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Congress is about to rubber-stamp Arthur Levitt's reappointment. First, it should find out where he stands.
Ronald Fink, CFO Magazine
April 1, 1998
Arthur Levitt, the dapper, 67-year-old chairman of the Securities and Exchange Commission, likes to present himself as the investor's best friend. Then again, you'd expect as much of any SEC chairman. But Levitt's fans contend that in this case, the self-characterization is right on the money.
They note, for example, that Levitt has forced state and local politicians to stop demanding campaign contributions in return for municipal bond business, which adds to the cost of underwriting tax-exempt bonds. He's threatening to crack down on accountants who manage their consulting business in ways that compromise the integrity of corporate audits. And he's demanding that companies adopt tough new accounting standards for derivatives, helping show how much risk such instruments pose. All to the benefit of investors.
"The chairman takes seriously his responsibility to protect shareholders," says Edmund Jenkins, who last summer was appointed chairman of the Financial Accounting Standards Board, with Levitt's blessing. For that reason, supporters are confident that Congress will approve Levitt for a second five-year term now that President Clinton has renominated him. Levitt failed to respond to CFO's requests for an interview, although he answered a few questions via E-mail shortly before this issue went to press; a spokesman cited scheduling conflicts.
But in light of Republican control of Congress, Levitt's inability to make time for an interview might also reflect a certain wariness about how his renomination hearings will proceed. Powerful GOP members like Sen. Phil Gramm of Texas and Rep. Richard Baker of Louisiana contend that Levitt's efforts on behalf of investors have gone too far,hampering the ability of corporations and others to raise capital. Given such concerns, critics on Capitol Hill may vote to deny Levitt a second term.
Although Levitt is the only incumbent chairman of the SEC ever to be nominated for a second term, rejection is unlikely. Republican Sen. Alphonse D'Amato of New York, who chairs the Senate committee that will hold the hearings, says that he expects quick approval.
Whether Levitt deserves a second term is another matter. And the answer isn't as clear as either his supporters or his opponents suggest. Levitt's track record is inconsistent, and his agenda is something of a puzzle. Where, for example, does the SEC chairman stand on the fundamental issue of technology's role in financial market reform? "A good question," says James Angel, finance professor at the Georgetown University School of Business, in Washington, D.C.
Indeed, look more closely at those investor-oriented actions cited by Levitt's biggest fans and you'll see that some served Wall Street's interests, too. For one thing, political contributions to municipal bond issuers came directly out of underwriters' pockets, and the brokers may or may not be passing along the savings to investors. It's impossible to tell, because the secondary market for municipal bonds is extremely thin, with price quotes for the same issue all over the map.
Also, brokers have as much of an interest as investors do in trustworthy corporate audits. Without them, investors would have ample reason to doubt whether the research that brokers often provide in return for their buy and sell orders is worth anything. And while requiring more disclosure of companies' holdings of derivatives, Levitt let the six largest securities dealers set the voluntary standards for oversight of their derivatives affiliates.
"That's like asking Microsoft to set the standards for computer operating systems," says an SEC observer.
Policing the Exchanges
Not that Levitt hasn't taken stands that served investors' interests at the expense of the financial middlemen. Consider, for instance, his decision to overhaul the board of the National Association of Securities Dealers (NASD) in the wake of allegations of collusion among brokers on price spreads. In essence, Levitt decided that the board was not sufficiently independent of NASD members to take actions that serve investors' interests, so he added new representatives from outside the industry. That served to more clearly separate the NASD's two roles as market operator and regulator, effectively acknowledging that the conflict of interest facing the NASD had been an obstacle to fundamental change.
Still, proponents of financial market reform contend that Levitt did not go far enough to resolve the NASD's conflict. And other U.S. markets share such a conflict to one degree or another, including the most powerful of all, the New York Stock Exchange (NYSE). As the battle over price collusion among NASD members showed, such a conflict invites regulatory policies designed to gain and retain business even when, in a deregulated environment, that business might be better off elsewhere. And despite assertions to the contrary by the NYSE's supporters, the exchange may be little better at policing itself than the NASD was, if recent, unprecedented allegations of illegal trading by floor brokers are proved. Yet Levitt has shown little inclination to challenge the NYSE's power.
