Appropriations for Fiscal Year 2001
By Chairman Arthur Levitt
U.S. Securities & Exchange Commission
Before the House Subcommittee on Commerce, Justice, State and the Judiciary
Committee on Appropriations
March 30, 2000
Chairman Rogers, Ranking Member Serrano, and Members of the Subcommittee:
I appreciate this opportunity to testify in support of the Securities and Exchange Commission's (SEC or Commission) fiscal 2001 budget. When I spoke before you last year, I described a market environment that was characterized by unprecedented volume, tremendous growth, increasing complexity, and globalization. I also indicated that the SEC would need multi-year increases in budget and staffing to meet these demands. These same forces and the increasing use of new technologies continue to dominate our markets and needs today.
Recent advances now permit a variety and combination of services that blur the distinction between markets, intermediaries, and service providers. Electronic Communication Networks (ECNs) are challenging traditional trading floors. The nation's stock exchanges are considering shedding their long-held membership status. Online trading is empowering retail investors. Institutional trading has increased the demand for greater liquidity, anonymity, and even new trading venues. Market participants are demanding more: twenty-four hour trading, immediate execution of orders, and lower costs.
It is against this backdrop that the President's fiscal 2001 budget request seeks an appropriation for the SEC of $422.8 million, 12 percent above the Commission's fiscal 2000 spending level of $377 million. This $422.8 million request will fund 3,037 staff years, an increase of 77 staff years (2.6%) over our current staffing levels. Our funding request covers $15.6 million in mandatory and inflationary expenses, $15 million to reinstitute special pay authority, $10 million for information systems, and $5.2 million for new staff. 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 online information services, as well as respond to continued growth and change in electronic forms of communication.
Assuming we are able to retain the necessary staff in fiscal 2001, this request will provide the Commission with the resources necessary to responsibly fulfill our mission of protecting investors and maintaining our markets' integrity. In particular, it will allow the Commission to:
- continue combatting fraudulent conduct on the Internet;
- provide effective oversight of the increasingly complex activities of regulated entities, including examining on-line and day trading activities;
- further implement a formal inspection cycle program of the increasing number of alternative trading systems;
- continue focusing on financial accounting frauds, earnings management practices, and developments in domestic and international accounting, independence, and auditing matters;
- meet the anticipated workload stemming from the increasing number of mergers resulting from the convergence of the gas and electric markets and the globalization of the utility industry;
- update and improve prospectus requirements for variable insurance products;
- develop a tailored disclosure document for unit investment trusts; and
- strengthen its technological infrastructure to support the agency in its three most rapidly growing areas: electronic forms, document and records management, and market data and analysis tools.
In requesting the funding to support these activities, however, I must focus on two specific areas that are dominating the Commission's agenda: the Internet and our inability to retain qualified staff. Without bringing these factors into our discussion of the SEC's budget needs, I believe we would fail to give a clear picture of how we plan to meet the challenges that lie ahead, including protecting investors and maintaining the integrity of our markets.
The Challenges of the Internet
The Internet is having a profound effect on the way investors participate in the capital markets and on the Commission. By the end of this year, there will be nearly 5.5 million domestic online brokerage accounts1, with 20 million expected by 2003.2 During the first quarter of 1999, nearly one in six equity trades was placed through online brokerage accounts. For retail investors, the percentage of trades executed via the Internet is even higher. A November 1999 report by SEC Commissioner Laura S. Unger notes that more than one in three trades by retail investors are effected online.3 These numbers will only increase as a greater percentage of investors avail themselves of the economies of online trading.
Moreover, the Internet has changed the way investment research is conducted. The Internet affords retail investors easy access to all kinds of information, both fact (real-time stock quotes, SEC filings, and corporate news releases) and opinion (newsgroup or message board postings, Internet mailing lists, analysts' reports, website discussions, and chat rooms). Entire Internet communities some with their own celebrity spokespersons have grown up around particular industries, technologies or issuers, providing an incubator for investment ideas, and a forum for competing viewpoints. One of the most popular Internet message board services, for example, has over 13.2 million investment-related messages available for its patrons' viewing.4
The Internet and Securities Fraud
While the Internet has brought significant benefits to investors, it also has created significant dangers for the unwary. The Internet, coupled with the greatest bull market in history, has brought millions of relative novices to the markets, while also providing simple, effective, and anonymous ways for unscrupulous people to defraud them. A single mass e-mail, or "spam," sent through the click of a mouse, can more easily and cheaply reach investors than hundreds of cold calls from an old-fashioned boiler room. The use of digital media also can lend fraudulent material an air of credibility. Someone with a home computer and knowledge of computer graphics can create an attractive, professional-looking website, rivaling that of a Fortune 500 company.
