Richard A. Levan & Associates, PC - Smart Money

May 1999

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Ten Things
by Robinson G. Clark

Ten Things the SEC Won't Tell You

1. "We're overwhelmed."

A LOT OF PEOPLE are singing the praises of the Securities and Exchange Commission these days, citing the agency's crackdown on Nasdaq price fixing, the creation of "plain English" mutual fund prospectuses and its investor-education efforts. Typical is Joseph Grundfest, a Stanford University law professor and former SEC commissioner, who says, "Arthur Levitt is clearly one of the most effective chairmen that the agency has had in its history."

Just imagine, then, what the agency could be doing if it had the proper resources. While the SEC's budget more than quadrupled to $335 million between 1980 and 1998, its full-time staff has grown by just one-third. Meanwhile, the number of brokers has tripled. The number -of equity funds has soared 12-fold. Investments in all mutual funds have rocketed more than 41 times. And trading volume on U.S. exchanges has jumped 20-fold.

The result? The SEC is ill-equipped to confront old and new problems alike. It has even taken to farming out critical work: In 1997 the agency put states in charge of supervising investment advisers with assets below $25 million.

What's more, fat salaries on Wall Street and at law firms are creating a turnover nightmare. During the past two years, the SEC's New York office has lost more than half of its 137-member enforcement team, and turnover throughout the agency has soared since 1994.

Says SEC spokesman Chris Ullman: "The old saying goes, if you had more, you could do more. But we're doing a good job with what we have."

2. "We're a political football."

THE SEC'S BUDGET woes aren't made any easier by its delicate relationship with Congress, which is acutely sensitive to the needs of securities firms and trade associations, among the biggest political donors on Capitol Hill. As a result, the budget-conscious SEC has had to keep a close eye on what Congress wants. In 1994, for example, the SEC ended up siding with corporations and Congress in rejecting a Financial Accounting Standards Board proposal that would have forced companies to reflect stock-options grants in their earnings.

"Congress wants the SEC to be just aggressive enough to inspire confidence in our markets, but not so aggressive as to cause serious damage to the process, the Street and the financial world," says Richard Levan, a former SEC litigator.

The agency may well be in for leaner times with Sen. Phil Gramm (R-Tex.) as the new head of the Senate banking committee, which oversees the SEC. In 1994 Gramm opposed a plan that would have let the SEC fund itself, fearing the agency would become too independent, and in 1995 he sought a 20 percent SEC budget cut. This year Gramm said he wants a cut in trading fees collected by the SEC, which help fund the agency.

3. "Our talk is cheap."

LAST MAY, Levirt chided the mutual fund industry for not disclosing fees more clearly, particularly amid claims that they were rising. But the SEC never went beyond suggesting solutions to actually ordering rule changes.

Levitt has made no secret of the fact that he prefers to have industry, not government, promote change. He's followed the same route on investing on the Internet, questionable broker compensation practices and companies' inequitable disclosure of market-sensitive information to select investors and analysts: jawboning them from the bully pulpit, then leaving the reforms up to the industry.

When the SEC does move, its pace tends to be glacial. Take the current transition to pricing stocks with decimals instead of fractions, a move first suggested more than 20 years ago but one that's not expected to be instituted until after 2000. The change should save investors money by allowing stocks to be priced in increments smaller than an eighth. Junius Peake, a former NASD vice chairman and now a finance professor at the University of Northern Colorado, remembers recommending the switch to the SEC in 1976. "I got laughed out of the room," he says.

"The chairman doesn't think that rule-making and legislative fixes are always the best way to get things done," says the SEC's Ullman. "The SEC is not responsible for some of these things and doesn't have the authority to regulate them."

4. "We put the fox in charge of the henhouse."

PERHAPS THE SEC would be more effective if its relationship with Wall Street weren't so cozy. Think about it: That's where the agency recruits its best and brightest; Levitt himself once headed a brokerage and the American Stock Exchange. The SEC relies on Wall Street to help police itself through self-regulatory organizations such as the National Association of Securities Dealers and the stock exchanges. It has even allowed brokerage firms to pay for Levitt's "town meetings" with investors, though the SEC denies that the payments created conflicts of interest.

