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Testimony:

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

United States General Accounting Office:

GAO:

For Release on Delivery Expected at 10:30 a.m. EST:

Tuesday, April 20, 2004:

SEC Operations:

Oversight of Mutual Fund Industry Presents Management Challenges:

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

GAO-04-584T:

GAO Highlights:

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

Why GAO Did This Study:

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

What GAO Found:

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

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

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

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

SEC Unit: Investment Management Division[A]; 
Actual 2002: 173; 
Actual 2003: 167; 
Estimated 2004: 190; 
Requested 2005: 200; 
Percent change 2002-2005: 16%.

SEC Unit: OCIE[B]; 
Actual 2002: 397; 
Actual 2003: 439; 
Estimated 2004: 545; 
Requested 2005: 579; 
Percent change 2002-2005: 46.

SEC Unit: Enforcement Division[C]; 
Actual 2002: 980; 
Actual 2003: 1,016; 
Estimated 2004: 1,248; 
Requested 2005: 1,278; 
Percent change 2002-2005: 30. 

Source: GAO analysis of SEC data.

Notes:

[A] Includes staff in the office that administers the Public Utility 
Holding Company Act of 1935.

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

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

[End of table]

What GAO Recommends:

Although this testimony statement makes no recommendations, GAO 
discusses challenges that SEC will have to successfully overcome to 
improve its effectiveness and restore investor confidence in the 
securities markets.

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

To view the full product, including the scope and methodology, click on 
the link above. For more information, contact Richard Hillman at (202) 
512-8678 or hillmanr@gao.gov.

[End of section]

Mr. Chairman and Members of the Subcommittee:

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

Today, I will discuss our work examining how well SEC is positioned to 
effectively oversee the mutual fund industry. Specifically, I will 
discuss (1) how the abusive practices involving mutual funds came to 
light and SEC's subsequent responses, (2) SEC's plans for increasing 
its staffing in the divisions and offices responsible for overseeing 
mutual funds and its progress in developing a new strategic plan to 
guide staff deployment, and (3) challenges that may be affecting SEC's 
ability to effectively oversee the mutual fund industry. In preparing 
this testimony, we summarized perspectives gained from our recent 
series of reports and testimonies on practices in the mutual fund 
industry.[Footnote 1] In addition, we also relied on information 
gathered from our previous and ongoing work involving SEC's resources 
and strategic planning efforts.[Footnote 2] We also met with SEC 
officials to discuss the status of their strategic planning efforts, 
including their plans to oversee the mutual fund industry. Finally, we 
reviewed SEC budget-related documents for fiscal years 2003 and 2004, 
and its 2005 budget request. We conducted our work from March to April 
2004 in accordance with generally accepted government auditing 
standards.

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

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

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

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

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

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

SEC did not identify these abusive practices involving mutual funds for 
various reasons. According to SEC staff, many of the cases involved 
fraud and collusion among personnel and such activity is very hard to 
detect in a routine examination. Also, according to testimony by the 
head of the SEC office that conducts mutual fund examinations, SEC 
examiners did not reveal these practices because their examinations 
focused primarily on the operations of the mutual fund and trading of 
the fund's portfolio securities practices with an acknowledged 
potential for abuse. As a result, their examinations did not generally 
address the trading in the fund's own shares. SEC has also faced 
resource challenges for years that have affected its ability to conduct 
oversight in the mutual fund industry and other areas. For example, we 
reported on SEC's difficulties during the 1990s to keep pace with the 
growth in the industry and its inability to examine funds and 
investment advisers frequently.[Footnote 6] In recent testimony, the 
director of the SEC office that conducts examinations noted that, prior 
to 1998, SEC examinations of mutual fund firms had been as infrequent 
as once every 12-24 years.[Footnote 7] Scarce resources may have also 
affected SEC's decision to, unfortunately, not follow up on information 
it obtained regarding the recent wrongdoing in the mutual fund 
industry. In the summer of 2003, SEC staff had received a tip from a 
former fund employee who was aware of how his former employer was 
accommodating market timing by some investors, but SEC staff ultimately 
chose not to use further resources to pursue this case. The former fund 
employee then reported the matter to the Massachusetts Securities 
Division, which subsequently took action against the firm's executives. 
As a result of another tip, however, the SEC staff promptly recommended 
and brought an enforcement action against the fund complex and two 
portfolio managers based on market timing and excessive short-term 
trading by investment professionals employed by the fund complex.

