On June 22, 2011, the SEC issued an order (the “SEC Order”) settling 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 found that between January 2007 and July 2007 (the “Relevant Period”) the daily net asset value (“NAV”) of each of the Funds, which consisted 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”). The more detailed description of these and related events in the early part of this article is a summary of the SEC’s principal findings, which the SEC Respondents neither admitted nor denied.
Concurrently with the issuance of the SEC Order, (i) the FINRA accepted a Letter of Acceptance, Waiver and Consent (the “FINRA Letter”) from the Distributor settling proceedings regarding violations of FINRA rules arising out of the same general facts, and (ii) the Adviser, the Distributor and the Portfolio Manager entered into settlements (the “State Orders”) with state securities regulators in the states of Alabama, Kentucky, Mississippi, South Carolina and Tennessee (collectively, the “States”) based on the same general facts and related findings regarding violations of provisions of the securities laws of each of the States (the “State Securities Acts”).
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 Funds’ portfolio manager; and the Controller, through his oversight of the Distributor’s Fund Accounting Department (“Fund Accounting”), was responsible for oversight of the pricing of the Funds’ securities and the calculation of each Fund’s 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 which, in accordance with Section 2(a)(41)(B) of the Investment Company Act of 1940 (the “1940 Act”) were required to be priced using 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 and required that fair valued securities 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. The SEC found that during the Relevant Period, the Distributor did not price the Funds’ securities in accordance with the Valuation Procedures and that 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 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 discretion beyond the parameters of the Valuation Procedures in validating the prices of portfolio securities by allowing him to determine which broker‑dealer price confirmations (“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 portfolio securities 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 SEC found that the Controller either knew or was reckless in not knowing, of the deficiencies in the implementation of the Valuation Procedures and failed to remedy them or otherwise ensure that 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 found 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 published daily NAVs for the Funds which it could not know were accurate and sold and redeemed shares based on those NAVs.
Fraudulent Manipulation of the Funds’ Securities Prices. The Portfolio Manager actively screened and influenced Dealer Quotes received during the Relevant Period from 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 Dealer 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 Dealer 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 Dealer 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 Dealer 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 found that during the Relevant Period the Portfolio Manager withheld from Fund Accounting material information regarding a substantial decrease in value of an Asset-Backed Security held in the Funds 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, including omissions of material facts, 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, were 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 influencing Dealer Quotes and providing Fund Accounting with unsubstantiated price adjustments. In addition, the SEC Documents incorrectly described the Adviser as responsible for fair valuation of the Funds’ portfolio securities, when, in fact, as discussed above, the Valuation Procedures delegated such responsibility to the Distributor, which was actually performing the valuation function for the Funds.
Violations. As a result, the SEC found violations of the following provisions of the federal securities laws:
The SEC found that the Adviser willfully violated, and the Portfolio Manager willfully aided, abetted and caused violations of, Section 206(4) of the Investment Advisers Act of 1940 (the “Advisers Act”) and Rule 206(4)‑7 thereunder (which, respectively, (a) prohibit fraudulent, deceptive or manipulative practices or courses of business by an investment adviser, and (b) require an investment adviser to adopt and implement written policies and procedures reasonably designed to prevent violation of the Advisers Act and the rules thereunder by its supervised persons);
The SEC found that the Adviser willfully violated, and the Portfolio Manager willfully aided and abetted and caused violations of, Sections 206(1) and 206(2) of the Advisers Act (which prohibit fraudulent conduct by an investment adviser);
The SEC found that the Adviser and Portfolio Manager willfully violated, and the Distributor willfully aided, abetted and caused violations of, Section 34(b) of the 1940 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 1940 Act or the keeping of which is required pursuant to Section 31(a) of the 1940 Act);
The SEC found that the Distributor willfully violated, and the Adviser, Portfolio Manager and Controller willfully aided, abetted and caused violations of, Rule 22c-1 under the 1940 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
The SEC found that the Adviser, Distributor, Portfolio Manager and Controller willfully aided, abetted and caused violations of Rule 38a-1 under the 1940 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).
