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MUTUAL FUND TRADING ABUSES

HEARING

BEFORE THE

SUBCOMMITTEE ON 

COMMERCIAL AND ADMINISTRATIVE LAW

OF THE

COMMITTEE ON THE JUDICIARY 

HOUSE OF REPRESENTATIVES

ONE HUNDRED NINTH CONGRESS

FIRST SESSION

JUNE 7, 2005

Serial No. 109–42

Printed for the use of the Committee on the Judiciary

(

Available via the World Wide Web: http://www.house.gov/judiciary 

(II)

COMMITTEE ON THE JUDICIARY 

F. JAMES SENSENBRENNER, JR., Wisconsin, Chairman 

HENRY J. HYDE, Illinois 

HOWARD COBLE, North Carolina 

LAMAR SMITH, Texas 

ELTON GALLEGLY, California 

BOB GOODLATTE, Virginia 

STEVE CHABOT, Ohio 

DANIEL E. LUNGREN, California 

WILLIAM L. JENKINS, Tennessee 

CHRIS CANNON, Utah 

SPENCER BACHUS, Alabama 

BOB INGLIS, South Carolina 

JOHN N. HOSTETTLER, Indiana 

MARK GREEN, Wisconsin 

RIC KELLER, Florida 

DARRELL ISSA, California 

JEFF FLAKE, Arizona 

MIKE PENCE, Indiana 

J. RANDY FORBES, Virginia 

STEVE KING, Iowa 

TOM FEENEY, Florida 

TRENT FRANKS, Arizona 

LOUIE GOHMERT, Texas 

JOHN CONYERS, JR., Michigan 

HOWARD L. BERMAN, California 

RICK BOUCHER, Virginia 

JERROLD NADLER, New York 

ROBERT C. SCOTT, Virginia 

MELVIN L. WATT, North Carolina 

ZOE LOFGREN, California 

SHEILA JACKSON LEE, Texas 

MAXINE WATERS, California 

MARTIN T. MEEHAN, Massachusetts 

WILLIAM D. DELAHUNT, Massachusetts 

ROBERT WEXLER, Florida 

ANTHONY D. WEINER, New York 

ADAM B. SCHIFF, California 

LINDA T. SA ́ NCHEZ, California 

ADAM SMITH, Washington 

CHRIS VAN HOLLEN, Maryland

PHILIP G. KIKO, General Counsel-Chief of Staff 

PERRY H. APELBAUM, Minority Chief Counsel 

SUBCOMMITTEE ON COMMERCIAL AND ADMINISTRATIVE LAW

CHRIS CANNON, Utah Chairman

HOWARD COBLE, North Carolina 

TRENT FRANKS, Arizona 

STEVE CHABOT, Ohio 

MARK GREEN, Wisconsin 

RANDY J. FORBES, Virginia 

LOUIE GOHMERT, Texas 

MELVIN L. WATT, North Carolina 

WILLIAM D. DELAHUNT, Massachusetts 

ADAM SMITH, Washington 

CHRIS VAN HOLLEN, Maryland 

JERROLD NADLER, New York

RAYMOND V. SMIETANKA, Chief Counsel 

SUSAN A. JENSEN, Counsel 

JAMES DALEY, Full Committee Counsel 

STEPHANIE MOORE, Minority Counsel 

(III)

C O N T E N T S 

JUNE 7, 2005

OPENING STATEMENT 

Page 

The Honorable Chris Cannon, a Representative in Congress from the State 

of Utah, and Chairman, Subcommittee on Commercial and Administrative 

Law ........................................................................................................................ 1

The Honorable William D. Delahunt, a Representative in Congress from 

the State of Massachusetts ................................................................................. 3

The Honorable Melvin L. Watt, a Representative in Congress from the State 

of North Carolina, and Ranking Member, Subcommittee on Commercial 

and Administrative Law ...................................................................................... 4

WITNESSES 

Mr. Richard J. Hillman, Director, Financial Markets and Community Investment, U.S. Government Accountability Office 

Oral Testimony ..................................................................................................... 6

Prepared Statement ............................................................................................. 8

Ms. Lori A. Richards, Director, Office of Compliance Inspections and Examinations, U.S. Securities and Exchange Commission 

Oral Testimony ..................................................................................................... 33

Prepared Statement ............................................................................................. 36

The Honorable William Francis Galvin, Secretary of the Commonwealth of 

Massachusetts 

Oral Testimony ..................................................................................................... 55

Prepared Statement ............................................................................................. 57

Mr. Eric W. Zitzewitz, Stanford Graduate School of Business, Stanford, California 

Oral Testimony ..................................................................................................... 59

Prepared Statement ............................................................................................. 62

APPENDIX 

MATERIAL SUBMITTED FOR THE HEARING RECORD

Prepared Statement of the Honorable Chris Cannon, a Representative in 

Congress from the State of Utah, and Chairman, Subcommittee on Commercial and Administrative Law ........................................................................ 81

Response to post-hearing questions from Lori A. Richards, Director, Office 

of Compliance Inspections and Examinations, U.S. Securities and Exchange 

Commission ........................................................................................................... 83

Response to post-hearing questions from the Honorable William Francis 

Galvin, Secretary of the Commonwealth of Massachusetts ............................. 95

Response to post-hearing questions from Eric W. Zitzewitz, Stanford Graduate School of Business, Stanford, California .................................................... 97

(1)

MUTUAL FUND TRADING ABUSES 

TUESDAY, JUNE 7, 2005

HOUSE OF REPRESENTATIVES, 

SUBCOMMITTEE ON COMMERCIAL

AND ADMINISTRATIVE LAW, 

COMMITTEE ON THE JUDICIARY, 

Washington, DC.

The Subcommittee met, pursuant to notice, at 4:05 p.m., in Room 

2141, Rayburn House Office Building, the Honorable Chris Cannon 

(Chair of the Subcommittee) presiding. 

Mr. CANNON. The Committee will come to order. Before I begin 

my formal remarks, I’d like to welcome the gentlelady from the 

State of Florida, Ms. Wasserman Schultz, who we anticipate will 

be named to replace the gentleman from Washington, Mr. Smith, 

on the Committee. I understand there is a unanimous request that 

Ms. Wasserman Schultz participate in today’s hearing. 

Mr. WATT. I ask unanimous consent that Ms. Wasserman 

Schultz be allowed to participate fully as if she were already a 

Member of this Committee. 

Mr. CANNON. And it has been the habit of this Committee to 

yield time to a Member of the Committee and have that Member 

then yield to a person who may be a Member of the full Committee, 

but not a Member of the Subcommittee. Since Ms. Wasserman 

Schultz is going to, we hope, become a Member of the Committee 

quite soon, we will set that precedent aside, and without objection, 

so ordered. Welcome to the Subcommittee, Ms. Wasserman Schultz. 

And now for my formal remarks. In the fall of 2003, the New 

York State Attorney announced what would become the first of 

many law enforcement initiatives that his office and other State officials and the SEC would later champion to ferret out mutual fund 

trading abuses. Within the ensuing months many well-respected 

mutual fund companies and others were caught up in this scandal, 

including Canary Capital, Janus Capital Group, Bank of America, 

Alliance Capital Management, Prudential Securities, Millennium 

Partners, Fred Alger Management, Putnam Investments, Massachusetts Financial Services, Security Trust, Franklin Resources 

and Invesco Funds Group. 

In the fall and winter of 2003, it seemed as if every day the press 

reported on yet another shocking instance of mutual fund trading 

abuses. These abuses included the illegal practice of late trading, 

which involves trading shares after the markets have closed so that 

the trader can take advantage of information that becomes available after the closing. The Congressional Research Service analoVerDate 0ct 09 2002 13:44 Sep 06, 2005 Jkt 000000 PO 00000 Frm 00005 Fmt 6633 Sfmt 6601 G:\WORK\COMM\060705\21653.000 HJUD1 PsN: 21653
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gized this practice to a race track that allows certain customers to 

bet on yesterday’s races. 

Other abuses included the more nuanced problem of market timing. Market timing typically involves frequent buying and selling 

of mutual fund shares by sophisticated investors, such as hedge 

funds, that seek opportunities to make profits on the differences 

between foreign and domestic markets. 

While not per se illegal, market timing can constitute illegal conduct, if, for example, it takes place as a result of undisclosed agreements between investment advisers and favored customers in contravention of stated fund trading limits. Frequent trading can 

harm mutual fund shareholders because it lowers fund returns and 

increases transaction costs. 

According to an estimate provided by one of the witnesses at today’s hearing, Professor Zitzewitz, market timing abuses may have 

resulted in $5 billion in annual losses. As of November 2003, the 

SEC estimated that 50 percent of the 80 largest mutual fund companies had entered into undisclosed arrangements permitting certain shareholders to engage in market timing practices that were 

inconsistent with the funds’ policies, prospectus disclosures or fiduciary obligations. 

As the mutual fund scandal unfolded, questions were raised 

about the fitness of the SEC’s overall regulation, inspection, and 

enforcement of this industry. The Congressional Research Service 

posed possible explanations, including the following: the possibility 

that the SEC’s resources devoted to the fund industry were 

dwarfed by the expansion in the number of mutual funds; the possibility that the SEC’s overall effectiveness may have been marred 

by interdivisional disharmonies; the possibility that the SEC officials may have placed too much trust in the fund industry’s integrity and ability to police itself; the possibility that the mutual fund 

industry may be too close to the relevant parts of the SEC entrusted with its oversight and regulation; and the possibility that 

the SEC may have had a somewhat understandable focus on the 

prevention of more traditional types of fund misconduct. 

In response to these concerns, House Judiciary Committee Chairman Sensenbrenner and Ranking Member Conyers requested the 

GAO to undertake a comprehensive review of the SEC’s efforts to 

proactively detect and prevent illegal activities in the mutual fund 

industry. Today’s hearing provides an opportunity for GAO to report on its findings and recommendations and to allow the SEC 

and others to respond to them. 

Accordingly, our first witness is Richard Hillman, who is the Director of GAO’s Financial Markets and Community Investment 

Team. With 29 years of experience at GAO, Mr. Hillman is currently responsible for directing research engagements on various 

cross-cutting financial services matters within the banking securities and insurance industry. Mr. Hillman graduated with honors 

from the University of Scranton with a bachelor’s degree in science 

and accounting, and has completed additional course work in Government management and information technology issues at the 

Federal Executive Institute and Harvard’s John F. Kennedy School 

of Government. 

