	Lessons Learned from SEC Not Detecting Abusive Market Timing Can Be Useful in Preventing Future Abuses

SEC did not examine for market timing abuses or test company controls in  that area, largely because the agency had competing examination  priorities and believed that companies had financial incentives to control  frequent trading. Conducting independent testing of controls at a sample of  companies, at a minimum, could serve to verify that areas, such as market  timing, do in fact represent low risks and that effective controls are in  place. Second, SEC must develop the institutional capacity to identify and  evaluate evidence of potential risks and deploy examination staff as  necessary to review controls and potentially detect violations in these  areas. For example, academic studies indicated that market timing, while  legal, remained a persistent risk prior to September 2003 and by one  estimate was costing mutual fund shareholders approximately $5 billion  annually in certain funds. Third, ensuring the independence and effective operation of mutual fund  companies’ compliance staff is central to preventing violations of the  securities laws, regulations, and fund policies. We also found that routine communication with compliance staff could  potentially enhance SEC’s capacity to detect potential violations at an  earlier stage if such staff are forthcoming with relevant information. SEC Has Taken Steps to Strengthen Mutual Fund Oversight, but It Is Too Soon to Assess the Effectiveness of Some Initiatives

SEC has taken several steps over the past two years to strengthen its  oversight of the mutual fund industry and improve company practices. With increased appropriations over recent years, SEC also has hired  additional staff to carry out its mutual fund and other oversight programs,  potentially enhancing the agency’s capacity to test a variety of controls. Further, SEC adopted rules that require mutual fund companies and  investment advisers to appoint chief compliance officers (CCO) who are  responsible for monitoring compliance with laws and regulations. SEC  also requires mutual fund company CCOs to prepare annual reports on  company policies and violations. We also pointed  out that while SEC examiners planned to review CCO annual reports as  part of examinations, the agency has not established a process to receive  and review such reports on an ongoing basis. Penalties in Mutual Fund Trading Abuse 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. These  penalties are among the highest SEC has obtained for securities laws  violations in its history. Before January 2003, penalties SEC obtained in  settlement were generally under $20 million. 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, SEC staff did not need  to make specific criminal referrals to bring these cases to their attention. Without proper  documentation, SEC cannot readily determine and verify whether staff  make appropriate and prompt referrals. SEC Efforts to Encourage Staff Compliance with Federal Conflict-of-Interest Laws On New Employment Do Not Include Tracking Post-SEC Employment Plans

SEC provides training and guidance to its staff on federal laws and  regulations regarding employment with regulated entities, and also  requires former staff to notify it if they plan to make an appearance before  the agency. However, SEC does not require departing staff to report  where they plan to work as do other financial regulators. However, before 2003, SEC did not identify the undisclosed arrangements  between investment advisers and favored customers through the agency’s  oversight process. Several lessons can  be drawn from the experience in regard to regulators (1) performing  independent assessments of internal controls, (2) having the capacity to  identify and evaluate evidence of potential risks, and (3) ensuring the  independence of the compliance function at mutual fund companies.
Why GAO Did This Study

Trading abuses--including market timing and late trading violations--uncovered among some of the most well-known companies in the mutual fund industry permitted favored customers to profit at the expense of long-term shareholders. Questions have also been raised as to why the New York State Office of the Attorney General identified the trading abuses in September 2003 before the industry's primary regulator: the Securities and Exchange Commission (SEC). Based on two recently issued GAO reports, this testimony discusses (1) the reasons SEC did not detect the abusive practices at an earlier stage and lessons learned from the agency not doing so, (2) steps the agency has taken to strengthen its mutual fund oversight program, and (3) enforcement actions taken by SEC and criminal prosecutors in response to these abuses and SEC management procedures for making criminal referrals and ensuring staff independence.

What GAO Found

Prior to September 2003, SEC did not examine mutual fund companies for trading abuses such as market timing violations because agency staff viewed other activities as representing higher risks and believed that companies had financial incentives to establish effective controls. While SEC has competing examination priorities, it can draw lessons from not detecting the trading abuses earlier. First, by conducting independent assessments of controls in areas such as market timing (through interviews, reviews of exception reports, reviews of independent audit reports, or transaction testing as necessary), SEC could reduce the risk that violations may go undetected. Second, SEC could further develop its capacity to identify and evaluate evidence of potential risk (for example, academic studies completed between 2000 and 2002 identified certain market timing concerns as a persistent risk to mutual fund customers). Third, ensuring the independence of company compliance staff is critical and SEC staff could better assess company risks and controls through routine interactions with such staff. SEC has taken several steps to strengthen its mutual fund oversight program and the operations of mutual fund companies, but it is too soon to assess the effectiveness of several key initiatives. For example, SEC has instructed its staff to make additional assessments of company controls and established a new office to identify and assess potential risks. SEC also adopted a rule that requires mutual fund companies to appoint independent compliance officers who are to prepare annual reports on their companies' policies and violations. However, SEC has not developed a plan to receive and review these annual reports on an ongoing basis and thereby enhance its capacity to detect potential violations. Since September 2003, SEC has brought 14 enforcement actions against mutual fund companies and 10 enforcement actions against other firms for mutual fund trading abuses. Penalties obtained in settlements with mutual fund companies 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. 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. However, GAO found certain weaknesses in SEC's management procedures for making referrals to criminal law enforcement and ensuring staff independence. In particular, SEC does not require staff to document whether a criminal referral was made or why. Without such documentation, SEC cannot readily determine whether staff make appropriate referrals. Further, SEC does not require departing staff to report where they plan to work, information gathered by other financial regulators to assess staff compliance with federal laws regarding employment with regulated entities. In the absence of such information, SEC's capacity to ensure compliance with these conflict-of-interest laws is limited.