Mutual Fund Industry:

SEC's Revised Examination Approach Offers Potential Benefits, but Significant Oversight Challenges Remain

GAO-05-415: Published: Aug 17, 2005. Publicly Released: Sep 19, 2005.

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As the frontline regulator of mutual funds, the Securities and Exchange Commission (SEC) plays a key role in protecting the nearly half of all U.S. households owning mutual funds, valued around $8 trillion in 2005. Mutual fund abuses raised questions about the integrity of the industry and quality of oversight provided by SEC and self-regulatory organizations (SRO) that regulate broker-dealers selling funds. This report assesses (1) changes SEC has made to, or is planning for, its mutual fund exam program; (2) key aspects of SEC's quality control framework for routine fund exams; and (3) the adequacy of SEC's oversight of NASD and the New York Stock Exchange in protecting shareholders from mutual fund sales abuses.

SEC is initiating several changes intended to strengthen its mutual fund exam program but faces challenges overseeing the fund industry. In the wake of the fund abuses, SEC has revised its past approach of primarily conducting routine exams of all funds on a regular schedule. It concluded these exams were not the best tool for identifying emerging problems, since funds were not selected for examination based on risk. To quickly identify problems, SEC is shifting resources away from routine exams to targeted exams that focus on specific risks. It will conduct routine exams on a regular schedule but only of funds deemed high risk. SEC also is forming teams to monitor some of the largest groups of advisers and funds. Although SEC is seeking to focus its resources on higher risk funds and activities, the resource tradeoffs it made in revising its oversight approach raise significant challenges. The tradeoffs may limit SEC's capacity not only to examine funds considered lower risk within a 10-year period but also to accurately identify which funds pose higher risk and effectively target them for routine examination. Potentially taxing its resources further, SEC recently adopted a rule to require advisers to hedge funds (investment vehicles generally not widely available to the public) to register with it. This rule is expected to increase SEC's exam workload, but the precise extent is not yet known. SEC has integrated some quality controls into its routine exams, but certain aspects of its framework could be improved. It relies on experienced staff to oversee all exam stages but does not expressly require supervisors to review work papers or document their review. GAO found deficiencies in key SEC exam work papers, raising questions about the quality of supervisory review. SEC also does not require examiners to prepare written exam plans, though they use considerable judgment in customizing each exam. Written plans could serve as a guide for conducting exams and reviewing whether exams were completed as planned. As done by other regulators, SEC also could review a sample of work papers to test compliance with its standards. A primary tool that SEC uses to assess the adequacy of SRO oversight of broker-dealers offering mutual funds provides limited information for achieving its objective and imposes duplicative costs on firms. To assess SRO oversight, SEC reviews SRO exam programs and conducts oversight exams of broker-dealers, including their mutual fund sales practices. SEC's oversight exams take place 6 to 12 months after SROs conduct their exams and serve to assess the quality of SRO exams. However, GAO reported in 1991 that SEC's oversight exams provided limited information in helping SROs to improve their exam quality, because SEC and the SROs used different exam guidelines and their exams often covered different periods. GAO found that these problems remain, raising questions about the considerable resources SEC devotes to oversight exams. GAO also found that SEC has not developed an automated system to track the full scope of work done during its oversight exams. Thus, SEC cannot readily determine the extent to which these exams assess mutual fund sales practices.

Status Legend:

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  • Review Pending-GAO has not yet assessed implementation status.
  • Open-Actions to satisfy the intent of the recommendation have not been taken or are being planned, or actions that partially satisfy the intent of the recommendation have been taken.
  • Closed-implemented-Actions that satisfy the intent of the recommendation have been taken.
  • Closed-not implemented-While the intent of the recommendation has not been satisfied, time or circumstances have rendered the recommendation invalid.
    • Review Pending
    • Open
    • Closed - implemented
    • Closed - not implemented

    Recommendations for Executive Action

    Recommendation: To improve SEC's oversight of mutual funds and SRO oversight of broker-dealers that sell mutual funds, and to strengthen SEC's approach to mutual fund examinations, SEC should establish a policy or procedure for supervisory review of work papers prepared during routine examinations and for documenting such reviews; establish a policy or procedure for preparing a written plan for each routine examination, documenting at a minimum the preliminary objectives and scope of the examination; and consider reviewing on a sample basis completed routine examinations and work papers to assess the quality and consistency of work within and across the field offices conducting examinations.

