Mutual Fund Trading Abuses: Lessons Can Be Learned from SEC Not
Having Detected Violations at an Earlier Stage (20-APR-05,
GAO-05-313).
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.
-------------------------Indexing Terms-------------------------
REPORTNUM: GAO-05-313
ACCNO: A21978
TITLE: Mutual Fund Trading Abuses: Lessons Can Be Learned from
SEC Not Having Detected Violations at an Earlier Stage
DATE: 04/20/2005
SUBJECT: Brokerage industry
Financial analysis
Law enforcement
Mutual funds
Regulatory agencies
Securities regulation
Internal controls
General management reviews
Lessons learned
Noncompliance
Risk management
Abuse
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GAO-05-313
United States Government Accountability Office
GAO
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
a
GAO-05-313
Highlights of GAO-05-313, a report to the Committee on the Judiciary,
House of Representatives
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.
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.
April 2005
MUTUAL FUND TRADING ABUSES
Lessons Can Be Learned from SEC Not Having Detected Violations at an Earlier
Stage
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.
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, [email protected].
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
1 4 7
10
21 33 35 36
Appendixes
Appendix I: Appendix II: Appendix III: Appendix IV: Appendix V:
Objectives, Scope, and Methodology
Mutual Fund Trade Processing and Recordkeeping
SEC Proposed Rule to Prevent Late Trading
Comments from the Securities and Exchange Commission
GAO Contacts and Staff Acknowledgments
GAO Contacts
Staff Acknowledgments
38
40
43
45
47 47 47
Tables Table 1: Staff Positions for SEC Divisions and Offices with
Responsibilities for Mutual Fund Regulation, Oversight,
and Enforcement, as of February 2005 27
Table 2: SEC Mutual Fund-related Rules, Adopted after September
2003 29
Figures Figure 1: SEC Settled Enforcement Actions against Investment
Advisers Related to Market Timing Violations as of
February 28, 2005 (dollars in thousands) 26
Figure 2: Processing Paths of Mutual Fund Transactions 41
Contents
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
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A
United States Government Accountability Office Washington, D.C. 20548
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.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.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
1For 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.
2The 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.
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.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 brokerdealers 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.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'
3In 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.
4The 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.
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.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
5Fair 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.
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.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 emails
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.
6Eric 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.
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.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.
7As 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.
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.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.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:
o Custodian: A custodian holds the fund assets, maintaining them
separately to protect shareholder interests.
o Transfer agent: A transfer agent processes orders to buy and redeem
fund shares and has customer recordkeeping responsibilities.
o 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
8Although 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.
9In some cases, the adviser may contract with other firms to provide
investment advice, the latter firms becoming subadvisers to those funds.
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.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
10In 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.
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.11 In
11GAO, SEC Operations: Increased Workload Creates Challenges, GAO-02-302
(Washington, D.C.: Mar. 5, 2002).
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.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.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
12Under 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. S:
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.
S: 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."
13GAO, 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.
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.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 riskbased
examination approach in 2002.)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
14We 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.
15Our work did not include an analysis of whether bank regulators actually
implement these standards during bank examinations.
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.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.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
16The 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.
17Mercer 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):
287309 and Zitzewitz (2002).
timing activity.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.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.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. 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
18Zitzewitz (2002) estimated the total annualized loss at $4.9 billion per
year, $4.3 billion of which is in international equity funds.
19The 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.
20Letter 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).
21Under 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.
with fewer independent directors to adopt fair value pricing. 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
22Zitzewitz (2002).
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.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
23For 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.
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.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.
24Section 10(a) of the 1940 Act, 15 U.S.C. S: 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).
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.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
25Other 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.
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
brokerdealer 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)
Source: SEC.
aThe entities named in this column are investment advisers associated with
these 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.
bBank of America settled charges involving both abusive market timing and
late trading on the part of its investment adviser and broker-dealer
subsidiaries, respectively.
cFremont Investment Advisors, Inc. settled charges involving both abusive
market timing and late trading.
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.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
Percent
Actual Actual Actual Estimated change 2002-
SEC Unit 2002a 2003a 2004a 2005a 2005a
Division of Investment
Managementb 173 167 190 200 16%
OCIEc 397 439 513 547
Division of
Enforcementd 980 1,016 1,308 1,338
Source: GAO analysis of SEC data.
aFiscal years.
bIncludes staff in the office that administers the Public Utility Holding
Company Act of 1935.
CThe amounts for OCIE include all staff in SEC's headquarters and regional
offices who support or conduct examinations of mutual funds and investment
advisers.
dThe 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, brokerdealers, and all
other entities that SEC regulates.
