Fair Valuation And Mutual Fund Directors: History Of Enforcement Actions Against Independent Directors

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:

Matter

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...