It's not that the Securities and Exchange Commission wasn't working hard during the years that Enron, WorldCom, and others were allegedly submitting fictional financials. In many instances, the agency, overburdened and lacking strategy, was simply working wrong.
Consider the case of Ants Software Inc., a software company trading over-the-counter that has not yet booked revenue. For nearly two years, starting in January 2000, the SEC tried its hardest to document suspected wrongdoings ranging from incorrectly identifying a director in a filing to failing to file periodic reports from 1988 to 1999.
Meanwhile, Ants CFO Ken Ruotolo spent hours with company attorneys and more than $150,000 in legal fees trying to convince the agency it was on the wrong track. "We had very reasonable explanations for all four elements of their inquiry," he says. SEC investigators wouldn't budge, even when the company agreed to settle by promising to cease and desist without admitting or denying guilt. "We implored them to come forward with some kind of official pronouncement about what they found in the investigation. They never would, but they wouldn't close the case either," says Ruotolo.
Ultimately, he says, the SEC dropped the case, with no material modifications, charges, sanctions, or fines involved. The real victory, as he sees it, was getting the case officially closed last January (two months after the SEC decided not to bring action). "We understand that that is very rare," says Ruotolo. "A lot of times they just leave these open on the books and never give issuers a final resolution."
Indeed, such tenacious butterfly-chasing has not been uncommon at the agency. Given increased filings and an infamous lack of resources, "simple multiplication would tell one very clearly that the odds are good to excellent that the SEC will not be able to successfully investigate many of the financial fraud cases in front of it," former SEC chief accountant Lynn Turner told Congress in April. "It was not unusual at all that a case would become stale and grow old and the staff assigned to the case would pursue other job opportunities...and the case would never be completed, because of this lack of resources," he said. Greg Bruch, an assistant director in the SEC's enforcement division until last October and now a partner at law firm Foley & Lardner, agrees, adding: "People don't understand what a remarkable achievement it is that the SEC brings any cases."
Since 1996, the SEC's aggregate workload has grown about four times as much as its staff resources--because of both increased volume and problems with staff turnover. Lingering low-priority cases such as Ants have created a crushing backlog--more than 2,400 investigations were still ongoing at the beginning of fiscal year 2002, about four times the number opened during the year. Meanwhile, some 40 percent of the agency's staff left between 1998 and 2001, with average tenures in some departments shorter than standard training periods.
On top of this shaky structure comes the Sarbanes-Oxley Act of 2002, with its laundry list of responsibilities. During the next year, the SEC is expected to devise 24 sets of new rules, launch and complete six major studies, shepherd the formation of the new public accounting oversight board, hire 200 new employees, and review one out of three filings. To smooth the way, Congress promised $776 million (sliced to $750 million in the current Senate appropriations bill), which amounts to a 77 percent year-over-year budget increase.
Whether the money and power are enough to create an agency that can sniff out the next Enron before the stock collapses is uncertain. But what no one disputes is that digesting the new resources could be as difficult as winning them from Congress. "You have to realize there will be about a two-year time lag between passing this bill and having troops in the field," says Richard C. Breeden, who chaired the SEC from 1989 to 1993. Turner says it may take three to five years to see any impact from those changes. "Any organization, be it government or be it business, has to have a process in place for managing change," he says. "As with almost all government agencies, the SEC hasn't had that in the past."
A key step in making the SEC more effective is improving staff recruitment and retention. But even with the additional $76 million earmarked for pay increases and $97 million for new hires, accomplishing those goals won't be easy. For starters, the SEC must deal with a federal hiring system that gives insiders little discretion over the speed or integrity of the process. Second, there are signs that the pay increases (known as "pay parity" because they put SEC salaries on par with those at other federal financial regulatory agencies) aren't buying the agency the love it needs from employees.
"Employee morale is at an all-time low," said one SEC attorney as the raises hit paychecks in August. Managers received double the 6 percent raise that union employees got, he says, so employees "feel like the agency basically hijacked pay parity for the managers."
That sentiment is shared by many in the National Treasury Employees Union (NTEU), which represents about two-thirds of the SEC's approximately 3,000 employees, says union president Colleen Kelley. "As far as we can tell, about 60 percent of salaries today are paid to front-line [nonmanagement] employees represented by the NTEU," she says, "but it appears the SEC has allocated only 40 percent [of the money for raises] to those employees." In addition, Kelley maintains that employees are not satisfied with a new system for promotions that makes advancement criteria more subjective and caps pay raises at half the annual percentage increase previously attainable. "So far, we don't believe that what they have created is going to solve turnover and retention problems; we think it's going to exacerbate them, actually," she says.
