"THE STATE OF THE BROKERAGE PROFESSION" REMARKS BY ARTHUR LEVITT, CHAIRMAN UNITED STATES SECURITIES AND EXCHANGE COMMISSION BEFORE THE SECURITIES INDUSTRY ASSOCIATION'S LEGAL AND COMPLIANCE SEMINAR SCOTTSDALE, ARIZONA APRIL 20, 1998 UNITED STATES SECURITIES AND EXCHANGE COMMISSION 450 Fifth Street, N.W. Washington, D.C. 20549 Check against delivery .. Remarks by Chairman Arthur Levitt United States Securities and Exchange Commission Scottsdale, Arizona April 20, 1998 Not taking ourselves too seriously is one of life's more important lessons -- for brokers, lawyers, and government officials. But taking our professional responsibilities seriously is one of society's most crucial obligations. Two years ago I asked you to join with the SEC in a partnership to improve sales practices within the brokerage profession. Today I am here to report on our progress, and to continue this vital undertaking. Indeed, the issue is so important that I intend to deliver a `State of the Profession' speech like this one annually during the remainder of my term at the Commission. If there's one thing everyone in this room agrees on -- and by the way, if you disagree with this proposition, I'd be interested to hear about it -- the one idea I think we all hold in common is that the best interests of investors are the best interests of the firm -- they are identical. In a sense, everything you and I do is aimed at making sure those two interests are more exactly aligned. I want to discuss with you a framework that will help us achieve that goal, not just for the next few quarters or years, but for generations to come. At its heart, our mission must be to continue to elevate standards of professionalism in the brokerage industry.The basic elements of the framework are familiar. I think they derive from three fundamental priorities. First, efforts to reduce and eliminate conflicts of interest between brokers and clients must not only continue -- they must be taken to new and higher levels. Second, better investor education is essential. Informed investors increase professional accountability by encouraging brokers and firms to work smarter. And third, the SEC and the SROs must step in to set certain standards. We must reinforce your genuine compliance efforts by bringing actions in those cases where compliance is viewed either as a nuisance or an afterthought. I. Every single person in this room knows why enhancing p rofessional standards is important. But today, it's a more urgent priority than ever before. Discussions about the growing role of investing usually cite three common goals shared by most Americans: owning a home; providing for our children's education; and securing a dignified retirement. The goals are cited so often they sometimes sound more like a mantra than a mission. But we must not forget how much more difficult it is to achieve these goals than it was just a few generations ago. Millions of families are worried about their basic financial security. Largely by necessity, many have concluded that investing may help provide for their future. The long bull market has not only proven attractive -- it's created a stampede. In 1980, one in eighteen households invested in securities; today it's more than one in three. This cascade of dollars has done wonders for the industry's bottom line -- I have no argument with that. But those dollars represent something that no bar chart or profit & loss statement can ever convey: they represent the toil, sweat, and tears of millions of decent, hard-working people. By soliciting and accepting their money and their trust, Wall Street has solicited and accepted an awesome responsibility for the future of our people. As that responsibility grows, it's our job -- yours and mine -- to make sure the industry works harder and more effectively to be worthy of it. In that spirit, I offer these thoughts to you today. II. The first element of the framework to enhance professional standards is familiar to all of you -- it has to do with the way brokers get paid. We simply must accelerate efforts to reduce or eliminate conflicts of interest between brokers and their clients. There is no question that our focus on broker compensation practices has resulted in important improvements. The 1995 industry report on compensation practices played a critical role in changing the climate surrounding these issues. The Report described a series of specific best practices with respect to compensating brokers. These were not pie-in-the- sky schemes that only work on classroom chalkboards. They were field-tested practices that had been embraced by respected brokerages around the country. Many firms endorsed the Report and the best practices it set forth. The SIA endorsed them too, and includes them in a publication identifying best practices in several areas. In fact, the Report's most enduring achievement may be the one most easily overlooked. In it, the brokerage profession acknowledged the existence of these conflicts of interest. More important, the profession committed itself to a specific agenda to reduce or eliminate them. I wrote to a small group of firms last year to obtain a candid and confidential assessment of their progress in implementing these best practices. My questions were not encyclopedic. But from the responses I received and other reports, I think we have a reasonably complete picture of where things stand. The good news is there are accomplishments about which compliance professionals and brokers can be proud. Here are four highlights: … First, recruits entering the profession are receiving a fixed salary for an extended training and mentoring period, often lasting two years. This reduces pressure on inexperienced brokers to generate commissions. … Second, firms have enacted policies prohibiting single product and short duration sales contests. If followed, these policies remove incentives that can harm investors. … Third, firms have moved to level compensation rates for proprietary and non-proprietary products, and principal and agency trades. This also removes incentives that can compromise a broker's advice. … And fourth, more firms are basing compensation on success in managing client assets, rather than focusing exclusively on ringing up new sales. I applaud you for helping implement these important policies. Your commitment to best practices was instrumental in this process. It is especially significant that meaningful changes were