These days, companies like Apple Computer, MCI, and Tandem are choosing to remain over-the-counter, and the American Stock Exchange, for one, is fighting mad.
Back in the days when ticker tape was made of real paper and printed with real ink, particularly observant tape-watchers might have noticed the daily message embedded in the American Stock Exchange test run just before the opening bell. "GOOD MORNING," read the character string sent out to brokerage office printers around the country. "REJECT OLD WAYS." Twenty-five years ago, that was a quaint but effective way for the tape system to test itself. When the exchange converted to the modern, high-speed tape, the tradition bowed out quietly, taking its own sound advice. Little did the Amex suspect that the sentiment might someday come back to haunt it.
But now that day has come, as the American Exchange finds itself under siege from competitors and critics who charge that it has become a creature of old ways and should be rejected accordingly. Indeed, many companies are doing just that. In the past 10 years, listings on the Amex have been sliced by a third, from 1,249 to 913, thanks mainly to attrition. More to the point, the dropouts haven't been replaced with new, emerging public companies, drawn from the ranks of the over-the-counter market. Most of those companies appear content to continue having their stock traded OTC, through the National Association of Securities Dealers Automated Quotation system (NASDAQ), whose listings have risen 65% in the past decade, from 2,436 to 4,025. Among these are some 1,600 companies that right now meet the financial requirements for American Exchange listing. Six hundred of these companies, moreover, also qualify for the New York Stock Exchange (NYSE), which has been losing listings as well, albeit not as fast as the Amex.
These are remarkable -- some might say, astounding -- statistics. An OTC listing was once considered something of a stigma, not to mention a liability, in the capital markets. For one thing, major investors, notably the institutional and foreign varieties, steered clear of companies unless their stock was traded on the NYSE or the Amex (and thus had passed the exchanges' screening processes). Small wonder, then, that newly public companies hastened to get listed as soon as they became eligible.
But all that has changed. With names like Apple Computer, Intel, and MCI Communications trading through NASDAQ, the OTC label can no longer be seen as the mark of a lesser company. On the contrary, it has become something of a status symbol in certain circles. "Growing companies are with NASDAQ, and I like the association," says Donald A. Pels, president of Manhattan's LIN Broadcasting Corp., explaining why his company has remained OTC despite being NYSE-eligible for about 10 years. Besides, says Pels, he would just as soon avoid the procedures imposed by the exchange on all listed companies.
Then there is Multimedia Inc., an old-line publishing and communications conglomerate in Greenville, S.C., which qualified for the NYSE three years ago. After studying the possibility of a switch, the company's officers concluded that 12 to 16 market makers handling their company's stock were doing a much better job than a single specialist could. Besides, the exchange offered little more than NASDAQ did, required additional paperwork, and charged stiffer fees.
But perhaps NASDAQ's most active corporate proselytizer is William G. McGowan, chairman and chief executive officer of MCI Communications, and an exuberant visionary who believes that the quasi-automated NASDAQ is "probably the prototype for what the exchanges are going to have to come around to looking like in the future." He insists that MCI has never had the "the slightest bit of interest in getting on" an exchange.
Such talk is particularly distressing to the Amex, the traditional home of promising young companies of a certain size and stature. Given the spate of initial public offerings during the past 18 months, it could normally expect its house to fill up again in the next couple of years, as the newly public companies grow and mature. Under the circumstances, however, that is far from a sure bet -- a fact that president Gordon Macklin of the National Association of Securities Dealers (NASD) never tires of pointing out. Indeed, he has been quoted as predicting that the Amex won't even be around in five years.
The Amex, for its part, concedes no such possibility. "I don't think that's the kind of thing a representative of this industry should be saying," retorts Macklin's American Exchange counterpart, Robert Birnbaum, formerly an attorney with the Securities and Exchange Commission, who became Amex president in 1977. "He knows it's not true. It's a sales pitch."
What Macklin is selling is a product that, in 13 years, has brought the over-the-counter market out of the Dark Ages and into the 20th century. That product is a securities trading apparatus that departs markedly from the machinery used by the NYSE and the Amex. The latter both operate what is known as a controlled auction market. Each has an actual trading floor on which specialists make exclusive buy-or-sell markets in specified stocks. The specialist firm must meet certain capital standards that ensure it will be able to continue buying and selling even under the most adverse circumstances, when it might have to commit much of its assets in support of an orderly market.
