Mutual Fund Trading Abuses: SEC Consistently Applied Procedures
in Setting Penalties, but Could Strengthen Certain Internal
Controls (16-MAY-05, GAO-05-385).
The Securities and Exchange Commission (SEC) and other regulators
have recently identified two significant types of trading
abuses--market timing and late trading--in the mutual fund
industry. The more widespread abuse was market timing, which
involved situations where investment advisers (firms that may
manage mutual funds) entered into undisclosed arrangements with
favored customers who were permitted to trade frequently in
contravention of stated trading limits. These arrangements harmed
long-term mutual fund shareholders by increasing transaction
costs and lowering fund returns. Late trading, a significant but
less widespread abuse, occurs when investors place trades after
the mutual fund has calculated the price of its shares, usually
at the 4:00 p.m. Eastern Time close of financial markets, but
receive that day's fund share price. Investors who late trade
have an opportunity to profit, which is not available to other
investors. To assess SEC's efforts to impose penalties on
violators, this report (1) discusses SEC's civil penalties in
settled trading abuse cases, (2) provides information on related
criminal enforcement actions, and (3) evaluates SEC's criminal
referral procedures.
-------------------------Indexing Terms-------------------------
REPORTNUM: GAO-05-385
ACCNO: A24139
TITLE: Mutual Fund Trading Abuses: SEC Consistently Applied
Procedures in Setting Penalties, but Could Strengthen Certain
Internal Controls
DATE: 05/16/2005
SUBJECT: Brokerage industry
Federal law
Federal regulations
Internal controls
Investment companies
Law enforcement
Mutual funds
Risk management
Sanctions
Securities
Securities fraud
Securities regulation
Regulatory agencies
Fines (penalties)
Policies and procedures
Abuse
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GAO-05-385
United States Government Accountability Office
GAO
Report to Congressional Requesters
May 2005
MUTUAL FUND TRADING ABUSES
SEC Consistently Applied Procedures in Setting Penalties, but Could Strengthen
Certain Internal Controls
GAO-05-385
[IMG]
May 2005
MUTUAL FUND TRADING ABUSES
SEC Consistently Applied Procedures in Setting Penalties, but Could Strengthen
Certain Internal Controls
What GAO Found
Since September 2003, SEC has brought 14 enforcement actions against
investment advisers and 10 enforcement actions against other firms for
mutual fund trading abuses. Penalties obtained in settlements with
investment advisers are among the agency's highest-ranging from $2 million
to $140 million and averaging $56 million. In contrast, penalties obtained
in settlements for securities law violations prior to 2003 were typically
under $20 million. SEC's penalties in the investment adviser cases are
also generally consistent with penalties it has obtained from firms
involved in similarly egregious corporate misconduct. Further, SEC brought
enforcement actions against 24 individuals associated with the investment
advisers, many of them high-ranking, and obtained penalties as high as $30
million as well as life-time industry bars for some persons. In reviewing
a sample of investment adviser cases, GAO found that SEC followed a
consistent process for determining penalties and that it coordinated
penalties and other sanctions with interested states.
State and federal criminal prosecutors told us that while they have
recently investigated market timing conduct, they have generally not
pursued criminal prosecution in those cases. They have, however, brought
criminal charges in cases involving late trading violations. These
officials said that the criminal prosecution of market timing is
complicated by the fact that market timing conduct itself is not illegal.
Although SEC instituted administrative proceedings in the investment
adviser cases discussed above by alleging that the undisclosed market
timing conduct involved constituted securities fraud, both federal and
state criminal prosecutors told us they reviewed cases involving such
market timing conduct and generally concluded that it did not warrant
criminal fraud prosecutions. In contrast, criminal charges have been
brought against at least 12 individuals for alleged late trading
violations. Federal criminal prosecutors said that criminal prosecution of
late trading is fairly straightforward because federal securities laws
prohibit the practice.
SEC officials said that as state and federal criminal prosecutors were
already aware of and generally evaluated the mutual fund trading abuse
cases for potential criminal violations on their own initiative, they did
not need to make specific criminal referrals to bring these cases to their
attention. However, during the course of its review, GAO found that SEC's
capacity to effectively manage its overall criminal referral process may
be limited by inadequate recordkeeping. In particular, SEC does not
require staff to document whether a referral was made or why. According to
federal internal control standards, appropriate documentation of agency
actions helps ensure that management directives are carried out. Without
such documentation, SEC cannot readily determine whether staff make
appropriate referrals. Such information is also important as an agency
performance indicator and for congressional oversight purposes.
United States Government Accountability Office
Contents
Letter
Results in Brief
Background
SEC Consistently Applied Penalty-Setting Procedures in Mutual
Fund Cases and Coordinated Most Monetary Sanctions with States
Several Factors Have Complicated Criminal Prosecution of Market Timing,
but State and Federal Authorities Have Brought Criminal Charges in Late
Trading Cases
Inadequate Documentation Procedures Limit SEC's Capacity to Effectively
Manage the Criminal Referral Process
SEC Efforts to Encourage Staff Compliance with Federal Conflictof-Interest
Laws on New Employment Do Not Include Tracking Post-SEC Employment Plans
Conclusions
Recommendations
Agency Comments and Our Evaluation
1
4 8
13
21
24
28 32 33 33
Appendix I Scope and Methodology
Appendix II Comments from the Securities and Exchange Commission
Appendix III Major Contributors to this Report
Tables
Table 1: Statutory Maximums for SEC Penalties in Noninsider Trading
Securities Violations, Adjusted for Inflation 11 Table 2: Average
Penalties in SEC Settlements with Investment Advisers, Public Companies,
and Investment Firms 15 Table 3: Penalties SEC Obtained in Settlement from
Individuals Charged in Investment Adviser Cases 16
Figure
Figure 1: SEC Settlements with Investment Advisers for Market Timing
Abuses as of February 28, 2005 (in thousands of dollars)
Abbreviations
1940 Act Investment Company Act of 1940
Advisers Act Investment Advisers Act of 1940
ALJ Administrative law judge
CEO Chief Executive Officer
CFTC Commodity Futures Trading Commission
DOJ Department of Justice
Enforcement Division of Enforcement
NYSOAG New York State Office of the Attorney General
OCC Office of the Comptroller of the Currency
OCIE Office of Compliance Inspections and Examinations
penalties civil money penalties
Remedies Act The Securities Enforcement Remedies and Penny
Stock Reform Act of 1990 SEC Securities and Exchange Commission SOX
Sarbanes-Oxley Act of 2002 USAO U.S. Attorney's Office
This is a work of the U.S. government and is not subject to copyright
protection in the United States. It may be reproduced and distributed in
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separately.
United States Government Accountability Office Washington, DC 20548
May 16, 2005
The Honorable F. James Sensenbrenner, Jr.
Chairman
The Honorable John Conyers, Jr.
Ranking Minority Member
Committee on the Judiciary
House of Representatives
Trading abuses allowing privileged mutual fund investors to profit at the
expense of other fund shareholders were recently uncovered among some
of the most well-known companies in the mutual fund industry. The
Securities and Exchange Commission (SEC), an independent agency
headed by a five-member Commission, is charged with oversight of the
mutual fund industry and has the authority to bring civil enforcement
actions against individuals and mutual fund companies that violate federal
securities laws.1 SEC carries out enforcement activities through its
Division of Enforcement (Enforcement).2 Swift and effective enforcement
by SEC of federal securities laws is essential to punish violators and
help
deter future misconduct in the mutual fund industry. In accomplishing its
mission, SEC can coordinate enforcement actions with state authorities
that may also have responsibility to bring civil actions. Further, it can
make referrals to the Department of Justice (DOJ) and state criminal
enforcement authorities to help ensure that potential violations of
federal
and state criminal statutes are identified and prosecuted. In carrying out
its work, SEC has a responsibility to ensure that its enforcement staff
and
examiners are free of any real or apparent conflicts of interest that
could
raise questions about their ability to detect violations of and enforce
securities laws.
1For purposes of this report, "mutual fund companies" generally refer to
mutual fund companies and their related investment advisers and service
providers, such as transfer agents, unless otherwise specified. As
described in this report, many mutual fund companies have no employees,
although they typically have boards of directors, and rely on investment
advisers to perform key functions such as providing management and
administrative services.
2Enforcement investigates possible violations of securities laws,
recommends Commission action when appropriate (either in a federal court
or before an administrative law judge), and negotiates settlements on
behalf of the Commission.
Since the New York State Office of the Attorney General (NYSOAG) made
public its discovery of mutual fund trading abuses in September 2003, that
office, SEC, the NASD, which regulates broker-dealers that may offer
mutual funds to their customers, and certain other state regulators have
pursued enforcement actions for two principal types of mutual fund
violations-market timing and late trading.3
Market timing typically involves the frequent buying and selling of mutual
fund shares by sophisticated investors, such as hedge funds, that seek
opportunities to make profits on the differences in prices between
overseas and U.S. markets.4 As frequent trading can harm mutual fund
shareholders through lowered fund returns and increased transaction costs,
many mutual fund companies have disclosed limits in their fund
prospectuses on the number of trades individual customers may place per
year. Although market timing is not itself illegal, it can constitute
illegal conduct if, for example, investment advisers (firms that may
manage mutual fund companies) enter into undisclosed agreements with
favored customers permitting them to trade frequently and in contravention
of the fund prospectuses-as certain investment advisers did prior to
September 2003. Another type of violation commonly referred to as late
trading was significant but less widespread than market timing violations.
Unlike market timing, late trading is illegal. It occurs when investors
place orders to buy or sell mutual fund shares after the mutual fund has
calculated the price of its shares, usually once daily at the 4:00 p.m.
Eastern Time (ET) market close, but receive that day's fund share price.5
Investors who are
3NYSOAG uncovered the abuses in the summer of 2003 after following up on a
tip provided by a securities industry insider. We recently issued a report
identifying reasons why SEC did not detect these trading abuses prior to
September 2003. See GAO, Mutual Fund Trading Abuses: Lessons Can Be
Learned from SEC Not Having Detected Violations at an Earlier Stage,
GAO-05-313 (Washington, D.C.: Apr. 20, 2005).
