IP: Quality Information: The Lifeblood of Our Markets

[David Farber <farber () cis upenn edu>]

> From: "the terminal of Geoff Goodfellow" <geoff () iconia com>
> To: "Dave e-mail pamphleteer Farber" <farber () cis upenn edu>
>
>
> Speech by SEC Chairman:
>
> Quality Information:
> The Lifeblood of Our Markets
>
>
> Remarks by
> by Chairman Arthur Levitt
> U.S. Securities & Exchange Commission
> The Economic Club of New York, New York City
> October 18, 1999
>
>
> Today, the unbridled forces of competition, technology, and globalization have
> converged to spur greater innovation, unleash new discoveries, and 
> rekindle the
> belief that our potential is without confines. Every day we are seeing new
> ideas, new inventions, and new imperatives that are dramatically reshaping our
> world.
>
> Vestigial barriers of the Cold War have all but disappeared. Countries once
> shut out from the sunlight of opportunity – from the free flow of capital,
> goods, and services – now bask in the illumination of grand possibilities.
> Through rapid technological advancements, the notion of geography as a barrier
> has been all but archived.
>
> An explosion of on-line information sources, real-time news feeds, and TV
> channels devoted to business news has reinvented how we gather and disseminate
> financial information. Across the globe, a broad movement towards an equity
> culture has taken root as traditional bank financing takes a back seat to the
> emergence of globally interconnected capital markets.
>
> But as the ground shifts, our mandate to protect the public interest remains
> absolute. Nowhere is that interest more implicated than in the evolving
> structure of our capital markets, and in the integrity and transparency of the
> information that binds these markets together. Tonight, I want to talk about
> the structure of our markets and then emphasize why continued U.S. supremacy
> globally depends on our total commitment to quality financial reporting.
>
>
> Quality in the Marketplace
> I have been talking about quality in the marketplace a lot recently. But
> quality – in concept and in practice – cannot be allowed to deteriorate with
> time or wilt with age. It is not a catch-phrase or a sound-byte for 
> a marketing
> campaign.
>
> Quality in our markets is a commitment to integrity and transparency 
> in the way
> we do business; in the way we execute and report trades; in the way companies
> report their financial performance; in the way analysts communicate with
> companies and investors; and in the way auditors fulfill their mandate for
> independent and objective oversight.
>
> As more countries embrace a true equity culture, and investors respond by
> allocating capital globally, a transparent and trustworthy global financial
> reporting framework has also become more important than ever.
>
>
> Progress Towards Better Markets
> A few weeks ago, I talked about many of the issues and developments unfolding
> as U.S. markets respond to the forces of technology and competition. 
> Electronic
> communication networks – or ECNs – are challenging trading floors. 
> The nation's
> stock exchanges are pushing forward in their plans to go public. Options
> contracts are now listed on multiple exchanges. Financial markets, at their
> most basic level, are being reconstituted. And the impending changeover to
> decimals, while benefiting investors, will create enormous challenges both to
> firms and to our markets. We should not underestimate the effect 
> decimalization
> could have on profitability, on commission rates, and on market structure as a
> whole.
>
> Significant steps are already being taken to address many of these
> developments. The Commission and market participants are working together on
> ways to craft a fairer, more open, and more efficient marketplace. 
> In doing so,
> the SEC embraces free market principles to foster greater competition, while
> ensuring effective regulatory oversight to protect the investor interest.
>
> For competition to flourish, anticompetitive exchange rules and obstacles must
> be eliminated and new market entrants must be free to compete with traditional
> markets. Towards this end, the Commission will soon vote on 
> Intermarket Trading
> System Plan amendments that will give the NASD access to all listed stocks.
> Additionally, I hope and expect serious proposals will develop in short order
> giving ECNs entry to ITS. And lastly, we are working together with market
> participants to determine whether ECN fees – the fees that these electronic
> networks charge to access their trading platforms – should be eliminated.
>
> Regarding the options markets, I recently expressed my concern to the heads of
> the options exchanges about the lack of progress in establishing linkages. In
> the next few days, we will issue an order that requires the options markets to
> implement an effective linkage plan. Linkages are simply essential to enabling
> a customer's order to receive the best execution available in any market,
> regardless of the market to which it was first routed. I'm convinced that
> technological obstacles can be overcome promptly. Now, I would prefer that the
> Commission not impose a linkage plan on the industry. But, if these markets do
> not take significant steps on their own initiative, we stand ready to act.
