Mutual Fund Trading Abuses: SEC Consistently Applied Procedures in Setting Penalties, but Could Strengthen Certain Internal Controls
Published: 2005-05-16T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: The Securities and Exchange Commission (SEC) and other regulators have recently identified two significant types of trading abuses--market timing and late trading--in the mutual fund industry. The more widespread abuse was market timing, which involved situations where investment advisers (firms that may manage mutual funds) entered into undisclosed arrangements with favored customers who were permitted to trade frequently in contravention of stated trading limits. These arrangements harmed long-term mutual fund shareholders by increasing transaction costs and lowering fund returns. Late trading, a significant but less widespread abuse, occurs when investors place trades after the mutual fund has calculated the price of its shares, usually at the 4:00 p.m. Eastern Time close of financial markets, but receive that day's fund share price. Investors who late trade have an opportunity to profit, which is not available to other investors. To assess SEC's efforts to impose penalties on violators, this report (1) discusses SEC's civil penalties in settled trading abuse cases, (2) provides information on related criminal enforcement actions, and (3) evaluates SEC's criminal referral procedures.
section_title: What GAO Found
paragraphs: Since September 2003, SEC has brought 14 enforcement actions against investment advisers and 10 enforcement actions against other firms for mutual fund trading abuses. Penalties obtained in settlements with investment advisers are among the agency's highest--ranging from $2 million to $140 million and averaging $56 million. In contrast, penalties obtained in settlements for securities law violations prior to 2003 were typically under $20 million. SEC's penalties in the investment adviser cases are also generally consistent with penalties it has obtained from firms involved in similarly egregious corporate misconduct. Further, SEC brought enforcement actions against 24 individuals associated with the investment advisers, many of them high-ranking, and obtained penalties as high as $30 million as well as life-time industry bars for some persons. In reviewing a sample of investment adviser cases, GAO found that SEC followed a consistent process for determining penalties and that it coordinated penalties and other sanctions with interested states. State and federal criminal prosecutors told us that while they have recently investigated market timing conduct, they have generally not pursued criminal prosecution in those cases. They have, however, brought criminal charges in cases involving late trading violations. These officials said that the criminal prosecution of market timing is complicated by the fact that market timing conduct itself is not illegal. Although SEC instituted administrative proceedings in the investment adviser cases discussed above by alleging that the undisclosed market timing conduct involved constituted securities fraud, both federal and state criminal prosecutors told us they reviewed cases involving such market timing conduct and generally concluded that it did not warrant criminal fraud prosecutions. In contrast, criminal charges have been brought against at least 12 individuals for alleged late trading violations. Federal criminal prosecutors said that criminal prosecution of late trading is fairly straightforward because federal securities laws prohibit the practice. SEC officials said that as state and federal criminal prosecutors were already aware of and generally evaluated the mutual fund trading abuse cases for potential criminal violations on their own initiative, they did not need to make specific criminal referrals to bring these cases to their attention. However, during the course of its review, GAO found that SEC's capacity to effectively manage its overall criminal referral process may be limited by inadequate recordkeeping. In particular, SEC does not require staff to document whether a referral was made or why. According to federal internal control standards, appropriate documentation of agency actions helps ensure that management directives are carried out. Without such documentation, SEC cannot readily determine whether staff make appropriate referrals. Such information is also important as an agency performance indicator and for congressional oversight purposes.

section_title: Letter
paragraphs: Trading abuses allowing privileged mutual fund investors to profit at the  expense of other fund shareholders were recently uncovered among some  of the most well-known companies in the mutual fund industry. The  Securities and Exchange Commission (SEC), an independent agency  headed by a five-member Commission, is charged with oversight of the  mutual fund industry and has the authority to bring civil enforcement  actions against individuals and mutual fund companies that violate federal  securities laws. SEC carries out enforcement activities through its  Division of Enforcement (Enforcement). Swift and effective enforcement  by SEC of federal securities laws is essential to punish violators and help  deter future misconduct in the mutual fund industry. In accomplishing its  mission, SEC can coordinate enforcement actions with state authorities  that may also have responsibility to bring civil actions. Further, it can  make referrals to the Department of Justice (DOJ) and state criminal  enforcement authorities to help ensure that potential violations of federal  and state criminal statutes are identified and prosecuted. In carrying out  its work, SEC has a responsibility to ensure that its enforcement staff and  examiners are free of any real or apparent conflicts of interest that could  raise questions about their ability to detect violations of and enforce  securities laws.
Since the New York State Office of the Attorney General (NYSOAG) made  public its discovery of mutual fund trading abuses in September 2003, that  office, SEC, the NASD, which regulates broker-dealers that may offer  mutual funds to their customers, and certain other state regulators have  pursued enforcement actions for two principal types of mutual fund  violations—market timing and late trading.
Market timing typically involves the frequent buying and selling of mutual  fund shares by sophisticated investors, such as hedge funds, that seek  opportunities to make profits on the differences in prices between  overseas and U.S. markets. As frequent trading can harm mutual fund  shareholders through lowered fund returns and increased transaction  costs, many mutual fund companies have disclosed limits in their fund  prospectuses on the number of trades individual customers may place per  year. Although market timing is not itself illegal, it can constitute illegal  conduct if, for example, investment advisers (firms that may manage  mutual fund companies) enter into undisclosed agreements with favored  customers permitting them to trade frequently and in contravention of the  fund prospectuses—as certain investment advisers did prior to September  2003. Another type of violation commonly referred to as late trading was  significant but less widespread than market timing violations. Unlike  market timing, late trading is illegal. It occurs when investors place orders  to buy or sell mutual fund shares after the mutual fund has calculated the  price of its shares, usually once daily at the 4:00 p.m. Eastern Time (ET)  market close, but receive that day’s fund share price. Investors who are  permitted to late trade can profit on the knowledge of events in the  financial markets that take place after 4:00 p.m., an opportunity that other  fund shareholders do not have. Although late trading can involve mutual  fund company personnel, late trading violations have typically occurred at  intermediaries, such as broker-dealers, before these institutions submit  their daily aggregate orders to mutual fund companies for final settlement.
Because of your interest in ensuring the effective enforcement of federal  securities laws and effective federal-state coordination, you asked that we  assess a range of issues associated with SEC’s market timing and late  trading enforcement actions. Specifically, our report    compares the severity of civil money penalties (penalties) obtained in the  mutual fund cases with penalties obtained in the past and with similarly  egregious cases, reviews SEC’s penalty-setting process in these cases, and  discusses SEC’s coordination with state authorities in pursuing civil  enforcement actions;   provides information on state and federal criminal enforcement actions for  market timing and late trading violations;   assesses SEC’s management procedures for making referrals to DOJ and  state authorities for potential criminal prosecution; and   evaluates SEC’s procedures for ensuring compliance with federal laws and  regulations that govern employees’ ability to negotiate and take positions  with regulated entities, such as mutual fund companies.
