oversight

Mutual Funds: SEC Adjusted Its Oversight in Response to Rapid Industry Growth

Published by the Government Accountability Office on 1997-05-28.

Below is a raw (and likely hideous) rendition of the original report. (PDF)

                United States General Accounting Office

GAO             Report to Congressional Committees




May 1997
                MUTUAL FUNDS
                SEC Adjusted Its
                Oversight in Response
                to Rapid Industry
                Growth




GAO/GGD-97-67
                   United States
GAO                General Accounting Office
                   Washington, D.C. 20548

                   General Government Division

                   B-271654

                   May 28, 1997

                   The Honorable Alfonse M. D’Amato
                   Chairman
                   The Honorable Paul S. Sarbanes
                   Ranking Minority Member
                   Committee on Banking, Housing, and
                     Urban Affairs
                   United States Senate

                   The Honorable Thomas J. Bliley, Jr.
                   Chairman
                   The Honorable John D. Dingell
                   Ranking Minority Member
                   Committee on Commerce
                   House of Representatives

                   This report discusses our self-initiated review of the Securities and
                   Exchange Commission’s (SEC) regulation and oversight of investment
                   companies. We initiated this review because rapid growth in open-end
                   investment companies, commonly known as mutual funds, had the
                   potential to outstrip SEC’s ability to properly oversee the industry.1 In our
                   September 1995 report on bank mutual funds, we noted that SEC had
                   obtained additional staff to oversee mutual funds, but that continued
                   industry expansion could create new challenges for SEC in meeting its
                   oversight responsibilities.2 Our objective for this review was to determine
                   how SEC has responded to this rapid industry growth in carrying out its
                   mutual fund oversight through inspections, disclosure review, and other
                   regulatory activities. We are sending this report to you because it pertains
                   to matters under your jurisdiction.


                   SEC has increased its inspection staffing and adjusted the focus of its
Results in Brief   inspections in response to the rapid growth in the mutual fund industry.
                   Since fiscal year 1990, SEC has more than doubled the number of its staff
                   available to do mutual fund inspections. SEC used the increased staff to


                   1
                    The term “open-end” refers to the fact that shareholders may redeem shares issued by the mutual fund
                   on any day on which the fund is open for business. Other types of investment companies include
                   closed-end funds, unit investment trusts, separate accounts of insurance companies issuing variable
                   annuities, and business development companies. The distinguishing feature between closed-end and
                   open-end funds is that closed-end fund shares are not redeemable. Instead, closed-end fund shares are
                   generally traded on one of the major stock exchanges or in the over-the-counter market. As used in
                   this report, the term “mutual funds” refers to open-end investment companies.
                   2
                    Bank Mutual Funds: Sales Practices and Regulatory Issues (GAO/GGD-95-210, Sept. 27, 1995).



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expand the scope of its inspections to focus primarily on the activities of
families of funds, called fund complexes, that may present high risks to
investors. It also expanded its coverage of investment advisers, and SEC
inspectors spent more time on each mutual fund inspection. As a result,
the number of mutual fund inspections completed each year has remained
relatively constant. SEC still met its current goal of inspecting fund
complexes at least once every 5 years, and most had been inspected more
than once since fiscal year 1992. As inspections became more
comprehensive, the number of deficiencies that inspectors found
increased each year, but few deficiencies were considered serious enough
to be referred for potential enforcement action. SEC reported that the
mutual fund industry had generally been free of major scandal for the last
2 decades.

SEC selectively reviews mutual funds’ disclosure documents. A large part of
the growth in the mutual fund industry has been in adding new funds to
already existing fund complexes. As a result, although each new mutual
fund must submit disclosure documents, these documents often contain
disclosures that are very similar to those of other funds within the same
complex. SEC officials told us that, by selectively reviewing these
documents, they have been able to review all new or materially different
disclosures, despite an almost 8-percent increase in the number of
documents that SEC has received since fiscal year 1994 and despite a
relatively constant staffing level in this function over the same period.

SEC’s other regulatory activities relating to mutual funds include
(1) granting exemptions from various provisions in mutual fund laws and
regulations, (2) developing and modifying rules to implement these
provisions, and (3) providing the industry, Congress, and other
government agencies with SEC interpretations of mutual fund laws and
regulations. These activities have allowed the mutual fund industry to
change dramatically in size and scope without substantially amending
existing laws. SEC staff devoted to these regulatory activities increased
nearly 45 percent from fiscal years 1990 to 1993. However, by 1996, this
staffing had declined 14 percent from its peak in 1993. Nonetheless, SEC
reduced its backlog of pending applications for exemptions in 1996. SEC
officials said that the National Securities Market Improvement Act of 1996
(P.L. 104-290) will increase their rulemaking workload by about 30 percent
through 1997, and that this increased workload may delay progress on
other rulemaking initiatives.




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             Lower returns on alternative investments and a rapidly rising stock market
Background   have contributed to mutual funds becoming an increasingly popular and
             important investment vehicle. Assets managed by mutual funds have more
             than tripled since the end of fiscal year 1990 from about $1 trillion to
             nearly $3.2 trillion by June 1996, exceeding insured commercial bank
             deposits, which totaled about $2.6 trillion in June 1996. As of April 1996, an
             estimated 63 million individuals, making up about 37 million households,
             owned mutual funds. At that time, these fund-owning households
             represented 37 percent of all U.S. households, which was up from
             31 percent in mid-1994. Much of this growth in mutual fund ownership has
             been attributed to investors buying mutual funds to save for retirement.

             SEC regulates and supervises the operations of all mutual funds under four
             federal securities laws: the Investment Company Act of 1940 (Investment
             Company Act), the Investment Advisers Act of 1940 (Investment Advisers
             Act), the Securities Act of 1933 (1933 Act), and the Securities Exchange
             Act of 1934 (1934 Act). Of these four acts, only the Investment Company
             Act was written specifically to regulate the formation and operation of
             mutual funds. The Investment Company Act requires mutual funds to
             register with SEC and subjects their activities to SEC regulation. The act also
             imposes detailed requirements on the operation and structure of mutual
             funds.3 The core objectives of the act are to (1) ensure that investors
             receive adequate, accurate information about the mutual fund; (2) protect
             the physical integrity of the fund’s assets; (3) prohibit abusive forms of
             self-dealing; (4) prevent the issuance of securities that have inequitable or
             discriminatory provisions; and (5) ensure the fair valuation of investor
             purchases and redemptions.

             The other three acts regulate mutual fund activity in various ways. The
             Investment Advisers Act requires mutual funds’ advisers to register with
             SEC; imposes reporting requirements on those registered investment
             advisers; and prohibits the advisers from engaging in fraudulent,
             deceptive, or manipulative practices.4 The 1933 Act requires that mutual
             fund shares offered to the public be registered with SEC. In addition, SEC
             has adopted rules under this act and the Investment Company Act that
             require extensive disclosures in a mutual fund’s prospectus. The 1933 Act

             3
              The Investment Company Act’s requirements include rules on the composition and election of boards
             of directors, disclosure of investment objectives and policies, and approval of investment advisory and
             underwriting contracts. The act also imposes limitations on transactions with affiliates, defines
             permissible capital structures and custodial arrangements, requires reports to shareholders, and
             requires maintenance of records.
             4
              Banks are exempt from the registration requirements of the Investment Advisers Act when their
             employees directly sell mutual funds.



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also regulates mutual fund advertising. The 1934 Act, among other things,
regulates how mutual funds are sold. This act requires that persons
distributing mutual fund shares or executing purchase or sale transactions
in mutual fund shares be registered with SEC as securities broker-dealers.5

Broker-dealers who sell mutual funds are regulated and examined by both
SEC and the National Association of Securities Dealers (NASD). NASD, which
is subject to SEC’s oversight, was established pursuant to the 1934 Act as a
self-regulatory organization for brokerage firms, including those firms that
engage in mutual fund distribution. SEC and NASD regulate broker-dealers
by periodically examining broker-dealer operations on-site and
investigating customer complaints. NASD has also established specific rules
of conduct for its members that, among other things, provide standards for
advertising and sales literature, including filing requirements, review
procedures, approval and recordkeeping obligations, and general
standards. In addition, NASD tests individuals to certify their qualifications
as registered representatives6 and has primary responsibility for regulating
advertising and sales literature used to solicit and sell mutual funds to
investors.

