United States General Accounting Office

GAO Report to Congressional Committees

May 1997 MUTUAL FUNDS

SEC Adjusted Its

Oversight in Response

to Rapid Industry

Growth

GAO/GGD-97-67

GAO United States

General Accounting Office

Washington, D.C. 20548

General Government Division

B-271654 

May 28, 1997

The Honorable Alfonse M. D’Amato

Chairman

The Honorable Paul S. Sarbanes

Ranking Minority Member

Committee on Banking, Housing, and

 Urban Affairs

United States Senate

The Honorable Thomas J. Bliley, Jr.

Chairman

The Honorable John D. Dingell

Ranking Minority Member

Committee on Commerce

House of Representatives

This report discusses our self-initiated review of the Securities and

Exchange Commission’s (SEC) regulation and oversight of investment

companies. We initiated this review because rapid growth in open-end

investment companies, commonly known as mutual funds, had the

potential to outstrip SEC’s ability to properly oversee the industry.1

 In our

September 1995 report on bank mutual funds, we noted that SEC had

obtained additional staff to oversee mutual funds, but that continued

industry expansion could create new challenges for SEC in meeting its

oversight responsibilities.2

 Our objective for this review was to determine

how SEC has responded to this rapid industry growth in carrying out its

mutual fund oversight through inspections, disclosure review, and other

regulatory activities. We are sending this report to you because it pertains

to matters under your jurisdiction.

Results in Brief SEC has increased its inspection staffing and adjusted the focus of its

inspections in response to the rapid growth in the mutual fund industry.

Since fiscal year 1990, SEC has more than doubled the number of its staff

available to do mutual fund inspections. SEC used the increased staff to

1

The term “open-end” refers to the fact that shareholders may redeem shares issued by the mutual fund

on any day on which the fund is open for business. Other types of investment companies include

closed-end funds, unit investment trusts, separate accounts of insurance companies issuing variable

annuities, and business development companies. The distinguishing feature between closed-end and

open-end funds is that closed-end fund shares are not redeemable. Instead, closed-end fund shares are

generally traded on one of the major stock exchanges or in the over-the-counter market. As used in

this report, the term “mutual funds” refers to open-end investment companies.

2

Bank Mutual Funds: Sales Practices and Regulatory Issues (GAO/GGD-95-210, Sept. 27, 1995).

Page 1 GAO/GGD-97-67 SEC Adjusted Its Mutual Fund Oversight
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expand the scope of its inspections to focus primarily on the activities of

families of funds, called fund complexes, that may present high risks to

investors. It also expanded its coverage of investment advisers, and SEC

inspectors spent more time on each mutual fund inspection. As a result,

the number of mutual fund inspections completed each year has remained

relatively constant. SEC still met its current goal of inspecting fund

complexes at least once every 5 years, and most had been inspected more

than once since fiscal year 1992. As inspections became more

comprehensive, the number of deficiencies that inspectors found

increased each year, but few deficiencies were considered serious enough

to be referred for potential enforcement action. SEC reported that the

mutual fund industry had generally been free of major scandal for the last

2 decades.

SEC selectively reviews mutual funds’ disclosure documents. A large part of

the growth in the mutual fund industry has been in adding new funds to

already existing fund complexes. As a result, although each new mutual

fund must submit disclosure documents, these documents often contain

disclosures that are very similar to those of other funds within the same

complex. SEC officials told us that, by selectively reviewing these

documents, they have been able to review all new or materially different

disclosures, despite an almost 8-percent increase in the number of

documents that SEC has received since fiscal year 1994 and despite a

relatively constant staffing level in this function over the same period.

SEC’s other regulatory activities relating to mutual funds include

(1) granting exemptions from various provisions in mutual fund laws and

regulations, (2) developing and modifying rules to implement these

provisions, and (3) providing the industry, Congress, and other

government agencies with SEC interpretations of mutual fund laws and

regulations. These activities have allowed the mutual fund industry to

change dramatically in size and scope without substantially amending

existing laws. SEC staff devoted to these regulatory activities increased

nearly 45 percent from fiscal years 1990 to 1993. However, by 1996, this

staffing had declined 14 percent from its peak in 1993. Nonetheless, SEC

reduced its backlog of pending applications for exemptions in 1996. SEC

officials said that the National Securities Market Improvement Act of 1996

(P.L. 104-290) will increase their rulemaking workload by about 30 percent

through 1997, and that this increased workload may delay progress on

other rulemaking initiatives.

Page 2 GAO/GGD-97-67 SEC Adjusted Its Mutual Fund Oversight
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Background Lower returns on alternative investments and a rapidly rising stock market

have contributed to mutual funds becoming an increasingly popular and

important investment vehicle. Assets managed by mutual funds have more

than tripled since the end of fiscal year 1990 from about $1 trillion to

nearly $3.2 trillion by June 1996, exceeding insured commercial bank

deposits, which totaled about $2.6 trillion in June 1996. As of April 1996, an

estimated 63 million individuals, making up about 37 million households,

owned mutual funds. At that time, these fund-owning households

represented 37 percent of all U.S. households, which was up from

31 percent in mid-1994. Much of this growth in mutual fund ownership has

been attributed to investors buying mutual funds to save for retirement.

SEC regulates and supervises the operations of all mutual funds under four

federal securities laws: the Investment Company Act of 1940 (Investment

Company Act), the Investment Advisers Act of 1940 (Investment Advisers

Act), the Securities Act of 1933 (1933 Act), and the Securities Exchange

Act of 1934 (1934 Act). Of these four acts, only the Investment Company

Act was written specifically to regulate the formation and operation of

mutual funds. The Investment Company Act requires mutual funds to

register with SEC and subjects their activities to SEC regulation. The act also

imposes detailed requirements on the operation and structure of mutual

funds.3

 The core objectives of the act are to (1) ensure that investors

receive adequate, accurate information about the mutual fund; (2) protect

the physical integrity of the fund’s assets; (3) prohibit abusive forms of

self-dealing; (4) prevent the issuance of securities that have inequitable or

discriminatory provisions; and (5) ensure the fair valuation of investor

purchases and redemptions.

The other three acts regulate mutual fund activity in various ways. The

Investment Advisers Act requires mutual funds’ advisers to register with

SEC; imposes reporting requirements on those registered investment

advisers; and prohibits the advisers from engaging in fraudulent,

deceptive, or manipulative practices.4

 The 1933 Act requires that mutual

fund shares offered to the public be registered with SEC. In addition, SEC

has adopted rules under this act and the Investment Company Act that

require extensive disclosures in a mutual fund’s prospectus. The 1933 Act

3

The Investment Company Act’s requirements include rules on the composition and election of boards

of directors, disclosure of investment objectives and policies, and approval of investment advisory and

underwriting contracts. The act also imposes limitations on transactions with affiliates, defines

permissible capital structures and custodial arrangements, requires reports to shareholders, and

requires maintenance of records.

4

Banks are exempt from the registration requirements of the Investment Advisers Act when their

employees directly sell mutual funds.

Page 3 GAO/GGD-97-67 SEC Adjusted Its Mutual Fund Oversight
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also regulates mutual fund advertising. The 1934 Act, among other things,

regulates how mutual funds are sold. This act requires that persons

distributing mutual fund shares or executing purchase or sale transactions

in mutual fund shares be registered with SEC as securities broker-dealers.5

Broker-dealers who sell mutual funds are regulated and examined by both

SEC and the National Association of Securities Dealers (NASD). NASD, which

is subject to SEC’s oversight, was established pursuant to the 1934 Act as a

self-regulatory organization for brokerage firms, including those firms that

engage in mutual fund distribution. SEC and NASD regulate broker-dealers

by periodically examining broker-dealer operations on-site and

investigating customer complaints. NASD has also established specific rules

of conduct for its members that, among other things, provide standards for

advertising and sales literature, including filing requirements, review

procedures, approval and recordkeeping obligations, and general

standards. In addition, NASD tests individuals to certify their qualifications

as registered representatives6

 and has primary responsibility for regulating

advertising and sales literature used to solicit and sell mutual funds to

investors.

On October 11, 1996, the National Securities Market Improvement Act of

1996 (1996 Act) was signed into law. This legislation represented the most

significant overhaul of the securities regulatory structure in decades.