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

SEC and NASD also have issued at least 11 rule proposals to address 
abusive and other practices in the mutual fund industry. For example, 
to address late trading and market timing, SEC issued proposed rule 
changes that would require orders for mutual fund shares to be 
processed by intermediaries and received by funds or their agents by 
4:00 p.m.[Footnote 8] SEC is also proposing a rule that would require 
that funds charge investors holding fund shares less than 5 days a 2-
percent redemption fee, which would reduce the likely profitability of 
short-term trading strategies involving late trading or market 
timing.[Footnote 9] SEC also proposed that funds disclose information 
about their policies regarding market timing and their use of a pricing 
technique called fair-value pricing, which is designed to better ensure 
that fund shares are priced accurately and thus are less susceptible to 
market timing.[Footnote 10] SEC's Commissioners approved these rules on 
April 13, 2004.

In addition to issuing proposals to address late trading and market 
timing, SEC has also taken some actions that address longstanding 
concerns over other mutual fund practices, including the lack of 
transparency of some fees and costs and the potential for conflicts of 
interest in fund distribution and sales practices. Some of the actions 
SEC and NASD are proposing would require greater disclosure of fees 
that funds charge or the payments that broker-dealers receive from fund 
firms for marketing certain funds. We discussed these and the late 
trading and market timing proposals and our views on them in testimony 
for the Senate Committee on Banking, Housing and Urban Affairs on March 
10, 2004.[Footnote 11]

Although SEC and the other regulators have acted swiftly to respond to 
the revelations of abusive mutual fund trading practices, other issues 
warrant SEC's continued attention. For example, SEC is seeking 
information on how fund advisers use investors' dollars to obtain 
research. This practice, called soft dollars, involves fund advisers 
receiving research or other services from broker-dealers in exchange 
for the commissions the advisers pay on trades conducted in fund 
portfolio securities. Although this practice can benefit the fund's 
investors, whose assets are used to pay these commissions, it can also 
create conflicts of interest or potential for abuse. Given the 
increased spotlight Congress and regulators are placing on the mutual 
fund industry, in our view, the time is right to address the conflicts 
created by soft-dollar arrangements. In addition, we have identified 
other actions that SEC should take that would improve disclosure of 
mutual fund fees, thus improving investor awareness of the fees they 
pay on their mutual fund investments. These actions would increase the 
transparency of fund fees and likely enhance competition among funds on 
the basis of the fees charged investors.

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

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

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

After years of facing imbalances in its workload, SEC recently received 
additional resources that can help it more effectively oversee the 
securities markets, including the mutual fund industry. In March 2002, 
we reported that the growth rate of demands on SEC's staff, including 
the number of corporate and regulatory filings they must review, the 
complaints and allegations of wrongdoing they must investigate, and the 
numbers of mutual funds, investment advisers and other entities they 
must examine, had increased by about 60 percent from 1996 to 
2000.[Footnote 12] The rapid growth of the mutual fund industry during 
this time also posed challenges to SEC's staff. For example, the number 
of mutual funds in existence grew from about 4,500 at the end of 1993 
to over 8,100 by the end of 2000. In addition, the issues that SEC 
staff had to address had also become more complex. However, SEC's staff 
resources during this period remained relatively flat. As a result, 
SEC's ability to fulfill its mission had become increasingly strained 
because of the imbalance between its workload and staffing resources.

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

In addition to addressing other needs with these additional resources, 
SEC has also been able to respond to the mutual fund scandals by 
increasing the staff allocated to the three primary divisions and 
offices within the agency responsible for mutual fund regulation, 
oversight, and enforcement. Within SEC, the Division of Investment 
Management is responsible for creating rules and reviewing filings for 
mutual funds and investment advisers.[Footnote 14] Staff in SEC's 
Office of Compliance Inspections and Examinations (OCIE) conducts 
examinations and inspections of mutual funds companies and investment 
advisers.[Footnote 15] Finally, staff in SEC's Division of Enforcement 
investigate possible violations of securities laws, including the 
Investment Company Act of 1940 and the Investment Advisers Act of 1940, 
and pursue legal actions against violators.[Footnote 16]

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

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

SEC Unit: Investment Management Division[A]; 
Actual 2002: 173; 
Actual 2003: 167; 
Estimated 2004: 190; 
Requested 2005: 200; 
Percent change 2002-2005: 16%.

SEC Unit: OCIE[B]; 
Actual 2002: 397; 
Actual 2003: 439; 
Estimated 2004: 545; 
Requested 2005: 579; 
Percent change 2002-2005: 46.