Sure, Levitt has convinced the exchange to revise its much-maligned Rule 500, which makes it virtually impossible for a company to delist its shares from the exchange. To delist from the NYSE at present, two-thirds of a company's outstanding shares must vote in favor and fewer than 10 percent against, which effectively locks in listed companies. Junius Peake, a finance professor at the University of Northern Colorado and former NASD vice chairman, cites the rule as an instance of "anticompetitive behavior" that threatens to make the exchange a "high-cost provider."
After prodding from Levitt, the NYSE has proposed easing Rule 500. Under the proposal, a shareholder vote for delisting would require only a simple majority, approval from an audit committee made up of independent directors, and written notice to all shareholders between 45 and 60 days in advance. But congressional critics contend the change does not go far enough, and want Levitt to lean harder on the exchange.
An Underwriting Radical
On the other hand, critics' arguments that Levitt's efforts on behalf of investors have hurt issuers don't square with his stance on changes in the securities underwriting process. During the past two years alone, the SEC chairman has overseen a series of steps that would drastically alter the underwriting process. These include:
Indeed, Levitt is no Luddite when it comes to the Internet's role in the underwriting process. The commission "has been remarkably supportive," says Andrew Klein, chief strategist at Wit Capital, a New York online investment bank that raised more than $5 million over the Internet for several companies in its first six months of existence.
And while most of the capital raised so far this way has merely augmented traditional offerings, the SEC expects the trend eventually to go much further. "Technology is opening the door to a host of new possibilities," says Brian Lane, director of the SEC's division of corporate finance. "As the Internet provides a low-cost mechanism for reaching millions of buyers, it may provide greater opportunities for direct public offerings independent of intermediaries."
Quarrel over Derivatives
Levitt's embrace of this alternative to traditional underwriting ought to win him more praise than he usually gets from issuers. Perhaps they have been distracted by the hue and cry over his insistence on accounting standards for derivatives, which have banks inparticularly high dudgeon. Even the nation's chief monetary guardian, Federal Reserve chairman Alan Greenspan, has publicly crossed swords with Levitt over the issue, arguing that such a change would make corporate earnings and stock prices more volatile.
But while Levitt has tried hard to parry the antiregulatory thrusts over derivatives, he has not objected to FASB's postponement of the effective date of its new accounting rule. The official explanation is that this will give issuers more time to comply with a burdensome requirement. But Levitt may also be reacting to accusations that he has packed FASB's overseer, the Financial Accounting Foundation, with supporters of more disclosure, compromising FASB's independence. In a recent letter to the editor of the Wall Street Journal, Citibank chairman John Reed opined that the SEC might as well take over FASB's rulemaking function. Similarly, brokers and other critics accused Levitt of disregarding the NASD's independence when he strong-armed its board into accepting members from outside the industry.
Sour grapes, say Levitt's supporters. They contend that if Levitt employed those same tactics on behalf of an agenda more to his opponents' liking, his opponents would applaud the chairman for his effectiveness instead of criticizing him. "They just don't like the outcome," observes Barry Melancon, president and CEO of the American Institute of Certified Public Accountants and an outside adviser to FASB.
Says Levitt: "Congress created FASB as an independent standards setter. Public confidence is essential to that process, and public representation is essential to public confidence."
Nonetheless, Representative Baker has introduced a bill that would mandate closer SEC oversight of FASB, subjecting its decisions to greater public accountability. Baker says he's out to correct a flaw in FASB's process that makes it difficult if not impossible to challenge its decisions. "Questions have arisen whether persons aggrieved by FASB pronouncements have the right to judicial review of their complaints," he said in a statement accompanying his bill. "Congress should not have to inject itself in these controversies each time they erupt--as it has in recent years with squabbles over accounting for stock options and derivatives."
But others contend that those who have come down on FASB over derivatives fail to understand that the financial markets need not be a contest between investors and issuers. Says FASB's Jenkins: "The better information you provide to investors, the lower your cost of capital." From that perspective, he insists, Levitt's push for more disclosure is anything but a black mark, and his apparent retreat in the face of opposition is insignificant. "His emphasis and interest and support" on such issues "go well beyond" what previous SEC chairmen have shown, says Jenkins.
