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Report to Congressional Requesters: 

August 2005: 

Mutual Fund Industry: 

SEC's Revised Examination Approach Offers Potential Benefits, but 
Significant Oversight Challenges Remain: 

GAO-05-415: 

GAO Highlights: 

Highlights of GAO-05-415, a report to congressional requesters: 

Why GAO Did This Study: 

As the frontline regulator of mutual funds, the Securities and Exchange 
Commission (SEC) plays a key role in protecting the nearly half of all 
U.S. households owning mutual funds, valued around $8 trillion in 2005. 
Mutual fund abuses raised questions about the integrity of the industry 
and quality of oversight provided by SEC and self-regulatory 
organizations (SRO) that regulate broker-dealers selling funds. This 
report assesses (1) changes SEC has made to, or is planning for, its 
mutual fund exam program; (2) key aspects of SECs quality control 
framework for routine fund exams; and (3) the adequacy of SECs 
oversight of NASD and the New York Stock Exchange in protecting 
shareholders from mutual fund sales abuses. 

What GAO Found: 

SEC is initiating several changes intended to strengthen its mutual 
fund exam program but faces challenges overseeing the fund industry. In 
the wake of the fund abuses, SEC has revised its past approach of 
primarily conducting routine exams of all funds on a regular schedule. 
It concluded these exams were not the best tool for identifying 
emerging problems, since funds were not selected for examination based 
on risk. To quickly identify problems, SEC is shifting resources away 
from routine exams to targeted exams that focus on specific risks. It 
will conduct routine exams on a regular schedule but only of funds 
deemed high risk. SEC also is forming teams to monitor some of the 
largest groups of advisers and funds. Although SEC is seeking to focus 
its resources on higher risk funds and activities, the resource 
tradeoffs it made in revising its oversight approach raise significant 
challenges. The tradeoffs may limit SECs capacity not only to examine 
funds considered lower risk within a 10-year period but also to 
accurately identify which funds pose higher risk and effectively target 
them for routine examination. Potentially taxing its resources further, 
SEC recently adopted a rule to require advisers to hedge funds 
(investment vehicles generally not widely available to the public) to 
register with it. This rule is expected to increase SECs exam 
workload, but the precise extent is not yet known. 

SEC has integrated some quality controls into its routine exams, but 
certain aspects of its framework could be improved. It relies on 
experienced staff to oversee all exam stages but does not expressly 
require supervisors to review work papers or document their review. GAO 
found deficiencies in key SEC exam work papers, raising questions about 
the quality of supervisory review. SEC also does not require examiners 
to prepare written exam plans, though they use considerable judgment in 
customizing each exam. Written plans could serve as a guide for 
conducting exams and reviewing whether exams were completed as planned. 
As done by other regulators, SEC also could review a sample of work 
papers to test compliance with its standards. 

A primary tool that SEC uses to assess the adequacy of SRO oversight of 
broker-dealers offering mutual funds provides limited information for 
achieving its objective and imposes duplicative costs on firms. To 
assess SRO oversight, SEC reviews SRO exam programs and conducts 
oversight exams of broker-dealers, including their mutual fund sales 
practices. SECs oversight exams take place 6 to 12 months after SROs 
conduct their exams and serve to assess the quality of SRO exams. 
However, GAO reported in 1991 that SECs oversight exams provided 
limited information in helping SROs to improve their exam quality, 
because SEC and the SROs used different exam guidelines and their exams 
often covered different periods. GAO found that these problems remain, 
raising questions about the considerable resources SEC devotes to 
oversight exams. GAO also found that SEC has not developed an automated 
system to track the full scope of work done during its oversight exams. 
Thus, SEC cannot readily determine the extent to which these exams 
assess mutual fund sales practices. 

What GAO Recommends: 

This report makes four recommendations to SEC designed to help ensure 
that it is using its resources effectively to oversee mutual funds and 
broker-dealers selling mutual funds, to improve aspects of its quality 
control framework for routine fund exams, and to enhance its oversight 
of SRO exams of broker-dealers selling mutual funds. In its written 
comments, SEC provided additional information on the benefits of its 
revised exam strategy for overseeing funds and advisers and on the 
benefits of its broker-dealer oversight exams. 

www.gao.gov/cgi-bin/getrpt?GAO-05-415. 

To view the full product, including the scope and methodology, click on 
the link above. For more information, contact Richard Hillman at (202) 
512-8678 or hillmanr@gao.gov. 

[End of section] 

Contents: 

Letter: 

Results in Brief: 

Background: 

SEC's Revised Mutual Fund Examination Program Offers Potential Benefits 
but also Poses Significant Oversight Challenges: 

SEC Can Improve Certain Mutual Fund Examination Quality Control 
Measures: 

SEC's Oversight Examinations of Broker-Dealers Provide Limited 
Information on the Adequacy of SRO Oversight: 

Conclusions: 

Recommendations for Executive Action: 

Agency Comments and Our Evaluation: 

Appendixes: 

Appendix I: Scope and Methodology: 

Appendix II: Securities and Exchange Commission's (SEC) Broker-Dealer 
Examination Guidance and Training: 

Appendix III: Comments from the Securities and Exchange Commission: 

Appendix IV: GAO Contact and Staff Acknowledgments: 

Table: 

Table 1: Strategic Areas Covered by SEC's Risk Scorecards as of April 
2005: 

Figures: 

Figure 1: Number of Examiners and Entities Subject to Examination by 
SEC and Federal Bank Regulators in 2004: 

Figure 2: Violations Found by SEC during Oversight Examinations of NASD 
but Not Found by NASD, and SEC Oversight Examinations Conducted of 
NASD, Fiscal Years 2002-2004: 

Abbreviations: 

FDIC: Federal Deposit Insurance Corporation: 

MRO: Midwest Regional Office: 

NERO: Northeast Regional Office: 

NFA: National Futures Association: 

NYSE: New York Stock Exchange: 

OCC: Office of the Comptroller of the Currency: 

OCIE: Office of Compliance Inspections and Examinations: 

ORA: Office of Risk Assessment: 

PDO: Philadelphia District Office: 

SEC: Securities and Exchange Commission: 

SRO: self-regulatory organization: 

STARS: super tracking and reporting system: 

Letter August 17, 2005: 

The Honorable Barney Frank: 
Ranking Member: 
Committee on Financial Services: 
House of Representatives: 

The Honorable Paul E. Kanjorski: 
Ranking Member: 
Subcommittee on Capital Markets, Insurance and Government Sponsored 
Enterprises: 
Committee on Financial Services: 
House of Representatives: 

Nearly half of all U.S. households own mutual funds, with total assets 
of about $8 trillion as of February 2005, and roughly one-third of the 
total assets are held in retirement accounts.[Footnote 1] Recent 
trading abuses implicating well-known mutual funds have called into 
question the integrity of the mutual fund industry and quality of 
oversight provided by the Securities and Exchange Commission (SEC), 
which is the industry's frontline regulator. State regulators rather 
than SEC were the first to uncover in the summer of 2003 abuses 
involving market timing, which typically involves the frequent buying 
and selling of mutual fund shares by sophisticated investors seeking 
opportunities to profit from differences in prices between overseas and 
U.S. markets. Although market timing is not itself illegal, it can 
constitute illegal conduct if, for example, investment advisers (firms 
that manage mutual funds) enter into undisclosed agreements with 
favored customers, such as hedge funds, permitting them to trade 
frequently and in contravention of fund prospectuses--as certain 
advisers did before September 2003.[Footnote 2] Another type of abuse 
commonly referred to as late trading was significant but less 
widespread than market timing abuses. Late trading occurs when 
investors place orders to buy or sell mutual fund shares after the 
mutual fund has calculated the price of its shares, usually once daily 
at the 4:00 p.m. Eastern Time (ET) market close, but receive that day's 
fund share price.[Footnote 3] Investors who are permitted to late trade 
can profit from their knowledge of events in the financial markets that 
take place after 4:00 p.m., an opportunity that other fund shareholders 
do not have. Although late trading can involve fund personnel, late 
trading violations typically have occurred at intermediaries, such as 
broker- dealers that offer mutual funds to their customers, before 
these institutions submit their daily aggregate orders to mutual funds 
for final settlement. 

SEC's initial inability to detect the market timing abuses before late 
2003 raised questions about the agency's mutual fund examination 
program, which is the agency's primary means of detecting deficiencies 
and violations and thereby protecting investors.[Footnote 4] However, 
following the detection of the mutual fund trading abuses, SEC 
initiated a series of examinations to determine the extent of the 
abuses, vigorously pursued enforcement actions against violators of 
securities laws, and issued new rules to overhaul the regulatory 
framework in which funds operate. The agency also initiated changes to 
its examination program that are intended to make it more focused on 
detecting abuses and emerging problems more quickly. 

In addition, the involvement of some broker-dealers in the recent 
mutual fund trading abuses has raised concerns about regulatory 
oversight of that industry. NASD and the New York Stock Exchange (NYSE) 
are self-regulatory organizations (SRO) and have primary responsibility 
for regulating and examining their member broker-dealers, including 
their mutual fund sales practices. Although NASD is primarily 
responsible for assessing broker-dealer mutual fund sales practices, it 
did not detect the trading abuses through examinations or other 
means.[Footnote 5] SEC is responsible for overseeing the quality of SRO 
regulation of broker-dealers and does so through on-site inspections of 
SRO regulatory programs. SEC also conducts oversight examinations of 
broker-dealers recently examined by SROs to assess the quality of their 
examination programs. 

This report responds to your request that we review various issues 
concerning SEC's oversight of the mutual fund industry. Specifically, 
you asked us to (1) identify and assess changes SEC has made to, or is 
planning for, its mutual fund examination program; (2) assess key 
aspects of the quality control framework of SEC's routine mutual fund 
examinations; and (3) determine the adequacy of SEC's oversight of NASD 
and NYSE, particularly in regard to the SROs' oversight of mutual fund 
sales practices. 

To accomplish our reporting objectives, we reviewed policies, 
procedures, and other guidance applicable to SEC's mutual fund 
examination program as well as laws and regulations related to mutual 
funds. We also reviewed policies, procedures, and other guidance 
applicable to SEC's oversight of NASD's and NYSE's broker-dealer 
examination programs. At three SEC field offices that accounted for the 
largest number of completed routine fund examinations in fiscal year 
2004, we reviewed all routine examinations of funds completed that 
year. In addition, we interviewed officials at SEC headquarters and 
four field offices, NASD, NYSE, the Investment Company Institute, and 
other industry participants about SEC's oversight of mutual funds or 
broker-dealers. Finally, we interviewed officials from the Federal 
Deposit Insurance Corporation (FDIC), the Board of Governors of the 
Federal Reserve System, the Office of the Comptroller of the Currency 
(OCC), NASD, NYSE, and the National Futures Association (NFA) about 
their examination programs. We also reviewed guidance related to those 
programs. We performed our work in Boston, Massachusetts; Chicago, 
Illinois; New York, New York; Philadelphia, Pennsylvania; and 
Washington, D.C. We conducted our work between February 2004 and July 
2005 in accordance with generally accepted government auditing 
standards. Appendix I provides a detailed description of our scope and 
methodology. 

Results in Brief: 

Although SEC is initiating several significant changes intended to 
strengthen its mutual fund examination program, it faces challenges in 
effectively overseeing the mutual fund industry. In the wake of the 
recent mutual fund trading abuses, SEC has revised its traditional 
approach of primarily conducting routine examinations of all funds 
generally within a 5-year period to oversee the industry. Agency staff 
concluded that these examinations were not the best tool for 
identifying emerging compliance problems, because funds were selected 
for examination based on the passage of time and not based on risk. To 
more proactively identify and address compliance risks, SEC is shifting 
resources away from routine examinations to targeted examinations that 
narrowly focus on specific risks (e.g., market timing) at individual or 
groups of funds based on tips or other information. SEC is continuing 
to conduct routine examinations on a regular schedule but only of funds 
it perceives to pose higher risk. It will randomly select a sample of 
lower risk advisers and funds for routine examination each year. In 
addition, SEC plans to implement a pilot program to assign examination 
teams to continuously monitor some of the largest mutual funds, an 
approach modeled after the use of similar teams by federal bank 
regulators to supervise large banks. Although SEC is seeking to focus 
its resources on higher risk advisers and funds as well as higher risk 
activities, the resource tradeoffs it made in revising its oversight 
approach raise significant challenges. Specifically, the tradeoffs may 
limit SEC's capacity to examine funds considered lower risk within a 10-
year period. In turn, this outcome could limit SEC's capacity to 
accurately identify which mutual funds pose relatively higher or lower 
risk and effectively target higher risk funds for routine examination. 
Potentially taxing its examination resources further, SEC recently 
adopted a rule to require hedge fund advisers--some of which were 
involved in the recent mutual fund abuses--to register with the agency. 
This rule is expected to increase SEC's examination workload, but the 
precise extent is not yet known. 

