Reflections on the NYSE and the ‘Grasso Affair’

By Dwight M. Owsen and Jerry G. Kreuze

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Consequently, those still under public suspicion in the “Grasso Affair” must have their activities thoroughly and publicly aired for their personal benefit and for the benefit of the financial markets. “Anyone [including members of the compensation committee and those who supported NYSE chairman Richard Grasso to the end] who continued to ignore the responsibilities they were elected to perform should resign immediately,” said James K. Rutledge, a former NYSE floor broker.

Excess Compensation

Grasso accepted compensation totaling more than $140 million from the NYSE, which is organized as a nonprofit organization. Brendan Sullivan, Jr., Grasso’s attorney, argued in a letter to former NYSE interim chairman John S. Reed that the former head of the exchange did nothing wrong in accepting the compensation. He argued that Grasso deserved the compensation by nearly doubling the number of listed companies and overall revenue, and accordingly he had no intention of returning any portion of the compensation. Grasso argued that the value of a membership seat nearly tripled (from $700,000 to $2 million) during his tenure; the income to seat owners leasing their seats to others likewise jumped from $100,000 to $300,000. Moreover, under Grasso’s leadership, the NYSE earned more than $900 million and had more than $800 million in cash and other liquid assets when the compensation was awarded.

On the other hand, Reed and NYSE CEO John Thain have maintained that Grasso’s pay package was excessive and reportedly want Grasso to return up to $120 million. New York State Attorney General Eliot Spitzer has asked a state court judge to rescind the pay package and to determine a “reasonable” level of compensation for Grasso. The appropriateness of his level of compensation, it appears, will be decided in the courts.

But let us remember that Grasso was working for a nonprofit rather than a for-profit organization; that his organization receives a tax subsidy from the federal government, unlike for-profit organizations; and that none of his board had their own money invested as stock in the organization. Also, in contrast, for-profit executives face the full force of competition and struggle through a more competitive managerial environment on the way to the top of their organization. Nonprofit CEOs rarely face the kind of stockholder suits or stockholder voting revolts that happen when owners have their own money at stake. Stakeholder lawsuits against management and board members claiming economic loss frequently can be substantiated for for-profit organizations. Moreover, these organizations often pay substantial amounts of corporate income taxes, providing the necessary funds for the infrastructure needed for businesses to operate profitably.

The appropriateness of this compensation level must also be analyzed in relationship to the NYSE’s regulatory role. By not being subject to an outside agency, the NYSE arguably retains the initiative to control its own regulation by those most informed about its problems. A conflict of interest can occur, of course, when the leaders of the organizations whose activities are regulated are also on the compensation board that determines the pay of the chief regulator. This situation allows skeptics to contend that NYSE board members can “buy” the leadership of the NYSE. New York State Comptroller Alan Hevesi has said that “when an official is paid an extraordinary amount of money by those he is supposed to regulate, there is an obvious conflict of interest.”

Nevertheless, as dangerous as this overcompensation scheme was as a precedent for similar future incidents, the related public perception that insiders are controlling the NYSE and are being targeted for prosecution may well adversely affect the stock prices of NYSE-traded companies. Certainly, compensation that the public would perceive as excessive for the head of a nonprofit organization can only feed this skepticism.

Reaction to a Malefactor

Frequently, for-profit businesses allow alleged malefactors to quietly leave employment, then develop structural firewalls and safeguards to ensure that the problem, even if only perceptional, does not recur. These proactive measures provide an important visible precedent that business leaders are not to be prosecuted for personal “mistakes.” This idea also perpetuates the culture supporting corporate leadership. In contrast, nonprofit organizations have greater accountability to the public. Because nonprofit organizations are funded directly by the public or indirectly through tax advantages, they have a heightened public responsibility. Consistent with this accountability concern, Hevesi further maintained that “it would not be enough to change the leadership of the NYSE without implementing reforms that will ensure the exchange is an effective regulator and leader in corporate America.” The problem with allowing an individual to quietly leave and then developing safeguards after the fact is that certain individuals seeking to maximize opportunities for self-enrichment see little deterrent in these policies. With certain behaviors exempt from penalty other than the loss of position, retirement-seeking CEOs may be tempted to seek a last-minute windfall. Those potential malefactors may be only too willing to provide unspecified services that the public perceives as selectively unprosecutable by those being regulated, in exchange for significant career-exiting gains.

Enhanced Investigations Are Essential

To rectify these perceptions and repair the reputation of the NYSE, hearings should be held by legislative committees to fully uncover and document the relevant details in the hopes of minimizing future incidents. This investigative process will send a message that should be understood by potential malefactors in all areas of the securities markets. Strict penalties are important, because social psychologists warn that such potential malefactors assess only what punishments actually occur and not rhetoric. Only when Grasso and the board members that provided his extraordinary compensation are thoroughly investigated, for their own benefit as well as for the public interest, can the NYSE begin to repair its reputation. After all, procedures established after a leadership problem occurs can be systematically dismantled as soon as memories fade, as illustrated by the savings and loan debacle of the 1980s.

Fixing the Problem

A rotten tone set at the top of an organization usually permeates to middle and lower levels once it seems that the leadership has “gotten away with it.” Now may well be time for the regulatory responsibilities concerning the internal operations of the financial markets to be removed from the NYSE. The SEC, the Treasury Department, or the Justice Department should instead set up shop on the floor of the exchange.

In the 1970s, Abraham Briloff argued before the Moss and Metcalf Committees that as long as the leaders in the financial markets were going to manipulate financial regulation, the investor might do better by simply dispensing with such regulation. On the other hand, Gabriel Kolko, a leading historian of politics and warfare, argues that it was the financial industry itself that asked for financial regulation in order to assuage the fears of wealthy investors that the masses would take their money out of the stock market and place it in real estate and other investment options. This regulatory process has been in place since shortly after the 1929 stock market crash because of public revelations of corruption in the financial markets. The financial industry has a history of giving in to outside regulators only when necessary to placate worried investors, a reactionary regulatory process.

Today more than ever, it would be in the best interests of these financial institutions to concede more of the regulatory power remaining with the NYSE to an outside agency—or to the government—to lower the business risk premium of investors revealed by the Grasso Affair. Otherwise, the financial markets will be swimming upstream against a steady current, until memories of these events fade sufficiently.