Electronic Trading: Too Cautious?
Maybe so. Yet Levitt has failed to pursue an equally aggressive tack in another arena in which the interests of U.S. issuers and investors are no less virtuously aligned. That arena is securities trading. Here proponents of reform contend he has an even greater opportunity to help both camps. How? By embracing electronic securities-trading systems that promise to challenge the dominance over the financial markets exercised by traditional stock exchanges and brokers. To the extent that electronic systems can reduce the role of brokers in handling transactions, the cost of trading securities should decline.
Electronic trading systems, such as Posit and Instinet, that are regulated as brokers and run by such companies as Investment Technology Group Inc. of New York and Reuters Group Plc of London, respectively, started out in the late 1960s as proprietary computer networks, but are increasingly accessible through the Internet and other networks, including those of other brokers. The Arizona Stock Exchange makes extensive use of such systems; so do several European bourses, including those of London, Paris, and Stockholm.
Not so the NYSE, Nasdaq, the American Stock Exchange, and other exchanges, which depend on traditional brokers and specialists to handle all but the smallest transactions. And while Nasdaq has announced plans to offer an electronic trading system, large transactions executed there and on the NYSE and other exchanges are still subject to so much intervention on the part of brokers that mutual funds and other institutions often cannot buy or sell before giving their intentions away to other investors.
Granted, specialists and other traditional brokers often put up their own capital to buy and sell stocks, which can provide liquidity when there is none, helping reduce volatility in the market. But critics of the current setup contend that buyers and sellers alone could provide sufficient liquidity if they could communicate more freely with one another, and that the middlemen simply drive up costs.
Investors have an obvious interest in lower trading costs. And issuers would also benefit. They, too, are investors when buying back shares or funding an employee stock ownership plan. And their role as overseers of pension plans subjects them to Department of Labor rules that require them to seek "best execution" for plan trades. CFOs also have a fiduciary obligation to shareholders, and higher trading costs do nothing to maximize shareholder value.
"If you're a big organization, you already have quite a bit of liquidity," says Michael Brown, former CFO of Microsoft Corp. and chairman of Nasdaq's board. But, Brown adds, "midcap companies can get a lot more liquidity [via electronic trading systems], especially if they have employee stock ownership programs or stock buyback programs."
Richard Lindsey, the SEC's director of market regulation, says the commission is doing all it can to foster competition among the traditional markets and electronic systems. The commission is studying how it might overhaul the present regulatory scheme to allow for more competition, with proposed rules that would pave the way for such reform possibly as early as June.
Under one scenario suggested in a so-called concept release that the SEC issued last May, electronic trading systems would be regulated as exchanges instead of as brokers. But that, under the current SEC regime, would limit their competitive advantage by making it more difficult for them to let institutional buyers and sellers deal directly with each other.
That prospect, says Georgetown's Angel, "is somewhat horrifying." Levitt says the proposal was merely "the beginning of a dialogue."
Others who want to see the SEC embrace electronic systems are more generous. Levitt "tends to be cautious," explains Edward Fleischman, a former SEC commissionerand now a consultant to the London-based law firm of Linklaters & Paines. "Arthur is very careful not to tear down the temple walls without being fairly confident of the structure that will replace it."
Change, of course, is always risky. And Levitt evidently worries that encouraging alternatives to the existing system might make the markets less transparent or accessible to small investors. Also, proponents of the current setup contend the U.S. markets are already the most efficient in the world, so why fix what isn't broken? But even Fleischman says the potential cost savings from more competition in the financial markets more than justify the risk of less transparency or accessibility.
Exactly how inefficient U.S. markets currently are is hard to say. But Rutgers University finance professor David Whitcomb, who first began analyzing the price structure of the markets in 1981, testified before Congress last year that the system provides a "multibillion-dollar subsidy" to Wall Street firms each year. And former SEC commissioner Steven Wallman has estimated the potential savings from new competition at $5 billion annually.
