Alert January 24, 2012

SEC Settles Enforcement Proceeding over Registered Investment Adviser’s Failure to Comply with Mutual Fund Pricing Procedures

The SEC settled an enforcement action against a registered investment adviser (the “Adviser”) based on the Adviser’s failure to cause certain fixed-income securities purchased in June 2008 by mutual funds it managed (the “Funds”) to be valued in accordance with the funds’ fair valuation procedures.  The fixed-income securities in question (the “Securities”) were primarily non-agency mortgage-backed securities, but also included asset-backed securities and collateralized debt obligations.  This article provides a summary of the SEC’s principal findings in the settlement, which the Adviser neither admitted nor denied. 

The Funds’ Valuation Policies and Procedures.  The boards of the Funds established valuation policies and procedures that in relevant part used prices provided by broker-dealers and designated third-party pricing vendors (collectively “Pricing Sources”).  These procedures required that a security be valued at its trade price for up to five business days if there was a difference of three percent or more between the security’s trade price and the valuation provided by a Pricing Source.  During the five day period, the Adviser’s valuation committee could direct that the valuation provided by the Pricing Source be used if deemed appropriate.  If no decision was made by the fifth day, the committee was required to make a valuation determination.  The Adviser’s compliance procedures included automated price checks that tested for these variances and when they were detected, generated Price Tolerance Reports, which were provided to the Adviser’s compliance department.  In the event of a three percent or greater variance, the procedures called for the Adviser to issue a price challenge to the Pricing Source requesting a justification for the variance.

Adviser’s Practices.  The SEC found that in June 2008, shortly after the securities were purchased, the quotations received for the Securities from broker-dealer Pricing Sources were more than 100% higher than the Securities’ trade prices and, in some cases, were more than 1,000% higher.  The prices received from third-party pricing vendor Pricing Sources were similarly in excess of the Securities’ trade prices.

Given the large variance between trade prices and prices from Pricing Sources, Price Tolerance Reports were generated for almost all of the Securities.  The Securities were not, however, valued at their trade prices during the succeeding five business days, and the Adviser did not issue price challenges to the Pricing Sources for a majority of the Securities that appeared on the Price Tolerance Reports.  In addition, the Adviser did not follow up with challenged Pricing Sources or make fair value determinations at the conclusion of the five-day periods.  The Adviser’s valuation committee ultimately elected to fair value the Securities at the midpoint between their trade prices and the prices received from the Pricing Sources until the committee received responses to the price challenges.  Price challenges were not issued for a majority of the Securities until July 1, 2008, and were never issued for some Securities.  As a consequence of the foregoing, the NAVs of the Funds were misstated between one cent and ten cents per share for several days in June 2008.

Violations.  Due to the practices noted above, the SEC found that by misstating their NAVs and executing transactions in redeemable securities at prices not based on current net asset values, the Funds violated Rule 22c-1 under the Investment Company Act, which prohibits a registered investment company from selling, redeeming, or repurchasing any redeemable security it has issued except at a price based on that security’s current net asset value.  Additionally, the SEC found that the funds’ failure to adequately implement their pricing procedures violated Rule 38a‑1 under the Investment Company Act relating to compliance programs for registered investment companies.  The SEC found that the Adviser willfully aided and abetted and caused each of the foregoing violations by the Funds.

Sanctions.  Under the terms of the settlement, among other sanctions, the Adviser agreed to pay a civil penalty of $300,000.