The American Stock Exchange: Scandal on Wall Street In the April issue of the New York Stock Exchange monthly newsletter, Chairman Richard A. Grasso made a rare and embarrassing admission. The Securities & Exchange Commission had commenced an investigation at the NYSE. And the target was not a rogue broker, insider trader, or some other transgressor, but rather the NYSE itself. Under scrutiny is a subject that could not have been more fundamental to the operations of the nation's premier stock exchange: Has the NYSE adequately regulated the brokers who execute trades on the exchange floor? With word of the SEC probe, the scandal scorecard for U.S. stock markets became a decisive, and apparently definitive, score of 2-1: two stock markets tarred by scandals at the millennium's close, and one untouched for the greater part of two decades. The NYSE, which pledged cooperation with the SEC, has had to cope with the aftermath of a federal court indictment last year alleging improper trading by floor brokers. Its archrival, NASDAQ, has been bruised by incessant micro-cap scandals and by accusations, in lawsuits and in an SEC report, that NASDAQ market makers were conspiring to fix prices. The exception, the apparent island of relative tranquility, was that venerable Wall Street institution, the American Stock Exchange. NO PROBES. To be sure, the Amex has had its troubles--notably a longtime weakness in luring and holding top-notch equity listings. Five years ago, it wrestled with concerns about the quality of some of the smaller companies listing on the exchange. And the Amex is in transition. In a few weeks, the exchange will be losing its chief executive officer, respected economist Richard F. Syron, and it has entered a potentially rocky partnership with NASDAQ. But the Amex brings to the merger a fast-growing options business and something the NASDAQ is striving to attain--a reputation for integrity that is second to none. Amex officials note with pride that its floor membership has not been subject to a single criminal indictment or major SEC investigation since the late 1970s. As Syron takes his leave, the Amex's public image has never been better. ''Before he leaves June 1,'' Barron's observes in its Apr. 12 issue, ''Dick Syron could be forgiven if he took a victory lap around the old Curb floor.'' But on the ''old Curb floor,'' not everyone feels much like cheering. For there is another Amex that has remained in the background--and is considerably darker than the one in the public eye. This Amex was the subject of a six-month investigation by BUSINESS WEEK. And what emerged was, in its own way, more troublesome than the difficulties encountered by its two competitors. Unlike the scandals that rocked NASDAQ and the NYSE in recent years, the troubles that have beset the Amex have had absolutely no publicity. But they have not been secret by a long shot. For the difficulties besetting the Amex have taken place under the noses of the Amex officials charged with enforcing the rules of conduct on the Amex floor. BUSINESS WEEK interviewed traders, floor brokers, specialists, and clerks, as well as current and former Amex officials and current and former federal and local regulators. We also reviewed thousands of pages of documents, most not publicly available. What emerged was a multifaceted, often complex story with but one common theme: The American Stock Exchange has failed to adequately police itself. It is a failing that seems most vividly apparent when its most powerful and influential firms and personalities are involved. The key findings: -- Amex options specialists and traders are said to regularly engage in price-fixing. The aim is to keep as wide as possible the ''spread'' between the bid--what the public can get to sell an option--and the ask, which is what the public must pay to buy an option. Because the prices are allegedly skewed to favor the denizens of the Amex floor, the public is hurt each year, BUSINESS WEEK estimates, to the tune of $150 million. The Amex denies knowledge of improper options pricing (page 99). -- Amex sources maintain that a host of other trading improprieties are commonplace. Chief among these are what they describe as illegal trading by floor brokers and specialists, similar to the accusations in the indictments of the NYSE floor brokers. But Amex officials say that there is no broad SEC inquiry--of the kind just announced at the NYSE--into how the Amex regulates its floor personnel. -- With the SEC's tacit concurrence, the Amex routinely doles out light punishment when it uncovers wrongdoing on the floor. In contrast to its merger partners at NASDAQ, who work closely with the SEC and federal and state prosecutors, the Amex deals with most allegations of even serious wrongdoing ''in the family'' (page 108). -- The American Stock Exchange's scandal-free reputation is a mirage. Since 1995, the Amex floor has been rocked by a major floor-trading scandal involving alleged improper trading by Pasquale Schettino, a top official of its most powerful specialist firm, Spear, Leads & Kellogg. The Amex apparently did not follow up on testimony indicating knowledge and approval of Schettino's activities by top Spear officials--including its former senior partner, Peter R. Kellogg. Spear and Kellogg, who were not charged by the Amex, declined to comment, as did Schettino's lawyer (page 102). -- Allegations have been made regarding another influential force on the Amex