Testimony 

Before the Subcommittee on Commercial 

and Administrative Law, Committee on 

the Judiciary, House of Representatives

United States Government Accountability Office

GAO

For Release on Delivery 

Expected at 4:00 p.m. EDT 

Tuesday, June 7, 2005 SEC MUTUAL FUND 

OVERSIGHT 

Positive Actions Are Being 

Taken, but Regulatory 

Challenges Remain 

Statement of Richard J. Hillman, Director 

Financial Markets and Community Investment 

GAO-05-692T 
What GAO Found

United States Government Accountability Office

Why GAO Did This Study

Highlights

Accountability Integrity Reliability

www.gao.gov/cgi-bin/getrpt?GAO-05-692T.

To view the full product, including the scope 

and methodology, click on the link above. 

For more information, contact Richard J. 

Hillman at (202) 512-8678 or 

hillmanr@gao.gov. 

Highlights of GAO-05-692T, a testimony to 

the Subcommittee on Commercial and 

Administrative Law, Committee on the 

Judiciary, House of Representatives 

June 7, 2005

SEC MUTUAL FUND OVERSIGHT

Positive Actions Are Being Taken, but 

Regulatory Challenges Remain 

Prior to September 2003, SEC did not examine mutual fund companies for 

trading abuses such as market timing violations because agency staff viewed 

other activities as representing higher risks and believed that companies had 

financial incentives to establish effective controls. While SEC has competing

examination priorities, it can draw lessons from not detecting the trading 

abuses earlier. First, by conducting independent assessments of controls in 

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

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

necessary), SEC could reduce the risk that violations may go undetected. 

Second, SEC could further develop its capacity to identify and evaluate 

evidence of potential risk (for example, academic studies completed 

between 2000 and 2002 identified certain market timing concerns as a 

persistent risk to mutual fund customers). Third, ensuring the independence 

of company compliance staff is critical and SEC staff could better assess 

company risks and controls through routine interactions with such staff. 

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 several key initiatives. For example, SEC has instructed its 

staff to make additional assessments of company controls and established a 

new office to identify and assess potential risks. SEC also adopted a rule 

that requires mutual fund companies to appoint independent compliance 

officers who are to prepare annual reports on their companies’ policies and 

violations. However, SEC has not developed a plan to receive and review 

these annual reports on an ongoing basis and thereby enhance its capacity to 

detect potential violations. 

Since September 2003, SEC has brought 14 enforcement actions against 

mutual fund companies and 10 enforcement actions against other firms for 

mutual fund trading abuses. Penalties obtained in settlements with mutual 

fund companies are among the agency’s highest—ranging from $2 million to 

$140 million and averaging $56 million. In contrast, penalties obtained in 

settlements for securities law violations prior to 2003 were typically under 

$20 million. In reviewing a sample of investment adviser cases, GAO found 

that SEC followed a consistent process for determining penalties and that it 

coordinated penalties and other sanctions with interested states. However, 

GAO found certain weaknesses in SEC’s management procedures for making 

referrals to criminal law enforcement and ensuring staff independence. In 

particular, SEC does not require staff to document whether a criminal 

referral was made or why. Without such documentation, SEC cannot readily 

determine whether staff make appropriate referrals. Further, SEC does not 

require departing staff to report where they plan to work, information 

gathered by other financial regulators to assess staff compliance with federal 

laws regarding employment with regulated entities. In the absence of such 

information, SEC’s capacity to ensure compliance with these conflict-ofinterest laws is limited. 

Trading abuses—including market 

timing and late trading violations—

uncovered among some of the most 

well-known companies in the 

mutual fund industry permitted 

favored customers to profit at the 

expense of long-term shareholders. 

Questions have also been raised as 

to why the New York State Office of 

the Attorney General identified the 

trading abuses in September 2003 

before the industry’s primary 

regulator: the Securities and 

Exchange Commission (SEC). 

Based on two recently issued GAO 

reports, this testimony discusses (1) 

the reasons SEC did not detect the 

abusive practices at an earlier stage 

and lessons learned from the 

agency not doing so, (2) steps the 

agency has taken to strengthen its 

mutual fund oversight program, and 

(3) enforcement actions taken by 

SEC and criminal prosecutors in 

response to these abuses and SEC 

management procedures for making 

criminal referrals and ensuring staff 

independence. 

What GAO Recommends

Among other steps, the GAO 

reports recommend that SEC 

develop a plan to review annual 

compliance reports on an ongoing 

basis and document criminal 

referrals and the post-employment 

plans of departing staff. SEC 

generally agreed to implement the 

reports’ recommendations. 
Page 1 GAO-05-692T 

Mr. Chairman, Mr. Ranking Member, and Members of the Subcommittee: 

I am pleased to be here today to discuss two recently issued GAO reports 

that assess the Securities and Exchange Commission’s (SEC) response to 

trading abuses uncovered in the mutual fund industry. We prepared these 

reports at the request of Chairman Sensenbrenner and Ranking Member 

Conyers of the full committee.1

 As you know, trading abuses—including 

fraudulent market timing and late trading violations—were uncovered in 

many well-known companies in the mutual fund industry and raised 

significant concerns about the industry’s ethical practices.2

 Maintaining 

public confidence in the mutual fund industry is critical because about 95 

million Americans have invested more than $8 trillion in mutual funds, a 

significant share of the nation’s privately held wealth. Moreover, it is 

critical that SEC and NASD have the capacity to identify abusive practices 

and to bring enforcement actions that punish violators and deter those 

who are contemplating similar abuses.3

Questions have been raised as to why so many mutual fund companies and 

broker-dealers were able to engage in trading abuses, sometimes for years, 

without being detected by SEC and NASD. In fact, the trading abuses only 

came to light after the New York State Office of the Attorney General 

(NYSOAG) received a tip from a hedge fund insider, conducted an 

investigation, and, in September 2003, settled an enforcement action 

against a hedge fund company and a hedge fund official for market timing 

 1

GAO, Mutual Fund Trading Abuses: Lessons Can Be Learned from SEC Not Having 

Detected Violations at an Earlier Stage, GAO-05-313 (Washington, D.C.: April 20, 2005) and 

Mutual Fund Trading Abuses: SEC Consistently Applied Procedures in Setting Penalties, 

but Could Strengthen Certain Internal Controls, GAO-05-385 (Washington, D.C.: May 16, 

2005). 

