Finra warns B-Ds about their bond ratings

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. Against this backdrop, regulators last week filed enforcement actions against Morgan Keegan & Co. Inc. and its asset management unit, Morgan Asset Management Inc. Although the administrative complaint against Morgan Keegan involves a broad array of allegations of misconduct by firm management, Finra's action focuses on how fund distributors disclose the credit ratings of bonds in their portfolios. 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 spokesman Herb Perone. “Each firm does them differently and it appears to investors to be apples to apples, but it's not.” As a result, firms using self-determined ratings must now refer to bonds carrying such ratings as “unrated securities,” he said. Finra has told firms to remove references not backed up by an independent rater from their websites and to make sure any such language isn't used in future shareholder communications. 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 of investor assets, regulators estimated — following the collapse of the real estate market. Given the Morgan Keegan case and overall heightened scrutiny by regulators and members of Congress over the use of credit ratings, it's not surprising that Finra is taking a closer look at how funds are disclosing ratings 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,” Mr. Rothenberg 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.” [Dan Jamieson contributed to this story.]