[Senate Hearing 110-]
[From the U.S. Government Publishing Office]
FINANCIAL SERVICES AND GENERAL GOVERNMENT APPROPRIATIONS FOR FISCAL
YEAR 2008
----------
WEDNESDAY, MAY 16, 2007
U.S. Senate,
Subcommittee of the Committee on Appropriations,
Washington, DC.
The subcommittee met at 3:07 p.m., in room SD-192, Dirksen
Senate Office Building, Hon. Richard J. Durbin (chairman)
presiding.
Present: Senators Durbin, Brownback, and Allard.
SECURITIES AND EXCHANGE COMMISSION
STATEMENT OF HON. CHRISTOPHER COX, CHAIRMAN
STATEMENT OF SENATOR RICHARD J. DURBIN
Senator Durbin. Good afternoon. This hearing will come to
order.
I am pleased to convene this session before the Financial
Services and General Government Appropriations Subcommittee.
Our focus today is on the President's fiscal year 2008 budget
request for the Securities and Exchange Commission (SEC). In
previous years funding for this agency was provided through the
Commerce, Justice, and State, the Judiciary Subcommittee. It
now has a new home in the Senate Financial Services
Subcommittee.
I welcome my colleague Senator Allard who has joined me and
others who may arrive. Appearing before the subcommittee this
afternoon is the Chairman of the SEC, the Honorable Chris Cox.
Welcome, Chairman Cox. Glad to have you here, my former
colleague from the House.
The mission of the SEC is to administer and enforce Federal
securities laws, to protect investors, and maintain fair,
honest, and efficient markets. This includes ensuring full
disclosure of financial information, regulating the Nation's
security markets, and preventing and policing fraud and
malpractice in the securities and financial markets.
The administration's budget proposal for fiscal year 2008
seeks $905.3 million for the SEC. This is a 2.7-percent
increase, $23.7 million over the fiscal year 2007 spending
level. The $905.3 million includes $30.3 million in carryover
balances.
It is interesting and important to note that the entire
amount of the SEC budget authority is derived from the
collection of fees, fees that are collected and deposited in
special offset accounts, available to appropriators, not to the
Treasury's general fund. As a result of these fee collections,
no direct appropriations are used to fund the SEC.
The proposed funding level of $905.3 million is similarly
structured: $648.5 million designated for enforcement, $59.4
million for regulatory function, $126 million directed to
disclosure reviews and investor education, and $71.4 million
for operations.
I would like to invite my colleague Senator Allard, if he
would like, to make an opening remark at this point.
STATEMENT OF SENATOR WAYNE ALLARD
Senator Allard. Mr. Chairman, thank you. I would like to
make a brief remark if I might. I want to thank you for holding
this hearing.
Currently the securities and financial markets of the
United States are thriving and investors are enjoying the
longest bull run in over 80 years. The Dow Jones Industrial
Average has recorded 22 record closes since the start of the
year and the S&P 500 is 24 points below its record close it set
in March 2000. The Dow is no longer showing lingering effects
of the 416-point drop it suffered on February 27 and the U.S.
economy is continuing to expand and is adding jobs.
With more than one-half of American families investing in
the securities market, it is vital to our Nation's economic
health that we enjoy fairness, integrity, and efficiency in the
marketplace.
I would like to take this time to welcome my good friend
and former colleague, Chairman Cox, whose responsibility it is
to uphold the SEC's mission to protect investors, maintain
fair, orderly, and efficient markets, and facilitate capital
formation. I am used to seeing Chairman Cox testify before the
full Senate Banking Committee, but I welcome him here and this
opportunity to discuss important issues involving the SEC.
We will be holding a hearing tomorrow, Mr. Chairman, in the
authorizing committee on the consolidation of the National
Association of Securities Dealers (NASD) and the New York Stock
Exchange (NYSE) regulatory functions. I would like to thank
you, Chairman Cox, for allowing a member of the SEC to testify
in front of that committee on this matter.
Again, Mr. Chairman, thank you for holding today's hearing.
I look forward to hearing Chairman Cox's testimony and working
with him and the SEC as a member of this subcommittee and as
the ranking member of the Securities and Insurance and
Investment Subcommittee.
Thank you, Mr. Chairman.
Senator Durbin. Thank you, Senator Allard.
I want to just join in noting that the stock market has
been doing very well and I hope there is nothing we will do
here today that will change that.
I turn now to Chairman Cox for your presentation. Welcome,
Mr. Chairman.
SUMMARY STATEMENT OF CHRISTOPHER COX
Mr. Cox. Thank you very much, Chairman Durbin. I know that
Ranking Member Brownback will perhaps be here soon. Senator
Allard. It is a pleasure to testify before you today. Thank you
for giving me this opportunity to engage in some sharing of
information about our budget request for fiscal 2008.
Before I begin, I would like to congratulate you, Mr.
Chairman, on assuming this new role. I am very, very pleased
and looking forward to working with you.
As you know, we are requesting $905.3 million for the SEC
in 2008, and that represents an increase, as you noted, Mr.
Chairman, over fiscal year 2007 that will allow the SEC to
continue the important initiatives underway to protect and
inform investors. These initiatives all have in common that
they are aimed at benefiting the average retail customer, whose
savings are dependent on healthy and well-functioning markets.
Since I became Chairman I have worked to reinvigorate the
agency's focus on the ordinary investor. This is the SEC's
traditional responsibility. Back in Joe Kennedy's day, our
first SEC Chairman could marvel that 1 in 10 Americans owned
stocks. Today one-half of Americans own securities, and the
median income for shareholders is a very middle class $65,000.
When you then consider all the teachers, the Government
employees, and the workers in other industries who have
pensions, it becomes clear that nearly all taxpayers have a
personal interest in fair and honest securities markets. In
fact, when one considers the staggering growth in Americans'
participation in the market, the enormity of the SEC's task
becomes apparent. About 3,600 staff at the SEC are responsible
for overseeing over 10,000 public companies, investment
advisers that manage over $32 trillion in assets, nearly 1,000
fund complexes, 6,000 broker-dealers with 172,000 branches, and
the $44 trillion worth of trading conducted each year on
America's stock and options exchanges.
These daunting numbers make it clear that, even if the SEC
budget were to double or to triple, the agency would have to
carefully set priorities. That is exactly what we are doing in
our proposed budget for fiscal 2008.
Our risk-based and flexible approach to our examination
program is permitting us to focus the agency's energies on the
particular marketplace practices that are most likely to be
high risk and on the particular investment advisers and mutual
funds that are most likely to be sources of trouble. It also
provides the basis for the selection of targets for
comprehensive exam sweeps on crosscutting issues that could
present a significant threat to investors, and it drives the
SEC's enforcement, rulemaking, and disclosure reviews as well.
In each case, the objective is to apply the taxpayers'
resources in ways that make the most significant positive
contribution to investor protection.
If I may, Mr. Chairman, I would like to point out some of
the major areas in which the SEC is currently focusing its
energies. Our most important initiatives begin with our focus
on fighting fraud against seniors. There are an estimated 75
million Americans who will turn 60 over the next 20 years, and
they are going to live longer than any generation before them.
As the baby boomers turn 60, that is 10,000 of them every day
for the next 20 years, they will need to continue to actively
manage their investments for higher yield over their longer
lifetimes. It was not that way with their parents.
Rather than switching into low-yield safe investments as
their parents did, they are going to have to be active managers
overseeing their returns to provide for a much longer lifetime.
That is going to have enormous consequences for our capital
markets.
Households today led by people over 40 already own 91
percent of America's net worth; and, as the baby boomers
retire, very quickly the vast majority of our Nation's net
worth will be in the hands of our Nation's seniors. So
following the Willie Sutton principle, scam artists are going
to swarm like locusts over this increasingly vulnerable group
because that is where the money is.
Nearly every day, the SEC receives letters and phone calls
from seniors and their caregivers who have been targeted by
fraudsters. That is why the SEC has focused its energies in
this area and why we have organized our fellow regulators and
law enforcement officials at the first-ever national senior
summit, here in Washington last July. This year's summit, the
second annual, will integrate even more of our national
resources, and it will take place in just a few months with our
partners.
We have developed a strategy to attack the problem from all
angles. It includes aggressive enforcement, targeted
examinations, and, very importantly, investor education. Over
the past year the SEC's Division of Enforcement has brought 26
enforcement actions specifically aimed at protecting elderly
investors. Many of those were coordinated with State
authorities.
For example, the Commission coordinated with law
enforcement authorities in California to crack down on a $145
million Ponzi scheme that lured elderly victims, elderly would-
be investors, into workshops with the promise of free food and
then bilked them out of their retirement money by purporting to
sell them safe guaranteed notes. In another case we filed an
emergency action to halt an ongoing securities fraud that
targeted individuals' retirement funds.
By focusing on free lunch seminars and dozens of other
techniques that would-be fraudsters aim at seniors, the Federal
Government is serving notice that there will be a special place
in hell reserved for those who prey on the life savings of
older Americans.
Another important focus for the Commission is a program I
know that is of significant interest to you, Mr. Chairman, and
that is the agency's Office of Global Security Risk. As you
know, this office, which is located in the Division of
Corporation Finance, is responsible for monitoring companies'
disclosures regarding their contacts with countries that have
been identified by the State Department as State sponsors of
terrorism and for coordinating with other Federal Government
agencies to ensure the sharing of information that is relevant
to that assessment.
The office reviews Securities Act registration statements
and Exchange Act filings whenever it appears that a company may
have material contacts with countries that raise global
security concerns, and it requires enhanced disclosure where
appropriate.
In the past year, the office issued comments to
approximately 212 companies. The office conducts reviews both
independently and in concert with the rest of the division's
disclosure review staff. In reviewing companies' disclosures,
the office draws upon a variety of data sources. It also
coordinates with the Treasury's Office of Foreign Assets
Control and Commerce's Bureau of Industry and Security.
I appreciate the leadership of this subcommittee in
ensuring that investors have the relevant information that they
need to make informed investment decisions regarding the
foreign activities of companies that they own, and I am
confident that the Office of Global Security Risk is well
positioned to continue fulfilling these vitally important
responsibilities.
Another priority for the Commission is ensuring that the
money that is recovered in SEC settlements and court cases is
distributed as quickly as possible to injured investors. The
Sarbanes-Oxley Act in 2002 gave the SEC this new ``fair funds''
authority. Since then we have begun to develop a very
considerable expertise in this area. When I became Chairman in
2005, the SEC had completed the process of disbursing funds to
investors in only a few cases. Since then we have returned over
$1.7 billion in penalties and disgorgements to injured
investors in significant cases, including WorldCom, Global
Analysts Research, New York Stock Exchange Specialists,
Hartford, and Bristol-Myers-Squibb.
In addition, several large disbursements are pending and
will be announced very shortly.
To completely fulfill the vision that Congress wrote into
Sarbanes-Oxley, however, will require a sustained effort to
train professionals in this area. That is why I have ordered
the creation of a new office that will work full time to return
these funds to investors. The efforts of this new office will
be aided by a new information system called Phoenix, that will
more accurately track, collect, and distribute the billions of
dollars in penalties and disgorgements that flow from our
enforcement work. The efficiency of a dedicated tracking system
will remove what has been a major hindrance in our efforts to
quickly distribute fair funds.
Another major initiative I want to bring to your attention
holds great potential for investors. It is called interactive
data. By using interactive data, we can give investors far more
information in a far more useful form than anything they have
ever gotten from the SEC before. In the very near future,
investors will be able to easily search through and make sense
of the mountains of financial data contained in current company
disclosures.
We are going to convert the SEC's current online system,
called EDGAR (electronic data gathering analysis and retrieval
system), from what is really now just a vast electronic filing
cabinet into something that is truly interactive, a tool that
lets an investor, an analyst, anyone, manage all of that
information in ways that are truly useful to them. With a few
clicks of the mouse, investors will be able to find, for
example, the mutual funds with the lowest expense ratios, the
companies within a particular industry that have the highest
net income, or the overall trend in their favorite company's
earnings.
To take advantage of the capabilities of interactive data,
the SEC is modernizing the entire EDGAR system; and, as part of
this effort, the very new and different EDGAR will be renamed
later in 2007. It came as a bit of a shock to viewers of the
hit TV show ``24'' when Edgar bit the dust and it may take a
while for people to get used to the new, improved EDGAR with a
new name, but the effort will be supremely worthwhile.
In all, the Commission is investing $54 million over
several years to build the infrastructure to support widespread
adoption of interactive data.
Finally, I want to discuss a significant new responsibility
that the SEC is undertaking this year to oversee credit rating
agencies. As you know, in 2006 the Congress gave the SEC this
new responsibility and new authority to register and inspect
the Nation's credit rating agencies, including industry giants
Standard and Poor's, Moody's, Fitch Ratings, and A.M. Best, as
well as several other large, medium, and smaller current and
potential industry participants.
Because of congressional concern that the industry faces
potential conflicts of interest, imposes barriers to entry for
new rating agencies, and has failed to warn the market of such
significant impending financial failures as Enron and WorldCom,
even immediately before their collapse, the SEC is tasked with
devoting significant manpower and resources to this area. Under
the new law and the SEC's proposed implementing rules, credit
rating agencies will be required to register with the
Commission. In addition, they will be required to submit to
periodic inspections to ensure that they are implementing
policies to mitigate conflicts of interest, prevent leaks of
material nonpublic information, and to refrain from coercive or
unfair practices.
The SEC takes this new responsibility very seriously. We
remain committed to finalizing the new rules before the
statutory deadline, and we are assembling a team of staff to
oversee the program and begin conducting inspections over the
next several months.
So with that background, Mr. Chairman, that brings us to
our requested budget increase for fiscal 2008. That level will
permit us to continue our ongoing hiring to reach a level of
approximately 3,600 full-time staff. This level of personnel
strength, which as you know is 21 percent higher than in 2001,
will permit the agency to vigorously pursue its mission and
maintain strong regulatory, enforcement, examination, and
disclosure review functions. It will also allow the SEC to
continue our commitment to information technology.
In addition to the SEC's interactive data initiative, the
SEC is deploying new systems to better manage enforcement and
examination programs. We are using new techniques and new
technology to help make our existing staff more productive.
There is absolutely no question that these technology
improvements will make the SEC more productive and give
investors and taxpayers more value for the money.
Over the last 2 years, the SEC has made tremendous progress
in improving its operations. This fiscal 2008 request will
permit us to continue improving the agency's internal financial
controls. The SEC has poured tremendous energy into this area
since I have been Chairman. As you know, a few years before I
joined the SEC, the agency began to publish audited financial
statements. I am pleased to report that for the first time in
its history the SEC last year received a clean opinion of its
audited financial statements for 2006, with no material
weaknesses in internal controls. That is vitally important, Mr.
Chairman, because the SEC must set an example not only for
other Federal agencies, but also for the many public companies
whose financial statements and disclosures we review.
For this reason, we plan to continue upgrading the agency's
financial system and to beef up security over our information
security.
