SEC Blasts NYSE Oversight
Of 'Specialist' Trading Firms
Investors Were Shortchanged $155 Million
Over 3 Years, Confidential Report Says
By DEBORAH SOLOMON and SUSANNE CRAIG
Staff Reporters of THE WALL STREET JOURNAL
Wall Street Journal.com
The Securities and Exchange Commission, in a confidential report, blasted the New York Stock Exchange for failing to police its elite floor-trading firms and for ignoring blatant violations in which investors were shortchanged by millions of dollars in trades involving more than two billion shares over the past three years.
The 40-page report, dated Oct. 10 and reviewed by The Wall Street Journal, is a severe rebuke of both the floor-trading firms, known as "specialists," and the self-regulatory structure that monitors the Big Board floor. It paints a picture of a floor-trading system riddled with abuses, with firms routinely placing their own trades ahead of those by customers -- and an in-house regulator either ill-equipped or too worried about increasing its workload to care. And it concludes that when the NYSE does act on investor abuses, the exchange often does little more than admonish the specialists in a letter or slap them on the wrist with a light fine.
Highlights of the SEC's report on the New York Stock Exchange:
• LOSSES: Specialists allegedly short-changed investors at least $155 million, in trades on 2.2 billion shares over three years. (Average daily volume is 1.4 billion)
• EXCHANGE DEFICIENCIES: Didn't conduct routine checks on many trading violations; when it found wrongdoing, response was "inadequate"
• SPECIALIST-FIRM DEFICIENCIES: Didn't have "meaningful" ways to track violations
• REMEDIES: NYSE agreed to make improvements to curb alleged abuses, including adding staff and committing more money to regulation
The SEC staff "is concerned that the NYSE's disciplinary program is viewed by specialists and specialist firms as a minor cost of doing business, and that it does not adequately discipline or deter violative conduct," the report says. It adds that the floor-trading firms "have no meaningful compliance programs for reviewing their specialists' compliance" to various trading rules.
The SEC report says that about 2.2 billion shares were improperly traded over the past three years, costing investors $155 million. In the context of overall Big Board trading activity, the improper transactions cited by the SEC involved less than 1% of the shares traded during the period -- equivalent to about 1½ days' typical trading volume.
The report cuts to the heart of public trust in the 211-year-old exchange -- the world's biggest, and one of the last that still matches buyers and sellers with human traders. And it comes as the Big Board is reeling over the pay-related ouster of Chairman Dick Grasso and is being criticized for how it conducts business.
The findings are likely to bolster those who argue that the NYSE's regulatory arm should be taken out from under the exchange's control. And it is sure to raise further questions by investors over whether the specialist system should be scrapped in favor of an electronic-trading model embraced by most other exchanges. Fidelity Investments and some other institutional investors have called for an end to specialists, which are charged with assuring that trading is orderly for specific stocks. This week, the NYSE's interim chairman, John Reed, will propose major changes in the exchange's governance, including an overhaul of the NYSE's board, in a bid to reduce conflicts of interest.
The NYSE, which was given 15 days to respond to the report, declined to comment on it or to say whether it had responded to the SEC. The Big Board also said it would be inappropriate to speak about a confidential SEC inspection report "that was provided to The Wall Street Journal by someone who acted unethically." The SEC also criticized the Journal for publishing the report.
SEC Chairman William Donaldson, who headed the Big Board in the early 1990s, has been critical of the exchange's governance over the past several months, saying he wants to see some separation of the NYSE's regulatory and business operations. However, Mr. Donaldson hasn't called for a complete split of the regulatory and market operations and has suggested that the NYSE's specialist system should continue to operate alongside newer, electronic marketplaces.
An SEC spokeswoman declined to comment on the report and wouldn't discuss Mr. Donaldson's reaction to its contents.
