Fiscal 2006 Appropriations Request for the U.S. Securities and Exchange Commission
by William H. Donaldson
Chairman, U.S. Securities & Exchange Commission
Before the Subcommittee on Science, State, Justice and Commerce and Related Agencies Committee on Appropriations
March 11, 2005
Chairman Wolf, Ranking Member Mollohan, and Members of the Subcommittee:
Thank you for the opportunity to testify before you today on the Securities and Exchange Commission's fiscal 2006 budget request. Due in large part to your ongoing leadership and support, the SEC has made substantial progress in regaining its stature and the capacity required to fulfill its mission. Over the past several years, we have grown more proactive, forward-looking, skilled, and better able to meet the large number of challenges facing our markets, investors, and public companies. These improvements have been some of our central achievements since my arrival at the Commission in 2003.
The subject of my testimony today is the Commission's fiscal 2006 budget. I support the President's budget request for the Commission, and I believe that this budget, while responsive to the tight budgetary environment faced by the federal government, will allow us to maintain our course and continue serving and protecting the nation's investors.
The SEC requests a total funding level of $888 million for fiscal 2006. This proposed level is comprised of $863 million in new funding and an estimated $25 million in carryover funds from fiscal 2005. To help explain how we have structured our fiscal 2006 request and why we believe it is adequate, I will briefly describe the Commission's funding over the last several years.
In fiscal 2004, the Commission received an appropriation of $811 million. This funding level permitted the Commission to complete the hiring of the more than 840 new positions we received in fiscal 2003. It also allowed us, among other initiatives, to commence our Enforcement imaging backlog project, create our new Office of Risk Assessment, and implement a new risk-focused approach to our examination activities. Due to the large number of entry-level employees who came on board, and due to the fact that the timing of this hiring was affected by the delay in receiving our appropriation, the Commission incurred lower salaries and benefits costs than we originally projected. As a result, the Commission's actual spending for fiscal 2004 totaled $755 million, roughly $57 million less than we were appropriated.
In late December 2004, the Commission received its fiscal 2005 appropriation of $913 million, including our prior year carryover funds. This amount permits the SEC to fully annualize the costs associated with all of our prior year hires and to hire an additional 106 new staff who primarily will assist in our regulation and oversight of mutual funds and investment advisers. Our fiscal 2005 funding level also includes funds for several non-recurring expenses that I will discuss in further detail below. In anticipation of a lean fiscal 2006, the SEC, in conjunction with the Office of Management and Budget, revisited our fiscal 2005 spending assumptions and determined that, by adjusting the implementation schedule for some of our initiatives, we could again fund all of our top priorities for less than we had been appropriated. In particular, we estimated that partially due to the timing of when our fiscal 2005 appropriation was enacted and the timing of our hiring 106 new employees, we could fully fund our fiscal 2005 operations for $888 million and carryover roughly $25 million into fiscal 2006.
In considering our fiscal 2006 funding needs, it is important to note that our current budget includes a number of one-time costs that will not recur. In particular, the agency will not incur approximately $21 million in costs associated with the completion of our move into Station Place, along with costs associated with the relocation of our Northeast Regional Office in New York. In addition, because of the expected completions of the SEC's new Alternate Data Center and our Enforcement imaging backlog project, along with shifts in the implementation of certain information technology systems, the SEC likewise will not require that an additional $17 million be kept in our base funding level for fiscal 2006. These one-time base reductions of nearly $38 million help explain how we can maintain all of our major initiatives in fiscal 2006.
Having described our overall budgetary approach, I will highlight the agency's operational and programmatic agenda for fiscal 2006.
In 2006, the SEC will continue to concentrate on ensuring that taxpayer dollars are used to maximum effect to fulfill the agency's mission. Some of the key areas in which we will continue to make progress are our risk-assessment activities, management "dashboards", strategic planning efforts, and information technology.
Our Office of Risk Assessment will continue to expand the depth and complexity of risk assessment activities throughout the agency. In particular, the Office will lead the efforts of multi-disciplinary risk teams to detect new risks and assist division and office efforts to mitigate and manage previously identified risks on an ongoing basis. ORA also will continue to strengthen the SEC's risk assessment infrastructure, both within the divisions and offices and for the agency as a whole.
We will continue using our dashboard management reports to track the agency's progress in meeting its budgetary, staffing, and operational objectives. The reports will be refined as necessary to gauge the success of the agency's evolving programs and to help ascertain whether we need to adjust our operations. Moreover, the SEC will continue to conduct comprehensive workforce and workflow reviews of divisions and offices, with an eye towards maintaining an alignment between agency resources, needs, and mission priorities.
