Speech by SEC Chairman:
Plain Talk About On-line Investing
by Chairman Arthur Levitt
U.S. Securities & Exchange Commission
at the National Press Club
May 4, 1999
Today, you can hardly pick up a newspaper, turn on a television, overhear a conversation, or talk to a friend without mention of the Internet. It has done nothing short of change the way our world works and the way our nation invests. And overall, it has changed us for the better.
Iím here today not to extol the Internetís virtues -- as they are self-evident -- or to raise a red flag of danger. Instead, I want to talk plainly and sensibly about the challenges it presents in the most practical ways.
Last week, I visited Martin Luther King High School in New York City to talk about the importance of financial literacy. The first question I got was from a young student who asked what "Internet stock should I buy." We are living in a time when the stock market is more a part of the American consciousness than ever before. After years of nothing but "up" markets and empowering technology, the investor psyche has gone through a lot of changes. Memories have shortened and important points may have gotten lost in the excitement.
We -- as a nation, as investors, as businesses and as regulators -- should not get manic about the mania. One day, a little-known company stock soars 38,000 percent after on-line investors invest using the wrong ticker symbol. Another day, someone fabricates a news story by copying a web page of a news organization and the stock in question rises 32 percent. Or, sadly, itís an investor who didnít take the time to appreciate what he was getting into and ended up losing his life savings in one fell swoop. It seems that with every passing day, we come across one story more amazing than the other.
As cliché as it may be, fundamentals still apply. I want to review them here -- whether they take the form of advice to investors, guidance to brokers, or reasoned action for regulators.
I want to discuss a number of important issues that should give all of us sufficient pause. First to investors, I want to talk about your responsibilities when investing over the Internet; second, to on-line brokerages, in the enthusiasm over on-line trading, you can never lose sight of the fundamental obligations to customers; and third, I want to discuss how the SEC is responding to these rapid changes to protect investors and help maintain market integrity.
By one account, more than seven million Americans trade on-line -- comprising 25 percent of all trades made by individual investors. In 1994, not one person traded over the Internet. In the next few years, the number of on-line brokerage accounts will roughly equal the metropolitan populations of Seattle, San Francisco, Boston, Dallas, Denver, Miami, Atlanta and Chicago, combined.
The breadth and pace of change prompted by the Internet are phenomenal. But, while it changes the way millions of Americans invest, on-line investing does not alter the basic framework that has governed our markets for the past 65 years.
The laws regulating our markets are a product of the New Deal era. To me, their concepts are as indelible as the Constitution. They have weathered challenge after challenge, decade after decade, and are every bit as relevant and effective today as they were the day they were written. Companies offering their shares -- whether off a website or through a paper prospectus -- still have to disclose what they are selling and why. Brokers -- whether traditional or on-line -- still have the same obligations to their customers. And fraud -- whether perpetrated over the Internet, on the phone, or in-person -- is still fraud.
Consequently, I am not convinced itís necessary for the SEC to pronounce a totally new and radical scheme of regulation specifically tailored to on-line investing. Yet, I donít rule out the possibility that there may come a time when the SEC sees a need for new approaches to better meet the imperatives of the Internet.
What must occur now is a greater recognition by investors of their individual responsibility. Iím talking specifically about an individual investorís duty to understand and control the level of risk he or she is assuming. That level can vary with the type of activity an investor undertakes. On one end of the spectrum lie investors who trade occasionally on-line and hold their investments for the longer term. They are basically retail investors who manage their portfolios through on-line accounts.
On the other end of that spectrum are so-called "day traders" whose time horizon for moving in and out of stock positions is measured by minutes, if not seconds. Some argue day trading is really nothing more than speculation. And, speculation is not new to our markets. Personally, I donít think day traders are speculating because traditional speculation requires some market knowledge. They are instead gambling, which doesnít. Historically, short-term trading has been an activity filled by a relatively small number of professional traders.
I am concerned that more and more people may be undertaking day trading strategies without a full appreciation of the risk and difficulty involved. No one should have any illusions of what he is getting involved in. I know of one state that recently found that 67 out of 68 day traders at a firm had in fact lost money.
Somewhere in the middle of this spectrum -- with long-term investors on one side and day traders on the other -- is an increasing number of Americans who use their on-line accounts both to invest longer term and to trade short term on momentum or small changes in the price of a stock. Call this mixed strategy day trading "light."
Iím concerned about the great influx of new and relatively inexperienced investors who may be so seduced by the ease and speed of Internet trading that they may be trading in a way that does not match their specific goals and risk tolerance. I also wonder about many of these investors who have never experienced a down market. On the other hand, a greater number of Americans investing for their futures and helping to raise capital is, in the long-term, good for our markets and good for our country.