To respond to the first objective, we obtained copies from SEC of  enforcement actions and settlement orders related to the mutual fund  trading abuses and cases of comparable egregiousness. We also obtained  information from SEC, the Commodity and Futures Trading Commission  (CFTC), the Office of the Comptroller of the Currency (OCC), and NASD  on the criteria and processes they use to determine penalties and data on  the highest penalties they have obtained in settlement. The data we  obtained from SEC allowed us to compare the penalties obtained in the  mutual fund trading abuse cases to the penalties obtained in past cases. To  determine the consistency of SEC’s penalty-setting process in the mutual  fund trading abuse cases, we reviewed a selection of 11 out of the 14  enforcement actions SEC brought against investment advisers charged  with market timing abuses. We also obtained information from states that  coordinated settlement negotiations with SEC in bringing their own  enforcement actions against several of the same investment advisers  involved in SEC’s 14 settled enforcement actions. To respond to the  second objective, we interviewed SEC staff and NYSOAG, Wisconsin  Attorney General’s Office, and DOJ officials and obtained copies of  criminal complaints related to late trading and market timing. To respond  to the third objective, we obtained information from SEC, CFTC, and  NASD on the procedures these agencies follow for making criminal  referrals to DOJ and states. To respond to the fourth objective, we  reviewed the policies and procedures of SEC, OCC, the Federal Reserve  Banks of Chicago and New York, and NASD for promoting staff  compliance with federal laws limiting the seeking of employment  opportunities and postemployment activities of federal executive  employees and, in the case of NASD and the Federal Reserve Banks, codes  of ethics that also include seeking employment restrictions for their  employees. We performed our work in Boston, Mass.; Chicago, Ill.;  Denver, Colo.; New York, N.Y.; Philadelphia, Penn.; and Washington, D.C.,  between May 2004 and May 2005 in accordance with generally accepted  government auditing standards. Appendix I provides a detailed description  of our scope and methodology.
subsections: section_title: Background
paragraphs: Although typically organized as a corporation, a mutual fund’s structure  and operation differ from those of a traditional corporation. In a typical  corporation, the firm’s employees operate and manage the firm, and the  corporation’s board of directors, elected by the corporation’s  stockholders, oversees its operations. Mutual funds also have a board of  directors that is responsible for overseeing the activities of the fund and  negotiating and approving contracts with an adviser and other service  providers for necessary services. Unlike a typical corporation, a typical  mutual fund has no employees; it is created and operated by another party,  the adviser. The adviser is an investment adviser/management company  that manages the fund’s portfolio according to the objectives and policies  described in the fund’s prospectus. The adviser contracts with the fund,  for a fee, to administer its operations. These fees are typically based on the  size of assets under management. In managing the fund’s assets, the  adviser owes a fiduciary duty to the investors in the mutual funds to act  for the benefit of the investors and not use the fund’s assets to benefit  itself.
Mutual funds are subject to SEC oversight and are regulated primarily  under the Investment Company Act of 1940 (1940 Act) and the rules it has  adopted under that act. SEC has authority under this act to promulgate  rules to address a constantly changing financial services industry  environment in which mutual funds and other investment companies  operate. The advisory firms that manage mutual funds are regulated under  the Investment Advisers Act of 1940 (Advisers Act), which requires certain  investment advisers to register with SEC and conform to SEC regulations  designed to protect investors. In addition to its rulemaking authority, SEC  carries out its mutual fund oversight responsibilities through  examinations. SEC’s Office of Compliance Inspections and Examinations  (OCIE) establishes examination policies and procedures and has primary  responsibility for conducting mutual fund company examinations.
SEC is vested with the authority to bring civil enforcement actions against  individuals and companies that violate provisions of the 1940 Act, the  Advisers Act, and other federal securities laws and regulations. While SEC  has civil enforcement authority only, it works with various federal and  state criminal law enforcement agencies throughout the country to  develop and bring criminal cases when the misconduct warrants more  severe action. SEC carries out its enforcement activities through  Enforcement. Enforcement identifies potential securities laws violations  through referrals from SEC examiners or other regulatory organizations  such as NASD, tips from securities industry insiders or the public, the  press, and its own surveillance of the marketplace. After conducting an  investigation, Enforcement staff present their findings to the Commission  for its review and approval. The Commission can authorize staff to bring  an enforcement action in federal court or through administrative  proceedings.
When bringing a civil enforcement action in federal court, SEC files a  complaint with a U.S. District Court that describes the misconduct,  identifies the laws and rules violated, and identifies the sanction or  remedial action that is sought. Administrative proceedings differ from civil  enforcement actions brought in federal court in that they are heard by an  administrative law judge (ALJ), who is independent of SEC. The ALJ  presides over a hearing and considers the evidence presented by  Enforcement staff, as well as any evidence submitted by the subject of the  proceeding. SEC may also enter into settlements with defendants who  choose not to contest the charges against them. In a typical settlement of  an administrative proceeding, the defendant neither admits nor denies the  violation of the securities laws and agrees to the imposition of sanctions.  According to senior Enforcement staff, both SEC and the defendants have  an incentive to avoid litigation and seek a settlement, as litigation is costly  and time-consuming.
SEC can seek a variety of sanctions against defendants in federal court or  as part of administrative proceedings. These include officer and director  bars and monetary sanctions, such as disgorgement and penalties. The  amount of disgorgement SEC seeks in a particular case is usually  determined by the amount of monetary gain, if any, realized from the  violative conduct. SEC can use these funds to compensate investors  harmed by the misconduct. Penalties, on the other hand, are intended to  punish wrongdoing and deter others from engaging in similar misconduct.  The Sarbanes-Oxley Act of 2002 (SOX) authorizes federal courts and SEC  to establish “fair funds” to compensate victims of securities violations.  Section 308(a) of SOX provides that if in an administrative or a civil  proceeding involving a violation of federal securities laws an order  requiring disgorgement is entered, or if a person agrees in settlement to  the payment of disgorgement, any penalty assessed against such person  may, together with the disgorgement amount, be deposited into a fair fund  and disbursed to victims of the violation pursuant to a distribution plan  approved by SEC.
The Securities Enforcement Remedies and Penny Stock Reform Act of  1990 (Remedies Act) amended existing federal securities laws to  authorize SEC and federal district courts to impose penalties for securities  violations other than insider trading, for which penalties were already  authorized. The Remedies Act specifies the maximum penalty that SEC  can seek in administrative proceedings from a firm or individual in  noninsider trading cases according to a three-tier framework, which  allows for increasing penalties based on the presence of fraud and harm to  investors (see table 1). For example, if SEC finds that a firm’s securities  law violations did not involve fraud or cause substantial harm to investors,  a tier one penalty may be appropriate. In that case, the maximum penalty  SEC can seek would be $65,000 per violation. However, if SEC finds that a  firm’s misconduct involved fraud and caused substantial harm to  investors, it can apply the third tier maximum penalty— $650,000 per  violation.
