Appropriations for Fiscal Year 2000
By Chairman Arthur Levitt
U.S. Securities & Exchange Commission
Before the Senate Subcommittee on Commerce, Justice, State and the Judiciary,
Committee on Appropriations
March 25, 1999
Chairman Gregg, Ranking Member Hollings, and Members of the Subcommittee:
I appreciate this opportunity to testify in support of the Securities and Exchange Commission's (SEC or Commission) fiscal year 2000 budget. The current market environment can best be characterized by precedent-setting trading volume, tremendous growth, increasing complexity and volatility, and globalization. In addition, the nation's capital markets are undergoing major changes as a result of technological innovations. The Internet is already having a profound impact on both individual investors and institutions. Alternative trading systems using on-line technology are changing the structure of our trading markets. Expanded trading hours to meet the demands of a global marketplace are also nearly upon us.
Technological innovations have lowered transactions costs and increased the ease and speed of trading, encouraging an influx of new investors into the markets. Moreover, on-line trading despite its popularity is not without its problems, and the number of complaints from investors about on-line brokerage services received by the SEC increased 330% in the past year alone. There are also an enormous number of messages sent to the Commission about potential frauds conducted through the Internet. The Commission has been creative and diligent in leveraging its existing resources to continue working to protect investors and promote the integrity and efficiency of our markets. It is abundantly clear, however, that the Commission needs additional staff and funding to keep pace with market changes.
These challenges come at a time when other areas of SEC responsibility require an increased commitment of our resources as well. For example, in the past year we have focused on the erosion in the quality of financial reporting, which directly impacts the success of our disclosure-based system. In addition, we continue to expend a significant amount of resources promoting the Y2K readiness of the securities industry and the SEC as the year 2000 approaches.
The challenges facing the SEC are enormous and underscore the agency's need for sufficient resources to promote the continued integrity, efficiency, liquidity, and resiliency of U.S. capital markets. Accordingly, the President's fiscal year 2000 request seeks an appropriation for the SEC of $360.8 million, $19.5 million, or 5.7%, above the Commission's fiscal 1999 spending level of $341.3 million. The $360.8 million will fund 2,899 staff years, an increase of 55 staff years (1.9%) over our current staffing level.
Current Challenges Facing the SEC Extraordinary Market Growth and Technological Change
More Americans than ever before invest in the securities markets, and today many are investing through the Internet. The Internet has given individual investors the ability to trade stocks unheard of only a few years ago, encouraging many new and inexperienced investors to enter the markets. Whether through tuition funds or retirement accounts, our collective stake in U.S. markets continues to grow, and we are increasingly dependent on the success and integrity of those markets. Consider the following statistics:
- Approximately 5 million people trade on-line on a typical day, accounting for approximately 25% to 30% of all retail stock trades.
- More than 100 firms now offer on-line brokerage services, with approximately 7.5 million on-line brokerage accounts, up from only 1.5 million in 1996.
- Approximately 37% of all households invest in mutual funds today, up from 6% in 1980.
- Assets in mutual funds increased 24% in calendar year 1998, reaching a record $5.5 trillion.
- Issuers registered a record $2.55 trillion in securities with the Commission in 1998, a 77% increase over the $1.44 trillion registered in 1997.
Technological innovation has resulted in market developments that were unknown just a few years ago, including on-line brokerages, day trading, and alternative trading systems, among others. The Internet has not only become a medium for investors to send orders to their brokers, but also a source of information for investors, placing at investors' fingertips a tremendous amount of investment information. For example, the Internet links investors to a growing number of services that provide immediate access to market information, as well as company press releases, SEC filings, and research reports. In addition, investors are using the Internet to communicate with other investors more than 30,000 messages are posted to the four largest stock message boards on a typical day. While the SEC has been adept at staying abreast of these developments, we are concerned about our ability to continue to adequately oversee their impact on investors.
The Commission's enforcement staff conducts investigations into possible violations of the federal securities laws, and prosecutes civil suits in the federal courts as well as in administrative proceedings. The Commission continues to be vigilant in prosecuting violations of the federal securities laws and to look for ways to leverage existing resources. For example, in 1998, the staff began to focus on important areas such as Internet and accounting fraud in an attempt to maximize the impact of the Commission's enforcement activities. The SEC continues to try to adapt its enforcement program to respond to these dynamically changing market conditions.
