Report to Congressional Requesters

United States Government Accountability Office

GAO 

May 2005 MUTUAL FUND 

TRADING ABUSES 

SEC Consistently 

Applied Procedures in 

Setting Penalties, but 

Could Strengthen 

Certain Internal 

Controls 

GAO-05-385 
What GAO Found

United States Government Accountability Office

Why GAO Did This Study

Highlights

Accountability Integrity Reliability

www.gao.gov/cgi-bin/getrpt?GAO-05-385.

To view the full product, including the scope 

and methodology, click on the link above. 

For more information, contact Richard Hillman 

at (202) 512-8678 or hillmanr@gao.gov. 

Highlights of GAO-05-385, a report to 

congressional requesters 

May 2005

MUTUAL FUND TRADING ABUSES

SEC Consistently Applied Procedures in 

Setting Penalties, but Could Strengthen 

Certain Internal Controls 

Since September 2003, SEC has brought 14 enforcement actions against 

investment advisers and 10 enforcement actions against other firms for 

mutual fund trading abuses. Penalties obtained in settlements with 

investment advisers 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. SEC’s penalties in the investment adviser cases 

are also generally consistent with penalties it has obtained from firms 

involved in similarly egregious corporate misconduct. Further, SEC brought 

enforcement actions against 24 individuals associated with the investment 

advisers, many of them high-ranking, and obtained penalties as high as $30 

million as well as life-time industry bars for some persons. 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. 

State and federal criminal prosecutors told us that while they have recently 

investigated market timing conduct, they have generally not pursued 

criminal prosecution in those cases. They have, however, brought criminal 

charges in cases involving late trading violations. These officials said that the 

criminal prosecution of market timing is complicated by the fact that market 

timing conduct itself is not illegal. Although SEC instituted administrative 

proceedings in the investment adviser cases discussed above by alleging 

that the undisclosed market timing conduct involved constituted 

securities fraud, both federal and state criminal prosecutors told us they 

reviewed cases involving such market timing conduct and generally 

concluded that it did not warrant criminal fraud prosecutions. In 

contrast, criminal charges have been brought against at least 12 individuals 

for alleged late trading violations. Federal criminal prosecutors said that 

criminal prosecution of late trading is fairly straightforward because federal 

securities laws prohibit the practice. 

SEC officials 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, they did not need to 

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

However, during the course of its review, GAO found that SEC’s capacity to 

effectively manage its overall criminal referral process may be limited by 

inadequate recordkeeping. In particular, SEC does not require staff to 

document whether a referral was made or why. According to federal internal 

control standards, appropriate documentation of agency actions helps 

ensure that management directives are carried out. Without such 

documentation, SEC cannot readily determine whether staff make 

appropriate referrals. Such information is also important as an agency 

performance indicator and for congressional oversight purposes. 

The Securities and Exchange 

Commission (SEC) and other 

regulators have recently identified 

two significant types of trading 

abuses—market timing and late 

trading—in the mutual fund 

industry. The more widespread 

abuse was market timing, which 

involved situations where 

investment advisers (firms that 

may manage mutual funds) entered 

into undisclosed arrangements 

with favored customers who were 

permitted to trade frequently in 

contravention of stated trading 

limits. These arrangements 

harmed long-term mutual fund 

shareholders by increasing 

transaction costs and lowering 

fund returns. Late trading, a 

significant but less widespread 

abuse, occurs when investors place 

trades after the mutual fund has 

calculated the price of its shares, 

usually at the 4:00 p.m. Eastern 

Time close of financial markets, 

but receive that day’s fund share 

price. Investors who late trade have

an opportunity to profit, which is 

not available to other investors. To 

assess SEC’s efforts to impose 

penalties on violators, this report 

(1) discusses SEC’s civil penalties 

in settled trading abuse cases, (2) 

provides information on related 

criminal enforcement actions, and 

(3) evaluates SEC’s criminal 

referral procedures. 

What GAO Recommends

GAO recommends that SEC 

document referrals to criminal law 

enforcement authorities. SEC 

agrees with this recommendation. 
Page i GAO-05-385 Mutual Fund Trading Abuses 

Letter 1

Results in Brief 4 

Background 8 

SEC Consistently Applied Penalty-Setting Procedures in Mutual 

Fund Cases and Coordinated Most Monetary Sanctions with 

States 13 

Several Factors Have Complicated Criminal Prosecution of Market 

Timing, but State and Federal Authorities Have Brought 

Criminal Charges in Late Trading Cases 21 

Inadequate Documentation Procedures Limit SEC’s Capacity to 

Effectively Manage the Criminal Referral Process 24 

SEC Efforts to Encourage Staff Compliance with Federal Conflictof-Interest Laws on New Employment Do Not Include Tracking 

Post-SEC Employment Plans 28 

Conclusions 32 

Recommendations 33 

Agency Comments and Our Evaluation 33 

Appendix I Scope and Methodology 35 

Appendix II Comments from the Securities and Exchange 

Commission 38 

Appendix III Major Contributors to this Report 40 

Tables 

Table 1: Statutory Maximums for SEC Penalties in Noninsider 

Trading Securities Violations, Adjusted for Inflation 11 

Table 2: Average Penalties in SEC Settlements with Investment 

Advisers, Public Companies, and Investment Firms 15 

Table 3: Penalties SEC Obtained in Settlement from Individuals 

Charged in Investment Adviser Cases 16 

Contents 
Page ii GAO-05-385 Mutual Fund Trading Abuses 

Figure 

Figure 1: SEC Settlements with Investment Advisers for Market 

Timing Abuses as of February 28, 2005 (in thousands of 

dollars) 14 

Abbreviations 

1940 Act Investment Company Act of 1940 

Advisers Act Investment Advisers Act of 1940 

ALJ Administrative law judge 

CEO Chief Executive Officer 

CFTC Commodity Futures Trading Commission 

DOJ Department of Justice 

Enforcement Division of Enforcement 

NYSOAG New York State Office of the Attorney General 

OCC Office of the Comptroller of the Currency 

OCIE Office of Compliance Inspections and Examinations 

penalties civil money penalties 

Remedies Act The Securities Enforcement Remedies and Penny 

 Stock Reform Act of 1990 

SEC Securities and Exchange Commission 

SOX Sarbanes-Oxley Act of 2002 

USAO U.S. Attorney’s Office 

This is a work of the U.S. government and is not subject to copyright protection in the 

United States. It may be reproduced and distributed in its entirety without further 

permission from GAO. However, because this work may contain copyrighted images or 

other material, permission from the copyright holder may be necessary if you wish to 

reproduce this material separately. 
Page 1 GAO-05-385 Mutual Fund Trading Abuses 

May 16, 2005 

The Honorable F. James Sensenbrenner, Jr. 

Chairman 

The Honorable John Conyers, Jr. 

Ranking Minority Member 

Committee on the Judiciary 

House of Representatives 

Trading abuses allowing privileged mutual fund investors to profit at the 

expense of other fund shareholders were recently uncovered among some 

of the most well-known companies in the mutual fund industry. The 

Securities and Exchange Commission (SEC), an independent agency 

headed by a five-member Commission, is charged with oversight of the 

mutual fund industry and has the authority to bring civil enforcement 

actions against individuals and mutual fund companies that violate federal 

securities laws.1

 SEC carries out enforcement activities through its 

Division of Enforcement (Enforcement).2

 Swift and effective enforcement 

by SEC of federal securities laws is essential to punish violators and help 

deter future misconduct in the mutual fund industry. In accomplishing its 

mission, SEC can coordinate enforcement actions with state authorities 

that may also have responsibility to bring civil actions. Further, it can 

make referrals to the Department of Justice (DOJ) and state criminal 

enforcement authorities to help ensure that potential violations of federal 

and state criminal statutes are identified and prosecuted. In carrying out 

its work, SEC has a responsibility to ensure that its enforcement staff and 

examiners are free of any real or apparent conflicts of interest that could 

raise questions about their ability to detect violations of and enforce 

securities laws. 

 1

For purposes of this report, “mutual fund companies” generally refer 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

Enforcement investigates possible violations of securities laws, recommends Commission 

action when appropriate (either in a federal court or before an administrative law judge), 

and negotiates settlements on behalf of the Commission. 

