UNITED STATES of AMERICA Before the SECURITIES and EXCHANGE COMMISSION

UNITED STATES OF AMERICA Before the SECURITIES AND EXCHANGE COMMISSION

ADMINISTRATIVE PROCEEDING File No. 3-15127 ______| In the Matter of |

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

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

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).

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, and was Board Vice-Chair, Co- Chair of the Board’s Governance Committee and Chair of the NCS Audit and Compensation Committees. I also previously served for four years (2004-2008) on the Board of Directors of Approva Corporation, a privately-held software manufacturer that assisted corporations in improving their internal controls and compliance with the requirements of S-OX. I was also a member of the Board’s Audit and Strategic Planning Committees.

Since 2007, I have provided expert testimony in the U.S. District Court for the District of New Jersey in In re Johnson & Johnson Derivative Litigation (2012); U.S. District Court for the Southern District of New York in In re Bank of America Securities, Derivative and ERISA Litigation (2012); U.S. District Court for the Eastern District of New York in Michael J. Goodman et al. v. Genworth Financial Wealth Management, Inc. et al. (2011); U.S. District Court for the District of Columbia in In re Fannie Mae Securities Litigation (2011); Superior Court of New Jersey in Fairfax Financial Holdings Limited and Crum & Forster Holdings Corp. v. S.A.C. Capital Management, LLC, et al. (2011); U.S. District Court for the Southern District of New York in In re Pfizer Inc. Shareholders

2 Pub. L. 107-204, 116 Stat. 745 (July 30, 2002).

Derivative Litigation (2010); and Delaware Chancery Court in San Antonio Fire & Police Pension Fund v. Amylin Pharmaceuticals, Inc. (2009).

I served on the Staff of the Securities and Exchange Commission (“SEC”) from 1968 until 1978, the last three years of which I served as General Counsel, the Agency’s Chief Legal Officer. A significant part of my responsibilities involved the fiduciary, disclosure, and compliance obligations of public companies and their boards, managers and outside advisors, as well as the regulatory obligations of all capital markets securities professionals, including investment companies and SEC-registered investment advisers.

After my first tour of duty at the SEC, for nearly a quarter of a century (1978-2001), I was a senior corporate partner at an international law firm now known as Fried, Frank LLP (“Fried Frank”). From 1998-2001, I was Co-Chairman of Fried Frank, responsible for all facets of the administration of a global law firm. Prior to 2001, I chaired Fried Frank’s Washington, D.C. office, headed the Firm’s securities and regulatory practice group, and served as Chair of the Firm’s Policy Planning Committee. My practice at Fried Frank covered all aspects of corporate and financial services law, including federal securities regulation, corporate compliance, corporate governance and corporate transactional work.

While at Fried Frank, I represented mutual funds, hedge funds, public corporations, accounting firms and all major entities engaged in financial services work, as well as the trade association for the mutual fund industry, the Investment Company Institute (“ICI”). I regularly advised mutual funds, the ICI, and a number of hedge funds on valuation issues.3 As a more general matter, during my tenure at Fried Frank, I advised boards, audit committees, management and accountants as to proper disclosure, regulatory compliance, shareholder litigation, transactional practices and the like. I represented boards, management, audit committees, and accountants, both with respect to transactional and regulatory matters as well as in SEC enforcement investigations, and I represented special board committees and audit committees in connection with internal investigations.

In my second tour of duty with the SEC, from 2001 to 2003, I served as its 26th Chairman. During my tenure as Chairman, I oversaw the SEC’s response to market disruptions resulting from the terrorist attacks of 9/11. I created the SEC’s “real time enforcement” program, a policy geared towards making the

3 I provided this advice both prior to 2007 and subsequently.

SEC’s enforcement initiative more efficient and effective for the protection of investors. I also led the SEC’s adoption of dozens of rules in response to the corporate and accounting crises generated by the excesses of the 1990s (for example, scandals involving WorldCom, Enron, Adelphia and Tyco), including implementation of the S-OX rules.

As mentioned above, I am currently (and have been since 2003) Chief Executive Officer of the Kalorama firms, which specialize in offering strategic (and related legal) advice to corporations and financial service firms, as well as their boards of directors and audit committees, in a wide variety of areas, including corporate governance, compliance, valuation, transparency, auditing and financial reporting issues. Kalorama also offers SEC regulatory and compliance advice, and counsels on the enhancement of corporate policies and procedures, including internal audit and valuation procedures. In addition, Kalorama represents special committees and audit committees in internal investigations and advises corporations on crisis management in the wake of litigation, public reputational concerns and financial, disclosure, fiduciary or accounting problems.

I have taught—in an adjunct law professor capacity—courses on fraud and fiduciary duties under the federal securities laws (Georgetown University Law Center), market structure (George Washington University Law School), fraud and fiduciary duties, and takeover practice/law (University of Pennsylvania School of Law) and corporate governance (Yale Law School). I have been a guest lecturer on various topics at (among other places) Harvard Law School, Yale Law School, The Wharton School, MIT Sloan School of Management and Georgetown University’s McDonough School of Business. From 2002-2010, I was a regular contributing columnist to Compliance Week® on subjects relating to corporate law, compliance, governance and asset valuation. I am a frequent contributor to other publications on related subjects, as well as a frequent lecturer on various issues related to securities and corporate law, as well as economics.4

My government experience with the enforcement of the federal securities laws and the regulation of financial services professionals, and my experiences in private practice counseling and representing corporate boards and management, as well as accounting firms, and my current experience in

4 Attachment 1 contains a list of articles I have written and various lectures of mine that have been published, from 2000 to the present, including articles and lectures relating to the importance of public disclosure, Disclosure Committees, Audit Committees, valuation and systems of internal control.

4 providing compliance and governance advice at Kalorama, provide the predicate for the views I express below on the importance of adequate valuation policies and procedures, as well as the duties of directors of mutual funds to provide proper oversight to satisfy their statutory fiduciary obligations.

3. SUMMARY OF ENGAGEMENT AND CONCLUSIONS

3.1. Background and Scope

On December 10, 2012, the SEC filed an order instituting administrative and cease-and-desist proceedings (“OIP”) against:

 J. Kenneth Alderman, CPA (“Mr. Alderman”);  Jack R. Blair (“Mr. Blair”);  Albert C. Johnson, CPA (“Mr. Johnson”);  James Stillman R. McFadden (“Mr. McFadden”);  Allen B. Morgan Jr. (“Mr. Morgan”);  W. Randall Pittman, CPA (“Mr. Pittman”);  Mary S. Stone, CPA (“Ms. Stone”); and  Archie W. Willis III (“Mr. Willis”).5

Collectively, these eight directors are referenced herein as “Respondents” or “Directors.” Respondents are former members of the Boards of Directors of the following five registered investment companies:

 RMK High Income Fund, Inc., a closed-end fund with a March 31st fiscal year end;  RMK Multi-Sector High Income Fund, Inc., a closed-end fund with a March 31st fiscal year end;  RMK Strategic Income Fund, Inc., a closed-end fund with a March 31st fiscal year end;  RMK Advantage Income Fund, Inc., a closed-end fund with a March 31st fiscal year end; and  Morgan Keegan Select Fund, Inc. (“Select Fund”), an open-end company with a June 30th fiscal year end that contained three open- ended series: (i) The Select High Income portfolio,

5 Order Instituting Public Administrative and Cease-and-Desist Proceedings Pursuant to Sections 9(b) and 9(f) of the Investment Company Act of 1940, Rel. No. 30300, A.P. File No. 3- 15127 (Dec. 10, 2012) ("Order”), available at http://www.sec.gov/litigation/admin/2012/ic- 30300.pdf.

(ii) Select Intermediate Bond portfolio, and (iii) Select Short Term, Bond portfolio.

Collectively, these five mutual funds are referenced as “Funds.” Substantial portions of the Funds’ portfolios included below-investment grade debt securities, including securities backed by subprime mortgages that did not have readily available market quotations such that the Funds were required to follow their “fair value” policies and procedures (these securities are referred to herein as “Unquoted Securities”).

The Division alleges that, between at least January and August 2007, (“Relevant Period”), Respondents were a cause of the Funds’ violations of Investment Company Act of 1940 (“Investment Company Act”) Rule 38a-1, 6 because the Respondents failed to adopt, implement and review meaningful fair valuation methodologies and related procedures with respect to the Unquoted Securities. The Division further alleges that the Respondents were a cause of the Funds’ violation of Investment Company Act Rules 22c-1 and 30a-3(a),7 and were a cause of the Funds filing of a registration statement with the SEC pursuant to the Investment Company Act containing materially false or misleading statements or omissions.8

I have been retained by the Division to examine particular issues raised in the OIP—specifically, those matters involving the Respondents’ directorial duties and responsibilities with regard to the fair valuation of the Unquoted Securities. I have been asked to assess the Respondents’ conduct relative to the legal requirements and industry practice during the Relevant Period.

3.2. Summary of Opinions

As detailed below, my principal conclusions are:

i. Respondents failed to specify—or ensure the specification of—an appropriate methodology pursuant to which fair values for the Unquoted Securities would be determined.

6 17 C.F.R. §270.38a-1, available at http://www.law.uc.edu/sites/default/files/CCL/InvCoRls/rule38a-1.html, adopted in Investment Company Act Rel. No. 26299 (Dec. 17, 2003) [68 FR 74714 (Dec. 24, 2003) (“Adopting Release”), available at http://www.sec.gov/rules/final/ia-2204.htm. 7 17 C.F.R. §§270.22c-1 & 270.30a-3(a). 8 Order at ¶¶39-42.

ii. Respondents delegated their responsibilities with respect to the fair value determination of the Unquoted Securities to a Valuation Committee, without providing substantive guidance for, or oversight of, how those determinations should be made.

iii. Respondents did not sufficiently understand the valuation methodology employed by the Valuation Committee, a legally-mandated precondition for satisfying their directorial duties.

iv. Contrary to the Funds’ written Policies and Procedures, the Respondents did not ensure that written explanations of the methodology utilized in valuing the Unquoted Securities were provided to them, even though those explanations were necessary for Respondents to understand and evaluate the appropriateness of the methodology claimed to have been employed.

v. Respondents failed to review regularly the appropriateness of the method used in valuing the Unquoted Securities by neglecting to mandate appropriate policies, such as reports to identify potentially stale prices and adviser overrides of external price quotations.

vi. Unquoted Securities made up the majority of the Funds’ net asset values (“NAV”), rendering the Respondents’ failures especially egregious.

vii. While comparing past sales to fair values (the so-called “Look-Back Test”)9 can serve as one appropriate tool to review the efficacy of valuation methodologies, it is of minimal significance—and could not have provided comfort to Respondents—in a context where, as here, a relatively small percentage of the Unquoted Securities were sold during the Relevant Period.

viii. Respondents failed to respond to number of red flags that arose at varying points in time that should have alerted them that serious deficiencies existed with respect to the Funds’ valuation methodologies, and their policies and procedures, including:

9 As discussed further in § 5.4 infra, the Look-Back Test is an analytical tool used to assess valuation methodologies by comparing securities values resulting from a particular valuation methodology with actual sales of the same or similar securities.

a. Incidents suggesting that Mr. Kelsoe, a senior portfolio manager for Morgan Asset Management, Inc., exercised undue influence over the Valuation Committee;

b. Warnings from Mr. Miriyagalla, the Funds’ external auditor, that the Board needed valuation assistance; and

c. Indications by the Funds’ accountants that they were unable to document how valuations were determined.

ix. Respondents failed to exercise the appropriate standard of care required by the Investment Company Act and Commission pronouncements to value securities in good faith, and failed to comply with the standard of care generally followed by the industry at that time.

4. STANDARDS OF CARE DURING THE RELEVANT TIME PERIOD

4.1. Relevant Legal Framework and Relevant Sources of Guidance

4.1.1. Commission Requirements

Mutual fund securities reflect an ownership interest in the fund (and, as a result, the fund’s portfolio assets). A mutual fund is obligated to determine, on a daily basis, the value of its shares, based on the NAV of the fund’s portfolio securities, and to use that NAV when the fund sells or redeems its shares.10 There are two types of portfolio securities assets a fund might own—securities for which market quotations are “readily available,” and those for which such market quotations are not readily available. When valuing portfolio securities for which market quotations are “readily available,” funds must use those market quotations. 11 When valuing portfolio securities for which market quotations are not readily available, funds’ boards of directors must determine, in good faith, the “fair value” of the security.12 As a general rule, the “fair value”

10 Investment Company Act Rule 22c-1(b), 17 CFR §270.22c-1(b).

11 Investment Company Act §2(a)(41), 15 U.S.C. §80a-2(a)(41), and Rule 2a-41-1 thereunder, 17 CFR §270.2a-41-1.

12 Id. See also Investment Company Act §2(a)(41)(B), 15 U.S.C. §80a-2(a)(41)(B), which defines “fair value” as:

“(i) with respect to securities for which market quotations are readily available, the market value of such securities; and (ii) with respect to other securities and assets, fair value as determined in good faith by the board of directors. . . .”

8 of a security is the price a fund might reasonably expect to receive upon the current sale of that security, even if the fund intends to hold it until maturity.13

As discussed below, the SEC repeatedly has emphasized the critical importance of assessing the fair value of a fund’s portfolio securities in ensuring fairness to all existing and prospective mutual fund shareholders. Since the passage of the Investment Company Act, the SEC has issued guidance numerous times to assist fund boards in assessing when market quotations are or are not “readily available,” and in determining the “fair value” of securities for which such quotations are not available. This guidance highlights various circumstances and challenges fund boards might encounter in fulfilling their important statutory valuation obligations.

A number of the Commission’s pronouncements vis-à-vis valuation over the years are particularly relevant and illustrative of the legal and regulatory framework governing a fund board’s portfolio valuation obligations. Thus, the SEC issued fair valuation guidance with respect to Unquoted Securities in 1969 in Accounting Series Release (“ASR”) No. 113.14 That release was followed by ASR 118,15 in which the SEC provided more general valuation guidance. In 1999, the Staff of the Division of Investment Management (“IM Division”) issued an interpretative letter to the ICI (“Scheidt 1999 Letter”),16 providing guidance on valuation issues in emergency or other unusual situations. The IM Division issued follow-up advice to the ICI in 2001, regarding the valuation of foreign securities (“Scheidt 2001 Letter”). 17 Thereafter, the IM Division provided

13 SEC Accounting Series Release (“ASR”) No. 113, Financial Reporting Codification (CCH) § 404.04 (Oct. 21, 1969), available at http://www.sec.gov/rules/interp/1969/ic-5847.pdf; ASR No. 118, Financial Reporting Codification (CCH) §404.03 (Dec. 23, 1970) [35 FR 19986 (Dec. 31, 1970)], available at http://www.sec.gov/rules/interp/1970/ic-6295.pdf.

14 ASR 113 (Commission interpretive release discussing valuation issues for Unquoted Securities, and the board’s good faith obligation to determine those securities’ fair value). As Legal Assistant to Commissioner Francis M. Wheat in 1969, I participated in the drafting of ASR No. 113.

15 ASR 118 (Commission interpretive release discussing, among other things, the valuation of securities listed or traded on national stock exchanges, over-the-counter securities, and securities valued in “good faith”).

16 Letter from Douglas Scheidt, Assoc. Dir. and Chief Counsel, SEC’s IM Division to Craig S. Tyle, General Counsel, ICI, regarding Valuation Issues (Dec. 8, 1999), available at http://www.sec.gov/divisions/investment/guidance/tyle120899.htm (discussing the need for exchanges or markets on which portfolio securities are traded to be open the entire day for price quotations to be deemed “readily available,” certain factors fund Boards should consider in fair value pricing, and the obligations of fund boards in determining fair value).

17 Letter from Douglas Scheidt, Assoc. Dir. and Chief Counsel, SEC’s IM Division to Craig S. Tyle, General Counsel, ICI (Apr. 30, 2001), available at 9 additional guidance and clarification regarding a fund board’s obligations, utilizing various channels, including senior-level Staff speeches published on the SEC’s website for widespread dissemination.

This guidance articulates the factors fund boards must take into account in assessing whether or not market quotations are readily available and, if market quotations are not readily available, the factors to be considered in making good faith fair value determinations. In addition, the SEC’s repeated emphasis and guidance on valuation practices and policies has reinforced the importance of the role played by fund boards in determining their funds’ NAV, thereby protecting existing and prospective fund shareholders.

In 2003, the SEC adopted Investment Company Act Rule 38a-1, requiring mutual fund boards to “adopt and implement written policies and procedures reasonably designed to prevent violation of the Federal Securities Laws by the fund, including policies and procedures that provide for the oversight of compliance by each investment adviser, principal underwriters, administrator, and transfer agent of the fund.”18 The Rule also requires each fund’s board, including a majority of independent directors, to approve the “fund’s policies and procedures” as well as “those of each investment adviser, principal underwriters, administrator, and transfer agent of the fund.”19 Board approval must be based on a board finding that the fund’s various policies and procedures are designed to achieve the Rule’s mandate—“to prevent violation of the federal securities laws”—by the fund and the various persons and entities involved in its administration.20 In addition, the Rule provides for an annual review of the fund’s compliance policies and procedures, and the designation of a Chief Compliance Officer.21 Rule 38a-1 is designed to function as an additional obligation imposed on fund boards--thus, a board’s failure to comply with Rule 38a-1 constitutes a distinct violation of the securities laws, whether or not any specific harm can be attributed to instances of noncompliance with the Rule. In promulgating this compliance rule, the SEC explicitly highlighted this point: http://www.sec.gov/divisions/investment/guidance/tyle043001.htm (clarifying certain valuation issues, and noting instances when fair value pricing would be inappropriate).

18 17 C.F.R. §270.38a-1(a)(1).

19 17 C.F.R. §270.38a-1(a)(2).

20 17 C.F.R. §270.38a-1(a)(2).

21 See 17 C.F.R. §§270.38a-1(a)(3) (“Annual Review”) and (a)(4) (“Chief compliance officer”).

Failure of an adviser or fund to have adequate compliance policies and procedures in place will constitute a violation of our rules independent of any other securities law violation.22

This focus on process as well as on substance reflected the Commission’s decision to alert mutual fund boards that they would be sanctioned if they failed to adopt and implement written compliance policies and procedures—before such failures have a chance to harm shareholders and investors.23

The Adopting Release for Rule 38a-1 confirmed that the rule was “critically important for [ensuring that registered] funds and advisers . . . have strong systems of controls in place to prevent violations of the federal securities laws and to protect the interests of shareholders and clients.”24 While the Rule focuses on policies and procedures, the SEC stated that its broader goal was to encourage fund boards to cultivate a “culture of compliance.”25

4.1.2. Rule 38a-1 Imposes Specific Requirements on the Fund Boards with Respect to Portfolio Valuation

Rule 38a-1 has broad coverage, imposing a general requirement on mutual fund boards to adopt and implement written policies and procedures for preventing violations of the federal securities laws, and protecting the interests of shareholders and clients. The Adopting Release highlights the application of Rule 38a-1 to certain key obligations, most notably, “[p]ricing of portfolio

22 Adopting Release at § II. Moreover, “the SEC will be able to bring enforcement actions against . . . registered funds solely for the failure to create adequate compliance controls, even if the absence of an effective program doesn’t necessarily harm clients or investors.” Cohen, Lawrence The SEC is picking monitors for the classroom, New rules for funds and advisers tighten the compliance process, ABA Business Law Section Release, Vol. 14, No. 1 (Sept./Oct. 2004), http://apps.americanbar.org/buslaw/blt/2004-09-10/cohen.shtml.

23 Shortly after the Rule was implemented, in February 2004, Paul Roye, then-Director of the IM Division, observed that, “[t]he recent fund scandals underscore the importance of rules and processes. They are not meaningless red tape.” Paul F. Roye, Dir., IM Division, Remarks before the National Investment Company Service Association 22nd Annual Conference & Expo (Feb. 23, 2004), http://www.sec.gov/news/speech/spch022304pfr.htm.

24 Adopting Release at Section I.

25 Lori A. Richards, Dir., SEC Office of Compliance Inspections and Examinations (“OCIE”), Put The Compliance Rule To Work: IA Compliance Best Practices Summit (Mar. 15, 2004), http://www.sec.gov/news/speech/spch031504lar.htm (“It's up to the business leaders of the firm to take steps to imbue a culture of compliance throughout the firm. . . . This is a message that the Commission intended to send unequivocally when it adopted the ‘Compliance Rule’ last December.”).

11 securities and fund shares.”26 In adopting Rule 38a-1, the SEC stated that the Rule imposes an obligation on fund boards to adopt and implement written policies and procedures that require funds to:

1. Monitor for circumstances that may necessitate the use of fair value prices;

2. Establish criteria for determining when market quotations are no longer reliable for a particular portfolio security;

3. Provide a methodology or methodologies by which the fund determines the current fair value of the portfolio security; and

4. Regularly review the appropriateness and accuracy of the method used in valuing securities and make any necessary adjustments.27

From this general requirement, fund boards are tasked with creating and overseeing more specific policies and procedures to ensure accurate valuation methodologies. The generality of the requirement provides “fund complexes with flexibility so that each complex may apply the rule in a manner best suited to its organization.”28

4.1.3. Industry Guidance and Practice

Aside from various forms of guidance the SEC and its Staff have issued relating to policies and procedures that fund boards must develop to ensure that their fund’s valuation methodologies comply with Rule 38a-1, during the Relevant Period fund boards also regularly received industry guidance that the Respondents here could—and should—have consulted. 29 In seeking to

26 Adopting Release at II.A.2.c.

27 Id.

28 Id. at II.A.2.a. 29 There is an abundance of existing valuation guidance that has already been provided to registrants. Indeed, the SEC Staff recently reminded those who counsel funds on valuation issues that

[t]he Commission’s website includes a bibliography of materials regarding valuation, including relevant provisions of the Investment Company Act and related rules, Commission and staff guidance, and enforcement actions in order to assist funds and their counsel in understanding and applying the valuation requirements under the Investment Company Act.

Norm Champ, Dir., IM Division, Remarks to the ALI CLE 2012 Conference on Investment Adviser Regulation: Legal and Compliance Forum on Institutional Advisory Services (Dec. 6, 2012), 12 encourage mutual fund boards to be proactive in complying with Rule 38a-1, the SEC, concomitant with its adoption of the Rule, urged boards to look to industry best practices that were being developed in response to the new legal requirements and the recent mutual fund scandals.30 In my experience, boards during the Relevant Period were advised, and understood, that they were subject to exacting requirements with regard to their valuation responsibilities.

A significant resource providing industry guidance on valuation practices is a report published by the Mutual Fund Directors Forum (“MFDF”) entitled, Best Practices and Practical Guidance for Mutual Fund Directors, published in July 2004—several months before boards were required to be compliant with Rule 38a-1.31 While it is not uncommon for the SEC to engage in such constructive

available at http://www.sec.gov/news/speech/2012/spch120612nc.htm. Mr. Champ also indicated that the IM Division intended to provide additional guidance in this area, given changes since the Commission (as opposed to its Staff) “last issued guidance regarding valuation.” Id. The SEC Staff’s valuation guidance bibliography is set forth at http://www.sec.gov/divisions/investment/icvaluation.htm. Even a cursory review of this bibliography makes it clear that the guidance available, both during the Relevant Period and now, is quite extensive.

It is, unfortunately, not uncommon for some regulated entities to complain that they need additional guidance. Of course, even if additional guidance might be helpful, that does not undermine the efficacy of existing rules already in place, as well as the wealth of Staff guidance referenced on the Commission’s website, or somehow suggest that existing requirements should not be enforced rigorously. In reference to some less well-intentioned requests for SEC guidance, one former IM Division Director, Paul Roye, observed that, in

[r]esponding to complaints about the lack of guidance, the Commission recently asked for comment on what guidance we might provide. We have received little help, leading some of us to wonder whether the complaints were really just an excuse for avoiding responsibility for employing effective fair valuation policies.

Paul F. Roye, Dir., IM Division, Remarks Before the ICI General Membership Meeting, (May 20, 2004), available at http://www.sec.gov/news/speech/spch052004pfr.htm.

30 Adopting Release at II.A.2.b (“We urge boards to also consider best practices used by other fund complexes, and to consult with fund counsel (and independent directors with their counsel), compliance specialists and other experts familiar with compliance practices successfully employed by similar funds or service providers.”).

31 MFDF, Report on Best Practices and Practical Guidance for Mutual Fund Directors 32-35 (Jul. 2004) (“MFDF Report”), available at http://www.mfdf.org/images/uploads/resources_files/best_pra.pdf. The MFDF, which was formally organized in 2002, during my tenure as Chairman of the SEC, is an independent nonprofit membership organization that serves to educate the independent directors of U.S. mutual funds, and seeks to advance the development of dedicated, vigilant and best-in-class independent directors. See MFDF Report at 1; “About the Mutual Fund Directors Forum,” http://www.mfdf.org/about_mfdf/overview/. While Chairman of the SEC in 2003 and continuing thereafter, I have commended the Forum’s efforts to provide rigorous training for, and education of, independent mutual fund directors. See, e.g., Harvey L. Pitt, Chairman, SEC, Remarks at 13 private-public initiatives, it is rare for the SEC Chairman to be directly involved, as was then-Chairman William Donaldson; indeed, the Forum’s project was undertaken in direct response to a request by then-Chairman Donaldson.32 The Chairman’s connection with this project, as well as the substantive merit of the MFDF Report itself, led the SEC’s then-Director of Enforcement, Stephen Cutler, to describe the Report as reflective of “the type of proactive thinking that is essential for independent directors to be able to serve as an effective force in actively safeguarding the interests of fund investors.”33

Subsequent to the July 2004 MFDF Report—still well before the Relevant Period—the mutual fund industry continued to focus its collective efforts on developing guidance to assist boards in exercising their duties with regard to valuation methodologies. This is evidenced by two publications that were also available to Respondents during the Relevant Period, both of which emanated from the well-established mutual fund industry trade association, the ICI. Both publications focus squarely on fair valuation within the mutual fund context.34

Mutual Fund Directors Forum (Jan. 8, 2003), available at http://www.sec.gov/news/speech/spch010803hlp.htm.

Demonstrating the efficacy of private sector guidance initiatives, the MFDF has continued to provide quality guidance for fund directors relating to a range of timely and relevant issues. Perhaps most noteworthy in the present context is the MFDF’s recent publication, Practical Guidance for Fund Directors on Valuation Oversight (June 2012), available at http://www.mfdf.org/images/uploads/newsroom/Valuation-web.pdf, which provides guidance that expands on the Forum’s 2004 Report.

