Donald D. Kittell Remarks to Internal Auditors' Conference
October 11, 2004 in St. Petersburg, Florida
HIGHLIGHTS OF CURRENT SECURITIES INDUSTRY CHALLENGES, INITIATIVES AND TRENDS
Introduction
Thank you Marc and good morning!
It is a pleasure to join you this morning – particularly because I think this is an unusually critical time for the industry and a critical time for you as internal auditors.
We are now at the peak period for political promises – with both presidential candidates promising more than they can possibly afford - and more to come this Wednesday night. And we all know it – the voters and the media. It's part of The Game.
Alan Greenspan – speaking at the SIA annual meeting last November – identified the magnitude of projected long-term budget deficits and expressed the hope that our political leaders would have the wisdom, the strength and the will to do what was necessary. What he left unsaid was the qualifier "after the election."
And it occurred to me that you, as internal auditors, might hear more "promises" than any other group in our industry.
I currently sit on one audit committee and I have served a number of audit committees as staff over the years. What audit committees essentially do is 1) hope that you are good at identifying problems before they get too big and 2) monitor management's promises that they are addressing those problems effectively.
The one group in our industry that hears more promises than you do are the clients of our firms – whose relationships with us are based on the promises we make to look after their interests.
The reason why I say this is an unusually critical time for the securities industry is that – based on the experience of the last four years - there is good reason to be skeptical about the promises that managements make to you – and a good reason to be skeptical about the promises that we make to our clients.
In my judgment, watching the promises made in the presidential debates can be an amusing game – depending on your sense of humor or sense of optimism. You can either enjoy the same or you can be dismayed by it.
But – fooling around with the promises made to you and with the promises made to our clients cannot be an amusing game in any sense.
And it occurred to me that what SIA's essential business has been over the last four years – and how we spent most of our time today – is dealing with those two sets of promises – the promises to you, to compliance people and regulators, and secondly, the promises we make to our clients.
I believe that the business environment we are in continues to be driven by the bursting of three great bubbles in 2001 – and we continue to be impacted by the "aftershocks" of those events.
Those three bubbles are:
- The Market Bubble – characterized by tech stocks running up for the five years prior to 2001, and echoing today with the Google IPO.
- The Trust Bubble – characterized by the great corporate scandals beginning with Enron and MCI-World Com and echoing today with Fannie Mae and AIG.
- The Innocence Bubble – burst by the 9/11 attack and echoing today as we worry about the war in Iraq and threatened violence leading up to elections in Afghanistan over the weekend, in the United States in November and Iraq in January.
It is not surprising that the financial markets are acting as skittishly as they are in this environment.
The Dow was down by 3-4% in the quarter just ended – and NASDAQ was down 7%.
Markets dislike uncertainty and today's list of uncertainties is uncommonly long:
- A divisive presidential election too close to call
- Tough news every day coming out of Iraq
- Oil at $50-$60 a barrel
- The Fed on course to increase short-term interest rates further after three increases in July, August and September
- Earnings warnings coming out of our growth industries like pharmaceuticals and technology
- Concerns about jobs
- Continuing headlines involving scandals in corporate America and the financial services industry
The bond market has fooled the consensus by rallying in the quarter – reflecting doubts about corporate earnings and the growth in the economy, as well as an aversion to risk on the part of both traders and long-term investors.
This month marks the anniversary of two notable market events:
First – this is the 75th anniversary of the great crash of 1929. The bottom of that crash occurred in 1932 – down 86% from the market's highs. The market did not recover to the 1929 level until 1954 – twenty-five years later.
Second – this is the second anniversary of the market's bottom since the bursting of the bubble in 2001. That low was down 50% from the 2000 all-time highs. Since that low two years ago, the market has recovered by 50% - still about 25% lower than the highs of 2000.
Bears among us marvel that the equity market has held up as well as it has in the face of the current list of uncertainties. Bulls see this as cause for hope.
Securities firms are less than exuberant in this environment. The winners include those few firms who got the bond market right so far this year. But we don't see the kind of broad base of traditional business in agency commissions or investment banking that would signal a more optimistic outlook.
SIA and other industry analysts have had to revise downward their earnings estimates for the industry for 2004. And firms are being cautious with respect to hiring, risk-taking and investing in infrastructure.