United States Government Accountability Office

Washington, DC 20548 
Page 2 GAO-05-385 Mutual Fund Trading Abuses 

Since the New York State Office of the Attorney General (NYSOAG) made 

public its discovery of mutual fund trading abuses in September 2003, that 

office, SEC, the NASD, which regulates broker-dealers that may offer 

mutual funds to their customers, and certain other state regulators have 

pursued enforcement actions for two principal types of mutual fund 

violations—market timing and late trading.3

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 and U.S. markets.4

 As frequent trading can harm mutual fund 

shareholders through lowered fund returns and increased transaction 

costs, many mutual fund companies have disclosed limits in their fund 

prospectuses on the number of trades individual customers may place per 

year. Although market timing is not itself illegal, it can constitute illegal 

conduct if, for example, investment advisers (firms that may manage 

mutual fund companies) enter into undisclosed agreements with favored 

customers permitting them to trade frequently and in contravention of the 

fund prospectuses—as certain investment advisers did prior to September 

2003. Another type of violation commonly referred to as late trading was 

significant but less widespread than market timing violations. Unlike 

market timing, late trading is illegal. It occurs when investors place orders 

to buy or sell mutual fund shares after the mutual fund has calculated the 

price of its shares, usually once daily at the 4:00 p.m. Eastern Time (ET) 

market close, but receive that day’s fund share price.5

 Investors who are 

 3

NYSOAG uncovered the abuses in the summer of 2003 after following up on a tip provided 

by a securities industry insider. We recently issued a report identifying reasons why SEC 

did not detect these trading abuses prior to September 2003. See GAO, Mutual Fund 

Trading Abuses: Lessons Can Be Learned from SEC Not Having Detected Violations at 

an Earlier Stage, GAO-05-313 (Washington, D.C.: Apr. 20, 2005). 

4

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 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). 

5

Under SEC rules, mutual fund companies accept orders to sell and redeem fund shares at 

a price based on the current net asset value, which most funds calculate once a day at the 

4:00 p.m. ET close of the U.S. securities markets. 
Page 3 GAO-05-385 Mutual Fund Trading Abuses 

permitted to late trade can profit on the knowledge of events in the 

financial markets that take place after 4:00 p.m., an opportunity that other 

fund shareholders do not have. Although late trading can involve mutual 

fund company personnel, late trading violations have typically occurred at 

intermediaries, such as broker-dealers, before these institutions submit 

their daily aggregate orders to mutual fund companies for final settlement. 

Because of your interest in ensuring the effective enforcement of federal 

securities laws and effective federal-state coordination, you asked that we 

assess a range of issues associated with SEC’s market timing and late 

trading enforcement actions. Specifically, our report 

• compares the severity of civil money penalties (penalties) obtained in the 

mutual fund cases with penalties obtained in the past and with similarly 

egregious cases, reviews SEC’s penalty-setting process in these cases, and 

discusses SEC’s coordination with state authorities in pursuing civil 

enforcement actions;6

• provides information on state and federal criminal enforcement actions for 

market timing and late trading violations; 

• assesses SEC’s management procedures for making referrals to DOJ and 

state authorities for potential criminal prosecution; and 

• evaluates SEC’s procedures for ensuring compliance with federal laws and 

regulations that govern employees’ ability to negotiate and take positions 

with regulated entities, such as mutual fund companies. 

To respond to the first objective, we obtained copies from SEC of 

enforcement actions and settlement orders related to the mutual fund 

trading abuses and cases of comparable egregiousness. We also obtained 

information from SEC, the Commodity and Futures Trading Commission 

(CFTC), the Office of the Comptroller of the Currency (OCC), and NASD 

on the criteria and processes they use to determine penalties and data on 

the highest penalties they have obtained in settlement. The data we 

obtained from SEC allowed us to compare the penalties obtained in the 

mutual fund trading abuse cases to the penalties obtained in past cases. To 

determine the consistency of SEC’s penalty-setting process in the mutual 

fund trading abuse cases, we reviewed a selection of 11 out of the 14 

 6

For purposes of this report, the term “penalties” refers to “civil money penalties” 

authorized by applicable law. 
Page 4 GAO-05-385 Mutual Fund Trading Abuses 

enforcement actions SEC brought against investment advisers charged 

with market timing abuses. We also obtained information from states that 

coordinated settlement negotiations with SEC in bringing their own 

enforcement actions against several of the same investment advisers 

involved in SEC’s 14 settled enforcement actions. To respond to the 

second objective, we interviewed SEC staff and NYSOAG, Wisconsin 

Attorney General’s Office, and DOJ officials and obtained copies of 

criminal complaints related to late trading and market timing. To respond 

to the third objective, we obtained information from SEC, CFTC, and 

NASD on the procedures these agencies follow for making criminal 

referrals to DOJ and states. To respond to the fourth objective, we 

reviewed the policies and procedures of SEC, OCC, the Federal Reserve 

Banks of Chicago and New York, and NASD for promoting staff 

compliance with federal laws limiting the seeking of employment 

opportunities and postemployment activities of federal executive 

employees and, in the case of NASD and the Federal Reserve Banks, codes 

of ethics that also include seeking employment restrictions for their 

employees. We performed our work in Boston, Mass.; Chicago, Ill.; 

Denver, Colo.; New York, N.Y.; Philadelphia, Penn.; and Washington, D.C., 

between May 2004 and May 2005 in accordance with generally accepted 

government auditing standards. Appendix I provides a detailed description 

of our scope and methodology. 

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

among the highest in the agency’s history and generally consistent with 

penalties obtained in cases involving similarly egregious corporate 

misconduct. Additionally, SEC appears to have followed its process for 

setting penalties consistently in determining penalties in the cases we 

reviewed. Since 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 that conducted or facilitated improper or illegal 

trading. 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, SEC penalties in cases 

for securities law violations issued prior to January 2003 were generally 

less than $20 million. SEC’s penalties in the investment adviser cases also 

are generally consistent with penalties the agency has obtained in 

settlements resulting from recent investment banking analyst and 

Results in Brief 
Page 5 GAO-05-385 Mutual Fund Trading Abuses 

corporate accounting fraud cases, which SEC staff identified as involving 

similarly egregious misconduct.7

 In addition to actions against advisers, 

SEC brought enforcement actions against 24 individuals, many of them 

high-ranking company executives. SEC has obtained penalties as high as 

$30 million against investment adviser executives (among the highest 

penalties obtained in individual cases) and barred some individuals from 

their industry for life. 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 as well as 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 (which forces 

firms to forfeit ill-gotten monetary gain) with state authorities in many of 

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

additional monetary sanctions. 

State and federal criminal prosecutors told us that while they have 

recently investigated market timing conduct, they have generally not 

pursued criminal prosecution in those cases. They have, however, brought 

criminal charges in cases involving late trading violations. These officials 

said that the criminal prosecution of market timing is complicated by the 

fact that market timing conduct itself is not illegal. Although SEC 

instituted administrative proceedings in the investment adviser cases 

discussed above by alleging that the undisclosed market timing conduct 

involved constituted securities fraud, both federal and state criminal 

prosecutors told us they reviewed cases involving such conduct and 

generally concluded that they did not warrant criminal fraud prosecutions. 

Federal officials did identify one instance of market timing conduct that 

led to the initiation of criminal proceedings; however, an undisclosed 

 7

The investment analyst cases involved several investment firms who allegedly provided 

securities research that was biased by investment banking interests, while the corporate 

accounting fraud cases involved publicly traded companies that allegedly used fraudulent 

accounting techniques to inflate their revenues and thereby drive up stock prices. 
Page 6 GAO-05-385 Mutual Fund Trading Abuses 

market timing arrangement was not central to the criminal allegations. The 

case involved a broker-dealer’s alleged efforts to facilitate and conceal 

short-term trading by its customers despite warnings from mutual fund 

companies that such trades would not be accepted. In contrast, NYSOAG 

and DOJ have brought at least 12 criminal prosecutions against individuals 

involving late trading violations. For example, NYSOAG charged a former 

executive and senior trader of a prominent hedge fund with conducting 

late trading on behalf of the fund through certain registered brokerdealers. This individual pled guilty in the New York State Supreme Court. 

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, they 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 agency staff with what they 

characterize as “formal” and “informal” procedures to use when making 

referrals to appropriate authorities if the facts of a particular investigation 

indicate potential criminal violations. Formal referral procedures, which 

according to SEC staff have not been used for over 20 years, require that 

the Director of Enforcement review cases to be recommended for criminal 

prosecution in coordination with the Office of the General Counsel and, 

according to Enforcement staff, that the Commission approve the 

recommended referrals. Under the informal procedures, SEC regional 

management staff or their designees are allowed to contact federal or state 

authorities and apprise them of a particular case. Although SEC 

procedures provide for informal referrals and such referrals may be 

efficient, the process as currently implemented does not provide critical 

management information. In particular, SEC does not require staff to 

document the reasons for making an informal referral or even whether 

such a referral has been made. SEC staff told us that such documentation 

would not aid them in managing the referral process as they already have 

in place processes to ensure that appropriate referrals are made. However, 

without such documentation, the Commission cannot readily determine 

and verify whether staff make appropriate and prompt referrals. This lack 

of recordkeeping is inconsistent with federal internal control standards, 

which recommend that documentation be designed to provide evidence 

that management directives have been carried out, and with the practices 

of other financial regulators such as CFTC and NASD, which maintain 
Page 7 GAO-05-385 Mutual Fund Trading Abuses 

records on referrals. Documentation of referrals might serve as an 

additional internal indicator of the effectiveness of SEC’s referral process 

and would also be important for congressional oversight of law 

enforcement efforts in the securities industry. 

