The Economist reported on a study by Grant Thornton about a decline in US securities markets.  The Study, A Wake-up Call for America, is here. 

It seems that as the number of listed companies decline, replacements are few and far between.  The lack of replacements comes from an IPO market that has yet to revive in any significant matter.  The reasons for the decline?  Not SOX, as much as some would like to believe. 

Instead, the problem can be traced to deregulation that encouraged "high-frequency" trading that largely ignores smaller public companies.  As the Economist described:

• The slide in listings began in the mid-1990s, at around the time that America saw an array of regulatory changes designed to advance high-speed, low-cost trading, such as the introduction of online brokerages and new order-handling rules. An accidental victim of this technological revolution, the report says, was the ecosystem that helped bring small firms to market and then nourished them once there. “It’s a bargain-basement market today,” says David Weild, a co-author of the report. “You get what you pay for, and that’s nothing but trade execution.”     

We haven't heard any good SOX bashing lately, particulary in an era when the need for more rather than less regulation of corporate governance is the order of the day.  Nonetheless, we were treated to a dose of criticism by Duncan Niederauer, the CEO of the NYSE.  After discussing the delisting of the insurance giant, Allianz, and conceding that the company went home because of deeper, more liquid markets, he turned his sights on SOX.

• The bad news, according to Mr. Niederauer, is that while Allianz had some legitimate reasons to delist, the 2002 Sarbanes-Oxley law may very well have been the nail in the coffin. The act—which increased the reporting burden on companies—is "one of the things that has made us less competitive," and "hurt the U.S. capital markets competitiveness."

• How so? He says some companies "use it as a differentiator because they don't have a strong reputation and don't come from markets with solid regulatory oversight." But "I'm afraid in the case of companies like Allianz, it's a drag," because complying with Sarbanes-Oxley ends up costing companies a lot of money. It is worth noting, he adds, that though five Russian companies are listed in New York, not one has been added since 2004.

There are several observations to make about this comment.  First, Allianz is a very large company, with 703 billion euros under management.  Could it really be the case that a company this large decided to delist because of the marginal costs associated with SOX?  Highly unlikely.

Second, Niederaus notes in his own remarks that 70 Chinese companies have listed on the NYSE.  These companies did not have to turn to the NYSE.  If they merely wanted a presence outside of China, they could have listed on the London Stock Exchange (LSE).  One reason they likely chose to list in the US is that the NYSE has a much tougher set of corporate disclosure and corporate governance requirements.  Because of these stricter requirements, investors in China know that companies listing on the NYSE are the best and safest.  As a result, they attract more investors and their share prices undergo a commensurate increase.  It has long been empirically demonstrated that foreign companies listing in their home market and on the NYSE see a statistically significant increase in share prices.  The same is not true for the LSE. 

In other words, SOX helped the NYSE get those 70 Chinese companies.  Regulations can go too far but in this case, the US (and the NYSE) benefited from the higher bar rather than the lower one that Niederauer seems to want.

With Rule 452 amended, are matters finished?  Not exactly. 

First, the rule applies to members of the NYSE.  Brokers that are not subject to the requirement are outside the rule's boundaries.  That means that brokers who hold shares for NYSE or Nasdaq companies but are not members of the NYSE (only members of FINRA) can vote in uncontested elections (or on any other matter).  The only limits are those imposed by state law.  As a result, management may still receive in each election a block of discretionary votes.  Having said that, it is likely that most discretionary votes are in the hands of NYSE brokers.  Moreover, non-NYSE brokers may follow Rule 452 anyway as a sort of safe harbor.

Second, the Rule continues to regulate discretionary voting in the negative.  There is no definition of routine.  Instead, there are 18 categories of non-routine and one catch-all category.  The catch-all provides:  

• the person in the member organization giving or authorizing the giving of the proxy has no knowledge of any contest as to the action to be taken at the meeting and provided such action is adequately disclosed to stockholders and does not include authorization for a merger, consolidation of any matter which may affect substantially the rights or privileges of such stock.

In other words, a proposal that has the potential to substantially affect the rights or privileges of stock would be included. 

Notwithstanding the list, the NYSE will note each matter that is or is not subject to discretionary voting in the weekly bulletin.  See Rule 452.11 (“When member organization may not vote without customer instructions.—In the list of meetings of stockholders appearing in the Weekly Bulletin, after proxy material has been reviewed by the Exchange, each meeting will be designated by an appropriate symbol to indicate either (a) that members may vote a proxy without instructions of beneficial owners, (b) that members may not vote specific matters on the proxy, or (c) that members may not vote the entire proxy."). 

This places extraordinary discretion in the hands of the NYSE in determining when discretionary votes can be cast.  Indeed, the NYSE has been criticized on occasion for its exercise of discretion in this area.  See Amy Goodman & John Olson, A practical guide to SEC proxy and compensation rules, at 12.3[1], n. 21 (2001).

Rule 452 should be amended to reverse the presumption.  All matters submitted to shareholders should be deemed non-routine, with discretionary voting not allowed.  Only if specifically listed as routine would discretionary voting be permitted (approval of the auditor, etc.).  This will reduce the discretion of the NYSE and ensure that shareholders and investors are aware of the matters considered routine.  It will put on public display the matters that brokers can influence with their discretionary votes, making the system more transparent.