SEC has integrated some quality controls into its routine mutual fund 
examinations, but quality control improvements could further ensure 
that examinations are conducted in a thorough and consistent manner 
throughout SEC field offices. Under its revised examination priorities, 
SEC's routine examinations are continuing to serve as the primary 
regulatory tool for testing whether higher risk mutual funds are 
complying with the federal securities laws. As part of its quality 
controls, SEC relies extensively on experienced supervisory examiners 
to oversee all stages of the routine examination process, but three 
controls could be enhanced to facilitate and ensure the adequacy of 
supervisory review. First, although SEC has standards for preparing 
examination work papers, it does not expressly require supervisors to 
review work papers or document their review. Requiring documented 
supervisory review could further ensure that work is reviewed and meets 
SEC standards. Deficiencies we found raise questions about the adequacy 
or completeness of supervisory review of completed risk scorecards-- 
work papers that play a key role in determining the scope of a fund's 
routine examination and the timing of the fund's next routine 
examination. Second, SEC standards do not require examiners to prepare 
written examination plans for supervisory review, even though examiners 
use considerable judgment in customizing the examination scope to the 
particular risks of a mutual fund. Written plans could serve as a guide 
for conducting examinations, coordinating examination work, and 
reviewing whether examinations were completed as planned. Third, while 
SEC uses several methods to ensure examination quality and consistency, 
federal bank and other regulators take the additional step of reviewing 
some completed examinations and work papers to test compliance with and 
evaluate the effectiveness of applicable policies and procedures. SEC 
officials cited staff resource constraints for not reviewing completed 
examinations and work papers. While reviews of a sample of completed 
examinations and work papers involve resource tradeoffs, they can yield 
important benefits and are an integral part of an effective quality 
control system. 

A primary tool that SEC uses to assess the adequacy of SRO oversight of 
broker-dealers offering mutual funds to customers provides limited 
information for achieving its objective and imposes duplicative 
regulatory costs on the securities industry. To assess SRO oversight, 
SEC reviews SRO examination programs and conducts oversight 
examinations of broker-dealers, including their mutual fund sales 
practices. SEC's oversight examinations take place 6 to 12 months after 
SROs conduct their examinations of broker-dealers and are intended to 
assess the quality of SRO examinations. However, we reported in 1991 
that SEC's broker-dealer examination program had significant 
problems.[Footnote 6] For example, we reported that the way in which 
SEC conducted these broker-dealer oversight examinations provided 
limited information in helping SROs to improve the quality of their 
examination programs. This was because SEC and the SROs used different 
broker-dealer examination guidelines, and their examinations often 
covered different periods of time. Our recent work found that these 
problems still remain, which raises questions about SEC's goal of 
conducting about 40 percent of its broker-dealer examinations as 
oversight examinations. Another deficiency we found during our review 
is that SEC has not developed an automated system to track the full 
scope of work performed during broker-dealer examinations. Absent such 
an automated system, SEC managers cannot readily determine the extent 
to which the agency's broker-dealer examinations assess mutual fund 
sales practices or other issues. Given the resource challenges that SEC 
faces in its role as the frontline regulator of mutual funds, SEC's 
current commitment of staff to broker-dealer oversight examinations may 
need to be reexamined. 

This report makes four recommendations to the SEC Chairman for 
improving oversight of mutual funds and SRO oversight of broker-dealers 
that sell mutual funds. First, we recommend that SEC periodically 
assess the level of resources allocated to the various types of 
examinations in light of their regulatory benefits to help ensure that 
the agency is using its resources efficiently and effectively to 
oversee the mutual fund industry, including broker-dealers that offer 
mutual funds. As part of this assessment, SEC should seek to ensure 
that it allocates sufficient resources to mitigate any regulatory gaps 
that may currently exist concerning the timely examination of mutual 
funds perceived to represent lower risk; complete fund risk assessments 
within a more reasonable period; and fulfill its new oversight 
responsibilities of the hedge fund industry. Second, in so doing, we 
recommend that SEC assess its methodology for conducting broker-dealer 
oversight examinations and whether some portion of the resources 
currently devoted to these examinations could be better utilized to 
perform mutual fund examinations. Third, to strengthen SEC's approach 
to mutual fund examinations, we recommend that SEC establish additional 
policies or procedures for improving its controls to ensure examination 
quality and consistency throughout SEC field offices. Fourth, we 
recommend that SEC electronically track information about the full 
scope of work performed during broker-dealer oversight examinations. 

We received comments on a draft of this report from SEC, which are 
included in appendix III. SEC also provided technical comments on a 
draft of the report, which were incorporated into the final report, as 
appropriate. SEC focused most of its comments on providing further 
elaboration on the potential benefits of its examination strategy for 
overseeing mutual funds and investment advisers and on the benefits 
obtained from its broker-dealer oversight examinations. In addition, 
SEC briefly commented that it will consider our recommendation directed 
at improving its quality controls for routine fund examinations and 
that it has formed a working group to explore ways to enhance the value 
of its broker-dealer oversight examinations. 

Background: 

SEC oversees mutual funds primarily through its Office of Compliance 
Inspections and Examinations (OCIE), Division of Investment Management, 
and Division of Enforcement. OCIE examines mutual funds to evaluate 
their compliance with the federal securities laws, to determine if they 
are operating in accordance with disclosures made to investors, and to 
assess the effectiveness of their compliance control systems. The 
Division of Investment Management administers the securities laws 
affecting funds and advisers. It reviews disclosure documents that 
mutual funds are required to file with SEC and engages in other 
regulatory activities, such as rulemaking, responding to requests for 
exemptions from federal securities laws, and providing interpretation 
of those laws. Finally, SEC's Division of Enforcement investigates and 
prosecutes violations of securities laws related to mutual funds. 

SEC regulates mutual funds under the Investment Company Act of 1940, 
the Investment Advisers Act of 1940, the Securities Act of 1933, and 
the Securities Exchange Act of 1934. The Investment Company Act was 
passed specifically to regulate mutual funds and other types of 
investment companies. Under the act, mutual funds are required to 
register with SEC, subjecting their activities to SEC regulation. The 
act also imposes requirements on the operation and structure of mutual 
funds. Its core objectives are to: 

* ensure that investors receive adequate and accurate information about 
mutual funds,

* protect the integrity of fund assets,

* prohibit abusive forms of self-dealing,

* prevent the issuance of securities that have inequitable or 
discriminatory provisions, and: 

* ensure the fair valuation of investor purchases and redemptions. 

The Investment Advisers Act requires mutual fund advisers to register 
with SEC, imposes reporting requirements on them, and prohibits them 
from engaging in fraudulent, deceptive, or manipulative practices. The 
Securities Act requires fund shares offered to the public to be 
registered with SEC and regulates mutual fund advertising. Under the 
Securities Act and Investment Company Act, SEC has adopted rules to 
require mutual funds to make extensive disclosures in their 
prospectuses. The Securities Exchange Act, among other things, 
regulates how funds are sold and requires persons distributing funds or 
executing fund transactions to be registered with SEC as broker- 
dealers. 

SEC, NASD, and NYSE regulate broker-dealers, including their mutual 
fund sales practices, by examining their operations and reviewing 
customer complaints. Broker-dealers that are members of NYSE and do 
business with the public are typically also required to be members of 
NASD. Historically, NASD has conducted the mutual fund 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 mutual fund sales practices. NASD has established 
specific rules of conduct for its members that provide, among other 
things, standards for advertising and sales literature, including 
filing requirements, review procedures, approval and recordkeeping 
obligations, and general standards. NASD also tests members to certify 
their qualifications as registered representatives. 

SEC evaluates the quality of NASD and NYSE oversight in enforcing their 
member compliance with federal securities laws through SRO oversight 
inspections and broker-dealer oversight examinations. SROs are private 
organizations with statutory responsibility to regulate their own 
members through the adoption and enforcement of rules of conduct for 
fair, ethical, and efficient practices. As part of this responsibility, 
they conduct examinations of the sales practices of their broker-dealer 
members. SEC's SRO oversight inspections cover all aspects of an SRO's 
compliance, examination, and enforcement programs. The inspections 
determine whether an SRO is (1) adequately assessing risks and 
targeting its examinations to address those risks, (2) following its 
examination procedures and documenting its work, and (3) referring 
cases to enforcement authorities when appropriate. Under its broker- 
dealer oversight examinations, SEC examines some of the broker-dealers 
that SROs recently examined. SEC conducts these examinations to assess 
the adequacy of the SRO examination programs. In addition to its 
oversight examinations, SEC conducts cause, special, and surveillance 
examinations of broker-dealers, but these examinations do not serve to 
assess the quality of SRO examinations. 

SEC's Revised Mutual Fund Examination Program Offers Potential Benefits 
but also Poses Significant Oversight Challenges: 

Since the detection of the mutual fund trading abuses in the summer of 
2003, SEC has made significant changes to its traditional examination 
approach, which generally focused on conducting routine examinations of 
all funds on an established schedule. To better detect potential 
violations, SEC has reallocated or plans to reallocate its staff to 
conducting targeted examinations focusing on specific risks and 
monitoring larger funds on a continuous basis. SEC's revised 
examination approach offers the potential for the agency to more 
quickly identify emerging risks and better understand the operations of 
large and complex funds, although it is too soon to reach definitive 
judgments. However, due to the limited number of SEC's examination 
staff relative to the number of mutual funds and advisers for which the 
agency has oversight responsibility, the decision to focus examination 
resources on particular areas involved tradeoffs that raise regulatory 
challenges. In particular, SEC's capacity to examine lower risk 
advisers and funds within a reasonable time period and develop industry 
risk ratings has been limited. 

SEC Has Revised Its Traditional Mutual Fund Examination Approach in the 
Wake of the Mutual Fund Trading Abuses: 

Historically, routine examinations of mutual fund complexes--groups or 
families of funds sharing the same adviser or underwriter--have served 
as the cornerstone of SEC's mutual fund oversight, accounting for 85 
percent of the total fund examinations done from 1998 through 2003. 
During that period, SEC generally tried to examine each complex at 
least once every 5 years.[Footnote 7] Due to resource constraints, SEC 
examinations typically focused on discrete areas that staff viewed as 
representing the highest risks of presenting compliance problems that 
could harm investors. Major areas of review have included portfolio 
management, order execution, allocation of trades, and advertising 
returns. In late 2002, SEC implemented a revised approach to conducting 
routine examinations that included a systematic process for documenting 
and assessing risks and controls for managing those risks in a range of 
areas related to the asset management function.[Footnote 8] Besides 
routine examinations, SEC conducts sweep examinations to probe specific 
activities of a sample of funds identified through tips, complaints, 
the media, or other information. The agency also conducts cause 
examinations when it has reason to believe something is wrong at a 
particular fund. Sweep and cause examinations accounted for about 5 and 
10 percent, respectively, of the total examinations done during 1998 
through 2003. 

After the detection of the market timing and late trading abuses in the 
summer of 2003, SEC officials concluded that the agency's traditional 
focus on routine examinations had limitations. In particular, SEC staff 
said that routine examinations were not the best tool for broadly 
identifying emerging compliance problems, since funds were selected for 
examination based largely on the passage of time, not based on their 
particular risk characteristics.[Footnote 9] In addition, SEC officials 
stated that they concluded the growth in the number of mutual fund 
companies and the breadth of their operations, combined with the need 
to perform more in-depth examinations of discrete areas, did not allow 
SEC to maintain its existing routine examination cycle. 

To focus its resources on issues and funds presenting the greatest risk 
of having compliance problems that may harm investors, SEC has made 
significant revisions to its examination priorities and oversight 
processes as described below: 

* First, SEC is placing a higher priority on sweep and cause 
examinations and a lower priority on routine examinations. SEC has 
directed its 10 field offices that conduct fund examinations to give 
priority to initiating, as warranted, sweep examinations of funds or 
advisers, focusing particularly on operational or compliance 
issues.[Footnote 10] To address the market timing and late trading 
abuses surfacing in late 2003, SEC shifted resources away from routine 
examinations to support sweep and cause examinations, according to SEC 
officials. As a result, sweep and cause examinations accounted for 87 
percent of the 690 fund examinations completed in fiscal year 2004. SEC 
officials said that about 17 percent of these examinations resulted in 
referrals to the agency's Division of Enforcement for potential 
violations of securities laws and regulations. (We note that the large 
increase in the number of sweep and cause examinations in fiscal year 
2004 as well as the number of referrals was likely due to SEC's 
focusing a substantial amount of resources on detecting market timing 
and late trading abuses.)

* Second, SEC no longer will routinely examine all funds and advisers 
on a regular basis, but it will conduct routine examinations of funds 
and advisers perceived to be high risk, once every 2 to 3 years. In 
addition, SEC will randomly select a sample of advisers and their 
affiliated funds perceived to be low risk for routine examination each 
year. Because these firms will be selected randomly, each firm will 
have an equal chance of being examined each year. According to SEC 
officials, the random selection process will enable agency staff to 
project the examination findings to the population of firms deemed low 
risk and assess the possible existence of problems within the 
population. 

* Third, SEC plans to provide more continuous and in-depth oversight of 
the largest mutual funds. Specifically, SEC is creating teams of 
examiners dedicated to regularly interacting with and closely 
monitoring and examining the activities of firms in the largest and 
most complex groups of affiliated advisers and mutual funds. SEC 
initially plans to form teams under a pilot program to monitor 10 large 
advisory groups. Any decision to form additional monitoring teams will 
depend on how the pilot program develops, according to an SEC official. 
SEC officials said that the monitoring teams are loosely modeled on the 
federal bank regulators' use of on-site teams to continuously monitor 
operations of large banks. However, unlike the bank regulator approach, 
SEC staff said the monitoring teams would not be located on-site at 
large mutual fund companies. 

* Fourth, an SEC task force is considering the development of a 
surveillance program to support the agency's oversight of all funds and 
advisers. The purpose of this program is to obtain from firms 
information that would enable examiners to identify aberrant patterns 
in fund and adviser activities and the possible existence of fraud or 
abusive schemes that require follow-up through examinations. In its 
fiscal 2006 budget request, SEC reported that the agency expects the 
surveillance system to begin operations during the second half of 
2006.[Footnote 11]

* Fifth, SEC has promulgated rules that require investment advisers and 
investment companies to appoint independent chief compliance officers 
(CCO) who are responsible for ensuring that their companies adopt 
policies and procedures designed to prevent violations of federal 
securities laws and regulations.[Footnote 12] Fund CCOs are also 
responsible for preparing annual reports that must, among other things, 
identify any material compliance matter at the company since the date 
of the last report. SEC staff said that they plan to review such annual 
compliance reports while conducting examinations to assist in 
identifying problems at mutual funds and determine whether the funds 
have taken corrective actions. (As described later in this report, SEC 
is missing opportunities to take full advantage of CCO compliance 
reports to detect potential violations in the mutual fund industry.)