Internet Fraud. Much of the remarkable expansion and momentum of the markets is a reflection of the current, ongoing technological revolution. By providing a medium for cheap, quick, and relatively anonymous access to vast numbers of potential investors, the Internet has breathed new life into old schemes to defraud investors, including offering frauds, market manipulations, and touting. The Commission has been active in addressing these challenges. For example:
- We created an Internet Enforcement Unit in July 1998 to centralize enforcement activities relating to the Internet.
- The Commission stepped up its efforts to combat fraud committed over the Internet by forming the "cyberforce," a specially trained nationwide group of approximately 125 staff attorneys, accountants, and analysts who spend a portion of their time monitoring the Internet for fraudulent activities.
- The enforcement staff has used a "sweep" approach to Internet fraud, in which multiple investigations are coordinated and culminate in the filing and announcement of numerous cases on the same day, thereby achieving a potent deterrent effect. We announced the first sweep in October 1998, when we filed 23 enforcement actions against 44 defendants. A follow-up sweep was announced last month, in which we brought 4 enforcement actions against 13 individuals and companies.
- The Commission has brought approximately 66 Internet-related enforcement actions to date.
- The Commission has coordinated its efforts with other law enforcement authorities, including the Department of Justice, the Federal Bureau of Investigation, the Federal Trade Commission, the U.S. Secret Service, and a range of other civil and criminal law enforcement authorities.
These efforts show that the Commission is well aware of the potential use of the Internet to perpetrate frauds, and that it has been vigilant in developing proactive and flexible responses to those abuses. Our greatest problem in fighting Internet fraud is one of resources, as staff size has remained relatively constant in the face of the phenomenal growth of the Internet.
Accounting Fraud. The integrity of financial reporting is a fundamental building block of the full and fair disclosure that gives investors confidence and trust in our markets. To promote the continued integrity of financial reporting, pursuit of accounting fraud is one of the Commission's top enforcement priorities. Financial fraud cases are generally complex and resource intensive. Among other things, the SEC has been focusing on the professionals involved, especially the auditors, who stand as the watchdog of the integrity of the reporting process.
Microcap Fraud. The market shows signs of continued abuses in low-priced or "microcap" stocks. Microcap stocks are issued by companies with lower capitalizations and are usually quoted on the National Association of Securities Dealers Over-the-Counter Bulletin Board, the pink sheets operated by the National Quotation Bureau, and the Nasdaq SmallCap Market. This part of the market provides legitimate opportunities for small and new businesses to raise capital. However, it can also provide opportunities for criminals using small, unknown stocks to prey on innocent investors. Microcap fraud often is accomplished using abusive sales practices such as high-pressure cold calling, unauthorized trading in customer accounts, and stock manipulation schemes that enable the manipulator to reap profits while investors suffer losses after the manipulation stops. The Commission has been active in this area as well. For example:
- This past year, the Commission filed 5 enforcement actions against 58 defendants as a result of an undercover investigation into bribery and illegal manipulation of microcap securities.
- Our examination staff intensified its examinations of broker-dealers and performed a "sweep„ of brokers trading in microcap securities.
- We increased our coordination of enforcement efforts with criminal authorities, the states, and self-regulatory organizations.
- The Commission implemented a number of trading suspensions in stocks for which there was suspicious activity.
- The Commission is considering additional regulatory steps to strengthen disclosure requirements to reduce opportunities for microcap fraud.
Insider Trading. The torrid pace of mergers and acquisitions activity continues to present opportunities for insider trading. The agency brought 49 insider-trading cases in fiscal 1998, 27 of which involved mergers, acquisitions, or corporate reorganizations.
International Fraud. An increasing number of the SEC's enforcement cases have substantial international dimensions, such as securities transactions initiated outside U.S. borders. The Commission continues to negotiate information sharing agreements with foreign regulators to minimize the extent to which borders are used to escape detection and prosecution of fraudulent securities activities. These information sharing agreements and less formal arrangements provide a framework for the SEC to seek and provide assistance to foreign jurisdictions.