Although the Remedies Act requires that in order to impose a penalty in an  administrative proceeding SEC must find that the penalty is in the public  interest, the act did not impose criteria that SEC must consider in making  this determination. Instead, the Remedies Act provides a nonexclusive list  of factors that SEC may consider, such as whether the conduct involved  fraud or directly or indirectly resulted in harm to other persons.  Enforcement staff told us that over the years SEC has internally developed  more extensive criteria based on this guidance, case law, and policy  directives from the Commission, which are documented for Enforcement  staff in internal division memorandums. These criteria include  the egregiousness of conduct—whether it involved fraud, and if so, the  degree of scienter present; the degree of harm to investors resulting from the conduct; the extent of the defendant’s cooperation;   whether the defendant derived any economic benefit from the conduct;  the duration of the conduct;   whether the defendant is a recidivist;  the seniority of individuals that participated in the conduct; the need for deterrence; the defendant’s ability to pay; the size of the firm or net worth of the individual; and the penalties obtained in cases involving the same or a similar scheme.
When negotiating settlements on behalf of the Commission, SEC  Enforcement staff apply these factors to the facts and circumstances of  each case when determining what penalty to seek. These criteria are  similar to the criteria other financial regulators use in their penalty-setting  process, including CFTC, OCC, and NASD.
One key factor for SEC in effectively fulfilling law enforcement objectives  such as penalty-setting is the implementation of appropriate internal  controls. According to the Standards for Internal Control in the Federal  Government, internal controls (also called management controls)  comprise the plans, methods, and procedures used to meet missions,  goals, and objectives and, in doing so, support performance-based  management. They are a major part of managing an organization. Among  other things, they should promote the effectiveness and efficiency of  operations, including the use of the entity’s resources, and the agency’s  compliance with applicable laws and regulations. They should also be  designed to provide reasonable assurance that the objectives of the agency  are being achieved.
section_title: SEC Consistently Applied Penalty- Setting Procedures in Mutual Fund Cases and Coordinated Most Monetary Sanctions with States
paragraphs: SEC has responded to the widespread trading abuses in the mutual fund  industry by bringing 14 enforcement actions against investment advisers  and 10 enforcement actions against broker-dealer, brokerage-advisory, and  financial services firms that conducted or facilitated the illicit trading.  Penalties SEC has obtained in settlements with these firms have included  some of the highest in the agency’s history and are consistent with other  penalties obtained in cases of similarly egregious and pervasive  misconduct. Further, SEC has held individuals, many of them high- ranking, responsible for their role in the misconduct and also obtained  historically high penalties in settlements with several of them. In reviewing  a selection of 11 out of the 14 enforcement actions SEC brought against  investment advisers and their associated individuals, we found that SEC  consistently applied its penalty-setting process and that this process  contained various levels of review to help ensure that no one individual or  group of individuals had disproportionate influence on penalty decisions.  Additionally, SEC coordinated penalties and disgorgements (which force  firms to give up ill-gotten gains) with interested states in the majority of  cases, although some states obtained additional monetary sanctions.
subsections: section_title: Penalties in Mutual Fund Trading Abuses Cases Are among SEC’s Highest and Are Consistent with Penalties in Similarly Egregious Cases
paragraphs: Since NYSOAG announced its discovery of the trading abuses in the  mutual fund industry in September 2003, SEC has brought 14 enforcement  actions against investment advisers primarily for market timing abuses  and 10 enforcement actions against broker-dealer, brokerage-advisory, and  financial services firms for market timing abuses and late trading. SEC has  entered into settlements in all 14 investment adviser cases and obtained  penalties ranging from $2 million to $140 million (see fig. 1). These  penalties are among the highest SEC has ever obtained for securities laws  violations. Before January 2003, penalties SEC obtained in settlement were  generally under $20 million. In contrast, 11 of the 14 penalties obtained in  the investment adviser cases are over $20 million, with 8 penalties at $50  million or more. Pursuant to the fair fund provision of SOX, SEC plans to  use the penalties and disgorgement moneys, a total of about $800 million  and $1 billion, respectively, to provide restitution to harmed investors. In  addition to settling with investment advisers, as of February 28, 2005, SEC  has settled with two broker-dealers, two insurance companies, and one  brokerage-advisory firm, with penalties totaling $17.5 million.
The penalties SEC obtained in the 14 investment adviser cases are also  consistent with penalties obtained in settled enforcement actions in two  types of cases that senior Enforcement staff identified as being as  egregious as the mutual fund trading abuses—the recent corporate  accounting fraud and investment banking conflict-of-interest cases. The  recent, large corporate accounting frauds surfaced in late 2000 and  concerned publicly traded companies that allegedly used fraudulent  accounting techniques to inflate their revenues and drive up stock prices.  The investment banking analyst cases involved several investment firms  that settled enforcement actions brought by SEC in 2003 for allegedly  producing securities research that was biased by investment banking  interests. Table 2 compares the range of penalties and average penalties  SEC obtained from settlements of enforcement actions brought against  firms for mutual fund trading abuses, corporate accounting fraud, and  investment banking conflicts of interest. Although particular penalties  reflect the facts and circumstances of each case, table 2 shows that the  average penalties among the three types of cases have generally been  consistent (when excluding the record $2.25 billion penalty obtained in a  corporate accounting fraud case), particularly when compared with the  lower penalties obtained in past years. In a public speech, the Director of  Enforcement said that the comparatively large penalties in these cases  represented an effort to increase accountability and enhance deterrence in  the wake of such extreme misconduct in the securities industry and noted  that such penalties create powerful incentives for firms to institute  preventative programs and procedures. Others, however, including two  members of the Commission, have questioned the appropriateness of  these relatively large penalties, particularly for public companies, arguing  that the cost of penalties are borne by shareholders who are frequently  also the victims of the corporate malfeasance.
Further, the penalties SEC has obtained in the mutual fund and other  recent scandals are generally higher than those obtained in settlement by  NASD and other federal financial regulators. For example, NASD has also  brought nine enforcement actions against broker-dealers for market  timing and late trading abuses and obtained penalties ranging from  $100,000 to $1 million. Similarly, CFTC and OCC have obtained  consistently lower penalties in settlement. For example, as of December  2004, the highest penalties OCC and CFTC obtained were for $25 million  and $35 million, respectively.
