Speech by SEC Chairman:
The Future for America’s Investors –
Their Rights and Obligations

by  Chairman Arthur Levitt

U.S. Securities & Exchange Commission

Investors Town Hall Meeting
Arch Street Meeting House
Philadelphia, Pennsylvania

January 16, 2001

Thank you. And I thank Philadelphia Inquirer for demonstrating their commitment to investor education and community service by sponsoring today's Town Meeting. The Inquirer's news and advertising support was the best I've ever seen, and is largely responsible for tonight's wonderful turnout. Before we begin, I want to recognize some local students for their outstanding participation in the Stock Market Game, a program that gives students real life experience in the financial services industry. From Woodrow Wilson Middle School: Billy Yeager, Byrum Slaughter, and Jason Adams. And from Mount St. Joseph Academy: Colleen Strawhacker, Alina Ispas, Shubha Soni, and LaDonna Suber. Let's give them a round of applause.

When I look upon all of you here tonight, I can't help but think back to the first Town Hall we ever did. It was a little over six years ago, in Cherry Hill, New Jersey, where I spoke to a relatively small group of older investors. Since that time, I've conducted forty-two of these investor meetings across the country. And I have been thrilled to see people of every age, income, background, and level of experience attend. These town meetings have been one of my greatest rewards during my eight years with the Commission. In many ways, however, I view this meeting as my most important.

Tonight, we gather in the very city where our rights – as individual Americans – were first enshrined. And so I could think of no place more fitting than the city of America's birth to talk with you about your rights as individual investors. Today, in Washington, D.C., you'll hear a lot of talk about the needs of the big brokerage firms, accounting firms, mutual fund complexes and exchanges. Now, many of these issues are indeed important to our markets. But, you'll less often hear about the specific needs and rights of America's individual investors.

Both in the private sector and during my time at the Commission, I've come across a number of instances that, quite frankly, do not honor an investor's rights. Instances where conflicts of interest cast doubt on the motivation of a broker, analyst, or corporate manager; where hidden costs hurt an investment's bottom line; where "spin" and "hype" mask the true performance of a mutual fund; and where accounting tricks and sleight of hand dress up a company's financial results.

At the same time, however, it has always been about more than what we are "owed" in this country. In a democracy that prizes the initiative and promise of the individual, it's not enough to talk about your rights, but also your obligations. As an investor, you certainly have the right to be treated fairly, to get straight answers to straight questions, to know what you are buying and what you are paying for it. But as an investor, you also have an obligation to ask questions – many questions – to seek out information, and contemplate your own tolerance for risk.

Let's begin with the first step for a lot of investors: selecting a broker. The very first question that a person should ask his or her broker is "How do you get paid?"

Commissions reward a broker for the quantity of his transactions, not necessarily the quality. That means the more times your broker trades in your account, the more money he or she makes. Study after study shows that the more times you trade, the less money you make. So if you are paying your broker through commissions, your interests may not be necessarily aligned with your broker's – and sometimes that leads to trouble.

Some firms offer alternatives such as a flat fee, or a percentage of your assets under management. So ask your broker: Do I have choices about how to pay you? Does it make sense for me to pay by the transaction? Or should I be paying a flat fee regardless of the number of transactions? If you don't get a straight answer, or one that makes sense for you, take your business elsewhere.

You should also ask your broker if he or she gets paid more for selling one product vs. another, mutual funds vs. stocks, or the in-house brand of mutual fund vs. another. Any product that comes out of a firm's own holdings may have an extra incentive attached to it. Your broker could be on his or her way to Hawaii right now because you bought the product of the month.

You have a right to a broker that works in your best interest, and to financial advice that is not tainted by salesmanship or self-interest. But you also have an obligation to find out how your broker gets paid, to ask the uncomfortable but important question – "What's in it for you?" It's also your obligation to find out what types of investments make the best sense for you.

Now, let's say you've found a broker and you want to buy or sell a stock. You call up your broker and place the order, or simply go on-line and do the transaction yourself. But have you ever thought about what actually happens to your orders after you click "Submit?"

Many investors know little about how their orders are handled. In fact, some think that when they place an order on-line, they are actually sending it directly to a stock exchange. That simply isn't the case.