The largest single application of our requested budget
increase will be to fund pay raises for SEC staff that will
average between 5 percent and 6 percent next year. These
healthy increases are in accordance with the SEC's pay parity
authority and our collective bargaining agreement. I should
point out, Mr. Chairman, the fact that cost-of-living
adjustments, career ladder promotions, and merit pay increases
that are essentially built into our system amount to between 5
and 6 percent each year. That is a challenge for the SEC and
for this subcommittee because two-thirds of our budget is
personnel; and, if two-thirds of our budget is growing each
year automatically by as much as 6 percent, then the agency's
total budget has to increase by 4 percent just to maintain
personnel at a steady state from year to year.
The final and most important reason that the SEC needs the
budget increase that we are requesting is to provide the tools
that we need to address emerging risks in the Nation's capital
markets, including not just known areas of concern, such as
hedge fund insider trading, the safety and security of 401(k)
plans, and fraud in the municipal securities market, but also
threats to market integrity and investor confidence that have
yet to emerge.
PREPARED STATEMENT
So I appreciate, Mr. Chairman, the opportunity to discuss
with you the SEC appropriation for fiscal 2008. I look forward
to working with the subcommittee on the best ways to meet the
needs of our Nation's investors. I would be happy to take your
questions.
Senator Durbin. Thank you very much, Chairman Cox.
[The statement follows:]
Prepared Statement of Christopher Cox
Chairman Durbin, Ranking Member Brownback, and Members of the
Subcommittee: Thank you for the opportunity to testify today about the
Securities and Exchange Commission's budget request for fiscal year
2008.
Before I begin, I would like to congratulate you, Mr. Chairman, on
your new role as head of this subcommittee. I look forward to working
with you and all the members of this subcommittee for the benefit of
the nation's investors.
As you know, the President's budget requests $905.3 million for the
SEC in 2008. I fully support this request for increased funding over
fiscal year 2007, which will allow the SEC to continue the important
initiatives underway to protect and assist the average investor.
These initiatives all have in common that they are aimed at
benefiting the average retail customer whose savings are dependent on
healthy, well-functioning markets. Since I became Chairman, I have
worked to reinvigorate the agency's focus on the ordinary investor.
This is the SEC's traditional responsibility. Back in Joseph Kennedy's
day, our first SEC Chairman was amazed that ``one person in every ten''
owned stocks. But today, more than half of all households own
securities, and the median income for shareholders is a very middle-
class $65,000. When you then consider all of the teachers, government
employees, and workers in other industries who have pensions, it
becomes clear that nearly all taxpayers have a personal interest in
fair and honest securities markets.
In fact, when one considers the staggering growth in Americans'
participation in the markets, the enormity of the SEC's task becomes
apparent. About 3,600 staff at the SEC are responsible for overseeing
more than 10,000 publicly traded companies, investment advisers that
manage more than $32 trillion in assets, nearly 1,000 fund complexes,
6,000 broker-dealers with 172,000 branches, and the $44 trillion worth
of trading conducted each year on America's stock and options
exchanges.
These daunting numbers make it clear that, even if the SEC budget
were to double or triple, the agency would have to carefully set
priorities. That is exactly what we are doing in this proposed budget
for fiscal year 2008. We must continue to think strategically about
which areas of the market pose the greatest risk, and which areas of
potential improvement hold the greatest benefit for investors. And
given the fast changing conditions in America's and the world's capital
markets, we must remain agile and flexible enough to redirect our
resources with little notice.
This risk-based and flexible approach guides the SEC's examination
program as we focus the agency's energies on those practices in the
marketplace, and those investment advisers and mutual funds, that are
most likely to be high-risk. It also provides the basis for the
selection of targets for comprehensive examination sweeps on cross-
cutting issues that could present a significant threat to investors.
And it drives the SEC's enforcement, rulemaking, and disclosure review
functions as well. In each case, the objective is to apply the
taxpayer's resources in ways that provide the biggest investor
protection bang for the buck.
In recent years, the SEC has professionalized the culture of risk
assessment that informs so many of our programs throughout the SEC.
From relatively modest beginnings as a discrete office within the SEC
established by my predecessor, William Donaldson, the risk assessment
function is now wholeheartedly embraced in every major functional
division and office of the agency.
If I may, Mr. Chairman, I would now like to discuss some of the
major areas in which the SEC is currently focusing its energies, in
order to provide the maximum benefit to America's retail investors.
FIGHTING FRAUD AGAINST SENIORS
As you know, an estimated 75 million Americans will turn 60 over
the next 20 years. And they will live longer than any generation before
them. As the Baby Boomers turn 60--more than 10,000 of them every day
for the next 20 years--they will need to continue to actively manage
their investments for higher yield over their longer lifetimes, rather
than switching into low-yield, safe investments as their parents did.
This will have enormous consequences for our capital markets.
Households led by people aged 40 or over already own 91 percent of
America's net worth. The impending retirement of the baby boomers will
mean that, very soon, the vast majority of our nation's net worth will
be in the hands of our nation's seniors.
Following the Willie Sutton principle, scam artists will swarm like
locusts over this increasingly vulnerable group--because that is where
the money is. And it is already occurring. Nearly every day, our agency
receives letters and phone calls from seniors and their caregivers who
have been targeted by fraudsters.
That is why the SEC has focused its energies in this area, and why
we organized our fellow regulators and law enforcement officials at the
first-ever Seniors Summit in July 2006. This year's Seniors Summit,
which will integrate even more of our national resources, will take
place in just a few months. With our partners, the SEC has developed a
strategy to attack the problem from all angles--from aggressive
enforcement efforts, to targeted examinations, to investor education.
Fighting fraud against seniors means taking aggressive action. Over
the past year, the SEC's Division of Enforcement has brought 26
enforcement actions aimed specifically at protecting elderly investors.
Many of these were coordinated with state authorities.
For example, the Commission coordinated with law enforcement
authorities in California to crack down on a $145 million Ponzi scheme
that lured elderly victims to investor workshops with the promise of
free food--and then bilked them out of their retirement money by
purporting to sell them safe, guaranteed notes.
In another case, we filed an emergency action to halt an ongoing
securities fraud that targeted individuals' retirement funds. At
``free'' dinner and retirement planning seminars, seniors were urged to
invest their savings in non-existent businesses with promises of
alluringly high rates of return.
By bringing cases like these, and dozens more like them, the
federal government is putting would-be fraudsters on notice that they
will be caught and punished if they prey upon seniors.
SEC examiners are also working closely with state regulators across
the country to stop abusive practices before seniors are actually
injured. With our state partners, we're sharing regulatory intelligence
about abusive sales tactics targeting seniors, and conducting focused
examinations of any firms whose practices raise red flags.
For example, in Florida we initiated an examination sweep of firms
selling investments to seniors, in cooperation with the State of
Florida and the National Association of Securities Dealers. We
subsequently expanded the sweep to include other states with large
retiree populations--including California, Texas, North Carolina,
Alabama, South Carolina, and Arizona. Working together with state
securities regulators in those states, the NASD, and the NYSE, our goal
is to see to it that the sales people at ``free lunch'' seminars are
properly supervised by their firms, and that the seminars are not used
as a vehicle to sell unsuitable investment products to seniors.
Another tool in fighting securities fraud against seniors is
education. These efforts are aimed not only at seniors, but also their
caregivers--as well as pre-retirement workers, who are encouraged to
plan for contingencies in later life. The SEC is expanding our efforts
to reach out to community organizations, and to enlist their help in
educating Americans about investment fraud and abuse that is aimed at
seniors. We have also devoted a portion of the SEC website specifically
to senior citizens (http://www.sec.gov/investor/seniors.shtml). The
site provides links to critical information on investments that are
commonly marketed to seniors, and detailed warnings about common scam
tactics.
GLOBAL SECURITY RISK
Another important area of focus for the Commission is a program of
significant interest to you and other members of this subcommittee--the
agency's Office of Global Security Risk. As you know, this office,
which is located within the Division of Corporation Finance, is
responsible for monitoring companies' disclosures regarding their
contacts with countries that have been identified by the State
Department as state sponsors of terrorism and coordinating with other
federal government agencies to ensure the sharing of relevant
information.
The Office reviews Securities Act registration statements and
Exchange Act filings whenever it appears that a company may have
material contacts with countries that raise global security concerns,
and pursues enhanced disclosure where appropriate. In the past year,
the Office issued comments to approximately 212 companies. The Office
conducts reviews both independently and in concert with the rest of the
Division's disclosure review staff.
In reviewing companies' disclosures, the Office draws upon a
variety of data sources. The staff considers the information in a
company's filings and information available from other sources. In
addition, the Office continues to coordinate with other relevant
federal agencies, such as Treasury's Office of Foreign Assets Control
and Commerce's Bureau of Industry and Security.
I fully support the goals of this office and believe its efforts
are increasing the quality of information that investors receive
regarding companies' contacts with countries identified by our
government as state sponsors of terrorism. I appreciate the leadership
of this subcommittee in endeavoring to ensure that investors have the
relevant information they need to make informed investment decisions
regarding the foreign activities of the companies that they own. And I
am confident that the Office of Global Security Risk is well positioned
to continue fulfilling these vitally important responsibilities.
RETURNING FUNDS TO WRONGED INVESTORS
We at the SEC work diligently to uncover fraud against investors,
gather the evidence needed to build a case, and then prosecute cases to
bring fraudsters to justice. But our efforts do not end at the
courthouse door. Once we succeed in convincing a court to order a
penalty, we must ensure that as many of those dollars as possible go
back into the hands of wronged investors as quickly as possible.
Since the Sarbanes-Oxley Act created ``Fair Funds,'' through which
penalties in SEC cases can be returned directly to injured investors,
the SEC has begun to develop a considerable expertise in using this
important new authority. At the time I became Chairman in 2005, this
authority was only three years old, and the SEC had completed the
process of disbursing funds to investors in only a few cases. Since
then, we have returned over $1.7 billion to injured investors,
including significant distributions from cases involving WorldCom,
Global Analysts Research, New York Stock Exchange Specialists,
Hartford, and Bristol-Myers Squibb. In addition, several large
disbursements are pending and will be announced shortly.
To completely fulfill the vision that Congress wrote into Sarbanes-
Oxley, however, will require a sustained effort within the Commission
to train professionals in this area, to develop consistent practices,
and to routinize the execution of the Fair Funds function. Too much
money is still undisbursed because of the complexities of the process,
leaving investors uncompensated.
That is why I have ordered the creation of a new office that will
focus the efforts of all of the SEC's offices around the country, and
work full-time to return these funds to wronged investors. The creation
of this specialized function within the SEC will ensure that investors'
money is returned as quickly as possible, while minimizing the costs of
the distributions.
The efforts of this new office will be aided by a new information
system, called Phoenix. The system will more accurately track, collect,
and distribute the billions of dollars in penalties and disgorgements
that flow from our enforcement work. The efficiency of a dedicated
tracking system will remove what had been a major hindrance in our
efforts to quickly distribute Fair Funds.
The agency is taking other steps in this area as well. We are
collaborating with the Bureau of the Public Debt to invest disgorgement
and penalty funds in interest-bearing accounts. And we are working to
consolidate funds from related cases into a single distribution, where
appropriate, to potentially save investors hundreds of thousands of
dollars.
The SEC is dedicated to doing the very best job possible for
investors in handling this responsibility. We know that you in the
Congress, who entrusted us with this task, expect and deserve no less.
INTERACTIVE DATA
Another major initiative I want to bring to your attention holds
great potential for investors. By using what I call ``interactive
data,'' we can give investors far more information, in far more useful
form, than anything they've ever gotten from the SEC before. In the
very near future, investors will be able to easily search through and
make sense of the mountains of financial data contained in current
company disclosures.
For years, ordinary investors have been stymied by the time and
effort it takes to separately look up each SEC filing for a single
company they might own, and then to do that again and again for every
additional company in which they're interested. Even once the right
forms are located, wading through all of the legal gobbledygook to find
the right numbers has been nearly impossible for the average retail
investor.
That is because the SEC's online system, know as EDGAR, is really
just a vast electronic filing cabinet. It can bring up electronic
copies of millions of pieces of paper on your computer screen, but it
doesn't allow you to manage all of that information in ways that
investors commonly need.
Not surprisingly, financial firms--who can afford it--usually end
up getting the bulk of their information about companies not from the
SEC filings, but from middlemen all over the world who re-key the
information in SEC reports and put it in more useful form. This process
is expensive and inefficient, and it also creates errors in the data.
Worse, it feeds the notion that the rich and the highly sophisticated
have a leg up in today's markets.
Interactive data will let any investor quickly focus on the
disclosure they need. With a few clicks of the mouse, investors will be
able to find, for example, the mutual funds with the lowest expense
ratios, the companies within an industry that have the highest net
income, or the overall trend in their favorite companies' earnings. It
works by giving each piece of information a unique label, written in
the eXtensible Business Reporting Language (XBRL) computer language.
The agency has taken a variety of steps to expand the use of
interactive data. First, the Commission created a voluntary program for
companies and mutual funds to submit disclosures using XBRL, and
offered expedited reviews of disclosures if firms agree to share their
experiences with the agency. More than 35 companies, including some of
corporate America's biggest names, are already participating in this
program.
Second, the SEC is working with outside groups to develop the
standardized computer labels for different kinds of numbers that appear
in financial statements. The collections of these labels for each
industry--the so-called ``taxonomies''--will be completed in 2007. With
the taxonomies available to every SEC registrant, we will have in place
the basic building blocks of the universal language that explains the
components of every firm's financial statements.
Third, the agency is modernizing the entire EDGAR system to convert
it to one based on interactive data. As part of this effort, the SEC
expects to rename the EDGAR system in 2007.
In all, the Commission is investing $54 million over several years
to build the infrastructure to support widespread adoption of
interactive data. Companies have told us that the costs of implementing
XBRL are minimal, while the benefits are substantial. In addition to
providing far more useful information to investors, we believe the use
of interactive data will be more efficient for companies' internal
processes, for their registration and compliance reporting to the SEC,
and for the SEC's own disclosure reviews for regulatory and enforcement
purposes.
CREDIT RATING AGENCIES
Finally, I want to discuss a significant new responsibility that
the SEC is undertaking this year to oversee credit rating agencies.
This new role was given to the SEC by Congress last year.
As you know, in 2006 the Congress gave the SEC both the
responsibility and the authority to register and inspect the nation's
credit rating agencies, including industry giants Standard & Poor's,
Moody's, Fitch Ratings, A.M. Best, as well as several other large,
medium, and smaller current and potential industry participants.
Because of congressional concern that the industry faces potential
conflicts of interest, imposes barriers to entry for new rating
agencies, and has failed to warn the market of such significant
impending financial failures as Enron and WorldCom even immediately
before their collapses, the SEC is tasked with devoting significant
manpower and resources to this area.
