How Grasso's Rule Kept NYSE On Top but Hid Deep Troubles

Big Board Chief Ran Exchange With Iron Fist, Holding Computer Age at Bay 

GREG IP, KATE KELLY, SUSANNE CRAIG and IANTHE JEANNE DUGAN / Wall Street Journal 30dec03

[More on Grasso]

Only one obstacle remained after Michael LaBranche agreed in 2000 to merge his company with a smaller rival to create the largest "specialist" firm working on the New York Stock Exchange's trading floor: the blessing of Big Board Chairman Dick Grasso.

There was, however, a hitch. Much to the surprise of Mr. LaBranche, Mr. Grasso strongly suggested that Robert Murphy, head of the smaller firm, be named chief executive of LaBranche & Co.'s main operating unit after the merger, according to current and former LaBranche executives. Mr. Murphy, a longtime friend and booster of Mr. Grasso, needed to remain at the top of a specialist firm if he was to continue serving on the exchange's board. And that's where Mr. Grasso wanted him.

As a member of the NYSE's board, Mr. Murphy had voted to approve a lucrative contract for Mr. Grasso that led to a payout of $139.5 million in retirement compensation and other benefits. Outrage over that stratospheric payment ultimately led to Mr. Grasso's ouster in September.

Operating much like an old-time political boss, Mr. Grasso often ran the world's biggest stock market as though he owned it. He controlled the composition of the board and its agenda. Having quit college and joined the NYSE in 1968 as an $80-a-week listings clerk, he fought mightily to uphold its traditions. Although he spent heavily on new technology, he didn't let the onslaught of automation significantly alter the exchange's century-old system of using specialists to individually match buyers and sellers of stock.

For many years the results looked fabulous. His political savvy and hard work helped preserve the Big Board's status as the world's most prestigious stock exchange. The NYSE's bustling floor, projected daily onto television screens in offices and living rooms, was the icon of U.S. capitalism. Mr. Grasso's push to get the exchange up and running after the Sept. 11, 2001, terror attacks made him celebrated far beyond Wall Street.

But behind his energetic marketing, the true legacy of his autocratic reign was something entirely different: deep problems that now make the exchange more vulnerable to change -- and competition -- than at any other time in its 211-year history. His efforts to ward off electronic trading meant that the Big Board relied on a people-oriented system arguably more fitting to the Manhattan of 1792, when the exchange was founded under a buttonwood tree, than to a global marketplace dominated by software. As some Wall Street firms made quiet attempts to take trading away from the NYSE and move it in-house, he and his staff prodded and cajoled them to roll back their efforts.

Mr. Grasso's strategy of spiffing up the exchange's image also came at the expense of its regulatory side. The funds allocated to regulatory oversight grew much more slowly than the budget for marketing and communications, according to people familiar with the NYSE's budgeting. That ultimately left the Big Board open to attack by the Securities and Exchange Commission and, in the wake of Mr. Grasso's ouster, scrutiny by its new overseers. An unpublished SEC staff report stemming from a recent examination accuses Big Board regulators of inadequately monitoring their member specialist firms and punishing significant trading-rule violations with a slap on the wrist.

Finally, the machinations that kept Mr. Grasso's friends and allies on the board became a symbol of corporate governance gone bad when it was revealed that those same people doled out his big pay package.

Three months after Mr. Grasso's departure, it is already clear that his strategy helped undermine the credibility, reputation and traditions of the institution he wanted to protect. An internal investigation, conducted by former federal prosecutor Dan Webb, discovered substantial evidence that Mr. Grasso's pay was inappropriately granted by the exchange's board, according to people familiar with the probe. Mr. Webb's report, circulated among NYSE board members in recent days, concluded that there are grounds for asking Mr. Grasso to return at least $50 million of his compensation, these people say.

The SEC has found that during Mr. Grasso's reign, specialists repeatedly traded for their own benefit in the place of customers who were ready to trade at the same price. This spurt of questionable trading may have cost investors at least $155 million, according to the SEC staff. Two weeks ago, the California Public Employees Retirement System cited that finding when it sued the NYSE in federal court alleging that it was shortchanged by specialist firms.

