[Senate Hearing 109-998]
[From the U.S. Government Publishing Office]
S. Hrg. 109-998
A REVIEW OF SELF-REGULATORY
ORGANIZATIONS IN THE SECURITIES MARKETS
=======================================================================
HEARING
before the
COMMITTEE ON
BANKING,HOUSING,AND URBAN AFFAIRS
UNITED STATES SENATE
ONE HUNDRED NINTH CONGRESS
SECOND SESSION
ON
THE EXAMINATION OF SELF-REGULATORY ORGANIZATIONS IN THE SECURITIES
MARKETS, FOCUSING ON STRENGTHS AND WEAKNESSES OF THE CURRENT SYSTEM,
CONFLICTS OF INTEREST, AND ELIMINATING EXCESSIVE MARKET DATA FEES
__________
MARCH 9, 2006
__________
Printed for the use of the Committee on Banking, Housing, and Urban
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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 THOMAS R. CARPER, Delaware
JOHN E. SUNUNU, New Hampshire DEBBIE STABENOW, Michigan
ELIZABETH DOLE, North Carolina ROBERT MENENDEZ, New Jersey
MEL MARTINEZ, Florida
Kathleen L. Casey, Staff Director and Counsel
Steven B. Harris, Democratic Staff Director and Chief Counsel
Mark Oesterle, Counsel
Justin Daly, Counsel
Joseph Cwiklinski, Legislative Assistant
Dean V. Shahinian, Democratic Counsel
Alex Sternhell, Democratic Professional Staff
Joseph R. Kolinski, Chief Clerk and Computer Systems Administrator
George E. Whittle, Editor
(ii)
?
C O N T E N T S
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THURSDAY, MARCH 9, 2006
Page
Opening statement of Chairman Shelby............................. 1
Opening statements, comments, or prepared statements of:
Senator Sarbanes............................................. 2
Senator Hagel................................................ 3
Senator Schumer.............................................. 20
WITNESSES
John A. Thain, Chief Executive Officer, NYSE Group, Inc.......... 4
Prepared statement........................................... 31
Robert Glauber, Chairman and CEO, National Association of
Securities Dealers............................................. 6
Prepared statement........................................... 36
Henry T.C. Hu, Allan Shivers Chair in the Law of Banking and
Finance, University of Texas School of Law..................... 8
Prepared statement........................................... 40
Marc E. Lackritz, President, Securities Industry Association..... 11
Prepared statement........................................... 45
Richard Ferlauto, Director of Pension and Investment Policy,
American Federation of State, County and Municipal Employees,
AFL-CIO........................................................ 12
Prepared statement........................................... 53
Ann Yerger, Executive Director, Council of Institutional
Investors...................................................... 15
Prepared statement........................................... 55
(iii)
A REVIEW OF SELF-REGULATORY
ORGANIZATIONS IN
THE SECURITIES MARKETS
----------
THURSDAY, MARCH 9, 2006
U.S. Senate,
Committee on Banking, Housing, and Urban Affairs,
Washington, DC.
The Committee met at 10 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 will come to order.
Self-regulatory organizations have been a part of the
statutory scheme for the U.S. securities industry since the
passage of the landmark Federal securities laws in the 1930's.
At that time, Congress decided that investors would be better
served by ``cooperative regulation'' of the markets and market
participants. The SRO's, for reasons of proximity and technical
expertise, were given responsibility for supervising market
operations. The Securities and Exchange Commission would
oversee the SRO's, ``standing in the corner with the well-oiled
shotgun,'' as they said, if necessary. Of course, the markets
have grown dramatically in size and complexity since then, but
the basic structure remains in place today.
The level of success achieved by self-regulatory
organizations in protecting investors has been the subject of
considerable debate. In recent years, that debate has only
intensified, particularly in the aftermath of the governance
and specialist trading scandals at the New York Stock Exchange,
the largest SRO, and the NYSE's conversion from a not-for-
profit, member-owned organization to a for-profit, shareholder-
owned entity.
The performance of the self-regulatory unit at the New York
Stock Exchange has been a source of controversy. Between 1999-
2003, the regulatory program repeatedly failed to discipline
New York Stock Exchange specialists who were constantly trading
ahead of customer orders and pocketing a small profit on each
trade. All that skimming off the top cost investors $155
million over the 3-year period alone. In one particular case,
the senior specialist responsible for the trading of General
Electric and other blue-chip companies made 40,000 illegal
trades in three stocks over the 3-year period, according to the
Department of Justice and the SEC.
According to a Wall Street Journal report, a comprehensive
SEC investigation of the New York Stock Exchange regulation in
2003 revealed ``serious deficiencies,'' including a habit of
ignoring repeat violations by specialist firms. When the unit
did respond, it was usually a slap on the wrist and
``inadequate to deter future violations.'' In connection with
this scandal, last April, Federal prosecutors indicted 15 New
York Stock Exchange specialists for securities fraud. The
criminal probe grew out of a civil case brought by the SEC
against all seven New York Stock Exchange specialist firms. It
was settled for $247 million in 2004.
The New York Stock Exchange's record is especially relevant
now that it has become a for-profit entity. While there have
been changes in the Exchange's governance structure, questions
remain as to whether robust and vigorous self-regulation will
be subordinated to profit-making activities. This issue has
been one of concern to the SEC for some time. In 2004, the
Commission called the obvious conflicts between an SRO's
regulatory functions and its shareholders the most
controversial aspect of the current self-regulatory system.
Regulatory duplication is another issue that has arisen in
this debate. Almost 200 firms are members of both the New York
Stock Exchange and the NASD. For these firms, that means two
sets of rules, exams, interpretations and enforcement, and
fees. This dual structure for broker-dealers raises questions
relating to whether the high regulatory costs can be justified.
This morning we want to welcome a distinguished panel of
witnesses as we learn more about this. From left to right, no
stranger--a lot of you are not--to this Committee, Mr. John
Thain, Chief Executive Officer of the New York Stock Exchange
Group, Inc.; Mr. Robert Glauber, Chairman and Chief Executive
Officer, NASD; Professor Henry Hu, Professor of Law, University
of Texas Law School; Mr. Marc Lackritz, President, Securities
Industry Association; Mr. Richard Ferlauto, Director of Pension
and Benefit Policy, American Federation of State, County and
Municipal Employees AFL-CIO; and Ms. Ann Yerger, Executive
Director, Council of Institutional Investors.
Senator Sarbanes.
STATEMENT OF SENATOR PAUL S. SARBANES
Senator Sarbanes. Mr. Chairman, thank you very much, and
thank you for holding today's oversight hearing on self-
regulatory organizations in the securities markets.
It is, obviously, timely and appropriate that we are
examining the structure of our securities industry self-
regulatory apparatus, and examining thoroughly the issue of
whether there are any conflicts of interest, real or apparent,
which need to be addressed in a self-regulatory organization
conducting both its business and regulatory functions under the
same umbrella organization.
Yesterday, the New York Stock Exchange Group stock started
trading on the New York Stock Exchange. Upon approving the
merger, February 27, of the New York Stock Exchange and
Archipelago Holdings, Chairman Cox of the Securities and
Exchange Commission said ``the Commission is continuing its
review of our current regulatory structure for all self-
regulatory organizations,'' and he went on to pledge to
``enhance the independence and effectiveness of regulation for
the benefit of investors, our economy, and our Nation.''
I encourage the Commission to continue its review in light
of the comments that we have been receiving. For example, today
we will hear from Ann Yerger, representing the Council of
Institutional Investors.
Sometimes we read your statements ahead of time. I just
want to register that point.
[Laughter.]
That in the Council's opinion, ``an exchange faces an
inherent and untenable conflict of interest when it is
responsible not only for running an efficient and effective
marketplace but also for regulating its customers and
protecting the investing public.''
Earlier, in December of last year, the Wall Street Journal
editorialized, ``the NYSE could do a good turn by using its new
for-profit status as an excuse to spin off its self-regulatory
duties to an outside organization.''
USA Today, also back in December, reported that Columbia
Professor Jack Coffee, who has testified many times before this
Committee, says, ``that in a for-profit environment, it will be
difficult for NYSE regulators to exercise their most powerful
weapon--delisting a company--since it will deprive the parent
company of revenue. `If your principal sanction is delisting,
you almost never use it,' he says.''
And, yesterday, the Chairman and I received a letter from
Charles Schwab stating, ``one concern we have with the current
regulatory structure is the potential conflict of interest
inherent in a for-profit, self-regulatory organization . . .
This conflict has the potential to compromise the integrity of
our self-regulatory system. In our view, for-profit exchanges
should divorce themselves from the ownership of self-regulatory
organizations. The NASD is finalizing its complete separation
from the Nasdaq market and we believe that a similar course
would be best for the NYSE/Arca combination.''
We have received a number of comments, actually, on this
issue. A number of letters have come into the Committee, and,
of course, we will be reviewing those and the testimony this
morning very carefully.
I think this is an important issue, and I am pleased the
Chairman is focusing attention on it.
Thank you very much, Mr. Chairman.
Chairman Shelby. Thank you, Senator Sarbanes.
Senator Hagel.
STATEMENT OF SENATOR CHUCK HAGEL
Senator Hagel. Mr. Chairman, thank you. I have no opening
statement. Look forward to our witnesses' testimony this
morning, and appreciate them spending some time with us. This
is a critically important issue, not only for the reasons that
Senator Sarbanes outlined, but for other reasons, which will,
to a great extent, shape and frame the future for these
markets. So thank you.
Chairman Shelby. Mr. Thain, we will start with you. All of
your written testimony will be made part of the hearing record,
as you recall. You are no stranger to these proceedings. Thank
you, sir, glad to have you all here.
STATEMENT OF JOHN A. THAIN
CHIEF EXECUTIVE OFFICER, NYSE GROUP, INC.
Mr. Thain. Chairman Shelby, Senator Sarbanes, Senator
Hagel, thank you very much for inviting me to speak today on
the issues of self-regulation. I appreciate the opportunity to
address these issues and to respond to your questions from my
vantage point as the CEO of NYSE Group, the new public company
that, as you said, began trading yesterday. I do want to
mention that Rick Ketchum, who is here sitting behind me is the
CEO of NYSE Regulation, and so the regulatory piece of the NYSE
Group reports to Rick.
Let me first begin by briefly describing our own SRO
experience and lessons we have learned from that. Second, I
would like to discuss the new structure of NYSE regulation, and
finally, I would like to speak about the importance of reducing
duplication and the initiatives to achieve that goal, which you
also mentioned.
When I took this position 2 years ago as the Chief
Executive Officer of the New York Stock Exchange, our
marketplace was in a crisis for many of the reasons which you
articulated, the problems that occurred prior to my coming. One
of my first priorities was to restore investor confidence and
public trust in the Exchange. Toward that end, we created an
entirely new governance system based on three core principles.
The first was independence. We appointed a new Board of
Directors. Our Board is completely new. And stipulated that
except for me, because I am an employee, all of the members of
our board had to be completely independent, which means they
had to be independent of the member firms, they had to be
independent of the big broker-dealers. They had to be
independent of the listed company executive officers, the
companies listed on our Exchange.
The second principle we adopted was the separation of
duties. So we first separated the functions of the Chairman
from the CEO, so Marsh Carter is currently our Chairman. We
also separated--and this is the most important piece--the
regulatory functions from the business of the Exchange, so that
our regulatory functions, which are run by Rick Ketchum, never
intersect with the business of the Exchange, which I run. Rick
reported up to a subcommittee of the board. That subcommittee
of the board was called the Regulatory Oversight Board. That
board was made up of 100 percent independent directors, which
means it did not include me.
The third principle that we adopted was one of
transparency. We wanted to become fully transparent, so we now
have an annual report that has full financials and full
footnotes. We disclose the compensation of our top five
executive officers, and we also disclose all of our charitable
and political contributions.
Mr. Chairman, I believe that this new governance system
that we adopted that was approved by the SEC in December 2003,
has worked very well. It has worked well for our listed
companies, and it has worked well for investors. I believe the
principles of independence, the separation of the regulatory
functions from the business of the Exchange, and the
transparency, have made a major contribution toward restoring
confidence and trust in the New York Stock Exchange. In
changing our structure to become a public company, we have gone
even further to ensure that regulation will be both independent
and robust.
Under our new structure, which was approved earlier this
month by the SEC, Rick Ketchum is now the CEO of a separate
not-for-profit company inside the NYSE Group. This not-for-
profit company has its own board, which is totally independent,
except for Rick, who will be on the board and will be an
employee, but that board does not include me. So, again, total
separation from the business and the regulatory side.
Importantly, the new NYSE Regulation Board of Directors, is
also made up of a majority of directors who do not sit on the
board of the new public company, NYSE Group. So in addition to
the total independence of the public company board, we also
have a majority of unaffiliated directors on the Regulatory
Board.
NYSE Regulation also has its own contractual funding
agreement with the NYSE Marketplace, and the regulatory company
cannot distribute any excess cash outside of NYSE Regulation,
nor can it use fine income for anything other than regulatory
purposes. I believe that no other exchange in the United States
has this level of independence from the industry that it
regulates. We believe that the SRO system not only ensures
independence, but it is also better.
Why? Because of the proximity of the regulatory functions
to the market. We live in a new financial era of high-speed,
multiproduct, very rapid electronic trading. Regulators who are
closer to the markets and who work in real time, can more
readily stay ahead of the curve and anticipate changes that are
going on in the marketplace.
I had the opportunity to observe firsthand, in my prior
life at a very large investment bank, and in my experience
there, the New York Stock Exchange Regulation had a better
understanding of the business of the broker-dealers, and I
believe in large part that is because they were closer to the
marketplace. Regulators working in close proximity are also
better positioned to design cost effective regulatory
solutions. An example is the way that we have worked with Rick
Ketchum and his team as we developed our hybrid market
initiative. Having the regulatory functions involved in the
design process from the outset has enabled us to build
regulatory protections into the software platform as it is
developed. We believe that proximity produces better, more
nimble regulation, and we believe it is also better for the
business of the Exchange.
Why is that? Because we compete by striving to offer the
highest value package to investors and to our listed companies,
and part of that value package is determined by the quality of
our market. Companies list on our exchange because we offer the
highest standards in the world, and a well-regulated market is
an indispensable ingredient of market quality and the trust of
investors. Therefore it is essential to the business of the
Exchange to have good, well-functioning independent regulation.
Let me turn to the examination of our member firms and the
importance of reducing regulatory overlap. Both Rick Ketchum
and I have spoken on this issue, and have taken steps to
address this; however, we still need to do more work. We need
to rationalize rules. We need to avoid duplication, and we need
to use our resources wisely to ensure that investors and
issuers have confidence that they are protected by a strong
regulatory structure. Ending regulatory duplication is a top
priority.
We believe that this initiative should go forward through a
joint venture with NASD. I invite our colleagues at the NASD to
work with us to develop a common approach of joint governance
and joint ownership of the responsibilities of regulating the
member firms. We are supportive of adopting a single set of
rules. We support a single-member firm examination process. We
are committed to working with NASD, with the SEC, and with the
Members of this Committee, to achieve the best solution for
U.S. markets and investors.
Finally, let me close by noting that these regulatory
issues should not be taken in isolation. U.S. financial markets
operate today in an increasingly competitive international
capital market. Regulation that is ineffective or unworkable
will place U.S. financial markets at a disadvantage in the
global competition for capital, and will discourage companies
from coming here to list in our marketplace. Regulation that is
sound and sensible will help U.S. financial markets to remain
competitive, and to provide the optimal environment for
economic growth, job creation, and prosperity.
In conclusion, Mr. Chairman, we are confident that the
regulatory model established for the New York Stock Exchange
will provide independent, robust, and efficient regulation that
inspires confidence among investors and our listed companies in
a time of rapidly changing and competitive markets.
I thank you for giving me this opportunity. I will be happy
to answer questions.
Chairman Shelby. Thank you.
Mr. Glauber.
STATEMENT OF ROBERT GLAUBER
CHAIRMAN AND CHIEF EXECUTIVE OFFICER,
NATIONAL ASSOCIATION OF SECURITIES DEALERS
Mr. Glauber. Chairman Shelby, Senator Sarbanes, Senator
Hagel, good morning and thank you. I am Robert Glauber,
Chairman and CEO of NASD, a private sector regulator of the
U.S. securities industry. I am grateful to the Committee for
inviting me to testify on the current and future state of the
self-regulatory system. This is a terribly important subject.
The Committee is to be commended for addressing it. As the
Committee begins to examine the changing nature of securities
regulation at a time when exchanges are demutualizing and
becoming for-profit, publicly traded companies, I think it is
important that the recent evolution of NASD be understood.
Mr. Chairman, we are at a watershed in our capital markets
history. The U.S. capital markets are unique in that they are
markets with huge retail investor participation. This
involvement is based on trust. As market centers migrate from
nonprofit facilities to for-profit enterprises, the best way of
ensuring that that public trust is maintained is by clear
separation of the regulation of securities firms, which are, of
course, customers of the exchanges into an independent SRO.
As you know, NASD was the creator, owner, and regulator of
Nasdaq. In the mid-1990's NASD faced a conflict that
fundamentally altered its existence. The SEC found NASD to be
negligent in how it regulated its member firms and their
trading on Nasdaq. This finding called into question NASD's
governance structure and whether it was appropriate for
maintaining both the regulation of securities firms and the
operation of a trillion dollar trading market.
As a result, NASD formed two subsidiaries: NASD Regulation
and Nasdaq. And just importantly, we implemented a new
governance structure that ensured a majority of NASD's Board of
Governors would be from outside the securities industry. But
when Nasdaq decided, in 2000, to become a for-profit,
shareholder-owned, and publicly traded company, the conflicts
confronting NASD as a regulator increased significantly. The
challenge for NASD was to create a corporate structure that
would assure the public that commercial, financial, and stock
price considerations did not taint regulatory decisions. We
chose complete structural separation between Nasdaq and
Regulation, in a completely separate SRO, two separate
managements, two separate nonoverlapping boards, two separate
balance sheets. In January, this separation was completed when
the SEC designated Nasdaq as an exchange. NASD still regulates
trading on Nasdaq under contract.
Yesterday, as all of us know and have discussed, the NYSE
began a new era as a for-profit, shareholder-owned exchange.
Whether it should continue operating as a regulator, especially
of firms that are also its customers and competitors, has been
the subject of a great deal of healthy and needed debate in our
industry, and, of course, discussion in this Committee. The
concern is that for-profit, publicly traded exchanges will be
faced with the conflicting goal of having to maximize profits
while not compromising regulation.
Mr. Chairman, late last year, the SEC floated some
alternatives to the present SRO system. The SEC recognized
there were inherent conflicts and inefficiencies in the current
regulatory environment. As we told the SEC in our response, one
glaring inefficiency in today's regulatory scheme is the dual
regulation of firms that are members of both the NYSE and NASD.
Currently, these approximately 200 firms, the largest firms,
are faced with dual rule books, dual examinations,
interpretations and enforcement, and dual fees.
A solution that could deal with this is a partnership
between the NYSE and NASD to handle the regulation of the firms
that are members of both organizations. Under such a
partnership, firms would be regulated according to one rule
book instead of two. They would pay one regulator instead of
two, and they would have only one examination and enforcement
staff to contend with, significantly lowering their compliance
costs.
NASD believes that one very effective approach to such a
partnership would be some form of the hybrid models set forth
by the SEC in its concept release. The hybrid model would pull
the regulation of all securities firms, who do business with
the public, away from the exchanges, and unify such regulation
under a single SRO.
Meanwhile, market surveillance and listing standards would
be left at the specific exchanges. This model would enhance
efficiency by eliminating inconsistent rules, eliminating
redundant infrastructure, strengthening intermarket
surveillance, and meaningfully reducing the current conflicts
in the self-regulatory system.
It is no secret that there have been discussions between
NASD and the NYSE about how a partnership could work. While it
is too soon to know where these discussions will lead, my hope
is that our two organizations can find a way to create a
structure that best serves investors and solves some of these
vexing problems.
To best protect the interests of investors, any new
structure will have to solve the conflict inherent in both
regulating and managing a for-profit exchange. The regulator
will have rule-writing and enforcement authority over firms
trading on the exchanges for sales practices, financial
operations, and transaction routing decisions. Thus, absent
complete separation of a for-profit exchange and regulation of
its member conduct, there is an unavoidable inherent conflict
that regulation of member conduct may be influenced by the
commercial, financial, and stock price impact of such
regulation on the affiliated exchange.
That is the guiding principle for NASD as we move forward
in any discussion about SRO consolidation. We cannot agree to
any structure that would result in a loss of independence over
rule-writing, as well as examination, investigation, and
enforcement. It would be a case in any 50/50 joint venture,
where each side holds a veto over the other.
As we stated earlier, NASD has worked diligently over the
last 5 years to become an independent, unconflicted regulator
that does not own or control markets. Any integrated structure
with NYSE cannot cause us to give up that independence and the
benefits it brings to investors.
Mr. Chairman, that concludes my statement. Again, thank you
for inviting me, and I look forward to answering your
questions.
Chairman Shelby. Thank you.
Professor Hu.
STATEMENT OF HENRY T.C. HU
ALLAN SHIVERS CHAIR IN
THE LAW OF BANKING AND FINANCE,
UNIVERSITY OF TEXAS SCHOOL OF LAW
Mr. Hu. Mr. Chairman, Senator Sarbanes, Senator Hagel,
thank you for inviting me. My name is Henry Hu, and I hold the
Allan Shivers Chair in the Law of Banking and Finance at the
University of Texas Law School. My oral and written testimony
today reflects my preliminary personal views, and does not
represent the views of my employer or any other entity. In the
interest of disclosure, I had served, without compensation, on
the Legal Advisory Board of the NASD.
While the topic of today's hearing opens the door to a
number of important issues, I would like to focus on the
delicate questions raised by the relationship between NYSE
Regulation and NYSE Group. I am concerned about the issue of
togetherness, the structural and institutional bonds that link
NYSE Regulation and NYSE Group. Ironically, the Exchange has
long been the symbol of American capitalism, notwithstanding
its nonprofit status. Now, as the Exchange is itself joining
the capitalist parade it holds a nonprofit entity close to its
heart.
This is a curious structure, one where ends and means do
not quite seem to line up. From the standpoint of first
principles, it is extremely difficult to ensure that an
organization actually pursues the objectives the organization
is supposed to pursue. As Members of Congress, you are well
aware that bureaucracies often take on a life of their own,
developing their own agendas, pursuing their own interest.
Simply setting out the formal ends of an organization is not
enough. Experience demonstrates that carefully conceived legal
and other mechanisms are essential.
Even when relatively simple ends are involved, ensuring
that an organization follows those ends is a difficult task.
