SEC Mutual Fund Oversight: Positive Actions Are Being Taken, but Regulatory Challenges Remain
Published: 2005-06-07T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: Trading abuses--including market timing and late trading violations--uncovered among some of the most well-known companies in the mutual fund industry permitted favored customers to profit at the expense of long-term shareholders. Questions have also been raised as to why the New York State Office of the Attorney General identified the trading abuses in September 2003 before the industry's primary regulator: the Securities and Exchange Commission (SEC). Based on two recently issued GAO reports, this testimony discusses (1) the reasons SEC did not detect the abusive practices at an earlier stage and lessons learned from the agency not doing so, (2) steps the agency has taken to strengthen its mutual fund oversight program, and (3) enforcement actions taken by SEC and criminal prosecutors in response to these abuses and SEC management procedures for making criminal referrals and ensuring staff independence.
section_title: What GAO Found
paragraphs: Prior to September 2003, SEC did not examine mutual fund companies for trading abuses such as market timing violations because agency staff viewed other activities as representing higher risks and believed that companies had financial incentives to establish effective controls. While SEC has competing examination priorities, it can draw lessons from not detecting the trading abuses earlier. First, by conducting independent assessments of controls in areas such as market timing (through interviews, reviews of exception reports, reviews of independent audit reports, or transaction testing as necessary), SEC could reduce the risk that violations may go undetected. Second, SEC could further develop its capacity to identify and evaluate evidence of potential risk (for example, academic studies completed between 2000 and 2002 identified certain market timing concerns as a persistent risk to mutual fund customers). Third, ensuring the independence of company compliance staff is critical and SEC staff could better assess company risks and controls through routine interactions with such staff. SEC has taken several steps to strengthen its mutual fund oversight program and the operations of mutual fund companies, but it is too soon to assess the effectiveness of several key initiatives. For example, SEC has instructed its staff to make additional assessments of company controls and established a new office to identify and assess potential risks. SEC also adopted a rule that requires mutual fund companies to appoint independent compliance officers who are to prepare annual reports on their companies' policies and violations. However, SEC has not developed a plan to receive and review these annual reports on an ongoing basis and thereby enhance its capacity to detect potential violations. Since September 2003, SEC has brought 14 enforcement actions against mutual fund companies and 10 enforcement actions against other firms for mutual fund trading abuses. Penalties obtained in settlements with mutual fund companies 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. 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. However, GAO found certain weaknesses in SEC's management procedures for making referrals to criminal law enforcement and ensuring staff independence. In particular, SEC does not require staff to document whether a criminal referral was made or why. Without such documentation, SEC cannot readily determine whether staff make appropriate referrals. Further, SEC does not require departing staff to report where they plan to work, information gathered by other financial regulators to assess staff compliance with federal laws regarding employment with regulated entities. In the absence of such information, SEC's capacity to ensure compliance with these conflict-of-interest laws is limited.

section_title: Letter
paragraphs: I am pleased to be here today to discuss two recently issued GAO reports  that assess the Securities and Exchange Commission’s (SEC) response to  trading abuses uncovered in the mutual fund industry. We prepared these  reports at the request of Chairman Sensenbrenner and Ranking Member  Conyers of the full committee. As you know, trading abuses—including  fraudulent market timing and late trading violations—were uncovered in  many well-known companies in the mutual fund industry and raised  significant concerns about the industry’s ethical practices. Maintaining  public confidence in the mutual fund industry is critical because about 95  million Americans have invested more than $8 trillion in mutual funds, a  significant share of the nation’s privately held wealth. Moreover, it is  critical that SEC and NASD have the capacity to identify abusive practices  and to bring enforcement actions that punish violators and deter those  who are contemplating similar abuses.
Questions have been raised as to why so many mutual fund companies and  broker-dealers were able to engage in trading abuses, sometimes for years,  without being detected by SEC and NASD. In fact, the trading abuses only  came to light after the New York State Office of the Attorney General  (NYSOAG) received a tip from a hedge fund insider, conducted an  investigation, and, in September 2003, settled an enforcement action  against a hedge fund company and a hedge fund official for market timing  and late trading of several mutual funds. The federal regulators’ failure to  identify the abuses at an earlier stage has generated concern about the  effectiveness of their examination and other oversight procedures.
