[House Hearing, 109 Congress]
[From the U.S. Government Publishing Office]
MUTUAL FUND TRADING ABUSES
=======================================================================
HEARING
BEFORE THE
SUBCOMMITTEE ON
COMMERCIAL AND ADMINISTRATIVE LAW
OF THE
COMMITTEE ON THE JUDICIARY
HOUSE OF REPRESENTATIVES
ONE HUNDRED NINTH CONGRESS
FIRST SESSION
__________
JUNE 7, 2005
__________
Serial No. 109-42
__________
Printed for the use of the Committee on the Judiciary
Available via the World Wide Web: http://www.house.gov/judiciary
______
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COMMITTEE ON THE JUDICIARY
F. JAMES SENSENBRENNER, Jr., Wisconsin, Chairman
HENRY J. HYDE, Illinois JOHN CONYERS, Jr., Michigan
HOWARD COBLE, North Carolina HOWARD L. BERMAN, California
LAMAR SMITH, Texas RICK BOUCHER, Virginia
ELTON GALLEGLY, California JERROLD NADLER, New York
BOB GOODLATTE, Virginia ROBERT C. SCOTT, Virginia
STEVE CHABOT, Ohio MELVIN L. WATT, North Carolina
DANIEL E. LUNGREN, California ZOE LOFGREN, California
WILLIAM L. JENKINS, Tennessee SHEILA JACKSON LEE, Texas
CHRIS CANNON, Utah MAXINE WATERS, California
SPENCER BACHUS, Alabama MARTIN T. MEEHAN, Massachusetts
BOB INGLIS, South Carolina WILLIAM D. DELAHUNT, Massachusetts
JOHN N. HOSTETTLER, Indiana ROBERT WEXLER, Florida
MARK GREEN, Wisconsin ANTHONY D. WEINER, New York
RIC KELLER, Florida ADAM B. SCHIFF, California
DARRELL ISSA, California LINDA T. SANCHEZ, California
JEFF FLAKE, Arizona ADAM SMITH, Washington
MIKE PENCE, Indiana CHRIS VAN HOLLEN, Maryland
J. RANDY FORBES, Virginia
STEVE KING, Iowa
TOM FEENEY, Florida
TRENT FRANKS, Arizona
LOUIE GOHMERT, Texas
Philip G. Kiko, General Counsel-Chief of Staff
Perry H. Apelbaum, Minority Chief Counsel
------
Subcommittee on Commercial and Administrative Law
CHRIS CANNON, Utah Chairman
HOWARD COBLE, North Carolina MELVIN L. WATT, North Carolina
TRENT FRANKS, Arizona WILLIAM D. DELAHUNT, Massachusetts
STEVE CHABOT, Ohio ADAM SMITH, Washington
MARK GREEN, Wisconsin CHRIS VAN HOLLEN, Maryland
RANDY J. FORBES, Virginia JERROLD NADLER, New York
LOUIE GOHMERT, Texas
Raymond V. Smietanka, Chief Counsel
Susan A. Jensen, Counsel
James Daley, Full Committee Counsel
Stephanie Moore, Minority Counsel
C O N T E N T S
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JUNE 7, 2005
OPENING STATEMENT
Page
The Honorable Chris Cannon, a Representative in Congress from the
State of Utah, and Chairman, Subcommittee on Commercial and
Administrative Law............................................. 1
The Honorable William D. Delahunt, a Representative in Congress
from the State of Massachusetts................................ 3
The Honorable Melvin L. Watt, a Representative in Congress from
the State of North Carolina, and Ranking Member, Subcommittee
on Commercial and Administrative Law........................... 4
WITNESSES
Mr. Richard J. Hillman, Director, Financial Markets and Community
Investment, U.S. Government Accountability Office
Oral Testimony................................................. 6
Prepared Statement............................................. 8
Ms. Lori A. Richards, Director, Office of Compliance Inspections
and Examinations, U.S. Securities and Exchange Commission
Oral Testimony................................................. 33
Prepared Statement............................................. 36
The Honorable William Francis Galvin, Secretary of the
Commonwealth of Massachusetts
Oral Testimony................................................. 55
Prepared Statement............................................. 57
Mr. Eric W. Zitzewitz, Stanford Graduate School of Business,
Stanford, California
Oral Testimony................................................. 59
Prepared Statement............................................. 62
APPENDIX
Material Submitted for the Hearing Record
Prepared Statement of the Honorable Chris Cannon, a
Representative in Congress from the State of Utah, and
Chairman, Subcommittee on Commercial and Administrative Law.... 81
Response to post-hearing questions from Lori A. Richards,
Director, Office of Compliance Inspections and Examinations,
U.S. Securities and Exchange Commission........................ 83
Response to post-hearing questions from the Honorable William
Francis Galvin, Secretary of the Commonwealth of Massachusetts. 95
Response to post-hearing questions from Eric W. Zitzewitz,
Stanford Graduate School of Business, Stanford, California..... 97
MUTUAL FUND TRADING ABUSES
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TUESDAY, JUNE 7, 2005
House of Representatives,
Subcommittee on Commercial
and Administrative Law,
Committee on the Judiciary,
Washington, DC.
The Subcommittee met, pursuant to notice, at 4:05 p.m., in
Room 2141, Rayburn House Office Building, the Honorable Chris
Cannon (Chair of the Subcommittee) presiding.
Mr. Cannon. The Committee will come to order. Before I
begin my formal remarks, I'd like to welcome the gentlelady
from the State of Florida, Ms. Wasserman Schultz, who we
anticipate will be named to replace the gentleman from
Washington, Mr. Smith, on the Committee. I understand there is
a unanimous request that Ms. Wasserman Schultz participate in
today's hearing.
Mr. Watt. I ask unanimous consent that Ms. Wasserman
Schultz be allowed to participate fully as if she were already
a Member of this Committee.
Mr. Cannon. And it has been the habit of this Committee to
yield time to a Member of the Committee and have that Member
then yield to a person who may be a Member of the full
Committee, but not a Member of the Subcommittee. Since Ms.
Wasserman Schultz is going to, we hope, become a Member of the
Committee quite soon, we will set that precedent aside, and
without objection, so ordered. Welcome to the Subcommittee, Ms.
Wasserman Schultz.
And now for my formal remarks. In the fall of 2003, the New
York State Attorney announced what would become the first of
many law enforcement initiatives that his office and other
State officials and the SEC would later champion to ferret out
mutual fund trading abuses. Within the ensuing months many
well-respected mutual fund companies and others were caught up
in this scandal, including Canary Capital, Janus Capital Group,
Bank of America, Alliance Capital Management, Prudential
Securities, Millennium Partners, Fred Alger Management, Putnam
Investments, Massachusetts Financial Services, Security Trust,
Franklin Resources and Invesco Funds Group.
In the fall and winter of 2003, it seemed as if every day
the press reported on yet another shocking instance of mutual
fund trading abuses. These abuses included the illegal practice
of late trading, which involves trading shares after the
markets have closed so that the trader can take advantage of
information that becomes available after the closing. The
Congressional Research Service analogized this practice to a
race track that allows certain customers to bet on yesterday's
races.
Other abuses included the more nuanced problem of market
timing. Market timing typically involves frequent buying and
selling of mutual fund shares by sophisticated investors, such
as hedge funds, that seek opportunities to make profits on the
differences between foreign and domestic markets.
While not per se illegal, market timing can constitute
illegal conduct, if, for example, it takes place as a result of
undisclosed agreements between investment advisers and favored
customers in contravention of stated fund trading limits.
Frequent trading can harm mutual fund shareholders because it
lowers fund returns and increases transaction costs.
According to an estimate provided by one of the witnesses
at today's hearing, Professor Zitzewitz, market timing abuses
may have resulted in $5 billion in annual losses. As of
November 2003, the SEC estimated that 50 percent of the 80
largest mutual fund companies had entered into undisclosed
arrangements permitting certain shareholders to engage in
market timing practices that were inconsistent with the funds'
policies, prospectus disclosures or fiduciary obligations.
As the mutual fund scandal unfolded, questions were raised
about the fitness of the SEC's overall regulation, inspection,
and enforcement of this industry. The Congressional Research
Service posed possible explanations, including the following:
the possibility that the SEC's resources devoted to the fund
industry were dwarfed by the expansion in the number of mutual
funds; the possibility that the SEC's overall effectiveness may
have been marred by interdivisional disharmonies; the
possibility that the SEC officials may have placed too much
trust in the fund industry's integrity and ability to police
itself; the possibility that the mutual fund industry may be
too close to the relevant parts of the SEC entrusted with its
oversight and regulation; and the possibility that the SEC may
have had a somewhat understandable focus on the prevention of
more traditional types of fund misconduct.
In response to these concerns, House Judiciary Committee
Chairman Sensenbrenner and Ranking Member Conyers requested the
GAO to undertake a comprehensive review of the SEC's efforts to
proactively detect and prevent illegal activities in the mutual
fund industry. Today's hearing provides an opportunity for GAO
to report on its findings and recommendations and to allow the
SEC and others to respond to them.
Accordingly, our first witness is Richard Hillman, who is
the Director of GAO's Financial Markets and Community
Investment Team. With 29 years of experience at GAO, Mr.
Hillman is currently responsible for directing research
engagements on various cross-cutting financial services matters
within the banking securities and insurance industry. Mr.
Hillman graduated with honors from the University of Scranton
with a bachelor's degree in science and accounting, and has
completed additional course work in Government management and
information technology issues at the Federal Executive
Institute and Harvard's John F. Kennedy School of Government.
Our next witness is Lori Richards, who is the Director of
the SEC's Office of Compliance Inspections and Examinations.
