Fair Valuation and Mutual Fund Directors: History of Enforcement Actions Against Independent Directors

by Reed Smith

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:


Findings Regarding Independent Directors

Sanctions for Independent Directors

In the Matter of Parnassus Investments, et al. [hereinafter the Parnassus Directors Order]2

Directors approved the overvaluation of a portfolio company (including using quotations for unrestricted shares to value restricted shares) over a period of more than two years.

Cease & Desist

In the Matter of Monetta Financial Services, Inc., et al. [hereinafter the Monetta Directors Order]3

Insufficient evidence for the SEC to conclude that investment adviser gave directors preferred treatment with respect to IPOs also allocated to the directors’ funds and other clients.

SEC reversed sanctions imposed by ALJ

In the Matter of Jon D. Hammes, et al. [hereinafter the Hartland Directors Order]4

Directors failed adequately to assure that a number of high-yield municipal bonds were priced at “fair value,” or failed adequately to monitor and assure the bonds’ liquidity.

Cease & Desist

In the Matter of Robert S. Colman [hereinafter the Van Wagoner Director Order]5

Director invested in nine private placements at the same time as his funds, which constituted joint arrangements subject to Rule 17d-1, without first seeking exemptive relief from the SEC.

Cease & Desist
$16,800 Disgorgement
$25,000 Civil Penalty

Rockies Fund, Inc. v. S.E.C. [hereinafter the Rockies Directors Order]6

Directors overvalued a portfolio company (including using quotations for unrestricted shares to value restricted shares) in financial reports for a period of five quarters, and also misclassified some of the shares as unrestricted and overstated the number of shares owned by the fund.

Three-year bar
$20,000 Civil Penalty

In the Matter of J. Kenneth Alderman, CPA, et al. [hereinafter the RMK Directors Order]7

Directors did not specify a fair valuation methodology pursuant to which the securities (which represented upwards of 60 percent of some of their fund’s net assets) were to be fair valued. They failed to review continuously how each issue of security in the funds’ portfolios were being valued. Directors delegated their responsibility to determine fair value to a Valuation Committee of the investment adviser to the funds, but did not provide any meaningful substantive guidance on how the committee should determine fair values. In addition, they did not learn how the Valuation Committee actually determined fair values. They received only limited information on the factors considered in making fair value determinations, and almost no information explaining why fair values were assigned to specific portfolio securities.

Three-year bar
$20,000 Civil Penalty

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

In the next Client Alert, we will examine the Investment Company Act’s definition of “value” and consider some of its shortcomings. 

  1. As used in this Client Alert, an “independent director” is a director or trustee of an investment company registered with the SEC who is not an “interested person” as defined in § 2(a)(19).
  2. Release No. ID-131, 67 S.E.C. Docket 2760 (Sep. 3, 1998).
  3. Inv. Co. Act Release No. 26070, 80 S.E.C. Docket 1257 (June 9, 2003); vacated in part with respect to other parties, Monetta Financial Services, Inc. v. S.E.C., 390 F.3d 952 (7th Cir. Nov. 30, 2004).
  4. Inv. Co. Act Release No. 26290, 81 S.E.C. Docket 2467 (Dec. 11, 2003).
  5. Inv. Co. Act Release No. 26581, 83 S.E.C. Docket 1979 (Aug. 26, 2004).
  6. 428 F.3d 1088 (D.C. Cir. Nov. 15, 2005); on remand, In the Matter of the Rockies Fund, Inc., et al., Inv. Co. Act Release No. 27593, 89 S.E.C. Docket 1384 (Dec. 7, 2006); reconsideration denied, Inv. Adv. Act Release No. 27961, 91 S.E.C. Docket 1289 (Aug. 31, 2007); review denied, Rockies Fund, Inc. v. S.E.C., 298 Fed. Appx. 4 (D.C. Cir. Oct. 21, 2008).
  7. Inv. Co. Act Release No. 30557, 2013 WL 2646182 (June 13, 2013).



DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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