SPEAKERS CONTENTS INSERTS
Page 1 TOP OF DOC21653 PDF
MUTUAL FUND TRADING ABUSES
COMMERCIAL AND ADMINISTRATIVE LAW
COMMITTEE ON THE JUDICIARY
HOUSE OF REPRESENTATIVES
ONE HUNDRED NINTH CONGRESS
JUNE 7, 2005
Serial No. 10942
Printed for the use of the Committee on the Judiciary
Page 2 PREV PAGE TOP OF DOC
Available via the World Wide Web: http://www.house.gov/judiciary
COMMITTEE ON THE JUDICIARY
F. JAMES SENSENBRENNER, Jr., Wisconsin, Chairman
HENRY J. HYDE, Illinois
HOWARD COBLE, North Carolina
LAMAR SMITH, Texas
ELTON GALLEGLY, California
BOB GOODLATTE, Virginia
STEVE CHABOT, Ohio
DANIEL E. LUNGREN, California
WILLIAM L. JENKINS, Tennessee
CHRIS CANNON, Utah
SPENCER BACHUS, Alabama
BOB INGLIS, South Carolina
JOHN N. HOSTETTLER, Indiana
MARK GREEN, Wisconsin
RIC KELLER, Florida
DARRELL ISSA, California
JEFF FLAKE, Arizona
MIKE PENCE, Indiana
J. RANDY FORBES, Virginia
STEVE KING, Iowa
Page 3 PREV PAGE TOP OF DOCTOM FEENEY, Florida
TRENT FRANKS, Arizona
LOUIE GOHMERT, Texas
JOHN CONYERS, Jr., Michigan
HOWARD L. BERMAN, California
RICK BOUCHER, Virginia
JERROLD NADLER, New York
ROBERT C. SCOTT, Virginia
MELVIN L. WATT, North Carolina
ZOE LOFGREN, California
SHEILA JACKSON LEE, Texas
MAXINE WATERS, California
MARTIN T. MEEHAN, Massachusetts
WILLIAM D. DELAHUNT, Massachusetts
ROBERT WEXLER, Florida
ANTHONY D. WEINER, New York
ADAM B. SCHIFF, California
LINDA T. SÁNCHEZ, California
ADAM SMITH, Washington
CHRIS VAN HOLLEN, Maryland
PHILIP G. KIKO, General Counsel-Chief of Staff
PERRY H. APELBAUM, Minority Chief Counsel
Page 4 PREV PAGE TOP OF DOCSubcommittee on Commercial and Administrative Law
CHRIS CANNON, Utah Chairman
HOWARD COBLE, North Carolina
TRENT FRANKS, Arizona
STEVE CHABOT, Ohio
MARK GREEN, Wisconsin
RANDY J. FORBES, Virginia
LOUIE GOHMERT, Texas
MELVIN L. WATT, North Carolina
WILLIAM D. DELAHUNT, Massachusetts
ADAM SMITH, Washington
CHRIS VAN HOLLEN, Maryland
JERROLD NADLER, New York
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
JUNE 7, 2005
Page 5 PREV PAGE TOP OF DOC
The Honorable Chris Cannon, a Representative in Congress from the State of Utah, and Chairman, Subcommittee on Commercial and Administrative Law
The Honorable William D. Delahunt, a Representative in Congress from the State of Massachusetts
The Honorable Melvin L. Watt, a Representative in Congress from the State of North Carolina, and Ranking Member, Subcommittee on Commercial and Administrative Law
Mr. Richard J. Hillman, Director, Financial Markets and Community Investment, U.S. Government Accountability Office
Ms. Lori A. Richards, Director, Office of Compliance Inspections and Examinations, U.S. Securities and Exchange Commission
The Honorable William Francis Galvin, Secretary of the Commonwealth of Massachusetts
Page 6 PREV PAGE TOP OF DOCPrepared Statement
Mr. Eric W. Zitzewitz, Stanford Graduate School of Business, Stanford, California
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
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
MUTUAL FUND TRADING ABUSES
TUESDAY, JUNE 7, 2005
Page 7 PREV PAGE TOP OF DOC
House of Representatives,
Subcommittee on Commercial
and Administrative Law,
Committee on the Judiciary,
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.
Page 8 PREV PAGE TOP OF DOC 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.
Page 9 PREV PAGE TOP OF DOC
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.
Page 10 PREV PAGE TOP OF DOC 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 hisI 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.
Page 11 PREV PAGE TOP OF DOC
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 isI hope can bring to bear, and I believe will bring to beara 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.
Page 12 PREV PAGE TOP OF DOC
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.
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.
Page 13 PREV PAGE TOP OF DOC 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 haveI 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.
Page 14 PREV PAGE TOP OF DOC
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 andbut 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 notwell, you know, we have got a clear role here, and we just need to not stumble over each over, I guess, is the
Page 15 PREV PAGE TOP OF DOC
Mr. DELAHUNT. Never enough oversight.
Mr. WATT. Never enough oversight.
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.
Page 16 PREV PAGE TOP OF DOC
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.
Page 17 PREV PAGE TOP OF DOC
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.
Page 18 PREV PAGE TOP OF DOC
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.
Page 19 PREV PAGE TOP OF DOC
Mr. CANNON. Thank you, Mr. Hillman.
[The prepared statement of Mr. Hillman follows:]
PREPARED STATEMENT OF RICHARD J. HILLMAN
Page 20 PREV PAGE TOP OF DOCRJH0010.eps
Page 21 PREV PAGE TOP OF DOC
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.
Page 22 PREV PAGE TOP OF DOC
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.
Page 23 PREV PAGE TOP OF DOC
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.