Goldman Sachs Group Inc. President John Thain, who will become the Big Board's chief executive next month, said on Dec. 18 that specialists should continue to play an important role at the exchange, but that more trading should be automated, as it is at rival markets. He will likely have the support of Wall Street players including Goldman Sachs and Fidelity Management & Research Co., which in the past have lobbied for increased electronic trading.

Brokerage firms, no longer under pressure from Mr. Grasso, are directing more of their business elsewhere. The Big Board's share of trading in stocks it lists is likely to slip below 80% this year for the first time since the exchange began keeping records in 1976. Brokerage house Credit Suisse First Boston recently sold two of its nine seats on the exchange because it expects to be doing less business there, people familiar with the decision say. Prices for seats, or membership stakes, have fallen 21% to $1.5 million since Mr. Grasso's ouster on Sept. 17. Some legislators are questioning whether the Big Board can remain the regulator of its own members.

That said, it would be a mistake to understate Mr. Grasso's contributions to the NYSE. His imperious style helped hold together the exchange's many, often-bickering, constituencies. Thanks to his spending on additional technology, the NYSE easily handled the high volume and volatility of the recent bull and bear markets, no small task.

"I think he was the best chairman in the history of the exchange," says Joseph Grano, head of the brokerage unit of UBS AG. "He grew up at the NYSE, had passion for the place and putting aside all the noise about the compensation, the statistics about his time there speak for themselves, be it increased volume or prestige."

And the NYSE has bounced back from numerous crises before, including the stock-market crash of 1987. It has continually reinvented itself, and its centralized market remains a formidable competitive advantage because buyers and sellers can meet there much more easily and cheaply than in a smaller, less heavily used venue.

Mr. Grasso, 57 years old, declined repeated requests for comment through a representative, who said the former chairman is unlikely to speak publicly until questions about his compensation are resolved.

Evils of Complacency

When Mr. Grasso took over as the Big Board's chairman and chief executive officer in 1995, he preached the evils of complacency. He warned his members not to underestimate the threat of new electronic competitors, such as those that now handle more than half of the stock trading on the Nasdaq Stock Market. He liked to remind his colleagues that Americans first bought Honda Civics as commuter cars so they could leave their fancier Oldsmobiles in their driveways. Soon, he noted, people were buying Hondas instead of Oldsmobiles, and the Japanese had U.S. car makers on the ropes.

Mr. Grasso worked tirelessly to persuade Nasdaq's biggest companies to defect. He flew to Denver in 1999 to offer Qwest Communications International Inc.'s then-CEO Joseph Nacchio one of the exchange's prized single-letter symbols, "Q," if he left Nasdaq. The pitch worked, and the NYSE built a huge marketing campaign around Qwest's shift, culminating with Mr. Nacchio's ringing the opening bell on the first trading day of the millennium. During Mr. Grasso's tenure as chairman, the NYSE listed over 1,300 new companies.

He was similarly obsessed with trading volume. When shares of AT&T Corp. or Johnson & Johnson traded on another exchange, Mr. Grasso took note. Sometimes he would call the trading desk at the Wall Street firm that handled the order to demand why. For years, Mr. Grasso pressed Mr. Grano, then president of PaineWebber (now part of UBS AG), to stop doing business on regional stock markets, such as the Cincinnati Stock Exchange. In 1998, Mr. Grano shut down his firm's regional exchange operations, though he says it wasn't to please Mr. Grasso, whom he calls a friend.

Early this year, Mr. Grasso was invited to meet with UBS AG executives after he was told they were considering filling customer stock orders internally -- matching buyers and sellers with the firm's own inventory of stock -- instead of sending them to the NYSE floor. He argued that the NYSE offered customers the best prices and ease of trading, according to Mr. Grano, now head of UBS's brokerage unit. Mr. Grasso tempered his comments by adding that UBS should execute its orders wherever it could get the best price.

Despite Mr. Grasso's arguments, UBS went on to test a program in which its traders matched customer orders on 100 stocks internally if they were able to beat the NYSE's quoted price by at least a penny per share. The upshot: UBS was able to improve the prices on 30% of the stocks tested, says Mr. Grano. While UBS plans to expand the program, Mr. Grano says that he remains a staunch defender of the NYSE's trading system.

