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Report to the Committee on the Judiciary, House of Representatives:
April 2005:
Mutual Fund Trading Abuses:
Lessons Can Be Learned from SEC Not Having Detected Violations at an
Earlier Stage:
[Hyperlink, //www.gao.gov/cgi-bin/getrpt?GAO-05-313]:
GAO Highlights:
Highlights of GAO-05-313, a report to the Committee on the Judiciary,
House of Representatives:
Why GAO Did This Study:
Recent violations uncovered in the mutual fund industry raised
questions about the ethical practices of the industry and the quality
of its oversight. A widespread abuse involved mutual fund companies�
investment advisers (firms that provide management and other services
to funds) entering into undisclosed arrangements with favored customers
to permit market timing (frequent trading to profit from short-term
pricing discrepancies) in contravention of stated trading limits. These
arrangements harmed long-term mutual fund shareholders by increasing
transaction costs and lowering fund returns. Questions have also been
raised as to why the New York State Attorney General�s Office disclosed
the trading abuses in September 2003 before the Securities and Exchange
Commission (SEC), which is the mutual fund industry�s primary
regulator. Accordingly, this report (1) identifies the reasons that SEC
did not detect the abuses at an earlier stage and the lessons learned
in not doing so, and (2) assesses the steps that SEC has taken to
strengthen its mutual fund oversight program and improve mutual fund
company operations.
What GAO Found:
Prior to September 2003, SEC did not examine for market timing abuses
because agency officials viewed other activities as representing higher
risks and believed that companies had financial incentives to control
frequent trading because it could lower fund returns. While SEC faced
competing examination priorities prior to September 2003 and made good
faith efforts to mitigate the known risks associated with market
timing, lessons can be learned from the agency not having detected the
abuses earlier. First, without independent assessments during
examinations of controls over areas such as market timing (through
interviews, reviews of exception reports, reviews of independent audit
reports, or transaction testing as necessary) the risk increases that
violations may go undetected. Second, SEC can strengthen its capacity
to identify and assess evidence of potential risks. Articles in the
financial press and academic studies that were available prior to
September 2003 stated that market timing posed significant risks to
mutual fund company shareholders. Finally, GAO found that fund company
compliance staff often detected evidence of undisclosed market timing
arrangements with favored customers but lacked sufficient independence
within their organizations to correct identified deficiencies. Ensuring
compliance staff independence is critical, and SEC could potentially
benefit from their work.
SEC has taken several steps to strengthen its mutual fund oversight
program and the operations of mutual fund companies, but it is too soon
to assess the effectiveness of certain initiatives. To improve its
examination program, SEC staff recently instructed agency staff to
conduct more independent assessments of fund company controls. To
improve its risk assessment capabilities, SEC also has created and is
currently staffing a new office to better anticipate, identify, and
manage emerging risks and market trends. To better ensure company
compliance staff independence, SEC recently adopted a rule that
requires compliance officers to report directly to funds� boards of
directors. While this rule has the potential to improve fund company
operations and is intended to increase compliance officers�
independence, certain compliance officers may still face organizational
conflicts of interest. Under the rule, compliance officers may not work
directly for mutual fund companies, but rather, for investment advisers
whose interests may not necessarily be fully aligned with mutual fund
customers. The rule also requires compliance officers to prepare annual
reports on their companies� compliance with laws and regulations, but
SEC has not developed a plan to routinely receive and review the annual
compliance reports. Without such a plan, SEC cannot be assured that it
is in the best position to detect abusive industry practices and
emerging trends.
What GAO Recommends:
GAO recommends that SEC routinely assess the effectiveness of
compliance officers and plan to review compliance reports on an ongoing
basis. SEC agreed with these recommendations.
www.gao.gov/cgi-bin/getrpt?GAO-05-313.
To view the full product, including the scope
and methodology, click on the link above.
For more information, contact Richard J. Hillman, 202-512-8678,
.
[End of section]
Contents:
Letter:
Results in Brief:
Background:
Lessons Can be Drawn from SEC Not Having Detected Market Timing
Arrangements:
SEC Has Taken Steps to Strengthen Its Mutual Fund Oversight Program,
but It Is Too Soon to Assess the Effectiveness of Several Key
Initiatives:
Conclusions:
Recommendations:
Agency Comments and Our Evaluation:
Appendixes:
Appendix I: Objectives, Scope, and Methodology:
Appendix II: Mutual Fund Trade Processing and Recordkeeping:
Appendix III: SEC Proposed Rule to Prevent Late Trading:
Appendix IV: Comments from the Securities and Exchange Commission:
Appendix V: GAO Contacts and Staff Acknowledgments:
GAO Contacts:
Staff Acknowledgments:
Tables:
Table 1: Staff Positions for SEC Divisions and Offices with
Responsibilities for Mutual Fund Regulation, Oversight, and
Enforcement, as of February 2005:
Table 2: SEC Mutual Fund-related Rules, Adopted after September 2003:
Figures:
Figure 1: SEC Settled Enforcement Actions against Investment Advisers
Related to Market Timing Violations as of February 28, 2005 (dollars in
thousands):
Figure 2: Processing Paths of Mutual Fund Transactions:
Abbreviations:
1940 Act: Investment Company Act of 1940:
Advisers Act: Investment Advisers Act of 1940:
CCO: chief compliance officer:
ICI: Investment Company Institute:
Investment Management: Division of Investment Management:
NASD: National Association of Securities Dealers:
NAV: net asset value:
NSCC: National Securities Clearing Corporation:
NYSOAG: New York State Office of the Attorney General:
NYSE: New York Stock Exchange:
OCIE: Office of Compliance Inspections and Examinations:
ORA: Office of Risk Assessment:
SEC: Securities and Exchange Commission:
SRO: self-regulatory organization:
Letter April 20, 2005:
The Honorable F. James Sensenbrenner, Jr.:
Chairman:
Committee on the Judiciary:
House of Representatives:
The Honorable John Conyers, Jr.:
Ranking Minority Member:
Committee on the Judiciary:
House of Representatives:
Recent trading abuses uncovered among some of the most well-known
companies in the mutual fund industry identified significant lapses in
the ethical standards of the industry and raised concerns about the
quality of its oversight. A widespread type of violation engaged in by
mutual fund companies involved market timing.[Footnote 1] Market timing
typically involves the frequent buying and selling of mutual fund
shares by sophisticated investors, such as hedge funds, that seek
opportunities to make profits on the differences in prices between
overseas markets and U.S. markets or for other purposes.[Footnote 2]
Although market timing is not itself illegal, frequent trading can harm
mutual fund shareholders because it lowers fund returns and increases
transaction costs. However, market timing can constitute illegal
conduct if, for example, it takes place as a result of undisclosed
agreements between investment advisers (firms that may manage mutual
fund companies) and favored customers such as hedge funds who are
permitted to trade frequently and in contravention of stated fund
trading limits. Market timing may also constitute illegal conduct, if
as happened in some cases, investment adviser officials engage in
frequent trading of fund shares in violation of fund policies and
disclosures. Another type of violation commonly referred to as late
trading was significant but less widespread than market timing
violations. Late trading typically involved intermediaries, such as
broker-dealers or pension plans that offer mutual funds, that permitted
certain customers to place trades after the 4 p.m. Eastern Time close
of the financial markets.[Footnote 3] Investors who are permitted to
engage in late trading can profit on knowledge of events in the
financial markets that take place after 4 p.m., an opportunity that
other fund shareholders do not have.
Questions have also been raised as to why securities industry
regulators, such as the Securities and Exchange Commission (SEC) and
the National Association of Securities Dealers (NASD), did not detect
the undisclosed market timing arrangements and late trading abuses.
Instead, the New York State Office of the Attorney General (NYSOAG)
uncovered the abuses in the summer of 2003 after following up on a tip
provided by a hedge fund insider. SEC, which has direct supervisory
oversight responsibility for mutual fund companies, did not detect the
undisclosed arrangements through its routine examination program. NASD,
which regulates broker-dealers that may sell mutual funds as part of
their overall business, also did not detect undisclosed market timing
or late trading abuses through its examinations.[Footnote 4] However,
once early indications of undisclosed market timing arrangements and
late trading surfaced, SEC surveyed mutual fund companies and initiated
a series of examinations, as did NASD regarding broker-dealers, to
determine the extent of the problem. By November 2003, SEC estimated
that 50 percent of the 80 largest mutual fund companies had entered
into undisclosed arrangements permitting certain shareholders to engage
in market timing practices that appeared to be inconsistent with the
funds' policies, prospectus disclosures, or fiduciary obligations.
Additionally, SEC and NASD investigated and pursued companies and
individuals found to have responsibility for market timing and late
trading abuses through filing and settling enforcement actions, which
have generated substantial fines and penalties. Nevertheless, the
regulators' failure to identify the abuses at an earlier stage has
generated concern about the effectiveness of their examination and
other oversight procedures.
This report responds to your requests that we review issues relating to
regulatory oversight of the mutual fund industry. Because undisclosed
market timing arrangements were more widespread than late trading
violations and SEC is the mutual fund industry's frontline regulator,
the report primarily focuses on SEC's oversight of the market timing
area. The report also addresses NASD's oversight of broker-dealers that
failed to prevent customers' late trading and market timing activities
but does not discuss late trading at pension plans and plan
administrators, which are subject to oversight by the Department of
Labor. Accordingly, the report (1) identifies the reasons that SEC did
not detect the abusive market timing agreements at an earlier stage and
lessons learned from the agency's failure to do so; and (2) assesses
steps that SEC has taken to strengthen its mutual fund oversight, deter
abusive trading, and improve mutual fund company operations.
To accomplish our reporting objectives, we interviewed SEC staff at
headquarters and at a judgmental sample of six regional and district
offices located nationwide; NASD officials; and officials from the
Investment Company Institute (ICI), which is the trade group that
represents the mutual fund industry, a judgmental sample of large
mutual fund companies; broker-dealers; pension plans; the National
Securities Clearing Corporation (NSCC), which plays a role in
processing certain mutual fund transactions; the Securities Industry
Association; and other industry participants. At the six SEC offices,
we also reviewed enforcement actions and examination reports for 11
large mutual fund companies that regulators identified as having
entered into undisclosed market timing arrangements or where late
trading violations took place. Each of these companies was among the
100 largest mutual fund companies in the United States as measured by
assets under management on August 1, 2003. We also reviewed general
financial regulation and auditing standards pertaining to the oversight
of regulated entities and federal agencies as well as relevant academic
and other studies. We reviewed relevant documentation and discussed the
cases with knowledgeable SEC staff to provide a basis for understanding
the reasons that the agency did not detect abuses at an earlier stage.
Our work was performed in Atlanta, Ga; Boston, Mass; Chicago, Ill;
Denver, Colo; New York, N.Y; Philadelphia, Pa; and Washington, D.C. We
conducted our work between May 2004 and April 2005 in accordance with
generally accepted government audit standards. Appendix I provides a
detailed description of our scope and methodology.
Results in Brief:
Prior to September 2003, SEC staff did not examine for market timing
abuses or assess company controls over that activity because agency
staff (1) viewed market timing as a relatively low-risk area that did
not involve per se violations; (2) determined that mutual fund
companies had financial incentives to establish effective controls over
frequent trading because such trading can reduce fund returns resulting
in a loss of business; and (3) were told by company officials that they
had designated compliance staff to monitor and control market timing.