Preventing Fraud through Investor Education. With the proliferation of on-line trading and Internet and microcap fraud, the number of investor complaints has been increasing. Our Electronic Enforcement Complaint Center now receives between 200 and 300 complaints each day, many related to possible instances of Internet and other types of fraud. Many of the complaints are also related to problems with on-line brokerage services.
The best defense to any securities scam is an informed and alert investing public. The Commission has several initiatives to help investors detect and avoid potential fraudulent schemes.
- The staff publishes an Internet Advisor Alert on our website that contains an analysis and discussion of on-line investment fraud and abuse together with suggestions for investors on how to avoid becoming the next victim.
- Our guide, "Microcap Stocks: A Guide for Investors," informs investors about microcap stocks, how to find information about them before investing, and what "red flags" investors should watch out for.
- The Commission posts relevant information on Internet forums where such information may reach actual and potential investors of a specific security. For example, the Commission posted press releases concerning recent trading suspensions and copies of the actual suspension orders in discussion forums dedicated to discussing the stocks subject to suspension.
- The SEC has held 28 Investors' Town Meetings to date. Last year alone, we organized 6 investors' town meetings and 32 educational seminars on investing wisely.
Promoting Fair and Successful Markets
Technological innovations and globalization are changing and increasing competition in U.S. securities markets. We continue to see increasingly complex financial instruments, greater trading volume and volatility, and new trading mechanisms that present new and demanding challenges to the SEC. For example, electronic communication networks (ECNs) continue to proliferate, growing from one a few years ago to nine currently. ECNs represent an increasing proportion of trading volume. For example, the nine ECNs accounted for approximately 26% of Amazon.com's January trading volume. In addition, the globalization of capital markets is leading to an expansion of trading hours here in the United States and possible ties between foreign markets and U.S. markets. The New York Stock Exchange has proposed to expand its trading day beginning in 2000 in an attempt to remain competitive with markets in Europe and Asia for foreign company listings. It would be logical to surmise that 24-hour trading is not far behind. The Commission will need to devote an increasing amount of resources to respond to these and other changes in U.S. securities markets.
The SEC seeks to be flexible in adapting its regulations to encourage innovative products and services, consistent with investor protection. The Commission has several initiatives to promote improvements and competition in market structures and operations and respond to technological advances. The implementation of these new measures will require significant staff hours over the next few years, as our market structure continues to evolve. The Commission has adopted:
- a new regulatory framework for alternative trading systems, allowing these systems significant regulatory flexibility, including the choice to register as exchanges instead of as broker-dealers,
- several measures designed to help registered exchanges better compete with alternative trading systems and foreign markets, including allowing them to operate as for-profit entities, and
- rules that implement an alternative regulatory structure for over-the-counter derivatives dealers that will allow these entities to compete more effectively in global over-the-counter markets while remaining subject to U.S. regulatory oversight.
The Commission also continues to address soft dollar issues, as well as pay-to-play both in the municipal securities market and in the public pension fund arena. In addition, the Commission has identified improved investment company governance as one of its top priorities.
Proposals to invest a portion of the Social Security Trust Fund in the markets, either directly by the government or through individual Social Security accounts, would pose additional challenges to the Commission. Although the Commission has not yet expressed an opinion on any particular Social Security reform proposal, we will continue to work with Congress to address the market integrity, investor protection, and corporate governance issues in the reform debates and any reform legislation.
Improving Financial and Non-Financial Disclosure
An important facet of investors' confidence in our markets is their access to reliable information about investments. The Commission continually strives to promote fair, equal, complete, and quick access to useful information. Towards that end, the Commission:
- overhauled the prospectus disclosure requirements for mutual funds to provide investors with clearer and more understandable information about funds;
- permitted mutual funds to offer investors a new disclosure document (the profile) that summarizes key information about the fund;
- implemented plain English disclosure rules to improve the readability of the prospectuses of public companies, including mutual funds; and
- awarded a three-year contract to modernize EDGAR, our electronic filing and dissemination system.
Additionally, the Commission recognizes that the securities offering system needs to be flexible enough to adapt to changes in the capital markets of today and the future. In November 1998, we published proposals to modernize the regulation of capital formation and provide significant benefits to public investors, issuers of securities, and securities professionals. The process of refining and revising this proposal will also consume significant staff time.
