SEC Operations: Oversight of Mutual Fund Industry Presents Management Challenges
Published: 2004-04-20T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: Having grown to over $7.5 trillion in assets, mutual funds have become vital components of the financial security of more than 95 million American investors. However, in 2003, various allegations of misconduct and abusive practices involving mutual funds came to light. Therefore, ensuring that the Securities and Exchange Commission (SEC), which has primary oversight of the mutual fund industry, has the necessary resources and strategic focus to adequately oversee fund practices has never been more important. To assess how SEC is positioned to oversee mutual funds, GAO reviewed (1) how the abusive mutual fund practices were identified and SEC's subsequent responses, (2) SEC's plans for increasing its staffing in the divisions and offices responsible for overseeing mutual funds and its progress in developing a new strategic plan to guide staff deployment, and (3) the challenges SEC faces in overseeing the mutual fund industry.
section_title: What GAO Found
paragraphs: In late 2003, state law enforcement authorities were the first to bring to light various abusive practices in the mutual fund industry. SEC did not identify these practices because detecting fraud in routine examinations is difficult and it has been challenged to keep pace with the rapid growth of the mutual fund industry using its existing resources. However, since the abuses were identified SEC has acted vigorously to address these inappropriate practices, including taking various enforcement actions to punish wrongdoers and issuing numerous rule proposals designed to better prevent or detect abusive practices in the future. After years during which its workload grew faster than its resources, SEC recently received budget increases that have allowed it to significantly increase its staffing. SEC also plans to significantly increase the numbers of staff that oversee mutual funds. However, SEC made these allocation decisions without the benefit of an updated and complete strategic plan, which it is preparing but has yet to finalize. As a result, GAO was unable to determine whether SEC has optimally allocated its limited resources to achieve the greatest benefits. Although it has received additional resources in recent years, SEC faces a number of agencywide challenges impacting its mission and ability to oversee the mutual fund industry. These include improving its ability to better anticipate and detect problems in the industry and identifying and obtaining all the staff it needs to achieve its mission. SEC has experienced difficulty in effectively implementing various agencywide information technology initiatives, such as an electronic document imaging system and projects needed by units responsible for mutual funds. SEC also has various gaps in its authority that impede its ability to gather information, cooperate with other law enforcement authorities, and collect monies owed by violators.

section_title: Letter
paragraphs: I am pleased to be here today to discuss the Securities and Exchange  Commission’s (SEC) ongoing strategic planning efforts and the challenges  that it is facing to proactively oversee our nation’s mutual fund industry. In  the last 20 years, mutual funds have grown from under $400 billion to over  $7.5 trillion in assets and have become vital components of the financial  security of the more than 95 million American investors estimated to own  them. These funds have also grown to represent a significant portion of  the nation’s retirement wealth with 21 percent of the more than $10 trillion  in pension plan assets now invested in mutual funds. However, various  allegations of misconduct and abusive practices involving mutual funds  have recently come to light. As a result, ensuring that SEC has the  necessary resources and strategic focus to adequately oversee our nation’s  mutual fund industry has never been more important.
Today, I will discuss our work examining how well SEC is positioned to  effectively oversee the mutual fund industry. Specifically, I will discuss (1)  how the abusive practices involving mutual funds came to light and SEC’s  subsequent responses, (2) SEC’s plans for increasing its staffing in the  divisions and offices responsible for overseeing mutual funds and its  progress in developing a new strategic plan to guide staff deployment, and  (3) challenges that may be affecting SEC’s ability to effectively oversee the  mutual fund industry. In preparing this testimony, we summarized  perspectives gained from our recent series of reports and testimonies on  practices in the mutual fund industry. In addition, we also relied on  information gathered from our previous and ongoing work involving SEC’s  resources and strategic planning efforts. We also met with SEC officials to  discuss the status of their strategic planning efforts, including their plans  to oversee the mutual fund industry. Finally, we reviewed SEC budget- related documents for fiscal years 2003 and 2004, and its 2005 budget  request. We conducted our work from March to April 2004 in accordance  with generally accepted government auditing standards.
In summary, in late 2003 state authorities were the first to bring a case  after being alerted to various abusive practices in the mutual fund  industry. Although SEC is the organization primarily responsible for  oversight of the mutual fund industry, it did not identify these abusive  practices because of the difficulty of detecting fraud, the lack of focus on  the trading of fund shares in its examinations, and the challenges it faces  in overseeing a growing industry using its existing resources. However,  since the abuses came to light, SEC has taken various enforcement actions  and issued numerous rule proposals designed to punish wrongdoers and  better prevent or detect abusive practices in the future.