* Finally, SEC has established the Office of Risk Assessment (ORA) to 
assist the agency in carrying out its overall oversight 
responsibilities, including mutual fund oversight. ORA's director 
reports directly to the SEC Chairman. According to SEC staff, ORA will 
enable the agency to analyze risk across divisional boundaries, 
focusing on 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, industries, and markets; and (3) preparing 
assessments of the agency's risk environment. ORA is to work in 
coordination with internal risk teams established in each of the 
agency's major program areas--including OCIE--and a Risk Management 
Committee responsible for reviewing implications of identified risks 
and recommending appropriate courses of action. 

SEC's Revised Oversight Approach Reflects Some of the Lessons Learned 
from the Recent Mutual Fund Scandals: 

As we recently reported, the market timing and late trading abuses that 
surfaced in 2003 revealed weaknesses in SEC's mutual fund oversight 
approach.[Footnote 13] We noted in the report that lessons can be 
learned from SEC not having detected market timing arrangements at an 
earlier stage. The key initiatives that SEC is taking to strengthen its 
mutual fund oversight program are largely intended to focus the 
agency's resources on the largest and highest risk funds and 
activities. Although it is too soon to assess the effectiveness of the 
initiatives in light of their recent or planned implementation, the 
initiatives are consistent with some of the lessons learned concerning 
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. 

By placing greater priority on sweep examinations, SEC may be better 
positioned to independently assess, as needed, the adequacy of fund 
controls designed to prevent and detect abusive practices. As we 
reported, SEC staff did not examine mutual funds for market timing 
abuses before late 2003, because they viewed market timing as a 
relatively lower risk area since agency staff believed that funds had 
adequate financial incentives to establish effective controls for it. 
In that regard, we noted the importance for SEC to conduct independent 
assessments of controls at a sample of funds, at a minimum, to verify 
that areas viewed as low risk, such as market timing, are in fact low 
risk and effective controls are in place. SEC's revised examination 
priorities, particularly their emphasis on initiating sweep 
examinations that focus on operational or compliance issues, may 
provide the agency with greater opportunity to conduct independent 
assessments of controls for emerging risks, in part to validate 
critical assumptions about such risks and confirm the adequacy of 
controls in place to address those risks. 

By forming examiner teams dedicated to monitoring the largest and most 
complex groups of affiliated advisers and funds, SEC may have the 
opportunity to more efficiently or effectively use its resources and 
help ensure the independence and effectiveness of the monitored firms' 
compliance staff. SEC estimates that the 100 largest advisory groups of 
affiliate advisers and funds accounted for about $7.1 trillion, or 85 
percent, of the fund assets under management as of the end of September 
2004. Thus, focusing on the largest advisory groups may enable SEC to 
attain the greatest dollar coverage with its limited examination 
resources. Focusing on the largest advisory groups may also be 
appropriate due to the control deficiencies that have been found at 
such companies. For example, SEC determined that nearly 50 percent of 
the 80 largest mutual funds had entered into undisclosed arrangements 
permitting certain shareholders to engage in market timing that 
appeared to be inconsistent with the funds' policies, prospectus 
disclosures, or fiduciary obligations. In our earlier mutual fund work, 
we also found that compliance staff at some funds identified market 
timing but lacked the independence or authority necessary to control 
it. This finding suggested that routine communications with fund 
compliance staff could enhance SEC's capacity to detect potential 
violations at an earlier stage, if compliance staff are effective and 
forthcoming about the problems they detect. SEC's monitoring teams will 
provide agency staff with the opportunity to be in routine 
communication with fund compliance staff, including CCOs. Furthermore, 
such communications, combined with examinations, could help SEC ensure 
that fund CCOs, as required under SEC's compliance rules, are in a 
position of authority to compel others to adhere to applicable 
compliance policies and procedures. 

By creating ORA, SEC is laying an important part of the foundation for 
developing the institutional capability to identify and analyze 
evidence of potential risks. SEC staff said that ORA will seek to 
ensure that SEC will have the information necessary to make better, 
more informed decisions on regulation. 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. SEC's 
compliance rules create opportunities for ORA to leverage the knowledge 
of fund CCOs, including their annual compliance reports. 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. 

Finally, SEC's fund and adviser surveillance system is in the 
exploratory stage but, if properly designed and implemented, may help 
the agency to leverage its limited resources to augment its 
examinations and oversee funds and advisers. Federal bank and other 
regulators use off-site surveillance programs to complement their on- 
site examinations. Each federal bank regulator has an off-site 
surveillance program to monitor the financial condition of banks 
between examinations. Information from off-site monitoring is used in 
setting bank examination schedules and determining the allocation of 
examiner resources for higher risk banks. Similarly, a recently 
deployed NASD surveillance program is used to analyze trends in broker- 
dealer activities and identify unusual patterns that indicate potential 
problems.[Footnote 14] NASD uses surveillance analyses to initiate 
cause examinations and to help its examiners focus on high-risk areas 
during their routine broker-dealers examinations. 

SEC's Revised Examination Approach Raises Oversight Challenges: 

SEC's planned changes to its mutual fund examination program offer 
potential advantages, but they also involve significant tradeoffs that 
raise important regulatory challenges for the agency. In comparison to 
federal bank regulators, SEC has significantly less examiners relative 
to the number of entities it regulates (see fig. 1), although bank and 
mutual fund regulatory regimes, including their examinations, differ 
from each other.[Footnote 15] As reflected in SEC's revised oversight 
approach, any decision by SEC to focus additional examination resources 
on one or more fund areas involves tradeoffs that could result in less 
oversight of, or create a regulatory gap in, other areas. We are 
particularly concerned about SEC's capacity going forward to review the 
operations of firms considered to be lower risk, conduct risk 
assessments of the industry, and potentially oversee the hedge fund 
industry. 

Figure 1: Number of Examiners and Entities Subject to Examination by 
SEC and Federal Bank Regulators in 2004: 

[See PDF for image] 

[End of figure] 

By shifting examination resources to targeted sweep and cause 
examinations as well as monitoring teams for larger funds, SEC may be 
limiting its capacity to examine the operations of funds perceived to 
pose lower risk (generally smaller funds) within a reasonable period. 
As stated previously, between 1998 and 2003, SEC generally sought to 
conduct routine examinations of all funds once every 5 years and 
shortened the cycle to 2 or 4 years in fiscal year 2004 following an 
increase in resources.[Footnote 16] However, under SEC's revised 
examination program, some mutual funds may not be examined within a 10- 
year period. This is because SEC plans to annually review the 
operations of 10 percent of the funds deemed lower risk on a random 
basis. While reviewing funds on a random basis means each firm will 
have an equal chance of being reviewed annually, it is not clear that 
this approach will have more of an effect in deterring abuses than if 
each fund was assured of being examined every 5 years or less. 
Moreover, if SEC lacks sufficient resources to annually examine 10 
percent of the funds deemed lower risk, its approach would have less of 
a deterrent effect. We recognize that through sweep examinations, SEC 
may review particular facets of funds deemed lower risk much more 
frequently than every 10 years or more. At the same time, sweep 
examinations are much more narrowly scoped than routine examinations 
and may exclude other potential areas of noncompliance at individual 
firms. 

Similarly, SEC's inability to conduct examinations of all mutual funds 
within a reasonable period may limit its capacity to accurately 
distinguish relatively higher risk funds from lower risk funds and 
effectively conduct routine examinations of higher risk funds. Between 
late 2002 and October 2004, SEC routinely examined 297, or 30 percent, 
of the existing fund complexes and used its revised examination 
guidelines to assess the effectiveness of the funds' compliance 
controls in deterring and preventing abuses and to assign the funds 
risk ratings of low, medium, or high. Had SEC not decided in late 2003 
and 2004 to shift examination resources to sweep and cause 
examinations, it might have been able to assign risk ratings to all 982 
fund complexes within the following 3 years in accordance with its 
routine examination cycle. Completing risk ratings for all fund 
complexes would have provided SEC with an additional basis for 
allocating resources to the highest risk firms.[Footnote 17] Over time, 
SEC's risk ratings can become outdated, or stale, raising the 
possibility for funds deemed lower risk to become higher risk. For 
example, changes in a fund's management, such as CCO, could lead to 
changes that weaken the fund's compliance culture and controls. 
However, because SEC may not examine all fund complexes within a 10- 
year period under its revised examination program, its ability to 
assign risk ratings to all fund complexes and routinely examine all 
higher risk funds may be limited.[Footnote 18]

In a previous report, we found that SEC may be missing opportunities to 
obtain useful information about the compliance controls of mutual 
funds, including those perceived to represent lower risks and may not 
be examined within a reasonable period of time.[Footnote 19] While SEC 
plans to review investment company CCO annual compliance reports during 
examinations, the agency has not developed a plan to receive and review 
the reports on an ongoing basis. Obtaining access to such annual 
reports and reviewing them on an annual basis could provide SEC 
examiners with insights into the operations of all mutual funds, 
including those perceived to represent lower risks, and could serve as 
a basis for initiating examinations to correct potential deficiencies 
or violations. SEC noted that it is considering how best to utilize the 
annual reports but noted any required filing of the reports with SEC 
would require rulemaking by SEC. 

A final oversight challenge facing SEC's mutual fund examination 
program involves a new rule requiring hedge fund advisers to register 
with the agency.[Footnote 20] Issued in December 2004, the new rule 
requires hedge fund advisers to register with SEC as investment 
advisers by February 2006. The rule is designed, in part, to enhance 
SEC's ability to deter or detect fraud by unregistered hedge fund 
advisers, some of which were involved in the recent mutual fund abuses. 
Once hedge fund advisers register, SEC will have the authority to 
examine their activities. The rule is expected to increase SEC's 
examination workload, but because of data limitations the precise 
extent will not be known until hedge fund advisers actually register. 
Currently, comprehensive information on the number of hedge funds and 
advisers is not available, but SEC estimates that from 690 to 1,260 
additional hedge fund advisers may be required to register under the 
new rule, increasing the pool of registered advisers by 8 to 15 
percent.[Footnote 21]

SEC officials estimate that at least 1,000 hedge fund advisers have 
previously registered as investment advisers with SEC to meet client 
needs or requirements. Under its examination program, SEC has examined 
these hedge fund advisers in the same way it has examined all other 
registered advisers. According to SEC officials, it is anticipated that 
the additional hedge fund advisers that register with SEC will be 
treated the same as all other registered advisers under SEC's 
examination program. SEC has recognized that providing oversight of the 
additional registered hedge fund advisers will pose a resource 
challenge and has identified options for addressing the challenge. It 
could require fewer hedge fund advisers to register with SEC by raising 
the threshold level of assets under management required for adviser 
registration. It also has the option of seeking additional resources 
from Congress for the increased workload resulting from an increased 
number of registered advisers. Whatever approach is ultimately taken, 
SEC will have to consider the potential resource implications of the 
new rule for its oversight of mutual funds. 

SEC Can Improve Certain Mutual Fund Examination Quality Control 
Measures: 

SEC has integrated quality controls into its routine examinations but 
could benefit from additional controls to ensure that policies and 
procedures are being implemented effectively and consistently 
throughout SEC field offices. Under its new initiatives, SEC's routine 
examinations will continue to be the primary regulatory tool for 
determining whether all funds and advisers are complying with the 
federal securities laws. Examination quality controls provide, among 
other things, assurances that important documents are provided 
supervisory review, and examinations are conducted according to agency 
policies, procedures, and individual examination plans.[Footnote 22] 
SEC could improve its quality control measures in three areas: 
supervisory review of risk scorecards, preparation of written 
examination plans, and review of completed examinations and work 
papers. Bank and other financial regulators have quality control 
measures that provide assurances above and beyond those measures used 
by SEC. 

SEC Standards for Reviewing Mutual Fund Risk Scorecards Do Not Ensure 
Accuracy or Completeness: 

The risk scorecards prepared by SEC during each mutual fund examination 
are critical work papers, providing the basis for determining areas to 
review in depth and an overall risk rating for a fund. A set of 
individual scorecards has been developed to assist examiners in 
assessing and documenting a fund's compliance controls in 13 strategic 
areas and to determine the amount of additional testing examiners will 
do.[Footnote 23] (See table 1.)

Table 1: Strategic Areas Covered by SEC's Risk Scorecards as of April 
2005: 

Name of scorecard area: 

Firm Maintains a Strong Compliance Culture; 
Minimize Ability of Dominant Individual to Override Control System; 
Consistency of Portfolio Management with Clients' Mandates; 
Order Placement Practices Consistent with Seeking Best Execution and 
Disclosures; 
Personal Trading of Access Persons Is Consistent with Code of Ethics; 
Fair Allocation of Blocked and Initial Public Offering Trades; 
Fund/Advisory Clients' Assets Are Priced and Fund Net Asset Values Are 
Calculated Accordingly; 
Accuracy and Fairness of Performance Information; 
Information That Is Created, Recorded, Maintained, and Reported Is 
Protected from Unauthorized Alterations; 
Safety of Clients' Funds and Assets; 
Third Party Sends Periodic Account Statement to Clients; 
Fund/Shareholder Order Processing and Cash-Book Reconciliations; 
Fund Corporate Governance. 

Source: SEC. 

