Speech by SEC Chairman:
Remarks before the 2000 Annual Meeting
Securities Industry Association
by Chairman Arthur Levitt
U.S. Securities & Exchange Commission
Boca Raton, Florida
November 9, 2000
Thirty-five years ago, I came to my first SIA conference. It was in the midst of the so-called "go-go years." I remember walking the halls sensing a feeling among us of unlimited potential and boundless opportunity. Our markets were experiencing an enormous volume surge, growing institutionalization and quite rampant speculation. It was big news I recall that Kentucky Fried Chicken was selling at close to 100 times earnings.
I also remember the tough times when we've come together. The back office paper crunch, the abolition of fixed-commissions, the debate over Rule 394, the down markets of the 1970's, the market break in '87. This year, however, much like the ten or so before it, we meet in a time of great prosperity. And, the industry continues to grow, innovate and thrive because of that prosperity.
Certainly, the growth in new technologies, low inflation, higher productivity, new markets are at the basis for our general good fortune. For me, there's another, even more compelling reason - the rise of the individual investor.
In my mind, the emergence of the retail investor will have done more for the long-term health of this industry, than any other single factor. Nothing more than the power of an informed investor increases competition. Nothing more than the power of a pragmatic, but demanding investor boosts innovation. And, nothing more than the power of a confident investor guarantees a steady flow of business.
Those of you who attended these conferences some years back know that talk of the individual investor was fairly limited. Today, the topic of investors’ needs is one of the centerpieces of your program this week and it is the subject of my remarks today.
Having spent a good bit of my professional life in this industry, I know this audience fairly well, and many of you personally. So I ask your patience in revisiting with me one of the most basic elements of our markets: the costs of investing. I recognize that this concept is virtually second nature to all of you. But this morning I’d like to talk about what it means to pay costs with "other people’s money" particularly in light of today’s new breed of retail investor.
This phrase, drawn from the title of Louis Brandeis’ seminal book, puts in stark relief a simple fact we all know intuitively – people tend to act differently when the money on the table isn’t their own, to treat lightly expenses they do not feel. But our markets are essentially built on a system where intermediaries are charged with the care of other people’s money – most of the time people they’ve never met. Despite this tension, this system has served our markets and America’s investors remarkably well for decades.
The Commission’s regulatory approach to this basic and, in many respects, natural tension is two-fold. First, disclosure. Recognizing that it is impossible to measure and compare what you can’t see, whenever practicable, costs should be transparent both to the market professional and to the investing public. Second, duty. Market intermediaries are bound by a fiduciary duty to act in the best interest of their customer. In other words, those who spend other people’s money must exercise the same care as they would in spending their own.
The Stealth Attack Of Compounding Costs
Given the incredible influx of money into mutual funds this past decade, there are no costs worthy of closer scrutiny than the fees associated with these investment vehicles. Simply put, too many investors today focus on a fund’s past performance and pay too little attention to how management, sales, and other costs can impact their investment over time. In one study, Jack Bogle called this concept the tyranny of compounding high costs and illustrated how a potential half a million dollar return on an investment could be whittled down to just $65,000 when factoring in the compounding costs of some non tax efficient mutual funds.
Now, instinct tells me that many investors would be shocked to know how seemingly small fees can, over time, create such drastic erosion in returns. Meaningful disclosure of these facts, it has always seemed to me, is the clear answer. In the past, we have refined prospectus disclosure and sharpened disclosure of mutual fund costs. Our website includes a mutual fund cost calculator that allows shareholders to compute the impact costs will have on their investments. The Commission is also considering a rule proposal that would require funds to disclose the impact taxes have on investment returns. While these measures take important steps, we can do more.
Presently, the Commission’s Division of Investment Management is completing a comprehensive study of mutual fund fees. The study will recommend, among other things, standardized dollar disclosure of fees. For example, the actual impact of fees on a $10,000 investment will now be more clearly visible – in dollar denomination – to fund shareholders. Investors will be able to quickly and effectively estimate the actual amount they have paid fund managers during a given period. These measures, I believe, will help break the too-little-recognized tyranny of compounding high costs.
