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Heartland Debacle Called Guidance Failure

A U.S. District Court order issued late last month placing three of the high-yield municipal bond funds of the Heartland Group of Milwaukee in receivership probably will lead to liquidation of the funds. But it may also be a prelude to new guidance and regulation on fund valuation procedures, according to industry analysts and lawyers.

The Heartland funds' demise highlights the need for more guidance from the Securities and Exchange Commission on valuation procedures, said Richard Phillips, a lawyer in the Washington office of Kirkpatrick & Lockhart.

"The SEC is emphasizing the need for funds, particularly funds in the fixed income area, to pay special attention to their pricing methodology," he said. "Having said that, they haven't given a lot of guidance."

Trouble for Heartland began last Oct. 13 when the firm was forced to significantly write down the net asset value of its High-Yield Municipal Bond Fund, Short Duration High-Yield Municipal Fund and Taxable Municipal Fund. In the case of the Heartland High Yield Municipal Bond Fund, Heartland was forced to write down its net asset value by 70 percent.

In an Oct. 16 letter addressed to the funds' shareholders, William Nasgovitz, president of Heartland Advisors, explained the firm's move.

"Because of a current lack of liquidity in the high-yield municipal bond markets generally, and due to credit quality concerns and a lack of market makers, market bids and representative market transactions in funds' securities, the funds decided to change the method by which they value their portfolios," he said in the letter.

Because Heartland's funds held highly illiquid securities, fair value pricing methods were used to establish the funds' value, Phillips said. The problem is, there is no established, SEC-approved fair value pricing methodology. Fair value pricing methodologies vary considerably, and, as was the case with the three Heartland funds, the value of illiquid securities can vary just as much, he said.

The Heartland blow-up should be a signal to similar bond funds and loan participation funds to disclose their pricing practices more frequently and prominently, said Rami Shalaan senior funds analyst at Wiesenberger/Thomson Financial of Rockville, Md. Thomson Financial is also the publisher of this newsletter.

"I would think the SEC would issue pricing techniques or guidelines," Shalaan said. In addition, companies should be required to disclose how they price their securities, he said.

Besides revealing a need for greater regulation and guidance, the Heartland debacle is significant because only a handful of mutual funds have been placed in receivership and none of those few have been as large as the three Heartland funds, said Daniel Gregus, assistant regional director for the SEC's Midwest office in Chicago.

The SEC moved to secure a court order placing the funds in receivership after the Heartland Group of Milwaukee, Wis. failed to issue annual reports and audit statements for the funds by a March 1 deadline, he said.

The funds could not issue the statements because the funds' auditor declined to issue valuations for the underlying securities, according to a copy of the complaint filed by the SEC in U.S. District Court in the Northern District of Illinois.

"Heartland Group's auditors refusal to opine on the valuation of the securities held by the funds raises serious concerns about the value of the funds and the securities held by the funds," the SEC's complaint said.

PriceWaterhouseCoopers of New York, the independent accountant appointed to audit the funds, could not accurately value the underlying bonds in each of the funds because of their highly illiquid nature, according to Gregus. Without an independent auditor's statement, the funds were out of compliance with SEC regulations, allowing the SEC to seek a court order to place the funds in receivership, he said.

The Heartland Group also offers three equity funds and a tax-free fund, none of which are affected by the order.

The court order removed Heartland Advisors as the funds' manager, froze the funds' assets and appointed Phillip L. Stern, a lawyer with Freeman, Freeman & Salzman of Chicago, receiver of the funds. The funds' fate is now entirely up to Stern. He will base his decision on whether to liquidate the funds on the soundness of the funds' investment strategies and their underlying investments, Stern said. All redemption activity in the funds has been stopped, he said.

However, receivership is probably the funds' last stop before liquidation, according to Shaalan. The SEC probably sought the court order to freeze the assets, allowing the receiver to determine the funds' actual value before dividing the assets among the funds' remaining shareholders, he said.

Since last October, investors have scrambled to get out of the three Heartland funds, according to flow figures provided by Financial Research Corp. of Boston. From October of last year through Feb. 28, the funds' flows have been negative, totaling $29.7 million, $37.1 and $3.7 million in outflows for Heartland's Taxable Municipal Fund, Short Duration High Yield Municipal Bond Fund and High Yield Municipal Bond Fund, respectively, according to Financial Research Corp.

As of Feb. 28, Heartland's Taxable Municipal Fund, Short Duration High Yield Municipal Bond Fund and High Yield Municipal Bond Fund held $6.3 million, $14.8 million and $15.9 million in assets, respectively, according to FRC.