William H. Donaldson Chairman Before the Subcommittee on Science, St…

William H. Donaldson Chairman
Before the Subcommittee on Science, State, Justice and Commerce
And Related Agencies
Committee on Appropriations,
United States House of Representatives

March 11, 2005 – LAWFUEL – The Law News Network – Chairman Wolf, Ranking Member Mollohan, and Members of the Subcommittee:

Thank you for the opportunity to testify before you today on the Securities
and Exchange Commission’s fiscal 2006 budget request. Due in large part to
your ongoing leadership and support, the SEC has made substantial progress
in regaining its stature and the capacity required to fulfill its mission.
Over the past several years, we have grown more proactive, forward-looking,
skilled, and better able to meet the large number of challenges facing our
markets, investors, and public companies. These improvements have been some
of our central achievements since my arrival at the Commission in 2003.

The subject of my testimony today is the Commission’s fiscal 2006 budget. I
support the President’s budget request for the Commission, and I believe
that this budget, while responsive to the tight budgetary environment faced
by the federal government, will allow us to maintain our course and continue
serving and protecting the nation’s investors.


The SEC requests a total funding level of $888 million for fiscal 2006.
This proposed level is comprised of $863 million in new funding and an
estimated $25 million in carryover funds from fiscal 2005. To help explain
how we have structured our fiscal 2006 request and why we believe it is
adequate, I will briefly describe the Commission’s funding over the last
several years.

In fiscal 2004, the Commission received an appropriation of $811 million.
This funding level permitted the Commission to complete the hiring of the
more than 840 new positions we received in fiscal 2003. It also allowed us,
among other initiatives, to commence our Enforcement imaging backlog
project, create our new Office of Risk Assessment, and implement a new
risk-focused approach to our examination activities. Due to the large
number of entry-level employees who came on board, and due to the fact that
the timing of this hiring was affected by the delay in receiving our
appropriation, the Commission incurred lower salaries and benefits costs
than we originally projected. As a result, the Commission’s actual spending
for fiscal 2004 totaled $755 million, roughly $57 million less than we were

In late December 2004, the Commission received its fiscal 2005 appropriation
of $913 million, including our prior year carryover funds. This amount
permits the SEC to fully annualize the costs associated with all of our
prior year hires and to hire an additional 106 new staff who primarily will
assist in our regulation and oversight of mutual funds and investment
advisers. Our fiscal 2005 funding level also includes funds for several
non-recurring expenses that I will discuss in further detail below. In
anticipation of a lean fiscal 2006, the SEC, in conjunction with the Office
of Management and Budget, revisited our fiscal 2005 spending assumptions and
determined that, by adjusting the implementation schedule for some of our
initiatives, we could again fund all of our top priorities for less than we
had been appropriated. In particular, we estimated that partially due to
the timing of when our fiscal 2005 appropriation was enacted and the timing
of our hiring 106 new employees, we could fully fund our fiscal 2005
operations for $888 million and carryover roughly $25 million into fiscal

In considering our fiscal 2006 funding needs, it is important to note that
our current budget includes a number of one-time costs that will not recur.
In particular, the agency will not incur approximately $21 million in costs
associated with the completion of our move into Station Place, along with
costs associated with the relocation of our Northeast Regional Office in New
York. In addition, because of the expected completions of the SEC’s new
Alternate Data Center and our Enforcement imaging backlog project, along
with shifts in the implementation of certain information technology systems,
the SEC likewise will not require that an additional $17 million be kept in
our base funding level for fiscal 2006. These one-time base reductions of
nearly $38 million help explain how we can maintain all of our major
initiatives in fiscal 2006.

Having described our overall budgetary approach, I will highlight the
agency’s operational and programmatic agenda for fiscal 2006.


In 2006, the SEC will continue to concentrate on ensuring that taxpayer
dollars are used to maximum effect to fulfill the agency’s mission. Some of
the key areas in which we will continue to make progress are our
risk-assessment activities, management “dashboards”, strategic planning
efforts, and information technology.

