Take on the Street What Wall Street and Corporate America Don't Want You to Know What You Can Do to Fight Back Arthur Levitt with Paula Dwyer Pantheon Books, New York I dedicate this book to my wife, Marylin, and our six grandchildren. Marylin's patience during trying periods in Washington as well as her encouragement during my transition back to private life made this project possible. If investors benefit from this undertaking, Matt and Will Friedland and Sydney, Emma, Molly, and Jake Levitt will enjoy the benefits of a fairer and more trustworthy market. CONTENTS Acknowledgments Introduction One: How to Sleep as Well as Your Broker Two: The Seven Deadly Sins of Mutual Funds Three: Analyze This Four: Reg FD: Stopping the Flow of Inside Information Five: The Numbers Game Six: Beware False Profits: How to Read Financial Statements Seven: Pay Attention to the Plumbing Eight: Corporate Governance and the Culture of Seduction Nine: How to Be a Player Ten: Getting Your 401(K) in Shape Appendix: Power Games Glossary ACKNOWLEDGMENTS No one writes a book alone. I owe thanks to many people for helping me with my first book, which proved to be more of a challenge than I thought. First and foremost, my friend and former colleague Russell Horwitz was an extraordinarily creative participant throughout the process. His patience, inspired editorial comments, institutional memory, and dedication to investor interests were invaluable. I can't thank him enough. Harvey Goldschmid's assistance was also invaluable. Many times I relied on his knowledge of the securities laws. He also faithfully read and commented on much of the book. Joe Lombard gave countless hours of assistance with market structure issues, as did Lynn Turner on accounting matters. Gregg Corso and Jim Glassman are some of the most creative thinkers I know. I am grateful that they were always available to serve as a sounding board for ideas. Lenny Sacks has exquisite taste. His editorial and conceptual suggestions made this book better. Dan Tully, my friend of many years, was my beacon of balance in terms of investor relationships. Others whom I admire and respect read chapters and faithfully responded to my request for comment. They were Bob Denham, Holman Jenkins, Charlie Munger, Brent Baird, and Karl-Hermann Baumann. I especially want to thank Warren Buffett for helping me get to the core of the matter on broker compensation, mutual funds, and corporate governance issues, and for making himself available when needed. He has been one of the strongest and most ethical advocates of the public interest, and America's markets have benefited from his wisdom. Since I left the SEC, I have been blessed by the extreme loyalty of many aides who worked by my side and continue to provide valuable counsel. Many of them gave unstintingly of their time. I want to thank Jane Adams, Tracey Aronson, Nick Balamaci, Barry Barbash, David Becker, Bob Colby, Carrie Dwyer, Rich Lindsey, Bill McLucas, Annette Nazareth, Susan Ochs, Lori Richards, Paul Roye, Jennifer Scardino, Michael Schlein, Nancy Smith, Mike Sutton, Mark Tellini, Chris Ullman, and Dick Walker. I am very lucky to have Carol Morrow as my executive assistant and the person who helps organize my life. I owe her a huge debt of gratitude for keeping me on track everyday. My collaborator, Paula Dwyer, accepted the challenge of putting together with me our first book. Her knowledge of the Commission, the securities industry, and the political environment yielded unique perspectives and insights. More than that, she has won my trust and inspired confidence through her sense of fair play, calm determination, and reasoned judgment. Erroll McDonald, my editor, championed this project from the beginning. His encouragement and wisdom got me past many moments of doubt about how I could produce a book that would engage my mythical "Aunt Edna" and the millions of American investors who need to know more about the snares that can diminish the likelihood of investing success. Erroll shares my obsession for protecting investors and helped me focus on producing something that would help level the playing field for them. He is a patient, dedicated, and passionate advocate for the things he believes in and the people he trusts. I am better for our relationship. INTRODUCTION W hen I first became a broker in 1963, and for many years after, my mother, Dorothy Levitt, was my most difficult client. For thirty-eight years she taught second grade at P.S. 156 in Brooklyn, New York. Like so many of her generation who grew up during the Great Depression, her mistrust of the stock market was visceral. So she invested in municipal bonds, because of their safety but also because "they charged no commissions," she would often say. I could never get her to understand that a bond purchased from the inventory of a brokerage firm included a markup that was usually far greater than an ordinary commission. In the hands of any other broker, my mother might have been easy