As we describe in our reports, market timing and late trading violations  permitted favored customers to benefit at the expense of long-term mutual  fund company shareholders. 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 markets and U.S. markets. Although market  timing is not itself illegal, frequent trading can harm mutual fund  shareholders because it increases transaction costs and lowers a fund’s  returns. However, market timing can constitute illegal conduct if, for  example, it takes place as a result of undisclosed agreements between  mutual fund investment advisers (companies that provide management  and other services to mutual funds) and favored customers who are  permitted to trade frequently and in contravention of stated company  trading limits. Late trading, a significant but less widespread abuse than  market timing violations, occurs when investors place orders to buy or sell  mutual fund shares after the mutual fund has calculated price of its shares,  usually once daily at the 4 p.m. Eastern Time close of the financial  markets. Investors who are permitted to engage in late trading can profit  from the knowledge of events in the financial markets that take place after  4 p.m., an opportunity that other fund shareholders do not have.
My testimony today focuses largely on the market timing area, because  such abuses were more widespread than late trading violations, and on  SEC, which is the mutual fund industry’s frontline regulator. I will discuss  late trading issues and NASD oversight activities to a lesser degree. More  specifically, my testimony covers (1) the reasons that SEC did not detect  the market timing abuses at an earlier stage and lessons learned from the  agency not doing so, (2) the steps SEC has taken to strengthen its  oversight of the mutual fund industry and strengthen industry business  practices, and (3) enforcement actions taken by SEC and criminal  prosecutors in response to these abuses and SEC management procedures  related to the making of criminal referrals and ensuring staff  independence from the mutual fund industry.
Before September 2003, SEC did not examine fund companies for market  timing abuses because agency officials (1) viewed other activities as  representing higher risks, (2) concluded that companies had financial  incentives to control frequent trading because it could lower fund returns,  and (3) were told by company officials that the companies had established  controls over frequent trading. While SEC faced competing examination  priorities before September 2003 and had made good faith efforts to  mitigate the known risks associated with legal market timing, lessons can  be learned from the agency not having detected the abuses earlier. First,  without independent assessments of controls over areas such as market  timing during examinations (through interviews, reviews of exception  reports, reviews of independent audit reports, or transaction testing as  necessary), the risk increases that violations may go undetected. Second,  SEC can strengthen its capacity to identify and assess any evidence of  potential risks. For example, a 2002 study estimated that market timing in  certain funds resulted in about $5 billion in annual losses to shareholders,  and raised the possibility that investment advisers did not always act  decisively to control such risks due to potential conflicts of interest.   Third, we found that compliance staff at mutual fund companies often  detected evidence of undisclosed market timing arrangements with  favored customers but lacked sufficient independence within their  organizations to correct identified deficiencies. Ensuring the  independence of compliance staff is critical, and SEC could potentially  benefit from using their work.
SEC has taken several steps to strengthen its oversight of mutual fund  companies, but it is too soon to assess the effectiveness of certain  initiatives. To improve its examination program, SEC staff recently  instructed agency staff to conduct more independent assessments of the  fund companies’ internal controls. To improve its risk assessment  capabilities, SEC also has created and is currently staffing a new office to  help the agency better anticipate, identify, and manage emerging risks and  market trends. To better ensure the independence of company compliance  staff, SEC recently adopted a rule that requires compliance officers to  report directly to the funds’ boards of directors. While this rule has the  potential to improve fund company operations and is intended to increase  the independence of compliance officers, certain compliance officers may  still face organizational conflicts of interest. For example, under the rule  compliance officers may not work directly for mutual fund companies, but  rather, may be employed by investment advisers—who manage the  funds—whose interests may not necessarily be fully aligned with mutual  fund customers. In addition, although the rule also requires compliance  officers to prepare annual reports on their companies’ compliance with  laws and regulations, SEC has not developed a plan to routinely receive  and review the reports. Without such a plan, SEC cannot be assured that it  is in the best position to detect abusive industry practices and emerging  trends. SEC has agreed to implement recommendations from our April  2005 report to help ensure the effectiveness of compliance officers and to  determine how to best utilize the annual compliance reports, or the  material findings cited in those reports.