Under the new law and the SEC's proposed implementing rules, credit
rating agencies will be required to register with the Commission. In
addition, they will be required to submit to periodic inspections to
insure that they are implementing policies to mitigate conflicts of
interest, prevent leaks of material non-public information, and refrain
from unfair or coercive practices. The SEC takes this new
responsibility very seriously. We remain committed to finalizing the
new rules by the statutory deadline, and we will assemble a team of
staff to oversee the program and begin conducting inspections over the
next several months.
FISCAL 2008 REQUEST
With all of this as background, I'll take just a moment to provide
some useful detail about the President's budget request for fiscal year
2008.
As you know, the request is for $905.3 million. That will permit
the agency to maintain its staffing levels from 2007. This level
personnel strength, which as you know is significantly higher than five
years ago, will permit the agency to vigorously pursue its mission and
maintain strong regulatory, enforcement, examination, and disclosure
review programs.
This funding level will allow the SEC to continue its commitment to
information technology, which has the potential both to reduce
regulatory costs and to give investors vastly more useful information
than what they receive today. In addition to the SEC's interactive data
initiative, the SEC is deploying new systems to better manage
enforcement and examination resources, to help us manage a higher level
of enforcement activity at existing personnel and funding levels. There
is absolutely no question that these technology improvements will make
the SEC more productive, and give both investors and taxpayers better
value for their money.
Over the last two years, the SEC has made tremendous progress in
improving its operations. The fiscal 2008 request will permit us to
continue improving the agency's internal financial controls. The agency
has poured tremendous energy into this area during my tenure as
Chairman. I am pleased to say that these efforts have generated
success: under the leadership of a new Executive Director, the SEC
received a clean opinion on its audited financial statements for 2006
and, for the first time, there were no material weaknesses in internal
controls. This is vitally important, Mr. Chairman, because the SEC must
set the example not only for other federal agencies, but for all public
companies whose financial statements and disclosures we review. For
this reason, the SEC will continue to upgrade its financial system, and
to beef up security over its information systems.
The President's budget request also will fund pay raises for SEC
staff, in accordance with the SEC's pay parity authority and our
collective bargaining agreement. This is a significant fact. Including
cost-of-living increases, career-ladder promotions, and merit pay
increases, these raises amount to between five and six percent each
year. Given that from a budgetary standpoint the increases are
essentially automatic, and given further that payroll represents about
two-thirds of our budget, the agency's total budget has to increase by
over 3.5 percent just to maintain personnel at a steady state from year
to year.
Finally, and most importantly, the level of funding in this budget
request will give the SEC the tools we need to address new, emerging
risks in the nation's capital markets--including not only such known
areas of concern as hedge fund insider trading, the safety and security
of 401(k) plans, and the quality of disclosure to protect against fraud
in the municipal securities market, but also those threats to market
integrity and investor confidence that have yet to emerge.
CONCLUSION
Thank you for this opportunity to discuss the SEC appropriation for
fiscal 2008. I look forward to working with you on the best ways to
meet the needs of our nation's investors, and I would be happy to
answer any questions you may have.
SIMPLIFYING INVESTMENT INFORMATION
Senator Durbin. Let me ask you a few questions. Most
Americans may come in contact with your agency when they
receive quarterly reports on their mutual funds or stocks that
they own, and I assume that the contents of those reports are
monitored, regulated by the Securities and Exchange Commission.
Is that correct?
Mr. Cox. That is correct.
Senator Durbin. I would dare say as an attorney with little
business background beyond law school that I find these
overwhelmingly boring and unintelligible. Has anyone at the
Securities and Exchange Commission taken a look at the required
disclosures to try to follow the model that you suggested for
EDGAR, to bring this down to a level where it might have some
value to the average person, to require in simple,
understandable terms some fundamentals about mutual funds that
we own or stocks that we own, things that we should be aware of
in the most direct way?
Mr. Cox. Absolutely, Mr. Chairman. You are singing our
song; we are singing your song. You sound like the average
American customer that the SEC is supposed to be serving. When
I have a chance to address large audiences, I often ask them:
When you get your proxy information or your annual report in
the mail, the SEC-mandated disclosure for the mutual fund or
the stock or the security that you own, do you rush to your
comfortable chair and sit down, open it up and read it? Nobody
raises their hand and says yes to that.
I ask: How many of you--tell the truth--throw it away? And
the whole room will raise their hand. I think the SEC has to be
very concerned when the customers are throwing away the
product.
The whole point of this exercise is meant to serve ordinary
investors. Now, we recognize that what is being described is
complex, and sometimes there is some required complexity in
fully disclosing what is going on. But there is also a lot of
complexity that is getting in the way, that is making it hard
for investors to understand this information. Increasingly, I
think, as we move to web-based tools, we are going to find that
we can layer this information so that there can be some clearly
understandable information on top; and then, if you want to
keep drilling down for hyper-technical detail, you can find it.
That I think holds great promise.
But, meanwhile, we are focused on plain English in all of
the retail disclosures for which the SEC is responsible. We
have a ways to go there, Mr. Chairman. I recognize that. But it
is a top priority for the Commission in everything that we do.
Senator Durbin. So let me ask you, do we have to change the
law so that we can receive reports that are intelligible and of
practical value to investors? Is it congressional
responsibility or do you have the power at the SEC to say that
these things that you are mailing to millions of investors all
over America, should at least have in the first four or five
pages in very plain English important information that they
should know about the company that is involved in it?
Mr. Cox. We definitely have the power to do this. We are
doing it now very formally in rule. The executive compensation
disclosure that investors are receiving for the first time this
year, much more detailed information about what the boss makes
than they have ever had before, must be by rule in plain
English, and we are going to review these disclosures with that
in mind.
Senator Durbin. Good.
PRIVATIZING SALLIE MAE
Now let me ask you about the proposed sale of Sallie Mae.
This proposal suggests that it may be purchased largely by
private entities, except for two banks. Chase and Bank of
America, I believe, are involved in the proposed purchase of
Sallie Mae. From the viewpoint of the public and especially
students and their families, the current disclosures by Sallie
Mae through SEC and other Federal agencies gives us an insight
into how this agency is operating.
Should we have concern that if this private sale goes
forward there will be less information available about how the
new entity is operating, how student loans are being handled,
the compensation of officers, how it is being spent? What kind
of disclosure level do you think there would be in this new
entity that is proposing to buy Sallie Mae?
Mr. Cox. Well, it is an excellent question. Obviously the
Congress has a special interest and the public has a special
interest in GSE disclosure. There has been voluntary disclosure
that is meant to conform with the SEC requirements that apply
to all public companies. There is nothing that would prevent
that under any private ownership.
Senator Durbin. But would it have to be voluntary? This is
what I am getting to. When I have raised this question with one
of the banks involved in the proposed sale they said: Well, we
have so many things we are already disclosing; there will be
more disclosure than you know what to do with. So I was trying
to get to the bottom line. Current disclosure standards for a
public corporation like Sallie Mae I would assume are at this
level [indicating], and now that we have a private entity
buying this public entity will the disclosures at least reach
this level [indicating] of information and transparency?
Is this something that maybe I could ask your staff to take
a look at and give us some feedback?
Mr. Cox. We are, as you can imagine, keenly interested
ourselves, and I would be happy to continue to work with you on
this.
Senator Durbin. Good.
SUDAN DIVESTMENT
Before I turn it over to my colleague here for a few
questions, let me ask you about the situation in Sudan. I
contacted you earlier this year about the divestment interest
which I have in order to put pressure on the Sudanese
government to finally respond to the genocide in Darfur, which
has been acknowledged by this administration. After receiving
some information from your Commission--there was a list of some
16 companies--it turns out that that is only a fraction of the
actual activity that goes on in Sudan.
When we asked your staff why we did not have more
information, we were told that the SEC can only compile such a
list based on available information and such a list is obsolete
almost as soon as it is created since companies shift
operations continuously. So we are now working with Treasury
and the State Department to create stronger reporting
requirements to the SEC so that better information is
available.
Before I ask you the specific question, I would like to add
a footnote to that. There has been a great deal said recently
by myself and others about Fidelity, a major brokerage company
which it has been alleged has large holdings in PetroChina, the
largest oil company in Sudan. You may have seen some ads on
television and in publications. We were informed today it has
been announced that Fidelity has sold at least 30 percent of
the $1.1 billion in Hong Kong-listed PetroChina shares held as
of December last year. We are still looking into it to
determine how much they have divested.
But going back to my earlier point, if we are looking for
companies like Fidelity and others doing business in Sudan,
what do you recommend that we do to ensure the SEC can collect
the kind of data that makes our effort more likely to succeed?
Mr. Cox. As you know, Mr. Chairman, your efforts, which we
have been assisting, I think are properly aimed at a universe
that is larger than just U.S.-listed companies, and the
PetroChina example that you gave--PetroChina did not appear on
the list that we provided of our registrants for the simple
reason that it was not a U.S.-listed company. That is, the
subsidiary listed in the United States did not have material
contacts in Sudan and the parent, PetroChina, is not a U.S.-
listed company. Because of the U.S. sanctions regime, not very
many listed U.S. companies are the entities that themselves
have the material contacts.
So I think, if we are after the information that you seek,
we need to broaden our horizons a little bit. Although the SEC
can be very helpful in this regard, and I know that you are
also working with the Treasury Department and the State
Department, I think a multiagency effort is the best way to go.
Senator Durbin. Well, I hope we can find that information,
because I think at a minimum if Americans who are concerned
about the issue are alerted to those companies that are doing
business in Sudan and have a choice as consumers and investors
to act accordingly that is the best we can do at this moment in
time. We need to have a more robust effort to bring this
information together and I will work with you to achieve that.
I see Senator Brownback has arrived. I do not know if you
would like to ask or let Senator Allard.
Senator Brownback. Let Senator Allard.
Senator Durbin. Senator Allard is recognized for 5 minutes.
NASD-NYSE CONSOLIDATION
Senator Allard. Thank you, Mr. Chairman. I mentioned in my
opening comments about the consolidation of the National
Association of Security Dealers and the New York Stock Exchange
regulatory function. The question I have for you, Chairman Cox,
it is my understanding that the Division of Market Regulation
is going to be responsible for regulation and supervision of
the proposed consolidation. Do you feel that the SEC's budget
request provides enough for these challenges and other
initiatives that will modernize the national market system?
Mr. Cox. I do. In fact, I think in some ways the
consolidation of the regulatory functions of the NASD and the
NYSE will make it easier to track fraud across markets. We had
a problem heretofore with the sheriff having to stop at the
county line. Fraud does not neatly restrict itself these days
to one particular platform, one particular market, and, to the
extent we have a more crosscutting view of what is going on in
our market surveillance, we will be much more efficient at
tracking down fraud.
PROGRAM ASSESSMENT RATINGS
Senator Allard. As you will recall when we were in the
House, the Contract with America, we worked with the Government
Performance and Results Act (GPRA) and the way that became law
and the way the Government agencies now is implementing it is
the President's PART program. I am developing a reputation that
on these Appropriations subcommittees I always ask whoever is
testifying about how well their agency is doing in the PART
program.
I look here and I pulled the information off of the
Internet on Expectmore.gov, and I see where the Securities and
Exchange Commission, you have four programs that they refer to.
The regulation of the investment management industry is listed
as effective, and I congratulate you on that. The examining and
compliance with security laws, that is characterized as
moderately effective. Then there is a couple of agencies, what
we call the Securities and Exchange Commission enforcement and
then the Securities and Exchange Commission full disclosure
program, that it says results not demonstrated, which tells me
that they are not bothering to set objectives and try and move
toward those.
Now, I noticed in your comments that you referred to these
programs and that some of the money you are requesting is to
upgrade those programs. So my question is how are you coming
along on getting more accountability in those two particular
programs, where results are not demonstrated?
Mr. Cox. First, thank you for asking about this, because it
is something that we are very focused on from a management
standpoint at the SEC. You are right to point out that the 2007
PART review that focused on the Division of Investment
Management gave the SEC the highest rating. As you know, that
rating of ``effective'' is very rarely awarded. It is hard to
get, and so that was cause for I think well-deserved
celebration at the agency. We are very proud of having achieved
that in 2007.
Likewise, the Office of Compliance, Inspections, and
Examinations received the next to the highest rating last year.
Prior to the time that I came to the Securities and Exchange
Commission, these other reviews that you mentioned were
performed. The Enforcement Division, results not demonstrated,
and the Division of Corporation Finance likewise, are for that
reason very much in our focus. We are working right now with
the Government Accountability Office (GAO), which is performing
another management review of the Division of Enforcement, and
we hope that, as a result of that collaboration and also our
own internal management assessment, we will be able to develop
additional measurable performance ratings.
The enforcement area, as you can imagine, it is difficult.
We are first and foremost a law enforcement agency, and it is
the greater part of what we do. So we are very interested in
anything that we can do to measure results.
One of the things that we observe in the economy right now
is that there are fewer security class actions being filed now
than there have been in prior periods. There are a number of
potential explanations for that, and I think only social
scientists can parse, perhaps only to their own satisfaction,
what the causes are for this.
But looking for a measure of less fraud, which would be the
ultimate performance that you would like our enforcement to
achieve, is very difficult. So we are trying to come up with
any way that we can measure this. We probably will not use such
external measures for the reason that there is so much social
science involved. But certainly we are going to develop even
more rigorous measurements than we have used in the past so
that we can satisfy ourselves that the taxpayers' resources are
being put to the best use for the protection of investors.
Senator Allard. Well, thank you for your response. Next
year when you show up I will probably repeat that question and
see how well we are doing.
Now, has the GAO reviewed from the PART program
perspective, have they reviewed all your programs, and if not
how many more remain to be reviewed?
Mr. Cox. Well, the GAO has on a number of occasions
reviewed aspects of the SEC's operations. Their current ongoing
study involves the Division of Enforcement.
Senator Allard. Okay. So are there more programs that need
to be reviewed yet that are not listed on here, or is this
pretty much it?
Mr. Cox. Well, the PART program, as you know, picks a
different portion of the agency each year.
Senator Allard. Right.
Mr. Cox. And I do not know, frankly, where the Office of
Management and Budget (OMB) will go next.
Senator Allard. Okay. Well, we will want to follow up on
that one too.
Thank you for your testimony.
Mr. Cox. Thank you.
Senator Durbin. Senator Brownback.
Senator Brownback. Thank you, Mr. Chairman.
Welcome, Chairman Cox. Good to see you again. I want to
join the chairman in his comments on Sudanese divestiture. We
have a strong, growing campaign across the country. I am not
sure where we are on the number of States. I do know Kansas
just divested. We have probably between 8 to 10 States now that
are involved in public divestiture from Sudan. I would hope you
could help us out with that. It seems to me that is one of the
best ways that a citizenry can express its displeasure with the
genocide. You can say, you can conduct a genocide, we do not
like it, and we are going to fight you every bit of the way,
but it is certainly not going to be on our dime that you are
going to do it. So your willingness to help is greatly
appreciated.
