a

GAO

United States Government Accountability Office

Report to the Committee on the Judiciary, 

House of Representatives

April 2005 MUTUAL FUND 

TRADING ABUSES

Lessons Can Be 

Learned from SEC Not 

Having Detected 

Violations at an Earlier 

Stage

GAO-05-313
www.gao.gov/cgi-bin/getrpt?GAO-05-313.

To view the full product, including the scope 

and methodology, click on the link above. 

For more information, contact Richard J. 

Hillman, 202-512-8678, hillmanr@gao.gov. 

Highlights of GAO-05-313, a report to the 

Committee on the Judiciary, House of 

Representatives 

April 2005

MUTUAL FUND TRADING ABUSES

Lessons Can Be Learned from SEC Not 

Having Detected Violations at an Earlier 

Stage 

Prior to September 2003, SEC did not examine for market timing abuses 

because agency officials viewed other activities as representing higher risks 

and believed that companies had financial incentives to control frequent 

trading because it could lower fund returns. While SEC faced competing 

examination priorities prior to September 2003 and made good faith efforts 

to mitigate the known risks associated with market timing, lessons can be 

learned from the agency not having detected the abuses earlier. First, 

without independent assessments during examinations of controls over 

areas such as market timing (through interviews, reviews of exception 

reports, reviews of independent audit reports, or transaction testing as 

necessary) the risk increases that violations may go undetected. Second, 

SEC can strengthen its capacity to identify and assess evidence of potential 

risks. Articles in the financial press and academic studies that were 

available prior to September 2003 stated that market timing posed significant 

risks to mutual fund company shareholders. Finally, GAO found that fund 

company compliance staff often detected evidence of undisclosed market 

timing arrangements with favored customers but lacked sufficient 

independence within their organizations to correct identified deficiencies. 

Ensuring compliance staff independence is critical, and SEC could 

potentially benefit from their work. 

SEC has taken several steps to strengthen its mutual fund oversight program 

and the operations of mutual fund companies, but it is too soon to assess the 

effectiveness of certain initiatives. To improve its examination program, 

SEC staff recently instructed agency staff to conduct more independent 

assessments of fund company controls. To improve its risk assessment 

capabilities, SEC also has created and is currently staffing a new office to 

better anticipate, identify, and manage emerging risks and market trends. To 

better ensure company compliance staff independence, SEC recently 

adopted a rule that requires compliance officers to report directly to funds’ 

boards of directors. While this rule has the potential to improve fund 

company operations and is intended to increase compliance officers’ 

independence, certain compliance officers may still face organizational 

conflicts of interest. Under the rule, compliance officers may not work 

directly for mutual fund companies, but rather, for investment advisers 

whose interests may not necessarily be fully aligned with mutual fund 

customers. The rule also requires compliance officers to prepare annual 

reports on their companies’ compliance with laws and regulations, but SEC 

has not developed a plan to routinely receive and review the annual 

compliance reports. Without such a plan, SEC cannot be assured that it is in 

the best position to detect abusive industry practices and emerging trends. 

Recent violations uncovered in the 

mutual fund industry raised 

questions about the ethical 

practices of the industry and the 

quality of its oversight. A 

widespread abuse involved mutual 

fund companies’ investment 

advisers (firms that provide 

management and other services to 

funds) entering into undisclosed 

arrangements with favored 

customers to permit market timing 

(frequent trading to profit from 

short-term pricing discrepancies) 

in contravention of stated trading 

limits. These arrangements 

harmed long-term mutual fund 

shareholders by increasing 

transaction costs and lowering 

fund returns. Questions have also 

been raised as to why the New 

York State Attorney General’s 

Office disclosed the trading abuses 

in September 2003 before the 

Securities and Exchange 

Commission (SEC), which is the 

mutual fund industry’s primary 

regulator. Accordingly, this report 

(1) identifies the reasons that SEC 

did not detect the abuses at an 

earlier stage and the lessons 

learned in not doing so, and (2) 

assesses the steps that SEC has 

taken to strengthen its mutual fund 

oversight program and improve 

mutual fund company operations. 

GAO recommends that SEC 

routinely assess the effectiveness 

of compliance officers and plan to 

review compliance reports on an 

ongoing basis. SEC agreed with 

these recommendations. 
Page i GAO-05-313 Mutual Fund Trading Abuses

Contents

Letter 1

Results in Brief 4

Background 7

Lessons Can be Drawn from SEC Not Having Detected Market 

Timing Arrangements 10

SEC Has Taken Steps to Strengthen Its Mutual Fund Oversight 

Program, but It Is Too Soon to Assess the Effectiveness of Several 

Key Initiatives 21

Conclusions 33

Recommendations 35

Agency Comments and Our Evaluation 36

Appendixes

Appendix I: Objectives, Scope, and Methodology 38

Appendix II: Mutual Fund Trade Processing and Recordkeeping 40

Appendix III: SEC Proposed Rule to Prevent Late Trading 43

Appendix IV: Comments from the Securities and Exchange Commission 45

Appendix V: GAO Contacts and Staff Acknowledgments 47

GAO Contacts 47

Staff Acknowledgments 47

Tables Table 1: Staff Positions for SEC Divisions and Offices with 

Responsibilities for Mutual Fund Regulation, Oversight, 

and Enforcement, as of February 2005 27

Table 2: SEC Mutual Fund-related Rules, Adopted after September 

2003 29

Figures Figure 1: SEC Settled Enforcement Actions against Investment 

Advisers Related to Market Timing Violations as of 

February 28, 2005 (dollars in thousands) 26

Figure 2: Processing Paths of Mutual Fund Transactions 41
Contents

Page ii GAO-05-313 Mutual Fund Trading Abuses

Abbreviations

1940 Act Investment Company Act of 1940

Advisers Act Investment Advisers Act of 1940

CCO chief compliance officer

ICI Investment Company Institute

Investment Management Division of Investment Management

NASD National Association of Securities Dealers

NAV net asset value

NSCC National Securities Clearing Corporation

NYSOAG New York State Office of the Attorney General

NYSE New York Stock Exchange

OCIE Office of Compliance Inspections and 

Examinations

ORA Office of Risk Assessment

SEC Securities and Exchange Commission

SRO self-regulatory organization

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Page 1 GAO-05-313 Mutual Fund Trading Abuses

United States Government Accountability Office

Washington, D.C. 20548

A

April 20, 2005 Letr

The Honorable F. James Sensenbrenner, Jr.

Chairman

Committee on the Judiciary

House of Representatives

The Honorable John Conyers, Jr.

Ranking Minority Member

Committee on the Judiciary

House of Representatives

Recent trading abuses uncovered among some of the most well-known 

companies in the mutual fund industry identified significant lapses in the 

ethical standards of the industry and raised concerns about the quality of 

its oversight. A widespread type of violation engaged in by mutual fund 

companies involved market timing.1

 Market timing typically involves the 

frequent buying and selling of mutual fund shares by sophisticated 

investors, such as hedge funds, that seek opportunities to make profits on 

the differences in prices between overseas markets and U.S. markets or for 

other purposes.2

 Although market timing is not itself illegal, frequent 

trading can harm mutual fund shareholders because it lowers fund returns 

and increases transaction costs. However, market timing can constitute 

illegal conduct if, for example, it takes place as a result of undisclosed 

agreements between investment advisers (firms that may manage mutual 

fund companies) and favored customers such as hedge funds who are 

permitted to trade frequently and in contravention of stated fund trading 

limits. Market timing may also constitute illegal conduct, if as happened in 

some cases, investment adviser officials engage in frequent trading of fund 

1

For purposes of this report, the term “mutual fund companies” generally refers to mutual 

fund companies and their related investment advisers and service providers, such as 

transfer agents, unless otherwise specified. As described in this report, many mutual fund 

companies have no employees, although they typically have boards of directors, and rely on 

investment advisers to perform key functions such as providing management and 

administrative services. 

2

The term “hedge fund” generally identifies an entity that holds a pool of securities and 

perhaps other assets that is not required to register its securities offerings under the 

Securities Act and is excluded from the definition of an investment company under the 

Investment Company Act of 1940. Hedge funds are also characterized by their fee structure, 

which compensates the adviser based upon a percentage of the hedge fund’s capital gains 

and capital appreciation. 
Page 2 GAO-05-313 Mutual Fund Trading Abuses

shares in violation of fund policies and disclosures. Another type of 

violation commonly referred to as late trading was significant but less 

widespread than market timing violations. Late trading typically involved 

intermediaries, such as broker-dealers or pension plans that offer mutual 

funds, that permitted certain customers to place trades after the 4 p.m. 

Eastern Time close of the financial markets.3 Investors who are permitted 

to engage in late trading can profit on knowledge of events in the financial 

markets that take place after 4 p.m., an opportunity that other fund 

shareholders do not have.

Questions have also been raised as to why securities industry regulators, 

such as the Securities and Exchange Commission (SEC) and the National 

Association of Securities Dealers (NASD), did not detect the undisclosed 

market timing arrangements and late trading abuses. Instead, the New York 

State Office of the Attorney General (NYSOAG) uncovered the abuses in 

the summer of 2003 after following up on a tip provided by a hedge fund 

insider. SEC, which has direct supervisory oversight responsibility for 

mutual fund companies, did not detect the undisclosed arrangements 

through its routine examination program. NASD, which regulates brokerdealers that may sell mutual funds as part of their overall business, also did 

not detect undisclosed market timing or late trading abuses through its 

examinations.4

 However, once early indications of undisclosed market 

timing arrangements and late trading surfaced, SEC surveyed mutual fund 

companies and initiated a series of examinations, as did NASD regarding 

broker-dealers, to determine the extent of the problem. By November 2003, 

SEC estimated that 50 percent of the 80 largest mutual fund companies had 

entered into undisclosed arrangements permitting certain shareholders to 

engage in market timing practices that appeared to be inconsistent with the 

funds’ policies, prospectus disclosures, or fiduciary obligations. 

Additionally, SEC and NASD investigated and pursued companies and 

individuals found to have responsibility for market timing and late trading 

abuses through filing and settling enforcement actions, which have 

generated substantial fines and penalties. Nevertheless, the regulators’ 

3

In this report, we assume for convenience that all funds choose to price their securities 

daily as of 4:00 p.m. Funds may, however, elect to price their securities more than once per 

day, and according to SEC, many funds price their securities earlier than 4:00 p.m.

4

The New York Stock Exchange (NYSE) is also responsible for oversight of its member 

firms, but NASD typically conducts the sales practice portions of examinations for firms 

that are dually registered with it and NYSE. As a result, NYSE generally plays a lesser role in 

examining broker-dealers for matters involving mutual fund sales. We therefore did not 

include NYSE in the scope of this review.
Page 3 GAO-05-313 Mutual Fund Trading Abuses

failure to identify the abuses at an earlier stage has generated concern 

about the effectiveness of their examination and other oversight 

procedures.

This report responds to your requests that we review issues relating to 

regulatory oversight of the mutual fund industry. Because undisclosed 

market timing arrangements were more widespread than late trading 

violations and SEC is the mutual fund industry’s frontline regulator, the 

report primarily focuses on SEC’s oversight of the market timing area. The 

report also addresses NASD’s oversight of broker-dealers that failed to 

prevent customers’ late trading and market timing activities but does not 

discuss late trading at pension plans and plan administrators, which are 

subject to oversight by the Department of Labor. Accordingly, the report (1) 

identifies the reasons that SEC did not detect the abusive market timing 

agreements at an earlier stage and lessons learned from the agency’s failure 

to do so; and (2) assesses steps that SEC has taken to strengthen its mutual 

fund oversight, deter abusive trading, and improve mutual fund company 

operations.

To accomplish our reporting objectives, we interviewed SEC staff at 

headquarters and at a judgmental sample of six regional and district offices 

located nationwide; NASD officials; and officials from the Investment 

Company Institute (ICI), which is the trade group that represents the 

mutual fund industry, a judgmental sample of large mutual fund companies; 

broker-dealers; pension plans; the National Securities Clearing Corporation 

(NSCC), which plays a role in processing certain mutual fund transactions; 

the Securities Industry Association; and other industry participants. At the 

six SEC offices, we also reviewed enforcement actions and examination 

reports for 11 large mutual fund companies that regulators identified as 

having entered into undisclosed market timing arrangements or where late 

trading violations took place. Each of these companies was among the 100 

largest mutual fund companies in the United States as measured by assets 

under management on August 1, 2003. We also reviewed general financial 

regulation and auditing standards pertaining to the oversight of regulated 

entities and federal agencies as well as relevant academic and other 

studies. We reviewed relevant documentation and discussed the cases with 

knowledgeable SEC staff to provide a basis for understanding the reasons 

that the agency did not detect abuses at an earlier stage. Our work was 

performed in Atlanta, Ga.; Boston, Mass.; Chicago, Ill.; Denver, Colo.; New 

York, N.Y.; Philadelphia, Pa.; and Washington, D.C. We conducted our work 

between May 2004 and April 2005 in accordance with generally accepted 
Page 4 GAO-05-313 Mutual Fund Trading Abuses

government audit standards. Appendix I provides a detailed description of 

our scope and methodology.

