SEC Mutual Fund Oversight: Positive Actions Are Being Taken, but 
Regulatory Challenges Remain (07-JUN-05, GAO-05-692T).		 
                                                                 
Trading abuses--including market timing and late trading	 
violations--uncovered among some of the most well-known companies
in the mutual fund industry permitted favored customers to profit
at the expense of long-term shareholders. Questions have also	 
been raised as to why the New York State Office of the Attorney  
General identified the trading abuses in September 2003 before	 
the industry's primary regulator: the Securities and Exchange	 
Commission (SEC). Based on two recently issued GAO reports, this 
testimony discusses (1) the reasons SEC did not detect the	 
abusive practices at an earlier stage and lessons learned from	 
the agency not doing so, (2) steps the agency has taken to	 
strengthen its mutual fund oversight program, and (3) enforcement
actions taken by SEC and criminal prosecutors in response to	 
these abuses and SEC management procedures for making criminal	 
referrals and ensuring staff independence.			 
-------------------------Indexing Terms------------------------- 
REPORTNUM:   GAO-05-692T					        
    ACCNO:   A25958						        
  TITLE:     SEC Mutual Fund Oversight: Positive Actions Are Being    
Taken, but Regulatory Challenges Remain 			 
     DATE:   06/07/2005 
  SUBJECT:   Brokerage industry 				 
	     Federal regulations				 
	     Financial analysis 				 
	     Fines (penalties)					 
	     General management reviews 			 
	     Internal controls					 
	     Investment companies				 
	     Law enforcement					 
	     Lessons learned					 
	     Mutual funds					 
	     Regulatory agencies				 
	     Risk management					 
	     Sanctions						 
	     Securities 					 
	     Securities fraud					 
	     Securities regulation				 
	     Strategic planning 				 

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GAO-05-692T

United States Government Accountability Office

GAO Testimony

Before the Subcommittee on Commercial and Administrative Law, Committee on
the Judiciary, House of Representatives

For Release on Delivery

Expected at 4:00 p.m. EDT SEC MUTUAL FUND

Tuesday, June 7, 2005

OVERSIGHT

       Positive Actions Are Being Taken, but Regulatory Challenges Remain

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

GAO-05-692T

[IMG]

June 7, 2005

SEC MUTUAL FUND OVERSIGHT

Positive Actions Are Being Taken, but Regulatory Challenges Remain

  What GAO Found

Prior to September 2003, SEC did not examine mutual fund companies for
trading abuses such as market timing violations because agency staff
viewed other activities as representing higher risks and believed that
companies had financial incentives to establish effective controls. While
SEC has competing examination priorities, it can draw lessons from not
detecting the trading abuses earlier. First, by conducting independent
assessments of controls in areas such as market timing (through
interviews, reviews of exception reports, reviews of independent audit
reports, or transaction testing as necessary), SEC could reduce the risk
that violations may go undetected. Second, SEC could further develop its
capacity to identify and evaluate evidence of potential risk (for example,
academic studies completed between 2000 and 2002 identified certain market
timing concerns as a persistent risk to mutual fund customers). Third,
ensuring the independence of company compliance staff is critical and SEC
staff could better assess company risks and controls through routine
interactions with such staff.

SEC has taken several steps to strengthen its mutual fund oversight
program and the operations of mutual fund companies, but it is too soon to
assess the effectiveness of several key initiatives. For example, SEC has
instructed its staff to make additional assessments of company controls
and established a new office to identify and assess potential risks. SEC
also adopted a rule that requires mutual fund companies to appoint
independent compliance officers who are to prepare annual reports on their
companies' policies and violations. However, SEC has not developed a plan
to receive and review these annual reports on an ongoing basis and thereby
enhance its capacity to detect potential violations.

Since September 2003, SEC has brought 14 enforcement actions against
mutual fund companies and 10 enforcement actions against other firms for
mutual fund trading abuses. Penalties obtained in settlements with mutual
fund companies are among the agency's highest-ranging from $2 million to
$140 million and averaging $56 million. In contrast, penalties obtained in
settlements for securities law violations prior to 2003 were typically
under $20 million. In reviewing a sample of investment adviser cases, GAO
found that SEC followed a consistent process for determining penalties and
that it coordinated penalties and other sanctions with interested states.
However, GAO found certain weaknesses in SEC's management procedures for
making referrals to criminal law enforcement and ensuring staff
independence. In particular, SEC does not require staff to document
whether a criminal referral was made or why. Without such documentation,
SEC cannot readily determine whether staff make appropriate referrals.
Further, SEC does not require departing staff to report where they plan to
work, information gathered by other financial regulators to assess staff
compliance with federal laws regarding employment with regulated entities.
In the absence of such information, SEC's capacity to ensure compliance
with these conflict-ofinterest laws is limited.

