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SEC Missed Mutual Fund Abuses

SEC Was "Asleep at the Switch," Rep. Conyers Charges

April 25, 2005
The Government Accountability Office (GAO) has found in a new report that the Securities and Exchange Commission (SEC) failed to uncover market timing abuses by mutual funds that cost shareholders billions of dollars over many years because SEC officials focused on other regulatory activities.

Mutual Fund Market Timing • Prudential to Pay $600 Million for Market Timing • Waddell & Reed Settles Market Timing Case • Court Overturns Key Mutual Fund Investor Protection • SEC Missed Mutual Fund Abuses, GAO Finds • Mutual Fund Firms Fined $21 Million • Merrill Lynch to Pay $10 Million • Kaplan Brokers Plead Guilty to Late Trading • PBHG Agrees to Refund $120 Million • Fremont Investment Advisors Settles • INVESCO Settles Market Timing Charges with Colorado • Spitzer Spoils Bank of America's Party

The GAO reports says that despite industry experts warning of financial risks to mutual fund company shareholders, the SEC did not examine for this practice.

The SEC's failure to act cost mutual fund shareholders approximately $5 billion annually, according to one estimate. Alarmed by reports of this abusive practice, House Judiciary Committee Chairman F. James Sensenbrenner, Jr. (R-Wis.) and Ranking Member John Conyers, Jr. (D-Mich.) requested the GAO undertake this study.

Market timing typically involves frequent buying and selling of mutual fund shares, such as hedge funds, by sophisticated investors seeking opportunities to make profits on the differences between foreign and domestic markets. It can constitute illegal conduct if, for example, it takes place as a result of undisclosed agreements between investment advisors (firms that may manage mutual fund companies) and favored customers (such as hedge funds) in contravention of stated fund trading limits.

"Market timing abuses in the mutual fund industry are particularly offensive because most mutual fund investors are regular people, with no special experience or expertise with investing in the stock market. They have no choice but to trust that mutual fund companies will act in their best interest," Rep. Conyers said.

"But the GAO report shows how even the largest mutual fund companies betrayed that trust, while the SEC was asleep at the switch."

The GAO found that the SEC, which has direct supervisory oversight responsibility for mutual fund companies, didn't detect the undisclosed arrangements through its routine examination program.

The National Association of Securities Dealers (NASD), which regulates broker dealers allowed to sell mutual funds as part of their overall business, also didn't detect undisclosed market timing or late trading abuses through its examinations.

However, by November 2003, the SEC estimated that 50 percent of the 80 largest mutual fund companies had entered into undisclosed arrangements permitting certain shareholders to engage in market timing practices that were at odds with the regulations for disclosures to stockholders, or the fiduciary obligations recognized by the industry and the law. According to GAO, these arrangements harmed long-term mutual fund shareholders by increasing transaction costs and lowering fund returns.

Although the GAO found that the SEC has taken several steps to strengthen its mutual fund oversight enforcement activities, it noted that more needs to be done so that the agency is "in the best position to detect abusive industry practices and emerging trends."

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