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entitled 'Mutual Fund Trading Abuses: SEC Consistently Applied
Procedures in Setting Penalties, but Could Strengthen Certain Internal
Controls' which was released on June 7, 2005.
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Report to Congressional Requesters:
United States Government Accountability Office:
GAO:
May 2005:
Mutual Fund Trading Abuses:
SEC Consistently Applied Procedures in Setting Penalties, but Could
Strengthen Certain Internal Controls:
GAO-05-385:
GAO Highlights:
Highlights of GAO-05-385, a report to congressional requesters:
Why GAO Did This Study:
The Securities and Exchange Commission (SEC) and other regulators have
recently identified two significant types of trading abuses—market
timing and late trading—in the mutual fund industry. The more
widespread abuse was market timing, which involved situations where
investment advisers (firms that may manage mutual funds) entered into
undisclosed arrangements with favored customers who were permitted to
trade frequently in contravention of stated trading limits. These
arrangements harmed long-term mutual fund shareholders by increasing
transaction costs and lowering fund returns. Late trading, a
significant but less widespread abuse, occurs when investors place
trades after the mutual fund has calculated the price of its shares,
usually at the 4:00 p.m. Eastern Time close of financial markets, but
receive that day’s fund share price. Investors who late trade have an
opportunity to profit, which is not available to other investors. To
assess SEC’s efforts to impose penalties on violators, this report (1)
discusses SEC’s civil penalties in settled trading abuse cases, (2)
provides information on related criminal enforcement actions, and (3)
evaluates SEC’s criminal referral procedures.
What GAO Found:
Since September 2003, SEC has brought 14 enforcement actions against
investment advisers and 10 enforcement actions against other firms for
mutual fund trading abuses. Penalties obtained in settlements with
investment advisers are among the agency’s highest—ranging from $2
million to $140 million and averaging $56 million. In contrast,
penalties obtained in settlements for securities law violations prior
to 2003 were typically under $20 million. SEC’s penalties in the
investment adviser cases are also generally consistent with penalties
it has obtained from firms involved in similarly egregious corporate
misconduct. Further, SEC brought enforcement actions against 24
individuals associated with the investment advisers, many of them high-
ranking, and obtained penalties as high as $30 million as well as life-
time industry bars for some persons. In reviewing a sample of
investment adviser cases, GAO found that SEC followed a consistent
process for determining penalties and that it coordinated penalties and
other sanctions with interested states.
State and federal criminal prosecutors told us that while they have
recently investigated market timing conduct, they have generally not
pursued criminal prosecution in those cases. They have, however,
brought criminal charges in cases involving late trading violations.
These officials said that the criminal prosecution of market timing is
complicated by the fact that market timing conduct itself is not
illegal. Although SEC instituted administrative proceedings in the
investment adviser cases discussed above by alleging that the
undisclosed market timing conduct involved constituted securities
fraud, both federal and state criminal prosecutors told us they
reviewed cases involving such market timing conduct and generally
concluded that it did not warrant criminal fraud prosecutions. In
contrast, criminal charges have been brought against at least 12
individuals for alleged late trading violations. Federal criminal
prosecutors said that criminal prosecution of late trading is fairly
straightforward because federal securities laws prohibit the practice.
SEC officials said that as state and federal criminal prosecutors were
already aware of and generally evaluated the mutual fund trading abuse
cases for potential criminal violations on their own initiative, they
did not need to make specific criminal referrals to bring these cases
to their attention. However, during the course of its review, GAO found
that SEC’s capacity to effectively manage its overall criminal referral
process may be limited by inadequate recordkeeping. In particular, SEC
does not require staff to document whether a referral was made or why.
According to federal internal control standards, appropriate
documentation of agency actions helps ensure that management directives
are carried out. Without such documentation, SEC cannot readily
determine whether staff make appropriate referrals. Such information is
also important as an agency performance indicator and for congressional
oversight purposes.
What GAO Recommends:
GAO recommends that SEC document referrals to criminal law enforcement
authorities. SEC agrees with this recommendation.
www.gao.gov/cgi-bin/getrpt?GAO-05-385.
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]
Contents:
Letter:
Results in Brief:
Background:
SEC Consistently Applied Penalty-Setting Procedures in Mutual Fund
Cases and Coordinated Most Monetary Sanctions with States:
Several Factors Have Complicated Criminal Prosecution of Market Timing,
but State and Federal Authorities Have Brought Criminal Charges in Late
Trading Cases:
Inadequate Documentation Procedures Limit SEC's Capacity to Effectively
Manage the Criminal Referral Process:
SEC Efforts to Encourage Staff Compliance with Federal Conflict-of-
Interest Laws on New Employment Do Not Include Tracking Post-SEC
Employment Plans:
Conclusions:
Recommendations:
Agency Comments and Our Evaluation:
Appendix I: Scope and Methodology:
Appendix II: Comments from the Securities and Exchange Commission:
Appendix III: Major Contributors to this Report:
Tables:
Table 1: Statutory Maximums for SEC Penalties in Noninsider Trading
Securities Violations, Adjusted for Inflation:
Table 2: Average Penalties in SEC Settlements with Investment Advisers,
Public Companies, and Investment Firms:
Table 3: Penalties SEC Obtained in Settlement from Individuals Charged
in Investment Adviser Cases:
Figure:
Figure 1: SEC Settlements with Investment Advisers for Market Timing
Abuses as of February 28, 2005 (in thousands of dollars):
Abbreviations:
1940 Act: Investment Company Act of 1940:
Advisers Act: Investment Advisers Act of 1940:
ALJ: Administrative law judge:
CEO: Chief Executive Officer:
CFTC: Commodity Futures Trading Commission:
DOJ: Department of Justice:
Enforcement: Division of Enforcement:
NYSOAG: New York State Office of the Attorney General:
OCC: Office of the Comptroller of the Currency:
OCIE: Office of Compliance Inspections and Examinations:
penalties: civil money penalties:
Remedies Act: The Securities Enforcement Remedies and Penny Stock
Reform Act of 1990:
SEC: Securities and Exchange Commission:
SOX: Sarbanes-Oxley Act of 2002:
USAO: U.S. Attorney's Office:
United States Government Accountability Office:
Washington, DC 20548:
May 16, 2005:
The Honorable F. James Sensenbrenner, Jr.:
Chairman:
The Honorable John Conyers, Jr.:
Ranking Minority Member:
Committee on the Judiciary:
House of Representatives:
Trading abuses allowing privileged mutual fund investors to profit at
the expense of other fund shareholders were recently uncovered among
some of the most well-known companies in the mutual fund industry. The
Securities and Exchange Commission (SEC), an independent agency headed
by a five-member Commission, is charged with oversight of the mutual
fund industry and has the authority to bring civil enforcement actions
against individuals and mutual fund companies that violate federal
securities laws.[Footnote 1] SEC carries out enforcement activities
through its Division of Enforcement (Enforcement).[Footnote 2] Swift
and effective enforcement by SEC of federal securities laws is
essential to punish violators and help deter future misconduct in the
mutual fund industry. In accomplishing its mission, SEC can coordinate
enforcement actions with state authorities that may also have
responsibility to bring civil actions. Further, it can make referrals
to the Department of Justice (DOJ) and state criminal enforcement
authorities to help ensure that potential violations of federal and
state criminal statutes are identified and prosecuted. In carrying out
its work, SEC has a responsibility to ensure that its enforcement staff
and examiners are free of any real or apparent conflicts of interest
that could raise questions about their ability to detect violations of
and enforce securities laws.
Since the New York State Office of the Attorney General (NYSOAG) made
public its discovery of mutual fund trading abuses in September 2003,
that office, SEC, the NASD, which regulates broker-dealers that may
offer mutual funds to their customers, and certain other state
regulators have pursued enforcement actions for two principal types of
mutual fund violations--market timing and late trading.[Footnote 3]
Market timing typically involves the frequent buying and selling of
mutual fund shares by sophisticated investors, such as hedge funds,
that seek opportunities to make profits on the differences in prices
between overseas and U.S. markets.[Footnote 4] As frequent trading can
harm mutual fund shareholders through lowered fund returns and
increased transaction costs, many mutual fund companies have disclosed
limits in their fund prospectuses on the number of trades individual
customers may place per year. Although market timing is not itself
illegal, it can constitute illegal conduct if, for example, investment
advisers (firms that may manage mutual fund companies) enter into
undisclosed agreements with favored customers permitting them to trade
frequently and in contravention of the fund prospectuses--as certain
investment advisers did prior to September 2003. Another type of
violation commonly referred to as late trading was significant but less
widespread than market timing violations. Unlike market timing, late
trading is illegal. It occurs when investors place orders to buy or
sell mutual fund shares after the mutual fund has calculated the price
of its shares, usually once daily at the 4:00 p.m. Eastern Time (ET)
market close, but receive that day's fund share price.[Footnote 5]
Investors who are permitted to late trade can profit on the knowledge
of events in the financial markets that take place after 4:00 p.m., an
opportunity that other fund shareholders do not have. Although late
trading can involve mutual fund company personnel, late trading
violations have typically occurred at intermediaries, such as broker-
dealers, before these institutions submit their daily aggregate orders
to mutual fund companies for final settlement.
Because of your interest in ensuring the effective enforcement of
federal securities laws and effective federal-state coordination, you
asked that we assess a range of issues associated with SEC's market
timing and late trading enforcement actions. Specifically, our report:
* compares the severity of civil money penalties (penalties) obtained
in the mutual fund cases with penalties obtained in the past and with
similarly egregious cases, reviews SEC's penalty-setting process in
these cases, and discusses SEC's coordination with state authorities in
pursuing civil enforcement actions;[Footnote 6]
* provides information on state and federal criminal enforcement
actions for market timing and late trading violations;
* assesses SEC's management procedures for making referrals to DOJ and
state authorities for potential criminal prosecution; and:
* evaluates SEC's procedures for ensuring compliance with federal laws
and regulations that govern employees' ability to negotiate and take
positions with regulated entities, such as mutual fund companies.
