November 27, 2005

Dear SEC:

I am writing in response to the NYSE's November 18, 2005 comment letter on the above-referenced rule submission. As is the case far too often in recent months, the NYSE's attempts at "defending" its positions and "responding" to substantive criticism only make matters worse for the NYSE and underscore how truly ignorant the current NYSE staff actually are with respect to the NYSE's own rules and trading procedures.

The Failure to Address the Overarching Problem

The NYSE's November 18, 2005 comment letter simply reviews several technical trading scenarios and offers no response whatsoever to the principal substantive criticism of the NYSE proposal, namely the absurdity of assigning a price to an order that existed before the order even entered the market, and which may no longer be the pr evailing price once the order does in fact enter the market.

The fundamental fallacy of the NYSE's position is its assertion (see pages 2-3 of the NYSE's June 7, 2005 comment letter on this matter) that the specialist, having just effected a trade, has in fact determined that the price of this trade must of necessity be the appropriate price for a subsequently arriving order. In the NYSE's view, this ipso facto obviates the need for the specialist to expose the subsequently arriving order to the market for price improvement, as otherwise clearly required by NYSE Rules 76/91.

On pages 5-8 of my June 15, 2005 comment letter, I demonstrated in detail exactly why the NYSE's position in this regard is untenable. (I ask that my entire June 15, 2005 comment letter be incorporated by reference herein). The NYSE offered absolutely no rebuttal in its November 18, 2005 comment letter on this point, which is absolutely central to its proposal.

As the NYSE noted in its June 7, 2005 comment letter, the proposal springs from a recommendation by SEC auditors apparently exasperated by the NYSE's surveillance inadequacies. The auditor recommendation, while well-intentioned, is clearly short-sighted, as it results in the "ex post facto" pricing absurdity I've repeatedly emphasised.

The task for the SEC Market Regulation staff is straight-forward: they must recognise that the proposed "cure" (orders given prices prevailing in the market before they arrived) is worse than the "disease" (the occasional instance of possibly illegal specialist trading). The "disease", such as it is, is surely "curable" by enhanced surveillance, not a distortion of the basic pricing mechanism whereby orders are executed at prices existing when the order actually enters the market, not previously existing prices.

If the Commission approves SR-NYSE-2004-70, it risks becoming a laughingstock among world regulatory agencies, as "ex post facto" pricing is an absurd concept unknown in any market anywhere.

It really is that simple.

The Infamous Scenario 1

In its June 7, 2005 comment letter, the NYSE presented (page 3) two market scenarios to illustrate the operation of its market and its order exposure/price improvement rules. The examples are not of the essence (the essential point is the "overarching" one discussed above), but they are worth reviewing (particularly scenario 1) because of what they reveal about the NYSE staff's credibility and their approach to the rule submission process.

The June 7, 2005 comment letter posited, as scenario 1, a situation in which the market was .50 - .60 (each side of the market being a limit order represented by the specialist), with the last sale bein g .49. According to the NYSE, "The specialist decides to sell to the bid for his own account. Consistent with Exchange rules, he orally bids for the stock at .51 but attracts no sellers. He consummates a transaction as principal at .50." My June 15, 2005 comment letter (pages 8-9) described in detail the monumental stupidity of this example.

In its November 18, 2005 comment letter, the NYSE acknowledged that scenario 1 "was set out incorrectly" and ascribed the error to an "editing mistake." The NYSE "corrected" scenario 1 to read "The specialist decides to sell to an order at the bid from is own account. Consistent with Exchange rules, he orally offers stock at .51 but attracts no buyers. He consummates a transaction as principal at .50."

One is thankful for the admission of error, particularly since the NYSE staff had suggested that it was I, not they, who did not understand the NYSE market. Those of us who write for a living are certainly prone to mistakes (which we're too close to to catch) and the occasional "Homeric nod." I certainly don't expect the NYSE staff to fall on their swords shouting "mea culpa" as they expire. However, as the "corrected" scenario 1 is still seriously flawed (see below), the notion that all we are dealing with here is an "editing mistake" will not withstand simple scrutiny, for the four reasons discussed below.

