he message couldn't have been any clearer. During William Donaldson's Feb. 5 confirmation hearing, senator after senator told him exactly what they expected from him as the head the Securities and Exchange Commission: Make Americans feel good again about investing in the financial markets.
Banking Committee Chairman Richard Shelby, R-Ala., summed up the overwhelming challenge facing the 71-year-old Donaldson: "Our capital markets, which are the envy of the world, have been shaken by scandal and corporate malfeasance. We have all suffered accordingly. Investors have seen trillions of dollars of market capital evaporate," he told the packed hearing room. "Without integrity, there can be no such thing as rational investor confidence . . . and few people have as important a role to play in safeguarding the integrity of our markets as the chairman of the SEC."
This is especially true given the amount of money Americans have invested in the stock market-both in individual accounts and through 401k retirement plans. At the end of 2001, according to the SEC, 52 percent of U.S. households had invested in mutual funds. The amount invested in such funds-by individuals, businesses and other organizations-hit $7 trillion, about twice the amount deposited in commercial banks, according to SEC data. Stocks account for nearly half of all mutual fund assets.
Donaldson is no stranger to the market's incredible growth. He started the Wall Street brokerage firm Donaldson Lufkin & Jenrette; was founding dean of the Yale School of Management; ran Aetna, one of the nation's largest publicly held insurance companies; and was head of the New York Stock Exchange.
Despite those impressive credentials, Donaldson will be in for one of the most daunting tasks of his professional life as he seeks to rebuild the SEC and restore public confidence in the nation's financial markets. By all accounts, Donaldson is not as steeped in day-to-day operations of the agency as was former chairman Harvey Pitt, who began his career in 1968 as an SEC attorney. Pitt worked there for 10 years before going into private practice. Agency staff say Pitt was a hands-on chairman. Donaldson is less likely to get involved in management issues, says John Olson, a senior partner and securities law expert at the D.C. law firm Gibson, Dunn & Crutcher. Rather, Donaldson is likely to set an overall tone for the agency and allow its division directors to manage more freely.
Indeed, during his first public speech as commissioner, Donaldson said, "I know that those at the agency know best how we can operate better." He made the remarks at the annual "SEC Speaks" conference sponsored by the Practicing Law Institute, a nonprofit continuing education organization.
Still, Donaldson will be the one responsible for solving a series of underlying management problems that have plagued the SEC for years. The agency has struggled to keep up with an ever-increasing workload. Resources-both financial and human-have been hard to come by. Divisions tend to act in isolation with little coordination. And woefully inadequate technology impedes better use of information. As a result, the agency has done a poor job of setting priorities and allocating resources. It tends to be much more reactive than proactive, according to agency watchers and staff.
"Everything is done ad hoc," contends Michael Clampitt, a lawyer and accountant in the agency's corporate finance division. Clampitt also is president of the National Treasury Employees Union local that represents SEC employees. "The agency relies on newspapers and other outsiders to bring problems to light. It doesn't initiate enough of its own cases."
A top-to-bottom review of the agency ordered by Pitt was supposed to address these crucial issues. In April 2002, Pitt hired the consulting firm McKinsey & Co. to assess the agency's shortcomings. Appearing on NBC's Meet the Press in July, Pitt promised to publish a report later that summer. That never happened.
In November, after a series of political snafus, Pitt was forced to resign as chairman and, as of mid-March, the report had yet to materialize. Agency employees, congressional oversight committees, the General Accounting Office and the investment community were eagerly awaiting its arrival. But a spokesman would not say when-or if-the report would be forthcoming.
In addition to dealing with long-standing management challenges, the SEC also must implement the 2002 Sarbanes-Oxley Act. The law, which mandates the most far-reaching reform of business accounting practices since the 1930s, was a direct result of the corporate scandals that shook the nation two years ago. It requires the SEC to issue a host of new regulations governing everything from enhanced financial disclosures to professional standards for attorneys, analysts and auditors. The law also mandates that the SEC increase the number of corporate financial reports it reviews each year.
Recognizing the increased workload, the Bush administration in its fiscal 2004 budget proposed a dramatic increase in the SEC's funding-42 percent more than fiscal 2003 levels and 92 percent more than fiscal 2002. The funding increase, if approved by Congress, would enable the agency to hire hundreds of new employees. Everyone in the financial world is eager to see what Donaldson actually does with the cash infusion.