Separately, the SEC will begin planning to revise and update its five-year strategic plan. Staff also will continue working with contractors to implement an activity-based costing and performance-based budgeting solution to help us better allocate our operating costs and achieve greater cost efficiencies.
I will now turn to the subject of information technology. In 2006, the Office of Information Technology will continue implementing several major initiatives from 2005 and extend them into new parts of the organization. OIT plans to:
- Upgrade the agency Internet website and portal for the Electronic Data Gathering and Retrieval (EDGAR) system. The new site will substantially improve investors' access to filings through a new full-text search function and a more intuitive user interface. The redesign also will enhance the accessibility and searchability of information related to the SEC's rulemaking activities.
- Fully implement our redesigned case management system and fully integrate it into the agency's broader suite of workflow management, document management, and knowledge management tools. The result will be a more seamless set of core business processes for enforcement activities and improved reporting for senior attorneys to manage the agency's caseload.
- Fully deploy the examination management system throughout headquarters and the field offices. As a result, all of the agency's examinations will be subject to uniform methodologies and audit plans, and examiners will be better able to manage inspection work products.
- Expand our intrusion detection and prevention capabilities, improve incident response practices, and provide specialized technical training. OIT also will continue to assess the security of standing applications and infrastructure as part of its ongoing certification and accreditation process.
- Continue transitioning to its "future state" enterprise architecture, changing business processes as necessary to better support its mission. Improvements will include a unified content and document management platform; a consolidated infrastructure for the agency's storage and application servers; agency-wide data warehousing, analytics, and reporting tools; and a common, agency-wide portal for receiving and storing disclosure and surveillance information.
Another area that I would like to discuss is telework. Over the last several months, we have made great strides in increasing the availability of telework to all eligible employees. We now have approximately 17 percent of our eligible workforce on a telework schedule, up markedly from the 9.5 percent of employees we had at the end fiscal 2003. We have made this rapid progress by, among other things, working to foster a telework culture at the Commission and implementing a new agency-wide Enterprise Telework Program.
To help us achieve this success, I assigned my Executive Director overall responsibility for overseeing our telework program and directed two other senior executives to serve as Telework Program Sponsors to help institute a new telework mindset at the Commission, one that appreciates and actively promotes the benefits that can be gained by staff and the SEC from providing this flexibility more broadly throughout the agency. As we embarked on this new course, we consulted with your staff and, at their recommendation, we began partnering with the Telework Consortium. Thus far, we have had several meetings with the Consortium to discuss technical options to support a larger number of our workforce operating from home.
In January 2005, to stress our commitment, I personally announced our new Enterprise Telework Program to the entire SEC community. The SEC's new telework program allows all of our eligible employees more flexibility to balance work with personal life. The program will help the SEC attract new talent, reduce traffic congestion, meet mission requirements during inclement weather, and, if necessary, implement some of the agency's continuity of operations activities. In rolling out this program, we have begun educating the entire SEC community about the benefits of telework, working to address its challenges, and training supervisors on their responsibilities handling telework requests and managing remote workers.
We also are looking beyond telework for additional ways to improve staff effectiveness while supporting the need for an employee work-life balance. In particular, we are exploring having certain staff work full-time from alternative locations, such as their homes. This "virtual workforce" initiative, which is highlighted in our most recent Strategic Plan, would meet many of the same ends as telecommuting. I am committed to introducing this virtual workforce concept in 2005, and will soon commence a pilot, in which 20 volunteer employees will be permitted to operate exclusively from a remote location. We will evaluate this pilot in light of our human resources, security, and information technology infrastructures. Upon completion of this review, we will determine how best to expand the pilot to a substantially larger number of employees in future years.
While not a part of our fiscal 2006 funding request, I also would like to discuss the SEC's upcoming move to Station Place. We are very excited about this move, and I wanted to review for you the process whereby we selected this location.
The SEC has been in its current headquarters facility since 1982, when the entire Commission had a total of roughly 1,900 employees, less than half our current size. The SEC first began planning for a new headquarters facility in 1999 when it became clear that the agency could no longer house all of its headquarters employees in our current location at 450 5th Street, NW. Around the same time, the agency also began procuring a short-term lease for additional space at 901 E Street, NW to accommodate our immediate space needs.
Our solicitation and procurement strategy was, as required by the Competition in Contracting Act, to run a full and open competition that would satisfy the SEC's requirements for a new headquarters facility. Although the SEC has independent leasing authority, we executed our strategy by partnering with the General Services Administration and using one of their approved brokers. We also held a variety of meetings with all appropriate House and Senate committees to discuss, among other things, how best to proceed with the procurement, the location for a new facility, and the general requirements that the SEC should include in its solicitation.