Elaborate legal and market-driven means are necessary, and they
sometimes do not work. We need look no further than the
publicly held corporation.
The theme of means and ends has dominated thinking about
governance of publicly held corporations since the 1930's.
Modern corporate governance has largely revolved around one
question: What mechanisms will lead managers to act in the
interest of shareholders, that is, to act in accordance with
the formal ends of the corporation?
So in terms of legal means, we have State substantive law,
as well as Federal disclosure requirements. In terms of market
means we have institutional investor activism and the pervasive
threat of corporate takeovers to discipline wayward managers.
This highly sophisticated system has evolved over many
decades with the benefit of both hard experience and new
learning. Yet, in the cases of Enron, WorldCom, and other
corporate debacles still fresh in our minds, all of the legal
and market mechanisms, all four engines on the jet plane,
failed simultaneously. The scandals remind us of the difficulty
of ensuring that corporate managers behave in a manner
consistent with even ``simple'' ends. Today, our system for the
governance of the publicly held corporation, although the best
in the world, is still a work in progress.
Turning to the new corporate structure of the New York
Stock Exchange, our previous example of the typical corporation
with a relatively one-dimensional objective, serving
shareholder objectives, becomes far more complex. Here, the
ends diverge along different paths: Shareholder wealth
maximization at the level of the holding company, but the
fulfillment of regulatory responsibilities at the level of a
wholly owned subsidiary. The governance question this Committee
must consider revolves around this question: Are the legal and
other mechanisms equal to the task of ensuring adherence to
these complex ends?
The written testimony has the analysis of some of the
structural features, so I want to focus on, in a sense, my
preliminary conclusions instead here in this oral testimony,
that is, that the legal protections created by the Exchange to
avoid conflicts and to protect the integrity of its dual
functions appear robust, but let us take a closer look.
With respect to the legal framework, a fundamental
assumption of the new governance structure is the notion the
NYSE regulations, independence will be preserved by limiting
the participation of NYSE Group's directors on NYSE
Regulation's board. The basic argument is that because only a
minority of directors on NYSE Regulation's Board and various
committees, will come from NYSE Group, that truly independent
NYSE directors are in full control and completely directed to
proper regulatory ends.
I am not fully persuaded by this minority of directors
argument. A minority position does not automatically equate to
minority influence or minor influence. For example, let us just
say that the Chairman of the NYSE Group happens to be one of
the members of NYSE Regulation's Board. He would be the 800-
pound gorilla in the room.
Moreover, board meetings generally operate through
consensus, not by actual contested voting. Thus, the fact that
NYSE Group directors constitute a minority of NYSE Regulation's
Board does not render them powerless over important regulatory
decisions. And the reality is, many corporate boards operate
with a certain element of structural bias, a ``go along to get
along'' mentality.
Another structural concern that warrants the Committee's
attention is the relationship between NYSE LLC and NYSE
Regulation. NYSE LLC is a wholly owned subsidiary of the NYSE
Group, and a vital element in the NYSE Group's efforts as
shareholder wealth maximization. Although NYSE LLC lacks
authority over NYSE Regulation's individual disciplinary
actions--and there is SEC oversight--NYSE LLC does have
authority over other actions undertaken by the regulatory arm.
Indeed, NYSE LLC has explicitly retained a right to, among
other things, resolves any disputes between NYSE Regulation and
NYSE Market.
The foregoing focuses on formalisms, on these boxes that
are created. As we all know, in the area of executive
compensation, actual incentive structures matter. In the case
of NYSE Regulation, compensation will be set by its board. But
as discussed above, the board remains susceptible to NYSE
Group's influence. In addition, because of likely differences
between NYSE Group and NYSE Regulation compensation, the
prospect of an alternative career path at the for-profit parent
level may be attractive to those at NYSE Regulation.
In conclusion, SEC Chairman Christopher Cox has stated that
he intends to closely monitor the NYSE's performance under the
new structure. This is commendable. It is also vital. The not-
for-profit NYSE Regulation, within the for-profit NYSE Group
structure is an experimental structure. It is one that is far
more complicated than that of the usual publicly held
corporation. Yet, ironically, the legal and market mechanisms
in place seem far more primitive than those operating in the
publicly held context.
When the playwright, Henrik Ibsen was ill, a nurse came to
take a look. The nurse said to Ibsen that he ``seemed to be a
little better.'' Ibsen said, ``[o]n the contrary''--and died.
[Laughter.]
It is important to go beyond a quick look. It is important
to go beyond stated goals and to try to assess whether the
legal and market mechanisms in place will in fact nurture and
sustain those goals. I say ``maybe.''
Thank you.
Chairman Shelby. Thank you, Professor.
Mr. Lackritz.
STATEMENT OF MARC E. LACKRITZ
PRESIDENT, SECURITIES INDUSTRY ASSOCIATION
Mr. Lackritz. Thank you, Mr. Chairman, Senator Sarbanes,
and Senator Hagel. Thank you very much, Mr. Chairman, for
holding this hearing, and thank you very much for the
opportunity to testify on this very, very important issue.
Mr. Chairman, as we have often testified, our Nation's
securities markets are the most transparent, liquid, and
dynamic in the world, and self-regulation has really been a
critical ingredient to our success. Self-regulators or SRO's,
are on the front line and have an intimate knowledge of the
operations, trading and practices. As a result, they can
develop rules quickly, and set standards that exceed statutory
or even common law legal minimums.
Despite these compelling benefits, Mr. Chairman, self-
regulation has two drawbacks. First is conflicts of interest
between SROs' roles as both market operators and regulators,
and second, regulatory inefficiencies resulting from
duplication among SRO's.
To address these deficiencies, we have supported a
consolidated hybrid for broker-dealer regulatory functions for
firms that are regulated by both the New York Stock Exchange
and the NASD. This consolidated self-regulatory structure would
eliminate conflicts of interest and regulatory duplication. In
addition, a single principles-based rule book would strengthen
investor protection and improve the global competitiveness of
our markets.
Mr. Chairman, our primary concern revolves around conflicts
of interest as for-profit SRO's attempt to wear two hats, as
both market operators and regulators. The recent merger of New
York and Archipelago fell short of the separation that is
necessary to insulate regulation from the business interest of
its for-profit parent. However, we have no interest in
disturbing that restructuring. Rather, we hope that the SEC,
with the support of this Committee, will ensure that the New
York and NASD move the primary source of the conflict,
regulation by the New York Stock Exchange of its competitors,
into an entity that consolidates their overlapping regulatory
programs.
Other major concerns include duplicative regulation and
redundant infrastructure. Both the New York Stock Exchange and
the NASD frequently adopt separate rules on similar or
identical topics, leaving many firms to cope with two different
recordkeeping, procedural and audit trail requirements for the
exact same product or service. It is a little bit like trying
to play basketball, following both the college rules and the
pro rules at the same time. The resulting unnecessary
compliance costs obviously impact our firms and their
customers, the investors, by either increasing costs or
reducing choices.
Now, consolidation of New York and NASD rules make sense to
ensure global competitiveness. But in light of the variations
in institutional culture, history, and constituency between the
New York and the NASD, just reconciling existing rules will be
inferior to what could be produced by a single regulator.
Think if--and I apologize to my colleagues--if Hemingway
and Faulkner--see, I thought by citing Hemingway and Faulkner I
would be reaching for the stars, but I did not realize
Professor would going to cite Henrik Ibsen, so I am obviously
way behind here.
But think about if we urged Hemingway and Faulkner to
harmonize their work. Right now, actually, is an ideal time for
a new risk-based rule book, and consolidated interpretations,
examinations, and enforcement can follow.
Mr. Chairman, in brief, what we are looking for is a single
set of rules, a single set of interpretations, a single set of
examinations, and a single organization. The SRO's have broad
agreement that consolidation is needed, but differences on
details remain. As you have heard earlier, the New York favors
a true joint venture controlled by both SRO's, while the NASD
wants to move the New York regulatory functions into itself, or
to create an entirely new regulatory entity.
Any of these approaches, Mr. Chairman, could eliminate the
conflicts of interest and regulatory inefficiency that would
create a single entity that is responsive, accountable,
transparent, and well-funded.
We strongly urge this Committee, Mr. Chairman, and the
Securities and Exchange Commission, to take the lead on
capitalizing on this present opportunity. The differences
between New York and the NASD are much less significant than
their agreement that consolidation should occur. As long as the
SEC and this Committee stay engaged, these differences should
be bridged in short order.
In summary, Mr. Chairman, we ask for one set of rules, one
set of interpretations, one set of examinations, and one
organization. We must remove these conflicts of interest and
regulatory inefficiencies if we are to maintain the preeminence
of our securities markets and our securities industry. We are
here to work with all the parties that are interested in this
to achieve the result.
Thank you very much.
Chairman Shelby. Thank you.
Mr. Ferlauto.
STATEMENT OF RICHARD FERLAUTO
DIRECTOR OF PENSION AND INVESTMENT POLICY,
AMERICAN FEDERATION OF STATE, COUNTY, AND
MUNICIPAL EMPLOYEES, AFL-CIO
Mr. Ferlauto. Good morning, Chairman Shelby, Senator
Sarbanes, Senator Hagel, and Senator Schumer. My name is
Richard Ferlauto. I am the Director of Pension and Investment
Policy at the American Federation of State, County, and
Municipal Employees. Our union represents 1.4 million State
government health care and child care workers.
I appreciate the opportunity to appear before the Committee
on behalf of AFSCME. I am also representing the views of the 9
million member AFL-CIO to discuss regulation of the New York
Stock Exchange.
The appropriate level of regulation and oversight of
capital markets is a key concern to us because it impacts on
the financial condition and retirement security of every
working family in this new ownership society. As a matter of
fact, AFSCME members, through the public pension systems, have
assets totalling well over one trillion dollars in the public
markets. These public systems lost more than $300 billion in
assets due to the loss of market confidence in the 2 years
following the scandals of Enron and WorldCom. That totaled
about 15 percent of the net assets, and one reason our defined
benefit plans are now underwater, if you will, in many places,
is because of the impact of those scandals.
All told, union members participate in benefit plans with
well over $5 trillion in assets, not including the individual
dollars that our members invest as individuals, which is about
that same number.
Institutional investment funds are highly indexed, and are
long-term owners as patient investors. Confidence in the
markets, transparency, and appropriate regulation are the
foundation of their success as investors.
As a matter of fact, for our retial, our individual
investors who are our members, information and regulatory
support is absolutely key to their success in managing their
personal savings.
The AFL-CIO and AFSCME are convinced that the NYSE and
other self-regulatory organizations play an absolutely vital
role in the marketplace. We have been supportive of NYSE's
unique strengths as an in-person market maker. As a matter of
fact, we have well over 200,000 members who rely on the
economic dynamisms of the NYSE in the metro region and are
strong supporters of that organization.
But, very importantly, the recent conversion to for-profit
status and its unwise determination to retain and finance its
regulatory unit within the NYSE Group creates a clear conflict
of interest, which we believe poses a significant danger to
investors.
We urge Congress to call on the SEC to directly regulate,
or in an alternative, to support the creation of a genuinely
independent organization to regulate the NYSE. Whether
regulation is a hybrid model between NASD and the NYSE, or an
individual regulation model, or the partnership described by
Mr. Glauber earlier in his testimony, we believe that
independence is vital.
As Mr. Glauber has said before, there was a conflict in an
enterprise operating as a regulator.
As a matter of fact, there are many new statistics we could
cite and examples we could talk about. A recent report by
Glass, Lewis, a proxy advisory firm, shows that the amount of
company restatements has doubled in 2005, and as a matter of
fact, in the NYSE, 12 percent of their listed companies had to
restate last year. We are very concerned that the lack of
significant and aggressive regulation has led to some of those
restatements.
There are a number of examples that I would like to cite
that further indicate the problems that we see. One is the case
of Qwest. It is a company that has had a troubled financial
history, and it took investors and the NYSE an extended period
of time before we were able to get reliable reports out of that
company.
Most recently, we have had Sovereign Bank that was able to
proceed with a restructured sale of stock in which they were
able to sell Treasury shares in order to skirt NYSE listing
standards on technical grounds.
Following that we had a similar problem with Fannie Mae.
Fannie Mae was also able to skirt rules around delisting
requirements. It is also interesting to note that Fannie Mae
pays an annual listing fee of half a million dollars to the
NYSE. So that there is a direct conflict of interest that we
see.
As a matter of fact, as Professor Hu talked about earlier,
even though a majority of directors are so called independent,
in fact, a significant number of the board of the NYSE
Regulatory Group will overlap, and we believe that any
overlapping at all causes a conflict of interest.
We urge Congress to work with the SEC with the goal of
eliminating self-regulation by the exchanges. The Commission
should set timelines for pursuing reform goals, and open up the
process through public roundtables and other forums allowing
for investor participation and public engagement.
The oversight role of the SEC might be enhanced during this
review of the powers of SRO's. While the Commission has the
power under the Exchange Act to improve changes in SRO rules,
the full extent of its authority remains unclear and has caused
concerns for investors for many years. For example, as
investors focused on corporate governance, which many of our
public funds are, we believe that the Commission should have
the ability to regulate listing standards, contrary to the
limitations imposed by the SEC on the business roundtable
versus the SEC.
Despite these concerns, we are also afraid that the SEC
does not have or will not have the administrative capacity to
guard against the NYSE's historic lack of oversight. We are
very concerned that the annual budget for 2005 reflects actual
program costs, which is a cut back from prior years. As a
matter of fact, the 2005 annual report for the SEC notes that
staff turnover is up 7.5 percent, the highest turnover rate
since 2001.
So we support a regulatory structure for the NYSE that
fosters investor confidence, ensures fairness for all market
participants, and encourages competition to promote efficiency
in today's markets. This system should ensure that all
exchanges meet or exceed established standards for investor
protection, and should prohibit a race to the bottom.
Equally important, this system should guarantee regulatory
oversight functions that are adequately and securely funded.
Simply, we believe that there should be no conflict of
interests between the regulator and the owner, and this calls
for complete separation between the two.
And I might add, given Mr. Lackritz's testimony before
mine, I think this is one occasion where we agree completely in
terms of a regulatory approach. It is a very odd occasion.
Thank you very much, Mr. Chairman.
Senator Sarbanes. Another first has been accomplished here
this morning.
[Laughter.]
Ms. Yerger. Miracles can happen.
Chairman Shelby. Ms. Yerger.
STATEMENT OF ANN YERGER
EXECUTIVE DIRECTOR,
COUNCIL OF INSTITUTIONAL INVESTORS
Ms. Yerger. Good morning. I appreciate the opportunity to
share the Council's views on SRO's and the securities markets.
The Council shares the prior panelists' concerns over the
potential conflicts facing an exchange, particularly in a for-
profit context, when it is responsible, not only for running a
marketplace, but also for regulating its customers, its
competitors, and protecting investors.
The Council believes separating the regulatory and exchange
functions is the best way to protect the 84 million Americans
and others investing their hard-earned savings in our U.S.
equity markets.
Council members number more than 130 public, corporate, and
union pension funds with more than 3 trillion in assets. They
are long-term investors in our markets. They have a very
significant stake in the success of the markets. As a result,
they are keenly interested in keeping the U.S. markets the best
in the world. They strongly support the Exchange's work to
provide the highest quality, most efficient, and cost effective
marketplaces.
However, a critical component of market effectiveness and
success is investor confidence. Part of that confidence comes
from knowing that rules and safeguards are in place to protect
investors. Unfortunately, lapses in self-regulation over the
years, including failures to adequately oversee specialists,
enforce rules, and maintain up-to-date listing standards have
harmed investors and shown that the SRO model is in need of
reform.
The Council has three recommendations. First, we believe
regulatory arms should be independent of the exchanges, and
they should be securely and fully funded. Such structures are
currently in place at the NASD. They are not at the NYSE. We
believe the structure of NYSE regulation would be greatly
improved if it were independent of the NYSE Group, and it
shared no directors with the public company. We believe the
need for independence also applies to any merger of Exchange
regulatory operations. While such a combination certainly could
improve efficiencies, it would be deeply flawed if it failed to
be independent of the exchanges.
Second, listing standards should be a regulatory
responsibility, and processes should be in place to keep these
standards current. In the Council's experience, the exchanges
have been hesitant to update their listing standards, perhaps
for fear of upsetting listed companies and driving business to
competing exchanges. As a result, too often it has taken major
corporate scandals, along with suggestions from the SEC to prod
the exchanges into action. The Council's written testimony
details a few examples of challenges in this area. It took
nearly 8 years to strengthen the rights of owners to vote on
equity compensation plans. More than 10 years of discussion has
not yet changed the NYSE's 70-year-old rule allowing broker
votes, a process which the Council believes amounts to ballot
box stuffing for management.
Third, SEC oversight of the SRO's, particularly of listing
standards, should be strengthened. The SEC's oversight role is
an important safety net to ensure that SRO's continue to
protect investors and the integrity of the marketplace.
However, the SEC's power over listing standards has been
unclear, particularly since a 1990 court ruling invalidating
the SEC's imposition of a one-share one-vote listing standard.
Since then, the Commission seems reluctant to do more than use
a bully pulpit to encourage reforms at the exchanges. The
Council believes Congress can and should clarify the SEC's
authority to amend or impose listing standards when doing so
would protect investors and serve the public interest. Such a
reform would help curtail the challenges currently faced by
investors interested in modernizing listing requirements.
In conclusion, this is a transformative time for our
capital markets, and we believe it is an opportunity to put in
place not only the best structures for the marketplace, but
also the best structures for the regulatory arms.
Thank you for considering this important issue.
Chairman Shelby. Thank you, Ms. Yerger.
Professor Hu, I will direct this question to you. When
other stock exchanges across the globe demutualized and became
for-profit entities over the past 10 years or more, I
understand that they all took steps to ensure structural
separation between the supervisory authority and the management
of the exchange. I am referring to the London Stock Exchange--
correct me if I am wrong--Euronext, the Hong Kong Exchange, the
Exchange in Stockholm, the Australian Stock Exchange, the
Singapore Stock Exchange--these are busy exchanges--and others.
So is it your understanding as well, Professor, and if so, what
is your view about the New York Stock Exchange going forward
employing a different structure? Do you feel this structure
could have implications for investor protection?
Mr. Hu. The bottom line is, I think that this structure
represents the triumph of hope over experience. In terms of the
various exchanges that have demutualized, they vary all over,
they go all over the map in terms of how they achieve this
separation. As you know, this trend basically accelerated only
in the past few years. So it is still an ongoing experiment,
but people have recognized throughout the world the need for
this separation.
In terms of the London Stock Exchange, the one that
probably is the one we want to look to most carefully simply
because, well, you know, it is the Anglo-American system of
corporate governance, and the London Stock Exchange, preeminent
for a long period of time, and in terms of the London Stock
Exchange and its relationship to the FSA, I think it is
particularly instructive.
The London Stock Exchange, basically in terms of its power
overreach, in a sense, the regulatory power, essentially
focuses only on trading, only in trading. In terms of, for
instance, the listing and delisting powers, it is up at the
financial services supervisory authority, at the FSA, the super
regulator that controls fairness, transparency, and order of
conduct in the financial markets, overseeing basically all U.K.
financial banking markets, basically takes over delisting-
listing powers, and retains general oversight of the LLC. The
LLC is focused on trading.
In terms of some other examples, the Toronto Stock
Exchange, basically keeps the listing-delisting powers, but the
Market Regulation Services Authority is this national
authority, basically has everything else.
So you see, patterns differ, but there is this expressed
concern in terms of how you adjust for these conflicts.
Perhaps the most extreme example of not trusting the
markets, may be in Germany, in terms of Deutsche Borse. the
regulation of Deutsche Borse is basically controlled by the
Hessian Ministry of Finance, the government. So it is all over
the map.
It is too early to figure out what the lessons are in terms
of these experiences. We have not really seen what happens in
terms of market stress, or fraud, or those other things, but I
would like to think about the fact that these issues really
coming to a head for instance, those NYSE Group directors who
also happen to serve on the board of NYSE Regulation. They have
a divided allegiance, as at the parent company level, they are
supposed to do everything they can to maximize the wealth of
shareholders. But when they have their hat on as members of the
NYSE Regulation Board, they have responsibilities to fulfill
the regulatory ends of NYSE Regulation. They are put in a real
spot in terms of normal corporate governance, this kind of
thing comes up when say a controlling shareholder has directors
on the board of its subsidiary.
Corporate law goes all over the map in terms of how you
control these conflicts, but it is a very difficult, precarious
situation.
Chairman Shelby. Mr. Thain, you want to answer that?
Mr. Thain. Sure. I think there are two pieces here. When we
talk about regulation, the regulatory functions really oversee
three distinct groups. First, they surveil the market itself.
And if you look at what other exchanges around the world do,
many of those exchanges have maintained their surveillance of
the trading activities inside the exchange functions. They have
not separated that out. There are lots of example, actually,
both in the United States as well as internationally, the
Boston Exchange, the Philly Exchange, all the futures
exchanges, as well, actually, London Stock Exchange, a
significant part of the markets, the trading itself, is
actually maintained inside the exchange.
The second major piece is the listed companies. Here, what
is particularly interesting is we took our listed company
compliance and moved that to the regulatory side. In the case
of Nasdaq, the regulatory compliance of listed companies with
the listing standards is actually directly reporting to the
business of Nasdaq. So here we have a circumstance where best
practice would say the listed company compliance should be
separated and put inside the regulatory function. In the case
of Nasdaq, it continues to report directly to the businesses
exchange.
The third piece which you have heard the most about is the
member firm examination, and there are different models, and as
a matter of fact, what is interesting is the model that the
futures markets have taken, where they have actually combined
and they have created an association, a group, a partnership,
to create one set of rules and one examination process. And,
again, I actually think that there is pretty broad agreement
here that we do want to have one set of rules and that we do
want to have one examination process, and the real question is
how we get there.
The second thing I want to talk about just for a moment is
this governance question, because Professor Hu made a very
interesting point about minority positions on board and having
a minority of the directors of the regulatory board coming from
the parent company board. This goes to the point that there is
no perfect model here. NASD's board has a very significant
number of its board members directly affiliated with the
members who it regulates. So if you believe, as Professor Hu
said, or actually as Mr. Ferlauto said as well, that a minority
position on the board can represent something beyond minority
influence, then NASD should not allow any of its board members
to have affiliations with its members that it directly
regulates.
Chairman Shelby. Thank you.
Do you have any response to that?
Mr. Hu. I agree totally with Mr. Thain that no model is
perfect. Indeed, in my written testimony, I acknowledge that
even with a traditional SRO, there are conflicts and it is far
from a perfect model.
