Mutual Funds: SEC Adjusted Its Oversight in Response to Rapid Industry
Growth (Letter Report, 05/28/97, GAO/GGD-97-67).

GAO reviewed the Securities and Exchange Commission's (SEC) regulation
and oversight of open-end investment companies, focusing on how SEC has
responded to rapid industry growth in carrying out its mutual fund
oversight through inspections, disclosure review, and other regulatory
activities.

GAO noted that: (1) SEC has increased its inspection staffing and
adjusted the focus of its inspections to keep up with the rapid growth
in the mutual fund industry; (2) since fiscal year (FY) 1990, SEC has
more than doubled the number available to do mutual fund inspections;
(3) SEC used the increased staff to expand the scope of its inspections
to focus primarily on the activities of families of funds, called fund
complexes, that may present high risks to investors; (4) it also
expanded its coverage of investment advisers, and SEC inspectors spent
more time on each mutual fund inspection; (5) as a result, the number of
mutual fund inspections completed each year has remained relatively
constant; (6) SEC still met its current goal of inspecting fund
complexes at least once every 5 years, and most had been inspected more
than once since FY 1992; (7) as inspections became more comprehensive,
the number of deficiencies that inspectors found increased each year,
but few deficiencies were serious enough to be considered for potential
enforcement action; (8) SEC reported that the mutual fund industry had
generally been free of major scandal for the last 2 decades; (9) SEC
selectively reviews mutual funds' disclosure documents; (10) a large
part of the growth in the mutual fund industry has been in adding new
funds to already existing fund complexes; (11) as a result, although
each new mutual fund must submit disclosure documents, these documents
often contain disclosures that are very similar to those of other funds
within the same complex; (12) SEC officials told GAO that, by
selectively reviewing these documents, they have been able to review all
new or materially different disclosures, despite an almost 8-percent
increase in the number of documents that SEC has received since FY 1994
and despite a relatively constant staffing level in this function over
the same period; (13) SEC's other regulatory activities relating to
mutual funds include: (a) granting exemptions from various provisions in
mutual fund laws and regulations, (b) developing and modifying rules to
implement these provisions, and (c) providing the industry, Congress,
and other government agencies with SEC interpretations of mutual fund
laws and regulations; (14) these activities have allowed the mutual fund
industry to change dramatically in size and scope without substantially
amending existing laws; (15) SEC staff devoted to these regulatory acti*

--------------------------- Indexing Terms -----------------------------

 REPORTNUM:  GGD-97-67
     TITLE:  Mutual Funds: SEC Adjusted Its Oversight in Response to 
             Rapid Industry Growth
      DATE:  05/28/97
   SUBJECT:  Mutual funds
             Investments
             Inspection
             Regulatory agencies
             Securities regulation
             Stocks (securities)
             Information disclosure

             
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Cover
================================================================ COVER


Report to Congressional Committees

May 1997

MUTUAL FUNDS - SEC ADJUSTED ITS
OVERSIGHT IN RESPONSE TO RAPID
INDUSTRY GROWTH

GAO/GGD-97-67

SEC Adjusted Its Mutual Fund Oversight

(233490)


Abbreviations
=============================================================== ABBREV

  GPRA - Government Performance and Results Act of 1993
  ICI - Investment Company Institute
  IM - Investment Management
  NASD - National Association of Securities Dealers
  OCIE - Office of Compliance Inspections and Examinations
  OIG - Office of Inspector General
  SEC - Securities and Exchange Commission

Letter
=============================================================== LETTER


B-271654

May 28, 1997

The Honorable Alfonse M.  D'Amato
Chairman
The Honorable Paul S.  Sarbanes
Ranking Minority Member
Committee on Banking, Housing, and
 Urban Affairs
United States Senate

The Honorable Thomas J.  Bliley, Jr.
Chairman
The Honorable John D.  Dingell
Ranking Minority Member
Committee on Commerce
House of Representatives

This report discusses our self-initiated review of the Securities and
Exchange Commission's (SEC) regulation and oversight of investment
companies.  We initiated this review because rapid growth in open-end
investment companies, commonly known as mutual funds, had the
potential to outstrip SEC's ability to properly oversee the
industry.\1 In our September 1995 report on bank mutual funds, we
noted that SEC had obtained additional staff to oversee mutual funds,
but that continued industry expansion could create new challenges for
SEC in meeting its oversight responsibilities.\2 Our objective for
this review was to determine how SEC has responded to this rapid
industry growth in carrying out its mutual fund oversight through
inspections, disclosure review, and other regulatory activities.  We
are sending this report to you because it pertains to matters under
your jurisdiction. 


--------------------
\1 The term "open-end" refers to the fact that shareholders may
redeem shares issued by the mutual fund on any day on which the fund
is open for business.  Other types of investment companies include
closed-end funds, unit investment trusts, separate accounts of
insurance companies issuing variable annuities, and business
development companies.  The distinguishing feature between closed-end
and open-end funds is that closed-end fund shares are not redeemable. 
Instead, closed-end fund shares are generally traded on one of the
major stock exchanges or in the over- the-counter market.  As used in
this report, the term "mutual funds" refers to open-end investment
companies. 

\2 Bank Mutual Funds:  Sales Practices and Regulatory Issues
(GAO/GGD-95-210, Sept.  27, 1995). 


   RESULTS IN BRIEF
------------------------------------------------------------ Letter :1

SEC has increased its inspection staffing and adjusted the focus of
its inspections in response to the rapid growth in the mutual fund
industry.  Since fiscal year 1990, SEC has more than doubled the
number of its staff available to do mutual fund inspections.  SEC
used the increased staff to expand the scope of its inspections to
focus primarily on the activities of families of funds, called fund
complexes, that may present high risks to investors.  It also
expanded its coverage of investment advisers, and SEC inspectors
spent more time on each mutual fund inspection.  As a result, the
number of mutual fund inspections completed each year has remained
relatively constant.  SEC still met its current goal of inspecting
fund complexes at least once every 5 years, and most had been
inspected more than once since fiscal year 1992.  As inspections
became more comprehensive, the number of deficiencies that inspectors
found increased each year, but few deficiencies were considered
serious enough to be referred for potential enforcement action.  SEC
reported that the mutual fund industry had generally been free of
major scandal for the last 2 decades. 

SEC selectively reviews mutual funds' disclosure documents.  A large
part of the growth in the mutual fund industry has been in adding new
funds to already existing fund complexes.  As a result, although each
new mutual fund must submit disclosure documents, these documents
often contain disclosures that are very similar to those of other
funds within the same complex.  SEC officials told us that, by
selectively reviewing these documents, they have been able to review
all new or materially different disclosures, despite an almost
8-percent increase in the number of documents that SEC has received
since fiscal year 1994 and despite a relatively constant staffing
level in this function over the same period. 

SEC's other regulatory activities relating to mutual funds include
(1) granting exemptions from various provisions in mutual fund laws
and regulations, (2) developing and modifying rules to implement
these provisions, and (3) providing the industry, Congress, and other
government agencies with SEC interpretations of mutual fund laws and
regulations.  These activities have allowed the mutual fund industry
to change dramatically in size and scope without substantially
amending existing laws.  SEC staff devoted to these regulatory
activities increased nearly 45 percent from fiscal years 1990 to
1993.  However, by 1996, this staffing had declined 14 percent from
its peak in 1993.  Nonetheless, SEC reduced its backlog of pending
applications for exemptions in 1996.  SEC officials said that the
National Securities Market Improvement Act of 1996 (P.L.  104-290)
will increase their rulemaking workload by about 30 percent through
1997, and that this increased workload may delay progress on other
rulemaking initiatives. 


   BACKGROUND
------------------------------------------------------------ Letter :2

Lower returns on alternative investments and a rapidly rising stock
market have contributed to mutual funds becoming an increasingly
popular and important investment vehicle.  Assets managed by mutual
funds have more than tripled since the end of fiscal year 1990 from
about $1 trillion to nearly $3.2 trillion by June 1996, exceeding
insured commercial bank deposits, which totaled about $2.6 trillion
in June 1996.  As of April 1996, an estimated 63 million individuals,
making up about 37 million households, owned mutual funds.  At that
time, these fund-owning households represented 37 percent of all U.S. 
households, which was up from 31 percent in mid-1994.  Much of this
growth in mutual fund ownership has been attributed to investors
buying mutual funds to save for retirement. 