Mr. Grasso sometimes played hardball to keep business at the NYSE. In 2001, trading technicians at Citigroup Inc.'s brokerage unit, Salomon Smith Barney, developed a software program to screen its customers' incoming orders. When it could fill them internally at a better price than was quoted by NYSE specialists, it did so. That let Citigroup save time and money by avoiding sending the orders to the NYSE trading floor.

Soon, the program was filling 2% to 3% of the firm's orders on NYSE listed stocks -- a situation that did not sit well with Mr. Grasso. In conversations during the fall of 2002 with Robert Moore and Robert DiFazio, senior equity-division executives at Citigroup, Mr. Grasso warned that investors might take a dim view of the matching system if the details of how it worked were publicized, according to people with knowledge of the conversations. Citigroup, already burned by allegations its analysts had issued misleading research, was sensitive to any suggestion it was taking advantage of its customers and decided to shut down the system that October to review its performance more closely. Mr. DiFazio, who has since left the firm, did not return calls for comment. Through a spokesperson, Mr. Moore declined to comment.

Less than two weeks after Mr. Grasso's departure in September, Citigroup resumed its internal order-matching program.

These kinds of moves are beginning to chip away at the NYSE's market share. Between 1976 and 2002, the percentage of NYSE-listed stocks trading at the Big Board typically fluctuated between 81% and 89%. But in the first 11 months of this year, it slipped to 80%. In October and November, following Mr. Grasso's ouster, it was 79%.

Many Wall Streeters believed that the Big Board needed to modernize -- and even embrace automation. But Mr. Grasso and the specialists argued that their system of human judgment was superior because it helped investors get the best prices, damped volatility in the market and brought together buyers and sellers who might otherwise not find each other.

Even as he propped up the roles of his human traders behind the scenes, Mr. Grasso took pains to trumpet how much technology was installed at the Big Board. He liked to boast that the NYSE had spent $2 billion on technology over the last decade. Flat screens displayed buy and sell orders on an array of stocks. One instrument showed a three-dimensional simulation of the activity on the exchange. The new technology sped orders to the floor. But once they arrived there, orders were executed the old-fashioned way: A specialist oversaw an auction in which floor brokers could step in and participate.

The NYSE claims much of the public prefers it this way. It did put in place an automated system three years ago that permitted small investors to bypass specialists. But a Big Board spokesman said few investors actually use it.

Still, in recent years, as specialists' trading and profits rose sharply, so did complaints that they were hurting rather than helping investors. Officials at Goldman in 1999 began trying to persuade Big Board officials to permit buy and sell orders for the most heavily traded stocks to pair up automatically on the NYSE, without the interference of specialists and floor brokers.

That year, Goldman CEO Henry Paulson Jr. visited Mr. Grasso to press his firm's point. Mr. Grasso's response was to take Mr. Paulson, who didn't have a background in stock trading, on a tour of the floor, trying to impress him with its electronic enhancements. Later, Mr. Paulson says he told Robert Steel, Goldman's co-head of equities, "I think they are further advanced than we give them credit for."

But Mr. Paulson's staffers were quick to point out that the technology didn't resolve their fundamental complaint that floor traders could still interfere with their orders. "Dick still wants the specialists to be in the middle," Mr. Steel recalls telling Mr. Paulson.

Mr. Paulson teamed up in the fall of 1999 with a group of Wall Street CEOs to pressure Mr. Grasso to automate trading in the exchange's busiest stocks. Mr. Grasso refused to meet with them, according to people involved.

Around the same time, Mr. Grasso appointed a committee of the NYSE board to study the exchange's system of trading. Five months later, the committee concluded that the NYSE was fine as it was. Undeterred, Goldman trading executives returned to the NYSE last April with a scaled-down proposal: All orders that can be executed at or better than the best quoted prices should be traded automatically, without the involvement of specialists. Catherine Kinney, one of the NYSE's two presidents, rebuffed the proposal after consulting with Mr. Grasso, according to people involved. She declined repeated requests for comment.

