©2005 Investment Company Institute. All rights reserved. Information may be abridged and therefore incomplete.
Communications from the Institute do not constitute, and should not be considered a substitute for, legal advice.
[18801]
April 27, 2005
TO: BOARD OF GOVERNORS No. 17-05
CHIEF COMPLIANCE OFFICER COMMITTEE No. 35-05
COMPLIANCE ADVISORY COMMITTEE No. 31-05
PRIMARY CONTACTS - MEMBER COMPLEX No. 16-05
SEC RULES MEMBERS No. 53-05
SMALL FUNDS MEMBERS No. 36-05
RE: GAO REPORT REGARDING MUTUAL FUND TRADING ABUSES
The U.S. Government Accountability Office has issued a report to the House of
Representatives’ Committee on the Judiciary regarding the mutual fund trading abuses.* The
report, which responds to the Committee’s requests concerning issues relating to regulatory
oversight of the mutual fund industry, (i) identifies the reasons the Securities and Exchange
Commission did not detect the abusive market timing agreements at an earlier stage and
lessons learned from the SEC’s failure to do so; and (ii) assesses steps that the SEC has taken to
strengthen its mutual fund oversight, deter abusive trading, and improve mutual fund
company operations.
Report Overview
The report found that prior to September 2003, SEC staff did not examine for market
timing abuses or assess company controls over that activity because the staff (i) viewed market
timing as a relatively low-risk area that did not involve per se violations; (ii) determined that
mutual fund companies had financial incentives to establish effective controls over frequent
trading because such trading can reduce fund returns resulting in a loss of business; and (iii)
were told by company officials that they had designated compliance staff to monitor and
control market timing. The report acknowledges that the SEC faced competing examination
priorities prior to September 2003 and made good faith efforts to control known risks associated
with market timing through the regulatory process, such as by issuing guidance on “fair value”
pricing.
* See Mutual Fund Trading Abuses: Lessons Can be Learned from SEC Not Having Detected Violations at an Earlier Stage,
GAO Report to the Committee on the Judiciary, House of Representatives (April 2005). Because undisclosed market
timing arrangements were more widespread than late trading violations, the report primarily focuses on the SEC’s
oversight of the market timing area. The report also addresses the NASD’s oversight of broker-dealers that failed to
prevent customer’s late trading and market timing activities.
2
Nevertheless, the report concludes that lessons can be learned to strengthen the SEC’s
mutual fund company oversight program going forward. In particular, the report states that
conducting independent assessments of controls over various activities within a mutual fund
company, including areas perceived to represent relatively low risks at a sample of companies,
is, at a minimum, an essential means to verify assessments about risks and the adequacy of
controls in place to mitigate those risks. The SEC can also strengthen its capacity to identify and
assess evidence of potential risks. For example, articles in the financial press and academic
studies that were available prior to September 2003 stated that market timing posed significant
risks to mutual fund company shareholders. Finally, the report found that fund company
compliance staff often detected evidence of undisclosed market timing arrangements with
favored customers but lacked sufficient independence within their organizations to correct
identified deficiencies. The report recommends that ensuring compliance staff independence is
critical and that the SEC could potentially benefit from their work.
SEC Steps to Improve Compliance by Funds and Advisers
The report recognizes that the SEC has taken several steps to strengthen its mutual fund
oversight program and the operations of mutual fund companies over the past two years,
although it notes that it is too soon to assess the effectiveness of several key initiatives. To
improve its examination program, the SEC has instructed examiners to make additional
assessments of mutual fund company controls. For example, SEC staff has identified a range of
areas that potentially represent high-risk compliance problems, such as personal trading by
mutual fund company officials, and examiners have initiated independent examinations of
these areas. To improve its capacity to anticipate, identify, and manage emerging risks and
market trends in the securities industry, the SEC has created an Office of Risk Assessment. The
report also notes that the SEC has adopted rules designed to improve mutual fund company
operations, including rules that require funds and advisers to each designate a chief compliance
officer. Finally, the report states that the SEC has adopted two specific rules designed to
address market timing and is working on a rule designed to prevent late trading.
Report Recommendations
Among other steps, the report recommends that the SEC’s examination staff assess the
independence and effectiveness of the CCOs required under the new SEC rule. The report also
recommends that the SEC develop a plan to assess the feasibility of receiving and reviewing the
new mutual fund annual compliance reports (or material findings in those reports) on an
ongoing basis.
Jane G. Heinrichs
Assistant Counsel