Appropriations for Fiscal 2004
William H. Donaldson
Chairman, U.S. Securities and Exchange Commission
Before the Subcommittee on Commerce, Justice, State, and the Judiciary, Committee on Appropriations, United States House of Representatives
March 13, 2003
Chairman Wolf, Ranking Member Serrano, and Members of the Subcommittee:
Thank you for inviting me to testify today on behalf of the Securities and Exchange Commission in support of the President's fiscal 2004 budget request. The fiscal 2004 budget request of $841.5 million is the largest amount ever requested for the SEC and comes on the heels of last year's appropriation, which was the largest single-year percentage increase ever provided to the Commission.
At the outset, I would like to take this opportunity to thank you for the tremendous support and leadership you have shown in ensuring that the Commission receives the resources and staff necessary to fulfill its mission. Your backing, along with the strong support of our authorizing committees, demonstrates convincingly that the Congress is dedicated to ensuring the financial integrity and vitality of our markets. While recent events have shaken investor confidence in the financial reporting by public companies and the integrity of our securities markets, your support of the SEC in both fiscal 2003 and 2004, and the landmark Sarbanes-Oxley Act, will help reinforce the foundations of our markets and demonstrate their resiliency.
Although I have been at the Commission for less than a month, I look forward to continuing and building on the strong and cooperative relationship that our Agency has developed with you in the past as we work together on the SEC's resource needs to implement the Sarbanes-Oxley Act and fulfill all of our statutory duties. This is a critical time for the agency and the way we address the challenges before us will determine not only where we go tomorrow, but for years to come.
In many ways, it may be time for the SEC to go through a transition much like the transition that the U.S. military has experienced in recent years and evolve into a much more efficient force, becoming quicker, more agile, and more pro-active. I am now reviewing with senior staff the Agency's operations and resource needs to determine appropriate changes to address both our internal and external needs. My hope is that the SEC can develop a new approach to our mission, as the military has done, so that we can play offense more often, be more pro-active, and anticipate the problems we may face.
Although this hearing is for the Commission's 2004 appropriations request, I believe it is necessary to put this request in the context of our fiscal 2003 funding level. Thanks to your efforts, the Commission was appropriated $711.7 million to fund its operations this year as part of the recent omnibus appropriation.1 These funds will enable us to meet the remaining fast-approaching deadlines of the Sarbanes-Oxley Act, hire over 800 new staff, advance initial start-up funds to the Public Company Accounting Oversight Board, improve our training efforts, and address our most pressing information technology needs. We will continue each of these activities in fiscal 2004 and for that reason I would like to discuss them now.
The new staff provided in fiscal 2003 will focus equally on the complex issues that we currently face and on the fundamentals upon which the Commission was built: full disclosure, fairness, transparency, and investor protection. Investor confidence is predicated on "minding our knitting" in these core areas. I believe that any budget increases we receive must be targeted to the programs and activities that will have the largest impact on our mission. In this regard, the budget that was prepared prior to my arrival calls for the following staffing increases in our major program areas:
Prevention and Suppression of Fraud 188
Full Disclosure 204
Investment Management Regulation 178
Regulation of Securities Markets 201
Legal and Economic Services 22
Program Direction 49
My initial review of these numbers suggests that overall this level of increase is warranted. However, during the next several weeks and months I intend to delve more deeply into each program area to verify personally that this is the best and most effective and efficient use of our new staffing. I would therefore like to reserve my option to make changes.
As discussed below, we will hire aggressively but thoughtfully, not just to increase head-count. As a result, these hiring targets may only be met over a longer period of time, but they will be met with people that we are sure can perform the vital tasks that we assign to them. And we are committed to train and integrate new staff as we bring them on. We are grateful that legislation has been introduced in both the House and Senate to help the Commission expedite and streamline the hiring process so that we can bring on additional, mission-critical securities industry accountants, compliance examiners and economists as quickly as possible to get on with the business of protecting America's investors.2 The Commission strongly supports this legislation and hopes that it will be adopted at the soonest possible time and signed into law by the President. Without this expedited hiring authority, the Commission will not be able to hire the additional staff it needs and which the Sarbanes/Oxley Act contemplates in any responsive time frame.