After years in which its workload grew faster than its resources, SEC  recently received budget increases that have allowed it to significantly  increase its staffing, including expanding the staff in the divisions and  offices with mutual fund oversight responsibilities. However, SEC made  these allocation decisions without the benefit of an updated and complete  strategic plan. As a result, we are unable to determine whether SEC has  optimally allocated its limited resources to achieve the greatest benefits.
In addition, SEC continues to face a number of challenges in improving  and maintaining an effective mutual fund oversight structure, including  improving its ability to better anticipate and detect problems in the  industry and hiring all the staff it intends to bring on board in the coming  years. In trying to improve its oversight effectiveness, SEC is also  challenged to obtain and make effective use of information technology and  faces various gaps in its authority that impede its ability to gather  information, cooperate with other law enforcement authorities, and  collect the monies owed by violators.
subsections: section_title: State Authorities Were First to Uncover Mutual Fund Trading Abuses but SEC Has Since Acted Swiftly to Address Problems
paragraphs: State authorities uncovered various abusive practices in the mutual fund  industry in 2003, but since then SEC has taken swift action designed to  punish wrongdoers and better prevent or detect abusive practices in the  future. In September 2003, the Attorney General of the State of New York  filed a case alleging abusive practices involving mutual funds. After  receiving a tip, the Attorney General’s staff investigated and filed fraud  charges against a hedge fund manager for arranging with several mutual  fund companies to improperly trade in fund shares and profit at the  expense of other fund shareholders.  The abuses in this case, and in  others subsequently filed, included allegations of late trading and market  timing. Late trading occurs when investors are able to illegally purchase or  sell mutual fund shares after the 4:00 p.m. Eastern Time close of U.S.  securities markets, when funds typically price their shares. Market timing  occurs when certain fund investors place orders to take advantage of  temporary disparities between the share value of a fund and the values of  the underlying assets in the fund’s portfolio. Although not illegal, most  mutual funds discourage such trading because it increases their costs and  lowers returns for their long-term investors.  These inappropriate market  timing cases generally involved either fund companies with stated policies  against such trading that were facilitating market timing for selected  investors or broker-dealers or others that took deceptive actions to assist  their customers to conduct market timing transactions.
Since this case was filed, the New York State Attorney General’s Office has  filed at least 10 additional cases involving mutual funds, broker-dealers,  and other entities that were involved in late trading or market timing  abuses. As of March 2004, state legal or regulatory authorities in at least  three other states, including Massachusetts (3 cases), New Jersey (1 case),  and Colorado (1 case) have taken actions against participants in the  mutual fund industry for their involvement in late trading, market timing,  or other abuses. Some of these cases also allegedly involved mutual fund  executives or employees who were conducting market-timing activities in  their own firms’ funds.
SEC did not identify these abusive practices involving mutual funds for  various reasons. According to SEC staff, many of the cases involved fraud  and collusion among personnel and such activity is very hard to detect in a  routine examination. Also, according to testimony by the head of the SEC  office that conducts mutual fund examinations, SEC examiners did not  reveal these practices because their examinations focused primarily on the  operations of the mutual fund and trading of the fund’s portfolio securities  practices with an acknowledged potential for abuse. As a result, their  examinations did not generally address the trading in the fund’s own  shares. SEC has also faced resource challenges for years that have  affected its ability to conduct oversight in the mutual fund industry and  other areas. For example, we reported on SEC’s difficulties during the  1990s to keep pace with the growth in the industry and its inability to  examine funds and investment advisers frequently. In recent testimony,  the director of the SEC office that conducts examinations noted that, prior  to 1998, SEC examinations of mutual fund firms had been as infrequent as  once every 12-24 years. Scarce resources may have also affected SEC’s  decision to, unfortunately, not follow up on information it obtained  regarding the recent wrongdoing in the mutual fund industry. In the  summer of 2003, SEC staff had received a tip from a former fund employee  who was aware of how his former employer was accommodating market  timing by some investors, but SEC staff ultimately chose not to use further  resources to pursue this case. The former fund employee then reported the  matter to the Massachusetts Securities Division, which subsequently took  action against the firm’s executives. As a result of another tip, however,  the SEC staff promptly recommended and brought an enforcement action  against the fund complex and two portfolio managers based on market  timing and excessive short-term trading by investment professionals  employed by the fund complex.
However since these abuses have come to light, SEC and NASD, which  oversees the broker-dealers that sell fund shares, have acted vigorously to  address inappropriate practices in the mutual fund industry. For example,  SEC has sent numerous requests for information to funds and broker- dealers about their trading practices. SEC’s preliminary analysis of these  data show that 25 percent of responding broker-dealers had accepted  orders after the 4:00 p.m. close and 30 percent allowed market timing.  Since September 2003, SEC also has taken 15 enforcement actions that  involved late trading and inappropriate market timing, in many cases  against some of the same participants also pursued by state authorities. As  of March 2004, NASD has also brought multiple enforcement cases against  broker-dealers, including a February 2004 case against one of its broker- dealer members that failed to prevent market timing occurring in one of its  affiliated firm’s mutual funds.
