SEC Operations: Oversight of Mutual Fund Industry Presents	 
Management Challenges (20-APR-04, GAO-04-584T). 		 
                                                                 
Having grown to over $7.5 trillion in assets, mutual funds have  
become vital components of the financial security of more than 95
million American investors. However, in 2003, various allegations
of misconduct and abusive practices involving mutual funds came  
to light. Therefore, ensuring that the Securities and Exchange	 
Commission (SEC), which has primary oversight of the mutual fund 
industry, has the necessary resources and strategic focus to	 
adequately oversee fund practices has never been more important. 
To assess how SEC is positioned to oversee mutual funds, GAO	 
reviewed (1) how the abusive mutual fund practices were 	 
identified and SEC's subsequent responses, (2) SEC's plans for	 
increasing its staffing in the divisions and offices responsible 
for overseeing mutual funds and its progress in developing a new 
strategic plan to guide staff deployment, and (3) the challenges 
SEC faces in overseeing the mutual fund industry.		 
-------------------------Indexing Terms------------------------- 
REPORTNUM:   GAO-04-584T					        
    ACCNO:   A09840						        
  TITLE:     SEC Operations: Oversight of Mutual Fund Industry	      
Presents Management Challenges					 
     DATE:   04/20/2004 
  SUBJECT:   Fraud						 
	     Mutual funds					 
	     Strategic planning 				 
	     Regulatory agencies				 
	     Financial management				 
	     Labor force					 

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GAO-04-584T

United States General Accounting Office

GAO Testimony

Before the Subcommittee on Government Efficiency and Financial Management,
Committee on Government Reform, House of Representatives

For Release on Delivery

Expected at 10:30 a.m. EST SEC OPERATIONS

Tuesday, April 20, 2004

        Oversight of Mutual Fund Industry Presents Management Challenges

Statement of Richard J. Hillman, Director, Financial Markets and Community
Investment

GAO-04-584T

Highlights of GAO-04-584T, a testimony to the Subcommittee on Government
Efficiency and Financial Management, Committee on Government Reform, House
of Representatives

Having grown to over $7.5 trillion in assets, mutual funds have become
vital components of the financial security of more than 95 million
American investors. However, in 2003, various allegations of misconduct
and abusive practices involving mutual funds came to light. Therefore,
ensuring that the Securities and Exchange Commission (SEC), which has
primary oversight of the mutual fund industry, has the necessary resources
and strategic focus to adequately oversee fund practices has never been
more important. To assess how SEC is positioned to oversee mutual funds,
GAO reviewed (1) how the abusive mutual fund practices were identified and
SEC's subsequent responses, (2) SEC's plans for increasing its staffing in
the divisions and offices responsible for overseeing mutual funds and its
progress in developing a new strategic plan to guide staff deployment, and
(3) the challenges SEC faces in overseeing the mutual fund industry.

Although this testimony statement makes no recommendations, GAO discusses
challenges that SEC will have to successfully overcome to improve its
effectiveness and

April 20, 2004

SEC OPERATIONS

Oversight of Mutual Fund Industry Presents Management Challenges

In late 2003, state law enforcement authorities were the first to bring to
light various abusive practices in the mutual fund industry. SEC did not
identify these practices because detecting fraud in routine examinations
is difficult and it has been challenged to keep pace with the rapid growth
of the mutual fund industry using its existing resources. However, since
the abuses were identified SEC has acted vigorously to address these
inappropriate practices, including taking various enforcement actions to
punish wrongdoers and issuing numerous rule proposals designed to better
prevent or detect abusive practices in the future.

After years during which its workload grew faster than its resources, SEC
recently received budget increases that have allowed it to significantly
increase its staffing. As shown in the table below, SEC also plans to
significantly increase the numbers of staff that oversee mutual funds.
However, SEC made these allocation decisions without the benefit of an
updated and complete strategic plan, which it is preparing but has yet to
finalize. As a result, GAO was unable to determine whether SEC has
optimally allocated its limited resources to achieve the greatest
benefits.

Although it has received additional resources in recent years, SEC faces a
number of agencywide challenges impacting its mission and ability to
oversee the mutual fund industry. These include improving its ability to
better anticipate and detect problems in the industry and identifying and
obtaining all the staff it needs to achieve its mission. SEC has
experienced difficulty in effectively implementing various agencywide
information technology initiatives, such as an electronic document imaging
system and projects needed by units responsible for mutual funds. SEC also
has various gaps in its authority that impede its ability to gather
information, cooperate with other law enforcement authorities, and collect
monies owed by violators.

Staff Positions for SEC Divisions and Offices with Responsibilities for
Mutual Fund Regulation, Oversight, and Enforcement, at Fiscal Year End
Actual Actual Estimated Requested Percent change, SEC Unit 2002 2003 2004
2005 2002-2005

restore investor confidence      Investment                            
             in the                                                       
       securities markets.     Management Division  173  167   190   200  16% 
                               Office of Compliance                       
                                 Inspections and                          
                                  Examinations a    397  439   545   579   46 
                                   Enforcement                            
                                    Division b      980 1,016 1,248 1,278  30 

                       Source: GAO analysis of SEC data.

www.gao.gov/cgi-bin/getrpt?GAO-04-584T. Notes:

a These include only staff conducting or supporting mutual fund and
investment adviserTo view the full product, including the scope
examinations.and methodology, click on the link above.

For more information, contact Richard Hillman b These include staff that
conduct enforcement of all securities activities. at (202) 512-8678 or
[email protected].

Mr. Chairman and Members of the Subcommittee:

I am pleased to be here today to discuss the Securities and Exchange
Commission's (SEC) ongoing strategic planning efforts and the challenges
that it is facing to proactively oversee our nation's mutual fund
industry. In the last 20 years, mutual funds have grown from under $400
billion to over $7.5 trillion in assets and have become vital components
of the financial security of the more than 95 million American investors
estimated to own them. These funds have also grown to represent a
significant portion of the nation's retirement wealth with 21 percent of
the more than $10 trillion in pension plan assets now invested in mutual
funds. However, various allegations of misconduct and abusive practices
involving mutual funds have recently come to light. As a result, ensuring
that SEC has the necessary resources and strategic focus to adequately
oversee our nation's mutual fund industry has never been more important.

