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entitled 'Securities and Exchange Commission: Additional Actions Needed
to Ensure Planned Improvements Address Limitations in Enforcement
Division Operations' which was released on September 17, 2007.
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Report to the Ranking Member, Committee on Finance, U.S. Senate:
United States Government Accountability Office:
GAO:
August 2007:
Securities And Exchange Commission:
Additional Actions Needed to Ensure Planned Improvements Address
Limitations in Enforcement Division Operations:
Securities and Exchange Commission:
GAO-07-830:
GAO Highlights:
Highlights of GAO-07-830, a report to the Ranking Member, Committee on
Finance, U.S. Senate.
Why GAO Did This Study:
The Securities and Exchange Commission’s (SEC) Division of Enforcement
(Enforcement) plays a key role in meeting the agency’s responsibility
to enforce securities laws and regulations. While Enforcement has
brought a number of high-profile cases, questions have been raised over
how effectively the division manages its operations and resources. For
example, GAO has previously reported on challenges Enforcement faces in
managing its investigation information systems and overseeing the Fair
Fund program. Under this program, funds are distributed to investors
who have suffered losses resulting from securities fraud and other
violations.
GAO was asked to evaluate Enforcement’s (1) investigation planning and
information systems, and (2) oversight of the Fair Fund program.
Among other things, GAO analyzed SEC and Enforcement documents and data
and interviewed agency officials as well as consultants involved in
administering the Fair Fund program.
What GAO Found:
Enforcement’s processes and systems for planning, tracking, and closing
investigations had some significant limitations that hampered its
ability to effectively manage operations and allocate resources. While
SEC and Enforcement officials have begun addressing these issues,
additional actions would ensure that limitations identified in the
division’s operations are fully corrected. The following summarizes key
issues:
* In March 2007, Enforcement established a centralized process for
reviewing and approving new investigations. Unlike the previous
decentralized approach, the new process is designed to better
prioritize investigation staffing and to maintain quality control in
the investigative process. However, Enforcement has not yet established
written procedures and assessment criteria for reviewing and approving
new investigations; such procedures and criteria are needed to help
effectively manage the division’s operations and resources.
* By late 2007, Enforcement plans to update its current information
system for managing investigations with a new system that could
significantly enhance the division’s operations. However, Enforcement
has not taken sufficient steps to help ensure that data are entered
into the new system on a timely and consistent basis to maximize the
system’s usefulness as a management tool.
* In May 2007, Enforcement announced plans to better ensure the prompt
closure of investigations that are no longer being pursued. In the
past, the division has not always promptly closed many such
investigations, which may have resulted in negative consequences for
individuals and companies no longer suspected of securities violations.
While Enforcement’s plans to address this issue are positive, they will
not fully resolve the potentially large backlog of investigations that
have remained open for extended periods.
Enforcement’s approach to managing the Fair Fund program may have
contributed to delays in distributing funds to harmed investors. While
factors such as the complexity of identifying harmed investors and tax
issues likely contributed to some distribution delays, Enforcement’s
decentralized approach to managing the program may have created
inefficiencies. SEC has announced plans to centralize Fair Fund
management within a new office but has not yet defined the office’s
roles or described its responsibilities and procedures. Therefore, it
is too soon to assess how the new office will affect the Fair Fund
program.
What GAO Recommends:
GAO makes several recommendations to strengthen Enforcement’s
management of the investigation process and the Fair Fund program. In
written comments, SEC agreed with GAO’s conclusions and
recommendations.
[hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-07-830].
To view the full product, click on the link above. For more
information, contact Orice Williams at (202) 512-8678 or
williamso@gao.gov.
[End of section]
Contents:
Letter:
Results in Brief:
Background:
Enforcement Has Taken Steps to Better Manage the Investigative Process,
but These Steps May Not Fully Address Existing Limitations:
Enforcement's Management of Fair Funds May Have Contributed to
Distribution Delays, and the Division Lacks Data Necessary for
Effective Program Oversight:
Enforcement Coordinates Its Investigative Activities Internally and
with Other Agencies and Is in the Process of Documenting Criminal
Referrals:
Conclusions:
Recommendations for Executive Action:
Agency Comments and Our Evaluation:
Appendix I: Scope and Methodology:
Appendix II: Selected Division of Enforcement Investigation and
Personnel Data:
Appendix III: Comments from the Securities and Exchange Commission:
Appendix IV: GAO Contact and Staff Acknowledgments:
Tables:
Table 1: Roles and Responsibilities of SEC Divisions and Offices:
Table 2: The 10 Largest Fair Funds Ordered, as of June 2007:
Table 3: Fair Fund Orders and Distributions, as of June 2007:
Table 4: Ratio of Open Investigations to Staff Attorneys:
Table 5: Ratio of All Investigative (Staff and Supervisory) Attorneys
to Paralegals:
Table 6: Ratio of Staff Attorneys to Supervisory Attorneys:
Figures:
Figure 1: Organizational Structure of SEC's Enforcement Division Home
Office:
Figure 2: Number of Investigative Attorneys at Fiscal Year End, 2002-
2006:
Figure 3: Flowchart of SEC's Investigation and Enforcement Process:
Abbreviations:
AIG: American International Group, Inc.:
CATS: Case Activity Tracking System:
ERISA: Employee Retirement Income Security Act of 1974:
FINRA: Financial Industry Regulatory Authority:
MUI: matter under inquiry:
OCIE: Office of Compliance Inspections and Examinations:
OIT: Office of Information Technology:
OMB: Office of Management and Budget:
OMS: Office of Market Surveillance:
SEC: Securities and Exchange Commission:
SRO: self- regulatory organization:
[End of section]
United States Government Accountability Office:
Washington, DC 20548:
August 15, 2007:
The Honorable Charles E. Grassley:
Ranking Member:
Committee on Finance:
United States Senate:
Dear Senator Grassley:
The Securities and Exchange Commission's (SEC) ability to conduct
investigations and bring enforcement actions for violations of
securities laws is critical to its mission to protect investors and
maintain fair and orderly markets. SEC's Division of Enforcement
(Enforcement) is charged with investigating securities law violations;
recommending civil enforcement actions when appropriate, either in a
federal court or before an administrative law judge; and negotiating
settlements on behalf of the Commission. The types of sanctions that
Enforcement can seek on behalf of the Commission include monetary
penalties or fines and disgorgements of the profits that individuals or
companies may derive by having committed securities
violations.[Footnote 1] While SEC has only civil authority, it also
works with various law enforcement agencies, including the United
States Department of Justice (Justice), to bring criminal cases when
appropriate. In addition, Enforcement is responsible for overseeing the
Fair Fund program, which seeks to compensate investors who suffer
losses resulting from fraud or other securities violations by
individuals and companies.[Footnote 2] Under the Fair Fund program, SEC
can combine the proceeds of monetary penalties and disgorgements into a
single fund and then distribute the proceeds to harmed investors.
In recent years, Enforcement has initiated high-profile actions that
resulted in record civil fines against companies and senior officers
and in some cases contributed to criminal convictions.[Footnote 3]
However, the capacity of SEC in general and Enforcement in particular
to appropriately plan and effectively manage their activities and
fulfill their critical law enforcement and investor protection
responsibilities on an ongoing basis has been criticized in the past.
Although SEC received a substantial increase in its appropriations as a
result of the Sarbanes-Oxley Act of 2002, questions have been raised in
Congress and elsewhere on the extent to which the agency is using these
resources to better fulfill its mission.[Footnote 4] Moreover, we have
reported that aspects of Enforcement's information systems and
management procedures could limit the efficiency and effectiveness of
its operations.[Footnote 5] For example, we found in 2004 that
Enforcement faced challenges in developing the advanced information
technology necessary to facilitate the investigative process.[Footnote
6] In addition, we reported in 2005 that the distribution of funds to
harmed investors under the Fair Fund program was limited and that
Enforcement had not developed adequate systems and data to fulfill its
oversight responsibilities.[Footnote 7]
Because of your interest in ensuring that SEC effectively manages its
resources and helps ensure compliance with securities laws and
regulations, you requested that we review key Enforcement management
processes and systems and follow up on our previous work where
appropriate. Accordingly, this report evaluates Enforcement's (1)
internal processes and information systems for planning, tracking, and
closing investigations and planned changes to these processes and
systems; (2) implementation of SEC's Fair Fund program
responsibilities; and (3) efforts to coordinate investigative
activities with other SEC divisions and federal and state law
enforcement agencies.
To address all three objectives, we obtained and reviewed relevant SEC
and Enforcement documentation and data. Specifically, we reviewed
documentation and data relating to Enforcement's planning processes;
its automated system for tracking investigations and enforcement
actions--the Case Activity Tracking System (CATS)--and a planned
successor system; the Fair Fund program; and internal and external
coordination.[Footnote 8] We also reviewed our relevant prior reports
and federal standards for internal controls. Further, we interviewed
the SEC Chairman and two commissioners, senior agency and Enforcement
officials in Washington, and officials in three SEC regional offices
(Boston, New York, and Philadelphia) that are responsible for a
significant share of Enforcement's investigative activity. We also
contacted Enforcement officials in other SEC offices as appropriate.
Additionally, we interviewed consultants that assist Enforcement in
developing plans to distribute funds to harmed investors under the Fair
Fund program.
We conducted our work in Washington, D.C., Boston, Massachusetts, New
York, New York, and Philadelphia, Pennsylvania, between November 2006
and July 2007 in accordance with generally accepted auditing standards.
Appendix I explains our scope and methodology in greater detail.
Results in Brief:
Enforcement's processes and systems for planning, tracking, and closing
investigations have had some significant limitations that have hampered
the division's capacity to effectively manage its operations and
allocate limited resources. While Enforcement and SEC officials are
aware of these deficiencies and have recently begun addressing them,
additional actions are necessary to help ensure that the planned
improvements fully address limitations in the division's operations.
The following points summarize key issues:
* In March 2007, Enforcement said it would centrally review and approve
all new investigations of potential securities law violations by
individuals or companies. Under Enforcement's previous, largely
decentralized approach (senior Enforcement attorneys in the agency's
home and 11 regional offices could approve new investigations), the
division was not always able to ensure the efficient allocation of
resources or maintain quality control in the investigative process.
While the new centralized approach was designed to help address these
issues, Enforcement has not yet established written procedures and
criteria for reviewing and approving new investigations. Without such
procedures and criteria, Enforcement may face challenges in
consistently communicating the new approach to existing and new staff.
The lack of written procedures and criteria could also limit the
Commission's ability to evaluate the implementation of the new approach
and help ensure that the division is managing its operations and
resources efficiently.
* Recognizing that the division's current information system for
tracking investigations and enforcement actions--CATS--is severely
limited as a management tool, Enforcement plans to start using a new
system (the Hub) by late 2007. The deficiencies of CATS include its
inability to produce detailed reports on investigations of certain
types (for example, those for hedge funds) or the status of such
investigations.[Footnote 9] While the Hub is designed to address many
of CATS's deficiencies--it will, for example, be able to produce
detailed management reports on ongoing investigations--the way that the
system is being implemented may not address all existing limitations.
More specifically, Enforcement has not established written controls to
help ensure that staff enter investigative data in the Hub in a timely
and consistent manner. Without such controls, management reports
generated by the Hub may have limited usefulness, and the system's
capacity to assist Enforcement in better managing ongoing
investigations will not be fully realized.