The SEC's conclusions also could raise questions among critics about whether the NYSE underfunded its regulatory arm at the expense of hefty pay for senior executives such as Mr. Grasso, who was ousted as CEO and chairman following a public outcry over his $187.5 million retirement nest egg. At the request of the SEC, the NYSE recently assigned 25 to 30 enforcement lawyers and 20 market-surveillance analysts to cases. The exchange's market-surveillance group also will hire nine additional staff members and is getting a $3 million annual budget increase.
Prepared by the SEC's office of compliance, inspections and examinations, the report recommends overhauling everything from the way the Big Board monitors its trading floor to how it sanctions those who violate the rules. According to the report, the SEC began its investigation after an April 17 article in the Journal about an NYSE investigation into whether specialists traded ahead of customers.
Possible Action
Now, the SEC's enforcement division is looking into the issues raised in the inspection report to determine whether to bring an enforcement action against the Big Board for failing to fulfill its self-regulatory duty, according to people familiar with the matter. Such a move would be only the second time in recent memory that the SEC has taken action against the NYSE for failing to adequately police its floor. In 1999, the SEC found that the NYSE failed to enforce compliance with federal securities laws and NYSE rules in the case of a non-Big Board brokerage firm, Oakford Corp., which the SEC accused of participating in an illegal-trading scheme. Two weeks ago, the SEC took action against the Chicago Stock Exchange for lax oversight.
The SEC itself has faced pressure for more vigorous enforcement recently. In the past year, the securities-industry watchdog has lost ground to New York Attorney General Eliot Spitzer, who launched his own probes of overly enthusiastic Wall Street research and improper trading at mutual funds.
More than any other exchange, the NYSE relies on humans to oversee trillions of dollars in investor trading each year on its floor. Specialists match buyers and sellers of stock, sometimes providing capital from their firm's account to complete a trade and keep the markets orderly. As specialists have increasingly turned to trading for their own accounts as a source of profits, more attention has been focused on the question of whether they are using their inside knowledge of the market to gain at the expense of their customers.
The SEC report comes as the NYSE continues its own probe into specialist trading. The Big Board recently alleged that the five largest specialists may have shortchanged investors by more than $100 million over three years through improper trading. The NYSE is sending out unvarnished data on trades to the specialists who in turn will analyze the data and come back to the exchange to argue which trading was proper and which wasn't.
Under investigation by the NYSE are LaBranche & Co.; Fleet Specialist, a unit of FleetBoston Financial Corp.; Bear Wagner Specialists LLC, which is minority-owned by Bear Stearns Cos.; Spear, Leeds & Kellogg, a unit of Goldman Sachs Group Inc.; and Van der Moolen Specialists USA, a unit of Van der Moolen Holdings NV.
Spokespeople or senior executives from LaBranche and Bear Stearns didn't return calls for comment. A senior executive from Van der Moolen Specialists declined to comment. Spokesmen for Goldman and Fleet Specialists also declined to comment.
The NYSE's investigation, which began last fall in response to a foreign-listed company's complaint about trading in its stock, had inched along for months until, at the behest of the SEC, it was broadened to include several trading violations.
The SEC's confidential findings "reveal serious deficiencies" in the NYSE's surveillance and investigative procedures, including a habit of ignoring repeat violations by specialist firms. The NYSE had "no meaningful surveillance," allowing inappropriate behavior to continue and causing "significant" customer harm, the report said. When the exchange did detect violations the response was weak, the SEC said, and "inadequate to deter future violations."
Catalogued in the SEC report are a series of inappropriate actions by specialists over the past three years that went unchecked and unpunished. Dozens of individual specialists routinely violated exchange rules by trading for their own accounts ahead of customer orders, giving investors inferior prices to those they gave themselves and inappropriately stepping between buyers and sellers, the report says. In at least one area, the SEC says, the NYSE followed an unwritten policy that "a maximum of five violations could be referred" to the investigative division in any one-week period.
Customers lost out on $128 million over the three-year period because specialists traded ahead of 1.9 million customer orders representing 1.6 billion shares, the SEC said. "Trading ahead" occurs when a specialist takes advantage of an attractive price and completes a trade for the firm's own account before one placed by a customer.