Today, I will discuss our work examining how well SEC is positioned to
effectively oversee the mutual fund industry. Specifically, I will discuss
(1) how the abusive practices involving mutual funds came to light and
SEC's subsequent responses, (2) SEC's plans for increasing its staffing in
the divisions and offices responsible for overseeing mutual funds and its
progress in developing a new strategic plan to guide staff deployment, and
(3) challenges that may be affecting SEC's ability to effectively oversee
the mutual fund industry. In preparing this testimony, we summarized
perspectives gained from our recent series of reports and testimonies on
practices in the mutual fund industry.1 In addition, we also relied on
information gathered from our previous and ongoing work involving SEC's
resources and strategic planning efforts.2 We also met with SEC officials
to

1See U.S. General Accounting Office, Mutual Funds: Information on Trends
in Fees and Their Related Disclosure, GAO-03-551T (Washington, D.C.: Mar.
12, 2003); Mutual Funds: Greater Transparency Needed in Disclosures to
Investors, GAO-03-763 (Washington, D.C.: June 9, 2003); Mutual Funds:
Additional Disclosures Could Increase Transparency of Fees and Other
Practices, GAO-03-909T (Washington, D.C.: June 18, 2003); Mutual Funds:
Additional Disclosures Could Increase Transparency of Fees and Other
Practices, GAO-04-317T (Washington, D.C.: Jan. 27, 2004); and Mutual
Funds: Assessment of Regulatory Reforms to Improve the Management and Sale
of Mutual Funds, GAO-04-533T (Washington, D.C.: Mar. 10, 2004).

2See U.S. General Accounting Office, Securities and Exchange Commission:
Human Capital Challenges Require Management Attention, GAO-01-947
(Washington, D.C.,: Sept. 17, 2001); SEC Operations: Increased Workload
Creates Challenges, GAO-02-302 (Washington, D.C.: Mar. 5, 2002); and
Securities and Exchange Commission: Preliminary Observations on SEC's
Spending and Strategic Planning, GAO-03-969T (Washington, D.C.: July 23,
2003).

discuss the status of their strategic planning efforts, including their
plans to oversee the mutual fund industry. Finally, we reviewed SEC
budgetrelated documents for fiscal years 2003 and 2004, and its 2005
budget request. We conducted our work from March to April 2004 in
accordance with generally accepted government auditing standards.

In summary, in late 2003 state authorities were the first to bring a case
after being alerted to various abusive practices in the mutual fund
industry. Although SEC is the organization primarily responsible for
oversight of the mutual fund industry, it did not identify these abusive
practices because of the difficulty of detecting fraud, the lack of focus
on the trading of fund shares in its examinations, and the challenges it
faces in overseeing a growing industry using its existing resources.
However, since the abuses came to light, SEC has taken various enforcement
actions and issued numerous rule proposals designed to punish wrongdoers
and better prevent or detect abusive practices in the future.

After years in which its workload grew faster than its resources, SEC
recently received budget increases that have allowed it to significantly
increase its staffing, including expanding the staff in the divisions and
offices with mutual fund oversight responsibilities. However, SEC made
these allocation decisions without the benefit of an updated and complete
strategic plan. As a result, we are unable to determine whether SEC has
optimally allocated its limited resources to achieve the greatest
benefits.

In addition, SEC continues to face a number of challenges in improving and
maintaining an effective mutual fund oversight structure, including
improving its ability to better anticipate and detect problems in the
industry and hiring all the staff it intends to bring on board in the
coming years. In trying to improve its oversight effectiveness, SEC is
also challenged to obtain and make effective use of information technology
and faces various gaps in its authority that impede its ability to gather
information, cooperate with other law enforcement authorities, and collect
the monies owed by violators.

  State Authorities Were First to Uncover Mutual Fund Trading Abuses but SEC Has
  Since Acted Swiftly to Address Problems

State authorities uncovered various abusive practices in the mutual fund
industry in 2003, but since then SEC has taken swift action designed to
punish wrongdoers and better prevent or detect abusive practices in the
future. In September 2003, the Attorney General of the State of New York
filed a case alleging abusive practices involving mutual funds. After
receiving a tip, the Attorney General's staff investigated and filed fraud
charges against a hedge fund manager for arranging with several mutual
fund companies to improperly trade in fund shares and profit at the
expense of other fund shareholders. 3 The abuses in this case, and in
others subsequently filed, included allegations of late trading and market
timing. Late trading occurs when investors are able to illegally purchase
or sell mutual fund shares after the 4:00 p.m. Eastern Time close of U.S.
securities markets, when funds typically price their shares.4 Market
timing occurs when certain fund investors place orders to take advantage
of temporary disparities between the share value of a fund and the values
of the underlying assets in the fund's portfolio. Although not illegal,
most mutual funds discourage such trading because it increases their costs
and lowers returns for their long-term investors. 5 These inappropriate
market timing cases generally involved either fund companies with stated
policies against such trading that were facilitating market timing for
selected

3A hedge fund is generally an entity that holds a pool of securities and
perhaps other assets whose securities are sold to a limited number of high
income or high net worth individuals or institutional investors through
private placements. As a result, hedge fund offerings are not required to
be registered under the Securities Act of 1933 and hedge funds are not
registered as investment companies under the Investment Company Act of
1940.

4Under current rules, mutual funds accept orders to sell and redeem fund
shares at a price based on the current net asset value, which most funds
calculate once a day at 4:00 p.m. Eastern Time. Orders received after this
time are required to be executed at the next day's asset value. Many
investors, however, purchase mutual fund shares through other
intermediaries such as broker-dealers, banks, and pension plan
administrators. Because of the time required to combine and process these
orders, SEC rules currently permit such intermediaries to forward the
order information to funds after 4:00 p.m. An investor engaging in late
trading is allowed to buy or sell shares at the current day's price after
4:00 p.m. With knowledge of developments in the financial markets that
occurred after 4:00 p.m., such investors have an unfair opportunity for
profits that is not provided to other fund shareholders.