Such employee dissatisfaction could dampen the SEC's ability to hire new staff, some 200 of whom are supposed to be on board by next October, according to the Sarbanes-Oxley Act. And without more people, departments such as the division of corporation finance may fall short of their new mandates.
"Back in 1990, we were able to review about one in four filings with about the same number of accountants," says Turner. Then, between 1991 and 2000, the number of corporate filings grew by some 60 percent, while related review staff grew only 29 percent, according to an April General Accounting Office (GAO) report. Little wonder that only 16 percent of filers were reviewed last year. "To get it down to one in three, they'll have to add at least 50 accountants," says Turner.
Meanwhile, the enforcement division is equally desperate for staff. With 900 employees nationwide, it has typically had about twice the staff of corporation finance. But that's not enough, say former insiders, based on the explosion of new investigations and the likelihood that corporate defendants will accept fewer settlements given the harsher penalties for accounting fraud. "Enforcement has 28 accountants [at the Washington, D.C., headquarters]. They could double that easily," says Turner. Moreover, the shortage of support staff, including file clerks, means there is about 1 secretary per 10 attorneys, says Bruch, compared with the 1-to-3 ratio at most private firms.
The 17 percent turnover among the attorneys themselves--including former general counsel David Becker--also creates a major liability for the agency. Martin Weinstein, a Foley & Lardner attorney who recently defended a former Fortune 500 CFO against the SEC, notes: "In the past year since they've filed the case, they've had five [different] lawyers handling the proceedings at different times," including one who had joined the SEC only 10 days earlier, he says. In private practice, "if the case were passed from attorney to attorney, I think the client would refuse to pay."
The Justice Department would be a natural poaching ground for the SEC, says Turner. But, in terms of legal muscle, parity between the agencies just doesn't exist. "If you want to be an experienced trial lawyer, you're still going to go to a U.S. Attorney's office before the SEC, because you're going to get more cases that move faster with a lot more at stake," says Weinstein. Besides, the Justice Department will need new staff just as much as the SEC if it is to take up more of the civil charges brought against corporations. And while some have floated the idea of giving the SEC authority to bring criminal charges on its own, that power is unlikely to be ceded anytime soon. "I don't think there's any likelihood in the foreseeable future that the SEC will have criminal enforcement power," says Joel Seligman, dean of the University of Washington at St. Louis Law School. Not only would Justice "be very uncomfortable" with such an arrangement, he thinks it is "better able to balance the needs for prosecution, which doesn't always mean securities cases."
Even if the SEC had the number and caliber of staff that it needed, observers say it would have to retool its workflow to truly be effective. To start with, the SEC needs to prioritize its enforcement cases, as the Ants Software example underscores. "The hard part is having the discipline to close the old, less-worthy investigations," says Bruch. "It's not that it's not real fraud--oftentimes, it's outrageous fraud--but I don't think you can say anymore that microcap fraud or Internet fraud is what they should be doing." The SEC has paid particular attention to Internet-based scams in the past five years, forming special enforcement units dedicated to the task and creating a "cyberforce" to conduct Internet surveillance that was 240 people strong at one point, according to a 2000 Government Performance and Results Act report.
Bruch also thinks enforcement should "actively dispel the notion they are obtaining disgorgements to return to investors," since "it rarely happens, takes up a disproportionate amount of time, and distracts staff from more important functions." Indeed, a recent GAO report reveals that according to the SEC's records, it collected only 14 percent of the $3.1 billion in disgorgements due it between 1995 and 2001, in part because the amounts were often more than the offenders could afford to pay.
The division of corporate finance is also lacking the strategic processes it needs, experts say. While the division is currently able to keep up with 10-K reviews, "all we need is for the offerings [IPO] market to get juiced up again and those demands will strain us," notes one longtime SEC professional, who likens the division's ad hoc handling of the August 14 certification statements to "a Turkish bazaar." A lack of coordination between numbers-focused accountants and prose-oriented attorneys creates "a no-man's land in terms of MD&A analysis." And a grab bag of IT tools doesn't help. The SEC's technology can't routinely prescreen financial statements for unusual trends, or automatically draw in the outside data sources SEC staff needs for analysis, or easily attach outgoing comment letters to a company's internal Edgar file.
