James T. McCurdy, a 23-year veteran mutual fund auditor who was recently sanctioned by the Securities and Exchange Commission and given a one-year "time out" from the industry, has vowed to appeal that decision to the SEC's Commissioners, and will file for a stay of that penalty.

On Feb. 4, almost three years after filing an initial administrative proceeding against McCurdy, who is the lead partner in McCurdy & Associates of Westlake, Ohio, the SEC handed down the sanction after charging that he engaged in improper professional conduct in the auditing of a now-defunct aggressive growth fund based in Hawaii.

With three partners, McCurdy & Associates claims to be the sixth-largest mutual fund auditor. It has carved out a niche by catering to the needs of small, independent and start-up mutual funds. The SEC sanction is against McCurdy, but not his firm.

That recent SEC ruling and time-out sanction were handed down by the SEC Commissioners on review, after an administrative law judge in August 2002 initially cleared McCurdy of all charges. In her ruling, the judge found no evidence that McCurdy had engaged in "highly unreasonable" or reckless conduct in carrying out his auditor duties, and the SEC's original administrative proceeding was dismissed. But the SEC's Commissioners subsequently overturned that ruling and refiled an action against McCurdy.

McCurdy's time out became effective last week, on Tuesday, Feb. 17, just days before many of McCurdy's 40-plus fund clients are scheduled to file their annual reports for year-end 2003. If the appeal and request for a stay of the timeout are denied, those clients could face problems, as their current auditor would then not be recognized in good standing by the SEC.

Trouble in Hawaiian Paradise

For McCurdy, the turmoil dates back to June 2001, when the SEC originally instituted the administrative proceeding against him. The SEC charged that McCurdy, as part of his first-ever audit of the JWB Aggressive Growth Fund for the year ending Dec. 31, 1988, did not obtain "sufficient competent evidence" to properly assess the likelihood that a receivable on the small equity fund's balance sheet was collectable. That receivable stemmed from the fund advisor's voluntary commitment to reimburse the fund for all expenses incurred in excess of a certain percentage of the fund's daily net assets. That percentage varied from 1.95% to 2.35%, according to a review of the fund's SEC filings.

The SEC charged that by the end of 1997 the fund's advisor, JWB Investment Advisory & Research of Honolulu, had yet to reimburse the fund for $3,783 in already incurred expenses. By the end of 1998, that promissory note had ballooned to nearly $80,000. According to the SEC, at its height, the fund had less than $500,000 in assets. The fund debuted in March of 1996 and eventually liquidated, repaying all investors in 2001.

That receivable represented more than 25% of the then total assets of the fund and, being judged as a "material" amount, should have been a red flag to McCurdy as the fund's auditor, the SEC noted. Moreover, the SEC charged, part of McCurdy's responsibility was to then carefully determine if that receivable was going to be recoverable at all from the fund advisor.

That's where the SEC and McCurdy differ in opinions.

The SEC charged that McCurdy's actions fell short in determining the recoverability of that receivable, and therefore, the fund's financial statements were not compliant with generally accepted accounting principles(GAAP).

In a telephone interview, McCurdy defends that he took all of the necessary steps, as laid out in standard accounting guidelines, to determine if the receivable was recoverable, and he determined in good faith that it was.

Counting the Beans

That determination was based upon several audit procedures McCurdy took, including reviewing the minutes of a December 1998 board of directors' meeting at which time the fund trustees were told by JWB's primary principal, John W. Bagwell, that he could not immediately repay the total reimbursement. According to the board minutes, the board had determined that the receivable was collectable, and granted the advisor six months to pay it off. In addition, McCurdy noted that his review revealed that the advisor had a consistent history of repayment, and since the amount to be repaid was material, but not extraordinarily high, that repayment was likely.

McCurdy said that he also relied upon the renewal of the fund's fidelity bond, which, he explained, would not have been renewed by the fund's insurance company had there been problems with the fund advisor or fund's assets.

"The SEC claimed that it was an illegal loan on the balance sheet," McCurdy said. "The Commission is essentially saying that we are not allowed to use our judgment in determining whether a receivable on the fund is allowable. I've spent over four years and $115,000 on this, and I am not going to drop it. My reputation is at stake."

McCurdy also said that last month he formed a joint venture audit firm, Cohen McCurdy, which now has 20 partners and will continue to provide services to fund clients who were being called last week to be brought up to date.

Expense-ive IOUs

Reimbursing a fund for its expenses above a certain cap is a common industry practice, say fund experts. Fund expenses are calculated monthly, and expenses above and beyond the stipulated expense limitation are supposed to be reimbursed by the advisor each time the monthly calculation is made.

In many cases, it has become customary for the fund's investment advisory fee, typically paid quarterly, to be voluntarily reduced by any amounts that are owed to the fund as reimbursement of expenses, said Larry Friend, partner with PricewaterhouseCoopers in Washington, and a former chief accountant with the SEC's division of investment management. Many auditors will require that any necessary reimbursement to the fund be made before they will sign off on the fund's financial statements, he added.

But there is no current regulatory requirement that management fees must be offset by expense reimbursements owed to the fund, Friend said. There are cases in which the advisor is receiving its regular advisory fee, while the payable expenses -- which may actually be in excess of that advisory fee -- are accruing, he added. Those are the cases in which receivables begin to rear their ugly heads, and must then be put onto the fund's balance sheet.

In some cases, especially where smaller startup funds with high expenses are involved, that receivable simply keeps going, and going, and going.

If the expenses of a fund exceed the management fee paid to the advisor, we ask for the payment due, said Joe Nueberger, SVP with US Bancorp Fund Services. Fund advisors should be paying these expenses on a monthly basis, but in rare cases, there can be a month or two delay in seeing the reimbursement, he said. If the request for reimbursement goes beyond the quarter, US Bancorp will ask for documentation of the receivable to be included for discussion at the next meeting of the fund's board. If the problem continues beyond the quarter, very often the auditor will be asked to become involved, he added.

At that point, the job of the auditor is to determine the value of that receivable and whether or not that amount is likely to ever be collectable from the advisor, according to fund industry auditors.

We Told You So...

The SEC's sanction against McCurdy may drive home a point that the regulator made back in early 2000.

In its then annual "Dear CFO" letter dated Dec. 30, 1999, the SEC's division of investment management's chief accountant made a point of cautioning mutual fund finance chiefs against allowing receivables to languish, uncollected, on fund balance sheets, said John Capone, partner with auditor KPMG in Boston, and the former SEC chief accountant who authored that letter. "Where receivables are uncollected, it is the job of the auditor to evaluate the creditworthiness of the receivable," he noted.

The SEC had seen several cases like this, Capone said. The SEC views languishing receivables as loans, and regulations prohibit funds from making loans to advisors.

"In the hot economy, everyone was jumping into the market to take advantage of hot stocks," Capone reflected. With a low barrier to entry, lots of folks had started and marketed funds, but didn't have the ability or financial wherewithal to efficiently run them, he added.

Copyright 2004 Thomson Media Inc. All Rights Reserved.

http://www.thomsonmedia.com http://www.mmexecutive.com

Subscribe Now

Access to premium content including in-depth coverage of mutual funds, hedge funds, 401(K)s, 529 plans, and more.

3-Week Free Trial

Insight and analysis into the management, marketing, operations and technology of the asset management industry.