking
sufficient independent directors. Many also contend that the
Exchange's self-regulatory structure in which the chairman is
essentially paid by the industry that he oversees, calls into
question the Exchange's role as an unbiased regulator.
In early November, interim Chairman and CEO John Reed, who
is with us today, proposed several reforms aimed at eliminating
the conflicts of interest within the Exchange's governance
structure. These proposals were approved by the Exchange's
membership on November 18 and are currently awaiting final SEC
approval. Mr. Reed proposed bifurcating the Exchange's
governance structure into a board of directors and a board of
executives. There will be, under that plan, 8 independent
directors on the board and approximately 20 constituent
representatives on the board of executives. Mr. Reed also
proposed a litany of new disclosure practices to improve the
transparency of the Exchange's operations. And, finally, Mr.
Reed proposed the creation of a Chief Regulatory Officer who
would report to the board's regulatory committee comprised of
independent directors.
The public reaction to Mr. Reed's proposals has been
decidedly mixed. Some have endorsed the plan for significantly
altering the Exchange's board structure, improving the
transparency of the Exchange operations and insulating the
Exchange's regulatory function from the influence of its
members. Others have criticized the proposals for not going far
enough to address conflicts at the Exchange. Some find the
proposals deficient for failing to require the Exchange to
separate its regulatory function from the business operations,
contending that as long as the business and regulatory
functions of the Exchange are combined within one entity,
member firms will continue to influence the directors and
impede proper regulation.
Some have also criticized the proposals for failing to
require an independent chairman of the board and for neglecting
to put a representative of the investing public on the board of
directors.
The Committee has a significant interest in examining
reforms to the Exchange's governance structure and
understanding how any such changes will impact the Exchange's
regulatory function. Given our reliance on self-regulatory
organizations in actively monitoring our markets, I believe it
is critical that the Congress, the SEC and, most importantly,
investors have confidence that the self-regulatory
organizations are on the job and keeping a watchful eye.
Following the recent revelations of abuses in the mutual fund
industry, many are questioning the effectiveness of the
regulatory structures for our markets.
I understand that Chairman Donaldson has worked closely
with Mr. Reed since he began his tenure at the Exchange. I
fully expect the SEC to continue scrutinizing the governance
structure and regulatory capabilities of the Exchange during
the coming months. It seems to me that Mr. Reed's proposals may
be the first step in a more lengthy reform process.
Mr. Chairman, I understand that the Exchange governance
proposals are currently pending before the Securities and
Exchange Commission and awaiting approval. Therefore, I
recognize that you must refrain from providing us with certain
confidential information regarding the SEC's deliberations.
Mr. Chairman, it has been a busy week for you. You have
been here, this is your second time. You can just about move in
if you want to.
[Laughter.]
Chairman Shelby. Thank you for testifying before this
Committee twice in one week, and I look forward to your
testimony.
In addition, this morning--before I recognize Senator
Sarbanes--the Committee will consider S. 1531, the Chief
Justice John Marshall Commemorative Coin Act. This piece of
legislation, introduced by Senator Hatch, with the support of
75 of our colleagues, will commemorate the 250th anniversary of
John Marshall's birth. Often considered the founder of
constitutional law, John Marshall is the longest-serving Chief
Justice whose tenure, from 1801 to 1835, spanned 34 years and
five Presidents. The influence of his decisions, most notably
in Marbury v. Madison, established the principle of judicial
review and ultimately helped shape and define our Nation's
judicial system. A prominent figure in our Nation's history, it
is fitting, I believe, to recognize and honor the Great Chief
Justice, whose influence continues to be reflected, even in the
Court's work today.
We will also be voting, when we get a quorum, on two
important nominations this morning. Today's nominees, if
confirmed, will play a vital role in overseeing the safety and
soundness of our Nation's financial institutions. Our nominees
are Ms. Alicia Castaneda, nominated to be a Member of the Board
of Directors of the Federal Housing Finance Board, and Mr.
Thomas J. Curry, nominated to be a Member of the Board of
Directors of the Federal Deposit Insurance Corporation.
Senator Sarbanes.
STATEMENT OF SENATOR PAUL S. SARBANES
Senator Sarbanes. Thank you, Mr. Chairman, and this is a
very timely hearing on the governance and operation of the New
York Stock Exchange. Actually, the Exchange is virtually as old
as our country. It was organized in 1792, when 24 New York City
stockbrokers or merchants met on Wall Street, under a
Buttonwood tree, as we are reminded, to sign what was
thereafter called the Buttonwood Agreement. To many, the
Exchange, since then, has been an important symbol of
capitalistic economic system.
Few institutions play as important a role in our economy as
the components of our securities markets. These include the
stock exchanges, the over-the-counter markets, and combinations
of the two. Together, they form the central mechanism for
raising capital for our businesses and for investing the
savings of our citizens. Their reputation for maintaining fair,
liquid, and efficient markets, and continuing to do so as the
volume of shares traded daily has climbed ever higher, is what
makes the U.S. markets the center of the international capital
markets, and in my judgment, a very important and major
economic asset for this Nation.
If the New York Stock Exchange is to continue to command
the confidence of investors at home and abroad, it obviously
will have to address effectively some serious questions have
arisen in recent months concerning its governance, its strength
as a self-regulatory organization, and the efficiency of its
market-making mechanisms.
The adequacy of the Exchange's governance was brought into
question by disclosures only a few months ago, which led to the
resignation of its Chairman, followed by some members of the
Exchange's Board.
Under the Securities Exchange Act, the Exchange has been
granted the right, ever since 1934, to act as a self-regulatory
organization, subject to SEC oversight. A recent SEC
investigation of floor trading practices has cast doubt on the
effectiveness of Exchange self-regulation. In fact, SEC
Chairman Donaldson himself has said that there was a
``distressing breakdown'' in the regulation of trading-floor
specialists, and according to a report in The Wall Street
Journal, an internal Commission report, ``paints a picture of a
floor-trading system riddled with abuses, with firms routinely
placing their own trades ahead of those by customers--and an
in-house regulator, either ill-equipped or too worried about
increasing its workload to care.''
Further, changes in technology and the globalization of
financial markets have led some to ask whether a trading floor
in which brokers match buyers and sellers, and liquidity is
maintained by ``specialists'' who trade in assigned stocks, is
out-of-date. Most of the rest of the world has moved to
electronic systems on which securities dealers advertise prices
at which they will buy and sell securities, rather than
matching buyers and sellers.
Each of these subjects obviously raise it to its own set of
specific issues, and important issues are being raised about
the independence of the Exchange's regulatory function. In
fact, some have raised the question whether its regulatory
operations should be spun off from the business function of the
Exchange.
The cumulative impact of these questions have left the New
York Stock Exchange facing major challenges at a very important
time. Chairman Donaldson emphasized, during our last hearing on
this subject, that the Nation's market structure and governance
are the result of 200 years of growth and that it is important
that the consequences of any regulatory or structural changes
be carefully considered. I think that is an important
admonition. But we also need to recognize that we have seen
during the last few years that the trust in the institutions of
our capital markets, once lost, is hard to regain.
The answers to the questions faced by the Exchange must
involve a thorough and comprehensive review carried out of the
Exchange's structures and functions by the Exchange itself, by
the Commission, and by the Congress. And this hearing, Mr.
Chairman, is a valuable step in that process, and I appreciate
your convening it, and I welcome the opportunity we have this
morning to hear again from Chairman Donaldson. I join you in
welcoming him back before the Committee. Any time, Chairman
Donaldson, we are happy to receive you, and we are also looking
forward to the hearing from Mr. Reed and the subsequent panel.
Thank you.
Chairman Shelby. Senator Bunning.
STATEMENT OF SENATOR JIM BUNNING
Senator Bunning. Thank you, Mr. Chairman. I would like to
thank you for holding this timely hearing today. Also, I would
like to thank all of our witnesses for their testimony.
We all have been very concerned with the reports about the
corporate governance issue and the New York Stock Exchange. I
am very happy to see that the Exchange has moved to correct
some of those problems. I look forward to hearing from Mr. Reed
on exactly how the Exchange is going to change, and from
Chairman Donaldson, who has been up here a lot, as we have
said, we have a chair in the back that you can have and share
with us any time.
Chairman Donaldson. Thank you.
Senator Bunning. You have been here a lot lately, and we
are getting the SEC's take on the Exchange's proposals. It
seems like this Committee has spent an enormous amount of time
on corporate governance issues in the past couple of years. I
wish we did not have to. I wish corporations and organizations
would do a better job of behaving in self-policing. But,
obviously, in many cases they have not, and Congress has been
forced to get involved. That is not good.
I do not like it when we have to get involved. Sometimes we
do a good job--such as when we passed the Sarbanes-Oxley Act
last year--sometimes we do not, and at times we have overkill.
But if we are forced to do something, we will do the best job
we can.
Investors have taken a lot of hits over the past few years,
and the Exchange's turmoil is another hit on investors'
confidence. This needs to end. I am hopeful the Exchange-
proposed reforms will help restore confidence. I hope you end
up with a strong, tough, and independent self-regulator that
will work with the SEC and restore confidence.
It is essential that you have, for the American investor
and the economy, to have that type of self-regulator. If your
new model does not restore confidence, then there may be many
on Capitol Hill who will feel the need to get Congress
involved. You do not want that to happen. I do not want that to
happen, but I know you really will try to get it done. Please
make sure the reforms you make are thought out, executed well,
fully disclosed, and the right ones.
Once again, Mr. Chairman, I want to thank you for holding
this very timely and important hearing.
Chairman Shelby. Senator Schumer.
STATEMENT OF SENATOR CHARLES E. SCHUMER
Senator Schumer. Thank you, Mr. Chairman, and I want to
thank you for holding this hearing. You are really ``Johnny on
the spot'' having timely hearings on important issues.
I want to thank Chairman Donaldson and Mr. Reed for being
here on an issue of great importance, obviously, to me as a New
Yorker, but also to all of America and the world, in terms of
our financial system. I also want to thank Mr. Reed for taking
this job. It was not an easy job, and your expertise is really
important.
We are all here today because of the circumstances that led
to the former New York Stock Exchange Chairman Dick Grasso's
resignation, and they are serious, and they have to be
addressed. It is now clear there was not enough hands-on
oversight, that there was too much abuse of the regulatory
function, there were too many conflicts of interest. The new
governance proposal that is the subject of the hearing today is
an important step in that reform process. Government is really
about trust. Is the right system in place to look out for all
of the people's interests, not just the insiders? My biggest
concern with the market today is that although stock prices are
way up, trust is down, and nothing is worse for New York or our
markets if that continues. The stories are not getting any
better, as the mutual fund scandals indicate. Trust is the glue
that holds our markets together and makes this hearing so
important.
I want to commend Mr. Reed for taking decisive action. I
think your job, Mr. Reed, is a little like being a tightrope
walker. Everyone knows what you need to do. There is a big
audience watching, and there are a few people who may secretly
be hoping that you fall off the wire. The trick is keeping the
right balance, and that is what I think you have done.
On the one hand, we have very substantial reform. You have
changed the board 180 degrees, from a large insider group to a
small outsider group. I am impressed with the talent of the
board members you have attracted. It is clearly a world-class
group. You have realized the admonition that some degree of
self-regulation, through an advisory board, listed companies
and traders, who will know what rocks to look under and help
ensure regulation keeps pace with the dynamic market.
People inside the business will know, and react, much more
quickly to abuses than any regulator outside the business. We
have seen that in the last while. But at the same time, you
have cut the knot of conflicts of interest within that
structure. It strikes me as a good balance. Self-regulation
without conflicts of interest seems to me to be the right place
to go. And I want to say that self-regulation--or lack of it--
or having outside regulation is not a panacea. Unfortunately,
in the past year, we have seen problems with all areas of our
financial markets, highly regulated areas, less regulated
areas, areas supervised by the SEC, areas supervised by SRO's.
I think the self-regulation debate is important, but we
cannot forget the larger challenge of reinstilling some basic
principles in the markets. Smart and unethical people will find
a way around whatever regulatory structure we come up with if
we fail to have strong rules and tough enforcement.
Finally, I believe your proposal leaves room for future
adjustment. We make some major changes now, see how they go and
adjust as necessary, and I think that is the right thing to do.
This approach is important. Because while there is no excuse
for governance issues and conflicts of interest that have come
to light in management and governance of the NYSE, in the
spirit of fixing what is broken, we need to be mindful that
change can have unforeseen consequences. Striking the right
balance is critical. You have renovated the structure of self-
regulation without losing benefits, but we have to be careful
not to throw out the baby with the bathwater, and there are
real risks if we move in a precipitous or wrong-headed way.
We need to keep in mind that the Exchange is a huge asset
for this country. It gives the United States home-field
advantage, with the largest equity market in the world and the
deepest pool of liquidity. It is home to almost $15 trillion of
market value. Thanks, in part, to the Exchange, the United
States, and New York became--and remain--the global center for
financial innovation.
We also need to recognize that in this global age there are
other exchanges, some in other countries, that would love to
take market share from the NYSE, particularly in a time of
perceived weakness. From my State's perspective, of course, the
Exchange supports thousands of jobs on the trading floor, it is
supportive, et cetera, and it also supports jobs in both
Senator Dodd's and Corzine's States.
But that is not the main issue here. The main issue is to
have a deep liquid and unified market. So, I want to comment on
what I think is one of the keys to the Exchange's success and
related to this issue, and that is the unique specialist-based
trading system.
I know that it is not subject of today's hearing, but it
has come under fire under the guise of reform. We clearly need
to get to the bottom of charges that a few specialists may have
violated the rules and regulations, and it is important we do
that quickly, but that is not what the controversy is about.
Some are now arguing that specialists are outdated and that
making the quickest trade on an electronic black box is more
important than finding and delivering the best price. I could
not disagree more. The human element at the heart of the
specialist system is still critical, and the proof is in the
pudding. The NYSE specialist system beats competing markets,
100-percent electronic markets, and gets the best price 94
percent of the time on listed shares.
More importantly, most average investors, want the best
price. That is what they think they are getting when the
execute a trade. My father is a small stock trader. I know what
he wants. I have asked him. He wants best price. He does not
care if he has to wait 10 minutes to get the best price. He
wants the best price. So it is not how fast; it is, rather,
getting the best price, and the specialist system beats all
others hands-down.
I hope today and other times, when we hear some criticism
of the specialists, we recognize where it is coming from. It
seems to me the cards are not always on the table. Some of the
vocal critics are guilty of their own conflicts of interests
through their ownership of rival electronic markets. I have
heard a lot from some people in Fidelity. They say we have to
get rid of the specialist system. They do not mention that
Fidelity, a vocal critic of the NYSE, owns a big stake in
Archipelago, an ECN and a competitor. Schwab is also part of an
ECN.
