KRAMER LEVIN NAFTALIS & FRANKEL LLP
SEC Sues Fund Directors, Alleging Improper Valuation Oversight
The SEC sued the directors of seven registered investment companies advised by Morgan
Keegan Asset Management, claiming that the directors caused the funds to violate several
provisions of the Investment Company Act of 1940 by failing to properly oversee valuation of
securities held by the funds. The case is the second half of the saga revealed in June 2011, which
revealed that a portfolio manager had been manipulating the fair values assigned to illiquid MBS
positions, preventing the full impact of the devaluations on the Funds’ net asset values. Morgan
Keegan settled the proceeding, and was barred from serving as an investment adviser to a
registered fund for three years. The Directors announced that they intend to vigorously contest
the proceeding.
Claims against Directors
According to the SEC, the directors:
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Delegated the fair valuation process without providing meaningful guidance; and
Did not make an effort to learn how fair values were actually determined.
From these two alleged failures, the SEC claims that the Directors caused the Funds to violate:
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Rule 22c-1, which requires a fund to sell and redeem shares at prices based on the
current net asset value of the fund;
Rule 30a-3(a), which requires a fund to “maintain internal control over financial
reporting”, which means a fund must have a process that provides reasonable
assurance that the financial reporting is reliable and the financial statements are
prepared in accordance with generally accepted accounting principles (GAAP); and
Rule 38a-1, which requires a fund to adopt and implement written policies and
procedures reasonably designed to prevent violations of federal securities laws by the
fund.
The Valuation process
The Directors oversaw four closed-end funds and three open end funds, which held between 50%
and 60% of their assets in subordinated tranches of mortgage-backed securities, which were
illiquid, thinly traded and commonly fair valued. The Funds adopted Valuation Procedures,
which delegated to a Valuation Committee the task of determining the fair value of securities for
which values were not readily ascertainable or reliable. The Valuation Committee was
composed of fund officers and fund accounting personnel, but no Directors served on the
Valuation Committee.
According to the SEC, the Valuation Procedures listed factors identified by a 1970 SEC
Accounting Series Release, ASR 118, but did not provide “meaningful guidance” on the
methodology to be used to value each type of security held by the Funds, or specific directions
on how to value securities that did not fit within the scope of the Valuation Procedures, such as
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newly developed securities.1 The SEC alleges that the Valuation Procedures were inadequate
because they did not:
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Specify the methodology for valuing particular types of securities;
Provide guidance of the relative weight of the fair valuation factors and their
interpretation;
Specify methodologies or processes to determine methodologies for valuations of
securities not otherwise covered;
Include how the Valuation Committee should identify or review fair values assigned
to securities for which priced remained unchanged; and
Provide sufficient reporting to the Board of Directors, which received information on
securities fair valued but did not receive other relevant information about the process
of fair valuation.
Although the Valuation Procedures required a written report of how fair value was determined
for each security and showing the accuracy of the fair values as compared to the next reliable
price, the SEC believed this report was not sufficient and only covered a portion of the fair
valuations during the period.
How valuation worked at Morgan Keegan
According to the SEC, the Fund Accounting department established the initial fair value for each
securities as its purchase price. No change in fair value was considered until there was a 5%
variance from this value based on other inputs, which were normally price confirmations from
broker-dealers. The price confirmations were not broker quotations, but rather, non-binding
opinions on the value of a particular security. The price confirmations received by the Funds
were not offers to purchase the security at the particular price.
In 2011, when the SEC sued the investment adviser,2 it alleged that Fund Accounting
periodically permitted the Funds’ portfolio manager to make changes in the values of securities
held in the Funds’ portfolios. According to the SEC’s administrative proceeding in that case, the
portfolio manager
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actively screened and influenced at least one broker-dealer to either change price
confirmations provided to the fund accounting group and the funds’ independent
auditor, or decline to provide confirmations if the confirmations would be lower than
the value at which the security was currently carried on the funds’ books ;
failed to notify the fund accounting department or the funds’ boards of information
suggesting particular security valuations should be reduced;
provided arbitrary “price adjustments” to the fund accounting department without
providing a reasonable basis, as required by the procedures;
1
The first mortgage-backed security, issued by Fannie Mae and guaranteed by Ginnie Mae, debuted May 1, 1970, 6
months before the SEC’s ASR 118. ASR 118 does not address pass-through securities directly, but discusses the
factors involved in valuing securities.
2
In the matter of Morgan Asset Mgmt. Inc. et al, SEC Admin. File No. 3-13847 (June 22, 2011). Morgan did not
admit or deny the SEC’s allegations and paid fines of $200 million. The portfolio manager was barred indefinitely.
Morgan Asset Management and its broker-dealer affiliate, Morgan Keegan, agreed to “abstain from involvement” in
valuing fair valued securities of registered funds for three years, effectively ending its role as investment adviser and
distributor of registered funds.