* In May 2007, Enforcement implemented procedures to help ensure the
prompt closure of investigations that are no longer being pursued and
thereby better ensure the fair treatment of individuals and companies
under review, but these procedures do not fully address the entire
backlog of these investigations. One regional Enforcement official said
that as of March 2007, nearly 300 (about 35 percent) of the office's
840 open investigations were 2 or more years old, were no longer being
pursued, and had no pending enforcement actions.[Footnote 10]
Enforcement officials said that the failure to close such
investigations promptly could have negative consequences for
individuals and companies no longer suspected of having committed
securities violations. They attributed the failure to close many
investigations to several factors, such as time-consuming
administrative requirements for attorneys to prepare detailed
investigation closing memorandums that then must be routed to senior
division officials for review and approval. To address these issues,
Enforcement plans to inform individuals and companies more promptly
that they are no longer under review and expedite the review and
closure of the existing backlog of investigations for which
administrative tasks have been completed (as of March 2007, there were
464 such investigations). However, Enforcement's plans do not include
clearing the potentially large backlog of investigations for which such
administrative tasks have not been completed, which could be negatively
impacting individuals and companies no longer actively under review.
Enforcement's management of the Fair Fund program may have contributed
to delays in distributing funds to harmed investors, and the division
lacks data necessary for effective program oversight. For the 115 Fair
Funds currently tracked by Enforcement (which were created by federal
courts or through SEC administrative proceedings), only about $1.8
billion (about 21 percent) of the $8.4 billion ordered since the
program's inception in 2002 had been distributed to harmed investors as
of June 2007, according to SEC data.[Footnote 11] Enforcement officials
and consultants who administer Fair Fund plans have attributed the
limited payout rate to factors such as difficulties in identifying
harmed investors, the complexity of individual cases, and the need to
resolve related tax issues. However, Enforcement's largely
decentralized approach to managing the Fair Funds program may have also
contributed to distribution delays. While senior Enforcement officials
in Washington have a coordination and oversight role, staff attorneys
in either the home or the regional offices that brought the related
enforcement action are primarily responsible for overseeing consultants
who design and execute Fair Fund distribution plans. However, this
delegated management structure appears to have impeded the development
of uniform Fair Fund procedures that otherwise could have facilitated
the distribution of funds to harmed investors. In addition, Enforcement
officials said that the management structure diverts investigative
attorneys from their primary law enforcement mission. In response to
these concerns, in March 2007 SEC's Chairman announced a plan to
centralize the administration of the Fair Fund program within a new
office. However, it is too soon to assess how this new office will
affect the program because SEC has not yet staffed the office or
developed written guidance to define its role, responsibilities, and
procedures. Moreover, Enforcement does not yet systematically collect
or analyze key Fair Fund data, such as the administrative expenses that
consultants are incurring to design and execute Fair Fund plans, as we
recommended in 2005.[Footnote 12] While Enforcement officials agree
that reviewing such data would enhance their capacity to assess the
reasonableness of Fair Fund administrative costs, an information system
designed to collect and report such expense data for ongoing plans is
not expected to be completed until 2008. In the meantime, Enforcement
has not ensured that reports intended to provide expense data for
completed Fair Fund plans contain consistent information or are
analyzed.[Footnote 13] Without such information, Enforcement's Fair
Fund oversight capacity is limited.
Enforcement coordinates investigations and other activities with other
SEC divisions and outside law enforcement authorities and is
implementing our previous recommendation that it document referrals to
criminal investigative authorities. According to Enforcement officials,
they regard coordinating the division's investigative activities with
SEC's Office of Compliance Inspections and Examinations (OCIE) as
particularly important because OCIE staff regularly examine regulated
entities and have a broad understanding of the extent of their
compliance with laws and regulations. However, Enforcement officials
historically have been concerned that OCIE referrals lacked sufficient
information. As a result, Enforcement and OCIE have recently instituted
a new committee process to formally review such referrals and track
their outcome. Further, Enforcement officials said that the division
has established working relationships with U.S. attorney offices and
state securities regulators to leverage investigative resources.
Enforcement also held coordination conferences attended by federal and
state agencies. However, Enforcement is in the process of implementing
our 2005 recommendation to document informal referrals of potential
criminal matters, which it intends to do through the planned
investigation and enforcement action tracking system--the Hub.[Footnote
14] Until the system is in place, Enforcement cannot readily determine
and verify whether staff make appropriate and prompt referrals, and the
division lacks an institutional record of the types of matters that
have been referred over the years. Without such information,
Enforcement's ability to manage and oversee the referral process is
limited.
This report makes several recommendations designed to strengthen
Enforcement's management of the investigation process and the Fair Fund
program. In brief, the report recommends that the SEC Chairman direct
Enforcement and other agency offices, as appropriate, to (1) establish
written policies and assessment criteria for reviewing and approving
new investigations, (2) establish controls to better ensure the
reliability of investigative data entered into the Hub information
system, (3) consider developing expedited procedures for closing
investigations, and (4) establish a comprehensive plan to staff and
identify the roles and responsibilities of the new Fair Fund program
office and collect and analyze reports on completed Fair Fund plans.
We provided a draft of this report to SEC, and the agency provided
written comments that are reprinted in appendix III. In its written
comments, SEC agreed with our conclusions and stated that it would
implement all of our recommendations. Moreover, SEC officials noted
that the agency has since established that the new Fair Fund office--
referred to as the Office of Distributions, Collections and Financial
Management--will be located within the Division of Enforcement. SEC
said that a senior officer and two assistant directors will lead the
operations of the office and the agency is developing the office's
responsibilities. SEC also provided technical comments, which we have
incorporated as appropriate.
Background:
SEC is an independent agency created in 1934 to protect investors;
maintain fair, honest, and efficient securities markets; and facilitate
capital formation. The agency has a five-member Commission that the
President appoints, with the advice and consent of the Senate, and that
a Chairman designated by the President leads. The Commission oversees
SEC's operations and provides final approval of SEC's interpretation of
federal securities laws, proposals for new or amended rules to govern
securities markets, and enforcement activities. Table 1 identifies
several key SEC units and summarizes their roles and responsibilities.
Table 1: Roles and Responsibilities of SEC Divisions and Offices:
Division or office: Division of Enforcement;
Roles and responsibilities: Conducts investigations of registered
entities (such as broker-dealers and investment advisers) or
unregistered entities (such as unregistered and fraudulent securities
offerings over the Internet), recommends Commission action (either in a
federal court or before an administrative law judge), negotiates
settlements on behalf of the Commission, and works with criminal law
enforcement agencies when warranted.
Division or office: Division of Corporation Finance;
Roles and responsibilities: Reviews corporate disclosures, assists
companies in interpreting the Commission's rules, and recommends new
rules for adoption.
Division or office: Division of Market Regulation;
Roles and responsibilities: Establishes and maintains standards for
fair, orderly, and efficient markets by regulating the major securities
market participants, including broker-dealers, self-regulatory
organizations (SRO), transfer agents (parties that maintain records of
stock and bond owners), and securities information processors.[A].
Division or office: Division of Investment Management;
Roles and responsibilities: Regulates the investment management
industry and administers the securities laws affecting investment
companies and advisors.
Division or office: Office of the Chief Accountant;
Roles and responsibilities: Establishes and enforces accounting and
auditing policy to enhance financial reporting and improve the
professional performance of public company auditors.
Division or office: Office of Compliance Inspections and Examinations;
Roles and responsibilities: Administers a nationwide examination and
inspection program for registered SROs, broker-dealers, transfer
agents, clearing agencies, and investment companies and advisors to
quickly and informally correct compliance problems.
Division or office: Office of Economic Analysis;
Roles and responsibilities: Serves as the chief advisor to the
Commission and its staff on all economic issues associated with the
SEC's regulatory activities, analyzes the likely consequences of
proposed regulations, and engages in research to support longer term
SEC policy initiatives and plans.
Division or office: Office of General Counsel;
Roles and responsibilities: Represents SEC in various proceedings,
prepares legislative materials, and provides independent advice and
assistance to the Commission, divisions, and offices.
Division or office: Office of Investor Education and Assistance;
Roles and responsibilities: Provides information to investors, seeks
informal resolutions of complaints, and collects data on investor
contacts to track trends in the security industry and provide
intelligence to other SEC divisions and offices.
Source: SEC.
[End of table]
[A] SROs include national securities exchanges (stock exchanges), the
Financial Industry Regulatory Authority (FINRA), and clearing agencies,
which facilitate trade settlements. FINRA was created in July 2007
through the consolidation of NASD (formerly an SRO) and the member
regulation, enforcement, and arbitration functions of the New York
Stock Exchange; it is now the largest nongovernmental regulator for all
securities firms doing business in the United States.
SEC's current 2004-2009 strategic plan established four goals: (1)
enforce compliance with the federal securities laws, (2) promote
healthy capital markets through an effective and flexible regulatory
environment, (3) foster informed investment decision-making, and (4)
maximize the use of SEC resources. Enforcement and OCIE share joint
responsibility for implementing the agency's first strategic goal. The
Commission and the Office of the Executive Director, which develops and
implements all the agency's management policies, are updating the
agency's strategic plan, which is to be issued in the summer of 2007.
Enforcement personnel are located in SEC's home office in Washington,
D.C., as well as the agency's 11 regional offices.[Footnote 15]
Enforcement staff located in the home office include the director and
one of two deputy directors, five investigative groups or Offices of
Associate Directors, as well as internal support groups, including its
Offices of Chief Counsel and Chief Accountant (see fig. 1).[Footnote
16] An associate director heads each Office of Associate Director and
has one or more assistant directors. Branch chiefs report to assistant
directors and supervise the work of investigative staff attorneys
assigned to individual investigations, with review and support provided
by division management. SEC regional office staff are typically divided
between Enforcement and OCIE personnel. Enforcement units in the
regional offices have Office of Associate Director structures similar
to those in the home office and report to the Director of Enforcement
in Washington, D.C.
Figure 1: Organizational Structure of SEC's Enforcement Division Home
Office:
[See PDF for image]
Source: SEC.
[End of figure]
The Sarbanes-Oxley Act of 2002 substantially increased SEC's
appropriations, and Enforcement subsequently increased its staffing
levels. In 2002, Enforcement had 1,012 staff and, at the end of fiscal
year 2006, 1,273 staff.[Footnote 17] As shown in figure 2, the number
of investigative attorneys in Enforcement increased substantially, from
596 in 2002 to 740 in 2005.[Footnote 18] However, the number of staff
in Enforcement, in particular its investigative attorneys, decreased
from 2005 to 2006 because of a May 2005 hiring freeze (instituted
across the agency in response to diminished budgetary resources) and
subsequent attrition. Since October 2006, however, SEC has permitted
Enforcement and other SEC divisions and offices to replace staff that
leave the agency. However, the agency does not contemplate returning to
early 2005 staffing levels. Appendix II provides additional information
on Enforcement's staffing resources and workload indicators.
Figure 2: Number of Investigative Attorneys at Fiscal Year End, 2002-
2006:
[See PDF for image]
Source: GAO analysis of SEC data.
[End of figure]
Figure 3 provides a general overview Enforcement's investigative
process. At the initial stage of the investigative process, attorneys
evaluate information that may indicate the existence of past or
imminent securities laws violations. The information can come from
sources such as tips or complaints from the public as well as referrals
from other SEC divisions or government agencies. If Enforcement staff
decide to pursue the matter, they will open either a Matter Under
Inquiry (MUI) or an investigation. Staff open a MUI when more
information is required to determine the merits of an investigation;
otherwise, staff may open an investigation immediately.[Footnote 19]
Investigations can be conducted informally--without Commission
approval--or formally, in which case the Commission must first approve
a formal order if staff find it necessary to issue subpoenas for
testimony or documentation. Based on the analysis of collected
evidence, Enforcement will decide whether or not to recommend that the
Commission pursue enforcement actions, which can be administrative or
federal civil court actions (both of which must be authorized by the
Commission). Enforcement has established a variety of controls over the
enforcement action process, including reviews by senior division
officials in Washington, D.C., and, ultimately, review and approval by
the Commission.[Footnote 20] Enforcement has an information technology
system--CATS--that tracks the progress of its MUIs, investigations, and
enforcement actions.
Figure 3: Flowchart of SEC's Investigation and Enforcement Process:
[See PDF for image]
Source: GAO.