My point relates in part to the experimental structure of
the setup here, the complexity and ends in terms of shareholder
wealth maximization, at the parent level for regulatory
purposes at the subsidiary level. It is tough to get things
right as far as getting organizations to actually behave. With
a traditional SRO, we basically have more experience. We have
learned some things, and that we are constantly tweaking with
the structure. And in terms of a traditional SRO the ends are a
little bit simpler. There is no profit end that we have to
contend with.
So, I agree totally with Mr. Thain. Every system has flaws,
and the issue is--and we also have to take into account what--
--
Chairman Shelby. What is the best system, that is what we
are getting to, is it not? What would be the best system?
Mr. Hu. This, obviously, calls for a major research grant.
[Laughter.]
Chairman Shelby. Thank you.
Senator Sarbanes, I have to share my time.
Senator Sarbanes. Thank you very much, Mr. Chairman.
First of all, I want to thank each of the panelists for the
care and thought that obviously has been put into your prepared
statement, and your oral presentations, but the prepared
statements are all quite lengthy, and they have obviously
reflected a very careful consideration of the issue, and we
appreciate that very much. It is enormously helpful to us to
have that material.
Mr. Thain, I want to address this issue to you first,
because a lot of the focus, of course, is on what the exchange
is going to do, or not do, as we move ahead. I quoted The Wall
Street Journal earlier. There was another article they ran that
said a key concern for consumer advocates and regulators is the
Exchange's self-regulatory responsibilities. Some consumer
advocates say the NYSE, which the SEC has criticized in the
past for lax oversight, should shed its self-regulation unit if
it goes public. The Consumer Federation of America says the
for-profit environment adds to the pressures, potential
conflicts of interest. Arthur Levitt said that an independent
regulator would no longer care about offending the principal
clients of the Exchange.
And in that Journal editorial I reference earlier, they
went on to say, ``A split from the regulators would minimize
any conflicts of interest, whether real or perceived. Even if
the NYSE were to run the most hard-nosed enforcement outfit in
the world, it can always be accused of playing both sides.''
What is your response to all of that, and particularly, to
what extent are you concerned that, as the Journal says, even
if you run a very hard-nosed enforcement outfit, if something
goes wrong, it is going to be laid at the doorstep of the model
that you are using, so that it seems to me you have quite an
exposure here in pursuing this path, as you look out into the
future?
Mr. Thain. I go back to my fundamental view that good,
strong, robust, independent regulation is key to the confidence
of investors and the confidence in participating, either as an
investor or a listed company on our exchange. Our structure
does that. It is not the only structure that can be used, but
as we heard before, there is no perfect answer, and there are
always conflicts in whatever structure you come up with. You
know, you have heard the comment about WorldCom and Enron.
WorldCom was a Nasdaq company. Enron was a New York Stock
Exchange company. Neither system is foolproof. It is up to us
to make sure that our regulatory functions are sufficiently
independent, sufficiently well-funded, and in fact, work well,
because ultimately that is what reinforces confidence on the
part of investors.
Senator Sarbanes. How do you get away from being accused of
playing both sides the way you are structuring it?
Mr. Thain. Again, I think that those types of conflicts
exist in the NASD model as well. There is no model that is void
of conflicts. In addition to the board conflicts that NASD has,
NASD also has multimillion dollar contracts with Nasdaq, with
the AMEX and with ISE, which is the options exchange. NASD also
supports a trade reporting facility in which broker-dealers,
who internalizing trades, not exposing them to the market,
print the trades on NASD's trade reporting facility, and then
they rebate that money that they get from the market data from
those trades to Nasdaq. So there is a direct conflict there
between supporting that trade reporting facility, as well as
supporting the internalization of trades, which is not
generally good for the marketplace itself.
Then finally, the point about the listed company
compliance, there is no reason why Nasdaq, the business, should
be responsible for the compliance of its listed company with
its own standards, as opposed to NASD.
So, no model here is perfect, and I think it really is up
to the regulatory side of the New York Stock Exchange to
demonstrate that it can in fact maintain its independence, that
it can in fact maintain its proximity to the marketplace, and
that it can in fact maintain investor confidence.
Senator Sarbanes. Mr. Glauber, what would you say with
respect to those critiques of the NASD model?
Mr. Glauber. Senator Sarbanes, let me try and take them
piece by piece if I can. As Mr. Thain has said, clearly,
conflicts abound all over. What we have focused on in our
testimony, and indeed what Mr. Thain and I are focusing on in
our discussions, is a particular set of conflicts that occur
when a now for-profit, shareholder-owned exchange regulate the
financial institutions, the securities firms that are its
customers, fundamentally, and as I said in my testimony, we
believe structural separation is the way to deal with it, the
way we have dealt with it at Nasdaq when it became a for-profit
exchange back in 2000.
On the specific issues, we do indeed regulate under
contract market activities of certain exchanges, the ISE, the
AMEX, Nasdaq. In each one of those cases, none of those
revenues in any way support our regulation of firms, our
primary activity under the statute, of regulating the
activities or securities firms. And indeed, none of those in
aggregate are very important. The Nasdaq contract accounts for
5 or 6 percent of our revenue in total. So if we did not do
that, if they decided to take that activity somewhere else, do
as the New York Stock Exchange does, and internalize that and
do it themselves, we would survive in fine shape, and it does
not in any way affect our primary responsibility of regulating
what we call member firms.
On the trade reporting facility, it is indeed a facility
that we operate to permit trades to be reported. It is a
facility that we made available to any exchange, and we are in
fact in discussions with other exchanges, and offer that
facility on the same terms that it is proposed to be used by
Nasdaq.
Senator Sarbanes. What about the independence of the
directors?
Mr. Glauber. Well, that particular conflict was raised
initially in the legislation that was passed by Congress in
1934, and the conflict centered on securities firms being part
of SRO's, and indeed, that is an inherent conflict. We have
chosen to deal with that by assuring that those security firms
are a minority of the board. The majority of the board are
nonindustry, nonsecurities industry people. It was the view of
Congress when it passed that legislation that there was a value
to having the input of the securities industry in this
regulatory process, obviously, a conflict as well, but that
that could be managed by this kind of board structure.
Senator Sarbanes. My time is up, Mr. Chairman.
Chairman Shelby. Senator Schumer.
STATEMENT OF SENATOR CHARLES E. SCHUMER
Senator Schumer. Thank you, Mr. Chairman, for holding this
hearing.
I want to welcome everyone here, but particularly the New
Yorkers. I guess there must be a few, given that this is
financial services. Just a few brief points. I understand the
need to have strong regulation. I like to describe my views on
these issues as both probusiness and proregulation, and I think
if you are probusiness, you will be proregulation. Those who
say regulation hinders business, have not looked at history.
Sure, outliers do not like regulation, but good, mainstream
businesses do.
Now, we have two issues here. One issue I am sympathetic
with and one I am not. I think it is tough to have duplicatory
regulators with different rules. When New York firms come to me
and say it is crazy to jump through two different hoops, then
they are right, and we know this in many walks of life. So to
try to come up with one set of rules makes a great deal of
sense.
The second issue is what set of rules should those be? And
I do not see any reason inherently to say we should pick NASD's
set of rules over the NYSE set of rules. It is clear from
Senator Sarbanes' questions, conflicts are there all along. As
Professor Hu said, no model is perfect. And I think some kind
of hybrid that combines both and comes up with one set of
rules, but allows for the differences in the structures of the
two organizations makes the most sense. I do not think it is a
good idea, frankly, to just say let's impose NASD's rules on
the NYSE or its firms. It just does not fit, just does not
work. I would work hard against that kind of situation.
Let me ask some questions here. As for self-regulation, all
of it is in one degree or another, self-regulation with the SEC
overseeing it. That is not a model I am adverse to. Day to day
you cannot ask the SEC--you cannot have a cop on every street
corner. You are not going to have an SEC personnel person
looking over every single trade. It would be expensive, and it
probably would not be as efficient, and particularly now that
we have two competitive models, the merger of NYSE with
Archipelago, the merger of Nasdaq with Instanet--I forget which
of the other ones you bought--make two very strong competitors,
and to me that is a great model. I always worry about
fragmentation of the markets, Mr. Chairman, seven or eight
places. But to have two strong competitors, each doing it a
slightly different way, that is probably the best of all worlds
for the moment. So that is my basic view.
I have some questions here. I think it is clear there are
as many conflicts, more conflicts, on the regulatory board of
NASD than there are on NYSE, and Senator Sarbanes brought that
out. I understand, Mr. Thain, that you have worked with the SEC
on your structure closely because you obviously have to win
approval from them. And even though places like my good friend
Mr. Lackritz, and the SIA, have asked that they have their
member firms on your board, you have said no.
Mr. Thain. Correct.
Senator Schumer. Which may be one of the reasons they are
not as happy with your structure. I love the SIA.
Mr. Lackritz. Thank you, Senator.
Senator Schumer. But, Mr. Glauber, you criticized the
NYSE's Group structure because of conflicts, but are there not
as many conflicts in your situation, if not more, in terms of
the board members, than there is with the NYSE structure? I
mean that seems pretty clear to me. You may say they do not
matter in your type of organization, but the conflicts are
there.
Mr. Glauber. Senator Schumer, I would not say they do not
matter. Conflicts are there. What I will say is that we think
the inherent structure of having a for-profit, shareholder-
owned exchange, responsible for regulating the activities of
the financial firms that are its customers, is a conflict at
the heart of the issue.
Senator Schumer. Will you explain to me why, if someone is
a bad person, and is conflicted, why they could do any less
damage on your board than the NYSE's board? It seems to me,
just because there is a different structure, if you have
someone with a conflict who wants to exercise that conflict,
they will find a way with your setup and with New York Stock
Exchange's setup, and to me, the best thing to do is to say
your board should not have those conflicts, which they have
done and you have not.
Mr. Glauber. Senator Schumer, I think the fundamental
difference is that at the end of the day what we regulate in
financial firms, securities firms, are members who have to be
members of our institution or they cannot do business with the
public, they are out of business. What New York is put in the
position of, now that it is for-profit and shareholder-owned,
it is regulating financial firms that are its customers and can
take that business elsewhere.
Let me, if I might, just make one point.
Senator Schumer. But could the people you regulate, the
American and the others, not take their business elsewhere and
their customers?
Mr. Glauber. No. Senator Schumer, we are talking about our
regulation of firms as firms, not of exchanges, and----
Senator Schumer. But that argument would apply to your
contractual arrangements with the other people you regulate.
Mr. Glauber. And as I answered earlier----
Senator Schumer. You have been frank and forthright, which
we appreciate.
Mr. Glauber. No. As I answered earlier, were those
contracts to go somewhere else, that is fine. They are a small
part of what we do. The fundamental thing we do is regulate the
activities of financial firms, of securities firms, and they
have to be members of the NASD.
My point was, when exchanges become for-profit entities,
they now are regulating customers who can in fact go somewhere
else. That I think is the fundamental difference.
Senator Schumer. So if you want to set a rule no one should
regulate their customers, then you should not be allowed to
have contracts with all these other exchanges. It is the same
conflict. You are saying it is one context or another, but it
is the exact same conflict open to the exact same problems.
What is good for the goose is good for the gander, or not good
for the goose, not good for the gander.
Mr. Glauber. Senator Schumer, when we regulate the ISE
under a contract, I do not think they are our customers. We
have a contract, and they can take their contract anywhere they
want.
Senator Schumer. And they are paying you money to do it.
Mr. Glauber. Of course, but they can take it anywhere they
want. I think that is fundamentally different from what is the
focus of Mr. Thain's and my discussions, which is the
regulation of the securities firms that are members of NASD by
law, and are customers of the exchanges.
If I could just ask your indulgence.
Senator Schumer. Sure.
Mr. Glauber. The point I want to make is what we are
talking over and over again here is about problems of
structure, not of people. I have known Rick Ketchum for 20
years, and----
Senator Schumer. Right. But every structure is fraught with
conflict, and to me, the best way to deal with that is to
eliminate the conflicts at the outset. And I think this
structure that NYSE has proposed would do that very well,
because their board, their regulatory--now, obviously, if the
NYSE leans on the regulatory board, there is a problem, but
your board can be leaned on by a whole variety of people too,
including, the broker-dealers who pay their fees to the--anyone
can lean on anybody, and one structure does not make that
different.
Let me ask you this. Would you be adverse to coming up with
a hybrid system that would take the account of the different
structures--which are great structures. I am glad you are both
here. I am glad you are both in New York. I am glad you are
both competing. I think it is good for each of you, and most of
all, good for the customers. But would you be adverse to
sitting down and trying to come up with a hybrid that
recognizes the differences in the way you people trade, but at
the same time would create the kind of single regulatory
standard that the people you serve are justifiably seeking?
Would you be willing to do that?
Mr. Glauber. Senator Schumer, I am happy to answer that.
Could I just intervene as required by a part of your question.
We do not compete with the New York Stock Exchange. We are just
a regulator. We are not in business. We do not compete with
these firms that are our members and have trading licenses at
the New York Stock Exchange. So we do not think of ourselves as
competing with the New York Stock Exchange. Let me just clarify
that.
Senator Schumer. No, I am talking about----
Mr. Glauber. And again, we are separate from Nasdaq.
Senator Schumer. I know, I know.
Mr. Glauber. Over a 5-year period have achieved that.
Senator Schumer. Five years is not--I know Professor Hu
said experience. Five years is not that long, and there have
been some problems with your structure, as well as with the
NYSE's, right?
Mr. Glauber. Absolutely, correct. Let me answer the
question you posed to me.
Senator Schumer. Yes.
Mr. Glauber. The answer is, of course, we are prepared to
work on some kind of partnership, as I said, and we have some
discussions. I am sure we will have some more. We seek to do
something to eliminate this duplication and deal with these
inherent structural conflicts.
Senator Schumer. That is a very good place for me to end.
Thank you, Mr. Chairman.
Chairman Shelby. Thank you, Senator Schumer.
Conflicts do abound, all of you know, and they are relative
at times. I want to ask Mr. Lackritz, is there any larger
potential conflict, a more fundamental one, than one between
SRO's regulatory function and its shareholders?
Mr. Lackritz. Senator, conflicts abound throughout this
process, and I think at the core of self-regulation is in fact
the conflict that we have member involvement with regulating
themselves at some level, and it is something that Senator
Schumer just addressed with Mr. Thain and Mr. Glauber. We
believe that self-regulation has actually worked very
effectively. It has involved members in regulation, it has
provided expertise, experience, knowledge, to help regulation
in a way that is going to be very effective and efficient. So
that has actually worked.
When you in fact take members out of that picture
completely, we can call it self-regulation, but really, the
self is out of self-regulation when that happens.
Chairman Shelby. It changes.
Mr. Lackritz. That is right. It is changed. It is a
different system.
Chairman Shelby. Ms. Yerger, you have a comment on that?
Ms. Yerger. I think that this really is an issue that the
SEC needs to address and consider because it has been a concern
for us, frankly, and I think the question of whether----
Chairman Shelby. The SEC has the power to do this.
Ms. Yerger. Absolutely.
Chairman Shelby. I think they do.
Ms. Yerger. And it would be a logical follow-up to the
concept release issued last year.
Chairman Shelby. Mr. Thain, you have already touched on
this some. I would like to explore some of the concerns about
conflicts of interest between the regulatory side and the
profit-making side of the New York Stock Exchange. I understand
the argument that NYSE should maintain responsibility, your
argument, for policing its own marketplace, subject oversight
by the SEC. But now that you are a for-profit company, what is
the argument for allowing it to continue to regulate how other
for-profit companies, namely broker-dealers, interact with
their customers? Do you see a conflict, given that these
brokers are in direct competition with the New York Stock
Exchange?
Mr. Thain. I do not believe that these broker-dealers are
in direct competition with the New York Stock Exchange. They
are our customers, yes. They are not our competitors, and these
broker-dealers provide the vast majority of all of our order
flow to the floor of the exchange. The importance of having the
New York Stock Exchange regulatory functions involved with
those member firms is they drive a lot of the behavior that is
going on on the floor of the exchange. They are the
participants on the floor of the exchange for the most part,
and so it is actually quite important that the regulatory
functions be involved with the oversight of those member firms.
Chairman Shelby. Professor Hu, you have any comment on
that?
Mr. Hu. We have to take into account, in a sense, some of
the benefits of proximity, togetherness. I think in a sense
that has to be weighed together with these issues of conflict.
With self-regulatory organizations, we do not want the SEC to
regulate all this stuff. There is a place for SRO's. I think
that even the SEC really concedes that.
Chairman Shelby. Would you need a single nonprofit self-
regulator?
Mr. Hu. You may.
Chairman Shelby. Would that work?
Mr. Hu. That may be one model you need. That may be one
model. There may be this hybrid model in terms of trading, plus
this joint--you know, each responsible for trading, plus this
joint venture. These are the kinds of issues that we have to
explore, but I do want to emphasize that in a sense, I have
been as guilty about this as anybody. I have only, in a sense,
focused on the negatives. But in designing----
Chairman Shelby. But there is a positive side to self-
regulation.
Mr. Hu. Yes, there is a positive side, and in terms of the
positive side, how you structure the hybrid or these
alternative models makes a huge difference in terms of trying
to figure out the best way of maximizing those proximity or
togetherness benefits with the inevitable cost of conflicts of
interest.
Getting rid of conflicts of interest is not the goal. That
is not the goal. It is really the balancing----
Chairman Shelby. But you want to minimize it, do you not?
Mr. Hu. Oh, on the whole, but you have to weigh that
against all the----
Chairman Shelby. Nobody is pure, I understand that, not
totally, but we try to work at that goal.
Mr. Hu. Absolutely.
Chairman Shelby. Mr. Thain, what, if it is determined that
the New York Stock Exchange Regulation needs more resources,
and that fees need to be raised, who would make that final
decision on that?
Mr. Thain. The resource needs of regulation are dictated
ultimately by Rick Ketchum who runs it, and ultimately, by the
board of the regulatory entity.
Chairman Shelby. Mr. Glauber, you want to comment on any of
that? I did not mean to ignore you.
Mr. Glauber. Indeed, that would be, I think, where it would
be done. The structure inherent there I think leads to an
obvious tension. Raising fees could get some of these customers
to give up their trading licenses and do business somewhere
else. So the structure is at the heart of the problem. It is
not Mr. Ketchum. It is not Mr. Thain, who clearly are going to
run this operation in the public interest. But the structure
provides these kinds of conflicts, which we think in the case
of firm regulation, really are so great that they should be the
subject of structural separation.
Chairman Shelby. Mr. Hu.
Mr. Hu. I think the funding issue is an important one, and
because there is this--according to the February 27 SEC order,
there is this agreement to provide for, ``adequate funding of
NYSE Regulation,'' and I understand NYSE Regulation, of course,
collects fees, and cannot distribute to fees to the for-profit
side and so forth. But there is this element of what adequate
funding means. Unless, in a sense, the actual agreement is much
more specific than that, there is the issue of what is
adequate? On what basis is adequacy determined? How often is
this determination reviewed and revised? Will NYSE Regulation's
actions be influenced by a possible leverage or refunding that
NYSE LLC, NYSE Market, may have. So, I am concerned about this
funding issue because this relates to the incentive structure.
Chairman Shelby. It could be a real problem, could it not?
Mr. Hu. Yes.
Chairman Shelby. Mr. Glauber, in your written testimony,
you described a process of separating NASD from Nasdaq. How
does NASD's current structure compare with the current
structure of the New York Stock Exchange? And do you believe it
better ensures that Regulation will be free from conflicts of
interest? Compare and contrast those, if you can, as objective
as you can be.
[Laughter.]
Mr. Glauber. As you correctly point out, Mr. Chairman, NASD
faced the same issue 5 years ago when Nasdaq decided to become
a for-profit, shareholder-owned institution. So we took some
steps to deal with that new conflict the way we thought was
right. What we ended up with is an institution that is
completely separate of all exchanges, that has no alliance now
with any exchanges, that is a member organization, who, as I
said earlier, has members that have to be members to us, or
they cannot do business with the public.
The difference is that NYSE, as of yesterday now, is a for-
profit, shareholder-owned institution like Nasdaq, and----
Chairman Shelby. You think there is enough separation
there?
Mr. Glauber. The point is, they now are going to regulate
these firms----
Chairman Shelby. Because the professor says conflict is
going to be there, it is a question of how much, right? Those
are my words.
Mr. Glauber. Well, and whether the structure can handle it.
And in their case, what they are going to regulate, these
firms, financial institutions, securities firms, are going to
be customers, as Mr. Thain just said, not members that have to
stay there, they are customers that can leave and go somewhere
else. We think that that is a conflict that needs to be handled
by full structural separation, completely separate boards, no
overlap of the boards, separate balance sheets, no overlap of
the finances.
Chairman Shelby. It is your judgment that the SEC can do
this?
Mr. Glauber. The SEC certainly has the right to order
that----
Chairman Shelby. Do you agree with that, Professor? You are
a law professor.
Mr. Hu. Absolutely. The SEC has to take a strong stand on
this issue.
Chairman Shelby. Mr. Thain, what about the global
competitiveness of U.S. capital markets? They are the biggest
in the world. I have visited the London Stock Exchange, the
German Stock Exchange, the French Stock Exchange, even Italian
in Milan. They all seem to be functioning, but they are not as
big yet as ours. Why are some of the biggest foreign companies,
IPO's, some of them, increasingly decided not to trade their
shares in this country? Some of them have gone to London and
elsewhere.
Mr. Thain. Mr. Chairman, that is a very real concern,
certainly for us, as it should be for everyone concerned about
the competitiveness of the American marketplace. As you said,
we are much bigger. The market value of the companies that
trade on the New York Stock Exchange is over 21 trillion U.S.
dollars, which is more than five times bigger than the next
biggest marketplace. But we have seen a very concerning trend.
In 2000, $9 out of every $10 raised in the IPO market was
raised in this country. Last year, in 2005, none of the 10
largest IPO's in the world----
Chairman Shelby. Say this again. I want you to say it for
the record.
Mr. Thain. None of the 10 largest IPO's in the world were
registered in the United States. Only 2 of the 25 largest IPO's
in the world were registered in the United States.
Chairman Shelby. That is not good news, is it?
Mr. Thain. No, it is not. Why is that? There are probably
five reasons why that is. The first reason is not one that we
can really do anything about, which is, the euro has been
successful, and companies can raise very large amounts of money
in the euro. They can also raise very large amounts of money
outside the United States, so they do not have to come here any
more.
Chairman Shelby. But the British do not have the euro.
Mr. Thain. No, no, but they are accessing the European
marketplace, and, of course, the British are raising it in
sterling.
