TCS Daily


Spitzer v. Grasso

By Stephen Bainbridge - May 26, 2004 12:00 AM

In light of the filing of New York Attorney General Eliot Spitzer's long-awaited suit against former New York Stock Exchange CEO Richard Grasso, two thoughts come to mind:

(1) The government has no business setting executive compensation. Granted, Spitzer has authority to bring compensation suits against New York not-for-profits like the NYSE. Even so, it is bad policy for the government -- more precisely, an elected official with aspirations to higher office -- to be deciding how much money a corporate executive should be paid.

How much you get paid depends in large part on the thickness of the market for your services. In a thick market, wages tend to be low because there are many potential employees -- all more or less fungible -- competing for jobs. In a thin market, however, wages tend to be high because many employers are competing to hire a small number of eligible workers. The market for burger flippers is very thick. The market for law professors is relatively thick, to my considerable regret. The market for CEOs of Fortune 500 companies (which is what the NYSE essentially is) is thin. I'd guess the number of people who have what it takes to run a Fortune 500 company isn't much larger than the number of people who can run an NBA fast break. So even though much executive pay seems excessive, it's just supply and demand. Eliot Spitzer is unlikely to do a better job than competitive markets.

(2) Yet, Grasso and the NYSE are a special case. According to the WSJ ($), Spitzer alleges that Grasso abused his position as Wall Street's top regulator:

"The 54-page filing paints Mr. Grasso as an iron-fisted ruler, intimidating Wall Street titans that he regulated and manipulating the pay process to enrich himself. It portrays the board and its compensation committee as dysfunctional and its governance structure as conflict-ridden before it was overhauled in the aftermath of Mr. Grasso's ouster last September to strip its chief executive of regulatory authority. ...

"The complaint accuses Mr. Grasso, as the NYSE's chief regulator, of leaving some board members with the impression that if they opposed his pay packages, it would be at their peril. One unnamed board member from Wall Street told investigators that Mr. Grasso 'confronted' him after he expressed concern about his proposed 2000 pay to a staffer, the suit says. The member voted in favor of that year's package and later recalled thinking, 'Thank God I escaped that one. This man was also our regulator [so] you have to be careful,' the suit says.

"It also alleges that Mr. Grasso took actions that benefited firms run by executives determining his compensation, at one point calling the National Association of Securities Dealers on behalf of Mr. Langone [a NYSE board member] as the regulatory organization was investigating his boutique investment bank, Invemed. The NASD eventually sued the bank for improperly sharing profits with favored clients but not Mr. Langone. A NASD spokeswoman said Mr. Grasso's call took place "after the complaint was finalized."

Although Grasso was nominally subject to evaluation by the NYSE board, that board was comprised in large part of ceremonial "public" directors who did not take the job as seriously as they should have and representatives of Wall Street firms who had various conflicts of interest.

The solution, however, is not to make Eliot Spitzer the czar of executive compensation. After all, the problem at the NYSE is a creature of government regulation. The NYSE is a government-created hybrid. On the one hand, it is a private corporation that creates a securities market for the benefit of the specialist brokers who own it; on the other hand, the NYSE is a quasi-public regulator with the primary responsibility for ensuring that its various stakeholders comply with SEC and exchange rules.

This duality has long insulated the NYSE from outside accountability. Its quasi-government status insulates it from discipline by markets and investors. The NYSE is part of a trading market oligopoly with very high barriers to entry, moreover, most of which are attributable to SEC rules. (The SEC, for example, long let the NYSE get away with listing standards making it almost impossible for a firm to de-list.)

Part of the solution is privatization. The NASD and NASDAQ went their separate ways after repeated problems with the SEC over inadequate supervision of its member broker-dealers. It is time for the NYSE to follow their lead.

Privatization, however, is not a complete solution. As the NYSE is organized today, there is an obvious conflict of interest given that the Exchange is owned by the very people who it needs to investigate when there are concerns about trading ahead or front running. In some respects, that conflict of interest would be lessened if the Exchange were owned by public shareholders rather than the specialists. Yet, public ownership might just introduce a different set of conflicts. What if maximizing shareholder returns required the Exchange to overlook misconduct by specialists or others with floor trading privileges, for example?

The answer, it seems to me, is to follow the NASDAQ model. The NYSE's roles as a regulator and a market should be separated. The regulatory functions could be assumed by the SEC, a new SRO, or maybe even the NASD (or some combination thereof). The market then could be spun off through an IPO.

Privatization and reallocation of the exchange's regulatory function have been resisted by virtually all the relevant players. Yet, it is the only solution that addresses both the current governance problems and the longstanding conflicts that are inherent in the Exchange's dual roles.

Stephen Bainbridge is a frequent contributor. He recently wrote for TCS about how pension funds play politics.


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