United States Government Accountability Office

Mr. Chairman, Mr. Ranking Member, and Members of the Subcommittee:

I am pleased to be here today to discuss two recently issued GAO reports
that assess the Securities and Exchange Commission's (SEC) response to
trading abuses uncovered in the mutual fund industry. We prepared these
reports at the request of Chairman Sensenbrenner and Ranking Member
Conyers of the full committee.1 As you know, trading abuses-including
fraudulent market timing and late trading violations-were uncovered in
many well-known companies in the mutual fund industry and raised
significant concerns about the industry's ethical practices.2 Maintaining
public confidence in the mutual fund industry is critical because about 95
million Americans have invested more than $8 trillion in mutual funds, a
significant share of the nation's privately held wealth. Moreover, it is
critical that SEC and NASD have the capacity to identify abusive practices
and to bring enforcement actions that punish violators and deter those who
are contemplating similar abuses.3

Questions have been raised as to why so many mutual fund companies and
broker-dealers were able to engage in trading abuses, sometimes for years,
without being detected by SEC and NASD. In fact, the trading abuses only
came to light after the New York State Office of the Attorney General
(NYSOAG) received a tip from a hedge fund insider, conducted an
investigation, and, in September 2003, settled an enforcement action
against a hedge fund company and a hedge fund official for market timing

1GAO, Mutual Fund Trading Abuses: Lessons Can Be Learned from SEC Not
Having Detected Violations at an Earlier Stage, GAO-05-313 (Washington,
D.C.: April 20, 2005) and Mutual Fund Trading Abuses: SEC Consistently
Applied Procedures in Setting Penalties, but Could Strengthen Certain
Internal Controls, GAO-05-385 (Washington, D.C.: May 16, 2005).

2For purposes of this testimony, the term "mutual fund companies"
generally refers to mutual fund companies and their related investment
advisers and service providers, such as transfer agents, unless otherwise
specified. Many mutual fund companies have no employees, although they
typically have a board of directors, and rely on investment advisers to
perform key functions such as providing management and administrative
services.

3SEC is the primary regulator of the mutual fund industry. NASD has direct
oversight responsibility for broker-dealers that may sell and execute
other orders for investment products, including mutual funds.

and late trading of several mutual funds.4 The federal regulators' failure
to identify the abuses at an earlier stage has generated concern about the
effectiveness of their examination and other oversight procedures.

As we describe in our reports, market timing and late trading violations
permitted favored customers to benefit at the expense of long-term mutual
fund company shareholders. 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 markets and U.S. markets. Although market
timing is not itself illegal, frequent trading can harm mutual fund
shareholders because it increases transaction costs and lowers a fund's
returns. However, market timing can constitute illegal conduct if, for
example, it takes place as a result of undisclosed agreements between
mutual fund investment advisers (companies that provide management and
other services to mutual funds) and favored customers who are permitted to
trade frequently and in contravention of stated company trading limits.
Late trading, a significant but less widespread abuse than market timing
violations, occurs when investors place orders to buy or sell mutual fund
shares after the mutual fund has calculated price of its shares, usually
once daily at the 4 p.m. Eastern Time close of the financial markets.
Investors who are permitted to engage in late trading can profit from the
knowledge of events in the financial markets that take place after 4 p.m.,
an opportunity that other fund shareholders do not have.

My testimony today focuses largely on the market timing area, because such
abuses were more widespread than late trading violations, and on SEC,
which is the mutual fund industry's frontline regulator. I will discuss
late trading issues and NASD oversight activities to a lesser degree. More
specifically, my testimony covers (1) the reasons that SEC did not detect
the market timing abuses at an earlier stage and lessons learned from the
agency not doing so, (2) the steps SEC has taken to strengthen its
oversight of the mutual fund industry and strengthen industry business

4The term "hedge fund" generally refers to 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).

practices, and (3) enforcement actions taken by SEC and criminal
prosecutors in response to these abuses and SEC management procedures
related to the making of criminal referrals and ensuring staff
independence from the mutual fund industry.