At Donaldson's confirmation hearing, Sen. Paul Sarbanes, D-Md., ranking member of the Senate Banking Committee, didn't mince words: "It now appears that increased funding for the SEC will be forthcoming. But leadership will be required to restore the SEC to its historic place as the crown jewel among federal regulatory agencies."
The SEC was created in 1934, during the depths of the Great Depression. The nation's economy was stagnant, unemployment had reached record levels and financial institutions were imploding. Congressional hearings in 1933 exposed significant misdoings on Wall Street, including rampant insider trading.
By forming the SEC, lawmakers hoped to create an agency that would keep vigilant watch over the country's stock exchanges. To achieve this, securities laws required public companies to register with the SEC and publish accounts of their financial health. The information is designed for use by all investors, large and small. Legislative changes throughout the years have added to the agency's oversight role. The 1999 Gramm-Leach-Bliley Act, for instance, made the SEC the primary regulator for all securities firms. Previously, brokerage operations affiliated with banks or other financial institutions were not subject to SEC regulation.
Today, roughly 14,000 companies file annual statements with the SEC. The agency reviews the reports to ensure that they comply with financial disclosure rules. In addition, the SEC monitors nine stock exchanges, the over-the-counter market, 70 alternative trading systems, 12 registered clearinghouses, 8,000 registered broker-dealers, 5,000 investment companies and 7,400 registered investment advisers.
For much of its history, the SEC earned kudos for effectively uncovering corporate wrongdoing. To be sure, critics have complained over the years that various SEC chairmen were too closely aligned with Wall Street or that some of the agency's rules were too lax. Yet Richard Hillman, director of financial markets and community investment at GAO, says by and large the agency has done a credible job.
But the tremendous growth of the stock market during the late 1990s has put a major strain on the SEC's resources. For the past several years, the agency's workload-from reviewing initial public offerings and annual financial statements to monitoring investment and brokerage houses-has grown dramatically. Staff and budget increases have not kept pace. In a March 2002 report (GAO-02-302), GAO reported that between 1991 and 2001, the SEC's workload in different areas increased anywhere from 60 percent to 264 percent. Meanwhile, staffing rose between 9 percent and 166 percent. For example, the number of corporate filings of paperwork with the SEC increased by 60 percent between 1991 and 2001, but the staff needed to review those filings grew by just 29 percent. As a result, SEC officials reviewed companies' financial statements, on average, only once every five years. Before it collapsed in 2001, Enron last had its filings reviewed in 1997, according to an agency staffer. Sarbanes-Oxley requires the SEC to review a company's filings once every three years.
Staffing constraints can have a damaging impact on the markets. Take, for example, the self-regulatory organizations, such as the stock exchanges, that the SEC monitors. These organizations create and enforce membership rules based on federal securities laws. To change their rules, the organizations must file notices and get approval from the SEC. According to GAO, the number of such filings still awaiting approval at the end of a year jumped from 174 in 1998 to 243 in 2001.
"A [self-regulating organization] official said that when SEC takes a year or more to approve a proposed change, the SRO can lose the competitive advantage from making the change," GAO noted.
In the wake of corporate accounting scandals and the enactment of Sarbanes-Oxley, the Bush administration seems to have gotten the message that the SEC is starved for resources. The $842 million budget the administration has proposed for 2004 is the largest in the agency's history.
"We've never seen anything like this," James McConnell, the SEC's executive director, said during a February press briefing on the agency's budget. "During much of the 1990s, we were relatively flat." Between 1995 and 1999, the agency's budget increased just 12 percent. To a degree, the SEC has itself to blame. The agency generally develops its annual budget request based upon the previous year's appropriation and how much top executives think they can get out of the Office of Management and Budget, not what it actually needs to accomplish its mission, says GAO's Orice Williams, who works on SEC issues with Hillman.
If enacted, the 2004 budget will enable the SEC to hire 710 additional employees. David Martin, former director of the SEC's corporation finance division, says there should be a strong push to hire more accountants and MBAs. According to Martin, now a securities attorney at the law firm Covington & Burling, accountants are in short supply at the SEC, especially in management. GAO also noted the problem in its March 2002 report. Historically, the SEC has relied more on attorneys than accountants to conduct its work. Of the agency's 3,285 employees in 2001, 39 percent were attorneys, 18 percent were accountants or financial advisers and 6 percent were investigators or examiners. The remaining staff were other professionals or administrative workers.
With the emphasis under Sarbanes-Oxley on conducting more reviews of financial statements, accountants are in much higher demand. They are better trained than lawyers to review such documents, says Shelley Parratt, deputy director of the SEC's Division of Corporation Finance.
