UNITED STATES of AMERICA Before the SECURITIES and EXCHANGE COMMISSION
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UNITED STATES OF AMERICA Before the SECURITIES AND EXCHANGE COMMISSION ADMINISTRATIVE PROCEEDING File No. 3-15127 ____________________________________ | In the Matter of | | J. Kenneth Alderman, CPA; Jack R. Blair; Albert C. Johnson, CPA; | James Stillman R. McFadden; | | Allen B. Morgan Jr.; W. Randall | Pittman, CPA; Mary S. Stone, | CPA; and Archie W. Willis III, | | Respondents. | | EXPERT REPORT OF HARVEY L. PITT March 1, 2013 Table of Contents 1. Introduction ................................................................................................. 1 2. Professional Qualifications .......................................................................... 1 3. Summary of Engagement and Conclusions .................................................. 5 3.1. Background and Scope ........................................................................ 5 3.2. Summary of Opinions ........................................................................... 6 4. Standards of Care During the Relevant Time Period .................................... 8 4.1. Relevant Legal Framework and Relevant Sources of Guidance ............ 8 4.1.1. Commission Requirements ............................................................. 8 4.1.2. Rule 38a-1 Imposes Specific Requirements on the Fund Boards with Respect to Portfolio Valuation ............................................................ 11 4.1.3. Industry Guidance and Practice ................................................... 12 4.2. A Fund Board’s Approval of Fair Valuation Policies and Procedures Must be Based on Specific Findings by the Board ..................... 15 4.2.1. SEC Guidance .............................................................................. 15 4.2.2. Industry Guidance and Practice ................................................... 18 4.3. Rule 38a-1 Requires that Boards Must “Provide a Methodology or Methodologies by Which the Fund Determines the Current Fair Value of the Portfolio Security” .................................................................................. 21 4.3.1. SEC Guidance .............................................................................. 21 4.3.2. Industry Guidance and Practice ................................................... 26 4.4. Rule 38a-1 Requires that Boards Must “Regularly Review the Appropriateness and Accuracy of the Method Used in Valuing Securities and Make any Necessary Adjustments” ....................................................... 29 4.4.1. SEC Guidance .............................................................................. 29 4.4.2. Industry Guidance and Practice ................................................... 34 5. Based on the Evidence Directors Failed to Meet even Minimum Standards40 5.1. Respondents Knew their Valuation Responsibilities ........................... 40 5.2. Respondents Failed to Specify a Valuation Methodology .................... 41 5.3. Respondents Did Not Sufficiently Understand the Fair Valuation Methodology Used by the Valuation Committee or Fund Accounting ............ 44 5.3.1. The Written Information Provided by the Valuation Committee Did Not Satisfy Respondents’ Obligation to Understand the Valuation i Methodology or Enable Respondents to Review Adequately the Valuation Committee’s Findings ................................................................................ 46 5.3.2. The Fair Valuation Forms Provided Insufficient Information ......... 47 5.3.2.1. The Joint Valuation Report Provided Insufficient Information ... 48 5.3.3. The Forms Provided to Respondents Did Not Contain Explanatory Notes as Required by the Funds’ Written Valuation Policies and Procedures ......................................................................................... 49 5.3.4. The Forms Did Not Advise Respondents of Price Overrides, Severely Impeding Respondents’ Ability to Review Carefully the Valuation Committee’s Findings ................................................................ 51 5.3.5. The Respondents Failed to Monitor Periodically for Price Validation .................................................................................................. 52 5.4. The Look-Back Test Did Not Enable Respondents to Review the Valuation Committee’s Findings Adequately ................................................ 54 5.5. The Directors’ Failure to Review for Potentially Stale Prices Limited Their Ability to Review Carefully the Valuation Committee’s Findings ....................................................................................................... 55 5.6. The Valuation Committee Did Not Sufficiently Understand How to Value Securities ........................................................................................... 