The SEC have just settled a case under which Morgan Keegan, a Tennessee subsidiary of Regions Bank, agreed to pay $200 million (without - of course - admitting or denying any of the findings!) to settle fraud charges related to deliberate mismarking of ABS / subprime positions in a 1940 Act registered mutual fund. The SEC's press release is available here, and the full text of the SEC's order is presented here.
According to the latter document, Morgan Keegan was responsible for valuing securities in its own mutual funds. The first warning sign, therefore, is the absence of a third party administrator or valuation agent. Despite being a highly regulated mutual fund, the funds were still exposed to the unavoidable conflict of the management company marking its own book.
In this case, things went predictably wrong as the sub prime market fell apart in early 2008. According to the SEC, the alleged actions included:
- Morgan Keegan's fund accounting group periodically obtained broker-dealer price confirmations for certain fair valued securities. Unbeknownst to the fund accounting group and the fund's independent auditor, the portfolio manager actively screened and influenced a broker-dealer to change the price confirmations that the fund accounting group and auditor obtained from that broker dealer;
- Morgan Keegan's valuation committee left pricing decisions to lower level employees in the fund accounting who "did not have the training or qualifications to make fair value pricing determinations";
- Fund accounting personnel relied on the portfolio manager's "price adjustments" to determine the prices assigned to portfolio assets. Per the SEC, these adjustments were "arbitrary and did not reflect fair value. The price adjustments were routinely entered upon receipt by the staff accountant in a spreadsheet used to calculate the NAV of the Funds." (They are using a spreadsheet to calculate the NAV of a 40 Act mutual fund??) Further, "Fund accounting and the Funds did not record which securities had been assigned values by the portfolio manager"';
- Fund accounting personnel gave the portfolio manager discretion...to determine which dealer price confirmations to use and which to ignore, without obtaining documentation to support his adjustments;
- The valuation committee and fund accounting did not ensure that the fair value prices assigned to many of the portfolio securities were periodically re-evaluated, allowing them to be carried at stale values for months at a time (months??);
- In some instances, when price confirmations were received that were substantially lower than current portfolio values, Fund Accounting personnel, acting at the discretion of the portfolio manager, lowered values of bonds over a period of days, in a series of pre-planned reductions to values at or closer to, but still above, the price confirmations.
Cherry picking of broker quotes, manipulation of broker dealer information, control of the pricing process by the portfolio manager without challenge from the back office - this one has it all.
For hedge fund investors, this case is yet another reminder that some portfolio managers - either to make more money or to cover up losses - will push pricing issues to the edge. Some will inevitably push beyond into deliberate misvaluation. In this instance, the strongest form of regulated fund structure - a 40 Act mutual fund - made not one bit of difference to prevent the PM cooking the pricing books.
As such, this case is a $200 million reminder that, as always, best practice must be to separate portfolio management from the valuation process, with an independent, third party responsible for pricing portfolio securities in the NAV. After all, even the most honest portfolio manager can make an honest mistake and, inevitably, a handful of portfolio managers will be dishonest.
Equally, Morgan Keegan shows the enormous value that an effective, third party administrator can provide to the hedge fund investor. However, readers of Risk Without Reward will not be surprised with our final comment = investors need (and are prepared to pay for) an administrator who prices the portfolio themselves, not as directed by the manager, and who applies a degree of skill and expertise far beyond the apparent level of the back office employees in this case.
As always, it is the most difficult to price securities which are the most susceptible to deliberate mispricing, so it is these securities where investors need administrators to focus their greatest efforts on independent pricing. Otherwise the next Morgan Keegan could very easily be a hedge fund.
Hedge Fund Operational Due Diligence
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