"Sticky" Brokerage Commissions
Among the most significant costs of investing today are brokerage commissions. The good news for investors is that retail commissions have dropped to only a fraction of what they were just a few years ago. Faster electronic engines now match buyers and sellers virtually instantaneously. Dramatic increases in bandwidth make the transmission of enormous amounts of data possible. Some mutual fund managers now obtain immediate executions on electronic markets for less than a penny a share. According to data from one fund, such costs were over twice that only four years ago.
But some investors might be stunned to know that "full-service" commissions paid by mutual funds to traditional brokers to fill their orders have remained steady at five to six cents a share for nearly a decade. These facts point to an unavoidable question: Are portfolio managers bringing to bear the pressure they should on brokerage rates today?
Now, I am aware that Congress has granted statutory protection to "soft dollar" arrangements – that is, where fund managers use brokers who charge relatively high commissions but in return provide research and other services for the fund. I also know there is a lot more to execution quality than commissions; the market impact of a poorly executed trade will almost certainly dwarf the commissions charged by most firms.
Yet, when I think about today’s soft dollar arrangements and their impact for investors, I keep coming back to the notion that fund advisers are paying their expenses with other people’s money. Let’s face it – extraordinary increases in volume over the last few years have generated revenues that are just as impressive for most brokers. So why haven’t these increases produced more competition in full-service commission rates? Why hasn’t the emergence of electronic markets – which offer execution five times cheaper – driven these commissions lower?
Part of the reason, I fear, is a perception among portfolio managers and independent directors that six cents is safe – or rather, fund managers can pay up to six cent commissions and not raise any red flags. But what’s "safe" for these market professionals may not be what’s best for investors. Managers have a duty to seek best execution and directors have a duty to inquire about the process.
To this point, a recent Commission examination of independent director oversight of soft dollar arrangements has turned up findings that are troublesome. Some directors, it appears, pay little or no meaningful attention to the brokerage costs of mutual funds. Directors must ask the tough questions of fund advisors. Our study showed that independent directors need to put more pressure on managers to drive hard-bargains with their brokers.
As dramatic changes sweep our markets, managers as well as independent directors simply cannot adopt a static measure of what is merely "good enough." There is no substitute for asking hard questions about order routing arrangements, to ensuring investors reap the full benefits of the dynamic competition unfolding in our markets.
Order Flow and IPOs
The issue of advisers paying expenses with shareholder funds also relates to the question of who owns the order flow controlled by advisers. Clearly, the answer is the adviser’s client. Yet, this plain fact seems to be lost on some advisers today, particularly where IPO allocations are concerned. It’s no secret that the driving force behind allocation of today’s hot IPOs is the weight of the brokerage relationship. Those clients that direct the most brokerage business to investment banks are more likely to be rewarded when it comes time to divvy up an IPO. Quite frankly, given the nature of business, it would surprise me if this were not the case.
But how do advisers, in turn, distribute the piece of the pie that comes from the underwriter? Too often, it seems, advisers are allocating IPO shares among their clients without meaningful disclosure, and in ways that are simply unfair to clients. Shares that are awarded to the advisor based on the brokerage relationship at large are being given to the adviser’s favored accounts. In other words, a bonus earned by one client is being awarded without his knowledge to another. Sometimes the lucky recipient is a new fund whose performance the adviser wants to boost. Other times it’s a client that, in the adviser’s eyes, has potential to produce large advisory fees. And, if you can believe it, in some situations, allocation favors members of the adviser’s family.
In short, other people’s money is being put to work for the adviser’s own interest. Absent disclosure, these allocation practices plainly threaten the interests of investors and fuel cynicism about the industry. Regulatory and examination scrutiny in this area should remain steadfast – if not intensify – and enforcement action should follow suit where egregious facts are present.