I am not saying the specialist system does not need to make
adjustments, but if we eliminate the specialist system by
design or by accident, we risk fragmenting the market into many
little electronic black boxes, where trades are quick, but
prices suffer. It is in a fragmented, nontransparent market
that investors suffer the most. That is where all of the
behind-the-scenes tricks and things will occur, not in an open
system. That is what we found. So keeping one efficient deep
and liquid market, where orders compete head-to-head, is a goal
that serves all investors worldwide. Fragmentation of the
markets to me is the greatest nightmare we face, not just for
New York, not just for America, but for every investor who
wants to be treated fairly worldwide.
In closing, Mr. Chairman, I appreciate the indulgence of
the Committee. This issue is important to me. I would ask that,
while the governance reforms that are so important to
maintaining trust in the NYSE are paramount, and we have to get
them right, I also hope that we will hear about efforts to
maintain the Exchange's place at the cutting edge of innovation
and preeminence. We need to do that for the sake of investors
worldwide.
Thank you.
Chairman Shelby. Senator Crapo.
STATEMENT OF SENATOR MIKE CRAPO
Senator Crapo. Thank you very much, Mr. Chairman, Mr.
Donaldson, and Mr. Reed. I appreciate you coming here before
us. As has been indicated already, we seem to have a full
agenda of issues relating to corporate governance and
management of the problems that have arisen in our markets in
the United States and globally every week, as we go through
these issues in Congress, and I appreciate your constant and
sincere attention to these issues.
Thank you very much, Mr. Chairman. I do deeply appreciate
the concern that is being brought here and share the concerns
that already have been raised by many of my colleagues. I look
forward to the testimony we will hear today.
Thank you.
Chairman Shelby. Senator Allard.
STATEMENT OF SENATOR WAYNE ALLARD
Senator Allard. Mr. Chairman, I just have a few comments I
would like to make.
First of all, I want to compliment you on having this
hearing. We have had a lot of good hearings I think this past
year, and as Chairman and the hard work that goes into the
hearings, sometimes you are not recognized for the hard work,
but I think lots of times it makes a bigger difference, and you
do not get credit for it. And sometimes I think it is much
better than passing legislation, more laws and whatnot if we
can just get things to happen without legislation, and that is
the value I think of close oversight, and I want to compliment
you on all of that hard work.
This is a challenge with what we have facing today on
confidence, and I agree with what my predecessors have said
here on this panel. Trust and confidence is key. That is what
we all want to look forward to. I am looking forward to the
testimony. The New York Stock Exchange and the SEC have some
serious challenges, and I want to hear what your solutions are,
and we need to restore confidence as quickly as possible.
Here, in the United States, I view our exchanges, not just
the New York Stock Exchange, but all of our exchanges, as
premier in the world. There is no other country in the world
that has the kind of exchanges that we have, and the New York
Stock Exchange is always one that has been looked up to. And it
is getting more and more competitive on a worldwide basis, and
we have to make sure that we have that confidence because that
is what separates us from the other markets.
I, as a small businessman, learned to appreciate the value
of good records and accountability. And as you are looking on
your internal controls and everything, you have to know what is
happening, and so you need to be open, you need to know what is
happening, you have the records and accountability, but it
needs to be done within so that it is a minimal--we do not want
to get carried away with our rules and regulations, but we need
to have enough there that the customers have confidence that
the management has confidence that they know what is happening
in the business.
I look forward to hearing about what your reform proposals
are, and I think that self-regulation can work when it is done
properly, and I am hopeful, in this particular case, that that
will happen.
Again, I would just like to thank Mr. Donaldson, Chairman
of the Securities and Exchange Commission, for coming before
the Committee, and I also thank Mr. Reed, Chairman and CEO of
the New York Stock Exchange, for coming here. I know it takes
away from your daily responsibilities, but this is important.
Thank you very much, Mr. Chairman.
Chairman Shelby. Senator Chafee.
STATEMENT OF SENATOR LINCOLN D. CHAFEE
Senator Chafee. Thank you, Mr. Chairman, and welcome to Mr.
Donaldson and Mr. Reed. We look forward to your testimony.
Chairman Shelby. Chairman Donaldson, welcome again to the
Committee. Your written statement will be made part of the
record in its entirety. You may proceed as you wish.
STATEMENT OF WILLIAM H. DONALDSON
CHAIRMAN, U.S. SECURITIES AND EXCHANGE COMMISSION
Chairman Donaldson. Good morning Chairman Shelby, Ranking
Member Sarbanes, and Members of the Committee. I am very
pleased to be here today and to discuss the governance of the
New York Stock Exchange. This issue is one that has received my
attention from my very first day in office. I was confirmed as
the SEC Chairman in mid-February of this year. In March, I
wrote to the New York Stock Exchange and other SRO's asking for
a thorough review of their governance, a review that has led to
changes at the New York Stock Exchange under consideration
today. While distinct from the issues of market structure,
which the Commission is also working strenuously to address, as
we have discussed before, the governance issue has been of
great importance to me.
This issue has my attention because of its importance for
the markets. As I have said in the past--and I will say again
today--we have the world's most efficient and effective
securities markets, but the success of our markets is directly
dependent on the confidence the investors have in their
integrity. This is particularly true with respect to the New
York Stock Exchange. The NYSE has a leading role in our markets
as the largest equity market in the world, as the regulator of
the Nation's largest securities firms, and as the arbiter of
corporate governance standards for many of the Nation's largest
corporations. The New York Stock Exchange's leading role makes
it imperative that the NYSE's own governance be above reproach.
The link between governance and the New York Stock
Exchange's role was recognized as far back as 1938 in the New
York Stock Exchange Conway Committee Report, which said it
recommended governance changes which, ``Really represent merely
another step in a long evolutionary development of the Exchange
as the Nation's primary securities market.'' It was also
recognized again in 1971, when the last major changes in the
governance of the New York Stock Exchange were shaped by a
report by William McChesney Martin. Among other things, the
Martin Report said that the New York Stock Exchange should be
reorganized, ``to give proper recognition of its public nature
and the respective interests of the public, the companies
listed on the Exchange and the members of the securities
industry involved.'' In response to the Martin Report, the New
York Stock Exchange created a board balanced between securities
firms and issuers, institutional investors, and public
representatives. It also created a nominating committee that
was independent of members and the New York Stock Exchange
board to select new candidates for the board. The New York
Stock Exchange itself, at that time, became a nonprofit,
nondividend paying corporation owned by its members.
Although these 1971 changes in the governance of the NYSE
were dramatic for their era, time brings new challenges, and
even an institution once looked to as the model must respond to
these challenges to retain its preeminence. As the Conway
Committee said in 1938: ``It is apparent to us that the
organization of the New York Stock Exchange should be revised
to accord with changing times and conditions.''
The current pressing need for a review of the New York
Stock Exchange's governance was signalled by a series of recent
events. In the Sarbanes-Oxley Act, the Congress entrusted the
New York Stock Exchange, as a listing market for the Nation's
largest corporations, and other listing markets, with
heightened responsibility to set standards for the governance
of these listed companies. This initiative raised the bar for
the New York Stock Exchange's own governance structure. In
addition, the New York Stock Exchange's selection of the
chairman of a financial services company that owned a large
broker-dealer to serve as a public director called into
question the New York Stock Exchange's board selection process,
if not its dedication to the principle of a balanced board. And
the reports of the compensation of the New York Stock Exchange
Chairman and CEO gave further credence to concerns about the
New York Stock Exchange governance process.
In March of this year, I wrote to the Chairman and CEO of
the New York Stock Exchange, as well as to the heads of the
other SRO's, asking them to review their SRO's governance
practices in light of the standards that had just been proposed
for listing companies. In that letter, I expressed the view
that, just as the New York Stock Exchange and Nasdaq were
demanding that publicly traded companies meet high governance
standards in order to list on their markets, SRO's must demand
the same standard of themselves. I asked each SRO to undertake
an exhaustive review of its governance procedures and report
back to me by mid-May.
Each SRO submitted written responses that detailed its
governance practices and, in my view, revealed some areas that
appear to warrant improvement. Following my letter, and I hope
perhaps in response to my letter, several SRO's convened
special governance committees whose mandates were to examine
the strengths and weaknesses of the SRO's governance practices.
The New York Stock Exchange provided an interim report, but
indicated it was conducting a thorough review through a Special
Governance Committee which would subsequently provide the New
York Stock Exchange board with a final report.
While the New York Stock Exchange's review was still
underway, and before issuance of the report, we learned of the
New York Stock Exchange's extension of the New York Stock
Exchange Chairman's employment agreement, as well as its
substantial payout of his accrued compensation. In response, I
wrote to the head of the New York Stock Exchange Compensation
Committee and Special Governance Committee, asking for further
information regarding the then-Chairman's compensation and the
decisionmaking processes at the NYSE that led to his pay
package. In my letter, I indicated that approval of such an
extraordinary compensation package raised serious questions
regarding the effectiveness of the New York Stock Exchange
governance structure, and asked the New York Stock Exchange to
provide me with detailed information regarding the then-
Chairman's compensation arrangement and how it was approved by
the NYSE board.
In my view, the documents produced by the New York Stock
Exchange raised troubling questions about its governance. The
then-Chairman's package was set by the Compensation Committee
of the New York Stock Exchange board and approved by the full
board of directors. However, the then-Chairman appears to have
exercised considerable influence, both formal and informal,
over the composition and operation of the board in the
Compensation Committee. In addition, it is not clear that the
full New York Stock Exchange board or the Compensation
Committee fully endorsed the intricacies of the then-chairman's
compensation arrangements, and the ``ripple effects'' the
approval of one element had on the others. Finally, there
appears to have been a lack of transparency at the New York
Stock Exchange regarding the operation of the Compensation
Committee and the nature and substance of its review of
compensation matters. In my opinion, if there had been broader
dissemination of information regarding executive compensation
at the New York Stock Exchange, it is unlikely it would have
reached such extraordinary levels.
In light of the governance issues at the NYSE relating to
the then-Chairman's compensation package, I again wrote to the
heads of each of the SRO's to ask for more details about the
extent of public representation on their boards and key
committees, including the compensation committees, the
decisionmaking process with respect to the nomination of
directors, their assignments to committees, the compensation of
executives, and the SRO's past practices and current plans for
public disclosure of these processes and compensation
arrangements of key executives. Commission staff is in the
process of assessing the responses of those SRO's.
As you know, Congress and the Commission have long
recognized that self-regulation has both benefits and
weaknesses. The principle of self-regulation is based on the
notion that regulation can best be done as close as possible to
the regulated activity. As a Congressional committee said in
1938, the alternative to SRO oversight will mean: ``A
pronounced expansion of the organization of the Securities and
Exchange Commission, the multiplication of branch offices, a
large increase in the expenditure of public funds, an increase
in the problem of avoiding the evils of bureaucracy and a
minute, detailed, and rigid regulation of business conducted by
law.'' SEC Chairman William O. Douglas, back in 1937, said it
all when he said: ``By and large, Government can operate
satisfactorily only by proscription. That leaves untouched
large areas of conduct and activity, some of it susceptible of
Government regulation, but in fact too minute for satisfactory
control, some of it lying beyond the periphery of the law in
the realm of ethics and morality. Into these areas, self-
government, and self-government alone, can effectively reach.''
The utility of self-regulation has been reiterated many
times through the years in Congressional, Commission, and
industry studies. In 1975, the House Commerce Committee said,
``Perhaps expectantly, SRO regulation has, on occasion, been
found seriously deficient, and it has not operated as
effectively or as fairly as the public interest will require.
Nonetheless, the Committee found that the system, on the whole,
has worked and recommended that it be preserved and
strengthened.''
Where self-regulation has not worked, this often is the
result of the inherent tension between an SRO's role as the
regulator and as the operator of a market, and between its role
as a regulator and a membership organization. Today, two key
factors in addressing these conflicts are the independence of
the SRO board from the interests of specific members or even
specific users of the SRO's market and the independence of the
regulatory function of the SRO from the self-interest of the
members or the business interests of the market itself.
The independence of the regulatory function can be
accomplished through a range of alternatives along a spectrum.
At one end of the spectrum is an SRO that is wholly separate
from any market, yet responsible for supervising member firms
and the operations of unaffiliated markets. I would consider a
model that has an autonomous regulatory office of an Exchange
that is supervised and controlled directly by an entirely
independent Exchange board to be toward the middle of this
spectrum. I would also put the NASD-NASDR-Nasdaq model of
separate regulatory and market affiliates overseen by a
balanced board in this same middle category. At the further end
is the prior New York Stock Exchange model of regulation and
market combined in one entity under the direction of the
Exchange CEO, and ultimately a balanced Exchange board. The
appropriate regulatory structure for one SRO may not be
appropriate for others, given their different memberships,
sizes and regulatory responsibility. For all SRO's, however,
the challenge before the Commission and the SRO's is to develop
governance structures that help assure SRO regulatory programs
that are effective, yet insulated from any undue influence of
potentially conflicting business or membership pressures.
As you know, under the leadership of Interim Chairman John
Reed, the New York Stock Exchange recently took a critical step
toward governance reform that deserves our serious
consideration. On November 7, the NYSE filed with the
Commission a proposal that would amend the New York Stock
Exchange Constitution to implement a series of governance
changes at the New York Stock Exchange, including those
designed to strengthen the independence of the New York Stock
Exchange board and its key committees and better insulate the
New York Stock Exchange regulatory function from its business
as a market. These steps include creation of an autonomous
regulatory office headed by a Chief Regulatory Officer who
reports directly to a committee of the new, wholly independent
New York Stock Exchange board. This board committee is
responsible for ensuring the effectiveness, vigor, and
professionalism of the New York Stock Exchange regulatory
program. The Committee determines the budget, regulatory plan,
and staffing of the regulatory office, assesses the New York
Stock Exchange regulatory performance, and recommends
compensation and regulatory actions to the independent board.
The New York Stock Exchange proposal is subject to
Commission approval. Because of the significant public interest
in the New York Stock Exchange's proposed governance reforms,
the Commission immediately issued a notice seeking public
comment on the NYSE's proposal. To assure widespread awareness
of the New York Stock Exchange proposal, the Commission has
both published it in the Federal Register and highlighted it on
the Commission's website. The comment period will extend
through December 4. I encourage any interested persons to
formally submit comments on the New York Stock Exchange's
proposal for Commission consideration. Although the Commission
reserves judgment on the proposal until all public comments are
received and evaluated, I must commend the New York Stock
Exchange, and in particular John Reed, for taking this
substantial and critical first step toward revamping its
governance structure.
In conclusion, I would like to thank the Committee for
recognizing the importance of effective governance of the NYSE
and other self-regulatory organizations. I look forward to
continued input from your Committee. Thanks again for inviting
me. I would be delighted to answer any questions.
