Summary
As the frontline regulator of mutual funds, the Securities and Exchange Commission (SEC) plays a key role in protecting the nearly half of all U.S. households owning mutual funds, valued around $8 trillion in 2005. Mutual fund abuses raised questions about the integrity of the industry and quality of oversight provided by SEC and self-regulatory organizations (SRO) that regulate broker-dealers selling funds. This report assesses (1) changes SEC has made to, or is planning for, its mutual fund exam program; (2) key aspects of SEC's quality control framework for routine fund exams; and (3) the adequacy of SEC's oversight of NASD and the New York Stock Exchange in protecting shareholders from mutual fund sales abuses.
SEC is initiating several changes intended to strengthen its mutual fund exam program but faces challenges overseeing the fund industry. In the wake of the fund abuses, SEC has revised its past approach of primarily conducting routine exams of all funds on a regular schedule. It concluded these exams were not the best tool for identifying emerging problems, since funds were not selected for examination based on risk. To quickly identify problems, SEC is shifting resources away from routine exams to targeted exams that focus on specific risks. It will conduct routine exams on a regular schedule but only of funds deemed high risk. SEC also is forming teams to monitor some of the largest groups of advisers and funds. Although SEC is seeking to focus its resources on higher risk funds and activities, the resource tradeoffs it made in revising its oversight approach raise significant challenges. The tradeoffs may limit SEC's capacity not only to examine funds considered lower risk within a 10-year period but also to accurately identify which funds pose higher risk and effectively target them for routine examination. Potentially taxing its resources further, SEC recently adopted a rule to require advisers to hedge funds (investment vehicles generally not widely available to the public) to register with it. This rule is expected to increase SEC's exam workload, but the precise extent is not yet known. SEC has integrated some quality controls into its routine exams, but certain aspects of its framework could be improved. It relies on experienced staff to oversee all exam stages but does not expressly require supervisors to review work papers or document their review. GAO found deficiencies in key SEC exam work papers, raising questions about the quality of supervisory review. SEC also does not require examiners to prepare written exam plans, though they use considerable judgment in customizing each exam. Written plans could serve as a guide for conducting exams and reviewing whether exams were completed as planned. As done by other regulators, SEC also could review a sample of work papers to test compliance with its standards. A primary tool that SEC uses to assess the adequacy of SRO oversight of broker-dealers offering mutual funds provides limited information for achieving its objective and imposes duplicative costs on firms. To assess SRO oversight, SEC reviews SRO exam programs and conducts oversight exams of broker-dealers, including their mutual fund sales practices. SEC's oversight exams take place 6 to 12 months after SROs conduct their exams and serve to assess the quality of SRO exams. However, GAO reported in 1991 that SEC's oversight exams provided limited information in helping SROs to improve their exam quality, because SEC and the SROs used different exam guidelines and their exams often covered different periods. GAO found that these problems remain, raising questions about the considerable resources SEC devotes to oversight exams. GAO also found that SEC has not developed an automated system to track the full scope of work done during its oversight exams. Thus, SEC cannot readily determine the extent to which these exams assess mutual fund sales practices.
Recommendations
Our recommendations from this work are listed below with a Contact for more information. Status will change from "In process" to "Open," "Closed - implemented," or "Closed - not implemented" based on our follow up work.
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Recommendations for Executive Action
Recommendation: To improve SEC's oversight of mutual funds and SRO oversight of broker-dealers that sell mutual funds, SEC should periodically assess the level of resources allocated to the various types of examinations in light of their regulatory benefits to help ensure that the agency is using its resources efficiently and effectively to oversee the mutual fund industry, including broker-dealers that offer mutual funds. As part of this assessment, SEC should seek to ensure that it allocates sufficient resources to mitigate any regulatory gaps that may currently exist concerning the timely examination of mutual funds perceived to represent lower risk, complete mutual fund risk assessments within a more reasonable period, and fulfill its new oversight responsibilities for the hedge fund industry.
