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House Subcommittee Reviews SEC's Mutual Fund Oversight

Lori Richards, the director of the SEC's Office of Compliance Inspections and Examinations, testified yesterday before the House Subcommittee on Commercial and Administrative Law regarding the SEC's oversight of the mutual fund industry. Richard Hillman, the Government Accountability Office's director of financial markets and community investment, reviewed the recent GAO report on mutual fund trading abuses which found that the SEC has consistently applied procedures in setting penalties, but recommended that the SEC institute a system for documenting referrals to criminal law enforcement authorities and that it request from departing employees the names of their next employers as part of the exit procedures to review for potential conflicts of interest. William Galvin, the chief securities regulator for the Commonwealth of Massachusetts , criticized the SEC's efforts in overseeing the mutual fund industry. He said the SEC let investors down and the GAO report failed to note the vital role the state securities regulators played in uncovering the scandals in the mutual fund industry.

The GAO found that the penalties the SEC obtained in the market timing and late trading abuses were among the highest in its history and were generally consistent with the penalties obtained in cases involving similarly egregious corporate misconduct. The GAO found that the SEC's informal criminal referral process may be efficient, but it does not provide critical management information, and the lack of recordkeeping is inconsistent with federal internal control standards. The documentation of the referrals would be useful for Congressional oversight of enforcement efforts in the securities industry, according to the report.

The GAO report also noted that former staff must notify the SEC if they plan to make an appearance before the agency, but they were not required to report where they planned to work. However, the staff advised the GAO that their mutual fund oversight program now includes the assignment of monitoring teams to the highest risk mutual fund companies.

The new SEC rule requiring all mutual fund companies and investment advisers to appoint chief compliance officers may increase the demand for SEC examiners to fill those positions in the compliance departments of the regulated entities, according to the GAO, which could increase the potential for conflicts of interest. In a response to the report dated April 28, then Enforcement Director Stephen Cutler advised that the SEC is increasing the number of ethics liaison officers who are employed in the exam program and increasing the training related to post-employment issues. As part of the exit process, employees will now be asked about their next employer and, if a potential conflict is identified, the SEC will investigate the situation, as appropriate.

Galvin maintained that monopoly regulators get complacent and become too cozy with the industry that they regulate. They attend the same conferences in appealing cities, he noted, where they may develop comfortable relationships. He said that the Division of Investment Management was one of the SEC's most toothless divisions and that it ignored both academics and tipsters about market timing abuses. Galvin also characterized the mutual fund scandals as the post-legislative result of the dilution of the states' authority over the industry. The states need more cops on the street to provide enforcement competition to the federal regulators, in his view.

Richards argued that matters are not as dire as Galvin's remarks would suggest and said the SEC has a number of ongoing initiatives with the states. Relationships grow over time, she said. Galvin applauded the SEC's rulemaking in response to the mutual fund scandals but pointed to the vastness of the industry and an attitude that continues. He believes that sales practices continue to pose a problem in the industry. The SEC must be the industry's primary rulemaker, he said, but it needs the states to assist in the enforcement area. Subcommittee Chairman Chris Cannon (R-UT) said these are not partisan issues and should be resolvable.