SEC and NASD also have issued at least 11 rule proposals to address  abusive and other practices in the mutual fund industry. For example, to  address late trading and market timing, SEC issued proposed rule changes  that would require orders for mutual fund shares to be processed by  intermediaries and received by funds or their agents by 4:00 p.m. SEC is  also proposing a rule that would require that funds charge investors  holding fund shares less than 5 days a 2-percent redemption fee, which  would reduce the likely profitability of short-term trading strategies  involving late trading or market timing. SEC also proposed that funds  disclose information about their policies regarding market timing and their  use of a pricing technique called fair-value pricing, which is designed to  better ensure that fund shares are priced accurately and thus are less  susceptible to market timing. SEC’s Commissioners approved these rules  on April 13, 2004.
In addition to issuing proposals to address late trading and market timing,  SEC has also taken some actions that address longstanding concerns over  other mutual fund practices, including the lack of transparency of some  fees and costs and the potential for conflicts of interest in fund  distribution and sales practices. Some of the actions SEC and NASD are  proposing would require greater disclosure of fees that funds charge or the  payments that broker-dealers receive from fund firms for marketing  certain funds. We discussed these and the late trading and market timing  proposals and our views on them in testimony for the Senate Committee  on Banking, Housing and Urban Affairs on March 10, 2004.
Although SEC and the other regulators have acted swiftly to respond to  the revelations of abusive mutual fund trading practices, other issues  warrant SEC’s continued attention. For example, SEC is seeking  information on how fund advisers use investors’ dollars to obtain research.  This practice, called soft dollars, involves fund advisers receiving research  or other services from broker-dealers in exchange for the commissions the  advisers pay on trades conducted in fund portfolio securities. Although  this practice can benefit the fund’s investors, whose assets are used to pay  these commissions, it can also create conflicts of interest or potential for  abuse. Given the increased spotlight Congress and regulators are placing  on the mutual fund industry, in our view, the time is right to address the  conflicts created by soft-dollar arrangements. In addition, we have  identified other actions that SEC should take that would improve  disclosure of mutual fund fees, thus improving investor awareness of the  fees they pay on their mutual fund investments. These actions would  increase the transparency of fund fees and likely enhance competition  among funds on the basis of the fees charged investors.
section_title: SEC Has Increased Resource Allocations Without the Benefit of An Updated Strategic Plan
paragraphs: After experiencing an extended period in which increases in SEC’s  workload grew faster than its staffing and other resources, SEC has  received recent budget increases that have begun to allow it to increase its  staffing, including positions in the divisions and offices with  responsibilities for mutual fund regulation, oversight, and enforcement.  However, SEC has taken these actions without the benefit of an updated  strategic plan to guide staff deployment and the divisions and offices with  responsibilities for mutual funds followed varying processes to determine  their staffing needs. As a result, it is difficult to determine whether SEC  has optimally allocated its limited resources to achieve the greatest  benefits.
subsections: section_title: Additional Resources SEC Receives to Address Workload Imbalances Will Also Benefit Mutual Fund Oversight
paragraphs: After years of facing imbalances in its workload, SEC recently received  additional resources that can help it more effectively oversee the  securities markets, including the mutual fund industry. In March 2002, we  reported that the growth rate of demands on SEC’s staff, including the  number of corporate and regulatory filings they must review, the  complaints and allegations of wrongdoing they must investigate, and the  numbers of mutual funds, investment advisers and other entities they must  examine, had increased by about 60 percent from 1996 to 2000. The rapid  growth of the mutual fund industry during this time also posed challenges  to SEC’s staff. For example, the number of mutual funds in existence grew  from about 4,500 at the end of 1993 to over 8,100 by the end of 2000. In  addition, the issues that SEC staff had to address had also become more  complex. However, SEC’s staff resources during this period remained  relatively flat. As a result, SEC’s ability to fulfill its mission had become  increasingly strained because of the imbalance between its workload and  staffing resources.
