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Enforcement Surveillance of Markets

Audit Report No. 246
January 7, 1997

SUMMARY

We found that the Office of Market Surveillance in the Division of Enforcement is effectively performing its responsibilities (processing referrals from SROs, market surveillance, and investigative support). Our most significant recommendations to further enhance the Office's effectiveness include: notifying the regions of SRO referrals that otherwise would be closed without further action; documenting the basis of decisions on referrals classified as ""management decisions""; periodically sending market surveillance staff to visit the SROs' market surveillance units; and enhancing referral reporting.

The Division of Enforcement and the Office of the Executive Director provided informal comments on a draft of this report. We have modified the report as appropriate to reflect the comments.

OBJECTIVE AND SCOPE

The objective of the audit was to evaluate the effectiveness of Enforcement's market surveillance activities. We interviewed Commission and former Commission staff, and visited two SRO's (the New York Stock Exchange and the Chicago Board Options Exchange) and Commission regional offices in New York and Chicago.

We also sent a questionnaire to regional contacts for the Office of Market Surveillance, and interviewed the Chairman of the Intermarket Surveillance Group. Finally, we reviewed available documentation, observed conditions in the market surveillance room, and tested the accuracy and timeliness of referral data in Commission tracking systems. We did not independently evaluate the effectiveness of the Office's investigative support activities, but instead relied on staff interviews.

The audit was performed between February and October 1996, in accordance with generally accepted government auditing standards.

BACKGROUND

The Office of Market Surveillance in the Division of Enforcement is an important source of intelligence information for the Commission's Enforcement program. It obtains information through referrals from Self-Regulatory Organizations (SROs), which have primary responsibility for surveillance of their markets, and through its own surveillance, including reviews of filings and trading data (for example, from blue sheets and external data bases).

When the Office receives or identifies information on suspicious trading patterns (insider trading or market manipulation), it conducts additional analysis. If warranted, based on materiality and other considerations, the Office refers the matter internally within the Division of Enforcement or to the appropriate region.

During 1995, the Office received 256 SRO referrals. It referred 188 of these with domestic gains totaling $88 million to headquarters and the regions.

The Office's staff of ten market surveillance specialists also provides investigative support as needed to enforcement attorneys (mostly in the Division). This support includes obtaining information from SROs, analyzing trading records and other documentation, and assisting in the taking of testimony.

AUDIT RESULTS

Office of Market Surveillance Effective

Given its limited staff and analytical resources, Enforcement's Office of Market Surveillance is generally effective in its market surveillance activities. SRO referrals are generally distributed on a timely basis, and the Office provides quality investigative support services, based on our interviews. It coordinates well with the Intermarket Surveillance Group, and the SRO referral tracking system (the SRO Case Referral Listing) appears accurate and complete.

We have several recommendations to further enhance the Office's effectiveness.

Afford Regions an Opportunity to Review Lower Dollar Referrals

One of the criteria used by Market Surveillance to determine whether to pursue SRO referrals is the dollar amount of profit gained or losses avoided by the alleged violation. This dollar value is calculated by the SRO, although the SRO may not know the full scope of the alleged violation when making a referral.

Since 1989, 157 matters have not been referred and were closed without Commission action. Their total value was $5,971,567, an average of $38,035. The average value of SRO referrals that were investigated during the same period was approximately $780,000.

Some regions indicated that they would be interested in reviewing cases not currently being referred. The Northeast Regional Office mentioned that its review of an apparently low dollar referral identified a significant problem warranting investigation.

Recommendation A

Before closing a case without action, Market Surveillance should send a copy of the SRO referral to the appropriate region.

Explain Basis for Management Decisions

If Market Surveillance decides a case is worth investigating, it then has to decide whether a headquarters component or a region should get it. The Associate Director who supervises Market Surveillance makes the final determination based on several factors, including the resources needed for the investigation, the geographical location of the company involved, and the location of the traders.

If headquarters is chosen for a case, then Market Surveillance assigns it to a component (Associate Director), based on informal assessments of staff availability and expressions of interest by supervisory personnel.

