©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.
[18941]
June 15, 2005
TO: BOARD OF GOVERNORS No. 29-05
CHIEF COMPLIANCE OFFICER COMMITTEE No. 48-05
COMPLIANCE MEMBERS No. 5-05
PRIMARY CONTACTS - MEMBER COMPLEX No. 26-05
SEC RULES MEMBERS No. 79-05
SMALL FUNDS MEMBERS No. 57-05
RE: GAO ISSUES SECOND REPORT REGARDING MUTUAL FUND TRADING ABUSES
The U.S. Government Accountability Office has issued another report to Congressional
requesters regarding the mutual fund trading abuses.* The report, which assesses the Securities
and Exchange Commission’s efforts to impose penalties on violators, (i) discusses the SEC’s
civil penalties in settled mutual fund market timing and late trading cases; (ii) provides
information on related criminal enforcement actions; (iii) evaluates the SEC’s criminal referral
procedures; and (iv) evaluates the SEC’s employee exit procedures.
Report Overview
The report found that since September 2003, the SEC has brought 14 enforcement actions
against investment advisers and 10 enforcement actions against broker-dealer, brokerage-
advisory, and financial services firms for mutual fund trading abuses. The penalties the SEC
obtained in the market timing and late trading cases are among the highest in the agency’s
history, ranging from $2 million to $140 million, with an average of about $56 million. In
contrast, SEC penalties in cases for securities law violations issued prior to January 2003 were
generally less than $20 million. The SEC’s penalties in the investment adviser cases also are
generally consistent with penalties obtained in cases involving similarly egregious corporate
misconduct. In addition, the SEC brought enforcement actions against 24 individuals, many of
them high-ranking company executives. The SEC obtained penalties as high as $30 million
* See Mutual Fund Trading Abuses: SEC Consistently Applied Procedures in Setting Penalties, but Could Strengthen Certain
Internal Controls, GAO Report to Congressional Requesters (May 2005). In April, the GAO issued a report identifying
reasons why the SEC did not detect the trading abuses at an earlier stage. 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). For a summary of that report, see Memorandum 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, and Small Funds Members No. 36-
05, dated April 27, 2005 [18801].
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against investment adviser executives (among the highest penalties obtained in individual
cases) and barred some individuals from their industry for life.
The report also found that in determining appropriate penalties to recommend to the
Commission in the investment adviser cases, SEC staff consistently applied criteria that the
agency has established. These criteria require the SEC to consider such things as the
egregiousness of the conduct, the amount of harm caused, the degree of cooperation, and the
penalties obtained in similar cases. The SEC may also consider litigation risks in determining
appropriate penalties. Moreover, the SEC has coordinated penalties and disgorgement with
state authorities in many of its market timing and late trading cases, although some states
obtained additional monetary sanctions.
The report notes that state and federal criminal prosecutors told the GAO that, while
they have recently investigated market timing conduct, they have generally not pursued
criminal prosecution in those cases because market timing is not illegal. On the other hand,
they have brought criminal charges in cases involving late trading violations because the
practice is a clear violation of the federal securities laws.
According to the report, SEC staff said that because state and federal criminal
prosecutors were already aware of and generally evaluated the mutual fund trading abuse cases
for potential criminal violations on their own initiative, they did not need to make specific
criminal referrals to bring these cases to their attention. The report found, however, that the
SEC’s capacity to effectively manage its overall criminal referral process to be limited by
inadequate recordkeeping. For instance, the SEC does not require staff to document that a
referral has been made to a federal or state criminal investigative authority or the reasons for
such referrals. The report notes that a lack of recordkeeping is inconsistent with federal internal
control standards, which recommend that documentation be designed to provide evidence that
management directives have been carried out, and with the practices of other financial
regulators, which maintain records on referrals. The report also notes that documentation of
referrals might serve as an additional internal indicator of the effectiveness of the SEC’s referral
process and would also be important for congressional oversight of law enforcement efforts in
the securities industry.
The report found that although the SEC provides training and guidance to staff on
federal laws regarding employment with regulated entities and requires former staff to notify
the SEC if they plan to make an appearance before the agency, it does not require departing
staff to report where they plan to work. In contrast, the report notes that other financial
regulators obtain information on where departing staff will be employed to assess the potential
for violations of employment restrictions. The report states that, in the absence of such
information, the SEC’s capacity to ensure compliance with conflict-of-interest laws related to
postemployment opportunities is limited.
Recommendations
To strengthen the SEC’s management procedures and better ensure that agency
responsibilities are being met, the report recommends that the SEC Chairman ensure that the
agency take the following two actions:
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• Document referrals to criminal authorities for potential criminal prosecutions
and the reasons for such referrals; and
• Request that departing employees identify their next employer as part of exit
procedures and establish procedures to review the departing employees’ related
work products if a potential conflict of interest is determined to exist.
Jane G. Heinrichs
Assistant Counsel