This is the third in a series of Client Alerts regarding the risks that misvalued securities pose for the independent directors¹ of investment companies. The first Client Alert detailed the cases in which the SEC sanctioned independent directors for misvalued securities. These cases led to the conclusion that misvalued securities represent the greatest enforcement risk for independent directors, particularly for directors of small, stand-alone investment companies, and for directors of investment companies with large, fixed-income holdings. The second Client Alert reviewed how securities are valued under the Investment Company Act of 1940 (the “1940 Act”), and contrasted this with the approach taken in Accounting Standards Codification 820. This comparison showed how independent directors might benefit from the more modern approach to valuation taken in the accounting standards.

The Client Alert continues to examine why misvalued securities pose a risk to independent directors. Having reviewed the law, we now examine the facts: specifically, we consider how differences in the markets for equity and fixed-income securities affect their valuation.

The 1940 Act’s requirements for valuing portfolio securities may be summarized as follows: the board of directors must determine, in good faith, the fair value of every portfolio security for which a market quotation is not readily available. A market quotation is readily available if, on the date of valuation:

• The portfolio security was traded on that date; or
• Bid and asked prices for the portfolio security are being published by brokers; and
• The number of trades and published quotations do not indicate that there is a thin market for the portfolio, and circumstances do not otherwise bring the validity of the trades or quotations into question.

Subject to this last condition, on any day that a portfolio security trades, its last sale price is its market quotation; otherwise, its market quotation must be a published bid price or a value in the range of published bid and asked prices.

These requirements place directors at risk whenever a market quotation for a portfolio security is not readily available. Structural differences in their respective markets result in market quotations for equity securities being more commonly available than market quotations for fixed-income securities. This “great divide” in the relative availability of market quotations helps explain why some mutual funds pose a greater risk of misvaluation than do others.

1. Availability of Market Quotations for Equity Securities
Most equity securities held by investment companies are listed on exchanges. Most listed equity securities trade every day, and market-makers and specialists regularly publish bid and asked prices for all listed securities. Normally, equity trades are brokered, which means that agents for buyer and seller negotiate to trade at a single price. Buyers and sellers compensate their brokers by paying separate commissions. Public equity trades are reported in real time over a “consolidated tape.”²

The structure of the listed equity market makes it easy for securities pricing services to compile and disseminate market quotations for equity securities as of the close of trading on each day. Pricing services can easily identify any last sale price reported on the consolidated tape and can obtain bid/asked prices for securities that did not trade. Thus, as the SEC has observed: “Ordinarily, little difficulty should be experienced in valuing securities listed or traded on one or more national securities exchanges, since quotations of completed transactions are published daily.”³

2. Availability of Trading Information for Fixed-Income Securities
The market for fixed-income securities is the opposite of the equity market in every important respect. First, rather than trading on an exchange, the bulk of fixed-income trading occurs “over the counter.” According to a presentation made at the SEC’s Roundtable on Fixed-Income Securities, only 5 percent of corporate bonds are listed on an exchange and only 19 percent of the trading in these bonds occurs on an exchange.⁴ Government securities (federal, state, local and their agencies) and securitized assets are not listed on any exchanges. According to SIFMA, corporate debt represented only a quarter of the U.S. fixed-income market at the end of 2013,⁵ so only a small percentage of fixed-income securities ever trade on an exchange.

Second, trading information for fixed-income securities was not always publicly available. Prior to the establishment of TRACE (FINRA’s “Trade Reporting and Compliance Engine”) in 2002 and EMMA (the MSRB’s “Electronic Municipal Market Access”) in 2005, the public did not have access to any information regarding fixed-income securities traded outside an exchange. Even today, a significant amount of fixed-income trading is not reported on either system.

