[Senate Hearing 108-158]
[From the U.S. Government Publishing Office]
DEPARTMENTS OF COMMERCE, JUSTICE, AND STATE, THE JUDICIARY, AND RELATED
AGENCIES APPROPRIATIONS FOR FISCAL YEAR 2004
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TUESDAY, APRIL 8, 2003
U.S. Senate,
Subcommittee of the Committee on Appropriations,
Washington, DC.
The subcommittee met at 10 a.m., in room S-146, the
Capitol, Hon. Judd Gregg (chairman) presiding.
Present: Senators Gregg and Hollings.
SECURITIES AND EXCHANGE COMMISSION
STATEMENT OF WILLIAM H. DONALDSON, CHAIRMAN
OPENING STATEMENT OF SENATOR JUDD GREGG
Senator Gregg. The committee will come to order. It is
great to have the Chairman of the SEC here today, William
Donaldson.
First, I want to thank you on behalf of the Congress and
the American people for being willing to come out of the
private sector, with your tremendous experience and expertise,
and take over this job. I consider it to be one of the most
significant jobs we have in the Federal Government because it
is the job which makes capital markets vibrant and reliable,
and capital markets which are transparent and properly
regulated are critical to the well-being of the American
economy.
International confidence in our markets is essential to the
survival of our Nation and our free market system, so having
your leadership at the SEC is crucial, and we are excited you
are there.
Senator, did you have any opening comments?
Senator Hollings. I am equally excited and grateful that he
would take this assignment. Thank you.
Senator Gregg. We would be happy to hear any thoughts you
have to add. You can summarize your statement or read it,
however you wish to proceed.
OPENING REMARKS
Mr. Donaldson. Thank you for your comments, Senator. I am
honored to be here and to be in the position I'm in. Let me
just make a couple of brief comments, and then we can do
whatever you would like in terms of carrying on from there.
I appreciate the chance to speak. Our request is for $841.5
million. That's the largest amount that's ever been requested
for the SEC, and it comes on the heels of last year's
appropriation, which was the largest single year percentage
increase ever provided the Commission. I want to thank you and
the subcommittee for the tremendous support and leadership
you've shown in ensuring that the Commission receives the
resources that are necessary to fulfill our mission.
Thanks to your efforts, the Commission has been
appropriated $716.4 million to fund its operations this fiscal
year as part of the omnibus appropriation. These funds will
enable us to meet the remaining deadline for the Sarbanes-Oxley
Act, hire over 800 new staff and advance the initial startup
funds to the Public Company Accounting Oversight Board, improve
our training efforts, and address our most pressing information
technology needs.
Ensuring that our new resources are used to promote the
effectiveness and support the modern mission of the SEC, rather
than simply increasing our numbers, is one of my most important
responsibilities as Chairman. During the next several weeks and
months I intend to get more deeply into each program area to
verify personally that this is the best, most effective and
efficient use of our new staffing. I would therefore like to
reserve my option to make changes. I have been at the
Commission I think a total of almost 8 weeks now, and my staff
and I hope to (a) examine our budgets carefully and (b) work
closely with the subcommittee as we finalize our resource
allocations.
PREPARED STATEMENT
As I said at the beginning, I'm honored to be Chairman of
the SEC. I think it is the most important time in the history
of the country to have this job, and I will be delighted to
answer any questions you might have. Thank you.
[The statement follows:]
Prepared Statement of William H. Donaldson
Chairman Gregg, Ranking Member Hollings, and Members of the
Subcommittee: Thank you for inviting me to testify today on behalf of
the Securities and Exchange Commission in support of the President's
fiscal 2004 budget request. The fiscal 2004 budget request of $841.5
million is the largest amount ever requested for the SEC and comes on
the heels of last year's appropriation, which was the largest single-
year percentage increase ever provided to the Commission.
At the outset, I would like to take this opportunity to thank you
for the tremendous support and leadership you have shown in ensuring
that the Commission receives the resources and staff necessary to
fulfill its mission. Your backing, along with the strong support of our
authorizing committees, demonstrates convincingly that the Congress is
dedicated to ensuring the financial integrity and vitality of our
markets. While recent events have shaken investor confidence in the
financial reporting by public companies and the integrity of our
securities markets, your support of the SEC in both fiscal 2003 and
2004, and the landmark Sarbanes-Oxley Act, will help reinforce the
foundations of our markets and demonstrate their resiliency.
Although I have been at the Commission only since February 18th, I
look forward to continuing and building on the strong and cooperative
relationship that our Agency has developed with you in the past as we
work together on the SEC's resource needs to implement the Sarbanes-
Oxley Act and fulfill all of our statutory duties. This is a critical
time for the agency and the way we address the challenges before us
will determine not only where we go tomorrow, but for years to come.
In many ways, it may be time for the SEC to go through a
transition--much like the transition that the U.S. military has
experienced in recent years--and evolve into a much more efficient
force, becoming quicker, more agile, and more pro-active. I am now
reviewing with senior staff the Agency's operations and resource needs
to determine appropriate changes to address both our internal and
external needs. My hope is that the SEC can develop a new approach to
our mission, as the military has done, so that we can play offense more
often, be more pro-active, and anticipate the problems we may face.
fiscal 2003
Although this hearing is for the Commission's 2004 appropriations
request, I believe it is necessary to put this request in the context
of our fiscal 2003 funding level. Thanks to your efforts, the
Commission was appropriated $716.4 million to fund its operations this
year as part of the recent omnibus appropriation. These funds will
enable us to meet the remaining fast-approaching deadlines of the
Sarbanes-Oxley Act, hire over 800 new staff, advance initial start-up
funds to the Public Company Accounting Oversight Board, improve our
training efforts, and address our most pressing information technology
needs. We will continue each of these activities in fiscal 2004 and for
that reason I would like to discuss them now.
