Are we risking the integrity of our securities markets?

Are we risking the integrity of our securities markets? As technology and the movement of capital encourage a worldwide explosion of securities markets, a former SEC commissioner feels that only halting steps have been taken to deal with the regulatory problems caused by these developments. In a world of exciting and constant change, perhaps no phenomenon in the financial world is as important, as far reaching, and as certain as the rapidly increasing internationalization of securities markets. A few years ago a topic for scholarly dissertation, it is daily becoming a fuller and more challenging reality. The extent to which the markets of the world have become intertwined was seen dramatically in the events of October, 1987. Markets with markedly different characteristics impacted one another swiftly and even harshly.

But that reality is seen as clearly every day. As securities firms become increasingly international, as barriers to the movements of funds and securities evaporate, as investors learn more about foreign securities and seek international diversification as well as industry and issuer diversification, the growing interrelation of markets is plain. Today, we have not only specialists on the Midwest Stock Exchange in Chicago competing with their counterparts on the New York Stock Exchange, but traders on the Tokyo Stock Exchange competing with specialists on the New York Stock Exchange and London marketmakers competing with U.S. marketmakers on the NASDAQ system.

The truth is that technology--the computer and sophisticated communications apparatus--and the elimination of barriers to the movement of capital have permitted giant steps in the internationalization of markets, while only halting steps have been taken to deal with the regulatory problems posed by these developments.

This lag is clearly seen in the two areas discussed in this article--insider trading and corporate, especially financial, disclosure.

While we speak more frequently of the internationalization of markets, the simple fact is that securities markets remain preeminently national, as does their regulation, and they are becoming more and more competitive, both in seeking listings and in luring investors. In 1986, there were 150 stock exchanges in 54 countries, and it is likely that since then others have been founded. Developing countries regard the organization of an exchange as a necessary step in the maturing of their economies, and rightly so. And each of these exchanges has its own structure, relationship to its government, trading style and techniques, and rules. As John Phelan, Jr., the chairman of the New York Stock Exchange, has said, "Each of the major stock exchanges not only has its own rules and regulations, but its own personality as well."

The rules of corporate disclosure In each country, the exchanges, the government, or some organization such as an accounting board--or a combination of these--has established some standards for disclosure of information concerning the affairs of issuers. And, as we all know, these standards vary hugely.

First, of course, there are differences in accounting principles--for instance, the consolidation of accounts, depreciation practices, accounting for inflation, foreign currency, and transfer pricing. The standards for the licensing of auditors, and the extent to which independent auditors must be involved with published financial information, vary over a wide range.

The result is a bewildering pattern of disclosure requirements, all ostensibly aimed at assuring that investors have sufficient reliable information on the basis of which they then can make rational investment decisions.

A number of efforts are underway to eliminate, or at least reduce, the dimensions and significance of these differences. These include: * The International Accounting Standards Committee is turning out standards that it hopes will influence the development of standards not only in the sponsoring nations but elsewhere as well. * The International Association of Securities Commissions has organized a committee to find acceptable standards in multinational offerings that will satisfy securities regulators. * The EEC is moving toward the implementation of uniform disclosure and accounting standards for members of the European Community. * The Organization for Economic Cooperation and Development has developed detailed guidelines on disclosure of information by multinational issuers. * And the United Kingdom, Canada, and the U.S., which have accounting and reporting standards that closely resemble each other, are working toward the acceptance of each other's disclosures in connection with transboundary offerings. Not only are the requirements different, of course, but the means of enforcing them, and the effectiveness of the enforcement of them, vary from market to market and country to country.

Where once the flow of money was impeded by barriers erected even by some of the most economically advanced countries, those barriers have steadily fallen, with the result that a New York investor can trade in securities listed on the Tokyo Stock Exchange as readily as on the New York Stock Exchange. Numerous investment companies have been organized in the U.S., pioneered by John Templeton, for the purpose of investing in the securities of foreign issuers. As all this happens, the inevitable demand is for information similar in quality and completeness to that the investor is accustomed to in his home country.

One of the competitive tools at hand for exchanges seeking more trading and countries seeking greater inflow of capital is disclosure by issuers. Investors accustomed to the steady flow and huge volume of disclosure by corporate issuers in countries like the U.S. and the United Kingdom, which have long histories of mandated disclosure (the U.K. has required prospectuses in connection with public offerings since 1844), are understandably hesitant to commit their funds in enterprises whose financial statements reflect different mixes of information, different modes of presentation, and suspect degrees of reliability caused by soft standards, lax enforcement, and the absence of a cultural commitment to candor and forthrightness.