To respond to the first objective, we obtained copies from SEC of
enforcement actions and settlement orders related to the mutual fund
trading abuses and cases of comparable egregiousness. We also obtained
information from SEC, the Commodity and Futures Trading Commission
(CFTC), the Office of the Comptroller of the Currency (OCC), and NASD
on the criteria and processes they use to determine penalties and data
on the highest penalties they have obtained in settlement. The data we
obtained from SEC allowed us to compare the penalties obtained in the
mutual fund trading abuse cases to the penalties obtained in past
cases. To determine the consistency of SEC's penalty-setting process in
the mutual fund trading abuse cases, we reviewed a selection of 11 out
of the 14 enforcement actions SEC brought against investment advisers
charged with market timing abuses. We also obtained information from
states that coordinated settlement negotiations with SEC in bringing
their own enforcement actions against several of the same investment
advisers involved in SEC's 14 settled enforcement actions. To respond
to the second objective, we interviewed SEC staff and NYSOAG, Wisconsin
Attorney General's Office, and DOJ officials and obtained copies of
criminal complaints related to late trading and market timing. To
respond to the third objective, we obtained information from SEC, CFTC,
and NASD on the procedures these agencies follow for making criminal
referrals to DOJ and states. To respond to the fourth objective, we
reviewed the policies and procedures of SEC, OCC, the Federal Reserve
Banks of Chicago and New York, and NASD for promoting staff compliance
with federal laws limiting the seeking of employment opportunities and
postemployment activities of federal executive employees and, in the
case of NASD and the Federal Reserve Banks, codes of ethics that also
include seeking employment restrictions for their employees. We
performed our work in Boston, Mass; Chicago, Ill; Denver, Colo; New
York, N.Y; Philadelphia, Penn; and Washington, D.C., between May 2004
and May 2005 in accordance with generally accepted government auditing
standards. Appendix I provides a detailed description of our scope and
methodology.
Results in Brief:
The penalties SEC obtained in the market timing and late trading cases
are among the highest in the agency's history and generally consistent
with penalties obtained in cases involving similarly egregious
corporate misconduct. Additionally, SEC appears to have followed its
process for setting penalties consistently in determining penalties in
the cases we reviewed. Since September 2003, SEC has brought 14
enforcement actions against investment advisers primarily for market
timing abuses and 10 enforcement actions against broker-dealer,
brokerage-advisory, and financial services firms that conducted or
facilitated improper or illegal trading. Penalties that SEC obtained in
settling the 14 enforcement actions with investment advisers range from
$2 million to $140 million, with an average penalty of about $56
million. In contrast, SEC penalties in cases for securities law
violations issued prior to January 2003 were generally less than $20
million. SEC's penalties in the investment adviser cases also are
generally consistent with penalties the agency has obtained in
settlements resulting from recent investment banking analyst and
corporate accounting fraud cases, which SEC staff identified as
involving similarly egregious misconduct.[Footnote 7] In addition to
actions against advisers, SEC brought enforcement actions against 24
individuals, many of them high-ranking company executives. SEC has
obtained penalties as high as $30 million against investment adviser
executives (among the highest penalties obtained in individual cases)
and barred some individuals from their industry for life. In
determining appropriate penalties to recommend to the Commission in the
investment adviser cases we reviewed, SEC staff consistently applied
criteria that the agency has established. These criteria require SEC to
consider such things as the egregiousness of the conduct, the amount of
harm caused, and the degree of cooperation as well as to compare
proposed penalties with penalties obtained in similar cases. SEC staff
may also consider litigation risks in determining appropriate
penalties. For example, if SEC pursues an overly aggressive penalty, a
defendant may be less likely to settle and a judge or other arbitrator
may not agree with SEC's analysis and impose a lesser penalty. A range
of SEC officials participate in SEC's process for setting appropriate
penalties--including the Commissioners--to help ensure that no one
individual or small group has disproportionate influence over the final
decision. Moreover, SEC has coordinated penalties and disgorgement
(which forces firms to forfeit ill-gotten monetary gain) with state
authorities in many of its market timing and late trading cases,
although some states obtained additional monetary sanctions.
State and federal criminal prosecutors told us that while they have
recently investigated market timing conduct, they have generally not
pursued criminal prosecution in those cases. They have, however,
brought criminal charges in cases involving late trading violations.
These officials said that the criminal prosecution of market timing is
complicated by the fact that market timing conduct itself is not
illegal. Although SEC instituted administrative proceedings in the
investment adviser cases discussed above by alleging that the
undisclosed market timing conduct involved constituted securities
fraud, both federal and state criminal prosecutors told us they
reviewed cases involving such conduct and generally concluded that they
did not warrant criminal fraud prosecutions. Federal officials did
identify one instance of market timing conduct that led to the
initiation of criminal proceedings; however, an undisclosed market
timing arrangement was not central to the criminal allegations. The
case involved a broker-dealer's alleged efforts to facilitate and
conceal short-term trading by its customers despite warnings from
mutual fund companies that such trades would not be accepted. In
contrast, NYSOAG and DOJ have brought at least 12 criminal prosecutions
against individuals involving late trading violations. For example,
NYSOAG charged a former executive and senior trader of a prominent
hedge fund with conducting late trading on behalf of the fund through
certain registered broker-dealers. This individual pled guilty in the
New York State Supreme Court. According to DOJ officials, criminal
prosecution of late trading is fairly straightforward because the
practice is a clear violation of federal securities laws.
SEC staff said that as state and federal criminal prosecutors were
already aware of and generally evaluated the mutual fund trading abuse
cases for potential criminal violations on their own initiative, they
did not need to make specific criminal referrals to bring these cases
to their attention. However, in the course of our review we found that
SEC's capacity to effectively manage its overall criminal referral
process may be limited by inadequate recordkeeping. SEC rules provide
agency staff with what they characterize as "formal" and "informal"
procedures to use when making referrals to appropriate authorities if
the facts of a particular investigation indicate potential criminal
violations. Formal referral procedures, which according to SEC staff
have not been used for over 20 years, require that the Director of
Enforcement review cases to be recommended for criminal prosecution in
coordination with the Office of the General Counsel and, according to
Enforcement staff, that the Commission approve the recommended
referrals. Under the informal procedures, SEC regional management staff
or their designees are allowed to contact federal or state authorities
and apprise them of a particular case. Although SEC procedures provide
for informal referrals and such referrals may be efficient, the process
as currently implemented does not provide critical management
information. In particular, SEC does not require staff to document the
reasons for making an informal referral or even whether such a referral
has been made. SEC staff told us that such documentation would not aid
them in managing the referral process as they already have in place
processes to ensure that appropriate referrals are made. However,
without such documentation, the Commission cannot readily determine and
verify whether staff make appropriate and prompt referrals. This lack
of recordkeeping is inconsistent with federal internal control
standards, which recommend that documentation be designed to provide
evidence that management directives have been carried out, and with the
practices of other financial regulators such as CFTC and NASD, which
maintain records on referrals. Documentation of referrals might serve
as an additional internal indicator of the effectiveness of SEC's
referral process and would also be important for congressional
oversight of law enforcement efforts in the securities industry.
While SEC provides training and guidance to staff on federal laws and
regulations regarding employment with regulated entities and requires
former staff to notify SEC if they plan to make an appearance before
the agency, it does not require departing staff to report where they
plan to work. In contrast, OCC and two Federal Reserve Banks obtain
information on where departing staff will be employed to assess the
potential for violations of employment restrictions. NASD also obtains
information on departed employees' subsequent employment with member
firms. Officials from three of these agencies said that they also ask
for this information to assess whether the quality of the employee's
prior regulatory work could have been compromised by a potential
conflict of interest with the employee's new place of employment.
According to SEC staff, they have not tracked postemployment
information because SEC examiners and other staff are highly aware of
employment-related restrictions. Further, SEC staff said that since
agency examiners have traditionally visited mutual fund companies
periodically to conduct examinations, they are less likely to face
potential conflicts of interest than bank examiners who may be located
full-time at large institutions. However, SEC staff have told us that
as part of recently implemented and planned changes to their mutual
fund oversight program, they are assigning monitoring teams to the
largest and highest-risk mutual fund companies. The teams would have
more regular contact with fund management over a potentially longer
period of time. In addition, a new SEC rule requiring all mutual fund
companies and investment advisers to designate chief compliance
officers may increase an existing demand for SEC examiners to fill open
positions in the compliance departments at regulated entities.[Footnote
8] As a result, the potential for employment conflicts of interest
might increase.
This report contains recommendations related to improving SEC
documentation of informal referrals and the postemployment plans of
departed staff. SEC provided written comments on a draft of this report
that are reprinted in appendix II. SEC agreed with the recommendations
and noted that it will take steps to implement them as part of other,
ongoing efforts to modify the forms Enforcement staff use to record
investigation-related information and to enhance staff awareness of the
conflict-of-interest issues associated with seeking employment and
postemployment. SEC's comments are discussed in greater detail at the
end of this report. SEC also provided technical comments, which have
been incorporated as appropriate.
Background:
Although typically organized as a corporation, a mutual fund's
structure and operation differ from those of a traditional corporation.
In a typical corporation, the firm's employees operate and manage the
firm, and the corporation's board of directors, elected by the
corporation's stockholders, oversees its operations. Mutual funds also
have a board of directors that is responsible for overseeing the
activities of the fund and negotiating and approving contracts with an
adviser and other service providers for necessary services.[Footnote 9]
Unlike a typical corporation, a typical mutual fund has no employees;
it is created and operated by another party, the adviser. The adviser
is an investment adviser/management company that manages the fund's
portfolio according to the objectives and policies described in the
fund's prospectus.[Footnote 10] The adviser contracts with the fund,
for a fee, to administer its operations. These fees are typically based
on the size of assets under management. In managing the fund's assets,
the adviser owes a fiduciary duty to the investors in the mutual funds
to act for the benefit of the investors and not use the fund's assets
to benefit itself.
Mutual funds are subject to SEC oversight and are regulated primarily
under the Investment Company Act of 1940 (1940 Act) and the rules it
has adopted under that act. SEC has authority under this act to
promulgate rules to address a constantly changing financial services
industry environment in which mutual funds and other investment
companies operate. The advisory firms that manage mutual funds are
regulated under the Investment Advisers Act of 1940 (Advisers Act),
which requires certain investment advisers to register with SEC and
conform to SEC regulations designed to protect investors. In addition
to its rulemaking authority, SEC carries out its mutual fund oversight
responsibilities through examinations. SEC's Office of Compliance
Inspections and Examinations (OCIE) establishes examination policies
and procedures and has primary responsibility for conducting mutual
fund company examinations.