prey. She was not unlike many investors who, even today, don't understand how brokers are paid or why they recommend certain stocks and bonds over others. I grew up in the Crown Heights section of Brooklyn, where I lived in a modest brownstone with my parents and Orthodox Jewish immigrant grandparents. Nearly all our meals took place at an oilcloth- covered, metal kitchen table. The dinner talk focused on low finance— the comparative cost of milk or lettuce at Kushner's Troy Avenue grocery store as opposed to Waldbaum's on Albany Avenue. But often we veered into politics. The views of my grandfather, Pops, were mostly diatribes leveled, in equal measure, at the "rotten socialists" and "crooked politicians." Pops amused me, but it was my father's less strident observations that made a bigger impression. The politics of my father, Arthur Levitt, Sr., were nominally Democratic, with a fiscal conservative streak. Six times he was elected New York State comptroller as a Democrat, but otherwise he had little to do with party politics. For twenty-four years he was the sole custodian of the multibillion-dollar pension fund of thousands of New York public employees, including teachers like my mother. The rights of the small pensioner and efforts by politicians in both parties to raid the state pension funds dominated our discussions. My father fiercely defended his independence, whether he worked with a Democratic or Republican governor, and placed the well-being of New York retirees above all other considerations. I shall never forget the day when he encountered New York City mayor Ed Koch in the halls of the state capitol building in Albany. It was 1978, and the city, having barely avoided bankruptcy three years earlier, was facing another fiscal crisis. To Mayor Koch, tapping the state retirement funds appeared to be the only way out. But the comptroller had refused to give his approval. As Mayor Koch approached, he pointed at my father and said menacingly: "If New York City fails, it will be your fault." This confrontation upset my father so much that, moments later, he suffered a minor stroke, which left him unable to speak for several hours. Only his closest staff was aware of this episode, from which he thankfully recovered. Unable to overcome my father's tenacious protection of the pension funds, the city secured the financing it needed when the federal government agreed to guarantee the city's bonds. I learned that when it comes to protecting investors, no political party has an edge over the conscience of an honest public servant. My first exposure to high finance and politics came in the late 1950s and early '60s, when I sold cattle and ranches to wealthy people who needed tax shelters. When the Internal Revenue Service tried to do away with the tax shelter benefits in 1960, I joined forces with the National Cattlemen's Association to try to protect the subsidy. At a House Ways and Means Committee hearing, I recall arguing before Representative Wilbur Mills, the powerful committee chairman, that reducing this tax benefit would result in farmers' producing fewer breeding cattle, which in turn would raise beef prices and irreparably harm America's consumers. In retrospect, it was a specious argument. But I learned that one of the Washington lobbyist's most common tools is to cloak business benefits in the garb of some supposed public good, and was always alert for it thereafter. My life changed dramatically when one of the prospects I called upon, M. Peter Schweitzer, then a top official of Kimberly-Clark, said to me, "Arthur, if you can sell cows, chances are you'd be good at selling stock." He told me his son-in-law, Arthur Carter, was starting up a brokerage firm with a group of friends and that they were looking for suitable partners. I met with Carter and signed on with his tiny firm. My partners were Carter, today the owner of the New York Observer newspaper; Roger Berlind, now a successful Broadway producer; and Sandy Weill, the current chairman of Citigroup. We were young, ambitious Jewish boys of middle-class origins fighting for recognition in a white-shoe industry. Initially I worked with retail clients, sought underwriting business, and learned the ins and outs of building a Wall Street firm. It was during these years that I dealt with thousands of retail investors— first as a broker and then as president of Shearson Hayden Stone, which our firm came to be called after a series of acquisitions. By the time I left in 1978, the firm was one of the nation's largest brokerages, and would ultimately become part of Citigroup. I embraced the craft of the broker, endeavoring to help my clients, but always mindful of how a buy or sell transaction might help our profits. Most of the brokers I encountered were good, honest, and intelligent businesspeople, but their primary motivation came from a compensation system that rewarded them for the number of transactions they executed, not on how well client portfolios performed. Even