SEC Unit: Enforcement Division[C]; 
Actual 2002: 980; 
Actual 2003: 1,016; 
Estimated 2004: 1,248; 
Requested 2005: 1,278; 
Percent change 2002-2005: 30. 

Source: GAO analysis of SEC data.

Notes:

[A] Includes staff in the office that administers the Public Utility 
Holding Company Act of 1935.

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

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

[End of table]

The units responsible for mutual fund oversight benefited from the 
additional staff they received. For example, OCIE staff said that with 
the added resources they received in 2003, they were able to begin 
conducting additional examinations that they hoped would allow them to 
increase the frequency of the reviews they conduct of the largest fund 
companies as well as those that pose the greatest compliance risks to 
as often as every 2 years. OCIE staff said that additional positions 
requested for 2005 would be used to expand its examination program in 
the SEC regional offices. SEC's Chairman also recently testified that 
he has asked the staff to prepare a rule proposal that would require 
managers to hedge funds to register with SEC and submit to 
examinations.[Footnote 17] OCIE staff said that some of the additional 
staff SEC requested for 2005 could likely be used to assist with those 
efforts.

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

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

SEC Allocated Resources Absent a Current Strategic Plan:

Although SEC has directed increased resources to oversee mutual funds, 
these allocation decisions were made without the benefit of an updated 
strategic plan; thus, it is difficult to determine the extent to which 
these increases reflect the optimal use of SEC's limited resources. 
According to GAO guidance on effectively developing and implementing 
strategic plans, leading organizations recognize that their activities, 
core processes, and resources must be aligned to support their missions 
and help them achieve their goals.[Footnote 18] To achieve this, 
leading organizations articulate a well-defined mission in their 
overall strategic plan that forms the foundation for the key business 
systems and processes they use to ensure the successful outcome of 
their operations. By aligning activities to support mission-related 
goals, the organizations are also better able to link the levels of 
funding for their activities and anticipated results. As a complement 
to the strategic plan, organizations should also determine the specific 
staff competencies needed to fulfill their mission and develop a human 
capital plan that addresses how they will acquire, develop, and retain 
the employees they need.[Footnote 19]

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

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

Although lacking an updated strategic plan, SEC did use an internal 
study of its operations to guide resource decisions for 2003. The large 
budget increase resulting from Sarbanes-Oxley provided SEC with an 
additional 842 positions for fiscal year 2003. To allocate these 
positions across its various units, SEC drew upon an internal study 
that analyzed its operations, including workload, resource allocations, 
methods for assigning and managing work, and measures of performance, 
productivity, and quality of effort. Each SEC division and office also 
had to provide the SEC Chairman with details of what would be 
accomplished if additional resources were provided.

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

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

Some Progress Made in Human Capital Management and Performance 
Measurement:

Although SEC has yet to complete updated strategic and human capital 
plans, it has made some progress in addressing strategic human capital 
management and measuring its performance. For example, it has taken 
steps to improve its recruiting and hiring processes and has 
implemented an agencywide training program to increase its overall 
staff competency. Recognizing that retention of staff is important to 
achieving its mission, SEC has negotiated an agreement with its new 
employee union that includes various "worklife" programs such as 
flextime, flexiplace, and tuition reimbursement as a means for 
increasing morale and job satisfaction.

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

SEC Faces Agencywide Challenges That Also Affect Mutual Fund Oversight:

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

Timely Anticipation and Identification of Problems Is a Challenge:

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

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

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

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

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

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

SEC staff in the units with responsibility for mutual funds told us 
they have begun activities to identify emerging risks within their 
areas. For example, OCIE officials said that examiners have begun 
efforts to identify what they believe to be the key risks in their 
ongoing examinations. With this information, OCIE officials hope to 
develop a formalized process in which this information would flow up 
through the office and into the risk assessment office. Similarly, 
according to Division of Enforcement officials, the division has 
reorganized staff in its Office of Chief Counsel by functional lines 
rather than by geographical location. The functional lines include 
investment adviser and mutual funds, broker-dealers and markets, and 
corporate accounting. The intent of this reorganization is to increase 
the staff's subject matter expertise and better detect emerging issues. 
Enforcement officials said they have already hired experts in the first 
two lines to further increase the division's expertise and assist in 
the agencywide risk analysis project, and have plans to hire a 
corporate accounting expert soon.

