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Take on the Street?

Mises Daily: Monday, January 20, 2003 by

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Review of Take on the Street: What Wall Street and Corporate America Don't Want You to Know. What You Can Do to Fight Back by Arthur Levitt, with Paula Dwyer. (Pantheon, New York, 338 pages) $24.95.

Arthur Levitt is frustrated. 

He should be. Even by his own admission, Levitt, who held the chairmanship of the SEC longer than anyone else, wasn't able to catch many of the so-called bad guys that regulators are supposed to nab. Maybe there's another reason for the regulatory problems. Levitt, whose book entertainingly rampages through most of the securities industry, never considers if the system of regulation, that he has been a part of for so many years, should be on trial. 

Instead, Levitt uses this book, in part, to work out his frustration. The high and the mighty of Wall Street and Capitol Hill will want to go to the extensive index immediately and find out how much this former chairman of SEC has skewered them. And does the angry Levitt ever hammer the big shots of the securities business along with the pols that he charges are their enablers!

But Levitt's frustration—and the former chairman looks very unhappy on the book jacket—goes back through a long career in public service and the securities industry. Levitt is now eulogized by many in the media, but this is a man who should have known where the bodies were buried even before they were cold. Levitt began as a Wall Street broker some 40 years ago. He sold cattle futures. But his career was actually a family matter. 

Levitt's father's was a longtime controller of the state of New York, a liberal with a spotless record. But that, fumes Levitt, didn't stop one prominent Rancid Apple politico from roughing him up during the city's persistent fiscal woes in the mid and late 1970s.

New York City Mayor Ed Koch, Levitt writes, in 1978 demanded his father use state pension funds to save the city from yet another potential fiscal crisis that our venal municipality seems to go through at least once every twenty years (As I write this, the city faces another fiscal disaster. The more things change…). 

Levitt's father refused Koch's demand. The mayor didn't think that was the right answer. Mayor Koch, Levitt recounts, screamed that, if the city went bankrupt, the responsibility would be the controller's. (Why it is never the fault of elected officials? They were the ones who used accounting gimmicks for decades that brought Sodom on the Hudson to the brink of disaster. This is something that no one has ever explained to the groaning taxpayers! Levitt, whose forte seems to be sniffing out accounting and securities flim flams, never says anything about that either. But he does complain that his father was abused.)

"This confrontation upset my father so much that, moments later, he suffered a minor stroke, which left him unable to speak for several hours," (page 4) Levitt writes. Luckily, padre Levitt recovered. But the incident obviously left young Levitt with a scar. He was learning a painful lesson. Politicians, especially when money and power are at stake, are not nice people. Levitt is just warming up at this point in the book. After recounting his father's clash with Koch, he aims to strike out the heavy hitters of the securities industry. 

And this is what will make this a page-turner on Wall Street. That and Levitt's feral frankness. He roughs up some of the biggest names in the securities business. Among those bloodied are Nasdaq's Hardwick Simmons, Merrill's Dan Tully and Citigroup's Sandy Weill. The last named was Levitt's former partner in Weill's first brokerage back in the 1960s. Levitt believes many of the securities laws are a joke; that the average retail investor is rooked. For example, Levitt railed against various practices back in the 1970s in a speech called "Profits and Professionalism." 

In the speech, Levitt asked, "How can a broker view himself as a professional—as a counselor who considers his client's interest before his own—when his livelihood is dependent upon him taking an action which may not be appropriate or timely to take?" (page 25). Levitt's speech drew much criticism, especially from his partners at his firm. 

"This is ridiculous. I can't stop you from doing this, but I certainly don't agree," Levitt quotes Sandy Weill, then his partner. Hardwick Simmons, at that time the marketing manager of his firm, tells Levitt that he doesn't understand the business. 

Levitt, obviously, smarts from this incident. So some two decades later, as chairman of the SEC, he set out to transform the securities industry with a report that he hoped would expose its mountebankery and lead to a miraculous transformation. Unfortunately, as with many reformers who think their reports and their administrations can change decades of customs and traditions with one stroke of the pen, Levitt found out that an industry can't be changed overnight. 

Levitt thought his report was a landmark achievement. He says the industry finally documented and acknowledged the conflicts of interest in selling products that it originated.

The Tully Commission, headed by Dan Tully, then Merrill's chief executive officer, detailed bad business practices in the securities industry. Levitt says the most important accomplishment of the commission "was getting industry leaders to acknowledge the existence of conflicts" (page 25). However, Levitt seems not to be a student of the 18th century British philosopher/statesman Edmund Burke. Otherwise, this regulatory Robespierre, this incorruptible, would have understood that revolutionary reform wasn't going to happen because of one report by a well meaning chairman of the SEC. 