Additional Staff
The new staff provided in fiscal 2003 will focus equally on the
complex issues that we currently face and on the fundamentals upon
which the Commission was built: full disclosure, fairness,
transparency, and investor protection. Investor confidence is
predicated on ``minding our knitting'' in these core areas. I believe
that any budget increases we receive must be targeted to the programs
and activities that will have the largest impact on our mission. In
this regard, the budget that was prepared prior to my arrival calls for
the following staffing increases in our major program areas:
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Prevention and Suppression of Fraud........................ 188
Full Disclosure............................................ 204
Investment Management Regulation........................... 178
Regulation of Securities Markets........................... 201
Legal and Economic Services................................ 22
Program Direction.......................................... 49
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My initial review of these numbers suggests that overall this level
of increase is warranted. However, during the next several weeks and
months I intend to delve more deeply into each program area to verify
personally that this is the best and most effective and efficient use
of our new staffing. I would therefore like to reserve my option to
make changes.
As discussed below, we will hire aggressively but thoughtfully, not
just to increase head-count. As a result, these hiring targets may only
be met over a longer period of time, but they will be met with people
that we are sure can perform the vital tasks that we assign to them.
And we are committed to train and integrate new staff as we bring them
on. We are grateful that legislation has been introduced in both the
House and Senate to help the Commission expedite and streamline the
hiring process so that we can bring on additional, mission-critical
securities industry accountants, compliance examiners and economists as
quickly as possible to get on with the business of protecting America's
investors.\1\ The Commission strongly supports this legislation and
hopes that it will be adopted at the soonest possible time and signed
into law by the President. Without this expedited hiring authority, the
Commission will not be able to hire the additional staff it needs--and
which the Sarbanes/Oxley Act contemplates--in any responsive time
frame.
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\1\ See H.R. 658/S. 496, ``The Accountant, Compliance, and
Enforcement Staffing Act of 2003''.
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Today, over half of all U.S. households are invested in our capital
markets. Twenty years ago, that rate was less than 20 percent. Just to
use one example: mutual fund investments today exceed by more than $2
trillion the amount on deposit at commercial banks and are approaching
the approximately $7 trillion in total financial assets in the
commercial banking system. The SEC has only 354 examiners to oversee
these mutual funds and investment advisers. In addition, while there
are over 7,800 registered broker-dealers--with more than 88,200 broker-
dealer branch offices--in the United States, the SEC's broker-dealer
examination program has only 218 staff to conduct inspections of these
institutions. These facts, along with the accounting scandals that have
plagued us, reinforce what we all know: our markets have changed, and
grown, dramatically, investor confidence has been shaken, and the SEC
must act decisively to deal with these challenges.
Equally important, I believe that the efficient functioning of the
SEC is as much a part of investor protection as ushering in new rules
and regulations. I have presided over similar management challenges
while in the private sector and seen first hand what it takes to grow
rapidly and responsibly and improve performance. The organizational and
cultural changes that accompany the opportunity you have provided me
are significant and require regular attention. Toward this end, the
yardstick for measuring our success will be based both on the number
and quality of immediate program improvements and on meeting the
agency's long-term goals of investor protection and market strength.
Two operational areas that play a significant role in this regard are
staff training and management accountability.
Training and Management
New staff and the need for regular training go hand-in-hand. For
this reason, the Commission will increase significantly its emphasis on
frequent, in-depth staff training. Given the challenges we face, we
need to ensure that staff continue to have the tools and skills
necessary to fulfill their duties effectively. We cannot afford to have
our most skilled employees leave the agency or be underutilized. Pay
parity and the downturn in the economy have helped attract top talent,
but there is more that we can do.
Management accountability is also central to our ability to perform
our duties. I intend to enhance the Commission's operations by
establishing a system to better train, evaluate, develop, and mentor
managers and supervisors. This effort is consistent with the goals of
the President's management agenda and is the right thing to do. We
cannot expect SEC staff to successfully fulfill their duties if they do
not have supervisors with the skills and tools to lead them. We must
set expectations and reward our managers and staff accordingly.
Information Technology
The Commission's operational challenges also extend to our
information technology program. Prior to enactment of our fiscal 2003
appropriation, our Office of Information Technology had been structured
to maintain our existing information technology systems, undertake a
few smaller projects each year, and complete only one large-scale
initiative at a time. We have accomplished this level of activity
primarily by developing a robust information technology capital
planning program and relying heavily on contractors and outsourcing.
This approach has been essential given past resource constraints, but
it has left us with badly outdated IT capabilities. We must now be
critically introspective, bring in broad IT expertise to evaluate our
needs and further increase the involvement of our agency's divisions
and offices in our information technology decisions. To meet our needs,
program staff must work side-by-side with a reinforced information
technology staff, and we must increase the number of information
technology program managers we have available to assist the program
offices in developing major applications to improve our effectiveness.
While these hiring and cultural changes may not appear revolutionary,
they are nonetheless significant and multi-year in nature, especially
when viewed against our current inventory of major information
technology needs.
The fiscal 2003 funding level allows the SEC to undertake three new
major, multi-year information technology projects. The first one
addresses the Commission's need to move away from paper documents. It
is the development of a robust document management and imaging system
that will make it easier for our attorneys, examiners, and others to
cull through the tremendous volumes of information that they review and
file as part of their investigative, inspection, and enforcement
activities. This system will provide agency-wide electronic capture,
search, and retrieval of all investigative and examination materials
and will be designed to meet the demands of our document-intensive
litigation program, and to assist our examination staff in analyzing
the content of documents more effectively.
As an aside, one of the first things I noticed when I arrived at
the Commission's headquarters and walked around was the extent to which
the SEC is physically drowning in paper files. We need to make it
easier for staff to do their jobs and to share information with each
other. Document management and imaging are key components of this and,
while it will be a multi-year effort, it is long overdue.