DECLINE IN IPOS ON U.S. EXCHANGES
I want to target you in on two things that have been seen
in some of the publications. One is the reduction in IPOs in
our capital markets that have been the subject of a number of
articles recently, the New York Times, Wall Street Journal,
Financial Times, and Economist. There is a recent report from
McKinsey and Company commissioned by Senator Schumer and New
York City Mayor Bloomberg that found in the first 10 months of
2006 U.S. exchanges attracted barely one-third of the share of
the IPOs they captured back in 2001. They noted at the same
time European exchanges increased their market share by 30
percent, and Asian exchanges doubled their share.
The study found the trend was due to non-U.S. issuers'
concern about compliance with Sarbanes-Oxley (SOx) section 404
and operating in what they see as a complex and unpredictable
legal and regulatory environment.
I would ask you, as I am sure you have seen the same
things, do you agree with these findings and what could be done
to stem this flow of companies going to foreign exchanges?
Mr. Cox. Well, Senator, I think the United States always
needs to be focused on sharpening our competitive edge in every
way that we can. The SEC has, of course, as our statutory
mission protecting investors, but another statutory mission of
the Securities and Exchange Commission is promoting capital
formation, and we are focused on that, as we are focused on our
third statutory mission, which is maintaining orderly markets.
All of these things I think are complementary.
We have to be concerned, when we see that there is more
competition in the world now than there ever has been before,
to see that the United States of America has a regulatory
system that is pro-competition, that is efficient, that
achieves all the objectives of investor protection that we
want, but that it also succeeds in our market regulatory
objective and also our objective of----
Senator Brownback. Do you think it is due to section 404 of
Sarbanes-Oxley? Is that a key part of why we are losing
competitiveness?
Mr. Cox. We have heard from foreign private issuers who
listed in the United States that they are very concerned about
the operation of section 404. We have also heard that same
complaint from U.S. issuers. Because of this, we have gone back
to the drawing board. We are on the threshold--and it will
occur on May 23 and May 24--of repealing in its entirety the
audit standard that was issued shortly after the passage of
Sarbanes-Oxley by the Public Company Accounting Oversight Board
under SOx 404 and replacing it with one that has the benefit of
the interim years of experience.
It is going to be top-down, risk-based, principles-based,
materiality-focused, and scalable for companies of all sizes.
None of those things was really a forte of the original
standard.
Senator Brownback. Do you think that will get at this loss
of the flight of companies to foreign markets?
Mr. Cox. That is certainly a part of it. But I started with
a reference to competition for this reason. There is more
competition now than there used to be. In days gone by there
simply were not the large pools of capital around the world to
tap, nor the technological means and the commercial means that
would offer a feasible choice for many issuers.
Today that competition exists. I think the competition
itself is good. It is healthy. It tends to reduce the cost of
capital. But we want to make sure that that competition is not
a regulatory competition that lowers standards for investor
protection. So we are working with our counterpart regulators
to make sure that, as we flense the blubber from the regulatory
system and wash out any unnecessary costs, we, if anything,
increase the level of investor protection by closer
collaboration overseas.
If you take a look at what is actually going on in the
markets, while it is true that the lion's share of foreign IPOs
went elsewhere and we did not attract them in the United States
in recent years, this year we are on track, according to
Thomson Financial, to add the most foreign listings on U.S.
exchanges since 1997. That is a good development.
It was also recently reported that foreign companies
accounted for over 23 percent of IPO proceeds last year, and
that is the highest since 1994. So there is every reason to
think that the United States will maintain its lead and the
largest market share on Earth. We are still the largest,
deepest, most liquid pool of capital in the world. But we do
not want to take that for granted, and regulators as well as
marketplace participants all have to constantly sharpen our
competitive edge.
Senator Brownback. I appreciate you looking at that and
considering that. I am putting in a bill today on the
Communities First Act, that is to provide targeted regulatory
relief for community banks--these are small banks across the
United States--that will provide some relief on section 102 of
Sarbanes-Oxley by exempting insured depository institutions
with consolidated assets of $1 billion or less from provisions
of the internal control requirements in section 404.
I just advise you of that. In my State we have a number of
small banks, small institutions. A number of the Sarbanes-Oxley
provisions have been very difficult, very onerous on them, and
this regulatory relief would be something that would be
helpful. I want to make sure that this regulation is not
putting the United States at a competitive disadvantage in
global capital markets.
I appreciate your answer and working with us on these
topics.
Thank you, Mr. Chairman.
Senator Durbin. Thank you, Senator Brownback.
RIGHTS AND REMEDIES AVAILABLE TO INVESTORS
A few more questions if I might. It is my understanding,
Chairman Cox, based on the Wall Street Journal article of April
16 that the SEC is exploring the idea of eliminating the rights
of investors to pursue legal remedies in court, instead
shifting to arbitration. Inasmuch as your responsibility as
Chairman of the SEC includes protecting investors and
maintaining fair, orderly, and efficient markets, I would like
to ask you a few questions if I might.
You stated earlier there are fewer class actions that are
being filed, which is an indication that the litigation rate is
not increasing. But when it comes to this suggestion of moving
the rights of investors to arbitration as opposed to the court
system and this limitation of the legal rights of investors,
how would you rationalize that decision against the fact that
most of the arbitration hearings are going to be private in
nature and some of the most dramatic information we have
received about corporate wrongdoing, such as the Enron case,
came in public forums, before the courts, leading to
congressional response and perhaps a little more wariness on
the part of investors?
Are you not going to sacrifice some of that openness and
transparency in this process if you move to an arbitration
standard?
Mr. Cox. Well, Mr. Chairman, I appreciate the opportunity
to state very clearly, as I did to the reporter who wrote the
story that you mentioned, that there is no pending rule or
proposal before the Securities and Exchange Commission to allow
corporations to mandate arbitration of shareholder claims. The
source for the story is unclear. It was not explained to me by
the reporter. But, as you will note, there were no other such
stories, and I hope that I can speak authoritatively to that
subject.
Senator Durbin. Thank you.
EXPEDITING FAIR FUND DISBURSEMENTS
Let me ask you, you have addressed this earlier, but I want
to make sure it is clear in the record here. The fair funds for
investors provision in Sarbanes-Oxley requires the SEC to
return money to investors victimized by securities fraud. I
think that your earlier statement was that you were making a
more concentrated effort in trying to return these funds. The
Government Accountability Office determined that as of 2005 the
SEC had disbursed money to wronged investors in only a few
cases--that is in 2005--and criticized the SEC for its slow
process for disbursing more than $4.8 billion in disgorgement
and penalties it had collected during the previous 3 years.
While the SEC had used the fair funds provision in 75 cases,
collecting money in a majority of those cases, the investors in
only 3 of those cases had received any money.
You quoted an earlier figure which I believe was $1.8
billion. I may be wrong.
Mr. Cox. $1.7 billion.
Senator Durbin. $1.7 billion.
Could you tell me, what is the status of this fair funds
activity and whether that represents--it does not represent
one-half, I believe, of what the GAO reported. But does it
represent or is it an indication that this next year there will
be even more funds to be disbursed?
Mr. Cox. It is in fact, Mr. Chairman. The figures that you
mentioned and the report that you mentioned from 2005, of
course, represented the state of affairs that I found at the
agency when I became Chairman in August 2005. That is why I
made it an immediate priority. The $1.7 billion that we have
distributed as of now is a substantial increase over what was
the case in 2005.
There is also $3.4 billion that we are very soon going to
be able to distribute that relates to the recent mutual funds
scandals, and that will be then the lion's share of the $3.8
billion remaining backlog.
Senator Durbin. Let me ask you about the WorldCom matter.
The SEC collected $750 million in penalties and fines there.
Could you tell me, what is the status of that reimbursement? I
understand some $150 million should be doled out to investors.
Mr. Cox. We have recently distributed $500 million,
beginning this past October. There is, however, more to be
distributed. The $750 million in total fair fund that was
established and approved by the court in July 2004 was
subsequently appealed to the Second Circuit Court of Appeals,
and they then approved the lower court's decision in October
2006.
WorldCom also recently emerged from bankruptcy and there
was a 9-month claims period because WorldCom was one of the
most heavily traded stocks in the market and was widely held by
small investors. The former Chairman of the Securities and
Exchange Commission, Richard Breeden, is serving as our
distribution consultant in this matter, and he has submitted a
distribution plan that we started executing immediately after
they emerged from bankruptcy.
VOLUME OF DISCLOSURE REVIEWS
Senator Durbin. Mr. Chairman, your budget submission
projects that the Divisions of Corporate Finance and Investment
Management expect to review the disclosures of about 33 percent
of all reporting companies and investment company portfolios.
In last year's request you indicated that 44 percent of the
disclosures would be reviewed. First, how do you select the
disclosures to be reviewed? What is the total volume of
filings, and why would you propose in next year's budget a 25-
percent decrease in the number of disclosure reviews?
Mr. Cox. The basis for the selection of submissions to
review is risk. That is true not only in the Division of
Corporation Finance, but it is true in our Office of
Compliance, Inspections, Examinations, and the Division of
Enforcement.
SOx requires now that we review all the registrants once
every 3 years, and so we are embarking upon that approach
separately. The volume of filings as against the risk of
filings gives us a tradeoff, therefore, that we have to make,
because SOx is just purely quantitative. We have got to get to
all of them ultimately. On a risk-based approach, we can focus
our resources where they are better used.
The figures that we provided to you about the number that
we expect to reach are projections; and we do not know
precisely where we will end up, of course, until we have the
experience.
Senator Durbin. Why would the percentage of those reviewed
decline by 25 percent from this fiscal year to next fiscal
year?
Mr. Cox. That is simply an estimate based on meeting our
SOx obligations at the same time that we pursue a risk-based
approach to reviewing the filings.
SCHEME LIABILITY LITIGATION
Senator Durbin. Let me ask you about the issue of scheme
liability litigation. The SEC has in the past taken the
position in amicus curiae filings that someone who engages in
deceptive conduct may be liable for engaging in a scheme to
defraud even without making false statements directly to the
public if the person undertook acts with the purpose and effect
of creating a misleading impression. For example, in October
21, 2004, the SEC filed a brief in the Home Store case in the
Ninth Circuit saying that if a third party engages with an
issuer of securities, ``in a transaction whose principal
purpose and effect is to create a false appearance of revenues
intending to deceive investors in the corporation's stocks, it
may be a primary violator.''
The Ninth Circuit relied on the SEC's interpretation in its
ruling and said: ``We agree with the SEC that engaging in a
transaction the principal purpose and effect of which is to
create the false appearance of fact constitutes a deceptive
act.''
Has anything occurred, Mr. Chairman, in the past 3 years
that would cause the SEC to change its position on the
liability of third parties?
Mr. Cox. No.
Senator Durbin. The issue of scheme liability is going to
be before the Supreme Court next term in the Stoneridge case.
This is also an issue that is at the heart of the decision by
the Fifth Circuit effectively denying the Enron victims their
day in court against the investment banks allegedly involved in
the fraud. The SEC has an opportunity to file an amicus brief
on June 11 standing up for its own rule and for the integrity
of the financial markets, as it did in the Home Store case. Can
investors count on the commission's support?
Mr. Cox. As you know, Mr. Chairman, the Solicitor General
will file a brief on behalf of the United States. The SEC will,
I believe, soon receive a recommendation from our General
Counsel on precisely how to proceed in that particular case.
The Commission will vote on it, and then we will make our
recommendations to the Solicitor General.
I expect that the net result of all of that will be that
the United States Government will do its level best to make
sure that injured Enron investors receive the full amount of
recovery to which they are entitled in our legal system.
Senator Durbin. So this matter has not been decided? It
will be under consideration after the Solicitor General----
Mr. Cox. Yes, this is all relatively recent in the last few
weeks.
STUDENT LOAN REPAYMENT FOR SECURITIES AND EXCHANGE COMMISSION EMPLOYEES
Senator Durbin. I would like to ask you one last question.
Do you use student loan forgiveness to recruit and retain
professional personnel?
Mr. Cox. It is an excellent question. I do not know the
answer. Let me see. Yes. Our Executive Director, sitting right
behind me, tells me that we do.
Senator Durbin. The staff just handed me a long list of
people who have benefited from this. So it appears that you do
use it. In fact, I would like to congratulate you for being a
Federal Government leader in using this program. It turns out
365 employees receive some money in student loan repayment
benefits. This is a program which I have encouraged. I think it
is an excellent way of attracting the best and the brightest to
public service when they are burdened with student debt and
might consider other careers. So I hope that you will continue
to use that.
Mr. Cox. We certainly will take your enthusiasm as it is
intended.
Senator Durbin. Thank you very much, Mr. Chairman, for
testifying today. I thank all those who have come from the
Securities and Exchange Commission.
ADDITIONAL COMMITTEE QUESTIONS
Our record will remain open for 10 days if there are any
written questions to be sent to you from our staff or the
staffs of the other Senators involved.
[The following questions were not asked at the hearing, but
were submitted to the Commission for response subsequent to the
hearing:]
Questions Submitted by Senator Richard J. Durbin
ARBITRATION
Question. In response to an inquiry at the hearing, you mentioned
that a report in The Wall Street Journal that the Commission is
considering a proposal originally described in the Capital Markets
Study that would empower corporations to amend their bylaws to mandate
arbitration of securities fraud class action cases was ``inaccurate''
although you did not specify how the article was inaccurate. What
assurance can you provide the Subcommittee that the SEC is not
considering any changes regarding arbitration?
Answer. There is no pending rule or proposal before the Commission
to allow corporations to mandate arbitration of shareholder claims.
Corporations should not be able unilaterally to limit the rights of
investors to sue, and I can assure you that the Commission does not
plan to advance any proposal that diminishes investor rights.
MARKET COMPETITIVENESS
Question. Three recently issued reports--the Committee on Capital
Markets Regulation Report, the McKinsey Report, and a report from the
U.S. Chamber of Commerce--raise concerns about the competitiveness of
the U.S. capital markets. These reports concluded that the
competitiveness of the U.S. markets is being hampered by our
overzealous regulatory and litigation environment.
All three reports relied on the same fact to support their claim--
that the U.S. share of the global IPO market dropped between 2000 and
2006. This statistic, however, is highly misleading. In fact, since the
implementation of the Sarbanes-Oxley Act, the number of U.S. IPOs has
risen dramatically. According to a recent article in Barron's, IPOs in
2006 increased 22 percent over 2005, and 170 percent over 2003. During
that same period, the number of foreign companies listing in U.S.
markets and the amount of money they raised here have also increased.
Furthermore, a recent study by Craig Doidge of the University of
Toronto and Andrew Karolyi and Rene Stulz of Ohio State University
found that there remains a significant premium for companies that list
in the United States, and this premium has not declined in recent
years, despite recent regulatory developments. The professors also
found that an exchange listing in New York still continues to provide
significant benefits to firms.
These facts confirm that U.S. markets are among the most highly
competitive in the world, and suggest that we are so competitive
precisely because of the unmatched protections we provide to our
investors.
What is your opinion? Do you believe that a market that provides
such protection and transparency actually increases competitiveness?