Results in Brief Prior to September 2003, SEC staff did not examine for market timing 

abuses or assess company controls over that activity because agency staff 

(1) viewed market timing as a relatively low-risk area that did not involve 

per se violations; (2) determined that mutual fund companies had financial 

incentives to establish effective controls over frequent trading because 

such trading can reduce fund returns resulting in a loss of business; and (3) 

were told by company officials that they had designated compliance staff to 

monitor and control market timing. We recognize that SEC staff faced 

competing examination priorities and that detecting fraudulent activities, 

particularly previously unknown frauds such as the undisclosed 

arrangements between investment advisers and favored investors, is 

challenging. Further, SEC staff made good faith efforts to control the 

known risks associated with market timing through the regulatory process, 

such as by issuing guidance on “fair value” pricing.5

 Nevertheless, lessons 

can be learned to strengthen SEC’s mutual fund company oversight 

program going forward from the agency not having detected the 

undisclosed market timing arrangements at an earlier stage. In particular, 

conducting independent assessments of controls (through a variety of 

means including interviews, reviews of exception reports, reviews of 

internal audit or other company reports, and transaction testing as 

necessary) over various activities within a mutual fund company, including 

areas perceived to represent relatively low risks at a sample of companies, 

is, at a minimum, an essential means to verify assessments about risks and 

the adequacy of controls in place to mitigate those risks. Without such 

independent assessments, the potential increases that violations will go 

undetected. Further, our review identified information that was available 

prior to September 2003 that was inconsistent with SEC staff’s views that 

market timing was a low risk area and that companies would necessarily 

act to protect fund returns from the harmful consequences of frequent 

trading. For example, academic studies indicated that market timing by 

sophisticated investors, while legal, remained a persistent risk prior to 

September 2003 that by one estimate was costing mutual fund shareholders 

5

Fair value pricing involves mutual funds using the estimated market value of shares when 

market quotes are not readily available. As described in this report, fair value pricing of 

mutual fund shares can minimize discrepancies in pricing between foreign and U.S. financial 

markets and thereby minimize market timing opportunities. 
Page 5 GAO-05-313 Mutual Fund Trading Abuses

approximately $5 billion annually in certain funds and that companies were 

not acting aggressively to control these risks through fair value pricing, 

despite SEC’s guidance that they do so. The author of a 2002 study raised 

the possibility that certain investment advisers were not implementing fair 

value pricing because such advisers benefited financially from permitting 

frequent trading, which turned out to be the case.6

 Moreover, a mutual fund 

insider provided information to an SEC district office in early 2003 that 

indicated a company had poor market timing controls but the office did not 

act promptly on this information. SEC must develop the institutional 

capacity to identify and evaluate such evidence of potential risks and 

deploy examiners as necessary to assess company controls in such areas 

and help identify potential violations. Finally, our review found that 

company compliance staff in the majority of cases that we reviewed 

identified evidence of market timing arrangements with favored customers 

as early as 1998 but lacked sufficient independence within their 

organizations to correct identified deficiencies. Ensuring compliance staff 

independence is critical, and SEC staff could potentially better assess 

company risks and controls through routine interactions with such staff 

and reviewing relevant documentation.

SEC has taken several steps to strengthen its mutual fund oversight 

program and the operations of mutual fund companies over the past 2 

years, but it is too soon to assess the effectiveness of several key initiatives. 

To improve its examination program, SEC has instructed examiners to 

make additional assessments of mutual fund company controls. For 

example, SEC staff has identified a range of areas that potentially represent 

high-risk compliance problems, such as personal trading by mutual fund 

company officials, and examiners have initiated independent examinations 

of these areas, as well as obtaining more internal documentation, such as emails about these control areas. In a forthcoming report, we assess SEC 

staff’s implementation of these revised examination guidelines. To improve 

its capacity to anticipate, identify, and manage emerging risks and market 

trends in the securities industry, SEC has created a new office that reports 

directly to the agency’s chairman. However, it is too soon to assess the 

effectiveness of the new office as it had only 5 of 15 planned employees as 

of February 2005 and was still defining its role within the agency. 

6

Eric Zitzewitz “Who cares about shareholders? Arbitrage-proofing mutual funds,” Stanford 

Graduate School of Business Research Paper No. 1749 (October 2002). As described later in 

this report, some favored investors agreed to place assets in mutual funds in exchange for 

market timing privileges (referred to as “sticky assets”). Investment advisers’ fees are often 

based on the size of assets under management.
Page 6 GAO-05-313 Mutual Fund Trading Abuses

Additionally, SEC has adopted rules designed to improve mutual fund 

company operations, including rules that require registered investment 

companies (mutual funds) and investment advisers to each designate a 

chief compliance officer (CCO). The CCO of the investment company 

reports directly to the company’s board of directors and is responsible for 

preparing annual reports on company compliance with federal laws and 

regulations. By requiring the CCO to report directly to the board of 

directors, SEC helped ensure the independence of the compliance function, 

with one potentially important exception. Because many investment 

companies do not have any employees, SEC provided that an investment 

company’s CCO could be an employee of an investment adviser. As 

described in this report, investment adviser staff frequently entered into 

undisclosed market timing arrangements with favored customers at the 

expense of mutual fund shareholders. Although the rule provides 

safeguards to ensure the independence of CCOs, it is too soon to reach 

definitive judgments on their effectiveness.7

 Moreover, SEC has not 

developed a plan to ensure that agency staff receive and can review the 

annual compliance reports on an ongoing basis. Without such a plan, SEC 

cannot ensure that it has taken full advantage of opportunities to enhance 

its mutual fund oversight program and detect potential violations on a 

timely basis. 

Among other steps, this report recommends that SEC, through the 

examination process, ensure that investment company CCOs operate 

independently and are effective in carrying out their responsibilities and 

that SEC develop a plan to assess the feasibility of receiving and reviewing 

annual compliance report findings on an ongoing basis. SEC provided 

written comments on a draft of this report that are reprinted in appendix IV. 

SEC commented that the agency has taken several steps to strengthen its 

mutual fund oversight program and agreed with these recommendations. 

SEC’s comments are discussed in more detail at the end of this report. 

NASD provided technical comments as did SEC, which have been 

incorporated where appropriate. 

7

As described in this report, SEC also amended rules that require that in order for mutual 

funds to rely on any of 10 commonly used exemptive rules, the chairperson and at least 75 

percent of the members of mutual fund boards of directors be independent of the funds’ 

investment advisory firms. SEC believes the fact that mutual fund boards have sole 

authority to designate and remove compliance offices will help ensure the officers’ 

independence. The exemptive rules (i) exempt mutual funds or their affiliated persons from 

provisions of the Investment Company Act of 1940 that can involve serious conflicts of 

interest and (ii) condition the exemptive relief on the approval or oversight of independent 

directors.
Page 7 GAO-05-313 Mutual Fund Trading Abuses

Background Although it is typically organized as a corporation, a mutual fund’s 

structure and operation differ from that of a traditional corporation. In a 

typical corporation, the firm’s employees operate and manage the firm, and 

the corporation’s board of directors, elected by the corporation’s 

stockholders, oversees its operations.8

 Mutual funds also have a board of 

directors that is responsible for overseeing the activities of the fund and 

negotiating and approving contracts with an adviser and other service 

providers. Unlike a typical corporation, a typical mutual fund has no 

employees; another party, the adviser, which contracts with the fund for a 

fee, administers fund operations. The adviser is an investment 

adviser/management company that manages the fund’s portfolio according 

to the objectives and policies described in the fund’s prospectus.9

 Advisers 

may also perform various administrative services for the funds they 

operate, although they also frequently subcontract with other firms to 

provide these services. Functions that a fund adviser or other firms may 

perform for a fund include the following:

• Custodian: A custodian holds the fund assets, maintaining them 

separately to protect shareholder interests.

• Transfer agent: A transfer agent processes orders to buy and redeem 

fund shares and has customer recordkeeping responsibilities.

• Distributor: A distributor sells fund shares through a variety of 

distribution channels, including directly through telephone or mail 

solicitations handled by dedicated sale forces, or through third-party 

intermediaries’ sales forces. 

Mutual funds are also structured so that each investor in the fund owns 

shares, which represent a percentage of the fund’s investment portfolio, 

and investors share in the fund’s gains, losses, and costs. Mutual fund 

families offer investors multiple funds from which to choose, each with 

varying investment objectives and levels of risk. Investors may exchange 

8

Although the Investment Company Act of 1940, as amended, does not dictate a specific 

form of organization for mutual funds, most funds are organized either as corporations 

governed by a board of directors or as business trusts governed by trustees. When 

establishing requirements relating to the officials governing a fund, the act uses the term 

“directors” to refer to such persons, and this report also follows that convention.

9

In some cases, the adviser may contract with other firms to provide investment advice, the 

latter firms becoming subadvisers to those funds.
Page 8 GAO-05-313 Mutual Fund Trading Abuses

assets between funds within a fund family at any time. Investors also may 

purchase shares directly from their mutual fund company or through 

intermediaries such as broker-dealers or pension plans that offer mutual 

fund company products to their customers. Intermediaries typically 

aggregate customer mutual fund orders and submit them to mutual fund 

companies at one time on a daily basis and may perform certain customer 

recordkeeping functions on behalf of mutual fund companies. NSCC, a 

SEC-registered clearing agency, is responsible for processing and clearing 

most of the mutual fund transactions that take place between broker-dealer 

intermediaries and mutual fund companies. Appendix II provides detailed 

information on mutual fund trade processing and recordkeeping.

Mutual fund companies are subject to SEC registration and regulation 

(unless an exemption from registration applies), and numerous 

requirements established for the protection of investors. Mutual fund 

companies are regulated primarily under the Investment Company Act of 

1940 (1940 Act) and the rules adopted under that act. For example, mutual 

fund company boards are required to have members who are independent 

of the company’s investment advisers to help ensure that fund companies 

act in the best interest of their shareholders. SEC has authority under the 

1940 Act to promulgate rules to address the changing financial services 

industry environment in which mutual funds and other investment 

companies operate. The advisory firms that manage mutual funds are 

regulated under the Investment Advisers Act of 1940 (Advisers Act), which 

among other provisions requires certain investment advisers to register 

with SEC and conform to regulations designed to protect investors. Subject 

to SEC oversight, NASD, which is a self-regulatory organization (SRO), is 

responsible for regulation of its member broker-dealers that sell various 

investment products, including mutual funds. NASD, however, has no 

jurisdiction over investment companies or their advisers. NASD carries out 

its oversight responsibilities by issuing rules, conducting examinations, and 

pursuing enforcement actions as necessary. However, certain other 

intermediaries that may offer mutual fund products to their customers are 

outside of SEC’s regulatory jurisdiction. For example, the Department of 

Labor is responsible for regulating pension plans and their administrators. 

In addition to its rulemaking authority, SEC carries out its mutual fund 

oversight responsibilities through examinations. SEC’s Office of 

Compliance Inspections and Examinations (OCIE) establishes examination 

policies and procedures and has primary responsibility for conducting 

mutual fund company and adviser examinations. Between 1998 and 2003, 

OCIE and its regional and district staff typically conducted routine 
Page 9 GAO-05-313 Mutual Fund Trading Abuses

examinations, which were scheduled on a regular basis (such as every 2 to 

5 years), depending on their size or SEC’s assessments of the risks that they 

represented to shareholders.10 SEC may also conduct “sweep” 

examinations, which involve reviewing particular issues—such as 

securities valuation procedures—at a number of mutual fund companies or 

advisers to determine whether deficiencies or violations exist industrywide 

for a particular issue. Additionally, SEC may conduct “cause” examinations, 

which are based on indications, allegations, or tips regarding wrongdoing 

or inappropriate conduct at a firm. The goal of a cause examination is to 

quickly determine whether there is a problem at a particular entity. SEC’s 

Division of Enforcement is responsible for pursuing civil enforcement 

actions for violations of securities laws or regulations that are identified 

through SEC examinations, referrals from other regulatory organizations 

such as NASD, tips from fund insiders or the public, and other sources. 

