[House Hearing, 109 Congress]
[From the U.S. Government Publishing Office]



                       MUTUAL FUND TRADING ABUSES

=======================================================================

                                HEARING

                               BEFORE THE

                            SUBCOMMITTEE ON
                   COMMERCIAL AND ADMINISTRATIVE LAW

                                 OF THE

                       COMMITTEE ON THE JUDICIARY
                        HOUSE OF REPRESENTATIVES

                       ONE HUNDRED NINTH CONGRESS

                             FIRST SESSION

                               __________

                              JUNE 7, 2005

                               __________

                           Serial No. 109-42

                               __________

         Printed for the use of the Committee on the Judiciary


    Available via the World Wide Web: http://www.house.gov/judiciary


                                 ______

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                       COMMITTEE ON THE JUDICIARY

            F. JAMES SENSENBRENNER, Jr., Wisconsin, Chairman
HENRY J. HYDE, Illinois              JOHN CONYERS, Jr., Michigan
HOWARD COBLE, North Carolina         HOWARD L. BERMAN, California
LAMAR SMITH, Texas                   RICK BOUCHER, Virginia
ELTON GALLEGLY, California           JERROLD NADLER, New York
BOB GOODLATTE, Virginia              ROBERT C. SCOTT, Virginia
STEVE CHABOT, Ohio                   MELVIN L. WATT, North Carolina
DANIEL E. LUNGREN, California        ZOE LOFGREN, California
WILLIAM L. JENKINS, Tennessee        SHEILA JACKSON LEE, Texas
CHRIS CANNON, Utah                   MAXINE WATERS, California
SPENCER BACHUS, Alabama              MARTIN T. MEEHAN, Massachusetts
BOB INGLIS, South Carolina           WILLIAM D. DELAHUNT, Massachusetts
JOHN N. HOSTETTLER, Indiana          ROBERT WEXLER, Florida
MARK GREEN, Wisconsin                ANTHONY D. WEINER, New York
RIC KELLER, Florida                  ADAM B. SCHIFF, California
DARRELL ISSA, California             LINDA T. SANCHEZ, California
JEFF FLAKE, Arizona                  ADAM SMITH, Washington
MIKE PENCE, Indiana                  CHRIS VAN HOLLEN, Maryland
J. RANDY FORBES, Virginia
STEVE KING, Iowa
TOM FEENEY, Florida
TRENT FRANKS, Arizona
LOUIE GOHMERT, Texas

             Philip G. Kiko, General Counsel-Chief of Staff
               Perry H. Apelbaum, Minority Chief Counsel
                                 ------                                

           Subcommittee on Commercial and Administrative Law

                      CHRIS CANNON, Utah Chairman

HOWARD COBLE, North Carolina         MELVIN L. WATT, North Carolina
TRENT FRANKS, Arizona                WILLIAM D. DELAHUNT, Massachusetts
STEVE CHABOT, Ohio                   ADAM SMITH, Washington
MARK GREEN, Wisconsin                CHRIS VAN HOLLEN, Maryland
RANDY J. FORBES, Virginia            JERROLD NADLER, New York
LOUIE GOHMERT, Texas

                  Raymond V. Smietanka, Chief Counsel

                        Susan A. Jensen, Counsel

                  James Daley, Full Committee Counsel

                   Stephanie Moore, Minority Counsel


                            C O N T E N T S

                              ----------                              

                              JUNE 7, 2005

                           OPENING STATEMENT

                                                                   Page
The Honorable Chris Cannon, a Representative in Congress from the 
  State of Utah, and Chairman, Subcommittee on Commercial and 
  Administrative Law.............................................     1
The Honorable William D. Delahunt, a Representative in Congress 
  from the State of Massachusetts................................     3
The Honorable Melvin L. Watt, a Representative in Congress from 
  the State of North Carolina, and Ranking Member, Subcommittee 
  on Commercial and Administrative Law...........................     4

                               WITNESSES

Mr. Richard J. Hillman, Director, Financial Markets and Community 
  Investment, U.S. Government Accountability Office
  Oral Testimony.................................................     6
  Prepared Statement.............................................     8
Ms. Lori A. Richards, Director, Office of Compliance Inspections 
  and Examinations, U.S. Securities and Exchange Commission
  Oral Testimony.................................................    33
  Prepared Statement.............................................    36
The Honorable William Francis Galvin, Secretary of the 
  Commonwealth of Massachusetts
  Oral Testimony.................................................    55
  Prepared Statement.............................................    57
Mr. Eric W. Zitzewitz, Stanford Graduate School of Business, 
  Stanford, California
  Oral Testimony.................................................    59
  Prepared Statement.............................................    62

                                APPENDIX
               Material Submitted for the Hearing Record

Prepared Statement of the Honorable Chris Cannon, a 
  Representative in Congress from the State of Utah, and 
  Chairman, Subcommittee on Commercial and Administrative Law....    81
Response to post-hearing questions from Lori A. Richards, 
  Director, Office of Compliance Inspections and Examinations, 
  U.S. Securities and Exchange Commission........................    83
Response to post-hearing questions from the Honorable William 
  Francis Galvin, Secretary of the Commonwealth of Massachusetts.    95
Response to post-hearing questions from Eric W. Zitzewitz, 
  Stanford Graduate School of Business, Stanford, California.....    97

