Speech by SEC Chairman:
Remarks at the Economic Club of Washington
by Chairman Arthur Levitt
U.S. Securities & Exchange Commission
April 6, 2000
Thank you very much. Today, we are enjoying the longest period of economic expansion this country has ever known. Low interest rates, low inflation, heightened productivity and record employment have cultivated fertile ground for almost a decade of growth. Whatís more, they have created greater opportunity, more wealth, and better lives for millions of Americans. These are the economic factors for todayís prosperity. But, thatís only half of the equation.
When we look back on these extraordinary times and try to make sense of the many different forces at play, the discussion will probably be as much a sociological one as it will an economic one. Today, a new, heightened optimism is fueling an almost unbridled culture of entrepreneurship, innovation, and investing. And more and more investors are pouring their hard earned dollars into the stock market. Why?
Certainly itís because investors believe they will get a good return on their money in the short term and longer term. And itís probably safe to say there is a certain amount of euphoria out there as well. But if we think about it more fundamentally, todayís willingness to invest runs much deeper than that -- it goes to the very core of what makes markets function.
Investors today commit capital because they have confidence in the quality and the integrity of Americaís markets. That faith does more than fuel markets -- it makes markets possible. In many respects, the dynamism of our market system depends on integrity, professionalism, and the public confidence they inspire.
Now some may ask, "Does it really matter if the numbers in a prospectus are just slightly off, or if an investor receives a price that is only a little bit worse than the best market price?" The answer is simple. If investors lose faith in the integrity of our marketsí prices, they will go elsewhere. If investors believe that they are not receiving high quality financial information, they will go elsewhere. If they believe that their interests are being placed secondary for any reason whatsoever, they will go elsewhere.
We are living in a time when investors are increasingly able to shift their capital in and out of markets cheaply and easily; it may not always happen overnight, but the history of markets teaches us it can happen quickly. And the road to restoring lost confidence is a long one indeed. As those of you in the room with a bit of gray hair know well, no market has a divine right to the savings of Americaís investors -- we have seen capital move from stocks, to gold, to oil and gas, to real estate, and these days, back to stocks.
Whatís more, investors today, as a practical matter, have access not only to U.S. markets but almost any market in the world. If the integrity of our financial reporting and the mechanisms of our market ever lose their luster in the eyes of Americaís investors, those companies and those markets that vigilantly guard a reputation for quality will draw them away.
It takes discipline -- particularly in these prosperous times -- to remain focused on guarding integrity and maintaining confidence. But there is simply no substitute for steadfast vigilance. Nowhere is the investor interest more implicated than in the evolving structure of our capital markets, and in the integrity and transparency of the information that binds these markets together.
Investor Confidence -- Quality Financial Information
Confidence in our markets begins with the quality of the financial information investors use to decide where to invest their hard-earned dollars. Quality information is the lifeblood of strong, vibrant markets. Without it, liquidity dries up. Fair and efficient markets simply cease to exist. Today, as the quantity of information increases exponentially through the Internet and other technologies, the quality of that information must be our signal priority.
We have the most accessible, reliable, and transparent financial reporting in the world. Iím worried, however, that a gradual but perceptible erosion in the quality of this reporting may be undermining the systemic integrity of our marketplace.
The motivation to satisfy Wall Street earnings expectations may be overriding long established precepts of financial reporting and ethical restraint. In the past, Iíve referred to this as a "culture of gamesmanship" -- one that is weaving itself into the fabric of accepted conduct, threatening investor confidence, and potentially weakening Americaís brand in the global arena.
A gamesmanship that says itís okay to bend the rules, tweak the numbers, and let small, but obvious and important discrepancies slide; a gamesmanship where companies bend to the desires and pressures of Wall Street analysts rather than to the reality of numbers; where auditors are pressured not to rock the boat; and where short-term numbers override long-term performance.
Now, I know that many of those in corporate America took to heart the call for greater integrity and accountability in the financial reporting process. I recognize and applaud their efforts to "raise the bar" of ethical standards. But, unfortunately, the gamesmanship persists.
