The U.S. Securities and Exchange Commission (SEC) recently issued an order (the Order) instituting public administrative and cease-and-desist proceedings against eight former interested and independent directors (Morgan Keegan Directors) of five registered funds advised by Morgan Asset Management, Inc. (the Adviser).
The Order, issued December 10, 2012, alleges the directors failed to properly carry out their duties during several months in 2007 with respect to overseeing the fair valuation of certain securities held by the funds. According to the Order, the Morgan Keegan Directors delegated their asset-pricing responsibilities to the Adviser’s valuation committee without asking meaningful questions, specifying a fair valuation methodology or continuously reviewing the appropriateness of that methodology, among other problems. As a result, the SEC claims, one of the open-end funds fraudulently overstated its net asset value during the same time period.
The majority of each fund’s assets were below investment grade complex securities, including structured investment vehicles, collateralized debt obligations, collateralized mortgage obligations and collateralized loan obligations, home-equity loan-backed securities and mortgage-backed securities. According to the Order, fair valued securities made up more than 60 percent of the net asset value for most of the funds.
The SEC claims violations of rules 22c-1, 30a-3(a) and 38a-1 under the Investment Company Act of 1940, amended. A copy of the Order can be found at: http://www.sec.gov/litigation/admin/2012/ic-30300.pdf.
Although the Order represents only the beginning of a formal fact-finding and litigation process, it raises practical questions regarding how boards of directors fulfill their responsibilities with respect to valuation.
SEC’s Issues with Respect to Valuation Procedures
In the Order, the SEC points out numerous deficiencies in the funds’ valuation procedures. These procedures required the funds to apply fair value as determined in good faith by the Adviser’s valuation committee. The procedures listed general and specific factors to be considered. However, the SEC noted that the procedures “were copied nearly verbatim” from the SEC’s Account Release Series 118 and “provided no meaningful methodology or other specific direction on how to make fair value determinations for specific portfolio assets or classes of assets” (e.g., weight of factors, how they should be interpreted for specific securities, what information qualified as “fundamental analytical data relating to the investments”). The SEC also asserted that the procedures “did not include any mechanism for identifying and reviewing fair valued securities whose prices remained unchanged for weeks, months and even entire quarters.”
The SEC’s Order also faults the Morgan Keegan Directors for failing to establish “any guidelines regarding the use of price confirmations, such as how frequently they should be requested for any particular type of security, or the selection of broker-dealers used to provide such price confirmations.” Additionally, the directors did not establish a process for reviewing security prices where price confirmations were not sought for lengthy periods of time.
According to the SEC, as a result of the Morgan Keegan Directors’ failure to adopt reasonable valuation procedures, one fund’s net asset values were materially misstated for a period of four-plus months in 2007. Consequently, the prices at which this fund sold, redeemed, and repurchased its shares were inaccurate. Furthermore, other reports and at least one registration statement filed by the funds with the SEC contained net asset values that were materially misstated. The Order noted that the Morgan Keegan Directors’ alleged failures were “particularly egregious” because fair valued securities comprised the majority of the funds’ portfolios.
SEC’s Issues with Controls and Supervision
The SEC also argues that Morgan Keegan’s fund accounting unit (Fund Accounting), which assigned values to the securities, “did not use any reasonable analytical method to arrive at fair value. For example, neither Fund Accounting nor the valuation committee used a pricing model or made any real effort to analyze future cash flows that a particular bond in the portfolio would likely generate.” The SEC’s Order also alleges that Fund Accounting often allowed the portfolio manager to arbitrarily set values. Additionally, Fund Accounting set the initial fair value at a security’s purchase price and did not change it unless there was a 5 percent variance.
The SEC also maintains that, as a primary fair valuation method, Fund Accounting relied upon randomly selected price confirmation for as few as 10 percent of the funds’ securities, which were broker-supplied opinions of prices, rather than bids or firm quotes. According to the Order, these price confirmations were also not timely obtained, often coming up to two weeks after the open-end funds had to price. The Order further states that the Morgan Keegan Directors “knew or should have known that Fund Accounting relied heavily on price confirmations when making fair value decisions, but that there was nothing requiring Fund Accounting to identify or explain those instances where the price confirmations differed materially from the Funds’ price.”
The SEC’s Order also highlights that while the Adviser’s valuation committee was responsible for the fair value process, it met only monthly and received insufficient information regarding the basis for the fair values assigned to various securities. The Order also faults the Adviser’s valuation committee for failing to perform backtesting to validate the fair values of securities that had not been sold or confirmed from a broker-dealer.
SEC’s Allegations Regarding Insufficient Board Reports
The SEC’s Order states that the Morgan Keegan Directors received flimsy reports and failed to ask meaningful questions. The “Report from the Joint Valuation Committee,” for example, was a single page long and contained two paragraphs, the SEC says. While it noted how many times the valuation committee met, it didn’t say how securities were priced. In other reports, the Morgan Keegan Directors received a list of portfolio securities required to be fair valued that contained no way for the board to determine the securities’ type, the basis for a particular assigned fair value or whether the price had changed since previous quarters. And while the Morgan Keegan Directors did meet more frequently after the SEC contacted them with valuation-related concerns, they failed to ask specific questions regarding the methodology for valuing the funds’ assets and whether the values were backtested.
