This is an extended version of the commentary that BoardIQ was kind enough to publish May 6, 2014.

At the ICI 2014 Mutual Funds and Investment Management Conference, the staff of the Division of Investment Management announced that it would not propose comprehensive guidance on valuation of investment company portfolios this year. Only more targeted guidance on unspecified areas may be coming. Some investment managers and even fund directors consider this welcome news. No doubt, this reflects their fundamentally conservative nature and a complacency about portfolio valuation that has grown as the financial crisis has receded.

In this series of Client Alerts, I will argue that this complacency is shortsighted. The financial crisis and subsequent SEC enforcement actions revealed fundamental concerns regarding the valuation of portfolio securities, particularly complex fixed-income securities. Until the SEC addresses these concerns, mutual funds will remain at risk of systemic and widespread misvaluations. Directors of mutual funds may find themselves held accountable for such misvaluations, even though they had no reasonable means of preventing them.

We begin the analysis by reviewing the history of SEC enforcement actions against independent directors for misvalued securities.

During a presentation at the ICI 2011 General Membership Meeting, I made an observation to the effect that: “The SEC does not bring many enforcement actions against independent directors1 of investment companies, but nearly all the actions it brings involve valuation issues. Misvaluation of securities and related concerns therefore represent the biggest risk for independent directors.”

The SEC’s settlement with the independent directors of Regions/Morgan-Keegan’s investment companies prompted me to confirm whether my observation was true. A search of the CCH and Westlaw databases for SEC releases and enforcement decisions yielded the following six cases in which an independent director was a named respondent:

Click here to view the table.

I ran multiple searches using different criteria, some of which returned 70 documents. While it is possible I missed a case or two, these results should at least constitute a representative sample of SEC enforcement actions against independent directors. The sample supports my observation: four of the six orders (the Parnassus Directors Order, the Heartland Directors Order, the Rockies Directors Order and the aforementioned RMK Directors Order) involved misvalued securities. More significantly, these are four of the five cases in which the SEC found independent directors to have violated federal securities laws and imposed sanctions. Based on this sample, misvalued securities clearly entail the greatest risk of SEC sanctions against independent directors.

Although admittedly a small sample, the orders display some interesting patterns. First, the two non-valuation cases both involved independent directors investing side-by-side with their funds in securities offerings: investing in IPOs in the case of the Monetta Directors Order and investing in private placements in the case of the Van Wagoner Director Order. This type of investment activity, which creates a potential for conflicts of interest between the independent directors and their funds, may constitute the second most significant risk of enforcement for independent directors.

Second, of the four valuation cases, two involved misvaluation of restricted securities of an unlisted, thinly traded and troubled company (the Parnassus Directors Order and the Rockies Directors Order), and the other two involved misvaluation of large numbers of high-yielding, fixed-income securities (the Heartland Directors Order and the RMK Directors Order). The directors in the restricted security cases oversaw individual funds that were relatively small; the directors in the fixed-income cases oversaw complexes of funds with much more substantial assets. This pattern may reflect the fact that most equity securities held by investment companies are listed on exchanges and traded daily, which allows them to be regularly valued at their last-traded price, whereas fixed-income securities are traded infrequently over the counter, which requires them to be fair-valued on a regular basis.

Restricted securities (which cannot be publicly traded) are the exception to the rule for equity securities, which is why they are a likely source of valuation issues. Large, well-managed fund complexes know, from SEC guidance, not to value restricted securities at the same price as unrestricted securities. Small operations managing single funds may not be as well informed, which increases the risks to independent directors of these funds.

In contrast, fixed-income securities are regularly fair-valued by securities-pricing services. Regardless of the size and sophistication of the complex, there is a risk of a breakdown in the fair valuation process, which may affect a number of securities held by multiple funds. This suggests that enforcement risks are higher for independent directors of fixed-income funds than for independent directors of equity funds.

Third, of the five cases imposing sanctions, the SEC imposed monetary sanctions on an independent director only in the case involving the most egregious conduct (the Rockies Directors Order). Any solace a director may find in this pattern should be tempered, however, by Commissioner Campos’ extraordinary dissent in the Heartland Directors Order, because he did not consider the cease and desist order “meaningful.” “Meaningful sanctions in [Commissioner Campos’] opinion would have included as a minimum: a finding of scienter-based fraud [citations omitted]; a civil penalty of at least one year’s director fees; and an officer and director bar of at least three years.”

Finally, in all the valuation cases except the Heartland Directors Order, the investment company’s independent auditors had reviewed the valuations for which the independent directors were sanctioned. It would be a mistake to believe that a clean audit opinion will protect an independent director from sanctions for misvalued securities. As noted in the RMK Directors Order, “These audits did not provide the Directors with sufficient information about the valuation methodologies actually employed by Fund Accounting and the Valuation Committee to satisfy the Directors’ obligations.”

In conclusion, this sample of enforcement orders shows:

  • Misvalued securities represent the greatest enforcement risk for independent directors
  • Directors of fixed-income funds and small isolated funds are at greater risk of enforcement  actions stemming from misvalued securities
  • Independent directors may avoid monetary sanctions if their conduct in relation to the misvalued  securities is not egregious
  • The annual audit process does not protect directors from sanctions stemming from misvalued  securities