The amendment to Rule 452 adopted by the Commission is a start but there is a long way yet to go.

The Supreme Court has agreed to hear the case arguing against the constitutionality of the PCAOB.  The case raises issues about the limits that can be imposed on presidential removal authority for officials in the executive branch.  The PCAOB members can only be removed for cause by the Securities and Exchange Commission.  As a result, there is a double layer of removal restrictions, not something unheard of but the first time it has been raised so explicitly before the Supreme Court.  The PCAOB was a unique organization created with the intent of melding together private market sensibilities and government regulation.  Thus, the organization is a non-profit that pays private sector salaries but is overseen by the SEC. 

To the extent that the PCAOB is struck down (and there is reason to believe the conservative majority will do so), it will ironically eliminate an experiment with a more market driven form of regulation.  The PCAOB can instead be transformed into a full blown independent agency or a division of the SEC, something one would ordinarily think the plaintiffs in the case would eschew.

We wrote on Feb 4^th that Nasdaq received an extension of its request to suspend the one dollar minimum listing standards until April 19^th. That request has now been extended through July 19, 2009, and the NYSE filed a proposed rule to adopt a similar suspension until June 30.

The rule to be suspended requires that if a security fails to have a closing bid price of at least one dollar for 30 consecutive business days, it is considered deficient and given a 180-day period to regain compliance. Under the suspension, both the 30-day period and the 180-day period are held in abeyance until the suspension is ended.

In addition to suspending the dollar bid value requirement, the NYSE previously suspended its average global market capitalization listing requirement that companies not fall below $15 million for 30 consecutive days. This rule suspension was to have expired April 22, but is now proposed to be extended to June 30, corresponding to the dollar value suspension.

These requests for continued suspension of the listing standard are not surprising. The suspension is immediately effective and is certain to be approved as markets continue to be in “unprecedented turmoil.”

Last October Nasdaq requested that the SEC allow it to suspend the listing requirement that requires companies to have a minimum bid price of $1. Nasdaq rules classify a security as “deficient” if it has a closing bid price of less than $1 for thirty consecutive business days. Once deficient, issuers have an automatic180 day period to regain compliance by having a closing bid price of at least $1 for ten consecutive business days, and can receive an additional 180 days if all other listing requirements are met. According to the Nasdaq proposal to the SEC, by October 9, 2008 there were 344 securities trading below $1, and another 300 securities trading between $1 and $2, up from 64 securities below $1 at the end of September.

The SEC agreed with Nasdaq’s assessment that this drop in bid price was not a result of a “fundamental change in the underlying business model or prospects” for these companies, but was a result of “decline in general investor confidence,” and that these companies remain “suitable for continued listing.” Since the proposed rule change would not endanger investors or burden competition and was in the best public interest, the SEC waived the 30-day operative delay between receipt of the proposal and its implementation. The rule suspension became immediately effective on October 16, 2008 and was to expire January 16, 2009.

The effect of the rule suspension is not only to ignore share bid price in determining whether a listing deficiency exists, but also to suspend calculating the 180-day recovery period for any security that was deficient before October 16. If a company’s security was 150 days into its initial deficiency period at October 16, the company would have 30 days after January 16^th to recover or seek an additional 180-day extension.

On Dec 18, 2008, Nasdaq requested an extension of the rule suspension to April 19, 2009, noting that “extraordinary” market conditions continue. (As of January 30, 2009, there were 430 shares listed on Nasdaq for $1 or less.) Unlike the first proposal, for which the SEC waived the 30-day operative delay, there is time for the SEC to publish this rule for notice and comment. The initial proposal was published post-approval, and received one supportive comment.  One blogger suggests that the rule be permanently eliminated as a way to discourage companies from doing a reverse stock split merely to meet the listing requirement.  Comments must be submitted to the SEC referencing File Number SR-NASDAQ-2008-009 on or before February 5, 2009.

The Race to the Bottom has recently added a Donate link. The Blog is advertisement free and plans to remain that way. If you have an interest and enjoy the content, consider a contribution.

Wachovia agreed to lock the transaction on behalf of Wells Fargo by turning over 40% of the Bank's voting power to the purchaser (by issuing ten shares of supervoting stock, perhaps a new record for the number of votes per share).  With that percentage, Wells Fargo need not worry about any other suitor swooping in and making a better offer.  We have no trouble understanding why Wells Fargo would want the shares and assume that the Wachovia Board issued them in a manner consistent with its fiduciary obligations.  Watching financial institutions drop like stones, the Wachovia Board managed to work out a deal with Wells Fargo that saved some value for its shareholders.

The more problematic part of this, however, is the decision to dispense with shareholder approval and its approval by the NYSE.  The two banks could have avoided the need for a dispensation had Wachovia issued less than 20% of its voting shares, a still formidable percentage that would likely have locked up the transaction for Wells Fargo.  But instead, by going above 20%, Wachovia triggered the obligation to obtain shareholder approval imposed by the NYSE.

