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U.S. Securities and Exchange Commission

Testimony Concerning
Fiscal 2005 Appropriations Request for the U. S. Securities and Exchange Commission

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 31, 2004

Chairman Wolf, Ranking Member Serrano, and Members of the Subcommittee:

I appreciate the opportunity to testify today on behalf of the Securities and Exchange Commission in support of the President's fiscal 2005 budget request. At the outset, I would like to thank you for your continued support and leadership in ensuring that the Commission receives the staff and resources necessary to fulfill our mission. As corporate malfeasance and fraudulent and unethical trading schemes have shown, the need for an effective, vigilant, forward-looking SEC is more important than ever. We cannot afford to fail in fulfilling our duty to investors, corporate America, and our financial markets.

The fiscal 2005 budget request of $913 million is the largest amount ever requested for the SEC. It builds on the substantial increases in funding over the previous two fiscal years, and is critical to the agency as it continues its reform efforts.

I am committed to ensuring that these resources are utilized efficiently, and in a manner that will help the SEC address the most fundamental and immediate problems facing corporate America, the securities industry and our financial markets. Consistent with our emphasis on long-term performance and effectiveness versus short-term gain, the policy goals and internal management reforms that we've initiated --- and have made great progress toward accomplishing — are critical to a fundamental restoration of credibility for the SEC and for those we regulate.

That said, I recognize the difficulty you as appropriators face with tight budget constraints and the need to reassure the taxpayer that every regulatory penny is wisely spent.

To recap the progress we've made during the past 14 months, and to report to you on how we are putting our additional resources to use, I'll first provide a brief overview of the immediate challenges we faced during this period. I will outline the progress we've made toward addressing those challenges and others that have arisen in this timeframe. Finally, I will provide a brief assessment of the significant policy reforms being considered in each Division and Office in the period ahead. Taken together, I think you'll see a compelling picture of the critical nature of our work — now perhaps more than at any time since the SEC was created in the 1930s.

In late 2002, when President Bush first approached me about assuming the Chairmanship of the SEC, the landscape was bleak. The country faced a deluge of corporate fraud and malfeasance coupled with an overall market decline and the burst of the dot-com bubble. The implosion of several high-profile companies--coincident with an overall economic slowdown---threw thousands of people out of work. Public outrage was widespread and deep-seated. The SEC, traditionally one of the most respected government agencies, was shouldering much of that outrage. Under-funded and understaffed, the agency faced an expanded workload, and was reeling from criticism that it had not done enough to prevent these corporate scandals. It was against this ominous backdrop that I arrived at the SEC.

Like most Americans, I was, and continue to be, concerned about the high-profile scandals we have seen. More troubling, however, was that the corporate and financial worlds had allowed an erosion of standards, integrity and ethics during the 1990s bull market, as long-term investment decisions were sacrificed for short-term gains and gatekeepers, such as accountants and other professional advisers, turned their backs on efforts to manipulate earnings and mislead the public.

It was clear to me that a strong SEC would be essential to addressing these problems and setting a course toward restoring investor confidence.

Addressing Key SEC Operational Issues and Instilling Proactive Ideology

During my first few days at the Commission I could see that we needed to adopt a more proactive and anticipatory approach to our work — an ideology that would drive each staff person to look around corners and over hills in anticipation of where the next problems would come. To do this effectively required a complete reevaluation of how the SEC historically functioned, so as to foster an unprecedented level of communication, coordination and cooperation between staff in divisions and offices.

As part of our broader internal reforms, I also reorganized the Chairman's office, with the traditional SEC chief of staff role now divided among three experienced executives who I recruited last year to oversee policy, external relations, and management and operations, respectively.

Hiring, Training and Accountability

New Hires

Thanks to significant budgetary help from the President and Congress, the agency received appropriations in February 2003 for resources needed to hire 842 new employees. In July 2003, President Bush signed the "Accountant, Compliance, and Enforcement Staffing Act of 2003," which provided the SEC with the same expedited hiring authority for accountants, economists and securities compliance examiners as it has for lawyers. This was especially important because it allowed us to use our additional resources to put critical staff in place much more quickly than would otherwise have been possible. Indeed, the number of vacant positions would have been much higher without this legislation.