The penalties SEC obtained in the market timing and late trading cases are  among the largest in the agency’s history and are generally consistent with  penalties obtained in cases involving similarly egregious corporate  misconduct. As of February 28, 2005, SEC had brought 14 enforcement  actions against investment advisers and 10 enforcement actions against  other firms for market timing and late trading abuses. It has also brought  enforcement actions against several high ranking company officials.  Penalties that SEC obtained in settling the 14 enforcement actions with  investment advisers range from $2 million to $140 million, with an average  penalty of about $56 million. In contrast, penalties obtained in settlements  for securities law violations before 2003 were typically under $20 million.  In reviewing a sample of cases involving investment advisers, we found  that SEC followed a consistent process for determining penalties and that  it coordinated penalties and other sanctions with interested states.  However, we found certain weaknesses in SEC’s overall procedures for  referring securities cases to other agencies for potential criminal  violations and ensuring that departing employees compiled with conflict- of-interest laws and regulations. SEC has agreed to implement  recommendations from our May 2005 report to strengthen these  processes.
To address our reporting objectives, we conducted in-depth reviews of 11  SEC enforcement actions against mutual fund companies for market  timing and other abusive practices. We reviewed examination reports for  these companies as well as related enforcement action documents. We  interviewed representatives from SEC, NASD, mutual fund companies,  broker-dealers, pension plan administrators, and other industry  participants about practices and procedures industry participants use to  prevent abuses and monitor trading activity. We also interviewed SEC staff  in headquarters and various regional and district offices about how its  oversight examination and enforcement efforts were conducted and how  penalty amounts were determined. We also obtained information from  Department of Justice (DOJ) officials and selected state regulators and  attorney generals on criminal enforcement actions brought in cases  involving market timing and late trading abuses. In addition, we reviewed  relevant academic and other studies. We interviewed SEC staff regarding  SEC’s management procedures for making criminal referrals to DOJ and  state criminal authorities and reviewed related SEC rules. We evaluated  these rules using Standards for Internal Controls in the Federal  Government. We reviewed federal laws and regulations that govern  employees’ ability to negotiate and take positions with regulated entities,  such as mutual fund companies, and reviewed SEC and other financial  regulators’ policies and procedures for ensuring staff compliance with  these laws. We conducted our work on these reports between May 2004  and May 2005 in accordance with generally accepted government auditing  standards.
subsections: section_title: Lessons Learned from SEC Not Detecting Abusive Market Timing Can Be Useful in Preventing Future Abuses
paragraphs: SEC did not examine for market timing abuses or test company controls in  that area, largely because the agency had competing examination  priorities and believed that companies had financial incentives to control  frequent trading. Lessons learned from SEC not having detected these  abuses earlier can be useful to the agency in administering its examination  program going forward.
subsections: section_title: SEC Did Not Examine for Market Timing Abuses
paragraphs: SEC staff have stated that given the number of mutual fund companies, the  breadth of their operations, and limited examination resources, SEC’s  examinations were limited in scope. Examiners focused on discrete areas  that staff viewed as representing the highest risks of presenting  compliance problems that could impact investors. SEC staff stated that  before September 2003, they considered funds’ portfolio trading (i.e.,  purchases and sales of securities on behalf of investors) and other areas as  representing higher risks than potential market timing abuses and noted  that examinations and enforcement cases in these other areas revealed  many deficiencies and violations. SEC staff also said that they did not  review market timing controls because they believed that fund companies  had financial incentives to control frequent trading because it can lower  fund share prices, thereby resulting in a loss of business. An SEC staff  member also said that officials from mutual fund companies told agency  examiners that they had appointed compliance staff called “market timing  police” to enforce compliance with the funds’ trading limit policies.