SEC may also refer cases to criminal authorities, such as the Department of 

Justice, for violations that appear to indicate criminal activity.

Market timing, although not illegal per se, can be unfair to long-term fund 

investors because it provides the opportunity for selected fund investors to 

profit from fund assets at the expense of long-term investors. Typically, 

sophisticated investors may engage in market timing to take advantage of 

differences in prices between stocks in overseas markets—particularly 

Asia—and U.S. markets and for other reasons. Mutual funds that fail to 

update their share prices are particularly vulnerable to sophisticated 

market timing. SEC examiners identified this phenomenon in 1997 after the 

Asian markets crisis when some funds “fair valued” their holdings and were 

not subject to market timing by shareholders while other funds that did not 

“fair value” their holdings were subject to market timing. Market timing 

may require fund managers to hold additional cash to redeem frequent 

trading orders, which lowers long-term investors’ overall returns since the 

fund may hold fewer securities than would be the case in the absence of 

market timing. In addition, market timing increases transaction costs—

such as trading fees—further lowering shareholder returns. Consequently, 

many mutual funds have established limits on the number of trades that 

individual customers may place per year—such as four trades—and 

disclose these limits in fund prospectuses. However, prior to September 

10In 2004, SEC staff developed plans to revise its examination program so that teams of 

examiners monitored the largest mutual fund companies on an ongoing basis rather than on 

a regular schedule. We are assessing SEC’s planned strategy as part of a separate 

engagement.
Page 10 GAO-05-313 Mutual Fund Trading Abuses

2003, certain investment advisers entered into undisclosed arrangements 

with favored customers, including hedge funds, allowing the customers to 

circumvent the established limits. These undisclosed agreements 

sometimes allowed favored customers to place hundreds of trades annually 

at the expense of long-term shareholders, who were subject to established 

trading limits. In exchange for market timing privileges, favored customers 

often secretly agreed to make investments in certain mutual funds or other 

investment vehicles that were managed by that company (commonly 

referred to as “sticky assets” arrangements). 

Unlike market timing, late trading is illegal under all circumstances. Under 

SEC rules, mutual fund companies accept orders to purchase and redeem 

fund shares at a price based on the current net asset value (NAV), which 

most funds calculate once a day at 4:00 p.m. Eastern Time. As previously 

discussed, intermediaries—such as broker-dealers and pension funds—

typically aggregate orders received from investors and submit a single 

purchase or redemption order that nets all the individual shares their 

customers are seeking to buy or sell. Because processing takes time, SEC 

rules permit these intermediaries to forward the order information to funds 

after 4:00 p.m. However, late trading occurs when some investors submit 

orders to purchase or sell mutual fund shares after the 4:00 p.m. close of 

U.S. securities markets (or the mutual fund’s pricing time) and receive that 

same day pricing for the orders. Although late trading can involve mutual 

fund company personnel, late trading violations have typically occurred at 

intermediaries, before these institutions submitted their daily aggregate 

orders to mutual fund companies for final settlement. An investor 

permitted to engage in late trading could be buying or selling shares at the 

current day’s 4:00 p.m. price with knowledge of developments in the 

financial markets that occurred after 4:00 p.m. Such investors thus have 

unfair access to opportunities for profit that are not provided to other fund 

shareholders.

Lessons Can Be Drawn 

from SEC Not Having 

Detected Market 

Timing Arrangements 

Prior to September 2003, SEC did not examine for market timing abuses 

because agency staff viewed market timing as a relatively low-risk area and 

believed that companies had financial incentives to establish effective 

controls, that is, by maximizing fund returns in order to sell fund shares. 

SEC staff also said that agency examiners were told by company officials 

that they had established “market timing police” to control frequent 

trading. In retrospect, SEC staff’s inability to detect the widespread market 

timing violations demonstrates the importance of (1) conducting 

independent assessments of the adequacy of controls over areas such as 
Page 11 GAO-05-313 Mutual Fund Trading Abuses

market timing, (2) developing the institutional capability to identify and 

analyze evidence of potential risks, and (3) ensuring the independence and 

effectiveness of company compliance staff and potentially using their work 

to benefit the agency’s oversight program.

SEC Did Not Examine for 

Mutual Fund Company 

Market Timing Abuses

OCIE staff have stated that given the number of mutual fund companies, 

the breadth of their operations, and limited examination resources, SEC’s 

examinations were limited in scope and examiners focused on discrete 

areas that staff viewed as representing the highest risks of presenting 

compliance problems that could impact investors. OCIE staff stated that 

prior to September 2003, they considered funds’ portfolio trading (i.e., the 

fund’s purchases and sales of securities on behalf of investors) and other 

areas as representing higher risks than potential market timing abuses. For 

example, examiners focused on whether funds were trying to inflate the 

returns of the fund, or taking on undisclosed risk. SEC’s staff’s concern was 

that in attempting to produce strong investment returns to attract and 

maintain shareholders, fund portfolio managers had an incentive to engage 

in misconduct in the management of the fund. As a result, SEC examination 

protocols instructed that significant attention be focused on portfolio 

management, order execution, allocation of investment opportunities, 

pricing and calculation of NAV, advertising returns, and safeguarding fund 

assets from theft. SEC staff stated that examinations and enforcement 

cases in these areas revealed many deficiencies and violations. Our 

discussions with SEC staff nationwide, review of selected examination 

reports, and discussions with officials of mutual fund companies verified 

that the agency did not review market timing controls prior to September 

2003. 

OCIE and SEC district staff we contacted said that the agency also did not 

review mutual fund market timing controls because market timing is not 

illegal per se, and they viewed fund companies as having financial 

incentives to control frequent trading. That is, since frequent trading can 

reduce shareholder returns, fund companies had incentives to establish 

controls that would prevent market timing. Failure to establish such 

controls could result in a loss of new sales and assets under management, 

which would harm investment advisers because they are compensated 

based on the amount of assets under management. Thus, SEC staff 

concluded the advisers had a financial incentive to grow or maintain assets 

under management in order to receive higher fees. SEC staff also said that 

mutual fund company officials told agency examiners that they had 
Page 12 GAO-05-313 Mutual Fund Trading Abuses

appointed “market timing police” to enforce compliance with the funds’ 

trading limit policies.

SEC staff also stated that they were surprised when the NYSOAG identified 

abusive market timing and late trading violations in September 2003. SEC 

staff said that they did not anticipate that mutual fund companies would 

enter into market timing arrangements that were detrimental to fund 

performance because poor performance could impact sales and have a 

negative effect on the fee received by the adviser. After the abusive 

practices were identified, SEC moved aggressively to assess the scope and 

seriousness of the problem. For example, SEC surveyed about 80 large 

mutual fund companies and determined that nearly 50 percent had some 

form of undisclosed market timing arrangement with certain customers 

that appeared to be inconsistent with internal policies, prospectus 

disclosure, or fiduciary duties. SEC also initiated immediate “cause” 

examinations and investigations at many of these mutual fund companies 

to further review potential violations. As described in a later section, SEC 

also initiated numerous enforcement actions to penalize violators and deter 

the abusive mutual fund trading practices. 

NASD in its examinations of broker-dealers also did not discover market 

timing arrangements involving broker-dealers before September 2003. 

According to an NASD official, this was because market timing was not 

illegal per se and, to the extent a mutual fund company had stated 

customer trading limits, broker-dealers may not have perceived themselves 

as being responsible for the enforcement of such policies. Regarding late 

trading, NASD officials said that the organization did not have specific 

examination guidance to detect the violation prior to September 2003. 

NASD officials also said that some broker-dealers created fictitious 

accounts or otherwise falsified documents, which made the detection of 

late trading violations difficult.

Independent Assessments 

of Controls are Essential 

We recognize that SEC faces competing examination priorities and had 

limited examination resources prior to September 2003. In a 2002 report, 

we noted that over the previous decade the size and complexity of financial 

markets had increased substantially, whereas SEC’s staff size had remained 

essentially flat, which significantly increased the agency’s workload.11 In 

11GAO, SEC Operations: Increased Workload Creates Challenges, GAO-02-302 (Washington, 

D.C.: Mar. 5, 2002).
Page 13 GAO-05-313 Mutual Fund Trading Abuses

particular, our report noted the large increase in investment company and 

investment adviser assets under management over a 10-year period, 

relative to the growth in examination staff. As discussed later in this report, 

in recent years, Congress has provided SEC with substantial budgetary 

increases to assist in overseeing the securities markets. Some of these new 

resources were allocated to oversight of mutual funds. We also recognize 

that SEC examiners cannot anticipate every potential fraud, particularly 

novel frauds such as the undisclosed market timing arrangements between 

investment advisers and favored customers, such as hedge funds.

Although we recognize that SEC faced competing priorities, the fact that 

the agency subsequently found that about half of the largest mutual fund 

companies had entered into undisclosed arrangements with certain 

shareholders, demonstrates the importance of examination and auditing 

standards that call for independent assessments of the adequacy of 

controls to prevent or detect abusive practices. SEC’s examination 

standards acknowledge the importance of independent control testing. For 

example, SEC examination guidance in effect since 1997 states:

A primary task and responsibility of the SEC inspection staff is to review a fund’s control 

environment and underlying internal control or compliance system(s). By applying certain 

examination procedures and techniques, examiners should be able to evaluate the control 

environment and determine the effectiveness of each system in ensuring compliance. 

In addition, commonly accepted examination and auditing guidelines call 

for a degree of professional skepticism in assessing controls (such as 

mutual fund company market timing controls) and independent 

verification of their adequacy to confirm other assessments of potential 

risks or statements by company officials. Conducting independent testing 

of controls at a sample of companies, at a minimum, could serve to verify 

that areas, such as market timing, do in fact represent low risks and that 

effective controls are in place. Independent control assessments can be 

accomplished through a variety of means including interviewing officials 

responsible for the control, assessing organizational structure to ensure 

that compliance staff have adequate independence to carry out their 

responsibilities, reviewing internal and external audit reports, reviewing 

exceptions to stated policies, and testing transactions as necessary. If 

examiners or auditors detect indications of noncompliance with stated 

policies or requirements, they are expected to expand the scope of their 

work to determine the extent of identified deficiencies.

We also note that SEC examination guidance potentially limited examiners’ 

capacity to develop overall assessments of mutual fund company risks and 
Page 14 GAO-05-313 Mutual Fund Trading Abuses

controls and identify potential violations---such as market timing abuses—

outside of identified or perceived high-risk areas. Specifically, SEC 

examination guidance of March 2002 generally instructed examiners to 

request only a sample of selected internal audit reports when reviewing a 

registrant’s internal control or supervisory systems or as part of a review of 

a particular problem, rather than instructing examiners to routinely request 

all internal audit and compliance reports or listings thereof. According to 

SEC staff, SEC has the legal authority to request and obtain access to all 

investment adviser and transfer agent books and records—including 

internal audit reports. Although restrictions exist on SEC’s access to 

investment company books and records, SEC staff said that the agency can 

generally obtain needed documents through investment advisers or 

transfer agents, which typically keep documents similar to investment 

companies.12 However, SEC staff said that routinely requesting all internal 

audit reports in planning for examinations could have unintended negative 

consequences. For example, SEC staff said that routinely requesting all 

audit reports may discourage companies from establishing effective 

internal audit departments out of concern that findings in internal audit 

reports could result in SEC investigations. In a May 2004 report that 

addressed SEC’s oversight of SRO listing standards, SEC staff made similar 

arguments regarding the “chilling effect” of requesting internal audit 

reports.13 However, we pointed out that it is standard practice among 

financial regulators to request a range of internal audit reports in planning 

examinations and that SRO internal audit reports contained information 

relevant to SEC’s listing oversight responsibilities. Accordingly, we 

recommended that SEC review SRO internal audit reports as part of its 

12Under the Advisers Act, SEC has the authority to examine all adviser books and records, 

whether the agency has enacted regulations requiring particular records to be maintained. 

However, under the 1940 Act, SEC has the authority to examine those books and records of 

mutual fund companies that are required by statute or rule to be maintained. Although SEC 

has authority under the 1940 Act Section 31(b)(3) (codified at 15 U.S.C. § 80a-30(a)(2)) to 

prescribe recordkeeping rules it deems necessary or appropriate for investors, the statute 

directs SEC to “take steps to avoid unnecessary recordkeeping by, and minimize the 

compliance burden on” regulated entities. The 1940 Act Section 31(b)(3) (codified at 15 

U.S.C. § 80a-30(b)(3)) further directs SEC to exercise its examination authority with “due 

regard to the benefits of internal compliance departments and procedures and the effective 

implementation and operation thereof.” 