Our Office of Risk Assessment will continue to expand the depth and
complexity of risk assessment activities throughout the agency. In
particular, the Office will lead the efforts of multi-disciplinary risk
teams to detect new risks and assist division and office efforts to mitigate
and manage previously identified risks on an ongoing basis. ORA also will
continue to strengthen the SEC’s risk assessment infrastructure, both within
the divisions and offices and for the agency as a whole.

We will continue using our dashboard management reports to track the
agency’s progress in meeting its budgetary, staffing, and operational
objectives. The reports will be refined as necessary to gauge the success
of the agency’s evolving programs and to help ascertain whether we need to
adjust our operations. Moreover, the SEC will continue to conduct
comprehensive workforce and workflow reviews of divisions and offices, with
an eye towards maintaining an alignment between agency resources, needs, and
mission priorities.

Separately, the SEC will begin planning to revise and update its five-year
strategic plan. Staff also will continue working with contractors to
implement an activity-based costing and performance-based budgeting solution
to help us better allocate our operating costs and achieve greater cost

Information Technology

I will now turn to the subject of information technology. In 2006, the
Office of Information Technology will continue implementing several major
initiatives from 2005 and extend them into new parts of the organization.
OIT plans to:

* Upgrade the agency Internet website and portal for the
Electronic Data Gathering and Retrieval (EDGAR) system. The new site will
substantially improve investors’ access to filings through a new full-text
search function and a more intuitive user interface. The redesign also will
enhance the accessibility and searchability of information related to the
SEC’s rulemaking activities.

* Fully implement our redesigned case management system
and fully integrate it into the agency’s broader suite of workflow
management, document management, and knowledge management tools. The result
will be a more seamless set of core business processes for enforcement
activities and improved reporting for senior attorneys to manage the
agency’s caseload.

* Fully deploy the examination management system
throughout headquarters and the field offices. As a result, all of the
agency’s examinations will be subject to uniform methodologies and audit
plans, and examiners will be better able to manage inspection work products.

* Expand our intrusion detection and prevention
capabilities, improve incident response practices, and provide specialized
technical training. OIT also will continue to assess the security of
standing applications and infrastructure as part of its ongoing
certification and accreditation process.

* Continue transitioning to its “future state” enterprise
architecture, changing business processes as necessary to better support its
mission. Improvements will include a unified content and document
management platform; a consolidated infrastructure for the agency’s storage
and application servers; agency-wide data warehousing, analytics, and
reporting tools; and a common, agency-wide portal for receiving and storing
disclosure and surveillance information.


Another area that I would like to discuss is telework. Over the last
several months, we have made great strides in increasing the availability of
telework to all eligible employees. We now have approximately 17 percent of
our eligible workforce on a telework schedule, up markedly from the 9.5
percent of employees we had at the end fiscal 2003. We have made this rapid
progress by, among other things, working to foster a telework culture at the
Commission and implementing a new agency-wide Enterprise Telework Program.

To help us achieve this success, I assigned my Executive Director overall
responsibility for overseeing our telework program and directed two other
senior executives to serve as Telework Program Sponsors to help institute a
new telework mindset at the Commission, one that appreciates and actively
promotes the benefits that can be gained by staff and the SEC from providing
this flexibility more broadly throughout the agency. As we embarked on this
new course, we consulted with your staff and, at their recommendation, we
began partnering with the Telework Consortium. Thus far, we have had
several meetings with the Consortium to discuss technical options to support
a larger number of our workforce operating from home.

In January 2005, to stress our commitment, I personally announced our new
Enterprise Telework Program to the entire SEC community. The SEC’s new
telework program allows all of our eligible employees more flexibility to
balance work with personal life. The program will help the SEC attract new
talent, reduce traffic congestion, meet mission requirements during
inclement weather, and, if necessary, implement some of the agency’s
continuity of operations activities. In rolling out this program, we have
begun educating the entire SEC community about the benefits of telework,
working to address its challenges, and training supervisors on their
responsibilities handling telework requests and managing remote workers.