4The term "hedge fund" generally identifies an entity that holds a pool of
securities and perhaps other assets that is not required to register its
securities offerings under the Securities Act and which is excluded from
the definition of investment company under the Investment Company Act of
1940. Hedge funds are also characterized by their fee structure, which
compensates the adviser based upon a percentage of the hedge fund's
capital gains and capital appreciation. Pursuant to a new rule recently
adopted by SEC, advisers of certain hedge funds are required to register
with SEC under the Investment Advisers Act of 1940. See Registration Under
the Advisers Act of Certain Hedge Fund Advisers, 69 Fed. Reg. 72054 (2004)
(to be codified in various sections of 17 C.F.R. Parts 275 and 279).
5Under SEC rules, mutual fund companies 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 the 4:00 p.m. ET close of the U.S.
securities markets.
permitted to late trade can profit on the knowledge of events in the
financial markets that take place after 4:00 p.m., an opportunity that
other fund shareholders do not have. Although late trading can involve
mutual fund company personnel, late trading violations have typically
occurred at intermediaries, such as broker-dealers, before these
institutions submit their daily aggregate orders to mutual fund companies
for final settlement.
Because of your interest in ensuring the effective enforcement of federal
securities laws and effective federal-state coordination, you asked that
we assess a range of issues associated with SEC's market timing and late
trading enforcement actions. Specifically, our report
o compares the severity of civil money penalties (penalties) obtained in
the mutual fund cases with penalties obtained in the past and with
similarly egregious cases, reviews SEC's penalty-setting process in these
cases, and discusses SEC's coordination with state authorities in pursuing
civil enforcement actions;6
o provides information on state and federal criminal enforcement actions
for market timing and late trading violations;
o assesses SEC's management procedures for making referrals to DOJ and
state authorities for potential criminal prosecution; and
o evaluates SEC's procedures for ensuring compliance with federal laws
and regulations that govern employees' ability to negotiate and take
positions with regulated entities, such as mutual fund companies.
To respond to the first objective, we obtained copies from SEC of
enforcement actions and settlement orders related to the mutual fund
trading abuses and cases of comparable egregiousness. We also obtained
information from SEC, the Commodity and Futures Trading Commission (CFTC),
the Office of the Comptroller of the Currency (OCC), and NASD on the
criteria and processes they use to determine penalties and data on the
highest penalties they have obtained in settlement. The data we obtained
from SEC allowed us to compare the penalties obtained in the mutual fund
trading abuse cases to the penalties obtained in past cases. To determine
the consistency of SEC's penalty-setting process in the mutual fund
trading abuse cases, we reviewed a selection of 11 out of the 14
6For purposes of this report, the term "penalties" refers to "civil money
penalties" authorized by applicable law.
enforcement actions SEC brought against investment advisers charged with
market timing abuses. We also obtained information from states that
coordinated settlement negotiations with SEC in bringing their own
enforcement actions against several of the same investment advisers
involved in SEC's 14 settled enforcement actions. To respond to the second
objective, we interviewed SEC staff and NYSOAG, Wisconsin Attorney
General's Office, and DOJ officials and obtained copies of criminal
complaints related to late trading and market timing. To respond to the
third objective, we obtained information from SEC, CFTC, and NASD on the
procedures these agencies follow for making criminal referrals to DOJ and
states. To respond to the fourth objective, we reviewed the policies and
procedures of SEC, OCC, the Federal Reserve Banks of Chicago and New York,
and NASD for promoting staff compliance with federal laws limiting the
seeking of employment opportunities and postemployment activities of
federal executive employees and, in the case of NASD and the Federal
Reserve Banks, codes of ethics that also include seeking employment
restrictions for their employees. We performed our work in Boston, Mass.;
Chicago, Ill.; Denver, Colo.; New York, N.Y.; Philadelphia, Penn.; and
Washington, D.C., between May 2004 and May 2005 in accordance with
generally accepted government auditing standards. Appendix I provides a
detailed description of our scope and methodology.
The penalties SEC obtained in the market timing and late trading cases are
among the highest in the agency's history and generally consistent with
penalties obtained in cases involving similarly egregious corporate
misconduct. Additionally, SEC appears to have followed its process for
setting penalties consistently in determining penalties in the cases we
reviewed. Since September 2003, SEC has brought 14 enforcement actions
against investment advisers primarily for market timing abuses and 10
enforcement actions against broker-dealer, brokerage-advisory, and
financial services firms that conducted or facilitated improper or illegal
trading. Penalties that SEC obtained in settling the 14 enforcement
actions with investment advisers range from $2 million to $140 million,
with an average penalty of about $56 million. In contrast, SEC penalties
in cases for securities law violations issued prior to January 2003 were
generally less than $20 million. SEC's penalties in the investment adviser
cases also are generally consistent with penalties the agency has obtained
in settlements resulting from recent investment banking analyst and
Results in Brief
corporate accounting fraud cases, which SEC staff identified as involving
similarly egregious misconduct.7 In addition to actions against advisers,
SEC brought enforcement actions against 24 individuals, many of them
high-ranking company executives. SEC has obtained penalties as high as $30
million against investment adviser executives (among the highest penalties
obtained in individual cases) and barred some individuals from their
industry for life. In determining appropriate penalties to recommend to
the Commission in the investment adviser cases we reviewed, SEC staff
consistently applied criteria that the agency has established. These
criteria require SEC to consider such things as the egregiousness of the
conduct, the amount of harm caused, and the degree of cooperation as well
as to compare proposed penalties with penalties obtained in similar cases.
SEC staff may also consider litigation risks in determining appropriate
penalties. For example, if SEC pursues an overly aggressive penalty, a
defendant may be less likely to settle and a judge or other arbitrator may
not agree with SEC's analysis and impose a lesser penalty. A range of SEC
officials participate in SEC's process for setting appropriate penalties-
including the Commissioners-to help ensure that no one individual or small
group has disproportionate influence over the final decision. Moreover,
SEC has coordinated penalties and disgorgement (which forces firms to
forfeit ill-gotten monetary gain) with state authorities in many of its
market timing and late trading cases, although some states obtained
additional monetary sanctions.
State and federal criminal prosecutors told us that while they have
recently investigated market timing conduct, they have generally not
pursued criminal prosecution in those cases. They have, however, brought
criminal charges in cases involving late trading violations. These
officials said that the criminal prosecution of market timing is
complicated by the fact that market timing conduct itself is not illegal.
Although SEC instituted administrative proceedings in the investment
adviser cases discussed above by alleging that the undisclosed market
timing conduct involved constituted securities fraud, both federal and
state criminal prosecutors told us they reviewed cases involving such
conduct and generally concluded that they did not warrant criminal fraud
prosecutions. Federal officials did identify one instance of market timing
conduct that led to the initiation of criminal proceedings; however, an
undisclosed
7The investment analyst cases involved several investment firms who
allegedly provided securities research that was biased by investment
banking interests, while the corporate accounting fraud cases involved
publicly traded companies that allegedly used fraudulent accounting
techniques to inflate their revenues and thereby drive up stock prices.
market timing arrangement was not central to the criminal allegations. The
case involved a broker-dealer's alleged efforts to facilitate and conceal
short-term trading by its customers despite warnings from mutual fund
companies that such trades would not be accepted. In contrast, NYSOAG and
DOJ have brought at least 12 criminal prosecutions against individuals
involving late trading violations. For example, NYSOAG charged a former
executive and senior trader of a prominent hedge fund with conducting late
trading on behalf of the fund through certain registered brokerdealers.
This individual pled guilty in the New York State Supreme Court. According
to DOJ officials, criminal prosecution of late trading is fairly
straightforward because the practice is a clear violation of federal
securities laws.
SEC staff said that as state and federal criminal prosecutors were already
aware of and generally evaluated the mutual fund trading abuse cases for
potential criminal violations on their own initiative, they did not need
to make specific criminal referrals to bring these cases to their
attention. However, in the course of our review we found that SEC's
capacity to effectively manage its overall criminal referral process may
be limited by inadequate recordkeeping. SEC rules provide agency staff
with what they characterize as "formal" and "informal" procedures to use
when making referrals to appropriate authorities if the facts of a
particular investigation indicate potential criminal violations. Formal
referral procedures, which according to SEC staff have not been used for
over 20 years, require that the Director of Enforcement review cases to be
recommended for criminal prosecution in coordination with the Office of
the General Counsel and, according to Enforcement staff, that the
Commission approve the recommended referrals. Under the informal
procedures, SEC regional management staff or their designees are allowed
to contact federal or state authorities and apprise them of a particular
case. Although SEC procedures provide for informal referrals and such
referrals may be efficient, the process as currently implemented does not
provide critical management information. In particular, SEC does not
require staff to document the reasons for making an informal referral or
even whether such a referral has been made. SEC staff told us that such
documentation would not aid them in managing the referral process as they
already have in place processes to ensure that appropriate referrals are
made. However, without such documentation, the Commission cannot readily
determine and verify whether staff make appropriate and prompt referrals.
This lack of recordkeeping is inconsistent with federal internal control
standards, which recommend that documentation be designed to provide
evidence that management directives have been carried out, and with the
practices of other financial regulators such as CFTC and NASD, which
maintain
records on referrals. Documentation of referrals might serve as an
additional internal indicator of the effectiveness of SEC's referral
process and would also be important for congressional oversight of law
enforcement efforts in the securities industry.