Third, more often than not, there is no trading information to report for a given fixed-income security. The presentation at the Roundtable on Fixed-Income Securities included a study of trading in 47,629 TRACE eligible corporate bonds during a period of 1,156 trading days (more than four years).⁶ The study found that 18 percent of the bonds were never traded during the period. The median number of days on which a bond traded was 121. In other words, on average, a trade for a given bond would occur on slightly more than 10 percent of the trading days covered by the study. Another study found that most of this trading occurs shortly after the initial issuance of a bond. Three months after issuance, the median number of trades fell to zero.⁷

There is evidence that the volume of bond trading has declined since this study. According to a recent Wall Street Journal article:

From 2002 through 2008, the average daily volume of bond trading was more than 3% of the total outstanding stock of bonds…. Following the financial crisis, however, bond velocity dropped off sharply.

Last year, it was just 2.03%. This year it has fallen to 1.79%. That compounds the negative impact of low issuance, so that traders are buying and selling a smaller share of a bond market whose growth has slowed.⁸

Fourth, over-the-counter markets operate through dealers rather than brokers. A dealer sells securities directly to its client, after acquiring the security from another dealer or client. Rather than a commission, the dealer receives a “spread” between the price at which the dealer sells the security (the “asked price”) and the price at which the dealer acquires the security (the “bid price”). This form of trading produces multiple prices during the course of each trade. For example, a dealer may buy securities from a client for one price and resell them to another dealer for a slightly higher price, and the second dealer may then sell the securities to its client for a still higher price.

Dealers may also sell a security at the same time to different clients at different prices. A broker who receives multiple orders for an equity security can charge higher commission rates to clients with smaller orders, so the broker receives roughly the same commission for executing each client’s order. To achieve the same result in an over-the-counter trade, a dealer must charge a higher spread to clients with smaller orders, which results in these clients paying a higher price for the security. These differences in dealer spreads bifurcate the markets for retail (i.e., smaller) and institutional fixed-income trades, with retail traders receiving lower bid prices and higher asked prices than institutional traders for the same security.

These factors explain why, 90 percent of the time, there is no publicly available last sale price for a corporate bond. Moreover, on those occasions when a bond trades, the price at which the bond was sold always differs from the price at which it was purchased by the amount of the dealer’s spread, so it may not be clear which price should be treated as the market value. In addition, a dealer may buy or sell bonds in contemporaneous trades at different prices.

The lack of trading information is not limited to corporate bonds. Although Treasury securities and to-be-announced (TBA) federally guaranteed mortgage-backed securities trade on a daily basis, other sectors of the fixed-income market trade less frequently than corporate bonds. For example, according to information provided at the Roundtable on Fixed-Income Securities, municipal securities trade only three times per year on average, and 70 percent never trade after they are issued.⁹ Consequently, on any trading day, there is no trading information for most fixed-income securities.

3. Availability of Bid and Asked Prices for Fixed-Income Securities
The lack of trading in most fixed-income securities leaves bid and asked prices as the only potential source of market quotations for these securities. I have not found helpful research on the availability of market quotations for fixed-income securities, and must therefore rely on my limited exposure to the fixed-income market. I trust that any bond traders who might read this alert will inform me if I have underestimated the availability of bid/asked prices for fixed-income securities.

In my experience, lack of regular trading deters dealers from publishing bid and asked prices. Making a market for a security entails costs, just like any other business activity. A dealer can only recoup its market-making costs when a security trades. If a dealer has no reason to expect anyone to sell a fixed-income security, the dealer lacks an incentive to offer to make a market in the security by publishing bid and asked prices. Accordingly, dealers publish bid/asked prices for only the fixed-income securities most likely to trade on a regular basis, which is a fraction of the fixed-income market.

Instead of regularly publishing bid/asked prices, dealers may engage in market-making for a fixed-income security only in response to a client’s request. Upon receiving a potential order, the dealer tries to find the other side of the trade and determine an appropriate spread. When this is completed, the dealer will offer a bid price to the potential seller and an asked price to the potential buyer. If both parties agree, a trade will occur and the trade information may be reported through TRACE or EMMA. If either party rejects the offer, no trade occurs and the bid/asked prices never become publicly available.

Even if bid/asked prices were regularly available for most fixed-income securities, compiling these prices every day would be a gargantuan undertaking. According to CUSIP Global Services, as of March 2014, the CUSIP database had approximately 2.2 million outstanding debt issues, as compared with approximately 360,000 equity issues. This means there are approximately six times as many fixed-income securities as equity securities to be priced each day. Without a consolidated system for reporting bid/asked prices for fixed-income securities – comparable with the equity market’s consolidated tape – compiling this many market quotations would be prohibitively expensive for any pricing service.