Virtual Workforce

We also are looking beyond telework for additional ways to improve staff
effectiveness while supporting the need for an employee work-life balance.
In particular, we are exploring having certain staff work full-time from
alternative locations, such as their homes. This “virtual workforce”
initiative, which is highlighted in our most recent Strategic Plan, would
meet many of the same ends as telecommuting. I am committed to introducing
this virtual workforce concept in 2005, and will soon commence a pilot, in
which 20 volunteer employees will be permitted to operate exclusively from a
remote location. We will evaluate this pilot in light of our human
resources, security, and information technology infrastructures. Upon
completion of this review, we will determine how best to expand the pilot to
a substantially larger number of employees in future years.

Station Place

While not a part of our fiscal 2006 funding request, I also would like to
discuss the SEC’s upcoming move to Station Place. We are very excited about
this move, and I wanted to review for you the process whereby we selected
this location.

The SEC has been in its current headquarters facility since 1982, when the
entire Commission had a total of roughly 1,900 employees, less than half our
current size. The SEC first began planning for a new headquarters facility
in 1999 when it became clear that the agency could no longer house all of
its headquarters employees in our current location at 450 5th Street, NW.
Around the same time, the agency also began procuring a short-term lease for
additional space at 901 E Street, NW to accommodate our immediate space

Our solicitation and procurement strategy was, as required by the
Competition in Contracting Act, to run a full and open competition that
would satisfy the SEC’s requirements for a new headquarters facility.
Although the SEC has independent leasing authority, we executed our strategy
by partnering with the General Services Administration and using one of
their approved brokers. We also held a variety of meetings with all
appropriate House and Senate committees to discuss, among other things, how
best to proceed with the procurement, the location for a new facility, and
the general requirements that the SEC should include in its solicitation.

After conducting a robust competition, and working with the Office of
Management and Budget to obtain the necessary budgetary approvals, the SEC
awarded the lease of its new headquarters to Station Place on May 29, 2001.
As part of this, the SEC negotiated a rate of less than $44.00 per rentable
square foot for the entire 14-year period of our lease, a rate that given
current market conditions is quite favorable. The lease agreement also
contained an expansion option that, in retrospect, we are fortunate was
included. With the agency’s growth associated with the new requirements of
the Sarbanes-Oxley Act, the SEC exercised its option for additional space
roughly one-year after entering into its original lease agreement. As part
of this agreement, the SEC was able to obtain its expansion space at the
same favorable lease rate of roughly $44.00 per rentable square foot.

Our lease agreement also contains a provision that allows for the Government
to purchase the building at a specific price at the end of the lease period
by paying additional rent over our 14-year term. While the SEC does not
currently have the authority to exercise this option, we believe that the
purchase of Station Place should be considered, as it would save the
Government money over the longer term. Separately, it is worth noting that
our lease procurement process started well in advance of the events of
September 11, 2001. In response to those events, the SEC received emergency
supplemental funds to enhance the building’s security features by adding
laminated glass, bollards, and other blast resistant features.

The SEC greatly appreciates the support we have received from the
Subcommittee in procuring our new headquarters facility, and I would like to
personally invite each of you over for a tour.


Before turning to our programmatic agenda, I would like to thank you for
your support in ensuring that the integrity of the Commission’s policy
decisions and regulatory processes are respected and remain inviolate.
While some may be critical of certain of our actions, the Commission’s
regulatory decisions are the result of robust and informed legal and
quantitative analyses and are fully consistent with our mission. In
addition, in all our rulemaking we take great pains to consider the scope of
our legal authority, and provide all interested parties with a full and fair
opportunity for comment. The Commission was specifically designed by
Congress to be independent and must remain fully so if we are to continue
restoring the public’s faith in the fairness of our markets. I hope that we
can continue to rely on your support to maintain the independence of the


Sarbanes-Oxley Implementation

I will now turn to our programmatic agenda, and will begin with an overview
of our efforts under the Sarbanes-Oxley Act of 2002.

