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The collapse of the subprime mortgage market has triggered investigations by the Securities and Exchange Commission (SEC), state and federal criminal authorities and other regulators of a wide range of financial institutions, including the banks and brokerage firms that packaged the loans and offered the resulting securities to the market. These investigators are examining, among other things, whether institutions that were providing securities valuations to investors were applying like valuations to the same or similar securities that they held themselves. As the investigations proceed, to the extent that instances emerge in which similar securities received materially different valuations, the government may turn its attention to the investors, including mutual funds, hedge funds and other pooled investment vehicles that may have purchased the securities. Specifically, the government may ask whether these large, sophisticated investors were appropriately diligent in assigning valuations to the securities that they held in their portfolios, whether they reported reasonably accurate valuations to their own investors and whether they had information available to them � either from representations made by the firms that had sold them the securities or from their own due diligence and monitoring activities � that should have alerted them to the impending crisis. This article discusses what may be a coming wave of government investigations (and private lawsuits) flowing from the continuing effects of the meltdown of the market for mortgage-backed securities. (The focus is on the subprime mortgage market, although its lessons also may apply to other illiquid, difficult-to-price securities. Similarly, the focus is on mutual funds, where valuation obligations are most explicit, although similar considerations may apply to hedge funds and other pooled investment vehicles.) In a subprime mortgage securitization, the originator of the mortgage loans directly or indirectly creates a trust and sells to the trust all of its legal rights to receive any payments on the mortgage loans. As a result, the trust becomes the owner of the loans, controls the loans and engages a “servicer” to fulfill the role of collecting the loan payments from the borrowers. The servicer remits the collections that it receives each month on the loans to a trustee or securities administrator who acts as paying agent for the securities issued by the trust. Because securities derived from mortgage loans contain various risks to investors, subprime mortgage securitizations include various types of credit enhancements in order to receive and maintain the desired ratings. These credit enhancements can be “external,” using a third-party guarantee, or “internal,” in which the transaction relies wholly or in part on a senior/subordinate structure that allows certain portions of the transaction to provide credit enhancement to other portions of the transaction. These senior/subordinate structures are designed so that the higher-rated, senior classes of securities issued by the deal get paid preferentially while the lower-rated, subordinate classes get paid only if there is cash remaining after the more senior-rated pieces get paid their allocated amounts. The trade-off is that the lower-rated pieces get a higher interest rate and projected yield. When a subprime mortgage deal relying on internal credit enhancement is created, credit tranching is used to divide the securities into various classes according to the expected risk of each such class. The most senior tranches are rated AAA and, depending on the transaction’s structure, one or more tranches are issued with ratings below AAA. Since each class of securities is, in effect, backed by each mortgage loan in the asset pool, it is this credit-tranching process that allows the majority of the deal to receive the AAA rating, even though the entire pool of assets consists of subprime collateral. Factors relevant to valuation This brief discussion demonstrates the complexity of mortgage-backed securities and suggests the difficulty inherent in valuation decisions. Questions that must be answered in order to evaluate the liquidity, credit risk and other factors relevant to the economics of any particular mortgage-backed security include: • What are the constituents and anticipated payment potential for the underlying mortgage pool, and has actual performance been consistent with those expectations? • What credit enhancements were incorporated into the securities, and are other factors (such as the financial condition of the enhancement provider) calling those enhancements into question? • Was the risk associated with the rating assigned to the tranche in which one is investing understood, and has that rating remained valid, given fluctuation in the values of other tranches? Mutual funds must value securities held in their portfolios and publish a net asset value (NAV) on a daily basis. The basic standards governing valuation of portfolio securities held by mutual funds are set forth in � 2(a)(41) of the Investment Company Act of 1940, which defines the value of fund assets in two categories: Securities for which market quotations are readily available are to be valued at market value, and all other securities are to be valued at fair value as determined in good faith by the board of directors. In particular, “fair value” means the price at which the security could be sold within seven days in an arm’s-length transaction. The basic standards are reiterated in SEC regulations such as Rule 2a-4 (establishing the method by which NAV should be calculated) and Rule 2a-7 (requiring fund boards to periodically review valuations of securities that exhibit certain inconsistencies brought to light by alternate NAV calculation methods). Because market quotations are not readily available for subprime mortgage-backed securities, to the extent that a mutual fund holds such securities, it must “fair value” them in setting its NAV. Important guidance as to how funds should fair-value securities is contained in letters that the SEC staff issued to the Investment Company Institute on Dec. 8, 1999, and April 30, 2001. The 1999 letter analyzes two relevant pricing issues: It offers guidance on the process of fair-value pricing, including descriptions of certain factors that funds should consider when fair-value pricing their portfolio securities, and it addresses the measures that boards may take when discharging those responsibilities. In particular, the letter discusses what funds should do during periods of market crises in which a significant event has occurred but during which foreign or domestic markets were not open and so no market quotations were available. The 2001 letter clarifies the earlier letter by stating that the phrase “readily available” includes an evaluation of the “validity and reliability” of the available market quotations. Other sources of guidance from the SEC (or its staff) on valuation issues include Accounting Series Release (ASR) nos. 113 and 118 (although issued in 1969 and 1970, respectively, the releases define fundamental terms of a discussion and so form the foundation for later guidance), various no-action letters, instructions to forms and other indicators. Financial Accounting Standards Board (FASB) Statement No. 157, entitled “Fair Value Measurements,” issued