In summary:

Before September 2003, SEC did not examine fund companies for market
timing abuses because agency officials (1) viewed other activities as
representing higher risks, (2) concluded that companies had financial
incentives to control frequent trading because it could lower fund
returns, and (3) were told by company officials that the companies had
established controls over frequent trading. While SEC faced competing
examination priorities before September 2003 and had made good faith
efforts to mitigate the known risks associated with legal market timing,
lessons can be learned from the agency not having detected the abuses
earlier. First, without independent assessments of controls over areas
such as market timing during examinations (through interviews, reviews of
exception reports, reviews of independent audit reports, or transaction
testing as necessary), the risk increases that violations may go
undetected. Second, SEC can strengthen its capacity to identify and assess
any evidence of potential risks. For example, a 2002 study estimated that
market timing in certain funds resulted in about $5 billion in annual
losses to shareholders, and raised the possibility that investment
advisers did not always act decisively to control such risks due to
potential conflicts of interest.5

Third, we found that compliance staff at mutual fund companies often
detected evidence of undisclosed market timing arrangements with favored
customers but lacked sufficient independence within their organizations to
correct identified deficiencies. Ensuring the independence of compliance
staff is critical, and SEC could potentially benefit from using their
work.

SEC has taken several steps to strengthen its oversight of mutual fund
companies, but it is too soon to assess the effectiveness of certain
initiatives. To improve its examination program, SEC staff recently
instructed agency staff to conduct more independent assessments of the
fund companies' internal controls. To improve its risk assessment
capabilities, SEC also has created and is currently staffing a new office
to help the agency better anticipate, identify, and manage emerging risks
and

5Eric Zitzewitz, "Who Cares About Shareholders? Arbitrage-Proofing Mutual
Funds," Stanford Graduate School of Business Research Paper No. 1749
(October 2002).

market trends. To better ensure the independence of company compliance
staff, SEC recently adopted a rule that requires compliance officers to
report directly to the funds' boards of directors. While this rule has the
potential to improve fund company operations and is intended to increase
the independence of compliance officers, certain compliance officers may
still face organizational conflicts of interest. For example, under the
rule compliance officers may not work directly for mutual fund companies,
but rather, may be employed by investment advisers-who manage the
funds-whose interests may not necessarily be fully aligned with mutual
fund customers. In addition, although the rule also requires compliance
officers to prepare annual reports on their companies' compliance with
laws and regulations, SEC has not developed a plan to routinely receive
and review the reports. Without such a plan, SEC cannot be assured that it
is in the best position to detect abusive industry practices and emerging
trends. SEC has agreed to implement recommendations from our April 2005
report to help ensure the effectiveness of compliance officers and to
determine how to best utilize the annual compliance reports, or the
material findings cited in those reports.

The penalties SEC obtained in the market timing and late trading cases are
among the largest in the agency's history and are generally consistent
with penalties obtained in cases involving similarly egregious corporate
misconduct. As of February 28, 2005, SEC had brought 14 enforcement
actions against investment advisers and 10 enforcement actions against
other firms for market timing and late trading abuses. It has also brought
enforcement actions against several high ranking company officials.
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, penalties obtained in
settlements for securities law violations before 2003 were typically under
$20 million. In reviewing a sample of cases involving investment advisers,
we found that SEC followed a consistent process for determining penalties
and that it coordinated penalties and other sanctions with interested
states. However, we found certain weaknesses in SEC's overall procedures
for referring securities cases to other agencies for potential criminal
violations and ensuring that departing employees compiled with
conflictof-interest laws and regulations. SEC has agreed to implement
recommendations from our May 2005 report to strengthen these processes.