The SEC always has had a problem hiring and retaining accountants-or any other professionals, for that matter. The turnover rate for attorneys, accountants and examiners averaged 15 percent in 2000, nearly double the rate for similar positions governmentwide, according to GAO. The result is that inexperienced junior employees are left to work on complex cases. Agency insiders say these employees do not have the authority to make critical decisions, such as whether to bring an enforcement action.
The SEC's pay structure often is cited as the top reason people leave. Salaries pale in comparison with those in the private sector and even similar federal agencies, such as the Federal Deposit Insurance Corporation. The agency and the National Treasury Employees Union, which represents 2,000 SEC workers, have been negotiating a pay parity system. After hitting an impasse last summer, the SEC implemented its own system. The union went to the Federal Service Impasses Panel to resolve the dispute. The SEC's plan is essentially a pay-for-performance plan. The union is pushing for an across-the-board raise for agency employees.
Last November, the impasses panel ruled that the SEC could implement its system, which it did after Congress passed the 2003 omnibus appropriations bill earlier this year.
Pay is not the sole contributor to the mass exodus of staff. Morale has hit an all-time low, according to several agency insiders. Even Donaldson acknowledged the situation during his confirmation hearing, saying, "The recent scandals have depleted [employees'] morale and taxed their resources like never before."
To be sure, criticism of the SEC staff for failing to catch problems at Enron, WorldCom and Arthur Andersen has taken its toll, but morale was a problem before, says Clampitt, who alleges that few top officials at the agency receive any management training. And junior staff members interviewed for this story were frustrated that their cases often languish on a manager's desk for months before any action is taken.
Clampitt says there is little incentive for employees to tackle controversial issues. For example, in the division of corporate finance, employees have a quota of financial reviews they must conduct each month. There is no distinction between reviewing a complex filing-such as Enron's corporate report-and examining the paperwork of a much smaller company.
"A filing is a filing," Clampitt says. "What's the incentive to work on the hard ones? And if we do find something and refer it to enforcement, it gets ignored. They accept about 10 percent of the referrals we send them."
Martin takes issue with that assertion, saying the corporate finance division "has an extraordinary desire to review complex filings because they are more interesting." He acknowledges that a handful of employees tend to cherry-pick easier cases. But for the majority, he says, "It's dull sitting in those offices. So people would covet getting juicy filings."
How the agency will handle the need to review companies every three years remains to be seen. Sarbanes-Oxley doesn't specify how detailed they should be. For the time being, that decision will be left up to the SEC staff.
Clampitt isn't convinced that hiring more staff is the answer to the SEC's problems. Rather, he says, the real problem is "bad management. I'm a conservative Republican and I hate to see taxpayer money wasted the way we are wasting it here."
Top among his concerns are that the agency does a poor job of strategic planning and that its divisions function in separate silos. GAO's Hillman shares that assessment. "The agency needs more of a strategic focus," he says. "Right now, there are individual fiefdoms vying for resources. They need to be able to determine what their priorities are across the agency-what are the staffing and resource levels required to do the important work that they have to do."
Better strategic planning will require the agency to make more investments in information technology, says Williams. Divisions have a hard time sharing information because their databases aren't linked. For instance, if a company is filing with the agency to offer new securities, a single SEC division can't do a comprehensive search of agency databases to determine what, if any, actions on that company are pending before the commission.
"If you are in the office of compliance, you can't access the enforcement office's system to know if it is up-to-date," she says. "You have to find a staff person."
Clampitt says the SEC also needs to become more proactive. For instance, he claims the agency was aware that Arthur Andersen was advising Enron to keep some information off the balance sheet so it wouldn't be reflected in financial statements. "I suggested that we concentrate on some of Andersen's clients and see if they were doing the same things," he says. "If Andersen was doing that for Enron, wouldn't it hold that they were doing it for others? I got no response."
Martin agrees that the SEC can do a better job of strategic planning, but he says there is a delicate balance between being proactive and going after companies with known problems. A fair amount of the agency's work always is going to be reactive.
Williams says the SEC could benefit from having a chief operating officer to look across the agency and make critical decisions about resource allocation and help set priorities. That is not necessarily the chairman's role. He is more involved in broad policy decisions. And several sources say the executive director focuses more on administrative matters rather than taking a comprehensive view of the agency's strategic plan.
"The SEC needs to have the capabilities to look out into the future. In market regulation, for instance, they need people to think outside of the box and consider issues that may be coming down the pipe. Right now they don't have that luxury," Williams says.