In mid-June, eight former fund directors of Morgan Keenan & Co. settled allegations with the Securities and Exchange Commission that they had failed to exercise proper oversight with respect to mutual funds that had overvalued mortgage-backed securities during the 2007-08 housing market collapse. The settlement comes two years after Morgan Keenan agreed to pay $200 million to settle similar SEC claims against the firm itself and two employees who managed the funds. A copy of the directors’ settlement is available here.

The settlement took the form of a cease-and-desist order. The directors neither admitted nor denied the SEC’s allegations, but they nevertheless submitted to a finding that they had failed to satisfy their pricing responsibilities under the federal securities laws. The directors oversaw open- and closed-end funds that were heavily invested in below-investment grade securities, which were backed by subprime mortgages. The directors delegated responsibility for valuing the securities to a valuation committee, which was not offered meaningful guidance as to what valuation methods could be used. The SEC alleged that, without guidance, Morgan Keenan’s portfolio managers often arbitrarily set values that were artificially high, with the result that investors were unable to determine the true financial health of the funds. By March 2007, the funds held securities with a net asset value of approximately $3.85 billion, of which 60% came from mortgage-backed securities. The settlement ordered the directors to refrain from future violations of SEC Rule 38a-1, which requires that funds adopt policies and procedures aimed at preventing violations of the securities laws.

The June settlement is not simply a vestige of the Subprime Meltdown. Recent press coverage of the finance industry shows that investment bankers, driven by investors’ thirst for yield, are not only again underwriting mortgage-backed securities, they are again underwriting synthetic mortgage-backed securities. Furthermore, the Fed’s recent pronouncements on future monetary policy have led to increased volatility in interest rates, and thus in the market values of existing fixed-income products. Directors of fixed-income mutual funds will continue to be exposed to regulatory and civil liability for their supervisory responsibility for the valuation of these portfolio securities.