Today, over half of all U.S. households are invested in our capital markets. Twenty years ago, that rate was less than 20 percent. Just to use one example: mutual fund investments today exceed by more than $2 trillion the amount on deposit at commercial banks and are approaching the approximately $7 trillion in total financial assets in the commercial banking system. The SEC has only 354 examiners to oversee these mutual funds and investment advisers. In addition, while there are over 7,800 registered broker-dealers with more than 88,200 broker-dealer branch offices in the U.S., the SEC's broker-dealer examination program has only 218 staff to conduct inspections of these institutions. These facts, along with the accounting scandals that have plagued us, reinforce what we all know: our markets have changed, and grown, dramatically, investor confidence has been shaken, and the SEC must act decisively to deal with these challenges.
Equally important, I believe that the efficient functioning of the SEC is as much a part of investor protection as ushering in new rules and regulations. I have presided over similar management challenges while in the private sector and seen first hand what it takes to grow rapidly and responsibly and improve performance. The organizational and cultural changes that accompany the opportunity you have provided me are significant and require regular attention. Toward this end, the yardstick for measuring our success will be based both on the number and quality of immediate program improvements and on meeting the agency's long-term goals of investor protection and market strength. Two operational areas that play a significant role in this regard are staff training and management accountability.
Training and Management
New staff and the need for regular training go hand-in-hand. For this reason, the Commission will increase significantly its emphasis on frequent, in-depth staff training. Given the challenges we face, we need to ensure that staff continue to have the tools and skills necessary to fulfill their duties effectively. We cannot afford to have our most skilled employees leave the agency or be underutilized. Pay parity and the downturn in the economy have helped attract top talent, but there is more that we can do.
Management accountability is also central to our ability to perform our duties. I intend to enhance the Commission's operations by establishing a system to better train, evaluate, develop, and mentor managers and supervisors. This effort is consistent with the goals of the President's management agenda and is the right thing to do. We cannot expect SEC staff to successfully fulfill their duties if they do not have supervisors with the skills and tools to lead them. We must set expectations and reward our managers and staff accordingly.
The Commission's operational challenges also extend to our information technology program. Prior to enactment of our fiscal 2003 appropriation, our Office of Information Technology had been structured to maintain our existing information technology systems, undertake a few smaller projects each year, and complete only one large-scale initiative at a time. We have accomplished this level of activity primarily by developing a robust information technology capital planning program and relying heavily on contractors and outsourcing. This approach has been essential given past resource constraints, but it has left us with badly outdated IT capabilities. We must now be critically introspective, bring in broad IT expertise to evaluate our needs and further increase the involvement of our agency's divisions and offices in our information technology decisions. To meet our needs, program staff must work side-by-side with a reinforced information technology staff, and we must increase the number of information technology program managers we have available to assist the program offices in developing major applications to improve our effectiveness. While these hiring and cultural changes may not appear revolutionary, they are nonetheless significant and multi-year in nature, especially when viewed against our current inventory of major information technology needs.
The fiscal 2003 funding level allows the SEC to undertake three new major, multi-year information technology projects. The first one addresses the Commission's need to move away from paper documents. It is the development of a robust document management and imaging system that will make it easier for our attorneys, examiners, and others to cull through the tremendous volumes of information that they review and file as part of their investigative, inspection, and enforcement activities. This system will provide agency-wide electronic capture, search, and retrieval of all investigative and examination materials and will be designed to meet the demands of our document-intensive litigation program, and to assist our examination staff in analyzing the content of documents more effectively.
As an aside, one of the first things I noticed when I arrived at the Commission's headquarters and walked around was the extent to which the SEC is physically drowning in paper files. We need to make it easier for staff to do their jobs and to share information with each other. Document management and imaging are key components of this and, while it will be a multi-year effort, it is long overdue.
The second project holds equal potential to improve the efficiency and effectiveness of the Commission: a comprehensive change in our filing and disclosure processes, especially regarding financial reporting. The effort to improve the filing and transparency of public company disclosures is expected to lead to significant business process changes that will result in the elimination of confusing forms, the collection of uniform data from filers, and internal operations improvements that will allow staff to conduct more rigorous financial, industry-specific, and comparative analyses. Although this project will be carried out by issuers, their accountants and their other advisors, under the leadership of the SEC, the principal beneficiaries of this initiative ultimately will be the nation's investors, who will have more understandable and reliable financial information upon which to base their investment decisions. This will result in a fundamental improvement in the transparency and comparability of firms' financial statements, which should significantly increase investor confidence.