To address our reporting objectives, we conducted in-depth reviews of 11
SEC enforcement actions against mutual fund companies for market timing
and other abusive practices. We reviewed examination reports for

these companies as well as related enforcement action documents. We
interviewed representatives from SEC, NASD, mutual fund companies,
broker-dealers, pension plan administrators, and other industry
participants about practices and procedures industry participants use to
prevent abuses and monitor trading activity. We also interviewed SEC staff
in headquarters and various regional and district offices about how its
oversight examination and enforcement efforts were conducted and how
penalty amounts were determined. We also obtained information from
Department of Justice (DOJ) officials and selected state regulators and
attorney generals on criminal enforcement actions brought in cases
involving market timing and late trading abuses. In addition, we reviewed
relevant academic and other studies. We interviewed SEC staff regarding
SEC's management procedures for making criminal referrals to DOJ and state
criminal authorities and reviewed related SEC rules. We evaluated these
rules using Standards for Internal Controls in the Federal Government.6 We
reviewed federal laws and regulations that govern employees' ability to
negotiate and take positions with regulated entities, such as mutual fund
companies, and reviewed SEC and other financial regulators' policies and
procedures for ensuring staff compliance with these laws. We conducted our
work on these reports between May 2004 and May 2005 in accordance with
generally accepted government auditing standards.

SEC did not examine for market timing abuses or test company controls in
that area, largely because the agency had competing examination priorities
and believed that companies had financial incentives to control frequent
trading. Lessons learned from SEC not having detected these abuses earlier
can be useful to the agency in administering its examination program going
forward.

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

SEC Did Not Examine for SEC staff have stated that given the number of
mutual fund companies, the

Market Timing Abuses 	breadth of their operations, and limited examination
resources, SEC's examinations were limited in scope. Examiners focused on
discrete areas that staff viewed as representing the highest risks of
presenting

6GAO, Standards for Internal Controls in the Federal Government,
GAO/AIMD-00-21.3.1 (Washington, D.C.:1999).

compliance problems that could impact investors. SEC staff stated that
before September 2003, they considered funds' portfolio trading (i.e.,
purchases and sales of securities on behalf of investors) and other areas
as representing higher risks than potential market timing abuses and noted
that examinations and enforcement cases in these other areas revealed many
deficiencies and violations. SEC staff also said that they did not review
market timing controls because they believed that fund companies had
financial incentives to control frequent trading because it can lower fund
share prices, thereby resulting in a loss of business.7 An SEC staff
member also said that officials from mutual fund companies told agency
examiners that they had appointed compliance staff called "market timing
police" to enforce compliance with the funds' trading limit policies.

SEC staff said they were surprised in September 2003 when NYSOAG
identified the market timing abuses. However, after the abusive practices
were identified, SEC moved aggressively to assess the scope and
seriousness of the problem. For example, SEC surveyed about 80 large
mutual fund companies and determined that nearly 50 percent had some form
of undisclosed market timing arrangement with certain customers that
appeared to be inconsistent with internal policies, prospectus disclosure,
or fiduciary duties. SEC also initiated immediate "cause" examinations and
investigations at many of these mutual fund companies to further review
potential violations.

I would note that NASD's examinations of broker-dealers also did not
discover market timing arrangements involving broker-dealers before
September 2003. According to an NASD official, these arrangements went
undetected because market timing was not illegal per se and, to the extent
that a mutual fund company had stated customer trading limits,
brokerdealers may not have perceived themselves as being responsible for
enforcing such policies. Regarding late trading, NASD officials said that
the organization did not have specific examination guidance to detect the
violation before September 2003. NASD officials also said that some
broker-dealers created fictitious accounts or otherwise falsified
documents, so that detecting late trading violations was difficult.

7Since investment adviser fees are often based on the size of assets under
management, SEC staff reasoned that companies would establish effective
controls to help ensure that assets under management did not decline.

Key Regulatory Lessons Have Emerged from Mutual Fund Trading Abuses

We recognize that SEC faces competing examination priorities and had
limited examination resources before September 2003. We also recognize
that SEC examiners cannot anticipate every potential fraud, particularly
novel frauds such as the undisclosed market timing arrangements between
investment advisers and favored customers, such as hedge funds. Further,
SEC staff made good faith efforts to control the known risks associated
with legal market timing, such as issuing guidance on "fair value"
pricing.8 Nevertheless, three key lessons can be drawn from this
experience and used to strengthen SEC's mutual fund oversight program
going forward:

o  	First, performing independent assessments of company controls is
essential to confirm views held by regulatory staff regarding risks and
the adequacy of controls in place to mitigate those risks. Commonly
accepted examination and auditing guidelines call for a degree of
professional skepticism in assessing controls (such as mutual fund company
market timing controls) and independent verification of their adequacy to
mitigate potential risks. Conducting independent testing of controls at a
sample of companies, at a minimum, could serve to verify that areas, such
as market timing, do in fact represent low risks and that effective
controls are in place. A variety of means can be used to independently
test controls, including interviewing responsible officials, assessing
organizational structure to ensure that compliance staff have adequate
independence to carry out their responsibilities, reviewing internal and
external audit reports, reviewing exceptions to stated policies, and
testing transactions as necessary. If examiners or auditors detect
indications of noncompliance with stated policies or requirements, they
are expected to expand the scope of their work to determine the extent of
identified deficiencies.