[End of table]

If controls in an area are strong, examiners may do limited or no 
additional testing to detect potential abuses, but if weak, additional 
testing is expected to be performed. Collectively, the 13 areas 
reviewed with the set of individual scorecards provides the basis for 
determining a mutual fund's overall risk rating, which OCIE uses to 
determine how frequently the fund will be examined. While the risk 
scorecards currently cover 13 areas, SEC officials stated that each 
scorecard serves, in concept, as a model for assessing controls in a 
particular area of a firm's activities. As such, SEC staff could create 
additional scorecards to assist them in their review of areas not 
covered by existing scorecards or modify existing scorecards not 
suitable for reviewing the controls used by a firm in a critical area. 
OCIE and field office officials told us that all applicable risk 
scorecards generally should be completed during routine examinations, 
but if there are time constraints due to extenuating factors, all 
scorecards may not be completed. 

Even though risk scorecards are important work papers for documenting 
and assessing fund compliance controls, SEC standards do not expressly 
require that they receive supervisory review. Current OCIE standards 
for preparing examination work papers, including scorecards, specify 
that they should be prepared in an organized manner facilitating 
supervisory review and examination reporting. The standards do not 
provide further supervisory review requirements such as who should do 
the review, how, or when. While the review of scorecards is not 
expressly required, OCIE headquarters and SEC field office officials 
stated that supervisors do review scorecards and other examination work 
papers but typically do not sign or initial them to document that they 
have been reviewed. In addition, we were told that lead examiners and 
branch chiefs review work papers throughout the examination process. 
These officials also review risk scorecards and other work papers when 
reviewing final examination reports, making sure that all findings are 
adequately supported and summaries of the scorecard findings included 
in the examination reports are accurate. After completing their review 
of examination reports, branch chiefs sign a form to document their 
review. 

In contrast to OCIE, federal bank and other regulators have standards 
requiring supervisors to document that they have reviewed examination 
work papers. Examples of the work paper standards include: 

* Federal Reserve guidance requires examiners-in-charge or other 
experienced examiners to review all work papers as soon as practicable 
and to sign or initial the applicable documents to evidence their 
review. 

* OCC guidance requires examiners-in-charge or other experienced 
examiners to sign or initial work paper cover sheets to evidence their 
review. The guidance allows reviewers to tailor the thoroughness of 
their review based on the experience of the examiner preparing the work 
paper. 

* According to NYSE and NFA officials, the organizations require senior 
staff to review and sign work papers. NFA officials said that their 
work papers are electronic, so staff mark a checkbox to evidence their 
work paper review. 

While SEC officials stated that the review of the scorecards is 
documented indirectly by the supervisor's signature on the examination 
report, without the supervisor's signature or initials on the 
scorecards themselves, there is no way to readily verify that the 
scorecards were reviewed. Our review of 546 scorecards from 66 routine 
examinations of funds completed in fiscal year 2004 by SEC's Midwest 
Regional Office (MRO), Northeast Regional Office (NERO), and 
Philadelphia District Office (PDO) disclosed a number of deficiencies 
potentially stemming from quality control weaknesses. Most of the 
scorecards did not contain evidence of supervisory review as expected, 
based on statements by SEC officials, but 34 scorecards, or about 6 
percent, were signed or initialed as evidence of review. Regardless of 
whether the completed scorecards were signed or initialed, we found 
deficiencies in four areas that raise questions about the adequacy or 
completeness of supervisory review. 

* First, each scorecard should be marked as to whether examiners rated 
the compliance controls in the area as highly effective, effective, or 
ineffective. We found 32, or about 6 percent, of the total scorecards 
where the control rating was not marked. 

* Second, copies of scorecards should be included with the work papers 
to facilitate supervisory review, but we found 11, or about 17 percent, 
of the 66 examinations lacked any scorecards and 15, or about 23 
percent, were missing one or more scorecards.[Footnote 24]

* Third, documentary evidence should be cited on scorecards to support 
effective and highly effective ratings, but we found 25, or about 5 
percent, of the total scorecards did not cite documentary evidence 
supporting such ratings. 

* Fourth, scorecard ratings are included in examination reports, but we 
found the ratings marked on 21, or about 4 percent, of the total 
scorecards had ratings that differed from the ones in the examination 
reports. 

SEC supervisors document their review of examination reports, which 
include a summary of the risk scorecard findings. Nonetheless, without 
documenting that the scorecards themselves were reviewed, SEC does not 
know if deficiencies resulted from a lack of or inadequate supervisory 
review. The systematic supervisory review of work papers, particularly 
risk scorecards, is essential for ensuring examination quality. Such 
reviews help to ensure that the work is adequate and complete to 
support the assessment of fund compliance controls as well as report 
findings and conclusions. Likewise, documentation of the review is 
important to ensure that all critical areas are reviewed. The 
reviewer's initials or signature are written verification that a 
specific employee checked the work. 

Written Examination Plans for Fund Examinations Are Not Required but 
Would Be Useful for Documenting Agreements Reached on Review Areas: 

Written examination plans that document the scope and objectives of 
routine examinations are not required by OCIE. Instead, OCIE officials 
stated that written examination plans are optional. OCIE allows branch 
chiefs and lead examiners to decide whether to prepare written plans, 
with branch chiefs typically meeting with examination teams to discuss 
the preliminary scope of examinations. Each routine examination is 
somewhat different because of the risk-based approach used by OCIE. 
Under this approach, all areas of compliance or fund business 
activities are not reviewed and instead review areas are judgmentally 
selected based on their degree of risk to shareholders. As a result, 
each examination is customized to the activities of the particular fund 
under examination, with the success of routine examinations depending, 
in part, on proper planning. The documentation of this planning is 
important for tracking agreements reached on examination scope and 
objectives and can be used as a guide for the examination team. 
Furthermore, the plan can be used to determine whether the examination 
was completed in accordance with the planned scope. According to OCIE 
officials, written plans may be helpful in planning examinations of 
large fund complexes, but many of the examinations conducted are of 
small firms that have five or fewer employees. For these small firms, 
the officials said that it may not be necessary to prepare a written 
examination plan, especially if the examination team conducting the 
work consists of one or two persons. 

While OCIE does not require the preparation of written examination 
plans, we found that SEC's NERO requires examiners to prepare a 
planning memorandum to document examination scope and objectives, 
including firms to be examined within a fund complex, areas considered 
high risk, and areas to be reviewed. NERO branch chiefs approve the 
memorandums before the on-site work begins, and the memorandums 
effectively serve as examination plans. In contrast, SEC's MRO and PDO 
do not require planning memorandums or examination plans. Instead, 
branch chiefs in these two offices meet with the examination teams to 
discuss the scope of examinations and then let the staff decide whether 
to prepare a written plan, according to MRO and PDO officials. MRO 
officials said that some branch chiefs will recommend that for large 
funds, teams prepare written examination plans since it helps 
coordinate the work. For 66 routine examinations we reviewed at these 
three offices, about half, or 53 percent, had written planning 
memorandums or examination plans. Examinations of the larger fund 
complexes that were managing more than $1 billion in assets also had 
examination plans for about half, or 54 percent. 

In contrast to OCIE, federal bank and other regulators require their 
staff to prepare written examination plans before conducting 
examinations. Examples of examination plan requirements include: 

* FDIC guidance requires the examiner-in-charge to prepare a scope 
memorandum to document, among other things, the preliminary examination 
scope; areas to be reviewed, including the reasons why; and areas not 
to be included in the examination scope, including the reasons why. 

* Federal Reserve guidance requires that a comprehensive risk-focused 
supervisory plan be prepared annually for each banking organization. 
The guidance also requires the examiner-in-charge, before going on- 
site, to prepare a scope memorandum to document, among other things, 
the objectives of the examination and activities and risks to be 
evaluated; level of reliance on internal risk management systems and 
internal and external audit findings; and the procedures that are to be 
performed. To ensure consistency, the guidance requires the scope 
memorandum to be reviewed and approved by Reserve Bank management. 

* OCC guidance requires the examiner-in-charge or portfolio manager to 
develop and document a supervisory strategy for the bank that 
integrates all examination areas and is tailored to the bank's 
complexity and risk profile. The strategy includes an estimate of 
resources that will be needed to effectively supervise the bank and 
outlines the specific strategy and examination activities that are 
planned for that supervisory cycle. The strategies are reviewed and 
approved by the examiner-in-charge's or portfolio manager's supervisor. 

* NYSE and NFA officials told us that staff are required to prepare 
written examination or audit plans. NYSE officials said that staff meet 
with examination directors to reach agreement on the scope of their 
examination plans. NFA officials said that staff complete a planning 
module that includes a series of questions that staff answer to 
determine the scope of the audit, and the completed planning module 
serves as the audit plan. 

Examination planning meetings between SEC branch chiefs and examination 
teams are important for providing the opportunity to discuss and reach 
decisions about critical areas of examination scope and objectives. 
These discussions by themselves, however, do not provide a record of 
the agreements reached and may not result in a clear and complete 
understanding for examiners about the scope and objectives of a 
particular examination. A written examination plan would provide such a 
record--potentially enabling branch chiefs to better supervise 
examinations and assisting lead examiners to better communicate the 
examination strategy to the examination team. Such quality control is 
especially important given that staff must exercise considerable 
judgment for examination scope under SEC's risk-based approach. 

SEC Efforts to Ensure Quality Do Not Include Review of Work Papers of 
Completed Mutual Fund Examinations: 

SEC uses several methods to ensure the quality of its examinations but 
does not review completed examinations and work papers as done by other 
regulators to determine whether the examinations were conducted 
according to procedures or done consistently across field offices. OCIE 
has issued various policies and procedures to promote examination 
quality and consistency across the 10 SEC field offices that conduct 
the majority of its examinations. To help ensure that these policies 
and procedures are followed, SEC relies on experienced supervisors in 
its field offices to oversee all stages of routine examinations. 
Specifically, branch chiefs meet with examination staff to discuss the 
preliminary scope of examinations, advise staff during the fieldwork, 
and review all examination reports. Assistant directors in SEC field 
offices also assist in overseeing examinations and review all 
examination reports. Also, associate directors and regional or district 
administrators in SEC field offices may review examination reports. In 
addition, SEC field offices send each report and deficiency letter, if 
any, to an OCIE liaison, who reviews them. Finally, OCIE annually 
evaluates each field office examination program based on factors such 
as the overall quality of the office's examination selection and 
findings; new initiatives and special projects; use of novel or 
effective risk assessment approaches; and overall productivity, 
including achievement of numerical examination goals. 

In contrast to OCIE, we were told that federal bank and other 
regulators have quality assurance programs that include reviews of 
completed examinations or other activities. Examples of such reviews 
include: 

* FDIC guidance states that the agency reviews each regional office's 
compliance examination program every 2 years, in part, to evaluate the 
consistency of supervision across the regions and compliance with 
policies and procedures. According to the guidance, evaluations include 
a review of examination reports and work papers. 

* Federal Reserve officials said that the agency conducts on-site 
operations reviews of the banking supervision function of individual 
Reserve Banks at least every 3 years. The review targets each Reserve 
Bank's risk-focused supervision program and includes a review of a 
sample of examination reports, work papers, and other supporting 
documentation. It also encompasses the bank's ongoing quality 
management function, or the processes, procedures, and activities the 
bank uses to ensure that examination reports and related documents are 
of high quality and comply with established policy. 

* OCC officials told us that the agency reviews its large bank 
examination program, including specific examination procedures. It 
conducts reviews to determine whether lead examiners are supervising 
banks according to plans. It also assesses specific examination 
procedures across samples of banks. Agency officials said that teams 
periodically review how examiners are conducting certain procedures to 
ensure that they are being implemented consistently throughout all 
field offices. 

* NASD conducts quality and peer reviews to improve the quality, 
consistency, and effectiveness of its examination program. Under 
quality reviews, each NASD district office annually evaluates its 
performance in two or three areas. Under peer reviews, staff go on-site 
to district offices to evaluate particular program areas. 

* NFA officials told us that the organization randomly selects 
completed audits for review on a quarterly basis and, as part of the 
review, supervisory teams review work papers to determine whether the 
audits complied with established policies and procedures. 

While OCIE staff evaluate all completed examinations by reviewing the 
final examination report, they do not review a sample of completed 
examinations and work papers to periodically assess examination quality 
and consistency across SEC's field offices. SEC officials stated that 
after-the-fact reviews of underlying work papers may not be a cost- 
effective use of resources, given that key findings and evidentiary 
materials should be discussed and described in the examination report 
itself, which is reviewed by OCIE staff. Further, it would be difficult 
to second-guess decisions made by examiners when on-site, since 
reviewers would not have access to the same information. Finally, 
agency officials said that OCIE resources are limited, and time spent 
reviewing completed examination work papers would result in less time 
spent on conducting examinations. While reviewing completed examination 
work papers involves resource tradeoffs, it may yield important 
benefits. OCIE may be able to better determine whether its examiners 
are complying with established policies and procedures and whether its 
built-in quality controls are working. A review of underlying work 
papers also may allow OCIE to better assess the consistency of 
examination quality within and across SEC's field offices as well as 
the extent to which existing quality controls are helping to ensure 
that quality is maintained. 

According to SEC officials, the agency is implementing a computer-based 
document management system. Under this system, it is anticipated that 
most, if not all, of the work papers created during examinations will 
be converted into electronic files, and these files will be maintained 
in a consistent manner online for a number of years. SEC officials said 
that when the system is fully operational, estimated to be some time in 
2006, all work papers created during an examination will be available 
electronically to OCIE staff. At that point, OCIE liaisons could review 
electronic examination work papers on a sample basis in conjunction 
with their review of examination reports. In addition, electronic work 
papers would eliminate the need to be on-site to review underlying 
examination documentation and work papers across SEC's examination 
program. 