Mixed Message

When it came to regulation, Mr. Grasso's approach was similar. Publicly, he portrayed himself as a fierce regulator. But behind the scenes, he did not give his regulators the money they said they needed to cope with a growing workload. "Our self-regulatory unit is key to the high quality of our business brand," he told the Senate banking committee in 1999. The money spent on regulating member firms, Mr. Grasso told the committee, is "an investment in our brand and [is] building equity in the public's confidence in our markets."

On the trading floor, Mr. Grasso reacted harshly to wrongdoing. In late 2002, he admonished specialist firms because his regulators had uncovered evidence that some specialists were improperly "trading ahead," or stepping in to trade a stock for their firm's account when a customer was willing to trade at the same price, or better. The improper trading subsided after his warning, according to a confidential SEC staff report. (Some specialists say the $155 million the SEC alleges customers lost because of their trading ahead is overstated.)

After the NYSE installed a trading system in late 2000 designed to automatically fill small orders, specialists devised a way to "pause" the system to more easily handle a barrage of incoming orders. But such pauses could deny small investors the immediate execution they expected. When Mr. Grasso saw Todd Abrahall, the Susquehanna Investment Group specialist who trades Lexmark and Calpine, pause the system one day in late 2001, he sharply rebuked him and said he'd talk to his boss if Mr. Abrahall tried to do it again, according to two people who were briefed on the incident. (Mr. Abrahall referred calls to a spokesperson, who had no comment.)

But Mr. Grasso's tough talk wasn't always backed up. The SEC, in a 1999 civil administrative proceeding, accused the NYSE of failing to catch illegal trading by independent floor brokers over a five-year period.

In October, the SEC's compliance staff excoriated the NYSE's enforcement arm in its confidential report for neglecting to detect the extent of, and adequately punish, the "trading ahead" episodes Mr. Grasso had warned his specialists about late last year.

In fact, the Big Board often fixed its systems long after misdeeds were uncovered. For example, it took until May for the NYSE to develop software to prevent specialists from disabling the automated trading system, as Mr. Abrahall did in 2001. The exchange, however, has taken some disciplinary actions against specialists who paused the system.

The NYSE has spent $142 million on regulation this year. Exchange officials say the budget has increased an average of about 10% for each of the last five years. In both 1999 and this year, the NYSE complied with the SEC's demand that it put more staff into surveillance and improve its electronic systems to deter wrongdoing on its floor. But former regulatory officials at times complained that they didn't have the resources to keep up with their growing workload. These officials were frustrated that Mr. Grasso's lieutenants turned down their requests for additional funding while the marketing and communications departments' budgets surged.

Days after Mr. Grasso's ouster, Ms. Kinney got an earful in a meeting with the firm's regulatory staff. Executive Vice President Sal Pallante groused that his division, charged with regulating the NYSE's member firms, had been denied resources while Mr. Grasso had received millions of dollars in pay, according to a person who heard the exchange.

The exchange's arbitration department -- where many investors' trading complaints are resolved -- was particularly starved, according to Robert Clemente, the exchange's former arbitration chief. The number of arbitration cases filed with the NYSE more than doubled to 1,315 between 2000 and 2002, according to the NYSE. But Mr. Clemente says his budget, which included allocations for items ranging from renting conference rooms to compensation, remained roughly flat, at about $3 million.

An NYSE spokesman disputed Mr. Clemente's account, saying that the arbitration department's total budget roughly doubled in the last four years. He declined to give specific figures. He also noted that marketing budgets have gone up in recent years in part because of one-time expenses including a corporate rebranding campaign.

Mr. Clemente says his pleas for more lawyers were met with the occasional addition of a clerk. A stained Victorian-style couch sits in the main lobby of the arbitration department and was the butt of jokes by lawyers who visited. Mr. Clemente says the NYSE marketing area looks like the Rainbow Room -- the fancy restaurant atop Rockefeller Center -- compared with his department, which he says looked more like a "hot-dog stand."

"Each year I went and asked for more resources and more money and each year they said no," Mr. Clemente says. "There were always more pressing issues. I guess we know now that Grasso's compensation was one of those." Mr. Clemente says the exchange let him go in October after it brought in a senior executive to perform many of his duties.