2

For purposes of this testimony, 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. Many mutual fund companies have no 

employees, although they typically have a board of directors, and rely on investment 

advisers to perform key functions such as providing management and administrative 

services. 

3

SEC is the primary regulator of the mutual fund industry. NASD has direct oversight 

responsibility for broker-dealers that may sell and execute other orders for investment 

products, including mutual funds. 
Page 2 GAO-05-692T 

and late trading of several mutual funds.4 The federal regulators’ failure to 

identify the abuses at an earlier stage has generated concern about the 

effectiveness of their examination and other oversight procedures. 

As we describe in our reports, market timing and late trading violations 

permitted favored customers to benefit at the expense of long-term mutual 

fund company shareholders. 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. Although market 

timing is not itself illegal, frequent trading can harm mutual fund 

shareholders because it increases transaction costs and lowers a fund’s 

returns. However, market timing can constitute illegal conduct if, for 

example, it takes place as a result of undisclosed agreements between 

mutual fund investment advisers (companies that provide management 

and other services to mutual funds) and favored customers who are 

permitted to trade frequently and in contravention of stated company 

trading limits. Late trading, a significant but less widespread abuse than 

market timing violations, occurs when investors place orders to buy or sell 

mutual fund shares after the mutual fund has calculated price of its shares, 

usually once daily at the 4 p.m. Eastern Time close of the financial 

markets. Investors who are permitted to engage in late trading can profit 

from the knowledge of events in the financial markets that take place after 

4 p.m., an opportunity that other fund shareholders do not have. 

My testimony today focuses largely on the market timing area, because 

such abuses were more widespread than late trading violations, and on 

SEC, which is the mutual fund industry’s frontline regulator. I will discuss 

late trading issues and NASD oversight activities to a lesser degree. More 

specifically, my testimony covers (1) the reasons that SEC did not detect 

the market timing abuses at an earlier stage and lessons learned from the 

agency not doing so, (2) the steps SEC has taken to strengthen its 

oversight of the mutual fund industry and strengthen industry business 

 4

The term “hedge fund” generally refers to 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 which is excluded from the definition of 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. Pursuant to a new rule recently adopted by SEC, advisers of 

certain hedge funds are required to register with SEC under the Investment Advisers Act of 

1940. See Registration Under the Advisers Act of Certain Hedge Fund Advisers, 69 Fed. 

Reg. 72054 (2004) (to be codified in various sections of 17 C.F.R. Parts 275 and 279). 
Page 3 GAO-05-692T 

practices, and (3) enforcement actions taken by SEC and criminal 

prosecutors in response to these abuses and SEC management procedures 

related to the making of criminal referrals and ensuring staff 

independence from the mutual fund industry. 

In summary: 

Before September 2003, SEC did not examine fund companies for market 

timing abuses because agency officials (1) viewed other activities as 

representing higher risks, (2) concluded that companies had financial 

incentives to control frequent trading because it could lower fund returns, 

and (3) were told by company officials that the companies had established 

controls over frequent trading. While SEC faced competing examination 

priorities before September 2003 and had made good faith efforts to 

mitigate the known risks associated with legal market timing, lessons can 

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

without independent assessments of controls over areas such as market 

timing during examinations (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 any evidence of 

potential risks. For example, a 2002 study estimated that market timing in 

certain funds resulted in about $5 billion in annual losses to shareholders, 

and raised the possibility that investment advisers did not always act 

decisively to control such risks due to potential conflicts of interest.5

 Third, we found that compliance staff at mutual fund companies often 

detected evidence of undisclosed market timing arrangements with 

favored customers but lacked sufficient independence within their 

organizations to correct identified deficiencies. Ensuring the 

independence of compliance staff is critical, and SEC could potentially 

benefit from using their work. 

SEC has taken several steps to strengthen its oversight 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 the 

fund companies’ internal controls. To improve its risk assessment 

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

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

 5

Eric Zitzewitz, “Who Cares About Shareholders? Arbitrage-Proofing Mutual Funds,” 

Stanford Graduate School of Business Research Paper No. 1749 (October 2002). 
Page 4 GAO-05-692T 

market trends. To better ensure the independence of company compliance 

staff, SEC recently adopted a rule that requires compliance officers to 

report directly to the funds’ boards of directors. While this rule has the 

potential to improve fund company operations and is intended to increase 

the independence of compliance officers, certain compliance officers may 

still face organizational conflicts of interest. For example, under the rule 

compliance officers may not work directly for mutual fund companies, but 

rather, may be employed by investment advisers—who manage the 

funds—whose interests may not necessarily be fully aligned with mutual 

fund customers. In addition, although the rule also requires compliance 

officers to prepare annual reports on their companies’ compliance with 

laws and regulations, SEC has not developed a plan to routinely receive 

and review the reports. Without such a plan, SEC cannot be assured that it 

is in the best position to detect abusive industry practices and emerging 

trends. SEC has agreed to implement recommendations from our April 

2005 report to help ensure the effectiveness of compliance officers and to 

determine how to best utilize the annual compliance reports, or the 

material findings cited in those reports. 

