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REVIEW OF INVESTMENT
Audit No. 273
June 26, 1998
Our review found that the Division of Investment Management has generally implemented an efficient and effective review process for investment company filings. However, management controls to assure the continued effectiveness of the process need further enhancement.
We are making several recommendations in the Audit Results section, including developing plans to address the potential impact on workload of recent filing initiatives; updating review guidance and issuing it electronically; ensuring that EDGAR enhancements to identify fund series and classes are made during the initial three year modernization period; and performing spot checks of post-effective amendments filed under rule 485(b) and semiannual reports to shareholders.
SCOPE AND OBJECTIVES
Our objective was to evaluate the efficiency and effectiveness of the investment company filing review process. During the review, we interviewed staff from the Division of Investment Management and selected investment companies. Also, we reviewed information from the EDGAR (Electronic Data Gathering, Analysis, and Retrieval) system and Division policies and procedures related to disclosure, as well as selected staff and management performance plans.
The audit was performed from November 1997 to April 1998 in accordance with generally accepted government auditing standards.
The Office of Disclosure and Review within the Division reviews investment company (IC) filings, including registration statements and amendments, and proxy statements. The review is intended to ensure full disclosure to investors of IC policies, procedures, and risks, and that proposed IC activities are lawful.
The Office has four branches with approximately six staff each, composed of accountants, attorneys, and financial analysts. From 1994 to 1998, the Office's staffing increased approximately 9%. During that same period, the number of investment companies increased 24% (from 4300 to a projected 5,350) and assets managed increased 75% (from $2.4 trillion to a projected $4.2 trillion).
The Office strives to maintain adequate review coverage despite limited resources by focusing on new disclosures. Routine, recurring, and immaterial disclosures are not reviewed or given only a cursory review.
To facilitate the staff's review, fund counsel provides information on new and material disclosures in the registration filing's cover letter. In this letter, fund counsel represents that the disclosure has not changed materially from previous filings, or identifies new disclosures and material changes to previous disclosures.
Several reviewers told us that they always review certain parts of the filing. For example, they ensure that company's investments are consistent with its investment objectives and that the fund's costs and its investment risks are appropriately disclosed.
The office has set time goals for review comments, based on the type of filing. Initial comments on registration statements must be issued within 30 days of receipt of the filing by the reviewer, post-effective amendments within 45 days, and proxies within 10 days.
Two recent Division initiatives to enhance disclosure to investors may result in temporary, but significant, increases in the Office's workload. One initiative involves revision of the registration form for mutual funds, the N-1A. All initial filings of the new form will be treated as new registrations for review purposes. The other initiative involves the "fund profile," a summary of key information about the fund included in the selling document, or prospectus. The initiatives became effective June 1, 1998.
Our review found that the Division of Investment Management has generally implemented an efficient and effective review process for investment company filings. However, management controls to assure the continued effectiveness of the process need further enhancement. Our findings and recommendations are presented below.
PLANNING FOR WORKLOAD INCREASE
The Division has not developed a formal plan for addressing the potential increase in workload from the N-1A and profile prospectus initiatives discussed in the Background section. The increase could reduce coverage of the current workload and prevent review of all new disclosures, an Office goal.
Division officials indicated that they focused their limited resources on developing the new rules, analyzing industry and investor comments, and getting the rules adopted. The Division intends to develop a plan now that the rules have been adopted and will meet with the industry to discuss the requirements.
The Division has begun to evaluate the effect of the workload increases and to consider alternatives. For example, the Office could obtain staff through details from other offices and divisions, or a task force could be formed. The Office could also determine review goals and resource needs, develop review strategies, and monitor the results of the reviews. As it gains more experience with the new filings, the Office could modify its plans accordingly.
The Division of Investment Management should finalize a plan to address the expected temporary increase in IC filings.
The Division's written guidance for filing reviews has been in draft since 1994. In some respects it does not reflect current practices.
The guidance refers to paper filings, but almost all filings are now made electronically through EDGAR. It requires name searches through the Name Relational Search Index (NRSI), but to save time staff now check NRSI only for new managers and directors. Similarly, the guidance requires checks of the inspection and reporting management system. Instead, staff obtain information directly from inspection staff in the Office of Compliance, Inspections and Examinations.
The guidance also does not reflect the new initiatives. Review procedures for the N-1A form and profile prospectus will need to be developed (the staff now plan to use the instructions on the new N-1A form as guidance).
The review staff we interviewed, particularly senior staff, indicated that they rarely consulted the draft procedures. Updated, consolidated guidance would be a more useful reference, especially for newer staff.
