TESTIMONY OF BRIAN LANE, DIRECTOR DIVISION OF CORPORATION FINANCE U.S. SECURITIES AND EXCHANGE COMMISSION CONCERNING H.R. 3310, THE "SMALL BUSINESS PAPERWORK REDUCTION ACT AMENDMENTS OF 1998" BEFORE THE SUBCOMMITTEE ON NATIONAL ECONOMIC GROWTH, NATURAL RESOURCES AND REGULATORY AFFAIRS OF THE COMMITTEE ON GOVERNMENT REFORM AND OVERSIGHT U.S. HOUSE OF REPRESENTATIVES MARCH 17, 1998 U.S. SECURITIES AND EXCHANGE COMMISSION 450 FIFTH STREET, N.W. WASHINGTON, D.C. 20549 Mr. Chairman, Members of the Subcommittee: My name is Brian Lane. I am the director of the Division of Corporation Finance of the Securities and Exchange Commission ("SEC" or "Commission"). The Division of Corporation Finance, through its Small Business Office, is at the forefront of the Commission's efforts to promote small business capital formation. I am very pleased to have the opportunity today to testify on behalf of the Commission concerning H.R. 3310, the "Small Business Paperwork Reduction Act of 1998." We support the goals of H.R. 3310 -- to limit the burdens that federal regulation imposes on small businesses. It is important that good faith, or inadvertent, first-time violations not be the basis for routine fines. The Commission is extremely sensitive to the needs of small business and is engaged in ongoing efforts to respond to small business concerns. Moreover, our examination program is geared towards resolving informally compliance problems that are technical, inadvertent, or do not threaten significant harm to investors or the markets. Thus, the theme and goals of H.R. 3310 strike a resonant chord with the Commission. However, we are concerned that the broad sweep of H.R. 3310's penalty exception, as currently drafted, could inadvertently protect intentional or serious misconduct that would harm investors. In our view, the bill could be improved by: expanding the existing exception for "public health and safety" to include fines for violations that involve investor protection or the integrity of the securities markets; and narrowing the penalty exception to apply only to "good faith" violations. This would permit fines (i) when the conduct involves fraud, intentional wrongdoing, or destruction of records, and (ii) when the owner or principal of the small business is a repeat offender. THE COMMISSION'S SMALL BUSINESS INITIATIVES Before commenting more fully on the specifics of H.R. 3310, I would like to describe the Commission's longstanding efforts to assist small business. The Commission understands the importance of small business to the U.S. economy, and is committed to addressing the special concerns of small business. Over the years, the SEC has worked to improve communications between the SEC and the small business community. In its first Annual Report, in 1935, the Commission stated that it would provide informal guidance to the securities industry, both to foster improved compliance and to establish a spirit of cooperation with the public.[1] This spirit continues to play an important role in the Commission's programs. The SEC works in partnership with industry, self- regulatory organizations and the public to set standards that protect investor and market confidence while reflecting sensitivity to the realities of the business world. Our efforts specifically to aid small business fall into two broad categories: (1) cutting through red tape and providing compliance assistance, and (2) reviewing existing and proposed rules for ways to reduce burdens on small businesses. Cutting Through Red Tape and Providing Compliance Assistance. * The SEC's Small Business Office: The Office, which was created in 1979 and enhanced significantly in 1996, serves as a liaison between the Commission and small business. The Office now directs the Commission's small business rulemaking initiatives and provides uniform review of small business filings and disclosures. * The SEC's Annual Government-Small Business Forum: Begun in 1982, this forum is the only annual government-sponsored national small business gathering that offers small business the chance to tell federal and state government officials how the laws, rules and regulations impact their ability to raise capital. * SEC-Small Business Town Hall Meetings: The Commission is conducting "town hall" meetings with small businesses around the country, and has held nine so far. These meetings are designed to educate small businesses about the many opportunities to raise capital. They also help the Commission learn more about the problems small businesses face in raising capital, and design programs that meet small businesses' needs while protecting investors. * SEC Web Site: The Commission operates a web site with special pages targeted to small businesses. These pages provide access to proposed new regulations affecting small businesses, as well as information about specific issues of current interest. * Public Inquiries: Each major office of the Commission has staff who are available to answer questions from members of the public, including small businesses, by telephone and e- mail. Notably, because of programs like these, when the Small Business Regulatory Enforcement Fairness Act ("SBREFA")[2] was passed, Congress recognized the Commission as one of several agencies which "already have established successful programs to provide compliance assistance."