In the past year I have expressed my deep concern about the erosion in the quality of financial reporting. We will devote significant resources in the coming year to the promotion of high quality accounting standards and transparency by focusing on inappropriate earnings management, auditor independence, and the role of audit committees. The staff has established an Earnings Management Task Force to coordinate and focus efforts on detecting and challenging deterioration in financial reporting practices. The efforts of the Task Force will focus on public companies that announce restructurings and major write-offs, as well as provide interpretive guidance on revenue recognition. We are also working together with the financial community on these issues. For example, a "blue ribbon" panel organized by the New York Stock Exchange and the National Association of Securities Dealers announced a ten-point plan in February to strengthen the role of audit committees in overseeing the corporate financial reporting process. Year 2000
Overseeing and reviewing the industry's preparations for the year 2000 is one of our highest priorities. To accomplish this role, we:
- issued staff guidance to the public and industry on disclosure obligations arising from year 2000 conversion,
- required broker-dealers, investment advisers, mutual funds, and non-bank transfer agents to provide detailed reporting on their progress,
- brought enforcement actions against entities that failed to report or that reported inadequately,
- conducted on-site reviews of the year 2000 plans and activities of regulated entities,
- worked closely with the securities industry to promote their year 2000 readiness, and
- are now focusing our efforts in working with industry participants on developing contingency plans.
The SEC operates in a global marketplace. It works bilaterally and multilaterally in the international arena to promote cooperation and to encourage the development of high standards of securities regulation. The international financial crises of the past year continue to underscore the connections among markets around the world. Many of the SEC's international regulatory activities have focused on responses to these crises and ways to strengthen the international financial architecture. The SEC also is active in global regulatory initiatives in many other areas. In the past year, the SEC's international activities included developing a set of core principles for regulation of securities markets, addressing issues related to year 2000 preparedness, developing international disclosure standards, and commenting on the development of international accounting standards.
We believe that the Commission has been successful in carrying out its broad mandate, and investor confidence in our markets is high. Investor confidence must remain high if our markets are to continue to grow. Limited resources, however, may pose a threat to investor protection and market integrity. In recent years, the Commission has targeted its existing resources carefully to maintain effective performance levels. The Commission's request for additional funds is necessary for it to continue to protect investors and promote market integrity and fairness.
Priorities and Allocation of Additional Resources
The SEC currently operates with 2,844 staff years. The agency is able to accomplish its objectives by regulating, to a large extent, through a public-private partnership. This system of shared regulation among the SEC, state regulators, self-regulatory organizations, and the industry is markedly different from the approach taken by other federal regulators. It enables the Commission to leverage its resources with the efforts of state regulators and the private sector. Even so, additional resources are urgently needed to keep up with market developments.
Just in the last few years, industry growth has far surpassed our growth in resources. Between 1995 and 1998, the number of SEC authorized positions remained flat at 3,039 positions. For the same period, assets under management of investment companies and investment advisers increased 70% and 42%, respectively. If you look at the change over a longer period of time, SEC positions increased 45% between 1980 and 1998, but investment company assets increased over 2000% and investment adviser assets increased over 3300%.
We were able to maintain a vigorous program at the SEC with flat staffing between 1995 and 1998 through fiscal restraint, conservative management, and the reallocation of existing resources. The 2% increase in staffing we received in 1999, while appreciated, will not be enough for us to keep pace with market expansion. Additional resources will allow us to continue to address existing priorities and enable us to meet new challenges.
Combatting Fraud. As discussed above, changing markets present new challenges for the Commission. Use of the Internet to commit securities fraud is but one example of the challenges. Additional staffing for our law enforcement activities will better enable us to detect and take action against fraudulent securities activity on the Internet and other on-line information services, as well as respond to continued growth and change in electronic forms of communication. Additional staffing will also enable us to commit more resources to investigate a broad range of potential misconduct, including accounting fraud, microcap fraud, and insider trading. We will further our efforts to help investors avoid problems by using the Internet to quickly and widely disseminate investor alerts on potential fraudulent schemes.
Additional personnel are also needed to litigate the cases that the Commission brings. Our increased litigation also requires increased funding for expert witnesses, electronic document management, and other litigation support services. These costs have increased significantly in recent years due, in part, to the effects of the Securities Enforcement Remedies and Penny Stock Reform Act of 1990. As more defendants choose to litigate rather than face these stiffer penalties, it is crucial that the agency devote sufficient resources to continue the SEC's outstanding law enforcement record.