3

Our next witness is Lori Richards, who is the Director of the 

SEC’s Office of Compliance Inspections and Examinations. She has 

served in that capacity for 10 years. Her office is responsible for administering the SEC’s security compliance examination and inspection program for entities registered with the SEC as self-regulatory 

organizations, broker-dealers, transfer agents, clearing agencies, investment companies and investment advisors. Before beginning her 

career with the SEC in 1985, Ms. Richards received her B.A. From 

Northern Illinois University and her J.D. From American University. 

Our third witness is William Francis Galvin, the Secretary of the 

Commonwealth of the Massachusetts. I understand that my colleague on the other side of the aisle Mr. Delahunt would like to say 

a few words. The gentleman is recognized. 

Mr. DELAHUNT. Thank you, Mr. Chairman. I am really pleased 

to see my friend, my colleague in State government for many years, 

Bill Galvin here as a witness. He has an extraordinary record as 

secretary of state. In Massachusetts the securities industry is 

under his—I should say it is the office that regulates the securities 

industry in Massachusetts, and he has earned justifiably a national 

reputation for aggressively protecting investors and has been successful in recovery of millions of dollars for victims of security 

fraud. 

Bill Galvin was an integral part of the 2003 multistate examination of research analysts’ practices on Wall Street, which resulted 

in a finding of fraud against First Boston and developed into investigations into mutual fund industry practices. So it is a pleasure 

to have you here, Bill, and I look forward to your testimony. 

Mr. CANNON. Thank you, Mr. Delahunt. 

We are pleased, Mr. Galvin, to have a person of such a national 

reputation and one who is—I hope can bring to bear, and I believe 

will bring to bear—a great deal of information and understanding 

for us on this Committee. Thank you. 

Our final witness is Mr. Eric Zitzewitz. He has been an assistant 

professor of economics at Stanford Graduate School of Business 

since 2001, and published extensively on the securities industry as 

well as on other subject matter dealing with economics. He received 

his undergraduate degree in economics from Harvard and his Ph.D. 

In economics from MIT. 

I extend to each of you my warm regards and appreciation for 

your willingness to participate in today’s hearing. In light of the 

fact that your written statements will be included in the record, I 

request that you limit your oral remarks to 5 minutes. And accordingly, please feel free to summarize the salient points of your testimony. 

And you will note that there is a lighting system in front of you. 

After 4 minutes the light will turn from green to yellow, and then 

at 5 minutes it will turn to red. It’s my habit to tap the gavel, probably the handle or maybe a pen, to just indicate that that’s happened. You don’t need to cut off at that point. We are not trying 

to cut you off mid-thought, but just as a matter of comity, because 

there are several people that will want to ask questions today. I 

can almost assure you that you will have plenty of time to come 

4

back and add to your statements as we give 5 minutes to each of 

the members of the panel. 

After you have presented your remarks, the Subcommittee Members in order of their arrival will be permitted to ask questions for 

5 minutes. And again, in the case of the clock, I will tap when we 

get close to when we hit the red light. You don’t have to stop immediately, but just as a matter of comity, we would like to move on. 

And pursuant to the directive of the Chairman of the Judiciary 

Committee, I ask the witnesses to please stand and raise your right 

hand to take the oath. 

[Witnesses sworn.] 

Mr. CANNON. The record will reflect that each of the witnesses 

answered in the affirmative. 

You may be seated. 

And, Mr. Hillman, if you’d like to proceed, you’re recognized for 

5 minutes. 

Mr. HILLMAN. Thank you very much, Mr. Chairman. 

Mr. CANNON. Pardon me, Mr. Hillman. If I could interrupt you, 

we would love to hear from the Ranking Member and I apologize 

for not having recognized him a moment ago. If the gentleman 

would like to speak, he is recognized for 5 minutes. 

Mr. WATT. Thank you, Mr. Chairman. I won’t take 5 minutes. I 

just wanted an opportunity to join you in welcoming Ms. 

Wasserman Schultz to the hearing today and hopefully to the membership on the Committee tomorrow, once that is formalized. 

I want to thank the Chairman for convening the hearing to begin 

the process of reviewing the SEC’s failure to detect mutual fund 

abuses. More than one-half of American households invest in mutual funds. They invest to enhance their futures and their children’s futures. These investments should be treated with great care 

and confidently secured from abuses. 

I think we all agree the market should be free from unscrupulous 

activities of mutual fund companies. Although this Subcommittee 

is addressing the GAO’s recommendations with respect to the 

SEC’s role in detecting the mutual fund abuses that hinder longterm shareholders from proper fund returns, I would like to emphasize the important role the States play and continue to play in 

the collaborative efforts to detect and deter mutual fund abuse. 

Many of the abuses examined by the GAO at the request of 

Chairman Sensenbrenner and Ranking Member Conyers surfaced 

due to the diligence of the State Attorney General Eliot Spitzer of 

New York. So while I think it is important that we determine 

whether the SEC is broken and, if so, how to fix it, I can’t overemphasize the critical role that the States must continue to play 

in protecting investors, large and small. 

Additionally, I have—I don’t know whether it’s enviable, but I 

serve on both the Judiciary Committee and the House Financial 

Services Committee, and those are the Committees that actually 

share jurisdiction over mutual funds and securities. And so I want 

to emphasize the important role that the Financial Services Committee also plays over law enforcement in the mutual fund industry. I believe we should focus narrowly on enforcement issues in 

this Subcommittee and take care to divine precisely what role this 

Committee can and should take in response to the problems of 

5

abuses that have been revealed. So I am particularly interested in 

hearing the testimony here today, and I welcome the witnesses and 

yield back. 

Mr. DELAHUNT. Would the gentleman yield for a moment? 

Mr. WATT. I am happy to yield to my friend from Massachusetts. 

Mr. DELAHUNT. Yeah, I just wanted to echo some of the sentiments that you expressed, Mr. Watt, particularly regarding the role 

of the Judiciary Committee as well as the Financial Services Committee. I know you serve on both. And I want to applaud the Chairman for calling this particular hearing into an issue obviously that 

has great significance and impact to the lives of millions, tens of 

millions of Americans. And I would hope that this Subcommittee 

would even be more aggressive in the future in terms of exercising 

its oversight responsibilities, particularly as it relates to enforcement not only in this area, but in the entire jurisdiction within the 

Committee’s purview. 

One can only reflect on the number of administrative bodies that 

exist in the executive branch of Government that I would respectfully suggest are not the subjects of significant oversight. One only 

has to think of the alphabet that we deal with in terms of administrative agencies, and yet I have served on this Committee in the 

past, and this is the first time, in my memory, I can think of a significant agency such as the SEC that has been before the Committee. And I would hope that we would continue to be aggressive 

and send that message out to the executive branch that this Subcommittee in particular intends to be aggressive about oversight. 

And with that I yield back. 

Mr. WATT. I appreciate the gentleman’s comments and—but I do 

want to assure him that the Financial Services Committee has had 

the SEC and a number of these agencies in front of that Committee 

on a regular basis, so it is not that oversight is not being done. It 

is being done. And our role, I think, is more on the enforcement 

side to emphasize not—well, you know, we have got a clear role 

here, and we just need to not stumble over each over, I guess, is 

the——

Mr. DELAHUNT. Never enough oversight. 

Mr. WATT. Never enough oversight. 

Yield back. 

Mr. CANNON. I thank the gentleman. Let me also point out that 

I believe there is never enough oversight, whether it is a Republican administration or a Democrat administration, whether the 

Republicans control Congress or the Democrats do. That is one of 

the great, great things about this body. And so to the degree that 

the Minority has had issues that they want to look at, I hope we 

have been receptive and are anxious actually to carry out that 

oversight role. So thank you, Mr. Delahunt, for your kind comments, and Mr. Watt. 

Mr. Hillman, if you would like to go ahead, you’re recognized for 

5 minutes now. 

6

TESTIMONY OF RICHARD J. HILLMAN, DIRECTOR, FINANCIAL 

MARKETS AND COMMUNITY INVESTMENT, U.S. GOVERNMENT ACCOUNTABILITY OFFICE 

Mr. HILLMAN. Thank you, Mr. Chairman. I am pleased to be here 

today to discuss two recently issued GAO reports that assess SEC’s 

response to trading abuses uncovered in the mutual fund industry. 

We prepared these reports at the request of Chairman Sensenbrenner and Ranking Member Conyers of the full Committee. 

As you know, trading abuses, including fraudulent market timing 

and late trading violations, were uncovered in many well-known 

companies in the mutual fund industry and raise significant concerns about the industry’s ethical practices. Maintaining public 

confidence in the mutual fund industry is critical because about 95 

million Americans have invested more than 8 trillion in mutual 

funds, a significant share of the Nation’s privately held wealth. 

Moreover, it is critical that the SEC have the capacity to identify 

abusive practices and to bring enforcement actions that punish violators and deter those who are contemplating similar abuses. 

My written statement today discusses the reasons the SEC did 

not detect the market timing abuses at an earlier stage, some of 

the steps that SEC has taken to strengthen its oversight of the mutual fund industry, and enforcement actions taken by SEC and 

criminal prosecutors in response to these abuses, and SEC’s management of procedures related to the making of criminal referrals 

and ensuring staff independence from the mutual fund industry. 

In summary, regarding our first objective, before September 

2003, SEC did not examine fund companies for market timing 

abuses because agency officials, one, viewed other activities as representing much higher risk; two, concluded that companies had financial incentives to control frequent trading because it could 

lower fund returns; and three, were told by company officials and 

the companies that they had established controls over frequent 

trading. 

While SEC faced competing examination priorities before September 2003, and had made good-faith efforts to mitigate the 

known risks associated with legal market timing, lessons can be 

learned from the Agency not having detected the abuses earlier. 

First, without paying additional attention to conducting independent assessments of the adequacy of mutual fund company controls, the potential increases that violations may go undetected. 