Filling New Positions and Existing Vacancies May Not Address All Needs:

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

As we reported to you in July 2003, the competitive service hiring 
requirements with which SEC was required to comply to hire staff 
involved the completion of various lengthy processes, such as ranking 
candidates by position, before filling a vacancy. According to SEC 
staff, the considerable time required to complete these processes 
hampered the agency's ability to meet its hiring goals. As a result, 
the agency asked for and received relief from these requirements under 
the Accountant, Compliance and Enforcement Staffing Act of 2003, 
enacted in July 2003 and intended to enable SEC to expedite the hiring 
of accountants, economists, and examiners. SEC staff told us that 
bypassing competitive processes has helped them hire individuals for 
such positions more quickly. In recent testimony, SEC's Chairman noted 
that the number of vacant positions would have been much higher without 
this legislation.

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

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

Although OCIE has had some success in hiring additional examiners, the 
revelations of the widespread abuses in the industry has also resulted 
in an expansion of its workload. OCIE staff told us that in trying to 
reach their mutual fund-related staffing goals for the end of fiscal 
year 2004, only about 3 percent of their positions were vacant as of 
March 2004, primarily as a result of attrition. However, OCIE staff 
also told us that as a result of the mutual fund abuses, examiners will 
be conducting more comprehensive examinations and more targeted mini-
sweeps, which are focused examinations that deal with just a single 
issue across a number of firms. For example, to aid in detecting any 
misconduct that might not otherwise be reflected in the books and 
records kept by a firm and shown to examiners, OCIE staff said that 
their routine examinations would now include a review of a sample of 
fund executives' internal e-mail communications. Other new examination 
steps OCIE said they were implementing include reviewing personal 
trading records that show fund executives trading in their funds' 
shares and reviews of procedures to ensure that fund share orders are 
processed to receive the appropriate day's net asset value, including 
firms' procedures governing order receipt time and order time stamping.

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

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

Obtaining and Effectively Using Information Technology Also a 
Challenge:

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

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

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

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

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

OCIE officials also stated that they are considering a longer-term 
project involving the development of a mutual fund surveillance 
program. On March 5, 2004, the SEC Chairman announced the formation of 
an internal task force to draft the outlines of this new surveillance 
program. This group will examine the mutual fund reporting regime and 
consider changes to both the frequency of reporting to the Commission 
and the categories of information to be reported, as well as how new 
technologies can be used to enhance SEC's oversight responsibilities. 
OCIE's director stated that the goal of such a surveillance program 
would be to identify indications of problems, and then target the 
particular fund or adviser for a follow-up inquiry. With such 
information, SEC staff would also likely be able to examine relevant 
data on an industrywide basis to determine if a systemic problem was 
emerging. Implementation of such an initiative will require a continued 
commitment to enhancing SEC's information technology capabilities.

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

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

Investigation and Collection Difficulties Also Hamper SEC's Regulatory 
Efficiency:

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

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

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

The need for SEC staff to make lengthy and complicated efforts to 
collect fines or disgorgements also prevent them from investigating 
other matters. As a result, SEC staff indicated their efficiency would 
be improved if they had authority to contract with private attorneys to 
undertake litigation to enforce collection orders. The House is 
considering a bill introduced in 2003 that would give SEC authority to 
obtain these contracts, as well as other enhancements to the authority 
of SEC Enforcement staff.[Footnote 23]

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

Contacts and Acknowledgements:

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

FOOTNOTES

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

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

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

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

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

[6] See U.S. General Accounting Office Investment Advisers: Current 
Level of Oversight Puts Investors at Risk, GGD-90-83 (Washington, D.C.: 
June 26, 1990); Bank Mutual Funds: Sales Practices and Regulatory 
Issues, GGD-95-210 (Washington, D.C.: Sep. 27, 1995); and Mutual Funds: 
SEC Adjusted Its Oversight in Response to Rapid Industry Growth, GGD-
97-67 (Washington, D.C.: May 28, 1997).

[7] See U.S. Securities and Exchange Commission, Lori A. Richards, 
Director, Office of Compliance Inspections and Examinations, Testimony 
Before the U.S. Senate Committee on Banking, Housing and Urban Affairs 
Concerning Investor Protection Issues Regarding the Securities and 
Exchange Commission's Examinations of Mutual Funds (Mar. 10, 2004).

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

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

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

[11] See GAO-04-533T.

[12] GAO-02-302.

[13] Pub. L. No. 107-204.

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

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

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

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

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

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

[20] GAO-02-302. 

[21] See U.S. Securities and Exchange Commission Chairman William H. 
Donaldson, Testimony Before the Subcommittee on Commerce, Justice, 
State, and the Judiciary, Committee on Appropriations, United States 
House of Representatives Concerning Fiscal 2005 Appropriations Request 
for the U. S. Securities and Exchange Commission (Mar. 31, 2004).

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

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