SEC Probe Potential Fair-Value Pricing Problems

Although the federal securities regulator is in the early stages of its fair-value pricing probe, any resulting disciplinary cases would represent yet another front in the SEC’s expanded scrutiny of the fund industry, the Wall Street Journal reported. The SEC and a variety of state regulators including New York State Attorney General Eliot Spitzer have been pursuing a wide-ranging industry investigation focusing on market timing, late trading and several aspects of fund sales practices.

Fair-valuation involves using estimates to set the value of portfolio holdings when the securities’ closing market prices become out of date because of later developments. Such mispricing is particularly an issue for U.S. mutual funds holding foreign stocks whose closing values are hours old by the time the funds calculate their share prices at the end of trading for U.S. markets. The key issue is that funds using such out-of-date prices have been targets of market timers.

The SEC approved fair-value techniques in 1981 and strongly recommended, but never required, that funds use them. However, under other SEC rules, funds have an obligation to make sure their share prices are as accurate as possible after events such as major swings in U.S. markets after the close of overseas stock trading.As a result, agency officials said the SEC investigation is focusing on whether funds in such circumstances violated their obligations to set the most accurate share prices possible if they didn’t consider using fair-value techniques.

Since disclosures of widespread market timing in the fund industry, fair-value pricing has received added attention. Many observers contend that employing fair-value techniques is the best method for combating outdated prices exploited by fund market timers.

Last month, the SEC unveiled results from a September survey in which it found that nearly a third of the more than 960 funds questioned hadn’t done any fair-value pricing whatsoever in the prior 20 months (See  SEC: Many Funds Still Not Doing ‘Fair-Value’ Pricing ). More than half of the funds questioned — all of which held half or more of their assets in foreign securities — said they had only used the pricing techniques five times or less during that period, which included numerous volatile stretches.

The SEC also discovered that the funds that didn’t use any fair-value pricing had high levels of share turnover, which is often a sign of market timing, and that, in about 15% of the funds surveyed, profit for long-term investors may have been reduced.

Presenting the findings at a fund-industry conference, Douglas Scheidt, chief counsel of the SEC’s Division of Investment Management, said that the SEC had found that most funds don’t require follow-up testing to see if the correct decision was made when fair-value prices aren’t used.