The Division of Investment Management should issue updated guidance for filing reviews.
The Office staff document the results of their filing reviews in certain respects. They provide written comments on reviews of new registrations and maintain notes regarding contacts with filers. The Office also maintains documentation on novel issues and on staff positions regarding industry-wide issues. However, comments on new series funds added by post-effective amendments and proxy contests are generally not documented.
While documentation would take time, it could be used for training new staff and ensuring consistent approaches to reviews. Current guidance does not address this issue.
The Division of Investment Management should issue written guidance on documentation of comments on new series funds added by post-effective amendments and proxy contests. The comments should be made available to other staff.
ELECTRONIC FORMAT FOR REVIEW GUIDANCE
The Office distributed its draft review guidance (see above) on paper and it also maintains a paper binder of novel issues. Making the guidance available electronically (in addition to paper) would make it easier to update the guidance and make it more accessible to all staff.
The Division of Investment Management should make all review guidance available electronically.
The Commission's record of filings on the EDGAR system does not reflect the total number of funds registered because EDGAR does not identify individual fund series and classes. The Division currently downloads information on individual fund series and classes into EDGAR from another mainframe database (containing information from semiannual reports to the Commission on Form N-SAR). This process is more time consuming and less efficient than having EDGAR directly record the information.
The statement of work for the new EDGAR contract indicates that EDGAR will likely be modified to include individual information on funds. However, it does not indicate whether the modifications will be made during the initial three year modernization of EDGAR (as desired by the Division), or later.
The Division of Investment Management should ask the EDGAR Contracting Officer to authorize modification of EDGAR to track individual fund information during the initial three year modernization.
Under its selective review procedures, the Division does not review certain filings, including post-effective amendments under Rule 485(b) of registration statements and semi-annual reports to shareholders (Form N-30D). The Division indicated that it concentrates its limited resources on filings with new disclosures.
Rule 485(b) amendments become effective immediately, or on a date specified by the registrant, without review by the Division. Under this rule, the registrant represents that the amendments contain no material events requiring disclosure. The N-30D contains information concerning the performance of the fund for the previous six months, including a discussion by the fund manager of significant events and investment decisions affecting the performance of the fund.
In our opinion, limited spot checks of post-effective amendments and semi-annual reports could be useful. If the IC industry was informed, the spot checks would encourage voluntary compliance. We identified several possible issues to be checked.
In a judgment sample of 50 485(b) amendments, we found five deficiencies. Four filings did not have a required certification1 and one filing did not designate the effectiveness date on the facing page as required.
Division staff also indicated that registrations subject to review may be mistakenly filed under 485(b) and thus miss review. They further stated that although changes since the last registration may be immaterial, cumulative changes over several years may be material.
As for semi-annual reports, Form N-30D contains information on fund performance and other important information (e.g., changes in the fund's investments). The Division is considering what type of review, if any, is appropriate for this form. One option would be to compare the way the fund operated as described on Form N-30D with the fund's intended method of operation, as shown on the prospectus.
Timeliness is another potential issue for Form N-30D. ICs are to send these reports to shareholders within 60 days of their period end. The Commission is to receive the reports within 10 days after they are sent to shareholders.
To monitor these filings, the Division could request exception reports from EDGAR. For example, it could generate reports on late N-30D filings, or exception reports on 485(b) filings based on word searches and comparisons of input fields (to identify missing certifications or effectiveness dates).
The Division of Investment Management should consider performing spot checks of post-effective amendments and semiannual shareholder reports. It should notify the IC industry of the spot checks.
STAFF PERFORMANCE PLANS
The Division has established timeliness and quality goals for its staff. These goals (which need not be quantitative), if included in staff performance plans, would help focus the staff on Division goals.
The Division of Investment Management should modify performance plans for disclosure staff to include timeliness and quality goals.
Registrants often leave their registrations in an inactive status while they wait for more favorable market conditions.
Inactive filings increase the Division's pending caseload. Also, reviewers spend time repeatedly checking the status of filings. Under rule 479, the Commission may ask registrants with filings over 270 days old if they want to abandon the registration.
Contacting registrants periodically to determine if they want to abandon their registrations under Rule 479 would help the reviewers get definite dispositions on these pending filings.
The Division of Investment Management should consider implementing procedures under rule 479 for periodic contact of registrants with pending filings over 270 days.
1 That the amendment was filed for one or more of the purposes of 485(b) and that no material event requiring disclosure had occurred since its last registration or post-effective amendment was filed or became effective.