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U.S. Securities and Exchange Commission

Speech by SEC Chairman:
Remarks Before the Securities Industry Association’s Legal and Compliance Seminar

by Chairman Arthur Levitt

U.S. Securities & Exchange Commission

in Boca Raton, Florida

April 13, 1999

Thank you very much. It is a pleasure to be with you all this morning. Six years ago, when I first spoke to you, I could not have ever imagined the pace and breadth of change our markets and the securities industry have experienced. Nor could I have foreseen the boundless opportunity that today's technology presents for all of us.

Last year, I discussed our mutual commitment to creating a culture of unimpeachable professionalism; a culture where integrity and unbiased judgment are not only expected, but absolutely essential to navigating the issues and situations that increasingly move beyond the bright line of right and wrong. In particular, I talked about our common obligation, our mandate – as professionals – to elevate sales practices in the brokerage profession to the highest levels.

Our commitment to professionalism must remain absolute. The world, however – and the securities industry in particular – are changing at a bewildering pace. Today, we must apply our professional ideals to contexts beyond the traditional environment in which broker-dealers have operated for decades. My generation and the generations before us bought and sold securities by placing orders with real live people. We took for granted that it would always be so. Not more than a few years ago, the thought that millions of people would invest without any human intervention was nothing but a thought – and a pretty far- fetched one at that. Today, it is a reality.

A broker and firm's priorities, conduct and values will endure a greater degree of scrutiny by investors than ever before because of technology. If an investor loses trust in the profession and feels his interests are being used as a means to someone else's end, he will simply employ other options to invest which don't involve brokers.

As an industry, we have no choice but to pursue continually and aggressively a culture of professionalism that extends through every department, every employee, and every transaction, through every contact with your client – whether it be on the phone, on the computer or on paper.

But, there is one group of professionals that I consider first among equals. They are the conscience of the brokerage industry. They are the men and women who safeguard the best of this industry's traditions and fight every day to eliminate the unworthy, destructive practices that threaten its future. These people are all of you here.

A few years ago, someone likened a firm's compliance department to the Internal Affairs division of a police department. Both absolutely necessary, but not exactly appreciated. I appreciate the difficulties many of you face. Saying no, pointing out problems, assessing responsibility is not for the fainthearted. But, if internal controls are not strong and are not driven by accomplished, smart and courageous people, a firm's future hangs in the balance. All it takes is one incident to destroy a reputation and eviscerate trust.

During my six years at the Commission, I have been tremendously encouraged by the prominence and influence of compliance departments within broker-dealer firms. I urge all of you to continue to demand excellence; to continue to demand the highest standards possible; and to demand a culture of unimpeachable professionalism.

Professionalism that prevails through everything – from how we sell our products to how transactions are cleared and settled. Annette Nazareth, the Commission's Director of Market Regulation will have something to say on the clearance and settlement process later in the day.

Let me discuss broker compensation. As you all remember, the Tully Report identified several practices that raised the potential for conflicts of interest between registered representatives and their customers. It also described a series of best practices, which were later adopted by many firms and endorsed by the SIA.

Among the issues the Report cited were compensation incentives such as single-product sales contests, higher commissions for proprietary products and up-front compensation to lure brokers away from firm A to firm B. Over the years, because of the efforts of reps and compliance professionals, tremendous progress has been made in discouraging the use of these incentives. Today, we take another step to ensure that this progress endures.

Last year, I asked the NASD to examine whether these compensation practices pose inherent conflicts of interest between the interests of investors and those of brokers. The NASD has done so and has decided to take further, significant action.

I understand that the NASD is considering rules that would do three things: (1) ban single-product sales contests; (2) require disclosure when a broker is getting paid more for selling a proprietary product than he would for selling a similar product from an unaffiliated source; and (3) mandate disclosure when brokers ask their customers to transfer their accounts to a firm that has paid the broker to switch.

Contests to sell single products are virtually extinct. Banning them will ensure their demise. Similarly, whatever the justification for paying registered reps more for selling house products than those available elsewhere, customers ought to be told when the only difference between the products is that the rep gets paid more for selling it.