There will be no shareholder approval, however.  The NYSE in lightning quick fashion approved the setting aside of the vote, needing only days (perhaps a single day) to do so.  Apparently, the Exchange determined that the delay "would seriously jeopardize the financial viability of the enterprise".  Exactly how was that the case?  No one doubts the importance of Wachovia's need for a rescuer.  But there did not seem to be a shortage of suitors, with Wells Fargo and Citgroup vying for control of the financial institution.  The issuance of the preferred stock seems less likely to have been necessary to induce Wells Fargo to enter the fray than it was to prevent Citigroup from making a competing offer.  In other words, the decision by the NYSE to set aside shareholder approval wasn't about "financial viability" but about allowing Wachovia to favor one side over the other.  

The decision seems questionable on other grounds.  First, there was in fact time to get shareholder approval since shareholders still have to vote on the merger.  Second, the transaction could have been structured to avoid the need for a vote.  Had Wachovia issued less than 20% of the voting shares of the company, the voting issue would have been avoided.  

It is possible that the NYSE weighed all of the facts and concluded that waiver of the requirement was necessary for reasons of financial viability.  It is also possible that the NYSE takes a very broad view of the exclusion, one that allows issuers to dispense with shareholder votes whenever management wants to issue a lock up percentage of shares.  

The central problem is that the NYSE is enforcing a legal requirement (listing standards) but as a for profit company not subject to government transparency requirements (the FOIA, for example), it does so in secrecy with little opportunity for transparency.  The public has no real opportunity to learn the reasons for the decision or to study the patterns to try to determine the true motivation for the decision, something particularly important given the for-profit nature of the business.  If the NYSE is going to stay in the regulatory business, its decisions ought to be subject to transparency requirements.  The decisions to set aside listing standards, particulary those that protect shareholders, and the process by which the decision was reached, should become public, allowing investors to know how often and when the NYSE will set aside the requirement.  Either the Exchange should voluntarily do so or it should be required by federal legislation.

The WSJ contained a somewhat confusing article indicating that Wachovia would not submit its "deal to be acquired" by Wells Fargo to shareholders "because delaying the transaction to get shareholder approval would seriously jeopardize the financial viability of the bank." The article also noted that the NYSE has approved the decision to cancel the shareholder vote.

The problem with the article is that the "deal to be acquired" is a merger. The merger agreement is here. Neither Wachovia nor the NYSE has the authority to waive shareholder approval of a merger. So what's going on?

It turns out that what Wachovia wanted was to avoid shareholder approval of a lock up option issued to Wells Fargo. Under theShare Exchange Agreement filed on Thursday, Wachovia agreed to issue Class M preferred stock to Wells Fargo representing approximately 40% of the target company's voting power. Under the rules of the NYSE, shareholders must approve the transaction. Rule 312.03(c) provides that shareholders must approve the issuance of 20% or more of the voting power of a company. The rules contain exceptions. Rule 312.05 provides that approval is not necessary where, upon application to the Exchange, the "delay in securing stockholder approval would seriously jeopardize the financial viability of the enterprise" and the decision to invoke the exception has been "expressly approved by the Audit Committee of the Board."

It is this exception that Wachovia is invoking. The Bank filed a current report on Form 8-K on Friday announcing that it would invoke the exception. As the Company explained in a letter to shareholders:

• Simultaneously and in connection with the entry into the Merger Agreement, Wachovia and Wells Fargo also entered into a Share Exchange Agreement (the “Share Exchange Agreement”), pursuant to which Wachovia will issue and sell 10 shares of Series M, Class A Preferred Stock, no par value, of Wachovia, which shares will represent in the aggregate approximately 39.9% of the voting power of Wachovia’s outstanding voting securities after giving effect to the issuance, in exchange for 1,000 shares of Wells Fargo common stock and the entry by Wells Fargo into the Merger Agreement.
  

What was the purpose of the transaction? To lock up the deal for Wells Fargo. As the letter to shareholders explained, "The share issuance and exchange contemplated by the Share Exchange Agreement was a necessary condition to Wachovia’s ability to obtain the benefits of the Merger Agreement, which in turn were essential to maintaining Wachovia’s financial stability."

The letter also explained that there would be no shareholder approval despite the apparent requirements of the NYSE. This was because "the Audit Committee of Wachovia’s Board of Directors unanimously determined that the delay necessary in securing shareholder approval prior to the issuance of the preferred stock to Wells Fargo would seriously jeopardize the financial viability of Wachovia and has expressly approved the reliance by Wachovia on the exception under Para. 312.05 of the NYSE Listed Company Manual." The letter listed various factors that were considered in reaching the decision, "including factors specific to Wachovia, the extraordinary and highly uncertain economic, financial and political environment and the experience of other financial institutions."

Finally, the letter noted that "The Exchange has accepted Wachovia’s application of the exception." It is this last item that requires more consideration. We will discuss this in the next post.

Last month the SEC approved a proposal by NASDAQ to change the definition of director independence. The NYSE is seeking approval for an identical change to its independence tests, which is still in the comment phase. While the rule change does not significantly alter independence requirements, we follow all developments in this area with great interest.