SEC regulates and supervises the operations of all mutual funds under
four federal securities laws:  the Investment Company Act of 1940
(Investment Company Act), the Investment Advisers Act of 1940
(Investment Advisers Act), the Securities Act of 1933 (1933 Act), and
the Securities Exchange Act of 1934 (1934 Act).  Of these four acts,
only the Investment Company Act was written specifically to regulate
the formation and operation of mutual funds.  The Investment Company
Act requires mutual funds to register with SEC and subjects their
activities to SEC regulation.  The act also imposes detailed
requirements on the operation and structure of mutual funds.\3 The
core objectives of the act are to (1) ensure that investors receive
adequate, accurate information about the mutual fund; (2) protect the
physical integrity of the fund's assets; (3) prohibit abusive forms
of self-dealing; (4) prevent the issuance of securities that have
inequitable or discriminatory provisions; and (5) ensure the fair
valuation of investor purchases and redemptions. 

The other three acts regulate mutual fund activity in various ways. 
The Investment Advisers Act requires mutual funds' advisers to
register with SEC; imposes reporting requirements on those registered
investment advisers; and prohibits the advisers from engaging in
fraudulent, deceptive, or manipulative practices.\4 The 1933 Act
requires that mutual fund shares offered to the public be registered
with SEC.  In addition, SEC has adopted rules under this act and the
Investment Company Act that require extensive disclosures in a mutual
fund's prospectus.  The 1933 Act also regulates mutual fund
advertising.  The 1934 Act, among other things, regulates how mutual
funds are sold.  This act requires that persons distributing mutual
fund shares or executing purchase or sale transactions in mutual fund
shares be registered with SEC as securities broker-dealers.\5

Broker-dealers who sell mutual funds are regulated and examined by
both SEC and the National Association of Securities Dealers (NASD). 
NASD, which is subject to SEC's oversight, was established pursuant
to the 1934 Act as a self-regulatory organization for brokerage
firms, including those firms that engage in mutual fund distribution. 
SEC and NASD regulate broker-dealers by periodically examining
broker-dealer operations on-site and investigating customer
complaints.  NASD has also established specific rules of conduct for
its members that, among other things, provide standards for
advertising and sales literature, including filing requirements,
review procedures, approval and recordkeeping obligations, and
general standards.  In addition, NASD tests individuals to certify
their qualifications as registered representatives\6 and has primary
responsibility for regulating advertising and sales literature used
to solicit and sell mutual funds to investors. 

On October 11, 1996, the National Securities Market Improvement Act
of 1996 (1996 Act) was signed into law.  This legislation represented
the most significant overhaul of the securities regulatory structure
in decades.  Among other things, the 1996 Act divided responsibility
for regulation of the financial markets between the federal and state
governments.  The 1996 Act amended the Investment Company Act to
promote more efficient management of mutual funds, protect investors,
and provide more effective and less burdensome regulation.  The
amendments, in effect, made the regulation of mutual fund disclosures
and advertising the exclusive province of the federal government by
preempting state securities registration, merit review, and
prospectus disclosure requirements for investment companies.  In
connection with investment company offerings, states (1) can continue
to require companies to file, with the state, documents they file
with SEC and can charge fees for such filings; and (2) will retain
jurisdiction over fraud and deceit and unlawful broker-dealer conduct
under applicable state law.  The 1996 Act also amended the Investment
Advisers Act, including provisions that divided responsibility for
regulation of investment advisers between the states and SEC. 

SEC's oversight focuses on protecting mutual fund investors by
minimizing the risk to investors from fraud, mismanagement, conflicts
of interest, and misleading or incomplete disclosure.  SEC oversees
mutual funds primarily through (1) performing on-site inspections of
mutual funds' compliance with federal securities laws; (2) reviewing
disclosure documents that mutual funds are required to file with SEC;
and (3) engaging in other regulatory activities, such as rulemaking,
responding to requests for exemptions from applicable federal
securities laws, and providing interpretations of those laws.  In
addition, although not discussed in this report, SEC's enforcement
program is responsible for investigating and prosecuting violations
of securities laws related to mutual funds. 

In the early 1990s, SEC considered its oversight of the investment
management industry, including mutual funds, to be severely
understaffed.  SEC attributed its staffing shortage to the explosive
growth in the industry since 1983; the industry's use of increasingly
complex products, such as derivatives, which may be difficult both to
value and trade during falling markets;\7

and the use of more complex organizational structures.  Believing
that inadequate staffing threatened its ability to protect investors,
SEC reallocated positions from its other regulatory programs to
investment management oversight and obtained additional positions
through congressional appropriations.  Of SEC's six major regulatory
programs, its investment management program was the second smallest
in fiscal year 1990, comprising about 12 percent of SEC's total
authorized positions.\8 By fiscal year 1996, the investment
management program had become SEC's second largest regulatory
program, comprising almost 20 percent of SEC's total authorized
positions. 


--------------------
\3 The Investment Company Act's requirements include rules on the
composition and election of boards of directors, disclosure of
investment objectives and policies, and approval of investment
advisory and underwriting contracts.  The act also imposes
limitations on transactions with affiliates, defines permissible
capital structures and custodial arrangements, requires reports to
shareholders, and requires maintenance of records. 

\4 Banks are exempt from the registration requirements of the
Investment Advisers Act when their employees directly sell mutual
funds. 

\5 Broker-dealers combine the functions of brokers and dealers. 
Brokers are agents who handle public orders to buy and sell
securities.  Dealers are principals who buy and sell stocks and bonds
for their own accounts and at their own risk. 

\6 A registered representative is a person who is associated with a
broker-dealer and who must acquire a background in the securities
business and pass relevant qualifications examinations that are
administered for the industry by NASD.  The broker-dealer must
register with SEC and be a member of a self-regulatory organization,
such as NASD or a stock exchange. 

\7 Derivatives are financial products whose value is determined from
an underlying reference rate, index, or asset.  The underlying
includes stocks, bonds, commodities, interest rates, foreign currency
exchange rates, and indexes that reflect the collective value of
various financial products. 

\8 In addition to Investment Management Regulation, SEC's five other
major regulatory programs are the following:  Prevention and
Suppression of Fraud, Full Disclosure, Supervision and Regulation of
Securities Markets, Program Direction, and Legal and Economic
Services. 


   OBJECTIVE, SCOPE, AND
   METHODOLOGY
------------------------------------------------------------ Letter :3

Our objective was to determine how SEC has responded to the rapid
growth in mutual funds in carrying out three parts of its mutual fund
oversight--inspections, review of disclosure documents, and other
regulatory activities.  To determine the requirements for SEC's
oversight, we reviewed applicable securities laws; SEC rules and
regulations implementing these laws; and relevant testimony,
commentary, and studies, including a 1992 SEC study on the regulation
of investment companies.\9

To determine how SEC carries out these responsibilities, we (1)
reviewed agency documents that described SEC's mutual fund oversight
activities, including relevant mission statements, policies and
procedures, training materials, staffing data, budget estimates, and
annual reports, and (2) interviewed SEC officials.  We also reviewed
workload and performance data for these oversight activities,
including the number and results of inspections completed during
fiscal years 1992 through 1996, the number and type of disclosure
documents SEC received and reviewed during fiscal years 1994 through
1996, and the number of applications for exemptions and requests for
no-action and interpretive letters that SEC processed during fiscal
years 1994 through 1996.  We were unable to include and compare data
for all disclosure documents from previous fiscal years because of
changes in how SEC counted the filings received. 

To determine how frequently SEC has inspected mutual funds, we
compared the inspections completed between fiscal years 1992 and 1996
with a list of fund complexes SEC prepared for its field offices to
use in scheduling their fiscal year 1996 inspections.  We
judgmentally selected for this analysis 5 of the 10 SEC field offices
that inspect investment companies.  We selected the four field
offices--New York, Chicago, Boston, and Philadelphia--that are
responsible for inspecting the largest number of mutual funds, and
one field office--Fort Worth--that is responsible for inspecting a
smaller number of mutual funds.  To obtain more information on how
SEC conducts and documents mutual fund inspections, we interviewed
SEC officials from the New York, Boston, and Philadelphia field
offices and reviewed selected inspection reports and workpaper files
at those locations. 

We did our work between March 1996 and March 1997 at SEC in
Washington, D.C., and at SEC field offices in New York, Boston, and
Philadelphia.  We did our work in accordance with generally accepted
government auditing standards.  SEC officials provided written
comments on a draft of this report, which are reprinted in appendix
I.  Our evaluation of these comments is presented on page 29. 


