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News December 24, 2012 Issue

SEC Charges Eight Mutual Fund Directors with Fair Valuation Failures

The sub-prime mortgage crisis continues to provide fertile ground for SEC enforcement actions related to valuation issues. Whether for violations related to valuation practices that strayed from stated disclosures, or from outright manipulation of values when the sub-prime markets collapsed, funds, portfolio managers, and others are paying the price.

Since the SEC's Division of Enforcement launched its specialized Asset Management investigative Unit (AMU), valuation actions have only been on the rise. Now in the wake of another action already settled related to sub-prime mortgage valuations, the AMU has moved to charge other related persons.

Two years ago in April 2010, the SEC charged Morgan Keegan, Morgan Asset Management, and two of the adviser's employees with fraudulent valuations of securities backed by sub-prime mortgages. The SEC action alleged that the funds' portfolio manager arbitrarily instructed the firm's Fund Accounting department to make "price adjustments" that increased the fair values of certain portfolio securities. The price adjustments ignored lower values for those same securities quoted by various dealers as part of the pricing validation process.

The head of the Fund Accounting Department "did nothing to remedy the deficiencies in Morgan KeeganíŽs valuation procedures, nor did he otherwise make sure that fair-valued securities were being accurately priced and NAVs were being accurately calculated."

The funds ultimately settled the charges for $200 million. The portfolio manager was fined $500,000 and barred from the industry, and the head of Fund Accounting paid a fine of $50,000.

At the time, Enforcement director Robert Khuzami said, "[t]his scheme had two architects - a portfolio manager responsible for lies to investors about the true value of the assets in his funds, and a head of fund accounting who turned a blind eye to the fund's bogus valuation process."

The AMU now has taken the analysis of valuation deficiencies to the next level.

The scheme couldn't have succeeded if the funds' directors had done their job, said an order issued by the SEC on December 10.

It is the board of directors' responsibility to value portfolio securities, said the order. This function may be delegated, but not into a vacuum.

"[T]he Directors delegated their responsibility to determine fair value to a valuation committee without providing any meaningful substantive guidance on how those determinations should be made. In addition, they made no meaningful effort to learn how fair values were actually being determined," the order said. 

The directors received only limited information on the factors considered in making fair value determinations and almost no information explaining why particular fair values were assigned to portfolio securities.

These failures were "particularly egregious" in light of the fact that significant portions of the funds' holdings - in most cases upwards of 60 percent - were represented by fair valued securities backed by sub-prime mortgages.

"Investors rely on board members to establish an accurate process for valuing their mutual fund investments. Otherwise, they are left in the dark about the value of their investments and handicapped in their ability to make informed decisions," said Khuzami in the press release accompanying the order.

"Had the board not abdicated its responsibilities, investors may have stood a better chance of preserving their hard-earned assets." Khuzami called the directors' failure in light of the funds' significant holdings of fair valued securities "inexcusable."

In particular, the order said that the directors:

  • Failed to sufficiently specify a fair valuation methodology;
  • Provided only factors copied verbatim from Accounting Series Release 118 and failed to describe how to make fair value determinations;
  • Failed to specify valuation procedures for each type of security;
  • Failed to provide a process for evaluating the appropriateness of a methodology; and
  • "did not include any mechanism [in the Valuation Procedures] for identifying and reviewing fair-valued securities whose prices remained unchanged for weeks, months and even entire quarters."

When presented with security valuations, they were unaccompanied by any meaningful explanatory notes. Further, the order alleges the directors didníŽt understand how internal matrix pricing in the fair valuation process operated.

The order alleges the directors relied heavily on price confirmations, which "could not have sufficed" given that such confirmations typically came weeks after a month-end, and that no methods were specified to evaluate or challenge the price confirmations.

The former independent directors of the funds issued a statement denying that the board failed in its duties and vowing ultimate vindication.

"The SEC action can only be explained as a misguided attempt to retroactively regulate by enforcement in an area in which the SEC has been unwilling or unable to provide meaningful guidance through the normal regulatory process," said the statement.

Saying the SEC itself has described valuation as a "notoriously gray area," the directors' statement charged the staff with tabling the issuance of meaningful guidance for years.

"Nevertheless, the SEC now has decided to use enforcement proceedings to make new rules, and "send a message" to mutual fund boards, by holding these independent directors to standards not applicable at the time and, in any event, based on allegations not supported by the actual facts and circumstances," they said.

The directors filed an administrative proceeding against the SEC on the same day the SEC issued its order instituting proceedings.

The SEC's administrative law judge has 300 days within which to try the case and issue an initial decision.