Two years ago, when I became Chairman of the Commission, the country was
still reeling from its disappointment with cooked books, indefensible lapses
in audit and corporate governance responsibilities, and intentional
manipulation of accounting rules. These lapses led to staggering financial
losses and a crisis in investor confidence. The resulting Sarbanes-Oxley Act
called for the most significant reforms affecting our capital markets since
the Securities Exchange Act of 1934. The Act established the foundation
necessary to improve financial reporting and the behavior of companies and
gatekeepers, and we have completed the rule-making to implement these
critically important reforms. Key Sarbanes-Oxley requirements include:

* CEO and CFO certifications of the material completeness
and accuracy of SEC periodic filings

* Enhanced disclosure of off-balance sheet transactions

* Electronic reporting within two business days of
insider transactions

* Increased disclosure of material current events
affecting companies

* Establishment of the PCAOB

* Issuance of the first PCAOB inspection reports on the
large accounting firms

* Issuance of important auditing standards by the PCAOB,

* Public reporting, by both management and auditors, on
internal controls and their effectiveness.

I would like to focus for a moment on the Section 404 requirement for
internal controls disclosure. This section of Sarbanes-Oxley may have the
greatest long-term potential to improve financial reporting. It may also
well be the most urgent financial reporting challenge facing a large share
of corporate America and the audit profession in 2005. I expect that we
will begin to see a number of companies announce that they or their auditors
have been unable to complete their assessments or audits of controls. I
also expect that some companies will announce that they have material
weaknesses in their controls.

For this initial pass, these results should not, by themselves, necessarily
be a motivation for immediate or severe market reactions. Section 404 is a
disclosure provision, and investors will benefit from receiving full
disclosure about the nature of any material weaknesses, their impact on
financial reporting and the control environment and management’s plans for
remediating them. This disclosure will allow investors and markets to make
the appropriate judgments about what companies and auditors find. Section
404 will work as intended if it brings this information into public view,
and in that event the disclosure of material weaknesses in internal controls
should be the beginning and not the end of the analysis for investors and
markets. The goal should be continual improvement in controls over
financial reporting and increased investor information and confidence. This
should lead to better input for management decisions and higher quality
information being provided to investors.

While these benefits are clear, it is also important that we evaluate the
implementation of our rules and the auditing standard issued by the Public
Company Accounting Oversight Board (PCAOB) to ensure that these benefits are
achieved in the most sensible way. We have been very sensitive to the
implementation of all aspects of the Sarbanes-Oxley Act, and especially to
this very significant aspect. This has included several measured extensions
over this past year to accommodate the first wave of reporting.

In addition, in order to assess SEC and PCAOB rules for implementing Section
404 now that we will have the first year of actual experience under the
rules, the Commission will hold a roundtable discussion this April and is
currently soliciting written feedback from the public regarding registrants’
and accounting firms’ implementation of these new reporting requirements.
Through the roundtable and this feedback, we will be closely listening to
and assessing the experiences with the management and auditor internal
control requirements, including seeking to identify best practices for the
preparation of these reports and evaluating whether there are ways to make
the process more efficient and effective, while fully preserving the
benefits of the requirements. Throughout this process the Commission and
its staff will closely coordinate with the PCAOB and its staff, and we will
seriously consider whether any additional guidance is necessary or

We are also actively engaged in other activities to evaluate and assess the
effects of the recent reforms, including the internal control reporting
rules. For example, we have announced we are establishing the Securities
and Exchange Commission Advisory Committee on Smaller Public Companies. The
advisory committee will conduct its work with a view to protecting
investors, considering whether the costs imposed by the current regulatory
system for smaller public companies are proportionate to the benefits, and
identifying methods of minimizing costs and maximizing benefits.

In addition, and at the request of Commission staff, a task force of the
Committee of Sponsoring Organizations (COSO) has been established and
anticipates publishing additional guidance this summer in applying COSO’s
framework to smaller companies. Our actions have not been limited to
smaller companies. We also are cognizant of the regulatory challenges our
foreign registrants face. For all of these reasons, we recently extended
the compliance date for internal control reporting for an additional year
for smaller and foreign public companies. Review of the first year
experiences of our larger registrants also should help smaller and foreign
issuers in preparing their first reports.

