Former Mutual Fund Directors Agree to Settle Claims that They Failed to Properly Oversee Asset Valuation (with Lofchie Comment)

The SEC announced a settlement, in connection with the improper valuation of securities by a family of mutual funds, that was quite significant in that the action was taken against the funds' directors. These enforcement proceedings resulted in settled charges against eight former directors of five Regions Morgan Keegan open- and closed-end funds that were heavily invested in securities backed by subprime mortgages. The SEC had previously settled charges with, and collected a substantial fine from, the adviser to the mutual funds (as linked below).

The settled order found that the directors failed to satisfy their pricing responsibilities under the federal securities laws. Specifically, the directors delegated their fair valuation responsibility to a valuation committee of the investment adviser without providing adequate substantive guidance on how fair valuation determinations should be made. Further, the directors made no meaningful effort to learn how fair values were being determined. The directors' limited control over the valuation process due to the limited information provided to them was problematic as these fair valued securities comprised a significant percentage of the funds' assets.

Lofchie Comment: This is one of those cases where it is very difficult to know, from the outside, whether the charges were appropriate, but which, in any case, require attention. In connection with its prosecution of this case, the SEC had submitted an amicus brief from former SEC Chairman Harvey Pitt that provided a very substantial list of alleged failures by the directors in the oversight of the valuation process. For their part, the directors had submitted a number of briefs from equally respected securities lawyers asserting that the conduct of the directors was consistent with market norms. My view on reading the briefs was that, even if the directors had been somewhat delinquent, the brief of former Chairman Pitt set the bar on the responsibility of the directors so high that it is doubtful that any director would be able to reach it. (Bear in mind that mutual funds are subject to numerous rules, of which valuation is just one.) Interestingly, the settlement of the case reflects the fact that the SEC did not want to battle the issue of the directors' responsibilities to the bitter end. That is, the SEC order does not censure the directors for past failures; rather, it only orders them to cease and desist from future violations. Leaving aside the appropriateness of the enforcement action, mutual fund directors clearly must take the case as a warning from the SEC that they must be mindful of whether there are control processes in place that allow them to fulfill their obligations to the funds on whose boards they serve. This is most obviously the case where the directors have sanctioned a control process that allows for a conflict of interest; i.e., the complete delegation of the valuation process to the investment adviser. Advisers to private funds should also pay attention to this case: they must, at a minimum, attend to whether their actual valuation process is consistent both with the valuation process that they describe to investors and with the valuation process in their compliance manuals.

See: SEC Order and SEC Press Release.See also: Litigation Release regarding Morgan Keegan from last April.Related Enforcement: Morgan Keegan to Pay $200 Million to Settle Fraud Charges Related to Subprime Mortgage-Backed Securities (June 22, 2011) and SEC Charges Morgan Keegan and Two Employees With Fraud Related to Subprime Mortgages (April 7, 2010).