When the agency's electronic filing system (EDGAR) was originally created, it did a terrific job of converting paper disclosures and filings into electronic documents and making more information available to the public. We now need to take the next step. As part of a comprehensive review of our business processes, we need to change how we work and alter EDGAR accordingly. We need to revisit what information staff must have readily available to conduct more intensive and robust disclosure reviews. For instance, while we receive and archive the EDGAR data, we cannot immediately analyze them. Instead, we depend on outside vendors to transfer the numbers in the text of the filings to machine-readable form that we can then analyze. We are in the process of designing tags for EDGAR filings that would allow anybody to extract machine-readable data from them. These initiatives will allow us to conduct analyses and monitor trends in real-time.
Our third major information technology requirement is to enhance our disaster recovery program. The SEC learned first-hand from the events of 9/11 and the experiences of its Northeast Regional Office, in New York, of the importance of keeping its data even more secure than it already is. In addition, we need to have the capacity to store and move large amounts of data from one regional or district office to another without first going through Washington. We need to move to a true "point to point" information technology system that allows us to mitigate the loss of data and to recover quickly in the event that we need to implement our continuity of operations plan. When this project is complete, the agency's critical files and information systems will be backed up daily and in multiple locations.
Since enactment of the landmark Sarbanes-Oxley Act last summer, the Commission has worked vigilantly to meet the Act's timeline and mandates. Within 30 days of the Act's signing, we adopted rules requiring CEOs and CFOs to certify their financial statements and accelerating insider transaction reporting to two days.
This past January was the busiest month of rulemaking in the history of the SEC. We adopted nine other Sarbanes-Oxley mandated rules relating to:
- Pro-forma financial information,
- Codes of ethics for senior executives,
- Financial experts on audit committees,
- Trading during pension fund blackout periods,
- Disclosure of material off-balance sheet transactions,
- Retention of audit records,
- Independence standards for public company auditors,
- Standards of conduct for corporate attorneys, and
- The application of certain Sarbanes-Oxley certification and disclosure requirements to registered investment companies.
In addition, we sent four separate studies to Congress related to:
- Penalties and disgorgements in our enforcement cases,
- Securities professionals who have "aided and abetted" federal securities law violations,
- Commission enforcement actions involving reporting violations and restatements, and
- The role and function of credit rating agencies.
We met these deadlines without sacrificing our other work or obligations including our robust enforcement program and numerous regulatory initiatives unrelated to Sarbanes-Oxley. For example, in January we also adopted rules regarding proxy voting by investment companies and investment advisers, and in February we adopted rules regarding analyst certification of research reports. And we're hard at work on other rules and studies, including rules related to:
- Improper influence on auditors,
- Listing standards related to audit committees,
- Governance of the Public Company Accounting Oversight Board,
- Investment adviser and investment company compliance policies,
- Public company internal control reports,
- Critical accounting policies, and
- Expanded current reporting.
Public Company Accounting Oversight Board
Selection of a new chairman
Last week, the Commission announced that it had adopted a plan to select a Chairman of the Public Company Accounting Oversight Board established pursuant to the Sarbanes-Oxley Act of 2002.3 The plan calls for the Chairman, the Commissioners, and the staff to reach out and solicit input from a variety of sources, including key members of Congress, investor advocates, academics, and members of the business community.
As I said in my confirmation hearing before the Senate Banking Committee, the selection of a Chairperson for the Public Company Accounting Oversight Board is my number one priority, and I am pleased that the Commission has been able to build upon the recommendations of the General Accounting Office and quickly devise a thorough and expeditious process to identify and vet potential candidates.
The SEC staff will incorporate new suggestions, update the list of qualified candidates and circulate it to the members of the Commission. The Chairman and the Commissioners will narrow that list based on the criteria in the Sarbanes-Oxley legislation, additional criteria that the Commission finds desirable, but not mandatory, and the individual's willingness to serve.
Each candidate on the narrowed list will undergo a preliminary vetting process. Upon completion, each member of the Commission will interview the leading candidates and a thorough background review will be completed. Following this review and consultation with the Chairman of the Federal Reserve and Secretary of the Treasury, as required, the Commission will vote to approve the appointment of a Chairperson.
The Commission will be looking for an individual who has experience running a dynamic and innovative organization; is well recognized by those participating in the financial markets and possesses a keen understanding of those markets; is independent from any particular constituency; has experience that demonstrates an understanding of the role of auditors in the Commission's financial accounting and disclosure system; has no known impediments or controversies that might impair his or her ability to lead, or the public's ability to rely on the individual to lead; and is willing and able to serve a five-year term.