Specialists also cost investors another $27 million during the same three-year period by "interpositioning," or failing to match orders, 253,785 times in transactions totaling 332 million shares. Instead, the specialists stepped between the buyer and seller -- purchasing the shares and often reselling them moments later -- for a small profit. The cost to investors could grow as the probe continues, the SEC suggests in the report.
The SEC's staff also identified another violation in which specialists "freeze" their so-called display book of orders. That's when specialists prevent electronic orders that arrive through the NYSE's "Designated Order Turnaround" system from immediately reaching the floor to be executed, even as other orders continue to be filled. Most customers are unaware of this practice. The SEC said specialists were inappropriately using "freeze mode" to trade ahead of certain customers and avoid obligations under a rule requiring that all orders be executed at the best price. The SEC has directed the NYSE to file a rule change to provide for enforcement of this violation.
The management of the specialist firms is partly to blame for the alleged trading abuses, the SEC says. These practices persisted in part because the specialist firms lacked internal compliance programs, instead relying primarily on the exchange's weak surveillance and examination programs as their compliance tool, the report said.
'Numerous Violations'
The NYSE often ignored blatant examples of improper behavior. For instance, in 2001 and 2002, the NYSE's "Member Firm Regulation" division examined each specialist firm and found "numerous violations of trading rules" including trading ahead and repeat offenses by some firms' specialists who had committed identical violations in prior years. The Big Board referred some violations to its investigative division, but many others were ignored, the SEC said.
Instead of trying to determine the extent of a firm's violation, the regulatory division routinely closed cases "even when the examinations included evidence of recidivist conduct," according to the SEC report. Take the NYSE's examination of Van der Moolen, which found, among other trading violations, 21 instances of trading ahead by specialists in a two-hour period in 2002 and 14 trading-ahead violations over a 2½ hour period in 2001. The regulatory division didn't expand its investigation to determine if more violations had occurred and simply referred the 35 violations to the investigations department, according to the SEC report.
The NYSE investigative arm also failed to take proper action, the SEC said, by not thoroughly investigating cases and often taking more than a year to make a determination about a firm's conduct. The division would often focus on a sample that was too small to determine whether violations had occurred, the report said, and then close cases or send ineffective letters to firms that had sometimes committed serious rule violations.
Moreover, instead of reviewing all violations separately, the division often aggregated multiple violations for a single firm. That was the case with Spear Leeds, which was bought by Goldman in 2000, and cited for dozens of violations in 2000 and 2001, according to the SEC. The exchange's investigative unit found that Spear Leeds had violated several order-handling rules and noted that the firm "had similar violations in prior examinations." The division sent the firm a letter of admonishment and closed the case, the SEC said.
The exchange did spot some serious violations by specialists over the years, but the SEC said the response was often to close cases without taking action or to send a letter to the firm. From January 2001 to June 2003, the SEC says, NYSE imposed a total of $604,000 in fines against specialists and specialist firms for both minor rule violations and other improper conduct. Included in that total was $8,500 in fines levied against the firms for 462 trading-ahead violations found by NYSE investigators in 2001 and 2002. The firms weren't required by the NYSE to return the illegal profits.
The NYSE now is taking action to address the problems. In addition to adding enforcement attorneys and market-surveillance analysts to cases, the NYSE agreed to "ensure that its regulatory budget is fully funded to meet all regulatory needs." The exchange will also file a proposed rule with the SEC that governs the use of "freeze mode" and agreed to put in place a system to inhibit specialists from trading ahead of customer orders. In the report, the NYSE notes that some violations already have "significantly decreased."
In early October, SEC staff members met with Mr. Reed, the NYSE's interim chairman, to discuss the report and ways in which the SEC could improve its oversight and disciplinary functions. The staff told the exchange to refer all important trading-rule violations directly to the NYSE's enforcement division, rather than to its investigative division. The SEC also is recommending that the regulatory division develop and adopt procedures to review "the adequacy of specialist firm compliance programs" and refer all repeat violators for formal disciplinary action. And the SEC wants the exchange to create a surveillance system that detects any orders that remain unexecuted.