NASDAQ Rule 4200(a)(15)(B) and NYSE Rule 303A.02 previously disqualified any director from being considered independent who received, or had an immediate family member who received, over one hundred thousand dollars in compensation from the company during any twelve month period in the last three years. The new rules adopted by the exchanges increases this threshold amount to one hundred twenty thousand dollars. The SEC notes in its releases that this is the same amount requiring disclosure of a single transaction between a director and the company under Reg. S-K, Item 404.

The NYSE has also requested a change to the independence test for a director’s relationship to the company’s outside auditor. The current NYSE standard disqualifies a director from being considered independent if the company’s external auditor employs an immediate family member of the director. This applies even if the family member has never worked on an audit of the company. The NYSE is requesting a new test that only includes family members that are partners of the company’s outside auditor or have worked on the company’s audit during the past three years.

Both SEC releases are available on the DU Corporate Governance web site.

The government has seized control of Fannie Mae and Freddie Mac, with both having gotten themselves into serious financial trouble during the current crisis in the financial markets.   The decision by the government to seize control of Fannie Mae and Freddie Mac eliminates an uncomfortable fiction.  The two companies were garbed in private sector clothing, with shareholders, boards of directors and, most critically, an obligation to profit maximize. 

Lets take a look at the proxy statement for Fannie Mae.  The directors weren't paid at Goldman Sachs rates, but they did do nicely.  In 2007, the Fannie Mae board met 22 times. See 2007 Proxy Statement , at 23 ("The Board of Directors met 22 times during 2007. During 2007, each of our current directors attended at least 75% of the total number of meetings of the Board of Directors and Board committees on which he or she served.").  They  earned, in general, somewhere in the vicinity of $200,000 each.  Admittedly, they had to work harder for the pay than most other boards.

So the directors won't paid excessively by public company standards but they were certainly well paid by government standards.  How about the CEO of the company?  How well was he paid?  Total compensation was over $12 million, with almost a million in salary, $2.2 million in "performance" bonus and $9 million in long term incentive awards. 

In other words, Fannie Mae (and presumably Freddie Mac) were set up with all of the flaws associated with Delaware corporations.  The directors received lucrative amounts and so did the top officers they were responsible for supervising.  At the same time, the financial giants had an incentive to maximize short term profits for shareholders, something that no doubt contributed to the decision, as the WSJ descirbed, to "expand[] their exposure to riskier loans."  In other words, while some government responsibilities can be offloaded to the private sector and improved with a healthy dose of profit maximizing behavior, some cannot.  This is one of them.  

Are there other entities garbed with regulatory or public sector responsibilities that are now engaging in profit maximizing behavior?  Nasdaq and the NYSE.  

Self regulation predates the adoption of the securities laws and has long been a component of the system of oversight for the capital markets.  There has always been problems with the approach, most noticeably concerns over adequate enforcement.  Particularly with respect to the exchanges, there has been the potential of capture by the industry being regulated and the possibility that requirements designed to protect investors would remain unenforced.  The SEC's actions against the the Boston Stock Exchange for failing to police the activities of the specialists is a good example.

The problems have only been exacerbated in recent years.  Nasdaq and the NYSE have tranformed into "for profit" organizations.  As a result, they have the additional burden of profit maximization, something that did not exist before.  Profit maximization and strong enforcement do not always go hand in hand.  As a result of this change, pressure has already been brought to bear to weaken aspects of exchange behavior designed to protect investors. 

The NYSE reduced its regulatory role when it transferred broker-dealer oversight to FINRA.  Nonetheless, the exchanges retain two important regulatory aspects.  They retain the authority to write and enforce listing standards.  In addition, they retain market surveillance functions.

The Commission recently took steps to centralize the monitoring function.  In Exchange Act Release No. 58350 (August 13, 2008), it approved a plan to centralize "surveillance, investigation, and enforcement of common insider trading rules" in the hands of the NYSE and FINRA.  The NYSE gets responsibility for companies traded on its exchange, all the rest fall to FINRA.  In short, this approach removes surveillance functions from all other exchanges, including Nasdaq and the Amex.  All of the participating entities have entered into a cost sharing arrangement and have agreed to meet periodically "to discuss the conduct of regulatory responsibilities, identify issue or concerns, and receive and review reports." 

There are several interesting observations to make about this approach.  Centralization has its benefits, including the concentration of resources and improved expertise.  But of great interest, the SEC has effectively removed most of the surveillance function from entities that operate on a for profit basis, having transferred much of the surveillance function to FINRA, a private, non-profit organization.  That leaves Nasdaq and the Amex with little more than enforcement of listing standards as the exclusive regulatory function.

The NYSE becomes the only "for profit" organization to continue to have surveillance functions.  In any for profit organization, pressure always exists to cut overhead (and increase profits), with surveillance falling into the overhead category.  It may well be the case that the NYSE will eventually give up the surveillance function, allowing FINRA to do all of it.  This is in fact what happened with broker-dealer oversight, a function already moved from the NYSE to FINRA.

This will leave the "for profit" exchanges with one primary regulatory function, the drafting and enforcement of listing standards.  This is another area that may suffer in a "for profit" environment.