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

regulations regarding employment with regulated entities and requires 

former staff to notify SEC if they plan to make an appearance before the 

agency, it does not require departing staff to report where they plan to 

work. In contrast, OCC and two Federal Reserve Banks obtain information 

on where departing staff will be employed to assess the potential for 

violations of employment restrictions. NASD also obtains information on 

departed employees’ subsequent employment with member firms. Officials 

from three of these agencies said that they also ask for this information to 

assess whether the quality of the employee’s prior regulatory work could 

have been compromised by a potential conflict of interest with the 

employee’s new place of employment. According to SEC staff, they have 

not tracked postemployment information because SEC examiners and 

other staff are highly aware of employment-related restrictions. Further, 

SEC staff 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. However, SEC staff have told 

us that as part of recently implemented and planned changes to their 

mutual fund oversight program, they are assigning monitoring teams to the 

largest and highest-risk mutual fund companies. The teams would have 

more regular contact with fund management over a potentially longer 

period of time. In addition, a new SEC rule requiring all mutual fund 

companies and investment advisers to designate chief compliance officers 

may increase an existing demand for SEC examiners to fill open positions 

in the compliance departments at regulated entities.8

 As a result, the 

potential for employment conflicts of interest might increase. 

This report contains recommendations related to improving SEC 

documentation of informal referrals and the postemployment plans of 

 8

On December 17, 2003, SEC adopted compliance rules requiring all investment companies 

and investment advisers registered with the agency to adopt and implement policies and 

procedures designed to prevent violations of the federal securities laws and to designate a 

chief compliance officer to be responsible for administering such policies and procedures. 

See Compliance Programs of Investment Companies and Investment Advisers, 68 Fed. Reg. 

74714 (2003) (to be codified at 17 C.F.R. § 270.38(a)-1 and 17 C.F.R. § 275.206(4)-7. 
Page 8 GAO-05-385 Mutual Fund Trading Abuses 

departed staff. SEC provided written comments on a draft of this report 

that are reprinted in appendix II. SEC agreed with the recommendations 

and noted that it will take steps to implement them as part of other, 

ongoing efforts to modify the forms Enforcement staff use to record 

investigation-related information and to enhance staff awareness of the 

conflict-of-interest issues associated with seeking employment and 

postemployment. SEC’s comments are discussed in greater detail at the 

end of this report. SEC also provided technical comments, which have 

been incorporated as appropriate. 

Although typically organized as a corporation, a mutual fund’s structure 

and operation differ from those 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. 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 for necessary services.9

 Unlike a typical corporation, a typical 

mutual fund has no employees; it is created and operated by another party, 

the adviser. 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.10 The adviser contracts with the fund, 

for a fee, to administer its operations. These fees are typically based on the 

size of assets under management. In managing the fund’s assets, the 

adviser owes a fiduciary duty to the investors in the mutual funds to act 

for the benefit of the investors and not use the fund’s assets to benefit 

itself. 

Mutual funds are subject to SEC oversight and are regulated primarily 

under the Investment Company Act of 1940 (1940 Act) and the rules it has 

adopted under that act. SEC has authority under this act to promulgate 

rules to address a constantly changing financial services industry 

environment in which mutual funds and other investment companies 

 9

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. 

10In some cases, the adviser may contract with other firms to provide investment advice, 

becoming a subadviser to those funds. 

Background 
Page 9 GAO-05-385 Mutual Fund Trading Abuses 

operate. The advisory firms that manage mutual funds are regulated under 

the Investment Advisers Act of 1940 (Advisers Act), which requires certain 

investment advisers to register with SEC and conform to SEC regulations 

designed to protect investors. 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 examinations. 

SEC is vested with the authority to bring civil enforcement actions against 

individuals and companies that violate provisions of the 1940 Act, the 

Advisers Act, and other federal securities laws and regulations. While SEC 

has civil enforcement authority only, it works with various federal and 

state criminal law enforcement agencies throughout the country to 

develop and bring criminal cases when the misconduct warrants more 

severe action. SEC carries out its enforcement activities through 

Enforcement. Enforcement identifies potential securities laws violations 

through referrals from SEC examiners or other regulatory organizations 

such as NASD, tips from securities industry insiders or the public, the 

press, and its own surveillance of the marketplace. After conducting an 

investigation, Enforcement staff present their findings to the Commission 

for its review and approval. The Commission can authorize staff to bring 

an enforcement action in federal court or through administrative 

proceedings. 

When bringing a civil enforcement action in federal court, SEC files a 

complaint with a U.S. District Court that describes the misconduct, 

identifies the laws and rules violated, and identifies the sanction or 

remedial action that is sought. Administrative proceedings differ from civil 

enforcement actions brought in federal court in that they are heard by an 

administrative law judge (ALJ), who is independent of SEC. The ALJ 

presides over a hearing and considers the evidence presented by 

Enforcement staff, as well as any evidence submitted by the subject of the 

proceeding. SEC may also enter into settlements with defendants who 

choose not to contest the charges against them. In a typical settlement of 

an administrative proceeding, the defendant neither admits nor denies the 

violation of the securities laws and agrees to the imposition of sanctions. 

According to senior Enforcement staff, both SEC and the defendants have 

an incentive to avoid litigation and seek a settlement, as litigation is costly 

and time-consuming. 

SEC can seek a variety of sanctions against defendants in federal court or 

as part of administrative proceedings. These include officer and director 
Page 10 GAO-05-385 Mutual Fund Trading Abuses 

bars and monetary sanctions, such as disgorgement and penalties. The 

amount of disgorgement SEC seeks in a particular case is usually 

determined by the amount of monetary gain, if any, realized from the 

violative conduct. SEC can use these funds to compensate investors 

harmed by the misconduct. Penalties, on the other hand, are intended to 

punish wrongdoing and deter others from engaging in similar misconduct. 

The Sarbanes-Oxley Act of 2002 (SOX) authorizes federal courts and SEC 

to establish “fair funds” to compensate victims of securities violations.11

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. 

The Securities Enforcement Remedies and Penny Stock Reform Act of 

1990 (Remedies Act)12 amended existing federal securities laws to 

authorize SEC and federal district courts to impose penalties for securities 

violations other than insider trading, for which penalties were already 

authorized.13 The Remedies Act specifies the maximum penalty that SEC 

can seek in administrative proceedings from a firm or individual in 

noninsider trading cases according to a three-tier framework, which 

allows for increasing penalties based on the presence of fraud and harm to 

investors (see table 1).14 For example, if SEC finds that a firm’s securities 

law violations did not involve fraud or cause substantial harm to investors, 

 11Pub. 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). 

12The Securities Enforcement Remedies and Penny Stock Reform Act of 1990, Pub. L. No. 

101-429, 104 Stat. 931 (codified in various sections of Title 15). 

13Section 2 of the Insider Trading Sanctions Act of 1984, Pub. L. No. 98-376, 98 Stat. 1264 

(codified as amended at 15 U.S.C. § 78u) authorized the Commission to seek in federal 

district court civil money penalties of up to three times the profit gained or loss avoided by 

a person who commits illegal insider trading. 

14Securities Enforcement Remedies and Penny Stock Reform Act of 1990 §§ 202, 301 and 

401, 15 U.S.C. §§ 21B, 80a-9(d) and 80b-3(i). The Federal Civil Penalties Inflation 

Adjustment Act of 1990, Pub. L. No. 101-410, 104 Stat. 890 (codified at 28 U.S.C. 2461, note) 

requires each federal agency to adopt rules adjusting the maximum penalties it is 

authorized by statute to seek for inflation at least once every 4 years. SEC most recently 

carried out this adjustment in February 2005. See 70 Fed. Reg. 7606-08 (2005) (to be 

codified at 17 C.F.R. § 201.1003 and Table III). 
Page 11 GAO-05-385 Mutual Fund Trading Abuses 

a tier one penalty may be appropriate. In that case, the maximum penalty 

SEC can seek would be $65,000 per violation. However, if SEC finds that a 

firm’s misconduct involved fraud and caused substantial harm to 

investors, it can apply the third tier maximum penalty— $650,000 per 

violation. 

Table 1: Statutory Maximums for SEC Penalties in Noninsider Trading Securities 

Violations, Adjusted for Inflation 

Tier Maximum penalty amount for firm (individual) 

1 $65,000 ($6,500) per violation. 

