Panel I Of A Hearing Of The Subcommittee On Financial Services And General Government Of The Senate Commitee On Appropriations - Review Of The President's FY 2010 Funding Request And Budget Justification For The Securities And Exchange Commission, And Th

Statement

Panel I Of A Hearing Of The Subcommittee On Financial Services And General Government Of The Senate Commitee On Appropriations - Review Of The President's FY 2010 Funding Request And Budget Justification For The Securities And Exchange Commission, And The Commodity Futures Trading Commission

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SEN. DURBIN: Good morning. I'm pleased to convene this hearing to consider the fiscal year 2010 funding request of two key federal regulatory agencies within the jurisdiction of this Appropriations Subcommittee on Financial Services and General Government: the Securities and Exchange Commission, and the Commodity Futures Trading Commission.

I also want to welcome my friend and my distinguished ranking member, Senator Susan Collins. We have worked together in many venues. I'm glad that we're going to share the responsibilities of this subcommittee.

Joining us today to present testimony on their two budgetary proposals are the Honorable Mary Schapiro, chairman of the SEC, and the Honorable Gary Gensler, chairman of the Commodity Futures Trading Commission.

Both of the agencies enjoy unique histories, hold specialized and independent responsibilities, and take different approaches to markets that serve differing purposes. Yet the CFTC and SEC both occupy pivotal positions at the forefront of stimulating and sustaining economic growth and prosperity.

We are enduring an extraordinary set of circumstances in our nation today. We are beginning to slowly emerge from one of the greatest economic crises in decades. After years of struggle, countless families have lost their hard-earned savings, seen their dreams daunted, deferred, and even denied. Some may view the subject matter of this hearing as dry as dust -- how much money to give to two federal agencies? But if you step back for a moment an translate their work into the real world, realize that their oversight and their regulation literally protects the savings and futures of American families and ensures that economies in countries around the world will view our economy and the way we run it with respect as to whether or not the rule of law is going to be followed.

The unprecedented price volatility of our markets for fiscal commodities such as energy and grains has hurt our economy, in addition to the previous mention I made of some of the problems that we've had with savings and the like. Now, perhaps more than ever, we need our markets to function transparently and be insulated from manipulation and unfettered, excessive speculation. Much remains to be done to stabilize and sustain our financial system.

Chairman Schapiro, Chairman Gensler each bring vast experience to their new leadership posts in this administration and have undauntedly identified in their brief tenure ways to improve the way we approach regulating securities and futures markets. As the subcommittee prepares to make difficult funding decisions, I look forward to hearing about the challenges their agencies will face.

In the interest of time, I am going to ask that the remainder of my statement be made a part of the record so that we will have opportunity for testimony and for questions. And I now turn it over to my ranking Republican member, Senator Collins.

SEN. SUSAN COLLINS (R-ME): Thank you, Mr. Chairman.

Let me begin by saluting you for your leadership on this committee. I am just delighted to be your new ranking member.

About two decades ago, I spent five years in Maine's state government as a financial regulator overseeing the Bureau of Banking, Insurance, Securities Administration, and I have a great personal interest in this area because I know that the decisions made by the SEC and the CFTC do, as you have pointed out, have such an impact not only on our economy but on the daily lives of most American families. So it's a great honor to serve with you as your ranking member, and I very much look forward to working cooperatively with you throughout this Congress.

As we begin to consider the fiscal year 2010 budget requests for the SEC and the CFTC, let me also salute the chairman for his leadership in securing significant increases for both of these agencies. Thanks to the work of this subcommittee and the chairman's leadership, the budget for the SEC is now nearly 9 percent above the fiscal year '07 funding level, and the budget for the CFTC is 49 percent above that year. These increases are extremely important given that both of these agencies were woefully underfunded for years. I personally believe that they're still underfunded and that more work needs to be done.

I want to congratulate the two chairmen for appearing before our committee today with aggressive agendas for change and reform. I look forward to hearing the details about the budget request.

As the chairman has indicated, the current economic crisis has left our markets in turmoil, and the loss of trillions of dollars of value in these markets has depleted family savings, shuttered small businesses, and damaged retirement and pension funds. I am convinced that we not only need to make sure these two agencies have the resources necessary but that we need to proceed with regulatory reform as well in order to restore confidence in our markets and to prevent the root causes of the current financial crisis from springing up once again.

Mr. Chairman, I am going to follow your lead and submit the remainder of my statement as well, but I am delighted to be joining you to work on these critical issues. Thank you.

SEN. DURBIN: Thanks a lot, Senator Collins.

Senator Tester, would you like to make an opening statement?

SEN. JON TESTER (D-MT): Just -- thank you, Mr. Chairman -- just to welcome Mary and Gary to the committee today.

I appreciate the work that you have done and I appreciate the work that you are about to do. I think it's critically important that we have good, solid, reasonable enforcement and I think both of you are up to that challenge.

So with that, we'll move on.

Thank you, Mr. Chairman.

SEN. DURBIN: Thanks, Senator Tester.

Chairman Schapiro, the floor is yours.

MS. SCHAPIRO: Chairman Durbin, Ranking Member Collins, and Senator Tester, thank you very much for the opportunity to testify today.

In the short time that I've been at the SEC, we have taken on an active agenda all with the goal of protecting investors, revitalizing the agency, and restoring confidence in the markets. We are making great strides, yet recognize that we have quite a distance to go.

In the area of enforcement, we have changed our policies so that our investigators do not have to jump over unnecessary hurdles before seeking penalties or launching investigations. We have hired a former federal prosecutor to lead the enforcement division, someone who is focused on bringing significant cases with a meaningful impact as quickly as possible and ensuring that the division is appropriately organized to do just that.

We have begun to update our management systems to upgrade our risk-assessment capabilities so that we can better detect fraud. And we have expanded and improved upon our training so that our staff will be able to keep pace with the new financial products and strategies created on Wall Street.

Already we are seeing results. Since the end of January, as compared with the same period last year, we have filed nearly three times as many temporary restraining order cases, issued more than twice as many formal orders, and opened over 20 percent more investigations into fraud.