 
                       MUTUAL FUND TRADING ABUSES

                              ----------                              


                         TUESDAY, JUNE 7, 2005

                  House of Representatives,
                         Subcommittee on Commercial
                            and Administrative Law,
                                Committee on the Judiciary,
                                                    Washington, DC.
    The Subcommittee met, pursuant to notice, at 4:05 p.m., in 
Room 2141, Rayburn House Office Building, the Honorable Chris 
Cannon (Chair of the Subcommittee) presiding.
    Mr. Cannon. The Committee will come to order. Before I 
begin my formal remarks, I'd like to welcome the gentlelady 
from the State of Florida, Ms. Wasserman Schultz, who we 
anticipate will be named to replace the gentleman from 
Washington, Mr. Smith, on the Committee. I understand there is 
a unanimous request that Ms. Wasserman Schultz participate in 
today's hearing.
    Mr. Watt. I ask unanimous consent that Ms. Wasserman 
Schultz be allowed to participate fully as if she were already 
a Member of this Committee.
    Mr. Cannon. And it has been the habit of this Committee to 
yield time to a Member of the Committee and have that Member 
then yield to a person who may be a Member of the full 
Committee, but not a Member of the Subcommittee. Since Ms. 
Wasserman Schultz is going to, we hope, become a Member of the 
Committee quite soon, we will set that precedent aside, and 
without objection, so ordered. Welcome to the Subcommittee, Ms. 
Wasserman Schultz.
    And now for my formal remarks. In the fall of 2003, the New 
York State Attorney announced what would become the first of 
many law enforcement initiatives that his office and other 
State officials and the SEC would later champion to ferret out 
mutual fund trading abuses. Within the ensuing months many 
well-respected mutual fund companies and others were caught up 
in this scandal, including Canary Capital, Janus Capital Group, 
Bank of America, Alliance Capital Management, Prudential 
Securities, Millennium Partners, Fred Alger Management, Putnam 
Investments, Massachusetts Financial Services, Security Trust, 
Franklin Resources and Invesco Funds Group.
    In the fall and winter of 2003, it seemed as if every day 
the press reported on yet another shocking instance of mutual 
fund trading abuses. These abuses included the illegal practice 
of late trading, which involves trading shares after the 
markets have closed so that the trader can take advantage of 
information that becomes available after the closing. The 
Congressional Research Service analogized this practice to a 
race track that allows certain customers to bet on yesterday's 
races.
    Other abuses included the more nuanced problem of market 
timing. Market timing typically involves frequent buying and 
selling of mutual fund shares by sophisticated investors, such 
as hedge funds, that seek opportunities to make profits on the 
differences between foreign and domestic markets.
    While not per se illegal, market timing can constitute 
illegal conduct, if, for example, it takes place as a result of 
undisclosed agreements between investment advisers and favored 
customers in contravention of stated fund trading limits. 
Frequent trading can harm mutual fund shareholders because it 
lowers fund returns and increases transaction costs.
    According to an estimate provided by one of the witnesses 
at today's hearing, Professor Zitzewitz, market timing abuses 
may have resulted in $5 billion in annual losses. As of 
November 2003, the SEC estimated that 50 percent of the 80 
largest mutual fund companies had entered into undisclosed 
arrangements permitting certain shareholders to engage in 
market timing practices that were inconsistent with the funds' 
policies, prospectus disclosures or fiduciary obligations.
    As the mutual fund scandal unfolded, questions were raised 
about the fitness of the SEC's overall regulation, inspection, 
and enforcement of this industry. The Congressional Research 
Service posed possible explanations, including the following: 
the possibility that the SEC's resources devoted to the fund 
industry were dwarfed by the expansion in the number of mutual 
funds; the possibility that the SEC's overall effectiveness may 
have been marred by interdivisional disharmonies; the 
possibility that the SEC officials may have placed too much 
trust in the fund industry's integrity and ability to police 
itself; the possibility that the mutual fund industry may be 
too close to the relevant parts of the SEC entrusted with its 
oversight and regulation; and the possibility that the SEC may 
have had a somewhat understandable focus on the prevention of 
more traditional types of fund misconduct.
    In response to these concerns, House Judiciary Committee 
Chairman Sensenbrenner and Ranking Member Conyers requested the 
GAO to undertake a comprehensive review of the SEC's efforts to 
proactively detect and prevent illegal activities in the mutual 
fund industry. Today's hearing provides an opportunity for GAO 
to report on its findings and recommendations and to allow the 
SEC and others to respond to them.
    Accordingly, our first witness is Richard Hillman, who is 
the Director of GAO's Financial Markets and Community 
Investment Team. With 29 years of experience at GAO, Mr. 
Hillman is currently responsible for directing research 
engagements on various cross-cutting financial services matters 
within the banking securities and insurance industry. Mr. 
Hillman graduated with honors from the University of Scranton 
with a bachelor's degree in science and accounting, and has 
completed additional course work in Government management and 
information technology issues at the Federal Executive 
Institute and Harvard's John F. Kennedy School of Government.
    Our next witness is Lori Richards, who is the Director of 
the SEC's Office of Compliance Inspections and Examinations. 
She has served in that capacity for 10 years. Her office is 
responsible for administering the SEC's security compliance 
examination and inspection program for entities registered with 
the SEC as self-regulatory organizations, broker-dealers, 
transfer agents, clearing agencies, investment companies and 
investment advisors. Before beginning her career with the SEC 
in 1985, Ms. Richards received her B.A. From Northern Illinois 
University and her J.D. From American University.
    Our third witness is William Francis Galvin, the Secretary 
of the Commonwealth of the Massachusetts. I understand that my 
colleague on the other side of the aisle Mr. Delahunt would 
like to say a few words. The gentleman is recognized.
    Mr. Delahunt. Thank you, Mr. Chairman. I am really pleased 
to see my friend, my colleague in State government for many 
years, Bill Galvin here as a witness. He has an extraordinary 
record as secretary of state. In Massachusetts the securities 
industry is under his--I should say it is the office that 
regulates the securities industry in Massachusetts, and he has 
earned justifiably a national reputation for aggressively 
protecting investors and has been successful in recovery of 
millions of dollars for victims of security fraud.
    Bill Galvin was an integral part of the 2003 multistate 
examination of research analysts' practices on Wall Street, 
which resulted in a finding of fraud against First Boston and 
developed into investigations into mutual fund industry 
practices. So it is a pleasure to have you here, Bill, and I 
look forward to your testimony.
    Mr. Cannon. Thank you, Mr. Delahunt.
    We are pleased, Mr. Galvin, to have a person of such a 
national reputation and one who is--I hope can bring to bear, 
and I believe will bring to bear--a great deal of information 
and understanding for us on this Committee. Thank you.
    Our final witness is Mr. Eric Zitzewitz. He has been an 
assistant professor of economics at Stanford Graduate School of 
Business since 2001, and published extensively on the 
securities industry as well as on other subject matter dealing 
with economics. He received his undergraduate degree in 
economics from Harvard and his Ph.D. In economics from MIT.
    I extend to each of you my warm regards and appreciation 
for your willingness to participate in today's hearing. In 
light of the fact that your written statements will be included 
in the record, I request that you limit your oral remarks to 5 
minutes. And accordingly, please feel free to summarize the 
salient points of your testimony.
    And you will note that there is a lighting system in front 
of you. After 4 minutes the light will turn from green to 
yellow, and then at 5 minutes it will turn to red. It's my 
habit to tap the gavel, probably the handle or maybe a pen, to 
just indicate that that's happened. You don't need to cut off 
at that point. We are not trying to cut you off mid-thought, 
but just as a matter of comity, because there are several 
people that will want to ask questions today. I can almost 
assure you that you will have plenty of time to come back and 
add to your statements as we give 5 minutes to each of the 
members of the panel.
    After you have presented your remarks, the Subcommittee 
Members in order of their arrival will be permitted to ask 
questions for 5 minutes. And again, in the case of the clock, I 
will tap when we get close to when we hit the red light. You 
don't have to stop immediately, but just as a matter of comity, 
we would like to move on.
    And pursuant to the directive of the Chairman of the 
Judiciary Committee, I ask the witnesses to please stand and 
raise your right hand to take the oath.
    [Witnesses sworn.]
    Mr. Cannon. The record will reflect that each of the 
witnesses answered in the affirmative.
    You may be seated.
    And, Mr. Hillman, if you'd like to proceed, you're 
recognized for 5 minutes.
    Mr. Hillman. Thank you very much, Mr. Chairman.
    Mr. Cannon. Pardon me, Mr. Hillman. If I could interrupt 
you, we would love to hear from the Ranking Member and I 
apologize for not having recognized him a moment ago. If the 
gentleman would like to speak, he is recognized for 5 minutes.
    Mr. Watt. Thank you, Mr. Chairman. I won't take 5 minutes. 
I just wanted an opportunity to join you in welcoming Ms. 
Wasserman Schultz to the hearing today and hopefully to the 
membership on the Committee tomorrow, once that is formalized.
    I want to thank the Chairman for convening the hearing to 
begin the process of reviewing the SEC's failure to detect 
mutual fund abuses. More than one-half of American households 
invest in mutual funds. They invest to enhance their futures 
and their children's futures. These investments should be 
treated with great care and confidently secured from abuses.
    I think we all agree the market should be free from 
unscrupulous activities of mutual fund companies. Although this 
Subcommittee is addressing the GAO's recommendations with 
respect to the SEC's role in detecting the mutual fund abuses 
that hinder long-term shareholders from proper fund returns, I 
would like to emphasize the important role the States play and 
continue to play in the collaborative efforts to detect and 
deter mutual fund abuse.
    Many of the abuses examined by the GAO at the request of 
Chairman Sensenbrenner and Ranking Member Conyers surfaced due 
to the diligence of the State Attorney General Eliot Spitzer of 
New York. So while I think it is important that we determine 
whether the SEC is broken and, if so, how to fix it, I can't 
overemphasize the critical role that the States must continue 
to play in protecting investors, large and small.
    Additionally, I have--I don't know whether it's enviable, 
but I serve on both the Judiciary Committee and the House 
Financial Services Committee, and those are the Committees that 
actually share jurisdiction over mutual funds and securities. 
And so I want to emphasize the important role that the 
Financial Services Committee also plays over law enforcement in 
the mutual fund industry. I believe we should focus narrowly on 
enforcement issues in this Subcommittee and take care to divine 
precisely what role this Committee can and should take in 
response to the problems of abuses that have been revealed. So 
I am particularly interested in hearing the testimony here 
today, and I welcome the witnesses and yield back.
    Mr. Delahunt. Would the gentleman yield for a moment?
    Mr. Watt. I am happy to yield to my friend from 
Massachusetts.
    Mr. Delahunt. Yeah, I just wanted to echo some of the 
sentiments that you expressed, Mr. Watt, particularly regarding 
the role of the Judiciary Committee as well as the Financial 
Services Committee. I know you serve on both. And I want to 
applaud the Chairman for calling this particular hearing into 
an issue obviously that has great significance and impact to 
the lives of millions, tens of millions of Americans. And I 
would hope that this Subcommittee would even be more aggressive 
in the future in terms of exercising its oversight 
responsibilities, particularly as it relates to enforcement not 
only in this area, but in the entire jurisdiction within the 
Committee's purview.
    One can only reflect on the number of administrative bodies 
that exist in the executive branch of Government that I would 
respectfully suggest are not the subjects of significant 
oversight. One only has to think of the alphabet that we deal 
with in terms of administrative agencies, and yet I have served 
on this Committee in the past, and this is the first time, in 
my memory, I can think of a significant agency such as the SEC 
that has been before the Committee. And I would hope that we 
would continue to be aggressive and send that message out to 
the executive branch that this Subcommittee in particular 
intends to be aggressive about oversight. And with that I yield 
back.
    Mr. Watt. I appreciate the gentleman's comments and--but I 
do want to assure him that the Financial Services Committee has 
had the SEC and a number of these agencies in front of that 
Committee on a regular basis, so it is not that oversight is 
not being done. It is being done. And our role, I think, is 
more on the enforcement side to emphasize not--well, you know, 
we have got a clear role here, and we just need to not stumble 
over each over, I guess, is the----
    Mr. Delahunt. Never enough oversight.
    Mr. Watt. Never enough oversight.
    Yield back.
    Mr. Cannon. I thank the gentleman. Let me also point out 
that I believe there is never enough oversight, whether it is a 
Republican administration or a Democrat administration, whether 
the Republicans control Congress or the Democrats do. That is 
one of the great, great things about this body. And so to the 
degree that the Minority has had issues that they want to look 
at, I hope we have been receptive and are anxious actually to 
carry out that oversight role. So thank you, Mr. Delahunt, for 
your kind comments, and Mr. Watt.
    Mr. Hillman, if you would like to go ahead, you're 
recognized for 5 minutes now.

 TESTIMONY OF RICHARD J. HILLMAN, DIRECTOR, FINANCIAL MARKETS 
AND COMMUNITY INVESTMENT, U.S. GOVERNMENT ACCOUNTABILITY OFFICE