Following the issuance of our March 2002 report, several high-profile  corporate failures and accounting scandals came to light in 2002. In  response to the resulting demands that public companies be held more  accountable for information they report to investors, Congress passed the  Sarbanes-Oxley Act of 2002 (Sarbanes-Oxley). The act, which addressed a  number of concerns involving corporate governance, auditor  independence, and regulation and oversight of the accounting profession,  also provided additional resources to SEC. Subsequently, Congress  appropriated $716 million for SEC in 2003, an increase of 45 percent over  its fiscal year 2002 budget. SEC was directed to use this increase both to  add personnel and acquire new information technology to increase its  effectiveness. The new personnel were expected to assist SEC in  addressing its workload imbalance and to help it conduct the additional  reviews of corporate filings mandated by the act. In recognition of the  important role SEC plays in ensuring the integrity of U.S. securities  markets, it has continued to receive additional budgetary resources since  then with an appropriation for 2004 of $811.5 million and a requested  budget of $913 million for 2005.
In addition to addressing other needs with these additional resources, SEC  has also been able to respond to the mutual fund scandals by increasing  the staff allocated to the three primary divisions and offices within the  agency responsible for mutual fund regulation, oversight, and  enforcement. Within SEC, the Division of Investment Management is  responsible for creating rules and reviewing filings for mutual funds and  investment advisers. Staff in SEC’s Office of Compliance Inspections and  Examinations (OCIE) conducts examinations and inspections of mutual  funds companies and investment advisers. Finally, staff in SEC’s Division  of Enforcement investigate possible violations of securities laws, including  the Investment Company Act of 1940 and the Investment Advisers Act of  1940, and pursue legal actions against violators.
To address the mutual fund scandals, SEC has plans to substantially  increase the staffing in the units responsible for mutual fund oversight. As  shown in table 1, between 2002 and 2005, SEC plans to increase the  staffing for OCIE and the Division of Enforcement by 46 and 30 percent,  respectively. SEC also plans to increase the staffing within the Division of  Investment Management by 16 percent. SEC staff told us that many of the  new personnel will be working on mutual fund issues.
The units responsible for mutual fund oversight benefited from the  additional staff they received. For example, OCIE staff said that with the  added resources they received in 2003, they were able to begin conducting  additional examinations that they hoped would allow them to increase the  frequency of the reviews they conduct of the largest fund companies as  well as those that pose the greatest compliance risks to as often as every 2  years. OCIE staff said that additional positions requested for 2005 would  be used to expand its examination program in the SEC regional offices.
SEC’s Chairman also recently testified that he has asked the staff to  prepare a rule proposal that would require managers to hedge funds to  register with SEC and submit to examinations. OCIE staff said that some  of the additional staff SEC requested for 2005 could likely be used to assist  with those efforts.
SEC’s Enforcement Division has also been able to devote more resources  to mutual fund cases. After filing less than 10 cases involving mutual funds  in 2003, Enforcement Division staff told us that they had already filed 18  cases involving funds as of March 2004 and currently had about 20 percent  of their staff pursuing mutual fund-related matters.
Division of Investment Management officials told us that the 2003 budget  increase allowed them to hire additional accountants to review investment  company financial statements, as mandated by Sarbanes-Oxley. The  officials said that additional resources obtained in 2004 and requested for  2005 will enable the division to increase its reviews of funds’ financial  statements from 1,134 in 2003, which represents about 10 percent of funds,  to 4,800 in 2004, or about 40 percent of all funds.
section_title: SEC Allocated Resources Absent a Current Strategic Plan
paragraphs: Although SEC has directed increased resources to oversee mutual funds,  these allocation decisions were made without the benefit of an updated  strategic plan; thus, it is difficult to determine the extent to which these  increases reflect the optimal use of SEC’s limited resources. According to  GAO guidance on effectively developing and implementing strategic plans,  leading organizations recognize that their activities, core processes, and  resources must be aligned to support their missions and help them achieve  their goals. To achieve this, leading organizations articulate a well- defined mission in their overall strategic plan that forms the foundation for  the key business systems and processes they use to ensure the successful  outcome of their operations. By aligning activities to support mission- related goals, the organizations are also better able to link the levels of  funding for their activities and anticipated results. As a complement to the  strategic plan, organizations should also determine the specific staff  competencies needed to fulfill their mission and develop a human capital  plan that addresses how they will acquire, develop, and retain the  employees they need.
SEC is in the process of updating its strategic plan but as of April 13, 2004,  had not completed this process. Under the Government Performance and  Results Act, federal agencies are required to prepare strategic plans that  address how they will fulfill their mission over the next 5 years. These  strategic plans are required to be updated to reflect current circumstances  every 3 years. Since SEC’s last plan was prepared in 2000, significant  changes in the securities markets and its budgetary resources have  occurred. SEC was slated to complete its latest update by September 30,  2003. According to SEC staff, a draft summary of the agency’s plan was  present to the SEC Chairman in October 2003 but he directed staff to start  fresh and not rely on the previous strategic plan. As of April 2004, SEC  staff told us that the latest draft of the plan was awaiting approval by the  Office of the Chairman and would need to be approved by the other SEC  Commissioners.