The second project holds equal potential to improve the efficiency
and effectiveness of the Commission: a comprehensive change in our
filing and disclosure processes, especially regarding financial
reporting. The effort to improve the filing and transparency of public
company disclosures is expected to lead to significant business process
changes that will result in the elimination of confusing forms, the
collection of uniform data from filers, and internal operations
improvements that will allow staff to conduct more rigorous financial,
industry-specific, and comparative analyses. Although this project will
be carried out by issuers, their accountants and their other advisors,
under the leadership of the SEC, the principal beneficiaries of this
initiative ultimately will be the nation's investors, who will have
more understandable and reliable financial information upon which to
base their investment decisions. This will result in a fundamental
improvement in the transparency and comparability of firms' financial
statements, which should significantly increase investor confidence.
When the agency's electronic filing system (EDGAR) was originally
created, it did a terrific job of converting paper disclosures and
filings into electronic documents and making more information available
to the public. We now need to take the next step. As part of a
comprehensive review of our business processes, we need to change how
we work and alter EDGAR accordingly. We need to revisit what
information staff must have readily available to conduct more intensive
and robust disclosure reviews. For instance, while we receive and
archive the EDGAR data, we cannot immediately analyze them. Instead, we
depend on outside vendors to transfer the numbers in the text of the
filings to machine-readable form that we can then analyze. We are in
the process of designing tags for EDGAR filings that would allow
anybody to extract machine-readable data from them. These initiatives
will allow us to conduct analyses and monitor trends in real-time.
Our third major information technology requirement is to enhance
our disaster recovery program. The SEC learned first-hand from the
events of 9/11 and the experiences of its Northeast Regional Office, in
New York, of the importance of keeping its data even more secure than
it already is. In addition, we need to have the capacity to store and
move large amounts of data from one regional or district office to
another without first going through Washington. We need to move to a
true ``point to point'' information technology system that allows us to
mitigate the loss of data and to recover quickly in the event that we
need to implement our continuity of operations plan. When this project
is complete, the agency's critical files and information systems will
be backed up daily and in multiple locations.
Sarbanes-Oxley Act
Since enactment of the landmark Sarbanes-Oxley Act last summer, the
Commission has worked vigilantly to meet the Act's timeline and
mandates. Within 30 days of the Act's signing, we adopted rules
requiring CEOs and CFOs to certify their financial statements and
accelerating insider transaction reporting to two days.
This past January was the busiest month of rulemaking in the
history of the SEC. We adopted nine other Sarbanes-Oxley mandated rules
relating to: Pro-forma financial information, codes of ethics for
senior executives, financial experts on audit committees, trading
during pension fund blackout periods, disclosure of material off-
balance sheet transactions, retention of audit records, independence
standards for public company auditors, standards of conduct for
corporate attorneys, and the application of certain Sarbanes-Oxley
certification and disclosure requirements to registered investment
companies.
In addition, we sent four separate studies to Congress related to:
Penalties and disgorgements in our enforcement cases, securities
professionals who have ``aided and abetted'' federal securities law
violations, commission enforcement actions involving reporting
violations and restatements, and the role and function of credit rating
agencies.
We met these deadlines without sacrificing our other work or
obligations--including our robust enforcement program and numerous
regulatory initiatives unrelated to Sarbanes-Oxley. For example, in
January we also adopted rules regarding proxy voting by investment
companies and investment advisers, and in February we adopted rules
regarding analyst certification of research reports. And we're hard at
work on other rules and studies, including rules related to: Improper
influence on auditors, listing standards related to audit committees,
governance of the Public Company Accounting Oversight Board, investment
adviser and investment company compliance policies, public company
internal control reports, critical accounting policies, and expanded
current reporting.
Public Company Accounting Oversight Board
Selection of a new chairman
The Commission recently announced that it adopted a plan to select
a Chairman of the Public Company Accounting Oversight Board established
pursuant to the Sarbanes-Oxley Act of 2002.\2\ The plan calls for the
Chairman, the Commissioners, and the staff to reach out and solicit
input from a variety of sources, including key members of Congress,
investor advocates, academics, and members of the business community.
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\2\ See ``Statement of the Commission Regarding Selection Process
for Chairperson of the Public Company Accounting Oversight Board
(PCAOB)'' March 4, 2003, http://www.sec.gov/news/press/2003-28.htm.
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As I said in my confirmation hearing before the Senate Banking
Committee, the selection of a Chairperson for the Public Company
Accounting Oversight Board is my number one priority, and I am pleased
that the Commission has been able to build upon the recommendations of
the General Accounting Office and quickly devise a thorough and
expeditious process to identify and vet potential candidates.
The SEC staff will incorporate new suggestions, update the list of
qualified candidates and circulate it to the members of the Commission.
The Chairman and the Commissioners will narrow that list based on the
criteria in the Sarbanes-Oxley legislation, additional criteria that
the Commission finds desirable, but not mandatory, and the individual's
willingness to serve.
Each candidate on the narrowed list will undergo a preliminary
vetting process. Upon completion, each member of the Commission will
interview the leading candidates and a thorough background review will
be completed. Following this review and consultation with the Chairman
of the Federal Reserve and Secretary of the Treasury, as required, the
Commission will vote to approve the appointment of a Chairperson.
The Commission will be looking for an individual who has experience
running a dynamic and innovative organization; is well recognized by
those participating in the financial markets and possesses a keen
understanding of those markets; is independent from any particular
constituency; has experience that demonstrates an understanding of the
role of auditors in the Commission's financial accounting and
disclosure system; has no known impediments or controversies that might
impair his or her ability to lead, or the public's ability to rely on
the individual to lead; and is willing and able to serve a five-year
term.
In addition, we are seeking a person who has the ability to
consider impartially ideas, information, and data from all sources, to
seek additional input whenever it appears necessary, and to make timely
decisions, as well as the ability to absorb complex information,
analyze it objectively, and make rational decisions. Of course, we want
someone who has the ability to communicate effectively, has a
demonstrated commitment to public service and to the PCAOB's mission,
as well as an awareness of the financial reporting and auditing
environment. The individual we choose should have a demonstrated
ability to create a collegial working environment and instill public
trust.
My hope and expectation is that the Commission will move
expeditiously and select a new chairman for the PCAOB as quickly as the
process allows.