Answer. Yes. I agree. U.S. markets thrive because of the global
trust we've earned. That makes the SEC itself a key part of America's
capital markets that helps secure our global leadership, maintain our
markets' competitive edge, and secure the benefits of robust capital
formation for millions of Americans as well as countless people the
world over. But the SEC can only continue in this role if we constantly
update our rules, our policies, and our own way of operating to keep
pace with the increasingly rapid changes in the world of finance that
we regulate. The new global competition is good in that it tends to
reduce the cost of capital. But we are working to make sure that that
competition is not a regulatory competition that lowers standards for
investor protection and ultimately undercuts America's role as the
leading capital market in the world.
INVESTOR FRAUD TARGETING SENIORS
Question. Chairman Cox, in your prepared statement you discuss the
SEC's initiatives to combat investor fraud schemes which particularly
target seniors. I understand that the SEC recently teamed with the
University of Illinois College of Law and the Federal Reserve Bank of
Chicago to host a symposium focusing on this issue in Chicago.
Are there certain schemes that are aimed at older Americans?
What recommendations do you have for older Americans to better
guard their retirement funds? What is the SEC doing to inform and
educate consumers?
What specific actions has the SEC taken to reduce the prevalence of
these unscrupulous practices? What remedies have been the most
effective?
Answer. It was a great pleasure to be in Chicago on May 18 for the
Senior Symposium the Commission hosted with the Elder Law Journal of
the University of Illinois College of Law and the Federal Reserve Bank
of Chicago. The Symposium featured a distinguished panel of
representatives from the business, law, regulatory and academic
communities with significant experience tackling the issues facing
seniors as they prepare for and enjoy their retirement. The panelists
discussed how older Americans can protect themselves from investment
fraud while financially preparing for the future. It was a very
instructive and successful event.
As you know, fighting fraud against seniors requires aggressive
action. That's why last year I launched the SEC's ``Seniors
Initiative,'' which is designed to better coordinate the work of the
SEC's various offices and divisions and with state securities
regulators when it comes to prosecuting and preventing securities fraud
aimed at swindling senior citizens.
Educational efforts are an important of the Commission's strategy
for seniors and we are dedicated to putting better information in their
hands so they can make informed investment decisions. We are conducting
a series of seniors events around the country and will hold the second
Senior's Summit this fall.
We know that many seniors, and many children and caregivers of
seniors, use the Internet to search for information on investing. That
is why we created a section on our website (http://www.sec.gov/
investor/seniors.shtml) aimed specifically at senior investors.
The information on this website can help seniors fend off high
pressure sales pitches for legitimate, but arguably unsuitable
products. After reading our materials on equity-indexed annuities, for
example, seniors will know to avoid any salesperson claiming that
individuals ``can't lose money'' in that product. Investors can lose
money buying an equity-indexed annuity, especially if the investor
needs to cancel the annuity early.
In addition to providing critical information on other investments
commonly marketed to seniors, such as variable annuities, promissory
notes, and certificates of deposit, the website also provides key
information about how to detect and avoid fraudulent schemes.
This is also a top enforcement priority for the SEC. Since many of
the scams targeted at seniors involve ongoing fraud or Ponzi schemes,
time is often of the essence--both to stop the ongoing fraud and to
recover lost investor funds. In these instances, the staff may move
very quickly and seek emergency relief in the district courts. Once
emergency relief is obtained and the status quo is preserved to the
extent possible, the Enforcement staff generally goes through the same
detailed process it would in any investigation, which include
interviewing witnesses, requesting and reviewing documents, and taking
formal testimony.
The existing statutory penalties provide a broad range of available
sanctions, including cease-and-desist orders, censures, injunctive
relief, disgorgement, civil penalties, and industry bars. Moreover,
civil monetary penalties may be imposed in cases involving repeat
violations and severe frauds. I believe that the Commission's full
range of existing remedies allows enough flexibility to ensure that the
Commission can effectively prosecute cases involving fraud against
seniors. This is particularly true given the SEC's ability to make
criminal referrals in the most egregious cases.
STOCK OPTION BACKDATING AND SPRINGLOADING
Question. Numerous media accounts in recent months have reported
that many companies may have bent our securities laws by engaging in
stock option backdating and springloading as a way to provide senior
corporate management with manufactured gains.
Do you view the proliferation of this practice as a serious threat
to the integrity of the securities laws which you oversee?
If so, how many cases has the SEC brought in this area in the last
year?
Does the SEC need greater enforcement resources to combat
compensation practices such as these?
Answer. The SEC's Division of Enforcement is currently
investigating more than 140 companies for possible fraudulent reporting
of stock option grants. The companies under investigation are located
across the country, are of various sizes, and span multiple industry
sectors. All of the SEC's regional offices are currently involved in
these investigations.
Longstanding SEC policy precludes the disclosure of any information
about these ongoing investigations; however, enforcement actions have
been filed against former executives of Symbol Technologies, Peregrine,
Brocade, Comverse Technology, McAfee, Monster Worldwide, TakeTwo
Interactive Software, Engineered Support Systems, Apple Inc. and
Mercury Interactive. To date, the Commission has brought enforcement
cases against 4 issuers and 19 former executives. These cases involved
alleged misconduct of chief executive officers, general counsels, chief
financial officers, and other accounting and human resources employees.
The Department of Justice has also brought parallel criminal actions
against 10 of the 18 former executives charged by the Commission.
The SEC has taken many steps to ensure clear, full, and fair
disclosure about executive compensation, including that relating to
employee stock options. The revised executive compensation disclosure
rules the Commission adopted in July 2006 include a number of
provisions that directly or indirectly address backdating of options.
For example:
--A company must now disclose how it determines when it will make
equity awards. This will require a company to disclose how, and
why, it backdates for its executives.
--A company must disclose the grant date of equity awards. If the
grant date is different than the date on which the board took
action, the company must disclose the date of the board's
action.
--A company must disclose the exercise or base price of an option if
it is less than the market price of the underlying security on
the grant date. If it is less than the market price on the
grant date, the company must disclose the market price on the
grant date. This disclosure is intended to provide an investor
with a complete picture of the true terms of each option award
by allowing the investor to compare the grant date market price
to the in-the-money exercise price.
--Further, if the exercise or base price of an option grant is not
the closing market price per share on the grant date, a company
must describe its methodology for determining the exercise or
base price.
In addition, the Sarbanes-Oxley Act of 2002 tightened up a
company's obligation to report stock option grants. Before Sarbanes-
Oxley, officers and directors were not required to disclose their
receipt of stock option grants until after the end of the fiscal year
in which the transaction took place--which meant that an individual, in
some cases, had more than a year to disclose a grant. In August 2002,
the SEC issued rules requiring officers and directors to disclose
option grants within two business days.
In combination, these steps are an important contribution to
preventing backdating abuse. They have effectively eliminated easy
opportunities for companies to secretly grant options. Companies are
beginning to file reports with disclosure of executive stock option
grants in accordance with the Commission's new rules. Staff from the
Commission's Division of Corporation Finance will selectively review
these reports for compliance with the new rules, including those
relating to stock option awards. Where the disclosures indicate
possible violations of the federal securities laws, appropriate
referral of the matter will be made to our Division of Enforcement.
COMMISSION APPROVAL FOR SETTLEMENT TALKS
Question. On April 13, 2007, the Washington Post reported that SEC
had made a change in procedures such that your enforcement lawyers must
seek approval from the Commission before they begin settlement talks
that involve fining corporations, including seeking ranges for possible
fines. It has also been reported that this action may lead to lower
penalties.
Please comment on whether this report is accurate and whether you
believe it will lead to lower penalties and if so, was that its intent?
Answer. The Commission's procedures for authorizing settlement
negotiations in cooperate penalties cases are not designed to increase
or decrease the amount of monetary penalties paid by companies or to
make penalty payments more or less frequent. Rather, they are intended
to strengthen the negotiating position of our Enforcement Division in
settlement negotiations involving corporate penalties and streamline
the approval process for those cases. The implementation of the
procedures will be carefully monitored, and the procedures will not be
continued if they do not achieve these key objectives.
The process is designed to ensure that the laws are vigorously
enforced by giving the professional enforcement staff the full backing
of the Commission in the staff's settlement negotiations.
The pilot streamlines the settlement process by shortening final
Commission review and approval when the staff reaches a settlement
within the range authorized by the Commission.
The staff may always return to the Commission to recommend a higher
or lower penalty range if their recommendation changes based on new
information or a development that occurs during the settlement
negotiations.
WEAKNESSES IN INFORMATION SECURITY CONTROLS
Question. In carrying out its mission to ensure that securities
markets are fair, orderly, and efficiently maintained, the SEC relies
extensively on computerized systems. Integrating effective information
security controls into a layered control strategy is essential to
ensure that SEC's financial and sensitive information is protected from
inadvertent or deliberate misuse, disclosure, or destruction. In fact,
one of SEC's four strategic goals is ``maximizing the use of SEC
resources,'' which expressly includes ``enhancing internal controls.''
A recent GAO study acknowledged that the SEC has made progress
toward correcting previous weaknesses in information systems security,
and attributed progress to active engagement by SEC senior management
in implementing reforms. However, GAO emphasized that despite progress,
the SEC has not consistently implemented key controls to effectively
safeguard the confidentiality, integrity, and availability of its
financial and sensitive information and systems.
GAO recommends that the SEC Chairman improve the implementation of
its policies and procedures, control tests and evaluations, and
remedial action plans as part of its agency-wide information security
program.
Chairman Cox, what is the SEC actively doing to implement GAO's
recommendations to correct information security control weaknesses?
Answer. The SEC now devotes about 7 percent of the agency's
information technology budget on technology security--a significantly
greater share of overall information technology resources than many
other agencies. Our efforts run the gamut from highly technical
initiatives such as server configuration management, to equally
critical but ``softer'' programs such as user awareness training.
In one major improvement initiative, the SEC has invested over $2
million during fiscal year 2006 to enhance our core financial
management system. These upgrades include new hardware and software, as
well as implementing a more secure database. As part of this upgrade,
the SEC will continue to make enhancements to business processes and
automated workflows that will improve internal controls, eliminate
traditional financial management paper processes, and enhance reporting
capability and efficiency. Beyond these benefits, the updated hardware
and software will provide much greater assurance that the system
complies with modern information security standards.
We have also taken significant steps to upgrade physical security
throughout SEC buildings. Specialists have evaluated the structures and
installed computerized identification card authentication systems,
cameras, and alarms in key facilities. The number of entrances at our
data operations center has been reduced. Guards have been redeployed
and retrained. We have also put in place new technology and changes in
procedures to restrict access to sensitive rooms on SEC premises, such
as data centers and network closets.
We are continuing our efforts to tighten access controls that
prevent, limit, or identify inappropriate access to data, equipment,
and facilities. All of these controls are designed to prevent
unauthorized disclosure, modification, or destruction of sensitive
information.
While the SEC has strong access control policies, a number of
issues identified during the audit were related to inadequate
compliance with existing agency policies by individuals responsible for
the system and technical staff. To address this concern, the SEC has
stepped up educational and enforcement efforts. System owners--
individuals responsible for the system--have been presented with all
agency information technology policies and have been directed to sign
documentation showing that they have reviewed those policies. Beyond
developing an educated population, we are also focused on errors that
can happen through inattention. To address such issues, the SEC is
implementing a systemic scanning program administered by teams that are
organizationally separate from the system owners. System owners will be
presented with the results of those scans and directed to correct any
vulnerabilities and mitigate risks on systems that do not comply with
SEC policies. By implementing a continuous scanning approach, the
agency expects to achieve dramatic cost savings. These savings can be
achieved because configurations will be corrected early on, before they
can have a negative effect on operations. Such practices will also
reduce the amount of resources and time required to correct problems in
the future.
The SEC also is making efforts to address weaknesses in its IT
``change management'' processes. These are the processes and procedures
that govern the way that software and other technologies are deployed
into the SEC's environment. The GAO has recommended a number of
improvements to ensure that such deployments do not introduce security
weaknesses, whether inadvertently or as the result of an insider with
malicious intent. Therefore, we are taking steps to better oversee our
environment through such measures as weekly change control board
meetings, better communication between the involved groups, improved
version management procedures, and an enhanced test environment.
As Chairman, I am committed to implementing all of the GAO's
recommendations. I anticipate that we will again see significant
improvements in our information security posture at the conclusion of
this year's audit.
RISK-BASED EXAMINATIONS--TARGETED ACTIVITIES
Question. In your budget justification document for fiscal year
2008, in the section covering the Office of Compliance Inspections and
Examinations and your risk-based examination program, you explain that
SEC's resources will be focused on those firms and practices that have
the greatest potential for violative conduct that can harm investors.
You state that ``higher-risk activities'' include those that
``create significant conflicts of interest where compliance policies
and procedures are insufficient to mitigate those conflicts.''
Please explain in greater detail what these ``higher risk
activities'' include, and how you target them.
Answer. Higher risk activities at adviser, funds, and broker-
dealers include business practices that create significant conflicts of
interest that, if not monitored and mitigated in some fashion, may
result in harm to clients or investors, such as: soft dollar
arrangements; directed brokerage; performance advertising; custody and
possession of client funds and securities; difficult-to-value
securities; access to non-public information; and significant personal
trading by employees of the firm. In examinations of broker-dealers,
our risk-based focus is on areas such as: compliance with capital
requirements and operational issues; sales practices including
suitability, churning, and unauthorized trading; supervision; new
products; order handling and trading rules; and anti-money laundering
rules.
The Office of Compliance Inspections and Examinations (OCIE) has
implemented a risk-based approach to examinations. OCIE's goal is to
identify emerging areas of compliance risk, conduct examinations and
take steps to remedy identified problems. Given the number of firms
registered with the SEC and the breadth of their operations, the staff
continues to focus examination resources on those registrants and
activities where the investing public or market integrity is most at
risk.
In recent years, the examination program has enhanced its efforts
to proactively detect and address potential risks, and provide
balanced, cost-effective and reasonable oversight of the regulated
community. Many of these higher risk activities have been identified
through years of experience with examinations and enforcement
activities at registered firms. However, we are continually searching
for areas of risk that are new or unique to the investment management
community. To assist the staff in identifying risks warranting
examination follow-up, OCIE utilizes a risk-identification and risk-
assessment methodology. This methodology uses an internal database to
identify and prioritize risks, consider mitigating and aggravating
conditions, and recommend regulatory or other actions to be taken to
remove or mitigate the risks. As part of this risk assessment process,
examination staff nationwide provide feedback about where risks may
exist in the industry and to propose possible solutions. This risk-
assessment process is used to identify risks requiring regulatory or
examination follow-up and to build a culture of risk-assessment within
the examination program.
Higher risk activities are targeted primarily through our
examination process. All of our routine examinations will focus on
those activities and areas presenting the greatest concern to investors
(many of which are identified above). In addition, exam staff may
specifically conduct focused risk targeted examination sweeps to
determine the extent and interpret emerging risks in the regulated
community. In such examinations, examiners review risk conditions and
responsive controls for a particular compliance risk at a sample of
firms. This approach allows the staff to obtain a more comprehensive
view of the particular risk, assess the gravity of the risk, evaluate
the compliance performance of individual firms compared to that of
their peers, and suggest regulatory solutions. These examinations may
often identify specific areas of interest and risk that are
incorporated into our regular examination process.