Second, SEC can strengthen its capacity to identify and assess 

any evidence of potential risk. Information was available to the 

SEC before these market timing problems were uncovered indicating the possibility of illegal market timing activities. For example, a 2002 study estimated that market timing in certain funds resulted in about 5 billion in annual losses to shareholders and 

raised the possibility that investment advisors did not always act 

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

Third, our review of individual market timing enforcement cases 

found that compliance staff at mutual fund companies often detected evidence of undisclosed market timing arrangements with 

favored customers, but lacked sufficient independence within their 

organizations to correct identified deficiencies. Ensuring the indeVerDate 0ct 09 2002 13:44 Sep 06, 2005 Jkt 000000 PO 00000 Frm 00010 Fmt 6633 Sfmt 6601 G:\WORK\COMM\060705\21653.000 HJUD1 PsN: 21653
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pendence of compliance staff is critical, and SEC could potentially 

benefit from using their work. 

Since these abuses were uncovered SEC has acted aggressively 

to address identified abuses through proposed and final 

rulemakings, bringing and settling enforcement cases and conducting targeted examinations. In particular, SEC has take a variety of steps to strengthen its mutual fund oversight program and 

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

effectiveness of several key initiatives. For example, SEC has instructed its staff to make additional assessments of company controls and established a new office to improve its capacity to anticipate, identify and manage emerging risks and market trends in the 

securities industry. SEC also adopted a rule that requires mutual 

fund companies to appoint independent compliance officers who are 

to prepare annual reports on their companies’ policies and violations; however, SEC has not yet developed a plan to receive and 

review these annual reports on an ongoing basis and thereby enhance its capacity to detect potential violations. 

SEC has agreed with recommendations in our report to strengthen its oversight, including assessing how best to use such compliance reports. At the time of our review, SEC had brought 14 enforcement actions against mutual fund companies and 10 enforcement actions against other firms for mutual fund trading abuses. 

The penalties obtained in settlements with mutual fund companies 

are amongst the Agency’s highest, ranging from 2 million to 140 

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

settlements for securities laws violations prior to 2003 were typically under 20 million. 

In reviewing a sample of investment advisor cases, we found the 

SEC followed a consistent process for determining penalties, and 

that it coordinated penalties and other sanctions with interested 

parties. However, we found certain weaknesses in SEC’s management procedure for making referrals to criminal law enforcement 

and ensuring staff independence. In particular, SEC does not require staff to document whether a criminal referral was made or 

why. Without such documentation, SEC cannot readily determine 

whether staff make appropriate referrals. Further, SEC does not 

require departing staff to report where they plan to work, information gathered by other financial regulators to assess staff compliance with Federal laws regarding employment with regulated entities. In the absence of such information, SEC’s capacity to ensure 

compliance with these conflict-of-interest laws is more limited. 

SEC agreed with our report recommendations to document criminal referrals and employees’ postemployment plans. 

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

happy to respond at the appropriate time to any questions that 

might arise. 

Mr. CANNON. Thank you, Mr. Hillman. 

[The prepared statement of Mr. Hillman follows:]

8

PREPARED STATEMENT OF RICHARD J. HILLMAN


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Mr. CANNON. Ms. Richards, you’re recognized for 5 minutes. 

TESTIMONY OF LORI A. RICHARDS, DIRECTOR, OFFICE OF 

COMPLIANCE INSPECTIONS AND EXAMINATIONS, U.S. SECURITIES AND EXCHANGE COMMISSION 

Ms. RICHARDS. Thank you, Chairman Cannon, Ranking Member 

Watt, Members of the Committee. I am Lori Richards. I am Director of the SEC’s Office of Compliance Inspections and Examinations. Thank you for inviting me to testify here today about the 

SEC’s oversight of the mutual fund industry, the recent mutual 

fund trading abuses and recent GAO reports. 

In the last 21 months, the SEC has moved quickly to implement 

a series of reforms with respect to mutual funds. We rapidly examined and investigated fund firms and brought numerous enforcement actions. We adopted new rules designed to improve mutual 

funds governance, ethical standards, compliance and internal controls. We initiated reforms to SEC rules designed specifically to address market timing and late trading. And finally, we improved 

SEC examiners’ ability to detect emerging compliance problems 

promptly. It is our expectation that, taken together, these reforms 

will minimize the possibility of these types of abuses from occurring again. 

My testimony today focuses primarily on the significant steps 

that the SEC has taken with respect to its examination oversight 

of mutual funds. There are now over 8,000 mutual funds managed 

in over 900 mutual fund complexes, and over 8,000 investment advisors registered with the SEC. The size of the mutual fund industry does not allow the SEC to conduct comprehensive audits of all 

of their operations. Until recently the SEC had approximately 360 

staff people who were dedicated to these examinations. In 2003, 

however, budget increases allowed us to increase the size of the 

SEC’s examination staff to approximately 500 staff people. 

Given the size of the industry, our examinations focus on those 

areas that, in our view, pose the greatest risk to investors. The 

challenge for any regulator with limited resources is to identify and 

to effectively target those areas that pose the greatest risk. SEC 

examinations are, therefore, focused on the use of a fund investor’s 

assets, their money and their securities, and primarily whether the 

mutual fund is making investments on behalf of investors that are 

appropriate, how mutual funds are being marketed and sold to retail investors, and whether funds were trying to inflate the returns 

of the fund or take on undisclosed risk in order to generate more 

sales. 

It is important for me to note that while market timing was the 

subject of recent GAO reports, SEC examinations have often detected serious compliance problems in other areas, and those have 

resulted in serious enforcement actions. For example, the SEC has 

been on the forefront of discovering and addressing abuses with respect to the widespread failure to deliver mutual fund discounts to 

investors on their purchases of mutual funds; investment advisors’

undisclosed favoritism in the allocation of shares amongst their client accounts; the failure to disclose the use of mutual funds money 

to pay the cost of selling fund shares; and various types of sales 

abuses, in particular selling one type of fund to an investor when 

34

another type of fund would be better for that particular investor, 

and various unsuitable sales associated with the sales of variable 

annuity products. 

Since the first instances of market timing and late trading were 

identified by a tip to the New York Attorney General’s Office, the 

SEC moved very rapidly to investigate this issue in the broader 

mutual fund industry. As of May 31, 2005, the SEC has brought 

29 enforcement actions involving mutual fund complexes and their 

employees and 12 enforcement actions involving broker-dealers and 

their employees. The recent GAO report outlined some of these enforcement actions, and recognizes that the penalties obtained in 

these cases are among the largest ever imposed by the SEC. Prior 

to 2003, as the GAO report notes, we did not identify the covert 

secret market timing arrangements between mutual funds and active traders. 

It is important to note that there is a difference between market 

timing that is legal and market timing that is illegal. Illegal market timing involved secret arrangements between fund executives 

and select market timers. By their nature these were secret, undisclosed arrangements, some of which we now know involved nominee accounts and false trading records. The SEC did not have prior 

notice of these secret arrangements that some mutual fund executives had with favored traders. 

GAO has stated that we can learn lessons from our experience 

with market timing. I suppose I would recast that statement slightly to say that we have learned lessons from our experience with 

market timing. We have implemented changes to our examination 

protocols that will allow examiners not only to detect abusive market timing and late trading, but, perhaps more importantly, to be 

more nimble, to be more aggressive, to be more proactive in identifying other types of misconduct associated with mutual funds. 

The new methodology is described in some detail in my written 

testimony, but key enhancements include conducting focused routine examinations on the highest-risk firms; increasing the use of 

data and technology in examinations, including by randomly reviewing mutual fund employees’ e-mails. One of the lessons we 

learned is that the secret market timing arrangements were often 

negotiated between mutual fund executives and market timers via 

e-mail communications. So those are now critical aspects of our 

routine examinations. 

We are studying the development of an off-site surveillance program for mutual funds and investment advisors. We implemented 

a new risk mapping program to better identify areas of emerging 

risk. We have implemented a new program to rapidly investigate 

emerging compliance problems by use of sweep examinations. We 

are implementing dedicated monitoring teams for the largest fund 

organizations, and, very importantly, to help reduce violations or 

help eliminate the possibility that violations could occur in the first 

place. We are reaching out to the new chief compliance officers at 

mutual fund firms and investment advisors in a new chief compliance officers outreach program to help them better eliminate compliance problems in the first place. 

In sum, the SEC has taken aggressive steps to address abusive 

market timing and late trading in mutual fund shares, but more 

35

broadly, the SEC has taken steps to protect investors from the next 

instance of fraud and abuse by improving our ability to spot emerging problems more quickly. 

Thank you, and I am happy to answer any questions you may 

have. 

Mr. CANNON. Thank you. 

[The prepared statement of Ms. Richards follows:]

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PREPARED STATEMENT OF LORI A. RICHARDS


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ATTACHMENT


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Mr. CANNON. Secretary Galvin. 

TESTIMONY OF WILLIAM FRANCIS GALVIN, SECRETARY OF 

THE COMMONWEALTH OF MASSACHUSETTS 

Mr. GALVIN. Thank you, Mr. Chairman. 

Chairman Cannon, Ranking Member Watt, distinguished Members of the Committee, thank you very much for having me here 

this afternoon. I am Bill Galvin. I’m the Secretary of the Commonwealth of Massachusetts and its chief securities regulator. Among 

the duties of my office are protecting investors in the Commonwealth of Massachusetts through our securities division. 

I am here today to offer my perspective on mutual fund trading 

abuses, and more specifically this recent April 2005 GAO report. 

The subtitle of this report is, quote, Lessons Can Be Learned from 

the SEC Not Having Detected Violations at an Earlier Stage, close 

quote. From my perspective, the lessons are pretty simple. In the 

past the SEC simply didn’t do it’s job. It dropped the ball. It ignored warning signs and inexplicably didn’t follow up on tips. In 

short, it failed to protect mutual fund investors. 

Let me be blunt. Had the SEC done what it was supposed to do, 

we probably wouldn’t be here today. Unfortunately, it’s not the first 

time the SEC has let investors down. Consider the history from 

just the past 10 years. Almost every major enforcement action or 

investor protection issue was first brought or raised not by the SEC 

or the NASD, but by State securities regulators. These include 

penny stock and microstock fraud, day trading abuses, misleading 

Internet brokerage advertising, analyst conflict of interest matters, 

and lastly mutual fund trading abuses. In virtually every case the 

States took the lead. 