While SEC provides training and guidance to staff on federal laws and
regulations regarding employment with regulated entities and requires
former staff to notify SEC if they plan to make an appearance before the
agency, it does not require departing staff to report where they plan to
work. In contrast, OCC and two Federal Reserve Banks obtain information on
where departing staff will be employed to assess the potential for
violations of employment restrictions. NASD also obtains information on
departed employees' subsequent employment with member firms. Officials
from three of these agencies said that they also ask for this information
to assess whether the quality of the employee's prior regulatory work
could have been compromised by a potential conflict of interest with the
employee's new place of employment. According to SEC staff, they have not
tracked postemployment information because SEC examiners and other staff
are highly aware of employment-related restrictions. Further, SEC staff
said that since agency examiners have traditionally visited mutual fund
companies periodically to conduct examinations, they are less likely to
face potential conflicts of interest than bank examiners who may be
located full-time at large institutions. However, SEC staff have told us
that as part of recently implemented and planned changes to their mutual
fund oversight program, they are assigning monitoring teams to the largest
and highest-risk mutual fund companies. The teams would have more regular
contact with fund management over a potentially longer period of time. In
addition, a new SEC rule requiring all mutual fund companies and
investment advisers to designate chief compliance officers may increase an
existing demand for SEC examiners to fill open positions in the compliance
departments at regulated entities.8 As a result, the potential for
employment conflicts of interest might increase.
This report contains recommendations related to improving SEC
documentation of informal referrals and the postemployment plans of
8On December 17, 2003, SEC adopted compliance rules requiring all
investment companies and investment advisers registered with the agency to
adopt and implement policies and procedures designed to prevent violations
of the federal securities laws and to designate a chief compliance officer
to be responsible for administering such policies and procedures. See
Compliance Programs of Investment Companies and Investment Advisers, 68
Fed. Reg. 74714 (2003) (to be codified at 17 C.F.R. S: 270.38(a)-1 and 17
C.F.R. S: 275.206(4)-7.
Background
departed staff. SEC provided written comments on a draft of this report
that are reprinted in appendix II. SEC agreed with the recommendations and
noted that it will take steps to implement them as part of other, ongoing
efforts to modify the forms Enforcement staff use to record
investigation-related information and to enhance staff awareness of the
conflict-of-interest issues associated with seeking employment and
postemployment. SEC's comments are discussed in greater detail at the end
of this report. SEC also provided technical comments, which have been
incorporated as appropriate.
Although typically organized as a corporation, a mutual fund's structure
and operation differ from those of a traditional corporation. In a typical
corporation, the firm's employees operate and manage the firm, and the
corporation's board of directors, elected by the corporation's
stockholders, oversees its operations. Mutual funds also have a board of
directors that is responsible for overseeing the activities of the fund
and negotiating and approving contracts with an adviser and other service
providers for necessary services.9 Unlike a typical corporation, a typical
mutual fund has no employees; it is created and operated by another party,
the adviser. The adviser is an investment adviser/management company that
manages the fund's portfolio according to the objectives and policies
described in the fund's prospectus.10 The adviser contracts with the fund,
for a fee, to administer its operations. These fees are typically based on
the size of assets under management. In managing the fund's assets, the
adviser owes a fiduciary duty to the investors in the mutual funds to act
for the benefit of the investors and not use the fund's assets to benefit
itself.
Mutual funds are subject to SEC oversight and are regulated primarily
under the Investment Company Act of 1940 (1940 Act) and the rules it has
adopted under that act. SEC has authority under this act to promulgate
rules to address a constantly changing financial services industry
environment in which mutual funds and other investment companies
9Most funds are organized either as corporations governed by a board of
directors or as business trusts governed by trustees. When establishing
requirements relating to the officials governing a fund, the act uses the
term "directors" to refer to such persons, and this report also follows
that convention.
10In some cases, the adviser may contract with other firms to provide
investment advice, becoming a subadviser to those funds.
operate. The advisory firms that manage mutual funds are regulated under
the Investment Advisers Act of 1940 (Advisers Act), which requires certain
investment advisers to register with SEC and conform to SEC regulations
designed to protect investors. In addition to its rulemaking authority,
SEC carries out its mutual fund oversight responsibilities through
examinations. SEC's Office of Compliance Inspections and Examinations
(OCIE) establishes examination policies and procedures and has primary
responsibility for conducting mutual fund company examinations.
SEC is vested with the authority to bring civil enforcement actions
against individuals and companies that violate provisions of the 1940 Act,
the Advisers Act, and other federal securities laws and regulations. While
SEC has civil enforcement authority only, it works with various federal
and state criminal law enforcement agencies throughout the country to
develop and bring criminal cases when the misconduct warrants more severe
action. SEC carries out its enforcement activities through Enforcement.
Enforcement identifies potential securities laws violations through
referrals from SEC examiners or other regulatory organizations such as
NASD, tips from securities industry insiders or the public, the press, and
its own surveillance of the marketplace. After conducting an
investigation, Enforcement staff present their findings to the Commission
for its review and approval. The Commission can authorize staff to bring
an enforcement action in federal court or through administrative
proceedings.
When bringing a civil enforcement action in federal court, SEC files a
complaint with a U.S. District Court that describes the misconduct,
identifies the laws and rules violated, and identifies the sanction or
remedial action that is sought. Administrative proceedings differ from
civil enforcement actions brought in federal court in that they are heard
by an administrative law judge (ALJ), who is independent of SEC. The ALJ
presides over a hearing and considers the evidence presented by
Enforcement staff, as well as any evidence submitted by the subject of the
proceeding. SEC may also enter into settlements with defendants who choose
not to contest the charges against them. In a typical settlement of an
administrative proceeding, the defendant neither admits nor denies the
violation of the securities laws and agrees to the imposition of
sanctions. According to senior Enforcement staff, both SEC and the
defendants have an incentive to avoid litigation and seek a settlement, as
litigation is costly and time-consuming.
SEC can seek a variety of sanctions against defendants in federal court or
as part of administrative proceedings. These include officer and director
bars and monetary sanctions, such as disgorgement and penalties. The
amount of disgorgement SEC seeks in a particular case is usually
determined by the amount of monetary gain, if any, realized from the
violative conduct. SEC can use these funds to compensate investors harmed
by the misconduct. Penalties, on the other hand, are intended to punish
wrongdoing and deter others from engaging in similar misconduct. The
Sarbanes-Oxley Act of 2002 (SOX) authorizes federal courts and SEC to
establish "fair funds" to compensate victims of securities violations.11
Section 308(a) of SOX provides that if in an administrative or a civil
proceeding involving a violation of federal securities laws an order
requiring disgorgement is entered, or if a person agrees in settlement to
the payment of disgorgement, any penalty assessed against such person may,
together with the disgorgement amount, be deposited into a fair fund and
disbursed to victims of the violation pursuant to a distribution plan
approved by SEC.
The Securities Enforcement Remedies and Penny Stock Reform Act of 1990
(Remedies Act)12 amended existing federal securities laws to authorize SEC
and federal district courts to impose penalties for securities violations
other than insider trading, for which penalties were already authorized.13
The Remedies Act specifies the maximum penalty that SEC can seek in
administrative proceedings from a firm or individual in noninsider trading
cases according to a three-tier framework, which allows for increasing
penalties based on the presence of fraud and harm to investors (see table
1).14 For example, if SEC finds that a firm's securities law violations
did not involve fraud or cause substantial harm to investors,
11Pub. L. No. 107-204, 116 Stat. 745 (2002) (codified in various sections
of the United States Code). The "fair fund" provision is codified at 15
U.S.C. S: 7246(a).
12The Securities Enforcement Remedies and Penny Stock Reform Act of 1990,
Pub. L. No. 101-429, 104 Stat. 931 (codified in various sections of Title
15).
13Section 2 of the Insider Trading Sanctions Act of 1984, Pub. L. No.
98-376, 98 Stat. 1264 (codified as amended at 15 U.S.C. S: 78u) authorized
the Commission to seek in federal district court civil money penalties of
up to three times the profit gained or loss avoided by a person who
commits illegal insider trading.
14Securities Enforcement Remedies and Penny Stock Reform Act of 1990 S:S:
202, 301 and 401, 15 U.S.C. S:S: 21B, 80a-9(d) and 80b-3(i). The Federal
Civil Penalties Inflation Adjustment Act of 1990, Pub. L. No. 101-410, 104
Stat. 890 (codified at 28 U.S.C. 2461, note) requires each federal agency
to adopt rules adjusting the maximum penalties it is authorized by statute
to seek for inflation at least once every 4 years. SEC most recently
carried out this adjustment in February 2005. See 70 Fed. Reg. 7606-08
(2005) (to be codified at 17 C.F.R. S: 201.1003 and Table III).
a tier one penalty may be appropriate. In that case, the maximum penalty
SEC can seek would be $65,000 per violation. However, if SEC finds that a
firm's misconduct involved fraud and caused substantial harm to investors,
it can apply the third tier maximum penalty- $650,000 per violation.
Table 1: Statutory Maximums for SEC Penalties in Noninsider Trading
Securities Violations, Adjusted for Inflation
Tier Maximum penalty amount for firm (individual)
1 $65,000 ($6,500) per violation.
2 $325,000 ($65,000) per violation when the violation involved fraud,
deceit, manipulation, or deliberate or reckless disregard of a regulatory
requirement.
3 $650,000 ($130,000) per violation when, in addition to satisfying the
requirements of a second tier penalty, the violation directly or
indirectly resulted in substantial losses or created a significant risk of
substantial losses to other persons.
Source: Adjustment of Civil Monetary Penalties - 2005, 70 Fed. Reg. 7,606
(2005) (to be codified at 17 C.F.R. S: 201.1003 and Table III).
Although the Remedies Act requires that in order to impose a penalty in an
administrative proceeding SEC must find that the penalty is in the public
interest, the act did not impose criteria that SEC must consider in making
this determination. Instead, the Remedies Act provides a nonexclusive list
of factors that SEC may consider, such as whether the conduct involved
fraud or directly or indirectly resulted in harm to other persons.