In addition to bringing enforcement actions against firms, SEC has held  individuals responsible for their roles in the trading abuses. As of February  28, 2005, SEC had brought enforcement actions against 24 individuals and  settled with 18, obtaining penalties and industry bars in all cases and  disgorgement from some (see table 3). Almost all of these settled  enforcement actions involved high-level executives, including eight chief  executive officers (CEO), chairmen, and presidents. Penalties SEC  obtained in these settlements ranged from $40,000 to $30 million. The  penalties obtained from 3 individuals are among the four highest in SEC’s  history—one for $30 million (the highest) and two for $20 million. SEC  also obtained a combined $150 million in disgorgement from these three  individuals. In addition, as part of its settlements, SEC permanently  barred 5 individuals, including the 3 mentioned above, from association  with investment advisers, investment companies, and in some cases other  regulated entities, and barred the remaining 13 for various periods from  their industries.
section_title: SEC Consistently Weighed Penalty Determinations Using Established Criteria and Procedures among the Investment Adviser Cases We Reviewed
paragraphs: In reviewing 11 of the 14 settled enforcement actions related to the  investment adviser cases, we found that SEC followed a similar penalty- setting process in each of them. SEC regional staff in the six offices that  were part of our review generally began their penalty analysis by  determining the amount of money earned by the firms and individuals  from the abusive market timing and the economic harm such trading  caused to investors. For example, as a measure of monetary gain, staff  determined the fees the firms earned on the assets market timers invested  short-term for market timing purposes. As a measure of harm to fund  investors, staff determined the amount of dilution to fund shares that  occurred as a result of this improper trading, using the same methodology  for each case. SEC’s Office of Economic Analysis, which determined this  methodology, assisted staff with these analyses. Staff assessments of  monetary gain and harm caused were also used to help them determine  appropriate disgorgement.
After establishing the economic benefit and harm caused, staff generally  then determined the monetary range within which they could seek a  penalty by calculating the maximum penalty that applied to their  particular case. According to SEC staff at several regional offices, the  penalty statutes did not limit them from seeking penalties they thought  appropriate, largely because the statutes leave it up to SEC to define the  term “violation.” Staff did not necessarily seek the statutory maximum in  these cases because they considered SEC criteria for assessing the relative  egregiousness of the misconduct and in some cases concluded that it  warranted a lesser penalty, and also because they considered the risk that  the case would be litigated instead of settled. For example, in one case  where staff could have argued a statutory maximum of $1 billion based on  the hundreds of improper trades found, staff said they could not have  made a convincing argument for such a high penalty based on the  relatively small amount of economic harm and level of scienter involved  (scienter refers to the requisite degree of knowledge that makes a person’s  actions culpable). These staff told us that even if they disregarded SEC  criteria and sought the maximum it was very unlikely that they would have  achieved an amount close to it. The staff said that the firm involved would  never have settled and it was unlikely that the judge or ALJ assigned to the  case would have found staff’s underlying rationale for the penalty  recommendation credible. As judges and ALJs make independent  determinations of the facts when determining whether a penalty or other  sanctions are warranted, staff said that they may decide on a lesser  penalty than what staff recommended. For that reason, staff said that  while the penalty statutes provide a baseline for their analysis, they seek  penalties in settlement that reflect the facts and circumstances of the case  and the penalties obtained in similar cases.
To determine a penalty appropriate to the facts and circumstances of each  case, SEC staff used the criteria discussed earlier to establish the  egregiousness of the case relative to that of other market timing and late  trading cases—considering, for example, the level of scienter involved, the  amount of harm caused and benefit gained, the level of cooperation, and  the seniority of the individuals involved. We found that staff sought  penalties that reflected these differences. Barring the presence of  aggravating or mitigating factors, conduct perceived as more egregious  received relatively greater penalties. For example, the highest penalty that  SEC obtained from an individual in the market timing and late trading  cases was from the former founder and chairman of an investment adviser  who SEC found to have market timed the funds he managed for his own  personal gain. Regional staff said that this individual’s $30 million penalty  was merited because as the most senior official in the firm, he was duty- bound to protect the interests of all fund investors and should have set an  example in proper ethical conduct for the rest of the firm’s employees.  Instead, SEC found that he continued his market timing activities even  after compliance officials at the firm detected his improper trading and  counseled him to cease. Further, this was the second time he had been the  subject of an SEC enforcement action—in 1994, SEC charged him with  improper personal trading in the fund’s portfolio securities. Finally, they  said he cooperated very little in the investigation.
In some cases we found that where SEC perceived a high level of  egregiousness, the presence of other factors mitigated a more severe  penalty determination, such as the degree of cooperation or the firm’s  ability to pay. For example, staff required firms that argued they could not  pay the penalty initially sought to provide documentation of any financial  constraints and the financial consequences of paying the higher penalty.
Regional staff regularly consulted with senior Enforcement staff in  preparing their penalty recommendations. Enforcement’s Office of the  Chief Counsel is responsible for reviewing all sanction recommendations,  including penalties, for consistency with penalties recommended in  analogous cases. This office reviewed all of the penalty and other  sanctions recommended in the 11 cases we reviewed. Additionally, staff  shared information about penalty-setting in the market timing and late  trading settlements with a range of agency officials outside of  Enforcement. Once staff had negotiated with the defendant the amount of  the disgorgement and penalties and the application of other sanctions they  believed were appropriate for a case and obtained a formal offer of  settlement from the defendant, staff prepared a memorandum for the  Commission describing the settlement offer and their rationale for  recommending that the Commission accept it. For example, the  memorandums explained how the disgorgement figure related to any  calculations of economic benefit or harm and discussed the factors most  relevant to the penalty analysis. Before sending the memorandum to the  Commission for review and approval, other interested SEC divisions and  offices, such as Investment Management, Corporation Finance, and the  Office of the General Counsel, first reviewed it. Enforcement staff said  that by asking staff from other areas of SEC to review their sanction  recommendations, they help ensure that no one individual or small group  has a disproportionate influence over the penalty recommended to the  Commission and that the penalty reflects the Commission’s policy goals.  The Commission either approved the settlement terms outlined in the  memorandum or advised Enforcement as to any adjustments they wanted  made, which staff then renegotiated with the defendants.
section_title: SEC Coordinated Penalties and Disgorgement with States in the Majority of Settlements with Investment Advisers, but Some States Obtained Additional Sanctions
paragraphs: SEC coordinated penalties and disgorgements with interested states in  many of the settled enforcement actions related to late trading and market  timing. For example, in 11 cases, three states (New York, Colorado, and  New Hampshire) coordinated their settlement negotiations with SEC,  agreeing to seek the same disgorgement and penalty amounts and  requiring in their individual settlement orders that the payments be  remitted to and administered by SEC pursuant to the related SEC  settlement order. As a result of this collaboration, the penalty moneys  collected in these cases can be used to compensate harmed investors,  under the fair fund provision of SOX. In one case, a state required a  separate, duplicative payment from one firm of disgorgement and  penalties, but SEC noted in its own settlement order that it had considered  this fact when seeking penalties against the subject firm.
While in most cases states agreed to the same penalty and disgorgement as  SEC and to have the payments made directly to SEC, some states, most  notably New York, obtained additional monetary sanctions. In addition to  disgorgement and penalties, NYSOAG ordered most of the investment  advisers with whom it settled to reduce the fees that they charge mutual  fund investors over the next 5 years. The value of these reductions totaled  about $925 million and in some cases more than doubled the value of the  disgorgement and penalties SEC obtained in an individual case. According  to NYSOAG, these investment advisers did not just allow improper market  timing and late trading, but they had also charged mutual fund investors  significantly more in fees than institutional investors for similar services.  NYSOAG said that the SEC settlements focusing on disgorgement and  penalties for trading abuses did not compensate investors who were  overcharged and that the fee reductions it obtained provided this needed  restitution.