SEC is vested with the authority to bring civil enforcement actions
against individuals and companies that violate provisions of the 1940
Act, the Advisers Act, and other federal securities laws and
regulations. While SEC has civil enforcement authority only, it works
with various federal and state criminal law enforcement agencies
throughout the country to develop and bring criminal cases when the
misconduct warrants more severe action. SEC carries out its enforcement
activities through Enforcement. Enforcement identifies potential
securities laws violations through referrals from SEC examiners or
other regulatory organizations such as NASD, tips from securities
industry insiders or the public, the press, and its own surveillance of
the marketplace. After conducting an investigation, Enforcement staff
present their findings to the Commission for its review and approval.
The Commission can authorize staff to bring an enforcement action in
federal court or through administrative proceedings.
When bringing a civil enforcement action in federal court, SEC files a
complaint with a U.S. District Court that describes the misconduct,
identifies the laws and rules violated, and identifies the sanction or
remedial action that is sought. Administrative proceedings differ from
civil enforcement actions brought in federal court in that they are
heard by an administrative law judge (ALJ), who is independent of SEC.
The ALJ presides over a hearing and considers the evidence presented by
Enforcement staff, as well as any evidence submitted by the subject of
the proceeding. SEC may also enter into settlements with defendants who
choose not to contest the charges against them. In a typical settlement
of an administrative proceeding, the defendant neither admits nor
denies the violation of the securities laws and agrees to the
imposition of sanctions. According to senior Enforcement staff, both
SEC and the defendants have an incentive to avoid litigation and seek a
settlement, as litigation is costly and time-consuming.
SEC can seek a variety of sanctions against defendants in federal court
or as part of administrative proceedings. These include officer and
director bars and monetary sanctions, such as disgorgement and
penalties. The amount of disgorgement SEC seeks in a particular case is
usually determined by the amount of monetary gain, if any, realized
from the violative conduct. SEC can use these funds to compensate
investors harmed by the misconduct. Penalties, on the other hand, are
intended to punish wrongdoing and deter others from engaging in similar
misconduct. The Sarbanes-Oxley Act of 2002 (SOX) authorizes federal
courts and SEC to establish "fair funds" to compensate victims of
securities violations.[Footnote 11] Section 308(a) of SOX provides that
if in an administrative or a civil proceeding involving a violation of
federal securities laws an order requiring disgorgement is entered, or
if a person agrees in settlement to the payment of disgorgement, any
penalty assessed against such person may, together with the
disgorgement amount, be deposited into a fair fund and disbursed to
victims of the violation pursuant to a distribution plan approved by
SEC.
The Securities Enforcement Remedies and Penny Stock Reform Act of 1990
(Remedies Act)[Footnote 12] amended existing federal securities laws to
authorize SEC and federal district courts to impose penalties for
securities violations other than insider trading, for which penalties
were already authorized.[Footnote 13] The Remedies Act specifies the
maximum penalty that SEC can seek in administrative proceedings from a
firm or individual in noninsider trading cases according to a three-
tier framework, which allows for increasing penalties based on the
presence of fraud and harm to investors (see table 1).[Footnote 14] For
example, if SEC finds that a firm's securities law violations did not
involve fraud or cause substantial harm to investors, a tier one
penalty may be appropriate. In that case, the maximum penalty SEC can
seek would be $65,000 per violation. However, if SEC finds that a
firm's misconduct involved fraud and caused substantial harm to
investors, it can apply the third tier maximum penalty--$650,000 per
violation.
Table 1: Statutory Maximums for SEC Penalties in Noninsider Trading
Securities Violations, Adjusted for Inflation:
Tier: 1;
Maximum penalty amount for firm (individual): $65,000 ($6,500) per
violation.
Tier: 2;
Maximum penalty amount for firm (individual): $325,000 ($65,000) per
violation when the violation involved fraud, deceit, manipulation, or
deliberate or reckless disregard of a regulatory requirement.
Tier: 3;
Maximum penalty amount for firm (individual): $650,000 ($130,000) per
violation when, in addition to satisfying the requirements of a second
tier penalty, the violation directly or indirectly resulted in
substantial losses or created a significant risk of substantial losses
to other persons.
Source: Adjustment of Civil Monetary Penalties - 2005, 70 Fed. Reg.
7,606 (2005) (to be codified at 17 C.F.R. § 201.1003 and Table III).
[End of table]
Although the Remedies Act requires that in order to impose a penalty in
an administrative proceeding SEC must find that the penalty is in the
public interest, the act did not impose criteria that SEC must consider
in making this determination. Instead, the Remedies Act provides a
nonexclusive list of factors that SEC may consider, such as whether the
conduct involved fraud or directly or indirectly resulted in harm to
other persons. Enforcement staff told us that over the years SEC has
internally developed more extensive criteria based on this guidance,
case law, and policy directives from the Commission, which are
documented for Enforcement staff in internal division memorandums.
These criteria include:
* the egregiousness of conduct--whether it involved fraud, and if so,
the degree of scienter present;[Footnote 15]
* the degree of harm to investors resulting from the conduct;
* the extent of the defendant's cooperation;
* whether the defendant derived any economic benefit from the conduct;
* the duration of the conduct;
* whether the defendant is a recidivist;
* the seniority of individuals that participated in the conduct;
* the need for deterrence;
* the defendant's ability to pay;
* the size of the firm or net worth of the individual; and:
* the penalties obtained in cases involving the same or a similar
scheme.
When negotiating settlements on behalf of the Commission, SEC
Enforcement staff apply these factors to the facts and circumstances of
each case when determining what penalty to seek. These criteria are
similar to the criteria other financial regulators use in their penalty-
setting process, including CFTC, OCC, and NASD.
One key factor for SEC in effectively fulfilling law enforcement
objectives such as penalty-setting is the implementation of appropriate
internal controls. According to the Standards for Internal Control in
the Federal Government, internal controls (also called management
controls) comprise the plans, methods, and procedures used to meet
missions, goals, and objectives and, in doing so, support performance-
based management.[Footnote 16] They are a major part of managing an
organization. Among other things, they should promote the effectiveness
and efficiency of operations, including the use of the entity's
resources, and the agency's compliance with applicable laws and
regulations. They should also be designed to provide reasonable
assurance that the objectives of the agency are being achieved.
SEC Consistently Applied Penalty-Setting Procedures in Mutual Fund
Cases and Coordinated Most Monetary Sanctions with States:
SEC has responded to the widespread trading abuses in the mutual fund
industry by bringing 14 enforcement actions against investment advisers
and 10 enforcement actions against broker-dealer, brokerage-advisory,
and financial services firms that conducted or facilitated the illicit
trading. Penalties SEC has obtained in settlements with these firms
have included some of the highest in the agency's history and are
consistent with other penalties obtained in cases of similarly
egregious and pervasive misconduct. Further, SEC has held individuals,
many of them high-ranking, responsible for their role in the misconduct
and also obtained historically high penalties in settlements with
several of them. In reviewing a selection of 11 out of the 14
enforcement actions SEC brought against investment advisers and their
associated individuals, we found that SEC consistently applied its
penalty-setting process and that this process contained various levels
of review to help ensure that no one individual or group of individuals
had disproportionate influence on penalty decisions. Additionally, SEC
coordinated penalties and disgorgements (which force firms to give up
ill-gotten gains) with interested states in the majority of cases,
although some states obtained additional monetary sanctions.
Penalties in Mutual Fund Trading Abuses Cases Are among SEC's Highest
and Are Consistent with Penalties in Similarly Egregious Cases:
Since NYSOAG announced its discovery of the trading abuses in the
mutual fund industry in September 2003, SEC has brought 14 enforcement
actions against investment advisers primarily for market timing abuses
and 10 enforcement actions against broker-dealer, brokerage-advisory,
and financial services firms for market timing abuses and late trading.
SEC has entered into settlements in all 14 investment adviser cases and
obtained penalties ranging from $2 million to $140 million (see fig.
1). These penalties are among the highest SEC has ever obtained for
securities laws violations. Before January 2003, penalties SEC obtained
in settlement were generally under $20 million. In contrast, 11 of the
14 penalties obtained in the investment adviser cases are over $20
million, with 8 penalties at $50 million or more. Pursuant to the fair
fund provision of SOX, SEC plans to use the penalties and disgorgement
moneys, a total of about $800 million and $1 billion, respectively, to
provide restitution to harmed investors.[Footnote 17] In addition to
settling with investment advisers, as of February 28, 2005, SEC has
settled with two broker-dealers, two insurance companies, and one
brokerage-advisory firm, with penalties totaling $17.5 million.
Figure 1: SEC Settlements with Investment Advisers for Market Timing
Abuses as of February 28, 2005 (in thousands of dollars):
[See PDF for image]
[A] The entities named in this column are investment advisers
associated with these cases. In some cases, SEC simultaneously charged
other entities, such as an associated investment adviser, distributor,
or broker-dealer for their roles in the market timing abuses. The
penalties and disgorgements shown for each case are the totals obtained
in settlement from all the entities associated with the case.
[B] Bank of America settled charges involving both abusive market
timing and late trading on the part of its investment adviser and
broker-dealer subsidiaries, respectively.
[C] Fremont Investment Advisors, Inc., settled charges involving both
abusive market timing and late trading.
[End of figure]
The penalties SEC obtained in the 14 investment adviser cases are also
consistent with penalties obtained in settled enforcement actions in
two types of cases that senior Enforcement staff identified as being as
egregious as the mutual fund trading abuses--the recent corporate
accounting fraud and investment banking conflict-of-interest cases. The
recent, large corporate accounting frauds surfaced in late 2000 and
concerned publicly traded companies that allegedly used fraudulent
accounting techniques to inflate their revenues and drive up stock
prices. The investment banking analyst cases involved several
investment firms that settled enforcement actions brought by SEC in
2003 for allegedly producing securities research that was biased by
investment banking interests. Table 2 compares the range of penalties
and average penalties SEC obtained from settlements of enforcement
actions brought against firms for mutual fund trading abuses, corporate
accounting fraud, and investment banking conflicts of interest.
Although particular penalties reflect the facts and circumstances of
each case, table 2 shows that the average penalties among the three
types of cases have generally been consistent (when excluding the
record $2.25 billion penalty obtained in a corporate accounting fraud
case), particularly when compared with the lower penalties obtained in
past years. In a public speech, the Director of Enforcement said that
the comparatively large penalties in these cases represented an effort
to increase accountability and enhance deterrence in the wake of such
extreme misconduct in the securities industry and noted that such
penalties create powerful incentives for firms to institute
preventative programs and procedures. Others, however, including two
members of the Commission, have questioned the appropriateness of these
relatively large penalties, particularly for public companies, arguing
that the cost of penalties are borne by shareholders who are frequently
also the victims of the corporate malfeasance.