Since December 2002, we have hired 740 new staff — 39 percent as attorneys, 23 percent as accountants, 23 percent as examiners, and the remaining 15 percent to fill other positions. Approximately 100 new staff members will begin working at the SEC by the end of May — roughly 40 percent of them as accountants and another 40 percent as attorneys.

Hiring must be viewed in connection with the agency's ability to retain staff. The SEC traditionally has operated with a vacancy rate of approximately 5 percent or higher. The Commission's turnover rate in fiscal year 2001 was approximately 8 percent, but had previously risen as high as 13.8 percent. Pay parity has been important tool for reducing staff turnover. Since it was approved, the turnover rates dropped to 1.2 percent in fiscal year 2002 and 1.5 percent in fiscal year 2003.

In addition to pay parity, we provide staff with a challenging work environment where they are responsible for ideas, issues and initiatives critical to the nation's economy. We have also worked to improve our organizational structure, management, communication, and direct employee benefits.

Finally, the Commission's new pay-for-performance system, which is designed to reward job performance based on employee contribution to the Commission's overall mission, is helping to ensure that the SEC's talent pool of experienced, dedicated, high-quality staff remains strong. These changes help to ensure an exciting and dynamic workplace that rewards leadership, commitment and dedication.

Notwithstanding improvements in retention, we continue to have vacancies. After the 100 new staff members join us in May, we will have 425 (or 11 percent) vacancies. Of those, about 150 (or 35 percent) are attorney positions; about 120 (or 28 percent) are accountant positions; about 60 (or 14 percent) are examiner positions, and about 95 (or 22 percent) represent other positions. Recruiting and hiring the most qualified individuals takes time, but is critical to the Commission's success. We have refused to hire employees simply to fill chairs, but rather are focused on hiring the best and most appropriate people to fill these important positions, and are keenly focused on where each staff person can do the most good. By the end of the year, we fully expect that our hiring efforts will achieve targeted staffing levels.

Staff Diversity

The Commission has made significant effort to reach out to diverse populations to attract them to the agency. We have strong programs to reach out to candidates of all races and ethnicities. For example, we are actively recruiting attorneys at the top 20 most diverse law schools, according to the National Association of Law Placement; we are recruiting accountants through events sponsored by the American Women's Society of Certified Public Accountants, the National Association of Black Accountants, and the Association of Latino Professionals in Finance and Accounting; and in calendar 2004, we are planning to participate actively in 30 diversity-focused recruitment events.

I am very satisfied with our efforts so far directed to increasing the diversity of our staff. However, we are not finished in our drive to develop a highly qualified staff with the diversity of background, experience, and skills that make an organization strong and effective.

Tracking Staff Effectiveness

Once the Congress had authorized substantial new resources and staff for the SEC, it was immensely important to ensure that both were being deployed effectively. To do this, we undertook comprehensive reviews of every SEC division and office — assessing current needs and resources, reviewing content and supervisory methodology, and establishing performance measures, which we refer to as "dashboards." These are management reports designed to present regular snapshots of the divisions' and offices' progress in meeting budget, staffing, and performance objectives. The "dashboards" continue to evolve and improve, as divisions and offices refine their performance measures, but they are already starting to have an effect as programs focus on the workflows measured in the "dashboards" to make them more efficient and effective. "Dashboards" will be an increasingly important tool for the executives managing these divisions and offices. We will use this time to identify emerging problems, discuss solutions, and reinforce each executive's accountability for their staff, performance and key initiatives. In conjunction with our risk assessment initiatives, which I will discuss more in a moment, the dashboards will help us proactively adjust operations and resources as environmental changes require.

Training and Employee-Retention Initiatives

We also created and launched SEC University, an agency-wide, on-line training program to help Commission employees better understand the SEC's mission, enhance employee performance, broaden awareness of the agency's programs and responsibilities, and deepen employee knowledge of key issues ranging from accounting and economics to management. To complement this effort, we have developed and are continuing to develop new in-class programs to enhance employee supervisory, management and leadership skills necessary to effectively manage staff.