The concerns, the reasons why companies do not list here
is, first, some of the concerns about how Section 404 of
Sarbanes-Oxley is being implemented. Section 404, and having
good internal controls is a very important thing. The way it
was implemented really resulted in a substantial cost and
duplication of effort in a way that international companies
find the benefits are dramatically outweighed by the cost.
Second concern is the litigation environment in this
country, and the lack of tort reform is a very significant
problem for international companies. Now, frankly, it is a
problem for U.S. companies as well. However, they cannot do
anything about it other than lobby to get tort reform.
International companies have a choice.
The third is, and this is particularly true for European
companies, is there is a concern about the lack of accounting
convergence. We are making progress, and the SEC and the FASB
are working toward accounting convergence, but there is no
question that European companies, who are just adopting the new
international accounting standards, are much less willing to
have duplicative U.S. GAAP financials. Particularly, as they
get closer together, there is seemingly less difference.
Chairman Shelby. If they get closer together, will that
hopefully work out some of our problem, or are they deeper than
that?
Mr. Thain. No, no, it will solve one of the four problems,
of which I have gotten to three.
The fourth problem is the competition between the various
different enforcement bodies at the moment, between the
enforcement agencies at the SEC, the enforcement agencies at
various different States, particularly New York, and that
competition for who can be the toughest cop is also a concern
on the part of international companies.
Chairman Shelby. Thank you.
Senator Sarbanes.
Senator Sarbanes. Thank you very much, Mr. Chairman.
How important is the perception that our capital markets
are honest, efficient, transparent, have integrity in the
overall success of the workings of the system, as contrasted
with a market that is very lax, and someone says, ``We can go
into that market. There are hardly any limitations on us,
hardly any restrictions. Standards are low. No one inspects.
There is no enforcement. We can have a free and easy ride in
that market.''
That is one model at one end. Then you come and people
start raising all these problems. They say, ``Your standards
are too tough. You inspect, you really mean it,'' and so forth
and so on. How important is the reputation for the integrity as
far as the investor is concerned in the success of these
markets? Mr. Glauber, anyone who wants to address that?
Mr. Glauber. I will start, but I am sure others have views.
I think it is of absolutely crucial importance, and it is
particularly true in our markets in the United States that
depend much more heavily on retail investors than markets in
other countries. Investors simply are not going to go to
markets where they do not believe they are going to be taken
care of properly and protected properly. As I say, I think that
is even more important, retail investors.
As Mr. Thain now competes in a global marketplace, he has
said, and he fully appreciates, having good, effective
regulation is going to be at the heart of one of his
competitive weapons. So, I think the answer is of utmost
importance, and particularly, when retail investors are as
important to a marketplace as they are in the United States.
Mr. Hu. I completely agree with it. It is critically
important, and it is particularly important for retail
investors, but the integrity of the market, the trust in the
market are core to what we offer to the world.
Chairman Shelby. Mr. Lackritz.
Mr. Lackritz. Senator, I completely share those views, but
I would just add that I think the entire success and global
preeminence of our industry really rests on a bedrock of the
public's trust and confidence in the marketplace and in the
industry and in the integrity of what is going on. So it is
absolutely critical. It is an asset without which we could not
be successful.
Senator Sarbanes. Ms. Yerger, you represent----
Ms. Yerger. I would just comment that the integrity of the
market is not just a real concern for retail clients, but also
institutional clients, and our members simply will not invest
in markets where they do not feel they are adequately
protected.
Chairman Shelby. That would go to pensions too, would it
not, Mr. Ferlauto?
Mr. Ferlauto. Absolutely. But again, I want to emphasize
the retail investment that has been done by our members is that
they remain frightened. And they look at their 401(k)
statements and others, and there still has not been a return of
confidence in the markets. So that if you are concerned about
the American investor, my members, and other average folk,
confidence in regulation is key.
Senator Sarbanes. Sorry, I had to leave the room, but
Senator Schumer was making the point, you can have people who
misbehave whatever the structure is, and I think that is a
reasonable point. But the question becomes, what is the
structure most likely to preclude the misbehavior, and in
particular, you can have one structure, and if something goes
wrong, then immediately people say, ``It was not the right
structure. That structure had in it an essential conflict of
interest.'' Or you can have a structure that seems to address
that question if something goes wrong, and then the focus is on
the misbehavior of the individual, and the response is, ``Well,
no system is perfect, so if you have somebody who really wants
to cheat and maneuver, you are going to face that, and that is
what happened in the latter instance.''
There is a difference between a situation in which the
structure is open to the criticism as something goes wrong, and
where the structure, to the extent you can do it, seems to take
into account all of that, and then if something goes wrong,
they say, ``Well, we had errant behavior here, and this person
is going to be punished,'' and all the rest of it. I think that
is one of the things we are trying to search for here.
As I understand it, listening to the testimony, I think,
Mr. Thain, you are the only one at the panel who feels that the
regulator of an exchange ought not to be separate from the
business side. Is that correct? Let me ask the others. You feel
there should be the separation, is that right?
Ms. Yerger. Correct.
Mr. Ferlauto. Complete separation.
Mr. Thain. With all due respect, I do not believe that is
correct, because the panel has talked about the regulation of
different pieces, and so I do not think this panel is
recommending that the regulation of the marketplace itself be
separated. I think that most of the conversation has been
around the member firm examination, and we really have not
talked much about the listed company surveillance.
Mr. Glauber. Senator Sarbanes, let me just add to what Mr.
Thain has said. The focus of our discussions have been on what
we call firm regulation, the regulation of the firms that use
the exchange. Mr. Thain has made, on a number of occasions,
arguments that this particular benefit in the surveillance of
the activities on an exchange, to have that close to the
exchange. It is a different set of issues, and I think the
argument is stronger there for surveillance.
Senator Sarbanes. Professor Hu.
Mr. Hu. I want to point out that I have an open mind in
terms of this separation, or the togetherness issue. I do want
to mention one thing in connection with your perception point.
I did not comment earlier. The New York Stock Exchange really
is the crown jewel of capitalism. Because of that, we have to
hold it to, in a sense, especially high standards because the
new New York Stock Exchange I really do think is emblematic of
basically our whole approach to how the economy should be run.
In this particular instance, it is important to be purer than
Caesar's wife in this context, so that we have to take a
special care in terms of watching out for conflicts and so
forth because of this symbolic iconic role of the new New York
Stock Exchange.
Mr. Lackritz. Senator, I guess I want to go back to the
point Mr. Thain raised. Part of the reason that we came out
with our support of a hybrid self-regulatory organization was
the effort to separate member regulation from market
surveillance and regulation, and we strongly believe that
market surveillance and enforcement should be with the market
themselves. They are close to the problem as was described
before. They have proximity. They have experience. They have
understanding, and it is much more effective to have that kind
of hybrid, as we called it, organization, where you then remove
member regulation into a separate body where you have one
single set of rules, one set of interpretations, one set of
examinations, and one organization.
Senator Sarbanes. So on member regulation, other than Mr.
Thain, everyone so far has taken the position that it should be
independent, correct?
Mr. Ferlauto.
Mr. Ferlauto. Just so long as there is a relationship in
which a regulator's action can impact the profitability, we
believe that there is a conflict, so there should be a
separation there, obviously. I think we also may go a step
beyond other members of this panel, is that we believe there
have been inherent problems in modernizing the listing
standards, and the structural problems there are such that we
would recommend separation on those matters also.
Senator Sarbanes. Ms. Yerger.
Ms. Yerger. I agree that there is benefits for proximity in
the market surveillance issues, but in terms of regulating the
member firms and listed companies, we believe that should be
handled by a separate independent entity.
Senator Sarbanes. Thank you very much, Mr. Chairman.
Chairman Shelby. I have a few observations just from the
meeting. We appreciate this. This is, I know a lot of
preparation, as Senator Sarbanes said. And you have really
prepared for this. You all know this subject. And we have tried
to put together a cross-section. We have security industry
representatives. We have labor representatives. We have
academics. We have the SRO's and we have the pension funds, and
we appreciate this very much.
We know it is complicated, and we know no model is perfect,
as Professor Hu points out, among others.
We have also seen that there are conflicts and real
potential conflicts in the SRO model. Some of these conflicts
can be managed. They have to be. They are managed every day.
Others are, I believe, fundamental, and perhaps they cannot be
managed. I am not sure.
Because of such conflicts, it calls into question the basic
integrity of our markets. Senator Sarbanes asked the question,
what is the most important thing of the markets? It is
integrity, trust, not just for retailers like me, but the
pension people. People have to have trust above everything.
And so I think it is our responsibility to closely monitor
this. These issues will be going forward, and we plan to work
on this. We know the SEC is listening to this today, make no
mistake about it. They will be up here, Chairman Cox, soon, and
I am sure these questions will probably be asked, among others.
For all of you today, we appreciate your involvement. We
appreciate your candid testimony, and we thank you very much.
The hearing is adjourned.
[Whereupon, at 11:52 a.m., the hearing was adjourned.]
[Prepared statements supplied for the record follow:]
PREPARED STATEMENT OF JOHN A. THAIN
Chief Executive Officer, NYSE Group, Inc.
March 9, 2006
Introduction
Chairman Shelby, Senator Sarbanes, and distinguished Members of the
Committee, I am John Thain, Chief Executive Officer of the NYSE Group.
I thank you for the opportunity to address issues raised regarding the
current structure of securities industry self-regulation. Given the
sweeping changes affecting our Nation's securities markets today, your
examination of these issues could not be more timely. As many of the
matters the Committee is examining are within the purview of NYSE
Regulation, I want to state from the beginning that my comments reflect
my perspective as the CEO of the NYSE Group, where I oversee the
business of the Exchange, as opposed to the functioning of NYSE
Regulation. That separate subsidiary is led by its own Chief Executive
Officer, Rick Ketchum, who reports directly to the NYSE Regulation
Board.
The U.S. Needs to Remain the Global Leader in Financial Services
We find ourselves at the center of sweeping changes: March 7, 2006
was a milestone in the 213-year history of the New York Stock Exchange.
On that date, the Exchange became a publicly owned, for-profit company,
the NYSE Group, and we began trading yesterday under the symbol NYX. In
the days ahead, we will introduce new products, platforms, and
strategies to modernize our business, increase our listings, serve our
shareholders, and gain market share against formidable, global
competitors.
The competition from other exchanges in Europe, Asia, and the
United States, and our desire to keep not just the NYSE, but the United
States markets ahead, is one of the primary drivers of the
transformation we have undertaken at the NYSE. In an increasingly
globalized world, foreign companies are avoiding the U.S. markets when
they raise capital. A recent Wall Street Journal article provided some
troubling statistics: In 2000, $9 out of every $10 raised by foreign
companies through new stock offerings were done in the United States.
But last year, the top 10 IPO's measured by global market
capitalization were not registered in the U.S. markets. Indeed, 23 out
of 25 of the largest IPO's in the world did not register in the United
States. That is a major concern for U.S. markets.
A number of well-capitalized, Europe-based global exchanges are
competing for the listing and trading of securities. The Deutsche
Borse, Euronext, and London Stock Exchange are all well-capitalized,
public, for-profit markets that offer broader product mixes, and they
are positioned to compete aggressively to capture U.S. and global
market share.
Our new structure will help us to compete with these markets and,
we believe, help keep the capital formation and resulting job creation
that is the lifeblood of the U.S. economy here in our own country,
rather than fleeing to foreign markets.
As technology links domestic and international exchanges through
instantaneous, electronic trading, transaction costs decline and
investors are empowered. Investors today can send their orders to
virtually any market to invest in a plethora of products at very low
costs. This has raised the bar of competition for U.S. exchanges.
The New York Stock Exchange is responding comprehensively, by
transforming our structure, modernizing our market, and adapting our
strategy. Becoming a public company will enhance our ability to invest
in technology and to offer new products that investors from around the
world want to trade. We will also have a currency for acquisition,
allowing us to play an active role globally in the next stages of
consolidation in the exchange space.
We will modernize our market and provide customers more choices by
expanding our portfolio of product offerings and categories. With the
Archipelago merger, we have begun trading options. We are planning to
expand significantly trading in the bonds of our listed companies,
driving down spreads and enhancing investment opportunities for retail
investors. We will expand our listings business through a second
listings platform that will provide growing companies that today cannot
meet the high financial listing standards of the NYSE with a new
choice: To list with Archipelago and begin on a track toward an NYSE
listing.
As we champion innovation and choices for customers, we will
redouble efforts to provide investors the most reliable, cost-
efficient, and competitive venue for trading our listed stocks.
Specialists and floor brokers will continue to provide the best
execution prices, best-quoted spreads among U.S. markets along with the
deepest liquidity of any capital market in the world. These metrics of
market quality translate into real savings. On February 9, 2006, we
released the findings of a NYSE study that compared the market quality
of 67 companies that transferred to the NYSE from Nasdaq from 2002 to
2005. The study showed that intraday volatility declined by 48 percent,
average quoted spreads tightened by 46 percent, and execution costs to
investors decreased by 38 percent on average for these companies after
moving to the NYSE.
Capital is the lifeblood of American dynamism, innovation,
productivity, and prosperity. The global competition for capital is a
contest of paramount importance for our country's future. Nothing is
written in stone that decrees American capital will stay here or that
global capital will continue to come here. The competition we face to
keep America at the center of global financial markets is becoming
tougher by the day. We must succeed in the future through superior,
competitive performance in our financial markets, and through sound,
forward-looking public policies. And those are the driving forces
behind the transaction that has led us to create the new NYSE Group.
SRO Regulation
As our markets are evolving, it is entirely appropriate, and, we
think, necessary to examine the self-regulatory structure governing our
financial markets.
In 2003, the NYSE faced a crisis like few it had ever known. The
NYSE's governance structure was perceived to have broken down, its
specialist firms were accused of self-dealing at the expense of
customers, and public confidence in the NYSE reached historic lows. The
NYSE, critics argued, could not effectively manage the conflicts of
interest inherent in its structure. In swift reaction, however, the
NYSE implemented--with SEC approval--sweeping changes to its governance
structure. Among other things, the NYSE created a structure in which
members of the Board of Directors were independent of the interests of
the NYSE members whom they regulated. The new structure functionally
separated market operations from regulation, assured the independence
of regulatory decisionmaking, and installed a Chief Regulatory Officer
(CRO)--Rick Ketchum, who reported directly to the Board of Directors
through the Board's Regulatory Oversight Committee (ROC). The NYSE also
separated the functions of Chief Executive Officer (CEO) and Chairman
of the Board, installed new board members, including a new chairman,
and hired a new CEO--me.
Based on over 2 years of experience, this structure has proven
effective. The ROC played an active role in overseeing Rick's
activities at NYSE Regulation ensuring that Regulation received both
staff and technology resource increases, and in assuring its
independence. Rick has been aggressive in the oversight of market and
member firm activities and has been proactive by embracing a risk-based
approach to regulation.
Under the new structure that was just approved by the SEC, we have
sought to establish the NYSE Group as a model corporation guided by
integrity and strict standards for transparency and accountability to
our shareholders and the public. The new structure adheres to the
principles that made our initial reforms 2 years ago effective--
proximity with independence. Under our new structure, the independence
of NYSE Regulation will be strengthened. While the market is now a for-
profit entity, NYSE Regulation has become a separate, not-for-profit
corporation. Members of the Board of NYSE Regulation will meet the
independence standards of NYSE Group Board members, which precludes
ties to member organizations and listed companies.
Most important, the NYSE Regulation Board will have a majority of
directors who are unaffiliated with the NYSE Group. Their fiduciary
obligation as directors will be to NYSE Regulation, undiluted by
service on any other board within the NYSE Group.
Maintaining NYSE Regulation within the NYSE Group will Improve
Regulatory Performance
A More Knowledgeable Regulator
While, as I mentioned earlier, NYSE Regulation is not part of my
executive responsibilities, I am pleased to offer my views on the
benefits of having a regulator that is proximate to the markets that I
do run.
The rationale underlying self-regulation is straightforward:
Regulators are in the best position to regulate when they are
intimately knowledgeable about the activities they are regulating.
Market regulators who are integrally tied to the regulated market know
the conduct and activities that they should be examining when they
engage in compliance reviews and surveillance. This knowledge also
allows regulators to know when rule changes are needed to address
systemic concerns.
Based on my experience here at the Exchange, as well as in my
previous position with a large broker-dealer, I believe a regulator
with a real-time understanding of how the marketplace is evolving in
the face of competitive forces has a better chance of keeping ahead of
the curve and being integrally involved in shaping marketplace
evolution to ameliorate any regulatory concerns. That real-time
understanding can be obtained most effectively when the regulator
functions on a day-to-day basis alongside the market it is regulating.
Similarly, a regulator who is proximate to the market is more
likely to devise the optimal solution to a regulatory challenge or
problem--one that is cost-effective and minimizes regulatory
interference with sensitive market mechanisms. Proximity also reduces
the risk of misaligning the performance incentives of regulatory
personnel, avoiding the ``small town speed trap'' syndrome of police
officers writing speeding tickets to fund municipal services rather
than deterring reckless driving.
Cooperative Regulatory Risk Assessment and Sensible Regulation
The coordination and communication that arises from affiliation
also reduces the ``us versus them'' mentality that prevents cooperative
regulatory risk assessment and management. Affiliation also creates a
regulator with market sensitivity and a businessperson who understands
regulation. Finally, the affiliation of a regulator with an exchange
focuses accountability for the direct and indirect costs that
regulatory activities impose on the market. Neither the effectiveness
nor the efficiency of regulation becomes ``someone else's problem.''
Preventive Regulation to Deter Issues from Arising in the First Place
I also believe that proximity benefits the market participants
being regulated. By taking early advice and input from the regulator,
those being regulated can create a more effectively regulated
environment by designing compliance and surveillance systems into their
products and services.
A recent example of this is the NYSE's development of the NYSE
Hybrid Market\SM\. The NYSE designed the hybrid market to improve its
competitiveness, achieve the efficiencies demanded by its customers and
comply with Regulation NMS. We on the business side of the NYSE have
benefited greatly by having Rick Ketchum and his team at the table.
While we were designing our systems and building order types to meet
the demands of the market, Rick was in a position to tell us whether
NYSE Regulation would have the tools to properly regulate that
platform. A ``distant'' regulator also could have vigorously regulated
the hybrid market, but, by having NYSE Regulation involved in the
development of the hybrid market from the outset, regulatory
protections were designed into the platform.
NYSE Group's Structure will Protect the Independence of the Regulator
There is a Strong Market Incentive for NYSE to Maintain a Robust
Regulator
We have heard the concern that self-regulation within a for-profit
holding company structure that includes an affiliated market is
problematic because the for-profit goals of a marketplace are in direct
conflict with the regulatory duties of that marketplace. The premise
underlying this argument is false. In order to attract listing and
trading on their platforms, stock exchanges must run a fair, well-
regulated marketplace, or risk losing business. Companies list on a
trading venue in part to associate themselves with the branding that
comes from meeting high standards in a regulated environment. In
addition, broker-dealers send their order flow to a trading venue to
seek access to liquidity in a fair and orderly marketplace. A trading
scandal or a poorly regulated market undermines investor confidence and
erodes business at a stock exchange. The reorganization of the NYSE in
2003 to separate the regulatory function from the marketplace and
strengthen our regulator is a perfect example of the strong business
incentives that are created by a perceived weakness in regulation.
Accordingly, those of us running the business side of the Exchange have
every incentive to ensure that the regulatory oversight of our listed
companies, member organizations, and trading platforms is robust.
Conflicts are Inherent in Self-Regulation: The Corporate and Functional
Separation of NYSE Regulation from the Market Guards Against Conflicts
No matter what model one chooses, self-regulation has inherent
conflicts of interest. While we believe that our model sufficiently
accounts for and addresses these conflicts, we acknowledge their
existence and work to mitigate its potential for harm to the investor.
Likewise, NASD and Nasdaq have inherent conflicts of interest because
of their financial interrelationships and the fact that NASD has board
members who would not meet standards of independence we have
established for NYSE Regulation Board members. With the SEC's approval
of Nasdaq's exchange application and the impending separation of NASD
and Nasdaq, the NASD is moving closer to true independence, but there
remain financial interrelationships that create conflicts regardless of
corporate structure. These include large dollar contracts for the NASD
to conduct regulatory activities for Nasdaq, the American Stock
Exchange, and the International Stock Exchange as well as the proposed
NASD Trade Reporting Facility, through which the NASD will provide a
market it regulates, Nasdaq, with considerable revenues. Further, a key
regulatory function, listing compliance, remains within Nasdaq as
opposed to the NASD. We, however, moved this function to NYSE
Regulation in July 2004 to ensure independent decisionmaking and remove
potential conflicts of interest.
The question is not whether conflicts exist but rather how they are
accounted for and controlled.
(Appendix A contains a more detailed description of the ways in
which the NYSE Structure complies with the principles and proposed
rules of Regulation SRO.) *
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* Held in Committee files.
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Independent Directors Represent a Majority of the NYSE Regulation Board
of Directors
As noted above, the board governing NYSE Regulation is structured
to ensure the independence of the regulator from the marketplace. Every
director of NYSE Regulation, except for Rick, will be independent of
broker-dealers, New York Stock Exchange-listed companies and management
of NYSE Group. A majority of the directors of NYSE Regulation must be
persons who are not directors of NYSE Group. These requirements
insulate NYSE Regulation from the for-profit interests of NYSE Group
and from the interests of the other entities and persons that NYSE
Regulation regulates. The final form of this structure evolved out of
the careful review conducted by the SEC before approving our merger
rule filing.
NYSE Regulation has a separate compensation committee that will be
appointed by the NYSE Regulation board of directors. A majority of the
members of this compensation committee must be persons who are not
directors of NYSE Group. NYSE Regulation will also have a separate
nominating and governance committee. As with the compensation
committee, a majority of the members of this nominating and governance
committee must be persons who are not directors of NYSE Group.
Any disciplinary decision of the NYSE Regulation board of directors
will be deemed to be final and is not subject to review or approval
except by the SEC. In addition, with respect to the promulgation of
rules and regulations, any proposed changes to them must be published
in the Federal Register and will be subject to public comment and the
SEC approval process. Moreover, the SEC oversees all of NYSE
Regulation's regulatory responsibilities.
Finally, the Chief Executive Officer of NYSE Regulation will report
solely to the NYSE Regulation board of directors and will not be an
officer or director of NYSE Group. In addition, neither he nor any
other NYSE Regulation employee will be permitted to own NYSE Group
stock or options.
NYSE Regulation Board Members should not be Affiliated with Industry,
in Order to Protect against Conflicts of Interest
Some have made arguments that broker-dealer members should be
members of the Board of NYSE Regulation.