The funds’ valuation procedures also required that the Morgan Keegan Directors be given explanatory notes for the fair values assigned to securities on a quarterly basis. However, the SEC’s Order states that no such notes were ever provided to the Morgan Keegan Directors, and they never followed up to request the notes or any other specific information about the basis for the assigned fair values.
Independent Directors’ Response to SEC Order
On January 3, 2013, attorneys for the former independent directors filed a response to the Order, seeking dismissal of the SEC cease-and-desist proceeding. A central argument in the response is that the SEC, while often speaking of the need for fair valuation guidance, has never outlined a preferred fair valuation method or issued overarching valuation guidance.
The response argues that the SEC “repeatedly found that respondents had ‘failed to adequately fulfill Morgan Keegan’s responsibilities…to price the Funds’ securities in accordance with their valuation policies and procedures regarding valuation,’ and that the individuals were ‘reckless in not knowing of the deficiencies in the implementation of the valuation procedures.’” But, according to the response, the SEC “did not allege or identify the absence of specific methodologies as a cause of any violation…The premise of these Commission findings was that if the Valuation Procedures had been followed, then no violation would have occurred.”
Need for Additional Valuation Guidance from SEC
Norm Champ, director of the SEC’s Division of Investment Management, stated in early December that the SEC believes “additional guidance in this area would be useful because much has changed since the commission last issued guidance regarding valuation.”
A few years ago, the Division of Investment Management organized all of its material on valuation in one place. The SEC, however, did not issue any further communication in the form of a new rule or guidance. A link to the Division of Investment Management’s publication can be found at: http://www.sec.gov/divisions/investment/icvaluation.htm.
In the absence of SEC guidance, others in the industry have stepped forward in an attempt to fill the void. For example, in June 2012, the Mutual Fund Directors Forum published practical valuation oversight guidance for directors. A link to the publication can be found at: http://www.mfdf.org/images/uploads/newsroom/Valuation-web.pdf.
In 2005 and 2006, the Investment Company Institute, the Independent Directors Council and ICI Mutual Insurance Company published a Fair Valuation Series to assist funds and their boards in addressing securities valuations. The 2005 publication, “An Introduction to Fair Valuation,” can be found at: http://www.idc.org/pdf/05_fair_valuation_intro.pdf. The 2006 publication, “The Role of the Board,” can be found at: http://www.idc.org/pdf/06_fair_valuation_board.pdf.
Impact of Case on Boards of Directors
The SEC rarely brings enforcement actions against fund directors, let alone independent directors. In those rare instances where it has brought enforcement actions, the SEC has focused on what they believed were egregious violations or failures to act. This case seems noteworthy, though, for the specificity of the allegations against the board of directors, and we believe it provides insight into how the SEC’s enforcement division will pursue cases against fund directors in the future. The last time the SEC made a claim against independent directors with respect to valuation was in 2003, when it brought civil fraud charges against Heartland Advisors and four of its independent directors, among others, for misrepresentation, mispricing and insider trading in two Heartland Group high-yield bond funds. The directors were sanctioned in that case.
The SEC may or may not prevail in its case against the Morgan Keegan Directors. Regardless of the outcome, however, fund directors may want to consider the following actions as applicable to their funds:
- Fund Procedures: Review fund fair value procedures with counsel and fund accounting and compliance personnel to ensure that they contain appropriately specific procedures for fair valuing specific types of securities that the funds expect to hold from time to time.
- Board Reports: Review board reports to ensure that they contain thorough explanations of the actual methodologies used to fair value securities as well as historical information on fair valued security prices from quarter to quarter. Reports should also contain information on backtesting of the effectiveness of methodologies used by fund personnel.
- Fair Value Pricing Sources: The use of broker price confirmations to fair value securities, rather than firm bids or quotes, was an important factor in the Morgan Keegan case. Consider, therefore, the extent to which broker price confirmations are used to fair value securities and whether such confirmations are appropriately used, whether there are alternative pricing sources available to validate such confirmations and whether directors have a thorough enough understanding of the various pricing sources available at any given time.
- Fair Value Pricing Models: Review with fund personnel the appropriateness of any pricing models used, including matrices, and ask questions to ensure that the directors have a thorough understanding of how these models and matrices operate as well as their limitations, if any, or alternative pricing methods that may be available.
- Portfolio Manager Conflicts of Interest: Discuss with fund personnel the extent of portfolio manager involvement in fair value pricing, as well as pricing generally. Understand the extent of the compliance staff’s oversight of conflicts of interest and the controls that exist to mitigate conflicts with regard to portfolio management’s involvement in the process.
- Stale Pricing: Review the stale pricing policy within the funds’ procedures and ask whether it is robust.
- Backtesting of Fair Valued Securities: Consider the robustness of the backtesting of the fair value process by fund personnel.
- Board Oversight Framework: Review with counsel the board framework for oversight of the fair value process. Questions that the board may want to consider are: What is the level of delegation of fair valuing, if any, to fund personnel? Is it too much? Do the directors understand the fair valuation process sufficiently to approve the methodologies used for each security?
- Additional Expertise: Requesting professional expertise from valuation consultants, if useful.
Lastly, the events that gave rise to the Morgan Keegan case against the fund directors occurred in 2007 during the onset of one of the most illiquid and volatile markets in recent memory. Directors may want to consider amplifying their oversight in volatile market conditions and requesting additional and/or more frequent reports from service providers with respect to fair valuations.