Financial Services Alert - June 18, 2013

On June 13, 2013, eight former directors (the “Directors”) of seven registered funds (three open-end and four closed-end) (collectively, the “Funds”) settled claims by the SEC that they failed to fulfill their responsibility to properly oversee the fair valuation process for the Funds during the period from January 2007 to August 2007 (the “Relevant Period”).   In large part, the settlement’s findings track the allegations in the SEC’s December 2012 order commencing proceedings against the Directors, except that the SEC ultimately determined that the Directors had caused only one of the four violations of law originally alleged, that being the violation relating to the adequacy of the Funds’ compliance program.  Without admitting or denying its findings, the Directors agreed to the settlement order (the “Order”), which this article summarizes.

Background

In December 2012, the SEC filed an order (the “December Order”) commencing administrative proceedings against the Directors, alleging that they had caused the Funds to violate provisions of the Investment Company Act of 1940 (the “1940 Act”) relating to (a) transactions in open-end fund shares at a price based on current net asset value (“NAV”), (b) the maintenance of internal control over financial reporting, (c) the implementation of compliance procedures relating to fair valuation and (d) the making of false statements/material omissions in registration statements.  The allegations in the December Order were discussed in the December 18, 2012 Financial Services Alert.

Previously, in June 2011, the SEC, along with FINRA and various state securities regulators, settled administrative proceedings against (1) the Funds’ investment adviser (the “Adviser”), (2) the Adviser’s affiliate (the “Broker Affiliate”) that provided Fund accounting services to the Funds through its Fund Accounting Group (“Fund Accounting”), (3) the Funds’ portfolio manager (the “Portfolio Manager”), and (4) the head of Fund Accounting (together, the “2011 Respondents”), arising out of the same general matters that the Order addresses. (The SEC’s June 2011 order (the “2011 Order”) and the related FINRA and state settlements were discussed in the July 5, 2011 Financial Services Alert.)  In broad terms, the 2011 Order is based on SEC findings that between January 2007 and July 2007 the daily NAV of each of the Funds was materially inflated as a result of fraudulent conduct on the part of the 2011 Respondents, particularly the Portfolio Manager, relating to the pricing of securities backed by subprime mortgages held by the Funds.

The Directors

Each Fund’s board consisted of six Directors who were not interested persons of the Funds within the meaning of the 1940 Act (the “Independent Directors”) and two interested Directors.  In describing the Directors, the Order identifies four of the Directors (including three of the Independent Directors) as Certified Public Accountants, and notes that four of the Independent Directors, who collectively made up each Fund’s audit committee, were designated as Audit Committee Financial Experts.  The Order also identifies one of the interested Directors as a Chartered Financial Analyst.

High Proportion of Fair Valued Securities

The Order states that during the Relevant Period, a significant portion of the Funds’ portfolios consisted of subordinated tranches of various securitizations, for which market quotations were not readily available, and which accordingly were required to be fair valued in accordance with the requirements of Section 2(a)(41)(B) of the 1940 Act.

Fair Value Process

The Directors delegated to the Adviser responsibility for fair value determinations, which were to be made in accordance with valuation procedures adopted by the Directors.  The Adviser’s Valuation Committee (the “Valuation Committee”), which consisted of Fund officers and Fund Accounting employees, was responsible for overseeing a process that in practice was performed to a large extent by Fund Accounting.  The procedures did not require the Directors to ratify any fair value determinations, and they did not do so.

Fund Accounting and the Portfolio Manager.  Fund Accounting typically used a security’s purchase price as its initial fair value and did not change that fair value unless a subsequent sale or price confirmation varied more than 5% from the previously assigned fair value.  In addition, the Portfolio Manager occasionally contacted Fund Accounting to specify prices for particular securities, which the SEC found that Fund Accounting routinely accepted without explanation.  The SEC also found that Fund Accounting used “preplanned daily reductions in value provided by the Portfolio Manager to gradually reduce, over days or weeks, a bond to its current proper valuation.”  The Order notes that neither the Directors, the Adviser, nor the Broker Affiliate provided guidelines for Fund Accounting or the Valuation Committee to use in evaluating the reasonableness of the Portfolio Manager’s price adjustments.   And, although required to explain the basis for fair value determinations under the Funds’ valuation procedures, the Valuation Committee never identified to the Directors the bonds for which values were based on the Portfolio Manager’s price adjustments.

