Lawsuits Against UltraShort Bond Funds Highlight The Enforcement Risks Of Valuing Illiquid Portfolio Assets In An Uncertain Economic Environment

In recent months, major mutual fund complexes[1] have been named as defendants in securities class action lawsuits and others have received subpoenas from the Staff's of regulatory enforcement agencies contending that they have overstated asset value. In substance, the suits allege and the investigative subpoenas suggest that the fund companies, their investment advisers, or Boards of Directors misrepresented or failed to disclose the "true value" of underlying portfolios which were invested heavily in asset-backed securities. While these proceedings are somewhat unexceptional in their focus on garden-variety misrepresentation claims, they nevertheless highlight a growing regulatory risk related to the valuation of illiquid portfolio assets.

The Investment Company Act of 1940 ("'40 Act") requires mutual fund Boards to determine and report the "fair value" of fund portfolio investments. The recently enacted Financial Accounting Standards Board Rule 157 ("FAS 157"), specifies a more rigorous process for ascertaining "fair value." FAS 157 identifies three types of assets for fair value accounting: (1) Level One, involving assets with prices quoted in active markets, such as stocks traded on the major exchanges; (2) Level Two, involving assets without prices quoted in active markets and for which valuation depends on other comparable, observable inputs; and (3) Level Three, which relates to assets with "no observable inputs." Unlike the other asset tiers, the valuation of Level Three assets tests a series of assumptions (unobservable inputs), rather than by reference to an explicit market price. Under FAS 157, a reporting entity is required to give the highest priority to observable inputs to the extent available.[2]

In the current credit crisis, billions of dollars of ultrashort bond fund portfolio investments have become illiquid or significantly declined in value (for example, in the case of mezzanine structured-finance CDOs based on BBB- or AA-rated mortgage-backed securities tranches). Fund companies should expect securities regulators to closely scrutinize whether fund Boards have fulfilled their responsibilities under the '40 Act to ensure that any Level 2 or Level 3 portfolio assets have been priced at fair market value.

Fixed income valuation is a relatively new arena for financial regulators, particularly in light of the recently adopted FAS 157, and enforcement agencies are likely to begin from the familiar premise that portfolio assets can be valued with precision based on reference to ascertainable market prices. That much is clear from several investigations currently underway in which the regulators believe that funds have overstated the value of Level 3 assets to boost their overall portfolio values.

Notwithstanding the intensity of enforcement efforts in the current economic environment, fund companies who are confident as to the adequacy of their valuation processes should stand by the resultant valuations of Level 2 and Level 3 assets. Even if a security subsequently suffered a decline in value, a defensible pricing procedure satisfies a fund Board's obligation under the '40 Act. Indeed, the SEC itself has recognized that there may be multiple "fair values" for a portfolio of assets within a range of reasonable valuations.[3] In assessing the adequacy of valuation procedures, fund companies should consider the consistency, transparency, and appropriateness of their pricing methodologies to ensure that the valuation process is sound and free from apparent or actual conflicts of interest.

Aside from the procedural valuation issues, fund companies should also be mindful of the potential conflicts emerging from internal oversight and valuation committee structures. Cross-investment and cross-directorship arrangements are commonplace in large fund complexes. But in an environment where fund assets are increasingly priced on the basis of the discretionary valuation determinations, even the appearance of conflict may be sufficient to trigger an investigation and enforcement activity. The appearance of conflict may arise, for example, when the Director of a fund with a large ownership interest in an affiliated fund is tasked with pricing the portfolio assets of the affiliated fund. Similarly, the practice of having the portfolio manager, rather than an independent committee, get pricing indications, in many cases from the broker-dealer who originally sold them the securities, may also raise conflict issues. Investment companies should carefully inventory all director and committee membership assignments (particularly valuation and pricing committee membership) and the underlying fund reporting relationships to identify potential conflicts before they arise in the enforcement context.