--------------------
\9 Protecting Investors:  A Half Century of Investment Company
Regulation, Division of Investment Management, United States
Securities and Exchange Commission, May 1992. 


   INCREASED STAFFING BENEFITED
   THE SEC INSPECTION PROGRAM
------------------------------------------------------------ Letter :4

Periodic, on-site inspections are the cornerstone of SEC's oversight
of mutual funds.  Increasing its inspection staff during the 1990s
allowed SEC to broaden its inspection objectives.  Although SEC
frequently changed its objectives, it met its goal of inspecting fund
complexes at least once every 5 years, and most of the complexes were
inspected about once every 3 years.  Despite SEC's increase in
staffing, the total number of yearly investment company inspections
did not increase because SEC used the staffing increase to expand its
coverage of investment advisers and because inspectors spent more
time on each investment company inspection.  The total number of
deficiencies that inspectors found increased each year.  The
inspectors referred an average of about 5 percent of these
deficiencies to SEC's Division of Enforcement for potential
enforcement action. 


      ON-SITE INSPECTIONS ARE THE
      CORNERSTONE OF SEC OVERSIGHT
---------------------------------------------------------- Letter :4.1

SEC's inspections are meant to enhance investor protection because
they provide a direct check of mutual funds' compliance with the
securities laws, including the accuracy of disclosures made to
investors.  Rather than inspecting individual mutual funds, SEC's
inspections primarily focus on fund complexes, which are generally
groups of mutual funds--sometimes called fund families--that are
associated with common advisers or underwriters.  In most cases,
investors can, with a telephone call, switch between individual funds
within the same fund complex and change their investment strategies. 
Fund complexes can be large.  For example, as of June 1996, the
Fidelity fund complex, which was the largest complex, consisted of
over 200 funds and more than $400 billion in assets. 

The growth in the number of fund complexes has not been as great as
the growth in the number of individual mutual funds because many
existing fund complexes have expanded their complement of individual
funds to attract and serve diverse market segments.  According to
data provided by SEC, between December 1991 and June 1996, the number
of individual mutual funds grew by about 75 percent, from 3,427 funds
to 5,996 funds.  In comparison, the number of fund complexes grew by
40 percent, from 578 complexes in December 1991 to 812 complexes in
June 1996.\10 As of June 1996, the 50 largest fund complexes
accounted for about 74 percent of total complex assets. 

Before May 1995, SEC's Division of Investment Management (Division of
IM) was responsible for conducting and coordinating inspections of
mutual funds as well as disclosure reviews and regulation.  In an
effort to enhance its overall inspection efforts and promote a more
effective use of its inspection resources, SEC created the Office of
Compliance Inspections and Examinations (OCIE), which began operating
on May 1, 1995, to consolidate its inspection programs for entities
over which it had regulatory authority.  These entities include
investment companies, investment advisers, broker-dealers, and
self-regulatory organizations.\11

OCIE conducts inspections to (1) evaluate mutual funds' compliance
with securities laws and regulations, (2) determine if funds are
operating in accordance with disclosures made to investors, and (3)
assess the effectiveness of funds' internal control systems. 
Inspections of mutual funds and their related investment advisers are
carried out primarily by staff in 10 of SEC's 11 field offices.\12 If
a mutual fund's principal investment adviser is located outside of
the United States, responsibility for inspecting that fund is
assigned to headquarters, rather than a field office.  Although OCIE
provides detailed inspection manuals and general guidance on
selecting mutual funds for inspection, the SEC field offices have
primary responsibility for selecting which mutual funds to inspect in
accordance with those guidelines. 

The separation of the inspection function from the Division of IM has
caused the Investment Company Institute (ICI), the national trade
association of the mutual fund industry, some concern about the
potential for inconsistent oversight of mutual funds.  ICI officials
told us that separating the staff members who write and interpret the
law from those who inspect companies for compliance with the law
creates the potential for differences in how the laws are interpreted
and applied.  SEC officials agreed that this potential exists but
told us that staff members in the Division of IM and OCIE have worked
well together since the oversight functions were separated, and that
both units have made an effort to maintain ongoing communication. 
However, the SEC officials also said that the current good working
relationship between the two units is largely because the staff
members in OCIE who oversee mutual fund inspections are essentially
the same people who were responsible for doing these inspections in
the Division of IM before OCIE's creation.  SEC officials said they
intend for these two units to work well together regardless of who
the individuals are in each unit.  However, according to some SEC
officials, as personnel changes occur in the future--in either the
Division of IM or OCIE--maintaining good communications and
consistent oversight of mutual funds may become more difficult. 

SEC generally does two types of inspections:  routine and for cause. 
Routine inspections result primarily from the passage of time, but
they are done more frequently if (1) the inspection staff believes
that a fund or its agents are engaged in risky activities or (2) the
fund has a history of significant problems.  Inspection staff do
for-cause inspections when, for example, specific facts come to their
attention that suggest something may be wrong at a fund.  Most
inspections are routine.  Inspections either can be announced in
advance or can be done on a surprise basis.  According to SEC, the
first inspection of a fund and its service agents usually is done on
a surprise basis.  Generally, for-cause inspections are also done on
a surprise basis or with short notice.  However, for most SEC
inspections, inspectors notify the fund several weeks in advance of
the starting date for on-site work. 

Before going on-site to the offices of the fund complex, inspectors
are to obtain and review information from the complex about its
structure and operations and prepare an inspection plan.  When they
arrive on-site, inspectors typically will meet with senior management
and do a walk-through of the offices.  The inspectors will then begin
reviewing documents and interviewing other fund personnel as
necessary.  During the on-site inspection, inspectors are to look for
patterns of activity and evidence that (1) the fund complex and its
agents are conducting their activities in compliance with the
securities laws, (2) potential conflicts of interest are being
identified and resolved to the benefit of shareholders, (3)
operations are being conducted consistent with disclosures made to
shareholders, and (4) internal control systems seem to be effective. 
Inspectors are usually on-site for 1 or 2 weeks, but they could be
on-site for up to 2 months when inspecting very large fund complexes. 
Inspectors also usually review the activities of mutual funds'
advisers concurrent with their inspection of the fund complex.  After
inspectors complete on-site work, they generally spend additional
time in the SEC field offices preparing the inspection report and
completing any follow-up work. 

SEC inspectors also collect compliance-related data and investigate
particular industry-related issues.  For example, early in fiscal
year 1995, SEC was interested in obtaining information on the types
of controls that were in place to address personal trading by fund
personnel.  At that time, SEC directed the inspection staff to obtain
information on the content of funds' codes of ethics during their
inspections.  The Investment Company Act permits fund personnel to
engage in personal trading in securities that are held or are to be
bought by a fund, as long as the investment activities are not
fraudulent, manipulative, or abusive.  However, conflicts of interest
between fund personnel and shareholders can arise, for example,
whenever fund personnel with access to information about securities
and potential fund transactions buy and sell securities for their
personal accounts.  To address conflicts of interest, the act
requires mutual funds--as well as their investment advisers and
principal underwriters--to adopt a code of ethics designed to prevent
abusive personal trading.  SEC found that most funds inspected
appeared to have the controls necessary to identify abusive trading
practices by fund personnel after the trading occurred. 

More recently, SEC directed its inspection staff to do inspections
that target "soft-dollar" payments among investment companies,
investment advisers, and broker-dealers.  A provision in the 1934 Act
allows advisers to receive soft-dollar payments for directing
transactions to a specific broker for execution.  These payments are
typically in the form of investment research services.  SEC officials
told us that they were examining whether advisers are using the
soft-dollar payments for expenses that are unrelated to research,
such as salaries.  Such uses of soft-dollar payments would constitute
a conflict of interest that, if not disclosed, would violate the
Investment Advisers Act. 


--------------------
\10 SEC includes open-end funds, closed-end funds, separate accounts
of insurance companies, or some combination of these in its
definition of fund complexes.  SEC also considers single or
stand-alone funds to be fund complexes.  According to SEC, only a
small number of stand-alone funds remain. 

\11 Responsibility for inspecting these entities previously was
divided between SEC's Division of Market Regulation and Division of
IM. 

\12 One SEC field office does not have investment company inspection
staff. 


      INCREASES IN INSPECTION
      STAFFING ALLOWED SEC TO
      BROADEN ITS INSPECTION
      OBJECTIVES
---------------------------------------------------------- Letter :4.2

SEC allocated most of the increase in its investment management
industry oversight staffing during fiscal years 1990 through 1996 to
doing investment company and investment adviser inspections.  During
this period, SEC frequently changed the objectives of its investment
company inspection program in an effort to more efficiently use these
resources.  Although many of these changes were in response to
industry growth, SEC broadened its inspection objectives in fiscal
year 1995 primarily because of the increase it had attained in
inspection staffing. 