Although enforcement is central, it is still just one part of our agency. As you know, we are tasked with overseeing broker-dealers, investment advisers and mutual funds, and we are taking steps to improve our ability to do just that. For instance, we are working on a risk-based initiative to improve our oversight methods so that we can better identify and focus resources on riskier institutions. We also are recruiting senior professionals with new skill sets, such as trading, risk assessment and financial analysis. And we have created an Industry and Risk Management Fellows Program to bring top talent into the agency.

In addition to internal management directives, we also have engaged in an active rulemaking agenda. Last month, the SEC proposed significant changes to the rules governing investment advisers who maintain custody of their clients' assets. Should the proposals be adopted, advisers with custody will have to undergo a surprise exam by an independent public accountant once a year to verify client assets, and any custodian affiliated with an adviser would also be subject to custody controls reviews by an independent accountant. The goal is to expose Ponzi schemes and other frauds earlier.

In the area of short selling, the commission unanimously voted to propose two distinct approaches to limit short selling. One would impose a permanent market-wide short sale price test. The other approach would impose temporary short selling restrictions upon individual securities during periods of severe price declines.

Later this month, the SEC will consider proposals to strengthen the money market fund regulatory regime. We will focus on tightening credit quality, maturity and liquidity standards for money market funds. We're also exploring whether more fundamental changes are necessary, such as converting money market funds to a floating rate net asset value to better prevent abuses and avoid runs on the funds.

Additionally, I have asked the staff to undertake a comprehensive review of Rule 12b-1, which allows mutual funds to use fund assets to compensate broker-dealers and other intermediaries for distribution and servicing expenses.

In the area of proxy access, the commission already has proposed rules that would enhance the ability of shareholders to nominate company directors. And next month we will take up a broad package of corporate disclosure improvements around compensation policies, the use of compensation consultants, and the interplay between risk taking and incentive arrangements.

But there is still more to do in the regulatory arena. We have been working closely with other federal agencies to bring the unregulated world of credit default swaps into the sunlight. Operating under the limitations of the current legislative structure, we recently issued temporary orders to facilitate the establishment of central counterparties for clearing credit default swaps. In the coming months, we will also tackle issues related to municipal market reform, stock lending, trading in nontransparent markets or dark pools, and hedge fund oversight. I look forward to working with Congress on these issues.

The financial crisis has reminded us all just how large, complex and critical to our economy the securities markets have become. At the SEC, our 3,700-person staff now oversees more than 35,000 registrants, including about 12,000 public companies, 8,000 mutual funds, 11,000 advisers, and 5,000 broker-dealers. And it is a number that is growing rapidly.

Nonetheless, during the same period, the SEC's resources have fallen. Between 2005 and 2007, the agency saw three years of flat or declining budgets and lost 10 percent of its employees. This has an impact. With support from this subcommittee during the last two fiscal years, the SEC has been able to lift its hiring freeze and begin rebuilding its work force, and I am very grateful for that support. But even with these important steps, the number of staff remains below the levels of only a few years ago. I believe additional resources are essential to restoring the SEC as a vigorous and effective regulator.

The president is requesting a total of just over $1 billion to the agency in fiscal year 2010, a 7 percent increase over this year's level. This budget request would permit us to fully fund an additional 50 staff positions over 2008 levels. These positions would help the SEC's enforcement program enhance its pursuit of tips and complaints and fully fund our new fellow's program that brings in seasoned industry professionals. In addition to expanding our work force, the president's request also would enable us to invest more in new technology, a budget item that has dropped by more than half in the last four years.

Mr. Chairman, I came to the SEC to shape public policy in the interest of investors and to strengthen our enforcement program. The measures I have described today are important to those efforts. But what I have also discovered is that we cannot neglect the internal operations of the agency, the processes that guide our work, and the agency's infrastructure.

I am committed to a complete review of internal operations to ensure that we meet the highest standards and that we are fully supporting the important work of our employees. To ensure that we do it right, I intend to bring in a chief operating officer to manage that process.

I want to thank you for your continued strong support of the SEC and its critical mission. I believe that by strengthening our enforcement program, enhancing risk-based oversight, and leveraging technology, we can restore investors' confidence in both the SEC and in our nation's securities markets.

I look forward to answering your questions. Thank you.

SEN. DURBIN: Thanks, Chairman Schapiro.

We'll have five-minute rounds here. And I'm sure we'll have several questions.

It seems to me that there are two things we're dealing with here just on the surface: first, the number of people working in your agency. It appears that over the years, as Senator Collins noted, we've allowed the number of professionals working there to decline in real terms and, certainly, decline precipitously in relation to the volume of trade that you have to keep an eye on.

Between 2005 and 2007, the SEC lost 10 percent of its employees, if you can imagine at that moment of time, undermining the agency's ability to oversee the markets. Between that -- in that same period of time, the market ballooned in size and complexity. Registered investment advisers grew 32 percent, assets jumped by over 70 percent. So we're seeing the caseload or at least the area that needs to be regulated is growing and the number of people to keep an eye on it is diminishing. So there is, on the first instance, which you addressed in your testimony, the question of the right number of people working at the agency.

And the second issue goes to -- I don't know how to characterize it -- I guess the internal culture of the agency. Bernard Madoff was a wake-up call. The fact that this man could swindle as many people as he did with impunity for so long, to me, is nothing short of amazing.

According to SEC data, in fiscal year 2008, the SEC staff handled over 600,000 tips sent by individuals to your enforcement complaint center. I did a quick calculation in my mind. I think that's more than 2,000 a day for every business day people sending in "here's something you ought to look at." Well, that, to me, is an overwhelming number and perhaps you could put it in some kind of perspective.

Now, some have taken a look inside your agency and asked whether the enforcement function within the agency is a healthy one. Is there a risk-averse culture within the SEC to step up and say, you know, we ought to take a look at this Mr. Madoff, or people like him?

So let me ask you at the outset, number one, what would be the optimal number of people that you believe you need to do an effective job at the SEC in light of the volume of business that you have to regulate? And secondly, do you perceive a cultural problem within the agency when it comes to enforcement?

MS. SCHAPIRO: Thank you very much, Mr. Chairman.

I think you've really summarized very well with respect to the staffing pressures on the SEC, the current situation. With over 35,000 regulated entities and 3,700 staff, it's a job that we really can't do in the way I think the public would like to believe we can do in the sense of routine, on-sight presence in many regulated entities.