She has served in that capacity for 10 years. Her office is
responsible for administering the SEC's security compliance
examination and inspection program for entities registered with
the SEC as self-regulatory organizations, broker-dealers,
transfer agents, clearing agencies, investment companies and
investment advisors. Before beginning her career with the SEC
in 1985, Ms. Richards received her B.A. From Northern Illinois
University and her J.D. From American University.
Our third witness is William Francis Galvin, the Secretary
of the Commonwealth of the Massachusetts. I understand that my
colleague on the other side of the aisle Mr. Delahunt would
like to say a few words. The gentleman is recognized.
Mr. Delahunt. Thank you, Mr. Chairman. I am really pleased
to see my friend, my colleague in State government for many
years, Bill Galvin here as a witness. He has an extraordinary
record as secretary of state. In Massachusetts the securities
industry is under his--I should say it is the office that
regulates the securities industry in Massachusetts, and he has
earned justifiably a national reputation for aggressively
protecting investors and has been successful in recovery of
millions of dollars for victims of security fraud.
Bill Galvin was an integral part of the 2003 multistate
examination of research analysts' practices on Wall Street,
which resulted in a finding of fraud against First Boston and
developed into investigations into mutual fund industry
practices. So it is a pleasure to have you here, Bill, and I
look forward to your testimony.
Mr. Cannon. Thank you, Mr. Delahunt.
We are pleased, Mr. Galvin, to have a person of such a
national reputation and one who is--I hope can bring to bear,
and I believe will bring to bear--a great deal of information
and understanding for us on this Committee. Thank you.
Our final witness is Mr. Eric Zitzewitz. He has been an
assistant professor of economics at Stanford Graduate School of
Business since 2001, and published extensively on the
securities industry as well as on other subject matter dealing
with economics. He received his undergraduate degree in
economics from Harvard and his Ph.D. In economics from MIT.
I extend to each of you my warm regards and appreciation
for your willingness to participate in today's hearing. In
light of the fact that your written statements will be included
in the record, I request that you limit your oral remarks to 5
minutes. And accordingly, please feel free to summarize the
salient points of your testimony.
And you will note that there is a lighting system in front
of you. After 4 minutes the light will turn from green to
yellow, and then at 5 minutes it will turn to red. It's my
habit to tap the gavel, probably the handle or maybe a pen, to
just indicate that that's happened. You don't need to cut off
at that point. We are not trying to cut you off mid-thought,
but just as a matter of comity, because there are several
people that will want to ask questions today. I can almost
assure you that you will have plenty of time to come back and
add to your statements as we give 5 minutes to each of the
members of the panel.
After you have presented your remarks, the Subcommittee
Members in order of their arrival will be permitted to ask
questions for 5 minutes. And again, in the case of the clock, I
will tap when we get close to when we hit the red light. You
don't have to stop immediately, but just as a matter of comity,
we would like to move on.
And pursuant to the directive of the Chairman of the
Judiciary Committee, I ask the witnesses to please stand and
raise your right hand to take the oath.
[Witnesses sworn.]
Mr. Cannon. The record will reflect that each of the
witnesses answered in the affirmative.
You may be seated.
And, Mr. Hillman, if you'd like to proceed, you're
recognized for 5 minutes.
Mr. Hillman. Thank you very much, Mr. Chairman.
Mr. Cannon. Pardon me, Mr. Hillman. If I could interrupt
you, we would love to hear from the Ranking Member and I
apologize for not having recognized him a moment ago. If the
gentleman would like to speak, he is recognized for 5 minutes.
Mr. Watt. Thank you, Mr. Chairman. I won't take 5 minutes.
I just wanted an opportunity to join you in welcoming Ms.
Wasserman Schultz to the hearing today and hopefully to the
membership on the Committee tomorrow, once that is formalized.
I want to thank the Chairman for convening the hearing to
begin the process of reviewing the SEC's failure to detect
mutual fund abuses. More than one-half of American households
invest in mutual funds. They invest to enhance their futures
and their children's futures. These investments should be
treated with great care and confidently secured from abuses.
I think we all agree the market should be free from
unscrupulous activities of mutual fund companies. Although this
Subcommittee is addressing the GAO's recommendations with
respect to the SEC's role in detecting the mutual fund abuses
that hinder long-term shareholders from proper fund returns, I
would like to emphasize the important role the States play and
continue to play in the collaborative efforts to detect and
deter mutual fund abuse.
Many of the abuses examined by the GAO at the request of
Chairman Sensenbrenner and Ranking Member Conyers surfaced due
to the diligence of the State Attorney General Eliot Spitzer of
New York. So while I think it is important that we determine
whether the SEC is broken and, if so, how to fix it, I can't
overemphasize the critical role that the States must continue
to play in protecting investors, large and small.
Additionally, I have--I don't know whether it's enviable,
but I serve on both the Judiciary Committee and the House
Financial Services Committee, and those are the Committees that
actually share jurisdiction over mutual funds and securities.
And so I want to emphasize the important role that the
Financial Services Committee also plays over law enforcement in
the mutual fund industry. I believe we should focus narrowly on
enforcement issues in this Subcommittee and take care to divine
precisely what role this Committee can and should take in
response to the problems of abuses that have been revealed. So
I am particularly interested in hearing the testimony here
today, and I welcome the witnesses and yield back.
Mr. Delahunt. Would the gentleman yield for a moment?
Mr. Watt. I am happy to yield to my friend from
Massachusetts.
Mr. Delahunt. Yeah, I just wanted to echo some of the
sentiments that you expressed, Mr. Watt, particularly regarding
the role of the Judiciary Committee as well as the Financial
Services Committee. I know you serve on both. And I want to
applaud the Chairman for calling this particular hearing into
an issue obviously that has great significance and impact to
the lives of millions, tens of millions of Americans. And I
would hope that this Subcommittee would even be more aggressive
in the future in terms of exercising its oversight
responsibilities, particularly as it relates to enforcement not
only in this area, but in the entire jurisdiction within the
Committee's purview.
One can only reflect on the number of administrative bodies
that exist in the executive branch of Government that I would
respectfully suggest are not the subjects of significant
oversight. One only has to think of the alphabet that we deal
with in terms of administrative agencies, and yet I have served
on this Committee in the past, and this is the first time, in
my memory, I can think of a significant agency such as the SEC
that has been before the Committee. And I would hope that we
would continue to be aggressive and send that message out to
the executive branch that this Subcommittee in particular
intends to be aggressive about oversight. And with that I yield
back.
Mr. Watt. I appreciate the gentleman's comments and--but I
do want to assure him that the Financial Services Committee has
had the SEC and a number of these agencies in front of that
Committee on a regular basis, so it is not that oversight is
not being done. It is being done. And our role, I think, is
more on the enforcement side to emphasize not--well, you know,
we have got a clear role here, and we just need to not stumble
over each over, I guess, is the----
Mr. Delahunt. Never enough oversight.
Mr. Watt. Never enough oversight.
Yield back.
Mr. Cannon. I thank the gentleman. Let me also point out
that I believe there is never enough oversight, whether it is a
Republican administration or a Democrat administration, whether
the Republicans control Congress or the Democrats do. That is
one of the great, great things about this body. And so to the
degree that the Minority has had issues that they want to look
at, I hope we have been receptive and are anxious actually to
carry out that oversight role. So thank you, Mr. Delahunt, for
your kind comments, and Mr. Watt.
Mr. Hillman, if you would like to go ahead, you're
recognized for 5 minutes now.
TESTIMONY OF RICHARD J. HILLMAN, DIRECTOR, FINANCIAL MARKETS
AND COMMUNITY INVESTMENT, U.S. GOVERNMENT ACCOUNTABILITY OFFICE
Mr. Hillman. Thank you, Mr. Chairman. I am pleased to be
here today to discuss two recently issued GAO reports that
assess SEC's response to trading abuses uncovered in the mutual
fund industry. We prepared these reports at the request of
Chairman Sensenbrenner and Ranking Member Conyers of the full
Committee.
As you know, trading abuses, including fraudulent market
timing and late trading violations, were uncovered in many
well-known companies in the mutual fund industry and raise
significant concerns about the industry's ethical practices.
Maintaining public confidence in the mutual fund industry is
critical because about 95 million Americans have invested more
than 8 trillion in mutual funds, a significant share of the
Nation's privately held wealth. Moreover, it is critical that
the SEC have the capacity to identify abusive practices and to
bring enforcement actions that punish violators and deter those
who are contemplating similar abuses.
My written statement today discusses the reasons the SEC
did not detect the market timing abuses at an earlier stage,
some of the steps that SEC has taken to strengthen its
oversight of the mutual fund industry, and enforcement actions
taken by SEC and criminal prosecutors in response to these
abuses, and SEC's management of procedures related to the
making of criminal referrals and ensuring staff independence
from the mutual fund industry.
In summary, regarding our first objective, before September
2003, SEC did not examine fund companies for market timing
abuses because agency officials, one, viewed other activities
as representing much higher risk; two, concluded that companies
had financial incentives to control frequent trading because it
could lower fund returns; and three, were told by company
officials and the companies that they had established controls
over frequent trading.
While SEC faced competing examination priorities before
September 2003, and had made good-faith efforts to mitigate the
known risks associated with legal market timing, lessons can be
learned from the Agency not having detected the abuses earlier.
First, without paying additional attention to conducting
independent assessments of the adequacy of mutual fund company
controls, the potential increases that violations may go
undetected.
Second, SEC can strengthen its capacity to identify and
assess any evidence of potential risk. Information was
available to the SEC before these market timing problems were
uncovered indicating the possibility of illegal market timing
activities. For example, a 2002 study estimated that market
timing in certain funds resulted in about 5 billion in annual
losses to shareholders and raised the possibility that
investment advisors did not always act decisively to control
such risks due to potential conflicts of interest.
