The SEC issued an order (the “SEC Order”) commencing administrative proceedings against a registered investment adviser (the “Adviser”), a registered broker-dealer affiliate of the Adviser (the “Distributor”), the Adviser’s portfolio manager (the “Portfolio Manager”) for seven affiliated bond funds sponsored by the Adviser (the “Funds”), and the Distributor’s Controller and Head of Fund Accounting (the “Controller”). The SEC Order alleges that during the period between January 2007 and July 2007 (the “Relevant Period”) the daily net asset value (“NAV”) of each of the Funds, which consist of three open-end funds and four closed-end funds, was materially inflated as a result of fraudulent conduct relating to the pricing of securities backed by subprime mortgages (“Asset Backed Securities”) on the part of the Adviser, the Distributor, the Portfolio Manager and the Controller (collectively, the “SEC Respondents”). This article summarizes the SEC’s allegations as included in the SEC Order. The SEC Respondents have not yet filed an answer to the SEC Order nor has there yet been any finding with respect to the SEC’s allegations.
Background. During the Relevant Period, the Adviser served as the investment adviser to each of the Funds; the Distributor served as the principal underwriter and exclusive distributor for the Funds’ shares and provided certain accounting services, including valuation services, to the Funds; the Portfolio Manager served as the portfolio manager of the Funds; and the Controller, in his capacity as Head of the Distributor’s Fund Accounting Department (“Fund Accounting”), was responsible for oversight of the pricing of the Funds’ securities and calculating of the Funds’ daily NAV. Each of the Funds pursued its investment objectives in part by investing, in varying amounts, in Asset Backed Securities, which lacked readily available market quotations and in accordance with Section 2(a)(41)(B) of the Investment Company Act were required to be priced in accordance with their fair value. The Funds’ Boards of Directors (collectively, the “Board”) established pricing policies and procedures (the “Valuation Procedures”) which, among other things, delegated daily pricing of the Funds’ securities to the Distributor under the terms of an accounting services arrangement and required that fair valued securities would be valued in “good faith” by a Valuation Committee, which was comprised of the Controller and other the Distributor personnel. Further, the Valuation Procedures required that dealer quotes be obtained by the Distributor for certain securities that were to be fair valued, including the Asset Backed Securities.
Acting Contrary to Public Disclosures. During the Relevant Period, the Distributor did not price the Funds’ securities in accordance with the Valuation Procedures and the valuation process set forth in the Funds’ documents filed with the SEC (the “SEC Documents”), including each Fund’s prospectus, differed significantly from the process described in the Valuation Procedures. The SEC Documents stated that the fair value of securities would be determined by the Adviser’s valuation committee using procedures adopted by the Funds; however, this responsibility was delegated to the Distributor, which primarily staffed the Valuation Committee. The Distributor and the Valuation Committee failed to comply with the Valuation Procedures in several ways, including: (i) pricing decisions were made by lower level employees in the Distributor’s Fund Accounting Department (“Fund Accounting”) who did not have the training or qualifications to make fair value pricing determinations; (ii) Fund Accounting relied on “price adjustments” provided by the Portfolio Manager without obtaining any basis for or documentation supporting the price adjustments or applying the factors set forth in the Valuation Procedures; (iii) the Distributor gave the Portfolio Manager excessive discretion in validating the prices of portfolio securities by allowing him to determine which dealer quotes to use, without obtaining supporting documentation; and (iv) neither the Valuation Committee nor the Distributor ensured that the fair value prices assigned to many of the portfolio securities were periodically re-evaluated, allowing them to be carried at stale values for many months at a time. Further, the Adviser adopted its own procedures to determine the actual fair value of portfolio securities and to “validate” those values “periodically.” Among other things, those procedures provided that “[q]uarterly reports listing all securities held by the Funds that were fair valued during the quarter under review, along with explanatory notes for the fair values assigned to the securities, shall be presented to the Board for its review.” The Adviser failed to fully implement this provision of its policy. The Portfolio Manager was aware that the “price adjustments” he provided, which in many cases were arbitrary and did not reflect fair value, were used to compute the Funds’ NAVs.
Moreover, the Controller either knew or was highly reckless in not knowing, of the deficiencies in the implementation of the Valuation Procedures and did nothing to remedy them or otherwise to make sure fair-valued securities were accurately priced and the Funds’ NAVs were accurately calculated. Among other things, the Controller was aware of each of the deviations from the Valuation Procedures set forth above, and that the only pricing test regularly applied by the Valuation Committee was the “look back” test, which compared the sales price of any security sold by a Fund to the valuation of that security used in the NAV calculation for the five business days preceding the sale. The Controller nevertheless signed the Funds’ annual and semi-annual financial reports on Forms N-CSR, filed with the SEC, including certifications pursuant to Sections 302 and 906 of the Sarbanes-Oxley Act of 2002.