13GAO, Securities Markets: Opportunities Exist to Enhance Investor Confidence and 

Improve Listing Program Oversight, GAO-04-75 (Washington, D.C.: Apr. 8, 2004). Listing 

standards are the minimum financial and nonfinancial requirements that issuers must meet 

to become and remain listed for trading on a market. SROs, such as NASD and NYSE, have 

responsibility to regulate their members under the oversight of the SEC.
Page 15 GAO-05-313 Mutual Fund Trading Abuses

examinations and the agency agreed to do so. Moreover, SEC staff’s 

assertion of a “chilling effect” is based on a questionable premise. In fact, 

companies may have the opposite incentive knowing that SEC staff will not 

routinely review all of their internal audit reports. As described later in this 

report, internal staff at two mutual fund companies produced internal 

compliance reports in 2002 that documented evidence of undisclosed 

market timing arrangements and their negative consequences for 

shareholders.14 SEC staff has revised its policy on requesting internal 

reports and this is also described later in this report.

In contrast, federal bank regulators had implemented procedures that 

directed examiners to use a range of information sources to help develop 

an overall and independent perspective on bank risks and the adequacy of 

their controls. The Federal Reserve System and the Office of the 

Comptroller of the Currency (OCC), typically assign on-site examiners to 

large institutions on an ongoing basis but may conduct examinations of 

smaller institutions every 12 to 18 months or more (SEC also has typically 

examined mutual funds on a regular schedule). Under the Federal Reserve 

System’s commercial bank examination guidelines dated May 2000, 

examiners were required to make an evaluation of the overall risks facing 

large and small banks and the controls that were in place to manage those 

risks, including the adequacy of internal audit and compliance 

departments. (As discussed later in this report, SEC adopted a revised riskbased examination approach in 2002.)15 Among the potential range of steps 

specified in such standards, examiners could assess controls by 

interviewing compliance or audit staff and reviewing internal audit or other 

relevant internal reports without restrictions. While we recognize that 

there are important differences between the safety and soundness focus of 

bank examinations and the traditional compliance and enforcement focus 

of SEC examinations, as well as staffing of the various agencies, bank 

regulator approaches to carrying out their responsibilities provided a 

14We note that these reports were not produced by the companies’ internal audit 

departments. However, SEC’s March 2002 examination guidance defined a range of internal 

compliance reports and limited examiners’ discretion to request such reports during 

examinations. Additionally, the responsible SEC district office staff did not examine the 

companies during the period in which the internal reports were produced. However, district 

office staff said they would have not requested any studies regarding market timing even if 

they had reviewed the companies because market timing was not perceived as a high-risk 

area.

15Our work did not include an analysis of whether bank regulators actually implement these 

standards during bank examinations. 
Page 16 GAO-05-313 Mutual Fund Trading Abuses

practical means for examiners to verify control adequacy and identify 

potential deficiencies. 

SEC Can Strengthen Its 

Capacity to Identify and 

Evaluate Potential Risks

We also identified information that was available prior to September 

2003—including academic studies and a tip from an industry insider—that 

was inconsistent with SEC examination staff’s rationale for not 

independently assessing mutual fund company market timing controls. 

That is, the staff viewed market timing as a relatively low risk area, had 

been told by company officials that they had established effective controls, 

and believed that fund companies had financial incentives to establish such 

controls to ensure high fund returns. Although the available information 

did not directly identify evidence of undisclosed arrangements between 

investment advisers and favored customers, it did identify significant and 

persistent risks associated with market timing by sophisticated investors 

and suggested that mutual fund companies were not always acting 

aggressively to control these risks potentially due to conflicts of interest. 

We note that SEC staff in the Division of Investment Management 

(Investment Management) were also aware of these market timing risks 

and had attempted to mitigate them through the regulatory process, with 

limited success according to academic studies.16 In retrospect, the 

information suggested that market timing was an area that might have 

merited the focus of the agency’s examination function and that the agency 

needed to strengthen its capacity to identify and evaluate evidence of 

potential risks. As described later in this report, SEC has established a new 

risk assessment office. 

Articles in the financial press and academic studies that were available 

prior to September 2003 stated that market timing posed significant risks to 

mutual fund company shareholders.17 For example, a 2002 academic study 

estimated that mutual fund company shareholders were losing nearly $5 

billion per year in certain international and other funds due to such market 

16The Division of Investment Management oversees and regulates the investment 

management industry and administers the securities laws affecting investment companies 

(including mutual funds) and investment advisers.

17Mercer Bullard, “Your International Fund May Have the Arbs Welcome Sign Out” The 

Street.com (June 10, 2000) and Mercer Bullard, “International Funds Still Sitting Ducks for 

Arbs” The Street.com (July 1, 2000). Also, William Goetzmann with Zoran Ivkovic and K. 

Geert Rouwenhorst, “Day Trading International Mutual Funds: Evidence and Policy 

Solutions,” Journal of Financial and Quantitative Analysis 36 (3) (September 2001): 287-

309 and Zitzewitz (2002). 
Page 17 GAO-05-313 Mutual Fund Trading Abuses

timing activity.18 In 2001 and 2002, a senior Investment Management staff 

member also made public statements that market timing posed risks to 

mutual fund company shareholders by requiring companies to, among 

other things, hold excess cash. These articles and the statements of the 

SEC staff member focused on the hesitant approach of many mutual fund 

companies to meet their legal obligations under the 1940 Act to adopt “fair 

value” pricing of their securities despite SEC guidance that they do so.19

Establishing fair value prices in international and other funds was viewed, 

including by SEC staff, as an essential means to minimize arbitrage 

opportunities for sophisticated investors and thereby minimize the 

negative consequences for fund performance. In 1999, 2001, and 2002, SEC 

staff wrote “interpretive” letters to the mutual fund industry reminding 

industry officials of their obligations to adopt fair value pricing and 

providing guidance and regulatory assistance in controlling market 

timing.20 For example, in November 2002, SEC staff wrote to ICI—the trade 

group that represents the mutual fund industry—to state that a fund 

company may, consistent with the 1940 Act provisions, make an exchange 

on a specified delayed basis, so long as the offer is fully and clearly 

disclosed in the fund’s prospectus. 21 

Several reasons have been advanced for mutual fund companies’ failure to 

adopt fair value pricing and thereby help avoid losses due to market timers. 

Among other reasons, a 2002 article suggested that mutual fund company 

boards with a higher percentage of directors who are independent of their 

investment advisers were more likely than boards 

18Zitzewitz (2002) estimated the total annualized loss at $4.9 billion per year, $4.3 billion of 

which is in international equity funds. 

19The 1940 Act requires mutual funds to value their portfolio securities by using the market 

value of the securities when market quotations for the securities are not readily available. 

20Letter from Douglas Scheidt, Associate Director and Chief Counsel, SEC’s Division of 

Investment Management, to Craig S. Tyle, General Counsel, ICI (Dec. 8, 1999); letter from 

Scheidt to Tyle on April 30, 2001; and Division of Investment Management Letter to 

Investment Company Institute re: Delayed Exchange of Fund Shares, (Nov. 13, 2002).

21Under a delayed exchange policy, exchange transactions (in which proceeds from shares 

are redeemed in one fund are used to purchase shares in another fund) are executed on a 

delayed basis, such as the next business day. Delaying an exchange transaction can help 

deter market timing because market timing relies on effecting transactions on specific days 

to take advantage of perceived market conditions.
Page 18 GAO-05-313 Mutual Fund Trading Abuses

with fewer independent directors to adopt fair value pricing. 22 The article 

also suggested that investment advisers may face conflicts of interest 

regarding fund shareholders and may benefit from permitting arbitrage. 

According to the author, he believed the potential existed that market 

timers were investing assets in mutual funds, which allowed investment 

advisers to increase their fees for assets under management, in exchange 

for market timing privileges. As discussed previously, SEC later determined 

that many investment advisers did benefit from such “sticky assets.” Senior 

SEC staff cited other reasons for the industry’s slow implementation of fair 

value pricing. For example, the staff said the companies were concerned 

about the lack of objectivity in using estimated prices and due to concerns 

about lawsuits from market timers whose trading strategies would be 

negatively affected. Nevertheless, the study suggested that companies were 

not always acting aggressively to ensure optimal performance, as SEC staff 

assumed they would do, and that conflicts of interest may have 

compromised companies’ willingness to adopt corrective measures.

Finally, by not acting promptly on information suggesting that a large 

mutual fund company had not established effective market timing controls, 

an SEC office may have missed an opportunity to detect violations. In early 

2003, an insider at a Boston-based fund company provided information and 

documentation to SEC’s Boston district office suggesting that company 

management failed to control widespread abusive market timing by fund 

customers. According to SEC district staff, they reviewed the information 

provided by the insider but did not act on it because they did not view the 

alleged activity as representing a violation of federal securities laws or 

regulations. For example, the district staff said that the fund company’s 

disclosures to investors were vague and that they could not conclusively 

demonstrate that the company had violated its prospectus disclosures. 

Subsequently, the insider turned the information over to the Massachusetts 

Securities Division, which settled state charges against the fund company 

related to the insider’s allegations. Although SEC staff subsequently began 

a review of the fund company in response to a separate tip in September 

2003 and initiated a related enforcement action in October, this action was 

related to market timing by fund insiders rather than fund customers as 

alleged earlier by the fund insider. SEC district staff said the fact that SEC 

did not bring an enforcement action against the mutual fund company for 

the actions alleged by the insider substantiated their original position not to 

act on the initial tip. While we do not dispute SEC’s contention that the 

22Zitzewitz (2002).
Page 19 GAO-05-313 Mutual Fund Trading Abuses

insider’s allegations did not necessarily involve violations of federal laws or 

regulations, they did indicate a failure by the company’s management to 

establish effective controls against market timing as SEC staff assumed 

was in the company’s interests to do. If the district office had pursued this 

information in early 2003, the potential exists that examiners would have 

identified other weaknesses, such as the market timing abuses by company 

insiders sooner than they did in late 2003. 

Independent and Effective 

Company Compliance Staff 

Are Essential to Detecting 

and Preventing Trading 

Abuses 

In the majority of the 11 SEC enforcement cases that we reviewed, 

company compliance staff—the first line of defense in ensuring company 

adherence to laws, regulations, and internal policies—lacked the 

independence necessary to carry out their responsibilities. According to 

SEC examination reports, enforcement actions, and discussions with SEC 

staff, the compliance staff—in some cases referred to as “market timing 

police”—were often successful in identifying and controlling market timing 

by certain customers, typically those who did not have special 

arrangements with the companies. The compliance staff reviewed trading 

data in funds considered vulnerable to market timing—such as 

international funds—and notified customers who exceeded specified limits 

on the number of trades placed within a specified period that their trading 

privileges would be suspended if the violations continued. When customers 

continued to violate company restrictions, SEC staff and related 

documents indicated that the companies would suspend their trading. 

However, contrary to established financial and corporate standards 

regarding the proper role of compliance staff, the compliance staff at these 

firms did not have sufficient independence to ensure that corrective 

actions always were taken to address violations.23 Consequently, when the 

compliance staff identified violations of company trading standards by 

favored customers, other company officials would routinely overrule their 

efforts to limit the customers’ trading. In some cases, the compliance staff 

23For example, Federal Deposit Insurance Corporation revised compliance examination 

procedures state that a bank’s “...board and senior management must grant a compliance 

officer sufficient authority and independence to...effect corrective action.” The U.S. 

Sentencing Commission has established minimum standards for compliance and ethics 

programs for companies that seek reductions in their sentences for criminal convictions. 

Companies that establish effective compliance and ethics programs to detect and prevent 

criminal conduct can obtain reduced penalties. Among other requirements, the compliance 

and ethics program must, at a minimum, be promoted and enforced consistently throughout 

the organization.
Page 20 GAO-05-313 Mutual Fund Trading Abuses

kept separate lists of customers who were permitted to exceed the 

companies’ specified trading limits.