32 See Letter from William H. Donaldson, Chairman, SEC, to David S. Ruder, Chairman, and Allan S. Mostoff, President, MFDF (Nov. 17, 2003), MFDF Report at 40 (“I would welcome your help in providing practical guidance to fund directors as to how they can fulfill their obligations to fund investors. You and your organization are in a unique position to educate fund directors and provide them with information and insights to carry out their fiduciary obligations.”); Letter from David S. Ruder, Chairman, and Allan S. Mostoff, President, MFDF, to William H. Donaldson, Chairman, SEC (Nov. 21, 2003), MFDF Report at 42. Further, the Report noted,

The “best practices” described in this report were developed by the Forum at the request of William H. Donaldson, Chairman of the Securities and Exchange Commission (“SEC”). Noting that “statutory provisions and regulations can only go so far,” Chairman Donaldson asked the Forum to provide practical guidance to fund independent directors in five areas in which director oversight and decision-making is critical for the protection of fund shareholders.

MFDF Report at 1 (footnotes omitted).

33 Remarks before the 2004 ICI Securities Law Developments Conference, by Stephen M. Cutler, Director, Division of Enforcement, Washington, DC at ¶15 (Dec. 6, 2004), http://www.sec.gov/news/speech/spch120604smc.htm#16. Mr. Cutler noted, “Directors can be a powerful force in establishing and maintaining a culture within a mutual fund organization in which the interests of fund shareholders are treated as paramount.” Id.

34 Indeed, both publications were issued as part of ICI’s “Fair Valuation Series.” 14

The first of these, An Introduction to Fair Valuation, published in 2005, provided the basic legal and regulatory framework governing fair valuation in mutual funds.35 The following year, in 2006, the ICI published The Role of the Board, as part of its Valuation Series, in which it specifically addressed the functions and obligations of fund boards in determining and overseeing fair value determinations.36 Thus, prior to and during the Relevant Period, Respondents had at their disposal multiple sophisticated and well-regarded resources they could draw upon to comply with their duties in a thoughtful and effective manner.

4.2. A Fund Board’s Approval of Fair Valuation Policies and Procedures Must be Based on Specific Findings by the Board

A fund board’s duty to adopt and implement written policies and procedures requires the board formally to conclude that the policies and procedures are “reasonably designed to prevent violation of the federal securities laws” by either the fund or the fund’s service providers.37 To make such a finding, a fund board must understand those policies and procedures. Further, the board must also consider the roles of all participants in the promulgation, implementation, and review of the policies and procedures, which includes the board itself, and anyone to whom the board assigns responsibilities.

4.2.1. SEC Guidance

Rule 38a-1 explicitly requires,

a fund’s board, including a majority of its independent directors, to approve the policies and procedures of the fund and each of its service providers. The approval must be based on a finding by the board that the policies and procedures are reasonably designed to prevent violation of the federal securities laws by the fund and its service providers. 38

35 ICI Fair Valuation Series: An Introduction to Fair Valuation (2005), available at http://www.ici.org/pdf/05_fair_valuation_intro.pdf.

36 ICI, Fair Valuation Series: The Role of the Board (2006), available at http://www.ici.org/pdf/06_fair_valuation_board.pdf.

37 Adopting Release at II.A.2.b. 38 Id. (internal footnotes omitted) (emphasis supplied).

As the Adopting Release notes, “[m]ost of the operations of funds are carried out by service providers, which have their own compliance policies and procedures.”39 Responding to that reality, the Rule provides that the board may obtain assistance, but that it always retains ultimate accountability and must therefore remain closely engaged in the valuation process.

In satisfying its obligations under Rule 38a-1, a fund board must approve the fund’s policies and procedures as well as the policies and procedures of each of its service providers—and such approval must be based on a “finding” by the board.40 Furthermore, fund boards must oversee the compliance of their service providers, and their policies and procedures must account for oversight responsibility.41 A fund board may obtain assistance from persons it selects to assist it in determining in good faith the fair value of portfolio securities, but it cannot delegate its fiduciary obligation to select those who will assist it, understand the methodology they will utilize, and oversee the actual performance of valuation activities.42

The Rule’s requirement that a board’s approval of policies and procedures must be based on a specific and detailed finding illustrates that boards cannot simply outsource their responsibilities. Rather, fund boards retain ultimate responsibility for the valuation process, and must therefore exercise meaningful oversight of it. This, in turn, requires that fund boards obtain a meaningful understanding of the policies and procedures of both the fund and each of the fund’s service providers. 43 As the Adopting Release

39 Adopting Release II.A.2.a.

40 17 C.F.R. §270.38a-1(a)(2).

41 17 C.F.R. §270.38a-1(a)(1)

42 See, e.g., Scheidt 2001 Letter at n.23 (“Consistent with the good faith requirement, boards may appoint persons to assist them in determining fair values and to make actual fair value calculations under the boards' direction”) (referencing and citing ASR No. 113, ASR 118, and Scheidt 1999 Letter).

43 See In the Matter of Jon D. Hammes, et al., Investment Company Act Release No. 26290 (Dec. 11, 2003), available at http://www.sec.gov/litigation/admin/33-8346.htm, where the SEC settled charges brought against four independent directors of Heartland Group, Inc., a registered open-end management investment company (“Heartland”). The SEC found that the directors failed to discharge their responsibility to oversee the valuation of bonds held by two Heartland funds. The Heartland board had instituted commonly used procedures for bond valuation, including delegating day-to-day responsibilities to a Pricing Committee, and also had taken specific actions to address the fund’s mispricing of bonds, including requesting information from the fund’s Adviser and requesting that the fund sell certain bonds. Despite these efforts, the SEC found that the directors failed to satisfy their regulatory obligations because they failed to 16 explains, while fund directors “may satisfy their obligations under the rule by reviewing summaries of compliance programs,” this only applies if the summaries “familiarize directors with the salient features of the programs (including programs of service providers) and provide them with a good understanding of how the compliance programs address particularly significant compliance risks.”44

The Rule emphasizes fund boards’ ongoing responsibility for their fund’s compliance by requiring that their fund’s policies and procedures specifically address board obligations to oversee the compliance of their fund’s service providers. Thus, the Commission’s Rule makes clear that fund boards cannot satisfy their duties by relying on the policies and procedures of their service providers, even if the board previously examined those policies and procedures and formally found them to have merit. Instead, each fund’s policies and procedures must provide a framework that requires the board itself to oversee compliance by the fund’s service providers. In discussing this requirement, the Adopting Release noted:

Some commenters urged us to permit funds to simply rely on their service providers’ policies and procedures. We have not adopted this suggestion because it would permit funds and their boards to absolve themselves of responsibility for compliance activities of the service providers through which funds conduct most of their activities.45

Indeed, it is precisely because service providers play such a fundamental role in administering the fund’s activities that fund boards must oversee their compliance. This concern was also highlighted by the mutual fund scandals that were a significant impetus for the promulgation and adoption of Rule 38a-1, since the improper conduct involved in those scandals was the product of follow up after the Adviser neglected to provide the requested reports, and the directors failed to insist—consistent with their duty—that the fund execute the sale of the problematic securities. The SEC also found that the independent directors did not adequately discharge their responsibility to participate meaningfully in the valuation of the funds’ securities, and that the directors knew, or should have known, that the Adviser was selling, redeeming, and repurchasing funds’ shares at prices that were not based on the funds’ current NAVs. As the SEC stated in its Order, “[w]hile mutual fund directors are permitted to delegate some responsibility for pricing a fund’s securities to a separate committee, each director retains responsibility to be involved in the valuation process and may not passively rely on securities valuations provided by such a committee.” Id. at §D.2 (emphasis supplied). 44 Adopting Release at II.A.2.b.

45 Id.\at n. 29.

17 malfeasance on the part of fund intermediaries.46 For these reasons, the Rule emphasizes that fund boards must oversee their service providers, their policies and procedures, and their legal compliance.

4.2.2. Industry Guidance and Practice

Available industry guidance during the Relevant Period emphasized the balance between a fund board’s ability to rely—within appropriate limits—on third-party service providers with the requirement that it evidence direct involvement with the valuation process. That industry guidance recognized—as must be the case—that fund boards typically, and appropriately obtain various forms of assistance in satisfying their valuation responsibilities, and that they could use a number of organizational structures and strategies to do so. But, all industry guidance emanating during the Relevant Period consistently stressed the fundamental notion that, in the end, it is the fund’s board that is accountable for determining and overseeing portfolio valuation.

Thus, in discussing a fund board’s ability to obtain the assistance of valuation and pricing committees in fulfilling certain valuation functions, the ICI 2006 Report cautioned its members that the SEC’s Staff had noted that although a fund board can use a valuation committee, a fund’s “board must oversee the committee(s) and retains ultimate responsibility for valuation matters.”47 It also cautioned boards that the SEC had demonstrated its readiness to hold fund directors liable for their role—or the absence of their meaningful involvement— in overseeing a fund’s fair valuation process.48

The MFDF’s Report also highlighted the responsibilities of fund directors and their accountability, when it discussed the balance fund directors could draw between the performance of day-to-day functions—something as to which fund directors could utilize service providers—and fund board directors’ oversight functions that must actually be performed by fund directors

46 See Paul F. Roye, IM Division Director, Remarks before the National Investment Company Service Association 22nd Annual Conference & Expo (Feb. 23, 2004), http://www.sec.gov/news/speech/spch022304pfr.htm (“Unfortunately, many of the problems related to mutual funds that have recently surfaced directly involved fund service providers. . . . Even more alarming and distressing is that certain service providers were also involved in facilitating late trading of fund shares—a practice that is clearly fraudulent.”)

47 ICI 2006 at 8.

48 See ICI 2006 at 15-16 (noting, for example, that the SEC brought an enforcement action against directors for their “failure to follow up” on important valuation matters, referencing In the Matter of Jon D. Hammes, et al., Investment Company Act Rel. No. 26290 (Dec. 11, 2003), available at http://www.sec.gov/litigation/admin/33-8346.htm.

18 themselves. The Report recommended that, in order for fund directors to “organize themselves to oversee fund valuation and pricing,” they should consider issuing a written statement that “clearly articulates the separation of the directors' oversight responsibilities from the daily fund management valuation and pricing responsibilities.”49 The MFDF Report encourages fund independent directors to “[c]onsult with management directors” in overseeing valuation, but cautioned that “independent directors need to reach their own conclusions regarding the sufficiency of the valuation and pricing policies and procedures followed by management's valuation and pricing committee,” and cannot merely rely on management directors or others.50

Consistent with these industry publications, in my experience during the Relevant Period, boards were advised that they could utilize service providers for the performance of day-to-day valuation responsibilities, but were strongly cautioned that they retained, and were required to exercise, ultimate responsibility for ensuring the development and implementation of appropriate valuation policies and procedures. Some fund boards created board valuation committees, comprised of experienced professionals with the requisite expertise to value a fund’s portfolio securities, and to assist fund boards’ oversight of the fund investment adviser’s internal valuation and pricing policies, procedures and practices. Alternatively, other fund boards were advised that those functions could be assigned to other board committees, often the audit or compliance committees. In selecting a particular structure, boards were advised to consider the implications of that structure on the reporting cycle for valuation determinations—that is, fund boards were advised to take into account how frequently directors would receive reports on the valuation process.

Given fund boards’ ultimate responsibility for valuation policies, procedures and calculations, boards were advised to give careful attention to the precise procedures they would employ to oversee and review fair value determinations. In that regard, fund boards were advised—and understood— that their receipt of reports from those performing value calculations must be frequent enough to enable them to oversee and monitor fair valuation efforts adequately, and ensure that those efforts were implemented in accordance with the specific pricing policies adopted by the board. Boards were advised to anticipate that certain types of securities, such as Unquoted Securities, or

49 See MFDF 2004 at 55.

50 Id.

19 securities with unusual market conditions, would require that the board receive valuation calculation reports more frequently and also require that the board conduct reviews more often.

In my experience, boards were advised that it was critical and obligatory that they understand their fund’s fair valuation methodologies, the policies and procedures, and the implementation of the methodologies and procedures. While no one suggested that fund directors themselves were required to possess valuation expertise, fund directors were advised that they were required to become familiar with valuation techniques in order to develop their fund’s valuation methodologies, and in order to permit them adequately to evaluate their valuation committee’s and fund adviser’s valuation processes. Developing this familiarity was understood by fund directors to be critical for them to properly approve their fund’s valuation policies, as well as their fund adviser’s internal governance structure.

In my experience, it frequently was useful for management and a fund’s board to collaborate in developing the policies and procedures that govern day- to-day valuation activities. In order to ensure that their fund’s valuation committee was adhering to board policies in implementing valuation methodologies, and to maintain a regular flow of information between the board and the fund’s valuation committee, many board policies provided that at least one director would serve on their fund’s valuation committee. Directors were also advised that they were required to have a clear understanding of the nature and extent of the involvement of portfolio managers in the valuation process. While portfolio managers can provide valuable information to a fund’s valuation committee, fund boards were continually reminded that portfolio managers have inherent conflicts vis-à-vis the valuation process.

This is so because no portfolio manager wants to see low values attributed to the portfolio he or she manages, since that could adversely affect the portfolio manager’s performance record (and, frequently, the portfolio manager’s compensation).51 Accordingly, it has always been well understood

51 See, e.g., Mercer Capital, Value Matters, Vol. 2008-07 at 2 (Jul. 22, 2008), available at http://mercercapital.com/assets/Mercer-Capital_Value-Matters-2008-07.pdf (indicating that valuation committees should ensure a “significant degree of independence from portfolio managers and trading personnel,” in order “to ensure the valuation committee is reasonably free from potential conflicts of interest”); Houlihan Lokey, Independent Third-Party Valuation Insights: Portfolio Valuation Best Practices, at 5 (undated), available at http://www.hl.com/email/pdf/ValuationBestPractices_International.pdf (“Fund managers’ compensation is normally tied to total assets under management and portfolio performance; a fund manager’s influence over the valuation of illiquid assets may create a conflict of interest.”).

20 that the extent of a portfolios manager’s input in any fund’s valuation process must be constrained.

In my experience, some boards received information on the market price for Unquoted Securities, if and when that information was available, and those boards that were well-advised double-checked the validity of the valuation after- the-fact. Similarly, boards were advised that they were required to understand the role of third party pricing services. In my experience, boards that received appropriate advice invariably developed policies outlining when their funds would or would not rely on third party pricing services.

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”

Rule 38a-1 imposed a variety of obligations on mutual funds, including the requirement that funds establish criteria for determining when market quotations are no longer reliable for a particular portfolio security, triggering a need to determine the fair value of that security. As discussed below, the Rule also requires boards to determine the methodology to be used in coming up with the fair value of such securities. 4.3.1. SEC Guidance

This aspect of a fund board’s obligations relate to the fundamental duty of boards to ensure that their funds sell and redeem their shares based on current NAV.52 When market quotations are not readily available, boards must make good faith determinations of the securities’ fair value. Rule 38a-1 requires that boards adopt and implement written procedures defining the methodology (or methodologies) that will be utilized to determine fund securities’ fair values.

Rule 38a-1 requires fund boards to focus their efforts on those aspects of compliance that are most important to, and relevant for, their specific fund, and areas that pose higher compliance risks. The Adopting Release notes that portfolio valuation is a primary concern for the mutual fund industry in general, and this is exceedingly true for funds whose portfolio securities raise significant valuation issues. The Adopting Release states that “[i]n considering whether to approve a fund’s or service provider’s compliance policies and procedures, boards should consider the nature of the fund’s exposure to compliance failures.” 53 Prior guidance consistently emphasized this point as well.

52 See Investment Company Act Rule 22c-1(b), 17 CFR §270.22c-1(b).

53 Adopting Release at §II.A.2.b.

Reflecting on the anticipated focus of OCIE personnel in examining a fund’s Rule 38a-1 compliance policies, then-OCIE Director Lori Richards advised that the SEC’s examiners, “will be looking for a program that reflects the reality of the firm’s business and the conflicts and risks presented by that business.” 54

Consistent with the need to tailor compliance policies and procedures to a fund’s specific circumstances and risks, fund methodologies for determining the fair value of its securities must also be sufficiently detailed and meaningful.55

54 Speech by Lori A. Richard, Dir., OCIE, Put The Compliance Rule To Work: IA Compliance Best Practices Summit at ¶3 (Mar. 15, 2004), available at http://www.sec.gov/news/speech/spch031504lar.htm.

If OCIE conducts an examination and does not indicate specific deficiencies with a fund’s compliance policies, that does mean that there were no deficiencies in that fund’s compliance policies, or constitute a defense against an enforcement action for compliance policy deficiencies that OCIE did not note. Indeed, Investment Company Act §35(b), 15 U.S.C. §80- 35(b), makes it unlawful for any fund director to claim that his or her fund’s policies have been “approved” or “passed upon” by the SEC. More directly, Securities Exchange Act §26 makes it a criminal offense for any person to contend that any “action or failure to act by the Commission” constitutes approval of any particular conduct.. In other words, the lack of a cited deficiency during or following an OCIE examination does not somehow constitute a finding that the examined person did not engage in wrongdoing during the time period covered by the examination. To re-emphasize this point, the SEC Staff has rejected any such assertion:

We caution Boards that SEC examinations are risk-based and are not comprehensive in nature, and do not substitute for direct Board oversight of fund activities.

Speech by Lori A. Richard, Director, Office of Compliance Inspections and Examinations, SEC, The New Compliance Rule: An Opportunity for Change at n.16 (June 28, 2004), available at http://www.sec.gov/news/speech/spch063004lar.htm#P17_525.

55 This should be distinguished from a fund board’s duties apart from those imposed by Rule 38a-1. Prior to Rule 38a-1’s adoption, SEC guidance regarding fund boards’ valuation obligations required that the board be intimately involved in valuation determinations for situations that required more specific attention than provided by general valuation policies. The Scheidt 1999 Letter, for example, explained that the degree of a board’s involvement in meeting its good faith obligation depends on the “comprehensiveness of the pricing procedures” that the board adopted and “the degree of discretion vested in fund management.” Scheidt 1999 Letter at ¶15. The Letter noted:

If, for example, a board has approved comprehensive procedures which provide methodologies for how fund management should fair value price portfolio securities, including procedures which would be appropriate for that particular emergency situation, a board would need to have comparatively little involvement in the valuation process in order to satisfy its good faith obligation[.]

When the board has vested a comparatively greater amount of discretion in fund management, or when pricing procedures are relatively vague, we believe that the board's involvement must be greater and more immediate. In these instances, a fund board may be required to evaluate how emergency conditions are affecting the fund's pricing mechanisms, whether the pricing procedures are appropriate, what inquiries fund management is making, and what factors 22

The policies must consider all appropriate factors, and must be clearly defined and detailed. Referring to the guidance in ASR 113 and 118, a Staff letter in 2004 noted that fund directors’ obligations require “clearly defined policies and procedures to be established by an investment company's board of directors,” and that these policies and procedures “should encompass all appropriate factors relevant to the valuation of investments for which market quotations are not readily available.”56

Fund boards also must approve and oversee detailed policies. Rule 38a-1 requires that fund boards adopt and implement policies that provide meaningful guidance on fair value methodologies. It would be ineffectual if a board were to approve or oversee compliance with policies or methodologies if those policies and methodologies are not sufficiently detailed and informative. Fund boards ultimately are responsible for ensuring that each of their funds “determines the current fair value of the portfolio security.” 57 Boards must approve the methodologies that service providers implement—even if boards do not enmesh themselves in every specific decision, they must at least formally approve the conceptual framework these service providers use and apply.58 For a fund board’s authorization or approval of policies and procedures to provide any

management is considering when making valuation recommendations. Depending on the particular circumstances, the board may need to evaluate how particular portfolio securities are being priced, or, when the fund has limited or no fair value pricing procedures, authorize the specific pricing methodology used.

Scheidt 1999 Letter at ¶¶15-16. While Rule 38a-1 did not change the regulatory framework governing fund boards’ obligations vis-à-vis the valuation of portfolio securities—the standard remained a “good faith determination”—Rule 38a-1 did introduce the separate and distinct requirement that boards adopt and implement policies and procedures to prevent violations of the federal securities laws, including those related to portfolio valuation. Rule 38a-1 imposed obligations on fund boards to adopt and implement policies and procedures—irrespective of what the board’s day-to-day involvement may or may not be. In short, prior to the adoption of Rule 38a-1, comprehensive policies and procedures were encouraged but not mandatory, once Rule 38a-1 was adopted, comprehensive policies and procedures became mandatory.

56 SEC Staff Generic Comment Letter for Investment Company CFOs at 2 (Nov. 1, 1994) (staff letter to industry), available at http://www.sec.gov/divisions/investment/noaction/1994/cfo110194.pdf.

57 Adopting Release at §II.A.2.c. 58 Boards were required to understand pricing processes and various methodologies even prior to the adoption of Rule 38a-1. See Remarks by Lori A. Richard, OCIE Director (June 14, 2001), available at http://www.sec.gov/news/speech/spch499.htm (“The board needs to understand the pricing process -- and will want to review the process with the adviser -- including the criteria considered and the valuation methods used.”).

23 meaningful shareholder protections and benefits, such guidance cannot merely reflect boilerplate provisions, or be either indefinite or “perfunctory.”59

In order to have meaning, a board’s regular “review [of] the appropriateness and accuracy of the method used in valuing securities and . . . any necessary adjustments,” the framework that the board provides or approves for service providers must be sufficiently definitive and specific to assure the board that its service providers know how they are supposed to perform their functions, and to enable the board to hold those service providers accountable if they do not adhere to the board’s prescribed framework.

Effective accountability is only possible if there are clear standards with sufficient specificity for how service providers must act in assisting boards with their valuation responsibilities. Overly broad, or general, policies and methodologies effectively allow service providers to argue that virtually any course of conduct was justified, and thereby preclude their accountability. This means that robust compliance policies are critical for the proper performance of board oversight functions. Commenting on Rule 38a-1 in January 2004, just one month after the Commission’s adoption of the Rule, the then-Director of the IM Division urged fund directors to

make a significant commitment in working with [their] funds’ service providers to ensure that your fund groups have in place the necessary controls and procedures to avoid the types of compliance failures that we have recently observed. This requirement should facilitate fund directors' oversight of the effectiveness of a fund's internal controls and procedures.60

59 Given the goals of the new rule . . . . If you view this rule as “just another compliance obligation,” if you stage compliance with the rule for show, if you take only minimal steps, if you do not believe in its importance, you will fail to seize the opportunity it presents. And, I dare say, the result will be your firm’s vulnerability to the next form of abuse and securities laws’ violations. And, we at the SEC will not tolerate a perfunctory show of compliance. Strong words? Absolutely. There has been talk recently about the industry just “not getting it.”

Speech by Lori A. Richard, Director, OCIE Director, The New Compliance Rule: An Opportunity for Change (June 28, 2004) (internal citations/footnotes omitted), http://www.sec.gov/news/speech/spch063004lar.htm#P17_525.

60 Enhancing the Fund Director's Tool Box, speech by Paul F. Roye, Dir., IM Division Director, before the Fourth Annual Policy Conference Critical Issues for Investment Company Directors, Mutual Fund Directors Forum, Washington, DC (Jan. 8, 2004), available at http://www.sec.gov/news/speech/spch010804pfr.htm.

Policies or methodologies that are general and vague, and lack a sufficient level of detail, fail to satisfy a board’s obligations to provide valuation methodologies, as required under Rule 38a-1.

These requirements—that a fund’s valuation policies and methodologies be tailored to the specific fund, and contain sufficient detail—emphasize that policies and methodologies that simply restate SEC guidance, without customizing it to the specific fund in sufficient detail, do not satisfy a board’s obligations. It also follows that fund boards that merely consult SEC guidance in developing policies for fair valuation methodologies, have not fulfilled their statutory and fiduciary obligations. Documents that provide general guidance for an entire class of entities do not purport to be, nor would it be possible for them to serve as, a “model” policy for the specific valuation methodologies employed by any individual fund.

For example, the general and specific valuation methodology factors discussed in ASR 118 merely demarcate the outside boundaries for what funds should do in developing their own policies—they do not provide a model policy precisely because they are, necessarily, general, and therefore are not tailored to any specific fund. Indeed, attempting to convert prior SEC guidance into a specific fund’s verbatim policies would convert something intended only as guidance into the effective equivalent of a one-size-fits-all policy, something that would be inherently deficient for any fund foolish enough to attempt that.61 ASR

61 As former OCIE Director Lori Richards explained:

Whatever process you use to review and implement new compliance processes, remember that your Compliance Program must be tailored to your business. Why? Because to be effective, it must be integral to your own operations. In this regard, I urge that you not slap together a Compliance Program at the last minute, or buy an off-the-shelf "one-size-fits-all" compliance manual. These Compliance Programs are not likely to be effective. If we find, after October 5th, Compliance Programs that are ill-suited to the firm's business and ineffective, our examiners will assume that compliance is not well-respected by these firms, determine that these firms are at high risk of violations, and will likely conduct a top-to-bottom, in-depth review of the firm's entire operations. And where appropriate we will make referrals to the Enforcement Division.

As you know, the Compliance Rule does not list or mandate the particular areas for which firms must have compliance procedures, or the particular compliance procedures that must be adopted. Funds and advisers are too varied in their operations for them to have the same list of required elements. Instead, the Commission said that each firm's policies and procedures should take into account the nature of, and risks presented by, each organization's operations. The Commission also said that the policies and procedures should be designed to prevent violations from occurring (which is certainly the best outcome!), detect violations that have occurred, and correct promptly any violations that have occurred.