In recent years, SEC has taken various steps to determine its resource  allocations but has done so without an updated strategic plan to guide  these decisions. As we reported in 2002, SEC traditionally had not  reviewed its staffing and resources in terms of its overall strategic plan.  Instead, it generally developed its annual budget request, including  requests for additional staff positions, by basing the request on its previous  year’s appropriation, rather than on the level of resources it actually may  need to fulfill its mission.
Although lacking an updated strategic plan, SEC did use an internal study  of its operations to guide resource decisions for 2003. The large budget  increase resulting from Sarbanes-Oxley provided SEC with an additional  842 positions for fiscal year 2003. To allocate these positions across its  various units, SEC drew upon an internal study that analyzed its  operations, including workload, resource allocations, methods for  assigning and managing work, and measures of performance, productivity,  and quality of effort. Each SEC division and office also had to provide the  SEC Chairman with details of what would be accomplished if additional  resources were provided.
To allocate the positions included in the 2004 budget, the various units  with responsibility for mutual fund oversight took varying steps to  determine their staffing needs. Staff in the Enforcement and Investment  Management divisions told us their managers were required to consider  priorities and goals for the coming year and then estimate the number of  staff needed to complete the activities associated with those goals. Staff in  these divisions told us that determining those numbers was difficult  because the amount of time required to complete the activities they  perform, such as developing rules or investigating cases, can vary widely.  In the case of the Enforcement Division, their resulting staffing allocation  reflected an estimate of what they believed they could obtain rather than  the amount of staff required to investigate all matters they might receive.  Moreover, staff told us that it was not possible to determine how much  fraud existed within the securities markets and therefore it was difficult to  determine what level of resources realistically were needed to ensure  enforcement of the federal securities laws. OCIE staff, in contrast, told us  that they were better able to estimate workload measures, including the  number and types of examinations to be completed and the amount of  time required to complete them, in order to determine the number of staff  they needed.
In the absence of a complete and updated strategic plan that identifies its  key mission-related goals, we were unable to determine whether SEC’s  recent allocation decisions made the best possible use of its resources. In  making these decisions, SEC has obviously increased staffing in key areas,  including providing additional resources to develop rules, examine  participants, and pursue enforcement actions against abusive practices in  the mutual fund industry. However, without a complete and current  strategic plan that outlines the agency’s priorities, the agency lacks a key  guide for ensuring that it is deploying its resources across these areas in  the most efficient way to achieve the most effective outcomes.
section_title: Some Progress Made in Human Capital Management and Performance Measurement
paragraphs: Although SEC has yet to complete updated strategic and human capital  plans, it has made some progress in addressing strategic human capital  management and measuring its performance. For example, it has taken  steps to improve its recruiting and hiring processes and has implemented  an agencywide training program to increase its overall staff competency.  Recognizing that retention of staff is important to achieving its mission,  SEC has negotiated an agreement with its new employee union that  includes various “worklife” programs such as flextime, flexiplace, and  tuition reimbursement as a means for increasing morale and job  satisfaction.
SEC also has made progress in developing performance measures that are  part of an overall strategic planning framework. To track the performance  of its various units, SEC staff recently developed various measures of the  activities undertaken within their units that they are calling the  “performance dashboard.” Although still undergoing revision, these appear  to contain key measures of performance for each program area within  SEC. SEC staff acknowledged that many of the measures are still output- oriented, but they will likely be useful for improving SEC’s effectiveness.  For example, Division of Investment Management staff told us that after  seeing the “dashboard” reports, they made changes to their procedures  that helped them reduce the number of applications for exemptions that  were pending for 12 months or more by almost 30 percent. While the  development of the dashboard report is promising, we are concerned that  creating performance measures before the latest version of the agency’s  strategic plan is complete may mean that SEC will have to replace some  measures with others to be consistent with its newly defined strategic  vision.
section_title: SEC Faces Agencywide Challenges That Also Affect Mutual Fund Oversight
paragraphs: Although it has received additional resources in recent years, SEC still  faces a number of agencywide challenges impacting its mission and its  ability to oversee the mutual fund industry. These challenges include  improving its ability to head off major problems before they occur by  better anticipating and detecting abuses in the securities industry. SEC  also faces challenges in hiring and retaining all the staff it needs to achieve  its mission as demands on staff continue to grow. Moreover, SEC has  experienced difficulties in obtaining the information technology it needs to  effectively oversee the mutual funds industry. Finally, SEC faces  challenges in overcoming impediments to its ability to gather information,  cooperate with other law enforcement authorities, and collect monies  owed. Overall, SEC must effectively address these challenges to  successfully restore and, in the long-run, maintain investor confidence in  our securities markets.