when the best course of action was to do nothing in a client's account, the commission system encouraged brokers to recommend sometimes questionable trades. We knew, for example, that we would get five times the normal commission by placing secondary offerings— shares issued by companies that had already gone public but needed more capital— with our customers. One hundred shares of AT&T, for example, at $40 a share paid a 1 percent commission for a total of $40. But the commission on 100 shares in a secondary offering of the same AT&T stock was 5 percent, or $200. We could have purchased the same shares a month, or even a week, earlier had we thought it a good investment. Why did we suddenly find AT&T attractive one day, when we weren't recommending the stock the day before? Our motivation was self-interest, pure and simple. As our firm struggled to develop new lines of business, it was my job to call on state agencies and communities around the country to secure the lucrative franchise of managing the issuance of, or underwriting, their municipal bonds. Many times I was told that the quid pro quo of "getting on the list" of potential underwriters was to buy a table of tickets at the mayor's or governor's campaign fund-raiser. This experience provided the origins of my determination in 1994 to eliminate "pay-to-play" from the municipal bond business. When I solicited investment banking business from companies considering a public offering, I spoke of our "retail distribution" as well as the fact that our "analyst's coverage" would be vital to "getting their story out." Retail distribution meant that our sales managers would pressure our salespeople to sell these underwritings. Often, the local manager's bonus depended upon his ability to market our merchandise, and future allocations of "hot issues" were based on the salesperson's ability to place all new issues we brought to market. Analyst's coverage, of course, was always favorable; I can recall no sell recommendations (there must have been some) during my years with the firm. I also came to understand the motivations of CEOs who cared only about the price of their stock— often to the exclusion of any long-term vision for their company. To persuade our brokers to place more of their securities in customer accounts, corporate heads conveyed important company information to our sales and research departments that was not yet available to the investing public. At the same time, I heard from many, many retail clients that "the big guys get information before the general public" and that "the small investor will always play second fiddle to large institutions and people in the know." What I witnessed was just the tip of the iceberg. The web of dysfunctional relationships among analysts, brokers, and corporations would grow increasingly worse over the coming decades, and ending it would be one of my primary goals at the Securities and Exchange Commission (SEC). While I am proud of helping to build one of America's largest and most distinguished brokerage and investment banking firms— and remain friendly with most of my partners and co-workers— I grew uncomfortable with practices and attitudes that were misleading and sometimes deceptive. I first spoke out against them in a 1972 speech called "Profits and Professionalism." Over my partners' protests, I called on the industry to think quality over quantity— to pay brokers on the returns their clients received, not on the number of transactions in their accounts. It caused a minor stir, but was soon forgotten. Over the next twenty years, these issues would continue to nag at me. I had an agenda but not a forum. The ideal forum would be the SEC chairmanship, which if offered, I would have accepted without hesitation. By the time Bill Clinton tapped me for the post in 1992, almost six months after he became president, I had spent sixteen years as an executive of a brokerage firm, twelve years at the American Stock Exchange, and four years as the publisher of a newspaper about Congress. I'd like to think my Wall Street and Washington experience recommended me. But I suppose the $750,000 I raised as one of twenty-two co-chairmen of a New York dinner for Clinton just before the 1992 nominating convention was not lost on the new president's inner circle. I first heard that I was under consideration, not from anyone in the White House, but from a Wall Street Journal story. No Clinton insider had ever interviewed me about my policy ideas, or asked me if I was interested in the job. From the day President Clinton nominated me, I knew I wanted the individual investor to be my passion, and I wanted to pursue change in a nonpartisan way. I had spent twenty-eight years on Wall Street, and I understood the culture. Actually, there were two conflicting cultures. One rewarded professionalism, honesty, and entrepreneurship. This culture recognized that without individual investors, the markets could not work. The other culture was driven