Lessons Learned From The Morgan Keegan Case, Part I – Valuation

by Pepper Hamilton LLP
Contact

The U.S. Securities and Exchange Commission (SEC)’s recent settlement in the latest chapter of the enforcement proceeding involving Morgan Keegan provides important guideposts on two of the hottest regulatory topics in the asset management industry – valuation and corporate governance. This article addresses the impact of the Morgan Keegan settlement on valuation procedures; a subsequent article on corporate governance is to follow.

The SEC has been beating the drum on valuation for the last year, and it should come as no surprise. Valuation of assets held by funds or in client separate accounts is one of the most critical matters for an asset management firm. Valuation requires the participation of portfolio management, finance and accounting, compliance, and senior management and/or the board of directors. Valuation plays a role in numerous core functions – in PPM presentation of track record, in ongoing performance reporting, in calculation of fees, and in transactions affecting fund interests. While valuation spans all asset classes, alternative asset managers face particular challenges in this area, given that the securities or assets in which they invest are typically illiquid and lack ready markets, and accordingly must be fair valued.

The Morgan Keegan proceeding involved five mutual funds that were heavily invested in complex structured product securities and below-investment-grade debt. More than half of the funds’ nearly $4 billion in assets consisted of these types of securities, and all of these assets were required under the Investment Company Act to be fair valued. James Kelsoe, Morgan Keegan’s portfolio manager, allegedly manipulated price quotations and valuations in an effort to conceal losses in these securities and forestall declines in the NAVs of the funds. The SEC alleged violations based not only on Kelsoe’s misleading conduct, but on the adviser’s failure to supervise Kelsoe adequately and its failure to have reasonable valuation processes and procedures in place.

In June 2011, the SEC entered into a consent order with several of the Morgan Keegan entities, with Kelsoe and other officers, and with the underwriter, imposing sanctions and $200 million in penalties. The SEC then proceeded to set its sights on Morgan Keegan’s Board of Directors. In December 2012, notwithstanding the fact that the SEC had alleged in the first proceeding that the Board was misled by Kelsoe, the SEC filed a complaint charging Morgan Keegan’s former directors with four separate violations of the federal securities laws.

In the end, the SEC pursued only the "failure to supervise" complaint and settled with the board on a single simple charge – failure to adopt and implement adequate valuation policies and procedures. The SEC found that Morgan Keegan’s valuation policies and procedures consisted of broad general statements that did little more than state general valuation concepts and regulatory standards. What was missing from these policies were concrete procedures to be followed when dealing with various types of illiquid and hard-to-price securities – in Morgan Keegan’s case, these included structured products such as CDOs, CMOs, CLOs, and various types of asset-backed securities, among others.

While the Morgan Keegan proceeding involved mutual funds and violations under the Investment Company Act, the valuation issues are no different from those faced by investment advisers under the Investment Advisers Act generally. Morgan Keegan’s valuation procedures read like many compliance policies that we see in the manuals of asset managers, especially those newly registered private fund managers, which are now subject to SEC oversight as a result of Dodd-Frank. Those compliance manuals recite the applicable law but often fail to take the critical step of outlining procedures that specifically relate to the adviser’s business and the securities in which it invests. The Morgan Keegan matter highlights the dangers of this practice.

So what should you do? Compliance policies as a general matter cannot and should not be one-size-fits-all. That is especially true for critical functions such as valuation of assets. Take a hard look at your valuation policies and procedures and ask the following questions:

  • Do your procedures outline a set of specific methodologies that are used to value different categories of securities and other investments, or are they a generic set of principles that offer no meaningful guidance relevant to the business of your firm? In the Morgan Keegan matter, Morgan Keegan’s valuation policies and procedures listed several factors for the funds’ valuation committee to consider in making fair-value determinations. As the SEC pointed out, however, these factors were taken nearly verbatim from Accounting Series Release No. 118 (which provides general guidance on fair valuation), and provided no meaningful methodologies for actually making fair-value determinations applicable to Morgan Keegan’s securities. The lesson: valuation policies should include specifics as to methodologies to be employed in undertaking fair-value determinations. The challenge is figuring out the appropriate level of specifics for your firm.

