Home Legislative Action Congressional Testimony Strengthening the S.E.C.’s Vital Enforcement Responsibilities

Strengthening the S.E.C.’s Vital Enforcement Responsibilities

5/07/2009

Senate Committee on Banking, Housing & Urban Affairs Subcommittee on Securities, Insurance and Investment

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Chairman Reed, Ranking Member Bunning and members of the Subcommittee, I

greatly appreciate the opportunity to provide testimony to this distinguished

subcommittee.

These are challenging times for the United States Securities and Exchange

Commission and for its Division of Enforcement in particular – but these times also

present a unique opportunity to engage SEC leadership to recognize and utilize what is

best about government service to make the agency more responsive to our nation’s needs.

During our nation’s current financial crisis, I am confident that the talents and expertise

of front line SEC employees, many of whom have been too often overlooked, can and

will be tapped to help restore confidence in our nation’s capital markets achieve the

fundamental goal of protecting our nation’s investors. As president of the National

Treasury Employees Union (NTEU), representing more than 150,000 federal employees

in over 31 different agencies and departments throughout the government, including the

over 2,500 bargaining unit employees at the SEC, I look forward to working with you to

help the SEC succeed in its fundamental mission.

The challenges that we face as we work together to revive our economy and ailing

financial institutions are complicated and broad ranging. But much has happened in the

past several months. We have a new president and a new SEC chairman who see

government as part of the solution to our nation’s challenges, rather than as the problem.

We are hopeful that, in this new era, the SEC will begin the work of restoring the morale

of the SEC’s front line staff and rededicating the agency to its mission as the investor’s

advocate, rather than as an arbiter between those who favor a smart, efficient regulatory

landscape and those who oppose it.

Indeed, a renewed dedication to public service has never been more important. I

was proud that NTEU’s award winning public service campaign, “Federal

Employees…They Work for U.S.,” was well received throughout the country. We were

proud to air radio spots on 65 stations, in 50 markets nearly 17,000 times, and TV spots

that resulted in 74 million impressions. These ads reminded the public of the important

work federal employees do in an array of agencies and communities throughout the

nation.

NTEU believes that fundamental improvements to the SEC’s Enforcement

Division are long overdue. We support the new Director of the Division of Enforcement,

Robert Khuzami, and his basic goal of a smart, swift, strategic and successful

enforcement program. In our view, Enforcement Division reforms should be carefully

considered and based upon lessons learned about the Division’s strengths and weaknesses

over the past several years. And I think it is important to note, that whether in connection

with market timing, options backdating, the subprime mortgage crisis, or the Madoff

Ponzi scheme, the common thread among these failures has not been a failure of the front

line investigative staff, but rather a failure of past SEC management to acknowledge or

respond swiftly to significant allegations of improper conduct and inordinately high

systemic risks.

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The extent to which the SEC’s Division of Enforcement will be successful in its

mission rests in large measure with the federal employees charged with carrying out the

agency’s fundamental mission of enforcing the federal securities laws to protect our

nation’s investors. In the final analysis, a great country is the sum of the actions of its

people – and in few, if any endeavors, does that hold more truth than in the work of the

attorneys, accountants and support staff who are employed in the SEC’s Division of

Enforcement. These highly skilled women and men have dedicated themselves to

answering the call to public service. The change in administrations clearly provides a

window of opportunity not only for improvements in the Division of Enforcement and

the way it conducts itself – and thus how it serves the public – but in the way it attracts

and retains those who perform the people’s work.

Improving the Organizational Structure of the Enforcement Division

The primary challenge currently faced by the front line SEC enforcement staffers

that NTEU represents is the existence of a multi-layered and redundant management

structure within the Division of Enforcement. Every four or five front line enforcement

employees currently report to a “Branch Chief,” who reports to an Assistant, who reports

to an Associate. The vast majority of these front line enforcement staffers are highly

qualified, skilled and motivated attorneys and accountants who are fully capable of

handling their investigations independently, without the level of constant supervision that

flows naturally from this ratio of managers to staff persons.

