Just when you thought it was safe to declare confidence in the US markets, the Richard Grasso scandal broke at the New York Stock Exchange. Grasso, both chairman and chief executive of the exchange, was forced to resign after it emerged that his contract had earned him a payday of close to $200 mn. Several directors of the exchange followed Grasso to the exit, and a roots-to-branch shake-up of the constitution of the exchange and its regulatory powers is sure to follow.
The NYSE isn’t a listed company like Enron or WorldCom, nor has it collapsed in a welter of charges of false accounting, failed audits and fraud. Nevertheless, the events at the exchange have profound implications for US companies and the way that they are governed.
The first striking aspect of Grassogate was that it revealed just how woeful governance standards at the exchange actually were. Despite Enron and the succession of other scandals, the NYSE had apparently learned nothing. Grasso’s pay deal was only a symptom of the real problem: a board of directors that was both out of touch and riddled with conflicts of interest.
In a scathing analysis of the exchange’s governance written in July 2003, the Council of Institutional Investors, a powerful lobby representing $2 tn in investment assets, pointed out that not only was the exchange’s board an unwieldy 27 directors-strong, there were also no fewer than 24 cross-directorships and other relationships. ‘The board was a self-perpetuating loop that had Grasso picking his own directors,’ says Nell Minow, editor of the Corporate Library, an online governance research company.
Many of the directors were already in major jobs – the board included the chief executives of Goldman Sachs, Merrill Lynch, and Morgan Stanley – and perhaps paid insufficient attention to overseeing the exchange. Linda Crompton, chief executive of the Investor Responsibility Research Center, which advises investors on voting issues, says, ‘Not only do you have an absolutely outrageous pay packet, but you also have a board that approved it in the first place and that didn’t think about the implications of making it public.’
It also transpired that Grasso’s remuneration was set by a pay committee chaired by Kenneth Langone, chief executive of Home Depot, the home improvements chain. Grasso in turn used to serve on the board of Home Depot and chaired its compensation committee.
‘There was an unstated assumption that the NYSE would be a leader rather than a laggard – but that was an untested assumption,’ remarks Stephen Davis, president of Davis Global Advisors, an international corporate governance consulting firm. ‘The exchange was mired in secrecy and tethered to some antiquated practices.’
Emerging problems
The Sarbanes-Oxley Act and the NYSE’s own review of its listing standards represented the most extensive regulation of US business since the Great Depression of the 1930s. But the upheavals at the exchange have demonstrated that more needs to be done. ‘It is just deeply shocking that after all the scandals we’ve seen, we still have these kinds of problems emerging,’ Crompton says. ‘You won’t see investor confidence returning until some action is taken.’
‘Every time we think we’ve turned the corner, there’s another scandal,’ adds Ann Yerger, director of the research service at CII. ‘These things are still shaking out.’
At any other company, governance shortcomings might be seen as just another example of unreconstructed boardroom behavior. But the NYSE is not just any other company; it is an entity that, through its listing rules, has a decisive say in how large US companies are held to account.
Reforming the NYSE promises a major shake-up not just for the exchange itself but for all companies listed on the world’s largest stock exchange. No wonder that Sean Harrigan, president of the board of administration of Calpers, the largest public pension fund in the US, says, ‘Make no mistake, what is at risk here is the credibility of our entire capital system.’
This may sound like politician’s hyperbole, but Harrigan is right to stress that reforming the NYSE could potentially usher in a new era of investor power in US markets.
Short-changed
To date the exchange has placed the interests of listed companies and their advisors above those of investors. This favoritism was reflected in the NYSE’s governance structure: of the 27 directors, the vast majority were representatives of listed companies, broker-dealers or investment banks. There was just one director representing investor interests. As Minow puts it, ‘The NYSE acts like a wholly-owned subsidiary of Wall Street.’
The NYSE was responsible for regulating listed companies, yet those same companies had a say in how the exchange was managed and even played a role in setting Grasso’s pay. In other words, the regulated set the pay of the regulator! Minow calls it ‘the fox-guarding-the-henhouse model of regulation.’
‘The exchange had taken positions contrary to investor interests, and now we can see why that is,’ adds Davis. ‘There can be no better example of how bad architecture leads to bad governance – which leads to investors getting short-changed.’
Take the example of share-based pay schemes. In the late 1990s the NYSE altered its listing rules so that companies could implement certain kinds of incentive schemes without first seeking shareholder approval. These schemes represented a transfer of assets without the original owner’s permission – or, as UK fund manager Hermes called it, theft.
For years investors pleaded with the NYSE to close this loophole. ‘It just stalled and stalled,’ says Davis. And, Crompton adds, ‘The exchange gave the impression of trying to find a way around a problem without trying to solve it and without offending its key constituency.’ The exchange was only shamed into acting after the Enron and WorldCom scandals. ‘We’ve long had frustrations with its treatment of investor concerns – shareholder approval of equity plans is one aspect of that,’ notes Yerger.
Another issue concerns the right of brokers to vote their clients’ shares of stock on most agenda items, even if no voting instructions have been received from clients. Brokers invariably vote in the company’s favor, thus artificially boosting votes for management. Again, investors have long sought an end to this practice. But the exchange, beholden to its corporate constituency, has resisted. ‘If the architecture of the exchange is modernized so that it reflects investors’ views, broker votes will be history before too long,’ Davis says.
Fundamental reforms
Intense pressure is now being applied to reconstruct the exchange so that companies no longer have a critical voice in how they are regulated. It seems certain that the NYSE will either have to give up its regulatory powers or recast itself solely as an independent regulator with no profit-seeking element.
‘We would like to see the regulatory function split from the business side,’ says Yerger, while Crompton adds, ‘The exchange is going to have to do something about the conflict that it has. It’s untenable for the exchange to stay in its present form.’
‘The issue is not just Mr Grasso,’ declares Alan Hevesi, controller for the state of New York. ‘The issue is making fundamental reforms at the stock exchange to restore investor confidence. The issue is also to establish a model for the entire financial community of good corporate governance, accountability and disclosure.’
Harrigan similarly demands that the exchange set about ‘finding a permanent chairman with impeccable credentials who can meet the needs of the NYSE’s ultimate customer – the investors.’ He calls for a smaller, more accountable board, of which at least half should directly represent investors’ interests.
Whether the SEC takes an enhanced role in regulating companies or another self-regulatory organization like the National Association of Securities Dealers takes on the mantle remains to be seen. What does seem to be certain is that US companies will soon be overseen by a new, independent regulatory authority.
L’affaire Grasso has also left institutional investors chasing the scent of blood. A handful of public pension funds have successfully demanded both Grasso’s resignation and a reform of the exchange. As Davis says, ‘There’s no better evidence that investor collective action can lead to reform.’
The same critics who lambasted Grasso for his excessive pay and criticized the board for being asleep at the wheel will surely look for new targets. The governance of the exchange may well have been outrageous but it most certainly was not uniquely bad. Like Grasso, most US company leaders combine the roles of chairman and chief executive. Most continue to enjoy long-term contracts and lavish pay awards. ‘The architecture of the exchange reflects the governance problems at most US companies, namely excessive concentration of power with no counterbalancing watchdogs,’ says Davis.
Both boards and executives who display poor judgment on governance issues can expect to draw heat from their investors. ‘This became very personal for the directors – we haven’t seen that before,’ says Yerger. ‘This might be the first of many instances of investors holding individual directors accountable for compensation decisions.’
For now, Grasso faces a comfortable retirement with his tens of millions of dollars; for every other chief executive, the future looks a lot less certain.
