On SEC Funding, Congress Must Put Up or Shut Up (or Give Up and Allow Self-Funding)

Back in January, U.S. Rep. Gary Ackerman (D-N.Y.) was recognized to speak at a House sub-committee hearing about the Madoff Ponzi scheme and the need for better regulatory oversight to prevent such fraud. He promptly lashed out at a witness from the Securities and Exchange Commission, stating: “I want to know who is responsible for protecting the securities investor, because I want to tell that person or those people whose job it is that they suck at it.”

While Ackerman’s rant drew publicity and attention and fixed the blame on the SEC for failing to uncover Bernard Madoff’s fraud sooner, the truth is not that simple. Indeed, a less polite witness might have answered: “Well, I want to know who is responsible for appropriating funds for protecting the securities investor because I want to tell that person or those people whose job it is that they suck at it.”

The Madoff case has helped spotlight, yet again, the dramatic need to better fund the SEC’s Enforcement Division. For years (if not decades) leading up to the Madoff scandal, the Enforcement Division has been known as a lean, effective unit that has performed well despite often lacking the resources and manpower of its opponents. The problem with constantly trying to “do more with less,” however, is that eventually you’re almost always forced either to ignore matters that deserve attention, or to stretch resources so thin that the chance of costly mistakes soars. It also means that when mistakes do occur, there isn’t likely to be much of a safety net available for the fall.

A report issued by the Government Accountability Office in March chronicled how much funding for SEC enforcement has failed to keep pace with demand and showed the effect that this shortfall has had on the workings of the Enforcement Division. Staffing of investigative attorneys, who are the engine of the SEC’s enforcement efforts, is down 4.4 percent from its peak. In addition, the number of non-supervisory investigative attorneys has declined 11.5 percent, from a peak of 566 in 2004 to 501 for 2008. The GAO stated that a key reason for this decrease was a hiring freeze that left positions vacant. The GAO report also showed that the Enforcement Division’s budget has followed a similar pattern, with 2008 funding down 8.2 percent from the 2005 peak.

As a result of its dwindling personnel numbers and surging workload, the GAO found, the SEC simply cannot pursue some worthwhile cases, and other open cases are closed prematurely due to insufficient resources. And some cases that are pursued are delayed significantly as a result of the SEC’s resource issues.

The GAO’s report also details the severe disadvantages the enforcement staff face every day as they take on the world’s top law firms in litigation and investigations. Among other things, the already-thin Enforcement Division staff contends with:

• little or no administrative or paralegal support, which causes lawyers to waste as much as half of their workday on duties such as copying, filing, document scanning, preparing exhibits, making travel arrangements, and logging and processing documents submitted by respondents;

• an outdated system for managing documents with such poor search functionality that enforcement lawyers must sometimes call defense counsel asking to be directed to information of interest in records;

• no knowledge management system for sharing information within the Enforcement Division, meaning attorneys developing cases cannot easily take advantage of documents, legal analysis, and other work already done by their colleagues;

• no access to information maintained by the SEC’s inspection division;

• lengthy delays for IT support staff to retrieve contents from hard drives obtained during an investigation;
• an antiquated taping system that is slower and results in more errors that those used by private parties;

• inadequate access to specialized services that would aid in case development, such as forensic accounting;

• delayed investigations due to inadequate in-house expertise in areas including complex trading, government securities, collateralized debt obligations, credit default swaps, sub-prime bonds, and collateralized mortgage obligations; and

• no access to real-time trading information, which is needed to pursue “pump and dump” schemes.

Although the issue of inadequate funding managed to simmer quietly for many years until the Madoff scandal broke, it has been both obvious and alarming to many of the SEC’s relative newcomers, such as Chairman Mary Schapiro and Commissioner Luis Aguilar. Within months of joining the SEC, Aguilar began speaking out on this issue. Last March, Aguilar observed that at a time when robust SEC enforcement was critical to improving conduct and restoring investor confidence, “the need for the SEC to have a bigger budget is obvious.”

Aguilar noted that in the last four years, the SEC’s budget has been stuck at just under $900 million and its staff has been steady at approximately 3,500 to 3,600 people. With those resources, it oversees the entire investment realm (tens of thousands of companies, brokers, or other parties), and watches the Financial Accounting Standards Board too. By comparison, the self-funded Federal Depositor Insurance Corp. employs 5,000 staff to oversee 5,100 FDIC-insured banks, and has a budget that ranges from $1.2 to $2.2 billion.

Schapiro has made similar observations since joining the Commission. Most recently, in Congressional testimony in July, Schapiro made a pitch for a huge increase in the SEC’s funding in its 2011 budget. Specifically, she noted, the SEC has since FY2005:

“[F]aced three consecutive years of flat or declining budgets, the end result being a 10 percent reduction in its workforce and a cut of more than 50 percent in its new technology investments. This occurred at the same time that the securities markets we regulate were growing significantly in size and complexity. Since 2005, when these cutbacks began, average daily trading volume has nearly doubled; the investment advisor industry has grown by over 30 percent in number and over 40 percent in assets under management.”

Schapiro added that she was grateful for President Obama’s proposed 6 percent budget increase for the SEC in 2010 (to $1.026 billion), but reiterated that the SEC actually wants $200 million more than that. This dramatic increase is what it will take, she said, to add more than 375 additional full-time positions and $30 million in new technology investments, mainly in the enforcement, examination, risk assessment, and market oversight functions.

The initial Congressional response to Schapiro’s request for $1.2 billion in 2011 suggests that the Madoff disaster may finally spur Congress to provide adequate funding for the SEC. Rep. Paul Kanjorski (D-Penn.), chairman of the House Financial Services Capital Markets Sub-committee before which Schapiro gave her recent testimony, indicated at the hearing that he will push for major increases in the agency’s budget or even consider legislation that would allow the SEC to be self-funded. “The financial crisis shows what happens when unbridled capitalism lacks a strong regulatory check,” Kanjorski said at the hearing.

Notably, Kanjorski also stated that Congress might decide to let the SEC fund itself. That idea has been another one of Aguilar’s key proposals. For months Aguilar has stated in his speeches that self-funding (through the filing fees it collects), as opposed to the traditional Congressional appropriations process, would allow the SEC to set multi-year budgets and respond in real time to a drastically changing market, while also maintaining appropriate staffing.

Aguilar points out that other regulators such as the FDIC and the Federal Reserve, for instance, are self-funded. He has also highlighted the FDIC’s recent announcement that it will more than double its budget to increase staffing and respond to the changing market conditions, an action Aguilar believes is only possible because the FDIC is self-funded and controls its own budget. The SEC should be in the same position, Aguilar says, because it faces “similarly important, if not greater, challenges.”

Whether it comes from a dramatic increase in the SEC’s budget or a move to self-funding, it is well past time for the SEC’s Enforcement Division to receive the manpower, technology, and support needed to do its job. Only after Congress has carried out its own responsibility for properly supporting the SEC will it be fair to start pointing fingers on the question of protecting investors.

Originally published in Compliance Week. Reprinted with permission. © 2009 Financial Media Holdings Group, Inc. All Rights Reserved. Compliance Week can be found at http://www.complianceweek.com. Call (888) 519-9200 for more information.