Enforcement staff told us that over the years SEC has internally developed
more extensive criteria based on this guidance, case law, and policy
directives from the Commission, which are documented for Enforcement staff
in internal division memorandums. These criteria include
o the egregiousness of conduct-whether it involved fraud, and if so, the
degree of scienter present;15
o the degree of harm to investors resulting from the conduct;
o the extent of the defendant's cooperation;
o whether the defendant derived any economic benefit from the conduct;
15Scienter refers to the requisite degree of knowledge that makes a
person's actions culpable.
o the duration of the conduct;
o whether the defendant is a recidivist;
o the seniority of individuals that participated in the conduct;
o the need for deterrence;
o the defendant's ability to pay;
o the size of the firm or net worth of the individual; and
o the penalties obtained in cases involving the same or a similar scheme.
When negotiating settlements on behalf of the Commission, SEC Enforcement
staff apply these factors to the facts and circumstances of each case when
determining what penalty to seek. These criteria are similar to the
criteria other financial regulators use in their penalty-setting process,
including CFTC, OCC, and NASD.
One key factor for SEC in effectively fulfilling law enforcement
objectives such as penalty-setting is the implementation of appropriate
internal controls. According to the Standards for Internal Control in the
Federal Government, internal controls (also called management controls)
comprise the plans, methods, and procedures used to meet missions, goals,
and objectives and, in doing so, support performance-based management.16
They are a major part of managing an organization. Among other things,
they should promote the effectiveness and efficiency of operations,
including the use of the entity's resources, and the agency's compliance
with applicable laws and regulations. They should also be designed to
provide reasonable assurance that the objectives of the agency are being
achieved.
16GAO, Standards for Internal Control in the Federal Government,
GAO/AIMD-00-21.3.1 (Washington, D.C.: November 1999), which was prepared
to fulfill our statutory requirement under the Federal Managers' Financial
Integrity Act, provides an overall framework for establishing and
maintaining internal controls and for identifying and addressing major
performance and management challenges and areas at greatest risk of fraud,
waste, abuse, and mismanagement.
SEC Consistently Applied Penalty-Setting Procedures in Mutual Fund Cases and
Coordinated Most Monetary Sanctions with States
SEC has responded to the widespread trading abuses in the mutual fund
industry by bringing 14 enforcement actions against investment advisers
and 10 enforcement actions against broker-dealer, brokerage-advisory, and
financial services firms that conducted or facilitated the illicit
trading. Penalties SEC has obtained in settlements with these firms have
included some of the highest in the agency's history and are consistent
with other penalties obtained in cases of similarly egregious and
pervasive misconduct. Further, SEC has held individuals, many of them
highranking, responsible for their role in the misconduct and also
obtained historically high penalties in settlements with several of them.
In reviewing a selection of 11 out of the 14 enforcement actions SEC
brought against investment advisers and their associated individuals, we
found that SEC consistently applied its penalty-setting process and that
this process contained various levels of review to help ensure that no one
individual or group of individuals had disproportionate influence on
penalty decisions. Additionally, SEC coordinated penalties and
disgorgements (which force firms to give up ill-gotten gains) with
interested states in the majority of cases, although some states obtained
additional monetary sanctions.
Penalties in Mutual Fund Trading Abuses Cases Are among SEC's Highest and
Are Consistent with Penalties in Similarly Egregious Cases
Since NYSOAG announced its discovery of the trading abuses in the mutual
fund industry in September 2003, SEC has brought 14 enforcement actions
against investment advisers primarily for market timing abuses and 10
enforcement actions against broker-dealer, brokerage-advisory, and
financial services firms for market timing abuses and late trading. SEC
has entered into settlements in all 14 investment adviser cases and
obtained penalties ranging from $2 million to $140 million (see fig. 1).
These penalties are among the highest SEC has ever obtained for securities
laws violations. Before January 2003, penalties SEC obtained in settlement
were generally under $20 million. In contrast, 11 of the 14 penalties
obtained in the investment adviser cases are over $20 million, with 8
penalties at $50 million or more. Pursuant to the fair fund provision of
SOX, SEC plans to use the penalties and disgorgement moneys, a total of
about $800 million and $1 billion, respectively, to provide restitution to
harmed investors.17 In addition to settling with investment advisers, as
of February 28, 2005, SEC has settled with two broker-dealers, two
insurance companies, and one brokerage-advisory firm, with penalties
totaling $17.5 million.
17We are reviewing SEC's implementation of the fair funds provision of SOX
as part of a forthcoming report.
Figure 1: SEC Settlements with Investment Advisers for Market Timing
Abuses as of February 28, 2005 (in thousands of dollars)
Source: SEC.
aThe entities named in this column are investment advisers associated with
these cases. In some cases, SEC simultaneously charged other entities,
such as an associated investment adviser, distributor, or broker-dealer
for their roles in the market timing abuses. The penalties and
disgorgements shown for each case are the totals obtained in settlement
from all the entities associated with the case.
bBank of America settled charges involving both abusive market timing and
late trading on the part of its investment adviser and broker-dealer
subsidiaries, respectively.
cFremont Investment Advisors, Inc., settled charges involving both abusive
market timing and late trading.
The penalties SEC obtained in the 14 investment adviser cases are also
consistent with penalties obtained in settled enforcement actions in two
types of cases that senior Enforcement staff identified as being as
egregious as the mutual fund trading abuses-the recent corporate
accounting fraud and investment banking conflict-of-interest cases. The
recent, large corporate accounting frauds surfaced in late 2000 and
concerned publicly traded companies that allegedly used fraudulent
accounting techniques to inflate their revenues and drive up stock prices.
The investment banking analyst cases involved several investment firms
that settled enforcement actions brought by SEC in 2003 for allegedly
producing securities research that was biased by investment banking
interests. Table 2 compares the range of penalties and average penalties
SEC obtained from settlements of enforcement actions brought against firms
for mutual fund trading abuses, corporate accounting fraud, and investment
banking conflicts of interest. Although particular penalties reflect the
facts and circumstances of each case, table 2 shows that the
average penalties among the three types of cases have generally been
consistent (when excluding the record $2.25 billion penalty obtained in a
corporate accounting fraud case), particularly when compared with the
lower penalties obtained in past years. In a public speech, the Director
of Enforcement said that the comparatively large penalties in these cases
represented an effort to increase accountability and enhance deterrence in
the wake of such extreme misconduct in the securities industry and noted
that such penalties create powerful incentives for firms to institute
preventative programs and procedures. Others, however, including two
members of the Commission, have questioned the appropriateness of these
relatively large penalties, particularly for public companies, arguing
that the cost of penalties are borne by shareholders who are frequently
also the victims of the corporate malfeasance.
Table 2: Average Penalties in SEC Settlements with Investment Advisers,
Public Companies, and Investment Firms
Number of settled Average
Case type enforcement actions Range of penalties penalty
Investment 14 $2-$125 million $56 million
adviser
a
Public company 11 $3-$250 million, $61.5 million $2.2 billion
Investment firm 12 $5-$150 million $43 million
Source: SEC.
aThe average penalty SEC obtained in settled enforcement actions involving
corporate accounting fraud at public companies does not include its record
$2.2 billion penalty obtained in its settlement with WorldCom, Inc., in
July 2003. A federal district court order that the penalty would be
satisfied, post bankruptcy, by the company's payment of $500 million in
cash and the transfer of common stock in the reorganized company valued at
$250 million to a court-appointed distribution agent.
Further, the penalties SEC has obtained in the mutual fund and other
recent scandals are generally higher than those obtained in settlement by
NASD and other federal financial regulators. For example, NASD has also
brought nine enforcement actions against broker-dealers for market timing
and late trading abuses and obtained penalties ranging from $100,000 to $1
million. Similarly, CFTC and OCC have obtained consistently lower
penalties in settlement. For example, as of December 2004, the highest
penalties OCC and CFTC obtained were for $25 million and $35 million,
respectively.
In addition to bringing enforcement actions against firms, SEC has held
individuals responsible for their roles in the trading abuses. As of
February 28, 2005, SEC had brought enforcement actions against 24
individuals and
settled with 18, obtaining penalties and industry bars in all cases and
disgorgement from some (see table 3). Almost all of these settled
enforcement actions involved high-level executives, including eight chief
executive officers (CEO), chairmen, and presidents. Penalties SEC obtained
in these settlements ranged from $40,000 to $30 million. The penalties
obtained from 3 individuals are among the four highest in SEC's
history-one for $30 million (the highest) and two for $20 million. SEC
also obtained a combined $150 million in disgorgement from these three
individuals.18 In addition, as part of its settlements, SEC permanently
barred 5 individuals, including the 3 mentioned above, from association
with investment advisers, investment companies, and in some cases other
regulated entities, and barred the remaining 13 for various periods from
their industries.
Table 3: Penalties SEC Obtained in Settlement from Individuals Charged in
Investment Adviser Cases
Individuals charged, by investment adviser casea Penalty Strong Capital
Management, Inc.
b
o Founder and former chairman
o Former executive vice presidentb
b
o Former director of compliance
$30 million 375,000 50,000
Pilgrim Baxter & Associates, Ltd.
o Former presidentb 20 million
o Former chief executive officer (CEO)b 20 million
Invesco Funds Group, Inc.
o Former CEO 500,000
o Chief investment officer 150,000
o National sales manager 150,000
o Assistant vice president of sales 40,000
Massachusetts Financial Services, Co.
o Former president 250,000
o Former CEO 250,000
RS Investment Management, LP
o CEO 150,000
o Chief financial officer 150,000
18SEC obtained an additional $529,000 in disgorgement from five other
individuals.
Individuals charged, by investment adviser casea Penalty
Columbia Management Advisors, Inc.
o Former portfolio manager $100,000
o Former chief operating officer 100,000
o Former national sales manager 50,000
Banc One Investment Advisors, Corporation
o Former CEO of related fund 100,000
Fremont Investment Advisers, Inc.
o Former CEO 100,000
Total $72,515,000
Source: SEC.
aSome individuals charged in the investment adviser cases had more than
one title with the investment adviser or with an associated entity, such
as the related mutual fund. Unless otherwise indicated, the position
indicated refers to the position the individual held with the investment
adviser.
bSEC permanently barred this individual from association with certain
regulated entities, including investment advisers and investment
companies.