In conjunction with the settlement order related to one investment adviser  case, the Commission issued a public statement on its position regarding  fee reductions. The Commission stated that it did not seek fee reductions  with this investment adviser because this sanction did not serve its law  enforcement objectives. First, the Commission said that there were no  allegations that the fees charged by the adviser in question were illegally  high. Fee reductions would provide compensation to investors who were  not harmed by the market timing abuses SEC set forth in the settlement  order. Second, they said that mandatory fee discounts would require that  customers do business with the firms to receive the benefits of the fee  reductions (meaning that prior customers that received allegedly illegal  prices but already redeemed their shares would not benefit). For those  reasons, the Commission said that their efforts focused on addressing the  market timing abuses by providing full compensation to investors harmed  by this activity and a significant up-front penalty.
In addition to NYSOAG, Colorado and New Hampshire also obtained  additional monetary sanctions in its settlements in three investment  adviser cases. Colorado required the firms involved in two cases to pay $1  million and $1.5 million, respectively, to reimburse its costs and for  consumer and investor education and future enforcement activities within  that state. New Hampshire required the firm involved in another case to  pay $1 million for investor education and protection purposes and an  additional $100,000 to defray the costs of the investigation.
section_title: Several Factors Have Complicated Criminal Prosecution of Market Timing, but State and Federal Authorities Have Brought Criminal Charges in Late Trading Cases
paragraphs: After NYSOAG announced its discovery of mutual fund trading abuses in  September 2003, officials from that office, DOJ, and SEC told us that they  met to discuss potential criminal violations in cases involving these abuses  and clarify subsequent investigative responsibilities and coordination.  Other state officials told us they also reviewed cases involving mutual fund  trading abuses for criminal potential. These officials said that the criminal  prosecution of market timing is complicated by the fact that market timing  conduct itself is not illegal. DOJ officials told us that they have brought  criminal charges in cases where late trading occurred, primarily because  late trading is a clear violation of federal securities laws and authorities  can readily prosecute cases once evidence of late trading is established.
subsections: section_title: Several Factors Have Complicated Criminal Prosecution of Market Timing Cases
paragraphs: Officials from DOJ, NYSOAG, and the Wisconsin Attorney General’s Office  told us that they have declined to bring criminal charges for market timing  conduct, largely because market timing itself is not illegal. In instituting  administrative proceedings in the 14 investment adviser cases discussed  above, SEC alleged that the undisclosed market timing conduct involved  constituted securities fraud, conduct expressly prohibited under federal  securities laws. According to DOJ officials, although state and federal  criminal prosecutors can also seek criminal sanctions for securities fraud,  such prosecutions may be more difficult to prove than civil actions. DOJ  officials told us that criminal prosecutors must be able to prove beyond a  reasonable doubt that the defendant committed fraud, whereas civil  authorities generally need only show that a preponderance of the evidence  indicated a fraudulent action. According to DOJ and NYSOAG officials, for  a variety of reasons their review of cases involving market timing  arrangements concluded that they did not warrant criminal fraud  prosecutions. For example, in commenting on one case involving an  investment adviser’s undisclosed market timing arrangement, the  Wisconsin Attorney General stated that the risk in trying to convince a jury  beyond a reasonable doubt that the particular behavior was criminal  motivated his office and other state prosecutors to instead pursue a civil  enforcement action.
According to a recent law journal article, the ambiguous nature of some  funds’ prospectus language may have further weakened the ability of  federal and state prosecutors to bring criminal charges against investment  advisers that allowed favored investors to market time. The article stated  that it is often unclear whether and to what extent a fund prohibits market  timing. For example, many mutual funds merely “discouraged” market  timing to the extent that it caused “harm” to the funds. According to the  article, such language is subject to various interpretations as to what  constitutes discouraging and what constitutes harm to fund performance.  Further, it stated that even prospectus disclosures that allow a specific  number of exchanges can be ambiguous because the term “exchange” is  subject to various interpretations. Such ambiguities may hamper criminal  prosecutors’ efforts to prove that the market timing arrangements  constituted a willful intent to defraud.
As of March 31, 2005, federal prosecutors have brought one criminal case  involving abusive market timing. However, this case involved a broker- dealer’s alleged efforts to facilitate and conceal short-term trading by its  customers despite warnings from mutual fund companies that such trades  would not be accepted, as opposed to allegations of undisclosed  arrangements between a mutual fund company and favored customers. In  that case federal prosecutors filed a criminal complaint alleging securities  fraud and conspiracy charges against three top executives at this firm. The  complaint alleges that these individuals devised and executed a number of  deceptive practices to circumvent market timing restrictions placed on  their firm by mutual funds companies. These deceptive practices allegedly  included creating and using multiple account numbers for the same client  and executing trades through multiple clearing firms. As of March 31, 2005,  these individuals were awaiting trial.
section_title: Most Criminal Cases Brought Have Been Based on Late Trading Charges
paragraphs: NYSOAG and DOJ have brought at least 12 criminal prosecutions against  individuals for charges that include late trading. The individuals charged  included high-level executives, traders, and other employees of three  broker-dealers, two banking-related organizations, and one hedge fund  who allegedly either conducted or facilitated late trading for others in  mutual fund shares. In one case, NYSOAG charged a former executive and  senior trader of a prominent hedge fund with conducting late trading on  behalf of that firm through certain registered broker-dealers in violation of  New York’s state securities fraud statute. This individual pleaded guilty in  the New York State Supreme Court. In another case brought by DOJ,  prosecutors charged several broker-dealers with conducting late trading  for their clients. According to DOJ officials, criminal prosecution of late  trading is fairly straightforward because the practice is a clear violation of  federal securities laws.
section_title: Inadequate Documentation Procedures Limit SEC’s Capacity to Effectively Manage the Criminal Referral Process
paragraphs: SEC staff said that as state and federal criminal prosecutors were already  aware of and generally evaluated the mutual fund trading abuse cases for  potential criminal violations on their own initiative, they did not need to  make specific criminal referrals to bring these cases to their attention.  However, in the course of our review, we found that SEC’s capacity to  effectively manage its overall criminal referral process may be limited by  inadequate recordkeeping. SEC rules provide for what SEC staff  characterize as both formal and informal processes for making referrals  for criminal prosecutions; however, senior Enforcement staff told us that  SEC uses only the informal procedures for making criminal referrals,  describing them as less time-consuming and more effective than the more  cumbersome formal processes. While potentially efficient, SEC’s informal  procedures do not provide critical management information on the referral  process. Specifically, SEC staff do not document referrals or reasons for  making them. According to federal internal control standards, policies and  procedures, including appropriate documentation, should be designed to  help ensure that management’s directives are carried out. Without proper  documentation, SEC cannot readily determine and verify whether staff  make appropriate and prompt referrals. Documentation of referrals might  serve as an additional internal indicator of the effectiveness of SEC’s  referral process and is also important for congressional oversight of law  enforcement efforts in the securities industry.
subsections: section_title: SEC Prefers Informal Procedures for Making Criminal Referrals
paragraphs: SEC rules set forth what SEC staff characterize as “formal” and “informal”  procedures for making referrals for criminal prosecution. Under what SEC  staff described as the formal referral procedures, the Director of  Enforcement reviews cases to be recommended for criminal prosecution  in coordination with the Office of the General Counsel, and, according to  senior Enforcement staff, seeks Commission authorization for the  recommended referral. Senior Enforcement staff told us that SEC has not  used the formal procedures in over 20 years because the Commission has  given the ability for making informal criminal referrals to Enforcement  staff. According to these staff, the Commission found that it was approving  all formal staff requests to make criminal referrals, so it was more efficient  to give SEC staff the authority to make the referrals themselves. Under  these more informal procedures, staff at the assistant director level or  higher have delegated authority to communicate with other agencies  regarding cases of mutual interest, including referring cases for criminal  prosecution.