Employee retention has always been a challenge at the SEC. In addition to providing continuing education opportunities, we've also created programs to increase employee quality-of-life through our Work/Life Plus Program. This program provides for: telecommuting opportunities where appropriate, enhanced health benefits, a student loan repayment program, and a childcare assistance program. We have negotiated a supplemental benefits package with our union for vision and dental care. A reprogramming request for your approval of these new benefits is pending before the subcommittee.

A New Focus Designed to Assess Risk

As I mentioned earlier, the Commission's ability to anticipate and plan for new and evolving risks to investors and U.S. financial markets is critical to the agency's long-term success.

This year, following a thorough internal review of how the agency deals with risk, we initiated a new risk management program and laid the groundwork for the Office of Risk Assessment and Strategic Planning, the first of its kind at the Commission. The first phase has been to organize internal risk teams for each major program area. The new office, working in coordination with the internal risk teams, will push the agency to proactively identify potential problem areas within our industry, focusing on early identification of new or resurgent forms of fraudulent, illegal, or questionable activities. In addition to fostering better communication and coordination between Divisions and Offices within the Commission, the risk assessment initiative will help to ensure a process whereby senior managers at the Commission have the information necessary to make better, more informed decisions and to proactively adjust operations and resources to address these new challenges.

Improving Information Technology

Another critical initiative in the Commission's 2005 Budget request is our continued commitment to developing a strategic, state-of-the-art information technology program. Our comprehensive, multi-year strategic program will help the Commission to more effectively support the work of enforcement, inspection, and other programmatic and regulatory functions. A new Chief Information Officer, who assumed his duties earlier this year, is leading this critical effort.

First, we will continue our investment in electronic document management to provide agency-wide systems and processes for electronically capturing, searching, and retrieving investigative and examination materials and integrating them into the workflow of our staff. The initial phase of the system should be fully operational in fiscal year 2005, and will continue to be integrated with data-mining, case tracking and correspondence systems.

As we continue to focus on streamlining our enterprise architecture and our business processes, our IT and program staff will restructure Commission filings and forms to eliminate redundant data, particularly within the EDGAR filing system. We are actively pursuing a strategy for improving the filing and disclosure process, modifying filings and using new data formats — including "tagged data" — to improve how content is organized and analyzed. This effort will benefit the investing community as well as the Commission.

We will continue our investment in state-of-the-art information security. Our upgraded "point-to-point" network will be operational later this year, allowing continued communications between remaining SEC sites in the event that a disaster forces the headquarters or operations center to close. At the end of this calendar year, we should complete the construction of the Commission's alternate data center, providing further protection against disruption of our infrastructure. The Commission is currently undergoing a complete security certification and accreditation for current and future financial systems.

New Building

The first section of the new SEC headquarters at Station Place here in Washington, DC will be finished in early 2005, with the second section scheduled for completion in fiscal 2006. The Commission's budget request covers the costs associated with the move, including the period of time — five months — when the agency will be paying hold-over rent at the 450 Fifth Street building, as well as rent at Station Place.

Improving Investor Confidence and Protection

As we continue to uncover and address revelations of wrongdoing that have shaken investor confidence — including the recent mutual fund scandals — the fiscal year 2005 resources we are requesting will be critical to responding to these challenges. I'd like to focus the rest of my testimony on the range of policy areas that are front-and-center at the SEC. I will touch on them in the context of the major divisions and offices within the SEC: Enforcement, Investment Management, the Office of Compliance and Inspections, Market Regulation, Corporation Finance, and the Office of the Chief Accountant.

Enforcement

In the enforcement area, we are working aggressively to pursue wrongdoing in a manner that is both forceful and fair. Over the past year, the Enforcement Division was intimately involved in negotiating the terms of the global settlement on equity analyst conflicts, which is currently driving important reforms in the investment-research industry. It is important to recognize the outstanding achievement of the division, which filed 679 enforcement actions in fiscal 2003 — more than in any previous year — and nearly 200 of these actions involved financial fraud or reporting violations.