Upholding the Image

Mr. Grasso was obsessed with upholding the image of the stock exchange, and at times it seemed that he viewed the NYSE as an extension of himself. He got especially angry when he felt he or the exchange was being publicly embarrassed. When Mr. LaBranche gave an interview from the Nasdaq market site last year, Mr. Grasso angrily summoned him to his office. Replaying the interview on a television screen, Mr. Grasso broke his pencil jabbing it on a pad as he recorded the number of times the "Nasdaq" logo appeared, according to people in the room.

In the chaotic days following the Sept. 11 terrorist attacks, Robert Fagenson, a specialist and former NYSE director, told a newswire that the exchange was able to reopen. But Mr. Grasso and government officials were still discussing timing. The next day, Mr. Grasso told Mr. Fagenson he had embarrassed the Big Board, and Mr. Fagenson apologized. Still Mr. Grasso barely spoke to him for 20 months. "It was an extremely difficult time," Mr. Fagenson recalls. Eventually, Mr. Grasso forgave Mr. Fagenson and invited him to rejoin the board.

As time went on, Mr. Grasso increasingly polished his own image. He shaved his balding head and got laser surgery so that he could quit wearing glasses. He was driven to the NYSE's lower Manhattan headquarters in a large SUV with tinted windows, and was accompanied by bodyguards.

Many exchange members were infuriated with Mr. Grasso when he installed a plaque outside an exchange visitors' entrance on the first anniversary of the 2001 terrorist attacks. Titled "Let freedom ring," the plaque was dedicated to victims and the police officers and fire fighters who "helped save more than 26,000 lives that day." The plaque was signed, "Dick Grasso, chairman and CEO."

The plaque symbolized "a misguided generalization that Dick was the only one that personified the exchange," says James Rutledge, an NYSE member. Many floor members, quite a few of whom had donated money to victims' families, thought the plaque should have been hung in the name of all of them.

Fears of the '87 Crash

Floor members also resented the heavy hand Mr. Grasso had on their daily lives, but often it was to make the exchange more secure. He insisted that specialist firms beef up their financial strength by consolidating. The idea was that with increased capital, it would be easier for specialists to keep buying stocks even if share prices plummeted in a falling market. What Mr. Grasso feared most, recalls Michael Manza, a former specialist at the firm M.J. Meehan, was a crash like the one in 1987, which wiped out much of the specialists' capital and forced one firm to sell itself to Merrill Lynch. While Mr. Grasso was chairman, the number of NYSE specialist firms shrank to seven from 36.

By 1997, Mr. Grasso was pushing Terence Meehan, the chief executive of M.J. Meehan, to sell his relatively small firm, Mr. Manza says. "Dick didn't make any bones about the fact that when new listings came up, if they were really good companies, these smaller-capitalized firms were not going to be in the running" to handle trades of the companies' shares, says Mr. Manza. Faced with pressure from Mr. Grasso and a variety of other business problems, Mr. Meehan sold his firm to FleetBoston Financial Corp. in July 2000.

Mr. Grasso also pushed his favored candidates for board posts, which are divided between representatives of the securities industry and representatives of the public. This alienated some powerful Wall Street players on the board. In early 2003, Mr. Grasso campaigned for the nomination of Citigroup Chairman and then-CEO Sanford Weill as a representative of the public on the board. "Dick's position was: 'We need to have somebody from Citigroup, because they bring a lot of order flow,' " recalls former NYSE director H. Carl McCall.

But several members of the NYSE nominating committee questioned the Weill recommendation, because Mr. Weill's firm had just agreed to pay $400 million to settle a case in which regulators accused the firm of misleading investors through stock research. Instead, the committee members proposed nominating Kraft Foods Inc. then co-CEO Betsy Holden or American Express Co. Chairman Kenneth Chenault, among others, a person in the room recalls. But Mr. Grasso held firm. Mr. Weill had been a big supporter of the exchange and a big player on Wall Street, he argued.