The penalties SEC obtained in the market timing and late trading cases are 

among the largest in the agency’s history and are generally consistent with 

penalties obtained in cases involving similarly egregious corporate 

misconduct. As of February 28, 2005, SEC had brought 14 enforcement 

actions against investment advisers and 10 enforcement actions against 

other firms for market timing and late trading abuses. It has also brought 

enforcement actions against several high ranking company officials. 

Penalties that SEC obtained in settling the 14 enforcement actions with 

investment advisers range from $2 million to $140 million, with an average 

penalty of about $56 million. In contrast, penalties obtained in settlements 

for securities law violations before 2003 were typically under $20 million. 

In reviewing a sample of cases involving investment advisers, we found 

that SEC followed a consistent process for determining penalties and that 

it coordinated penalties and other sanctions with interested states. 

However, we found certain weaknesses in SEC’s overall procedures for 

referring securities cases to other agencies for potential criminal 

violations and ensuring that departing employees compiled with conflictof-interest laws and regulations. SEC has agreed to implement 

recommendations from our May 2005 report to strengthen these 

processes. 

To address our reporting objectives, we conducted in-depth reviews of 11 

SEC enforcement actions against mutual fund companies for market 

timing and other abusive practices. We reviewed examination reports for 
Page 5 GAO-05-692T 

these companies as well as related enforcement action documents. We 

interviewed representatives from SEC, NASD, mutual fund companies, 

broker-dealers, pension plan administrators, and other industry 

participants about practices and procedures industry participants use to 

prevent abuses and monitor trading activity. We also interviewed SEC staff 

in headquarters and various regional and district offices about how its 

oversight examination and enforcement efforts were conducted and how 

penalty amounts were determined. We also obtained information from 

Department of Justice (DOJ) officials and selected state regulators and 

attorney generals on criminal enforcement actions brought in cases 

involving market timing and late trading abuses. In addition, we reviewed 

relevant academic and other studies. We interviewed SEC staff regarding 

SEC’s management procedures for making criminal referrals to DOJ and 

state criminal authorities and reviewed related SEC rules. We evaluated 

these rules using Standards for Internal Controls in the Federal 

Government.6

 We reviewed federal laws and regulations that govern 

employees’ ability to negotiate and take positions with regulated entities, 

such as mutual fund companies, and reviewed SEC and other financial 

regulators’ policies and procedures for ensuring staff compliance with 

these laws. We conducted our work on these reports between May 2004 

and May 2005 in accordance with generally accepted government auditing 

standards. 

SEC did not examine for market timing abuses or test company controls in 

that area, largely because the agency had competing examination 

priorities and believed that companies had financial incentives to control 

frequent trading. Lessons learned from SEC not having detected these 

abuses earlier can be useful to the agency in administering its examination 

program going forward. 

SEC 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. Examiners focused on discrete areas 

that staff viewed as representing the highest risks of presenting 

 6

GAO, Standards for Internal Controls in the Federal Government, GAO/AIMD-00-21.3.1 

(Washington, D.C.:1999). 

Lessons Learned from 

SEC Not Detecting 

Abusive Market 

Timing Can Be Useful 

in Preventing Future 

Abuses 

SEC Did Not Examine for 

Market Timing Abuses 
Page 6 GAO-05-692T 

compliance problems that could impact investors. SEC staff stated that 

before September 2003, they considered funds’ portfolio trading (i.e., 

purchases and sales of securities on behalf of investors) and other areas as 

representing higher risks than potential market timing abuses and noted 

that examinations and enforcement cases in these other areas revealed 

many deficiencies and violations. SEC staff also said that they did not 

review market timing controls because they believed that fund companies 

had financial incentives to control frequent trading because it can lower 

fund share prices, thereby resulting in a loss of business.7

 An SEC staff 

member also said that officials from mutual fund companies told agency 

examiners that they had appointed compliance staff called “market timing 

police” to enforce compliance with the funds’ trading limit policies. 

SEC staff said they were surprised in September 2003 when NYSOAG 

identified the market timing abuses. However, 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. 

I would note that NASD’s examinations of broker-dealers also did not 

discover market timing arrangements involving broker-dealers before 

September 2003. According to an NASD official, these arrangements went 

undetected because market timing was not illegal per se and, to the extent 

that a mutual fund company had stated customer trading limits, brokerdealers may not have perceived themselves as being responsible for 

enforcing such policies. Regarding late trading, NASD officials said that 

the organization did not have specific examination guidance to detect the 

violation before September 2003. NASD officials also said that some 

broker-dealers created fictitious accounts or otherwise falsified 

documents, so that detecting late trading violations was difficult. 

 7

Since investment adviser fees are often based on the size of assets under management, 

SEC staff reasoned that companies would establish effective controls to help ensure that 

assets under management did not decline. 
Page 7 GAO-05-692T 

We recognize that SEC faces competing examination priorities and had 

limited examination resources before September 2003. 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. Further, 

SEC staff made good faith efforts to control the known risks associated 

with legal market timing, such as issuing guidance on “fair value” pricing.8

Nevertheless, three key lessons can be drawn from this experience and 

used to strengthen SEC’s mutual fund oversight program going forward: 

• First, performing independent assessments of company controls is 

essential to confirm views held by regulatory staff regarding risks and the 

adequacy of controls in place to mitigate those risks. 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 mitigate 

potential risks. 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. A variety of means can be used to independently test controls, 

including interviewing responsible officials, 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. 