When you place an order with a broker, he or she often has choices of what to do with it. Brokers can send it to an exchange such as the New York Stock Exchange, to a dealer market such as Nasdaq, to a smaller electronic market called an ECN, or even make the trade with their own inventory of stocks. In each case, the market that receives your order makes money by executing your trade.

Now, suppose you're a broker holding something that many different markets want. What do you think is going to happen?

I'd like to see a show of hands – how many of you have ever heard of "payment for order flow?" That's where your broker is paid by a particular market to have your order sent to it. But, as you can imagine, this may not always be in your best interest. If your broker's decision about where to send your order is being influenced by payment for order flow, the first thing on his or her mind may not always be getting you the best price.

Now, I understand that order execution is not something many investors have focused on or even fully understood. But consider this: If your order is executed just a nickel better than the best price advertised, the benefit to you is $25 on a five hundred share trade. That's three times the commission that some on-line brokers advertise today.

Some markets will do better than the best advertised price. You can bet that your broker doesn't pay the sticker price when buying a car, so shouldn't he or she do a bit of negotiating when deciding where to send your order? The truth is, the race to having brokers bargain for better prices won't happen unless you fire the starting pistol. Later this year you are going to get that chance.

New rules will soon require markets and brokers to disclose their performance in executing your order – that is, how often they beat the best advertised price, how fast they execute your trades, and how often your limit orders get filled. Most importantly, you will be able to determine who – you or your broker – is the one profiting from where your order is sent.

But while the law tells brokers they must do what's best for you – that's your right – it's up to you to decide what that means. Now, you can't have it all. We all know it takes time to negotiate a better price on a car, and the same is true with our securities markets. With the new disclosure, you may see that those markets that deliver the best prices may not always be the fastest, and visa versa.

Ultimately, it's your decision to make the trade-off between speed and price in a way that best serves your interest. The more you know about how markets measure up, the more you will be able to hold your broker's feet to the fire when he or she is deciding where to send your orders.

Now for most investors, the issue is not just how you trade, but what to invest in. Many have decided that Certificates of Deposit, or CDs, are the way to go. But CDs are no longer the safe, straightforward investment vehicle they once were. "Brokered" CDs now can have 20-year terms, and are often "callable." This means the bank – not you – can redeem them if interest rates fall.

Recently, we've seen an increase in complaints from elderly citizens who have been sold long-term CDs. Too often, investors confuse the statement "one year, non-callable" with the maturity date. Then, when they try to cash-in the CD after a year – for example, to meet an unexpected medical expense – they discover the maturity date exceeds their probable life span.

CDs may also have new features, such as variable rates and hefty fees for early withdrawal. Or they may have no fee for early withdrawal, but you have to sell them for a big loss if you want to get out. As investors, you need to read the fine print to understand what you are buying. Ask: Does this make sense for my investing time frame? Are there any penalties if I have to get my money back sooner than expected?

Many more investors have chosen mutual funds as an effective way to diversify risk. Nearly 50 percent of U.S. households own them. But just because you buy a mutual fund doesn't mean it's time to let your guard down. In my own experiences as a broker and regulator, I've come to believe that when you buy mutual funds, you may not get what you pay for.

Much of the mutual fund growth in recent years has been fueled by some of the sales and advertising practices today – ads for the "hot new fund" boasting returns of "over 100 percent." But a lot of funds advertise their returns as of the end of the most recent quarter – even though those returns have deteriorated substantially since then. We've even seen funds citing one-year returns ending with dates like April 13 or May 3 or June 10.

Now if your investment strategy coincides with the Chinese calendar, or somehow targets the time period between Sadie Hawkins Day and National Flower Week, maybe these time frames make sense to you.

The truth is, these windows may be carefully selected by the mutual funds to reflect those times when funds have reached their best returns. By the time the ads appear in print, however, the very opposite may be true.

Don't get caught up in the past performance hype. Maybe a fund invested early in a few successful IPOs giving it unusually high returns. If it's a small fund, this would boost the overall performance even more as each stock accounts for a larger part of the total fund. Or maybe a fund had an extraordinary year or two, but over the longer term, has not done as well. Research and know what you are investing in. Remember what folksinger Pete Seeger once said, "Education," he said, "is when you read the fine print; experience is what you get when you don't."