subsections: section_title: Timely Anticipation and Identification of Problems Is a Challenge
paragraphs: One of the challenges SEC faces is being able to anticipate potential  problems and identify the extent to which they exist. Historically, limited  resources have forced the SEC to be largely reactive, focusing on the most  critical events of the day. In this mode, the agency lacked the institutional  structure and capability to systematically anticipate risks and align  agencywide resources against those risks. In an environment such as this,  it is perhaps not surprising that SEC was not able to identify the  widespread misconduct and trading abuses in the mutual fund industry.  Increasing SEC’s effectiveness would require it to become more proactive  by thinking strategically, identifying and prioritizing emerging issues, and  marshalling resources from across the organization to answer its most  pressing needs.
To improve its ability to better anticipate, identify, and manage emerging  risks and market trends that stand to threaten SEC’s ability to fulfill its  mission, SEC is implementing a centralized risk assessment function  within the agency. According to SEC’s Chairman, this function will be  housed in SEC’s newly created Office of Risk Assessment and Strategic  Planning, whose duties include:    gathering and maintaining data on new trends and risks from external  experts, domestic and foreign agencies, surveys, focus groups, and other  market data;   analyzing data to identify and assess new areas of concern across  professions, companies, industries, and markets; and   preparing assessments and forecasts on the agency’s risk environment.
According to statements by SEC’s Chairman, the yet-unstaffed office will  work in coordination with staff assigned to conduct risk assessment  activities from each division and a Risk Management Committee  responsible for reviewing implications of identified risks and  recommending an appropriate course of action. The new office is also  intended to foster better communication and coordination between  divisions and offices within the Commission.
SEC staff in the units with responsibility for mutual funds told us they  have begun activities to identify emerging risks within their areas. For  example, OCIE officials said that examiners have begun efforts to identify  what they believe to be the key risks in their ongoing examinations. With  this information, OCIE officials hope to develop a formalized process in  which this information would flow up through the office and into the risk  assessment office. Similarly, according to Division of Enforcement  officials, the division has reorganized staff in its Office of Chief Counsel by  functional lines rather than by geographical location. The functional lines  include investment adviser and mutual funds, broker-dealers and markets,  and corporate accounting. The intent of this reorganization is to increase  the staff’s subject matter expertise and better detect emerging issues.  Enforcement officials said they have already hired experts in the first two  lines to further increase the division’s expertise and assist in the  agencywide risk analysis project, and have plans to hire a corporate  accounting expert soon.
section_title: Filling New Positions and Existing Vacancies May Not Address All Needs
paragraphs: SEC continues to face agencywide challenges in hiring and retaining  sufficient numbers of quality staff to achieve its mission. With the  additional staff positions authorized in 2003 and vacancies and attrition in  existing positions, SEC staff indicated that they were faced with hiring  over 1,280 people in the last 1 ½ years. Although it has made considerable  progress in filling these positions, SEC’s Chairman stated in his recent  testimony to a House Appropriations subcommittee that SEC still expects  to have as many as 425 vacancies by May 2004, which is equal to an   11 percent agencywide vacancy rate. According to the Chairman’s  statement, about 150 of these vacancies are attorney positions, 120 are  accountant positions, and 60 are examiner positions. In addition, by the  end of 2005, SEC hopes to receive funding to hire an additional 106 staff,  which SEC intends to use to, among other things, further enhance its  oversight of mutual funds and to address its market structure reform  initiatives.
As we reported to you in July 2003, the competitive service hiring  requirements with which SEC was required to comply to hire staff  involved the completion of various lengthy processes, such as ranking  candidates by position, before filling a vacancy. According to SEC staff,  the considerable time required to complete these processes hampered the  agency’s ability to meet its hiring goals. As a result, the agency asked for  and received relief from these requirements under the Accountant,  Compliance and Enforcement Staffing Act of 2003, enacted in July 2003  and intended to enable SEC to expedite the hiring of accountants,  economists, and examiners. SEC staff told us that bypassing competitive  processes has helped them hire individuals for such positions more  quickly. In recent testimony, SEC’s Chairman noted that the number of  vacant positions would have been much higher without this legislation.
In addition, acting under recently granted compensation authority, SEC  also implemented a new compensation system, which established a pay  structure more comparable to other federal financial regulators. SEC  officials stated that the new hiring and compensation authority, along with  current economic conditions, has improved the hiring and retention of  staff. For example, according to SEC staff, since 2001 the agency’s  turnover rate dropped from approximately 8 percent in fiscal year 2001 to  1.2 percent in fiscal year 2002 and 1.5 percent in fiscal year 2003.  Previously turnover had been as high as almost 14 percent.