We recognize that SEC staff faced competing examination priorities and
that detecting fraudulent activities, particularly previously unknown
frauds such as the undisclosed arrangements between investment advisers
and favored investors, is challenging. Further, SEC staff made good
faith efforts to control the known risks associated with market timing
through the regulatory process, such as by issuing guidance on "fair
value" pricing.[Footnote 5] Nevertheless, lessons can be learned to
strengthen SEC's mutual fund company oversight program going forward
from the agency not having detected the undisclosed market timing
arrangements at an earlier stage. In particular, conducting independent
assessments of controls (through a variety of means including
interviews, reviews of exception reports, reviews of internal audit or
other company reports, and transaction testing as necessary) over
various activities within a mutual fund company, including areas
perceived to represent relatively low risks at a sample of companies,
is, at a minimum, an essential means to verify assessments about risks
and the adequacy of controls in place to mitigate those risks. Without
such independent assessments, the potential increases that violations
will go undetected. Further, our review identified information that was
available prior to September 2003 that was inconsistent with SEC
staff's views that market timing was a low risk area and that companies
would necessarily act to protect fund returns from the harmful
consequences of frequent trading. For example, academic studies
indicated that market timing by sophisticated investors, while legal,
remained a persistent risk prior to September 2003 that by one estimate
was costing mutual fund shareholders approximately $5 billion annually
in certain funds and that companies were not acting aggressively to
control these risks through fair value pricing, despite SEC's guidance
that they do so. The author of a 2002 study raised the possibility that
certain investment advisers were not implementing fair value pricing
because such advisers benefited financially from permitting frequent
trading, which turned out to be the case.[Footnote 6] Moreover, a
mutual fund insider provided information to an SEC district office in
early 2003 that indicated a company had poor market timing controls but
the office did not act promptly on this information. SEC must develop
the institutional capacity to identify and evaluate such evidence of
potential risks and deploy examiners as necessary to assess company
controls in such areas and help identify potential violations. Finally,
our review found that company compliance staff in the majority of cases
that we reviewed identified evidence of market timing arrangements with
favored customers as early as 1998 but lacked sufficient independence
within their organizations to correct identified deficiencies. Ensuring
compliance staff independence is critical, and SEC staff could
potentially better assess company risks and controls through routine
interactions with such staff and reviewing relevant documentation.
SEC has taken several steps to strengthen its mutual fund oversight
program and the operations of mutual fund companies over the past 2
years, but it is too soon to assess the effectiveness of several key
initiatives. To improve its examination program, SEC has instructed
examiners to make additional assessments of mutual fund company
controls. For example, SEC staff has identified a range of areas that
potentially represent high-risk compliance problems, such as personal
trading by mutual fund company officials, and examiners have initiated
independent examinations of these areas, as well as obtaining more
internal documentation, such as e-mails about these control areas. In a
forthcoming report, we assess SEC staff's implementation of these
revised examination guidelines. To improve its capacity to anticipate,
identify, and manage emerging risks and market trends in the securities
industry, SEC has created a new office that reports directly to the
agency's chairman. However, it is too soon to assess the effectiveness
of the new office as it had only 5 of 15 planned employees as of
February 2005 and was still defining its role within the agency.
Additionally, SEC has adopted rules designed to improve mutual fund
company operations, including rules that require registered investment
companies (mutual funds) and investment advisers to each designate a
chief compliance officer (CCO). The CCO of the investment company
reports directly to the company's board of directors and is responsible
for preparing annual reports on company compliance with federal laws
and regulations. By requiring the CCO to report directly to the board
of directors, SEC helped ensure the independence of the compliance
function, with one potentially important exception. Because many
investment companies do not have any employees, SEC provided that an
investment company's CCO could be an employee of an investment adviser.
As described in this report, investment adviser staff frequently
entered into undisclosed market timing arrangements with favored
customers at the expense of mutual fund shareholders. Although the rule
provides safeguards to ensure the independence of CCOs, it is too soon
to reach definitive judgments on their effectiveness.[Footnote 7]
Moreover, SEC has not developed a plan to ensure that agency staff
receive and can review the annual compliance reports on an ongoing
basis. Without such a plan, SEC cannot ensure that it has taken full
advantage of opportunities to enhance its mutual fund oversight program
and detect potential violations on a timely basis.
Among other steps, this report recommends that SEC, through the
examination process, ensure that investment company CCOs operate
independently and are effective in carrying out their responsibilities
and that SEC develop a plan to assess the feasibility of receiving and
reviewing annual compliance report findings on an ongoing basis. SEC
provided written comments on a draft of this report that are reprinted
in appendix IV. SEC commented that the agency has taken several steps
to strengthen its mutual fund oversight program and agreed with these
recommendations. SEC's comments are discussed in more detail at the end
of this report. NASD provided technical comments as did SEC, which have
been incorporated where appropriate.
Background:
Although it is typically organized as a corporation, a mutual fund's
structure and operation differ from that of a traditional corporation.
In a typical corporation, the firm's employees operate and manage the
firm, and the corporation's board of directors, elected by the
corporation's stockholders, oversees its operations.[Footnote 8] Mutual
funds also have a board of directors that is responsible for overseeing
the activities of the fund and negotiating and approving contracts with
an adviser and other service providers. Unlike a typical corporation, a
typical mutual fund has no employees; another party, the adviser, which
contracts with the fund for a fee, administers fund operations. The
adviser is an investment adviser/management company that manages the
fund's portfolio according to the objectives and policies described in
the fund's prospectus.[Footnote 9] Advisers may also perform various
administrative services for the funds they operate, although they also
frequently subcontract with other firms to provide these services.
Functions that a fund adviser or other firms may perform for a fund
include the following:
* Custodian: A custodian holds the fund assets, maintaining them
separately to protect shareholder interests.
* Transfer agent: A transfer agent processes orders to buy and redeem
fund shares and has customer recordkeeping responsibilities.
* Distributor: A distributor sells fund shares through a variety of
distribution channels, including directly through telephone or mail
solicitations handled by dedicated sale forces, or through third-party
intermediaries' sales forces.
Mutual funds are also structured so that each investor in the fund owns
shares, which represent a percentage of the fund's investment
portfolio, and investors share in the fund's gains, losses, and costs.
Mutual fund families offer investors multiple funds from which to
choose, each with varying investment objectives and levels of risk.
Investors may exchange assets between funds within a fund family at any
time. Investors also may purchase shares directly from their mutual
fund company or through intermediaries such as broker-dealers or
pension plans that offer mutual fund company products to their
customers. Intermediaries typically aggregate customer mutual fund
orders and submit them to mutual fund companies at one time on a daily
basis and may perform certain customer recordkeeping functions on
behalf of mutual fund companies. NSCC, a SEC-registered clearing
agency, is responsible for processing and clearing most of the mutual
fund transactions that take place between broker-dealer intermediaries
and mutual fund companies. Appendix II provides detailed information on
mutual fund trade processing and recordkeeping.
Mutual fund companies are subject to SEC registration and regulation
(unless an exemption from registration applies), and numerous
requirements established for the protection of investors. Mutual fund
companies are regulated primarily under the Investment Company Act of
1940 (1940 Act) and the rules adopted under that act. For example,
mutual fund company boards are required to have members who are
independent of the company's investment advisers to help ensure that
fund companies act in the best interest of their shareholders. SEC has
authority under the 1940 Act to promulgate rules to address the
changing financial services industry environment in which mutual funds
and other investment companies operate. The advisory firms that manage
mutual funds are regulated under the Investment Advisers Act of 1940
(Advisers Act), which among other provisions requires certain
investment advisers to register with SEC and conform to regulations
designed to protect investors. Subject to SEC oversight, NASD, which is
a self-regulatory organization (SRO), is responsible for regulation of
its member broker-dealers that sell various investment products,
including mutual funds. NASD, however, has no jurisdiction over
investment companies or their advisers. NASD carries out its oversight
responsibilities by issuing rules, conducting examinations, and
pursuing enforcement actions as necessary. However, certain other
intermediaries that may offer mutual fund products to their customers
are outside of SEC's regulatory jurisdiction. For example, the
Department of Labor is responsible for regulating pension plans and
their administrators.
In addition to its rulemaking authority, SEC carries out its mutual
fund oversight responsibilities through examinations. SEC's Office of
Compliance Inspections and Examinations (OCIE) establishes examination
policies and procedures and has primary responsibility for conducting
mutual fund company and adviser examinations. Between 1998 and 2003,
OCIE and its regional and district staff typically conducted routine
examinations, which were scheduled on a regular basis (such as every 2
to 5 years), depending on their size or SEC's assessments of the risks
that they represented to shareholders.[Footnote 10] SEC may also
conduct "sweep" examinations, which involve reviewing particular
issues--such as securities valuation procedures--at a number of mutual
fund companies or advisers to determine whether deficiencies or
violations exist industrywide for a particular issue. Additionally, SEC
may conduct "cause" examinations, which are based on indications,
allegations, or tips regarding wrongdoing or inappropriate conduct at a
firm. The goal of a cause examination is to quickly determine whether
there is a problem at a particular entity. SEC's Division of
Enforcement is responsible for pursuing civil enforcement actions for
violations of securities laws or regulations that are identified
through SEC examinations, referrals from other regulatory organizations
such as NASD, tips from fund insiders or the public, and other sources.
SEC may also refer cases to criminal authorities, such as the
Department of Justice, for violations that appear to indicate criminal
activity.
Market timing, although not illegal per se, can be unfair to long-term
fund investors because it provides the opportunity for selected fund
investors to profit from fund assets at the expense of long-term
investors. Typically, sophisticated investors may engage in market
timing to take advantage of differences in prices between stocks in
overseas markets--particularly Asia--and U.S. markets and for other
reasons. Mutual funds that fail to update their share prices are
particularly vulnerable to sophisticated market timing. SEC examiners
identified this phenomenon in 1997 after the Asian markets crisis when
some funds "fair valued" their holdings and were not subject to market
timing by shareholders while other funds that did not "fair value"
their holdings were subject to market timing. Market timing may require
fund managers to hold additional cash to redeem frequent trading
orders, which lowers long-term investors' overall returns since the
fund may hold fewer securities than would be the case in the absence of
market timing. In addition, market timing increases transaction costs-
-such as trading fees--further lowering shareholder returns.
Consequently, many mutual funds have established limits on the number
of trades that individual customers may place per year--such as four
trades--and disclose these limits in fund prospectuses. However, prior
to September 2003, certain investment advisers entered into undisclosed
arrangements with favored customers, including hedge funds, allowing
the customers to circumvent the established limits. These undisclosed
agreements sometimes allowed favored customers to place hundreds of
trades annually at the expense of long-term shareholders, who were
subject to established trading limits. In exchange for market timing
privileges, favored customers often secretly agreed to make investments
in certain mutual funds or other investment vehicles that were managed
by that company (commonly referred to as "sticky assets" arrangements).
Unlike market timing, late trading is illegal under all circumstances.
Under SEC rules, mutual fund companies accept orders to purchase and
redeem fund shares at a price based on the current net asset value
(NAV), which most funds calculate once a day at 4:00 p.m. Eastern Time.
As previously discussed, intermediaries--such as broker-dealers and
pension funds--typically aggregate orders received from investors and
submit a single purchase or redemption order that nets all the
individual shares their customers are seeking to buy or sell. Because
processing takes time, SEC rules permit these intermediaries to forward
the order information to funds after 4:00 p.m. However, late trading
occurs when some investors submit orders to purchase or sell mutual
fund shares after the 4:00 p.m. close of U.S. securities markets (or
the mutual fund's pricing time) and receive that same day pricing for
the orders. Although late trading can involve mutual fund company
personnel, late trading violations have typically occurred at
intermediaries, before these institutions submitted their daily
aggregate orders to mutual fund companies for final settlement. An
investor permitted to engage in late trading could be buying or selling
shares at the current day's 4:00 p.m. price with knowledge of
developments in the financial markets that occurred after 4:00 p.m.
Such investors thus have unfair access to opportunities for profit that
are not provided to other fund shareholders.
Lessons Can Be Drawn from SEC Not Having Detected Market Timing
Arrangements:
Prior to September 2003, SEC did not examine for market timing abuses
because agency staff viewed market timing as a relatively low-risk area
and believed that companies had financial incentives to establish
effective controls, that is, by maximizing fund returns in order to
sell fund shares. SEC staff also said that agency examiners were told
by company officials that they had established "market timing police"
to control frequent trading. In retrospect, SEC staff's inability to
detect the widespread market timing violations demonstrates the
importance of (1) conducting independent assessments of the adequacy of
controls over areas such as market timing, (2) developing the
institutional capability to identify and analyze evidence of potential
risks, and (3) ensuring the independence and effectiveness of company
compliance staff and potentially using their work to benefit the
agency's oversight program.
