Regulators Previously Collected $200Mn from Managers of the RMK and Morgan Keegan Funds.

[ by Howard Haykin ]

The SEC slammed 8 former members of the Boards of Directors overseeing 5 Memphis-based mutual funds - the charges related to violating their asset pricing responsibilities under the federal securities laws.

Five Funds Identified in this SEC Case.  The 5 Mutual Funds, or Registered Investment Companies ("RICs"), are identified below.  The first 4 are closed-end funds;  the fifth is an open-end fund with 3 open-end series: (i) The Select High Income portfolio;  (ii) the Select Intermediate Bond portfolio;  and,  (iii) the Select Short Term Bond portfolio. 

1. RMK High Income Fund, Inc.
2. RMK Multi-Sector High Income Fund, Inc.
3. RMK Strategic Income Fund, Inc.
4. RMK Advantage Income Fund, Inc.
5. Morgan Keegan Select Fund, Inc. (“Select Fund”)

Morgan Entities Also Identified in SEC Case.   Morgan Asset Management, Inc. is an RIA investment adviser registered with the SEC, and Morgan Keegan & Company, Inc. (is a BD-IA registered with the SEC.  Both were headquartered in Memphis, TN.  During the Relevant Period, Morgan Asset served as the investment adviser for the Funds.  Morgan Keegan provided accounting services to the Funds through its Fund Accounting group (“Fund Accounting”).
 

Eight Respondent Directors.   Their names, followed by their profiles:  Kenneth Alderman, CPA; Jack Blair; Albert Johnson, CPA; James Stillman McFadden; Allen Morgan Jr.; Randall Pittman, CPA; Mary Stone, CPA; and Archie Willis III.

• Kenneth Alderman, 60, residing in Birmingham, AL;  an interested director of the Funds beginning in 2003 and during the entire Relevant Period. He's a CPA, licensed in Florida and Alabama, and is a CFA (Chartered Financial Analyst).

• Jack Blair, 70, residing in Germantown, TN;  an independent director and member of the Audit Committee of the Funds beginning in 2005 and during the entire Relevant Period.  He also was designated as an Audit Committee Financial Expert, even though Blair has never held any professional licenses.

• Albert Johnson, 68, residing in Hoover, AL;  an independent director and a member of the Audit Committee of the Funds beginning in 2005 and during the entire Relevant Period.  He also was designated as an Audit Committee Financial Expert. Johnson is a CPA licensed in Alabama and Texas.

• James Stillman McFadden, 55, years of age and a resident of Germantown, Tennessee, was an independent director and a member of the Audit Committee of the Funds beginning in 2002 and during the entire Relevant Period. Though he has never held any professional licenses, too was designated as an Audit Committee Financial Expert.

• Allen Morgan Jr., 70, residing in Memphis;  an interested director of the Funds beginning in 2002 and during the entire Relevant Period, he was Chairman and CEO of Morgan Keegan until he retired in December 2003.

• Randall Pittman, 59, residing in Birmingham, AL;  an independent director and member of the Audit Committee of the Funds beginning in 2003 and during the entire Relevant Period. A CPA licensed in Alabama, he too was designated as an Audit Committee Financial Expert.

• Mary Stone, 62, residing in Birmingham. Alabama, was an independent director and Chairman of the Audit Committee of the Funds beginning in 2003 and during the entire Relevant Period. She was also designated as an Audit Committee Financial Expert. Stone is a CPA licensed in Florida.

• Archie Willis III, 54, years of age and a resident of Memphis, Tennessee, was an independent director and a member of the Audit Committee of the Funds beginning in 2002 and during the entire Relevant Period. He was also designated as an Audit Committee Financial Expert. Willis has never held any professional licenses.

SEC Findings and Allegations. Between at least January 2007 and August 2007, significant portions of the Funds’ portfolios contained below-investment grade debt securities, some of which were backed by subprime mortgages, for which market quotations were not readily available.  Under the Investment Company Act, those securities were required to be valued at fair value as determined in good faith by the Directors.  