As shown in table 1, SEC's inspection staff years grew by 154 percent
during fiscal year 1990 through fiscal year 1996, with about 53
percent of that growth occurring during fiscal year 1993 through
fiscal year 1996. 



                                Table 1
                
                SEC Inspection Staff Years, Fiscal Years
                                1990-96

Fiscal year                                      Number of staff years
----------------------------------------  ----------------------------
1990                                                               114
1991                                                               137
1992                                                               148
1993                                                               189
1994                                                               216
1995                                                               262
1996                                                               290
Percentage change, 1990-96                                        154%
Percentage change, 1993-96                                         53%
----------------------------------------------------------------------
Source:  SEC. 

SEC devoted more staff to its inspection program to increase both the
scope and frequency of mutual fund inspections.  SEC reported that
its inspections of mutual funds are particularly important because
SEC, rather than a self-regulatory organization, is responsible for
providing first-line oversight of the investment management industry. 
An OCIE official told us that SEC's inspection program now has enough
staff for examining existing investment companies. 

With the availability of additional inspection staff, SEC changed its
inspection objectives during the 1990s.  During fiscal years 1991
through 1993, SEC's inspection objective was to attain the greatest
dollar coverage with the limited number of inspection staff years
available.  With this in mind, SEC directed its inspection staff to
concentrate on inspecting the 100 largest fund complexes and all
money market funds.  SEC also directed its inspection staff to
inspect small and medium-sized fund complexes, if time was available
after this objective was achieved.  SEC reported that the inspections
completed during these fiscal years were limited in scope, focusing
mainly on whether fund activities were consistent with the
information disclosed to investors and whether funds accurately
valued their shares.  SEC also reported that some activities, such as
fund marketing and shareholder services, were rarely scrutinized. 

SEC revised its inspection objectives for fiscal year 1994 because a
large number of small and medium-sized fund complexes had never been
examined and others had not been examined for several years.  Because
of the focus during fiscal years 1991 through 1993 on inspecting
large fund complexes and all money market funds, inspectors had only
been able to inspect about 200 small and medium-sized fund complexes. 
SEC estimated that about 350 fund complexes had not been inspected
since 1990, and that many, especially those fund complexes connected
with banks, had been formed after 1990 and had never been inspected. 
Consequently, for its fiscal year 1994 inspection program, SEC
headquarters directed the field offices to inspect all small and
medium-sized fund complexes that had not been inspected since 1990
and all new fund complexes formed during that year.  Again, except
for fund complexes that had never been inspected, inspections were to
be limited in scope, with an emphasis on portfolio management
activities. 

Reflecting the increase in inspection staffing as well as the
significantly increased use of mutual funds by American investors,
SEC broadened its inspection objectives for fiscal year 1995. 
Inspection staff were to begin doing comprehensive inspections of all
fund complexes.  These comprehensive inspections were to include all
fund activities and cover all funds in a complex, not just certain
types of funds as had been the case before 1995.  In addition,
inspection staff were to inspect the 50 largest complexes on a 2-year
cycle and inspect all other complexes on a 4-year cycle. 

Responding to suggestions from field office staff members, SEC
revised its inspection objectives for fiscal year 1996. 
Specifically, instead of reviewing the activities of all funds within
a complex on a set schedule, SEC officials decided that a more
efficient use of inspection staff would be to focus on those
activities and complexes that presented higher risks to investors. 
Using the following criteria, SEC field offices were to select for
inspection those fund complexes with (1) a history of compliance
problems, (2) a sudden increase in the number of investor complaints,
(3) an appearance on one of the Division of IM's "watch lists,"\13
(4) a report of processing problems, and (5) length of time since
last inspected.  While the field offices were given discretion in
selecting fund complexes for inspection, SEC instructed them to
examine all fund complexes at least once every 5 years.  An SEC
official told us that a 5-year inspection cycle was chosen on the
basis of feedback from field office staff members and experience with
varying inspection cycles over the years.  Together, these factors
indicated that a maximum of 5 years between inspections allowed for
the most cost-effective use of SEC's inspection staff.  The official
also said that 5 years is the most time allowed between inspections
but that if inspectors considered a fund complex to present a greater
risk of having problems, it would be inspected more frequently. 

SEC did not change its inspection program objectives for fiscal year
1997.  However, SEC deferred routine inspections through the end of
March 1997, while the field offices focused exclusively on doing the
fieldwork for the soft-dollar study.  An SEC official told us that
for-cause inspections took precedence over the soft- dollar study
during this period.  The official said that although using the
inspection staff to do the soft-dollar study would likely result in
fewer inspections being completed during fiscal year 1997, this would
not prevent SEC from meeting its overall goal of inspecting fund
complexes at least once every 5 years. 


--------------------
\13 The Division of IM develops several watch lists for particular
types of funds on the basis of characteristics that may indicate the
need for additional scrutiny by the Division of IM and OCIE. 


      DESPITE CHANGING OBJECTIVES,
      SEC INSPECTED MOST FUND
      COMPLEXES
---------------------------------------------------------- Letter :4.3

As SEC changed its objectives between the ends of fiscal years 1990
and 1996, its field offices changed their inspection plans to meet
these objectives.  Instead of focusing on the results of these
changing annual objectives, we determined the extent to which SEC
inspected the total number of fund complexes existing during this
period. 

To assess SEC's inspection coverage, we analyzed data on completed
inspections for 5 of the 10 SEC field offices responsible for
inspecting fund complexes.\14 These 5 field offices, which included
the 4 offices with the largest number of complexes to inspect, were
responsible for inspecting 547 of the 757 fund complexes (about 72
percent) in SEC's database as of the beginning of fiscal year
1996.\15

As indicated in table 2, our analysis showed that between the
beginning of fiscal year 1992 and the end of fiscal year 1996, these
5 field offices completed inspections of 493 of the 519 fund
complexes (about 95 percent) for which they were responsible.\16
Table 2 also displays the last year in which these 493 fund complexes
had been inspected.  For example, of the 168 fund complexes that the
New York field office was responsible for inspecting, 4 were last
inspected in fiscal year 1992.  The data show that the 5 field
offices last inspected 408 of the 519 fund complexes (about 79
percent) between the beginning of fiscal year 1994 and the end of
fiscal year 1996. 



                                     Table 2
                     
                      Inspections of Fund Complexes by Year
                        Last Inspected for Five SEC Field
                          Offices, Fiscal Years 1992-96


                Fund
        complexes at
              end of                                                  Total fund
Field    fiscal year                                                   complexes
office          1996          1992    1993    1994    1995    1996     inspected
------  ------------  ------------  ------  ------  ------  ------  ============
Boston            82             0      19      16      25      18            78
Chicag           159             0      14      36      43      57           150
 o
Fort              30             0       8       3      10       8            29
 Worth
New              168             4      26      44      63      23           160
 York
Philad            80             3      11      23      22      17            76
 elphia
================================================================================
Total            519             7      78     122     163     123           493
Percen            --            1%     15%     24%     31%     24%           95%
 tage
--------------------------------------------------------------------------------
Note:  Although some fund complexes were inspected more than once
during these 5 fiscal years, the data shown for each fiscal year
reflect only the last year they were inspected.  Therefore, the total
shown for the number of fund complexes inspected is not the total
number of inspections completed by these five field offices during
these fiscal years. 

Source:  GAO analysis. 

We also found that the five field offices, on average, inspected fund
complexes more frequently than every 5 years.  For example, these
offices inspected about 52 percent of the 519 fund complexes for
which they were responsible more than once since the start of fiscal
year 1992 and inspected each of the top 50 complexes about 3 times. 


--------------------
\14 Completed inspections included both limited scope and
comprehensive inspections. 

\15 Of the 547 fund complexes, 460 (about 84 percent) included mutual
funds.  Some of these fund complexes were first established after
fiscal year 1992. 

\16 We eliminated 6 fund complexes determined to be inactive and
another 22 complexes that were not inspected by these field offices
because they were the responsibility of another field office. 