Market Infrastructure: Implicit Costs
There are other types of costs that employ a more subtle tyranny over investors – the costs imbedded within the infrastructure of our markets. When our markets neglect the systems that bind together our national market system, when they fail to modernize their approach to operating these systems in the face of market developments, investors suffer. One disturbing example of such neglect can be seen today in our options markets. For over a year, it’s been clear that decimal pricing was imminent. For over a year, the options markets have known that the volume of pricing information would mushroom with the advent of decimal pricing – that existing infrastructure could not accommodate the projected increase in data. And for over a year, they’ve been well aware of clear paths to reduce the volume of pricing data.
Despite these early warning signs and signals indicating the way, our options markets have been unable to agree on strategies necessary to pave the way for penny – or even nickel – pricing. Investors, unfortunately, are bearing the brunt of the options markets’ neglect. On the eve of full scale decimal trading in listed equities with penny increments, the options markets in many cases will be trading only in dime increments. More pointedly, investors are being denied the benefit of narrower spreads – and the industry is keeping the difference for itself. How much more progress would have been made toward a workable solution, I wonder, if the excessive costs that investors will surely be swallowing in the months ahead were borne instead by the markets and their members?
I do not underestimate the technological and regulatory challenges these markets face. Nor do I minimize how sharp the clash of commercial interests is between some of these markets. No one needs reminding that these are intensely competitive times. But anything less than an unequivocal commitment to a prompt resolution is, in my judgment, in square conflict with the public interest.
Towards this end, yesterday I wrote to the directors of each of our options markets, reiterating my belief that the current situation can and should be remedied within one year. As any delay benefits the industry – not investors – I have asked the independent directors of each market to closely monitor the progress of their market toward this critical goal. It is issues like these – where there is a tension between the interest of the public and those of the market – that have led me to urge all markets to enlist at least 50% of their boards from the non-industry sector.
Clearly, fresh thinking is in order and innovative approaches must be explored. The challenge is considerable, but the stakes are even higher. I am hopeful that the markets will commit the abundant talent and energy it has to the task, and that a timely solution will result.
The Cost of Clicking "Submit"
Now, as many of you here know well, the broader subject of market structure has drawn considerable focus from regulators and the industry alike over the last year. All too often, investors today will devote time and energy searching for the lowest commission around, but know virtually nothing about what happens to their orders once they click the "submit" button. More specifically, they know nothing about the implicit costs which may accompany their broker’s decision of where to route their order.
Unlike overt costs such as commissions, implicit costs – such as the dealer’s spread, – are largely invisible to customers today. Are current spreads subject to the full force of competition in our markets today? If the answer is no, then investors are bearing the burden of market inefficiencies. Similarly, is execution speed increasing as fast as investor demands? If not, investors are being needlessly exposed to the implicit cost of market risk.
The execution quality rules proposed by the Commission this July, along with a recent study of the equity markets being completed by our economists, will provide important indicators on these critical questions. In a national market system driven by inter-market competition, investors simply must have the ability to compare costs – explicit or implicit – across markets.
Dilution In the Dark
There are few duties more fundamental to the integrity of our capital markets than the obligation of corporate executives to act with scrupulous honor when spending shareholder dollars. Now, to be certain, things get a little complicated when that money is spent by officers and directors for officers and directors – that is, on executive compensation packages.
So, how do corporations ensure that executive compensation is rooted in the best interests of shareholders? Several years ago, the answer was straightforward: executive stock option plans and other equity benefits were simply submitted for a shareholder vote. A clear-cut rule, grounded firmly in both fairness and common sense. Why is this so important for shareholders? Well for one thing, to ensure that executive compensation levels are fair and appropriately tied to corporate performance. For another, to ensure that shareholders favor the "wealth transfer" inherent in these plans. When options are exercised, it dilutes the percentage stake that each shareholder has in the company.
This rule, however, has experienced significant erosion in recent years. Today, our two largest markets permit companies to grant options to executives and other employees in a way that bypasses the shareholder’s critical eye. Shareholder approval is not required to adopt certain stock option plans that permit grants to officers and directors, as long as those plans also include other employees. I am deeply concerned by reports of companies making increasing use of this exception to side-step shareholder approval.
Now, in the spirit of full disclosure, the Commission opened up this issue when it eliminated shareholder approval as a condition to exempting option grants to officers and directors from some of our insider trading rules. But whatever the history, the current situation must not be tolerated.
