It looks like it's every firm for itself.
Ernst & Young's recent independent audit report of San-Francisco-based Van Wagoner Funds may be a sign that fund companies are going to face significantly more scrutiny from their accountants following the Enron affair, according to industry observers.
The report, which accompanied Van Wagoner's annual shareholder reports, indicated that Van Wagoner did not document its reasons for pricing illiquid securities sufficiently to the board of directors. Ordinarily, accountants signing off on a firm's financials do not issue a separate report like this one.
"I've never seen anything like it," said Mercer Bullard, founder of shareholder advocacy group Fund Democracy of Chevy Chase, Md., and former assistant chief counsel in the SEC's division of investment management. "I think it's definitely an example of Enronitis attacking the industry, and it's the first sign of it showing up in investment regulation. After the Enron debacle, I think the auditors felt they had to cover themselves."
In addition to their inadequate disclosure, Van Wagoner Funds purchased private placement securities above a self-imposed 15% cap in 2001, the report said. Ernst & Young determined the actions to be "reportable conditions," which the firm defines as "significant deficiencies in the design or operation of internal control that...could adversely affect the Funds' ability to record, process, summarize and report financial data consistent with the assertions of management in the financial statements."
Ernst & Young does not comment on matters discussed in its reports or about its clients' actions, a company spokesman said.
The report could be reason for other funds, which price illiquid securities, to worry that its procedures might be contested, even though they have been in place for years.
"I think it may be indicative of what's going to happen in the future with respect to what auditors are going to be doing," said Barry Barbash, a partner with the Washington, D.C. law firm Shearman & Sterling and former director of the SEC's division of investment management. "I can't remember seeing something quite like this."
"We have done everything exactly the same way since inception six years ago," said Peter Kris, a spokesman for Van Wagoner. "We've received a clean opinion from auditors every year. This year is no different."
The difference this year, however, was that Ernst & Young "scrutinized us amazingly, double and triple checking our books," Kris said.
Van Wagoner is not the first firm to engage in security pricing indiscretions, but most, if not all, have never received a report like that issued by Ernst & Young, Bullard said.
"There are more valuation issues out there, it's not just Van Wagoner," said Barbash. "This is an across-the-board issue."
Issues like this one, particularly with regard to the directors' documentation, do not occur very frequently, but they do occur often enough that fund accountants should have detected and commented on them before, Bullard said.
"If this sort of review is what's required, why haven't we seen it before?" he said.
Certainly, accountants have found firms in violation of policies during audits in the past. For example, when Heartland Advisors of Milwaukee was investigated for having improperly priced illiquid securities in 2000, the firm's independent accountant, PriceWaterhouseCoopers, refused to sign off on the firm's financials because the actions were so egregious, according to Bullard. However, in cases that involve grayer areas, accountants may now be less inclined to give funds a clean bill without mentioning policy violations.
"It very well might be a harbinger of things to come," Bullard said. "[E&Y] has definitely raised the bar of the accounting industry as a whole. I think there's a pretty good likelihood that it'll bring about a change in what auditors are saying when signing off on pricing issues."
And pricing issues will continue to arise more often for a variety of reasons. An increase in market volatility, concentrated fund portfolios and investment in foreign countries all contribute to making fair value pricing more difficult.
Also, the SEC has stepped up its regulation of fair value pricing procedures and increased the number of investigations it has initiated involving those issues (see MFMN 12/10/01). While valuation has always been on the SEC's radar screen and has been a priority for fund directors, those factors have brought the area of pricing to the forefront, Barbash said.
"I can tell you that much more time is being spent in fund board meetings on valuations than anytime in the past," he said.