Among other things, the 1996 Act divided responsibility for regulation of

the financial markets between the federal and state governments. The 1996

Act amended the Investment Company Act to promote more efficient

management of mutual funds, protect investors, and provide more

effective and less burdensome regulation. The amendments, in effect,

made the regulation of mutual fund disclosures and advertising the

exclusive province of the federal government by preempting state

securities registration, merit review, and prospectus disclosure

requirements for investment companies. In connection with investment

company offerings, states (1) can continue to require companies to file,

with the state, documents they file with SEC and can charge fees for such

filings; and (2) will retain jurisdiction over fraud and deceit and unlawful

broker-dealer conduct under applicable state law. The 1996 Act also

5

Broker-dealers combine the functions of brokers and dealers. Brokers are agents who handle public

orders to buy and sell securities. Dealers are principals who buy and sell stocks and bonds for their

own accounts and at their own risk.

6

A registered representative is a person who is associated with a broker-dealer and who must acquire a

background in the securities business and pass relevant qualifications examinations that are

administered for the industry by NASD. The broker-dealer must register with SEC and be a member of

a self-regulatory organization, such as NASD or a stock exchange.

Page 4 GAO/GGD-97-67 SEC Adjusted Its Mutual Fund Oversight
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amended the Investment Advisers Act, including provisions that divided

responsibility for regulation of investment advisers between the states and

SEC.

SEC’s oversight focuses on protecting mutual fund investors by minimizing

the risk to investors from fraud, mismanagement, conflicts of interest, and

misleading or incomplete disclosure. SEC oversees mutual funds primarily

through (1) performing on-site inspections of mutual funds’ compliance

with federal securities laws; (2) reviewing disclosure documents that

mutual funds are required to file with SEC; and (3) engaging in other

regulatory activities, such as rulemaking, responding to requests for

exemptions from applicable federal securities laws, and providing

interpretations of those laws. In addition, although not discussed in this

report, SEC’s enforcement program is responsible for investigating and

prosecuting violations of securities laws related to mutual funds.

In the early 1990s, SEC considered its oversight of the investment

management industry, including mutual funds, to be severely understaffed.

SEC attributed its staffing shortage to the explosive growth in the industry

since 1983; the industry’s use of increasingly complex products, such as

derivatives, which may be difficult both to value and trade during falling

markets;7

 and the use of more complex organizational structures.

Believing that inadequate staffing threatened its ability to protect

investors, SEC reallocated positions from its other regulatory programs to

investment management oversight and obtained additional positions

through congressional appropriations. Of SEC’s six major regulatory

programs, its investment management program was the second smallest in

fiscal year 1990, comprising about 12 percent of SEC’s total authorized

positions.8

 By fiscal year 1996, the investment management program had

become SEC’s second largest regulatory program, comprising almost

20 percent of SEC’s total authorized positions.

Objective, Scope, and

Methodology

Our objective was to determine how SEC has responded to the rapid

growth in mutual funds in carrying out three parts of its mutual fund

oversight—inspections, review of disclosure documents, and other

regulatory activities. To determine the requirements for SEC’s oversight, we

7

Derivatives are financial products whose value is determined from an underlying reference rate,

index, or asset. The underlying includes stocks, bonds, commodities, interest rates, foreign currency

exchange rates, and indexes that reflect the collective value of various financial products.

8

In addition to Investment Management Regulation, SEC’s five other major regulatory programs are the

following: Prevention and Suppression of Fraud, Full Disclosure, Supervision and Regulation of

Securities Markets, Program Direction, and Legal and Economic Services.

Page 5 GAO/GGD-97-67 SEC Adjusted Its Mutual Fund Oversight
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reviewed applicable securities laws; SEC rules and regulations

implementing these laws; and relevant testimony, commentary, and

studies, including a 1992 SEC study on the regulation of investment

companies.9

To determine how SEC carries out these responsibilities, we (1) reviewed

agency documents that described SEC’s mutual fund oversight activities,

including relevant mission statements, policies and procedures, training

materials, staffing data, budget estimates, and annual reports, and

(2) interviewed SEC officials. We also reviewed workload and performance

data for these oversight activities, including the number and results of

inspections completed during fiscal years 1992 through 1996, the number

and type of disclosure documents SEC received and reviewed during fiscal

years 1994 through 1996, and the number of applications for exemptions

and requests for no-action and interpretive letters that SEC processed

during fiscal years 1994 through 1996. We were unable to include and

compare data for all disclosure documents from previous fiscal years

because of changes in how SEC counted the filings received.

To determine how frequently SEC has inspected mutual funds, we

compared the inspections completed between fiscal years 1992 and 1996

with a list of fund complexes SEC prepared for its field offices to use in

scheduling their fiscal year 1996 inspections. We judgmentally selected for

this analysis 5 of the 10 SEC field offices that inspect investment

companies. We selected the four field offices—New York, Chicago,

Boston, and Philadelphia—that are responsible for inspecting the largest

number of mutual funds, and one field office—Fort Worth—that is

responsible for inspecting a smaller number of mutual funds. To obtain

more information on how SEC conducts and documents mutual fund

inspections, we interviewed SEC officials from the New York, Boston, and

Philadelphia field offices and reviewed selected inspection reports and

workpaper files at those locations.

We did our work between March 1996 and March 1997 at SEC in

Washington, D.C., and at SEC field offices in New York, Boston, and

Philadelphia. We did our work in accordance with generally accepted

government auditing standards. SEC officials provided written comments

on a draft of this report, which are reprinted in appendix I. Our evaluation

of these comments is presented on page 29.

9

Protecting Investors: A Half Century of Investment Company Regulation, Division of Investment

Management, United States Securities and Exchange Commission, May 1992.

Page 6 GAO/GGD-97-67 SEC Adjusted Its Mutual Fund Oversight
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Increased Staffing

Benefited the SEC

Inspection Program

Periodic, on-site inspections are the cornerstone of SEC’s oversight of

mutual funds. Increasing its inspection staff during the 1990s allowed SEC

to broaden its inspection objectives. Although SEC frequently changed its

objectives, it met its goal of inspecting fund complexes at least once every

5 years, and most of the complexes were inspected about once every 3

years. Despite SEC’s increase in staffing, the total number of yearly

investment company inspections did not increase because SEC used the

staffing increase to expand its coverage of investment advisers and

because inspectors spent more time on each investment company

inspection. The total number of deficiencies that inspectors found

increased each year. The inspectors referred an average of about 5 percent

of these deficiencies to SEC’s Division of Enforcement for potential

enforcement action.

On-Site Inspections Are the

Cornerstone of SEC

Oversight

SEC’s inspections are meant to enhance investor protection because they

provide a direct check of mutual funds’ compliance with the securities

laws, including the accuracy of disclosures made to investors. Rather than

inspecting individual mutual funds, SEC’s inspections primarily focus on

fund complexes, which are generally groups of mutual funds—sometimes

called fund families—that are associated with common advisers or

underwriters. In most cases, investors can, with a telephone call, switch

between individual funds within the same fund complex and change their

investment strategies. Fund complexes can be large. For example, as of

June 1996, the Fidelity fund complex, which was the largest complex,

consisted of over 200 funds and more than $400 billion in assets.

The growth in the number of fund complexes has not been as great as the

growth in the number of individual mutual funds because many existing

fund complexes have expanded their complement of individual funds to

attract and serve diverse market segments. According to data provided by

SEC, between December 1991 and June 1996, the number of individual

mutual funds grew by about 75 percent, from 3,427 funds to 5,996 funds. In

comparison, the number of fund complexes grew by 40 percent, from 578

complexes in December 1991 to 812 complexes in June 1996.10 As of

June 1996, the 50 largest fund complexes accounted for about 74 percent

of total complex assets.

Before May 1995, SEC’s Division of Investment Management (Division of

IM) was responsible for conducting and coordinating inspections of mutual

10SEC includes open-end funds, closed-end funds, separate accounts of insurance companies, or some

combination of these in its definition of fund complexes. SEC also considers single or stand-alone

funds to be fund complexes. According to SEC, only a small number of stand-alone funds remain.

