TESTIMONY OF ARTHUR LEVITT, CHAIRMAN U.S. SECURITIES AND EXCHANGE COMMISSION CONCERNING APPROPRIATIONS FOR FISCAL YEAR 1999 BEFORE THE SUBCOMMITTEE ON COMMERCE, JUSTICE, STATE AND JUDICIARY OF THE HOUSE COMMITTEE ON APPROPRIATIONS U.S. HOUSE OF REPRESENTATIVES MARCH 18, 1998 U.S. Securities and Exchange Commission 450 Fifth Street, N.W. Washington, D.C. 20549 ======END OF PAGE 1====== TESTIMONY OF ARTHUR LEVITT, CHAIRMAN U.S. SECURITIES AND EXCHANGE COMMISSION CONCERNING APPROPRIATIONS FOR FISCAL YEAR 1999 BEFORE THE SUBCOMMITTEE ON COMMERCE, JUSTICE, STATE AND JUDICIARY OF THE HOUSE COMMITTEE ON APPROPRIATIONS MARCH 18, 1998 Chairman Rogers and Members of the Subcommittee: I appreciate this opportunity to testify in support of the Securities and Exchange Commission's (SEC or Commission) fiscal 1999 budget. During the past year, we have seen phenomenal growth in our markets. The Dow reached an all-time high, more investors are investing in our markets than ever, and technological advances have made our markets more accessible to more people. In this time of record-breaking growth and technological innovation, we also see an increase in innovative schemes to defraud American investors. The Commission has been creative and diligent in trying to protect investors and promote the integrity and efficiency of our markets. It is abundantly clear that if we are to keep pace with market changes, the Commission needs additional staff and funding. Accordingly, the President's appropriation request for the SEC includes $341.1 million and 2,827 staff years in fiscal 1999, an increase of $26.1 million and 30 staff years from the Commission's fiscal 1998 appropriation. If approved, this will be the first increase in appropriated staffing and funding (except primarily for mandatory expenses) that the agency will have had since 1995. Role of the SEC The SEC performs an essential function: overseeing one of the largest sectors of our national economy--the U.S. capital markets. The trillions of dollars invested in our markets fuel the U.S. economy. Since its creation in 1934, the Commission has been charged with protecting investors and maintaining fair and orderly markets. Since 1991, our markets have enjoyed the longest and most vigorous bull market in history. Accordingly, to put the SEC's requested appropriation in perspective, it has to be viewed against the backdrop of exponential growth and rapid changes in our markets. Current Challenges Facing the SEC Extraordinary Market Growth. Many Americans now invest their retirement savings in the securities markets, often through mutual funds. Americans now have an unprecedented stake in our markets. Our children's futures, our retirement money, and our future financial well-being are increasingly dependent on the success of our markets. More than ever before, Americans are investing in America. Consider the following statistics. * As recently as 1980, only one in 17 households invested in mutual funds; today that number has risen to more than one in three. * Assets in mutual funds have reached record levels of $4.5 trillion--a figure that greatly surpasses the more than $2.7 trillion Americans have on deposit at commercial banks--and continue to grow monthly. * The number of first-time small investors participating in the U.S. securities markets continues to grow. * A recent survey (conducted by a private concern) indicated that 24% of those responding were very much dependent on the market for their retirement and 46% were somewhat dependent. ======END OF PAGE 3====== The U.S. markets are widely regarded as the deepest, most liquid, and fairest markets in the world. We have seen tremendous expansion in our capital markets, and this exponential growth continues. * Within the past two years, the Dow broke 6,000, then 7,000, and then 8,000. * Within the past six months, the New York Stock Exchange and the Nasdaq Stock Market each have seen stock trading volume hit record highs. * In 1997, total dollar volume traded on the exchanges and the Nasdaq Stock Market exceeded 1996 dollar volume by 41%. * After three years of rapidly rising stock prices, American households have more of their assets invested in the stock market than at any time in history. * In 1997, the number of investment company portfolios increased 8% from 24,265 in 1996 to 26,231. * A record $1.44 trillion in securities were registered with the Commission during 1997, a 20% increase over the $1.2 trillion registered in 1996. * Over $100 billion in securities was registered in 1997 by foreign companies, setting a record for foreign company offerings in a single year. Market participation is at an all-time high. The influx of less sophisticated investors into our markets, however, has emboldened some to prey upon the unwary. In addition, new securities products and new technology have created new opportunities for fraud and abuse. Combatting Fraud. Commission staff investigate and prosecute violations of the federal securities laws. These violations include fraudulent offerings of securities, market manipulation, insider trading, and violative conduct by regulated entities. The Commission has been vigilant in pursuing its law enforcement responsibilities, while trying to adapt its programs to changing market conditions. ======END OF PAGE 4====== Internet Fraud. Much of the remarkable expansion and momentum of the markets is a reflection of the current, ongoing technological revolution. The Internet now allows securities to be marketed directly to, and traded directly by, individuals around the world. We have seen fraudulent offerings of securities, manipulations, and other violative action conducted over the Internet. These developments, in combination, present extraordinary challenges to the SEC's law enforcement