Last week I called on our markets to restore promptly the rightful balance between shareholder and management interests by requiring shareholder approval for all plans that grant options or award stock to officers and directors. To their credit, the New York Stock Exchange is already considering such a requirement and its management has given me its personal commitment to push hard for this change if Nasdaq does likewise. I am greatly disappointed, however, that up to now, Nasdaq has been unwilling to make the same commitment. Let me assure you that the Commission will not stand idle if this important shareholder protection is not soon forthcoming from our nation’s SRO’s.
As for other stock option plans -- those that don’t include officers and directors -- I hope and expect that the Commission will move forward in the coming weeks to require companies to disclose all option grants that would dilute existing shareholders. And I have urged the markets to consider requiring plans to be presented to shareholders for approval if those plans would dilute shareholders’ interests to a material degree. Nasdaq has committed to taking a serious look at a dilution standard. And the NYSE has taken a useful first step by developing a proposed dilution cap, although this is not to say that the NYSE test will fit every issuer or that narrow exceptions for special situations will not be necessary.
It goes without saying that a commitment to shareholder rights must remain critical priorities for all of our markets. Investors would be ill served, to be sure, if permissiveness on the part of any market triggers a race to the bottom in dilution standards. If the markets do not act in short order, the Commission should.
Ensuring Strong Oversight
As history shows, only those industries that are responsive to change stand the test of time. Those that are not, fail – it’s that simple. The securities industry has proven itself again and again resilient enough to sustain for America the most robust markets in the world. I have always shared the conviction of my predecessors that the most important force shaping our markets – spurring technology, competition, and innovation – is the natural genius embedded in competition.
It’s a genius that is given life, sustenance, and rebirth by the relentless demands of America’s investors. There is simply no disputing the powerful coalescence of these multiple forces -- the ingenuity, innovation and integrity of market professionals, and the demands of an increasingly informed customer base. It’s a synergy that has produced the most vibrant, efficient and fair markets in the world. But, after nearly eight years at the helm of an agency filled with the most talented and dedicated group of professionals I have ever worked with, I can’t help but conclude that the reputation of our markets is rooted -- in part -- in the quality of their regulation, as well.
Without strong, effective regulation that works in the interests of America’s investors, we risk nothing less than our preeminence as the most trusted capital markets in the world. I find it distressing that we have not yet addressed the disparity between compensation for employees at the SEC and employees at other government regulatory agencies. It is one thing for staff to make salary comparisons with the private sector, but quite another for them to see their government counterparts making anywhere from 24 to 39 percent more than they are. While the maximum salary for a second-year attorney at the SEC is $66,000, an FDIC staff member with similar levels of experience can be paid as much as $91,000.
The sacrifices our employees and their families make are nothing short of inspiring. Unfortunately, jurisdictional debates and industry passivity have created circumstances that may ultimately implicate the quality of regulation and, as a direct result, the quality of our markets. Many of you, when we have spoken privately, have praised the work of the staff. So allow me to be blunt: as a group, you can and should be more clear and vocal in your support. The industry faces fundamental issues, but none more prominent than the public perception of our markets’ integrity.
The Rising Wave of Retail Investors
And this brings us to a fundamental truth. Investors commit capital because they have confidence in the quality and the integrity of America’s markets. That faith does more than fuel markets – it makes markets possible.
These past seven years, I have attended forty-one Town Hall meetings across the country. I’ve spent many hours talking with investors, listening to their concerns, answering their questions. And the more I speak with America’s investors, the more it becomes clear that a new breed of investor is emerging from the Information Age -- more informed, more inquisitive, and more in touch with financial activity than ever before. Just last week, talking to investors in Atlanta, I fielded questions on loan-loss reserves, payment for order flow, and the impact of Nasdaq’s proposed SuperMontage. That would have been hardly imaginable just a few years ago.