That is the old way, and, prior to 1971, it was undeniably the better way. Back then, the over-the-counter market existed in a state of chaos and ill repute. Instead of specialists, it relied on a network of market makers -- that is, broker-dealers prepared to buy or sell a given stock -- which were listed each day on the famous "pink sheets" published by the National Quotation Service. To fill a customer's order, a trader was obliged to contact three different market makers and then go with the one offering the best price. The problem was, the best price was often not available on the return phone call, and so the hapless man-on-the-street might unknowingly suffer an execution half-a-point or so to his detriment. The setting was ripe for plucking. Sure enough, many an outsider got royally plucked.
Then, in 1971, NASDAQ came along and automated the process, replacing the pink sheets with computers. Into its mainframes it gathered the names of market makers, together with the prices they were offering and asking for the particular stocks they handled. These mainframes were linked to video screens in brokerage offices around the country, allowing traders to locate market makers almost instantaneously. Now, to execute an order, a trader simply calls the market maker with the best quote, negotiates a price, and buys or sells the stock for the customer.
Clearly, this computerized stock market represents an improvement over the old pink-sheet system, as everyone is willing to agree. "The NASD has done an outstanding job of bringing themselves into the 20th century, and nobody can dispute that," admits Amex president Birnbaum.
But does NASDAQ represent an improvement over the specialist system used by the exchanges?
Absolutely, says Macklin, who disdainfully refers to the specialist system as a "monopolistic franchise," which, in effect, it is. Unlike the exchanges, he argues, NASDAQ creates a free market in the stock of each member company through the participation, via computer, of an unlimited number of broker-dealers.
Balderdash, says Birnbaum, who not inaccurately describes the typical NASDAQ trading room as "50 guys with coffee spilled all over their shirts, screaming and yelling at one another, executing orders the way they did half a century ago."
Indeed, the debate over which entity offers most to smaller companies is proving to be surprisingly virulent for usually staid Wall Street, which has in recent weeks been littered with the detritus of accusations and countercharges. The NASD has prepared a soon-to-be-published booklet called "Why NASDAQ," which freely takes potshots at the listed exchanges. Back at 86 Trinity Place in New York City, where the American Exchange conducts business, a rejoinder entitled "AMEX vs. OTC" has been drafted in apparent response. What makes these parties even more entertaining is the ill-disguised snideness on both sides.
"More and more companies are choosing NASDAQ's nationwide network of competing market makers linked by state-of-the-art communications over a single specialist on the floor of stock exchanges," reads "Why NASDAQ." "They not only believe NASDAQ's advantages overshadow those of the exchanges now, but that NASDAQ is the stock market of the future."
This line of argument drives the Amex people straight up the wall. "They're not connected by state-of-the-art communications," says Birnbaum disdainfully. "In the majority of instances, if you want to buy an over-the-counter stock, you pick up the telephone and call some guy. Most orders are not handled by machines, they're handled by conversations," just as in days of yore.
In contrast, says Birnbaum, the exchanges really have automated themselves, appearances notwithstanding. "Sure it looks the same, but the only way the Amex and New York have handled the business that's around today is because it isn't the same. Huge orders come in by machine and go back by machine. As far as getting an order from your broker to the floor of the Amex, nobody's faster than us, and nobody's faster getting it back. So this talk about better communications is not really accurate. Thirty percent of the orders on this exchange, and probably 45% on New York, come in on a machine and go back on a machine. That's a huge number of orders. And we're the only exchange in the country to have Autoper, where a specialist does the whole thing with a touch screen. Comes in on a screen, he touches the screen, and the order goes back to the firm."
Birnbaum also gets upset about NASDAQ's name-dropping. "They go around today, naturally, and talk about MCI and Apple Computer. A few years ago, they were talking about American Express and Anheuser-Busch. Important names have been there all the time. It's not a new phenomenon. We have some, too."
But most of all, Birnbaum resents what he considers to be a campaign of slur and innuendo. "[The NASDAQ people] make statements on the record which tend to downgrade the exchanges. Nobody who works for us would go around [saying such things] about another marketplace. It's bad for the industry. If one of the regional exchanges has a manipulation, I don't shout in glee, because that's bad for everyone. The NASD tends to say, 'We really didn't say that; that was one of our company heads.' But the statements are written by the same people, so that's a lot of nonsense."
Beneath all the sound and fury, however, there are some important issues. One of them has to do with the question of liquidity -- that is, the availability of stock on the upside and of customers on the downside.