On October 11, 1996, the National Securities Market Improvement Act of
1996 (1996 Act) was signed into law. This legislation represented the most
significant overhaul of the securities regulatory structure in decades.
Among other things, the 1996 Act divided responsibility for regulation of
the financial markets between the federal and state governments. The 1996
Act amended the Investment Company Act to promote more efficient
management of mutual funds, protect investors, and provide more
effective and less burdensome regulation. The amendments, in effect,
made the regulation of mutual fund disclosures and advertising the
exclusive province of the federal government by preempting state
securities registration, merit review, and prospectus disclosure
requirements for investment companies. In connection with investment
company offerings, states (1) can continue to require companies to file,
with the state, documents they file with SEC and can charge fees for such
filings; and (2) will retain jurisdiction over fraud and deceit and unlawful
broker-dealer conduct under applicable state law. The 1996 Act also


5
 Broker-dealers combine the functions of brokers and dealers. Brokers are agents who handle public
orders to buy and sell securities. Dealers are principals who buy and sell stocks and bonds for their
own accounts and at their own risk.
6
 A registered representative is a person who is associated with a broker-dealer and who must acquire a
background in the securities business and pass relevant qualifications examinations that are
administered for the industry by NASD. The broker-dealer must register with SEC and be a member of
a self-regulatory organization, such as NASD or a stock exchange.



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                        amended the Investment Advisers Act, including provisions that divided
                        responsibility for regulation of investment advisers between the states and
                        SEC.


                        SEC’s oversight focuses on protecting mutual fund investors by minimizing
                        the risk to investors from fraud, mismanagement, conflicts of interest, and
                        misleading or incomplete disclosure. SEC oversees mutual funds primarily
                        through (1) performing on-site inspections of mutual funds’ compliance
                        with federal securities laws; (2) reviewing disclosure documents that
                        mutual funds are required to file with SEC; and (3) engaging in other
                        regulatory activities, such as rulemaking, responding to requests for
                        exemptions from applicable federal securities laws, and providing
                        interpretations of those laws. In addition, although not discussed in this
                        report, SEC’s enforcement program is responsible for investigating and
                        prosecuting violations of securities laws related to mutual funds.

                        In the early 1990s, SEC considered its oversight of the investment
                        management industry, including mutual funds, to be severely understaffed.
                        SEC attributed its staffing shortage to the explosive growth in the industry
                        since 1983; the industry’s use of increasingly complex products, such as
                        derivatives, which may be difficult both to value and trade during falling
                        markets;7 and the use of more complex organizational structures.
                        Believing that inadequate staffing threatened its ability to protect
                        investors, SEC reallocated positions from its other regulatory programs to
                        investment management oversight and obtained additional positions
                        through congressional appropriations. Of SEC’s six major regulatory
                        programs, its investment management program was the second smallest in
                        fiscal year 1990, comprising about 12 percent of SEC’s total authorized
                        positions.8 By fiscal year 1996, the investment management program had
                        become SEC’s second largest regulatory program, comprising almost
                        20 percent of SEC’s total authorized positions.


                        Our objective was to determine how SEC has responded to the rapid
Objective, Scope, and   growth in mutual funds in carrying out three parts of its mutual fund
Methodology             oversight—inspections, review of disclosure documents, and other
                        regulatory activities. To determine the requirements for SEC’s oversight, we

                        7
                         Derivatives are financial products whose value is determined from an underlying reference rate,
                        index, or asset. The underlying includes stocks, bonds, commodities, interest rates, foreign currency
                        exchange rates, and indexes that reflect the collective value of various financial products.
                        8
                         In addition to Investment Management Regulation, SEC’s five other major regulatory programs are the
                        following: Prevention and Suppression of Fraud, Full Disclosure, Supervision and Regulation of
                        Securities Markets, Program Direction, and Legal and Economic Services.



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reviewed applicable securities laws; SEC rules and regulations
implementing these laws; and relevant testimony, commentary, and
studies, including a 1992 SEC study on the regulation of investment
companies.9

To determine how SEC carries out these responsibilities, we (1) reviewed
agency documents that described SEC’s mutual fund oversight activities,
including relevant mission statements, policies and procedures, training
materials, staffing data, budget estimates, and annual reports, and
(2) interviewed SEC officials. We also reviewed workload and performance
data for these oversight activities, including the number and results of
inspections completed during fiscal years 1992 through 1996, the number
and type of disclosure documents SEC received and reviewed during fiscal
years 1994 through 1996, and the number of applications for exemptions
and requests for no-action and interpretive letters that SEC processed
during fiscal years 1994 through 1996. We were unable to include and
compare data for all disclosure documents from previous fiscal years
because of changes in how SEC counted the filings received.

To determine how frequently SEC has inspected mutual funds, we
compared the inspections completed between fiscal years 1992 and 1996
with a list of fund complexes SEC prepared for its field offices to use in
scheduling their fiscal year 1996 inspections. We judgmentally selected for
this analysis 5 of the 10 SEC field offices that inspect investment
companies. We selected the four field offices—New York, Chicago,
Boston, and Philadelphia—that are responsible for inspecting the largest
number of mutual funds, and one field office—Fort Worth—that is
responsible for inspecting a smaller number of mutual funds. To obtain
more information on how SEC conducts and documents mutual fund
inspections, we interviewed SEC officials from the New York, Boston, and
Philadelphia field offices and reviewed selected inspection reports and
workpaper files at those locations.

We did our work between March 1996 and March 1997 at SEC in
Washington, D.C., and at SEC field offices in New York, Boston, and
Philadelphia. We did our work in accordance with generally accepted
government auditing standards. SEC officials provided written comments
on a draft of this report, which are reprinted in appendix I. Our evaluation
of these comments is presented on page 29.



9
Protecting Investors: A Half Century of Investment Company Regulation, Division of Investment
Management, United States Securities and Exchange Commission, May 1992.



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                              Periodic, on-site inspections are the cornerstone of SEC’s oversight of
Increased Staffing            mutual funds. Increasing its inspection staff during the 1990s allowed SEC
Benefited the SEC             to broaden its inspection objectives. Although SEC frequently changed its
Inspection Program            objectives, it met its goal of inspecting fund complexes at least once every
                              5 years, and most of the complexes were inspected about once every 3
                              years. Despite SEC’s increase in staffing, the total number of yearly
                              investment company inspections did not increase because SEC used the
                              staffing increase to expand its coverage of investment advisers and
                              because inspectors spent more time on each investment company
                              inspection. The total number of deficiencies that inspectors found
                              increased each year. The inspectors referred an average of about 5 percent
                              of these deficiencies to SEC’s Division of Enforcement for potential
                              enforcement action.


On-Site Inspections Are the   SEC’s inspections are meant to enhance investor protection because they
Cornerstone of SEC            provide a direct check of mutual funds’ compliance with the securities
Oversight                     laws, including the accuracy of disclosures made to investors. Rather than
                              inspecting individual mutual funds, SEC’s inspections primarily focus on
                              fund complexes, which are generally groups of mutual funds—sometimes
                              called fund families—that are associated with common advisers or
                              underwriters. In most cases, investors can, with a telephone call, switch
                              between individual funds within the same fund complex and change their
                              investment strategies. Fund complexes can be large. For example, as of
                              June 1996, the Fidelity fund complex, which was the largest complex,
                              consisted of over 200 funds and more than $400 billion in assets.

                              The growth in the number of fund complexes has not been as great as the
                              growth in the number of individual mutual funds because many existing
                              fund complexes have expanded their complement of individual funds to
                              attract and serve diverse market segments. According to data provided by
                              SEC, between December 1991 and June 1996, the number of individual
                              mutual funds grew by about 75 percent, from 3,427 funds to 5,996 funds. In
                              comparison, the number of fund complexes grew by 40 percent, from 578
                              complexes in December 1991 to 812 complexes in June 1996.10 As of
                              June 1996, the 50 largest fund complexes accounted for about 74 percent
                              of total complex assets.

                              Before May 1995, SEC’s Division of Investment Management (Division of
                              IM) was responsible for conducting and coordinating inspections of mutual

                              10
                                SEC includes open-end funds, closed-end funds, separate accounts of insurance companies, or some
                              combination of these in its definition of fund complexes. SEC also considers single or stand-alone
                              funds to be fund complexes. According to SEC, only a small number of stand-alone funds remain.