      NUMBER OF INVESTMENT COMPANY
      INSPECTIONS HAS NOT
      INCREASED
---------------------------------------------------------- Letter :4.4

The increase in the number of SEC inspectors has not led to an
increase in the number of investment company inspections completed
each year.  This total remained relatively constant, with the
inspection staff averaging about 320 inspections a year since fiscal
year 1992.\17 According to an SEC official, the number of investment
company inspections has not increased because SEC has used the
increase in inspection staffing to expand its coverage of investment
advisers.  Also, inspectors spent more time on each investment
company inspection due to (1) a need to train newly hired inspectors,
(2) a change in how inspectors approached mutual fund inspections,
and (3) a change in how inspectors inspected fund administrators. 

Generally, inspectors are to be cross-trained to inspect both
investment companies and investment advisers.  Of the 10 field
offices that do investment company and investment adviser
inspections, an SEC official said that only 2 field offices do not
extensively cross-train their inspectors to do both types of
inspections.  Because the same pool of inspectors inspect both
investment companies and investment advisers, there is an ongoing
trade-off in the number of investment company and investment adviser
inspections completed.  Therefore, although the number of investment
company inspections done each year since fiscal year 1992 has
remained relatively constant, averaging about 320 a year (see table
3), the number of investment adviser inspections completed has
increased from 614 in fiscal year 1992 to 1,446 in fiscal year 1996. 
The 1996 Act transfers to the states regulatory responsibility for
investment advisers that manage less than $25 million in assets, and
SEC expects the number of investment adviser inspections completed in
fiscal year 1997 to decrease partly because of the transition.  SEC
has projected that it will increase investment adviser inspections 13
percent in fiscal year 1998. 

Since fiscal year 1992, the average time SEC inspectors spent on each
investment company inspection more than doubled, from about 164 hours
in fiscal year 1992 to about 376 hours in fiscal year 1996.  An SEC
official attributed the increase in inspection time primarily to the
use of senior inspectors to provide on-the-job training for the large
number of new inspectors that were hired beginning in fiscal year
1994.  The official said that it took longer to complete inspections
because the new inspectors were inexperienced and were still being
trained during fiscal years 1995 and 1996.  During fiscal year 1997,
SEC expects senior inspectors to continue devoting considerable time
to on-the-job training of the 38 new inspectors hired during 1996. 
SEC reported that, by the end of fiscal year 1997, all inspectors
hired since fiscal year 1994 will have received classroom and
on-the-job training and are expected to be able to function as fully
qualified investment company and investment adviser examiners. 
Although all new inspectors are to be fully trained, SEC is not
planning to increase the number of fund complexes inspected beyond
320 during fiscal year 1998.  At that level, fund complexes would be
inspected at an average frequency of once every 3.1 years.  SEC
reported that this inspection frequency, combined with more frequent
inspections of fund complexes that present above average risk
factors, provides adequate inspection oversight of mutual funds.  An
SEC official said that inspecting fund complexes any more frequently
would not be an efficient use of inspection staff. 

Another reason for the increase in time spent on each inspection was
a change in SEC's approach to mutual fund inspections.  Before fiscal
year 1994, SEC primarily did limited-scope inspections of the 100
largest fund complexes and all money market mutual funds.  In fiscal
year 1995, SEC directed its inspectors to do comprehensive
inspections of all fund types.  SEC reported that these inspections
required more time to complete because inspectors were to review all
activities of funds in the complex.  In fiscal years 1996 and 1997,
SEC directed its inspectors to use a risk-based approach to doing
inspections.  These inspections required inspectors to focus on fund
activities that presented higher risks to investors.  As a result,
each inspection is customized, to some extent, according to the types
of activities of each fund complex.  Areas in which these risk-based
inspections may focus include portfolio management, such as brokerage
commissions and principal trades; sales practices; internal controls;
classification, diversification, and appropriateness of investments;
and personal securities transactions, including funds' code of
ethics. 

SEC inspections of fund administrators also contributed to the
increase in inspection time.  Administrators perform many of a fund's
key functions such as keeping the fund's books and records, filing
the necessary reports with SEC, helping the fund establish and
maintain compliance procedures and internal controls, and calculating
the fund's net asset value.\18 Some administrators perform these
functions for several fund complexes, which different SEC field
offices may be responsible for inspecting.  Before fiscal year 1995,
inspectors assessed the adequacy and appropriateness of services that
administrators provided to funds as a part of their inspection of the
fund complex.  As a result, inspections of administrators usually
focused on only a limited number of funds and did not always consider
all of the key functions.  In fiscal year 1995, SEC began conducting
more comprehensive inspections of administrators that served more
than one fund complex.  The inspections were to provide an adequate
test of all administrator systems used in serving multiple mutual
funds.  These inspections involved larger inspection teams and, on
average, took more time to perform than an inspection of a fund
complex.  For example, during fiscal years 1995 and 1996, inspectors
spent an average of nearly 750 hours on each of the 28 inspections of
administrators that served more than one fund complex. 


--------------------
\17 The total number of inspections completed each year includes, in
addition to fund complexes, inspections of administrators, business
development companies, sponsors of unit investment trusts, and
insurance company sponsors of variable insurance products.  Of the
1,613 inspections completed from the end of fiscal year 1992 to the
end of fiscal year 1996, 120 were inspections of these entities. 

\18 Net asset value is the daily share price of a mutual fund.  It is
based on the market value of assets held by the fund, less
liabilities, divided by the number of outstanding fund shares. 


      MORE DEFICIENCIES WERE
      FOUND, BUT FEW WERE REFERRED
      FOR ENFORCEMENT ACTION
---------------------------------------------------------- Letter :4.5

During fiscal years 1993 through 1996, the number of deficiencies
that SEC inspectors found increased steadily.  In fiscal year 1993,
inspectors found 1,281 deficiencies; in fiscal year 1996, the
inspectors found 4,713 deficiencies.  To some extent, this increase
reflects the changes in the scope of SEC's inspections from primarily
doing annual, limited scope inspections of the 100 largest fund
complexes and all money market funds to inspecting complexes on the
basis of the risks they pose as well as the length of time since last
inspected.  Another reason for the increase in the number of
deficiencies was a change in SEC's system for reporting deficiencies
after fiscal year 1993.  Specifically, instead of reporting each
deficiency identified at a fund complex as one violation, inspectors
were to begin reporting any systemic deficiencies as having been
found in each individual fund within the complex.  For example, if a
systemic pricing problem was identified at a fund complex that had
six funds, the inspector would report that six deficiencies, not one,
had been identified. 

When inspectors find that a fund complex has failed to comply with
the securities laws, the deficiency may relate to any of a broad
range of issues, from recordkeeping to misrepresentations or other
sales practice abuses.  According to SEC, if the deficiencies found
are serious, such as when investor funds or securities are at risk,
the inspectors may refer the matter to the Division of Enforcement,
which would decide whether to pursue an investigation and possible
enforcement action.  If deficiencies are not referred to the Division
of Enforcement, SEC sends a letter to the fund complex identifying
all the deficiencies inspectors found and requiring that they be
corrected.  SEC requests that the fund complex respond to the
deficiency letter within 30 days by informing SEC of what the complex
has done or plans to do to correct the problems identified.  If no
deficiencies are found, no further action is taken. 

SEC reported in 1994 that the mutual fund industry had generally been
free of major scandal for the last 2 decades.\19 As shown in table 3,
during fiscal years 1992 through 1996, SEC referred deficiencies to
the Division of Enforcement in about 5 percent of the investment
company inspections.  SEC addressed the majority of these
deficiencies by sending deficiency letters to the fund complexes. 



                                     Table 3
                     
                        Disposition of Investment Company
                        Inspections, Fiscal Years 1992-96


Disposit                                                               Total for
ion             1992        1993        1994        1995        1996     1992-96
--------  ----------  ----------  ----------  ----------  ----------  ==========
Deficien         235         240         244         261         254       1,234
 cy             (74)        (73)        (78)        (75)        (82)        (77)
 letters
Enforcem          14           8          21          23          14          80
 ent             (4)         (2)         (7)         (7)         (5)         (5)
 referra
 ls
No                65          74          37          53          37         266
 action         (21)        (23)        (12)        (15)        (12)        (17)
Other              2           6          11          11           3          33
                 (1)         (2)         (4)         (3)         (1)         (2)
================================================================================
Total            316         328         313         348         308       1,613
               (100)       (100)       (100)       (100)       (100)       (100)
--------------------------------------------------------------------------------
Note 1:  In addition to dispositions of fund complex inspections,
investment company inspections also include inspections of
administrators, business development companies, sponsors of unit
investment trusts, and insurance company sponsors of variable
insurance products.  Of the 1,613 inspections completed between
fiscal years 1992 and 1996, 120 were inspections of these entities. 

