Progress Towards Better Markets (Speech presented by Mr Arthur Levitt, Chairman of the US Securities and Exchange Commission)

Attached for your reference is a speech given today by Mr Arthur Levitt, Chairman of the US Securities and Exchange Commission, at a luncheon co-organised by the Asia Society Hong Kong Center and the Securities and Futures Commission.

Only English version of the speech is available.

Recent developments pose tremendous challenges and opportunities that stand to broadly redefine markets for decades to come. And while each marketplace around the world must grapple with its own unique set of issues, obstacles, and concerns, we all share certain fundamental challenges that implicate both the evolving structure of capital markets, and the financial information that binds these markets together.

The Evolving Structure of Markets

Any discussion of global markets must consider the implications of the so-called new economy – an environment defined by the information revolution – just as we defined the institutions of a market economy for the industrial revolution more than a century ago.

Without getting into a discussion of what is truly new in our economy, it is important to note that there have been other times in our history when new technologies did great things to our economy, when business was better than it had ever been, and or economic climate the most successful ever.

One of those times was the 1920s. To me that means the new economy needs constant renewal. And that will only happen on the basis of old values.

Today I will touch on the cornerstone of those values – investor confidence – and how market structure, auditor independence and full disclosure are essential predicates to the preservation of this quality which distinguishes the world’s best markets.

The forces of competition and centrality, in my view, are the defining propositions at the heart of the debate on market structure today. Central markets have always had an allure. Basic economics tells us that the greater the supply and demand that congregate in one place, the more efficient the price-setting mechanism. This means the more customer orders that interact with one another, the better the prices will be.

Questions about best execution begin to fade. Spreads may narrow, liquidity may increase, and markets become more orderly. But, there is another side to centralization. As centrality tends towards monopoly, it also becomes more immune to innovation and the benefits of competition.

In the U.S., electronic communications networks have introduced new competition driving traditional markets to innovate like never before. Across Europe, exchanges are consolidating, heading possibly toward a Pan-European platform.

Many Asian and European exchanges are fully electronic trading venues. In fact, centralized, electronic national markets are not a new development for these exchanges. If one surveys the construct of exchanges around the world, it’s safe to say that the open outcry has been replaced, to a great extent, by the silent screen.

U.S. markets, however, have not moved as fast towards order-driven electronic systems with central order books. The reasons are as much historically rooted as they are economically rooted.

For the last twenty-five years, America’s capital markets have been characterized by a system of competing market centers. In the Nasdaq market, you have competing dealers with large numbers of connected pools of liquidity.

Our listed market, in contrast, consists of a largely central pool of liquidity, governed by auction principles. But, it too faces competition, for example, from the third market which trades listed securities in the Nasdaq dealer market.

And, with the recent move to repeal certain anti-competitive rules in the marketplace, it remains to be seen whether the powerful force of a central market will mean the continuation of one dominant exchange in light of competition from electronic communication networks.

As one compares U.S. markets to those around the world, one can easily be struck by the vast structural differences. Many Asian and European exchanges, for example, have for years automated their trading and altered their ownership structures.

And with economic and monetary union, exchanges are under greater pressure to meld diverse operations or develop common settlement systems.

Asian and European exchanges are better positioned to deal with competition from ECNs than the traditional U.S. markets. Yet, as on-line investing grows in Asia and Europe, some investors may demand execution services better performed by a dealer than by a central order book.

Traditional markets, however, whether they are auction-based or screen-based, are increasingly under fire from new, innovative trading systems and platforms. It could be a dealer with automatic execution and liquidity guarantees or an Electronic Crossing Network. In both cases, the promise of disintermediation, or greater anonymity, or lower costs, is pushing traditional markets to cut costs and to become more efficient.

The question those in America’s markets and I suspect many in Asia are wrestling with is how do you couple vibrant competition and the innovation it produces with the efficiency of centralizing orders.

Put another way, how do you ensure that a market is central enough to maximize the possibility that buyers and sellers will meet on terms that serve them best, and at the same time competitive enough to spur enduring innovation? It is not good enough to have a brilliantly designed trading platform that solely produces efficient prices. There is a big difference between an efficient trading system and an efficient national market system.

I view our role at the Commission as maintaining and upholding a framework that fosters vibrant systemic competition. In this framework, multiple market centers – traditional exchanges, electronic markets, and dealers – compete with one another for business, spurring a race towards faster, cheaper execution of transactions.

Prices across these markets are visible – or transparent – to market participants. Brokers are legally obligated to obtain the best prices reasonably available for their customers. And multiple market centers are linked, ensuring that brokers have access to the best prices in the overall market.

Selective Disclosure

As more countries embrace a true equity culture, and investors respond by allocating capital globally, a transparent and trustworthy global financial reporting framework has never been more important. Nothing erodes investor confidence more quickly than when the financial reporting process is grounded in anything but fairness and integrity.

One particular practice that has the potential to undermine the quality of the reporting process is selective disclosure. In a time when instantaneous and free flowing information is the norm, “whispered” information is an insult to the principles of free and open disclosure upon which the success of our capital markets are based.

The SEC has recently initiated a new proposal, which would require that when a company discloses material information, it does so through public disclosure rather than limiting initial access to that information for the benefit of a privileged, select few. And, when a company learns that it has made an unintentional selective disclosure, it would have to make that information known to the public in short order.