[End of figure]
Enforcement also is responsible for implementing and overseeing the
Sarbanes-Oxley Act's Fair Fund provision, which allows SEC to combine
civil monetary penalties and disgorgement amounts collected in
enforcement cases to establish funds for investors harmed by securities
laws violations.[Footnote 21] Fair Funds may be created through either
SEC administrative proceedings or litigation in U.S. District Court,
and either SEC or the courts may administer the funds. However, SEC is
responsible for general monitoring of all Fair Funds created.
Typically, for SEC-ordered Fair Funds, the agency hires consultants to
create Fair Fund distribution plans (independent distribution
consultants) and oversee payments to harmed investors (fund
administrators). However, in some cases, SEC staff will take care of
all of the distribution responsibilities internally. The development of
a Fair Fund plan can include estimating losses suffered by harmed
investors. For court-ordered funds, SEC recommends a receiver or
distributions agent, who creates a distribution plan that is presented
for court approval.
Enforcement Has Taken Steps to Better Manage the Investigative Process,
but These Steps May Not Fully Address Existing Limitations:
Enforcement's approaches for planning, tracking, and closing
investigations have had some significant limitations that have hampered
its ability to effectively manage its operations, allocate limited
staff resources, and ensure the fair treatment of individuals and
companies under investigation. While SEC and Enforcement officials are
aware of these limitations and have begun addressing them, some of
their actions may not fully correct identified weaknesses.
Specifically, Enforcement has not (1) established written procedures
and criteria for its newly centralized review and approval process for
new investigations, which could limit its ability to ensure its
consistent implementation and reduce the Commission's ability to
oversee the division's operations; (2) established controls to help
ensure the reliability of the investigative data that division
attorneys will be required to enter into a new information system,
which could limit the usefulness of management reports generated by the
system; and (3) established plans and procedures to ensure that all
investigations that are no longer being actively pursued are closed
promptly to reduce the negative impact on individuals and companies no
longer under review.
Enforcement Recently Centralized the Review and Approval of New
Investigations, but the Lack of Written Procedures and Criteria Could
Limit the Effectiveness of its Approach:
To establish overall investigative priorities, Enforcement officials
said that they regularly communicate with senior SEC officials and
their counterparts in other agency units. For example, Enforcement
officials said that they hold weekly meetings with the SEC Chairman and
other commissioners as appropriate. During the Chairman's tenure, he
has identified the pursuit of securities fraud against senior citizens
as a key investigative priority for Enforcement and other agency
offices, including OCIE.[Footnote 22] In addition to specific
priorities, Enforcement officials said that they seek to maintain a
constant investigative presence across all areas of potential
securities violations (for example, insider trading abuses) and that
this "cover the waterfront" approach is designed to prosecute and
possibly deter securities law offenders. While an Enforcement official
said that the division has not established minimum quotas for different
types of investigations and enforcement actions, it will intervene if
any one type threatens to overwhelm the division's operations. Based on
internal analysis of enforcement action data, Enforcement officials
determined that if the division's pursuit of any type of securities
enforcement action exceeded 40 percent of total enforcement actions, an
unacceptable commitment of division resources would result.[Footnote
23]
While Enforcement has established planning processes for determining
overall priorities, the division has used a largely decentralized
approach for reviewing and approving individual new investigations,
which may have limited the division's operational effectiveness,
according to senior SEC and Enforcement officials. Under this
traditional approach, associate directors in either SEC's home or 11
regional offices approved the opening of MUIs after staff came across a
potential violation of federal securities law.[Footnote 24] While
Enforcement's senior leadership in the home office reviewed proposals
for formal investigations and received weekly reports on MUIs and new
investigations that had been approved in each office (and reviewed
summaries of all investigations on a quarterly basis), it did not have
formal approval responsibility for such new MUIs and investigations.
According to Enforcement officials, staff in each office generally
decided to open MUIs and investigations based on considerations such as
the likelihood that they would be able to find and prove a violation of
federal securities laws, the potential amount of investor loss, the
gravity of the misconduct, and the potential message the case would
deliver to the industry and public. Typically, the staff attorney who
opened the MUI was responsible for conducting the investigation.
According to Enforcement officials, this decentralized approach was
generally viewed as fostering creativity in the investigative process
and providing staff with incentives to actively seek potential
investigations.
However, without a centralized control mechanism for reviewing and
approving all new MUIs and investigations, Enforcement's capacity to
ensure the efficient use of available resources, which is one of SEC's
four strategic goals, was limited. For example, SEC's Chairman,
officials from his office and the Office of the Executive Director, and
Enforcement officials said that the division has not always been able
to prioritize or ensure an efficient allocation of limited
investigative staff resources. Officials said that in some cases staff
attorneys worked on investigations that were outside of their
geographic area (for example, San Francisco staff conducting an
investigation in the Atlanta region). Consequently, the officials said
that the division incurred travel and other related costs that could
have been minimized if a centralized process had been in place to
approve all new investigations. Further, one official from the
Chairman's office said that without a formal quality check by senior
Enforcement officials, in some cases MUIs and investigations had been
opened and allowed to linger for years with little likelihood of
resulting in enforcement actions.
In March 2007, Enforcement began using a new, more centralized approach
to review and approve investigations. Under the new approach, two
deputy directors, who report directly to the Director of Enforcement,
are to review and approve all newly opened MUIs and investigations to
ensure the appropriateness of resource allocation considerations and
whether the MUI should be pursued. One deputy director is to review
MUIs opened in the division's home office and another deputy director,
based in New York, is to review MUIs opened in regional offices. In
addition to the MUI review, after an investigation is open for 6
months, staff will be required to prepare a memorandum with information
on evidence gathered to date, whether an enforcement action is likely,
resources, and estimated time frames for review by their deputy
director. According to Enforcement officials, the goal of this new
approach is to provide early assessments of whether an investigation
ought to be pursued further and resources reallocated. The deputy
directors are also expected to use this review to determine if the
investigation is being conducted in a timely manner, if it should be
reprioritized based on Enforcement's current caseload, or if it should
be closed.
While these are positive developments, Enforcement has not yet
established comprehensive written policies specifying how the new
approach will be carried out or the criteria that will be used to
assess new MUIs and ongoing investigations. According to our and Office
of Management and Budget (OMB) standards, documentation is one type of
control activity that will help ensure that management's directives,
such as these new procedures, are carried out.[Footnote 25] In spring
2007, Enforcement developed and distributed divisionwide a one-page
planning document that, among other items, identified the new
centralized approach for reviewing and approving MUIs and
investigations. However, without the establishment of agreed-upon and
written procedures for carrying out the new approach and relevant
assessment criteria, the division may face challenges in consistently
communicating and explaining the new approach to all current and new
staff. Moreover, the Commission's ability to oversee how effectively
Enforcement is implementing the new approach and generally managing its
operations may be limited. For example, the lack of a transparent and
documented standard could limit the Commission's capacity to identify
inconsistencies in the implementation of the new approach, determine
whether any such inconsistencies have affected Enforcement's
operations, and take corrective action as warranted.
Planned Investigative Information System Has Significant Potential
Benefits, but Enforcement Has Not Taken Sufficient Steps to Help Ensure
Data Reliability:
Enforcement officials have consistently stated that the division's
current information system for tracking investigations and enforcement
actions--CATS--is severely limited and virtually unusable as a
management tool. In particular, the officials have said that access to
CATS is limited and the system does not allow division management to
generate summary reports, which could be used to help manage operations
on an ongoing basis. Currently, the only summary reports CATS readily
produces for management review are lists of all open MUIs,
investigations, and enforcement actions by general violation types,
such as violations involving broker-dealers or investment advisers.
CATS does not allow its users to create timely reports on more specific
topics, such as ongoing investigations involving hedge funds, which do
not exist as classification fields in the system. As a result of the
system's limitations, several senior Enforcement management officials
said that they maintain their own manual lists of certain types of
investigations (such as those for hedge funds) to assist in managing
division activities.
Further, to obtain customized reports and statistics on Enforcement
operations, division officials said that they must submit requests to
SEC's Office of Information Technology (OIT) and then wait for OIT
staff to create and run a computer program to respond to the request.
Enforcement officials said that OIT staff generally are responsive and
work very hard to address these requests; however, given their heavy
workload, one Enforcement official said that it generally takes 1-2
days to receive the information, and more complex requests can take as
long as a week. Further, Enforcement officials said that obtaining
technical support for CATS can be difficult because the system is
proprietary and the company that created it is no longer in business.
According to Enforcement officials, CATS's deficiencies result from the
fact that the system was hastily designed in preparation for expected
year 2000 technical challenges.
Having recognized CATS's limitations, SEC and Enforcement officials are
developing a new investigation information management system, called
the Hub, which is scheduled to be in use divisionwide by the end of
fiscal year 2007. According to Enforcement officials, division
officials and staff in SEC's Boston office developed a prototype of the
Hub in 2004 because of their dissatisfaction with CATS. Subsequently,
Enforcement, in coordination with OIT, developed an enhanced version of
the Hub, which was then tested among home and regional office staff in
late 2006 and early 2007. Enforcement officials said that the Hub is an
interim system that will continue to interface with the CATS database
until the second phase of the Hub fully replaces CATS, which is
expected to occur in fiscal year 2009.
Although the Hub is an interim system, Enforcement officials said that
it will significantly enhance the division's capacity to manage the
investigative process. In particular, the officials said that the Hub
will facilitate the creation of a variety of management reports on the
division's investigative activities, including detailed reports on
ongoing investigations by certain types (for example, reports on the
number of hedge fund investigations). The Hub will also provide more
detailed information on the status of investigations so management can
better track their progress and timeliness. Further, the officials said
that the Hub is designed to be (1) generally accessible to all division
staff, although highly sensitive investigative information will be
restricted on a need-to-know basis; (2) user-friendly, primarily
employing drop-down menus for data entry; (3) searchable so that staff
can identify relevant information associated with an investigative
matter; and (4) flexible, because new data fields can be added. We
reviewed prototype screens for the Hub and found that they were
consistent with the descriptions of Enforcement officials, and staff we
contacted generally made favorable comments about the system.
However, due to significant planned changes to Enforcement's
traditional approach for recording investigative data, there is a risk
that data may not be entered into the Hub on a timely and consistent
basis, as required by federal internal control standards.[Footnote 26]
Enforcement has traditionally required support personnel or case
management specialists (rather than attorneys) to enter investigative
data into CATS because of the limited access to the system and its lack
of user friendliness. However, once the Hub is implemented in late
2007, Enforcement officials said that they plan to require division
attorneys to enter relevant data into the system for all investigations
opened after that date. Further, Enforcement officials said that
attorneys will be responsible for entering relevant data into the Hub
for ongoing investigations that are being actively pursued but were
initiated prior to the system's implementation.[Footnote 27]
Enforcement officials regard the entry of such data as critical;
otherwise, management reports generated by the Hub would only include
information on investigations begun after the system's scheduled
implementation in late 2007. One Enforcement official said that the
decision to require attorneys to enter data into the Hub was based on
the view that such attorneys have first-hand knowledge of ongoing
investigations and thus would be able to streamline the process.
However, another Enforcement official said that requiring attorneys to
maintain timely, accurate, and consistent investigative data in the Hub
would require a cultural change on the attorneys' part because they
have become accustomed to relying on case management specialists to
perform this task. Another Enforcement official questioned whether
division attorneys would enter investigative data into the Hub on a
timely and consistent basis because they may view doing so as another
administrative requirement diverting them from their primary
investigative responsibilities.