5Reduction of the returns of a fund's long-term investors can occur, for
example, when a U.S. mutual fund uses the last traded price for foreign
securities (whose markets close hours before the U.S. markets) to value
their portfolio. Opportunities for market timing can happen when events
occur between the close of foreign securities markets and the close of
U.S. securities markets that are likely to cause significant movements in
the prices of those foreign securities when their home markets reopen.
Investors with knowledge of such market-moving events and knowledge of a
mutual fund's portfolio holdings can make swift profits, or limit losses,
at the expense of long-term fund investors.

investors or broker-dealers or others that took deceptive actions to
assist their customers to conduct market timing transactions.

Since this case was filed, the New York State Attorney General's Office
has filed at least 10 additional cases involving mutual funds,
broker-dealers, and other entities that were involved in late trading or
market timing abuses. As of March 2004, state legal or regulatory
authorities in at least three other states, including Massachusetts (3
cases), New Jersey (1 case), and Colorado (1 case) have taken actions
against participants in the mutual fund industry for their involvement in
late trading, market timing, or other abuses. Some of these cases also
allegedly involved mutual fund executives or employees who were conducting
market-timing activities in their own firms' funds.

SEC did not identify these abusive practices involving mutual funds for
various reasons. According to SEC staff, many of the cases involved fraud
and collusion among personnel and such activity is very hard to detect in
a routine examination. Also, according to testimony by the head of the SEC
office that conducts mutual fund examinations, SEC examiners did not
reveal these practices because their examinations focused primarily on the
operations of the mutual fund and trading of the fund's portfolio
securities practices with an acknowledged potential for abuse. As a
result, their examinations did not generally address the trading in the
fund's own shares. SEC has also faced resource challenges for years that
have affected its ability to conduct oversight in the mutual fund industry
and other areas. For example, we reported on SEC's difficulties during the
1990s to keep pace with the growth in the industry and its inability to
examine funds and investment advisers frequently.6 In recent testimony,
the director of the SEC office that conducts examinations noted that,
prior to 1998, SEC examinations of mutual fund firms had been as
infrequent as once every 12-24 years.7 Scarce resources may have also
affected SEC's

6See U.S. General Accounting Office Investment Advisers: Current Level of
Oversight Puts Investors at Risk, GGD-90-83 (Washington, D.C.: June 26,
1990); Bank Mutual Funds: Sales Practices and Regulatory Issues,
GGD-95-210 (Washington, D.C.: Sep. 27, 1995); and Mutual Funds: SEC
Adjusted Its Oversight in Response to Rapid Industry Growth, GGD97-67
(Washington, D.C.: May 28, 1997).

7See U.S. Securities and Exchange Commission, Lori A. Richards, Director,
Office of Compliance Inspections and Examinations, Testimony Before the
U.S. Senate Committee on Banking, Housing and Urban Affairs Concerning
Investor Protection Issues Regarding the Securities and Exchange
Commission's Examinations of Mutual Funds

(Mar. 10, 2004).

decision to, unfortunately, not follow up on information it obtained
regarding the recent wrongdoing in the mutual fund industry. In the summer
of 2003, SEC staff had received a tip from a former fund employee who was
aware of how his former employer was accommodating market timing by some
investors, but SEC staff ultimately chose not to use further resources to
pursue this case. The former fund employee then reported the matter to the
Massachusetts Securities Division, which subsequently took action against
the firm's executives. As a result of another tip, however, the SEC staff
promptly recommended and brought an enforcement action against the fund
complex and two portfolio managers based on market timing and excessive
short-term trading by investment professionals employed by the fund
complex.

However since these abuses have come to light, SEC and NASD, which
oversees the broker-dealers that sell fund shares, have acted vigorously
to address inappropriate practices in the mutual fund industry. For
example, SEC has sent numerous requests for information to funds and
brokerdealers about their trading practices. SEC's preliminary analysis of
these data show that 25 percent of responding broker-dealers had accepted
orders after the 4:00 p.m. close and 30 percent allowed market timing.
Since September 2003, SEC also has taken 15 enforcement actions that
involved late trading and inappropriate market timing, in many cases
against some of the same participants also pursued by state authorities.
As of March 2004, NASD has also brought multiple enforcement cases against
broker-dealers, including a February 2004 case against one of its
brokerdealer members that failed to prevent market timing occurring in one
of its affiliated firm's mutual funds.

SEC and NASD also have issued at least 11 rule proposals to address
abusive and other practices in the mutual fund industry. For example, to
address late trading and market timing, SEC issued proposed rule changes
that would require orders for mutual fund shares to be processed by
intermediaries and received by funds or their agents by 4:00 p.m.8 SEC is
also proposing a rule that would require that funds charge investors

8See Securities and Exchange Commission, Proposed Rule: Amendments to
Rules Governing Pricing of Mutual Fund Shares, Release No. IC-26288 (Dec.
11, 2003). Because many of the cases of late trading involved orders
submitted through intermediaries, including banks and pension plans not
regulated by SEC, this proposal requires that to obtain the current day's
price, orders to purchase or redeem mutual fund shares be received by a
fund, its transfer agent, or a registered clearing agency before the time
the fund calculates the net asset value price of its shares, which for
most funds occurs at 4:00 p.m. Eastern Time.

holding fund shares less than 5 days a 2-percent redemption fee, which
would reduce the likely profitability of short-term trading strategies
involving late trading or market timing.9 SEC also proposed that funds
disclose information about their policies regarding market timing and
their use of a pricing technique called fair-value pricing, which is
designed to better ensure that fund shares are priced accurately and thus
are less susceptible to market timing.10 SEC's Commissioners approved
these rules on April 13, 2004.