According to senior Enforcement staff and regional staff, if staff attorneys  uncover what they believe might be criminal violations, they inform their  assistant director and other management officials about such findings.  Staff at the assistant director or associate director level decide whether  the staff’s findings merit a criminal referral, and if so, call the local U.S.  Attorney’s Office or other criminal authority to see whether they have an  interest in the case. According to SEC staff, if the criminal authority is  interested in the case they send a letter requesting formal access to SEC’s  investigative files for that case. These staff said that the primary benefit of  the informal referral process is that it allows for an efficient flow of  information between agencies. For example, SEC staff can tip off DOJ  about potential criminal cases and DOJ officials also can call SEC and  make informal referrals of cases for potential civil prosecution.
section_title: While Potentially Efficient, Informal Procedures Do Not Provide Critical Management Information on the Referral Process
paragraphs: Although SEC’s informal procedures may make the communication of  criminal violations to DOJ efficient and enable an effective cooperative  relationship between the agencies, they do not include requirements for  the documentation of these referrals. Currently, Enforcement staff do not  document what cases have been referred, to whom, or why. Senior  Enforcement staff told us that the documentation of criminal referrals was  unnecessary for several reasons. First, they said that such documentation  would not aid them in managing the referral process, as they already have  processes to ensure that cases with criminal potential are appropriately  referred. For example, in addition to the day-to-day monitoring of cases at  the associate director level, which results in informal referrals to criminal  authorities, the Director or Deputy Director of Enforcement conducts  quarterly reviews of SEC’s case inventory to ensure, among other things,  that referrals are being made. Further, they said that Commission  members as a matter of course question staff about their cooperation with  criminal authorities when staff request approval for an enforcement  action. Second, they said that since the wave of high profile corporate  accounting scandals that began in 2000, DOJ has had unprecedented  interest in pursuing securities fraud cases. According to SEC staff, senior  DOJ officials discuss cases of mutual interest with SEC staff in regular  joint meetings and as part of federal regulatory and law enforcement  working groups of which both SEC and DOJ are members. SEC staff  cited the recent cooperation between criminal law enforcement and SEC  in the mutual fund cases as a good example of how well these processes  work in alerting criminal prosecutors to appropriate cases. Further, they  said that as each local U.S. Attorney’s Office (USAO) sets its own  prosecutorial priorities, the most effective way for SEC staff to learn what  each USAO considers a useful referral is through strong, informal  relationships.
While such informal relationships between SEC and criminal law  enforcement authorities might be essential to their effective cooperation,  appropriate documentation of decision-making is an important  management tool. According to federal internal control standards  previously discussed, policies and procedures, including appropriate  documentation, helps ensure that management directives are carried out.  Internal control procedures include a wide range of diverse activities such  as authorizations, verifications, and the creation and maintenance of  related records that provide evidence that these activities were executed.  Without such documentation, the Commission cannot readily determine  and verify whether staff make appropriate and prompt referrals. Also, the  Commission does not have an institutional record of the types of cases  that are referred over the years. Such information is essential for  appropriate management and oversight of the referral process. For  example, although Enforcement staff told us that the director’s quarterly  review of cases involves a discussion of cooperative law enforcement  activities, they said that it does not include a written report on criminal  referrals made. Instead, the director must informally poll his staff if he  wants to develop a list of such referrals, which introduces the likelihood of  reporting error. Similarly, in conducting our work, SEC was unable to tell  us what cases had been referred to criminal law enforcement without  contacting staff assigned to the case or directing us to do the same.  Further, we found that other financial regulators such as NASD and CFTC  record their criminal referrals to manage their referral processes.  Documentation of referrals might also serve as an additional internal  indicator of the effectiveness of SEC’s referral process.
In addition to aiding SEC management, information about the number,  type, and reasons for SEC criminal referrals could also serve as an  important tool for congressional oversight. Although SEC does not have  jurisdiction over DOJ and other criminal law enforcement authorities and  is not responsible for their decision to act or not upon a referral, the  maintenance of evidence of SEC referrals could serve as verification that  criminal authorities were made aware of appropriate cases. For example,  senior Enforcement staff told us that prior to the corporate accounting  fraud scandals, DOJ was not as interested as it is now in pursuing  securities fraud. In an environment where changing priorities can  influence the types of cases criminal law enforcement agencies pursue, the  documentation of referrals would provide some assurance that SEC is  consistently considering cases for potential criminal prosecution.
section_title: SEC Efforts to Encourage Staff Compliance with Federal Conflict-of- Interest Laws on New Employment Do Not Include Tracking Post-SEC Employment Plans
paragraphs: SEC provides training and guidance to its staff on federal laws and  regulations regarding employment with regulated entities and also  requires former staff to notify SEC if they plan to make an appearance  before the agency. However, SEC does not require departing staff to report  where they plan to work as do other financial regulators. According to  SEC staff, they have not tracked postemployment information because  SEC examiners and other staff are highly aware of employment-related  restrictions. SEC staff also said that since agency examiners have  traditionally visited mutual fund companies periodically to conduct  examinations, they are less likely to face potential conflicts of interest  than bank examiners who may be located full-time at large institutions.  Nonetheless, SEC staff have told us that as part of recently implemented  and planned changes to SEC’s mutual fund oversight program they are  assigning monitoring teams to the largest and highest-risk mutual fund  companies. The teams would have more regular contact with fund  management over a potentially longer period of time. In addition, a new  SEC rule requiring all mutual fund firms to designate a chief compliance  officer may increase an existing demand for SEC examiners to fill open  positions in the compliance departments at regulated entities. As a result,  the potential for employment conflicts of interest might increase.
subsections: section_title: SEC Offers Ethics Training and Counseling Services to Employees on Federal Employment Restrictions but Does Not Ask Where Employees Plan to Work
paragraphs: Federal laws place restrictions on the postfederal employment of  executive branch employees. Specifically, these laws generally prohibit  federal executive branch employees from participating personally and  substantially in a particular matter that a person or organization with  whom the employee is negotiating prospective employment has a financial  interest. For example, a senior staff member of SEC’s Ethics Office told  us that as a result of this law, SEC examiners and enforcement staff  cannot negotiate employment with a firm that is the subject of an ongoing  examination or enforcement action in which they have direct involvement,  although they are not prohibited from obtaining employment with such  firms after the completion of the examination or enforcement action in  which they had such involvement. However, federal law prohibits former  federal executive branch employees from “switching sides” and  representing their new employer before any federal court or agency  concerning any matter in which the employees were personally and  substantially involved during the time of their federal employment.  According to the SEC ethics staff, if a former SEC examiner accepted  employment with a firm that the examiner had previously examined, the  examiner would be permanently barred from communicating with SEC  regarding the examination in which he or she had participated. In addition,  former senior employees are prohibited for a period of 1 year following  federal employment from communicating with or appearing before their  former federal employer on behalf of anyone with the intent to influence  agency action. This “cooling-off’ period is 2 years concerning any matter  that was pending under a former employee’s official responsibility during  the 1-year period prior to termination of federal employment. Violation of  either the “seeking employment” or postfederal employment activity  restrictions can result in civil and criminal sanctions.