o  	Second, SEC must develop the institutional capacity to identify and
evaluate evidence of potential risks and deploy examination staff as
necessary to review controls and potentially detect violations in these
areas. Our review identified information that was available prior to
September 2003 and that was inconsistent with SEC staff's views that
market timing was a low-risk area because companies would necessarily act
to protect fund returns from the harmful consequences of frequent trading.
For example, academic studies indicated that market timing, while legal,
remained a persistent risk prior to September 2003 and by one estimate was
costing mutual fund shareholders approximately $5 billion

8Fair value pricing involves mutual funds using the estimated market value
of shares when market quotes are not readily available. Fair value pricing
of mutual fund shares can minimize discrepancies between foreign and U.S.
markets and thereby minimize market timing opportunities.

annually in certain funds. Further, these studies showed that companies

were not acting aggressively to control these risks through fair value

pricing, despite SEC's guidance that they do so. The author of a 2002
study

raised the possibility that certain investment advisers were not

implementing fair value pricing because they were benefiting financially

from permitting frequent trading, as turned out to be the case.9 Moreover,
a

mutual fund company insider provided information to an SEC district

office in early 2003 indicating that a company had poor market timing

controls, but the office did not act promptly on this information. If the
SEC

office had acted on this tip in early 2003, it might have identified

potentially illegal market timing activity by company insiders.

o  	Third, ensuring the independence and effective operation of mutual
fund companies' compliance staff is central to preventing violations of
the securities laws, regulations, and fund policies. In the majority of
the 11 SEC mutual fund company enforcement cases we reviewed, compliance
staff lacked such independence. Although the compliance staff- sometimes
referred to as "market timing police"-often identified frequent trading
that violated company limits, other company officials would routinely
overrule the compliance staff's efforts to control such trading. We also
found that routine communication with compliance staff could potentially
enhance SEC's capacity to detect potential violations at an earlier stage
if such staff are forthcoming with relevant information. In cases we
reviewed, compliance staff were obviously aware of violations and, in two
cases, had documented their findings regarding the harmful consequences of
frequent trading in internal company reports. For example, in one case,
the sales staff at a mutual fund company overrode the compliance staff's
efforts to control hundreds of market timing transactions between 1998 and
2003. In another case, a company's chief compliance officer sent
memorandums to the chief executive officer in 2002 and 2003 complaining
about the effects of the company's market timing arrangements on long-term
shareholders.

9Zitzewitz,(2002). Subsequent to September 2003, SEC determined that some
favored investors agreed to place assets in mutual funds in exchange for
market timing privileges (referred to as "sticky assets"). According to
the author, he believed the potential existed that market timers were
investing assets in mutual funds, which benefited the related investment
advisers because such assets increased their fees.

  SEC Has Taken Steps to Strengthen Mutual Fund Oversight, but It Is Too Soon to
  Assess the Effectiveness of Some Initiatives

SEC has taken several steps over the past two years to strengthen its
oversight of the mutual fund industry and improve company practices. These
steps include strengthening the agency's mutual fund examination program,
establishing an office to better identify emerging risks, hiring
additional staff, establishing new tip handling procedures, and enacting a
series of rules and rule amendments. Although SEC has taken steps to
strengthen its mutual fund company oversight program, it is generally too
soon to assess the effectiveness of these initiatives.

