$200 Million Settlement Paid Relating to Mortgage Backed Security Valuations

Posted by Susan Mangiero on July 06, 2011

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Investors rely on the net asset values ("NAVs") provided to them as a way to make all sorts of financial decisions such as asset allocation, rebalancing, hedging and possibly exiting a particular money pool.

In a recent case, the bear invaded the tent, eventually denying investors for several funds any illusion about security related to being able to use "good" valuation numbers. According to a June 22, 2011 cease and desist order against Morgan Asset Management, Inc. and other respondents, the way that valuation numbers were assembled for purposes of providing daily NAVs "inaccurately inflated the prices of certain securities, contrary to the Funds' valuation procedures." In addition, several accounting professionals failed to "document justifications for such pricing adjustments."

At stake with any of these valuation cases is a legitimate desire on the part of the investing public to understand how the numbers come to be. In this particular case, Morgan funds held subprime mortgages that had to be "fair valued" with market quotations not always readily available. When broker-dealer confirmations were available, they were not always used and sometimes discarded.

Besides the payment of $200 million in disgorgement and civil fines, Morgan Asset Management Inc. and Morgan Keegan & Company agreed to be censured, fully cooperate with the SEC in any other investigations that relate to trading and/or valuing a fund's portfolio or its components and a prohibition against fair valuing any fund portfolio instruments for three years. Click to download the SEC Cease and Desist Order "In the Matter of Morgan Asset Management" et al, June 22, 2011. 

The harm to investors should be clear. For one thing, in bad markets when it became harder to liquidate complex instruments, inflated valuation numbers may have incorrectly dissuaded some investors from redeeming had they known the truth. Additionally, better than real numbers line the pockets of fund personnel when investors end up paying "higher" fees for "artificially" better performance.

Attorney Robert Robertson at Dechert has an interesting article about this case, laying out the facts, the violations and related cases. His conclusion from a review of various SEC cases involving the valuation of fund portfolios is that sound procedures must be adopted and followed. Moreover, he adds that procedures need to be properly documented and that "there should be checks and balances so that one person does not have the ability to circumvent the system." Click to read "Morgan Keegan Settles SEC Fraud Charges Related to Mortgage-Backed Securities Valuations in its Registered Funds," Dechert On Point, July 2011.

The terms of the settlement are far from trivial and may have influenced the decision to find a suitor for the Morgan Keegan enterprise. According to "TARP pressure behind Regions putting Morgan Keegan up for sale" by Ted Carter (Mississipi Business Journal, June 27, 2011), raising capital and regulatory costs are proffered explanations for why Regions Bank (owner of Morgan Keegan) has hired Goldman Sachs to "review 'strategic alternatives' for Morgan Keegan."

Life for Broker-Dealers With An Expanded Definition of Fiduciary

Posted by Susan Mangiero on March 10, 2011

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The U.S. Department of Labor's ("DOL") proposal to expand the definition of fiduciary is stirring the pot for multiple sectors of the investment world. Investment News journalist Darla Mercado writes that the U.S. Securities and Exchange Commission ("SEC") and the DOL should work together on any initiative that expands the scope of the fiduciary in order to ensure compatiability across regulators. See "B-Ds plead for DOL, SEC to team up on fiduciary rule: Efforts to rewrite regulations produce overlap, angst" (March 3, 2011). In reviewing the comment letters submitted to the U.S. Department of Labor on this matter, I came across a particularly interesting response on behalf of broker-dealers and asked the primary author to elaborate. In the Q&A that follows, Attorney John R. Fahy (with Whitaker Chalk Swindle & Sawyer) predicts big changes ahead.

Q: You represent broker-dealers as a securities attorney and authored the 33-page letter to the Employee Benefit Security Administration ("EBSA") dated January 11, 2011. In that letter, you suggest that certain transactions may no longer be available to ERISA plans should rules change. As things stand today, SEC-licensed securities brokers and dealers who act only as "executor of instructions relating to securities transactions during the ordinary course of its business as a  broker or dealer" are exempted from the definition of ERISA fiduciary. Would you elaborate?

A: It's helpful to consider what broker-dealers are likely to stop doing on behalf of ERISA plans should they be forced to wear the hat of fiduciary. For one thing, if a plan sponsor wants to get a second opinion about something like asset allocation trends or the state of the economy from a broker-dealer with which it has a long-standing relationship, that broker-dealer is almost surely going to say "no" for fear of being seen as giving advice and, by extension, having fiduciary liability. Plan sponsors won't get the benefit of a "give and take." This may not be a huge problem for larger plans that have the budget to hire consultants. It could be a problem for smaller plans and individual investors such as IRA account owners. Blocked communications could impede investment literacy at a time when financial planning education is critical.

Q: ERISA currently defines certain transactions as "prohibited." Should the ERISA fiduciary definition be expanded, how will the universe of services now provided by broker-dealers to ERISA plans change?