After conducting a robust competition, and working with the Office of Management and Budget to obtain the necessary budgetary approvals, the SEC awarded the lease of its new headquarters to Station Place on May 29, 2001. As part of this, the SEC negotiated a rate of less than $44.00 per rentable square foot for the entire 14-year period of our lease, a rate that given current market conditions is quite favorable. The lease agreement also contained an expansion option that, in retrospect, we are fortunate was included. With the agency's growth associated with the new requirements of the Sarbanes-Oxley Act, the SEC exercised its option for additional space roughly one-year after entering into its original lease agreement. As part of this agreement, the SEC was able to obtain its expansion space at the same favorable lease rate of roughly $44.00 per rentable square foot.
Our lease agreement also contains a provision that allows for the Government to purchase the building at a specific price at the end of the lease period by paying additional rent over our 14-year term. While the SEC does not currently have the authority to exercise this option, we believe that the purchase of Station Place should be considered, as it would save the Government money over the longer term. Separately, it is worth noting that our lease procurement process started well in advance of the events of September 11, 2001. In response to those events, the SEC received emergency supplemental funds to enhance the building's security features by adding laminated glass, bollards, and other blast resistant features.
The SEC greatly appreciates the support we have received from the Subcommittee in procuring our new headquarters facility, and I would like to personally invite each of you over for a tour.
INDEPENDENCE OF COMMISSION
Before turning to our programmatic agenda, I would like to thank you for your support in ensuring that the integrity of the Commission's policy decisions and regulatory processes are respected and remain inviolate. While some may be critical of certain of our actions, the Commission's regulatory decisions are the result of robust and informed legal and quantitative analyses and are fully consistent with our mission. In addition, in all our rulemaking we take great pains to consider the scope of our legal authority, and provide all interested parties with a full and fair opportunity for comment. The Commission was specifically designed by Congress to be independent and must remain fully so if we are to continue restoring the public's faith in the fairness of our markets. I hope that we can continue to rely on your support to maintain the independence of the Commission.
I will now turn to our programmatic agenda, and will begin with an overview of our efforts under the Sarbanes-Oxley Act of 2002.
Two years ago, when I became Chairman of the Commission, the country was still reeling from its disappointment with cooked books, indefensible lapses in audit and corporate governance responsibilities, and intentional manipulation of accounting rules. These lapses led to staggering financial losses and a crisis in investor confidence. The resulting Sarbanes-Oxley Act called for the most significant reforms affecting our capital markets since the Securities Exchange Act of 1934. The Act established the foundation necessary to improve financial reporting and the behavior of companies and gatekeepers, and we have completed the rule-making to implement these critically important reforms. Key Sarbanes-Oxley requirements include:
- CEO and CFO certifications of the material completeness and accuracy of SEC periodic filings
- Enhanced disclosure of off-balance sheet transactions
- Electronic reporting within two business days of insider transactions
- Increased disclosure of material current events affecting companies
- Establishment of the PCAOB
- Issuance of the first PCAOB inspection reports on the large accounting firms
- Issuance of important auditing standards by the PCAOB, and
- Public reporting, by both management and auditors, on internal controls and their effectiveness.
I would like to focus for a moment on the Section 404 requirement for internal controls disclosure. This section of Sarbanes-Oxley may have the greatest long-term potential to improve financial reporting. It may also well be the most urgent financial reporting challenge facing a large share of corporate America and the audit profession in 2005. I expect that we will begin to see a number of companies announce that they or their auditors have been unable to complete their assessments or audits of controls. I also expect that some companies will announce that they have material weaknesses in their controls.
For this initial pass, these results should not, by themselves, necessarily be a motivation for immediate or severe market reactions. Section 404 is a disclosure provision, and investors will benefit from receiving full disclosure about the nature of any material weaknesses, their impact on financial reporting and the control environment and management's plans for remediating them. This disclosure will allow investors and markets to make the appropriate judgments about what companies and auditors find. Section 404 will work as intended if it brings this information into public view, and in that event the disclosure of material weaknesses in internal controls should be the beginning and not the end of the analysis for investors and markets. The goal should be continual improvement in controls over financial reporting and increased investor information and confidence. This should lead to better input for management decisions and higher quality information being provided to investors.
While these benefits are clear, it is also important that we evaluate the implementation of our rules and the auditing standard issued by the Public Company Accounting Oversight Board (PCAOB) to ensure that these benefits are achieved in the most sensible way. We have been very sensitive to the implementation of all aspects of the Sarbanes-Oxley Act, and especially to this very significant aspect. This has included several measured extensions over this past year to accommodate the first wave of reporting.
