The role of mutual fund boards in the valuation of portfolio securities continues to receive a great deal of attention from the Securities and Exchange Commission, fund directors, and the ’40 Act bar. When I was director of the Division of Investment Management at the SEC, I often spoke with fund directors and their counsel about the issue. In this article, I will outline directors’ obligations regarding valuation and suggest some best practices for directors.
Mutual funds are managed by directors who have state law duties to shareholders. However, under state law, directors generally are not responsible for the day-to-day operations of the business. Delaware, for example, acknowledges that directors are “required only to authorize the most significant corporate acts or transactions. …” Directors owe a state law fiduciary duty to the fund’s shareholders, a duty which generally aligns directors with the portion of the SEC’s mission that is to “protect investors.” However, the recent enforcement case brought against directors in Morgan Keegan has strained the SEC’s relationship with fund directors over directors’ role in the valuation of securities held by funds.
The Investment Company Act and the SEC’s rules thereunder impose significant additional duties on fund directors beyond state law. In fact, when I was a regulator, it worried me that the default policy solution on many tough issues is to add board responsibility to approve or disprove an action. The problem with the approach of additional responsibility is that I have never seen the Commission take away any duties from boards, leaving directors with an awfully full plate.
Section 2(a)(41) of the Investment Company Act states that, with some exceptions, the value of an investment company’s portfolio will be “(i) with respect to securities for which market quotations are readily available, the market value of such securities; and (ii) with respect to other securities and assets, fair value as determined in good faith by the board of directors. …” However, if the investment company controls the companies whose assets are being valued, it is allowed to calculate the value on its own as long as its calculated value does not exceed market price.
As recently as the 2014 Money Market Fund Reform adopting release, the Commission acknowledged that funds can use pricing services to value the fund holdings, but emphasized that ”a fund’s board of directors has a non-delegable responsibility to determine whether an evaluated price provided by a pricing service, or some other price, constitutes a fair value for a fund’s portfolio security.”
The SEC has brought cases against fund directors for violating the Investment Company Act’s valuation responsibilities. In Morgan Keegan, the SEC charged eight former members of the boards of five investment companies, for which Morgan Asset Management, Inc., served as investment adviser. The funds held below-investment-grade debt securities without ready market quotations that were fair valued. The SEC found that “[t]he directors did not provide…guidance…on how to determine fair value beyond what was stated in the Valuation Procedures,” which were, in turn, an almost exact copy of the procedures in an SEC document, without demonstrating further thought or consideration for how those policies should be tailored to the funds’ individual situations.
Morgan Keegan is not the first time the SEC charged an investment company’s directors with valuation failures. In the 2005 case Rockies Fund, Inc. v. S.E.C., the SEC found that Rockies Fund, Inc., directors overvalued the largest holding within the fund’s portfolio. On appeal, the D.C. Circuit ruled that the fund followed neither its own prospectus (in which four valuation methods had been disclosed) nor standard accounting practices. The D.C. Circuit noted that “[s]uch a haphazard process for valuing the largest holding of the fund constitutes an ‘extreme departure from the standards of ordinary care’ that should have been obvious to all the fund’s directors.”
Although it was not the first case involving improper valuations, the Morgan Keegan case generated understandable concern among directors that they would be held liable for valuation decisions even though they are not on-site at the fund making valuation decisions every day. As I visited fund firms while at the SEC, directors expressed their concern that they have limited power over valuation, as they are not full-time employees of the fund. As with recent cases against another group that the SEC relies on to protect investors—chief compliance officers at investment advisers—the SEC must always be careful that their lawsuits and enforcement actions do not discourage qualified people from becoming directors or CCOs.
The Way Forward to Protect Directors
In my experience, SEC personnel understand that directors are not conducting valuations of securities themselves. Although directors are not expected to actually do the required calculations—officers and employees are—they play an essential role in ensuring securities are fairly valued. Directors who want to avoid liability for valuation should focus on the fund’s policies and procedures. I recommend:
- Establishing robust policies and procedures on how securities will be valued;
- Overseeing the fund’s valuation process to make sure that the policies and procedures are being carried out and document any exceptions;
- To the extent possible, testing fund valuations to judge effectiveness of the policies and procedures; and
- Revising the policies and procedures to reflect any valuation issues that the board discovers.
The first task is for directors to set the policies and procedures the investment company will follow to conduct valuations. In the recent liquidity rule proposal, the SEC re-emphasized the board’s responsibility regarding valuation:
A fund’s board historically has held significant responsibility regarding valuation- and pricing-related matters, as well as in approving valuation and compliance-related policies and procedures. Additionally, in the past we have stated that a fund’s compliance policies and procedures, which must be approved by the fund’s board (including a majority of independent directors), should include procedures for the pricing of portfolio securities and fund shares.