The units responsible for mutual fund oversight generally have been  making progress in meeting their goals for hiring additional staff, but  demands on their staff continue to grow. SEC’s Investment Management  Division is attempting to reach a staffing level of 190 positions by the end  of fiscal year 2004. According to division staff, at midyear they had about  175 staff on board. Of the remaining 15 vacancies, 5 are staff that are  designated for public utility holding company oversight. Staff from the  Enforcement program, which is attempting to reach 1,248 positions by the  end of fiscal year 2004, had about 1,070 on board as of April 2004.  However, staff from both these divisions told us that they have had  difficulty in recruiting accountants due to competition from the private  sector as well as the Public Company Accounting Oversight Board, which  they said is able to pay much higher salaries.
Although OCIE has had some success in hiring additional examiners, the  revelations of the widespread abuses in the industry has also resulted in  an expansion of its workload. OCIE staff told us that in trying to reach  their mutual fund-related staffing goals for the end of fiscal year 2004, only  about 3 percent of their positions were vacant as of March 2004, primarily  as a result of attrition. However, OCIE staff also told us that as a result of  the mutual fund abuses, examiners will be conducting more  comprehensive examinations and more targeted mini-sweeps, which are  focused examinations that deal with just a single issue across a number of  firms. For example, to aid in detecting any misconduct that might not  otherwise be reflected in the books and records kept by a firm and shown  to examiners, OCIE staff said that their routine examinations would now  include a review of a sample of fund executives’ internal e-mail  communications. Other new examination steps OCIE said they were  implementing include reviewing personal trading records that show fund  executives trading in their funds’ shares and reviews of procedures to  ensure that fund share orders are processed to receive the appropriate  day’s net asset value, including firms’ procedures governing order receipt  time and order time stamping.
Given these additional activities, OCIE staff said that the time required to  complete an examination has increased dramatically and threatens their  ability to meet the newly established goals for increased examination  frequency. With the additional resources added to the examination  program in 2003, SEC was able to increase examination frequency of the  largest fund firms and of those posing the greatest compliance risk from  once every 5 years to once every 2 years. As noted previously, SEC’s  examinations of some mutual fund companies had been as infrequent as  once every 12-24 years during the 1990s. OCIE staff said that they are  currently considering ways in which they could save time as well as  maximize coverage of the industry, but they are not yet in a position to  provide assurances that they have sufficient resources to both increase the  frequency of examinations and conduct more in-depth reviews and mini- sweeps at their currently projected resource levels.
Staff in both OCIE and the Investment Management Division also told us  that they will face additional demands on their time in the event that SEC  requires hedge fund advisers to register with the agency, which SEC’s  Chairman has publicly stated he intends to propose. Potentially SEC staff  might have to conduct additional regulatory filing reviews and  examinations. The amount of additional effort required to oversee hedge  fund advisers is not currently known, but Investment Management staff  told us that they estimate that between 600 and 1,100 additional advisers  would be required to register with SEC.
section_title: Obtaining and Effectively Using Information Technology Also a Challenge
paragraphs: Having traditionally lacked sufficient funding for information technology,  SEC is in the process of implementing various agencywide initiatives, and  the units responsible for mutual funds also have identified projects that  could further improve their efficiency. Like the rest of the government,  SEC’s needs in the area of information technology continue to increase,  but SEC recently received authorizations for additional funding to address  its needs. As we reported in July 2003, SEC’s fiscal year 2003 information  technology budget increased more than 100 percent, from around $44  million to $100 million, which allowed SEC to begin funding a number of  agencywide, long-term technology projects. Many of these major initiatives  are still in process. These projects include  Implementing a document management and imaging initiative, intended to  eventually eliminate paper documents and allow SEC staff to review and  electronically file the large volumes of information that are part of  litigation, examination, and enforcement activities. Staff told us that the  planned system will provide an agencywide electronic capture, search, and  retrieval mechanism for all investigative and examination materials.
Converting SEC’s Electronic Data Gathering Analysis and Retrieval  (EDGAR) system into a searchable database that would help SEC conduct  various types of industry and trend analyses. EDGAR is the database  system that public companies use to file registration statements, periodic  reports, and other forms electronically. Currently, EDGAR receives and  archives data, but staff cannot immediately and easily analyze it. The goal  is to create filings that will allow anyone to extract relevant data.
Implementing a disaster recovery program that is being designed to store  and move large amounts of data among regional or district offices without  first going through Washington, D.C. The current project, when completed,  will allow the agency to back up critical information and data on a daily  basis at multiple locations.