The revelations of recent years about the securities industry 

teach an even more compelling lesson, and that is the critical importance of what goes on in what I will call the risk marketplace 

for average Americans. Their savings, their pensions, their children’s education funds, in short their financial futures are now as 

never before in play in this marketplace. 

The GAO report is fine as far as it goes, but it leaves out the 

most important lesson, in my view, and that is the vital role played 

by State securities regulators. We need more cops on the securities 

beat and more constructive competition among them to protect the 

investing public. Our regulatory monopoly is as bad as any other 

kind of monopoly. Customers and investors are ill served by monopolies. Monopoly regulators, like monopoly companies, get complacent. They miss things. They can get too cozy with the folks 

they’re supposed to regulate. 

I have seen how it works in the securities industry. The regulators and the regulated go to each others’ conferences, usually in 

nice places like Palm Beach and Palm Desert. The revolving door 

through which Federal regulators go to find lucrative jobs on Wall 

Street should be the subject of another hearing perhaps on another 

day. 

As I said, we probably wouldn’t be here today if the SEC had 

done its job. Unfortunately it did not. From my perspective as a 

State securities regulator, I think the SEC has to be aggressive 

across the board. 

56

Chairman William Donaldson has made some important progress 

during his time at the Commission. The pending nomination of Mr. 

Cox and other anticipated vacancies at the SEC raises a most serious question. Is the era of reform and vigorous enforcement over? 

There is no doubt we are at a crossroads. Just 2 years ago this 

House of Representatives voted by a margin of 418 to 2 to reform 

the mutual fund industry. The bill died in the Senate. Was that 

just for show, or are we serious about giving average Americans 

real protection? 

Over the years the SEC has been criticized for not being 

proactive and tough enough. I think it is a fair criticism. Traditionally one of the weakest and most toothless divisions of the SEC 

was in investment management. It has not been known for aggressive examinations, and certainly not for enforcement actions. I’d 

even call it a regulatory backwater. This is strange and unacceptable, given that nearly 100 million Americans entrust their money 

to the mutual fund industry. Yet here we have a regulator that ignored reports from academics and even anonymous tipsters from 

within the industry that market timing was costing investors billions of dollars. 

This chicanery and fraud would likely still be going on if it were 

not for a couple of State securities divisions that acted when the 

SEC and the NASD did not, despite having a tiny fraction of the 

resources these two organizations have. In Massachusetts, for example, we brought many—several market timing and late trading 

enforcement actions based on the tips we received and the exams 

we conducted. These involved Putnam Mutual Funds, Prudential 

Securities, Franklin-Templeton and A.G. Edwards. Like State securities regulators across the country who follow up on tips, we answer the phone, we listen to investors, and we’re easy to reach. 

There are those who would like to see the State securities regulators just go away. They argue our complementary system of State 

and industry self-regulation is burdensome and duplicative. It is 

neither. Quite the contrary, it serves to protect investors. The mutual fund trading abuse described in the GAO report are proof of 

that. 

Our system works. That’s the lesson of all this. So next time 

some free market think tank underwritten by Wall Street money 

says we don’t need State securities regulators, that the industry 

can regulate itself just fine out of enlightened self-interest, you 

have a simple four-word answer, which also happens to be the title 

of this report: Mutual Fund Trading Abuses. 

The fact is we need more, not fewer, cops on the securities beat. 

That is the lesson of this scandal. And we need cooperation among 

regulators, not corruption. We need to check each other’s work. 

Sometimes we need to backstop each other. 

A few years ago in 1996, in the name of so-called regulatory reform and efficiency, the States were essentially preempted from the 

regulation of mutual funds. The scandal we are here today to discuss is a legacy of that misguided policy. Investor protection, including aggressive enforcement of State and Federal securities 

laws, isn’t a partisan issue. Democrats, Republicans, Libertarians, 

Greens and Independents, we all rely on our Nation’s securities 

markets for financial security. Investors vote, and they are a very 

57

large constituency. They need to be protected, and they’re relying 

on us. We must make sure that they are protected. 

To sum up, the lessons of this chapter on Wall Street history are 

simple. While SEC and the NASD dropped the ball, the States 

picked it up. Our system worked. Now we are about to write the 

next chapter. Will it be back to business as usual, or will it be real 

protections for the hard-earned money that our citizens have invested? The answer is up to us. 

Thank you very much, Mr. Chairman. I will be happy to answer 

any question at the appropriate time. 

Mr. CANNON. Thank you, Mr. Secretary. 

[The prepared statement of Mr. Galvin follows:]

PREPARED STATEMENT OF WILLIAM FRANCIS GALVIN

Chairman Cannon, Ranking Member Watt, and distinguished members of the 

committee. 

My name is William Galvin. I am Secretary of the Commonwealth of Massachusetts and the Chief Securities Regulator. 

Among the duties of my office are protecting investors in the Commonwealth 

through the Securities Division. 

I’m here today to offer my perspective on mutual fund trading abuses and, more 

specifically, this April 2005 GAO report. 

The subtitle of this report is ‘‘Lessons Can Be Learned from SEC Not Having Detected Violations at an Earlier Stage.’’

From my perspective, the lessons are pretty simple. 

In the past, the SEC simply didn’t do its job. It dropped the ball. It ignored warning signs and, inexplicably, didn’t follow up on tips. In short, it failed to protect mutual fund investors. 

Let me be blunt: Had the SEC done what it was supposed to do, we probably 

would not be here today. 

Unfortunately, it’s not the first time the SEC has let investors down. Consider the 

history from just the past 10 years. 

Almost every major enforcement action or investor protection issue was first 

brought or raised not by the SEC or NASD but by state securities regulators.

• Penny stock and microcap stock fraud

• Day trading abuses

• Misleading Internet brokerage advertising

• Analyst conflicts of interest

• Mutual fund trading abuses

In virtually every case, the states took the lead. 

The revelations of recent years about the securities industry—teach an even more 

compelling lesson—that is—the critical importance of what goes on in what I will 

call the ‘‘risk’’ marketplace to average Americans. 

Their savings—their pensions—their children’s education—in short—their financial futures are now as never before in play in this marketplace. 

This GAO report is fine as far as it goes. But it leaves out the most important 

lesson, in my view. 

And that is: The vital role played by state securities regulators. We need more 

cops on the securities beat—and more constructive competition among them—to protect the investing public. 

A regulatory monopoly is as bad as any other kind of monopoly. Customers and 

investors are ill-served by monopolies. 

Monopoly regulators, like monopoly companies, get complacent. They miss things. 

They can get too cozy with the folks they’re supposed to regulate. I’ve seen how it 

works in the securities industry. The regulators and the regulated go to each others 

conferences, usually in nice places like Palm Beach and Palm Desert. 

The revolving door through which federal regulators go to find lucrative jobs on 

Wall Street should be the subject of another hearing on another day. 

As I said, we probably wouldn’t be here today if the SEC had done its job. 

Unfortunately it did not. 

58

From my perspective, as a state securities regulator, I think the SEC has to be 

aggressive across the board. Chairman William Donaldson made some important 

progress during his time at the Commission. 

The pending nomination of Mr. Cox and other anticipated vacancies at the SEC 

raises a most serious question—is the era of reform and vigorous enforcement over? 

There is no doubt we are at a crossroad. Just two years ago the House of Representatives voted by a margin of 418 in favor to 2 against to reform the mutual 

fund industry. The bill died in the Senate. Was that just for show?—or are we serious about giving average Americans real protection. 

Over the years, the SEC has been criticized for not being proactive and tough 

enough. I think it’s a fair criticism. 

Traditionally, one of the weakest and most toothless divisions at the SEC was Investment Management. It has not been known for aggressive examinations, and certainly not for enforcement actions. I’d even call it a regulatory backwater. 

This is strange—and unacceptable—given that nearly 100 million Americans entrust their money to the mutual fund industry. 

Yet here we have a regulator that ignored reports from academics and even anonymous tipsters from within the industry that market timing was costing investors 

billions of dollars. 

This chicanery and fraud would likely still be going on if it weren’t for a couple 

of state securities divisions that acted when the SEC and NASD did not, despite 

having a tiny fraction of the resources these two organizations have. 

In Massachusetts, for example, we brought several market-timing and late-trading enforcement actions based on tips we received and exams we conducted. These 

involved Putnam Mutual Funds, Prudential Securities, Franklin-Templeton and 

A.G. Edwards. 

Like state securities regulators across the country, we follow up on tips. We answer the phone. We listen to investors. We’re easy to reach. 

There are those who would like to see state securities regulators just go away. 

They argue that our complementary system of state, federal and industry self-regulation is burdensome and duplicative. 

It is neither. Quite the contrary. It serves to protect investors. The mutual fund 

trading abuses described in this GAO report are proof of that. 

Our system works. That’s the lesson of all this. 

So next time some free-market think tank, underwritten by Wall Street money, 

says we don’t need state securities regulators, that the industry can regulate itself 

just fine out of enlightened self-interest—you have a simple four-word answer, 

which also happens to be title of this report: ‘‘Mutual Fund Trading Abuses.’’

The fact is, we need more, not fewer, cops on the securities beat. That is the lesson of this scandal. 

And we need cooperation among regulators, not co-option. We need to check each 

other’s work sometimes. We need to backstop each other. 

Years ago, in the name of so-called regulatory reform and efficiency, the states 

were essentially pre-empted from the regulation of mutual funds. The scandal we 

are here today to discuss is a legacy of that misguided policy. 

Investor protection—including aggressive enforcement of state and federal securities laws—isn’t a partisan issue. 

Democrats, Republicans, Libertarians, Greens and Independents—they all rely on 

our nation’s securities markets for their financial futures. 

Investors vote and they’re a very large constituency—larger than teachers, larger 

than labor, bigger than the AARP and bigger than the Baby Boomers. 

They need to be protected. They’re relying on us. If for some reason investors lost 

faith in our markets, it would be more than a pocket-book issue. It would be a national security issue. 

We can’t allow that to happen. 

To sum up, the lessons of this sad chapter in Wall Street’s history are simple: 

While the SEC and the NASD dropped the ball, the states picked it up. The system 

worked. 

Now we are about to write the next chapter—will it be back to business as 

usual?—or will it be real protections for the hard-earned money that our citizens 

have invested. 

The answer is up to us. 

Thank you, Mr. Chairman.