Against this less-than-bullish environment, firms are devoting significant resources to the wave of regulatory reforms and litigation settlements that have swept through the Congress, the SEC, the SRO's and the states.
Taken together, this adds up to serious pressure on profit margins in investment banking and asset management, and a tough-minded approach to new business on the part of securities industry CEO's.
It is in an environment like this that organizations like SIA are the bridge between their member firms and their legislators and regulators. A great deal of what SIA is doing currently is being driven by the SEC and the SRO's.
I would like to discuss four subjects that are at the top of the industry's priorities.
- Let's start with the Investment Banking and Research Scandal. Underwriting and research practices, which were well known and accepted in the industry, were developed to a new art form in the tech bubble and when the bubble burst, were found to be illegal.
The so-called "global settlement," calling for fines and penalties of $1.4 billion, is now behind us. But left in its wake is a complete restructuring of the underwriting and research business model and a new regulatory regime governing the way corporate information and research is disseminated to investors. This has changed accepted practice by corporate issuers – investment banks, the media and investors.
Note that one of the outcomes of the research and investment-banking scandals is a dramatic change in the nature of the promises made to our clients.
The industry now promises that the research it undertakes is on behalf of investors. Prior to the settlement, the research "promise" was ambiguous to investors and was compromised by the investment banking business model.
Let's move on to Asset Management.
One of the great opportunities for financial services firms is providing asset management to the baby boomers who are now focusing on retirement. The age and wealth demographics of the U.S. population projected out over the next twenty years have never been more favorable for financial services firms.
And where are we? In the spring of 2003 – less than two years ago – prominent speakers at the annual meeting of the Investment Company Institute celebrated the trust and confidence (and the scandal-free track record) earned by the mutual funds industry!
Since that time, as you know, we have been faced with the late trading scandals, the market timing scandals, the inability to administer breakpoints and a wide range of abuses involving the disclosure and charging of distribution and asset management fees – abuses with directed brokerage, 12 B1 fees, revenue sharing arrangements, mismanagement of class A, B and C shares and so on.
This has resulted in a torrent of regulatory proposals addressing fee disclosure, governance of mutual funds and a new look at the esoteric practices of soft dollar economics.
As investor funds and industry talent moved from mutual funds to other forms of asset management – notably wrap accounts, annuities and hedge funds – many of the abuses have followed with the regulators close behind.
Just as there were newly discovered conflicts of interest between broker-dealers and mutual funds – there are conflicts between broker dealers and annuities and hedge funds.
Note that one of the outcomes of the mutual fund scandals is a dramatic change in the nature of the promises made to clients.
The regulatory reforms are still in process – but the new promise is that fund boards act on behalf of fund investors and have the strength to be effective. The old promise was ambiguous to investors and compromised by the mutual fund management and distribution business model.
Let's move to Market Structure.
No institutions in our industry have been more impacted by change than the marketplaces – the NYSE, NASDAQ, the regional exchanges, the new alternative markets and ECN's and the fixed income markets.
In the last two years we have witnessed a complete change in the way these markets are perceived. A complete change of management at both the NYSE and NASDAQ, and a technological and philosophical battle between markets that has simmered for decades but which has now become a matter of survival for the traditional markets.
In 2004, we witnessed the release of Regulation NMS by the SEC, which opened up the most fundamental issues in the way stocks are traded. Essentially, Regulation NMS attempts to harmonize two philosophies:
The listed market governed by a trade-through rule that imposed a trade x trade standard for execution prices across all markets
And the NASDAQ market, governed by the principle of "best execution," which is more flexible than strict trade x trade compliance
Reg NMS also spotlighted the differences between traditional floor-based auction markets and electronic matching and smart order routing systems - each of which was trading the same securities.
Reg NMS was followed by the NYSE's proposed "Hybrid" market proposal, which attempts to merge the best features of its specialist auction system with the so-called "fast" electronic markets.
Both Reg NMS and the NYSE Hybrid proposal continue to be debated in the industry and at the Commission. (SIA is attempting to represent the views of all of its members – who are on every side of the issues.) In the background is a continuing debate over the structure of the marketplaces themselves – their role as both marketplace and regulator – and their economics.