The SEC Ethics Office provides annual ethics training and offers ethics  counseling to SEC examiners, Enforcement staff, and other employees to  explain these and other conflict-of-interest laws and how to avoid violating  them. Further, under SEC rules, former SEC staff are required to file a  notice with SEC within 10 days after being employed or retained as the  representative of any person outside of the government in any matter in  which an appearance before, or communication with, SEC or its  employees is contemplated. This notice must include a description of the  contemplated representation, an affirmative statement that the former  employee did not have either personal and substantial responsibility or  official responsibility for the matter that is the subject of the  representation while employed by SEC, and the name of the SEC division  or office in which the former employee had been employed. Senior Ethics  Office staff said that upon receiving these notices they verify with the  former division or office that the contemplated representation does not  involve a matter that the person had responsibility for during his or her  employment with SEC.
While these notices provide SEC with information on some employees’  postemployment activities and allow SEC to monitor compliance with  postfederal employment activity restrictions, they do not provide SEC  with information on the postemployment plans of all of its departing staff  at the time they announce their intention to leave the agency. SEC  currently does not require departing staff to report where they plan to  work, a procedure required by other financial regulators to better ensure  that seeking employment restrictions have not been violated. For example,  OCC and the Federal Reserve Banks of New York and Chicago obtain  information from departing staff, or at least examination staff in the case  of the Federal Reserve Banks, on where they are going to work. NASD  also tracks information on departing staff’s subsequent employment with  member firms, although they do not ask staff directly for it. Officials from  three of these agencies said that they also ask for this information to  assess whether the quality of the employee’s prior regulatory work could  have been compromised by a potential conflict of interest with the  employee’s new place of employment. For example, when departing  examiners, enforcement attorneys, and other professional staff go to work  for a bank with whom they have recently been involved in a regulatory  matter, OCC requires a review of their related work products, as does the  Federal Reserve Bank of New York for departing examiners. Similarly,  NASD requires staff to conduct a reexamination of a member firm if that  firm hires an employee who was involved in a recent examination of that  firm or a review of the related examination workpapers if the employee  was a former supervisor, assistant/associate director, or attorney who   reviewed or worked on the examination. SEC currently does not require  similar workpaper reviews or reexaminations.
section_title: Changes to SEC Examination Program and Potential Increased Private Sector Demand for Examiners Could Increase Conflicts of Interest and Need for Postemployment Tracking
paragraphs: According to senior staff from SEC’s Office of Compliance Inspections and  Examinations (OCIE), which administers SEC’s nationwide examination  program for investment companies and other regulated entities,  postemployment tracking has not been viewed as essential because SEC  examiners face fewer potential conflicts of interest than bank examiners.  Senior OCIE staff told us that unlike bank examiners, SEC examiners  typically participate in multiple examinations in the course of the year.  Banking regulators, on the other hand, often have examiners stationed  permanently on site at the largest financial institutions. OCIE staff said  that because SEC examiners do not have prolonged contact with  management at regulated entities, there is little opportunity for them to  develop the type of relationships that could lead to conflicts of interest.
However, recently implemented and planned changes to SEC’s mutual  fund oversight program might increase the potential for employment  conflicts of interest. As part of these changes (which we review in a  forthcoming report), OCIE is creating monitoring teams of two or three  examiners to be assigned to review the operations and activities of the  largest and highest-risk mutual fund companies on an ongoing basis, as  opposed to conducting periodic routine examinations. We note that SEC’s  planned approach for large mutual fund companies is intended to be  similar to the bank regulators’ approach to bank supervision at large  financial institutions, in which teams are assigned full-time to monitor the  largest institutions. Such an approach would increase the contact SEC  examiners have with fund management and potential for conflicts of  interest.
Further, SEC’s new rule requiring all mutual fund firms to designate a  chief compliance officer may increase an existing demand for SEC  examiners and other staff to fill open positions at the compliance  departments of regulated entities. SEC examiners told us that departing  SEC examiners commonly obtained employment in the compliance  departments of regulated entities. Further, these examiners and securities  industry officials told us that having former SEC staff at these firms was  very beneficial because SEC staff have expertise in compliance issues and  are compliance-oriented. One securities industry official said former SEC  examiners and other staff are a natural source of expertise for firms that  were involved in the recent mutual fund trading abuses and that want to  correct their problems. While the compliance departments at regulated  entities may benefit by hiring experienced SEC staff, an increase in the  employment potential of examiners and other staff at these firms could  also increase the potential for conflicts of interest.
section_title: Conclusions
paragraphs: After the mutual fund trading abuses were uncovered in September 2003,  SEC acted swiftly to bring enforcement actions against prominent firms  and individuals involved in the misconduct and obtained some of its  highest penalties in history from them in settlements. SEC has also  consistently applied its procedures for establishing such penalties.  However, we identified weaknesses in SEC’s internal controls that may  limit its capacity to effectively manage its criminal referral process.  Currently, SEC does not require staff to document that a referral has been  made to a federal or state criminal investigative authority or the reasons  for such referrals. According to federal internal control standards, such  documentation is important for verifying that management directives have  been carried out. Without such documentation, SEC’s ability to measure  the performance of its criminal referral process and to help ensure  effective congressional oversight of that process is limited.