Page 7 GAO/GGD-97-67 SEC Adjusted Its Mutual Fund Oversight
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funds as well as disclosure reviews and regulation. In an effort to enhance

its overall inspection efforts and promote a more effective use of its

inspection resources, SEC created the Office of Compliance Inspections

and Examinations (OCIE), which began operating on May 1, 1995, to

consolidate its inspection programs for entities over which it had

regulatory authority. These entities include investment companies,

investment advisers, broker-dealers, and self-regulatory organizations.11

OCIE conducts inspections to (1) evaluate mutual funds’ compliance with

securities laws and regulations, (2) determine if funds are operating in

accordance with disclosures made to investors, and (3) assess the

effectiveness of funds’ internal control systems. Inspections of mutual

funds and their related investment advisers are carried out primarily by

staff in 10 of SEC’s 11 field offices.12 If a mutual fund’s principal investment

adviser is located outside of the United States, responsibility for inspecting

that fund is assigned to headquarters, rather than a field office. Although

OCIE provides detailed inspection manuals and general guidance on

selecting mutual funds for inspection, the SEC field offices have primary

responsibility for selecting which mutual funds to inspect in accordance

with those guidelines.

The separation of the inspection function from the Division of IM has

caused the Investment Company Institute (ICI), the national trade

association of the mutual fund industry, some concern about the potential

for inconsistent oversight of mutual funds. ICI officials told us that

separating the staff members who write and interpret the law from those

who inspect companies for compliance with the law creates the potential

for differences in how the laws are interpreted and applied. SEC officials

agreed that this potential exists but told us that staff members in the

Division of IM and OCIE have worked well together since the oversight

functions were separated, and that both units have made an effort to

maintain ongoing communication. However, the SEC officials also said that

the current good working relationship between the two units is largely

because the staff members in OCIE who oversee mutual fund inspections

are essentially the same people who were responsible for doing these

inspections in the Division of IM before OCIE’s creation. SEC officials said

they intend for these two units to work well together regardless of who the

individuals are in each unit. However, according to some SEC officials, as

personnel changes occur in the future—in either the Division of IM or

11Responsibility for inspecting these entities previously was divided between SEC’s Division of Market

Regulation and Division of IM.

12One SEC field office does not have investment company inspection staff.

Page 8 GAO/GGD-97-67 SEC Adjusted Its Mutual Fund Oversight
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OCIE—maintaining good communications and consistent oversight of

mutual funds may become more difficult.

SEC generally does two types of inspections: routine and for cause. Routine

inspections result primarily from the passage of time, but they are done

more frequently if (1) the inspection staff believes that a fund or its agents

are engaged in risky activities or (2) the fund has a history of significant

problems. Inspection staff do for-cause inspections when, for example,

specific facts come to their attention that suggest something may be

wrong at a fund. Most inspections are routine. Inspections either can be

announced in advance or can be done on a surprise basis. According to

SEC, the first inspection of a fund and its service agents usually is done on

a surprise basis. Generally, for-cause inspections are also done on a

surprise basis or with short notice. However, for most SEC inspections,

inspectors notify the fund several weeks in advance of the starting date for

on-site work.

Before going on-site to the offices of the fund complex, inspectors are to

obtain and review information from the complex about its structure and

operations and prepare an inspection plan. When they arrive on-site,

inspectors typically will meet with senior management and do a

walk-through of the offices. The inspectors will then begin reviewing

documents and interviewing other fund personnel as necessary. During

the on-site inspection, inspectors are to look for patterns of activity and

evidence that (1) the fund complex and its agents are conducting their

activities in compliance with the securities laws, (2) potential conflicts of

interest are being identified and resolved to the benefit of shareholders,

(3) operations are being conducted consistent with disclosures made to

shareholders, and (4) internal control systems seem to be effective.

Inspectors are usually on-site for 1 or 2 weeks, but they could be on-site

for up to 2 months when inspecting very large fund complexes. Inspectors

also usually review the activities of mutual funds’ advisers concurrent with

their inspection of the fund complex. After inspectors complete on-site

work, they generally spend additional time in the SEC field offices

preparing the inspection report and completing any follow-up work.

SEC inspectors also collect compliance-related data and investigate

particular industry-related issues. For example, early in fiscal year 1995,

SEC was interested in obtaining information on the types of controls that

were in place to address personal trading by fund personnel. At that time,

SEC directed the inspection staff to obtain information on the content of

funds’ codes of ethics during their inspections. The Investment Company

Page 9 GAO/GGD-97-67 SEC Adjusted Its Mutual Fund Oversight
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Act permits fund personnel to engage in personal trading in securities that

are held or are to be bought by a fund, as long as the investment activities

are not fraudulent, manipulative, or abusive. However, conflicts of interest

between fund personnel and shareholders can arise, for example,

whenever fund personnel with access to information about securities and

potential fund transactions buy and sell securities for their personal

accounts. To address conflicts of interest, the act requires mutual

funds—as well as their investment advisers and principal underwriters—to

adopt a code of ethics designed to prevent abusive personal trading. SEC

found that most funds inspected appeared to have the controls necessary

to identify abusive trading practices by fund personnel after the trading

occurred.

More recently, SEC directed its inspection staff to do inspections that target

“soft-dollar” payments among investment companies, investment advisers,

and broker-dealers. A provision in the 1934 Act allows advisers to receive

soft-dollar payments for directing transactions to a specific broker for

execution. These payments are typically in the form of investment

research services. SEC officials told us that they were examining whether

advisers are using the soft-dollar payments for expenses that are unrelated

to research, such as salaries. Such uses of soft-dollar payments would

constitute a conflict of interest that, if not disclosed, would violate the

Investment Advisers Act.

Increases in Inspection

Staffing Allowed SEC to

Broaden Its Inspection

Objectives

SEC allocated most of the increase in its investment management industry

oversight staffing during fiscal years 1990 through 1996 to doing

investment company and investment adviser inspections. During this

period, SEC frequently changed the objectives of its investment company

inspection program in an effort to more efficiently use these resources.

Although many of these changes were in response to industry growth, SEC

broadened its inspection objectives in fiscal year 1995 primarily because

of the increase it had attained in inspection staffing.

As shown in table 1, SEC’s inspection staff years grew by 154 percent

during fiscal year 1990 through fiscal year 1996, with about 53 percent of

that growth occurring during fiscal year 1993 through fiscal year 1996.

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Table 1: SEC Inspection Staff Years,

Fiscal Years 1990-96 Fiscal year Number of staff years

1990 114

1991 137

1992 148

1993 189

1994 216

1995 262

1996 290

Percentage change, 1990-96 154%

Percentage change, 1993-96 53%

Source: SEC.

SEC devoted more staff to its inspection program to increase both the

scope and frequency of mutual fund inspections. SEC reported that its

inspections of mutual funds are particularly important because SEC, rather

than a self-regulatory organization, is responsible for providing first-line

oversight of the investment management industry. An OCIE official told us

that SEC’s inspection program now has enough staff for examining existing

investment companies.

With the availability of additional inspection staff, SEC changed its

inspection objectives during the 1990s. During fiscal years 1991 through

1993, SEC’s inspection objective was to attain the greatest dollar coverage

with the limited number of inspection staff years available. With this in

mind, SEC directed its inspection staff to concentrate on inspecting the 100

largest fund complexes and all money market funds. SEC also directed its

inspection staff to inspect small and medium-sized fund complexes, if time

was available after this objective was achieved. SEC reported that the

inspections completed during these fiscal years were limited in scope,

focusing mainly on whether fund activities were consistent with the

information disclosed to investors and whether funds accurately valued

their shares. SEC also reported that some activities, such as fund marketing

and shareholder services, were rarely scrutinized.

SEC revised its inspection objectives for fiscal year 1994 because a large

number of small and medium-sized fund complexes had never been

examined and others had not been examined for several years. Because of

the focus during fiscal years 1991 through 1993 on inspecting large fund

complexes and all money market funds, inspectors had only been able to

Page 11 GAO/GGD-97-67 SEC Adjusted Its Mutual Fund Oversight
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inspect about 200 small and medium-sized fund complexes. SEC estimated

that about 350 fund complexes had not been inspected since 1990, and that

many, especially those fund complexes connected with banks, had been

formed after 1990 and had never been inspected. Consequently, for its

fiscal year 1994 inspection program, SEC headquarters directed the field

offices to inspect all small and medium-sized fund complexes that had not

been inspected since 1990 and all new fund complexes formed during that

year. Again, except for fund complexes that had never been inspected,

inspections were to be limited in scope, with an emphasis on portfolio

management activities.