As far as Iím concerned, for most individuals, the stock market is best used for investing, not trading. And, itís important to make that distinction. On-line trading may be quick and easy; on-line investing -- and I emphasize investing -- requires the same old-fashioned elbow grease like researching a company or making the time to appreciate the level of risk. Iím often surprised by investors who spend more time deciding what movie theyíll rent than on which stock to buy.
Regardless of how frequently a person trades or invests, the opportunity to make these decisions comes with the responsibility to take the time to understand the implications of those decisions. We have noticed four common misconceptions that investors have about on-line trading.
The first is that although the Internet makes it seem as if you have a direct connection to the securities markets, you donít. When you push that enter key, your order is sent to your broker, who then sends it to a market to be executed. This process is usually seamless and electronic; it is not, however, guaranteed. Lines may clog; systems may break; orders may back-up.
Even when automated systems can handle a lot of investors who want to buy or sell the same stock at the same time, a line often forms. Price quotes are only for a limited number of shares; some investors may not receive the currently quoted price. And, as you would expect, the price of that stock will then go up if there are more buyers and down if there are more sellers. By the time you get to the front of the line, the price of the stock could be very different.
So, how do investors protect themselves from a rapid change in the price of a stock? One way is to use a limit order. Thatís the second thing every on-line investor needs to know. A limit order buys or sells a security at a specific price. In other words, the order can be executed only if the market price has not moved past a certain level. On the other hand, a market order buys or sells the stock at whatever price the security is at the time the order reaches the market. So, if you place a market order to buy an IPO stock at $9, you could end up paying $90 by the time your order is executed.
This isnít theoretical. More than a few investors have lost most of their savings -- thousands and thousands of dollars -- because they failed to limit their price. Now, sometimes limit orders may not get executed in a fast moving market and some firms may charge more for them. But, at the very least, Iíd rather not own a stock or pay a little more upfront than be totally unprepared or incapable of paying a whole lot more later. My goals as an investor may be different from yours, but considering the costs and benefits of a limit order is part of responsible investing in todayís market.
The third misconception is that an order is canceled when you hit "cancel" on your computer. But, the fact is itís canceled only when the market receives the cancellation. You may get an electronic confirmation, but that may only mean your request to cancel was received -- not that your order was actually canceled. Recently, one major brokerage wasnít able to process 20 percent of the cancellation orders on a fast moving IPO. One investor placed an on-line order for 2,000 shares of the stock -- thought she canceled it -- and then placed another order for 1,000 shares.
After realizing that she had two orders outstanding, she tried to cancel both. Instead, she owed her broker over a quarter-million dollars for 3,000 shares after wanting to invest roughly $18,000. Most cases may not be this exceptional, but I urge investors to contact their firms to see how they can ensure a cancellation order actually worked.
Fourth, if you plan to borrow money to buy a stock, you also need to know the terms of the loan your broker gave you. This is called margin. When you buy on margin, the stock you purchase is collateral for that loan. In volatile markets, investors who put up an initial margin payment for a stock may find themselves required to provide additional cash if the price of the stock falls.
But, some investors have been shocked to find out that if they donít meet the margin call the brokerage firm has the right to sell their securities -- without any notification and potentially at a substantial loss to the investor. Others investors have been surprised to learn that they are lending to or borrowing from other customers in their firm through excess balances in their margin accounts. Itís clear that if an investor fails to understand the use and consequences of a margin account, he does so at his own peril.
You also may have heard about plans by the major markets to extend their trading hours into the evening. Thatís another way the markets are being responsive to ever-changing investment patterns brought about by individual investors. But with this new flexibility comes a catch -- the price you pay or receive might be affected by the fewer number of people in the market at that hour. Thatís simply a product of the law of supply and demand.
THE CARDINAL RULE OF ACTING IN THE CUSTOMERíS INTEREST
Let me turn to some of the concerns I have about the role of on-line firms. Firms should remember that while on-line trading may place significantly more responsibility in the hands of investors, it doesnít absolve the firms of their obligations to customers. Most firms are doing a pretty good job -- especially in light of the dramatic growth they are experiencing. But as the Internet rapidly becomes more and more an integral part of investing for more and more Americans, I ask brokerage firms to help protect the integrity of it for the long-run.