>
> I've also asked the Commission's staff to prepare a public release requesting
> comments, proposals, and ideas on how we can effectively garner the 
> benefits of
> centralizing orders without stifling competition. Specifically, we cannot
> ignore the possibility that aggregating limit orders across markets, and
> rewarding those that post the best price first, may produce better prices for
> customers. This moment in history – replete with technological opportunity –
> demands that every market participant begin considering and refining concepts
> that may move us towards a better market.
>
> Lastly, effective regulatory oversight must never be sacrificed. The 
> Commission
> has no intention of standing in the way of exchanges moving to for-profit
> status. But in any structure, the self-regulatory obligation must be 
> vigorously
> fulfilled, adequately funded, and dedicated to serving the public interest.
>
> I am optimistic about our chances for creating a marketplace worthy 
> of the 21st
> Century. Never before have I seen such a broad range of market participants
> discuss thoughtfully and boldly the future of our markets. But, we can talk
> about liquidity and order flow, we can talk about barriers to competition, we
> can talk about new market entrants, and we can talk about linkages 
> all we want.
> It's nothing more than an academic exercise if investors can't rely on the
> quality of the underlying financial information.
>
>
> Quality Financial Reporting Under Stress
> Quality information is the lifeblood of strong, vibrant markets. Without it,
> investor confidence erodes. Liquidity dries up. Fair and efficient markets
> simply cease to exist. As the quantity of information increases exponentially
> through the Internet and other technologies, the quality of that information
> must be our signal priority.
>
> Over the last sixty years, our markets have been models for transparency and
> integrity. This is due, in no small part, to the professionalism of corporate
> management, financial analysts, accountants, and members of the legal
> community. My observations here this evening, however, arise from a perennial
> obligation shared by all of us: to be ever vigilant in shining the light on
> ethical gray areas before their shade becomes even darker, their effects more
> corrosive.
>
> A little over a year ago, I voiced concerns over a gradual, but perceptible,
> erosion in the quality of financial reporting. The motivation to satisfy Wall
> Street earnings expectations was beginning to override long established
> precepts of financial reporting and ethical restraint. A culture of
> gamesmanship over the numbers was not only emerging, but weaving itself into
> the fabric of accepted conduct.
>
> I thank those in corporate America who took to heart the call for greater
> integrity and accountability in the financial reporting process. I also
> recognize and applaud the efforts of private industry groups that strive to
> "raise the bar" in the investment management industry through voluntary
> compliance with high ethical standards. Your commitment and your efforts have
> made a real difference. While we have made strong progress, the gamesmanship,
> unfortunately, persists.
>
> A gamesmanship that says it's okay to bend the rules, tweak the numbers, and
> let small, but obvious and important discrepancies slide; a gamesmanship that
> tells managers it's fine to cut corners and look the other way to boost the
> stock price; where companies bend to the desires and pressures of Wall Street
> analysts rather than to the reality of numbers; where auditors are pressured
> not to rock the boat; and a gamesmanship that focuses exclusively on 
> short-term
> numbers rather than long-term performance.
>
> We've all seen what happens when a company misses an analyst's earnings target
> by just a few pennies. The stock plummets. It's remarkable, but today, a near
> miss is a miss by a mile. I can't tell you how many times an investor has come
> up to me – incredulous and exasperated – because a company's market
> capitalization dropped by millions of dollars simply because it was a penny or
> two shy of its earnings estimates. Unfortunately, there is no law of economics
> I can cite, no reasonable correlation from which investors can draw.
>
> I can only point to what I see as a web of dysfunctional relationships – where
> analysts develop models to gauge a company's earnings but rely heavily on a
> company's guidance; where companies' reported results are tailored 
> more for the
> benefit of consensus estimates than to the reality of the ups and downs of
> business; where companies work to lower expectations when they fully expect
> they'll beat the estimates; and where the analyst attempts to walk the
> tightrope of fairly assessing a company's performance without upsetting his
> firm's investment banking relationships.
>
> Our review of the relationship between companies and the analysts who follow
> them indicates that analysts, all too often, are falling off that tightrope on
> the side of protecting the business relationship at the cost of fair analysis.
