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Avoiding Fraud in US Investing: Town Meeting
From: Columbia University
| By:
Eric R. DinalloArthur LevittCharles E. Schumer |
EDITOR'S INTRODUCTION |
A multitude of new online brokerage firms has enticed many newcomers to the stock market. But whether you're investing in the stock market or mutual funds, online or off, it pays to be educated and sensible. At a town hall meeting sponsored by the Columbia Law School, Arthur Levitt, chairman of the US Securities and Exchange Commission (SEC), Charles Schumer, United States senator from New York, and Eric Dinallo, bureau chief of the Investor Protection and Securities Bureau in the New York State Attorney General's Office, joined forces to address questions and concerns from the public. |
Question: You spoke a little bit about brokers and broker fraud that may exist. I'm wondering if there's any possibility that a broker might be taken out of the picture; in other words, if you've actually considered the possibility of creating some sort of Internet link where you can directly trade. |
Arthur Levitt: Well, right now there is an Internet link. You can trade without your broker. You'll trade with your brokerage firm. I would hate to see the broker removed from the process. I think the broker provides a very important service. |
Technology is going to bring about all kinds of changes in the future, and they'll be changes that create not an American market but a global market. I hope the headquarters for that market will be New York. But it might not be. And I would like to see the broker be part of it, because I think he's important. |
Q: You mentioned that earnings were critical, and my understanding is that a lot of technology stocks have reported positive earnings, such as Microsoft. But in actuality they've lost $15 billion, and the reason they've been able to hide that is because our accounting principles haven't caught up with the times. When are we going to correct that? |
Levitt: The Securities and Exchange Commission is very concerned about what we call managed earnings, companies that are using accounting tricks and devices to hide earnings and not represent them accurately. We have a special part of our Enforcement Division that does nothing but address accounting fraud. We've brought more accounting fraud cases than have ever been brought before in the past year. |
We intend to make accounting fraud a major goal of the commission. We're working very actively with the heads of the major accounting firms to have them crack down on their clients in terms of how they're reporting their numbers. This is a major priority for the commission. It's something we care a lot about, and we're going to work on that. |
Q: But we have no provision in our accounting regulations to highlight the fact that the reason for this loss is that companies are paying out options to their employees. |
Levitt: That's a very complex issue. Many companies today will reward their executives with stock options, and there is no formal requirement for companies to put down an expense factor for those options, which would be a deduction from earnings. The compromise reached between the Accounting Standards Board and the industry is for companies to report, as a footnote, the number of options, and the value of those options. |
Q: There's one thing that has not been discussed: the function of the taxes. If you make $100,000 or more in the stock market, the capital gains is 20 percent, city and state taxes another 10 percent, perhaps, and you have to add it on to your income, etc. |
And if you lose $100,000, you're given the next 50 years to take off $3,000 a year, for your rewards. You know, that's called lean and mean. Now, there's a bill in the House of Representatives, HR 2525, which you may or may not be aware of. It's being introduced by two individuals--one Republican and one Democrat--Representative Linder and Representative Peterson, which will do away with the whole business of changing the tax code; namely, the fair tax. There's also a flat tax, but it would take hours to discuss the whole thing. |
Levitt: Before I turn this question over to Senator Schumer, I want to say two things. One, I have enough difficulty with the securities laws without taking on the tax code. But I do feel that in reporting of mutual fund results, mutual funds should develop a way of reporting the tax impact of the trading of securities within those funds so that an investor knows that the results aren't exactly what they seem to be, but are tax-impacted. But I think your question is more appropriately directed to the senator. |
This is extremely important for everybody who's investing money in the market, because you don't make 10 percent and 20 percent and so on. You've got to figure in the taxes that you're going to lose in the process of investing. It's something that we should be taking into account. So my question is very simple: What do we do in terms of the tax code? Let's change the whole tax code! Ten thousand pages of garbage. |
Charles Schumer: Well, thank you. There are lots of proposals for changing the tax code around. |
Your first point, that a good investor should realize the tax consequences of an investment, and that your net take-home amount of money in your pocket at the end of the day may be different depending on the investment, is extremely well taken. And as somebody who believes in the free market but also believes very much in disclosure, I have no problem with seeing any of that disclosed and disclosed fully. |