Third, our review of individual market timing enforcement
cases found that compliance staff at mutual fund companies
often detected evidence of undisclosed market timing
arrangements with favored customers, but lacked sufficient
independence within their organizations to correct identified
deficiencies. Ensuring the independence of compliance staff is
critical, and SEC could potentially benefit from using their
work.
Since these abuses were uncovered SEC has acted
aggressively to address identified abuses through proposed and
final rulemakings, bringing and settling enforcement cases and
conducting targeted examinations. In particular, SEC has take a
variety of steps to strengthen its mutual fund oversight
program and the operations of fund companies, but it is too
soon to assess the effectiveness of several key initiatives.
For example, SEC has instructed its staff to make additional
assessments of company controls and established a new office to
improve its capacity to anticipate, identify and manage
emerging risks and market trends in the securities industry.
SEC also adopted a rule that requires mutual fund companies to
appoint independent compliance officers who are to prepare
annual reports on their companies' policies and violations;
however, SEC has not yet developed a plan to receive and review
these annual reports on an ongoing basis and thereby enhance
its capacity to detect potential violations.
SEC has agreed with recommendations in our report to
strengthen its oversight, including assessing how best to use
such compliance reports. At the time of our review, SEC had
brought 14 enforcement actions against mutual fund companies
and 10 enforcement actions against other firms for mutual fund
trading abuses. The penalties obtained in settlements with
mutual fund companies are amongst the Agency's highest, ranging
from 2 million to 140 million and averaging 56 million. In
contrast, penalties obtained in settlements for securities laws
violations prior to 2003 were typically under 20 million.
In reviewing a sample of investment advisor cases, we found
the SEC followed a consistent process for determining
penalties, and that it coordinated penalties and other
sanctions with interested parties. However, we found certain
weaknesses in SEC's management procedure for making referrals
to criminal law enforcement and ensuring staff independence. In
particular, SEC does not require staff to document whether a
criminal referral was made or why. Without such documentation,
SEC cannot readily determine whether staff make appropriate
referrals. Further, SEC does not require departing staff to
report where they plan to work, information gathered by other
financial regulators to assess staff compliance with Federal
laws regarding employment with regulated entities. In the
absence of such information, SEC's capacity to ensure
compliance with these conflict-of-interest laws is more
limited.
SEC agreed with our report recommendations to document
criminal referrals and employees' postemployment plans.
Mr. Chairman, this completes my prepared statement. I would
be happy to respond at the appropriate time to any questions
that might arise.
Mr. Cannon. Thank you, Mr. Hillman.
[The prepared statement of Mr. Hillman follows:]
Prepared Statement of Richard J. Hillman
Mr. Cannon. Ms. Richards, you're recognized for 5 minutes.
TESTIMONY OF LORI A. RICHARDS, DIRECTOR, OFFICE OF COMPLIANCE
INSPECTIONS AND EXAMINATIONS, U.S. SECURITIES AND EXCHANGE
COMMISSION
Ms. Richards. Thank you, Chairman Cannon, Ranking Member
Watt, Members of the Committee. I am Lori Richards. I am
Director of the SEC's Office of Compliance Inspections and
Examinations. Thank you for inviting me to testify here today
about the SEC's oversight of the mutual fund industry, the
recent mutual fund trading abuses and recent GAO reports.
In the last 21 months, the SEC has moved quickly to
implement a series of reforms with respect to mutual funds. We
rapidly examined and investigated fund firms and brought
numerous enforcement actions. We adopted new rules designed to
improve mutual funds governance, ethical standards, compliance
and internal controls. We initiated reforms to SEC rules
designed specifically to address market timing and late
trading. And finally, we improved SEC examiners' ability to
detect emerging compliance problems promptly. It is our
expectation that, taken together, these reforms will minimize
the possibility of these types of abuses from occurring again.
My testimony today focuses primarily on the significant
steps that the SEC has taken with respect to its examination
oversight of mutual funds. There are now over 8,000 mutual
funds managed in over 900 mutual fund complexes, and over 8,000
investment advisors registered with the SEC. The size of the
mutual fund industry does not allow the SEC to conduct
comprehensive audits of all of their operations. Until recently
the SEC had approximately 360 staff people who were dedicated
to these examinations. In 2003, however, budget increases
allowed us to increase the size of the SEC's examination staff
to approximately 500 staff people.
Given the size of the industry, our examinations focus on
those areas that, in our view, pose the greatest risk to
investors. The challenge for any regulator with limited
resources is to identify and to effectively target those areas
that pose the greatest risk. SEC examinations are, therefore,
focused on the use of a fund investor's assets, their money and
their securities, and primarily whether the mutual fund is
making investments on behalf of investors that are appropriate,
how mutual funds are being marketed and sold to retail
investors, and whether funds were trying to inflate the returns
of the fund or take on undisclosed risk in order to generate
more sales.
It is important for me to note that while market timing was
the subject of recent GAO reports, SEC examinations have often
detected serious compliance problems in other areas, and those
have resulted in serious enforcement actions. For example, the
SEC has been on the forefront of discovering and addressing
abuses with respect to the widespread failure to deliver mutual
fund discounts to investors on their purchases of mutual funds;
investment advisors' undisclosed favoritism in the allocation
of shares amongst their client accounts; the failure to
disclose the use of mutual funds money to pay the cost of
selling fund shares; and various types of sales abuses, in
particular selling one type of fund to an investor when another
type of fund would be better for that particular investor, and
various unsuitable sales associated with the sales of variable
annuity products.
Since the first instances of market timing and late trading
were identified by a tip to the New York Attorney General's
Office, the SEC moved very rapidly to investigate this issue in
the broader mutual fund industry. As of May 31, 2005, the SEC
has brought 29 enforcement actions involving mutual fund
complexes and their employees and 12 enforcement actions
involving broker-dealers and their employees. The recent GAO
report outlined some of these enforcement actions, and
recognizes that the penalties obtained in these cases are among
the largest ever imposed by the SEC. Prior to 2003, as the GAO
report notes, we did not identify the covert secret market
timing arrangements between mutual funds and active traders.
It is important to note that there is a difference between
market timing that is legal and market timing that is illegal.
Illegal market timing involved secret arrangements between fund
executives and select market timers. By their nature these were
secret, undisclosed arrangements, some of which we now know
involved nominee accounts and false trading records. The SEC
did not have prior notice of these secret arrangements that
some mutual fund executives had with favored traders.
GAO has stated that we can learn lessons from our
experience with market timing. I suppose I would recast that
statement slightly to say that we have learned lessons from our
experience with market timing. We have implemented changes to
our examination protocols that will allow examiners not only to
detect abusive market timing and late trading, but, perhaps
more importantly, to be more nimble, to be more aggressive, to
be more proactive in identifying other types of misconduct
associated with mutual funds.
The new methodology is described in some detail in my
written testimony, but key enhancements include conducting
focused routine examinations on the highest-risk firms;
increasing the use of data and technology in examinations,
including by randomly reviewing mutual fund employees' e-mails.
One of the lessons we learned is that the secret market timing
arrangements were often negotiated between mutual fund
executives and market timers via e-mail communications. So
those are now critical aspects of our routine examinations.
We are studying the development of an off-site surveillance
program for mutual funds and investment advisors. We
implemented a new risk mapping program to better identify areas
of emerging risk. We have implemented a new program to rapidly
investigate emerging compliance problems by use of sweep
examinations. We are implementing dedicated monitoring teams
for the largest fund organizations, and, very importantly, to
help reduce violations or help eliminate the possibility that
violations could occur in the first place. We are reaching out
to the new chief compliance officers at mutual fund firms and
investment advisors in a new chief compliance officers outreach
program to help them better eliminate compliance problems in
the first place.
In sum, the SEC has taken aggressive steps to address
abusive market timing and late trading in mutual fund shares,
but more broadly, the SEC has taken steps to protect investors
from the next instance of fraud and abuse by improving our
ability to spot emerging problems more quickly.
Thank you, and I am happy to answer any questions you may
have.
Mr. Cannon. Thank you.
[The prepared statement of Ms. Richards follows:]
Prepared Statement of Lori A. Richards
Mr. Cannon. Secretary Galvin.
TESTIMONY OF WILLIAM FRANCIS GALVIN, SECRETARY OF THE
COMMONWEALTH OF MASSACHUSETTS
Mr. Galvin. Thank you, Mr. Chairman.
Chairman Cannon, Ranking Member Watt, distinguished Members
of the Committee, thank you very much for having me here this
afternoon. I am Bill Galvin. I'm the Secretary of the
Commonwealth of Massachusetts and its chief securities
regulator. Among the duties of my office are protecting
investors in the Commonwealth of Massachusetts through our
securities division.
I am here today to offer my perspective on mutual fund
trading abuses, and more specifically this recent April 2005
GAO report. The subtitle of this report is, quote, Lessons Can
Be Learned from the SEC Not Having Detected Violations at an
Earlier Stage, close quote. From my perspective, the lessons
are pretty simple. In the past the SEC simply didn't do it's
job. It dropped the ball. It ignored warning signs and
inexplicably didn't follow up on tips. In short, it failed to
protect mutual fund investors.
Let me be blunt. Had the SEC done what it was supposed to
do, we probably wouldn't be here today. Unfortunately, it's not
the first time the SEC has let investors down. Consider the
history from just the past 10 years. Almost every major
enforcement action or investor protection issue was first
brought or raised not by the SEC or the NASD, but by State
securities regulators. These include penny stock and microstock
fraud, day trading abuses, misleading Internet brokerage
advertising, analyst conflict of interest matters, and lastly
mutual fund trading abuses. In virtually every case the States
took the lead.
The revelations of recent years about the securities
industry teach an even more compelling lesson, and that is the
critical importance of what goes on in what I will call the
risk marketplace for average Americans. Their savings, their
pensions, their children's education funds, in short their
financial futures are now as never before in play in this
marketplace.