Price Confirmations.  The Order recounts that Fund Accounting randomly selected and sought price confirmations for a small portion of the Funds’ fair valued securities and describes such confirmations as “essentially opinions on price from broker-dealers, rather than bids or firm quotes.”  In the ordinary course, confirmations were generally sought for month-end prices, but were obtained several weeks after the respective month-end.  According to the Order, if a price confirmation showed a  more than 5% variance from a Fund’s current price for that security, Fund Accounting “effectively allowed” the Portfolio Manager to determine the security’s fair value.

Reporting to the Directors.  The SEC found that the Directors received inadequate reports on fair value determinations at their quarterly meetings, consisting in part of the following:

• a brief report from the Valuation Committee that typically stated how often the Committee had met and attested to the confirmation of fair values with third parties and the appropriateness of the valuations assigned;
• a “Fair Valuation Form” that listed the source or method of price determination as being an “[i]nternal matrix based on actual dealer prices and/or Treasury spread relationships provided by dealers” without further definition.  There was no explanation of the “internal matrix” and no indication of what was meant by the terms “actual dealer prices” or “Treasury spread relationships provided by dealers”; and
• a security sales report that listed “information about the securities sold in each Fund in the preceding quarter, including: (1) par value sold; (2) sales price; (3) the previous day’s assigned price; (4) whether it was priced externally or internally, i.e., fair valued; (5) the resulting variance; and (6) the impact on the Fund.”  The SEC observed that this report was subject to a significant limitation in that the Funds sold only 24 of the approximately 290 securities that were fair valued during the period between November 2006 and the end of July 2007.

Shortcomings in the Fair Value Process

The Order reiterates the SEC’s view expressed in Accounting Series Release No. 118 that, although directors may assign others the task of calculating fair value, a fund’s board remains responsible for establishing fair value methodologies used, and for continuously reviewing the appropriateness of those methodologies and the valuations they produce.

The SEC found that the Directors had failed to “specify a fair valuation methodology pursuant to which the securities were to be fair valued” noting that the Funds’ valuation procedures listed various general and specific factors, which the Valuation Committee was to consider in making fair value determinations, but that

[o]ther than listing these factors, which were copied nearly verbatim from [Accounting Series Release No.] 118, the Valuation Procedures provided no meaningful methodology or other specific direction on how to make fair value determinations for specific portfolio assets or classes of assets.  For example, there was no guidance in the Valuation Procedures on how the listed factors should be interpreted, on whether some of the factors should be weighed more heavily or less heavily than others, or on what specific information qualified as “fundamental analytical data relating to the investments”. Additionally, the Valuation Procedures did not specify what valuation methodology should be employed for each type of security or, in the absence of a specified methodology, how to evaluate whether a particular methodology was appropriate or inappropriate. Also, the Valuation 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 Order concludes that the Directors “neither established clear and specific valuation methodologies nor followed up their general guidance to review and approve the actual methodologies used and the resulting valuations.  Instead, they approved policies generally describing the factors to be considered but failed to determine what was actually being done to implement those policies.  As a result, Fund Accounting implemented deficient procedures, effectively allowing the Portfolio Manager to determine valuations without a reasonable basis.  In this regard, the Directors failed to exercise their responsibilities with regard to the adoption and implementation by the Funds of procedures reasonably designed to prevent violations of the federal securities laws.”

Auditors’ Assurances on Valuation.  The Order notes that, during the Relevant Period, the  Funds’ auditors sought price confirmations for all fair valued securities in connection with annual audits, provided unqualified opinions, and advised the Directors that their valuation procedures were appropriate and reasonable.  The SEC also observed, however, that the auditors were not retained to opine on the funds’ internal controls and had advised the Directors that the auditors’ “consideration will not be sufficient to enable us to provide assurances on the effectiveness of internal control over financial reporting.”  On this basis, the SEC concluded that the audits did not provide the Directors with sufficient information about the valuation methodologies actually employed to satisfy the Directors’ valuation obligations.  Specifically, the SEC noted that the auditors did not advise the Directors in any meaningful detail as to what pricing methodologies were actually being employed.