program. The Commission has been active in addressing these challenges. * The Commission stepped up its efforts to combat fraud committed over the Internet, forming a "cyberforce" to monitor Internet activity through surveillance. * The Commission focused its efforts on investor education. The Commission's website provides information to investors about fraudulent schemes. * The Commission is actively investigating fraud on the Internet and brought approximately 20 enforcement actions to curb the use of the Internet to perpetrate securities fraud. Microcap Fraud. The market shows signs of an increase in abuses in the market for low-priced stocks or "microcap" stocks. Microcap stocks are issued by companies with lower capitalizations and are usually quoted on the National Association of Securities Dealers Over-the-Counter Bulletin Board, the pink sheets operated by the National Quotation Bureau, and the Nasdaq SmallCap Market. This part of the market provides legitimate opportunities for small and new businesses to raise capital, but also provides opportunity for criminals to prey on innocent investors. Microcap fraud often is accomplished through the use of sales practices such as abusive high-pressure cold calling, unauthorized trading in a customer's ======END OF PAGE 5====== account, and stock manipulation schemes that enable the manipulator to reap profits while investors suffer losses after the manipulation stops. Addressing microcap stock fraud presents the difficult challenge of controlling the fraud without damaging the market for securities issued by legitimate small businesses. The Commission has begun a far-reaching campaign against microcap fraud. The Commission's initiatives include examinations and inspections, investor education, enforcement, and regulatory oversight. * Through Investor Alerts, the Commission's website, and town meetings, the Commission educated investors about practical tips on how to spot securities fraud. * Our examination staff intensified its examinations of broker- dealers and performed a "sweep" of brokers trading in microcap securities. * We increased our coordination of enforcement efforts with criminal authorities, the states, and self-regulatory organizations. * The Commission implemented a number of ten-day trading suspensions in stocks for which there was suspicious activity. * The Commission recently proposed amendments to strengthen its disclosure and broker-dealer regulations to reduce opportunities for microcap fraud. Municipal Securities Markets. The Commission continues to work to eliminate pay-to-play practices, improve transparency, and improve disclosures made to investors. We brought a number of significant enforcement cases in the municipal securities area. In 1997, we brought 14 cases, as compared to 8 cases in 1996. Inspections and Examinations. The Commission's inspections and examinations provide compliance oversight of self-regulatory organizations, broker-dealers, transfer agents, and investment companies and advisers. In recent years, a number of developments in the securities industry have ======END OF PAGE 6====== required significant staff attention and resources. These include: development of highly sophisticated products, increasing dependence on complex technology, a dramatic increase in assets under management by investment advisers, and growing popularity of microcap securities. Despite the demands placed on its resources, the Commission has remained vigilant in overseeing regulated entities. Recent initiatives include: a heightened emphasis on coordinating examinations with other regulators; using sweep examinations to obtain a more systematic view of industry problems and practices; and developing risk-based examination techniques that allow the more effective use of resources. Of course, our examination program continues to emphasize fundamental investor protection issues such as broker-dealer sales practices. International Agreements. We now live in a global marketplace. The growing internationalization of the securities markets increasingly affects U.S. markets. While this trend provides new opportunities for investment and capital formation, it also creates new challenges for securities regulators. The Commission negotiates information-sharing agreements with foreign regulators to minimize the extent to which borders are used to escape detection and prosecution of fraudulent securities activities. During the past year, the Commission entered into formal information sharing agreements with the Bank of England, with Germany's securities regulator, and, just last week, with India's securities regulator, among others. Improving Disclosure and Educating Investors. The Commission recognizes that the increase in less sophisticated investors presents new challenges for the Commission in carrying out its responsibility to protect investors. ======END OF PAGE 7====== The Commission has tried to develop programs to promote more informed investment decisions. The Commission implemented a number of initiatives to improve disclosure and educate investors about investing and their investments. For example, the SEC: * began a series of national and community initiatives that will culminate at the end of this month in an unprecedented national public awareness campaign, "The Facts on Saving and Investing Campaign," and will include a town meeting broadcast nationwide and to 21 countries participating in a hemispheric conference; * held town meetings in local communities to educate investors about investing; * required issuers to use plain English principles in drafting prospectuses and developed a plain English writing guide for issuers; * adopted rules to improve the disclosure of information about mutual funds to investors, including