In the earliest days of the Commission's Internet fraud program, the frauds that prevailed online were simply electronic versions of scams that had long been conducted through paper newsletters, mass organizational meetings, and orchestrated telephone solicitations. Principal among these were: stock manipulations, offerings frauds, and illegal touts. We continue to witness these scams, particularly manipulation, with too great a frequency on the Internet. For example, on March 2, 2000 the Commission brought a settled manipulation case against several Washington, D.C. area law students. We allege that one of the students created a website that he used to drive up the short-term price of four stocks. According to the complaint, the student inflated the short-term price for each stock by as much as 700 percent. By trading in advance of his stock recommendations, the student generated over $345,000 in total profits for himself, his mother, three of his law school classmates, and two of his friends.
As the Internet has evolved, however, so too has Internet fraud. New fraudulent schemes have begun to emerge, such as: momentum trading websites, day trading recommendation websites, recommendation scalping, imposter message board frauds, and messages that appear to be misdirected. These scams often result in sizable investors losses. One purported pyramid scheme offered through the Internet, for example, raised more than $150 million from over 155,000 investors before the Commission shut it down. In another action, a popular online stock touter, whom the Commission recently charged with improperly trading ahead of his stock recommendations to the detriment of his subscribers, maintained a website with 3,800 paying members.
The Commission's ongoing program to fight Internet securities law violations is a team effort, in which every Division and Office plays a significant part. Since it is charged with uncovering, investigating and litigating Internet cases, however, the lead role in combatting online fraud is played by the Division of Enforcement. The SEC brought its first Internet enforcement action in 1995. While the amount of any fraud is impossible to quantify with precision, based on our surveillance and the number of complaints we receive, Internet securities fraud is on the rise. To date, the Commission has filed approximately 120 Internet actions most in the last two years alleging securities law violations by hundreds of persons and entities.
In July 1998, as a result of the Internet's growing importance and the rising incidence of Internet fraud, a formal Office of Internet Enforcement ("OIE") was created within the Enforcement Division. OIE began serving primarily as a coordinator of the Commission's Internet program and as a liaison with other regulatory and criminal law enforcement agencies at the federal, state, and local levels.
Between the spring of 1999 and the present, OIE has grown from three to 13 attorneys, with experience and expertise in a wide variety of areas pertinent to Internet enforcement. OIE's current functions include:
- identifying areas for surveillance and conducting surveillance,
- analyzing the complaints we receive from our online Enforcement Complaint Center ("ECC"),
- formulating investigative procedures,
- coordinating Internet initiatives,
- conducting staff and outside law enforcement training,
- engaging in special projects,
- ensuring staff compliance with federal communications privacy statutes and applicable laws, and
- working on Internet matters for the entire Commission.
Alongside OIE is the so-called "Cyberforce" – approximately 240 Commission attorneys, accountants, and investigators nationwide – whose purpose is to conduct regular Internet surveillance. Cyberforce members dedicate a portion of their work week to surfing the Internet, developing leads for potential enforcement cases. The Cyberforce also participates in coordinated surveillance projects both within the SEC and with other federal agencies, such as the law enforcement "surf days" orchestrated over the past three years by the Federal Trade Commission.
With the vital support of this Committee and Chairman Rogers, the Commission has made immediate strides in its Internet initiatives. In November 1999, the Commission received a fiscal 2000 appropriation that provided an additional $7 million over our request which supplemented a reprogramming of an additional $5.5 million specifically to combat Internet fraud. These funds are being spent both to augment the staff investigating online securities law violations and otherwise studying aspects of the electronic marketplace, and to supplement and improve the technological systems that support those staff members. Already the Commission has turned these dollars into tangible additions to its Internet program. We have created 92 positions for our Internet fraud program with these funds. Seventy-five of these positions have been assigned to our Division of Enforcement and 17 have been assigned to aid other offices and divisions in their Internet-related efforts. In addition, staff currently is evaluating contractor proposals to provide technological assistance in our surveillance of the Internet, in response to a request for proposals that we issued in January.
Most of the new Enforcement staff will spend all of their time investigating and prosecuting Internet fraud. Among these 75 positions, 23 have been allocated to our headquarters in Washington, D.C. and the remaining 52 positions to our regional offices throughout the country. The 17 positions allocated to the other divisions and offices will be used for a variety of purposes, including bolstering our inspections and examinations of regulated entities operating online, developing policies for the securities industry's use of the Internet, and furthering investor education and assistance. These additional resources no doubt better equip us to prosecute Internet-related securities fraud and keep the Internet safe for investors.