Violation and Sanction

Of the four violations of law the SEC originally alleged in December 2012, the Order contains a finding with respect to only one – the SEC found that the Directors caused the Funds to violate Rule 38a-1 under the 1940 Act, which requires the Funds to maintain compliance programs reasonably designed to prevent violations of the federal securities laws (including “policies and procedures that provide for the oversight of compliance by the fund’s investment adviser”).  Each Director was ordered to cease and desist from causing any future violations of Rule 38a-1.  No monetary sanctions were assessed (in contrast to the 2011 Order which included $100 million in disgorgement by the Adviser, a $250,000 fine for the Portfolio Manager, and a $50,000 fine for the head of Fund Accounting).

The SEC did not find, as it had originally alleged, that the Directors caused the Funds to violate (1) Rule 22c-1 under the 1940 Act, which requires the price at which the open-end funds sell or redeem their shares to be based on current NAV and (2) Rule 30a-3(a) under the 1940 Act, which requires registered funds to maintain internal controls over financial reporting.  The SEC also originally alleged, but did not ultimately determine, that the Directors willfully caused a false or misleading statement with respect to a material fact to be made in a registration statement filed with the SEC under the 1940 Act.

In the Matter of J. Kenneth Alderman, CPA, et al., SEC Release No. IC-30557 (June 13, 2013)

The Massachusetts Division of Banks (“DOB”) approved a net present value (“NPV”) model designed by the Massachusetts Bankers Association to assist community banks in complying with Massachusetts’ new foreclosure law.  In August 2012, the Massachusetts legislature passed, and Governor Deval Patrick signed into law, An Act Preventing Unlawful and Unnecessary Foreclosures (the “Act”).  The Act requires creditors to take, among other things, reasonable steps and make a good faith effort to avoid foreclosure of certain mortgage loans by considering foreclosures alternatives, including modifying the loan.  A creditor is presumed to have acted reasonably and in good faith if it identifies a modified mortgage loan that achieves the borrower’s affordable monthly payment and conducts a compliant NPV analysis comparing the net present value of the modified mortgage loan and the creditor’s anticipated net recovery that would result from foreclosure.  The Act requires the creditor to agree to modify the loan where the NPV of the modified mortgage loan exceeds the anticipated net recovery at foreclosure.  Both the Act and its implementing regulations provide that the NPV analysis must be based on models used by the federal Home Affordable Modification Program, FDIC Loan Modification Program, Massachusetts Housing Finance Agency loan program, or any model approved by the DOB.  As noted above, the NPV model developed by the Massachusetts Bankers Association is designed primarily for use by community banks.

The OCC issued a bulletin, OCC 2013-15 (the “Bulletin”), describing the OCC’s revised policy (the “Policy”) by which national banks, federal savings associations and federal branches and agencies (collectively, “Banks”) may appeal OCC decisions and actions.  The Bulletin replaces and supersedes the OCC’s prior guidance on the subject entitled “Bank Appeals Process:  Guidance for Bankers” dated November 1, 2011.  The OCC said that the appeals process described in the Bulletin ensures that a Bank will not be disadvantaged by filing an appeal.  The OCC also stresses in the Bulletin that Banks are encouraged to discuss with the OCC’s Ombudsman any OCC policy, decision or action that could develop into an appealable matter.

Under the Policy, a Bank may appeal to either the Deputy Controller in the applicable OCC District or the Ombudsman a broad spectrum of matters, including, but not limited to:

• Examination ratings;
• Adequacy of the Bank’s allowance for loan and lease loss methodology;
• Individual loan ratings;
• Cited apparent violations of law;
• Shared National Credit commercial loan decisions;
• Fair-lending-related decisions;
• Licensing decisions; and
• Material supervisory decisions, e.g., conclusions in a Report of Examination.

Matters that a Bank may not appeal to the OCC under the Policy include:

• Appointments of receivers and conservators;
• Preliminary examination conclusions prior to receipt by the Bank of a Report of Examination;
• Any formal enforcement action;
• Formal and informal rulemakings under the Administrative Procedure Act;
• Decisions following formal and informal adjudications under the Administrative Procedure Act;
• Requests for OCC records under the Freedom of Information Act;
• OCC decisions that disapprove proposed Bank directors and senior executive officers; and
• Any other OCC decisions that are subject to judicial review (other than those listed above as appealable to the OCC).