2 $325,000 ($65,000) per violation when the violation involved fraud, deceit, 

manipulation, or deliberate or reckless disregard of a regulatory requirement.

3 $650,000 ($130,000) per violation when, in addition to satisfying the 

requirements of a second tier penalty, the violation directly or indirectly 

resulted in substantial losses or created a significant risk of substantial 

losses to other persons. 

Source: Adjustment of Civil Monetary Penalties – 2005, 70 Fed. Reg. 7,606 (2005) (to be codified at 17 C.F.R. § 201.1003 and Table 

III). 

Although the Remedies Act requires that in order to impose a penalty in an 

administrative proceeding SEC must find that the penalty is in the public 

interest, the act did not impose criteria that SEC must consider in making 

this determination. Instead, the Remedies Act provides a nonexclusive list 

of factors that SEC may consider, such as whether the conduct involved 

fraud or directly or indirectly resulted in harm to other persons. 

Enforcement staff told us that over the years SEC has internally developed 

more extensive criteria based on this guidance, case law, and policy 

directives from the Commission, which are documented for Enforcement 

staff in internal division memorandums. These criteria include 

• the egregiousness of conduct—whether it involved fraud, and if so, the 

degree of scienter present;15

• the degree of harm to investors resulting from the conduct; 

• the extent of the defendant’s cooperation; 

• whether the defendant derived any economic benefit from the conduct; 

 15Scienter refers to the requisite degree of knowledge that makes a person’s actions 

culpable. 
Page 12 GAO-05-385 Mutual Fund Trading Abuses 

• the duration of the conduct; 

• whether the defendant is a recidivist; 

• the seniority of individuals that participated in the conduct; 

• the need for deterrence; 

• the defendant’s ability to pay; 

• the size of the firm or net worth of the individual; and 

• the penalties obtained in cases involving the same or a similar scheme. 

When negotiating settlements on behalf of the Commission, SEC 

Enforcement staff apply these factors to the facts and circumstances of 

each case when determining what penalty to seek. These criteria are 

similar to the criteria other financial regulators use in their penalty-setting 

process, including CFTC, OCC, and NASD. 

One key factor for SEC in effectively fulfilling law enforcement objectives 

such as penalty-setting is the implementation of appropriate internal 

controls. According to the Standards for Internal Control in the Federal 

Government, internal controls (also called management controls) 

comprise the plans, methods, and procedures used to meet missions, 

goals, and objectives and, in doing so, support performance-based 

management.16 They are a major part of managing an organization. Among 

other things, they should promote the effectiveness and efficiency of 

operations, including the use of the entity’s resources, and the agency’s 

compliance with applicable laws and regulations. They should also be 

designed to provide reasonable assurance that the objectives of the agency 

are being achieved. 

 16GAO, Standards for Internal Control in the Federal Government, GAO/AIMD-00-21.3.1

(Washington, D.C.: November 1999), which was prepared to fulfill our statutory 

requirement under the Federal Managers’ Financial Integrity Act, provides an overall 

framework for establishing and maintaining internal controls and for identifying and 

addressing major performance and management challenges and areas at greatest risk of 

fraud, waste, abuse, and mismanagement. 
Page 13 GAO-05-385 Mutual Fund Trading Abuses 

SEC has responded to the widespread trading abuses in the mutual fund 

industry by bringing 14 enforcement actions against investment advisers 

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

financial services firms that conducted or facilitated the illicit trading. 

Penalties SEC has obtained in settlements with these firms have included 

some of the highest in the agency’s history and are consistent with other 

penalties obtained in cases of similarly egregious and pervasive 

misconduct. Further, SEC has held individuals, many of them highranking, responsible for their role in the misconduct and also obtained 

historically high penalties in settlements with several of them. In reviewing 

a selection of 11 out of the 14 enforcement actions SEC brought against 

investment advisers and their associated individuals, we found that SEC 

consistently applied its penalty-setting process and that this process 

contained various levels of review to help ensure that no one individual or 

group of individuals had disproportionate influence on penalty decisions. 

Additionally, SEC coordinated penalties and disgorgements (which force 

firms to give up ill-gotten gains) with interested states in the majority of 

cases, although some states obtained additional monetary sanctions. 

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 ever obtained for securities laws 

violations. 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 more. Pursuant to the fair fund provision of SOX, SEC plans to 

use the penalties and disgorgement moneys, a total of about $800 million 

and $1 billion, respectively, to provide restitution to harmed investors.17 In 

addition to settling with investment advisers, as of February 28, 2005, SEC 

has settled with two broker-dealers, two insurance companies, and one 

brokerage-advisory firm, with penalties totaling $17.5 million. 

 17We are reviewing SEC’s implementation of the fair funds provision of SOX as part of a 

forthcoming report. 

SEC Consistently 

Applied PenaltySetting Procedures in 

Mutual Fund Cases 

and Coordinated Most 

Monetary Sanctions 

with States 

Penalties in Mutual Fund 

Trading Abuses Cases Are 

among SEC’s Highest and 

Are Consistent with 

Penalties in Similarly 

Egregious Cases 
Page 14 GAO-05-385 Mutual Fund Trading Abuses 

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 2 compares the range of penalties and average penalties 

SEC obtained from settlements of 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 2 shows that the 

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 15 GAO-05-385 Mutual Fund Trading Abuses 

average penalties among the three types of cases have generally been 

consistent (when 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 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, particularly for public companies, arguing 

that the cost of penalties are borne by shareholders who are frequently 

also the victims of the corporate malfeasance. 

Table 2: 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—$125 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 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. 

Further, the penalties SEC has obtained in the mutual fund and other 

recent scandals are generally higher than those obtained in settlement by 

NASD and other federal financial regulators. For example, NASD has also 

brought nine enforcement actions against broker-dealers for market 

timing and late trading abuses and obtained penalties ranging from 

$100,000 to $1 million. Similarly, CFTC and OCC have obtained 

consistently lower penalties in settlement. For example, as of December 

2004, the highest penalties OCC and CFTC obtained were for $25 million 

and $35 million, respectively. 

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 
Page 16 GAO-05-385 Mutual Fund Trading Abuses 

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

disgorgement from some (see table 3). Almost all of these settled 

enforcement actions involved high-level executives, including eight chief 

executive officers (CEO), chairmen, and presidents. Penalties SEC 

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

penalties obtained from 3 individuals are among the four highest in SEC’s 

history—one for $30 million (the highest) and two for $20 million. SEC 

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

individuals.18 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. 

Table 3: 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 presidentb

• 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

 18SEC obtained an additional $529,000 in disgorgement from five other individuals. 
Page 17 GAO-05-385 Mutual Fund Trading Abuses 

Individuals charged, by investment adviser casea Penalty

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. 

In reviewing 11 of the 14 settled enforcement actions related to the 

investment adviser cases, we found that SEC followed a similar penaltysetting process in each of them. SEC regional staff in the six offices that 

were part of our review generally began their penalty analysis by 

determining the amount of money earned by the firms and individuals 

from the abusive market timing and the economic harm such trading 

caused to investors. For example, as a measure of monetary gain, staff 

determined the fees the firms earned on the assets market timers invested 

short-term for market timing purposes.19 As a measure of harm to fund 

investors, staff determined the amount of dilution to fund shares that 

occurred as a result of this improper trading, using the same methodology 

for each case.20 SEC’s Office of Economic Analysis, which determined this 

methodology, assisted staff with these analyses. Staff assessments of 

monetary gain and harm caused were also used to help them determine 

appropriate disgorgement. 

After establishing the economic benefit and harm caused, staff generally 

then determined the monetary range within which they could seek a 

 19SEC also found that in some instances market timers invested assets long-term in return 

for market timing privileges, which also generated fees for the investment adviser. 

20The frequent trading of mutual fund shares lowers, or dilutes, the value of fund shares 

held by long-term fund investors. According to experts, this dilution is approximately equal 

to the profits market timers earn as a result of their short-term trading of the fund shares. 

SEC Consistently Weighed 

Penalty Determinations 

Using Established Criteria 

and Procedures among the 

Investment Adviser Cases 

We Reviewed 
Page 18 GAO-05-385 Mutual Fund Trading Abuses 

penalty by calculating the maximum penalty that applied to their 

particular case. According to SEC staff at several regional offices, the 

penalty statutes did not limit them from seeking penalties they thought 

appropriate, largely because the statutes leave it up to SEC to define the 

term “violation.”21 Staff did not necessarily seek the statutory maximum in 

these cases because they considered SEC criteria for assessing the relative 

egregiousness of the misconduct and in some cases concluded that it 

warranted a lesser penalty, and also because they considered the risk that 

the case would be litigated instead of settled. For example, in one case 

where staff could have argued a statutory maximum of $1 billion based on 

the hundreds of improper trades found, staff said they could not have 

made a convincing argument for such a high penalty based on the 

relatively small amount of economic harm and level of scienter involved 

(scienter refers to the requisite degree of knowledge that makes a person’s 

actions culpable). These staff told us that even if they disregarded SEC 

criteria and sought the maximum it was very unlikely that they would have 

achieved an amount close to it. The staff said that the firm involved would 

never have settled and it was unlikely that the judge or ALJ assigned to the 

case would have found staff’s underlying rationale for the penalty 

recommendation credible. As judges and ALJs make independent 

determinations of the facts when determining whether a penalty or other 

sanctions are warranted, staff said that they may decide on a lesser 

penalty than what staff recommended. For that reason, staff said that 

while the penalty statutes provide a baseline for their analysis, they seek 

penalties in settlement that reflect the facts and circumstances of the case 

and the penalties obtained in similar cases. 