118 plainly states that the general and specific factors it includes “should be considered as guidelines, one or more of which may be appropriate in the circumstances of a particular case.”62 The Scheidt 1999 Letter emphasized this point:

Although we recognize the limited scope of these ASRs [referring to ASR 113 and 118], we also note that they were not intended to provide comprehensive guidance to funds on how to address all pricing issues, nor were they specifically addressed to emergency or unusual situations. ASR Nos. 113 and 118 were intended to provide general illustrative guidance on certain valuation issues, and we believe that they continue to represent the views of the Commission.63

At a minimum, a fund’s policies regarding valuation methodologies should delineate the relative importance of the various factors listed in ASR 118 as they relate to specific circumstances and different types of securities. In addition to considering how various factors should be applied in different circumstances, the board’s valuation methodologies must be related to the valuation of each security in a fund’s portfolio. In discussing fund directors’ statutory valuation obligations, the Commission has stated that directors must determine the method of arriving at the fair value of each such security. For example, ASR 118 provides in relevant part that, To comply with section 2(a)(39) of the Act and Rule 2a-4 (17 CFR 270.2a-4) under the Act, it is incumbent upon the Board of Directors to satisfy themselves that all appropriate factors relevant to the value of securities for which market quotations are not readily available have been considered and to determine the method of arriving at the fair value of each such security. 64

4.3.2. Industry Guidance and Practice

In assisting boards in the development of appropriate valuation methodologies, the available industry guidance echoed and expanded upon the

Speech by Lori A. Richard, Dir., OCIE, Put The Compliance Rule To Work: IA Compliance Best Practices Summit at ¶¶ 5-7 (Mar. 15, 2004) (emphasis supplied), available at http://www.sec.gov/news/speech/spch031504lar.htm.

62 ASR 118 at 35 FR 19987.

63 Scheidt 1999 Letter at ¶6 (footnote omitted)(emphasis supplied).

64 ASR 118 at 19988 (emphasis supplied).

26 themes referenced in prior and subsequent SEC guidance. For example, effective board requires that funds not only adopt written policies and methodologies, but that they actually comply with those policies and methodologies.65

Boards were advised that they must ensure that their funds had in place, and exercised, a disciplined and thorough methodology for calculating fair value. The relevant question is not where the ultimate valuation falls on a spectrum of values, but rather, whether the methodology employed was rational, and offered the prospect of providing values for Unquoted Securities that had integrity. If the valuation methodology employed is designed to reach a predetermined conclusion, the methodology by which that conclusion is reached, by definition, was neither rational nor possessed of integrity. One approach that boards utilized to provide assurances that their policies and procedures regarding valuation methodologies were independent and had integrity was to retain an independent economist to review their valuation methodology and certify that it had a rational basis and reflected a methodology that an independent person might utilize to ascertain the true marketable value of the assets. Economists are trained to utilize objective methodologies to assign economic values to different classes of assets, and thus offer greater integrity in evaluating valuation methodologies than accountants do.

As a fundamental rule, fund boards that were well advised, and made a conscientious effort to read and absorb available guidance, understood that they were obligated to consider the nature of their fund and to tailor the fund’s policies, procedures and valuation methodologies to the fund’s actual circumstances and portfolio. In fact, ICI guidance instructed boards to “approve valuation policies and procedures that are tailored to the funds you oversee.” 66 In more practical terms, this meant that each fund’s valuation policies must be “appropriate in light of the fund’s anticipated investments.”67 Thus, in crafting or approving valuation policies and procedures, directors were urged to,

65 See ICI 2006 at 16 (cautioning of an SEC enforcement action brought against directors for “not being alert for circumstances indicating that the procedures were not being followed”).

66 Id. at 6.

67 Id. at 3 (noting that “[r]egardless of individual levels of involvement and expertise in fair valuation issues,” the appropriateness of policies and procedures is an important consideration for directors to consider).

take into account the specific valuation issues that are likely to arise by virtue of the types of funds they oversee and the kinds of securities that these funds will reasonably be expected to hold.68

During the Relevant Period, boards received advice about various kinds of risks, depending on the nature of the fund’s strategy and the securities it held. For example, funds that invested in thinly traded securities were advised of risks associated with market volatility and changing market liquidity. Boards considered how potentially limited liquidity could affect the fund’s valuation and what the effects of changes in liquidity might be. Another significant factor frequently considered was how a fund’s adviser monitored changes in liquidity applicable to the fund’s portfolio holdings. In my experience, boards were advised to consider the specific attributes of their funds’ securities, and ensure that their valuation policies and procedures, as well as the implementation of those policies and procedures, were tailored to take account of the composition of the funds’ portfolios.

Industry guidance was also instructive as to the level of detail that valuation policies should aim to capture. The ICI observed that valuation procedures were “increasingly” including specific methodologies the fund would use, “including methodologies for particular types of securities.”69 For example, the ICI noted that the board of a “fixed income fund that invests primarily in fixed income securities” should design its policies and procedures to “describe, in specific quantitative terms, the formulas used for fair value in certain situations.” 70 Similarly, to ensure that a board’s policies were meaningful and relevant, the MFDF Report advised that policies ought to “address the impact of market volatility (both domestic and foreign).”71

68 See id. at 6; see also MFDF Report at 56 (recommending that directors should “[u]nderstand whether there are regular occurrences that need fair valuations and whether a policy is warranted to aid fund management in addressing the need for fair valuations”).

69 See ICI 2005 at 16

70 See id. at 16.

71 See MFDF 2004 at 57.

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”

4.4.1. SEC Guidance

Parallel to a board’s obligation to ascertain the fair value of its fund’s securities, a board also has a duty regularly to review the efficacy of its fund’s valuation methodologies as applied to each security in the fund’s portfolio. As ASR 118 states, “[t]he board must also, consistent with this responsibility, continuously review the appropriateness of the method used in valuing each issue of security in the company’s portfolio.”72 A board’s regular review must be designed to ensure that existing valuation methodologies are achieving their goals—namely, that the values ascribed to each security reflects the amount that the fund might reasonably expect to receive upon a current sale of the securities.73

In this context, the SEC advised that a board’s review should analyze how frequently the valuations applied to specific securities required revaluation.74 Boards were also cautioned to review regularly the circumstances under which their valuation methodologies are exercised.75 In addition, boards were advised to review regularly the accuracy and appropriateness of the methods used in valuing their funds’ securities, including rigorous back-testing of the fund’s assigned valuations The SEC has noted that policies and procedures for valuing portfolio securities must be a “dynamic process” that includes regular back- testing, thereby assisting boards in identifying any biases or unusual patterns in their funds’ past valuations and the methods utilized. In 2004, Mr. Roye advised fund directors:

You should also ask about follow up to the fair valuations assigned. In hindsight, were they accurate? Did the fair valuations appropriately approximate actual market value? Fair valuation

72 ASR 118 at 19988.

73 See, e.g., Scheidt 2001 Letter at II.A.

74 See Remarks Before the 2004 New Directors Workshop: Mutual Fund Scandals: Lessons for Fund Directors, by Paul F. Roye, Dir., IM Division at Section III (Apr. 2, 2004), http://www.sec.gov/news/speech/spch040204pfr.htm (“Fund directors must monitor how fair valuation procedures are applied in practice. You should know how often, and under what circumstances, a fund's securities are fair valued.”).

75 See id.

procedures must continuously be back tested, critiqued and refined in order to maximize their effectiveness for the benefit of shareholders. Fair valuation, therefore, must be a dynamic process.76

Further, boards were advised to compare their assigned valuations “with values that are available from other sources, including actual trade prices, as well as quotations from pricing services and dealers.”77

Using back-testing or other methods, boards were required to have a mechanism for identifying stale-priced securities whose value has not changed over a significant period of time. SEC guidance in 2001 alerted funds to be wary of stale pricing, and the need for vigilance and monitoring in this area.78 Follow- up guidance from the SEC in 2004 noted that its upcoming examinations of fund valuations “will be looking, in part, for stale or inaccurate prices.”79

In order to review its fund’s valuation methodologies effectively, a board should demand specific information and reports from management and other service providers on both an ongoing and as-needed basis. As with other areas of board responsibilities under Rule 38a-1, thorough documentation is critical to oversee fund valuation methodologies effectively.80 Documentation is critical to enable a board to detect “unusual patterns” in fund valuations which, in turn, may help expose compliance deficiencies.81 In addition to unusual patterns, thorough documentation facilitates a Board’s ability to monitor for exceptions and overrides made to its funds’ valuation methodologies, which are key pressure points for compliance concerns. As Mr. Roye advised,

76 Id.

77 Scheidt 2001 Letter at II.A.

78 Remarks by Lori A. Richard, Dir., OCIE at ¶16 (June 14, 2001), available at http://www.sec.gov/news/speech/spch499.htm (“Monitor for ‘stale pricing’ . . . Is someone overriding incorrectly or is something wrong with the input?”). 79 The Need for More Proactive Risk Assessment NRS Annual Spring Compliance Conference, by Lori A. Richards, Dir., OCIE, SEC at Section II (Apr. 14, 2004), http://www.sec.gov/news/speech/spch041404lar.htm.

80 See ASR 113 at 5 (noting that the board’s valuation obligations entail the retention of information on which the board has relied in making its valuation determinations).

81 “I further encourage you to analyze information over time in order to identify unusual patterns that may point to compliance problems or deficiencies.” Keynote Address at the Tenth Annual Advanced ALI-ABA Course of Study: Investment Management Regulation, by Paul F. Roye, Dir., IM Division, (Oct. 28, 2004), http://www.sec.gov/news/speech/speecharchive/2004speech.shtml.

Furthermore, fund directors should closely scrutinize—and be particularly skeptical of—any exceptions that are made to a fund's market timing policies—or, for that matter, exceptions to any of a fund's compliance policies and procedures. If exceptions are made, they should be documented and you should be sure that there is adequate justification for any deviations from policy.82

Indeed, the SEC noted in 2004, that its examinations of mutual funds would focus on fund “failure[s] to correct errors or restrict or monitor overrides,”83 and warned against the fatal tendency to “allow exceptions to your compliance policies and procedures to compromise their effectiveness.” 84 Robust and sophisticated policies and procedures notwithstanding, the SEC cautioned funds that OCIE staff “is sensitized to this issue [of exceptions/overrides]” and would therefore,

be asking probing questions about the exceptions that are allowed under your compliance policies and procedures, who is authorized to approve any exceptions and whether a fund’s board is notified of exceptions to the fund’s compliance procedures.85

To ensure that overrides by advisers or other parties do not compromise the integrity of a fund’s valuations, funds were advised that internal controls and procedures should be in place and should require a supervisor to approve and document the rationale for all overrides.86 In addition, the available guidance made clear that someone uninvolved in the day-to-day pricing process should review all overrides to identify instances that were not properly explained or

82 Remarks Before the 2004 New Directors Workshop: Mutual Fund Scandals: Lessons for Fund Directors, by Paul F. Roye, Dir., IM Division at Section III (Apr. 2, 2004), available at http://www.sec.gov/news/speech/spch040204pfr.htm.

83 The Need for More Proactive Risk Assessment NRS Annual Spring Compliance Conference, by Lori A. Richards, Dir., OCIE at Section II (Apr. 14, 2004), available at http://www.sec.gov/news/speech/spch041404lar.htm.

84 Keynote Address at the Tenth Annual Advanced ALI-ABA Course of Study: Investment Management Regulation, by Paul F. Roye, Dir., IM Division at Section II.A (Oct. 28, 2004), available at http://www.sec.gov/news/speech/spch102804pfr.htm.

85 Keynote Address at the Tenth Annual Advanced ALI-ABA Course of Study: Investment Management Regulation, by Paul F. Roye, Dir., IM Division at Section II.A (Oct. 28, 2004), available at http://www.sec.gov/news/speech/spch102804pfr.htm.

86 See Remarks by Lori A. Richard, Dir., OCIE at ¶18 (June 14, 2001), available at http://www.sec.gov/news/speech/spch499.htm (discussing the importance of controls and procedures for instances of adviser overrides).

31 documented, and boards should be provided with a report discussing overrides on a periodic basis.87

Recognizing that the Board would obtain assistance from fund management and service providers in developing and exercising valuation methodologies, 88 SEC guidance has consistently highlighted that a board’s review of valuation methodologies must extend to all parties involved in the valuation process. This includes, for example, board review of “the quality of prices obtained through” a fund’s valuation methodologies, with the board “mak[ing] changes when appropriate.”89 Thus, ASR 118 noted in reference to portfolio valuation, “whenever technical assistance is requested from individuals who are not directors, the findings of such individuals must be carefully reviewed by the directors in order to satisfy themselves that the resulting valuations are fair.”90

SEC guidance over the years has also repeatedly stressed that board review of management and service providers is especially critical in light of the externalized mutual fund structure and the resulting institutional conflicts of interest. Due to the “potential for abuse . . . inherent in the external management structure typical of mutual funds,” boards must be particularly attentive to the conduct of fund management and service providers, whose views are too often “skewed by self-interest.”91 Consequently, SEC guidance has emphasized the specific concern that boards must be particularly attentive to their oversight functions. While portfolio managers can provide some relevant data in connection with valuation reviews, boards cannot “rely solely on the portfolio manager for valuations” because “he or she has a built-in conflict of

87 See Remarks by Lori A. Richard, Dir., OCIE at ¶18 (June 14, 2001), available at http://www.sec.gov/news/speech/spch499.htm (“Ensure that someone who is not involved in the pricing process, such as compliance staff, reviews all overrides to look for individual overrides that aren't supportable, and for patterns of overrides that suggest problems. Also consider providing a periodic report to the board on all overrides and the reasons for them.”). 88 See, e.g., Scheidt 1999 Letter at ¶14 (“Most boards fulfill their obligations by reviewing and approving pricing methodologies, which may be formulated by the board, but more typically are recommended and applied by fund management.”).

89 Scheidt 1999 Letter at ¶15.

90 ASR 118 at 19988.

91 Remarks Before the 2004 New Directors Workshop: Mutual Fund Scandals: Lessons for Fund Directors, by Paul F. Roye, Dir. IM Division at Section IV (Apr. 2, 2004), http://www.sec.gov/news/speech/spch040204pfr.htm.

32 interest.”92 Boards must also understand the details of what pricing services provide, and exercise caution in avoiding services that merely “spit back at [the fund] exactly the information that your portfolio manager has provided to them.”93

Reflecting on the mutual fund scandals that immediately preceded the adoption of Rule 38a-1, the Staff expressed the need for directors to be vigilant in instituting policies and procedures that “demand accountability from fund management” by ensuring that the directors remain informed by setting a clear tone of compliance, and by outlining clear expectations of management. Specifically, Mr. Roye stated that,

Another lesson we can learn from the recent fund scandals is that directors must demand accountability from fund management. It is wholly inappropriate for fund directors to be left in the dark about major compliance lapses involving a fund they oversee. Directors, however, must set the tone at the top. You must make sure that management understands that you expect them to report to you regarding material conflicts of interest and compliance-related issues. You should insist on a “doctrine of no surprises.”94

In overseeing fund management and the fund’s various service providers in an effective manner, the board must bring a “healthy dose of skepticism” in conducting its oversight role, especially for those areas that are subject to conflicts of interest.95 Indeed, chief among the areas that are vulnerable to management conflicts of interest is portfolio valuation. As ASR 113 observed, “investment managers who are compensated on the basis of net asset value or performance may be unduly compensated” if the fund over-values its securities.96 Fund directors, and especially independent directors, are tasked with “asking the tough questions” and ensuring that management and service providers are focused on the best interests of the fund’s shareholders—not their

92 Remarks by Lori A. Richard, Dir., OCIE at ¶18 (June 14, 2001), available at http://www.sec.gov/news/speech/spch499.htm. 93 Id. (emphasis in original). 94 Remarks Before the 2004 New Directors Workshop: Mutual Fund Scandals: Lessons for Fund Directors, by Paul F. Roye, Dir., IM Division at Section IV (Apr. 2, 2004), http://www.sec.gov/news/speech/spch040204pfr.htm.

95 Remarks Before the 2004 New Directors Workshop: Mutual Fund Scandals: Lessons for Fund Directors, by Paul F. Roye, Dir. IM Division at Section IV (Apr. 2, 2004), http://www.sec.gov/news/speech/spch040204pfr.htm

96 ASR 113 at p.2.

33 own.97 Indeed, the Supreme Court has referred to mutual fund independent directors as “independent watchdogs.”98

4.4.2. Industry Guidance and Practice

As with all areas of board responsibility, directors need to ensure that they are continually well informed about the fund’s valuation process and are confident that it is being implemented and functioning properly. To do so in an effective manner, the board must inform itself of the valuation process by reviewing reports from management and other engaged parties.99 In reviewing valuation reports, the board should assess the accuracy and appropriateness of the methods used and whether modifications are necessary. The ICI advised directors, however, that their duties did not “stop there,” but required them to “follow up on any fair valuation issues” previously raised with management.100 Directors were advised to follow up by requesting that management perform specific analyses comparing vendor prices with prior or subsequent sale prices.101

In my experience, boards were advised that their fund’s valuation methodology should set forth a hierarchy of pricing sources that the fund’s adviser would utilize to value securities. But, Relevant Period advice cautioned that it was the board’s obligation to determine what reports and analyses would

97 Enhancing the Fund Director's Tool Box, by Paul F. Roye, Dir., IM Division, before the Fourth Annual Policy Conference Critical Issues for Investment Company Directors, Mutual Fund Directors Forum at Section II (Jan. 8, 2004), available at http://www.sec.gov/news/speech/spch010804pfr.htm.

98 Burks v. Lasker, 441 U.S. 471, 484 (1979). Specifically, the Court explained that, Congress’ purpose in structuring the [Investment Company] Act as it did is clear. It “was designed to place the unaffiliated directors in the role of independent watchdogs,” Tannenbaum v. Zeller, 552 F.2d at 406, “who would furnish an independent check upon the management” of investment companies, Hearings on H.R. 10065 before a Subcommittee of the House Committee on Interstate and Foreign Commerce, 76th Cong., 3d Sess., 109 (1940). This “watchdog” control was chosen in preference to the more direct controls on behavior exemplified by the options not adopted. Id. (emphasis in original). 99 See MFDF 2004 at 56-58.

100 ICI 2006 at 12.

101 See ICI 2006 at 13 (urging directors to utilize such reports in their oversight of pricing information, and cautioning directors that “SEC enforcement actions have highlighted the need to for a board to follow up on fair valuation issues raised during board meetings so that fund management addresses questions or concerns expressed by directors”).

34 be most helpful in carrying out its valuation responsibilities. Beyond that, it was, and is, crucial that the board obtain and review whatever documentation would enable it to satisfy its obligations. In some cases, boards reviewed summary information that might be sufficient. In other cases, however, boards received more timely or additional information about the securities being valued. For example, boards were advised at times to learn the valuation assigned to a particular security, the effect of that security’s valuation on the fund’s NAV and the reason that the adviser decided to value the particular security at the level assigned.

Boards were also advised to understand the procedures that management followed in valuing a security when obtaining quotes from broker- dealers. In my experience, boards were advised to inquire whether the adviser used an average of multiple quotes, discarded the high and low quotes, or applied some other method. Additional understanding is often required to affirm that management properly determined whether a transaction could be executed at a suggested price for the security.

Boards were also advised to understand the processes and practices of their funds’ portfolio advisers. For instance, directors were advised that they needed to understand how the adviser addressed the valuation of securities held across multiple funds in the complex. Similarly, boards were advised to inquire and make themselves aware of different valuation procedures their funds’ adviser used across the business as a whole.

Perhaps the most critical component of a board’s ongoing review of management valuation exercises is “back-testing” assigned valuations with other data. The ICI outlined three general methods of back-testing that might be relevant for particular valuation situations:

i. “Testing actual trades,” which compares the fund’s fair valuation with prices utilized in actual trades;

ii. “Testing fair values against subsequent market prices,” which compares the fund’s fair valuation with subsequent market prices (relevant for, e.g., foreign securities); and

iii. “Back-testing by Vendors,” which examines the vendor’s own back- testing either prior to employing the vendor and/or on an ongoing basis.102

102 See ICI 2005 at 17-18.

Boards were advised to dedicate considerable efforts to back-testing in order to “identify any significant bias in the fair value procedures” and as a method of reviewing the integrity of vendor services.103 Done regularly and methodically, boards were advised that back-testing could allow them to identify specific areas in which a fund’s valuation policies and methodologies may not be achieving its goals.104

Boards were also encouraged to make use of the available input from all parties participating in the valuation process—not merely from fund management. The 2004 MFDF Report urged directors to work together with, among others, their fund’s audit committee, its independent auditor, as well as the Chief Compliance Officer, in order to review the efficacy of compliance policies relating to valuation.105

Boards were also advised to adopt methods to ensure that their fund’s valuation methodologies were being implemented as written, and that they were effective in preventing violations of the securities laws. Boards understood that they were required to understand the adviser’s resources for valuing securities, especially if there was an anticipated need to develop fair values for the fund’s Unquoted Securities. In particular, directors were cautioned that fund portfolio managers were repositories of critical data relevant to the process of assigning fair values to portfolio securities, but that they needed to apply caution in placing reliance on portfolio managers due to their inherent conflicts of interest. Portfolio managers were expected to provide information during times when securities price movements were not anticipated.

Boards were also advised to ensure that their funds’ advisers had established procedures for ongoing monitoring of pricing services, including paying due diligence visits to service providers, to determine whether the pricing service remained competent to value particular securities and maintained an adequate control environment. For example, some fund directors accompanied management on their due diligence visits, and others periodically interviewed pricing vendors to determine for themselves their qualifications and independence.

Directors were also advised to understand how broker quotes were used in valuing their fund’s securities. In particular, directors were cautioned that

103 See id. at 17. 104 See id.

105 See MFDF 2004 at 58.

36 they needed to understand the process in place when broker quotes were used to value portfolio securities. In this regard, directors were advised to know whether valuation procedures allowed broker quotes to be the sole source for determining the value of a particular security. Directors were further advised to understand whether the procedures employed for obtaining and utilizing broker quotes included a requirement that quotes be obtained from two or three brokers, as well as any circumstances under which only one quote could be relied on.

In my experience, boards were advised to inquire and understand the adviser’s process regarding its selection of brokers and the frequency with which it changed those brokers, as well as who obtained relevant quotes— portfolio management personnel, traders, or others. Similarly, it has always been important for boards to satisfy themselves that the pricing quotations portfolio management personnel obtained were not the product of a result- oriented process. Well-advised boards also sought input from their funds’ advisers on the performance of third parties that provided securities pricing data, at times seeking that input from third parties directly.

Boards were under an obligation to ensure that their funds’ advisers conducted appropriate due diligence when selecting pricing and other related services. As part of this effort, boards were advised to obtain comfort that their funds’ advisers’ due diligence included an examination of the financial stability of the pricing service as well as its ownership and any affiliations that might exist between pricing services and fund advisers. Boards were also advised that it was incumbent upon them to understand and approve how management evaluated the quality of a vendor’s prices.

In coordinating efforts with, and soliciting information from, other parties, best practices demanded that fund directors remain alert to potential and actual conflicts of interest, especially with fund management, whose compensation could frequently be a direct product of the valuation process’ impact on fund performance.106 For this reason, fund boards were advised to make sure that their funds’ valuation processes were not administered exclusively by persons whose credibility might be influenced by the presence of such conflicts.107

106 See ICI 2006 at 9 (noting that while “portfolio managers and analysis” can serve constructive roles in the valuation process, they “may have potential conflicts of interest if the valuation used by the fund affect a fund’s performance and their own compensation”).

107 See id. (encouraging that funds take proactive measures “to enhance their valuation procedures to minimize any potential conflicts of interest”).

A board’s oversight responsibilities extend to its funds’ service providers, such as pricing services, making it necessary for boards to monitor whether valuations were based upon theoretical pricing or actual broker-dealer sales. Boards understood the importance of considering the nature and value of the information provided by pricing services, including the degree to which such services communicate with securities issuers and the timeliness of such communication.108 It was also deemed important for boards to pay attention to the identities and affiliations of those persons responsible for communicating with pricing vendors, especially if fund portfolio managers played a direct role in that process. Directors were advised to monitor whether management obtained independent verification of data supplied by pricing services.109

Back-testing, as well as other methods, were recommended to boards to enable them to identify potentially harmful practices such, as allowing stale- pricing of securities. Stale-pricing can occur if directors neglect to assess the relevance of certain pricing information. 110 As noted above, boards were advised to assure that their oversight efforts distinguished between different types of securities, such as restricted securities, thinly traded and foreign securities.111

Best practices during the Relevant Period also required boards to be exercise skepticism of exceptions to, and management overrides of, valuation methodologies. Boards were counseled, in the first instance, to understand and ask relevant questions regarding the valuation policies themselves that assertedly warranted management overrides, even when no apparent deficiency was identified as the result of input from an independent source.112 Override trends can raise serious questions for the board. As the ICI explained,

Board reports also may include security-specific information for instances where management, pursuant to the fund’s policies and procedures, used a price other than the one provided by the external vendor because management reasonably believed that it did not reflect the security’s value . . . frequent use of prices other

108 See MFDF Report at 56.

109 See id. at 57.

110 ICI 2006 at 15

111 See MFDF 2004 at 56.

112 See id. at 56 (urging directors to develop an understanding of “procedures permitting management override of valuations”).

than those provided by an external vendor that increase the value of portfolio securities might indicate that a vendor’s prices are not reliable. It may also be a “red flag” suggesting potential conflict of interest concerns and the need for greater board scrutiny.113

In this regard, boards were advised to understand the circumstances under which management personnel had the discretion to override prices provided by a pricing service, to review the instances such discretion was exercised, and to ensure that sufficient checks and balances were in place to review each override. Some advisers developed processes for challenging quotations by pricing services if a price quote appeared inconsistent with information known to the adviser, such as information about recent trades. Boards were advised to be sensitive, and establish controls, to protect against conflicts of interest, particularly when a portfolio manager attempted to override a price from a pricing vendor. In this regard, and to prevent improper overrides, boards were advised to set forth specific procedures in which overrides could be completed, including requirements that they must be authorized, tracked, and monitored.

