Morgan Keegan & Company, Morgan Keegan Asset Management ("MK") and 2 employees agreed to settle fraud proceedings with the SEC, FINRA and 5 state regulators (AL, KY, MS, SC, TN) related to sales of 7 affiliated funds invested in subprime mortgage-backed securities.  Morgan Keegan & Company (broker-dealer) distributed the funds;  MK Asset Management (adviser) managed the funds.

The Memphis-based firms, former portfolio manager James Kelsoe Jr., and Comptroller Joseph Weller were accused last year of causing the false valuation of subprime mortgage-backed securities in five funds managed by Morgan Asset Management from January 2007 to July 2007.  The SEC’s order issued today in settling the charges also finds that Morgan Keegan failed to employ reasonable pricing procedures and consequently did not calculate accurate “net asset values” for the funds.  Morgan Keegan nevertheless published the inaccurate daily NAVs and sold shares to investors based on the inflated prices.

“The falsification of fund values misrepresented critical information exactly when investors needed it most – when the subprime mortgage meltdown was impacting the funds."  --  Robert Khuzami, SEC Enforcement Director. investors.

"Firms must ensure that their marketing materials fully and accurately describe the products they sell, including the attendant risks and any relevant information about market conditions that may impact those products.  By not fully disclosing the risks, Morgan Keegan portrayed the Intermediate Fund as a safer investment than it was."  -- Brad Bennett, FINRA EVP, Chief of Enforcement.

Alleged Failures by the Broker-Dealer, MK & Company (MKC).   The Regions Morgan Keegan Select Intermediate Bond Fund was one of the 7 funds.  FINRA found that from January 2006 through September 2007, broker-dealer MKC marketed and sold the Intermediate Fund to investors using sales materials that contained exaggerated claims, failed to provide a sound basis for evaluating the facts regarding the fund, were not fair and balanced, and did not adequately disclose the impact of market conditions in 2007 that caused substantial losses to the value of the Intermediate Fund. 

The Intermediate Fund invested predominantly in structured products, including mezzanine and subordinated tranches of structured securities including sub-prime products.  Yet, MKC marketed the fund as a relatively safe, investment-grade fixed income mutual fund investment when, in fact, it was exposed to risks associated with its investments in mortgage-backed and asset-backed securities, and subordinated tranches of structured products.  By the beginning of 2007, Morgan Keegan was aware that the Intermediate Fund was experiencing difficulties related to the holdings in the fund impacted by turmoil in the mortgage-backed securities market yet failed to adequately disclose those risks in the sales materials or internal guidance.  In March 2007, when adverse market conditions began to affect the fund, over 54% of the portfolio was invested in ABS's and MBS's, and 13.5% was invested in subprime products.

FINRA found that MKC failed to establish, maintain and enforce an adequate supervisory system and WSP's - that could not adequately ensure that sales literature disclosed certain information as to risk and did not contain exaggerated claims.  As a result, MKC failed to adequately describe the nature, holdings and certain risks of the Intermediate Fund.  Then, in 2007, when the particular risks associated with the Intermediate Fund's holdings began to impact negatively the holdings in the fund, MKC failed to take steps reasonably designed to revise its advertising materials to inform customers of the specific risks of investing in the fund under the current market conditions.

Kelsoe Leads Wrongful Fund Accounting.   James Kelsoe allegedly instructed MK's fund accounting department to make arbitrary “price adjustments” to the fair values of certain portfolio securities - which ignored lower values for those same securities provided by outside broker-dealers ("B/Ds") as part of the pricing process, and often lacked a reasonable basis.  In some cases, upon receiving pricings that were substantially lower than current portfolio values, fund accounting personnel followed Kelsoe's direction and lowered values of bonds over a period of days in a series of pre-planned reductions to values at or closer to the price confirmations.  Throughout this interim period, the bonds were not priced at their current fair value.

Kelsoe also allegedly screened and influenced the price confirmations obtained from at least one B/D.  Among other things, that B/D was induced to provide interim price confirmations that were lower than the values at which the funds were valuing certain bonds, but higher than the initial confirmations that the B/D had intended to provide.  The interim price confirmations enabled the funds to avoid marking down the value of securities to reflect current fair value.  In some cases, Kelsoe induced the B/D to withhold price confirmations, where those confirmations would have been significantly lower than the funds’ current valuations of the relevant bonds.

Through his actions, Kelsoe also fraudulently prevented a reduction in the NAVs of the funds that should otherwise have occurred as a result of the deterioration in the subprime securities market in 2007.  His misconduct occurred in the context of a nearly complete failure by Morgan Keegan to employ the fair valuation policies and procedures adopted by the funds’ boards of directors to fair value the funds’ portfolio securities.

Settlement Sanctions.  Morgan Keegan agreed to pay $200 million - $25mn in disgorgement and interest, a $75mn penalty to be placed into an SEC Fair Fund, and $100mn into a state fund that also will be distributed to investors.  Both firms are required to abstain for 3 years from valuing fair valued securities on behalf of investment companies.

James Kelsoe agreed to pay $500K in penalties and be barred from the industry. 

Joseph Weller agreed to pay $50,000 in penalties. 

For further details, go to:   [SEC PR 11-132, 6/22/11]  and  [FINRA News Release, 6/22/11].

SEC Staff Credits.   Barbara Martin, Glen Richards, Christopher Ray originated the SEC’s case conducted the SEC examination;  Steve Donahue, Jack Westrick, Ed Saunders conducted the investigation.  Litigation was handled by Graham Loomis, Rob Gordon, John O’Halloran, Shawn Murnahan, Jerome Dewitt, Debbie Moore, Eunita Holton, assisted by valuation specialist Rick Mayfield. Supervising was Atlanta Regional Director Rhea Dignam,  Assoc. Regional Director William Hicks.

FINRA Staff Credits.   Enforcement's Gino Ercolino, David Fenimore, Gregory Firehock, Theresa Ridder, Richard Santiago conducted the investigation, assisted by FINRA's Advertising Regulation Department.