Mr. CANNON. I couldn’t help but think while you were talking 

about the incomparable Andrew Jackson and his veto of the Second 

National Bank’s charter, which was passed by a Congress popuVerDate 0ct 09 2002 13:44 Sep 06, 2005 Jkt 000000 PO 00000 Frm 00062 Fmt 6633 Sfmt 6601 G:\WORK\COMM\060705\21653.000 HJUD1 PsN: 21653
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lated by a large number of people on the payroll of the Second National Bank. And in America, the reason we are having this hearing is because we need to strive to break up those cozy and often 

funded relationships that result in a loss of confidence. The only 

way you can have confidence is by having transparency and by 

having what you call protection; that is, enforcement against those 

people who commit crimes. And I love your idea. Pardon me for 

taking a couple of moments here, but I love the idea of cooperation 

and competition among enforcement agencies. 

Thank you very much, Mr. Galvin. 

And Mr. Zitzewitz. 

TESTIMONY OF ERIC W. ZITZEWITZ, STANFORD GRADUATE 

SCHOOL OF BUSINESS, STANFORD, CALIFORNIA 

Mr. ZITZEWITZ. Chairman Cannon, Ranking Member Watt, and 

Members of the Committee, thank you for the opportunity to appear here today. 

We are discussing two recent reports by the GAO that ask 

whether there are lessons to be learned from the SEC’s handling 

of recent issues in the pricing and trading of mutual fund shares. 

Both reports deal with the general issue of regulatory capture, 

whether the SEC is influenced by the industry in a way that adversely affects investors, and whether reforms can make it more 

immune to that influence. 

The first report concluded that the SEC was aware of inefficiencies in the pricing of mutual fund shares that created arbitrage opportunities, and that it relied too heavily on assurances from the 

industry that they were preventing these inefficiencies from being 

exploited. This was despite being aware of evidence to the contrary: 

academic studies of the issues, press reports, complaints from investors and fund employees, and the high fund share turnover rate 

publicly reported by some international mutual funds. 

The GAO report focuses on failings in the handling of referrals 

and in routine inspections. It does not mention policymaking, and 

I understand there are some jurisdictional issues involved, but 

that’s an issue to which I will return. 

The second report examines the negotiation of settlements with 

fund advisors who priced their funds in a way that created arbitrage opportunities and then facilitated arbitrage trading. The report appeared motivated by concerns that prosecutorial discretion 

could lead to excessive leniency, leniency that might be rewarded 

in a staff member’s post-SEC career. 

The GAO concluded that participation in the settlement negotiations was broad, and that negotiations were always conducted in 

the context of a damage analysis by SEC economists, and that this 

limited the influence of any individual. That said, the GAO concluded, and the SEC concurred, that improved monitoring of the 

subsequent employment of SEC enforcement staff would be a useful reform. 

Before commenting on these two issues, I should preface everything by noting that the SEC and mutual fund industry have made 

a remarkable amount of progress in addressing these issues since 

September of ’03. Furthermore, while economists often critique the 

incentives created by and the outcomes of an institution’s design, 

60

we do so without impugning the character and work of its staff. I 

have met many members of the SEC in the last 2 years, and without exception found them to be smart and dedicated people whose 

primary concern is that our capital markets operate as efficiently 

and fairly as possible. Nothing I say today should be taken to imply 

otherwise. 

The GAO reports are very thorough, and they adroitly handle a 

set of very sensitive issues. My only major critique of the first report is that it reflects the conventional framing of the market timing issue as one of trading abuses as opposed to one of pricing inefficiencies. The difference is subtle, but important for two reasons. 

First, focusing on pricing rather than trading leads one to the correct policy fixes. And second, focusing on pricing leads one to ask 

the right or at the very minimum an additional set of questions 

about the pre-2003 SEC stance on this issue. 

The great irony is that the SEC understood the inefficiencies in 

international mutual fund pricing and had twice urged the industry to eliminate them through a procedure known as fair value 

pricing. But when the industry resisted, the SEC essentially 

backed down, despite the fact that it was clear from publicly available data that most funds were fair valuing infrequently if at all. 

The SEC provided no further formal guidance on this issue. 

Even since September 2003 there has been in some cases a striking similarity between what the industry’s asked for and what the 

SEC has proposed. The primary direct fix for the market timing 

problem proposed by the Investment Company Institute in October 

of ’03 was a mandatory 2 percent fee for redemptions within 5 days 

of purchase. As I and others pointed out at the time, a severe limitation of this fix is that arbitragers could just hold their shares 

until day 6. Even if enforcement of the rule were perfect, it would 

only reduce the excess return available to the arbitragers by a factor of roughly 2. Despite this limitation this exact proposal became 

the primary direct fix for the market timing problem proposed by 

the SEC. 

What I and others argued at the time would be a better first step 

is for the SEC to set and enforce standards for fund valuation that 

would substantially eliminate any arbitrage opportunity. Doing so 

would largely eliminate the need for measures such as monitoring 

and short-term trading fees. It will also eliminate the component 

of arbitrage that these measures will never be able to address. 

While the industry has made progress in improving the valuation 

of international equity funds, there is still scope for further improvement. In other asset classes, such as illiquid bonds and small 

cap equity, substantial arbitrage opportunities still exist. This is 

possible because the industry is waiting for guidance on evaluating 

these asset classes from the SEC. There have been rumors for some 

time that the SEC is planning to issue such guidance, but there appears to be a delay. Regardless, the question remains why fixing 

the valuation of funds is the last step being taken as opposed to 

the first. 

This brings me to my only substantial critique of the second report, which is also about the report’s scope more than its content. 

The second report focuses on one form of regulatory capture while 

neglecting one potentially more important. The report is concerned 

61

with firm-level capture where a prosecutor might settle on attractive terms with a fund advisor and then go work for that advisor. 

My suspicion is that this scenario is fairly unlikely, particularly in 

the current climate. A more likely and difficult-to-address form of 

capture is industry-level capture in which a prosecutor settles on 

attractive terms out of fear that aggressive prosecution of a member of the industry will limit his or her subsequent career throughout the industry, or alternatively in which a policymaker is reluctant to push a policy that an entire industry opposes for the same 

reason. Is this type of capture a problem? The experience with pre-

’03 policymaking suggests that it might be, while the scale of the 

penalties summarized in the second GAO report suggest that it’s 

not. 

The important question, of course, is not about what happened 

in the past, but what we can expect in the future. The extent to 

which the changed regulatory environment in ’03-’04 turns out to 

be temporary or permanent, of course, remains to be seen. 

How does one address this form of capture? The economists’ answer would be higher salaries and longer employment tenures at 

the SEC to reduce the importance of post-SEC income. Personally 

I am a little more optimistic about my guess as to what the sociologists’ answer would be: to collectively recognize that capture is a 

problem and that attempting to influence policy in this manner as 

opposed to winning arguments based on the facts is not something 

that should be rewarded. 

A more radical suggestion would be to revisit the organization of 

SEC. Currently the policymaking divisions of the SEC are largely 

organized around the industries they regulate. A well-known empirical regularity is that single industry regulators are typically 

more prone to capture than mutli-industry regulators. The reason 

is straightforward. A DOJ lawyer prosecuting a case against the vitamin cartel need not seek future employment from the vitamin industry, whereas this is less true for an airline pricing specialist at 

the CAB seeking to limit a requested airfare increase. In this sense 

the current organization of the SEC may be exacerbating the influence of industry. If a formal reorganization is viewed as too costly, 

then a positive step may be to simply institutionalize the crossfunctional involvement that the second GAO report notes was a favorable feature of the SEC’s work on fund settlements. 

In conclusion, thank you for the opportunity to share with you 

my thoughts on these issues. I look forward to your questions. 

Mr. CANNON. Thank you, Mr. Zitzewitz. 

[The prepared statement of Mr. Zitzewitz follows:]

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PREPARED STATEMENT OF ERIC W. ZITZEWITZ


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Mr. CANNON. Does the gentleman from North Carolina seek recognition? 

Mr. WATT. Thank you, Mr. Chairman. 

Mr. CANNON. The gentleman’s recognized for 5 minutes. 

Mr. WATT. Ms. Richards, I am trying to assess whether there is 

a different attitude at the SEC regarding oversight and enforcement related to mutual funds than there is at the SEC regarding 

other securities. First of all, is there a different attitude, and if so, 

why? Second, is there a different level of personnel numbers quality, and if so, why? You said there were 500 employees overseeing 

the mutual funds. What would be the comparable number, for example, overseeing other kinds of securities matters? Could you just 

talk about that a little bit to see whether there is some historic difference in attitude? 

Ms. RICHARDS. Sure. Let me say at the outset, my office examines stock exchanges, broker-dealers, transfer agents, as well as 

mutual funds and investment advisors. I was a member of the 

SEC’s enforcement division for 10 years before I came to this job. 

Our examiners are uniformly, I believe, aggressive, and they are 

incentivized to find problems. The mission of the SEC is to detect 

fraud. Having examiners in a single division, I think, allows us to 

be single-minded and focused in that goal. Similarly, having enforcement staff in a single division, with their only goal is to prosecute violations of the securities law, I think helps further that 

mission. 

I can speak very candidly and personally about the attitude of 

my staff certainly in the exam program, but also of the SEC staff, 

that our mission and our goal is to detect fraud. Chairman Donaldson, when he came to the SEC, his primary goal in terms of managing the SEC was to institute reforms that would allow us to see 

around the corner and over the hill to detect the next type of 

emerging fraud and to be better focused on emerging risks in the 

securities industry. 

Mr. WATT. I’m not sure I have yet heard, is there a division with 

reference to mutual funds enforcement and other securities enforcement, or is it all one? 

Ms. RICHARDS. It’s all in one. The examination function for all 

those entities in the securities industry is in one program. The enforcement function is in one program. There are other offices of the 

SEC that do policymaking. Within the examination program we 

have now about 500 staff people who are responsible for examining 

mutual funds and investment advisors. We have about 350 staff 

people who examine broker-dealers. They are complemented by the 

work of the stock exchanges. The self-regulatory organizations also 

have examiners that examine broker-dealers. With respect to the 

stock exchanges, we have about 50 staff people who are responsible 

for examining the stock exchanges. 