But the most troubling aspect stems from its pattern of putting Wall Street in charge of fixing the problems that its director highlights from his soapbox.

Take the antiquated bond market: It's the largest securities market on earth, dwarfing the U.S. stock exchanges. Yet while investor groups and members of Congress have pushed for broader reforms since the 1970s, the SEC has maintained a largely hands-off policy. There is no central bond exchange, no record of prices and trading volume, no requirement that brokers have to reveal their commission-like profits known as markups. The lack of information often leaves investors-especially individuals-at a disadvantage. Levitt finally announced an investigation into corporate bonds last year.

"Working with the industry is the best way to leverage resources," says Ullman.

5. "Our arbitration system favors the big boys."

WHEN YOU OPEN a brokerage account, you kiss your right to sue a broker in court goodbye. So what sort of redress are you granted in return?

Arbitration is the most common alternative, and it leaves some critics wondering whether the system wasn't designed to benefit brokers-a troubling thought, given that the agency overseeing most cases, the NASD, is made up of brokerages.

"The SEC hasn't exercised the kind of proactive oversight of the NASD to make sure the arbitration is a fair process for investors," says Scot Bernstein, a director of the Public Investors Arbitration Bar Association. Counters the SEC's Ullman: "We keep close tabs on the arbitration process and feel it is working well."

Sure, arbitration usually saves time and money, but that's a plus for brokers as well. And there's no guarantee of speed, since brokers can drag out the process by stalling on producing documents. Plus, arbitration proceedings are off the record, so brokerages can play hardball with investors without risk to their public image.

Consider also that of the roughly 6,500 NASD arbitrators, only 15 percent are female and just 4.5 percent minority. "The arbitration panels are still old white guys who seldom lose money in the market," says James Beckiey, a plaintiff's securities attorney in Wheaton, 111. Arbitrators are paid $400 a day to sit on a panel, creating an incentive to render decisions and awards that don't hurt their chances of being selected again. Perhaps that explains why investors seldom recoup all the money they lost or spent on fees, even though they win a majority of the cases.

6. "We allow insider trading- every day."

WEEKEND RETREATS. Private meetings. Closed conference calls. Company executives routinely spoon-feed market-sensitive information to institutional investors and analysts in these venues- information often unavailable to individual investors. Between the time of that "selective disclosure" and the moment the news is made public, there is often what Levitt himself calls "a great deal of unusual trading."

"All these things where individual investors are excluded are pushing them to the bottom rung of the ladder," says John Markese, president of the American Association of Individual Investors.

In February 1998, Levitt deplored the uneven playing field as "a stain upon our market." But he resisted ordering rule changes, claiming companies were fixing the problem. Yet a recent National Investor Relations Institute survey showed only a quarter of the public companies that conduct conference calls allow retail investors to listen in. In March the SEC finally changed its stance, announcing an investigation that could result in new rules.

7. "The Internet befuddles us."

THE SEC HAS the fight of its life on its hands with the Internet and the challenges it poses to public markets and private finances. And its odds of winning look decidedly poor.

In the Internet's corner: More than 5 million online brokerage accounts (and triple that number by 2002), says the-SEC. Almost a third of all retail trades. More than 100 online trading companies, many ill-equipped to meet the stampede. And by Levitt's count, almost 10,000 financial Web sites in the English language alone.

In the SEC's corner: Three full-time staffers in the agency's 10-month-old Internet Enforcement Office, along with assistance from other SEC and state securities agents.

"The SEC is like the Dutch boy with his finger in the dike," says John F. Ol-son, a senior partner at Gibson, Dunn & Crutcher, a law firm in Washington, D.C. "Information in the electronic age is all over the place, and controlling it may be impossible."