While Enforcement's plans to require attorneys rather than case
management specialists to enter data into the Hub may be appropriate,
the division plans only a limited number of actions to ensure that data
entered into the system are timely, consistent, and reliable. For
example, Enforcement plans to train attorneys on the Hub as it is
implemented and is developing a system user manual. However,
Enforcement is not developing written guidance identifying data entry
into the Hub as a priority for division attorneys and specifying how
and when such data entry is to be done. Moreover, Enforcement has not
yet established a written process that would allow division officials
to independently review and determine the extent to which data entry
for the Hub is performed on a timely, consistent, and reliable basis in
accordance with federal internal control standards.[Footnote 28]
Without doing so, the usefulness of management reports generated by the
Hub may be limited, and the system's potential to significantly enhance
Enforcement's capacity to better manage the investigative process may
not be fully realized.
Enforcement Has Planned Improvements to Its Investigation Closure
Processes, but Plans May Not Fully Address Backlog of Cases:
Enforcement may leave open for years many investigations that are not
being actively pursued with potentially negative consequences for
individuals and companies no longer under review. According to CATS
data, about two-thirds of Enforcement's nearly 3,700 open
investigations as of the end of 2006 were started 2 or more years
before, one-third of investigations at least 5 years before, and 13
percent at least 10 years before. According to an Enforcement official,
technical limitations in CATS make it difficult to readily determine
how many of these investigations resulted in enforcement actions and
how many did not.[Footnote 29] Nevertheless, other data suggest that
the number of aged investigations that did not result in an enforcement
action may be substantial. For example, Enforcement officials at one
SEC regional office said that as of March 2007, nearly 300 of 841 open
investigations (about 35 percent) were more than 2 years old, had not
resulted in an enforcement action, and were no longer being actively
pursued.
Enforcement officials cited several reasons for division attorneys not
always closing investigations promptly. In particular, the officials
said that Enforcement attorneys may view pursing potential securities
violations as the division's highest priority and lack sufficient time,
administrative support, and incentives to comply with established
administrative procedures for closing investigations. For example,
Enforcement requires attorneys to complete closing memoranda for each
investigation that is to be closed. These memoranda must identify why
the investigation was opened, describe the work performed, and detail
the reasons for recommending that the investigation be closed without
an action. Staff must also prepare draft termination letters, which
inform individuals or companies that they are no longer under review. A
closing memorandum is also required for investigations with associated
enforcement actions. In these cases, the staff attorney must account
for all ordered relief before the investigation is closed. One regional
Enforcement official estimated that it could take as long as a month
for a staff attorney to complete this process and submit the closing
package to the home office, although senior division officials noted
that attorneys typically would not spend all their time doing so. Once
closing packages are received by the home office, Enforcement's Office
of Chief Counsel must then approve the closing of the investigation, at
which point final termination letters are sent to affected individuals
and companies.
Enforcement officials in SEC's home office said that a lack of
resources in their office also contributed to delays in closing
investigations. They noted that only one person in the division was
assigned to processing closing packages for investigations.
Consequently, the officials said there was a backlog of investigations
for which the closing package had been completed but not reviewed. As
of March 1, 2007, the backlog consisted of 464 investigations,
according to an Enforcement official.
However, Enforcement officials told us that in May 2007 they began
eliminating the backlog of investigations with completed--but
unreviewed--closing packages and had almost eliminated the backlog by
mid-June 2007. The division recently added one staff person to work on
administering closing procedures in the home office, and Enforcement
officials have set a goal of processing new closing documentation
within 2 weeks of receipt.
Also in May 2007, Enforcement implemented revised procedures for
sending termination letters for investigations that will not result in
an enforcement action. Under the procedures, Enforcement will send the
letters to individuals and companies at the start of the closing
process rather than at the end. This particular effort will be
emphasized on Enforcement's intranet--EnforceNet. Enforcement officials
said they changed this procedure out of concerns about fairness to
those under investigation and to reduce any negative impact an open
investigation may have on them. For example, a company may bar an
individual from performing certain duties until a pending SEC
investigation is resolved. Staff are generally encouraged to close
investigations if they know they will not be bringing any enforcement
actions, even if all of their investigative steps have not yet been
completed.
While the above steps are a positive development, they do not address
the potentially large backlog of investigations that are not likely to
result in enforcement actions and for which closing packages have not
been completed. As a result, the subjects of many aged and inactive
investigations may continue to suffer adverse consequences until
closing actions are completed. We recognize that reviewing and
resolving this potentially large backlog of investigations and
enforcement actions likely would impose resource challenges for
Enforcement. Nevertheless, the failure to address this issue--
potentially through expedited administrative closing procedures for
particularly aged investigations--would limit Enforcement's capacity to
manage its operations and ensure the fair treatment of individuals and
companies under its review.
Enforcement's Management of Fair Funds May Have Contributed to
Distribution Delays, and the Division Lacks Data Necessary for
Effective Program Oversight:
According to available SEC data, the distribution of funds to harmed
investors under the Fair Fund program remains limited after 5 years of
operation. Enforcement officials, as well as consultants involved in
Fair Fund plans, have cited a variety of reasons for the slow
distribution, including challenges in identifying harmed investors, the
complexity of certain Fair Funds, and the need to resolve tax and other
issues. However, the largely decentralized approach that Enforcement
and SEC have used in managing the Fair Fund program may also have
contributed to distribution delays. SEC has announced plans to create a
central Fair Funds office, but it is too early to assess this proposal,
as final determinations about its staffing, roles and responsibilities,
and procedures have not yet been determined. Further, Enforcement does
not yet collect key data necessary to effectively monitor the Fair Fund
program (such as data on fund administrative expenses for ongoing
plans) because an information system designed to capture such data is
not expected to be implemented until 2008. In the meantime, Enforcement
has not ensured that reports intended to provide expense data for
completed Fair Fund plans contain consistent information or are
analyzed. Until Enforcement clearly defines the Fair Fund office's
oversight roles and responsibilities and officials establish procedures
to consistently collect and analyze additional data, the division will
not be in an optimal position to help ensure the effective management
of the Fair Fund program.
Fair Fund Distributions Have Been Limited:
As of June 2007, Enforcement officials said that they were tracking 115
Fair Funds created since the program's inception in 2002--up from the
75 identified in our 2005 report--largely because funds were created as
part of a series of enforcement actions against mutual fund
companies.[Footnote 30] The Fair Fund plans vary considerably in size
and complexity, ranging from plans for small broker-dealers with
relatively few customers to large corporate cases, according to SEC
data. The smallest Fair Fund plan established (measured by the amount
of funds ordered returned to investors) was $29,300 for alleged fraud
at a hedge fund; the largest was $800 million for alleged securities
fraud at American International Group, Inc. (AIG). Table 2 shows the 10
largest Fair Funds ordered through June 2007; 7 are court-created
plans, and 3 have been established through SEC administrative
proceedings. SEC monitors all Fair Fund plans regardless of their
source.
Table 2: The 10 Largest Fair Funds Ordered, as of June 2007:
Fair Fund: AIG;
Alleged type of activity: Improper accounting and workers' compensation
practices;
Source: Court;
Judgment date: 2/17/ 2006;
Total ordered: $800,000,000.
Fair Fund: Worldcom;
Alleged type of activity: Overstating income;
Source: Court;
Judgment date: 7/7/2003;
Total ordered: $750,000,000.
Fair Fund: Wall Street research analysts;
Alleged type of activity: Research and investment banking conflicts of
interest;
Source: Court;
Judgment date: 10/31/2003;
Total ordered: $432,750,000.
Fair Fund: Enron;
Alleged type of activity: Earnings manipulation;
Source: Court;
Judgment date: 7/30/2003;
Total ordered: $422,995,012.
Fair Fund: Invesco/AIM;
Alleged type of activity: Market timing trading in mutual funds;
Source: SEC;
Judgment date: 10/8/2004;
Total ordered: $375,840,004.
Fair Fund: Bank of America;
Alleged type of activity: Market timing trading and late trading in
mutual funds;
Source: SEC;
Judgment date: 2/9/2005;
Total ordered: $375,000,000.
Fair Fund: Fannie Mae;
Alleged type of activity: Fraudulent accounting;
Source: Court;
Judgment date: 8/9/2006;
Total ordered: $350,000,000.
Fair Fund: Time Warner;
Alleged type of activity: Overstating online revenue and number of
Internet subscribers;
Source: Court;
Judgment date: 3/29/2005;
Total ordered: $300,000,000.
Fair Fund: Qwest;
Alleged type of activity: Overstating income;
Source: Court;
Judgment date: 6/22/2004;
Total ordered: $253,606,432.
Fair Fund: Alliance;
Alleged type of activity: Market timing trading in mutual funds;
Source: SEC;
Judgment date: 4/28/2005;
Total ordered: $250,850,003.
Source: SEC.
[End of table]
According to SEC data, from 2002 to 2007, federal courts and SEC
administrative proceedings ordered individuals and entities subject to
SEC enforcement actions to pay a total of $8.4 billion into Fair Fund
plans, an increase of about 75 percent from the $4.8 billion total Fair
Funds we identified in our 2005 report. As of June 2007, $1.8 billion
of the $8.4 billion (about 21 percent) had been distributed to harmed
investors, according to SEC data. As shown in table 3, the amount
distributed from court-overseen plans exceeded that distributed from
SEC-overseen plans. According to Enforcement officials, the funds were
distributed more slowly from SEC-overseen plans largely because much of
the money ordered through SEC proceedings involves mutual fund market
timing matters, which, as discussed later, are among the most complex
Fair Fund plans.
Table 3: Fair Fund Orders and Distributions, as of June 2007:
Number of plans;
SEC-overseen Fair Funds: 46;
Court-overseen Fair Funds: 69;
All Fair Funds: 115.
Total amount ordered (in thousands);
SEC-overseen Fair Funds: $3,934,371;
Court-overseen Fair Funds: $4,512,860;
All Fair Funds: $8,447,231.
Total amount distributed (in thousands);
SEC-overseen Fair Funds: $644,450;
Court-overseen Fair Funds: $1,122,351;
All Fair Funds: $1,766,802.
Percent distributed;
SEC-overseen Fair Funds: 16.4;
Court-overseen Fair Funds: 24.9;
All Fair Funds: 20.9.
Source: GAO analysis of SEC data.
[End of table]
Fair Fund Distribution Delays Have Been Attributed to Difficulties in
Identification of Harmed Investors, the Complexity of Certain Cases,
and Tax Issues:
According to Enforcement officials and consultants who work on Fair
Funds, a key reason for the slow distribution of Fair Funds has been
the difficulty of identifying harmed investors in certain cases. Unlike
typical securities class action lawsuits, Fair Funds may not rely on a
claims-based process in which injured parties identify themselves by
filing claims with trustees or other administrators. For example, in
Fair Fund cases involving mutual fund market timing abuses, which
account for many funds ordered into Fair Fund plans, Enforcement
attorneys and plan administrators have assumed responsibility for
identifying harmed investors. This step was taken because with the
large number of affected investors and the nature of market timing
violations, many such investors may not even have been aware that their
accounts experienced losses.[Footnote 31] One Fair Fund plan consultant
said that many harmed investors already had redeemed their shares in
the affected mutual fund companies in prior years. Tracking down such
former customers can be challenging because they may have changed their
addresses several times, the consultant said. Several consultants and
Enforcement officials also said that tracking down customers can be
hard because securities brokers, through whom individuals may purchase
mutual funds, may maintain customer account information rather than the
mutual fund company itself.[Footnote 32] As a result, a Fair Fund
administrator might need to contact and obtain the cooperation of
relevant broker-dealers to obtain customer account information and make
related distributions.
The complexity of some cases can also impede the timely distribution of
Fair Funds. For example, in mutual fund market timing cases,
sophisticated analysis might be required to first identify trades that
benefited from improper activity and then to calculate profits earned
from those transactions and associated losses to investors, which may
be spread across many such customers.[Footnote 33] According to a Fair
Fund plan consultant and Enforcement officials, another significant
challenge to the Fair Fund distribution involves retirement plans and
the Employee Retirement Income Security Act of 1974 (ERISA), the
federal law setting minimum standards for pension plans in private
industry.[Footnote 34] Retirement plans hold assets on behalf of their
beneficiaries, and it is not unusual for those assets to be invested
with entities that become subject to Fair Fund enforcement actions.