On this basis, the SEC Order alleges that the Distributor failed to employ reasonable procedures to price the Funds’ portfolio securities and, as a result of that failure, did not calculate accurate NAVs for the Funds. In addition, the Distributor recklessly published daily NAVs for the Funds which it could not know were accurate and sold shares to investors based on those NAVs.
Fraudulent Manipulation of the Funds’ Securities Prices. The Portfolio Manager fraudulently manipulated the dealer quotes received during the Relevant Period from at least one broker-dealer (the “Submitting Firm”) by pressuring the Submitting Firm to in certain cases to (1) refrain from providing dealer quotes that reflected actual bid prices, and (2) provide interim quotes that did not reflect fair value to enable the Portfolio Manager to avoid marking down securities to fair value in one adjustment. In each case the Portfolio Manager was aware that the securities in question would ultimately be required to be marked down over time. The Portfolio Manager did not disclose to Fund Accounting or the Funds’ Boards that he had received quotes from the Submitting Firm which were lower than the current valuations recorded by the Funds, and that the Submitting Firm had refrained from submitting quotes to Fund Accounting or had submitted quotes at higher prices than it had originally planned. The Portfolio Manager also did not disclose that he caused the Submitting Firm to alter or withhold quotes. Additionally, in certain instances the Portfolio Manager provided “price adjustments” for securities that were above the dealer quote received from the Submitting Firm in violation of the Valuation Procedures. The SEC Order also alleges that in at least one instance during the Relevant Period the Portfolio Manager withheld material information regarding a substantial decrease in value of an Asset Backed Security held in the Funds from Fund Accounting in breach of his fiduciary duty as portfolio manager of the Funds.
Misrepresentations to Investors and the Board. By including a signed letter to investors reporting on the Funds’ performance “based on net asset value” in each of the Funds’ annual and semi-annual reports filed with the SEC on Forms N-CSR during the Relevant Period, the Portfolio Manager made fraudulent misrepresentations to and omissions of material fact directly to the Funds’ investors concerning the Funds’ performance. By virtue of the Portfolio Manager’s manipulation of the NAV of the Funds’ and the valuation of certain securities the Portfolio Manager, and through him the Adviser, was aware that the performance of the Funds was materially misstated. Additionally, the Adviser, through the Portfolio Manager, also defrauded the Funds by providing a quarterly valuation packet reflecting inflated prices for certain securities to the Board, failing to disclose to the Board information indicating that the Funds’ NAVs were inflated, and that the Portfolio Manager was actively screening and manipulating dealer quotes and providing Fund Accounting with unsubstantiated price adjustments. In addition, the SEC Documents described the Adviser as responsible for fair valuation of the Funds’ portfolios; however, as noted above the Distributor was actually performing the valuation services for the Funds.
Violations. As a result of the conduct described above, the SEC Order alleges violations of the following provisions of the federal securities laws by various of the SEC Respondents:
Section 17(a) of the Securities Act; Section 10(b) of the Exchange Act and Rule 10b-5, thereunder (which prohibit fraudulent conduct in the offer and sale of securities and in connection with the purchase or sale of securities);
Section 206(4) of the Advisers Act and Rule 206(4)-7 thereunder (which prohibit fraudulent, deceptive or manipulative practices or courses of business by an investment adviser, and requires investment advisers to adopt and implement written policies and procedures reasonably designed to prevent violation of the Advisers Act and the rules thereunder by their supervised persons, respectively)
Sections 206(1) and 206(2) of the Advisers Act (which prohibit fraudulent conduct by an investment adviser);
Section 34(b) of the Investment Company Act (which prohibits untrue statements of material fact or omissions to state facts necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, in any registration statement, report or other document filed pursuant to the Investment Company Act or the keeping of which is required pursuant to Section 31(a) of the Investment Company Act)
Rule 22c-1 promulgated under the Investment Company Act, (which makes it unlawful for an open-end fund to sell, redeem, or repurchase such securities except at prices based on current net asset value); and
Rule 38a-1 promulgated under the Investment Company Act, (which requires that a registered investment company adopt and implement written policies and procedures reasonably designed to prevent violation of the federal securities laws, including policies and procedures that provide for oversight of compliance by the investment company’s investment adviser).
Possible Sanctions. Among the possible sanctions contemplated by the SEC Order are civil penalties, disgorgement and censure.