Chairman Shelby. Thank you, Chairman Donaldson.
Mr. Chairman, many people contend that the Exchange's
proposals do not get at the root of the problems at the Stock
Exchange. Some believe that after the reforms are implemented,
we will be left with a situation perhaps where the Exchange's
regulators will continue to report to a board elected by
members of the Exchange.
Mr. Chairman, as head of the SEC, how do you respond to
that criticism, that as long as the members select the
directors, then the institutional conflict remains and true
regulation will not occur. Have you heard that?
Chairman Donaldson. Yes. You know I have to reserve
judgment, basically, until all of the public comment----
Chairman Shelby. So, when you say the ``first step,'' is
that in the context of all of it?
Chairman Donaldson. Well, no. All I want to say is that
this is out there for the public to comment on, and I want to
make sure that everybody recognizes that.
Chairman Shelby. But you are very cognizant of the
concerns.
Chairman Donaldson. The structure is set up in such a way,
and I will not go through the details of that structure, that,
in effect, every possible safeguard has been given so that the
reporting of the regulatory function, the compensation of those
involved in implementing it, and so forth reports to an
independent board, and that the CEO of the New York Stock
Exchange, whether that be a Chairman and CEO in one person or
two separate functions, will have absolutely nothing to do with
the regulatory function and so that the regulatory function
will not be compromised.
Now, to address your specific question, there will be an
opportunity for the board to have its own nominating committee,
to nominate new directors as their terms expire, and I think
that, fundamentally, you have a group of shareholders, if you
will, who are called seat-holders, who have tremendous
investments in their seats, and I believe they will understand
that the integrity of the Stock Exchange, the integrity and the
independence of the board is something that we should not, and
could not, and would not allow to be compromised in terms of an
election process.
Chairman Shelby. It is in their interest, is it not?
Chairman Donaldson. I would also say that----
Chairman Shelby. But is it not in their interests to have
integrity first, a board that functions well, too? It is in the
interests of the seat-owners, the owners of the seats on the
Exchange for the Exchange to work well, to be independent as
much as you can, to function well, to not be in the critical
path every day.
Chairman Donaldson. I think that the fundamental proposal
that Interim Chairman Reed has put forward has, at its core, a
totally independent, highly experienced group of former
executives or sitting executives, and I think that that is
absolutely critical to the going forward of the Exchange.
In terms of what happens in the future, there will be
continuing elections of new boards as the years go on, and I
think the self-interests of the owners of the Exchange, I mean,
the seat-holders of the Exchange, will be such that they will
not even begin to dare to change the integrity of the process.
Now, having said that, there is scope for, and
responsibility for, the SEC to oversee the governance of the
Exchange. And should there be any deterrence from the new
course that is being set out here, we have the power, and the
independent board of directors has the power, to make sure that
any changes in directorship that do not meet our standards do
not happen.
Chairman Shelby. Mr. Chairman, you have been quoted as
stating that the SEC will continue to consider further
marketwide reforms, including governance, and regulatory
reforms and additional reforms beyond what Mr. Reed proposed.
You have alluded to this already.
Assuming that the SEC approves Mr. Reed's proposals that
you are now considering, what are the SEC's next steps in
evaluating the Exchange's market structure, including the role
of specialist and its regulatory function.
Chairman Donaldson. Well, I would answer that in two
phases.
Number one, this is, if approved, definitely a first step.
I think the second step is to give the new independent board an
opportunity to function, and give it an opportunity to move in
as it, I am sure will, in the evaluation, reorganization and so
forth of the regulatory function itself.
There is a second part of this which is not in the purview
of the New York Stock Exchange itself, and that is market
structure. In other words, there will be, as we have talked
about before in this Committee, and as we are working on very
diligently right now, there will be changes in market structure
coming down the pike that will affect the way the New York
Stock Exchange operates, but I think that is separate from the
issue of the governance of the Exchange. And separate from the
paramount issue, as far as I am concerned, is the locus of this
regulatory function.
Chairman Shelby. Senator Schumer.
Senator Schumer. Thank you, Mr. Chairman. And I thank you
for your testimony, and I understand that you do not want to
prejudge whatever the SEC does. I guess it is pretty clear from
you comments I think it is a good structure, and I think you
should go with it and then see how it works, just as you said.
But let me ask you, I guess you heard what I had to say. Do
you worry about fragmentation of the markets? Do you worry, and
do you think, that the one has anything to do with the other.
Changing the regulatory structure, whether it is done by the
NYSE itself or by the SEC or the SEC recommends changes, has an
effect on the market issues, the way stocks are traded, the
things that are within the SEC's exclusive purview.
Chairman Donaldson. We are very concerned, as we deal with
market structure, about fragmentation.
Senator Schumer. Good.
Chairman Donaldson. We are very concerned also with the
arrival on the scene in recent years of new ways of trading
stocks, and in particularly electronic ways, ECN's. And by the
way, the electronics at the New York Stock Exchange are much
greater than they are given credit for.
Senator Schumer. And much changed over the last 10 years.
Chairman Donaldson. Yes. Having said that, our dilemma, if
you will, is to try to create a structure that involves
bringing together the benefits of some of the so-called ``rapid
markets,'' the nanosecond trading that we have talked about
before in this Committee, the ability to execute in seconds--
and that, of course, has been exacerbated by the decimalization
of spreads and the fact that you have just a penny between the
bid and the ask, and you have a nanosecond ability to trade--
trying to make that way of trading available to those who want
it. And there is a segment of the market population that wants
to interface that with the price improvement auction market
specialist system that has stood for years for getting a better
price for people.
And I do not throw out the idea that speed is important to
some people, and I definitely do not throw out the idea that
getting a better price is important to probably a lot more
people.
So the job here is to bring these two systems together in a
way that basically gets for the public investor out there what
they want.
Senator Schumer. And without fragmenting the markets
because the depth and liquidity of markets, I believe, you tell
me, not only is the best system and gets the best price, but
also is the best one for openness, for regulation, to avoid the
problems that we have seen throughout the financial markets in
the last while.
Chairman Donaldson. Well, there are two aspects to what you
are saying, Senator, and that is we are not only talking about
speed, price improvement, and fragmentation, but we are also
talking about liquidity. We are also talking about the massing
of liquidity. And, again, there are all sorts of statistics
about who has the better prices and so forth. I do not want to
get into that now, but I just would remind the Committee of the
importance of the liquidity pool that exists at the New York
Stock Exchange.
Senator Schumer. So you share my worries about
fragmentation.
Chairman Donaldson. And particularly in times of stress,
and I do not mean this to be a brief for the New York Stock
Exchange because there are other markets here, and there are
other ways of trading. But I think, since we are talking about
the New York Stock Exchange this morning, I just cannot pass by
without making that statement: The liquidity and the liquidity
that develops in down markets, when I say ``liquidity,'' that
is depth of markets. It is a great national asset that we have
there, and we do not want fragmentation to break that up.
Senator Schumer. Correct. Let me ask you this, and I could
not agree more with your comments, and I am glad to hear you
were saying them. I think that if most people study the markets
without any specific bias, they would agree with that comment.
Does technology not, the trick here I guess is to harness
the technology and keep the depth and liquidity.
Chairman Donaldson. That is it.
Senator Schumer. That is a tough job.
Chairman Donaldson. Yes.
Senator Schumer. And in my view, that has been a strength
of the New York Stock Exchange. As you may know, I was a critic
of the Exchange 5 years ago and got them pretty mad because I
thought they were not moving quickly enough to deal with that
issue, but I think they have, and I think they have done a
pretty good job of that. And maybe while they were focusing on
that, they let some of these other things go by the wayside
that you, and Mr. Reed, and others have to correct now because
you need both. There is no question about it.
I guess my fundamental question--he is telling me my time
is up--is it an either/or proposition?
Chairman Donaldson. Either/or in what sense, Senator?
Senator Schumer. Either/or the governance issues, and the
regulatory issues, and the technology, trading, liquidity
issues--can we not have both?
Chairman Donaldson. We have to have the purest governance
structure that we can possibly create. We have to have the
cleanest separation of responsibility for regulation that we
possibly can create, and not to repeat myself, I believe that
can be created in a number of different ways, and I do not
think we should mistake form over substance here. I believe
that the concept that John Reed has come up with has gone a
long way, almost all the way toward the separation of that
responsibility from the business side of the Exchange.
In terms of market structure, I do not think it is an
either/or situation. I think that we will be coming up with
what we hope are approaches to the structure of the market that
will get the best of these two different worlds, if you will,
without throwing out the liquidity and so forth that have made
the New York Stock Exchange successful.
Senator Schumer. Thank you, Mr. Chairman.
Chairman Shelby. Senator Bunning, thank you very much for
your indulgence.
Senator Bunning. Thank you.
Chairman Donaldson, I would like to follow up on something
that the Chairman spoke about earlier. It seems to me, in most
cases, that self-regulation does not work. Self-regulation does
not work, whether it be mutual fund self-regulation, whether it
be New York Stock Exchange self-regulation, whether it be the
Federal Home Loan Bank self-regulation, whether it be Fannie
Mae and Freddie Mac self-regulation or wherever we are going.
And in the proposals that Mr. Reed has, there is still
self-regulation, and I want to know how investors' confidence
is going to be restored in the New York Stock Exchange or any
exchange, for that matter, mutual funds, whatever it might be,
if we still have the fox in the henhouse.
Chairman Donaldson. I think that the failures of self-
regulation are what has caused the changes that are going on
right now at the New York Stock Exchange. I think the
governance aspect is only one part of self-regulation. I think
that if you go back in history, I believe that the fundamental
decision that was made in 1933 and 1934 to give the right of
self-regulation down to the people who are operating the
markets was the right decision. I think if we had gone the
other way and had a Securities and Exchange Commission or some
other agency that tried to run these markets from Washington,
we would have had a bureaucracy, and we would have had a
Federal expenditure that would have impeded the growth of the
markets.
Senator Bunning. Mr. Chairman, I am not going to violently
disagree with you, but we had an antique called the Securities
and Exchange Commission and the Act of 1934 that made certain
rules and regulations in governing the security markets. Just
like the Social Security System was founded a few years later,
we have made strong changes in how we operate Social Security,
and we are about to do it again somehow because it needs to be
done.
While we have this great opportunity because we have found
some major flaws in what we have been doing, I am not going
back to 1934 and saying that was a good thing to do. Maybe it
was in 1934, but it is not in 2003.
Chairman Donaldson. I could not agree with you more,
Senator, and I do not mean to imply that we are going back. I
just use that as a reference point. What I do believe is what
we are attempting to do now is to gain from our experience with
self-regulation and to change the rules, as you suggest, to
enhance self-regulation. I think it is too soon to simply say
self-regulation does not work and to throw it out.
Senator Bunning. Well, history dictates otherwise. And I am
an old baseball player, and when owners in baseball elect the
commissioner and run the game, the health of the game is in
jeopardy.
You need someone with a knowledge of the game but outside
of the game. That is what I think is almost essential if we are
going to restore investors' confidence in these markets.
Without investors' confidence, I do not give a darn how good
the exchange is run and how great the executions are and if it
is a nanosecond and we get the best price. The investor has to
have confidence in that market. And if we do not restore that
investor confidence, that market is going to go to England,
that market is going to go somewhere other than New York.
I would suggest in the regulatory section of governance
that we really look at who is the last person to have the say,
because it is essential that that not be somebody from the
floor, that it not be somebody from one of the brokerage
businesses, that it be somebody that has the knowledge but is a
separate, independent operator. And I would suggest that you
look at that, and I thank you for your time.
Chairman Donaldson. Senator, can I just thank you, and I
hear what you are saying, and I believe that the structure that
has been put forth--and it is only a first step--does exactly
what you say. It has taken all that conflict out from those who
were responsible for--it has taken the conflicts inherent in
what seat-holders want, what floor brokers want, what
institutions want, and so forth. It has put it aside, and that
is to be run as a business. And it has taken the regulatory
side of things and has as pure a structure as you could
possibly conceive of, even though it is still in under the same
umbrella, it is a structure inside that goes from independent
regulatory function reporting to an independent board who has
on it nobody with special interests. That is the nature of this
board.
Senator Bunning. Well, we will see how it works.
Chairman Donaldson. Okay. Thank you for your comments,
Senator.
Chairman Shelby. Senator Corzine.
STATEMENT OF SENATOR JON S. CORZINE
Senator Corzine. Thank you, Mr. Chairman.
Welcome back, Chairman Donaldson. It seems like you spend a
lot of time here these days. Unfortunately, the read of the
newspapers I think makes that far too important the reality of
what we see in the markets. It is going to be disappointing to
all of us who have been a part and have benefited from markets,
and I must say the ongoing revelations we see almost day-to-day
is extraordinarily disturbing to me. And I think this
discussion of the New York Stock Exchange, which is really
emblematic of the greatness of our markets in its totality,
needs to make sure that we do this right, because there is
this--there has to be a serious erosion based on the
multiplicity of events, starting with the corporate problems
that we had in the late 1990's and the early part of this
decade, the mutual fund discussion that we had the other day. I
am personally seriously disturbed by the events in the foreign
exchange market revealed, at least to the public, yesterday.
I think that is why it is so important that in one of the
most important institutions we get it absolutely right, and I
congratulate Mr. Reed for taking on this herculean task. I
think his own personal integrity is one that starts us off in
the right process.
But I do have some sympathy for looking for the purest
response because I think the seriousness of the nature of the
undermining of the confidence that people have with regard to
the integrity ultimately is the fundamental issue that will
determine whether we have price, speed, depth, breadth,
liquidity, and the capital formation function going on, and
that somehow or another we have to get that restored in an
absolute sense. And I think that the pattern that is
established here is essential.
I did not mean to give a statement. I have a formal
statement, Mr. Chairman, that I will put into the record, but
this discussion and the quality of leadership we have seen so
far on this from the people at the exchange post some of the
problems I think has been terrific. But I do not know whether
it goes far enough in my view.
I want to take off on a question--I think I understood the
question that Senator Schumer was talking about, either/or. I
think the governance issue is absolutely linked to the
structural issue because ultimately the governance issue is
where you are going to get the best perspective and effort to
drive to the results. And then you are going to actually, even
outside of the regulatory function, make sure that the best
structural ideas that are laid down get implemented and
executed.
Am I missing something? I think they are actually linked.
Chairman Donaldson. I do not think you are. If I understand
what you are saying, I think the structure of the governance of
the New York Stock Exchange is the fundamental fountain from
which the integrity of the place will flow. And I think that
the structure that has been suggested by Chairman Reed goes
amazingly far in that direction.