Reflecting the increase in inspection staffing as well as the significantly

increased use of mutual funds by American investors, SEC broadened its

inspection objectives for fiscal year 1995. Inspection staff were to begin

doing comprehensive inspections of all fund complexes. These

comprehensive inspections were to include all fund activities and cover all

funds in a complex, not just certain types of funds as had been the case

before 1995. In addition, inspection staff were to inspect the 50 largest

complexes on a 2-year cycle and inspect all other complexes on a 4-year

cycle.

Responding to suggestions from field office staff members, SEC revised its

inspection objectives for fiscal year 1996. Specifically, instead of reviewing

the activities of all funds within a complex on a set schedule, SEC officials

decided that a more efficient use of inspection staff would be to focus on

those activities and complexes that presented higher risks to investors.

Using the following criteria, SEC field offices were to select for inspection

those fund complexes with (1) a history of compliance problems, (2) a

sudden increase in the number of investor complaints, (3) an appearance

on one of the Division of IM’s “watch lists,”13 (4) a report of processing

problems, and (5) length of time since last inspected. While the field

offices were given discretion in selecting fund complexes for inspection,

SEC instructed them to examine all fund complexes at least once every 5

years. An SEC official told us that a 5-year inspection cycle was chosen on

the basis of feedback from field office staff members and experience with

varying inspection cycles over the years. Together, these factors indicated

that a maximum of 5 years between inspections allowed for the most

cost-effective use of SEC’s inspection staff. The official also said that 5

years is the most time allowed between inspections but that if inspectors

13The Division of IM develops several watch lists for particular types of funds on the basis of

characteristics that may indicate the need for additional scrutiny by the Division of IM and OCIE.

Page 12 GAO/GGD-97-67 SEC Adjusted Its Mutual Fund Oversight
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considered a fund complex to present a greater risk of having problems, it

would be inspected more frequently.

SEC did not change its inspection program objectives for fiscal year 1997.

However, SEC deferred routine inspections through the end of March 1997,

while the field offices focused exclusively on doing the fieldwork for the

soft-dollar study. An SEC official told us that for-cause inspections took

precedence over the soft-dollar study during this period. The official said

that although using the inspection staff to do the soft-dollar study would

likely result in fewer inspections being completed during fiscal year 1997,

this would not prevent SEC from meeting its overall goal of inspecting fund

complexes at least once every 5 years.

Despite Changing

Objectives, SEC Inspected

Most Fund Complexes

As SEC changed its objectives between the ends of fiscal years 1990 and

1996, its field offices changed their inspection plans to meet these

objectives. Instead of focusing on the results of these changing annual

objectives, we determined the extent to which SEC inspected the total

number of fund complexes existing during this period.

To assess SEC’s inspection coverage, we analyzed data on completed

inspections for 5 of the 10 SEC field offices responsible for inspecting fund

complexes.14 These 5 field offices, which included the 4 offices with the

largest number of complexes to inspect, were responsible for inspecting

547 of the 757 fund complexes (about 72 percent) in SEC’s database as of

the beginning of fiscal year 1996.15

As indicated in table 2, our analysis showed that between the beginning of

fiscal year 1992 and the end of fiscal year 1996, these 5 field offices

completed inspections of 493 of the 519 fund complexes (about

95 percent) for which they were responsible.16 Table 2 also displays the

last year in which these 493 fund complexes had been inspected. For

example, of the 168 fund complexes that the New York field office was

responsible for inspecting, 4 were last inspected in fiscal year 1992. The

data show that the 5 field offices last inspected 408 of the 519 fund

complexes (about 79 percent) between the beginning of fiscal year 1994

and the end of fiscal year 1996.

14Completed inspections included both limited scope and comprehensive inspections.

15Of the 547 fund complexes, 460 (about 84 percent) included mutual funds. Some of these fund

complexes were first established after fiscal year 1992.

16We eliminated 6 fund complexes determined to be inactive and another 22 complexes that were not

inspected by these field offices because they were the responsibility of another field office.

Page 13 GAO/GGD-97-67 SEC Adjusted Its Mutual Fund Oversight
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Table 2: Inspections of Fund Complexes by Year Last Inspected for Five SEC Field Offices, Fiscal Years 1992-96

Last fiscal year fund complexes were inspected

Field office

Fund complexes

at end of fiscal

year 1996 1992 1993 1994 1995 1996

Total fund

complexes

inspected

Boston 82 0 19 16 25 18 78

Chicago 159 0 14 36 43 57 150

Fort Worth 30 0 8 3 10 8 29

New York 168 4 26 44 63 23 160

Philadelphia 80 3 11 23 22 17 76

Total 519 7 78 122 163 123 493

Percentage • 1% 15% 24% 31% 24% 95%

Note: Although some fund complexes were inspected more than once during these 5 fiscal years,

the data shown for each fiscal year reflect only the last year they were inspected. Therefore, the

total shown for the number of fund complexes inspected is not the total number of inspections

completed by these five field offices during these fiscal years.

Source: GAO analysis.

We also found that the five field offices, on average, inspected fund

complexes more frequently than every 5 years. For example, these offices

inspected about 52 percent of the 519 fund complexes for which they were

responsible more than once since the start of fiscal year 1992 and

inspected each of the top 50 complexes about 3 times.

Number of Investment

Company Inspections Has

Not Increased

The increase in the number of SEC inspectors has not led to an increase in

the number of investment company inspections completed each year. This

total remained relatively constant, with the inspection staff averaging

about 320 inspections a year since fiscal year 1992.17 According to an SEC

official, the number of investment company inspections has not increased

because SEC has used the increase in inspection staffing to expand its

coverage of investment advisers. Also, inspectors spent more time on each

investment company inspection due to (1) a need to train newly hired

inspectors, (2) a change in how inspectors approached mutual fund

inspections, and (3) a change in how inspectors inspected fund

administrators.

Generally, inspectors are to be cross-trained to inspect both investment

companies and investment advisers. Of the 10 field offices that do

17The total number of inspections completed each year includes, in addition to fund complexes,

inspections of administrators, business development companies, sponsors of unit investment trusts,

and insurance company sponsors of variable insurance products. Of the 1,613 inspections completed

from the end of fiscal year 1992 to the end of fiscal year 1996, 120 were inspections of these entities.

Page 14 GAO/GGD-97-67 SEC Adjusted Its Mutual Fund Oversight
B-271654 

investment company and investment adviser inspections, an SEC official

said that only 2 field offices do not extensively cross-train their inspectors

to do both types of inspections. Because the same pool of inspectors

inspect both investment companies and investment advisers, there is an

ongoing trade-off in the number of investment company and investment

adviser inspections completed. Therefore, although the number of

investment company inspections done each year since fiscal year 1992 has

remained relatively constant, averaging about 320 a year (see table 3), the

number of investment adviser inspections completed has increased from

614 in fiscal year 1992 to 1,446 in fiscal year 1996. The 1996 Act transfers to

the states regulatory responsibility for investment advisers that manage

less than $25 million in assets, and SEC expects the number of investment

adviser inspections completed in fiscal year 1997 to decrease partly

because of the transition. SEC has projected that it will increase investment

adviser inspections 13 percent in fiscal year 1998.

Since fiscal year 1992, the average time SEC inspectors spent on each

investment company inspection more than doubled, from about 164 hours

in fiscal year 1992 to about 376 hours in fiscal year 1996. An SEC official

attributed the increase in inspection time primarily to the use of senior

inspectors to provide on-the-job training for the large number of new

inspectors that were hired beginning in fiscal year 1994. The official said

that it took longer to complete inspections because the new inspectors

were inexperienced and were still being trained during fiscal years 1995

and 1996. During fiscal year 1997, SEC expects senior inspectors to

continue devoting considerable time to on-the-job training of the 38 new

inspectors hired during 1996. SEC reported that, by the end of fiscal year

1997, all inspectors hired since fiscal year 1994 will have received

classroom and on-the-job training and are expected to be able to function

as fully qualified investment company and investment adviser examiners.