    Mr. Hillman. Thank you, Mr. Chairman. I am pleased to be 
here today to discuss two recently issued GAO reports that 
assess SEC's response to trading abuses uncovered in the mutual 
fund industry. We prepared these reports at the request of 
Chairman Sensenbrenner and Ranking Member Conyers of the full 
Committee.
    As you know, trading abuses, including fraudulent market 
timing and late trading violations, were uncovered in many 
well-known companies in the mutual fund industry and raise 
significant concerns about the industry's ethical practices. 
Maintaining public confidence in the mutual fund industry is 
critical because about 95 million Americans have invested more 
than 8 trillion in mutual funds, a significant share of the 
Nation's privately held wealth. Moreover, it is critical that 
the SEC have the capacity to identify abusive practices and to 
bring enforcement actions that punish violators and deter those 
who are contemplating similar abuses.
    My written statement today discusses the reasons the SEC 
did not detect the market timing abuses at an earlier stage, 
some of the steps that SEC has taken to strengthen its 
oversight of the mutual fund industry, and enforcement actions 
taken by SEC and criminal prosecutors in response to these 
abuses, and SEC's management of procedures related to the 
making of criminal referrals and ensuring staff independence 
from the mutual fund industry.
    In summary, regarding our first objective, before September 
2003, SEC did not examine fund companies for market timing 
abuses because agency officials, one, viewed other activities 
as representing much higher risk; two, concluded that companies 
had financial incentives to control frequent trading because it 
could lower fund returns; and three, were told by company 
officials and the companies that they had established controls 
over frequent trading.
    While SEC faced competing examination priorities before 
September 2003, and had made good-faith efforts to mitigate the 
known risks associated with legal market timing, lessons can be 
learned from the Agency not having detected the abuses earlier. 
First, without paying additional attention to conducting 
independent assessments of the adequacy of mutual fund company 
controls, the potential increases that violations may go 
undetected.
    Second, SEC can strengthen its capacity to identify and 
assess any evidence of potential risk. Information was 
available to the SEC before these market timing problems were 
uncovered indicating the possibility of illegal market timing 
activities. For example, a 2002 study estimated that market 
timing in certain funds resulted in about 5 billion in annual 
losses to shareholders and raised the possibility that 
investment advisors did not always act decisively to control 
such risks due to potential conflicts of interest.
    Third, our review of individual market timing enforcement 
cases found that compliance staff at mutual fund companies 
often detected evidence of undisclosed market timing 
arrangements with favored customers, but lacked sufficient 
independence within their organizations to correct identified 
deficiencies. Ensuring the independence of compliance staff is 
critical, and SEC could potentially benefit from using their 
work.
    Since these abuses were uncovered SEC has acted 
aggressively to address identified abuses through proposed and 
final rulemakings, bringing and settling enforcement cases and 
conducting targeted examinations. In particular, SEC has take a 
variety of steps to strengthen its mutual fund oversight 
program and the operations of 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 
improve its capacity to anticipate, identify and manage 
emerging risks and market trends in the securities industry. 
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 yet developed a plan to receive and review 
these annual reports on an ongoing basis and thereby enhance 
its capacity to detect potential violations.
    SEC has agreed with recommendations in our report to 
strengthen its oversight, including assessing how best to use 
such compliance reports. At the time of our review, SEC had 
brought 14 enforcement actions against mutual fund companies 
and 10 enforcement actions against other firms for mutual fund 
trading abuses. The penalties obtained in settlements with 
mutual fund companies are amongst the Agency's highest, ranging 
from 2 million to 140 million and averaging 56 million. In 
contrast, penalties obtained in settlements for securities laws 
violations prior to 2003 were typically under 20 million.
    In reviewing a sample of investment advisor cases, we found 
the SEC followed a consistent process for determining 
penalties, and that it coordinated penalties and other 
sanctions with interested parties. However, we found certain 
weaknesses in SEC's management procedure 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 more 
limited.
    SEC agreed with our report recommendations to document 
criminal referrals and employees' postemployment plans.
    Mr. Chairman, this completes my prepared statement. I would 
be happy to respond at the appropriate time to any questions 
that might arise.
    Mr. Cannon. Thank you, Mr. Hillman.
    [The prepared statement of Mr. Hillman follows:]

                Prepared Statement of Richard J. Hillman




    Mr. Cannon. Ms. Richards, you're recognized for 5 minutes.

 TESTIMONY OF LORI A. RICHARDS, DIRECTOR, OFFICE OF COMPLIANCE 
  INSPECTIONS AND EXAMINATIONS, U.S. SECURITIES AND EXCHANGE 
                           COMMISSION

    Ms. Richards. Thank you, Chairman Cannon, Ranking Member 
Watt, Members of the Committee. I am Lori Richards. I am 
Director of the SEC's Office of Compliance Inspections and 
Examinations. Thank you for inviting me to testify here today 
about the SEC's oversight of the mutual fund industry, the 
recent mutual fund trading abuses and recent GAO reports.
    In the last 21 months, the SEC has moved quickly to 
implement a series of reforms with respect to mutual funds. We 
rapidly examined and investigated fund firms and brought 
numerous enforcement actions. We adopted new rules designed to 
improve mutual funds governance, ethical standards, compliance 
and internal controls. We initiated reforms to SEC rules 
designed specifically to address market timing and late 
trading. And finally, we improved SEC examiners' ability to 
detect emerging compliance problems promptly. It is our 
expectation that, taken together, these reforms will minimize 
the possibility of these types of abuses from occurring again.
    My testimony today focuses primarily on the significant 
steps that the SEC has taken with respect to its examination 
oversight of mutual funds. There are now over 8,000 mutual 
funds managed in over 900 mutual fund complexes, and over 8,000 
investment advisors registered with the SEC. The size of the 
mutual fund industry does not allow the SEC to conduct 
comprehensive audits of all of their operations. Until recently 
the SEC had approximately 360 staff people who were dedicated 
to these examinations. In 2003, however, budget increases 
allowed us to increase the size of the SEC's examination staff 
to approximately 500 staff people.
    Given the size of the industry, our examinations focus on 
those areas that, in our view, pose the greatest risk to 
investors. The challenge for any regulator with limited 
resources is to identify and to effectively target those areas 
that pose the greatest risk. SEC examinations are, therefore, 
focused on the use of a fund investor's assets, their money and 
their securities, and primarily whether the mutual fund is 
making investments on behalf of investors that are appropriate, 
how mutual funds are being marketed and sold to retail 
investors, and whether funds were trying to inflate the returns 
of the fund or take on undisclosed risk in order to generate 
more sales.
    It is important for me to note that while market timing was 
the subject of recent GAO reports, SEC examinations have often 
detected serious compliance problems in other areas, and those 
have resulted in serious enforcement actions. For example, the 
SEC has been on the forefront of discovering and addressing 
abuses with respect to the widespread failure to deliver mutual 
fund discounts to investors on their purchases of mutual funds; 
investment advisors' undisclosed favoritism in the allocation 
of shares amongst their client accounts; the failure to 
disclose the use of mutual funds money to pay the cost of 
selling fund shares; and various types of sales abuses, in 
particular selling one type of fund to an investor when another 
type of fund would be better for that particular investor, and 
various unsuitable sales associated with the sales of variable 
annuity products.
    Since the first instances of market timing and late trading 
were identified by a tip to the New York Attorney General's 
Office, the SEC moved very rapidly to investigate this issue in 
the broader mutual fund industry. As of May 31, 2005, the SEC 
has brought 29 enforcement actions involving mutual fund 
complexes and their employees and 12 enforcement actions 
involving broker-dealers and their employees. The recent GAO 
report outlined some of these enforcement actions, and 
recognizes that the penalties obtained in these cases are among 
the largest ever imposed by the SEC. Prior to 2003, as the GAO 
report notes, we did not identify the covert secret market 
timing arrangements between mutual funds and active traders.
    It is important to note that there is a difference between 
market timing that is legal and market timing that is illegal. 
Illegal market timing involved secret arrangements between fund 
executives and select market timers. By their nature these were 
secret, undisclosed arrangements, some of which we now know 
involved nominee accounts and false trading records. The SEC 
did not have prior notice of these secret arrangements that 
some mutual fund executives had with favored traders.
    GAO has stated that we can learn lessons from our 
experience with market timing. I suppose I would recast that 
statement slightly to say that we have learned lessons from our 
experience with market timing. We have implemented changes to 
our examination protocols that will allow examiners not only to 
detect abusive market timing and late trading, but, perhaps 
more importantly, to be more nimble, to be more aggressive, to 
be more proactive in identifying other types of misconduct 
associated with mutual funds.
    The new methodology is described in some detail in my 
written testimony, but key enhancements include conducting 
focused routine examinations on the highest-risk firms; 
increasing the use of data and technology in examinations, 
including by randomly reviewing mutual fund employees' e-mails. 
One of the lessons we learned is that the secret market timing 
arrangements were often negotiated between mutual fund 
executives and market timers via e-mail communications. So 
those are now critical aspects of our routine examinations.
    We are studying the development of an off-site surveillance 
program for mutual funds and investment advisors. We 
implemented a new risk mapping program to better identify areas 
of emerging risk. We have implemented a new program to rapidly 
investigate emerging compliance problems by use of sweep 
examinations. We are implementing dedicated monitoring teams 
for the largest fund organizations, and, very importantly, to 
help reduce violations or help eliminate the possibility that 
violations could occur in the first place. We are reaching out 
to the new chief compliance officers at mutual fund firms and 
investment advisors in a new chief compliance officers outreach 
program to help them better eliminate compliance problems in 
the first place.
    In sum, the SEC has taken aggressive steps to address 
abusive market timing and late trading in mutual fund shares, 
but more broadly, the SEC has taken steps to protect investors 
from the next instance of fraud and abuse by improving our 
ability to spot emerging problems more quickly.
    Thank you, and I am happy to answer any questions you may 
have.
    Mr. Cannon. Thank you.
    [The prepared statement of Ms. Richards follows:]

                 Prepared Statement of Lori A. Richards




    Mr. Cannon. Secretary Galvin.