Boards were also advised to inform themselves of related risks that can occur when internal information provided by portfolio managers was used to estimate fair value. Under those circumstances, directors were advised to institute controls that would protect against the potential consequences of conflicts of interest when valuation information was provided by portfolio managers or members of the valuation committee. Boards were also advised that it would be effective to require that all valuation committee members possess the requisite expertise for valuation and require that the entire committee agree upon ultimate valuation judgments, rather than allowing single individuals to exercise that kind of authority. In my experience, boards were advised to institute controls that had the effect of limiting the deference accorded to advisers’ input in the valuation process. Boards were also advised of the potentially significant risks that could arise when models that were internally developed were utilized to value securities. These risks required boards to ensure that advisers tested their models regularly, and reviewed the accuracy of the results obtained from applying the model. In addition, boards were advised that all valuation committee members needed to possess requisite valuation expertise, and

113 ICI 2006 at 13.

39 required that the entire membership of valuation committees determine the assumptions incorporated into any models. When boards considered using matrix pricing, in which the price of a security is based on the price of another security that is comparable in credit rating or interest rate, boards understood that they (and their funds’ advisers) needed to comprehend vendor processes for matrix pricing. There are frequently limitations that inhere in the extensive use of matrix pricing, and therefore, boards must understand what those limitations are and restrict the percentage of a fund’s portfolio that is priced in that manner. Boards were advised to ask probing questions of vendors, such as whether their pricing matrix considered differing liquidity levels among different securities, and whether the matrix was tested against subsequent sales prices. Pricing services had to be reviewed on an ongoing basis. Similarly, boards were regularly advised to consider the reliability of information obtained from credit rating agencies. Particularly where matrix pricing models were used for asset-backed securities, it was deemed critical that advisers monitor changes in credit ratings or any incident that has the potential to impact a security’s credit rating. In order to do this, advisers must fully understand the factors and criteria considered by credit rating agencies in promulgating their ratings. Similarly, boards were advised to set forth policies and procedures that would ensure that significant rating-related events were identified and considered, and to implement monitoring procedures pursuant to which their advisers would identify significant events that might affect the values assigned to portfolio securities. 5. BASED ON THE EVIDENCE DIRECTORS FAILED TO MEET EVEN MINIMUM STANDARDS

5.1. Respondents Knew their Valuation Responsibilities

The Directors should be deemed to have been fully aware of their duties and obligations, including those regarding fair valuation of securities. The Directors received a short list of “publications of interest” in a Board Package,114 which cited, among others,

(i) Fair Valuation Series: The Role of the Board, January 2006, http://www.idc1.org, and is described as the “second installment of the joint IDC and ICI Fair Valuation Series [and]

114 Board Package, Joint Meeting of the Boards of Directors/Trustees of Certain Morgan Keegan Funds (Jan. 24, 2007) (“Jan. 24, 2007 Board Package”) at 331—33, A.P. File No. A-3211 Bates Nos. MAM-8-000746714—16.

provides an overview of the board’s role in fair valuation and examples of the do’s and don’ts that directors may want to consider.”

(ii) An Introduction to Fair Valuation, Spring 2005, http://www.idc1.org, and is described as “a report from the IDC and ICI [and] is the first installment of the Fair Valuation Series, and provides an overview of the issues to consider in developing and administering valuation policies and procedures.”

(iii) Best Practices and Practical Guidance for Mutual Fund Directors, July 2004, http://www.mfd.com/UserFiles/File/best_pra.pdf, and is described as a:

response to a request from SEC Chairman Donaldson that the Forum, an organization of independent fund directors, develop written practical guidance and best practices for independent directors in areas in which director oversight and decision-making is particularly critical for the protection of fund shareholders. The areas discussed include: board review of management contracts and fees; . . . valuation and pricing; . . . and conflicts of interest between funds and their managers.115

Notably, all three of the foregoing publications are discussed above in the section of my Report discussing industry guidance and practice for fund boards of directors, which outlines their duties and responsibilities with respect to valuation.116

5.2. Respondents Failed to Specify a Valuation Methodology The Funds’ valuation procedures themselves, as set forth in the Policy and Procedure Manual failed to provide adequate guidance to the Valuation Committee for how to fair value securities.117 The written valuation procedures

115 Id. at 333. 116 See generally supra, §4.

117 Policy and Procedure Manual (Updated Jan. 25, 2007), A.P. File No. A-03211 Investigative Ex. 4 (“P&P Manual”) at App. A Ex. L pp. 6—10; P&P Manual at §7, pp. 52-55.

41 begin by laying out what is essentially an excerpt from ASR 118, copied nearly verbatim. In particular, the procedures require the Valuation Committee to use “fundamental analytical data” or “forces which influence the market in which these securities are purchased and sold,” but Respondents failed to give further guidance to management as to what these terms—“fundamental analytical data” and “market sources”—refer to with any level of detail.118 General policies that simply mirror the language of ASR 118 do not establish meaningful methodologies of how to perform fair valuations.119 Indeed, the Board’s Chief Compliance Officer (“CCO”), Ms. Wood, testified that the Funds’ actual valuation practices did not follow the policies and procedures.120

In my experience, a critical feature of an effective valuation process is the designation of clear roles for the various persons and committees involved in the process. Without such clarity, it is very difficult for the participants to understand their objectives, and the type of conduct that is expected of, and appropriate for, them in satisfying their respective roles. The failure of Respondents to prescribe a valuation methodology or methodologies resulted in conflicting understandings by Fund Accounting and the Valuation Committee on the one hand, and the portfolio manager, Mr. Kelsoe, on the other hand, as to the use of pricing information supplied by Mr. Kelsoe.

Mr. Kelsoe claims that he thought Fund Accounting independently analyzed the securities in order to determine the correct fair valuation for the Funds’ respective NAVs, and that the price adjustments he sent to Fund Accounting were merely a consideration in the process.121 But, the evidence

118 P&P Manual at App. A Ex. L pp. 6—8. 119 See Scheidt 1999 Letter at ¶6 (noting that ASRs 113 and 118 were not intended to provide comprehensive guidance to funds on how to address all pricing issues,” but rather “to provide general illustrative guidance”).

120 Michele Wood Tr., A.P. No. A-3211 (Nov. 3, 2011) (“Wood Tr.”) at 60:21––61:23 & 64:16–– 25; see also 38:8––12 (stating that she had no recollection of the Board ever providing the Valuation Committee “with more specific guidance about how they wanted it to determine fair value, more specific than was in the policy and procedure manual”). 121 See James Kelsoe Tr., A.P. No. A-3042 (May 1, 2008) (“Kelsoe II Tr.”) at 251:6––15; see also id. at 343:25––344:1 (Mr. Kelsoe’s attorney referencing that Kelsoe “doesn’t have anything to do with valuing” the securities in the fund’s portfolio.); James Kelsoe Tr., A.P. No. A-3042 (May 21, 2009) (“Kelsoe III Tr.”) at 80:18––81:10 (Mr. Kelsoe’s attorney stating that Kelsoe did not value securities for purpose of calculating the Funds NAVs); id. at 106:14––23 (Mr. Kelsoe’s attorney explaining that Kelsoe’s price adjustments represented no more than a portfolio manager’s view of the intrinsic value of the securities and were not offered as “prices” to be input into the NAV); id. at 90:18––21 (testifying that he had no role in pricing securities); James Kelsoe Tr., A.P. No. A-3042 (June 10, 2009) (“Kelsoe IV Tr.”) at 239:15––240:7 (testifying that he does not recall Fund Accounting calling him to inquire into his explanation for his valuation observations).

42 demonstrates that members of the Valuation Committee and Fund Accounting viewed and treated Mr. Kelsoe’s inputs as authoritative, and they therefore did not believe that any additional analysis—independent of the portfolio manager— was necessary to reach valuation conclusions. Ms. Walker, a senior accountant in Fund Accounting, and a member of the Valuation Committee, testified that she routinely valued securities by accepting Mr. Kelsoe’s prices without question, and further, that she used Mr. Kelsoe’s prices for purposes of computing the NAVs of the respective funds.122 Moreover, Mr. Hale, the individual at Morgan Keegan with direct supervision over Fund Accounting and a member of the Valuation Committee, testified that when Mr. Kelsoe submitted a price, Fund Accounting regularly used Mr. Kelsoe’s price to calculate the fund’s NAV, without any type of independent investigation by Fund Accounting.123

In my opinion, Respondents’ failure to include the specific roles of the Valuation Committee, Fund Accounting, and the portfolio manager in the Funds’ valuation policies and procedures—fostered the above-described confusion regarding responsibilities in connection with the valuation process. Ultimately, Respondents’ failure to provide more specific valuation methodologies led to a breakdown of responsibility and accountability with respect to the valuation of the Funds’ securities. Absent such clarity, the Valuation Committee and Fund Accounting were permitted to operate without a basic understanding of the role of the portfolio manager’s pricing adjustments, and what, if any, independent analysis Fund Accounting should have performed.

In my experience, another critical role of valuation policies and procedures—particularly within the context of mutual funds—is to prevent situations in which fund portfolio managers have the ability to exercise substantial influence over the valuation of securities. In this regard, the documentary evidence demonstrates that Mr. Kelsoe, by his own admission, regularly previewed quotes and discussed them with at least one broker prior to

122 See Amy Walker Tr., A.P. No. A-3042 (Aug. 8, 2008) (“Walker I Tr.”) at 73:1––5, 73:14––21; see also id. at 46:17––25, 47:3 (testifying that when broker confirmations materially varied from the fund’s price, Walker routinely used Kelsoe’s price for purpose of the NAV). 123 See Michael Louis Hale Tr., A.P. No. A-03042-A (Aug, 14, 2008) (“Hale Tr,”) 51:6––14; see also id. at 40:2040:12—43:2 (testifying that when the broker quotes differed from Kelsoe’s price adjustments, the he, in his role of overseeing Fund Accounting, typically gave greater weight to Kelsoe’s price). The testimony of the Funds’ CCO, Ms. Wood, also evidences the degree to which the Valuation Committee was subject to Kelsoe’s influence. See Wood Tr. at 55:11––14 (testifying as to whether she recalled “any instances where the [V]aluation [C]ommittee didn’t think the portfolio manager’s explanation was reasonable,” that, “Yes, but that wasn’t Jim Kelsoe”).

43 the broker’s submission of quotes to Fund Accounting.124 Mr. Kelsoe has further admitted that it was not uncommon for him to take the position with the broker that certain quotes were too low and should be increased.125 Fund Accounting and Valuation Committee members testified that they were unaware of this practice. 126 In my opinion, Respondents’ failure to provide clear valuation policies and procedures, with appropriately designed internal controls and oversight measures, enabled Mr. Kelsoe to exercise undue influence over the valuation process, and, more generally, to manipulate the Funds’ NAV to serve his own interests at the expense of the Funds’ shareholders.

5.3. Respondents Did Not Sufficiently Understand the Fair Valuation Methodology Used by the Valuation Committee or Fund Accounting The documentary evidence demonstrates that the Directors did not know or understand the fundamental features of the Funds’ valuation methodologies. Specifically, as set forth below, the Directors failed to obtain an understanding of, among other things,

i. How the methodology weighted the various factors listed in the Fund’s policies and procedures; ii. The nature of the “qualitative analysis” that was performed, and by whom; iii. The extent to which Fund Accounting and the Valuation Committee accepted the price inputs of the Portfolio Manager, Mr. Kelsoe, without performing or obtaining further analysis; iv. The instances in which price confirmations were randomly obtained (price confirmation as distinct from price quotes), and how randomly price confirmations were obtained; v. The nature of the process governing management overrides of broker pricing, and the extent to which controls were in place to approve and oversee such overrides; vi. Whether there was a procedure in place to address stale prices; and

124 See James Kelsoe Tr., A.P. No. A-3042 (Apr. 30, 2008) (“Kelsoe I Tr.”) at 127:20—128:6, 147:9-14; James Kelsoe Tr., A.P. No. A-3042 (June 11, 2009) (“Kelsoe V Tr.”) at 425:11––14; 405:24––407:18; see also Kelsoe I Tr. at 127:1––25; 129:13––130:9. 125 See Kelsoe I Tr. at 129:13––130:14, 147:9––14. 126 See Walker I Tr. at 57:23--58:4; Hale Tr. at 125:22––126:3, 126:20––128:5; Joseph Thompson Weller Tr., A.P. No. A-3042 (Nov. 6, 2008) (“Weller Tr.”) at 150:11––21.

vii. How the “matrix” was used to determine the fair value of the securities.

In a telephonic conference call that Respondents had with OCIE Staff on August 2, 2007, they were specifically asked to explain or describe the Funds’ methodology for valuation. Ms. Stone, then the Chairman of the Audit Committee, responded that they needed to consult management to be able to respond.127 In this telephone conference, Respondents were unable to give any information about the valuation methodology for which they were responsible. If Respondents understood the methodology at even an elementary level, they could have answered this question instead of needing to consult management.

The Valuation Committee only provided Respondents with its conclusions that the policies, procedures, and valuation prices were appropriate. The Valuation Committee did not, however, explain the basis for its conclusions, nor did Respondents demand such explanations. Respondents were not provided with, and did not request, any information regarding the pricing methodologies, as opposed to mere conclusions. In addition, while Respondents were aware in a general sense that the Valuation Committee was responsible for determining valuations, Respondents never obtained an understanding of who specifically was performing the valuation analysis and rendering pricing conclusions.128 In short, the documentary evidence demonstrates that Respondents lacked any meaningful knowledge of the valuation process and methodologies.

127 SEC Notes of RMK Conference Call at 5 (Aug. 2, 2007 11 AM), A.P. File No. 313847 Bates No. OCIE 28119.

128 This is in stark contrast to other mutual funds, such as Hyperion Strategic Mortgage Fund and Total Return Fund, both of which the Funds acknowledged as “peer funds.” Similar to Respondents, the Hyperion Board delegated the day-to-day valuation responsibilities to a valuation committee. Unlike Respondents, however, the directors of Hyperion informed themselves about the identity of the persons who would be performing the valuations, and ensured that those individuals were qualified experts to perform such tasks. See Hyperion Brookfield Total Return Fund, Inc., et al. Valuation Policies and Procedures (Adopted Sept. 21, 2004; Revised July 26, 2007), SEC-HELIOS-000002 (identifying three persons by position that were tasked with reviewing each security price to determine if reasonable). In addition, Hyperion’s procedures required for any Unquoted Security, a memorandum “detail[ing] the methodology to be used to price the bond and the reasoning behind it”). Id. at SEC-Helios- 0000011. Hyperion also required its valuation committee to “review and approve the use of such methodology, with notification of the Board to be made at the next regularly scheduled meeting.” Id. The failure of Respondents to perform such a basic analysis—which would have required minimal time or effort—demonstrates that they did not embrace their duties in a good faith manner.

5.3.1. The Written Information Provided by the Valuation Committee Did Not Satisfy Respondents’ Obligation to Understand the Valuation Methodology or Enable Respondents to Review Adequately the Valuation Committee’s Findings

In connection with their quarterly meetings, Respondents received two forms from the Valuation Committee regarding valuation. The first form, entitled “Report from the Joint Valuation Committee,” was a two-paragraph form, consisting of less than one-half of a page, which stated, in relevant part,

The values of internally-priced securities were randomly confirmed with third parties and no material exceptions were noted. The Valuation Committee feels that all securities are being priced fairly and there are no material misstatements.129

The second form, entitled “Fair Valuation Form,” was a one-page form that requested that the Valuation Committee state the “basis/source for determining price used[.]” The Valuation Committee responded by stating that the basis was an “internal matrix based on actual dealer prices and/or treasury spread relationships provided by dealers.”130 This response provided the Respondents with no information that would enable them to determine if there was a rational basis for the valuations assigned, and what that basis was. This overly broad response was devoid of meaning or substance.

Attached to the Fair Valuation Form was a list of all Unquoted Securities held by the Funds, with a value assigned to each security,131 which similarly, was uninformative as to the valuation methodology employed. Neither of these forms provided sufficient information for Respondents to satisfy their valuation responsibilities. The forms did not adequately, or correctly, describe the methodology used to assign values to portfolio securities, nor did it identify what, if any, factors were considered in the valuation process. Moreover, as is discussed below, the forms did not even satisfy the Funds’ written valuation policies and procedures. Finally, as is discussed more fully below, the Respondents lacked a sufficient understanding of even the general terminology used in the forms.

129 See Board Package, Joint Meeting of the Boards of Directors/Trustees of Certain Morgan Keegan Funds (May 21, 2007) (“May 21, 2007 Board Package”) at 203, A.P. File No. A-3211 Bates No. MAM-8-000747076. 130 See May 21, 2007 Board Package at 205––6, Bates Nos.MAM-8-000747078––9. 131 See May 21, 2007 Board Package at 207––14, Bates Nos. MAM-8-000747080––087.

5.3.2. The Fair Valuation Forms Provided Insufficient Information

Although the forms represented that all Unquoted Securities were valued through an internal matrix, Respondents lacked a meaningful understanding of how the matrix worked. Respondents did not know who created it, which variables were, or whether it generated prices or just reflected a list of factors to be considered.132 Moreover, contrary to the form provided to Respondents, the internal matrix was used only to value a small percentage of the Unquoted Securities.133 The remainder of those securities were “subjectively” valued by Mr. Kelsoe and, purportedly, the Valuation Committee.134

Nor did the Fair Valuation form or the attachments thereto contain the explanatory notes required by the Funds’ written valuation policies and procedures. The lack of explanatory notes would make it nearly impossible for the Directors to ascertain what pricing methodology was used to value any particular security or group of securities, whether their valuation policies and procedures were being implemented and whether the valuations achieved were appropriate. Mr. Miriyagalla, in connection with the June 2007 audit, drafted an internal email that noted a lack of documentation from Mr. Kelsoe, the Fund Manager, and wrote that “[m]anagement should have asked PM for external information to support his assertions. Communication between Accounting and [Portfolio Manager] is weak.” 135 Mr. Miriyagalla raised an additional control deficiency—Mr. Kelsoe provided PwC with a list of assumptions made when pricing securities but “[i]t did not seem that management had put this into practise [sic], and even if they did, it was not documented.” 136 He also commented on the lack of timeliness and lack of involvement by the Audit Committee. He indicated that “[t]hey should have asked more questions on how

132 See, e.g., Archie Willis Tr. A.P. No. A-3211 (July 28, 2011) (“Willis Tr.”) at 93:17––94:13 (discussing that the internal matrix was a formula used to create price); James McFadden Tr. A.P. No. A-3211 (July 6, 2011) (“McFadden Tr.”) at 85:4––18 (same); Mary Stone Tr. A.P. No. A- 3211 (Sept. 26, 2011) (“Stone Tr.”) at 182:1––16, 186:23––188:9 (explaining that the internal matrix was merely a compilation of factors to be considered). 133 Division Ex. 459, A.P. File No. 3-13847. 134 Some of the Board members knew that the matrix was not used to value all of the Unquoted Securities, but the form was never changed during the Relevant Period to more accurately reflect the methodology used. See Al Johnson Tr. A.P. No. A-3211 (June 29, 2011) (“Johnson Tr.”) at 155:15––156:9; James Kenneth Alderman Tr. A.P. No. A-3211 (Oct. 25, 2011) (“Alderman Tr.”) at 63:11––21, 65:4––15. 135 Email from Manura M Miriyagalla to Mike P. Quakenbush (Sept. 17, 2007), PwC-MKE-S- 000158865-66.

136 Id.

47 management is fair valuing securities and the level of documentation to support it.”137 The requirement to provide explanatory notes is discussed more fully in Section 5.3.3 infra.

5.3.2.1. The Joint Valuation Report Provided Insufficient Information

While the Joint Valuation Form certified that “these securities were randomly confirmed and no material exceptions were noted,” Respondents failed to provide the necessary guidance to the Valuation Committee to provide substantive content for the relevant terms, “randomly confirmed” and “material exception.” For example, Respondents did not specify the percentage of securities that should be randomly confirmed at any given time. Nor did the Joint Valuation Committee Report advise how many securities had been randomly confirmed, or more importantly, how many securities had not received any confirmation. Moreover, it is not clear whether Respondents and the Valuation Committee interpreted the term “material exceptions,” consistently. The Valuation Committee in fact received multiple confirmations as of March 31, 2007, that had materially different prices from the Funds’ prices on that date.138

137 Id.

138 See Division Ex. 291 A.P. File No. 3-13847, Bates Nos. MAM-8-00009579––97). The following are examples of the material differences—with percentage variations noted in the far- right column—between the broker confirmations and the Funds’ March 31, 2007, prices as reflected in this Exhibit: Row CUSIP RMK Dealer Dealer Variance Fund Price Price 17 80382QBC5 98.45 UBS 10.00 -89.84% 19 3623412S7 59.50 Stifel Nicolaus & Co., Inc. 10.00 -83.19% 20 83610YAC7 40.00 Greenwich Capital Market 10.00 -75.00% 21 004421SE4 66.00 Deutsche Bank 20.00 -69.70% 22 83611MHZ4 9.85 Greenwich Capital Market 3.00 -68.54% 23 00764PAH3 24.00 Piper Jaffray Companies 10.00 -58.33% United Capital Markets 11.00 -62.06% 24 00764PAX8 29.00 Piper Jaffray Companies 13.00 -55.17% 25 59001FBQ3 85.25 Greenwich Capital Market 40.00 -53.08% 26 70557RAD2 0.50 United Capital Markets 0.25 -50.00% 27 70557RAG5 0.50 United Capital Markets 0.25 -50.00% 28 803827AS3 70.00 Lehman Brothers 37.50 -46.43% 29 05366VAG3 35.00 United Capital Markets 20.00 -42.86% 30 553121AK0 94.00 Greenwich Capital Market 55.63 -40.82% 31 83611PBH3 64.00 Greenwich Capital Market 38.00 -40.63% 32 57643LMK9 81.00 UBS 50.00 -38.27% 33 83610YAB9 80.00 Greenwich Capital Market 50.00 -37.50% 34 881561TC8 17.00 The Winter Group 11.69 -31.24% 35 35711EAD7 97.78 Greenwich Capital Market 68.75 -29.69% 48

Yet the Valuation Committee Report for March 31, 2007, advised that “no material exceptions were noted.”139

The absence of such guidance or definition effectively rendered the Form’s certification meaningless and further reflects Respondents’ lack of understanding. Further, by allowing the process to operate with terms that were devoid of practical application, Respondents made futile their ability to oversee the Funds’ fair-value methodology and to satisfy their fiduciary duties.

5.3.3. The Forms Provided to Respondents Did Not Contain Explanatory Notes as Required by the Funds’ Written Valuation Policies and Procedures

The Funds were subject to the Policy and Procedure Manual (“P&P Manual”), which was updated on January 25, 2007.140 The P&P Manual states that the Board delegated to the Funds’ Adviser, Morgan Asset Management, Inc., “the responsibility for carrying out certain functions relating to the calculation of the portfolio of securities and other instruments in connection with calculating the [NAV] for the Fund.”141 The procedure continues to set forth controls to enable the Board of Directors to oversee the valuation of the securities. Respondents failed to comply with and enforce these controls, rendering oversight of the valuation process impossible.

Of relevance here is In the Matter of Parnassus Investments, Initial Decision Rel. No. 131, A.P. File No. 3-9317 (Sept. 3, 1998), in which the Judge held that the independent trustees of the Parnassus Fund violated Rule 22c-1 for failing to give adequate consideration to the requirements of ASRs 113 and 118 in valuing an Unquoted Security, and flatly rejecting the argument proffered by respondents in the case that they had not violated Rule 22c-1 because “the impact” of the mispriced security “on the Fund’s NAV would be immaterial on the basis of the total return.” Id. at n.28, available at http://www.sec.gov/litigation/aljdec/id131rgm.txt. As a “pricing provision, not an antifraud provision,” the Judge explained, “Rule 22c-1 does not contain a materiality element”; rather, “[m]ispricing, standing alone, constitutes a violation of Rule 22c-1.” Id. In addition to material pricing variances between the Funds’ pricing and dealer confirmations, Division Exhibit 291 also demonstrates that after requesting dealer confirmations, the Funds did not receive any confirmations for a number of securities. See Ex. 291, Price Confirm Analysis Report, Bates Nos. MAM-8-00009582––83 (indicating that the Funds did not receive any dealer confirmations for the securities listed in Rows 1 and 3-12). 139 May 21, 2007 Board Package at 203, Bates No. MAM-8-000747076. 140 P&P Manual, A.P. File No. A-03211 Investigative Ex. 4.

141 P&P Manual, App. A, Ex. L at 6.

The Funds’ procedures required that there be written142 reports of fair value determinations with explanatory notes, which the Directors were required to review. Specifically, the procedures provided that,

Upon making a determination as to the fair value of a security, the Valuation Committee shall maintain a written report documenting the manner in which the fair value of a security was determined and the accuracy of the valuation made based on the next reliable public price quotation for that security. Quarterly reports listing all securities held by the Fund that were fair valued during the quarter under review, along with explanatory notes for the fair values assigned to the securities, shall be presented to the Board for its review.143

Based on the documentary evidence I have reviewed, no explanatory notes for the fair value determinations were even created for the Directors to review—and the Directors certainly did not receive or demand such reports. For example, in the Board Package dated January 24, 2007, the Report from the Joint Valuation Committee of the Funds includes three valuation forms, which attach lists of securities and their prices.144 The Valuation Committee failed to include the required information and provide any explanatory notes for the prices. In response to the requested data for the “Basis/Source/Method For Determining Priced Used,” all the forms generically state, “[i]nternal matrix based on actual dealer prices and/or Treasury spread relationships provided by dealers. The entry for requested data for “Price Comparisons (Pricing Services, Broker-Dealers, etc.)” was left blank on all three forms. And again, the last requested data entry on the form asks for: Reason For Pricing (If no price was available, include the source from which the price is normally obtained. If you are adjusting a dealer quote because the position is an odd lot or because the quote is stale, include the last dealer quote obtained and the reason for the adjustment)[.]145

142 Mr. Miriyagalla noted that it was alleged that “there were several meetings held on pricing at the end of June but there are no minutes to support it.” Email from Manura M Miriyagalla to Mike P Quakenbush (Sept. 17, 2007), Pl’s Ex. 458 A.P. No. 3-13847, Bates No. PWC-MKE-S-000158865-66.