As for changes in the tax code, yes, there are many that should be there. We made an attempt--I was in the House then, in 1986--to have sort of a flatter tax code that was also supposed to get rid of lots of special deductions. As you can tell by your comment of the 10,000 pages, it didn't work all that well. |
If you didn't have any deductions at all, you'd throw the economy into turmoil. For instance, if home owners had bought a home with the knowledge that they'd have a mortgage deduction, and then had that taken away in the middle of their paying the mortgage, it would change their finances. So you wouldn't do that. |
And yet, if you allowed lots of deductions for the major costs, food and shelter and certain parts of health care, etc., you'd end up with a rate that would be much higher than you would imagine. Most of the flat taxes I've seen that have a lower rate and maintain the deductions would throw us back into the kind of deficit that we have finally climbed out of. |
I think one of the great things about what's happened in the last six years is that the federal government has finally gotten a handle on the deficit, and, while it still existed, by applying accurate accounting principles. In 1998, it was probably one-tenth of what it was at its height in the late '80s. So I'd be dubious of moving to a flat tax here. |
Q: A few years ago, Congress passed the Fair Harbor provisions. I think they were right to do that. But my problem as an individual investor is, when I'm on the Internet, and I see people making claims about dubious stocks, I know that if I challenge those claims I run the risk of getting an expensive lawsuit from the company that could cost me tens, or even hundreds of thousands of dollars to defend, even though the company really has no chance of prevailing. |
And that has had a chilling effect on some of the people out there. We're trying to help the understaffed but wonderful SEC in their efforts to combat this type of fraud. I'm wondering if there's any hope for some sort of Fair Harbor provision for investors that would protect them from companies coming in and attacking them, when the companies don't particularly like what they're saying? |
Schumer: Well, that's an interesting idea that, frankly, I had not thought of. It's something I'd like to look at. I will say this: With or without Fair Harbor, an individual often doesn't have the ability to litigate, compared with the company. |
They can afford to write off hundreds of thousands of dollars in legal fees, and you have to scrounge to do it yourself. That's really why I think the best way to deal with those issues, and something that we should be doing in this Congress, is that, given all these changes, we should be giving the SEC enforcement more money. |
It's just absolutely ridiculous, in my opinion, that at a time when things are changing, and we need the SEC to be examining all the new kinds of online trading and day trading and everything else--not changing the rules, but just applying the old rules to them--that many in Congress want to cut back their enforcement money. Arthur has to spend, I don't know, a good portion of his time fighting to see even that the SEC's dollars stay the same. |
And I, for one, would give the SEC a much bigger increase than they've gotten, and that would solve your problem in a different way. As for the Fair Harbor provision, I'd have to explore that before giving an answer. |
The key, I think, to investor protection is the triage between what the SEC can do, what private rights of action can bring, the lawsuits that are brought, and finally what the self-regulating organizations can do. Together, I think we can do a job of helping investors. And if you take any one of those away, you really hurt investor interest. |
Q: I have two mini-questions. Why is it that an average citizen has to wait until 12 or one o'clock to see the prices of an IPO, when they announce on the radio that the price opened at a certain point? By the time an average citizen like myself could check the price on the screen, like sometime between 12 and three o'clock, it's jumped up a lot by then. And when I call, people said it costs a lot of money to get in at the earlier time, and you have to hold it for six months. Is this true? What's going on? |
Levitt: No, it's not true. There's no reason why you'd have to hold it for six months, and if any broker tells you that, you should change brokers, and let us know about it, or let the state know about it. |
Q: So it should be available to everyone at nine o'clock, when it's public? |
Levitt: Well, it depends when it's priced, but it may not begin trading until 9:45 or 10:00 or whenever that may be. But whenever it starts to trade, you should be able to find out from your broker what it's trading at. Whether or not you can buy it depends upon how many orders are ahead of you. |
In recent years, new issues have been priced at levels that have risen to great heights. Why that happens and who's buying them are a function of the fact that a lot of institutions have been playing the new issue game. They've been buying them and selling them--a practice called flipping. Individual investors have much less of a crack at that than institutions have. I'm concerned about that practice; I'm concerned about the distortions that it represents. |