[3] Reviewing Existing and Proposed Rules for Ways to Reduce Burdens on Small Businesses. * Plain English: Nothing is more frustrating than trying to comply with regulations that are difficult to understand because they are written in jargon or legalese. The Commission has made efforts to issue regulations and releases in "plain English" and has required registrants to use plain English in certain of their disclosures to investors. At the end of the day, plain English disclosure is shorter and less expensive and should be particularly helpful for small businesses. * Small Business Initiatives: Beginning in 1992, the SEC launched a major regulatory initiative to make raising capital easier for small businesses. Rule changes arising out of this initiative simplified the process for registering securities of small business issuers for public sale; increased the dollar threshold for exemptions permitting unregistered public and private sales of securities; and simplified ongoing periodic reporting requirements of registered small issuers. In 1996 Congress enacted SBREFA, which required agencies to publish small business compliance guides, to establish programs of informal guidance for small businesses, and to establish policies or programs to reduce or waive penalties for small entities. The Commission has undertaken these steps, and will soon report to Congress about its experience with these initiatives. At the end of 1997, the National Ombudsman appointed under SBREFA singled out the SEC as one of a group of agencies which "deserve special commendation, as they are clearly moving toward a more cooperative regulatory environment for their small business customers." He stated in his 1997 Report to Congress on Regulatory Fairness that the Commission "deserve[s] high marks."[4] Limiting Enforcement Actions to the Most Serious Violations. The Commission's examination and inspection staff attempts to exercise its discretion to resolve compliance problems informally, without enforcement action, when deficiencies are technical, inadvertent or do not threaten significant harm to investors, markets or the public. When SEC examiners identify deficiencies, they generally provide the registrant with a "deficiency letter" identifying the problems and requiring appropriate remedial steps. In instances where examiners identify compliance failures that appear numerous, more serious in nature, or systemic, but do not appear to warrant enforcement action, they may also hold a conference call or an in-person meeting with the registrant to discuss the problems and the remedial steps the registrant intends to take. Most SEC examinations are resolved through the deficiency letter process.[5] When the registrant's compliance failures appear too serious for informal resolution, such as when fraud is discovered or when investor funds or securities are at risk, the examination staff will refer the matter to the Division of Enforcement.[6] In addition, when the Division of Enforcement intends to recommend enforcement action, it is Commission policy generally to provide notice to the proposed respondents,[7] and to afford them an opportunity to present their side of the matter.[8] This process ensures that respondents have an opportunity to directly inform the Commission, which authorizes all enforcement matters, when they believe that a violation was inadvertent and that formal enforcement action is not warranted. THE SEC'S INVESTOR PROTECTION AND MARKET REGULATION MANDATE While the Commission has sought to address the needs of small businesses, our commitment to limiting burdensome regulation or unnecessary paperwork must be viewed in the context of the overall size and complexity of the securities markets and the goals of the federal securities laws. The United States' securities markets involve securities and trades worth trillions of dollars. Thousands of businesses look to the capital markets for the funds needed to grow and to compete in a global economy. Millions of Americans invest in these markets in their own accounts, through mutual funds, or through employee pension funds and retirement accounts. These millions of investors and their families count on their investments to pay for education, to save for retirement or, for those already retired, to meet current expenses. The federal securities laws mandate the protection of investors and the maintenance of fair, efficient and competitive securities markets. In enacting the federal securities laws, Congress rejected a scheme of direct federal regulation in favor of a system that provides information to investors and gives them the opportunity to make informed choices. The SEC implements that mandate and protects investors and markets by requiring full, fair and truthful disclosure of material information to investors. Companies that sell stock or other securities to the public are generally required to disclose information about their businesses as well as ongoing information about their results. Similarly, market professionals -- brokers, dealers, mutual funds, other investment companies, investment advisers, and transfer agents -- are required to make truthful disclosures to clients or other market participants about their activities. They are also required to keep records necessary to account for client funds and their own activities in the market. The Commission carefully weighs the impact of its rules on all entities, including small businesses. However, the Commission's primary considerations as to the adoption and enforcement of each rule must be the effects of the rule on investor protection and market integrity. As a general matter, uniform rules must be applied to firms that are part of a larger national market system to ensure fair, efficient markets and the same level of protection for all investors, regardless of the size of the firm to which they entrust their funds. ANALYSIS OF H.R. 3310 As noted above, the Commission supports the goals of H.R. 3310, which are to reduce paperwork burdens on small business and to provide relief for inadvertent first-time paperwork violations. To summarize, H.R. 3310 has four central requirements with respect to collection of information by agencies. It would limit an agency's ability to enforce existing information collection requirements through the use of civil fines.