Henry Paulson, the Secretary of the Treasury, has built much of his tenure around the them of excessive regulation.  His preference is for the market to solve matters.  Yet the current crisis has demonstrated the failings of the market and put pressure on him to devise a regulatory correction.  He is having a hard time philosophically coming to terms with this new approach. 

One example concerns his treatment of self regulatory organizations. While Paulson usually refers to SROs generically, he seems most concern with the stock exchanges (NYSE-Euronext and Nasdaq).  His proposals calls for the streamlining of SEC approval of SRO rule changes, with some becoming effective upon filing.  As the summary notes:

• The SEC should issue a rule to update and streamline the self-regulatory organization (“SRO”) rulemaking process to recognize the market and product innovations of the past two decades. The SEC should consider streamlining and expediting the SRO rule approval process, including a firm time limit for the SEC to publish SRO rule filings and more clearly defining and expanding the type of rules deemed effective upon filing, including trading rules and administrative rules. The SEC should also consider streamlining the approval for any securities products common to the marketplace as the agency did in a 1998 rulemaking vis-à-vis certain derivatives securities products. An updated, streamlined, and expedited approval process will allow U.S. securities firms to remain competitive with the over-the-counter markets and international institutions and increase product innovation and investor choice.

There is no question that the exchanges, both of which are for profit companies, face competitive pressures.  There is also no doubt that they would like the right to act more quickly in the face of changed competitive circumstances. 

But if the exchanges want to act like profit making entities, they should receive the responsibilities that come with it.  For all of the difficulty or delay associated with regulatory approval, the exchanges receiveimmunity from lawsuits for anything done pursuant to their regulatory mission. 

The exchanges have reduced their regulatory role, particularly in the aftermath of the NYSE merging its broker-dealer oversight role into the NASD (now FINRA).  Perhaps the future for the exchanges ought to be that they exist the regulatory function entirely.  They would benefit competitively by reducing regulatory oversight but would likewise be subject to the market disciplining process, including law suits for wrongful behavior. 

We have noted numerous times that the for profit status of the NYSE (and Nasdaq) creates an disincentive to rigorously enforce its rules, including listing standards.  It is not a phenomena limited to the US, as we noted in a post about the Nordic Stock Exchange.

With JP Morgan Chase raising its offering price for Bear Stearns from $2 to $10, it received the right to buy 39.5% of Bear Stearn's shares, effectively locking up the deal.  It so happens that the NYSE has a rule requiring shareholder approval anytime the company issues more than 20% of its shares.  As Rule 312.03 of the NYSE Manual provides:

• (c) Shareholder approval is required prior to the issuance of common stock, or of securities convertible into or exercisable for common stock, in any transaction or series of related transactions if:
  (1) the common stock has, or will have upon issuance, voting power equal to or in excess of 20 percent of the voting power outstanding before the issuance of such stock or of securities convertible into or exercisable for common stock; or
  (2) the number of shares of common stock to be issued is, or will be upon issuance, equal to or in excess of 20 percent of the number of shares of common stock outstanding before the issuance of the common stock or of securities convertible into or exercisable for common stock.

But JP Morgan is acquiring 39.5% without shareholder approval.  The acquisition, therefore, would seem to violate the listing standards of the exchange.  Buried in theJournal article was how the bank planned to avoid the requirement -- ignore it. 

• The New York Stock Exchange, where shares of J.P. Morgan and Bear Stearns are listed, generally requires shareholders to approve an issue of new shares that are convertible into more than 20% of a listed company. Bear Stearns and J.P. Morgan said that approval isn't necessary, citing an exception for cases where "delay...would seriously jeopardize the financial viability of the listed company."

But in fact while one could argue that the JP Morgan and Bear Stearns acquisition was important to the stability of the financial markets and perhaps even the solvency of Bear Stearns, a lock up purchase of almost 40% was another matter.  Particularly with the Fed spigot open and the JP Morgan guarantee, the public case for a cash infusion involving more than 20% of Bear Stearn's shares has not been made.  Moreover, the purchases are in stark contrast to the original deal where JP Morgan obtained the right to buy 29 million shares but in no case more than 19.9% of the outstanding stock of Bear Stearns.  As theoptions agreement noted:

• Issuer hereby grants to Grantee an unconditional, irrevocable option (the "Option") to purchase, subject to the terms hereof, up to 29,000,000 fully paid and nonassessable shares of Issuer's Common Stock, par value $1.00
  per share ("Common Stock"), at a price of $2.00 per share (the "Option Price");  provided, however, that in no event shall the number of shares of Common Stock for which this Option is exercisable exceed 19.9% of the Issuer's issued and outstanding shares of Common Stock without giving effect to any shares subject to or issued pursuant to the Option. The number of shares of Common Stock that may be received upon the exercise of the Option and the Option Price are subject to adjustment as herein set forth.

In other words, at a time when the financial health of Bear Stearns was even more precarious, JP Morgan found a way to live with the 20% cap on new shares. 

At the same time, the 39% could have had a purpose unrelated to a necessary financial infusion.  The size of the purchase all but makes the agreement a sure thing.  In other words, with 39% plus any votes by Bear Stearns management, JP Morgan doesn't have to worry about an interloper coming in and making a counter offer. 