First, firms need to ensure that their ability to provide effective customer service keeps pace with their growth. If youíre marketing your firm to new customers, youíd better be able to provide them service when they do business with you. Firms are opening roughly 15,000 new accounts a day. That means 15,000 new potential complaints a day -- especially if a system goes down. Are investors having a hard time getting their e-mails answered? Are customer service 800 numbers always busy? Are complaints about failures or delays in order execution, account accessibility, and other issues overwhelming the firmís compliance department?
If the answer to any of these questions is "yes," then what are firms doing about it? It doesnít take a regulator to tell you what unhappy customers mean to a companyís future, or more broadly, to the future of on-line investing.
Second, all firms -- whether on-line, discount or full service -- have an obligation to ensure the best execution of their customersí orders. Thatís not just good business practice; itís a legal obligation. Firms have this same duty to their customers to find the best prices -- whether they charge $10 per trade or $100 per trade.
The Commission has long stressed to firms the importance of obtaining the best possible price when they route their customersí orders. They simply canít let payment for order flow or other relationships or inducements determine where they do business. Thatís why I have directed our examiners to focus in on firmsí order routing practices in an examination sweep. I urge all firms now to review their practices to ensure theyíre doing right by their customers.
Third, firms need to communicate more clearly to investors. We have reviewed the disclosure in account agreements both on paper and on web pages. Overall, we found that most firms address the different types of orders available, fewer firms discuss how market volatility and the use of margin can affect on-line investors, and almost none talk about the risks or what to do in the event of system capacity and outage problems. I know that customersí orders can be slowed down for reasons outside of a firmís control. But explaining clearly to customers rather than merely disclaiming liability through complex and legalistic language would go a long way toward reducing the complaints pouring into the SEC, Congress and firms.
So, to every on-line firm I challenge you to meaningfully communicate with your customers. Talk in realistic terms; let them know their options; and focus on the quality of your disclosure in your agreements, instead of just the acceptability of them.
Lastly, I worry about how some on-line firms advertise. Quite frankly, some advertisements more closely resemble commercials for the lottery than anything else. When firms, again and again, tell investors that on-line investing can make them rich, it creates unrealistic expectations. And, when firms sow those grandiose and unrealistic expectations, they stand a good chance of reaping the adverse results when many of them go unmet.
Now, in todayís Bull Market, there may be an increasing population of tow truck drivers who now own their own islands as a result of on-line investing. Assuming thereís not, I donít rule out the fact that some of these commercials are tongue-in-cheek. But, in a market environment where many investors are susceptible to quixotic euphoria, Iím worried these commercials step over the line and border on irresponsibility.
I recently saw one commercial that showed two women rushing in from their jog to trade before the stock market closed. After a few clicks of the mouse, one woman proclaims, "I just made $1700." The other woman sheepishly replies by admitting she invests in mutual funds. Whatís the implication of the message here? Has it become passé to invest for the longer-term and to diversify your risk?
Now, some may argue that we shouldnít tell firms how to sell their products as long as its lawful. I agree. But selling securities is not like selling soap. Brokers have always had duties to their customers that go beyond simply "buyer beware."
Iíve asked the NASD regulatory unit to hold a roundtable on advertising to add to the work theyíre already doing to improve fairness in advertising. I call on all of the firms to join in this effort. Iíve also asked Jay Chiat, former head of the advertising firm, Chiat Day, to work with the NASD and industry leaders to consider the public interest issues this type of advertising implicates.
WHAT THE SEC IS DOING
Today, Iíve talked about what investors need to be aware of if they invest over the Internet and Iíve also discussed some of the issues firms should be addressing. As technology recasts our markets and helps attract more and more investors than ever before, the SECís mission to protect investors and maintain market integrity remains absolute.
Securities fraud perpetrated over the Internet represents a signal challenge for the SEC. While the scams we have seen on the Internet are the same basic frauds that have always accompanied the flow of money, the Internetís speed, low cost and relative anonymity give con artists access to an unprecedented number of innocent investors.
Policing this marketplace will require more resources, more manpower, and more money. Nevertheless, we are prepared to do whatever is necessary to help protect investors. While we contend with the Internetís growing presence, it offers us important tools to track down and catch criminals. Law enforcement will tell you that itís a lot easier to catch someone who uses the Internet than the telephone. For example, although the individual who perpetrated last monthís news hoax about a corporate takeover tried to cover up his footprints, we tracked him down within a week.
Last year, we created the SECís Cyberforce -- a specially trained nationwide corps of 125 attorneys, accountants and analysts tasked with searching for Internet fraud. This year, we will increase that number by 100 percent. For next year, the Commission has asked for an $11 million increase to expand our efforts to combat fraud. And, with the support and insight of Congressional and Administration leaders, we will continue to step up our efforts in the future.
