"FINANCIAL SELF-DEFENSE: PROTECTION IN THE MODERN MARKETS" REMARKS BY CHAIRMAN ARTHUR LEVITT U.S. SECURITIES & EXCHANGE COMMISSION INVESTORS' TOWN MEETING LOS ANGELES, CALIFORNIA FEBRUARY 8, 1998 It's a pleasure to join you today in Los Angeles, and it's great to see another big turnout for the Times' annual investment conference. You'd think that -- early on a Sunday morning --you'd all be home reading the Sunday Times right now. I think that this turnout is a wonderful sign -- that, instead of being at home, you're all eager to be here to learn more about investing. We've sure come a long way since last year at this conference, when I joined you for a similar discussion. Any way you measure it, this has been a record-setting year. The stock and bond markets have continued to climb. The Dow Jones Industrial Average is back up around its all-time high, at about 8,000. The broader Standard and Poors index has hit the 1,000 level, for the first time ever. The markets have experienced record trading volume, including the first billion-share days on both the new York and NASDAQ exchanges. And, along the way, the markets endured the sharpest one-day downturn ever: the 554-point plunge last October. In some ways, today's marketplace reminds me of what Charles Dickens said in A Tale Of Two Cities: "It is the best of times, and it is the worst of times." It is the best of times, because more Americans are enjoying the rewards of investing in our nation's prosperity. We have the most productive, most resilient economy in human history -- and the financial industry is helping Americans find ways to share in the nation's growth. But, in some ways, it also seems like the worst of times. It's a sad reality: The best markets bring out the worst elements. There are more ways to invest than ever before. But there also seem to be more ways to be confused -- or to be misled. America's marketplace is generally honest -- but there are some crooks out there, too. With the recent influx of so many first-time investors -- many of them gullible -- fraudulent salesmen are eager to take advantage of the ill-informed. The S.E.C. and your state securities regulators are working hard as the cops on the beat. The news media are doing their part, too. I've been impressed by much of the work in the Los Angeles Times. Reporters like Debra Vrana and columnists like Jim Flanigan help equip you with vital information. The fact is, in every area of the marketplace, your best defense is knowledge. Today, I'm going to help you learn how to approach investing, so that you can make decisions with confidence. I'll focus on three things: * First, how to take a realistic view of investing -- and how to make decisions that are right for you; * Second, how to spot some of the obvious danger signs of fraud; * Third, how to ask the right questions -- and how to find reliable answers. I know that some of you, in the audience today, may have also attended last year's conference. At the risk of giving you a double dose of this advice, I think it's worthwhile to go over the fundamentals of investing, again and again. Let's start with a realistic view of today's markets. More and more Americans are focusing intensely on saving and investing. Today's financial challenges are leading American families to see the virtue of a well- disciplined approach to the markets. It's the surest way to secure a more prosperous future. In the 1990s, more than ever before, the people of America are investing in America. There's a startling new fact of life in the American economy: Mutual-fund assets -- at about $4 trillion -- now total just about as much as the deposits of commercial banks. Through mutual funds and other investments, you are the biggest holders -- directly and indirectly -- of American stocks and bonds. Not the banks, not the insurance companies, not big businesses . . . . but people like you. The massive movement into our stock markets has provided new opportunities. But it has also increased the risks. There sure is a lot of euphoria today about the market. Some of that optimism is justified -- but some is not. A lot of folks apparently have forgotten that markets move down as well as up. We all got an abrupt wake-up call when the Dow Jones Industrial Average plunged, last October. That sudden decline awoke a lot of people to the reality of risk. But since then, many of them seem to have been lulled back into complacency. Yes, the stock market has done remarkably well for the past three years -- with returns averaging 30 percent. But the strong gains of the last few years are the exception, not the rule. I'm certainly not making predictions. I'm just reminding you that it's important to have realistic expectations. Investing is best done patiently. Don't fall for the illusion of easy money. Don't be pressured by the aggressive salesman who promises that you'll make a fortune with one quick gamble. Let me be clear: Most people in the securities industry are honest. But some are not -- and they can do enormous damage to people's lives. At the S.E.C., we're always pursuing cases of brokers who have enriched themselves at