     TESTIMONY OF WILLIAM FRANCIS GALVIN, SECRETARY OF THE 
                 COMMONWEALTH OF MASSACHUSETTS

    Mr. Galvin. Thank you, Mr. Chairman.
    Chairman Cannon, Ranking Member Watt, distinguished Members 
of the Committee, thank you very much for having me here this 
afternoon. I am Bill Galvin. I'm the Secretary of the 
Commonwealth of Massachusetts and its chief securities 
regulator. Among the duties of my office are protecting 
investors in the Commonwealth of Massachusetts through our 
securities division.
    I am here today to offer my perspective on mutual fund 
trading abuses, and more specifically this recent April 2005 
GAO report. The subtitle of this report is, quote, Lessons Can 
Be Learned from the SEC Not Having Detected Violations at an 
Earlier Stage, close quote. From my perspective, the lessons 
are pretty simple. In the past the SEC simply didn't do it's 
job. It dropped the ball. It ignored warning signs and 
inexplicably didn't follow up on tips. In short, it failed to 
protect mutual fund investors.
    Let me be blunt. Had the SEC done what it was supposed to 
do, we probably wouldn't be here today. Unfortunately, it's not 
the first time the SEC has let investors down. Consider the 
history from just the past 10 years. Almost every major 
enforcement action or investor protection issue was first 
brought or raised not by the SEC or the NASD, but by State 
securities regulators. These include penny stock and microstock 
fraud, day trading abuses, misleading Internet brokerage 
advertising, analyst conflict of interest matters, and lastly 
mutual fund trading abuses. In virtually every case the States 
took the lead.
    The revelations of recent years about the securities 
industry teach an even more compelling lesson, and that is the 
critical importance of what goes on in what I will call the 
risk marketplace for average Americans. Their savings, their 
pensions, their children's education funds, in short their 
financial futures are now as never before in play in this 
marketplace.
    The GAO report is fine as far as it goes, but it leaves out 
the most important lesson, in my view, and that is the vital 
role played by State securities regulators. We need more cops 
on the securities beat and more constructive competition among 
them to protect the investing public. Our regulatory monopoly 
is as bad as any other kind of monopoly. Customers and 
investors are ill served by monopolies. Monopoly regulators, 
like monopoly companies, get complacent. They miss things. They 
can get too cozy with the folks they're supposed to regulate.
    I have seen how it works in the securities industry. The 
regulators and the regulated go to each others' conferences, 
usually in nice places like Palm Beach and Palm Desert. The 
revolving door through which Federal regulators go to find 
lucrative jobs on Wall Street should be the subject of another 
hearing perhaps on another day.
    As I said, we probably wouldn't be here today if the SEC 
had done its job. Unfortunately it did not. From my perspective 
as a State securities regulator, I think the SEC has to be 
aggressive across the board.
    Chairman William Donaldson has made some important progress 
during his time at the Commission. The pending nomination of 
Mr. Cox and other anticipated vacancies at the SEC raises a 
most serious question. Is the era of reform and vigorous 
enforcement over? There is no doubt we are at a crossroads. 
Just 2 years ago this House of Representatives voted by a 
margin of 418 to 2 to reform the mutual fund industry. The bill 
died in the Senate. Was that just for show, or are we serious 
about giving average Americans real protection?
    Over the years the SEC has been criticized for not being 
proactive and tough enough. I think it is a fair criticism. 
Traditionally one of the weakest and most toothless divisions 
of the SEC was in investment management. It has not been known 
for aggressive examinations, and certainly not for enforcement 
actions. I'd even call it a regulatory backwater. This is 
strange and unacceptable, given that nearly 100 million 
Americans entrust their money to the mutual fund industry. Yet 
here we have a regulator that ignored reports from academics 
and even anonymous tipsters from within the industry that 
market timing was costing investors billions of dollars.
    This chicanery and fraud would likely still be going on if 
it were not for a couple of State securities divisions that 
acted when the SEC and the NASD did not, despite having a tiny 
fraction of the resources these two organizations have. In 
Massachusetts, for example, we brought many--several market 
timing and late trading enforcement actions based on the tips 
we received and the exams we conducted. These involved Putnam 
Mutual Funds, Prudential Securities, Franklin-Templeton and 
A.G. Edwards. Like State securities regulators across the 
country who follow up on tips, we answer the phone, we listen 
to investors, and we're easy to reach.
    There are those who would like to see the State securities 
regulators just go away. They argue our complementary system of 
State and industry self-regulation is burdensome and 
duplicative. It is neither. Quite the contrary, it serves to 
protect investors. The mutual fund trading abuse described in 
the GAO report are proof of that.
    Our system works. That's the lesson of all this. So next 
time some free market think tank underwritten by Wall Street 
money says we don't need State securities regulators, that the 
industry can regulate itself just fine out of enlightened self-
interest, you have a simple four-word answer, which also 
happens to be the title of this report: Mutual Fund Trading 
Abuses.
    The fact is we need more, not fewer, cops on the securities 
beat. That is the lesson of this scandal. And we need 
cooperation among regulators, not corruption. We need to check 
each other's work. Sometimes we need to backstop each other.
    A few years ago in 1996, in the name of so-called 
regulatory reform and efficiency, the States were essentially 
preempted from the regulation of mutual funds. The scandal we 
are here today to discuss is a legacy of that misguided policy. 
Investor protection, including aggressive enforcement of State 
and Federal securities laws, isn't a partisan issue. Democrats, 
Republicans, Libertarians, Greens and Independents, we all rely 
on our Nation's securities markets for financial security. 
Investors vote, and they are a very large constituency. They 
need to be protected, and they're relying on us. We must make 
sure that they are protected.
    To sum up, the lessons of this chapter on Wall Street 
history are simple. While SEC and the NASD dropped the ball, 
the States picked it up. Our system worked. Now we are about to 
write the next chapter. Will it be back to business as usual, 
or will it be real protections for the hard-earned money that 
our citizens have invested? The answer is up to us.
    Thank you very much, Mr. Chairman. I will be happy to 
answer any question at the appropriate time.
    Mr. Cannon. Thank you, Mr. Secretary.
    [The prepared statement of Mr. Galvin follows:]

              Prepared Statement of William Francis Galvin

    Chairman Cannon, Ranking Member Watt, and distinguished members of 
the committee.
    My name is William Galvin. I am Secretary of the Commonwealth of 
Massachusetts and the Chief Securities Regulator.
    Among the duties of my office are protecting investors in the 
Commonwealth through the Securities Division.
    I'm here today to offer my perspective on mutual fund trading 
abuses and, more specifically, this April 2005 GAO report.
    The subtitle of this report is ``Lessons Can Be Learned from SEC 
Not Having Detected Violations at an Earlier Stage.''
    From my perspective, the lessons are pretty simple.
    In the past, the SEC simply didn't do its job. It dropped the ball. 
It ignored warning signs and, inexplicably, didn't follow up on tips. 
In short, it failed to protect mutual fund investors.
    Let me be blunt: Had the SEC done what it was supposed to do, we 
probably would not be here today.
    Unfortunately, it's not the first time the SEC has let investors 
down. Consider the history from just the past 10 years.
    Almost every major enforcement action or investor protection issue 
was first brought or raised not by the SEC or NASD but by state 
securities regulators.

          Penny stock and microcap stock fraud

          Day trading abuses

          Misleading Internet brokerage advertising

          Analyst conflicts of interest

          Mutual fund trading abuses

    In virtually every case, the states took the lead.
    The revelations of recent years about the securities industry--
teach an even more compelling lesson--that is--the critical importance 
of what goes on in what I will call the ``risk'' marketplace to average 
Americans.
    Their savings--their pensions--their children's education--in 
short--their financial futures are now as never before in play in this 
marketplace.
    This GAO report is fine as far as it goes. But it leaves out the 
most important lesson, in my view.
    And that is: The vital role played by state securities regulators. 
We need more cops on the securities beat--and more constructive 
competition among them--to protect the investing public.
    A regulatory monopoly is as bad as any other kind of monopoly. 
Customers and investors are ill-served by monopolies.
    Monopoly regulators, like monopoly companies, get complacent. They 
miss things. They can get too cozy with the folks they're supposed to 
regulate. I've seen how it works in the securities industry. The 
regulators and the regulated go to each others conferences, usually in 
nice places like Palm Beach and Palm Desert.
    The revolving door through which federal regulators go to find 
lucrative jobs on Wall Street should be the subject of another hearing 
on another day.
    As I said, we probably wouldn't be here today if the SEC had done 
its job.
    Unfortunately it did not.
    From my perspective, as a state securities regulator, I think the 
SEC has to be aggressive across the board. Chairman William Donaldson 
made some important progress during his time at the Commission.
    The pending nomination of Mr. Cox and other anticipated vacancies 
at the SEC raises a most serious question--is the era of reform and 
vigorous enforcement over?
    There is no doubt we are at a crossroad. Just two years ago the 
House of Representatives voted by a margin of 418 in favor to 2 against 
to reform the mutual fund industry. The bill died in the Senate. Was 
that just for show?--or are we serious about giving average Americans 
real protection.
    Over the years, the SEC has been criticized for not being proactive 
and tough enough. I think it's a fair criticism.
    Traditionally, one of the weakest and most toothless divisions at 
the SEC was Investment Management. It has not been known for aggressive 
examinations, and certainly not for enforcement actions. I'd even call 
it a regulatory backwater.
    This is strange--and unacceptable--given that nearly 100 million 
Americans entrust their money to the mutual fund industry.
    Yet here we have a regulator that ignored reports from academics 
and even anonymous tipsters from within the industry that market timing 
was costing investors billions of dollars.
    This chicanery and fraud would likely still be going on if it 
weren't for a couple of state securities divisions that acted when the 
SEC and NASD did not, despite having a tiny fraction of the resources 
these two organizations have.
    In Massachusetts, for example, we brought several market-timing and 
late-trading enforcement actions based on tips we received and exams we 
conducted. These involved Putnam Mutual Funds, Prudential Securities, 
Franklin-Templeton and A.G. Edwards.
    Like state securities regulators across the country, we follow up 
on tips. We answer the phone. We listen to investors. We're easy to 
reach.
    There are those who would like to see state securities regulators 
just go away. They argue that our complementary system of state, 
federal and industry self-regulation is burdensome and duplicative.
    It is neither. Quite the contrary. It serves to protect investors. 
The mutual fund trading abuses described in this GAO report are proof 
of that.
    Our system works. That's the lesson of all this.
    So next time some free-market think tank, underwritten by Wall 
Street money, says we don't need state securities regulators, that the 
industry can regulate itself just fine out of enlightened self-
interest--you have a simple four-word answer, which also happens to be 
title of this report: ``Mutual Fund Trading Abuses.''
    The fact is, we need more, not fewer, cops on the securities beat. 
That is the lesson of this scandal.
    And we need cooperation among regulators, not co-option. We need to 
check each other's work sometimes. We need to backstop each other.
    Years ago, in the name of so-called regulatory reform and 
efficiency, the states were essentially pre-empted from the regulation 
of mutual funds. The scandal we are here today to discuss is a legacy 
of that misguided policy.
    Investor protection--including aggressive enforcement of state and 
federal securities laws--isn't a partisan issue.
    Democrats, Republicans, Libertarians, Greens and Independents--they 
all rely on our nation's securities markets for their financial 
futures.
    Investors vote and they're a very large constituency--larger than 
teachers, larger than labor, bigger than the AARP and bigger than the 
Baby Boomers.
    They need to be protected. They're relying on us. If for some 
reason investors lost faith in our markets, it would be more than a 
pocket-book issue. It would be a national security issue.
    We can't allow that to happen.
    To sum up, the lessons of this sad chapter in Wall Street's history 
are simple: While the SEC and the NASD dropped the ball, the states 
picked it up. The system worked.
    Now we are about to write the next chapter--will it be back to 
business as usual?--or will it be real protections for the hard-earned 
money that our citizens have invested.
    The answer is up to us.
    Thank you, Mr. Chairman.