As the Commission enters the new millennium, profound changes are drastically reshaping the securities industry, and compelling the agency to reassess traditional approaches to its mission of investor protection. In order to fulfill that mission, the SEC must be forward-looking, strive to anticipate issues and challenges, and welcome new ideas and new strategies for meeting those challenges. The $12.5 million we received in fiscal 2000 for combatting Internet fraud was a critical first step in this direction. We intend to build on our past achievements, refine those practices that continue to serve us well, and introduce new methods that will make us even more responsive to changes in law and technology. Equally important, we intend to work responsibly with the resources we have been given. For this reason, aside from fixed costs and our information technology program, we have requested only a minimal increase above our fiscal 2000 level to fund our Internet activities in fiscal 2001. We also are requesting only a small increase in Internet funding because we cannot do more without being able to retain and recruit staff, which brings me to the second issue we would like to discuss today.
The SEC is in the midst of a serious staffing crisis. On February 24, I wrote a letter to you, Committee Chairman Young, Ranking Member Obey, and the Congressional leadership alerting you to our inability to retain staff. This problem goes to the very heart of the agency's ability to oversee the nation's growing securities markets and to protect America's savers and investors. In the last two years, the Commission has lost 25 percent of its attorneys, accountants, and examiners. (In fiscal 1999, we lost 13.5 percent of our attorneys, 16.8 percent of our accountants, and 9.9 percent of our examiners.) Our overall attrition rate was 13 percent nearly twice the government-wide average, and our largest regional office alone lost a devastating 20% of its attorney workforce.
The Commission is losing staff before they become fully productive because we cannot pay them enough. In a world where first-year associates are routinely making six-figure salaries in Washington, D.C. law firms, the salaries the SEC can provide simply are not competitive to attract and retain a sufficient number of talented professionals to reduce high turnover, let alone to fill open positions.
While we fully recognize that the SEC cannot match the higher salaries offered by brokerages, law firms, self-regulatory organizations, and other securities-related businesses, something needs to be done to narrow the pay gap and reduce the turnover problems we face.5 Practically every day at least one of my senior managers comes to me expressing his or her frustration in not being able to keep tomorrow's leaders.
Effect on the Commission
Our current level of turnover and inability to attract qualified staff is threatening our ability to oversee the nation's securities markets and to respond in a timely manner to the changing events and innovations in our markets by:
We also become less productive. SEC staff work hard and well to handle the Commission's increasing, and increasingly complex, workload. The time that our managers and senior staff can devote to this workload is, however, reduced by the time it takes to recruit and train new staff. The SEC conservatively estimates that it takes approximately two years for new staff to become fully productive. During this period, new staff are actually a drag on the efficiency of the agency because they are still moving up the learning curve. If these staff leave just as they become fully productive to the agency, we do not recover our substantial investment in training them. That is a loss not only for us, but also for the investing public and our markets.
- hampering our ability to bring cases to trial and disrupting the continuity we need when pursuing cases;
- hindering us from responding to changing markets in a timely fashion, including through targeted de-regulatory efforts;
- limiting our institutional memory, which is a crucial component of our long-term effectiveness as a regulator; and
- lowering employee morale, which in turn reinforces the staffing crisis.
Over the past several years the Commission has explored virtually every available approach to keeping staff longer. In 1992, we petitioned and received from the Office of Personnel Management the authority to pay the majority of our attorneys and accountants approximately 10 percent above their base pay. While special pay was a step in the right direction, it proved to be a short-term solution. This is because staff that receive special pay do not receive the government-wide locality increase each year, which means that their special pay becomes less valuable over time (it is now almost entirely superseded by locality pay) and hence becomes less effective as a retention tool. In addition to our special pay authority, which the President's fiscal 2001 budget requests the funds to reinstate, the Commission has used retention allowances and economist special pay to help alleviate our retention problem. While all of these tools have proved somewhat effective when targeted to specific staff and situations, we believe they are incapable of providing the broad relief that we need to combat the Commission's losses and treat all staff fairly.
The SEC also is facing a problem recruiting attorneys and accountants. We have used recruitment bonuses where possible, but have not met with much success. A typical first-year associate in a top-tier New York or Washington D.C. law firm makes at least double the salary of a comparable staff attorney at the SEC. The costs of three years of law school leave most graduates entering the job market with significant amounts of student loan debt. It is not difficult to understand why the private sector looks so appealing.
Our problem is even worse for accountants, who need to be experienced when they walk in the door. This is of particular concern in an era where financial fraud and earnings management has been on the rise. Experienced accountants are difficult to find and expensive to hire because their ability to analyze complex financial statements is highly prized. We do not have the luxury, if you can call it that, of being able to take someone directly out of school. The Commission has attempted to ameliorate this problem by developing an "in-service" placement program that allows certain Securities Compliance Examiners to be reassigned as accountants if they meet specific criteria, but even this effort has fallen short. In fact, last year only 46 percent of our available accountant positions were filled. The Commission needs the ability not only to keep staff longer, but also to bring them to the Commission in the first place.