But I also urge investors not to make that a basic part of their investment activities. Let it be a part, but if you're playing that game in the totality of your investments, you're going to lose money. |
Q: Secondly, do you have any thoughts on cyberterrorism as far as securities? For example, if the exchange is a backup exchange but it's not tied with other exchanges, how serious would it be if all the stocks collapsed in the same day, if the outages went out in different places? |
Eric Dinallo: I think there is a real issue that needs to be explored, because more and more people are going online. The system capacities of the individual, of brokerage houses and even the exchanges themselves are not regulated. |
It has not been mandated by Congress or the SEC what the necessary capacities are. It would not be an irrational system if the SEC or Congress stepped up and said that these are the minimum capacity requirements an online brokerage firm has to have before it can be trusted with the Internet commerce of the nation's stock market. |
Levitt: There are backup systems, and one of the great concerns of the commission is capacity. Can the over-the-counter market, can the New York Stock Exchange, can the other markets, the options markets in particular, handle the capacity that's coming upon the scene? |
We're going to move to decimalization. If you think about the increase in the numbers of quotes that decimals will create, that's a major issue, and we have a whole division that does nothing but inspect these institutions to find out what their capacity is, and to encourage them to put aside advertising dollars. |
I hate it when I see the NASD and the New York Stock Exchange advertise. I just personally don't like it. I'd like to see those dollars go into technology, not to try to tell you why one market is superior to another, because I personally don't believe that any one of you is motivated to trade on one market or another because of an ad. You'll trade there because you want to buy a security there. |
Q: I have a question about fiduciary responsibilities and boards of directors. Most institutions have a board of directors that represents some of the outside interests of the firm, their organizations. The SEC recently has been discussing trying to increase the requirement for outside directors on boards of mutual funds, and I'm wondering why you're focusing on the mutual-fund industry as opposed to the other industries? |
Levitt: We're not. We recently convened a "blue-ribbon" panel, consisting of the heads of the major exchanges and accounting firms, to develop best practices for audit committees. We accepted those; within the next 10 days we're going to pass a number of rules. The New York Stock Exchange has already implemented those rules as part of their listing practices, to see to it that audit committees have much greater power than they've ever had before. |
But audit committees include outside directors that--the outside accountants--report directly to the audit committees, rather than the corporation. So, corporate governances are as much a factor for the SEC with respect to nonmutual funds as they are to mutual funds. |
Q: But there is no requirement for nonmutual funds to have a certain proportion of outside directors. Is that correct? |
Levitt: He's asking whether there's a requirement for mutual funds to have a set number of outside directors. The requirement with respect to audit committees of boards, and I think the audit committee is the most important committee of a board, will be for them to have a set number of outside directors as well. |
Q: One fairly consistent source of frustration for investors is found in trying to trade at the open, in the Nasdaq market, because of the chaos there. And it's not because e-brokers' computers aren't fast enough. It's because of the way they open their market. And I was wondering what the commission felt about the possibility of Nasdaq going to a single price open? |
Levitt: I think I would be supportive of that. Certainly we're encouraging that, and I think Nasdaq is going to move to that in the not too distant future. |
Q: Chairman Levitt, how far do you think today's corporate employers can comfortably go in providing fund-specific Internet-based investment advisory services for their employees, and is this something that they should be involved with at all? |
Levitt: Oh, boy, that's a political policy question. I think that a major gap in the knowledge level held by American investors today is in those corporate funds where, unfortunately, corporations are not providing their employees with enough information to make judgments about what sound investments are. I'm sure the senator has some thoughts about this. |
Schumer: I agree with you, and it's not just about Internet funds. It's in general, in terms of how employees will invest their pension, 401(k), and other issues. |
I think it's an interesting area, because, in general, we have a laissez-faire view when an investor makes an investment. But when it's an employer giving certain options, which are limited to the employee, you take it out of the complete laissez-faire approach, and probably more has to be done in this regard. Not just with Internet funds, but with all kinds of disclosure and information that employers make to employees, in terms of investment. |