On the other hand, the exchanges compete vigorously for listings, not only of domestic securities, but foreign ones as well, and often that competition is characterized, not by pressures for more rigorous disclosure, but by the opposite: pressure for relaxation of standards. This is particularly true of exchanges in countries with highly developed disclosure standards. U.S. exchanges have long complained that the rigidities of SEC accounting and disclosure requirements have prevented them from securing listings of foreign issuers who are unwilling to submit to the SEC requirements.

The SEC has made modest responses to these complaints from American exchanges. In recent years, the Commission has been willing to forego such requirements as disclosure of segment revenues and profitability by foreign issuers and detailed information concerning compensation of top officials. It also has been willing to accept financial statements prepared in accordance with foreign accounting principles if accompanied by an appropriate reconciliation to U.S. principles.

The dilemma the SEC confronts as it seeks to accommodate disclosure documents that comply with foreign standards, but not U.S. ones, is simply this: if foreign issuers are permitted to compete for the capital of American investors using disclosure less full than that required of American issuers, is it not unfair to compel American issuers to comply with more stringent standards? And, of course, this question is accompanied by a belief among American regulators that the American disclosure system is more fully developed than those in most other countries. A similar conviction for many years kept the Financial Accounting Standards Board (FASB) from fully cooperating with the efforts of the International Accounting Standards Committee. But happily that hesitancy is disappearing.

At one time, the efficient market hypothesis, lately somewhat tarnished as a result of the events in October of 1987, begat the idea that mandated disclosure was passe, an unwarranted intrusion of the government into private affairs. Less is heard of these notions today. Experience in many countries has proven that the demand of users is a weak whip with which to induce issuers to tell the truth--fully, candidly, honestly, and in a timely fashion.

Forsaking the basics of disclosure While these pressures for fuller and more reliable disclosure are driving countries and exchanges to higher standards of accounting and disclosure, there is in a sense a debasing of the significance of disclosure occurring at the same time. Though these phenomena were discussed before October, 1987, since then they have become a central subject of concern: they are conveniently lumped by the term "commoditization of securities." This includes the increasingly common practice by large investors, principally institutions, of trading securities with little, if any, concern for issuer-specific information. For instance, there has steadily grown in the United States "portfolio investing." This consists of mechanically assembling a portfolio of securities to reflect an index or other mix of securities; the most popular mix mirrored in portfolios in the U.S. is Standard & Poor's 500 stock index.

The manager of such a portfolio is completely indifferent to the investment characteristics of the securities included in the index. He never pays heed to the disclosures in the financial statements or the annual reports; he is concerned only with which securities are included in the index. Even more remote from fundamentals are those who buy and sell index futures contracts, which are simply contracts to purchase or sell a portfolio of securities (e.g., the S&P 500), but which are settled in cash rather than delivery of securities.

The social consequences of this style of investing, it is fair to suggest, may be significant. Issuers of securities not included in the indices, therefore, will find the markets for their securities less liquid, and that will result in greater difficulty in raising equity capital. And that, of course, could have profound effects upon innovation, entrepreneurial initiative, the creation of jobs, and a host of other social and economic concerns.

Of only slightly less concern to those who believe in the importance of investment decisions made on the basis of fundamental analysis has been the dominance of speculative activity in world markets--much of it originating with institutions which preeminently should be investing on the basis of fundamentals. In 1960, stocks listed on the New York Stock Exchange turned over at a rate of 12 percent; in 1986, the rate was 87 percent; and it is indeed probable that the rate in 1987 was in excess of 100 percent. Most of this activity is accounted for by institutions. It has been estimated that the average institution turns its portfolio at a rate of 70 percent a year.

Not surprisingly, many investors have lost faith in the value of fundamental analysis as they have seen the securities in which they have invested whip-sawed by broad market movements that have no relationship to the individual merits of a security. Securities that on the basis of fundamental analysis were excellent securities by any measure dived along with less worthy brethren in October of 1987.

This disillusionment with fundamental analysis poses a perplexing contrast with the widely accepted belief, increasingly reflected in exchange and government rules, that information--accurate, reliable, timely, relevant information--is important to investors and should be assured to them by some authority. And beneath this is an even deeper conundrum: more and more investing is being done without concern for fundamental analysis--diversified portfolios, portfolio investments, speculation on market trends, decision-making by charts, and so on--and, yet, without some investors investing on the basis of individual stock selection, such "mindless" investing would be impossible.