The GAO report is fine as far as it goes, but it leaves out
the most important lesson, in my view, and that is the vital
role played by State securities regulators. We need more cops
on the securities beat and more constructive competition among
them to protect the investing public. Our regulatory monopoly
is as bad as any other kind of monopoly. Customers and
investors are ill served by monopolies. Monopoly regulators,
like monopoly companies, get complacent. They miss things. They
can get too cozy with the folks they're supposed to regulate.
I have seen how it works in the securities industry. The
regulators and the regulated go to each others' conferences,
usually in nice places like Palm Beach and Palm Desert. The
revolving door through which Federal regulators go to find
lucrative jobs on Wall Street should be the subject of another
hearing perhaps on another day.
As I said, we probably wouldn't be here today if the SEC
had done its job. Unfortunately it did not. From my perspective
as a State securities regulator, I think the SEC has to be
aggressive across the board.
Chairman William Donaldson has made some important progress
during his time at the Commission. The pending nomination of
Mr. Cox and other anticipated vacancies at the SEC raises a
most serious question. Is the era of reform and vigorous
enforcement over? There is no doubt we are at a crossroads.
Just 2 years ago this House of Representatives voted by a
margin of 418 to 2 to reform the mutual fund industry. The bill
died in the Senate. Was that just for show, or are we serious
about giving average Americans real protection?
Over the years the SEC has been criticized for not being
proactive and tough enough. I think it is a fair criticism.
Traditionally one of the weakest and most toothless divisions
of the SEC was in investment management. It has not been known
for aggressive examinations, and certainly not for enforcement
actions. I'd even call it a regulatory backwater. This is
strange and unacceptable, given that nearly 100 million
Americans entrust their money to the mutual fund industry. Yet
here we have a regulator that ignored reports from academics
and even anonymous tipsters from within the industry that
market timing was costing investors billions of dollars.
This chicanery and fraud would likely still be going on if
it were not for a couple of State securities divisions that
acted when the SEC and the NASD did not, despite having a tiny
fraction of the resources these two organizations have. In
Massachusetts, for example, we brought many--several market
timing and late trading enforcement actions based on the tips
we received and the exams we conducted. These involved Putnam
Mutual Funds, Prudential Securities, Franklin-Templeton and
A.G. Edwards. Like State securities regulators across the
country who follow up on tips, we answer the phone, we listen
to investors, and we're easy to reach.
There are those who would like to see the State securities
regulators just go away. They argue our complementary system of
State and industry self-regulation is burdensome and
duplicative. It is neither. Quite the contrary, it serves to
protect investors. The mutual fund trading abuse described in
the GAO report are proof of that.
Our system works. That's the lesson of all this. So next
time some free market think tank underwritten by Wall Street
money says we don't need State securities regulators, that the
industry can regulate itself just fine out of enlightened self-
interest, you have a simple four-word answer, which also
happens to be the title of this report: Mutual Fund Trading
Abuses.
The fact is we need more, not fewer, cops on the securities
beat. That is the lesson of this scandal. And we need
cooperation among regulators, not corruption. We need to check
each other's work. Sometimes we need to backstop each other.
A few years ago in 1996, in the name of so-called
regulatory reform and efficiency, the States were essentially
preempted from the regulation of mutual funds. The scandal we
are here today to discuss is a legacy of that misguided policy.
Investor protection, including aggressive enforcement of State
and Federal securities laws, isn't a partisan issue. Democrats,
Republicans, Libertarians, Greens and Independents, we all rely
on our Nation's securities markets for financial security.
Investors vote, and they are a very large constituency. They
need to be protected, and they're relying on us. We must make
sure that they are protected.
To sum up, the lessons of this chapter on Wall Street
history are simple. While SEC and the NASD dropped the ball,
the States picked it up. Our system worked. Now we are about to
write the next chapter. Will it be back to business as usual,
or will it be real protections for the hard-earned money that
our citizens have invested? The answer is up to us.
Thank you very much, Mr. Chairman. I will be happy to
answer any question at the appropriate time.
Mr. Cannon. Thank you, Mr. Secretary.
[The prepared statement of Mr. Galvin follows:]
Prepared Statement of William Francis Galvin
Chairman Cannon, Ranking Member Watt, and distinguished members of
the committee.
My name is William Galvin. I am Secretary of the Commonwealth of
Massachusetts and the Chief Securities Regulator.
Among the duties of my office are protecting investors in the
Commonwealth through the Securities Division.
I'm here today to offer my perspective on mutual fund trading
abuses and, more specifically, this April 2005 GAO report.
The subtitle of this report is ``Lessons Can Be Learned from SEC
Not Having Detected Violations at an Earlier Stage.''
From my perspective, the lessons are pretty simple.
In the past, the SEC simply didn't do its job. It dropped the ball.
It ignored warning signs and, inexplicably, didn't follow up on tips.
In short, it failed to protect mutual fund investors.
Let me be blunt: Had the SEC done what it was supposed to do, we
probably would not be here today.
Unfortunately, it's not the first time the SEC has let investors
down. Consider the history from just the past 10 years.
Almost every major enforcement action or investor protection issue
was first brought or raised not by the SEC or NASD but by state
securities regulators.
Penny stock and microcap stock fraud
Day trading abuses
Misleading Internet brokerage advertising
Analyst conflicts of interest
Mutual fund trading abuses
In virtually every case, the states took the lead.
The revelations of recent years about the securities industry--
teach an even more compelling lesson--that is--the critical importance
of what goes on in what I will call the ``risk'' marketplace to average
Americans.
Their savings--their pensions--their children's education--in
short--their financial futures are now as never before in play in this
marketplace.
This GAO report is fine as far as it goes. But it leaves out the
most important lesson, in my view.
And that is: The vital role played by state securities regulators.
We need more cops on the securities beat--and more constructive
competition among them--to protect the investing public.
A regulatory monopoly is as bad as any other kind of monopoly.
Customers and investors are ill-served by monopolies.
Monopoly regulators, like monopoly companies, get complacent. They
miss things. They can get too cozy with the folks they're supposed to
regulate. I've seen how it works in the securities industry. The
regulators and the regulated go to each others conferences, usually in
nice places like Palm Beach and Palm Desert.
The revolving door through which federal regulators go to find
lucrative jobs on Wall Street should be the subject of another hearing
on another day.
As I said, we probably wouldn't be here today if the SEC had done
its job.
Unfortunately it did not.
From my perspective, as a state securities regulator, I think the
SEC has to be aggressive across the board. Chairman William Donaldson
made some important progress during his time at the Commission.
The pending nomination of Mr. Cox and other anticipated vacancies
at the SEC raises a most serious question--is the era of reform and
vigorous enforcement over?
There is no doubt we are at a crossroad. Just two years ago the
House of Representatives voted by a margin of 418 in favor to 2 against
to reform the mutual fund industry. The bill died in the Senate. Was
that just for show?--or are we serious about giving average Americans
real protection.
Over the years, the SEC has been criticized for not being proactive
and tough enough. I think it's a fair criticism.
Traditionally, one of the weakest and most toothless divisions at
the SEC was Investment Management. It has not been known for aggressive
examinations, and certainly not for enforcement actions. I'd even call
it a regulatory backwater.
This is strange--and unacceptable--given that nearly 100 million
Americans entrust their money to the mutual fund industry.
Yet here we have a regulator that ignored reports from academics
and even anonymous tipsters from within the industry that market timing
was costing investors billions of dollars.
This chicanery and fraud would likely still be going on if it
weren't for a couple of state securities divisions that acted when the
SEC and NASD did not, despite having a tiny fraction of the resources
these two organizations have.
In Massachusetts, for example, we brought several market-timing and
late-trading enforcement actions based on tips we received and exams we
conducted. These involved Putnam Mutual Funds, Prudential Securities,
Franklin-Templeton and A.G. Edwards.
Like state securities regulators across the country, we follow up
on tips. We answer the phone. We listen to investors. We're easy to
reach.
There are those who would like to see state securities regulators
just go away. They argue that our complementary system of state,
federal and industry self-regulation is burdensome and duplicative.
It is neither. Quite the contrary. It serves to protect investors.
The mutual fund trading abuses described in this GAO report are proof
of that.
Our system works. That's the lesson of all this.
So next time some free-market think tank, underwritten by Wall
Street money, says we don't need state securities regulators, that the
industry can regulate itself just fine out of enlightened self-
interest--you have a simple four-word answer, which also happens to be
title of this report: ``Mutual Fund Trading Abuses.''
The fact is, we need more, not fewer, cops on the securities beat.
That is the lesson of this scandal.
And we need cooperation among regulators, not co-option. We need to
check each other's work sometimes. We need to backstop each other.
Years ago, in the name of so-called regulatory reform and
efficiency, the states were essentially pre-empted from the regulation
of mutual funds. The scandal we are here today to discuss is a legacy
of that misguided policy.
Investor protection--including aggressive enforcement of state and
federal securities laws--isn't a partisan issue.
Democrats, Republicans, Libertarians, Greens and Independents--they
all rely on our nation's securities markets for their financial
futures.
Investors vote and they're a very large constituency--larger than
teachers, larger than labor, bigger than the AARP and bigger than the
Baby Boomers.
They need to be protected. They're relying on us. If for some
reason investors lost faith in our markets, it would be more than a
pocket-book issue. It would be a national security issue.
We can't allow that to happen.
To sum up, the lessons of this sad chapter in Wall Street's history
are simple: While the SEC and the NASD dropped the ball, the states
picked it up. The system worked.
Now we are about to write the next chapter--will it be back to
business as usual?--or will it be real protections for the hard-earned
money that our citizens have invested.
