On December 10, 2012, the SEC issued an order (the “Order”) instituting administrative proceedings (the “Proceedings”) against the eight former directors (the “Directors”) of three registered open-end funds and four registered closed-end funds (the open-end and closed-end funds, collectively, the “Funds”). The SEC alleges that by failing 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”), the Directors caused the Funds to violate provisions of the Investment Company Act of 1940 (the “1940 Act”) relating to (a) the sale of open-end fund shares at a price based on 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.
This article summarizes the SEC’s allegations in the Order. There have been no findings with respect to the SEC’s allegations. The Directors have not yet filed an answer to the Order, although those who were not interested persons of the Funds within the meaning of the 1940 Act (the “Independent Directors”) have issued a public response that is briefly discussed below. Pursuant to the SEC’s Rules of Practice, the Proceedings will be tried by an Administrative Law Judge who will issue an initial decision within 300 days from the date of service of the Order.
The Proceedings follow on the June 2011 settlement of proceedings brought by the SEC, FINRA and various state securities regulators against (1) the Funds’ investment adviser (the “Adviser”), (2) the Adviser’s affiliate, registered as both an investment adviser and a broker-dealer, which 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 22, 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 the SEC’s finding 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 relating to the pricing of securities backed by subprime mortgages held by the Funds.
As set forth in the Order, each Fund’s board consisted of two interested directors and six Independent Directors. In describing the Directors, the Order notes that four of the Directors (including three of the Independent Directors) are Certified Public Accountants and that all six of the Independent Directors, who collectively made up each Fund’s audit committee, were designated as Audit Committee Financial Experts.
High Proportion of Fair Valued Securities
The Order provides that during the Relevant Period, significant portions of the Funds’ portfolios contained 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. For example, as of March 31, 2007, more than 60% of the net assets of each of the four closed-end Funds consisted of securities that had to be fair valued, as did more than 50% of the net assets of each of the two largest open-end Funds as of June 30, 2007.
Fair Value Process
As described in the Order, the Directors delegated the responsibility for fair value determinations to the Adviser. The Adviser’s Valuation Committee (the “Valuation Committee”), which consisted of Fund officers and Fund Accounting employees, was responsible for overseeing a process that was performed to a large extent by Fund Accounting. 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 alleges Fund Accounting routinely accepted without explanation.
The Order highlights the role that price confirmations played in the fair value process. It notes that Fund Accounting randomly selected and sought price confirmations for as few as 10% of the Funds’ fair valued securities (except for March and June 2007 when, in connection with annual audits, confirmations were sought for 100% of the fair valued securities) and describes such confirmations as “essentially opinions on price from broker-dealers, rather than bids or firm quotes.” Confirmations were generally sought for month-end prices, but were obtained several weeks after the respective month-end. If a month-end price confirmation showed a price more than 5% different from a Fund’s current price for that security, Fund Accounting would typically consult the Portfolio Manager as to how the security should be priced.
During most of the Relevant Period, the Valuation Committee met monthly. It received security sales reports for the Funds, brief explanations for greater-than-5% variances between fair values and price confirmations, and the price confirmations obtained from broker-dealers. (A security sales report 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.”) In reviewing the pricing information provided by Fund Accounting, the Valuation Committee compared reports of sales prices to previously assigned fair values, but did not test the fair values of portfolio securities for which there had been no sale or price confirmation. The Order notes that less than 25% of the approximately 350 fair valued securities held by the Funds were sold in the first six months of 2007.
As described in the Order, the Directors received at each quarterly meeting the following documents on fair valuation matters:
- 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.
Alleged Failures in the Directors’ Oversight
The Order alleges, both directly and indirectly, a number of deficiencies in the Funds’ fair value process.
The Order cites the Directors’ failure 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’ or ‘forces that influence the market in which these securities are bought and sold’ for particular types of securities held by the Funds. 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 notes that the Valuation Procedures permitted the Adviser to override prices in certain instances, a feature of the process that allowed the Portfolio Manager to “arbitrarily set values without a reasonable basis and did so in a way that postponed the degree of decline in the NAVs of the Funds which should have occurred during the Relevant Period.” The Order also notes that the Board had a responsibility consistent with Accounting Series Release No. 118 to “continuously review the appropriateness of” such valuation methods as it might specify.
The SEC asserts in the Order that throughout the Relevant Period the Directors “made no meaningful effort to learn how fair values were actually being determined” and “received at best only limited information on the factors considered in making fair value determinations and almost no information explaining why particular fair values were assigned to portfolio securities.” For example, the SEC alleges that there was “no way” a Director could determine from quarterly board meeting materials the basis for a particular assigned fair value and that the materials relating to fair value determinations contained “boilerplate phraseology” and were “largely uninformative” and of limited utility. In addition, meaningful explanations of fair value determinations were neither presented to the Directors (e.g., the quarterly Valuation Committee report provided no details on how fair valued securities were “randomly confirmed with third parties”) nor requested by the Directors, despite the fact that the Valuation Procedures required that the Directors receive such information on a quarterly basis.
Meaningful “explanatory notes for the fair values assigned to the securities” were not presented to the Directors, quarterly or otherwise, despite the fact that the Valuation Procedures required that the Directors receive them on a quarterly basis. The Directors did not follow up to request explanatory notes or any other specific information regarding the basis for the values assigned them, such as how the internal matrix pricing referred to in the Fair Valuation Form, which the Directors are alleged not to have understood, operated.
The SEC alleges Board that although Fund Accounting relied heavily on price confirmations when making fair valuation decisions, the Board did not (a) establish guidelines regarding the use of price confirmations, such as how frequently they should be requested for any particular type of security, and how broker-dealers used to provide such price confirmations should be selected, or (b) require (i) identification of securities for which no price confirmation had been obtained for a particular length of time and (ii) identification and explanation of those instances where a price confirmation differed materially from the fair value assigned by Fund Accounting. More fundamentally, the Order finds fault with reliance on price confirmations for the open-end Funds, saying that price confirmations “could not have sufficed as the primary valuation method, given the open-end [Funds’] obligation to timely price the securities” since price confirmations were typically obtained weeks after month-end.
As a result of the conduct described above, the Order alleges violations of the following rules under the 1940 Act:
- Rule 22c-1, which requires the price at which the open-end Funds sell or redeem shares to be based on net asset value;
- Rule 30a-3(a), which requires the Funds to maintain internal controls over financial reporting; and
- Rule 38a-1, which requires the Funds to maintain compliance programs reasonably designed to prevent violations of the federal securities laws (including “meaningful fair-valuation methodologies and related procedures”).
The Order also alleges 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.
Independent Directors’ Statement in Response
In addition to denying the SEC’s charges, a statement released on behalf of the Independent Directors in response to the Order noted, among other things, that they had received assurances on fair value prices and the fair valuation process from a major accounting firm and the Funds’ Chief Compliance Officer, and the Funds had received no adverse comment on fair valuation in a 2005 SEC staff exam.