Table 2: Average Penalties in SEC Settlements with Investment Advisers,
Public Companies, and Investment Firms:
Case type: Investment adviser;
Number of settled enforcement actions: 14;
Range of penalties: $2--$125 million;
Average penalty: $56 million.
Case type: Public company;
Number of settled enforcement actions: 11;
Range of penalties: $3--$250 million, $2.2 billion;
Average penalty: $61.5 million[A].
Case type: Investment firm;
Number of settled enforcement actions: 12;
Range of penalties: $5--$150 million;
Average penalty: $43 million.
Source: SEC.
[A] The average penalty SEC obtained in settled enforcement actions
involving corporate accounting fraud at public companies does not
include its record $2.2 billion penalty obtained in its settlement with
WorldCom, Inc., in July 2003. A federal district court order that the
penalty would be satisfied, post bankruptcy, by the company's payment
of $500 million in cash and the transfer of common stock in the
reorganized company valued at $250 million to a court-appointed
distribution agent.
[End of table]
Further, the penalties SEC has obtained in the mutual fund and other
recent scandals are generally higher than those obtained in settlement
by NASD and other federal financial regulators. For example, NASD has
also brought nine enforcement actions against broker-dealers for market
timing and late trading abuses and obtained penalties ranging from
$100,000 to $1 million. Similarly, CFTC and OCC have obtained
consistently lower penalties in settlement. For example, as of December
2004, the highest penalties OCC and CFTC obtained were for $25 million
and $35 million, respectively.
In addition to bringing enforcement actions against firms, SEC has held
individuals responsible for their roles in the trading abuses. As of
February 28, 2005, SEC had brought enforcement actions against 24
individuals and settled with 18, obtaining penalties and industry bars
in all cases and disgorgement from some (see table 3). Almost all of
these settled enforcement actions involved high-level executives,
including eight chief executive officers (CEO), chairmen, and
presidents. Penalties SEC obtained in these settlements ranged from
$40,000 to $30 million. The penalties obtained from 3 individuals are
among the four highest in SEC's history--one for $30 million (the
highest) and two for $20 million. SEC also obtained a combined $150
million in disgorgement from these three individuals.[Footnote 18] In
addition, as part of its settlements, SEC permanently barred 5
individuals, including the 3 mentioned above, from association with
investment advisers, investment companies, and in some cases other
regulated entities, and barred the remaining 13 for various periods
from their industries.
Table 3: Penalties SEC Obtained in Settlement from Individuals Charged
in Investment Adviser Cases:
Individuals charged, by investment adviser case[A]: Strong Capital
Management, Inc;
* Founder and former chairman[B];
Penalty: $30 million;
* Former executive vice president[B];
Penalty: $375,000;
* Former director of compliance[B];
Penalty: $50,000.
Individuals charged, by investment adviser case[A]: Pilgrim Baxter &
Associates, Ltd;
* Former president[B];
Penalty: $20 million;
* Former chief executive officer (CEO)[B];
Penalty: $20 million.
Individuals charged, by investment adviser case[A]: Invesco Funds
Group, Inc;
* Former CEO;
Penalty: $500,000;
* Chief investment officer;
Penalty: $150,000;
* National sales manager;
Penalty: $150,000;
* Assistant vice president of sales;
Penalty: $40,000.
Individuals charged, by investment adviser case[A]: Massachusetts
Financial Services, Co;
* Former president;
Penalty: $250,000;
* Former CEO;
Penalty: $250,000.
Individuals charged, by investment adviser case[A]: RS Investment
Management, LP;
* CEO;
Penalty: $150,000;
* Chief financial officer;
Penalty: $150,000.
Individuals charged, by investment adviser case[A]: Columbia Management
Advisors, Inc;
* Former portfolio manager;
Penalty: $100,000;
* Former chief operating officer;
Penalty: $100,000;
* Former national sales manager;
Penalty: $50,000.
Individuals charged, by investment adviser case[A]: Banc One Investment
Advisors, Corporation;
* Former CEO of related fund;
Penalty: $100,000.
Individuals charged, by investment adviser case[A]: Fremont Investment
Advisers, Inc;
* Former CEO;
Penalty: $100,000.
Individuals charged, by investment adviser case[A]: Total;
Penalty: $72,515,000.
Source: SEC.
[A] Some individuals charged in the investment adviser cases had more
than one title with the investment adviser or with an associated
entity, such as the related mutual fund. Unless otherwise indicated,
the position indicated refers to the position the individual held with
the investment adviser.
[B] SEC permanently barred this individual from association with
certain regulated entities, including investment advisers and
investment companies.
[End of table]
SEC Consistently Weighed Penalty Determinations Using Established
Criteria and Procedures among the Investment Adviser Cases We Reviewed:
In reviewing 11 of the 14 settled enforcement actions related to the
investment adviser cases, we found that SEC followed a similar penalty-
setting process in each of them. SEC regional staff in the six offices
that were part of our review generally began their penalty analysis by
determining the amount of money earned by the firms and individuals
from the abusive market timing and the economic harm such trading
caused to investors. For example, as a measure of monetary gain, staff
determined the fees the firms earned on the assets market timers
invested short-term for market timing purposes.[Footnote 19] As a
measure of harm to fund investors, staff determined the amount of
dilution to fund shares that occurred as a result of this improper
trading, using the same methodology for each case.[Footnote 20] SEC's
Office of Economic Analysis, which determined this methodology,
assisted staff with these analyses. Staff assessments of monetary gain
and harm caused were also used to help them determine appropriate
disgorgement.
After establishing the economic benefit and harm caused, staff
generally then determined the monetary range within which they could
seek a penalty by calculating the maximum penalty that applied to their
particular case. According to SEC staff at several regional offices,
the penalty statutes did not limit them from seeking penalties they
thought appropriate, largely because the statutes leave it up to SEC to
define the term "violation."[Footnote 21] Staff did not necessarily
seek the statutory maximum in these cases because they considered SEC
criteria for assessing the relative egregiousness of the misconduct and
in some cases concluded that it warranted a lesser penalty, and also
because they considered the risk that the case would be litigated
instead of settled. For example, in one case where staff could have
argued a statutory maximum of $1 billion based on the hundreds of
improper trades found, staff said they could not have made a convincing
argument for such a high penalty based on the relatively small amount
of economic harm and level of scienter involved (scienter refers to the
requisite degree of knowledge that makes a person's actions culpable).
These staff told us that even if they disregarded SEC criteria and
sought the maximum it was very unlikely that they would have achieved
an amount close to it. The staff said that the firm involved would
never have settled and it was unlikely that the judge or ALJ assigned
to the case would have found staff's underlying rationale for the
penalty recommendation credible. As judges and ALJs make independent
determinations of the facts when determining whether a penalty or other
sanctions are warranted, staff said that they may decide on a lesser
penalty than what staff recommended. For that reason, staff said that
while the penalty statutes provide a baseline for their analysis, they
seek penalties in settlement that reflect the facts and circumstances
of the case and the penalties obtained in similar cases.
To determine a penalty appropriate to the facts and circumstances of
each case, SEC staff used the criteria discussed earlier to establish
the egregiousness of the case relative to that of other market timing
and late trading cases--considering, for example, the level of scienter
involved, the amount of harm caused and benefit gained, the level of
cooperation, and the seniority of the individuals involved. We found
that staff sought penalties that reflected these differences. Barring
the presence of aggravating or mitigating factors, conduct perceived as
more egregious received relatively greater penalties. For example, the
highest penalty that SEC obtained from an individual in the market
timing and late trading cases was from the former founder and chairman
of an investment adviser who SEC found to have market timed the funds
he managed for his own personal gain. Regional staff said that this
individual's $30 million penalty was merited because as the most senior
official in the firm, he was duty-bound to protect the interests of all
fund investors and should have set an example in proper ethical conduct
for the rest of the firm's employees. Instead, SEC found that he
continued his market timing activities even after compliance officials
at the firm detected his improper trading and counseled him to cease.
Further, this was the second time he had been the subject of an SEC
enforcement action--in 1994, SEC charged him with improper personal
trading in the fund's portfolio securities. Finally, they said he
cooperated very little in the investigation.
In some cases we found that where SEC perceived a high level of
egregiousness, the presence of other factors mitigated a more severe
penalty determination, such as the degree of cooperation or the firm's
ability to pay. For example, staff required firms that argued they
could not pay the penalty initially sought to provide documentation of
any financial constraints and the financial consequences of paying the
higher penalty.
Regional staff regularly consulted with senior Enforcement staff in
preparing their penalty recommendations. Enforcement's Office of the
Chief Counsel is responsible for reviewing all sanction
recommendations, including penalties, for consistency with penalties
recommended in analogous cases. This office reviewed all of the penalty
and other sanctions recommended in the 11 cases we reviewed.
Additionally, staff shared information about penalty-setting in the
market timing and late trading settlements with a range of agency
officials outside of Enforcement. Once staff had negotiated with the
defendant the amount of the disgorgement and penalties and the
application of other sanctions they believed were appropriate for a
case and obtained a formal offer of settlement from the defendant,
staff prepared a memorandum for the Commission describing the
settlement offer and their rationale for recommending that the
Commission accept it. For example, the memorandums explained how the
disgorgement figure related to any calculations of economic benefit or
harm and discussed the factors most relevant to the penalty analysis.
Before sending the memorandum to the Commission for review and
approval, other interested SEC divisions and offices, such as
Investment Management, Corporation Finance, and the Office of the
General Counsel, first reviewed it. Enforcement staff said that by
asking staff from other areas of SEC to review their sanction
recommendations, they help ensure that no one individual or small group
has a disproportionate influence over the penalty recommended to the
Commission and that the penalty reflects the Commission's policy goals.
The Commission either approved the settlement terms outlined in the
memorandum or advised Enforcement as to any adjustments they wanted
made, which staff then renegotiated with the defendants.
SEC Coordinated Penalties and Disgorgement with States in the Majority
of Settlements with Investment Advisers, but Some States Obtained
Additional Sanctions:
SEC coordinated penalties and disgorgements with interested states in
many of the settled enforcement actions related to late trading and
market timing. For example, in 11 cases, three states (New York,
Colorado, and New Hampshire) coordinated their settlement negotiations
with SEC, agreeing to seek the same disgorgement and penalty amounts
and requiring in their individual settlement orders that the payments
be remitted to and administered by SEC pursuant to the related SEC
settlement order. As a result of this collaboration, the penalty moneys
collected in these cases can be used to compensate harmed investors,
under the fair fund provision of SOX. In one case, a state required a
separate, duplicative payment from one firm of disgorgement and
penalties, but SEC noted in its own settlement order that it had
considered this fact when seeking penalties against the subject firm.