Inspections and Examinations. The SEC expects to meet its inspection goals in 2000. These goals include inspecting each of the large investment advisers that are qualified for federal registration and investment company complexes at least once every five years. A portion of the additional funding request for automation initiatives will be used to continue a multi-year effort to develop and implement important new automated examination tools to help us meet these goals. We will expand a recently developed tracking system to include examination data from self- regulatory organizations. These automated examination tools will leverage our existing resources by helping us better target examinations of broker-dealers and investment advisers.
We will also continue to work on improving our efficiency by concentrating on the areas of greatest risk in our examinations of self-regulatory organizations, broker- dealers, transfer agents, and investment companies and advisers. Examiners will continue to identify areas to be covered in examinations as well as the most appropriate examination techniques by considering the unique characteristics of each registrant and the presence or lack of effective internal controls and compliance procedures. In addition, we will further enhance cooperation with foreign, federal, and state regulators and self-regulatory organizations.
Disclosure and Promoting Honest and Efficient Markets
With additional staffing in 2000, we will initiate integrated reviews of selected disclosure filings of mutual funds. These reviews will focus on whether a fund is investing in accordance with its stated objectives and policies. The staff also will continue developing an electronic filing and dissemination system for investment advisers.
New staff will support the supervision and regulation of securities markets by monitoring the industry's final preparations for the year 2000, fostering competition in the new electronic trading environment, and further responding to ongoing changes in the markets' structure.
We will continue to rely on outside contractors with technical expertise to enable us to better address the challenges presented by the fast pace of technological change and the pressure to quickly deliver computer products and services. Outsourcing allows the Commission to leverage private sector expertise and shift staff focus from day-to- day operations to contract and project management, as well as oversight and strategic planning.
Additional funding ($5.9 million) is requested to support the SEC's automation efforts to improve efficiency and productivity through the use of automated PC-based computer applications. The funding will enable the SEC to conduct the final year 2000 testing and respond to any problems experienced, continue the multi-year effort to develop and implement important new tools for the inspections and examinations activity, develop an electronic filing and dissemination system for investment advisers, and maintain an adequate infrastructure replacement program. Priority initiatives include improving the capital planning process, researching hardware leasing alternatives, exploring solutions for document and electronic records management, matching information technology application development with Government Performance and Results Act goals, and finding better ways to access and manage the vast amounts of data filed with the Commission.
The President's fiscal 2000 budget proposes total funding for the SEC of $360.8 million, from two funding sources: $230 million from fiscal 2000 offsetting fee collections and $130.8 million in carryover from fiscal 1998 offsetting fee collections. The proposed budget is consistent with the declining fee rates established in NSMIA. However, this approach continues the SEC's reliance on a combination of excess fee collections from prior years and new collections, thereby continuing to postpone the shift to a full appropriation.
The SEC plays a vital role in protecting U.S. securities markets from fraud, manipulation, and other practices that continually threaten to undermine the integrity of our markets. The Commission has requested additional resources to enable us to target those areas of market growth and change where our efforts can have the greatest impact. This request recognizes that important work lies ahead of us. The challenges we face over the coming year include:
- aggressively combatting fraud both on and off the Internet and maintaining public confidence in the markets,
- maintaining the integrity of financial reporting, and
- maintaining vigilant oversight of traditional and alternative trading systems, as well as developments in on-line brokerage and day trading.
As the 21st century approaches, the U.S. must be ready to meet the challenges presented by a changing marketplace in order to maintain the leadership of its markets. To take on new challenges and to continue the Commission's excellent record of effective investor protection, law enforcement, and market oversight, the Commission needs the increased resources requested today.
I do not expect that the resources we are requesting for fiscal 2000 will be sufficient to deal with all the challenges facing the agency. For the next several years, I envision staffing requests with increases in excess of that identified for this year. We recognize the constraints faced by this Subcommittee and the competing demands for funding, and I can assure you we do not make this request casually. You can be certain that requested increases will be supported by both our achievements and a compelling justification.
The Commission looks forward to working with the Subcommittee in its continuing efforts to promote the effectiveness of the SEC and the strength of our markets.