The answer is up to us.
Thank you, Mr. Chairman.
Mr. Cannon. I couldn't help but think while you were
talking about the incomparable Andrew Jackson and his veto of
the Second National Bank's charter, which was passed by a
Congress populated by a large number of people on the payroll
of the Second National Bank. And in America, the reason we are
having this hearing is because we need to strive to break up
those cozy and often funded relationships that result in a loss
of confidence. The only way you can have confidence is by
having transparency and by having what you call protection;
that is, enforcement against those people who commit crimes.
And I love your idea. Pardon me for taking a couple of moments
here, but I love the idea of cooperation and competition among
enforcement agencies.
Thank you very much, Mr. Galvin.
And Mr. Zitzewitz.
TESTIMONY OF ERIC W. ZITZEWITZ, STANFORD GRADUATE SCHOOL OF
BUSINESS, STANFORD, CALIFORNIA
Mr. Zitzewitz. Chairman Cannon, Ranking Member Watt, and
Members of the Committee, thank you for the opportunity to
appear here today.
We are discussing two recent reports by the GAO that ask
whether there are lessons to be learned from the SEC's handling
of recent issues in the pricing and trading of mutual fund
shares. Both reports deal with the general issue of regulatory
capture, whether the SEC is influenced by the industry in a way
that adversely affects investors, and whether reforms can make
it more immune to that influence.
The first report concluded that the SEC was aware of
inefficiencies in the pricing of mutual fund shares that
created arbitrage opportunities, and that it relied too heavily
on assurances from the industry that they were preventing these
inefficiencies from being exploited. This was despite being
aware of evidence to the contrary: academic studies of the
issues, press reports, complaints from investors and fund
employees, and the high fund share turnover rate publicly
reported by some international mutual funds.
The GAO report focuses on failings in the handling of
referrals and in routine inspections. It does not mention
policymaking, and I understand there are some jurisdictional
issues involved, but that's an issue to which I will return.
The second report examines the negotiation of settlements
with fund advisors who priced their funds in a way that created
arbitrage opportunities and then facilitated arbitrage trading.
The report appeared motivated by concerns that prosecutorial
discretion could lead to excessive leniency, leniency that
might be rewarded in a staff member's post-SEC career.
The GAO concluded that participation in the settlement
negotiations was broad, and that negotiations were always
conducted in the context of a damage analysis by SEC
economists, and that this limited the influence of any
individual. That said, the GAO concluded, and the SEC
concurred, that improved monitoring of the subsequent
employment of SEC enforcement staff would be a useful reform.
Before commenting on these two issues, I should preface
everything by noting that the SEC and mutual fund industry have
made a remarkable amount of progress in addressing these issues
since September of '03. Furthermore, while economists often
critique the incentives created by and the outcomes of an
institution's design, we do so without impugning the character
and work of its staff. I have met many members of the SEC in
the last 2 years, and without exception found them to be smart
and dedicated people whose primary concern is that our capital
markets operate as efficiently and fairly as possible. Nothing
I say today should be taken to imply otherwise.
The GAO reports are very thorough, and they adroitly handle
a set of very sensitive issues. My only major critique of the
first report is that it reflects the conventional framing of
the market timing issue as one of trading abuses as opposed to
one of pricing inefficiencies. The difference is subtle, but
important for two reasons. First, focusing on pricing rather
than trading leads one to the correct policy fixes. And second,
focusing on pricing leads one to ask the right or at the very
minimum an additional set of questions about the pre-2003 SEC
stance on this issue.
The great irony is that the SEC understood the
inefficiencies in international mutual fund pricing and had
twice urged the industry to eliminate them through a procedure
known as fair value pricing. But when the industry resisted,
the SEC essentially backed down, despite the fact that it was
clear from publicly available data that most funds were fair
valuing infrequently if at all. The SEC provided no further
formal guidance on this issue.
Even since September 2003 there has been in some cases a
striking similarity between what the industry's asked for and
what the SEC has proposed. The primary direct fix for the
market timing problem proposed by the Investment Company
Institute in October of '03 was a mandatory 2 percent fee for
redemptions within 5 days of purchase. As I and others pointed
out at the time, a severe limitation of this fix is that
arbitragers could just hold their shares until day 6. Even if
enforcement of the rule were perfect, it would only reduce the
excess return available to the arbitragers by a factor of
roughly 2. Despite this limitation this exact proposal became
the primary direct fix for the market timing problem proposed
by the SEC.
What I and others argued at the time would be a better
first step is for the SEC to set and enforce standards for fund
valuation that would substantially eliminate any arbitrage
opportunity. Doing so would largely eliminate the need for
measures such as monitoring and short-term trading fees. It
will also eliminate the component of arbitrage that these
measures will never be able to address.
While the industry has made progress in improving the
valuation of international equity funds, there is still scope
for further improvement. In other asset classes, such as
illiquid bonds and small cap equity, substantial arbitrage
opportunities still exist. This is possible because the
industry is waiting for guidance on evaluating these asset
classes from the SEC. There have been rumors for some time that
the SEC is planning to issue such guidance, but there appears
to be a delay. Regardless, the question remains why fixing the
valuation of funds is the last step being taken as opposed to
the first.
This brings me to my only substantial critique of the
second report, which is also about the report's scope more than
its content. The second report focuses on one form of
regulatory capture while neglecting one potentially more
important. The report is concerned with firm-level capture
where a prosecutor might settle on attractive terms with a fund
advisor and then go work for that advisor. My suspicion is that
this scenario is fairly unlikely, particularly in the current
climate. A more likely and difficult-to-address form of capture
is industry-level capture in which a prosecutor settles on
attractive terms out of fear that aggressive prosecution of a
member of the industry will limit his or her subsequent career
throughout the industry, or alternatively in which a
policymaker is reluctant to push a policy that an entire
industry opposes for the same reason. Is this type of capture a
problem? The experience with pre-'03 policymaking suggests that
it might be, while the scale of the penalties summarized in the
second GAO report suggest that it's not.
The important question, of course, is not about what
happened in the past, but what we can expect in the future. The
extent to which the changed regulatory environment in '03-'04
turns out to be temporary or permanent, of course, remains to
be seen.
How does one address this form of capture? The economists'
answer would be higher salaries and longer employment tenures
at the SEC to reduce the importance of post-SEC income.
Personally I am a little more optimistic about my guess as to
what the sociologists' answer would be: to collectively
recognize that capture is a problem and that attempting to
influence policy in this manner as opposed to winning arguments
based on the facts is not something that should be rewarded.
A more radical suggestion would be to revisit the
organization of SEC. Currently the policymaking divisions of
the SEC are largely organized around the industries they
regulate. A well-known empirical regularity is that single
industry regulators are typically more prone to capture than
mutli-industry regulators. The reason is straightforward. A DOJ
lawyer prosecuting a case against the vitamin cartel need not
seek future employment from the vitamin industry, whereas this
is less true for an airline pricing specialist at the CAB
seeking to limit a requested airfare increase. In this sense
the current organization of the SEC may be exacerbating the
influence of industry. If a formal reorganization is viewed as
too costly, then a positive step may be to simply
institutionalize the cross-functional involvement that the
second GAO report notes was a favorable feature of the SEC's
work on fund settlements.
In conclusion, thank you for the opportunity to share with
you my thoughts on these issues. I look forward to your
questions.
Mr. Cannon. Thank you, Mr. Zitzewitz.
[The prepared statement of Mr. Zitzewitz follows:]
Prepared Statement of Eric W. Zitzewitz
Mr. Cannon. Does the gentleman from North Carolina seek
recognition?
Mr. Watt. Thank you, Mr. Chairman.
Mr. Cannon. The gentleman's recognized for 5 minutes.
Mr. Watt. Ms. Richards, I am trying to assess whether there
is a different attitude at the SEC regarding oversight and
enforcement related to mutual funds than there is at the SEC
regarding other securities. First of all, is there a different
attitude, and if so, why? Second, is there a different level of
personnel numbers quality, and if so, why? You said there were
500 employees overseeing the mutual funds. What would be the
comparable number, for example, overseeing other kinds of
securities matters? Could you just talk about that a little bit
to see whether there is some historic difference in attitude?
Ms. Richards. Sure. Let me say at the outset, my office
examines stock exchanges, broker-dealers, transfer agents, as
well as mutual funds and investment advisors. I was a member of
the SEC's enforcement division for 10 years before I came to
this job. Our examiners are uniformly, I believe, aggressive,
and they are incentivized to find problems. The mission of the
SEC is to detect fraud. Having examiners in a single division,
I think, allows us to be single-minded and focused in that
goal. Similarly, having enforcement staff in a single division,
with their only goal is to prosecute violations of the
securities law, I think helps further that mission.
I can speak very candidly and personally about the attitude
of my staff certainly in the exam program, but also of the SEC
staff, that our mission and our goal is to detect fraud.
Chairman Donaldson, when he came to the SEC, his primary goal
in terms of managing the SEC was to institute reforms that
would allow us to see around the corner and over the hill to
detect the next type of emerging fraud and to be better focused
on emerging risks in the securities industry.
Mr. Watt. I'm not sure I have yet heard, is there a
division with reference to mutual funds enforcement and other
securities enforcement, or is it all one?
Ms. Richards. It's all in one. The examination function for
all those entities in the securities industry is in one
program. The enforcement function is in one program. There are
other offices of the SEC that do policymaking. Within the
examination program we have now about 500 staff people who are
responsible for examining mutual funds and investment advisors.
We have about 350 staff people who examine broker-dealers. They
are complemented by the work of the stock exchanges. The self-
regulatory organizations also have examiners that examine
broker-dealers. With respect to the stock exchanges, we have
about 50 staff people who are responsible for examining the
stock exchanges.