From the company's standpoint, liquidity is important in part because it tends to reduce the volatility of stock prices (in theory, at least), and volatile prices are bad for the company whose stock is being traded. If a particular stock tends to be illiquid and volatile, major investors -- pension funds, mutual funds, even well-heeled individuals -- will shy away from it. Conversely, they are more likely to buy into a stock that they perceive to be both liquid and relatively stable. The participation of major investors, in turn, tends to support stock prices, especially in a faltering market. Moreover, the company can use that participation as a selling point when it goes out to raise additional capital.
On the liquidity issue, NASDAQ claims to have the edge, hands down. "Where are you more likely to get the broadest, most liquid market?" Macklin tosses out rhetorically. "In an environment which is essentially dominated by a single specialist, or in an environment in which liquidity is produced by a nationwide network of competing market makers?"
Rhetoric aside, the argument goes that any NASDAQ market maker -- of which there were 451 at the end of March -- can trade any stock in the system, with the result that all of them have to keep on their toes. "Market makers often don't know where the next big order's coming from," says Macklin. "If they want to get the inquiry, they've got to keep their prices at the best possible level."
And, with so many dealers' thumbs in the pie, liquidity is purportedly enhanced. "When you have an alternative place to shop, you don't get gypped. The only time you get gypped is when you get cornered," reasons Macklin, dropping a thinly veiled reference to the specialist system. "With NASDAQ, if you don't like the price, you're going to hang up. That's what creates the liquidity. [The market maker] knows if he doesn't take your thousand, you're going to hang up. If I'm on the floor and the only one you can deal with and you can't call someone else, am I going to give you that treatment?"
To back up this argument, NASDAQ trots out a 1983 study published by the College of Business Administration of Texas A&M University and written by three Texas business PhDs, who concluded that "OTC liquidity tends to dominate Amex liquidity for stocks of the same size. The liquidity argument sometimes given by corporate financial officers for listing on the Amex seems questionable. . . . Our study results add to a growing body of evidence that exchange listing is of little (or at least questionable) benefit to companies."
Needless to say, the Amex disputes this whole line of reasoning. To begin with, Birnbaum charges that NASDAQ paints a distorted picture of the way its system actually works. "They always talk about how it's better to have Salomon Bros.; Goldman, Sachs; and Morgan Stanley making a market in your company stock as against the specialist on the Amex," he says. "Well, every little company doesn't have a market maker like Salomon Bros.; Goldman, Sachs; and Morgan Stanley."
On this point, he is absolutely correct. Market makers naturally flock to where the action is, and the action is in highly capitalized stocks such as Apple Computer, Tandem Computers, Intel, and MCI Communications. This April, for example, MCI, with 234.7 million shares outstanding, boasted no fewer than 37 market makers. Obscure Fluid Corp., however, with 577 million shares outstanding, and selling for less than $1, has only 3.
Birnbaum also questions NASDAQ's claim that, on average, there are more than eight market makers per stock. "There's not that kind of trading. Maybe two guys dominate [the market in a given stock], and the rest come in and out -- who knows what they're doing?" he asks dubiously. "It's absolute nonsense."
More important, Birnbaum challenges the assertion that the liquidity achieved by NASDAQ necessarily promotes stability in stock prices. His argument goes to the heart of the differences between the two systems.
"In the specialist system, the orders all come to one person, who is highly regulated," Birnbaum explains. That person, the specialist, is seldom on one side of the trade. Whereas a NASDAQ market maker frequently trades for his or her own accounts, Amex studies show that its specialists participate in only 12% of trades executed on the exchange. By SEC edict, moreover, the specialists are allowed to participate only when necessary "to maintain fair and orderly markets." In so doing, they are obliged to minimize price changes, and, indeed, they generally do. The Amex claims that more than 99% of its trades take place at a thin 25 cents or less from the previous trade. Moreover, an Amex internal memo reports that the American Exchange handily beats NASDAQ on an average spread (the gap between the bid and the asked price), 29 cents to 58 cents.
To be sure, the ability to maintain such tight markets depends to a large extent on the skill and available capital of the particular specialist. The Amex has 27 specialist units (more than 200 specialists), ranging from 8 whom Birnbaum calls "fantastic," to "a couple of guys a company would be unhappy with." (The Amex has recently filed a request with the SEC asking for permission to allow a company to select its own specialist; as it stands now, the specialist is assigned arbitrarily.) "I'm not saying every specialist is the same. These are not machines, they're people. " Then again, ex-regulator Birnbaum can help to smooth out the differences by keeping tabs on the specialists' trading performances -- which he does. "The guy downstairs is a person I know, and I can go down there and get every single trade."