  • Do your valuation procedures specify the process for applying these methodologies? In addition to specifying appropriate methodologies for making fair-value determinations, you need to evaluate whether your valuation policies identify the process for applying these methodologies to the specific security types or asset classes in which your firm invests. This was another problem identified by the SEC in Morgan Keegan – Morgan Keegan’s valuation procedures provided no guidance on how to make fair-value determinations or how the factors listed in the policy should be interpreted.

  • Do your valuation procedures include procedures for the reporting, correction, and adjustment of valuations, in instances where these actions may be necessary? Policies and procedures should recognize and account for the fact that valuations change, and that valuations sometimes prove to be incorrect. In the case of Morgan Keegan, the firm adjusted valuations only where a sale or price confirmation indicated a variation of more than 5 percent from the security’s valuation. The SEC also found that portfolio manager James Kelsoe would repeatedly exercise discretion and give the fund accountants who were performing the valuations price adjustments for specific securities. The SEC faulted the Morgan Keegan board for not providing guidelines by which the reasonableness of adjustments could be evaluated.

  • Most importantly, do your valuation procedures reflect your actual practices, and are you following the procedures that your firm has adopted? This may sound like stating the obvious, but whatever policies and procedures you have in place, you need to follow them (although blindly following inadequate written procedures will not insulate you from regulatory repercussions). In Morgan Keegan, the SEC found several lapses in this regard. For instance, while Morgan Keegan’s procedures placed the responsibility for valuation with a valuation committee, in practice it was the firm’s fund accounting personnel who were running the valuations. Also, while the firm’s valuation procedures required that the directors be given meaningful explanatory notes for fair-value determinations on a quarterly basis, the SEC found that no such notes were presented to the board. The lesson: develop sound policies, say exactly what your procedures are and who is responsible for performing them, and then do what you said you were going to do.

In addition to these questions, you also need to assess your valuation procedures in the context of any track records used in PPMs and other marketing materials. For instance, do your valuation procedures address setting values for track records, the circumstances in which those valuations may need to be updated (and the associated documentation of those changes), and consistency between track records and ongoing performance reports? These questions take on added importance for managers who are considering whether to take advantage of the recent elimination of the ban on general advertising for private placements (see our July 17, 2013 Corporate and Securities Alert on this issue, "SEC Relaxes Ban on Advertising and Solicitation for Private Placements to Accredited Investors."

Morgan Keegan is the most recent and clearest indication of the SEC’s approach to valuation practices of asset managers. While these obviously are not the only considerations that boards, managers, and CCOs need consider when it comes to valuation and the procedures that govern this process, the deficiencies identified by the SEC in Morgan Keegan should guide managers on what to expect in a regulatory exam. Even before the release of Morgan Keegan, we were seeing an increased focus on valuation procedures by investment managers, which have increasingly sought outside guidance for improving their valuation practices. If any added incentive is needed in this regard, just pick up a copy of the Morgan Keegan decision and read it firsthand.

In Part 2, we’ll address corporate governance issues that flow out of Morgan Keegan, and the significant implications that the SEC’s aggressive approach has for directors that sit on fund boards. Stay tuned.

Written by:

Pepper Hamilton LLP
Contact
more
less

Pepper Hamilton LLP on:

Readers' Choice 2017
Reporters on Deadline

"My best business intelligence, in one easy email…"

Your first step to building a free, personalized, morning email brief covering pertinent authors and topics on JD Supra:
Sign up using*

Already signed up? Log in here

*By using the service, you signify your acceptance of JD Supra's Privacy Policy.
Privacy Policy (Updated: October 8, 2015):
hide

JD Supra provides users with access to its legal industry publishing services (the "Service") through its website (the "Website") as well as through other sources. Our policies with regard to data collection and use of personal information of users of the Service, regardless of the manner in which users access the Service, and visitors to the Website are set forth in this statement ("Policy"). By using the Service, you signify your acceptance of this Policy.