I think the same rules should apply to Internet-based advisory services as non-Internet-based advisory services, in terms of disclosure. The Internet, in general, is a quicker and more encompassing means of transmitting knowledge. But the basic rules that have governed society before the Internet should continue to govern society with the Internet. We just have to apply those rules to the Internet. |
Q: The issue is whether employers will be held accountable for the advisory services and the advice given to employees. |
Schumer: Right, and that's a general policy question related to Internet advisory services and non-Internet advisory services. I think more ought to be done in that regard. |
Q: I read a few years ago that the SEC is encouraging mutual fund companies to be more forthcoming with information, such as providing their prospectuses right on their websites or possibly even though e-mail. Now, I do a lot of mutual fund research on the Internet, and it's been pretty frustrating. I've been to a lot of websites and even the large, popular mutual fund companies don't really seem to be providing their prospectuses there. |
I was wondering what the SEC's position is on that. Is it still encouraging, and do you think that mutual fund companies eventually will be taking the SEC up on that challenge? |
Levitt: When I first came to Washington, I had to sell virtually everything I had and put the proceeds into mutual funds. I had never owned a mutual fund before, and I began to read the prospectuses. And I found, in spite of many years in the securities industries, I couldn't understand a lot of what I was reading. I took one really terrible page of gobbledygook, and it included about eight paragraphs, and I sent it to Warren Buffett, who I think is one of the clearest thinkers and writers in America. And I said, "Could you rewrite this for me?" And he came back with one paragraph. |
So, we have insisted that mutual funds and corporations now use a new language, plain English. And the commission uses a new language, plain English, because we wrote in gobbledygook as well. If you look at the prospectuses today, you'll see they're much better. We've passed a rule that funds have to put all the salient information in the first two pages in a certain fashion. |
I think using the Internet is very important. The group that represents the mutual fund industry, the Investment Company Institute (ICI), is a very responsible group. And, generally speaking, we don't have to necessarily pass rules but simply sit down with the ICI and say that this is what we think is required. |
I share your feeling that the Internet is a tool that could be more effectively used by mutual funds. I'm kind of surprised that they're not doing that, and I think that competition will move them to do it. But because you've raised the issue, I will raise it with mutual fund leaders that I know, and with the ICI, because I think it is important. |
Q: About a year ago, a speculative hedge fund based in Greenwich, Connecticut, succeeded with the advice of Nobel laureates in losing many billions of dollars. A rescue was cobbled together by the New York Federal Reserve Bank and some big institutions. |
Do you think that this is an appropriate role for a governmental agency, that it is in the public interest to rescue a speculative hedge fund, and if so, why? And if the losses of these funds are critical to the public interest, should the SEC regulate them more tightly, and have more oversight on their functioning? |
Levitt: It's very difficult for the SEC or any other agency to regulate a hedge fund, because a hedge fund can operate outside our jurisdiction, and often does. It can move to Anguilla, it can move to London. So it's very hard to do that. |
As to what this gentleman is asking about, about a year and a half ago Greenwich Long-Term Capital went under. People at the Federal Reserve Board and others felt that if they were allowed to fail, they could represent a damage to the whole system. |
As a general notion I don't think it's the role of government to bail out businesses. I think that distorts the market. I think it gives people the notion that there is an invisible hand out there that's going to protect them, and they then are motivated to take risks that they shouldn't be taking. |
I'm not really prepared to say whether it was appropriate or inappropriate for that bailout to take place. Those are judgments that have to be made almost instantly. And on reflection, those judgments look better or worse than they may have been at the time. I don't know what I would have done, had I been asked to make that decision. It's a marginal call. In general, I don't like to see it happen, but I wouldn't criticize this, at this point in time. |
Q: Why have we not seen the proliferation of trading fixed-income securities, like bonds, online? Is this in the cards for the future? |
Levitt: I think it is. We have encouraged the Bond Market Association, which represents the bond interests of this country, to get moving with this. Unfortunately, our debt markets have not kept pace with our equity markets. |
The commission has made a major issue of greater transparency in our bond markets. It's sometimes very difficult for investors to know what they're buying, what the proper pricing is, what the rating of the bond is. |