To determine a penalty appropriate to the facts and circumstances of each 

case, SEC staff used the criteria discussed earlier to establish the 

egregiousness of the case relative to that of other market timing and late 

trading cases—considering, for example, the level of scienter involved, the 

amount of harm caused and benefit gained, the level of cooperation, and 

the seniority of the individuals involved. We found that staff sought 

penalties that reflected these differences. Barring the presence of 

aggravating or mitigating factors, conduct perceived as more egregious 

received relatively greater penalties. For example, the highest penalty that 

SEC obtained from an individual in the market timing and late trading 

 21For example, they said that they could count each type of misconduct as one violation or 

count each instance of misconduct (such as each improper market timing trade) as a 

separate violation. 
Page 19 GAO-05-385 Mutual Fund Trading Abuses 

cases was from the former founder and chairman of an investment adviser 

who SEC found to have market timed the funds he managed for his own 

personal gain. Regional staff said that this individual’s $30 million penalty 

was merited because as the most senior official in the firm, he was dutybound to protect the interests of all fund investors and should have set an 

example in proper ethical conduct for the rest of the firm’s employees. 

Instead, SEC found that he continued his market timing activities even 

after compliance officials at the firm detected his improper trading and 

counseled him to cease. Further, this was the second time he had been the 

subject of an SEC enforcement action—in 1994, SEC charged him with 

improper personal trading in the fund’s portfolio securities. Finally, they 

said he cooperated very little in the investigation. 

In some cases we found that where SEC perceived a high level of 

egregiousness, the presence of other factors mitigated a more severe 

penalty determination, such as the degree of cooperation or the firm’s 

ability to pay. For example, staff required firms that argued they could not 

pay the penalty initially sought to provide documentation of any financial 

constraints and the financial consequences of paying the higher penalty. 

Regional staff regularly consulted with senior Enforcement staff in 

preparing their penalty recommendations. Enforcement’s Office of the 

Chief Counsel is responsible for reviewing all sanction recommendations, 

including penalties, for consistency with penalties recommended in 

analogous cases. This office reviewed all of the penalty and other 

sanctions recommended in the 11 cases we reviewed. Additionally, staff 

shared information about penalty-setting in the market timing and late 

trading settlements with a range of agency officials outside of 

Enforcement. Once staff had negotiated with the defendant the amount of 

the disgorgement and penalties and the application of other sanctions they 

believed were appropriate for a case and obtained a formal offer of 

settlement from the defendant, staff prepared a memorandum for the 

Commission describing the settlement offer and their rationale for 

recommending that the Commission accept it. For example, the 

memorandums explained how the disgorgement figure related to any 

calculations of economic benefit or harm and discussed the factors most 

relevant to the penalty analysis. Before sending the memorandum to the 

Commission for review and approval, other interested SEC divisions and 

offices, such as Investment Management, Corporation Finance, and the 

Office of the General Counsel, first reviewed it. Enforcement staff said 

that by asking staff from other areas of SEC to review their sanction 

recommendations, they help ensure that no one individual or small group 

has a disproportionate influence over the penalty recommended to the 
Page 20 GAO-05-385 Mutual Fund Trading Abuses 

Commission and that the penalty reflects the Commission’s policy goals. 

The Commission either approved the settlement terms outlined in the 

memorandum or advised Enforcement as to any adjustments they wanted 

made, which staff then renegotiated with the defendants. 

SEC coordinated penalties and disgorgements with interested states in 

many of the settled enforcement actions related to late trading and market 

timing. For example, in 11 cases, three states (New York, Colorado, and 

New Hampshire) coordinated their settlement negotiations with SEC, 

agreeing to seek the same disgorgement and penalty amounts and 

requiring in their individual settlement orders that the payments be 

remitted to and administered by SEC pursuant to the related SEC 

settlement order. As a result of this collaboration, the penalty moneys 

collected in these cases can be used to compensate harmed investors, 

under the fair fund provision of SOX. In one case, a state required a 

separate, duplicative payment from one firm of disgorgement and 

penalties, but SEC noted in its own settlement order that it had considered 

this fact when seeking penalties against the subject firm. 

While in most cases states agreed to the same penalty and disgorgement as 

SEC and to have the payments made directly to SEC, some states, most 

notably New York, obtained additional monetary sanctions. In addition to 

disgorgement and penalties, NYSOAG ordered most of the investment 

advisers with whom it settled to reduce the fees that they charge mutual 

fund investors over the next 5 years. The value of these reductions totaled 

about $925 million and in some cases more than doubled the value of the 

disgorgement and penalties SEC obtained in an individual case. According 

to NYSOAG, these investment advisers did not just allow improper market 

timing and late trading, but they had also charged mutual fund investors 

significantly more in fees than institutional investors for similar services. 

NYSOAG said that the SEC settlements focusing on disgorgement and 

penalties for trading abuses did not compensate investors who were 

overcharged and that the fee reductions it obtained provided this needed 

restitution. 

In conjunction with the settlement order related to one investment adviser 

case, the Commission issued a public statement on its position regarding 

fee reductions. The Commission stated that it did not seek fee reductions 

with this investment adviser because this sanction did not serve its law 

enforcement objectives. First, the Commission said that there were no 

allegations that the fees charged by the adviser in question were illegally 

high. Fee reductions would provide compensation to investors who were 

SEC Coordinated Penalties 

and Disgorgement with 

States in the Majority of 

Settlements with 

Investment Advisers, but 

Some States Obtained 

Additional Sanctions 
Page 21 GAO-05-385 Mutual Fund Trading Abuses 

not harmed by the market timing abuses SEC set forth in the settlement 

order. Second, they said that mandatory fee discounts would require that 

customers do business with the firms to receive the benefits of the fee 

reductions (meaning that prior customers that received allegedly illegal 

prices but already redeemed their shares would not benefit). For those 

reasons, the Commission said that their efforts focused on addressing the 

market timing abuses by providing full compensation to investors harmed 

by this activity and a significant up-front penalty. 

In addition to NYSOAG, Colorado and New Hampshire also obtained 

additional monetary sanctions in its settlements in three investment 

adviser cases. Colorado required the firms involved in two cases to pay $1 

million and $1.5 million, respectively, to reimburse its costs and for 

consumer and investor education and future enforcement activities within 

that state. New Hampshire required the firm involved in another case to 

pay $1 million for investor education and protection purposes and an 

additional $100,000 to defray the costs of the investigation. 

After NYSOAG announced its discovery of mutual fund trading abuses in 

September 2003, officials from that office, DOJ, and SEC told us that they 

met to discuss potential criminal violations in cases involving these abuses 

and clarify subsequent investigative responsibilities and coordination. 

Other state officials told us they also reviewed cases involving mutual fund 

trading abuses for criminal potential. These officials said that the criminal 

prosecution of market timing is complicated by the fact that market timing 

conduct itself is not illegal. DOJ officials told us that they have brought 

criminal charges in cases where late trading occurred, primarily because 

late trading is a clear violation of federal securities laws and authorities 

can readily prosecute cases once evidence of late trading is established. 

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

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

conduct, 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 conduct involved 

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 

Several Factors Have 

Complicated Criminal 

Prosecution of Market 

Timing, but State and 

Federal Authorities 

Have Brought 

Criminal Charges in 

Late Trading Cases 

Several Factors Have 

Complicated Criminal 

Prosecution of Market 

Timing Cases 
Page 22 GAO-05-385 Mutual Fund Trading Abuses 

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.22 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 

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.23 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 

 22DOJ 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. 