In addition, in order to assess SEC and PCAOB rules for implementing Section 404 now that we will have the first year of actual experience under the rules, the Commission will hold a roundtable discussion this April and is currently soliciting written feedback from the public regarding registrants' and accounting firms' implementation of these new reporting requirements. Through the roundtable and this feedback, we will be closely listening to and assessing the experiences with the management and auditor internal control requirements, including seeking to identify best practices for the preparation of these reports and evaluating whether there are ways to make the process more efficient and effective, while fully preserving the benefits of the requirements. Throughout this process the Commission and its staff will closely coordinate with the PCAOB and its staff, and we will seriously consider whether any additional guidance is necessary or appropriate.
We are also actively engaged in other activities to evaluate and assess the effects of the recent reforms, including the internal control reporting rules. For example, we have announced we are establishing the Securities and Exchange Commission Advisory Committee on Smaller Public Companies. The advisory committee will conduct its work with a view to protecting investors, considering whether the costs imposed by the current regulatory system for smaller public companies are proportionate to the benefits, and identifying methods of minimizing costs and maximizing benefits.
In addition, and at the request of Commission staff, a task force of the Committee of Sponsoring Organizations (COSO) has been established and anticipates publishing additional guidance this summer in applying COSO's framework to smaller companies. Our actions have not been limited to smaller companies. We also are cognizant of the regulatory challenges our foreign registrants face. For all of these reasons, we recently extended the compliance date for internal control reporting for an additional year for smaller and foreign public companies. Review of the first year experiences of our larger registrants also should help smaller and foreign issuers in preparing their first reports.
Separately, it is important to note that the Commission itself has been following the goals and spirit of the Sarbanes-Oxley Act as we have been completing our first-ever audited financial statements under the Accountability of Tax Dollars Act of 2002. Our fiscal 2004 audit, which was conducted by the U.S. Government Accountability Office, should be completed shortly and I expect our results to be favorable. In preparing for this audit, we have been reviewing and updating our management controls, developing our own management certification process, and taking steps to make sure that we lead by example. The SEC has invested significant resources in fulfilling our own financial reporting and audit responsibilities because it is only appropriate that we conduct the same kinds of management reviews and internal control enhancements that we require of all public companies.
Office of Global Security Risk
I would like to update you on the activities of our Office of Global Security Risk.
When I testified before you last year, I reported on several enhancements to our review program in the Division of Corporation Finance, including the establishment of the Office of Global Security Risk. This Office is up and running as my quarterly reports to you have indicated. The Chief of this Office, Cecilia Blye, was selected last May. Ms. Blye served for 20 years as special counsel in the Division of Corporation Finance prior to her selection as head of this Office. Last summer, Ms. Blye hired two staff attorneys. She may be hiring additional staff, but that will be influenced in part by the Office's research needs. Ms. Blye is currently pursuing the purchase of an online global security risk assessment product. While a possible product has been identified, this procurement is still in process. Once completed, it will enable Ms. Blye to better assess what additional staffing may be necessary.
The Office continues to develop and refine its operations and procedures. The Division's examination staff continues to monitor filings for global security risk issues and, with the support and assistance of the Office of Global Security Risk, to evaluate company disclosure and pursue enhanced disclosure where appropriate.
Given that the issues surrounding global security risk are much broader than the SEC's role in examining public company disclosure, the Office coordinates with other relevant federal agencies. The Office has coordinated most closely with Treasury's Office of Terrorist Financing and Financial Crimes. We also coordinate with the State Department's Office of Terrorism Finance and Economic Sanctions, and Office of Monetary Affairs, and with Treasury's Office of Foreign Assets Control.
I am confident that, with the important role this office will take in the Division's review program, the SEC is properly positioned to obtain and evaluate disclosure regarding global security risk.
Turning to market structure, the Commission has been working to update and modernize the regulatory structure of the U.S. equity markets. Most notably, we proposed Regulation NMS (National Market System) in February 2004. This proposal would: (i) create a uniform trade-through rule for all national market centers; (ii) require uniform market access; (iii) establish a uniform quoting increment to address sub-penny trading and promote greater transparency; (iv) amend the arrangements for dissemination of market information; and (v) modernize and restructure the national market system rules under the Exchange Act. Over the past year, we have held a public hearing on Regulation NMS and published a supplemental request for comment based on a number of important matters raised at the public hearing.
More recently, in December 2004 the Commission reproposed Regulation NMS to provide investors and market participants with another opportunity to comment on the proposal, particularly as to whether it would be advisable to establish an inter-market trade through rule that applies to a market's displayed "depth of book" or simple "top of book." The comment period for our reproposed regulation recently ended in late January, and we are currently reviewing all of the comments that we have received. It is my hope that we will conclude our deliberation on this subject in the next several weeks.