In addition to criticizing whoever leaked the report, an NYSE spokesman said in a statement: "It is equally inappropriate for The Wall Street Journal to disclose at this early stage of an iterative inspection process. Disclosure now also compromises a confidential regulatory proceeding and damages the rights of the specialist firms and their personnel before any charges have been filed or any defenses offered.
"Moreover, by making confidential regulatory information public, the disclosure may chill future inspections; may compromise the NYSE's surveillance, investigative and enforcement processes; and may interfere with our Enforcement Division's ability to bring the specialist investigation to a timely and effective resolution that serves the public interest."
The spokesman added that that the NYSE is committed to effective regulation of the market and will take whatever steps are necessary to ensure investor confidence.
Sore Subject
The SEC often has locked horns with the exchange over how to fix the perceived inadequacies. In 1998, for example, the SEC found that the exchange's tools to police trading-ahead violations were inadequate. While the exchange took some steps to fix the problem, it resisted the SEC's recommendation to do more. NYSE managers, according to the report, argued that doing more would increase the workload for its investigators. In 2002, the exchange rejected the SEC's request that it adjust its regulatory program to ensure that specialists weren't freezing their display book for more than 30 seconds, choosing instead to use a 60-second parameter.
With increasing automation at the Big Board, it should take less time to complete a trade, the SEC argued. Longer time frames can permit more trading abuses. But the exchange's regulatory staff told the SEC that producing reports using the broader parameters wasn't likely to identify any additional specialists who had violated rules. "The NYSE stated that many of the specialist firms have merged with existing firms and that many of the specialists who may have violated the law have since retired," the SEC said in the report. And the exchange said it might not have the resources to generate surveillance reports using historical trade data.
The NYSE frequently issued "admonition letters" after finding violations, rather than starting enforcement cases. In an investigation into trading-quote violations by Van der Moolen, the Big Board's investigative division consolidated 16 referrals of improper activity by the firm over 20 months and issued an admonition letter for violating the rule.
The investigative division didn't launch probes into the individual specialists that were responsible for the violation and didn't investigate the 2,300 "alerts" -- indicating possible trading violations -- that were generated but not reviewed, the report said. Furthermore, the SEC said that when the NYSE uncovered additional alleged violations, the NYSE dismissed them as "cumulative" and then stopped reviewing quote violations generated for Van der Moolen for a "grace period" of three months.
One NYSE surveillance system issued 640 alerts in 2001 and 2002, but the SEC said a more comprehensive system would likely have triggered more than 8,000 alerts in that time. Of the 640 alerts that were found, NYSE analysts concluded that 494 were violations. But in many cases, the SEC said, "analysts inappropriately concluded that a violation did not occur." For example, the SEC said, analysts concluded that a violation hadn't occurred because even though a specialist traded ahead of a customer order, he or she did so within the 60-second parameter, which also applies to trades made with the firm's own capital.
For five years, the SEC has been pushing the NYSE to narrow that 60-second window. But the SEC noted in its report that "managers appeared to be concerned primarily with the impact on the analysts' workload as a consequence of reducing the time parameter, not on the fact that the increase in alerts was highlighting increased patterns of illegal trading by NYSE specialists." Earlier this summer, the SEC told the Big Board to cut the time frame to 10 seconds from 60 seconds.
NYSE officials seemed to play down the SEC report in a conference call last month to discuss the widening of the specialist probe. Edward Kwalwasser, the Big Board's regulatory chief, said in the call: "We have received an oversight report that went into a lot of different things and we received it yesterday so it hasn't taken us anywhere." Mr. Kwalwasser Sunday declined to comment through a spokesman.
Write to Deborah Solomon at deborah.solomon@wsj.com and Susanne Craig at susanne.craig@wsj.com
Updated November 3, 2003 12:11 a.m.
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