23Roberto M. Braceras, “Late Trading and Market Timing,” Securities & Commodities 

Regulation, vol. 37, no. 7 (2004). 
Page 23 GAO-05-385 Mutual Fund Trading Abuses 

prosecutors’ efforts to prove that the market timing arrangements 

constituted a willful intent to defraud.24

As of March 31, 2005, federal prosecutors have brought one criminal case 

involving abusive market timing. However, this case involved a brokerdealer’s alleged efforts to facilitate and conceal short-term trading by its 

customers despite warnings from mutual fund companies that such trades 

would not be accepted, as opposed to allegations of undisclosed 

arrangements between a mutual fund company and favored customers. In 

that case federal prosecutors filed a criminal complaint alleging securities 

fraud and conspiracy charges against three top executives at this firm. The 

complaint alleges that these individuals devised and executed a number of 

deceptive practices to circumvent market timing restrictions placed on 

their firm by mutual funds companies. These deceptive practices allegedly 

included creating and using multiple account numbers for the same client 

and executing trades through multiple clearing firms. As of March 31, 2005, 

these individuals were awaiting trial. 

NYSOAG and DOJ have brought at least 12 criminal prosecutions against 

individuals for charges that include late trading. The individuals charged 

included high-level executives, traders, and other employees of three 

broker-dealers, two banking-related organizations, and one hedge fund 

who allegedly either conducted or facilitated late trading for others in 

mutual fund shares. 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 

 24On 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. 

Most Criminal Cases 

Brought Have Been Based 

on Late Trading Charges 
Page 24 GAO-05-385 Mutual Fund Trading Abuses 

New York’s state securities fraud statute.25 This individual pleaded guilty in 

the New York State Supreme Court. In another case brought by DOJ, 

prosecutors charged several broker-dealers with conducting late trading 

for their clients. According to DOJ officials, criminal prosecution of late 

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

federal securities laws.26

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, they 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 what SEC staff 

characterize as both formal and informal processes for making referrals 

for criminal prosecutions; however, senior Enforcement staff told us that 

SEC uses only the informal procedures for making criminal referrals, 

describing them as less time-consuming and more effective than the more 

cumbersome formal processes. 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. 

 25The 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. 

26The practice of placing an order after the calculation of net asset value, but receiving the 

previously calculated net asset value is a violation of SEC Rule 270.22c-1, the SEC’s 

forward pricing rule. Rule 270.22c-1 requires funds, their principal underwriters, dealers, 

and other intermediaries authorized to consummate transactions in fund shares to assign 

the net asset value that is calculated after the receipt of any purchase or redemption order. 

Inadequate 

Documentation 

Procedures Limit 

SEC’s Capacity to 

Effectively Manage 

the Criminal Referral 

Process 
Page 25 GAO-05-385 Mutual Fund Trading Abuses 

SEC rules set forth what SEC staff characterize as “formal” and “informal” 

procedures for making referrals for criminal prosecution. Under what SEC 

staff described as the formal referral procedures, the Director of 

Enforcement reviews cases to be recommended for criminal prosecution 

in coordination with the Office of the General Counsel, and, according to 

senior Enforcement staff, seeks Commission authorization for the 

recommended referral. Senior Enforcement staff told us that SEC has not 

used the formal procedures in over 20 years because the Commission has 

given the ability for making informal criminal referrals to Enforcement 

staff. According to these staff, the Commission found that it was approving 

all formal staff requests to make criminal referrals, so it was more efficient 

to give SEC staff the authority to make the referrals themselves. Under 

these more informal procedures, staff at the assistant director level or 

higher have delegated authority to communicate with other agencies 

regarding cases of mutual interest, including referring cases for criminal 

prosecution.27

According to senior Enforcement staff and regional staff, if staff attorneys 

uncover what they believe might be criminal violations, they inform their 

assistant director and other management officials about such findings. 

Staff at the assistant director or associate director level decide whether 

the staff’s findings merit a criminal referral, and if so, call the local U.S. 

Attorney’s Office or other criminal authority to see whether they have an 

interest in the case.28 According to SEC staff, if the criminal authority is 

interested in the case they send a letter requesting formal access to SEC’s 

investigative files for that case. These staff said that the primary benefit of 

the informal referral process is that it allows for an efficient flow of 

information between agencies. For example, SEC staff can tip off DOJ 

about potential criminal cases and DOJ officials also can call SEC and 

make informal referrals of cases for potential civil prosecution. 

 27See 17 C.F.R. § 203.2, which authorizes Enforcement staff at the assistant director level to 

communicate, or to authorize attorneys to communicate, information gleaned from SEC 

investigations or examinations to law enforcement authorities. 

28Several regional assistant and associate directors told us that when deciding whether to 

refer a case to DOJ they consider factors such as the severity and seriousness of the 

conduct, whether the case is outside SEC’s jurisdiction (for example, obstruction of 

evidence is outside of SEC’s jurisdiction), and whether individuals involved have previous 

records of illegal conduct. 

SEC Prefers Informal 

Procedures for Making 

Criminal Referrals 
Page 26 GAO-05-385 Mutual Fund Trading Abuses 

Although SEC’s informal procedures may make the communication of 

criminal violations to DOJ efficient and enable an effective cooperative 

relationship between the agencies, they do not include requirements for 

the documentation of these referrals. Currently, Enforcement staff do not 

document what cases have been referred, to whom, or why. Senior 

Enforcement staff told us that the documentation of criminal referrals was 

unnecessary for several reasons. First, they said that such documentation 

would not aid them in managing the referral process, as they already have 

processes to ensure that cases with criminal potential are appropriately 

referred. For example, in addition to the day-to-day monitoring of cases at 

the associate director level, which results in informal referrals to criminal 

authorities, the Director or Deputy Director of Enforcement conducts 

quarterly reviews of SEC’s case inventory to ensure, among other things, 

that referrals are being made. Further, they said that Commission 

members as a matter of course question staff about their cooperation with 

criminal authorities when staff request approval for an enforcement 

action. Second, they said that since the wave of high profile corporate 

accounting scandals that began in 2000, DOJ has had unprecedented 

interest in pursuing securities fraud cases. According to SEC staff, senior 

DOJ officials discuss cases of mutual interest with SEC staff in regular 

joint meetings and as part of federal regulatory and law enforcement 

working groups of which both SEC and DOJ are members.29 SEC staff 

cited the recent cooperation between criminal law enforcement and SEC 

in the mutual fund cases as a good example of how well these processes 

work in alerting criminal prosecutors to appropriate cases. Further, they 

said that as each local U.S. Attorney’s Office (USAO) sets its own 

prosecutorial priorities, the most effective way for SEC staff to learn what 

each USAO considers a useful referral is through strong, informal 

relationships. 

While such informal relationships between SEC and criminal law 

enforcement authorities might be essential to their effective cooperation, 

appropriate documentation of decision-making is an important 

management tool. According to federal internal control standards 

previously discussed, policies and procedures, including appropriate 

documentation, helps ensure that management directives are carried out. 

Internal control procedures include a wide range of diverse activities such 

as authorizations, verifications, and the creation and maintenance of 

 29SEC is a member of the Corporate Fraud Task Force, Bank Fraud Working Group, and the 

Commodities Fraud Working Group. 

While Potentially Efficient, 

Informal Procedures Do 

Not Provide Critical 

Management Information 

on the Referral Process 
Page 27 GAO-05-385 Mutual Fund Trading Abuses 

related records that provide evidence that these activities were executed. 

Without such documentation, the Commission cannot readily determine 

and verify whether staff make appropriate and prompt referrals. Also, the 

Commission does not have an institutional record of the types of cases 

that are referred over the years. Such information is essential for 

appropriate management and oversight of the referral process. For 

example, although Enforcement staff told us that the director’s quarterly 

review of cases involves a discussion of cooperative law enforcement 

activities, they said that it does not include a written report on criminal 

referrals made. Instead, the director must informally poll his staff if he 

wants to develop a list of such referrals, which introduces the likelihood of 

reporting error. Similarly, in conducting our work, SEC was unable to tell 

us what cases had been referred to criminal law enforcement without 

contacting staff assigned to the case or directing us to do the same. 

Further, we found that other financial regulators such as NASD and CFTC 

record their criminal referrals to manage their referral processes. 

Documentation of referrals might also serve as an additional internal 

indicator of the effectiveness of SEC’s referral process. 

In addition to aiding SEC management, information about the number, 

type, and reasons for SEC criminal referrals could also serve as an 

important tool for congressional oversight. Although SEC does not have 

jurisdiction over DOJ and other criminal law enforcement authorities and 

is not responsible for their decision to act or not upon a referral, the 

maintenance of evidence of SEC referrals could serve as verification that 

criminal authorities were made aware of appropriate cases. For example, 

senior Enforcement staff told us that prior to the corporate accounting 

fraud scandals, DOJ was not as interested as it is now in pursuing 

securities fraud. In an environment where changing priorities can 

influence the types of cases criminal law enforcement agencies pursue, the 

documentation of referrals would provide some assurance that SEC is 

consistently considering cases for potential criminal prosecution. 
Page 28 GAO-05-385 Mutual Fund Trading Abuses 

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

regulations regarding employment with regulated entities and also 

requires former staff to notify SEC if they plan to make an appearance 

before the agency. 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, SEC staff have told us that as part of recently implemented 

and planned changes to SEC’s mutual fund oversight program they are 

assigning monitoring teams to the largest and highest-risk mutual fund 

companies. The teams would have more regular contact with fund 

management over a potentially longer period of time. In addition, a new 

SEC rule requiring all mutual fund firms to designate a chief compliance 

officer 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. 