SEC Did Not Examine for Mutual Fund Company Market Timing Abuses:
OCIE staff have stated that given the number of mutual fund companies,
the breadth of their operations, and limited examination resources,
SEC's examinations were limited in scope and examiners focused on
discrete areas that staff viewed as representing the highest risks of
presenting compliance problems that could impact investors. OCIE staff
stated that prior to September 2003, they considered funds' portfolio
trading (i.e., the fund's purchases and sales of securities on behalf
of investors) and other areas as representing higher risks than
potential market timing abuses. For example, examiners focused on
whether funds were trying to inflate the returns of the fund, or taking
on undisclosed risk. SEC's staff's concern was that in attempting to
produce strong investment returns to attract and maintain shareholders,
fund portfolio managers had an incentive to engage in misconduct in the
management of the fund. As a result, SEC examination protocols
instructed that significant attention be focused on portfolio
management, order execution, allocation of investment opportunities,
pricing and calculation of NAV, advertising returns, and safeguarding
fund assets from theft. SEC staff stated that examinations and
enforcement cases in these areas revealed many deficiencies and
violations. Our discussions with SEC staff nationwide, review of
selected examination reports, and discussions with officials of mutual
fund companies verified that the agency did not review market timing
controls prior to September 2003.
OCIE and SEC district staff we contacted said that the agency also did
not review mutual fund market timing controls because market timing is
not illegal per se, and they viewed fund companies as having financial
incentives to control frequent trading. That is, since frequent trading
can reduce shareholder returns, fund companies had incentives to
establish controls that would prevent market timing. Failure to
establish such controls could result in a loss of new sales and assets
under management, which would harm investment advisers because they are
compensated based on the amount of assets under management. Thus, SEC
staff concluded the advisers had a financial incentive to grow or
maintain assets under management in order to receive higher fees. SEC
staff also said that mutual fund company officials told agency
examiners that they had appointed "market timing police" to enforce
compliance with the funds' trading limit policies.
SEC staff also stated that they were surprised when the NYSOAG
identified abusive market timing and late trading violations in
September 2003. SEC staff said that they did not anticipate that mutual
fund companies would enter into market timing arrangements that were
detrimental to fund performance because poor performance could impact
sales and have a negative effect on the fee received by the adviser.
After the abusive practices were identified, SEC moved aggressively to
assess the scope and seriousness of the problem. For example, SEC
surveyed about 80 large mutual fund companies and determined that
nearly 50 percent had some form of undisclosed market timing
arrangement with certain customers that appeared to be inconsistent
with internal policies, prospectus disclosure, or fiduciary duties. SEC
also initiated immediate "cause" examinations and investigations at
many of these mutual fund companies to further review potential
violations. As described in a later section, SEC also initiated
numerous enforcement actions to penalize violators and deter the
abusive mutual fund trading practices.
NASD in its examinations of broker-dealers also did not discover market
timing arrangements involving broker-dealers before September 2003.
According to an NASD official, this was because market timing was not
illegal per se and, to the extent a mutual fund company had stated
customer trading limits, broker-dealers may not have perceived
themselves as being responsible for the enforcement of such policies.
Regarding late trading, NASD officials said that the organization did
not have specific examination guidance to detect the violation prior to
September 2003. NASD officials also said that some broker-dealers
created fictitious accounts or otherwise falsified documents, which
made the detection of late trading violations difficult.
Independent Assessments of Controls are Essential:
We recognize that SEC faces competing examination priorities and had
limited examination resources prior to September 2003. In a 2002
report, we noted that over the previous decade the size and complexity
of financial markets had increased substantially, whereas SEC's staff
size had remained essentially flat, which significantly increased the
agency's workload.[Footnote 11] In particular, our report noted the
large increase in investment company and investment adviser assets
under management over a 10-year period, relative to the growth in
examination staff. As discussed later in this report, in recent years,
Congress has provided SEC with substantial budgetary increases to
assist in overseeing the securities markets. Some of these new
resources were allocated to oversight of mutual funds. We also
recognize that SEC examiners cannot anticipate every potential fraud,
particularly novel frauds such as the undisclosed market timing
arrangements between investment advisers and favored customers, such as
hedge funds.
Although we recognize that SEC faced competing priorities, the fact
that the agency subsequently found that about half of the largest
mutual fund companies had entered into undisclosed arrangements with
certain shareholders, demonstrates the importance of examination and
auditing standards that call for independent assessments of the
adequacy of controls to prevent or detect abusive practices. SEC's
examination standards acknowledge the importance of independent control
testing. For example, SEC examination guidance in effect since 1997
states:
A primary task and responsibility of the SEC inspection staff is to
review a fund's control environment and underlying internal control or
compliance system(s). By applying certain examination procedures and
techniques, examiners should be able to evaluate the control
environment and determine the effectiveness of each system in ensuring
compliance.
In addition, commonly accepted examination and auditing guidelines call
for a degree of professional skepticism in assessing controls (such as
mutual fund company market timing controls) and independent
verification of their adequacy to confirm other assessments of
potential risks or statements by company officials. Conducting
independent testing of controls at a sample of companies, at a minimum,
could serve to verify that areas, such as market timing, do in fact
represent low risks and that effective controls are in place.
Independent control assessments can be accomplished through a variety
of means including interviewing officials responsible for the control,
assessing organizational structure to ensure that compliance staff have
adequate independence to carry out their responsibilities, reviewing
internal and external audit reports, reviewing exceptions to stated
policies, and testing transactions as necessary. If examiners or
auditors detect indications of noncompliance with stated policies or
requirements, they are expected to expand the scope of their work to
determine the extent of identified deficiencies.
We also note that SEC examination guidance potentially limited
examiners' capacity to develop overall assessments of mutual fund
company risks and controls and identify potential violations---such as
market timing abuses--outside of identified or perceived high-risk
areas. Specifically, SEC examination guidance of March 2002 generally
instructed examiners to request only a sample of selected internal
audit reports when reviewing a registrant's internal control or
supervisory systems or as part of a review of a particular problem,
rather than instructing examiners to routinely request all internal
audit and compliance reports or listings thereof. According to SEC
staff, SEC has the legal authority to request and obtain access to all
investment adviser and transfer agent books and records--including
internal audit reports. Although restrictions exist on SEC's access to
investment company books and records, SEC staff said that the agency
can generally obtain needed documents through investment advisers or
transfer agents, which typically keep documents similar to investment
companies.[Footnote 12] However, SEC staff said that routinely
requesting all internal audit reports in planning for examinations
could have unintended negative consequences. For example, SEC staff
said that routinely requesting all audit reports may discourage
companies from establishing effective internal audit departments out of
concern that findings in internal audit reports could result in SEC
investigations. In a May 2004 report that addressed SEC's oversight of
SRO listing standards, SEC staff made similar arguments regarding the
"chilling effect" of requesting internal audit reports.[Footnote
13]However, we pointed out that it is standard practice among financial
regulators to request a range of internal audit reports in planning
examinations and that SRO internal audit reports contained information
relevant to SEC's listing oversight responsibilities. Accordingly, we
recommended that SEC review SRO internal audit reports as part of its
examinations and the agency agreed to do so. Moreover, SEC staff's
assertion of a "chilling effect" is based on a questionable premise. In
fact, companies may have the opposite incentive knowing that SEC staff
will not routinely review all of their internal audit reports. As
described later in this report, internal staff at two mutual fund
companies produced internal compliance reports in 2002 that documented
evidence of undisclosed market timing arrangements and their negative
consequences for shareholders.[Footnote 14] SEC staff has revised its
policy on requesting internal reports and this is also described later
in this report.
In contrast, federal bank regulators had implemented procedures that
directed examiners to use a range of information sources to help
develop an overall and independent perspective on bank risks and the
adequacy of their controls. The Federal Reserve System and the Office
of the Comptroller of the Currency (OCC), typically assign on-site
examiners to large institutions on an ongoing basis but may conduct
examinations of smaller institutions every 12 to 18 months or more (SEC
also has typically examined mutual funds on a regular schedule). Under
the Federal Reserve System's commercial bank examination guidelines
dated May 2000, examiners were required to make an evaluation of the
overall risks facing large and small banks and the controls that were
in place to manage those risks, including the adequacy of internal
audit and compliance departments. (As discussed later in this report,
SEC adopted a revised risk-based examination approach in
2002.)[Footnote 15] Among the potential range of steps specified in
such standards, examiners could assess controls by interviewing
compliance or audit staff and reviewing internal audit or other
relevant internal reports without restrictions. While we recognize that
there are important differences between the safety and soundness focus
of bank examinations and the traditional compliance and enforcement
focus of SEC examinations, as well as staffing of the various agencies,
bank regulator approaches to carrying out their responsibilities
provided a practical means for examiners to verify control adequacy and
identify potential deficiencies.
SEC Can Strengthen Its Capacity to Identify and Evaluate Potential
Risks:
We also identified information that was available prior to September
2003--including academic studies and a tip from an industry insider--
that was inconsistent with SEC examination staff's rationale for not
independently assessing mutual fund company market timing controls.
That is, the staff viewed market timing as a relatively low risk area,
had been told by company officials that they had established effective
controls, and believed that fund companies had financial incentives to
establish such controls to ensure high fund returns. Although the
available information did not directly identify evidence of undisclosed
arrangements between investment advisers and favored customers, it did
identify significant and persistent risks associated with market timing
by sophisticated investors and suggested that mutual fund companies
were not always acting aggressively to control these risks potentially
due to conflicts of interest. We note that SEC staff in the Division of
Investment Management (Investment Management) were also aware of these
market timing risks and had attempted to mitigate them through the
regulatory process, with limited success according to academic
studies.[Footnote 16] In retrospect, the information suggested that
market timing was an area that might have merited the focus of the
agency's examination function and that the agency needed to strengthen
its capacity to identify and evaluate evidence of potential risks. As
described later in this report, SEC has established a new risk
assessment office.
Articles in the financial press and academic studies that were
available prior to September 2003 stated that market timing posed
significant risks to mutual fund company shareholders.[Footnote 17] For
example, a 2002 academic study estimated that mutual fund company
shareholders were losing nearly $5 billion per year in certain
international and other funds due to such market timing
activity.[Footnote 18] In 2001 and 2002, a senior Investment Management
staff member also made public statements that market timing posed risks
to mutual fund company shareholders by requiring companies to, among
other things, hold excess cash. These articles and the statements of
the SEC staff member focused on the hesitant approach of many mutual
fund companies to meet their legal obligations under the 1940 Act to
adopt "fair value" pricing of their securities despite SEC guidance
that they do so.[Footnote 19] Establishing fair value prices in
international and other funds was viewed, including by SEC staff, as an
essential means to minimize arbitrage opportunities for sophisticated
investors and thereby minimize the negative consequences for fund
performance. In 1999, 2001, and 2002, SEC staff wrote "interpretive"
letters to the mutual fund industry reminding industry officials of
their obligations to adopt fair value pricing and providing guidance
and regulatory assistance in controlling market timing.[Footnote 20]
For example, in November 2002, SEC staff wrote to ICI--the trade group
that represents the mutual fund industry--to state that a fund company
may, consistent with the 1940 Act provisions, make an exchange on a
specified delayed basis, so long as the offer is fully and clearly
disclosed in the fund's prospectus.[Footnote 21] Several reasons have
been advanced for mutual fund companies' failure to adopt fair value
pricing and thereby help avoid losses due to market timers. Among other
reasons, a 2002 article suggested that mutual fund company boards with
a higher percentage of directors who are independent of their
investment advisers were more likely than boards with fewer independent
directors to adopt fair value pricing. [Footnote 22] The article also
suggested that investment advisers may face conflicts of interest
regarding fund shareholders and may benefit from permitting arbitrage.
According to the author, he believed the potential existed that market
timers were investing assets in mutual funds, which allowed investment
advisers to increase their fees for assets under management, in
exchange for market timing privileges. As discussed previously, SEC
later determined that many investment advisers did benefit from such
"sticky assets." Senior SEC staff cited other reasons for the
industry's slow implementation of fair value pricing. For example, the
staff said the companies were concerned about the lack of objectivity
in using estimated prices and due to concerns about lawsuits from
market timers whose trading strategies would be negatively affected.