To improve its examination program, SEC has instructed examiners to make
additional assessments of internal controls at mutual fund companies. For
example, SEC staff have identified a range of areas that potentially
represent high-risk compliance problems, such as personal trading by
company officials, and examiners have initiated independent examinations
of these areas. SEC staff also plan to significantly revise the agency's
approach to mutual fund company examinations. Rather than evaluating all
mutual fund companies on a set cycle as they did between 1998 and 2003,
SEC staff plan to begin focusing on the largest and riskiest companies on
an ongoing basis. For example, SEC is creating monitoring teams of 2 to 3
individuals who would be responsible for reviewing the largest companies
on a more continuous basis, and is placing more emphasis on examinations
that target emerging risks. SEC also plans to review some portion of other
mutual fund companies on a randomized basis. In a forthcoming report, we
assess these and other planned changes to SEC's mutual fund company
oversight program. I note that NASD has also recently implemented new
examination procedures to better detect market timing and late trading
abuses.

SEC also has established the Office of Risk Assessment (ORA) to assist the
agency in carrying out its overall oversight responsibilities, including
mutual fund oversight. The office's director reports directly to the SEC
chairman. According to SEC staff, ORA will enable agency staff to analyze
risk across divisional boundaries, focusing on early identification of new
or resurgent forms of fraudulent, illegal, or questionable behavior or
products. SEC staff said that ORA will seek to ensure that SEC has the
information necessary to make better, more informed regulatory decisions.
Although ORA may help SEC be more proactive and better identify emerging
risks, it is too soon to assess its effectiveness. In this regard, at the
close of our review, ORA had established an executive team of 5
individuals but still planned to hire an additional 10 staff to assist in
carrying out its responsibilities.

With increased appropriations over recent years, SEC also has hired
additional staff to carry out its mutual fund and other oversight
programs, potentially enhancing the agency's capacity to test a variety of
controls. For example, Office of Compliance Inspections and Examinations
staff dedicated to mutual fund company oversight increased by 38 percent
between 2002 and 2005 (from 397 to an estimated 547 positions). While the
additional staff has the potential to enhance SEC's capacity to oversee
key areas within the mutual fund industry, we previously reported that the
agency hired the staff without having an updated strategic plan.10 Without
an updated strategic plan in place that identifies the agency's priorities
and aligns these priorities with an effective human capital program, it is
not clear that SEC's recent hiring decisions will ensure that it has the
right amount of resources with the right expertise to do the most
effective job possible. In August 2004, SEC revised its strategic plan. We
are reviewing SEC's strategic workforce planning as part of a separate
engagement.

In addition to hiring staff, SEC has centralized its processes and
established new procedures for handling tips and complaints. For example,
before the abuses were detected, the agency's Division of Enforcement
(Enforcement) had no process under which regional and district office
staff would refer complaints and tips to headquarters for review and
similarly no process for centralized review of how staff handled
complaints and tips. Under the new process, information concerning all
enforcement-related tips and complaints, whether received through
telephone calls, correspondence, emails, or in-person, is reported to and
maintained by a dedicated group within SEC headquarters.

Additionally, SEC has adopted a series of rules and rule amendments
designed to strengthen ethical and business practices at mutual fund
companies. Among the most significant initiatives, SEC now requires that
in order for a mutual fund company to use the agency's exemptive rules, at
least 75 percent of its board of directors and the board chair must be
independent of the company's investment adviser. 11 SEC believes that
increasing boards' independence from investment advisers will help

10GAO, SEC Operations: Oversight of Mutual Fund Industry Presents
Management Challenges, GAO-04-584T (Washington, D.C.: Apr. 20, 2004).

11SEC's exemptive rules (i) allow mutual funds to engage in transactions
that would otherwise be prohibited under the1940 Act because they present
inherent conflicts of interests and (ii) condition the exemptive relief on
such transactions being subject to the approval or oversight of
independent directors.

prevent the types of trading abuses that we have been discussing today.
Further, SEC adopted rules that require mutual fund companies and
investment advisers to appoint chief compliance officers (CCO) who are
responsible for monitoring compliance with laws and regulations. SEC also
requires mutual fund company CCOs to prepare annual reports on company
policies and violations.

Although SEC's rulemaking has the potential to strengthen the operations
of mutual fund companies and their investment advisers, the incentive
structure these rules rely on may not always be sufficient, and further
steps may be necessary. More specifically, in our April 2005 report we
pointed out that under SEC's rule, fund company CCOs could be investment
adviser officials. SEC permitted this arrangement because fund companies
often do not have any staff. SEC also believes that it has instituted
rules designed to prevent potential conflicts of interest; for example, a
mutual fund company's board-including a majority of its independent
directors-is solely responsible for removing the CCO. While such steps may
mitigate potential conflicts, we recommended that SEC review CCOs'
independence as part of the examination process to ensure that those who
are advisory firm officials are actually acting independently. SEC agreed
with this recommendation. We also pointed out that while SEC examiners
planned to review CCO annual reports as part of examinations, the agency
has not established a process to receive and review such reports on an
ongoing basis. Without such a process, SEC is not in the best position
possible to monitor the industry and identify emerging trends. SEC agreed
with our recommendation to determine how to best utilize their annual
compliance reports, and any material findings cited in those reports.