    Mr. Cannon. I couldn't help but think while you were 
talking about the incomparable Andrew Jackson and his veto of 
the Second National Bank's charter, which was passed by a 
Congress populated by a large number of people on the payroll 
of the Second National Bank. And in America, the reason we are 
having this hearing is because we need to strive to break up 
those cozy and often funded relationships that result in a loss 
of confidence. The only way you can have confidence is by 
having transparency and by having what you call protection; 
that is, enforcement against those people who commit crimes. 
And I love your idea. Pardon me for taking a couple of moments 
here, but I love the idea of cooperation and competition among 
enforcement agencies.
    Thank you very much, Mr. Galvin.
    And Mr. Zitzewitz.

  TESTIMONY OF ERIC W. ZITZEWITZ, STANFORD GRADUATE SCHOOL OF 
                 BUSINESS, STANFORD, CALIFORNIA

    Mr. Zitzewitz. Chairman Cannon, Ranking Member Watt, and 
Members of the Committee, thank you for the opportunity to 
appear here today.
    We are discussing two recent reports by the GAO that ask 
whether there are lessons to be learned from the SEC's handling 
of recent issues in the pricing and trading of mutual fund 
shares. Both reports deal with the general issue of regulatory 
capture, whether the SEC is influenced by the industry in a way 
that adversely affects investors, and whether reforms can make 
it more immune to that influence.
    The first report concluded that the SEC was aware of 
inefficiencies in the pricing of mutual fund shares that 
created arbitrage opportunities, and that it relied too heavily 
on assurances from the industry that they were preventing these 
inefficiencies from being exploited. This was despite being 
aware of evidence to the contrary: academic studies of the 
issues, press reports, complaints from investors and fund 
employees, and the high fund share turnover rate publicly 
reported by some international mutual funds.
    The GAO report focuses on failings in the handling of 
referrals and in routine inspections. It does not mention 
policymaking, and I understand there are some jurisdictional 
issues involved, but that's an issue to which I will return.
    The second report examines the negotiation of settlements 
with fund advisors who priced their funds in a way that created 
arbitrage opportunities and then facilitated arbitrage trading. 
The report appeared motivated by concerns that prosecutorial 
discretion could lead to excessive leniency, leniency that 
might be rewarded in a staff member's post-SEC career.
    The GAO concluded that participation in the settlement 
negotiations was broad, and that negotiations were always 
conducted in the context of a damage analysis by SEC 
economists, and that this limited the influence of any 
individual. That said, the GAO concluded, and the SEC 
concurred, that improved monitoring of the subsequent 
employment of SEC enforcement staff would be a useful reform.
    Before commenting on these two issues, I should preface 
everything by noting that the SEC and mutual fund industry have 
made a remarkable amount of progress in addressing these issues 
since September of '03. Furthermore, while economists often 
critique the incentives created by and the outcomes of an 
institution's design, we do so without impugning the character 
and work of its staff. I have met many members of the SEC in 
the last 2 years, and without exception found them to be smart 
and dedicated people whose primary concern is that our capital 
markets operate as efficiently and fairly as possible. Nothing 
I say today should be taken to imply otherwise.
    The GAO reports are very thorough, and they adroitly handle 
a set of very sensitive issues. My only major critique of the 
first report is that it reflects the conventional framing of 
the market timing issue as one of trading abuses as opposed to 
one of pricing inefficiencies. The difference is subtle, but 
important for two reasons. First, focusing on pricing rather 
than trading leads one to the correct policy fixes. And second, 
focusing on pricing leads one to ask the right or at the very 
minimum an additional set of questions about the pre-2003 SEC 
stance on this issue.
    The great irony is that the SEC understood the 
inefficiencies in international mutual fund pricing and had 
twice urged the industry to eliminate them through a procedure 
known as fair value pricing. But when the industry resisted, 
the SEC essentially backed down, despite the fact that it was 
clear from publicly available data that most funds were fair 
valuing infrequently if at all. The SEC provided no further 
formal guidance on this issue.
    Even since September 2003 there has been in some cases a 
striking similarity between what the industry's asked for and 
what the SEC has proposed. The primary direct fix for the 
market timing problem proposed by the Investment Company 
Institute in October of '03 was a mandatory 2 percent fee for 
redemptions within 5 days of purchase. As I and others pointed 
out at the time, a severe limitation of this fix is that 
arbitragers could just hold their shares until day 6. Even if 
enforcement of the rule were perfect, it would only reduce the 
excess return available to the arbitragers by a factor of 
roughly 2. Despite this limitation this exact proposal became 
the primary direct fix for the market timing problem proposed 
by the SEC.
    What I and others argued at the time would be a better 
first step is for the SEC to set and enforce standards for fund 
valuation that would substantially eliminate any arbitrage 
opportunity. Doing so would largely eliminate the need for 
measures such as monitoring and short-term trading fees. It 
will also eliminate the component of arbitrage that these 
measures will never be able to address.
    While the industry has made progress in improving the 
valuation of international equity funds, there is still scope 
for further improvement. In other asset classes, such as 
illiquid bonds and small cap equity, substantial arbitrage 
opportunities still exist. This is possible because the 
industry is waiting for guidance on evaluating these asset 
classes from the SEC. There have been rumors for some time that 
the SEC is planning to issue such guidance, but there appears 
to be a delay. Regardless, the question remains why fixing the 
valuation of funds is the last step being taken as opposed to 
the first.
    This brings me to my only substantial critique of the 
second report, which is also about the report's scope more than 
its content. The second report focuses on one form of 
regulatory capture while neglecting one potentially more 
important. The report is concerned with firm-level capture 
where a prosecutor might settle on attractive terms with a fund 
advisor and then go work for that advisor. My suspicion is that 
this scenario is fairly unlikely, particularly in the current 
climate. A more likely and difficult-to-address form of capture 
is industry-level capture in which a prosecutor settles on 
attractive terms out of fear that aggressive prosecution of a 
member of the industry will limit his or her subsequent career 
throughout the industry, or alternatively in which a 
policymaker is reluctant to push a policy that an entire 
industry opposes for the same reason. Is this type of capture a 
problem? The experience with pre-'03 policymaking suggests that 
it might be, while the scale of the penalties summarized in the 
second GAO report suggest that it's not.
    The important question, of course, is not about what 
happened in the past, but what we can expect in the future. The 
extent to which the changed regulatory environment in '03-'04 
turns out to be temporary or permanent, of course, remains to 
be seen.
    How does one address this form of capture? The economists' 
answer would be higher salaries and longer employment tenures 
at the SEC to reduce the importance of post-SEC income. 
Personally I am a little more optimistic about my guess as to 
what the sociologists' answer would be: to collectively 
recognize that capture is a problem and that attempting to 
influence policy in this manner as opposed to winning arguments 
based on the facts is not something that should be rewarded.
    A more radical suggestion would be to revisit the 
organization of SEC. Currently the policymaking divisions of 
the SEC are largely organized around the industries they 
regulate. A well-known empirical regularity is that single 
industry regulators are typically more prone to capture than 
mutli-industry regulators. The reason is straightforward. A DOJ 
lawyer prosecuting a case against the vitamin cartel need not 
seek future employment from the vitamin industry, whereas this 
is less true for an airline pricing specialist at the CAB 
seeking to limit a requested airfare increase. In this sense 
the current organization of the SEC may be exacerbating the 
influence of industry. If a formal reorganization is viewed as 
too costly, then a positive step may be to simply 
institutionalize the cross-functional involvement that the 
second GAO report notes was a favorable feature of the SEC's 
work on fund settlements.
    In conclusion, thank you for the opportunity to share with 
you my thoughts on these issues. I look forward to your 
questions.
    Mr. Cannon. Thank you, Mr. Zitzewitz.
    [The prepared statement of Mr. Zitzewitz follows:]

