The independent directors of two
muni bond funds soon may have to explain to the
Securities and Exchange Commission
how they allowed pricing of the funds' portfolio securities to get so out of whack that the funds lost a combined $62 million in value in a single day.
In a speech last month to a mutual fund directors conference, Paul Roye, head of the agency's funds division, hinted the directors may be squarely in the agency's crosshairs. Roye quoted former
Supreme Court Justice
-- and former SEC Chairman --
William O. Douglas'
description of the agency's role as akin to keeping a "shotgun, so to speak, behind the door, loaded, well-oiled, cleaned, ready for use, but with the hope that it would never have to be used."
"Unfortunately," Roye concluded, "Douglas' proverbial shotgun in the closet sometimes has to be fired at fund directors."
On Oct. 13, Heartland's
Short-Duration High Yield Municipal and
High Yield Municipal funds, under pressure to raise cash to meet investor redemptions, were forced to reprice their portfolio securities. That resulted in a decline in the funds'
net asset values, or NAVs, of 70% and 44%, respectively. (For more on the funds' collapse, see
Two Muni Funds Pay the Price for Extreme Credit Risk.)
The agency won't confirm the existence of an investigation into the funds' portfolio pricing practices, but if there is one, Roye's comments suggest a primary target may be the independent directors.
More Than a Slap This Time
In his speech, Roye repeatedly emphasized the responsibility of independent fund directors to ensure the accuracy of their funds' net asset values. "Independent" directors, who typically make up more than 50% of a fund's board of directors, are those who are not affiliates of the company managing the funds.
Roye pointedly cited a number of agency cases against fund directors, including a 1999 case in which the agency sued the independent directors of the
money market fund for mispricing the fund's securities in violation of pricing rules. Roye also reminded his audience that, in 1998, a court found that the independent directors of the
Parnassus fund "showed a reckless disregard for the computation of
the fund's NAV."
Despite the emphasis the agency has placed on fund pricing in the past, it let off each of the independent directors in the Community Bankers case with a $5,000 fine. The Parnassus judge, finding that the violations were "technical," imposed no fines at all.
Shareholders of Heartland's Short Duration and High Yield funds may wonder what's so technical about foul-ups that can leave two relatively small funds with a one-day, $62 million aggregate loss. And judging from Roye's remarks, the agency may use the Heartland case to send a stronger message to fund directors.
Indeed, fund pricing has been getting so much attention lately, it's hard to understand how the Heartland funds could have allowed their NAVs to stray so far from reality. Concerned that the lessons of the Community Bankers and Parnassus cases weren't getting through, the agency staff sent a letter to the fund industry last December (in which I participated as a member of the agency staff) that detailed directors' pricing responsibilities.
Second Opinion on Prices Required
The agency's focus on fund portfolio pricing begs the question: Why weren't the Heartland fund directors paying especially close attention to their pricing procedures? While we probably won't know the precise answer for a couple of years, it appears one reason may have been that the Heartland directors' oversight may have fallen short of agency standards.
For example, Heartland relied on an independent pricing service,
, to price its portfolio, a practice that was not sufficient, according to standards outlined by Roye. "Prices provided by third parties should be subject to appropriate controls," Roye said in his speech, including "periodic cross-checks of prices received from
other pricing services."
The Wall Street Journal
reported that the Heartland funds were carrying a number of securities at much higher prices than those provided by
, another leading provider of bond pricing information.
Language in the funds' prospectuses seems to say the funds' NAVs were based solely on the prices provided by Interactive Data and did not take into account other "indications of value."
Paul Beste, chief operating officer of Heartland Advisors, disagrees, saying that the funds' pricing committee considered other factors before Oct. 13. But citing pending litigation, Beste declined to comment specifically on whether those factors included prices provided by other pricing services or whether the consideration of these factors ever led Heartland to reject a price provided by Interactive Data.
The impressive investment credentials of some of Heartland's independent directors make it hard to understand how the directors allowed the funds' pricing problems to reach disastrous proportions in the first place. One independent director, A.. Gary Shilling, runs his own investment adviser and economic consulting firm. The firm's Web site boasts of his ability to predict the performance of the bond markets with "alarming accuracy."
Another independent director, Jon Hammes, is the founder of a private investment and real estate firm and the chairman of the
Wisconsin State Investment Board
, or WSIB. Upon appointing Hammes to this position, Wisconsin's
Gov. Tommy Thompson
said that he "couldn't imagine anyone who would be a better investor for Wisconsin's future." (For more on Hammes and the Heartland-WSIB connection, see
Viewpoint: Heartland Fiasco Shows Need for Conflict-of-Interest Rules.)
Of the remaining two independent directors, neither has any obvious financial expertise. Allan Stefl is a senior vice president with
. Linda Stephenson is president of a public relations firm. The independent directors all referred my inquiries to Heartland Advisors.
While brandishing the proverbial shotgun, Roye noted the agency's efforts to help directors fulfill their responsibilities. Last year, the agency proposed to require that independent directors' legal counsel also be independent of the fund and its affiliates. Roye said the proposal is close to adoption by the agency.
Portfolio valuation creates a conflict of interest between the fund and the investment adviser because the adviser has a financial interest in assigning a higher value to portfolio securities. The "overvaluation of a fund's assets will overstate the performance of the fund," says Roye, and "will result in overpayment of fund expenses that are calculated on the basis of the fund's net assets, e.g., the fund's investment advisory fee."
Hammes, like Heartland Advisors, also had a stake in an inflated valuation of the funds' portfolios. The
Milwaukee Journal Sentinel
reports that Heartland Advisors is the anchor tenant of a 68,000-square-foot, half-vacant building developed and managed by Hammes' real estate firm. Hammes would have benefited from the funds' higher NAVs because they generated higher advisory fees for his tenant and ensured that it could pay its rent.
This is the kind of conflict of interest that makes it more likely that the agency will not look kindly on Heartland funds' independent directors. If
George W. Bush
appoints the next agency chairman, how the agency treats Hammes -- the finance co-chairman for the Bush campaign in Wisconsin -- will be worth watching.
Mercer Bullard, a former assistant chief counsel at the Securities and Exchange Commission, is the founder and CEO of Fund Democracy, a mutual fund shareholder advocacy group in Chevy Chase, Md.