[9] It would require agencies to publish annually a list of requirements applicable to small business concerns.[10] It would require each agency to establish one point of contact as a liaison to small business concerns.[11] And it would create a task force to study and report to Congress about ways to lessen paperwork burdens on small businesses.[12] The Commission's main concern with H.R. 3310 is its provision to limit an agency's ability to impose civil fines. The language of the bill is so broad as to sweep within its "safe harbor" serious or deliberate violations that could harm investors or the securities markets. The bill would be strengthened in our view by amendments that distinguish between minor violations and those recordkeeping violations of a more serious nature -- which could harm investors or the markets more generally. We discuss this point in greater detail below. Limitations on Civil Fines for First-Time Violators. H.R. 3310 would generally prohibit civil fines on a small business "in any case of a first-time violation regarding collection of information by the agency" if the small business corrects the violation within six months of notice by the agency. A fine could be imposed only if the head of the agency determines that the violation has caused actual serious harm to the public health or safety. Although the Commission generally seeks to resolve technical recordkeeping violations informally (regardless of the size of the company), we believe there may be instances where no disclosure or partial disclosure was intentionally done to advance a fraud. The Commission would like the flexibility to continue to seek fines in egregious cases, and we fear that a "public health or safety" standard would be construed so narrowly as to exclude economic harm. Also, the six-month "grace period" could be too long in a marketplace that depends on immediate, accurate information. Finally, repeat violators (who relocate to open new firms) may abuse the first-time exception from penalties. Thus, this provision is troubling for a number of reasons. (1) There are first-time recordkeeping violations which are serious, and should be subject to fines. As currently drafted, H.R. 3310 does not sufficiently distinguish inadvertent or trivial violations that should not be sanctioned with fines from more serious violations. Under the Paperwork Reduction Act ("PRA"),[13] the term "collection of information" is defined to include not only recordkeeping and reporting requirements imposed on a business by a government agency, but also any disclosures that an agency requires a business to make to third parties, such as clients or prospective client.[14] Thus, the reach of the PRA includes information provided to investors to protect them from fraud, as well as enable them to make informed investment choices. For example, a company's prospectus, annual reports, and customer confirmations of securities transactions are all "collections of information" under the PRA. Similarly, other important "collections of information" include items such as broker stock quotations -- which are required to be transmitted accurately and rapidly to make the markets work properly and fairly. Under H.R. 3310, violations involving these important documents are exempted from civil fines as well as those more trivial "paperwork" violations that may be imposed for more bureaucratic purposes. Here are examples of some of the "important" SEC paperwork requirements that would be subject to penalty exemption under H.R. 3310. * The Commission's penny stock rules, which were mandated by Congress, provide investor protections through both recordkeeping and disclosure requirements. These rules require that certain disclosures be given, and that customers agree to certain types of transactions, before the transactions are effected. Violations of this type of rule harm investors by denying them information necessary to make an informed decision, and in many cases, lead to the purchase of disastrous investments in speculative issues. * Another example is in the reporting of a public company's earnings. Virtually every accounting fraud by a public company involves a violation of the requirement to accurately keep the company's books and records. Protection for companies that make inadvertent or innocent mistakes is already built into the law by the requirement that violations be material. * Another type of serious recordkeeping violations involves the deliberate falsification of records and record destruction. These kinds of violations can mask serious fraud. For example, the Commission recently sued eight floor brokers of the New York Stock Exchange for conducting what the Exchange's chairman has described as a "massive falsification of books and records" to conceal illegal trading for their own account.