A: ERISA has a list of specific prohibited transactions that cover many of the services that broker-dealers provide to plans and plan participants. For example, ERISA prohibits ERISA fiduciaries from loaning money or otherwise providing credit facilities to plan and plan participants. In the broker-dealer context, this would mean no more margin accounts from broker-dealers deemed to be fiduciaries. Margin accounts are required for options. So plan and plan participants would not be able to engage in legitimate option-based hedges of their holdings through such accounts. The broker-dealer industry does have a split between the clearing brokers - those who provide the margin loans - and the introducing broker-dealers that provides the personalized services. An argument could be made that the firm providing the credit facility is not the one that recommends transactions. However, clearing agreements typically allow the clearing firm to pursue the introducing broker-dealer for unpaid customer margin losses. In this sense, the introducing broker(s) would be on the hook for the credit facility. I am not sure what impact that would have as an ERISA prohibited transaction. Additionally, none of the foregoing applies to self-clearing firms that may be in the position of both recommending a transaction and providing the credit facility. These organizations may be deemed to be a fiduciary and forced to shed the margin loan(s) in place. Generally speaking, plans and their participants will have a narrower universe of investment and financing choices. Investment services will cost more and there will be fewer counterparties available. ERISA also prohibits self-dealing transactions. As a result, principal trades would be construed as a prohibited transaction, even if the principal trade settlement could have fulfilled the trade order at a better prices than an agency trade. Firmly underwritten offerings such as IPOs would be off limits as they would be deemed principal trades. To reiterate, ERISA plans and plan participants would see their investment selection pool shrink.

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Fiduciary Duties, Post Madoff

Posted by Susan Mangiero on March 02, 2011

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In "The Post-Madoff Emergence of a Fiduciary Duty of Due Diligence - Recent Regulatory Enforcement Actions and Their Impact on Best Practices for Investment Managers" (Practical Compliance & Risk Management For The Securities Industry, September-October 2009), Attorneys Scott A. Meyers and James G. Martignon describe a renewed scrutiny of the relationship between hedge funds, investment advisers, broker-dealers and their investors. As a follow-up, Chicago-based Attorney Martignon (with Ulmer & Berne LLP) answered additional questions about the investment world in the aftermath of highly publicized financial fallout.

Q: Jim, I came across your interesting article in research for my new book on investment risk governance. You and Attorney Meyers did a terrific job of elaborating on fiduciary duties and the relationship between asset managers and their clients. Thanks for joining me today to talk further about this important topic. Let's start with understanding your motivation to write the article.

A: It's pretty straightforward. Our clients are mostly asset managers and broker-dealers. With so much news about regulatory mandates and the increased number of lawsuits being filed in the last few years, our clients asked for more information about their responsibilities to investors and what they should be doing differently, if anything, to mitigate their risks.

Q: Whom do you think bears the responsibility for compliance at a fund and is good governance seen as a differentiator?

A: Good fund managers care about doing the right thing for their investors. It's always a balancing act between the general counsel and chief compliance officer and the sales team. However, unless a fund is around for the long haul, everyone loses. Business development professionals have a lot to gain by supporting their colleagues in legal and compliance. Importantly, it's not just adhering to the letter of the law. Fiduciary duty means applying common sense as well. I recall hearing the former head of the SEC's Office of Compliance and Investigations and Examinations tell a story that stayed with me. A hedge fund chose not to do something that was legal but didn't quite pass the smell test. The examiners were impressed that the fund was sensitive to going the extra mile. 

Q: Is there a difference between vulnerability to litigation for a fund that trades more frequently?

A: Probably. For example, the trigger factors for a hedge fund that actively trades are likely to be different than let's say a private equity fund that can perhaps dedicate more resources to monitor fewer positions. With more active trading (and I'm not even addressing high frequency trading issues here), issues that attract scrutiny include compensation, performance reports, trading across multiple entities and delegation of some work to others (such as a custodial bank or prime broker).

Q: You write extensively about fiduciary duties that include (a) good faith, full and fair disclosure (b) prudence in selecting agents and in making and monitoring investments (c) fulfilling representations made to clients and(d) furnishing information to clients, obtain material information and disclose limitations on inquiry or investigation. Are you saying that these duties are more important now than in the past?

A: No. Discharging one's fiduciary duties have always been important. It's just that so many investors were surprised by situations involving investment fraud as well as those that reflected poor oversight of operational and financial risks. Things go in waves and financial reform is no different. The Madoff scandal revealed chinks in the armor. You had a name fund manager that consistently reported great returns and continued to attract investors. Given the scale of losses, it's no surprise that people took a further look at what went wrong. We've lived through investment fraud before but never had multiple catalysts occurring at the same time. After news broke about Lehman Brothers, Bear Stearns and others, investors clamored for answers about systemic vulnerability. For example, if an investor allocates money to a hedge fund, they have to understand that they are exposed to a wide array of risks, not just the price movement of what's inside the hedge fund's portfolio.

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