Having said that, you know, the structure is out for
comment. It is out for people to make their own judgments and
come back to us with them. I believe it is a first step. And,
again, without prejudicing the listening to other people's
views that we will do, I will do, the Commission will do, I
believe that this step probably deserves a chance. I think
that, if it does not work, if that board itself says it does
not work and cannot work, they have the power to go one step
further if they want, if they determine that somehow this
structure is imperfect.
They have been given that power now by the change in the
constitution. There is tremendous power that resides with that
board in terms of taking it another step. And we will see where
that goes.
Senator Corzine. Let me ask something slightly less macro.
Do you believe that there is the potential to transform the
auction system into a technologically executed system? Is it
possible to do?
Chairman Donaldson. I guess anything is possible, you know,
in this day and age in terms of technology. I believe that you
can probably someday take an airplane and fly it from New York
to Washington without any human beings flying it. I would not
want to fly on that plane. And although that is a poor analogy,
I think there is some merit here. I think the combination of
technology and human judgment becomes particularly important in
the marketplace, particularly important when there is stress in
the marketplace. So, I think that the agency auction specialist
system has to modify itself to have enough increased technology
side-by-side, but, again, I am not prepared to throw human
judgment out of it.
Senator Corzine. Thank you.
Chairman Shelby. Senator Sarbanes.
Senator Sarbanes. Has he had a chance?
Chairman Shelby. No, but you were here earlier.
Senator Sarbanes. No, that is all right. Go on.
Chairman Shelby. Okay. If you want to defer to Senator
Sununu, that is fine with me.
Senator Sununu.
STATEMENT OF SENATOR JOHN E. SUNUNU
Senator Sununu. I do not want to get into any trouble.
Senator Sarbanes. Oh, no, you are not in trouble.
Senator Sununu. Thank you.
Chairman Shelby. He is having a good day.
[Laughter.]
Senator Sununu. He deserves a very good day.
Chairman Shelby. So take advantage of it.
Senator Sununu. Thank you.
Mr. Donaldson, the last time you were here, I asked some
questions about specialist behavior, about their use of
proprietary information, perhaps inappropriately, about
practices of front-running, and whether there were rules that
encouraged that kind of behavior or that facilitated that kind
of behavior.
You gave a reasonable answer, I thought at the time. It was
not especially specific, though. And the next day the SEC
announced that it was taking action against five specialist
firms for front-running and other violations of SEC rules. I
guess I can understand why you were maybe a bit vague in
responding to my inquiries.
What is the status of the action in those specific cases?
What have the findings of the SEC been with regard to the rules
violations in those cases? And what changes to specialist rules
might you propose or recommend as a result of these cases?
Chairman Donaldson. Well, there are two aspects to your
question: One is violations of existing rules, and number two
is an examination of those existing rules to see whether they
should be changed. I think they are two very different things.
Clearly, there have been a series of events originally
discovered, if you will, by the New York Stock Exchange
regulatory system itself, that involves alleged breaking of
those rules. The SEC moved in swiftly because we thought the
possible breaking of the rules, if you will, went beyond what
was being investigated. We broadened the investigation. And we
are now in the process--and I am being very careful here
because, you know, we do not comment on possible enforcement
proceedings, for obvious reasons. But you can be sure that the
SEC will take whatever enforcement actions are indicated by our
surveillance system and act upon them.
I want to make sure that I am making it very clear that
that is one part of the problem.
Senator Sununu. Okay. And I do want you to move forward to
the second issue about the rules changes. But let me ask you,
with regard to that answer, why did the SEC have to step in to
broaden the investigation? Why in your opinion wasn't the
investigation appropriately broad to begin with?
Chairman Donaldson. I think that is a very legitimate
question, and I guess the bottom line is there was what we
considered to be a failure or something lacking in the
oversight at the Stock Exchange itself. And that is why we
stepped in, and that has been the problem, and that is a
problem that needs to be solved.
Senator Sununu. But if I understand your answer to Senator
Bunning's question, when you answered his question you seemed
to suggest that the nature of this self-regulatory structure
was not a problem, was not necessarily a limiting factor and
that here you seem to suggest that the nature of the regulatory
structure resulted in the SEC having to step in to broaden what
in my view is a very important investigation.
Chairman Donaldson. I think that what I was trying to say
was that the concept of self-regulation is born of an attempt
to accomplish two things: To have regulation close to the
marketplace so that the marketplace can operate in rapidly
changing times, to not have that regulation outside,
disembodied by a bureaucratic organization that would impede
the functioning of the market. And this is not to say that
self-regulation cannot break down. And I think we have a
particular instance here where in that particular niche on the
floor of the Stock Exchange it did break down.
But that is not a reason to throw it out, in my view. What
you do about that is you change the rules and then you make
sure that the rules are followed, and you change the reporting
structure of the regulation to enhance the enforcement.
Chairman Shelby. Senator Sarbanes.
Senator Sarbanes. Thank you.
Chairman Shelby. We want this good day to continue.
Senator Sarbanes. Thank you, Mr. Chairman.
Chairman Donaldson, do you know how many people work in the
Enforcement Division at the New York Stock Exchange as they
carry out their self-regulation? Do you have any idea?
Chairman Donaldson. Do I--I am sorry. I did not----
Senator Sarbanes. How many people work in the Enforcement
Division of the New York Stock Exchange?
Chairman Donaldson. Broadly defined, in terms of both
enforcement, surveillance, and so forth, I would say close to
half of their employment is involved in that somehow.
Senator Sarbanes. How many people would that be?
Chairman Donaldson. Five hundred fifty.
Senator Sarbanes. Five hundred fifty people. Well, I am
interested in that figure because and I am not suggesting this
as a remedy, but just in terms of the range of thinking that is
done--it is constantly asserted that unless the Exchange does
its self-regulation, the alternative would be a huge Government
agency. I think is the way the phrase is put.
Now, how many people work at the SEC currently?
Chairman Donaldson. Well, as you know, we are adding
people. I cannot give you the exact up-to-date figure, but we
started at the 3,200 level, and we are moving toward 4,000.
Senator Sarbanes. Four thousand. The New York Stock
Exchange, I understand, has 550 doing regulation.
Chairman Donaldson. That is apples and oranges, though,
Senator, because, you know, the regulation being done by those
500 people is very different than what the 4,000 people at the
SEC are doing.
Senator Sarbanes. Well, I understand that. But if the SEC
were to do the regulation that the New York Stock Exchange
does, conceivably the SEC could do it with an expansion of 10
to 15 percent in its current staff. I only throw that out to
try to address this constant assertion that is being made that
this alternative that maybe it should be done directly by an
independent Government agency, that has none of these conflict
problems built into it, would create this huge bureaucracy. It
is thrown out as though, you know, it is going to require a
doubling or tripling of the SEC.
If reasonable resources are now being devoted to it by the
Exchange--and maybe there are not. Maybe they should have more
people. But on this current calculation a significant but not
an overwhelming increase in the SEC staffing would enable
another alternative to be considered, namely, that the
regulation be done directly.
Chairman Donaldson. First of all, you are talking about not
just one entity, the New York Stock Exchange. You are talking
about 12 exchanges----
Senator Sarbanes. So we would have to see what the NASD
does and others. Yes, that is a reasonable----
Chairman Donaldson. And all the other players in the
marketplace, the ECN's and so forth. I mean, you have a major
array of organizations.
Senator Sarbanes. But the direct approach would eliminate a
lot of these conflict problems, wouldn't it?
Chairman Donaldson. And I think it would bring on a lot of
bureaucratic problems.
Senator Sarbanes. It is very clear that some people in the
system at the Exchange have been prepared to feather the nest
for everybody else in order to gain--to aggrandize themselves.
Would you say that is correct? Actually, let me ask the
question this way because I want to quote. The Wall Street
Journal on November 3 wrote an article, and it quotes, I guess,
from an SEC report. I am not sure this report has been made
public yet. It says,
The SEC report paints a picture of a floor-trading system
riddled with abuses, with firms routinely placing their own
trades ahead of those by customers and an in-house regulator
either ill-equipped or too worried about increasing its
workload to care. And it concludes that when the New York Stock
Exchange does act on investor abuses, the exchange often does
little more than admonish the specialists in a letter or slap
them on the wrist with a light fine. The SEC staff is concerned
that the New York Stock Exchange's disciplinary program is
viewed by specialists and specialist firms as a minor cost of
doing business, that it does not adequately discipline or deter
violative conduct, the report says. It adds that the four
trading firms have no meaningful compliance programs for
reviewing their specialists' compliance to various trading
rules.
I want to make it very clear at the outset. The report they
are referring to, as I understand it, deals with conduct that
took place before Chairman Reed took over and moved in there in
order to----
[Laughter.]
Senator Dodd. The record should note he is smiling.
Senator Sarbanes. Yes.
Chairman Shelby. I think that is an acknowledgment.
Senator Sarbanes. Before he moved in there to try to clean
this thing up.
But does the Journal article, in your view, accurately
describe what has been going on at the Exchange?
Chairman Donaldson. Senator, you know, that was a
journalistic review of a confidential report, and I do not
think that it is perhaps fair for me to comment on the
journalist's comments on a confidential report in terms of some
of the language being used by the journalist. And I cannot
comment on whether any of that language was used in our report.
And I do not mean to sit here and tell you that there was
not a failure in supervision and there was not a failure in
adherence to the rules and regulations of the Stock Exchange.
And we are addressing that.
Senator Sarbanes. Aside from the bureaucracy argument--and
one would have to look carefully at the numbers and make some
judgment about it--what other arguments are there against the
SEC assuming these responsibilities directly?
Chairman Donaldson. Well, I think in talking about
bureaucracy, I think what you are--what I am talking about is a
package that addresses a remoteness from where decisions have
to be made, and a remoteness that will slow down the decisions
that have to be made in a fast-moving marketplace. There are
decisions all the time being made on the floor of the Stock
Exchange by its own--not only the regulatory, the hired
employees of the stock exchange, but the informal network of
exchange governors and so forth on the floor that interpret
those rules and make sure that they are being adhered to. And
as you know, rules can be interpreted in a lot of different
ways, so it is a day-to-day activity, and I think it does not
fit with the concept of a Government agency operating out of
Washington trying to do that.
Senator Sarbanes. Of course, it could operate out of New
York, too. I mean, the Chairman of the SEC could have an office
right there in New York, and you could have a much larger----
Chairman Donaldson. That is a great idea.
Senator Sarbanes. You could have a much larger New York
staff in order to do that. I mean, the ultimate aim is the
honesty and integrity of the Exchange and how it works.
Now, we have a system where we have these self-regulating
organizations under the oversight of the SEC. Now, if they are
not producing the result--and, of course, some would argue,
well, the SEC has fallen down, you know, on the job, for
instance, on the mutual funds, but we are trying to boost your
capacities now, and we have some good leadership at the SEC
now. So we think progress is being made.
The question then becomes whether the system with the SRO's
has so much conflict of interest almost built into it and
abuses that you despair of making that system work in order to
assure this overarching objective of the honesty and integrity
of the trading floor there. And it is not clear. I mean, if
someone said, ``Well, you know, you are going to have to get 5
times--you are going to have to expand the SEC by a factor of 3
or 4 or 5, or something,'' then I would say, ``Oh, wow, this is
really big''--but, you know, just on this preliminary
examination of this, the numbers are not in that category.
I guess in part I am sending a message not to Mr. Reed
because I think he is trying to address this situation, but he
has to deal with a big constituency up there. And presumably
some of that constituency is resistant to change. He is trying
to perhaps go as far as he thinks he can, but maybe it is not
as far as he should go, and maybe the SEC will reach that
judgment. And that is something we are going to have to look
at. But the people that he is encountering who are resisting
change and shaping up the organization itself in order to do it
I think should be sent a message that the alternative of the
direct assumption of responsibility by the Securities and
Exchange Commission is not something that is so far out of
proportion that it could not be considered.
I want to get the debate into a more open environment on
these important issues, and that is the only reason I am
putting these questions to you. I think the SEC--I know you are
trying to make it work, and good luck. But I do not think you
should just, in effect, find yourself constrained in a way
where you cannot say to people, well, if you cannot make it
work, maybe this is going to happen.
Chairman Donaldson. Senator, I understand your point, and I
think that I would make a statement in terms of the reluctance
to change and so forth. I think this is the greatest change
that the New York Stock Exchange has seen during my lifetime in
terms of the change of the constitution and the willingness of
the owners, if you will, the seat-holders, to delegate to a
totally independent board the future of the stock exchange.
And then, going back to your original question--is it just
a matter of bureaucracy?--no. It is a matter of regulation that
goes beyond law. It goes to integrity. It goes into certain
concepts of integrity and business conduct that cannot be done
by red-line laws. I think we have the same thing in corporate
governance issues in front of us. We write the laws, we have
independent audit committees, et cetera. But it is going to be
the personal integrity that goes beyond the law. And I think
that is what has to be reinstated at the New York Stock
Exchange. And I think that is what this structure does.
Senator Sarbanes. Well, I think that is a reasonable point.
I would make this observation: When the securities laws were
enacted in the 1930's, at a hearing before the Senate in which
the representative of the accounting profession was at the
table, one of the Senators asked, ``Well, now, we are putting
this whole system into place,'' he said, ``but who is going to
oversee the accounting industry?'' They were setting up the SEC
to oversee certain aspects of the securities industry. And the
response that he got was, ``Well, our conscience will do that,
Senator.''
And, of course, they were allowed all these years to
proceed on that basis. But it did not seem to work, and that is
now why we have Bill McDonough and his colleagues over at the
Public Company Accounting Oversight Board.
Further, I would make one final observation. If the
exchange were to commit these resources that they were
committing to these outsized compensation payments, that would
go a long way to funding an effective enforcement budget.
Thank you, Mr. Chairman.
Senator Corzine. Mr. Chairman, would the Chairman object to
a follow-on question? This leads right out of----
Chairman Shelby. Would Senator Dodd yield you the time, do
you think?
Senator Dodd. No.
[Laughter.]
Go ahead.
Senator Corzine. I actually wanted to ask about this SEC
report that was reported in The Wall Street Journal on November
3. Is that going to be made public? If not, why? If so, when?
Chairman Donaldson. This is a matter where the SEC has
traditionally not made these internal reports public. I am not
sure of the law on it.
I think a referral to Enforcement and an action by
Enforcement would make these allegations public.
Chairman Shelby. Senator Dodd.
Senator Dodd. Thank you, Mr. Chairman. And let me thank you
once again, Mr. Chairman, for having these hearings, and we
thank the Chairman of the SEC for being back here. You may want
to consider moving the SEC building a little closer to the
Senate. We have a tunnel we are putting in over here. Maybe you
could arrange it, given the frequency of your appearances here.
We thank you very much and are looking to hearing from John
Reed as well when he testifies.
Let me, if I can, Chairman Donaldson, follow up with a
couple of questions. I do not know if you had a chance, with
everything else you have got to do--there was a recent
article--I think it is about 2 or 3 days old--in Business Week.