SEC Consistently Weighed Penalty Determinations Using Established Criteria
and Procedures among the Investment Adviser Cases We Reviewed
In reviewing 11 of the 14 settled enforcement actions related to the
investment adviser cases, we found that SEC followed a similar
penaltysetting process in each of them. SEC regional staff in the six
offices that were part of our review generally began their penalty
analysis by determining the amount of money earned by the firms and
individuals from the abusive market timing and the economic harm such
trading caused to investors. For example, as a measure of monetary gain,
staff determined the fees the firms earned on the assets market timers
invested short-term for market timing purposes.19 As a measure of harm to
fund investors, staff determined the amount of dilution to fund shares
that occurred as a result of this improper trading, using the same
methodology for each case.20 SEC's Office of Economic Analysis, which
determined this methodology, assisted staff with these analyses. Staff
assessments of monetary gain and harm caused were also used to help them
determine appropriate disgorgement.
After establishing the economic benefit and harm caused, staff generally
then determined the monetary range within which they could seek a
19SEC also found that in some instances market timers invested assets
long-term in return for market timing privileges, which also generated
fees for the investment adviser.
20The frequent trading of mutual fund shares lowers, or dilutes, the value
of fund shares held by long-term fund investors. According to experts,
this dilution is approximately equal to the profits market timers earn as
a result of their short-term trading of the fund shares.
penalty by calculating the maximum penalty that applied to their
particular case. According to SEC staff at several regional offices, the
penalty statutes did not limit them from seeking penalties they thought
appropriate, largely because the statutes leave it up to SEC to define the
term "violation."21 Staff did not necessarily seek the statutory maximum
in these cases because they considered SEC criteria for assessing the
relative egregiousness of the misconduct and in some cases concluded that
it warranted a lesser penalty, and also because they considered the risk
that the case would be litigated instead of settled. For example, in one
case where staff could have argued a statutory maximum of $1 billion based
on the hundreds of improper trades found, staff said they could not have
made a convincing argument for such a high penalty based on the relatively
small amount of economic harm and level of scienter involved (scienter
refers to the requisite degree of knowledge that makes a person's actions
culpable). These staff told us that even if they disregarded SEC criteria
and sought the maximum it was very unlikely that they would have achieved
an amount close to it. The staff said that the firm involved would never
have settled and it was unlikely that the judge or ALJ assigned to the
case would have found staff's underlying rationale for the penalty
recommendation credible. As judges and ALJs make independent
determinations of the facts when determining whether a penalty or other
sanctions are warranted, staff said that they may decide on a lesser
penalty than what staff recommended. For that reason, staff said that
while the penalty statutes provide a baseline for their analysis, they
seek penalties in settlement that reflect the facts and circumstances of
the case and the penalties obtained in similar cases.
To determine a penalty appropriate to the facts and circumstances of each
case, SEC staff used the criteria discussed earlier to establish the
egregiousness of the case relative to that of other market timing and late
trading cases-considering, for example, the level of scienter involved,
the amount of harm caused and benefit gained, the level of cooperation,
and the seniority of the individuals involved. We found that staff sought
penalties that reflected these differences. Barring the presence of
aggravating or mitigating factors, conduct perceived as more egregious
received relatively greater penalties. For example, the highest penalty
that SEC obtained from an individual in the market timing and late trading
21For example, they said that they could count each type of misconduct as
one violation or count each instance of misconduct (such as each improper
market timing trade) as a separate violation.
cases was from the former founder and chairman of an investment adviser
who SEC found to have market timed the funds he managed for his own
personal gain. Regional staff said that this individual's $30 million
penalty was merited because as the most senior official in the firm, he
was dutybound to protect the interests of all fund investors and should
have set an example in proper ethical conduct for the rest of the firm's
employees. Instead, SEC found that he continued his market timing
activities even after compliance officials at the firm detected his
improper trading and counseled him to cease. Further, this was the second
time he had been the subject of an SEC enforcement action-in 1994, SEC
charged him with improper personal trading in the fund's portfolio
securities. Finally, they said he cooperated very little in the
investigation.
In some cases we found that where SEC perceived a high level of
egregiousness, the presence of other factors mitigated a more severe
penalty determination, such as the degree of cooperation or the firm's
ability to pay. For example, staff required firms that argued they could
not pay the penalty initially sought to provide documentation of any
financial constraints and the financial consequences of paying the higher
penalty.
Regional staff regularly consulted with senior Enforcement staff in
preparing their penalty recommendations. Enforcement's Office of the Chief
Counsel is responsible for reviewing all sanction recommendations,
including penalties, for consistency with penalties recommended in
analogous cases. This office reviewed all of the penalty and other
sanctions recommended in the 11 cases we reviewed. Additionally, staff
shared information about penalty-setting in the market timing and late
trading settlements with a range of agency officials outside of
Enforcement. Once staff had negotiated with the defendant the amount of
the disgorgement and penalties and the application of other sanctions they
believed were appropriate for a case and obtained a formal offer of
settlement from the defendant, staff prepared a memorandum for the
Commission describing the settlement offer and their rationale for
recommending that the Commission accept it. For example, the memorandums
explained how the disgorgement figure related to any calculations of
economic benefit or harm and discussed the factors most relevant to the
penalty analysis. Before sending the memorandum to the Commission for
review and approval, other interested SEC divisions and offices, such as
Investment Management, Corporation Finance, and the Office of the General
Counsel, first reviewed it. Enforcement staff said that by asking staff
from other areas of SEC to review their sanction recommendations, they
help ensure that no one individual or small group has a disproportionate
influence over the penalty recommended to the
Commission and that the penalty reflects the Commission's policy goals.
The Commission either approved the settlement terms outlined in the
memorandum or advised Enforcement as to any adjustments they wanted made,
which staff then renegotiated with the defendants.
SEC Coordinated Penalties and Disgorgement with States in the Majority of
Settlements with Investment Advisers, but Some States Obtained Additional
Sanctions
SEC coordinated penalties and disgorgements with interested states in many
of the settled enforcement actions related to late trading and market
timing. For example, in 11 cases, three states (New York, Colorado, and
New Hampshire) coordinated their settlement negotiations with SEC,
agreeing to seek the same disgorgement and penalty amounts and requiring
in their individual settlement orders that the payments be remitted to and
administered by SEC pursuant to the related SEC settlement order. As a
result of this collaboration, the penalty moneys collected in these cases
can be used to compensate harmed investors, under the fair fund provision
of SOX. In one case, a state required a separate, duplicative payment from
one firm of disgorgement and penalties, but SEC noted in its own
settlement order that it had considered this fact when seeking penalties
against the subject firm.
While in most cases states agreed to the same penalty and disgorgement as
SEC and to have the payments made directly to SEC, some states, most
notably New York, obtained additional monetary sanctions. In addition to
disgorgement and penalties, NYSOAG ordered most of the investment advisers
with whom it settled to reduce the fees that they charge mutual fund
investors over the next 5 years. The value of these reductions totaled
about $925 million and in some cases more than doubled the value of the
disgorgement and penalties SEC obtained in an individual case. According
to NYSOAG, these investment advisers did not just allow improper market
timing and late trading, but they had also charged mutual fund investors
significantly more in fees than institutional investors for similar
services. NYSOAG said that the SEC settlements focusing on disgorgement
and penalties for trading abuses did not compensate investors who were
overcharged and that the fee reductions it obtained provided this needed
restitution.
In conjunction with the settlement order related to one investment adviser
case, the Commission issued a public statement on its position regarding
fee reductions. The Commission stated that it did not seek fee reductions
with this investment adviser because this sanction did not serve its law
enforcement objectives. First, the Commission said that there were no
allegations that the fees charged by the adviser in question were
illegally high. Fee reductions would provide compensation to investors who
were
not harmed by the market timing abuses SEC set forth in the settlement
order. Second, they said that mandatory fee discounts would require that
customers do business with the firms to receive the benefits of the fee
reductions (meaning that prior customers that received allegedly illegal
prices but already redeemed their shares would not benefit). For those
reasons, the Commission said that their efforts focused on addressing the
market timing abuses by providing full compensation to investors harmed by
this activity and a significant up-front penalty.
In addition to NYSOAG, Colorado and New Hampshire also obtained additional
monetary sanctions in its settlements in three investment adviser cases.
Colorado required the firms involved in two cases to pay $1 million and
$1.5 million, respectively, to reimburse its costs and for consumer and
investor education and future enforcement activities within that state.
New Hampshire required the firm involved in another case to pay $1 million
for investor education and protection purposes and an additional $100,000
to defray the costs of the investigation.
After NYSOAG announced its discovery of mutual fund trading abuses in
September 2003, officials from that office, DOJ, and SEC told us that they
met to discuss potential criminal violations in cases involving these
abuses and clarify subsequent investigative responsibilities and
coordination. Other state officials told us they also reviewed cases
involving mutual fund trading abuses for criminal potential. These
officials said that the criminal prosecution of market timing is
complicated by the fact that market timing conduct itself is not illegal.
DOJ officials told us that they have brought criminal charges in cases
where late trading occurred, primarily because late trading is a clear
violation of federal securities laws and authorities can readily prosecute
cases once evidence of late trading is established.