And don't rely on a fund's name as the only source of information about its investments and risks. If you consider yourself a "value investor," don't just buy a fund with the word "value" in it. Your definition of value may be stocks that pay regular dividends; the fund manager may interpret it as beaten-down Internet stocks. As the winds shift direction, you shouldn't be surprised to see what was called yesterday's tech fund is now today's value fund.

The Commission recently adopted new rules to prevent investors from being misled by deceptive fund names. Funds with names suggesting they hold certain types of investments – such as the Acme Health Care Fund, the Acme European Stock Fund, or the Acme Government Securities Fund – are now required to invest at least 80 percent of their assets consistent with their name.

Now, it's your right to have fund names that accurately reflect their holdings, and to receive a prospectus from the mutual fund you are considering buying. But it's your obligation to review that prospectus before you invest, and to look at the specific types of companies the fund manager is buying.

Often, when investors focus too much on past performance, a fund's name or hype, they pay too little attention to how management, sales, and other costs can impact their investment over time. The founder of Vanguard, Jack Bogle, has called this concept the tyranny of compounding high costs. Now, for those of you who think "tyranny" is too strong a characterization, consider Jack's favorite illustration of what fees can do to your investment over time.

A $1,000 mutual fund investment made in 1950 with returns mirroring the S&P 500 would be worth over half a million dollars today. But, before you start shopping for the yacht, there's still a bit of math to do.

After you figure in the compounding costs of mutual funds, conservatively a little under 2 percent, that figure is reduced to just $230,000. If the fund is not meant to be tax efficient, that number drops to – if you can believe it – just $65,000. Without paying attention to costs, an investor stands a better chance of earning a million dollars as a contestant on "Survivor."

Ben Franklin once said – which you can read for yourself in the little black book we've provided for you today – "Beware of little expenses; a small leak will sink a great ship."

It has been recommended that the Commission require that fees' impact be made more visible, and that funds show the effect – in dollar amounts – that fees have on actual returns in your shareholder reports. In the meantime, it takes only minutes to use the SEC's Mutual Fund Cost Calculator to compute how the costs of different mutual funds add up over time. You can find this calculator at www.sec.gov in the section on Investor Education and Assistance.

In recent years, we've also seen a surge in a practice called "switching." That's when your broker sells your holdings in one mutual fund or annuity, and uses the proceeds to buy another. Problems arise when industry professionals – in order to line their own pockets with extra commissions – induce investors to "switch" funds, even if the costs to investors greatly outweigh the benefits.

A few months ago, the Commission alleged, for the first time, that a broker-dealer and financial advisor used false performance comparisons to justify switching in variable annuities. As a result, investors allegedly paid more than $168,000 in unnecessary sales charges and even lost some of their original investment. The brokers, on the other hand, earned an extra $210,000 in commissions.

"Bonus annuity programs" have also caught investors' attention. In these cases, investors are given a credit up front in the form of waived fees or extra money for every dollar they invest. Certainly sounds good. As you can imagine, these products have grown at more than twice the rate of total variable annuities.

I've been around our markets long enough to know that if someone is offering you free money, cover your pockets and run. The truth is, these bonuses often are not only offset by hidden or back-end costs – they actually end up costing you more. Extra costs might include inflated charges if you decide to sell your stake, or extra-high operating expenses.

Not surprisingly, as competition for your dollar has increased, many investors switch brokers or fund companies to handle their portfolios. An account transfer should take place within days. More often, it takes months.

Part of the problem is that sometimes an investor holds a specific mutual fund not carried in the inventory of their new broker. In that case, you may have to sell off that particular fund. Unfortunately, some funds and brokers aren't even bothering to tell investors this important fact.

Even transferring stocks can be difficult. If your securities salesman makes a mistake on the paperwork, your account won't transfer. Your entire account stays in limbo. You can't trade. After months of waiting and dozens of phone calls, too many investors are finding that nothing happens.

It's become increasingly clear that too many brokers and mutual fund companies are dragging their feet when it comes to transferring an individual investor's account. I know of specific cases where investors have just given up altogether trying to transfer their accounts.

Here's what you can do. First, ask your new broker or mutual fund advisor what specific investments will or won't transfer. Ask how long a transfer should take. Second, if your account doesn't transfer when it should, complain in writing to the compliance officer of both your current and future firm. And, be sure to "cc" the SEC when you do.