Certainly, a good portion of the new funds are likely to be spent on arming the staff with technology to better discern red flags from false alarms, and bring more cases to the "final resolution" CFOs like Ruotolo so desperately want. The current appropriations bill sets no requirements for IT spending, but Sarbanes-Oxley suggested a total of $108 million should go toward improving IT as well as postSeptember 11 recovery efforts.
Measures of Effectiveness
Yet no one thinks that spending alone will be enough--particularly not SEC chairman Harvey Pitt, who engaged McKinsey & Co. last spring "to find out how we can use what we have more efficiently, to find out how we can use technology to help us, and then to find out what we really need," as he said during a July appearance on "Meet the Press." McKinsey's report, which was due to be made public as CFO went to press, could indeed offer some important insights into how the SEC should direct its funds. Whatever the outcome, though, experts say the agency will have to create new and regular operational metrics to gauge the success of its strategy.
Currently, it's the enforcement statistics that grab the headlines. But the number of actions alone can be deceptive, since the investigation of a single company can generate multiple actions. Plus, the numbers don't capture the numerous inquiries and investigations that take up the staff's time but don't escalate to charges, which Bruch estimates outnumber the actions by a multiple of 10. And some say those metrics are underscoring the wrong philosophy of fraud-fighting. "I have long taken the position that it's better to spend the money on the front side of the process, on the division of corporation finance, than it is on the back side of the process, in enforcement," says Walter Scheutze, former chief accountant for the SEC. "By the time enforcement gets to it, the horses are out of the barn."
One way to better track the agency's effectiveness, says Turner, would be to require fuller disclosure in its annual reports to Congress of the number and types of cases opened, as well as details about their outcomes. "People manage what they are measured on, and no doubt the SEC and Justice would become more accountable if they each provided these disclosures," he says. Even better, Turner adds, would be to create a benchmark for restatements that would gauge whether more companies are getting their financials right the first time. "The idea is not to catch all fraudsters, but to create a system so you'll have less fraud in the first place," he says.
The ultimate irony, of course, is that for all of the financial controls and measures the SEC enforces, it has few of its own. A July GAO report, in fact, notes that "creating a system of internal controls within the budget process could prove particularly challenging for the SEC." The agency currently has no CFO or accountants experienced in external GAAP-basis financial reporting. It is probably three to five years away from producing auditable financial statements, according to Turner. That's one of the reasons that Congress has not given it full control over the money it collects through fees, which has outstripped its budget for nearly 20 years. In 2001, for example, it collected $2.1 billion but was allocated only $423 million to spend. While the GAO report did not purport to make recommendations on whether the SEC should have more control over its collections, it was hardly enthusiastic about the prospect.
The upshot? "We continue to believe that it would be useful for [the] SEC to determine its staffing and resource needs to fulfill its mission regardless of its funding status," wrote GAO director Richard Hillman.
To be sure, changes are in store. Chairman Pitt, who has argued that the agency deserves cabinet-level status, replied to the GAO that he is not only planning to "develop a more forward-looking, strategic budget process," but also intends to "implement aggressive risk management and strategic planning that will affect all the agency's programs to help ensure that the SEC anticipates and plans for major market changes." How successful he'll be--and what that strategy will mean for corporate issuers--is still an open question.
Alix Nyberg is a staff writer at CFO.
The SEC's To-Do List
Studies Due Within 180 Days of Passage of the Sarbanes-Oxley Act:
1. A study of the civil penalties and disgorgements still owed the SEC from the past five years of enforcement actions, and the likelihood of getting them back to investors, as well as a study of methods to improve the collection rates.
2. A study of the number of accountants, investment bankers, brokers, attorneys, and other professionals who were convicted between January 1, 1998, and December 21, 2001, of violating federal laws, and the status of the fines and disgorgements collected or due from them.
3. A review and analysis of all SEC enforcement actions involving violations of reporting requirements during the past five years, in order to identify the areas most susceptible to fraud and manipulation.
4. A study of the "role and function of credit-rating agencies in the operation of the securities market."
Studies Due by July 30, 2003:
1. The extent to which principles-based accounting exists in the United States, the costs and benefits of switching to such a system, and the costs and benefits involved in switching U.S. financial reporting to such a system.
2. The extent to which off-balance-sheet transactions are used, and how well "generally accepted accounting rules" reflect the economics of such transactions to investors, with a six-month interim report due.