  1. The error here is consistent with the types of errors appearing with distressing regularity in recent NYSE rule submissions. See, e.g., the absolute debacle of SR-NYSE-2005-57 and SR-NYSE-2005-69, as well as the latest "clarification" thereof, SR-NYSE-2005-79, which will be the subject of a forthcoming comment letter. These filings are chock-a-block with ignorant misrepresentations of the NYSE's rules. See also (a real howler) the NYSE staff's inability to distinguish between the specialist's affirmative and nega tive obligations, as I discuss in my November 8, 2005 comment letter on SR-NYSE-2004-05. These fundamental errors (and others I could mention) are not "editing mistakes." As I have discussed in other comment letters, NYSE members have advised me that heavy staff turnover has resulted in the NYSE's having to assign rule submission work to inexperienced staff who lack the in-depth knowledge to do the work to the requisite professional standard. While one sympathises with the NYSE's plight, the resulting mess places an unfair burden on the Commission and the public.

  2. The NYSE staff's actions with regard to scenario 1 are not consistent with simply correcting a good faith "editing mistake." They were put on clear notice of their error in my June 15, 2005 comment letter. Every conscientious lawyer I have known, or heard of, would rush immediately to correct a highly embarrassing error in a public legal document, for reasons of fundamental fairness as w ell as professional reputation. But it took the NYSE staff almost half a year to correct the public record, notwithstanding the fact that the NYSE staff submitted amendments to SR-NYSE-2004-70 on August 11, 2005, and October 14, 2005. The reasonable expectation is that the NYSE staff would have submitted a correction (to an error so ridiculous it is a total embarrassment as part of the public record) shortly after June 15, 2005. Certainly, the two amendments provided the opportunity, but again nothing. The NYSE staff's actions are so inconsistent with basic professional responsibility that only one conclusion reasonably presents itself: the NYSE staff did not accept that they had made an error after it was pointed out to them, and are only grudgingly conceding the point almost six months later. "Editing mistake" indeed. Remedial education, anyone?

  3. Even if one accepts the notion of an "editing mistake" at face value, one is left with the distressing realisation that the NYSE's internal review procedures are either non-existent or have completely broken down. It's one thing for the immediate preparer of a document to make a mistake (we all do). But the mistake here is so obvious, fundamental and ridiculous that I am at a complete loss to understand how any knowledgeable person reviewing the document could not have caught it. I am, perhaps wrongly, assuming that there are "adults" at the NYSE who review legal documents before they are submitted to the SEC. I'm afraid to say that only one answer seems likely. As several NYSE members have told me, the "adults" themselves are mostly new. They appear to be unversed in the obscure, technical subtleties of NYSE rules and are apparently delegating the rule submission work and hoping it turns out well, as they themselves are incapable of closely evaluating it (a classic "blind leading the blind" situation). No other explanation seems possible for scenario 1, or for the other debacles I've noted. And, again, this is hugely unfair to the Commission and to the public.

  4. The most significant reason for doubting that we are dealing with an "editing mistake" here is that the "corrected" scenario 1 is still deeply flawed. The NYSE staff obviously do not understand the background and purpose of Rule 91. (I've noted in other comment letters that a serious deficiency in the NYSE rule submission work generally is the NYSE staff's incomprehension of the background and purpose of the rules they propose to amend).

As SEC and NYSE staff have explained to me over the years, Rule 91 is rooted in the U.S. law of agency, and is intended to minimise conflicts of interest when an agent (the specialist) seeks to trade as dealer with an order he/she is representing as agent. Rule 91 has nothing to do with the specialist's interaction with other market interest, or to the specialist's attemp ting to obtain price improvement for him/herself before trading with an agency order.

The fundamental premise of Rule 91 is that the specialist should be permitted to effect a dealer trade with an agency order at a particular price only after first ascertaining that no one else in the market will provide a better price to the agency order, not a better price for the dealer account. The language in Rule 91(c) [the provision applicable to scenario 1] about bidding at a price "lower than his offer" has always been interpreted to mean, consistent with the rule's purpose, that the specialist must make a bid on behalf of the agency order that is lower than the price at which the specialist intends to trade with the agency order. This gives other market participants the opportunity to trade with the agency order at an improved price for that order, and minimises the possibility that the specialist will simply seize a proprietary trading opportunity to the det riment of his fiduciary duty to obtain the best possible price for the order he/she is representing as agent.