floor, specialist Joseph Giamanco, who heads the specialist firm GHM Inc. Persons familiar with Giamanco's operations maintain that he has, for years, traded for his personal profit in stocks of companies in which his firm specializes. If so, that would be a serious violation of exchange rules and would fall afoul of the federal securities laws if nonpublic information was exploited. Giamanco's attorney denies that the veteran specialist has committed wrongdoing (page 104). -- Specialists are permitted by the Amex to obtain cut-rate ''cheap'' stock in publicly traded, chiefly micro-cap companies. This practice--which is legal and sanctioned by the exchange--raises the danger that companies may give influential Amex specialists cheap stock to get their support for listing company stock on the Amex. -- The Amex, the SEC, and law enforcement have failed to adequately investigate numerous allegations of improprieties at the Amex that were made in recent years by an options trader turned whistle-blower, Edward R. Manfredonia (page 110). The Amex maintains that Manfredonia's allegations were investigated and dismissed as without merit, and the SEC says his letters were forwarded to the appropriate officials. But officials privately concede that little weight was given to his allegations--important aspects of which were substantiated by BUSINESS WEEK's investigation. PROBLEMS FIXED. To be sure, none of the Amex's hidden troubles necessarily overshadow the many positive developments at the Amex in recent years, particularly since the appointment of Syron, its chairman since 1994, who previously was CEO of the Federal Reserve Bank of Boston. There's no denying that the Amex has made headway against its nagging problems--lagging listings and weak equity trading volume. In recent weeks, the Amex lost its largest stock listing--Viacom, which accounted for some 4% of all volume on the floor of the exchange. But for every such problem in recent years, there has been a solution in the form of a new product--such as its series of well-received index-linked equities based on the Standard & Poor's 500-stock index. The S&P index products are issued under an agreement with The McGraw-Hill Companies, which publishes BUSINESS WEEK and owns S&P. In an interview with BUSINESS WEEK, Syron vigorously defended the Amex's record as a regulator. He expressed surprise and concern about the allegations concerning the options market--but also dismissed them as routine grousing. ''I think over the last several years...there's always room for improvement, but [we have done] a pretty good job here in the regulatory climate at the Amex,'' asserts Syron. Another high Amex official, speaking privately to BUSINESS WEEK, also expressed surprise at the allegations and the hope that floor personnel would bring any allegations of improprieties to his attention. But on the floor of the exchange, such sentiments would be viewed with disdain. Indeed, the brokerage officials and Amex floor personnel, current and former, of all levels of seniority, who were interviewed by BUSINESS WEEK did so on condition of confidentiality--in the belief that their livelihoods would be ruined if they were known to be talking to the press. For the National Association of Securities Dealers, which now runs both NASDAQ and the Amex, the implications of the Amex's hidden troubles are serious. The Amex will continue to regulate itself despite the merger, albeit under the NASD's general aegis, because the merger leaves intact the Amex's enforcement and surveillance apparatus. But what becomes of a corporate culture that, people on the floor maintain, turns a blind eye to improper conduct? BY GARY WEISS To read a letter to the editor about this story, click here. http://www.businessweek.com/1999/99_17/b3626001.htm
Price-Fixing, the Amex Way Two-tier pricing can guarantee a tidy profit Options have never been more crucial for the American Stock Exchange. In the first quarter of 1999, the Amex reported a 30% growth in options volume over the year before--vs. a mere 5% gain in stock-trading volume. But beneath the cheery statistics is one of the dirty little secrets of the Amex floor: two-tiered options pricing that, as described by people familiar with the practice, amounts to a form of price-fixing. Early this year, the U.S. Justice Dept. initiated an antitrust investigation into how options are traded at all four major options exchanges, and nine class actions alleging anticompetitive practices were filed against the exchanges in federal court in Manhattan. The Chicago Board of Options declined comment, and the Pacific Exchange pledged cooperation with the probe. The investigation was sparked by the exchanges' reluctance to list options already listed by other exchanges. Critics have long maintained that this practice keeps customers from getting the best possible prices. That may be so. But current and former Amex floor personnel point to another, more direct reason. BIG MONEY. According to these sources, investors often pay too much when they buy an option and get too little when they sell. It means they put in ''limit orders''--orders specifying prices--based on incorrect information. If just one-tenth of options trades, now about 120 million a year, are skewed against the public by merely an eighth of a point, investors are hurt to the tune of $150 million a year. Here's how Amex options price-fixing is said to work: The specialist establishes the option's