While in most cases states agreed to the same penalty and disgorgement
as SEC and to have the payments made directly to SEC, some states, most
notably New York, obtained additional monetary sanctions. In addition
to disgorgement and penalties, NYSOAG ordered most of the investment
advisers with whom it settled to reduce the fees that they charge
mutual fund investors over the next 5 years. The value of these
reductions totaled about $925 million and in some cases more than
doubled the value of the disgorgement and penalties SEC obtained in an
individual case. According to NYSOAG, these investment advisers did not
just allow improper market timing and late trading, but they had also
charged mutual fund investors significantly more in fees than
institutional investors for similar services. NYSOAG said that the SEC
settlements focusing on disgorgement and penalties for trading abuses
did not compensate investors who were overcharged and that the fee
reductions it obtained provided this needed restitution.
In conjunction with the settlement order related to one investment
adviser case, the Commission issued a public statement on its position
regarding fee reductions. The Commission stated that it did not seek
fee reductions with this investment adviser because this sanction did
not serve its law enforcement objectives. First, the Commission said
that there were no allegations that the fees charged by the adviser in
question were illegally high. Fee reductions would provide compensation
to investors who were not harmed by the market timing abuses SEC set
forth in the settlement order. Second, they said that mandatory fee
discounts would require that customers do business with the firms to
receive the benefits of the fee reductions (meaning that prior
customers that received allegedly illegal prices but already redeemed
their shares would not benefit). For those reasons, the Commission said
that their efforts focused on addressing the market timing abuses by
providing full compensation to investors harmed by this activity and a
significant up-front penalty.
In addition to NYSOAG, Colorado and New Hampshire also obtained
additional monetary sanctions in its settlements in three investment
adviser cases. Colorado required the firms involved in two cases to pay
$1 million and $1.5 million, respectively, to reimburse its costs and
for consumer and investor education and future enforcement activities
within that state. New Hampshire required the firm involved in another
case to pay $1 million for investor education and protection purposes
and an additional $100,000 to defray the costs of the investigation.
Several Factors Have Complicated Criminal Prosecution of Market Timing,
but State and Federal Authorities Have Brought Criminal Charges in Late
Trading Cases:
After NYSOAG announced its discovery of mutual fund trading abuses in
September 2003, officials from that office, DOJ, and SEC told us that
they met to discuss potential criminal violations in cases involving
these abuses and clarify subsequent investigative responsibilities and
coordination. Other state officials told us they also reviewed cases
involving mutual fund trading abuses for criminal potential. These
officials said that the criminal prosecution of market timing is
complicated by the fact that market timing conduct itself is not
illegal. DOJ officials told us that they have brought criminal charges
in cases where late trading occurred, primarily because late trading is
a clear violation of federal securities laws and authorities can
readily prosecute cases once evidence of late trading is established.
Several Factors Have Complicated Criminal Prosecution of Market Timing
Cases:
Officials from DOJ, NYSOAG, and the Wisconsin Attorney General's Office
told us that they have declined to bring criminal charges for market
timing conduct, largely because market timing itself is not illegal. In
instituting administrative proceedings in the 14 investment adviser
cases discussed above, SEC alleged that the undisclosed market timing
conduct involved constituted securities fraud, conduct expressly
prohibited under federal securities laws. According to DOJ officials,
although state and federal criminal prosecutors can also seek criminal
sanctions for securities fraud, such prosecutions may be more difficult
to prove than civil actions. DOJ officials told us that criminal
prosecutors must be able to prove beyond a reasonable doubt that the
defendant committed fraud, whereas civil authorities generally need
only show that a preponderance of the evidence indicated a fraudulent
action. According to DOJ and NYSOAG officials, for a variety of reasons
their review of cases involving market timing arrangements concluded
that they did not warrant criminal fraud prosecutions.[Footnote 22] For
example, in commenting on one case involving an investment adviser's
undisclosed market timing arrangement, the Wisconsin Attorney General
stated that the risk in trying to convince a jury beyond a reasonable
doubt that the particular behavior was criminal motivated his office
and other state prosecutors to instead pursue a civil enforcement
action.
According to a recent law journal article, the ambiguous nature of some
funds' prospectus language may have further weakened the ability of
federal and state prosecutors to bring criminal charges against
investment advisers that allowed favored investors to market
time.[Footnote 23] The article stated that it is often unclear whether
and to what extent a fund prohibits market timing. For example, many
mutual funds merely "discouraged" market timing to the extent that it
caused "harm" to the funds. According to the article, such language is
subject to various interpretations as to what constitutes discouraging
and what constitutes harm to fund performance. Further, it stated that
even prospectus disclosures that allow a specific number of exchanges
can be ambiguous because the term "exchange" is subject to various
interpretations. Such ambiguities may hamper criminal prosecutors'
efforts to prove that the market timing arrangements constituted a
willful intent to defraud.[Footnote 24]
As of March 31, 2005, federal prosecutors have brought one criminal
case involving abusive market timing. However, this case involved a
broker-dealer's alleged efforts to facilitate and conceal short-term
trading by its customers despite warnings from mutual fund companies
that such trades would not be accepted, as opposed to allegations of
undisclosed arrangements between a mutual fund company and favored
customers. In that case federal prosecutors filed a criminal complaint
alleging securities fraud and conspiracy charges against three top
executives at this firm. The complaint alleges that these individuals
devised and executed a number of deceptive practices to circumvent
market timing restrictions placed on their firm by mutual funds
companies. These deceptive practices allegedly included creating and
using multiple account numbers for the same client and executing trades
through multiple clearing firms. As of March 31, 2005, these
individuals were awaiting trial.
Most Criminal Cases Brought Have Been Based on Late Trading Charges:
NYSOAG and DOJ have brought at least 12 criminal prosecutions against
individuals for charges that include late trading. The individuals
charged included high-level executives, traders, and other employees of
three broker-dealers, two banking-related organizations, and one hedge
fund who allegedly either conducted or facilitated late trading for
others in mutual fund shares. In one case, NYSOAG charged a former
executive and senior trader of a prominent hedge fund with conducting
late trading on behalf of that firm through certain registered broker-
dealers in violation of New York's state securities fraud
statute.[Footnote 25] This individual pleaded guilty in the New York
State Supreme Court. In another case brought by DOJ, prosecutors
charged several broker-dealers with conducting late trading for their
clients. According to DOJ officials, criminal prosecution of late
trading is fairly straightforward because the practice is a clear
violation of federal securities laws.[Footnote 26]
Inadequate Documentation Procedures Limit SEC's Capacity to Effectively
Manage the Criminal Referral Process:
SEC staff said that as state and federal criminal prosecutors were
already aware of and generally evaluated the mutual fund trading abuse
cases for potential criminal violations on their own initiative, they
did not need to make specific criminal referrals to bring these cases
to their attention. However, in the course of our review, we found that
SEC's capacity to effectively manage its overall criminal referral
process may be limited by inadequate recordkeeping. SEC rules provide
for what SEC staff characterize as both formal and informal processes
for making referrals for criminal prosecutions; however, senior
Enforcement staff told us that SEC uses only the informal procedures
for making criminal referrals, describing them as less time-consuming
and more effective than the more cumbersome formal processes. While
potentially efficient, SEC's informal procedures do not provide
critical management information on the referral process. Specifically,
SEC staff do not document referrals or reasons for making them.
According to federal internal control standards, policies and
procedures, including appropriate documentation, should be designed to
help ensure that management's directives are carried out. Without
proper documentation, SEC cannot readily determine and verify whether
staff make appropriate and prompt referrals. Documentation of referrals
might serve as an additional internal indicator of the effectiveness of
SEC's referral process and is also important for congressional
oversight of law enforcement efforts in the securities industry.
SEC Prefers Informal Procedures for Making Criminal Referrals:
SEC rules set forth what SEC staff characterize as "formal" and
"informal" procedures for making referrals for criminal prosecution.
Under what SEC staff described as the formal referral procedures, the
Director of Enforcement reviews cases to be recommended for criminal
prosecution in coordination with the Office of the General Counsel,
and, according to senior Enforcement staff, seeks Commission
authorization for the recommended referral. Senior Enforcement staff
told us that SEC has not used the formal procedures in over 20 years
because the Commission has given the ability for making informal
criminal referrals to Enforcement staff. According to these staff, the
Commission found that it was approving all formal staff requests to
make criminal referrals, so it was more efficient to give SEC staff the
authority to make the referrals themselves. Under these more informal
procedures, staff at the assistant director level or higher have
delegated authority to communicate with other agencies regarding cases
of mutual interest, including referring cases for criminal
prosecution.[Footnote 27]
According to senior Enforcement staff and regional staff, if staff
attorneys uncover what they believe might be criminal violations, they
inform their assistant director and other management officials about
such findings. Staff at the assistant director or associate director
level decide whether the staff's findings merit a criminal referral,
and if so, call the local U.S. Attorney's Office or other criminal
authority to see whether they have an interest in the case.[Footnote
28] According to SEC staff, if the criminal authority is interested in
the case they send a letter requesting formal access to SEC's
investigative files for that case. These staff said that the primary
benefit of the informal referral process is that it allows for an
efficient flow of information between agencies. For example, SEC staff
can tip off DOJ about potential criminal cases and DOJ officials also
can call SEC and make informal referrals of cases for potential civil
prosecution.
While Potentially Efficient, Informal Procedures Do Not Provide
Critical Management Information on the Referral Process:
Although SEC's informal procedures may make the communication of
criminal violations to DOJ efficient and enable an effective
cooperative relationship between the agencies, they do not include
requirements for the documentation of these referrals. Currently,
Enforcement staff do not document what cases have been referred, to
whom, or why. Senior Enforcement staff told us that the documentation
of criminal referrals was unnecessary for several reasons. First, they
said that such documentation would not aid them in managing the
referral process, as they already have processes to ensure that cases
with criminal potential are appropriately referred. For example, in
addition to the day-to-day monitoring of cases at the associate
director level, which results in informal referrals to criminal
authorities, the Director or Deputy Director of Enforcement conducts
quarterly reviews of SEC's case inventory to ensure, among other
things, that referrals are being made. Further, they said that
Commission members as a matter of course question staff about their
cooperation with criminal authorities when staff request approval for
an enforcement action. Second, they said that since the wave of high
profile corporate accounting scandals that began in 2000, DOJ has had
unprecedented interest in pursuing securities fraud cases. According to
SEC staff, senior DOJ officials discuss cases of mutual interest with
SEC staff in regular joint meetings and as part of federal regulatory
and law enforcement working groups of which both SEC and DOJ are
members.[Footnote 29] SEC staff cited the recent cooperation between
criminal law enforcement and SEC in the mutual fund cases as a good
example of how well these processes work in alerting criminal
prosecutors to appropriate cases. Further, they said that as each local
U.S. Attorney's Office (USAO) sets its own prosecutorial priorities,
the most effective way for SEC staff to learn what each USAO considers
a useful referral is through strong, informal relationships.