> Analysts are a fixture on business pitches and investor road shows – doing
> their bit to market their own firm's underwriting talents and to sell a
> company's prospects. What's more, analysts' compensation is increasingly based
> on the profitability of their firm's corporate finance division, and their
> contribution to the deals to which they are assigned.
>
> Needless to say, you can see how an analyst who recommends selling a client's
> stock because it's overvalued would not be terribly popular. In many respects,
> analysts' employers expect them to act more like promoters and marketers than
> unbiased and dispassionate analysts.
>
> An all too candid memo from a leading Wall Street firm's corporate finance
> department couldn't have framed the conflict more plainly: " . . . We do not
> make negative or controversial comments about our clients as a 
> matter of sound,
> business practice. . . the philosophy and practical result needs to be 'no
> negative comments about our clients'."
>
> An analyst who goes against the grain may find himself excluded from 
> conference
> calls, or worse, as I recently read, even silenced by his own firm. Is it any
> wonder that today, a "sell" recommendation from an analyst is as common as a
> Barbara Streisand concert. And, is it any wonder that many Wall Street firms
> would prefer that analysts heed their mothers' admonitions: "If you can't say
> anything nice, then don't say anything at all."
>
> How many times have we seen an analyst on television being asked to list his
> top five picks? And, how many times has that analyst taken the opportunity to
> caution viewers, "By the way, my employer recently underwrote three of these
> stocks?" More often than not, he hasn't. And that's because some firms claim
> that these recommendations are either "extemporaneous" or covered by a prior
> disclaimer, or that disclosure is just plain distracting or impractical.
> Frankly, I don't find any of these arguments very persuasive.
>
> I think the time has come for the SROs to consider whether investors 
> are told –
> in a meaningful way – when the analyst's employer has a recent investment
> banking or advisory relationship with the company that is being 
> recommended. We
> cannot settle for boilerplate disclosure, cloudy language that masks a firm's
> position, or small type disclaimers at the end of the document. In addition,
> firms should reexamine their compensation practices for analysts and ask
> themselves this simple question: Do our payment practices ensure unbiased and
> quality information?
>
> Let me turn to another important issue in the area of analyst communications:
> selective disclosure. The behind-the-scenes feeding of material non-public
> information from companies to analysts is a stain on our markets. This
> selectiveness is a disservice to investors and it undermines the fundamental
> principle of fairness.
>
> In a time when instantaneous and free flowing information is the norm, these
> sort of whispers are an insult to fair and public disclosure. We've also all
> heard about those roadshows where the banker's analysts give some investors a
> select look at an IPO that's not available to ordinary investors. While
> roadshows obviously serve a valued purpose, they shouldn't be the vehicle for
> giving a very different look at the company that's not in the prospectus.
>
> Unfortunately, there is no simple regulatory or legal fix to this problem. But
> the Commission is planning to take action where it can. Within the next few
> months, we will consider proposing rules to close the gap between those in the
> so-called "know" and the rest of us in the public. But edict can never replace
> ethic. I appeal to companies, in the spirit of fair play: make your quarterly
> conference calls open to everyone, post them on the Internet, invite 
> the press.
>
> Don't misunderstand me, analysts serve an important role in ensuring the
> efficiency of our markets by ferreting out disparate facts and offering
> valuable insights. In a market that increasingly demands that all participants
> add value to compete, analysts have positioned themselves well to do 
> so. But if
> analysts continue to view the world through rose-colored lenses, they doom
> themselves to irrelevance. As more and more investors, even retail investors,
> recognize sell-side analysis as a marketing tool, they will increasingly turn
> elsewhere for reliable research.
>
>
> Ensuring Quality Through Vigilant Oversight
> Corporate management and analysts are not the only market participants who
> share the responsibility of assuring integrity and transparency. It is
> absolutely imperative that a cultural shift envelop all key participants,
> including corporate auditors and directors. Its foundation, as always, must be
> an unwavering commitment to quality. Its cornerstone – an undying 
> commitment to
> the investor. This culture should be safeguarded by those entrusted with the
> public's interest. And this begins with an active and independent board of
> directors.
>
>
> Directors and Audit Committees
> A board must understand a company's operations – top to bottom. It must
> demonstrate both a keen interest in hunting down problems, and a genuine
> eagerness in finding solutions. This is especially true for a board's audit
> committee. Earlier this month, the Commission – building on the work of the
> Blue Ribbon Committee on Improving the Effectiveness of Audit Committees –
> proposed rules to improve communications through greater disclosure between
> management, the board, and outside auditors.