Another concept using the term "Hybrid Model" suggests that regulation of securities firms should no longer be in the hands of marketplaces like the NYSE or NASDAQ.
Note that at the heart of the debate on market structure are the promises made to investors. A fair price, a level playing field with professional traders and market makers, transparency of market information - "Best Execution."
The market structure debate is very difficult. All market centers describe their business models in terms of doing what is best for investors. And doing what is best for investors may be different from a short-term vs long-term perspective. And for actively traded, large cap stocks vs thinly traded small caps. And for small orders vs large orders. And for large program trades and individual one-off trades. And for trades requiring capital vs trades that do not.
It is clear that the SEC and all of us in the industry are struggling with the answers - and will continue to do so as long as markets exist.
- SIA's number one priority is promoting Public Trust and Confidence in the industry and the markets.
This effort seeks to get ahead of problems before they are out of control. And seeks to go beyond legislation and regulation by influencing industry culture.
The most difficult challenge to this effort is our inability to foresee what is so obvious on hindsight. Our capacity for denial appears to be unlimited.
We do market research with investors to help identify problems and, as a result of that research, we have developed two action programs.
You play a role in a third action program.
SIA's annual investor survey is now in its tenth year – and we will report results at our annual meeting next month.
We will report (first) that investor concerns about dishonesty/fraud and corruption, which went off the chart in 2002 (after seven years of not being a problem), continued off the chart in 2003 and again in 2004 – in fact, concerns in 2004 are at the highest level recorded in 10 years.
We also will report that the majority of investors have confidence that reforms in the way the industry operates will be effective. And that a significant number of investors feel this way than they did last year.
The survey shows that investor confidence – while troubled by the war, the election, oil prices, jobs and the economy – is on the rise.
(If SIA's survey were the evidence, President Bush would be re-elected.)
Here are our two action programs:
First, we are convinced that the industry needs to promote investor education and we do that in a number of ways. We have an education program called "the Path to Investing" which features industry experts delivering educational curriculum in a variety of ways.
And we have the Stock Market Game Program, which delivers curriculum to elementary, middle and high schools across the country.
Both these programs base their offerings on market research we do with investors and with teachers, and we are investing to further develop their reach.
Second, we have developed a new program called "A Commitment to Clarity."
A third party corporate communications expert bases the Commitment to Clarity on interviews with our Board over the last year.
The premise is that the promises the industry makes to its clients are clear and unambiguous.
The specific issues we are addressing within this overall commitment are:
(1) Client rights and responsibilities
(2) The management of conflicts of interest
(3) Disclosure of mutual fund economics
(4) Education about asset management products – MF's/wraps/annuities/hedge funds
(5) Education about soft dollars
(6) Disclosure of international regulatory regimes
We are well along in developing material for release at our annual meeting next month.
There is a third action program that you are part of. And that is encouraging each firm to take a clean sheet look at its client relationships and the management of the conflicts that may be involved with those relationships.
I have a list of ten issues that you might want to take a look at.
Internal Audit Scope (DDK top 10)
- Defense against cyber attacks
- Generic attacks like the slammer worm
- Specific attacks like denial of service or phishing
- Participation in FS-ISAC
- Soft Dollar activities
- Documentation
- Disclosure to clients
- Implied economics of execution/research/other services
- Mutual Fund/annuity/wrap fees
- Disclosure
- Distorted incentives
- Management of conflicts
- Fee-based vs commission a/c's
- Mutual Fund "Hard Close," excessive S/T trading, breakpoints
- Analogous products (auction rate preferred)
- Hedge Fund relationships
- Distribution vs prime brokerage
- Section 31 Fees
- Over-collection from clients
- Reconciliation with other market participants (ECN's)
- Street name Proxy voting
- Stock loan
- Fails to deliver
- Reconciliation with DTCC and tabulator
- ADP proxy service over-voting
- Proprietary trading desks
- Relationship to agency desks and customer order flow information
- Compliance with Sarbanes-Oxley, AML and Patriot Act
- Always my favorite – the activity (and the individual) in your firm that makes the most $ - understand how that money is being made.
I thank you for your attention and wish you good luck in the remainder of your excellent conference program.
