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.