That isn't to say the agency isn't making some headway. It has stepped up its investor-education programs, charged 57 individuals and firms with violations in two nationwide Internet securities fraud sweeps, launched a study of online trading issues and promised greater scrutiny of the online trading industry following a series of trading glitches.

Still, the SEC is months, if not years, away from answering major questions about what responsibility and suitability requirements to place upon online brokerage firms and about how to monitor chat rooms, Web sites and e-mail-what one regulator calls "an electronic restroom wall"-for bogus information.

"We're further ahead than any other agency or department in dealing with the Internet," says the SEC's Ullman.

8. "We make stock fraud too easy."

THE NAMES have changed. It's micro-cap-not penny-stock-fraud now. Bad brokerages such as Stratton Oakmont and First Jersey Securities have been shut down. And the Internet has created new twists. But scammers still take advantage of uneducated investors, thanks to a lack of information about public shares of tiny companies and those stocks' inherent susceptibility to manipulation, to score quick, ill-gotten profits. "Penny" stocks rack up big losses every year-some $6 billion annually.

Along with other regulators, the SEC has been cracking down on crooks and reforming laws for decades, while urging investors to exercise caution. But problems persist: For one thing, the SEC doesn't require more in-depth financial disclosure from these companies, since such reporting costs a lot of money. In turn, the lack of information translates into a cost shouldered by investors instead.

"That has always been the dilemma, the cross between the burden on small business and protecting the investor," says Phil Fei-gin, executive director of the North American Association of Securities Administrators, an organization of state securities regulators. "There ought to be a higher regulatory burden [on these companies] in order to gain access to the secondary market."

"It is something we grapple with on a daily basis," says Chris Ullman. "You don't want to inhibit small businesses from raising capital by imposing disclosure requirements they can't afford."

9. "We'll steamroll shareholders when we have to."

THAT'S WHAT HAPPENS when one of the SEC's three main directives-to protect investors-clashes with its other two-to maintain fair and efficient markets, and to make it easy for companies to raise money. Sometimes the agency sacrifices its first goal.

A few years ago, for example, the SEC proposed making it more difficult for small investors to place certain shareholder resolutions on proxy ballots. The proposal would have curtailed some of the democratic rights that come with being a shareholder in favor of relieving companies from the time and cost of being inundated with resolutions. The SEC eventually backed down.

"The SEC wants to make companies' filing requirements easier because it means less work," says Thomas Flanagan, president of the Investors' Rights Association of America. "But their first proposal inthis case was antishareholder."

"Investor protection and interests are the absolute top priority on Arthur Levin's agenda," says Ullman. "The goal with [the shareholder resolution proposal] was to achieve a balance."

10. "Kickbacks? We look the other way."

WALL STREET is home to the kinds of conflicts of interest and kickback schemes that make the Olympics bidding process look like a pig auction at a county fair. The SEC has helped stop some of the more egregious problems in recent years, such as the municipal bond market's unwritten "pay to play" underwriting rules and sales contests used as incentives for brokers. But other problems persist.

Brokers continue to receive incentives for selling particular products, often those created by their own firms. And brokerages themselves continue to take so-called support payments from mutual fund companies for selling their funds. An SEC-appointed panel highlighted such abuses back in 1995, but the agency has yet to tighten the rules addressing these problems. Its solution? Asking Wall Street to clean up its act.

"There are all sorts of hidden payments made to brokers or firms by product sponsors" such as mutual fund companies, says Dan Jamieson, editor of Registered Representative, a trade magazine. "Where's the SEC on these issues?"

Meanwhile, the agency still hasn't moved to eliminate other types of kickbacks. For example, a 1998 SEC investigation that found widespread abuses of so-called soft dollar contributions-rebates that broker-dealers pay mutual funds and other investment advisers in order to ensure their business, resulting in higher costs for investors-recommended nothing more than greater disclosure. "The SEC has done a thorough review of soft dollars and found problems and pointed them out to companies when they found them," says Chris Ullman.