Nevertheless, the study suggested that companies were not always acting
aggressively to ensure optimal performance, as SEC staff assumed they
would do, and that conflicts of interest may have compromised
companies' willingness to adopt corrective measures.
Finally, by not acting promptly on information suggesting that a large
mutual fund company had not established effective market timing
controls, an SEC office may have missed an opportunity to detect
violations. In early 2003, an insider at a Boston-based fund company
provided information and documentation to SEC's Boston district office
suggesting that company management failed to control widespread abusive
market timing by fund customers. According to SEC district staff, they
reviewed the information provided by the insider but did not act on it
because they did not view the alleged activity as representing a
violation of federal securities laws or regulations. For example, the
district staff said that the fund company's disclosures to investors
were vague and that they could not conclusively demonstrate that the
company had violated its prospectus disclosures. Subsequently, the
insider turned the information over to the Massachusetts Securities
Division, which settled state charges against the fund company related
to the insider's allegations. Although SEC staff subsequently began a
review of the fund company in response to a separate tip in September
2003 and initiated a related enforcement action in October, this action
was related to market timing by fund insiders rather than fund
customers as alleged earlier by the fund insider. SEC district staff
said the fact that SEC did not bring an enforcement action against the
mutual fund company for the actions alleged by the insider
substantiated their original position not to act on the initial tip.
While we do not dispute SEC's contention that the insider's allegations
did not necessarily involve violations of federal laws or regulations,
they did indicate a failure by the company's management to establish
effective controls against market timing as SEC staff assumed was in
the company's interests to do. If the district office had pursued this
information in early 2003, the potential exists that examiners would
have identified other weaknesses, such as the market timing abuses by
company insiders sooner than they did in late 2003.
Independent and Effective Company Compliance Staff Are Essential to
Detecting and Preventing Trading Abuses:
In the majority of the 11 SEC enforcement cases that we reviewed,
company compliance staff--the first line of defense in ensuring company
adherence to laws, regulations, and internal policies--lacked the
independence necessary to carry out their responsibilities. According
to SEC examination reports, enforcement actions, and discussions with
SEC staff, the compliance staff--in some cases referred to as "market
timing police"--were often successful in identifying and controlling
market timing by certain customers, typically those who did not have
special arrangements with the companies. The compliance staff reviewed
trading data in funds considered vulnerable to market timing--such as
international funds--and notified customers who exceeded specified
limits on the number of trades placed within a specified period that
their trading privileges would be suspended if the violations
continued. When customers continued to violate company restrictions,
SEC staff and related documents indicated that the companies would
suspend their trading. However, contrary to established financial and
corporate standards regarding the proper role of compliance staff, the
compliance staff at these firms did not have sufficient independence to
ensure that corrective actions always were taken to address
violations.[Footnote 23] Consequently, when the compliance staff
identified violations of company trading standards by favored
customers, other company officials would routinely overrule their
efforts to limit the customers' trading. In some cases, the compliance
staff kept separate lists of customers who were permitted to exceed the
companies' specified trading limits.
Although the companies' compliance staff were generally ineffective in
controlling market timing by favored customers, our review suggests
that routine communications with such compliance staff could
potentially enhance SEC's capacity to detect potential violations at an
earlier stage, if compliance staff are forthcoming about the problems
they detect. At these companies, the compliance staff obviously were
aware of violations of company policies for several years and, in some
cases, had documented their findings in internal reports. In one case,
the sales staff at the mutual fund company overrode the compliance
staffs' efforts to control hundreds of market timing transactions
between 1998 and 2003. In another case dating from 2002, the company's
compliance officer sent a memorandum to the company's chief executive
officer complaining about the long-term effects of market timing
arrangements on long-term shareholders. In a January 2003 memorandum,
the compliance officer notified the chief executive officer that the
company was a "timer-friendly complex" and had granted numerous
exceptions to company trading restrictions, which was not consistent
with protecting customer interests. In another case, an internal
company study from the fall of 2002--that was widely circulated among
company executives--found similar abuses and recommended that the
company terminate market timing arrangements, but the company did not
do so until the summer of 2003.
In cases we reviewed, company compliance staff or other officials had
taken action against company officials for failure to comply with
market timing policies, but their actions did not always deter this
behavior. In 2000, compliance staff at one company found that the
chairman had engaged in market timing contrary to shareholder interests
and warned him to stop the practice. However, the chairman continued to
engage in market timing until SEC identified his abusive practices in
2003. Compliance staff of another investment adviser to a large fund
identified a senior fund manager who engaged in market timing in
violation of internal policies in 2000. Officials warned the fund
manager to stop the practice, but he resisted and continued the market
timing until 2003.
SEC Has Taken Steps to Strengthen Its Mutual Fund Oversight Program,
but It Is Too Soon to Assess the Effectiveness of Several Key
Initiatives:
Over the past 2 years, SEC staff has taken steps to better detect
abusive practices in the mutual fund industry and plans significant
changes to its overall examination program. For example, SEC staff has
implemented guidance instructing examiners to conduct expanded reviews
of company controls and make increased use of internal company reports
in doing so, although examiners still are not expected to request
listings of all relevant reports. SEC has also established the Office
of Risk Assessment (ORA) to help the agency better anticipate,
identify, and manage emerging risks and market trends. However, it is
too soon to assess ORA's effectiveness. SEC and NASD have also brought
numerous enforcement actions for mutual fund violations, and SEC has
hired additional staff and established new procedures for handling
tips. In addition, SEC has amended existing rules and adopted new rules
to help improve fund operations and better protect investors, including
a requirement that in order for mutual funds to rely on certain
exemptive rules, the chairperson and at least 75 percent of a mutual
fund's board be independent of the mutual fund's investment
adviser.[Footnote 24] SEC also adopted a compliance rule that requires
mutual fund company boards to designate CCOs whose duties include
preparing annual reports on the adequacy of the company's policies and
procedures to ensure compliance with the federal securities laws.
Although the compliance rule has the potential to strengthen mutual
fund company operations, certain CCOs may still face organizational
conflicts of interest in carrying out their duties, of which SEC must
be cognizant in its oversight responsibilities. Moreover, SEC has not
developed a plan to ensure that its staff receive and review the annual
reports prepared by CCOs on an ongoing basis to detect potential
violations and identify emerging trends in the mutual fund industry.
SEC's Examination-Related Initiatives Were Designed to Strengthen
Mutual Fund Oversight:
SEC staff has issued guidance designed to provide examiners with an
overall perspective on the risks facing mutual fund companies and the
adequacy of controls to mitigate those risks. For example, in November
2003, SEC staff directed its examination staff to request in planning
examinations that mutual fund company officials provide written
summaries of any compliance problems or violations, or repeated
compliance problems, that occurred after the company's last
examination. According to SEC staff, this information previously had
been requested orally but SEC staff were not confident that fund
companies were providing all information orally, and thus formalized
this process. According to testimony by OCIE's director on March 10,
2004, the agency has also begun to make increased use of interviews of
company officials in conducting mutual fund examinations. The director
stated that interviews had begun to play an increased role in assessing
companies' critical risks and control environments.
In late 2002, nearly a year before the NYSOAG identified the market
timing and late trading violations, SEC staff revised its guidance for
mutual fund examinations, including expanded requests for internal
company documents, but it is not clear that the revised guidance is
sufficient to fully assist in identifying abusive practices. Under the
revised risk-based guidelines, SEC examiners are expected to complete
"scorecards" during routine examinations for specific areas, such as
personal trading by company insiders, which SEC staff has identified as
presenting possible risks to mutual fund companies.[Footnote 25] In
general, each scorecard requires SEC examiners to perform several steps
to assess the adequacy of company controls for each risk area. For
example, examiners are expected to identify the company official
responsible for establishing controls for each risk area and identify
the documentation reviewed to assess the adequacy of identified
controls. Additionally, the scorecards direct SEC examiners to record
their overall observations about the adequacy of company controls for
each of the risk areas. As part of the examination planning process,
SEC staff also now request that mutual fund companies provide copies of
management reports, self-assessments, exception reports, and internal
audit and other reports relevant to the 13 risk areas. Although
requesting these internal reports should enhance SEC's capacity to
oversee mutual fund companies, we note that other areas that the agency
has not considered could pose significant risks. To illustrate, prior
to the detection of the mutual fund trading abuses in September 2003,
SEC staff did not anticipate that investment advisers would enter into
undisclosed market timing arrangements with favored customers.
Therefore, it is not clear that SEC's expanded procedures for
collecting internal audit and other reports would have resulted in
companies producing any reports that addressed this activity.
SEC staff has also implemented examination procedures designed to
detect market timing abuses. More specifically, SEC staff now instruct
examiners to review (1) fund sales and redemption (shareholder
turnover) data to detect patterns of market timing; (2) a sample of
internal e-mails of fund executives to detect misconduct not reflected
in the fund's books and records, such as agreements to allow certain
investors to market time; and (3) the personal trading of fund
executives. In addition, SEC staff directs examiners to speak with
company compliance officials regarding their efforts to control market
timing.
SEC staff also plan to significantly revise its approach to mutual fund
examinations and are evaluating the development of a surveillance
system to monitor the industry. (We review both initiatives in a
forthcoming report.) Traditionally, SEC has relied on routine
examinations of all mutual funds over a specified cycle to carry out
its oversight responsibilities. Between 1998 and 2003, SEC established
an examination cycle that would ensure that each investment company and
its advisers would be examined once every 5 years. In mid-2004, SEC
staff told us that they planned to move from scheduled examinations of
all mutual fund companies to a system where they focused examination
resources on the largest and riskiest companies and advisers (200 fund
groups and 600 advisers). To focus on the largest entities, SEC staff
is creating monitoring teams of two or three examiners to review the
companies' operations on an ongoing basis. According to OCIE staff,
they have not yet determined the specific roles and responsibilities of
the monitoring teams but generally expect the teams also would monitor
their assigned fund company by periodically contacting fund compliance
staff and conducting a program of continuous inspections. According to
the staff, they would also continue to examine advisers and funds with
higher risk profiles every 2 to 3 years, and conduct random inspections
of some portion of the remaining firms. We note that SEC's planned
approach for large mutual fund companies is similar to the bank
regulators' approach to bank supervision, in which examiners are
permanent members of a monitoring team assigned to monitor the largest
institutions. Concerning the surveillance system, an SEC task force is
currently considering the development of an automated system that would
allow agency staff to monitor the industry by reviewing company
financial and other data that may indicate systemic risks or potential
problems at individual companies. According to SEC staff, such
information could help target examination resources toward the highest
potential risks. SEC staff also said that the task force has been
making progress but has not set a time frame for providing SEC with its
proposal.
According to NASD officials, in response to the recent mutual fund
scandals, NASD has also changed its examination modules to detect
market timing and late trading abuses at broker-dealers, making these
issues more prominent in broker-dealer examinations. NASD examiners ask
a series of questions and review documentation of broker-dealers to
help determine if inappropriate activity is taking place. NASD also
employs a risk-assessment strategy to rate the level of risk associated
with a broker-dealer and determines how often it will be examined.
SEC Established a New Office to Identify and Manage Emerging Risks:
SEC has established ORA to assist the agency in carrying out its
overall oversight responsibilities, including mutual fund oversight.
The office's director reports directly to the SEC chairman. According
to SEC staff, ORA will enable agency staff to analyze risk across
divisional boundaries, focusing on early identification of new or
resurgent forms of fraudulent, illegal, or questionable behavior or
products. ORA's duties include (1) gathering and maintaining data on
new trends and risks from external experts, domestic and foreign
agencies, surveys, focus groups, and other market data; (2) analyzing
data to identify and assess new areas of concern across professions,
companies, industries, and markets; and (3) preparing assessments and
forecasts on the agency's risk environment. SEC staff said that ORA
will seek to ensure that SEC will have the information necessary to
make better, more informed decisions on regulation. This new office is
to work in coordination with internal risk teams established in each of
the agency's major program areas and a Risk Management Committee
responsible for reviewing implications of identified risks and
recommending appropriate courses of action. Working with other SEC
offices, ORA staff expect to identify new technologies, such as data
mining systems that can help agency staff detect and track risks.