We also found that SEC has not established controls that could help  ensure the independence of staff from the fund industry as they carry out  SEC’s critical oversight work. Although SEC provides ethics training to its  employees regarding seeking employment and postemployment conflict- of-interest laws, the agency does not require departing staff to provide  information on their future employment plans. In the absence of such  information, SEC’s capacity to ensure compliance with conflict-of-interest  laws related to postemployment opportunities is limited. Further, SEC  does not have procedures in place requiring review of departing  employees’ workpapers should a potential conflict of interest be  discovered. SEC’s recently implemented and planned changes to its  mutual fund examination program that will likely involve greater contact  between examiners and company officials as well as the potential that  agency staff will seek to become compliance officers underscore the need  for the agency to ensure compliance with these critical conflict of interest  laws.
section_title: Recommendations
paragraphs: To strengthen SEC’s management procedures and better ensure that  agency responsibilities are being met, the SEC Chairman should ensure  that the agency take the following two actions:    document informal referrals to criminal authorities for potential criminal  prosecutions and the reasons for such referrals; and request that departing employees provide the name of their next employer  as part of exit procedures and establish procedures to review the  departing employees’ related work products if a potential conflict of  interest is determined to exist.
section_title: Agency Comments and Our Evaluation
paragraphs: SEC provided written comments on a draft of this report, which are  reprinted in appendix II. SEC also provided technical comments, which  were incorporated into the final report, as appropriate. SEC agreed with  our recommendations. SEC indicated that it is in the process of converting  its investigation opening form to a web-based application, which will  provide for documentation of informal referrals to criminal authorities.  SEC also noted steps it is taking to avoid conflicts of interests that could  affect the implementation of SEC programs and activities, which include  establishing a formal ethics component to exit procedures. As part of this  process, SEC will ask departing staff to provide information about the  identity of their next employer, and, to the extent a potential conflict is  identified, will investigate as appropriate.
As agreed with your office, unless you publicly announce the contents of  this report earlier, we plan no further distribution of this report until 30  days from the report date. At that time we will provide copies of this  report to SEC and interested congressional committees. We will also make  copies available to others upon request. In addition, the report will be  available at no cost on GAO’s Web site at http://www.gao.gov.
If you or your staff have any questions about this report, please contact  Wesley M. Phillips, Assistant Director, or me at (202) 512-8678. GAO staff  who made major contributions to this report are listed in appendix III.
section_title: Appendix I: Scope and Methodology
paragraphs: The objectives of our report were to (1) compare the severity of civil  money penalties (penalties) obtained in the mutual fund cases with  penalties obtained in the past and with similarly egregious cases, review  the Securities and Exchange Commission’s (SEC) penalty-setting process  in these cases, and discuss SEC’s coordination with state securities  regulators in civil enforcement actions; (2) provide information on state  and federal criminal enforcement actions regarding market timing and late  trading violations; (3) assess SEC’s management procedures for making  referrals to the Department of Justice (DOJ) and state authorities for  potential criminal prosecution; and (4) evaluate SEC’s procedures for  ensuring compliance with federal laws and regulations that govern  employees’ ability to negotiate and take positions with regulated entities,  such as mutual fund companies.
To compare the severity of penalties obtained in the mutual fund cases  with penalties obtained in the past and with similarly egregious cases,  review SEC’s penalty-setting process in these cases, and discuss SEC’s  coordination with state securities regulators in civil enforcement actions,  we obtained copies of SEC enforcement actions and settlement orders  related to market timing and late trading cases and compared them to  corporate accounting fraud and investment banking analyst cases, which  SEC staff identified as similar to the mutual fund cases in the  egregiousness and pervasiveness of misconduct. We obtained these  documents from SEC’s Web site and SEC staff reviewed the list of cases  we compiled for accuracy. We then calculated and compared the average  penalties obtained in these three types of cases. We also obtained data  from SEC on the 30 highest penalties obtained from entities in settlement,  according to their records, and similar data for individuals. This data  allowed us to compare the penalties obtained in the mutual fund trading  abuse cases to the penalties obtained in past cases. In addition, we  obtained information from SEC, the Commodity and Futures Trading  Commission (CFTC), the Office of the Comptroller of the Currency (OCC),  and the NASD on the criteria and processes they use to determine  penalties and data from CFTC and OCC on their highest settlements and  from NASD on its mutual fund trading abuse settlements. Then, to  determine whether SEC used its criteria and processes consistently when  evaluating what penalties to seek in the late trading and market timing  cases, we reviewed documentation pertaining to a selection of 11 out of 14  enforcement actions SEC brought against investment advisers charged  with market timing abuses. These 11 cases were distributed among six  regional SEC offices. We interviewed regional examiners and attorneys  assigned to each case and reviewed the related investigative record. For  example, we reviewed enforcement actions and settlement orders, staff  analyses of economic harm caused and benefit gained, memorandums  from the Division of Enforcement to the Commission, and SEC  examinations for each of these investment advisers and their associated  fund companies dating back several years. The mutual fund companies we  chose to review were among the 100 largest mutual fund companies  nationwide, as measured by the size of customer assets under  management as of August 1, 2003. We also interviewed two legal scholars  and economists who have conducted recent research on SEC penalties or  mutual fund trading abuses to obtain additional views on SEC’s penalty- setting process. In addition, we interviewed securities regulators or law  enforcement officials from three states that coordinated settlement  negotiations with SEC in bringing their own enforcement actions against  investment advisers involved in 11 of the 14 SEC enforcement actions  mentioned above and obtained copies of the related enforcement actions  and settlement orders from their Web sites. These regulatory or law  enforcement entities were the New York State Office of the Attorney  General (NYSOAG), the Colorado Attorney General’s Office, and the New  Hampshire Bureau of Securities Regulation.
To provide information on state and federal criminal enforcement actions  regarding market timing and late trading violations, we interviewed staff  from SEC, NYSOAG, the Wisconsin Attorney General’s Office, and DOJ  and obtained copies of late trading and market timing-related criminal  complaints from the Web sites of the relevant federal or state criminal  authorities.
To assess SEC’s management procedures for making referrals to DOJ and  state authorities for potential criminal prosecution, we reviewed SEC rules  governing these referrals and interviewed staff from SEC, DOJ, and  NYSOAG. We also interviewed officials from NASD and CFTC on their  referral procedures and obtained copies of relevant rules and policies. We  evaluated SEC’s referral procedures using Standards for Internal  Controls in the Federal Government.
To evaluate SEC’s procedures for ensuring compliance with federal laws  and regulations that govern employees’ ability to negotiate and take  positions with regulated entities, such as mutual fund companies, we  reviewed applicable laws and regulations, interviewed staff from and  reviewed the policies and procedures of SEC, OCC, the Federal Reserve  Banks of Chicago and New York, and NASD for promoting staff  compliance with federal laws limiting the seeking of employment  opportunities and postemployment activities of federal executive  employees and, in the case of the Federal Reserve Banks and NASD, codes  of ethics that also include seeking employment restrictions.
We performed our work in Boston, Mass.; Chicago, Ill.; Denver, Colo.; New  York, N.Y.; Philadelphia, Penn.; and Washington, D.C., between May 2004  and May 2005 in accordance with generally accepted government auditing  standards. SEC provided written comments on a draft of this report, which  are reprinted in appendix II. Our evaluation of these comments is  presented in the agency comments section.
section_title: Appendix II: Comments from the Securities and Exchange Commission
section_title: Appendix III: Major Contributors to this Report
subsections: section_title: GAO Contacts
section_title: Acknowledgments
paragraphs: In addition to those named above, Fred Jimenez, Stefanie Jonkman, Marc  Molino, Omyra Ramsingh, Barbara Roesmann, Rachel Seid, David Tarosky,  and Anita Zagraniczny made key contributions to this report.