In addition to these agencywide initiatives, staff in the units responsible  for mutual fund oversight have identified a number of other technology  projects that could help to improve the efficiency of their operations. For  example, OCIE officials told us that they would like to provide audit  guidance in an electronic format for examination staff, and create Web site  links for staff to use in accessing information useful in an examination.  They said that having these capabilities would likely reduce the time  required to complete examinations.
OCIE officials also stated that they are considering a longer-term project  involving the development of a mutual fund surveillance program. On  March 5, 2004, the SEC Chairman announced the formation of an internal  task force to draft the outlines of this new surveillance program. This  group will examine the mutual fund reporting regime and consider  changes to both the frequency of reporting to the Commission and the  categories of information to be reported, as well as how new technologies  can be used to enhance SEC’s oversight responsibilities. OCIE’s director  stated that the goal of such a surveillance program would be to identify  indications of problems, and then target the particular fund or adviser for  a follow-up inquiry. With such information, SEC staff would also likely be  able to examine relevant data on an industrywide basis to determine if a  systemic problem was emerging. Implementation of such an initiative will  require a continued commitment to enhancing SEC’s information  technology capabilities.
Additionally, Investment Management officials said that they have started  a project designed to allow investment companies to submit more of their  required filings electronically. Their staff are evaluating available  technology that will allow them to identify and analyze the data they  receive more readily. Currently, most of the filings come in as pure text  files and thus are not very well suited for quick quantitative analysis.  Officials in the Division of Enforcement said that recent upgrades to their  computers have been helpful. We also spoke with an official in SEC’s  Office of Investor Education and Assistance, which is responsible for  analyzing investor complaints, responding to inquiries, and providing  educational materials on numerous investing topics, including mutual  funds. This official also told us about a number of technology projects that  could improve staff operational efficiency. For example, according to the  official, the office could benefit from data imaging and retrieval  technology for inquiries and complaints that come in a paper format, as  the technology would allow staff to access this information by topic or  complainant. The official did note that one project, a database that  catalogs complaints from the Internet, is currently being implemented.
In addition to the agency’s ongoing document management and imaging  initiative, SEC staff told us that additional efficiencies could be gained  from an improved case tracking system and having greater ability to  analyze data to look for trends taking place in the securities industry,  particularly in the mutual fund area. Moreover, all of the SEC officials with  whom we spoke agreed that the high costs associated with new  technologies coupled with a limited information technology budget  created a challenge for SEC in meeting its information technology needs.
section_title: Investigation and Collection Difficulties Also Hamper SEC’s Regulatory Efficiency
paragraphs: SEC also faces challenges that affect its ability to investigate violations  and to collect monetary fines and disgorgements that violators are ordered  to pay, a process integral to effective oversight. Investigations of  securities law violations can be labor intensive, complex, and sometimes  require SEC staff to coordinate with staff from other law enforcement or  regulatory authorities as has occurred in many of the mutual fund cases  that SEC has brought recently. In addition, according to SEC staff,  collecting the amounts that violators are ordered to pay can be time  consuming and difficult.
SEC’s staff has identified various issues that they believe hamper their  efficiency in conducting enforcement and collections activities, including  investigations involving mutual funds. At a February 2003 congressional  hearing, the director of SEC’s Enforcement Division testified that under  existing criminal procedure law, SEC staff generally are not allowed  access to grand jury information. In such cases SEC staff must conduct a  separate, duplicative investigation to obtain the same information already  in the hands of federal criminal authorities. In some cases, involving  mutual funds, state law enforcement authorities convened grand juries.
SEC’s ability to protect privileged information also remains in question,  hampering its ability to collect such material. In a report mandated by the  Sarbanes-Oxley Act, SEC staff noted that their investigative efforts are less  efficient and effective at times because the parties under investigation  have a disincentive to provide privileged or protected information to SEC.  By disclosing such information to SEC, the parties risk that others, such as  an adversary in private litigation, could argue that the disclosure waives  the protection of that information. SEC staff would like to be able to  ensure that these parties can maintain protection over such information  after a disclosure to SEC.
The need for SEC staff to make lengthy and complicated efforts to collect  fines or disgorgements also prevent them from investigating other matters.  As a result, SEC staff indicated their efficiency would be improved if they  had authority to contract with private attorneys to undertake litigation to  enforce collection orders. The House is considering a bill introduced in  2003 that would give SEC authority to obtain these contracts, as well as  other enhancements to the authority of SEC Enforcement staff.
This concludes my prepared statement. I would be happy to respond to  questions.
section_title: Contacts and Acknowledgements
paragraphs: For further information regarding this testimony, please contact Cody J.  Goebel at (202) 512-8678. Individuals making key contributions to this  testimony include Toayoa Aldridge, James Lawrence, and David Tarosky.
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