Although ORA may help SEC be more proactive and better identify
emerging risks, it is too soon to assess its effectiveness. In this
regard, we note that as of February 2005, ORA had established an
executive team of 5 individuals but still planned to hire an additional
10 staff to assist in carrying out its responsibilities.
SEC and NASD Have Taken a Number of Enforcement Actions for Abusive
Market Timing and Late Trading:
Based on examination findings both SEC and NASD have taken enforcement
actions against investment advisers to mutual fund companies, broker-
dealers, and other regulated persons and entities who have engaged in
market timing and late trading. As of February 28, 2005, SEC had
settled 14 enforcement actions against investment advisers generally
for facilitating market in their own funds (see fig. 1). SEC has also
brought 10 enforcement actions against broker-dealer, brokerage-
advisory, and financial services firms for market timing abuses and
late trading and, as of February 28, 2005, settled five of these cases
for about $17 million. SEC also has brought enforcement actions against
individuals associated with investment advisers and other firms and has
obtained significant penalties ($30 million in one case) and barred
several officials from the securities industry for life. The penalties
and disgorgements (which force firms to give up ill-gotten gains) SEC
has obtained in all of the settlements total about $2 billion. In
addition to penalties and disgorgements, SEC settlements contained
undertakings that required companies to improve their corporate
governance structure and practices. NASD has taken 12 actions against
broker-dealers for late trading and market timing abuses with fines and
restitutions totaling more than $6 million. NASD has also imposed
restrictions on broker-dealers. A forthcoming GAO report will address
all SEC enforcement actions related to the mutual fund trading abuses
in greater detail.
Figure 1: SEC Settled Enforcement Actions against Investment Advisers
Related to Market Timing Violations as of February 28, 2005 (dollars in
thousands):
[See PDF for image]
[A] The entities named in this column are investment advisers
associated with this cases. In some cases, SEC simultaneously charged
other entities, such as an associated investment adviser, distributor,
or broker-dealer for their role in the market timing abuses. The
penalties and disgorgements shown for each case are the totals obtained
in settlement from all the entities associated with the case.
[B] Bank of America settled charges involving both abusive market
timing and late trading on the part of its investment adviser and
broker-dealer subsidiaries, respectively.
[C] Fremont Investment Advisors, Inc. settled charges involving both
abusive market timing and late trading.
[End of figure]
SEC Has Hired Additional Staff to Carry Out Its Oversight
Responsibilities:
In recent years, Congress has given SEC substantial budgetary increases
to assist it in overseeing the securities markets and increase the
agency's effectiveness. SEC staff positions in the areas that pertain
to the agency's regulation and oversight of the mutual fund industry
are shown in table 1. Between 2002 and 2005, SEC increased the staffing
for OCIE and the Division of Enforcement by 38 and 29 percent,
respectively. SEC also increased staffing within Investment Management
by 16 percent. SEC staff told us that many of the new personnel have
been working on mutual fund issues. While the additional staff has the
potential to enhance SEC's capacity to oversee key areas such as the
mutual fund industry, we previously reported that the agency hired the
staff without having updated its strategic plan.[Footnote 26] In the
absence of a strategic plan that identified the agency's priorities and
aligned those priorities with an effective human capital program, it is
not clear that SEC's hiring decisions ensured that the right
individuals were in place to do the most effective job possible. In
August 2004, SEC revised its strategic plan. We are reviewing SEC's
strategic workforce planning effort as part of a separate engagement.
Table 1: Staff Positions for SEC Divisions and Offices with
Responsibilities for Mutual Fund Regulation, Oversight, and
Enforcement, as of February 2005:
SEC Unit: Division of Investment Management[B];
Actual 2002[A]: 173;
Actual 2003[A]: 167;
Actual 2004[A]: 190;
Estimated 2005[A]: 200;
Percent change 2002-2005[A]: 16%.
SEC Unit: OCIE[C];
Actual 2002[A]: 397;
Actual 2003[A]: 439;
Actual 2004[A]: 513;
Estimated 2005[A]: 547;
Percent change 2002-2005[A]: 38%.
SEC Unit: Division of Enforcement[D];
Actual 2002[A]: 980;
Actual 2003[A]: 1,016;
Actual 2004[A]: 1,308;
Estimated 2005[A]: 1,338;
Percent change 2002-2005[A]: 37%.
Source: GAO analysis of SEC data.
[A] Fiscal years.
[B] Includes staff in the office that administers the Public Utility
Holding Company Act of 1935.
[C] The amounts for OCIE include all staff in SEC's headquarters and
regional offices who support or conduct examinations of mutual funds
and investment advisers.
[D] The amounts for the Division of Enforcement include all staff in
SEC's headquarters and regional offices who support or conduct
enforcement activities over mutual funds, investment advisers, broker-
dealers, and all other entities that SEC regulates.
[End of table]
SEC Has Acted to Improve Its Tip Handling Processes:
Since the mutual fund trading abuses surfaced, SEC has acted to improve
its processes for handling tips and complaints. SEC's Division of
Enforcement, which receives enforcement-related tips and complaints,
has centralized its process for receiving, analyzing, and responding to
tips from the public. According to the head of the office that
administers the division's tip handling process, before the abuses were
detected the division had no process for regional and district office
staff to refer complaints and tips to headquarters for review and no
system by which management could review how staff handled complaints
and tips. Under the new process, information concerning all enforcement-
related tips and complaints, whether received through telephone calls,
correspondence, e-mails, or in-person, is reported to and maintained by
a dedicated group within SEC headquarters. That group maintains a
centralized log of all complaints and tips, which includes the date of
the complaint or tip, the name, address, and telephone number of the
complainant, and the nature of the complaint or tip. It also includes a
summary of the action taken by staff in response to the complaint or
tip--such as assigned to division staff for follow-up, referred to
another SEC unit for further investigation, or referred to another
agency. According to the office head, senior management within the
division review the log regularly to confirm that each complaint or tip
was appropriately handled by staff. Additionally, Investment Management
and OCIE have taken recent steps to strengthen their collection and
analysis of tips received from the public or referrals of potential
violations received from other SEC offices or regulatory agencies.
SEC Has Adopted Rules Designed to Improve Mutual Fund Company
Operations, but Questions Remain about the Implementation of the
Compliance Rule:
Since late 2003, SEC has adopted seven new rules and 3 amendments
designed to improve fund operations and to protect investors (see table
2). Among the most significant initiatives, SEC adopted a series of
amendments to its exemptive rules on July 27, 2004, that are intended
to strengthen mutual fund company governance. In SEC's press release
regarding these rule amendments, SEC stated that investment advisers
may dominate mutual fund company boards and management and that the
advisers have inherent conflicts of interest in carrying out their
responsibilities. SEC further stated that independent board members can
minimize these potential conflicts of interest and act to protect
shareholder interests. Accordingly, SEC now requires that in order for
a mutual fund company to rely on the exemptive rules, at least 75
percent of the members of its board of directors must be independent
and the board chair must also be independent. SEC also required fund
directors to assess at least annually the performance of the fund board
and its committees. This annual self-assessment requirement is intended
to improve fund performance by strengthening directors' understanding
of their role and fostering better communications and greater
cohesiveness. Moreover, SEC believes that the annual review will assist
fund boards in identifying potential weaknesses in the boards'
performance.
Table 2: SEC Mutual Fund-related Rules, Adopted after September 2003:
Rule name: Compliance Rule;
Date adopted: December 17, 2003;
Description of rule: Requires each investment company and investment
adviser registered with SEC to adopt and implement written policies and
procedures reasonably designed to prevent violation of the federal
securities laws and the Advisers Act, respectively, review those
policies and procedures annually for their adequacy and the
effectiveness of their implementation, and designate a chief compliance
officer (CCO) to be responsible for administering the policies and
procedures.
Rule name: Shareholder Reports and Quarterly Portfolio Disclosures of
Registered Management Investment Companies;
Date adopted: February 24, 2004;
Description of rule: Requires a registered management investment
company to include in its shareholder reports disclosure of fund
expenses borne by shareholders during the reporting period. Also
permits a registered management investment company to include a summary
portfolio schedule of investments in its reports to shareholders,
provided that the complete schedule is filed with SEC and is provided
to shareholders upon request, free of charge.
Rule name: Disclosure Regarding Market Timing and Selective Disclosure
of Portfolio Holdings;
Date adopted: April 16, 2004;
Description of rule: Requires open-ended management investment
companies to disclose in their prospectuses both the risks to
shareholders of frequent purchases and redemptions of investment
company shares, and the investment company's policies and procedures
with respect to such frequent purchases and redemptions.
Rule name: Disclosure Regarding Approval of Investment Advisory
Contracts by Directors of Investment Companies;
Date adopted: June 23, 2004;
Description of rule: Requires a registered management investment
company to provide disclosure in its reports to shareholders regarding
the material factors and the conclusions with respect to those factors
that formed the basis for the board's approval of advisory contracts
during the most recent fiscal half-year.
Rule name: Investment Adviser Codes of Ethics;
Date adopted: July 2, 2004;
Description of rule: Requires that registered investment advisers adopt
codes of ethics that sets forth standards of conduct expected of
advisory personnel and address conflicts that arise from personal
trading by advisory personnel. Among other things, the rule requires
advisers' supervised persons to report their personal securities
transactions, including transactions in any mutual fund managed by the
adviser.
Rule name: Investment Company Governance;
Date adopted: July 27, 2004;
Description of rule: A series of amendments to certain exemptive rules
under the 1940 Act that are designed to enhance the independence and
effectiveness of fund boards and to improve their ability to protect
the interests of the funds and fund shareholders they serve. The
amended rules require that in order for mutual funds to rely on any of
10 commonly used exemptive rules, the chairperson and at least 75
percent of the members of mutual fund boards of directors be
independent of the funds' investment advisory firms.
Rule name: Disclosure Regarding Portfolio Managers of Registered
Management Investment Companies;
Date adopted: August 23, 2004;
Description of rule: A series of amendments to forms prescribed under
the Securities Act of 1933, the Securities and Exchange Act of 1934,
and the 1940 Act, which among other things extends the existing
requirement that a registered management company provide basic
information in its prospectus regarding its portfolio managers to
include the members of management teams. The amendments also require a
registered management investment company to disclose additional
information about its portfolio managers, including other accounts they
manage, compensation structure, and ownership of securities in the
investment company.
Rule name: Prohibition on the Use of Brokerage Commissions to Finance
Distribution;
Date adopted: September 2, 2004;
Description of rule: Amends rule under the 1940 Act that governs the
use of assets of open-end management investment companies to
distribute their shares. The amended rule prohibits funds from paying
for the distribution of their shares with brokerage commissions.
According to SEC, the amendments are designed to end a practice that
poses significant conflict of interest and may be harmful to funds and
fund shareholders.
Rule name: Registration Under the Advisers Act of Certain Hedge Fund
Advisers;
Date adopted: December 2, 2004;
Description of rule: Requires advisers to certain private investment
pools (hedge funds) to register with the SEC under the Advisers Act.
The rule and amendments are designed to provide the protections
afforded by the Advisers Act to investors in hedge funds.
Rule name: Mutual Fund Redemption Fees;
Date adopted: March 11, 2005;
Description of rule: Prohibits funds from redeeming shares within 7
calendar days after purchase, unless (i) the fund's board has either
approved a redemption fee or determined that a redemption fee is not
necessary or appropriate; (ii) the fund (or its principal underwriter)
has entered into a written agreement with each of its financial
intermediary under which the intermediary agrees to provide certain
shareholder transaction information to the fund and to execute the
fund's instructions to restrict or prohibit future purchases or
exchanges by any shareholder; and (iii) the fund maintains copies of
such agreements with its financial intermediaries for at least six
years. The rule authorizes funds that adopt a redemption fee to impose
a redemption fee up to 2 percent of the amount redeemed.
