"A Good Year for the Markets, A Busy Year for the SEC" Remarks by Chairman Arthur Levitt United States Securities and Exchange Commission SIA Regional Firms Committee Chicago, Illinois -- May 6, 1997 This past year has been monumental for the industry and for the markets. A major revision of the securities laws was enacted. The SEC concluded its case against the NASD. And Wall Street has done very well. The Dow broke 6,000, and then 7,000. IPOs are running at a record pace -- in 1996, you raised some $50 BILLION for new businesses. Think of all the jobs that represents. According to SIA figures, 1996 set an all-time record for profits. Return on equity is higher than at any time in the last decade. Underwriting of equities continues at a furious pace -- 1996 saw an all-time record of $152 billion. The daily volume on the New York Stock Exchange and Nasdaq is also at an all-time high. And not only are mutual fund assets at a record level of $3.7 trillion -- that figure surpasses the amount Americans have on deposit at commercial banks, $2.6 trillion. For the capital markets, last year was one of the best in history. Some people look at this happy scenario of record highs and see proof that the markets are strong, that nothing is wrong with the industry, that the SEC ought to leave everything alone. Why, then, was 1996 such an active year for us? Because it's not at the heights that a market is tested -- it's at the downturns. And a downturn is the worst time to try to fix problems in the marketplace. As President Kennedy once said, "The time to repair the roof is when the sun is shining." There is a universe of investors out there who have never been tested -- whose only experience has been a bull market. We have to take advantage of good times to educate these investors and make sure our markets are as trusted, efficient, and professional as possible. Our actions in the Nasdaq market are a case in point. Nasdaq is a powerful engine of growth. But some within it apparently forgot that markets exist by the grace of investors. There will always be incentives to act in ways that are not in investors' interests. If not policed, then over time, people in the industry can come to believe that there is no conflict of interest; they can develop an ethical blind spot, and even form a new "ethic" that makes it OK to cheat. It's essential for all of us -- the SEC, the SROs, and the firms -- to take a step back from time to time and re-evaluate how business is being done. In the case of Nasdaq, the SRO wasn't always there to ensure that investors' interests came first. So we had a much bigger problem than we should have. There's an irony here: Congress expected SROs not only to enforce the law, but to induce higher ethical standards than the law could mandate. A strong and vigilant SRO should catch things earlier, preventing problems and sparing headaches all around. The SEC and the NASD are now taking steps to bolster investor confidence in our markets. We want to ensure that the NASD moves into the next century as a staunch defender of investor interests and that Nasdaq remains a vibrant marketplace. The SEC's order handling rules will reinforce the settlement and help protect investors in all markets. I think we can all agree that the rules are bringing about fundamental change to the NASDAQ market. We are studying the impact of the rules on the markets and early signs are very positive. Since the rules were implemented, the markets have witnessed a historic decline in spreads. Some reports have put the decline at better than 30 percent. And all this, with no significant decrease in liquidity or increase in volatility. This is great news. It means that investors are getting better prices, which was an important goal of the rules. The markets have become fairer for all investors, and I truly believe that in the long run this increased fairness and openness will be to everyone's benefit. Some predicted an operational "melt-down." It didn't happen. But that is not to say that the road has been free of bumps. My experience in running a large firm during the tempestuous transition away from fixed commissions attests to my awareness that the profitability of firms is essential to the maintenance of liquid and competitive markets. Fundamental change never comes without some pain. But I think the Commission staff has bent over backward to do what it can to make the transition a smooth one. We want to continue to work with you to make this happen. I believe that the changes now taking place will result in the strongest, most innovative, and best-led markets in history -- and I'm personally dedicated to making them so. One unpleasant note I want to raise: There have been complaints that the Order Execution Rules are being abused by some to take unfair advantage of the new requirements. Let me assure you that the Commission has a "zero tolerance" policy for attempts to undermine the rules, no matter who the perpetrator. There's another thing we have zero tolerance for: the con men and criminals attracted by the great success of the securities industry. These people only seem to get the message when the door to a jail cell slams shut behind them. Today, the SEC is only too happy to accommodate them. You may have read about a sting operation conducted by the FBI, working in close cooperation with the SEC and the NASD, in which 46 stock promoters, company officials, and current or former brokers, were charged criminally for illegal kickbacks to brokers for sales of over-the-counter and NASDAQ stocks. The SEC also brought 22 administrative proceedings against 29 of the individuals charged criminally. Along with last year's arrest of a number of rogue brokers, this was the second major action we've taken with the Department of Justice during my tenure. It will not be the last. We will show no mercy to predators who prey on the public's trust. I don't want to give the impression that making life hard for con artists is ALL we do. This past year, we also worked to make life EASIER for some people -- those we regulate. The recent signing of the National Securities Markets Improvement Act will make our rules and laws work better for all of you without sacrificing important investor protections. Thanks to flexibility and bipartisan leadership on Capitol Hill, as well as the cooperation of the industry and state regulators, we ended up with a revised bill that can fairly be described as a milestone: * Redundant regulation of mutual funds by the states has been eliminated; * Redundant regulation of certain listed securities has also been eliminated; * Rules that once constrained broker-dealer borrowing have been liberalized; * The SEC will be responsible for supervising large investment advisers, while the states keep an eye on the smaller ones; * The SEC budget has been put on a more solid footing, and the fees we charge will be reduced by some $850 million over the next 10 years; and * Books and records and capital requirements will become uniform throughout the land. I thank the SIA for engaging constructively in the dialogue with state regulators and Capitol Hill. Nor was this the only area in which we collaborated in the past year. The SEC continued its strong emphasis on investor education, through brochures, the Internet, seminars, and town meetings. The SIA has become a permanent partner at these meetings, helping us pull them together and sending us Mort Wagner and D'Arcy Fox to lead one of the most popular seminars. Of course, not every issue works out as well as the ones I've mentioned thus far. To put it mildly, the Commission's proposal to amend its books and records rules for broker-dealers was not warmly received by the industry. We received 175 comment letters, many complaining about the costs. Perhaps the biggest target was the requirement that brokers record the percentage of a customer's capital dedicated to speculation on the account statement. Some have also complained about the requirement that the investment objective be updated annually. I want to assure you that we're reviewing ALL comments. Members of the Commission's staff have already met with state regulators and we plan to meet with people in the industry to see if we can come up with a proposal that all of us can live with. By working together, we've achieved many things that will serve investors for decades to come. And if we continue to work together, we'll do much more. There's no lack of issues for us to deal with in the closing years of this century. Let me sketch out some of the items on our very full agenda. The SEC will continue to remove impediments to capital formation, starting with our own rules. Last year, our Task Force on Disclosure Simplification recommended that we eliminate or modify fully a quarter of our rules and half of our forms related to corporate finance. We've already eliminated 44 rules and 4 forms; more will go this year. We're also considering ways to improve the securities offering process. In a far-reaching effort last year, the Commission sought public comment on some of the fundamental concepts governing offerings. Several possible reforms were described, including the idea of "company registration" put forth by the Advisory Committee on Capital Formation, led by SEC Commissioner Wallman. I approach this challenge with an open mind. You play a central role in the offering process, and we appreciate your continued input on this project. As you know, another factor that can affect the capital formation process is meritless litigation. We will continue to monitor the effects of the Private Securities Litigation Reform Act, as requested by the President. I still believe the new federal law should be given time to work before further major actions are taken -- such as California's Proposition 211, which I opposed, and which was defeated by a wide margin: only 24 percent in favor, 76 percent opposed. I expect to see a profound rethinking of the way the financial markets are regulated in the next few years. Although major Glass-Steagall reform failed in the last Congress, thoughtful and important modernization proposals continue to emerge. I support common sense reform in financial services. What does that mean? Several things: It means that the agency that Congress formed to regulate securities activities should regulate securities activities. Separate the securities side from the banking side. Banking should be governed by bank regulators and securities activities should be governed by the SEC. It's been called functional regulation. I call it a system that works. Second, fair is fair. If banks are allowed to own securities firms, securities firms should be allowed to own banks. It's a "two-way street." Third, let's do away with those safety and soundness restrictions on broker-dealers that are affiliated with banks. Risk-taking by broker-dealers supports entrepreneurship and growth. Repeal of Glass-Steagall should not insulate securities firms from risk-taking. There is no reason this can't be structured in a way that maintains our commitment to protecting investors without further jeopardizing the taxpayers who ultimately underwrite federal deposit insurance. Also on the market regulation front: We are currently considering a plan to establish a new class of limited-purpose broker-dealers to facilitate derivatives transactions. It would allow a U.S. securities firm to create a single affiliate capable of acting as a counterparty for certain types of derivatives. The affiliate would be subject to modified capital, margin, and other regulatory requirements. In addition, we are working with the industry to provide qualified immunity for disclosures made in good faith on form U- 5. It is in everyone's best interest that the information on Form U-5 be complete and accurate. From a broker-dealer's perspective, it can help identify problem employees before they are hired. From a regulator's perspective, it can help locate trouble spots in the industry. And from an investor's perspective, it can be an invaluable tool in selecting a professional with whom to entrust your life savings. But let us not forget that, from an EMPLOYEE'S perspective, if the information is not accurate or complete, it can also ruin a career. I think that the best approach for all concerned is to protect those brokerage firms that act in good faith to provide information on Form U-5. The legal types are calling it "qualified immunity," but I call it a fair deal for firms that are trying their best to do what's right. Will it give firms a license to make claims about former employees that they can't back up? Not on my watch. The NASDR and other regulators are working with the industry to come up with a workable solution. The Commission's attempts to stay at the forefront of technology continue. One important area has to do with electronic communications -- especially what e-mail to keep and what