Funding advance
The fiscal 2003 budget provides the resources necessary for the
Commission to advance start-up funds to the Board. The Commission
initially advanced $1.9 million to the Board on January 15, 2003. On
March 28, the Commission approved a more substantial second advance of
$13.5 million that will fund the Board's operations through May and
allow them to begin the development of state-of-the-art information
systems to be used in their registration, billing and collection, and
professional oversight programs. The Board has stated its intention to
repay all of these funds to the Commission by the end the current
fiscal year.
Commission Oversight
The Commission has significant responsibilities related to the
oversight of the Board, including approving the Board's budget and
rules and adjudicating appeals from the Board's decisions on
registration, inspection, and disciplinary matters. We have developed
close communications and a good working relationship. For example, the
Board and the Commission recently participated in a roundtable on
issues related the Board's registration and oversight of foreign
accounting firms.
Utilization of Commission Resources
We have tremendous needs for the new resources made available in
2003 and have plans in place to meet these needs. However, I want to be
sure--and I am committed to making sure--that every penny of that new
money is spent wisely. I am determined that we take an aggressive but
thoughtful approach to resource allocation. We will bring on the people
we need to help us fulfill our mission, and not simply increase our
head-count. I view this allocation of resources and renewed commitment
to the SEC's needs as a multi-year effort to ensure that we make long-
lasting and substantial improvements in the SEC's programs that will
restore confidence and benefit our nation's investors.
fiscal 2004
The President's request for $841.5 million in fiscal 2004
recognizes that the Commission's needs are growing and ongoing. As I
stated earlier, this request is the largest amount the Commission has
ever received and will allow us to continue all of the efforts that we
are undertaking in fiscal 2003. In particular, it will allow us to
focus further on financial frauds, review of public company filings,
our new risk-based examination program, and the ongoing requirements of
the Sarbanes-Oxley Act.
Enforcement Activities
The Commission has played, and will continue to play, a vital role
in protecting our markets from fraud, manipulation and other practices
that continually threaten to undermine their integrity. To meet the
challenges facing us--including the unprecedented number of significant
financial frauds and accounting failures, new securities products,
technologies, and globalization--the Commission's enforcement program
will continue to add personnel, including investigative attorneys,
accountants, and market surveillance specialists.
The Commission has responded swiftly to the recent rash of
accounting failures. In fiscal 2002, approximately 27 percent of all
filed enforcement actions involved financial disclosure and issuer
reporting violations. Financial reporting and accounting cases remain
our number one enforcement priority, and numerous financial fraud
investigations are currently underway. These types of investigations
require a significant commitment of staff resources because they are
fact- and document-intensive and include reviews of the conduct of a
variety of individuals and entities. The Commission's enforcement
program will continue to need additional attorneys and accountants to
assist in these complex financial fraud investigations.
As the Commission seeks to aggressively investigate and punish
corporate fraud, an increasing number of defendants are choosing to
litigate. Even many cases that are ultimately settled are the subject
of protracted litigation prior to settlement. Commission litigators are
now actively involved in nearly one-half of recently filed cases. In
addition, our litigation and investigative staff are increasingly
involved in emergency court actions in an attempt to secure investor
funds before they are lost forever and to alert the investing public to
false and misleading disclosures being made by issuers. It is critical
that the Commission maintain a strong litigation capability because it
is the credible threat of litigation that allows us to pursue
wrongdoers effectively and win our cases or settle them on favorable
terms.
Additionally, the growing internationalization of the securities
industry and the securities markets has added new challenges for the
Commission in combating securities fraud. An increasing number of the
SEC's enforcement cases have substantial international dimensions that
make it more important for the Commission to work closely with its
international counterparts in enforcement and inspection activities.
Our staff devotes much time and resources to tracking down assets that
have been sent abroad.
And finally, the Commission's enforcement staff works closely with
U.S. Attorneys' Offices and the Department of Justice to obtain
criminal sanctions as appropriate. This association was recently
institutionalized by President Bush when he created Corporate Fraud
Task Force, of which the Commission is a member and the Department of
Justice heads. We also will continue to detail enforcement staff, in
appropriate situations, to U.S. Attorneys' Offices around the country
to support criminal prosecution of securities fraud.
Market Structure Issues
The rules governing trading within equity markets and the
relationship among competing equity markets is another area that the
Commission will focus on this year. Aware that such issues were coming
to a head, the Commission organized two full days of market structure
hearings in October and November 2002. Participants at the hearings
included senior staff members of the New York Stock Exchange, Nasdaq,
American Stock Exchange, and Chicago Stock Exchange; market makers,
specialists, Electronic Communication Networks, and agency brokers;
buy-side traders; representatives of individual investors; and
respected academics. In the remainder of this fiscal year, the
Commission will devote significant resources to the development,
proposal, adoption, and enforcement of the policy actions that will be
necessary in this area.
Review of Filings of Public Companies
The Division of Corporation Finance has been enhancing its
selective review program to target issuers whose review would most
protect investors--large companies, companies in critical sectors,
companies that present particular perceived financial or disclosure
risks. This targeted approach is consistent with the directives
contained in the Sarbanes-Oxley Act. The review of the Fortune 500
companies undertaken last year is an example of this approach. As
review resources and technological enhancements that will assist in the
assessment of risk are added to the Division, the review process will
become more robust. While the review process cannot eliminate or
identify all financial fraud or identify those who are determined to
commit fraud, the review process will better fulfill its objectives of
improving disclosure and deterring fraud.
The review process is increasingly focusing on financial reporting
and financial disclosure because these are the areas where defective
disclosure puts investors at most risk. To permit this focus,
recruiting and hiring of review staff will emphasize accountants and
those who are able to perform financial reviews.
The Sarbanes-Oxley Act also requires review of each reporting
company at least once every three years. We are in the process of
developing review processes that will permit us to meet that goal. Here
too, the additional resources that we are adding to the Division are an
essential element and will allow us to satisfy that mandate over a
multi-year period. We will also use those resources to meet that review
requirement in an efficient and effective way, and we intend to do so
in a manner that does not undercut our investor protection objective.