Parity with the Banking Regulators
Another real concern the Commission has about staff salaries is the effect of the landmark Gramm-Leach-Bliley Act of 1999 ("GLBA"). By allowing securities firms, banks, and insurance companies to affiliate with one another, GLBA requires increased coordination of activities among all the financial regulators. Even more so than in the past, Commission staff will work side-by-side with their counterparts from the banking regulatory agencies, like the Federal Reserve, the Office of the Comptroller of the Currency, and the Federal Deposit Insurance Corporation ("FDIC"). However, we cannot match the salaries that these regulators pay.
Since all of the federal banking regulators are exempted from the standard government-wide pay schedule established under the civil service laws, they are able to provide their staffs with appreciably more in compensation and benefits than we can. While the maximum salary for a second-year attorney at the SEC, for example, is $66,000, an FDIC attorney with similar levels of experience, technical skills, and responsibilities can be paid as much as $91,000. This is a significant drain on morale. It is difficult to explain to SEC staff why they should not be paid at similar levels, especially when they are conducting similar oversight, regulatory, and examination activities. It is one thing for staff to make salary comparisons with the private sector, but quite another for them to see their government counterparts making anywhere from 24 to 39 percent more than they are. Moreover, the Commission has already seen several staff leave to take positions with these agencies, primarily because of pay. Unless we are put on equal footing, this trend will continue and most likely intensify.
Given the complexities of our markets and the new business affiliations we are likely to see, the SEC believes it is most beneficial to have all the financial regulators working together from the same starting point. Towards that end, the Commission believes that providing our staff with pay comparable to the banking regulatory agencies would significantly help in extending the tenures of key employees and help the Commission attract sufficient staff in the first place.
The Agency and Its Staff
The SEC should be a place where highly motivated people come to perform public service and hone their skills, both before entering the private sector and after a stint in the private sector. Such career paths speak highly of the Commission's professionalism and the industry's regard for the agency and its staff. However, the Commission should be able to keep staff for a minimum of three to five years before they leave, and show existing staff how much their efforts are valued. The SEC can ill afford to have its future walk out the door. Moreover, we need to ensure that the Commission has the staffing resources to meet the significant regulatory challenges that lie ahead as technology in general, and the Internet in particular, continue to re-shape our markets.
Proposals to Provide Relief
The President's fiscal 2001 budget request includes $15 million to reinstitute 10 percent special pay for certain attorneys and accountants. As I stated before, we previously had this authority and used it in conjunction with recruitment bonuses, retention allowances, and other retention tools. However, we do not believe that bringing back special pay will be sufficient to resolve our staffing problem. A legislative solution that would provide the Commission with the same pay authority as the banking agencies is vital. I have been discussing our need for pay relief with the Senate Banking and House Commerce Committees, and the Administration. I hope we can all work together to attract and keep the best possible professionals at the SEC. I cannot emphasize too strongly the importance of this issue as it relates to our mission of protecting investors and ensuring market integrity.
The Commission applauds the support that this Committee has given us to respond to the changing face and form of our nation's securities markets. Our fiscal 2001 request for $422.8 million will go a long way toward enabling the Commission to fulfill its mission of protecting investors and maintaining the integrity of our markets as they continue to dramatically change. In addition, we are dedicated to making the Internet a safe medium for investors and are grateful for the support that this Committee has given us in helping pursue this objective. At this time, our most significant challenge is to ensure that the Commission maintains the skills, abilities, and expertise necessary to address the tremendous and competing demands presented by the industry with which we work. For this reason, we look forward to working with you to obtain the fiscal 2001 funding level we need and the pay authority essential to keeping the people necessary to fulfill our mission of keeping our nation's securities markets the safest, fairest, and most liquid in the world.
1 See Adam Zagorin, Taking Stock Scams Offline, Time Magazine, March 13, 2000.
2 See Rebecca Bickman, What now? The growth in online investing heralds all sorts of changes in the near future, Wall St. Journal, June 14, 1999.
3 See Online Brokerage: Keeping Apace of Cyberspace, Report of Laura S. Unger, Commissioner, U.S. Securities and Exchange Commission, November 1999. This Report is available online at http://www.sec.gov/pdf/cybrtrnd.pdf [Webmaster's note: this report is a PDF file]
4 See http://www.siliconinvestor.com (viewed March 14, 2000).
5 The Commission recently contracted for a study comparing the significant disparity between SEC salaries and what the private sector offers for the same line of work. We would be happy to share the results of that study if you think it would be helpful in highlighting the magnitude of our problems.