Despite a sudden turnover in its leadership ranks, reports of a looming budget crisis and new criticisms that it is failing in its mission to police the mutual fund industry, Securities and Exchange Commission Director Lori A. Richards is defending the regulator's record and claims that it's stronger, smarter and more nimble than it was 21 months ago.
Future Crimes Minimized'
Richards, who heads the SEC's Office of Compliance Inspections and Examinations, told the U.S. House Subcommittee on Commercial and Administrative Law on June 7 that recent reforms undertaken by the SEC will "minimize the possibility" that the market timing, late trading and conflicts of interest that have surfaced in the mutual fund industry since September 2003 will ever occur again.
The testimony from Richards was compelled by a new report from the Government Accountability Office that sharply criticizes SEC examiners for creating potential conflicts of interest and inadequate recordkeeping.
Just two months ago, the GAO released a separate report indicating that the Commission deserved a "C" grade for its effectiveness in detecting mutual fund trading abuses.
Other critics haven't been so kind.
Subcommittee Chairman F. James Sensenbrenner Jr. (R-Wis.) said at the hearing that the SEC was "years late in uncovering the trading abuses," that when the scandal broke the Commission did not consider it a "priority issue," and that the Commission must take a "stronger position" in the future.
Testifying alongside Richards, Massachusetts Secretary of the Commonwealth William Galvin said if the SEC had done its job correctly, "we probably wouldn't be here today."
"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," Galvin continued, adding that the Commission "ignored warning signs, and, inexplicably, didn't follow up on tips [and] failed to protect mutual fund investors.
Galvin, whose office has joined fund scandal champion and New York Attorney General Eliot Spitzer in bringing criminal charges against fund complexes and their intermediaries for violating state securities laws, also called the SEC's Division of Investment Management "one of the weakest and most toothless divisions at the SEC."
But Richards, whose section is tasked with executing the SEC's nationwide inspection and examination program, told lawmakers that the overall size of the industry - an $8 trillion business that numbers some 8,000 funds over 900 fund complexes and 8,000 investment advisors - makes it impossible to conduct a comprehensive audit of every single player.
Her comments echo that of the previous director of the Division of Investment Management, Paul Roye (see MME cover story, 5/17/04), whose permanent replacement has yet to be named.
So, prior to the scandal in September 2003, the SEC, whose staff has since been increased by one-third, would primarily focus examinations on conflicts of interest within the management of mutual funds and whether funds were inflating their returns.
Therefore, she said, the greatest attention was paid to areas like portfolio management, allocation of investment opportunities, pricing and calculation of net asset value, marking of returns and safeguarding fund assets from theft.
As a result, examiners would typically uncover items such as abusive soft-dollar arrangements, investment allocation favoritism, pricing inaccuracies and failures to provide proper breakpoints, among others.
Richards additionally reasoned that the SEC was unaware of market timing and late trading simply because the shenanigans were so closely guarded by their perpetrators.
"The illegal market timing involved secret arrangements between fund executives and select market timers. Some of the arrangements involved nominee accounts and false trading records. These were covert, non-disclosed arrangements.
"In fact, many fund firms stated at the time that they deterred market timers, and had even hired market-timing police to prevent this type of trading," Richards continued. "The SEC did not have prior notice of these secret arrangements that some mutual fund executives had with favored traders."
Once news of the abusive trading broke, however, "the SEC moved rapidly to investigate this issue in the broader mutual fund industry," Richards added.
That action, the GAO yields in its report, has resulted in 14 enforcement actions against investment advisers and 10 enforcement actions against other firms for trading abuses. Penalties, the report continued, have been the SEC's highest, ranging from $2 million to $140 million and averaging $56 million. Prior to 2003, penalties obtained in settlements for securities laws violation were typically under $20 million.
The report commends the SEC's sanctions as "generally consistent with penalties obtained in cases involving similarly egregious corporate conduct." But the report also criticizes the SEC's capacity to effectively manage its criminal referral process, or how it alerts state and federal prosecutors to potentially criminal conduct, saying that it may be hampered by inadequate record keeping.
"In particular," the report noted, "SEC does not require staff to document whether a referral was made or why. Without proper documentation, SEC cannot readily determine and verify whether staff make appropriate and prompt referrals. Documentation of referrals might serve as an additional internal indicator of the effectiveness of SEC's referral process and is also important for Congressional oversight of law enforcement efforts in the securities industry."
Richards defended the SEC's referral process, calling it "informal, but "highly effective." She told lawmakers that in fiscal year 2004, the SEC, which does not have authority to bring criminal cases, worked with 41 U.S. Attorneys Offices and eight state prosecutors on 159 cases involving 302 individuals.
"In the mutual fund trading abuse area, the SEC coordinated extensively with the criminal authorities," she said. "Criminal authorities are aware of all SEC investigations relating to mutual fund market-timing abuses."
Nonetheless, Richards reported that, per the GAO's recommendation, the SEC is in the process of converting its case-opening form to a Web-based application, "which will provide for documentation of referrals to criminal authorities."
The GAO report also takes issue with the examination teams that the SEC has assigned to some fund complexes on a full-time basis and isn't satisfied with the Commission's process for tracking employees who re-enter the private sector. In fact, according to the GAO, SEC employees do not have to inform the Commission of where they intend to work next, as is common with other financial regulators like the NASD and the Federal Reserve.
The GAO, the effective watchdog of government agencies and the federal budget, is also concerned that private sector demand for the newly created chief compliance officer position will woo even more examination professionals away from the Commission. The GAO report noted one securities industry official who characterized SEC examiners as a "natural source for expertise."
Rep. Debbie Wasserman (D-Fla.) called the SEC's post-employment restrictions "disturbing" and said a "revolving door" exists between employment within the Commission and that of the fund industry.
Richards contends that the SEC has established and maintained the highest levels of ethics and integrity. Dating back to 1997, she said, the SEC staff has developed a series of guidelines for examiners that exceed those of the Office of Government Ethics. SEC staff also receive regular ethics training and her office, which perhaps works most closely with the fund industry on an everyday basis, recently enhanced its ethics program by adding at least one ethics official to the examination program of every regional and district office. In addition, the SEC does not allow employees to join firms that are under investigation and maintains a one- to two-year "cooling-off" period, where former employees are not allowed to work with the SEC on examination or enforcement matters.
Per the GAO recommendation, the SEC also intends to establish a new process for obtaining future employment information from its staff, Richards said. But in terms of keeping examiners on site at the largest and highest-risk fund complexes full-time, an approach the GAO thinks "would increase the contact SEC examiners have with fund management and potential for conflicts of interest," the Commission seems steadfast in duplicating the sort of onsite examiner method used by the banking industry.
Lawmakers, however, may have the last word on that issue, too, as the GAO is currently compiling a report on the monitoring teams. A publication date has not been set.
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