	Regulators Are Taking Actions to Address Abusive Mutual Fund Practices

In reaction to allegations of widespread misconduct and abusive practices  involving mutual funds, regulators have responded with various proposals. In September 2003, SEC sought  information from fund advisers and broker-dealers about their pricing of  mutual fund orders and late trading policies. Another abuse that has come to light is known as market timing. Additional abusive practices associated with mutual funds have also come  to light. Since many of the cases of late trading involved  orders submitted through intermediaries, including banks and pension  plans not regulated by SEC, the proposed amendments to its rules would  require that orders to purchase or redeem mutual fund shares be received  by a fund, its transfer agent, or a registered clearing agency before the  time of pricing (that is, 4:00 p.m. Eastern Time). Because the hard close could affect some investors’ ability to trade at the  current day’s price, some groups have called on SEC to allow industry  participants to develop systems of internal controls that would serve to  ensure that intermediaries receive individual orders before 4:00 p.m. With  such controls in place, these orders could continue to be processed after  this time. SEC is also proposing to take actions to address market timing. SEC’s proposal to  address late trading with a hard 4:00 p.m. close appears, in the short-term,  to be the solution that provides the most certainty that all orders being  submitted to the funds legitimately deserve that day’s price. We also commend SEC for proposing to require that mutual funds more  fully disclose their market timing and portfolio disclosure policies. However, such disclosures would likely also require improving  related investor education programs to better ensure that investors  understand the importance of these new disclosures. Regulators Are Taking Actions to Improve the Effectiveness of Mutual Fund Boards of Directors

Mutual fund boards of directors have a responsibility to protect  shareholder interests and SEC has issued various proposals to increase  the effectiveness of these bodies. These rules are designed to protect  investors by ensuring that all funds and advisers have internal programs to  enhance compliance with federal securities laws. To further ensure that board members are truly  independent, we would support the Congress giving SEC rulemaking  authority to specify the types of persons who qualify as “interested  persons.” Having compliance officers report to fund boards and having  advisers implement codes of ethics should also provide additional tools to  hold fund advisers and boards accountable for ensuring that all fund  activities are conducted in compliance with legal requirements and with  integrity. Specifically, SEC is  seeking comments on how to revise a rule that allows mutual funds to  deduct fees to pay for the marketing and sale of fund shares. In addition,  to address a practice that raises potential conflicts of interest between  broker-dealers and their customers, SEC and NASD have also proposed  rules that would require broker-dealers to disclose revenue sharing  payments that fund advisers make to broker-dealers to compensate them  for selling fund shares. We support this action as a means of better ensuring that fund  advisers choose broker-dealers based on their ability to effectively execute  trades and not for other reasons. Although SEC  has taken some actions, we believe that additional steps could be taken to  provide further benefits to investors by increasing the transparency of  certain mutual fund practices and enhancing competition among funds on  the basis of the fees that are charged to shareholders. Soft Dollar Arrangements Provide Benefits, but Could Adversely Impact Investors

Soft dollar arrangements allow fund investment advisers to obtain  research and brokerage services that could potentially benefit fund  investors but also increase investor costs. Regulators in other countries and other industries have acted to address  the conflicts created by soft dollars. To address concerns over soft dollars, our June 2003 report recommends  that SEC evaluate ways to provide additional information to fund directors  and investors on their fund advisers’ use of soft dollars. As such, an  enhanced investor education campaign would also likely be warranted.
Why GAO Did This Study

Since September 2003, widespread allegations of abusive practices involving mutual funds have come to light. An abuse called late trading allowed some investors, at times in collusion with pension plan intermediary, broker-dealer, or fund adviser staff, to profit at other investors' expense by submitting orders for fund shares to receive that day's price after the legal cutoff. Other investors were allowed to conduct market timing trades to take advantage of stale prices used by funds to calculate their net asset values at funds with stated policies against such trading. SEC and other regulators have responded with numerous proposals for new or revised practices. Based on a body of work that GAO has conducted involving mutual funds, GAO analyzed and provides views on proposed and final rules involving (1) fund pricing and compliance practices intended to address various mutual fund trading abuses that have come to light recently, (2) fund boards' independence and effectiveness, (3) fund adviser compensation of broker-dealers that sell fund shares, and (4) additional actions regulators could take to further improve transparency and investor understanding of the fees they pay.

What GAO Found

GAO commends SEC and other regulators for their swift regulatory response to recently revealed abusive mutual fund practices. However, some proposed actions need to be thoroughly assessed to ensure equitable treatment for all investors and others will need to be reinforced with enhanced compliance, enforcement, and investor education programs to be truly effective. In particular, to prevent further late trading, SEC has proposed that all mutual fund orders be received by funds or designated processors by 4:00 p.m. Eastern Time, but this action may unfairly impact some retail investors that place orders through financial intermediaries. Although GAO supports in the short run the proposed hard 4:00 p.m. close as a way of increasing the certainty that all orders have been legitimately received, GAO believes that SEC should continue to work with industry participants, including pension plan intermediaries, to address concerns that the hard close would adversely affect investors that use such intermediaries. To address market timing, SEC is proposing that funds make greater disclosure of market timing, securities pricing, and portfolio disclosure policies. GAO supports these steps and encourages regulators to educate investors about the importance of such disclosures. To improve mutual fund corporate governance and oversight, SEC has also proposed increasing the proportion of independent directors to 75 percent and to require independent chairs. SEC is also proposing that fund advisers appoint compliance officers that report to fund boards. GAO sees these actions as giving increased prominence to independent members on fund boards of directors and providing them with additional tools to effectively oversee fund practices. However, additional actions may be needed to ensure that independent directors have no relationships with the fund adviser or its personnel that could impair their independence. SEC and other regulators have also proposed that the broker-dealers that sell fund shares make more extensive disclosures about payments they receive from fund advisers. SEC is also seeking comments on how to revise the fees they charge investors that also compensate broker-dealers for selling fund shares. GAO supports these actions as increasing the transparency of these costs to investors but recognizes that the effectiveness of these proposals could be enhanced by expanded compliance and investor education programs. SEC is also seeking information on how fund advisers use investor dollars to obtain research under a practice called soft dollars. Given the increased spotlight that Congress and regulators are placing on the mutual fund industry, GAO believes the time is right to more effectively address the conflicts of interest created by soft-dollar arrangements. In addition, GAO identifies further actions that could be taken to improve disclosure of mutual fund fees to enhance competition among funds on the basis of the fees that are charged to shareholders.