Yesterday, the SEC issued a settlement of the case it brought last December against eight former directors of the RMK Funds, alleging that the directors had failed to satisfy their statutory obligations to value properly securities held in the funds’ portfolios. The settlement is significant because it articulates in some detail what the SEC sees as directors' duties to fair value portfolio securities.
In a section entitled "Responsibilities of the Board," the settlement order states that “the Directors did not calculate the valuations themselves, and neither established clear and specific valuation methodologies nor followed up their general guidance to review and approve the actual methodologies used and the resulting valuations.” The settlement order finds that the directors accordingly caused violations of Rule 38a-1, the rule requiring funds to adopt and implement policies and procedures designed to prevent violations of the federal securities laws. The settlement order states that a fund’s board must “ensure” that a fund implements policies and procedures designed to prevent violations, particularly with respect to fair value. The SEC did not impose any monetary sanctions on the directors, instead, they were ordered to cease and desist from committing or causing any violations of Rule 38a-1.
At issue in the case was how the RMK Funds valued various structured products, including collateralized debt obligations, collateralized mortgage obligations and collateralized loan obligations during the initial stages of the financial crisis in 2007.
The settlement order found that the valuation procedures did not provide sufficient guidance for fair valuing the securities in the funds. Specifically, the valuation procedures
• Listed “general” and “specific” factors that the valuation committee was supposed to use in making fair value determinations, but did not provide “meaningful methodology or other specific direction on how to make the fair value determinations for specific portfolio assets or classes of assets.” (emphasis in original)
• Did not provide guidance on “how the listed factors should be interpreted, on whether some of the factors should be weighed more heavily or less heavily than others, or on what specific information qualified as ‘fundamental analytical data relating to the investments’.”
• Did not “specify what valuation methodology should be employed for each type of security or, in the absence of a specified methodology, how to evaluate whether a particular methodology was appropriate or inappropriate.”
• Did not include a mechanism to identify stale prices.
• Contained no guidelines regarding the use of price confirmations.
• Did not require the board to ratify the valuations made by the adviser.
The settlement order also found that the “information and reports provided to Directors at their board meetings did not provide sufficient information for Directors to understand what methodology was being used by Fund Accounting to fair value particular securities.” Specifically, the reports provided to the directors:
• While providing a list of securities that were fair valued along with the value assigned, did not “identify the type of security, the basis for a particular assigned fair value, or whether that price had changed from prior quarters.”
• From the valuation committee did not state “how fair values were determined, and gave no details on how fair valued securities, which it referred to as ‘internally priced securities,’ were randomly confirmed with third parties.”
• Did not contain information about securities that received no price confirmations for a particular length of time, despite the importance of such confirmations in the valuation process for the funds.
• Did not contain explanations of the internal matrix used to value securities, and inaccurately stated that the internal matrix was used often when it actually was used only for a small percentage of the fair valued securities.
• Did not include meaningful “explanatory notes for the fair values assigned to the securities” despite a requirement in the valuation procedures that the directors receive them quarterly.
• Did not include information about stale prices, limiting the “Directors’ ability to (a) review carefully the findings of the Valuation Committee and (b) satisfy themselves that all relevant factors had been considered.
The settlement found that the “failures were particularly significant given that fair-valued securities made up a substantial percentage of the portfolios of each of the funds.”
In discussing the board’s responsibilities, the settlement revisited guidance provided by the Commission in 1970 in ASR 118, stating that “while a board may enlist the assistance of individuals who are not board members, it remains the board’s duty to establish the fair value methodology to be used and to continuously review both the appropriateness of the methods used in valuing each issue of security and the valuation findings resulting from such methods.” The order emphasized that boards have the ultimate responsibility for fair valuing securities, and “that this responsibility cannot be delegated away.”
The settlement was the second dealing with valuation issues at the same funds. In 2011, the SEC and Morgan Keegan reached a settlement that required Morgan Keegan to pay a penalty of $200 million.
The Forum has several resources available as directors consider their role in the valuation process. On Thursday, June 20 at 2pm Eastern, Elizabeth Duggan of Interactive Data and Paul Kraft of Deloitte will present a webinar outlining valuation issues for fund directors. In addition, please consult the Forum’s paper Practical Guidance for Directors on Valuation Oversight.