                              Page 7                               GAO/GGD-97-67 SEC Adjusted Its Mutual Fund Oversight
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funds as well as disclosure reviews and regulation. In an effort to enhance
its overall inspection efforts and promote a more effective use of its
inspection resources, SEC created the Office of Compliance Inspections
and Examinations (OCIE), which began operating on May 1, 1995, to
consolidate its inspection programs for entities over which it had
regulatory authority. These entities include investment companies,
investment advisers, broker-dealers, and self-regulatory organizations.11

OCIE conducts inspections to (1) evaluate mutual funds’ compliance with
securities laws and regulations, (2) determine if funds are operating in
accordance with disclosures made to investors, and (3) assess the
effectiveness of funds’ internal control systems. Inspections of mutual
funds and their related investment advisers are carried out primarily by
staff in 10 of SEC’s 11 field offices.12 If a mutual fund’s principal investment
adviser is located outside of the United States, responsibility for inspecting
that fund is assigned to headquarters, rather than a field office. Although
OCIE provides detailed inspection manuals and general guidance on
selecting mutual funds for inspection, the SEC field offices have primary
responsibility for selecting which mutual funds to inspect in accordance
with those guidelines.

The separation of the inspection function from the Division of IM has
caused the Investment Company Institute (ICI), the national trade
association of the mutual fund industry, some concern about the potential
for inconsistent oversight of mutual funds. ICI officials told us that
separating the staff members who write and interpret the law from those
who inspect companies for compliance with the law creates the potential
for differences in how the laws are interpreted and applied. SEC officials
agreed that this potential exists but told us that staff members in the
Division of IM and OCIE have worked well together since the oversight
functions were separated, and that both units have made an effort to
maintain ongoing communication. However, the SEC officials also said that
the current good working relationship between the two units is largely
because the staff members in OCIE who oversee mutual fund inspections
are essentially the same people who were responsible for doing these
inspections in the Division of IM before OCIE’s creation. SEC officials said
they intend for these two units to work well together regardless of who the
individuals are in each unit. However, according to some SEC officials, as
personnel changes occur in the future—in either the Division of IM or

11
 Responsibility for inspecting these entities previously was divided between SEC’s Division of Market
Regulation and Division of IM.
12
  One SEC field office does not have investment company inspection staff.



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OCIE—maintaining good communications and consistent oversight of
mutual funds may become more difficult.

SEC generally does two types of inspections: routine and for cause. Routine
inspections result primarily from the passage of time, but they are done
more frequently if (1) the inspection staff believes that a fund or its agents
are engaged in risky activities or (2) the fund has a history of significant
problems. Inspection staff do for-cause inspections when, for example,
specific facts come to their attention that suggest something may be
wrong at a fund. Most inspections are routine. Inspections either can be
announced in advance or can be done on a surprise basis. According to
SEC, the first inspection of a fund and its service agents usually is done on
a surprise basis. Generally, for-cause inspections are also done on a
surprise basis or with short notice. However, for most SEC inspections,
inspectors notify the fund several weeks in advance of the starting date for
on-site work.

Before going on-site to the offices of the fund complex, inspectors are to
obtain and review information from the complex about its structure and
operations and prepare an inspection plan. When they arrive on-site,
inspectors typically will meet with senior management and do a
walk-through of the offices. The inspectors will then begin reviewing
documents and interviewing other fund personnel as necessary. During
the on-site inspection, inspectors are to look for patterns of activity and
evidence that (1) the fund complex and its agents are conducting their
activities in compliance with the securities laws, (2) potential conflicts of
interest are being identified and resolved to the benefit of shareholders,
(3) operations are being conducted consistent with disclosures made to
shareholders, and (4) internal control systems seem to be effective.
Inspectors are usually on-site for 1 or 2 weeks, but they could be on-site
for up to 2 months when inspecting very large fund complexes. Inspectors
also usually review the activities of mutual funds’ advisers concurrent with
their inspection of the fund complex. After inspectors complete on-site
work, they generally spend additional time in the SEC field offices
preparing the inspection report and completing any follow-up work.

SEC inspectors also collect compliance-related data and investigate
particular industry-related issues. For example, early in fiscal year 1995,
SEC was interested in obtaining information on the types of controls that
were in place to address personal trading by fund personnel. At that time,
SEC directed the inspection staff to obtain information on the content of
funds’ codes of ethics during their inspections. The Investment Company



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                          Act permits fund personnel to engage in personal trading in securities that
                          are held or are to be bought by a fund, as long as the investment activities
                          are not fraudulent, manipulative, or abusive. However, conflicts of interest
                          between fund personnel and shareholders can arise, for example,
                          whenever fund personnel with access to information about securities and
                          potential fund transactions buy and sell securities for their personal
                          accounts. To address conflicts of interest, the act requires mutual
                          funds—as well as their investment advisers and principal underwriters—to
                          adopt a code of ethics designed to prevent abusive personal trading. SEC
                          found that most funds inspected appeared to have the controls necessary
                          to identify abusive trading practices by fund personnel after the trading
                          occurred.

                          More recently, SEC directed its inspection staff to do inspections that target
                          “soft-dollar” payments among investment companies, investment advisers,
                          and broker-dealers. A provision in the 1934 Act allows advisers to receive
                          soft-dollar payments for directing transactions to a specific broker for
                          execution. These payments are typically in the form of investment
                          research services. SEC officials told us that they were examining whether
                          advisers are using the soft-dollar payments for expenses that are unrelated
                          to research, such as salaries. Such uses of soft-dollar payments would
                          constitute a conflict of interest that, if not disclosed, would violate the
                          Investment Advisers Act.


Increases in Inspection   SEC allocated most of the increase in its investment management industry
Staffing Allowed SEC to   oversight staffing during fiscal years 1990 through 1996 to doing
Broaden Its Inspection    investment company and investment adviser inspections. During this
                          period, SEC frequently changed the objectives of its investment company
Objectives                inspection program in an effort to more efficiently use these resources.
                          Although many of these changes were in response to industry growth, SEC
                          broadened its inspection objectives in fiscal year 1995 primarily because
                          of the increase it had attained in inspection staffing.

                          As shown in table 1, SEC’s inspection staff years grew by 154 percent
                          during fiscal year 1990 through fiscal year 1996, with about 53 percent of
                          that growth occurring during fiscal year 1993 through fiscal year 1996.




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Table 1: SEC Inspection Staff Years,
Fiscal Years 1990-96                   Fiscal year                                                Number of staff years
                                       1990                                                                         114
                                       1991                                                                         137
                                       1992                                                                         148
                                       1993                                                                         189
                                       1994                                                                         216
                                       1995                                                                         262
                                       1996                                                                         290
                                       Percentage change, 1990-96                                                   154%
                                       Percentage change, 1993-96                                                    53%
                                       Source: SEC.



                                       SEC devoted more staff to its inspection program to increase both the
                                       scope and frequency of mutual fund inspections. SEC reported that its
                                       inspections of mutual funds are particularly important because SEC, rather
                                       than a self-regulatory organization, is responsible for providing first-line
                                       oversight of the investment management industry. An OCIE official told us
                                       that SEC’s inspection program now has enough staff for examining existing
                                       investment companies.

                                       With the availability of additional inspection staff, SEC changed its
                                       inspection objectives during the 1990s. During fiscal years 1991 through
                                       1993, SEC’s inspection objective was to attain the greatest dollar coverage
                                       with the limited number of inspection staff years available. With this in
                                       mind, SEC directed its inspection staff to concentrate on inspecting the 100
                                       largest fund complexes and all money market funds. SEC also directed its
                                       inspection staff to inspect small and medium-sized fund complexes, if time
                                       was available after this objective was achieved. SEC reported that the
                                       inspections completed during these fiscal years were limited in scope,
                                       focusing mainly on whether fund activities were consistent with the
                                       information disclosed to investors and whether funds accurately valued
                                       their shares. SEC also reported that some activities, such as fund marketing
                                       and shareholder services, were rarely scrutinized.

                                       SEC revised its inspection objectives for fiscal year 1994 because a large
                                       number of small and medium-sized fund complexes had never been
                                       examined and others had not been examined for several years. Because of
                                       the focus during fiscal years 1991 through 1993 on inspecting large fund
                                       complexes and all money market funds, inspectors had only been able to




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inspect about 200 small and medium-sized fund complexes. SEC estimated
that about 350 fund complexes had not been inspected since 1990, and that
many, especially those fund complexes connected with banks, had been
formed after 1990 and had never been inspected. Consequently, for its
fiscal year 1994 inspection program, SEC headquarters directed the field
offices to inspect all small and medium-sized fund complexes that had not
been inspected since 1990 and all new fund complexes formed during that
year. Again, except for fund complexes that had never been inspected,
inspections were to be limited in scope, with an emphasis on portfolio
management activities.