"I have to go through seven people" to execute a trade on the New York exchange, complains Harold Bradley, portfolio manager for American Century Investments, a mutual fund management company based in Kansas City, Missouri, that handles $67 billion in assets. "There are simply too many proprietary, and predatory, interests at work."
In fact, the barrier to the temple's reconstruction may not be technological, but political. Taking on some of the country's most powerful private interests--the brokerage firms that belong to the NYSE and the NASD — isn't easy for anyone in Washington. Through campaign contributions, "Wall Street gives Congress even more than it gets," observes Larry Fondren, founder and majority owner of InterVest Financial Services Inc., a Philadelphia-based electronic system that is struggling against firmly entrenched dealers for a toehold in the bond market (see "What's a Bond Really Worth?" at the end of this article.)
Why hasn't Levitt pushed the NYSE to embrace competition as hard as he has the NASD? Some suggest that personal experience has blinded him to the flaws of traditional exchanges. Levitt spent almost three decades on Wall Street, starting as a stockbroker in 1963 with the firm that would eventually become Salomon Smith Barney. And he left Wall Street as a millionaire in 1989, when he stepped down as chairman of the American Stock Exchange. (He used some of his money to buy Roll Call, a newspaper that covers Capitol Hill, and then sold it to The Economist Newspaper Group Inc., which owns CFO, after Clinton tapped him for the SEC in 1993.)
"He's shed his affiliation with the industry to a great extent," says Morris Mendelson, professor emeritus of finance at the University of Pennsylvania, "but that's not to say he's not influenced by his experience." That's apparent, Peake of the University of Northern Colorado contends, in disputes that Levitt had with Steven Wallman, who left the SEC last October after serving three and a half years as commissioner. Wallman was clearly one of the most outspoken proponents of financial market reform within the SEC in recent history, often vigorously and publicly arguing that the commission needed to take a more flexible regulatory approach to spur innovation and competition.
Based on reports from people who have worked with the two men, observers say Wallman's reformist zeal did not sit well with Levitt. Not that these observers are surprised. From July 1995 until February 1996, Wallman and Levitt held the only two occupied seats on the five-member commission, which meant that "Arthur couldn't do anything policywise without getting Steve on board," says former commissioner Fleischman. "And while Steve was reasonably deferential, the chairman couldn't have been very happy with the situation."
Levitt responds that Wallman and he "are in total agreement that we must encourage competition between alternative and traditional markets." And he describes Wallman as "a creative and forward-looking thinker" who contributed "tremendous energy and commitment during his tenure."
For his part, Wallman vigorously denies reports of tension between Levitt and himself. "Arthur and I were very complementary," Wallman says. Yet Wallman reiterates his oft-stated view that the commission should become much more flexible in its approach.
One is therefore left wondering what accounts for Levitt's greater receptivity to changes in underwriting than in trading. A possible explanation, says Peake, is that reducing the traditional role of Wall Street in the former would cut its fees, helping issuers raise that much more capital, which he says is a higher priority for the SEC than it likes to admit. Underwriting is also a simpler activity to oversee than trading. The SEC's approach to underwriting is based almost entirely on disclosure, whereas the commission finds itself micromanaging a very complicated trading system. In other words, there's much less the SEC has to do to free underwriting from Wall Street's domination than to free trading.
Again, however, politics may also influence Levitt's approach. Most of the same Wall Street firms that underwrite securities are also involved in trading. But their interests in trading are ably represented in Washington, by the NYSE, whereas each firm is more or less on its own when it comes to lobbying for underwriting efforts. In underwriting, "you don't have a lot of money concentrated in a single place," says Peake. In his view, Levitt has a freer hand to pursue reform of the underwriting process, and he's taken advantage of that freedom.
Some observers suggest that the increasing efficiency and availability of new technology may make the secondary markets more competitive without the SEC's help. Bradley of American Century says it's possible that most if not all of the "real issues" facing the regulators "could be technologically competed away" without any change in its approach. Along those lines, Peake predicts that the NYSE might be forced to acquire the Pacific Stock Exchange to compete with Nasdaq, once the Pacific's systems are integrated with a new electronic trading system known as Optimark. Such a prospect would look even more likely if the Amex's proposed acquisition by Nasdaq becomes a reality.