Although all new inspectors are to be fully trained, SEC is not planning to

increase the number of fund complexes inspected beyond 320 during fiscal

year 1998. At that level, fund complexes would be inspected at an average

frequency of once every 3.1 years. SEC reported that this inspection

frequency, combined with more frequent inspections of fund complexes

that present above average risk factors, provides adequate inspection

oversight of mutual funds. An SEC official said that inspecting fund

complexes any more frequently would not be an efficient use of inspection

staff.

Another reason for the increase in time spent on each inspection was a

change in SEC’s approach to mutual fund inspections. Before fiscal year

Page 15 GAO/GGD-97-67 SEC Adjusted Its Mutual Fund Oversight
B-271654 

1994, SEC primarily did limited-scope inspections of the 100 largest fund

complexes and all money market mutual funds. In fiscal year 1995, SEC

directed its inspectors to do comprehensive inspections of all fund types.

SEC reported that these inspections required more time to complete

because inspectors were to review all activities of funds in the complex. In

fiscal years 1996 and 1997, SEC directed its inspectors to use a risk-based

approach to doing inspections. These inspections required inspectors to

focus on fund activities that presented higher risks to investors. As a

result, each inspection is customized, to some extent, according to the

types of activities of each fund complex. Areas in which these risk-based

inspections may focus include portfolio management, such as brokerage

commissions and principal trades; sales practices; internal controls;

classification, diversification, and appropriateness of investments; and

personal securities transactions, including funds’ code of ethics.

SEC inspections of fund administrators also contributed to the increase in

inspection time. Administrators perform many of a fund’s key functions

such as keeping the fund’s books and records, filing the necessary reports

with SEC, helping the fund establish and maintain compliance procedures

and internal controls, and calculating the fund’s net asset value.18 Some

administrators perform these functions for several fund complexes, which

different SEC field offices may be responsible for inspecting. Before fiscal

year 1995, inspectors assessed the adequacy and appropriateness of

services that administrators provided to funds as a part of their inspection

of the fund complex. As a result, inspections of administrators usually

focused on only a limited number of funds and did not always consider all

of the key functions. In fiscal year 1995, SEC began conducting more

comprehensive inspections of administrators that served more than one

fund complex. The inspections were to provide an adequate test of all

administrator systems used in serving multiple mutual funds. These

inspections involved larger inspection teams and, on average, took more

time to perform than an inspection of a fund complex. For example,

during fiscal years 1995 and 1996, inspectors spent an average of nearly

750 hours on each of the 28 inspections of administrators that served more

than one fund complex.

18Net asset value is the daily share price of a mutual fund. It is based on the market value of assets held

by the fund, less liabilities, divided by the number of outstanding fund shares.

Page 16 GAO/GGD-97-67 SEC Adjusted Its Mutual Fund Oversight
B-271654 

More Deficiencies Were

Found, but Few Were

Referred for Enforcement

Action

During fiscal years 1993 through 1996, the number of deficiencies that SEC

inspectors found increased steadily. In fiscal year 1993, inspectors found

1,281 deficiencies; in fiscal year 1996, the inspectors found 4,713

deficiencies. To some extent, this increase reflects the changes in the

scope of SEC’s inspections from primarily doing annual, limited scope

inspections of the 100 largest fund complexes and all money market funds

to inspecting complexes on the basis of the risks they pose as well as the

length of time since last inspected. Another reason for the increase in the

number of deficiencies was a change in SEC’s system for reporting

deficiencies after fiscal year 1993. Specifically, instead of reporting each

deficiency identified at a fund complex as one violation, inspectors were

to begin reporting any systemic deficiencies as having been found in each

individual fund within the complex. For example, if a systemic pricing

problem was identified at a fund complex that had six funds, the inspector

would report that six deficiencies, not one, had been identified.

When inspectors find that a fund complex has failed to comply with the

securities laws, the deficiency may relate to any of a broad range of issues,

from recordkeeping to misrepresentations or other sales practice abuses.

According to SEC, if the deficiencies found are serious, such as when

investor funds or securities are at risk, the inspectors may refer the matter

to the Division of Enforcement, which would decide whether to pursue an

investigation and possible enforcement action. If deficiencies are not

referred to the Division of Enforcement, SEC sends a letter to the fund

complex identifying all the deficiencies inspectors found and requiring

that they be corrected. SEC requests that the fund complex respond to the

deficiency letter within 30 days by informing SEC of what the complex has

done or plans to do to correct the problems identified. If no deficiencies

are found, no further action is taken.

SEC reported in 1994 that the mutual fund industry had generally been free

of major scandal for the last 2 decades.19 As shown in table 3, during fiscal

years 1992 through 1996, SEC referred deficiencies to the Division of

Enforcement in about 5 percent of the investment company inspections.

SEC addressed the majority of these deficiencies by sending deficiency

letters to the fund complexes.

19Personal Investment Activities of Investment Company Personnel, Report of the Division of IM, SEC,

Sept. 1994.

Page 17 GAO/GGD-97-67 SEC Adjusted Its Mutual Fund Oversight
B-271654 

Table 3: Disposition of Investment Company Inspections, Fiscal Years 1992-96

Number (percentage) of inspections, by fiscal year

Disposition 1992 1993 1994 1995 1996

Total for

1992-96

Deficiency

letters

235

(74)

240

(73)

244

(78)

261

(75)

254

(82)

1,234

(77)

Enforcement

referrals

14

(4)

8

(2)

21

(7)

23

(7)

14

(5)

80

(5)

No action 65

(21)

74

(23)

37

(12)

53

(15)

37

(12)

266

(17)

Other 2

(1)

6

(2)

11

(4)

11

(3)

3

(1)

33

(2)

Total 316

(100)

328

(100)

313

(100)

348

(100)

308

(100)

1,613

(100)

Note 1: In addition to dispositions of fund complex inspections, investment company inspections

also include inspections of administrators, business development companies, sponsors of unit

investment trusts, and insurance company sponsors of variable insurance products. Of the 1,613

inspections completed between fiscal years 1992 and 1996, 120 were inspections of these

entities.

Note 2: Percent totals may not add to 100 due to rounding.

Source: SEC.

Among the reasons SEC officials cited for inspections not producing more

enforcement referrals were that (1) the Investment Company Act imposes

detailed, substantive requirements on the structure and operations of

mutual funds; (2) frequent inspections by SEC inspectors instill discipline

in funds’ operations; (3) the industry generally supports strong regulation

and strict compliance with the securities laws; (4) a self-regulatory

organization, NASD, separately reviews funds’ sales literature; and

(5) market conditions have generally been favorable as the industry has

grown. An SEC official also said that because violations of the Investment

Company Act typically do not involve fraud or investor losses, these

violations generally are not remedied through enforcement actions.

However, the official noted that, although many of the violations were

“technical,” they are still violations of the act that need to be remedied,

especially before the violations become a major problem that could cause

investor losses.

Page 18 GAO/GGD-97-67 SEC Adjusted Its Mutual Fund Oversight
B-271654 

SEC Selectively

Reviewed Disclosure

Documents

SEC’s responsibility for ensuring that mutual funds comply with applicable

disclosure requirements has become particularly important because of the

increasing number of mutual fund investors. Many of these investors may

be investing for the first time and may not be sophisticated in legal or

financial matters. SEC’s disclosure review staffing level has remained

relatively constant during fiscal years 1990 through 1996. However, despite

receiving an increased number of documents to review since 1994, SEC

officials said that by selectively reviewing mutual funds’ disclosure

documents, staff members have been able to review all new or materially

different disclosures.

SEC’s disclosure review process is intended to ensure that (1) disclosure

documents filed by mutual funds are complete, (2) all proposed activities

are legal, and (3) information contained in the filings is not misleading to

investors. Disclosure documents filed by mutual funds include initial

registration statements, amendments to registration statements, proxy

statements, and periodic reports. Initial registration statements have three

parts: (1) a prospectus, which must be provided to every fund investor and

includes information about a fund’s investment objectives and policies,

investment risks, and all fees and expenses; (2) a statement of additional

information, which contains more detailed information on all aspects of

the fund and must be provided upon request to fund investors; and

(3) other information required to be in the registration statement,

including copies of a fund’s contracts with its various service providers.