Importantly, deficiencies we found during our review of risk scorecards 
highlight the need for OCIE to periodically assess the consistency of 
examination staff's use of scorecards and other steps being taken 
during examinations. While the requirement to complete risk scorecards 
became effective in October 2002, SEC has not yet evaluated, for 
instance, whether the risk scorecards are being completed according to 
the guidance provided, whether changes to the design of the scorecards 
are needed, and whether additional guidance or training is needed. In 
March 2003, OCIE provided one training course on the scorecards, which 
was attended by 98 examiners, or about 20 percent of the SEC examiners 
devoted to fund and adviser examinations. According to SEC officials, 
two senior OCIE staff visited each field office during the spring and 
summer of 2003 and provided a full day of training on the scorecards to 
all examination staff. Nevertheless, the scorecard deficiencies we 
found during our review may indicate that additional training is 
needed. 

In addition, the scorecards may have design weaknesses that result in 
inconsistencies across SEC field offices. For example, field office 
officials stated that scorecards are designed for investment companies 
organized as mutual funds and do not readily apply to investment 
companies organized as unit investment trusts.[Footnote 25] NERO 
examiners did not complete scorecards for unit investment trusts, but 
MRO examiners did by modifying the scorecards as needed. Similarly, SEC 
field office officials stated that while the scorecards are designed to 
cover a broad range of fund compliance controls, fund controls for 
detecting and preventing market timing do not fall squarely under any 
of the 13 areas covered by the scorecards. As a result, staff have used 
work papers other than the risk scorecards to document their assessment 
of market timing controls. SEC officials said that the scorecards are 
models created to assist examiners in assessing fund controls. As such, 
scorecards are not intended to exist necessarily for every conceivable 
control and examiners have the flexibility to modify the scorecards as 
necessary. Moreover, the officials said that some inconsistencies in 
the preparation of risk scorecards are expected because not all funds 
and advisers are the same. In that regard, SEC officials told us that 
the approach taken by MRO staff in modifying a scorecard to fit the 
circumstances of an examination appears to be consistent with the 
approach to scorecard use expected by OCIE. 

SEC's Oversight Examinations of Broker-Dealers Provide Limited 
Information on the Adequacy of SRO Oversight: 

To assess SRO oversight of broker-dealers, including their mutual fund 
sales practices, SEC conducts examinations of broker-dealers shortly 
after they have been examined by SROs. However, these SEC broker-dealer 
examinations, which involve a significant commitment of agency 
examination resources, provide limited information on the adequacy of 
SRO oversight and impose duplicative regulatory costs on the securities 
industry. SEC and SROs' broker-dealer examinations often cover 
different time periods, and generally employ different sampling 
methodologies and use different examination guidelines. Consequently, 
SEC cannot reliably determine whether its examination findings are due 
to weaknesses in SRO examination procedures or some other factor. 
Another deficiency we found regarding SEC's SRO oversight of broker- 
dealer mutual fund sales practices is that the agency does not have 
automated information on the full scope of areas reviewed during its 
broker-dealer oversight examinations and, therefore, cannot readily and 
reliably track useful examination information. 

SEC Often Cannot Attribute Broker-Dealer Oversight Violations It Finds 
to Weaknesses in SRO Examination Programs, Because Different 
Examination Procedures Are Used: 

SEC performs two types of activities to review the quality of SRO 
oversight of broker-dealers, including their sales of mutual funds. 
First, SEC conducts inspections of NASD and NYSE on a 3-year cycle that 
cover various aspects of their compliance, examination, and enforcement 
programs. These SRO oversight inspections are designed to determine 
whether an SRO is (1) adequately assessing risks and targeting its 
examinations to address those risks, (2) following its examination 
procedures and documenting its work, and (3) referring cases to 
enforcement authorities when appropriate. When conducting these 
inspections, SEC reviews a sample of the SRO's examination reports and 
work papers to identify problems in examination scope or methods. As a 
result of these inspections, SEC has identified deficiencies in SRO 
examinations, including ones related to the SROs' examinations of 
mutual fund sales practices, and communicated those to the SRO to 
remedy the problem. Second, SEC conducts broker-dealer oversight 
examinations, during which it examines some broker-dealers from 6 to 12 
months after an SRO examines the firms. The purpose of broker-dealer 
oversight examinations is to help the SROs improve their examination 
programs by identifying violations that the SROs did not find and also 
by assisting them in evaluating improvements in how SRO examiners 
perform their work. SEC officials told us that a secondary goal of 
these examinations is to supplement the SROs' enforcement of broker- 
dealer compliance with federal securities laws and regulations. 

SEC's broker-dealer oversight examinations involve a significant 
commitment of agency resources and expose firms to duplicative 
examinations and costs. In addition to conducting broker-dealer 
examinations for the purposes of assessing SRO oversight (including for 
mutual fund sales practices), SEC conducts cause, special, and 
surveillance examinations of broker-dealers to directly assess broker- 
dealer compliance with federal securities laws and regulations, 
including those related to mutual fund sales. SEC currently has an 
internal goal of having oversight examinations account for 40 percent 
of all broker-dealer examinations each year. In 2004, 250, or 34 
percent, of its 736 broker-dealer examinations were oversight 
examinations.[Footnote 26] Broker-dealers that are subject to similar 
SEC and SRO examinations that may take place within a 6 to 12 month 
period incur the costs associated with assigning staff to respond to 
examiner inquiries and to make available relevant records as requested. 

Although SEC broker-dealer oversight examinations involve a significant 
commitment of agency examination resources and impose costs on 
securities firms, our past work questioned their cost-effectiveness. In 
a 1991 report, we found that the way SEC conducted oversight 
examinations of broker-dealers provided limited information to help 
SROs improve the quality of their broker-dealer examination 
programs.[Footnote 27] Specifically, during its oversight examinations 
of broker-dealers, SEC often found violations not identified by SROs 
and frequently could not attribute the violations it found to 
weaknesses in SRO examination programs. Because SEC and SROs used 
different examination procedures or covered different time periods of 
broker-dealer activity, SEC examiners often could not determine whether 
the violations they found resulted from the improper implementation of 
procedures by SRO examiners or differences between the procedures used 
or the activity period covered. We previously recommended that SEC 
directly test SRO examination methods and results. However, based on 
its efforts to replicate some examinations conducted by SROs, the 
agency concluded that this was unproductive because it only confirmed 
findings identified by SROs during their examinations. 

Our current review has shown that despite our 1991 findings, SEC 
continues to conduct oversight examinations in a similar manner--by 
using different examination guidelines and time periods. First, SEC 
continues to review firm activities during the time between the 
completion of the SRO examination and its own examination. Next, when 
SEC is reviewing a firm's transactions or customer accounts to identify 
potential abuses, it generally does not duplicate the sampling 
technique used by the SRO, but instead selects its own sample of 
transactions or customer accounts based on its own procedures. Finally, 
SEC examiners ask different questions to identify potential abuses. For 
example, although SEC and NASD both direct their examiners to ask 
questions to assess potential weaknesses in a firm's internal controls 
to prevent market timing and late trading, their procedures call for 
examiners to ask about different potential internal control weaknesses. 

According to SEC officials, its examiners do not use the same 
procedures as SROs because using different procedures allows them to 
find violations that would not otherwise be found if they just 
duplicated the SRO procedures. Also, SEC officials stated that SEC has 
an obligation to review the broker-dealer's activities at the time of 
the SEC examination to ensure compliance with securities laws at that 
time. However, as a result, SEC often cannot determine the specific 
reason why the SRO did not find the violations, limiting its ability to 
suggest improvements to SRO programs. SEC routinely provides SROs 
copies of deficiency letters it sends to broker-dealers as a result of 
oversight examinations. These deficiency letters sometimes include 
oversight comments that include steps the SRO can take to enhance its 
program. SRO officials stated they can often identify the reasons why 
SEC found the violations, but in many cases the reason is due to SEC's 
use of different procedures, such as different review periods or 
samples. Consequently, SEC often cannot attribute a violation it finds 
to a problem with the SRO's examination program. SEC officials said in 
some cases when SEC identifies a violation, it is able to determine 
whether the violation was occurring at the time of the original 
examination and should have been detected by the SRO. For example, in 
some cases when SEC finds an error in a broker-dealer's net capital 
calculation, it is able to trace the error to previous calculations and 
determine whether it existed during the SRO examination. Even in cases 
when SEC can attribute a violation it found to a weakness in the SRO 
examination, it does not track this information in its automated 
examination tracking system and, as a result, cannot use it to identify 
trends in SRO problems it discovered during oversight examinations. SEC 
officials stated that they have a staff committee conducting a 
comprehensive review of oversight examination procedures and plan to 
add a feature to SEC's examination tracking system to allow it to more 
systematically track identified weaknesses in SROs' examination 
programs. 

Although SEC's oversight examinations continue to find violations at 
broker-dealers and, thus, provide investor protection benefits, the 
violations provide limited information for assessing the quality of the 
SRO program. This information is particularly important given that the 
number of violations that SEC has found during its oversight 
examinations and determined as not found by NASD has increased in 
recent years. As shown in figure 2, the number of these violations that 
SEC found but has categorized as not found by NASD more than doubled 
between fiscal years 2002 and 2004. 

Figure 2: Violations Found by SEC during Oversight Examinations of NASD 
but Not Found by NASD, and SEC Oversight Examinations Conducted of 
NASD, Fiscal Years 2002-2004: 

[See PDF for image] 

[End of figure] 

Despite this significant increase, SEC officials could not explain why 
the number of these violations increased but stated that the increase 
did not necessarily represent a decrease in the quality of NASD's 
examination program. They said some of the increase is due to a 
significant increase in the number of rules applicable to broker- 
dealers. SEC officials told us that SRO officials have noted, and they 
agree, that the number of these violations, alone, is not always an 
appropriate measure of the quality of SRO examination programs. 
Accordingly, SEC officials told us that the agency recently began 
tracking findings deemed to be significant to allow it to better assess 
the materiality of an increase in the number of missed violations. If 
SEC had tested NASD's examination methods or better tracked the reasons 
why NASD did not find a violation, SEC would have more information to 
assess the quality of NASD's examination program. 

SEC Does Not Track the Full Scope of Work Performed during Its 
Oversight Examinations: 

Another deficiency we found regarding SEC's SRO oversight is that the 
agency cannot readily and reliably track key examination information. 
In assessing the quality of SEC's oversight of broker-dealer sales of 
mutual funds, we asked SEC to provide data on which of its broker- 
dealer oversight examinations in recent years included reviews of 
mutual fund sales practices. The data would help determine the extent 
that SEC has reviewed mutual fund sales practices. SEC was not able to 
provide this information because it does not have automated information 
on the full scope of areas reviewed during its broker-dealer oversight 
examinations. 

SEC maintains a broad range of automated information about its 
examinations in its Super Tracking and Reporting System (STARS), 
including basic information about the firm, SEC staff assigned to 
conduct the examination, and the deficiencies and violations found 
during the examination. STARS identifies examinations that reviewed 
specific areas of special interest to SEC, called "focus areas," as 
identified by senior SEC staff in headquarters, and new areas are added 
in part based on the emergence of new abuses. For example, SEC added 
breakpoints as a focus area in January 2003 and market timing and late 
trading in 2004.[Footnote 28] Although focus area designations provide 
useful information about how often SEC reviews some areas, focus areas 
do not cover all areas potentially reviewed by SEC during its 
examinations. Without methodically tracking the full scope of work 
performed during oversight examinations, SEC lacks information for 
determining how effective its oversight is in two important areas. 

First, because SEC does not know how often it has reviewed particular 
areas such as mutual fund sales practices during its oversight 
examinations, it cannot ensure that it has adequately reviewed all 
areas it considers important. When SEC reviews particular areas, its 
examiners generally refer to a set of written procedures, known as 
examination modules that provide information to guide examiners' work. 
STARS does not include data fields to track whether staff use the 
module on mutual funds during an examination. Therefore, the extent of 
coverage of mutual funds is unknown. As a result, SEC officials could 
not determine how many of the approximately 1,400 broker-dealer 
oversight examinations conducted between 2000 and 2004 included a 
review of mutual fund sales practices. SEC officials stated that they 
have a separate database containing examination reports that can be 
electronically searched to identify relevant examinations containing a 
search term such as "mutual fund," which would yield an estimate of the 
number of examinations that reviewed broker-dealer mutual fund sales 
practices. However, according to an official, not all examinations 
covering mutual fund sales practices would be captured because some 
examination reports that included reviews of mutual fund sales 
practices would not necessarily include any mention of mutual funds, 
especially if SEC identified no deficiencies or violations in that 
area. 

In contrast to SEC, both NASD and NYSE have systems with capability to 
track the full scope of examinations including the use of mutual fund 
and other examination modules. For NASD, some of its offices are able 
to track which of its broker-dealer examinations were followed by an 
SEC oversight examination. At 8 of its 15 district offices, which 
account for 55 percent of its examinations, NASD tracked this 
information and SEC conducted oversight examinations of approximately 5 
percent of the 2,602 NASD examinations conducted between January 1999 
and August 2004 that reviewed mutual fund sales practices. The 
remaining seven offices were not able to track this information 
because, according to an NASD official, the SEC field office conducting 
oversight examinations did not always provide a letter informing them 
that an oversight examination was conducted. With mutual fund sales 
practices being a regulatory priority, the percentage of SEC 
examinations reviewing these practices would be a useful measure for 
ensuring that the agency is addressing this priority. 