Risk-Based Examinations
With the additional staffing provided in fiscal 2003, the
Commission's examination and inspection staff will be able to implement
our new enhanced risk-based inspection program. For investment advisers
and mutual funds, this enhanced program will allow examiners to
recognize the different levels of risk inherent in the operations,
management, and compliance processes of investment advisers and funds.
In particular, those registrants that have relatively higher risk
profiles will be examined every two years, while all remaining firms
will be examined no less frequently than every four years. New firms
will be inspected within the first year of their operation. These more
frequent inspections are a substantial improvement over the five-year
inspection cycle used to schedule inspections prior to fiscal 2003. For
broker-dealers, the new staffing levels will allow us to increase
substantially our oversight of the risk management and internal
controls of the largest broker-dealers that have the most customer
accounts, and also to increase the small number of broker-dealer branch
office inspections that we are currently able to conduct.
Other Sarbanes-Oxley Act Requirements
While the Commission has made tremendous progress in implementing
many of the critical components of the Sarbanes-Oxley Act and has met
each of its statutory deadlines, important initiatives and additional
rulemaking pursuant to this historic legislation will continue to be a
top priority for the SEC. In addition to the numerous substantive rules
already adopted, a number of Commission actions are still mandated by
deadlines set within the Sarbanes-Oxley Act. These forthcoming SEC
actions include: the ratification of key rules and procedures for the
Public Company Accounting Oversight Board; the adoption of rules on
analyst conflicts of interest; the recognition of generally accepted
accounting standards; as well as studies and reports relating to both
principles-based accounting and off-balance sheet transactions and
special purpose entities. I am confident that the Commission and its
dedicated staff will continue to work tirelessly to implement these
remaining provisions of the Sarbanes-Oxley Act.
Other rulemakings under the Sarbanes-Oxley Act, although not
limited to a statutory deadline, also will play an important role in
improving investor confidence in the credibility of reported financial
information. For example, management and auditor reports on an issuer's
quality controls over its accounting and financial reporting systems
may enhance the quality and implementation of those controls, which, in
turn, should improve the quality of financial reports and audits.
Another important area that will require the use of more Commission
resources is international affairs. The development of international
accounting, auditing, disclosure and enforcement standards is gaining
momentum and will require more monitoring of and participation in
international bodies that are promulgating and interpreting standards
that could impact the credibility of information used by American
investors.
conclusion
In closing, let me reiterate how honored I am to serve as Chairman
of the Commission at this time of great opportunity. Thank you again
for inviting me today to speak on behalf of the needs of the investing
public. I would be happy to answer any questions that you may have.
PAY PARITY
Senator Gregg. Well, thank you, Chairman Donaldson. I have
a couple of questions. First, after considerable effort we were
able to get pay parity in place for the SEC. I'm wondering how
it is working, whether you think it is going to allow you to
attract the types of individuals you need and keep the
individuals who are there and who are critical. You are in a
business which, up until a few years ago at least, was
extremely competitive for staff, although now you may be able
to find staff with a little more ease. Our concern is that the
SEC retain its caliber staff. Is there something further we
should do, or is pay parity working?
Mr. Donaldson. Well, I think, bottom line, pay parity is
working. We probably have had too short a period of time to
measure, but just to give you some numbers, our attrition rate
before pay parity was averaging around 14 percent, and our
latest figures indicate that it's 4 percent or less right now,
so so far, so good. There are other items associated with the
hiring of professionals which maybe we can get into, but as far
as pay parity, it seems to be working. It's a tremendous help.
HEDGE FUNDS
Senator Gregg. A question in another area, hedge funds are
sort of viewed as the Wild West of the investing community
these days, especially Wall Street. I'm wondering if the SEC
has any concerns about whether or not we need additional, or
whether or not you intend to propose additional, regulatory
activity in the area of hedge funds and accounting disclosures
and activities there.
Mr. Donaldson. Clearly, the whole area of hedge funds is
one in which we need to have more information. The latest
numbers indicate that there are some 6,000 hedge funds in
operation right now, with some $600 billion under management.
The money is flowing in. The growth in hedge funds over the
last decade has been considerable.
I would stop and say that I think there's a slight misnomer
that the name hedge fund implies. Many of the funds that are
classified as hedge funds are not hedged at all, they're simply
investment pools, but let's use that term.
I think our posture on this is that the SEC has been,
before I got to the SEC, attempting to get information about
hedge funds, and since I've arrived we have initiated what will
be a roundtable discussion in May for 2 days in which we're
inviting a broad cross section of people associated with hedge
funds and so forth to come in and tell us about what they're
doing. So by the end of May we'll have a lot more information.
I would say generally that we just need to know more about
the techniques that are being used by hedge funds. We need to
know more than we know now about who is investing in these
funds. By and large they are unregulated by the SEC. Some are
regulated under the Investment Advisors Act. We see some trends
in terms of what I would call the retailization of hedge funds,
that is, the putting together of groups of smaller investors,
which is something I think we have to examine.
Up until now, by and large, you've had to have certain
investable assets and certain income levels in order to be
invested in these funds, and in order for the funds to maintain
their nonreporting status, and I think that game has shifted.
So I think it's too early for us to make a judgment, but we're
going to put some resources into looking at that so the next
time you ask that question we can give you a good answer.
Senator Gregg. Well, following up on that, from what you
said I understand you are still early into this issue, but what
do you see is the basic risk that you would be concerned about
from the standpoint of protecting the public relative to hedge
funds?
Mr. Donaldson. Well, as you well know, there was a serious
risk that almost caused a financial collapse in the case of
Long-Term Capital Management, which was a particular kind of
hedge fund that employed macroinvestment decisions and heavy
leverage. That was a great concern when the markets turned
against them, and I think the U.S. Government did a terrific
job of stepping in with the Treasury Department and the Federal
Reserve, and basically avoiding a collapse that could have been
very damaging to other people.