Mutual Fund Reforms
I will turn to our mutual fund reform agenda.
As you know, the past 18 months have been a difficult and troubling period for the mutual fund industry. One indication of the troubles has been the Commission's enforcement actions. During this period, the Commission has brought 61 cases related to mutual funds and levied approximately $1.4 billion in disgorgements and $1 billion in penalties. In fact, these numbers demonstrate how mutual fund managers violated the trust handed to them by the individuals who invest in mutual funds.
In addition to our enforcement actions, the Commission also has undertaken several major rulemaking initiatives to reform fund governance and enhance internal oversight of fund activities. Particular reforms that we have adopted include: (i) enhancing fund governance requirements for funds that rely on certain exemptive rules by providing for independent board chairmen and for fund boards to be comprised of 75 percent independent directors; (ii) a requirement that all registered investment advisers adopt codes of ethics, and that funds and their advisers have comprehensive compliance policies and procedures in place, including the appointment of a designated compliance officer; and (iii) new disclosure requirements designed to more fully inform investors about mutual fund conflicts of interest and the policies and procedures in place to control them. The Commission also is continuing to review comments received in connection with our 4:00 p.m. "hard close" proposal. This is the last of our pending rule-making proposals that we hope to see final action on in the coming weeks. However, this proposal poses some significant technological challenges, and we want to make sure we adopt rules that are effective, without imposing unintended negative consequences on investors or funds.
I appreciate that these efforts have received significant attention. We have taken these steps because mutual funds have become primary investment vehicles for Americans who are planning for retirement, saving for their children's educational expenses, and striving to meet a variety of other personal investment goals. It is essential that investors receive a "fair deal" from mutual funds-and that Americans have reason to regain confidence that the mutual fund industry has investors' best interests at heart.
Turning to hedge funds, as you may know, one of my earliest priorities for the Commission was to get out in front of emerging issues, rather than react after a problem has occurred and investors have been harmed. As such, I strongly believe that the Commission cannot turn a blind eye to the remarkable growth of hedge funds. Thus in December 2004, the Commission adopted a new rule that requires advisers to hedge funds to register as investment advisers under the Investment Advisers Act starting in early 2006.
At nearly $1 trillion, hedge fund assets have grown significantly-increasing an estimated 260 percent in the last five years. In addition, a broader cross-section of investors is exposed to hedge fund investing through pension plans and registered funds of hedge funds. It is essential that the Commission know more about the activities of hedge fund advisers so that we can appropriately fulfill our investor protection mission on behalf of hedge fund investors and those investors on the other side of these transactions. Registration under the Investment Advisers Act is a way for the Commission to oversee these investment advisers with minimal intrusion on hedge funds' operations. Advisers Act registration places no limits on hedge funds' ability to provide liquidity and efficiency to our nation's markets or on hedge funds' proprietary trading strategies. I can assure you that we are working with the hedge fund industry to ensure that implementation of the new rule is done in an effective and efficient manner.
2005 was a remarkable year of achievement for the Commission and its staff in many areas in addition to those that I have just reviewed for you. To cite just a few of our accomplishments:
- The Division of Corporation Finance completed a major overhaul of the rules governing the asset-backed securities market, and proposed ground-breaking reforms to the securities offering process. The Division is now at the forefront of our efforts to reach out to the small business community so that we understand their concerns about the implementation of the public company reforms of the last three years.
- The Division of Market Regulation took a significant step to combat the problem of naked short-selling, with the adoption in July of our new Regulation SHO.
- The Division of Enforcement brought enforcement actions in all of the Commission's program areas, and obtained billions of dollars in disgorgement and penalties, much of which will be returned to investors.
- The Office of Compliance Inspections and Examinations implemented a risk-based methodology program-wide, which will help us look over the hills and around the corners.
- The Office of the Chief Accountant increased its oversight of the accounting and auditing standard setting process in the United States.
We are all very pleased with these accomplishments and I would be happy, if you wish, to review them with you in detail at a later time.
Thanks to this Subcommittee, the Commission has made significant progress over the last several years in rebuilding public confidence in our markets. Our fiscal 2006 budget request requires an appropriate amount of fiscal control given the budgetary environment faced by the federal government, but it will not prevent us from continuing along this course. Given the importance of our work to our nation's economy and the investing public, we will continue to meet our mission by strengthening our human capital, investing in information technology, being proactive, and maintaining our independence.
I appreciate your giving me the opportunity to speak before you today and I am happy to answer any questions you may have.