>
>
> Outside Auditors
> Let me turn to the responsibilities of this latter group. The audit profession
> has a long and distinguished history of guarding the integrity of our
> companies' financial statements. They must live up to their history and remain
> inquisitive, skeptical, and rigorous in their application of the highest
> standards.
>
> Like all businesses, the practices of the biggest accounting firms have
> undergone enormous changes. Entities once devoted exclusively to auditing now
> resemble diversified professional practices. If recent industry trends
> continue, I fear that the audit process, long rooted in independence and
> professionalism, may be diminished in the name of these increasingly lucrative
> and commercial opportunities.
>
> In 1981, management consulting services for traditional audit firms 
> represented
> approximately 15% of their total revenue. Today, its share stands at 40%.
> Meanwhile, revenues from auditing services have dropped to approximately a
> third of total revenues. I can't help but wonder what impact this changing
> business mix has had on a culture that has prided itself on objectivity. Can
> the audit engagement partner truly be perceived as discharging his public
> duties while trying to sell his audit clients legal advice or consulting
> services?
>
> Right now, a distinguished group called the "Independence Standards Board,"
> drawing an equal number of representatives from inside and outside the
> profession, is wrestling with these very issues. The ISB's 
> "balanced" structure
> will prove to be either a stroke of genius, or a fatal flaw.
>
> But financial markets wait for no one. It has always been an 
> unassailable truth
> that what markets dread most is uncertainty and a lack of information. Nowhere
> could that lack of information be more detrimental than in judging the
> credibility of the financial statements. Regardless of how this issue of
> auditor independence is ultimately resolved, wouldn't investors be better off
> knowing what other types of services their auditors are performing? With such
> knowledge they can more fully evaluate the question of independence for
> themselves. Without it, they are completely in the dark.
>
> More generally, perhaps we should give some thought to whether the accounting
> profession has become so big and complex that we need an alternative
> self-regulatory approach. Under the current regime, that responsibility is
> divided under a multitude of entities. Is the alphabet soup of regulatory
> bodies – the POB, the AICPA's PEEC, the SECPS, the QCIC, the ASB and the ISB –
> really the best way to serve the public interest?
>
>
> Reporting on the New Economy
> The dynamic nature of today's capital markets creates issues that increasingly
> move beyond the bright line of black and white. New industries, spurred by new
> services and new technologies, are creating new questions and challenges that
> must be addressed. Today, we are witnessing a broad shift from an industrial
> economy to a more service based one; a shift from bricks and mortar to
> technology and knowledge.
>
> This has important ramifications for our disclosure and financial reporting
> models. We have long had a good idea of how to value manufacturing 
> inventory or
> assess what a factory is worth. But today, the value of R&D invested in a
> software program, or the value of a user base of an Internet 
> shopping site is a
> lot harder to quantify. As intangible assets continue to grow in both size and
> scope, more and more people are questioning whether the true value – and the
> drivers of that value – is being reflected in a timely manner in publicly
> available disclosure.
>
> These questions may have some merit. Groups, past and present including one
> sponsored by the FASB, have worked on variations of this issue. 
> Nevertheless, I
> have asked Professor Jeffrey Garten, Dean of Yale's School of Management to
> assemble a group of leaders from the business community, academia, the
> accounting profession, standard setting bodies, and corporate America to
> examine expeditiously whether our current business reporting 
> framework can more
> effectively capture these momentous changes in our economy. But let 
> me be quite
> clear: The work of this group is not an invitation to delay any initiative
> currently underway, especially those involving business combinations. These
> projects must be evaluated on their own merits.
>
>
> Building a Global Financial Reporting Framework
> The very same forces driving our own economy are driving the world's economy.
> In today's hot-wired financial markets, modern technology allows traders to
> move money anywhere in the world at lightning speed, more than $1.5 trillion
> every day – a sum equal to world trade for four months. With markets 
> around the
> world more interconnected than ever before, investors and companies are
> increasingly seeking opportunities beyond their own borders. As a result, the
> need for a common business language has become compelling.
>
>
> International Accounting Standards
> Financial reporting is a language, just like German, English, or 
> Spanish. It is
> the language that companies use to talk to investors. It is what people use
> everyday to decide where to invest their hard earned dollars for financial
> security and future opportunity. These decisions can be hard enough. 