the expense of their clients. Lately, southern California has had all too many cases like that. Let me tell you about . . . . Robert White. He's a Los Angeles broker who -- after being fired from a reputable securities firm -- promised his new customers that he'd play it safe. He told them that he'd invest their money in high- quality stocks, bonds, and mutual funds. Instead, he used their money to pay his own expenses, and to speculate in investments for himself. In order to fool his clients, he set up a classic Ponzi scheme. To show a profit, he relied on a steady stream of new customers: He'd simply take the new customers' money, and he would pay off his earlier clients. Over almost eight years, he raised about $1.9 million from more than 30 investors -- and he misused $1.2 million of it. His victims should have been suspicious: He'd hand-deliver their account statements instead of mailing them. He'd meet with them in coffee shops, not in an office. Sometimes, when I'm in Washington, and I'm asked to review a case like this, I think to myself: If only those investors had known that they could make a couple of phone calls, to check out his operation with regulators. His firm was not registered -- although he had claimed it was -- with either the S.E.C. or the National Association of Securities Dealers. The clients' accounts were not insured -- although he had claimed they were -- by the Securities Investors Protection Corporation. If investors had known those facts, they might have protected themselves from fraud. Let me tell you about another case, close to home: the case of . . . . William Madon. He's a California man who took more than $5 million from about 250 investors, who thought they were investing in his mutual fund. There was no such fund. It was just another Ponzi scheme. We caught up with him, and we shut his operation down. You might be interested to know how we found out about Madon's fraud. Right here, at last year's Los Angeles Times conference, a worried investor spoke to one of my colleagues from the S.E.C. -- and followed up that conversation with a letter giving us some more details of the case. We have a booth here at the conference here today, too. If anyone has any concern about an investment operation that seems suspicious, we encourage you to talk to us about it. Ask federal regulators; ask your state regulators; call the telephone "hot lines" of the securities industry itself. We're all here to keep the system honest, and to try to protect you from fraud. But regulators can only do so much. You, too, need to be alert to the dangers in the marketplace. There are some real problems out there, and it pays to know how to avoid them. That leads to the second of my themes today: how to be alert to some of the dangerous practices in the marketplace. I've spent a lifetime in the securities industry. I've been a broker, a manager, and I've run a large firm. I've seen the best and the worst that the industry has to offer. The worst instincts of the market are all too evident today. They're especially clear in the increase in fraudulent practices involving small companies -- what we call the "microcap" sector of the economy. We used to call these securities "penny stocks" -- typically those with low prices, issued by very small companies. In most cases, stock sales by small businesses are entirely legitimate: Like larger firms, they're raising money for expansion by selling stock "over the counter" to the public. So, it's not that all microcap stock sales are dangerous. But you've got to do your homework. You don't want to invest in a company that's riskier than you were led to believe -- and you certainly don't want to fall victim to a scam. We're trying to put a stop to microcap fraud with a combination of tougher law enforcement and tighter regulation, and with the cooperation of leaders in the securities industry. Next week, the S.E.C. will launch a new initiative to close regulatory loopholes and strengthen the crackdown on that kind of fraud. But all our efforts rely on greater investor awareness. The classic warning sign of fraud is a high-pressure sales pitch, where the salesman may pretend that he has inside information about a small company that, he says, "just can't miss." In a microcap case, the hard sell usually involves a company that you've never heard of. Or maybe it's a company that has a slightly familiar name -- sounding a little like the name of a large, reputable firm. The scam involves sending money right away, before you've had much time to think. And it almost always promises quick, easy, astronomical profits. Usually, microcap fraud is conducted over the telephone -- but it's increasingly popping up on the Internet, too. There's a reason that criminals hawk their wares by phone, or on the Internet. They don't give you anything in writing, so that you don't have the chance to study the details closely. They don't meet you face-to-face in an office, so that you never have the chance to see what may be a "boiler room" operation. And they don't put anything in the mail, allowing them to avoid potential federal charges of mail