You have a right to a timely transfer of your portfolio. And in this instance, the firms have anobligation to fix their paperwork to make it right.

Now, more and more, it's not just separating good information from the bad – often, it's a question of gauging objectivity or bias. In many respects, a culture of gamesmanship has taken root in the financial community making it difficult to tell salesmanship from honest advice. And that means, more than ever, investors must stay on their toes. How many of you have seen analysts from Wall Street firms on television talking about one company or another? Many of you probably have not thought twice about that person's recommendation to buy a particular stock. But you should.

A lot of analysts work for firms that have business relationships with the same companies these analysts cover. Some analysts' paychecks are tied to the performance of their employers, who make a lot of money underwriting or owning those stocks. You can imagine how unpopular an analyst would be who downgrades his firm's best client. Is it any wonder that today, a "sell" recommendation from an analyst is as common as a Philly steak sandwich without the cheese?

Just last month, we received a complaint from an investor who bought shares in an Internet retailer, based on the recommendation of a reputable Wall Street analyst. As the price continued to drop, the analyst continued to recommend: Buy. Only after the company claimed it might go out of business soon did the analyst downgrade the stock. But, as you might have guessed, he refused to comment further based on an investment banking relationship with the company, while that investor lost money.

Recently, the New York Stock Exchange and the NASD committed to improving disclosure by analysts both on television and in written reports in the near future. It's your right to know when conflicts exist. And while I can't say it's your obligation, I would ask every investor to help bring pressure to bear on these markets to ensure that greater disclosure is soon a reality.

In today's marketplace, companies are under extraordinary pressure to meet Wall Street earnings expectations. While these estimates have always been around, the quest to beat these numbers has ascended to an almost mystical importance.

We've all seen one analyst or another on television or in the newspaper saying he or she expects the company to come out with "such and such" earnings by the end of the quarter. And, we all know what happens when a company fails to meet those short-term expectations – the stock gets hammered.

It's no wonder that many companies – even some of the biggest public companies in this country – dress up their financial performance to look prettier than it really is. Unfortunately, you can't just blindly accept the statement in a company's press release that it was profitable. On closer inspection, you may find that just isn't the case.

Here are some warning signs to watch for. First, look for companies that have a real affinity for earnings press releases that highlight in the grandest terms "pro-forma" earnings. Unlike these press releases, which sometimes seem to spin straw into gold, a company's SEC filing must include what it actually earned and what is expensed. But in a press release with so-called "pro forma" numbers, some companies wax poetic about just the earnings side of the ledger, and ignore costs that may tell a story of impending dangers.

So what you may end up with is a nice, big earnings number that, at first blush, makes the company look quite profitable – more profitable than it really is.

The second way companies play games with earnings is to shift your attention away from the bottom line to words such as "cash earnings per share" or "EBITDA" – earnings before interest, taxes, depreciation and amortization. For some companies, these substitutes for the real bottom line are just a way of saying: "Don't look at our true earnings. Let us take you to a special place, where you never have to diet, say you're sorry, or sit in traffic."

Now, sometimes these numbers can be a legitimate measure for companies with mature assets. But all too often, they're being used as a diversion for companies with negative earnings. We've all heard that old saying that, "You take the good with the bad." Unfortunately, some companies think you can "sell the good and ignore the bad."

Another thing that affects a shareholder's bottom line is dilution – when management awards options or stock as compensation. Now, this form of compensation may serve shareholders well, but don't forget – options and stock grants spend shareholder money. Isn't it only right that you have a say in the decision to grant these options? Nasdaq has solicited public comment to decide whether shareholder approval should be required before management quietly awards stock and options to itself. Make sure your voices are heard on this question of fundamental fairness and good corporate governance.

You have the right to decide whether your interests should be diluted, and to clear, understandable, and most importantly, accurate information about a company. In the last 8 years, the SEC has pushed companies, broker-dealers, investment advisors, and mutual funds to communicate with their customers in Plain English. Instead of talking above the heads of investors with legalistic words, these same groups must now communicate with the public in sentences everybody can understand – not just corporate lawyers.

I'm proud to say that Plain English is now more the rule than the exception in today's disclosures. That's due in no small part to Bill Lutz, a professor from Rutgers here with us today, who was instrumental in developing the Plain English guidelines. But it's up to all of you – it's your obligation – to take advantage of this newly accessible information.