This proposal has attracted a high degree of public comment. Some argue that stricter rules will “chill” the flow of information as companies respond by providing less disclosure altogether. I disagree. The Commission’s proposed rules on this issue exemplify the “best practices” standards of investor relations and analyst groups. They will provide issuers with a great degree of flexibility in the way they distribute information – including the use of new technologies over the Internet to offer extraordinary broad access at minimal cost and give investors equal access to issuer information.

Auditor Independence

Integrity, transparency and fairness also serve as the bedrock of a strong and trustworthy financial reporting framework. Independence is at the core of the accounting and auditing profession, the very essence that gives an auditor’s work its value.

More than five decades ago, one of the profession’s own said, “The accounting profession must be like Caesar’s wife. To be suspected is almost as bad as to be convicted.” There has always been this higher standard for the auditor. It is not enough that the accountant on an engagement act independently. For investors to have confidence in the quality of the audit, the public must perceive the accountant as independent.

Today, the accounting profession stands at a pivotal moment in its history. During the last several months, you’ve no doubt heard about broad reorganization plans by the largest and most prestigious accounting firms. These proposals, designed to monetize some or all of the firms’ consulting businesses, have the potential to advance the public interest by returning the core focus to accounting and auditing.

But these constructive divestitures of consulting businesses must be accomplished without creating conflicts of interest through long-term financial relationships.

In fact, today, auditing no longer dominates the practices of the largest firms. It accounts for just 30 percent of total revenues – down from 70 percent in 1977. Consulting and other management advisory services now represent over half – up from 12 percent.

Since 1993, auditing revenues have been growing by 9 percent per year on average – while consulting and similar services have been growing at a rate of 27 percent each year.

Not surprisingly, product line expansion has been an outgrowth of market forces. But the truth is, providing consulting and other services may shorten the distance between the auditor and management. Independence – if not in fact, then certainly in appearance – becomes a more elusive proposition.

When an audit firm performs valuations of numbers that appear in its client’s financials, the mandate for independence is threatened. When an audit firm also keeps its clients books, the principle of independence is undermined. And when some firms take on tax and other assignments where the size of the fee is based on the answer given, one has to wonder how such a practice is consistent with a culture that has long prided itself on objectivity.

What’s more, the audit is sometimes priced lower to attract clients willing to pay for higher margin consulting services. But, the audit foothold as a distribution channel for consulting services is at the very root of the inherent tension that these interdependent relationships foster. The audit engagement partner, upon whose shoulders much of the credibility of the profession rests, makes decisions each day that affect the underlying quality of the audit. These often unrecognized guardians of our capital markets exercise the judgement that validates the integrity of the financial information.

It’s been said, “A public accountant acknowledges no master but the public.” But, when auditors engage in extensive services for an audit client truly unrelated to the audit, they must now also serve another master – management. In this dual role, the auditor, who guards the integrity of the numbers, now both oversees and answers to management.

Assuming the role of “relationship” manager, the auditor helps develop and coordinate extensive cross-selling and marketing strategies with, for example, his firm’s information technology consulting group.

And while it may never be quite so explicit, some auditors know, and others suspect, that their compensation is influenced by how well they “manage” that relationship in its entirety. As the firms’ business objectives drive them into broader alliances, it’s becoming more difficult to ascertain where one relationship ends and another begins.

Now, some say that appearance simply doesn’t matter; that auditors should be free to perform almost any service unless it can be proven that a business or financial relationship directly undermines the audit.

But that view misses one of the most important aspects of an auditor’s responsibilities. It is not the bright line of right and wrong that the lack of auditor independence often implicates as much as it is that grey area where the answers aren’t so clear; where the temptation to “see it the way your client does” is subtle, yet real.

Independence is, in many respects, a condition of the mind of the auditor, its reflection the trust and confidence of the public. To suggest that we should wait to experience erosion before we act to preserve this confidence is to ignore the wisdom of Benjamin Franklin, “Glass, china, and reputation are easily cracked, and never mended well.”

In the coming months, the Commission will consider how to address the long-term ramifications of today’s restructurings on both auditor independence and investor confidence.

In my view, any regulatory action must address a few fundamental public policy questions: Should there be more appropriate limits on the types of services that an audit firm can render to a public company client? How should audit firms be structured to assure independence? What are the consequences, if any, of public ownership? Should firms be permitted to affiliate with entities who provide services to the firms’ audit clients that the firms themselves would not be allowed to provide?

Conclusion

As we address these and other questions, some still may ask “Does it really matter if the numbers in the balance sheet or prospectus are just slightly off, or if an investor receives a price that is only a little bit worse than the best market price?” The answer is simple.

If investors lose faith in the integrity of our markets’ prices, they will go elsewhere. If investors believe that they are not receiving high quality financial information, they will go elsewhere. If they believe that their interests are being placed secondary for any reason whatsoever, they will go elsewhere.

We are living in a time when investors are increasingly able to shift their capital in and out of markets cheaply and easily; it may not always happen overnight, but the history of markets teaches us it can happen quickly. And the road to restoring lost confidence is a long one indeed.

Confidence is not a measurable commodity that can be either mandated or purchased. Rather, it is a quality, an amalgam of beliefs, convictions, sensibilities that ultimately are the result of experience. Once lost, this fragile but strong characteristic is almost impossible to rehabilitate.

Promoting and preserving investor confidence: this is the challenge, I believe, for all financial regulators regardless of how or where their markets operate.

Thank you very much.