143 P&P Manual, App. A Ex. L at 8 (Subpart III.D.) (emphasis supplied).

144 Jan. 24, 2007 Board Package, at 225-34.

145 Id. at 225-27.

This requested data was answered by the generic statement that “[t]hese portfolio securities are generally not quoted daily by a pricing vendor.”146 Based on the evidence I have reviewed, the Respondents failed to comply with their own Funds’ policies and procedures requiring written explanations for the valuation of portfolio securities. 5.3.4. The Forms Did Not Advise Respondents of Price Overrides, Severely Impeding Respondents’ Ability to Review Carefully the Valuation Committee’s Findings

Within the context of requisite written records, the documentation and review of price overrides is especially critical when dealing with valuation determinations. The Funds’ procedures required that, before overriding prices provided from external sources, the Adviser must have a reasonable basis for doubting the externally-provided price, and any such rationale was to be documented and reviewed by the Valuation Committee. Specifically, the procedure stated that,

The Adviser may override prices provided by a pricing service or broker-dealer only when it has a reasonable basis to believe that the price provided by the pricing source does not adequately reflect the fair value of the portfolio security. The basis for overriding the price shall be documented and provided to the Valuation Committee for its review. The Valuation Committee will take such action as it deems necessary or appropriate with respect to price overrides.147

Based on the evidence I have reviewed, no documentation was regularly provided in instances where Mr. Kelsoe submitted a price to Fund Accounting that was materially different from prices obtained from external pricing sources. Ms. Walker, who was on the Valuation Committee,148 stated that there were no records explaining price changes made by Mr. Kelsoe, and if there had been any such documentation it would have been an “exception” to Mr. Kelsoe’s routine practices.149 Ms. Walker testified that Mr. Kelsoe would make price changes in his handwriting, there were no instances she could recall where he provided an explanation substantiating a substituted price he gave the Fund Accounting

146 Id. 147 P&P Manual, App. A Ex. L at 9 (Subpart IV.B.) (emphasis supplied).

148 The terms “Pricing Committee” and “Valuation Committee” are interchangeable and refer to the same group of people. Walker I Tr. at 122:17––22.

149 Id. at 70:2––73:5.

Group, and Mr. Kelsoe’s practices in this regard were generally accepted without question.150 Mr. Miriyagalla noted that “[t]here was no documentation of why a dealer quote was overridden and priced higher that what the confirmation said.” 151

The Valuation Committee did not consider it to be an “override” if Fund Accounting or the Valuation Committee disagreed with a price contained on a broker confirmation, even if the Funds’ price was materially different.152 The Directors apparently knew that the Valuation Committee adopted this narrow interpretation of overrides, 153 but did nothing to consider or change that interpretation. 5.3.5. The Respondents Failed to Monitor Periodically for Price Validation

Within the context of the Funds’ required written records, the P&P Manual sets forth three Periodic Monitoring Procedures:

(i) Review of Independent Pricing Service Data,

(ii) Review of Broker-Dealer Supplied Prices, and

(iii) Review of Fair Value Prices.

150 Id. at 70:2––25, 72:12––73:18.

151 Email from Manura M Miriyagalla to Mike P Quakenbush (Sept. 17, 2007), Pl’s Ex. 458 AP 3-13847, PWC-MKE-S-000158865-66.

152 Weller Tr. at 53:8––13. 153 The testimony of Mr. Willis is illustrative of this awareness: Q: . . . If the confirmation came in on April 10th and it specified a price of 80 as of March 21st, but as of April 10th the funds had it valued at 90, as you understood it, would it have been a price override if they decided—fund accounting decided not to use the price of 80, but to stick with the price of 90? A: It was not my understanding that that was necessarily the process. The confirmation, unless it was, in fact, a trade where someone bought the security and paid for the security, it’s still, again, somebody’s opinion of value. And that information would be taken into consideration, but not necessarily be automatically utilized for pricing. Therefore, if the pricing was not adjusted, that would not necessarily constitute, as I understood it, an override. Willis Tr. at 198:22––199:13.

These procedures are important to ensure the integrity of the valuation process, ensure the reliability of the pricing data, and “identify potential valuation issues.”154

As set forth in further detail below, the documentary evidence demonstrates that none of the Periodic Monitoring Procedures were implemented, which resulted in the lack of any meaningful review or oversight of Unquoted Securities valuations. As discussed above, under Rule 38a-1, the Board had the ultimate responsibility to ensure proper oversight and monitoring of the ongoing implementation of the valuation methodologies, and to modify the methodologies, policies, and procedures as appropriate. Respondents failed to ensure that they were provided with periodic monitoring data from the Advisor and Valuation Committee. Due to this failure, Respondents were unable to satisfy their oversight duties.

For example, the Valuation Committee was obligated to review the procedures governing valuation prices. Specifically, the Review of Fair Value Prices procedure required the Valuation Committee, for each valued security, to “check and refine the valuation methodology by comparing the fair value of the security with the values that are available from other sources (if any),” and to document all comparisons in a “report.”155 As set forth in Section 5.6. infra, the Valuation Committee did not understand the valuation process and certainly could not have reviewed it. Based on the documentary evidence, the Valuation Committee produced no such reports, and the Board did not receive any such reports.156

In addition, the procedure for the Review of Independent Pricing Service Data provided that,

The Adviser shall periodically cross-check the prices of individual securities received from an independent pricing service, selected on the basis of potential impact on the NAV of the Fund, against quotations from other pricing services; quotations from the dealers making a market in the particular securities; prices from actual sales in the particular securities, when and if they occur; and/or prices for comparable securities. Where significant variances appear, the Adviser shall further analyze the appropriateness of the

154 P&P Manual, App. A Ex. L at 8––9 (Subpart IV.).

155 Id. at 9 (IV.A.3.) (emphasis supplied).

156 See Walker I Tr. at 66:25-––3:21.

price used in calculating NAV. Any price overrides and their justification shall be documented, consistent with the Procedure indicated below.157

Mr. Miriyagalla noted that at least some of these requirements were not met. For example, he found several control deficiencies related to independent price reviews. Specifically, he noted that “[e]ven in cases where management had sought dealer sentiment, it was from just one dealer. They did not attempt to obtain from multiple dealers.”158 He further concluded that “[t]he client had not done a thorough review of the market at the end of June to determine if any general market adjustment was required to the securities.”159 He also noted that there was a lack of due diligence on brokers, stating that, “[c]onsidering the downturn in the sub-prime market since March, the client should have done a better job investigating and documenting the pricing process of the pricing brokers.”160 He further noted that “in some cases, management did not agree with the pricing from certain dealers (such as Winter Group), yet they still sent out the confirmation to them.”161

5.4. The Look-Back Test Did Not Enable Respondents to Review the Valuation Committee’s Findings Adequately Respondents placed undue emphasis on the look-back test. While the comparison of actual subsequent sales to previously attributed values can be a useful tool, particularly when securities are thinly traded, there also must be some analysis of how many securities in the portfolio were actually sold, or alternatively, how many securities were not sold. In this matter, the Division has identified roughly 290 pertinent Unquoted Securities for which the Funds’ valuation methodologies were applied.162 These securities comprised up to 50% of the total asset values of the individual Funds’.163 I have reviewed the Funds’ securities Sale Reports from November 2006 to July 2007. These reports show that only 24 of the approximately 290

157 P&P Manual, App. A Ex. L at 8 (IV.A.1.) (emphasis supplied).

158 Email from Manura M Miriyagalla to Mike P Quakenbush (Sept. 17, 2007), Pl’s Ex. 458 AP 3-13847, PwC-MKE-S-000158865-66.

159 Id.

160 Id.

161 Id.

162 See Division Summary Ex. 243, AP File No. 3-15127. 163 See Division Summary Ex. 244, AP File No. 3-15127 for March 31 and June 30, 2007.

Unquoted Securities identified by the Division—just 8.28 percent—were sold during this 8-month period.164 Given the small percentage of sales, the look- back test could not have provided a significant source of comfort for Respondents. Here, due to the large amount of Unquoted Securities that were not sold, the Directors should have recognized that the significance of the look- back test was quite limited. The Directors’ failure to consider the limited significance of the look-back test reflects their lack of genuine understanding of, and participation in, the Funds’ valuation methodologies. Indeed, the evidence I have reviewed demonstrates that none of the Directors had adequate knowledge of the valuation methodologies and processes actually performed.

5.5. The Directors’ Failure to Review for Potentially Stale Prices Limited Their Ability to Review Carefully the Valuation Committee’s Findings Consistent with their obligation to carefully review findings of those tasked with performing daily valuations of Unquoted Securities, boards of directors during the Relevant Period frequently reviewed securities prices to identify potentially stale prices. As mentioned previously, there was substantial guidance available during the Relevant Period advocating such board reviews.165 Moreover, as discussed below, at least one of the Funds’ claimed Peer Funds had implemented a rigorous stale price review during the Relevant Time Period.

Here, a review for stale prices would have been particularly appropriate, given the high level of Unquoted Securities within the portfolios and the Funds’ concession that prices for many of these securities could be volatile.166 The

164 My staff independently reviewed the Sales Reports for the Funds from November 2006 until July 2007 that were provided to me in Excel format and aggregated all securities sold during those eight months. I then compared the securities that were identified as having been sold with the securities listed on Division Summary Exhibit 243. My analysis is consistent with the securities sales reflected on Division Summary Exhibit 250. Specifically, I have identified only 24 of the approximately 290 securities on Division Summary Exhibit 243 that were actually sold during this 8-month period. 165 See generally, §4.4 supra. 166 See Annual Report for closed-end funds for FYE March 30, 2007 (Significant Accounting Policies note that between 55% and 65% of total assets were required to be fair-valued); Annual Report for open-ended fund for FYE June 30, 2007 (Significant Accounting Policies note that more than 50% of the net assets in the High Income and Intermediate Funds were required to be fair-valued); RMK Strategic Income Fund, Inc., Form N-2/A at 2 (Feb. 26, 2004) (“Because the Fund’s investments may be concentrated in below investment grade debt securities, the Fund may be subject to the risks of such securities…They involve greater risk of loss, are subject to greater price volatility and are less liquid, especially during periods of economic uncertainty or 55 auditors recognized this issue and raised a concern about the need for a stale price review in connection with the audit of the March 31, 2007 financial statements.167 Respondents should not have needed the outside auditors to identify the need for this procedure, given its common use in the industry at this time. Nevertheless, the evidence I have reviewed suggests that, even after learning of PwC’s concern, Respondents did not immediately implement this procedure. Indeed, a July 31, 2007 e-mail, from Mr. King to other Valuation Committee members, shows that, as of that date, the Funds had not yet responded to PwC’s concerns by implementing a stale price review.168

Given the large percentage of Unquoted Securities in the Funds’ portfolio and the volatility in the market during the Relevant Time Period, procedures to maintain current pricing and avoid stale prices were particularly important. Notwithstanding the volatility of these securities in the Relevant Time Period, which converts once timely data into stale and useless data more rapidly, Ms. Walker testified that, even if the pricing of one of these securities did not change for periods ranging from ninety days up to possibly five months, that would not raise a red flag for her that the data had become stale.169 She further stated that she “didn’t have a red flag for how the prices stayed the same.”170 In fact, Fund Accounting did not have a procedure in place for tracking the length of time that had expired since a security was last valued, and thus had no process to determine whether or not the price of a security was stale.171

change”) and RMK High Income Fund, Inc., Form N-2/A at 10 (June 23, 2003) (noting that the Fund’s investment strategy was to invest in “below investment grade debt securities” and, due to illiquidity, the market price “generally is more volatile than that of more liquid securities” ). 167 See Letter from PwC to Thom Weller (May 21, 2007), Bates Nos. MAM-8-00522842––43. I understand that some Respondents contend that they did not learn of PwC’s suggestion for a stale price review until around June 18, 2007. See White Paper Submission on Behalf of Messrs. Blair, Johnson, McFadden, Pittman, Willis, and Ms. Stone, A.P. No. A-3211 (Dec. 29, 2011) at 20. This claim is suspect given that on May 29, 2007, Casey King authored a memo to Thom Weller and Louis Hale proposing several changes to the Valuation Committee procedures “based on the experience of the pricing section of the March 31 audit.” Among the new procedures proposed was a review for stale prices. See C. King Mem. to T. Weller and L. Hale (May 29, 2007), A.P. No. 3-13847 Pls.’ Ex. 535, Bates No. MAM-8-00753659-60. 168 Email from C. to T. Weller, et al. (July 31, 2007), at 1––2, Bates No. MAM-8-00687674––75 (suggesting, as one of several “revamps” to the Pricing Committee package, that it “[a]dd section for stale price review” that would “[p]erform a stale price review four times per year” and would “obtain explanations from the Adviser and insert in the Pricing Committee package”). 169 Walker II Tr. at 235:5––25.

170 Id. at 246:20––247:3.

171 Id. at 250:11––19.

Funds that Morgan Keegan described as “Peer Funds” indeed had measures to avoid stale pricing. The two Hyperion “Peer Funds” identified automatically generated Variance Reports to indicate pricing anomalies. With regard to stale pricing, if a price had not changed for 29 days, the peer funds’ computer system would automatically revert the price to zero, and “the Portfolio Administration Group will obtain an updated price for the security and refresh” their computer system.172

The Directors acknowledged that the Funds carried a very high level of below- investment-grade securities, and that prices would therefore be volatile. 173 This increased the necessity for stale price reviews even more critical, given the clear expectation that prices would be moving on a regular basis. The most logical approach to ensure that these securities were actually being priced daily, as the Directors were obligated to ensure, was to implement stale pricing reviews, something the Directors here failed to do.

The failure of the Directors to review for stale prices, or to require a stale price review by the Valuation Committee, prevented the Directors from reviewing and effectively overseeing the findings of the Valuation Committee. Had the Directors instituted a policy that provided them with regular reports about potentially stale prices, the Directors would have possessed the critical information necessary and could have raised concerns about the failure of the assigned valuations to change. The Directors’ stated ignorance regarding such fundamental matters of valuation policy—that a stale price review was critical, and that they should be attentive to securities prices that remain static for extended periods of time—further demonstrates that Respondents failed to take even the most minimal proactive measures necessary to satisfy their obligations to value the Funds’ portfolio securities in good faith.

172 Hyperion Brookfield Asset Mgmt., Inc., Inv. Advisory Servs., Report on Controls Placed in Operation and Tests of Operating Effectiveness (Oct. 1, 2005-Sept. 30, 2006) at 35, Bates No. SEC-Helios-0001139.

173 See MK Select Fund 2006 N-CSR (June 30, 2006) at 28 (“The Fund invests primarily in below investment-grade bonds rated CCC- or better . . . . Below investment grade debt securities are considered speculative with respect to an issuer’s capacity to pay interest and repay principal and are susceptible to default or decline in market value due to adverse economic and business developments.”); see also RMK Strategic Income Fund, Inc., Form N-2/A (Feb. 26, 2004) (similar representations); RMK High Income Fund, Inc., Form N-2/A (June 23, 2003) (similar representations).

5.6. The Valuation Committee Did Not Sufficiently Understand How to Value Securities

While boards of directors may obtain technical assistance to perform valuation calculations, boards must ensure that those from whom technical assistance is requested possess the requisite expertise to perform the tasks assigned, and they must themselves oversee the performance of these calculations. The evidence I have reviewed raises serious questions about the competency of Fund Accounting and the Valuation Committee to perform the fair-value calculations.

Ms. Walker, who was a senior accountant in Fund Accounting and a member of the Valuation Committee, testified that she did not know of anyone in the Fund Accounting Group who obtained and analyzed bond performance data and could, thus, provide a reasonable analysis of Mr. Kelsoe’s pricing.174 She stated that it was her understanding that analyzing Mr. Kelsoe’s pricing was not the role of the Fund Accounting Group, but rather, that of Mr. Kelsoe’s analysts.175 In fact, Ms. Walker stated that she was not aware of the types of collateral underlying the bonds, information regarding the payment rates or default rates, or, in effect, any information related to the bonds.176 Ms. Walker further indicated that, if Mr. Kelsoe tendered a price confirmation, she expected that the exact price Mr. Kelsoe tendered would be entered into the NAV as the Funds’ valuation.177 While Ms. Walker’s testimony demonstrates her lack of understanding or oversight of the Funds’ valuations, it appears that Morgan Keegan’s accounting department substantially relied on Ms. Walker for assuring the validity of the Funds’ valuations.178

174 Walker I Tr. I at 71:18––25.

175 Id.

176 Id. at 66:25––67:9.

177 Id. at 73:1––21 (stating further that the majority of the time, she assumed Mr. Kelsoe’s pricing changes were reasonable and her process was that “if [she] deemed them to be reasonable and [she] knew they came from [Mr. Kelsoe, she] would have processed them” without question “[f]or the most part”).

178 For example, the testimony of Mr. Weller, who headed Morgan Keegan’s Fund Accounting department, shows that while there did not exist a strong foundation for assuming that Ms. Walker had the training or ability to participate meaningfully in the valuation process, Fund Accounting and the Valuation Committee apparently relied on her to provide audits of Mr. Kelsoe’s pricing conclusions. Q: . . . I think you testified before that – that you didn’t think that Ms. Walker any way was a CFA or had any experience with bond trading or portfolio 58

Moreover, an external auditor, Mr. Miriyagalla, expressed concern at the May 21, 2007 Audit Committee meeting that those persons who were valuing the Funds’ securities needed help and were not adequately trained or knowledgeable.179 Similarly, an attorney from K&L Gates who serves as outside counsel, Jennifer Gonzalez (“Ms. Gonzalez”), attended the Board and Audit Committee meetings and took contemporaneous notes therein. In her notes of the May 2007 Audit Committee Meeting, she indicated that the Chairman of the Audit Committee, Mary Stone, asked whether Tom Weller’s group, Fund Accounting, employs “enough skepticism when dealing with Jim [Kelsoe].”180 Mr. Miriyagalla answered that they did not, they had “so much respect for him,” and that “intimidation” was an issue, such that Fund Accounting had not sufficiently questioned his pricing.181 Mr. Miriyagalla recommended to the Audit Committee that they should hire pricing experts who could ascertain market information and bring more integrity to the pricing of securities.182

Mr. Miriyagalla expressed a similar concern in PwC’s audit work papers. He wrote there that “[t]he technical support provided to management in their efforts to understand the market effects at the end of June was poor. There should have been more fixed income experts available to management.”183

Further indication that the Valuation Committee and Fund Accounting Group lacked sufficient qualifications is evidenced by their blindly adoption of

management or bond sales, so how would she know that this is something relevant that needs to be considered with the price? A: Ms. Walker would have received hundreds if not thousands of trade tickets on these CUSIPs, so I think she became very familiar with – with trades on these and how those were priced, how those prices reflected compared to how we had them the day before and things like that but if but once she’s receiving thousands of those and looking at Bloomberg and pricing these securities I can’t answer exactly how she worked her magic but all I know is it worked and I got 100 percent clean audits ever audit period. Weller Tr. at 137:21—138:10. 179 Jennifer Gonzalez Tr. A.P. No. A-3211 (Aug. 29, 2012) (“Gonzalez Tr.”) at 169:8––170:20 (reading and explaining J. Gonzalez Audit Comm. Meeting Notes (May 21, 2007) at Bates No. SEC-KLG-000638); see also Manura Miriyagalla Tr. A.P. No. A-3042 (May 6, 2009) (“Miriyagalla Tr.”) at 39:10––25, 61:14--62:5, 283:1––285:25.

180 J. Gonzales Audit Committee Notes (May 21, 2007) at Bates No. SEC-LKG-000638. 181 Id.

182 Gonzalez Tr. at 170:22––171:9.

183 Email from M. Miriyagalla to M. Quakenbush (Sept. 17, 2007), Pls.’ Ex. 458 A.P. No. 3- 13847, Bates Nos. PwC-MKE-S-000158865––66.

Mr. Kelsoe’s smoothing instructions, as captured by Ms. Walker’s handwritten notes on an email dated June 19, 2007, from Countrywide Financial Corp. (“Countrywide”), setting forth a price decrease in ten-dollar increments per day. 184 Specifically, Countrywide priced one security, with CUSIP No. 12666MAL5 at 7-16, which effectively meant a price of $7.50 on the day in question. As Ms. Walker's handwritten notes reflect, the Funds were carrying that same security at $82.75, which was a considerable disparity from the third- party quote received from Countrywide. In dealing with what was an unbelievable pricing chasm, (approximately $7.50), and Ms. Walker wrote, “[i]nstructions [p]er Kelsoe” were to decrease the current price of $82.75, down to $70 on June 19, then decrease it by $10 increments on June 20, June 21, June 22, June 25, and again on June 26 to a price of $20. This reflects several serious deficiencies in the valuation process over which Respondents presided:

 The carrying value for this security was clearly wrong, grossly inflating NAV;

 The mere recognition of such an unacceptable gap between carrying value and reality did not trigger any inclination on anyone's part to report this to anyone in authority;

 The system in place permitted some of the Funds' employees deliberately to create a fictitious path to achieve a valuation that would get closer—but by no means reasonably close—to a different number;

 The entire process—which had no connection to reality—was dictated by Mr. Kelsoe, evidencing the enormous power he wielded; and

 The final result produced a number that was still 300% higher than the only independent valuation number anyone at the Funds actually had.

Furthermore, based on the daily pricing data, the price was in fact decreased by approximately ten-dollar increments per day, in precise accordance with Mr. Kelsoe’s directives. 185 This evidence demonstrates to me that Ms. Walker

184 Email from R. Gibson (Countrywide) to A. Walker (June 19, 2007), Bates No. Div-Ex-248- 000003. Ms. Walker’s handwriting was authenticated by counsel in this action. Ex. 588 A.P. No. 3-13847 at 001, 002, 038 (counsel identifies Amy Walker’s handwriting).

185 See Joint Exhibit 2 AP File 3-13847 for CUSIP No. 12666NAL5.

60 repeatedly—and unquestioningly—followed Mr. Kelsoe’s directives to change the future valuations of Unquoted Securities in set increments.186 Even on the Price Confirmation Analysis forms, the overwhelming majority of valuations were stated to have been “based on conversations with [Fund Manager].”187

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

By March 2007, Respondents were aware that there was trouble in the industry and that the market for its Unquoted Securities—which had been volatile—was becoming increasingly so.188 The Directors were aware that the securities held by the Funds were low-grade and highly volatile.189 Moreover, the May 21, 2007 Board Meeting Minutes reflect some discussion of the Valuation Committee’s ability to price securities under “current market conditions.” 190 At that meeting there was also reference to the “poor performance” of the High Income Fund.191

Based on the Annual Reports for the Funds FYE March 31 and June 30, 2007, the percentage of Unquoted Securities for these Funds was up to 60% of total NAV.192 In my experience, this is an extraordinarily high level of Unquoted

186 See, e.g., Facsimile of comparison of Credit Suisse First Boston prices with MAM prices as of Apr. 30, 2007, Bates No. Div-Ex-247-000016; Facsimile of comparison of Stifel Nicolaus & Co., Inc. prices with MAM prices as of Apr. 30, 2007, Bates No. Div-Ex-247-000028.

187 Morgan Keegan Select High Income Fund Sub-Prime Confirm Analysis (July 10, 2007), A.P. File No. 3-13847 Pl.’s Ex. 548.

188 A New York Times article in the Relevant Period discusses mutual funds that held subprime mortgage-related debt securities, “indicating that everyday investors are among those who will probably be hurt by the turmoil that is tearing through the residential mortgage market.” Gretchen Morgenson, Mutual Funds at Some Risk On Mortgages, N.Y. TIMES, Mar. 14, 2007, § C, Column C, Bus./Fin. Desk, at 1 “NYT Article”), Bates Nos. SEC-MSS-001546-47; Respondents were aware of this article, see J. Gonzalez Tr. (Aug. 29, 2012) A.P. File No. 3211 (“Gonzalez Tr.”) at 180:3––184:11 (discussing the NYT Article, which appeared on the K&L Gates bill for the RMK High Income Fund).

189 See Annual Report for Select Income Funds (June 2006) & RMK Funds Annual Report (Mar. 30, 2006) (stating that the securities were low grade and highly volatile). 190 Board Minutes (May 21, 2007) at 8, Bates No. MAM-8-000745372. 191 Id. at 3, Bates No. MAM-8-000745367. 192 For relevant closed-ended funds, see Form N-CSR for RMK High Income Fund for FYE March 31, 2007 at 84 (Unquoted Securities represented approximately 61.52%, 57.99%, 65.08%, and 59.94% of the total investments of RMK Advantage Income Fund, RMK High Income Fund, RMK Multi-Sector Fund, and RMK Strategic Income Fund, respectively). For relevant open- 61

Securities within a mutual fund portfolio. This percentage, coupled with the turbulent market conditions during the Relevant Time Period and the unfettered pricing by a rogue portfolio manager who was not overseen, renders Respondents’ failures particularly egregious.

5.8. Reliance on “Experts” and Others Cannot Excuse or Justify Respondents’ Failings

Auditors, compliance officers, attorneys, and other professionals are resources of which boards can and should avail themselves, but directors cannot abdicate their duties by relying on others to execute their statutory and fiduciary duties. The responsibility of implementing, understanding and overseeing policies and procedures for the appropriate valuation of portfolio securities lies ultimately with fund directors—these are duties that cannot be outsourced. Rule 38a-1, as well as many securities laws impose individual accountability.

As an initial matter, attempts to rely on the advice and guidance of experts as a defense to allegations of directorial misfeasance or nonfeasance is an effort to disprove the existence of any intent to commit alleged violations of law.193 In general, the defense requires that the one asserting it made full disclosure to the experts retained, received appropriate advice, and then relied upon that advice in good faith.194 Here, there can be no reliance on expert advice for several critical reasons.

First, intent is not a necessary element of the violations alleged, and thus efforts to disprove intent are irrelevant.

Second, from a governance perspective, directors must take a proactive approach and make certain inquires before they can rely on experts. For example, directors must know:

 Who the advisers are,

 That the advisers qualify as experts,

ended funds, see Form N-CSR for MK Select Fund Inc., for FYE June 30, 2007 at 66 (Unquoted Securities represented approximately 29%, 51%, and 59%, of the net assets of the Short-Term Bond Fund, Select Intermediate Bond Fund, and Select High Income Fund, respectively).

193 See, e.g., United States v. Miller, 658 F.2d 235, 237 (4th Cir. 1981). 194 See, e.g., Markowski v. SEC, 34 F.3e 99, 104-05 (2d Cir. 1994); United States v. Smith, 523 F.2d 771, 778 (5th Cir. Fla. 1975).

 That the advice falls within the scope of their engagement,

 That conflicts of interest were vetted,

 That they were provided with all the facts, and

 Any caveats to their advice.

Third, there is no evidence that the Directors here attempted to obtain advice on what their obligations were under Rule 38a-1. Rather, the only documentation of which I am aware indicates that the Directors allowed management and others to dictate how the valuation process would operate. There was no effort to raise any questions regarding the way the duties in question here should be performed, or whether the way those duties were being performed was sufficient or in accordance with accepted practice and extensive government and private sector advice. As we have seen, the practices here fell far short of the available guidance.

Fourth, there is no evidence that the Directors made any disclosure, or asked any questions regarding their actions and inactions. Under those circumstances, there was no advice on which the Directors could rely.

Fifth, directors cannot blindly follow the guidance of others. Directors must conclude that any advice they did receive was “reasonable,” and therefore, any circumstances that would render the advice unreasonable or unjustifiable precludes good faith reliance on experts.

