"OUR PARTNERSHIP TO IMPROVE PRACTICES" REMARKS BY CHAIRMAN ARTHUR LEVITT UNITED STATES SECURITIES AND EXCHANGE COMMISSION SIA COMPLIANCE & LEGAL DIVISION PALM DESERT, CALIFORNIA -- MARCH 18, 1996 I want to talk to you today about our partnership to improve practices -- about the problems we've faced, and the progress we've made. I come as an ally, not an adversary -- one who deeply appreciates your work as compliance and legal professionals on the front lines of self-regulation. Since I became SEC Chairman three years ago, the Commission has reserved a special place, high on its agenda, for raising sales practice standards. That emphasis stems from two factors that converged during the 1990s. First, we're witnessing a historic change in the way Americans plan for the future. Today, small investors are more likely to seek advice from brokers than from bankers, and more willing to take on higher risk for a higher return. They're taking Wall Street by storm. Consider just three statistics: * For the first time in history, mutual fund assets have surpassed commercial bank deposits. * In 1980, 30 million Americans owned stock; today that figure exceeds 50 million. * And our newest milestone: Americans now have more household wealth invested in stocks than in real estate. While this huge influx of new investors is surely a healthy development for our markets, a lot of those people are just not as informed as they should be. That's the first problem. The second problem is the inordinately low level of confidence in the industry -- which is quite different from confidence in the market. People have come into the marketplace for many reasons - - low interest rates, an expanding economy, the demise of defined benefit pension plans -- but faith in registered representatives does not seem to be one of them. Public opinion surveys have shown that of all professionals, lawyers, lobbyists, and brokers are among the least trusted. And while a November SIA survey found a silver lining -- investors were by and large satisfied with their own brokers -- it also found that investors continue to have real misgivings about the industry. We in this room know that there are valid reasons for some of these concerns. We also know that things are getting better. I believe that the industry today is more professional, more capable, more creative, and more farsighted than at any time over the last 60 years. The vast majority of brokers are honest, and the vast majority of firms guard their reputation with almost religious fervor. In recent years, the industry has undertaken initiative after initiative to protect the interests of investors; I'll go over several of these later in my remarks, but let me mention one I just learned of: Prudential and Paine Webber have agreed to make their proprietary mutual fund shares "portable." Clients who transfer from one firm to the other can now take their mutual fund shares with them. I hope other firms will follow their example. No one can deny that many improvements have been made, and I applaud each and every one of them. But no one can assert that standards in the industry are where they should be, either. We can do better. A revealing survey last December asked sales professionals in a number of industries whether they thought honesty was important to their job. Insurance salespersons led the list of those who answered "yes," with 88 percent; brokers were at the bottom of the list, with only 52 percent -- below those who sell used cars or real estate. I'm not holding that survey up as definitive, and I grant that the extent of the problem has been exaggerated. Bad brokers are a minority -- but they damage the reputation of the entire profession. We also know that the front line of defense against them is not the SEC, the SROs, or the state regulators -- it is you, the compliance officers and counsels of the firms. The SEC is not the KGB of capitalism; we can't pre-screen and monitor brokers -- only firms and SROs can do that. And in our day-to-day policing of the industry, we've found that some firms are much better at maintaining high standards than others. This shows that the tone set at the top can make a real difference -- it is managers who make the choice between an honest shop and a bucket shop. That's a crucial insight: Brokers don't set company standards; firms do. And you are the guardians of those standards. The SEC is working to create an atmosphere that empowers you, through our campaign to raise professional standards in the industry. We want to encourage a sales culture that makes the right choices. One of the ways we're doing so is by conducting periodic sweeps of the industry to weed out problem brokers -- we've done two of these during my tenure, one in 1994 and one we completed just last week. I'll reveal the findings of our latest sweep to you today, but first let me bring you up to date on the recommendations made after our earlier sweep. Two years ago, we outlined a four-part strategy to raise standards: first, stepping up enforcement; second, rethinking incentives, including compensation; third, better educating brokers; and fourth, undertaking a major effort to educate investors as well. Enforcement Efforts We said we would increase our emphasis on sales practices during examinations, and we did -- since 1994, sales practices have taken priority in our examination efforts. We also reorganized and consolidated our examination and inspection programs into a single, streamlined office, the Office of Compliance Inspections and Examinations. We said in 1994 that we would increase sanctions, and we've done that as well. We've restored meaning to the phrase "unqualified bar" by making sure that, absent the most extraordinary circumstances -- I call it the administrative equivalent of climbing Mt. Everest -- such a bar will be permanent. Since 