While such informal relationships between SEC and criminal law
enforcement authorities might be essential to their effective
cooperation, appropriate documentation of decision-making is an
important management tool. According to federal internal control
standards previously discussed, policies and procedures, including
appropriate documentation, helps ensure that management directives are
carried out. Internal control procedures include a wide range of
diverse activities such as authorizations, verifications, and the
creation and maintenance of related records that provide evidence that
these activities were executed. Without such documentation, the
Commission cannot readily determine and verify whether staff make
appropriate and prompt referrals. Also, the Commission does not have an
institutional record of the types of cases that are referred over the
years. Such information is essential for appropriate management and
oversight of the referral process. For example, although Enforcement
staff told us that the director's quarterly review of cases involves a
discussion of cooperative law enforcement activities, they said that it
does not include a written report on criminal referrals made. Instead,
the director must informally poll his staff if he wants to develop a
list of such referrals, which introduces the likelihood of reporting
error. Similarly, in conducting our work, SEC was unable to tell us
what cases had been referred to criminal law enforcement without
contacting staff assigned to the case or directing us to do the same.
Further, we found that other financial regulators such as NASD and CFTC
record their criminal referrals to manage their referral processes.
Documentation of referrals might also serve as an additional internal
indicator of the effectiveness of SEC's referral process.
In addition to aiding SEC management, information about the number,
type, and reasons for SEC criminal referrals could also serve as an
important tool for congressional oversight. Although SEC does not have
jurisdiction over DOJ and other criminal law enforcement authorities
and is not responsible for their decision to act or not upon a
referral, the maintenance of evidence of SEC referrals could serve as
verification that criminal authorities were made aware of appropriate
cases. For example, senior Enforcement staff told us that prior to the
corporate accounting fraud scandals, DOJ was not as interested as it is
now in pursuing securities fraud. In an environment where changing
priorities can influence the types of cases criminal law enforcement
agencies pursue, the documentation of referrals would provide some
assurance that SEC is consistently considering cases for potential
criminal prosecution.
SEC Efforts to Encourage Staff Compliance with Federal Conflict-of-
Interest Laws on New Employment Do Not Include Tracking Post-SEC
Employment Plans:
SEC provides training and guidance to its staff on federal laws and
regulations regarding employment with regulated entities and also
requires former staff to notify SEC if they plan to make an appearance
before the agency. However, SEC does not require departing staff to
report where they plan to work as do other financial regulators.
According to SEC staff, they have not tracked postemployment
information because SEC examiners and other staff are highly aware of
employment-related restrictions. SEC staff also said that since agency
examiners have traditionally visited mutual fund companies periodically
to conduct examinations, they are less likely to face potential
conflicts of interest than bank examiners who may be located full-time
at large institutions. Nonetheless, SEC staff have told us that as part
of recently implemented and planned changes to SEC's mutual fund
oversight program they are assigning monitoring teams to the largest
and highest-risk mutual fund companies. The teams would have more
regular contact with fund management over a potentially longer period
of time. In addition, a new SEC rule requiring all mutual fund firms to
designate a chief compliance officer may increase an existing demand
for SEC examiners to fill open positions in the compliance departments
at regulated entities. As a result, the potential for employment
conflicts of interest might increase.
SEC Offers Ethics Training and Counseling Services to Employees on
Federal Employment Restrictions but Does Not Ask Where Employees Plan
to Work:
Federal laws place restrictions on the postfederal employment of
executive branch employees. Specifically, these laws generally prohibit
federal executive branch employees from participating personally and
substantially in a particular matter that a person or organization with
whom the employee is negotiating prospective employment has a financial
interest.[Footnote 30] For example, a senior staff member of SEC's
Ethics Office told us that as a result of this law, SEC examiners and
enforcement staff cannot negotiate employment with a firm that is the
subject of an ongoing examination or enforcement action in which they
have direct involvement, although they are not prohibited from
obtaining employment with such firms after the completion of the
examination or enforcement action in which they had such involvement.
However, federal law prohibits former federal executive branch
employees from "switching sides" and representing their new employer
before any federal court or agency concerning any matter in which the
employees were personally and substantially involved during the time of
their federal employment.[Footnote 31] According to the SEC ethics
staff, if a former SEC examiner accepted employment with a firm that
the examiner had previously examined, the examiner would be permanently
barred from communicating with SEC regarding the examination in which
he or she had participated. In addition, former senior employees are
prohibited for a period of 1 year following federal employment from
communicating with or appearing before their former federal employer on
behalf of anyone with the intent to influence agency action. This
"cooling-off' period is 2 years concerning any matter that was pending
under a former employee's official responsibility during the 1-year
period prior to termination of federal employment.[Footnote 32]
Violation of either the "seeking employment" or postfederal employment
activity restrictions can result in civil and criminal sanctions.
The SEC Ethics Office provides annual ethics training and offers ethics
counseling to SEC examiners, Enforcement staff, and other employees to
explain these and other conflict-of-interest laws and how to avoid
violating them. Further, under SEC rules, former SEC staff are required
to file a notice with SEC within 10 days after being employed or
retained as the representative of any person outside of the government
in any matter in which an appearance before, or communication with, SEC
or its employees is contemplated.[Footnote 33] This notice must include
a description of the contemplated representation, an affirmative
statement that the former employee did not have either personal and
substantial responsibility or official responsibility for the matter
that is the subject of the representation while employed by SEC, and
the name of the SEC division or office in which the former employee had
been employed. Senior Ethics Office staff said that upon receiving
these notices they verify with the former division or office that the
contemplated representation does not involve a matter that the person
had responsibility for during his or her employment with SEC.
While these notices provide SEC with information on some employees'
postemployment activities and allow SEC to monitor compliance with
postfederal employment activity restrictions, they do not provide SEC
with information on the postemployment plans of all of its departing
staff at the time they announce their intention to leave the agency.
SEC currently does not require departing staff to report where they
plan to work, a procedure required by other financial regulators to
better ensure that seeking employment restrictions have not been
violated. For example, OCC and the Federal Reserve Banks of New York
and Chicago obtain information from departing staff, or at least
examination staff in the case of the Federal Reserve Banks, on where
they are going to work.[Footnote 34] NASD also tracks information on
departing staff's subsequent employment with member firms, although
they do not ask staff directly for it.[Footnote 35] Officials from
three of these agencies said that they also ask for this information to
assess whether the quality of the employee's prior regulatory work
could have been compromised by a potential conflict of interest with
the employee's new place of employment. For example, when departing
examiners, enforcement attorneys, and other professional staff go to
work for a bank with whom they have recently been involved in a
regulatory matter, OCC requires a review of their related work
products, as does the Federal Reserve Bank of New York for departing
examiners.[Footnote 36] Similarly, NASD requires staff to conduct a
reexamination of a member firm if that firm hires an employee who was
involved in a recent examination of that firm or a review of the
related examination workpapers if the employee was a former supervisor,
assistant/associate director, or attorney who reviewed or worked on the
examination. SEC currently does not require similar workpaper reviews
or reexaminations.[Footnote 37]
Changes to SEC Examination Program and Potential Increased Private
Sector Demand for Examiners Could Increase Conflicts of Interest and
Need for Postemployment Tracking:
According to senior staff from SEC's Office of Compliance Inspections
and Examinations (OCIE), which administers SEC's nationwide examination
program for investment companies and other regulated entities,
postemployment tracking has not been viewed as essential because SEC
examiners face fewer potential conflicts of interest than bank
examiners. Senior OCIE staff told us that unlike bank examiners, SEC
examiners typically participate in multiple examinations in the course
of the year. Banking regulators, on the other hand, often have
examiners stationed permanently on site at the largest financial
institutions.[Footnote 38] OCIE staff said that because SEC examiners
do not have prolonged contact with management at regulated entities,
there is little opportunity for them to develop the type of
relationships that could lead to conflicts of interest.
However, recently implemented and planned changes to SEC's mutual fund
oversight program might increase the potential for employment conflicts
of interest. As part of these changes (which we review in a forthcoming
report), OCIE is creating monitoring teams of two or three examiners to
be assigned to review the operations and activities of the largest and
highest-risk mutual fund companies on an ongoing basis, as opposed to
conducting periodic routine examinations. We note that SEC's planned
approach for large mutual fund companies is intended to be similar to
the bank regulators' approach to bank supervision at large financial
institutions, in which teams are assigned full-time to monitor the
largest institutions. Such an approach would increase the contact SEC
examiners have with fund management and potential for conflicts of
interest.
Further, SEC's new rule requiring all mutual fund firms to designate a
chief compliance officer may increase an existing demand for SEC
examiners and other staff to fill open positions at the compliance
departments of regulated entities. SEC examiners told us that departing
SEC examiners commonly obtained employment in the compliance
departments of regulated entities. Further, these examiners and
securities industry officials told us that having former SEC staff at
these firms was very beneficial because SEC staff have expertise in
compliance issues and are compliance-oriented. One securities industry
official said former SEC examiners and other staff are a natural source
of expertise for firms that were involved in the recent mutual fund
trading abuses and that want to correct their problems. While the
compliance departments at regulated entities may benefit by hiring
experienced SEC staff, an increase in the employment potential of
examiners and other staff at these firms could also increase the
potential for conflicts of interest.
Conclusions:
After the mutual fund trading abuses were uncovered in September 2003,
SEC acted swiftly to bring enforcement actions against prominent firms
and individuals involved in the misconduct and obtained some of its
highest penalties in history from them in settlements. SEC has also
consistently applied its procedures for establishing such penalties.
However, we identified weaknesses in SEC's internal controls that may
limit its capacity to effectively manage its criminal referral process.