• Second, SEC 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. Our review identified information that was available prior to 

September 2003 and that was inconsistent with SEC staff’s views that 

market timing was a low-risk area because companies would necessarily 

act to protect fund returns from the harmful consequences of frequent 

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

legal, remained a persistent risk prior to September 2003 and by one 

estimate was costing mutual fund shareholders approximately $5 billion 

 8

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

market quotes are not readily available. Fair value pricing of mutual fund shares can 

minimize discrepancies between foreign and U.S. markets and thereby minimize market 

timing opportunities. 

Key Regulatory Lessons 

Have Emerged from 

Mutual Fund Trading 

Abuses 
Page 8 GAO-05-692T 

annually in certain funds. Further, these studies showed 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 they were benefiting financially 

from permitting frequent trading, as turned out to be the case.9

 Moreover, a 

mutual fund company insider provided information to an SEC district 

office in early 2003 indicating that a company had poor market timing 

controls, but the office did not act promptly on this information. If the SEC 

office had acted on this tip in early 2003, it might have identified 

potentially illegal market timing activity by company insiders. 

• Third, ensuring the independence and effective operation of mutual fund 

companies’ compliance staff is central to preventing violations of the 

securities laws, regulations, and fund policies. In the majority of the 11 

SEC mutual fund company enforcement cases we reviewed, compliance 

staff lacked such independence. Although the compliance staff—

sometimes referred to as “market timing police”—often identified frequent 

trading that violated company limits, other company officials would 

routinely overrule the compliance staff’s efforts to control such trading. 

We also found that routine communication with compliance staff could 

potentially enhance SEC’s capacity to detect potential violations at an 

earlier stage if such staff are forthcoming with relevant information. In 

cases we reviewed, compliance staff were obviously aware of violations 

and, in two cases, had documented their findings regarding the harmful 

consequences of frequent trading in internal company reports. For 

example, in one case, the sales staff at a mutual fund company overrode 

the compliance staff’s efforts to control hundreds of market timing 

transactions between 1998 and 2003. In another case, a company’s chief 

compliance officer sent memorandums to the chief executive officer in 

2002 and 2003 complaining about the effects of the company’s market 

timing arrangements on long-term shareholders. 

 9

Zitzewitz,(2002). Subsequent to September 2003, SEC determined that some favored 

investors agreed to place assets in mutual funds in exchange for market timing privileges 

(referred to as “sticky assets”). According to the author, he believed the potential existed 

that market timers were investing assets in mutual funds, which benefited the related 

investment advisers because such assets increased their fees. 
Page 9 GAO-05-692T 

SEC has taken several steps over the past two years to strengthen its 

oversight of the mutual fund industry and improve company practices. 

These steps include strengthening the agency’s mutual fund examination 

program, establishing an office to better identify emerging risks, hiring 

additional staff, establishing new tip handling procedures, and enacting a 

series of rules and rule amendments. Although SEC has taken steps to 

strengthen its mutual fund company oversight program, it is generally too 

soon to assess the effectiveness of these initiatives. 

To improve its examination program, SEC has instructed examiners to 

make additional assessments of internal controls at mutual fund 

companies. For example, SEC staff have identified a range of areas that 

potentially represent high-risk compliance problems, such as personal 

trading by company officials, and examiners have initiated independent 

examinations of these areas. SEC staff also plan to significantly revise the 

agency’s approach to mutual fund company examinations. Rather than 

evaluating all mutual fund companies on a set cycle as they did between 

1998 and 2003, SEC staff plan to begin focusing on the largest and riskiest 

companies on an ongoing basis. For example, SEC is creating monitoring 

teams of 2 to 3 individuals who would be responsible for reviewing the 

largest companies on a more continuous basis, and is placing more 

emphasis on examinations that target emerging risks. SEC also plans to 

review some portion of other mutual fund companies on a randomized 

basis. In a forthcoming report, we assess these and other planned changes 

to SEC’s mutual fund company oversight program. I note that NASD has 

also recently implemented new examination procedures to better detect 

market timing and late trading abuses. 

SEC also has established the Office of Risk Assessment (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. SEC staff said that ORA will seek to ensure that SEC has the 

information necessary to make better, more informed regulatory 

decisions. Although ORA may help SEC be more proactive and better 

identify emerging risks, it is too soon to assess its effectiveness. In this 

regard, at the close of our review, ORA had established an executive team 

of 5 individuals but still planned to hire an additional 10 staff to assist in 

carrying out its responsibilities. 

SEC Has Taken Steps 

to Strengthen Mutual 

Fund Oversight, but It 

Is Too Soon to Assess 

the Effectiveness of 

Some Initiatives 
Page 10 GAO-05-692T 

With increased appropriations over recent years, SEC also has hired 

additional staff to carry out its mutual fund and other oversight programs, 

potentially enhancing the agency’s capacity to test a variety of controls. 

For example, Office of Compliance Inspections and Examinations staff 

dedicated to mutual fund company oversight increased by 38 percent 

between 2002 and 2005 (from 397 to an estimated 547 positions). While the 

additional staff has the potential to enhance SEC’s capacity to oversee key 

areas within the mutual fund industry, we previously reported that the 

agency hired the staff without having an updated strategic plan.10 Without 

an updated strategic plan in place that identifies the agency’s priorities and 

aligns these priorities with an effective human capital program, it is not 

clear that SEC’s recent hiring decisions will ensure that it has the right 

amount of resources with the right expertise to do the most effective job 

possible. In August 2004, SEC revised its strategic plan. We are reviewing 

SEC’s strategic workforce planning as part of a separate engagement. 