1992, the Commission has been focusing greater attention on broker misconduct and supervisory breakdown. During that time, the number of enforcement actions against broker-dealers or their employees for fraud has increased by 50 percent, and the number of defendants in such cases has more than doubled. We've also worked with the Justice Department to put brokers who cheat or steal from their clients in jail. We said we would explore the possibility of offering firms qualified immunity on Form U-5, to address liability concerns based on claims of defamation by staff who have been terminated. One federal court has since gone even further by deciding that U-5 information is absolutely privileged. Incentives & Compensation We convened an industry-led Committee on Compensation Practices, which identified "best practices" that offer the right incentives and reduce conflicts of interest between brokers and their clients. We've since seen major firms eliminate extra compensation for proprietary products; eliminate higher payouts for new recruits; reduce up-front money; and eliminate product- specific sales contests. Broker Education We also asked in 1994 for a system of continuing education for registered representatives, and today, for the first time, every broker must take a state-of-the-art computer-based training program that is a model for other industries. Here's a statistic you probably know -- 80 percent of those selling stocks today have been at it for 10 years or less. Combine that with all the new and unsophisticated investors in our markets and you've got the raw materials for a real problem. We're working hard to avert that: Continuing education has been up and running since July, and already, some 44,500 brokers have cycled through the system. Moreover, firms are developing extensive training programs for the products they sell. Investor education Through these and other initiatives, we've been asking the industry to do more to protect American investors. At the same time, we've also been asking investors to do more to protect themselves. In the last 2 years, the SEC -- working with the industry, the states, and the SROs -- has undertaken perhaps the most far-reaching investor education initiative in its history. Using speeches, radio, television, brochures, videotapes, town meetings, and the Internet, we have reached a huge cross-section of investors and helped them become better informed about the risks and rewards of our markets. Let me cite one other positive development that has its roots in our first joint sweep: increasing cooperation among regulators. This helps all the parties at the table. For example, we've encouraged the NASD and state regulators to reach agreement on making complaints against brokers public through the CRD, and it now looks as if such an agreement is imminent. Investors will benefit from the increased information, and yet a broker's right to due process will be preserved. The dialogue established among regulators has also led to an agreement to coordinate broker-dealer examinations. The firms will benefit from reduced duplication and disruption. By working together, the industry and its regulators have done much to raise standards since our first joint sweep. Today, I want to share with you the results of our second sweep. It stands as something of a landmark, for it is the first such joint effort by the SEC, the NASD, the New York Stock Exchange, and state regulators. As in our first sweep, the brokers and firms we selected are not a representative sample; to the contrary, we targeted a pool of reps based on disciplinary or complaint histories, and movement within the securities industry. Between December 1994 and November 1995, we conducted 179 examinations at 101 different firms. One-fifth of these examinations resulted in referrals to enforcement. An additional quarter resulted in deficiency letters. In other words, we found problems in nearly half of the branches we visited. That's too many. There is still too much questionable behavior out there. Let me go over some of the specific findings: * Of the 347 registered reps selected for scrutiny, about one- third had managed -- during the one-year period of our examination alone -- to switch firms, despite a history of disciplinary actions or customer complaints. Some reps switched as many as six times in one year. Hard as it may be to believe, they still hire these guys -- too many firms are willing to turn a blind eye; * And indeed, we found that many branches conducted only a minimal pre-hiring review, such as looking at Forms U-4 or U- 5, checking the CRD, or calling the person's previous employer; * We found cold-calling violations or deficiencies in almost half of the branches that engaged in cold-calling; * And finally, in many of the branches we visited, supervisors conducted inadequate reviews of their brokers' transactions to detect sales practice abuses. Sometimes, supervisors conducted no review at all. One branch manager asserted that his registered reps supervised themselves. I'm a big fan of self-regulation, but that may be taking it just a little too far... As I see it, where our first sweep found problems among reps, our second points to problems in supervision. This is a crucial factor in ensuring good sales practices, one we've emphasized for several years. Indeed, fully one-third of our examinations found supervisory problems, in varying degrees. My experience in the industry convinced me that it's up to supervisors to create a culture in which dishonesty is not tolerated; in which mistakes, once made, are quickly found or 'fessed up; in which the long view prevails over short-sightedness, and the high road is taken over the low. It's our belief that many cases of investor fraud, if not most, really constitute two failures -- that of the broker, and that of his