Levitt acknowledges that years after the commission's "best practices" recommendations were made, they were roundly ignored by many of the biggest firms. The biggest securities firms, for example, continued to pay their reps more for selling proprietary products than outside ones. That was contrary to the Tully recommendations. They were not going to change their practices to please Levitt, especially Dean Witter, which, by the late 1990s, was recording 75% of its fund sales in proprietary products. 

"Surprisingly," Levitt writes, "Merrill Lynch was also one of the resisters." Levitt complains of the quality of Dean Witter funds, which tended to turn in poor performances. But maybe, just maybe, all of Levitt's best practices weren't the best, after all. 

Levitt doesn't mention that Merrill Lynch funds, in the 1990s, had a good reputation; supposedly the best of the wirehouse funds. I'd like to remind Levitt that, no matter how expensive proprietary funds usually are, not all proprietary funds are the same. Indeed, some investors are willing to pay more for these funds, even though there are plenty of low cost, no-load funds available. That's because the effective reps can provide advice along with the sale of the funds. There will always be some people who will pay more for a product that others believe is overpriced. This is not a revelation except possibly to Levitt.

Is this is a good deal for the investor? It's up to him or her to decide. And some proprietary funds have actually performed admirably, a point that I don't think Levitt would concede. He could have at least mentioned that there was a debate about this when discussing this difficult issue. He didn't.

But possibly the greatest example of regulatory problems came soon after he took over at the SEC. There were rumors of a Nasdaq price fixing scandal, which I remember vividly because, at that time, one of my editors took to constantly yelping "Nasdaq fraud" at anyone associated with the over-the-counter market. Here Levitt and his minions must take some criticism too. He says the SEC initially ignored the rumors of Nasdaq skullduggery. 

"At first," he writes, "some of the staff at the Division of Market Regulation, which is the part of the SEC that oversees exchanges, didn't want to believe the allegations." (pages 183–84). 

Levitt here touches on what is the eternal problem of regulation—that the regulators, who often have been part of the industry they regulate or will be part of the industry after they leave the government—often are so close to the industry, that they virtually become a part of the industry. This is the "Triumph of Conservatism" thesis, which refers to Gabriel Kolko's pathbreaking book of several decades ago. This is a work which held that the regulators and the biggest railroads in the 1880s worked together to stop new entrants from undercutting them. 

We will return to this theme of regulators becoming players anon when we discuss Levitt's attempt to obtain a nice job for one of his former employees. So how did Nasdaq bid-rigging scandals happen right under the noses of the mighty regulators?

"We had let ourselves," Levitt continues, "as regulators, get too cozy with the stock market we were supposed to be watching over." (page 184). 

Agreed!

When Levitt, summing up the situation, says new rules were later put in to ensure a bid-rigging scandal will never happen again, I think he means well. Still, I doubt that he, or any other regulator, should make these guarantees. The reader at some point, I think, must wonder why the solution to these breakdowns of market regulation inevitably is, well, a call for more of the same from the Levitts of this world. Let's have more regulators and regulations to correct the problem of prior regulators and regulations! George W. Bush, who supposedly ran against big government, who was supposedly not happy with the failures of the SEC, is—surprise!—proposing a big increase in the budget of the SEC. 

One even wonders if these "cozy" regulators understand what is going on. The SEC, in cleaning up the bid-rigging scandal, acted on the study of two academics, not the findings of the SEC's staff. (By the way, parts of that study have been disputed to this day).

According to the academics, dealers were penalizing other dealers who weren't part of the price fixing cartel. Day traders, who weren't part of the fix, were practically persecuted by NASD disciplinary committees. Levitt tells the reader that Nasdaq market makers were conspiring to keep spreads fat. Levitt said the behavior was shameful and "shocking" (page 183). 

By the way, on the subject of conflicts of interest, the usually candid Levitt fails on one point. He never addresses the possibility that he may have breached the highest ethical standards with his own actions some three years ago. Levitt, at a time when the SEC was investigating Bear Stearns, made a phone call to the same firm, recommending one of his former department chiefs as a senior managing director in the firm's clearing division. 

This former official, Richard Lindsay, had been the SEC's head of the market regulation division. He ended up working for Bear Stearns. A spokesman for the firm would say of the Lindsay hire, "We consider Richard Lindsay a tremendous asset to the firm." No doubt he was. 

Some on Capitol Hill charged that Levitt's phone call was inappropriate. Levitt, at the time, said he checked with the SEC's lawyers and they said it was ok. Levitt should be reminded of what people like him constantly tell people in the securities business: Even things that are not conflicts of interest can have the appearance of conflict. That can be almost as bad as an actual conflict of interest.