5.8.1. Respondents Could Not Discharge their Statutory and Fiduciary Obligations by Purporting to Have Relied on the Chief Compliance Officer

A fund’s CCO is a valuable board resource as the board carries out its valuation responsibilities. Thus, the CCO can assist the board in establishing effective valuation policies and procedures, improving its understanding of valuation methodologies, contributing to the board’s ongoing oversight efforts and monitoring for conflicts of interest and other risks. In my experience, however, the CCO’s role must also be understood to reflect the fact that the CCO, unlike the board members, operates as part of management, alongside the investment adviser. This enables CCOs to provide insight regarding the extent to which the adviser or others to whom the board has delegated day-to-day responsibilities, are, as a practical matter, complying with the board’s policies and vision, but it also means that boards must exercise their own oversight and due diligence, lest they fail to understand all the nuances of the actual

63 functioning of their funds’ valuation policies.

Boards have been advised to request their CCOs to perform compliance checks to provide insights into the ongoing functioning of the valuation process and to devote special attention to any valuation overrides by the manager. By doing so, boards can gain valuable insight from effectively using a qualified CCO who can assist in identifying potentially problematic patterns that arise in day- to-day pricing.

Here, however, the Board could not rely on Ms. Wood, who was the Funds’ CCO beginning in April 2006, for valuation matters, since she conceded that she had no experience whatsoever with valuation, and virtually the same level of familiarity with finance and accounting more generally.195 Respondents were aware of her lack of qualifications because it was Respondents who interviewed her for the position of CCO.196 Therefore, they knew—or certainly should have known—that her ability to assist them in satisfying their fiduciary and statutory duties relating to valuation, and especially to understand, adopt, implement and review policies and procedures regarding valuation, as well as for specific valuation methodologies, was well-nigh impossible.

While Ms. Wood served as a member of Valuation Committee during the Relevant Period, she never obtained a basic understanding of who was responsible or accountable for performing or overseeing valuations at the Funds. Perhaps most alarming, is the fact that Ms. Wood never understood what role she herself was supposed to serve on the Valuation Committee. Indeed, when asked, “[a]s chief compliance officer, what did you understand that you were supposed to do as a member of the valuation committee?” she responded with a sense of befuddlement, “You know, I don’t know. I don’t know that I

195 See Wood Tr. at 8:17––22 (explaining that she had never taken any finance or accounting classes throughout her education and career); id. at 16:21––17:1(stating that she did not have “any experience valuing securities” or “evaluating financial statements”); id. at 46:3––7 (“. . . when you’re talking about valuation, I knew that I didn’t have the expertise to behind fund accounting and double check. I didn’t have a Bloomberg machine, I didn’t have the subject matter expertise to second guess how they were valuing the funds.”). Ms. Wood’s background, which ostensibly made her qualified to the position of CCO, consisted of considerable experience as an employment attorney (prior to joining Morgan Keegan in 2002), and then joining Morgan Keegan’s legal department, where she focused on arbitration cases, until early 2006. Then, in April of 2006, she transitioned to the position of CCO of the Funds. Wood Tr. at 9:23––10:7. 196 When Ms. Wood was asked who interviewed her for the position of CCO, she identified “[t]he independent directors who were based in Memphis,” and referred specifically to “Stilly McFadden, Archie Willis, and Jack Blair.” Wood Tr. at 43:8––14.

64 thought about it.”197 Reflective of what seems to have been a broader trend across the Funds, Ms. Wood does not seem to have been provided with any substantive guidance regarding her objective—in her role as CCO or as a member of the Valuation Committee—from the Directors or anyone else.198

Further, Ms. Wood’s recollections, or lack thereof, depict a working relationship between the Directors and the Valuation Committee that was dysfunctional at best. Ms. Wood was not able to recall a single instance in which Respondents provided information for the Valuation Committee to consider in its valuation process.199 Nor could Ms. Wood recall an instance in which the Board provided the Valuation Committee with guidance to consider in determining assigned valuations.200 The relationship seems to have been reciprocal—Ms. Wood’s testimony indicates that the Valuation Committee never asked the Directors for information either. 201 It is also evident that Ms. Wood played absolutely no role in bridging the communication gap between the Directors and the Valuation Committee, since she never reported to the Directors the substance of what transpired during Valuation Committee meetings,202 nor did she ever convey to the Directors how the Valuation Committee operated. 203

197 Wood Tr. at 31:10––3 (emphasis supplied). This testimony can only be described as appalling in the extreme, in my opinion. 198 Q: Were you ever given any instruction by anyone, by the board or otherwise, as to what you were supposed to do in these valuation committee meetings? A: No. Q: As a CCO, would you typically be privy to information that Mr. Kelsoe had provided to fund accountants with respect to valuation, other than his explanation of variances between sales price and fund price? A: No. Id. at 31:14-23 199 Id. at 38:22––25 (stating she had no recollection of the Board ever “identify[ing] specific information they wanted” the VC to consider “with respect to daily NAV calculations”). 200 Id. at 38:8––12 (stating she no recollection of the Board ever providing the Valuation Committee “with more specific guidance about how they wanted it to determine fair value, more specific than was in the policy and procedure manual”). 201 Id. at 41:15––18 (stating she had no recollection of the Valuation Committee ever asking the Board “for guidance on what it should be doing with respect to determining fair value”). 202 Ms. Wood testified, Q: To what extent did you – did you report to the board on what happened in valuation committee meetings, either generally or specifically? A: I didn’t. Id. at 32:9––13

203 Id. at 36:17––23. Ms. Wood testified, in relevant part,

Similarly, Ms. Wood did not have any discussions with any Board Member “concerning what the valuation committee was doing, its process for valuing,”204 or “about valuation of securities in the portfolio.”205 While the CCO’s central goal is typically understood to monitor critical compliance areas, Ms. Wood viewed her role differently. When asked if part of her role as CCO was to “monitor compliance with the valuation procedures,” Ms. Wood responded “I was, as chief compliance officer, an overseer of how procedures were carried out. I don’t know if monitoring would be a word I would use to describe it.”206 Indeed, she seems to have been entirely uninformed as to Mr. Kelsoe’s participation in the valuation process throughout her tenure as CCO—she didn’t “think that the fund manager was doing anything that should have touched on valuation necessarily.”207 As a consequence, the Funds’ CCO paid no attention to Mr. Kelsoe’s compliance with valuation procedures because, according to Ms. Wood, he was not a relevant participant in the valuation process.208

Most shocking with respect to the relevance of Rule 38a-1 to the Funds’ valuation methodologies, Ms. Wood testified that it was understood and accepted at the Funds that the Valuation Procedures approved by the Board did

Q: Did you ever describe to the board or any of the board members what - - how a valuation committee typically worked? A: Did I, no. Q: Did you ever describe to the board the contents of the pricing committee packet like Exhibit 28? A: No. Id. 204 Id. at 42:18––12. 205 Id. at 42:12––17. 206 Id. at 20:8––13. 207 Id. at 22:116––17. 208 Id. at 22:10––17. Ms. Wood testified in relevant part, Q: Okay. So as far as you understood your responsibilities, they didn’t include monitoring activities of portfolio managers to see whether they were complying with any type of valuation procedures? A: Correct. Because I don’t think the valuation procedures really required – well, let me back up. I don’t think that the fund manager was doing anything that should have touched on valuation necessarily. Id.

66 not match the realty of the Funds’ valuation process.209 In fact, according to Ms. Wood, it was “not a mystery” to the Board of Directors that “the [valuation] procedures, didn’t, you know, always mesh necessarily with how things happened in day-to-day practice.”210 And, she partially disagreed when asked whether the Funds’ Valuation Procedures as approved by the Board “represent[ed] the process by which the [B]oard wanted valuation to be performed.”211 She explained, “Well, I disagree from the extent that, again, these were drafted by lawyers and I think they were intended to cover rules and regulations that were applicable and maybe did not fully account for some of the day-to-day practices that could have also been incorporated in here.”212 Further demonstrating the irrelevance of the Policies and Procedures to the Funds’ operation in practice, Ms. Wood, after having attended Valuation Committee meetings as a regular member, could not recall a single instance in which the Committee referenced the Valuation Policies.213

The artificial nature of the CCO’s role is further suggested by the CCO Report, which afforded the Directors the hollow conclusory statement that the Funds were complying with policies and procedures, but provided no actual information about the Funds’ valuation methodology or anything that would help the Directors understand the appropriateness of such a methodology.214 The CCO was not qualified to price securities and did not have sufficient understanding of the discipline to comprehend it—and certainly not to convey such an understanding to Respondents. Moreover, nothing in the Report describes the valuation methodologies used or assures that all relevant factors

209 Id. at 61:4-13 (testifying that “written policies doesn’t describe what the [actual] review process was” by the Valuation Committee); id. at 64:16––25 (stating that “I think there is a difference between how the process worked in practice versus a rule base set of procedures” [i.e., the written policies and procedures]). Ms. Wood further testified in relevant part, Q: As – as chief compliance officer, how did you view the valuation procedures in Exhibit L? What did they represent with respect to your job? A: Sitting here after all this time, honestly I don’t know. Id. at 26:18––22. 210 Id. at 61:20––23. 211 Id. at 60:22––61:1. 212 Id. at 61:4-8. 213 Id.at 41:119––23 (stating she had no recollection of VC meetings ever referencing Board’s Valuation Policies and Procedures). 214 See Valuation Policies and Procedures, MAM-8-0000746359––369.

67 are being considered and considered properly. The CCO Report did not provide any specific information on which Respondents could rely.

Whatever the appropriate reach is of reliance on experts, the sine qua non of such a doctrine is that there must be an “expert” somewhere in the picture. Ms. Wood may have had the title of CCO, but she certainly was not an expert, and definitely not one on whom any Director should want to place even an iota of reliance.

5.8.2. Reliance Cannot Discharge their Responsibilities by Claiming They Relied on the Funds’ Auditors

A fund’s auditors are another valuable tool and resource for directors in assessing the effectiveness of a fund’s valuation procedures, and can provide meaningful assistance to the fund’s directors. As of the year-end reporting period for mutual funds, the fund’s auditors assess the reasonableness of the valuation of all securities. In doing so, the auditors review the information presented to the board for securities that required valuation procedures, and may obtain comparative prices from secondary sources. As such, auditors are able to provide an independent perspective on the implementation of a fund’s valuation procedures, and can discuss their independent evaluation of the results of those valuation procedures with the board.

Respondents’ efforts to place reliance on PwC to demonstrated they fulfilled their valuation responsibilities is unwarranted and misguided. For one thing, auditors do not play a role in a fund’s daily control environment; therefore, the import of their perspective on year-end valuations is that they provide another source of data and insight for boards to consider, but they are not performing a control or oversight function on which boards or fund advisers can rely. Further, when auditing a fund’s financial statements, valuation of securities is tested in the context of the financial statements taken as a whole—it is not the entire, or even a principal, focus of the audit process. The limitations inherent in the auditor’s role are critical—the auditor cannot supplant the board’s obligation to understand the valuation methodology being used and the appropriateness of that methodology.

Of course, even putting those compelling difficulties aside for a moment, in this matter, the Funds’ auditor, PwC, unequivocally defined and limited the scope of the audit work it would perform. The engagement letters for the March 31, 2007 and June 30, 2007 audits both provide, in relevant part, We will consider the Funds’ internal control over financial reporting solely for the purpose of determining the nature, timing and extent

of auditing procedures necessary for expressing our opinion on the financial statements. This consideration will not be sufficient to enable us to provide assurances on the effectiveness of internal control over financial reporting. However, any significant deficiencies and material weaknesses related to internal control over financial reporting identified during our audit will be communicated to the audit committee.215

Because the engagement letters specifically advised that the PwC audits would not provide assurance regarding the effectiveness of internal controls, Respondents should not have derived significant comfort from the audits as to the appropriateness of the pricing methodologies.

I note that, at the conclusion of each audit, PwC represented to the Audit Committee that the Funds’ valuation procedures were “appropriate and reasonable.” 216 This, however, did not eliminate or modify Respondents’ obligations to:

(1) Identify a valuation methodology;

(2) Satisfy themselves that all relevant factors were being considered in the fair-valuation process;

(3) Carefully review the findings of the Valuation Committee; and

(4) Periodically review the appropriateness of the methodology;

Indeed, it is apparent from the Auditors’ testimony and work papers that the Auditors never obtained a meaningful understanding of the Funds’ valuation methodologies, such that PwC could not have adequately explained the methodology in sufficient detail for Respondents to satisfy their valuation obligations.

For example, when Mr. Miriyagalla was asked to “describe more of a step- by-step process “of what “the policies and procedures were” for “obtaining

215 PwC Audit Engagement Letter (Mar. 30, 2007), Bates Nos. PWC-MKC-S-YE033107- 000000003––09; PwC Audit Engagement Letter (June 30, 2007), Bates Nos. PWC-MKE-S- 000009353––359); see also PwC Report to Audit Committee for March 31, 2007 Audit at 3 (internal pagination), Bates No. SEC-MSS-001138 (discussing similar limitations by PwC, and stating “[o]ur study would not necessarily disclose all material weakness in the Fund’s internal control. Accordingly, we do not express an opinion on the internal controls of the Funds taken as a whole.”). 216 See, e.g., PwC Report to Audit Committee for March 31, 2007 Audit at 2, Bates No. SEC- MSS-001137.

69 prices for securities that could not be valued by an independent pricing vendor,” and securities for which “prices could not be obtained by a model,” Mr. Miriyagalla’s response demonstrated the limited role the auditor served regarding valuation. He noted that PwC “does not rely on controls for valuation,” that its understanding “does not go into the level of detail as what you are asking me to describe,” and that PwC’s “understanding of pricing is very high level, merely to obtain an understanding.”217 PwC’s June audit work papers provide additional evidence that PwC did not sufficiently understand the actual valuation methodology to explain it adequately to Respondents.218

217 Miriyagalla Tr. at 39:10—40:1. Mr. Miriyagalla further testified in relevant part, Q: . . . . I’d like to focus really on just the daily pricing and how it’s established. I think you’ve testified clearly that the fair valuation was, in your view, performed by management, being management of Morgan Keegan as embodied by fund accounting. A: Correct Q: And yet— A: And the valuation committee. Q: And the valuation committee. Thank you. And yet, it sounds like the information for all of that fair value determination is coming from Jim Kelsoe for fair valuation, or from his group. Do you know, once they obtained that information, whether they do any type of evaluation of the information that they obtained from Jim Kelsoe for appropriateness or to analyze it an [sic] any way? A: I did not see evidence of that, although through the discussions they said that they did assess. And we concluded that the information they provided was reasonable. Q: So, their verbal representations to you, anyway, was that they did some sort of a reasonableness analysis of the information that Jim Kelsoe provided them regarding fair-valued securities. A: Correct. Q: Do you have any—Did they tell you any information as to how they went about that reasonableness determination? A: No, I do not recall. And, honestly, they did not provide any evidence of that, which was one of our issues. Miriyagalla Tr. at 61:1—62:5. 218 See Aug. 31, 2007 e-mail from Mike P. Quackenbush, the audit engagement partner, stating, I think it is likely that we’ll need to sit down with the appropriate members of management and go security by security to understand what process was used and the various assumptions that were considered. For much of the limited sample documentation that I have looked at thus far, there is no context around 70

In any event, PwC clearly expressed concerns to Respondents during the March 31, 2007 audit that put them on notice about the deficiencies in the valuation process, and should have raised serious concerns that spurred the Board to take affirmative action. Specifically, in addition to cautioning about the need for a stale price review (previously discussed), Mr. Miriyagalla described concerns during the May 21, 2007 Joint Audit Committee meeting, which discussed the March 31, 2007 audit, that there was a lack of documentation explaining the valuation rationale.219 He sent Respondents a letter dated May 21, 2007, memorializing and informing them of this same deficiency.220 Thereafter, on May 29, 2007, Mr. King drafted a memorandum to Messrs. Weller and Hale that “proposed changes to the Pricing Committee based on the experience during the pricing segment of the March 31, 2007 audit.” 221 The proposed changes included a significant focus on the documentation requirements for pricing as well as instituting a stale price review.222 Yet, on July 31, 2007, these changes still had not been made, as evidenced by Mr. King’s email to the Valuation Committee, attempting to add the same action items to the agenda for the Valuation Committee that day.223

Without an understanding of the valuation methodologies, PwC could not describe those methodologies to Respondents or otherwise provide meaningful assistance to Respondents in evaluating them. Respondents should have arrived at this conclusion—and would have therefore treated any attempt by the auditor to provide reassurance regarding the Funds’ valuation with appropriate skepticism—had the Directors exercised even modest efforts at overseeing the

the range of value that was selected, and why a particular value was selected vs. say another value within that range. As such, it is hard for us to understand all factors that were considered. Bates No. PWC-MKE-PCAOB-000159623 219 The Audit Committee minutes state that “there was limited documentation supporting securities valuations in the Valuation Committee minutes. [H]e indicated that this lack of documentation may make it difficult for a third party to determine the thought process for conclusions reached regarding valuations.” May 21, 2007 Audit Committee Minutes at 2, Resps.’ Ex. 39, AP File No. 3-13847.

220 Bates No. MAM-8-00522842 to 43.

221 Mem. From C. King to T. Weller & L. Hale (May 29, 2007), A.P. File No. 3-13847 Pl.’s Ex. 535, Bates Nos. MAM-8-000753659––60.

222 Id.

223 Email from C. King to T. Weller, et al. (July 31, 2007), Bates Nos. MAM-8-00687674––75.

71 auditor. Indeed, Ms. Stone considered the possibility of a controls-based audit, but ultimately determined such an audit should not be undertaken.224

Recognizing that Respondents are required to obtain a sufficient understanding of valuation methodologies in order to approve them initially, as well as to review them on an ongoing basis, the failure of the Funds’ auditor to obtain a meaningful understanding of the valuation methodologies should make clear that their presence could not assist Respondents in satisfying their obligation to ensure the valuation of portfolio securities in good faith.

5.8.3. Respondents’ Purported Reliance on Attorneys Could Not Discharge their Statutory and Fiduciary Obligations

As is true of their attempts to deflect their responsibilities onto the Funds’ auditors and CCO, Respondents cannot invoked an asserted reliance on counsel as a means of evading their statutory and fiduciary obligations. Boards appropriately seek the assistance of counsel in drafting valuation and other procedures, but doing so does not change the fact that the ultimate responsibility for ensuring the adequacy of a fund’s valuation methodologies, guidance, policies, and procedures rests with the board and its individual members.225 Moreover, even if the receipt of advice could serve to ameliorate a board’s fiduciary duties, mere observations, or silence, do not constitute advice. Respondents’ outside counsel, K&L Gates, assisted in drafting the written Valuation Policies and Procedures, and were also present for some Board meetings at which Respondents received some valuation information.226 This does not lead to the Respondents’ hoped-for conclusion that the Directors adequately performed their duties. Based on the documentary evidence I have reviewed, I have not seen any indication that any attorneys opined on the adequacy of the actual valuation methodologies employed by the Valuation Committee and/or Fund Accounting. Nor have I seen any documentary evidence indicating that the attorneys explained this methodology to Respondents.

224 M. Stone Notes at Bates No. SEC-MSS-002133 (May 21, 2007) (stating that “in looking at new auditors, do we want to talk about cost to get in position to do control-based audit”). 225 See discussion above at Section 4.2, including references to Adopting Release and ASRs 113 and 118. 226 Gonzalez Tr. at 23:18––26:11, 27:8-28:5. Arthur Brown was the lead partner for the engagement until he died In August 2007. Resps.’ Answer at ¶ 49; Gonzalez Tr. at 11––17. At that time, Ms. Gonzalez became the attorney who assumed the role of the K&L Gates point person for the board. Gonzalez Tr. at 18:6––19:15. Mr. Brown ceased attending any board and committee meetings in late 2006. Resps.’ Answer at ¶ 49.

Perhaps even more importantly, there is no evidence of which I am aware that Respondents sought to obtain advice from K&L Gates regarding whether their actions—and their inactions—constituted the fulfillment of Respondents’ statutory and fiduciary obligations. Having failed to seek such advice, it is not a surprise that there is also no evidence that counsel rendered such unsolicited advice to Respondents. Indeed, I did not find any evidence indicating that counsel assisted Respondents in carefully reviewing the findings of the Valuation Committee or that counsel explained to Respondents how the valuation methodology being used provided sufficient assurance that all relevant factors were being considered in the valuation process. I did not see any evidence demonstrating that counsel was made aware that, as noted by the CCO, the actual valuation methodology differed from the written policies and procedures.

In my opinion, Respondents cannot rely on counsel’s physical presence at Board and Audit Committee meetings—with no assessment of the adequacy of Respondents’ conduct—as constituting evidence of their compliance with their duties and responsibilities under Investment Company Act Rule 38a-1, or their duties and responsibilities effectively to oversee the Funds’ valuation process. In order to rely on the advice of counsel, it surely is a prerequisite that counsel must first render advice. That never occurred here.

The board’s ultimate responsibility to understand and approve the methodologies being used, and to satisfy themselves that those methodologies inured to the benefit of the Funds’ shareholders are not obligations that can be outsourced, and especially not to lawyers who are not asked for advice and do not render it.

6. CONCLUSION One of the most important roles independent mutual fund directors are required to perform is overseeing the establishment, implementation and improvement of the process by which their mutual funds value securities— especially securities for which there is no regular and continuous quotation system. In this case, the Directors were—at best—cavalier about their fiduciary and statutory obligations in this regard. At worst, they were uncaring and unconcerned with the consequences of their actions, and perhaps more importantly, their inaction. The standards sought to be applied in this proceeding were well understood during the Relevant Period.

In my expert opinion, Respondents did not take their statutory and fiduciary obligations seriously, and as a result, did not satisfy them. If mutual

Attachment

Attachment A: List of Published Materials (since 2000)

I. Published Speeches/Lectures (ascending)227

1. Speech by SEC Chairman: Remarks Before the AICPA Governing Council, U.S. Securities & Exchange Commission, Miami Beach, FL, (Oct. 22, 2001) (SEC’s relationship with the accounting profession on a going forward basis), available at http://www.sec.gov/news/speech/spch516.htm.

2. Speech by SEC Chairman: Remarks at the PLI 33rd Annual Institute on Securities Regulation, , U.S. Securities & Exchange Commission, New York, NY (Nov. 8, 2001) (aspects of the SEC’s agenda to occupy the Commission over the coming months and years, with a focus on ways the SEC could be improved), available at http://www.sec.gov/news/speech/spch520.htm.

3. Speech by SEC Chairman: Remarks at the Securities Industry Association Annual Meeting, U.S. Securities & Exchange Commission, Boca Raton, FL (Nov. 9, 2001) (state of the securities market in the aftermath of 9/11 and other challenges facing the securities markets), available at http://www.sec.gov/news/speech/spch521.htm.

4. Speech by SEC Chairman: Remarks at the SEC Historical Society Major Issues Conference, U.S. Securities & Exchange Commission, Washington, DC (Nov. 14, 2001) (highlighting marketplace developments, at home and abroad, that require us to rethink our approach to regulation), available at http://www.sec.gov/news/speech/spch523.htm. 5. Speech by SEC Chairman: Fall Meeting of the ABA's Committee on Federal Regulation of Securities, U.S. Securities & Exchange Commission, Washington, DC (Nov. 16, 2001) (personal journey from private bar back into government, and major initiatives that SEC is or will be undertaking), available at http://www.sec.gov/news/speech/spch524.htm.

6. Speech by SEC Chairman: Consumer Federation of America Financial Services Conference, U.S. Securities & Exchange Commission, Washington, DC (Nov. 29, 2001) (challenges and opportunities SEC must meet to ensure that U.S. markets are transparent and can facilitate capital raising, with a focus on improving financial disclosure and the SEC’s program of real time enforcement), available at http://www.sec.gov/news/speech/spch525.htm.

227 All of Former Chairman Pitt’s speeches during his tenure as the 26th Chairman of the U.S. Securities and Exchange Commission are publicly available on the Commission’s website, and those website addresses have been provided.

7. Public Statement by SEC Chairman: Regulation of the Accounting Profession, U.S. Securities & Exchange Commission, Washington, DC (Jan. 17, 2002) (Enron and lessons we can learn about how to prevent failures like this from recurring), available at http://www.sec.gov/news/speech/spch535.htm.

8. Speech by SEC Chairman: Remarks at the 29th Annual Securities Regulation Institute, U.S. Securities & Exchange Commission, Coronado, CA (Jan. 23, 2002) (in the aftermath of Enron, how we must improve our existing disclosure and financial reporting system, and what the SEC is proposing), available at http://www.sec.gov/news/speech/spch536.htm.

9. Speech by SEC Chairman: Remarks at the Winter Bench and Bar Conference of the Federal Bar Council, U.S. Securities & Exchange Commission, Puerto Rico (Feb. 19, 2002) (perspectives on lessons to be learned from the Enron debacle), available at http://www.sec.gov/news/speech/spch539.htm.

10. Speech by SEC Chairman: Remarks at the SEC Speaks Conference, U.S. Securities & Exchange Commission, Washington, DC (Feb. 22, 2002) (crises of Enron and 9/11 require us to reassess how our system functions and likewise how we function within our system; for lawyers and accountants there are professional and ethical issues to consider), available at http://www.sec.gov/news/speech/spch540.htm.

11. Speech by SEC Chairman: Remarks at SIA Compliance and Legal Division Seminar, U.S. Securities & Exchange Commission, Palm Desert, CA (Mar. 11, 2002) (what we can learn from the disasters of 9/11 and Enron), available at http://www.sec.gov/news/speech/spch544.htm.

12. Speech by SEC Chairman: Remarks at the Inaugural Lecture of the JD/MBA Lecture Series, U.S. Securities & Exchange Commission, Kellogg Graduate School of Management, Northwestern Law School, Chicago, Illinois (Apr. 4, 2002) (the need for people of integrity in accounting, law and business is stronger than ever; in the aftermath of Enron need to assess our corporate governance system), available at http://www.sec.gov/news/speech/spch547.htm.

13. Speech by SEC Chairman: Remarks Before the Annual Meeting of the Bond Market Association, U.S. Securities & Exchange Commission, New York, NY (Apr. 25, 2002) (transparency, T+1 initiative, special purpose entities and Securities Act Reform initiatives), available at http://www.sec.gov/news/speech/spch553.htm.