by conflicts of interest, self-dealing, and hype. It put Wall Street's short-term interests over investor interests. This culture, regrettably, often overshadowed the other. When I arrived at the SEC in July 1993, we were in the third year of a bull market, which would run for another seven years. Individual investors were buying stocks as never before. On the surface, everything seemed fine. But there was much about Wall Street and corporate America that made me uneasy. For instance, many CEOs were paying more attention to managing their share price than to managing their business. Companies technically were following accounting rules, while in reality revealing as little as possible about their actual performance. The supposedly independent accounting firms were working hand in glove with corporate clients to try to water down accounting standards. When that wasn't enough, they were willing accomplices— helping companies disguise the true story behind the numbers. With one-third of accounting firm revenues coming from management consulting in 1993— that proportion would balloon to 51 percent within six years— it was hard not to conclude that auditors had become partners with corporate management rather than the independent watchdogs they were meant to be. CEOs and their finance chiefs had learned they could indirectly control their stock price by currying favor with research analysts. Some were trading important information about earnings and product development with selected analysts, who in return were writing glowing reports. Such selective disclosures got passed on to powerful institutional investors— mutual funds and pension funds— and to brokers who could be counted on to place a substantial number of shares in the accounts of individual clients. Analysts were often paid more to help their firms win investment banking deals than for the quality of their research. This unholy alliance was producing revenue for the analyst's firm but hardly any benefits for most of their clients. Mutual funds and pension funds were getting far better information, and a lot earlier, than retail investors. Because of their muscle, they were also getting superior service and better prices when they bought or sold securities. Mutual funds were very successful at passing themselves off as investor-friendly, but they had their own, more subtle, ways of taking investors' money through a confusing array of fees. Fund companies were spending billions advertising past results rather than informing investors of more important factors, such as the effect that fees, taxes, and portfolio turnover had on returns. From my twelve years as chairman of the American Stock Exchange, I knew that investors were almost totally in the dark about how the stock markets worked. Collusive practices among Nasdaq dealers were costing investors billions of dollars a year. At the New York Stock Exchange (NYSE), floor brokers, specialists, and listed companies set the agenda, one that protected their franchise, sometimes at the expense of investor interests. The New York Stock Exchange was also resisting a truly competitive national market system that linked all the markets, as Congress had directed years earlier. Individual investors were unaware of this side of Wall Street. And yet they were the victims of these long-standing conflicts. I wasn't alone in my observations, either. Frank Zarb, with whom I worked at Shearson Hayden Stone and who would later become head of the National Association of Securities Dealers (NASD) and the Nasdaq Stock Market, first urged me to attack pay-to-play in the municipal bond market. I discussed with Merrill Lynch chairman Dan Tully the problems I saw with broker compensation long before I got to the SEC. Shortly after my confirmation, several CEOs pleaded with me to end the unseemly practice of leaking corporate information to analysts. And analysts sent me confidential letters exposing how selective disclosure had become routine on Wall Street. They wanted me to stop it, even though they were beneficiaries. I would spend nearly eight years at the SEC trying to correct these imbalances. I would soon learn that many people harbored doubts about me. Within the agency, the senior staff viewed me as a wealthy New Yorker who got the job by raising lots of money for Clinton. They thought I would be a shill for the industry. On Capitol Hill, pro-consumer lawmakers who considered the SEC part of their turf were also wary. When I made a courtesy call on Representative John Dingell, the Michigan Democrat whose committee oversaw the SEC, his parting comment was "Arthur, I worry you're not tough enough for these bastards." Within the financial services industry, my appointment was welcome news, but for the wrong reason. Somehow my reputation was that of a consensus builder— someone who looked for solutions in the safety of the middle ground and didn't stick his neck out too far. My guess is that they thought they could control me. I now had an