rules to improve fund prospectuses and a rule permitting funds to use a summary "profile" document; * issued staff guidance to the public and industry on disclosure obligations arising from year 2000 conversion; * transmitted its billionth page of text and data on the SEC's World Wide Web site, which now has an average of 3 million "hits" per week and downloads an average of approximately 35 million pages of financial information per week -- making it, we believe, consistently to be the most active federal website in operation; and * created a Task Force on Investment Adviser Regulation to implement the National Securities Markets Improvement Act of 1996 (NSMIA), to review and modernize Commission regulations, and to develop a means by which investors can easily obtain information about investment advisers. Promoting Fair and Successful Markets. During the past year, we also have seen increasingly complex financial instruments in our markets that have presented new and demanding challenges to the SEC. The SEC seeks to be flexible in adapting its regulations to encourage innovative products ======END OF PAGE 8====== and services, consistent with investor protection. The Commission has undertaken several initiatives designed to promote improvements in market structures and operations and to encourage innovation in capital-raising activities. * The Commission issued a concept release that reexamines the regulation of the U.S. securities markets in light of technological developments, particularly with respect to alternatives to traditional exchange trading and electronic links to foreign markets. * The Commission implemented the new order handling rules to assure that markets are fair and open to investors and are based on competition. * The Commission published for comment rules for a class of registered dealers active in OTC derivatives markets. The proposal is designed to allow U.S. securities firms to establish dealer affiliates -- called OTC derivatives dealers -- that would be able to compete more effectively in global OTC derivatives markets by tailoring capital and other regulatory requirements for the OTC derivatives business. * The Commission held a series of town meetings with small businesses to educate them on capital raising strategies. To date, we believe that the Commission has been successful in carrying out its mandate, and investor confidence in our markets is high. Investor confidence must remain high if our markets are to continue to grow. Limited resources, however, may pose a threat to investor protection and market integrity. In recent years, the Commission has targeted its existing resources carefully to maintain effective performance levels. The Commission's request for additional funds is necessary for it to continue to fulfill its mandate to protect investors and support its efforts to promote market integrity and fairness. ======END OF PAGE 9====== Priorities and Allocation of Additional Resources The SEC currently carries out its broad mandate with 2,797 staff years. The agency is able to accomplish its objectives by regulating, to a large extent, through a public-private partnership. This system of shared regulation between the SEC, self-regulatory organizations, and the industry is markedly different from the approach taken by other federal regulators. It enables us to leverage our resources with the efforts of the private sector. Even so, additional resources are urgently needed. Between 1980 and 1994, the number of SEC authorized positions increased 35%. To put that in perspective, for the same period assets under management of investment companies and investment advisers increased 964% and 2082%, respectively. However, since 1995, authorized positions have been flat. We have been able to maintain a vigorous program at the SEC with flat staffing through fiscal restraint, conservative management, and the reallocation of existing resources. Of course, the Commission is mindful of the need to be fiscally responsible. However, if we fail to increase our staffing levels to keep pace with market expansion, we may risk failing to fulfill our mandated responsibilities. Expanding our human resources will allow us to further existing priorities and pursue new initiatives. Law Enforcement Combatting Fraud. As discussed above, changing markets present new challenges for the Commission. The recent resurgence of microcap fraud and the use of the Internet to accomplish securities fraud are but two examples of the challenges. Thus, the Commission intends to allocate 15 additional staff years for the Prevention and Suppression of Fraud program. Staff in ======END OF PAGE 10====== the program will monitor potential fraudulent securities activity on the Internet and other on-line information services and will respond to continued growth and change in electronic forms of communication. While existing resources were devoted in 1998 to combatting microcap fraud, with the new staff, the SEC will be better able to coordinate its nationwide effort to address microcap issues, including: intervening in microcap frauds at the earliest point possible to minimize investor harm; enhancing surveillance; and coordinating with other federal, state, and industry regulators. Inspections and Examinations. Although Commission staffing levels have remained constant since 1995, we reallocated resources to enhance inspection and examination activities. As a result of those additional examiners and new legislation that divided the regulatory responsibility over investment advisers between the Commission and the states, the SEC expects to meet its inspection goals in 1999. These goals include inspecting each of the large investment advisers qualified for federal registration and investment company complex at least