That's going to really require that we leverage third parties. So, for example, in the rules I discussed related to the custody of customer assets by investment advisers -- a huge problem in the Madoff area -- we're going to rely on PCAOB-registered accounting firms to leverage our capability to ensure the customer assets are being protected by the custodians and by the investment advisers. And we will look for every opportunity we can to leverage third-party resources. But at the end of the day, we do need significantly more staff, I believe, over the next several years to keep up with the growth and the complexity of this industry. And if there are additional responsibilities as a result of regulatory reform that accrue to the SEC in the context of hedge funds, credit default swaps, or other areas, that, of course, will require sufficient additional resources because we can't stretch any thinner than we already are.

So I do believe -- and if you look at our 2011 budget request, you will see we've asked for a significant ramp-up in the number of FTE -- close to 400 FTE and a thousand new positions. And I believe if we're able to achieve that number in 2011 or over the course of the next several years that will go a long way towards getting this agency to the appropriate size to handle the job that's in front of it. I don't think there's any danger that we're about to become too big in any event.

I think, with respect to your second question, the Madoff fraud is a tremendous tragedy. It's really a tragedy of epic proportions. And I think it really will put the onus on this agency to prove that it is capable of managing the responsibilities that it has been given under the law. And it's really critically important for us to ensure that both our culture, our operations, and our procedures, our staff, and our skill sets are up to the task.

You pointed out, for example, that we get somewhere around 600,000 to, in peak years, a million and a half tips a year. We can't manage those. They come into the organization through a wide variety of entry points. We don't have databases that are connected so that we can do a trend analysis of those tips and complaints or connect that data to external sources of data to see what might be developing more broadly in the marketplace.

Right after I started, I brought in the MITRE Corporation Center for Enterprise Modernization to do a complete review of how we handle tips and complaints. They've concluded the first round of their work, and we're now in the implementation phase of some short-term and intermediate-term remedies and processes to help us manage tips and complaints.

But it's also about leadership, and it's about freeing our enforcement division to do the kind of job that I know they're capable of doing. I was at the SEC 15 years ago when the agency had a really first-class reputation for aggressive enforcement. And I know we're capable of that again. We have a new enforcement director who's very committed to bringing large cases in a timely way that have the maximum investor protection impact.

It's about enabling our enforcement staff through technology and the right skill sets to bring those kinds of cases so that when a whistleblower presents them with information, as happened in the Madoff case, they have the ability to understand it and pursue it. It's about being a little bit humble about the information that comes to us and appreciating that there may be real value in what's being presented to us.

We're also going to seek whistleblower legislation to enable us to reward whistleblowers as the IRS and other agencies do when they bring us well-formed cases and documentation of fraud that we can then pursue. And it's about filling the regulatory gaps through rules such as the custody requirements I just spoke of so that we are assured that the regulatory regime, coupled with aggressive enforcement, coupled with the tools and the skill sets, combine to create an agency that's absolutely committed and focused on investor protection.

I'm sorry. That's a very long answer.

SEN. DURBIN: No. It's a very good answer, and I thank you for it.

And I'm going it turn to Senator Collins and return in later rounds.

SEN. COLLINS: Thank you, Mr. Chairman.

Ms. Schapiro, you talked about the increased number of positions that you have requested as part of the fiscal year '11 budget, 2011. But in fact, the president's budget for this coming fiscal year does not allow you to hire any new positions. Is that correct?

MS. SCHAPIRO: That's correct, Senator. The increase in the 2010 budget covers the annualized cost of the increases in the FY 2009 budget that we were able to have as a result of the approval of our reprogramming request and taking $17 million of unobligated funds from prior years, dedicating those to staffing, additional staffing in 2009. The annualized cost of those additional 50 positions that we're bringing on this year are the increase in the 2010 budget.

SEN. COLLINS: Do you need new positions for the upcoming fiscal year?

MS. SCHAPIRO: Well, I would say that we're, first of all, extremely grateful to the president for the increase in the 2010 budget, and it's a meaningful increase for this agency. And as I pointed out, 2011, we saw a much greater increase. The opportunity to start to move towards that 2011 budget earlier would be a wonderful opportunity for us to bring that number of staff on over a two-year period rather than all in 2011 if Congress ultimately approves that number.

SEN. COLLINS: Because I am troubled that the current funding level supports a staff that is 5 percent lower than your peak level back in fiscal year '05. If you look at the growth of regulated entities, if you look at the amount of money involved, if you look at the number of American families who now have savings in the stock market, the fact that these staffing levels are below what they were five years ago is troubling to me. So are you saying that it would be helpful to be able to ramp up those staffing starting in the next fiscal year rather than waiting to fiscal year '11?

MS. SCHAPIRO: Absolutely it would be helpful. The reprogramming request, in addition to allowing us to get a little bit of a jump on 2010, enabled us to do some technology investment. We need fundamentally more investment in technology at the SEC to support our enforcement and examination programs. And we can use more boots on the ground in enforcement and examination, absolutely.

SEN. COLLINS: Aggressive enforcement is absolutely critical. There's another way that's important for protecting investors, particularly smaller investors who may be less sophisticated in choosing their investments. And that is through a robust education effort.

You've spoken a lot about the need to protect investors. And I know that, in my state, I've seen thousands of individuals who have seen their retirement nest egg shrank, money set aside for their children's college education virtually disappear. And they're wondering what can be done about it. They're seeking more information.

Several years ago, the SEC used to conduct very valuable educational sessions, town meetings, outreach to seniors groups. What are your plans to reach out to investors, particularly small investors or senior citizens, in two ways: one, to help them better understand risk and suitability requirements but, two, to help them spot scams?

MS. SCHAPIRO: It's a wonderful question, and I'm very committed and personally quite passionate about investor education and had a program at my former employer, FINRA -- Senator Tester knows -- where we do the investor forums which the SEC used to do years ago around the country, and to great success and with tremendous participation all over the country.

The SEC has a small program that does that now. Commissioner Walter, in fact, did an investor forum just last week with our Boston office in the state of Maine. My plans would be, given sufficient resources, that we dramatically increase that program, that we enable our offices around the country to provide local education in senior citizen centers, community centers, local high schools and that we really take a leadership role in the federal government in educating investors about the kinds of questions they need to ask when they're being offered investment products, about the kinds of scams and pitfalls that they need to be on the alert to.