It is possible that the 39% is necessary for the financial safety of Bear Stearns.  It is also possible it is not, a point made by others.  Eyes will by on the NYSE to see if in fact the SRO takes this requirement seriously and engages in the type of due diligence necessary to determine whether in fact the rule is being violated.  To the extent it has already approved the exception, it makes a mockery out of the notion that listing standards are meaningful devices to protect the rights of shareholders, creating an argument that alternative enforcement mechanisms for these requirements should exist.       

In a February 1, 2008, press release, Senator Charles Grassley (R-Iowa) announced that the SEC will employ greater measures to fulfill its responsibility to police self-regulatory organizations, such as the New York Stock Exchange and other financial markets.

Grassley, who is the ranking member of the Senate Finance Committee, issued his release in response to a new report on the SEC by the Government Accountability Office. The report focuses primarily on the SEC’s oversight of the various stock and options exchanges- investors’ first line of defense against market manipulation and insider trading. The report details how the commission has declined to use the audits in its oversight procedures despite that the internal audits conducted by the nation’s stock and options exchanges are the best tool that the SEC has in its battles against insider trading and market manipulation. Moreover, the report noted that the SEC investigators’ efforts to track questionable trading are hampered by a computer system that does not allow investigative referrals from the major exchanges to be searched easily and efficiently.

Grassley asked the SEC to explain why its staff has not routinely obtained and reviewed the internal audits and investigations of the organizations, and asked SEC Chairman Christopher Cox to remedy the Commission's failure to use such investigative resources provided by self-regulatory organizations as part of its work to safeguard the integrity of U.S. markets. While SEC guidance called for the organizations "to allow ‘on-site’ access to internal documents during SEC inspections," Grassley noted that this does not provide an adequate substitute. Rather, he explained that “reliance on self regulatory organizations, such as the major stock exchanges, to police their members can work effectively only if the operations of the self regulatory organizations are open and transparent." As such, Grassley urged Chairman Cox to ensure that SEC staff obtain and review internal self regulatory organization audit reports on a routine basis. "It took way too long, but now maybe the SEC is finally getting serious about its duty to oversee self-regulatory organizations,” Grassley said in the release.

One of the topics addressed often on this Blog is the role played by the stock exchanges in the corporate governance process.  It is the stock exchanges that require a majority of the board to be independent and that boards have audit, compensation and nominating committees.  But with requirements come concerns.  Particularly as the stock exchanges have converted to "for profit" businesses, with the traditional pressure (indeed fiduciary obligation) to profit maximize, concern arises with its regulatory role.  In the context of listing standards, one of the issues concerns the adequacy of enforcement, a problem that was identified as early as 1934 when Congress held hearings on the role of the NYSE.

Courts have, in the past, found that stock exchanges, because of their regulatory role, have absolute immunity from suit.  But in a for profit era, the courts are being forced to differentiate between the regulatory and non-regulatory role of the exchanges.  The most notable example so far has been the 11th Circuit's decision (en banc) in Weissman allowing a private suit to go forward against Nasdaq for allegedly misleading advertisements.  Michelle Larson, a student at the University of Denver Sturm College of Law, has a post today that examines another step in this direction, a petition for certiorari filed by Calpers in a case that will explore the immunity issue. 

The other issue concerns SEC oversight.  It is the Commission that can sanction the exchanges for failing to enforce their rules.  A second post today by JP Thibeault, examines efforts, based upon a GAO Report, to get the Commission to step up its oversight of the stock exchanges. 

On January 16, 2008, the California Public Employees’ Retirement System (CalPERS) filed a petition for writ of certiorari requesting Supreme Court review of a decision to dismiss fraud claims against the New York Stock Exchange (NYSE) based on governmental immunity. The Second Circuit’s Judge Sotomayor held that the NYSE is entitled to absolute immunity even when it abandons its quasi-governmental role as a regulator. In re: NYSE Specialists Securities Litigation (California Public Employees’ Retirement System v. New York Stock Exchange, Inc.), 503 F.3d 89 (2d Cir. 2007).

Because of the NYSE’s status as a self-regulatory organization (SRO) under the Securities Exchange Act of 1934, the SEC delegates significant authority to the NYSE to enforce trading rules and regulations. When the NYSE stands in the shoes of the SEC, the absolute immunity that shields the government entity from liability also extends to the exchange.

In the lower courts, CalPERS’ class action lawsuit contended that the exchange effectively abandoned its regulatory role when the NYSE and the specialist firms that managed trading for its listed companies acted to defraud public investors from October 17, 1998 until October 15, 2003.  Specifically, CalPERS alleged that the NYSE falsified trading records, tipped off the specialist firms to pending investigations, and worked with the specialists to hide evidence from the SEC during the class period. Petition for Writ of Certiorari at 4, California Public Employees’ Retirement System v. New York Stock Exchange, Inc., No. 07-946 (U.S. Jan. 16, 2008).

The recently filed petition asks the Supreme Court to consider whether the NYSE should be entitled to absolute immunity even when it fails to perform the regulatory function delegated to it by the SEC. CalPERS exhorts the Court to resolve what it views as the Second Circuit’s inconsistent holdings: 1) SROs are private, non-governmental actors beyond the reach of constitutional limits on governmental power; and 2) SROs are entitled to absolute immunity even when failing to perform their delegated regulatory duties.

