SEC oversees mutual funds primarily through its Office of Compliance Inspections and Examinations (OCIE), Division of Investment Management, and Division of Enforcement. OCIE examines mutual funds to evaluate their compliance with the federal securities laws, to determine if they are operating in accordance with disclosures made to investors, and to assess the effectiveness of their compliance control systems. The Division of Investment Management administers the securities laws affecting funds and advisers. It reviews disclosure documents that mutual funds are required to file with SEC and engages in other regulatory activities, such as rulemaking, responding to requests for exemptions from federal securities laws, and providing interpretation of those laws. Finally, SEC’s Division of Enforcement investigates and prosecutes violations of securities laws related to mutual funds. SEC regulates mutual funds under the Investment Company Act of 1940, the Investment Advisers Act of 1940, the Securities Act of 1933, and the Securities Exchange Act of 1934. The Investment Company Act was passed specifically to regulate mutual funds and other types of investment companies. Under the act, mutual funds are required to register with SEC, subjecting their activities to SEC regulation. The act also imposes requirements on the operation and structure of mutual funds. Its core objectives are to ensure that investors receive adequate and accurate information about mutual funds, protect the integrity of fund assets, prohibit abusive forms of self-dealing, prevent the issuance of securities that have inequitable or ensure the fair valuation of investor purchases and redemptions. The Investment Advisers Act requires mutual fund advisers to register with SEC, imposes reporting requirements on them, and prohibits them from engaging in fraudulent, deceptive, or manipulative practices. The Securities Act requires fund shares offered to the public to be registered with SEC and regulates mutual fund advertising. Under the Securities Act and Investment Company Act, SEC has adopted rules to require mutual funds to make extensive disclosures in their prospectuses. The Securities Exchange Act, among other things, regulates how funds are sold and requires persons distributing funds or executing fund transactions to be registered with SEC as broker-dealers. SEC, NASD, and NYSE regulate broker-dealers, including their mutual fund sales practices, by examining their operations and reviewing customer complaints. Broker-dealers that are members of NYSE and do business with the public are typically also required to be members of NASD. Historically, NASD has conducted the mutual fund sales practice portions of examinations for firms that are dually registered with it and NYSE. As a result, NYSE generally plays a lesser role in examining broker-dealers for mutual fund sales practices. NASD has established specific rules of conduct for its members that provide, among other things, standards for advertising and sales literature, including filing requirements, review procedures, approval and recordkeeping obligations, and general standards. NASD also tests members to certify their qualifications as registered representatives. SEC evaluates the quality of NASD and NYSE oversight in enforcing their member compliance with federal securities laws through SRO oversight inspections and broker-dealer oversight examinations. SROs are private organizations with statutory responsibility to regulate their own members through the adoption and enforcement of rules of conduct for fair, ethical, and efficient practices. As part of this responsibility, they conduct examinations of the sales practices of their broker-dealer members. SEC’s SRO oversight inspections cover all aspects of an SRO’s compliance, examination, and enforcement programs. The inspections determine whether an SRO is (1) adequately assessing risks and targeting its examinations to address those risks, (2) following its examination procedures and documenting its work, and (3) referring cases to enforcement authorities when appropriate. Under its broker-dealer oversight examinations, SEC examines some of the broker-dealers that SROs recently examined. SEC conducts these examinations to assess the adequacy of the SRO examination programs. In addition to its oversight examinations, SEC conducts cause, special, and surveillance examinations of broker-dealers, but these examinations do not serve to assess the quality of SRO examinations. Since the detection of the mutual fund trading abuses in the summer of 2003, SEC has made significant changes to its traditional examination approach, which generally focused on conducting routine examinations of all funds on an established schedule. To better detect potential violations, SEC has reallocated or plans to reallocate its staff to conducting targeted examinations focusing on specific risks and monitoring larger funds on a continuous basis. SEC’s revised examination approach offers the potential for the agency to more quickly identify emerging risks and better understand the operations of large and complex funds, although it is too soon to reach definitive judgments. However, due to the limited number of SEC’s examination staff relative to the number of mutual funds and advisers for which the agency has oversight responsibility, the decision to focus examination resources on particular areas involved tradeoffs that raise regulatory challenges. In particular, SEC’s capacity to examine lower risk advisers and funds within a reasonable time period and develop industry risk ratings has been limited. Historically, routine examinations of mutual fund complexes—groups or families of funds sharing the