Wednesday, June 22, 2011

Funds’ Distributor and Adviser Settle Fraud Charges Related to Subprime Mortgage-Backed Securities in Coordinated Federal-State Action

The SEC, state regulators, and FINRA have settled proceedings against an investment adviser to investment companies and a broker-dealer that underwrote and distributed the funds’ shares. Without admitting or denying the charges, the broker and adviser agreed to pay $200 million to settle fraud charges related to subprime mortgage-backed securities and a former senior portfolio manager agreed to pay penalties for his alleged misconduct, and was barred from the securities industry. The SEC brought its enforcement action in coordination with FINRA and a task force of state regulators from Alabama, Kentucky, Mississippi, Tennessee and South Carolina.
Alabama Securities Commissioner Joe Borg said that, while the SEC and the state regulators proceeded on parallel tracks, there was some overlap and also a tremendous amount of cooperation.

Commissioner Borg noted that the state regulators focused on sales practices, the SEC focused on pricing, and FINRA focused on advertising. Of the $200 million settlement fund, Commissioner Borg noted that $100 million is going into an SEC Fair Fund for the benefit of investors and $100 million into a state fund that also will be distributed to investors. He also emphasized that investors are not giving up any arbitration claims that they may have in connection with the activities of the firms. Shonita Bossier of the Kentucky Department of Financial Institutions emphasized that the proceedings put firms on notice that these types of practices will not be tolerated.

William Hicks, Associate Director for the SEC’s Atlanta Regional Office, added that this enforcement action clarifies that the SEC will deal firmly with those who abuse their responsibility to assign accurate values to securities or other assets held by funds. Robert Khuzami, Director of the SEC’s Division of Enforcement emphasized that the falsification of fund values misrepresented critical information exactly when investors needed it most, that is, when the subprime mortgage meltdown was impacting the funds.

Specifically, the SEC found that the portfolio manager instructed the fund’s accounting department to make arbitrary price adjustments to the fair values of certain portfolio securities. The price adjustments ignored lower values for those same securities provided by outside broker-dealers as part of the pricing process, and often lacked a reasonable basis. In some instances, when price information was received that was substantially lower than current portfolio values, fund accounting personnel acted at the direction of the manager and lowered values of bonds over a period of days in a series of pre-planned reductions to values at or closer to the price confirmations. As a result, during the interim days, the fund did not price those bonds at their current fair value.

The SEC also found that the portfolio manager screened and influenced the price confirmations obtained from at least one broker-dealer. Among other things, the broker-dealer was induced to provide interim price confirmations that were lower than the values at which the funds were valuing certain bonds, but higher than the initial confirmations that the broker-dealer had intended to provide. The interim price confirmations enabled the funds to avoid marking down the value of securities to reflect current fair value. According to the SEC’s order, through his actions the portfolio manager fraudulently prevented a reduction in the NAVs of the funds that should otherwise have occurred as a result of the deterioration in the subprime securities market in 2007. This misconduct, said the SEC, occurred in the context of a nearly complete failure to employ the fair valuation policies and procedures adopted by the funds’ boards of directors to fair value the funds’ portfolio securities

Many of the securities held by the funds and backed by subprime mortgages lacked readily available market quotations and, as a result, were required by the Investment Company Act to be priced by the funds’ boards of directors, using fair value methods. Under Section 2(a)(41)(B) of the Investment Company Act, the funds were required to use market values for portfolio securities with readily available market quotations and use fair value for all other portfolio assets, as determined in good faith by the board of directors. The fair value of securities for which market quotations are not readily available is the price the funds would reasonably expect to receive on a current sale of the securities

Under the state consent orders, the firms were prohibited from creating, offering or selling any proprietary funds for a period of two years. Further, if the firms form and sell any proprietary investment products before January 1, 2016, for three years the firms are required to retain an independent auditor acceptable to the SEC and state securities regulators from Alabama, Kentucky, Mississippi, South Carolina and Tennessee.

Also, for the next three years, the firms must provide special mandatory training to all of their registered agents and investment adviser representatives, which is required to be comprehensive for each of the products and offerings sold or recommended to clients. The firms must also conduct training on suitability and risks of investments. They are also prohibited from having one person simultaneously hold the positions of general counsel and chief compliance officer.

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