Although the companies’ compliance staff were generally ineffective in 

controlling market timing by favored customers, our review suggests that 

routine communications with such compliance staff could potentially 

enhance SEC’s capacity to detect potential violations at an earlier stage, if 

compliance staff are forthcoming about the problems they detect. At these 

companies, the compliance staff obviously were aware of violations of 

company policies for several years and, in some cases, had documented 

their findings in internal reports. In one case, the sales staff at the mutual 

fund company overrode the compliance staffs’ efforts to control hundreds 

of market timing transactions between 1998 and 2003. In another case 

dating from 2002, the company’s compliance officer sent a memorandum to 

the company’s chief executive officer complaining about the long-term 

effects of market timing arrangements on long-term shareholders. In a 

January 2003 memorandum, the compliance officer notified the chief 

executive officer that the company was a “timer-friendly complex” and had 

granted numerous exceptions to company trading restrictions, which was 

not consistent with protecting customer interests. In another case, an 

internal company study from the fall of 2002—that was widely circulated 

among company executives—found similar abuses and recommended that 

the company terminate market timing arrangements, but the company did 

not do so until the summer of 2003. 

In cases we reviewed, company compliance staff or other officials had 

taken action against company officials for failure to comply with market 

timing policies, but their actions did not always deter this behavior. In 2000, 

compliance staff at one company found that the chairman had engaged in 

market timing contrary to shareholder interests and warned him to stop the 

practice. However, the chairman continued to engage in market timing until 

SEC identified his abusive practices in 2003. Compliance staff of another 

investment adviser to a large fund identified a senior fund manager who 

engaged in market timing in violation of internal policies in 2000. Officials 

warned the fund manager to stop the practice, but he resisted and 

continued the market timing until 2003. 
Page 21 GAO-05-313 Mutual Fund Trading Abuses

SEC Has Taken Steps 

to Strengthen Its 

Mutual Fund Oversight 

Program, but It Is Too 

Soon to Assess the 

Effectiveness of 

Several Key Initiatives 

Over the past 2 years, SEC staff has taken steps to better detect abusive 

practices in the mutual fund industry and plans significant changes to its 

overall examination program. For example, SEC staff has implemented 

guidance instructing examiners to conduct expanded reviews of company 

controls and make increased use of internal company reports in doing so, 

although examiners still are not expected to request listings of all relevant 

reports. SEC has also established the Office of Risk Assessment (ORA) to 

help the agency better anticipate, identify, and manage emerging risks and 

market trends. However, it is too soon to assess ORA’s effectiveness. SEC 

and NASD have also brought numerous enforcement actions for mutual 

fund violations, and SEC has hired additional staff and established new 

procedures for handling tips. In addition, SEC has amended existing rules 

and adopted new rules to help improve fund operations and better protect 

investors, including a requirement that in order for mutual funds to rely on 

certain exemptive rules, the chairperson and at least 75 percent of a mutual 

fund’s board be independent of the mutual fund’s investment adviser.24 SEC 

also adopted a compliance rule that requires mutual fund company boards 

to designate CCOs whose duties include preparing annual reports on the 

adequacy of the company’s policies and procedures to ensure compliance 

with the federal securities laws. Although the compliance rule has the 

potential to strengthen mutual fund company operations, certain CCOs 

may still face organizational conflicts of interest in carrying out their 

duties, of which SEC must be cognizant in its oversight responsibilities. 

Moreover, SEC has not developed a plan to ensure that its staff receive and 

review the annual reports prepared by CCOs on an ongoing basis to detect 

potential violations and identify emerging trends in the mutual fund 

industry.

24Section 10(a) of the 1940 Act, 15 U.S.C. § 80a-10(a), requires that at least 40 percent of the 

members of the mutual fund board of directors be independent directors. To enhance the 

independence and effectiveness of fund boards, in January 2001, the SEC adopted a fund 

governance requirement that required the board of directors of a fund seeking to rely on any 

of the SEC’s commonly used exemptive rules to be comprised of a majority of independent 

directors. The exemptive rules allow funds to engage in transactions that would otherwise 

be prohibited under the 1940 Act and that present conflicts between the fund and its 

management company. In the wake of recent enforcement actions related to late trading, 

market timing and misuse of nonpublic information about fund portfolios, and in 

recognition of the fact that a simple majority of independent directors may not adequately 

ensure that independent directors dominate the decision-making process, SEC strengthened 

this fund governance requirement for 10 exemptive rules by adopting the 75 percent 

independence and independent board chair requirements in August 2004. 69 Fed. Reg. 46378 

-79 (August 2, 2004).
Page 22 GAO-05-313 Mutual Fund Trading Abuses

SEC’s Examination-Related 

Initiatives Were Designed to 

Strengthen Mutual Fund 

Oversight

SEC staff has issued guidance designed to provide examiners with an 

overall perspective on the risks facing mutual fund companies and the 

adequacy of controls to mitigate those risks. For example, in November 

2003, SEC staff directed its examination staff to request in planning 

examinations that mutual fund company officials provide written 

summaries of any compliance problems or violations, or repeated 

compliance problems, that occurred after the company’s last examination. 

According to SEC staff, this information previously had been requested 

orally but SEC staff were not confident that fund companies were 

providing all information orally, and thus formalized this process. 

According to testimony by OCIE’s director on March 10, 2004, the agency 

has also begun to make increased use of interviews of company officials in 

conducting mutual fund examinations. The director stated that interviews 

had begun to play an increased role in assessing companies’ critical risks 

and control environments. 

In late 2002, nearly a year before the NYSOAG identified the market timing 

and late trading violations, SEC staff revised its guidance for mutual fund 

examinations, including expanded requests for internal company 

documents, but it is not clear that the revised guidance is sufficient to fully 

assist in identifying abusive practices. Under the revised risk-based 

guidelines, SEC examiners are expected to complete “scorecards” during 

routine examinations for specific areas, such as personal trading by 

company insiders, which SEC staff has identified as presenting possible 

risks to mutual fund companies.25 In general, each scorecard requires SEC 

examiners to perform several steps to assess the adequacy of company 

controls for each risk area. For example, examiners are expected to 

identify the company official responsible for establishing controls for each 

risk area and identify the documentation reviewed to assess the adequacy 

of identified controls. Additionally, the scorecards direct SEC examiners to 

record their overall observations about the adequacy of company controls 

for each of the risk areas. As part of the examination planning process, SEC 

staff also now request that mutual fund companies provide copies of 

management reports, self-assessments, exception reports, and internal 

audit and other reports relevant to the 13 risk areas. Although requesting 

25Other areas assessed include portfolio management, brokerage arrangements and best 

execution, allocations of trades, pricing of clients’ portfolios and calculation of net asset 

value, information processing and protection, performance advertising, marketing and fund 

distribution activities, safety of clients’ funds and assets, fund shareholder order processing, 

anti-money laundering, and corporate governance.
Page 23 GAO-05-313 Mutual Fund Trading Abuses

these internal reports should enhance SEC’s capacity to oversee mutual 

fund companies, we note that other areas that the agency has not 

considered could pose significant risks. To illustrate, prior to the detection 

of the mutual fund trading abuses in September 2003, SEC staff did not 

anticipate that investment advisers would enter into undisclosed market 

timing arrangements with favored customers. Therefore, it is not clear that 

SEC’s expanded procedures for collecting internal audit and other reports 

would have resulted in companies producing any reports that addressed 

this activity. 

SEC staff has also implemented examination procedures designed to detect 

market timing abuses. More specifically, SEC staff now instruct examiners 

to review (1) fund sales and redemption (shareholder turnover) data to 

detect patterns of market timing; (2) a sample of internal e-mails of fund 

executives to detect misconduct not reflected in the fund’s books and 

records, such as agreements to allow certain investors to market time; and 

(3) the personal trading of fund executives. In addition, SEC staff directs 

examiners to speak with company compliance officials regarding their 

efforts to control market timing. 

SEC staff also plan to significantly revise its approach to mutual fund 

examinations and are evaluating the development of a surveillance system 

to monitor the industry. (We review both initiatives in a forthcoming 

report.) Traditionally, SEC has relied on routine examinations of all mutual 

funds over a specified cycle to carry out its oversight responsibilities. 

Between 1998 and 2003, SEC established an examination cycle that would 

ensure that each investment company and its advisers would be examined 

once every 5 years. In mid-2004, SEC staff told us that they planned to move 

from scheduled examinations of all mutual fund companies to a system 

where they focused examination resources on the largest and riskiest 

companies and advisers (200 fund groups and 600 advisers). To focus on 

the largest entities, SEC staff is creating monitoring teams of two or three 

examiners to review the companies’ operations on an ongoing basis. 

According to OCIE staff, they have not yet determined the specific roles 

and responsibilities of the monitoring teams but generally expect the teams 

also would monitor their assigned fund company by periodically contacting 

fund compliance staff and conducting a program of continuous 

inspections. According to the staff, they would also continue to examine 

advisers and funds with higher risk profiles every 2 to 3 years, and conduct 

random inspections of some portion of the remaining firms. We note that 

SEC’s planned approach for large mutual fund companies is similar to the 

bank regulators’ approach to bank supervision, in which examiners are 
Page 24 GAO-05-313 Mutual Fund Trading Abuses

permanent members of a monitoring team assigned to monitor the largest 

institutions. Concerning the surveillance system, an SEC task force is 

currently considering the development of an automated system that would 

allow agency staff to monitor the industry by reviewing company financial 

and other data that may indicate systemic risks or potential problems at 

individual companies. According to SEC staff, such information could help 

target examination resources toward the highest potential risks. SEC staff 

also said that the task force has been making progress but has not set a 

time frame for providing SEC with its proposal. 

According to NASD officials, in response to the recent mutual fund 

scandals, NASD has also changed its examination modules to detect 

market timing and late trading abuses at broker-dealers, making these 

issues more prominent in broker-dealer examinations. NASD examiners 

ask a series of questions and review documentation of broker-dealers to 

help determine if inappropriate activity is taking place. NASD also employs 

a risk-assessment strategy to rate the level of risk associated with a brokerdealer and determines how often it will be examined. 

SEC Established a New 

Office to Identify and 

Manage Emerging Risks

SEC has established ORA to assist the agency in carrying out its overall 

oversight responsibilities, including mutual fund oversight. The office’s 

director reports directly to the SEC chairman. According to SEC staff, ORA 

will enable agency staff to analyze risk across divisional boundaries, 

focusing on early identification of new or resurgent forms of fraudulent, 

illegal, or questionable behavior or products. ORA’s duties include (1) 

gathering and maintaining data on new trends and risks from external 

experts, domestic and foreign agencies, surveys, focus groups, and other 

market data; (2) analyzing data to identify and assess new areas of concern 

across professions, companies, industries, and markets; and (3) preparing 

assessments and forecasts on the agency’s risk environment. SEC staff said 

that ORA will seek to ensure that SEC will have the information necessary 

to make better, more informed decisions on regulation. This new office is 

to work in coordination with internal risk teams established in each of the 

agency’s major program areas and a Risk Management Committee 

responsible for reviewing implications of identified risks and 

recommending appropriate courses of action. Working with other SEC 

offices, ORA staff expect to identify new technologies, such as data mining 

systems that can help agency staff detect and track risks. Although ORA 

may help SEC be more proactive and better identify emerging risks, it is too 

soon to assess its effectiveness. In this regard, we note that as of February 

2005, ORA had established an executive team of 5 individuals but still 
Page 25 GAO-05-313 Mutual Fund Trading Abuses

planned to hire an additional 10 staff to assist in carrying out its 

responsibilities.

SEC and NASD Have Taken 

a Number of Enforcement 

Actions for Abusive Market 

Timing and Late Trading 

Based on examination findings both SEC and NASD have taken 

enforcement actions against investment advisers to mutual fund 

companies, broker-dealers, and other regulated persons and entities who 

have engaged in market timing and late trading. As of February 28, 2005, 

SEC had settled 14 enforcement actions against investment advisers 

generally for facilitating market in their own funds (see fig. 1). SEC has also 

brought 10 enforcement actions against broker-dealer, brokerage-advisory, 

and financial services firms for market timing abuses and late trading and, 

as of February 28, 2005, settled five of these cases for about $17 million. 

SEC also has brought enforcement actions against individuals associated 

with investment advisers and other firms and has obtained significant 

penalties ($30 million in one case) and barred several officials from the 

securities industry for life. The penalties and disgorgements (which force 

firms to give up ill-gotten gains) SEC has obtained in all of the settlements 

total about $2 billion. In addition to penalties and disgorgements, SEC 

settlements contained undertakings that required companies to improve 

their corporate governance structure and practices. NASD has taken 12 

actions against broker-dealers for late trading and market timing abuses 

with fines and restitutions totaling more than $6 million. NASD has also 

imposed restrictions on broker-dealers. A forthcoming GAO report will 

address all SEC enforcement actions related to the mutual fund trading 

abuses in greater detail.
Page 26 GAO-05-313 Mutual Fund Trading Abuses

Figure 1: SEC Settled Enforcement Actions against Investment Advisers Related to Market Timing Violations as of February 28, 

2005 (dollars in thousands) 

a

The entities named in this column are investment advisers associated with these cases. In some cases,

SEC simultaneously charged other entities, such as an associated investment adviser, distributor, or 

broker-dealer for their role in the market timing abuses. The penalties and disgorgements shown for 

each case are the totals obtained in settlement from all the entities associated with the case. 

b

Bank of America settled charges involving both abusive market timing and late trading on the part of 

its investment adviser and broker-dealer subsidiaries, respectively. 

c

Fremont Investment Advisors, Inc. settled charges involving both abusive market timing and late 

trading. 