Right now, I think that area has been well covered. The
area of potential risk now is the new entrants into the field
that we see as Wall Street has had its problems here in the
last 3 or 4 years. We see a lot of people breaking off from
Wall Street firms, from investment counseling firms, and
setting up hedge funds--one or two people raising money for
those hedge funds--so you have a lot of potential here for
inexperienced people with a totally unregulated vehicle getting
themselves in trouble.
We don't know how much leverage is being used in some of
these funds. We need to know more about that. We need to know
more about some of the trading techniques, so that I think
right now all I can say is that we need to know more about
what's going on.
Senator Gregg. Senator Hollings.
STATUS OF ENRON CASE
Senator Hollings. Chairman Donaldson, we are very lucky, in
my opinion, to have you take this particular assignment,
because everyone has confidence in you.
I want to ask about two touchy things, one on the Kenneth
Lay case. The reason I ask is, we had the Attorney General just
the other day, and he appears before us and he relates all of
the hard-charging comedown on corporate corruption, we've
cleaned up corporate corruption in this Government of ours and
everything else, and he listed the cases and what-have-you, and
then when you ask about the leading case that we all know
about, Kenneth Lay, he said, wait a minute, I've recused
myself, I don't know anything about it. Do you?
I mean, they've made reports to the Securities and Exchange
Commission, and you're the Chairman. I hope you haven't recused
yourself. Kenny boy didn't give you a contribution, did he?
Mr. Donaldson. Let me say what I can say.
Senator Hollings. The reason we're interested in this is,
right to the point, we as good lawyers know how you can bring--
we've defended the charges and we've brought charges and
assisted in the prosecution. Before the Commerce Committee the
entire California crowd appeared, and the authorities just
listed out the fraud and how it was conducted, whereby they
would ask for way more than their allocation in energy
shortages and then take the excess of that allocation and ship
it out, ship it back in and get it at the higher price because
it was imported and what-have-you.
So I said, well, wait a minute now, referring to Mr. Lay
and Enron knowing about it, I said, I remember specifically
earlier this morning Ms. Lay appeared on my TV and said her
husband didn't know anything about it, and Mr. Freeman was the
witness. He said, the dickens he didn't, he knew everything
about it. He was running it. He was in charge.
So you know, there are a lot of things about knowledge and
what-have-you, but here you've got testimony before the
Congress that they knew it, and it was a fraud, and California
now has brought suit for $7 billion or $8 billion, whatever it
is, for reimbursement, but we don't ever hear anything, and
1\1/2\ years has passed, and we all are proud about how we have
come down hard on corporate corruption, but all of a sudden
this case disappears.
In the meantime, back at the ranch, they said, wait a
minute, you know, the fellow in charge of corporate corruption
was out of the law firm that represented Enron, namely Mr.
Larry Thompson, so what gives here? I mean, I'm trying to find
out the status of that case.
Mr. Donaldson. Well, you bring up a number of issues; there
is the criminal case, and there is the civil case. Just to give
you a little background, the Enron criminal investigation is
being led by the Enron Task Force, and that was formed in
January of 2002 to investigate all the matters related to
Enron, and it is overseen by President Bush's Corporate Fraud
Task Force which includes us, the SEC, and the Department of
Justice. It is a team of federal prosecutors supervised by the
Criminal Division and agents of the FBI and the IRS Criminal
Division.
That task force also has coordinated with and received
considerable assistance from the Securities and Exchange
Commission. Now, as far as the civil case is concerned, last
August the SEC filed a case against Michael Kopper, who is a
former top Enron official accused of violating antifraud
provisions, and then in October we filed a case against Andrew
Fastow, who is Enron's former CFO, alleging violations of the
antifraud, periodic reporting, books and records provisions and
so forth.
Most recently, last month the Commission charged Kevin A.
Howard, the former chief financial officer, and Michael W.
Krautz, the former senior director of accounting of Enron
Broadband Services, and also March 17, charged Merrill Lynch &
Company and four of its former senior executives with aiding
and abetting Enron securities fraud. Now, that is the first
time that the SEC has brought an aider and abettor action
against a bank.
Now, as far as a general comment on your question
specifically referring to Lay----
Senator Hollings. He was the chief executive officer.
Mr. Donaldson. He was the chief executive officer, and I
think I can say that the coordination of the criminal and civil
action requires a lot of very careful building blocks, if I can
put it that way.
Senator Hollings. You are building a case, is what you're
saying?
Mr. Donaldson. The building blocks have to do with the way
the criminal justice system works. It has to do with the way
information is received. Information can be received by the
Justice Department a little more completely than it can by us.
I guess what I'm saying is, without commenting specifically on
that case, that we're on the case of all the Enron activities.
EXPENSING STOCK OPTIONS
Senator Hollings. If Mr. Donaldson says you're on the case,
that's sufficient for me. Let me ask this, and go to another
thing that Arthur Levitt, when he was the Chairman, he tried to
get these stock options expensed. We tried to, Senator Levin
from Michigan, he put in an amendment. We were all ready to
vote on the amendment, then all of a sudden the majority leader
and the minority leader said no, we are not going to take--
we're going to take it up later, and later is 1 year ago I
think, and we haven't ever taken it up.
I got right to the point with WorldCom, and one of the
officials I'm asking, I'm saying how in the Lord's world did
you give Ebbers a $400 million loan, and the answer was, we had
to. I said, you had to? He said, yeah, he had all of these
options and he had built them up and built them up, and he had
them, and he was going to cash them in twofold. He was going to
ruin the financing we had on course for WorldCom-MCI on the one
hand and of course destroy the value of the stock, so we had to
give it.
Corporate governance shouldn't work itself into that kind
of cul-de-sac, and we're ready to do it, and I have heard, I
believe, your comment that they should be expensed. You can't
do it both ways. They are an expense, but they're not one. What
is the position that the Securities and Exchange Commission has
taken? What is being done? Do you want us to write it into this
bill? I would be glad to try to write it in here that we
expensed the stock options so we can really get corporate
governance back. That was the real thing, and it's still
bothering us, these excessive executive salaries.