As a result of this structure, it often takes as long to determine what to do about a

violation as it does to determine whether there was a violation in the first instance. This

robs the Division of its ability to have a swift and timely regulatory impact.

NTEU generally supports President Obama’s laudable reform goal of flattening

management layers in the federal government, as well as recent remarks by Enforcement

Director Khuzami indicating a willingness to consider such changes. The SEC’s

Enforcement Division is an example of an entity that would be well served by a reduction

in the number of redundant management layers. Such a flattening of the structure would

improve the speed and efficiency of the enforcement program, while simultaneously

increasing front line employee morale, engagement and empowerment. Re-designating

unnecessary enforcement managers would also result in a substantial increase of up to

20% in the number of frontline investigative enforcement staff who are actually

investigating cases, without requiring an increase in funding from Congress.

Need for Additional Market, Financial and Accounting Expertise

Mr. Khuzami has recently expressed the view that the SEC’s enforcement

program might benefit from hiring additional experts to assist the front line staff in

conducting their investigations, as well as by more effectively leveraging the experts that

it already employs. NTEU supports this recommendation. The SEC’s front line

enforcement attorneys are highly skilled experts at what they do – that is, identifying and

developing evidence critical to evaluating possible violations of the federal securities

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laws. However, in an increasingly complex global financial marketplace, those attorneys

would benefit greatly from more readily available technical and analytical support staff.

In recent years, the SEC has failed in providing this type of support.

As an example to place this issue in perspective, the Enforcement Division today

employs approximately 500 non-management investigative attorneys, but it has only nine

bargaining unit “market surveillance” experts nationwide. Increasing the staff of market,

accounting and financial analysts and other investigative support staff available to work

with SEC attorneys would be an efficient improvement that would help to achieve the

Director’s goal of smart, strategic, swift and successful results.

Reorganization of Enforcement into Specialist “Silos”

During his first few weeks at the SEC, Mr. Khuzami has suggested that the

agency might perhaps more effectively fight securities fraud by radically reorganizing its

enforcement staff into a number of “specialist” groups that would target specific types of

cases. Employees would shift in and out of particular specialty areas every couple of

years. This type of specialist, or “silo,” model would constitute an historic and

fundamental sea change in the organization of the Division of Enforcement. It therefore

requires extremely careful consideration and deliberation before implementation.

It is important to carefully consider the inherent logistical problems raised by

attempting to shift to such a model. If employees are reassigned en masse into specialist

“silos,” will the agency transfer their cases to other employees if those cases do not fall

under their current specialty? If so, how would it be an efficient use of agency resources

to transfer numerous cases from staff possessing historical knowledge of those cases to

staff having no such knowledge? If not, then what will specialization really mean? How

long will employees be expected to stay in a particular specialty area? When their “tour

of duty” in a particular specialty “silo” is over, will they transfer their uncompleted cases

to other employees? Will this be efficient for the agency? If not, then what will

specialization really mean? To deal with these problems, will employees be expected to

stay in certain specialty areas for extended periods of time, without the ability to work in

other areas of the federal securities laws? Who will decide which employees are

reassigned to which groups, and what will be the criteria for such reassignments? What

will be the long term impact of such decisions upon employee morale, and upon

recruitment and retention?

Even beyond these logistical difficulties, there are fundamental questions about

the efficacy of such a “silo” model that should be carefully considered by the SEC. Most

of the highly skilled SEC enforcement lawyers and accountants that NTEU represents are

organized into groups which handle all of the types of cases brought by the agency –

most notably cases enforcing the Securities Act of 1933, the Exchange Act of 1934, the

Investment Company Act of 1940, and the Investment Advisers Act of 1940. All of these

types of cases have basic similarities, and a great many investigations involve violations

under more than one provision. For this reason, the agency has traditionally believed that

it is important for the front line enforcement employees to possess a relatively broad

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knowledge of all of the securities laws, even if in some cases that knowledge is not

particularly deep.

In fact, it is not at all unusual for one enforcement investigation to present issues

that touch upon almost all aspects of the federal securities laws. A hedge fund

investigation may involve, among other things, insider trading, offering fraud, market

manipulation and accounting fraud, as well as violations of the Investment Advisers Act.