In addition, we are seeking a person who has the ability to consider impartially ideas, information, and data from all sources, to seek additional input whenever it appears necessary, and to make timely decisions, as well as the ability to absorb complex information, analyze it objectively, and make rational decisions. Of course, we want someone who has the ability to communicate effectively, has a demonstrated commitment to public service and to the PCAOB's mission, as well as an awareness of the financial reporting and auditing environment. The individual we choose should have a demonstrated ability to create a collegial working environment and instill public trust.
My hope and expectation is that the Commission will move expeditiously and select a new chairman for the PCAOB as quickly as the process allows.
The fiscal 2003 budget provides the resources necessary for the Commission to advance start-up funds to the Board. The Commission initially advanced $1.9 million to the Board. The Board has recently requested a more substantial amount that would fund its operations through June and allow them to begin the development of state-of-the-art information systems to be used in the Board's registration, billing and collection, and professional oversight programs. The Board has stated its intention to repay these funds to the Commission by the end the current fiscal year.
The Commission has significant responsibilities related to the oversight of the Board, including approving the Board's budget and rules and adjudicating appeals from the Board's decisions on registration, inspection, and disciplinary matters. We have developed close communications and a good working relationship. For example, we are planning for both the Board and the Commission to participate in a roundtable at the end of this month on issues related the Board's registration and oversight of foreign accounting firms.
Utilization of Commission Resources
We have tremendous needs for the new resources made available in 2003 and have plans in place to meet these needs. However, I want to be sure and I am committed to making sure that every penny of that new money is spent wisely. I am determined that we take an aggressive but thoughtful approach to resource allocation. We will bring on the people we need to help us fulfill our mission, and not simply increase our head-count. I view this allocation of resources and renewed commitment to the SEC's needs as a multi-year effort to ensure that we make long-lasting and substantial improvements in the SEC's programs that will restore confidence and benefit our nation's investors.
The President's request for $841.5 million in fiscal 2004 recognizes that the Commission's needs are growing and ongoing. As I stated earlier, this request is the largest amount the Commission has ever received and will allow us to continue all of the efforts that we are undertaking in fiscal 2003. In particular, it will allow us to focus further on financial frauds, review of public company filings, our new risk-based examination program, and the ongoing requirements of the Sarbanes-Oxley Act.
The Commission has played, and will continue to play, a vital role in protecting our markets from fraud, manipulation and other practices that continually threaten to undermine their integrity. To meet the challenges facing us including the unprecedented number of significant financial frauds and accounting failures, new securities products, technologies, and globalization the Commission's enforcement program will continue to add personnel, including investigative attorneys, accountants, and market surveillance specialists.
The Commission has responded swiftly to the recent rash of accounting failures. In fiscal 2002, approximately 27% of all filed enforcement actions involved financial disclosure and issuer reporting violations. Financial reporting and accounting cases remain our number one enforcement priority, and numerous financial fraud investigations are currently underway. These types of investigations require a significant commitment of staff resources because they are fact- and document-intensive and include reviews of the conduct of a variety of individuals and entities. The Commission's enforcement program will continue to need additional attorneys and accountants to assist in these complex financial fraud investigations.
As the Commission seeks to aggressively investigate and punish corporate fraud, an increasing number of defendants are choosing to litigate. Even many cases that are ultimately settled are the subject of protracted litigation prior to settlement. Commission litigators are now actively involved in nearly one-half of recently filed cases. In addition, our litigation and investigative staff are increasingly involved in emergency court actions in an attempt to secure investor funds before they are lost forever and to alert the investing public to false and misleading disclosures being made by issuers. It is critical that the Commission maintain a strong litigation capability because it is the credible threat of litigation that allows us to pursue wrongdoers effectively and win our cases or settle them on favorable terms.
Additionally, the growing internationalization of the securities industry and the securities markets has added new challenges for the Commission in combating securities fraud. An increasing number of the SEC's enforcement cases have substantial international dimensions that make it more important for the Commission to work closely with its international counterparts in enforcement and inspection activities. Our staff devotes much time and resources to tracking down assets that have been sent abroad.
And finally, the Commission's enforcement staff works closely with U.S. Attorneys' Offices and the Department of Justice to obtain criminal sanctions as appropriate. This association was recently institutionalized by President Bush when he created Corporate Fraud Task Force, of which the Commission is a member and the Department of Justice heads. We also will continue to detail enforcement staff, in appropriate situations, to U.S. Attorneys' Offices around the country to support criminal prosecution of securities fraud.