SEC staff said they were surprised in September 2003 when NYSOAG  identified the market timing abuses. However, after the abusive practices  were identified, SEC moved aggressively to assess the scope and  seriousness of the problem. For example, SEC surveyed about 80 large  mutual fund companies and determined that nearly 50 percent had some  form of undisclosed market timing arrangement with certain customers  that appeared to be inconsistent with internal policies, prospectus  disclosure, or fiduciary duties. SEC also initiated immediate “cause”  examinations and investigations at many of these mutual fund companies  to further review potential violations.
I would note that NASD’s examinations of broker-dealers also did not  discover market timing arrangements involving broker-dealers before  September 2003. According to an NASD official, these arrangements went  undetected because market timing was not illegal per se and, to the extent  that a mutual fund company had stated customer trading limits, broker- dealers may not have perceived themselves as being responsible for  enforcing such policies. Regarding late trading, NASD officials said that  the organization did not have specific examination guidance to detect the  violation before September 2003. NASD officials also said that some  broker-dealers created fictitious accounts or otherwise falsified  documents, so that detecting late trading violations was difficult.
section_title: Key Regulatory Lessons Have Emerged from Mutual Fund Trading Abuses
paragraphs: We recognize that SEC faces competing examination priorities and had  limited examination resources before September 2003. We also recognize  that SEC examiners cannot anticipate every potential fraud, particularly  novel frauds such as the undisclosed market timing arrangements between  investment advisers and favored customers, such as hedge funds. Further,  SEC staff made good faith efforts to control the known risks associated  with legal market timing, such as issuing guidance on “fair value” pricing.  Nevertheless, three key lessons can be drawn from this experience and  used to strengthen SEC’s mutual fund oversight program going forward:    First, performing independent assessments of company controls is  essential to confirm views held by regulatory staff regarding risks and the  adequacy of controls in place to mitigate those risks. Commonly accepted  examination and auditing guidelines call for a degree of professional  skepticism in assessing controls (such as mutual fund company market  timing controls) and independent verification of their adequacy to mitigate  potential risks. Conducting independent testing of controls at a sample of  companies, at a minimum, could serve to verify that areas, such as market  timing, do in fact represent low risks and that effective controls are in  place. A variety of means can be used to independently test controls,  including interviewing responsible officials, assessing organizational  structure to ensure that compliance staff have adequate independence to  carry out their responsibilities, reviewing internal and external audit  reports, reviewing exceptions to stated policies, and testing transactions  as necessary. If examiners or auditors detect indications of noncompliance  with stated policies or requirements, they are expected to expand the  scope of their work to determine the extent of identified deficiencies.
Second, SEC must develop the institutional capacity to identify and  evaluate evidence of potential risks and deploy examination staff as  necessary to review controls and potentially detect violations in these  areas. Our review identified information that was available prior to  September 2003 and that was inconsistent with SEC staff’s views that  market timing was a low-risk area because companies would necessarily  act to protect fund returns from the harmful consequences of frequent  trading. For example, academic studies indicated that market timing, while  legal, remained a persistent risk prior to September 2003 and by one  estimate was costing mutual fund shareholders approximately $5 billion  annually in certain funds. Further, these studies showed that companies  were not acting aggressively to control these risks through fair value  pricing, despite SEC’s guidance that they do so. The author of a 2002 study  raised the possibility that certain investment advisers were not  implementing fair value pricing because they were benefiting financially  from permitting frequent trading, as turned out to be the case. Moreover, a  mutual fund company insider provided information to an SEC district  office in early 2003 indicating that a company had poor market timing  controls, but the office did not act promptly on this information. If the SEC  office had acted on this tip in early 2003, it might have identified  potentially illegal market timing activity by company insiders.
