Auditors auditing themselves. Fund boards voting themselves pay raises even as assets decline. Directors acting not just as executives' lapdogs, but like "Chihuahuas." Com-plexes permitting recent alumni to meet independent directors requirements. Soft dollars. Portfolio pumping.
Arthur Levitt, former chairman of the Securities and Exchange Commission and of the American Stock Exchange, socks it to the mutual fund, accounting, investment banking and brokerage industries in Take on the Street, his new book set to come out next month (Pantheon).
The one-time publisher of Roll Call, now a television personality on Bloomberg TV and a director on a number of boards, including Neuberger Berman's, Levitt seems to relish in delivering zingers.
In person at his New York office at leveraged buyout firm The Carlyle Group, where he serves as senior adviser, however, Levitt delivers his opinions in a more quiet, reserved, almost reticent manner.
Levitt sat down with Richard Koreto, executive editor of Financial Planning, Tony Chapelle, senior editor of On Wall Street, and Lee Barney, editor of Mutual Fund Market News, on Sept. 11, after attending morning ceremonies at the World Trade Center, to talk about the state of the industry. Following are his remarks, interspersed with a few excerpts from his book.
What was your personal reaction to Enron, which, as you note in your book, robbed investors of $60 billion?
During my years at the SEC, I saw broad evidence of financial fraud among some of the most prominent companies in America. Every one of the Big Five accounting firms had fraudulent activity of one kind or another. Arthur Andersen was just caught more open-handedly.
I was saddened by the Enron affair because so many innocent people were caught up in it, not just investors, but employees who really believed in the hype and the promotion.
I never imagined a failure on the scale of Enron. The Enron/Andersen audit failure is a perfect example of what I was trying to prevent.
So, I'd use one word to characterize my reaction: Saddened.
If you were still chairman of the SEC, what would you do differently than your successor, Harvey Pitt, particularly to help brokers, say, in the next six months?
I certainly would focus on analysts, just as he's beginning to focus on analysts. And I would focus on governance issues, probably more than I did.
I don't think it's the job of the SEC to determine how brokers are compensated. Nevertheless, without regulating compensation, I'd probably be talking a lot about what can be done in the brokerage industry.
Brokers are vital in the lives of the people they serve in the same way that doctors or lawyers might be.
Do you believe that investors should only go to fee-only advisers?
Yes. The perception of conflict is so great in this environment, where investor confidence must be restored, a commission structure based on volume rather than quality of results just doesn't feel right.
Some of the best brokers I know have reoriented their businesses so that they're based on fees rather than commissions. I hope that brokers understand that by promoting investor interests, I'm really promoting their interests, as well.
What is the key point that you would like readers of Take on the Street to take away, particularly the professional audiences we reach?
I hope that they recognize that their future, their economic livelihood, depends upon public perception.
As far as brokers are concerned, I've been a broker, and I've run a brokerage firm. I have huge respect for brokers.
All of us, I have, made lots of mistakes. In my book, I point out that when I was a broker, I looked at my pad in the morning and said, "I've got to generate $200 to $300 in gross." And I found a way to do that. That wasn't good for my clients, and I recognize that.
The motivations induced by their managers and the companies for whom they work are skewed in the wrong direction; they're skewed by quantitative-based compensation. And I think that's wrong.
Brokers have got to reorient themselves as counselors and advisers, to do what is in the best interest of the customer.
As a former broker yourself, at a brokerage firm that, quite impressively, included Sandy Weill, the current chairman of Citigroup, how would you characterize the profession?
Brokers are individual entrepreneurs - creative, independent, feisty, intelligent risk-takers.
What's your biggest regret from your tenure at the SEC?
After noticing overly aggressive accounting practices by companies, with the approval of their auditors, to meet their earnings forecasts, I considered accounting standards, including expensing options. I also noticed how consulting contracts were turning accounting firms into extensions of management, even cheerleaders at times.
In case after case, we saw auditors who failed to probe behind the numbers CFOs gave them. It wasn't just a case of a few bad apples, either. Blue-chip companies with sterling reputations were manipulating the numbers in ways that were downright misleading.
I regard advising FASB [the Financial Accounting Standards Board] to back down on accounting standards as my
single biggest mistake during my years of service.
Out of a misguided belief that I was acting in the FASB's best interest, I failed to support this courageous and beleaguered organization in its time of need, and may have opened the door to more meddling by powerful corporations and Congress.
Is lax accounting possibly one of the reasons for the downfall of Enron, Adelphia, Tyco et al?
In 2002, companies began writing down billions of dollars worth of 1990s-era acquisitions. Instead of getting punished in the market for making bad decisions and vastly overpaying for their purchases, corporate executives were waving a magic wand over their mistakes and attributing these massive write-downs to a "change in accounting principles."
The FASB succumbed to corporate pressure, while the accounting industry waged guerrilla warfare against the SEC. The AICPA and accounting firms gave $145 million in the 2000 election cycle - less than telecom but more than defense.
The costly legacy of this compromise is likely to be years of financial reports that fail to reflect the true economics of many business combinations and the pooling of interests through cash swaps.
What's the biggest lesson the investment management industry should learn from these accounting scandals?
Self-regulation by the accounting profession is a bad joke.
Sometimes it takes a crisis to convince the world that the status quo has to change.
What was your biggest triumph while chairman of the SEC?
In the fourth quarter of 2000, nearly 1,474 companies publicly announced whether they would hit their earnings target, up an astounding 96% over the previous quarter's public pre-announcements.
Regulation Fair Disclosure has done more to restore investor confidence in the stock market than any other rule the SEC adopted during my tenure.
Do you agree with critics of the fund industry that some of the biggest remaining problems at fund companies include not disclosing holdings often enough, abusing 12b-1 fees and paying for supermarket shelf space?
Yes, I think there can be more disclosure. Mutual fund companies are eager to be seen as pro-investor, but the truth is, they aren't always.
I don't believe that fund holdings should be disclosed every day or every week. I think that's confusing and expensive. If a fund changes its emphasis - if it's a fund that's a high-tech fund that suddenly becomes a utility fund, or loses or changes a key manager - those are important areas to be revealed.
I think 12b-1 fees have been abused, and the cost of funds continues to be too high.
If you invested $10,000 in a domestic stock fund with an expense ratio of 2% and a sales load of 3% and you got annual returns of 7.5% for 20 years, your money would almost triple to $27,508. But you would also have lost $14,970 in fees and foregone earnings over the 20 years.
I also have reservations about the "favored-fund" status given by many resellers based upon the fund's paying fees to resellers. According to Financial Research Corp., the fund industry pays $2 billion a year for shelf space.
If a Merrill Lynch broker knows he'll get 25% more money for selling a Putnam mutual fund over an American Century fund, guess which fund the broker will try to sell you.
What would you advise mutual fund portfolio managers and analysts to scrutinize when analyzing a company?
Look at inventories, accounts receivable, inventory write-downs, the ratio of long-term debt to the company's total invested capital. A ratio above 20% is considered high.
Look at operating expenses, and whether their R&D expense is adequate; how many products are coming out of this pipeline. Look to see if restructuring costs are truly restructuring costs. Look at vendor financials and whether the company is recognizing revenue before its time.
Take a hard look at the cash-flow statement and do not ignore the footnotes. If a footnote seems obfuscatory, there's probably a reason.
What struck you the most when you were chairman of the SEC?
During my 7-1/2 years in Washington, I was constantly amazed by what I saw.
How did you time the release of a book at such a defining moment for Wall Street, with all of America riveted by the sight of corporate titans being led off in handcuffs and the state of the market being of such concern?
Pure luck.