Undertakings and Penalties. In determining to accept the offer of settlement, the SEC considered certain undertakings agreed to by the SEC Respondents, including agreements from each of the Adviser and the Distributor: (i) to refrain from being involved in, or responsible for, recommending to, or determining on behalf of, a registered investment company’s board of directors or trustees or such company’s valuation committee, the value of any portfolio security for which market quotations are not readily available, and (ii) to cooperate fully with the SEC in any and all investigations, litigations or other proceedings relating to or arising from the matters described in the SEC Order or otherwise involving valuation of, the securities of the Funds. Among other penalties, the SEC Order requires: the Adviser and the Distributor to collectively pay $100 million in disgorgement, interest, and penalties to a fund established for the benefit of the Funds’ investors (the “Fair Fund”), (ii) the Portfolio Manager and Controller to pay civil penalties of $250,000 and $50,000, respectively, to the Fair Fund, (iii) the Portfolio Manager to be barred from future participation in any securities business, and (iv) the Controller to be suspended from participation in any securities business for one year and barred from appearing or practicing before the SEC as an accountant.
Related Proceedings - FINRA
This section describes the principal findings in the FINRA Letter, which the Distributor neither admitted nor denied. The FINRA Letter states that during the Relevant Period, the Distributor, which is a broker‑dealer registered with the SEC and a member of FINRA, sold shares of one of the Funds (the “Bond Fund”) using false and misleading materials in violation of NASD Rules 2110, 2210 and 3010. 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 Letter states that during the Relevant Period, (1) the Bond Fund was heavily invested in risky structured products, including Asset-Backed Securities, and that these investments caused the Bond Fund to experience serious turmoil in early 2007; (2)misleading sales materials that were not fair and balanced and portrayed the Bond Fund as relatively low risk, led the Distributor’s brokers to make material misrepresentations to investors regarding the Bond 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 Bond Fund in early 2007 of 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 Bond Fund’s portfolio was acutely affected by then-current economic conditions; (4) the Distributor provided incomplete internal guidance on the Bond Fund, which ineffectively conveyed the Bond Fund’s risk profile and caused asset allocation models to give the Bond Fund greater weight in conservative portfolios than aggressive portfolios; and (5) the Distributor failed to establish, maintain and enforce a complete internal guidance system, including written supervisory procedures, reasonably designed to achieve compliance with federal securities laws and FINRA rules.
The FINRA Letter identifies the following violations: (i) the Bond Fund’s marketing materials violated NASD Conduct Rules 2110, 2110(d) and 2210 because they failed to provide a sound basis to evaluate the Bond Fund, lacked a fair and balanced presentation, and made exaggerated claims; (ii) the Distributor violated NASD Conduct Rules 2110 and 2210(c) by failing to file with FINRA during the Relevant Period updated Bond Fund profiles that were made available to the Bond Fund’s investors; (iii) the Distributor violated NASD Conduct Rules 3010(a), 3010(b) and 2110 when failing to establish, maintain and enforce an adequate supervisory system reasonably designed to comply with NASD Rules.
In the FINRA Letter, the Distributor agreed to the aggregate $200 million penalty payable to the Fair Fund, and a similar fund established pursuant to the State Orders. The Distributor also agreed to retain an independent compliance consultant to perform periodic reviews and provide certain employee training.
Related Proceedings - States
The State Orders settled related proceedings against the Adviser, the Distributor and the Portfolio Manager for violations of 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.
In broad terms, the State Orders found 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) failing to reasonably supervise their agents, employees and other associated persons; (3) failing to make suitable recommendations concerning purchase and concentration of the Funds in customer accounts; (4) failing to enforce supervisory procedures; (5) failing to review correspondence and marketing materials used by associated persons to sell the Funds; (6) failing to make suitable recommendations concerning purchase and concentration of the Funds in investor accounts; and (7) making material omissions and misrepresentations in the SEC Documents.
The State Orders also found that during the Relevant Period, the Portfolio Manager violated the relevant provisions of the State Securities Acts by: (1) failing to retain documentation relating to Funds’ securities pricing, (2) failing to adequately disclose or adequately describe the Funds’ risk profile(s), (3) failing to reasonably the Distributor’s mischaracterization of down turning market’s effect on Funds as “buying opportunit[ies].”
Under the State Orders, among other penalties and undertakings, (i) the Adviser and the Distributor will collectively pay $100 million to a fund established for the benefit of the Funds’ investors (the “State Fund”), (ii) the Portfolio Manager will $250,000 to the State Fund, and the (iii) the Adviser and Distributor will provide mandatory and comprehensive training related to each of their products and offerings sold or recommended to clients to their respective investment advisers and registered agents for the next three (3) years, and (iv) the Adviser and Distributor are each prohibited from creating, offering or selling any proprietary funds for a period of two years.