Thus, ERISA-covered retirement plans will be entitled to Fair Fund
proceeds by virtue of such investments. But depending on circumstances,
a Fair Fund distribution consultant may need to make determinations on
a variety of complex issues before funds can be distributed, such as
determining when such distributions become plan assets under
ERISA.[Footnote 35] One Fair Fund consultant told us he spent a year
waiting for Department of Labor clarification of relevant ERISA issues.
Finally, determining the tax treatment of funds may also slow the
distribution process. According to Fair Fund consultants, tax
information must accompany Fair Fund distributions to investors so that
recipients have some idea of how to treat their payments for tax
purposes. Consultants and Enforcement officials told us that
determining appropriate tax treatment has been time-consuming as they
had no precedents upon which to draw. Depending on circumstances, an
investor's recovery of disgorged profits can constitute ordinary income
or a capital gain--which can be taxed at different rates--or not
represent taxable income at all. SEC ultimately hired a consulting firm
to handle tax issues. One Fair Fund consultant told us that obtaining
tax guidance from the Internal Revenue Service delayed the plan's
distribution by about 1 year.
Enforcement's Approach to Managing Fair Funds May Also Have Slowed
Distributions, and SEC Has Not Defined Responsibilities of a New Office
to Administer the Program:
In addition to the factors discussed above, Enforcement's largely
decentralized approach to managing the process may also have
contributed to delays in the distribution of Fair Funds. Currently,
Enforcement staff attorneys in either SEC's home office or 1 of its 11
regional offices who are pursuing individual enforcement cases take a
lead role in the Fair Funds process, overseeing much of the work
necessary to establish and maintain a fund. This includes supervising
cases directly, overseeing consultants who design or administer
distribution plans, and advising or petitioning courts presiding over
Fair Fund plans. Enforcement officials said that the approach made
sense from a Fair Fund administration standpoint because division
attorneys have substantial knowledge of the regulated entity involved
and the relevant enforcement action. Enforcement officials also said
that senior officials in the home office have always played an
important role in the oversight of the program. Their responsibilities
have included providing guidance on selecting consultants, leading
information-sharing and problem-solving efforts (for example, leading
regular conference calls among fund consultants, parties involved in
Fair Fund enforcement actions, their legal counsel, and SEC staff in
Enforcement and elsewhere), and reviewing proposed Fair Fund
distribution plans and recommending modifications as necessary.
Outside consultants hired to design and implement Fair Fund plans told
us that Enforcement staff attorneys assigned to their cases were
dedicated and responsive and that the agency appears to be making a
good faith effort to implement and oversee the Fair Funds provision.
However, they also said that Enforcement's delegated approach has
resulted in delays, higher costs, and unnecessary repetition of effort.
With different Enforcement staff handling different Fair Fund cases,
the consultants said that Enforcement forgoes the opportunity to build
institutional expertise and efficiencies. For example, one consultant
said that Enforcement's delegated management of the Fair Fund program
has resulted in inefficiencies in key administrative aspects of the
program, such as the development of standardized means of communicating
with investors (for example, form letters) and the mechanics for
distributing funds to them. Consequently, the consultant said that the
Fair Fund program incurs a substantial amount of unnecessary
administrative costs. Further, the consultants generally agreed that it
would make sense for SEC to consider centralizing at least some aspects
of the administration of Fair Fund plans to improve the efficiency of
the distribution process.
While Enforcement officials have cited benefits associated with the
current management of the program, both SEC and division officials also
acknowledged that it has created challenges. An official within the
Chairman's office said that the slow distribution of funds to harmed
investors is of significant concern to the agency and that the lack of
a centralized management approach has limited the development of
standardized policies and controls necessary to facilitate
disbursements. Further, Enforcement officials said that while Fair Fund
work is important, it can divert investigative attorneys from pursuing
other cases. The officials said that the Fair Fund workload on any
particular case varies over time, but during peak periods it can
consume about 50 to 75 percent of a staff attorney's time. At one SEC
regional office, Enforcement officials said that administering the Fair
Fund program has resulted in a significant commitment of attorneys'
time, especially because the office lost almost 25 percent of its
investigative staff due to attrition in the past year or so.
In response to concerns about the slow distribution of Fair Fund
proceeds to harmed investors, SEC's Chairman took two actions in 2007.
First, he established an internal agency committee to examine the
program's operation. The committee--which includes representatives from
Enforcement, General Counsel, the Office of the Secretary, and the
Office of the Executive Director--is assessing lessons learned in
program implementation, the agency's selection of consultants to
administer the plans, and SEC's policies and procedures for managing
the program. An Enforcement official said that the committee is
expected to complete its analysis by September 30, 2007. Second, in
March 2007, the Chairman announced plans to create a centralized Fair
Fund office.[Footnote 36] The Chairman stated that the purpose of the
new office is to develop consistent fund distribution policies and
dedicate full-time trained staff to ensure the prompt return of funds
to harmed investors.
While creating a central office within SEC could facilitate the
distribution of Fair Funds, it was not yet possible to assess the
planned office's potential impact at the time of our review. For
example, SEC had not announced which SEC unit the office would report
to, although one official said that the office probably would be
located within Enforcement. Further, SEC had not staffed the new Fair
Fund office and had not established the roles and responsibilities of
the new office or written relevant policies and procedures.[Footnote
37] For example, SEC had not determined the extent to which the new
office might assume complete responsibility for managing at least some
Fair Fund plans, although it is expected the office will continue to
provide support to division attorneys who currently manage such plans.
Until such issues are resolved, the new office's potential efficiency
in more quickly distributing Fair Fund proceeds to harmed investors
will not be realized.
Enforcement Does Not Yet Collect Key Data Necessary to Effectively
Oversee the Fair Funds Program:
Enforcement does not collect key data, as we recommended in 2005, to
aid in division oversight of the Fair Fund program.[Footnote 38] In
particular, Enforcement does not systematically collect data on
administrative expenses for all ongoing Fair Fund plans. These costs
range from fees and expenses that Fair Fund administrators and
consultants charged to the costs of identifying harmed investors and
sending checks to them. Approximately two-thirds of individual Fair
Funds pay for administrative costs from fund proceeds, so that the
greater the administrative expenses, the less money is available for
distribution to harmed investors, according to our analysis of SEC Fair
Fund information.[Footnote 39] However, without data on administrative
expenses charged, Enforcement cannot judge the reasonableness of such
fees and take actions as necessary to minimize them.
Enforcement officials generally attributed SEC's inability to implement
our 2005 recommendation to changes in priorities for the development of
the agency's information systems. After we issued our 2005 report,
Enforcement officials said they began working to modify the CATS system
so that it could better track Fair Fund administrative expenses and
other data. However, SEC ultimately decided to accelerate the
development of a new financial management system for the division,
called Phoenix. SEC and Enforcement officials said that the agency
implemented the first phase of Phoenix in February 2007. The first
phase includes limited information relevant to the Fair Fund program
(the amount of money ordered in penalties and disgorgement and the
amount paid to the agency), but it does not include data on such items
as fund administrative expenses. Enforcement officials told us that a
second phase of the Phoenix system will contain additional features for
more complete management and monitoring of Fair Fund activity,
consistent with our 2005 recommendation. According to Enforcement
officials, Phoenix II has been funded and is expected to be in place in
2008. Until Phoenix II is implemented and tested, Enforcement officials
will continue to lack information necessary for effective Fair Fund
management and oversight.
We also note that in the meantime, Enforcement has not leveraged
reports that could enhance the division's understanding of Fair Fund
expenses, including administrative expenses. SEC rules generally
require that final accounting reports be prepared when SEC-overseen
Fair Funds are fully distributed and officially closed.[Footnote 40] We
reviewed four such reports and found that three of them were
inconsistent in data reported and did not include comprehensive
accounting information. For example, two of the accounting reports did
not include complete data on the expenses incurred to administer the
Fair Fund plan. Further, senior Enforcement officials said that the
division could improve its analysis of information contained in the
reports. As a result, Enforcement cannot evaluate the reasonableness of
administrative expenses for individual Fair Fund plans or potentially
gain a broader understanding of the reasonableness of such expenses
among a variety of plans.
Enforcement Coordinates Its Investigative Activities Internally and
with Other Agencies and Is in the Process of Documenting Criminal
Referrals:
Enforcement has established a variety of processes to coordinate its
investigative and law enforcement activities with other SEC offices.
Further, Enforcement has established processes to coordinate its
investigative activities with other law enforcement agencies, including
Justice. However, Enforcement and SEC have not yet implemented our 2005
recommendation that they document referrals of potential criminal
activity to other agencies, although plans to do so have been
established as part of the division's new investigation management
information system (the Hub).[Footnote 41] Until Enforcement completes
this process, its capacity to effectively manage the referral process
is limited.
Enforcement Coordinates with Other SEC Units through Regular Meetings
and a Referral Process:
Enforcement officials said that they hold a variety of meetings
periodically to coordinate investigative and other activities within
SEC. As discussed previously, senior Enforcement officials said they
meet regularly with the SEC Chairman and commissioners to establish
investigative priorities. According to the Director of Enforcement, she
meets weekly with the heads of other SEC divisions, and other senior
division officials said that they meet periodically with their
counterparts in other agency units. Enforcement officials cited their
coordination with other SEC units on investigations of the backdating
of stock options as an example of the agency's successful collaborative
efforts.[Footnote 42] One Enforcement official said that division staff
worked closely with the Office of Economic Analysis to analyze
financial data and trends related to options backdating, which allowed
them to identify patterns used to target companies for further
investigation. This official said that Enforcement also collaborated
with the Office of the Chief Accountant, the Division of Corporation
Finance, and the Office of the General Counsel throughout this effort.
Enforcement officials also said that coordinating their activities with
OCIE is particularly important and that the division places a high
value on referrals it receives from OCIE regarding potentially illegal
conduct. Enforcement officials said that because OCIE staff regularly
examine broker-dealers, investment advisers, and other registered
entities, they have a broad perspective on compliance with securities
laws and regulations. Enforcement officials in SEC's Philadelphia
regional office estimated that about 30 or 35 percent of the
enforcement actions the Philadelphia office initiates are based on
referrals from OCIE staff. They cited one notable recent insider
trading case--involving broker-dealer Friedman, Billings, Ramsey & Co.,
Inc., and which was among the first cases of its kind since the 1980s-
-as stemming from a referral from an OCIE examination.[Footnote 43]
However, other Enforcement officials said that historically they have
had some concerns about limitations in information contained in OCIE
referrals. These concerns centered on how clearly OCIE identifies
potentially improper conduct in its referrals and how much evidence it
provides in support of such matters. As a result, in November 2006,
OCIE and Enforcement instituted a process that would provide a more
formal review of the nature and quality of OCIE referrals. According to
OCIE and Enforcement officials, the new procedures expand and formalize
a preexisting committee process for reviewing OCIE referrals to
Enforcement and communicating the ultimate outcome of those referrals
to OCIE. The officials said the revised procedures were instituted to
(1) help identify the types of OCIE referrals that were likely (or not)
to result in enforcement actions and (2) provide better information to
OCIE on the ultimate disposition of its referrals.
Enforcement officials noted that the division receives many more
referrals from OCIE than from any other SEC division or office;
therefore, developing a formal committee and tracking process for other
internal referrals has not been viewed as warranted. SEC also receives
referrals from self-regulatory organizations (SRO)--such as what is now
the Financial Industry Regulatory Authority (FINRA)--often involving
allegations of insider trading, which are received by Enforcement's
Office of Market Surveillance (OMS).[Footnote 44] In a forthcoming
report, we assess OMS's and Enforcement's processes for reviewing and
prioritizing these SRO referrals.