fraud. Microcap fraud is all the more vicious because it preys on the most vulnerable members of our society -- especially senior citizens. Con-men who engage in microcap fraud don't care whom they hurt: They're just out for the quick buck. And -- sad to say -- the fraudulent brokers take advantage of the greed of some over-eager investors. Every once in awhile, we get news of some outlandish sales pitch that -- incredibly -- some people fall for. Not long ago, I heard of a case where people were responding to a "get rich quick" scheme they saw on the Internet. They sent in their hard-earned money -- sight-unseen -- to invest in an eel farm. I mean, if you fall for something like that, you really need to go back and re-study the basics of investing. I've seen some astonishing recent examples of the more outrageous sales pitches -- discovered by the S.E.C.'s Enforcement Division. Sometimes the scams come in unsolicited phone calls. Sometimes they come over the internet. But they're always dangerous. Hundreds of fraudulent sales pitches come in to the S.E.C. every month, for investigation. When you get any kind of sales solicitation, the best advice I can give is: Use your common sense. Keep your guard up. Remember the cardinal rule of investing: If it sounds too good to be true, it probably isn't true. I cannot assure you that you'll make money in the market -- no one can guarantee that. But we regulators are working hard to see that the marketplace is run honestly. And that brings me to the third of my themes for the day. The most important investment lesson I can convey to you comes down to this: Ask questions. Think of it this way: Many of you would never entrust your children to a baby-sitter without diligently checking references. Or choose a day-care center without checking for appropriate training and licenses. In this day and age, we all know it makes good sense to think carefully before opening up our homes to people we don't know. Those same instincts should be triggered when you consider opening up your finances to strangers. Many of you are making real sacrifices -- so that you will be able to educate your children, to help your aging parents, or to ensure that you will be able to retire someday. Why jeopardize such goals by neglecting to think carefully about your investment decisions? Take some time to think seriously about why a broker or investment adviser is trying to sell you something. Take a little time to investigate, and to ask questions. I imagine that some of you might think that's an unrealistic idea -- that it's beyond your ability to investigate a broker or a brokerage firm. I'm pleased to tell you about some truly positive news. When it comes to checking out a broker or a firm, investors will soon be able to use an investigative device that Sherlock Holmes would envy. Starting in about a month, the first phase of a remarkable service will become available over the world wide web. When fully implemented, by mid-1999, this service will present -- in a user-friendly way -- the disciplinary and employment background for every registered broker and every registered firm in the United States. I saw a preview of this service last week. There isn't anything comparable to it for any other profession or industry in the country: not for doctors, lawyers, carpenters, or plumbers. It requires no special expertise to use. This service will give every one of you the power to be the first line of defense against fraud and abuse. Whether you access the service by a computer or by toll-free phone call, you will be able to have the kind of information that the market treasures -- information that can prevent you from making a costly mistake. At the moment, this service is called the central registration depository, or CRD. The CRD is operated by the National Association of Securities Dealers -- the group that shares responsibility for regulating the securities industry. The president of NASD Regulation, Mary Schapiro, will speak here later today, and I am certain she will want to talk about the new CRD, too. The CRD helps you determine who you should not do business with. But it doesn't give you the final answer on who you should do business with. Even after you've checked out a broker's background and experience, you've got to make sure that you are comfortable with the style and approach used by the broker and his or her firm. That's why you still need to ask questions. And you should know that, when you ask a question to your broker -- or to your financial planner -- you have the support not only of the SEC, but also of the securities industry. No one supports the idea of educating investors more than the industry itself. What kinds of questions should you ask? Some are about products, and some are about the people who sell them. Let's start with money market funds. When you look at some of their names, you see reassuring words like "trust" -- "liquid" -- "government" -- "cash" -- "U.S." -- "ready assets." Well, I don't care if a fund is named "The Rock- Solid Honestly Safe U.S. Government Guaranty Trust Savings Fund." In any investment, you stand a chance of losing