Mr. Watt. So you actually have more people on mutual funds
because there are other supervisory entities such as the stock
exchanges' broker-dealer associations that are self-governing.
Is there not a separate self-governing entity for mutual funds?
Ms. Richards. That's right. The mutual funds have no self-
regulatory organization, so the SEC is the primary regulator,
complemented certainly by the work of other regulators,
including State securities regulators, but there is no
equivalent in the mutual fund industry, no equivalent self-
regulatory organization.
Mr. Watt. Mr. Zitzewitz, what say you about this issue that
I addressed to her, and how might it be improved?
Mr. Zitzewitz. Sir, when I was referring to the
organization of the SEC, I was referring primarily to the
policymaking divisions. I think that having a single division
for enforcement and a single division for inspections makes a
lot of sense. I suppose within those divisions for expertise
reasons it's always going to make sense to have some people
focusing on one area and some people focusing on another area.
I think, though, it's useful to consider the fact that
there might be a trade-off between allowing employees to build
expertise and having it be the case that once they have done
that, their future employment has to come from that industry.
It may be that having large numbers of specialists might make
sense to temper that with some cross-functional specialization
if you're thinking about controlling sources of potential
capture.
Mr. Watt. Thank you, Mr. Chairman. I yield back.
Mr. Cannon. I thank the Ranking Member.
The Chair would announce that it's his intention to allow
the other Members here to ask questions before I ask questions.
So the Chair recognizes Mr. Delahunt for 5 minutes.
Mr. Delahunt. Thank you, Mr. Chairman.
I would be interested in the opinion of both Ms. Richards
and Secretary Galvin about the relationship between Federal and
State regulators. I have a concern. You might have heard the
banter up here earlier, about there's never too much oversight.
And Mr. Galvin expressed it as in terms of there's not enough
cops on the beat.
Now, I don't know what happened, you know, prior to
September of 2003, but clearly there were abuses that either
were not identified or were identified and were not pursued by
the SEC. I'm not interested in the history. I'm interested in
solving the problem. But having been a State prosecutor myself,
I know that oftentimes there are problems in relationships
between State agencies and Federal agencies. But to use the
military concept of a force multiplier, where do we stand in
terms of the relationship between the State regulators and the
SEC at this point in time? And let me begin with Ms. Richards,
and then I would ask Secretary Galvin.
Ms. Richards. Well, I agree with everything you just said.
There are vast numbers of securities firms. We are outmanned
and outgunned by the securities firms that we regulate. There
are compliance departments of some of the large securities
firms that outnumber SEC in terms of the number of exam staff
that we have. To me that means that it's terribly important
that we work together with our colleagues at the State level.
And in my program, in the examination program, we have a
history of doing just that.
We meet with our colleagues across the country in regular
examination planning summits to plan priorities, to plan
targeted initiatives, to plan joint work and joint training. I
believe it's terribly important that we leverage off of one
another. We're made much more effective when we're all working
together.
There are certainly times where there are differences of
opinion. I suppose in any relationship that's bound to happen.
I think, speaking personally, it's terribly important that we
not let those differences of opinion overcome the need for us
to work together.
Mr. Delahunt. Let me interrupt you, and I will pose that
same question to Secretary Galvin.
Mr. Galvin. Thank you. I think you have to understand one
thing especially with regard to mutual funds that has to be
said. Ms. Richards has already mentioned the vast number of
mutual funds that we have and the difficulties that that
presents in any kind of enforcement regulation. But there's
also a bigger problem, it seems to me, and that is that mutual
funds have--the regulation of mutual funds has not really kept
pace with the role they play in our investment savings system.
You know, we still treat mutual funds in many respects like it
was some sort of a small group of people sitting around a table
trying to decide how to invest like a stock club. They have
become the bank of necessity for most Americans. Most Americans
have found themselves, whether directly or indirectly, invested
in mutual funds out of a sense of safety perhaps, or indirectly
through their employer or some other means.
So the challenge presented by mutual funds is greater
perhaps than many of the other segments of the securities
industry.
As far as the cooperation, I think cooperation is improved.
I think the experiences of 2003 have helped that. I--at the
same time, I think there are some distinctions that have to be
drawn. Generally speaking, the State securities regulators, of
course, are operating with people in their respective States,
individual consumers, more likely to hear about smaller
problems, individual problems, than perhaps industry-wide
problems.
I think the States accept the fact, as we ought to, that
the second should be the primary policymaker when it comes to
market-wide policies. There's no question about that.
When it comes to enforcement, I do think a little bit of
competition is healthy. We have never failed to refer something
to the SEC, at least in Massachusetts, when we thought it was
appropriate. We also have, in fact, referred them to Federal
prosecutors and State prosecutors when we thought it was
appropriate. I do think cooperation is improving.
I think the other player in this whole discussion, though,
which has to be brought to the table or at least mentioned, is
the attitude of the industry itself, which has resisted any
kind of regulation and indeed has been the sponsor many times
of efforts at State preemption. That clearly is out there and--
--
Mr. Delahunt. I mean, we have to deal with the issue of
preemption, not just in terms of this particular issue, but the
whole array of issues that come before this Committee. The
Ranking Member is the Chair of the States Rights Caucus. He is
not here right now. I have assumed the title of vice president.
One would be shocked at the number of bills that come out of
this Committee that preempt State law.
If the Chair would indulge me for an additional minute.
Mr. Cannon. Without objection.
Mr. Delahunt. Yes. I just want to pursue, I guess, with
both of you, but in terms of the jurisdiction of this
particular Subcommittee which falls in the area of compliance
and enforcement, is there any legislation?
Let me direct this to you, Mr. Secretary, and you can
respond, Ms. Richards, what you feel would add, if you will, to
that cooperation, which I think is absolutely essential.
You know, all too often, people can be going down the same
roads not being aware of what is happening in a parallel
universe, so to speak. I would be more than willing to consider
working with you and with others to file that legislation,
because I think you are both right. That industry is a very,
very powerful industry in terms of resources.
I don't think, Ms. Richards, you have the resources
necessary. I know that at the State level they face the same
fiscal constraints.
Mr. Galvin. If I may, and one thing I may have referred to
in my testimony is, I think it was a mistake in the 1996 act to
limit the States' authority of mutual funds. There were
amendments made to section 18 of the 1933 act, and I think that
was a mistake.
Now, if there needs to be some better definition of the
relationship, that's fine. But simply to say that the States
are limited to fraud when they see it or when they hear about
it, I don't think was the right way to go.
I think--again reflecting the unique situation of mutual
funds, I don't think it's an exaggeration to say that most
small savings banks around the country are under a greater
degree of scrutiny on their day-to-day operations than mutual
funds, despite the fact that they hold many more billions,
trillions of dollars.
And I think the one thing that there is absolutely no
disagreement among Federal and State regulators about is the
inadequacy of us, collectively even, to try to deal with this.
Mr. Delahunt. How do we solve that problem, Ms. Richards--
--
Mr. Galvin. Well, we certainly don't want to crimp--we
certainly don't want to crimp the free market. And mutual funds
have done a great deal for people in this country. But I think
we have to make sure that our regulatory efforts and our
enforcement effort is up to par to meet the challenge presented
by the vast number of them. So that's what I am saying.
I think, looking at some of the changes made in 1990 and
1996--you are asking in terms of specific legislation--would be
one thing. There may be other remedies which, I don't know
whether they would jurisdictionally be before this Committee or
other Committees.
But one of the things that troubles me when I look at the
whole industry is the whole issue of mandatory arbitration of
disputes and the way that the panels are set up that make those
decisions. Investors are forced into agreeing to an arbitration
process that I believe--and it is my personal opinion--is
stacked against them.
If we are going to say--and we all agree we don't want them
in the courts. We don't want them in the courts. They don't
belong in the courts,but nevertheless, there'd better be a
safer system and a better system for people to get relief when
they need it.
That may be another area that you might want to look at.
Mr. Delahunt. Mr. Chairman, that suggestion, I am
confident, is within the jurisdiction of this particular
Subcommittee.
Mr. Cannon. The gentleman yields back. Thank you.
The gentlelady from Florida is recognized for 5 minutes.
Ms. Wasserman Schultz. Thank you, Mr. Chairman. And I am
truly looking forward to serving on this Committee, hopefully,
as of tomorrow. And I appreciate the accommodation that you and
the Ranking Member have given me today.
I, too, sit on the Financial Services Committee as my other
Committee assignment, so we have spent a little bit of time on
this issue in that Committee.
Just to piggyback on what the gentleman from Massachusetts
asked you, Ms. Richards and Secretary Galvin and, actually,
anyone who chooses to answer it--not so much how you can, what
legislation you would need or how the law would need to be
changed for better coordination between State and Federal
regulators, but my question is, do you feel you need any change
in the law, generally, to do a better job of regulating?
Ms. Richards. I guess I would demur on the question of
whether the SEC would seek legislation. I would ask for
permission to come back to you with that.
The SEC has taken, as I said, a number of rule-making
initiatives, using its own authority to better shore up the
internal governance, the internal controls, and the compliance
operations of mutual funds. For the first time, beginning last
October, all mutual fund firms are required to have a chief
compliance officer and written policies and procedures for the
first time.
I think that that is one of the most significant steps the
SEC has taken in terms of ensuring better compliance by mutual
funds themselves.
We then, as the GAO report notes, are responsible for
making sure that those chief compliance officers are really
doing their job; and if they are really doing their job in
detecting and deterring violations of the law, I think we are
all--we are all better served by that.
In terms of--in terms of coordination, there are a number
of ongoing initiatives between the SEC and the State
regulators. And the picture is not as bleak as Secretary Galvin
would maybe paint it. We have regular examination planning
summits, regular meetings about enforcement topics. We worked
very effectively with the State securities regulators, not only
with respect to market timing and late trading, but before that
with respect to analysts' conflicts of interest.