Agency Affected: United States Securities and Exchange Commission
Status: Closed - implemented
Comments: SEC's implementation of its electronic exam system, Risk Assessment Documentation and Inspection Umbrella System (RADIUS), coupled with changes to its Super Tracking and Reporting System (STARS) database, has enabled the agency to assess the level of resources allocated to its various types of exams in light of their benefits and ensure that it can sufficiently plug any regulatory gaps. First, RADIUS guides examiners through the risk assessment of registrants. Each firm is given an overall risk rating, which is stored and tracked in RADIUS. SEC uses its risk ratings to determine which firms to give exam priority, focusing its exam resources on higher risk firms. SEC staff said that focusing most of their resources on higher risk firms is the most efficient and effective use of their limited resources. Second, SEC uses STARS to track exam resources and has linked STARS to RADIUS. As a result, SEC management can combine the risk-assessment functionality of RADIUS with the resource tracking functionality of STARS to allocate resources to exam areas in most need to mitigate potential regulatory gaps.
Recommendation: To improve SEC's oversight of mutual funds and SRO oversight of broker-dealers that sell mutual funds, SEC should assess its methodology for conducting broker-dealer oversight examinations and whether some portion of the resources currently devoted to these examinations could be better utilized to perform mutual fund examinations.
Agency Affected: United States Securities and Exchange Commission
Status: Closed - implemented
Comments: SEC created an internal task force to assess the agency's methodology, or approach, for conducting broker-dealer oversight exams. The task force identified areas for improvement, including the need to analyze the program on a national level to ensure consistent oversight and to identify better the underlying causes of deficiencies found by SEC examiners but missed by self-regulatory organization (SRO) examiners. SEC staff said that they disagree that resources should be shifted away from the broker-dealer oversight exams to mutual fund exams. They said that the broker-dealer oversight exams serve the dual purpose of evaluating the effectiveness of SRO exams and detecting violations and compliance risk at broker-dealers. SEC examiners find deficiencies not found by SROs in over 90 percent of their exams. Based on its overall risk-based approach, SEC staff do not support shifting resources away from broker-dealer oversight exams.
Recommendation: To improve SEC's oversight of mutual funds and SRO oversight of broker-dealers that sell mutual funds, and to strengthen SEC's approach to mutual fund examinations, SEC should establish a policy or procedure for supervisory review of work papers prepared during routine examinations and for documenting such reviews; establish a policy or procedure for preparing a written plan for each routine examination, documenting at a minimum the preliminary objectives and scope of the examination; and consider reviewing on a sample basis completed routine examinations and work papers to assess the quality and consistency of work within and across the field offices conducting examinations.
Agency Affected: United States Securities and Exchange Commission
Status: Closed - implemented
Comments: SEC has developed an electronic exam system, called "Risk Assessment Documentation and Inspection Umbrella System (RADIUS). RADIUS has a database component that guides examiners through a risk assessment of registrants and provides a variety of related functions, including document generation and management, data tracking, program reporting, and program-wide risk assessment and planning. SEC staff said that RADIUS establishes policies and procedures to meet our recommendation. First, it tracks the work examiners perform and requires supervisors to electronically sign-off on procedures before exam work can be deemed completed. Second, RADIUS provides templates for audit plans that examiners are to complete before starting their field work. Examiners can amend aspects of the audit plan template to customize their audit plans, as necessary. Third, RADIUS has a database that is used to centrally store all exam workpapers across SEC's field and regional offices. With this functionality, SEC management will be able to review workpapers to assess the quality and consistency of exam work across the offices.
Recommendation: To improve SEC's oversight of mutual funds and SRO oversight of broker-dealers that sell mutual funds, and to assess and improve the effectiveness of SEC's oversight of SRO broker-dealer examination programs, the Chairman, SEC, should electronically track information about the full scope of work performed during broker-dealer oversight examinations, including all major areas reviewed, to determine whether areas are receiving adequate review and to more fully assess the significance of deficiencies and violations found.
Agency Affected: United States Securities and Exchange Commission
Status: Closed - implemented
Comments: SEC's electronic exam system, Risk Assessment Documentation and Inspection Umbrella System (RADIUS), is being expanded to address the recommendation. When fully operational, RADIUS will track the scope of all exams and findings of such exams. In the interim, examiners are using the risk scorecards--which are used to assess the effectiveness of a firm's internal controls and, based on that assessment, identify areas in which to explore in more detail--to document the scope of exams. SEC has also modified its Super Tracking and Reporting System (STARS) database to track each major, or focus, area covered by exams.