Reflecting the increase in inspection staffing as well as the significantly
increased use of mutual funds by American investors, SEC broadened its
inspection objectives for fiscal year 1995. Inspection staff were to begin
doing comprehensive inspections of all fund complexes. These
comprehensive inspections were to include all fund activities and cover all
funds in a complex, not just certain types of funds as had been the case
before 1995. In addition, inspection staff were to inspect the 50 largest
complexes on a 2-year cycle and inspect all other complexes on a 4-year
cycle.

Responding to suggestions from field office staff members, SEC revised its
inspection objectives for fiscal year 1996. Specifically, instead of reviewing
the activities of all funds within a complex on a set schedule, SEC officials
decided that a more efficient use of inspection staff would be to focus on
those activities and complexes that presented higher risks to investors.
Using the following criteria, SEC field offices were to select for inspection
those fund complexes with (1) a history of compliance problems, (2) a
sudden increase in the number of investor complaints, (3) an appearance
on one of the Division of IM’s “watch lists,”13 (4) a report of processing
problems, and (5) length of time since last inspected. While the field
offices were given discretion in selecting fund complexes for inspection,
SEC instructed them to examine all fund complexes at least once every 5
years. An SEC official told us that a 5-year inspection cycle was chosen on
the basis of feedback from field office staff members and experience with
varying inspection cycles over the years. Together, these factors indicated
that a maximum of 5 years between inspections allowed for the most
cost-effective use of SEC’s inspection staff. The official also said that 5
years is the most time allowed between inspections but that if inspectors



13
 The Division of IM develops several watch lists for particular types of funds on the basis of
characteristics that may indicate the need for additional scrutiny by the Division of IM and OCIE.



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                            considered a fund complex to present a greater risk of having problems, it
                            would be inspected more frequently.

                            SEC did not change its inspection program objectives for fiscal year 1997.
                            However, SEC deferred routine inspections through the end of March 1997,
                            while the field offices focused exclusively on doing the fieldwork for the
                            soft-dollar study. An SEC official told us that for-cause inspections took
                            precedence over the soft-dollar study during this period. The official said
                            that although using the inspection staff to do the soft-dollar study would
                            likely result in fewer inspections being completed during fiscal year 1997,
                            this would not prevent SEC from meeting its overall goal of inspecting fund
                            complexes at least once every 5 years.


Despite Changing            As SEC changed its objectives between the ends of fiscal years 1990 and
Objectives, SEC Inspected   1996, its field offices changed their inspection plans to meet these
Most Fund Complexes         objectives. Instead of focusing on the results of these changing annual
                            objectives, we determined the extent to which SEC inspected the total
                            number of fund complexes existing during this period.

                            To assess SEC’s inspection coverage, we analyzed data on completed
                            inspections for 5 of the 10 SEC field offices responsible for inspecting fund
                            complexes.14 These 5 field offices, which included the 4 offices with the
                            largest number of complexes to inspect, were responsible for inspecting
                            547 of the 757 fund complexes (about 72 percent) in SEC’s database as of
                            the beginning of fiscal year 1996.15

                            As indicated in table 2, our analysis showed that between the beginning of
                            fiscal year 1992 and the end of fiscal year 1996, these 5 field offices
                            completed inspections of 493 of the 519 fund complexes (about
                            95 percent) for which they were responsible.16 Table 2 also displays the
                            last year in which these 493 fund complexes had been inspected. For
                            example, of the 168 fund complexes that the New York field office was
                            responsible for inspecting, 4 were last inspected in fiscal year 1992. The
                            data show that the 5 field offices last inspected 408 of the 519 fund
                            complexes (about 79 percent) between the beginning of fiscal year 1994
                            and the end of fiscal year 1996.

                            14
                              Completed inspections included both limited scope and comprehensive inspections.
                            15
                             Of the 547 fund complexes, 460 (about 84 percent) included mutual funds. Some of these fund
                            complexes were first established after fiscal year 1992.
                            16
                              We eliminated 6 fund complexes determined to be inactive and another 22 complexes that were not
                            inspected by these field offices because they were the responsibility of another field office.



                            Page 13                               GAO/GGD-97-67 SEC Adjusted Its Mutual Fund Oversight
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Table 2: Inspections of Fund Complexes by Year Last Inspected for Five SEC Field Offices, Fiscal Years 1992-96
                           Fund complexes                                                                                              Total fund
                            at end of fiscal      Last fiscal year fund complexes were inspected                                      complexes
Field office                     year 1996              1992        1993       1994        1995       1996                             inspected
Boston                                  82                       0            19            16            25            18                       78
Chicago                                159                       0            14            36            43            57                      150
Fort Worth                              30                       0             8             3            10              8                      29
New York                               168                       4            26            44            63            23                      160
Philadelphia                            80                       3            11            23            22            17                       76
Total                                  519                       7            78          122           163            123                      493
Percentage                               •                       1%           15%           24%           31%           24%                      95%
                                          Note: Although some fund complexes were inspected more than once during these 5 fiscal years,
                                          the data shown for each fiscal year reflect only the last year they were inspected. Therefore, the
                                          total shown for the number of fund complexes inspected is not the total number of inspections
                                          completed by these five field offices during these fiscal years.

                                          Source: GAO analysis.



                                          We also found that the five field offices, on average, inspected fund
                                          complexes more frequently than every 5 years. For example, these offices
                                          inspected about 52 percent of the 519 fund complexes for which they were
                                          responsible more than once since the start of fiscal year 1992 and
                                          inspected each of the top 50 complexes about 3 times.


Number of Investment                      The increase in the number of SEC inspectors has not led to an increase in
Company Inspections Has                   the number of investment company inspections completed each year. This
Not Increased                             total remained relatively constant, with the inspection staff averaging
                                          about 320 inspections a year since fiscal year 1992.17 According to an SEC
                                          official, the number of investment company inspections has not increased
                                          because SEC has used the increase in inspection staffing to expand its
                                          coverage of investment advisers. Also, inspectors spent more time on each
                                          investment company inspection due to (1) a need to train newly hired
                                          inspectors, (2) a change in how inspectors approached mutual fund
                                          inspections, and (3) a change in how inspectors inspected fund
                                          administrators.

                                             Generally, inspectors are to be cross-trained to inspect both investment
                                             companies and investment advisers. Of the 10 field offices that do

                                          17
                                            The total number of inspections completed each year includes, in addition to fund complexes,
                                          inspections of administrators, business development companies, sponsors of unit investment trusts,
                                          and insurance company sponsors of variable insurance products. Of the 1,613 inspections completed
                                          from the end of fiscal year 1992 to the end of fiscal year 1996, 120 were inspections of these entities.



                                          Page 14                                  GAO/GGD-97-67 SEC Adjusted Its Mutual Fund Oversight
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investment company and investment adviser inspections, an SEC official
said that only 2 field offices do not extensively cross-train their inspectors
to do both types of inspections. Because the same pool of inspectors
inspect both investment companies and investment advisers, there is an
ongoing trade-off in the number of investment company and investment
adviser inspections completed. Therefore, although the number of
investment company inspections done each year since fiscal year 1992 has
remained relatively constant, averaging about 320 a year (see table 3), the
number of investment adviser inspections completed has increased from
614 in fiscal year 1992 to 1,446 in fiscal year 1996. The 1996 Act transfers to
the states regulatory responsibility for investment advisers that manage
less than $25 million in assets, and SEC expects the number of investment
adviser inspections completed in fiscal year 1997 to decrease partly
because of the transition. SEC has projected that it will increase investment
adviser inspections 13 percent in fiscal year 1998.

Since fiscal year 1992, the average time SEC inspectors spent on each
investment company inspection more than doubled, from about 164 hours
in fiscal year 1992 to about 376 hours in fiscal year 1996. An SEC official
attributed the increase in inspection time primarily to the use of senior
inspectors to provide on-the-job training for the large number of new
inspectors that were hired beginning in fiscal year 1994. The official said
that it took longer to complete inspections because the new inspectors
were inexperienced and were still being trained during fiscal years 1995
and 1996. During fiscal year 1997, SEC expects senior inspectors to
continue devoting considerable time to on-the-job training of the 38 new
inspectors hired during 1996. SEC reported that, by the end of fiscal year
1997, all inspectors hired since fiscal year 1994 will have received
classroom and on-the-job training and are expected to be able to function
as fully qualified investment company and investment adviser examiners.
Although all new inspectors are to be fully trained, SEC is not planning to
increase the number of fund complexes inspected beyond 320 during fiscal
year 1998. At that level, fund complexes would be inspected at an average
frequency of once every 3.1 years. SEC reported that this inspection
frequency, combined with more frequent inspections of fund complexes
that present above average risk factors, provides adequate inspection
oversight of mutual funds. An SEC official said that inspecting fund
complexes any more frequently would not be an efficient use of inspection
staff.