The primary materials discussed in this post may be found at the DU Corporate Governance website.  Please see earlier posts for more on SROs.

We have noted problems associated with enforcement of listing standards.  The issue comes up most clearly in the context of director independence.  The NYSE provides that directors will not be independent if they have a "material relationship with the listed company (either directly or as a partner, shareholder or officer of an organization that has a relationship with the company)."  NYSE Guide 303A.02.  According to the attached comment,

• it is best that boards making "independence" determinations broadly consider all relevant facts and circumstances. In particular, when assessing the materiality of a director's relationship with the listed company, the board should consider the issue not merely from the standpoint of the director, but also from that of persons or organizations with which the director has an affiliation. Material relationships can include commercial, industrial, banking, consulting, legal, accounting, charitable and familial relationships, among others. However, as the concern is independence from management, the Exchange does not view ownership of even a significant amount of stock, by itself, as a bar to an independence finding.

In other words, its up to the board but the board should take into account all relevant facts and circumstances.  In addition to "material relationships," the NYSE includes a number of categorical rules that result in the payment of more than $100,000 in direct compensation from the listed company.  The $100,000 is calculated without considering "director and committee fees."   As the rule notes, this test is "in addition" to the material relationship test. 

So, under the rules, the board must first screen for material relationships, taking into account all relevant facts and circumstances.  Even where the board concludes that there is no material relationship, payments in excess of $100,000 render a director not independent.  While fees are specifically excluded from the $100,000 test, they are not specifically excluded from the material relationship portion of the definition. 

Proxy statements are full of representations that they have complied with the rules and made the requisite determinations.  See International Games 2008 Proxy Statement ("Our board of directors has made an affirmative determination that the following members of the board, constituting a majority of our directors, meet the standards for “independence” set forth in our Corporate Governance Guidelines and applicable NYSE rules.").  In making that determination, however, it is quite clear that boards do not typically consider fees when determining independence, including application of the material relationship portion. 

Some even admit it.  See Merrill Lynch2007 proxy statement (noting that compensation "for service as a Director is not considered in making independence determinations.").   And, where there is any doubt, there's always a pass from the stock exchange.  See Owens Corning Oct. 2007 Proxy Statement  ("The New York Stock Exchange has confirmed to us that receipt of such fees should not be considered in evaluating Mr. McMonagle's independence as a director of the Company.").   

There is little question that fees can result in a material relationship, whether objectively or subjectively.  Not always of course.  But it seems clear that with respect to fees, the stock exchanges simply do not enforce the "material relationship" test.  The failure to consider fees makes the concept of independence a charade.  Moreover, it also makes a mockery of the requirement in the listing standards that independence is lost through the existence of a "material relationship with the listed company."

We understand the motivation by the NYSE for not giving sufficient content to the "material relationship" requirement.  It is, after all, a for profit company.  But what about the Commission?  The Agency has increasingly relied on independent directors to ensure the integrity of the financial disclosure process.  Why isn't the Commission making sure that directors calling themselves "independent" in fact have no material relationship with the company, including through the payment of fees?  

We continue our discussion about the importance of listing standards as a source of corporate governance and the need for proper enforcement of these standards.  This has become particularly important in an era when self regulatory organizations such as stock exchanges have become for profit entities.  With a profit maximization motive, questions exist about whether stock exchanges will enforce their rules and listing standards even when it means a loss of trading revenue.  One thing that would help would be a private enforcement mechanism, either to sue the violator of the listing standard or the stock exchange for failing to enforce its own rules. 

With that in mind, we return to our analysis of Weissman v. NASD – a case that defines the limits of absolute immunity afforded to SROs for performing quasi-governmental function.  The case illustrates some of the consequences of the movement by stock exchanges to go public and the private remedies that may become available. 

On September 18, The United States Court of Appeals for the Eleventh Circuit, sitting en banc, upheld a lower court decision denying a Rule 12(b)(6) motion (failure to state a claim) made by the National Association of Securities Dealers, Inc. (NASD) and its subsidiary, NASDAQ Stock Market, Inc. (NASDAQ).  Weissman v. NASD, No. 04-13575, 2007 WL 2701308 (11th Cir. Sept. 18, 2007).  The court held that while NASDAQ enjoys absolute immunity from claims arising out of its “statutorily-delegated regulatory or disciplinary functions,” its alleged advertising activities promoting WorldCom, Inc. stock relate to private commercial conduct and as such are not afforded the same level of protection.  Id. at *14.

The present dispute arose from NASDAQ’s $100 million marketing and advertising campaign, allegedly aimed at promoting and selling WorldCom, Inc. stock, in early 2000 through 2002 (prior to the collapse of WorldCom & Enron).  Weissman claimed that during this period he purchased over 80,000 shares of WorldCom, Inc.’s stock while relying on NASDAQ’s statements regarding the credibility of WorldCom’s stock.  He asserted that NASDAQ violated Florida State law by “promoting WorldCom… without disclosing that its revenues were directly enhanced by increased trading in WorldCom stock.”  Id. at *3.