In addition to issuing proposals to address late trading and market
timing, SEC has also taken some actions that address longstanding concerns
over other mutual fund practices, including the lack of transparency of
some fees and costs and the potential for conflicts of interest in fund
distribution and sales practices. Some of the actions SEC and NASD are
proposing would require greater disclosure of fees that funds charge or
the payments that broker-dealers receive from fund firms for marketing
certain funds. We discussed these and the late trading and market timing
proposals and our views on them in testimony for the Senate Committee on
Banking, Housing and Urban Affairs on March 10, 2004.11

Although SEC and the other regulators have acted swiftly to respond to the
revelations of abusive mutual fund trading practices, other issues warrant
SEC's continued attention. For example, SEC is seeking information on how
fund advisers use investors' dollars to obtain research. This practice,
called soft dollars, involves fund advisers receiving research or other
services from broker-dealers in exchange for the commissions the advisers
pay on trades conducted in fund portfolio securities. Although this
practice can benefit the fund's investors, whose assets are used to pay

9See Securities and Exchange Commission, Proposed Rule: Mandatory
Redemption Fees for Redeemable Fund Securities, Release No. IC-26375A
(Mar. 5, 2004).

10See Securities and Exchange Commission, Proposed Rules: Disclosure
Regarding Market Timing and Selective Disclosure of Portfolio Holdings,
Release No. IC-26287 (Dec. 11, 2003). Specifically, this proposal would
require mutual funds to disclose in their prospectuses the risks to
shareholders of the frequent purchase and redemption of investment company
shares, and fund policies and procedures pertaining to frequent purchases
and redemptions. The proposal also would require funds to explain both the
circumstances under which they would use fair-value pricing and the
effects of using fairvalue pricing. Fair-value pricing involves the use of
models or other analytical techniques funds use to adjust the prices of a
fund's portfolio securities in cases in which the last traded price for a
security does not reflect its current market value.

11See GAO-04-533T.

these commissions, it can also create conflicts of interest or potential
for abuse. Given the increased spotlight Congress and regulators are
placing on the mutual fund industry, in our view, the time is right to
address the conflicts created by soft-dollar arrangements. In addition, we
have identified other actions that SEC should take that would improve
disclosure of mutual fund fees, thus improving investor awareness of the
fees they pay on their mutual fund investments. These actions would
increase the transparency of fund fees and likely enhance competition
among funds on the basis of the fees charged investors.

  SEC Has Increased Resource Allocations Without the Benefit of An Updated
  Strategic Plan

After experiencing an extended period in which increases in SEC's workload
grew faster than its staffing and other resources, SEC has received recent
budget increases that have begun to allow it to increase its staffing,
including positions in the divisions and offices with responsibilities for
mutual fund regulation, oversight, and enforcement. However, SEC has taken
these actions without the benefit of an updated strategic plan to guide
staff deployment and the divisions and offices with responsibilities for
mutual funds followed varying processes to determine their staffing needs.
As a result, it is difficult to determine whether SEC has optimally
allocated its limited resources to achieve the greatest benefits.

Additional Resources SEC Receives to Address Workload Imbalances Will Also
Benefit Mutual Fund Oversight

After years of facing imbalances in its workload, SEC recently received
additional resources that can help it more effectively oversee the
securities markets, including the mutual fund industry. In March 2002, we
reported that the growth rate of demands on SEC's staff, including the
number of corporate and regulatory filings they must review, the
complaints and allegations of wrongdoing they must investigate, and the
numbers of mutual funds, investment advisers and other entities they must
examine, had increased by about 60 percent from 1996 to 2000.12 The rapid
growth of the mutual fund industry during this time also posed challenges
to SEC's staff. For example, the number of mutual funds in existence grew
from about 4,500 at the end of 1993 to over 8,100 by the end of 2000. In
addition, the issues that SEC staff had to address had also become more
complex. However, SEC's staff resources during this period remained
relatively flat. As a result, SEC's ability to fulfill its mission had
become

12GAO-02-302.

increasingly strained because of the imbalance between its workload and
staffing resources.

Following the issuance of our March 2002 report, several high-profile
corporate failures and accounting scandals came to light in 2002. In
response to the resulting demands that public companies be held more
accountable for information they report to investors, Congress passed the
Sarbanes-Oxley Act of 2002 (Sarbanes-Oxley).13 The act, which addressed a
number of concerns involving corporate governance, auditor independence,
and regulation and oversight of the accounting profession, also provided
additional resources to SEC. Subsequently, Congress appropriated $716
million for SEC in 2003, an increase of 45 percent over its fiscal year
2002 budget. SEC was directed to use this increase both to add personnel
and acquire new information technology to increase its effectiveness. The
new personnel were expected to assist SEC in addressing its workload
imbalance and to help it conduct the additional reviews of corporate
filings mandated by the act. In recognition of the important role SEC
plays in ensuring the integrity of U.S. securities markets, it has
continued to receive additional budgetary resources since then with an
appropriation for 2004 of $811.5 million and a requested budget of $913
million for 2005.

In addition to addressing other needs with these additional resources, SEC
has also been able to respond to the mutual fund scandals by increasing
the staff allocated to the three primary divisions and offices within the
agency responsible for mutual fund regulation, oversight, and enforcement.
Within SEC, the Division of Investment Management is responsible for
creating rules and reviewing filings for mutual funds and investment
advisers.14 Staff in SEC's Office of Compliance Inspections and
Examinations (OCIE) conducts examinations and inspections of mutual funds
companies and investment advisers.15 Finally, staff in SEC's Division of
Enforcement investigate possible violations of securities laws, including

13Pub. L. No. 107-204.

14In addition to overseeing mutual funds and investment advisers, the
Division of Investment Management also oversees entities required to
register with SEC under the Public Utility Holding Company Act of 1935.

15In addition to investment management-related examinations, OCIE also
oversees the activities of self-regulatory organizations and conducts
their own reviews of brokerdealers, exchanges, and other entities active
in the securities industry.

the Investment Company Act of 1940 and the Investment Advisers Act of
1940, and pursue legal actions against violators.16

To address the mutual fund scandals, SEC has plans to substantially
increase the staffing in the units responsible for mutual fund oversight.
As shown in table 1, between 2002 and 2005, SEC plans to increase the
staffing for OCIE and the Division of Enforcement by 46 and 30 percent,
respectively. SEC also plans to increase the staffing within the Division
of Investment Management by 16 percent. SEC staff told us that many of the
new personnel will be working on mutual fund issues.