Goldman's Mr. Paulson says he urged Mr. Grasso not to proceed with the nomination. Still, in an early-February meeting, Mr. Weill's name was presented to the full board. Some NYSE directors, including Autodesk Inc. Chief Executive Carol Bartz, balked. At a Feb. 25 meeting of the board's nominating committee, Mr. Grasso said that there was "still work to do" on approving Mr. Weill, according to a person who attended.

In mid-March, the exchange nominated Mr. Weill. It created an uproar: New York Attorney General Eliot Spitzer, who had launched the regulatory investigation into misleading stock research, called Mr. Grasso. Mr. Spitzer says Mr. Grasso told him he couldn't stop the Weill nomination because it was the nominating committee's decision. Mr. Spitzer threatened to publicly denounce the move, and Mr. Weill withdrew his name from consideration.

The bungled Weill move was in some ways the beginning of the end of the Grasso era. Mr. Paulson was not pleased that Mr. Grasso had pushed the Weill nomination and was increasingly worried about other simmering problems. As a member of the Big Board's compensation committee, the Goldman chief had approved Mr. Grasso's pay. But Mr. Paulson says that he didn't learn about Mr. Grasso's large retirement-pay package until he was briefed about it in March by Frank Ashen, then the NYSE's chief of human resources. It turned out that some other board members, including LaBranche & Co.'s Mr. Murphy, also didn't fully grasp the value of the package.

In May, The Wall Street Journal for the first time publicly disclosed details of Mr. Grasso's compensation. That news, together with the Weill nomination and the continuing investigation into whether Big Board specialists had undercut their customers, and the Weill nomination set in motion a massive controversy. Inside and outside the exchange it sparked widespread criticism of Mr. Grasso's leadership and judgment. At first many NYSE board members thought it would all blow over, but eventually they realized that they had to take action to stem the uproar over Mr. Grasso's compensation.

The Big Board community split between those who thought Mr. Grasso had lost touch with ordinary members and others who insisted that he was crucial to the prosperity of the exchange and that if he was overpaid, it was the board's fault, not his. Some board members, such as Home Depot co-founder Ken Langone, argued that Mr. Grasso was worth every penny of his pay.

The tension mounted further, as Mr. Grasso pushed for permission to withdraw $139.5 million in accumulated retirement pay and other benefits. Mr. Paulson, among a few others on the NYSE board, opposed paying out the money prior to 2007, when Mr. Grasso was expected to retire.

Before Mr. Paulson left for a vacation in Brazil, he says, Mr. Grasso told him on two occasions that pay wouldn't be on the agenda for the August board meeting. He says Mr. McCall also told him this, based on similar conversations with Mr. Grasso.

But it was. After Mr. Paulson returned from his vacation, he learned from a fellow director that the board had voted to let Mr. Grasso cash out a retirement nest egg of $139.5 million. Mr. Paulson asked how it had come up. "Dick wanted it back on the agenda," Mr. Paulson recalls Mr. McCall saying. Mr. McCall confirms this account.

When the exchange later disclosed that Mr. Grasso was due an additional $48 million in retirement pay, Mr. Paulson became fed up and concerned about the damage the pay flap was causing the NYSE's reputation. He began lobbying his fellow directors to remove Mr. Grasso.

Many floor brokers and specialists were furious about the disclosures of Mr. Grasso's pay because in 2002 he had imposed new fees to pay for technology upgrades and regulation. At the time, Mr. Grasso told irate floor members that the Big Board was barely breaking even and had to generate more fees to compete with electronic-trading systems. That year, the NYSE earned $28 million, barely a quarter of its 1998 profit, while Mr. Grasso earned $12 million, double his 1998 compensation.

As the controversy escalated Mr. LaBranche was visited by Mr. Murphy, who stressed the importance of keeping Mr. Grasso at the exchange. He asked Mr. LaBranche whether he'd thought about what life at the exchange was going to be like after Mr. Grasso was gone, and suggested that the exchange's structure would be at risk without him.

Mr. LaBranche says he replied: "We're going to have to take our chances with that." A little more than a week later, on Sept. 17, Mr. LaBranche publicly called for Mr. Grasso's resignation, joining a chorus of other voices.

At an emergency board meeting that afternoon, a deeply divided board voted to oust Mr. Grasso as chairman of the exchange.