Another reason for the increase in time spent on each inspection was a
change in SEC’s approach to mutual fund inspections. Before fiscal year



Page 15                       GAO/GGD-97-67 SEC Adjusted Its Mutual Fund Oversight
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1994, SEC primarily did limited-scope inspections of the 100 largest fund
complexes and all money market mutual funds. In fiscal year 1995, SEC
directed its inspectors to do comprehensive inspections of all fund types.
SEC reported that these inspections required more time to complete
because inspectors were to review all activities of funds in the complex. In
fiscal years 1996 and 1997, SEC directed its inspectors to use a risk-based
approach to doing inspections. These inspections required inspectors to
focus on fund activities that presented higher risks to investors. As a
result, each inspection is customized, to some extent, according to the
types of activities of each fund complex. Areas in which these risk-based
inspections may focus include portfolio management, such as brokerage
commissions and principal trades; sales practices; internal controls;
classification, diversification, and appropriateness of investments; and
personal securities transactions, including funds’ code of ethics.

SEC inspections of fund administrators also contributed to the increase in
inspection time. Administrators perform many of a fund’s key functions
such as keeping the fund’s books and records, filing the necessary reports
with SEC, helping the fund establish and maintain compliance procedures
and internal controls, and calculating the fund’s net asset value.18 Some
administrators perform these functions for several fund complexes, which
different SEC field offices may be responsible for inspecting. Before fiscal
year 1995, inspectors assessed the adequacy and appropriateness of
services that administrators provided to funds as a part of their inspection
of the fund complex. As a result, inspections of administrators usually
focused on only a limited number of funds and did not always consider all
of the key functions. In fiscal year 1995, SEC began conducting more
comprehensive inspections of administrators that served more than one
fund complex. The inspections were to provide an adequate test of all
administrator systems used in serving multiple mutual funds. These
inspections involved larger inspection teams and, on average, took more
time to perform than an inspection of a fund complex. For example,
during fiscal years 1995 and 1996, inspectors spent an average of nearly
750 hours on each of the 28 inspections of administrators that served more
than one fund complex.




18
 Net asset value is the daily share price of a mutual fund. It is based on the market value of assets held
by the fund, less liabilities, divided by the number of outstanding fund shares.



Page 16                                 GAO/GGD-97-67 SEC Adjusted Its Mutual Fund Oversight
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More Deficiencies Were     During fiscal years 1993 through 1996, the number of deficiencies that SEC
Found, but Few Were        inspectors found increased steadily. In fiscal year 1993, inspectors found
Referred for Enforcement   1,281 deficiencies; in fiscal year 1996, the inspectors found 4,713
                           deficiencies. To some extent, this increase reflects the changes in the
Action                     scope of SEC’s inspections from primarily doing annual, limited scope
                           inspections of the 100 largest fund complexes and all money market funds
                           to inspecting complexes on the basis of the risks they pose as well as the
                           length of time since last inspected. Another reason for the increase in the
                           number of deficiencies was a change in SEC’s system for reporting
                           deficiencies after fiscal year 1993. Specifically, instead of reporting each
                           deficiency identified at a fund complex as one violation, inspectors were
                           to begin reporting any systemic deficiencies as having been found in each
                           individual fund within the complex. For example, if a systemic pricing
                           problem was identified at a fund complex that had six funds, the inspector
                           would report that six deficiencies, not one, had been identified.

                           When inspectors find that a fund complex has failed to comply with the
                           securities laws, the deficiency may relate to any of a broad range of issues,
                           from recordkeeping to misrepresentations or other sales practice abuses.
                           According to SEC, if the deficiencies found are serious, such as when
                           investor funds or securities are at risk, the inspectors may refer the matter
                           to the Division of Enforcement, which would decide whether to pursue an
                           investigation and possible enforcement action. If deficiencies are not
                           referred to the Division of Enforcement, SEC sends a letter to the fund
                           complex identifying all the deficiencies inspectors found and requiring
                           that they be corrected. SEC requests that the fund complex respond to the
                           deficiency letter within 30 days by informing SEC of what the complex has
                           done or plans to do to correct the problems identified. If no deficiencies
                           are found, no further action is taken.

                           SEC reported in 1994 that the mutual fund industry had generally been free
                           of major scandal for the last 2 decades.19 As shown in table 3, during fiscal
                           years 1992 through 1996, SEC referred deficiencies to the Division of
                           Enforcement in about 5 percent of the investment company inspections.
                           SEC addressed the majority of these deficiencies by sending deficiency
                           letters to the fund complexes.




                           19
                              Personal Investment Activities of Investment Company Personnel, Report of the Division of IM, SEC,
                           Sept. 1994.



                           Page 17                               GAO/GGD-97-67 SEC Adjusted Its Mutual Fund Oversight
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Table 3: Disposition of Investment Company Inspections, Fiscal Years 1992-96
                                                  Number (percentage) of inspections, by fiscal year
                                                                                                                                  Total for
Disposition                          1992                1993               1994                1995               1996            1992-96
Deficiency                            235                240                 244                 261                254               1,234
letters                               (74)               (73)                (78)                (75)               (82)                (77)
Enforcement                            14                   8                  21                 23                  14                    80
referrals                              (4)                 (2)                 (7)                (7)                 (5)                   (5)
No action                               65                 74                  37                  53                 37                266
                                       (21)               (23)                (12)                (15)               (12)               (17)
Other                                    2                  6                  11                 11                   3                    33
                                        (1)                (2)                 (4)                (3)                 (1)                   (2)
Total                                  316                328                313                 348                 308              1,613
                                      (100)              (100)              (100)               (100)               (100)              (100)
                                          Note 1: In addition to dispositions of fund complex inspections, investment company inspections
                                          also include inspections of administrators, business development companies, sponsors of unit
                                          investment trusts, and insurance company sponsors of variable insurance products. Of the 1,613
                                          inspections completed between fiscal years 1992 and 1996, 120 were inspections of these
                                          entities.

                                          Note 2: Percent totals may not add to 100 due to rounding.

                                          Source: SEC.



                                          Among the reasons SEC officials cited for inspections not producing more
                                          enforcement referrals were that (1) the Investment Company Act imposes
                                          detailed, substantive requirements on the structure and operations of
                                          mutual funds; (2) frequent inspections by SEC inspectors instill discipline
                                          in funds’ operations; (3) the industry generally supports strong regulation
                                          and strict compliance with the securities laws; (4) a self-regulatory
                                          organization, NASD, separately reviews funds’ sales literature; and
                                          (5) market conditions have generally been favorable as the industry has
                                          grown. An SEC official also said that because violations of the Investment
                                          Company Act typically do not involve fraud or investor losses, these
                                          violations generally are not remedied through enforcement actions.
                                          However, the official noted that, although many of the violations were
                                          “technical,” they are still violations of the act that need to be remedied,
                                          especially before the violations become a major problem that could cause
                                          investor losses.




                                          Page 18                              GAO/GGD-97-67 SEC Adjusted Its Mutual Fund Oversight
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                      SEC’s responsibility for ensuring that mutual funds comply with applicable
SEC Selectively       disclosure requirements has become particularly important because of the
Reviewed Disclosure   increasing number of mutual fund investors. Many of these investors may
Documents             be investing for the first time and may not be sophisticated in legal or
                      financial matters. SEC’s disclosure review staffing level has remained
                      relatively constant during fiscal years 1990 through 1996. However, despite
                      receiving an increased number of documents to review since 1994, SEC
                      officials said that by selectively reviewing mutual funds’ disclosure
                      documents, staff members have been able to review all new or materially
                      different disclosures.

                      SEC’s disclosure review process is intended to ensure that (1) disclosure
                      documents filed by mutual funds are complete, (2) all proposed activities
                      are legal, and (3) information contained in the filings is not misleading to
                      investors. Disclosure documents filed by mutual funds include initial
                      registration statements, amendments to registration statements, proxy
                      statements, and periodic reports. Initial registration statements have three
                      parts: (1) a prospectus, which must be provided to every fund investor and
                      includes information about a fund’s investment objectives and policies,
                      investment risks, and all fees and expenses; (2) a statement of additional
                      information, which contains more detailed information on all aspects of
                      the fund and must be provided upon request to fund investors; and
                      (3) other information required to be in the registration statement,
                      including copies of a fund’s contracts with its various service providers.
                      Amendments to registration statements are filed whenever important
                      information in a mutual fund’s original, effective registration statement has
                      changed. Mutual funds are also required to annually file amendments
                      updating their financial information. Most of the disclosure documents
                      that SEC receives are amendments. Proxy statements are to be filed when a
                      mutual fund is considering an event that requires shareholder approval
                      before taking action, such as changing its investment policies and
                      objectives or merging with another fund. Periodic reports primarily
                      contain statistical data about a mutual fund, such as the fund’s assets,
                      expenses, portfolio turnover, and type of investments.