  SEC Consistently Applied Procedures in Setting Mutual Fund Penalties, but
  Could Strengthen Certain Internal Processes

The penalties that SEC has obtained in enforcement cases related to market
timing and late trading violations are among the highest in the agency's
history and generally consistent with civil penalties obtained in cases
involving similarly egregious corporate misconduct. Additionally, SEC
appears to have followed its penalty-setting process consistently in
setting penalties in the cases we reviewed. Federal and state prosecutors
we contacted said that several factors complicate bringing criminal
actions for market timing violations whereas late trading violations are
more straightforward to prosecute. We also found certain weaknesses in
SEC's overall procedures for referring securities cases to other agencies
for potential criminal violations and ensuring that departing SEC
employees comply with conflict-of-interest laws and regulations. SEC
agreed to implement our recommendations to strengthen these processes.

Penalties in Mutual Fund Trading Abuse Cases Are Among SEC's Highest and
Are Consistent with Penalties in Similarly Egregious Cases

Since NYSOAG announced its discovery of the trading abuses in the mutual
fund industry in September 2003, SEC has brought 14 enforcement actions
against investment advisers primarily for market timing abuses and 10
enforcement actions against broker-dealer, brokerage-advisory, and
financial services firms for market timing abuses and late trading. SEC
has entered into settlements in all 14 investment adviser cases and
obtained penalties ranging from $2 million to $140 million (see fig. 1).
These penalties are among the highest SEC has obtained for securities laws
violations in its history. Before January 2003, penalties SEC obtained in
settlement were generally under $20 million. In contrast, 11 of the 14
penalties obtained in the investment adviser cases are over $20 million,
with 8 penalties at $50 million or over. Pursuant to the fair fund
provision of the Sarbanes-Oxley Act of 2002 (SOX),12 SEC plans to use the
penalties and disgorgement obtained (disgorgement forces firms to forfeit
any illgotten gain), a total of about $800 million and $1 billion,
respectively, to provide restitution to harmed investors.13 In addition to
settling with investment advisers, as of February 28, 2005, SEC has
settled with two broker-dealers, one brokerage-advisory firm, and two
insurance companies, with penalties totaling $17.5 million. I note that
NASD has taken 12 actions against broker dealers for late trading and
market timing abuses with fines and restitutions totaling more than $6
million.

12SOX authorizes federal courts and SEC to establish "fair funds" to
compensate victims of securities violations. 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.
See Pub. 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).

13We 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)

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 1 compares the range of penalties and average penalties
SEC obtained in settled 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 1 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 former 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 for public companies, arguing that the cost of
penalties are borne by shareholders who are frequently also the victims of
the corporate malfeasance.

Table 1: Average Penalties in SEC Settlements with Investment Advisers,
Public Companies, and Investment Firms

                       Number of settled                      
                              enforcement                     
             Case type            actions Range of penalties  Average penalty 
            Investment                 14     $2-$140 million   $56 million   
               adviser                                        

a

Public company 11	$3-$250 million, $2.2 $61.5 million 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 stated 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.

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 (see table 2 for penalties) and disgorgements in some. Almost
all of these settled enforcement actions involved high-level executives,
including eight chief executive officers (CEO), chairmen, and presidents.
The penalties SEC obtained in these settlements ranged from $40,000 to $30
million. The penalties obtained from three 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.14 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.

14SEC obtained an additional $529,000 in disgorgement from five other
individuals.

Table 2: 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 president $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

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 Applied Procedures in Setting Penalties

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 and 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 with state authorities in many of
its market timing and late trading cases, although some states obtained
additional monetary sanctions.

Several Factors Have Complicated Criminal Prosecution of Market Timing,
but State and Federal Authorities Have Brought Criminal Charges in Late
Trading 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, 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
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.15 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

15DOJ 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.