Amendments to registration statements are filed whenever important

information in a mutual fund’s original, effective registration statement has

changed. Mutual funds are also required to annually file amendments

updating their financial information. Most of the disclosure documents

that SEC receives are amendments. Proxy statements are to be filed when a

mutual fund is considering an event that requires shareholder approval

before taking action, such as changing its investment policies and

objectives or merging with another fund. Periodic reports primarily

contain statistical data about a mutual fund, such as the fund’s assets,

expenses, portfolio turnover, and type of investments.

All disclosure documents filed by mutual funds are subject to review and

comment by staff in SEC’s Division of IM. However, to focus on those filings

that are most in need of review, Division of IM staff members selectively

review the disclosure documents SEC receives. In fiscal year 1996, SEC

received a total of about 30,000 disclosure documents from all types of

investment companies, including mutual funds, which was an almost

8-percent increase since fiscal year 1994. SEC officials told us that

Page 19 GAO/GGD-97-67 SEC Adjusted Its Mutual Fund Oversight
B-271654 

completely reviewing all of these documents is not necessary because

many of them contain repetitive information. The officials also said that a

complete review would be an inefficient use of SEC’s limited resources.

Instead, SEC’s disclosure review process is intended to ensure that SEC’s

review focuses on new information in disclosure documents as well as

filings that contain material changes.20

SEC procedures specify that routine filings, presenting no novel questions

of law, need not be targeted for review. For example, many initial

registration statements filed by mutual funds that are members of the

same fund complex are similar to previous filings by other funds in the

complex. That is, even though certain funds in a complex may have

different investment objectives and techniques, their prospectuses often

contain similar disclosure information regarding other aspects of the

funds’ operations, such as procedures for share purchase and redemption

and the descriptions of the investment adviser, underwriters, transfer

agent, and officers and directors. In these instances, the funds’ initial

registration statements often include disclosures from previous filings that

had already been subject to SEC review and comment. Because SEC

considers that reviewing these disclosures again would be redundant, it

focuses its review on more substantive information in the filing by

identifying what information is new. SEC officials said that fund counsel

generally initiate requests for selective review and indicate to SEC which

parts of the filing have already been reviewed. SEC’s disclosure review staff

can also identify situations in which a selective review can be done and

are to alert fund counsel to that option.

SEC also selectively reviews amendments to registration statements so that

only material changes routinely undergo staff review. Similar to initial

registration statements, many matters in an amendment may already have

been considered by staff members in processing other filings by that fund.

To focus SEC’s disclosure review on significant changes, mutual fund

counsel represent to SEC whether changes contained in an amendment are

considered material. Amendments that contain only nonmaterial changes

may become automatically effective without SEC review.21 Examples of

nonmaterial changes include bringing a fund’s financial statements

up-to-date, changing the fund’s phone numbers, and increasing the number

20Material changes include disclosures that are significantly different from those disclosures previously

made by the investment company in its most recent filing of the same kind.

21Rule 485(b) [17 CFR230.485] permits amendments filed by registered mutual funds that contain

enumerated routine or nonmaterial changes to become automatically effective on the date the

amendments are filed with SEC or on a later date, designated by the fund, that does not exceed 30 days

after the date on which the amendment was filed.

Page 20 GAO/GGD-97-67 SEC Adjusted Its Mutual Fund Oversight
B-271654 

or amount of securities proposed to be offered. According to SEC officials,

most amendments filed by registered mutual funds contain nonmaterial

changes and, therefore, are not routinely reviewed. In contrast, they said

that amendments containing material changes are routinely reviewed with

a focus on the disclosures that have changed.

Proxy statements and periodic reports also undergo a targeted review by

SEC. Specifically, proxy statements covering nonroutine matters, such as a

merger, are targeted for review; although more routine proxies, such as

the standard approval of a mutual fund’s auditors, are not. Of the periodic

reports received, SEC only reviews the attachment to the second of two

semiannual reports that most mutual funds file every year. The attachment

is the fund auditor’s report on the mutual fund’s internal controls.

Table 4 shows SEC’s coverage of investment company disclosure

documents for fiscal years 1994 through 1996.22 During this period, SEC

devoted an average of 44 staff years to reviewing these documents.

Although the total percentage of disclosure documents reviewed over

these years averaged about 31 percent, the breakdown of documents

reviewed indicates that SEC dedicated its disclosure staff to reviewing

those documents most likely to have new or materially different

information. For example, the data show that SEC reviewed a high

percentage of initial registration and proxy statements each year,

reflecting the greater possibility that these filings would contain new or

materially different information. Furthermore, SEC reviewed at least

93 percent of the initial registration statements filed by mutual funds for

each of these years. In contrast, SEC reported that its staff members

reviewed between 12 and 15 percent of the amendments SEC received each

year, reflecting the high number of these filings that would contain

nonmaterial changes.

22We were unable to include and compare data for all disclosure documents from previous fiscal years

because of changes in how SEC counted the filings received.

Page 21 GAO/GGD-97-67 SEC Adjusted Its Mutual Fund Oversight
B-271654 

Table 4: SEC Coverage of Investment

Company Disclosure Documents,

Fiscal Years 1994-96

Number and percentage of disclosure

documents reviewed, by fiscal year

Disclosure document 1994 1995 1996

Initial registration statements

Filed 2,570 2,321 2,410

Revieweda 1,605 1,570 1,800

Percentage reviewed 62% 68% 75%

Initial mutual fund registration statements

Filed 1,040 819 811

Reviewed 960 755 761

Percentage reviewed 93% 93% 94%

Amendments

Filed 16,388 15,258 16,864

Reviewed 2,008 1,859 2,494

Percentage reviewed 12% 12% 15%

Proxy statements

Filed 624 711 750

Reviewed 579 595 669

Percentage reviewed 93% 84% 89%

Periodic reports

Filed 8,300 9,500 10,000

Reviewed 4,150 4,750 5,000

Percentage reviewed 50% 50% 50%

Total disclosure documentsb

Filed 27,882 28,060 30,024

Reviewed 8,342 8,774 9,963

Percentage reviewed 30% 31% 33%

aThe number of initial registration statements reviewed includes those submitted by open-end

(mutual funds), closed-end, and unit investment trust portfolios.

bThe total number of disclosure documents filed and reviewed includes the initial registration

statements, amendments, proxy statements, and periodic reports. The number of initial mutual

fund registration statements filed and reviewed is included as a subset of the initial registration

statements.

Source: SEC.

SEC officials told us that, because they already review the most important

disclosures, additional staffing would not necessarily be used to increase

the number of filings reviewed each year. Instead, the officials said they

could use more resources to help them in related disclosure activities,

Page 22 GAO/GGD-97-67 SEC Adjusted Its Mutual Fund Oversight
B-271654 

such as helping mutual funds improve and simplify prospectus language

and performing long-range strategic planning. However, SEC officials also

said that a current rulemaking project could substantially affect, at least

for the short term, SEC’s ability to maintain adequate review coverage of

disclosure documents. Specifically, the proposed rule would substantially

revise the registration form and prospectus requirements for mutual funds.

During the initial implementation period of the proposed rule, SEC does not

plan to use its selective review procedures for initial registration

statements or amendments because it would need to ensure that mutual

funds are complying with the new disclosure requirements.23

SEC’s Other

Regulatory Activities

Enabled the Industry

to Evolve Without

Major Legislative

Changes

SEC’s Division of IM is also responsible for other regulatory activities,

which include responding to requests for exemptions from the

requirements of the Investment Company Act, rulemaking, and providing

interpretations of applicable laws and rules through issuing interpretive

and “no-action” letters.24 According to SEC officials, these activities are a

primary way of allowing the industry to grow and change while continuing

to protect investors. During fiscal years 1990 through 1993, staff years for

these regulatory activities grew by nearly 45 percent. However, from the

end of fiscal year 1993 to the end of fiscal year 1996, staffing decreased by

almost 14 percent. SEC officials said that this staffing decrease occurred

largely because staff members often pursue opportunities created by rapid

growth in the investment management industry. They also said that

additional staff could help them keep pace with industry developments

and be more proactive in identifying and reacting to industry changes.