agenda and a forum. But that didn't mean I could do what I wanted. I first had to build up political capital. Many businessmen fail to make the transition from CEO to Washington official, leaving town after a couple of miserable years without achieving much. I was determined not to let that happen to me. I had several advantages over the typical CEO type. At the American Stock Exchange, I formed the American Business Conference, a research and lobbying group made up of the CEOs of high-growth companies. Amex companies were prominent among the founding members. I often led the group when it traveled to Washington to meet with members of Congress and cabinet officials, and once a year with the president. The organization was nonpartisan, and it became influential in both Democratic and Republican administrations. The experience taught me much about the symbiotic nature of Washington. For the CEOs, the ability to have access to and rub shoulders with well-known people who represented America's political elite had an addictive allure. The politicians, in turn, used these meetings as an opportunity to raise funds. And White House officials saw their chance to lobby the business community to push their own policy goals. I also knew the Washington ropes from my four-year ownership of Roll Call, the only newspaper that exclusively covered Capitol Hill. Roll Call allowed me to meet numerous legislators and their aides. I would interact with many of them later at the SEC. More importantly, Roll Call taught me how to work the legislative process— where to apply the pressure and how to find common ground with lawmakers, regardless of political party. When I came to Washington, I had a pretty clear understanding of how the main power centers worked. Once I began pursuing my agenda, however, I saw a dynamic I hadn't fully witnessed before: the ability of Wall Street and corporate America to combine their considerable forces to stymie reform efforts. Working with a largely sympathetic, Republican-controlled Congress, the two interest groups first sought to co-opt me. When that didn't work, they turned their guns on me. I first saw it happen on the issue of stock options. I spent nearly one-third of my first year at the commission meeting with business leaders who opposed a Financial Accounting Standards Board (FASB) proposal that, if adopted as a final rule, would have required companies to count their stock options as an expense on the income statement. The rule would have crimped earnings and hurt the share price of many companies, but it also would have revealed the true cost of stock options to unsuspecting investors. Dozens of CEOs and Washington's most skillful lobbyists came to my office to urge me not to allow this proposal to move forward. At the same time, they flooded Capitol Hill and won the support of lawmakers who didn't take the time to understand the complexities of the issue and the proposed solution. Fearful of an overwhelming override of the proposal, I advised the FASB to back down. I regard this as my single biggest mistake during my years of service. From there, I skirmished many times with the business community and Wall Street. During this period the stock market rose to incredible heights. Online trading became cool, luring millions of middle-class savers into believing that investing was a no-lose game. They traded impulsively, many basing their decisions on recommendations they heard on financial news shows, which were almost always "buy." Day traders gathered in offices that provided terminals and trading techniques that more resembled a crap game than an investment stategy. Some investors were even trading stocks on the basis of postings in Internet chat rooms— information that is as reliable as the graffiti on a bathroom stall. Investors snapped up initial public offerings of companies about which they knew very little, except that an analyst told them it was the "next new thing." But what investors didn't know was that many analysts were plugging companies that had banking relationships with the analyst's firm. For corporate executives, managing short-term earnings to meet the market's expectations became all-consuming, along with keeping the share price high so they could reap big rewards by cashing in their stock options. Business's clout was evident as we tried to stop the gamesmanship. Our cause was not helped by the fact that the economy was growing fast, the market was shooting upward, and investors were pleased by the plump returns their mutual funds and online trades were getting. My message— that the bull market would not last forever, and that it was covering up a multitude of sins— did not go over well. Wall Street saw me as Chicken Little; lawmakers either didn't believe me or didn't want to hear what I was saying. Some were downright hostile. I came to recognize certain behavioral patterns when business groups became concerned about commission actions. The first indication of trouble was often