On June 13, 2013, the U.S. Securities and Exchange Commission (SEC) announced a settlement in the previously filed enforcement proceeding against eight former interested and independent directors (the Directors) of five registered funds (the Funds) advised by Morgan Asset Management, Inc. (the Adviser). (See Former Mutual Fund Directors Agree to Settle Claims That They Failed to Properly Oversee Asset Valuation.) The enforcement proceeding, which was filed by the SEC on December 10, 2012, charged the Directors with several violations of the Investment Company Act of 1940 based upon their alleged failure to properly carry out their duties during several months in 2007 with respect to overseeing the fair valuation of certain securities held by the funds. More specifically, the SEC alleged that the Directors delegated their asset-pricing responsibilities to the Adviser’s valuation committee without asking meaningful questions, specifying a fair valuation methodology or continuously reviewing the appropriateness of that methodology. The SEC further claimed that as a result of the Directors’ failures, one of the funds fraudulently overstated its net asset value. (See our January 2013 alert, The Morgan Keegan Case and Director Responsibilities for Fair Valuation.)
The SEC’s June 13 Order (the Order) found that the Directors caused the Funds’ violations of Rule 38a-1 under the Investment Company Act, which requires investment companies to adopt and implement policies and procedures reasonably designed to prevent violations of the federal securities laws, and ordered the Directors to cease and desist from committing or causing any violations of Rule 38a-1. The Order did not impose any monetary sanctions. The Directors consented to the entry of the Order without admitting or denying the SEC’s findings.
The Order certainly reflects negotiation between the SEC and the Directors subsequent to the filing of the enforcement proceeding. The original enforcement proceeding alleged that the Directors caused the Funds to violate Rules 22c-1, 30a-3(a) and 38a-1 of the Investment Company Act and willfully caused the Funds to file a false and misleading registration statement with the SEC. The Order is limited to a finding that the Directors caused the Funds to violate Rule 38a-1. The language of the Order was also “softened” in several significant aspects.
For example, the original enforcement proceeding described the Directors’ failure to receive explanations for the valuation of portfolio securities as “egregious,” while the Order describes those failures as “significant.” The original enforcement proceedings also alleged that the Directors “made no meaningful effort to learn how fair values were being determined.” The Order employs much more passive language finding that the Directors “did not learn how fair values were actually being determined.” The Order also points out that the Directors received advice from outside counsel in connection with the Funds’ Valuation Procedures and notes that the Funds’ auditors provided unqualified opinions and advised the Directors that the Valuation Procedures were appropriate and reasonable. Importantly, however, the Order notes that the audits did not provide the Directors with sufficient information about the valuation methods actually being used by the Funds nor did the auditors advise the Directors in any meaningful detail as to these valuation methods.
The fact that the language and charges in the Order differ from the original enforcement proceeding should not, however, undermine the significance of the SEC’s message to mutual fund directors. Rather, the Order demonstrates the Commission’s expectation that mutual fund directors take serious their responsibility to ensure that a fund adopts and implements policies and procedures reasonably designed to prevent violations of the securities laws, including policies and procedures concerning the determination of the fair value of portfolio securities, and the SEC’s willingness to devote resources to enforce those responsibilities. Directors cannot merely approve policies generally describing the factors to be considered in the fair valuing of securities. Directors must take steps to determine what is actually being done to implement those policies. While the SEC did not impose monetary sanctions in the Morgan Keegan matter, it is likely that subsequent matters will involve monetary sanctions.
In light of the Morgan Keegan proceedings, directors should review fund policies and procedures to ensure they contain appropriately specific procedures for fair valuing specific types of securities that the funds expect to hold from time to time. Directors should also ensure that board reports contain thorough explanations of the actual methodologies used to fair value securities.