Second, because SEC does not track the full scope of work performed 
during its oversight examinations, it is limited in its ability to 
assess the significance of deficiencies and violations it finds. 
Because SEC does not know how often it has reviewed a particular area, 
the data it tracks on the number of deficiencies and violations it 
finds in a particular area are less meaningful. For example, it would 
be less significant if SEC found violations in a particular area during 
5 out of 100 examinations as opposed to finding violations during 5 out 
of 5 examinations during which it reviewed the area. Without knowing 
the full scope of each oversight examination and therefore the number 
of times a particular area was reviewed, data tracked by SEC on the 
number of deficiencies and violations it finds are less meaningful. 

In addition to conducting broker-dealer oversight examinations to 
evaluate the adequacy of SRO activities, SEC conducts other types of 
examinations, including cause and sweep examinations, which are 
designed to directly assess broker-dealer compliance with the law. SEC 
tracks the number of firms it targets during its examination sweeps 
along with the number of violations and deficiencies it finds. SEC 
officials told us that the agency tracks the number of findings from 
these examinations as a percentage of the number of firms examined, and 
that tracking such information helps SEC assess the prevalence of the 
findings relative to the number of firms. However, without tracking the 
scope of work performed during its oversight examinations, SEC is 
unable to make similar assessments about the prevalence of violations 
and deficiencies identified during those reviews. 

Appendix II provides information you requested about (1) how SEC, NASD, 
and NYSE share information, including written examination guidance, 
related to their review of mutual fund sales practices and other 
examination priorities; (2) how SEC distributes and stores examination 
guidance for use by its broker-dealer examiners; and (3) what training 
SEC has provided to broker-dealer examiners on mutual funds and other 
topics and how it tracks and assesses such training. 

Conclusions: 

In the wake of the market timing and late trading abuses, SEC staff 
implemented significant changes to the agency's mutual fund examination 
program in the view that doing so would help ensure the earlier 
detection and correction of violations. These changes--including 
conducting additional sweep examinations and continuously monitoring 
large companies--reflect a practical approach designed to focus SEC's 
limited resources on higher risk funds and activities and have the 
potential to strengthen SEC's oversight practices in certain regards. 
Nonetheless, the changes also involve tradeoffs, such as limiting the 
agency's capacity to review funds perceived to be lower risk and 
conduct risk assessments of all funds in a timely manner. Moreover, 
SEC's capacity to effectively monitor the hedge fund industry is open 
to question, given the tradeoffs that the agency has had to make in 
overseeing the mutual fund industry. While we recognize that SEC at 
some point may need to request additional resources from Congress to 
carryout its mutual fund and other oversight responsibilities, such 
requests should only occur after the agency has explored and achieved 
all available efficiencies within its existing resource limitations. 
Whether SEC's utilization of resources under its revised examination 
program will provide effective oversight remains to be seen. Future 
adjustments by SEC to resources devoted to various oversight 
activities, such as sweep examinations and randomly selected lower risk 
fund examinations, are likely to occur as the agency gains experience 
through conducting these oversight activities and changing conditions 
in the mutual fund industry. However, SEC has had extensive experience 
with its broker-dealer oversight examinations, and the effectiveness of 
these examinations for improving the quality of SRO oversight remains 
unclear. This situation raises concern, particularly in light of the 
significant level of resources devoted to oversight examinations and 
the resource challenges faced by SEC's fund and adviser examination 
program. 

We also identified basic weaknesses in SEC's approaches to conducting 
mutual fund and broker-dealer examinations. For mutual fund 
examinations, SEC does not require staff to document their examination 
plans to facilitate supervisory review. Second, SEC has issued work 
paper standards but lacks guidance on their supervisory review. 
Moreover, despite the importance of risk scorecards in determining the 
depth of work done during examinations, SEC has not yet assessed 
whether they are prepared according to standards since implementing the 
scorecards in 2002. For broker-dealer examinations, SEC has not 
developed an automated system to track the full scope of work completed 
during examinations and therefore lacks useful information about SRO 
oversight. Without addressing these deficiencies, SEC's capacity to 
effectively oversee the mutual fund industry and SROs is reduced. 

Recommendations for Executive Action: 

To improve SEC's oversight of mutual funds and SRO oversight of broker- 
dealers that sell mutual funds, we are making four recommendations to 
the SEC Chairman. First, we recommend that SEC periodically assess the 
level of resources allocated to the various types of examinations in 
light of their regulatory benefits to help ensure that the agency is 
using its resources efficiently and effectively to oversee the mutual 
fund industry, including broker-dealers that offer mutual funds. As 
part of this assessment, SEC should seek to ensure that it allocates 
sufficient resources to mitigate any regulatory gaps that may currently 
exist concerning the timely examination of mutual funds perceived to 
represent lower risk, complete mutual fund risk assessments within a 
more reasonable period, and fulfill its new oversight responsibilities 
for the hedge fund industry. Second, in so doing, we recommend that the 
agency assess its methodology for conducting broker-dealer oversight 
examinations and whether some portion of the resources currently 
devoted to these examinations could be better utilized to perform 
mutual fund examinations. 

Third, to strengthen SEC's approach to mutual fund examinations, we 
recommend that SEC: 

* establish a policy or procedure for supervisory review of work papers 
prepared during routine examinations and for documenting such reviews;

* establish a policy or procedure for preparing a written plan for each 
routine examination, documenting at a minimum the preliminary 
objectives and scope of the examination; and: 

* consider reviewing on a sample basis completed routine examinations 
and work papers to assess the quality and consistency of work within 
and across the field offices conducting examinations. 

Fourth, to assess and improve the effectiveness of SEC's oversight of 
SRO broker-dealer examination programs, we recommend that the Chairman, 
SEC, electronically track information about the full scope of work 
performed during broker-dealer oversight examinations, including all 
major areas reviewed, to determine whether areas are receiving adequate 
review and to more fully assess the significance of deficiencies and 
violations found. 

Agency Comments and Our Evaluation: 

SEC provided written comments on a draft of this report, which are 
reprinted in appendix III. SEC also provided technical comments that we 
incorporated into the final report, as appropriate. SEC focused most of 
its comments on providing further elaboration on the potential benefits 
of its examination strategy for overseeing mutual funds and investment 
advisers and on the benefits obtained from its broker-dealer oversight 
examinations. In addition, SEC briefly commented that it will consider 
our recommendation directed at improving its quality controls for 
routine fund examinations and that it has formed a working group to 
explore ways to enhance the value of its broker-dealer oversight 
examinations, including their ability to identify the reasons that 
violations may have been missed by SRO examinations. 

First, SEC stated that it is not possible for the agency to conduct 
timely, comprehensive routine examinations of every mutual fund and 
adviser, given the size of the industry and agency resources. Further, 
it expects its risk-targeted examinations to provide an effective means 
of addressing risks in the securities industry. Specifically, it 
believes that looking at the same type of risk at a number of different 
firms is a better approach than examining a single firm in depth. 
According to SEC, this approach will provide benefits by promptly 
identifying emerging trends and compliance problems, and individual 
firms can be compared to their industry peers. The agency believes this 
approach has already yielded benefits in identifying and addressing 
significant compliance problems before becoming major crises. In 
addition, SEC stated that the program it is developing to randomly 
select a sample of lower risk firms for routine examination will 
address our concern that such firms may not be given sufficient 
attention under its revised oversight strategy. According to SEC, this 
approach will provide a deterrent effect, enable the agency to test 
assumptions and techniques used throughout its examination program, and 
allow the agency to draw inferences about compliance in the adviser 
community, based on statistically valid sampling techniques. 

We recognize that SEC's revised examination strategy for mutual funds 
and advisers offers potential benefits, including focusing its limited 
resources on firms and activities that are perceived to pose higher 
risks. Nonetheless, we continue to be concerned about SEC's ability to 
examine all mutual funds within a reasonable period and accurately 
assess the relative risk of each fund on a timely basis. Unlike broker- 
dealers, mutual funds are regulated and examined solely by SEC. Under 
SEC's current plans to randomly sample 10 percent of the firms 
perceived to be lower risk for routine examination each year, it is 
possible that up to a third of the total number of firms would not be 
selected for examination within a 10-year period. We believe that this 
is a lengthy time period for firms to conduct business without being 
examined. Similarly, SEC's inability to conduct examinations of all 
mutual funds within a reasonable period will limit its capacity to 
accurately distinguish relatively higher risk funds from lower risk 
funds and effectively target its limited examination resources on those 
funds posing the highest risks. Therefore, we continue to believe that, 
as recommended, SEC should periodically assess the level of resources 
allocated to its various types of examinations and in so doing ensure 
that it allocates sufficient resources to mitigate any regulatory gaps 
that currently exist in the timely examination of funds perceived to 
represent lower risks and to ensure that it completes mutual fund risk 
assessments within a more reasonable time period. 

Second, SEC stated that its broker-dealer oversight examinations 
provide quality control over SRO examinations and serve other important 
goals. For example, SEC stated that oversight examinations allow it to 
detect violations that otherwise might not be detected, conduct routine 
examinations of new products or services, and test and validate 
assumptions and techniques used throughout the broker-dealer 
examination program. In addition, SEC expressed concern about our 
suggestion that it should reproduce SRO examinations if its oversight 
examinations are to provide accurate quality control information. SEC 
stated that this suggested approach would result in redundancies for 
broker-dealers being examined and limit the agency's ability to reach 
conclusions about SRO examination programs. By conducting its 
examinations as independent compliance reviews, SEC stated that it can 
assess whether SRO procedures were followed and whether SRO procedures 
need to be modified or enhanced. The agency stated that through its 
oversight program it has identified SRO procedures that need to be 
modified or enhanced and its examiners meet regularly with SRO 
examiners to review the results of oversight examinations. Finally, SEC 
commented that it has formed a working group to explore ways to gain 
additional value from its broker-dealer oversight examinations, such as 
by better identifying the reasons that a violation may not have been 
detected by an SRO examination, aiding the SRO in improving its 
program, and minimizing burden on the firm examined. 

We recognize that SEC's oversight examinations serve more than one goal 
and provide investor protection benefits. While such examinations serve 
a variety of purposes, one of their primary purposes is to assess the 
quality of SRO examinations. In fulfilling this purpose, we remain 
concerned that SEC's approach provides limited ability to identify the 
reasons why an SRO did not find violations that SEC found and, in turn, 
provide suggestions for improving SRO examinations. SEC is responsible 
for overseeing SROs that examine broker-dealers on a regular basis, and 
it conducts oversight examinations of only a small percentage of the 
total number of broker-dealers. Thus, it is critical for SEC to ensure 
that SROs conduct effective examinations. As discussed, SEC has formed 
a working group to evaluate its oversight examinations. We believe this 
is a step in the right direction and also provides the agency with the 
opportunity to evaluate its approach and level of resources devoted to 
broker-dealer oversight examinations. 

Finally, regarding our recommendation that SEC strengthen three aspects 
of its quality control framework for routine fund examinations, the 
agency stated it will fully consider the recommendation. Specifically, 
in 2006, the agency plans to deploy an electronic system for work 
papers. In preparation for this effort, it plans to review how new 
technology can be used to improve the quality of examinations and it 
will consider our recommendation in its review. While SEC did not 
directly comment on our recommendation that it electronically track 
information about the full scope of work performed during its broker- 
dealer oversight examinations, we believe that this would provide SEC 
important information to determine whether areas are receiving adequate 
review and the relative significance of violations found in each area. 

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 the Chairman of the House Committee on 
Financial Services; the Chairman of the Subcommittee on Capital 
Markets, Insurance and Government Sponsored Enterprises, House 
Committee on Financial Services; and the Chairman and Ranking Minority 
Member of the Senate Committee on Banking, Housing, and Urban Affairs. 
We also will provide copies of the report to SEC, FDIC, the Federal 
Reserve Board of Governors, NASD, NYSE, and OCC and will make copies 
available to others upon request. In addition, the report will be 
available at no cost on GAO's Web site at [Hyperlink, 
http://www.gao.gov]. 

If you or your staff have any questions about this report, please 
contact me at (202) 512-8678 or [Hyperlink, hillmanr@gao.gov]. Contact 
points for our Offices of Congressional Relations and Public Affairs 
may be found on the last page of this report. GAO staff who made key 
contributions to this report are listed in appendix IV. 

Signed by: 

Richard J. Hillman: 
Director, Financial Markets and Community Investment: 

[End of section]

Appendixes: 

Appendix I: Scope and Methodology: 

To identify and assess the changes SEC has made to or is planning for 
its mutual fund examination program, we reviewed SEC testimony, 
speeches, reports, and other documents related to the agency's mutual 
fund examination program. We also reviewed federal securities laws and 
regulations applicable to mutual funds and analyzed SEC data on the 
number, types, and results of its fund and adviser examinations. We 
also interviewed officials from SEC's Office of Compliance Inspections 
and Examinations (OCIE), Division of Investment Management, and Office 
of Risk Assessment and representatives from the Investment Company 
Institute to obtain information on the significance of planned changes. 
In addition, we interviewed federal bank regulatory officials from the 
Federal Deposit Insurance Corporation (FDIC), Board of Governors of the 
Federal Reserve System, and Office of the Comptroller of the Currency 
(OCC) and self-regulatory organization (SRO) officials from NASD, the 
New York Stock Exchange (NYSE), and the National Futures Association 
(NFA) to discuss their examination programs and supervisory tools. 