SEC Has Hired Additional 

Staff to Carry Out Its 

Oversight Responsibilities

In recent years, Congress has given SEC substantial budgetary increases to 

assist it in overseeing the securities markets and increase the agency’s 

effectiveness. SEC staff positions in the areas that pertain to the agency’s 

regulation and oversight of the mutual fund industry are shown in table 1. 

Between 2002 and 2005, SEC increased the staffing for OCIE and the 

Division of Enforcement by 38 and 29 percent, respectively. SEC also 

increased staffing within Investment Management by 16 percent. SEC staff 

told us that many of the new personnel have been working on mutual fund 

issues. While the additional staff has the potential to enhance SEC’s 

capacity to oversee key areas such as the mutual fund industry, we 

previously reported that the agency hired the staff without having updated 

Investment adviser casea Disgorgement Total

Source: SEC.

Penalty

Alliance Capital Management, LP 100,000 150,000 250,000

Columbia Management Advisors, Inc. 70,000 70,000 140,000

Banc of America Capital Management, LLC $250,000 $375,000 b $125,000

Putnam Investment Management, LLC 50,000 5,000 55,000

Massachusetts Financial Services, Co. 50,000 175,000 225,000

Pilgrim Baxter & Associates, Ltd. 50,000 40,000 90,000

Franklin Advisers, Inc. 20,000 30,000 50,000

Strong Capital Management, Inc. 40,000 40,000 80,000

Banc One Investment Advisors, Corporation 40,000 10,000 50,000

RS Investment Management, LP 13,500 11,500 25,000

Fremont Investment Advisors, Inc.c 2,000 2,146 4,146

Janus Capital Management, LLC 50,000 50,000 100,000

Invesco Funds Group, Inc. 140,000 235,000 375,000

PIMCO Advisors Fund Management, LLC 40,000 10,000 50,000

790,500 1,078,646 1,869,146
Page 27 GAO-05-313 Mutual Fund Trading Abuses

its strategic plan.26 In the absence of a strategic plan that identified the 

agency’s priorities and aligned those priorities with an effective human 

capital program, it is not clear that SEC’s hiring decisions ensured that the 

right individuals were in place to do the most effective job possible. In 

August 2004, SEC revised its strategic plan. We are reviewing SEC’s 

strategic workforce planning effort as part of a separate engagement.

Table 1: Staff Positions for SEC Divisions and Offices with Responsibilities for 

Mutual Fund Regulation, Oversight, and Enforcement, as of February 2005

Source: GAO analysis of SEC data.

a

Fiscal years.

b

Includes staff in the office that administers the Public Utility Holding Company Act of 1935.

CThe amounts for OCIE include all staff in SEC’s headquarters and regional offices who support or 

conduct examinations of mutual funds and investment advisers.

d

The amounts for the Division of Enforcement include all staff in SEC’s headquarters and regional 

offices who support or conduct enforcement activities over mutual funds, investment advisers, brokerdealers, and all other entities that SEC regulates.

SEC Has Acted to Improve 

Its Tip Handling Processes

Since the mutual fund trading abuses surfaced, SEC has acted to improve 

its processes for handling tips and complaints. SEC’s Division of 

Enforcement, which receives enforcement-related tips and complaints, has 

centralized its process for receiving, analyzing, and responding to tips from 

the public. According to the head of the office that administers the 

division’s tip handling process, before the abuses were detected the 

division had no process for regional and district office staff to refer 

complaints and tips to headquarters for review and no system by which 

management could review how staff handled complaints and tips. Under 

26GAO, SEC Operations: Oversight of Mutual Fund Industry Presents Management 

Challenges, GAO-04-584T (Washington, D.C.: April 20, 2004).

SEC Unit

Actual

2002a

Actual

2003a

Actual

2004a

Estimated

2005a

Percent

change 2002-

2005a

Division of Investment 

Managementb 173 167 190 200 16%

OCIEc 397 439 513 547 38

Division of 

Enforcementd

 980 1,016 1,308 1,338 37
Page 28 GAO-05-313 Mutual Fund Trading Abuses

the new process, information concerning all enforcement-related tips and 

complaints, whether received through telephone calls, correspondence, emails, or in-person, is reported to and maintained by a dedicated group 

within SEC headquarters. That group maintains a centralized log of all 

complaints and tips, which includes the date of the complaint or tip, the 

name, address, and telephone number of the complainant, and the nature 

of the complaint or tip. It also includes a summary of the action taken by 

staff in response to the complaint or tip—such as assigned to division staff 

for follow-up, referred to another SEC unit for further investigation, or 

referred to another agency. According to the office head, senior 

management within the division review the log regularly to confirm that 

each complaint or tip was appropriately handled by staff. Additionally, 

Investment Management and OCIE have taken recent steps to strengthen 

their collection and analysis of tips received from the public or referrals of 

potential violations received from other SEC offices or regulatory agencies.

SEC Has Adopted Rules 

Designed to Improve Mutual 

Fund Company Operations, 

but Questions Remain about 

the Implementation of the 

Compliance Rule 

Since late 2003, SEC has adopted seven new rules and 3 amendments 

designed to improve fund operations and to protect investors (see table 2). 

Among the most significant initiatives, SEC adopted a series of 

amendments to its exemptive rules on July 27, 2004, that are intended to 

strengthen mutual fund company governance. In SEC’s press release 

regarding these rule amendments, SEC stated that investment advisers may 

dominate mutual fund company boards and management and that the 

advisers have inherent conflicts of interest in carrying out their 

responsibilities. SEC further stated that independent board members can 

minimize these potential conflicts of interest and act to protect shareholder 

interests. Accordingly, SEC now requires that in order for a mutual fund 

company to rely on the exemptive rules, at least 75 percent of the members 

of its board of directors must be independent and the board chair must also 

be independent. SEC also required fund directors to assess at least 

annually the performance of the fund board and its committees. This 

annual self-assessment requirement is intended to improve fund 

performance by strengthening directors’ understanding of their role and 

fostering better communications and greater cohesiveness. Moreover, SEC 

believes that the annual review will assist fund boards in identifying 

potential weaknesses in the boards’ performance. 
Page 29 GAO-05-313 Mutual Fund Trading Abuses

Table 2: SEC Mutual Fund-related Rules, Adopted after September 2003

Rule name Date adopted Description of rule

Compliance Rule December 17, 2003 Requires each investment company and investment adviser registered 

with SEC to adopt and implement written policies and procedures 

reasonably designed to prevent violation of the federal securities laws 

and the Advisers Act, respectively, review those policies and procedures 

annually for their adequacy and the effectiveness of their 

implementation, and designate a chief compliance officer (CCO) to be 

responsible for administering the policies and procedures.

Shareholder Reports and 

Quarterly Portfolio Disclosures of 

Registered Management 

Investment Companies

February 24, 2004 Requires a registered management investment company to include in its 

shareholder reports disclosure of fund expenses borne by shareholders 

during the reporting period. Also permits a registered management 

investment company to include a summary portfolio schedule of 

investments in its reports to shareholders, provided that the complete 

schedule is filed with SEC and is provided to shareholders upon 

request, free of charge. 

Disclosure Regarding Market 

Timing and Selective Disclosure 

of Portfolio Holdings

April 16, 2004 Requires open-ended management investment companies to disclose in 

their prospectuses both the risks to shareholders of frequent purchases 

and redemptions of investment company shares, and the investment 

company’s policies and procedures with respect to such frequent 

purchases and redemptions. 

Disclosure Regarding Approval of 

Investment Advisory Contracts by 

Directors of Investment 

Companies

June 23, 2004 Requires a registered management investment company to provide 

disclosure in its reports to shareholders regarding the material factors 

and the conclusions with respect to those factors that formed the basis 

for the board’s approval of advisory contracts during the most recent 

fiscal half-year.

Investment Adviser Codes of 

Ethics

July 2, 2004 Requires that registered investment advisers adopt codes of ethics that 

sets forth standards of conduct expected of advisory personnel and 

address conflicts that arise from personal trading by advisory personnel. 

Among other things, the rule requires advisers’ supervised persons to 

report their personal securities transactions, including transactions in 

any mutual fund managed by the adviser.

Investment Company 

Governance

July 27, 2004 A series of amendments to certain exemptive rules under the 1940 Act 

that are designed to enhance the independence and effectiveness of 

fund boards and to improve their ability to protect the interests of the 

funds and fund shareholders they serve. The amended rules require that 

in order for mutual funds to rely on any of 10 commonly used exemptive 

rules, the chairperson and at least 75 percent of the members of mutual 

fund boards of directors be independent of the funds’ investment 

advisory firms. 

Disclosure Regarding Portfolio 

Managers of Registered 

Management Investment 

Companies

August 23, 2004 A series of amendments to forms prescribed under the Securities Act of 

1933, the Securities and Exchange Act of 1934, and the 1940 Act, which 

among other things extends the existing requirement that a registered 

management company provide basic information in its prospectus 

regarding its portfolio managers to include the members of management 

teams. The amendments also require a registered management 

investment company to disclose additional information about its portfolio 

managers, including other accounts they manage, compensation 

structure, and ownership of securities in the investment company.
Page 30 GAO-05-313 Mutual Fund Trading Abuses

Source: GAO analysis of the Federal Register.

Additionally, SEC adopted compliance rules on December 17, 2003, that 

required all investment companies and investment advisers that are 

registered or should be registered with SEC to adopt policies and 

procedures reasonably designed to prevent violation of federal securities 

laws and the Advisers Act, and designate a CCO to be responsible for 

administering the policies and procedures. The CCO should be in a position 

of authority to compel others to adhere to the compliance policies and 

procedures, and the investment company CCO must report directly to the 

company’s board of directors. The rules further require that each 

investment company and investment adviser conduct at least annually 

reviews of their policies and procedures and that the CCOs submit a 

written report to the board regarding their policies and procedures. An 

investment company must also review and the CCO must report on the 

policies and procedures of its investment adviser and certain other service 

providers. Under the investment company compliance rule, these reports, 

at a minimum, must address (1) the operation of the policies and 

procedures of each fund and each investment adviser, principle 

underwriter, administrator, and transfer agent for the fund; (2) any material 

changes to those policies and procedures since the date of the last report; 

(3) any material changes to the policies and procedures recommended as a 

result of the annual review; and (4) each material compliance matter that 

Prohibition on the Use of 

Brokerage Commissions to 

Finance Distribution

September 2, 2004 Amends rule under the 1940 Act that governs the use of assets of openend management investment companies to distribute their shares. The 

amended rule prohibits funds from paying for the distribution of their 

shares with brokerage commissions. According to SEC, the 

amendments are designed to end a practice that poses significant 

conflict of interest and may be harmful to funds and fund shareholders.

Registration Under the Advisers 

Act of Certain Hedge Fund 

Advisers

December 2, 2004 Requires advisers to certain private investment pools (hedge funds) to 

register with the SEC under the Advisers Act. The rule and amendments 

are designed to provide the protections afforded by the Advisers Act to 

investors in hedge funds.

Mutual Fund Redemption Fees March 11, 2005 Prohibits funds from redeeming shares within 7 calendar days after 

purchase, unless (i) the fund’s board has either approved a redemption 

fee or determined that a redemption fee is not necessary or appropriate; 

(ii) the fund (or its principal underwriter) has entered into a written 

agreement with each of its financial intermediary under which the 

intermediary agrees to provide certain shareholder transaction 

information to the fund and to execute the fund’s instructions to restrict 

or prohibit future purchases or exchanges by any shareholder; and (iii) 

the fund maintains copies of such agreements with its financial 

intermediaries for at least six years. The rule authorizes funds that adopt 

a redemption fee to impose a redemption fee up to 2 percent of the 

amount redeemed.