We had to write on the bill just the day before yesterday,
or last week I guess it was, Friday, that here we were
financing the airlines $3.5 billion. All the airlines' stock,
net worth of all the airlines does not come up to $3.5 billion.
We've given them more money than they are all worth if you put
them all together, and we said well, that's pretty bad, but
even worse is, look at these bonuses they are giving, these
millions and millions of dollars of bonuses as they all go
broke, rewards for going broke. This is what's ruining--nobody
wants to invest in a stock market that's got those kind of
stock options on the one hand and financing companies giving
excessive bonuses and everything else like that on the other
hand for going broke. That's the problem that you have.
Mr. Donaldson. Well, let me make just a couple of comments.
I have made, as you allude to, comments on this subject during
my confirmation hearing, and I will state again unequivocally
that I believe that stock options are an expense and that that
expense needs to be reflected. That is point number one.
Point number two, and the more difficult question, is how
to do it? How do you come up with a value? In a complex
situation in terms of valuing those options over differing
periods of years and so forth, and different markets, what is
the value that should be reflected on the day that those
options are given? A lot of them expire with no value. A lot of
them are tremendously valuable. How do you rate that? How do
you do it?
The FASB has committed themselves now to come up with a
formula for expensing those options and an accounting standard
for doing so, and I'm going to be very interested to see that
standard. It is not an easy calculation, but they have
committed themselves.
Senator Hollings. Will that be a rule of the Commission,
then, once they make that recommendation?
Mr. Donaldson. As you know, under the new arrangement with
the Public Accounting Board, we will both be very much
listening to the rules proposed by FASB. I think we are going
to see that your desires are fulfilled here.
Senator Hollings. And your desires.
Mr. Donaldson. And my desires, absolutely.
Senator Hollings. Thank you very much, Mr. Chairman.
Senator Gregg. That will have a tax effect too. Will the
Treasury be included in that exercise?
Mr. Donaldson. The final rule will be an accounting rule,
and our new oversight board with the primary responsibility at
the first level will be there, but of course their rulings and
so forth come through us and have to be approved by us, so we
will have the ultimate responsibility.
PUBLIC COMPANY ACCOUNTING OVERSIGHT BOARD
Senator Gregg. How about this accounting board? How are you
doing in getting that going, and especially what are we going
to pay these people, talking about pay?
Mr. Donaldson. As to the status of the Board, as I've said
publicly, it is a number one priority for me as the new SEC
Chairman to get the right person to be Chairman of the
Accounting Board. Although I'm saying me, it ultimately is our
Commission that will appoint that chairman.
We instituted a process within 1 week of my arrival, a
process for searching for that person. I will not bore you with
all the details of the process, except to say that we reached
out in a broad and public way to add to our list. We talked to
anybody and everybody that would talk to us about making
suggestions. We brought in a tremendous number of names. We
then had a time-phased process that boiled that down.
We have boiled it down. We are in an advanced stage now,
and I think that what I would say is that for anybody that has
been in the recruiting business, if you will, we don't want to
make a mistake on this. We want to get the right person, and
generally speaking, the right person is not always readily
available.
Again, my experience has been that oftentimes the right
person is happily doing something else, and so it is a
recruiting effort to get the right person to come. But I am
encouraged by the work to date, and I think presently we will
have somebody, sooner, I hope, than later.
Senator Gregg. Not to be parochial about this, but you're
the right person for the SEC. You would probably be the right
person for this board also, and obviously in taking the SEC job
you're not getting paid a lot of money compared to what you
made in the private sector. Yet the salary for this accounting
board is being set at like $500,000, which is about twice what
we pay the President.
Mr. Donaldson. I can tell you what the relationship is to
my salary.
Senator Gregg. Your salary and my salary. The Chief Justice
of the Supreme Court is paid about $160,000, I think. I'm not
sure that it is understandable why we need to pay so much. I
mean, isn't the person who takes this job going to be mostly
doing it as a public service, as you are doing your job, as the
President does his, and we hopefully do ours, and as the Chief
Justice of the Supreme Court does his?
Mr. Donaldson. Well, I understand exactly what you're
saying, and I think you have to go into the history, which you
probably know better than I do, of the Sarbanes-Oxley
legislation and what went into the status of the Public Company
Accounting Oversight Board, and it is not a Government agency.
It was set up as an independent privately incorporated agency.
Senator Hollings. Why?
Mr. Donaldson. The reason for that, and again I'm
speculating on this because I had nothing to do with
establishing it, was that there are a lot of other entities out
there in the private sector such as the FASB and other entities
like that, which are attracting people to work there with
private sector compensation. And I think the intention of
Sarbanes-Oxley was to be able to go out and get not only the
members of the Board, but also to get staff members, who were
competitive with the best people available out there. So the
Oversight Board was ordered to set a salary level that was
comparable to what would exist, not in total private sector
America, but comparable organizations.
They did that and came up with that salary level. Actually
it is slightly over $500,000 for the Chairman and $450,000, I
think, for the members of the Board, and that received the kind
of negative comments which you've expressed here.
I will stop there, except to say that they are doing what
they were ordered to do. Whether they could have modified it or
presented it in a better way remains to be seen.
Senator Gregg. I suspect the right person to do it won't do
it just to make money.
Mr. Donaldson. Excuse me, not to interrupt you, but I think
you just don't know--I mean, you just don't know. You're
absolutely right that certain people are not going to do it,
but certain other people maybe will.
SARBANES-OXLEY ACT
Senator Gregg. On Sarbanes-Oxley, how is it working? It's 8
months into it. I hear grumbling. Maybe that's because it's
working. Do you see issues out there that we're going to need
to revisit?
Mr. Donaldson. As you know, the SEC has been in an
extensive rulemaking mode here, and we're coming to the end of
that.
I think that so far, so good. I think that the system is
working the way it should work, which is that a law is passed
and the rulemaking based on public comment and so forth can
address some of the unintended consequences of the law,
maintaining the spirit of the law, but being practical about
the unintended consequences.
I think it is working quite well. If you go out into
corporate America, particularly in the audit committee
function, which is where some of the rules are most advanced, I
think there's a heightened awareness of the responsibility of
the audit committee.
