State authorities uncovered various abusive practices in the mutual fund industry in 2003, but since then SEC has taken swift action designed to punish wrongdoers and better prevent or detect abusive practices in the future. In September 2003, the Attorney General of the State of New York filed a case alleging abusive practices involving mutual funds. After receiving a tip, the Attorney General’s staff investigated and filed fraud charges against a hedge fund manager for arranging with several mutual fund companies to improperly trade in fund shares and profit at the expense of other fund shareholders. The abuses in this case, and in others subsequently filed, included allegations of late trading and market timing. Late trading occurs when investors are able to illegally purchase or sell mutual fund shares after the 4:00 p.m. Eastern Time close of U.S. securities markets, when funds typically price their shares. Market timing occurs when certain fund investors place orders to take advantage of temporary disparities between the share value of a fund and the values of the underlying assets in the fund’s portfolio. Although not illegal, most mutual funds discourage such trading because it increases their costs and lowers returns for their long-term investors. These inappropriate market timing cases generally involved either fund companies with stated policies against such trading that were facilitating market timing for selected investors or broker-dealers or others that took deceptive actions to assist their customers to conduct market timing transactions. Since this case was filed, the New York State Attorney General’s Office has filed at least 10 additional cases involving mutual funds, broker-dealers, and other entities that were involved in late trading or market timing abuses. As of March 2004, state legal or regulatory authorities in at least three other states, including Massachusetts (3 cases), New Jersey (1 case), and Colorado (1 case) have taken actions against participants in the mutual fund industry for their involvement in late trading, market timing, or other abuses. Some of these cases also allegedly involved mutual fund executives or employees who were conducting market-timing activities in their own firms’ funds. SEC did not identify these abusive practices involving mutual funds for various reasons. According to SEC staff, many of the cases involved fraud and collusion among personnel and such activity is very hard to detect in a routine examination. Also, according to testimony by the head of the SEC office that conducts mutual fund examinations, SEC examiners did not reveal these practices because their examinations focused primarily on the operations of the mutual fund and trading of the fund’s portfolio securities practices with an acknowledged potential for abuse. As a result, their examinations did not generally address the trading in the fund’s own shares. SEC has also faced resource challenges for years that have affected its ability to conduct oversight in the mutual fund industry and other areas. For example, we reported on SEC’s difficulties during the 1990s to keep pace with the growth in the industry and its inability to examine funds and investment advisers frequently. In recent testimony, the director of the SEC office that conducts examinations noted that, prior to 1998, SEC examinations of mutual fund firms had been as infrequent as once every 12-24 years. Scarce resources may have also affected SEC’s decision to, unfortunately, not follow up on information it obtained regarding the recent wrongdoing in the mutual fund industry. In the summer of 2003, SEC staff had received a tip from a former fund employee who was aware of how his former employer was accommodating market timing by some investors, but SEC staff ultimately chose not to use further resources to pursue this case. The former fund employee then reported the matter to the Massachusetts Securities Division, which subsequently took action against the firm’s executives. As a result of another tip, however, the SEC staff promptly recommended and brought an enforcement action against the fund complex and two portfolio managers based on market timing and excessive short-term trading by investment professionals employed by the fund complex. However since these abuses have come to light, SEC and NASD, which oversees the broker-dealers that sell fund shares, have acted vigorously to address inappropriate practices in the mutual fund industry. For example, SEC has sent numerous requests for information to funds and broker- dealers about their trading practices. SEC’s preliminary analysis of these data show that 25 percent of responding broker-dealers had accepted orders after the 4:00 p.m. close and 30 percent allowed market timing. Since September 2003, SEC also has taken 15 enforcement actions that involved late trading and inappropriate market timing, in many cases against some of the same participants also pursued by state authorities. As of March 2004, NASD has also brought multiple enforcement cases against broker-dealers, including a February 2004 case against one of its broker- dealer members that failed to prevent market timing occurring in one of its affiliated firm’s mutual funds. SEC and NASD also have issued at least 11 rule proposals to address abusive and other practices in the mutual fund industry. For example, to address late trading and market timing, SEC issued proposed rule changes that would require orders for mutual fund shares to be processed by intermediaries and received by