4. The Great Valuation Divide
The 1940 Act’s strict division between market value and fair value creates a divide between the valuation of equity and fixed-income securities. While funds encounter “little difficulty” in obtaining market quotations for most equity securities, on most days there are no market quotations for most fixed-income securities. Consequently, market value is the rule for equity securities, while fair value is the rule for fixed-income securities.

Of course, there are exceptions to these rules. For example, an exchange sometimes halts trading in an equity security so that market quotations are no longer available.¹⁰ Some equity securities are more like fixed-income securities in that they rarely trade, frequently because of legal restrictions on resales or on sales to the public (so-called “restricted securities”).

Treasury securities are the most notable exception to the fixed-income rule. Many Treasury securities trade every day and bid/asked prices are readily available for every CUSIP. This reflects the federal government’s status as the world’s largest and most creditworthy borrower, which generates a continual demand for and secondary market in its obligations. Few non-government issuers of debt securities have the status to attract such regular trading in their obligations.

The valuation divide between equity and fixed-income securities helps explain some of the patterns in the enforcement cases observed in the first Client Alert. Two of the five misvaluation-cases leading to sanctions against independent directors involved misvaluation of a single equity security. Market quotations were probably available for the other equity securities held by these funds, which limited the fair valuations for which the directors were responsible.

In contrast, the other three cases involved the misvaluation of a significant portion of one or more fixed-income portfolios. This was probably because of the need to fair-value nearly all of the securities in these portfolios. Problems with the process for fair valuing fixed-income securities are more likely to have a systemic effect, resulting in misvaluations of multiple securities held by multiple funds.

The valuation divide also explains the different risks faced by directors of equity funds as compared with directors of fixed-income funds. Fair values are the exception to the rule for equity funds. Equity funds directors are therefore most at risk if valuation procedures do not effectively identify exceptions and deal with them appropriately. In this respect, it is noteworthy that the misvalued security in each of the two equity security cases was a restricted security—an exception to the equity rule of market valuation.

Insofar as fair values are the rule for fixed-income funds, directors of these funds are at greater risk of sanctions for misvalued securities. The tendency for such misvaluations to be systemic further increases the directors’ risks. The enhanced risks posed by fixed-income funds suggest that their directors should devote more attention to the overall valuation process than do their counterparts at equity funds.

The next Client Alert will examine the operational risks created by this valuation divide between equity and fixed-income securities.

1. As used in this Client Alert, an “independent director” is a director or trustee of an investment company registered with the SEC who is not an “interested person” as defined in section 2(a)(19) of the 1940 Act.
2. See, cta.nyxdata.com/CTA.
3. Codification of Financial Reporting Policies section 404.03.b.ii.
4. Presentation of Michael Goldstein, Professor of Applied Investments at Babson College, Slide 13, http://www.sec.gov/spotlight/fixed-income-markets/fixed-income-markets-corporate-bonds-goldstein.pdf.
5. SIFMA, US Bond Market Issuance and Outstanding, http://www.sifma.org/uploadedFiles/Research/Statistics/StatisticsFiles/CM-US-Bond-Market-SIFMA.xls?n=24418, (shows approximately $9.77 trillion of corporate debt outstanding at December 31, 2013, out of a total of approximately $39.88 trillion).
6. Goldstein Presentation at Slide 8, supra, note 4.
7. Id. at Slide 25.
8. John Carney, “Heard on the Street: The Bond Market Is a Drag These Days,” WALL ST. J. (July 6, 2014).
9. Burton Hollifield, PNC Professor of Finance, Tepper School of Business, Slide 2, http://www.sec.gov/spotlight/fixed-income-markets/fixed-income-markets-municipal-bonds-hollifield.pdf.
10. Equity securities traded on foreign exchanges can be regarded as a regular trading halt, insofar as trading on these exchanges ends hours before the time at which a mutual fund is valued.

Client Alert 2014-196