______
Questions Submitted by Senator Sam Brownback
Question. As I mentioned in my statement, recent articles in the
``New York Times,'' ``Wall Street Journal,'' ``Financial Times'' and
``The Economist'' have all suggested that tenets of Sarbanes-Oxley are
cause for a decrease in American-listed public companies compared to
foreign exchanges such as London and Hong Kong, because the Act takes
away incentives to list on an American exchange. Do you agree with this
assessment?
A recent report by McKinsey & Company commissioned by Senator
Schumer and New York City Mayor Bloomberg found that over the first ten
months of 2006 U.S. exchanges attracted barely one-third of the share
of IPOs they captured back in 2001. During that same time, European
exchanges increased market share by 30 percent and Asian exchanges
doubled their share. Most importantly, the study found this trend was
``due to non-U.S. issuers' concerns about compliance with Sarbanes-
Oxley Section 404 and operating in what they see as a complex and
unpredictable legal and regulatory environment.'' Do you agree with
these findings? What can we do to stem the flow of companies to foreign
exchanges?
Answer. Over the past year, a number of reports have been published
which advise the SEC and Congress on how to deal with increasingly
global capital markets. They have offered the Commission and
policymakers in Congress and the Executive Branch many recommendations.
These reports, including the report by McKinsey & Company commissioned
by Senator Schumer and Mayor Bloomberg frequently cite the increase in
foreign-listed IPOs as cause for concern about the competitiveness of
U.S. markets, and cite the Sarbanes-Oxley Act as a contributor to
capital flight from the United States.
I agree that Sarbanes-Oxley is a factor in the decision of some
issuers to list overseas. I am comfortable stating this because several
issuers, underwriters, accountants, and attorneys have shared the
reasons behind their decisions to list overseas with me and have cited
SOX as a reason. But despite this kind of unfiltered, episodic
information much more is at work here. We need to recognize that our
capital markets are changing at an accelerating pace and that we are
living in a very dynamic, much more competitive world. There are more
opportunities to raise money and deeper, more varied pools of capital
in other countries than ever before. Even if SOX were provably and
quantifiably a determinant in the increase in foreign market IPOs--and
sound science does not permit such neat conclusions--the fact is there
are simply greater competitive challenges than ever before to the
United States' leading position in the world as the largest, deepest,
and most liquid markets.
Our continued global market leadership is not America's birthright.
We have to constantly earn it. That is true for our private sector and
it is true for our regulatory system. As regulators, we must constantly
work to sharpen our competitive edge as well. When it comes to SOX,
that has meant completely overhauling the expensive, inefficient
auditing standard that was used to implement section 404. We recently
repealed it and replaced it with a new standard that is clearly written
in plain English, is less than half as long, and is risk-based,
materiality-focused, and scalable for companies of different sizes. We
expect it to dramatically reduce the costs of SOX 404 compliance.
That said, the evidence of some high profile foreign IPOs no longer
listing in the United States may simply be an indication that other
markets have improved, not that the United States has become
unattractive. A steady stream of foreign companies continues to tap the
U.S. markets. In fact, according to Thomson Financial, this year is on
pace to add the most foreign listings on U.S. exchanges since 1997. It
was also recently reported that foreign companies accounted for 23.4
percent of IPO proceeds last year--the highest amount since 1994.
Question. Chairman Cox, the press has reported that the SEC intends
to put forward its management guidance in the next few weeks. Can you
comment on the timeline to putting forth this guidance and the process
for its adoption?
Answer. On May 23, 2007, the Commission unanimously approved
interpretive guidance to help public companies strengthen their
internal control over financial reporting while reducing unnecessary
costs, particularly at smaller companies. The new guidance will enhance
compliance under Section 404 of the Sarbanes-Oxley Act of 2002 by
focusing company management on the internal controls that best protect
against the risk of a material financial misstatement. It is currently
in effect.
The Commission also approved rule amendments providing that a
company that performs an evaluation of internal control in accordance
with the interpretive guidance satisfies the annual evaluation required
by Exchange Act Rules 13a-15 and 15d-15. The Commission also amended
its rules to define the term ``material weakness'' as ``a deficiency,
or combination of deficiencies, in internal control over financial
reporting, such that there is a reasonable possibility that a material
misstatement of the company's annual or interim financial statements
will not be prevented or detected on a timely basis.'' The Commission
also voted to revise the requirements regarding the auditor's
attestation report on the effectiveness of internal control over
financial reporting to more clearly convey that the auditor is not
evaluating management's evaluation process but is opining directly on
internal control over financial reporting. These changes, too, are now
in effect.
In addition, the SEC in July 2007 repealed the costly Auditing
Standard No. 2, which had made Sarbanes-Oxley compliance so difficult,
and replaced it with a completely new standard that is top down, risk-
based, materiality focused, and scalable for companies of all sizes.
The replacement standard, Auditing Standard No. 5, is now in effect.
Question. The data shows that smaller public companies have
experienced a disproportionate burden from Sarbanes-Oxley. Given that
you are re-writing the rule-book for management, are you going to do
anything to grant further relief for the non-accelerated filers? Some
of my colleagues (Sen. Snowe and Sen. Kerry) have called for delayed
implementation of the Sarbanes-Oxley Section 404 requirements for small
public firms to ease the burden on complying with the expected new
auditing standards.
Answer. The question of further deferral for non-accelerated filers
is still open. The SEC has, however, already deferred compliance for
non-accelerated filers four times in an effort to ensure that the
burden of compliance did not unduly impact smaller companies. The very
positive result of our determination to phase in 404 for smaller
companies is that we and they have had the opportunity to field test
the requirements so that smaller companies have the benefit of learning
from the experiences of larger firms.
These experiences have deeply informed the SEC's new Interpretive
Guidance and the PCAOB's new auditing standard. The continued phased
implementation will allow smaller firms to start complying with section
404(a) of SOX starting in 2008, while the first audit under section
404(b) won't be due until 2009.
The SEC's new guidance is intended to be of significant help to
small companies. Completing the implementation of Section 404 is
important to further enhancing the quality of reporting and increasing
investor confidence in the fairness and integrity of the securities
markets. The Commission and the PCAOB will continue our ongoing
outreach efforts over the coming months to ensure that the changes
recently made in the implementation of section 404 live up to our
expectations for a more effective and efficient system for all filers.
In particular, we will focus on the extent of the expected cost
reductions for first-time accelerated filers during 2008 under the new
Auditing Standard No. 5 and our new Interpretive Guidance.
Question. The majority of the problems with Sarbanes-Oxley have
been the implementation--not the language itself. What is the SEC going
to do to ensure that the fixes put forward in its new guidance are
successfully implemented in order to bring the cost-benefit back into
alignment?
Answer. With new guidance that allows management to scale and
tailor evaluations to focus on what matters most--and with a new
auditing standard that enables auditors to deliver more cost-effective
audit services--one final step remains. The SEC and the PCAOB expect a
change in the behavior of the individuals who are responsible for
following these new procedures. To that end, the PCAOB's inspection
program will monitor whether audit firms are implementing the new
auditing standard in a cost-effective way that is designed to achieve
the intended results. And the SEC, in our oversight capacity, will
monitor the effectiveness of the PCAOB's inspections. So both the SEC's
and the PCAOB's inspectors will be focused on whether audit firms are
achieving the desired audit and cost efficiencies in the implementation
of 404. The SEC staff will also conduct an economic analysis--using
real-world information--to evaluate whether the costs and benefits of
implementing section 404 are in line with our expectations.
Question. I understand that, due to concerns about the burdensome
effects of section 404 of Sarbanes-Oxley, the Chamber of Commerce has
asked that you delay 404 compliance for smaller public companies. Do
you plan to delay 404 compliance? How can you limit the burden of
section 404 on small companies?
Answer. With respect to the potential for a further delay of 404
compliance for smaller public companies, see the answer to Question 4,
above. With respect to other ways that the SEC can reduce the burden of
section 404 on small companies, we have very recently approved
Interpretive Guidance recognizes that smaller public companies
generally have less complex internal control systems than larger public
companies.\1\ The new Interpretive Guidance is intended to assist
management of smaller companies in scaling and tailoring their
evaluation methods and procedures, recognizing that what is necessary
in a large company may not be appropriate for smaller companies with
less complex internal controls systems.
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\1\ Final Report of the Advisory Committee on Smaller Public
Companies to the United States Securities and Exchange Commission (Apr.
23, 2006) at 39-40, (``Advisory Committee Report'') available at http:/
/www.sec.gov/info/smallbus/acspc/acspc-finalreport.pdf.
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The Interpretive Guidance is intended to allow management
sufficient and appropriate flexibility to design an evaluation process
that fits its facts and circumstances. We are encouraging smaller
public companies to take advantage of the flexibility and scalability
afforded in the guidance to conduct an evaluation of internal controls
that is both efficient and effective at identifying material
weaknesses.
In order to help smaller companies understand how they can tailor
their evaluation efforts, the guidance specifically highlights some of
the key areas where the evaluation at a smaller company might be
different than for a larger company. For example, three key points
within the evaluation process are the overall determination of
effectiveness of the design of controls, the testing of the operating
effectiveness, and the documentation needed to sufficiently support
both. The Interpretive Guidance includes guidance on each of those
points indicating how a smaller company may accomplish those
requirements of the evaluation process.
The guidance explains how a small company might approach 404
differently than a large company. For example:
--A smaller company would probably follow fewer and different steps
in evaluating whether its controls will provide reasonable
assurance about the reliability of its financial reports.
--Management in a smaller company can go about obtaining information
on whether its controls operate as designed in different and
less elaborate ways than would be necessary in a large company.
--The documentation needed to provide reasonable support for a
smaller company's controls will normally be less than what's
required in a larger company.
Question. The Chamber of Commerce has asked that you clarify a
number of defined terms so that companies have better guidance about
what is required of them to comply with section 404. These terms
include ``material weakness,'' ``significant deficiency,'' and
``materiality.'' Have you further clarified the use of these terms?
Answer. On May 23, 2007, the Commission adopted amendments to its
rules to define the term ``material weakness'' as ``a deficiency, or
combination of deficiencies, in internal control over financial
reporting (ICFR), such that there is a reasonable possibility that a
material misstatement of the company's annual or interim financial
statements will not be prevented or detected on a timely basis.'' Our
intention is to re-focus 404 compliance on the specific problem that
Congress had in mind: material risks to reliable financial reporting.
In that way, we will better protect investors and companies can more
wisely spend their money on meaningful evaluations of internal
controls. In addition, the definition of material weakness, including
the indicators of material weakness, has been aligned between the
Commission's management guidance and the PCAOB's Auditing Standard No.
5 to promote consistency in the considerations made by management and
auditors in evaluating deficiencies.
In addition, on June 20, 2007, the Commission issued a release
seeking additional comment on a proposed definition of a ``significant
deficiency.'' The proposal defines ``significant deficiency'' as ``a
deficiency, or combination of deficiencies, in internal control over
financial reporting that is less severe than a material weakness, yet
important enough to merit attention by those responsible for oversight
of a registrant's financial reporting.'' In drafting the proposed
definition, we considered comments received by the PCAOB in response to
its proposed auditing standard. We believe that the proposed definition
reflects the Commission's belief that the focus of the term
``significant deficiency'' should be the underlying communication
requirement that results between management, audit committees and
independent auditors. The comment period on this proposal ends on July
18, 2007 and we will evaluate comments received to ensure that the
final definition effectively communicates the Commission's objectives.
With regards to materiality, both the SEC and PCAOB received a
number of comments, including those received from the Chamber of
Commerce, suggesting that more guidance should be issued related to
materiality and how it applies to the evaluation and assessment of
ICFR. For management, judgments regarding materiality often must
consider many factors that can vary based on each company's individual
facts and circumstances. These areas are frequently complex and involve
significant judgment, which makes providing ``bright-line'' guidance
and examples difficult and presents the risk of unduly restricting
management's ability to effectively utilize and apply its informed
judgment. Nonetheless, we are continuing to seek feedback on the more
challenging issues relative to materiality considerations and the
appropriateness of providing additional guidance.
Question. Past chairman of the National Venture Capital
Association, Robert Grady, wrote a few weeks ago that section 404 is
causing an outcry because it requires ``tiny companies to provide shelf
after shelf of process-oriented paperwork, at the cost of millions of
dollars, that no investor is even likely to read.'' Do you agree with
this assessment? How can we--as Grady says--``bring sanity to this
process?''
Answer. The SEC is keenly attuned to making sure that the U.S.
capital markets remain robust and competitive, and to helping small
businesses remain competitive in the global marketplace. To date, no
tiny company--this is, no company with public float of less than $75
million--has had to comply with section 404.
To ``bring sanity to this process,'' as Mr. Grady suggests, the SEC
is working to make sure that its regulations are scalable and that they
do not impose an undue burden on small businesses. In May 2007, the SEC
proposed and adopted a number of changes--in the way private offerings
are conducted in the United States, and in the section 404 internal
controls reports that companies are required to file with us--that
address both scalability and competitiveness.
We continually review our regulations with a view towards reducing
the burdens of being a public company and to remove obstacles to
raising capital, consistent with investor protection. On May 23 the
Commission approved an entire package of rule change proposals designed
to modernize and streamline capital raising and reporting requirements
affecting small business. The small business improvements that the SEC
recently proposed include:
--Giving small businesses access to the expedited ``shelf''
registration process for their own securities offerings, which
previously was available only to big companies.
--Cutting paperwork for thousands of small businesses, by allowing
them to raise capital in a private offering after filing a
simplified Form D online.
--Establishing shortened holding periods for restricted securities,
making it easier for small business shareholders to put their
securities on the market sooner and hopefully reducing the
discount that small businesses must absorb to sell restricted
securities.
--Giving issuers the benefit of a new, limited offering exemption
from Securities Act registration requirements for offerings and
sales of securities to a newly defined category of ``qualified
purchasers'' in which limited advertising would be permitted.
--Eliminating the limit on the number of employees who can receive
stock options from their fast-growing private firms, improving
the ability of emerging growth companies to attract and retain
talent without prematurely triggering the requirements of the
Exchange Act.
--Providing a simplified system of disclosure for almost 1,600
additional smaller public companies, an increase of over 45
percent in the number of small companies that are currently
eligible.
Many of these rule proposals address key recommendations made by
the Commission's Advisory Committee on Smaller Public Companies. We
look forward to further input from the small business community as we
receive the public comments on those proposals. We will continue to
consider additional recommendations made by the Advisory Committee.
Question. A new undertaking of the SEC is the oversight of credit
rating agencies. Could you please tell me a little bit more about this
and what led the SEC to begin this new project?
