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Unequal justice: Can the NYSE police itself?
A small transgression can get a broker banned for life, but a well-connected floor specialist who costs investors millions may get just a slap on the wrist.
By Michael Brush
On a hot summer evening in August 2001, far from the inner circles of Wall Street, a North Carolina brokerage rep makes two withdrawals from an ATM that will change his life forever.
Using a cash card he stole from a fellow worker, he takes out $320. In no time, investigators at the brokerage confront him with videotapes of the transaction, and soon hes out of a job. But things get worse for this young rep. The New York Stock Exchange (NYSE) -- using its powers as a self-regulating body -- boots him out of the securities industry forever. A lifetime ban for a $320 transgression.
Rewind three years, and, according to NYSE documents, an exchange specialist suspiciously closes the price of Safeway (SWY, news, msgs) stock several dollars above the last trade. The move produces an estimated $9 million loss for investors -- and possibly a $1 million profit for his own firm. The specialist and his firm are fined a portion of those amounts. But the specialist is allowed to keep his job.
Critics of the NYSE see a troubling irony in a string of cases like these. The NYSE severely punishes petty thieves, as it should. But many transgressions involving far larger sums -- as much as millions of dollars -- routinely draw lighter penalties for privileged specialists positioned at the peak of the NYSE power structure. They arent kicked off the exchange, raising suspicions that the exchange is a clubby fraternity that goes too easy on its own.
Consider the stark contrasts in punishment in the following pairs of cases, all involving "specialists" -- those Wall Street insiders who manage the frantic bidding process and thus the crucial setting of stock prices.
For three months in early 1999, a Spear, Leeds & Kellogg specialist lets "limit orders" from the public back up in the NYSE automated order routing system for as long as seven minutes. During the backup, according to NYSE documents, he and several other floor brokers take advantage of better prices in the very same securities, potentially costing the public tens of thousands of dollars in lost profits. The specialist loses $25,000 in fines -- but keeps his career and his job. In August 2001, a lowly sales assistant at a regional brokerage, however, is barred for life by the NYSE for ringing up $1,500 in personal expenses on her corporate card.
In 1998, a Corroon, Lichtenstein & Co. specialist repeatedly forges NYSE documents to make it look like he had permission to open certain stocks low enough to trigger stop-loss orders, the case files state. These are insurance orders placed by investors to sell a stock if it trades low enough. In 2000, the specialist pays fines and is given permission to return to the NYSE floor. He takes early retirement instead. But in 2001, a sales assistant in a regional brokerage office gets kicked out of the securities industry for life for forging a personal check for $474. (Susquehanna International Group, which bought Corroon after these events, did not return phone calls seeking comment.)
A failure of self-regulation?
Contrasting cases like these paint a picture of a system that seems to come down hard on rank-and-file workers, but lets specialists off relatively lightly for offenses involving much bigger sums -- which raises troubling questions about whether the NYSE should be allowed to police itself, say critics.
If you are a clerk and you steal some money, you get banned for life, says Ken Morris, a former Morgan Stanley trader and an outspoken critic of the exchange who helped point us to some of the juicier cases. If you are a specialist and you break the rules and fail at your job of protecting the public interest, you pay a small percentage of your profits for the year. This is a failure of self-regulation.
No less than the Securities and Exchange Commission agrees. The Wall Street Journal reported this week that a confidential report by SEC staff concluded in October that the exchange doesnt police its floor traders and even ignored blatant violations in which investors were shortchanged by millions of dollars in trades involving more than two billion shares over the past three years.
Floor traders routinely put their interests ahead of investors, and the exchange itself only mildly enforces its rules, the report says. Disciplinary actions, when they occur, are viewed as a minor cost of doing business.
To be sure, the three cases involving floor specialists discussed here aren't as clear-cut as a simple theft, from a legal point of view. To nail NYSE specialists with an actual crime, as opposed to a violation of the rules of a self-regulatory body, one must determine intent. Did the specialist manipulate the price of Safeway stock in order to make a personal profit? Or were his price-setting actions merely incompetent or tragically inefficient? Since no one but the specialist knows, its harder in these cases to prove intent and get a successful criminal prosecution.
But this legal distinction brings little comfort to the investors like you and me who may have lost huge sums of money because lax enforcement at the NYSE has allowed specialists to get away with dirty tricks.
Whats at risk goes beyond the money potentially lost by the public. Tales of suspicious activities by specialists -- like those emerging this week from the SECs ongoing investigation into the matter -- erode public trust in the cornerstone of our successful economic system, the stock exchange. It doesnt help that earlier this year we learned that top managers of NYSE-listed companies were on the pay committee that approved a bloated $140 million pay package for former NYSE chairman Richard Grasso, again raising suspicions of conflicts of interest at the exchange.