[15] The Commission believes that cases involving this type of illegal conduct should not be trivialized or treated with leniency. Often we find that misleading disclosure is used to draw investors into a fraud, and false recordkeeping conceals it from regulators long enough for wrongdoers to profit at the expense of innocent investors. * Concerning a more time-sensitive matter, the Commission currently is engaging in a serious Year 2000 initiative which, in part, would require certain issuers and market participants to disclose material deficiencies in their systems' Year 2000 readiness. Any six-month grace period would not seem appropriate for failure to make such disclosures. The Commission believes that fines are an important enforcement tool. The threat of civil fines deters unlawful conduct by removing economic incentives to cut corners in recordkeeping or compliance. Congress recognized the importance of civil fines to upholding the federal securities laws when, in 1990, it gave the Commission new authority to assess penalties in administrative proceedings against regulated brokers, investment advisers and other regulated persons.[16] Congress also gave the Commission authority to seek civil penalties in court actions against any violator, whether or not registered with the Commission. Notably, Congress created three tiers of possible Commission fines, which link the amount of fines that can be imposed to the type of violations found and the degree of harm caused or the wrongful gain obtained. Thus, the securities regulatory scheme already provides for a penalty scheme that distinguishes more serious violations from those that are less important. A case by case approach has many benefits over a flat prohibition against civil penalties for first-time violators. (2) The six-month provision may become an excuse for delay in correcting mistakes. The securities markets rely on immediate, accurate information that moves at the speed of light. As described above, the Commission has an active inspections program. When violations are discovered, the staff works with registrants to resolve recordkeeping violations with informal action. In most cases, however, violations should and can be remedied in 30 days or less. The proposed amendments may inadvertently be subject to the interpretation that Congress created a presumption that wrongdoers have a six-month safe harbor to correct even the most serious mistakes. An individual investor may choose not to balance their checkbook each month. It is unacceptable, however, to think that a broker could ignore customer confirmation and other recordkeeping requirements, lose customer funds, and be allowed up to six months to correct its records and provide customers with relief. (3) An exception for all first-time violators may be unintentionally broad. The grace period for first-time violators allows an unscrupulous operator to regain protection from civil fines each time he establishes a new entity. In our experience, when the SEC moves to shut down a broker- dealer engaged in manipulating penny stocks, the rogue brokers and scam artists from the firm named in our enforcement action will quickly form a new firm and start up operations again. Under H.R. 3310, the new firm would have another "free pass" for a first-time violation. A related difficulty under the proposed amendments will be determining when there has been notice of a "first-time" violation that triggers the grace period. As described, the Commission has a vigorous inspections program and a longstanding policy of leaving to the staff to informally resolve minor, technical or inadvertent deficiencies. The success of this program lies in large measure with the understanding that continued inattention to the requirements of the securities laws could result in formal action. In the event that informal resolution does not cure a problem, violators should not automatically have the benefit of a safe harbor. The bill does not address whether a "first-time" violation is established simply by agency notice, or whether there must be any additional process. Suggestions for Improvement. Generally, the Commission believes that the concept of an automatic exemption from civil fines for first-time violators is not as effective as one tailored to prevent abuses. Whether such a provision should be included in the PRA may best be made a subject for study and consideration by the Task Force also proposed in H.R. 3310. If the provision is given detailed consideration, we suggest the following: * The exception that permits fines for violations that are found to pose an imminent and substantial danger to the public health or safety should be expanded to include violations that involve investor protection or the integrity of the securities markets. * The penalty exception should be limited to "good faith" violations. This would permit fines for violations (i) when the conduct involves fraud, intentional wrongdoing, or destruction of records, and (ii) when the owner or principal of the small business is a repeat offender. * As a more technical point, we suggest that the bill's definition of "small business" conform to the definition of "small business" that is currently in the Regulatory Flexibility Act and used now by all federal agencies. Task Force to Study Streamlining of Paperwork Requirements. The Commission also would like to take this opportunity to comment on the proposed task force to study the PRA. The Commission agrees that a task force should be established for the purposes of studying the PRA, but believes that its