There are still some issues that we have to cover by
rulemaking, but I think it's working pretty well. I say pretty
well because there's a lot of nervousness out in corporate
America about just exactly what these rules mean. There's a lot
of tentativeness, and that creates a kind of a distraction in
my view for people running companies. They can become so tied
up in trying to conform to the letter of the law that the risk
here is that they lose flexibility and lose sight of what's
needed to run an entrepreneurial company. That is a risk.
My own feeling in this is that--and I probably shouldn't
say this--but I feel very strongly that we can pass all the
laws that we want to, but we need the atmosphere inside the
company to be moral. The philosophy of running the company
should be that the chief executive and the board says this is
the kind of company we want to be, and we're not going to skate
right up to the minimum required by the letter of the law.
We're going to stop well short of that because that's the kind
of company we want to run, and until companies do that and have
a code of ethics that is more than just written on paper, I
think we will not have solved our problems.
I might go on to say that I think that there is a shift
here, largely as a result of Sarbanes-Oxley, of the power, if
you will, and authority to the board away from the chief
executive who operates as he or she wants to. Gradually the
boards of directors are recognizing that it is their
responsibility to the shareholders to set that tone, and then
to hire management that has the same feelings about the ethics
of doing business.
EFFECT OF SARBANES-OXLEY ON CORPORATE DIRECTORS
Senator Gregg. I couldn't agree more with your explanation
of the philosophy and how it should work. I'm wondering,
however, if, with Sarbanes-Oxley and the litigation atmosphere,
we haven't created a situation where the traditional director
no longer wishes to serve on a board of directors. In that
case, you're going to create an environment where you basically
end up with professional directors who are willing to take
risks. Taking risks is the way they make their money. This is,
I think, one of the strengths of corporate America, which is
that you get Main Street on your board of directors, and it may
be a well-heeled Main Street, but at least it's Main Street.
You talk to folks who serve as directors now and they're all
scared, and many of them won't serve.
Mr. Donaldson. This is a real problem, and I think there
are two solutions to it at least. One is that the corporate
directors themselves, the existing body of corporate directors
are going to have to figure out how many boards they can be on
to discharge their new obligations under Sarbanes-Oxley.
They're going to have to think through, and the boards are
going to have to think through as they recruit, that there is
an enhanced responsibility here and an enhanced risk, as you
say, and I think potential directors and existing directors are
going to have to look at that carefully.
Beyond that, I believe we're going to have to bring a whole
new cadre of directors into the game. It's been a relatively
small group of people who serve on many boards. That's been the
tradition, a lot of CEOs serving on other CEOs' boards. There
is a tremendous wealth of talent out there, out in corporate
America and elsewhere, who can be very good corporate
directors, and who have the time, and who will learn by doing
it and bring new dimensions.
This makes me feel that we have to organize the training of
these people, and searching for them, and we hope to be very
active in that. I commend the number of business schools and
law schools in the country, and the New York Stock Exchange,
who are all moving toward director education, if you will. And
we want to help them do that and intend to help them do that,
so I think you are going to find a lot of, I'll say young
people, but maybe older people who have not had a crack at it,
who have something to offer and are willing to take that
challenge. But we'll see.
Senator Hollings. Along that line, just as an aside, when I
was a young Governor from 1958 to 1962, that is what I had. My
Bible was right there, Dun & Brad, and I could just pick out
those corporate directors, and there wasn't any training. They
were just drinking buddies. I mean, the GE served on the IBM,
served on the General Motors, served on the Dupont. I mean, you
could find them all. I wove them into what we called the
plantation society. We've got over 100 plantations in the low
country of South Carolina, and each Sunday at 11 o'clock they
would have a brunch and go from one to the other, and I was
always at those brunches to meet those folks and everything
else, and then talk to them and try to get them to move their
industry, try to carpetbag New Hampshire.
Senator Gregg. You did a good job of it, too.
Senator Hollings. We had a good time doing it, but those
corporate--they were good. They were good. I found all the CEOs
and everything else very good, but it's gotten to the extreme.
The quarterly reports and the life of a CEO is what, 3 years or
something. He's got to get the stock up or they get him out, or
whatever it is. They just take the money and run, all kind of
bonuses, everything else like that. You've got a tough job
trying to change that with the stock exchange and everything
else and the business schools, as you indicate, working on it.
You do a lot of good work. Thank you.
CONCLUSION
Senator Gregg. Do you have anything else you wish to add?
Mr. Donaldson. Again, I'm delighted to be here.
Senator Gregg. The check is in the mail.
Mr. Donaldson. I might just add one thing, if I can, which
relates to the hiring of the people that we have to hire, we
can hire lawyers quite easily because they don't have to go
through the Civil Service posting and all of the competitive
service requirements.
We are having real problems hiring accountants and
economists and examiners. It is hard for us to compete out
there under existing hiring regulations; therefore we have been
working hard to see if we can't get those laws changed, and the
House is ready to vote out an excepted service exception for
us. By the way, our union has agreed with this, and we have
sent a letter from myself and the head of the union, who
cooperated with us. So--you asked if there was anything else
you could do.
Senator Gregg. Well, we have been known to put authorizing
language in our bill, so if you want to get us the language,
and if we can get the agreement of Senator Shelby----
Senator Hollings. That might help move it along. Any need
like that, just contact the chairman.
Mr. Donaldson. Well, I know it is not the direct
jurisdiction of this committee, but it helps us.
Senator Gregg. Well, everything is in the jurisdiction of
this committee. This is the Appropriations Committee.
Mr. Donaldson. Okay.
Senator Hollings. That's the way I was taught.
SUBCOMMITTEE RECESS
Senator Gregg. Thank you very much.
The next hearing is scheduled on Thursday, April 10, at 10
o'clock in this room, and at that time we will hear from the
Director of the FBI.
[Whereupon, at 10:40 a.m., Tuesday, April 8, the
subcommittee was recessed to reconvene subject to the call of
the Chair.]