Mr. WATT. So you actually have more people on mutual funds because there are other supervisory entities such as the stock exchanges’ broker-dealer associations that are self-governing. Is there 

not a separate self-governing entity for mutual funds? 

Ms. RICHARDS. That’s right. The mutual funds have no self-regulatory organization, so the SEC is the primary regulator, complemented certainly by the work of other regulators, including 

69

State securities regulators, but there is no equivalent in the mutual fund industry, no equivalent self-regulatory organization. 

Mr. WATT. Mr. Zitzewitz, what say you about this issue that I 

addressed to her, and how might it be improved? 

Mr. ZITZEWITZ. Sir, when I was referring to the organization of 

the SEC, I was referring primarily to the policymaking divisions. 

I think that having a single division for enforcement and a single 

division for inspections makes a lot of sense. I suppose within those 

divisions for expertise reasons it’s always going to make sense to 

have some people focusing on one area and some people focusing 

on another area. 

I think, though, it’s useful to consider the fact that there might 

be a trade-off between allowing employees to build expertise and 

having it be the case that once they have done that, their future 

employment has to come from that industry. It may be that having 

large numbers of specialists might make sense to temper that with 

some cross-functional specialization if you’re thinking about controlling sources of potential capture. 

Mr. WATT. Thank you, Mr. Chairman. I yield back. 

Mr. CANNON. I thank the Ranking Member. 

The Chair would announce that it’s his intention to allow the 

other Members here to ask questions before I ask questions. So the 

Chair recognizes Mr. Delahunt for 5 minutes. 

Mr. DELAHUNT. Thank you, Mr. Chairman. 

I would be interested in the opinion of both Ms. Richards and 

Secretary Galvin about the relationship between Federal and State 

regulators. I have a concern. You might have heard the banter up 

here earlier, about there’s never too much oversight. And Mr. 

Galvin expressed it as in terms of there’s not enough cops on the 

beat. 

Now, I don’t know what happened, you know, prior to September 

of 2003, but clearly there were abuses that either were not identified or were identified and were not pursued by the SEC. I’m not 

interested in the history. I’m interested in solving the problem. But 

having been a State prosecutor myself, I know that oftentimes 

there are problems in relationships between State agencies and 

Federal agencies. But to use the military concept of a force multiplier, where do we stand in terms of the relationship between the 

State regulators and the SEC at this point in time? And let me 

begin with Ms. Richards, and then I would ask Secretary Galvin. 

Ms. RICHARDS. Well, I agree with everything you just said. There 

are vast numbers of securities firms. We are outmanned and 

outgunned by the securities firms that we regulate. There are compliance departments of some of the large securities firms that outnumber SEC in terms of the number of exam staff that we have. 

To me that means that it’s terribly important that we work together with our colleagues at the State level. And in my program, 

in the examination program, we have a history of doing just that. 

We meet with our colleagues across the country in regular examination planning summits to plan priorities, to plan targeted initiatives, to plan joint work and joint training. I believe it’s terribly important that we leverage off of one another. We’re made much more 

effective when we’re all working together. 

70

There are certainly times where there are differences of opinion. 

I suppose in any relationship that’s bound to happen. I think, 

speaking personally, it’s terribly important that we not let those 

differences of opinion overcome the need for us to work together. 

Mr. DELAHUNT. Let me interrupt you, and I will pose that same 

question to Secretary Galvin. 

Mr. GALVIN. Thank you. I think you have to understand one 

thing especially with regard to mutual funds that has to be said. 

Ms. Richards has already mentioned the vast number of mutual 

funds that we have and the difficulties that that presents in any 

kind of enforcement regulation. But there’s also a bigger problem, 

it seems to me, and that is that mutual funds have—the regulation 

of mutual funds has not really kept pace with the role they play 

in our investment savings system. You know, we still treat mutual 

funds in many respects like it was some sort of a small group of 

people sitting around a table trying to decide how to invest like a 

stock club. They have become the bank of necessity for most Americans. Most Americans have found themselves, whether directly or 

indirectly, invested in mutual funds out of a sense of safety perhaps, or indirectly through their employer or some other means. 

So the challenge presented by mutual funds is greater perhaps 

than many of the other segments of the securities industry. 

As far as the cooperation, I think cooperation is improved. I 

think the experiences of 2003 have helped that. I—at the same 

time, I think there are some distinctions that have to be drawn. 

Generally speaking, the State securities regulators, of course, are 

operating with people in their respective States, individual consumers, more likely to hear about smaller problems, individual 

problems, than perhaps industry-wide problems. 

I think the States accept the fact, as we ought to, that the second 

should be the primary policymaker when it comes to market-wide 

policies. There’s no question about that. 

When it comes to enforcement, I do think a little bit of competition is healthy. We have never failed to refer something to the 

SEC, at least in Massachusetts, when we thought it was appropriate. We also have, in fact, referred them to Federal prosecutors 

and State prosecutors when we thought it was appropriate. I do 

think cooperation is improving. 

I think the other player in this whole discussion, though, which 

has to be brought to the table or at least mentioned, is the attitude 

of the industry itself, which has resisted any kind of regulation and 

indeed has been the sponsor many times of efforts at State preemption. That clearly is out there and——

Mr. DELAHUNT. I mean, we have to deal with the issue of preemption, not just in terms of this particular issue, but the whole 

array of issues that come before this Committee. The Ranking 

Member is the Chair of the States Rights Caucus. He is not here 

right now. I have assumed the title of vice president. One would 

be shocked at the number of bills that come out of this Committee 

that preempt State law. 

If the Chair would indulge me for an additional minute. 

Mr. CANNON. Without objection. 

Mr. DELAHUNT. Yes. I just want to pursue, I guess, with both of 

you, but in terms of the jurisdiction of this particular SubVerDate 0ct 09 2002 13:44 Sep 06, 2005 Jkt 000000 PO 00000 Frm 00074 Fmt 6633 Sfmt 6601 G:\WORK\COMM\060705\21653.000 HJUD1 PsN: 21653
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committee which falls in the area of compliance and enforcement, 

is there any legislation? 

Let me direct this to you, Mr. Secretary, and you can respond, 

Ms. Richards, what you feel would add, if you will, to that cooperation, which I think is absolutely essential. 

You know, all too often, people can be going down the same roads 

not being aware of what is happening in a parallel universe, so to 

speak. I would be more than willing to consider working with you 

and with others to file that legislation, because I think you are 

both right. That industry is a very, very powerful industry in terms 

of resources. 

I don’t think, Ms. Richards, you have the resources necessary. I 

know that at the State level they face the same fiscal constraints. 

Mr. GALVIN. If I may, and one thing I may have referred to in 

my testimony is, I think it was a mistake in the 1996 act to limit 

the States’ authority of mutual funds. There were amendments 

made to section 18 of the 1933 act, and I think that was a mistake. 

Now, if there needs to be some better definition of the relationship, that’s fine. But simply to say that the States are limited to 

fraud when they see it or when they hear about it, I don’t think 

was the right way to go. 

I think—again reflecting the unique situation of mutual funds, I 

don’t think it’s an exaggeration to say that most small savings 

banks around the country are under a greater degree of scrutiny 

on their day-to-day operations than mutual funds, despite the fact 

that they hold many more billions, trillions of dollars. 

And I think the one thing that there is absolutely no disagreement among Federal and State regulators about is the inadequacy 

of us, collectively even, to try to deal with this. 

Mr. DELAHUNT. How do we solve that problem, Ms. Richards——

Mr. GALVIN. Well, we certainly don’t want to crimp—we certainly 

don’t want to crimp the free market. And mutual funds have done 

a great deal for people in this country. But I think we have to 

make sure that our regulatory efforts and our enforcement effort 

is up to par to meet the challenge presented by the vast number 

of them. So that’s what I am saying. 

I think, looking at some of the changes made in 1990 and 1996—

you are asking in terms of specific legislation—would be one thing. 

There may be other remedies which, I don’t know whether they 

would jurisdictionally be before this Committee or other Committees. 

But one of the things that troubles me when I look at the whole 

industry is the whole issue of mandatory arbitration of disputes 

and the way that the panels are set up that make those decisions. 

Investors are forced into agreeing to an arbitration process that I 

believe—and it is my personal opinion—is stacked against them. 

If we are going to say—and we all agree we don’t want them in 

the courts. We don’t want them in the courts. They don’t belong in 

the courts,but nevertheless, there’d better be a safer system and a 

better system for people to get relief when they need it. 

That may be another area that you might want to look at. 

Mr. DELAHUNT. Mr. Chairman, that suggestion, I am confident, 

is within the jurisdiction of this particular Subcommittee. 

Mr. CANNON. The gentleman yields back. Thank you. 

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The gentlelady from Florida is recognized for 5 minutes. 

Ms. WASSERMAN SCHULTZ. Thank you, Mr. Chairman. And I am 

truly looking forward to serving on this Committee, hopefully, as 

of tomorrow. And I appreciate the accommodation that you and the 

Ranking Member have given me today. 

I, too, sit on the Financial Services Committee as my other Committee assignment, so we have spent a little bit of time on this 

issue in that Committee. 

Just to piggyback on what the gentleman from Massachusetts 

asked you, Ms. Richards and Secretary Galvin and, actually, anyone who chooses to answer it—not so much how you can, what legislation you would need or how the law would need to be changed 

for better coordination between State and Federal regulators, but 

my question is, do you feel you need any change in the law, generally, to do a better job of regulating? 

Ms. RICHARDS. I guess I would demur on the question of whether 

the SEC would seek legislation. I would ask for permission to come 

back to you with that. 

The SEC has taken, as I said, a number of rule-making initiatives, using its own authority to better shore up the internal governance, the internal controls, and the compliance operations of 

mutual funds. For the first time, beginning last October, all mutual 

fund firms are required to have a chief compliance officer and written policies and procedures for the first time. 

I think that that is one of the most significant steps the SEC has 

taken in terms of ensuring better compliance by mutual funds 

themselves. 

We then, as the GAO report notes, are responsible for making 

sure that those chief compliance officers are really doing their job; 

and if they are really doing their job in detecting and deterring violations of the law, I think we are all—we are all better served by 

that. 

