SEC Charges Eight Mutual Fund Directors for Failure to Properly Oversee Asset Valuation
The Securities and Exchange Commission today announced charges against eight former members of the boards of directors overseeing five Memphis, Tenn.-based mutual funds for violating their asset pricing responsibilities under the federal securities laws.
The funds, which were invested in some securities backed by subprime mortgages, fraudulently overstated the value of their securities as the housing market was on the brink of financial crisis in 2007. The SEC and other regulators previously charged the funds’ managers with fraud, and the firms later agreed to pay $200 million to settle the charges.
Under the securities laws, fund directors are responsible for determining the fair value of fund securities for which market quotations are not readily available. According to the SEC’s order instituting administrative proceedings against the eight directors, they delegated their fair valuation responsibility to a valuation committee without providing meaningful substantive guidance on how fair valuation determinations should be made. The fund directors then made no meaningful effort to learn how fair values were being determined. They received only limited information about the factors involved with the funds’ fair value determinations, and obtained almost no information explaining why particular fair values were assigned to portfolio securities.
“Investors rely on board members to establish an accurate process for valuing their mutual fund investments. Otherwise, they are left in the dark about the value of their investments and handicapped in their ability to make informed decisions,” said Robert Khuzami, Director of the SEC’s Division of Enforcement. “Had the board not abdicated its responsibilities, investors may have stood a better chance of preserving their hard-earned assets.”
The SEC Enforcement Division’s Asset Management Unit continues to prioritize asset valuation investigations, with recent enforcement actions including charges against three top executives at New York-based KCAP Financial and two executives at former $1 billion hedge fund advisory firm Yorkville Advisors LLC.
The eight fund directors named in today’s SEC enforcement action are:
- J. Kenneth Alderman of Birmingham, Ala.
- Jack R. Blair of Germantown, Tenn.
- Albert C. Johnson of Hoover, Ala.
- James Stillman R. McFadden of Germantown
- Allen B. Morgan Jr. of Memphis
- W. Randall Pittman of Birmingham
- Mary S. Stone of Birmingham
- Archie W. Willis III of Memphis
According to the SEC’s order, the eight directors’ failure to fulfill their fair value-related obligations was particularly inexcusable given that fair-valued securities made up the majority of the funds’ net asset values – in most cases more than 60 percent. The mutual funds involved were the RMK High Income Fund, RMK Multi-Sector High Income Fund, RMK Strategic Income Fund, RMK Advantage Income Fund, and Morgan Keegan Select Fund.
The SEC Enforcement Division alleges that the directors caused the funds to violate the federal securities laws by failing to adopt and implement meaningful fair valuation methodologies and procedures and failing to maintain internal control over financial reporting. For example, the funds’ 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.
“While it is understood that fund directors typically assign others the daily task of calculating the fair value of each security in a fund’s portfolio, at a minimum they must determine the method, understand the process, and continuously evaluate the appropriateness of the method used,” said William Hicks, Associate Regional Director of the SEC’s Atlanta Regional Office.
According to the SEC’s order, the funds’ valuation procedures required that the directors be given explanatory notes for the fair values assigned to securities. However, no such notes were ever provided to the directors, and they never followed up to request such notes or any other specific information about the basis for the assigned fair values. In fact, Morgan Keegan’s Fund Accounting unit, which assigned values to the securities, did not utilize reasonable procedures and often allowed the portfolio manager to arbitrarily set values. As a result, the net asset values of the funds were materially misstated in 2007 from at least March 31 to August 9. Consequently, the prices at which one open-end fund sold, redeemed, and repurchased its shares were inaccurate. Furthermore, other reports and at least one registration statement filed by the funds with the SEC contained net asset values that were materially misstated.
The SEC’s order alleges that the fund directors caused the funds’ violations of Rules 22c-1, 30a-3(a) and 38a-1 under the Investment Company Act of 1940.
The SEC’s investigation was conducted by members of the SEC’s Atlanta Regional Office and the Asset Management Unit.