58 5.7. Turbulent Market Conditions During the Relevant Time Period and the Significant Percentage of Unquoted Securities Made the Directors’ Lack of Appropriate Oversight Egregious .................................................... 61 5.8. Reliance on “Experts” and Others Cannot Excuse or Justify Respondents’ Failings .................................................................................. 62 5.8.1. Respondents Could Not Discharge their Statutory and Fiduciary Obligations by Purporting to Have Relied on the Chief Compliance Officer 63 5.8.2. Reliance Cannot Discharge their Responsibilities by Claiming They Relied on the Funds’ Auditors ........................................................... 68 5.8.3. Respondents’ Purported Reliance on Attorneys Could Not Discharge their Statutory and Fiduciary Obligations ................................. 72 6. Conclusion ................................................................................................ 73 ii 1. INTRODUCTION I have been retained by the Division of Enforcement (“Division”) of the Securities and Exchange Commission (“SEC” or “Commission”) in the above- captioned administrative proceeding, as an expert witness, regarding issues related to mutual fund valuation obligations. I have prepared this Report to set forth my professional opinions regarding the duties of mutual fund directors during the relevant time period. The views expressed in this Report are solely my own, and this Report has been drafted by me, with assistance from those who work under my supervision. My firm, Kalorama Partners, LLC (“Kalorama”), is being compensated by the SEC, at hourly rates ranging from $350 to $500, based solely upon the hours expended by me and my colleagues. Our compensation is unrelated to the outcome of this proceeding or to the contents of this Report or any testimony I may be asked to provide. I reserve the right to revise or supplement this Report if I later should become aware of additional relevant information. 2. PROFESSIONAL QUALIFICATIONS I am an attorney at law, admitted to practice in the State of New York and the District of Columbia. I am the founder and Chief Executive Officer of Kalorama Partners, LLC, a global strategic business consulting firm, specializing in corporate governance, regulatory, accounting, economic, and risk/crisis issues. I am also the Chief Executive Officer of Kalorama Legal Services, PLLC, the law firm affiliate of Kalorama Partners (collectively, “Kalorama firms”). I graduated with a BA degree in 1965 from the City University of New York (Brooklyn College), and received my JD degree from St. John’s University School of Law in 1968. In 2002, I was awarded an LL.D. (Hon.) from St. John’s University, and in 2003, I was awarded the Brooklyn College President’s Medal of Distinction. I have been admitted in, and have argued before, all the federal appellate courts as well as the U.S. Supreme Court. In addition to my positions as CEO of the Kalorama firms, I am currently a Director and Chairman of the Audit Committee of GWU Medical Faculty Associates, Inc., a not-for-profit corporation, organized pursuant to §501(c)(3) of the Internal Revenue Code,1 that is the largest health care provider in the Washington, DC metropolitan area. I am currently also a member of the Public 1 26 U.S.C. §501(c)(3). 1 Company Accounting Oversight Board’s Advisory Council, a not-for-profit corporation created by the Sarbanes-Oxley Act of 2002 (“S-OX”),2 to oversee the audits of public companies and broker-dealers for the protection of investors and the public. I serve as an advisor to the Global Advisory Forum for CQS (UK) LLP and CQS Investment Management Limited, an international group of alternative asset management funds principally operating out of London, England. Further, I am an independent director of the international hedge funds of Paulson & Co. Inc. (“Paulson”), and a member of their Audit Committees. In my capacity as a Paulson fiduciary Board Member, I regularly consider valuation issues. I am also a member of the Regulatory and Compliance Advisory Council for Millennium Capital Management, LLC, an international hedge fund manager. In addition, I serve as a senior advisor to Teneo Holdings LLC, a global consulting firm that offers strategic planning services to public and private companies as well as local governments. I currently serve on the Board of Directors, and I am a member of the Audit Committee of Premier Alliance Group, Inc., a publicly-owned professional services company focused on business and technology advisory and consulting services, including services related to governance, compliance and mergers and acquisitions. I previously served for three years (2006-2009) on the National Cathedral School’s (“NCS”) Board of Trustees,