Related Proceedings - FINRA
In a proceeding based on related factual allegations, the Financial Industry Regulatory Authority (“FINRA”) issued a complaint against the Distributor (the “FINRA Complaint”) alleging that during the Relevant Period, the Distributor sold the Funds using false and misleading materials in violation of NASD Rules 2110, 2210 and 3010. The Distributor is a broker-dealer registered with the SEC and a member of FINRA. During the Relevant Period the Distributor served as the principal underwriter of the Funds, exclusive distributor for the Funds’ shares and provided certain accounting services, including valuation services, to the Funds.
The FINRA Complaint alleges that during the Relevant Period, (1) the Funds were heavily invested in risky structured products, including Asset Backed Securities, and that these investments caused the Funds to experience serious financial difficulties beginning in early 2007, (2) misleading sales materials, combined with the Distributor’s misleading and deficient internal guidance and failure to train its brokers about the risks associated with the Funds, led the Distributor’s brokers to make material misrepresentations to investors regarding the Funds, and particularly with respect to one of the Funds (the “Intermediate Fund”), which was marketed as a relatively safe and conservative fixed income mutual fund investment when, in fact, it was exposed to undisclosed risks associated with its investment in Asset-Backed Securities and subordinated tranches of other structured products, (3) despite the negative impact on the Funds in early 2007 resulting from the turmoil in the mortgage-backed securities market the Distributor failed to disclose in any of its 2007 sales material that a substantial portion of the Funds' portfolios were acutely affected by then-current economic conditions, and (4) the Distributor failed to establish, maintain and enforce an adequate supervisory system, including written supervisory procedures, reasonably designed to achieve compliance with federal securities laws and FINRA rules.
Specifically, the FINRA noted that (1) in its research, investment advice and performance updates related to the Intermediate Fund, the Distributor failed to disclose the material characteristics and risks of investing in the Intermediate Fund, misstated the appropriate use of the Intermediate Fund and otherwise portrayed the Intermediate Fund as a safer investment than it was, even though the Distributor was aware of material, special risks that made the Intermediate Fund unsuitable for many retail investors; (2) the Distributor failed to ensure the accuracy of the advertising materials prepared by the Adviser and distributed by the Distributor, and failed to ensure that those materials disclosed all material risks, were not misleading and did not contain exaggerated claims; (3) the Distributor failed to train its brokers regarding the features, risks and suitability of the Funds; and (4) when the Distributor became aware of the adverse market effects on the Funds, the Distributor failed to timely warn its brokers or revise its advertising materials to reflect the disproportionately adverse effect the market was having on the performance of the securities that comprised the Funds.
As a result of the foregoing conduct, the FINRA Complaint requests that one or more of the sanctions provided under FINRA Rule 8310(a), including monetary sanctions, be imposed, including that the Distributor be required to disgorge fully any and all ill-gotten gains and/or make full and complete restitution, together with interest and/or offer rescission to Fund purchasers, and that the Distributor bear such costs of proceeding as are deemed fair and appropriate under the circumstances in accordance with FINRA Rule 8330.
Related Proceedings - States
In a related proceeding based on factual allegations similar to those contained in the FINRA Complaint, the state securities regulators of the states of Alabama, Kentucky, Mississippi and South Carolina (collectively, the “States”) have issued a Joint Notice of Intent to Revoke Registration and Impose Administrative Penalty (the “Joint Notice”) against the Adviser and the Distributor for violating the corresponding provisions of the securities act of each of the States (the “State Securities Acts”). In addition to being registered with the SEC as a broker-dealer and being a member of FINRA, the Distributor is registered as a broker-dealer with each of the States. The Adviser is registered as an investment adviser with the SEC and makes notice filings, but is not registered, with the States.
Specifically, the Joint Notice alleges that during the Relevant Period each of the Adviser and the Distributor violated the relevant provisions of the State Securities Acts by: (1) making material omissions and misrepresentations in marketing materials related to the Funds, (2) making material omissions and misrepresentations in the SEC Documents, (3) withholding information from and misrepresenting information concerning the Funds to the brokers selling the Funds, (4) providing preferential treatment to certain customers, (5) failing to make suitable recommendations concerning purchase and concentration of the Funds in customer accounts, (6) failing to adequately supervise their employees, and (7) failing to adequately respond to due diligence requests from the division of the Distributor responsible for oversight and implementation of asset allocation products that in part used the Funds as underlying investment options.
In connection with the Joint Notice each of the States is seeking restitution of investor losses in the amount of $2 billion, imposition of administrative penalties, reimbursement of investigative costs, revocation of the registration of the Distributor, and to bar each of the Adviser and the Distributor from further participation in the securities industry in the respective States. Additionally, each of the States is seeking to revoke the registration of, and to bar from further participation in the securities industry of, certain individuals, including the Portfolio Manager, the President and Chief Executive Officer of the Adviser, and the Chief Compliance Officer of the Funds and the Adviser.