I'm very concerned given the current environment and the amount of money people have lost in their retirement plans and in their other investments that they will be reaching to try to make that money back through some particularly risky investments. I have no doubt that the scam artists have already figured this out and are beginning to prey on people's real fears about their financial futures.

I think the SEC can play a critical role here bringing together other agencies of the federal government but also on its own reaching out very directly as well as through the development of content put on Web sites and in investor forums.

SEN. COLLINS: Thank you. Glad to hear it.

SEN. DURBIN: Senator Tester?

SEN. TESTER: Thank you, Mr. Chairman.

Chairman Schapiro, you come into an agency, the SEC, that's been around about 75 years and, to be honest, from my perspective, probably come into it at a time when it's at an all-time low as far as both morale and both effectiveness. So you've got to rebuild this agency, I think, maybe not from the ground up but from the foundation up.

We have talked about manpower levels. If you have the technology that you spoke about, do you have a figure in mind about what the right number of people are for this agency, considering the massive workload?

MS. SCHAPIRO: It's very hard to give an exact number. As I said, our 2011 budget request seeks a thousand additional positions, which would take us to just under 5,000. That would still be smaller, for example, than the FDIC, which regulates about 5(,000) to 6,000 banks.

SEN. TESTER: Okay.

MS. SCHAPIRO: I do think there's also a practical limitation on how many people you can just bring onboard and train at any given time.

SEN. TESTER: Right.

MS. SCHAPIRO: The faster that we can move towards a substantial increase like that I think the better.

SEN. TESTER: Okay.

MS. SCHAPIRO: It also depends largely on our ability to effectively utilize technology to save on human resources.

SEN. TESTER: Right on.

Consumer confidence is one of the things that everybody's concerned about. You know, we lost a bunch of money. People's confidence is shaken. What do you see as being two or three of the major things that you have to do in your agency to have consumer confidence back at a level that's reasonable? And quite honestly, what do you see we need to do, the two or three things that we need to do to help re-establish consumer confidence with the groups that you regulate?

MS. SCHAPIRO: I think it's a great question. I think enforcement is just a part of what we do, but it's a very visible part. And I think it's really critical for investors to see that there is a cop on the beat who's trying to ensure that the playing field is level, that the insiders aren't taking advantage of the rest of the participants in the marketplace. So we need to have a very timely enforcement response to the problems that arise in the marketplace.

And short of doing that, I think people won't have confidence. We can write all the rules we want, but if nobody is enforcing them, we're not going to restore investor confidence.

I think investors also need to have complete confidence in the transparency of corporate disclosure. They need to believe that the companies in whose stock they are buying are giving them the accurate numbers and the accurate disclosure and information about that company's prospects so they can make informed decisions about where to put their money.

And I think we have to have a focus on consumers' issues, on mutual funds sales, on sales practices generally, on the issues around fees and fee structures and disclosure that investors really care about at the end of the day.

We'll be announcing later this week the creation of an investor advisory committee for the first time in many, many years at the SEC that will give investors a regular way to interact with the commission on policy issues that are of interest to them. I think we have to reorient everything we do towards rebuilding investor confidence in both the agency and in the fairness of our markets.

SEN. TESTER: What do we need to do, Congress?

MS. SCHAPIRO: I think supporting the agency, quite honestly, as the appropriators, with sufficient resources to accomplish what we need to do and hold our feet to the fire that we're delivering on the commitments that we're making to the American public.

SEN. TESTER: Have you been able -- I mean, there's been talk about the future roles of the SEC, the CFTC, who we'll hear from shortly, after a regulatory modernization has been done. Assuming that that goes forward, can you talk about the challenges, opportunities, possible consequences of merging your two agencies?

MS. SCHAPIRO: Sure, and, you know, I have the unique position of having been chairman of the CFTC and now chairman of the SEC. So honestly I can tell you I've argued both for and against merger over the years.

I think it's obviously a decision ultimately for the Congress about whether or not to combine the two agencies. Short of that, I believe that with Gary as chairman of the CFTC that we can have an incredibly positive and constructive working relationship to ensure that products and practices don't fall between the cracks of the two agencies and that we don't leave large slots of the financial markets unregulated and unaccountable to the American public or to the regulatory --

SEN. TESTER: Do you think that that would be -- excuse me, but do you think that that would be done better if you were combined?

MS. SCHAPIRO: My personal view is that there is a logic and an efficiency that can be achieved through the merger of the two agencies. But short of that, I also think that the two agencies can do a better job of working together to ensure the protection of investors.

SEN. TESTER: My time is up. But we'll be back.

SEN. DURBIN: I was just advised by my colleague that there's a vote on. And I'm going to try to continue asking until someone returns. But I ask the indulgence of our witness and those in the audience as we try to balance a few things here.

The number of investigative attorneys at the SEC decreased 11.5 percent between fiscal years 2004, 2008. And some believe that that's resulted in delayed cases, reducing the number that can be brought to trial and potentially undermining the quality of cases that are pursued. How have resource constraints impacted the effectiveness of the SEC?

MS. SCHAPIRO: There's no question but that -- and there's a recent GAO report that suggests this as well -- that the resource constraints have hindered the ability of the enforcement division to pursue as many cases in as timely a way as I would like to see. In addition, there were some procedural difficulties placed in the path of the enforcement division over the last several years that slowed cases down and discouraged -- if not explicitly, implicitly -- seeking penalties from corporate issuers in certain kinds of cases. And we've eliminated those hurdles, and cases can be started much more quickly now. Investigations can be pursued with the approval of one commissioner and not the full commission sitting in a meeting.

We've eliminated what was called the penalty pilot program completely. And we're reorganizing the enforcement division under the leadership of our new director in a way that we hope will eliminate some layers of management and some of the stovepiping that's existed over the years and allow us to be more nimble and more aggressive pursuing much larger cases, particularly those arising out of the financial crisis.

SEN. DURBIN: On another issue, there was a mind-set for a long period of time that as long as the economy was expanding and wealth was being created we didn't dwell and ask a lot of embarrassing questions. But with the downturn in the economy, downturn in the fortunes of many families and the investment of our federal government into many of the largest businesses in America, there appears to be an awakening on the part of the average person about how many corporations are being managed and particularly in the area of executive compensation.