supervisor. Supervisory negligence permits wrongdoing. That's why, in every examination we do, we will focus on supervision -- just as, in every sales practice abuse case, we've been asking: Where was the supervisor? Did he ask the right questions? How did he let this happen? There's been some concern that every time a broker missteps, his supervisor will be charged by the SEC. That is not the case. The SEC, like every other law enforcement agency, examines the facts. We know that wrongdoing can take place even in the best- managed firms. If a firm has strong compliance procedures that have been aggressively policed, we will take that into account when deciding whether to bring failure to supervise enforcement actions. When a supervisor calls our attention to a problem broker, we'll consider that as well. But we will not hesitate to bring "failure to supervise" cases -- indeed, we're bringing twice as many of these cases today as we did in 1992. We feel it's important to send a clear signal to brokers, to supervisors, and to investors that unethical practices are simply not tolerated in this industry. In the wake of our second sweep, we're asking firms to make several changes. Hiring practices are at the top of the list. I'm sure you all saw last week's Wall Street Journal story about brokers with a disciplinary history moving from firm to firm. Stories like that are particularly disturbing, though a little perspective is in order: the number of brokers the reporter was able to find who met his criteria for "questionable" was 112 ... out of 505,000 registered reps. But if the story shows anything, it is the disproportionate damage such brokers do. You only have to hire a few clowns to make the industry look like a circus. And so we're telling firms that, when they do hire registered reps with a history of complaints or problems, they must supervise these brokers more closely, for a reasonable period of time. In addition, we're asking you, as compliance personnel, to review the customer account activity of any registered rep who accumulates three sales practice complaints in a year. And we're encouraging all firms to find ways to tie branch managers' compensation to effective supervision, not just the bottom line. The truth is, if the firm doesn't shut down bad brokers, sooner or later bad brokers will shut down the firm. And when I say we need to "shut down" bad brokers, I don't mean "slap them on the wrist" -- I don't even mean "fire them." I mean shut them down. SIA Chairman Buzzy Krongard put his finger on this the other day when he said that "Among firms, there has prevailed an attitude of ūGet him out of here' rather than ūGet him out of the industry.'" He's right. What industry needs people like that? You may think that you've stopped them from hurting your firm by firing them, but as long as these characters remain in the industry, they continue to hurt every firm, including your own. These are the people who've given the public such a poor opinion of the industry -- it seems to me that a crucial step in restoring trust will come when decisive action is taken to keep such people out. The resulting surge of investor confidence would benefit us all. That the industry is not policing its own ranks well enough is evident from another finding of our sweep: Good firms are still hiring bad reps. To address this, we're asking firms to do more than look at a U-4 or check the CRD. We'd like them also to discuss with all applicants the nature of their prior customers and the securities they sold; to check the credit and financial reports of applicants; and to be sure they get satisfactory, detailed, and verifiable explanations of any customer complaints or regulatory actions before hiring that person. It's our hope to make this best practice the common practice. A final recommendation resulting from our recent sweep was for the SEC and SROs to conduct one-year follow-up examinations of firms that have been subject to enforcement actions involving sales practice abuses, supervisory breakdown, or other egregious activity that harms customers. This should help ensure that firms that have engaged in such practices do not repeat them. Together, these measures will help raise sales practice standards yet another notch. There are other ideas, not in the report, that will also help achieve this. Many of these ideas come from the industry, which as I've noted is making a huge effort at self-improvement and professional enhancement. Firms are beginning to compete with one another to provide best execution for customers. Some are now studying the idea of higher education for brokers, leading to an advanced degree. I read the other day of NASD-R President Mary Schapiro's decision to make broker disciplinary records available to investors on the Internet -- I applaud this initiative and I hope we can link the SEC's World Wide Web site to that of the NASD. My friends, you and I are in a unique position to make many positive, long-overdue changes. We can help the industry improve its image and restore its reputation. Together, we've made progress toward that goal. We must continue and be firm in our resolve to do right -- especially when the market has reached such dizzying heights. As we move forward, some will ask you, as they have asked me, why you are worried, when the market is breaking records practically every week. Some will tell you, as they have told me, to leave it alone, everything is fine. In response, remind them that investors today are not as sophisticated as they should be. Remind them that they're talking about confidence in the markets, but we're talking about confidence in the industry. And remind them of President Kennedy's wise saying: "The time to repair the roof is when the sun is shining." Fortune has brought us a good measure of sunshine. Let's get the roof fixed. Thank you. # # #