I think it is impossible to overestimate the long-term problems associated with these trends in markets. As more and more decisions are made with scant or no concern for the financial fundamentals of enterprises, we confront the danger that Lord Keynes identified half a century ago: "Speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes the bubble on a whirlpool of speculation. When the capital development of a country becomes the byproduct of the activities of a casino, the job is likely to be ill done."

Notwithstanding all of this apparently increased investment on bases other than fundamental economic and financial characteristics of issuers, however, I believe governments and other regulators will and must continue in their efforts to improve the quality of disclosure and financial reporting. Perhaps the need for mandated disclosure, as contrasted with voluntary or market-driven disclosure, and for the vigorous enforcement of the mandate is even more important in this environment. Managements are not blind to the denigration of fundamental analysis and the increase in investment decisions made without concern for financial analysis. This recognition might well breed indifference to the quality of disclosure.

It is good that publicly held issuers still are compelled to disclose and disclose well. While they may seem at times to be a vanishing species, there still are many throughout the world who invest on the basis of issuer analysis, and their needs must and should be served. Issuers owe them the tools with which to make their judgments.

More nations and more markets will need to recognize that, in the strenuous arena of world competition for investors, the integrity of a nation's or an exchange's disclosure system will be a powerful competitive tool. As that happens, we will increasingly approach a worldwide market for securities, in which investors will have as much confidence in the information available about the securities of Malaysian or Philippine issuers as they have in the information available about U.S. or U.K. securities.

The rules of insider trading It is becoming increasingly apparent that the same may be said of rules restricting trading on the basis of inside information. For some time, it almost seemed as if the U.S. authorities were the only ones who prosecuted this form of market abuse with the vigor it deserved. Yet it was only in the mid '60s that insider trading began to be seen in the U.S. as a major menace to the integrity of markets. Since then, and particularly in the last half dozen years, the SEC and the federal prosecutors have been diligent in pursuing this type of wrongdoer, and their efforts have yielded some dramatic prosecutions.

Many countries have believed, and some still do, that the "gentleman's code," deep-seated custom, and the frowns of central bankers were sufficient to restrain the cupidity that has led to this particular offense. However, in the last 10 years, nation after nation has seen the futility of these reliances. Almost invariably, official attention has been focused on the problem as the consequence of a scandal that made headlines and shocked sensitivities. In England, Switzerland, France, the Low Countries, Japan, and in many other lesser financial centers, laws have been adopted that are intended to penalize at least the grosser kinds of insider trading, that of corporate insiders and their tippees.

This mounting concern with insider trading, like that with inadequate issuer reporting, has been accompanied by contrarian economic analyses that assert that the prohibition of insider trading interferes with the efficient assimilation of information by markets, that it makes conduct a crime that is essentially victimless, and that it makes capital-raising more costly.

Those who espouse these arguments are, according to their critics, blind to the more fundamental considerations that may properly be regarded as moral or ethical: fairness in trading on securities markets. This ethical concept is probably rooted in an even more fundamental, pragmatic one: if there is a widely held perception among investors that some, because of their unique access to undisclosed information, have an advantage in trading, then the market will be confined to people who think they can outwit the insiders through the securing of a better quality of inside information or through other artifices. The oft-made comparison of securities markets to casinos is not inappropriate in this context.

The increased willingness of governments and markets to strengthen their rules and laws against insider trading is strong evidence of their realization that their markets cannot compete if there is a perception among investors that the cards are stacked against them. Thus, we may expect that as trading becomes increasingly internationalized, and as the competition among markets worldwide increases, there will be more attention paid to insider trading and, at the same time, authorities will be less tolerant of transgressions.

The keys to integrity Insider trading and corporate disclosure are, of course, closely linked. If important information is promptly and adequately disclosed, there is less opportunity for the misuse of information.

They are also linked in perhaps more subtle ways. They are the two most important keys to integrity in financial markets and confidence in them. They thus provide conditions conducive to investors risking their money in enterprises that indeed provide enough perils in this rapidly changing world without the additional dangers of rigged and ignorant markets. Without confidence in markets, notwithstanding the growth of "mindless" investing, it will be impossible to sustain the worldwide growth that is essential if we are to avoid increased strife among nations.

Honest markets are more than a legal requirement. They are common sense necessities--if we are to enjoy an increasingly good life.

PHOTO : Another Deco Indian, Fritz Scholder, 1979, lithograph

PHOTO : An early twentieth-century satchel for valuables

PHOTO : Desert Markings, Joel Janowitz, 1977, oil on canvas Mr. Sommer is a former commissioner of the SEC and is currently chairman of the Public Oversight Board of the AICPA.