In terms of—in terms of coordination, there are a number of ongoing initiatives between the SEC and the State regulators. And 

the picture is not as bleak as Secretary Galvin would maybe paint 

it. We have regular examination planning summits, regular meetings about enforcement topics. We worked very effectively with the 

State securities regulators, not only with respect to market timing 

and late trading, but before that with respect to analysts’ conflicts 

of interest. 

Those relationships, I think, grow and develop over time. And I 

think they are terribly important at a SEC regional office level and 

a State level that we ensure that we grow and improve those relationships on the ground. 

Ms. WASSERMAN SCHULTZ. Mr. Secretary. 

Mr. GALVIN. Well, as I mentioned earlier, I think in terms of legislation, there needs to be—and I would suggest that you might 

look at the act that passed in late 2003, for some issues that were 

raised there. Some of them have been addressed by rule-making, 

and I applaud the SEC for that. I do say there has been an improvement in the coordination. I know definitely in our, for instance, region in Massachusetts, there has been an improvement in 

cooperation; and I am pleased for that. 

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But I do think, again it gets back to understanding the vastness 

of the mutual fund industry. There is a definite attitude problem 

persisting in that industry, in my opinion, and I think there needs 

to be sufficient address of these issues, such as, how do we remedy 

problems that individual investors have, sales practices—which I 

know Ms. Richards referred to in her testimony, and I agree with 

her. It is a very important area; it is continuing to be a problem, 

I think. 

As we look at some of the relationships that funds have with 

suppliers of funds, as they treat their customers context, other 

interaction with other individual customers, what they offer them 

as a—the role of pension funds and how individual investors find 

themselves caught up with a particular fund, either by a company 

or union or whoever directs them in that way—the relationships of 

those that direct that business to the mutual funds have with the 

pension funds. Those are all issues that I think are appropriate for 

enforcement and review and perhaps for regulation. 

Ms. WASSERMAN SCHULTZ. The other issue that was fairly disturbing in my review of the problems that are going on now: Chairman Donaldson has obviously done an excellent job at taking some 

fairly aggressive steps in getting a handle on it, but it was pretty 

disturbing to learn that there really haven’t been any post-employment restrictions, the revolving door back and forth between SEC 

employees, former employees, going into the mutual fund industry, 

the industry that they had formerly regulated. And I just wonder 

what steps are being taken, because that was pretty disturbing. 

Ms. RICHARDS. Thank you for asking me that question. SEC examiners are absolutely prohibited from discussing employment during an ongoing examination. They are absolutely prohibited from 

doing that. There are obvious conflicts of interest in that process. 

We are making our process more formal. Once an examination 

has concluded and the examiner has determined to discuss employment outside the SEC with a firm that we regulate and has made 

a determination to go to that firm, the employee must, as part of 

a formal exit procedure, notify the supervisor where they intend to 

go to work. That supervisor will then conduct a thorough review of 

conflicts of interest, including asking, Did you, as an examiner, 

ever participate in an examination of that firm? This process is a 

more formal process than we have in place now. 

We certainly agree with the GAO that we can shore up our conflicts of interest procedures to make sure that there is no question 

that SEC examiners are acting without conflicts of interest or the 

appearance of a conflict of interest. 

Ms. WASSERMAN SCHULTZ. Thank you, Mr. Chairman. 

Mr. CANNON. The gentlelady’s time has expired. 

Without objection, the record will be kept open for 5 legislative 

days for follow-up questions to the witnesses. 

Without hearing objection, so ordered. 

Now, I am deeply intrigued by the fact that many of the issues 

we are dealing with today are not really partisan issues, they are 

issues of how we solve fundamental problems. I suppose you could 

make them partisan, but I think one of the things we hear today 

is an inquiry of where we ought to go as opposed to any partisan 

divide. 

74

I was deeply intrigued, Mr. Secretary, by your idea of needing 

more cops and more competition in enforcement and tying that to 

cosy relationships. 

You know, we all hope that people don’t get co-opted, but they 

actually do. And so the idea of having multiple agencies that see 

different things, hear different things, have different relationships 

with their citizens, seems to be really interesting. 

I was just asking the staff up here—we don’t think there is an 

interstate compact dealing with securities enforcement. Are you 

aware, Mr. Secretary? 

Mr. GALVIN. No, there is not a compact. We do have an association. Regulation at the State level varies in where it resides. In 12 

States, it resides in the office I hold, secretary of state, or the 

equivalent thereof. In a very few States, it resides with the attorney general’s office. In many States, it resides in the executive 

agency of the State and in some places corporate commissions. 

But there is an umbrella organization that we have of State securities administrators that is helpful as an exchange of information and to present our point of view, and also effectively, I think, 

to give our point of view to the SEC. But there is no individual 

compact. 

Cooperation among States, however, is high. In general, when 

matters occur in one State that appear to have roots in another, 

there is frequent communication between the States and among 

the States. 

Mr. CANNON. The jurisdiction of this Committee is over interstate compacts. In my earlier days, I worked in the Interior Department with the Office of Service Mining back in the very early days 

of the regulation of the coal mining industry and the reclamation 

process. And we ended up devolving regulatory authority to the 

States, and it worked remarkably well. 

As a matter of fact, I was handed a ‘‘60 Minutes’’ investigation 

when I walked in the door. And by the time it got to television it 

was actually an exoneration of the Reagan administration, which 

I thought was actually fairly remarkable. 

So over a long period of time, a person could become committed 

to the idea that we do a much better job, and that was the conclusion about the Office of Service Mining; that is, at the Federal level 

is very difficult to do the kind of regulation that you could do in 

the States. 

In that case, you had a geographic distribution. But here it 

seems to me that you also have a great deal of opportunity to improve the way you enforce and bring more resources to the enforcement if you organize and are given a Federal charter to do an 

interstate compact. 

Is that a matter of interest, do you think? 

Mr. GALVIN. It is interesting. I think we have to explore further 

exactly what we mean. 

But I definitely think as we go forward—and I note your comments, and I appreciate them about the bipartisan nature of the 

problem and about the future, because that is really what it is 

about. But I think, as we go forward, one of the things we will all 

confront is that, increasingly, for most people in the country their 

financial future is going to be more in the risk marketplace. 

75

Defined benefit pensions, I know in another part of the Capitol 

today there are hearings on those. Problems—we all know they are 

there—increase, and the individuals are going to find themselves 

navigating their own way through the marketplace. 

So therefore I think some means of communication amongst the 

States, some plans, some protocols, are certainly helpful. 

Now, there are different philosophies amongst the States; I must 

say that there are—as is to be expected. 

Mr. CANNON. It is a competitive market. That’s what we want actually. 

Mr. GALVIN. That’s good. That’s good. But I still think there are 

certain base things. I mean, fraud is fraud and misrepresentation 

is misrepresentation. So I think there is some benefit to looking 

into that. 

As I said, I think there is no question the SEC must be the primary rule maker for national policy. Must be. But on an enforcement basis on some of the problems that emerge and some of the 

new techniques, this is a very inventive industry, the securities industry. Many of us—we could collectively agree as regulators we 

could solve this problem, and indeed we may well have, but they 

will find a new way to do it. 

So they are very creative. So I think we have to be, as Ms. Richards was quoted as saying, over the hill, looking over the hill. And 

so I think perhaps more people looking at it on a State level might 

be a good thing. 

Mr. CANNON. Could I ask your insight on one other item? 

In my personal life I invested in what they call the Thrift Savings Plan, TSP. Here, locally, we have four options; and we have, 

I suspect—I have never actually followed up on this, but the group 

that actually looks at the performance of those funds, which means 

that both the SEC and the States have an additional reach—in 

other words, you have got a bunch of cops who are looking at that 

on behalf of me and the many other thousands of public employees, 

Federal employees, that invest. 

Is there a way that we can empower more people to get involved 

in funds or more fund managers who can coordinate with your activities at the State and Federal level—this is both for Ms. Richards and Mr. Galvin—so that we can increase the security of individual investors by having a private layer of people who watch 

funds? 

Mr. GALVIN. Well, I think that it’s touching a very important 

area and a growing area of concern, namely, the intermediaries 

that have control over directing individual employees’ fund investments. 

Not long ago I was invited to speak to an audience of local public 

pension managers in Massachusetts, and during the course of my 

remarks—in fact, it was during lunch; they were eating while I was 

speaking, which was all right with me. But during the course of the 

lunch, I went on to talk in a very tangential way about some of the 

problems with people taking free things from people they were investing with—free golf, free this, free that. Deadening silence. 

I don’t mean to suggest that they were all acknowledging some 

sort of misdeed, but I think it comes as a revelation to some of 

these folks, who are actually not professional investors—they might 

76

be just other employees or union leaders, something like that, that 

are empowered with this responsibility—that they really have to 

exercise a fiduciary duty. 

And that is really the fundamental part, whether we are talking 

about mutual fund management, or even pension management or 

whatever it is, the responsibility of getting the best deal you can 

for the people you are representing. 

So I think—in this area that you are referring to, I think that 

the States certainly could provide some additional benefit—many of 

these smaller investors are in more limited plans—not just the 

places that manage them, but perhaps where the decisions are 

made in an individual State. This is certainly an area where I 

think the States could be of assistance because of the vastness of 

the problem. 

Ms. RICHARDS. I think, Mr. Chairman, your question is very 

timely. Just 2 weeks ago the SEC released the results of an examination sweep of pension consultants. These are investment advisors who are relied on to be the experts to help pension plan administrators navigate amongst the many intermediaries out there 

trying to sell them services. 

What we found in those examinations was that about half of the 

pension consultants also received money from the mutual funds or 

the investment advisors that they also may have been recommending to the pension plans. These, we thought, were serious conflicts of interest which needed to be addressed by pension consultants. 

So I think your question is timely and right on point with some 

of the work that we have been doing in our risk-based examinations. 

Mr. CANNON. Thank you. 

Mr. WATT. Could the Chairman yield for just a sec? 

Mr. CANNON. Certainly. 

Mr. WATT. Is what you just described illegal? 

Ms. RICHARDS. Yes. Existing law under the Federal securities 

laws requires these firms to disclose material conflicts of interest. 

One of the most disturbing findings——

Mr. WATT. But is it illegal after they disclose it? I mean, can you 

take action against them? 

Ms. RICHARDS. If they don’t disclose these conflicts of interest, 

yes, sir. 

Mr. WATT. No, that’s not what I asked. I asked, is it illegal if 

they disclose it? Is it illegal? Can you take action against them? 