The same is true about compensation paid to registered representatives to switch firms. I understand that the competition for representatives can get very intense, and I have no intention of interfering with that competition. But, reps who are paid to switch firms may feel pressure to trade more after the switch. So it is imperative that customers know the incentives that were offered to their brokers.

As technology lowers more barriers for more investors, the core of our profession remains what it has always been – expert, dependable and honest advice. The very technology that has lowered the price of information has multiplied the value of wisdom. While today there is healthy competition among firms based on the price of trade executions, tomorrow will surely bring more competition based on the value-added to the customer's investment decisions. I want to encourage that competition.

The Tully Report recommended that investors have a choice as to whether registered reps be paid not just on a commission basis, but also on the amount of assets under management. The idea was to avoid excessive incentives that served the rep's interests rather than the investor's. But, there are certain regulatory obstacles which could make it difficult for firms to implement such a recommendation. As you know, if you charge for your executions, you're a broker-dealer, subject to regulation under the Securities Exchange Act. If you charge separately for your advice, you may be an investment adviser, subject to the Investment Advisers Act.

Under the Advisers Act, an investment advisory firm must obtain the client's consent before selling him or her securities out of the inventory of an affiliated broker-dealer. But getting the explicit consent to do so can delay a transaction unreasonably. Many traditional brokerages do business over the phone and it can be quite cumbersome to secure timely consent. So, transactions that could have been good for the client and the firm may never take place because people just don't want to bother.

Given the changing structure of our markets and the corollary effects it is having on our business, I believe this is the right time to consider whether it might be appropriate to provide an exemption from the restrictions on principal trading. While we want to open new opportunities to firms and their customers, there are real risks to allowing principal trading in certain situations – such as in illiquid securities or large, market-moving orders where it is very difficult to know whether the client paid a fair price. While we want to make it easier for firms to get paid for their advice as well as their executions, we will not simply exchange one potential conflict of interest for another.

The Division of Investment Management will develop amendments to the rule that strike a balance between these two concerns. I believe we can do this without sacrificing the interests of the profession or investors.

I came here to talk about the value of professionalism this morning. But, I do so ever mindful that the securities industry, in many ways, is being recast through technological advances; changes that directly affect how broker-dealers have done business for the better part of this century.

Technological change, today, represents nothing short of a watershed transformation. In the past, technology was driven – for the most part – by crisis or by natural extensions of business. But going forward, technology will more and more drive business instead of the other way around. It is blurring the boundaries between our markets and leading us to re-configure our business to provide new services in new ways. As the Internet and high speed telecommunications become omnipresent tools, investors throughout the world are gaining unprecedented access to markets and instantaneous trading information.

Primarily through the Internet, today's individual investor has more power and information available at his fingertips than ever before. Investors now have ready access to information that up until a few years ago was available only to securities professionals.

Remember when everyone checked stock prices in the next day's newspaper? It seems like a long time ago, but up until earlier this decade, that was the case. But, the question, "How'd the Market do today" has practically been replaced with "How's the Market doing this minute." Thousands and thousands of investors are checking their stocks two, three, four times a day through real-time stock tickers on the Internet. Want to be notified every time a certain company is in the news? Simply type in the company name on a watch list and the computer does the rest. What about access to the most recent earnings forecast? Type in the company and you'll have it – with accompanying charts and graphs.

We are living in a time when our capital markets are more a part of people's everyday lives than ever before. Turn on a 24- hour news program and you'll get a constant update on the market in the corner of the screen. Financial channels have sprung up providing constant news, commentary and insight about markets from Asia to South America, to companies from the agricultural sector to telecommunications. Walk into Penn Station in New York and you're met by an enormous television screen that streams out business and market news. For years, a Kodak picture hung silently in that spot.

But, as the quantity of information increases, so does the value of dispensing clear and unbiased advice. A by-product of the unprecedented public interest in our markets and the accompanying explosion in media focus has been the proliferation of financial analysts providing commentary to the public. That's not what troubles me. More information is generally good. What troubles me is what purports to be utterly unbiased analysis could, in fact, be shaped by unspoken pressures between the analysts and the companies they follow.

