SEC’s Revised Mutual Fund Examination Program Offers Potential Benefits but also Poses Significant Oversight Challenges

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. SEC Has Revised Its Traditional Mutual Fund Examination Approach in the Wake of the Mutual Fund Trading Abuses

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. 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. The  key initiatives that SEC is taking to strengthen its mutual fund oversight  program are largely intended to focus the agency’s resources on the largest  and highest risk funds and activities. The rule is expected to  increase SEC’s examination workload, but because of data limitations the  precise extent will not be known until hedge fund advisers actually register. SEC Efforts to Ensure Quality Do Not Include Review of Work Papers of Completed Mutual Fund Examinations

SEC uses several methods to ensure the quality of its examinations but  does not review completed examinations and work papers as done by other  regulators to determine whether the examinations were conducted  according to procedures or done consistently across field offices. To help ensure that these policies and procedures are  followed, SEC relies on experienced supervisors in its field offices to  oversee all stages of routine examinations. SEC’s Oversight Examinations of Broker-Dealers Provide Limited Information on the Adequacy of SRO Oversight

To assess SRO oversight of broker-dealers, including their mutual fund  sales practices, SEC conducts examinations of broker-dealers shortly after  they have been examined by SROs. However, these SEC broker-dealer  examinations, which involve a significant commitment of agency  examination resources, provide limited information on the adequacy of  SRO oversight and impose duplicative regulatory costs on the securities  industry. For mutual fund  examinations, SEC does not require staff to document their examination  plans to facilitate supervisory review. For broker-dealer examinations, SEC has not developed an  automated system to track the full scope of work completed during  examinations and therefore lacks useful information about SRO oversight. Third, to strengthen SEC’s approach to mutual fund examinations, we  recommend that SEC  establish a policy or procedure for supervisory review of work papers  prepared during routine examinations and for documenting such  reviews;  establish a policy or procedure for preparing a written plan for each  routine examination, documenting at a minimum the preliminary  objectives and scope of the examination; and  consider reviewing on a sample basis completed routine examinations  and work papers to assess the quality and consistency of work within  and across the field offices conducting examinations. Similarly, SEC’s inability to conduct  examinations of all mutual funds within a reasonable period will limit its  capacity to accurately distinguish relatively higher risk funds from lower  risk funds and effectively target its limited examination resources on those  funds posing the highest risks. Scope and Methodology

To identify and assess the changes SEC has made to or is planning for its  mutual fund examination program, we reviewed SEC testimony, speeches,  reports, and other documents related to the agency’s mutual fund  examination program. Securities and Exchange Commission’s (SEC) Broker-Dealer Examination Guidance and Training

You asked us to provide information about aspects of SEC’s oversight of  the broker-dealer industry, including (1) how SEC, NASD, and the New  York Stock Exchange (NYSE) share information, including written  examination guidance, related to their review of mutual fund sales  practices and other examination priorities; (2) how SEC distributes and  stores examination guidance for use by its broker-dealer examiners; and  (3) what training SEC has provided to its broker-dealer examiners on  mutual funds and other topics, and how it tracks and assesses such  training. Through its oversight role, SEC reviews aspects of the self-regulatory  organization (SRO) examination modules, including the mutual fund sales  practice module.
Why GAO Did This Study

As the frontline regulator of mutual funds, the Securities and Exchange Commission (SEC) plays a key role in protecting the nearly half of all U.S. households owning mutual funds, valued around $8 trillion in 2005. Mutual fund abuses raised questions about the integrity of the industry and quality of oversight provided by SEC and self-regulatory organizations (SRO) that regulate broker-dealers selling funds. This report assesses (1) changes SEC has made to, or is planning for, its mutual fund exam program; (2) key aspects of SEC's quality control framework for routine fund exams; and (3) the adequacy of SEC's oversight of NASD and the New York Stock Exchange in protecting shareholders from mutual fund sales abuses.

What GAO Found

SEC is initiating several changes intended to strengthen its mutual fund exam program but faces challenges overseeing the fund industry. In the wake of the fund abuses, SEC has revised its past approach of primarily conducting routine exams of all funds on a regular schedule. It concluded these exams were not the best tool for identifying emerging problems, since funds were not selected for examination based on risk. To quickly identify problems, SEC is shifting resources away from routine exams to targeted exams that focus on specific risks. It will conduct routine exams on a regular schedule but only of funds deemed high risk. SEC also is forming teams to monitor some of the largest groups of advisers and funds. Although SEC is seeking to focus its resources on higher risk funds and activities, the resource tradeoffs it made in revising its oversight approach raise significant challenges. The tradeoffs may limit SEC's capacity not only to examine funds considered lower risk within a 10-year period but also to accurately identify which funds pose higher risk and effectively target them for routine examination. Potentially taxing its resources further, SEC recently adopted a rule to require advisers to hedge funds (investment vehicles generally not widely available to the public) to register with it. This rule is expected to increase SEC's exam workload, but the precise extent is not yet known. SEC has integrated some quality controls into its routine exams, but certain aspects of its framework could be improved. It relies on experienced staff to oversee all exam stages but does not expressly require supervisors to review work papers or document their review. GAO found deficiencies in key SEC exam work papers, raising questions about the quality of supervisory review. SEC also does not require examiners to prepare written exam plans, though they use considerable judgment in customizing each exam. Written plans could serve as a guide for conducting exams and reviewing whether exams were completed as planned. As done by other regulators, SEC also could review a sample of work papers to test compliance with its standards. A primary tool that SEC uses to assess the adequacy of SRO oversight of broker-dealers offering mutual funds provides limited information for achieving its objective and imposes duplicative costs on firms. To assess SRO oversight, SEC reviews SRO exam programs and conducts oversight exams of broker-dealers, including their mutual fund sales practices. SEC's oversight exams take place 6 to 12 months after SROs conduct their exams and serve to assess the quality of SRO exams. However, GAO reported in 1991 that SEC's oversight exams provided limited information in helping SROs to improve their exam quality, because SEC and the SROs used different exam guidelines and their exams often covered different periods. GAO found that these problems remain, raising questions about the considerable resources SEC devotes to oversight exams. GAO also found that SEC has not developed an automated system to track the full scope of work done during its oversight exams. Thus, SEC cannot readily determine the extent to which these exams assess mutual fund sales practices.