Note 2:  Percent totals may not add to 100 due to rounding. 

Source:  SEC. 

Among the reasons SEC officials cited for inspections not producing
more enforcement referrals were that (1) the Investment Company Act
imposes detailed, substantive requirements on the structure and
operations of mutual funds; (2) frequent inspections by SEC
inspectors instill discipline in funds' operations; (3) the industry
generally supports strong regulation and strict compliance with the
securities laws; (4) a self-regulatory organization, NASD, separately
reviews funds' sales literature; and (5) market conditions have
generally been favorable as the industry has grown.  An SEC official
also said that because violations of the Investment Company Act
typically do not involve fraud or investor losses, these violations
generally are not remedied through enforcement actions.  However, the
official noted that, although many of the violations were
"technical," they are still violations of the act that need to be
remedied, especially before the violations become a major problem
that could cause investor losses. 


--------------------
\19 Personal Investment Activities of Investment Company Personnel,
Report of the Division of IM, SEC, Sept.  1994. 


   SEC SELECTIVELY REVIEWED
   DISCLOSURE DOCUMENTS
------------------------------------------------------------ Letter :5

SEC's responsibility for ensuring that mutual funds comply with
applicable disclosure requirements has become particularly important
because of the increasing number of mutual fund investors.  Many of
these investors may be investing for the first time and may not be
sophisticated in legal or financial matters.  SEC's disclosure review
staffing level has remained relatively constant during fiscal years
1990 through 1996.  However, despite receiving an increased number of
documents to review since 1994, SEC officials said that by
selectively reviewing mutual funds' disclosure documents, staff
members have been able to review all new or materially different
disclosures. 

SEC's disclosure review process is intended to ensure that (1)
disclosure documents filed by mutual funds are complete, (2) all
proposed activities are legal, and (3) information contained in the
filings is not misleading to investors.  Disclosure documents filed
by mutual funds include initial registration statements, amendments
to registration statements, proxy statements, and periodic reports. 
Initial registration statements have three parts:  (1) a prospectus,
which must be provided to every fund investor and includes
information about a fund's investment objectives and policies,
investment risks, and all fees and expenses; (2) a statement of
additional information, which contains more detailed information on
all aspects of the fund and must be provided upon request to fund
investors; and (3) other information required to be in the
registration statement, including copies of a fund's contracts with
its various service providers.  Amendments to registration statements
are filed whenever important information in a mutual fund's original,
effective registration statement has changed.  Mutual funds are also
required to annually file amendments updating their financial
information.  Most of the disclosure documents that SEC receives are
amendments.  Proxy statements are to be filed when a mutual fund is
considering an event that requires shareholder approval before taking
action, such as changing its investment policies and objectives or
merging with another fund.  Periodic reports primarily contain
statistical data about a mutual fund, such as the fund's assets,
expenses, portfolio turnover, and type of investments. 

All disclosure documents filed by mutual funds are subject to review
and comment by staff in SEC's Division of IM.  However, to focus on
those filings that are most in need of review, Division of IM staff
members selectively review the disclosure documents SEC receives.  In
fiscal year 1996, SEC received a total of about 30,000 disclosure
documents from all types of investment companies, including mutual
funds, which was an almost 8-percent increase since fiscal year 1994. 
SEC officials told us that completely reviewing all of these
documents is not necessary because many of them contain repetitive
information.  The officials also said that a complete review would be
an inefficient use of SEC's limited resources.  Instead, SEC's
disclosure review process is intended to ensure that SEC's review
focuses on new information in disclosure documents as well as filings
that contain material changes.\20

SEC procedures specify that routine filings, presenting no novel
questions of law, need not be targeted for review.  For example, many
initial registration statements filed by mutual funds that are
members of the same fund complex are similar to previous filings by
other funds in the complex.  That is, even though certain funds in a
complex may have different investment objectives and techniques,
their prospectuses often contain similar disclosure information
regarding other aspects of the funds' operations, such as procedures
for share purchase and redemption and the descriptions of the
investment adviser, underwriters, transfer agent, and officers and
directors.  In these instances, the funds' initial registration
statements often include disclosures from previous filings that had
already been subject to SEC review and comment.  Because SEC
considers that reviewing these disclosures again would be redundant,
it focuses its review on more substantive information in the filing
by identifying what information is new.  SEC officials said that fund
counsel generally initiate requests for selective review and indicate
to SEC which parts of the filing have already been reviewed.  SEC's
disclosure review staff can also identify situations in which a
selective review can be done and are to alert fund counsel to that
option. 

SEC also selectively reviews amendments to registration statements so
that only material changes routinely undergo staff review.  Similar
to initial registration statements, many matters in an amendment may
already have been considered by staff members in processing other
filings by that fund.  To focus SEC's disclosure review on
significant changes, mutual fund counsel represent to SEC whether
changes contained in an amendment are considered material. 
Amendments that contain only nonmaterial changes may become
automatically effective without SEC review.\21

Examples of nonmaterial changes include bringing a fund's financial
statements up-to-date, changing the fund's phone numbers, and
increasing the number or amount of securities proposed to be offered. 
According to SEC officials, most amendments filed by registered
mutual funds contain nonmaterial changes and, therefore, are not
routinely reviewed.  In contrast, they said that amendments
containing material changes are routinely reviewed with a focus on
the disclosures that have changed. 

Proxy statements and periodic reports also undergo a targeted review
by SEC.  Specifically, proxy statements covering nonroutine matters,
such as a merger, are targeted for review; although more routine
proxies, such as the standard approval of a mutual fund's auditors,
are not.  Of the periodic reports received, SEC only reviews the
attachment to the second of two semiannual reports that most mutual
funds file every year.  The attachment is the fund auditor's report
on the mutual fund's internal controls. 

Table 4 shows SEC's coverage of investment company disclosure
documents for fiscal years 1994 through 1996.\22 During this period,
SEC devoted an average of 44 staff years to reviewing these
documents.  Although the total percentage of disclosure documents
reviewed over these years averaged about 31 percent, the breakdown of
documents reviewed indicates that SEC dedicated its disclosure staff
to reviewing those documents most likely to have new or materially
different information.  For example, the data show that SEC reviewed
a high percentage of initial registration and proxy statements each
year, reflecting the greater possibility that these filings would
contain new or materially different information.  Furthermore, SEC
reviewed at least 93 percent of the initial registration statements
filed by mutual funds for each of these years.  In contrast, SEC
reported that its staff members reviewed between 12 and 15 percent of
the amendments SEC received each year, reflecting the high number of
these filings that would contain nonmaterial changes. 



                                Table 4
                
                   SEC Coverage of Investment Company
                Disclosure Documents, Fiscal Years 1994-
                                   96

                             (fiscal year)


Disclosure document                           1994      1995      1996
----------------------------------------  --------  --------  --------
Initial registration statements
----------------------------------------------------------------------
Filed                                        2,570     2,321     2,410
Reviewed\a                                   1,605     1,570     1,800
Percentage reviewed                            62%       68%       75%

Initial mutual fund registration statements
----------------------------------------------------------------------
Filed                                        1,040       819       811
Reviewed                                       960       755       761
Percentage reviewed                            93%       93%       94%

Amendments
----------------------------------------------------------------------
Filed                                       16,388    15,258    16,864
Reviewed                                     2,008     1,859     2,494
Percentage reviewed                            12%       12%       15%

Proxy statements
----------------------------------------------------------------------
Filed                                          624       711       750
Reviewed                                       579       595       669
Percentage reviewed                            93%       84%       89%

Periodic reports
----------------------------------------------------------------------
Filed                                        8,300     9,500    10,000
Reviewed                                     4,150     4,750     5,000
Percentage reviewed                            50%       50%       50%

Total disclosure documents\b
----------------------------------------------------------------------
Filed                                       27,882    28,060    30,024
Reviewed                                     8,342     8,774     9,963
Percentage reviewed                            30%       31%       33%
----------------------------------------------------------------------
\a The number of initial registration statements reviewed includes
those submitted by open-end (mutual funds), closed-end, and unit
investment trust portfolios. 

\b The total number of disclosure documents filed and reviewed
includes the initial registration statements, amendments, proxy
statements, and periodic reports.  The number of initial mutual fund
registration statements filed and reviewed is included as a subset of
the initial registration statements. 

Source:  SEC. 