As a result, firms and markets must respond to a more demanding investor base. They must reach into untapped markets and reach out to under-served Americans – not only because it’s the right thing to do, but because it’s the smart thing to do. Today’s renewed focus on value demands that market participants cater to a more economically and ethnically diverse retail investor, that they be surveyors for new opportunities, new market niches, and new markets altogether. In this way, today’s more open and competitive marketplace erodes barriers to capital erected by narrow-mindedness and intolerance. The broader we reach, the more inclusive we become, the stronger and more vibrant our economy and country will be.
Creeping Cynicism and Its Antidote
Unfortunately, even in these times of great prosperity, our marketplace is not immune to creeping cynicism. Anyone who thinks this notion ill-conceived or slightly paranoid need only look at the public’s reaction to a 15-year-old who made nearly $800,000 in profits through Internet fraud. Instead of being treated like a cheat, some hailed him a hero.
What could possibly support such a claim? Simply put, a public perception that he did nothing different from what industry professionals do every day. Those of us in this room know well how false that perception is. Analysts, in particular, operate within a comprehensive regulatory framework that has, by and large, protected investors well. But still, some depart routinely – and in very public ways – from one of the basic principles of their code: disclosure of conflicts.
Analysts who recommend stocks on TV and radio rarely mention clear conflicts of interest; for example, that their trading desk, or they themselves, own stock in the company, or that their firm has an underwriting relationship tied to their recommendation. And while conflicts are often unavoidable, meaningful disclosure shouldn’t be. The SROs, I believe, will be issuing guidance to their members in short order which renews the analyst’s obligation to disclose conflicts whenever they recommend a security, whether on TV or in written reports. Meaningful but workable disclosure in these very public settings is not beyond our reach. It is a crucial antidote to public cynicism.
I firmly believe the same is true of Regulation Fair Disclosure, which went into effect just last month. I know that many of you in this room were adamantly opposed to the regulation, and may still be convinced it will increase volatility and dampen disclosure. But from what I’ve seen and heard first-hand, investors today do not need an analyst to interpret news – especially not earnings "guidance" from a CFO – or an institutional trading desk to protect them from volatility.
As with any new approach, initial implementation will in all likelihood produce extreme caution. But my sense is that some company officials should be more tight-lipped. Indeed, the complaints about the operation of the rule have revealed most clearly that some companies have for some time been communicating with analysts in entirely inappropriate ways.
But my experience tells me that the market itself exacts a penalty from executives whose obsession with the price of their stock outweighs strategic concerns for the long term well- being of their company -- companies using whispers and practicing favoritism and exclusion rather than openness and broad disclosure. America’s investors are too smart and too savvy to buy into pre-screened or over-simplified information, shielded by media scrutiny and doled out in ways that may favor some but disadvantage others.
The financial services industry in this country has built a proud record of achievement. While all of us can look back with some satisfaction, there is so much more to be done to ensure this sacred trust between a firm and its customers. A relationship of trust has less to do with gross revenues, profit margins or any other number that goes on the balance sheet. A relationship of trust has everything to do with what your customers say and think about you.
Louis Brandeis once said, "In business the earning of profit is something more than an incident of success. It is an essential condition of success; …But while loss spells failure, large profits do not connote success. Success must be sought in business also…in the improvement of products; in a more perfect organization, eliminating friction as well as waste;…and in the establishment of right relations with customers and with the community."
In the years ahead, what will mutual fund investors say if they realize too late their returns have fallen hard under the weight of compounding fees? What will options investors say if they are forced to trade in artificially large increments? What will investors say if they find their stake in a company diluted because of options allocations they were never told about? Perhaps they’ll say nothing at all, and take their business -- and their trust -- elsewhere.
And that reality should serve as our greatest threat and most compelling motivator – an enduring reminder of what’s really at stake when we take "other people’s money" in our trust and care. It’s a simple and salient truth – markets exist by the grace of investors. And the commitment made by your predecessors and mine to protecting America’s investors has been the very cornerstone of our markets for more than half a century. It’s what we do today, together, forged through a collective commitment to the public trust, that will determine what the next half-century will bring. And if past is prologue, a remarkable future for our markets, for our market participants, for America’s investors, surely awaits.