your money. Let me underscore that last point. It's a fundamental fact of investing. You should remember it whenever you invest: In any investment, you stand a chance of losing your money. An informed investor looks beyond the packaging. Read the prospectus, or the annual report. Make sure that the mutual fund invests in the kind of things you're comfortable with. If it invests in something that seems too risky -- something that would make you lose sleep at night -- then steer clear of it. Too many investors simply look at last year's results, and then throw money blindly into investments that did well yesterday -- scarcely thinking about how they'll do tomorrow. The truth is, past performance is not a reliable indicator of future performance. A fund that is number one in its category this quarter, or this year -- or over the past five years -- may be just average next year. Next, you should know what kind of sales charge, or "load," you'll pay -- front-end load, back-end load, or no-load. You should look at a "load" like a handicap in sports. A fund with a 3 percent load is effectively starting out at minus-3-percent, by comparison with a fund that has no load. On top of that, you should consider the annual fees that a fund may charge. Once you do own a mutual fund, keep track of how it's performing, relative to other funds that are similar to it. Watch it, not just quarter by quarter, but also over the long term -- and evaluate it against the market averages. Looking at the numbers in the record is probably a better indicator than listening to the self- styled pundits of investing. A journalist once poked fun at wall street forecasters by saying that they've "predicted nine of the last five recessions." Instead of the forecasters, try looking at the numbers. They're not infallible -- but they're the best benchmarks we have. Use them. So far, I've talked about investments. But some of the most important questions have to do with the judgment of the people who recommend the investments. Now, here's a question for you: Have you ever asked your broker precisely how he gets paid? Commissions reward a broker for the quantity of his transactions, not necessarily the quality. In other words, the broker has an incentive to persuade you to make a lot of trades -- whether or not trading is in your best interest -- because that's how he makes his money. You can ask a broker: How do you get paid? Do I have choices about how to pay you? Does it make sense for me to pay by the transaction? Or should I be paying a flat fee regardless of the number of transactions? Another question for you: How many of you have ever sat down to dinner with your family, only to be interrupted by a phone call -- from a salesman who doesn't seem to understand the meaning of the word, "no"? This practice is known as "cold calling." There are actually a lot of other names for it, but I can't repeat them in polite company. Cold calling can be a legitimate sales technique if a broker is trying to get to know a client's situation and needs. But cold calling, as a high- pressure sales tactic, can also be the first sign of something suspicious -- like a microcap scam. New rules have been written to compel a firm to stop calling you, if you ask to be put on a "do not call" list, and to prohibit cold calls before 8 a.m. and after 9 p.m. But you don't need a rule to tell you that you shouldn't buy securities from someone you've never met -- who calls you with a "hot stock" or with an "inside tip." We've developed a new brochure, called "Cold Calling Alert," that offers advice to investors about such aggressive sales practices. We have some copies here today -- and, if you want one, call our toll-free number: 1-800-SEC-0330. Because investors are better informed, many firms have already put an end to some of the more troublesome sales practices. Things are changing for the better -- and if you ask questions, they'll change even faster. The bottom line of all of these questions is this: A broker has a responsibility to his client. A broker should be expected to hold the client's interests above all others -- above his own, above his firm's, and above the industry's. Most brokers do so. That's my definition of professionalism. We've covered a lot of ground today. We discussed how to protect yourself in the marketplace. We discussed how to be on guard against fraud. And we discussed how to ask well-informed questions. But there's something more. I'm here today, not just to offer help, but to ask for it. I want to hear from you about the state of our securities markets, and I want your help in making them better. For, when all is said and done, the work of the S.E.C. is not about this rule or that regulation. It's about hard-working people seeking a better life -- buying that new home, sending the children to college, enjoying a decent retirement. It's about meeting your goals, and about giving you the chance to gain the resources to fulfill your dreams. It's about people like you. When you come right down to it, it's about the promise of America. Help America fulfill its promise: Become an educated investor. # # #