I won't go into chapter and verse about bonuses given to executives who have nothing to show for it other than failure. But let me ask you, what is the SEC currently doing to improve the accountability of corporate directors and enhanced disclosure of executive compensation?

MS. SCHAPIRO: Mr. Chairman, I've made corporate governance one of my highest priorities in the last four months. And we have engaged in a couple of things.

First of all, in May we approved for comment a proposal that will facilitate the ability of shareholders to nominate on the company's proxy directors to serve on the corporate -- on the company's board. And it's out for comment now. It will be highly controversial. But if ultimately approved and not challenged in court, it will greatly facilitate the abilities of shareholders to elect nominees to corporate boards and thereby hold directors more accountable for their oversight of the corporation.

With respect to compensation in particular, as you know, we already require disclosure of all plan and non-plan compensation by the senior-most officers of the company. Next month we'll be considering amendments to the compensation disclosure rules that will simplify something called the summary compensation disclosure table to provide more information there about compensation. It will require disclosure about the overall compensation approach within the company. There'll be enhanced disclosure about the use of compensation consultants who are sometimes in a conflicted position in advising both the compensation committee and the company's management.

And we're going to require disclosure about the linkage between compensation plans and risk-taking by executives, traders and others within the company so that investors will be able to understand how risk taking, which was such an important component of the financial crisis, has been potentially incentivized in some companies.

SEN. DURBIN: On another issue, in late 2006, the Credit Rating Agency Reform Act gave the SEC exclusive authority over rating agency registration and qualification. And in the less than three years since enactment, the SEC has undertaken no fewer than five rulemakings to implement the law. These rules, which are all still relatively new, extend from registration and record keeping to disclosure and managing conflicts of interest.

Yet even though the credit rating agencies were under SEC's purview, rating agency performance in the area of mortgage-backed securities backed by residential subprime loans and the collateralized debt obligations linked to such securities has shaken investor confidence to the core. It used to be that credit ratings were kind of like the gold standard in terms of whether you could trust a business to be in solid financial shape. Well, I think a lot of questions have been raised.

What are you doing at the SEC now to restore consumer and investor confidence? And what improvements are needed in the way that you monitor credit rating agencies?

MS. SCHAPIRO: There is no question but that credit rating agencies played a significant role in facilitating, I guess in some ways, the financial crisis. The agency has engaged, as you point out, in many rulemakings, most recently, the rules in 2008, which required a series of disclosures about performance statistics, the different kinds of models that were used for initial ratings versus surveillance ratings, documentation, disclosure of conflicts and so forth.

The Credit Rating Agency Reform Act which Congress passed in 2006 specifically does not allow the agency to regulate the substance or the procedures or the methodologies of the rating agencies. And something we're looking at is whether we need to ask Congress to reopen that legislation and provide greater authority.

SEN. DURBIN: Who does?

MS. SCHAPIRO: Nobody. But nonetheless, despite the limitations in the law, we are looking at doing a couple of things. One is -- my perhaps greatest concern in this area is something called ratings shopping, which allows the creator of a structured product to get preliminary ratings from multiple rating agencies and then select the one they want to rate the product, presumably that being the highest rating that they've gotten.

SEN. DURBIN: I wish I could have had that for my report card in grade school.

MS. SCHAPIRO: Don't we all? (Laughs.)

SEN. DURBIN: Shopping teachers.

MS. SCHAPIRO: Exactly. If you'll give me an A, I'll take your class is what it amounts to.

So we're looking at what we can do with respect to ratings shopping, removing references potentially to ratings in the federal securities laws and regulations, which gives an air of credibility and respectability to ratings that perhaps they don't entirely deserve.

We're looking at whether we should require different symbols for rating structured products versus rating plain vanilla corporate debt. And we're looking at more detailed disclosure about how ratings have performed over time. So there's some things the SEC clearly can do and we are doing. We held a roundtable with rating agencies just about a month ago to explore some of the failures of the different business models and some of the -- not the failures of the different models, but the different business models, some of the other failures that have become clear over the last year.

We're moving ahead with what we can do. And we will come back to Congress if we believe at the end of the day we need more authority.

SEN. DURBIN: Thank you.

I'm going to ask that the subcommittee stand in recess for just a few moments. And as soon as Senator Collins returns, I'm going to ask her to resume the hearing. I apologize, but it just so happens we have a roll call vote. The subcommittee will stand in recess.

(Recess.)

SEN. COLLINS: In Senator Durbin's absence, he's permitting me to continue the hearing. I'm certain he'll be back very soon. He's just voting.

Ms. Schapiro, last September the SEC's inspector general issued a report on its investigation of the Consolidated Supervised Entity program, the CSE program, through which the SEC monitors the five major investment banks.

This IG report found that the SEC had severely understaffed its CSE program and thus could not effectively manage its responsibilities to monitor or question these investment banks.

As you know, I'm particularly concerned that an investment bank like Bear Stearns was allowed to have a leverage ratio of 30 to 1 -- truly astonishing, and yet it appears that there was not a system in place other than a very loose, voluntary system that the SEC had to monitor these banks.

And in many ways, this report was truly prescient since just a few months after it was issued none of these investment banks existed anymore. They all had either failed, been acquired, or merged into bank holding companies. Let me ask you a number of questions about this.

First, does the SEC have the right mix of staff to conduct the kind of oversight of a large investment bank? A lot of the SEC's employees are attorneys, which is obviously very useful and helpful on the enforcement side, but does it need more auditors, more economists who have the expertise to analyze complex financial data and risk models? So the first question is the mix of expertise.

MS. SCHAPIRO: I believe that we haven't historically had enough financial analysis experience, experience with structured products and complex derivative products.

In the last couple of months, that's been an area of focus for recruitment not just in the enforcement program but also in the trading and markets division, which has responsibility for broker- dealer risk oversight, so that even though the CSE program is discontinued, there are still a large number of -- maybe not a large number, but a number of large investment banks and broker-dealers for whom the SEC still has responsibility. That's an area that we are building and increasing our capability in in a very conscientious and sort of directed way and have been working on over the last couple of months. It's really important for us to have that capability. Even with the presence, ultimately, of a systemic-risk regulatory that's the result of regulatory reform, it will be important for the SEC as a day-to-day regulator of over 5,000 broker-dealers to have the capability to really understand the financial and operational status and condition of those brokerage firms.