    Agency Affected: United States Securities and Exchange Commission

    Status: Closed - Implemented

    Comments: Following the recommendation, SEC's OCIE conducted a review of and revised its policies and procedures regarding its examination work papers. In November 2006, OCIE issued Oversight Examination Guidelines. With input from the regional offices, OCIE issued updated policies and procedures regarding the organization and supervisory review of examination work papers in July 2008. In addition, in November 2008, OCIE issued guidance on preparing a scope memorandum when planning an examination. In addition, OCIE electronically gathers and tracks a variety of information about firms and their examinations in a database, called Super Tracking and Reporting System (STARS). The information collected in STARS helps provide consistency among examinations. OCIE has been upgrading its ability to track examination information through the development of a new program, but progress has slowed due to funding limitations.

    Recommendation: To improve SEC's oversight of mutual funds and SRO oversight of broker-dealers that sell mutual funds, SEC should assess its methodology for conducting broker-dealer oversight examinations and whether some portion of the resources currently devoted to these examinations could be better utilized to perform mutual fund examinations.

    Agency Affected: United States Securities and Exchange Commission

    Status: Closed - Implemented

    Comments: SEC created an internal task force to assess the agency's methodology, or approach, for conducting broker-dealer oversight exams. The task force identified areas for improvement, including the need to analyze the program on a national level to ensure consistent oversight and to identify better the underlying causes of deficiencies found by SEC examiners but missed by self-regulatory organization (SRO) examiners. SEC staff said that they disagree that resources should be shifted away from the broker-dealer oversight exams to mutual fund exams. They said that the broker-dealer oversight exams serve the dual purpose of evaluating the effectiveness of SRO exams and detecting violations and compliance risk at broker-dealers. SEC examiners find deficiencies not found by SROs in over 90 percent of their exams. Based on its overall risk-based approach, SEC staff do not support shifting resources away from broker-dealer oversight exams.

    Recommendation: To improve SEC's oversight of mutual funds and SRO oversight of broker-dealers that sell mutual funds, SEC should periodically assess the level of resources allocated to the various types of examinations in light of their regulatory benefits to help ensure that the agency is using its resources efficiently and effectively to oversee the mutual fund industry, including broker-dealers that offer mutual funds. As part of this assessment, SEC should seek to ensure that it allocates sufficient resources to mitigate any regulatory gaps that may currently exist concerning the timely examination of mutual funds perceived to represent lower risk, complete mutual fund risk assessments within a more reasonable period, and fulfill its new oversight responsibilities for the hedge fund industry.

    Agency Affected: United States Securities and Exchange Commission

    Status: Closed - Implemented

    Comments: SEC's Office of Compliance Inspections and Examinations (OCIE) has taken various steps. In conjunction with NASD (now called the Financial Industry Regulatory Authority), it evaluated and modified its program of oversight examinations of broker-dealers. Based on its evaluation, OCIE reallocated selected examiner positions among SEC's regional offices to better implement the examination program and address resource disparities and significant risks. In 2007, OCIE created a surveillance branch for advisers and funds to address and mitigate potential regulatory gaps in its mutual fund examinations and added new positions. Each year, the surveillance branch uses an algorithm to analyze information provided electronically by each adviser through Web Central Registration Depository/Investment Adviser Public Disclosure. Also, OCIE examiners annually input risks into the agency's risk assessment database (RADAR). OCIE uses RADAR information to determine the issues and firms on which it should focus in setting examination schedules and allocating staff to those identified focus areas and examinations. OCIE staff document these decisions in an annual memorandum submitted to the Commission.

    Recommendation: To improve SEC's oversight of mutual funds and SRO oversight of broker-dealers that sell mutual funds, and to assess and improve the effectiveness of SEC's oversight of SRO broker-dealer examination programs, the Chairman, SEC, should electronically track information about the full scope of work performed during broker-dealer oversight examinations, including all major areas reviewed, to determine whether areas are receiving adequate review and to more fully assess the significance of deficiencies and violations found.

    Agency Affected: United States Securities and Exchange Commission

    Status: Closed - Implemented

    Comments: OCIE has been upgrading its ability to track examination information through the development of a new program, called Risk Assessment Documentation and Inspection Umbrella System (RADIUS). However, the development of RADIUS has slowed due to funding limitations. Once fully functional, RADIUS will permit OCIE to store examination documentation electronically. In the interim, OCIE has taken other steps. First, in 2006, OCIE issued guidance to standardize, strengthen, and document the process of assessing firm risk and identifying preliminary review areas before field work. Second, OCIE is in the process of migrating to an electronic examination workbook, which enables examiners to enter examine information into a central location. The workbook also permits managers to approve examination scope and review examiner work. OCIE is piloting the workbook in several regional offices and plans to implement it nationally in early 2011. Third, OCIE has implemented a quarterly management review process to determine the appropriateness of the scope and areas reviewed. Through the process, managers can identify and address difficulties encountered or new issues identified that may require modification of an examination's scope or plan. Finally, OCIE's regional office policies include a review of all examination reports with significant findings. Such findings are stored in an electronic database, which can be used to generate reports to assess common or emerging trends.

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