How many of you have gone to the SEC's web site and pulled down a corporate filing? There are few exercises more worth your while, and I'll tell you why. By reading a company's annual and quarterly reports, you can determine how much money the company made over the last year and how much is profit. You can find out how much cash, inventories, and debt the company has. You can figure out how much money the company is really making as it works through operations, makes investments, and borrows money. Much of this information is in the text of the filing, so you don't need to be an accountant to get the facts.

And getting the facts could not be more important in a day and age when we are bombarded with more information than ever before. That's due, in no small part, to the Internet, which in many respects has leveled the playing field and empowered America's investors.

But beware, the Internet – with its low cost, anonymity, and large number of innocent investors – also makes it ripe for out-and-out fraud. Chat rooms are a case in point. Chat rooms increasingly have become a source of information – and misinformation – for many investors.

I'm sure most of you probably heard about the 15-year old who had his own "pump and dump" scheme going. This young boy would get on message boards, say favorable but false things about little-known stocks, and then watch the stock price – and his own stake – soar. He would even place limit orders to sell his shares while he was at school. That's not something we should tolerate in our marketplace, and on an even deeper level, not something we should be encouraging in our children.

Conclusion

In recent years, there's been growing talk about the rise of the so-called "investor class" and its impact on politics and policymaking. Usually such talk revolves around the issue of tax cuts. That's unfortunate because there are any number of issues that are being discussed in Washington at this very moment that directly affect all of you as individual investors. What will the future structure of our markets be? What type of disclosure for mutual fund fees is best suited for investors? What accounting practices are most consistent with transparency and full disclosure?

You have the right and the obligation to have your voice represented at the table when these issues are being discussed. So, whose job is it to represent you? Certainly, the SEC, your state regulators and Congress each have a responsibility. But it's you who hold each of them accountable.

Just about every day, one special interest group or another in our markets is up on Capitol Hill persuading one Congressman or Senator why a certain issue is important to them. If it's important to them, you can bet that, more times than not, it's important to you. I would ask each of you here today to look out for your interests. Do you know that employees at the one agency whose sole mission is to protect investors are paid less than their counterparts at other federal agencies? That's not in your interest. Do you know that there is only a small handful of members of Congress who associate themselves with investor protection issues? That's not in your interest either.

Remember, these are your markets. You – the individual investor – have risen to become a force America's marketplace cannot ignore. But it's up to you to not give back an inch of the ground you've taken. Fortunately, you are armed with the tools to hold your ground. You have access to financial news, stock quotes and pricing information; to corporate filings and financial disclosure. You have the ability to know how your trades are executed, and what your options are. You can pick up a prospectus and sift through the facts in Plain English. And with the Commission's new rule, Regulation FD, for Fair Disclosure, you now are privy to the same information, and at the same time, as analysts, investment bankers, and every other professional on Wall Street.

In short, you have the ability to be the most informed and empowered investors in the history of our markets. And it is the application of your knowledge, your skepticism, your enduring vigilance as investors that will do more for the underlying fairness and health of our markets than any other force in our markets.

Say no to companies that play games with their earnings, who practice balance sheet cosmetology. Say no to option grants in the dead of night to executives; to executives who treat their companies as their personal play things; to mutual funds deceptively named or promoted; to fund managers who surreptitiously inflate returns through portfolio pumping; to trading systems or practices that favor brokers instead of their customers; to Internet fraudsters, high pressure sales tactics, get quick rich schemes, and those who prey on the elderly by hawking high-risk securities; to analysts that never met a stock that they didn't like; to regulators who take their eyes off the interests of investors, and politicians who care more about corporate interests than individual investors; and to members of Congress who vote to muzzle the FASB – an independent standards setter.

Say yes to lawmakers who take the time to understand what makes our markets work. Say yes to brokers and mutual funds who care about your long-term trust rather than short-term dazzle. Say yes to companies who don't let their financial reporting bend to the tune of Wall Street's quarterly dance. Say yes to management who understand they work for shareholders. Say yes to members of Congress who rigorously support the independent standard setting process. Say yes to corporate directors who demand that the company's auditors act as the guardians of the public interest, rather than cheerleaders for management. And above all, say yes to informed, careful, realistic, skeptical and long-term investing.

Thank you.

http://www.sec.gov/news/speech/spch457.htm