In addition to hiring staff, SEC has centralized its processes and 

established new procedures for handling tips and complaints. For 

example, before the abuses were detected, the agency’s Division of 

Enforcement (Enforcement) had no process under which regional and 

district office staff would refer complaints and tips to headquarters for 

review and similarly no process for centralized review of how staff 

handled complaints and tips. Under 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. 

Additionally, SEC has adopted a series of rules and rule amendments 

designed to strengthen ethical and business practices at mutual fund 

companies. Among the most significant initiatives, SEC now requires that 

in order for a mutual fund company to use the agency’s exemptive rules, at 

least 75 percent of its board of directors and the board chair must be 

independent of the company’s investment adviser. 11 SEC believes that 

increasing boards’ independence from investment advisers will help 

 10GAO, SEC Operations: Oversight of Mutual Fund Industry Presents Management 

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

11SEC’s exemptive rules (i) allow mutual funds to engage in transactions that would 

otherwise be prohibited under the1940 Act because they present inherent conflicts of 

interests and (ii) condition the exemptive relief on such transactions being subject to the 

approval or oversight of independent directors. 
Page 11 GAO-05-692T 

prevent the types of trading abuses that we have been discussing today. 

Further, SEC adopted rules that require mutual fund companies and 

investment advisers to appoint chief compliance officers (CCO) who are 

responsible for monitoring compliance with laws and regulations. SEC 

also requires mutual fund company CCOs to prepare annual reports on 

company policies and violations. 

Although SEC’s rulemaking has the potential to strengthen the operations 

of mutual fund companies and their investment advisers, the incentive 

structure these rules rely on may not always be sufficient, and further 

steps may be necessary. More specifically, in our April 2005 report we 

pointed out that under SEC’s rule, fund company CCOs could be 

investment adviser officials. SEC permitted this arrangement because fund 

companies often do not have any staff. SEC also believes that it has 

instituted rules designed to prevent potential conflicts of interest; for 

example, a mutual fund company’s board—including a majority of its 

independent directors—is solely responsible for removing the CCO. While 

such steps may mitigate potential conflicts, we recommended that SEC 

review CCOs’ independence as part of the examination process to ensure 

that those who are advisory firm officials are actually acting 

independently. SEC agreed with this recommendation. We also pointed 

out that while SEC examiners planned to review CCO annual reports as 

part of examinations, the agency has not established a process to receive 

and review such reports on an ongoing basis. Without such a process, SEC 

is not in the best position possible to monitor the industry and identify 

emerging trends. SEC agreed with our recommendation to determine how 

to best utilize their annual compliance reports, and any material findings 

cited in those reports. 

The penalties that SEC has obtained in enforcement cases related to 

market timing and late trading violations are among the highest in the 

agency’s history and generally consistent with civil penalties obtained in 

cases involving similarly egregious corporate misconduct. Additionally, 

SEC appears to have followed its penalty-setting process consistently in 

setting penalties in the cases we reviewed. Federal and state prosecutors 

we contacted said that several factors complicate bringing criminal 

actions for market timing violations whereas late trading violations are 

more straightforward to prosecute. We also found certain weaknesses in 

SEC’s overall procedures for referring securities cases to other agencies 

for potential criminal violations and ensuring that departing SEC 

employees comply with conflict-of-interest laws and regulations. SEC 

agreed to implement our recommendations to strengthen these processes. 

SEC Consistently 

Applied Procedures in 

Setting Mutual Fund 

Penalties, but Could 

Strengthen Certain 

Internal Processes 
Page 12 GAO-05-692T 

Since NYSOAG announced its discovery of the trading abuses in the 

mutual fund industry in September 2003, SEC has brought 14 enforcement 

actions against investment advisers primarily for market timing abuses 

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

financial services firms for market timing abuses and late trading. SEC has 

entered into settlements in all 14 investment adviser cases and obtained 

penalties ranging from $2 million to $140 million (see fig. 1). These 

penalties are among the highest SEC has obtained for securities laws 

violations in its history. Before January 2003, penalties SEC obtained in 

settlement were generally under $20 million. In contrast, 11 of the 14 

penalties obtained in the investment adviser cases are over $20 million, 

with 8 penalties at $50 million or over. Pursuant to the fair fund provision 

of the Sarbanes-Oxley Act of 2002 (SOX),12 SEC plans to use the penalties 

and disgorgement obtained (disgorgement forces firms to forfeit any illgotten gain), a total of about $800 million and $1 billion, respectively, to 

provide restitution to harmed investors.13 In addition to settling with 

investment advisers, as of February 28, 2005, SEC has settled with two 

broker-dealers, one brokerage-advisory firm, and two insurance 

companies, with penalties totaling $17.5 million. I note that NASD has 

taken 12 actions against broker dealers for late trading and market timing 

abuses with fines and restitutions totaling more than $6 million. 

 12SOX authorizes federal courts and SEC to establish “fair funds” to compensate victims of 

securities violations. Section 308(a) of SOX provides that if in an administrative or a civil 

proceeding involving a violation of federal securities laws an order requiring disgorgement 

is entered, or if a person agrees in settlement to the payment of disgorgement, any penalty 

assessed against such person may, together with the disgorgement amount, be deposited 

into a fair fund and disbursed to victims of the violation pursuant to a distribution plan 

approved by SEC. See Pub. L. No. 107-204, 116 Stat. 745 (2002) (codified in various 

sections of the United States Code). The “fair fund” provision is codified at 15 U.S.C. § 

7246(a). 

13We are reviewing SEC’s implementation of the fair funds provision of SOX as part of a 

forthcoming report. 