Beyond these statistics, there have been a number of significant cases involving not just Enron and WorldCom, but also KPMG, Xerox, AIG, Vivendi, and Gemstar. Equally important, we have used the full powers accorded to us by Sarbanes-Oxley to obtain more funds for return to harmed investors. We also are bringing enforcement actions against not only individuals, but also against financial institutions and corporations that have aided and abetted financial fraud. In addition to freezing assets of individuals and entities charged with securities violations, we have also pursued a number of enforcement actions against the mutual fund industry. In pursuing all of these enforcement actions, we have also strengthened our traditional cooperation with state officials, and where appropriate worked closely with the President's Corporate Fraud Task Force.

Investment Management

In the wake of late trading and market timing abuses, the Commission has embarked on a dramatic overhaul of the regulatory framework in which mutual funds operate. The Commission's regulatory actions are intended to prevent and deter the types of market timing, late trading and sales practice abuses that have dominated the headlines in recent months. Equally important, the Commission's rulemaking initiatives are aimed at restoring the trust and confidence of investors that are crucial to the continued success of the mutual fund industry and preserving funds' key role in our country's economy.

Approximately 91 million investors have entrusted more than $7 trillion dollars to mutual funds. As mutual fund investments increasingly fund the most important personal goals in Americans' lives, from retirement and education savings to charitable giving, our nation's investors rightfully look to fund managers and fund directors to act in their interests. Sadly, these investors have been let down, as some of those charged with protecting investors have willfully disregarded their responsibilities to investors.

In response, the Commission is pursuing a mutual fund rulemaking agenda with four main goals: (1) addressing late trading, market timing and related abuses; (2) improving the oversight of funds by enhancing fund governance, ethical standards, and compliance and internal controls; (3) addressing or eliminating certain conflicts of interest in the industry that are potentially harmful to fund investors; and (4) improving disclosure to fund investors, especially fee-related disclosure. We have recently completed the proposal phase for these rules and are collecting feedback from the public, and an aggressive rule adoption schedule is planned for this spring and summer.

To augment our oversight of mutual funds, we have also formed an SEC staff task force that will be drafting the outlines of a new surveillance program. I have asked the task force to examine the mutual fund reporting regime — looking at both the frequency of reporting to the Commission and the categories of information to be reported. I have also asked the task force to examine how new technologies can be used to enhance our oversight responsibilities.

The Investment Management staff is also considering a proposed rule that would be put before the Commission to register hedge fund managers as investment advisers, giving the Commission an oversight role in the explosive growth of hedge funds. Even though these hedge fund advisers manage substantial amounts of money for a large number of clients — approximately $700 billion and growing rapidly toward $1 trillion — they escape registration as investment advisers by reaching their clients indirectly though pooled vehicles.

Last fall, the staff completed its report on the implications of the growth of hedge funds. The report highlighted several key areas of concern related to this hedge fund growth, including the Commission's limited ability to obtain comprehensive and reliable information about hedge funds, the emergence of registered mutual funds that invest their assets in hedge funds, and the recent increase in the number of hedge fund enforcement cases. Our review of the mutual fund scandal revealed that hedge funds all too often were active participants in these frauds.

Given these concerns, the staff report recommends that the Commission require hedge fund managers to register as investment advisers, which would give the Commission greater insight into the activities of hedge fund managers and improve our ability to detect and deter fraud. We have already seen that the Commission's focus on hedge funds has caused many hedge fund managers to pay more attention to their accounting and how they price securities.

The Commission has voted to publish the staff report. We will solicit comments from all interested parties to ensure that a final rule strikes the right balance between giving the Commission the tools we need and supporting the important role that hedge funds can play in our financial markets.

Inspections and Examinations

Currently, there are approximately 8,000 mutual funds, with more than $7 trillion in assets, managed by 900 investment company complexes. In addition, there are approximately 8,000 federally registered investment advisers, managing $20.1 trillion in assets (which includes the assets in mutual funds). The fund industry also involves a number of other service providers, including transfer agents, third-party administrators, and broker-dealers doing business with the public.

During most of the period from 1998 to early 2003, the SEC's examination program for funds and advisers had approximately 370 members on its staff (including examiners, supervisors, and support staff). Routine examinations were conducted every five years. In the last two years, program staffing was increased by one-third, to approximately 495 employees. With this staffing increase, the SEC has increased the frequency of examinations of funds and advisers posing the greatest compliance risks, and is conducting more examinations targeted to areas of emerging compliance risk.