14. Speech by SEC Chairman: Investor Summit Opening, U.S. Securities & Exchange Commission, Washington, DC (May 10, 2002) (SEC mandates,

introduction of panelists, Summit rules), available at http://www.sec.gov/news/speech/spch560.htm.

15. Speech by SEC Chairman: Remarks before the Investment Company Institute, 2002 General Membership Meeting, U.S. Securities & Exchange Commission, Washington, DC (May 24, 2002) (challenges we face regarding US capital markets, SEC’s role and the solutions it envisions, SEC initiatives in the mutual fund industry), available at http://www.sec.gov/news/speech/spch562.htm.

16. Speech by SEC Chairman: Commencement Address, St. John's University School of Law, U.S. Securities & Exchange Commission, Queens, NY (June 2, 2002) (personal observations about the legal profession), available at http://www.sec.gov/news/speech/spch564.htm.

17. Speech by SEC Chairman: Remarks Before the New York Financial Writers Association, U.S. Securities & Exchange Commission, New York, NY (June 13, 2002) (important relationship between the SEC and the financial press, especially during troubled times), available at http://www.sec.gov/news/speech/spch567.htm.

18. Speech by SEC Chairman: Proposed Rules to Create a Framework for a Public Accountability Board, U.S. Securities & Exchange Commission, Washington, DC (June 20, 2002) (discussion of SEC’s proposal for a comprehensive system of rigorous private-sector regulation of the accounting profession), available at http://www.sec.gov/news/speech/spch569.htm.

19. Speech by SEC Chairman: Remarks before the Economic Club of New York, U.S. Securities & Exchange Commission, New York, NY (June 26, 2002) (SEC’s proposed framework for oversight of accounting profession, CEO and CFO certification, improvements at the FASB (e.g. independence, timeliness in addressing issues), retooling disclosure requirements, and far-reaching corporate governance changes), available at http://www.sec.gov/news/speech/spch573.htm.

20. Statement by SEC Chairman: On Fannie Mae/Freddie Mac, U.S. Securities & Exchange Commission, Washington, DC (Jul. 12, 2002) (Fannie Mae and Freddie Mac subjecting themselves to SEC disclosure requirements; partnership between government and private sector), available at http://www.sec.gov/news/speech/spch574.htm. 21. Speech by SEC Chairman: On the Passage of S. 2673, Public Company Accounting Reform and Investor Protection Act of 2002, U.S. Securities & Exchange Commission, Washington, DC (Jul. 15, 2002) (moving one step closer towards meaningful and effective oversight of accounting

regulation in America), available at http://www.sec.gov/news/speech/spch575.htm.

22. Speech by SEC Chairman: Remarks Before the National Press Club, U.S. Securities & Exchange Commission, Washington, DC (Jul. 19, 2002) (SEC’s achievements in 2001-2002 post-Enron, WorldCom and 9/11 disasters), available at http://www.sec.gov/news/speech/spch577.htm.

23. Statement by SEC Chairman: Proposal of Regulation AC, U.S. Securities & Exchange Commission, Open Meeting, Washington, DC (Jul. 24, 2002) (discussion of recommendation by the Division of Market Regulation that SEC propose a rule to require analysts to certify that research reports they issue represent their actual views and to provide disclosures as to whether they have received compensation for the opinions expressed in those reports), available at http://www.sec.gov/news/speech/spch578.htm.

24. Speech by SEC Chairman: Remarks Before the Annual Meeting of the American Bar Association's Business Law Section, U.S. Securities & Exchange Commission, Washington, DC (Aug. 12, 2002) (personal lessons learned in returning to the public sector, aspects of S-Ox that have special significance to lawyers), available at http://www.sec.gov/news/speech/spch579.htm.

25. Speech by SEC Chairman: Remarks at the September Symposium On Corporate Governance and Accounting Reform, U.S. Securities & Exchange Commission, Women in Housing and Finance, Washington, DC (Sept. 20, 2002) (SEC’s major tasks under S-Ox, e.g. creating regulatory regime for accounting profession, disclosure and governance reforms), available at http://www.sec.gov/news/speech/spch584.htm.

26. Speech by SEC Chairman: Remarks Before the Council of Institutional Investors' (CII) Fall Conference, U.S. Securities & Exchange Commission, New York, NY (Sept. 23, 2002) (various challenges we all face at this time, the SEC's important role and the solutions it envisions, and the critical role CII plays in SEC’s efforts to restore investor confidence and improve functioning of the capital markets), available at http://www.sec.gov/news/speech/spch582.htm.

27. Speech by SEC Chairman: Remarks before the U.S. Department of Justice Corporate Fraud Conference, U.S. Securities & Exchange Commission, Washington, DC (Sept. 26, 2002) (elements of an effective partnership between the SEC and the DOJ), available at http://www.sec.gov/news/speech/spch585.htm.

28. Speech by SEC Chairman: Remarks at the Financial Times' Conference on Regulation & Integration of the International Capital Markets, U.S. Securities & Exchange Commission, London, UK (Oct. 8, 2002) (discussion of S-Ox and its implementation for all companies—foreign and domestic, emphasis of the need for cooperation among global regulators), available at http://www.sec.gov/news/speech/spch588.htm.

29. Speech by SEC Chairman: A Single Capital Market in Europe: Challenges for Global Companies, Conference of the Institute of Chartered Accountants of England and Wales, Brussels, Belgium, U.S. Securities & Exchange Commission (Oct. 10, 2002) (discussion of S-Ox and its implementation for all companies—foreign and domestic, emphasis of the need for cooperation among global regulators), available at http://www.sec.gov/news/speech/spch589.htm.

30. Speech by SEC Chairman: Remarks at the Commission Open Meeting, Securities & Exchange Commission, Washington, DC (Oct. 16, 2002) (introductory remarks to the SEC’s proposal of significant new rules pursuant to S-Ox), available at http://www.sec.gov/news/speech/spch590.htm. 31. Speech by SEC Chairman: Remarks at the Directors' Education Institute, Duke University, Securities & Exchange Commission, Durham, NC (Oct. 22, 2002) (personal thoughts on the role of corporate directors, discussion of S-Ox and other SEC reforms), available at http://www.sec.gov/news/speech/spch594.htm.

32. Speech by SEC Chairman: Remarks at the Securities Industry Association Annual Meeting, U.S. Securities & Exchange Commission, Boca Raton, FL (Nov. 8, 2002) (discussion of professional standards necessary for private sector to ensure investor confidence, recap of achievements during Chairmanship), available at http://www.sec.gov/news/speech/spch603.htm.

33. Speech by SEC Chairman: Noah Krieger Memorial Lecture, U.S. Securities & Exchange Commission, Brown University, (Nov. 18, 2002) (importance of public service) http://www.sec.gov/news/speech/spch111802hlp.htm.

34. Speech by SEC Chairman: Remarks at the Commission Open Meeting, U.S. Securities & Exchange Commission, Washington, DC (Dec. 11, 2002) (relief for internet investment advisers, repeal of the trade-through disclosure rule, enhanced portfolio disclosure), available at http://www.sec.gov/news/speech/spch121102hlp.htm.

35. Speech by SEC Chairman: Remarks at the Commission Open Meeting, U.S. Securities & Exchange Commission, Washington, DC (Dec. 18, 2002)

(introduction to the consideration of two recommendations from the Division of Corporation Finance to make the SEC’s processes more efficient, including exemptions from the registration requirements for standardized options and electronic filing of insider ownership reports), available at http://www.sec.gov/news/speech/spch121802hlp.htm.

36. Speech by SEC Chairman: Remarks at Mutual Fund Directors Forum, U.S. Securities & Exchange Commission, Washington, DC (Jan. 8, 2003) (personal observations on how to address challenges facing the mutual fund industry from the perspective of independent directors and from the SEC’s perspective), available at http://www.sec.gov/news/speech/spch010803hlp.htm.

37. Speech by SEC Chairman: Remarks at the Commission Open Meeting, U.S. Securities & Exchange Commission, Washington, DC (Jan. 8, 2003) (investment company transactions with portfolio and subadviser affiliates, standards relating to listed company audit committees), available at http://www.sec.gov/news/speech/spch010803bhlp.htm.

38. Speech by SEC Chairman: Remarks at Commission Open Meeting, U.S. Securities & Exchange Commission, Washington, DC (Jan. 15, 2003) (introduction to three recommendations before the SEC from the Division of Corporation Finance, including Regulation G, Regulation BTR and two new types of disclosures in annual reports to implement Sections 406 and 407 of S-Ox), available at http://www.sec.gov/news/speech/spch011503hlp.htm.

39. Speech by SEC Chairman: Remarks at the Commission Open Meeting, U.S. Securities & Exchange Commission, Washington, DC (Jan. 22, 2003) (introduction for considering the adoption of four final rules related to the Sarbanes-Oxley, including: Form N-CSR and rules enhancing the independence of auditors of public companies, requiring public companies to provide a discussion of off-balance sheet arrangements in their MD&A and specifying information auditors must retain subsequent to the completion of an audit), available at http://www.sec.gov/news/speech/spch012203hlp.htm.

40. Speech by SEC Chairman: Remarks at the Commission Open Meeting, U.S. Securities & Exchange Commission, Washington, DC (Jan. 23, 2003) (introduction to the discussion of various recommendations, including a recommendation from the General Counsel to adopt rules setting forth minimum standards of professional conduct for attorneys who represent public companies before the Commission, and pair of recommendations from the Division of Investment Management regarding proxy voting by investment companies and investment advisers), available at http://www.sec.gov/news/speech/spch012303hlp.htm.

41. Speech by SEC Chairman: Alan B. Levenson Keynote Address, U.S. Securities & Exchange Commission, Securities Regulation Institute, Coronado, CA (Jan. 29, 2003) (overview of what the SEC has been up to, SEC’s attorney conduct rules, and observations about public service.), available at http://www.sec.gov/news/speech/spch012903hlp.htm.

42. Speech by SEC Chairman: Remarks at the Commission Open Meeting, U.S. Securities & Exchange Commission, Washington, DC (Feb. 4, 2003) (custody of investment company assets with U.S. securities depositories and compliance programs of investment companies and investment advisers), available at http://www.sec.gov/news/speech/spch020403hlp.htm.

43. Speech by SEC Chairman: Remarks at the Commission Open Meeting, U.S. Securities & Exchange Commission, Washington, DC (Feb. 6, 2003) (introducing recommendations from the Division of Market Regulation to adopt final rules implementing the dealer provisions of the Gramm-Leach- Bliley Act and to adopt Regulation AC), available at http://www.sec.gov/news/speech/spch020603hlp.htm.

44. Speech by Former SEC Chairman: Orange County Public Company Forum (Feb. 26, 2004) (importance of governance and transparency), available at http://www.kaloramapartners.com/SpeechDetails.aspx?SpeechId=25.

45. Speech by Former SEC Chairman: Keynote Address, SEC Historical Society Annual Meeting, New York, NY (June 9, 2005) (impressions and personal recollections of the events of 9/11), available at http://www.kaloramapartners.com/SpeechDetails.aspx?SpeechId=33.

II. Published Articles (ascending)228

1. Public Statement by SEC Chairman Harvey Pitt: How to Prevent Future Enrons, “Op-Ed” for WALL STREET JOURNAL (Dec. 11, 2001) (suggestions for modernizing the disclosure system to make it more meaningful and intelligible to average investors), available at http://www.sec.gov/news/speech/spch530.htm.

2. Harvey Pitt, Auditing Reform Can't Wait for Congress to Act, WALL STREET JOURNAL, Pg. A18 (Oct. 7, 2003) (discussion of SEC’s proposal to create a new system of strong and independent private-sector regulation, through a Public Accountability Board) [not publicly available—WSJ subscription required].

3. Harvey Pitt, A Fresh Look at Executive Compensation, COMPLIANCE WEEK (Oct. 7, 2003) (considerations for directors and officers to keep in mind when reviewing compensation policies and procedures) [not publicly available—Compliance Week subscription required].

4. Harvey Pitt, Dealing with Employee Complaints, COMPLIANCE WEEK (Oct. 21, 2003) (suggested approaches for responding to complaints of potential wrongdoing), available at http://www.kaloramapartners.com/ArticleDetails.aspx?Id=1.

5. Harvey Pitt, The Coming Storm: Mandatory Expensing of Stock Options, COMPLIANCE WEEK (Dec. 16, 2003) (expensing stock option plans and what boards and managements need to review in their stock option grant policies and procedures), available at http://www.kaloramapartners.com/ArticleDetails.aspx?Id=4.

6. Harvey Pitt, Facing Our Corporate Governance Mistakes, CORPORATE BOARD (Jan. 1, 2004) (corporate governance dos and don’ts), available at http://www.kaloramapartners.com/SpeechDetails.aspx?SpeechId=16.

7. Harvey Pitt, New Year's Resolutions For Independent Directors, COMPLIANCE WEEK (Jan. 27, 2004) (suggestions for independent directors on how to fulfill their duties and limit their liability in the wake of accounting scandals, S-Ox and an era of increased regulation and enforcement), available at http://www.kaloramapartners.com/ArticleDetails.aspx?Id=5.

228 If an article is publicly available, websites have been provided. Certain publications such as Compliance Week, Wall Street Journal and FT.com require a password to retrieve Former Chairman Pitt’s article, and are therefore not publicly available, as indicated.

8. Harvey Pitt, Certifying Internal Controls—A Trap for the Unwary?, COMPLIANCE WEEK (Feb. 24, 2004) (S-Ox § 404 and how it requires companies to approach internal and external audit functions), available at http://www.kaloramapartners.com/ArticleDetails.aspx?Id=13.

9. Harvey Pitt, Directorial Activism In The Face Of Alleged Or Actual Officer Misbehavior, COMPLIANCE WEEK (Mar. 30, 2004) (the need for outside directors to adopt a program to deal with issues of potential corporate wrongdoing), available at http://www.kaloramapartners.com/ArticleDetails.aspx?Id=11.

10. Harvey Pitt, The Critical Importance, and Changing Face, of Corporate Transparency, COMPLIANCE WEEK (Apr. 27, 2004) (governance approaches public companies should consider implementing), available at http://www.kaloramapartners.com/ArticleDetails.aspx?Id=9.

11. Harvey Pitt, Risky Business: Assessing And Managing Risk, COMPLIANCE WEEK (June 2, 2004) (steps directors can take to ensure a continuous and effective process for identifying, assessing and managing risk), available at http://www.kaloramapartners.com/ArticleDetails.aspx?Id=10.

12. Harvey Pitt, Practical Guidance On Being Worth One’s “Salt”, COMPLIANCE WEEK (Jul. 7, 2004) (practical guidance on how to assure that your company’s executives are worth their compensation), available at http://www.kaloramapartners.com/ArticleDetails.aspx?Id=14.

13. Harvey Pitt, The Changing Landscape Of Internal Corporate Investigations, COMPLIANCE WEEK (Jul. 27, 2004) (recent SEC enforcement cases highlight the high-bar required for internal investigations), available at http://www.kaloramapartners.com/ArticleDetails.aspx?Id=15.

14. Harvey Pitt, Enhanced D&O Responsibilities For Compliance, Ethics, COMPLIANCE WEEK (Aug. 24, 2004) (discussing new and refined ‘tone at the top’ obligations that corporate directors and officers will want to consider in advance of S-Ox’s implementation), available at http://www.kaloramapartners.com/ArticleDetails.aspx?Id=18.

15. Harvey Pitt and Suzanne Dans, The Brave New World of Sarbanes-Oxley, CRITICALEYE.NET (Sept.--Nov. 2004), available at http://www.kaloramapartners.com/pdfs/ceye-sep04-pitt__dans1.pdf.

16. Harvey Pitt, Instilling A Corporate Culture Of Integrity, Ethics And Compliance—Setting The Tone At The Top, COMPLIANCE WEEK (Sept. 28, 2004) (practical suggestions corporate leaders can consider to establish a “culture of discipline” and integrity), available at http://www.kaloramapartners.com/ArticleDetails.aspx?Id=16.

17. Harvey Pitt, How To Be An Effective Director As Standards Change, COMPLIANCE WEEK (Oct. 26, 2004) (practical suggestions to assist directors in understanding how they can be effective and in finding the correct balance between the unacceptable extremes of complete abdication to management and an adversarial relationship), available at http://www.kaloramapartners.com/ArticleDetails.aspx?Id=17.

18. Harvey Pitt, The Mythical Pendulum Isn’t Swinging Back the Other Way, COMPLIANCE WEEK (Nov. 23, 2004) (reasons why it’s in corporations’ self- interest to look beyond specific legislative and regulatory mandates and think about effecting real governance and transparency reforms) [not publicly available—Compliance Week subscription required].

19. Harvey Pitt, Helping Independent Directors Be Constructively Proactive, COMPLIANCE WEEK (Dec. 21, 2004) (ways in which directors can be constructively proactive), available at http://www.kaloramapartners.com/ArticleDetails.aspx?Id=19.

20. Harvey Pitt, Whither Directors’ Personal Liability? COMPLIANCE WEEK (Jan. 25, 2005) (prudent steps directors should consider before declining to serve on a public company board, or deciding to resign from a public company board on which they presently sit), available at http://www.kaloramapartners.com/ArticleDetails.aspx?Id=22.

21. Harvey Pitt, Conflict Of Interest Lessons From Financial Services, COMPLIANCE WEEK (Feb. 22, 2005) (steps for management and compliance officers to effectively patrol against conflicts of interest), available at http://www.kaloramapartners.com/ArticleDetails.aspx?Id=21.

22. Harvey Pitt, The Changing Standards by Which Directors Will be Judged, ST. JOHN’S LAW REVIEW (Mar. 23, 2005) (discussing the changing liability landscape for corporate directors), available at http://testwww.stjohns.edu/media/3/2d852f38d5b64d77862bd5052622fb3 0.pdf.

23. Harvey Pitt, The Emergence of Independent Chairmen, Lead Directors, COMPLIANCE WEEK (Mar. 29, 2005) (practical suggestions for how independent directors can enhance corporate performance, without usurping the roles necessarily entrusted to management) [not publicly available—Compliance Week subscription required].

24. Harvey Pitt, Two-Way Street: How Executives Should Work With The Board, COMPLIANCE WEEK (Apr. 26, 2005) (suggestions for how directors can establish a good working relationship with the executive officers of

the company) [not publicly available—Compliance Week subscription required].

25. Harvey Pitt, Anticipating The Concerns of Your Institutional Investors, COMPLIANCE WEEK (May 31, 2005) (approaches corporate managers should consider as they think about their relationships with institutional investors) [not publicly available—Compliance Week subscription required].

26. Harvey Pitt, The Gathering Storm In Retirement Funds, COMPLIANCE WEEK (June 28, 2005) (suggestions for areas that trustees should consider evaluating on a periodic basis in order to ferret out—and then address— problems or issues that may be lurking in their retirement funds) [not publicly available—Compliance Week subscription required].

27. Harvey Pitt, Summertime Compliance: Responding to Changes in Climate and Enforcement, COMPLIANCE WEEK (July 26, 2005) [not publicly available—Compliance Week subscription required].

28. Harvey Pitt, Caveat Emptor: Merger Considerations for Public Cos., COMPLIANCE WEEK (Aug. 30, 2005) (list of alphabet soup of regulatory concerns that boards will have to grapple with in considering whether to acquire/merge with another company) [not publicly available— Compliance Week subscription required].

29. Harvey Pitt, Lessons from the Not-Always-So-Wonderful World of Disney, COMPLIANCE WEEK (Sept. 27, 2005) (using Disney case in providing reasons why a course of action that is short-sighted is destined to produce bad results) [not publicly available—Compliance Week subscription required].

30. Harvey Pitt, Best Practices For Small- And Mid-Cap Companies, COMPLIANCE WEEK (Oct. 25, 2005) [not publicly available—Compliance Week subscription required].

31. Harvey Pitt, Effective Ways For Companies To Avoid Murphy’s Law, COMPLIANCE WEEK (Nov. 29, 2005) (reflecting on mistakes we’ve seen good companies grapple with—or successfully avoid—over the past two-and-a- half years), available at http://www.kaloramapartners.com/ArticleDetails.aspx?Id=41.

32. Harvey Pitt, Sorting Through Probabilities, Possibilities For 2006, COMPLIANCE WEEK (Jan. 3, 2006) (sorting through the probabilities and possibilities on what companies are likely to be contending with in 2006), available at http://www.kaloramapartners.com/ArticleDetails.aspx?Id=29.

33. Harvey Pitt, Trials And Tribulations of Enron and S-Ox, FORBES.COM (Jan. 23, 2006) (reviewing Enron and addressing the benefits and drawbacks of S-Ox), available at http://www.forbes.com/2006/01/20/enron-sarbox-pitt- commentary-cx_hlp_0123harveypitt.html.

34. Harvey Pitt, Fine Print: SEC Penalty Plan Explains Price Of Fraud, COMPLIANCE WEEK (Jan. 31, 2006) (how to avoid or reduce the magnitude of SEC corporate penalties, including incorporating lessons and recommendations from SEC’s recent statements, the U.S. Sentencing Commission’s Federal Sentencing Guidelines, and the SEC’s 2001 Seaboard release), available at http://www.kaloramapartners.com/ArticleDetails.aspx?Id=27.

35. Harvey Pitt, Executive Compensation: Spend It Carefully, COMPLIANCE WEEK (Feb. 28, 2006) (discussing the wake of escalating concerns about executive compensation and various ways companies can stay ahead of the issue), available at http://www.kaloramapartners.com/ArticleDetails.aspx?Id=24.

36. Harvey Pitt, The Principles vs. Prescriptive Rules Debate, COMPLIANCE WEEK (Mar. 28, 2006) (issues that businesses must confront in coming to terms with prescriptive and principles-based accounting rules and policies), available at http://www.kaloramapartners.com/ArticleDetails.aspx?Id=26.

37. Harvey Pitt, Make SOX Fit, WALL STREET JOURNAL, pg. A12 (Apr. 13, 2006) (addressing need for imbuing S-OX with fewer burdens, while providing the same measure of protection to investors that its framers intended) [not publicly available—WSJ subscription required].

38. Harvey Pitt, Crafting Effective Disclosure, Even When It Hurts, COMPLIANCE WEEK (Apr. 25, 2006) (tips for helping companies say the right words and take the right angle in the Information Age), available at http://www.kaloramapartners.com/ArticleDetails.aspx?Id=25.

39. Harvey Pitt, The Next Big Scandal, FORBES.COM (May 26, 2006) (addressing options backdating and suggesting best practices regarding compensation grants and recordation), available at http://www.forbes.com/2006/05/25/hpitt-column-stockoption- cx_hp_0526nextbigscandal.html.

40. Harvey Pitt, On The Road To Global Governance Standards, COMPLIANCE WEEK (May 31, 2006) (list of issues that the future will bring for corporations as we move toward global markets and harmonization of regulatory regimes), available at http://www.kaloramapartners.com/ArticleDetails.aspx?Id=28.

41. Harvey Pitt, Lessons of the Stock Options Scandal, FINANCIAL TIMES (June 2, 2006) (options backdating and suggested solutions for the Board of directors and its compensation committee in addressing the issue), available at http://www.kaloramapartners.com/SpeechPF.aspx?SpeechId=42.

42. Harvey Pitt, Sarbanes-Oxley is an Unhealthy Export, FINANCIAL TIMES, London Ed1, Page 21 (June 21, 2006) (difficulties S-Ox presents for multi- national companies and suggesting a solution to modify S-Ox to allow the SEC to give comity to comparable regulatory systems without requiring them to replicate every facet of S-Ox), available at http://www.kaloramapartners.com/SpeechDetails.aspx?SpeechId=41.

43. Harvey Pitt, A Risk-Based Approach To Section 404, COMPLIANCE WEEK (June 27, 2006) (tips for implementing a top-down approach, which is more effective at controlling risks), available at http://www.kaloramapartners.com/ArticleDetails.aspx?Id=31.

44. Harvey Pitt, Covering Up Naked Shorts, FORBES.COM (Jul. 11, 2006) (Companies must take to the initiative to uncover problems and prevent future crises), available at http://www.forbes.com/2006/07/11/leadership- harve-pitt-cs_hp_0711coveringupnakedshorts.html.

45. Harvey Pitt, Essentials For An Ethical Corporate Culture, COMPLIANCE WEEK (Jul. 25, 2006) (exploring ways companies can develop ethical corporate cultures, and keep themselves from becoming the next cautionary tale), available at http://www.kaloramapartners.com/ArticleDetails.aspx?Id=30.

46. Harvey Pitt, Over-Lawyered at the SEC, WALL STREET JOURNAL, (Jul. 26, 2006) (SEC’s failures a result of an over-reliance on lawyers instead of economists and analysts), available at http://www.kaloramapartners.com/SpeechDetails.aspx?SpeechId=40.

47. Harvey Pitt, Dollars and Sense, FORBES.COM (Aug. 14, 2006), (suggestions for rational process in determining and explaining executive compensation), available at http://www.forbes.com/2006/08/12/leadership-SEC-compensation- cx_hp_0814pitt.html.

48. Harvey Pitt, Finding A Cure for the Compensation Blues, COMPLIANCE WEEK (Aug. 29, 2006) (rules of thumb addressing major issues arising from the stock option grant scandal and requirements contained in the SEC’s new compensation disclosure rules), available at http://www.kaloramapartners.com/ArticleDetails.aspx?Id=35.

49. Harvey Pitt, Document Creation, Retention, and Destruction Policies, COMPLIANCE WEEK (Sept. 26 2006) (things companies should keep in mind in adopting or revamping their policies on document creation, retention, and destruction), available at http://www.kaloramapartners.com/ArticleDetails.aspx?Id=36.

50. Harvey Pitt, Learning The Lessons Of Hewlett-Packard, COMPLIANCE WEEK (Oct. 31, 2006) (fundamental lessons to be learned from HP’s woes), appears on Kalorama’s website at http://www.kaloramapartners.com/ArticleDetails.aspx?Id=37.

51. Harvey Pitt, What to Do When The SEC Comes Calling, COMPLIANCE WEEK (Jan. 3, 2007) (the discrete time periods to consider in responding to an SEC inquiry or investigation) [not publicly available—Compliance Week subscription required].

52. Harvey Pitt, SOX 404 Redux: It’s Groundhog Day, COMPLIANCE WEEK (Feb. 27, 2007) (steps that managements should consider in order to successfully implement new S-Ox 404 procedures), available at http://www.kaloramapartners.com/ArticleDetails.aspx?Id=38.