mandate should be broader, and should include problems with the existing statute. In addition, provisions should be made for input by agencies such as the SEC. Although the SEC has complied with the mandates of the PRA -- we have found it, in some situations, to be a roadblock to informed regulation, or even efforts to reduce regulatory burdens. For example, the PRA keeps us from informally surveying securities market participants regarding how our rules are working. To talk to more than nine firms, we must obtain OMB approval, a bureaucratic process that can constrain complete and timely discussion of regulatory issues. Similarly, we cannot even survey firms for cost-benefit analysis of proposed rules without going through an OMB clearance process. Even when a member of Congress asks us to study a proposal -- such as disclosure of charitable giving by public companies -- we have been constrained by the PRA in collecting information necessary to complete the inquiry. Finally, we would like to suggest that the PRA be amended to reduce the OMB paperwork clearance process when forms are being eliminated or streamlined. We would like issues such as these to be considered in any PRA study. CONCLUSION The SEC supports this Subcommittee's efforts to reduce paperwork burdens on small business. The securities laws mandate full and fair disclosure to investors and the public. Efforts to streamline paperwork burdens must distinguish with care between "collection of information" requirements that exist to verify regulatory compliance, but do not directly reach the public, and those requirements that involve direct communication by a business with the public or with other market participants. Great care must also be shown in distinguishing immaterial, inadvertent or technical mistakes from the deliberate falsification or destruction of records. The nation's capital markets are a crown jewel. We must be cautious not to adopt changes that appear to weaken the integrity of those markets or diminish investor confidence in the safety of investing with or through any firm, whether large or small. The Commission has concerns that the "broad brush" approach of the proposed amendments will inadvertently diminish investor protection. If small firms are to flourish, investors need to have confidence in the honesty of the firms. Small businesses have earned the confidence of investors, large and small. We must not let this confidence be eroded by appearing to tolerate intentional violations by small business. The Commission looks forward to an opportunity to work further with the Committee on these important issues. The Commission staff is available to consult with the Committee regarding alternatives that will protect investors and the securities markets. ENDNOTES 1/ SEC, 1 Annual Report 9-10 (1935). 2/ Pub. L. No. 104-122, title II, 110 Stat. 857 to 874 (Mar. 29, 1996), codified at 15 U.S.C. 657, 5 U.S.C. 801- 808. 3/ "Small Business Regulatory Enforcement Act -- Joint Managers' Statement of Legislative History and Congressional Intent," 142 Cong. Rec. S3234, S3243 (daily ed. Mar. 29, 1996). 4/ National Ombudsman, Report to Congress: Regulatory Fairness at 24 (December 31, 1997). See also id. at 5, 26, 34. 5/ In 1997, the Commission staff conducted approximately 2300 examinations. Approximately 64% of investment adviser, 80% of investment company, and 47% of broker- dealer examinations were concluded by issuing a deficiency letter. 6/ In 1997, approximately 5% of investment adviser, 7% of investment company, and 28% of broker-dealer examinations resulted in a referral to Enforcement. 7/ "Respondent" is used generically in this testimony to refer either to respondents in an administrative proceeding or defendants in a civil court action. 8/ See 17 C.F.R. 203.7(d) (Wells submissions). Notice is not given, for example, when emergency relief is sought, or if warning to a proposed respondent could harm investors or the public through the dissipation of assets, destruction of records, flight or other such action. 9/ Sec. 2(b) [i)(1)(B)]. 10/ Sec. 2(a)(6). 11/ Sec. 2(b) [(i)(1)(A)]. 12/ Sec. 3. 13/ Codified at 44 U.S.C. 3501-3520. 14/ 44 U.S.C. 3502(3). 15/ See Dean Starkman and Patrick McGeehan, "Floor Brokers on Big Board Charged in Scheme," Wall Street Journal, Feb. 26, 1998, at C1. The Commission's complaint alleges that the floor brokers concealed their personal trading by creating false order tickets and false monthly invoices, which showed that the trades were executed for a co-conspirator client broker. The Commission charged the floor brokers with violating the recordkeeping requirements of the Securities Exchange Act and its implementing regulations. The Commission alleges that, through this scheme, the floor brokers made almost $9 million in illegal profits. See Complaint of the Securities and Exchange Commission, SEC v. Oakford Corp. (S.D.N.Y.) (98 Civ. 1366). This scheme, if proven, will be a first violation for all of the floor brokers charged. Three of the eight floor brokers involved in the scheme qualify as "small businesses" under definitions applicable to the SEC under the Regulatory Flexibility Act. If H.R. 3310 had been the law at the time, the Commission could have been forced to seek lesser penalties against the smaller floor brokers, although they were just as culpable as the other defendants. 16/ Securities Enforcement and Penny Stock Reform Act of 1990, Pub. L. No. 101-429, 104 Stat. 931 (Oct. 15, 1990), codified at 15 U.S.C. 78u-2, 78u-3, 78q-2.