Open Letter to CalPERS Board regarding specialists | Subject: A Smoking Gun?

As correctly pointed out in many newspaper articles this morning, one of the biggest hurdles in tackling the specialist system at the NYSE is proving that specialists engage in willful manipulation, front-running, and self-dealing at the public’s expense. Intent is difficult to document, and the Exchange is a society with an impressive code of silence.

So, the question is, how much do specialists-individuals charged with the responsibility of maintaining an orderly and fair market in NYSE stocks-skim from investors? Are we talking about pennies? How much does it total in dollars? The SEC has suggested that over the last few years it is something like $155 million. Is that realistic?

One regulatory case against a specialist firm may illustrate the magnitude of the Exchange’s arrogance and indifference to those it is charged with serving.

In a ruling that came down on June 17, 1999, the NYSE Exchange Hearing Panel said of a transaction involving Spear, Leeds, & Kellogg Specialists LLC (the Firm):

{Firm} “violated Exchange Rule 401, in that through its specialist it failed to adhere to the principles of good business practice by failing to adequately disseminate timely market information.”

The firm, Spear, Leads & Kellogg, and the individual specialist, Robert Luckow, were fined a total of $350,000 and, without admitting to guilt, consented to the Panel’s findings.

This transaction in question is a fascinating case study in how the Exchange works for its own benefit and how much unreimbursed financial harm on the public has suffered at the hands of the NYSE specialists. Here’s what took place.

The shares of Safeway (NYSE: SA) were to be added to the Standard and Poors (S & P) 500 stock index at the close of business on November 12, 1998 (that information had been known for six days). As a result, indexed mutual funds, representing billions of investors’ dollars, were required to place Safeway shares into their funds (index funds exactly replicate an index like the S & P 500) at the close of business on November 12 so as to adjust their portfolios to the “newly” constructed index. This required mutual funds to place buy orders with the specialist at the close, no matter the price (“market on close” or MOC buy orders).

Because of the large number of captive buyers in the shares at the close, the activity in Safeway (which averaged nearly 4 million shares per day) was gigantic. The price during the day ranged from 48 ¼ to 50 and was pushing against the 12 month high of 50 ¾, despite the fact that the overall market was sharply lower that day. At 3:40 p.m., the specialist announced that there was a buy order imbalance of 4,272,000 shares (he had that many more shares to buy than he currently had for sale). At that point, exchange rules prohibit any additional buy side MOC orders.

For the next twenty minutes, the stock traded between 49 3/16 and 49 9/16, a range of only 3/8 of a dollar, on what the exchange characterized as “very active” trading (unfortunately, the Exchange Panel’s information is imprecise, failing to even name “Safeway” on their webpage, choosing instead to call it “Company XYZ”).

The specialist’s primary job in this instance was to provide timely market information so as to facilitate legitimate buyers and sellers in matching their orders (that is, pairing buyers and sellers at agreed upon prices) and “step aside” if necessary. As of 3:59 p.m., however, the specialist had indicated only a buy side imbalance without giving an indication of closing price. In fact, the market at 4:00:09 was quoted as 49 1/8 bid and 49 ½ offer. At the closing bell (4:00:00 sharp), some floor brokers reportedly heard the specialist indicate verbally that the indication was 52 bid and 54 offer, an estimation of where the specialist now expected to close Safeway’s shares. The problem with all of this is that sellers, wishing to take advantage of higher closing prices, must have their orders at the specialist’s booth by 4:00:00 p.m.

With no time to go back to clients and solicit sell orders for a stock suddenly indicated much higher in price, no institutions or individuals were able to benefit from the huge premium price. Worse, the indexed mutual funds were at the mercy of the specialist because, he hadn’t allowed sellers to pair off at realistic prices until it was too late. At 4:07 p.m., Luckow closed the stock at $55 a share, up 11% on a single trade and nearly ten percent above Safeway’s twelve month high.

Investors had paid a $5 5/8 dollar premium over what Safeway had traded at prior to the close. In gross dollar terms, if the stock had traded unchanged and buyers and sellers had been paired off at the last trade before the 4:07 spike, investors (of which nearly all were indexed mutual funds) would have saved $24 million on what they bought. Assuming a premium to $52 a share to adjust for the buy volume (a conservative number in my opinion) the savings would still have been $13 million. It is realistic to conclude that this specialist, on this one trade, cost the mutual fund industry between $13 million and $24 million. On one trade, millions of dollars vanished from investor portfolios.

And what did the specialist get out of all this? Specialists (with a monopoly on the shares they trade: one stock, one specialist) are permitted to use their own capital to buy and sell shares of the stocks they are assigned. They accumulate stock when the think it is going higher and sell when they think it is going lower. But they are not permitted to do so to the public detriment.

There can be little question, however, that Mr. Luckow, with perfect knowledge of all the buy and sell orders, bought stock throughout the days and hours leading up to Safeway’s inclusion into the S & P. How many shares did he buy? It wouldn’t surprise anyone if it were in excess of a million shares-a number that was still dwarfed by the 4,000,000+ buy imbalance. Assuming that he owned those shares at the day’s average price of 49 1/8, he stood to make nearly $6 million by selling to mutual fund buyers at $55. Additionally, it is probable that he sold shares short (a bet the stock would go lower) at this same closing price. Supposing that he shorted 500,000 shares and covered them at the opening (down two dollars) the next day, that would have an additional $1 million profit. The profit could, possibly, have been over $10 million.

Conflict of interest?

Unfortunately, we don’t know the exact details of what Speer, Leads did or didn’t buy and sell. The NYSE ruling-in typical vague fashion — makes no mention of the specialist’s direct involvement. Nor any mention of his profit. The Exchange did not require the firm to make restitution to mutual funds. Or to disgorge its profit. Surely the NYSE knows how big a profit Speer, Leads’ made on this transaction. Surely the Exchange well understood that these actions cost mutual fund investors millions of dollars. Why did they not disclose those details? Why do they never disclose those details? For the same reasons, I suspect, that specialist do not have to open up their books to scrutiny.

Interestingly, the Exchange’s investigation came about only because of loud complaints from the mutual fund industry. Mutual funds aren’t normally in a position to see the minute by minute abuses of the specialist system. It is only in extreme cases of apparent greed and investor damage that they get hit right between the eyes, understand the injustice, and express their outrage.

Member firms and NYSE floor participants — those who see these actions on a daily basis — seldom raise their voices. There are two reasons for this. The first is proverbial: “don’t bite the hand that feeds you.” The second is the punitive powers the NYSE has over the employees of all member firms. When a group-specialists in this case-control all the information (information others need to do their jobs) and have the ability to bring charges (founded or unfounded in some instances), it does not breed whistle-blowing.

In the case of Safeway, it is entirely likely that the scorecard looked like this: Specialists $7 million or more in profit (less the $350,000 fine, of course), Mutual funds $15 to $20 million in losses.

My guess is that, over the years, the public, chiefly through mutual fund holdings, has lost billions of dollars due to specialist trading practices, but getting at numbers will be rough. In a way, thank goodness for the extreme cases like Safeway. Maybe it represents only the smoke from a smoking gun, but it might be a fruitful start for any comprehensive investigation.

Regards,
Ken Morris