This may be one reason why the SEC’s historical experience with specialized groups has

often resulted in such groups dissolving back into general enforcement. Cases frequently

contain too many parts to classify easily. In addition, while the SEC has used task forces

in the past, they have only existed for limited durations.

Thus, although there is some natural appeal to the broad concept of

“specialization,” the SEC’s enforcement attorneys and accountants are already highly

specialized by focusing on enforcement of the federal securities laws. In this regard, the

Division of Enforcement is different from the Department of Justice, where law

enforcement is divided into specialist groups. Federal securities law is already a fairly

narrow area of the law. By contrast, a typical U.S. Attorney’s Office is divided into a

number of different groups dealing with unrelated criminal activities. Even a small white

collar crime group in a U.S. Attorney’s Office, for example, deals with a broader class of

investigations than just the violations of the federal securities laws currently handled by

the SEC’s Enforcement Division.

By creating “specialized” groups, the SEC would in reality be creating microspecialized

groups. This could be akin to transforming SEC enforcement attorneys into

assembly line workers who only attach one part during an assembly process. Although,

perhaps, some simpler types of securities fraud cases could be completed more quickly in

such an environment, the cost could very well be increased staff alienation and

balkanization, and a generally less effective enforcement program, particularly with

respect to larger, more complex cases.

NTEU shares Mr. Khuzami’s ultimate objective, which we believe is to empower

front line enforcement investigators with the expertise and resources necessary to

regulate increasingly complex financial markets. We believe, however, that the SEC

should proceed very carefully with any plans to fundamentally shift the organization of

the Enforcement Division towards a higher degree of specialization. In this regard,

federal labor law and the collective bargaining agreement between NTEU and the SEC

set forth the negotiating process that is required before a large scale reorganization of the

Division could occur. NTEU leaders look forward to engaging in a respectful and

constructive dialogue regarding these issues with SEC management.

Improved Enforcement Prioritization Metric

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NTEU supports Mr. Khuzami’s call for the introduction of an improved

Enforcement Division prioritization metric which would allow every front line employee

to effectively evaluate potential enforcement matters.

Walter Ricciardi, a Deputy Director in the Enforcement Division from 2005 to

2008, recently remarked in an April 1 speech in New York that SEC enforcement offices

are evaluated on the number of cases, or “stats,” that they bring in, rather than on the

regulatory impact of those cases. This system, in which every case receives the same onesize-

fits-all “stat,” is woefully inadequate. Bringing an enforcement action against Enron

yields one “stat,” but an office could receive 100 “stats” for delisting 100 defunct

companies for failing to file annual reports.

All cases are not the same, and treating them as though they are has the potential

to create perverse incentives, as well as to devalue the important work of front line

employees. Most importantly, the SEC’s prioritization metric should reflect actual harm

to investors, current or potential.

Empowering Front Line Investigative Staff

Over the past year, there have been a number of press reports regarding inquiries

by Congress and the Office of the Inspector General concerning SEC investigations in

which senior managers allegedly met with defense counsel outside the presence of the

front line staff assigned to those investigations. These reports led one Senator to comment

in the press on what he perceives to be a “culture of deference” towards “big players” on

Wall Street.

A renewed public commitment by Enforcement Division management to ensuring

that front line enforcement staff will be permitted to attend all meetings between

management and defense counsel on the matters that those staffers are investigating

would readily dispel such perceptions, while simultaneously reinforcing the important

role of the front line staff in enforcement investigations.

Reducing Bureaucratic Tasks

Today, front line employees in the Enforcement Division expend a great deal of

time on bureaucratic tasks such as the updating various internal databases and providing

repetitive reports on their cases up the management chain. Simply reducing these types of

activities would be an important step towards streamlining the enforcement process.

Expanded Regulatory Authority

NTEU supports increased regulatory authority for the SEC over unregulated

investment instruments and entities, including explicit statutory authority to regulate

hedge fund advisers as investment advisers and to require hedge funds to disclose the

contents of their portfolios, leverage amounts and counterparties.

