Davis Polk


SEC Charges Mutual Fund Directors for Inadequate Valuation Oversight

December 17, 2012

On December 10, 2012, the Securities and Exchange Commission (the “SEC”) charged eight former directors (the “Directors”) of five Morgan Asset Management (“MAM”) registered investment companies (“RICs”) with securities laws violations for their role in valuing the RICs’ securities from March 2007 through August 2007.  Section 2(a)(41)(B) of the Investment Company Act of 1940, as amended, requires that when market quotations are not readily available in respect of securities held by RICs, the securities must be given a fair value as determined in good faith by the RICs’ boards of directors.  Pursuant to SEC guidance, boards of directors are permitted to delegate their responsibility for calculating fair values, pursuant to board-approved policies and procedures.

According to the SEC’s Order Instituting Public Administrative and Cease-And-Desist Proceedings (the “Order”), RICs managed by MAM, which included one open-end RIC that had three series and four closed-end RICs, had approximately $3.85 billion in assets under management.  The RICs’ assets included mortgage-backed securities and other types of structured products.  According to the Order, the Directors delegated their asset pricing duties to MAM and, pursuant to the RICs’ policies and procedures (the “Valuation Procedures”), the MAM valuation committee (the “Valuation Committee”) determined the fair value of securities that did not have available quotations.  According to the Order, fair-valued securities made up more than 60 percent of the net asset value for most of the RICs. 

Primary Allegations Against the Directors

While the SEC noted multiple shortcomings in the Valuation Procedures, the SEC’s primary allegations against the Directors were that the Directors failed to put in place sufficiently detailed procedures and methodologies to guide personnel responsible for making fair value decisions and failed to adequately oversee the valuation procedures that were in place.  In terms of insufficiently meaningful guidance, the SEC alleged, among other things, that, although the Valuation Procedures listed various general and specific factors (copied nearly verbatim from ASR 118) that the Valuation Committee was required to consider when making fair value determinations, the Valuation Procedures gave “no meaningful methodology or other specific direction on how to make fair value determinations for specific portfolio assets or classes of assets” or guidance on how the listed factors should be interpreted or weighed.  With respect to the alleged oversight failure, the SEC charged, among other things, that the Directors “made no meaningful effort to learn how fair values were actually being determined.”  Further, the SEC alleged that the Directors “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.”

The Directors have denied the SEC’s allegations and have released a statement announcing they intend to contest the charges.

Implications for Registered Fund Directors

Whether or not the SEC prevails in the action against the Directors, in light of the issues raised in the Order and the SEC Enforcement Division’s current focus on valuation practices, directors and counsel to registered funds should review their funds’ valuation procedures and reports to evaluate whether they should be adjusted to address the concerns raised in the Order.  Among other things, this review should consider whether:

1) a fund’s valuation procedures provide meaningful guidance on how fair values are to be determined, including consideration of:

  • whether specific valuation methodologies have been identified for specific asset classes (e.g., pricing models or future cash flow analysis) and whether such methodologies are reasonable analytical methods for arriving at fair value;
  • whether any specified factors to be followed should be weighed more or less heavily than others and how such factors should be applied to specific types of securities in a fund’s portfolio;
  • whether the procedures include any mechanism or process for identifying and reviewing securities whose prices, including fair valuations, have remained unchanged;
  • whether the procedures use price confirmations appropriately, including:
    • whether they are obtained contemporaneously with the valuation decision;
    • whether they are required to be updated when stale;
    • the selection of the sources used to obtain such price confirmations;
    • whether there is a process for identifying and explaining instances where price confirmations differ materially from the fair value otherwise assigned to a security; and
    • whether non-binding price confirmations might be buttressed with additional methodologies for making fair value determinations;
  • whether the procedures provide for adequate checks on the price override process, including, in particular, that a portfolio manager not be able to unilaterally override a price;
  • whether the procedures require the performance of adequate tests (in terms of quality and scope) to validate fair value determinations; and

2) the periodic reports delivered to fund directors pursuant to the valuation procedures provide sufficient information such that the fund directors can understand which securities are being fair-valued and how fair values are being determined, including:

  • the fair values and information on the methodology used to make fair value determinations; and
  • information showing relevant historical pricing so that fund directors can identify whether prices or methodologies have changed from prior quarters.

We will continue to monitor developments in this area.

If you have questions regarding this publication, please call any of the lawyers listed below or your regular Davis Polk contact.

Susan Betteridge Baker 212 450 4291 susan.baker@davispolk.com
John G. Crowley 212 450 4550 john.crowley@davispolk.com
Nora M. Jordan 212 450 4684 nora.jordan@davispolk.com
Yukako Kawata 212 450 4896 yukako.kawata@davispolk.com
Leor Landa 212 450 6160 leor.landa@davispolk.com
Gregory S. Rowland 212 450 4930 gregory.rowland@davispolk.com
Danforth Townley 212 450 4240 danforth.townley@davispolk.com
Robert F. Young 212 450 4709 robert.young@davispolk.com

Also of Interest

November 2012

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