Ms. RICHARDS. No, sir. If they were disclosing it, it would be 

legal. What we found, however, was that they were not disclosing 

these conflicts of interest. 

Mr. WATT. And what is the penalty for nondisclosure? 

Ms. RICHARDS. We referred many of these firms to our Division 

of Enforcement, who is looking at these nondisclosures. 

We also made our findings public so that pension consultants, 

not just the firms we examined—there are 1,700 firms in this business—could look at our findings and make changes to make sure 

that they were disclosing these conflicts of interest. 

We think this is——

77

Mr. WATT. I guess the question I am asking is, does this Congress need to be making the law a brighter line standard or increasing the penalties? What do we need to be doing to help you 

all? 

I mean, you said you were outmanned, outgunned. Is it more personnel? Is it more staff? Is it a more enforceable law? What is it 

that we need to do? 

Ms. RICHARDS. I am not—I am not sure that it would be presumptuous of me to come to you with recommendations for this legislation. I think the securities laws adequately address this problem that I have just talked about. 

I think one of the things we are very much focused on at the 

SEC is using the resources we have in a more efficient, more productive and more nimble way. 

Mr. CANNON. The gentleman yields back. 

My time having expired, let me thank the panel for being here. 

Mr. DELAHUNT. Could I just ask a few follow-up——

Mr. CANNON. Very insightful. Would you like to be recognized? 

Mr. DELAHUNT. Yes, please. 

Mr. CANNON. The gentleman is recognized. 

Mr. DELAHUNT. Again, I want to concur with the sentiment you 

expressed. But I guess I am frustrated because, in summary, where 

the law seems to be adequate here, how come we missed so much 

up until 21 months ago? As you said, Chairman Donaldson is talking about looking around the horizon and around the curve. 

If we don’t somehow better coordinate, you know, between the 

States and the Federal Government—do you have like a shared 

data base, and do we have—as a former prosecutor that conducted 

a lot of white-collar investigations in conjunction with U.S. Attorney’s office and other Federal investigative agencies, we had a protocol which allowed for cross-designation. We had our own arrangement to do referrals, if you will. There was a constant sharing of 

information. 

Does that exist? 

Ms. RICHARDS. One of the findings of the GAO report is that with 

respect to market timing and late trading, we coordinated effectively with our colleagues at the State level, including with criminal prosecutors; and criminal prosecution of the Federal securities 

laws is a terribly important complement to what we do on the civil 

side. 

Mr. DELAHUNT. But that was missing up until 21 months ago. I 

mean, I just perused the GAO report, and one of the issues seems 

to be a lack of a consistent policy in terms of referral. 

Ms. RICHARDS. No, I think what the GAO found—and I won’t 

speak for Mr. Hillman—is that we could better document our referrals to criminal authorities, but the relationships, if you will, are 

ongoing and are informal and are active. 

Mr. DELAHUNT. See, my problem is informal. I have no doubt 

that you are an outstanding professional. And I concur with the 

good professor there in terms of the quality of people that are on 

the staff. But that changes, that waxes and wanes like anything. 

I guess I am looking for some sort of—whether it’s in the form 

of legislation, some other—maybe it’s by a compact of some sort 

among the States, whether it’s a formal mechanism, where this inVerDate 0ct 09 2002 13:44 Sep 06, 2005 Jkt 000000 PO 00000 Frm 00081 Fmt 6633 Sfmt 6601 G:\WORK\COMM\060705\21653.000 HJUD1 PsN: 21653
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1The memorandum of understanding was actually signed with the North American Securities 

Administrators Association (NASAA). 

formation moves around. Because there is no way that you are 

combined that—independently, that you have, even probably when 

you combine your resources—you can take on the kind of tasks that 

are an order of magnitude that clearly are enormous. 

You know, Secretary Galvin is right. You know, the era of the 

defined benefit, that is gone. We are not going to see pensions, you 

know, like my parents and others enjoyed in the 1950’s and 1960’s. 

People are going to be left to their own navigating the mutual fund 

industry and the securities industry just to survive. 

I mean, we are talking about Social Security reform. You know, 

that’s the end, if that happens, you know, that’s the end of the defined benefit plan. 

But, again, I guess my frustration is, I want to know, and I think 

the American people have a right to know, that there is some sort 

of formal mechanism that requires an information-sharing and resource-sharing between the States and the Federal Government. 

Ms. RICHARDS. Yes, sir. 

In 1997, the SEC signed a memorandum of understanding with 

the Association of State Securities Administrators (ASSA),1 that requires that we meet at least once a year on the national level and 

discuss emerging types of fraud, and more frequently on the local 

level. 

Mr. DELAHUNT. Good. You know, having a summit once a year—

I have been at a lot of summits, okay, and a lot of conferences. But 

I am talking about requiring, you know, agencies—and make it a 

2-way street that this becomes automatic on the—required and 

mandated by statute, as opposed to informal relationships that are 

obviously very important. 

Ms. RICHARDS. Yes, sir. 

Mr. DELAHUNT. However, that changes once, you know, Richards 

and Galvin are gone and Professor Eric and Hillman—I mean, then 

we have a whole new slate and maybe those relationships aren’t 

the same. 

Mr. CANNON. If the gentleman would yield, let me point out, this 

is a complex environment you are talking about. It would take a 

great deal to put together, but I would suspect that it makes an 

enormous amount of sense. 

I don’t want to interrupt you, Ms. Richards, you obviously had 

an answer. But I frankly think this is an interesting place to go. 

Ms. RICHARDS. I was just going to echo what you said, that this 

agreement between the SEC and the State securities regulators 

has been in place since 1997. And the whole purpose of it was to 

mandate these kinds of regular meetings, regardless of changes in 

staffing at the State or Federal level. 

There are regional examination planning summits that take 

place, I believe it is twice each year; and Secretary Galvin could 

talk about those, because I am sure he has participated in those 

along with our staff in the Boston office. 

But the whole goal was to make sure that there is that kind of 

mandated meeting and sharing of information and strategy planning about how we can use our resources. 

79

Mr. DELAHUNT. Right, and I am sure that is very positive. And 

I am sure the Secretary and the other panelists would agree. 

But I guess what I am saying is, I want more than an MOU, 

okay? I mean, I am coming from a different angle. Because I know, 

when I was the district attorney up in the metropolitan Boston 

area, I had MOUs. I had no idea whether my successor has, in 

those agencies that we had memoranda of understanding with, you 

know, complied with it today. You know, it’s probably gone the way 

of—of—— Mr. WATT. Of Bill Delahunt. 

Mr. DELAHUNT.—of Bill Delahunt, exactly. 

Mr. CANNON. The gentleman yields back. 

Again, let me thank the members of the panel and the Committee for your time. And we stand adjourned. 

[Whereupon, at 5:26 p.m., the Subcommittee was adjourned.] 

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A P P E N D I X 

MATERIAL SUBMITTED FOR THE HEARING RECORD

PREPARED STATEMENT OF THE HONORABLE CHRIS CANNON, A REPRESENTATIVE IN

CONGRESS FROM THE STATE OF UTAH, AND CHAIRMAN, SUBCOMMITTEE ON COMMERCIAL AND ADMINISTRATIVE LAW

In the fall of 2003, the New York State Attorney announced what would become 

the first of many law enforcement initiatives that his office, other state officials, and 

the SEC would later champion to ferret out mutual fund trading abuses. Within the 

ensuing months, many well-respected mutual fund companies and others were 

caught up in this scandal, including Canary Capital, Janus Capital Group, Bank of 

America, Alliance Capital Management, Prudential Securities, Millennium Partners, 

Fred Alger Management, Putnam Investments, Massachusetts Financial Services, 

Security Trust, Franklin Resources, and Invesco Funds Group. 

In the fall and winter of 2003, it seemed as if every day the press reported on 

yet another shocking instance of mutual fund trading abuses. These abuses included 

the illegal practice of late trading, which involves trading shares after the markets 

have closed so that the trader can take advantage of information that becomes 

available after the closing. The Congressional Research Service analogized this practice to ‘‘a racetrack that allows certain customers to bet on yesterday’s races.’’

Other abuses included the more nuanced problem of market timing. Market timing typically involves frequent buying and selling of mutual fund shares by sophisticated investors, such as hedge funds, that seek opportunities to make profits on the 

differences between foreign and domestic markets. 

While not per se illegal, market timing can constitute illegal conduct if, for example, it takes place as a result of undisclosed agreements between investment advisers and favored customers in contravention of stated fund trading limits. Frequent 

trading can harm mutual fund shareholders because it lowers fund returns and increases transaction costs. 

According to an estimate prepared by one of the witnesses at today’s hearing, Professor Zitzewitz, market timing abuses may have resulted in $5 billion in annual 

losses. As of November 2003, the SEC estimated that 50 percent of the 80 largest 

mutual fund companies had entered into undisclosed arrangements permitting certain shareholders to engage in market timing practices that were inconsistent with 

the funds’ policies, prospectus disclosures, or fiduciary obligations. 

As the mutual fund scandal unfolded, questions were raised about the fitness of 

the SEC’s overall regulation, inspection, and enforcement of this industry. The Congressional Research Service posed possible explanations, including the following:

• The possibility that SEC’s resources devoted to the fund industry were 

dwarfed by the expansion in the number of mutual funds.

• The possibility that the SEC’s overall effectiveness may have been marred by 

inter-divisional disharmonies.

• The possibility that SEC officials may have placed too much trust in the fund 

industry’s integrity and ability to police itself.

• The possibility that the mutual fund industry may be ‘‘too close’’ to the relevant parts of the SEC entrusted with its oversight and regulation.

• The possibility that the SEC may have had a somewhat understandable focus 

on the prevention of more traditional types of fund misconduct.

In response to these concerns, House Judiciary Committee Chairman Sensenbrenner and Ranking Member Conyers requested the GAO to undertake a comprehensive review of the SEC’s efforts to proactively detect and prevent illegal activities in the mutual fund industry. 

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Today’s hearing provides an opportunity for the GAO to report on its findings and 

recommendations and to allow the SEC and others to respond to them.

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OF COMPLIANCE INSPECTIONS AND EXAMINATIONS, U.S. SECURITIES AND EXCHANGE

COMMISSION


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