                      All disclosure documents filed by mutual funds are subject to review and
                      comment by staff in SEC’s Division of IM. However, to focus on those filings
                      that are most in need of review, Division of IM staff members selectively
                      review the disclosure documents SEC receives. In fiscal year 1996, SEC
                      received a total of about 30,000 disclosure documents from all types of
                      investment companies, including mutual funds, which was an almost
                      8-percent increase since fiscal year 1994. SEC officials told us that



                      Page 19                      GAO/GGD-97-67 SEC Adjusted Its Mutual Fund Oversight
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completely reviewing all of these documents is not necessary because
many of them contain repetitive information. The officials also said that a
complete review would be an inefficient use of SEC’s limited resources.
Instead, SEC’s disclosure review process is intended to ensure that SEC’s
review focuses on new information in disclosure documents as well as
filings that contain material changes.20

SEC procedures specify that routine filings, presenting no novel questions
of law, need not be targeted for review. For example, many initial
registration statements filed by mutual funds that are members of the
same fund complex are similar to previous filings by other funds in the
complex. That is, even though certain funds in a complex may have
different investment objectives and techniques, their prospectuses often
contain similar disclosure information regarding other aspects of the
funds’ operations, such as procedures for share purchase and redemption
and the descriptions of the investment adviser, underwriters, transfer
agent, and officers and directors. In these instances, the funds’ initial
registration statements often include disclosures from previous filings that
had already been subject to SEC review and comment. Because SEC
considers that reviewing these disclosures again would be redundant, it
focuses its review on more substantive information in the filing by
identifying what information is new. SEC officials said that fund counsel
generally initiate requests for selective review and indicate to SEC which
parts of the filing have already been reviewed. SEC’s disclosure review staff
can also identify situations in which a selective review can be done and
are to alert fund counsel to that option.

SEC also selectively reviews amendments to registration statements so that
only material changes routinely undergo staff review. Similar to initial
registration statements, many matters in an amendment may already have
been considered by staff members in processing other filings by that fund.
To focus SEC’s disclosure review on significant changes, mutual fund
counsel represent to SEC whether changes contained in an amendment are
considered material. Amendments that contain only nonmaterial changes
may become automatically effective without SEC review.21 Examples of
nonmaterial changes include bringing a fund’s financial statements
up-to-date, changing the fund’s phone numbers, and increasing the number

20
 Material changes include disclosures that are significantly different from those disclosures previously
made by the investment company in its most recent filing of the same kind.
21
 Rule 485(b) [17 CFR230.485] permits amendments filed by registered mutual funds that contain
enumerated routine or nonmaterial changes to become automatically effective on the date the
amendments are filed with SEC or on a later date, designated by the fund, that does not exceed 30 days
after the date on which the amendment was filed.



Page 20                                GAO/GGD-97-67 SEC Adjusted Its Mutual Fund Oversight
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or amount of securities proposed to be offered. According to SEC officials,
most amendments filed by registered mutual funds contain nonmaterial
changes and, therefore, are not routinely reviewed. In contrast, they said
that amendments containing material changes are routinely reviewed with
a focus on the disclosures that have changed.

Proxy statements and periodic reports also undergo a targeted review by
SEC. Specifically, proxy statements covering nonroutine matters, such as a
merger, are targeted for review; although more routine proxies, such as
the standard approval of a mutual fund’s auditors, are not. Of the periodic
reports received, SEC only reviews the attachment to the second of two
semiannual reports that most mutual funds file every year. The attachment
is the fund auditor’s report on the mutual fund’s internal controls.

Table 4 shows SEC’s coverage of investment company disclosure
documents for fiscal years 1994 through 1996.22 During this period, SEC
devoted an average of 44 staff years to reviewing these documents.
Although the total percentage of disclosure documents reviewed over
these years averaged about 31 percent, the breakdown of documents
reviewed indicates that SEC dedicated its disclosure staff to reviewing
those documents most likely to have new or materially different
information. For example, the data show that SEC reviewed a high
percentage of initial registration and proxy statements each year,
reflecting the greater possibility that these filings would contain new or
materially different information. Furthermore, SEC reviewed at least
93 percent of the initial registration statements filed by mutual funds for
each of these years. In contrast, SEC reported that its staff members
reviewed between 12 and 15 percent of the amendments SEC received each
year, reflecting the high number of these filings that would contain
nonmaterial changes.




22
 We were unable to include and compare data for all disclosure documents from previous fiscal years
because of changes in how SEC counted the filings received.



Page 21                               GAO/GGD-97-67 SEC Adjusted Its Mutual Fund Oversight
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Table 4: SEC Coverage of Investment
Company Disclosure Documents,                                                                 Number and percentage of disclosure
Fiscal Years 1994-96                                                                           documents reviewed, by fiscal year
                                      Disclosure document                                             1994              1995                1996
                                      Initial registration statements
                                          Filed                                                      2,570             2,321                2,410
                                          Revieweda                                                  1,605             1,570                1,800
                                          Percentage reviewed                                            62%               68%                75%
                                      Initial mutual fund registration statements
                                          Filed                                                      1,040               819                 811
                                          Reviewed                                                      960              755                 761
                                          Percentage reviewed                                            93%               93%                94%
                                      Amendments
                                          Filed                                                     16,388           15,258            16,864
                                          Reviewed                                                   2,008             1,859                2,494
                                          Percentage reviewed                                            12%               12%                15%
                                      Proxy statements
                                          Filed                                                         624              711                 750
                                          Reviewed                                                      579              595                 669
                                          Percentage reviewed                                            93%               84%                89%
                                      Periodic reports
                                          Filed                                                      8,300             9,500           10,000
                                          Reviewed                                                   4,150             4,750                5,000
                                          Percentage reviewed                                            50%               50%                50%
                                      Total disclosure documentsb
                                          Filed                                                     27,882           28,060            30,024
                                          Reviewed                                                   8,342             8,774                9,963
                                          Percentage reviewed                                            30%               31%                33%
                                      a
                                       The number of initial registration statements reviewed includes those submitted by open-end
                                      (mutual funds), closed-end, and unit investment trust portfolios.
                                      b
                                       The total number of disclosure documents filed and reviewed includes the initial registration
                                      statements, amendments, proxy statements, and periodic reports. The number of initial mutual
                                      fund registration statements filed and reviewed is included as a subset of the initial registration
                                      statements.

                                      Source: SEC.



                                      SEC officials told us that, because they already review the most important
                                      disclosures, additional staffing would not necessarily be used to increase
                                      the number of filings reviewed each year. Instead, the officials said they
                                      could use more resources to help them in related disclosure activities,



                                      Page 22                                 GAO/GGD-97-67 SEC Adjusted Its Mutual Fund Oversight
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                          such as helping mutual funds improve and simplify prospectus language
                          and performing long-range strategic planning. However, SEC officials also
                          said that a current rulemaking project could substantially affect, at least
                          for the short term, SEC’s ability to maintain adequate review coverage of
                          disclosure documents. Specifically, the proposed rule would substantially
                          revise the registration form and prospectus requirements for mutual funds.
                          During the initial implementation period of the proposed rule, SEC does not
                          plan to use its selective review procedures for initial registration
                          statements or amendments because it would need to ensure that mutual
                          funds are complying with the new disclosure requirements.23


                          SEC’s Division of IM is also responsible for other regulatory activities,
SEC’s Other               which include responding to requests for exemptions from the
Regulatory Activities     requirements of the Investment Company Act, rulemaking, and providing
Enabled the Industry      interpretations of applicable laws and rules through issuing interpretive
                          and “no-action” letters.24 According to SEC officials, these activities are a
to Evolve Without         primary way of allowing the industry to grow and change while continuing
Major Legislative         to protect investors. During fiscal years 1990 through 1993, staff years for
                          these regulatory activities grew by nearly 45 percent. However, from the
Changes                   end of fiscal year 1993 to the end of fiscal year 1996, staffing decreased by
                          almost 14 percent. SEC officials said that this staffing decrease occurred
                          largely because staff members often pursue opportunities created by rapid
                          growth in the investment management industry. They also said that
                          additional staff could help them keep pace with industry developments
                          and be more proactive in identifying and reacting to industry changes.