Table 1: Staff Positions for SEC Divisions and Offices with
Responsibilities for Mutual Fund Regulation, Oversight, and Enforcement,
at Fiscal Year End

                                                                      Percent
                               Actual Actual Estimated Requested change 2002-
                                            SEC Unit 2002 2003 2004 2005 2005

Investment

a

                    Management Division 173 167 190 200 16%

OCIEb 397 439 545 579

c

Enforcement Division 980 1,016 1,248 1,278

Source: GAO analysis of SEC data.

Notes:

aIncludes staff in the office that administers the Public Utility Holding
Company Act of 1935.

bThe amounts for OCIE present only those staff in SEC's headquarters and
regional offices who support or conduct examinations of mutual funds and
investment advisers.

cThe amounts for the Division of Enforcement include all staff in SEC's
headquarters and regional that support or conduct enforcement activities
over mutual funds, investment advisers, broker-dealers, and all other
entities that SEC regulates.

The units responsible for mutual fund oversight benefited from the
additional staff they received. For example, OCIE staff said that with the
added resources they received in 2003, they were able to begin conducting
additional examinations that they hoped would allow them to increase the
frequency of the reviews they conduct of the largest fund companies as
well as those that pose the greatest compliance risks to as often as every
2 years. OCIE staff said that additional positions requested for 2005
would be used to expand its examination program in the SEC regional
offices.

16SEC's Division of Enforcement also pursues cases against broker-dealers
for abuses involving the sale of mutual fund shares under rules and
regulations of the Securities Exchange Act of 1934.

SEC's Chairman also recently testified that he has asked the staff to
prepare a rule proposal that would require managers to hedge funds to
register with SEC and submit to examinations.17 OCIE staff said that some
of the additional staff SEC requested for 2005 could likely be used to
assist with those efforts.

SEC's Enforcement Division has also been able to devote more resources to
mutual fund cases. After filing less than 10 cases involving mutual funds
in 2003, Enforcement Division staff told us that they had already filed 18
cases involving funds as of March 2004 and currently had about 20 percent
of their staff pursuing mutual fund-related matters.

Division of Investment Management officials told us that the 2003 budget
increase allowed them to hire additional accountants to review investment
company financial statements, as mandated by Sarbanes-Oxley. The officials
said that additional resources obtained in 2004 and requested for 2005
will enable the division to increase its reviews of funds' financial
statements from 1,134 in 2003, which represents about 10 percent of funds,
to 4,800 in 2004, or about 40 percent of all funds.

SEC Allocated Resources Absent a Current Strategic Plan

Although SEC has directed increased resources to oversee mutual funds,
these allocation decisions were made without the benefit of an updated
strategic plan; thus, it is difficult to determine the extent to which
these increases reflect the optimal use of SEC's limited resources.
According to GAO guidance on effectively developing and implementing
strategic plans, leading organizations recognize that their activities,
core processes, and resources must be aligned to support their missions
and help them achieve their goals.18 To achieve this, leading
organizations articulate a welldefined mission in their overall strategic
plan that forms the foundation for the key business systems and processes
they use to ensure the successful outcome of their operations. By aligning
activities to support missionrelated goals, the organizations are also
better able to link the levels of funding for their activities and
anticipated results. As a complement to the

17See U.S. Securities and Exchange Commission, Chairman William H.
Donaldson, Testimony Before the U.S. Senate Committee on Banking, Housing
and Urban Affairs Concerning Investor Protection Issues Regarding the
Regulation of the Mutual Fund Industry (Apr. 8, 2004).

18U.S. General Accounting Office, Executive Guide: Effectively
Implementing the Government Performance and Results Act, GAO/GGD-96-118
(Washington, D.C.: June 1, 1996).

strategic plan, organizations should also determine the specific staff
competencies needed to fulfill their mission and develop a human capital
plan that addresses how they will acquire, develop, and retain the
employees they need.19

SEC is in the process of updating its strategic plan but as of April 13,
2004, had not completed this process. Under the Government Performance and
Results Act, federal agencies are required to prepare strategic plans that
address how they will fulfill their mission over the next 5 years. These
strategic plans are required to be updated to reflect current
circumstances every 3 years. Since SEC's last plan was prepared in 2000,
significant changes in the securities markets and its budgetary resources
have occurred. SEC was slated to complete its latest update by September
30, 2003. According to SEC staff, a draft summary of the agency's plan was
present to the SEC Chairman in October 2003 but he directed staff to start
fresh and not rely on the previous strategic plan. As of April 2004, SEC
staff told us that the latest draft of the plan was awaiting approval by
the Office of the Chairman and would need to be approved by the other SEC
Commissioners.

In recent years, SEC has taken various steps to determine its resource
allocations but has done so without an updated strategic plan to guide
these decisions. As we reported in 2002, SEC traditionally had not
reviewed its staffing and resources in terms of its overall strategic
plan.20 Instead, it generally developed its annual budget request,
including requests for additional staff positions, by basing the request
on its previous year's appropriation, rather than on the level of
resources it actually may need to fulfill its mission.

Although lacking an updated strategic plan, SEC did use an internal study
of its operations to guide resource decisions for 2003. The large budget
increase resulting from Sarbanes-Oxley provided SEC with an additional 842
positions for fiscal year 2003. To allocate these positions across its
various units, SEC drew upon an internal study that analyzed its
operations, including workload, resource allocations, methods for
assigning and managing work, and measures of performance, productivity,

19See U.S. General Accounting Office, Human Capital: Key Principles for
Effective Strategic Workforce Planning, GAO-04-39 (Washington, D.C.: Dec.
11, 2003) and A Model of Strategic Human Capital Management, GAO-02-373SP
(Washington, D.C.: Mar. 15, 2002).

