On Tuesday, the Senate Governmental Affairs Committee issued a report on its monthslong investigation into l'affaire Enron. The senators' conclusion—which any sentient American could have told them eight months ago—is: All the public and private agencies that were supposed to exercise oversight and protect investors failed miserably.
The report's cover letter, signed by Committee Chairman Joseph Lieberman, D-Conn., and ranking member Fred Thompson, R-Tenn., reserves particular scorn for the Securities and Exchange Commission. The SEC, they write, "never adjusted to a rapidly changing business environment in which accurate corporate information was harder and harder to come by." What's more, "SEC staff failed to review any of Enron's annual reports after its 1997 filing."
What hypocrisy! After all, Lieberman was a notable opponent of SEC-sponsored accounting reform in the 1990s. Perhaps the SEC could have done a better job ferreting out the fraud at Enron and other corporations—if only Lieberman and Thompson's colleagues had given the agency the resources it needed to do the job. When then-SEC Chairman Arthur Levitt suggested new rules to curtail aggressive accounting, senators explicitly threatened the agency's meager funding.
It's routine for Washington bureaucrats and their defenders to complain about inadequate funding. But here's one case where the complaint is entirely warranted. The field the SEC oversees—stock exchanges, mutual funds, publicly held companies—expanded with astonishing speed in the 1990s. The volume of stocks traded on U.S. exchanges rose from 53.7 billion in 1990 to 317 billion in 2000. The number of households owning mutual funds more than doubled, to 52 million. SEC filings increased 59 percent from 61,925 in 1991 to 98,745 in 2000. And they grew longer and more complicated. A 1994 Enron quarterly report ran 24 pages plus exhibits; in 2001 it was 74 pages.
But the SEC didn't keep pace. Between 1991 and 2000, the SEC's enforcement staff grew only 16 percent. Between 1997 and 2001, though the agency's budget rose from $311 million in 1996 to $427 million, the number of approved positions increased only 8 percent in that period. As the market exploded, experienced SEC employees were snapped up by higher-paying mutual fund and accounting companies. At the beginning of 2000, 75 percent of SEC examiners had been on the job less than three years. The SEC's employees were too few and too inexperienced to handle the flood. In 2001, just 16 percent of 10-K filings received financial reviews.
Throughout the '90s, Chairman Levitt consistently asked for more funds and was just as consistently turned down. Worse, members of the Senate Banking Committee—which oversees the SEC—used their control of his budget to coerce him into abandoning reforms. In his new book Take on the Street, which I heartily recommend, Levitt recounts what happened in 2000 when he pushed to bar accounting firms from doing consulting work for their audit clients. Levitt had one of his key staffers brief the Senate Banking Committee about several cases of alleged audit failure that "all involved allegations of auditors compromising their audits out of fear of jeopardizing a consulting relationship with the client."
The senators weren't impressed. Phil Gramm, R-Texas, called Levitt and warned him that Sen. Richard Shelby, R-Ala., a member of the banking committee, was preparing a rider that "would bar the agency from spending any of its funds to implement and enforce the rule." Levitt called then-Minority Leader Trent Lott, R-Miss., and asked for help. Levitt told him that the New York Times, Los Angeles Times, Washington Post,and Business Week had endorsed the rule. In Levitt's account, Lott professed ignorance, then said, "I'm not familiar with what you're proposing to do, but if those liberal publications are in favor of it, then I'm against it." Confronted with opposition, Levitt backed down. "Most of all, I feared retribution in the form of a funding cut for the agency," he recalls. "Never before had the SEC faced such a threat to its independence. What's more, I was simultaneously pleading with Congress to raise the salaries of SEC lawyers and other professionals to prevent a brain drain to the private sector."
Levitt's recollection is self-serving, but it's also damning.
The threat to the SEC budget highlights a fundamental problem in the SEC's structure. Ever since its inception in the '30s, the SEC has generated revenues by charging miniscule registration fees on transactions. Last year, the registration rate was 1/40 of 1 percent, meaning that when a company registers for a $100 million secondary offering, it pays $25,000. For transaction fees, the fee is 1/300 of a percent. Buy 100 shares of IBM, and you pay 23 cents. Each source accounts for about half the revenues the SEC generates. The registration and transaction rates are scheduled to fall to 1/150 of 1 percent and 1/800 of 1 percent, respectively, by 2007. Nobody believes that these fees are an obstacle to capital formation or trading.
The SEC doesn't keep the fees: It funnels them into the Treasury. Still, through the early 1980s, the agency generally received a congressional appropriation roughly equal to the amount of fees it generated. That has changed. As activity exploded, the SEC began to generate far more funds than it was given to spend. Indeed, the SEC turns out to be one of those rare entities that reported astonishing profit growth in the late 1990s without cooking the books! In 1997, the SEC generated about $1 billion in fees and had a budget of just over $300 million. Last year, it generated $2.06 billion in fees and had a budget of $423 million.
While it raises ample cash through fees, the agency nonetheless has to beg for adequate resources from its Senate overseers. And in general, senators have been unwilling to fund ambitious reform agendas, usually siding with accounting firms and Wall Street underwriters.
There's a simple solution to the SEC's money problems and to the problem of the malign influence of senators. Grant the SEC control of all the fees it generates.
With $2 billion per year—even with less than $1 billion per year after a rate cut—the SEC would have sufficient cash to hire and pay enough professionals to read through every 10-K, conduct rigorous examinations, and fight enforcement battles on many fronts. As important: It would no longer be vulnerable to the senators of both parties who use the purse string as a choke collar.
Mightn't the SEC become an unchecked power unto itself? A well-funded agency run amok? The president would still appoint commissioners, and the Senate would still confirm them. Congress could still investigate SEC operations and could raise and lower fee levels. Obviously, unleashing the SEC is a risk, but faced with the Hobson's choice of having policy made by a former accounting industry tool like SEC Chairman Harvey Pitt or a current accounting industry tool like Richard Shelby, I'll take the former.