We disagree. The presence of member organization executives on the
board of an entity charged with regulating those member organizations
raises potential conflicts of interest that can interfere with
effective regulation. The NYSE learned this lesson and, in 2003,
restructured its board from a constituent assembly into a corporate-
type board comprised of directors wholly independent from those that it
regulates. Significantly, we work closely with key legal and compliance
officials at our member firms to identify unnecessarily burdensome
regulatory requirements. We believe that industry access without
industry control appropriately manages the inherent conflicts of self-
regulation.
Direct involvement of constituents in the selection of our
independent directors is another matter. Through our Director Candidate
Recommendation Committees, member organizations of New York Stock
Exchange LLC select at least 20 percent, and no less than two, of the
directors of the boards of the New York Stock Exchange LLC, NYSE
Market, and NYSE Regulation. In addition, there is a formal director
nomination petition process incorporated into our rules, as well as
many informal ways in which our constituents can suggest director
candidates.
This structure not only carries forward the NYSE's former
governance structure, which required that each director of the NYSE be
independent from constituents, but also complies with the SEC's
proposed rules regarding fair representation of members in the
governance of a registered exchange.
No Particular NYSE Member Organization will have Undue Influence on
NYSE Group or its Subsidiaries
Under the NYSE Group certificate of incorporation, there are
limitations on the concentration of voting power and ownership of NYSE
Group stock to ensure that no member organization or other stockholder
will exert undue influence on the NYSE Group or its subsidiaries,
including NYSE Regulation. Specifically, the certificate of
incorporation requires that no person (either alone or together with
its related persons) will be entitled to (1) vote more than 10 percent
of the total number of votes entitled to be cast on any matter or (2)
beneficially own shares of stock of NYSE Group representing in the
aggregate more than 20 percent of the then outstanding votes entitled
to be cast on any matter.
NYSE Regulation will be Independently and Fully Funded
New York Stock Exchange LLC and NYSE Market have entered into a
contractual agreement with NYSE Regulation to provide funding to NYSE
Regulation. The Pacific Exchange, now known as NYSE Arca, has entered
into a similar services agreement with NYSE Regulation. NYSE Regulation
will also collect regulatory fees from the members it regulates, and
will collect fines from persons who are disciplined by NYSE Regulation
for rule violations. Under the operating agreement of New York Stock
Exchange LLC, New York Stock Exchange LLC will be prohibited from using
any of these regulatory fees, fines or penalties for commercial
purposes. Moreover, because NYSE Regulation is a New York not-for-
profit corporation, NYSE Regulation may not distribute these fees and
fines in the form of a distribution or dividend to New York Stock
Exchange LLC.
NYSE Regulation is Working to Reduce Regulatory Duplication
Separate and apart from the issue of the independence of NYSE
Regulation is the issue of regulatory duplication. NYSE Regulation has
committed to take steps to address the issue of duplication and has
taken numerous steps over the past 12 months to do so. These include:
Developing a coordinated plan for examinations of firms with the NASD
that divides responsibilities for each firm visited by regulators in a
given year; coordinating with industry committees and organizations in
response to major initiatives to harmonize interpretations and
rulemaking; participating with other exchanges and markets in the
Intermarket Financial Surveillance Group to share audit trail and
coordinate financial monitoring; and coordinating on Enforcement
actions to lessen duplicative efforts. That being said, while we
recognize that these initiatives are a step in the right direction, we
agree that there is more to be done.
In that regard, NYSE Regulation has pledged to the SEC that it will
work to eliminate inconsistent rules, and to use its best efforts, in
cooperation with the NASD, to submit to the Commission within 1 year,
proposed rule changes, reconciling inconsistent rules and a report
setting forth those rules that have not been reconciled. In addition,
as Rick and I have both said publicly, we are committed to finding
other ways to reduce regulatory duplication, including exploring the
possibility of forming a joint venture with the NASD. This joint
venture would leverage the talent, expertise and experience of two
seasoned regulators giving both organizations substantially authority
and control over the regulation of the broker/dealers in securities
industry. We believe the efforts taken to date, as well as our
willingness to work with the NASD in a joint venture, demonstrate our
substantial commitment to working through this issue.
Conclusion
The corporate governance and trading scandals that led up to and
followed Sarbanes-Oxley and other governance reforms hurt the
reputation of the NYSE and other U.S. markets and hindered us in the
competition for capital. We cannot afford to have ineffective
governance or regulation going forward. Companies and investors need to
trust U.S. governance standards and market regulation. We believe that
our structure embodies the principles necessary to deliver on that
goal.
We also need market regulation that is efficient. In order for the
NYSE and other markets to compete globally, we need knowledgeable
regulatory staff that is proximate to the market. They are in a better
position to regulate in an efficient manner that does not unduly
interrupt the workings of the market. We believe that our model
accomplishes this goal as well.
Ultimately, the industry, markets and policy leaders all play a
role in how competitive the United States remains. We believe that the
new NYSE Group with its new governance structure is properly positioned
to do its part alongside all of you to fight to preserve the
preeminence of the U.S. markets in this global race.
I thank the Chairman and the Committee for the opportunity to
testify.
PREPARED STATEMENT OF ROBERT GLAUBER
Chairman and CEO, National Association of Securities Dealers
March 9, 2006
Mr. Chairman and Members of the Committee: NASD is grateful for the
invitation to testify regarding self-regulation in the securities
industry. NASD commends the Committee's efforts in reviewing the self-
regulatory system. As a regulatory organization devoted to investor
protection and market integrity, NASD welcomes the Committee's focus on
possible enhancements to the current regulatory system that could
strengthen its operation and efficacy. As Congress considers the self-
regulatory structure, we hope that insights derived from NASD's recent
experiences may provide some helpful background.
NASD Experience
Founded in 1936, NASD is the world's preeminent private-sector
securities regulator. In 1939, the Securities and Exchange Commission
(SEC) approved NASD's registration as a national securities association
under authority granted by the 1938 Maloney Act Amendments to the
Securities Exchange Act of 1934. We regulate every broker-dealer in the
United States that conducts a securities business with the public--
about 5,100 securities firms that operate more than 108,000 branch
offices and employ about 664,000 registered representatives. We are the
only private-sector regulator with industry-wide scope.
Our rules regulate every aspect of the brokerage business. Our
market integrity and investor protection responsibilities include rule
writing, compliance examinations, enforcement, professional training,
licensing and registration, dispute resolution, and investor education.
NASD examines broker-dealers for compliance with NASD rules, MSRB
rules, and the Federal securities laws, and we discipline those who
fail to comply. Last year, NASD filed 1,399 new enforcement actions and
barred or suspended 740 individuals from the securities industry. NASD
has a nationwide staff of more than 2,400 with an operating budget of
more than $530 million and is overseen by a Board of Governors, more
than half of whom are not in the securities industry.
During the last 5 years, NASD has been in the process of separating
from the Nasdaq Stock Market, which in January of this year won SEC
approval to become a national securities exchange. Nasdaq is now on an
independent course under its own management and Board of Governors.
NASD still monitors all trading on Nasdaq pursuant to a regulatory
services agreement.
NASD also divested itself of the American Stock Exchange 15 months
ago by selling it back to the AMEX membership. As with Nasdaq, NASD
continues to monitor all activity on the AMEX pursuant to a regulatory
services agreement.
When Nasdaq decided to become for-profit, shareholder-owned, and
publicly traded, the conflicts confronting NASD as a regulator
increased significantly. The challenge for NASD was to create a
corporate structure that would assure the public that commercial,
financial, and stock price considerations did not taint regulatory
decisions. We chose complete structural separation between the Nasdaq
Exchange and regulation--regulation in a completely separate self-
regulatory organization (SRO), two separate managements, two separate,
nonoverlapping boards, two separate balance sheets. This structural
separation has allowed NASD to realign as a private-sector regulator
with an exclusive focus on regulating the broker-dealer industry and,
by contract, exchanges and markets.
Today, the New York Stock Exchange (NYSE) finds itself in a similar
position with its merger with Archipelago and its conversion to a
public company. To deal with these new conflicts, the NYSE has chosen
to place regulation inside the shareholder-owned, for-profit holding
company and to wall it off as a separate subsidiary with a different
governance structure. Whether this approach provides the requisite
assurance to the public that regulation will always be performed to
protect them, not the shareholders, has been the subject of a great
deal of healthy and needed debate in our industry. Interestingly, among
competing for-profit exchanges in this country the NYSE proposes to be
the only one that will have comprehensive regulatory authority over the
firms that are or would be its customers.
Last year, the SEC published a concept release examining the
current SRO system and sought public comment on a range of issues,
including: (1) the inherent conflicts of interest between an SRO's
regulatory obligations and the interests of its members, its market
operations, its listed issuers and, in the case of a demutualized SRO,
its shareholders; (2) the costs and inefficiencies of the multiple SRO
model; (3) the challenges of surveillance across markets by multiple
SRO's; and (4) how SRO's generate revenue and fund regulatory
operations. The SEC also is examining and seeking comment on certain
enhancements to the current SRO system and a number of regulatory
approaches and legislative initiatives.
The SEC stated that the most controversial aspect of the current
SRO system is the inherent conflicts of interest between an SRO's
regulatory functions and its members, market operations, listed issuers
and shareholders. Conflicts can result in poorly targeted and less
extensive SRO rulemaking, and weak enforcement of SRO rules.
As we told the SEC in our response, one glaring inefficiency in
today's regulatory scheme is the dual regulation of firms that are
members of both the NYSE and NASD. Currently, these approximately 200
firms are faced with dual rulebooks; dual examinations, interpretations
and enforcement; and dual fees. And, following the NYSE's current
restructuring, the number of dually regulated firms may increase
substantially, because NYSE has chosen to require that each firm that
desires a trading license must submit not only to market, but also full
member, regulation by the NYSE.
A solution that makes sense is a partnership between the NYSE and
NASD to jointly handle the regulation of the firms that are members of
both organizations. Under such a partnership, firms would be regulated
according to one rulebook instead of two. They would pay one regulator
instead of two, and they would have only one examination and
enforcement staff to deal with, lowering their compliance costs. These
savings could then be passed on to investors, while the regulation of
these firms would be more coherent, effective, and efficient.
This structure is very much in line with the hybrid SRO proposal
that the SIA put forward a few years ago and has recently reiterated.
It is no secret that John Thain and I have had discussions about
how a partnership between our two organizations could work. While it is
too soon to know where these discussions will lead, my hope is that our
two organizations can find a way to create a structure that best serves
investors and solves some of these vexing problems.
To best protect the interest of investors, any new structure would
have to solve the conflict inherent in both regulating and managing a
for-profit exchange. The regulator will have rule writing and
enforcement authority for sales practices, financial operations, and
transaction routing decisions. Thus, absent complete separation of a
for-profit exchange and regulation of member conduct, there is the
unavoidable inherent conflict that regulation of member conduct may be
influenced by the commercial, financial, and stock price impact of such
regulation on the affiliated exchange.
That is the guiding principle for NASD as we move forward in any
discussion about SRO consolidation. NASD has put forth to the NYSE
several proposals concerning a possible partnership, but we cannot
agree to any structure that would result in a loss of independence over
rule writing, as well as examination, investigation, and enforcement.
As stated earlier, NASD has worked diligently for the last 5 years to
become an independent, unconflicted regulator that does not own or
control markets. Any integrated structure with the NYSE must not cause
us to give up that independence. That means NASD cannot give the NYSE
control over our rulemaking, interpretation function and examination
decisions through a veto or any other mechanism.
A little history is important at this point. At the inception of
the securities laws, Congress was deliberate in its design of a
statutory scheme of self-regulation. It was recognized that it was
impractical for government to provide the necessary resources to
effectively regulate the securities industry and there was a
legislative preference that the industry, as opposed to greater
taxpayer-funded appropriations, pay for the task of necessary and
increasingly extensive regulation. Congress understood that conflicts
could arise in such a system of regulation, but, as the SEC's 1963
Special Study of Securities Markets noted in reflecting the intent of
Congress in words and scheme, ``regulation in the area of securities
should, in short, be a cooperative effort, with the Government
fostering maximum self-regulatory responsibility, overseeing its
exercise, and standing ready to regulate directly where and as the
circumstances require.''
But the views of Congress were fashioned at a time when all self-
regulatory bodies were not-for-profit, member-owned institutions, with
a manageable degree of conflicts. The relatively recent advent of
demutualized, shareholder-owned markets has significantly increased the
degree of conflict by potentially putting at odds the interests of
shareholders in maximizing profits with the interests of market
participants in operating fair and orderly markets. This significantly
increased conflict arising from the marriage of regulation and for-
profit markets is unavoidable; it is a matter of corporate structure
even if it is not fueled by intent. In short, the commercial for-profit
mandates of these SRO's threaten to belie that ``cooperative effort''
between government and self-regulation, noted in the SEC's 1963 Special
Study, when it comes to regulating member conduct. It is the
recognition of this conflict that has led all major European exchanges,
which have lead the way in converting to for-profit, shareholder-owned
structures, to give up the regulation of the financial institutions
that trade on their exchanges. Similarly, it is both the recognition of
conflict and an effective response that are critical to ensuring the
long-term integrity of the U.S. capital markets in international
finance.
NASD is in a unique position among U.S. securities SRO's. NASD has
separated its regulatory operations from any interest in an exchange.
NASD has fully divested itself of the American Stock Exchange, Inc.,
and with the SEC's recent approval of Nasdaq's application to become a
registered national securities exchange, will complete the process of
selling its remaining financial interest in Nasdaq before the end of
the year.
We also have taken effective actions to address member conflict
issues, implementing rigorous corporate structure changes to prevent
undue influence of regulated firms over boards, key committees and
staff. These actions reflect both structural and procedural changes to
many of the core aspects of NASD operations and address the very
conflicts of concern identified by the SEC in its review of self-
regulation. With respect to funding, as noted earlier, virtually all
broker-dealers are
required to be NASD members. We have the authority to assess our
members, as necessary, to fund our regulatory operations, and they
cannot resign membership unless they give up doing securities business
with the public. We do not face the same types of competitive pressures
as other SRO's to retain their members. NASD has members subject to
regulation, not customers.
For these reasons, any partnership with the NYSE, and any resulting
SRO structure, must preserve these attributes of independence in the
SRO exercise of the regulatory mandate.
Rule Harmonization
In its February 7, 2006, response to comments filed with the SEC
regarding its Archipelago merger, the NYSE suggests that rule
harmonization with NASD will effectively address the conflicts between
its for-profit exchange and its member regulatory function. But NASD
believes harmonized rules amount to a topical treatment of some--but
not all--symptoms of a more serious problem.
There are several reasons why harmonization of rules is a less-
than-ideal substitute for the hybrid model of self-regulation. First,
harmonization does not resolve the inescapable conflict where an SRO
both operates a trading market and regulates that market's
participants, which in some instances may be competitors of that
market. Under the hybrid model of self-regulation, the SRO responsible
for member regulation would have no incentive to promulgate rules that
either drive business to a particular market center or otherwise
protect the SRO's commercial interests; the NYSE model is unavoidably
embedded with these conflicts because of its shareholder-owned,
publicly held, for-profit structure, and the answer does not lie in
making the rulebooks of a conflicted SRO and a nonconflicted SRO look
alike.
Second, while harmonization would result in substantially similar
rulebooks, it would not eliminate all duplicative costs and efforts
associated with having two organizations, rather than one, write,
administer, and enforce those rules. Third, harmonization at the level
of the SRO rulebook will inevitably not be sustainable as divergence
will necessarily occur at the level of interpretation, examination, and
enforcement. Common sense dictates that more effective, efficient, and
evenhanded rules would result from a single rulemaking entity than from
an arranged marriage of two distinct entities with differing
institutional histories.
Benefits of Self-Regulation
Clearly, in light of developments at the SRO's, it is appropriate
to consider the future of the self-regulatory model. The evolving model
of securities regulation has proven effective through nearly 70 years
of regulatory experience. Both Congress and the SEC have periodically
examined the role of self-regulation in the securities industry, and
while each has taken steps when needed to remedy shortcomings, the
concept of self-regulation has been repeatedly reaffirmed and
strengthened.
The self-regulatory model has many important benefits to investors
and the markets. Self-regulation can and does extend past enforcing
just legal standards to adopting and enforcing ethical standards (that
is, just and equitable principles of trade). Government regulation is
well-suited for policing civil or criminal offenses, but less so for
ethical lapses, which, while not necessarily illegal, may be unfair or
hinder the functioning of a free and open market. Self-regulation is
uniquely capable of protecting investors from those sorts of
transgressions.
Private funding is another critical advantage to the self-
regulatory model. Millions of dollars can be spent by SRO's on
examination, enforcement, surveillance, and technology at no cost to
the U.S. Treasury. In a self-regulatory system, the industry--not the
taxpayers--pays for regulation by NASD. Regulators operating in the
private sector are also better positioned to move quickly to address
regulatory issues because, among other things, they are not subject to
spending restrictions of the Federal Government, and are better able to
develop large-scale systems for regulatory matters like market
surveillance, broker registration, and trade reporting.
Moreover, private-sector regulators are able to tap industry
expertise in ways not readily available to the government and to use
this expertise to better protect investors and ensure market integrity.
Among other things, this expertise helps to make certain that rules are
practical, workable, and effective. Also, industry participants often
are in the best position to identify potential problems, thus enabling
regulators to stay ahead of the curve.
Need for Separation of Market and Regulator
This is not to say that self-regulation is free from conflicts.
NASD's evolution into its current corporate structure and separation
from Nasdaq illustrates the conflicts that exist when an entity both
owns and regulates a market, and how NASD resolved those conflicts.
In the mid-1990's, NASD faced a conflict that fundamentally altered
its existence. The SEC found NASD to be negligent in how it regulated
its member firms and their trading on Nasdaq. This finding called into
question NASD's corporate structure and whether it was appropriate for
managing both the regulation of more than 5,000 firms and their half-
million securities professionals, and the operation of a trillion-
dollar securities market with its own myriad purposes.
In November 1994, the NASD Board of Governors appointed an
independent committee to review NASD's corporate governance structure
and recommend changes that would enable NASD to better meet its
regulatory and business obligations, including oversight of the Nasdaq
Stock Market. In September 1995, the committee recommended the
establishment of two distinct subsidiaries: One to perform NASD's
regulatory functions and the other to run Nasdaq. The committee
recommended that each subsidiary have a separate Board of Directors and
that NASD remain as the nonprofit parent corporation overseeing the
operations of both subsidiaries.
Based on those recommendations, NASD formed two subsidiaries--NASD
Regulation and Nasdaq. And, just as importantly, NASD implemented a new
corporate governance structure that ensured a majority of NASD's Board
of Governors would be from outside the securities industry. In 2000,
NASD created another subsidiary for its mediation and arbitration
functions, NASD Dispute Resolution.
In 2000, when Nasdaq decided to become a shareholder-owned,
publicly traded exchange, NASD determined that the existing structure
that placed regulatory activities in a subsidiary no longer afforded
sufficient protection for investors. Operating an exchange to maximize
profits for shareholders and simultaneously managing regulatory
activities to fully protect investors could not be conducted under the
same corporate structure without unmanageable conflicts, in our view.
We therefore restructured Nasdaq and NASD as two wholly separate
companies with separate managements, separate funding sources and
separate, nonoverlapping boards. The
governance separation is complete; economic separation is near
completion with the recent action by the SEC to designate Nasdaq an
exchange and the sale of NASD's remaining minority share ownership in
Nasdaq, which we are committed to doing by the end of this year.
Conclusion
Thank you for giving us the opportunity to testify on this
important topic and for your timely review of the securities industry's
self-regulatory structure. NASD looks forward to working with Congress
as it continues to review the changing regulatory landscape.
PREPARED STATEMENT OF HENRY T.C. HU
Allan Shivers Chair in the Law of Banking and Finance
University of Texas School of Law
March 9, 2006
Introduction
Mr. Chairman, Senator Sarbanes, and Members of the Committee, thank
you for inviting me. My name is Henry Hu and I hold the Allan Shivers
Chair in the Law of Banking and Finance at the University of Texas Law
School. My testimony today reflects preliminary personal views and does
not represent the views of my employer or any other entity. In the
interests of disclosure, I had served without compensation on the Legal
Advisory Board of the National Association of Securities Dealers.\1\
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\1\ I am on NASD's e-Brokerage Committee and anticipate being on
NASD's Market Regulation Committee.
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While the topic of today's hearing opens the door to a number of
important issues, I would like to focus on the delicate questions
raised by the relationship between NYSE Regulation and NYSE Group. In
the new environment in which the New York Stock Exchange (the Exchange)
operates on a for-profit basis, I am especially concerned by the issue
of ``togetherness''--the structural and institutional bonds that link
NYSE Regulation and NYSE Group--and the potentially troubling
implications for regulation.\2\ Ironically, the Exchange has long been
the symbol of American capitalism, notwithstanding its nonprofit
status. Now, as the Exchange is itself joining the capitalist parade,
it holds a nonprofit entity close to its heart.
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\2\ I largely leave aside the related issue of regulatory
duplication caused by the overlapping jurisdictions of the NYSE and the
NASD. Among other things, the NYSE has represented to the SEC that it
has undertaken to work with the NASD and industry representatives to
eliminate inconsistent rules and duplicative examinations and to submit
proposed rule changes within 1 year. See Securities and Exchange
Commission, Self-Regulatory Organizations; New York Stock Exchange,
Inc.; Order Granting Approval of Proposed Rule Change and Amendment
Nos. 1, 3, and 5 Thereto and Notice of Filing and Order Granting
Accelerated Approval to Amendment Nos. 6 and 8 Relating to the NY
Business Combination with Archipelago Holdings, Inc., Release No. 34-
53382, 2006 SEC LEXIS 457, at 11-12 (Feb. 27, 2006) [hereinafter
February 27 SEC Order].
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This is a curious structure, one where ends and means do not quite
seem to line up. From the standpoint of first principles, it is
extremely difficult to ensure that an organization actually pursues the
objectives the organization is supposed to pursue. As Members of
Congress, you are well aware that bureaucracies often take on a life of
their own--developing their own agendas and pursuing their own
interests. Simply setting out the formal ends of an organization is not
enough. Experience demonstrates that carefully conceived legal and
other mechanisms are essential. An expectation that the newly
configured Exchange can both fully pursue its regulatory ends at the
same time as it fully pursues its shareholder wealth-maximization ends
may represent the triumph of hope over experience.
I would like to emphasize that my concerns pertain to issues
inherent in structural design and do not reflect on the capabilities of
particular individuals. John Thain and Rick Ketchum are exceptional
managers who have risen to extraordinary challenges. But,
unfortunately, structures cannot be designed on the assumption that
exceptional individuals will always be in place.