Or that, as the SEC report contends, specialists allegedly shortchanged investors at least $155 million in trades on 2.2 billion shares over three years. Granted, the average daily volume on the exchange is 1.4 billion shares. So, the trades in question are a small part of the volume. But the patterns are clear and longstanding.
No wonder that Fidelity Investments, the NYSE's largest client, wants to banish the human-run auction system that holds sway on the trading floor in favor of computerized trading that might be less subject to abuses. For a deeper sense of how expensive the abuses can be, let's take a closer look at the Safeway case, all from the case files of the NYSE.
The Safeway affair
On a fall day in 1998, a specialist for Spear, Leeds & Kellogg is presiding over intensely active trading of stock in Safeway, the grocery chain. Standard and Poors has decided to give Safeway a spot in its widely tracked S&P 500 ($INX) stock index, which means index funds will be buying Safeway shares in bulk at the end of the day.
But when the end of trading nears, NYSE documents show, the Spear, Leeds & Kellogg specialist, a senior member of his firm, is unusually silent, failing to provide the constant pricing guidance that traders rely on. Eventually, though later than he should have, he offers an "indication" that the closing price will be $52 a share -- a guess as to where the stock will trade once the dust settles. However, when the session ends, Safeway shares are priced at $55 apiece.
This difference is no small matter, as some 4.6 million shares are purchased at the closing price. It's safe to assume that most of the buyers are index-fund managers who have to buy at the closing price because of internal mandates. It's also likely that many of those 4.6 million shares that changed hands were sold by Spear, Leeds & Kellogg itself, which purchased them earlier in the day at much better prices.
First question: How much did investors like you and me lose in this fiasco? Well, as it turned out, the $55 price was a temporary spike. Both before and after that day's close, Safeway shares could have been had in huge volume for $53 a share or less. So, if we conservatively assume there was an unnecessary $2 premium for each of the 4.6 million shares sold at $55, investors lost more than $9 million.
Second question: How much of that could Spear, Leeds have pocketed? Unfortunately, we dont know for sure, because specialists dont have to open their trading records for the public to see. Indeed, thats one of the big problems for anyone trying to judge if the NYSE is doing a fair job in policing its own members, says Morris, the ex-Morgan Stanley trader who's also author of a financial novel called Man in the Middle.
It wouldnt be unusual, Morris said, for a specialist to offload 1 million shares in closing trades of 4.6 million. But even if it were one-fourth of that, or 250,000 shares, at a roughly $6 profit over the last price for the day ($49.37), the specialist would have generated more than $1 million on the transaction for his firm.
Those numbers again: A $9 million loss for mostly index-fund investors -- and a conservatively estimated profit of $1 million for Spear, Leeds.
The penalties: The NYSE fined Spear, Leeds $275,000 and the specialist himself $75,000. Unlike the ATM bandit, however, the specialist wasn't banned for life from the securities industry.
Sure, its possible all this was just a simple mistake in the confusion of the moment. The NYSE found the specialist was guilty only of failing to disseminate timely information about prices. And Goldman Sachs (GS, news, msgs), which bought Speer, Leads after the incidents mentioned here, says: Any suggestion as to the motivation on the part of the specialist is pure speculation.
NYSE: We dont have a double standard
NYSE regulators insist there's no double standard in how they punish bad guys. In each of the cases against specialists cited above, NYSE investigators concluded there was no intent to defraud the public, but rather some basic rules violations that were essentially honest errors. Otherwise, they say, stiffer penalties would have been handed out. Or else the SEC would have found there were securities law violations. It declined to do so in the Safeway case.
The bottom line of your question is, are specialists getting special treatment? says David Doherty, the exchanges head of enforcement. And the answer is they are not. When we find them breaking the rules, we impose what we think is an appropriate sanction. We have brought plenty of cases against all walks of life and we have used very substantial sanctions against specialists.
Indeed, the exchange booted out two Spear, Leeds & Kellogg specialists for life in 1999, for getting better prices for investments put into family accounts. The NYSE also banned two specialists for life for failing to give testimony in the mid-1990s. And since the mid-'90s, it has fined at least six specialists $100,000 to $275,000 for rules violations.
But for many experts in securities regulation, the jury is still out. Clearly, the NYSE board did not function effectively with respect to (the Grasso) compensation issues. It seemed to be beset with conflict of interest, says Joel Seligman, dean of the Washington University School of Law in St. Louis. The real issue is what effect that conflict of interest is having on things like the quality of surveillance and enforcement.
As more details emerge about the SECs investigation, were likely to see there was a big impact indeed, speculates Morris. The quality of surveillance was abysmal. The public has been taken advantage of, he says.
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