enacted without resorting to the regulatory process. It is also apparent that more needs to be done. Much more. There are clearly areas where pressure can lead a firm to follow common practices that serve short term interests, rather than best practices that serve long term goals. This is certainly the case when up-front money is used to snatch high producing brokers from competing firms. I'm aware of only one firm that, as a result of the Report, adopted and adhered to a ban on up-front bonuses. Several firms had this policy before the Report, and to their great credit have stuck with it. One other firm adopted a ban, but attached an exception that has regrettably overwhelmed its rule. Better progress was made in dampening the use of accelerated payouts for experienced recruits, though pressure is mounting to move backwards. Four out of the nine firms prohibit accelerated payouts. One doesn't have a formal ban, but rarely uses them. Another adopted a ban, but one year later -- because of what it called intense competitive pressure -- reversed itself. Finally, one firm uses them, but is the only firm whose policy seems genuinely designed to provide brokers with a reasonable transition rather than a windfall. It won't surprise anybody to hear me say that I do not like either of these practices. When used to excess, they discredit a great profession. But I'm not the person who really matters. The person who matters most is the broker's client. But clients don't get to express their views on the use of up-front bonuses and accelerated payouts. They don't get to express a view because -- to the best of my knowledge -- not a single firm that uses them, discloses them to their clients. The 1995 Report described meaningful disclosure as a "time tested approach to protecting the interests of investors." Disclosure of up-front money, it said, could "lead to better decision making by clients." But disclosure of up-front money was not a recommended best practice. Why not? Because by definition, a best practice required at least one firm to make such disclosures. Not even one firm was doing that in 1995. And not one is doing it today. What are clients told when their broker leaves one firm to join another? Usually it's something like: "The only reason I'm moving is because my new firm will provide me with much more research, and that will help me serve you much better." We can't tolerate pitches that tell such a small part of a larger story. The NASD is to be congratulated for taking the initiative to address several of these matters. Last week, I asked the NASD to examine whether up-front bonuses, accelerated payouts, or certain other forms of broker compensation create inherent conflicts. If so, I suggested they consider requiring disclosure to clients -- or, if there is no other choice, banning them altogether. I am also concerned about several other compensation-related issues, one of which was not specifically addressed in the Compensation Practices Report. It has probably not occurred to many of you that buying securities from some firms in the month of December may be riskier than at other times of the year. But at least in theory it could be, because of the structure of certain broker compensation plans. Remember the book that was called: "Don't Buy A Car That Was Made On Mondays?" The concern was that absenteeism on Mondays was so high it affected the quality of cars built on those days. Well, many brokerage firms base their compensation plans on grids. Brokers receive a percentage of the commissions they generate. As their commissions increase, they can jump up to a higher payout level on the grid. The increased rate serves as an incentive to generate more transactions. I don't quarrel with prudent incentives. But some grids are structured in a way that seems destined to lead to conflicts. Some grids don't just provide a higher payout for sales beyond a certain level. Instead, they apply the higher rate retroactively, to all sales that have taken place since the beginning of the year. Imagine it's December 27th. You've generated $270,000 in commissions so far this year. Your payout rate is 35%. But if you get to $300,000 by December 31, your payout rate will go to 38%, applied retroactively. When you do the math, here's the bottom line: if the broker can generate $30,000 in additional commissions in four days, he or she will receive a $9000 windfall in addition to the standard commission. That kind of incentive can create strong pressures not only to sell, but to sell anything. Unless a firm's culture is strong and impeccable, that temptation may be difficult for the broker to avoid. We should be moving brokers away from such temptations. I have asked the NASD to examine this issue as part of its effort to respond to the Report on Compensation Practices. By this time next year, I hope to report that substantial progress has been made in removing such incentives. III. The second element of the framework to enhance professional standards may surprise you. It's promoting better informed investors. This may not be the first topic that comes to mind when you think about raising professional standards. But it's among the most venerable methods of improving sales practices in any industry. When expectations about performance, risk, and fees are informed by knowledge of the product and the market, the chance of a misunderstanding is greatly reduced. In other words -- helping investors help themselves is just plain good business. It is the surest and most certain way of avoiding problems. Two weeks ago, the SEC launched a campaign to motivate Americans to get the facts about saving and investing. The SIA, its Investor Education Committee, and many of its members made a tremendous contribution to our campaign's kick-off. I hope Irv Weiser, Marc Lackritz, and their colleagues know how grateful the Commission is for their efforts. Urging investors to invest their time before they invest their money is enormously important. Making sure that disclosure materials are in plain English is also essential. These were central goals of my first term at the SEC. But I think we all would agree that more needs to be done. Investors need tools to help them plan their financial future. To be useful, the tools have to be practical and meaningful. The Public Disclosure portion of the CRD is a tool for investors. But because it was not initially designed to serve the public, it was not