I presume maybe John has looked at this thing, but it is ``Too
Little, Too Late, Mr. Reed?'' A question mark on the end of it.
And I want to raise the issue about the governance question, if
I can, and there has been some discussion about whether or not
the SEC may do more following on Senator Sarbanes' questions
that he raised with you.
The question that I have for you has to do with the
possibility--or one of the criticisms that is being raised by
some people. Most agree that the steps that have been taken so
far are good steps in the right direction, but just on the
governance question, let me raise this, if I can, with you.
What the Business Week article says--and I would ask
unanimous consent, Mr. Chairman, that it be included as part of
the record.
Chairman Shelby. It will be included, without objection.
Senator Dodd. It reports that the plan--and I am quoting--
``allows just 40 members to nominate a director and 100 to
nominate an entire slate.'' It cites Jack Ehnes--I think that
is how you pronounce his name, E-h-n-e-s--who is the CEO of the
California State Teachers Retirement System, he says, ``Having
members in any way involved in setting up and getting board
members nominated is a problem. It is a regulatory body with a
public purpose, and in my mind, that is a clear conflict.''
The article goes on and quotes some other people as well.
It quotes this fellow who is the North Carolina Treasurer,
Richard Moore, as well here. Their concern is that you could
end up having a wonderful board. This board, I think, that John
has put together is a great board, but the possibility exists
for the membership coming in and just getting rid of a board.
There is a vote every June on the board. And I wonder if this
has gone--and John will have a chance to talk about this as
well when he comes up, but I would like your comments. I do not
know if you have had a chance to look at this. But it is almost
like you could drive a Mack truck through this when it comes to
governance. And if you do, then you have got the very people
back again picking the board again, and you are right back
potentially where you were before.
Are you familiar with this?
Chairman Donaldson. Well, I know you were not here earlier,
Senator Dodd.
Senator Dodd. I apologize.
Chairman Donaldson. I tried to address that question,
probably inadequately. You have a series of seat-holders, both
leasees and lessors. Their asset is principally the value of
their seat, and that seat is dependent upon the perception and
reality of the New York Stock Exchange having organized itself
to service and serve the public and to serve the public
investor. And I think any attempt by the electorate, if you
will, to move back to something that was not working is not
what is going to happen because that would be self-defeating
from a commercial point of view. However, having said that, the
SEC still has its oversight responsibility. And just as we
moved at this point, we could move again.
Senator Dodd. Well, am I taking from that that you would
object--and the article goes on to suggest--I do not know which
one of these individuals made the suggestion that the SEC
should actually approve the board members themselves rather
than just have oversight. Would you go further?
Chairman Donaldson. Well, we basically are interested in
comments such as yours that will be coming to us as people look
at this proposal. And, you know, we will take a look at the
comments. We will take a look at the questions that you put up.
We will take a look, I am sure, at a lot of other questions.
And I go back to what I have said before and what the
Commission has said: This is a first step. This is a first
step, and I think you cannot take all that has happened at the
New York Stock Exchange, all that needs to happen, and take it
out of the context of the reality now of needing to do
something now. I think a structure has been brought in. I think
there are people of the highest integrity involved. I think we
probably should give them a chance to address some of these
issues. And, again, I do not think this is the last step. I
think it is a first step. And I do not want to prejudice where
the Commission is going to come out on even this first step.
Senator Dodd. I understand that, and I appreciate your
point. It is a very rational and reasonable position to take.
But also having been around here a number of years, there are
moments when there is attention on these questions and that we
will move on to other issues--we already are--involved with the
mutual fund industry. There are going to be issues involving
the GSE's. There are all sorts of questions coming up, and it
is the natural inclination of these institutions and others for
their attention to get diverted. And so there is a moment here
in which we need to obviously take a look at all of this, and I
agree with you that it has to be done thoughtfully and you need
to think about what you are doing in all of this. And I do not
need to tell this to you, obviously, as someone who has spent
an adult lifetime working in this industry, how critically
important this exchange is. Of all the exchanges, this is the
gold-letter exchange. This is the one the world really looks
to, and a sense of confidence in it, for investor confidence
issues.
So there is a special responsibility, in my view, to really
get this right and to send a message to people that we are
getting it right. And, again, you can go overboard on this, and
you have to be careful in doing that. But I would hope there
would be some sense of urgency tempered by being responsible
and thinking clearly through all of this, but that we do not
miss this hour in time as other issues overtake us and we move
on to other questions.
So things like the question of is the chairman of the board
going to be independent, whether or not there is going to be a
good oversight or just kind of we will look at it when problems
arise, I would like to hear more. And I am not going to press
you on it today, but I would like to have you get back with
some of these ideas and suggestions and give us some sense of
where we should go.
Chairman Donaldson. I think your comments are well taken,
and without going overboard on my own observation, because John
Reed has had to contend with what is going on in the Stock
Exchange right now, but I believe that the very vote that was
taken, the fact that it was an almost 100-percent vote for
radical change, indicates something about the attitudes of that
group of people there. And I also think, the structure that has
been put forth and the type of people who have been brought on
board as new directors says something about the new leadership.
I look forward to hearing the comments. I look forward to
watching this thing evolve. And, clearly, the necessity now, I
think, is to take a first step but to recognize it as just
that, a first step.
Senator Dodd. Thank you.
Mr. Chairman, Senator Sarbanes--and this may have been
asked as well, so I will not pursue it. But on this inherent
tension between the notion of being the regulator as well as
creating the market issue--and you have addressed this in your
comments--and whether or not the proposal that has been made
fashioning the independence of the board and the independence
of the regulatory function, how you marry those in an effective
enough way so you can create the kind of confidence that there
will be a solid oversight function is really rather critical.
And I hope you will give that a lot of serious thought and get
back to us. But I think Senator Sarbanes' line of questioning
in that area--I regret it deeply. I have been a great advocate
over the years of SRO's. I am saddened in many ways that we are
even talking about having to go this route. But I do not know
of anything to do in the short-run, but to get you more
involved in this and get the SEC more involved. I wish I could
think of some other idea that would not have to move us in that
direction. But I do not think we are going to rebuild investor
confidence in the country without the SEC getting a lot
stronger. Maybe we will be able to come back to it at some
point, but for the time being, I think we make a mistake if we
assume that we can just rely on what has, fortunately, in many
ways worked very, very well for many years, but does not seem
to be doing the job today. So, I come down on the side of
getting you more actively involved in this, the Commission I
speak of.
Thank you, Mr. Chairman.
Chairman Shelby. Mr. Chairman, I just want to go back
briefly to the specialist role. I wish Senator Schumer were
here now. He talked about it. Others did, and Senator Sununu
asked some very important questions about some things that went
on at the market and what has happened.
I just throw out to you that we all know that the New York
Stock Exchange is very important to all of us as the capital
markets. It is the largest. But there are other markets, and my
predecessor here, Senator Gramm, used to talk about when the
candle makers of America came to Washington to try to block the
idea of electricity and the light bulbs for everybody that
Edison came up with, and you know that story. But you also
know, Mr. Chairman, you cannot block technology. Technology
will ultimately prevail.
So how do we implement or integrate technology into a
system where it has been the human being, you know, executing
orders and so forth? Because I do not believe technology is
going to go away. Can you manipulate technology? Absolutely.
Humans learned to do that a long time ago. But humans
manipulate a situation, as you well know, and he alluded to it
earlier.
Whenever we are looking at the New York Stock Exchange or
any market, I think to try to think technology in the future,
the electronic market is not going to play a role, I think that
is nonsense. You know, I think you have to do it. How you do it
I do not know. But you cannot protect people from progress. The
technology will trump it--or generally will. You might regulate
it. You might try to do this. But, you know, I think history is
a guide there.
Senator Sununu, I believe you had another question.
Senator Sununu. And it certainly relates to some of the
points you were making.
Mr. Donaldson, do you consider the terms ``best price'' and
``best execution'' to be synonymous?
Chairman Donaldson. Well, I think that there are different
concepts of what best execution means to different people.
There are certain people who consider the best execution to be
an immediate execution. There are certain investors who are
willing to sacrifice getting the best price in order to get a
rapid execution. And that is the essence of the electronic
markets, the ECN's, versus the New York Stock Exchange. And
that has been exacerbated by the decimalization and the penny-
ization, if you will, because the benefit of gaining an extra
penny may be not worth the wait to some people. But if you
really get into what goes on in a market and the amount of
transactions that take place at a single price point, you have
to get below that--into spreads that are larger than pennies,
and then price improvement really does mean something.
But I think the concept of best execution--I refuse to
believe in my own mind based on my own experience that the
concept of an organization that gets the best price for
somebody is something that gets easily thrown away. Again, I
will let Chairman Reed speak for the New York Stock Exchange.
But I believe that the liquidity that is inherent in and
developed on the floor of the stock exchange--again, I am
repeating myself--in times of stress is unique. And I also
believe that the meshing of human intelligence with technology
is where things are going. And I think there is a
characterization of the New York Stock Exchange, of a floor and
people running around on that floor, that is an outmoded model.
I think the technology on the New York Stock Exchange is
cutting-edge. The electronics on the New York Stock Exchange
are cutting-edge. It is just a matter of how much electronics
and how much human judgment you use and put together and then
mesh that with the ECN's.
Senator Sununu. Would it be appropriate to paraphrase your
answer as no?
[Laughter.]
Chairman Donaldson. I will let you do that, sure.
Senator Sununu. And I do want to explore this a little bit.
It is obviously relevant to the points made by the Chairman,
but it was brought up, I think, in some of the opening
statements as well. And I appreciate and agree with the
important points you make about technology and the utilization
at the NYSE and the liquidity role that it plays and the
important role that it plays in our capital markets. And I
think you would have a hard time finding any disagreement on
this Committee about those points.
But if someone wants to sell 100 shares of stock and an
investor has placed a bid to buy 100 shares of that stock at
$20 and a specialist sees that bid to buy 100 shares of stock
at $20 and chooses to buy 100 shares for $20.02 on their own
account, would that be appropriate?
Chairman Donaldson. Well, that particular circumstance you
set up--I mean, the specialist has both an affirmative and
negative obligation, and the specialist steps in--in terms of
his affirmative obligation, the specialist steps in to make a
market when the market--is to close the market and narrow the
spread.
Senator Sununu. To make a market--to narrow the spread or
to make a market when one is not available? Those are two
different things.
Chairman Donaldson. Well, both. I mean to make a market and
to narrow the spread.
Senator Sununu. So you think that is appropriate? The
hypothetical I just described where there is a bid to buy 100
shares at $20, someone is offering to sell the shares at
market, and the specialist buys on their own account for
$20.02, that is appropriate?
Chairman Donaldson. I think the particular thing you are
saying is that the specialist was stepping ahead in that
instance, and that is----
Senator Sununu. I am sorry. I do not mean to be flip, but I
really did not think it was that tricky a question. Is it
appropriate or not appropriate?
Chairman Donaldson. State it again, Senator.
Senator Sununu. Senator Shelby wants to sell 100 shares of
stock. He says, ``I am going to sell this stock at market.''
Sell it at the market. I want to buy 100 shares of stock, and I
offer $20. The specialist has Senator Shelby's request, has my
offer, my bid to buy at $20, and buys the shares, 100 shares,
at $20.02 for their own account.
Chairman Donaldson. No sir, he would be stepping ahead of a
public bid.
Senator Sununu. I would be inclined to agree with you. I
just wanted to make sure that that was your answer, because
that is a clear case where the person selling the shares got
the best price--got a better price than what I wanted to buy
them at, but it was not appropriate behavior, it was not right.
And it is a simple point, and I think maybe most people
understand it. But the best price only is not always the best
execution. It is not always legal. It is not always legal,
because if you are using proprietary information to take
advantage of your position in a way that is not fair to the
markets, then the markets are not being well-served, and
ultimately customers are not necessarily being well-served.
So, I am sorry to belabor the question, but I wanted to
make sure that you answered in a way that you were comfortable.
And certainly if I misunderstood anything, feel free to correct
it for the record.
Thank you, Mr. Chairman.
Chairman Shelby. Senator Corzine, would you like to ask any
more questions?
Senator Corzine. I actually will repeat the question on the
report because I did not hear the answer exactly. You are
saying because it was involved with an enforcement action or
mentioned or involved enforcement proceedings that it,
therefore, would not be made public?
Chairman Donaldson. No, what I said was that the report
that the SEC gave to the New York Stock Exchange is a
confidential report. A second step here would be a
recommendation by our Inspection Division to refer that report
to Enforcement.
If Enforcement decided, based on their own investigation,
that an enforcement action was warranted, then an enforcement
action would be taken, and that enforcement action would be
made public, and the reasons for it would be made public. But
during the enforcement process where the reinvestigation is
going on, you would not divulge that. But it would come out if
an enforcement action were taken.
Senator Corzine. Certainly the elements of discussion that
at least were categorized in the newspapers--again, commenting
on comments of private memos is never an attractive element,
but the commentary that surrounded the nonenforcement elements
of it seem very germane to the discussion that we are having
with regard to forming judgments about where one would go with
some of these structural issues that we talk about, and maybe
ultimately some of the corporate governance issues, very much
germane to that discussion. So that to the extent that the
elements that did not deal with Enforcement but were
categorization, it would certainly be useful for those of us
who are forming judgments about--or at least want to
participate or have a responsibility to participate in the
discussion have the best information available.
Thank you.
Chairman Shelby. Mr. Chairman, we appreciate your coming.
Again, as everybody says, we have a place for you back in the
back here. You are welcome again, and I know you will be back.
Let us continue to work for the right thing here.
Chairman Donaldson. Thank you.
Senator Dodd. We thank you for what you are doing.
Chairman Shelby. We do.
Senator Dodd. If the questions seem a little tough in some
cases, it is because it is obviously a deep concern we share.
But many of us have said it. I have said it before and I will
say it again: I think you are the right person for the job
today, and I have a lot of confidence in the work you are going
to do.
Chairman Shelby. I do not know if the Chairman is glad he
took the job, but we are glad he did.
[Laughter.]
Thank you.
Chairman Donaldson. Thank you.
Chairman Shelby. We will go to our second panel, Mr. John
S. Reed, the Interim Chairman of the New York Stock Exchange.
Mr. Reed, we appreciate your indulgence here today. These
are important issues not only for the Senate Banking Committee
but also for all Americans. Your written testimony, which we
have, will be made part of the record in its entirety. If you
would, sum up your points as quickly as you can, because you
can tell the day is moving fast.
STATEMENT OF JOHN S. REED
INTERIM CHAIRMAN AND CEO
NEW YORK STOCK EXCHANGE
Mr. Reed. Yes, Mr. Chairman and Ranking Member Sarbanes,
thank you very much.