Fund Boards should consider the following key principles when auditing or implementing their internal pricing and valuation protocols:

• Maintain a clearly stated valuation policy that provides a framework for valuing investments at fair value. The policy should ensure that all investment valuations are transparent and that procedures are consistently applied across portfolio investments. The policy should also require each valuation to be supported by appropriate documentation that describes the procedures for identifying and validating inputs, specify the process for assigning assets to a FAS 157 level, and provide for periodic review of pricing procedures to ensure continued compliance with relevant legal and accounting standards and market conditions. The persons participating in the valuation process should either be free of significant conflicts or their participation should be subject to well-designed oversight.
• Designate and maintain a clear valuating and pricing committee structure. Fund Boards should consider designating a non-Board committee with responsibility for overseeing and implementing the valuation policy. Committee responsibilities should include among other things, conducting regular reviews of fund portfolio investment valuations to ensure that such valuations adhere to the established valuation policy and that these determinations are made in a process free from conflict.
• Document all valuation determinations. Because the reasonableness of "fair value" determination of Level 3 assets will necessarily depend on the reasonableness of the process, it is essential that the valuation process be well-documented. In addition to supporting documentation for each valuation, the valuation committee (and any sub-committee to which it delegates valuation responsibilities) should maintain meeting minutes, including a record of all investment valuations approved at such meetings and documentation relied on by the committee to determine or approve such valuations.
  

Funds that do not already have a clear and consistent valuation process in place, which takes into account FAS 157, should consider implementing one immediately. The policies and procedures governing that valuation process should include full documentation of the considerations and debate surrounding the valuation of the assets underlying the bond fund. Designing and executing appropriate protocols, and undertaking a consistent review to ensure that they remain appropriate to the circumstances, should go a long way towards convincing enforcement authorities that the fund's valuation was reasonable. There should also be a process to cross-check among funds within a family to ensure that the same valuation range is applied to the same security across all funds. 

In light of the prolonged illiquidity in the structured product marketplace, fund Boards—and particularly Boards of bond funds and those funds that invest heavily in structured products—should take this opportunity to review their pricing and valuation policies and procedures to determine whether they are likely to provide a reasonable and transparent fair market valuation of illiquid assets. Funds should prepare to defend their process and resist the Staff's attempts to favor any points within the range of valuation over others. The tendency of the Staff to anchor its position to hindsight will likely, in the current environment, result in the lower end of the range appearing more reasonable than the higher end. A focus on individual points derived by application of reasonable assumptions should be rejected by re-directing the inquiry to the adequacy of the process. Fund Boards should prepare now for these inquiries by conducting a careful review of their pricing procedures, consistency of application, and committee structures to ensure that Level 2 and Level 3 assets are valued in a manner consistent with their obligations under the Investment Company Act of 1940.

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Footnotes:
1. See, e.g., Zametkin v. Fidelity Management & Research Co., et al. (D. Mass); Bohl v. The Charles Schwab Corp., et al., (D. Mass.); Keefe v. Evergreen Investment Management Co. LLC, et al. (D. Mass.); Houston Police Officers' Pension System v. State Street Bank and Trust, et al. (S.D. Tex.).
2. Following the implementation of FAS 157, the SEC issued guidance to public companies regarding enhanced Form 10-Q Management Discussion and Analysis disclosures with respect to the application of FAS 157. See http://www.sec.gov/divisions/corpfin/
guidance/fairvalueltr0308.htm. As a practical matter, this letter only provides guidance with respect to MD&A disclosures and does not purport to interpret or apply FAS 157.
3. For example, the Sample Letter Sent to Public Companies On MD&A Disclosure Regarding FAS 157, note 2 supra, states the public companies should: "consider providing a range of values around the fair value amount [they] arrived at to provide a sense of how the fair value estimate could potentially change as the significant inputs vary."
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This memorandum is a summary for general information and discussion only and may be considered an advertisement for certain purposes. It is not a full analysis of the matters presented, may not be relied upon as legal advice, and does not purport to represent the views of our clients or the Firm. Contributing to the content of this article are Lizzie Baird, an O'Melveny partner licensed to practice law in the District of Columbia and Virginia who traded bonds on Wall Street for nearly 10 years, Richard Grime, an O'Melveny partner licensed to practice law in the District of Columbia who spent over nine years in the Division of Enforcement at the U.S. Securities and Exchange Commission (SEC), Chris Salter, an O'Melveny partner licensed to practice law in the District of Columbia and Virginia and who formerly worked at the SEC as an Attorney in the Division of Market Regulation, and Schan Duff, an O'Melveny counsel licensed to practice law in the District of Columbia and California who has also represented financial services firms and other clients before state and federal courts around the nation, as well as before regulatory agencies including the Federal Trade Commission and SEC.

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