Exemptive Orders Enable

SEC to Adapt Its

Regulation to Industry

Changes

The Investment Company Act and the Investment Advisers Act allow SEC

to issue orders granting exemptions from one or more provisions of these

acts, or from rules issued by SEC under these acts. Congress gave SEC this

authority to prevent the acts from being unduly restrictive. To grant an

exemption, SEC must find that the exemption is necessary or appropriate in

the public interest, is consistent with investor protection, and is fairly

intended by the policy and provisions of the act. The exemptive order

permits the applicant to engage in the activity described in the application

that would otherwise be prohibited by the act. Exemptive orders apply

23The selective review procedures would still be applicable in some instances. For example, after SEC

reviews a fund’s revised registration form, all funds within the same complex can request a selective

review of subsequent filings using the revised form.

24A no-action letter is a request from investment companies and investment advisers that SEC staff

react to a particular set of circumstances or facts as outlined in the letter by indicating whether the

Division of IM would recommend taking an enforcement action if those circumstances were to occur.

Page 23 GAO/GGD-97-67 SEC Adjusted Its Mutual Fund Oversight
B-271654 

only to the applicant. However, if the exemption appears to have general

applicability, such as when a number of similar requests for exemptive

relief are made, SEC may decide to adopt a rule granting exemptions to all

funds that can meet the conditions.

According to SEC officials, SEC’s authority to grant exemptions from

various provisions of the Investment Company Act and the Investment

Advisers Act has enabled it to adapt its regulation of investment

companies so that SEC is both receptive to new innovations and able to

keep pace with the general evolution of the investment management

industry. For example, in the 1970s, SEC first allowed trading of money

market mutual funds through exemptive orders. These funds used

specialized pricing methods that were not contemplated by the Investment

Company Act. Also, SEC recently adopted a rule, following the issuance of

numerous exemptive orders, that allows mutual funds to sell multiple

classes of shares with different fee structures. In the 57 years since the

Investment Company Act was enacted, it has been amended significantly

only twice—in 1970 and again in 1996.

In a 1992 study of investment company regulation,25 SEC reported that

many responses to its 1990 request for comments on reforming investment

company regulation contained complaints that the process for obtaining

an exemptive order took too long. In 1995, SEC’s Office of Inspector

General (OIG) studied the exemptive order process, giving particular

attention to its timeliness. The OIG found that, although the process was

essentially sound, many outside attorneys were still dissatisfied with how

long SEC took to process exemptive applications when novel or complex

issues were involved. The OIG made several recommendations to improve

the process, including a recommendation that, for applications with these

types of issues, the Division of IM modify its guideline requiring initial

comments on all applications within 45 days.26

Although the Division of IM’s response to the OIG’s report agreed to adopt

most of the recommendations, it did not agree that changing this existing

45-day guideline for novel or complex applications would shorten the

amount of time spent reviewing those applications. The Division’s

response explained that these applications generally take longer to review

25Protecting Investors: A Half Century of Investment Company Regulation, Division of Investment

Management, United States Securities and Exchange Commission, May 1992.

26To prevent a disproportionate amount of staff time from being spent on routine applications, in part

to increase production as well as process applications within the 45-day time frame, the OIG suggested

that the Division of IM either provide a different timetable for complex applications or set appropriate

due dates for complex, individual applications.

Page 24 GAO/GGD-97-67 SEC Adjusted Its Mutual Fund Oversight
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because of the potential effect significant changes to policy may have on

the industry and investors. Nonetheless, in its response, the Division

agreed to monitor the progress of complex applications more closely and

continue to strive to meet its 45-day initial comment period for all

applications.

According to SEC data on all exemptive applications processed during

fiscal years 1994 through 1996, SEC processed about 10 percent more

applications in fiscal year 1996 than it processed in the preceding 2 fiscal

years. Although SEC reduced its backlog of pending applications during

fiscal year 1996, at the end of that fiscal year, the number of applications

not acted on within 45 days had more than doubled from the end of fiscal

year 1995. According to an SEC official, the latter increase was due to a loss

of staff near the end of fiscal year 1996.

SEC Shapes Mutual Fund

Regulation Through

Rulemaking

SEC issues rules and regulations that implement the provisions of the

securities laws. Through rulemaking, SEC develops rules relating to (1) the

disclosure requirements that are applicable to investment companies and

investment advisers and (2) the Investment Company Act and the

Investment Advisers Act. Rulemaking involves constantly reviewing how

well the various rules that SEC has adopted are working. SEC often consults

with industry representatives and others affected by the various rules and

reviews their suggestions to modify rules. For example, an SEC official told

us that, in its efforts to develop rule changes regarding fund disclosure

requirements, SEC (1) sponsored focus groups with fund investors,

(2) reviewed industry-sponsored surveys on investors’ views of fund

disclosures, and (3) encouraged comments from individual investors on

ways to improve mutual funds’ risk disclosure in April 1995. Of about 3,700

comment letters SEC received, about 3,600 were from individuals.

When SEC rulemaking staff find that a particular rule does not appear to be

achieving its objective or is burdensome in relation to its benefits, the staff

members are to present the problem to SEC Commissioners, who then may

consider modifying the rule. SEC gives advance public notice of proposals

to adopt new or amended rules and allows time for interested members of

the public to comment on the proposals. At the conclusion of the comment

period, staff members are to analyze the comments and prepare a

summary of their analysis for the Commissioners to consider when

determining whether any modifications to existing rules are warranted.

Proposals approved by the Commissioners take effect as final rules,

usually within a specific time after publication in the Federal Register.

Page 25 GAO/GGD-97-67 SEC Adjusted Its Mutual Fund Oversight
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In addition, if SEC receives several very similar requests for an exemption

from a particular provision, it may consider promulgating a rule to codify

the exemption. To determine if an exemptive rule is needed, the

rulemaking staff are to consider whether the exemption should also be

applicable to other entities. As previously discussed, money market funds

were first allowed to trade through a series of exemptive orders beginning

in the 1970s. These orders were later codified into a rule. According to SEC,

the exemptions granted and the subsequent rulemaking were critical to

the evolution and success of money market funds.

In recent years, much of the Division of IM’s disclosure-oriented

rulemaking has focused on improving mutual fund prospectuses. For

example, two major rule proposals focused on making prospectuses more

understandable to investors. The first rule proposal would update and

streamline the full prospectus that mutual funds are required to provide

investors. It also would improve the risk disclosures required to be made

in the prospectus. The second rule proposal would allow investors to

purchase shares of mutual funds solely on the basis of information

contained in a summary prospectus called a “fund profile.”27 The fund

profile provides a summary of the essential information about a mutual

fund by addressing nine items in a question-and-answer format. On

March 10, 1997, SEC published these proposed rules in the Federal

Register.

A number of rulemaking efforts regarding the Investment Company Act

and the Investment Advisers Act were under way in the Division of IM at

the time of our review. Many of these efforts were mandated by various

provisions in the 1996 Act. For example, the 1996 Act initially required SEC

to issue rules by April 9, 1997, that (1) separate the regulation of

investment advisers between the states and SEC based on asset size and

(2) exempt certain private investment companies from SEC regulation.

Congress subsequently amended the 1996 Act to provide a 90-day

extension of the April 9 deadline for separating investment adviser

regulation. However, the rule exempting certain private investment

companies from SEC regulation was effective April 9.

27The fund profile is a summary of the long-form prospectus. SEC intended that the fund profile

provide investors an easy-to-read summary of essential information about the fund, including the

fund’s investment objectives, risks, and fees. Although investors can buy shares after reading only the

fund profile, the profile must disclose that investors have the option to request a full prospectus before

making an investment decision. Funds are required to provide investors the full prospectus when the

funds confirm investors’ purchases. SEC has had a pilot program that permitted funds to use a fund

profile since July 31, 1995.