Penalties in Mutual Fund 

Trading Abuse Cases Are 

Among SEC’s Highest and 

Are Consistent with 

Penalties in Similarly 

Egregious Cases 
Page 13 GAO-05-692T 

Figure 1: SEC Settlements with Investment Advisers for Market Timing Abuses, as 

of February 28, 2005 (in thousands of dollars) 

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 roles 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. 

The penalties SEC obtained in the 14 investment adviser cases are also 

consistent with penalties obtained in settled enforcement actions in two 

types of cases that senior Enforcement staff identified as being as 

egregious as the mutual fund trading abuses—the recent corporate 

accounting fraud and investment banking conflict-of-interest cases. The 

recent, large corporate accounting frauds surfaced in late 2000 and 

concerned publicly traded companies that allegedly used fraudulent 

accounting techniques to inflate their revenues and drive up stock prices. 

The investment banking analyst cases involved several investment firms 

that settled enforcement actions brought by SEC in 2003 for allegedly 

producing securities research that was biased by investment banking 

interests. Table 1 compares the range of penalties and average penalties 

SEC obtained in settled enforcement actions brought against firms for 

mutual fund trading abuses, corporate accounting fraud, and investment 

banking conflicts of interest. Although particular penalties reflect the facts 

and circumstances of each case, table 1 shows that the average penalties 

among the three types of cases have generally been consistent (when 
Page 14 GAO-05-692T 

excluding the record $2.25 billion penalty obtained in a corporate 

accounting fraud case), particularly when compared with the lower 

penalties obtained in past years. In a public speech, the former Director of 

Enforcement said that the comparatively large penalties in these cases 

represented an effort to increase accountability and enhance deterrence in 

the wake of such extreme misconduct in the securities industry and noted 

that such penalties create powerful incentives for firms to institute 

preventative programs and procedures. Others, however, including two 

members of the Commission, have questioned the appropriateness of 

these relatively large penalties for public companies, arguing that the cost 

of penalties are borne by shareholders who are frequently also the victims 

of the corporate malfeasance. 

Table 1: Average Penalties in SEC Settlements with Investment Advisers, Public 

Companies, and Investment Firms 

Case type 

Number of settled 

enforcement 

actions Range of penalties Average penalty 

Investment 

adviser 

14 $2—$140 million $56 million 

Public company 11 $3—$250 million, $2.2 

billion 

$61.5 milliona

Investment firm 12 $5—$150 million $43 million 

Source: SEC. 

a

The average penalty SEC obtained in settled enforcement actions involving corporate accounting 

fraud at public companies does not include its record $2.2 billion penalty obtained in its settlement 

with WorldCom, Inc., in July 2003. A federal district court order stated that the penalty would be 

satisfied, post bankruptcy, by the company’s payment of $500 million in cash and the transfer of 

common stock in the reorganized company valued at $250 million to a court-appointed distribution 

agent. 

In addition to bringing enforcement actions against firms, SEC has held 

individuals responsible for their roles in the trading abuses. As of February 

28, 2005, SEC had brought enforcement actions against 24 individuals and 

settled with 18, obtaining penalties and industry bars in all cases (see table 

2 for penalties) and disgorgements in some. Almost all of these settled 

enforcement actions involved high-level executives, including eight chief 

executive officers (CEO), chairmen, and presidents. The penalties SEC 

obtained in these settlements ranged from $40,000 to $30 million. The 

penalties obtained from three individuals are among the four highest in 

SEC’s history—one for $30 million (the highest) and two for $20 million. 
Page 15 GAO-05-692T 

SEC also obtained a combined $150 million in disgorgement from these 

three individuals.14 In addition, as part of its settlements, SEC permanently 

barred 5 individuals, including the 3 mentioned above, from association 

with investment advisers, investment companies, and in some cases other 

regulated entities, and barred the remaining 13 for various periods from 

their industries. 

 14SEC obtained an additional $529,000 in disgorgement from five other individuals. 
Page 16 GAO-05-692T 

Table 2: Penalties SEC Obtained in Settlement from Individuals Charged in 

Investment Adviser Cases 

Individuals charged, by investment adviser casea

 Penalty 

Strong Capital Management, Inc. 

• Founder and former chairmanb

• Former executive vice-presidentb

• Former director of complianceb

$30 million 

$375,000 

 $50,000 

Pilgrim Baxter & Associates, Ltd. 

• Former president 

• Former chief executive officer (CEO)b

$20 million 

$20 million 

Invesco Funds Group, Inc. 

• Former CEO 

• Chief investment officer 

• National sales manager 

• Assistant vice president of sales 

$500,000 

$150,000 

$150,000 

 $40,000 

Massachusetts Financial Services, Co. 

• Former president 

• Former CEO 

$250,000 

$250,000 

RS Investment Management, LP 

• CEO 

• Chief financial officer 

$150,000 

$150,000 

Columbia Management Advisors, Inc. 

• Former portfolio manager 

• Former chief operating officer 

• Former national sales manager 

$100,000 

$100,000 

 $50,000 

Banc One Investment Advisors, Corporation 

• Former CEO of related fund $100,000 

Fremont Investment Advisers, Inc. 