investor-friendly. Obscure printouts full of mysterious regulatory codes baffled investors. That is about to change in a dramatic way. Part of the redesigned CRD is now accessible over the Internet. When fully implemented, it will present in a point and click format the disciplinary background for every registered broker and firm in the United States. It's my hope that after its first full year in operation, we'll be able to say that it was used by more than one million investors. Frank Zarb and Mary Schapiro deserve great credit for turning around this once star-crossed system. The new CRD and plain English disclosure documents represent important advances. But it's within our power to offer other important educational tools to help prepare the public for a lifetime of investing. We can do more to help investors understand that they should reassess their goals and risk tolerances from time to time. They should also periodically evaluate the success of their investments in meeting their objectives. To do so intelligently, investors need personalized information on the performance and total cost of their investments. The logical place to include this is in their account statements. I've read many account statements from brokerage and mutual fund firms. Very, very few have provided this information. That strikes me as short-sighted. If you believe you are providing high-quality services at a competitive price, why wouldn't you want your investors to know? I was delighted to learn recently that a prominent fund company is hoping to roll- out a new, state-of-the art account statement before year-end. The fund's current plans are to include a personalized performance report for an investor's total portfolio, as well as the specific performance for each separate investment. I am, of course, aware of the unusual number of technological challenges confronting the industry. So I'm not proposing new rules to require the preparation of personalized reports at this time. I am, however, going to monitor developments in this area. This is the next frontier in investor education, and I expect firms to respond quickly to the challenge. IV. The SEC has asked you to work with us to reduce conflicts, and to better educate investors. I know that the overwhelming majority of you will strive to do so, because you have done so in the past. But regulators have learned that voluntary cooperation and self-regulation do not make a bit of difference with a tiny but incorrigible sector of the industry. So the third and final part of the framework to enhance professional standards is enforcement. Both the Commission and the SRO's have as their overriding mission the protection of investors. Hundreds of thousands of brokers work diligently every day to earn investors' trust. We will not permit the honorable work of so many to be sullied by the outrageous conduct of so few. I can scarcely express publicly the contempt I feel for the very small number of brokerage firms whose record mocks the idea of best practices. These rogue firms are professional only in the sense they have mastered the art of hucksterism; of preying on investors' lack of sophistication. When one of their brokers picks up a phone, it's almost as dangerous as when a drunk gets behind a wheel. The time has come for zero tolerance of these firms, which demonstrate an utter disregard for professional standards. What is particularly galling is that, right from the outset, these firms target vulnerable investors: widows with insurance proceeds; retirees with a nest egg; parents with a college fund. Boiler rooms belong in power plants, not in professional brokerage houses. Whether they are hawking micro-cap securities, chop stocks, or penny stocks, we want to make sure that the only future cold calls these brokers make are to lawyers listed in the yellow pages. Our Microcap Fraud Task Force has made inspecting these firms a top priority. We've given examiners special training. We've developed procedures to help ensure that critical materials are not concealed or destroyed during an inspection. And we're leveraging our resources by working with federal prosecutors more than ever before. We are detailing staff to U.S. Attorneys in trouble spots around the country. We don't have unlimited resources, but we're marshaling what we have to try to find and shut down the most dangerous operations. Conclusion The three priorities we've talked about -- conflicts of interest, educational tools for investors, and targeted enforcement -- are not new. They are time-tested ways to bring the interests of investors and the interests of brokers and firms closer together -- a goal all of us share. But as the number of Americans in the markets increases, so does our responsibility, compelling us to find new ways to achieve old goals. Professionalism never goes out of style. The truth is, in an industry that's simultaneously consolidating and globalizing, professionalism is a competitive advantage. What qualities set truly professional, world-class firms apart, and help it establish standards for the next century? A world class firm views its brokers as reflections of itself. It provides continuous training and support, rewards clean records, and looks at more than just numbers in evaluating success. A world class firm is proud of its record. It doesn't fear disclosing the total costs of managing an account -- it welcomes it. A world class firm makes its proprietary products portable, confident that its offerings and advice will prevail in the marketplace. A world class firm doesn't hire brokers with disciplinary problems that might even remotely jeopardize investors, no matter how big the book, no matter how intense the pressure. At the end of the day, when all is said and done, a world class firm has put investors' interests above everything else -- above the broker, above the firm, above the industry. A world class firm is confident that this is the one thing it can do to ensure its own long term prosperity. Join with me in the weeks and months ahead to meet these challenges. Let us continue to prove to more than 100 million American investors that their confidence in the profession is justified -- and that their trust will be cherished and protected. If there is a strong partnership between the profession that seeks to serve investors and the agency that seeks to protect them, no challenge is insurmountable -- no goal is unattainable. Thank you very much.