Those relationships, I think, grow and develop over time.
And I think they are terribly important at a SEC regional
office level and a State level that we ensure that we grow and
improve those relationships on the ground.
Ms. Wasserman Schultz. Mr. Secretary.
Mr. Galvin. Well, as I mentioned earlier, I think in terms
of legislation, there needs to be--and I would suggest that you
might look at the act that passed in late 2003, for some issues
that were raised there. Some of them have been addressed by
rule-making, and I applaud the SEC for that. I do say there has
been an improvement in the coordination. I know definitely in
our, for instance, region in Massachusetts, there has been an
improvement in cooperation; and I am pleased for that.
But I do think, again it gets back to understanding the
vastness of the mutual fund industry. There is a definite
attitude problem persisting in that industry, in my opinion,
and I think there needs to be sufficient address of these
issues, such as, how do we remedy problems that individual
investors have, sales practices--which I know Ms. Richards
referred to in her testimony, and I agree with her. It is a
very important area; it is continuing to be a problem, I think.
As we look at some of the relationships that funds have
with suppliers of funds, as they treat their customers context,
other interaction with other individual customers, what they
offer them as a--the role of pension funds and how individual
investors find themselves caught up with a particular fund,
either by a company or union or whoever directs them in that
way--the relationships of those that direct that business to
the mutual funds have with the pension funds. Those are all
issues that I think are appropriate for enforcement and review
and perhaps for regulation.
Ms. Wasserman Schultz. The other issue that was fairly
disturbing in my review of the problems that are going on now:
Chairman Donaldson has obviously done an excellent job at
taking some fairly aggressive steps in getting a handle on it,
but it was pretty disturbing to learn that there really haven't
been any post-employment restrictions, the revolving door back
and forth between SEC employees, former employees, going into
the mutual fund industry, the industry that they had formerly
regulated. And I just wonder what steps are being taken,
because that was pretty disturbing.
Ms. Richards. Thank you for asking me that question. SEC
examiners are absolutely prohibited from discussing employment
during an ongoing examination. They are absolutely prohibited
from doing that. There are obvious conflicts of interest in
that process.
We are making our process more formal. Once an examination
has concluded and the examiner has determined to discuss
employment outside the SEC with a firm that we regulate and has
made a determination to go to that firm, the employee must, as
part of a formal exit procedure, notify the supervisor where
they intend to go to work. That supervisor will then conduct a
thorough review of conflicts of interest, including asking, Did
you, as an examiner, ever participate in an examination of that
firm? This process is a more formal process than we have in
place now.
We certainly agree with the GAO that we can shore up our
conflicts of interest procedures to make sure that there is no
question that SEC examiners are acting without conflicts of
interest or the appearance of a conflict of interest.
Ms. Wasserman Schultz. Thank you, Mr. Chairman.
Mr. Cannon. The gentlelady's time has expired.
Without objection, the record will be kept open for 5
legislative days for follow-up questions to the witnesses.
Without hearing objection, so ordered.
Now, I am deeply intrigued by the fact that many of the
issues we are dealing with today are not really partisan
issues, they are issues of how we solve fundamental problems. I
suppose you could make them partisan, but I think one of the
things we hear today is an inquiry of where we ought to go as
opposed to any partisan divide.
I was deeply intrigued, Mr. Secretary, by your idea of
needing more cops and more competition in enforcement and tying
that to cosy relationships.
You know, we all hope that people don't get co-opted, but
they actually do. And so the idea of having multiple agencies
that see different things, hear different things, have
different relationships with their citizens, seems to be really
interesting.
I was just asking the staff up here--we don't think there
is an interstate compact dealing with securities enforcement.
Are you aware, Mr. Secretary?
Mr. Galvin. No, there is not a compact. We do have an
association. Regulation at the State level varies in where it
resides. In 12 States, it resides in the office I hold,
secretary of state, or the equivalent thereof. In a very few
States, it resides with the attorney general's office. In many
States, it resides in the executive agency of the State and in
some places corporate commissions.
But there is an umbrella organization that we have of State
securities administrators that is helpful as an exchange of
information and to present our point of view, and also
effectively, I think, to give our point of view to the SEC. But
there is no individual compact.
Cooperation among States, however, is high. In general,
when matters occur in one State that appear to have roots in
another, there is frequent communication between the States and
among the States.
Mr. Cannon. The jurisdiction of this Committee is over
interstate compacts. In my earlier days, I worked in the
Interior Department with the Office of Service Mining back in
the very early days of the regulation of the coal mining
industry and the reclamation process. And we ended up devolving
regulatory authority to the States, and it worked remarkably
well.
As a matter of fact, I was handed a ``60 Minutes''
investigation when I walked in the door. And by the time it got
to television it was actually an exoneration of the Reagan
administration, which I thought was actually fairly remarkable.
So over a long period of time, a person could become
committed to the idea that we do a much better job, and that
was the conclusion about the Office of Service Mining; that is,
at the Federal level is very difficult to do the kind of
regulation that you could do in the States.
In that case, you had a geographic distribution. But here
it seems to me that you also have a great deal of opportunity
to improve the way you enforce and bring more resources to the
enforcement if you organize and are given a Federal charter to
do an interstate compact.
Is that a matter of interest, do you think?
Mr. Galvin. It is interesting. I think we have to explore
further exactly what we mean.
But I definitely think as we go forward--and I note your
comments, and I appreciate them about the bipartisan nature of
the problem and about the future, because that is really what
it is about. But I think, as we go forward, one of the things
we will all confront is that, increasingly, for most people in
the country their financial future is going to be more in the
risk marketplace.
Defined benefit pensions, I know in another part of the
Capitol today there are hearings on those. Problems--we all
know they are there--increase, and the individuals are going to
find themselves navigating their own way through the
marketplace.
So therefore I think some means of communication amongst
the States, some plans, some protocols, are certainly helpful.
Now, there are different philosophies amongst the States; I
must say that there are--as is to be expected.
Mr. Cannon. It is a competitive market. That's what we want
actually.
Mr. Galvin. That's good. That's good. But I still think
there are certain base things. I mean, fraud is fraud and
misrepresentation is misrepresentation. So I think there is
some benefit to looking into that.
As I said, I think there is no question the SEC must be the
primary rule maker for national policy. Must be. But on an
enforcement basis on some of the problems that emerge and some
of the new techniques, this is a very inventive industry, the
securities industry. Many of us--we could collectively agree as
regulators we could solve this problem, and indeed we may well
have, but they will find a new way to do it.
So they are very creative. So I think we have to be, as Ms.
Richards was quoted as saying, over the hill, looking over the
hill. And so I think perhaps more people looking at it on a
State level might be a good thing.
Mr. Cannon. Could I ask your insight on one other item?
In my personal life I invested in what they call the Thrift
Savings Plan, TSP. Here, locally, we have four options; and we
have, I suspect--I have never actually followed up on this, but
the group that actually looks at the performance of those
funds, which means that both the SEC and the States have an
additional reach--in other words, you have got a bunch of cops
who are looking at that on behalf of me and the many other
thousands of public employees, Federal employees, that invest.
Is there a way that we can empower more people to get
involved in funds or more fund managers who can coordinate with
your activities at the State and Federal level--this is both
for Ms. Richards and Mr. Galvin--so that we can increase the
security of individual investors by having a private layer of
people who watch funds?
Mr. Galvin. Well, I think that it's touching a very
important area and a growing area of concern, namely, the
intermediaries that have control over directing individual
employees' fund investments.
Not long ago I was invited to speak to an audience of local
public pension managers in Massachusetts, and during the course
of my remarks--in fact, it was during lunch; they were eating
while I was speaking, which was all right with me. But during
the course of the lunch, I went on to talk in a very tangential
way about some of the problems with people taking free things
from people they were investing with--free golf, free this,
free that. Deadening silence.
I don't mean to suggest that they were all acknowledging
some sort of misdeed, but I think it comes as a revelation to
some of these folks, who are actually not professional
investors--they might be just other employees or union leaders,
something like that, that are empowered with this
responsibility--that they really have to exercise a fiduciary
duty.
And that is really the fundamental part, whether we are
talking about mutual fund management, or even pension
management or whatever it is, the responsibility of getting the
best deal you can for the people you are representing.
So I think--in this area that you are referring to, I think
that the States certainly could provide some additional
benefit--many of these smaller investors are in more limited
plans--not just the places that manage them, but perhaps where
the decisions are made in an individual State. This is
certainly an area where I think the States could be of
assistance because of the vastness of the problem.
Ms. Richards. I think, Mr. Chairman, your question is very
timely. Just 2 weeks ago the SEC released the results of an
examination sweep of pension consultants. These are investment
advisors who are relied on to be the experts to help pension
plan administrators navigate amongst the many intermediaries
out there trying to sell them services.
What we found in those examinations was that about half of
the pension consultants also received money from the mutual
funds or the investment advisors that they also may have been
recommending to the pension plans. These, we thought, were
serious conflicts of interest which needed to be addressed by
pension consultants.
So I think your question is timely and right on point with
some of the work that we have been doing in our risk-based
examinations.
Mr. Cannon. Thank you.
Mr. Watt. Could the Chairman yield for just a sec?
Mr. Cannon. Certainly.
Mr. Watt. Is what you just described illegal?
Ms. Richards. Yes. Existing law under the Federal
securities laws requires these firms to disclose material
conflicts of interest.
One of the most disturbing findings----
Mr. Watt. But is it illegal after they disclose it? I mean,
can you take action against them?
Ms. Richards. If they don't disclose these conflicts of
interest, yes, sir.
Mr. Watt. No, that's not what I asked. I asked, is it
illegal if they disclose it? Is it illegal? Can you take action
against them?