If you could add for the record, to my written comments a
copy of our proxy.
Chairman Shelby. We will do that without objection.
Mr. Reed. Let me just very quickly summarize what I would
like to say to you.
First of all, let me say I enjoyed the prior session and
could have stayed here listening for quite a while. Much that
was discussed is quite germane, of course, to what I have been
trying to do. And I am only sorry I could not have participated
a little.
I was called in to deal with what was a serious breakdown
in governance. The exact circumstances of what happened are not
yet 100 percent clear, maybe never will be, but clearly we had
a very fundamental breakdown in governance at the New York
Stock Exchange which resulted in the departure of Mr. Grasso
and my coming in. And my mandate was pretty simple: Try to
understand what happened, propose a new governance structure,
find a replacement for myself, and return to retirement. And
that is what I am trying to do.
As you know, I did submit to the membership recently a
proposal for a new governance structure that reflects my
thinking on this subject and my assessment of what is going on
and, in fact, my concern about many of the issues that have
been raised here this morning.
The proposed structure, very simply, is that we create an
outside independent board of directors--we have a slate of
eight people that were voted for by the members on Tuesday--and
that we maintain our contact with the industry through the
mechanism of what we call a board of executives which consists
of the customers of the Exchange, the owners of the Exchange,
and the operators of the Exchange. This will be a forum that
allows us to deal with the substantive issues associated with
market performance and the evolution of market structure, but
it will be a forum that is totally separate from and distinct
from the responsibility with regard to governance of the
Exchange itself and the fiduciary responsibility that the board
of directors has to the New York Stock Exchange.
I happen to think that it is a pretty good structure. I
think it very clearly resolves the problem that we were trying
to deal with in the first instance, which was the breakdown of
the governance structure as it had to do with compensation and
management of the Exchange itself. But, frankly, when I was
looking at what to propose, I did not look only at how to
resolve that problem. I really wanted to position the Exchange
to be in a place where it could deal with all these very
important issues that the Committee has been talking about.
I did not try to deal with these issues in my proposal. I
did not think it was appropriate that you bring in somebody on
a temporary basis and try to deal with the very important
issues that you are talking about. What I did was try to create
a structure that would be robust and would serve the investing
public well and serve the Exchange well.
And so what I have proposed is an outside independent
board. It will be responsible as a fiduciary for the well-being
of the Exchange and the American public in that sense. They
clearly have the capability. The people that I recommended for
the original slate were people who have had experience as
chairmen of big public companies, because the breakdown of our
governance clearly reflected the fact that the prior board was
ill-equipped to deal with some of the responsibilities that are
associated with a good board of directors. There are four
people on that list who have been chairmen for an extended
period of time of major public companies.
I also recommended a number of people for that board who
know something about markets and finance, and more importantly
from my point of view, I put a good number of people on that
board who know an awful lot about technology and are
analytically strong, because some of the issues that have been
raised here about the structure of markets and what constitutes
good execution, ultimately are problems that are going to
require important analysis.
We have a two-tiered structure in the sense that the
discussions that require the input of the customer, be it on
the buy side, be it on the sell side, or be it our listed
companies, are going to be well represented on the board of
executives. I have set it up so the board of directors can
listen in, but this committee has nothing to do with the
responsibilities of the board, and I frankly think it is a
structure that is going to serve the Exchange well, and I think
deserves the support of this Committee.
Everything can be improved upon. I do not have any doubt
that as time goes on this also--but I think it is a good first
step. I simply say to you that I think it is something that the
members have voted for, indicating their own recognition of the
need to make this kind of change. I look forward to your
questions, where we can draw out some of the subtleties that
you were talking about before.
Thank you.
Chairman Shelby. Mr. Reed, thank you very much.
Some contend that you cannot eliminate the conflicts of
interest at the Exchange unless you change the ownership
structure. Some believe that as long as the business operations
and the regulatory function are located in the same entity,
then regulation will always be a secondary function. How do you
respond to that assertion?
Mr. Reed. I do not believe that is an accurate case. I
think it is very much in the interest of the Exchange that it
be well regulated. I believe that regulation of the Stock
Exchange is like quality control is to Toyota.
Chairman Shelby. Do the members know that? I agree with
what you are saying. It is in the long-term interest of the
Exchange to have no conflicts, no ethical problems, none of
that, but do all the members know that?
Mr. Reed. I would not say all. Clearly, there must be one
who does not. But my experience with the Exchange is that they
have been sobered by the recent problem with Mr. Grasso and I
think that the vote says something about what the Exchange
thinks, and I believe that the members know full well that the
integrity of the Exchange lies at the foundation of the
Exchange.
Chairman Shelby. It has to be number one, the integrity of
the Exchange?
Mr. Reed. It is number one. You have no market if you have
no integrity. I think they fully understand that, so I do not
see this inherent conflict.
I would also point out to you that 900 of the 1,400 members
are retired, and so they just look at this as an economic
interest. They are not active on the floor of the Exchange.
Chairman Shelby. They own the seats.
Mr. Reed. They own the seats, and they have rented them
out, often to Merrill Lynch and to others who need to have
seats on the floor, but they rent them as opposed to owning
them.
But the point is, these votes, which are more than 900 out
of 1,400, a pretty good majority, these are people whose
primary interest is in the economic well being and hence the
integrity of the Exchange.
Chairman Shelby. Mr. Reed, you stated that the Exchange's
regulatory arm should not be separated because regulators
really have to be engaged with the members in order to be
effective. It seems to a lot of people that the securities
industry is one of the few major industries that continue with
self regulation. Are there unique factors that make self
regulation more appropriate in the securities markets than any
other industries? If so, what are they?
Mr. Reed. I think really, Senator, if you look at it
carefully, all of your work with regard to audit committees and
all the efforts with regard to public companies, we rely on the
audit function that is contained within companies to ensure the
integrity of the operation of those companies, and that is true
in the banking industry or with regard to the internal audit.
It is true that we have external auditors in the banking
industry, but they rely tremendously on the internal audit
capability. Much in the legislation of Sarbanes-Oxley was
designed to ensure that the audit committee could supervise
appropriately the internal audit function, and that they
certify that the accounting is done properly, and that they
certify that controls are in place. So the fact of the matter
is, we rely on self-audit and self-regulation throughout the
entire private sector. We are not saying sole reliance. In the
case of individual companies you tend not to have an outside
agency that then sits on top of the auditors. In the financial
community, be it banks, be it the New York Stock Exchange, you
have banking regulators and the SEC that sits on top of the
internal capability, the self-regulating capability, and have
the capability to oversee and intervene, as Chairman Donaldson
just said, if they believe that is not being carried out
properly.
But the essence of what you all have put in Sarbanes-Oxley
with regard to the oversight of the internal audit function of
corporate America is contained in our proposal here. It is the
committee of the board of directors, which is comprised totally
of outsiders, to sit on top of the regulatory arm, approve the
budget, the staffing, the compensation, the audit plan, so
forth and so on. It is exactly the same as exists in the
Sarbanes-Oxley Act to ensure that that internal function is
held to the highest standard. There are no foxes in the chicken
coop.
Chairman Shelby. But there are no criminal penalties there.
Mr. Reed. With regard to?
Chairman Shelby. The self governance.
Mr. Reed. I am not a lawyer. I do not know about criminal
penalties.
Chairman Shelby. Sarbanes-Oxley has some criminal
penalties.
Mr. Reed. The board of the Exchange must come under those
same laws with regard to their duties, and so it seems to me
that that board that I am relying on to ensure that we get the
integrity that we must have, that board which surrounds the
self-regulatory process, has the same obligations to the
public, I believe, as any public board would have.
Chairman Shelby. Mr. Reed, what is your reaction--we have
already been talking about and you have been here in the
hearing--what is your reaction to allegations of trading
misconduct by the specialists? Senator Sununu asked the
Chairman about that, the status and so on.
Mr. Reed. We clearly discovered that there were instances
where the specialists misbehaved. That was originally
discovered by the internal surveillance at the New York Stock
Exchange. It later, as Chairman Donaldson says, was expanded in
terms of its scope.
Chairman Shelby. Is this widespread? Some people believe it
is widespread.
Mr. Reed. Let me try to put it in context. We looked at 3
years of activity in all shares. Approximately a billion
transactions would have occurred in that time. Something less
than a million transactions appear to us, ``us'' being both the
SEC and the enforcement arm of the Stock Exchange, to have been
inappropriate. They fall in three different buckets. We are in
the process now of trying to ascertain, of those approximately
one million transactions, just to what extent they were
improper and to what extent they were not. Clearly, some
significant portion was improper.
So, I would say there clearly were failures. There were
failures to follow the rules, and the people involved, there
are 450 individuals who work as specialists on the floor of the
Exchange every day. There is some lumpiness, that is, this
behavior is not uniformly distributed across 450 individuals.
Some people have already been dismissed. It is quite likely
that those people will never again work in any exchange.
There are some problems that are pretty evenly distributed,
which causes an analyst to say there is a systemic problem. The
great difficulty here has to do with a category where a
specialist intervened in a transaction that would appear not to
have been proper if you take into consideration that there was
an electronic order on the book and if he had done his job
properly he would have paid attention to it, but he did not.
We have corrected this going forward by putting a computer
fix in so that the specialists cannot hit an execution button
if that information is on the book. It stops him from being
able to do it. That was not there in the years we are talking
about.
Chairman Shelby. Stopping them, rather than the specialists
stopping themselves.
Mr. Reed. The question is, and this is the----
Chairman Shelby. True, though?
Mr. Reed. Yes, sir. The question is, how long does that
information have to be displayed for a reasonable person to
decide that the specialist should have seen it? That is what I
call waving for a taxicab in the rain. How often do you have to
wave before you decide, the taxi did not want to stop. It was
not that it did not see me, but he did, but nonetheless went
on, which I would tell you happens in New York. But it is
illegal. Taxis are supposed to stop, but it happens.
We have sliced it down to 5-second intervals. If you take a
look at the incidents, in the difference between using a 10-
second slice and 15-second slice there is a tremendous decay.
In other words, if you say 10 seconds is the criteria, there
are many more instances of missed opportunities than if you
take 15 seconds. Obviously, the problem is to find out--and we
will find out. There are mechanisms for finding out, and I was
talking to some of the enforcement people in the SEC yesterday.
I want truth. I am not trying to whitewash the specialists. If
a specialist misbehaves, that hurts all of us because we
promise the American public that if you go to the Exchange you
will get a fair and decent transaction.
Senator Dodd. Is misbehave the right word?
Mr. Reed. Pardon?
Senator Dodd. Misbehave has a tone or tenor to it that
almost sounds venial. I mean we are talking about violating the
law, are we not?
Mr. Reed. I do not know if it is law or not, Senator. It
certainly is regulation. There are very detailed rules on how
specialists are supposed to operate. This violates these rules.
Chairman Shelby. The Senator makes a good point.
Mr. Reed. I do not know if they are embedded in the law or
not. If they are, then they are violating--as far as I am
concerned, if we do not serve the customer properly, we have
failed.
Chairman Shelby. Whatever it is, it is either illegal or
unethical, is it not?
Mr. Reed. And it is wrong, just wrong, period.
Chairman Shelby. Both of those would be wrong.
Mr. Reed. But my point is, to the specialists, and I have
met with the head of the specialists, my point is if it is not
right from a customer's point of view, I do not care what
excuses, why, then it is not right, and we, (A) have stopped
it, but (B) you are going to pay the money back, and (C) you
are going to pay a fine. If there is a pattern----
Chairman Shelby. Do they keep on being a specialist too?
Mr. Reed. If there is a pattern of abuse that focuses on an
individual, the answer is no. We will have to go to court
because you are taking away a person's ability to work, but
they will not be working as a specialist.
Chairman Shelby. You are not going to be reluctant to do
that, are you?
Mr. Reed. I am not at all reluctant to do that, and I do
not think that the owners or the major specialist firms are
reluctant either.
Chairman Shelby. Mr. Reed, a lot of people have brought up
that the allegations surrounding specialist trading practices
are symptomatic of the New York Stock Exchange by its
regulatory structure. Assuming that the SEC approves your
reform proposals and that the Exchange fully implements the
reforms that you have brought forth, what additional reforms do
you think that the Exchange must adopt to strengthen its
regulatory function in light of recent criticism? Are you to
that point yet?
Mr. Reed. Clearly the criticisms are justified, and there
is reason to assess where we are as a regulator. I intend to
recommend to the new board, when we get it installed, that the
first thing we do is that we bring in some outside experts, do
a review of our regulatory competence, and use that as the
basis for change to our regulatory function. Frankly, the idea
of outside peer reviews of regulators is a very valid, and I
think a potentially strong tool, to rebase and rethink just how
good are we.
Chairman Shelby. Mr. Reed, you are very familiar with the
criticism that the reform proposals are lacking because they do
not mandate an independent chairman. Also, what is your current
thinking on whether the exchange should have an independent
chairman, and if not, why not?
Mr. Reed. I did not hard-wire it into the proposal changes
to the actual constitution of the Exchange because I did not
want to put future generations in a position where, every time
you change chairmen, you have to go back to have a vote to
change the constitution in the event that they do it
differently. What I said is that we could either have a
chairman and a CEO separate, or you could have it together. If
you have it together you must appoint a lead director as in
Sarbanes-Oxley, so I simply mirrored the private sector.
I frankly do not know which way we are going to end up
going because finding the right person for this job is
important. If we had a person who was exceptional but only was
interested in the job in the event that he or she could have
both chairman and CEO role, I sure would prefer that than to
have a less competent set of people in a split role. I happen
to have some personal sympathy for the idea that a split role
may turn out to be a more appropriate one at this time. We do
not yet have a board. It is very difficult for me to do my job.
I do not want to be a dictator, talk about bad corporate
governance. Having a visiting chairman is not great corporate
governance.
Chairman Shelby. He may not be a dictator, but it is a real
time for leadership.
Mr. Reed. It is a time and I think I am trying, without
overstepping, to do that. But I am intending to meet with the
proposed new board to see if they would allow me to move
forward to bring to them, when they become legal, candidates
for my position. I am going to press them. I have my own view,
but I would like to get the benefit of their view as to whether
they think a split is better or not. But we do provide for the
lead director, and all of the responsibilities of the lead
director with the board in the event we happen to end up with
one person in the chairman and CEO role.
Chairman Shelby. Mr. Reed, I understand you hired an
outside law firm to examine the circumstances surrounding the
approval of Mr. Grasso's pay package. What have you learned
from that investigation?
Mr. Reed. Nothing yet. I have asked Mr. Daniel Webb to give
us a verbal briefing on Monday of next week, and he is
intending to give me a written report around the first week of
the month of December.
Chairman Shelby. Will you share that with us?
Mr. Reed. I probably would prefer not to.