Rule 38a-1 of the ’40 Act states that investment companies have to “[a]dopt and implement written policies and procedures reasonably designed to prevent violation of the federal securities laws by the fund” and such policies and procedures must be approved by the investment company’s board of directors. In the release adopting the rule, the SEC said that the fund must:
- Adopt policies and procedures that require the fund to monitor for circumstances that may necessitate the use of fair value prices;
- Establish criteria for determining when market quotations are no longer reliable for a particular portfolio security;
- Provide a methodology or methodologies by which the fund determines the current fair value of the portfolio security.
Second, directors should oversee the performance of funds’ managers, officers, and employees in carrying out valuation policies and procedures. To do so, they need to set up reasonable systems of information and reporting to the board or some other method of verifying that valuations are correct. Given the focus on oversight, I suggest that the board consider valuation at as many meetings as possible. While some meetings can focus on the issue more than others, I think it would be wise for the board to receive updated reports and discuss those reports as often as practicable.
Third, directors should require that the fund regularly test the effectiveness of the valuation processes and report the results of these tests to the directors or a committee charged with valuation responsibility. The release for Rule 38a-1 provides that directors must “regularly review the appropriateness and accuracy of the method used in valuing securities, and make any necessary adjustments.” Boards should make sure that testing results are a part of the record of the boards’ activities. As with any human activity, there will be mistakes and errors. Directors should make sure errors are documented and that the steps taken to address the errors are recorded. SEC examination staff will be skeptical of a record that shows perfect compliance with any policy and procedure, including valuation.
Fourth, directors should make sure that valuation policies and procedures are regularly revised to reflect any exceptions. The D.C. Circuit in the Rockies Fund case emphasized that the funds’ valuation policies and procedures were not followed and were “ad hoc.” As an SEC official, I often said that stale and outdated procedures were worse than no procedures at all. Directors should be mindful of this and require updated policies and procedures on a regular basis.
The ’40 Act imposes responsibility on directors for valuation of securities in mutual fund portfolios. Boards that require fulsome policies and procedures and then supervise, test, and update those policies should be able to avoid SEC enforcement actions like Morgan Keegan and Rockies Fund.
Champ is a lecturer on investment management law at Harvard Law School and the former director of the SEC’s Division of Investment Management. He is working on a book about his experiences at the SEC. Harvard Law School research assistants Wilbert Obed Luna Arellanes and Jacqueline Trudeau helped in researching and drafting this article.
 15 U.S.C. § 80a–2(a)(12) defines the term “Director” as follows: “‘Director’ means any director of a corporation or any person performing similar functions with respect to any organization, whether incorporated or unincorporated, including any natural person who is a member of a board of trustees of a management company created as a common-law trust.”
 In re Caremark Int'l Inc. Derivative Litig., 698 A.2d 959, 968 (Del. Ch. 1996).
 15 U.S.C. § 80a–2(a)(41)(B).
 Money Market Fund Reform, 79 Fed. Reg. 47735, 47814 (Aug. 14, 2014).
 SEC v. Morgan Keegan & Co., 2013 U.S. Dist. LEXIS 189843 (N.D. Ga. Feb. 15, 2013).
 Bank for International Settlements, II. The global financial crisis, 79 (2009) (available at http://www.bis.org/publ/arpdf/ar2009e2.pdf).
 Order Making Findings and Imposing a Cease and Desist Order Pursuant to Section 9(f) of the Investment Company Act of 1940, Investment Company Act of 1940 Release No. 30557, Administrative Proceeding File No. 3-15127 (June 13, 2013) (available at http://www.sec.gov/litigation/admin/2013/ic-30557.pdf).
 Accounting Series Release No. 118, “Accounting for Investment Securities by Registered Investment Companies”, Investment Company Act of 1940 Release No. (Dec. 23, 1970) (available at http://3197d6d14b5f19f2f440-5e13d29c4c016cf96cbbfd197c579b45.r81.cf1.rackcdn.com/collection/papers/1970/1976_0101_SECAccountingReleases.pdf).
 Id. at 1097.
 Statement on Recent SEC Settlements Charging Chief Compliance Officers With Violations of Investment Advisers Act Rule 206(4)-7 by Comm. Daniel M. Gallagher (June 18, 2015) (available at http://www.sec.gov/news/statement/sec-cco-settlements-iaa-rule-206-4-7.html).
 Open-End Fund Liquidity Risk Management Programs; Swing Pricing; Re-Opening of Comment Period for Investment Company Reporting Modernization Release, 80 Fed. Reg. 62273, 62339 (Oct. 15, 2015).
 17 C.F.R. 270.38a-1(a)(1).
 17 C.F.R. 270.38a-1(a)(2).
 Compliance Programs of Investment Companies and Investment Advisers, Investment Company Act of 1940 Release No. IA-2204 (Feb. 5, 2004) [hereinafter 38a-1 Adopting Release].
 See KCAP Financial Inc., Exchange Act of 1934 Release No. 68307, Accounting and Auditing Enforcement Release No. 3425 (Nov. 23, 2012).
 38a-1 Adopting Release, supra note 16.
 Norm Champ, Dir., Div. of Inv. Mgmt, Remarks to the Practicing Law Institute, Hedge Fund Management Seminar 2014 (Sept. 11, 2014).