We are encouraging and pushing for more transparency. Your question is terribly important, because more and more investors own bonds as well as they do stocks. |
Q: My question has to do with online investing. Suppose a brokerage goes out of business; it goes bankrupt. And he's got your certificates and a street name. What safety precautions do you have? |
Levitt: We have the SIPC (Securities Investor Protection Corporation), which protects investors against that occurrence. And most firms have excess insurance that would protect investors against that as well. That's a question to ask the firm. |
Now and again, with online brokerage firms, generally speaking, those firms don't risk their own capital and as a result have less risk than firms that are not online firms. And sometimes you're talking about the same firms. You're talking about Merrill Lynch online and Merrill Lynch offline, and the risk, in my judgment, is precisely the same. |
You've got to look to the firm that you're dealing with. You've got to look to Schwab. You've got to look to Discovery. You've got to look to any of those firms and what lies behind them. But I don't think that there is a greater risk to dealing online than not. |
Q: But those are the major firms that have been in business for a while. I'm talking about these new firms that just started up on the Internet. Do they have the same safety precautions in place? |
Levitt: Some firms have greater resources than others do. We certainly inspect them in the same way, and have the same requirements. Mr. Dinallo, do you have any thoughts about this? |
Dinallo: I think it's extremely important that everyone understand that the mere fact that a brokerage firm may be able to put on its material "SIPC Insured" is absolutely no guarantee that you will not be the victim of securities fraud. Most of the bucket shops that I've been involved in prosecuting said "SIPC Insured" on their material. They were, in fact, SIPC insured. If the certificates had been stolen, then you would get your money back by SIPC Insurance. |
In one case, SIPC did come through and pay for unauthorized trades, because they could view that as an actual theft. But, generally, "SIPC Insured" is only a guarantee against a broker embezzling your assets, taking the certificates, or the certificates going up in smoke somehow. |
So, don't think that SIPC is there to protect you. It's not a stamp of approval in any way, shape or form, except that it performs an extremely valuable function in securing and insuring the national securities market, but it's not some Good Housekeeping stamp of approval. |
Q: Before, you said that money markets are pretty secure. Is there any specific kind of money market that you could recommend? You see, I'm very averse to risk. |
Levitt: Well, I'm not allowed to say a brand name, but I would say a money market fund that consists exclusively of short-term government securities is the safest fund you could buy. If you're averse to risk, that's one place I would go, besides your local savings bank. |
Q: Speaking of the globalization of financial services that was brought about by the technology, a website promoting stocks or, say, a stock tipper having his own agenda might be physically located outside the United States. |
Do you have any authority or any arrangement with the security authorities of other jurisdictions? For example, United States based, online scamsters might be publishing on Internet websites, targeting international investors in their native languages. |
Levitt: The question is whether, using the Internet, we have scamsters from other jurisdictions that may not be monitored by the SEC. Absolutely, and there will be more of that. We are working through letters of understanding with our counterparts all over the world, to go after those scamsters, to exchange information, and if we don't have jurisdiction we can count on the UK, the Germans, the French, the Indonesians, to do the same thing. We spend a lot of our resources doing that. |
Q: I'd like to praise the SEC for the implementation of EDGAR. It's a valuable source of information. |
I'd like to raise another area for the SEC to consider. When I look at price-earnings ratios at Standard & Poor's or Value Line, I'm going to see different numbers because they're using different bases, and yet they still quote a price-earnings ratio. I think that's a source of disinformation, in many hands, and I would like to urge the SEC to look into the possibility of standardizing terminology of that type. |
Q: Could you comment on the effect of extended hours? |
Levitt: I think that extended hours are here to stay. Right now, their use is relatively limited, and you have to be very careful about liquidity and extended hours. I think after the first of the year 2000 you're going to see much more of that, and it will be a safer vehicle than it is today. |
Q: There's a controversy now about whether mutual fund fees and expenses are too high. The Investment Company Institute has data showing that they've come down. Morningstar argues that only a few funds have brought them down. Do you have an opinion on whether mutual fund expenses are too high, and whether they should come down? |
