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News June 13, 2005 Issue

GAO Continues Post-Canary Probe of SEC’s Mutual Fund Oversight

The U.S. Government Accountability Office has released yet another report on the SEC’s role in detecting and responding to the late trading and market timing abuses. The report, titled "Mutual Fund Trading Abuses: SEC Consistently Applied Procedures in Setting Penalties, but Could Strengthen Certain Internal Controls," took a look at how the SEC sets enforcement penalties, makes enforcement referrals, and tracks departing employees’ plans for future employment.

In April, GAO released a report that discussed "lessons learned" from the SEC’s having failed to detect the trading abuses. Both the April report and last week’s report had been requested by House Judiciary Chairman James Sensenbrenner (R-WI) and ranking member John Conyers (D-MI).

But wait, there’s more! A third GAO mutual fund oversight report is in the works, this time requested by members of the House Financial Services committee. The upcoming report will be an "assessment of the SEC’s examination program’s ability to detect weaknesses in the mutual fund industry going forward," according to Richard Hillman, GAO’s director for financial markets and community investment. Hillman said that GAO likely will provide the committee with a report in mid-July, but added that the report may not be publicly released by the committee until mid-August.

Last week’s report provides an interesting look at how the SEC goes about determining enforcement penalties. When setting penalties, GAO found that the SEC considers factors such as:

  • the egregiousness of conduct (whether it involved fraud, and if so, the degree of scienter present);
  • the harm to investors;
  • the defendant’s cooperation;
  • whether the defendant derived any economic benefit from the conduct;
  • how long the conduct lasted;
  • whether the defendant is a recidivist;
  • the seniority of individuals that participated in the conduct;
  • the need for deterrence;
  • the defendant’s ability to pay;
  • the size of the firm or net worth of the individual; and
  • penalties obtained in similar cases.

Not surprisingly, some of those factors are similar to those mentioned by OCIE director Lori Richards in an October 2004 speech describing how OCIE decides to refer examination findings over to the SEC’s Division of Enforcement.

GAO noted that although the SEC is guided by statutory maximums when setting enforcement penalties, the staff also considers that likelihood that a firm will fight the charges. The report refers to one enforcement proceeding that involved "hundreds of improper trades." There, noted GAO, the SEC staff could have sought the statutory maximum of $1 billion in enforcement penalties. Given the level of scienter and lack of economic harm, however, GAO reported that the staff said it "could not have made a convincing argument" in favor of that penalty and that the firm involved "would never have settled."

The report also provides a handy graph of all SEC market timing settlements as of February 28, 2005. In a glance, you can see how the penalties assessed against Invesco, Banc of America, and Alliance Capital dwarf those of Strong, PIMCO, and Franklin. There’s also a graph showing penalties obtained from individuals, clearly illustrating how Dick Strong ($30 million), Gary Pilgrim ($20 million), and Harold Baxter ($20 million) incurred significantly more of the SEC’s wrath than the former CEOs of Invesco ($500,000) or MFS ($250,000).

According to GAO, the SEC went about setting penalties in the mutual fund trading cases the right way. The SEC consistently weighed penalty determinations using established criteria and procedures, they said. The penalties obtained by the SEC in the mutual fund trading cases (average: $56 million) were in the same ballpark as those obtained in the research analyst cases (average: $43 million) and corporate accounting cases (average: $61.5 million).

Criminal referrals. Why haven’t we seen more criminal market timing cases? GAO noted that criminal prosecution of the market timing cases has been hampered by the fact that market timing in and of itself isn’t illegal. And although the SEC’s civil cases have alleged fraud in connection with undisclosed market timing, prosecutors have a tougher time proving criminal fraud in the absence of an express violation, especially in light of ambiguous prospectus language. As a result, GAO found that most of the criminal cases stemming from the mutual fund scandal have involved late trading, which is clearly a no-no.

GAO criticized the SEC’s methods of tracking referrals to federal and state criminal prosecutors. According to GAO, the SEC staff currently rely on an informal system for making and tracking referrals, under the theory that allowing senior SEC staff to contact criminal authorities without formal Commission involvement allows the agency to be more nimble on its feet. The SEC staff told GAO that it was confident that appropriate referrals were being made, given that Commissioners routinely ask about referrals when voting to approve an enforcement proceeding. The staff also noted that the status of all enforcement proceedings are tracked within the Division of Enforcement. Nonetheless, GAO suggested that as a management control, the SEC staff document criminal referrals. The SEC indicated that it is implementing that suggestion.

SEC employee’s post-SEC employment. GAO suggested that the SEC obtain information about departing SEC employees’ employment plans. This, said GAO, can serve two purposes: it can help ensure that SEC alumni do not quickly pop up on the other side of a matter that they worked on while at the SEC, in violation of applicable ethics rules. Moreover, it will allow the SEC to identify instances where a former employee’s work should be reviewed.

OCIE director Richards, who testified before the House Subcommittee on Commercial and Administrative law June 7 (see related article, this issue) noted that in response to GAO’s suggestion, OCIE is implementing a new, formal process pursuant to which examiners leaving the SEC are required to notify their supervisors of their next place of employment. The examiner’s supervisor must then determine whether any conflicts of interest might have existed while the examiner was employed at the SEC and review the examiner’s work accordingly.