But the real test of any system comes when markets start to crumble. In this regard, NASDAQ was put to its severest test last August when, with adverse news on the wire, MCI traded 16.5 million shares in a single day, a U.S. record. The turnover represented 14% of the company's total capitalization. NASDAQ officials are justifiably proud that the system proved itself capable of handling such volume, but the fact remains that MCI fell $5 in six hours. Birnbaum, for one, thinks that much of the trading was not done by investors at all, but by market makers trying to outwit each other -- more or less at public expense. He points out that this could not have happened if MCI had been listed on an exchange.
On an exchange, in fact, trading in the stock would probably have been halted, as happened on March 16, when Warner Communications Inc. suffered comparably alarming news. In that instance, the specialist on the NYSE stopped trading on Friday, locking out would-be sellers and buyers until the following Monday afternoon. Although Macklin agrees with the exchanges' policy of suspending trading prior to the dissemination of important new information, he considers the Warner move indefensible, because the news was already out. "That was a protect-the-specialist halt, not a protect-the-public halt," he says. "The specialist can handle it more profitably if he's allowed to run on the field and call time out. . . . The absolute worst thing you can do to investors is to tell them they can't trade. If you don't want to trade in that kind of environment, then keep your stock in your pocket, but don't stop me from trading if I do want to trade."
Predictably, Birnbaum disagrees. "What in the heck is wrong with stopping trading in a company while things are going wrong? Is that bad? Shouldn't the public know what's happening?" When Warner reopened, it was off a mere 1 1/2. The jury is still out as to which system performs better under such circumstances.
While the jury makes up its mind, NASDAQ and the Amex are doing everything they can to enhance their respective appeals to smaller, growing companies. Both have their eyes on the offspring of the recent new-issues boom. At the moment, of course, most of those newly public companies are still in the over-the-counter market, since few can meet the exchanges' criteria, or care to pay the listing fees. Nevertheless, the Amex is fighting to get its share in the future, as the companies grow larger and more affluent.
The Amex has, though, held its own against the NYSE, a circumstance attributed in part to a company's ability to make the most active list. But, says Birnbaum, "if you go over to New York, you wouldn't make their most active list once a year." But the Amex finds that it is facing resistance from an unexpected quarter -- its own members. Many are also both market makers in NASDAQ and underwriters, and nowadays they are discouraging young, newly public companies from listing on an exchange. "In many cases, they're not only the market in that company, they are the dominant voice in management when it comes to what the company is going to do financially," says Birnbaum. "A lot of broker-dealers across the United States have made a tremendous amount of money trading over-the-counter securities. They don't want to see the security listed on an exchange. They say, 'We brought this company public; we want to make sure the market is right.' Actually, they've got all their own customers in it, and they're making a profit on it."
NASDAQ, for its part, turns the argument around and plays it to full advantage. The underwriters that bring a company to market, says Macklin, do a better job of focusing public awareness on the company and its common stock than an exchange could ever do. "Sponsorship is much more effective when you combine market-making capability, research capability, and distribution capability. You can take a supply of shares that comes on the market and actually do something with it. Stocks don't sell themselves." The pitch seems to have some merit: large-block transactions (more than 10,000 shares each) increased markedly over the past 12 months beyond a concomitant increase in NASDAQ companies, suggesting that conservative institutions are investing more heavily in OTC stocks.
Recognizing that stocks do not sell themselves, the Amex, meanwhile, has been building up the support services it offers to listed companies. Since his arrival in 1978, chairman Arthur Levitt Jr. has placed a strong emphasis on transforming the Amex's image -- emphasizing what he calls "the concept of exchange as domicile" for listed companies, rather than just a kind of junior NYSE catering to its broker-dealer members. Toward that end, he frequently invites the chief executive officers of listed companies to dinner at his home, and he offers the use of the Amex's Trinity Place facilities to any listed company that wants to hold its annual meeting there. On a more substantive level, he led a vigorous fight in 1978 against some members of his own board for a by-law change that would require brokerage houses to provide each listed company with names and addresses of stockholders who, trading on margin, had theretofore kept their stock in anonymous "street name." Because of the paperwork entailed, the brokerage firms fought it, but Levitt ultimately prevailed. Adapting the regulation, the SEC has declared it mandatory as of January 1, 1985.