> But try it
> in a language you don't understand, and it becomes all but impossible. Even
> worse, misleading.
>
> If anyone doubts the disparate effects that different accounting practices can
> have, consider the case of Daimler-Benz. Under German accounting standards,
> Daimler reported a profit of 168 million Deutschmarks in 1993. Under 
> U.S. GAAP,
> the company reported a loss of almost a billion Deutschmarks for the same
> period.
>
> Progress in establishing worldwide accounting standards is already well
> underway. Earlier this year, the International Organization of Securities
> Commissions and the SEC began their assessment of a set of standards developed
> by the International Accounting Standards Committee.
>
> But it has never been more clear that it's not enough to have a group reach
> compromises on a set of accounting rules and label them "international
> standards." The standards themselves must be high quality. By that I mean
> useful to investors in a way that provides transparency, consistency and
> comparability in the way companies report in a global capital market.
>
> The process that produces these standards is equally as critical. Our
> experiences with our own domestic standard setter, the FASB, has 
> taught us that
> for an entity to be credible it must select its members on the basis of
> technical competence and devotion to the public interest. The standard setter
> must be independent and objective, resisting the temptation to achieve
> diplomatic harmony by trying to accommodate everyone.
>
> Finally, any global financial reporting system must include an infrastructure
> that extends beyond the standards and the standard setters. This 
> infrastructure
> includes high-quality auditing standards, strong international audit 
> firms with
> effective quality controls, profession-wide quality assurance, and meaningful
> regulatory oversight.
>
> Profession-wide quality assurance is an especially relevant issue in today's
> environment. International auditing firms have been quite successful in
> branding their names worldwide. Today, you can't walk through an airport, ride
> a bus, or open a magazine without seeing ads for many of these 
> firms. But don't
> mistake their omnipresence for omnipotence over world-wide quality control
>
> An affiliated firm in South America or Asia is just that – 
> affiliated. There is
> no guarantee that the foreign affiliate adheres to anything resembling the
> high-quality auditing standards that apply to U.S. firms. While the laws of
> many jurisdictions do not prescribe sufficiently rigorous audit standards, I
> see a compelling market need for firms to require their worldwide 
> affiliates to
> subscribe to the highest possible global standards.
>
> The organizing agreement between these affiliated firms and their parents must
> ensure a consistent quality audit on a worldwide basis. In the 
> aftermath of the
> 1997 and 1998 crises, the World Bank questioned the quality of audits in the
> international arena and I must say, I share that concern.
>
> The international financial institutions, key foreign financial 
> regulators, and
> the SEC are now actively discussing how we can join together to ensure that we
> have high-quality, public-oriented, independent audits that guarantee credible
> financial reporting for both global investors and markets. I know that this is
> as much a concern for the profession as it is for regulators around the world.
> A global economy demands that investors have confidence in financial 
> numbers on
> a global basis.
>
>
> Conclusion
> It's hard to imagine a time when financial statements were wholly unreliable;
> when fabricated earnings statements were issued in reckless abandon; and when
> most companies wouldn't even report gross incomes. But at the 
> beginning of this
> century, this was, in fact, the reality. It may have been a free 
> market, but it
> was far from fair. And America would soon reap the bitter harvest of
> misinformation and obfuscation.
>
> Today, the stakes are even greater. No longer can we take for granted the
> international supremacy of U.S. capital markets. Technology has set 
> into motion
> dazzling challenges to market mechanisms whose free market dynamism is being
> impeded by anti-competitive handcuffs imposed by participants and 
> sanctioned by
> regulators. A free market is nurtured by a culture of disclosure and equal
> access to information that fuels rather than fetters the marketplace. The
> dangers are real and the opportunities abundant.
>
> The efficiency and expanse of an unburdened open market is 
> limitless. Tear down
> the barriers to competition, remove the obstacles to greater innovation,
> spotlight all conflicts of interest, and unleash the flow of timely and
> accurate information, and our markets – like never before – will be driven by
> the power and the brilliance of the human spirit.
>
> I appeal to every financial analyst, every corporate manager, every board
> member, and every auditor to renew your covenant with investors and reaffirm
> your commitment to quality – for the sake of greater public confidence in our
> markets, for the sake of a better marketplace.
>
> Thank you very much.
>
> http://www.sec.gov/news/speeches/spch304.htm
> Last update: 10/18/1999