``Simple'' Ends and Sophisticated Legal and Market-Driven Means:
The Publicly Held Corporation
Even when relatively ``simple'' ends are involved, ensuring that an
organization follows those ends is a difficult task. Elaborate legal
and market-driven means are necessary, and they sometimes do not work.
We need look no further than the publicly held corporation.
The theme of means and ends has dominated thinking about governance
of publicly held corporations since the 1930's. In the classic Berle-
Means framework, managers hold few shares but exercise substantial
control over their firms. Although shareholders own the company, they
face collective action problems in effectively overseeing corporate
managers. Modern corporate governance has largely revolved around one
question: What mechanisms will lead managers to act in the interest of
shareholders, that is, to act in accordance with the formal ends of the
corporation?
So, in terms of legal means, we have state substantive law (for
example, fiduciary duties such as the duty of loyalty owed by managers
to shareholders) as well as Federal disclosure requirements (for
example, proxy statements and annual reports). In terms of market
means, we have institutional investor activism and the pervasive threat
of corporate takeovers to discipline wayward managers.
This highly sophisticated system has evolved over many decades,
with the benefit of both hard experience and new learning. Yet, in the
cases of Enron, WorldCom, and other corporate debacles still fresh in
our minds, all of the legal and market mechanisms--all four engines on
the airplane--failed simultaneously. The scandals remind us of the
difficulty of ensuring that corporate managers behave in a manner
consistent with even ``simple'' ends. Today, our system for the
governance of the publicly held corporation, although the best in the
world, is still a work in progress.
``Complex'' Ends and Simple Means: NYSE Regulation-NYSE Group
Turning to the new corporate structure of the New York Stock
Exchange, our previous example of the typical corporation with a
relatively one-dimensional objective--serving shareholder interests--
becomes far more complex. Here, the ends diverge along different paths:
Shareholder wealth maximization at the level of the holding company,
but the fulfillment of regulatory responsibilities at the level of a
wholly owned subsidiary. The governance question Congress and the
Securities and Exchange Commission must consider revolves around this
question: Are the legal and other mechanisms equal to the task of
ensuring adherence to these complex ends?
The New NYSE Structure: The Ends
With this week's anticipated merger,\3\ the businesses of the
Exchange and Archipelago Holdings are now held under a single, publicly
traded holding company: The NYSE Group. The Exchange's current
businesses and assets are held in three separate entities: New York
Stock Exchange LLC (NYSE LLC), NYSE Market, and NYSE Regulation. NYSE
LLC will be a direct, wholly owned subsidiary of NYSE Group and is
expected to hold all of the equity interests of NYSE Market and NYSE
Regulation. The essential trading and regulatory activities which we
had associated with the traditional Exchange will be operated, under
the new system, by these latter two subsidiaries pursuant to two
contracts. NYSE LLC is delegating the exchange business to NYSE Market
under one contract. And, more importantly for our purposes, NYSE LLC is
delegating certain of the regulatory functions to NYSE Regulation. NYSE
Regulation is organized as a nonprofit corporation under New York law
and, as noted, is a wholly owned subsidiary of NYSE LLC, which in turn,
is a wholly owned subsidiary of the NYSE Group.
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\3\ I am assuming the system as approved in the February 27 SEC
Order and leave aside transitional provisions. Exhibits 5A through 5K
of Amendment No. 8 to the proposed rule change relating to NYSE's
business combination with Archipelago Holdings setting forth the text
of the NYSE rules and the governing documents, as proposed to be
amended, are available at http://www.sec.gov/rules/sro.shtml
[hereinafter SEC-Approved NYSE Documents].
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The ends with respect to the new structure are more complex than
with the usual publicly held corporation. The proper ends of the NYSE
Regulation are to further most of the traditional regulatory functions
of the Exchange: To engage in market surveillance, to regulate market
firms, and to ensure that listed companies comply with Exchange
rules.\4\ The proper ends of NYSE Group center on maximizing the wealth
of its shareholders. In certain circumstances, conflicts will arise
between NYSE Regulation's regulatory goals and NYSE Group's shareholder
wealth-maximization goals. In such circumstances, in theory, NYSE
Regulation's regulatory mission is to trump the interests of the parent
company's shareholders.
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\4\ See Certificate of Incorporation of NYSE Regulation, Inc.,
reproduced at SEC-Approved NYSE Documents, supra note 3, at Article II
(specifying the formal purposes of NYSE Regulation) [hereinafter NYSE
Regulation Certificate of Incorporation].
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NYSE Regulation: The Means
A variety of means are used to try to ensure that NYSE Regulation
adheres to its regulatory mission. Some of the key steps are:
(1) NYSE Regulation CEO and Board \5\
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\5\ See Amended and Restated Bylaws of NYSE Regulation, Inc.,
reproduced at SEC-Approved NYSE Documents, supra note 3, at Article III
(specifying directors and board committees) [hereinafter NYSE
Regulation Bylaws]; February 27 SEC Order, supra note 2; Securities and
Exchange Commission, Approval of SRO Rule Changes Necessary to
Effectuate Merger of NYSE and Archipelago Holdings, Feb. 27, 2006
(press release: 2006-29).
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(a) The CEO of NYSE Regulation will report solely to
NYSE Regulation's board. The CEO will be a member of
this board and may not be an officer or employee of any
unit of NYSE Group other than NYSE Regulation.
(b) NYSE LLC will choose NYSE Regulation directors,
subject to the following constraints:
(i) All directors on the board of NYSE
Regulation (other than its CEO) are required to
be ``independent'' as to NYSE Group under NYSE
Group guidelines (that is, independent from
management, listed companies, and member
organizations). Thus certain NYSE Group
directors can serve as directors of NYSE
Regulation.
(ii) A majority of the directors of NYSE
Regulation will be persons who are not NYSE
Group directors. These ``Non-Affiliated
Regulation Directors'' are nominated by the
``Nominating and Governance Committee,'' a
committee consisting solely of NYSE Regulation
directors.
(iii) 20 percent, and not less than two of the
NYSE Regulation directors will be chosen by
members of NYSE LLC. These ``Regulation Fair
Representation Directors'' are recommended by
the ``Director Candidate Recommendation
Committee'' (DCRC), a committee that is
appointed by the NYSE Regulation board but does
not consist of NYSE Regulation directors.
(iv) The Nominating and Governance Committee
will nominate at least one director candidate
to represent issuers and one director candidate
to represent investors, according to a
representation by the Exchange to the SEC.
(2) Committees of the Board and Committees Appointed by the
Board
(a) The NYSE Regulation board's ``Compensation
Committee'' shall be responsible for setting the
compensation for NYSE Regulation employees. Directors
of the NYSE Group shall constitute a minority of the
committee.
(b) Directors of the NYSE Group shall constitute a
minority of the NYSE Regulation board's Nominating and
Governance Committee. Members of the DCRC appointed by
the NYSE Regulation board do not have to meet any
independence requirements. Indeed, this latter
committee must include specified numbers of individuals
drawn from various NYSE Market members.
(c) The NYSE Regulation board will appoint a
``Committee for Review'' that will be comprised of any
NYSE Regulation board member other than the CEO as well
as persons who are not directors. A majority of the
members voting on a matter must be NYSE Regulation
directors. The other members will include
representatives of members of NYSE LLC, specialists,
and floor brokers. This committee will, among other
things, review disciplinary decisions on behalf of the
NYSE Regulation board.
(d) The Exchange has represented that it is expected
that the audit committee of the NYSE Group board will
perform the NYSE Regulation board's audit committee
functions.
(3) NYSE Regulation Finances \6\
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\6\ See February 27 SEC Order, supra note 2, at 128-32; Delegation
Agreement (among NYSE LLC, NYSE Regulation, and NYSE Market),
reproduced at SEC-Approved NYSE Documents, supra note 3, at II(A)(14)-
(17) [hereinafter NYSE LLC Delegation Agreement].
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(a) NYSE LLC has delegated to NYSE Regulation the
authority to assess NYSE LLC members in order to cover
the costs of regulation. Subject to SEC approval, NYSE
Regulation will determine, assess, collect, and retain
examination, registration, arbitration, and other
regulatory fees.
(b) NYSE Regulation will also receive funding
independently from the markets for which it will
provide regulatory services. For instance, the Exchange
has represented that there will be an explicit
agreement among NYSE Group, NYSE LLC, NYSE Market, and
NYSE Regulation to provide ``adequate funding'' to NYSE
Regulation.
(c) NYSE Regulation establishes and assesses fees and
other charges on NYSE LLC members and others using the
services or facilities of NYSE Regulation.
(d) NYSE LLC will not be permitted to use any assets of
or regulatory fees, fines, or penalties collected by
NYSE Regulation for commercial purposes or distribute
them to any other NYSE Group-related entity.
(e) NYSE Regulation determines its annual budget and
the allocation of its resources.
(4) Promises of Non-Interference \7\ and Delegation of
Responsibility \8\
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\7\ See, for example, Amended and Restated Certificate of
Incorporation of NYSE Group, Inc., reproduced at SEC-Approved NYSE
Documents, supra note 3, at Articles VI (Section 8), XI, XII, and XIII
[hereinafter NYSE Group Certificate of Incorporation].
\8\ See NYSE LLC Delegation Agreement, supra note 6.
---------------------------------------------------------------------------
(a) A variety of provisions in the NYSE Group's
certificate of incorporation and bylaws seek to
preclude the NYSE Group from interfering with the self-
regulatory obligations of NYSE LLC, NYSE Market, and
NYSE Regulation. By way of example, NYSE Group board
members must ``to the fullest extent permitted by
applicable law'' take into consideration the effect
that the NYSE Group's actions would have on the ability
of such regulated subsidiaries to carry out their
responsibilities under the Securities Exchange Act of
1934.
(b) Certain regulatory responsibilities are delegated
to NYSE Regulation. With exceptions, NYSE LLC delegates
to NYSE Regulation the responsibility to establish and
administer rules relating to the business of exchange
members and enforce rules relating to trading on the
NYSE Market and in NYSE-listed securities by member
firms. A decision upon appeal to the NYSE Regulation
board of disciplinary matters shall be the final action
of NYSE LLC.
(c) The exceptions just referred to are not
insignificant. Apart from NYSE Regulation disciplinary
decisions, the NYSE LLC board can review, approve, or
reject the actions of NYSE Regulation. In addition,
NYSE LLC has the right to, among other things, resolve
any disputes between NYSE Regulation and NYSE Market
and coordinate actions of NYSE Regulation and NYSE
Market ``as necessary.''
A Preliminary Evaluation
On the surface, the legal protections created by the Exchange to
avoid conflicts and to protect the integrity of its dual functions
appear robust. But a closer examination suggests that the legal means
and market-based incentives in place may prove inadequate.
Legal Means: The ``Minority of Directors'' Theme
With regard to the legal framework, a fundamental assumption of the
new governance structure is the notion that NYSE Regulation's
independence will be preserved by limiting the participation of NYSE
Group's insiders and directors on NYSE Regulation's board. The basic
argument is that because ``only a minority of directors'' on NYSE
Regulation's board and various committees will come from NYSE Group,
the truly independent NYSE Regulation directors are in full control and
completely directed to proper regulatory ends.
I am not fully persuaded by this ``minority of directors''
argument. A minority position does not automatically equate to minor
influence. For example, let us say that the Chairman of the NYSE Group
happens to be one of the members of NYSE Regulation's board. He would
be the 800 pound gorilla in the room. His influence will inevitably far
exceed his voting power as an individual board member.
Moreover, board meetings generally operate through consensus, not
by actual contested voting. Thus, the fact that NYSE Group directors
constitute a minority of NYSE Regulation's board does not render them
powerless over important regulatory decisions. And the reality is that
many corporate boards operate with a certain element of structural
bias--a ``go along to get along'' mentality. Such bias, inherent in the
governance of almost all publicly held corporations, may reduce the
incentive for NYSE Regulation's independent directors to aggressively
pursue regulatory matters that threaten the financial interests of
their corporate parent.
Finally, apart from a possible fixed fee for attendance at each
meeting, NYSE Regulation's bylaws prevent board members from being paid
for their directorial services. This fact further reduces the
likelihood that NYSE Regulation's independent directors will be willing
to fully engage with those directors with the luster and prestige of
being on the parent company's board.
Legal Means: The Relationship between NYSE LLC and NYSE Regulation
Another structural concern that warrants the Committee's attention
is the relationship between NYSE LLC and NYSE Regulation. NYSE LLC is a
wholly owned subsidiary of the NYSE Group and a vital element in the
NYSE Group's efforts at shareholder wealth maximization. Although NYSE
LLC lacks authority over NYSE Regulation's individual disciplinary
actions and there is SEC oversight, NYSE LLC does have authority over
general rules and other actions undertaken by the regulatory arm. These
general rules will guide future activity by NYSE Regulation--including
future disciplinary actions. NYSE LLC has explicitly retained the right
to, among other things, resolve any disputes between NYSE Regulation
and NYSE Market. The bottom line is that, other than as to individual
disciplinary matters, NYSE LLC has extensive authority with respect to
the behavior of NYSE Regulation.
Market Incentives
The above discussion has focused on ``legalisms'' and formal
governance issues. As important is another question which is often
overlooked--to what extent will reform of the New York Stock Exchange
alter incentives and other market mechanisms that play a crucial role
in our system of self-regulation. In the American model of corporate
governance, incentives and related mechanisms are terribly important.
When properly designed, executive compensation packages can help to
properly align the interests of managers with those of shareholders.
Too often, we have seen compensation packages that instead create
perverse incentives for managers, the detriment of shareholders as well
as the public alike.
In the case of NYSE Regulation, compensation will be set by its
board. But as discussed above, the board remains susceptible to NYSE
Group's influence. In addition, because of likely differences in NYSE
Group and NYSE Regulation compensation, the prospect of an alternative
career path at the for-profit parent level may be attractive to those
at NYSE Regulation. This may reduce incentives on the part of those at
NYSE Regulation to take actions inconsistent with the goals of the NYSE
Group.
Another matter of concern is the agreement that provides for
``adequate funding'' of NYSE Regulation. Who determines what is
adequate? On what basis is ``adequate'' determined? How often is this
determination reviewed and revised? Will NYSE Regulation's actions be
influenced by the possible leverage over funding that NYSE LLC and NYSE
Market may have?
Furthermore, NYSE Regulation provides regulatory services pursuant
to contract with a limited term. There are no answers as of yet as to
what happens when this contract terminates--and how this knowledge of
an impending change would influence NYSE Regulation decisions. Has the
Exchange fully considered what happens in the inevitable ``end-game''?
This is the Hong Kong-in-1999 issue.
NYSE Group Directors on the NYSE Regulation Board
The possible conflict between NYSE Group shareholder wealth-
maximization goals and NYSE Regulation regulatory goals is brought into
sharpest relief when looking at the duties of the NYSE Group directors
who serve on the NYSE Regulation board. As a matter of corporate law,
each such director has a divided allegiance. As an NYSE Group director,
he owes a duty of loyalty to NYSE Group shareholders; thus, he must
generally undertake decisions that would further the interests of the
shareholders. As an NYSE Regulation director, he owes a duty to further
the regulatory goals of NYSE Regulation. Can he serve two masters,
especially when the two masters' goals differ in their very nature?
In the normal corporate law context, one situation in which
corporations with common directors transact business with each other is
where one corporation is the controlling shareholder of another
corporation. To what extent will common directors participate in
intercorporate dealings when there are real or apparent conflicts? If
they do participate, to what extent should the dealings be voidable or
subject to special scrutiny? Given that the case law with respect to
common directors and the obligations of controlling shareholders do not
provide clear guidance, the actual behavior of such NYSE Group
directors may be especially difficult to predict. Moreover, because of
the special public responsibilities of the Exchange and the importance
of public confidence, the mere appearance of self-interested behavior
is troublesome.
Conclusion
In conclusion, SEC Chairman Christopher Cox has stated that he
intends to closely monitor the NYSE's performance under the new
structure. This is commendable. It is also vital.
The not-for-profit NYSE Regulation within the for-profit NYSE Group
structure is an experimental structure. It is one that is far more
complicated than that of the usual publicly held corporation. The ends
involved here cannot, as with the usual publicly held corporation, be
essentially reduced to the single end of shareholder wealth
maximization. Yet, ironically, the legal and market mechanisms in place
here seem far more primitive than those operating in the publicly held
corporation context. I worry whether, in fact, the mechanisms here are
sufficient to ensure adherence to the stated goals.
But just because there are possible problems with this NYSE
approach does not mean necessarily mean that some full or partial
alternative is better overall--whether that alternative is a spun-off
NYSE Regulation, a joint venture with the NASD, or something else. An
apples for apples comparison is necessary. After all, even traditional
not-for-profit self-regulatory organizations are hardly free from
conflicts of interest. Far from it. But one advantage to a more
traditional SRO is that we have experience. Moreover, the goals of such
an SRO are simpler and do not get so intertwined with the goal of
shareholder wealth maximization. Coming up with tolerably good
organizational structures may be easier as a result. On the other hand,
there are many benefits to the togetherness advocated by the NYSE. But
the benefits of such togetherness do need to be weighed against the
costs. And among the soft, hard-to-quantify, costs are the many
uncertainties associated with a complicated experimental structure.
When the playwright Henrik Ibsen was ill, a nurse came to take a
look. The nurse said to Ibsen that he ``seemed to be a little better.''
Ibsen said ``[o]n the contrary''--and died. It is important to go
beyond a quick look. It is important to go beyond stated goals and to
try to assess whether the legal and market mechanisms in place will in
fact nurture and sustain those goals. I say ``maybe.''
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PREPARED STATEMENT OF MARC E. LACKRITZ
President, Securities Industry Association
March 9, 2006
Introduction
Mr. Chairman and Members of the Committee, I am Marc E. Lackritz,
President of the Securities Industry Association.\1\ We commend you for
holding this hearing and appreciate the opportunity to testify on
reforming the securities industry's self-regulatory system.
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\1\ The Securities Industry Association brings together the shared
interests of approximately 600 securities firms to accomplish common
goals. Our primary mission is to build and maintain public trust and
confidence in the securities markets. Our members (including investment
banks, broker-dealers, and mutual fund companies) are active in all
U.S. and foreign markets and in all phases of corporate and public
finance. According to the Bureau of Labor Statistics, the U.S.
securities industry employs nearly 800,000 individuals, and its
personnel manage the accounts of nearly 93-million investors directly
and indirectly through corporate, thrift, and pension plans. In 2004,
the industry generated $236.7 billion in domestic revenue and an
estimated $340 billion in global revenues. (More information about SIA
is available at: www.sia.com.)
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Our Nation's securities markets are the most transparent, liquid,
and dynamic in the world. New forms of competition, technological
advances, globalization, and broader investor participation have driven
phenomenal changes in the capital markets and the securities industry
over the past decade. Our industry has embraced these changes, further
strengthening the preeminent status of the U.S. capital markets across
the globe. The mergers between the New York Stock Exchange (NYSE) and
Archipelago Holdings, Inc., as well as the Nasdaq Stock Market (Nasdaq)
merging with Instinet, LLC, are a natural and healthy outgrowth of
these trends.
Our markets' advantages are also grounded in their structural
framework. Self-regulation--and the historical level of member
cooperation in particular--has been a key ingredient to our success.
For example, the extensive expertise of members and their involvement
in the rulemaking process has undoubtedly led to more effective, less
costly self-regulatory rules. As the SEC has noted, self-regulation
``has been viewed as having certain advantages over direct governmental
regulation'' because ``[i]ndustry participants bring to bear expertise
and intimate knowledge of the complexities of the securities
industry.'' \2\ Self-regulatory organizations (SRO's) also ``supplement
the resources of the government and reduce the need for large
government bureaucracies'' and ``can adopt and enforce compliance with
ethical standards beyond those required by law.'' \3\
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\2\ Report Pursuant to Section 21(a) of the Securities Exchange Act
of 1934 Regarding the NASD and the Nasdaq Stock Market (Aug. 8, 1996),
available at http://www.sec.gov/litigation/investreports.shtml.
\3\ Id.
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Despite these compelling benefits, self-regulation has two
significant drawbacks: (1) conflicts of interest between SROs' roles as
both market operators and regulators, and (2) regulatory inefficiencies
resulting from duplication among multiple SRO's. In addition, the
regulatory environment in which the securities industry operates has
undergone a profound transformation in recent years, resulting in
dramatically higher compliance costs.\4\ One industry observer noted
the confluence of these issues, saying, ``Tighter regulation and more
disclosure and compliance give investors the feeling that they are
better off and safer, but that's only true when each level of
compliance adds to the others, rather than overlapping significantly.''
\5\
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\4\ We recently issued a report demonstrating that the cost of
compliance for the securities industry has nearly doubled over the past
3 years. The Costs of Compliance in the U.S. Securities Industry, SIA
Research Reports, Volume VII, No. 2 (Feb. 22, 2006), available at
http://www.sia.com/research/pdf/RsrchRprtVol7-2.pdf.
\5\ Jaffe, Commentary: Added Regulation Bringing Few Benefits,
MarketWatch.com, (March 1, 2005), available at http://
www.marketwatch.com/News/Story/Story.aspx?guid=%7B46193141
%2D1FB2%2D4506%2D852C%2D984A40692178%7D&siteid= google.
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The Committee's interest today in these developments is timely, as
the mergers present the perfect opportunity to undertake structural
reform and address the aforementioned drawbacks. However, if no action
is taken these deficiencies will redouble as conflicts of interest and
regulatory duplication extract an ever-increasing cost on industry and
investors.
To address these concerns, we support consolidation of the broker-
dealer regulatory functions for firms that are dually regulated by both
the NYSE and the NASD in accordance with the following objectives:
There should be one principles-based rulebook for broker-
dealer activities, and one source of interpretations, examinations,
and investigations for compliance with that rulebook;
Broker-dealers should have fair representation in the
governance of the SRO that oversees their affairs;
Broker-dealers should pay fees for regulation of broker-dealer
activities through a transparent fee-setting process, and fees for
specific services or products should be designed to recover costs,
but not to subsidize the general cost of regulation or to cross-
subsidize other products or business lines;
The SRO's costs should be contained in a budget that is
subject to independent review; and
Examination programs and queries for trade information should
be structured to eliminate duplication.