funds or their agents by 4:00 p.m. SEC is also proposing a rule that would require that funds charge investors holding fund shares less than 5 days a 2-percent redemption fee, which would reduce the likely profitability of short-term trading strategies involving late trading or market timing. SEC also proposed that funds disclose information about their policies regarding market timing and their use of a pricing technique called fair-value pricing, which is designed to better ensure that fund shares are priced accurately and thus are less susceptible to market timing. SEC’s Commissioners approved these rules on April 13, 2004. In addition to issuing proposals to address late trading and market timing, SEC has also taken some actions that address longstanding concerns over other mutual fund practices, including the lack of transparency of some fees and costs and the potential for conflicts of interest in fund distribution and sales practices. Some of the actions SEC and NASD are proposing would require greater disclosure of fees that funds charge or the payments that broker-dealers receive from fund firms for marketing certain funds. We discussed these and the late trading and market timing proposals and our views on them in testimony for the Senate Committee on Banking, Housing and Urban Affairs on March 10, 2004. Although SEC and the other regulators have acted swiftly to respond to the revelations of abusive mutual fund trading practices, other issues warrant SEC’s continued attention. For example, SEC is seeking information on how fund advisers use investors’ dollars to obtain research. This practice, called soft dollars, involves fund advisers receiving research or other services from broker-dealers in exchange for the commissions the advisers pay on trades conducted in fund portfolio securities. Although this practice can benefit the fund’s investors, whose assets are used to pay these commissions, it can also create conflicts of interest or potential for abuse. Given the increased spotlight Congress and regulators are placing on the mutual fund industry, in our view, the time is right to address the conflicts created by soft-dollar arrangements. In addition, we have identified other actions that SEC should take that would improve disclosure of mutual fund fees, thus improving investor awareness of the fees they pay on their mutual fund investments. These actions would increase the transparency of fund fees and likely enhance competition among funds on the basis of the fees charged investors. After experiencing an extended period in which increases in SEC’s workload grew faster than its staffing and other resources, SEC has received recent budget increases that have begun to allow it to increase its staffing, including positions in the divisions and offices with responsibilities for mutual fund regulation, oversight, and enforcement. However, SEC has taken these actions without the benefit of an updated strategic plan to guide staff deployment and the divisions and offices with responsibilities for mutual funds followed varying processes to determine their staffing needs. As a result, it is difficult to determine whether SEC has optimally allocated its limited resources to achieve the greatest benefits. After years of facing imbalances in its workload, SEC recently received additional resources that can help it more effectively oversee the securities markets, including the mutual fund industry. In March 2002, we reported that the growth rate of demands on SEC’s staff, including the number of corporate and regulatory filings they must review, the complaints and allegations of wrongdoing they must investigate, and the numbers of mutual funds, investment advisers and other entities they must examine, had increased by about 60 percent from 1996 to 2000. The rapid growth of the mutual fund industry during this time also posed challenges to SEC’s staff. For example, the number of mutual funds in existence grew from about 4,500 at the end of 1993 to over 8,100 by the end of 2000. In addition, the issues that SEC staff had to address had also become more complex. However, SEC’s staff resources during this period remained relatively flat. As a result, SEC’s ability to fulfill its mission had become increasingly strained because of the imbalance between its workload and staffing resources. Following the issuance of our March 2002 report, several high-profile corporate failures and accounting scandals came to light in 2002. In response to the resulting demands that public companies be held more accountable for information they report to investors, Congress passed the Sarbanes-Oxley Act of 2002 (Sarbanes-Oxley). The act, which addressed a number of concerns involving corporate governance, auditor independence, and regulation and oversight of the accounting profession, also provided additional resources to SEC. Subsequently, Congress appropriated $716 million for SEC in 2003, an increase of 45 percent over its fiscal year 2002 budget. SEC was directed to use this increase both to add personnel and acquire new information technology to increase its effectiveness. The new personnel were expected to assist SEC in addressing its workload imbalance and to help it conduct the additional reviews of corporate filings mandated by the act. In recognition of the important role SEC plays in ensuring the integrity of U.S. securities markets, it has continued to receive additional budgetary resources since then with an appropriation for 2004 of $811.5 million and a requested budget of $913 million for 2005.