20GAO-02-302.

and quality of effort. Each SEC division and office also had to provide
the SEC Chairman with details of what would be accomplished if additional
resources were provided.

To allocate the positions included in the 2004 budget, the various units
with responsibility for mutual fund oversight took varying steps to
determine their staffing needs. Staff in the Enforcement and Investment
Management divisions told us their managers were required to consider
priorities and goals for the coming year and then estimate the number of
staff needed to complete the activities associated with those goals. Staff
in these divisions told us that determining those numbers was difficult
because the amount of time required to complete the activities they
perform, such as developing rules or investigating cases, can vary widely.
In the case of the Enforcement Division, their resulting staffing
allocation reflected an estimate of what they believed they could obtain
rather than the amount of staff required to investigate all matters they
might receive. Moreover, staff told us that it was not possible to
determine how much fraud existed within the securities markets and
therefore it was difficult to determine what level of resources
realistically were needed to ensure enforcement of the federal securities
laws. OCIE staff, in contrast, told us that they were better able to
estimate workload measures, including the number and types of examinations
to be completed and the amount of time required to complete them, in order
to determine the number of staff they needed.

In the absence of a complete and updated strategic plan that identifies
its key mission-related goals, we were unable to determine whether SEC's
recent allocation decisions made the best possible use of its resources.
In making these decisions, SEC has obviously increased staffing in key
areas, including providing additional resources to develop rules, examine
participants, and pursue enforcement actions against abusive practices in
the mutual fund industry. However, without a complete and current
strategic plan that outlines the agency's priorities, the agency lacks a
key guide for ensuring that it is deploying its resources across these
areas in the most efficient way to achieve the most effective outcomes.

Some Progress Made in Although SEC has yet to complete updated strategic
and human capital Human Capital plans, it has made some progress in
addressing strategic human capital Management and management and measuring
its performance. For example, it has taken Performance Measurement steps
to improve its recruiting and hiring processes and has implemented

an agencywide training program to increase its overall staff competency.

Recognizing that retention of staff is important to achieving its mission,

SEC has negotiated an agreement with its new employee union that includes
various "worklife" programs such as flextime, flexiplace, and tuition
reimbursement as a means for increasing morale and job satisfaction.

SEC also has made progress in developing performance measures that are
part of an overall strategic planning framework. To track the performance
of its various units, SEC staff recently developed various measures of the
activities undertaken within their units that they are calling the
"performance dashboard." Although still undergoing revision, these appear
to contain key measures of performance for each program area within SEC.
SEC staff acknowledged that many of the measures are still outputoriented,
but they will likely be useful for improving SEC's effectiveness. For
example, Division of Investment Management staff told us that after seeing
the "dashboard" reports, they made changes to their procedures that helped
them reduce the number of applications for exemptions that were pending
for 12 months or more by almost 30 percent. While the development of the
dashboard report is promising, we are concerned that creating performance
measures before the latest version of the agency's strategic plan is
complete may mean that SEC will have to replace some measures with others
to be consistent with its newly defined strategic vision.

  SEC Faces Agencywide Challenges That Also Affect Mutual Fund Oversight

Although it has received additional resources in recent years, SEC still
faces a number of agencywide challenges impacting its mission and its
ability to oversee the mutual fund industry. These challenges include
improving its ability to head off major problems before they occur by
better anticipating and detecting abuses in the securities industry. SEC
also faces challenges in hiring and retaining all the staff it needs to
achieve its mission as demands on staff continue to grow. Moreover, SEC
has experienced difficulties in obtaining the information technology it
needs to effectively oversee the mutual funds industry. Finally, SEC faces
challenges in overcoming impediments to its ability to gather information,
cooperate with other law enforcement authorities, and collect monies owed.
Overall, SEC must effectively address these challenges to successfully
restore and, in the long-run, maintain investor confidence in our
securities markets.

Timely Anticipation and Identification of Problems Is a Challenge

One of the challenges SEC faces is being able to anticipate potential
problems and identify the extent to which they exist. Historically,
limited resources have forced the SEC to be largely reactive, focusing on
the most critical events of the day. In this mode, the agency lacked the
institutional structure and capability to systematically anticipate risks
and align agencywide resources against those risks. In an environment such
as this, it is perhaps not surprising that SEC was not able to identify
the widespread misconduct and trading abuses in the mutual fund industry.
Increasing SEC's effectiveness would require it to become more proactive
by thinking strategically, identifying and prioritizing emerging issues,
and marshalling resources from across the organization to answer its most
pressing needs.

To improve its ability to better anticipate, identify, and manage emerging
risks and market trends that stand to threaten SEC's ability to fulfill
its mission, SEC is implementing a centralized risk assessment function
within the agency. According to SEC's Chairman, this function will be
housed in SEC's newly created Office of Risk Assessment and Strategic
Planning, whose duties include:

o  	gathering and maintaining data on new trends and risks from external
experts, domestic and foreign agencies, surveys, focus groups, and other
market data;

o  	analyzing data to identify and assess new areas of concern across
professions, companies, industries, and markets; and

o  preparing assessments and forecasts on the agency's risk environment.

According to statements by SEC's Chairman, the yet-unstaffed office will
work in coordination with staff assigned to conduct risk assessment
activities from each division and a Risk Management Committee responsible
for reviewing implications of identified risks and recommending an
appropriate course of action. The new office is also intended to foster
better communication and coordination between divisions and offices within
the Commission.

SEC staff in the units with responsibility for mutual funds told us they
have begun activities to identify emerging risks within their areas. For
example, OCIE officials said that examiners have begun efforts to identify
what they believe to be the key risks in their ongoing examinations. With
this information, OCIE officials hope to develop a formalized process in
which this information would flow up through the office and into the risk

assessment office. Similarly, according to Division of Enforcement
officials, the division has reorganized staff in its Office of Chief
Counsel by functional lines rather than by geographical location. The
functional lines include investment adviser and mutual funds,
broker-dealers and markets, and corporate accounting. The intent of this
reorganization is to increase the staff's subject matter expertise and
better detect emerging issues. Enforcement officials said they have
already hired experts in the first two lines to further increase the
division's expertise and assist in the agencywide risk analysis project,
and have plans to hire a corporate accounting expert soon.