a staff discussion between one of the SEC division heads and an aide at one of our Congressional overseer's offices. A gentle letter from the committee chairman signaled the start of a skirmish. Face-to-face visits were next followed by hearings, press releases, and ultimately a drawn-out, costly battle. When the FASB, for example, tried to stop abusive practices in the way that many companies accounted for mergers, two of Silicon Valley's VIPs, Cisco Systems Inc. CEO John Chambers and venture capitalist John Doerr, tried to persuade me to rein in the standard-setters. When I refused, they threatened to get "friends" in the White House and on Capitol Hill to make me bend. When we proposed new rules to make sure that auditors were truly independent of corporate clients, some fifty members of Congress promptly wrote stinging letters in rebuke. In the final days of negotiation with the Big Five accounting firms (PricewaterhouseCoopers, Deloitte & Touche, KPMG, Ernst & Young, and Arthur Andersen) over new independence rules, I was constantly on the phone with lawmakers who were trying to push the talks toward a certain conclusion, or threatening me if they didn't like the outcome. In particular, Representative Billy Tauzin, the Louisiana Republican, became a self-appointed player, negotiating on behalf of the accountants. And when we began investigating possible price-fixing by Nasdaq dealers, Representative Tom Bliley called to say I was going too far. The Virginia Republican held great sway as chairman of the House Commerce Committee, which oversees the SEC, but he backed off once I told him that the Nasdaq matter could become a criminal case. The odds against the public interest were narrowed somewhat by the press. One of the only ways to alter the business-public interest balance was to see to it that the media understood an issue and wrote about it. Without an informed press, SEC cases against the NASD, the NYSE, and the municipal bond market would not have succeeded. Nor would the commission have been able to adopt new rules to improve auditor independence or ban selective disclosure. I can recall many instances when investigative reporters broke stories about unseemly industry practices that changed behavior by virtue of public exposure. The vast and growing number of individual investors, however, lacked focus, direction, or leadership to make much of an impression on Washington policy makers. I often wondered how to empower this expanding group that cut across economic, ethnic, and political lines. I knew that politicians, no matter where they were located on the political spectrum, understood the power of the people and would respond favorably to policy proposals if millions of investors supported them. Promoting the interests of the average investor made good policy sense, but it also made political sense. I decided to interact personally with individual investors through town hall meetings, went into communities and talked about current SEC projects, gave basic investment advice, and allowed attendees to ask questions. I brought along representatives from the mutual fund industry and other trade groups so they could learn what was on investors' minds. In the end, I held forty-three such meetings, often in the home states or districts of lawmakers who sat on committees that were important to the SEC, making sure to include in the forum the senator or House member whose vote or support I needed. The SEC's first Office of Investor Education provided useful information, such as the dangers of buying stock on margin, or how to calculate the effect of mutual fund expenses on investment returns. Early on, we pursued an initiative, called Plain English, to help investors understand the dense jargon used by companies in their SEC filings. And I didn't hesitate to use the bully pulpit to explain, prod, and sometimes even embarrass companies or Wall Street firms into stopping practices that hurt investors. When I left the SEC, much work remained to be done, but I thought Wall Street and the individual investor had at least come to understand their responsibilities and rights better. And I thought I had made progress by clamping down on some of the worst abuses. Then along came a wave of corporate accounting scandals, beginning with Enron Corp. In many ways, Enron's collapse was brought on by the collision of all the unhealthy attitudes, practices, and conflicts of Wall Street and corporate America that I tried to address at the SEC. It was as if everything I feared might happen did happen— within one company. Enron used accounting tricks to remove debt from the books, hide troublesome assets, and pump up earnings. Instead of revealing the true nature of the risks it had taken on, Enron's financial statements were absurdly opaque. Auditors went along with the fiction, blessing the off-the-books entities that brought the company down. Most analysts also played along, recommending Enron's stock even though they couldn't decipher