Levitt: I guess I always have the feeling that expenses are too high. I understand the dilemma faced by funds, but with the enormous increase of dollars going into funds, there should be some economies of size, and I don't see those economies to the extent to which I'd like to see them. |
Q: I dealt with a financial consultant, I assume, or broker. He sold stock of mine that he wasn't authorized to sell. I've written to the SEC, who then forwarded my complaint to the New York Stock Exchange. I've made inquiries about the individual at the Nasdaq, but there's no record of that individual ever having been censured. |
Now, this is a year already, and a follow-up still didn't indicate that there have been complaints against this individual. What are the consequences of a broker or a financial consultant who does things contrary to his client's wishes? And when there's a complaint, how is that filed? |
Levitt: If that broker sold securities that he was unauthorized to sell, that's a violation of the securities laws. The first thing that I would do is go to the brokerage firm and say, "If you don't make this good, I'm going to file an arbitration action." |
Q: Yes, I have a question with regards to security of online trading. Does the SEC have any concerns about the adequacy of the privacy being made available to the individuals and the firms? |
Levitt: Yes, we do. That's not within our jurisdiction. I am concerned about the privacy. There are various bills before Congress that have tried to address that issue, but I think we have a long way to go. |
Q: I have a general question in reference to Social Security. Where do you think we might be going, where part of Social Security might be invested somewhat? |
Levitt: There are some who say that individuals should be given the total right to take all of their Social Security funds and put them in any investment they wish. There are others who say, "Don't let them put a penny into it. Leave it up to the government to handle those investments." |
I think that we're probably moving toward a middle ground, where investors will be allowed to invest, at first, a very small part of their portfolio in a limited number of options, in the same way that government employees have a bond fund or an equity fund or a combined fund. And it seems to me that that would be a risk worth taking, as long as investors are educated in terms of the risk of investment. |
Q: I have a Fifth Amendment question, because it varies from state to state about being a victim. Let's say I feel I'm a victim, but I'm also afraid of violating or crossing a securities regulation, which I don't know about. |
I bought some stocks in a company. The stock went bankrupt and was taken off the board. I called Nasdaq, and Nasdaq says, "You're starting to cross the line by asking me to call the company to verify their bankruptcy." So I backed off, and I tried calling the company. But I don't know when I can make these inquiries, and when do I become victimized by paying out money on this? And when is the Fifth Amendment appropriate, you know, in terms of victim debriefing, and is it a policy in this state currently, or does it vary from state to state? |
Dinallo: You have no Fifth Amendment rights when you are a victim, which is obviously a big issue. In many of the securities frauds that we investigate, especially when it comes to some of the larger insiders, who dealt with the firm and took a lot of stock from the firm, there was always a line that is apparent, and it is somewhat blurred between who is a victim and who is somewhat of an insider. |
I think prosecutors and regulators are very, very sensitive to this and understand that the overall scheme would not exist without these blurred examples. I don't think that a fair prosecutor would try to turn someone who is, on objective analysis, obviously a victim--although maybe, because of their magnitude and sophistication, viewable as somehow more knowledgeable than the average victim--and turn that person into a target. |
Q: One thing I was puzzled about is the counting of these companies, and how accurate they are, when they give information. Every time they say they're losing money, bang, the stock goes down, people don't buy it. How could you control that? |
Levitt: We spend a major part of our resources on enforcing accounting standards established by an outside, independent board, and seeing to it that the accountants of America are totally independent and protect the interests of investors. And we bring security fraud cases against companies that don't accurately report their earnings. |
Q: You've mentioned that this is the 34th Town Meeting. I would like to know: What is the most important thing that you've learned from these meetings, from the public? |
Levitt: That's a great question. I know that people are frightened about various kinds of investments and their safety. I know that people care a lot about questions such as How do I pick a broker? and How can I decide how to pick a broker? I know they care about mutual funds. And now the question I'm hearing more often than ever is How safe is it to invest over the Internet? |
What I've learned from Town Meetings, and I wish the politicians of America would listen more carefully, is that Americans care. You're here because you care about protecting yourselves. And I care passionately about helping you in the limited ways that I can. |
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