Exemptive Orders Enable   The Investment Company Act and the Investment Advisers Act allow SEC
SEC to Adapt Its          to issue orders granting exemptions from one or more provisions of these
Regulation to Industry    acts, or from rules issued by SEC under these acts. Congress gave SEC this
                          authority to prevent the acts from being unduly restrictive. To grant an
Changes                   exemption, SEC must find that the exemption is necessary or appropriate in
                          the public interest, is consistent with investor protection, and is fairly
                          intended by the policy and provisions of the act. The exemptive order
                          permits the applicant to engage in the activity described in the application
                          that would otherwise be prohibited by the act. Exemptive orders apply

                          23
                            The selective review procedures would still be applicable in some instances. For example, after SEC
                          reviews a fund’s revised registration form, all funds within the same complex can request a selective
                          review of subsequent filings using the revised form.
                          24
                            A no-action letter is a request from investment companies and investment advisers that SEC staff
                          react to a particular set of circumstances or facts as outlined in the letter by indicating whether the
                          Division of IM would recommend taking an enforcement action if those circumstances were to occur.



                          Page 23                                GAO/GGD-97-67 SEC Adjusted Its Mutual Fund Oversight
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only to the applicant. However, if the exemption appears to have general
applicability, such as when a number of similar requests for exemptive
relief are made, SEC may decide to adopt a rule granting exemptions to all
funds that can meet the conditions.

According to SEC officials, SEC’s authority to grant exemptions from
various provisions of the Investment Company Act and the Investment
Advisers Act has enabled it to adapt its regulation of investment
companies so that SEC is both receptive to new innovations and able to
keep pace with the general evolution of the investment management
industry. For example, in the 1970s, SEC first allowed trading of money
market mutual funds through exemptive orders. These funds used
specialized pricing methods that were not contemplated by the Investment
Company Act. Also, SEC recently adopted a rule, following the issuance of
numerous exemptive orders, that allows mutual funds to sell multiple
classes of shares with different fee structures. In the 57 years since the
Investment Company Act was enacted, it has been amended significantly
only twice—in 1970 and again in 1996.

In a 1992 study of investment company regulation,25 SEC reported that
many responses to its 1990 request for comments on reforming investment
company regulation contained complaints that the process for obtaining
an exemptive order took too long. In 1995, SEC’s Office of Inspector
General (OIG) studied the exemptive order process, giving particular
attention to its timeliness. The OIG found that, although the process was
essentially sound, many outside attorneys were still dissatisfied with how
long SEC took to process exemptive applications when novel or complex
issues were involved. The OIG made several recommendations to improve
the process, including a recommendation that, for applications with these
types of issues, the Division of IM modify its guideline requiring initial
comments on all applications within 45 days.26

Although the Division of IM’s response to the OIG’s report agreed to adopt
most of the recommendations, it did not agree that changing this existing
45-day guideline for novel or complex applications would shorten the
amount of time spent reviewing those applications. The Division’s
response explained that these applications generally take longer to review

25
 Protecting Investors: A Half Century of Investment Company Regulation, Division of Investment
Management, United States Securities and Exchange Commission, May 1992.
26
  To prevent a disproportionate amount of staff time from being spent on routine applications, in part
to increase production as well as process applications within the 45-day time frame, the OIG suggested
that the Division of IM either provide a different timetable for complex applications or set appropriate
due dates for complex, individual applications.



Page 24                                GAO/GGD-97-67 SEC Adjusted Its Mutual Fund Oversight
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                         because of the potential effect significant changes to policy may have on
                         the industry and investors. Nonetheless, in its response, the Division
                         agreed to monitor the progress of complex applications more closely and
                         continue to strive to meet its 45-day initial comment period for all
                         applications.

                         According to SEC data on all exemptive applications processed during
                         fiscal years 1994 through 1996, SEC processed about 10 percent more
                         applications in fiscal year 1996 than it processed in the preceding 2 fiscal
                         years. Although SEC reduced its backlog of pending applications during
                         fiscal year 1996, at the end of that fiscal year, the number of applications
                         not acted on within 45 days had more than doubled from the end of fiscal
                         year 1995. According to an SEC official, the latter increase was due to a loss
                         of staff near the end of fiscal year 1996.


SEC Shapes Mutual Fund   SEC issues rules and regulations that implement the provisions of the
Regulation Through       securities laws. Through rulemaking, SEC develops rules relating to (1) the
Rulemaking               disclosure requirements that are applicable to investment companies and
                         investment advisers and (2) the Investment Company Act and the
                         Investment Advisers Act. Rulemaking involves constantly reviewing how
                         well the various rules that SEC has adopted are working. SEC often consults
                         with industry representatives and others affected by the various rules and
                         reviews their suggestions to modify rules. For example, an SEC official told
                         us that, in its efforts to develop rule changes regarding fund disclosure
                         requirements, SEC (1) sponsored focus groups with fund investors,
                         (2) reviewed industry-sponsored surveys on investors’ views of fund
                         disclosures, and (3) encouraged comments from individual investors on
                         ways to improve mutual funds’ risk disclosure in April 1995. Of about 3,700
                         comment letters SEC received, about 3,600 were from individuals.

                         When SEC rulemaking staff find that a particular rule does not appear to be
                         achieving its objective or is burdensome in relation to its benefits, the staff
                         members are to present the problem to SEC Commissioners, who then may
                         consider modifying the rule. SEC gives advance public notice of proposals
                         to adopt new or amended rules and allows time for interested members of
                         the public to comment on the proposals. At the conclusion of the comment
                         period, staff members are to analyze the comments and prepare a
                         summary of their analysis for the Commissioners to consider when
                         determining whether any modifications to existing rules are warranted.
                         Proposals approved by the Commissioners take effect as final rules,
                         usually within a specific time after publication in the Federal Register.



                         Page 25                       GAO/GGD-97-67 SEC Adjusted Its Mutual Fund Oversight
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In addition, if SEC receives several very similar requests for an exemption
from a particular provision, it may consider promulgating a rule to codify
the exemption. To determine if an exemptive rule is needed, the
rulemaking staff are to consider whether the exemption should also be
applicable to other entities. As previously discussed, money market funds
were first allowed to trade through a series of exemptive orders beginning
in the 1970s. These orders were later codified into a rule. According to SEC,
the exemptions granted and the subsequent rulemaking were critical to
the evolution and success of money market funds.

In recent years, much of the Division of IM’s disclosure-oriented
rulemaking has focused on improving mutual fund prospectuses. For
example, two major rule proposals focused on making prospectuses more
understandable to investors. The first rule proposal would update and
streamline the full prospectus that mutual funds are required to provide
investors. It also would improve the risk disclosures required to be made
in the prospectus. The second rule proposal would allow investors to
purchase shares of mutual funds solely on the basis of information
contained in a summary prospectus called a “fund profile.”27 The fund
profile provides a summary of the essential information about a mutual
fund by addressing nine items in a question-and-answer format. On
March 10, 1997, SEC published these proposed rules in the Federal
Register.

A number of rulemaking efforts regarding the Investment Company Act
and the Investment Advisers Act were under way in the Division of IM at
the time of our review. Many of these efforts were mandated by various
provisions in the 1996 Act. For example, the 1996 Act initially required SEC
to issue rules by April 9, 1997, that (1) separate the regulation of
investment advisers between the states and SEC based on asset size and
(2) exempt certain private investment companies from SEC regulation.
Congress subsequently amended the 1996 Act to provide a 90-day
extension of the April 9 deadline for separating investment adviser
regulation. However, the rule exempting certain private investment
companies from SEC regulation was effective April 9.



27
  The fund profile is a summary of the long-form prospectus. SEC intended that the fund profile
provide investors an easy-to-read summary of essential information about the fund, including the
fund’s investment objectives, risks, and fees. Although investors can buy shares after reading only the
fund profile, the profile must disclose that investors have the option to request a full prospectus before
making an investment decision. Funds are required to provide investors the full prospectus when the
funds confirm investors’ purchases. SEC has had a pilot program that permitted funds to use a fund
profile since July 31, 1995.