the numbers. Analysts were foils for their firms' investment banking divisions, which had been seduced by the huge fees Enron was paying them to sell its debt and equity offerings. Enron's smooth-talking management pushed the stock price ever higher, enabling them to make millions from their stock options. Brokers working on commission sold Enron shares to unsuspecting clients, who lost billions when Enron declared bankruptcy. Throughout it all, Enron's sleepy board of directors, and an especially inattentive audit committee, failed to ask the right questions. Eight months after Enron's explosion, long-distance supplier WorldCom Inc. revealed that it had improperly accounted for nearly $4 billion in expenses, topping off a string of sordid revelations about alleged accounting misdeeds at companies ranging from Adelphia Communications to Global Crossing to Tyco International. A slew of recommendations for new laws, SEC rules, and ethics codes emerged to address what looked like a massive outbreak of corporate crime. The biggest casualty was investor confidence. By mid-July 2002, the Dow Jones Industrial Average had declined 28 percent from its 2000 high-water mark, while the Nasdaq was off an astounding 70 percent. Accounting lobbyists at first tried to impede reforms, but Congress had no choice but to act. In the summer of 2002, lawmakers were on the verge of creating a new accounting oversight body to set audit standards and investigate and discipline audit firms. Despite Congress's belated lurch toward reform, only a few lawmakers truly care more about individual investors than about their corporate patrons. The Congress that enacted the landmark investor protection statute— the Securities Act of 1933— in response to the 1929 stock market crash bears little resemblance to recent legislatures that have shortchanged the SEC. Serious failures of corporate governance remain to be addressed, and that means a stronger role for independent directors, especially those who sit on committees that determine executive compensation and oversee the performance of the audit. Corporate audit committees are especially critical as the last line of protection for investors. They must ask more questions, test the company's disclosures and financial reports for accuracy, and hire their own experts if necessary. Audit committees also must strictly limit the amount and type of consulting work done for the company by their auditors. This is the surest way to reduce the conflicts of interest that inevitably occur when a company pays an accounting firm consulting fees that far outweigh the audit fee. The good news is that many positive changes have occurred, post-Enron. The stock exchanges have tightened their listing standards to require company managers to be more accountable to shareholders. The SEC has proposed new rules that should result in shareholders getting more timely and reliable information. In mid-2002, legislation was pending to create an accounting oversight board that finally would take away the audit firms' role as a self-regulator. The most positive changes have come at investors' behest, not as the result of new laws or rules. Under pressure from pension and mutual funds, companies are disclosing more detail in their earnings reports and letting shareholders vote on stock option plans. Some companies have decided not to use their auditors as consultants any longer. And many investors are avoiding the stock of companies with aggressive accounting, especially the kinds of off-balance-sheet devices that destroyed Enron. The farmer in Des Moines, the teacher in Coral Gables, and the truck driver in Syracuse all have a common interest in full disclosure, reliable numbers, clearly written documents, and a vigilant regulatory system. But no regulator can provide total protection against fraud. No law has been devised to anticipate the deceptions and distortions that are inevitable in markets fueled by hype and hope. America's markets operate by a set of rules that are half written and half custom. That makes the individual's responsibility to discern hidden motivations and conflicts of interest as important as any law or regulation. But there's another reason why individual investors must be vigilant of their own interests. Investor protection is supposed to be the responsibility of three institutions: the SEC, the stock exchanges, and the courts. Yet over the past several years, the effectiveness of each has eroded. The increasing power and sophistication of special interests through Congress have thwarted the SEC. Conflicts plague the self-regulatory organizations— the New York Stock Exchange and the National Association of Securities Dealers— whose revenues come from the companies they list and the order flow of brokerage firms, the very groups the exchanges are supposed to oversee. Adverse legislation and court decisions have limited aggrieved investors' access to the judicial system. This book is intended to give investors a