Answer. On May 23, 2007, the Commission voted to adopt final rules
to implement provisions of the Credit Rating Agency Reform Act of 2006,
which was enacted into law in September 2006. The Credit Rating Agency
Reform Act defines the term ``nationally recognized statistical rating
organization'' (NRSRO), provides authority for the Commission to
implement registration, recordkeeping, financial reporting, and
oversight rules with respect to registered credit rating agencies. The
Commission acted well in advance of the statutory deadline to establish
the regulatory regime for rating agencies and to lower the barriers to
entry into this market.
The goal of this new law is to improve credit ratings quality by
fostering competition, accountability, and transparency in the credit
rating industry. The heart of the Act calls on the Commission to
replace the barriers to entry that had previously existed. The
replacement is a transparent and voluntary Commission registration
system that favors no particular business model. The SEC adopted rules
in each of these areas that would implement the Credit Rating Agency
Reform Act.
Question. What are the methods of enforcement used against
violators of federal securities laws?
Answer. Investigations begin when the staff obtains information
from any of a wide range of sources about a possible violation of the
securities laws. Sources include the surveillance units at the
exchanges, examinations of regulated entities, issuer filings, news
reports, and investor complaints. When the staff first obtains a lead,
it conducts a preliminary inquiry. If the lead seems promising, the
staff opens an informal investigation and requests voluntary submission
of documents and sworn testimony from witnesses. If the staff cannot
obtain documents or testimony voluntarily, the Commission can issue a
formal order of investigation, which authorizes the staff to issue
subpoenas for testimony and the production of documents. If an
investigation uncovers evidence of wrongdoing, the staff meets with the
Commission, presents a description of the case, suggests what action is
appropriate and discusses various alternatives. The Commission may then
authorize the staff to begin public enforcement action in a federal
district court or before a Commission administrative law judge. The
Commission may also accept proposals submitted by the alleged violated
to settle the proposed charges.
The securities laws provide for a broad range of sanctions,
including: cease-and-desist orders, censures, injunctive relief,
disgorgement, civil penalties, and industry bars. Moreover, civil
monetary penalties may be imposed in cases involving repeat violations
and severe frauds. The Commission's full range of existing remedies
ensure that the Commission can effectively prosecute cases. This is
particularly true given the SEC's ability to make criminal referrals in
the most egregious cases.
Question. Commissioner Cox, would you please explain how the SEC
cooperates with foreign authorities especially regarding cross-border
enforcement?
Answer. Because fraudsters take advantage of borderless capital
markets, the SEC requests assistance from foreign counterparts in all
types of investigation--from fraud committed by investment advisers, to
market manipulation schemes, to account intrusion cases, to
international insider trading rings. To promote information sharing in
cross-border securities investigations, the SEC was a founding member
of the International Organization of Securities Commissions (IOSCO),
and supported IOSCO's endorsement of the Multilateral Memorandum of
Understanding (MMOU) in 2002. The MMOU requires signatories to meet
international standards for international enforcement cooperation. The
growing number of signatories to the MMOU is strong evidence of the
increasing ability of our foreign colleagues to assist in international
investigations. In fact, a number of foreign counterparts have
strengthened their laws in order to be able to meet the international
standard required to join the MMOU and thus be considered among the
responsible members of the international enforcement community. As of
September 2006, 34 securities and derivatives regulators had become
signatories to the MMOU, and 9 additional IOSCO members had expressed
their commitment to become signatories.
We are also witnessing an increase in the number of investigations
(and, consequently, the number of requests for assistance) in major
capital markets, such as Canada and Australia, with enforcement
programs similar to our own. We are also seeing fervent enforcement
efforts in other less developed markets. Some of the nations whose
markets are emerging, whose enforcement laws are newly minted or
strengthened, or whose regulatory agencies are recently established are
keen to establish robust enforcement programs. The tremendous demand
for the SEC to send staff to train foreign investigators demonstrates
our counterparts' interest in effective enforcement and in combating
securities fraud. In response, the SEC conducts technical assistance
and training which, over the course of close to 20 years, has resulted
in more effective enforcement programs around the world.
The most prominent type of illegal activity as to which our foreign
counterparts seek assistance is in the area of insider trading. In the
past 13 months, the SEC has received over 50 requests from our foreign
counterparts to assist in insider trading investigations. During this
same time frame, we have also received a substantial number of requests
from abroad seeking assistance in market manipulation investigations
(that is, cases where fraudsters may have manipulated the market price
of a company's stock by false representations about the company or by
illegal trading in the stock.)
CONCLUSION OF HEARINGS
Senator Durbin. This meeting of the subcommittee will stand
recessed.
[Whereupon, at 3:58 p.m., Wednesday, May 16, the hearings
were concluded, and the subcommittee was recessed, to reconvene
subject to the call of the Chair.]
Material Submitted Subsequent to the Hearings
FEDERAL DEPOSIT INSURANCE CORPORATION
Prepared Statement of Jon T. Rymer, Inspector General, Office of the
Inspector General
Mr. Chairman and Members of the Subcommittee: I am pleased to
present the fiscal year 2008 budget request totaling $26.8 million for
the Office of Inspector General (OIG) at the Federal Deposit Insurance
Corporation (FDIC), the first budget request since I took office on
July 5, 2006. This request will allow us to continue meeting our
statutory responsibilities and assist the FDIC in effectively carrying
out its mission.
As you know, the Congress created the FDIC in 1933 as an
independent executive agency, during the Great Depression, to maintain
stability and public confidence in the nation's banking system. Our
nation has weathered several economic downturns since that era without
the severe panic and loss of life savings unfortunately experienced in
those times. The federal deposit insurance offered by the FDIC is
designed to protect depositors from losses due to failures of insured
commercial banks and thrifts. The Congress enacted deposit insurance
reform legislation that will maintain insurance coverage for individual
accounts at $100,000, but provides for inflation indexing every 5 years
beginning in 2011. Also, as of April 1, 2006, coverage for certain
retirement accounts increased to $250,000 from $100,000, with similar
inflation indexing. According to most recent FDIC data, as of December
31, 2006, the FDIC insured $6.6 trillion in deposits for 8,693
institutions, of which the FDIC supervised 5,220. The FDIC promotes the
safety and soundness of these institutions by identifying, monitoring,
and addressing risks to which they are exposed.
The Corporation reports that industry earnings are at record-high
levels, bank capital is historically high, and loan performance has
slipped only slightly from record levels. Currently, there are 50
institutions on the ``problem list''--one of the lowest numbers in the
history of the FDIC. Unfortunately, the 31-month streak of no
failures--the longest in FDIC history--ended in February 2007, when one
small institution, Metropolitan Savings Bank, failed. Still, the
financial health of the banking industry remains very good overall. As
for the economy, it is now in a sixth year of expansion; however, U.S.
economic growth appears to be slowing significantly and some negative
trends are emerging in the banking sector. They include a narrowing of
net interest margins; increasing concentrations of riskier commercial
real estate loans; and signs of credit distress in subprime mortgage
portfolios. As economic conditions shift, the OIG is poised to focus
its work on the challenges facing the FDIC in monitoring and assessing
various existing and emerging risks to insured depository institutions
and the Deposit Insurance Fund.
The FDIC OIG is an independent and objective unit established under
the Inspector General Act of 1978, as amended. The OIG's mission is to
promote the economy, efficiency, and effectiveness of FDIC programs and
operations, and protect against fraud, waste, and abuse to assist and
augment the FDIC's contribution to stability and public confidence in
the nation's financial system.
Before discussing our budget needs for fiscal year 2008, I would
like to highlight some of our accomplishments from the past fiscal
year, our assistance to FDIC management, our planning and internal
initiatives to improve the OIG, and the management and performance
challenges facing the FDIC.
a review of the fdic oig's fiscal year 2006 accomplishments
As in past years, during fiscal year 2006, our work in audits,
evaluations, and investigations resulted in a number of major
achievements, as follows: $44.9 million in actual and potential
monetary benefits; 26 audit and evaluation reports issued; 82 non-
monetary recommendations to FDIC management; 49 referrals to the
Department of Justice; 42 indictments/informations; 26 convictions; 1
employee/disciplinary action.
More specifically, our accomplishments included investigations that
led to the above indictments and convictions as well as fines, court-
ordered restitution, and recoveries that constitute slightly over $39
million in actual and potential monetary benefits from our work. Our
audit and evaluation reports included about $3.4 million in questioned
costs and $1.5 million in recommendations that funds be put to better
use. The audit and evaluation reports contained non-monetary
recommendations to improve FDIC policies, operations, and controls that
ultimately are designed to improve the FDIC's ability to effectively
and efficiently accomplish its mission.
On the whole, the OIG accomplished all of its organizational goals
during the fiscal year, as outlined in our annual performance plan. Our
2006 Performance Report shows that we met or substantially met 100
percent of our goals. In a measurable way, this achievement shows the
progress we continue to make in adding value to the Corporation with
our audits, investigations, and evaluations in terms of impact,
quality, productivity, and timeliness.
The following audit, evaluation, and investigative work illustrates
some of the OIG's accomplishments in fiscal year 2006:
--Audit reports addressed significant issues. For example, one report
contained recommendations to ensure that the FDIC periodically
validates key assumptions, estimates, or other components that
factor into the calculation of the reserve ratio, which is the
ratio of the balance in the Deposit Insurance Fund to estimated
deposits in the banking system. In connection with corporate
governance practices, this report also recommended improved
communication of information relevant to deposit insurance
assessment determinations and other corporate matters and
activities to the FDIC Board of Directors. Several reports
dealt with various consumer protection and community
reinvestment issues, including predatory lending, use of Home
Mortgage Disclosure Act data to identify and assess instances
of potential discrimination in FDIC-supervised institutions,
and the FDIC's process for addressing the violations and
deficiencies reported in compliance examinations. Our Federal
Information Security Management Act-related audits have
contributed to the FDIC making significant progress in the past
several years in improving security controls and addressing
current and emerging information security requirements.
--Evaluation reports focused on a number of important corporate
issues, including the industrial loan company application
process, the FDIC's safeguards over personal information,
contract administration, and the FDIC's emergency response
plan. The reports have generally contributed to strengthened
program controls and improved corporate governance of FDIC
operations.
Successful investigative outcomes included the following:
--The former president and chief executive officer of Hawkeye State
Bank (HSB) was ordered to pay $3.7 million in restitution based
on his stipulating to having caused $4.9 million in losses to
HSB. He was sentenced to 65 months of incarceration and 5 years
of supervised release.
--The former president of the First National Bank of Blanchardville
was sentenced to 9 years' incarceration and ordered to pay
restitution of $13 million to the FDIC.
--The former chairman of the board and chief executive officer of
Hamilton Bank was sentenced to 30 years of incarceration and 36
months of supervised released. He had earlier been convicted on
all 16 charges of making false filings to the Securities and
Exchange Commission and to bank examiners, making false
statements, wire fraud, bank fraud, securities fraud,
obstruction of a bank examination, and conspiracy. He, along
with two other convicted Hamilton Bank officers, was ordered to
pay $32 million in total restitution for bank and securities
fraud, $16 million of which is payable to the FDIC.
--The former chief executive officer (CEO) of the now defunct Sunbelt
Savings and Loan of Dallas, Texas, an institution whose
insolvency cost taxpayers approximately $1.2 billion, was
sentenced to 15 years' imprisonment and ordered to pay a
criminal forfeiture of $2 million to the United States
Government and restitution in the amount of $312,828 to the
FDIC. The former CEO was convicted on 27 counts involving
defrauding the FDIC of its payments of $7.5 million and $8.5
million in a civil judgment resulting from his 1990 guilty plea
to federal fraud charges in connection with the collapse of
Sunbelt.
ASSISTANCE TO FDIC MANAGEMENT
In addition to audits, investigations, and evaluations, the OIG
made valuable contributions to the FDIC in several other ways. Among
these contributions were the following activities:
--Reviewed 14 proposed corporate policies and offered comments and
suggestions when appropriate (e.g., Employee Rights and
Responsibilities under the Privacy Act of 1974, Encryption and
Digital Signatures for Electronic Mail, Protection of Privacy
Information, the FDIC's Software Configuration Management
Program, and Enterprise Risk Management);
--Participated in division-level conferences and meetings to
communicate our audit, evaluation, and investigation work and
processes;
--Provided technical assistance and advice to several FDIC groups
working on information technology issues, including
participating at the FDIC's information technology security
meetings;
--Reviewed and/or commented on four draft legislative documents and
regulations.
We are committed to continuing to demonstrate to the Congress, the
public, the FDIC, and the banking industry that the OIG is doing the
right things and generating results that are a worthy return on the
investment made in us.
OIG PLANNING AND INTERNAL INITIATIVES
In fiscal year 2006, we undertook a comprehensive and integrated
approach to planning OIG audits, evaluations, investigations, and
internal activities, resulting in a Business Plan that captures our
strategic goals, performance goals, and key efforts. We have been
planning, conducting our work, and reporting our results in the context
of these strategic goals since that time and will continue to do so in
fiscal years 2007 and 2008. The OIG's work is centered on five
strategic goals that link directly to the FDIC's mission, principal
business lines, and significant challenges: Supervision, Insurance,
Consumer Protection, Receivership Management, and Internal Resources
Management. To these, we added a goal related to our internal processes
in the interest of continuing to build and sustain a high-quality OIG
work environment. We are pursuing that goal intently through a number
of operational improvement projects.
These projects include professional development; human capital
management and leadership development; client, stakeholder, and staff
relationships; quality and efficiency of OIG work; strategic and annual
performance planning and measurement; and information technology. These
initiatives are important for the OIG to ensure that we build and
sustain the quality of our work and remain a results oriented high-
performance organization, use our resources wisely, and stay abreast of
the significant and ever-changing challenges facing the FDIC and the
financial services industry.
The complete 2007 Business Plan can be found on our Web page at
http://fdicig.gov or obtained by contacting our office. Consistent with
our working Business Plan, we are currently developing performance
goals and key efforts for fiscal years 2008 and 2009, which will
continue building on our six strategic goals. We will also continue to
coordinate closely with the Congress, FDIC management, financial
regulatory OIGs, others in the IG community, the U.S. Government
Accountability Office, and law enforcement agencies as we plan and
conduct our upcoming work.
MANAGEMENT AND PERFORMANCE CHALLENGES FACING THE CORPORATION
As part of our planning and budgeting process, the OIG annually
assesses the most significant management and performance challenges
facing the Corporation, in the spirit of the Reports Consolidation Act
of 2000. In identifying those challenges, we consider the FDIC's
strategic goals and the Chairman's corporate priorities and objectives.
Identifying these challenges helps guide our work. In February 2007, we
identified the following management and performance challenges facing
the Corporation for inclusion in the Corporation's Performance and
Accountability Report: addressing risks in large banks; maintaining
strong regulatory capital standards; implementing deposit insurance
reform; maintaining an effective examination and supervision program;
granting insurance to and supervising industrial loan companies;
guarding against financial crimes in insured institutions; safeguarding
the privacy of consumer information; promoting fairness and inclusion
in the delivery of information, products, and services to consumers and
communities; ensuring compliance with consumer protection laws and
regulations and follow-up on violations; being ready for potential
institution failures; and promoting sound governance and managing and
protecting human, financial, information technology, physical, and
procurement resources.