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.30 For example, a senior staff member of SEC’s Ethics Office told 

us that as a result of this law, SEC examiners and enforcement staff 

cannot negotiate employment with a firm that is the subject of an ongoing 

examination or enforcement action in which they have direct involvement, 

although they are not prohibited from obtaining employment with such 

firms after the completion of the examination or enforcement action in 

which they had such involvement. However, federal law prohibits former 

federal executive branch employees from “switching sides” and 

representing their new employer before any federal court or agency 

concerning any matter in which the employees were personally and 

 3018 U.S.C § 208(a). Section 208(b) sets forth circumstances under which exceptions to the 

prohibition may be granted. 

SEC Efforts to 

Encourage Staff 

Compliance with 

Federal Conflict-ofInterest Laws on New 

Employment Do Not 

Include Tracking 

Post-SEC 

Employment Plans 

SEC Offers Ethics Training 

and Counseling Services to 

Employees on Federal 

Employment Restrictions 

but Does Not Ask Where 

Employees Plan to Work 
Page 29 GAO-05-385 Mutual Fund Trading Abuses 

substantially involved during the time of their federal employment.31

According to the SEC ethics staff, if a former SEC examiner accepted 

employment with a firm that the examiner had previously examined, the 

examiner would be permanently barred from communicating with SEC 

regarding the examination in which he or she had participated. 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. 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.32 Violation of 

either the “seeking employment” or postfederal employment activity 

restrictions can result in civil and criminal sanctions. 

The SEC Ethics Office provides annual ethics training and offers ethics 

counseling to SEC examiners, Enforcement staff, and other employees to 

explain these and other conflict-of-interest laws and how to avoid violating 

them. Further, under SEC rules, former SEC staff are required 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.33 This notice must include a description of the 

contemplated representation, an affirmative statement that the former 

employee did not have either personal and substantial responsibility or 

official responsibility for the matter that is the subject of the 

representation while employed by SEC, and the name of the SEC division 

or office in which the former employee had been employed. Senior Ethics 

Office staff said that upon receiving these notices they verify with the 

former division or office that the contemplated representation does not 

involve a matter that the person had responsibility for during his or her 

employment with SEC. 

While these notices provide SEC with information on some employees’ 

postemployment activities and allow SEC to monitor compliance with 

postfederal employment activity restrictions, they do not provide SEC 

 3118 U.S.C. § 207(a). 

3218 U.S.C. § 207(b). 

3317 C.F.R. § 200.735-8(b)(1). This rule applies to all former SEC staff for 2 years after 

leaving the agency. 
Page 30 GAO-05-385 Mutual Fund Trading Abuses 

with information on the postemployment plans of all of its departing staff 

at the time they announce their intention to leave the agency. SEC 

currently does not require departing staff to report where they plan to 

work, a procedure required by other financial regulators to better ensure 

that seeking employment restrictions have not been violated. For example, 

OCC and the Federal Reserve Banks of New York and Chicago obtain 

information from departing staff, or at least examination staff in the case 

of the Federal Reserve Banks, on where they are going to work.34 NASD 

also tracks information on departing staff’s subsequent employment with 

member firms, although they do not ask staff directly for it.35 Officials from 

three of these agencies said that they also ask for this information to 

assess whether the quality of the employee’s prior regulatory work could 

have been compromised by a potential conflict of interest with the 

employee’s new place of employment. For example, when departing 

examiners, enforcement attorneys, and other professional staff go to work 

for a bank with whom they have recently been involved in a regulatory 

matter, OCC requires a review of their related work products, as does the 

Federal Reserve Bank of New York for departing examiners.36 Similarly, 

NASD requires staff to conduct a reexamination of a member firm if that 

firm hires an employee who was involved in a recent examination of that 

firm or a review of the related examination workpapers if the employee 

was a former supervisor, assistant/associate director, or attorney who 

 34The Federal Reserve Banks of Chicago and New York have codes of ethics that contain 

seeking employment restrictions. 

35According to NASD, every month NASD staff generate a list of employees who have left 

the agency and submit this list to NASD’s Central Registration Depository (CRD), which is 

an electronic database that contains information on the employees of member firms. If the 

CRD identifies people from the list that are working at a member firm, NASD determines 

whether these individuals were involved in an examination of that firm within the last 12 

months of their employment with NASD. NASD also has a code of ethics that prohibits 

NASD employees from acting in any NASD matter with whom the employee is seeking 

employment. 

36Some senior bank examiners are prohibited by law from going to work directly for a bank 

they were recently involved in examining. Section 6303(b) of the Intelligence Reform and 

Terrorism Prevention Act of 2004 amended Section 10 of the Federal Deposit Insurance Act 

to prohibit former bank examiners from going to work for any depository institution if, 

during their last year as an employee of a federal banking regulator, they served more than 

2 months as senior bank examiner of that depository institution. This prohibition is in 

effect for a period of one year after the termination of their employment with the federal 

banking regulator. See Federal Deposit Insurance Act § 10(k), to be codified at 12 U.S.C. § 

1820(k). 
Page 31 GAO-05-385 Mutual Fund Trading Abuses 

reviewed or worked on the examination. SEC currently does not require 

similar workpaper reviews or reexaminations.37

According to senior staff from SEC’s Office of Compliance Inspections and 

Examinations (OCIE), which administers SEC’s nationwide examination 

program for investment companies and other regulated entities, 

postemployment tracking has not been viewed as essential because SEC 

examiners face fewer potential conflicts of interest than bank examiners. 

Senior OCIE staff told us that unlike bank examiners, SEC examiners 

typically participate in multiple examinations in the course of the year. 

Banking regulators, on the other hand, often have examiners stationed 

permanently on site at the largest financial institutions.38 OCIE staff said 

that because SEC examiners do not have prolonged contact with 

management at regulated entities, there is little opportunity for them to 

develop the type of relationships that could lead to conflicts of interest. 

However, recently implemented and planned changes to SEC’s mutual 

fund oversight program might increase the potential for employment 

conflicts of interest. As part of these changes (which we review in a 

forthcoming report), OCIE is creating monitoring teams of two or three 

examiners to be assigned to review the operations and activities of the 

largest and highest-risk mutual fund companies on an ongoing basis, as 

opposed to conducting periodic routine examinations. We note that SEC’s 

planned approach for large mutual fund companies is intended to be 

similar to the bank regulators’ approach to bank supervision at large 

financial institutions, in which teams are assigned full-time to monitor the 

largest institutions. Such an approach would increase the contact SEC 

examiners have with fund management and potential for conflicts of 

interest. 

Further, SEC’s new rule requiring all mutual fund firms to designate a 

chief compliance officer may increase an existing demand for SEC 

examiners and other staff to fill open positions at the compliance 

departments of regulated entities. SEC examiners told us that departing 

 37Procedures such as asking departing staff where they are going to work and reviewing 

their related work products when appropriate can help provide reasonable assurance, not 

absolute assurance, that conflicts of interests are avoided. 

38According to one banking regulator, examiners of smaller banks typically spend a few 

weeks on site while conducting their examinations. 

Changes to SEC 

Examination Program and 

Potential Increased Private 

Sector Demand for 

Examiners Could Increase 

Conflicts of Interest and 

Need for Postemployment 

Tracking 
Page 32 GAO-05-385 Mutual Fund Trading Abuses 

SEC examiners commonly obtained employment in the compliance 

departments of regulated entities. Further, these examiners and securities 

industry officials told us that having former SEC staff at these firms was 

very beneficial because SEC staff have expertise in compliance issues and 

are compliance-oriented. One securities industry official said former SEC 

examiners and other staff are a natural source of expertise for firms that 

were involved in the recent mutual fund trading abuses and that want to 

correct their problems. While the compliance departments at regulated 

entities may benefit by hiring experienced SEC staff, an increase in the 

employment potential of examiners and other staff at these firms could 

also increase the potential for conflicts of interest. 

After the mutual fund trading abuses were uncovered in September 2003, 

SEC acted swiftly to bring enforcement actions against prominent firms 

and individuals involved in the misconduct and obtained some of its 

highest penalties in history from them in settlements. SEC has also 

consistently applied its procedures for establishing such penalties. 

However, we identified weaknesses in SEC’s internal controls that may 

limit its capacity to effectively manage its criminal referral process. 