guide to avoiding pitfalls they never knew existed. I hope it helps investors understand the essential role they play in protecting their own financial future. By learning about conflicts, motivations, and political favoritism, investors can become more discerning in how they use the power of their money and the power of their shareholder vote. I hope this book makes you a more informed, skeptical, diligent, and successful investor. C O HAPTER NE HOW TO SLEEP AS WELL AS YOUR BROKER I f they have it, sell it. If they don't, buy it. That was the whispered joke on Wall Street in 1963 when I joined the brokerage firm of Carter, Berlind & Weill. It was only half in jest. It betrayed the callous attitude many brokers had toward their clients. Brokers are supposed to advise you on which securities to buy and sell, depending on your financial resources and your investment objectives. They offer garden- variety stocks, bonds, and mutual funds, or such exotic instruments as convertible debentures and single-stock futures, to help you shape a portfolio that fits your needs. Brokers may seem like clever financial experts, but they are first and foremost salespeople. Many brokers are paid a commission, or a service fee, on every transaction in accounts they manage. They want you to buy stocks you don't own and sell the ones you do, because that's how they make money for themselves and their firms. They earn commissions even when you lose money. Commissions can take many forms. On a stock trade, the commission is a percentage of the total value of the shares. For some mutual funds there are up-front commissions, or sales loads, which are paid when you make an investment. There also may be back-end commissions, or deferred loads, which are paid when you take your money out. On bonds, brokers don't charge commissions. Instead, they make their money off the "spread," or the difference between what the firm paid to buy the bond and the price at which the firm sells the bond to you. Warren Buffett, the chairman and CEO of Berkshire Hathaway Inc. and one of the smartest investors I've ever met, knows all about broker conflicts. He likes to point out that any broker who recommended buying and holding Berkshire Hathaway stock from 1965 to now would have made his clients fabulously wealthy. A single share of Berkshire Hathaway purchased for $12 in 1965 would be worth $71,000 as of April 2002. But any broker who did so would have starved to death. While working in the early 1950s for his father's brokerage firm in Omaha, Neb., Buffett says he learned that "the broker is not your friend. He's more like a doctor who charges patients on how often they change medicines. And he gets paid far more for the stuff the house is promoting than the stuff that will make you better." I couldn't agree more. In sixteen years as a Wall Street broker, I felt the pressures; I saw the abuses. "Levitt, is that all you can do?" Those stinging words rang in my ears at the end of many a week as I struggled to join the ranks of successful Wall Street brokers at Carter, Berlind & Weill. Eleven of us worked out of an 800-square-foot office on 60 Broad Street, in the shadow of the New York Stock Exchange. I divided my time between buying and selling stock and scouting for companies that might want to go public. When I joined the firm, America was riding high. A postwar economic boom that began in the 1950s marched onward through most of the 1960s, encouraging companies to look to Wall Street to finance their expansion. The growth in jobs and overall prosperity produced much wealth, and people flocked to the stock market in search of easy money. It was a heady time, and I wanted to be a part of it. I was thirty-two, and though I had no Wall Street experience whatsoever, I started calling potential clients right away. The competition among the partners was intense. We shared one large office so we could keep a watchful eye on one another. Arthur Carter kept a green loose-leaf binder on his desk, and in it he recorded how much gross— the total amount of sales— each of us was responsible for each week. Every Monday morning I stared, terrified, at an empty calendar page, worrying how I was going to generate a respectable $5,000 in sales. When we reviewed the results on Friday, there would be much scolding and finger- pointing. If I wasn't the lowest producer, I joined the others in berating the one who was. Our mandate was to grind out the gross and recruit new brokers with a proven knack for selling. But on the Wall Street I knew in the 1960s and '70s, the training of new brokers was almost nonexistent. Brokers were hired one day and put to work the next cold-calling customers. At all but a few firms, research was primitive. Starting salaries were a pittance, forcing brokers to learn at a young age that they had to sell aggressively to survive in the business. The drive for commissions sometimes motivated supervisors to look the other way when aggressive upstarts bent the rules.