SEN. COLLINS: Second, how should -- I realize these large investment banks don't exist anymore, but they could reappear -- how should they be regulated for safety and soundness?

I cannot imagine a federally or state-chartered bank being allowed to have a leverage ratio of 30 to 1.

MS. SCHAPIRO: I think the answer is they need to be regulated on a consolidated basis so that -- as you know, the securities laws are generally geared towards the protection of customer assets within the broker-dealer.

But there are affiliates of the broker-dealer. There's a holding company structure. There are a lot of other entities where significant risk can be taking place, and it's important that the regulator of the entire entity have a view into what's going on in all of the related parts of the operation, so not just in the broker- dealer but also in a holding company, affiliates and subsidiaries.

It is that consolidated view that will allow a regulator to make a judgment about whether leverage is excessive, capital is sufficient, the quality of management across the enterprise is up to the task.

SEN. COLLINS: Another reform that we need is the ability to identify and prevent what I refer to as regulatory black holes and the emergence of credit default swaps or other exotic and poorly disclosed derivatives certainly indicates that the current system has not been sufficient to prevent gaps in regulation of products or practices that can have consequences for the entire financial system. That's why I support having a council of regulators to look at systemic risk.

What do you think are the advantages and disadvantages of a council approach versus having -- vesting in the Federal Reserve the authority to be the systemic risk regulator?

MS. SCHAPIRO: Well, I'm very much in agreement that the existing regulatory regime is riddled with holes and that there were large parts of the financial marketplace that were really not under the regulatory umbrella at all, or in any meaningful way, and credit default swaps is an example. Hedge funds and some other private pools of funds -- pooled funds -- would fall into that category as well.

As you know, I like the concept of a council, whether it's a stand-alone council, or in conjunction with a systemic risk regulator, because it brings a diversity of perspectives that I think is really important to identifying where gaps may be arising, where new products may be being created in the interstices between regulatory authorities so that we can avoid those potentially harming the system.

And when you have a council of regulators where you've got a securities regulator, for example, which very much focused on investor protection and transparency, and bank regulators very much focused on prudential standards and safety and soundness, and insurance regulators with yet another perspective, I think you have a better chance of capturing the entire financial landscape and the potential places where those new products are arising or those new gaps are being created.

At the same time, I think there needs to be the ability, whether it's a council or a single systemic-risk regulator or a combination, to step in and raise standards when necessary where the functional regulator may not be aggressive enough in requiring higher capital standards or reining in leverage, that there be the ability, ultimately, to protect the system to force those kinds of changes.

SEN. COLLINS: Thank you.

Senator Tester?

SEN. TESTER: Thank you.

SEN. COLLINS: It's nice being temporarily chairman, so --

SEN. TESTER: (Laughs.) Thank you, Senator Collins. You're doing a fine job, I might add.

Secretary Schapiro, I'm sure you read the article yesterday in The Washington Post that dealt with enforcement actions the SEC over the past few years. If that article's true, it is more than just a little bit distressing.

You have stated the imperative to take the handcuffs off the enforcement division. That article yesterday would imply to me that I don't care how much money we put at the agency if people on top are making arbitrary decisions about how to not do their job appropriately, no amount of money is going to make it work correctly. You're not going to do that. I know that. I've met you and long before when you were in FINRA as you stated in your opening statement in Montana and did a fine job education-wise, and you have done a fine job in this position. But could you just give me a little bit of insight on how this budget would help you accomplish the goal of taking the handcuffs off the enforcement division?

MS. SCHAPIRO: I'd be happy to.

I should that in my four months at the agency, I talk a lot about enforcement. I've done some town halls with the staff. I e-mail with the staff. I will tell you that the response has been tremendous eagerness and enthusiasm on the part of employees to get back to what we do and what we can do so well, and particularly in the enforcement context.

I think what the budget will enable us to do is have more people to bring the cases that need to be brought. We are not in danger of running out of cases. So on a very simplistic level, more people will enable us to do that.

Bringing in the right skill sets so that we are not risk-averse, so that we're not afraid to tackle the most complex trading strategies or the most complex products or the most complex frauds will be important.

So we need to train our people better in more sophisticated methodologies. We need to bring in the right kinds of skill sets as well. And we need to support our people with technology.

The amount of data that comes into the agency that is unmanageable, even in the course of one major litigation, is extraordinary. And we have our people wasting their times archiving e-mails and dealing with millions and millions of records when we should be able to rely almost solely on technology to do that.

We need technology to help us sort out the tips and complaints that we get, as I spoke about earlier.

SEN. TESTER: The ranking member talked about potential inadequacies of this budget. In previous line of questions, you said you can't bring on everybody you need because it's simply impossible to manage that sort of influx of people. Is the budget adequate to get to where you need to go? I'm sure you have goals either written or mental where you want this agency to go. Is this budget adequate to get you where you need to be a year from now?

MS. SCHAPIRO: As I said, we are genuinely grateful to the president for the increase the 2010 budget represents over 2008 and 2009. We've asked for a very significant increase in 2011. And the ability to get to that number sooner, we could handle and I think would make a difference in our ability to do our job.

SEN. TESTER: Okay. Uptick rule: Can you discuss the commission's effort to reinstate the uptick rule? What's the likelihood, timing and opposition to that happening?

MS. SCHAPIRO: I would be happy to do that. This is an issue of enormous, enormous public interest. And it's an issue of investor confidence as well.

As you know, the SEC took the uptick rule off a couple of year ago after careful study and evaluation. In some ways, it was a model rulemaking to eliminate it. Nonetheless, that coincided with dramatic increases in volatility in the mark place, and investors have been clamoring for us to revisit this issue.

In April, the commission voted unanimously to seek public comment on two different approaches to short selling. One is essentially the reinstatement of the uptick rule as we used to know it, with some variations. The other is a short sale circuit breaker that would be kicked into effect in the price of a stock declined by, say, 10 percent in a day, no short selling therefore for a period of time.

We've already gotten 3,000 comment letters. The comment period closes in about two weeks. And then we will wade through those comment letters and, hopefully, bring back to the commission a proposal for consideration. At the same time, we're looking at a couple of other issues. There's a rule, a temporary rule that expires in July that's had a very, very positive effect on eliminating or diminishing the fails to deliver in securities in short sales requiring them to be closed out the next day. I expect that the commission will make that a permanent rule this summer. And we're looking at some other issues like the potential for a pre-borrower requirement. So we are actively focused on short selling and will continue to be so.