Source: GAO analysis of the Federal Register.
[End of table]
Additionally, SEC adopted compliance rules on December 17, 2003, that
required all investment companies and investment advisers that are
registered or should be registered with SEC to adopt policies and
procedures reasonably designed to prevent violation of federal
securities laws and the Advisers Act, and designate a CCO to be
responsible for administering the policies and procedures. The CCO
should be in a position of authority to compel others to adhere to the
compliance policies and procedures, and the investment company CCO must
report directly to the company's board of directors. The rules further
require that each investment company and investment adviser conduct at
least annually reviews of their policies and procedures and that the
CCOs submit a written report to the board regarding their policies and
procedures. An investment company must also review and the CCO must
report on the policies and procedures of its investment adviser and
certain other service providers. Under the investment company
compliance rule, these reports, at a minimum, must address (1) the
operation of the policies and procedures of each fund and each
investment adviser, principle underwriter, administrator, and transfer
agent for the fund; (2) any material changes to those policies and
procedures since the date of the last report; (3) any material changes
to the policies and procedures recommended as a result of the annual
review; and (4) each material compliance matter that occurred since the
date of the last report. The rules require that investment companies
and investment advisers maintain copies of all policies and procedures
that are or were in effect in the previous 5 years and maintain records
documenting annual reviews. Investment companies must retain copies of
the written reports for 5 years. According to SEC staff, the compliance
rule provides companies flexibility in carrying out provisions relating
to the annual reviews. For example, SEC staff said that a CCO could use
company internal audit departments to assess company compliance with
laws and regulations rather than hiring separate staff. SEC staff also
said that the companies may continue to use internal audit departments
to carry out internal compliance and other reviews and that such
departments will likely work closely with CCOs.[Footnote 27]
Although the compliance rules have the potential to improve mutual fund
company operations and address compliance staff independence
deficiencies, certain CCOs may face organizational conflicts of
interest. By requiring a fund's CCO to report to the board of directors
and to meet separately, at least annually, with the independent
directors, the rule helps ensure that compliance findings would not be
routinely overruled by the investment adviser or other officials.
However, in the rule, SEC also contemplates that the CCO could be an
employee of the investment adviser. SEC stated that permitting the CCO
to be an employee of the adviser is necessary because many investment
companies do not have any employees. SEC found that prohibiting CCOs
from being employees of an investment adviser company would result in a
situation where the investment company's CCO would be divorced from the
day-to-day fund operations and totally dependent on information
filtered through the adviser. SEC stated that the rule mitigates
potential conflicts of interest by prohibiting removal of the fund
company's CCO without the approval of the fund company's board of
directors, including a majority of the independent directors. However,
given that investment advisers typically entered into market timing
arrangements to the detriment of mutual fund shareholders, the fact
that a mutual fund's CCO could be employed by an investment adviser
raises potential concerns about the effectiveness of such officers, a
situation of which SEC must be cognizant when overseeing the rule's
implementation. SEC staff said that they plan to review implementation
of the compliance rules and requirements as part of the investment
company and investment advisers examination process, as resources
permit.
SEC staff also said that the agency plans to use the compliance reports
as part of the examination planning process. An OCIE staff member said
that by requesting the compliance reports and reviewing them prior to
examinations, agency examiners may be able to identify problems at
mutual fund companies and determine whether the companies have
implemented corrective actions. However, the OCIE staff member said
that the rule does not require mutual fund companies to submit the
annual reports to the agency for its ongoing review.
By not establishing a process for SEC staff to receive the compliance
reports on an ongoing basis, SEC may be missing an opportunity to
enhance its mutual fund oversight program. Under the rule, CCOs are
required to perform comprehensive assessments of mutual fund operations
and report on their findings annually. As demonstrated in this report,
compliance staff may be well aware of violations that SEC and other
regulators had not even considered. Given that SEC has limited
examination resources and certain companies may not be examined for
extended periods, reviewing the compliance reports on an ongoing basis
could provide valuable information to SEC by indicating emerging
problems at mutual fund companies or unmitigated risks at individual
companies. Further, reviewing the reports could provide insights to SEC
as to how the compliance rule is being implemented within the mutual
fund industry. With such information--potentially in conjunction with a
surveillance system--the agency may be able to better target
examinations towards high-risk areas and identify emerging trends in
the mutual fund industry.
We also note that SEC has adopted two specific rules designed to
address market timing and is working on a rule designed to prevent late
trading. On March 11, 2005, SEC adopted a rule that allows mutual fund
companies to establish redemption fees on a voluntary basis.[Footnote
28] The rule prohibits funds from redeeming shares within 7 calendar
days after they are purchased, unless, among other requirements, the
fund's board has previously determined that the imposition of a
redemption fee on shares redeemed within the 7-day holding period is
either in the best interest of the fund or that such a fee is not
necessary or appropriate.[Footnote 29] By imposing redemption fees on,
for example, the proceeds of fund shares redeemed within 7 calendar
days of a purchase, SEC believes that mutual fund companies may be able
to increase the costs associated with frequent trading and the
financial incentives to do so. Also, directly addressing the market
timing issue, SEC adopted a rule on April 16, 2004, requiring funds to
make disclosures regarding market timing and selective disclosure of
portfolio holdings. To stop late trading, SEC in late 2003, proposed
that all orders for fund transactions be received by mutual funds or
designated processors, which are regulated by SEC, no later than the
time the fund calculates its current day's price (usually 4:00 p.m.) in
order to receive that day's price (the "hard 4" close
proposal).[Footnote 30] However, due, in part, to industry concerns
about the fairness and potential costs of the proposal, SEC has not yet
adopted it and is assessing whether there are more cost-effective ways
to achieve the same result. SEC is continuing to work with industry
officials and considering alternative proposals that would address
industry concerns while curtailing late trading. We discuss the
proposed rule in more detail in appendix III.
Conclusions:
The undisclosed market timing arrangements and late trading abuses
detected in September 2003 represented one of the most widespread and
serious scandals in the history of the mutual fund industry. SEC has
determined that undisclosed market timing arrangements, in particular,
existed at many large mutual fund companies for as long as 5 years.
However, prior to 2003, SEC did not identify the undisclosed
arrangements between investment advisers and favored customers through
the agency's oversight process. Although SEC staff faced competing
examination priorities that may have affected its capacity to detect
the abusive practices and has taken several recent steps intended to
strengthen its mutual fund company oversight program and improve
company operations, several lessons can be drawn from the experience.
* First, performing independent assessments of company controls is
critical to confirm agency views regarding risks and the adequacy of
controls in place to address those risks. Even where regulated entities
may have a seeming interest in controlling a particular risk, abusive
or fraudulent activity can take place. Over the past 2 years, SEC has
hired additional examination staff and implemented a risk-based
approach to mutual fund company examinations that provides for
increased assessments of controls.[Footnote 31] SEC's staff's revised
examination guidance also expands the types of written reports (such as
internal audit reports) that examiners are to request in planning
examinations, although SEC still does not direct examiners to request
listings of all such reports. Requesting such listings could assist SEC
staff in detecting potential violations at an earlier stage.
* Second, the agency must develop the institutional capacity to
identify and evaluate evidence of potential risks and deploy
examination staff as necessary to review controls and potentially
detect violations in these areas. SEC has established ORA to help guide
the agency in better assessing new or emerging risks, but the office is
still hiring staff and establishing its position within the agency. SEC
has also implemented revised tip handling procedures, which have the
potential to enhance the agency's capacity to detect potential abuses.
It remains to be seen how well these new procedures work.
* Third, ensuring the independence of the compliance function is
central to preventing violations of the securities laws, regulations,
and fund policies. Company compliance staff must have sufficient
independence to carry out their responsibilities. By adopting the
compliance rule, SEC created a system that has the potential to
significantly improve mutual fund companies' compliance with laws and
regulations and help ensure the independence of compliance staff. CCOs
also may serve as valuable partners to SEC by reviewing and testing a
variety of controls. However, in adopting the rule, SEC also made a
conscious trade-off between the need to improve industry compliance and
the costs that would be imposed on mutual fund companies. In permitting
an investment company's designated CCO to be employed by the advisory
firm, SEC recognized that CCOs might face organizational conflicts of
interest in fulfilling their responsibilities. The fact that fund
company boards, with the approval of a majority of the independent
directors, have sole authority to remove fund company compliance
officers may mitigate some of these risks. However, it is uncertain at
this time how effectively CCOs faced with potential conflict of
interests, including possibly conflicting financial incentives as
illustrated in some of the cases we reviewed, will carry out their
responsibilities. Given the widespread nature of the abuses identified
at mutual fund companies, we believe that the failure of companies to
comply with the rule's provisions would likely warrant a significant
response by SEC through the agency's civil enforcement authority or
referrals to criminal authorities as deemed necessary.
We also note that while SEC staff plans to request annual reports
prepared by CCOs under the compliance rule during the examination
planning process, SEC staff does not require fund companies to submit
the annual reports to SEC on an ongoing basis. Obtaining access to the
annual compliance reports and regularly reviewing them or their
material findings is essential to assist SEC in monitoring mutual fund
companies during the potentially long intervals between examinations of
certain companies.
Recommendations:
To enhance the effectiveness of SEC's mutual fund oversight program and
help strengthen company operations, we recommend that the Chairman,
SEC, take the following three actions:
* Consistent with the agency's legal authority, request lists of all
compliance-related internal company reports during the examination
planning process and review such reports as necessary to obtain a broad
perspective on the risks identified by individual companies and the
adequacy of controls in place to monitor those risks;
* Ensure that examination staff assess the independence and
effectiveness of mutual fund company CCOs as a component of all mutual
fund company examinations; and:
* Develop a plan to receive and review mutual fund company and adviser
annual compliance reports, or the material findings thereof, on an
ongoing basis.
Agency Comments and Our Evaluation:
SEC provided written comments on a draft of this report, which are
reprinted in appendix IV. SEC and NASD also provided technical
comments, which were incorporated into the final report, as
appropriate. SEC generally agreed with our recommendations. SEC noted
the importance of its testing of internal controls, and that SEC
examiners now review mutual fund controls for market timing and fair
value pricing and that it anticipates providing additional guidance to
assist funds and their advisers in adopting appropriate controls over
the use of fair value pricing. SEC indicated that it had started
assessing the role of CCOs and that it is preparing formal examination
guidance for its examination staff to use in these assessments.
Additionally, SEC noted that it is considering how to best utilize the
new mutual fund annual compliance reports, of which any required filing
with the agency may require further rulemaking.
SEC did not directly address our recommendation on requesting listings
of all compliance-related internal reports, but suggested that such
reviews would be included in its testing of internal controls. We
continue to believe that requesting lists of all reports would be
beneficial for SEC's oversight program by assisting staff in detecting
potential violations.
SEC identified a number of steps it has taken to strengthen its mutual
fund oversight program. Our assessment of some of these recent actions
will be addressed in a forthcoming report.
As agreed with your office, unless you publicly announce the contents
of this report earlier, we plan no further distribution of this report
until 30 days from the report date. At that time we will provide copies
of this report to SEC, NASD, and interested congressional committees.
We will also make copies available to others upon request. In addition,
the report will be available at no cost on GAO's Web site at
[Hyperlink, //www.gao.gov].
If you or your staff have any questions about this report, please
contact Wesley M. Phillips, Assistant Director, or me at (202) 512-
8678. GAO staff who made major contributions to this report are listed
in appendix V.
Signed by:
Richard J. Hillman:
Director, Financial Markets and Community Investment:
[End of section]
Appendixes:
Appendix I: Objectives, Scope, and Methodology:
Because market timing violations were more widespread than late trading
violations and the Securities and Exchange Commission (SEC) is the
mutual fund industry's frontline regulator, the report primarily
focuses on SEC's oversight of the market timing area. The report also
addresses the National Association of Securities Dealers' (NASD)
oversight of broker-dealers that failed to prevent customers' market
timing and late trading activity but does not discuss late trading at
pension plans and their administrators, which are subject to Department
of Labor oversight. Accordingly, the report (1) identifies the reasons
that SEC did not detect the abusive market timing agreements at an
earlier stage and lessons learned from the agency's failure to do so;
and (2) assesses steps that SEC has taken to strengthen its mutual fund
oversight, deter abusive trading, and improve mutual fund company
operations.