SEC officials told us that, because they already review the most
important disclosures, additional staffing would not necessarily be
used to increase the number of filings reviewed each year.  Instead,
the officials said they could use more resources to help them in
related disclosure activities, such as helping mutual funds improve
and simplify prospectus language and performing long-range strategic
planning.  However, SEC officials also said that a current rulemaking
project could substantially affect, at least for the short term,
SEC's ability to maintain adequate review coverage of disclosure
documents.  Specifically, the proposed rule would substantially
revise the registration form and prospectus requirements for mutual
funds.  During the initial implementation period of the proposed
rule, SEC does not plan to use its selective review procedures for
initial registration statements or amendments because it would need
to ensure that mutual funds are complying with the new disclosure
requirements.\23


--------------------
\20 Material changes include disclosures that are significantly
different from those disclosures previously made by the investment
company in its most recent filing of the same kind. 

\21 Rule 485(b) [17 CFR230.485] permits amendments filed by
registered mutual funds that contain enumerated routine or
nonmaterial changes to become automatically effective on the date the
amendments are filed with SEC or on a later date, designated by the
fund, that does not exceed 30 days after the date on which the
amendment was filed. 

\22 We were unable to include and compare data for all disclosure
documents from previous fiscal years because of changes in how SEC
counted the filings received. 

\23 The selective review procedures would still be applicable in some
instances.  For example, after SEC reviews a fund's revised
registration form, all funds within the same complex can request a
selective review of subsequent filings using the revised form. 


   SEC'S OTHER REGULATORY
   ACTIVITIES ENABLED THE INDUSTRY
   TO EVOLVE WITHOUT MAJOR
   LEGISLATIVE CHANGES
------------------------------------------------------------ Letter :6

SEC's Division of IM is also responsible for other regulatory
activities, which include responding to requests for exemptions from
the requirements of the Investment Company Act, rulemaking, and
providing interpretations of applicable laws and rules through
issuing interpretive and "no-action" letters.\24

According to SEC officials, these activities are a primary way of
allowing the industry to grow and change while continuing to protect
investors.  During fiscal years 1990 through 1993, staff years for
these regulatory activities grew by nearly 45 percent.  However, from
the end of fiscal year 1993 to the end of fiscal year 1996, staffing
decreased by almost 14 percent.  SEC officials said that this
staffing decrease occurred largely because staff members often pursue
opportunities created by rapid growth in the investment management
industry.  They also said that additional staff could help them keep
pace with industry developments and be more proactive in identifying
and reacting to industry changes. 


--------------------
\24 A no-action letter is a request from investment companies and
investment advisers that SEC staff react to a particular set of
circumstances or facts as outlined in the letter by indicating
whether the Division of IM would recommend taking an enforcement
action if those circumstances were to occur. 


      EXEMPTIVE ORDERS ENABLE SEC
      TO ADAPT ITS REGULATION TO
      INDUSTRY CHANGES
---------------------------------------------------------- Letter :6.1

The Investment Company Act and the Investment Advisers Act allow SEC
to issue orders granting exemptions from one or more provisions of
these acts, or from rules issued by SEC under these acts.  Congress
gave SEC this authority to prevent the acts from being unduly
restrictive.  To grant an exemption, SEC must find that the exemption
is necessary or appropriate in the public interest, is consistent
with investor protection, and is fairly intended by the policy and
provisions of the act.  The exemptive order permits the applicant to
engage in the activity described in the application that would
otherwise be prohibited by the act.  Exemptive orders apply only to
the applicant.  However, if the exemption appears to have general
applicability, such as when a number of similar requests for
exemptive relief are made, SEC may decide to adopt a rule granting
exemptions to all funds that can meet the conditions. 

According to SEC officials, SEC's authority to grant exemptions from
various provisions of the Investment Company Act and the Investment
Advisers Act has enabled it to adapt its regulation of investment
companies so that SEC is both receptive to new innovations and able
to keep pace with the general evolution of the investment management
industry.  For example, in the 1970s, SEC first allowed trading of
money market mutual funds through exemptive orders.  These funds used
specialized pricing methods that were not contemplated by the
Investment Company Act.  Also, SEC recently adopted a rule, following
the issuance of numerous exemptive orders, that allows mutual funds
to sell multiple classes of shares with different fee structures.  In
the 57 years since the Investment Company Act was enacted, it has
been amended significantly only twice--in 1970 and again in 1996. 

In a 1992 study of investment company regulation,\25 SEC reported
that many responses to its 1990 request for comments on reforming
investment company regulation contained complaints that the process
for obtaining an exemptive order took too long.  In 1995, SEC's
Office of Inspector General (OIG) studied the exemptive order
process, giving particular attention to its timeliness.  The OIG
found that, although the process was essentially sound, many outside
attorneys were still dissatisfied with how long SEC took to process
exemptive applications when novel or complex issues were involved. 
The OIG made several recommendations to improve the process,
including a recommendation that, for applications with these types of
issues, the Division of IM modify its guideline requiring initial
comments on all applications within 45 days.\26

Although the Division of IM's response to the OIG's report agreed to
adopt most of the recommendations, it did not agree that changing
this existing 45-day guideline for novel or complex applications
would shorten the amount of time spent reviewing those applications. 
The Division's response explained that these applications generally
take longer to review because of the potential effect significant
changes to policy may have on the industry and investors. 
Nonetheless, in its response, the Division agreed to monitor the
progress of complex applications more closely and continue to strive
to meet its 45-day initial comment period for all applications. 

According to SEC data on all exemptive applications processed during
fiscal years 1994 through 1996, SEC processed about 10 percent more
applications in fiscal year 1996 than it processed in the preceding 2
fiscal years.  Although SEC reduced its backlog of pending
applications during fiscal year 1996, at the end of that fiscal year,
the number of applications not acted on within 45 days had more than
doubled from the end of fiscal year 1995.  According to an SEC
official, the latter increase was due to a loss of staff near the end
of fiscal year 1996. 


--------------------
\25 Protecting Investors:  A Half Century of Investment Company
Regulation, Division of Investment Management, United States
Securities and Exchange Commission, May 1992. 

\26 To prevent a disproportionate amount of staff time from being
spent on routine applications, in part to increase production as well
as process applications within the 45-day time frame, the OIG
suggested that the Division of IM either provide a different
timetable for complex applications or set appropriate due dates for
complex, individual applications. 


      SEC SHAPES MUTUAL FUND
      REGULATION THROUGH
      RULEMAKING
---------------------------------------------------------- Letter :6.2

SEC issues rules and regulations that implement the provisions of the
securities laws.  Through rulemaking, SEC develops rules relating to
(1) the disclosure requirements that are applicable to investment
companies and investment advisers and (2) the Investment Company Act
and the Investment Advisers Act.  Rulemaking involves constantly
reviewing how well the various rules that SEC has adopted are
working.  SEC often consults with industry representatives and others
affected by the various rules and reviews their suggestions to modify
rules.  For example, an SEC official told us that, in its efforts to
develop rule changes regarding fund disclosure requirements, SEC (1)
sponsored focus groups with fund investors, (2) reviewed
industry-sponsored surveys on investors' views of fund disclosures,
and (3) encouraged comments from individual investors on ways to
improve mutual funds' risk disclosure in April 1995.  Of about 3,700
comment letters SEC received, about 3,600 were from individuals. 

When SEC rulemaking staff find that a particular rule does not appear
to be achieving its objective or is burdensome in relation to its
benefits, the staff members are to present the problem to SEC
Commissioners, who then may consider modifying the rule.  SEC gives
advance public notice of proposals to adopt new or amended rules and
allows time for interested members of the public to comment on the
proposals.  At the conclusion of the comment period, staff members
are to analyze the comments and prepare a summary of their analysis
for the Commissioners to consider when determining whether any
modifications to existing rules are warranted.  Proposals approved by
the Commissioners take effect as final rules, usually within a
specific time after publication in the Federal Register. 

In addition, if SEC receives several very similar requests for an
exemption from a particular provision, it may consider promulgating a
rule to codify the exemption.  To determine if an exemptive rule is
needed, the rulemaking staff are to consider whether the exemption
should also be applicable to other entities.  As previously
discussed, money market funds were first allowed to trade through a
series of exemptive orders beginning in the 1970s.  These orders were
later codified into a rule.  According to SEC, the exemptions granted
and the subsequent rulemaking were critical to the evolution and
success of money market funds. 

