GAO Finds Holes in SEC's Improved Exams
September 26, 2005
If the mutual fund industry and the regulators who oversee it thought that the mutual fund trading scandal is a once-in-a-lifetime occurrence they will eventually be able to put behind them, the Government Accountability Office believes otherwise.
Despite vast improvements the Securities and Exchange Commission has made to its examination of mutual funds, the GAO fears the SEC may still fail to detect rampant fraud.
In a report released last week, the government watchdog applauded the SEC's decision to target high-risk fund complexes and inspect them once every two to three years rather than every five years. The GAO also praised the SEC for establishing teams to focus on the 100 largest fund complexes, representing 85%, or $7.1 trillion, of the industry's assets. "Focusing on the largest advisory groups may enable the SEC to attain the greatest dollar coverage with its limited examination resources," the GAO concluded.
Also on track, the GAO said, is the SEC's requirement for funds to have chief compliance officers, its establishment of the Office of Risk Assessment and plans to set up a surveillance program to support its examiners by late 2006.
The GAO also believes that in light of the market-timing scandal that erupted in late 2003, the SEC was absolutely correct to switch gears in fiscal 2004 to increase sweep and cause exams, and to direct its 10 field offices to continue to be ready to conduct such exams, as warranted. Whereas sweep and cause exams comprised only 5% and 10% of all exams between 1998 and 2003, respectively, they made up a whopping 87% of the 690 exams in fiscal 2004.
"The SEC's revised examination priorities, particularly its emphasis on sweep examinations that focus on operational or compliance issues," the GAO said, "may provide the agency with greater opportunity to conduct independent assessments of controls for emerging risks."
However, the SEC still has not done everything it should to detect and wipe out fraud in the fund industry, according to the GAO. By scheduling exams of smaller, lower-risk fund complexes only once every 10 years, the GAO said, the SEC might miss the mark on new areas for risk and fraud as they emerge.
Also, unlike the banking industry, the GAO said, the SEC has neither written examination policies for its inspectors to follow nor any formal documentation of its exams to enable SEC staff to track the scope of their examination work. And while the SEC has 13 risk scorecards for its examiners to fill out, the Commission has no requirements that they accurately complete them or that their supervisors check their work, the GAO charges. And once finished, SEC supervisors rarely review completed examinations. Further, the SEC should create additional risk scorecards, the GAO said.
In addition, the SEC does not review self-regulatory organizations' inspections of mutual fund sales until six to 12 months later, and, at that, the SEC holds them up to different criteria.
Finally, the GAO is concerned that requiring hedge funds to register with the SEC will only put additional strains on the agency.
Better Quality Control
As a result, the Government Accountability Office is calling for SEC headquarters and field offices to improve the quality control of their mutual fund oversight. For starters, the GAO wants the SEC to prepare written examination plans. Other bank and federal regulators, notably at the Federal Deposit Insurance Corporation and the Federal Reserve, write comprehensive, risk-focused examination plans, including all areas to be reviewed and the reasons why.
The GAO also wants the SEC to require examiners to document their reviews and supervisors to thoroughly go over these reviews, along with risk scorecards.
The GAO also believes the SEC should periodically step back to conduct fund risk assessments, to get a better handle on whether it is effectively allocating its exam resources and if there are any "regulatory gaps."
The Government Accountability Office is also calling for the SEC to review its broker/dealer oversight exams and to electronically track the full scope of work performed during these exams.
"The GAO report confirms my long-held suspicions," said Rep. Paul Kanjorski (D-Pa.), in a statement on the GAO study. "More can be done and more should be done to protect American investors. We need to ensure that the SEC's oversight of the mutual fund industry is adequate to protect consumers' investments and prevent abusive practices from developing again in the future." In defense of her agency's work, Lori Richards, director of the SEC's office of compliance inspections and examinations, said her division is committed to using its resources in the most effective way to spot fraud and compliance abuse.
SEC's New Risk Scorecards
The Securities and Exchange Commission established 13 new risk scorecards in April of this year. Specifically, the Commission is looking to see how well a fund company:
* Maintains a Strong Compliance Culture;
* Minimizes Ability of Dominant Individual to Override Control System;
* Manages Portfolios Consistently with Prospectus Mandates;
* Seeks Best Execution of Trades;
* Ensures Personal Trading of Access Persons is Consistent with Code of Ethics;
* Gives Fair Allocation of Blocked and Initial Public Offering Trades to All Funds in the Complex's Family;
* Calculates Fund/Advisory Clients' Assets and Fund Net Asset Value
* Accurately and Fairly Portrays Performance Information;
* Protects Fund Information From Unauthorized Alterations;
* Ensures Safe Custody of Clients' Funds and Assets;
* Issues Periodic Account Statement to Clients Via a Third Party;
* Properly Processes Fund/Shareholder Orders and Cash-Book Reconciliations;
* Maintains High Standards of Fund Corporate Governance.
(c) 2005 Money Management Executive and SourceMedia, Inc. All Rights Reserved.