[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 
                                Affairs


      Available at: http: //www.access.gpo.gov /congress /senate/
                            senate05sh.html


                                 ______

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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

                              ----------                              

                        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.) *
---------------------------------------------------------------------------
    * 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.
---------------------------------------------------------------------------
    \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.
---------------------------------------------------------------------------
    \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\
---------------------------------------------------------------------------
    \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\
---------------------------------------------------------------------------
    \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].
---------------------------------------------------------------------------
                (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\
---------------------------------------------------------------------------
    \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.''

                               ----------
                 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.
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
    \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).
---------------------------------------------------------------------------
    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).
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
    \21\ SIA-TBMA comment letter, note 13, supra, at 9.
---------------------------------------------------------------------------
    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\
---------------------------------------------------------------------------
    \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.
---------------------------------------------------------------------------
    \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.
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
    \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.
---------------------------------------------------------------------------
    \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.
---------------------------------------------------------------------------
    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\
---------------------------------------------------------------------------
    \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.
---------------------------------------------------------------------------
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.
---------------------------------------------------------------------------
    \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.
---------------------------------------------------------------------------
    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).
---------------------------------------------------------------------------
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.

                               ----------
                 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.

                               ----------
                    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.