in September 2006, established a fair-value hierarchy to categorize sources of information used in valuation measurements and expanded required disclosures in financial statement footnotes concerning fair-value measurements. FASB 157 attempted to clarify inconsistent definitions of fair value and other confusing guidance on the application of fair-value principles in current guidelines. Also, the Public Company Accounting Oversight Board issued Staff Audit Practice Alert No. 2 in December 2007 to highlight audit issues raised by the current mortgage market and FASB 157. Among other things, the alert admonished auditors to consider, in situations in which a company uses a pricing service to help it set fair value, the procedures and data inputs used by the pricing service. Taken as a whole, SEC guidance on valuation focuses primarily on the need for process and establishes a somewhat flexible standard for fair valuing securities. Unfortunately, the guidance described above is not crystalline, and the industry is often left to reason by analogy. Moreover, the application of this guidance in any particular situation, especially a situation bearing the hallmarks of a crisis, such as is occurring in the subprime mortgage and other credit markets, involves the exercise of extensive judgment. It is not surprising, therefore, that direction about what should be done in crisis situations often is provided in hindsight through SEC enforcement actions. In re Parnassus Investments, Rel. No. 40534 (SEC Oct. 8, 1998), established the principle that fair value cannot be based on what a buyer might pay at some later time, such as when the market ultimately recognizes the security’s true value as it was perceived by the portfolio manager at the time of purchase. The administrative law judge concluded that the board’s valuation of the securities of a company was not determined in good faith when there were doubts about whether the company could continue as a going concern and when there were no existing offers to purchase it as a going concern. The judge also found that the board, in its valuation analysis, had ignored several required factors, including dismissing or failing to consider “pink sheet” transactions in the securities, failing to give meaningful attention to the company’s financial statements, failing to address its delisting and failing to apply a liquidity discount. In re Piper Capital Management Inc., Rel. No. IA-2163 (SEC Aug. 26, 2003), examined the propriety of a fund’s reliance on a pricing service for pricing securities for the calculation and reporting of the fund’s daily NAV. On appeal, the SEC determined that the fund had deviated from its disclosed investment strategy, made material misstatements about the value of the portfolio securities and failed to follow the valuation procedures contained in its disclosures, which led to a mispricing of the fund’s NAV. In In re Van Wagoner, Rel. No. IA-2281 (SEC Aug. 26, 2004), the fund and its principal settled SEC charges that they had misrepresented the size, value and risk to shareholders of the funds’ investments in illiquid securities. Moreover, because no market-quoted prices existed for the securities, the federal securities laws and the funds’ own board procedures required that the funds fair-value price the securities. The funds did not fair-value the securities, and in fact “knowingly or recklessly lowered the funds’ valuations . . . in an attempt to comply with [a limitation on the percentage of illiquid securities that the funds could hold], causing the funds to understate their net asset values.” Finally, in the case In re Heartland Advisors Inc., Rel. No. IA-2698 (SEC Jan. 25, 2008), the SEC settled in an administrative proceeding allegations that it originally had brought in federal court against Heartland and related individuals. The SEC alleged violations of fund-pricing and disclosure regulations that allegedly stemmed from a precipitous decline in the value of Heartland’s high-yield municipal bond funds. Among other things, the SEC alleged that Heartland had failed to appropriately adjust valuations in light of various events, such as bids for the securities from “vulture” funds at prices significantly below the values that the funds had assigned. Also of note, the SEC previously had settled with other actors in the underlying events, including the funds’ independent directors and the pricing service that the adviser had used to help it establish valuations. In that earlier proceeding, the SEC had ordered the pricing service to comply with certain undertakings, including that the service would take into consideration all bids of which it was aware, regardless of whether any bid represented a fair exchange in a neutral market. Considerations for funds What lessons for funds and their boards and advisers are applicable to the subprime mortgage crisis? The basic principle that emerges is that boards and advisers should take nothing at face value. Although boards themselves are not expected to become expert on valuing mortgage-backed securities, they need to be able to ask sufficiently detailed questions � and insist on sufficiently detailed answers � to establish that they sought to fulfill their obligations in good faith. Among other things, the responsible party should consider whether it should: • Periodically check against other sources of pricing information, including back-testing against actual sales prices, and maintain appropriate awareness of potential biases in results (such as the possibility of cherry-picking valuations of more liquid securities). • Evaluate the performance of funds with similar investment strategies and portfolios to determine whether they generally are exhibiting similar trends. • Question whether sources of pricing information have conflicts that might compromise valuation data. For example, an investment bank that structured and offered mortgage-backed securities might be a ready source of valuation data, but it might not necessarily be a reliable source, given its role in structuring the security. • Consider engaging experts to offer alternative valuations on a periodic basis. • Review the prospectus and other disclosures to ensure that valuation risk is described and that all current events that may place greater tension on the fund’s valuation procedures are discussed. • And evaluate whether the adviser has the quantity and quality of personnel to provide credit or market analyses, to be able to meaningfully consider information available to it. To the extent that mutual funds, hedge funds and other pooled investment vehicles come under scrutiny, investigators likely will consider whether the funds or their advisers exercised appropriate care in the valuation process. To the extent that any such vehicles seek a proactive approach, they should evaluate whether their past efforts have included some or all of these techniques, and they should determine whether they should adopt some or all of them going forward.\ Paul Huey-Burns is a partner in the white-collar and securities litigation practice, and Joseph V. Gatti is a partner in the finance and real estate practice, of Dechert, both based in the Washington office. Tara Kelly, an associate at the firm, contributed to this article, and Geoffrey R.T. Kenyon, a partner in the financial services group, provided helpful comments.

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