Chairman Shelby. We might have to get you back down here.
Mr. Reed. Not having seen the report, it is a little----
Chairman Shelby. I know.
Senator Sarbanes.
Senator Sarbanes. Let me just follow right up on the
Chairman's question, because I was going to pursue that line
myself. The Financial Times on November 6 wrote an article
about bringing in the outside investigative attorney and former
prosecutor, Dan Webb, to look into this matter. The article
states that you expect to receive Mr. Webb's report by December
1, but that the report's findings will not be made public. The
article goes on to say in justifying the decision to keep the
report private, you said it could be highly embarrassing.
That does not strike me as an adequate rationale for
keeping the report private. Is that the rationale for it?
Mr. Reed. I have not seen the report, so I have no basis on
which to form an opinion one way or another. Obviously, I have
learned over the years that when something goes wrong, and
something clearly did here, you better figure out what actually
happened, and because to rely on the press or a similiar source
to tell you what happened is simply a mistake managerially.
I hired an outside law firm because I felt that having the
confidentiality surrounding a lawyer-client relationship was
important, and it was important to get people willing to talk
to this lawyer. They are not obliged to do so by law. I did
meet with the board of directors and ask that they all be
willing to meet with Mr. Webb. They all have. I understand Mr.
Grasso is meeting with Mr. Webb this week. I do not know that
that is true, but that is what I was told. So everybody has
been cooperating with Mr. Webb.
I think they cooperate with him in part because they
understand it is important. We know it happened, but I think
they believe there is some degree of confidentiality with
regard to what they might say, and having that assurance helps
in the process.
It is extremely important for us to understand what
happened and it obviously is the basis I am going to use for my
continued discussions with Mr. Grasso because there is a
contract that was signed with him that is floating out there.
He indicated publicly, but to my knowledge never in writing,
that he intended to waive payments that he might potentially
claim under that. I have no knowledge as to what he currently
intends. I have never either met or spoken to Mr. Grasso, and I
do not intend to until I have the benefit of seeing this
report.
Obviously, the purpose of the report was to help me in my
job, and to help the Stock Exchange, and it probably is a
better report because it does have the potential of staying
private.
Chairman Shelby. Senator Sarbanes, can I ask him a quick
question?
Senator Sarbanes. Certainly.
Chairman Shelby. You plan to share that report once it is
finished with the SEC?
Mr. Reed. Again, I have made no commitments whatsoever. I
did tell the SEC at the beginning that I was doing this. The
SEC asked if they could talk to Mr. Webb to be sure that the
scope of the investigation was something that they felt was
appropriate. I understand they did speak to Mr. Webb. I did not
check. I just know that they met. I assume, but do not know,
that the SEC thought the scope was proper. If I think it is the
right thing to do, and I think my objective here is to serve
the New York Stock Exchange and the American public, I would be
quite happy to share this with the SEC, with the Committee,
with whomever. I just do not want to be on the record up front,
not having seen the report, not having any idea what is there.
As you know, one has to be cautious in this modern world just
throwing raw material out into the public domain.
Senator Sarbanes. I will take that for now, although I
again underscore, I do not think embarrassment is an adequate
rationale.
Mr. Reed. I do not either, Senator. If that was the
question, I share your view. Embarrassment is not the
rationale.
Senator Sarbanes. On November 11, the Financial Times had
an article that said ``The big board must end its costly
costume drama.'' They went on in an editorial and said, ``Even
at a theoretical level, the specialist system makes little
sense for the top 500 listed U.S. companies. Why have a middle
man to ease trading in the most liquid stocks in the world? In
practical terms it is a recipe for abuse. Specialists can trade
ahead of large customer orders, using privileged knowledge to
make proprietary profits or favor other investors.'' The
article went on: ``While specialists have a place for illiquid
small cap stocks, an electronic auction book is sufficient for
large listed companies.''
I would like to get your view of that comment, because this
issue is being raised in a lot of places. I would just be
interested in your response to that.
Mr. Reed. I disagree with the editorial, and I think it is
superficial. It seems to me that the auction market, which is a
combination both of the specialist and the broker, is quite
robust, and seems, from everything I have seen, to be extremely
effective at what it tries to do. It is true that under normal
circumstances for the most liquid stocks, the role of the
specialist, per se, is minimal. Five hundred is a big number. I
think the most liquidity is much smaller than 500 stocks. But
if you really look at it, what exists in the Exchange today is,
number one, an electronic capability that does exist--we call
it Direct Plus--to go into the market electronically and
consummate a transaction at the then-price. There is no price
improvement. It is the then-price, and it is an ECN built into
the Exchange for all practical purposes, and about 7 percent of
our transactions are done that way. We could expand its
capacity as time goes by.
If you are a computernik--and I have written code and know
a little bit about computers--and you say, okay, how could we
automate this thing? You could imagine that you could replicate
the specialist function because it is pretty rules-based, and
you could replicate it with an intelligent system, and it would
be an expert system. It is not trivial, but it is probably
doable. It becomes the second feature of the specialist system
that is more difficult to replicate. They put capital at risk,
on an average day about $5 billion. So you would have to, on
the other side of this computer, have somebody willing to allow
the computer to commit capital. In other words, the specialists
create liquidity. An ECN finds a market, but it does not create
any liquidity. The specialist system actually injects liquidity
into the market by the specialist buying or selling securities,
and as I say, on a typical day $5 billion, not a trivial sum.
The thing that would be hardest to replicate,
interestingly, is the broker. There are two ways to get through
to the specialist. One is to put an order on the screen, what
we call a DOT system, where you have an electronic introduction
of the transaction, and the other way is to hand it off to a
broker. Now, to write a computer program that would tell a
broker--just imagine you go to Sotheby's and you want to buy a
Picasso, and you are going to write a computer program that is
going to tell your representative in the auction there when to
raise his paddle. That depends on getting a feel for the market
and seeing who else is waving paddles. I have watched--and I
will tell you, I think you could write a expert system to
replicate the specialist much more easily than you could write
a expert system replicating when the broker goes into the
market and how he or she presents the order.
There is important price advantage for an investor in
utilizing the broker's activity. In other words, I would guess
from what I have observed that if you hand an order off to a
broker who then goes and deals with a specialist, you could see
very significant price improvement, whether you are buying or
selling, because the broker senses whether he is going to wait
a half an hour and come back because the customer wants to buy
and he sees the market is going down. A computer, boom, you
have done it. You bought. You bought at whatever the price is.
The broker has the choice of when to introduce the order and
there is important price benefit.
Is there room for an ECN? There absolutely is. Do we have
an ECN embedded in the New York Stock Exchange? Yes, we do. It
is called Direct Plus. It is a pure computerized execution.
Could we expand Direct Plus, because it is limited now to 1,000
shares plus an odd lot, so 1,099 shares. So it is designed for
people like you and me who might buy 500 shares or whatever.
That is an ECN embedded today in the Stock Exchange. You get
the price of the market the instant that the order happens to
hit. Can you present yourself electronically to the Exchange so
that the specialist sees your order there electronically? Yes.
About 70 percent of the volume, 99 percent of the transactions,
but only 70 percent of the volume goes that way, because the
people who understand the market tend to go to a broker and get
the benefit that the broker offers in terms of introducing the
order at a time that is appropriate to the order.
Would I, as an average citizen, want to throw away that
market? I would not. I think, contrary to the Financial Times,
that there is room to have a specialist system even on a very
liquid stock because even on a very liquid stock, it is like
buying and selling a house. If you want to sell your house and
you say, I have to do so in the next 2 weeks, the price you get
is going to be quite different than if you say I am willing to
wait a month or two. The advantage of this auction system, the
specialist is wonderful. We love him. And he injects capital
into the market and facilitates the functioning of the market,
but it is the combination of the broker with the specialist
that constitutes the auction system.
There is much greater robustness there than is visible to
the naked eye, and no one is going to accuse me of not
believing in computers. I spent my life trying to computerize
the world, and I love ECN's and so forth. I will tell you, I
have written a lot of software. I would hate to try to
replicate that full auction market with an expert system.
Now, it can be done. I mean, we have bombs that seem to be
able to fly through windows and buildings. I am not saying that
it is inconceivable that it be done. But it is a difficult task
right now.
So my sense, Senator, is where we are going to end up is
going to be with a hybrid system. There are going to be ECN's.
They will be on the floor of the New York Stock Exchange. They
could be in California or wherever. But there is going to be an
auction market also. And, interestingly enough, the more
sophisticated people--I do not mean the bigger buyers; I mean
the more sophisticated people--understand that that auction
market does significantly improve the price you get if you are
selling or the price you pay if you are buying. And I would
really be quite concerned about taking it away as an
alternative. I do not say everybody must use it, but it should
be there.
The other thing is when you have disruptions in the market
and it is not smooth, then a system that has the combination of
brokers and specialists has a robustness that is going to be
awfully hard to write into a bunch of computer code.
Senator Sarbanes. Thank you, Mr. Chairman.
Chairman Shelby. Senator Schumer.
Senator Schumer. Thank you, and what you said is music to
my ears, Mr. Reed.
I think it is interesting that much of this hearing, which
was dedicated to governance, has moved to market structure. I
believe the reason is a very simple one. The two have some
relationship, although many--I would say many--who were against
the specialist system want to use the governance issues to undo
the specialist system when one does not necessarily lead to the
other.
But the other is that the governance part of this is
relatively easy compared to the market structure part of it. No
one is ever going to be paid $130 million again, even if we did
nothing. We have seen certain specialists not obeying the
rules, and I think the way they were regulated and punished was
too lax. But that is naturally going to change even if we did
not change structure a bit.
We should change structure, but that is the easy part. The
hard part is the issues that you have just touched on in your
questions with Paul Sarbanes and Chairman Shelby, that Chairman
Donaldson and I touched on earlier. And that is the real
challenge here.
Now, for me this is both parochial and catholic--parochial
because I care about New York, but catholic because we in
America and we in the world want to have the best markets we
can.
And so one question I have--I agree with you about the
specialist system, and it is true, right? The studies all show
that 94 percent of the time the specialists get the best price.
Mr. Reed. That is right.
Senator Schumer. Some may not care about best price or say
speed is more interesting to me, and there is no argument why
speed shouldn't be--if that is the consumer's choice, why that
should be there. But that does not necessarily mean you have to
do it in five different ECN's. You could have a system that
maximizes speed because they are all black boxes in one place.
Is that correct?
Mr. Reed. That is correct, yes.
Senator Schumer. Okay. So, you know, now there is a point
of competition, developing a better model. I understand that.
But it does not necessarily follow.
Here is my question, and I think this is a question that
many who are against the--there has been competition. Any stock
can go to a black box, and since the NYSE made the changes--and
Grasso, for the problems he had, deserves credit for that, in
my opinion, and he does not get it. In the world we work, you
know, the pendulum swings. He is a god one day and he is the
devil the next. There should be a little more balance there,
but both ways.
But the walk was that even though there was competition,
under Grasso the number of companies that decided to go, even
big companies, to the NYSE went up. The amount of trading went
up. And the argument the other side makes is, well, Grasso
strong-armed people, that this was not competition in its pure
form, but, rather, that he was able to force people to do
something that might not be in their economic interest.
How much of that was there? It seems to me companies that
are trading their stock, their lifeblood, are going to look for
the best thing economically for them, not, these extraneous
things. It may have happened in one or two instances when it is
a borderline situation, and that was terrible and it should
change. But give me your thoughts on that.
Mr. Reed. I have heard the same comments you have. As you
know, I was not there at the time, so it just has to be
hearsay, by definition. But I will tell you, the proof of the
pudding to some extent is that Mr. Grasso is not there today,
and we continue to run approximately the same numbers. We
continue to have listings. We have not lost, to my knowledge,
any listings. And we continue to run about 82 percent of the
transactions, meaning there are 18 percent of the transactions
involving our stocks that are consummated elsewhere, but it is
not a number any different than when Mr. Grasso was there.
So to the extent that he was holding this back
artificially, one would have expected to have observed it in
the current set of numbers, and we have not. It cannot have
been massive, and it cannot have been an immense build-up, or
we would be experiencing it.
Senator Schumer. Well, I guess, devil's advocate here, it
will take a while for people to realize this.
Mr. Reed. I suspect people who were strong-armed know very
quickly when the strong arm is no longer around their throat.
Senator Schumer. Okay. Another question. What are the
challenges for the NYSE, particularly in light of foreign
competition? Even whatever is here is going to be under our
regulatory structure, and overall I think our regulatory
structure, if you look at a 50-year period and even taking into
account the lapses of the last several years, has served us
fairly well. We have these deep, liquid markets that are now
quite democratized.
My worry is that we will go to a lowest common denominator,
that some foreign black box will say no regulation, you are not
an exchange, you can do whatever you want, and at least in the
short-term, some who will think the system is not going to rook
me--usually big, sophisticated people will go over there
because they can save the cost of regulation, which may be
milli-cents, but when you trade a lot it matters.
What is your worry about foreign competition and how the
NYSE specifically, and America in general, can deal with that
problem?
Mr. Reed. Well, clearly, if we start moving toward pure
ECN's--which, by the way, are harder to regulate than human
markets.
Senator Schumer. Of course.
Mr. Reed. There is a risk that once you get into that kind
of arena, people cannot tell the difference and they will go to
foreign markets, or wherever, if it appears they could pick up
a millionth of a cent and so forth. And you could see a
fragmentation of markets and a dissipation of any center of
trading, which would be horrendous for the capital markets of
the world.
Senator Schumer. Right.
Mr. Reed. You also will find, I am pretty sure, that if
Europe can manage to get an economic recovery going--and in the
case of Japan, I think they probably do have one going--you are
going to see activity in other currencies and in other markets
that is going to have an impact on the flows that go through
the U.S. markets.
Our defense has to be that we run the best market in the
world and that we keep that liquidity. You made the point
better, Senator, than I can. That pool of liquidity is
everything. I have been on the issuer side. Many here may
remember in the 1990's, Citibank had to go three times to the
capital markets for capital at a time when we needed it. And
there were people in the U.S. Congress who thought we were
illiquid and that we could not get there.
I looked at every market in the world. If we could issue a
piece of paper in Tokyo or London that would have gotten us our
capital, we would have done so, and I tried. I went to London
first, thinking that maybe in the London markets I would find
an appetite that I could not find in New York.
The reality is I did three issues in the New York stock
market, and the reason I did is that is where the money was.
And not only is it there normally, but also for companies that
are going through difficult times, which is when you need
capital--either when you are a start-up and no one knows
anything about you, or when you are a good company but you are
going through a transition or what have you--the depth of the
market that exists today in New York is the resource available
to issuers in order to access people who are willing to provide
capital in exchange for the potential upside.
If we saw a fragmentation toward international markets, I
assure you that that capital does not go to funny black boxes.