Currently, SEC does not require staff to document that a referral has been 

made to a federal or state criminal investigative authority or the reasons 

for such referrals. According to federal internal control standards, such 

documentation is important for verifying that management directives have 

been carried out. Without such documentation, SEC’s ability to measure 

the performance of its criminal referral process and to help ensure 

effective congressional oversight of that process is limited. 

We also found that SEC has not established controls that could help 

ensure the independence of staff from the fund industry as they carry out 

SEC’s critical oversight work. Although SEC provides ethics training to its 

employees regarding seeking employment and postemployment conflictof-interest laws, the agency does not require departing staff to provide 

information on their future employment plans. In the absence of such 

information, SEC’s capacity to ensure compliance with conflict-of-interest 

laws related to postemployment opportunities is limited. Further, SEC 

does not have procedures in place requiring review of departing 

employees’ workpapers should a potential conflict of interest be 

discovered. SEC’s recently implemented and planned changes to its 

mutual fund examination program that will likely involve greater contact 

between examiners and company officials as well as the potential that 

agency staff will seek to become compliance officers underscore the need 

Conclusions 
Page 33 GAO-05-385 Mutual Fund Trading Abuses 

for the agency to ensure compliance with these critical conflict of interest 

laws. 

To strengthen SEC’s management procedures and better ensure that 

agency responsibilities are being met, the SEC Chairman should ensure 

that the agency take the following two actions: 

• document informal referrals to criminal authorities for potential criminal 

prosecutions and the reasons for such referrals; and 

• request that departing employees provide the name of their next employer 

as part of exit procedures and establish procedures to review the 

departing employees’ related work products if a potential conflict of 

interest is determined to exist. 

SEC provided written comments on a draft of this report, which are 

reprinted in appendix II. SEC also provided technical comments, which 

were incorporated into the final report, as appropriate. SEC agreed with 

our recommendations. SEC indicated that it is in the process of converting 

its investigation opening form to a web-based application, which will 

provide for documentation of informal referrals to criminal authorities. 

SEC also noted steps it is taking to avoid conflicts of interests that could 

affect the implementation of SEC programs and activities, which include 

establishing a formal ethics component to exit procedures. As part of this 

process, SEC will ask departing staff to provide information about the 

identity of their next employer, and, to the extent a potential conflict is 

identified, will investigate as appropriate. 

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 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. 

Recommendations 

Agency Comments 

and Our Evaluation 
Page 34 GAO-05-385 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 III. 

Richard J. Hillman 

Director, Financial Markets and 

 Community Investment
Appendix I: Scope and Methodology 

Page 35 GAO-05-385 Mutual Fund Trading Abuses 

The objectives of our report were to (1) compare the severity of civil 

money penalties (penalties) obtained in the mutual fund cases with 

penalties obtained in the past and with similarly egregious cases, review 

the Securities and Exchange Commission’s (SEC) penalty-setting process 

in these cases, and discuss SEC’s coordination with state securities 

regulators in civil enforcement actions; (2) provide information on state 

and federal criminal enforcement actions regarding market timing and late 

trading violations; (3) assess SEC’s management procedures for making 

referrals to the Department of Justice (DOJ) and state authorities for 

potential criminal prosecution; and (4) evaluate SEC’s procedures for 

ensuring compliance with federal laws and regulations that govern 

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

such as mutual fund companies. 

To compare the severity of penalties obtained in the mutual fund cases 

with penalties obtained in the past and with similarly egregious cases, 

review SEC’s penalty-setting process in these cases, and discuss SEC’s 

coordination with state securities regulators in civil enforcement actions, 

we obtained copies of SEC enforcement actions and settlement orders 

related to market timing and late trading cases and compared them to 

corporate accounting fraud and investment banking analyst cases, which 

SEC staff identified as similar to the mutual fund cases in the 

egregiousness and pervasiveness of misconduct. We obtained these 

documents from SEC’s Web site and SEC staff reviewed the list of cases 

we compiled for accuracy. We then calculated and compared the average 

penalties obtained in these three types of cases. We also obtained data 

from SEC on the 30 highest penalties obtained from entities in settlement, 

according to their records, and similar data for individuals. This data 

allowed us to compare the penalties obtained in the mutual fund trading 

abuse cases to the penalties obtained in past cases. In addition, we 

obtained information from SEC, the Commodity and Futures Trading 

Commission (CFTC), the Office of the Comptroller of the Currency (OCC), 

and the NASD on the criteria and processes they use to determine 

penalties and data from CFTC and OCC on their highest settlements and 

from NASD on its mutual fund trading abuse settlements. Then, to 

determine whether SEC used its criteria and processes consistently when 

evaluating what penalties to seek in the late trading and market timing 

cases, we reviewed documentation pertaining to a selection of 11 out of 14 

enforcement actions SEC brought against investment advisers charged 

with market timing abuses. These 11 cases were distributed among six 

regional SEC offices. We interviewed regional examiners and attorneys 

assigned to each case and reviewed the related investigative record. For 

example, we reviewed enforcement actions and settlement orders, staff 

Appendix I: Scope and Methodology 
Appendix I: Scope and Methodology 

Page 36 GAO-05-385 Mutual Fund Trading Abuses 

analyses of economic harm caused and benefit gained, memorandums 

from the Division of Enforcement to the Commission, and SEC 

examinations for each of these investment advisers and their associated 

fund companies dating back several years. The mutual fund companies we 

chose to review were among the 100 largest mutual fund companies 

nationwide, as measured by the size of customer assets under 

management as of August 1, 2003. We also interviewed two legal scholars 

and economists who have conducted recent research on SEC penalties or 

mutual fund trading abuses to obtain additional views on SEC’s penaltysetting process. In addition, we interviewed securities regulators or law 

enforcement officials from three states that coordinated settlement 

negotiations with SEC in bringing their own enforcement actions against 

investment advisers involved in 11 of the 14 SEC enforcement actions 

mentioned above and obtained copies of the related enforcement actions 

and settlement orders from their Web sites. These regulatory or law 

enforcement entities were the New York State Office of the Attorney 

General (NYSOAG), the Colorado Attorney General’s Office, and the New 

Hampshire Bureau of Securities Regulation. 

To provide information on state and federal criminal enforcement actions 

regarding market timing and late trading violations, we interviewed staff 

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

and obtained copies of late trading and market timing-related criminal 

complaints from the Web sites of the relevant federal or state criminal 

authorities. 

To assess SEC’s management procedures for making referrals to DOJ and 

state authorities for potential criminal prosecution, we reviewed SEC rules 

governing these referrals and interviewed staff from SEC, DOJ, and 

NYSOAG. We also interviewed officials from NASD and CFTC on their 

referral procedures and obtained copies of relevant rules and policies. We 

evaluated SEC’s referral procedures using Standards for Internal 

Controls in the Federal Government.

1

To evaluate SEC’s procedures for ensuring compliance with federal laws 

and regulations that govern employees’ ability to negotiate and take 

positions with regulated entities, such as mutual fund companies, we 

reviewed applicable laws and regulations, interviewed staff from and 

 1

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

(Washington, D.C.: 1999) 
Appendix I: Scope and Methodology 

Page 37 GAO-05-385 Mutual Fund Trading Abuses 

reviewed the policies and procedures of SEC, OCC, the Federal Reserve 

Banks of Chicago and New York, and NASD for promoting staff 

compliance with federal laws limiting the seeking of employment 

opportunities and postemployment activities of federal executive 

employees and, in the case of the Federal Reserve Banks and NASD, codes 

of ethics that also include seeking employment restrictions. 

We performed our work in Boston, Mass.; Chicago, Ill.; Denver, Colo.; New 

York, N.Y.; Philadelphia, Penn.; and Washington, D.C., between May 2004 

and May 2005 in accordance with generally accepted government auditing 

standards. SEC provided written comments on a draft of this report, which 

are reprinted in appendix II. Our evaluation of these comments is 

presented in the agency comments section. 
Appendix II: Comments from the Securities and Exchange Commission 

Page 38 GAO-05-385 Mutual Fund Trading Abuses 

Appendix II: Comments from the Securities 

and Exchange Commission 
Appendix II: Comments from the Securities and Exchange Commission 

Page 39 GAO-05-385 Mutual Fund Trading Abuses 
Appendix III: Major Contributors to this 

Report 

Page 40 GAO-05-385 Mutual Fund Trading Abuses 

Richard J. Hillman (202) 512-8678 

Wesley M. Phillips (202) 512-5660 

In addition to those named above, Fred Jimenez, Stefanie Jonkman, Marc 

Molino, Omyra Ramsingh, Barbara Roesmann, Rachel Seid, David Tarosky, 

and Anita Zagraniczny made key contributions to this report. 

Appendix III: Major Contributors to this 

Report 

GAO Contacts 

Acknowledgments 

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