Several Factors Have Complicated Criminal Prosecution of Market Timing, but
State and Federal Authorities Have Brought Criminal Charges in Late Trading
Cases
Several Factors Have Complicated Criminal Prosecution of Market Timing Cases
Officials from DOJ, NYSOAG, and the Wisconsin Attorney General's Office
told us that they have declined to bring criminal charges for market
timing conduct, largely because market timing itself is not illegal. In
instituting administrative proceedings in the 14 investment adviser cases
discussed above, SEC alleged that the undisclosed market timing conduct
involved constituted securities fraud, conduct expressly prohibited under
federal securities laws. According to DOJ officials, although state and
federal criminal prosecutors can also seek criminal sanctions for
securities fraud, such prosecutions may be more difficult to prove than
civil actions. DOJ officials told us that criminal prosecutors must be
able to prove beyond a
reasonable doubt that the defendant committed fraud, whereas civil
authorities generally need only show that a preponderance of the evidence
indicated a fraudulent action. According to DOJ and NYSOAG officials, for
a variety of reasons their review of cases involving market timing
arrangements concluded that they did not warrant criminal fraud
prosecutions.22 For example, in commenting on one case involving an
investment adviser's undisclosed market timing arrangement, the Wisconsin
Attorney General stated that the risk in trying to convince a jury beyond
a reasonable doubt that the particular behavior was criminal motivated his
office and other state prosecutors to instead pursue a civil enforcement
action.
According to a recent law journal article, the ambiguous nature of some
funds' prospectus language may have further weakened the ability of
federal and state prosecutors to bring criminal charges against investment
advisers that allowed favored investors to market time.23 The article
stated that it is often unclear whether and to what extent a fund
prohibits market timing. For example, many mutual funds merely
"discouraged" market timing to the extent that it caused "harm" to the
funds. According to the article, such language is subject to various
interpretations as to what constitutes discouraging and what constitutes
harm to fund performance. Further, it stated that even prospectus
disclosures that allow a specific number of exchanges can be ambiguous
because the term "exchange" is subject to various interpretations. Such
ambiguities may hamper criminal
22DOJ and NYSOAG officials said that the fact that a criminal case has not
been brought against an investment adviser to date for entering into
undisclosed market timing arrangements with favored investors does not
preclude them from bringing one in the future if they believe the facts
and circumstances warrant it.
23Roberto M. Braceras, "Late Trading and Market Timing," Securities &
Commodities Regulation, vol. 37, no. 7 (2004).
prosecutors' efforts to prove that the market timing arrangements
constituted a willful intent to defraud.24
As of March 31, 2005, federal prosecutors have brought one criminal case
involving abusive market timing. However, this case involved a
brokerdealer's alleged efforts to facilitate and conceal short-term
trading by its customers despite warnings from mutual fund companies that
such trades would not be accepted, as opposed to allegations of
undisclosed arrangements between a mutual fund company and favored
customers. In that case federal prosecutors filed a criminal complaint
alleging securities fraud and conspiracy charges against three top
executives at this firm. The complaint alleges that these individuals
devised and executed a number of deceptive practices to circumvent market
timing restrictions placed on their firm by mutual funds companies. These
deceptive practices allegedly included creating and using multiple account
numbers for the same client and executing trades through multiple clearing
firms. As of March 31, 2005, these individuals were awaiting trial.
Most Criminal Cases Brought Have Been Based on Late Trading Charges
NYSOAG and DOJ have brought at least 12 criminal prosecutions against
individuals for charges that include late trading. The individuals charged
included high-level executives, traders, and other employees of three
broker-dealers, two banking-related organizations, and one hedge fund who
allegedly either conducted or facilitated late trading for others in
mutual fund shares. In one case, NYSOAG charged a former executive and
senior trader of a prominent hedge fund with conducting late trading on
behalf of that firm through certain registered broker-dealers in violation
of
24On April 16, 2004, SEC adopted amendments to Form N-1A requiring
open-ended management investment companies (mutual funds) to disclose in
their prospectuses both the risks to shareholders of frequent purchases
and redemptions of the mutual fund's shares and the mutual fund's policies
and procedures with respect to such frequent purchases and redemptions. If
the mutual fund's board has not adopted such policies and procedures, the
mutual fund must disclose the specific basis for the board's view that it
is appropriate for the mutual fund to not have such policies and
procedures. These rules are intended to require mutual funds to describe
with specificity the restrictions they place on frequent purchases and
redemptions, if any, and the circumstances under which any such
restrictions will not apply. See Disclosure Regarding Market Timing and
Selective Disclosure of Portfolio Holdings, 69 Fed. Reg. 22300 (2004)
(amendments to Form N-1A; text of the amendments do not appear in the Code
of Federal Regulations). Form N-1A is used by mutual funds to register
under the Investment Company Act of 1940 and to file a registration
statement under the Securities Act of 1933 to offer their shares to the
public.
Inadequate Documentation Procedures Limit SEC's Capacity to Effectively Manage
the Criminal Referral Process
New York's state securities fraud statute.25 This individual pleaded
guilty in the New York State Supreme Court. In another case brought by
DOJ, prosecutors charged several broker-dealers with conducting late
trading for their clients. According to DOJ officials, criminal
prosecution of late trading is fairly straightforward because the practice
is a clear violation of
26
federal securities laws.
SEC staff said that as state and federal criminal prosecutors were already
aware of and generally evaluated the mutual fund trading abuse cases for
potential criminal violations on their own initiative, they did not need
to make specific criminal referrals to bring these cases to their
attention. However, in the course of our review, we found that SEC's
capacity to effectively manage its overall criminal referral process may
be limited by inadequate recordkeeping. SEC rules provide for what SEC
staff characterize as both formal and informal processes for making
referrals for criminal prosecutions; however, senior Enforcement staff
told us that SEC uses only the informal procedures for making criminal
referrals, describing them as less time-consuming and more effective than
the more cumbersome formal processes. While potentially efficient, SEC's
informal procedures do not provide critical management information on the
referral process. Specifically, SEC staff do not document referrals or
reasons for making them. According to federal internal control standards,
policies and procedures, including appropriate documentation, should be
designed to help ensure that management's directives are carried out.
Without proper documentation, SEC cannot readily determine and verify
whether staff make appropriate and prompt referrals. Documentation of
referrals might serve as an additional internal indicator of the
effectiveness of SEC's referral process and is also important for
congressional oversight of law enforcement efforts in the securities
industry.
25The defendant pleaded guilty to a violation of New York's Martin Act,
General Business Law S: 352-c(6). This individual also settled a parallel
civil enforcement action instituted by SEC. The SEC settlement order found
that this individual willfully aided and abetted and caused violations of
SEC Rule 270.22c-1 by engaging in late trading of mutual fund shares on
behalf of a hedge fund operator.
26The practice of placing an order after the calculation of net asset
value, but receiving the previously calculated net asset value is a
violation of SEC Rule 270.22c-1, the SEC's forward pricing rule. Rule
270.22c-1 requires funds, their principal underwriters, dealers, and other
intermediaries authorized to consummate transactions in fund shares to
assign the net asset value that is calculated after the receipt of any
purchase or redemption order.
SEC Prefers Informal Procedures for Making Criminal Referrals
SEC rules set forth what SEC staff characterize as "formal" and "informal"
procedures for making referrals for criminal prosecution. Under what SEC
staff described as the formal referral procedures, the Director of
Enforcement reviews cases to be recommended for criminal prosecution in
coordination with the Office of the General Counsel, and, according to
senior Enforcement staff, seeks Commission authorization for the
recommended referral. Senior Enforcement staff told us that SEC has not
used the formal procedures in over 20 years because the Commission has
given the ability for making informal criminal referrals to Enforcement
staff. According to these staff, the Commission found that it was
approving all formal staff requests to make criminal referrals, so it was
more efficient to give SEC staff the authority to make the referrals
themselves. Under these more informal procedures, staff at the assistant
director level or higher have delegated authority to communicate with
other agencies regarding cases of mutual interest, including referring
cases for criminal prosecution.27
According to senior Enforcement staff and regional staff, if staff
attorneys uncover what they believe might be criminal violations, they
inform their assistant director and other management officials about such
findings. Staff at the assistant director or associate director level
decide whether the staff's findings merit a criminal referral, and if so,
call the local U.S. Attorney's Office or other criminal authority to see
whether they have an interest in the case.28 According to SEC staff, if
the criminal authority is interested in the case they send a letter
requesting formal access to SEC's investigative files for that case. These
staff said that the primary benefit of the informal referral process is
that it allows for an efficient flow of information between agencies. For
example, SEC staff can tip off DOJ about potential criminal cases and DOJ
officials also can call SEC and make informal referrals of cases for
potential civil prosecution.
27See 17 C.F.R. S: 203.2, which authorizes Enforcement staff at the
assistant director level to communicate, or to authorize attorneys to
communicate, information gleaned from SEC investigations or examinations
to law enforcement authorities.
28Several regional assistant and associate directors told us that when
deciding whether to refer a case to DOJ they consider factors such as the
severity and seriousness of the conduct, whether the case is outside SEC's
jurisdiction (for example, obstruction of evidence is outside of SEC's
jurisdiction), and whether individuals involved have previous records of
illegal conduct.
While Potentially Efficient, Informal Procedures Do Not Provide Critical
Management Information on the Referral Process
Although SEC's informal procedures may make the communication of criminal
violations to DOJ efficient and enable an effective cooperative
relationship between the agencies, they do not include requirements for
the documentation of these referrals. Currently, Enforcement staff do not
document what cases have been referred, to whom, or why. Senior
Enforcement staff told us that the documentation of criminal referrals was
unnecessary for several reasons. First, they said that such documentation
would not aid them in managing the referral process, as they already have
processes to ensure that cases with criminal potential are appropriately
referred. For example, in addition to the day-to-day monitoring of cases
at the associate director level, which results in informal referrals to
criminal authorities, the Director or Deputy Director of Enforcement
conducts quarterly reviews of SEC's case inventory to ensure, among other
things, that referrals are being made. Further, they said that Commission
members as a matter of course question staff about their cooperation with
criminal authorities when staff request approval for an enforcement
action. Second, they said that since the wave of high profile corporate
accounting scandals that began in 2000, DOJ has had unprecedented interest
in pursuing securities fraud cases. According to SEC staff, senior DOJ
officials discuss cases of mutual interest with SEC staff in regular joint
meetings and as part of federal regulatory and law enforcement working
groups of which both SEC and DOJ are members.29 SEC staff cited the recent
cooperation between criminal law enforcement and SEC in the mutual fund
cases as a good example of how well these processes work in alerting
criminal prosecutors to appropriate cases. Further, they said that as each
local U.S. Attorney's Office (USAO) sets its own prosecutorial priorities,
the most effective way for SEC staff to learn what each USAO considers a
useful referral is through strong, informal relationships.