In addition, Levitt has organized mid-range growth-business forums; maintains an effective small-business lobby in Washington that brings company presidents face-to-face with the President; has created a pool of volunteer directors available to any listed company that is having trouble attracting one; and arranges personal visits by exchange officers to listed companies. "I really take strong exception to the notion that we're less than we were 10 years ago," declares Levitt. And well he might: In 1983, the Amex spent more than $6 million for services that weren't available half a dozen years back.
To date, the NASD has not tried to match the Amex in providing such services, although it does stage yearly seminars and provides consulting services in such material matters as the best distribution method for shares. The reason, says Macklin, is that diverse extramarket undertakings "aren't really done well by a bureaucracy like ourselves."
But NASDAQ and Amex are going head-to-head in another area: options trading. The Amex first took the options business in the mid-1970s to help offset flagging stock-exchange revenues. Now, says Levitt, options trading has become "a tremendous help in making markets in equities," since members' liquidity is enhanced through simultaneous options business.
NASDAQ intends to follow suit, but with a difference: It plans to allow companies to choose whether they want options trading in their stocks or not. The elective feature is appealing to small companies, some of whom feel that options create volatility in their common stock, insofar as exercisers of options have to go into the equity market to fulfill delivery obligations. Others disagree, figuring that options give market makers a chance to hedge their common-stock bets, and thus enhance stability. A third group simply holds that options help to make the company more visible. But in opposition to options in their common stock are some companies that prefer to be able to raise money by issuing their own proprietary products, such as warrants or units. Macklin doesn't know who is right, so NASDAQ will let each company make up its own mind. "Our board feels it's not our decision to preempt or force them. The way to find out the pros and cons is to do it voluntarily."
Whatever income benefits accrue to NASDAQ through its entry into options trading, the key to its future undoubtedly lies elsewhere, in something called the National Market System (NMS). This is an SEC-mandated group of OTC stocks that meet certain, more rigorous financial and market criteria. They are separated out from the masses on desktop quote machines and in their own section of the newspaper, and their trades are electronically reported with the standard high-low-last-volume data that used to be the exclusive domain of the exchanges. Simply due to such reporting, institutions are taking a closer look at issues they once disdained. The added visibility has caught their attention, Macklin reports. But more significantly, since most institutions use technical analysis in helping to select stocks, NMS stocks now gain equal technical status with listed-exchange equities.
Instituted in 1981, the NMS has grown steadily, and now includes more than 900 stocks. That number will certainly increase in the near future: The SEC, which intends to make all stock trading national, recently proposed relaxation of some of its volume regulations, thus allowing as many as 1,400 more companies to make the jump into the modern age. With the coming of the NMS over-the-counter trading has been able to create an atmosphere of elitism in its own backyard a factor that helps keep NASDAQ companies contented. Beyond that, Macklin predicts that the NMS will be the springboard into an entirely automated market-of-the-future.
As one might expect, the Amex is none too impressed by all this. Birnbaum insists that, at the moment, the National Market System does not even fill its billing. "There's nothing national about it," he says. "They hoodwinked the SEC, and they hoodwinked the papers. Those companies are not tied in nationally with anything. The only thing 'national market' about them is that the SEC said in a release that when there is a national market -- which there is not -- those securities would be qualified for it. . . . I resent the sales aspect of it: You can be on the national market, like they're giving you something. We had last sale and quotes on this exchange for a hundred years. It's an absolute phony! They sell it like crazy for all it's worth."
Perhaps the NMS isn't all that it is cracked up to be, but then Gordon Macklin has never denied he is a salesman, and -- now that the battle lines are becoming clearer -- NASDAQ's future does seem to be market-oriented, after all. For the moment, it is concentrating on developing its National Market System into a smoothly operating, square-dealing organism that does what the exchanges do, only faster and better. It is already starting to do the job as well, give or take a half a point. That is an impressive start, and, before long, the NMS will be adding welcome fillips, such as automatic, best-available-price execution of orders of 300 shares or less, without the intercession of a trader.
Meanwhile, the future of the American Stock Exchange seems to lie down the path of support services already blazed by Arthur Levitt. There small companies will receive lessons in the politics and promotion aspects of being public that NASDAQ isn't geared to provide.
There is only one conclusion to draw from all this, and it is an odd one, given the rancor passing between the various parties to the squabble: In the long run, everyone stands to gain.