53. Harvey Pitt, Rethinking U.S. Regulation: Can America Restore its Leadership in Global Capital Markets, THE CHIEF EXECUTIVE (Mar. 1, 2007) (steps for rethinking our regulatory approach, created over 70 years ago, which stifles innovation, creativity and risk-taking) [not publicly available—Lexis/Nexis subscription required].

54. Harvey Pitt, The FCPA—Best Practices for a New Climate, COMPLIANCE WEEK (Apr. 24, 2007) (practical guidelines that companies may wish to heed in order to assure compliance with the FCPA’s anti-bribery provisions), available at http://www.kaloramapartners.com/ArticleDetails.aspx?Id=39.

55. Harvey Pitt, Accounting for Uncertain Tax Liabilities, COMPLIANCE WEEK (June 26, 2007) (fundamental questions audit committee members will need to consider and resolve when evaluating the company’s tax position), available at http://www.kaloramapartners.com/ArticleDetails.aspx?Id=40.

56. Harvey Pitt, Avoiding Murphy’s Law: Tips for Boards and Management, COMPLIANCE WEEK (Aug. 8, 2007) [not publicly available—Compliance Week subscription required].

57. Harvey Pitt, Learning the Lessons of the Sub-Prime Crisis, COMPLIANCE WEEK (Oct. 30, 2007) (simple approaches that institutions can take to

strengthen their risk-management systems), available at http://www.kaloramapartners.com/ArticleDetails.aspx?Id=42.

58. Harvey Pitt, A Regulatory Regime for Modern Times, COMPLIANCE WEEK (Dec. 18, 2007) (constructing a model for successful revision of the U.S. financial service regulatory process), available at http://www.kaloramapartners.com/ArticleDetails.aspx?Id=43.

59. Harvey Pitt, Sub-prime Mess: What a Way to Run a Railroad, COMPLIANCE WEEK (Feb. 26, 2008) (approaches to be considered by managements and boards in examining and taking corrective action regarding corporate governance and crisis management policies and procedures), available at http://www.kaloramapartners.com/ArticleDetails.aspx?Id=44.

60. Harvey Pitt, “For Want of a Nail”: ERM for the Regulators, COMPLIANCE WEEK (Apr. 29, 2008) (creating a governmental Risk Management Committee to avoid or ameliorate financial crises), available at http://www.kaloramapartners.com/ArticleDetails.aspx?Id=45.

61. Harvey Pitt, Regulation That Achieves What We Need Today, COMPLIANCE WEEK (June 24, 2008) (regulatory pendulums and what its recent trajectory means for public company executives) [not publicly available— Compliance Week subscription required].

62. Harvey Pitt, Bringing Financial Services Regulation into the Twenty First Century, YALE JOURNAL ON REGULATION (Summer 2008) (revolution brewing in our financial regulatory environment).

63. Harvey Pitt, The Inevitable Move to IFRS: Getting Started, COMPLIANCE WEEK (Aug. 26, 2008) (steps U.S. companies should consider in making the transition to IFRS as smooth as possible) [not publicly available— Compliance Week subscription required]

64. Harvey Pitt, Transparency Key to Securities Markets’ Comeback (Oct. 28, 2008) (fair value accounting and suggested steps for companies to ensure maximum transparency in its pricing policies and procedures for assets that are subject to it) [not publicly available—Compliance Week subscription required].

65. Harvey Pitt, Rules for Disclosing a CEO’s Unexpected Absence, COMPLIANCE WEEK (Feb. 24, 2009) (determining whether and how to disclose a CEO’s absence to the investing public) [not publicly available— Compliance Week subscription required].

66. Harvey Pitt, FIN 48 Turns Two, and Certainly Isn’t All That Bad, COMPLIANCE WEEK (Apr. 28, 2009) (need for boards and companies to

reconsider their income tax risk tolerance and consider additional steps to manage such risk effectively) [not publicly available—Compliance Week subscription required].

67. Harvey Pitt, Retaining Ethical Cultures During a Weak Economy, COMPLIANCE WEEK (June 30, 2009) (how companies can achieve good corporate governance and encourage ethical business behavior in turbulent times) [not publicly available—Compliance Week subscription required]

68. Harvey Pitt, Weder di Mauro roundtable: Better Regulators Needed, THE ECONOMIST (Oct. 2, 2009), available at http://www.economist.com/blogs/freeexchange/2009/10/weder_di_mauro_ roundtable_bett.

69. Harvey Pitt, Financial Services Regulatory Reform in the Face of an Economic Meltdown, 35 DAYTON L. REV. 15 (Fall 2009), available at http://www.udayton.edu/law/_resources/documents/law_review/financial_ services_regulatory_reform.pdf.

70. Roderick Hills, Harvey Pitt and David Ruder, Don't Let Banks Hide Bad Assets, WALL STREET JOURNAL (Nov. 18, 2009) (transferring accounting standards responsibility from the SEC to a systemic risk regulator. Such a radical move would have extremely negative consequences for our capital markets), available at http://online.wsj.com/article/NA_WSJ_PUB:SB10001424052748704782304 574542134264068424.html.

71. Harvey Pitt, The Board’s Role in Bringing Legal Trouble to an End, COMPLIANCE WEEK (Nov. 24, 2009) (rejection of SEC’s proposed settlement with Bank of America and suggested approaches for corporations to consider in avoiding litigation) [not publicly available—Compliance Week subscription required].

72. Harvey Pitt, Risk of Failing to Understand ERM Risks, COMPLIANCE WEEK (Feb. 23, 2010) (understanding enterprise risk management and lessons to be learned from the case of Abdulmutallab, who boarded a Northwest flight from Amsterdam to Detroit with an incendiary device strapped to his body) [not publicly available—Compliance Week subscription required].

73. Harvey Pitt, The SEC’s Dangerous Gamble, THE DAILY BEAST (Apr. 20, 2010), available at http://www.thedailybeast.com/articles/2010/04/20/betting-the-farm-on- goldman.html

74. Harvey Pitt, Following the Road to IFRS Convergence, COMPLIANCE WEEK (Apr. 27, 2010) (history of IFRS convergence and reasons why companies should embrace IFRS now) [not publicly available—Compliance Week subscription required].

75. Harvey Pitt, Learning From History on Financial Reform, WALL STREET JOURNAL, pg. A19 (May 17, 2010) (points on financial reform implications, what we still need and don’t have, and the need to consider history in implementing reform in order to avoid occurrence of past mistakes), available at http://online.wsj.com/article/SB10001424052748703460404575244810777 765420.html.

76. Harvey Pitt, Learning From the Goldman Sachs Debacle, COMPLIANCE WEEK (June 29, 2010) (lessons that can be learned from Goldman Sachs’ mistakes) [not publicly available—Compliance Week subscription required].

77. Harvey Pitt, The Truth About Financial Reform: It's A Big Fat Failure, DAILY BEAST (Jul. 14, 2010) (problems with the Dodd-Frank reform bill), available at http://www.businessinsider.com/ugly-truth-about-financial-regulatory- reform-2010-7.

78. Harvey L. Pitt & Roderick M. Hills, The Politics of Congressional Ethics, THE GADSDEN TIMES (Mar. 8, 2012), available at http://www.gadsdentimes.com/article/20120308/NEWS/120309783.

79. Harvey Pitt, Opening Remarks, Insider Trading Debate, THE ECONOMIST (May 2, 2012), available at http://www.economist.com/debate/days/view/834

80. Harvey Pitt, Rebuttal Remarks, Insider Trading Debate, THE ECONOMIST (May 7, 2012), available at http://www.economist.com/debate/days/view/835

81. Harvey Pitt, Closing Remarks, Insider Trading Debate, THE ECONOMIST (May 10, 2012), available at http://www.economist.com/debate/days/view/836

82. Harvey Pitt, Shaping Up a Divided SEC, WALL STREET JOURNAL (Nov. 27, 2012), available at http://professional.wsj.com/article/SB10001424127887324469304578144 972920939666.html?mod=wsj_share_tweet&mg=reno64-wsj

Attachment B

Attachment B—List of Materials Reviewed

1. Letter from Bruce G. Leto to Robert S. Khuzami, Dir., Div. of Enforcement, SEC, and Eileen Rominger, Dir. IM Division, SEC, dated Jan. 4, 2012 2. White Paper submitted by Peter Anderson to Robert S. Khuzami, Dir., Div. of Enforcement, SEC, and Eileen Rominger, Dir. IM Division, SEC, dated Jan. 3, 2012 [A3211-ALL-000004—053] 3. Jeffrey Maletta & Stephen J. Crimmins, K&L Gates, White Paper Submission for Respondents, File No. A-3211 (Dec. 29, 2011) (with accompanying exhibits) 4. Minutes of the Joint Meeting of the Audit Committees (Jan. 24, 2007) [Resp Ex 039-007—017] 5. Minutes of the Joint Meeting of the Boards of Directors/Trustees for Morgan Keegan Select Fund, Inc. and Regions Morgan Keegan Select Funds (Jan. 24 2007) [MAM-8-000745341—352] 6. Minutes of the Joint Meeting of the Boards of Directors for RMK Advantage Income Fund, Inc., RMK High Income Fund, Inc., RMK Multi- Sector High Income Fund, Inc., and RMK Strategic Income Fund, Inc. (May 21, 2007) [MAM-8-000745353—358] 7. Minutes of the Joint Meeting of the Boards of Directors for Morgan Keegan Select Fund, Inc., RMK Advantage Income Fund, Inc., RMK High Income Fund., Inc., RMK Multi-Sector High Income Fund, Inc., and RMK Strategic Income Fund, Inc. (Aug. 2, 2007) [MAM-8-000745379—381] 8. Minutes of the Joint Meeting of the Boards of Directors for Morgan Keegan Select Fund, Inc., RMK Advantage Income Fund, Inc., RMK High Income Fund., Inc., RMK Multi-Sector High Income Fund, Inc., and RMK Strategic Income Fund, Inc. (Aug. 7, 2007) [MK-13-00004358—360] 9. Letter from Jeffrey B. Maletta to Robert Khuzami et al. (Jan. 5, 2012) (with enclosures) 10. Expert Report of Cindy W. Ma, A.P. File No. 3-13847 (Mar. 18, 2011) 11. RMK Select Short Term Bond Fund, Security Sales for the period Jan. 1, 2007 to Mar. 31, 2007 [MAM-8-000747088—109] 12. Letter from PricewaterhouseCoopers to Mr. Weller at Regions Morgan Keegan (May 21, 2007) [PwC-MKE-S-000004795—796] 13. Valuation Procedures (“Exhibit L”) for Morgan Keegan Select Fund, Inc., Regions Morgan Keegan Select Funds, RMK Advantage Income Fund, Inc., RMK High Income Fund., Inc., RMK Multi-Sector High Income Fund, Inc., and RMK Strategic Income Fund, Inc. (internal paginated 6-9)

14. Report From Joint Valuation Committee [MAM-8-0000747076—077; 080— 087] 15. Pl’s Exhibit 391, Letter from PwC to J. Thompson Weller (Apr. 12, 2007) [PwC-MKC-S-YE033107-000000003—009] 16. Pl’s Exhibit 392, Letter from PwC to Charles D. Maxwell (July 2, 2007) [PwC-MKE-S-000009353—359] 17. Pl’s Exhibit 458, Email from Manura M Miriyagalla to Mike P Quackenbush (Sept. 17, 2007) [PwC-MKE-S-000158865—866] 18. Email from Casey King to Jim Kelsoe, Thom Weller, Al Landers, and Mary Webb, dated May 1, 2007, re “PwC Pricing Meeting on 5/2/07” incl. attachments (Pricing Audit Questions, Price Confirm Analysis), Pl’s Exhibit 291, A.P. File No. 3-13847 [MAM-8-00009579—9597] 19. Email from Mike P Quackenbush to Donald Smith, Gesing Witold, Manura M Miriyagalla, and Jason M Geisler, dated Aug. 31, 2007, re “RMK” [PwC- MKE-PCAOB-000159623] 20. PwC, Report to the Audit Committee, Resolution and Completion of the March 31, 2007 Audit [SEC-MSS-001132—167] 21. E-mail from Robbin Gibson to Amy Walker, dated June 19, 2007, re “Month End Prices” (incl. handwritten notes), Pl’s Exhibit 588 AP No. 3-13 22. Morningstar Classifications for Kelsoe Funds [MAM-8-00647997—013] 23. Memo from Mike Quackenbush to RMK Files (Sept. 7, 2007), Pl.’s Ex. 409, AP No. 3-13847 [PwC-MKE-S-000027596—602] 24. RMK Funds Internally Valued Securities Spreadsheet [A3211-MK-20-4000] 25. Minutes of the Valuation Committee (2006) [Resp Ex 008-0001—-12] 26. Minutes of the Valuation Committee (2007) [Resp Ex 009-0001—-081] 27. CCO Review and Summary (Jan. 24, 2007) [MAM-8-000746359— 000746369] 28. Handwritten Notes of J. Gonzalez re Audit Committee Meeting, May 2007 [SEC-KLG-000630—642] 29. Deloitte, Hyperion Brookfield Asset Mgmt., Inc. Report on Controls Placed in Operation and Tests of Operating Effectiveness (Oct. 1, 2005—Sept. 30, 2006) [SEC-Helios-0001137—179] 30. Hyperion Brookfield Funds, Minutes of a Meeting of the Securities Valuation Committee (June 29, 2007) [SEC-Helios-0000032—087] 31. Hyperion Brookfield Funds, Minutes of a Meeting of the Securities Valuation Committee (May 29, 2007) [SEC-Helios-0000088—149] 32. Email from Stilly McFadden to Marty Stone, dated Mar. 21, 2007 [SEC- MSS-0021253]

33. Gretchen Morgenson, Mutual Funds at Some Risk On Mortgages, N.Y. TIMES, Mar. 14, 2007, § C, Column C, Bus./Fin. Desk, at 1 [SEC-MSS- 001546-47] 34. Policy and Procedure Manual (Updated Jan. 25, 2007), A.P. File No. A- 03211 Investigative Ex. 4. 35. Board Package (Jan. 24, 2007) at 331-33, A.P. File No. A-3211 [MAM-8- 000746714—16] 36. Board Package (Nov. 10, 2006) A.P. File No. A-3211 [MAM-8-000747349— 16—607] 37. Board Package (Jan. 24, 2007 ) A.P. File No. A-3211 [MAM-8-000746370— 6772] 38. Board Package (May 21, 2007) A.P. File No. A-3211 [MAM-8-000746862— 7348] 39. Board Package (Aug. 23, 2007) A.P. File No. A-3211 [MAM-8-000746135— 6168] 40. Board Package (Oct. 26, 2007) A.P. File No. A-3211 [MAM-8-000748280— 8547] 41. A.P. File No. A-3211, Ex. 1a, Order Directing Private Investigation and Designating Officers to Take Testimony (4/15/2010) 42. A.P. File No. A-3211, Ex. 2a, Letter to Albert C. Johnson, K&L Gates from Douglas M. Dykhuizen, SEC re In the Matter of Certain Regions Morgan Keegan Funds (A-3211) (3/8/2011) 43. A.P. File No. A-3211, Ex. 2b, Letter to Randall Pittman, K&L Gates from Douglas M. Dykhuizen, SEC re In the Matter of Certain Regions Morgan Keegan Funds (A-3211) (3/8, 2011) 44. A.P. File No. A-3211, Ex. 2c, Letter to James Stillman R. McFadden, K&L Gates from Douglas M. Dykhuizen, SEC re In the Matter of Certain Regions Morgan Keegan Funds (A-3211) (3/8, 2011) 45. A.P. File No. A-3211, Ex. 2d, Letter to Jack R. Blair, K&L Gates from Douglas M. Dykhuizen, SEC re In the Matter of Certain Regions Morgan Keegan Funds (A-3211) (3/8, 2011) 46. A.P. File No. A-3211, Ex. 2e, Letter to Archie W. Willis, III, K&L Gates from Douglas M. Dykhuizen, SEC re In the matter of certain regions Morgan Keegan Funds (A-3211) (3/8, 2011) 47. A.P. File No. A-3211, Ex. 2f, Letter to Mary S. Stone, K&L Gates from Douglas M. Dykhuizen, SEC re In the Matter of Certain Regions Morgan Keegan Funds (A-3211) (3/8, 2011)

48. A.P. File No. A-3211, Ex. 2g, Letter to Allen B. Morgan, Jr., K&L Gates from Douglas M. Dykhuizen, SEC re In the Matter of Certain Regions Morgan Keegan Funds (A-3211) (3/8, 2011) 49. A.P. File No. A-3211, Ex. 2h, Letter to J. Kenneth Alderman, K&L Gates from Douglas M. Dykhuizen, SEC re In the Matter of Certain Regions Morgan Keegan Funds (A-3211) (3/8, 2011) 50. A.P. File No. A-3211, Ex. 2i, Letter to Charles D. Maxwell, Sutherland Asbill and Brennan from Douglas M. Dykhuizen, SEC re In the Matter of Certain Regions Morgan Keegan Funds (A-3211) (10/20/2011) 51. A.P. File No. A-3211, Ex. 2j, Letter to Michele F. Wood, Sutherland Asbill and Brennan from Douglas M. Dykhuizen, SEC re In the Matter of Certain Regions Morgan Keegan Funds (A-3211) (10/20/2011) 52. A.P. File No. A-3211, Ex. 2k, Letter to Jennifer R. Gonzalez, K&L Gates from Douglas M. Dykhuizen, SEC re In the Matter of Certain Regions Morgan Keegan Funds (A-3211) (8/21/2012) 53. A.P. File No. A-3211, Ex. 5, Board Package: Joint Meeting of Boards of Directors/Trustees of Certain Morgan Keegan Funds (11/10/2006) 54. A.P. File No. A-3211, Ex. 6, Board Package: Joint Meeting of Boards of Directors/Trustees of Certain Morgan Keegan Funds (1/24/2007) 55. A.P. File No. A-3211, Ex. 7, Board Package: Joint Meeting of Boards of Directors and Trustees of Certain Morgan Keegan Funds (5/21/2007) 56. A.P. File No. A-3211, Ex. 8, Board Package: Joint Meeting of Boards of Directors and Trustees of Certain Morgan Keegan Funds (8/23/2007) 57. A.P. File No. A-3211, Ex. 9, Board Package: Joint Meeting of Boards of Directors and Trustees of Certain Morgan Keegan Funds (10/26/2007) 58. A.P. File No. A-3211, Ex. 10, NY Times Article by Gretchen Morgenson; Mutual Funds At Some Risk On Mortgages (3/14/2007) 59. A.P. File No. A-3211, Ex. 11, Letter to Thom Weller, Regions Morgan Keegan from PWC (5/21/2007) 60. A.P. File No. A-3211, Ex. 18, Email from Charles Maxwell to Jim Kelsoe (Mar. 6, 2007) 61. A.P. File No. A-3211, Ex. 20, Administration Agreement between RMK Strategic Income Fund, and Morgan Keegan & Co., Inc. (Nov. 18, 2004) 62. A.P. File No. A-3211, Ex. 20a, Fund Accounting Service Agreement between Morgan Keegan & Co., Inc., and Morgan Keegan Select Fund, Inc. 63. A.P. File No. A-3211, Ex. 20b, RMK Multi-Sector High Income Fund, Administration Agreement (Jan. 19, 2006)

64. A.P. File No. A-3211, Ex. 20c, Admin. Agreement between RMK High Income Fund, Inc., and Morgan Keegan & Co., Inc. 65. A.P. File No. A-3211, Ex. 20d, Admin. Agreement between RMK Advantage Income Fund, Inc., and Morgan Keegan & Co., Inc. (Nov. 18, 2004) 66. A.P. File No. A-3211, Ex. 21, Morgan Asset Mgmt., Policies and Procedures (Mar. 2007) 67. A.P. File No. A-3211, Ex. 24, Email from Louis Hale to Thom Weller and Case King (May 14, 2007) 68. A.P. File No. A-3211, Ex. 28, Price Committee Report to Board (3/31/07) [MAM-8-00697337—7440] 69. A.P. File No. A-3211, Ex. 29, Email from Doug Edwards to Charles Maxwell (Mar. 14, 2007) 70. A.P. File No. A-3211, Ex. 30, Email from Elkan Scheidt to Charles Maxwell (Mar. 28, 2007) [MAM-8-00569494] 71. A.P. File No. A-3211, Ex. 31, Mem. from Charles Maxwell, Thompson Weller and Thomas Snyder to PwC (May 17, 2007) [Resp Ex 143-0001— 003] 72. A.P. File No. A-3211, Ex. 32, Letter from Casey King to Stifel Nicholaus & Co, Inc. (Mar. 30, 2007) [Joint Ex 001-265] 73. A.P. File No. A-3211, Ex. 33, Mem. from Michele Wood to Courtney Hines (Mar. 14, 2007) 74. A.P. File No. A-3211, Ex. 37, Invoice from K&L Gates for RMK High Income Fund, Inc. (Apr. 30, 2007) [KLG-013824—826] 75. A.P. File No. A-3211, Ex. 38, Invoice from K&L Gates for Morgan Keegan Select Fund, Inc. (Apr. 30, 2007) [KLG-013708—710] 76. A.P. File No. 3-13847, Pl’s Ex. 227, Mem. from FINRA to Robert W. Lough (May 14, 2009), Pl’s Ex. 227 77. Division Summary Ex. 243, AP File No. 3-15127 78. PwC Letter to Thom Weller (May 21, 2007) [MAM-8-00522842-43] 79. Email from Casey King to Thom Weller, et al. (July 31, 2007) [MAM-8- 00753661—662] 80. Morgan Keegan Select High Income Fund Sub-Prime Confirm Analysis (July 10, 2007), A.P. File No. 3-13847, Pl.’s Ex. 548 81. PwC Report to Audit Committee for March 31, 2007 Audit [SEC-MSS- 001137] 82. Email from Mike P. Quackenbush to PwC (Aug. 31, 2007) [PwC-MKE- PCAOB-000159623]

83. Order Instituting Public Administrative and Cease-and-Desist Proceedings Pursuant to Sections 9(b) and 9(f) of the Investment Company Act of 1940, Rel. No. 30300, A.P. File No. 3-15127 (Dec. 10, 2012) 84. Respondents’ Answer and Defenses, AP File No. 3-15127 (Jan. 3, 2013) 85. Respondent J. Kenneth Alderman, Answer and Defenses, AP File No. 3- 15127 (Jan. 3, 2013) 86. Respondent Allen B. Morgan, Jr., Answer and Defenses, AP File No. 3- 15127 (Jan. 3, 2013) 87. Independent Directors’ Motion for More Definite Statement, AP File No. 3- 15127 (Jan. 4, 2013) 88. Pricing Committee Report to the Board (as of Dec. 31, 2006) [Resp Ex 013- 0001—022] 89. Pricing Committee Report to the Board (as of Jan. 31, 2007) [Resp Ex 014- 0001—026] 90. Pricing Committee Report to the Board (as of Feb. 28, 2007) [Resp Ex 015- 0001—024] 91. Pricing Committee Report to the Board (as of Mar. 31, 2007) [Resp Ex 016- 0001—039] 92. Pricing Committee Report to the Board (as of Apr. 30, 2007) [Resp Ex 017- 0001—035] 93. Pricing Committee Report to the Board (as of May 31, 2007) [Resp Ex 018- 0001—002; 048—061] 94. Pricing Committee Report to the Board (as of June 30, 2007) [Resp Ex 019- 0001—002; 095—108] 95. Transcript of Albert Johnson (06/29/11) A-3211 96. Transcript of Allen Morgan (10/21/11) A-3211-A 97. Transcript of Amy Walker (08/08/08) A-3042 98. Transcript of Archie Willis (07/28/11) A-3211 99. Transcript of Charlie Maxwell (10/28/11) A-3211-A 100. Transcript of Jack Blair (07/28/11) A-3211 101. Transcript of James McFadden (07/06/11) A-3211 102. Transcript of Jennifer Gonzalez (08/29/12) A-03211-A 103. Transcript of James Kenneth Alderman (10/25/11) A-3211-A 104. Transcript of Mary Stone (9/26/11) A-3211-A 105. Transcript of Michelle Wood (11/03/11) A-3211-A 106. Transcript of William Randall Pitman (06/03/11) A-3211 107. Transcript of Manura M. Miriyagalla (05/06/09) A-3042

108. Transcript of Joseph Thompson Weller (11/06/08) A-3042 109. Transcript of Michael Louis Hale (08/14/08), A-03042-A 110. Transcript of James C. Kelsoe (4/30/08) A-3042 111. Transcript of James C. Kelsoe (05/01/08) A-3042 112. Notes of RMK Conference Call (Aug. 2, 2007) AP File No. 3-13847 [OCIE 28115—124] 113. Wells Submission o/b/o Independent Directors (May 11, 2012) 114. RMK Strategic Income Fund, Inc., Form N-2/A at 2 (Feb. 26, 2004) 115. RMK High Income Fund, Inc., Form N-2/A at 10 (June 23, 2003) 116. MK Select Fund 2006 N-CSR (June 30, 2006) 117. Morgan Keegan Select Fund, Form N-CSR (June 30, 2007) 118. Email from Casey King to Thomas Weller, David Wages, Louis Hale, Charles Maxwell, Michele Wood, Amy Walker, Raymond Jennings, and Tom Snyder (July 31, 2007) [MAM-8-00687674—75] 119. Morgan Keegan Select High Income Fund, Sub-Prime Price Confirm Analysis (7/10/07), Pl’s Ex. 584 [MAM-8-00524441—463] 120. Email from Robbin Gibson at Countrywide to Amy Walker (June 19, 2007) [Div-Ex-248-000003] 121. Memorandum from Casey King to Thom Weller & Louis Hale (May 29, 2007), A.P. File No. 3-13847, Pl.’s Ex. 535 [MAM-8-000753659—60] 122. PCAOB Rule 5109(d) Statement of Position of PwC No. 105-OFI-2011-003 (Aug. 13, 2012) 123. Submission of Joseph Vincent Robinson, et al. and PwC (Aug. 15, 2012), In the Matter of PwC LLP (A-3248) 124. Email from Louis Hale to Jason Geisler, Jennifer Matlock, Manura M Miriyagalla, Amy Walker, and Shauna Thomas (May 14, 2007) [PwC-MKE- S-000019487] Pl’s Ex. 457

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