Separately, it is important to note that the Commission itself has been
following the goals and spirit of the Sarbanes-Oxley Act as we have been
completing our first-ever audited financial statements under the
Accountability of Tax Dollars Act of 2002. Our fiscal 2004 audit, which was
conducted by the U.S. Government Accountability Office, should be completed
shortly and I expect our results to be favorable. In preparing for this
audit, we have been reviewing and updating our management controls,
developing our own management certification process, and taking steps to
make sure that we lead by example. The SEC has invested significant
resources in fulfilling our own financial reporting and audit
responsibilities because it is only appropriate that we conduct the same
kinds of management reviews and internal control enhancements that we
require of all public companies.

Office of Global Security Risk

I would like to update you on the activities of our Office of Global
Security Risk.

When I testified before you last year, I reported on several enhancements to
our review program in the Division of Corporation Finance, including the
establishment of the Office of Global Security Risk. This Office is up and
running as my quarterly reports to you have indicated. The Chief of this
Office, Cecilia Blye, was selected last May. Ms. Blye served for 20 years
as special counsel in the Division of Corporation Finance prior to her
selection as head of this Office. Last summer, Ms. Blye hired two staff
attorneys. She may be hiring additional staff, but that will be influenced
in part by the Office’s research needs. Ms. Blye is currently pursuing the
purchase of an online global security risk assessment product. While a
possible product has been identified, this procurement is still in process.
Once completed, it will enable Ms. Blye to better assess what additional
staffing may be necessary.

The Office continues to develop and refine its operations and procedures.
The Division’s examination staff continues to monitor filings for global
security risk issues and, with the support and assistance of the Office of
Global Security Risk, to evaluate company disclosure and pursue enhanced
disclosure where appropriate.

Given that the issues surrounding global security risk are much broader than
the SEC’s role in examining public company disclosure, the Office
coordinates with other relevant federal agencies. The Office has
coordinated most closely with Treasury’s Office of Terrorist Financing and
Financial Crimes. We also coordinate with the State Department’s Office of
Terrorism Finance and Economic Sanctions, and Office of Monetary Affairs,
and with Treasury’s Office of Foreign Assets Control.

I am confident that, with the important role this office will take in the
Division’s review program, the SEC is properly positioned to obtain and
evaluate disclosure regarding global security risk.

Market Structure

Turning to market structure, the Commission has been working to update and
modernize the regulatory structure of the U.S. equity markets. Most
notably, we proposed Regulation NMS (National Market System) in February
2004. This proposal would: (i) create a uniform trade-through rule for all
national market centers; (ii) require uniform market access; (iii) establish
a uniform quoting increment to address sub-penny trading and promote greater
transparency; (iv) amend the arrangements for dissemination of market
information; and (v) modernize and restructure the national market system
rules under the Exchange Act. Over the past year, we have held a public
hearing on Regulation NMS and published a supplemental request for comment
based on a number of important matters raised at the public hearing.

More recently, in December 2004 the Commission reproposed Regulation NMS to
provide investors and market participants with another opportunity to
comment on the proposal, particularly as to whether it would be advisable to
establish an inter-market trade through rule that applies to a market’s
displayed “depth of book” or simple “top of book.” The comment period for
our reproposed regulation recently ended in late January, and we are
currently reviewing all of the comments that we have received. It is my
hope that we will conclude our deliberation on this subject in the next
several weeks.

Mutual Fund Reforms

I will turn to our mutual fund reform agenda.

As you know, the past 18 months have been a difficult and troubling period
for the mutual fund industry. One indication of the troubles has been the
Commission’s enforcement actions. During this period, the Commission has
brought 61 cases related to mutual funds and levied approximately $1.4
billion in disgorgements and $1 billion in penalties. In fact, these
numbers demonstrate how mutual fund managers violated the trust handed to
them by the individuals who invest in mutual funds.