These objectives should be embodied in a single organization for
those broker-dealers currently subject to duplicative regulation by the
NYSE and the NASD. By eliminating unnecessary regulatory duplication
and inherent conflicts of interest, a revamped self-regulatory
structure can strengthen investor protection and increase the
competitiveness of the U.S. capital markets. A principles-based
rulebook would strengthen the competitiveness of our markets by
capturing the benefits of risk-based regulation now increasingly
practiced in other major markets around the world. Except for
regulation of trading on an exchange, all activities of broker-dealers
that are currently regulated by both the NYSE and the NASD--
encompassing licensing of individuals, sales practices, supervision,
communications with the public, net capital and margin requirements,
account statements and securities distributions--would be handled by
one body. This consolidation would not apply to each exchange's trading
rules, market surveillance, or listing standards, which should remain
separately administered by their respective marketplace SRO's, so as to
draw on specialized knowledge of their own market.
Strengths and Weaknesses of the Current SRO System
The success of today's self-regulatory governance is directly
related to member involvement in the process.\6\ Self-policing by
professionals who have the requisite working knowledge and expertise
about both marketplace intricacies and the technical aspects of
regulation creates a self-regulatory system with valuable checks and
balances. Supplemented by government oversight, this tiered regulatory
system can provide a greater level of investor protection than the
government alone might be able to achieve.
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\6\ See generally S. Rep. No. 94-75, at 22 (1975) (accompanying S.
249, 94th Cong., 1st Sess. (1975)) (In enacting the Exchange Act,
Congress balanced the limitation and dangers of permitting the
securities industry to regulate itself against ``the sheer
ineffectiveness of attempting to assure [regulation] directly through
the government on a wide scale.''); SEC Report of Special Study of
Securities Markets, H.R. Doc. No. 88-95, Part 4 (1963) (Special Study).
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Because self-regulators are on the frontline of marketplace
developments, they have an intimate knowledge of industry operations,
trading, and sales practices. As a result, they can develop and revise
rules--which are typically forward-looking and up-to-date with market
realities--more quickly and frequently than traditional government
regulators. In addition, SRO rules often set standards that exceed
statutory or common law legal minimums. For example, the NASD requires
that its member firms adhere to ``just and equitable principles of
trade,'' a standard that generally exceeds the antifraud requirements
of securities statutes and SEC rules.
Conflicts of Interest
In spite of how well self-regulation has worked, market
participants, governmental bodies, scholars and investor advocates have
recognized in recent years a growing need for structural reform of
self-regulation. The main concern revolves around the potential
conflicts of interest due to the SROs' roles as both market operators
and regulators.\7\ The profit motive of a shareholder-owned SRO further
heightens the concern that self-regulation could be impaired.\8\
Moreover, the current lack of transparency and competition in setting
market data fees is heightened with just two consolidated for-profit
market centers.
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\7\ ``Securities Markets: Competition and Multiple Regulators
Heighten Concerns about Self-Regulation,'' General Accounting Office,
May 2002, GAO-02-362, available at http://www.gao.gov/new.items/
d02362.pdf, at 1-2 (GAO SRO Report). The GAO also noted, ``Heightened
competitive pressures have generated concern that an SRO might abuse
its regulatory authority--for example, by imposing rules or
disciplinary actions that are unfair to the competitors it regulates.''
The SEC shares this concern. ``As intermarket competition increases,
regulatory staff may come under pressure to permit market activity that
attracts order flow to their market . . . . Also, SRO's may have a
tendency to abuse their SRO status by over-regulating members that
operate markets that compete with the SRO's own market for order
flow.'' Concept Release Concerning Self-Regulation, 69 Fed. Register
71256, 71262 (Dec. 8, 2004) (SEC SRO Concept Release).
\8\ The SEC has stated that:
``SRO demutualization raises the concern that the profit motive of
a shareholder-owned SRO could detract from self-regulation. For
instance, shareholder-owned SRO's may commit insufficient funds to
regulatory operations or use their disciplinary function as a revenue
generator with respect to member firms that operate competing trading
systems or whose trading activity is otherwise perceived as
undesirable.''
SEC SRO Concept Release, at 71263.
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This conflict between operating and regulating a market has been
publicly discussed since the NYSE first raised the idea of
demutualizing in the late 1990's. For example, NYSE Group (the for-
profit parent) would have an interest in promoting trading products
offered by it, and discouraging broker-dealers from offering competing
products. Similarly, NYSE Group would have a strong interest in
promoting trading on its exchange, and could discourage broker-dealers
or their affiliates from offering, or routing trades to, competing
platforms. These types of conflicts have long been an issue between
exchanges and their members, even predating for-profit exchanges.
Conflicts have grown as exchange members have become increasingly
competitive with the NYSE. For example, NYSE members have been
internalizing order flow and offering alternative trading venues that
compete with the NYSE for third party order flow.\9\ Once an exchange
or its parent gains for-profit status, this conflict of interest
becomes much more acute.\10\ In addition, as the NYSE Group or its
subsidiaries enter into a broader array of businesses, or add to their
trading products (as they have stated they plan to do) \11\ the
opportunities for conflicts will multiply.
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\9\ ``[S]elf-regulation now poses massive agency-cost problems
because exchanges are seeking to regulate members who are, in fact,
competing firms rather than firms with whom the exchanges' interests
are aligned with respect to most regulatory issues.'' Jonathan R. Macey
& Maureen O'Hara, From Markets to Venues: Securities Regulation in an
Evolving World, 58 Stan. L. Rev. 563, 578 (Macey & O'Hara). For an
illustration of the long history of competitive issues between the NYSE
and its members see, e.g, The Structure of the Securities Market--Past
and Future, Thomas A. Russo and William K.S. Wang, 61 Fordham L. Rev.
1, 42 (1972) (The New York Stock Exchange has taken every opportunity
to fight competition . . . .'' (citing then-current illustrations)).
\10\ Macey & O'Hara at 581.
\11\ Interview by CNBC News with NYSE Chairman Marshall N. Carter
and NYSE CEO John A. Thain (April 8, 2005)(quoting Mr. Thain as stating
``Well, as I've said before, I think we would like to see some
derivative trading, some options trading, and certainly some fixed
income trading.), available at http://www.nyse.com/
Frameset.html?displayPage=/about/1113302992 920.html.
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The SEC recently approved a restructuring of the NYSE regulatory
function in connection with the Archipelago merger.\12\ We think that
the proposal approved by the SEC falls short of the degree of
separation that is necessary to insulate regulation from the business
interests of a for-profit parent.\13\ However, we do not wish to
disturb the finality of the SEC's decision, on which the NYSE's
legitimate and urgent business plans rest. Rather, we hope that the
Commission, with the support of this Committee, will continue to
address this issue by ensuring that the NYSE and NASD finalize their
stated intentions to move the regulatory functions that are the primary
source of the conflict--regulation by the NYSE of its competitors
\14\--out of the sole control of the NYSE and into an entity that
consolidates the overlapping regulatory programs of the NASD and NYSE.
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\12\ Exchange Act Rel. No. 34-53382 (Feb. 27, 2005), available at
http://www.sec.gov/rules/sro/nyse/34-53382.pdf (SEC Approval Order).
\13\ Letter to Nancy M. Morris, Secretary, Securities and Exchange
Commission, from Marc E. Lackritz and Micah S. Green, (Feb. 2, 2006),
available at http://www.sec.gov/rules/sro/nyse/nyse200577/
melackritz020206.pdf. (SIA-TBMA comment letter). The SEC Approval
Order, while noting our main concerns, took few steps to address the
concerns raised by many commenters on the lack of sufficient separation
between NYSE Group and its regulatory affiliates.
\14\ Similar concerns relating to Nasdaq becoming a for-profit
company are less substantial due to the gradual shedding of the NASD's
equity interest in Nasdaq. However, the NASD still has a stake in
Nasdaq that it is trying to sell.
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Duplicative and Inconsistent Regulation
Another major concern is duplicative and inconsistent regulation
among multiple SRO's, as well as redundant SRO regulatory staff and
infrastructure.\15\ Regulatory duplication can, and does, occur with
rulemaking, data reporting, examinations, and enforcement actions. On
the rulemaking front alone, both the NYSE and the NASD frequently adopt
separate rules on similar or identical topics, leaving many firms to
cope with two different standards, including different recordkeeping,
procedural and audit trail requirements for the same product or
service. Similarly, on the examination front firms have expressed
concern about a lack of coordination among the SRO's, and between the
SRO's and the SEC's Office of Compliance Inspections and Examinations
(OCIE). Another area of significant and rising redundancy concerns
trade reporting. Currently, the trade information requested and the
formats may be different for each SRO. Since the information requested
could go back many years, firms must maintain access to all the old
historical data while allowing the flexibility to augment the data with
today's newly requested and created fields of information resulting
from new regulation. This process is extremely difficult and costly to
manage. A consolidated SRO would more easily be able to work with the
industry to develop a system that would submit all order and execution
data in a standardized format to an industry data warehouse. This will
eliminate a key unnecessary redundancy in the current SRO system.
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\15\ ``Multiple SRO's can result in duplicative and conflicting SRO
rules, rule interpretations, and inspection regimes, as well as
redundant SRO regulatory staff and infrastructure across SRO's.'' SEC
SRO Concept Release at 71264. The GAO has noted similar
``inefficiencies associated with SRO rules and examinations.'' GAO
Report at 2.
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Solutions
In addition to the waste of regulatory resources, the impact on
investors from unnecessary compliance costs, in terms of either
increased costs or reduction in choices of products and services,
should not be minimized. Fortunately, the senior staffs of both the
NYSE and the NASD are signaling a clear intention to address these
issues. We are greatly heartened, for example, by recent remarks by
senior officials of both organizations indicating a commitment to
combine their regulatory functions (albeit with different points of
view on how that should occur).\16\
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\16\ NYSE Seeks a Regulatory Alliance, Wall Street Journal, C-3
(Feb. 23, 2006).
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It is important to emphasize that some form of regulatory
consolidation of NYSE and NASD rules into one risk-based rulebook,
rather than merely seeking to ``harmonize'' two separate rulebooks, is
the only approach that makes sense in the long-term. We have worked
with both SRO's on specific discrepancies between their rulebooks and
interpretations, and many of these issues have been resolved through
great effort.\17\ A recent regulatory effort on business entertainment
is a good illustration of why this approach is only a stopgap solution
that is far less desirable than one consolidated rulebook. In the past
year, both the NYSE and the NASD have considered new rules on gifts and
entertainment given by broker-dealers or their employees to employees
of customers. Initially, the two SRO's considered vastly different
approaches. After we raised concerns about the inconsistent approaches,
the two SRO's worked with each other and with our industry to devise a
single, principles-based approach that is now in the process of being
adopted. Even now, however, there are small but substantive differences
in the key proposed definitions of ``business entertainment'' and
``customer.'' \18\
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\17\ We have also had productive discussions with the NYSE and
NASD, as well as OCIE, on improving coordination among these three
regulators' examination programs. An overview of the results to date of
those discussions is available at http://www.sia.com/
RegulatoryCoordination/index.html.
\18\ For example, the NASD definition requires that to be
considered as ``business entertainment'' rather than under its
different limitations for ``gifts,'' it is necessary that a person
associated with the broker-dealer ``accompanies and participates'' with
the customer's employee in the event, ``irrespective of whether any
business is conducted.'' The NYSE definition requires that an employee
of the broker-dealer ``accompanies'' the customer's employee, without
the added nuance of ``participation.'' Unlike the NASD, the NYSE waives
the accompaniment requirement if ``exigent circumstances make it
impracticable'' for the broker-dealer's employee to attend. See
Proposed NASD IM-3060, NASD Notice to Members 06-06, January 2006
(available at http://www.nasd.com/web/groups/rules_regs/documents/
notice_to_members/asdw_015876.pdf); Proposed NYSE Rule 350A, File No.
SR-NYSE-2006-06, Feb. 15, 2006 (available at SEC Public Information
Office).
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In its recent regulatory filing, the NYSE committed itself to
continuing to work with the NASD to address inconsistent rules and
duplicative examinations, and ``to use its best efforts, in cooperation
with the NASD, to submit to the Commission within 1 year proposed rule
changes reconciling inconsistent rules and a report setting forth those
rules that have not been reconciled.'' \19\ Although this determination
to address inconsistencies and duplication as they arise is
praiseworthy, it is not a satisfactory long-term solution. First, as
the business entertainment example illustrates, it requires continual
senior-level effort to reconcile new discrepancies as they arise, and
even then the resulting rules may have some discrepancies in nuance or
interpretation. Second, harmonization does not resolve the concern
about conflicts when a for-profit exchange has regulatory power over
its competitors. Third, no matter how capable the regulators or how
valiant their efforts to reconcile their rules, in light of the
variations in institutional culture, history, and constituency among
the NYSE and NASD, just synthesizing their rules will be inferior to
what could be produced by a single regulator. Think of the result if
Hemingway and Faulkner sought to ``harmonize'' their work. This is
particularly true given that rule interpretation is as important to the
outcome as the literal wording.
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\19\ Amendment No. 6 to SR-NYSE-2005-77, available at http://
www.sec.gov/rules/sro/nyse/34-53382amend6.pdf.
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Rather than trying to pick and choose between existing SRO rules,
or splitting the difference between two separate rules addressing the
same conduct, investors, issuers, and the industry would benefit
greatly from the more ``prudential'' regulatory approach followed by
other financial service regulators. A principles-based rulebook--one
that abjures the temptations to write highly proscriptive and
inflexible rules, then use examination and enforcement programs to set
unwritten policies that the rules fail to articulate--will benefit
investors and the U.S. capital markets alike. It will foster an
atmosphere in which broker-dealers will be more likely to take the
initiative and approach regulators with issues they have self-
identified in order to seek a rational solution, rather than simply
self-police for compliance with highly technical, and possibly
outdated, rules.
In short, duplication and inefficiency will continue to occur as
long as two separate entities regulate the same conduct of the same
firms. The only effective long-term answer is to combine the best
elements of the existing SRO broker-dealer regulatory programs in one
centrally managed entity that is responsive, accountable, transparent
and well-funded.
Significance of the NYSE-Archipelago Merger
The proposed NYSE-Archipelago merger represents an important
opportunity to address the valid concerns raised by critics of self-
regulation. The following are some observations about the implications
of the merger.
(1) There is strong economic justification for the NYSE's
transition to for-profit status, and none of our comments today should
be taken as opposition to the merger with Archipelago. The merger both
illustrates and accelerates the trend toward increased consolidation
of, and competition between, market centers around the globe. This
competition is, on balance, a very healthy development.
(2) This global competition applies not just to market centers, but
to all types of financial intermediaries. Unnecessary regulatory
duplication and failure to embrace risk-based regulation are weights
around the ankles of financial intermediaries in the United States that
has a real cost in terms of the future competitiveness of our capital
markets. The merger represents an opportunity to address these
disparities.
(3) The merger raises the exact issues that both the SEC and SIA
have identified previously concerning conflicts between shareholders'
interests and regulatory authority. In general, to the extent that
self-regulatory conflicts are seen to have contributed to lapses in
oversight in recent years, the incorporation of the regulatory function
in a for-profit exchange structure can only heighten those concerns. A
number of stock exchanges around the world have become for-profit over
the past decade, and all of them have taken steps to ensure
``structural separation between the supervisory authority and the
management of the exchange or market.'' \20\
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\20\ Macey & O'Hara, note 9, supra, at 581 (surveying the
Australian Stock Exchange, Deutsche Borse, Euronext, Hong Kong
Exchange, London Stock Exchange, OM (Stockholm), Singapore Stock
Exchange, and Toronto Stock Exchange).
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In fairness, the NYSE proposes some steps to address this conflict.
Each of its regulatory divisions (Listed Company Compliance, Member
Firm Regulation, Market Surveillance, Enforcement and Dispute
Resolution/Arbitration) and its 700 employees will be moved into a
separate affiliated nonprofit entity, which will regulate all aspects
of the NYSE parent's markets, as well as the activities of the Pacific
Stock Exchange (which Archipelago now owns).
While moving regulation out of the parent organization is certainly
necessary, it is not sufficient. We have expressed concern \21\ that
the new entity, titled ``NYSE Regulation,'' will be under the control
of a board of directors that will include a number of its members drawn
from the NYSE parent's own board. Moreover, the NYSE itself, which will
have plenary authority to review actions of NYSE Regulation, will be
controlled by directors of the for-profit parent. Just as the NYSE has
made solid efforts to foster more assertive and less conflicted boards
for the companies that it lists, we had hoped that it would recognize
the conflict that NYSE Group directors may bring to the boardroom when
they serve as directors of the subsidiaries that regulate NYSE Group's
competitors. While the SEC secured some modest adjustments to the
NYSE's proposal to address these concerns, they stopped well short of
what we thought was desirable.
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\21\ SIA-TBMA comment letter, note 13, supra, at 9.
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The SEC's approval order illuminated another potential conflict
between the NYSE for-profit parent and its regulatory affiliate: The
potential for misuse of NYSE Regulation's ability to impose fines and
penalties to benefit the parent's business. The NYSE's proposal states
that such monies cannot be used for commercial purposes or distributed
to any entity other than NYSE Regulation.\22\ However, even if
penalties or fines cannot be diverted to directly benefit the parent's
bottom line, the possibility still remains that NYSE Group directors
participating in the oversight of the regulatory function could
encourage heavy reliance on fines and penalties, most or all of which
would come from NYSE Group competitors, to sustain the regulatory
budget. The SEC appears to have concerns in this area, since as part of
the approval process it asked for and received from the NYSE a
commitment to file a separate proposed rule on NYSE Regulation's use of
regulatory fees, fines, and penalties.\23\
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\22\ SEC Approval Order, note 12, supra, at 46,
\23\ Id. at n. 231. The SEC has previously warned that
``shareholder-owned SRO's may . . . use their disciplinary function as
a revenue generator with respect to member firms that operate competing
trading systems or whose trading activity is otherwise perceived as
undesirable.'' SEC SRO Concept Release, n. 7 supra, at 71263.
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The most effective way of dealing with the conflict between the
NYSE's regulatory authority and its business interests, as well as with
duplicative regulation, is to combine the overlapping broker-dealer
regulatory functions of the NYSE and NASD in a separate entity.
Fortunately, senior NYSE officials in recent public statements have
seemed to recognize this, and have suggested they are ``open to the
idea of a `joint venture' with the NASD.'' \24\
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\24\ NYSE Seeks a Regulatory Alliance, Wall Street Journal, C3
(Feb. 23, 2006). Big Board and NASD Consider Merging Parts of
Regulatory Units, Wall Street Journal, C3 (November 11, 2005). Senior
NASD officials have also signaled receptivity to a hybrid SRO. See New
Theorem for Merging Regulators: 1>2, Wall Street Journal, C3 (November
14, 2005).
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This convergence of views suggests that this is an ideal moment for
implementing significant structural reform to self-regulation.
Unfortunately, the NYSE and NASD seem to be at an impasse on turning
their shared views into reality. From recent public statements, the
NYSE appears to favor a true ``joint venture,'' controlled by both the
NYSE and the NASD, to regulate the firms that are currently dually
regulated, while the NASD seems to seek to move the NYSE regulatory
functions into itself, or possibly to create an entirely new regulatory
entity totally separate from either existing SRO. We think any of these
approaches could achieve the five goals that we outlined.
For example, a joint venture by the two SRO's for dually regulated
firms could be structured so that it alleviates the conflicts inherent
in a for-profit parent regulating its competitors by providing (i) a
single principles-based rulebook, (ii) a single examination staff (for
example, by contracting the examination function out to one of the
SRO's, or by seconding examination staff from the NASD or the NYSE) so
that the purpose of a single rulebook is not undermined by duplicative
or inconsistent examinations by two sets of regulators, (iii) the
protections that we discuss below regarding public and industry
involvement in its oversight, and (iv) restrictions on the use of
market data fees or enforcement penalties to fund its operation. Since
the NASD arguably does not face conflict of interest issues to the same
degree as the NYSE,\25\ a structure involving folding dual-registrant
regulation into an arm of the NASD, or into a new entity entirely
independent of either SRO, could be at least as effective a means to
satisfy the conflict of interest concerns.
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\25\ The NASD does have a potential conflict due to its contract to
provide regulatory services to Nasdaq, but this appears much less
significant than the conflict faced by the NYSE's regulatory function,
which is wholly owned by the for-profit parent and contains substantial
representation of the for-profit parent's independent directors on its
oversight boards.
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We strongly urge this Committee and the SEC to take the lead in
capitalizing on the opportunities created by these developments. The
differences between the NYSE and NASD are much less significant than
their agreement with the principle that consolidation should occur, and
as long as the SEC and this and other Congressional oversight
committees stay engaged, these differences should be bridged in short
order. With the help of this Committee and the involvement of the SEC,
SRO's, market participants and investors working together, one of these
forms of a ``hybrid regulator'' could be the vehicle for driving self-
regulation into the 21st century.
Structural Reform of Self-Regulation
Consolidating broker-dealer regulation addresses the two primary
areas of weakness in the current self-regulatory structure we
identified previously--conflicts of interest and regulatory
inefficiency. In addition, the proposal will likely provide better
investor protection. Enhanced regulatory efficiency will allow both the
SRO's and firms to use compliance resources more effectively.
Regulatory accountability will be bolstered as the result of one entity
being responsible for overseeing broker-dealer activity at the SRO
level. Finally, the regulatory expertise of the SRO staff will expand
as a single SRO gains the resources, power, and prestige to attract
talented staff. At the same time, the existence of multiple-market
SRO's, each with responsibility over those regulations applicable to
its unique trading structures, will keep market expertise where it is
most useful. Much of the innovation that makes the U.S. markets so
strong occurs in market operations, so the maintenance of separate
market SRO's will foster continued competition and innovation and
preserve U.S. capital market dominance.
In general, the SEC has already begun moving toward more universal
capital market rules. For instance, parts of Regulation SHO \26\ and
Regulation NMS \27\ reflect a convergence of rules. Regulatory
consolidation will build on this streamlining of regulations while
eliminating redundancies and gaps in regulatory coverage.
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\26\ See Exchange Act Release No. 50103 (Jul. 28, 2004), 69 Fed.
Reg. 48008 (Aug. 6, 2004) (Regulation SHO).
\27\ See Regulation NMS.
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Overseeing a Consolidated Regulator
We realize that SRO regulatory consolidation would concentrate
regulatory power and authority in one entity. Therefore, this
regulatory structure will function effectively only if the SEC provides
attentive oversight that includes the vigilant review of the
consolidated regulator's costs and fee structures. Similarly, the
Commission should review the consolidated regulator's final
disciplinary proceedings in order to counter any self-serving interest
by the regulator in levying excessive enforcement fines that would be
paid into its own coffers.