Page 24 PREV PAGE TOP OF DOC
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
Page 25 PREV PAGE TOP OF DOC
Page 26 PREV PAGE TOP OF DOCLAR0013.eps
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.
Page 27 PREV PAGE TOP OF DOC
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.
Page 28 PREV PAGE TOP OF DOC
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.
Page 29 PREV PAGE TOP OF DOC
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 manyseveral 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.
Page 30 PREV PAGE TOP OF DOC 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.
Page 31 PREV PAGE TOP OF DOC 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.
Page 32 PREV PAGE TOP OF DOC
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 industryteach an even more compelling lessonthat isthe critical importance of what goes on in what I will call the ''risk'' marketplace to average Americans.
Their savingstheir pensionstheir children's educationin shorttheir 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 beatand more constructive competition among themto protect the investing public.
Page 33 PREV PAGE TOP OF DOC
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 questionis 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.
Page 34 PREV PAGE TOP OF DOC
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 strangeand unacceptablegiven 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.
Page 35 PREV PAGE TOP OF DOC
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-interestyou 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.
Page 36 PREV PAGE TOP OF DOC Investor protectionincluding aggressive enforcement of state and federal securities lawsisn't a partisan issue.
Democrats, Republicans, Libertarians, Greens and Independentsthey all rely on our nation's securities markets for their financial futures.
Investors vote and they're a very large constituencylarger 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 chapterwill 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.
Page 37 PREV PAGE TOP OF DOC
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.
Page 38 PREV PAGE TOP OF DOC
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.
Page 39 PREV PAGE TOP OF DOC
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.
Page 40 PREV PAGE TOP OF DOC
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.
Page 41 PREV PAGE TOP OF DOC
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:]
Page 42 PREV PAGE TOP OF DOC
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?
Page 43 PREV PAGE TOP OF DOC
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.
Page 44 PREV PAGE TOP OF DOC
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.
Page 45 PREV PAGE TOP OF DOC
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.
Page 46 PREV PAGE TOP OF DOC
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 havethe 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.
Page 47 PREV PAGE TOP OF DOC
As far as the cooperation, I think cooperation is improved. I think the experiences of 2003 have helped that. Iat 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.
Page 48 PREV PAGE TOP OF DOC
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.
Page 49 PREV PAGE TOP OF DOC 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 thinkagain 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 crimpwe 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 1996you are asking in terms of specific legislationwould be one thing. There may be other remedies which, I don't know whether they would jurisdictionally be before this Committee or other Committees.
Page 50 PREV PAGE TOP OF DOC
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 believeand it is my personal opinionis stacked against them.
If we are going to sayand 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.
Page 51 PREV PAGE TOP OF DOC
Just to piggyback on what the gentleman from Massachusetts asked you, Ms. Richards and Secretary Galvin and, actually, anyone who chooses to answer itnot 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 allwe are all better served by that.
In terms ofin 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.
Page 52 PREV PAGE TOP OF DOC
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 beand 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 practiceswhich 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 athe 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 waythe 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.
Page 53 PREV PAGE TOP OF DOC
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.
Page 54 PREV PAGE TOP OF DOC
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 herewe don't think there is an interstate compact dealing with securities enforcement. Are you aware, Mr. Secretary?
Page 55 PREV PAGE TOP OF DOC 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.
Page 56 PREV PAGE TOP OF DOC 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 forwardand 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. Problemswe all know they are thereincrease, and the individuals are going to find themselves navigating their own way through the marketplace.
Page 57 PREV PAGE TOP OF DOC 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 areas 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 uswe 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?
Page 58 PREV PAGE TOP OF DOC 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 suspectI 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 reachin 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 levelthis is both for Ms. Richards and Mr. Galvinso 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 remarksin 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 withfree 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 investorsthey might be just other employees or union leaders, something like that, that are empowered with this responsibilitythat they really have to exercise a fiduciary duty.
Page 59 PREV PAGE TOP OF DOC
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 thinkin this area that you are referring to, I think that the States certainly could provide some additional benefitmany of these smaller investors are in more limited plansnot 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.
Page 60 PREV PAGE TOP OF DOC 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.
Page 61 PREV PAGE TOP OF DOC 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 examinedthere are 1,700 firms in this businesscould 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 notI 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.
Page 62 PREV PAGE TOP OF DOC 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 Governmentdo you have like a shared data base, and do we haveas 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?
Page 63 PREV PAGE TOP OF DOC
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 foundand I won't speak for Mr. Hillmanis 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 ofwhether it's in the form of legislation, some othermaybe 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 thatindependently, that you have, even probably when you combine your resourcesyou can take on the kind of tasks that are an order of magnitude that clearly are enormous.
Page 64 PREV PAGE TOP OF DOC 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),(see footnote 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.
Mr. DELAHUNT. Good. You know, having a summit once a yearI have been at a lot of summits, okay, and a lot of conferences. But I am talking about requiring, you know, agenciesand make it a 2-way street that this becomes automatic on therequired and mandated by statute, as opposed to informal relationships that are obviously very important.
Page 65 PREV PAGE TOP OF DOC Ms. RICHARDS. Yes, sir.
Mr. DELAHUNT. However, that changes once, you know, Richards and Galvin are gone and Professor Eric and HillmanI 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.
Page 66 PREV PAGE TOP OF DOC 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 ofof
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
Page 67 PREV PAGE TOP OF DOC
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.
Page 68 PREV PAGE TOP OF DOC
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.
Page 69 PREV PAGE TOP OF DOC
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
Page 70 PREV PAGE TOP OF DOC
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
Page 71 PREV PAGE TOP OF DOCEZ0003.eps
(Footnote 1 return)
The memorandum of understanding was actually signed with the North American Securities Administrators Association (NASAA).