In addition to our enforcement actions, the Commission also has undertaken
several major rulemaking initiatives to reform fund governance and enhance
internal oversight of fund activities. Particular reforms that we have
adopted include: (i) enhancing fund governance requirements for funds that
rely on certain exemptive rules by providing for independent board chairmen
and for fund boards to be comprised of 75 percent independent directors;
(ii) a requirement that all registered investment advisers adopt codes of
ethics, and that funds and their advisers have comprehensive compliance
policies and procedures in place, including the appointment of a designated
compliance officer; and (iii) new disclosure requirements designed to more
fully inform investors about mutual fund conflicts of interest and the
policies and procedures in place to control them. The Commission also is
continuing to review comments received in connection with our 4:00 p.m.
“hard close” proposal. This is the last of our pending rule-making
proposals that we hope to see final action on in the coming weeks. However,
this proposal poses some significant technological challenges, and we want
to make sure we adopt rules that are effective, without imposing unintended
negative consequences on investors or funds.

I appreciate that these efforts have received significant attention. We
have taken these steps because mutual funds have become primary investment
vehicles for Americans who are planning for retirement, saving for their
children’s educational expenses, and striving to meet a variety of other
personal investment goals. It is essential that investors receive a “fair
deal” from mutual funds-and that Americans have reason to regain confidence
that the mutual fund industry has investors’ best interests at heart.

Hedge Funds

Turning to hedge funds, as you may know, one of my earliest priorities for
the Commission was to get out in front of emerging issues, rather than react
after a problem has occurred and investors have been harmed. As such, I
strongly believe that the Commission cannot turn a blind eye to the
remarkable growth of hedge funds. Thus in December 2004, the Commission
adopted a new rule that requires advisers to hedge funds to register as
investment advisers under the Investment Advisers Act starting in early

At nearly $1 trillion, hedge fund assets have grown significantly-increasing
an estimated 260 percent in the last five years. In addition, a broader
cross-section of investors is exposed to hedge fund investing through
pension plans and registered funds of hedge funds. It is essential that the
Commission know more about the activities of hedge fund advisers so that we
can appropriately fulfill our investor protection mission on behalf of hedge
fund investors and those investors on the other side of these transactions.
Registration under the Investment Advisers Act is a way for the Commission
to oversee these investment advisers with minimal intrusion on hedge funds’
operations. Advisers Act registration places no limits on hedge funds’
ability to provide liquidity and efficiency to our nation’s markets or on
hedge funds’ proprietary trading strategies. I can assure you that we are
working with the hedge fund industry to ensure that implementation of the
new rule is done in an effective and efficient manner.

Other Initiatives

2005 was a remarkable year of achievement for the Commission and its staff
in many areas in addition to those that I have just reviewed for you. To
cite just a few of our accomplishments:

* The Division of Corporation Finance completed a major
overhaul of the rules governing the asset-backed securities market, and
proposed ground-breaking reforms to the securities offering process. The
Division is now at the forefront of our efforts to reach out to the small
business community so that we understand their concerns about the
implementation of the public company reforms of the last three years.

* The Division of Market Regulation took a significant
step to combat the problem of naked short-selling, with the adoption in July
of our new Regulation SHO.

* The Division of Enforcement brought enforcement actions
in all of the Commission’s program areas, and obtained billions of dollars
in disgorgement and penalties, much of which will be returned to investors.

* The Office of Compliance Inspections and Examinations
implemented a risk-based methodology program-wide, which will help us look
over the hills and around the corners.

* The Office of the Chief Accountant increased its
oversight of the accounting and auditing standard setting process in the
United States.

We are all very pleased with these accomplishments and I would be happy, if
you wish, to review them with you in detail at a later time.


Thanks to this Subcommittee, the Commission has made significant progress
over the last several years in rebuilding public confidence in our markets.
Our fiscal 2006 budget request requires an appropriate amount of fiscal
control given the budgetary environment faced by the federal government, but
it will not prevent us from continuing along this course. Given the
importance of our work to our nation’s economy and the investing public, we
will continue to meet our mission by strengthening our human capital,
investing in information technology, being proactive, and maintaining our

I appreciate your giving me the opportunity to speak before you today and I
am happy to answer any questions you may have.

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