                Prepared Statement of Eric W. Zitzewitz




    Mr. Cannon. Does the gentleman from North Carolina seek 
recognition?
    Mr. Watt. Thank you, Mr. Chairman.
    Mr. Cannon. The gentleman's recognized for 5 minutes.
    Mr. Watt. Ms. Richards, I am trying to assess whether there 
is a different attitude at the SEC regarding oversight and 
enforcement related to mutual funds than there is at the SEC 
regarding other securities. First of all, is there a different 
attitude, and if so, why? Second, is there a different level of 
personnel numbers quality, and if so, why? You said there were 
500 employees overseeing the mutual funds. What would be the 
comparable number, for example, overseeing other kinds of 
securities matters? Could you just talk about that a little bit 
to see whether there is some historic difference in attitude?
    Ms. Richards. Sure. Let me say at the outset, my office 
examines stock exchanges, broker-dealers, transfer agents, as 
well as mutual funds and investment advisors. I was a member of 
the SEC's enforcement division for 10 years before I came to 
this job. Our examiners are uniformly, I believe, aggressive, 
and they are incentivized to find problems. The mission of the 
SEC is to detect fraud. Having examiners in a single division, 
I think, allows us to be single-minded and focused in that 
goal. Similarly, having enforcement staff in a single division, 
with their only goal is to prosecute violations of the 
securities law, I think helps further that mission.
    I can speak very candidly and personally about the attitude 
of my staff certainly in the exam program, but also of the SEC 
staff, that our mission and our goal is to detect fraud. 
Chairman Donaldson, when he came to the SEC, his primary goal 
in terms of managing the SEC was to institute reforms that 
would allow us to see around the corner and over the hill to 
detect the next type of emerging fraud and to be better focused 
on emerging risks in the securities industry.
    Mr. Watt. I'm not sure I have yet heard, is there a 
division with reference to mutual funds enforcement and other 
securities enforcement, or is it all one?
    Ms. Richards. It's all in one. The examination function for 
all those entities in the securities industry is in one 
program. The enforcement function is in one program. There are 
other offices of the SEC that do policymaking. Within the 
examination program we have now about 500 staff people who are 
responsible for examining mutual funds and investment advisors. 
We have about 350 staff people who examine broker-dealers. They 
are complemented by the work of the stock exchanges. The self-
regulatory organizations also have examiners that examine 
broker-dealers. With respect to the stock exchanges, we have 
about 50 staff people who are responsible for examining the 
stock exchanges.
    Mr. Watt. So you actually have more people on mutual funds 
because there are other supervisory entities such as the stock 
exchanges' broker-dealer associations that are self-governing. 
Is there not a separate self-governing entity for mutual funds?
    Ms. Richards. That's right. The mutual funds have no self-
regulatory organization, so the SEC is the primary regulator, 
complemented certainly by the work of other regulators, 
including State securities regulators, but there is no 
equivalent in the mutual fund industry, no equivalent self-
regulatory organization.
    Mr. Watt. Mr. Zitzewitz, what say you about this issue that 
I addressed to her, and how might it be improved?
    Mr. Zitzewitz. Sir, when I was referring to the 
organization of the SEC, I was referring primarily to the 
policymaking divisions. I think that having a single division 
for enforcement and a single division for inspections makes a 
lot of sense. I suppose within those divisions for expertise 
reasons it's always going to make sense to have some people 
focusing on one area and some people focusing on another area.
    I think, though, it's useful to consider the fact that 
there might be a trade-off between allowing employees to build 
expertise and having it be the case that once they have done 
that, their future employment has to come from that industry. 
It may be that having large numbers of specialists might make 
sense to temper that with some cross-functional specialization 
if you're thinking about controlling sources of potential 
capture.
    Mr. Watt. Thank you, Mr. Chairman. I yield back.
    Mr. Cannon. I thank the Ranking Member.
    The Chair would announce that it's his intention to allow 
the other Members here to ask questions before I ask questions. 
So the Chair recognizes Mr. Delahunt for 5 minutes.
    Mr. Delahunt. Thank you, Mr. Chairman.
    I would be interested in the opinion of both Ms. Richards 
and Secretary Galvin about the relationship between Federal and 
State regulators. I have a concern. You might have heard the 
banter up here earlier, about there's never too much oversight. 
And Mr. Galvin expressed it as in terms of there's not enough 
cops on the beat.
    Now, I don't know what happened, you know, prior to 
September of 2003, but clearly there were abuses that either 
were not identified or were identified and were not pursued by 
the SEC. I'm not interested in the history. I'm interested in 
solving the problem. But having been a State prosecutor myself, 
I know that oftentimes there are problems in relationships 
between State agencies and Federal agencies. But to use the 
military concept of a force multiplier, where do we stand in 
terms of the relationship between the State regulators and the 
SEC at this point in time? And let me begin with Ms. Richards, 
and then I would ask Secretary Galvin.
    Ms. Richards. Well, I agree with everything you just said. 
There are vast numbers of securities firms. We are outmanned 
and outgunned by the securities firms that we regulate. There 
are compliance departments of some of the large securities 
firms that outnumber SEC in terms of the number of exam staff 
that we have. To me that means that it's terribly important 
that we work together with our colleagues at the State level. 
And in my program, in the examination program, we have a 
history of doing just that.
    We meet with our colleagues across the country in regular 
examination planning summits to plan priorities, to plan 
targeted initiatives, to plan joint work and joint training. I 
believe it's terribly important that we leverage off of one 
another. We're made much more effective when we're all working 
together.
    There are certainly times where there are differences of 
opinion. I suppose in any relationship that's bound to happen. 
I think, speaking personally, it's terribly important that we 
not let those differences of opinion overcome the need for us 
to work together.
    Mr. Delahunt. Let me interrupt you, and I will pose that 
same question to Secretary Galvin.
    Mr. Galvin. Thank you. I think you have to understand one 
thing especially with regard to mutual funds that has to be 
said. Ms. Richards has already mentioned the vast number of 
mutual funds that we have and the difficulties that that 
presents in any kind of enforcement regulation. But there's 
also a bigger problem, it seems to me, and that is that mutual 
funds have--the regulation of mutual funds has not really kept 
pace with the role they play in our investment savings system. 
You know, we still treat mutual funds in many respects like it 
was some sort of a small group of people sitting around a table 
trying to decide how to invest like a stock club. They have 
become the bank of necessity for most Americans. Most Americans 
have found themselves, whether directly or indirectly, invested 
in mutual funds out of a sense of safety perhaps, or indirectly 
through their employer or some other means.
    So the challenge presented by mutual funds is greater 
perhaps than many of the other segments of the securities 
industry.
    As far as the cooperation, I think cooperation is improved. 
I think the experiences of 2003 have helped that. I--at the 
same time, I think there are some distinctions that have to be 
drawn. Generally speaking, the State securities regulators, of 
course, are operating with people in their respective States, 
individual consumers, more likely to hear about smaller 
problems, individual problems, than perhaps industry-wide 
problems.
    I think the States accept the fact, as we ought to, that 
the second should be the primary policymaker when it comes to 
market-wide policies. There's no question about that.
    When it comes to enforcement, I do think a little bit of 
competition is healthy. We have never failed to refer something 
to the SEC, at least in Massachusetts, when we thought it was 
appropriate. We also have, in fact, referred them to Federal 
prosecutors and State prosecutors when we thought it was 
appropriate. I do think cooperation is improving.
    I think the other player in this whole discussion, though, 
which has to be brought to the table or at least mentioned, is 
the attitude of the industry itself, which has resisted any 
kind of regulation and indeed has been the sponsor many times 
of efforts at State preemption. That clearly is out there and--
--
    Mr. Delahunt. I mean, we have to deal with the issue of 
preemption, not just in terms of this particular issue, but the 
whole array of issues that come before this Committee. The 
Ranking Member is the Chair of the States Rights Caucus. He is 
not here right now. I have assumed the title of vice president. 
One would be shocked at the number of bills that come out of 
this Committee that preempt State law.
    If the Chair would indulge me for an additional minute.
    Mr. Cannon. Without objection.
    Mr. Delahunt. Yes. I just want to pursue, I guess, with 
both of you, but in terms of the jurisdiction of this 
particular Subcommittee which falls in the area of compliance 
and enforcement, is there any legislation?
    Let me direct this to you, Mr. Secretary, and you can 
respond, Ms. Richards, what you feel would add, if you will, to 
that cooperation, which I think is absolutely essential.
    You know, all too often, people can be going down the same 
roads not being aware of what is happening in a parallel 
universe, so to speak. I would be more than willing to consider 
working with you and with others to file that legislation, 
because I think you are both right. That industry is a very, 
very powerful industry in terms of resources.
    I don't think, Ms. Richards, you have the resources 
necessary. I know that at the State level they face the same 
fiscal constraints.
    Mr. Galvin. If I may, and one thing I may have referred to 
in my testimony is, I think it was a mistake in the 1996 act to 
limit the States' authority of mutual funds. There were 
amendments made to section 18 of the 1933 act, and I think that 
was a mistake.
    Now, if there needs to be some better definition of the 
relationship, that's fine. But simply to say that the States 
are limited to fraud when they see it or when they hear about 
it, I don't think was the right way to go.
    I think--again reflecting the unique situation of mutual 
funds, I don't think it's an exaggeration to say that most 
small savings banks around the country are under a greater 
degree of scrutiny on their day-to-day operations than mutual 
funds, despite the fact that they hold many more billions, 
trillions of dollars.
    And I think the one thing that there is absolutely no 
disagreement among Federal and State regulators about is the 
inadequacy of us, collectively even, to try to deal with this.
    Mr. Delahunt. How do we solve that problem, Ms. Richards--
--
    Mr. Galvin. Well, we certainly don't want to crimp--we 
certainly don't want to crimp the free market. And mutual funds 
have done a great deal for people in this country. But I think 
we have to make sure that our regulatory efforts and our 
enforcement effort is up to par to meet the challenge presented 
by the vast number of them. So that's what I am saying.
    I think, looking at some of the changes made in 1990 and 
1996--you are asking in terms of specific legislation--would be 
one thing. There may be other remedies which, I don't know 
whether they would jurisdictionally be before this Committee or 
other Committees.
    But one of the things that troubles me when I look at the 
whole industry is the whole issue of mandatory arbitration of 
disputes and the way that the panels are set up that make those 
decisions. Investors are forced into agreeing to an arbitration 
process that I believe--and it is my personal opinion--is 
stacked against them.
    If we are going to say--and we all agree we don't want them 
in the courts. We don't want them in the courts. They don't 
belong in the courts,but nevertheless, there'd better be a 
safer system and a better system for people to get relief when 
they need it.
    That may be another area that you might want to look at.
    Mr. Delahunt. Mr. Chairman, that suggestion, I am 
confident, is within the jurisdiction of this particular 
Subcommittee.
    Mr. Cannon. The gentleman yields back. Thank you.
    The gentlelady from Florida is recognized for 5 minutes.
    Ms. Wasserman Schultz. Thank you, Mr. Chairman. And I am 
truly looking forward to serving on this Committee, hopefully, 
as of tomorrow. And I appreciate the accommodation that you and 
the Ranking Member have given me today.
    I, too, sit on the Financial Services Committee as my other 
Committee assignment, so we have spent a little bit of time on 
this issue in that Committee.
    Just to piggyback on what the gentleman from Massachusetts 
asked you, Ms. Richards and Secretary Galvin and, actually, 
anyone who chooses to answer it--not so much how you can, what 
legislation you would need or how the law would need to be 
changed for better coordination between State and Federal 
regulators, but my question is, do you feel you need any change 
in the law, generally, to do a better job of regulating?
    Ms. Richards. I guess I would demur on the question of 
whether the SEC would seek legislation. I would ask for 
permission to come back to you with that.
    The SEC has taken, as I said, a number of rule-making 
initiatives, using its own authority to better shore up the 
internal governance, the internal controls, and the compliance 
operations of mutual funds. For the first time, beginning last 
October, all mutual fund firms are required to have a chief 
compliance officer and written policies and procedures for the 
first time.
    I think that that is one of the most significant steps the 
SEC has taken in terms of ensuring better compliance by mutual 
funds themselves.
    We then, as the GAO report notes, are responsible for 
making sure that those chief compliance officers are really 
doing their job; and if they are really doing their job in 
detecting and deterring violations of the law, I think we are 
all--we are all better served by that.
    In terms of--in terms of coordination, there are a number 
of ongoing initiatives between the SEC and the State 
regulators. And the picture is not as bleak as Secretary Galvin 
would maybe paint it. We have regular examination planning 
summits, regular meetings about enforcement topics. We worked 
very effectively with the State securities regulators, not only 
with respect to market timing and late trading, but before that 
with respect to analysts' conflicts of interest.
    Those relationships, I think, grow and develop over time. 
And I think they are terribly important at a SEC regional 
office level and a State level that we ensure that we grow and 
improve those relationships on the ground.
    Ms. Wasserman Schultz. Mr. Secretary.
    Mr. Galvin. Well, as I mentioned earlier, I think in terms 
of legislation, there needs to be--and I would suggest that you 
might look at the act that passed in late 2003, for some issues 
that were raised there. Some of them have been addressed by 
rule-making, and I applaud the SEC for that. I do say there has 
been an improvement in the coordination. I know definitely in 
our, for instance, region in Massachusetts, there has been an 
improvement in cooperation; and I am pleased for that.
    But I do think, again it gets back to understanding the 
vastness of the mutual fund industry. There is a definite 
attitude problem persisting in that industry, in my opinion, 
and I think there needs to be sufficient address of these 
issues, such as, how do we remedy problems that individual 
investors have, sales practices--which I know Ms. Richards 
referred to in her testimony, and I agree with her. It is a 
very important area; it is continuing to be a problem, I think.
    As we look at some of the relationships that funds have 
with suppliers of funds, as they treat their customers context, 
other interaction with other individual customers, what they 
offer them as a--the role of pension funds and how individual 
investors find themselves caught up with a particular fund, 
either by a company or union or whoever directs them in that 
way--the relationships of those that direct that business to 
the mutual funds have with the pension funds. Those are all 
issues that I think are appropriate for enforcement and review 
and perhaps for regulation.
    Ms. Wasserman Schultz. The other issue that was fairly 
disturbing in my review of the problems that are going on now: 
Chairman Donaldson has obviously done an excellent job at 
taking some fairly aggressive steps in getting a handle on it, 
but it was pretty disturbing to learn that there really haven't 
been any post-employment restrictions, the revolving door back 
and forth between SEC employees, former employees, going into 
the mutual fund industry, the industry that they had formerly 
regulated. And I just wonder what steps are being taken, 
because that was pretty disturbing.
    Ms. Richards. Thank you for asking me that question. SEC 