Ms. Richards. No, sir. If they were disclosing it, it would
be legal. What we found, however, was that they were not
disclosing these conflicts of interest.
Mr. Watt. And what is the penalty for nondisclosure?
Ms. Richards. We referred many of these firms to our
Division of Enforcement, who is looking at these
nondisclosures.
We also made our findings public so that pension
consultants, not just the firms we examined--there are 1,700
firms in this business--could look at our findings and make
changes to make sure that they were disclosing these conflicts
of interest.
We think this is----
Mr. Watt. I guess the question I am asking is, does this
Congress need to be making the law a brighter line standard or
increasing the penalties? What do we need to be doing to help
you all?
I mean, you said you were outmanned, outgunned. Is it more
personnel? Is it more staff? Is it a more enforceable law? What
is it that we need to do?
Ms. Richards. I am not--I am not sure that it would be
presumptuous of me to come to you with recommendations for this
legislation. I think the securities laws adequately address
this problem that I have just talked about.
I think one of the things we are very much focused on at
the SEC is using the resources we have in a more efficient,
more productive and more nimble way.
Mr. Cannon. The gentleman yields back.
My time having expired, let me thank the panel for being
here.
Mr. Delahunt. Could I just ask a few follow-up----
Mr. Cannon. Very insightful. Would you like to be
recognized?
Mr. Delahunt. Yes, please.
Mr. Cannon. The gentleman is recognized.
Mr. Delahunt. Again, I want to concur with the sentiment
you expressed. But I guess I am frustrated because, in summary,
where the law seems to be adequate here, how come we missed so
much up until 21 months ago? As you said, Chairman Donaldson is
talking about looking around the horizon and around the curve.
If we don't somehow better coordinate, you know, between
the States and the Federal Government--do you have like a
shared data base, and do we have--as a former prosecutor that
conducted a lot of white-collar investigations in conjunction
with U.S. Attorney's office and other Federal investigative
agencies, we had a protocol which allowed for cross-
designation. We had our own arrangement to do referrals, if you
will. There was a constant sharing of information.
Does that exist?
Ms. Richards. One of the findings of the GAO report is that
with respect to market timing and late trading, we coordinated
effectively with our colleagues at the State level, including
with criminal prosecutors; and criminal prosecution of the
Federal securities laws is a terribly important complement to
what we do on the civil side.
Mr. Delahunt. But that was missing up until 21 months ago.
I mean, I just perused the GAO report, and one of the issues
seems to be a lack of a consistent policy in terms of referral.
Ms. Richards. No, I think what the GAO found--and I won't
speak for Mr. Hillman--is that we could better document our
referrals to criminal authorities, but the relationships, if
you will, are ongoing and are informal and are active.
Mr. Delahunt. See, my problem is informal. I have no doubt
that you are an outstanding professional. And I concur with the
good professor there in terms of the quality of people that are
on the staff. But that changes, that waxes and wanes like
anything.
I guess I am looking for some sort of--whether it's in the
form of legislation, some other--maybe it's by a compact of
some sort among the States, whether it's a formal mechanism,
where this information moves around. Because there is no way
that you are combined that--independently, that you have, even
probably when you combine your resources--you can take on the
kind of tasks that are an order of magnitude that clearly are
enormous.
You know, Secretary Galvin is right. You know, the era of
the defined benefit, that is gone. We are not going to see
pensions, you know, like my parents and others enjoyed in the
1950's and 1960's. People are going to be left to their own
navigating the mutual fund industry and the securities industry
just to survive.
I mean, we are talking about Social Security reform. You
know, that's the end, if that happens, you know, that's the end
of the defined benefit plan.
But, again, I guess my frustration is, I want to know, and
I think the American people have a right to know, that there is
some sort of formal mechanism that requires an information-
sharing and resource-sharing between the States and the Federal
Government.
Ms. Richards. Yes, sir.
In 1997, the SEC signed a memorandum of understanding with
the Association of State Securities Administrators (ASSA),\1\
that requires that we meet at least once a year on the national
level and discuss emerging types of fraud, and more frequently
on the local level.
---------------------------------------------------------------------------
\1\ The memorandum of understanding was actually signed with the
North American Securities Administrators Association (NASAA).
---------------------------------------------------------------------------
Mr. Delahunt. Good. You know, having a summit once a year--
I have been at a lot of summits, okay, and a lot of
conferences. But I am talking about requiring, you know,
agencies--and make it a 2-way street that this becomes
automatic on the--required and mandated by statute, as opposed
to informal relationships that are obviously very important.
Ms. Richards. Yes, sir.
Mr. Delahunt. However, that changes once, you know,
Richards and Galvin are gone and Professor Eric and Hillman--I
mean, then we have a whole new slate and maybe those
relationships aren't the same.
Mr. Cannon. If the gentleman would yield, let me point out,
this is a complex environment you are talking about. It would
take a great deal to put together, but I would suspect that it
makes an enormous amount of sense.
I don't want to interrupt you, Ms. Richards, you obviously
had an answer. But I frankly think this is an interesting place
to go.
Ms. Richards. I was just going to echo what you said, that
this agreement between the SEC and the State securities
regulators has been in place since 1997. And the whole purpose
of it was to mandate these kinds of regular meetings,
regardless of changes in staffing at the State or Federal
level.
There are regional examination planning summits that take
place, I believe it is twice each year; and Secretary Galvin
could talk about those, because I am sure he has participated
in those along with our staff in the Boston office.
But the whole goal was to make sure that there is that kind
of mandated meeting and sharing of information and strategy
planning about how we can use our resources.
Mr. Delahunt. Right, and I am sure that is very positive.
And I am sure the Secretary and the other panelists would
agree.
But I guess what I am saying is, I want more than an MOU,
okay? I mean, I am coming from a different angle. Because I
know, when I was the district attorney up in the metropolitan
Boston area, I had MOUs. I had no idea whether my successor
has, in those agencies that we had memoranda of understanding
with, you know, complied with it today. You know, it's probably
gone the way of--of----
Mr. Watt. Of Bill Delahunt.
Mr. Delahunt.--of Bill Delahunt, exactly.
Mr. Cannon. The gentleman yields back.
Again, let me thank the members of the panel and the
Committee for your time. And we stand adjourned.
[Whereupon, at 5:26 p.m., the Subcommittee was adjourned.]
A P P E N D I X
----------
Material Submitted for the Hearing Record
Prepared Statement of the Honorable Chris Cannon, a Representative in
Congress from the State of Utah, and Chairman, Subcommittee on
Commercial and Administrative Law
In the fall of 2003, the New York State Attorney announced what
would become the first of many law enforcement initiatives that his
office, other state officials, and the SEC would later champion to
ferret out mutual fund trading abuses. Within the ensuing months, many
well-respected mutual fund companies and others were caught up in this
scandal, including Canary Capital, Janus Capital Group, Bank of
America, Alliance Capital Management, Prudential Securities, Millennium
Partners, Fred Alger Management, Putnam Investments, Massachusetts
Financial Services, Security Trust, Franklin Resources, and Invesco
Funds Group.
In the fall and winter of 2003, it seemed as if every day the press
reported on yet another shocking instance of mutual fund trading
abuses. These abuses included the illegal practice of late trading,
which involves trading shares after the markets have closed so that the
trader can take advantage of information that becomes available after
the closing. The Congressional Research Service analogized this
practice to ``a racetrack that allows certain customers to bet on
yesterday's races.''
Other abuses included the more nuanced problem of market timing.
Market timing typically involves frequent buying and selling of mutual
fund shares by sophisticated investors, such as hedge funds, that seek
opportunities to make profits on the differences between foreign and
domestic markets.
While not per se illegal, market timing can constitute illegal
conduct if, for example, it takes place as a result of undisclosed
agreements between investment advisers and favored customers in
contravention of stated fund trading limits. Frequent trading can harm
mutual fund shareholders because it lowers fund returns and increases
transaction costs.
According to an estimate prepared by one of the witnesses at
today's hearing, Professor Zitzewitz, market timing abuses may have
resulted in $5 billion in annual losses. As of November 2003, the SEC
estimated that 50 percent of the 80 largest mutual fund companies had
entered into undisclosed arrangements permitting certain shareholders
to engage in market timing practices that were inconsistent with the
funds' policies, prospectus disclosures, or fiduciary obligations.
As the mutual fund scandal unfolded, questions were raised about
the fitness of the SEC's overall regulation, inspection, and
enforcement of this industry. The Congressional Research Service posed
possible explanations, including the following:
The possibility that SEC's resources devoted to the
fund industry were dwarfed by the expansion in the number of
mutual funds.
The possibility that the SEC's overall effectiveness
may have been marred by inter-divisional disharmonies.
The possibility that SEC officials may have placed
too much trust in the fund industry's integrity and ability to
police itself.
The possibility that the mutual fund industry may be
``too close'' to the relevant parts of the SEC entrusted with
its oversight and regulation.
The possibility that the SEC may have had a somewhat
understandable focus on the prevention of more traditional
types of fund misconduct.
In response to these concerns, House Judiciary Committee Chairman
Sensenbrenner and Ranking Member Conyers requested the GAO to undertake
a comprehensive review of the SEC's efforts to proactively detect and
prevent illegal activities in the mutual fund industry.
Today's hearing provides an opportunity for the GAO to report on
its findings and recommendations and to allow the SEC and others to
respond to them.
Response to post-hearing questions from Lori A. Richards, Director,
Office of Compliance Inspections and Examinations, U.S. Securities and
Exchange Commission
Response to post-hearing questions from the Honorable William Francis
Galvin, Secretary of the Commonwealth of Massachusetts
Response to post-hearing questions from Eric W. Zitzewitz,
Stanford Graduate School of Business, Stanford, California