Filling New Positions and Existing Vacancies May Not Address All Needs

SEC continues to face agencywide challenges in hiring and retaining
sufficient numbers of quality staff to achieve its mission. With the
additional staff positions authorized in 2003 and vacancies and attrition
in existing positions, SEC staff indicated that they were faced with
hiring over 1,280 people in the last 1  1/2 years. Although it has made
considerable progress in filling these positions, SEC's Chairman stated in
his recent testimony to a House Appropriations subcommittee that SEC still
expects to have as many as 425 vacancies by May 2004, which is equal to an
11 percent agencywide vacancy rate.21 According to the Chairman's
statement, about 150 of these vacancies are attorney positions, 120 are
accountant positions, and 60 are examiner positions. In addition, by the
end of 2005, SEC hopes to receive funding to hire an additional 106 staff,
which SEC intends to use to, among other things, further enhance its
oversight of mutual funds and to address its market structure reform
initiatives.

As we reported to you in July 2003, the competitive service hiring
requirements with which SEC was required to comply to hire staff involved
the completion of various lengthy processes, such as ranking candidates by
position, before filling a vacancy. According to SEC staff, the
considerable time required to complete these processes hampered the
agency's ability to meet its hiring goals. As a result, the agency asked
for and received relief from these requirements under the Accountant,
Compliance and Enforcement Staffing Act of 2003, enacted in July 2003

21See U.S. Securities and Exchange Commission Chairman William H.
Donaldson, Testimony Before the Subcommittee on Commerce, Justice, State,
and the Judiciary, Committee on Appropriations, United States House of
Representatives Concerning Fiscal 2005 Appropriations Request for the U.
S. Securities and Exchange Commission

(Mar. 31, 2004).

and intended to enable SEC to expedite the hiring of accountants,
economists, and examiners. SEC staff told us that bypassing competitive
processes has helped them hire individuals for such positions more
quickly. In recent testimony, SEC's Chairman noted that the number of
vacant positions would have been much higher without this legislation.

In addition, acting under recently granted compensation authority, SEC
also implemented a new compensation system, which established a pay
structure more comparable to other federal financial regulators. SEC
officials stated that the new hiring and compensation authority, along
with current economic conditions, has improved the hiring and retention of
staff. For example, according to SEC staff, since 2001 the agency's
turnover rate dropped from approximately 8 percent in fiscal year 2001 to
1.2 percent in fiscal year 2002 and 1.5 percent in fiscal year 2003.
Previously turnover had been as high as almost 14 percent.

The units responsible for mutual fund oversight generally have been making
progress in meeting their goals for hiring additional staff, but demands
on their staff continue to grow. SEC's Investment Management Division is
attempting to reach a staffing level of 190 positions by the end of fiscal
year 2004. According to division staff, at midyear they had about 175
staff on board. Of the remaining 15 vacancies, 5 are staff that are
designated for public utility holding company oversight. Staff from the
Enforcement program, which is attempting to reach 1,248 positions by the
end of fiscal year 2004, had about 1,070 on board as of April 2004.
However, staff from both these divisions told us that they have had
difficulty in recruiting accountants due to competition from the private
sector as well as the Public Company Accounting Oversight Board, which
they said is able to pay much higher salaries.

Although OCIE has had some success in hiring additional examiners, the
revelations of the widespread abuses in the industry has also resulted in
an expansion of its workload. OCIE staff told us that in trying to reach
their mutual fund-related staffing goals for the end of fiscal year 2004,
only about 3 percent of their positions were vacant as of March 2004,
primarily as a result of attrition. However, OCIE staff also told us that
as a result of the mutual fund abuses, examiners will be conducting more
comprehensive examinations and more targeted mini-sweeps, which are
focused examinations that deal with just a single issue across a number of
firms. For example, to aid in detecting any misconduct that might not
otherwise be reflected in the books and records kept by a firm and shown
to examiners, OCIE staff said that their routine examinations would now
include a review of a sample of fund executives' internal e-mail

communications. Other new examination steps OCIE said they were
implementing include reviewing personal trading records that show fund
executives trading in their funds' shares and reviews of procedures to
ensure that fund share orders are processed to receive the appropriate
day's net asset value, including firms' procedures governing order receipt
time and order time stamping.

Given these additional activities, OCIE staff said that the time required
to complete an examination has increased dramatically and threatens their
ability to meet the newly established goals for increased examination
frequency. With the additional resources added to the examination program
in 2003, SEC was able to increase examination frequency of the largest
fund firms and of those posing the greatest compliance risk from once
every 5 years to once every 2 years. As noted previously, SEC's
examinations of some mutual fund companies had been as infrequent as once
every 12-24 years during the 1990s. OCIE staff said that they are
currently considering ways in which they could save time as well as
maximize coverage of the industry, but they are not yet in a position to
provide assurances that they have sufficient resources to both increase
the frequency of examinations and conduct more in-depth reviews and
minisweeps at their currently projected resource levels.

Staff in both OCIE and the Investment Management Division also told us
that they will face additional demands on their time in the event that SEC
requires hedge fund advisers to register with the agency, which SEC's
Chairman has publicly stated he intends to propose. Potentially SEC staff
might have to conduct additional regulatory filing reviews and
examinations. The amount of additional effort required to oversee hedge
fund advisers is not currently known, but Investment Management staff told
us that they estimate that between 600 and 1,100 additional advisers would
be required to register with SEC.