The Bulletin provides additional detail concerning the process of filing appeals to the applicable OCC Deputy Controller or the Ombudsman.  The Bulletin also states that after an OCC official renders a decision on a formal appeal, the Ombudsman will contact the applicable Bank to ask the Bank whether it believes the OCC took the action against the Bank in retaliation for the Bank’s appeal.  If the Bank claims that the OCC’s action is retaliatory, the Ombudsman will investigate the claim.

The OCC emphasizes in the Bulletin that the Ombudsman operates independently from the bank supervision process and reports directly to the Comptroller.  The Bulletin also notes that the Ombudsman, with the prior consent of the Comptroller, may stay any applicable OCC decision or action during the resolution of an applicable matter and may make recommendations to the Comptroller for changes in OCC policy.

The OCC issued a booklet, “A Common Sense Approach to Community Banking” (the “Booklet”) designed to provide guidance to Boards of Directors and management of community banks concerning banking best practices and how management officials can guide a community bank “through economic cycles and environmental changes.”  The Booklet discusses how a community bank can appropriately identify, monitor and manage various types of risks.  The OCC describes its Risk Assessment System and how it can best be used by community banks.  The Booklet also emphasizes the need for a community bank to have a sound business plan with sufficient capital support that is based on an effective strategic planning process.  Finally, the Booklet provides community bankers with an overview of the OCC’s supervisory process and the key role of the OCC’s portfolio manager for the applicable community bank.

The CFTC issued an amended order adding to the list of approved providers of Legal Entity Identifiers (“LEIs”), which identify swap participants for purposes of CFTC reporting regulations.  Previously, the CFTC had only allowed LEIs (currently in the form of CFTC Interim Compliant Identifiers, or “CICIs”) issued by DTCC-SWIFT.  The amended order provides that the CFTC will also recognize LEIs issued by WM Datenservice, a European provider, after the European Securities Markets Authority (“ESMA”) informs the CFTC that it has begun to accept DTCC-SWIFT’s CICIs for purposes of European reporting regulations.  WM Datenservice’s codes are currently called “General Entity Identifiers” (“GEIs”) but, like CICIs, are expected to eventually transition to the LEI regime.  The amended order also provides for future acceptance of LEIs from additional providers, once certain conditions are met.

The CFTC’s Division of Clearing and Risk issued a time-limited no-action relief letter applicable to small banks (those with total assets of $10 billion or less and organized as a bank, savings association, farm credit system institution, or insured Federal or State-chartered credit union).  The relief provides that small banks that are issuers of securities may avail themselves of the end-user exception to the swap clearing requirement without obtaining prior board of directors approval for entering into uncleared swaps, provided that the small bank meets the other requirements of the end-user exception.  The relief is also conditional on the small bank obtaining retroactive board approval as soon as practicable, but no later than July 10, 2013.

The FDIC and the Canada Deposit Insurance Corporation (the “CDIC”) have entered into a Memorandum of Understanding (the “MOU”) intended to facilitate the exchange of information and cooperation between the two agencies with respect to monitoring of firms with cross-border operations in the United States and Canada for crisis management, recovery and resolution planning and implementation purposes.  The MOU relates to sharing of information concerning entities designated as globally systemically important by the Financial Stability Board, entities that are subject to the jurisdiction of either the FDIC or the CDIC as an authorized credit institution that is a depository institution, and member institutions under the Canada Deposit Insurance Act (including their affiliates) engaged in financial services activities in the United States and Canada.  The MOU states that its information sharing provisions relate to the CDIC’s and FDIC’s respective roles as resolution authorities and not to ongoing prudential supervision.  Although the MOU states that it does not create any legally binding obligations or supersede any laws applicable to the FDIC or CDIC, it creates a framework that the FDIC could potentially use in the event that it becomes the receiver or conservator under the Federal Deposit Insurance Act or the orderly liquidation authority provided by the Dodd-Frank Act with respect to an insured depository institution or a covered financial company with both U.S. and Canadian operations.