Enforcement Coordinates with Law Enforcement and Other Regulators and
Plans to Document Criminal Referrals in New Information Management
System:
Enforcement officials also said that division staff have established
processes to coordinate their investigative activities and working
relationships with other law enforcement and regulatory agencies. For
example, Enforcement officials in SEC's regional offices said they have
established effective working relationships with U.S. attorney offices
to prosecute alleged criminal violations of the securities laws. In our
2005 report, we discussed how Enforcement worked with Justice and state
attorneys general to prosecute investment advisers that allegedly
violated criminal statutes related to market timing and late
trading.[Footnote 45] In some cases, Enforcement details investigative
attorneys to Justice to assist in the criminal prosecution of alleged
securities law violators. Other outside organizations with which SEC
and Enforcement coordinate investigative activities include the Federal
Bureau of Investigation, federal banking regulators, the Commodity
Futures Trading Commission, state securities regulators, and local
police. Enforcement also participates in interagency investigative task
forces, such as the Corporate Fraud Task Force, the Bank Fraud
Enforcement Working Group, and the Securities and Commodities Fraud
Working Group.[Footnote 46]
Additionally, in March 2007, Enforcement held its annual conference at
SEC's Washington headquarters on securities law enforcement, which
federal and state regulators and law enforcement personnel attended.
Topics covered included coordination of SEC investigations with
criminal law enforcement agencies and advice on trying a securities
case. SEC also conducted sessions on market manipulation, insider
trading, financial fraud, stock options backdating, and executive
compensation. In September 2007, Enforcement will join other SEC units
in hosting the Commission's second Seniors Summit, at which SEC, other
regulators, and law enforcement agencies will discuss how to work
together to address the growing problem of fraud targeting the nation's
senior citizens.
Although Enforcement officials say they are planning to do so, they
have not yet fully implemented our 2005 recommendation to document
Enforcement's referrals of potential criminal matters--and the reasons
for making them--to other law enforcement agencies.[Footnote 47] As
discussed in that report, SEC has established a policy under which
Enforcement attorneys may make referrals on an informal basis to
Justice and other agencies with authority to prosecute criminal
violations. That is, Enforcement attorneys may alert other agencies to
potential criminal activity through phone calls or meetings, and such
referrals need not be formally approved by the division or the
Commission. We noted that such an informal referral process may have
benefits, such as fostering effective working relationships between SEC
and other agencies, but also found that Enforcement did not require
staff to document such referrals. Appropriate documentation of decision-
making is an important management tool. Without such documentation,
Enforcement and the Commission cannot readily determine whether staff
make appropriate and prompt referrals. Also, the division does not have
an institutional record of the types of cases that have been referred
over the years. However, Enforcement officials told us that the
forthcoming Hub system will include data fields that indicate when
informal referrals of potential criminal activity have been made.
Conclusions:
In recent years, SEC's Enforcement division and investigative attorneys
have initiated a variety of high-profile enforcement actions that
resulted in record fines and other civil penalties for alleged serious
securities violations and contributed to criminal convictions for the
most egregious offenses. While Enforcement has demonstrated
considerable success in carrying out its law enforcement mission, some
significant limitations in the division's management processes and
information systems have hampered its capacity to operate at maximum
effectiveness and use limited resources efficiently. One key reason for
these limitations appears to have been Enforcement's management
approach, which emphasized a broad delegation of key functions with
limited centralized management review and oversight, particularly in
the approval and review of new investigations and the administration of
the Fair Fund program. Delegation of authority is an important
management principle that can foster creativity at the local level and,
in the case of Enforcement, likely had some benefits for the
investigative process and the administration of the Fair Fund program.
However, without well-defined management processes to exercise some
control over delegated functions, inefficient program implementation
and resource allocation can also occur.
Officials from Enforcement and the Offices of the Chairman and
Executive Director have recognized limitations in the division's
operations and taken important steps to establish more centralized
oversight procedures. In particular, they have centralized the review
and approval of new investigations, moved forward to upgrade or replace
information systems key to division operations and management, and
announced the creation of a new Fair Fund office. However, as described
below, these plans require additional actions to fully address
identified limitations and maximize the division's operational
effectiveness.
* Enforcement has not developed written procedures and criteria for
reviewing and approving new investigations. Establishing such guidance
would help focus the review of investigations and reinforce the
consistency of reviews, as intended by the centralization of this
function, and assist in communicating the new policies to all current
and new staff. Further, developing written procedures and criteria
would establish a transparent and agreed-upon standard for the review
and approval of new investigations and thereby facilitate the
Commission's ability to oversee and evaluate the division's operations
and resource allocation.
* Enforcement has not developed written controls to help ensure the
timely and consistent entry of investigative data in the Hub
information system, which could increase the risk of misleading or
inaccurate management reports being generated by the system. Without
written guidance and the establishment of independent and regular
reviews of the accuracy of Hub data by division officials, Enforcement
is not well positioned to help ensure that it is receiving reliable
program information. Further, the lack of guidance and controls may
limit the new system's capacity to better manage the investigation
process.
* Enforcement's potentially large backlog of investigations for which
closing memoranda and other required administrative procedures have not
been completed requires division management's attention. We recognize
that clearing this potentially large backlog could pose challenges to
Enforcement given the resource commitment that would be required to do
so. Nevertheless, leaving such investigations open indefinitely
continues to compromise management's ability to effectively manage its
ongoing portfolio of cases. Moreover, it has potentially negative
consequences for individuals and companies that are no longer under
investigation.
* SEC has not yet staffed or defined the roles and responsibilities of
the new office that is being established to administer the Fair Fund
program. Therefore, it is not possible to determine the extent to which
the office may better facilitate the distribution of funds to investors
harmed by securities frauds and other violations. While Enforcement
awaits the development and implementation of a new information system
that would collect comprehensive information on Fair Fund expenses for
ongoing plans (for example, administrative expenses), the division has
not taken other steps that would, in the meantime, allow it to develop
a better perspective on the reasonableness of such expenses. That is,
Enforcement has not ensured the consistency of information contained in
reports on completed Fair Fund plans or sufficiently analyzed such
reports, compromising its capacity to monitor the program.
Given SEC and Enforcement's critical law enforcement mission, it is
important that senior officials ensure that weaknesses in their planned
improvements be addressed and implementation monitored. Without a full
resolution of existing limitations, a significant opportunity to
further enhance the division's effectiveness may be missed.
Recommendations for Executive Action:
To strengthen Enforcement's management processes and systems and help
ensure compliance with securities laws, we recommend that the Chairman
of the Securities and Exchange Commission direct the Division of
Enforcement and other agency offices, such as the Office of Information
Technology or Office of the Executive Director, as appropriate, to take
the following four actions:
* establish written procedures and criteria on which to base the review
and approval of new investigations;
* establish written procedures that reinforce the importance of
attorneys entering investigative data into the Hub, provide guidance on
how to do so in a timely and consistent way, and establish a control
process by which other division officials can independently assess the
reliability of investigative data maintained in the system;
* consider developing expedited administrative and review procedures
for closing investigations that have not resulted in enforcement
actions and are no longer being actively pursued; and:
* establish and implement a comprehensive plan for improving the
management of the Fair Fund program, to include (1) staffing the new
central Fair Fund office, defining its roles and responsibilities, and
establishing relevant written procedures and (2) ensuring the
consistency of and analyzing final accounting reports on completed Fair
Fund plans.
Agency Comments and Our Evaluation:
We provided a draft of this report to the Chairman of SEC for comment,
and he and the Director of the Division of Enforcement provided written
comments that are reprinted in appendix III. In its written comments,
SEC agreed with our conclusions and stated it would implement all of
our recommendations. Moreover, SEC officials noted that the agency has
since established that the new Fair Fund office--referred to as the
Office of Distributions, Collections and Financial Management--will be
located within the Division of Enforcement. SEC officials said that a
senior officer and two assistant directors will lead the operations of
the office and the agency is developing the office's responsibilities.
SEC also provided technical comments, which we have incorporated 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 to the Chairman of the Senate Committee on Finance; the Chairman
and Ranking Member of the Senate Committee on Banking, Housing, and
Urban Affairs; the Chairman and Ranking Member of the House Committee
on Financial Services; and other interested committees. We are also
sending a copy of this report to the Chairman of the Securities and
Exchange Commission. We will make copies available to others upon
request. In addition, the report will be available at no charge on our
Web site at [hyperlink, http://www.gao.gov]. Contact points for our
Offices of Congressional:
Relations and Public Affairs may be found on the last page of this
report. If you or your staff have any questions about this report,
please contact me at (202) 512-8678 or williamso@gao.gov. Key
contributors are acknowledged in appendix IV.
Sincerely yours,
Signed by:
Orice M. Williams:
Director, Financial Markets and Community Investment:
[End of section]
Appendix I: Scope and Methodology:
To address our first objective--evaluating the Securities and Exchange
Commission (SEC) Division of Enforcement's (Enforcement) internal
processes and information systems for planning, tracking, and closing
investigations and planned changes to these processes and systems--we
reviewed relevant SEC and Enforcement documentation and data, including
the agency's strategic plan, annual performance reports, performance
measurement data, investigation and enforcement action data from the
Case Activity Tracking System (CATS), and Enforcement personnel data.
We also reviewed guidance on Enforcement's intranet--EnforceNet--to
determine internal procedures for conducting and managing the
investigation process and obtained documentation and attended
demonstrations for the first phase of Enforcement's new planned
successor system for CATS (the Hub) and for the base model system for
the Hub (M&M).[Footnote 48] We also reviewed prior GAO reports on SEC
and Enforcement processes and information technology systems, as well
as federal internal control standards.[Footnote 49] Further, we
interviewed the SEC Chairman, two commissioners, officials from SEC's
Offices of the Executive Director and General Counsel, and Enforcement
officials in Washington and the agency's New York, Boston, and
Philadelphia regional offices.
To address our second objective--evaluating the implementation of SEC's
Fair Fund responsibilities--we reviewed a 2005 GAO report that
discussed SEC's Fair Fund process, as well as relevant
legislation.[Footnote 50] We also obtained and analyzed summary Fair
Fund statistics and documentation and data on individual funds, as
provided by Enforcement.[Footnote 51] However, Enforcement did not
provide data on 24 Fair Fund plans that were identified in our 2005
report. Among the reasons Enforcement officials cited for the omissions
were that some of the 24 funds had been fully distributed and thus were
not included in an information system established in 2006 that was
designed to track only ongoing plans. However, these 24 Fair Fund plans
are generally smaller (accounting for about $118 million or 1 percent
of total Fair Funds), and their exclusion does not change our overall
conclusion that distributions have been limited.
In addition to Fair Fund data, we reviewed SEC guidance on Fair Funds,
including rules on distribution plans, tax treatment, selection of
consultants, and distribution procedures. We also reviewed Fair Fund
guidance from the U.S. Department of Labor. In addition to discussing
the Fair Fund program with relevant SEC and Enforcement officials, we
interviewed six consultants hired to design and implement Fair Fund
plans, attorneys, consumer advocates, an academic expert, and a
representative of a trade group for a retirement plan service provider
trade group.
To address the third objective--evaluating Enforcement's efforts to
coordinate investigative activities with other SEC divisions and
federal and state law enforcement agencies--we reviewed previous GAO
reports on mutual fund trading abuses and Enforcement's coordination
efforts with law enforcement.[Footnote 52] We also reviewed relevant
SEC documentation, including internal referral policies, and guidance
regarding coordination between Enforcement and outside law enforcement
authorities. We also attended SEC's annual securities coordination
conference held in Washington in March 2007, which was attended
primarily by federal and state regulators and law enforcement
personnel. Further, we discussed Enforcement's coordination efforts
with relevant SEC and division officials.
We conducted our work in Washington, D.C; Boston, Massachusetts;
Philadelphia, Pennsylvania; and New York, New York, between November
2006 and July 2007 in accordance with generally accepted government
auditing standards.