Page 26 GAO/GGD-97-67 SEC Adjusted Its Mutual Fund Oversight
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The 1996 Act also gave SEC additional authority in several areas that will

require other rulemaking. For example, the 1996 Act (1) gave SEC

additional rulemaking authority to define certain fund names as materially

deceptive or misleading, (2) expanded SEC’s authority to require funds to

keep books and records, and (3) allowed SEC to require investment

companies to file information more frequently than quarterly to keep

information in investment companies’ registration statements current.

According to an SEC official, several of SEC’s ongoing rulemaking efforts,

such as proposed rules on personal trading, the use of foreign custodians,

and limits on purchasing securities from an affiliated underwriter, have

been delayed because SEC’s first priority is to complete the implementing

rules for the 1996 Act. On March 10, 1997, SEC published its proposed rule

on fund names in the Federal Register.

SEC officials told us that SEC’s rulemaking function has been affected in the

past by high staff turnover and, as a result, SEC has had more

inexperienced staff in the rulemaking area than it desired. In addition, the

Director of the Division of IM estimated that the 1996 Act is likely to

increase the division’s workload by about 30 percent in 1997.

SEC Provides Informal

Views and Interpretations

of Securities Laws

Through issuing no-action and interpretive letters, SEC staff members in

the Division of IM provide investment companies, investment advisers,

Congress, and other government agencies with their informal views and

interpretations about how the federal securities laws apply to proposed

transactions that appear to raise compliance issues. These letters, which

are available to the public, represent the views of SEC officials who are

responsible for administering the laws on a daily basis. SEC officials told us

that the letters are an effective method of providing information about

how the securities laws are likely to be interpreted and applied.

SEC issues no-action letters in response to requests for its staff members’

views on whether they would recommend enforcement action if the

particular facts and circumstances outlined in the request were to occur.

No-action letters do not make rulings on whether the particular

circumstances are legal or illegal—the letters only state whether the

Division of IM staff would or would not recommend an enforcement action

to the Commission under those specific circumstances. Consequently,

unlike exemptive orders, no-action letters do not shield the requester from

any liability that may otherwise result if the circumstances outlined in the

request were to occur. In addition, SEC has reported that positions in

Page 27 GAO/GGD-97-67 SEC Adjusted Its Mutual Fund Oversight
B-271654 

no-action letters are subject to reconsideration and should not be regarded

as precedents binding SEC.

An SEC official told us that no-action letters promote voluntary compliance

with the securities laws because the letters inform not only the requester

but others as well about the likely legality of a particular proposed

transaction. For example, Division of IM staff provided no-action

assurances to a mutual fund that wanted to include in its prospectus

performance information relating to another fund that its portfolio

manager had previously managed. The staff’s no-action assurances were

based on specific representations made in the request (1) that during the

portfolio manager’s tenure in managing the other fund, no other person

had played a significant part in achieving that fund’s performance and

(2) that the performance information would not be presented in the

prospectus in a misleading manner, nor would that information impede

investors’ understanding of required prospectus information.

SEC issues interpretive letters in response to requests for its staffs’ views

on whether the requester has interpreted and applied a particular statute

or rule correctly to a particular set of facts or circumstances. According to

an SEC official, interpretive letters differ from no-action letters because,

rather than simply stating it would not recommend an enforcement action,

the Division of IM agrees that the statute or rule in question permits the

proposed transaction. Again, SEC officials view interpretive letters as a

means of informing the investment management industry about how the

laws are actually being applied.

While the Investment Company Act requires that SEC respond to requests

for exemptions, responding to requests for no-action and interpretive

letters is a discretionary role that SEC has had in place for several decades.

According to SEC data, the Division of IM responded to 2,643 requests for

no-action and interpretive advice during fiscal years 1993 through 1996.

Although the number of no-action and interpretive responses increased

each fiscal year during 1993 through 1995—620, 674, and 747,

respectively—the number decreased to 602, or about 19 percent, in fiscal

year 1996. SEC reported that this decline was a result of its staff having

spent time during fiscal year 1996 providing technical assistance to

Congress on a number of provisions of the 1996 Act and other legislation.

Conclusions SEC has responded to the challenges presented by the growth in the mutual

fund industry through increasing its inspection staffing and adjusting the

Page 28 GAO/GGD-97-67 SEC Adjusted Its Mutual Fund Oversight
B-271654 

focus of its oversight activities. The effects of these responses cannot be

separated from other factors, such as the requirements of the Investment

Company Act, industry support for strict compliance with securities laws,

and favorable market conditions, that may have contributed to the

industry remaining generally free of major scandal. However, the

continued proliferation in the number and type of funds offered, the

industry’s use of increasingly complex products that may be difficult both

to value and to trade during falling markets, and the increased reliance by

millions of Americans on mutual funds as a source of retirement income

make it imperative that SEC’s efforts to protect mutual fund investors

against abuse continue to be a priority.

Agency Comments

and Our Evaluation

We requested comments on a draft of this report from the Chairman, SEC.

In response, the Chairman stated that the contents of our report provide a

detailed and accurate description of SEC’s program for inspecting and

regulating mutual funds. He also expressed concern that, if the industry

continues to grow at its current pace, SEC will need additional resources to

meet its oversight responsibilities.

We agree that industry growth can influence the resources needed to

oversee the industry. However, in determining the extent to which an

increase in resources would be the most effective response to rapid

industry growth, SEC may also be guided by the results it achieves from the

program goals and performance measurements that it is developing

pursuant to the Government Performance and Results Act of 1993 (GPRA).

In July 1993, Congress passed GPRA to improve the efficiency and

effectiveness of federal programs by establishing a system to set goals for

program performance and to measure results. GPRA directed all federal

agencies, including SEC, to develop by September 1997 long-range strategic

goals and the measures they will use to gauge their progress toward

achieving these goals. GPRA requires that agencies report annually to the

President and to Congress on their performance and progress toward

meeting their goals. These annual reports are intended to be used by

Congress and SEC to assess what SEC is accomplishing with its mutual fund

oversight resources and whether additional resources are needed.

We are sending copies of this report to the SEC Chairman and other

interested parties upon request. This report was prepared under the

direction of Michael A. Burnett, Assistant Director, Financial Institutions

and Markets Issues. Major contributors to this report are listed in

Page 29 GAO/GGD-97-67 SEC Adjusted Its Mutual Fund Oversight
B-271654 

appendix II. Please contact me on (202) 512-8678 if you have any questions

concerning this report.

Jean Gleason Stromberg

Director, Financial Institutions and

 Markets Issues

Page 30 GAO/GGD-97-67 SEC Adjusted Its Mutual Fund Oversight
Page 31 GAO/GGD-97-67 SEC Adjusted Its Mutual Fund Oversight
Contents

Letter 1

Appendix I 

Comments From the

Securities and

Exchange

Commission

34

Appendix II 

Major Contributors to

This Report

35

Tables Table 1: SEC Inspection Staff Years, Fiscal Years 1990-96 11

Table 2: Inspections of Fund Complexes by Year Last Inspected

for Five SEC Field Offices, Fiscal Years 1992-96

14

Table 3: Disposition of Investment Company Inspections, Fiscal

Years 1992-96

18

Table 4: SEC Coverage of Investment Company Disclosure

Documents, Fiscal Years 1994-96

22

Abbreviations

GPRA Government Performance and Results Act of 1993

ICI Investment Company Institute

IM Investment Management

NASD National Association of Securities Dealers

OCIE Office of Compliance Inspections and Examinations

OIG Office of Inspector General

SEC Securities and Exchange Commission

Page 32 GAO/GGD-97-67 SEC Adjusted Its Mutual Fund Oversight
Page 33 GAO/GGD-97-67 SEC Adjusted Its Mutual Fund Oversight
Appendix I 

Comments From the Securities and

Exchange Commission

Page 34 GAO/GGD-97-67 SEC Adjusted Its Mutual Fund Oversight
Appendix II 

Major Contributors to This Report

General Government

Division, Washington,

D.C.

Michael A. Burnett, Assistant Director

Frank J. Philippi, Assignment Manager

Suzanne Bright, Evaluator-in-Charge

Darleen A. Wall, Evaluator

(233490) Page 35 GAO/GGD-97-67 SEC Adjusted Its Mutual Fund Oversight
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