(The news featured below is a selection from the news covered in Federal Securities Law Reporter, which is distributed to subscribers of Federal Securities Law Reporter.)

GAO Finds SEC Mutual Fund Inspections Problematic

As the SEC refocuses its inspection resources to target higher risk mutual funds in light of recent industry abuses, a recent Government Accountability Office report found that the resulting trade-off may limit the Commission's capacity to examine lower-risk funds. The trade-off may also limit the agency's capacity to accurately identify and target for routine examination the funds that pose a higher risk. The GAO said that these challenges are compounded by the SEC rule requiring the registration of hedge fund advisers. The report was prepared at the request of Rep. Barney Frank, the ranking member on the House Financial Services Committee, and Rep. Paul Kanjorski, the ranking member of the Capital Markets Subcommittee.

The GAO found that, while the SEC has integrated some quality controls into its routine examinations, aspects of its framework could be improved. For example, the agency relies on experienced staff to oversee all exam stages but does not expressly require supervisors to review work papers or document their review. The GAO also found deficiencies in key SEC examination work papers, raising questions about the quality of supervisory review. In addition, the SEC does not require examiners to prepare written examination plans, though they use considerable judgment in customizing each examination. Written plans could serve as a guide for conducting examinations and reviewing whether examinations were completed as planned. The GAO noted that the SEC also could review a sample of work papers to test compliance with its standards, as done by other regulators.

In order to improve the SEC's oversight of mutual funds and Self-Regulatory Organization oversight of broker-dealers that sell mutual funds, the GAO made four recommendations to Chairman Christopher Cox. First, the SEC should periodically assess the level of resources allocated to the various types of examinations in light of their regulatory benefits to help ensure that they are being used effectively to oversee the fund industry. As part of this assessment, sufficient resources should be allocated to mitigate existing regulatory gaps concerning the timely examination of lower-risk funds, to complete mutual fund risk assessments within a more reasonable period and to fulfill the new oversight duties for the hedge fund industry. Second, the SEC should assess its methodology for conducting broker-dealer oversight examinations and examine if some portion of the resources currently devoted to these examinations could be better utilized to perform mutual fund examinations.

The GAO's third recommendation is designed to strengthen the SEC's approach to mutual fund examinations by establishing procedures for supervisory review of work papers prepared during routine examinations and for preparing a written plan for each routine examination, documenting, at a minimum, the preliminary objectives and scope of the examination. In addition, the SEC should consider conducting sample reviews of completed routine examinations and work papers to assess the quality and consistency of work within and across the field offices conducting the examinations. Fourth, to assess and improve the effectiveness of the SEC's oversight of SRO broker-dealer examination programs, the GAO recommended that the Commission electronically track information about the full scope of work performed during broker-dealer oversight examinations, including all major areas reviewed, to determine whether areas are receiving adequate review and to more fully assess the significance of deficiencies and violations.

After reviewing a draft of the report, Lori Richards, the SEC's director of the Office of Compliance, Inspections and Examinations, said that risk-targeted examinations are a reasonable and effective means of quickly addressing industry risks. In a risk-targeted review, she explained, the SEC staff conducts roughly contemporaneous examinations of the same risk at a number of firms. She described these as horizontal examinations in the sense that they look at the same risk across the industry, which allows the staff to promptly investigate emerging compliance risks and compare a firm to its industry peers. In addressing GAO concerns that this approach may give insufficient attention to low-risk advisers, Ms. Richards noted that the SEC is developing a program that will employ statistical techniques to select lower-risk advisers for full scope examinations.

Ms. Richards said that the SEC would consider the GAO's recommendation directed at improving the quality controls for routine fund examinations and that it has formed a working group to explore ways to enhance the value of its broker-dealer oversight examinations, including the ability to identify the reasons that violations may have been missed by SRO examinations. She added that the Commission expects to deploy an enhanced electronic system for workpapers in 2006.