• As such, the fund directors’ statutory fair valuation obligations called upon them to “determine the method of arriving at the fair value of each such security.
• At the board's discretion, it may appoint persons to assist them in making such determination of such value, and in making the actual calculations. 
• The board must also, consistent with this responsibility, continuously review the appropriateness of the method used in valuing each issue of security in the company’s portfolio.”

However, the SEC says that the Directors allegedly did not:   (i)  specify a fair valuation methodology pursuant to which the securities were to be fair value;  (ii) or continuously review the appropriateness of the method to be used in valuing each issue of security in the company’s portfolio.  Instead, they delegated that responsibility to a valuation committee - which might have been appropriate, except for the following alleged deficiencies in the board's actions and execution of the plan:

• they failed to provide any meaningful substantive guidance on how those determinations should be made.
• they made no meaningful effort to learn how fair values were actually being determined.
• they received at best only limited information on the factors considered in making fair value determinations and almost no information explaining why particular fair values were assigned to portfolio securities.
• these failures were particularly egregious given that fair valued securities made up the majority - and in most cases upwards of 60% - of the Funds’ net asset values (“NAVs”).

Overview of the Funds.   As of March 31, 2007, the Funds held securities with a combined net asset value of nearly $4 billion, which the Funds owning many of the same securities.  In addition, almost all of the Funds invested the majority of their total assets in complex securities known as structured products that included CDOs (collateralized debt obligations), CMOs (collateralized mortgage obligations), CLOs (collateralized loan obligations), home-equity loan-backed securities, various types of ABSs (asset-backed securities), and certificate-backed obligations.

Disclosure was made to the SEC that the funds anticipated that their respective portfoios would be concentrated in below-investment grade debt securities, which carried greater inherent risks, including:

• more frequent and pronounced changes in the perceived creditworthiness of issuers,
• greater price volatility,
• reduced liquidity,
• the presence of fewer dealers in the market for such securities.

Yet, the SEC specifically pointed out that the Funds’ holdings contained significant concentrations in mortgage-backed securities.  And a significant number of the structured products held were subordinated tranches of various securitizations, for which market quotations were not readily available during the Relevant Period. 

That effectively left the boards with the obligation to input an enormous good faith effort into accurately valuing the securities on a daily basis.  The fact that as much as 60% of the funds' respective portfolios had to be fair valued, would have made that obligation much harder to fulfill.

SEC's Next Actions.  It's in the public interest that public administrative and cease-and-desist proceedings be instituted to determine:

• Whether the allegations set forth above are true and, in connection therewith, to afford Respondents an opportunity to establish any defenses to such allegations;
• What, if any, remedial action is appropriate in the public interest against Respondents pursuant to Section 9(b) of the Investment Company Act including, but not limited to, civil penalties pursuant to Section 9(d) of the Investment Company Act; and
• Whether, pursuant to Section 9(f) of the Investment Company Act, Respondents should be ordered to cease and desist from committing or causing violations of and any future violations of Rules 22c-1, 30a-3(a) and 38a-1, promulgated under the Investment Company Act.

Submissions will be made by the fund directors and hearings will be on these matters in the relatively distant future. 

The SEC and other regulators previously charged the funds’ managers with fraud, and the firms later agreed to pay $200 million to settle charges that those funds holding securities backed by subprime mortgages were fraudulently overstated - particularly as the housing market approached the brink of financial crisis in 2007.  

Aside from the culpability of the fund managers, the SEC sees the fund directors as having made no meaningful effort to learn how fair values were being determined.  This reflected an abdication of the boards' responsibilities, according to SEC Enforcement Director, which was particularly inexcusable given that fair-valued securities made up the majority of the funds’ net asset values – in most cases more than 60 percent.  Such actions - or lack of actions - the SEC states - resulted in the funds’ violations of Rules 22c-1, 30a-3(a) and 38a-1 under the Investment Company Act of 1940.

For further details, go to:   [SEC PR 12-259, 12/10/12] and [SEC Investment Co'y Act of 1940, Release 30300, 12/10/12].