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.16 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 prosecutors' efforts to prove that the
market timing arrangements constituted a willful intent to defraud.17

In contrast, NYSOAG and DOJ have brought at least 12 criminal prosecutions
against individuals involving late trading violations. 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 New York's state

16Roberto M. Braceras, "Late Trading and Market Timing," Securities &
Commodities Regulation, vol. 37. no.7 (2004).

17On 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.

securities fraud statute.18 According to DOJ officials, criminal
prosecution of late trading is fairly straightforward because the practice
is a clear violation of federal securities laws.

Inadequate Documentation Procedures Limit SEC's Capacity to Effectively
Manage the Criminal Referral Process

SEC staff said that as state and federal criminal prosecutors were already
aware of and generally evaluated the mutual fund trading abuse cases for
potential criminal violations on their own initiative, SEC staff did not
need to make specific criminal referrals to bring these cases to their
attention. 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 both formal
and informal processes for making referrals for criminal prosecutions;
however, senior Enforcement staff told us that SEC uses only the informal
procedures (such as telephone calls to criminal authorities) for making
criminal referrals, describing them as less time-consuming and more
effective than the more cumbersome formal processes, which involved
multiple levels of agency review and approval including review and
approval by the Commission. 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. In response to a
recommendation in our report, SEC agreed to institute procedures requiring
the documentation of referrals and the reasons for such referrals.

18The 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.

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 entities19, and also
requires former staff to notify it if they plan to make an appearance
before the agency.20 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, as I described earlier, SEC is assigning staff to monitor
large mutual fund companies on an ongoing basis. These SEC examination
teams would likely have more regular contact with fund management over a
potentially longer period of time. In addition, the new SEC rule requiring
all mutual fund firms to designate CCOs 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. In response to a recommendation in our report,
SEC agreed to request that departing employees provide information on
where they plan to work and institute procedures (including reviewing
examination documentation) if agency staff believe that a departed
employee's work products may have been compromised due to interactions
with a regulated entity.

19 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. 18 U.S.C S: 208(a). 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. 18 U.S.C. S:
207(a). 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. 18 U.S.C. S:
207(b).Violation of either the "seeking employment" or postfederal
employment activity restrictions can result in civil and criminal
sanctions. 18 U.S.C. S: 216.

2017 C.F.R. S: 200.735-8(b)(1) requires former SEC staff 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. This rule applies to all former SEC staff for 2 years after
leaving the agency.

Observations

The undisclosed market timing arrangements and late trading abuses
detected in September 2003 represented one of the most widespread and
serious scandals in the history of the mutual fund industry. SEC has
determined that undisclosed market timing arrangements, in particular,
existed at many large mutual fund companies for as long as 5 years.
However, before 2003, SEC did not identify the undisclosed arrangements
between investment advisers and favored customers through the agency's
oversight process. SEC staff faced competing examination priorities that
may have affected its capacity to detect the abusive practices but has
taken several recent steps intended to strengthen its mutual fund company
oversight program and improve company operations. Several lessons can be
drawn from the experience in regard to regulators (1) performing
independent assessments of internal controls, (2) having the capacity to
identify and evaluate evidence of potential risks, and (3) ensuring the
independence of the compliance function at mutual fund companies.
Accordingly, our April 2005 report included recommendations to enhance the
effectiveness of SEC's mutual fund oversight program and help strengthen
fund company operations, which SEC agreed to either implement fully or
consider ways to implement them. Although our May 2005 report found that
SEC consistently applied its penalty setting procedures in the cases we
reviewed, it also identified weaknesses in the agency's procedures
relating to the referral of securities cases to other agencies for
potential criminal violations and ensuring that departing employees
compiled with conflict-of-interest laws and regulations. The report
included recommendations to better ensure that these agency
responsibilities are being met, which SEC agreed to implement.

Mr. Chairman, this completes my prepared statement. I would be happy to
respond to any questions that you may have.

GAO Contacts and For further information regarding this testimony, please
contact me at

(202) 512-8678 or [email protected], or Wesley M. Phillips, Assistant Staff
Director, at (202) 512-5660 or [email protected]. Individuals making
Acknowledgements contributions to this testimony include Emily Chalmers,
Fred Jimenez,

Stefanie Jonkman, Marc Molino, David Tarosky, and Anita Zagraniczny.

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