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
26GAO, SEC Operations: Oversight of Mutual Fund Industry Presents
Management Challenges, GAO-04-584T (Washington, D.C.: April 20, 2004).
the new process, information concerning all enforcement-related tips and
complaints, whether received through telephone calls, correspondence,
emails, 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 Date adopted Description of rule
Compliance Rule December 17, 2003 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.
Shareholder Reports and February 24, 2004 Requires a registered management
investment company to include in its Quarterly Portfolio Disclosures of
shareholder reports disclosure of fund expenses borne by shareholders
Registered Management during the reporting period. Also permits a
registered management Investment Companies 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.
Disclosure Regarding April 16, 2004 Requires open-ended management
Market investment companies to disclose in
Timing and Selective their prospectuses both the risks to
Disclosure shareholders of frequent purchases
of Portfolio Holdings and redemptions of investment
company shares, and the investment
company's policies and procedures
with respect to such frequent
purchases and redemptions.
Disclosure Regarding Approval of June 23, 2004 Requires a registered
management investment company to provide Investment Advisory Contracts by
disclosure in its reports to shareholders regarding the material factors
Directors of Investment and the conclusions with respect to those factors
that formed the basis Companies for the board's approval of advisory
contracts during the most recent
fiscal half-year.
Investment Adviser July 2, 2004 Requires that registered investment
Codes of advisers adopt codes of ethics that
Ethics 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.
Investment Company July 27, 2004 A series of amendments to certain
exemptive rules under the 1940 Act
Governance 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.
Disclosure Regarding A series of amendments to forms
Portfolio August 23, 2004 prescribed under the Securities
Act of
1933, the Securities and Exchange
Managers of Registered Act of 1934, and the 1940 Act,
which
among other things extends the
Management Investment existing requirement that a
registered
Companies 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.
(Continued From Previous Page)
Rule name Date adopted Description of rule
Prohibition on the Use Amends rule under the 1940 Act
of September 2, 2004 that governs the use of assets of
open-
Brokerage Commissions end management investment
to companies to distribute their
shares. The
amended rule prohibits funds from
Finance Distribution 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.
Registration Under the Requires advisers to certain
Advisers December 2, 2004 private investment pools (hedge
funds) to
register with the SEC under the
Act of Certain Hedge Fund Advisers Act. The rule and
amendments
are designed to provide the
Advisers protections afforded by the
Advisers Act to
investors in hedge funds.
Mutual Fund Redemption Fees March 11, 2005 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.
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.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.
27See C.F.R. S: 270.38-1 and 17 C.F.R. S: 275.20b(4)-7.
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.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
28Securities and Exchange Commission, "Mutual Fund Redemption Fees,"
Release No. IC26782 (Mar. 11, 2005).
that such a fee is not necessary or appropriate.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).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.
29The 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.
30SEC also has proposed, but not yet acted on, rule changes that would
require brokerdealers 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.
o 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.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.
o 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.
o 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
31As previously discussed, we assess the revised program in a forthcoming
report.
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:
o 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;
o Ensure that examination staff assess the independence and effectiveness
of mutual fund company CCOs as a component of all mutual fund company
examinations; and
o 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 http://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.
Richard J. Hillman Director, Financial Markets and Community Investment
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
brokerdealers 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
Appendix I
Objectives, Scope, and Methodology
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,
brokerdealers, 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.
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.).1 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
1In 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.
Appendix II
Mutual Fund Trade Processing and
Recordkeeping
agents or NSCC.2 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
Source: GAO.
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
2See 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.
Appendix II
Mutual Fund Trade Processing and
Recordkeeping
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.
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.1 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.2
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
1Securities and Exchange Commission, "Proposed Rule: Amendments to Rules
Governing Pricing of Mutual Fund Shares," Release No. IC-26288 (Dec. 11,
2003).
2See 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.
Appendix III
SEC Proposed Rule to Prevent Late Trading
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 SECregistered 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.
Appendix IV
Comments from the Securities and Exchange Commission
Appendix IV Comments from the Securities and Exchange Commission
Appendix V
GAO Contacts and Staff Acknowledgments
GAO Contacts Richard J. Hillman (202) 512-8678 Wesley M. Phillips (202)
512-5660
Staff In addition to those named above, Fred Jimenez, Stefanie Jonkman,
Marc Molino, Omyra Ramsingh, Barbara Roesmann, Rachel Seid, and David
Acknowledgments Tarosky made key contributions to this report.
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