once every five years. In addition, throughout the inspection program, the staff will continue development of risk-based examination techniques and maximize opportunities to coordinate with other regulators. While no additional inspection staff is being requested for 1999, additional funding is being requested to initiate a multi-year effort to develop and implement important new automated tools, including applications to track and monitor the examinations of self-regulatory organizations, broker-dealers, and investment companies and advisers, and applications to target examinations for broker-dealers and investment advisers. ======END OF PAGE 11====== Disclosure and Promoting Honest and Efficient Markets The review of financial statements and registrations filed with the SEC is a fundamental element of the Commission's full disclosure program, which is designed to provide investors with material information, foster investor confidence, and facilitate capital formation. Our goal is to encourage and enhance compliance with federal securities disclosure and accounting requirements. We intend to allocate six additional staff years to corporate disclosure review. These additional staff members will enable the agency to increase review of issuer reports 7% from 1998 levels. This review will focus particular attention on compliance with plain English requirements and will monitor how companies are addressing the consequences of year 2000 conversion. The review levels achieved with the additional staff will help provide investors with access to important information on emerging and novel issues and provide deterrents to fraud in public securities transactions. Simplification of disclosure initiatives, including projects designed to assist small businesses, also will remain a priority for 1999. With respect to accounting policy, as more foreign registrants access U.S. markets, two additional staff years are needed to keep pace with major developments in international accounting and auditing. The International Accounting Standards Committee is working to complete a comprehensive core set of international accounting standards. After this is completed, the staff will assess the standards and make a recommendation to the Commission regarding the acceptability of those standards for use by foreign registrants in cross-border offerings and listings. ======END OF PAGE 12====== Additionally, eight additional staff years are requested in 1999 for the Supervision and Regulation of Securities Markets program to continue the re-evaluation of our approach to regulating markets, particularly the oversight of alternative trading systems, registered exchanges, and foreign market activities in the United States. Investment Company Disclosure Eight additional staff years are requested for investment company disclosure activity. The Commission recently adopted sweeping reforms to investment company prospectus disclosure requirements. In 1999, the staff will work with mutual funds as they revise their prospectus disclosures to comply with the new form requirements; review the new "profiles" filed by mutual funds; and monitor compliance with the new rules, increasing the number of investment company filings reviewed by the staff. The review process enhances investor protection by seeking to ensure that an entity's policies, procedures, and risks are disclosed fully and fairly and that proposed activities are consistent with the new rules. The staff will continue to respond to the rapid changes in the investment management industry, addressing issues such as investment company advertising rules, periodic reporting requirements, financial statements, and the electronic delivery of information to investors. Improved Technology The fast pace of technology and the pressure to deliver quickly computer products and services has resulted in an increased reliance on contractors with technical expertise. Outsourcing allows the Commission to leverage private sector expertise and shift the technology staff's focus from day-to-day operations to contract and project management and oversight ======END OF PAGE 13====== and strategic planning. In 1997, the Commission hired an outside consultant to study how the operational efficiency of our information technology services could be improved. The study recommended the use of contractors for operations, maintenance, and application development. The shift in focus of the information technology staff from operations to strategic planning will result in a decrease of 15 staff years and also in the need for different skill sets with an emphasis on project management, contract administration, technology engineering, customer service, and network security skills. Additional funding ($5.7 million) also is requested to support the SEC's automation efforts to improve efficiency and productivity through the use of automated PC-based computer applications. The funding will enable the SEC to: complete the necessary conversion and testing for year 2000; initiate the multi-year effort to develop and implement important new tools for the inspections and examinations activity; establish an infrastructure replacement program; improve data delivery to the regions; further enhance document and correspondence management systems; develop software to access on-line trading information; implement user-friendly text search tools; and improve imaging, storage, and retrieval capabilities. Additionally, the staff will continue to work with various industry components to address year 2000 conversion and testing. We appreciate the work and support of your staff on the reprogramming of funds for the modernization of EDGAR--the SEC's Electronic Data Gathering, Analysis, and Retrieval system. While EDGAR is one of the government's