Additionally, strong public and member involvement will become even
more important to prevent the consolidated regulator from becoming an
unresponsive entity with prohibitive cost structures. While the
consolidated regulator should have a majority of nonmember
representatives on its board, it will need substantial member input--
especially from smaller cost-sensitive members--to effectively oversee
regulation across a diverse group of members with divergent needs and
business models.\28\ Member involvement and SEC oversight of the hybrid
SRO also will be
necessary to identify and harmonize any ``boundary'' issues between
conduct rules subject to the consolidated regulator's oversight, and
market rules subject to the continued oversight of the various market
SRO's.
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\28\ The needs of fixed-income markets differ from those of
equities markets, for instance. The knowledge members have about the
ramifications of these differences is essential to ensure that a self-
regulatory system works well for all participants.
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The SEC should develop increased transparency requirements for the
consolidated regulator, particularly concerning funding and budgetary
issues. Making the regulator's operations transparent to both members
and the investing public will place appropriate checks on the
consolidated regulator and will enhance accountability to its
constituents.
Funding the Regulator
Another significant issue is how best to fund the consolidated
regulator. The goal of the consolidated regulator is not to stint on
regulation, but to make each regulatory dollar more effective. At the
same time, fees for regulation should be apportioned to the industry on
a fair and reasonable basis. Imposing regulatory fees that exceed the
true costs of regulation acts as a tax on capital and imposes undue
harm on the capital-raising system. We recommend that the consolidated
regulator be required to define the costs necessary to meet its self-
regulatory obligations, prepare and make public a budget to meet those
obligations, and then fairly apportion those costs among members by
making periodic filings with the Commission subject to public notice
and comment.
Regulatory funding for the consolidated regulator should come from
regulatory fees assessed on broker-dealers, as well as from the issuers
and other constituents of the trading markets. Trading markets will
benefit significantly from regulatory oversight of broker-dealers and
the various examination and continuing education programs conducted by
the consolidated regulator. Such regulation and education initiatives
foster the market integrity and investor confidence that bring so much
business to the U.S. capital markets. Markets would receive these
benefits, and market SRO's should assume some of the associated
regulatory and administrative costs.
Market data fees should only fund the collection and dissemination
of market data--not regulatory costs.\29\ Combining the broker-dealer
regulatory functions of the NASD and NYSE should result in savings for
the SRO's that may offset much of the loss of market data fees as a
revenue source. If there is still a shortfall due to the elimination of
market data fees, the industry is willing to pay higher regulatory fees
to the consolidated regulator than it now pays to the NYSE and NASD.
For member firms, higher fees would be offset by relief from the
burdens of duplicative regulation and market data fees that vastly
exceed their costs. Our only qualification is that any increase in
regulatory fees on member firms should be, allocated with the SEC's
assistance and in a manner that does not place an undue burden on
smaller firms.\30\
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\29\ The SEC estimates that in 2003 market data fees provided 18
percent of the funding of the NYSE and NASD. SEC Concept Release
Concerning Self-Regulation, 69 Fed. Reg. 71256, 71270 (Dec. 8, 2004).
\30\ For example, such fees might be based on any number of factors
designed to approximate the degree of resources required of the Single
Member SRO in overseeing a particular firm, such as the number of
registered representatives of a firm, or the scope and nature of its
customer base or operations.
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Eliminating Excessive Market Data Fees
Regardless of the outcome of regulatory consolidation, it is
vitally important that the SEC deal with longstanding concerns by
market participants about the opaque and nonaccountable way in which
market data fees are currently set.\31\ The purpose of disseminating
market data is to create transparency in the prices that investors
receive for buying and selling securities and, where there are
competing market centers, to increase investor choice and opportunity.
For that reason, regulation should not depend on revenue from market
data fees. The current approach to market data fees hurts the
transparency of prices and imposes unjustifiable costs on market
participants and, ultimately, investors.
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\31\ For a more detailed discussion of our concerns about market
data fee practices that we believe the SEC should consider reforming,
see letter to Jonathan G. Katz, Secretary, SEC, from Marc E. Lackritz,
SIA, (Feb. 1, 2005) at 24 et seq., available at http://www.sia.com/
2005_comment_letters/4601.pdf.
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The conflicts arise from the danger that that the current lack of
transparency and competitiveness in setting market data fees will
foster monopolistic behavior, with the ability to use the monopoly
revenue to subsidize other activities. The proposed NYSE and Nasdaq
mergers heighten this danger, by creating the prospect of an oligopoly
over market data controlled by just two consolidated for-profit market
centers. A cost-based approach will minimize many of the conflicts of
interest related to market data fees that SRO's face now.
Market participants are legally required to provide certain
specific market data to the SRO's. Market participants should not be
required to relinquish any additional rights to market data as a
condition of membership in an SRO. Indeed, an SRO should not be
permitted to condition access to the exchange on the acceptance of
terms that seem designed primarily to advance the commercial interests
of the exchange.
We applaud the SEC's expressed intention to address many open
issues concerning market data fees in the context of SRO reform.\32\ We
strongly believe the resolution of these issues--sooner than later--is
of the utmost importance for the integrity of the markets.
---------------------------------------------------------------------------
\32\ See SEC Release Adopting Regulation NMS, 70 Fed. Reg. at 37560
(June 29, 2005).
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Conclusion
America's securities markets are the envy of the world, but we must
be vigilant about removing unnecessary regulatory inefficiencies if we
are to maintain our international preeminence. We are eager to work
with Congress, the SEC, the SRO's, and all other interested parties to
ensure that our markets remain the most transparent, liquid, and
dynamic, with unparalleled levels of investor protection.
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PREPARED STATEMENT OF RICHARD FERLAUTO
Director of Pension and Investment Policy,
American Federation of State, County and Municipal Employees, AFL-CIO
March 9, 2006
Good Morning Chairman Shelby, Senator Sarbanes, and Members of the
Committee. My name is Richard Ferlauto, and I am the Director of
Pension and Investment Policy at the American Federation of State,
County and Municipal Employees (AFSCME), a union representing 1.4
million State and local government, health-care, and childcare workers.
I appreciate the opportunity to appear today on behalf of AFSCME and
the 9 million member AFL-CIO to discuss regulation of the New York
Stock Exchange.
The appropriate level of regulation of capital markets is a key
concern to us because it impacts on the financial condition and
retirement security of every working family in this new ownership
society. AFSCME members have their retirement assets invested by pubic
pension systems with combined assets totaling over $1 trillion dollars.
These public systems have lost more than $300 billion in assets due to
the loss of market confidence following the scandals of Enron and
WorldCom. In addition to these public funds, union multi employer-
sponsored pension plans hold approximately $400 billion in total assets
and are beneficial shareholders of corporate issuers through banks,
brokers, and other custodians. All together, union members participate
in benefit plans with over $5 trillion in assets, not including the
dollars they invest as individuals. The institutional investment funds
are highly indexed and are long-term owners as patient investors.
Confidence in the markets, transparency and appropriate regulation are
the foundation of their success as investors.
AFSCME and the AFL-CIO are convinced that the New York Stock
Exchange (NYSE) and other self-regulatory organizations play a valuable
role in the marketplace. We have been supportive of the NYSE's unique
strengths as an in-person market maker. However, the NYSE's recent
conversion to ``for-profit status'' and its unwise determination to
retain and finance its regulatory unit within the NYSE Group creates a
clear conflict of interest that we believe poses a significant danger
to investors.
We urge Congress to call on the Securities and Exchange Commission
(SEC) to directly regulate, or in the alternative, to support the
creation of a genuinely independent organization to regulate the NYSE.
Recent press accounts of a possible consolidation of NYSE and National
Association of Security Dealers (NASD) regulation make it clear that
the SEC must act with haste to protect the public interest.
Speaking to regulators and leading Wall Street executives about the
NYSE Group's new structure at the Securities Industry Association's
November 11, 2005 meeting, NASD Chairman and CEO Robert Glauber said,
``There is a conflict in an enterprise operating as regulator.'' In
fact, according to a recent report by Glass, Lewis and Company, the
number of company restatements have surged, due in part to a lack of
adequate internal controls. Now that the auditors have determined what
was actually in these accounts, we are finding many of the problem
companies were on the NYSE. In its new structure as a corporation, the
NYSE has even fewer legal and financial resources to protect investors.
Indeed, its regulatory unit has a glaring conflict of interest. Since
making a profit would become even more critical to its ability to
sustain its stock price, it makes its in-house regulatory arm a bigger
issue.
Conflicts of Interest
We are very concerned about the potential for conflicts of
interest. For example, the NYSE/Archipelago Holdings, Inc. merger,
expected to become effective this quarter after SEC approval last week,
comes after 213 years in which the NYSE operated as a not-for-profit
corporation. The Exchange Act gave the NYSE ``front-line'' authority to
regulate itself. While this structure has resulted in significant
enforcement lapses, the new entity raises conflict concerns to an
entirely new level.
Importantly, the SEC has shown a willingness to criticize the NYSE
for lax oversight. In response, the NYSE has retained its regulatory
unit as a ``not-for-profit'' division of the corporation, with a board
that has at least 20 percent of its directors from outside the NYSE
Group board. What this means, of course, is that 80 percent of the
directors of the NYSE's regulatory unit can also be members of the NYSE
Group board. These directors unfortunately do have an inherent conflict
of interest since they have a duty to maximize returns for the
shareholders of the NYSE Group. Consequently, the NYSE regulatory
unit's actions may well have an adverse impact upon the revenues of the
NYSE thereby putting conflicting directors who serve on both boards in
a situation where the appearance of conflicts may be unavoidable.
Moreover, the NYSE regulatory unit's budget comes from the fines
and fees that brokerage firms pay to it. If this does not create a
conflict of interest for its Group board, any additional revenues for
the regulatory unit must, according to the NYSE, come from the NYSE
Group itself. Directors must then decide whether their duty to the NYSE
Group overrides their duty to the NYSE regulatory unit. Either the
directors agree to pay more for enforcement and potentially cut the
revenues of the NYSE Group, or they maximize revenues for the NYSE
Group and cut the necessary revenues for the regulatory unit.
Recent Examples of NYSE's Problematic Self-Regulation
Our public fund investors have come to rely on the considerable
efforts by New York Attorney General Eliot Spitzer and the SEC to
correct for lapses in the NYSE's self-regulation. In the area of
financial reporting, the NYSE has been lax in its supervision and when
problems were discovered at companies such as Qwest, it took extended
periods of time, in some cases over a year, before investors were once
again able to receive reliable reports.
In another case, the NYSE's decision last October to allow
Sovereign Bancorp to proceed with a restructured stock sale was a
striking example of a conflict and the need for an independent
regulator. Instead of requiring a shareholder vote on the proposed sale
of more than 20 percent of Sovereign shares to Banc Santander, the
NYSE's self-regulatory body allowed Sovereign to skirt the NYSE rule on
the technical grounds that Sovereign only sold ``treasury shares.''
Sovereign, as an NYSE listed company, virtually avoided any shareholder
accountability.
Less than a month after its decision in the Sovereign matter, the
NYSE also permitted Fannie Mae to skirt its filing rules, granting an
exemption from de-listing requirements when it failed to file its
financial statements on time. This certainly appears to be a serious
conflict of interest in light of the fact that Fannie Mae pays the NYSE
the maximum annual listing fee of $500,000.
Role of the Securities and Exchange Commission
The SEC is well aware of these concerns and has already identified
serious issues related to self regulation of a ``for-profit'' entity.
Its concept papers (File No. S7-39-04 and File No. S7-40-04) have
pointed out that demutualization raises the concern that the profit
motive of a shareholder-owned Self-Regulatory Organization (SRO) could
detract from proper self-regulation.
We urge Congress to work with the SEC with the goal of eliminating
self-regulation by the exchanges. The Commission should set timelines
for pursuing reform goals and open the process through public
roundtables and other forums allowing investor participation and public
engagement.
The oversight role of the SEC might also be enhanced during this
review of the self-regulatory powers of SRO's. While the Commission has
the power under the Exchange Act to approve changes in SRO rules, the
full extent of its authority remains unclear and has caused concerns
for investors for many years. For example, as investors focused on
corporate governance, we believe that the Commission should have the
ability to regulate listing standards contrary to the limitations posed
on the SEC by BusinessRound v. SEC.
Despite these concerns, we are also afraid the SEC will not have
the administrative capacity to guard against the NYSE's historically
lax oversight. The SEC's annual report for 2005 reflects actual program
costs of $917,650 million for the fiscal year 2007 budget which is a
cut back. The 2005 annual report also notes that staff turnover is up
to 7.5 percent, the highest since 2001.
While we raise these concerns, we stress that AFSCME and the AFL-
CIO are strong supporters of the NYSE and its in-person market.
Moreover, we support a regulatory structure for the NYSE that fosters
investor confidence, ensures fairness to all market participants, and
encourages competition to promote efficiency in today's markets. This
system should ensure that all exchanges meet or exceed established
standards of investor protection and should prohibit ``races to the
bottom'' by the ongoing lowering of regulatory standards and listing
requirements. Equally important, the system should guarantee that
regulatory oversight functions are adequately and securely funded.
The NYSE cannot, in any reasonable person's mind, be both a ``for-
profit'' entity whose critical success is tied to growing revenues,
including from listing fees, and at the same time be expected to take
actions that would result in a negative impact on those fees. As we saw
with the auditors, one cannot carry the water buckets for two masters
at the same time.
I appreciate your time and attention regarding this important issue
and would be happy to answer any questions you might have.
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PREPARED STATEMENT OF ANN YERGER
Executive Director, Council of Institutional Investors
March 9, 2006
The propriety of stock exchanges exercising regulatory authority
over their members and market participants has been discussed for many
years. This debate takes on greater significance now that the Nation's
largest stock exchange, the New York Stock Exchange, is set to become a
publicly owned, for-profit corporation.
The Council of Institutional Investors, an organization of more
than 300 investment professionals, including more than 130 public,
corporate and union pension funds with more than $3 trillion in
investments, has long advocated the separation of the exchanges'
regulatory and business functions. The Council believes such an
approach is in the best interests of the investing public. In the
Council's opinion, an exchange faces an inherent and untenable conflict
of interest when it is responsible not only for running an efficient
and effective marketplace but also for regulating its customers and
protecting the investing public.
Council members have a significant commitment to the U.S. capital
markets, particularly the public equity markets. The average Council
fund invests about 45 percent of its total portfolio in publicly traded
U.S. stocks and another 30 percent in domestic bonds. Council members
are long-term owners. As fiduciaries of employee benefit plans, they
have long-term investment horizons; and they are indexers, with an
average of about 45 percent of their U.S. stock portfolios and around
15 percent of their bond portfolios passively managed.
By virtue of their significant stake in U.S. publicly traded
companies, Council members are keenly interested in ensuring that the
U.S. capital markets continue to be the best in the world. As a result,
our members are very supportive of the efforts by the NYSE, the Nasdaq
stock market, and other exchanges to provide the highest quality, most
efficient, and cost-effective marketplaces.
However, the integrity of the U.S. equities markets and the
protections provided to investors are also of paramount importance. A
critical component of market effectiveness and success is investor
confidence. Part of that confidence comes from knowing that adequate
rules and other safeguards are in place to protect investors.
Unfortunately, lapses in self regulation over the years--including
failures to adequately oversee specialists, enforce rules, and maintain
up-to-date listing requirements--have harmed investors and shown that
the self-regulatory model is in need of reform.
The Council recognizes that the exchanges have adopted proactively
many reforms in recent years aimed at upgrading their corporate
governance structures, improving their transparency to the marketplace
at large and toughening their regulatory oversight. While laudable,
these changes cannot resolve the conflicts faced by a business also
charged with regulating its owners and its customers. These potential
conflicts only deepen when an exchange is a for-profit entity.
To address these potential conflicts, the Council recommends:
Any regulatory operation should be independent of the
exchange(s) and adequately funded.
Listing standard requirements should be a regulatory, rather
than an exchange, responsibility.
Congress should consider clarifying the SEC's oversight
authorities over the exchanges.
Regulatory Arms should be Independent and Adequately Funded
Combining exchange and regulatory functions puts the regulatory arm
in the difficult position of overseeing the primary customers of the
exchange. Such combinations have not worked in the past. For example, a
Nov. 3, 2003, Wall Street Journal article reported that a confidential
SEC report of the NYSE ``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.''
The Council believes that for regulatory arms to be functional and
effective they must be independent of the exchanges and have mechanisms
in place to ensure secure and full funding.
Such structures are currently in place at the NASD, which today is
an independent, not-for-profit organization responsible for overseeing
NASD members and regulating the Nasdaq stock market.
The NYSE has taken a different approach, with NYSE Regulation
structured as a wholly owned subsidiary of a soon-to-be-publicly traded
company, the NYSE Group. While the final structure approved Feb. 27,
2006, by the SEC included some refinements designed to enhance the
independence of NYSE Regulation and secure adequate funding for the
NYSE's regulatory program, the structure could be improved.
First, the Council believes NYSE Regulation should be an
independent entity separate from the publicly traded company. Second,
we believe the NYSE Regulation and NYSE Group boards should not have
interlocking directors. ``Shared'' directors, regardless of their
skills or backgrounds, face an impossible-to-resolve conflict of
interest between maximizing the long-term value of the for-profit
exchange business while ensuring the regulation side is adequately
resourced.
Additional changes to the regulatory models may be underway. In
recent weeks, officials of the NASD and the NYSE have expressed
interest in merging their regulatory arms. Certainly a combination
could improve regulatory efficiencies. However, the Council believes a
combined regulatory operation would be deeply flawed if it failed to be
independent from the exchanges.
Listing Standards should be a Regulatory Responsibility
The exchanges' listing rules are an important element in the total
system of legal protections on which investors rely. Given their
importance, the Council believes listing standards should be the
responsibility of the regulatory arms, and processes should be in place
to ensure that listing standards are kept up-to-date. Housing the
listing standard requirements with the business side of the exchanges
may harm the investing public by promoting: (1) a race to the bottom,
with exchanges competing for listings by watering down their standards;
(2) standoffs when it comes to updating outdated requirements; and (3)
a reluctance to enforce standards when pressured by listed companies.
In the past, the exchanges have been hesitant to update their
requirements, perhaps for fear of upsetting listed companies and
driving business to competing exchanges. As a result, historically it
has taken major corporate scandals, usually coupled with strong
suggestions from the Commission, to prod the exchanges into action.
Certainly the exchanges acted quickly in response to the 2002-2003
market scandals, proposing far-reaching upgrades to their listing
standard requirements. However, some of these rules were decades-old
and long in need of updating.
An example of the challenges facing investors interested in
ensuring modern listing standard requirements can be seen in the
lengthy fight to strengthen the rights of shareowners to vote on equity
compensation plans. In 1998, at the same time stock-based incentive
plans had exploded in popularity and potential cost, investors found
their rights to review these programs diminished by changes proposed by
the NYSE and approved by the SEC. What followed was a several-year
odyssey, largely due to a stand-off between the NYSE and the Nasdaq,
with the NYSE refusing to change its rules until the Nasdaq also made
changes.
Another example is the Council's decade-plus effort to have the
NYSE eliminate broker voting. This rule--now nearly 70 years old--
allows brokers to vote on certain ``routine'' proposals, including the
uncontested election of directors, if the beneficial owner has not
provided voting instructions at least 10 days before a scheduled
meeting. The Council believes broker votes amount to ballot-box
stuffing, because these shares are always cast for management. Despite
evidence that broker votes are not necessary for companies to ensure
that a quorum is present for a meeting, the rule remains in place.
Most recently the Council was troubled by the NYSE's decision to
allow Sovereign Bancorp to issue a block of stock greater than 20
percent to a third party without obtaining prior shareowner approval.
The Council believes the decision exemplifies the challenges facing a
self regulatory organization when it faces opposing pressures from
listed companies and investors.
SEC Oversight of the SRO's should be Strengthened
The Council views the Commission's oversight role as an important
safety net for ensuring that stock exchange regulators continue to
adequately protect investors and the integrity of the marketplace. The
Commission has long enjoyed significant authority over SRO rules,
including the power to approve or disapprove SRO rule changes, and to
amend SRO rules ``as the Commission deems necessary or appropriate to
ensure the fair administration of the self-regulatory organization, to
conform its rules to requirements of this chapter and the rules and
regulations thereunder applicable to such organization, or otherwise in
furtherance of the purposes of'' the Exchange Act.
Although protection of investors is unquestionably a purpose of the
Exchange Act, the extent to which that purpose gives the Commission
power over listing standards has been unclear. In 1990, the Court of
Appeals for the D.C. Circuit (Business Roundtable v. SEC) invalidated
the Commission's imposition of a one-share/one-vote listing standard on
the SRO's, holding that Congress did not intend to delegate power to
the Commission to regulate the internal corporate governance of listed
companies through the Exchange Act.
Since that time, the Sarbanes-Oxley Act arguably has extended the
Commission's jurisdiction over the corporate governance of listed
companies, and has shown that investor protection can extend to at
least some substantive corporate governance matters. Concern also has
grown regarding the potential harm to investors posed by competition
among SRO's based on listing standards. The one-share/one-vote
controversy, which was sparked in the mid-1980's when the NYSE refused
to enforce its own one-share/one-vote listing standard out of a desire
to compete for listings, illustrates this dynamic. Demutualization and
the emergence of SRO's as for-profit entities have exacerbated these
tensions.
These developments have not led, however, to any agreement about
the proper scope of the Commission's authority to shape SRO listing
standards. Because the Business Roundtable is the sole judicial
pronouncement in this area, the Commission's reluctance to test the
limits of its jurisdiction is perhaps understandable. The Council
believes that Congress can and should clarify the Commission's
authority to amend listing standards or impose them on the SRO's when
doing so would protect investors and serve the public interest.
In doing so, it may be desirable to distinguish between listing
standards and other SRO rules. The advantages of self-regulation--
industry expertise, efficiency, and superior incentives--are not as
acute in the context of listing standards as they are when an SRO is
investigating or disciplining market participants, enforcing rules
governing member firms, arbitrating disputes and regulating the
treatment of customers. The logic of fostering competition among SRO's,
which was among the purposes of the Exchange Act amendments in 1975,
may not extend to competition based on listing standards even as it may
continue to be relevant in other areas of SRO rulemaking.
Conclusion
The Council respects Congress' past affirmations of self-regulation
as the best oversight model for the complex securities industry.
However, times have changed. The Council believes a separation of
regulatory and business functions is the best way to protect the 84
million Americans and others who invest their hard-earned savings in
the U.S. equities markets. Such a change would not impede the capital
raising process, impose burdensome costs on listed companies or impede
the functioning of the markets. It may, however, strengthen investor
confidence in the U.S. markets by ensuring robust oversight of market
participants.
The Council commends the Committee for considering this very
important issue. We appreciate the opportunity to appear before the
Committee and look forward to working with you as you move forward.