Penalties in Mutual Fund Trading Abuses Cases Are among SEC’s Highest and Are Consistent with Penalties in Similarly Egregious Cases

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. Before January 2003, penalties SEC obtained in settlement were  generally under $20 million. SEC Coordinated Penalties and Disgorgement with States in the Majority of Settlements with Investment Advisers, but Some States Obtained Additional Sanctions

SEC coordinated penalties and disgorgements with interested states in  many of the settled enforcement actions related to late trading and market  timing. 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. 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 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. Most Criminal Cases Brought Have Been Based on Late Trading Charges

NYSOAG and DOJ have brought at least 12 criminal prosecutions against  individuals for charges that include late trading. Inadequate Documentation Procedures Limit SEC’s Capacity to Effectively Manage the Criminal Referral Process

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. Without proper  documentation, SEC cannot readily determine and verify whether staff  make appropriate and prompt referrals. 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. Appendix I: Scope and Methodology

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.
Why GAO Did This Study

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.

What GAO Found

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.