While such informal relationships between SEC and criminal law enforcement
authorities might be essential to their effective cooperation, appropriate
documentation of decision-making is an important management tool.
According to federal internal control standards previously discussed,
policies and procedures, including appropriate documentation, helps ensure
that management directives are carried out. Internal control procedures
include a wide range of diverse activities such as authorizations,
verifications, and the creation and maintenance of
29SEC is a member of the Corporate Fraud Task Force, Bank Fraud Working
Group, and the Commodities Fraud Working Group.
related records that provide evidence that these activities were executed.
Without such documentation, the Commission cannot readily determine and
verify whether staff make appropriate and prompt referrals. Also, the
Commission does not have an institutional record of the types of cases
that are referred over the years. Such information is essential for
appropriate management and oversight of the referral process. For example,
although Enforcement staff told us that the director's quarterly review of
cases involves a discussion of cooperative law enforcement activities,
they said that it does not include a written report on criminal referrals
made. Instead, the director must informally poll his staff if he wants to
develop a list of such referrals, which introduces the likelihood of
reporting error. Similarly, in conducting our work, SEC was unable to tell
us what cases had been referred to criminal law enforcement without
contacting staff assigned to the case or directing us to do the same.
Further, we found that other financial regulators such as NASD and CFTC
record their criminal referrals to manage their referral processes.
Documentation of referrals might also serve as an additional internal
indicator of the effectiveness of SEC's referral process.
In addition to aiding SEC management, information about the number, type,
and reasons for SEC criminal referrals could also serve as an important
tool for congressional oversight. Although SEC does not have jurisdiction
over DOJ and other criminal law enforcement authorities and is not
responsible for their decision to act or not upon a referral, the
maintenance of evidence of SEC referrals could serve as verification that
criminal authorities were made aware of appropriate cases. For example,
senior Enforcement staff told us that prior to the corporate accounting
fraud scandals, DOJ was not as interested as it is now in pursuing
securities fraud. In an environment where changing priorities can
influence the types of cases criminal law enforcement agencies pursue, the
documentation of referrals would provide some assurance that SEC is
consistently considering cases for potential criminal prosecution.
SEC Efforts to Encourage Staff Compliance with Federal Conflict-of-Interest
Laws on New Employment Do Not Include Tracking Post-SEC Employment Plans
SEC provides training and guidance to its staff on federal laws and
regulations regarding employment with regulated entities and also requires
former staff to notify SEC if they plan to make an appearance before the
agency. However, SEC does not require departing staff to report where they
plan to work as do other financial regulators. According to SEC staff,
they have not tracked postemployment information because SEC examiners and
other staff are highly aware of employment-related restrictions. SEC staff
also said that since agency examiners have traditionally visited mutual
fund companies periodically to conduct examinations, they are less likely
to face potential conflicts of interest than bank examiners who may be
located full-time at large institutions. Nonetheless, SEC staff have told
us that as part of recently implemented and planned changes to SEC's
mutual fund oversight program they are assigning monitoring teams to the
largest and highest-risk mutual fund companies. The teams would have more
regular contact with fund management over a potentially longer period of
time. In addition, a new SEC rule requiring all mutual fund firms to
designate a chief compliance officer may increase an existing demand for
SEC examiners to fill open positions in the compliance departments at
regulated entities. As a result, the potential for employment conflicts of
interest might increase.
SEC Offers Ethics Training and Counseling Services to Employees on Federal
Employment Restrictions but Does Not Ask Where Employees Plan to Work
Federal laws place restrictions on the postfederal employment of executive
branch employees. Specifically, these laws generally prohibit federal
executive branch employees from participating personally and substantially
in a particular matter that a person or organization with whom the
employee is negotiating prospective employment has a financial interest.30
For example, a senior staff member of SEC's Ethics Office told us that as
a result of this law, SEC examiners and enforcement staff cannot negotiate
employment with a firm that is the subject of an ongoing examination or
enforcement action in which they have direct involvement, although they
are not prohibited from obtaining employment with such firms after the
completion of the examination or enforcement action in which they had such
involvement. However, federal law prohibits former federal executive
branch employees from "switching sides" and representing their new
employer before any federal court or agency concerning any matter in which
the employees were personally and
3018 U.S.C S: 208(a). Section 208(b) sets forth circumstances under which
exceptions to the prohibition may be granted.
substantially involved during the time of their federal employment.31
According to the SEC ethics staff, if a former SEC examiner accepted
employment with a firm that the examiner had previously examined, the
examiner would be permanently barred from communicating with SEC regarding
the examination in which he or she had participated. In addition, former
senior employees are prohibited for a period of 1 year following federal
employment from communicating with or appearing before their former
federal employer on behalf of anyone with the intent to influence agency
action. This "cooling-off' period is 2 years concerning any matter that
was pending under a former employee's official responsibility during the
1-year period prior to termination of federal employment.32 Violation of
either the "seeking employment" or postfederal employment activity
restrictions can result in civil and criminal sanctions.
The SEC Ethics Office provides annual ethics training and offers ethics
counseling to SEC examiners, Enforcement staff, and other employees to
explain these and other conflict-of-interest laws and how to avoid
violating them. Further, under SEC rules, former SEC staff are required to
file a notice with SEC within 10 days after being employed or retained as
the representative of any person outside of the government in any matter
in which an appearance before, or communication with, SEC or its employees
is contemplated.33 This notice must include a description of the
contemplated representation, an affirmative statement that the former
employee did not have either personal and substantial responsibility or
official responsibility for the matter that is the subject of the
representation while employed by SEC, and the name of the SEC division or
office in which the former employee had been employed. Senior Ethics
Office staff said that upon receiving these notices they verify with the
former division or office that the contemplated representation does not
involve a matter that the person had responsibility for during his or her
employment with SEC.
While these notices provide SEC with information on some employees'
postemployment activities and allow SEC to monitor compliance with
postfederal employment activity restrictions, they do not provide SEC
3118 U.S.C. S: 207(a).
3218 U.S.C. S: 207(b).
3317 C.F.R. S: 200.735-8(b)(1). This rule applies to all former SEC staff
for 2 years after leaving the agency.
with information on the postemployment plans of all of its departing staff
at the time they announce their intention to leave the agency. SEC
currently does not require departing staff to report where they plan to
work, a procedure required by other financial regulators to better ensure
that seeking employment restrictions have not been violated. For example,
OCC and the Federal Reserve Banks of New York and Chicago obtain
information from departing staff, or at least examination staff in the
case of the Federal Reserve Banks, on where they are going to work.34 NASD
also tracks information on departing staff's subsequent employment with
member firms, although they do not ask staff directly for it.35 Officials
from three of these agencies said that they also ask for this information
to assess whether the quality of the employee's prior regulatory work
could have been compromised by a potential conflict of interest with the
employee's new place of employment. For example, when departing examiners,
enforcement attorneys, and other professional staff go to work for a bank
with whom they have recently been involved in a regulatory matter, OCC
requires a review of their related work products, as does the Federal
Reserve Bank of New York for departing examiners.36 Similarly, NASD
requires staff to conduct a reexamination of a member firm if that firm
hires an employee who was involved in a recent examination of that firm or
a review of the related examination workpapers if the employee was a
former supervisor, assistant/associate director, or attorney who
34The Federal Reserve Banks of Chicago and New York have codes of ethics
that contain seeking employment restrictions.
35According to NASD, every month NASD staff generate a list of employees
who have left the agency and submit this list to NASD's Central
Registration Depository (CRD), which is an electronic database that
contains information on the employees of member firms. If the CRD
identifies people from the list that are working at a member firm, NASD
determines whether these individuals were involved in an examination of
that firm within the last 12 months of their employment with NASD. NASD
also has a code of ethics that prohibits NASD employees from acting in any
NASD matter with whom the employee is seeking employment.
36Some senior bank examiners are prohibited by law from going to work
directly for a bank they were recently involved in examining. Section
6303(b) of the Intelligence Reform and Terrorism Prevention Act of 2004
amended Section 10 of the Federal Deposit Insurance Act to prohibit former
bank examiners from going to work for any depository institution if,
during their last year as an employee of a federal banking regulator, they
served more than 2 months as senior bank examiner of that depository
institution. This prohibition is in effect for a period of one year after
the termination of their employment with the federal banking regulator.
See Federal Deposit Insurance Act S: 10(k), to be codified at 12 U.S.C. S:
1820(k).
reviewed or worked on the examination. SEC currently does not require
similar workpaper reviews or reexaminations.37
Changes to SEC Examination Program and Potential Increased Private Sector
Demand for Examiners Could Increase Conflicts of Interest and Need for
Postemployment Tracking
According to senior staff from SEC's Office of Compliance Inspections and
Examinations (OCIE), which administers SEC's nationwide examination
program for investment companies and other regulated entities,
postemployment tracking has not been viewed as essential because SEC
examiners face fewer potential conflicts of interest than bank examiners.
Senior OCIE staff told us that unlike bank examiners, SEC examiners
typically participate in multiple examinations in the course of the year.
Banking regulators, on the other hand, often have examiners stationed
permanently on site at the largest financial institutions.38 OCIE staff
said that because SEC examiners do not have prolonged contact with
management at regulated entities, there is little opportunity for them to
develop the type of relationships that could lead to conflicts of
interest.
However, recently implemented and planned changes to SEC's mutual fund
oversight program might increase the potential for employment conflicts of
interest. As part of these changes (which we review in a forthcoming
report), OCIE is creating monitoring teams of two or three examiners to be
assigned to review the operations and activities of the largest and
highest-risk mutual fund companies on an ongoing basis, as opposed to
conducting periodic routine examinations. We note that SEC's planned
approach for large mutual fund companies is intended to be similar to the
bank regulators' approach to bank supervision at large financial
institutions, in which teams are assigned full-time to monitor the largest
institutions. Such an approach would increase the contact SEC examiners
have with fund management and potential for conflicts of interest.