To assess key aspects of the quality control framework of SEC's routine 
mutual fund examinations, we reviewed policies, procedures, and other 
guidance applicable to those examinations. We also reviewed routine 
fund examinations completed in fiscal year 2004 by SEC's Midwest 
Regional Office (MRO), Northeast Regional Office (NERO), and 
Philadelphia District Office (PDO). We selected these field offices 
because they were the three largest in the number of completed routine 
fund examinations in fiscal year 2004. The three offices completed 66 
routine fund examinations, accounting for about 72 percent of all 
routine fund examinations completed in fiscal year 2004.[Footnote 29] 
Where appropriate, we also reviewed examinations of advisers to the 
funds we reviewed.[Footnote 30] We used a standardized data collection 
instrument to document the methods examiners used to conduct 
examinations and areas examiners reviewed during examinations. In 
addition, we interviewed officials from OCIE and three SEC field 
offices--MRO, NERO, and PDO--about their examination policies and 
procedures and representatives from a mutual fund company and 
consulting firm about fund examinations. To gather information and 
compare SEC examinations with those of other regulators, we interviewed 
officials from FDIC, the Board of Governors of the Federal Reserve 
System, OCC, NYSE, and NFA about their quality controls and reviewed 
some of their quality control policies and procedures. 

To determine the adequacy of SEC's oversight of NASD and NYSE in 
protecting shareholders from mutual fund sales practice abuses, we 
reviewed SEC policies, procedures, and other guidance related to its 
broker-dealer oversight examinations and inspections and interviewed 
officials from SEC's OCIE and Boston District Office, NASD, and NYSE. 
We also reviewed judgmentally selected SEC broker-dealer oversight 
examinations conducted by SEC's Boston District Office in 2003 and 
2004, and reviewed all reports of SRO inspections conducted of NASD and 
NYSE between 2001 and 2003. To gather information on SEC's automated 
tracking system, Super Tracking and Reporting System, we interviewed 
SEC staff responsible for the system in headquarters and received an 
overview of the system and its capabilities at the Boston District 
Office. In addition, we reviewed reports generated from the system and 
training documents for the system. To help assess the extent to which 
SEC, NASD, and NYSE have shared written guidance, we compared and 
contrasted the examination modules they used to examine for certain 
mutual fund sales practice abuses. As part of our assessment of the 
training received by broker-dealer examiners, we obtained and analyzed 
SEC's training attendance rosters and list of examiners employed by SEC 
since 1999. 

To ensure that data provided about the number, nature, and results of 
examinations conducted by SEC, NASD, and NYSE were reliable, we 
reviewed written materials describing these systems and reviewed the 
data provided to check for missing or inaccurate entries. We also 
interviewed agency staff responsible for maintaining the information 
systems that track such data. We determined that the data were 
sufficiently reliable for use in this report. 

We performed our work in Boston, Massachusetts; Chicago, Illinois; New 
York, New York; Philadelphia, Pennsylvania; and Washington, D.C. We 
conducted our work between February 2004 and July 2005 in accordance 
with generally accepted government auditing standards. 

[End of section]

Appendix II: Securities and Exchange Commission's (SEC) Broker-Dealer 
Examination Guidance and Training: 

You asked us to provide information about aspects of SEC's oversight of 
the broker-dealer industry, including (1) how SEC, NASD, and the New 
York Stock Exchange (NYSE) share information, including written 
examination guidance, related to their review of mutual fund sales 
practices and other examination priorities; (2) how SEC distributes and 
stores examination guidance for use by its broker-dealer examiners; and 
(3) what training SEC has provided to its broker-dealer examiners on 
mutual funds and other topics, and how it tracks and assesses such 
training. 

Sharing of Written Mutual Fund Examination Guidance among Regulators: 

SEC, NASD, and NYSE have developed guidance for examiners to use in 
assessing compliance by broker-dealers with mutual fund sales practice 
rules. Each regulator has developed its own examination module, or set 
of procedures, covering various topics related to mutual fund sales. 
Moreover, all three regulators recently revised their modules to 
include procedures to detect market timing and late trading abuses. In 
addition, the regulators periodically have provided their staff with 
other written guidance related to mutual fund sales. For example, SEC 
issued internal memorandums in 1997 and 2001 to inform staff about 
abuses related to breakpoints[Footnote 31] and other mutual fund sales 
practices and provide them with procedures for detecting such abuses. 

Through its oversight role, SEC reviews aspects of the self-regulatory 
organization (SRO) examination modules, including the mutual fund sales 
practice module. First, SEC officials told us that NYSE and NASD e-mail 
SEC copies of their examination modules when they make material changes 
to them. Second, during SEC's on-site inspections of SRO examination 
programs, staff generally review SRO examination modules in connection 
with their review of completed SRO broker-dealer examinations and work 
papers. Third, as part of their broker-dealer oversight examinations, 
SEC staff generally review the SRO broker-dealer examinations and 
applicable examination modules before going on-site to conduct 
examinations of such broker-dealers. 

SEC and the SRO officials meet at least semiannually to discuss 
significant examination findings, customer complaints, trends in the 
industry, enforcement cases, and examination guidance. SEC officials 
told us that agency staff have met with NASD and NYSE officials 
semiannually and quarterly, respectively, to discuss, among other 
things, examination findings and guidance. The officials also said that 
they hold frequent telephone conversations to coordinate their 
examination efforts. For example, SEC, NASD, and NYSE staff talked with 
each other immediately following NASD's discovery of breakpoint abuses 
in 2002, and established a joint task force to determine the extent of 
the abuses by conducting examinations of firms designed to identify 
failures to provide breakpoint discounts. Similarly, SEC, NASD, and 
NYSE staff talked with each other in their efforts to respond to the 
late trading and market timing abuses uncovered in 2003. In addition, 
SEC and SRO staff jointly attended conferences and training that 
included examination guidance as a topic of discussion. Finally, SEC, 
NASD, and NYSE have jointly developed a number of examination modules 
to enforce recent changes in laws and rules applicable to broker- 
dealers. 

Although SEC, NASD, and NYSE coordinate in these ways to oversee broker-
dealers, they generally do not provide copies of their written 
examination materials to each other. That is, SEC typically does not 
provide copies of its modules or other internal written guidance to the 
SROs, nor do NASD and NYSE generally provide copies of such guidance to 
each other. Officials at these agencies shared benefits and drawbacks 
of providing written copies of examination materials to each other. The 
regulators agreed that sharing information about their examination 
approaches and outcomes is overall a positive way to more effectively 
oversee the broker-dealer industry. They cautioned, however, that 
certain drawbacks should be considered regarding the sharing of written 
examination materials. SEC officials said that sharing SEC examination 
modules could compromise its supervision of the SROs. According to the 
officials, if SEC shared its modules, the SROs may be less innovative 
and motivated to improve their methods. They said, for example, that 
the SROs may view SEC's procedures as the most that they would need to 
do. NASD officials strongly disagreed with SEC's assertions about the 
sharing of examination modules, saying they always seek the most 
effective examination procedures, regardless of those used by SEC; and 
an NYSE official said that while NYSE understands the SEC's position in 
this regard, the sharing of SEC's examination module would only enhance 
NYSE's pre-existing examination procedures related to mutual funds. 
NASD and NYSE officials said it would be helpful if SEC shared copies 
of its modules and other guidance it shares with its own examiners. 
However, SEC and NASD officials said that NASD and NYSE may not want to 
share their examination modules with each other because of competitive 
reasons. For example, if one SRO shared its modules with another SRO, 
it would run the risk that its competitor could be able to adopt 
similar procedures without the cost of developing them. Finally, NASD 
officials told us that differences exist between NASD's and NYSE's 
membership, culture, priorities, and strategies that can lead to 
differences in examination procedures, and the same is true for 
financial institutions overseen by the banking regulators. 

Distribution and Storage of Broker-Dealer Examination Guidance: 

SEC's Office of Compliance Inspections and Examinations (OCIE) oversees 
and directs SEC's broker-dealer examination program, but SEC's 11 field 
offices conduct the vast majority of the broker-dealer examinations. 
Among other things, OCIE creates and updates broker-dealer examination 
modules, or policies and procedures; issues other examination guidance; 
and reviews broker-dealer examination reports. Currently, when OCIE 
develops and issues policy changes and examination guidance, it 
typically distributes such guidance to the field offices by e-mail. In 
turn, each field office separately stores the guidance on one of its 
shared computer drives or in some other way to provide its examiners 
access to the information. Field office examiners generally are 
responsible for keeping abreast of changes in guidance and reviewing it 
as needed in performing examinations. 

To better ensure that SEC examiners across all field offices have 
access to current and complete broker-dealer examination guidance, OCIE 
is developing an internal Web site to serve as a central repository for 
all broker-dealer examination guidance. According to agency officials, 
OCIE launched its internal Web site in April 2005 on a pilot basis to 
select broker-dealer examiners nationwide to obtain their comments 
about its organization and comprehensiveness. Subsequently, SEC made 
the Web site available to all examiners in July 2005. According to SEC 
officials, the Web site will allow broker-dealer examiners to access 
not only all guidance at one location but also links to databases and 
numerous other examiner tools. 

Broker-Dealer Examiner Training and Tracking: 

SEC's OCIE has a training branch that provides routine and specialized 
training to its broker-dealer examiners, with some of the training 
related to mutual funds. More specifically, OCIE's training branch 
provides a two-phased training program for broker-dealer examiners that 
is designed to teach examiners how to handle increasingly complex 
examination issues. According to an SEC official, the phase-one course 
is designed for new examiners and includes some training on mutual fund 
operations and mutual fund sales practices of broker-dealers. OCIE's 
training branch also offers a range of specialized training delivered 
in a variety of formats. For example, it offers classroom training 
sessions and videoconferences taught by senior examiners or vendors, 
such as NASD, as well as training videos that examiners can view when 
convenient. An SEC official told us that since 1999 the training branch 
has offered over 25 training sessions that have included mutual fund 
topics, such as breakpoints. 

In addition, SEC periodically has coordinated its training efforts with 
SROs, including NASD and NYSE. For example, examiners representing SEC, 
NASD, NYSE, and other SROs, as well as state regulators have met 
annually for a 3-day joint regulatory seminar to receive training about 
emerging and recurring regulatory issues. In 2003 and 2004, the 
seminars provided training on mutual fund sales practice abuses, 
including late trading, market timing, and failure to provide 
breakpoint discounts. Finally, SEC examiners attend or participate in 
external training, such as industry conferences. 

Separate from OCIE's training branch, SEC has a central training center 
called SEC University that oversees the agency's training 
programs.[Footnote 32] SEC University uses an electronic database to 
track training received by SEC staff. According to SEC officials, the 
database has a number of weaknesses that limits its usefulness in 
helping SEC to track and assess the training received by examiners. For 
example, the database cannot be used to generate reports on which 
examiners have taken or not taken a particular course. Also, the 
database is not directly accessible to examiners or their supervisors 
and, thus, does not allow them to review their training records or 
enter external training they may have taken. Because of these 
weaknesses, OCIE's training branch uses training rosters as needed to 
manually track which examiners have taken particular courses. SEC 
training staff said that they are requesting that the agency purchase a 
learning management system that would better enable it, including OCIE, 
to track and assess all training and other developmental opportunities. 
According to one of the officials, the initiative is currently tabled 
and may or may not receive funding this year. 

Despite challenges in its ability to track training in an automated 
way, OCIE takes some steps to evaluate the training needs of its 
examiners. It gathers and evaluates training participants' reactions to 
and satisfaction with training programs and uses that information to 
decide on what training to offer in the future. Training branch staff 
told us that at the end of each course, they hand out course evaluation 
forms to participants. These forms include closed-ended questions about 
the extent to which participants found the course helpful and open- 
ended questions about what additional training needs they have. The 
training branch uses the information to improve individual classes and 
the program as a whole. In addition, training staff attend monthly 
meetings with management and staff from all field offices, in part, to 
identify training needs and opportunities, and they also attend yearly 
meetings with examination program managers to discuss the examiners' 
training needs. 

[End of section]

Appendix III: Comments from the Securities and Exchange Commission: 

UNITED STATES SECURITIES AND EXCHANGE COMMISSION: 
WASHINGTON, D.C 20549:
OFFICE OF COMPLIANCE INSPECTIONS AND EXAMINATIONS: 

July 7, 2005: 

Mr. Richard J. Hillman: 
Director:
Financial Markets and Community Investment:
U.S. Government Accountability Office: 
441 G Street, N.W.
Washington, D.C. 20548: 

Re: GAO Report 05-45: "SEC's Revised Examination Approach Offers 
Potential Benefits but Significant Oversight Challenges Remain"

Dear Mr. Hillman: 

Thank you for this opportunity to review and comment on a draft of your 
report regarding the Securities and Exchange Commission's ("SEC") 
examination oversight of mutual funds. We applaud your finding that our 
revised examination approach offers potential benefits. 

We are committed to utilizing our resources in the most effective 
manner to identify fraud and compliance violations for the protection 
of investors. As you note in your report, approximately 495 SEC staff 
persons are dedicated to examination oversight of mutual funds and 
investment advisers. Given the size and growth of the industry, it is 
not possible for the SEC to conduct comprehensive, timely, routine 
examinations of every registrant. We also believe that routine 
examinations, standing alone, are not the best mechanism to promptly 
identify and investigate emerging compliance risks. 

As you describe in your report, we have focused our resources on the 
highest risk activities and firms, and on identifying emerging 
compliance risks. The SEC has done so by establishing an Office of Risk 
Assessment for the agency, creating full-time risk assessment positions 
within the examination program, developing a risk mapping program that 
includes all examiners, developing a risk-targeted methodology for 
examinations, expediting internal reporting from examinations, 
conducting more frequent routine examinations of the highest risk 
firms, developing monitoring teams to work with the largest firms, 
developing a surveillance program, and conducting risk-targeted 
examinations. The last item, risk-targeted examinations, is of 
particular importance. We would like to describe their value in greater 
detail. 