That leads some proponents of financial-market reform to applaud Levitt for allowing competition to proceed as far and as fast as it has. "He deserves credit for the fact that it is happening on his watch," says former SEC commissioner Fleischman.
But the SEC chairman could help bring about more if he pushed harder. And he seems to need some pushing himself. With Wallman no longer around to egg Levitt on and no one else on the commission as committed to reform, reformers are looking to Congress.
Does Congress care enough about reform, and is it sufficiently independent of Wall Street's influence? Wallman's ideas have been embraced by key members of the committees on Capitol Hill that oversee the SEC. And they've taken Levitt to task for holding meetings with the exchanges over the transition from fractions to a decimal-based pricing system. These members contend that the SEC has no business involving itself in a discussion that has to do with pricing.
But in the absence of public pressure, Congress is unlikely to hold Levitt's feet much closer to the fire. "These things usually take a crisis," says Peake. Still, he suggests that competition from foreign exchanges could bring one about. He notes that the Eurobond market fled New York for London in a matter of weeks back in 1962, after President Kennedy imposed a withholding tax on bonds held by foreigners. "If we get to a point where the New York Stock Exchange is no longer competitive with London," Peake warns, "the U.S. may wake up to find it is no longer the financial capital of the world."
That day seems distant. But in light of Levitt's evident hesitation to take on Wall Street over trading, his record as SEC chairman can only be graded "incomplete." And based on Wallman's evident commitment to fundamental change on all fronts, he seems better suited to the task of leading the SEC into the next century. Congress, of course, cannot choose between the two men. But it shouldn't reconfirm Levitt until it's satisfied that he is no less eager to pursue reform across the board.
Ronald Fink is a senior editor at CFO.
While critics of the SEC chairman would argue that much of his record deserves anything but praise, Arthur Levitt has an impressive list of accomplishments to show for his first five-year term:
What's a Bond Really Worth?
While the Securities and Exchange Commission cracked down on the National Association of Securities Dealers over allegations of price fixing, the nation's top securities cop seems less concerned about allegations of price collusion among bond dealers.
Consider the case of InterVest Financial Services Inc., a Philadelphia-based electronic trading system for bonds. The InterVest system is designed to help bond investors get a range of price quotes from dealers on any given issue, which is currently quite hard to come by. Unlike stocks, bonds are not listed on exchanges. All trading is handled by dealers representing buyers and sellers. And because investors have no effective means of comparing bid and asked prices, dealers' spreads are suspected of being much wider than they would otherwise be.
Larry Fondren, founder and CEO of InterVest, estimates that the difference amounts to at least $15 billion a year, and believes the figure is probably many times that amount, considering that an estimated $60 billion in corporate bonds changes hands every day in the United States — dwarfing the value of stocks traded daily here.
After winning SEC approval of its system in 1992, InterVest arranged to provide access to its customers through Bloomberg LP's financial data network. But InterVest has had an extremely hard time getting dealers to participate, because of its transparency. And after InterVest announced in January that it would offer a new service that would let issuers market bonds directly to the public, Bloomberg canceled its agreement with InterVest.
Why? Bloomberg isn't saying. But Fondren suspects pressure from dealers, noting that the country's largest dealer, Merrill Lynch, has a 20 percent stake in Bloomberg. So he has asked the Justice Department's antitrust division and the SEC's division of market regulation to investigate.
Neither Justice nor the SEC will comment on the case, but Fondren says his complaints have fallen on deaf ears. "Justice told me that unless I can show that a bunch of bond dealers were sitting around in a room together, they won't have enough to go on." He says he got much the same response from the SEC.
However, federal regulators may soon have significantly more to work with besides Fondren's complaint, and it would come from a source that has proven extremely helpful in the past. The Nasdaq price-fixing scandal was the direct result of research on that market by academics Paul Schultz and William L. Christie. At Fondren's urging, Schultz, now a finance professor at the University of Chicago, has agreed to undertake a similar study of spreads in the corporate bond market, using trading data supplied by life insurers, which are the biggest holders of corporate issues. —R.F.