SEN. TESTER: Do you anticipate that the proposal you're going to back at the commission -- will be voted on when?

MS. SCHAPIRO: I think we're looking at August for a vote. The comment period closes toward the end of June. With 3,000 comment letters at this point, I expect significantly more and will have to evaluate those. But so sometime this summer.

SEN. TESTER: After the commission votes on a rule, is it typically an immediate effective date?

MS. SCHAPIRO: Generally not if it requires technology changes at either exchanges or brokerage firms.

SEN. TESTER: Would this?

MS. SCHAPIRO: Yes, the reinstatement of the uptick rule requires significantly more technology work than the circuit breaker would.

SEN. TESTER: Okay.

MS. SCHAPIRO: So it could be quite dependent upon which of the two approaches.

SEN. TESTER: One last; it has to do with this: Who's opposing the uptick rule from going back into effect?

MS. SCHAPIRO: I haven't been through the comment letters, to be honest. But I would say historically there's certain kinds of algorithmic traders, some kinds of hedge funds that are large short sellers that oppose it. There are --

SEN. TESTER: That are for the most part unregulated at this point in time, right?

MS. SCHAPIRO: That might be right. (Laughs.)

SEN. TESTER: Okay.

MS. SCHAPIRO: There are the others who believe that short selling plays a very legitimate role in the marketplace in terms of adding liquidity. It has impacts on options, market makers, and others. So there are -- there is opposition to reinstatement. I think the pure weight of the comment letters will tell us that there's much more support for doing something, whether it's the uptick rule or the circuit breaker.

SEN. TESTER: Thank you.

SEN. DURBIN: Thank you.

Chairman Schapiro, just for some perspective here, the SEC is fairly unique in that it collects a lot of money in fees. And if I'm not mistaken, that number is somewhere a little north of or around $1.4 billion. Is that correct?

MS. SCHAPIRO: The 2009 expectation is, yes, about $1.35 billion.

SEN. DURBIN: Okay. And the appropriation for your agency is around $1 billion?

MS. SCHAPIRO: Yes.

SEN. DURBIN: A little over ($)1 billion --

MS. SCHAPIRO: 2009, $960 million, including the reprogramming request.

SEN. DURBIN: So you are a cash generator.

MS. SCHAPIRO: We are.

SEN. DURBIN: In terms of the revenues into the Treasury.

MS. SCHAPIRO: And historically, a very significant cash generator.

SEN. DURBIN: And if the argument can be made that the industry is paying your agency to do its job and we started this testimony here today arguing that you needed more people to do your job, it might be fair for those who are being regulated saying we're doing our part; in fact, we're sending you about 40 percent more than you're actually spending in this agency.

Is that -- would that be a fair comment?

MS. SCHAPIRO: It might be. (Laughs.)

SEN. DURBIN: Okay. Well, this concerns me because if we were going in the other direction, we'd be arguing, well, we need to come up with some revenue source here to provide the regulatory structure to make sure that the government's doing its job. But in fact, the marketplace that you regulate is creating the revenue opportunity.

MS. SCHAPIRO: That's correct. And actually, that doesn't include penalties and fines that are paid into the Treasury in those instances where we don't create a fair fund to distribute back to investors. So there's actually additional funding over the fee generation.

SEN. DURBIN: Okay.

Let me go to a few more specific questions. Broker dealers who sell stocks and bonds on commissions and investment advisers who offer advice are regulated under different federal laws. The key difference is the rules governing their standard of conduct, investment advisers held to a fiduciary standard which requires them to make investment decisions in the best interest of their clients. Brokers, in contrast, are held to something called a suitability standard under which they can sell securities as long as they are suitable to their clients.

Interesting little distinction there, but the variations between brokers and advisers have been blurring in recent years, and it's raised concern among some regulators that customers won't be able to tell the difference. I understand you're taking a looking at this?

MS. SCHAPIRO: Absolutely. There's really no good reason for people not to get the same fiduciary protection and the same standard of -- quality of regulation from people who are essentially giving them the same service but are called by different names.

SEN. DURBIN: Let me ask you a question. And, first, let me preface it by saying I had my -- I asked my staff this. I said, now, is this for Chairman Schapiro or Chairman Gensler? They said, well, you better ask her. So here's a hedge fund issue for you.

The Pension Protection Act of 2006, would this be your jurisdiction?

MS. SCHAPIRO: The Pension Protection Act is provisions largely administered by the Department of Labor, but there are elements that intersect with the SEC.

SEN. DURBIN: Okay. Let me give you the situation; you tell me if this is something that you think falls in your jurisdiction.

This Pension Protection Act made it easier for hedge funds to take pension money without registering as an ERISA fiduciary, meaning they don't have disclosure and other requirements of other pension plan managers. Previously, fiduciary -- is this your field?

MS. SCHAPIRO: This is the Department of Labor, I believe.

SEN. DURBIN: Okay. Let me stop at that point and say this for the Department of Labor then: Derivatives, contracts between two investors betting on whether a stock, bond, or other security will go up and down in value, have ballooned into one of the world's largest trading markets, estimated to be tens of trillions of dollars, yet, it's largely outside the regulatory umbrella. Losses, as we know, at AIG, have led to a government bailout of ($)170 billion or $180 billion.

On May 13th, President Obama unveiled a plan to regulate this market which had four stated goals. What do you consider to be the role of the SEC in this regulation?

MS. SCHAPIRO: This is such an important area for both the SEC and the CFTC, and as you point out, the Treasury letter of May 13th lays out some requirements that we hope will be embodied in legislation with respect to credit default swaps and other standardized, over-the- counter derivatives.

It will be very important to have standardized clearly mechanism, potentially exchange trading of standardized contracts, promote transparency, have adequate margin and collateral requirements in place for these transactions and subject the dealers in these instruments to regulation.

Exactly where the lines between the SEC and the CFTC fall, I think, are something that we'll be discussing certainly over the next several weeks, but it is clearly my view, and I believe Chairman Gensler's view and Treasury's view, that we need to work together to ensure that we bring credit default swaps and other OTC derivatives firmly under the federal regulatory umbrella. And how we exactly draw those lines will be something we'll be discussing and obviously Congress will have a deep interest in as well.

