## Facts

- Eight directors oversaw five registered investment companies sponsored by Morgan Keegan and advised by Morgan Asset Management, Inc., with Morgan Keegan & Company, Inc. providing accounting and administrative services.
- From at least January 2007 through August 2007, significant portfolio holdings included below-investment-grade structured-finance and mortgage-related securities for which market quotations were not readily available.
- When market quotations were unavailable, the funds’ written procedures assigned fair-value determinations to Morgan Asset’s valuation committee, but provided limited guidance on how to value the securities; the directors provided no additional methodology.
- Day-to-day valuation work was performed by Morgan Keegan personnel under valuation-committee supervision.
- Morgan Keegan personnel allegedly allowed a portfolio manager to make arbitrary value adjustments and used practices that reduced the apparent decline in net asset value over a four-month period.
- Share sale, redemption, and repurchase prices during that period were inaccurate as a result of deficient valuation practices.
- Quarterly written valuation reports to the board were often incomplete; the board did not systematically ratify or review fair-value decisions.
- The directors received price and fair-value information primarily for securities that were sold, leaving limited visibility into unsold fair-valued positions and potential stale pricing.
- Independent auditors advised the directors that the valuation procedures were appropriate and reasonable.

## Issues

1. Whether the directors, through insufficient oversight of fair valuation and related compliance controls, caused the funds to violate Rule 38a-1 under the Investment Company Act of 1940.
2. Whether adopting valuation procedures with limited methodological guidance and weak reporting/review mechanisms fails Rule 38a-1’s requirement that policies be reasonably designed and implemented to prevent violations of federal securities laws.
3. Whether reliance on advisers and auditors can satisfy directors’ obligations to determine and oversee fair-value methodologies when market quotations are not readily available.

## Decision

- The SEC instituted administrative cease-and-desist proceedings under Investment Company Act §§ 9(b) and 9(f); the directors settled without admitting or denying the findings (except jurisdiction).
- The SEC found the directors caused the funds’ violations of Rule 38a-1.
- The SEC ordered each director to cease and desist from causing any violations, and any future violations, of Rule 38a-1.
- The SEC did not impose civil monetary penalties, suspensions, or bars.

## Legal Principles

- When market quotations are not readily available, portfolio securities must be valued at fair value determined in good faith by the fund’s board; the board may use assistants but remains responsible for the methodology and oversight.
- Rule 38a-1 requires funds to adopt and implement written compliance policies and procedures reasonably designed to prevent violations of federal securities laws; paper policies are insufficient without effective implementation and board-level oversight.
- Valuation procedures that provide limited methodological direction and do not ensure consistent application, meaningful reporting, or board review can be deficient under Rule 38a-1.
- Directors may be found to have “caused” a fund’s Rule 38a-1 violation when they approve or rely on inadequate procedures and fail to ensure they operate effectively.
- Reliance on advisers or auditors does not discharge directors’ duties to understand valuation methods used in practice, assess their appropriateness, and obtain sufficient information to detect stale or biased pricing.

## Conclusion

The SEC concluded that the directors’ failure to specify and supervise fair-value methodologies, combined with weak reporting and ineffective implementation of valuation controls, caused the funds to violate Rule 38a-1, warranting cease-and-desist relief without monetary or industry bars.


In re J. Kenneth Alderman, CPA, Investment Company Act Release No. 30557 (June 13, 2013)