2
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when broker confirmations varied from the funds’ valuation of a security by 5% or
more, determined whether security valuations should be adjusted or whether broker
price confirmations should be ignored; and
softened fund NAV declines by using pre-planned valuation adjustments over a
period of days, which lowered a security’s value over time (but still overvalued the
security compared to price confirmations received from broker-dealers until all daily
declines were implemented).
The SEC also alleged that the fund’s accounting agent failed to perform its role under the
valuation procedures, because the fund accounting agent:
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relied with no reasonable basis on the portfolio manager’s price adjustments;
permitted lower level and untrained employees to make pricing decisions; and
did not re-evaluate fair value prices assigned to securities, allowing them to be carried
at stale values for months.
According to the SEC in the complaint against the Directors, Fund Accounting randomly
checked the valuations of approximately 10% of each Fund’s portfolio by obtaining price
confirmations from broker-dealers of end of month pricing. These confirmations were obtained
mid-month for the prior month’s last business day. Actual broker-quotes were not obtained to
verify valuation.
The Valuation Procedures contained provisions addressing price overrides, which were supposed
to be reviewed and reported. Fund Accounting interpreted these price override provisions as
applying only to broker-quotes and not to price confirmations. Therefore, overrides of price
confirmations were not reviewed or reported. Effectively, Fund Accounting periodically
permitted the portfolio manager to determine which price confirmations should be ignored and
allowed him to set prices for some securities without providing evidence of market inputs and
without reporting that the portfolio manager was affecting fair values of the Funds’ securities.
According to the SEC, neither the Valuation Committee nor the Board of Directors received
adequate information about fair valuation. The Valuation Committee received three primary
documents:
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A security sales report, showing sales of securities that had been fair valued
An explanation of fair values for securities that exceeded the 5% variance threshold;
and
Copies of price confirmations.
The Valuation Committee compared the security sales report to the previously assigned fair
values. The SEC said they also should have been provided a report on fair values for securities
that were not sold or for which confirmations had not been obtained.
According to the SEC, the Board did not know or inquire about the methodologies used by the
Valuation Committee to fair value particular securities, and did not receive information
concerning the basis for fair valuations. The SEC alleges that even after the proceeding against
the adviser was commenced, the Board still did not inquire about how fair values were assigned
and confirmed.
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What the Directors saw
At Board meetings, Directors received
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A Valuation Committee Report
Fair Value forms for each security fair valued during the quarter, and
The Security Sales report (showing sales of securities that had been fair valuaed).
The SEC alleges that these documents did not provide sufficient information to the Directors
about the valuation process to permit them to oversee Fund valuations. According to the SEC,
the Valuation Committee Report was deficient because it did not provide details about how fair
value was determined for a particular security and it did not address fair values for positions that
were not sold during the period, or price confirmations. According to the SEC, the Directors did
not provide guidelines for the use of price confirmations, and did not require any review of
securities for which price confirmations were not obtained for any period of time.
The SEC alleges that the Fair Value form was deficient because it recited boilerplate
explanations for fair valuations: “internal matrix based on actual dealer prices and/or Treasury
spread relationships provided by dealers”. The form did not explain the “internal matrix” or
indicate what “actual dealer prices” or “Treasury spread relationships” meant, and the SEC
alleges that the Directors did not understand how the matrix operated. Although the Valuation
Procedures required meaningful “explanatory notes” to be provided to the Directors at least
quarterly, the SEC alleges that no such notes were provided an d that the Directors never
followed up to request such notes. The SEC also alleges that the internal pricing matrix was only
used to price approximately 12% of the holdings of the closed end funds during the period.
The SEC alleges that the Security Sales report had little utility to reviewing valuations because it
was only provided for securities that had been sold, which amounted to less than 25% of fair
valued assets during the time period.
In the Matter of J. Kenneth Alderman, et al., SEC Admin. Proc.
File No. 3-15127, Investment Company Act Rel. No. 30300 (Dec.
10, 2012).
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any questions, please call an attorney in our Financial Services Group.
Carl Frischling
212.715.7520
cfrischling@kramerlevin.com
Susan J. Penry-Williams
212.715.7510
spenrywilliams@kramerlevin.com
Ronald M. Feiman
212.715.9550
rfeiman@kramerlevin.com
George M. Silfen
212.715.7522
gsilfen@kramerlevin.com
S. Elliott Cohan
212.715.9512
ecohan@kramerlevin.com
Aviva Grossman
212.715.7514
agrossman@kramerlevin.com
Alexandra K. Alberstadt
212.715.9151
aalberstadt@kramerlevin.com
Jacqueline Edwards
212.715.9510
jedwards@kramerlevin.com
Mark F. Parise
212.715.9276
mparise@kramerlevin.com
Dana DeVivo
212.715.9348
ddevivo@kramerlevin.com
Rachael N. De Chacón
212.715.9212
rdechacon@kramerlevin.com
Patrick D. Sheridan
212.715.9355
psheridan@kramerlevin.com
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