To determine why SEC did not detect the abusive market timing
agreements at an earlier stage and what lessons can be learned from the
agency not doing so, we interviewed SEC staff at a judgmental sample of
six regional and district offices located nationwide, NASD officials;
representatives from the New York State Office of the Attorney General,
the Investment Company Institute (ICI), a judgmental sample of large
mutual fund companies, and we contacted academic officials. We also
reviewed relevant agency testimony, academic and other studies, and
other documents. At the six SEC offices, we reviewed documentation
pertaining to 11 mutual fund companies against which SEC had filed
enforcement actions for market timing abuses and late trading
violations. These mutual fund companies were among the largest 100
mutual fund companies nationwide as measured by the size of customer
assets under management as of August 1, 2003. We reviewed the
enforcement actions pertaining to these companies, related
documentation, and SEC examinations for each of these companies or
their investment advisers dating back several years. In addition, we
reviewed examination guidelines at the Federal Deposit Insurance
Corporation, the Federal Reserve System, and the Office of the
Comptroller of the Currency, and generally accepted government auditing
standards, particularly the standards relating to internal control
reviews. We then compared SEC staff's approach to reviewing mutual fund
market timing controls with these general examinations and auditing
standards. We also discussed with NASD the reasons that it did not
detect mutual fund-related abuses at broker-dealers for which it has
direct oversight responsibility.
To identify steps regulators had taken to strengthen mutual fund
oversight programs and enhance controls at mutual fund companies and
intermediaries, we interviewed SEC and NASD staff and reviewed relevant
agency documents as well as GAO reports and testimonies. We determined
what modifications the regulators had made to their examination
programs or plan to make, reviewed various final rules adopted since
September 2003 to improve mutual fund company operations and investor
protection, reviewed a proposed rule regarding late trading, and
reviewed regulators' enforcement actions for market timing and late
trading. In addition, we reviewed SEC procedures for handling tips and
complaints. Additionally, we interviewed officials of the National
Securities Clearing Corporation (NSCC), ICI, the Securities Industry
Association, pension plans, broker-dealers, and mutual fund companies.
Our work was performed in Atlanta, Ga; Boston, Mass; Chicago, Ill.,
Denver, Colo; New York, N.Y; Philadelphia, Pa; and Washington, D.C. We
conducted our work between May 2004 and April 2005 in accordance with
generally accepted government audit standards. SEC provided written
comments on a draft of this report, which are reprinted in appendix IV.
SEC and NASD also provided technical comments, which were incorporated
into the final report, as appropriate. Our evaluation of these comments
is presented in the agency comments and our evaluation section.
[End of section]
Appendix II: Mutual Fund Trade Processing and Recordkeeping:
Individual investors generally can purchase, exchange, or sell fund
shares through multiple channels either directly from fund companies or
through various intermediaries such as broker-dealers, financial
planners, banks, insurance companies, retirement plan sponsors, and
fund "supermarkets." To simplify and reduce the costs of mutual fund
transactions, intermediaries collect orders throughout the day and then
aggregate all the transactions they receive for a particular fund.
Those intermediaries that are licensed, such as broker-dealers, may
net, or match, purchase and redemption orders for the same funds among
their own clients. In a simplified example, if one investor were to
purchase 15 shares of fund A, and another investor were to redeem 10
shares of fund A, at the end of the day the intermediary could simply
transmit one order to purchase 5 shares of fund A--the net result of
the day's orders. Intermediaries then transmit the net results of
aggregate transactions to the mutual fund companies, where the
intermediaries hold omnibus accounts representing the collective shares
of their clients. Mutual fund companies generally do not have
information about the identities and specific transactions of the
individual investors in intermediaries' omnibus accounts.
Intermediaries have contact with their clients, such as defined
contribution plan participants and other individual investors ("retail
investors"), and control access to information about their trading
activity. ICI officials told us that, presently about 80 percent of
mutual fund orders are through intermediaries and most of these are
processed through omnibus accounts.
Mutual fund intermediaries accept purchase and redemption orders
throughout the day and are supposed to submit to funds only those
orders received by 4:00 p.m. Eastern Time to receive that same day's
net asset value (NAV), but an order received at 4:01 p.m. or later
would be submitted to receive the next day's NAV. According to
Securities and Exchange Commission Rule 22c-1 under the 1940 Act,
mutual funds are required to calculate current NAV at least once every
business day at a specific time (usually at 4:00 p.m.)[Footnote 32]
However, intermediaries are allowed to aggregate the orders they
receive prior to fund's designated price calculation time and submit
them to mutual fund companies as omnibus account transactions later in
the evening for settlement, either directly or through their transfer
agents or NSCC.[Footnote 33] Figure 2 illustrates how orders for mutual
fund transactions are transmitted from retail investors and plan
participants to mutual fund companies, either directly or through
intermediaries.
Figure 2: Processing Paths of Mutual Fund Transactions:
[See PDF for image]:
[End of figure]:
Most employers that sponsor defined contribution plans subcontract the
various administrative tasks of plan recordkeeping to companies that
have expertise in the administration of plans or investments. Pension
plan record keepers are intermediaries that keep track of day-to-day
transactions for each plan participant's account. The recordkeeper is
responsible for transactions--such as crediting accounts with employee
and employer contributions, processing changes in participant-directed
investment allocations, updating account values (usually each business
day) to reflect changes in the values of mutual fund shares held by
each plan participant--and acting as a mutual fund intermediary when
participants make exchanges between funds. In addition, recordkeepers
may function as the primary source of plan information and customer
service for plan participants.
[End of section]
Appendix III: SEC Proposed Rule to Prevent Late Trading:
Late in 2003, SEC proposed amending the rule that governs how mutual
funds price and receive orders for share purchases or sales.[Footnote
34] Since many of the cases of late trading involved orders submitted
through intermediaries, including banks and pension plans not regulated
by SEC, the proposed amendments would have required that orders to
purchase or redeem mutual fund shares be received by a fund, its
transfer agent, or a registered clearing agency--entities that are
regulated by SEC--before the time of pricing (usually 4:00 p.m. Eastern
Time). However, SEC has not yet acted on the "hard 4" close proposal
due in part to industry concerns about the associated costs and other
factors, and is assessing whether there are more cost effective ways to
achieve the same result.
Many organizations that purchase mutual fund shares, particularly those
that administer retirement savings plans have expressed concerns that
such a "hard close" would unfairly prohibit some of their participants
from receiving the same day's price on share purchases. Because
intermediaries generally combine individual investor orders and submit
single orders to funds to buy or sell, many officials at such firms are
concerned that the time required to complete this processing will not
allow them to meet the 4:00 p.m. deadline. In such cases, investors
purchasing shares from western states or through intermediaries would
either have to submit their trades earlier than other investors in
order to receive the current day's price or receive the next day's
price. Some plan sponsor organizations and plan recordkeepers have also
argued that they would face significant administrative costs in
adopting systems to accommodate the 4:00 p.m. hard close.[Footnote 35]
An alternative approach to control late trading, proposed by retirement
plans and some broker-dealers, is referred to as the "smart 4"
approach, which would require all companies that want to accept orders
until the market close, and process them thereafter, to adopt a three-
part series of controls: (1) electronic time stamping of all
transactions so all trades could be tracked from the initial customer
to the mutual fund company; (2) annual certifications by senior
executives that their companies have procedures to prevent or detect
unlawful late trading and that those procedures are working as
designed; and (3) annual, independent audits. Representatives of
intermediaries told us that they should be given an opportunity to
prove that they can comply with the same policies and procedures as
mutual fund companies in accepting and processing fund orders. However,
SEC staff have expressed concerns about the proposal. As previously
noted, SEC does not have regulatory jurisdiction over all entities that
process mutual fund share orders.
Another approach to prevent late trading, which has been suggested by
some industry participants, is to establish a central clearinghouse for
mutual fund trades. The clearinghouse proposal would require all mutual
fund orders to be time-stamped electronically by an SEC-registered
central clearing entity before the market close to receive that day's
fund price. The clearing entity's time stamp would be considered the
official time of receipt of an order for a mutual fund transaction.
NSCC is currently the only SEC-registered clearing agency operating an
automated processing system for mutual fund orders. The clearinghouse
proposal would expand NSCC's role, capabilities, and capacity to handle
all orders of mutual fund transactions. Each mutual fund company and
fund intermediary would consider its technological capabilities and
other factors in deciding how to meet the requirement of submitting
orders to NSCC by 4:00 p.m. Eastern Time in order to receive same-day
pricing. However, many intermediaries that do not use NSCC to process
transactions oppose the clearinghouse proposal because, among other
reasons, developing links to NSCC could be prohibitively expensive.
SEC is continuing to review alternatives to develop an acceptable
solution to prevent late trading. SEC staff told us that staff have
been meeting with industry participants and considering alternative
proposals but were uncertain about when a rule to prevent late trading
could be adopted.
[End of section]
Appendix IV: Comments from the Securities and Exchange Commission:
UNITED STATES SECURITIES AND EXCHANGE COMMISSION:
OFFICE OF COMPLIANCE INSPECTIONS AND EXAMINATIONS:
WASHINGTON, D.C. 20549:
April l, 2005:
Richard J. Hillman:
Director, Financial Markets and Community Investment:
United States Government Accountability Office:
Washington, DC 20548:
Dear Mr. Hillman:
Thank you for the opportunity to comment on your draft report
concerning mutual fund market timing abuses. As your report describes,
SEC examinations and enforcement investigations revealed that many
mutual fund employees had entered into secret arrangements with favored
customers to allow those customers to frequently trade fund shares, in
contravention of the prospectus or other disclosures, or the internal
policies of the fund. This frequent trading activity harmed other
mutual fund shareholders. When this misconduct came to light the SEC
took comprehensive action, including rule making, enforcement actions,
and enhanced examination oversight.
The GAO report describes many of the steps taken by the SEC to improve
compliance by funds and investment advisers, both generally and
specifically with respect to deterring and detecting abusive market
timing. As the report notes, the Commission adopted rules: requiring
funds and advisers to have a Chief Compliance Officer, to adopt formal
compliance programs, and to provide an annual compliance report to the
fund's board of directors; requiring funds to provide enhanced
disclosure of their policies with respect to the allowed frequency of
trading in fund shares; requiring all investment advisers to adopt a
Code of Ethics; requiring mutual funds to have a majority of
independent directors and an independent chairman; and allowing funds
to impose redemption fees to deter market timing.
The GAO report also describes many of the changes to the SEC's
examination oversight of mutual funds and advisers. Specifically, the
SEC's examination program has adopted a risk-based approach to
oversight that emphasizes the prompt identification and investigation
of emerging compliance risks. As the report notes, SEC has implemented
a risk-assessment process, and has created an Office of Risk Assessment
that is designed to identify emerging risks that face the securities
markets and the SEC. Based on the risk-identification process, SEC
examiners now conduct many stand-alone "risk targeted reviews" that are
designed to quickly probe discrete areas of compliance risk. These
examinations, along with comprehensive "wall-to-wall" examinations,
complement routine examinations, as they may indicate risk areas that
should be included in the routine examination protocol. SEC staff are
also evaluating the type of data that may further assist in better
targeting attention to firms and activities that pose the greatest risk
of compliance problems.
In addition, as GAO notes, prior to the identification of market timing
abuses, in mid-2001, SEC examiners adopted an approach for routine
examinations that was designed to evaluate the quality of internal
controls, including by testing controls in key operational areas. We
fully agree with GAO's suggestion that testing of internal controls is
critical to evaluate their effectiveness. Such testing takes a variety
of forms-including reviews of exception reports, internal audit
reports, reviewing email and other internal communications that might
indicate collusive or other undisclosed arrangements, transaction
testing and use of other forensic data. As the report notes, in light
of the market timing abuses, SEC examiners now review mutual funds'
controls for "fair value" pricing and market timing, including
shareholder turnover rates, during routine examinations. To assist
funds in adopting appropriate controls over the use of fair value, the
SEC anticipates providing guidance for mutual funds and their advisers.