examiners are absolutely prohibited from discussing employment 
during an ongoing examination. They are absolutely prohibited 
from doing that. There are obvious conflicts of interest in 
that process.
    We are making our process more formal. Once an examination 
has concluded and the examiner has determined to discuss 
employment outside the SEC with a firm that we regulate and has 
made a determination to go to that firm, the employee must, as 
part of a formal exit procedure, notify the supervisor where 
they intend to go to work. That supervisor will then conduct a 
thorough review of conflicts of interest, including asking, Did 
you, as an examiner, ever participate in an examination of that 
firm? This process is a more formal process than we have in 
place now.
    We certainly agree with the GAO that we can shore up our 
conflicts of interest procedures to make sure that there is no 
question that SEC examiners are acting without conflicts of 
interest or the appearance of a conflict of interest.
    Ms. Wasserman Schultz. Thank you, Mr. Chairman.
    Mr. Cannon. The gentlelady's time has expired.
    Without objection, the record will be kept open for 5 
legislative days for follow-up questions to the witnesses.
    Without hearing objection, so ordered.
    Now, I am deeply intrigued by the fact that many of the 
issues we are dealing with today are not really partisan 
issues, they are issues of how we solve fundamental problems. I 
suppose you could make them partisan, but I think one of the 
things we hear today is an inquiry of where we ought to go as 
opposed to any partisan divide.
    I was deeply intrigued, Mr. Secretary, by your idea of 
needing more cops and more competition in enforcement and tying 
that to cosy relationships.
    You know, we all hope that people don't get co-opted, but 
they actually do. And so the idea of having multiple agencies 
that see different things, hear different things, have 
different relationships with their citizens, seems to be really 
interesting.
    I was just asking the staff up here--we don't think there 
is an interstate compact dealing with securities enforcement. 
Are you aware, Mr. Secretary?
    Mr. Galvin. No, there is not a compact. We do have an 
association. Regulation at the State level varies in where it 
resides. In 12 States, it resides in the office I hold, 
secretary of state, or the equivalent thereof. In a very few 
States, it resides with the attorney general's office. In many 
States, it resides in the executive agency of the State and in 
some places corporate commissions.
    But there is an umbrella organization that we have of State 
securities administrators that is helpful as an exchange of 
information and to present our point of view, and also 
effectively, I think, to give our point of view to the SEC. But 
there is no individual compact.
    Cooperation among States, however, is high. In general, 
when matters occur in one State that appear to have roots in 
another, there is frequent communication between the States and 
among the States.
    Mr. Cannon. The jurisdiction of this Committee is over 
interstate compacts. In my earlier days, I worked in the 
Interior Department with the Office of Service Mining back in 
the very early days of the regulation of the coal mining 
industry and the reclamation process. And we ended up devolving 
regulatory authority to the States, and it worked remarkably 
well.
    As a matter of fact, I was handed a ``60 Minutes'' 
investigation when I walked in the door. And by the time it got 
to television it was actually an exoneration of the Reagan 
administration, which I thought was actually fairly remarkable.
    So over a long period of time, a person could become 
committed to the idea that we do a much better job, and that 
was the conclusion about the Office of Service Mining; that is, 
at the Federal level is very difficult to do the kind of 
regulation that you could do in the States.
    In that case, you had a geographic distribution. But here 
it seems to me that you also have a great deal of opportunity 
to improve the way you enforce and bring more resources to the 
enforcement if you organize and are given a Federal charter to 
do an interstate compact.
    Is that a matter of interest, do you think?
    Mr. Galvin. It is interesting. I think we have to explore 
further exactly what we mean.
    But I definitely think as we go forward--and I note your 
comments, and I appreciate them about the bipartisan nature of 
the problem and about the future, because that is really what 
it is about. But I think, as we go forward, one of the things 
we will all confront is that, increasingly, for most people in 
the country their financial future is going to be more in the 
risk marketplace.
    Defined benefit pensions, I know in another part of the 
Capitol today there are hearings on those. Problems--we all 
know they are there--increase, and the individuals are going to 
find themselves navigating their own way through the 
marketplace.
    So therefore I think some means of communication amongst 
the States, some plans, some protocols, are certainly helpful.
    Now, there are different philosophies amongst the States; I 
must say that there are--as is to be expected.
    Mr. Cannon. It is a competitive market. That's what we want 
actually.
    Mr. Galvin. That's good. That's good. But I still think 
there are certain base things. I mean, fraud is fraud and 
misrepresentation is misrepresentation. So I think there is 
some benefit to looking into that.
    As I said, I think there is no question the SEC must be the 
primary rule maker for national policy. Must be. But on an 
enforcement basis on some of the problems that emerge and some 
of the new techniques, this is a very inventive industry, the 
securities industry. Many of us--we could collectively agree as 
regulators we could solve this problem, and indeed we may well 
have, but they will find a new way to do it.
    So they are very creative. So I think we have to be, as Ms. 
Richards was quoted as saying, over the hill, looking over the 
hill. And so I think perhaps more people looking at it on a 
State level might be a good thing.
    Mr. Cannon. Could I ask your insight on one other item?
    In my personal life I invested in what they call the Thrift 
Savings Plan, TSP. Here, locally, we have four options; and we 
have, I suspect--I have never actually followed up on this, but 
the group that actually looks at the performance of those 
funds, which means that both the SEC and the States have an 
additional reach--in other words, you have got a bunch of cops 
who are looking at that on behalf of me and the many other 
thousands of public employees, Federal employees, that invest.
    Is there a way that we can empower more people to get 
involved in funds or more fund managers who can coordinate with 
your activities at the State and Federal level--this is both 
for Ms. Richards and Mr. Galvin--so that we can increase the 
security of individual investors by having a private layer of 
people who watch funds?
    Mr. Galvin. Well, I think that it's touching a very 
important area and a growing area of concern, namely, the 
intermediaries that have control over directing individual 
employees' fund investments.
    Not long ago I was invited to speak to an audience of local 
public pension managers in Massachusetts, and during the course 
of my remarks--in fact, it was during lunch; they were eating 
while I was speaking, which was all right with me. But during 
the course of the lunch, I went on to talk in a very tangential 
way about some of the problems with people taking free things 
from people they were investing with--free golf, free this, 
free that. Deadening silence.
    I don't mean to suggest that they were all acknowledging 
some sort of misdeed, but I think it comes as a revelation to 
some of these folks, who are actually not professional 
investors--they might be just other employees or union leaders, 
something like that, that are empowered with this 
responsibility--that they really have to exercise a fiduciary 
duty.
    And that is really the fundamental part, whether we are 
talking about mutual fund management, or even pension 
management or whatever it is, the responsibility of getting the 
best deal you can for the people you are representing.
    So I think--in this area that you are referring to, I think 
that the States certainly could provide some additional 
benefit--many of these smaller investors are in more limited 
plans--not just the places that manage them, but perhaps where 
the decisions are made in an individual State. This is 
certainly an area where I think the States could be of 
assistance because of the vastness of the problem.
    Ms. Richards. I think, Mr. Chairman, your question is very 
timely. Just 2 weeks ago the SEC released the results of an 
examination sweep of pension consultants. These are investment 
advisors who are relied on to be the experts to help pension 
plan administrators navigate amongst the many intermediaries 
out there trying to sell them services.
    What we found in those examinations was that about half of 
the pension consultants also received money from the mutual 
funds or the investment advisors that they also may have been 
recommending to the pension plans. These, we thought, were 
serious conflicts of interest which needed to be addressed by 
pension consultants.
    So I think your question is timely and right on point with 
some of the work that we have been doing in our risk-based 
examinations.
    Mr. Cannon. Thank you.
    Mr. Watt. Could the Chairman yield for just a sec?
    Mr. Cannon. Certainly.
    Mr. Watt. Is what you just described illegal?
    Ms. Richards. Yes. Existing law under the Federal 
securities laws requires these firms to disclose material 
conflicts of interest.
    One of the most disturbing findings----
    Mr. Watt. But is it illegal after they disclose it? I mean, 
can you take action against them?
    Ms. Richards. If they don't disclose these conflicts of 
interest, yes, sir.
    Mr. Watt. No, that's not what I asked. I asked, is it 
illegal if they disclose it? Is it illegal? Can you take action 
against them?
    Ms. Richards. No, sir. If they were disclosing it, it would 
be legal. What we found, however, was that they were not 
disclosing these conflicts of interest.
    Mr. Watt. And what is the penalty for nondisclosure?
    Ms. Richards. We referred many of these firms to our 
Division of Enforcement, who is looking at these 
nondisclosures.
    We also made our findings public so that pension 
consultants, not just the firms we examined--there are 1,700 
firms in this business--could look at our findings and make 
changes to make sure that they were disclosing these conflicts 
of interest.
    We think this is----
    Mr. Watt. I guess the question I am asking is, does this 
Congress need to be making the law a brighter line standard or 
increasing the penalties? What do we need to be doing to help 
you all?
    I mean, you said you were outmanned, outgunned. Is it more 
personnel? Is it more staff? Is it a more enforceable law? What 
is it that we need to do?
    Ms. Richards. I am not--I am not sure that it would be 
presumptuous of me to come to you with recommendations for this 
legislation. I think the securities laws adequately address 
this problem that I have just talked about.
    I think one of the things we are very much focused on at 
the SEC is using the resources we have in a more efficient, 
more productive and more nimble way.
    Mr. Cannon. The gentleman yields back.
    My time having expired, let me thank the panel for being 
here.
    Mr. Delahunt. Could I just ask a few follow-up----
    Mr. Cannon. Very insightful. Would you like to be 
recognized?
    Mr. Delahunt. Yes, please.
    Mr. Cannon. The gentleman is recognized.
    Mr. Delahunt. Again, I want to concur with the sentiment 
you expressed. But I guess I am frustrated because, in summary, 
where the law seems to be adequate here, how come we missed so 
much up until 21 months ago? As you said, Chairman Donaldson is 
talking about looking around the horizon and around the curve.
    If we don't somehow better coordinate, you know, between 
the States and the Federal Government--do you have like a 
shared data base, and do we have--as a former prosecutor that 
conducted a lot of white-collar investigations in conjunction 
with U.S. Attorney's office and other Federal investigative 
agencies, we had a protocol which allowed for cross-
designation. We had our own arrangement to do referrals, if you 
will. There was a constant sharing of information.
    Does that exist?
    Ms. Richards. One of the findings of the GAO report is that 
with respect to market timing and late trading, we coordinated 
effectively with our colleagues at the State level, including 
with criminal prosecutors; and criminal prosecution of the 
Federal securities laws is a terribly important complement to 
what we do on the civil side.
    Mr. Delahunt. But that was missing up until 21 months ago. 
I mean, I just perused the GAO report, and one of the issues 
seems to be a lack of a consistent policy in terms of referral.
    Ms. Richards. No, I think what the GAO found--and I won't 
speak for Mr. Hillman--is that we could better document our 
referrals to criminal authorities, but the relationships, if 
you will, are ongoing and are informal and are active.
    Mr. Delahunt. See, my problem is informal. I have no doubt 
that you are an outstanding professional. And I concur with the 
good professor there in terms of the quality of people that are 
on the staff. But that changes, that waxes and wanes like 
anything.
    I guess I am looking for some sort of--whether it's in the 
form of legislation, some other--maybe it's by a compact of 
some sort among the States, whether it's a formal mechanism, 
where this information moves around. Because there is no way 
that you are combined that--independently, that you have, even 
probably when you combine your resources--you can take on the 
kind of tasks that are an order of magnitude that clearly are 
enormous.
    You know, Secretary Galvin is right. You know, the era of 
the defined benefit, that is gone. We are not going to see 
pensions, you know, like my parents and others enjoyed in the 
1950's and 1960's. People are going to be left to their own 
navigating the mutual fund industry and the securities industry 
just to survive.
    I mean, we are talking about Social Security reform. You 
know, that's the end, if that happens, you know, that's the end 
of the defined benefit plan.
    But, again, I guess my frustration is, I want to know, and 
I think the American people have a right to know, that there is 
some sort of formal mechanism that requires an information-
sharing and resource-sharing between the States and the Federal 
Government.
    Ms. Richards. Yes, sir.
    In 1997, the SEC signed a memorandum of understanding with 
the Association of State Securities Administrators (ASSA),\1\ 
that requires that we meet at least once a year on the national 
level and discuss emerging types of fraud, and more frequently 
on the local level.
---------------------------------------------------------------------------
    \1\ The memorandum of understanding was actually signed with the 
North American Securities Administrators Association (NASAA).
---------------------------------------------------------------------------
    Mr. Delahunt. Good. You know, having a summit once a year--
I have been at a lot of summits, okay, and a lot of 
conferences. But I am talking about requiring, you know, 
agencies--and make it a 2-way street that this becomes 
automatic on the--required and mandated by statute, as opposed 
to informal relationships that are obviously very important.
    Ms. Richards. Yes, sir.
    Mr. Delahunt. However, that changes once, you know, 
Richards and Galvin are gone and Professor Eric and Hillman--I 
mean, then we have a whole new slate and maybe those 
relationships aren't the same.
    Mr. Cannon. If the gentleman would yield, let me point out, 
this is a complex environment you are talking about. It would 
take a great deal to put together, but I would suspect that it 
makes an enormous amount of sense.
    I don't want to interrupt you, Ms. Richards, you obviously 
had an answer. But I frankly think this is an interesting place 
to go.
    Ms. Richards. I was just going to echo what you said, that 
this agreement between the SEC and the State securities 
regulators has been in place since 1997. And the whole purpose 
of it was to mandate these kinds of regular meetings, 
regardless of changes in staffing at the State or Federal 
level.
    There are regional examination planning summits that take 
place, I believe it is twice each year; and Secretary Galvin 
could talk about those, because I am sure he has participated 
in those along with our staff in the Boston office.
    But the whole goal was to make sure that there is that kind 
of mandated meeting and sharing of information and strategy 
planning about how we can use our resources.
    Mr. Delahunt. Right, and I am sure that is very positive. 
And I am sure the Secretary and the other panelists would 
agree.
    But I guess what I am saying is, I want more than an MOU, 
okay? I mean, I am coming from a different angle. Because I 
know, when I was the district attorney up in the metropolitan 
Boston area, I had MOUs. I had no idea whether my successor 
has, in those agencies that we had memoranda of understanding 
with, you know, complied with it today. You know, it's probably 
gone the way of--of----
    Mr. Watt. Of Bill Delahunt.
    Mr. Delahunt.--of Bill Delahunt, exactly.
    Mr. Cannon. The gentleman yields back.
    Again, let me thank the members of the panel and the 
Committee for your time. And we stand adjourned.
    [Whereupon, at 5:26 p.m., the Subcommittee was adjourned.]

