Finra cracks down on credit disclosure

Third-party assessment will be required if bonds in funds are to be considered 'rated'

By Jessica Toonkel Marquez

Apr 11, 2010 @ 12:01 am (Updated 7:46 am) EST

In the midst of a crackdown by state and federal regulators on Morgan Keegan over its management and sale of failed bond funds, Finra is alerting the broker-dealer arms of fund companies that it is taking a tougher stance on how they portray the quality of bonds in the funds they distribute.

The Financial Industry Regulatory Authority Inc. has sent letters to 50 broker-dealers warning them to change how they disclose bond ratings information to investors.

Specifically, Finra said in the letter that the practice of using a weighted-average bond rating that has not been assessed by a nationally recognized statistical rating organization is misleading when used in shareholder communications because it gives the impression that the fund's overall credit quality has been independently determined.

“We learned that these weighted-average bond ratings are calculated by the funds themselves and not by the third-party independent credit ratings agencies,” said Finra spokes-man Herb Perone. “Each firm does them differently and it appears to investors to be apples to apples, but it's not.”

Finra's new position on bond fund disclosures comes as all regulators are taking a closer look at the validity of credit ratings, Mr. Perone said.

Finra has told firms to remove references not backed up by an independent rater from their websites and to make sure that any such language isn't used in future shareholder communications.

As a result, firms using self-determined ratings must now refer to bonds carrying such ratings as “unrated securities,” Mr. Perone said.

“What was interesting to me was that Finra isn't telling us to add more disclosure,” said a fund company executive who received the letter. “They are telling us to take the language [about a weighted-average bond rating] out altogether [if it hasn't been assessed by an independent party],” said the executive, who asked not to be identified.

Fund executives think that Finra may be particularly sensitive about the misuse of bond credit-rating information because of the losses suffered by investors who bought risky funds from Morgan Keegan, which is accused of intentionally mispricing its bond funds.

Regulators last week filed potentially devastating enforcement actions against Morgan Keegan & Co. Inc. and its asset management unit, Morgan Asset Management Inc., claiming that the firm misrepresented the funds to investors and brokers, manipulated the funds' net asset value, and failed to supervise the sale of funds and due-diligence efforts.

Morgan Keegan intends to “vigorously refute” the charges brought by regulators, company spokesman Eric Bran said in a statement.

“We are disappointed at the decision by these agencies and the states to bring charges which we believe are meritless and based upon erroneous hindsight analysis,” he said.

LOST THEIR VALUE

The Regions Morgan Keegan Select bond funds, which invested in risky mortgage-backed securities, lost most of their value in 2007 and 2008 — more than $1 billion in investor assets, regulators estimated — following the collapse of the real estate market.

“The Morgan Keegan case is why Finra is starting to look at this stuff,” the fund company executive said. “They're starting to look more carefully at how we portray the quality of the bonds in our portfolios, which is clearly linked to pricing.”

Given the Morgan Keegan case and overall heightened scrutiny by regulators and members of Congress over the use of credit ratings, it isn't surprising that Finra is taking a closer look at how funds are disclosing such information to investors, said James Rothenberg, an expert witness consultant on securities arbitration cases in New York.

“Finra is basically saying it is questioning the methodology of firms that are not using outside research,” he said.

Many fund companies, particularly smaller ones, tend to use their own research teams for some of the bond ratings and use their own analysis of weighted bond averages, said Geoff Bobroff, president of Bobroff Consulting Inc.

“These firms are going to need a third party to do the analysis of the information they use,” he said. “It might be more expensive, and it might complicate life a bit, but it adds credibility, or at least consistency.”

A number of experts predict that Finra eventually will issue a regulatory notice forcing firms to disclose credit ratings information in a specific manner.

“I think you are about to see a significant regulatory notice from Finra saying that everyone has to heed to the same standard,” said Richard Nummi, executive consultant at Accounting and Compliance International.

Mr. Perone said that the self-regulatory agency has no plans to issue such a notice.

Finra joined forces last week with the Securities and Exchange Commission, the Alabama Securities Commission, the Kentucky Department of Financial Institutions, the Mississippi Office of the Secretary of State and the South Carolina Office of the Attorney General to file coordinated administrative complaints against Morgan Keegan.

Regulators said that they have evidence that the bond funds' head portfolio manager, James Kelsoe, was allowed to work with little supervision — and at one point stonewalled a due-diligence officer.

In addition to the firm and Mr. Kelsoe, the regulators also targeted Joseph Weller, head of the fund accounting department; Brian Sullivan, president and chief investment officer of Morgan Asset Management; Gary Stringer, director of investments for the Morgan Keegan's wealth management division; and Michele Wood, chief compliance officer of the funds.

Dan Jamieson contributed to this story.

E-mail Jessica Toonkel Marquez at jmarquez@investmentnews.com.

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