Weíve all seen what happens when a company misses an analystís earnings target by just a few pennies. The stock plummets. Itís remarkable, but today, a near miss is a miss by a mile. I canít tell you how many times an investor has come up to me -- incredulous and exasperated -- because a companyís market capitalization dropped by millions of dollars simply because it was a penny or two shy of its earnings estimates. Unfortunately, there is no law of economics I can cite, no reasonable correlation from which investors can draw.
I can only point to what I see as a web of dysfunctional relationships -- where analysts develop models to gauge a companyís earnings but rely heavily on a companyís guidance; where companiesí reported results are tailored more for the benefit of consensus estimates than to the reality of the ups and downs of business; where companies work to lower expectations when they fully expect theyíll beat the estimates; and where the analyst attempts to walk the tightrope of fairly assessing a companyís performance without upsetting his firmís investment banking relationships.
Unfortunately, all too often, analysts are falling off that tightrope on the side of protecting the business relationship at the cost of fair analysis. Analysts have become a fixture on business pitches and investor road shows -- doing their bit to market their own firmís underwriting talents and to sell a companyís prospects. Whatís more, analystsí compensation is increasingly based on the profitability of their firmís corporate finance division, and their contribution to the deals to which they are assigned.
Needless to say, you can see how an analyst who recommends selling a clientís stock because itís overvalued would not be terribly popular. Is it any wonder that many Wall Street firms would prefer that analysts heed their mothersí admonitions: "If you canít say anything nice, then donít say anything at all."
How about another common practice that probably reaches more American households than any company prospectus: analyst stock picks on television. How many times have we seen an analyst being asked to list his top five picks? And, how often has that analyst taken the opportunity to caution viewers, "By the way, my employer recently underwrote three of these companies?" More often than not, he hasnít. And thatís because some firms claim that these recommendations are either "extemporaneous" or covered by a prior disclaimer, or that disclosure is just plain distracting or impractical.
Frankly, I donít find any of these arguments very persuasive. And, I presume, neither would Americaís investors. Thatís what worries me the most. Is this really the unbiased and dispassionate analysis that Americaís investors look to when they think about investing in our markets? More broadly, is this the type of system that promotes and preserves unwavering investor confidence?
I think itís time investors are told -- in a meaningful way -- when the analystís employer has a recent investment banking or advisory relationship with the company that is being recommended. Firms should also reexamine their compensation practices for analysts and ask themselves this simple question: Do our payment practices ensure unbiased and quality information?
Objectivity of Auditors
Nowhere should the reputation for objectivity and integrity be more jealously guarded than in the audit profession. Like all businesses, the practices of the biggest accounting firms have undergone enormous changes. Entities once devoted exclusively to auditing now resemble diversified professional practices. If recent industry trends continue, I fear that the audit process -- long rooted in independence and professionalism -- may be diminished in the name of these increasingly lucrative and commercial opportunities.
I canít help but wonder what impact this changing business mix has had on a culture that has prided itself on objectivity. Can the audit engagement partner truly be perceived as discharging his public duties while trying to sell his audit clients legal advice or consulting services?
Investment research can be difficult enough, and investors shouldnít have to wonder whether the numbers they are analyzing were prepared under anything but an objective and unfettered arrangement. I anticipate a meaningful dialogue on this and other relevant issues in the near future.
The Drive for Better Markets
Even with an abundance of quality financial information and accurate disclosure, investors must have confidence in the integrity of our market mechanisms before they will commit their capital. Our markets today are experiencing change at a pace and on a scale weíve never seen before. In its wake, old debates have been rekindled and new ones abound as all market participants grapple with the far-reaching implications of change.
As new imperatives transform our markets, all of us have a duty to be proactive in reinventing our roles and renewing our commitment adding value. This means rejecting initiatives rooted in political agendas, discarding outdated thinking, and rethinking archaic business models.