(Continued From Previous Page)

Rule name Date adopted Description of rule
Page 31 GAO-05-313 Mutual Fund Trading Abuses

occurred since the date of the last report. The rules require that investment 

companies and investment advisers maintain copies of all policies and 

procedures that are or were in effect in the previous 5 years and maintain 

records documenting annual reviews. Investment companies must retain 

copies of the written reports for 5 years. According to SEC staff, the 

compliance rule provides companies flexibility in carrying out provisions 

relating to the annual reviews. For example, SEC staff said that a CCO 

could use company internal audit departments to assess company 

compliance with laws and regulations rather than hiring separate staff. SEC 

staff also said that the companies may continue to use internal audit 

departments to carry out internal compliance and other reviews and that 

such departments will likely work closely with CCOs.27

Although the compliance rules have the potential to improve mutual fund 

company operations and address compliance staff independence 

deficiencies, certain CCOs may face organizational conflicts of interest. By 

requiring a fund’s CCO to report to the board of directors and to meet 

separately, at least annually, with the independent directors, the rule helps 

ensure that compliance findings would not be routinely overruled by the 

investment adviser or other officials. However, in the rule, SEC also 

contemplates that the CCO could be an employee of the investment 

adviser. SEC stated that permitting the CCO to be an employee of the 

adviser is necessary because many investment companies do not have any 

employees. SEC found that prohibiting CCOs from being employees of an 

investment adviser company would result in a situation where the 

investment company’s CCO would be divorced from the day-to-day fund 

operations and totally dependent on information filtered through the 

adviser. SEC stated that the rule mitigates potential conflicts of interest by 

prohibiting removal of the fund company’s CCO without the approval of the 

fund company’s board of directors, including a majority of the independent 

directors. However, given that investment advisers typically entered into 

market timing arrangements to the detriment of mutual fund shareholders, 

the fact that a mutual fund’s CCO could be employed by an investment 

adviser raises potential concerns about the effectiveness of such officers, a 

situation of which SEC must be cognizant when overseeing the rule’s 

implementation. SEC staff said that they plan to review implementation of 

the compliance rules and requirements as part of the investment company 

and investment advisers examination process, as resources permit. 

27See C.F.R. § 270.38-1 and 17 C.F.R. § 275.20b(4)-7.
Page 32 GAO-05-313 Mutual Fund Trading Abuses

SEC staff also said that the agency plans to use the compliance reports as 

part of the examination planning process. An OCIE staff member said that 

by requesting the compliance reports and reviewing them prior to 

examinations, agency examiners may be able to identify problems at 

mutual fund companies and determine whether the companies have 

implemented corrective actions. However, the OCIE staff member said that 

the rule does not require mutual fund companies to submit the annual 

reports to the agency for its ongoing review.

By not establishing a process for SEC staff to receive the compliance 

reports on an ongoing basis, SEC may be missing an opportunity to 

enhance its mutual fund oversight program. Under the rule, CCOs are 

required to perform comprehensive assessments of mutual fund operations 

and report on their findings annually. As demonstrated in this report, 

compliance staff may be well aware of violations that SEC and other 

regulators had not even considered. Given that SEC has limited 

examination resources and certain companies may not be examined for 

extended periods, reviewing the compliance reports on an ongoing basis 

could provide valuable information to SEC by indicating emerging 

problems at mutual fund companies or unmitigated risks at individual 

companies. Further, reviewing the reports could provide insights to SEC as 

to how the compliance rule is being implemented within the mutual fund 

industry. With such information—potentially in conjunction with a 

surveillance system—the agency may be able to better target examinations 

towards high-risk areas and identify emerging trends in the mutual fund 

industry. 

We also note that SEC has adopted two specific rules designed to address 

market timing and is working on a rule designed to prevent late trading. On 

March 11, 2005, SEC adopted a rule that allows mutual fund companies to 

establish redemption fees on a voluntary basis.28 The rule prohibits funds 

from redeeming shares within 7 calendar days after they are purchased, 

unless, among other requirements, the fund’s board has previously 

determined that the imposition of a redemption fee on shares redeemed 

within the 7-day holding period is either in the best interest of the fund or 

28Securities and Exchange Commission, “Mutual Fund Redemption Fees,” Release No. IC26782 (Mar. 11, 2005).
Page 33 GAO-05-313 Mutual Fund Trading Abuses

that such a fee is not necessary or appropriate.29 By imposing redemption 

fees on, for example, the proceeds of fund shares redeemed within 7 

calendar days of a purchase, SEC believes that mutual fund companies may 

be able to increase the costs associated with frequent trading and the 

financial incentives to do so. Also, directly addressing the market timing 

issue, SEC adopted a rule on April 16, 2004, requiring funds to make 

disclosures regarding market timing and selective disclosure of portfolio 

holdings. To stop late trading, SEC in late 2003, proposed that all orders for 

fund transactions be received by mutual funds or designated processors, 

which are regulated by SEC, no later than the time the fund calculates its 

current day’s price (usually 4:00 p.m.) in order to receive that day’s price 

(the “hard 4” close proposal).30 However, due, in part, to industry concerns 

about the fairness and potential costs of the proposal, SEC has not yet 

adopted it and is assessing whether there are more cost-effective ways to 

achieve the same result. SEC is continuing to work with industry officials 

and considering alternative proposals that would address industry 

concerns while curtailing late trading. We discuss the proposed rule in 

more detail in appendix III. 

Conclusions The undisclosed market timing arrangements and late trading abuses 

detected in September 2003 represented one of the most widespread and 

serious scandals in the history of the mutual fund industry. SEC has 

determined that undisclosed market timing arrangements, in particular, 

existed at many large mutual fund companies for as long as 5 years. 

However, prior to 2003, SEC did not identify the undisclosed arrangements 

between investment advisers and favored customers through the agency’s 

oversight process. Although SEC staff faced competing examination 

priorities that may have affected its capacity to detect the abusive practices 

and has taken several recent steps intended to strengthen its mutual fund 

company oversight program and improve company operations, several 

lessons can be drawn from the experience. 

29The rule permits a fund board that adopts a redemption fee to determine, in its judgment, 

whether a period longer than 7 calendar days is necessary or appropriate to protect fund 

shareholders.

30SEC also has proposed, but not yet acted on, rule changes that would require brokerdealers to disclose to investors prior to purchasing a mutual fund, at the point of sale and in 

order confirmations, whether the broker-dealer receives revenue sharing payments or 

portfolio commissions from that fund adviser as well as other cost-related information.
Page 34 GAO-05-313 Mutual Fund Trading Abuses

• First, performing independent assessments of company controls is 

critical to confirm agency views regarding risks and the adequacy of 

controls in place to address those risks. Even where regulated entities 

may have a seeming interest in controlling a particular risk, abusive or 

fraudulent activity can take place. Over the past 2 years, SEC has hired 

additional examination staff and implemented a risk-based approach to 

mutual fund company examinations that provides for increased 

assessments of controls.31 SEC’s staff’s revised examination guidance 

also expands the types of written reports (such as internal audit reports) 

that examiners are to request in planning examinations, although SEC 

still does not direct examiners to request listings of all such reports. 

Requesting such listings could assist SEC staff in detecting potential 

violations at an earlier stage. 

• Second, the agency must develop the institutional capacity to identify 

and evaluate evidence of potential risks and deploy examination staff as 

necessary to review controls and potentially detect violations in these 

areas. SEC has established ORA to help guide the agency in better 

assessing new or emerging risks, but the office is still hiring staff and 

establishing its position within the agency. SEC has also implemented 

revised tip handling procedures, which have the potential to enhance 

the agency’s capacity to detect potential abuses. It remains to be seen 

how well these new procedures work.

• Third, ensuring the independence of the compliance function is central 

to preventing violations of the securities laws, regulations, and fund 

policies. Company compliance staff must have sufficient independence 

to carry out their responsibilities. By adopting the compliance rule, SEC 

created a system that has the potential to significantly improve mutual 

fund companies’ compliance with laws and regulations and help ensure 

the independence of compliance staff. CCOs also may serve as valuable 

partners to SEC by reviewing and testing a variety of controls. However, 

in adopting the rule, SEC also made a conscious trade-off between the 

need to improve industry compliance and the costs that would be 

imposed on mutual fund companies. In permitting an investment 

company’s designated CCO to be employed by the advisory firm, SEC 

recognized that CCOs might face organizational conflicts of interest in 

fulfilling their responsibilities. The fact that fund company boards, with 

the approval of a majority of the independent directors, have sole 

31As previously discussed, we assess the revised program in a forthcoming report.
Page 35 GAO-05-313 Mutual Fund Trading Abuses

authority to remove fund company compliance officers may mitigate 

some of these risks. However, it is uncertain at this time how effectively 

CCOs faced with potential conflict of interests, including possibly 

conflicting financial incentives as illustrated in some of the cases we 

reviewed, will carry out their responsibilities. Given the widespread 

nature of the abuses identified at mutual fund companies, we believe 

that the failure of companies to comply with the rule’s provisions would 

likely warrant a significant response by SEC through the agency’s civil 

enforcement authority or referrals to criminal authorities as deemed 

necessary.

We also note that while SEC staff plans to request annual reports prepared 

by CCOs under the compliance rule during the examination planning 

process, SEC staff does not require fund companies to submit the annual 

reports to SEC on an ongoing basis. Obtaining access to the annual 

compliance reports and regularly reviewing them or their material findings 

is essential to assist SEC in monitoring mutual fund companies during the 

potentially long intervals between examinations of certain companies. 

Recommendations To enhance the effectiveness of SEC’s mutual fund oversight program and 

help strengthen company operations, we recommend that the Chairman, 

SEC, take the following three actions:

• Consistent with the agency’s legal authority, request lists of all 

compliance-related internal company reports during the examination 

planning process and review such reports as necessary to obtain a broad 

perspective on the risks identified by individual companies and the 

adequacy of controls in place to monitor those risks; 

• Ensure that examination staff assess the independence and 

effectiveness of mutual fund company CCOs as a component of all 

mutual fund company examinations; and

• Develop a plan to receive and review mutual fund company and adviser 

annual compliance reports, or the material findings thereof, on an 

ongoing basis.
Page 36 GAO-05-313 Mutual Fund Trading Abuses

Agency Comments and 

Our Evaluation

SEC provided written comments on a draft of this report, which are 

reprinted in appendix IV. SEC and NASD also provided technical 

comments, which were incorporated into the final report, as appropriate. 

SEC generally agreed with our recommendations. SEC noted the 

importance of its testing of internal controls, and that SEC examiners now 

review mutual fund controls for market timing and fair value pricing and 

that it anticipates providing additional guidance to assist funds and their 

advisers in adopting appropriate controls over the use of fair value pricing. 

SEC indicated that it had started assessing the role of CCOs and that it is 

preparing formal examination guidance for its examination staff to use in 

these assessments. Additionally, SEC noted that it is considering how to 

best utilize the new mutual fund annual compliance reports, of which any 

required filing with the agency may require further rulemaking.

SEC did not directly address our recommendation on requesting listings of 

all compliance-related internal reports, but suggested that such reviews 

would be included in its testing of internal controls. We continue to believe 

that requesting lists of all reports would be beneficial for SEC’s oversight 

program by assisting staff in detecting potential violations.

SEC identified a number of steps it has taken to strengthen its mutual fund 

oversight program. Our assessment of some of these recent actions will be 

addressed in a forthcoming report. 

As agreed with your office, unless you publicly announce the contents of 

this report earlier, we plan no further distribution of this report until 30 

days from the report date. At that time we will provide copies of this report 

to SEC, NASD, and interested congressional committees. We will also make 

copies available to others upon request. In addition, the report will be 

available at no cost on GAO’s Web site at http://www.gao.gov.
Page 37 GAO-05-313 Mutual Fund Trading Abuses

If you or your staff have any questions about this report, please contact 

Wesley M. Phillips, Assistant Director, or me at (202) 512-8678. GAO staff 

who made major contributions to this report are listed in appendix V.

Richard J. Hillman

Director, Financial Markets and 

Community Investment
Page 38 GAO-05-313 Mutual Fund Trading Abuses

Appendix I

Objectives, Scope, and Methodology ApApenednxidexiIs

Because market timing violations were more widespread than late trading 

violations and the Securities and Exchange Commission (SEC) is the 

mutual fund industry’s frontline regulator, the report primarily focuses on 

SEC’s oversight of the market timing area. The report also addresses the 

National Association of Securities Dealers’ (NASD) oversight of brokerdealers that failed to prevent customers’ market timing and late trading 

activity but does not discuss late trading at pension plans and their 

administrators, which are subject to Department of Labor oversight. 