Risk-targeted examination reviews are a reasonable and effective means 
of quickly addressing risks in the securities industry. In a risk- 
targeted review, we conduct 'roughly contemporaneous examinations of 
the same risk at a number of different firms. These are "horizontal" 
examinations, in the sense that they look at the same risk across the 
industry, as compared to a "vertical" examination in which we would 
look at a single firm from top-to-bottom. This methodology better 
enables us to: 

* promptly investigate emerging compliance risks;

* compare a firm to its industry peers;

* address risks on a consistent basis through consolidated management 
of the review and the preparation of a single consolidated report at 
the end, thus avoiding the danger that examiners will take inconsistent 
positions on the same issues in different examinations; and: 

* make findings that are amenable to meaningful empirical inferences, 
such as the incidence of a particular problem in the sample, thus 
facilitating quick reports to the Commission and the staff, including 
the Divisions that draft rules and provide guidance to the industry. 

The benefits of risk-targeted reviews in promptly identifying emerging 
trends and compliance problems have already been demonstrated. For 
example, as a result of coordinated reviews of both mutual funds and 
the broker-dealers that distribute their shares, we found that fund 
assets were increasingly being used to pay broker-dealers for "shelf 
space" with related disclosure weaknesses. The SEC brought several 
enforcement actions, adopted new rules restricting funds' ability to 
use brokerage for distribution and is considering improved "point of 
sale" disclosure to customers. In another example, we recently 
completed a risk-targeted review of pension plan consultants. We found 
significant conflicts of interest and inadequate disclosure of those 
conflicts and released a public report describing what we found. In 
both of these situations, and in many others that have not yet led to 
public action, our risk-targeted reviews have enabled us to address 
significant compliance problems before they became major crises. 

In your report, you express concern that as a result of our focus on 
risk-targeted reviews and more frequent routine examinations of high- 
risk advisers and funds, we may give insufficient attention to low-risk 
advisers. We believe your concern is addressed by the program we are 
developing to use statistical techniques to select lower-risk advisers 
for full scope examinations. In this program, each year we will 
randomly select a statistically valid sample of lower-risk advisers for 
full scope examinations. This methodology will: 

* provide compliance deterrence in the adviser community because 
advisers will not know if they will be selected that year;

* enable us to test the assumptions and assessment techniques used 
throughout the fund and adviser examination program; and: 

* enable us to make inferences about the overall state of compliance in 
the adviser community, based on the statistically valid sampling 
techniques. 

From year-to-year, we expect that the mix of risk-targeted reviews, 
statistically selected examinations of low-risk firms, and routine full 
scope examinations of higher risk firms will change in response to 
changes in the regulated community. We expect this three-pronged 
approach to enable us to provide effective oversight of the fund and 
adviser community without the significant increases in staff that would 
be necessary if we were to restore a fixed cycle of fund and adviser 
examinations. 

You express concern about the value of our oversight examinations of 
broker-dealers. Oversight examinations have a valuable role to play in 
achieving our mission. First, you should note that while oversight 
examinations provide quality control over the examinations performed by 
the self-regulatory organizations ("SROs"), they also address other 
important goals as well. Oversight examinations allow us to detect 
violations that might not otherwise be detected, to conduct routine 
reviews of new products and services that have not yet been identified 
as posing a significant compliance risk, to conduct surveillance type- 
oversight, and to test and validate the assumptions and assessment 
techniques used throughout the broker-dealer examination program. All 
of these are important elements of our program. 

It is important to note that oversight examinations have revealed 
significant violations at broker-dealers that likely would not 
otherwise have been detected. In fact, in the last two and two-thirds 
fiscal years, 95.6% of our oversight examinations have revealed 
violations by the broker-dealers examined, and 19.4% revealed 
violations of sufficient gravity that they warranted referral to the 
enforcement staff of the SEC (7.9%) or to an SRO (11.5%). SEC oversight 
exams have revealed extremely serious problems, such as a ponzi scheme, 
that were not discovered in repeated SRO examinations. Finally, since 
April 1, 2004, we have been tracking how many of our examinations have 
had "significant" findings. Since that date, 37.5% of our oversight 
examinations have had significant findings, including market 
manipulation, excessive markups and markdowns, possible insider 
trading, unregistered distribution of securities, best execution, anti- 
money laundering violations, net capital violations, and other 
significant problems. 

Second, you suggest that if our oversight examinations are to provide 
accurate quality control information, they should seek to reproduce the 
SRO examinations they review. We are concerned about this approach. If 
we were to reproduce an SRO examination, there would be substantial 
redundancies for the broker-dealer being examined, and our conclusions 
would be limited to whether the SRO examination followed the SRO's 
stated procedures. On the other hand, by conducting oversight 
examinations as independent compliance reviews, we obtain a results- 
oriented view of the SRO's examination program. We can assess not just 
whether the SRO's procedures were followed, but more importantly, 
whether the SRO's procedures need to be modified or enhanced. In recent 
years, through our oversight program, we have identified a number of 
SRO examination procedures that needed improvement, including sampling 
techniques and examiner training. 

Our oversight examinations also provide the SROs with feedback on 
specific examinations. Commission examiners regularly meet with SRO 
examiners to review the results of oversight examinations, including 
any problems or shortfalls they detected in individual examinations. 
These meetings range from formal, fully documented meetings at the 
larger offices, to informal discussions at the smaller offices. In all 
cases, however, the SROs are informed of the problems we have detected. 

Third, as you correctly suggest in your report, an important element in 
any examination program is to seek out risks and problems that the 
regulator does not otherwise suspect. We expect that our statistically- 
selected examinations will perform that function for funds and 
advisers, and oversight examinations perform that function for broker- 
dealers. Our continued vigilance in oversight examinations provides an 
important element of investor protection, particularly at firms and in 
areas where we may not expect to find problems. 

As you note in your report, we have formed a working group to explore 
ways to gain additional value from oversight examinations, including by 
better identifying the reasons that a violation may not have been 
detected by an SRO examination, to better aid the SRO in improving its 
program, and to minimize the burden on the firm examined. 

Finally, you recommend several changes to our internal administrative 
processes. We will fully consider your recommendations. Specifically, 
we expect to deploy an enhanced electronic system for workpapers in 
2006. In preparation for that deployment, we expect to review how the 
new technology can be used to its maximum potential to enhance the 
overall quality of our examination program. We will include your 
recommendations in that review. 

Thank you again for this opportunity to review and comment on your 
draft report. If we can be of any further assistance, please contact me 
at (202) 551-6200. 

Sincerely,

Signed by: 

Lori A. Richards: 
Director: 

[End of section]

Appendix IV: GAO Contact and Staff Acknowledgments: 

GAO Contact: 

Richard J. Hillman (202) 512-8678: 

Staff Acknowledgments: 

In addition to the contact named above, John Wanska, Randall Fasnacht, 
Joel Grossman, Christine Houle, Marc Molino, Wesley Phillips, David 
Pittman, Paul Thompson, Richard Tsuhara, and Mijo Vodopic made key 
contributions to this report. 

(250185): 

FOOTNOTES

[1] The term "mutual fund" refers to an open-end management company, 
which is a type of investment company and comprises the largest segment 
of the investment company industry. 

[2] The term "hedge fund" generally identifies an entity that holds a 
pool of securities and perhaps other assets that is not required to 
register its securities offerings under the Securities Act and is 
excluded from the definition of an investment company under the 
Investment Company Act of 1940. Hedge funds are also characterized by 
their fee structure, which compensates an adviser based upon a 
percentage of the hedge fund's capital gains and capital appreciation. 
Pursuant to a new rule recently adopted by SEC, advisers of certain 
hedge funds are required to register with SEC under the Investment 
Advisers Act of 1940. See Registration Under the Advisers Act of 
Certain Hedge Fund Advisers, 69 Fed. Reg. 72054 (2004) (to be codified 
in various sections of 17 C.F.R. Parts 275 and 279). 

[3] Unlike market timing, late trading is illegal. Under SEC rules, 
mutual funds accept orders to sell and redeem fund shares at a price 
based on the current net asset value, which most funds calculate once a 
day at the 4:00 p.m. ET close of the U.S. securities markets. 

[4] We discuss the reasons that SEC did not detect the market timing 
and late trading abuses in a recently issued report. See GAO, Mutual 
Fund Trading Abuses: Lessons Can Be Learned from SEC Not Having 
Detected Violations at an Earlier Stage, GAO-05-313 (Washington, D.C.: 
Apr. 20, 2005). 

[5] Although NYSE is also responsible for regulating its member broker- 
dealers, 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. 

[6] GAO, Securities Industry: Strengthening Sales Practice Oversight, 
GAO/GGD-91-52 (Washington, D.C.: Apr. 25, 1991). 

[7] In late 2003, SEC established a 2 or 4-year examination cycle based 
on the size or risk level of the fund complex. However, this cycle was 
not fully implemented before SEC made significant changes to its mutual 
fund examination program as described in this section. 

[8] Under this process, examiners use a set of standardized work papers 
called control or risk scorecards to guide and document their 
assessment of the effectiveness of a fund's compliance controls 
designed to prevent or detect violations of the federal securities 
laws. Based on that assessment, examiners assign the fund an overall 
compliance risk rating of low, medium, or high. 

[9] In an earlier report, we found that SEC's focus on areas 
traditionally considered to be high risk hindered its capacity to 
detect violations not traditionally considered to be high risk, such as 
market timing abuses. We concluded that SEC needed to test controls in 
a variety of areas at least at a sample of companies to validate its 
assumptions about risks and verify the adequacy of controls in place to 
mitigate them. 

[10] SEC has 11 field offices, but 1 office does not have fund 
examination staff. 

[11] SEC, In Brief: Fiscal 2006 Congressional Budget Request (Feb. 
2005). 

[12] SEC, Final Rule: Compliance Programs of Investment Companies and 
Investment Advisers, 68 Fed. Reg. 74714 (Dec. 24, 2003). 

[13] GAO-05-313. 

[14] NASD's surveillance program is called Integrated National 
Surveillance and Information Technology Enhancements. 

[15] SEC recently reported that mutual funds and other investment 
companies managed roughly $8 trillion in assets at the start of fiscal 
year 2005, nearly double the $4.5 trillion in insured deposits at 
commercial banks and about equal to the $8 trillion of financial assets 
at commercial banks. 

[16] In fiscal year 2004, SEC sought to conduct routine examinations of 
(1) the 20 largest funds as well as funds and advisers posing high risk 
every 2 years and (2) all other funds, including their advisers, every 
4 years. 

[17] Absent a compliance risk rating for a fund complex, SEC officials 
stated that an alternative risk rating assigned to the fund's adviser 
will be used to determine when the fund will be routinely examined. The 
alternative rating captures risks inherent in the adviser's business 
such as conflicts of interests but does not measure the effectiveness 
of the adviser's compliance controls designed to mitigate conflicts of 
interest or other risks that could harm mutual fund shareholders. 

[18] We note that, as described later in this report, our work has 
identified deficiencies in SEC's implementation of its revised mutual 
fund examination guidelines, which raise questions about the quality of 
risk assessments made between 2002 and 2004. Further, risk ratings 
completed in 2002 and much of 2003 do not reflect the quality of fund 
controls over market timing and late trading as SEC did not view these 
as high-risk areas. SEC subsequently implemented revised procedures to 
test these areas at each mutual fund that it examined. 

[19] GAO-05-313. 

[20] SEC, Final Rule: Registration Under the Advisers Act of Certain 
Hedge Fund Advisers, 69 Fed. Reg. 72054 (Dec. 18, 2004). 

[21] For additional detail on how SEC arrived at its estimates, see 
Proposed Rule: Registration Under the Advisers Act of Certain Hedge 
Fund Advisers, Release No. IA-2266, File No. S7-30-04 (July 20, 2004). 

[22] GAO, An Audit Quality Control System: Essential Elements, GAO/OP- 
4.1.6 (Washington, D.C.: August 1993). 

[23] When first implemented in October 2002, the risk scorecards 
covered 10 areas related to the asset management function. In July 
2003, OCIE developed three additional risk scorecards. 

[24] Of the 11 examinations lacking any risk scorecards, 8 of them 
covered funds organized as unit investment trusts. MRO and NERO 
officials told us that the risk scorecards were not designed for unit 
investment trusts and, thus, staff did not always complete the 
scorecards for such types of funds. In one of the other examinations, 
staff noted on the scorecards that they found extensive violations at 
the fund and did not have time to complete the scorecards. 

[25] A unit investment trust is an investment company that (1) is 
organized under a trust indenture, (2) does not have a board of 
directors, and (3) issues only redeemable securities, each of which 
represents an undivided interest in a unit of specified securities. 

[26] As of October 2004, about 40 percent of OCIE's total examination 
staff of 810 individuals was assigned to broker-dealer, transfer agent, 
and clearing agency examinations (315 examiners dedicated to broker- 
dealer, transfer agent, and clearing agency examinations and 495 
individuals assigned to mutual fund and investment adviser 
examinations). 

[27] GAO/GGD-91-52. 

[28] Breakpoints are discounts offered to investors on up-front sales 
charges on certain mutual fund shares when an investor makes a large 
purchase. 

[29] MRO, NERO, and PDO completed 40, 17, and 9 routine fund 
examinations, respectively, in fiscal year 2004. 

[30] SEC focuses its examinations on fund complexes, or groups of funds 
that generally share the same adviser. SEC officials told us they 
examine both the fund complex and affiliated adviser at the same time 
when both are located at the same site. 

[31] Breakpoints are discounts offered to investors on up-front sales 
charges on certain mutual fund shares when an investor makes a large 
purchase. 

[32] As part of its 2004-2009 Strategic Plan, SEC is implementing SEC 
University--a comprehensive redesign of the agency's training and 
orientation programs--to help the agency develop and reinforce a strong 
operating culture, enhance employee performance, and broaden staff 
knowledge. 

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