to discard. We think we've taken a common sense approach with our "business as such" policy. If you choose to sort e-mail, you need keep only those that relate to your business as such. If the message is about lunch plans, tennis dates, and the like, throw it out. There's been a related development: The NYSE and the NASD have proposed rules to change the way in which broker-dealers supervise their registered representatives' communications with customers, including their e-mails. Under these proposals, firms would no longer be required to review ALL outgoing correspondence, but instead could adopt "reasonable" supervisory procedures for review. It sounds good in principle. We would add some MINIMUM supervisory requirements to permit compliance inspections. We have also asked these SROs to continue to require supervision of all incoming customer correspondence in non- electronic form. This will help protect against misappropriation of customer funds and help ensure that customer complaints don't go unheard. You'll see us address several other issues this year: We'll keep up the focus on coordinating examinations with our fellow regulators -- indeed, I'm told that, since we began this initiative, 85 percent of the firms that have requested coordinated New York Stock Exchange-NASD exams have gotten them. And we'll continue our common effort to enhance diversity in the industry. It's no secret that we in the securities industry haven't done as well as we should. Minorities are not adequately represented in syndicate departments, corporate finance departments, branch management, and operations. I sincerely believe that Wall Street, AND its regulators, should LOOK like America, and that's an ideal I know you support as well. The industry is making progress -- several firms have made serious efforts to promote diversity. Smith Barney, for example, recently announced an ambitious plan to tie 10 percent of every manager's bonus to their efforts to promote diversity. It's a bold experiment, one we'll all be watching. The truth is, we work in diverse markets, domestically and internationally. It makes sense for the securities industry to reflect the population it interacts with every day. In the months ahead, you can also expect to see the SEC renew its emphasis on internal controls. This is something I worried about when I ran a firm, and it's something I know you worry about, too. There have been too many instances of so-called "rogue traders" causing millions, or even billions of dollars in losses -- not to mention the demise of some well-known institutions. In my view, there would be no "rogue traders" if every firm had good internal controls and risk management systems. Our campaign to improve broker sales practices will continue, and so will our focus on supervisors, who set standards for the firm. The Joint Sales Practice Sweep we concluded a year ago found deficiencies in sales practices and in the hiring, retention and supervisory mechanisms of more than 100 firms. There is a pressing need to review systems now in place and to devote additional resources to supervision. We will continue to talk about broker compensation. The industry has made significant progress since the Tully Report. Many firms have eliminated the most problematic practices: accelerated payouts for new recruits; product-specific sales contests; and extra compensation for proprietary products. Furthermore, many firms have extended the period that trainees are paid a salary. For a time, the industry made progress in reducing up-front recruiting -- but now that progress seems to be slipping. I will continue to draw attention to this practice. I know of some firms that have reintroduced accelerated payouts. I think this is wrong. It represents a clear conflict of interest and if not made known to the customer, represents a potential taint on the firm and the industry. I call on the firms to eliminate ANY practices that can conflict with the interests of investors. Speaking of the interests of investors -- we've got to make disclosure documents more readable. The SEC will continue its effort to encourage prospectuses to speak a new language -- the English language. We'll focus on the new mutual Fund Profiles as well as better designs for both corporate and mutual fund prospectuses. This summer we'll reach another milestone in the municipal bond market when dealers put in place procedures that will result in the reporting of retail price and trade information by January 1998. Transparency has characterized our equity markets and made them great. It will strengthen our muni markets as well. Among the greatest challenges in the years ahead are those that have to do with technology. In just one year, the SEC's Home Page has become one of the most popular government sites on the World Wide Web. Our EDGAR database of corporate information, which was on the cutting edge of technology 10 years ago, is due for a major overhaul this year. Every advance in communications brings new challenges in applying the securities laws. We are racing to keep up. The Internet has already changed the face of brokerage and investment management, through online trading and other innovations. It may also redefine disclosure and what constitutes an exchange before we're through. Finally, in the next few years, we will work to widen the range of choices available to US investors by promoting the internationalization of our markets. We're making great progress. In 1990, 434 foreign companies were reporting in the US; today, there are well over 900 foreign companies, from 48 countries. We'll continue to do all we can to encourage more companies to list here. * * * I've sketched out an agenda for the years ahead. But I hasten to add that an agenda is but a means to an end. We may not agree on every plan or initiative. But there's little doubt that we agree on our goals for this industry. I think we'd all like to see an industry where brokers are as trusted as doctors, and as proud of their professionalism; Where regulators throughout the world work together to reduce systemic risk; Where brokers and firms look more like America; Where brokers sell the best product for the investor, not necessarily the most profitable product for the firm; An industry in which the SROs do more, and the SEC does less. That's the kind of industry we seek -- it's the kind that investors deserve. I look forward to continuing to work with you to achieve it. # # #