The examination staff has already rolled out a comprehensive risk mapping initiative. Every examiner, from the most junior to the most senior, in Washington and in every regional and district office around the country, has helped map the compliance risks they need to address. They have identified risks, analyzed mitigating and aggravating conditions, and proposed solutions. The results of this initiative will play a key role in the coming months as we enhance the sophistication of our planning and better focus our examination efforts.

Market Regulation

Our financial markets are continually evolving due to innovative trading technologies, new market entrants, and changing investment patterns. One of the Commission's most important responsibilities is to monitor these changes and to ensure that the U.S. regulatory structure remains up to date.

On February 26, 2004, in an effort to enhance and modernize the National Market System, which was created in the 1970s, the Commission proposed rules designed to enhance and modernize the system. The rule proposals include the following regulatory initiatives:

(1) a uniform trade-through rule for all NMS market centers that would affirm the fundamental principle of price priority, while also addressing problems posed by the inherent difference in the nature of prices displayed by automated markets, which are immediately accessible, compared to prices displayed by manual markets;

(2) a uniform market access rule with a de minimis fee standard that would help assure non-discriminatory access to the best prices displayed by NMS market centers, but without mandating inflexible, "hard" linkages such as the Intermarket Trading System ("ITS");

(3) a sub-penny quoting rule establishing a uniform quoting increment for NMS stocks to promote greater price transparency and consistency;

(4) amendments to the arrangements for disseminating market information that would reward self-regulatory organizations ("SROs") for their contributions to public price discovery, as well as implement many of the recommendations of the Commission's Advisory Committee on Market Information; and

(5) Regulation NMS, which would modernize and restructure the Exchange Act rules governing the NMS to promote greater clarity and understanding of the rules.

If adopted, the proposals collectively would constitute a significant upgrade of the NMS regulatory framework and address a variety of issues that have arisen in recent years.

Corporate Finance

The SEC's Division of Corporation Finance, which works to ensure that investors have access to the material information that will allow them to make informed investment decisions, continues to focus on its mission of helping to improve disclosure at public companies. The bulk of the Sarbanes-Oxley rulemaking fell to Corp Fin, and last year it completed that significant task with a round of balanced rulemakings that implemented both the letter and the spirit of the new law.

More recently, the Commission adopted an interpretive release that sought to give guidance on improving MD&A. The general areas covered included presentation, with an emphasis on layered disclosure and increasing prominence of the most important information, as well as encouraging the use of introduction or executive overview. The SEC is urging corporate America's management to bring its unique perspective to the forefront of MD&A, to avoid boilerplate, and to embrace meaningful disclosure.

A second piece of enhancing public-company disclosure is a proposal the Commission will consider next week to expand our Form 8-K requirements to increase the number of important events that public companies must report on a current basis. These changes would shorten the time periods for filing current reports, and add a number of new items triggering current reports.

Enhanced Review Program

With increased resources, we have increased the number of filings reviewed by the Division of Corporation Finance. More frequent and targeted reviews will help deter and or identify fraud in public securities transactions, and should ensure that investors receive material information about emerging and novel issues. Under Sarbanes-Oxley, an increase in reviews to every three years, from an average of 5 years, is mandated. In fiscal year 2003, our reviews covered 2,975 reporting issuers, or approximately 23% of all reporting issuers, targeting the largest companies and "riskiest" offerings. In fiscal 2005, we expect to review 5,400 reporting issuers, or 39% of all reporting issuers.

The Sarbanes-Oxley Act also requires the SEC to review investment company filings at least once every three years. We are enhancing our program to review investment company financial statements shown in annual reports to shareholders, improving from reviewing 10% of filings in 2003 to over 40% in 2004 and 2005.

Additionally, as part of ongoing enhancements to our review program, we have established two new offices within the Division of Corporation Finance: The Office of Disclosure Standards, which will evaluate the review policies and review results of the Division's review program as carried out by its eleven review offices; and The Office of Global Security Risk, created in response to the 2004 appropriations report language. The Office of Global Security Risk, which will function within the traditional disclosure mission of the Commission, will have the following primary objectives: to identify companies whose activities raise concern about global security risks that are material to investors; to obtain appropriate disclosure where merited; and to share information as necessary and appropriate with the other key government agencies responsible for tracking terrorist financing.