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                            B-271654




                            The 1996 Act also gave SEC additional authority in several areas that will
                            require other rulemaking. For example, the 1996 Act (1) gave SEC
                            additional rulemaking authority to define certain fund names as materially
                            deceptive or misleading, (2) expanded SEC’s authority to require funds to
                            keep books and records, and (3) allowed SEC to require investment
                            companies to file information more frequently than quarterly to keep
                            information in investment companies’ registration statements current.
                            According to an SEC official, several of SEC’s ongoing rulemaking efforts,
                            such as proposed rules on personal trading, the use of foreign custodians,
                            and limits on purchasing securities from an affiliated underwriter, have
                            been delayed because SEC’s first priority is to complete the implementing
                            rules for the 1996 Act. On March 10, 1997, SEC published its proposed rule
                            on fund names in the Federal Register.

                            SEC officials told us that SEC’s rulemaking function has been affected in the
                            past by high staff turnover and, as a result, SEC has had more
                            inexperienced staff in the rulemaking area than it desired. In addition, the
                            Director of the Division of IM estimated that the 1996 Act is likely to
                            increase the division’s workload by about 30 percent in 1997.


SEC Provides Informal       Through issuing no-action and interpretive letters, SEC staff members in
Views and Interpretations   the Division of IM provide investment companies, investment advisers,
of Securities Laws          Congress, and other government agencies with their informal views and
                            interpretations about how the federal securities laws apply to proposed
                            transactions that appear to raise compliance issues. These letters, which
                            are available to the public, represent the views of SEC officials who are
                            responsible for administering the laws on a daily basis. SEC officials told us
                            that the letters are an effective method of providing information about
                            how the securities laws are likely to be interpreted and applied.

                            SEC issues no-action letters in response to requests for its staff members’
                            views on whether they would recommend enforcement action if the
                            particular facts and circumstances outlined in the request were to occur.
                            No-action letters do not make rulings on whether the particular
                            circumstances are legal or illegal—the letters only state whether the
                            Division of IM staff would or would not recommend an enforcement action
                            to the Commission under those specific circumstances. Consequently,
                            unlike exemptive orders, no-action letters do not shield the requester from
                            any liability that may otherwise result if the circumstances outlined in the
                            request were to occur. In addition, SEC has reported that positions in




                            Page 27                      GAO/GGD-97-67 SEC Adjusted Its Mutual Fund Oversight
              B-271654




              no-action letters are subject to reconsideration and should not be regarded
              as precedents binding SEC.

              An SEC official told us that no-action letters promote voluntary compliance
              with the securities laws because the letters inform not only the requester
              but others as well about the likely legality of a particular proposed
              transaction. For example, Division of IM staff provided no-action
              assurances to a mutual fund that wanted to include in its prospectus
              performance information relating to another fund that its portfolio
              manager had previously managed. The staff’s no-action assurances were
              based on specific representations made in the request (1) that during the
              portfolio manager’s tenure in managing the other fund, no other person
              had played a significant part in achieving that fund’s performance and
              (2) that the performance information would not be presented in the
              prospectus in a misleading manner, nor would that information impede
              investors’ understanding of required prospectus information.

              SEC issues interpretive letters in response to requests for its staffs’ views
              on whether the requester has interpreted and applied a particular statute
              or rule correctly to a particular set of facts or circumstances. According to
              an SEC official, interpretive letters differ from no-action letters because,
              rather than simply stating it would not recommend an enforcement action,
              the Division of IM agrees that the statute or rule in question permits the
              proposed transaction. Again, SEC officials view interpretive letters as a
              means of informing the investment management industry about how the
              laws are actually being applied.

              While the Investment Company Act requires that SEC respond to requests
              for exemptions, responding to requests for no-action and interpretive
              letters is a discretionary role that SEC has had in place for several decades.
              According to SEC data, the Division of IM responded to 2,643 requests for
              no-action and interpretive advice during fiscal years 1993 through 1996.
              Although the number of no-action and interpretive responses increased
              each fiscal year during 1993 through 1995—620, 674, and 747,
              respectively—the number decreased to 602, or about 19 percent, in fiscal
              year 1996. SEC reported that this decline was a result of its staff having
              spent time during fiscal year 1996 providing technical assistance to
              Congress on a number of provisions of the 1996 Act and other legislation.


              SEC has responded to the challenges presented by the growth in the mutual
Conclusions   fund industry through increasing its inspection staffing and adjusting the



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                     B-271654




                     focus of its oversight activities. The effects of these responses cannot be
                     separated from other factors, such as the requirements of the Investment
                     Company Act, industry support for strict compliance with securities laws,
                     and favorable market conditions, that may have contributed to the
                     industry remaining generally free of major scandal. However, the
                     continued proliferation in the number and type of funds offered, the
                     industry’s use of increasingly complex products that may be difficult both
                     to value and to trade during falling markets, and the increased reliance by
                     millions of Americans on mutual funds as a source of retirement income
                     make it imperative that SEC’s efforts to protect mutual fund investors
                     against abuse continue to be a priority.


                     We requested comments on a draft of this report from the Chairman, SEC.
Agency Comments      In response, the Chairman stated that the contents of our report provide a
and Our Evaluation   detailed and accurate description of SEC’s program for inspecting and
                     regulating mutual funds. He also expressed concern that, if the industry
                     continues to grow at its current pace, SEC will need additional resources to
                     meet its oversight responsibilities.

                     We agree that industry growth can influence the resources needed to
                     oversee the industry. However, in determining the extent to which an
                     increase in resources would be the most effective response to rapid
                     industry growth, SEC may also be guided by the results it achieves from the
                     program goals and performance measurements that it is developing
                     pursuant to the Government Performance and Results Act of 1993 (GPRA).
                     In July 1993, Congress passed GPRA to improve the efficiency and
                     effectiveness of federal programs by establishing a system to set goals for
                     program performance and to measure results. GPRA directed all federal
                     agencies, including SEC, to develop by September 1997 long-range strategic
                     goals and the measures they will use to gauge their progress toward
                     achieving these goals. GPRA requires that agencies report annually to the
                     President and to Congress on their performance and progress toward
                     meeting their goals. These annual reports are intended to be used by
                     Congress and SEC to assess what SEC is accomplishing with its mutual fund
                     oversight resources and whether additional resources are needed.


                     We are sending copies of this report to the SEC Chairman and other
                     interested parties upon request. This report was prepared under the
                     direction of Michael A. Burnett, Assistant Director, Financial Institutions
                     and Markets Issues. Major contributors to this report are listed in



                     Page 29                      GAO/GGD-97-67 SEC Adjusted Its Mutual Fund Oversight
B-271654




appendix II. Please contact me on (202) 512-8678 if you have any questions
concerning this report.




Jean Gleason Stromberg
Director, Financial Institutions and
  Markets Issues




Page 30                      GAO/GGD-97-67 SEC Adjusted Its Mutual Fund Oversight
Page 31   GAO/GGD-97-67 SEC Adjusted Its Mutual Fund Oversight
Contents



Letter                                                                                               1


Appendix I                                                                                          34

Comments From the
Securities and
Exchange
Commission
Appendix II                                                                                         35

Major Contributors to
This Report
Tables                  Table 1: SEC Inspection Staff Years, Fiscal Years 1990-96                   11
                        Table 2: Inspections of Fund Complexes by Year Last Inspected               14
                          for Five SEC Field Offices, Fiscal Years 1992-96
                        Table 3: Disposition of Investment Company Inspections, Fiscal              18
                          Years 1992-96
                        Table 4: SEC Coverage of Investment Company Disclosure                      22
                          Documents, Fiscal Years 1994-96




                        Abbreviations

                        GPRA      Government Performance and Results Act of 1993
                        ICI       Investment Company Institute
                        IM        Investment Management
                        NASD      National Association of Securities Dealers
                        OCIE      Office of Compliance Inspections and Examinations
                        OIG       Office of Inspector General
                        SEC       Securities and Exchange Commission


                        Page 32                    GAO/GGD-97-67 SEC Adjusted Its Mutual Fund Oversight
Page 33   GAO/GGD-97-67 SEC Adjusted Its Mutual Fund Oversight
Appendix I

Comments From the Securities and
Exchange Commission




              Page 34   GAO/GGD-97-67 SEC Adjusted Its Mutual Fund Oversight
Appendix II

Major Contributors to This Report


                        Michael A. Burnett, Assistant Director
General Government      Frank J. Philippi, Assignment Manager
Division, Washington,   Suzanne Bright, Evaluator-in-Charge
D.C.                    Darleen A. Wall, Evaluator




(233490)                Page 35                     GAO/GGD-97-67 SEC Adjusted Its Mutual Fund Oversight
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