In its defense, NASDAQ insisted it was absolutely immune from suit because it served important quasi-governmental statutorily delegated regulatory functions.  Id. at *10.  Although a publicly traded company:  

• “NASDAQ serves as a self regulatory agency (SRO) within the meaning of the Exchange Act § 78(c)(26), which vests it with a variety of adjudicatory, regulatory, and prosecutorial functions, including implementing and effectuating compliance with securities laws; promulgating and enforcing rules governing the conduct of its members and listing and de-listing stock offerings.”  Id. at *6. 

In its analysis, the court stated that simply because an entity performed governmental functions, did not mean it was afforded “immunity when [it] performs non-governmental functions” – noting SEC Release No. 34-5-700, expressing concern over the growing pressures for the markets to attract order flow, and the inherent conflict between “SRO regulatory and market operations functions.”  Id. at *7.  

The court then set the standards for determining the application of absolute immunity – stating that, in the interest of justice,  “grants of immunity must be narrowly construed.”   Therefore, when an SRO is not strictly performing quasi-governmental tasks, but is instead "acting in its own interest as a private entity, absolute immunity from suit ceases to obtain.”  To determine whether an SRO is performing quasi-governmental functions, “we look to the objective nature and function of the activity for which the SRO seeks to claim immunity,” without regard for the “SRO’s subjective intent and motivation.”  Id. at *9.  

As a result, the Eleventh Circuit concluded that NASDAQ’s advertising activities alleged in this case did not serve as quasi-governmental functions, and therefore affirmed the lower court’s decision.  Id. at *14-15.

The case stands for the proposition that private parties may sometimes successfully sue a self regulatory organization when it acts in a commercial rather than quasi-governmental role.  Primary materials for this case may be found on the DU Corporate Governance website.   

One of the topics covered by this Blog is the role of stock exchanges in the corporate governance process.  The exchanges impose a number of important governance obligations, including the need for a board with a majority of independent directors.  These requirements apply not only to the main exchanges (NYSE, Nasdaq, and Amex), but also to the regional exchanges such as the Boston Stock Exchange. 

Listing standards, however, are only enforceable by the stock exchanges themselves, or at least so the law has held to date.  Courts have refused to imply a private right of action for violations.  Most of the cases in this area, however, have involved broker-dealer regulation and not listing standards.  Whether courts would treat listing standards required under the Exchange Act (the audit committee requirements contained in SOX) differently is an open question.  

For now, however, enforcement rests with the stock exchanges themselves, with delisting the only real remedy for violations.  Because delisting costs the stock exchange revenue, there is an incentive not to want to delist (and, perforce, enforce listing standards).  The concern is even greater in an era when stock exchanges have become for profit entities and have a fiduciary obligation to profit maximize.  To the extent exchanges fails to enforce, it is the SEC that can bring actions.  This is, therefore, an area where the Commission needs to be particularly attentive.

The next two posts, written by a student, Armin Sarabi, examine some recent actions by the Commission against the Boston Stock Exchange. 

Regional stock exchanges are organized national securities exchanges that are registered with the Securities Exchange Commission (SEC), and are located outside of the main financial center in New York City. These exchanges operate in the trading of regional issues, over-the-counter (OTC) equities under the SEC's Unlisted Trading Privileges (UTP), and securities listed on the New York exchanges (broadening the market for regional exchanges' securities).

Through the use of electronic trading systems - such as the Intermarket Trading System (ITS) - regional exchanges have gained strength in their competitive positions on the market.

ITS is a computer system that links regional exchanges to the major exchanges in New York City. Using ITS, regional exchanges can view competing quotes for the securities traded on a computer screen, and members in any participating market can send orders to trade at the bid or offer on any other participating market. ITS has been criticised for being out of date, and was recently replaced with the NMS Linkage Plan.

Even though these stock exchanges are regional, they are still registered with the SEC and are under the same requirements to enforce rules governing member firms under Section 19(g) of the Exchange Act as the national stock exchanges.

Every self-regulatory organization shall comply with the provisions of this title, the rules and regulations thereunder, and its own rules, and (subject to the provisions of Section 17(d) of this title, paragraph (2) of this subsection, and the rules thereunder) absent reasonable justification or excuse enforce compliance-- in the case of a national securities exchange, with such provisions by its members and persons associated with its members; in the case of a registered securities association, with such provisions and the provisions of the rules of the Municipal Securities Rulemaking Board by its members and persons associated with its members; and in the case of a registered clearing agency, with its own rules by its participants.

Regional stock exchanges were more abundant during the early to mid 1900's, however, over the years they have either merged with other exchanges or simply died out.  Most recently, the Pacific Stock Exchange (PSX) closed the doors to its trading floor and its traders began trading remotely from separate offices rather than a centralized location.  The exchange was later purchased by the NYSE and is now known as NYSE Arca, Inc.  Additionally, Nasdaq announced its plans to purchase the Boston Stock Exchange in early October.  Regional exchanges currently registered with the SEC include:

• Boston Stock Exchange (BSE or BSX)

• Chicago Board Options Stock Exchange (CBSX)

• Chicago Stock Exchange (CHX)

• National Stock Exchange (NSX)

• Philadelphia Stock Exchange (PHLX)