                            A P P E N D I X

                              ----------                              


               Material Submitted for the Hearing Record

 Prepared Statement of the Honorable Chris Cannon, a Representative in 
    Congress from the State of Utah, and Chairman, Subcommittee on 
                   Commercial and Administrative Law

    In the fall of 2003, the New York State Attorney announced what 
would become the first of many law enforcement initiatives that his 
office, other state officials, and the SEC would later champion to 
ferret out mutual fund trading abuses. Within the ensuing months, many 
well-respected mutual fund companies and others were caught up in this 
scandal, including Canary Capital, Janus Capital Group, Bank of 
America, Alliance Capital Management, Prudential Securities, Millennium 
Partners, Fred Alger Management, Putnam Investments, Massachusetts 
Financial Services, Security Trust, Franklin Resources, and Invesco 
Funds Group.
    In the fall and winter of 2003, it seemed as if every day the press 
reported on yet another shocking instance of mutual fund trading 
abuses. These abuses included the illegal practice of late trading, 
which involves trading shares after the markets have closed so that the 
trader can take advantage of information that becomes available after 
the closing. The Congressional Research Service analogized this 
practice to ``a racetrack that allows certain customers to bet on 
yesterday's races.''
    Other abuses included the more nuanced problem of market timing. 
Market timing typically involves frequent buying and selling of mutual 
fund shares by sophisticated investors, such as hedge funds, that seek 
opportunities to make profits on the differences between foreign and 
domestic markets.
    While not per se illegal, market timing can constitute illegal 
conduct if, for example, it takes place as a result of undisclosed 
agreements between investment advisers and favored customers in 
contravention of stated fund trading limits. Frequent trading can harm 
mutual fund shareholders because it lowers fund returns and increases 
transaction costs.
    According to an estimate prepared by one of the witnesses at 
today's hearing, Professor Zitzewitz, market timing abuses may have 
resulted in $5 billion in annual losses. As of November 2003, the SEC 
estimated that 50 percent of the 80 largest mutual fund companies had 
entered into undisclosed arrangements permitting certain shareholders 
to engage in market timing practices that were inconsistent with the 
funds' policies, prospectus disclosures, or fiduciary obligations.
    As the mutual fund scandal unfolded, questions were raised about 
the fitness of the SEC's overall regulation, inspection, and 
enforcement of this industry. The Congressional Research Service posed 
possible explanations, including the following:

          The possibility that SEC's resources devoted to the 
        fund industry were dwarfed by the expansion in the number of 
        mutual funds.

          The possibility that the SEC's overall effectiveness 
        may have been marred by inter-divisional disharmonies.

          The possibility that SEC officials may have placed 
        too much trust in the fund industry's integrity and ability to 
        police itself.

          The possibility that the mutual fund industry may be 
        ``too close'' to the relevant parts of the SEC entrusted with 
        its oversight and regulation.

          The possibility that the SEC may have had a somewhat 
        understandable focus on the prevention of more traditional 
        types of fund misconduct.

    In response to these concerns, House Judiciary Committee Chairman 
Sensenbrenner and Ranking Member Conyers requested the GAO to undertake 
a comprehensive review of the SEC's efforts to proactively detect and 
prevent illegal activities in the mutual fund industry.
    Today's hearing provides an opportunity for the GAO to report on 
its findings and recommendations and to allow the SEC and others to 
respond to them.
  Response to post-hearing questions from Lori A. Richards, Director, 
Office of Compliance Inspections and Examinations, U.S. Securities and 

                          Exchange Commission



 Response to post-hearing questions from the Honorable William Francis 
         Galvin, Secretary of the Commonwealth of Massachusetts




      Response to post-hearing questions from Eric W. Zitzewitz, 
       Stanford Graduate School of Business, Stanford, California




                                 
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