• Former CEO $100,000 

Total $72,515,000 

Source: SEC 

a

Some individuals charged in the investment adviser cases had more than one title with the 

investment adviser or with an associated entity, such as the related mutual fund. Unless otherwise 

indicated, the position indicated refers to the position the individual held with the investment adviser. 

b

SEC permanently barred this individual from association with certain regulated entities, including 

investment advisers and investment companies. 
Page 17 GAO-05-692T 

In determining appropriate penalties to recommend to the Commission in 

the investment adviser cases we reviewed, SEC staff consistently applied 

criteria that the agency has established. These criteria require SEC to 

consider such things as the egregiousness of the conduct, the amount of 

harm caused, and the degree of cooperation and to compare proposed 

penalties with penalties obtained in similar cases. SEC staff may also 

consider litigation risks in determining appropriate penalties. For 

example, if SEC pursues an overly aggressive penalty, a defendant may be 

less likely to settle, and a judge or other arbitrator may not agree with 

SEC’s analysis and impose a lesser penalty. A range of SEC officials 

participate in SEC’s process for setting appropriate penalties—including 

the Commissioners—to help ensure that no one individual or small group 

has disproportionate influence over the final decision. Moreover, SEC has 

coordinated penalties and disgorgement with state authorities in many of 

its market timing and late trading cases, although some states obtained 

additional monetary sanctions. 

Officials from DOJ, NYSOAG, and the Wisconsin Attorney General’s Office 

told us that they have declined to bring criminal charges for market timing, 

largely because market timing itself is not illegal. In instituting 

administrative proceedings in the 14 investment adviser cases discussed 

above, SEC alleged that the undisclosed market timing constituted 

securities fraud, conduct expressly prohibited under federal securities 

laws. According to DOJ officials, although state and federal criminal 

prosecutors can also seek criminal sanctions for securities fraud, such 

prosecutions may be more difficult to prove than civil actions. DOJ 

officials told us that criminal prosecutors must be able to prove beyond a 

reasonable doubt that the defendant committed fraud, whereas civil 

authorities generally need only show that a preponderance of the evidence 

indicated a fraudulent action. According to DOJ and NYSOAG officials, for 

a variety of reasons their review of cases involving market timing 

arrangements concluded that they did not warrant criminal fraud 

prosecutions.15 For example, in commenting on one case involving an 

investment adviser’s undisclosed market timing arrangement, the 

Wisconsin Attorney General stated that the risk in trying to convince a jury 

beyond a reasonable doubt that the particular behavior was criminal 

 15DOJ and NYSOAG officials said that the fact that a criminal case has not been brought 

against an investment adviser to date for entering into undisclosed market timing 

arrangements with favored investors does not preclude them from bringing one in the 

future if they believe the facts and circumstances warrant it. 

SEC Consistently Applied 

Procedures in Setting 

Penalties 

Several Factors Have 

Complicated Criminal 

Prosecution of Market 

Timing, but State and 

Federal Authorities Have 

Brought Criminal Charges 

in Late Trading Cases 
Page 18 GAO-05-692T 

motivated his office and other state prosecutors to instead pursue a civil 

enforcement action. 

According to a recent law journal article, the ambiguous nature of some 

funds’ prospectus language may have further weakened the ability of 

federal and state prosecutors to bring criminal charges against investment 

advisers that allowed favored investors to market time.16 The article stated 

that it is often unclear whether and to what extent a fund prohibits market 

timing. For example, many mutual funds merely “discouraged” market 

timing to the extent that it caused “harm” to the funds. According to the 

article, such language is subject to various interpretations as to what 

constitutes discouraging and what constitutes harm to fund performance. 

Further, it stated that even prospectus disclosures that allow a specific 

number of exchanges can be ambiguous because the term “exchange” is 

subject to various interpretations. Such ambiguities may hamper criminal 

prosecutors’ efforts to prove that the market timing arrangements 

constituted a willful intent to defraud.17

In contrast, NYSOAG and DOJ have brought at least 12 criminal 

prosecutions against individuals involving late trading violations. In one 

case, NYSOAG charged a former executive and senior trader of a 

prominent hedge fund with conducting late trading on behalf of that firm 

through certain registered broker-dealers in violation of New York’s state 

 16Roberto M. Braceras, “Late Trading and Market Timing,” Securities & Commodities 

Regulation, vol. 37. no.7 (2004). 

17On April 16, 2004, SEC adopted amendments to Form N-1A requiring open-ended 

management investment companies (mutual funds) to disclose in their prospectuses both 

the risks to shareholders of frequent purchases and redemptions of the mutual fund’s 

shares and the mutual fund’s policies and procedures with respect to such frequent 

purchases and redemptions. If the mutual fund’s board has not adopted such policies and 

procedures, the mutual fund must disclose the specific basis for the board’s view that it is 

appropriate for the mutual fund to not have such policies and procedures. These rules are 

intended to require mutual funds to describe with specificity the restrictions they place on 

frequent purchases and redemptions, if any, and the circumstances under which any such 

restrictions will not apply. See Disclosure Regarding Market Timing and Selective 

Disclosure of Portfolio Holdings, 69 Fed. Reg. 22300 (2004) (amendments to Form N-1A; 

text of the amendments do not appear in the Code of Federal Regulations). Form N-1A is 

used by mutual funds to register under the Investment Company Act of 1940 and to file a 

registration statement under the Securities Act of 1933 to offer their shares to the public. 
Page 19 GAO-05-692T 

securities fraud statute.18 According to DOJ officials, criminal prosecution 

of late trading is fairly straightforward because the practice is a clear 

violation of federal securities laws. 

SEC staff said that as state and federal criminal prosecutors were already 

aware of and generally evaluated the mutual fund trading abuse cases for 

potential criminal violations on their own initiative, SEC staff did not need 

to make specific criminal referrals to bring these cases to their attention. 

However, in the course of our review we found that SEC’s capacity to 

effectively manage its overall criminal referral process may be limited by 

inadequate recordkeeping. SEC rules provide for both formal and informal 

processes for making referrals for criminal prosecutions; however, senior 

Enforcement staff told us that SEC uses only the informal procedures 

(such as telephone calls to criminal authorities) for making criminal 

referrals, describing them as less time-consuming and more effective than 

the more cumbersome formal processes, which involved multiple levels of 

agency review and approval including review and approval by the 

Commission. While potentially efficient, SEC’s informal procedures do not 

provide critical management information on the referral process. 

