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.
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.
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.