Obtaining and Effectively Using Information Technology Also a Challenge

Having traditionally lacked sufficient funding for information technology,
SEC is in the process of implementing various agencywide initiatives, and
the units responsible for mutual funds also have identified projects that
could further improve their efficiency. Like the rest of the government,
SEC's needs in the area of information technology continue to increase,
but SEC recently received authorizations for additional funding to address
its needs. As we reported in July 2003, SEC's fiscal year 2003 information
technology budget increased more than 100 percent, from around $44 million
to $100 million, which allowed SEC to begin funding a number of

agencywide, long-term technology projects. Many of these major initiatives
are still in process. These projects include

o  	Implementing a document management and imaging initiative, intended to
eventually eliminate paper documents and allow SEC staff to review and
electronically file the large volumes of information that are part of
litigation, examination, and enforcement activities. Staff told us that
the planned system will provide an agencywide electronic capture, search,
and retrieval mechanism for all investigative and examination materials.

o  	Converting SEC's Electronic Data Gathering Analysis and Retrieval
(EDGAR) system into a searchable database that would help SEC conduct
various types of industry and trend analyses. EDGAR is the database system
that public companies use to file registration statements, periodic
reports, and other forms electronically. Currently, EDGAR receives and
archives data, but staff cannot immediately and easily analyze it. The
goal is to create filings that will allow anyone to extract relevant data.

o  	Implementing a disaster recovery program that is being designed to
store and move large amounts of data among regional or district offices
without first going through Washington, D.C. The current project, when
completed, will allow the agency to back up critical information and data
on a daily basis at multiple locations.

In addition to these agencywide initiatives, staff in the units
responsible for mutual fund oversight have identified a number of other
technology projects that could help to improve the efficiency of their
operations. For example, OCIE officials told us that they would like to
provide audit guidance in an electronic format for examination staff, and
create Web site links for staff to use in accessing information useful in
an examination. They said that having these capabilities would likely
reduce the time required to complete examinations.

OCIE officials also stated that they are considering a longer-term project
involving the development of a mutual fund surveillance program. On March
5, 2004, the SEC Chairman announced the formation of an internal task
force to draft the outlines of this new surveillance program. This group
will examine the mutual fund reporting regime and consider changes to both
the frequency of reporting to the Commission and the categories of
information to be reported, as well as how new technologies can be used to
enhance SEC's oversight responsibilities. OCIE's director stated that the
goal of such a surveillance program would be to identify indications of
problems, and then target the particular fund or adviser for

a follow-up inquiry. With such information, SEC staff would also likely be
able to examine relevant data on an industrywide basis to determine if a
systemic problem was emerging. Implementation of such an initiative will
require a continued commitment to enhancing SEC's information technology
capabilities.

Additionally, Investment Management officials said that they have started
a project designed to allow investment companies to submit more of their
required filings electronically. Their staff are evaluating available
technology that will allow them to identify and analyze the data they
receive more readily. Currently, most of the filings come in as pure text
files and thus are not very well suited for quick quantitative analysis.
Officials in the Division of Enforcement said that recent upgrades to
their computers have been helpful. We also spoke with an official in SEC's
Office of Investor Education and Assistance, which is responsible for
analyzing investor complaints, responding to inquiries, and providing
educational materials on numerous investing topics, including mutual
funds. This official also told us about a number of technology projects
that could improve staff operational efficiency. For example, according to
the official, the office could benefit from data imaging and retrieval
technology for inquiries and complaints that come in a paper format, as
the technology would allow staff to access this information by topic or
complainant. The official did note that one project, a database that
catalogs complaints from the Internet, is currently being implemented.

In addition to the agency's ongoing document management and imaging
initiative, SEC staff told us that additional efficiencies could be gained
from an improved case tracking system and having greater ability to
analyze data to look for trends taking place in the securities industry,
particularly in the mutual fund area. Moreover, all of the SEC officials
with whom we spoke agreed that the high costs associated with new
technologies coupled with a limited information technology budget created
a challenge for SEC in meeting its information technology needs.

Investigation and Collection Difficulties Also Hamper SEC's Regulatory
Efficiency

SEC also faces challenges that affect its ability to investigate
violations and to collect monetary fines and disgorgements that violators
are ordered to pay, a process integral to effective oversight.22
Investigations of securities law violations can be labor intensive,
complex, and sometimes require SEC staff to coordinate with staff from
other law enforcement or regulatory authorities as has occurred in many of
the mutual fund cases that SEC has brought recently. In addition,
according to SEC staff, collecting the amounts that violators are ordered
to pay can be time consuming and difficult.

SEC's staff has identified various issues that they believe hamper their
efficiency in conducting enforcement and collections activities, including
investigations involving mutual funds. At a February 2003 congressional
hearing, the director of SEC's Enforcement Division testified that under
existing criminal procedure law, SEC staff generally are not allowed
access to grand jury information. In such cases SEC staff must conduct a
separate, duplicative investigation to obtain the same information already
in the hands of federal criminal authorities. In some cases, involving
mutual funds, state law enforcement authorities convened grand juries.

SEC's ability to protect privileged information also remains in question,
hampering its ability to collect such material. In a report mandated by
the Sarbanes-Oxley Act, SEC staff noted that their investigative efforts
are less efficient and effective at times because the parties under
investigation have a disincentive to provide privileged or protected
information to SEC. By disclosing such information to SEC, the parties
risk that others, such as an adversary in private litigation, could argue
that the disclosure waives the protection of that information. SEC staff
would like to be able to ensure that these parties can maintain protection
over such information after a disclosure to SEC.

The need for SEC staff to make lengthy and complicated efforts to collect
fines or disgorgements also prevent them from investigating other matters.
As a result, SEC staff indicated their efficiency would be improved if
they had authority to contract with private attorneys to undertake
litigation to enforce collection orders. The House is considering a bill
introduced in

22Fines are amounts violators are ordered to pay as punishment for
violating the securities laws. Disgorgement is the process by which a
violator is ordered to return money obtained as a result of a violation of
these laws.

2003 that would give SEC authority to obtain these contracts, as well as
other enhancements to the authority of SEC Enforcement staff.23

This concludes my prepared statement. I would be happy to respond to
questions.

Contacts and For further information regarding this testimony, please
contact Cody J. Goebel at (202) 512-8678. Individuals making key
contributions to this Acknowledgements testimony include Toayoa Aldridge,
James Lawrence, and David Tarosky.

23These additional authorities are included as part of the Securities
Fraud Deterrence and Investor Restitution Act of 2003, H.R. 2179.

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