The NYSE’s takeover advances to the London Stock Exchange captures headlines, but another merger involving the NYSE risks having more far-reaching consequences for the financial industry in the U.S.: the merger of the regulatory divisions of the NYSE (NYX) and the NASD (NDAQ). The SEC demanded this merger when the NYSE became a for-profit organization, as the for-profit status may compromise the NYSE’s regulatory zeal.
The principal beneficiaries of the merger will be the 200 large brokerage firms with dual membership of the NYSE and NASD, whose compliance costs will be reduced significantly. The bulk of the 5,100 NASD members see no obvious advantages. In order to get them to support the deal, NASD had to resort to the universal language of money: each firm will receive a $35,000 incentive payment, supposedly an advance payment of future savings from synergies. In a recent poll by an industry publication, a vast majority of respondents considered the payment a bribe. NASD plans to achieve these savings totaling $178 million without layoffs or office closings, but only through “natural attrition”. We are not familiar with NASD’s financials, but no matter how we slice and dice our back of the envelope calculation, such an enormous amount in savings through natural attrition alone implies astronomical attrition rates. Even though the NASD has a $1.6 billion hoard of cash, it claims that a higher payment would be vetoed and that the NASD would loose its tax-exempt status. This claim is contested by the opposition to the merger, and the NASD has provided no proof other than an alleged meeting with IRS officials.
The current self-regulatory regime is based on a one member, one vote principle. This simple system will be replaced by a new system that overweights the voting power of large firms. As investors, we are very concerned by this proposal because giving more say to large firms risks introducing new rules, such as higher capital requirements, and barriers of entry that favor large firms and eventually put smaller ones out of business. From a regulator’s point of view, it is more convenient to oversee a small number of large brokers than a large number of small firms, so we can understand why the NASD makes such a proposal. But for investors, a large number of firms means competition and hence low commissions as well as innovation in technology and products.
Most of the large scandals that have rocked financial markets in the last years did not involve small brokerage firms but the largest and most prestigious ones. After all, market timing is only profitable if large enough sums of money are involved, so it just isn’t profitable for a small firm. In addition, small firms typically specialize in one narrow area and are too small to have investment banking and research and trading operations under the same roof. As a result, they were not involved in the analyst scandals or IPO allocations. Why are mega-brokerage firms, many of whom did engage in these practices, now rewarded with a bigger say in regulatory matters?
The board of directors of the new regulator will be largely self-appointed. Today, 80% of the NASD’s board members have to stand for election by the membership. Under the new structure, however, only seven of the 23 board members will be elected: a guaranteed minority. Leadership selection of this type is reminiscent of a Politburo rather than a democracy and redefines the “self” in a “self-regulatory organization”. With the majority of the board appointed, it is clear that insiders, their friends and others who deserve a reward will monopolize the board. It is the same phenomenon against which corporate governance activists are fighting in the selection process of corporate directors. In a letter to the Wall Street Journal, Massachusetts’ chief securities regulator William Galvin shared this concern:
“I urge that a blue ribbon committee be established with the specific goal of assuring that the system of securities regulation will protect these market participants. Among the topics such a committee should examine is whether the boards of directors of self-regulatory organizations (like the NASD and the stock exchanges) adequately represent small investors. Too often, members of the securities industry have a voting majority on such boards.”
Considering the recent interest of the SEC in mutual fund governance and the nomination of company directors by shareholders, it is surprising that the SEC has not objected to this top-heavy governance structure.
Opposition to the merger has so far been been confined to NASD members themselves. A few years ago, smaller brokerage firms formed the Financial Industry Association (FIA) in order to better represent their interests against the well-organized lobbying efforts of large Wall Street firms. A wind of change was blowing through the NASD when for the first time, some elections were contested. NASD’s top honchos were shocked when several FIA-backed candidates won elections against candidates supported by NASD’s officials. The merger provides management with a convenient excuse to tighten its grip on the NASD and also punish small firms for their past voting record.
If NASD members reject the merger as proposed, NASD’s management is likely to return with a slightly modified proposal that increases the incentive payment and maybe increases the number of elected board members by one or two. The FIA estimates that the incentive payment could be increased to more than $135,000. NASD members will be tired of fighting another battle and will accept a modified proposal, especially if they can collect a six-figure amount. It appears that the current version of the proposal was drafted deliberately extreme because NASD’s management anticipated opposition and provided for some wiggle room for negotiations.
A merger of two regulators is a good idea to streamline rules and eliminate ambiguity between two separate, sometimes contradictory regulatory bodies. But it is a bad idea to restructure regulators at the same time in a way that risks upsetting the entire industry with unintended consequences that will could ultimately harm investors. The best solution would be to maintain a board with at least its majority of its members elected so that industry competition and innovation are ensured. In the interest of investors, their clients, the 90% of NASD members which are small firms should vote against the current proposal.
Disclaimer: The author and the Pennsylvania Avenue Event-Driven Fund [PAEDX] do not hold long or short positions in any of the companies mentioned, and are not members of the NYSE or the NASD.