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January 1, 2005

Pulling the Plug On the SROs: Dramatic Changes May Be on the Horizon

By Gregory Bresiger

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  • Pulling the Plug On the SROs: Dramatic Changes May Be on the Horizon

Self-regulatory organizations, or SROs, may never be the same.

These organizations, described by Securities and Exchange Commission officials as the "front line" of regulation, traditionally have been run as mutually-owned, non-profit groups. Their boards usually have not been required to have a majority of outside, or independent, directors. Self-regulatory organizations have often combined regulatory with business functions. They have sometimes had a few big members who potentially had the ability to control how the SROs would be run.

In other words, some front line regulators have had a considerable potential for conflicts of interest. Case in point: The sensational Nasdaq dealer price-collusion scandal, which surfaced in the late 1990s under the watch of the NASD, regulator and parent of Nasdaq. As part of a settlement, the SEC ordered the separation of Nasdaq from the NASD. (The NASD is today still Nasdaq's nominal parent.)

"Pressures that inhibit effective regulation and discourage vigorous enforcement against members can arise for a variety of reasons, including member domination of SRO funding, member control of SRO governance, and member influence over regulatory and enforcement staff," according to the SEC.

But much of that may change in the next year or two. That's because the SEC, in a 480-page proposed rule document re-examining SROs, wants to make extensive changes in how these groups function, including requiring that these organizations have more independent leadership.

"The Commission believes that requiring SRO boards to have a majority of independent directors...should help address the conflicts of interest that otherwise might arise when persons with a nexus to the SRO are involved in key decisions," according to the SEC in Proposed Rules Release No. 34-50699.

So at the same time the debate over Reg NMS is raging, another debate - of equal importance - is also at hand for officials of self-regulatory organizations such as the New York Stock Exchange,

the U.S. regionals and options exchanges. This comes as many SROs have gone though, or are considering, the demutualization process.

The specter of SEC action has been in the air since the ouster of NYSE Chairman and CEO Dick Grasso and the damage from other Street scandals. In fairness, the NYSE moved fast. It hired a new Chief Regulatory Officer, Richard Ketchum, added some 70 more investigators and came down hard - with massive penalties - on recent violators. For instance, it levied a fine last fall of $19 million on Morgan Stanley for numerous abuses.

Cost Savings

However, some say that a set of proposed reforms, now under review by the SEC, would be the greatest set of changes in the administration and governance of self-regulatory organizations since the 1970s. One idea raised was the combination of the regulatory units of the NYSE and NASD, which could result in huge cost savings.

The proposed reforms, which are now out for comment, cover everything from how SROs regulate and required disclosures to who will serve as the leaders of these organizations. They also cover listing procedures.

"The proposals would impose new governance standards on national securities exchanges and registered securities associations by requiring a majority of the members of an exchange's or association's board of directors be independent," according to the SEC.