same adviser or underwriter—have served as the cornerstone of SEC’s mutual fund oversight, accounting for 85 percent of the total fund examinations done from 1998 through 2003. During that period, SEC generally tried to examine each complex at least once every 5 years. Due to resource constraints, SEC examinations typically focused on discrete areas that staff viewed as representing the highest risks of presenting compliance problems that could harm investors. Major areas of review have included portfolio management, order execution, allocation of trades, and advertising returns. In late 2002, SEC implemented a revised approach to conducting routine examinations that included a systematic process for documenting and assessing risks and controls for managing those risks in a range of areas related to the asset management function. Besides routine examinations, SEC conducts sweep examinations to probe specific activities of a sample of funds identified through tips, complaints, the media, or other information. The agency also conducts cause examinations when it has reason to believe something is wrong at a particular fund. Sweep and cause examinations accounted for about 5 and 10 percent, respectively, of the total examinations done during 1998 through 2003. After the detection of the market timing and late trading abuses in the summer of 2003, SEC officials concluded that the agency’s traditional focus on routine examinations had limitations. In particular, SEC staff said that routine examinations were not the best tool for broadly identifying emerging compliance problems, since funds were selected for examination based largely on the passage of time, not based on their particular risk characteristics. In addition, SEC officials stated that they concluded the growth in the number of mutual fund companies and the breadth of their operations, combined with the need to perform more in-depth examinations of discrete areas, did not allow SEC to maintain its existing routine examination cycle. To focus its resources on issues and funds presenting the greatest risk of having compliance problems that may harm investors, SEC has made significant revisions to its examination priorities and oversight processes as described below: First, SEC is placing a higher priority on sweep and cause examinations and a lower priority on routine examinations. SEC has directed its 10 field offices that conduct fund examinations to give priority to initiating, as warranted, sweep examinations of funds or advisers, focusing particularly on operational or compliance issues. To address the market timing and late trading abuses surfacing in late 2003, SEC shifted resources away from routine examinations to support sweep and cause examinations, according to SEC officials. As a result, sweep and cause examinations accounted for 87 percent of the 690 fund examinations completed in fiscal year 2004. SEC officials said that about 17 percent of these examinations resulted in referrals to the agency’s Division of Enforcement for potential violations of securities laws and regulations. (We note that the large increase in the number of sweep and cause examinations in fiscal year 2004 as well as the number of referrals was likely due to SEC’s focusing a substantial amount of resources on detecting market timing and late trading abuses.) Second, SEC no longer will routinely examine all funds and advisers on a regular basis, but it will conduct routine examinations of funds and advisers perceived to be high risk, once every 2 to 3 years. In addition, SEC will randomly select a sample of advisers and their affiliated funds perceived to be low risk for routine examination each year. Because these firms will be selected randomly, each firm will have an equal chance of being examined each year. According to SEC officials, the random selection process will enable agency staff to project the examination findings to the population of firms deemed low risk and assess the possible existence of problems within the population. Third, SEC plans to provide more continuous and in-depth oversight of the largest mutual funds. Specifically, SEC is creating teams of examiners dedicated to regularly interacting with and closely monitoring and examining the activities of firms in the largest and most complex groups of affiliated advisers and mutual funds. SEC initially plans to form teams under a pilot program to monitor 10 large advisory groups. Any decision to form additional monitoring teams will depend on how the pilot program develops, according to an SEC official. SEC officials said that the monitoring teams are loosely modeled on the federal bank regulators’ use of on-site teams to continuously monitor operations of large banks. However, unlike the bank regulator approach, SEC staff said the monitoring teams would not be located on-site at large mutual fund companies. Fourth, an SEC task force is considering the development of a surveillance program to support the agency’s oversight of all funds and advisers. The purpose of this program is to obtain from firms information that would enable examiners to identify aberrant patterns in fund and adviser activities and the possible existence of fraud or abusive schemes that require follow-up through examinations. In its fiscal 2006 budget request, SEC reported that the agency expects the surveillance system to begin operations during the second half of 2006. Fifth, SEC has promulgated rules that require investment advisers and investment companies to appoint independent chief compliance officers (CCO) who are responsible for ensuring that their companies adopt policies and procedures designed to prevent violations of federal securities laws and regulations.