Currently, SEC does not require staff to document that a referral has
been made to a federal or state criminal investigative authority or the
reasons for such referrals. According to federal internal control
standards, such documentation is important for verifying that
management directives have been carried out. Without such
documentation, SEC's ability to measure the performance of its criminal
referral process and to help ensure effective congressional oversight
of that process is limited.
We also found that SEC has not established controls that could help
ensure the independence of staff from the fund industry as they carry
out SEC's critical oversight work. Although SEC provides ethics
training to its employees regarding seeking employment and
postemployment conflict-of-interest laws, the agency does not require
departing staff to provide information on their future employment
plans. In the absence of such information, SEC's capacity to ensure
compliance with conflict-of-interest laws related to postemployment
opportunities is limited. Further, SEC does not have procedures in
place requiring review of departing employees' workpapers should a
potential conflict of interest be discovered. SEC's recently
implemented and planned changes to its mutual fund examination program
that will likely involve greater contact between examiners and company
officials as well as the potential that agency staff will seek to
become compliance officers underscore the need for the agency to ensure
compliance with these critical conflict of interest laws.
Recommendations:
To strengthen SEC's management procedures and better ensure that agency
responsibilities are being met, the SEC Chairman should ensure that the
agency take the following two actions:
* document informal referrals to criminal authorities for potential
criminal prosecutions and the reasons for such referrals; and:
* request that departing employees provide the name of their next
employer as part of exit procedures and establish procedures to review
the departing employees' related work products if a potential conflict
of interest is determined to exist.
Agency Comments and Our Evaluation:
SEC provided written comments on a draft of this report, which are
reprinted in appendix II. SEC also provided technical comments, which
were incorporated into the final report, as appropriate. SEC agreed
with our recommendations. SEC indicated that it is in the process of
converting its investigation opening form to a web-based application,
which will provide for documentation of informal referrals to criminal
authorities. SEC also noted steps it is taking to avoid conflicts of
interests that could affect the implementation of SEC programs and
activities, which include establishing a formal ethics component to
exit procedures. As part of this process, SEC will ask departing staff
to provide information about the identity of their next employer, and,
to the extent a potential conflict is identified, will investigate as
appropriate.
As agreed with your office, unless you publicly announce the contents
of this report earlier, we plan no further distribution of this report
until 30 days from the report date. At that time we will provide copies
of this report to SEC and interested congressional committees. We will
also make copies available to others upon request. In addition, the
report will be available at no cost on GAO's Web site at http://
www.gao.gov.
If you or your staff have any questions about this report, please
contact Wesley M. Phillips, Assistant Director, or me at (202) 512-
8678. GAO staff who made major contributions to this report are listed
in appendix III.
Richard J. Hillman:
Director, Financial Markets and Community Investment:
[End of section]
Appendix I: Scope and Methodology:
The objectives of our report were to (1) compare the severity of civil
money penalties (penalties) obtained in the mutual fund cases with
penalties obtained in the past and with similarly egregious cases,
review the Securities and Exchange Commission's (SEC) penalty-setting
process in these cases, and discuss SEC's coordination with state
securities regulators in civil enforcement actions; (2) provide
information on state and federal criminal enforcement actions regarding
market timing and late trading violations; (3) assess SEC's management
procedures for making referrals to the Department of Justice (DOJ) and
state authorities for potential criminal prosecution; and (4) evaluate
SEC's procedures for ensuring compliance with federal laws and
regulations that govern employees' ability to negotiate and take
positions with regulated entities, such as mutual fund companies.
To compare the severity of penalties obtained in the mutual fund cases
with penalties obtained in the past and with similarly egregious cases,
review SEC's penalty-setting process in these cases, and discuss SEC's
coordination with state securities regulators in civil enforcement
actions, we obtained copies of SEC enforcement actions and settlement
orders related to market timing and late trading cases and compared
them to corporate accounting fraud and investment banking analyst
cases, which SEC staff identified as similar to the mutual fund cases
in the egregiousness and pervasiveness of misconduct. We obtained these
documents from SEC's Web site and SEC staff reviewed the list of cases
we compiled for accuracy. We then calculated and compared the average
penalties obtained in these three types of cases. We also obtained data
from SEC on the 30 highest penalties obtained from entities in
settlement, according to their records, and similar data for
individuals. This data allowed us to compare the penalties obtained in
the mutual fund trading abuse cases to the penalties obtained in past
cases. In addition, we obtained information from SEC, the Commodity and
Futures Trading Commission (CFTC), the Office of the Comptroller of the
Currency (OCC), and the NASD on the criteria and processes they use to
determine penalties and data from CFTC and OCC on their highest
settlements and from NASD on its mutual fund trading abuse settlements.
Then, to determine whether SEC used its criteria and processes
consistently when evaluating what penalties to seek in the late trading
and market timing cases, we reviewed documentation pertaining to a
selection of 11 out of 14 enforcement actions SEC brought against
investment advisers charged with market timing abuses. These 11 cases
were distributed among six regional SEC offices. We interviewed
regional examiners and attorneys assigned to each case and reviewed the
related investigative record. For example, we reviewed enforcement
actions and settlement orders, staff analyses of economic harm caused
and benefit gained, memorandums from the Division of Enforcement to the
Commission, and SEC examinations for each of these investment advisers
and their associated fund companies dating back several years. The
mutual fund companies we chose to review were among the 100 largest
mutual fund companies nationwide, as measured by the size of customer
assets under management as of August 1, 2003. We also interviewed two
legal scholars and economists who have conducted recent research on SEC
penalties or mutual fund trading abuses to obtain additional views on
SEC's penalty-setting process. In addition, we interviewed securities
regulators or law enforcement officials from three states that
coordinated settlement negotiations with SEC in bringing their own
enforcement actions against investment advisers involved in 11 of the
14 SEC enforcement actions mentioned above and obtained copies of the
related enforcement actions and settlement orders from their Web sites.
These regulatory or law enforcement entities were the New York State
Office of the Attorney General (NYSOAG), the Colorado Attorney
General's Office, and the New Hampshire Bureau of Securities
Regulation.
To provide information on state and federal criminal enforcement
actions regarding market timing and late trading violations, we
interviewed staff from SEC, NYSOAG, the Wisconsin Attorney General's
Office, and DOJ and obtained copies of late trading and market timing-
related criminal complaints from the Web sites of the relevant federal
or state criminal authorities.
To assess SEC's management procedures for making referrals to DOJ and
state authorities for potential criminal prosecution, we reviewed SEC
rules governing these referrals and interviewed staff from SEC, DOJ,
and NYSOAG. We also interviewed officials from NASD and CFTC on their
referral procedures and obtained copies of relevant rules and policies.
We evaluated SEC's referral procedures using Standards for Internal
Controls in the Federal Government.[Footnote 39]
To evaluate SEC's procedures for ensuring compliance with federal laws
and regulations that govern employees' ability to negotiate and take
positions with regulated entities, such as mutual fund companies, we
reviewed applicable laws and regulations, interviewed staff from and
reviewed the policies and procedures of SEC, OCC, the Federal Reserve
Banks of Chicago and New York, and NASD for promoting staff compliance
with federal laws limiting the seeking of employment opportunities and
postemployment activities of federal executive employees and, in the
case of the Federal Reserve Banks and NASD, codes of ethics that also
include seeking employment restrictions.
We performed our work in Boston, Mass; Chicago, Ill; Denver, Colo; New
York, N.Y; Philadelphia, Penn; and Washington, D.C., between May 2004
and May 2005 in accordance with generally accepted government auditing
standards. SEC provided written comments on a draft of this report,
which are reprinted in appendix II. Our evaluation of these comments is
presented in the agency comments section.
[End of section]
Appendix II: Comments from the Securities and Exchange Commission:
UNITED STATES SECURITIES AND EXCHANGE COMMISSION:
450 Fifth Street, N.W.
Washington, D.C. 20549:
DIVISION OF ENFORCEMENT:
April 28, 2005:
Mr. Richard J. Hillman:
Director:
Financial Markets and Community Investment:
U.S. Government Accountability Office:
441 G Street, N.W.:
Washington, DC 20548:
Re: Mutual Fund Trading Abuses:
Thank you for the opportunity to review and comment on the draft report
primarily concerning the Securities and Exchange Commission's
("Commission") penalties in settled mutual fund market timing and late
trading cases. The report discusses how well the Commission's Division
of Enforcement adhered to policy in setting the penalties. In addition,
it makes recommendations regarding criminal referrals and procedures
regarding employees' compliance with laws related to new employment.
I appreciate the collegiality with which your staff worked to prepare
the report and discussed the report's findings and recommendations with
my staff. As the report points out, the Division of Enforcement has
consistently applied Commission policy in setting penalties.
Furthermore, we agree with your findings and recommendations, and have
already decided to implement them. Our specific comments are as
follows:
I. Documenting Informal Criminal Referrals:
The draft report found that the Commission's procedures for making
informal criminal prosecution referrals do not require documentation of
the referral. The draft report recommends that we document informal
criminal referrals, including the types of cases referred, and the
reasons for such referrals. We agree with this finding and
recommendation. We are in the process of converting our investigation
opening form to a web-based application, which will provide for
documentation of informal referrals to criminal authorities. By
modifying the form, we will record the types of matters that are
informally referred to criminal authorities and provide the reasons for
the referral.
II. Employee Exit Procedures:
The draft report also recommends that the agency head should ensure
that the agency "requests that departing employees provide the name of
their next employer as part of exit procedures and, if a potential
conflict of interest is determined to exist, establish procedures to
review the departing employee's related work products, as appropriate."
The Commission is committed to avoiding even the appearance that
conflicts of interest could affect the implementation of Commission
programs and activities. To that end, the Commission is undertaking the
following actions: increasing the number of ethics liaison officers who
are employed in the exam program; increasing the amount of training
related to seeking employment and post-employment issues with a
particular emphasis on training current employees about the potential
issues regarding former employees; and establishing a formal ethics
component to exit procedures. As part of this exit process employees
will be asked to provide information about the identity of their next
employer. Should a potential conflict be identified, the Commission
will investigate, as appropriate.
We appreciate the care that is evident in the draft report and its
recommendations. If we can be of any further assistance, please contact
me at (202) 942-4500 or Joan McKown at 942-4530.
Yours truly,
Signed by:
Stephen M. Cutler:
Director:
[End of section]
Appendix III: Major Contributors to this Report:
GAO Contacts:
Richard J. Hillman (202) 512-8678;
Wesley M. Phillips (202) 512-5660:
Acknowledgments:
In addition to those named above, Fred Jimenez, Stefanie Jonkman, Marc
Molino, Omyra Ramsingh, Barbara Roesmann, Rachel Seid, David Tarosky,
and Anita Zagraniczny made key contributions to this report.
