The U.S. Securities and Exchange Commission issued a cease and desist order on June 13, 2013 (the “Order”) against former members of the boards of directors (the “RMK Directors” or the “RMK Boards”) of five Regions Morgan Keegan registered investment companies (the “RMK Funds”) that were invested in securities backed by subprime mortgages.1 The Order represents a settlement of administrative proceedings that had been initiated against the RMK Directors on December 10, 2012, alleging that the RMK Directors had violated their responsibilities to fair value portfolio securities for which market quotations were not readily available (the “Complaint”).2 The Order directs the RMK Directors to cease and desist from committing or causing any future violations of Rule 38a-1 under the Investment Company Act of 1940, as amended (the “1940 Act”).3
The Order is one of a series of recent actions arising from the continuing focus of the SEC and its staff on valuation issues in the asset management industry.4 As a result, the Order may provide the industry with some indication of the SEC’s expectations with respect to valuation policies and procedures in the absence of long-awaited formal guidance from the SEC and its staff. In addition, the Order provides yet another example of the SEC’s taking action against individual investment company board members – a tactic that previously had been rare, but more recently has emerged as a new enforcement strategy.5
Background on the Enforcement Action
The allegations in the Complaint against the RMK Directors are related to a previous enforcement action against the investment adviser, principal underwriter and certain management personnel of the RMK Funds, which was settled in 2011 (the “2011 Proceeding”).6 In the 2011 Proceeding, the SEC alleged that from January 2007 to August 2007, the subprime mortgage-backed securities held by the RMK Funds were not fair valued correctly. The SEC alleged that the incorrect valuations were the result of (i) fraudulent actions by the portfolio manager in manipulating price quotations, and (ii) the failure of the investment adviser and the treasurer to supervise the portfolio manager and to institute satisfactory valuation processes and practices. These failures allegedly resulted in the RMK Funds overstating their net asset values over an extended period and caused substantial losses to the RMK Funds’ shareholders. Ultimately, the SEC announced on June 22, 2011 that the RMK Funds’ investment adviser and principal underwriter had agreed to pay $200 million to settle the enforcement action.7
As addressed in the 2011 Proceeding and reiterated in the Complaint: (i) during the relevant period, a large percentage of the securities owned by the RMK Funds were structured products, including collateralized mortgage obligations and other types of asset-backed securities; (ii) during the relevant period, volatility in the financial markets created an environment where market quotations were not readily available for many of these securities; and (iii) Section 2(a)(41)(B)(ii) of the 1940 Act requires a registered fund’s board of directors to determine, in good faith, the fair value of securities for which market quotations are not readily available. Because a substantial portion of the RMK Funds’ portfolios was comprised of below-investment grade debt securities, at times up to 60% of the holdings of the RMK Funds were fair valued.
In contrast to the 2011 Proceeding, the Complaint specifically addressed the SEC’s views about a fund board’s responsibilities in connection with valuation matters. The Complaint reaffirmed SEC interpretive guidance first provided in 1970 that a “board may appoint persons to assist them in determination of such [fair values], and to make the actual calculations pursuant to the board’s direction.”8 According to the Complaint, a board must also, consistent with this responsibility, “continuously review the appropriateness of the method used in valuing each issue of security in the company’s portfolio.” On this basis, the Complaint alleged that the RMK Boards had failed in their responsibility in several ways, including by delegating their responsibility to determine the value of securities requiring fair valuation to a valuation committee of the investment adviser without providing “any meaningful substantive guidance” as to how those fair value determinations should be made.
The Complaint also alleged that the RMK Boards did not make any meaningful effort to learn how fair values actually were determined. The Complaint characterized these failures as “egregious” given the percentage of portfolio holdings that required fair valuation. According to the Complaint, as a result of these failures, net asset values of the RMK Funds were materially misstated during the relevant period, resulting in inaccurate prices for shares of the open-end funds that were sold, redeemed and repurchased.
Violations Alleged in the Complaint
The Complaint did not allege fraudulent conduct by the RMK Boards or a breach of fiduciary duty under the 1940 Act. However, the Complaint alleged the following four violations of the federal securities laws:
- The RMK Boards caused the open-end RMK Funds to violate Rule 22c-1 under the 1940 Act, which requires funds issuing redeemable securities (and persons authorized to sell them) to sell, redeem or repurchase those securities at the current net asset value.
- The RMK Boards caused the RMK Funds to violate Rule 38a-1 under the 1940 Act, which requires registered management investment companies to adopt and implement written policies and procedures reasonably designed to prevent violation of the federal securities laws.
- The RMK Boards caused the RMK Funds to violate Rule 30a-3(a) under the 1940 Act, which requires registered management investment companies to maintain internal control over financial reporting.
- The RMK Boards willfully caused one of the RMK Funds to make a false or misleading statement of a material fact in its SEC registration statement.
Terms of the Settlement
Although the Complaint had alleged four violations of the federal securities laws arising from the conduct of the RMK Directors, the settlement agreed to by the RMK Directors alleged only one violation – failure to adopt and implement adequate procedures reasonably designed to prevent violation of the federal securities laws, in violation of Rule 38a-1 under the 1940 Act. The RMK Directors were ordered to cease and desist from committing or causing any future violations of Rule 38a-1, but were not formally censured and were not required to pay any monetary penalty. However, it should be noted that related parties paid substantial fines and penalties in connection with settling the 2011 Proceeding.