FDIC Chairman Bair recently expressed her views on several
challenges that the Corporation is facing and that she believes will
continue to warrant attention over the next few years. The Chairman
highlighted the following challenges as ``front-burner'' issues:
--Making sure the FDIC has a strong, vigilant supervisory program and
creating a strong interrelationship between compliance and risk
management;
--Implementing deposit insurance reform to help ensure a deposit
insurance pricing system that reinforces the supervisory
program;
--Maintaining strong regulatory capital standards under Basel II;
--Granting insurance to and supervising industrial loan companies;
--Promoting fairness and inclusion in the delivery of information,
products, and services to consumers and communities; and
--Promoting sound governance and managing resources.
In addition to these priorities, Chairman Bair recently testified
before the House Subcommittee on Financial Institutions and Consumer
Credit of the Committee on Financial Services regarding other
management and performance challenges facing the Corporation. Chairman
Bair focused on the following:
--Strengthening protections available to borrowers in the subprime
mortgage market; and
--Ensuring that predatory lending practices do not take root in the
banking system.
Clearly, our assessment of corporate challenges and the Chairman's
articulation of priority issues are closely aligned. We look forward to
continuing to work with the Congress and corporate officials to address
all of these challenges successfully.
OIG'S FISCAL YEAR 2008 REQUEST
Our fiscal year 2008 budget request seeks the resources necessary
to allow the OIG to continue its efforts in audit, investigative, and
evaluation work. In addition, our funding allows us to continue to
enhance knowledge capacity, employee programs, and operational
improvement projects. These funds are essential to helping us remain
prepared to meet the complex issues and challenges confronting the
FDIC. The funds are critical to ensure that OIG can continue to provide
our clients with timely, objective, and reliable information on how
well FDIC programs, operations, and policies are working, and, when
needed, recommendations for improvement. The OIG is an invaluable tool
for helping the FDIC protect against fraud, waste, and abuse to assist
and augment the Corporation's contribution to stability and public
confidence in the nation's financial system.
At this time, we anticipate handling a 2008 investigative workload
comparable to that of 2007. With respect to 2008 audit and evaluation
work, we also anticipate a similar level of effort, with sustained
attention to many of the Chairman's corporate priorities. Some key
efforts begun in fiscal year 2007 will carry over into fiscal year
2008. To remain responsive to ever-changing priorities and emerging
issues, we will keep close track of our planned work and make
adjustments, as needed, to maximize the value that we add.
After 11 years of consecutive budgetary decreases, our fiscal year
2008 budget request in the amount of $26,848,000 represents a modest
increase of $592,000 (or 2.2 percent) over our fiscal year 2007 funding
level. This budget request reflects a stabilized OIG operating
environment and will support a full-time equivalent staff of 127, down
3 from fiscal year 2007. Even with the reduction in staffing, the
slight increase in budget is required to help absorb higher projected
expenses for employee salaries and benefits costs and non-personnel
related expenses. As in past years, funds for the OIG budget would be
derived from the Deposit Insurance Fund and the Federal Savings and
Loan Insurance Corporation Resolution Fund.
CONCLUDING REMARKS
I appreciate the support and resources we have received from this
Subcommittee, the Congress, and the FDIC. As a result, the OIG has
continued to pursue successful investigations and to make a difference
in FDIC operations in terms of financial benefits and improvements and
strengthened internal operations and efficiency. I look forward to
continue working with this Subcommittee in years to come. I believe our
fiscal year 2008 budget strikes an appropriate balance between the
mandate of the Inspector General Act, other legislative requirements,
our judgments of OIG workload needs, and the changing conditions in the
banking industry. We continue to seek your support so that we will be
able to effectively and efficiently conduct our work on behalf of the
Congress, the FDIC, and the American public.
______
NONDEPARTMENTAL WITNESS
Prepared Statement of Independent Sector
Mr. Chairman and Members of the Committee: Independent Sector
appreciates the opportunity to comment on fiscal year 2008 federal
appropriations for Internal Revenue Service activities.
Independent Sector is a nonprofit, nonpartisan coalition of
approximately 575 charities, foundations, and corporate philanthropy
programs, collectively representing tens of thousands of charitable
groups in every state across the nation. Our mission is to advance the
common good by leading, strengthening, and mobilizing the charitable
community. We have worked since our inception to help our member
organizations meet the highest standards of ethical practice,
accountability, and effectiveness.
We support increased funding of the Internal Revenue Service's
fiscal year 2008 budget and write today to urge you to appropriate the
level recommended by the IRS Oversight Board: $11.406 billion, $310.1
million above the President's budget request.\1\ The increased funding
is necessary to develop more effective oversight and enforcement of the
laws regulating charities and foundations as well as comprehensive
education of nonprofit organizations about their obligations under
those laws.
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\1\ IRS Oversight Board, ``Fiscal Year 2008 IRS Budget
Recommendation, Special Report,'' at 13 (April 2007).
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An Ethical, Accountable Nonprofit Community is Essential to Nonprofits'
Ability to Improve Lives
Our country's growing nonprofit community works to improve lives in
communities across America and around the world. It provides vital
services in such fields as health, education, social assistance,
community development, and the arts.
Crucial to fulfilling our missions is our ability to demonstrate to
our stakeholders--donors, beneficiaries, volunteers, and policymakers--
that we operate ethically and accountably. Only if we earn and maintain
their trust will we receive their continued support. Preservation of
that trust depends upon a combination of vigorous self-regulation by
charitable organizations and effective enforcement of the law.
In recent years, media stories have revealed a number of instances
of abuse by taxpayers using charitable organizations for personal gain
and individuals claiming excessive contributions. Former IRS
Commissioner Mark Everson encapsulated this threat in testimony before
Senate appropriators in April 2005, ``[i]f we do not act expeditiously,
there is a risk that Americans will lose faith in our nation's
charitable organizations. If that happens, Americans will stop giving
and those in need will suffer.'' \2\
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\2\ Hearing on Internal Revenue Service Fiscal Year 2006 Budget
Request Before the Senate Comm. on Appropriations, Subcommittee on
Transportation, Treasury, the Judiciary, Housing and Urban Development,
and Related Agencies, 109th Cong. 8 (2005) (statement of Mark W.
Everson, Commissioner, Internal Revenue Service).
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Concerned about the cumulative impact of abuse and convinced of the
need for better enforcement, in 2004, at the encouragement of the
Chairman and Ranking Member of the Senate Finance Committee,
Independent Sector brought together leaders from all corners of the
nonprofit community to create the Panel on the Nonprofit Sector. The
Panel was charged with considering and recommending actions to ensure
that charities and foundations maintain the highest possible ethical
standards. It submitted its Final Report to Congress and the Nonprofit
Sector \3\ in June 2005 proposing more than 120 actions to be taken by
charitable organizations, Congress, and the IRS.
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\3\ Panel on the Nonprofit Sector, ``Strengthening Transparency,
Governance, and Accountability of Charitable Organizations: A Final
Report to Congress and the Nonprofit Sector,'' available at http://
www.nonprofitpanel.org/final/Panel_Final_Report.pdf (June 2005).
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A key recommendation of the Panel is to increase resources
allocated to the IRS for oversight of charitable organizations as well
as overall tax enforcement. As noted by the Panel, effective oversight
of the nonprofit community requires vigorous enforcement of the law. It
continued, ``without adequate resources for oversight and enforcement,
those who willfully violate the law will continue to do so with
impunity.'' \4\
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\4\ Id. at 25.
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Comptroller General David Walker echoed the Panel's recommendation
in congressional testimony in 2005: ``Oversight can help sustain public
faith in the sector and ensure that exempt entities stay true to the
purposes that justify their tax exemption. It also can help protect the
entire sector from potential abuses initiated by a small minority.''
\5\
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\5\ Tax-Exempt Sector--Governance, Transparency, and Oversight are
Critical For Maintaining Public Trust: Hearing on an Overview of the
Tax-Exempt Sector Before the House Comm. on Ways and Means, 109th Cong.
1 (2005) (statement of David M. Walker, Comptroller General of the
United States, Government Accountability Office).
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Additional Resources are Needed to Restore and Grow IRS Enforcement
Capacity
Following a dramatic decline in IRS enforcement resources during
the 1990s, Congress has in recent years enacted targeted increases to
the IRS budget. We applaud and appreciate these investments, which have
enabled the IRS to initiate critical investigations into potential
areas of noncompliance, including political intervention by nonprofits,
executive compensation practices, and abuses by credit counseling
agencies.
However, the IRS's enforcement capacity has not yet fully
rebounded. As the Government Accountability Office noted in a recent
statement before this subcommittee, ``[a]lthough IRS has increased
direct revenue collected through its enforcement programs in recent
years, enforcement continues to be included on our list of high-risk
federal programs.'' \6\
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\6\ Internal Revenue Service, Assessment of the 2008 Budget Request
and an Update of 2007 Performance: Hearing on the Department of
Treasury's Budget Request and Justification for Fiscal Year 2008 Before
the Senate Comm. on Appropriations Subcommittee on Financial Services
and General Government, 110th Cong. 1 (2007) (statement of James R.
White, Director, Strategic Issues, Government Accountability Office and
David A. Powner, Director, Information Technology Management Issues,
Government Accountability Office).
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IRS enforcement resources have not kept pace with the dynamic
growth of the nonprofit community. Over the past 20 years, the number
of charities and foundations has nearly doubled in size, with
applications for tax-exempt status increasingly steadily. During that
time period, the number of staff within the IRS Tax Exempt and
Government Entities Division has remained essentially unchanged.\7\ In
fiscal year 2006, the most recent year for which data is available, the
IRS examined 34 percent fewer tax-exempt returns than it did in fiscal
year 1997.\8\
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\7\ Statement of David M. Walker, supra note 5, at 17.
\8\ Internal Revenue Service, ``Fiscal Year 2006 Enforcement and
Service Results,'' at 7 (November 20, 2006).
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The recent enactment of the Pension Protection Act of 2006 (Public
Law No. 109-280) has put yet additional pressure on the IRS, making the
need to strengthen the IRS more urgent. The Pension Protection Act
(PPA) included what one IRS official has categorized as the most
``significant, comprehensive legislation'' affecting tax-exempt
organizations since 1969.\9\ It contained various provisions, many of
which reflected the recommendations of the Panel on the Nonprofit
Sector, designed to deter individuals who would use charitable
organizations for personal benefit and to ensure that donations are
used for charitable purposes.
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\9\ Christopher Quay, IRS Focusing on Forms, Education Issues
Related to Pension Act, Official Says, Tax Analysts, March 14, 2007, at
Doc 2007-6377.
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Since enactment of PPA, the IRS has issued several pieces of
guidance implementing and explaining the new law. However, much more
has yet to be done. For example, PPA mandated that the IRS complete a
study on supporting organizations and donor-advised funds by August
2007. The IRS has additionally pledged to develop guidance on a number
of issues in the coming year as well as to continue efforts to overhaul
the Form 990, the annual Return of Organization Exempt From Income Tax,
to reflect new filing requirements enacted as part of PPA as well as
other much-needed modifications.
Recognizing the importance of building staff capacity and stronger
enforcement mechanisms, the Administration requested in its fiscal year
2008 budget funding to support 12 IRS enforcement initiatives,
including a program to increase tax-exempt entity compliance. Echoing
the IRS Oversight Board, we applaud the President's commitment to
restoring and strengthening the oversight capacity of the IRS. However,
we urge you to fund the initiatives at the level recommended by the
Board--$351.4 million, or $105 million above the President's
request.\10\ Increased funding will better equip the IRS to serve its
enforcement functions--to ensure nonprofits meet the requirements of
the tax laws, in particular the new mandates included in PPA, and help
to protect charitable organizations from unscrupulous individuals
looking to exploit them for personal gain.
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\10\ IRS Oversight Board, supra note 1, at 17-19.
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Education and Outreach are Needed to Enhance Voluntary Compliance
As articulated in its guiding principle--``service plus enforcement
equals compliance''--the IRS will only achieve maximum compliance with
our nation's tax laws if it balances its oversight activities with a
strong program of education, outreach, and accessibility.
Recent increases in the IRS budget have enabled the agency to
develop myriad new educational tools for charitable organizations,
including issue-specific teleconferences and web forums; an online
training workshop, www.stayexempt.org; and numerous fact sheets and
notifications. As in the enforcement arena, however, the passage of PPA
makes additional IRS education crucial.
PPA increased the complexity of laws governing charitable
organizations. Nonprofits will look to the IRS for explanation and
guidance as they attempt to comply with these important new mandates.
Tax practitioners too will turn to the IRS for technical guidance to
ensure that they accurately and effectively advise their nonprofit
clients.
The large number of small organizations within the nonprofit
community magnifies the need for stronger education. The majority of
nonprofit organizations are community-based groups, many of which rely
entirely on voluntary staff. Of the one million 501(c)(3) organizations
registered with the IRS in 2004, approximately 63 percent had annual
revenues of less than $25,000 and were not required to file with the
IRS. Of those obligated to file with the agency, nearly 63 percent
reported total budgets of less than $200,000.\11\
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\11\ Independent Sector analysis of the National Center for
Charitable Statistics Core Data Files for Public Charities and Private
Foundations. Analysis run on May 16, 2007. Internal Revenue Service,
``Internal Revenue Service Data Book, 2006,'' at 56.
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PPA mandates a new reporting requirement for the smallest
organizations, those with annual receipts of less than $25,000. Failure
to comply for three consecutive years will result in revocation of tax-
exempt status. Oversight alone will not ensure these organizations--
some 600,000 groups, the majority of which do not have access to tax
and accounting advisers--comply with the law. It will be incumbent upon
the IRS to find and notify these organizations of their new
responsibility. The IRS Oversight Board's budget recommendation would
enable the IRS to meet these service needs--to reach out to and educate
nonprofit organizations that want to comply with the law but may not
know how--while balancing its enforcement responsibilities.
CONCLUSION
Following a significant decline in resources, the Internal Revenue
Service has made great strides toward restoring its tax enforcement
program while maintaining adequate taxpayer services. This achievement
is due in large measure to recent investments by Congress. We applaud
and appreciate these efforts.
However, we concur with the recommendations of former IRS
Commissioner Everson, the GAO, and others that additional resources are
necessary to enable the IRS to continue to ensure effective oversight
of the charitable sector and enforcement of our tax laws, while also
maintaining taxpayer service. In order to help preserve and grow public
trust in the nonprofit community's ability to improve lives and
strengthen communities, we urge you to fund the IRS in fiscal year 2008
at the level recommended by the IRS Oversight Board: $11.406 billion.
We thank you for your consideration of these comments. If you have
any questions, please feel free to contact Patricia Read, Independent
Sector's Senior Vice President of Public Policy and Government Affairs,
by phone at (202) 467-6100 or by email at patr@independentsector.org.