And we need to keep our system robust, that kind of capital,
which does exist in the New York Stock Exchange, and the reason
we have foreign companies list here is they, too, understand
that the capital that is most willing to take a
businessperson's risk is in the New York Stock Exchange. And
the risk of this competition of black boxes--I could just see a
wonderful black box in Nassau. I would rather live in the
Bahamas in terms of the weather----
Senator Schumer. Not me.
Mr. Reed. --and I could be a software guy, but I will tell
you, the integrity of the system requires its location in this
country, and it is my job to try to ensure that we take the
steps to assure the investing public that there is nothing
about the governance or the responsibility that exists at the
New York Stock Exchange that is anything but a plus.
I do not want to just be neutral. I do not want to be seen
to be merely adequately governed. We have to be governed in a
superior way. Frankly, I think the proposal we have in front of
the SEC and the individual directors who have agreed to serve,
if they can serve, will meet that commitment. You are not going
to meet it in a day, but that is a board that is capable of
meeting its responsibilities, which is intellectually capable
of dealing with some of these challenges that we are facing,
and was designed with that in mind.
I knew what the job of the board was going to be. It has
access to people in the industry who are at the core, and for
the first time, by the way, including the buy side, which has
never before been officially represented. But we have access to
the industry competence, including the industry criticism,
which I think is important to listen to, but that board is
competent to deal with these issues in a responsible and
totally transparent way.
And so I think it is the right first step. I am not
suggesting that any one step is the end. This is an
evolutionary pathway. But I think it is the right first step on
that evolutionary pathway.
Senator Schumer. Two quick final questions, and thank you,
Mr. Chairman.
Number one, you touched on this. I think it is important to
emphasize it. It is your belief that the problems we have had
with specialists or others taking advantage of their customers
would be far easier for somebody, a broker-dealer or whatever,
to manipulate on a black box than in a specialist system. Is
that correct?
Mr. Reed. Without question.
Senator Schumer. So the great irony--and this is the second
question--is those who are using the governance problems to try
and kick the specialist system out are really involved in a J-
curve, in a sense, you know, they will accomplish what they
want in the short-run, and it could end up boomeranging on all
of us in the long-run.
Do you agree with me that some of them have conflicts of
interest?
Mr. Reed. Oh, without question. You know, there is no
question that Mr. Grasso's departure opened up the door for
people with quite legitimate competitive aspirations to make
use of this problem, which admittedly we have, not only to
raise legitimate issues about governance, but also to advance
their competitive cause and to gain a voice at a time when the
New York Stock Exchange seems to have lost its voice.
A significant portion of what we are hearing--not all, but
a significant portion--is from people arguing for their own
competitive position and other financial intermediaries trying
to move some of the profits from one financial intermediary to
another financial intermediary, without any benefit whatsoever
to the ultimate customer. We are getting the typical private
sector, great American response. You lose your voice a little
bit. Everybody piles on, some of it quite legitimate, some
good, but there is an awful lot of comment that is being
authored by competitors who are simply trying to improve their
competitive position.
Senator Schumer. And illegitimately using the real problems
to make a different argument when the one does not have much to
do with the other.
Mr. Reed. Yes, quite unrelated. Quite unrelated.
Senator Schumer. All right. Thank you, Mr. Chairman.
Chairman Shelby. Chairman Reed, you are not saying there is
not real competition out there sometimes?
Mr. Reed. There is real competition. I would assure you,
since arriving back from my retirement, the one thing I have
found continues to exist here is lots of interested people
trying to advance their own possibilities.
Chairman Shelby. Absolutely. Well, that is the nature of
the market, is it not?
Mr. Reed. It is indeed, and we all depend on it.
Chairman Shelby. Mr. Reed, we thank you for your
appearance, and we hope to get you back sometime.
Mr. Reed. Thank you, Mr. Chairman.
Chairman Shelby. The hearing is adjourned.
[Whereupon, at 12:51 p.m., the hearing was adjourned.]
[Prepared statements supplied for the record follow:]
PREPARED STATEMENT OF JOHN S. REED
Interim Chairman and CEO, New York Stock Exchange
November 20, 2003
Chairman Shelby, Ranking Member Sarbanes, and Members of the
Committee, my name is John Reed. Thank you for inviting me to testify
today concerning corporate governance at the New York Stock Exchange. I
assumed the role of Interim Chairman and CEO for a very focused but
challenging task: To reform the Exchange's governance and leave behind
a board and a leadership in which the public can place its trust.
In my testimony today, I will first outline some recent
developments in the Exchange's modernization of its governance and its
election of its new board. Second, I will talk about the critical issue
of self-regulation--both why broker-dealer self-regulation through the
NYSE remains the best answer for the U.S. capital markets and how our
new governance architecture better addresses the conflicts inherent in
self-regulation. Third, I will provide some more details concerning the
autonomy of our regulatory function. Last, I will outline our essential
next steps.
Collectively, we face many challenges. This Committee and the
Securities and Exchange Commission are now dealing with several key
issues that will shape the securities industry for a generation. The
securities industry itself--from the corporate suite to the mailroom--
must again embrace the principle that putting investors first is the
only way to do business. Standing astride the industry's epicenter, the
Exchange must lead this renewal to ensure that the industry regains the
trust and confidence of its customers, the SEC and this Committee.
Recent Developments
The day before yesterday, the membership of the Exchange
overwhelmingly approved my proposal to create a governance architecture
that empowers a small, outside board of directors to lead this renewal.
Subject to approval by the SEC, for the first time in its 211-year
history, the Exchange's board will be independent both from the
Exchange's management and from the Exchange's members and listed
companies. The membership also voted to populate our independent board
with eight seasoned and talented leaders: Madeleine K. Albright--former
Secretary of State; Herbert M. Allison, Jr.--Chairman & CEO of TIAA-
CREF; Euan D. Baird--Chairman of Rolls-Royce and former head of
Schlumberger; Marshall N. Carter--former Chief Executive of State
Street Corporation; Shirley Ann Jackson--President of Rensselaer
Polytechnic Institute; James S. McDonald--CEO of Rockefeller & Company;
Robert B. Shapiro--former head of Monsanto; and Sir Dennis
Weatherstone--former Chairman of J.P. Morgan.
If the SEC approves our new structure, these individuals will serve
until June 2004. Thereafter, the entire board will stand for election
in June of each year.
As you know, I accepted this challenge in the wake of disclosure
that the Exchange's board had failed in how it set its executives'
compensation, and then failed again in how it met the crisis that
resulted from that disclosure. It has since become evident that the
board also failed to foster a regulatory system that anticipated and
mitigated the regulatory risks arising from the vast changes in our
industry over the last decade. These failures all point to a board too
large and too conflicted to effectively govern the Exchange.
The NYSE's 31-year-old corporate governance structure had quite
simply not kept pace with either best practices in corporate governance
or the tremendous changes in the nature of our constituents.
Specifically, the Exchange's governance had to be revamped to manage
conflicts of interest and to increase transparency. To meet the special
challenge of serving as both a marketplace and the vehicle by which our
members regulate themselves, the Exchange's governance also needed to
meet and, indeed, surpass the independence standards to which our
listed companies adhere. The changes that our membership approved this
week create the framework to accomplish these goals.
From the outset, it was clear to me that the NYSE needed a
competent, engaged board free of conflicts and parochial agendas and
dedicated to the NYSE's long-term interests. It was also clear that the
NYSE would not recover its voice and legitimacy as a leader of the U.S.
capital market until the public saw it as an example of good governance
and capable of properly managing its own affairs. An ``insider board''
was not acceptable--not in general and certainly not as the supervisor
of our regulatory function.
The membership vote changed the Exchange's Constitution to achieve
three important objectives:
<bullet> Place responsibility for governance, compensation and internal
controls, as well as for supervision of regulation, in the hands of
a board of directors that is independent both from NYSE management
and from our members, member organizations, and listed companies.
<bullet> Separately preserve the existing engagement of the broker-
dealer community and listed company community with the NYSE by
creating a board of executives that will also include the
executives of major public and private ``buy side'' entities as
well as lessor members of the NYSE.
<bullet> Make transparent our governance process, its participants,
their compensation, and our charitable donations and political
contributions.
The following diagram depicts the architecture we designed to
achieve these objectives.
<GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT>
The proxy statement and supplemental letter sent to our membership
earlier this month describes the changes in detail. Copies are
available at this hearing.
Self-Regulation
Now I want to address an important issue that represents our
industry's best chance for regaining the trust and confidence of
investors: The reinvigoration of self-regulation. As you know, broker-
dealer self-regulation is at the core of our Nation's securities law
as, indeed, it has been at the core of the NYSE since merchants first
gathered on Wall Street 211 years ago to trade Revolutionary War bonds.
Yet, the governance failures at the Exchange have laid bare the
conflicts inherent in self-regulation. Critics have seized upon these
failures to argue that the NYSE's regulatory arm should be severed from
the Exchange. In essence, they are calling for the end of self-
regulation. I strongly disagree with that view.
Self-regulation recognizes that shared settlement and reputational
risk creates an interest in each member of the Exchange to assure the
financial responsibility and fair dealings of every other member.
Properly channeled through an independent, professional Exchange staff,
self-regulation represents the best chance of devising optimal
regulatory solutions that minimize interference with delicate market
mechanisms.
Since 1934, when Congress created the Securities and Exchange
Commission, self-regulation has been wedded to Government oversight.
Since 1938, when the Exchange appointed its first full-time president,
self-regulation has been effected through a professional staff. Since
1972, when the Exchange created a board that included, as one-half of
its members, men and women from outside the securities industry, self-
regulation has been enriched by the participation of customers of the
industry.
As the securities industry evolved, so has self-regulation. In
1934, in 1938, and in 1972 when the self-regulatory model of the
previous generation reached its limits, the answer to restoring
investor confidence in the marketplace was to strengthen and modernize
self-regulation, not to end it. I believe 2003 is no different.
At this latest point of inflection in the evolution of self-
regulation, the Exchange must bring the independence that has
characterized our professional staff to the board level. Yet, to be
effective, our regulatory function must remain pervasively engaged with
our customers, our member organizations, and our other users. Our
membership has now approved the architecture necessary to accomplish
both charges. If the SEC concurs, our challenge will be to implement
our new architecture to reinvigorate self-regulation by better
addressing its inherent conflicts while maintaining the advantages I
have just discussed.
In response to a question from Senator Shelby regarding the self-
regulatory structure of the NYSE, Chairman Donaldson recently reminded
this Committee that in the 1930's, the Commission wisely co-opted the
Exchange's existing self-regulation mechanism so there would not be a
huge, clumsy Government bureaucracy. He recognized that today's key
issues are (1) how the self-regulatory function is financed and (2) to
whom the self-regulatory function reports.
Our new architecture addresses both of these issues. The NYSE
Regulatory Group will now have its budget set by, and will report to, a
board that consists of directors who are independent of both the
securities industry and the companies listed on the Exchange. The board
will appoint a Chief Regulatory Officer (CRO) who will report directly
to the board, and no longer to the CEO. And to better enable the SEC,
the investing public, and Congress to ensure that we adhere to our
public purpose, the Exchange's governance is now transparent.
Accountability is enabled.
Regulatory Autonomy with Market Sensitivity
Now let me take some time to detail how our plan insulates our
regulatory function from our marketplace. As noted, our outside,
independent directors will be responsible for regulatory oversight and
regulatory budgeting. More specifically, our new regulatory oversight
committee will:
<bullet> Assure the effectiveness, vigor, and professionalism of our
regulatory program.
<bullet> Determine the budget, staffing, and technological resources
for the various regulatory units of the Exchange.
<bullet> Assess the Exchange's regulatory performance and recommend
compensation and personnel actions involving senior regulatory
personnel directly to the Human Resources and Compensation
Committee for action.
This means that our independent board, through its regulatory
oversight committee, will decide how to allocate resources to ensure
that our regulation function is adequately funded and staffed.
<GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT>
As the diagram depicting the regulatory architecture indicates,
while the regulatory function remains close to the marketplace, only
the independent directors bridge the substantive division between the
marketplace and the regulatory function. In particular, the CEO, while
a vital partner to the CRO, does not supervise the CRO.
Next Steps
So what is next? First and foremost, we await SEC action on these
governance changes. I want to note that the SEC staff gave us enormous
help by critiquing our proposal before we sent it to our membership for
a vote. In addition, we are grateful for the extraordinarily quick path
to publication in the Federal Register that the SEC staff provided in
order to start the 3-week comment period.
We believe that the SEC can find our architecture to be consistent
with the Securities Exchange Act--the statutory standard that governs
its review. The new architecture empowers a board of directors with the
independence to address issues objectively and the constituent input to
address them intelligently. Directors who have the degree of
independence and experience that our governance architecture promises--
as evidenced by the quality of our new board--will assure that the
Exchange's regulatory function is both independent and robust. Thus, we
believe our architecture guarantees the independence of our regulatory
function both from members and member organizations and from
inappropriate linkage with our marketplace, while assuring the
function's sensitivity to the market.
Nevertheless, we note that we are not asking the SEC to approve
either the continuation of self-regulation through the NYSE or in the
United States generally. That issue should be addressed in the context
of how well the new board implements both the architecture and the
necessary programmatic changes to our regulatory function.
Thus, while the Exchange does seek the SEC's approval of what we
regard as a greatly improved architecture for self-regulation, it does
not seek the SEC's determination of the future of self-regulation at
this time. All the Exchange seeks at this time is the SEC's approval of
a transitional structure that allows it to move from the current
situation to one in which a board of independent, distinguished and
experienced men and women can take on the formidable challenges facing
the Exchange. We are hopeful that the SEC will see the wisdom of our
proposal, review it expeditiously, and approve it in short order.
Second, the new board will hold its organizational meeting next
week. Among its first tasks will be to identify the appropriate person
or persons to replace me as Chairman and CEO, and to identify a person
to assume the responsibilities of Chief Regulatory Officer. Thus, upon
the SEC's action, we will have a new board and permanent management in
place, that can then begin to demonstrate that the new governance
structure works and thereby begin to restore investor confidence in the
institution of the NYSE. This new leadership, the board of directors
and the board of executives, will also be in a position to openly and
collectively address issues of market performance, access and market
structure that--in addition to self-regulation--are important to the
continual modernization of our capital markets.
To conclude, I want to assure you that we understand the damage
done to investor confidence as a result of the Exchange's governance
failures. We believe that we are on the right path to creating and
implementing a governance process that will reduce and manage the
conflicts of interests inherent in self-regulation, and provide greater
transparency to ensure accountability. And we will not lose sight of
the critical business of the NYSE--the business of operating the
world's deepest and fairest equity market for the benefit of investors
and listed companies.
Again, thank you for the opportunity to appear before you today. I
would be happy to answer your questions.