SEC Institutes Administrative Proceedings Against Eight Registered Fund Directors for Failure to Properly Oversee Asset Valuations

December 18, 2012

The Securities and Exchange Commission (“SEC”) continues to prioritize asset valuation enforcement actions against registered investment companies, private funds and investment advisers. On December 10, 2012, the SEC brought an enforcement action (the “Order”)1 against eight former directors (the “Directors”) of three open-end and four closed-end investment companies (the “Funds”)2 managed by Morgan Asset Management, Inc. (the “Manager”). The Order is particularly noteworthy because the SEC rarely brings enforcement actions against independent directors.

Under the Investment Company Act of 1940 (the “1940 Act”), a registered fund’s board of directors is required to determine, in good faith, the fair value of fund securities for which market quotations are not readily available.3 A substantial portion of the Funds’ portfolios were comprised of below-investment grade debt securities for which market quotations were not readily available. Specifically, during the period from January 2007 to August 2007, a large percentage of the securities owned by the Funds consisted of subordinated tranches of various structured products that included collateralized mortgage obligations and other types of asset-backed securities. Market quotations were not readily available for many of these securities and at times up to 60% of the portfolios of some Funds were required to be fair-valued.4

The Directors, pursuant to the Funds’ policies and procedures, had delegated the fair valuation responsibility to a valuation committee at the Manager that consisted of Fund officers and Fund accounting employees. In the Order, the SEC emphasized that, even when such responsibility is appropriately delegated, the responsibility remains with the Directors to determine the method of arriving at the fair value of each security, understand the process and provide meaningful guidance, and continuously review the appropriateness of the method used in valuing each issue of security in the portfolio.

Specifically, the SEC alleges (i) that the Directors caused the Funds to issue securities at a price other than one based on the current NAV of the securities, (ii) the Directors failed to maintain internal controls over financial reporting, (iii) the Directors failed to adopt and implement meaningful fair valuation methodologies and related procedures, and (iv) the Directors willfully caused a false or misleading statement to be made with respect to material fact in a registration statement filed with the SEC.5

Based upon the deficiencies noted in the Order, fund directors, with the advice of counsel, should review the adequacy of their funds’ valuation processes and procedures and may, depending on the types of funds they oversee and the securities held by those funds, need to increase their time and efforts in the oversight of the valuation process. The SEC noted that despite the Funds’ valuation procedures enumerating specific factors to be used by the valuation committee, the Directors provided no guidance as to how the factors should be interpreted or weighed, nor did they specify what valuation method should be employed for each type of security, or provide any mechanism for identifying and reviewing fair-valued securities, the prices of which remained unchanged.

In addition, fund directors must also ensure that the information provided to them permits them to understand the valuation process for each type of security. After alleging that the Directors failed to satisfy their fair valuation obligations, the SEC stated that the Directors did not know and did not inquire into the methodology used to fair value particular types of securities and that the Directors were not provided with sufficient information to understand the methodology being utilized. The SEC identified deficiencies with the valuation reports provided to the Directors, noting generally that the Directors could not determine from the reports the basis for a particular assigned fair value, whether the price had changed from prior quarters, or how fair valued securities were confirmed with third parties.

Finally, fund directors should review, question and in some instances, challenge delegated responsible parties regarding how fund assets are being fair-valued. The SEC specified that the Directors did not require fund accounting personnel to identify or explain instances where price confirmations differed materially from the Fund’s price. The SEC also stated that the valuation committee, despite meeting monthly, did not receive sufficient information as to the basis of the fair values assigned to various securities, nor did the committee perform additional tests to validate the fair values of securities that had not been sold or confirmed by a broker-dealer. The SEC further noted that the Directors did not ask specific questions about how the Funds’ assets were being valued and how those values were tested.

Fund directors, officers and compliance personnel should read the SEC order very closely and review the valuation processes, governance structure, compliance programs and insurance policies for your funds, especially the areas highlighted by the SEC in the enforcement action brought against the directors at Morgan Keegan.

If you have any questions concerning the matters discussed in this memorandum, please contact an attorney in the Investment Management Group at Seward & Kissel.


1 Order Instituting Public Administrative and Cease-and-Desist Proceedings Pursuant to Sections 9(b) and 9(f) of the Investment Company Act of 1940, Release No. IC-30300, December 10, 2012.

2 The Funds consisted of RMK High Income Fund, Inc.; RMK Multi-Sector High Income Fund, Inc.; RMK Strategic Income Fund, Inc.; RMK Advantage Income Fund, Inc.; and three series of the open-end Morgan Keegan Select Fund – the Select High Income Portfolio, the Select Intermediate Bond Portfolio, and the Select Short Term Bond Portfolio.

3 Section 2(a)(41)(B) of the 1940 Act defines “value” in relevant part to mean “with respect to securities for which market quotations are readily available, the market value of such securities; and (ii) with respect to other securities and assets, fair value as determined in good faith by the board of directors.”

4 In a related matter, the SEC announced on June 22, 2011 that Morgan Keegan & Company (“Morgan Keegan”) and the Manager had agreed to pay $200 million to settle an enforcement action that alleged that, during various periods between January 2007 and July 2007, the daily NAV of each of the Funds was materially inflated as a result of the fraudulent conduct of Morgan Keegan, the Manager and certain of their representatives. See Release No. IC-29704 (June 22, 2011).

5 The SEC alleges that the above conduct by the Directors caused the Funds to violate Rules 22c-1, 30a-3(a) and 38a-1 under the 1940 Act. On November 28, 2012, the SEC charged KCAP Financial, Inc. (“KCAP”), a business development company, and its Chief Executive Officer, Chief Investment Officer and former Chief Financial Officer with violations under the Securities and Exchange Act of 1934 for overstating the fund’s assets during the recent financial crisis. The SEC investigation found that KCAP did not account for certain market-based activity in determining the fair value of its debt securities. Unlike the Order, the SEC did not allege any violations under the 1940 Act notwithstanding the KCAP board’s delegation of its fair valuation obligation to a valuation committee.