Third, ensuring the independence and effective operation of mutual fund  companies’ compliance staff is central to preventing violations of the  securities laws, regulations, and fund policies. In the majority of the 11  SEC mutual fund company enforcement cases we reviewed, compliance  staff lacked such independence. Although the compliance staff— sometimes referred to as “market timing police”—often identified frequent  trading that violated company limits, other company officials would  routinely overrule the compliance staff’s efforts to control such trading.  We also found that routine communication with compliance staff could  potentially enhance SEC’s capacity to detect potential violations at an  earlier stage if such staff are forthcoming with relevant information. In  cases we reviewed, compliance staff were obviously aware of violations  and, in two cases, had documented their findings regarding the harmful  consequences of frequent trading in internal company reports. For  example, in one case, the sales staff at a mutual fund company overrode  the compliance staff’s efforts to control hundreds of market timing  transactions between 1998 and 2003. In another case, a company’s chief  compliance officer sent memorandums to the chief executive officer in  2002 and 2003 complaining about the effects of the company’s market  timing arrangements on long-term shareholders.
section_title: SEC Has Taken Steps to Strengthen Mutual Fund Oversight, but It Is Too Soon to Assess the Effectiveness of Some Initiatives
paragraphs: SEC has taken several steps over the past two years to strengthen its  oversight of the mutual fund industry and improve company practices.  These steps include strengthening the agency’s mutual fund examination  program, establishing an office to better identify emerging risks, hiring  additional staff, establishing new tip handling procedures, and enacting a  series of rules and rule amendments. Although SEC has taken steps to  strengthen its mutual fund company oversight program, it is generally too  soon to assess the effectiveness of these initiatives.
To improve its examination program, SEC has instructed examiners to  make additional assessments of internal controls at mutual fund  companies. For example, SEC staff have identified a range of areas that  potentially represent high-risk compliance problems, such as personal  trading by company officials, and examiners have initiated independent  examinations of these areas. SEC staff also plan to significantly revise the  agency’s approach to mutual fund company examinations. Rather than  evaluating all mutual fund companies on a set cycle as they did between  1998 and 2003, SEC staff plan to begin focusing on the largest and riskiest  companies on an ongoing basis. For example, SEC is creating monitoring  teams of 2 to 3 individuals who would be responsible for reviewing the  largest companies on a more continuous basis, and is placing more  emphasis on examinations that target emerging risks. SEC also plans to  review some portion of other mutual fund companies on a randomized  basis. In a forthcoming report, we assess these and other planned changes  to SEC’s mutual fund company oversight program. I note that NASD has  also recently implemented new examination procedures to better detect  market timing and late trading abuses.
SEC also has established the Office of Risk Assessment (ORA) to assist the  agency in carrying out its overall oversight responsibilities, including  mutual fund oversight. The office’s director reports directly to the SEC  chairman. According to SEC staff, ORA will enable agency staff to analyze  risk across divisional boundaries, focusing on early identification of new  or resurgent forms of fraudulent, illegal, or questionable behavior or  products. SEC staff said that ORA will seek to ensure that SEC has the  information necessary to make better, more informed regulatory  decisions. Although ORA may help SEC be more proactive and better  identify emerging risks, it is too soon to assess its effectiveness. In this  regard, at the close of our review, ORA had established an executive team  of 5 individuals but still planned to hire an additional 10 staff to assist in  carrying out its responsibilities.
With increased appropriations over recent years, SEC also has hired  additional staff to carry out its mutual fund and other oversight programs,  potentially enhancing the agency’s capacity to test a variety of controls.  For example, Office of Compliance Inspections and Examinations staff  dedicated to mutual fund company oversight increased by 38 percent  between 2002 and 2005 (from 397 to an estimated 547 positions). While the  additional staff has the potential to enhance SEC’s capacity to oversee key  areas within the mutual fund industry, we previously reported that the  agency hired the staff without having an updated strategic plan. Without  an updated strategic plan in place that identifies the agency’s priorities and  aligns these priorities with an effective human capital program, it is not  clear that SEC’s recent hiring decisions will ensure that it has the right  amount of resources with the right expertise to do the most effective job  possible. In August 2004, SEC revised its strategic plan. We are reviewing  SEC’s strategic workforce planning as part of a separate engagement.
In addition to hiring staff, SEC has centralized its processes and  established new procedures for handling tips and complaints. For  example, before the abuses were detected, the agency’s Division of  Enforcement (Enforcement) had no process under which regional and  district office staff would refer complaints and tips to headquarters for  review and similarly no process for centralized review of how staff  handled complaints and tips. Under the new process, information  concerning all enforcement-related tips and complaints, whether received  through telephone calls, correspondence, emails, or in-person, is reported  to and maintained by a dedicated group within SEC headquarters.