publicly quoted price. Specialists are traders who buy and sell options but with special responsibilities--and power. And that includes the power to establish the prices that appear on trading screens worldwide. Prices of both stocks and options are expressed by two numbers--a ''bid'' and an ''ask.'' The bid price is the price a member of the public can get when selling an option. The ask price, which is higher, is the price an investor will have to pay when buying the option. The difference between the bid and ask is the ''spread.'' At the same time the specialist establishes the official bid-ask prices of the option--the prices disseminated on trading screens--the options market makers establish their own price, often with narrower spreads. In the example described on this page, based on the recent pricing of a widely traded option, the trader was able to offer a spread of 4%--versus the 8% spread set by the specialist. Market-maker firms frequently can meet their expenses, and turn a handsome profit, while offering more modest spreads to traders on the floor. By offering better prices, they can draw business from professional investors who use floor brokers to negotiate better prices. Ordinary investors pay the prices set by the specialists--and not the better prices available from the market makers. That's because they don't know that better prices--narrower spreads--are available. The trading screens show the wider bid-ask spreads set by the specialists. Floor traders can insist that specialists display their better prices on the trading screens. But they don't. One reason is fear. As one trader points out, ''it is well known that specialists don't like it''--and can retaliate by excluding traders from getting a share of large trades that come in to the floor. But fear is not the only reason traders don't insist. Traders and specialists alike benefit from wide spreads. ''Market orders''--at the prevailing bid-ask price--are usually executed at the prevailing bid-ask spread set by the specialists. And investors base their limit orders on the same artificially wide bid-ask spreads. One trader notes that the growth of automatic execution of trades means that more and more trading is at prices set by the specialists. There are exceptions to the dual-pricing scheme. The vast majority of Amex options are very thinly traded. For such options, the bid-ask spreads quoted by everybody--specialists and traders alike--are wide. But the practice is described by floor sources as an everyday occurrence for more widely traded options. ''All the public sees is that their trade is executed instantly. They have no idea what's going on,'' says one trader. How widespread is this practice? Well, the class actions, filed in early February in the wake of the antitrust probe, allege that improperly wide spreads and price-fixing occur on all four options exchanges because of their supposed ''conspiracy'' against multiple listings. Each of the suits contends that market makers and specialists ''agreed not to compete by seeking to offer narrower spreads.'' But at the largest options exchange, the CBOE, the form of price-fixing allegedly occurring at the Amex seems less likely. At the CBOE, market makers shout at each other to compete for business, in this fashion exchanging bid-ask quotes that are written down by exchange employees and then shown on trading screens. By contrast, at the Amex, prices are set by the specialists, and floor price ''reporters'' do not play the active role of their counterparts at the CBOE. Resolving this problem would require a change in the way prices are reported--which SEC Chairman Arthur Levitt Jr. proposed in a letter to the options exchanges on Feb. 10. He observed: ''It is now feasible for each competing market maker to publish its own quote''--an innovation that would do away with any two-tiered pricing at the exchanges, the Amex included. With that proposal, Levitt appeared to acknowledge at least the potential for discriminatory pricing at the exchanges. Amex Chairman Richard F. Syron expressed surprise and chagrin when told of the alleged two-tier pricing. Syron says even the most informal price-fixing arrangements are simply not acceptable at the exchange. ''That would be wrong. That should not happen....There can't be tacit agreements.'' Syron, however, does not believe the allegations. ''It is not at all infrequent to have one group [the traders] complaining about the other group [the specialists],'' he says. Syron believes that such allegations underscore--rather than undermine--the importance of the system of self-regulatory organizations. ''The reason you have SROs is, these things are so complex that the only people who really understand all of the details of this in toto are the people who are there, engaged in it, on a moment-to-moment basis,'' says Syron. The complexity and speed of the options market, he notes, point up ''the degree of responsibility and the importance of SROs doing a good job.'' That's precisely the point. But just how well does the Amex regulate itself? If the allegations concerning options pricing have any validity, they indicate a deep malaise--one that permeates the Amex. http://www.businessweek.com/1999/99_17/b3626001.htm
This is why I refer to them as the AMEX crime family. Somebody name an exchange (foreign or domestic), that has had more regulatory problems than the AMEX. The new Chairman, Neal Wolkoff, should do more to address these issues.