[End of section]
Appendix II: Selected Division of Enforcement Investigation and
Personnel Data:
We collected data from the Securities and Exchange Commission (SEC) on
the Division of Enforcement's (Enforcement) investigative caseload and
other personnel information (see tables 4-6 below). As shown in table
4, the ratio of ongoing Enforcement investigations to staff attorneys
increased substantially from about five investigations per attorney in
2002 to eight per attorney in 2006, according to SEC data. However,
these SEC data should be interpreted with caution and may significantly
overestimate the number of investigations per Enforcement attorney. The
reported number of investigations includes all open investigations at
the end of each year, even investigations that have been open for many
years. As discussed in this report, Enforcement has not promptly closed
many investigations that have not resulted in enforcement actions and
are likely no longer being actively pursued. Accordingly, we requested
that SEC provide data on the number of ongoing investigations in
Enforcement that as of year-end 2006 had been initiated within the
previous 2 years. When pending investigations that were more than 2
years old are excluded, the investigation-to-staff-attorney ratio drops
to 2.54.[Footnote 53] While this ratio may provide a more accurate
assessment of Enforcement attorneys' active workloads, individual
investigations more than 2 years old could continue to be actively
pursued while some individual investigations less than 2 years old may
no longer be actively pursued. Enforcement officials estimated that
staff attorneys generally can be working on from 3 to 5 investigations
at one time, including administering individual Fair Fund plans.
Table 4: Ratio of Open Investigations to Staff Attorneys:
2002: 5.07;
2003: 5.43;
2004: 6.57;
2005: 7.20;
2006: 8.06.
Source: GAO analysis of SEC data.
Note: Open investigations refer to the number of investigations pending
as of the end of each fiscal year according to SEC's annual reports.
Staff attorneys do not include trial attorneys and accountants.
[End of table]
Table 5 shows that the ratio of Enforcement investigative attorneys to
paralegals, who provide support to the investigative process, generally
declined from 2003 to 2006. Our review of SEC data indicates that the
number of Enforcement paralegals increased substantially from 2003 to
2005 (from 58 to 98, or 69 percent) and remained stable in 2006 at 94
(a decline of just over 4 percent). While the number of Enforcement
staff and supervisory attorneys also increased from 2003 to 2005 (from
596 to 740, or 24 percent), the rate of increase was not nearly as high
as for paralegals. In addition, the number of Enforcement investigative
attorneys declined from 740 in 2005 to 684 in 2006, or 8 percent. The
relatively slower pace of attorney hiring from 2003 to 2005 and
relatively higher rate of attrition in 2006 helps explain why the ratio
of attorneys to paralegals has declined in recent years. Other SEC data
that we reviewed also indicated a decline in the ratio of investigative
attorneys to various types of administrative support staff, such as
research specialists, during this period.
Table 5: Ratio of All Investigative (Staff and Supervisory) Attorneys
to Paralegals:
2002: 10.28;
2003: 11.88;
2004: 9.00;
2005: 7.55;
2006: 7.28.
Source: GAO analysis of SEC data.
Note: All investigative attorneys include staff and supervisory
attorneys in the Enforcement division. Supervisory attorneys refer to
positions that SEC personnel data label as "(supervisory) general
attorneys." This does not include (supervisory) trial attorneys and
(supervisory) accountants. SEC personnel data label paralegals as
"paralegal specialists."
[End of table]
Table 6 shows that the ratio of investigative staff attorneys to
supervisory attorneys has remained relatively constant. Supervisory
attorneys are branch chiefs and assistant directors and do not include
attorneys at the associate director level and above.
Table 6: Ratio of Staff Attorneys to Supervisory Attorneys:
2002: 3.20;
2003: 3.59;
2004: 3.50;
2005: 3.30;
2006: 3.02.
Source: GAO analysis of SEC data.
[End of table]
[End of section]
Appendix III: Comments from the Securities and Exchange Commission:
Christopher Cox:
Chairman:
Headquarters:
100 F Street, NE:
Washington, DC 20549:
Regional Offices:
Atlanta, Boston, Chicago:
Denver, Fort Worth:
Los Angeles. Miami, New York:
Philadelphia, Salt Lake City:
San Francisco, United States:
Securities And Exchange Commission:
July 24, 2007:
Ms. Orice M. Williams:
Director:
Financial Markets and Community Investment:
U.S. Government Accountability Office:
441 G Street, N.W.:
Washington, DC 20548:
Dear Ms. Williams:
I appreciate having the opportunity to respond to the GAO's draft
report "Additional Actions Needed to Ensure Planned Improvements to
Address Limitation in Enforcement Division Operations" (GAO-07-830).
The report identifies a number of weaknesses in the Division of
Enforcement's processes and systems for planning, tracking, and closing
investigations and for managing and distributing Fair Funds to injured
investors.
We concur with the GAO's conclusions and with its recommendations for
improving the effectiveness of the Commission's enforcement program. We
agree with the GAO that improved procedures and systems will allow the
Division to more capably manage its operations, to better allocate
resources to priority investigations, and to more effectively oversee
the prompt distribution of Fair Funds to injured investors. The agency
is committed to moving with alacrity to implement each of the GAO's
recommendations, as is described in greater detail in the attached
letter from the Director of the Division of Enforcement.
Because the senior management of the Division of Enforcement and I both
place the highest priority on implementing the GAO's recommendations, I
am pleased to report that, two weeks ago, we hosted a meeting of the
agency's senior Enforcement management, including the heads of all 11
of the agency's regional offices. We were briefed by the GAO on its
findings, and we discussed our commitment to, and our plans for,
implementing the GAO's recommended reforms. As we work to implement
these recommendations, I would appreciate being able to continue to
draw on the GAO's expertise. Again, thank you, and your staff, for the
work you have done on this report, and for your commitment to improving
the operations of the Securities and Exchange Commission.
Sincerely,
Signed by:
Christopher Cox:
Chairman:
Enclosure:
United States:
Securities And Exchange Commission:
Washington, D.C. 20549:
Division of Enforcement:
July 24, 2007
Linda Chatman Thomsen:
Director:
(202) 551-4894:
(202) 772-9279 (fax):
thomsenl@a,sec.gov:
Ms. Orice M. Williams:
Director:
Financial Markets and Community Investment:
U.S. Government Accountability Office:
441 G Street, N.W.:
Washington, DC 20548:
Re: SEC Enforcement Division Operations:
Dear Ms. Williams:
Thank you for the opportunity to review and comment on the draft report
concerning the Securities and Exchange Commission's Division of
Enforcement's ("Enforcement") processes and systems for conducting
investigations and managing the Fair Fund program. The report discusses
how Enforcement has taken many positive steps in improving these
processes and systems. In addition, the report recommends how we can
most effectively manage operations and allocate resources while
continuing to meet the goal of deterring securities law violations and
returning funds to harmed investors.
I appreciate the collegiality your staff exhibited in preparing the
report and in discussing its findings and recommendations with us. We
agree with your findings and recommendations and are working with
alacrity to implement them.
Our specific comments are as follows:
I. Establish Written Procedures and Criteria Relating to New
Investigations:
The draft report notes the important steps Enforcement has recently
taken to improve the management of its operations by centralizing the
review and approval process of new investigations under the two deputy
directors' review. This ensures all newly opened MUIs and
investigations are an appropriate allocation of resources. The draft
report recommends that further action should be taken by Enforcement in
the form of establishing written procedures and assessment criteria for
reviewing and approving new investigations. We agree with this
recommendation and are in the process of developing written procedures
and criteria to focus this review and assure that it is consistently
applied.
II. Establish Controls to Ensure Reliability of Hub:
Your draft report notes that Enforcement has a new investigation
information management system, the Hub, which is an interim system
designed to aid in the management of Enforcement's investigative
process. The report recommends that written procedures be established
reinforcing the importance of staff entering investigative data into
the Hub in a timely and consistent basis and reviewing the system for
reliability. We agree with these findings and recommendations and are
working diligently to develop these written procedures.
III. Consider Developing Expedited Procedures for Closing
Investigations:
Your draft report notes that in the spring, Enforcement began
eliminating the backlog of investigations with completed, but
unreviewed, closing packages. At this time, Enforcement has
successfully eliminated this backlog and developed new procedures to
prevent such a backlog from occurring in the future. In addition, your
draft report suggests that Enforcement consider developing expedited
procedures in another area -- closing investigations that are not
likely to result in enforcement actions and for which closing packages
have not been completed. We agree that promptly closing investigations
that are not actively being pursued can improve the management of the
Division and ensure the fair treatment of individuals and companies
under its review. Thus, Enforcement plans to actively review these
"aged" pending investigations to determine which should be closed and
to review our closing process to determine how it can be streamlined.
IV. Establish Comprehensive Plan for Fair Fund Office:
The draft report notes that we recently announced our plan to establish
a centralized Fair Fund Office and recommends that we implement a plan
to staff this new office and develop written procedures to improve the
management of the Fair Fund Program. We agree with this recommendation
and have determined that this new office will be within the Division of
Enforcement and be called the Office of Distributions, Collections and
Financial Management. It will be led by a Senior Officer (SO) and two
Assistant Directors (SK-17s). The new office will be divided into two
groups, each of which will be headed by one of the Assistant Directors
– 1) the Fair Fund Distributions and Collections Unit and 2) the
Financial Information Management Unit. We are in the process of fully
developing the responsibilities of this office to assure the improved
distribution of funds to investors.
The draft report also notes that the SEC has developed a system called
Phoenix to manage financial information and that Phoenix will be built-
out to include features to manage and monitor Fair Fund activity,
including expenses. The second phase of Phoenix will become operational
in 2008. The report also recommends that the division take other steps
in the meantime that will allow it to develop a better perspective on
Fair Fund expenses, including administrative expenses. We agree with
this recommendation and will work to standardize the collection of Fair
Fund expense data so that it may be analyzed when the system becomes
fully operational and will work on developing interim procedures for
the staff to review such expenses. When the management of the new
Office of Fair Fund Distributions, Collections and 3
Financial Management is in place, which is presently anticipated to
occur in October 2007, we will make sure that there is appropriate
internal reporting on the status of Fair Fund distributions.
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) 551-4894 or Joan McKown at (202) 551-4933.
Yours truly,
Signed by:
Linda Chatman Thomsen:
[End of section]
Appendix IV: GAO Contact and Staff Acknowledgments:
GAO Contact:
Orice M. Williams (202) 512-8678 or williamso@gao.gov:
Acknowledgments:
In addition to the contact named above, Wesley M. Phillips, Assistant
Director; Allison Abrams; Christopher Forys; Marc Molino; Carl Ramirez;
Linda Rego; Barbara Roesmann; and Christopher Schmitt made significant
contributions to this report.
[End of section]
Footnotes:
[1] Disgorgement deprives securities law violators of ill-gotten gains
linked to their wrongdoing.
[2] 15 U.S.C. § 7246.
[3] See GAO, Mutual Fund Trading Abuses: SEC Consistently Applied
Procedures in Setting Penalties, but Could Strengthen Internal
Controls, GAO-05-385 (Washington, D.C.: May 16, 2005). This report
generally addressed SEC enforcement actions pertaining to market timing
and late trading violations. Market timing typically involves the
frequent buying and selling of mutual fund shares by sophisticated
investors who seek opportunities to make profits on the difference in
prices between overseas and U.S. markets. Late trading is illegal and
occurs when investors place orders to buy or sell mutual fund shares
after the mutual fund has calculated the price of its shares but still
receive that day's fund share price. As of February 2005, Enforcement
had initiated 24 enforcement actions that resulted in fines of almost
$2 billion against mutual fund companies and officers for market timing
and late trading violations.
[4] Pub. L. No. 107-204 § 601, 116 Stat. 745 (July 30, 2002). Amelia
Gruber, "SEC Urged to Flesh Out Performance Goals,"
GovernmentExecutive.Com (Washington, D.C.: Sept. 28, 2004).