Additionally, SEC has adopted a series of rules and rule amendments  designed to strengthen ethical and business practices at mutual fund  companies. Among the most significant initiatives, SEC now requires that  in order for a mutual fund company to use the agency’s exemptive rules, at  least 75 percent of its board of directors and the board chair must be  independent of the company’s investment adviser.  SEC believes that  increasing boards’ independence from investment advisers will help  prevent the types of trading abuses that we have been discussing today.  Further, SEC adopted rules that require mutual fund companies and  investment advisers to appoint chief compliance officers (CCO) who are  responsible for monitoring compliance with laws and regulations. SEC  also requires mutual fund company CCOs to prepare annual reports on  company policies and violations.
Although SEC’s rulemaking has the potential to strengthen the operations  of mutual fund companies and their investment advisers, the incentive  structure these rules rely on may not always be sufficient, and further  steps may be necessary. More specifically, in our April 2005 report we  pointed out that under SEC’s rule, fund company CCOs could be  investment adviser officials. SEC permitted this arrangement because fund  companies often do not have any staff. SEC also believes that it has  instituted rules designed to prevent potential conflicts of interest; for  example, a mutual fund company’s board—including a majority of its  independent directors—is solely responsible for removing the CCO. While  such steps may mitigate potential conflicts, we recommended that SEC  review CCOs’ independence as part of the examination process to ensure  that those who are advisory firm officials are actually acting  independently. SEC agreed with this recommendation. We also pointed  out that while SEC examiners planned to review CCO annual reports as  part of examinations, the agency has not established a process to receive  and review such reports on an ongoing basis. Without such a process, SEC  is not in the best position possible to monitor the industry and identify  emerging trends. SEC agreed with our recommendation to determine how  to best utilize their annual compliance reports, and any material findings  cited in those reports.
section_title: SEC Consistently Applied Procedures in Setting Mutual Fund Penalties, but Could Strengthen Certain Internal Processes
paragraphs: The penalties that SEC has obtained in enforcement cases related to  market timing and late trading violations are among the highest in the  agency’s history and generally consistent with civil penalties obtained in  cases involving similarly egregious corporate misconduct. Additionally,  SEC appears to have followed its penalty-setting process consistently in  setting penalties in the cases we reviewed. Federal and state prosecutors  we contacted said that several factors complicate bringing criminal  actions for market timing violations whereas late trading violations are  more straightforward to prosecute. We also found certain weaknesses in  SEC’s overall procedures for referring securities cases to other agencies  for potential criminal violations and ensuring that departing SEC  employees comply with conflict-of-interest laws and regulations. SEC  agreed to implement our recommendations to strengthen these processes.
subsections: section_title: Penalties in Mutual Fund Trading Abuse 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 obtained for securities laws  violations in its history. 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 over. Pursuant to the fair fund provision  of the Sarbanes-Oxley Act of 2002 (SOX), SEC plans to use the penalties  and disgorgement obtained (disgorgement forces firms to forfeit any ill- gotten gain), 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, one brokerage-advisory firm, and two insurance  companies, with penalties totaling $17.5 million.  I note that NASD has  taken 12 actions against broker dealers for late trading and market timing  abuses with fines and restitutions totaling more than $6 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 1 compares the range of penalties and average penalties  SEC obtained in settled 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 1 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 former 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 for public companies, arguing that the cost  of penalties are borne by shareholders who are frequently also the victims  of the corporate malfeasance.
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 (see table  2 for penalties) and disgorgements in some.  Almost all of these settled  enforcement actions involved high-level executives, including eight chief  executive officers (CEO), chairmen, and presidents. The penalties SEC  obtained in these settlements ranged from $40,000 to $30 million. The  penalties obtained from three 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 Applied Procedures in Setting Penalties
paragraphs: In determining appropriate penalties to recommend to the Commission in  the investment adviser cases we reviewed, SEC staff consistently applied  criteria that the agency has established. These criteria require SEC to  consider such things as the egregiousness of the conduct, the amount of  harm caused, and the degree of cooperation and to compare proposed  penalties with penalties obtained in similar cases. SEC staff may also  consider litigation risks in determining appropriate penalties. For  example, if SEC pursues an overly aggressive penalty, a defendant may be  less likely to settle, and a judge or other arbitrator may not agree with  SEC’s analysis and impose a lesser penalty. A range of SEC officials  participate in SEC’s process for setting appropriate penalties—including  the Commissioners—to help ensure that no one individual or small group  has disproportionate influence over the final decision. Moreover, SEC has  coordinated penalties and disgorgement with state authorities in many of  its market timing and late trading cases, although some states obtained  additional monetary sanctions.
