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SEC Steps Up Oversight of Valuations

WASHINGTON D.C. - Because of the volatility of the high-yield municipal bond market, SEC examiners will begin to watch more carefully how fund companies establish prices for illiquid securities, said SEC officials.

"Given the fact that there are problems, it would behoove advisors to know how pricing services are establishing those prices," said Gene Gohlke, an associate director with the SEC's office of compliance, inspections and examinations. "One would hope [advisers] would go back and ask how the service is coming up with those prices."

Recent market volatility has helped create wide spreads in the bid and the offer price in high- yield bonds and some firms have "taken a bath" in the municipal bond market, said Gohlke.

Heartland Advisors of Milwaukee, Wisc., is the most recent example of how a fund can get hurt by exposure to illiquid securities like high-yield municipal bonds. Shareholders of its high-yield municipal bond fund and short duration high-yield municipal fund filed a class-action lawsuit Oct. 27 against Heartland Advisors because its repricing of the securities resulted in a drop in the net asset values of the funds of 70 and 44 percent respectively, according to the complaint. The drop in net asset value occurred Oct. 16, after the firm adopted a fair value pricing procedure for the funds, according to a prospectus amendment the firm filed with the SEC the same day.

The firm issued false and misleading information about the funds' net asset values, performance and risk, according to the complaint. It names Heartland High-Yield Municipal Bond Fund, Heartland Short Duration High-Yield Municipal Fund, Heartland Advisors and Thomas J. Conlin, the funds' former portfolio manager.

"From an enforcement standpoint, we see all kinds of fallout when a fund runs into pricing problems," said Barbara C. Chretian-Dar, assistant director of the SEC's office of enforcement in the division of investment management.

Ultimately, a fund's board of directors must be held responsible for how a fund is priced, but portfolio managers, traders, broker/dealers and compliance departments all play a role in how a fund prices its illiquid securities, said Chretian-Dar. Accurate valuations are extremely important because shareholders have a right to know the value of what they are investing in, she said.

"Pricing is one of the most fundamental provisions in the 1940 Act," she said.

Gohlke declined to comment as to whether Heartland Advisors was under investigation.

Gohlke and Chretian-Dar made their comments here late last month at a conference hosted by the American Legal Institute and American Bar Association.

Much of the problem in establishing accurate valuations for illiquid securities lies in the details of how funds and pricing services establish price, Gohlke said. Funds usually have to specially price illiquid securities, relying on a fair value price established between the issuer of the security and the fund. Funds need to use an independent third party when pricing an illiquid security and they need to have a set of controls in place that will corroborate the services' prices, he said.

If portfolio managers are involved in pricing securities, there is an increased need for oversight of the pricing process, Gohlke said. Because a portfolio manager has an interest in keeping the value of a fund's holdings high, he might not scrutinize a security's price as closely as he should, he said.

"We've seen instances when the portfolio manager is left alone and they have overvalued the security," he said.

At a minimum, fund boards should establish a pricing process and establish a committee that oversees that process, Chretian-Dar said. But a process is only as strong as the people using it and compliance departments need to also watch their firm's pricing practices, she said.

The commission has encountered situations in which portfolio managers and traders have ignored the prices established by pricing services and instead established their own prices, she said. In another case, a portfolio manager established his own price for securities and then conducted trades with broker/dealers that would trade the security at that price, she said.