GAO Points Finger at SEC for Fund Abuse: Says Commission Missed Market-Timing Clues
May 2, 2005
A report released on April 22 from the U.S. Government Accountability Office (GAO) in Washington, gives the Securities and Exchange Commission a lukewarm grade of "C" in its lack of detecting the market-timing abuses that plagued the mutual fund industry and how it has flexed its regulatory muscle since the slew of secret deals were uncovered.
Among its report card recommendations, as to how the SEC could do a better job of regulating the fund industry, a report the GAO released April 22, the government watchdog group suggested that the SEC add routine assessments of the effectiveness of chief compliance officers to its inspection repertoire. The GAO also proposed the Commission conduct regular reviews of funds' compliance reports that would include detection of compliance breaches.
No Annual Checkups
Specifically, the GAO acknowledged that the SEC had missed several clues to the market-timing activity which, the SEC later estimated (the month after the fund scandal broke), had taken place at 50% of the 80 largest fund groups. It also noted that while the new regulations requiring chief compliance officers was a good start to curing industry ills, the SEC's regulations don't go far enough in that they don't require the SEC to monitor and evaluate annual mutual fund compliance reports on a regular basis.
The GAO, formerly known as the General Accounting Office, is an independent, non-partisan government protective organization that works for Congress and reports on the operations of the Federal government. This specific report regarding the SEC was undertaken at the request of the House Committee on the Judiciary.
Although detecting fraudulent activities previously unrecognized can be a difficult task for regulatory staff, the SEC is culpable for turning a blind eye to both academic studies and news reports surrounding market timing, as well as for ignoring early insider tips it had received indicating flagrant problems existed, the GAO report concluded.
Moreover, the SEC relied too heavily on assurances made by advisory company personnel of the existence of "market-timing police" without inspection staff performing independent assessments of stated controls and actual activities that may have violated company controls, the report added.
In addition, the SEC had not adequately determined whether fund company compliance staff, who the GAO's investigation showed had spotted market-timing abuses as far back as 1998, were sufficiently independent enough to correct market-timing breaches, or were essentially stifled by fund company executives.
Both late-trading and market-timing abuses first came to light in September 2003 when New York Attorney General Eliot Spitzer uncovered several undisclosed trading deals between several fund companies and certain hedge funds. At the center of the maelstrom was hedge fund Canary Capital and its proprietor, Edward Stern, who has since returned to running the family business and real estate empire at Hartz Mountain Industries, Secaucus, N.J.
In its report, "Mutual Fund Trading Abuses: Lessons Can Be Learned from SEC Not Having Detected Violations at an Earlier Stage," the GAO noted that the SEC had previously viewed market timing as a low-risk issue to which it was not inclined to focus inspection efforts predominantly because fund advisors had financial incentives not to allow investors to engage in frequent trading that could hurt fund performance and asset inflows. Instead, inspectors were told to focus on more vulnerable areas. Areas considered to be liable to risk included: portfolio management, allocation of trades, order execution, NAV calculations and fund performance advertising.
But, evidently, closer inspections of company records and reports could have revealed trading breaches.
"In particular, conducting independent assessments of controls (through a variety of means including interviews, reviews of exception reports, reviews of internal audit or other company reports and transaction testing, as necessary) 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," explained the report.
"Without such independent assessments, the potential increases that violations will go undetected," GAO said.
The GAO's proposed fix?
"The SEC must develop the institutional capacity to identify and evaluate such evidence of potential risks and deploy examiners as necessary to assess company controls and help identify potential violations."
In its report, the GAO lauded the SEC for its establishment of the Office of Risk Assessment, which was created to anticipate and address emerging issues. But the GAO conceded that it was too early to assess the new unit's effectiveness.
It also gave the SEC high marks for promulgating a series of new regulations intended to address issues. In addition, it acknowledged that SEC examiners are now actively on the lookout for timing abuses by requesting fund sales and redemption data to detect possible patterns; are requesting e-mail samples to detect otherwise invisible misconduct; are evaluating the personal trading of fund executives; and are speaking with compliance officials regarding controls.
The GAO also provided clues as to future regulatory changes. It revealed that the SEC is further revamping its approach to mutual fund exams, is "evaluating the development of a surveillance system to monitor the industry," and is creating "monitoring teams" that will focus exclusively on the ongoing monitoring of the biggest fund complexes. It also noted that the SEC has now developed a centralized system for handling tips that could lead to enforcement actions.