Market Surveillance documents its referral by completing a form. One question on this form relates to the basis for the referral. Choices include: a pre-existing case, the issuer or traders located in that region, office requested, management decision, and other (specify). A total of 215 cases out of 1,517 in the SRO tracking system were checked ""management decision,"" with no further explanation. In recent years, this category has not been extensively utilized, according to Market Surveillance.

An explanation of the basis for management's decision appears appropriate, since all referrals are ultimately management's decision anyway.

Recommendation B

Market Surveillance should briefly explain on the SRO referral form the basis for any referrals checked ""management decision."" Alternatively, Market Surveillance could eliminate ""management decision"" as a category, using the ""other"" response instead, which already requires an explanation. If necessary, it should provide additional guidance to its staff.

Enhance Referral Reporting

The Office of Market Surveillance provides several types of referral reports to the Intermarket Surveillance Group. The reports include the type of news which led to the referrals (for example, acquisition, merger, earnings), the case type (for example, insider trading, market manipulation), and the amount of profits.

To enhance referral reporting, Market Surveillance could also periodically provide these referral reports to the regions. Also, it could provide a report listing the number and amount of referrals for headquarters and the regions.

For example, we analyzed 957 referrals, of which 508 (53%) went to headquarters, while 449 (47%) went to the regions. The dollar value of these referrals (that is, the actual or potential disgorgement amount) was $359,341,745 for headquarters, and $387,261,788 for the regions.

Another way to provide referral information would be to put Market Surveillance's referral tracking system (the SRO Case Referral Listing, currently on Q&A software) on the Local and Wide Area Networks, or on the mainframe.

Market Surveillance could also ask the regions and the Division to notify it of any particularly significant cases, issues or trends arising out of SRO referrals. In turn, it could then disseminate this information (for example, by electronic mail or memorandum) to other regions and the Division.

Recommendation C

Market Surveillance should consider enhancing referral reporting as discussed above. It should consult with the Office of Information Technology as appropriate.

Periodically Visit SRO Market Surveillance Units

Since Enforcement relies on information provided by the SROs, Enforcement Market Surveillance staff would benefit from periodically visiting the SROs' market surveillance units. They could meet with their staff to discuss joint concerns, industry trends, and market surveillance techniques; observe the SROs' market surveillance procedures; and review available documentation.

Recommendation D

Market Surveillance staff should consider periodically visiting the SROs' market surveillance units. They should coordinate as necessary with the Office of Compliance Inspections and Examinations, which performs oversight examinations of those units.

Most Referrals Reviewed Timely

When Market Surveillance receives an SRO referral, it reviews the information provided and typically interviews the responsible SRO analyst. It then generally opens a Matter Under Inquiry (MUI). According to Market Surveillance management, the objective is to open a MUI within as short a period as possible.

We selected a judgment sample of 39 SRO referrals received during 1995, and determined whether a MUI was opened on a timely basis. Thirty-six of our sample were timely, that is, opened in less than 27 days. The other three were opened after 35, 45, and 90 days.

Since the MUI system is used to coordinate investigations among the regions and headquarters, MUI data must be in the system for this purpose to be achieved. Market Surveillance's present standard of 25 to 27 days for data entry delays the benefits of this coordination unnecessarily. The Office of Market Surveillance stated that the most promising referrals are acted upon very expeditiously, often within a few days, and that the more marginal referrals are the ones that require more time for consideration.

Recommendation E

Market Surveillance should consider shortening the standard for MUI data entry.

Recommendation F

  Market Surveillance should institute procedures to ensure all referrals are reviewed timely, for example, by periodically checking print-outs from its tracking system. If feasible, the system should automatically generate exception reports for those cases not reviewed timely or for which no MUI is opened.

Coordinate Requests for SRO Assistance with Market Surveillance

One SRO Market Surveillance Department indicated that Commission attorneys sometimes contact its staff directly, rather than through Market Surveillance, as recommended. The SRO is familiar with the case and may have data required by the attorney. Nevertheless, the SRO indicated that these requests place a burden on its limited staff.

Coordinating requests for SRO assistance through Market Surveillance has several advantages. Market Surveillance may already have the information required by the attorney, or may be able to consolidate a number of requests. Also, the SRO is used to working with it.

Recommendation G

Market Surveillance should remind enforcement attorneys that requests for information from SROs' Market Surveillance Departments should be coordinated with it.