Market Structure Issues
The rules governing trading within equity markets and the relationship among competing equity markets is another area that the Commission will focus on this year. Aware that such issues were coming to a head, the Commission organized two full days of market structure hearings in October and November 2002. Participants at the hearings included senior staff members of the New York Stock Exchange, Nasdaq, American Stock Exchange, and Chicago Stock Exchange; market makers, specialists, Electronic Communication Networks, and agency brokers; buy-side traders; representatives of individual investors; and respected academics. In the remainder of this fiscal year, the Commission will devote significant resources to the development, proposal, adoption, and enforcement of the policy actions that will be necessary in this area.
Review of Filings of Public Companies
The Division of Corporation Finance has been enhancing its selective review program to target issuers whose review would most protect investors large companies, companies in critical sectors, companies that present particular perceived financial or disclosure risks. This targeted approach is consistent with the directives contained in the Sarbanes-Oxley Act. The review of the Fortune 500 companies undertaken last year is an example of this approach. As review resources and technological enhancements that will assist in the assessment of risk are added to the Division, the review process will become more robust. While the review process cannot eliminate or identify all financial fraud or identify those who are determined to commit fraud, the review process will better fulfill its objectives of improving disclosure and deterring fraud.
The review process is increasingly focusing on financial reporting and financial disclosure because these are the areas where defective disclosure puts investors at most risk. To permit this focus, recruiting and hiring of review staff will emphasize accountants and those who are able to perform financial reviews.
The Sarbanes-Oxley Act also requires review of each reporting company at least once every three years. We are in the process of developing review processes that will permit us to meet that goal. Here too, the additional resources that we are adding to the Division are an essential element and will allow us to satisfy that mandate over a multi-year period. We will also use those resources to meet that review requirement in an efficient and effective way, and we intend to do so in a manner that does not undercut our investor protection objective.
With the additional staffing provided in fiscal 2003, the Commission's examination and inspection staff will be able to implement our new enhanced risk-based inspection program. For investment advisers and mutual funds, this enhanced program will allow examiners to recognize the different levels of risk inherent in the operations, management, and compliance processes of investment advisers and funds. In particular, those registrants that have relatively higher risk profiles will be examined every two years, while all remaining firms will be examined no less frequently than every four years. New firms will be inspected within the first year of their operation. These more frequent inspections are a substantial improvement over the five-year inspection cycle used to schedule inspections prior to fiscal 2003. For broker-dealers, the new staffing levels will allow us to increase substantially our oversight of the risk management and internal controls of the largest broker-dealers that have the most customer accounts, and also to increase the small number of broker-dealer branch office inspections that we are currently able to conduct.
Other Sarbanes-Oxley Act Requirements
While the Commission has made tremendous progress in implementing many of the critical components of the Sarbanes-Oxley Act and has met each of its statutory deadlines, important initiatives and additional rulemaking pursuant to this historic legislation will continue to be a top priority for the SEC. In addition to the numerous substantive rules already adopted, a number of Commission actions are still mandated by deadlines set within the Sarbanes-Oxley Act. These forthcoming SEC actions include: the ratification of key rules and procedures for the Public Company Accounting Oversight Board; the adoption of rules on analyst conflicts of interest; the recognition of generally accepted accounting standards; as well as studies and reports relating to both principles-based accounting and off-balance sheet transactions and special purpose entities. I am confident that the Commission and its dedicated staff will continue to work tirelessly to implement these remaining provisions of the Sarbanes-Oxley Act.
Other rulemakings under the Sarbanes-Oxley Act, although not limited to a statutory deadline, also will play an important role in improving investor confidence in the credibility of reported financial information. For example, management and auditor reports on an issuer's quality controls over its accounting and financial reporting systems may enhance the quality and implementation of those controls, which, in turn, should improve the quality of financial reports and audits.
Another important area that will require the use of more Commission resources is international affairs. The development of international accounting, auditing, disclosure and enforcement standards is gaining momentum and will require more monitoring of and participation in international bodies that are promulgating and interpreting standards that could impact the credibility of information used by American investors.
In closing, let me reiterate how honored I am to serve as Chairman of the Commission at this time of great opportunity. Thank you again for inviting me today to speak on behalf of the needs of the investing public. I would be happy to answer any questions that you may have.
1 This amount is net of the 0.65 percent rescission that was enacted as part of the Omnibus appropriation ($716.4 million $4.7 million rescission = $711.7 million).
2 See H.R. 658/S. 496, "The Accountant, Compliance, and Enforcement Staffing Act of 2003".
3 See "Statement of the Commission Regarding Selection Process for Chairperson of the Public Company Accounting Oversight Board (PCAOB)" March 4, 2003, http://www.sec.gov/news/press/2003-28.htm.