The vast majority of analysts speaking to the public today work for firms that have business relationships with the companies the analysts follow. As the financial services business becomes more concentrated, it is becoming harder and harder to find an analyst whose firm does not have an investment banking or, increasingly, commercial banking relationship with companies the analyst follows.

Today, analysts are under increased pressures to look for and attract business and to help the firm keep the business it has. Analysts are expected to be key players in the road show promoting securities to be issued in conjunction with a firm's investment bankers. An analyst's compensation is often based partially upon trading desk and investment banking profits. In this culture, companies quite naturally look more favorably on bankers whose analysts profess a full appreciation of their virtues. They are understandably less impressed with firms whose analysts are less impressed with them.

Recently, I received a letter from an analyst who had followed a company and the industry it operated in for the last two decades. After the analyst was deemed unsupportive of the company's stock, the company explicitly told him he was unwelcome at any public investor meetings. The message was simple: if you don't play by our rules, you are not going to play at all. This may be an unusual case, but, perhaps, only for its lack of subtlety.

I read that according to one study, sell recommendations account for 1.4 percent of all analyst recommendations, while buys comprised 68 percent. Certainly, the growth in the market has had something to do with this lopsidedness. But, I can't help but wonder what else is driving the number of buys to exceed sells by 8 to 1, when in the early 1980's that ratio was roughly one to one. Part of the explanation could be what more and more studies are showing: a direct correlation between the content of an analyst's recommendation and the amount of business his firm does with the issuer.

I worry that investors are being influenced too much by analysts whose evaluations read like they graduated from the Lake Woebegon School of Securities Analysis – the one that boasts that all its securities are above average. And I worry that investors hear from too many analysts who – whether they realize it or not – may be just a bit too eager to report that what looks like a frog is really a prince. Well, that's just not the way it is: every investor and every analyst must beware that - to paraphrase a very different type of analyst - sometimes a frog is just a frog.

I don't know how much of this is apparent to investors. I wonder how many investors realize when they see an analyst on television that the analyst's employer has a business relationship with the issuer that could be directly affected by that commentary. I wonder how many investors realize that the firm that is paying an analyst to talk about a particular company is the same firm that was paid to handle the issuance of that company's stock. And I wonder how many investors realize the professional and financial pressures many analysts face to dispense recommendations that are more in a company's interest rather than the public's interest.

Over the next few months, I expect to learn more about these matters. Every opportunity I have to speak with investors, I am going to ask them how they view an analyst's recommendation. And I hope to hear from anyone - analysts, investment and commercial bankers, and issuers - with insights as to how these dynamics work and how to improve them. I know this is also an issue of concern to the SIA and I look forward to hearing your thoughts.

This morning, I've talked about our progress since last year in elevating sales practices. I've talked about liberalizing the principal trading rule with appropriate caution to create greater opportunity for firms and their clients. And, I've talked about the relationship between analysts and investment banks. I realize that not all of these issues come under the direct purview of all of you here.

But, it demonstrates that while some conflicts of interest may be minimized, others come to the fore – almost over night – that demand our attention. And, whether you are a compliance professional, a broker, an analyst, an investment banker, an investment advisor or a regulator, we all share an obligation to be vigilant and trustworthy. None of us can afford to compartmentalize and worry about only our office or our division or our firm. We all have a stake in serving the investor's interest and the market's interest.

Despite all the tumultuous change, at its most basic level, any market is built around an agreement between a buyer and a seller. For that market to flourish, those two people must trust that the agreement will be honored and, if need be, enforced. Our thriving capital markets – our pride and the envy of the world – rest on the integrity of that commitment and on the honor and integrity of the professionals in our industry.

Coming here today reminds me of a story about one of my predecessors, Manny Cohen. He was an extremely able and gifted Chairman. But, someone once asked Manny's wife what her husband actually did as SEC Chairman. Her reply was, "I can't describe it exactly, but if I did it, it would be called nagging."

Some of you are probably saying that my wife might say the same thing. And, she probably would. But if our shared history proves one thing, it is that we fall and we rise on the strength of our values. Fidelity to honesty and professionalism will never go out of style. The world will continue to change. Our markets will continue to change. But investors will always value the protection of their interests. If we remain faithful to this ideal, the forces of change sweeping our markets can only make us stronger.

Thank you very much.