Further, SEC's new rule requiring all mutual fund firms to designate a
chief compliance officer may increase an existing demand for SEC examiners
and other staff to fill open positions at the compliance departments of
regulated entities. SEC examiners told us that departing
37Procedures such as asking departing staff where they are going to work
and reviewing their related work products when appropriate can help
provide reasonable assurance, not absolute assurance, that conflicts of
interests are avoided.
38According to one banking regulator, examiners of smaller banks typically
spend a few weeks on site while conducting their examinations.
Conclusions
SEC examiners commonly obtained employment in the compliance departments
of regulated entities. Further, these examiners and securities industry
officials told us that having former SEC staff at these firms was very
beneficial because SEC staff have expertise in compliance issues and are
compliance-oriented. One securities industry official said former SEC
examiners and other staff are a natural source of expertise for firms that
were involved in the recent mutual fund trading abuses and that want to
correct their problems. While the compliance departments at regulated
entities may benefit by hiring experienced SEC staff, an increase in the
employment potential of examiners and other staff at these firms could
also increase the potential for conflicts of interest.
After the mutual fund trading abuses were uncovered in September 2003, SEC
acted swiftly to bring enforcement actions against prominent firms and
individuals involved in the misconduct and obtained some of its highest
penalties in history from them in settlements. SEC has also consistently
applied its procedures for establishing such penalties. However, we
identified weaknesses in SEC's internal controls that may limit its
capacity to effectively manage its criminal referral process. Currently,
SEC does not require staff to document that a referral has been made to a
federal or state criminal investigative authority or the reasons for such
referrals. According to federal internal control standards, such
documentation is important for verifying that management directives have
been carried out. Without such documentation, SEC's ability to measure the
performance of its criminal referral process and to help ensure effective
congressional oversight of that process is limited.
We also found that SEC has not established controls that could help ensure
the independence of staff from the fund industry as they carry out SEC's
critical oversight work. Although SEC provides ethics training to its
employees regarding seeking employment and postemployment
conflictof-interest laws, the agency does not require departing staff to
provide information on their future employment plans. In the absence of
such information, SEC's capacity to ensure compliance with
conflict-of-interest laws related to postemployment opportunities is
limited. Further, SEC does not have procedures in place requiring review
of departing employees' workpapers should a potential conflict of interest
be discovered. SEC's recently implemented and planned changes to its
mutual fund examination program that will likely involve greater contact
between examiners and company officials as well as the potential that
agency staff will seek to become compliance officers underscore the need
Recommendations
o
o
Agency Comments and Our Evaluation
for the agency to ensure compliance with these critical conflict of
interest laws.
To strengthen SEC's management procedures and better ensure that agency
responsibilities are being met, the SEC Chairman should ensure that the
agency take the following two actions:
document informal referrals to criminal authorities for potential criminal
prosecutions and the reasons for such referrals; and
request that departing employees provide the name of their next employer
as part of exit procedures and establish procedures to review the
departing employees' related work products if a potential conflict of
interest is determined to exist.
SEC provided written comments on a draft of this report, which are
reprinted in appendix II. SEC also provided technical comments, which were
incorporated into the final report, as appropriate. SEC agreed with our
recommendations. SEC indicated that it is in the process of converting its
investigation opening form to a web-based application, which will provide
for documentation of informal referrals to criminal authorities. SEC also
noted steps it is taking to avoid conflicts of interests that could affect
the implementation of SEC programs and activities, which include
establishing a formal ethics component to exit procedures. As part of this
process, SEC will ask departing staff to provide information about the
identity of their next employer, and, to the extent a potential conflict
is identified, will investigate as appropriate.
As agreed with your office, unless you publicly announce the contents of
this report earlier, we plan no further distribution of this report until
30 days from the report date. At that time we will provide copies of this
report to SEC and interested congressional committees. We will also make
copies available to others upon request. In addition, the report will be
available at no cost on GAO's Web site at http://www.gao.gov.
If you or your staff have any questions about this report, please contact
Wesley M. Phillips, Assistant Director, or me at (202) 512-8678. GAO staff
who made major contributions to this report are listed in appendix III.
Richard J. Hillman Director, Financial Markets and Community Investment
Appendix I: Scope and Methodology
The objectives of our report were to (1) compare the severity of civil
money penalties (penalties) obtained in the mutual fund cases with
penalties obtained in the past and with similarly egregious cases, review
the Securities and Exchange Commission's (SEC) penalty-setting process in
these cases, and discuss SEC's coordination with state securities
regulators in civil enforcement actions; (2) provide information on state
and federal criminal enforcement actions regarding market timing and late
trading violations; (3) assess SEC's management procedures for making
referrals to the Department of Justice (DOJ) and state authorities for
potential criminal prosecution; and (4) evaluate SEC's procedures for
ensuring compliance with federal laws and regulations that govern
employees' ability to negotiate and take positions with regulated
entities, such as mutual fund companies.
To compare the severity of penalties obtained in the mutual fund cases
with penalties obtained in the past and with similarly egregious cases,
review SEC's penalty-setting process in these cases, and discuss SEC's
coordination with state securities regulators in civil enforcement
actions, we obtained copies of SEC enforcement actions and settlement
orders related to market timing and late trading cases and compared them
to corporate accounting fraud and investment banking analyst cases, which
SEC staff identified as similar to the mutual fund cases in the
egregiousness and pervasiveness of misconduct. We obtained these documents
from SEC's Web site and SEC staff reviewed the list of cases we compiled
for accuracy. We then calculated and compared the average penalties
obtained in these three types of cases. We also obtained data from SEC on
the 30 highest penalties obtained from entities in settlement, according
to their records, and similar data for individuals. This data allowed us
to compare the penalties obtained in the mutual fund trading abuse cases
to the penalties obtained in past cases. In addition, we obtained
information from SEC, the Commodity and Futures Trading Commission (CFTC),
the Office of the Comptroller of the Currency (OCC), and the NASD on the
criteria and processes they use to determine penalties and data from CFTC
and OCC on their highest settlements and from NASD on its mutual fund
trading abuse settlements. Then, to determine whether SEC used its
criteria and processes consistently when evaluating what penalties to seek
in the late trading and market timing cases, we reviewed documentation
pertaining to a selection of 11 out of 14 enforcement actions SEC brought
against investment advisers charged with market timing abuses. These 11
cases were distributed among six regional SEC offices. We interviewed
regional examiners and attorneys assigned to each case and reviewed the
related investigative record. For example, we reviewed enforcement actions
and settlement orders, staff
Appendix I: Scope and Methodology
analyses of economic harm caused and benefit gained, memorandums from the
Division of Enforcement to the Commission, and SEC examinations for each
of these investment advisers and their associated fund companies dating
back several years. The mutual fund companies we chose to review were
among the 100 largest mutual fund companies nationwide, as measured by the
size of customer assets under management as of August 1, 2003. We also
interviewed two legal scholars and economists who have conducted recent
research on SEC penalties or mutual fund trading abuses to obtain
additional views on SEC's penaltysetting process. In addition, we
interviewed securities regulators or law enforcement officials from three
states that coordinated settlement negotiations with SEC in bringing their
own enforcement actions against investment advisers involved in 11 of the
14 SEC enforcement actions mentioned above and obtained copies of the
related enforcement actions and settlement orders from their Web sites.
These regulatory or law enforcement entities were the New York State
Office of the Attorney General (NYSOAG), the Colorado Attorney General's
Office, and the New Hampshire Bureau of Securities Regulation.
To provide information on state and federal criminal enforcement actions
regarding market timing and late trading violations, we interviewed staff
from SEC, NYSOAG, the Wisconsin Attorney General's Office, and DOJ and
obtained copies of late trading and market timing-related criminal
complaints from the Web sites of the relevant federal or state criminal
authorities.
To assess SEC's management procedures for making referrals to DOJ and
state authorities for potential criminal prosecution, we reviewed SEC
rules
governing these referrals and interviewed staff from SEC, DOJ, and
NYSOAG. We also interviewed officials from NASD and CFTC on their
referral procedures and obtained copies of relevant rules and policies. We
evaluated SEC's referral procedures using Standards for Internal 1
Controls in the Federal Government.
To evaluate SEC's procedures for ensuring compliance with federal laws and
regulations that govern employees' ability to negotiate and take positions
with regulated entities, such as mutual fund companies, we reviewed
applicable laws and regulations, interviewed staff from and
1GAO, Standards for Internal Control in the Federal Government,
GAO/AIMD-00-21.3.1 (Washington, D.C.: 1999)
Appendix I: Scope and Methodology
reviewed the policies and procedures of SEC, OCC, the Federal Reserve
Banks of Chicago and New York, and NASD for promoting staff compliance
with federal laws limiting the seeking of employment opportunities and
postemployment activities of federal executive employees and, in the case
of the Federal Reserve Banks and NASD, codes of ethics that also include
seeking employment restrictions.
We performed our work in Boston, Mass.; Chicago, Ill.; Denver, Colo.; New
York, N.Y.; Philadelphia, Penn.; and Washington, D.C., between May 2004
and May 2005 in accordance with generally accepted government auditing
standards. SEC provided written comments on a draft of this report, which
are reprinted in appendix II. Our evaluation of these comments is
presented in the agency comments section.
Appendix II: Comments from the Securities and Exchange Commission
Appendix II: Comments from the Securities and Exchange Commission
Appendix III: Major Contributors to this Report
GAO Contacts Acknowledgments
(250199)
Richard J. Hillman (202) 512-8678 Wesley M. Phillips (202) 512-5660
In addition to those named above, Fred Jimenez, Stefanie Jonkman, Marc
Molino, Omyra Ramsingh, Barbara Roesmann, Rachel Seid, David Tarosky, and
Anita Zagraniczny made key contributions to this report.
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