The Office of Global Security Risk will focus on asymmetric risk by assisting review staff in giving consideration to whether U.S. or foreign companies that are registered with the SEC have operations or other exposure with or in areas of the world that may subject it and its investors to material risks, trends or uncertainties. This consideration would include whether a company has operations in a country or area of activity where political, economic or other risks exist that are material, or whether a company faces public or government opposition, boycotts, litigation, or similar circumstances that are reasonably likely to have a material adverse impact on a company's financial condition or results of operations.

Shareholder Access to the Proxy

The staff is also working on a proposed rule that would require companies, under certain conditions, to add shareholder nominees to the management slate in the proxy materials. The backdrop to this proposed rulemaking is the recognition that an important element needed to strengthen corporate governance is a stronger, more active board of directors and, to an increasing degree, a board that is independent of management. The combination of the Sarbanes-Oxley Act, our rulemaking efforts, and changes in exchange-listing standards has helped assure the independence of directors and to encourage them to be more assertive about exercising their oversight authority. Thus the question of how directors are nominated and elected becomes even more critical.

Today, nominees and directors emerge from a system that really excludes meaningful input from shareholders. In over-simplified terms, our current proxy rules give dissatisfied shareholders just two options: start a proxy fight for control or sell their stock. We are seeking to find middle ground, particularly at a time when corporate governance, while improving, is still not where it should be.

The pending SEC proposal seeks to provide a modest counterweight to this system: It requires substantial and demonstrable shareholder dissatisfaction; it provides the possibility of a structurally more independent nominee and director — one coming from shareholders; it is designed to stand apart from any contest for control and to focus instead on director and board independence and effectiveness; and it is designed to avoid special interest or single-issue directors. In seeking to allow shareholders a greater prospective voice at companies where shareholders' voices are not being heard, the proposal should make those other changes work better — even at companies where shareholder nominees are never put forward or elected.

We have received many thoughtful responses to the rule we proposed for comment in October. Earlier this month, the Commission held an illuminating daylong roundtable discussion, aimed at giving people on all sides of the issue an opportunity to speak out, and to help us examine any alternative or improved ways of moving ahead. Many of the comments were insightful enough to warrant further discussion, to ensure that we are indeed striking the right balance. If there is a better approach out there, we want to know about it. Following the Roundtable, the Commission extended the comment period on the proposal to March 31, today. From there the staff will analyze the different ideas that have been advanced, and make a recommendation to the Commission as to how best to proceed.

Chief Accountant: PCAOB Oversight

The Public Company Accounting Oversight Board — a centerpiece of the Sarbanes-Oxley Act — was brought to life over the past year with the Commission's determination that it was prepared to begin performing its duties. As part of this effort, we recruited the Board's Chairman, William McDonough, who is proving to be a strong and capable leader.

Under the Sarbanes-Oxley Act, the Secretary of the Treasury was authorized to advance to the PCAOB from the SEC's budget $20.3 million in Fiscal year 2003 to cover the Board's expenses to cover its first fiscal year. The PCAOB repaid this amount in full shortly before September 30, 2003.

The Board has registered hundreds of accounting firms, begun rewriting portions of the auditing standards, and begun conducting inspections of accounting firms. The PCAOB has already approved the registration of almost 800 public accounting firms and has performed targeted initial reviews of the four largest accounting firms that have the majority of SEC registrants as audit clients. The PCAOB recently completed a new auditing standard on audits of issuers' internal control systems for financial reporting and has forwarded that standard to the Commission for approval. The Commission will continue to oversee the operations and activities of the Board.

Conclusion

Looking back on the past 14 months, I'm immensely proud of the work the staff has set in motion, and I look forward — with your continued support — to building upon our record, delivering even more impressive results for our primary client — the American investor — in 2005.

Again, thank you for inviting me today to speak on behalf of my agency and investors. I would be happy to respond to any questions you may have.

 

http://www.sec.gov/news/testimony/ts033104whd.htm


Modified: 03/30/2004