SEN. DURBIN: My last question relates to a -- last week, it was reported that two attorneys from SEC's enforcement division engaged in suspicious trading in stocks of companies under SEC investigation, according to a March 3rd report by the SEC inspector general, David Kotz. Mr. Kotz concluded that the SEC previously had essentially no compliant system in place to ensure that its employees did not engage in insider trading themselves.

On May 22nd, the SEC issued a press release outlining how the agency would increase accountability. How will this new process impact the current SEC workload? Will it require additional resources or staff to implement it?

MS. SCHAPIRO: Thank you for asking that question. It's really an important area.

When I learned about this inspector general report in March, I immediately set in motion -- and some things were already under way, I should say -- a number of changes to our process, which was acceptable under the Office of Government Ethics rules but clearly not sufficient, in my view.

We now require all trades by employees to be pre-cleared. We've created a restricted list that prohibits an employee from trading in any stock of a company that's under investigation by the SEC, whether they know anything about the investigation or its existence or not.

We're prohibiting ownership in stocks of broker-dealers, investment advisers, publicly traded exchanges. And we're requiring employees to authorize that their brokers and duplicate trade confirmation statements to the SEC where they will be incorporated into a computerized system that will make monitoring compliance with all of these new rules much more effective. And we'll be hiring a chief compliance officer.

I expect we'll sign the contract for the new system in the next several days, and it should be operational in one to three months. The new rules requiring pre-clearance of all trades by the ethics office and the creation of the prohibited list and so forth are pending at the Office of Government Ethics and have been there for about a week. We jumped on this immediately.

SEN. DURBIN: Thanks very much.

Senator Collins?

SEN. COLLINS: Ms. Schapiro, there is an idea that is being discussed to consolidate the consumer protection functions of a variety of regulators under a single entity. And one such proposal would result in the SEC losing its consumer protection responsibilities.

I personally don't think this makes any sense at all because, to me, the whole reason we have an SEC is to act to protect consumers and investors. What are your views on creating a single consumer protection entity that would include the SEC's responsibilities?

MS. SCHAPIRO: I think that it's certainly one of the ideas that's being bandied about, and there are many. And I think discussions continue to be very vigorous and ongoing throughout the regulatory community about the right approach here. I think the one thing everybody agrees on is that we must have a reorientation towards consumer and investor protection among all of our financial regulatory agencies.

So whether we have the creation, ultimately, of a single entity or we just re-heighten and refocus within the bank regulatory agencies and the SEC on the protection of the end users of financial products, we, I think, all agree that we have to go down to path. My view is that -- and it's been reported -- that I don't want to create new gaps in the regulatory system, and I fear that moving mutual fund regulation out of the SEC and into a new agency has the potential to do that.

Mutual funds -- investor protection in the mutual fund concepts, it's about more than the end product of the sale to the investor. It's really about what's the governance of the mutual fund. What's the quality of execution that the mutual fund is getting when it's buying stocks for its portfolio? What's the quality of the disclosure of those companies that the mutual fund is buying? What's the quality of the disclosure that the mutual fund itself is making?

These are all of a piece. They're all woven together to create the fabric of investor protection in the mutual fund space. And so I want to be sure we don't damage that fabric.

That said, whatever Congress, in its wisdom and the administration working together to create -- that will protect investors better and consumers better, I mean, you know, we intend to, you know, play as strong a role as we can.

SEN. COLLINS: Thank you.

Mr. Chairman, I'm just going to ask one final question, if I may. And that has to do with the credit rating agencies.

I understand you two brought this issue up, but unfortunately, I wasn't here to -- I was voting when you did. So I apologize if this is redundant. I'm very concerned about the role that was played by credit rating agencies in this crisis as far as their ratings of subprime mortgages, of mortgage-backed securities.

It seems to me that the current system has so many inherent conflicts of interest built into it, not the least of which is that the credit rating agencies are being paid by the firms that are marketing the securities. What are you looking at to improve the integrity of the credit ratings process?

MS. SCHAPIRO: You very correctly highlight that in the issuer- paid model, where I create a security and then I ask you to rate it and I pay you for that rating and might pay you on an ongoing basis for future ratings if I'm happy, has profound conflicts of interest. And we are looking, in particular, as we discussed earlier, at the rating shopping phenomenon, which allows me to select the ratings agency that provides or promises to give the highest rating. We're also looking at more robust disclosure about fees that are paid and the conflicts of interest that exist in the issuer-paid model.

We held a roundtable about a month ago. We brought in all different kinds of rating agencies to talk about their different business models and the pros and cons of each, and we've gotten a lot of very good ideas from that process and we're hoping this summer to pursue some additional rulemaking in this area.

We will focus on ratings shopping. We will focus on disclosure. We will also look at whether we need to eliminate references to ratings in SEC rules, which creates a market for rating agencies and gives a certain amount of credibility and stature to ratings that perhaps they don't always deserve.

SEN. COLLINS: Thank you.

Thank you, Mr. Chairman.

SEN. DURBIN: Senator Tester?

SEN. TESTER: I just -- I do want to get to the CFTC chair, but I just want to just close by saying thank you. Thank you for what you've done; thank you for what you're going to do.

I would ask that as these budgets come forth -- '05 to '07 budgets were visited about here on a couple different occasions. Somebody dropped the ball. Congress probably had a part to do with it. Your predecessor may have had a part to do with it. But it ended up in a disaster and we need to make sure that you have the resources, no more, no less, but just the resources you need to do your job. And I think that, as a friend of mine pointed out last week, we need to quit thinking in government in silos and we need to start thinking about the consumer and whoever's consuming that product, whether it's in education or housing or, in this case, securities, and make sure that government works for the betterment of everybody.

But I really want to thank the work you've done so far. It's very impressive, and I look forward to working with you in the future.

MS. SCHAPIRO: Thank you very much.

SEN. DURBIN: Thank you very much, Senator Tester.

Chairman Schapiro, thank you for your testimony.

MS. SCHAPIRO: Thank you.

SEN. DURBIN: We'll be working closely with you and your agency as we put together the appropriation bill.

MS. SCHAPIRO: Thank you.

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