In the mean time, we are vigilantly pursuing those who seek to take advantage of innocent investors. In the next two weeks, the SECís Enforcement Division will present a number of cases charging fraudulent offerings over the Internet. These cases would charge issuers and promoters with making false claims about companies or offering investments in entirely fictitious companies. We have also been working with the FBI on a project called "Operation InvestNet" -- a nationwide initiative to address fraudulent securities activities taking place over the Internet.
Second, the SECís Office of Compliance and Inspections will continue to inspect firms offering on-line trading. Weíve already conducted inspections of firms that represent 80 percent of the market share. Based on our initial findings, I sent a letter this morning to all of the on-line brokerage firms asking them to improve the quality of their disclosure to investors. When firms achieve the highest quality of service and continually act in the interests of their customers, they create a customer for life -- instead of just another short-term trading opportunity.
The SEC and the self-regulatory agencies are also inspecting all of the brokerage firms that specialize in day trading. Clearly providing day trading opportunities is not itself against the law, but these firms should be on notice that they are still broker-dealers and must operate within the existing rules. That means complying with disclosure, capital, margin, and best execution requirements as well as maintaining updated and comprehensive books and records. And any firm, whether day trading or on-line, that recommends a type of investment strategy or customizes research should ensure that it is suitable for its customers.
Third, Iím announcing today the formation of a formal SEC private sector Advisory Committee on Technology. The Advisory Committeeís mandate will be a broad one. It will encompass not only how the Commission might better leverage its resources to protect investors and safeguard market integrity, but also examine issues specifically relating to on-line trading. Iíve asked General Ken Minihan, former head of the National Security Agency and Bran Ferren, a true innovator in technology, to lead this effort in lending cutting edge expertise to the SEC.
As its first priority, I will ask the Committee to convene a group of industry executives to hear their thoughts and concerns about how technology will affect our markets and its participants.
Fourth, the Commission is unveiling its new Investor Education Web Page. The Web site is www.sec.gov/investor.shtml. It includes detailed information and tips on on-line investing, how to detect fraud both on and off the Internet and other important information on saving and investing.
In addition, in the letter that I sent to on-line firms, I have asked them to create links from their web sites to the SECís investor education site. This is an idea that came up during a Senate hearing on this subject. I hope we can all agree that an informed and knowledgeable investor is good for the industry and good for individual businesses.
Lastly, I want to raise some points about chat rooms, which increasingly have become a source of information and mis-information for many investors. They have been compared to a high-tech version of morning gossip or advice at the company water cooler. But, at least you knew your co-workers at the water cooler. That just isnít true on the Internet. And, I hope investors recognize that.
I wonder how many chat room participants realize that if someone is waxing poetic about a certain stock, that person could well be paid to do it. For the future sake of this medium, I encourage investors to take what they see over chat rooms -- not with a grain of salt -- but with a rock of salt. By doing so, you protect yourself and you protect the Internet.
Iíve asked the major Internet providers who host these chat rooms to place a link to the SECís website where investors can learn more about on-line investing and file a complaint with us if necessary. I want everyone in a chat room to know that if someone is taking advantage of the technology, you have the opportunity to shine the light on it. Think of it as neighborhood watch on the Internet. With the help of investors, we can get those people who have only one motivation -- to ruthlessly make money at the expense of others -- out of our communities.
The SEC will do everything it can to protect and inform investors during this time of great innovation and change. But, Iíve said many times before that investor protection -- at its most basic and effective level -- starts with the investor. In this day and age, there simply is no substitute for a personís awareness and wariness.
Many of the issues I have raised today were not even a blip on the screen a few years ago. Who can confidently say what on-line issues will demand our time and attention in the future? But we wonít stop examining and thinking about how the Internet will affect investors and our markets. Through the efforts of Commissioner Unger who is spearheading the Commissionís work on technology issues and the rest of the SEC staff, we are going to do our best to ensure investors remain protected and our markets remain the strongest in the world.
All of us are participants in an extraordinary social phenomena. The democratization of our markets is a desirable development which regulators should not frustrate. Our mission is not to prevent losers or to modulate the sometimes mercurial movement of our markets. The standard by which we will determine our methods of surveillance, education, market structure, disclosure and , if need be, enforcement will be an unyielding commitment to the well being of investors. I call on all market participants, the media, fellow regulators and lawmakers to help us fulfill this commitment by working together to make the 21st Century defined as much by trust as technology.