Still, what is most disappointing is that this episode never makes it into the book. Yet it is an important issue. So many regulators end up working for the organizations they once oversaw. Is this right? What is Levitt's opinion on this? The reader never is informed because it never turns up on Levitt's radar screen. This, in my opinion, is a regrettable oversight. It is as relevant as the ethical breaches of the securities industry that Levitt targets. It goes to the heart of the debate over regulation. Who regulates the regulators?  

Indeed, one good point of this book is that Levitt is quite thorough in detailing the conflicts of interest of the most important regulator: his successor. This is ironic. Harvey Pitt is now a lameduck SEC chairman because of his ethical breaches. By the way, Pitt's designated successor, William Donaldson—you guessed it—is a veteran of the securities industry and the former head of one of its biggest firms.

Levitt, citing Pitt's connections to the accounting industry, contends that he stymied efforts to reform its bad practices. Levitt intimates that Pitt's prior connections to the American Institute of Certified Public Accountants (AICPA) should have disqualified him from heading the SEC. Levitt argues that Pitt, as an accounting industry lawyer, was ready to soften rules that would have reformed the practice of accounting firms offering both auditing and consulting services to the same client.

"Even after becoming the agency's chairman," Levitt writes, "Pitt continued to hold the view that the growth of consulting does not interfere with auditor independence. To him, the solution to the industry's problems are new rules that require companies to disclose more information, and more frequently than once a quarter, about their operations and strategic plans." (pages 119–120)

Pitt, who represented the AICPA through his law firm, was ready to water down needed reforms through the creation of an accounting industry Independence Standards Board (ISB), according to Levitt. Pitt concludes that the ISB would be unlikely to establish effective auditor standards. 

Only the SEC could do that, complained Pitt, but look who would be heading the SEC after he departed: A member of the industry. So, once again, the industry insider would be in charge; the fox would be given the policing power over the chickens. Levitt appears to be making a very effective case against the beleaguered Harvey Pitt, but actually I believe he is doing more: He is unconsciously making a case against the entire outdated system of regulation.

Levitt also criticizes many of the federal lawmakers, who he believes tried to intimidate him. He charged that they were attempting to restrain or delay his efforts to reform the securities industry before it imploded. Levitt even criticizes himself, which speaks well of the author. Nevertheless, there are several problems with Levitt's Prometheus, "I tried to save the world but was chained by the bad guys" view. 

First, Levitt is right that many of the wirehouses are operations that often favor themselves over the individual investor; in which institutions and big customers generally receive better treatment then the small retail investor. This is no surprise to most people who buy in big quantities specifically to obtain generous discounts.

Still, Levitt acts as though the average investor will never learn this and that there are no alternatives to the industry's conflict of interest model. There are plenty of Vanguards, low-cost, no load fund companies, in the investing world. And more and more investors want to do it alone. It is becoming ever easier for the average person—if he or she takes a little time and does a wee bit of researchto find the right investment—adviser or no adviser. Investors are smarter than Levitt assumes.

Second, there is a question about the regulatory saviors. Does the system of regulation work, even when the best of regulators is running the show? Going through Levitt's litany of complaints I found myself asking: Why couldn't the sagacious Levitt and his staff do better? He was chairman of the SEC throughout most of the 1990s. He was a smart regulator who knew all the games that were played. In his book, he claims he saw most of the reporting and accounting scandals coming. So why didn't he scream bloody murder? He might have had little influence with the Tweeds on Capitol Hill, but I'm sure the media would have been delighted to hear his complaints.

One has a sense that this book is almost a form of therapy for a former regulator suffering from weltschmerz. Despite his best efforts, the scandals exploded just after he left office. So blame it on the shady securities business. Blame it on anyone or everyone. Blame it on Rio, but don't blame me, Levitt seems to be saying.

But, one is obliged to ask, why weren't there public outcries from Levitt about accounting hijinks?  And why, given his long record as a player in the securities industry, couldn't he make a more effective case with the pols on Capitol Hill, so many of whom seemed to have been antagonistic to Levitt and his call for reforms? Why couldn't this veteran of the political wars build a constituency among the power brokers? 

This book is a call for reform. But it is also a chronicle of disappointment; of a regulator jaded by the securities business and by his ineffective attempts to transform it.

Yes, Levitt has wounded a lot of those in the security and political world.  He's exposed some of the seedy practices of the business. But in this book he's also done something else: He's also unintentionally wounded the system of regulation.


Gregory Bresiger, a business writer and editor living in Kew Gardens, New York, is assistant managing editor of Traders Magazine. His work has also appeared in the Journal of Libertarian Studies, the Free Market, Financial Advisor and the New York Post. See his Mises.org Articles Archive, and send him MAIL