IAI Funds Suit Raises Pricing Questions
February 22, 1999
A lawsuit filed this past July alleging securities fraud against Investment Adviser's, Inc. (IAI) of Minneapolis is continuing to twist its way through the legal system. In the meantime, the fund which is the target of the suit has revealed that approximately 65 percent of its portfolio is illiquid.
This past December, the lawsuit, originally filed in federal district court in San Diego, Calif. on behalf of two shareholders of the IAI Value Fund, was commuted back to Minnesota. Two weeks ago the plaintiffs filed an opposition to IAI's recent motion to dismiss the case. The case, which could become a class action lawsuit, is still pending. The plaintiffs are being represented by Sullivan, Hill, Lewin, Rez & Engel of San Diego and the firm is seeking other investors who may feel harmed and would join in a class-action suit.
The lawsuit charges IAI with artificially depressing the net asset value of its Value Fund. The suit alleges that the fund adviser, four of its executives including Noel P. Rahn, IAI's former ceo and a director who retired last year after 24 years of service, and five independent board trustees failed to take the appropriate steps to correctly price a privately-held security positioned within the IAI Value Fund's portfolio. The suit alleges that the Value Fund, that is allowed to invest in "privately-held, early-stage developing companies" as part of its capital appreciation objective, reneged on its promise to price all portfolio securities on a daily basis.
The controversy surrounds Pathnet, a privately held Washington, D.C. company that is developing a national digital telecommunications network. According to the lawsuit, IAI originally purchased several thousand shares of Pathnet in 1995 and again in 1996 for two of its funds including the Value Fund. The lawsuit claims IAI and its officers and directors largely ignored frequent public reports and publicly-available information about the company's financing plans and alliances with other companies issued during 1997 and 1998. By doing so, the lawsuit charges, IAI did not re-evaluate Pathnet's fair market value on a timely basis and consequently IAI Value Fund's net asset value was not appropriately boosted to reflect the firm's increased market value.
In addition, charges the lawsuit, although Pathnet announced its intention to file for an initial public offering on May 5, 1998, the IAI Value Fund's net asset value did not fully reflect this news until May 11, at which time the fund's net asset value increased 28 percent in one day. On May 12, IAI closed the fund to most new purchases noting that the increase in Pathnet's value had left the fund portfolio highly illiquid. As recently as February 2, 1999, Pathnet still represented 28 percent of the portfolio. To further complicate matters, although a July 1998 Pathnet IPO was expected, the IPO was postponed in August, and finally canceled in December.
The lawsuit charges that the plaintiffs David S. Lo and Lih-Lih C. Lo redeemed shares from the IAI Value Fund on both December 11, 1997 and again on April 27, 1998. In the later case, that was just two weeks before the fund's net asset value rose 28 percent on news of the intended IPO. The shareholders did not gain the benefit of the higher net asset value, the price of which should have been regularly changing in line with daily repricing of Pathnet's shares, the suit charges.
Steven Lentz, IAI's chief legal counsel declined to publicly comment beyond saying, "We view this lawsuit as frivolous." But one source close to the lawsuit defends the fair value pricing method employed by IAI in evaluating Pathnet's and other restricted securities as being proprietary in nature and perfectly sound. That process includes requiring input from the board of directors. As part of their fiduciary responsibilities, directors are required to have a hand in determining securities' prices where highly illiquid or thinly-traded securities are in question. In fact, IAI's publicly-filed documents note that the IAI board, which has oversight for all of the IAI mutual funds, maintains a separate pricing committee, a subset of the entire board, specifically charged with debating pricing issues and assigning fair values.
IAI is allowed, under prospectus guidelines, to hold up to 15 percent of its portfolio in securities deemed "illiquid." Though most equity funds prefer to primarily invest in equities publicly traded on a stock exchange, some funds buy restricted securities in hopes of realizing higher gains or the substantial profits which can sometimes be commanded following an IPO. According to the IAI Value Fund's prospectus, the fund invests in securities "believed by management to be undervalued and which are considered to offer unusual opportunity for capital growth." Successful IPOs can offer that reward.