most successful large information system initiatives, the dramatic changes in technology over the past few years necessitate its ======END OF PAGE 14====== modernization. This modernization, to be done over a three-year period, will greatly benefit issuers, investors, SEC staff, and other data users. Economic Analysis Three additional staff years are requested to provide conceptual and quantitative economic analysis focusing on issues such as investor protection, trading practices, market structure, and costs and benefits of rule changes. ======END OF PAGE 15====== Administrative Law Judges Three additional staff years are requested to enable the administrative law judges to file initial decisions within ten months of issuance of the order for proceedings, as stipulated in the SEC's "Guidelines for the Timely Completion of Proceedings." As a result, the number of proceedings pending disposition will start to decrease rather than continue on an upward trend. Additional Funding for Retention of Staff Our ability to retain our existing staff members is critically important to our ability to get our job done. In fiscal 1997, turnover at the SEC increased dramatically, especially in our three major program occupations (attorneys, accountants, and securities compliance examiners). For example, the SEC's overall turnover rate in fiscal 1997 was 11.9% compared to 9.5% in fiscal 1996. The 1997 turnover rate for attorneys was 16% compared to 11.3% in 1996. The 1997 turnover rate for accountants the rate was 12.1% compared to 9%, and for examiners the rate was 10.8% compared to 10.3%. By comparison, government-wide white collar turnover has been in the range of 7-8% a year for the last couple of fiscal years. The SEC's ability to retain experienced professional staff is critical to our ability to respond quickly to changing market events and enforcement activities. The securities industry is constantly seeking to hire lawyers, accountants, and securities compliance examiners with highly-valued SEC experience. Market growth will continue to increase demand for our seasoned securities professionals. To combat this growing high attrition rate, we have requested $7 million for retention allowances. This retention initiative will utilize ======END OF PAGE 16====== more fully the existing authorities available to federal agencies by expanding the use of retention allowances to retain, for one or more additional years, critically needed employees who might otherwise leave the Commission for higher-paying private sector jobs. While realizing that the agency cannot compete directly with private sector salary rates, we anticipate that this initiative will extend the tenure of key professional employees. The Office of Personnel Management and the Office of Management and Budget have reviewed the proposal and support the strategy as a reasonable way to use limited payroll dollars efficiently in order to try to retain key employees. Funding Structure The President has proposed in his 1999 budget total funding for the SEC of $341.1 million, using several funding sources: $118.1 million in new budget authority, $205 million in current year offsetting collections, and $18 million in carryover from 1998 fees. The funding mix reflects the Administration's government-wide fee initiative that would, among other things, discontinue the practice of providing agencies whose budgets are primarily financed by fees with an upfront guarantee of budget authority which is later reduced as actual collections are received. The $84.6 million increase in budget authority over 1998 would permit us to carry into fiscal 2000 fees that are collected late in 1999, allowing the SEC to be funded almost exclusively from fees. The proposed budget is consistent with the declining fee rates established in NSMIA. However, this approach continues the SEC's reliance on a combination of excess fee collections from prior years and new collections, thereby postponing the shift to a full appropriation. ======END OF PAGE 17====== Conclusion The Commission plays a vital role in protecting U.S. securities markets from fraud, manipulation, and other practices that continually threaten to undermine the integrity of our markets. In presenting today's budget request, the Commission has been mindful that government resources are limited. The Commission has requested a modest increase of staffing and retention authority that will enable us to continue targeting areas of market growth where our money can have the greatest impact. It also reflects the market realities -- the loss of trained staff. Finally, our request recognizes that important work lies ahead of us. Among the challenges we will face over the coming year are: * issues posed by the increasing number of small investors who invest their retirement savings in mutual funds through retirement plans; * aggressively combatting fraud and maintaining public confidence in the markets; and * maintaining vigilant oversight of markets as those markets grow increasingly complex and volatile. As the year 2000 approaches, the U.S. must be ready to meet the challenges presented by a changing marketplace in order to maintain the leadership of its markets. To take on new challenges, to continue the Commission's excellent record of effective investor protection, law enforcement, and market oversight, and to continue to fulfill its mission of protecting the millions of U.S. investors who have invested nearly $13 trillion in the U.S. securities markets, the Commission needs the increased resources requested today. ======END OF PAGE 18====== The Commission looks forward to working with the Subcommittee in its continuing efforts to ensure the effectiveness of the SEC and the viability of our markets. ======END OF PAGE 19======