Two lawsuits and two FINRA arbitration claims filed against the executives, directors, chief compliance officer, portfolio managers and independent auditor of three open-end funds and four closed-end funds managed by an affiliate of Memphis, Tenn., broker/dealer Morgan Keegan & Co., may be the tip of the subprime iceberg for the mutual fund industry.
"I concur. There certainly is a lot below the surface," said William Sullivan, a partner and chairman of the national securities litigation group with Paul Hastings in Los Angeles. Sullivan is also a member of the firm's subprime task force, assembled in July. Mutual funds may very well be dragged into this, but whether investors will bring lawsuits remains to be seen, Sullivan added.
According to Andrew Stoltmann of Stoltmann Law Offices PC of Chicago, which last Tuesday filed the two FINRA arbitration claims, up to 30 more claims against Morgan Keegan are being readied for filing in the coming weeks. One investor lost 70% of his money in one fund and is now living in his car, Stoltmann noted.
Morgan Asset Management is the investment advisory arm of Morgan Keegan, which is the securities subsidiary of banking firm Regions Financial Corp. of Birmingham, Ala. All companies are named in the lawsuits.
Last month, two potential class-action lawsuits filed in Memphis District Court on behalf of fund investors who lost a significant portion of their investments, paint a picture of fixed-income managers who had loaded their portfolios with market-sensitive mortgage-backed structured securities, including collateralized loan obligations and collateralized mortgage obligations, far exceeding both fund sector limitations and 15% regulatory limits on illiquid securities.
Moreover, the prospectus for one of the funds included an investment objective of attaining higher yield without excessive risk, contrary to the securities the fund was investing in, one suit charges.
The lawsuits also charge that despite the fund manager being required to price these securities daily, they were so thinly traded that daily, fair-value pricing was virtually absent until the subprime market began its descent in July, at which time the funds' net asset values (NAVs) took a sudden and severe dive. By November, the funds' share prices had nose-dived more than 40%.
According to Lipper, for all of 2007, the Regions Morgan Keegan Select High Income Fund dove 59.7%, the Regions Morgan Keegan Select Intermediate Bond Fund lost 50.3%, and the Regions Morgan Keegan Select Short-Term Bond Fund tumbled 11.58%. Consequently, each of the three funds ended the year as the worst performer in their respective peer group.
Morgan Keegan had not returned a call seeking comment.
Additionally, the funds' auditor, PricewaterhouseCoopers is named as a defendant in two of the lawsuits, charged with not properly carrying out its responsibilities. A spokesman for PwC, reached for comment, said the firm disagrees with the allegations and will vigorously defend itself.
"These extraordinary losses in share value were caused by the funds' heavy investment in relatively new types of manufactured or structured fixed-income securities that had not been tested through market cycles," claimed the suit filed Dec. 6 on behalf of Richard Atkinson and Patricia Atkinson. Although other mutual funds may have suffered losses due to the credit market crisis, the Morgan Keegan Select fixed-income funds suffered much greater losses because of the funds' "disproportionately large positions' in these untested securities, the suit claimed.
"It's clear to us that once they were beyond the 15% point [limit on illiquid securities], actions should have been taken," said Gregg Fishbein, an attorney with Lockridge Grindal Nauen of Minneapolis, one of the four law firms representing the Atkinsons. This lawsuit comes down not only to what wasn't disclosed to investors, but also points to pricing issues related to those illiquid securities, Fishbein said.
The Atkinson suit has not yet detailed specific damages to be determined later, Fishbein noted, although these investors invested a combined $152,000, according to the lawsuit.
The second lawsuit, filed Dec. 21, makes similar allegations and admonishes the fund group for not properly disclosing information. "The Select Funds registration statement and prospectus failed to provide adequate disclosures concerning the Select Funds' exposure to the subprime market and the risks associated with owning shares of the fund," according to the lawsuit, brought on behalf of investors Elizabeth Willis and Sam Pearson by Coughlin Stoia Geller Rudman & Robbins of San Diego.
The lawsuits' battle cry harkens back to 1994, when exotic derivatives, including inverse floaters, surprised many fund managers by sharply dropping in value as the Federal Reserve instituted a series of interest rate hikes. Those derivatives, found to be highly sensitive to interest rate changes, had been loaded into several funds, including money market funds that subsequently infused large quantities of money in order to preserve the fund's $1-per-share NAV, preventing those funds from "breaking the buck."
This time, the subprimse crisis has already caused a number of money fund investment advisors to pony up money to make their funds whole or otherwise sell illiquid or defaulted securities to affiliates in order to avoid losses. But will fund advisors do the same for non-money funds?
Morgan Keegan is also on the hot seat with two separate FINRA arbitration claims that Stoltmann filed against it.
In one case, an investor, on behalf of himself, two companies he was affiliated with and an investment account that was part of a divorce settlement with his former wife, lost a collective $1.8 million in the Morgan Keegan funds. "Morgan Keegan substantially misrepresented and omitted material information regarding the risk to which the claimants' irreplaceable life savings were being exposed," the arbitration complaint charges.
In the second case, a husband and wife, and a trust account set up for their children, lost a collective $285,000.
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