Specifically, SEC staff do not document referrals or reasons for making 

them. According to federal internal control standards, policies and 

procedures, including appropriate documentation, should be designed to 

help ensure that management’s directives are carried out. Without proper 

documentation, SEC cannot readily determine and verify whether staff 

make appropriate and prompt referrals. Documentation of referrals might 

serve as an additional internal indicator of the effectiveness of SEC’s 

referral process and is also important for congressional oversight of law 

enforcement efforts in the securities industry. In response to a 

recommendation in our report, SEC agreed to institute procedures 

requiring the documentation of referrals and the reasons for such 

referrals. 

 18The defendant pleaded guilty to a violation of New York’s Martin Act, General Business 

Law § 352-c(6). This individual also settled a parallel civil enforcement action instituted by 

SEC. The SEC settlement order found that this individual willfully aided and abetted and 

caused violations of SEC Rule 270.22c-1 by engaging in late trading of mutual fund shares 

on behalf of a hedge fund operator. 

Inadequate Documentation 

Procedures Limit SEC’s 

Capacity to Effectively 

Manage the Criminal 

Referral Process 
Page 20 GAO-05-692T 

SEC provides training and guidance to its staff on federal laws and 

regulations regarding employment with regulated entities19, and also 

requires former staff to notify it if they plan to make an appearance before 

the agency.20 However, SEC does not require departing staff to report 

where they plan to work as do other financial regulators. According to 

SEC staff, they have not tracked postemployment information because 

SEC examiners and other staff are highly aware of employment-related 

restrictions. SEC staff also said that since agency examiners have 

traditionally visited mutual fund companies periodically to conduct 

examinations, they are less likely to face potential conflicts of interest 

than bank examiners who may be located full-time at large institutions. 

Nonetheless, as I described earlier, SEC is assigning staff to monitor large 

mutual fund companies on an ongoing basis. These SEC examination 

teams would likely have more regular contact with fund management over 

a potentially longer period of time. In addition, the new SEC rule requiring 

all mutual fund firms to designate CCOs may increase an existing demand 

for SEC examiners to fill open positions in the compliance departments at 

regulated entities. As a result, the potential for employment conflicts of 

interest might increase. In response to a recommendation in our report, 

SEC agreed to request that departing employees provide information on 

where they plan to work and institute procedures (including reviewing 

examination documentation) if agency staff believe that a departed 

employee’s work products may have been compromised due to 

interactions with a regulated entity. 

 19 Federal laws place restrictions on the postfederal employment of executive branch 

employees. Specifically, these laws generally prohibit federal executive branch employees 

from participating personally and substantially in a particular matter that a person or 

organization with whom the employee is negotiating prospective employment has a 

financial interest. 18 U.S.C § 208(a). In addition, former senior employees are prohibited for 

a period of 1 year following federal employment from communicating with or appearing 

before their former federal employer on behalf of anyone with the intent to influence 

agency action. 18 U.S.C. § 207(a). This “cooling-off’ period is 2 years concerning any matter 

that was pending under a former employee’s official responsibility during the 1 year period 

prior to termination of federal employment. 18 U.S.C. § 207(b).Violation of either the 

“seeking employment” or postfederal employment activity restrictions can result in civil 

and criminal sanctions. 18 U.S.C. § 216. 

2017 C.F.R. § 200.735-8(b)(1) requires former SEC staff to file a notice with SEC within 10 

days after being employed or retained as the representative of any person outside of the 

government in any matter in which an appearance before, or communication with, SEC or 

its employees is contemplated. This rule applies to all former SEC staff for 2 years after 

leaving the agency. 

SEC Efforts to Encourage 

Staff Compliance with 

Federal Conflict-of-Interest 

Laws On New Employment 

Do Not Include Tracking 

Post-SEC Employment 

Plans 
Page 21 GAO-05-692T 

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, before 2003, SEC did not identify the undisclosed arrangements 

between investment advisers and favored customers through the agency’s 

oversight process. SEC staff faced competing examination priorities that 

may have affected its capacity to detect the abusive practices but 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 in regard to regulators (1) performing 

independent assessments of internal controls, (2) having the capacity to 

identify and evaluate evidence of potential risks, and (3) ensuring the 

independence of the compliance function at mutual fund companies. 

Accordingly, our April 2005 report included recommendations to enhance 

the effectiveness of SEC’s mutual fund oversight program and help 

strengthen fund company operations, which SEC agreed to either 

implement fully or consider ways to implement them. Although our May 

2005 report found that SEC consistently applied its penalty setting 

procedures in the cases we reviewed, it also identified weaknesses in the 

agency’s procedures relating to the referral of securities cases to other 

agencies for potential criminal violations and ensuring that departing 

employees compiled with conflict-of-interest laws and regulations. The 

report included recommendations to better ensure that these agency 

responsibilities are being met, which SEC agreed to implement. 

Mr. Chairman, this completes my prepared statement. I would be happy to 

respond to any questions that you may have. 

For further information regarding this testimony, please contact me at 

(202) 512-8678 or hillmanr@gao.gov, or Wesley M. Phillips, Assistant 

Director, at (202) 512-5660 or phillipsw@gao.gov. Individuals making 

contributions to this testimony include Emily Chalmers, Fred Jimenez, 

Stefanie Jonkman, Marc Molino, David Tarosky, and Anita Zagraniczny. 

Observations 

GAO Contacts and 

Staff 

Acknowledgements 

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