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Funding and Staffing

Any consideration of ways to strengthen the SEC’s vital enforcement

responsibilities should include a discussion of the important human capital issues

currently facing the SEC. As the agency deals with what is perhaps the most challenging

period in its history, its single most important asset continues to be its human capital –

the stock of skills and knowledge embodied by the talented group of front line employees

who work at the agency and carry out its complex mission every day. For that reason,

maintaining a sound strategy to both attract and retain the best possible work force will

be critical to the long term success of the SEC’s enforcement program.

During the previous administration, however, the SEC displayed what could only

be viewed as a marked indifference to human capital issues. Far too often, the agency

was hamstrung, understaffed, underfunded and led by political appointees who were at

best ambivalent about the agency’s mission. By actively engaging the SEC’s workforce

and refocusing its mission, the agency’s new management can take a fundamentally

different path which will assist it in more effectively tackling our nation’s problems while

simultaneously restoring vitality to the SEC, including its Division of Enforcement.

Last year, NTEU pressed the case in Congress for additional SEC staffing and an

increase in the performance based pay budget requested by the agency, even as the prior

administration was asserting that the SEC did not need any additional funds and that it

expected substantial staff attrition in FY 2009. In hindsight, it is now abundantly clear

that permitting attrition to shrink the size of the SEC’s staff, including its enforcement

staff – a strategy which was actively pursued by the agency’s previous management –

could not have been more gravely off the mark. For that reason, I am heartened by the

fact that current SEC Chairman Mary Schapiro has signaled a change in direction with

respect to staffing issues. I strongly support additional funding to increase the agency’s

front line staff.

But more needs to be done with respect to human capital issues at the SEC. For

example, the agency should deliver on its agreement, made more than two years ago

during its 2006 compensation negotiations with NTEU, to provide a 2% increase in its

retirement match for SEC employees. In addition, SEC management should reverse the

prior administration’s approach of repeatedly slashing the funding for its performance

based pay system.

The SEC’s performance based pay system has had many flaws, both in its

implementation and execution. This was clearly evidenced by NTEU’s national

arbitration victory against the agency in late 2007, which ultimately resulted in a $2.7

million monetary settlement after an arbitrator found that the system had had a

discriminatory impact upon hundreds of SEC employees. The most glaring problem with

the merit pay system, however, has been past management’s conscious decision to

inadequately fund it. For fiscal years 2007, 2008 and 2009, the agency slashed its

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performance based pay budget, culminating in its most recent request to Congress for

only a 1.5% increase for FY 2009. This amount represented only half of the historic merit

pay budget of 3%. Without SEC management support for adequate funding, the merit pay

system will never work as intended.

NTEU is looking forward to working closely with new SEC Chairman Schapiro

to alter the course of the misguided human capital policies of the past administration.

Without fundamental change in the agency’s approach to these issues, employee morale

will continue to suffer, which will have a concomitant negative impact upon recruitment

and retention – and ultimately upon the agency’s ability to effectively enforce the federal

securities laws.

Finally, NTEU supports a self-funding mechanism for the SEC to ensure its

independence in establishing its budget and staffing needs from the fees that it collects.

Currently, as you know, fees collected by the SEC go into the General Treasury and the

agency is funded and staffed through appropriations. Other financial regulatory agencies

represented by NTEU, however, such as the Federal Deposit Insurance Corporation, the

Office of the Comptroller of the Currency and the National Credit Union Administration,

all have such control over the funds that they collect. The SEC should be afforded the

same independence and discretion.

Conclusion

The challenges facing the SEC’s Division of Enforcement in our nation’s current

financial crisis are large and historically important. I think that it is important to

remember in this context that the Chinese symbol for “crisis” contains both the symbols

for “danger” and for “opportunity.”

It is truly a new day for us all. The SEC has been through a lot in recent years,

suffering from depleted resources and staffing, as well as poor judgment by prior

management. But it also enjoys a deep reservoir of highly skilled, resilient and capable

employees who will continue to play a critically important role as we move ahead

together to address the problems that we face.