Although the Order ultimately did not charge the RMK Directors with making false or misleading statements of a material fact in an SEC registration statement or with violations of Rules 22c-1 or 30a-3(a), the Order nevertheless reflects many of the allegations made in the Complaint – most notably, the notion that the RMK Boards delegated responsibilities to fund management without providing adequate oversight and guidance regarding the implementation and application of the fair valuation policies and procedures. Specifically, the SEC alleged that:
- The valuation policies adopted by the RMK Boards contained inadequate descriptions of the types of securities that required fair valuation and the method or process required to fair value such securities.
- The procedures did not require the RMK Boards to ratify fair valuations, and, as a result, the RMK Boards did not ratify fair valuations.
- The department of RMK Funds that addressed daily pricing failed to use reasonable analytical methods to arrive at fair valuations, and the portfolio manager exerted undue influence over fair valuations and in overriding prices.
- In confirming fair valuations, the RMK fund accounting unit used “opinions” from broker-dealers “rather than bids or firm quotes.” The SEC noted that the opinions “could not have sufficed as the primary valuation method.” In addition, the RMK Boards failed to provide adequate oversight and necessary guidelines in connection with the use of price confirmations.
- The RMK fund accounting unit allowed fair values to remain unchanged unless a price variation of 5% or more based on the confirmations was received from dealers.
- The reports on valuation presented by the adviser to the RMK Boards were inadequate, and the RMK Boards failed to ask for reports to substantiate fair valuations.
- The RMK Boards failed to set “clear and specific methodologies” or to review the implementation of their “general” valuation guidance, allowing the adviser to implement deficient procedures.
Significance of the Order: SEC Willingness to Take Action Against Directors
The Complaint against the RMK Boards represents another example of the SEC’s targeting of the directors of mutual funds. Until recently, enforcement actions against directors had been uncommon, but not unprecedented. And indeed, the SEC has been candid regarding the increased focus on fund boards specifically. Bruce Karpati, the former chief of the SEC Enforcement Division’s Asset Management Unit, is reported to have warned that the SEC is “looking at directors very closely,” and that he expects certain cases against directors to send a “significant deterrence message . . . to the industry.”9
In addition, the Director of the SEC’s Division of Investment Management, Norm Champ, recently spoke about the importance of fund boards in the context of that Division’s new Risk and Examinations Group (the “REG”). Mr. Champ noted that he and the REG staff are in the process of meeting with senior management personnel and fund boards from various fund complexes. Describing fund directors as “gatekeepers” and “the eyes and ears of fund investors,” Mr. Champ noted some important areas that he and the REG hope to discuss with fund boards, including “areas where directors believe they are adding value and, in contrast . . . areas where they feel that their oversight is more difficult to manage.”10
The SEC’s press release which accompanied the Order also emphasized the continued spotlight on directors. In the press release, George Canellos, co-chief of the SEC’s Division of Enforcement stated, “[o]ur settlement sends a clear warning of our commitment to enforce the duty of mutual fund directors and trustees to closely oversee the process of valuing securities held by their fund . . . .”11
The Complaint’s focus on the alleged failure by the RMK Boards to provide satisfactory oversight builds upon previous valuation enforcement actions against directors. Earlier enforcement actions involving valuation issues generally were grounded in circumstances where directors allegedly were engaged in affirmative bad acts12 or repeatedly ignored requests for valuation information.13 By contrast, the Complaint and Order raise questions as to certain more subjective and process-driven determinations regarding the role of directors with respect to valuation and the degree of involvement required to determine, in good faith, the fair value of securities for which market quotations are not readily available – and, more generally, the level of involvement and engagement of fund directors in the execution of their oversight and supervisory duties.
Significance of the Order: Valuation Guidance Through Enforcement Action
The Complaint against the RMK Directors and the resulting Order confirm that valuation issues remain a focal point for the SEC and its staff. Over the past several years, valuation concerns have publicly been listed at the top of the list of examination priorities14 and have been the catalyst for several recent enforcement actions.15 The SEC staff has expressed the belief that it should provide the industry with additional valuation guidance. In a recent speech, Mr. Champ stated that “there is a need to provide additional guidance on valuation of securities held by registered investment companies . . . because much has changed since the Commission last issued guidance regarding valuation.”16 Nevertheless, in the absence of such guidance from the SEC or its staff through the issuance of formal interpretative guidance or proposed regulation, the Compliant and the Order provide some insight into the current views of the SEC and its staff on valuation matters. In light of the views expressed in the Complaint and the Order, fund boards and management companies might wish to consider taking steps such as the following:
- Periodically reviewing valuation policies and practices to ensure that they address applicable regulatory requirements and reflect new instruments and valuation methodologies as they evolve, and that the valuation methodologies set forth therein remain appropriate in light of the current nature of the fund’s portfolio holdings.
- To the extent valuation policies and procedures mandate that reports be prepared and provided to a board, confirming that (i) the required reports are being prepared as required; and (ii) the reports provide the board with the information it needs to effectively oversee the valuation process.
- Assessing the level of board involvement in overseeing the valuation process – including (i) the board’s understanding of the fair valuation methodologies and processes used for the specific types of securities and other assets in a fund’s portfolio; and (ii) the formality with which the board oversees specific fair value determinations made in accordance with board-approved procedures.
- Examining the role of portfolio managers in the valuation process to address inherent conflicts of interest that may arise when portfolio managers have undue influence over the valuation process.
In addition, given the SEC’s willingness to hold boards accountable for funds’ valuation policies and procedures, fund boards and advisers may want to consider reassessing current procedures and practices to determine whether they are sound and do not otherwise raise the concerns identified by the SEC in the Order and the Complaint.