In recent years, much of the Division of IM's disclosure-oriented
rulemaking has focused on improving mutual fund prospectuses.  For
example, two major rule proposals focused on making prospectuses more
understandable to investors.  The first rule proposal would update
and streamline the full prospectus that mutual funds are required to
provide investors.  It also would improve the risk disclosures
required to be made in the prospectus.  The second rule proposal
would allow investors to purchase shares of mutual funds solely on
the basis of information contained in a summary prospectus called a
"fund profile."\27 The fund profile provides a summary of the
essential information about a mutual fund by addressing nine items in
a question-and-answer format.  On March 10, 1997, SEC published these
proposed rules in the Federal Register. 

A number of rulemaking efforts regarding the Investment Company Act
and the Investment Advisers Act were under way in the Division of IM
at the time of our review.  Many of these efforts were mandated by
various provisions in the 1996 Act.  For example, the 1996 Act
initially required SEC to issue rules by April 9, 1997, that (1)
separate the regulation of investment advisers between the states and
SEC based on asset size and (2) exempt certain private investment
companies from SEC regulation.  Congress subsequently amended the
1996 Act to provide a 90-day extension of the April 9 deadline for
separating investment adviser regulation.  However, the rule
exempting certain private investment companies from SEC regulation
was effective April 9. 

The 1996 Act also gave SEC additional authority in several areas that
will require other rulemaking.  For example, the 1996 Act (1) gave
SEC additional rulemaking authority to define certain fund names as
materially deceptive or misleading, (2) expanded SEC's authority to
require funds to keep books and records, and (3) allowed SEC to
require investment companies to file information more frequently than
quarterly to keep information in investment companies' registration
statements current.  According to an SEC official, several of SEC's
ongoing rulemaking efforts, such as proposed rules on personal
trading, the use of foreign custodians, and limits on purchasing
securities from an affiliated underwriter, have been delayed because
SEC's first priority is to complete the implementing rules for the
1996 Act.  On March 10, 1997, SEC published its proposed rule on fund
names in the Federal Register. 

SEC officials told us that SEC's rulemaking function has been
affected in the past by high staff turnover and, as a result, SEC has
had more inexperienced staff in the rulemaking area than it desired. 
In addition, the Director of the Division of IM estimated that the
1996 Act is likely to increase the division's workload by about 30
percent in 1997. 


--------------------
\27 The fund profile is a summary of the long-form prospectus.  SEC
intended that the fund profile provide investors an easy-to-read
summary of essential information about the fund, including the fund's
investment objectives, risks, and fees.  Although investors can buy
shares after reading only the fund profile, the profile must disclose
that investors have the option to request a full prospectus before
making an investment decision.  Funds are required to provide
investors the full prospectus when the funds confirm investors'
purchases.  SEC has had a pilot program that permitted funds to use a
fund profile since July 31, 1995. 


      SEC PROVIDES INFORMAL VIEWS
      AND INTERPRETATIONS OF
      SECURITIES LAWS
---------------------------------------------------------- Letter :6.3

Through issuing no-action and interpretive letters, SEC staff members
in the Division of IM provide investment companies, investment
advisers, Congress, and other government agencies with their informal
views and interpretations about how the federal securities laws apply
to proposed transactions that appear to raise compliance issues. 
These letters, which are available to the public, represent the views
of SEC officials who are responsible for administering the laws on a
daily basis.  SEC officials told us that the letters are an effective
method of providing information about how the securities laws are
likely to be interpreted and applied. 

SEC issues no-action letters in response to requests for its staff
members' views on whether they would recommend enforcement action if
the particular facts and circumstances outlined in the request were
to occur.  No-action letters do not make rulings on whether the
particular circumstances are legal or illegal--the letters only state
whether the Division of IM staff would or would not recommend an
enforcement action to the Commission under those specific
circumstances.  Consequently, unlike exemptive orders, no-action
letters do not shield the requester from any liability that may
otherwise result if the circumstances outlined in the request were to
occur.  In addition, SEC has reported that positions in no-action
letters are subject to reconsideration and should not be regarded as
precedents binding SEC. 

An SEC official told us that no-action letters promote voluntary
compliance with the securities laws because the letters inform not
only the requester but others as well about the likely legality of a
particular proposed transaction.  For example, Division of IM staff
provided no-action assurances to a mutual fund that wanted to include
in its prospectus performance information relating to another fund
that its portfolio manager had previously managed.  The staff's
no-action assurances were based on specific representations made in
the request (1) that during the portfolio manager's tenure in
managing the other fund, no other person had played a significant
part in achieving that fund's performance and (2) that the
performance information would not be presented in the prospectus in a
misleading manner, nor would that information impede investors'
understanding of required prospectus information. 

SEC issues interpretive letters in response to requests for its
staffs' views on whether the requester has interpreted and applied a
particular statute or rule correctly to a particular set of facts or
circumstances.  According to an SEC official, interpretive letters
differ from no-action letters because, rather than simply stating it
would not recommend an enforcement action, the Division of IM agrees
that the statute or rule in question permits the proposed
transaction.  Again, SEC officials view interpretive letters as a
means of informing the investment management industry about how the
laws are actually being applied. 

While the Investment Company Act requires that SEC respond to
requests for exemptions, responding to requests for no-action and
interpretive letters is a discretionary role that SEC has had in
place for several decades.  According to SEC data, the Division of IM
responded to 2,643 requests for no-action and interpretive advice
during fiscal years 1993 through 1996.  Although the number of
no-action and interpretive responses increased each fiscal year
during 1993 through 1995--620, 674, and 747, respectively--the number
decreased to 602, or about 19 percent, in fiscal year 1996.  SEC
reported that this decline was a result of its staff having spent
time during fiscal year 1996 providing technical assistance to
Congress on a number of provisions of the 1996 Act and other
legislation. 


   CONCLUSIONS
------------------------------------------------------------ Letter :7

SEC has responded to the challenges presented by the growth in the
mutual fund industry through increasing its inspection staffing and
adjusting the focus of its oversight activities.  The effects of
these responses cannot be separated from other factors, such as the
requirements of the Investment Company Act, industry support for
strict compliance with securities laws, and favorable market
conditions, that may have contributed to the industry remaining
generally free of major scandal.  However, the continued
proliferation in the number and type of funds offered, the industry's
use of increasingly complex products that may be difficult both to
value and to trade during falling markets, and the increased reliance
by millions of Americans on mutual funds as a source of retirement
income make it imperative that SEC's efforts to protect mutual fund
investors against abuse continue to be a priority. 


   AGENCY COMMENTS AND OUR
   EVALUATION
------------------------------------------------------------ Letter :8

We requested comments on a draft of this report from the Chairman,
SEC.  In response, the Chairman stated that the contents of our
report provide a detailed and accurate description of SEC's program
for inspecting and regulating mutual funds.  He also expressed
concern that, if the industry continues to grow at its current pace,
SEC will need additional resources to meet its oversight
responsibilities. 

We agree that industry growth can influence the resources needed to
oversee the industry.  However, in determining the extent to which an
increase in resources would be the most effective response to rapid
industry growth, SEC may also be guided by the results it achieves
from the program goals and performance measurements that it is
developing pursuant to the Government Performance and Results Act of
1993 (GPRA).  In July 1993, Congress passed GPRA to improve the
efficiency and effectiveness of federal programs by establishing a
system to set goals for program performance and to measure results. 
GPRA directed all federal agencies, including SEC, to develop by
September 1997 long-range strategic goals and the measures they will
use to gauge their progress toward achieving these goals.  GPRA
requires that agencies report annually to the President and to
Congress on their performance and progress toward meeting their
goals.  These annual reports are intended to be used by Congress and
SEC to assess what SEC is accomplishing with its mutual fund
oversight resources and whether additional resources are needed. 


---------------------------------------------------------- Letter :8.1

We are sending copies of this report to the SEC Chairman and other
interested parties upon request.  This report was prepared under the
direction of Michael A.  Burnett, Assistant Director, Financial
Institutions and Markets Issues.  Major contributors to this report
are listed in appendix II.  Please contact me on (202) 512-8678 if
you have any questions concerning this report. 

Jean Gleason Stromberg
Director, Financial Institutions and
 Markets Issues




(See figure in printed edition.)Appendix I
COMMENTS FROM THE SECURITIES AND
EXCHANGE COMMISSION
============================================================== Letter 


MAJOR CONTRIBUTORS TO THIS REPORT
========================================================== Appendix II

GENERAL GOVERNMENT DIVISION,
WASHINGTON, D.C. 

Michael A.  Burnett, Assistant Director
Frank J.  Philippi, Assignment Manager
Suzanne Bright, Evaluator-in-Charge
Darleen A.  Wall, Evaluator


*** End of document. ***