As I noted, the term "his offer" in Rule 91(c) has always been interpreted to mean the price at which the specialist would actually (in the absence of price improvement to the agency order) sell stock to the agency order, not to other market participants at an improved price for the specialist. It has never been interpreted to mean, as "corrected" scenario 1 would have it, that the specialist simply makes an offer higher than the maximum limit of an agency order so as to obtain an improved price for the dealer account. In "corrected" scenario 1, there is no way for the limit order at .50 (the order the rule is addressed to) to be executed at a better price (i.e., .49 or lower).

The NYSE staff reads Rule 91(c) as providing a vehicle for the specialist, rather than the specialist's agency order, to obtain price improvement. This is the exact opposite of what Rule 91 in fact requires, which the NYSE staff would understand if they educated themselves about the background and purpose of the rule.

I explained all this, with an example of how to expose the agency order for price improvement, on page 9 of my June 15, 2005 comment letter. (I noted that I'd even confirmed the point with an NYSE specialist).

I can understand the NYSE staff's ignorance (we are all "perpetual students", after all).

But I cannot understand in any way what appears to be the NYSE staff's persistent, willful ignorance.

We are obviously not dealing with an "editing mistake" here.

The Execution of a Later Arriving Order

Incredibly, the NYSE devotes the bulk of its November 18, 2005 comment letter to a minor, subsidiary point (the e xecution of a later arriving order), while ignoring completely the "overarching" problem I discussed above. Typically, the NYSE staff manage to distort completely the simple point I'd made in earlier correspondence in this regard. And, typically, the NYSE staff again demonstrate ignorance as to how their own market actually operates.

The NYSE proposal would permit the specialist to simply assign an earlier price to a later arriving order, regardless of whether that was in fact the market price existing when the subsequent order arrived. My only substantive point here is that the market price prevailing when the subsequent order arrives is the price at which that order should be executed. This is the way every market everywhere operates, and is obviously the way the NYSE market operates today, in the absence of the NYSE's strange proposal. And, of course, a subsequent order may receive a price that is better, worse, or the same as an earlier price, but the pricing is determined by the then-existing market, not the specialist's assignment of a price.

The NYSE makes the following, bizarre statement: "By contrast, Mr. Rutherfurd's scenario would, in effect, hold the later-arriving sell order open until the next bid came in, a benefit to which the order would not ordinarily be entitled."

Of course, I said no such thing. As the NYSE staff ought to be aware (but apparently are not), the NYSE prides itself on maintaining a continuous two-way auction, not a call market. Orders are never "held open" until contra side interest arrives. After a trade, the market is requoted, and subsequent orders trade in the requoted market, with no "holding period." The NYSE market has operated for more than 200 years in this fashion, and operates that way today. And this process has served the public fairly and well because the market itself sets all prices. My only point is the classic, "I f it isn't broken, don't fix it."

And it really isn't broken.The occasional surveillance issue should be addressed by enhanced surveillance, not by mucking up and distorting the fundamental pricing mechanism.

Or is the NYSE so incapable of surveilling its market that the only "solution" is a ridiculous concept unknown in any professional trading environment anywhere?

(I'll note here, parenthetically, that the NYSE's rationale, a prior trade determines the price of a subsequent trade, ought logically to be applied in every trading situation, not just those in which an order arrives before an earlier trade is reported. And this of course would render the auction obsolete, and Rules 76/91 meaningless. Such is the ultimate absurdity of the NYSE's position).


I reiterate points made in earlier correspondence about the remedial steps the NYSE needs to take in the unlikely event the Commission is inclined to approve this abomination. Specifically, the term "yield" needs to be replaced by the far more legally precise term "substitution of principals", as there is a highly significant, substantive legal difference between "yielding" and what is actually happening under the NYSE's proposal, namely the reformation of the contract to trade entered into by the specialist in the earlier trade. And the NYSE needs to propose amendments to to Rules 76 and 91, which by their plain terms require exposure of each and every order received by the specialist.

But the only honourable recourse here is for the NYSE simply to withdraw its nonsensical proposal.

Sincerely yours,

George Rutherfurd
Consultant (to two institutional investing organisations)
Chicago, IL