FOOTNOTES
[1] For purposes of this report, "mutual fund companies" generally
refer to mutual fund companies and their related investment advisers
and service providers, such as transfer agents, unless otherwise
specified. As described in this report, many mutual fund companies have
no employees, although they typically have boards of directors, and
rely on investment advisers to perform key functions such as providing
management and administrative services.
[2] Enforcement investigates possible violations of securities laws,
recommends Commission action when appropriate (either in a federal
court or before an administrative law judge), and negotiates
settlements on behalf of the Commission.
[3] NYSOAG uncovered the abuses in the summer of 2003 after following
up on a tip provided by a securities industry insider. We recently
issued a report identifying reasons why SEC did not detect these
trading abuses prior to September 2003. See GAO, Mutual Fund Trading
Abuses: Lessons Can Be Learned from SEC Not Having Detected Violations
at an Earlier Stage, GAO-05-313 (Washington, D.C.: Apr. 20, 2005).
[4] The term "hedge fund" generally identifies an entity that holds a
pool of securities and perhaps other assets that is not required to
register its securities offerings under the Securities Act and which is
excluded from the definition of investment company under the Investment
Company Act of 1940. Hedge funds are also characterized by their fee
structure, which compensates the adviser based upon a percentage of the
hedge fund's capital gains and capital appreciation. Pursuant to a new
rule recently adopted by SEC, advisers of certain hedge funds are
required to register with SEC under the Investment Advisers Act of
1940. See Registration Under the Advisers Act of Certain Hedge Fund
Advisers, 69 Fed. Reg. 72054 (2004) (to be codified in various sections
of 17 C.F.R. Parts 275 and 279).
[5] Under SEC rules, mutual fund companies accept orders to sell and
redeem fund shares at a price based on the current net asset value,
which most funds calculate once a day at the 4:00 p.m. ET close of the
U.S. securities markets.
[6] For purposes of this report, the term "penalties" refers to "civil
money penalties" authorized by applicable law.
[7] The investment analyst cases involved several investment firms who
allegedly provided securities research that was biased by investment
banking interests, while the corporate accounting fraud cases involved
publicly traded companies that allegedly used fraudulent accounting
techniques to inflate their revenues and thereby drive up stock prices.
[8] On December 17, 2003, SEC adopted compliance rules requiring all
investment companies and investment advisers registered with the agency
to adopt and implement policies and procedures designed to prevent
violations of the federal securities laws and to designate a chief
compliance officer to be responsible for administering such policies
and procedures. See Compliance Programs of Investment Companies and
Investment Advisers, 68 Fed. Reg. 74714 (2003) (to be codified at 17
C.F.R. § 270.38(a)-1 and 17 C.F.R. § 275.206(4)-7.
[9] Most funds are organized either as corporations governed by a board
of directors or as business trusts governed by trustees. When
establishing requirements relating to the officials governing a fund,
the act uses the term "directors" to refer to such persons, and this
report also follows that convention.
[10] In some cases, the adviser may contract with other firms to
provide investment advice, becoming a subadviser to those funds.
[11] Pub. L. No. 107-204, 116 Stat. 745 (2002) (codified in various
sections of the United States Code). The "fair fund" provision is
codified at 15 U.S.C. § 7246(a).
[12] The Securities Enforcement Remedies and Penny Stock Reform Act of
1990, Pub. L. No. 101-429, 104 Stat. 931 (codified in various sections
of Title 15).
[13] Section 2 of the Insider Trading Sanctions Act of 1984, Pub. L.
No. 98-376, 98 Stat. 1264 (codified as amended at 15 U.S.C. § 78u)
authorized the Commission to seek in federal district court civil money
penalties of up to three times the profit gained or loss avoided by a
person who commits illegal insider trading.
[14] Securities Enforcement Remedies and Penny Stock Reform Act of 1990
§§ 202, 301 and 401, 15 U.S.C. §§ 21B, 80a-9(d) and 80b-3(i). The
Federal Civil Penalties Inflation Adjustment Act of 1990, Pub. L. No.
101-410, 104 Stat. 890 (codified at 28 U.S.C. 2461, note) requires each
federal agency to adopt rules adjusting the maximum penalties it is
authorized by statute to seek for inflation at least once every 4
years. SEC most recently carried out this adjustment in February 2005.
See 70 Fed. Reg. 7606-08 (2005) (to be codified at 17 C.F.R. § 201.1003
and Table III).
[15] Scienter refers to the requisite degree of knowledge that makes a
person's actions culpable.
[16] GAO, Standards for Internal Control in the Federal Government,
GAO/AIMD-00-21.3.1 (Washington, D.C.: November 1999), which was
prepared to fulfill our statutory requirement under the Federal
Managers' Financial Integrity Act, provides an overall framework for
establishing and maintaining internal controls and for identifying and
addressing major performance and management challenges and areas at
greatest risk of fraud, waste, abuse, and mismanagement.
[17] We are reviewing SEC's implementation of the fair funds provision
of SOX as part of a forthcoming report.
[18] SEC obtained an additional $529,000 in disgorgement from five
other individuals.
[19] SEC also found that in some instances market timers invested
assets long-term in return for market timing privileges, which also
generated fees for the investment adviser.
[20] The frequent trading of mutual fund shares lowers, or dilutes, the
value of fund shares held by long-term fund investors. According to
experts, this dilution is approximately equal to the profits market
timers earn as a result of their short-term trading of the fund shares.
[21] For example, they said that they could count each type of
misconduct as one violation or count each instance of misconduct (such
as each improper market timing trade) as a separate violation.
[22] DOJ and NYSOAG officials said that the fact that a criminal case
has not been brought against an investment adviser to date for entering
into undisclosed market timing arrangements with favored investors does
not preclude them from bringing one in the future if they believe the
facts and circumstances warrant it.
[23] Roberto M. Braceras, "Late Trading and Market Timing," Securities
& Commodities Regulation, vol. 37, no. 7 (2004).
[24] On April 16, 2004, SEC adopted amendments to Form N-1A requiring
open-ended management investment companies (mutual funds) to disclose
in their prospectuses both the risks to shareholders of frequent
purchases and redemptions of the mutual fund's shares and the mutual
fund's policies and procedures with respect to such frequent purchases
and redemptions. If the mutual fund's board has not adopted such
policies and procedures, the mutual fund must disclose the specific
basis for the board's view that it is appropriate for the mutual fund
to not have such policies and procedures. These rules are intended to
require mutual funds to describe with specificity the restrictions they
place on frequent purchases and redemptions, if any, and the
circumstances under which any such restrictions will not apply. See
Disclosure Regarding Market Timing and Selective Disclosure of
Portfolio Holdings, 69 Fed. Reg. 22300 (2004) (amendments to Form N-1A;
text of the amendments do not appear in the Code of Federal
Regulations). Form N-1A is used by mutual funds to register under the
Investment Company Act of 1940 and to file a registration statement
under the Securities Act of 1933 to offer their shares to the public.
[25] The defendant pleaded guilty to a violation of New York's Martin
Act, General Business Law § 352-c(6). This individual also settled a
parallel civil enforcement action instituted by SEC. The SEC settlement
order found that this individual willfully aided and abetted and caused
violations of SEC Rule 270.22c-1 by engaging in late trading of mutual
fund shares on behalf of a hedge fund operator.
[26] The practice of placing an order after the calculation of net
asset value, but receiving the previously calculated net asset value is
a violation of SEC Rule 270.22c-1, the SEC's forward pricing rule. Rule
270.22c-1 requires funds, their principal underwriters, dealers, and
other intermediaries authorized to consummate transactions in fund
shares to assign the net asset value that is calculated after the
receipt of any purchase or redemption order.
[27] See 17 C.F.R. § 203.2, which authorizes Enforcement staff at the
assistant director level to communicate, or to authorize attorneys to
communicate, information gleaned from SEC investigations or
examinations to law enforcement authorities.
[28] Several regional assistant and associate directors told us that
when deciding whether to refer a case to DOJ they consider factors such
as the severity and seriousness of the conduct, whether the case is
outside SEC's jurisdiction (for example, obstruction of evidence is
outside of SEC's jurisdiction), and whether individuals involved have
previous records of illegal conduct.
[29] SEC is a member of the Corporate Fraud Task Force, Bank Fraud
Working Group, and the Commodities Fraud Working Group.
[30] 18 U.S.C § 208(a). Section 208(b) sets forth circumstances under
which exceptions to the prohibition may be granted.
[31] 18 U.S.C. § 207(a).
[32] 18 U.S.C. § 207(b).
[33] 17 C.F.R. § 200.735-8(b)(1). This rule applies to all former SEC
staff for 2 years after leaving the agency.
[34] The Federal Reserve Banks of Chicago and New York have codes of
ethics that contain seeking employment restrictions.
[35] According to NASD, every month NASD staff generate a list of
employees who have left the agency and submit this list to NASD's
Central Registration Depository (CRD), which is an electronic database
that contains information on the employees of member firms. If the CRD
identifies people from the list that are working at a member firm, NASD
determines whether these individuals were involved in an examination of
that firm within the last 12 months of their employment with NASD. NASD
also has a code of ethics that prohibits NASD employees from acting in
any NASD matter with whom the employee is seeking employment.
[36] Some senior bank examiners are prohibited by law from going to
work directly for a bank they were recently involved in examining.
Section 6303(b) of the Intelligence Reform and Terrorism Prevention Act
of 2004 amended Section 10 of the Federal Deposit Insurance Act to
prohibit former bank examiners from going to work for any depository
institution if, during their last year as an employee of a federal
banking regulator, they served more than 2 months as senior bank
examiner of that depository institution. This prohibition is in effect
for a period of one year after the termination of their employment with
the federal banking regulator. See Federal Deposit Insurance Act §
10(k), to be codified at 12 U.S.C. § 1820(k).
[37] Procedures such as asking departing staff where they are going to
work and reviewing their related work products when appropriate can
help provide reasonable assurance, not absolute assurance, that
conflicts of interests are avoided.
[38] According to one banking regulator, examiners of smaller banks
typically spend a few weeks on site while conducting their
examinations.
[39] GAO, Standards for Internal Control in the Federal Government,
GAO/AIMD-00-21.3.1 (Washington, D.C.: 1999)
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