The GAO report also recommends that examination staff assess the
independence and effectiveness of the Chief Compliance Officers
required under the new SEC rule. We agree with this recommendation,
have been assessing their role since the rule became effective in
October 2004, and are preparing formal examination guidance for SEC
examination staff. We also recently initiated a program called
"CCOutreach" designed to provide information to these new Chief
Compliance Officers that might assist in them in their important
responsibilities.
Finally, the GAO report recommends that SEC develop a plan to assess
the feasibility of integrating the new mutual fund annual compliance
reports (or material findings in those reports) into an SEC
surveillance program. We are considering how best to utilize these
reports and note that any required filing of the reports with the SEC
would require rulemaking by the SEC.
We appreciate the GAO's attention to these issues.
Signed by:
Lori A. Richards:
Director:
[End of section]
Appendix V: GAO Contacts and Staff Acknowledgments:
GAO Contacts:
Richard J. Hillman (202) 512-8678;
Wesley M. Phillips (202) 512-5660:
Staff Acknowledgments:
In addition to those named above, Fred Jimenez, Stefanie Jonkman, Marc
Molino, Omyra Ramsingh, Barbara Roesmann, Rachel Seid, and David
Tarosky made key contributions to this report.
(250200):
FOOTNOTES:
[1] For purposes of this report, the term "mutual fund companies"
generally refers to mutual fund companies and their related investment
advisers and service providers, such as transfer agents, unless
otherwise specified. As described in this report, many mutual fund
companies have no employees, although they typically have boards of
directors, and rely on investment advisers to perform key functions
such as providing management and administrative services.
[2] The term "hedge fund" generally identifies an entity that holds a
pool of securities and perhaps other assets that is not required to
register its securities offerings under the Securities Act and is
excluded from the definition of an investment company under the
Investment Company Act of 1940. Hedge funds are also characterized by
their fee structure, which compensates the adviser based upon a
percentage of the hedge fund's capital gains and capital appreciation.
[3] In this report, we assume for convenience that all funds choose to
price their securities daily as of 4:00 p.m. Funds may, however, elect
to price their securities more than once per day, and according to SEC,
many funds price their securities earlier than 4:00 p.m.
[4] The New York Stock Exchange (NYSE) is also responsible for
oversight of its member firms, but NASD typically conducts the sales
practice portions of examinations for firms that are dually registered
with it and NYSE. As a result, NYSE generally plays a lesser role in
examining broker-dealers for matters involving mutual fund sales. We
therefore did not include NYSE in the scope of this review.
[5] Fair value pricing involves mutual funds using the estimated market
value of shares when market quotes are not readily available. As
described in this report, fair value pricing of mutual fund shares can
minimize discrepancies in pricing between foreign and U.S. financial
markets and thereby minimize market timing opportunities.
[6] Eric Zitzewitz "Who cares about shareholders? Arbitrage-proofing
mutual funds," Stanford Graduate School of Business Research Paper No.
1749 (October 2002). As described later in this report, some favored
investors agreed to place assets in mutual funds in exchange for market
timing privileges (referred to as "sticky assets"). Investment
advisers' fees are often based on the size of assets under management.
[7] As described in this report, SEC also amended rules that require
that in order for mutual funds to rely on any of 10 commonly used
exemptive rules, the chairperson and at least 75 percent of the members
of mutual fund boards of directors be independent of the funds'
investment advisory firms. SEC believes the fact that mutual fund
boards have sole authority to designate and remove compliance offices
will help ensure the officers' independence. The exemptive rules (i)
exempt mutual funds or their affiliated persons from provisions of the
Investment Company Act of 1940 that can involve serious conflicts of
interest and (ii) condition the exemptive relief on the approval or
oversight of independent directors.
[8] Although the Investment Company Act of 1940, as amended, does not
dictate a specific form of organization for mutual funds, most funds
are organized either as corporations governed by a board of directors
or as business trusts governed by trustees. When establishing
requirements relating to the officials governing a fund, the act uses
the term "directors" to refer to such persons, and this report also
follows that convention.
[9] In some cases, the adviser may contract with other firms to provide
investment advice, the latter firms becoming subadvisers to those funds.
[10] In 2004, SEC staff developed plans to revise its examination
program so that teams of examiners monitored the largest mutual fund
companies on an ongoing basis rather than on a regular schedule. We are
assessing SEC's planned strategy as part of a separate engagement.
[11] GAO, SEC Operations: Increased Workload Creates Challenges, GAO-
02-302 (Washington, D.C.: Mar. 5, 2002).
[12] Under the Advisers Act, SEC has the authority to examine all
adviser books and records, whether the agency has enacted regulations
requiring particular records to be maintained. However, under the 1940
Act, SEC has the authority to examine those books and records of mutual
fund companies that are required by statute or rule to be maintained.
Although SEC has authority under the 1940 Act Section 31(b)(3)
(codified at 15 U.S.C. � 80a-30(a)(2)) to prescribe recordkeeping rules
it deems necessary or appropriate for investors, the statute directs
SEC to "take steps to avoid unnecessary recordkeeping by, and minimize
the compliance burden on" regulated entities. The 1940 Act Section
31(b)(3) (codified at 15 U.S.C. � 80a-30(b)(3)) further directs SEC to
exercise its examination authority with "due regard to the benefits of
internal compliance departments and procedures and the effective
implementation and operation thereof."
[13] GAO, Securities Markets: Opportunities Exist to Enhance Investor
Confidence and Improve Listing Program Oversight, GAO-04-75
(Washington, D.C.: Apr. 8, 2004). Listing standards are the minimum
financial and nonfinancial requirements that issuers must meet to
become and remain listed for trading on a market. SROs, such as NASD
and NYSE, have responsibility to regulate their members under the
oversight of the SEC.
[14] We note that these reports were not produced by the companies'
internal audit departments. However, SEC's March 2002 examination
guidance defined a range of internal compliance reports and limited
examiners' discretion to request such reports during examinations.
Additionally, the responsible SEC district office staff did not examine
the companies during the period in which the internal reports were
produced. However, district office staff said they would have not
requested any studies regarding market timing even if they had reviewed
the companies because market timing was not perceived as a high-risk
area.
[15] Our work did not include an analysis of whether bank regulators
actually implement these standards during bank examinations.
[16] The Division of Investment Management oversees and regulates the
investment management industry and administers the securities laws
affecting investment companies (including mutual funds) and investment
advisers.
[17] Mercer Bullard, "Your International Fund May Have the Arbs Welcome
Sign Out" The Street.com (June 10, 2000) and Mercer Bullard,
"International Funds Still Sitting Ducks for Arbs" The Street.com (July
1, 2000). Also, William Goetzmann with Zoran Ivkovic and K. Geert
Rouwenhorst, "Day Trading International Mutual Funds: Evidence and
Policy Solutions," Journal of Financial and Quantitative Analysis 36
(3) (September 2001): 287-309 and Zitzewitz (2002).
[18] Zitzewitz (2002) estimated the total annualized loss at $4.9
billion per year, $4.3 billion of which is in international equity
funds.
[19] The 1940 Act requires mutual funds to value their portfolio
securities by using the market value of the securities when market
quotations for the securities are not readily available.
[20] Letter from Douglas Scheidt, Associate Director and Chief Counsel,
SEC's Division of Investment Management, to Craig S. Tyle, General
Counsel, ICI (Dec. 8, 1999); letter from Scheidt to Tyle on April 30,
2001; and Division of Investment Management Letter to Investment
Company Institute re: Delayed Exchange of Fund Shares, (Nov. 13, 2002).
[21] Under a delayed exchange policy, exchange transactions (in which
proceeds from shares are redeemed in one fund are used to purchase
shares in another fund) are executed on a delayed basis, such as the
next business day. Delaying an exchange transaction can help deter
market timing because market timing relies on effecting transactions on
specific days to take advantage of perceived market conditions.
[22] Zitzewitz (2002).
[23] For example, Federal Deposit Insurance Corporation revised
compliance examination procedures state that a bank's "�board and
senior management must grant a compliance officer sufficient authority
and independence to�effect corrective action." The U.S. Sentencing
Commission has established minimum standards for compliance and ethics
programs for companies that seek reductions in their sentences for
criminal convictions. Companies that establish effective compliance and
ethics programs to detect and prevent criminal conduct can obtain
reduced penalties. Among other requirements, the compliance and ethics
program must, at a minimum, be promoted and enforced consistently
throughout the organization.
[24] Section 10(a) of the 1940 Act, 15 U.S.C. � 80a-10(a), requires
that at least 40 percent of the members of the mutual fund board of
directors be independent directors. To enhance the independence and
effectiveness of fund boards, in January 2001, the SEC adopted a fund
governance requirement that required the board of directors of a fund
seeking to rely on any of the SEC's commonly used exemptive rules to be
comprised of a majority of independent directors. The exemptive rules
allow funds to engage in transactions that would otherwise be
prohibited under the 1940 Act and that present conflicts between the
fund and its management company. In the wake of recent enforcement
actions related to late trading, market timing and misuse of nonpublic
information about fund portfolios, and in recognition of the fact that
a simple majority of independent directors may not adequately ensure
that independent directors dominate the decision-making process, SEC
strengthened this fund governance requirement for 10 exemptive rules by
adopting the 75 percent independence and independent board chair
requirements in August 2004. 69 Fed. Reg. 46378-79 (August 2, 2004).
[25] Other areas assessed include portfolio management, brokerage
arrangements and best execution, allocations of trades, pricing of
clients' portfolios and calculation of net asset value, information
processing and protection, performance advertising, marketing and fund
distribution activities, safety of clients' funds and assets, fund
shareholder order processing, anti-money laundering, and corporate
governance.
[26] GAO, SEC Operations: Oversight of Mutual Fund Industry Presents
Management Challenges, GAO04-584T (Washington, D.C.: April 20, 2004).
[27] See C.F.R. � 270.38-1 and 17 C.F.R. � 275.20b(4)-7.
[28] Securities and Exchange Commission, "Mutual Fund Redemption Fees,"
Release No. IC-26782 (Mar. 11, 2005).
[29] The rule permits a fund board that adopts a redemption fee to
determine, in its judgment, whether a period longer than 7 calendar
days is necessary or appropriate to protect fund shareholders.
[30] SEC also has proposed, but not yet acted on, rule changes that
would require broker-dealers to disclose to investors prior to
purchasing a mutual fund, at the point of sale and in order
confirmations, whether the broker-dealer receives revenue sharing
payments or portfolio commissions from that fund adviser as well as
other cost-related information.
[31] As previously discussed, we assess the revised program in a
forthcoming report.
[32] In this discussion, we assume for convenience that all funds
choose to price their securities daily as of 4:00 p.m. Funds may,
however, elect to price their securities more than once per day, and
according to SEC, many funds price their securities earlier than 4:00
p.m.
[33] See Staff Interpretive Position Relating to Rule 22c-1, Investment
Company Act Release No. 5569 (December 27, 1968). Mutual funds employ
transfer agents to conduct recordkeeping and related functions.
Transfer agents maintain records of shareholder accounts, calculate and
disburse dividends, and prepare and mail shareholder account
statements, federal income tax information, and other shareholder
notices. NSCC is currently the only clearing agency registered with SEC
that operates an automated system, called Fund/SERV, for processing
orders for mutual funds and other securities. Fund/SERV provides a
central processing system that collects order information from clearing
brokers and others, sorts all the incoming order information according
to fund, and transmits the order information to each fund's primary
transfer agent.
[34] Securities and Exchange Commission, "Proposed Rule: Amendments to
Rules Governing Pricing of Mutual Fund Shares," Release No. IC-26288
(Dec. 11, 2003).
[35] See GAO, Mutual Funds: SEC Should Modify Proposed Regulations to
Address Some Pension Plan Concerns, GAO-04-799 (Washington, D.C.: July
9, 2004) for a discussion of how the proposal could affect pension plan
participants.
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