Around the world, efficient, low cost trading systems have developed with new variations seeming to emerge almost daily. Technology has made the prospect of quick shifts in the flow of buy and sell orders more than just a theoretical possibility. Ensuring the primacy of Americaís capital markets presents nothing less than a national economic challenge. We meet that challenge by earning the confidence of investors with scrupulous fairness and enduring efficiency.
There is one clear path to markets that remain efficient over time, and that is vigorous competition. In this vein, I view the Commissionís role as maintaining and upholding a framework that fosters vibrant competition.
In this framework, multiple market centers -- traditional exchanges, electronic markets, and dealers -- compete with one another for business, spurring a race towards faster, cheaper execution of transactions. Prices across these markets are visible -- or transparent -- to market participants. Brokers are legally obligated to obtain the best prices reasonably available for their customers. And multiple market centers are linked, ensuring that brokers have access to the best prices in the overall market.
The technological advances driving our economy -- particularly those fueling the growth of the Internet -- are transforming and validating this framework. Upstart electronic markets are leveraging technology to challenge traditional exchanges, using computers rather than humans to match buyers and sellers. Dramatic increases in bandwidth now bring a broader, deeper market transparency within our reach, making it possible to transmit more pricing data through fewer channels. A fast expanding web of connections between customers, brokers, and markets seems destined to weave our many and diverse markets into a true National Market System.
With this increased connectivity, some question the Commissionís insistence that the markets themselves -- traditional exchanges, electronic markets, and dealers -- maintain basic links that ensure prices in one market can be accessed from another. Why not, they ask, simply rely on connections between brokers and markets?
If quote prices are changing rapidly, often the market where the broker routes an order no longer offers the best price by the time that order arrives. Linkages between markets help ensure that the order still gets the best price at the point of sale. If a market is not quoting the best price when it receives an order, it must be able to match the best price or ship it to the market with the best price. I continue to believe that these basic connections are an important guardian of confidence in our markets.
Now, I have heard some suggest that the Commission should step aside and rely on market forces alone to correct pricing disparities across markets -- that there is no need for the government to prod our markets to link. It may well be that the private sector will soon produce adequate connections in our markets without any action from the SEC. I look forward to that day. But the truth is, some of our markets have, at times, neglected the need for these basic connections at the expense of investors. In my judgment, it would be a profound mistake -- not to mention a dereliction of our statutory duty -- to permit the isolation of any significant market from the rest of our National Market System.
None of this is to say that todayís existing linkages should be maintained in anything like their current form. In particular, the markets should be able to take advantage of new, smarter, and more flexible technology.
But unconnected markets and the pricing disparities they can produce have the power to erode investor confidence in our market system. Over these last almost seven years, I have had the pleasure of speaking with literally thousands of investors. And itís become increasingly clear that a new breed of investor -- more informed, more inquisitive, and more in touch with financial activity than ever before -- is emerging from the Information Age. Sure, I can imagine some tolerating pricing inefficiencies for a while, particularly in good times like these. But the risk of neglect is grave. Like a summer squall, the erosion of confidence can sneak up on us, strike quickly and leave severe damage in its wake.
Investor confidence -- it is something thatís easy to take for granted in times of great prosperity. Maybe some market participants today canít imagine a marketplace where IPOs are not ten times oversubscribed, or when liquidity is not a concern, or when investors are not readily investing in new companies, new technologies, or new ideas.
But it would be the height of hubris and foolishness to dismiss the possibility of investors growing uncertain about the integrity of the system, distrustful and unwilling to commit their capital in the open market. We must remember that it is public confidence that distinguishes markets that are vibrant and deep from those that are anemic and shallow.
When we work to guarantee that investors have access to information that is timely and accurate, when we work to ensure that customers get the best price available, when we embrace innovation and new technologies to craft a better marketplace, when we honor our pledge to put the customer interest before all else, we are protecting more than just our capital markets, we are honoring something even greater -- the faith of Americaís investors.