Information Collection and Use by JD Supra

JD Supra collects users' names, companies, titles, e-mail address and industry. JD Supra also tracks the pages that users visit, logs IP addresses and aggregates non-personally identifiable user data and browser type. This data is gathered using cookies and other technologies.

The information and data collected is used to authenticate users and to send notifications relating to the Service, including email alerts to which users have subscribed; to manage the Service and Website, to improve the Service and to customize the user's experience. This information is also provided to the authors of the content to give them insight into their readership and help them to improve their content, so that it is most useful for our users.

JD Supra does not sell, rent or otherwise provide your details to third parties, other than to the authors of the content on JD Supra.

If you prefer not to enable cookies, you may change your browser settings to disable cookies; however, please note that rejecting cookies while visiting the Website may result in certain parts of the Website not operating correctly or as efficiently as if cookies were allowed.

Email Choice/Opt-out

Users who opt in to receive emails may choose to no longer receive e-mail updates and newsletters by selecting the "opt-out of future email" option in the email they receive from JD Supra or in their JD Supra account management screen.

Security

JD Supra takes reasonable precautions to insure that user information is kept private. We restrict access to user information to those individuals who reasonably need access to perform their job functions, such as our third party email service, customer service personnel and technical staff. However, please note that no method of transmitting or storing data is completely secure and we cannot guarantee the security of user information. Unauthorized entry or use, hardware or software failure, and other factors may compromise the security of user information at any time.

If you have reason to believe that your interaction with us is no longer secure, you must immediately notify us of the problem by contacting us at info@jdsupra.com. In the unlikely event that we believe that the security of your user information in our possession or control may have been compromised, we may seek to notify you of that development and, if so, will endeavor to do so as promptly as practicable under the circumstances.

Sharing and Disclosure of Information JD Supra Collects

Except as otherwise described in this privacy statement, JD Supra will not disclose personal information to any third party unless we believe that disclosure is necessary to: (1) comply with applicable laws; (2) respond to governmental inquiries or requests; (3) comply with valid legal process; (4) protect the rights, privacy, safety or property of JD Supra, users of the Service, Website visitors or the public; (5) permit us to pursue available remedies or limit the damages that we may sustain; and (6) enforce our Terms & Conditions of Use.

In the event there is a change in the corporate structure of JD Supra such as, but not limited to, merger, consolidation, sale, liquidation or transfer of substantial assets, JD Supra may, in its sole discretion, transfer, sell or assign information collected on and through the Service to one or more affiliated or unaffiliated third parties.

Links to Other Websites

This Website and the Service may contain links to other websites. The operator of such other websites may collect information about you, including through cookies or other technologies. If you are using the Service through the Website and link to another site, you will leave the Website and this Policy will not apply to your use of and activity on those other sites. We encourage you to read the legal notices posted on those sites, including their privacy policies. We shall have no responsibility or liability for your visitation to, and the data collection and use practices of, such other sites. This Policy applies solely to the information collected in connection with your use of this Website and does not apply to any practices conducted offline or in connection with any other websites.

Changes in Our Privacy Policy

We reserve the right to change this Policy at any time. Please refer to the date at the top of this page to determine when this Policy was last revised. Any changes to our privacy policy will become effective upon posting of the revised policy on the Website. By continuing to use the Service or Website following such changes, you will be deemed to have agreed to such changes. If you do not agree with the terms of this Policy, as it may be amended from time to time, in whole or part, please do not continue using the Service or the Website.

Contacting JD Supra

If you have any questions about this privacy statement, the practices of this site, your dealings with this Web site, or if you would like to change any of the information you have provided to us, please contact us at: info@jdsupra.com.

- hide
*With LinkedIn, you don't need to create a separate login to manage your free JD Supra account, and we can make suggestions based on your needs and interests. We will not post anything on LinkedIn in your name. Or, sign up using your email address.
Feedback? Tell us what you think of the new jdsupra.com!