Accordingly, the report (1) identifies the reasons that SEC did not detect 

the abusive market timing agreements at an earlier stage and lessons 

learned from the agency’s failure to do so; and (2) assesses steps that SEC 

has taken to strengthen its mutual fund oversight, deter abusive trading, 

and improve mutual fund company operations.

To determine why SEC did not detect the abusive market timing 

agreements at an earlier stage and what lessons can be learned from the 

agency not doing so, we interviewed SEC staff at a judgmental sample of 

six regional and district offices located nationwide, NASD officials; 

representatives from the New York State Office of the Attorney General, 

the Investment Company Institute (ICI), a judgmental sample of large 

mutual fund companies, and we contacted academic officials. We also 

reviewed relevant agency testimony, academic and other studies, and other 

documents. At the six SEC offices, we reviewed documentation pertaining 

to 11 mutual fund companies against which SEC had filed enforcement 

actions for market timing abuses and late trading violations. These mutual 

fund companies were among the largest 100 mutual fund companies 

nationwide as measured by the size of customer assets under management 

as of August 1, 2003. We reviewed the enforcement actions pertaining to 

these companies, related documentation, and SEC examinations for each 

of these companies or their investment advisers dating back several years. 

In addition, we reviewed examination guidelines at the Federal Deposit 

Insurance Corporation, the Federal Reserve System, and the Office of the 

Comptroller of the Currency, and generally accepted government auditing 

standards, particularly the standards relating to internal control reviews. 

We then compared SEC staff’s approach to reviewing mutual fund market 

timing controls with these general examinations and auditing standards. 

We also discussed with NASD the reasons that it did not detect mutual 

fund-related abuses at broker-dealers for which it has direct oversight 

responsibility.

To identify steps regulators had taken to strengthen mutual fund oversight 

programs and enhance controls at mutual fund companies and 
Appendix I

Objectives, Scope, and Methodology

Page 39 GAO-05-313 Mutual Fund Trading Abuses

intermediaries, we interviewed SEC and NASD staff and reviewed relevant 

agency documents as well as GAO reports and testimonies. We determined 

what modifications the regulators had made to their examination programs 

or plan to make, reviewed various final rules adopted since September 2003 

to improve mutual fund company operations and investor protection, 

reviewed a proposed rule regarding late trading, and reviewed regulators’ 

enforcement actions for market timing and late trading. In addition, we 

reviewed SEC procedures for handling tips and complaints. Additionally, 

we interviewed officials of the National Securities Clearing Corporation 

(NSCC), ICI, the Securities Industry Association, pension plans, brokerdealers, and mutual fund companies.

Our work was performed in Atlanta, Ga.; Boston, Mass.; Chicago, Ill., 

Denver, Colo.; New York, N.Y.; Philadelphia, Pa.; and Washington, D.C. We 

conducted our work between May 2004 and April 2005 in accordance with 

generally accepted government audit standards. SEC provided written 

comments on a draft of this report, which are reprinted in appendix IV. SEC 

and NASD also provided technical comments, which were incorporated 

into the final report, as appropriate. Our evaluation of these comments is 

presented in the agency comments and our evaluation section.
Page 40 GAO-05-313 Mutual Fund Trading Abuses

Appendix II

Mutual Fund Trade Processing and 

Recordkeeping ApendxiI

Individual investors generally can purchase, exchange, or sell fund shares 

through multiple channels either directly from fund companies or through 

various intermediaries such as broker-dealers, financial planners, banks, 

insurance companies, retirement plan sponsors, and fund “supermarkets.” 

To simplify and reduce the costs of mutual fund transactions, 

intermediaries collect orders throughout the day and then aggregate all the 

transactions they receive for a particular fund. Those intermediaries that 

are licensed, such as broker-dealers, may net, or match, purchase and 

redemption orders for the same funds among their own clients. In a 

simplified example, if one investor were to purchase 15 shares of fund A, 

and another investor were to redeem 10 shares of fund A, at the end of the 

day the intermediary could simply transmit one order to purchase 5 shares 

of fund A—the net result of the day’s orders. Intermediaries then transmit 

the net results of aggregate transactions to the mutual fund companies, 

where the intermediaries hold omnibus accounts representing the 

collective shares of their clients. Mutual fund companies generally do not 

have information about the identities and specific transactions of the 

individual investors in intermediaries’ omnibus accounts. Intermediaries 

have contact with their clients, such as defined contribution plan 

participants and other individual investors (“retail investors”), and control 

access to information about their trading activity. ICI officials told us that, 

presently about 80 percent of mutual fund orders are through 

intermediaries and most of these are processed through omnibus accounts. 

Mutual fund intermediaries accept purchase and redemption orders 

throughout the day and are supposed to submit to funds only those orders 

received by 4:00 p.m. Eastern Time to receive that same day’s net asset 

value (NAV), but an order received at 4:01 p.m. or later would be submitted 

to receive the next day’s NAV. According to Securities and Exchange 

Commission Rule 22c-1 under the 1940 Act, mutual funds are required to 

calculate current NAV at least once every business day at a specific time 

(usually at 4:00 p.m.).1

 However, intermediaries are allowed to aggregate 

the orders they receive prior to fund’s designated price calculation time and 

submit them to mutual fund companies as omnibus account transactions 

later in the evening for settlement, either directly or through their transfer 

1

In this discussion, we assume for convenience that all funds choose to price their securities 

daily as of 4:00 p.m. Funds may, however, elect to price their securities more than once per 

day, and according to SEC, many funds price their securities earlier than 4:00 p.m.
Appendix II

Mutual Fund Trade Processing and 

Recordkeeping

Page 41 GAO-05-313 Mutual Fund Trading Abuses

agents or NSCC.2 Figure 2 illustrates how orders for mutual fund 

transactions are transmitted from retail investors and plan participants to 

mutual fund companies, either directly or through intermediaries. 

Figure 2: Processing Paths of Mutual Fund Transactions

Most employers that sponsor defined contribution plans subcontract the 

various administrative tasks of plan recordkeeping to companies that have 

expertise in the administration of plans or investments. Pension plan 

record keepers are intermediaries that keep track of day-to-day 

2

See Staff Interpretive Position Relating to Rule 22c-1, Investment Company Act Release 

No. 5569 (December 27, 1968). Mutual funds employ transfer agents to conduct 

recordkeeping and related functions. Transfer agents maintain records of shareholder 

accounts, calculate and disburse dividends, and prepare and mail shareholder account 

statements, federal income tax information, and other shareholder notices. NSCC is 

currently the only clearing agency registered with SEC that operates an automated system, 

called Fund/SERV, for processing orders for mutual funds and other securities. Fund/SERV 

provides a central processing system that collects order information from clearing brokers 

and others, sorts all the incoming order information according to fund, and transmits the 

order information to each fund’s primary transfer agent. 

12

Plan participant(s) Retail investor(s)

Mutual fund/

Transfer agent

Orders transmitted after

4:00 p.m.

or

(Transactions in like funds

are aggregated or netted)

Single transaction order

Source: GAO.

Processing

and recording

Intermediary/

Plan record

keeper

A B

4 9

Orders received by 4:00 p.m.

NSCC
Appendix II

Mutual Fund Trade Processing and 

Recordkeeping

Page 42 GAO-05-313 Mutual Fund Trading Abuses

transactions for each plan participant’s account. The recordkeeper is 

responsible for transactions—such as crediting accounts with employee 

and employer contributions, processing changes in participant-directed 

investment allocations, updating account values (usually each business 

day) to reflect changes in the values of mutual fund shares held by each 

plan participant—and acting as a mutual fund intermediary when 

participants make exchanges between funds. In addition, recordkeepers 

may function as the primary source of plan information and customer 

service for plan participants.
Page 43 GAO-05-313 Mutual Fund Trading Abuses

Appendix III

SEC Proposed Rule to Prevent Late Trading ApendxiI

Late in 2003, SEC proposed amending the rule that governs how mutual 

funds price and receive orders for share purchases or sales.1

 Since many of 

the cases of late trading involved orders submitted through intermediaries, 

including banks and pension plans not regulated by SEC, the proposed 

amendments would have required that orders to purchase or redeem 

mutual fund shares be received by a fund, its transfer agent, or a registered 

clearing agency—entities that are regulated by SEC—before the time of 

pricing (usually 4:00 p.m. Eastern Time). However, SEC has not yet acted 

on the “hard 4” close proposal due in part to industry concerns about the 

associated costs and other factors, and is assessing whether there are more 

cost effective ways to achieve the same result.

Many organizations that purchase mutual fund shares, particularly those 

that administer retirement savings plans have expressed concerns that 

such a “hard close” would unfairly prohibit some of their participants from 

receiving the same day’s price on share purchases. Because intermediaries 

generally combine individual investor orders and submit single orders to 

funds to buy or sell, many officials at such firms are concerned that the 

time required to complete this processing will not allow them to meet the 

4:00 p.m. deadline. In such cases, investors purchasing shares from western 

states or through intermediaries would either have to submit their trades 

earlier than other investors in order to receive the current day’s price or 

receive the next day’s price. Some plan sponsor organizations and plan 

recordkeepers have also argued that they would face significant 

administrative costs in adopting systems to accommodate the 4:00 p.m. 

hard close.2

An alternative approach to control late trading, proposed by retirement 

plans and some broker-dealers, is referred to as the “smart 4” approach, 

which would require all companies that want to accept orders until the 

market close, and process them thereafter, to adopt a three-part series of 

controls: (1) electronic time stamping of all transactions so all trades could 

be tracked from the initial customer to the mutual fund company; (2) 

annual certifications by senior executives that their companies have 

procedures to prevent or detect unlawful late trading and that those 

1

Securities and Exchange Commission, “Proposed Rule: Amendments to Rules Governing 

Pricing of Mutual Fund Shares,” Release No. IC-26288 (Dec. 11, 2003).

2

See GAO, Mutual Funds: SEC Should Modify Proposed Regulations to Address Some 

Pension Plan Concerns, GAO-04-799 (Washington, D.C.: July 9, 2004) for a discussion of 

how the proposal could affect pension plan participants.
Appendix III

SEC Proposed Rule to Prevent Late Trading

Page 44 GAO-05-313 Mutual Fund Trading Abuses

procedures are working as designed; and (3) annual, independent audits. 

Representatives of intermediaries told us that they should be given an 

opportunity to prove that they can comply with the same policies and 

procedures as mutual fund companies in accepting and processing fund 

orders. However, SEC staff have expressed concerns about the proposal. 

As previously noted, SEC does not have regulatory jurisdiction over all 

entities that process mutual fund share orders. 

Another approach to prevent late trading, which has been suggested by 

some industry participants, is to establish a central clearinghouse for 

mutual fund trades. The clearinghouse proposal would require all mutual 

fund orders to be time-stamped electronically by an SEC-registered central 

clearing entity before the market close to receive that day’s fund price. The 

clearing entity’s time stamp would be considered the official time of receipt 

of an order for a mutual fund transaction. NSCC is currently the only SECregistered clearing agency operating an automated processing system for 

mutual fund orders. The clearinghouse proposal would expand NSCC’s 

role, capabilities, and capacity to handle all orders of mutual fund 

transactions. Each mutual fund company and fund intermediary would 

consider its technological capabilities and other factors in deciding how to 

meet the requirement of submitting orders to NSCC by 4:00 p.m. Eastern 

Time in order to receive same-day pricing. However, many intermediaries 

that do not use NSCC to process transactions oppose the clearinghouse 

proposal because, among other reasons, developing links to NSCC could be 

prohibitively expensive.

SEC is continuing to review alternatives to develop an acceptable solution 

to prevent late trading. SEC staff told us that staff have been meeting with 

industry participants and considering alternative proposals but were 

uncertain about when a rule to prevent late trading could be adopted. 
Page 45 GAO-05-313 Mutual Fund Trading Abuses

Appendix IV

Comments from the Securities and Exchange 

Commission ApendxiIV
Appendix IV

Comments from the Securities and Exchange 

Commission

Page 46 GAO-05-313 Mutual Fund Trading Abuses
Page 47 GAO-05-313 Mutual Fund Trading Abuses

Appendix V

GAO Contacts and Staff Acknowledgments ApendxiV

GAO Contacts Richard J. Hillman (202) 512-8678

Wesley M. Phillips (202) 512-5660

Staff 

Acknowledgments

In addition to those named above, Fred Jimenez, Stefanie Jonkman, Marc 

Molino, Omyra Ramsingh, Barbara Roesmann, Rachel Seid, and David 

Tarosky made key contributions to this report.

(250200)
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