[5] GAO, SEC Operations: Oversight of Mutual Fund Industry Presents
Management Challenges, GAO-04-584T (Washington, D.C.: Apr. 20, 2004).
[6] GAO-04-584T.
[7] Section 308(a) of the Sarbanes-Oxley Act of 2002, entitled "Fair
Fund for Investors," allowed SEC to combine civil monetary penalties
and disgorgement amounts collected in enforcement cases to establish
funds for the benefit of victims (investors) of securities law
violations. 15 U.S.C. § 7246. See also GAO, SEC and CFTC Penalties:
Progress Made in Collection Efforts, but Greater SEC Management
Attention Is Needed, GAO-05-670 (Washington, D.C.: August 2005).
[8] CATS contains information on ongoing investigations and enforcement
actions, such as the general nature of the potential violation (for
example, insider trading) and the date an investigation was opened.
[9] A hedge fund is generally an entity that holds a pool of securities
and other assets, is not required to register its securities offerings,
and is excluded from the definition of an investment company.
[10] Due to deficiencies in CATS, Enforcement cannot readily provide
data on the number of ongoing investigations that have not resulted in
enforcement actions.
[11] These 115 Fair Funds are tracked in Enforcement's distribution
management system. CATS tracks all Fair Fund distributions that have
occurred but by defendant, not by fund. When a Fair Fund is created
through an SEC administrative action, SEC oversees the case directly.
When a fund is created through court action, SEC is a party to the
court proceeding, but the court retains ultimate authority to supervise
the plan. In either an administrative or court proceeding, an
individual or company is ordered or agrees to pay an amount of money
into a Fair Fund plan. The Fair Fund data discussed in this report do
not include 24 cases that SEC had previously identified as Fair Funds.
These 24 cases generally are smaller (accounting for about $118 million
or 1 percent of total Fair Funds), and their exclusion does not change
the overall conclusion that distributions have been limited.
Enforcement did not include some of the 24 plans because they were
fully distributed to harmed investors and the division's information
system only tracks Fair Fund plans that were ongoing at the time this
system was established in 2006.
[12] GAO-05-670.
[13] Section 201.1105(f) of title 17 of the Code of Federal
Regulations, SEC's Rules of Practice regarding Fair Fund and
Disgorgement Plans, generally provides, inter alia, that "a final
accounting shall be submitted for approval of the Commission or hearing
officer prior to discharge of the administrator and cancellation of the
administrator's bond, if any." SEC also seeks to track activity and
expenses of court-overseen Fair Funds.
[14] GAO-05-385. In this report, "referrals" are Enforcement's
interactions and consultations with law enforcement agencies on
specific cases rather than the formal referral process mentioned in our
2005 report, which Enforcement no longer uses.
[15] SEC used to utilize regional offices to oversee district offices,
but as of March 2007, all 11 offices were designated regional offices.
[16] Both deputy directors used to be located in the home office, but
in April 2007, one relocated to the New York regional office.
[17] Regional offices comprise positions that (1) belong exclusively to
Enforcement, (2) are shared by Enforcement and other teams, and (3) do
not belong to Enforcement at all. For the purposes of computing the
total Enforcement staff numbers, we counted only those positions that
belonged exclusively to Enforcement. Pub. L. No. 107-204, tit. VI, §
601, 116 Stat. 745 (July 30, 2002);
15 U.S.C. § 78kk.
[18] The investigative attorney numbers include Enforcement staff with
position titles of general attorney or supervisory general attorney,
which do not include attorneys above an assistant director level.
Examples of position titles not included in these numbers, but included
in the numbers of total Enforcement staff, are case management
specialist, law clerk, legal technician, paralegal specialist, research
specialist, secretary, staff accountant, and trial attorney.
[19] After being open for more than 60 days, an MUI automatically
becomes an investigation.
[20] GAO-05-385.
[21] 15 U.S.C. § 7246.
[22] The Chairman stated that millions of individuals are expected to
retire in the coming decade, meaning they will need to actively manage
their investment accounts, and many individuals and companies may seek
to take advantage of this increased investment activity and defraud
them of their savings. Testimony of SEC Chairman Cox before the U.S.
House Subcommittee on Financial Services and General Government,
Committee on Appropriations, 110th Congress, 1st session, March 27,
2007.
[23] An Enforcement official told us that the 40 percent limit was
established based on analysis of 20 years of enforcement action data.
[24] This process does not apply to MUIs that are opened based on
referrals from SROs. Referrals from SROs are sent directly to
Enforcement's Office of Market Surveillance in the home office, which
then reviews the referral, decides whether or not to open a MUI, and,
if one is opened, sends the MUI to the appropriate office for action.
[25] See GAO, Standards for Internal Control in the Federal Government,
GAO/AIMD-00.21.3.1 (Washington, D.C.: November 1999) and Office of
Management and Budget, Management's Responsibility for Internal
Control, OMB Circular No. A-123 Revised, Appendix A, "Internal Control
Over Financial Reporting" (Washington, D.C.: December 2004).
[26] GAO/AIMD-00.21.3.1.
[27] Enforcement officials said that ongoing investigation data
maintained in CATS will be electronically transferred to the Hub when
the system is implemented. However, division attorneys will be
responsible for entering relevant data into the Hub for ongoing
investigations that are not maintained in CATS, such as detailed
information on the type of investigation (e.g., whether it is a hedge
fund investigation).
[28] In addition to directing federal agencies to establish written
controls, GAO/AIMD-00.21.3.1 and OMB Circular A-123 call for the
establishment of controls to ensure the reliability of data maintained
in information systems.
[29] We requested that SEC provide data on the number of investigations
open for 2 or more years that have outstanding enforcement actions. To
respond to this request, an Enforcement official said that OIT would
have had to spend a great deal of time creating complex programs. Due
to other demands on OIT's resources and our ability to obtain related
data from an SEC regional office, we decided not to request that OIT
provide this information.
[30] GAO-05-670. The Fair Fund data do not include 24 cases that SEC
had previously identified as Fair Funds. These 24 cases generally are
smaller (accounting for about $118 million or 1 percent of total Fair
Funds), and their exclusion does not change the overall conclusion that
distributions have been limited. Enforcement did not include some of
the 24 plans because they were fully distributed to harmed investors
and the division's information system tracks only Fair Fund plans that
were ongoing at the time this system was established in 2006.
[31] Market timing losses generally were distributed across many
individual mutual fund customers. The losses were often small and
investors may not even have realized that their account balances were
experiencing dilution for extended periods. They also may have redeemed
their shares in the mutual fund company while market timing violations
were occurring.
[32] Broker-dealers may maintain such customer account information on
an aggregated basis in what are known as omnibus accounts, and the
mutual fund would not have direct access to this information.
[33] Market timing is said to dilute the value of mutual fund shares,
as a market timer buys, sells, or exchanges shares rapidly and
repeatedly to take advantage of favorable prices. In addition, market
timing increases transaction costs for mutual funds. To take account of
investor losses due to dilution, a Fair Fund distribution plan might
attempt to estimate, on a daily basis, the extent to which a fund's net
asset value (analogous to share price) would have been more or less
than the actual net asset value had market timing not occurred. The
difference, where positive, is the estimate of dilution and harm to
investors. The sum of daily increments (both positive and negative)
represents aggregate harm to a fund's shareholders over the period in
which market timing occurred.
[34] Pub. L. No. 93-406, 88 Stat. 829 (Sept. 2, 1974).
[35] In some cases, retirement plans will be shareholders of record and
receive Fair Fund distributions directly. In other cases, an
intermediary--such as a broker-dealer, underwriter, or record-keeper--
will be the shareholder of record, and retirement plans will receive
Fair Fund distributions based on their interest in an account operated
by the intermediary.
[36] See testimony of SEC Chairman Cox before the U.S. House
Subcommittee on Financial Services and General Government, Committee on
Appropriations, 110th Congress, 1st session, March 27, 2007.
[37] GAO/AIMD-00.21.3.1 and OMB Circular A-123.
[38] GAO-05-670.
[39] According to information that SEC provided us, 81 of 115 Fair
Funds, or 70 percent, have provisions whereby fund proceeds are used to
pay administrative expenses. In the remaining 34 cases, the individual
or entity sued in the relevant enforcement action, such as a mutual
fund company, pay Fair Fund expenses.
[40] Section 201.1105(f) of title 17 of the Code of Federal
Regulations. SEC's Rules of Practice regarding Fair Fund and
Disgorgement Plans generally provides, inter alia, that "a final
accounting shall be submitted for approval of the Commission or hearing
officer prior to discharge of the administrator and cancellation of the
administrator's bond, if any." SEC also seeks to track activity of
court-overseen Fair Funds.
[41] GAO-05-385.
[42] In a typical case, companies misrepresent the date on which stock
options were granted (using a date on which the price was lower). When
the holders exercise their options, they can realize larger gains
because their exercise prices are based on the lower, misrepresented
grant date;
the company meanwhile doesn't report the larger gains as greater
compensation. The practice violates SEC's disclosure and accounting
rules, and tax laws.
[43] SEC v. Friedman, Billings, Ramsey & Co., Inc. No. 06-cv-02160
(D.D.C. 2006), SEC Litigation Release No. 19950 (December 20, 2006).
According to SEC Release No. 19950, Friedman, Billings, Ramsey, & Co.,
Inc. agreed to settle the matter without admitting to or denying the
allegations.
[44] FINRA was created in July 2007 through the consolidation of NASD
(formerly an SRO) and the member regulation, enforcement, and
arbitration functions of the New York Stock Exchange;
it is now the largest nongovernmental regulator for all securities
firms doing business in the U.S.
[45] GAO-05-385.
[46] The Corporate Fraud Task Force includes a Department of Justice
group that focuses on enhancing criminal enforcement internally and an
interagency group that focuses on cooperation and joint federal
regulatory and enforcement efforts. The Bank Fraud Enforcement Working
Group promotes coordination and communication among financial
institution regulators and federal law enforcement authorities. The
Securities and Commodities Fraud Working Group provides a forum for
federal law enforcement authorities to exchange information with
securities and commodities regulators, securities SROs, and the Public
Company Accounting Oversight Board.
[47] GAO-05-385.
[48] In 2004, the Boston regional office tasked one of its staff
members and an outside consultant to design a new case tracking system
for the office. This new database was implemented in 2005 and also
piloted in the Los Angeles and Chicago regional offices. When beginning
to develop the Hub in 2006, SEC decided to use Boston's system as the
base model for the Hub because of the amount of user input M&M already
had received.
[49] GAO, Mutual Fund Trading Abuses: SEC Consistently Applied
Procedures in Setting Penalties, but Could Strengthen Internal
Controls, GAO-05-385 (Washington, D.C.: May 16, 2005) and Standards for
Internal Control in the Federal Government, GAO/AIMD-00-21.3.1
(Washington, D.C.: Nov. 1999).
[50] GAO, SEC and CFTC Penalties: Continued Progress Made in Collection
Efforts, but Greater SEC Management Attention Is Needed, GAO-05-670
(Washington, D.C.: Aug. 31, 2005).
[51] Individual Fair Fund data obtained included information on the
type of enforcement action that produced the Fair Fund, type of
adjudication, amounts ordered placed into a Fair Fund and amounts
distributed, dates of issuance of Fair Fund orders, and whether parties
involved were responsible for paying the expenses of their respective
Fair Fund plan.
[52] GAO-05-385 and GAO, U.S. Attorneys: Performance-Based Initiatives
are Evolving, GAO-04-422 (Washington, D.C.: May 28, 2004).
[53] We computed this ratio by dividing the number of investigations
with a status of "active" in Enforcement's information system (CATS)
that had been open for less than 2 years as of December 31, 2006--
1,305--by the number of "staff attorneys" (nonsupervisory investigative
attorney positions that SEC personnel data label as "general
attorneys") as of September 31, 2006--514.
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