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: Officials from DOJ, NYSOAG, and the Wisconsin Attorney General’s Office  told us that they have declined to bring criminal charges for market timing,  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 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.
In contrast, NYSOAG and DOJ have brought at least 12 criminal  prosecutions against individuals involving late trading violations. 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. 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, SEC staff 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 both formal and informal  processes for making referrals for criminal prosecutions; however, senior  Enforcement staff told us that SEC uses only the informal procedures  (such as telephone calls to criminal authorities) for making criminal  referrals, describing them as less time-consuming and more effective than  the more cumbersome formal processes, which involved multiple levels of  agency review and approval including review and approval by the  Commission. 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. In response to a  recommendation in our report, SEC agreed to institute procedures  requiring the documentation of referrals and the reasons for such  referrals.
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 it 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, as I described earlier, SEC is assigning staff to monitor large  mutual fund companies on an ongoing basis. These SEC examination  teams would likely have more regular contact with fund management over  a potentially longer period of time. In addition, the new SEC rule requiring  all mutual fund firms to designate CCOs 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. In response to a recommendation in our report,  SEC agreed to request that departing employees provide information on  where they plan to work and institute procedures (including reviewing  examination documentation) if agency staff believe that a departed  employee’s work products may have been compromised due to  interactions with a regulated entity.
section_title: Observations
paragraphs: The undisclosed market timing arrangements and late trading abuses  detected in September 2003 represented one of the most widespread and  serious scandals in the history of the mutual fund industry. SEC has  determined that undisclosed market timing arrangements, in particular,  existed at many large mutual fund companies for as long as 5 years.  However, before 2003, SEC did not identify the undisclosed arrangements  between investment advisers and favored customers through the agency’s  oversight process. SEC staff faced competing examination priorities that  may have affected its capacity to detect the abusive practices but has  taken several recent steps intended to strengthen its mutual fund company  oversight program and improve company operations. Several lessons can  be drawn from the experience in regard to regulators (1) performing  independent assessments of internal controls, (2) having the capacity to  identify and evaluate evidence of potential risks, and (3) ensuring the  independence of the compliance function at mutual fund companies.  Accordingly, our April 2005 report included recommendations to enhance  the effectiveness of SEC’s mutual fund oversight program and help  strengthen fund company operations, which SEC agreed to either  implement fully or consider ways to implement them. Although our May  2005 report found that SEC consistently applied its penalty setting  procedures in the cases we reviewed, it also identified weaknesses in the  agency’s procedures relating to the referral of securities cases to other  agencies for potential criminal violations and ensuring that departing  employees compiled with conflict-of-interest laws and regulations. The  report included recommendations to better ensure that these agency  responsibilities are being met, which SEC agreed to implement.
Mr. Chairman, this completes my prepared statement. I would be happy to  respond to any questions that you may have.
section_title: GAO Contacts and Staff Acknowledgements
paragraphs: For further information regarding this testimony, please contact me at  (202) 512-8678 or hillmanr@gao.gov, or Wesley M. Phillips, Assistant  Director, at (202) 512-5660 or phillipsw@gao.gov. Individuals making  contributions to this testimony include Emily Chalmers, Fred Jimenez,  Stefanie Jonkman, Marc Molino, David Tarosky, and Anita Zagraniczny.
This is a work of the U.S. government and is not subject to copyright protection in the  United States. It may be reproduced and distributed in its entirety without further  permission from GAO. However, because this work may contain copyrighted images or  other material, permission from the copyright holder may be necessary if you wish to  reproduce this material separately.