Morgan Keegan's Alleged Fraud: Failure in the Midst of a Crisis

"During my 20 year career, these are truly unprecedented times. Amidst these difficult circumstances, I assure you of my continuous commitment to do all that I can to take care of our shareholders' best interests."

According to the SEC, those words were written around the same time that Kelsoe and other members of his firm were committing fraud. (Morgan Keegan seems to have taken down their link to that letter, which was available earlier this week. News articles quoting it, however, remain.)

The SEC's charges concern the pricing of sub-prime securities held by five Morgan Keegan income funds managed by Kelsoe. In most instances, prices for the securities held by mutual funds are readily available. There's no question, for example, what a share of Google or a ten-year Treasury bond maturing in June is worth.

At times, however, prices for a fund's holdings are more difficult to obtain because they're traded very infrequently. To ensure that the fund is valuing these securities accurately, the SEC requires that the firm obtain quotes for them from a third-party broker, asking them what they would pay for such a security today.

This process is typically handled by a fund manager's fund accounting group, which follows strict procedures established by the fund's Board of Directors and, in most cases, the firm's Valuation Committee, which exists to ensure that each fund's holdings are accurately priced.

So what happened in this case? In 2007, as the sub-prime mortgage market was in a tailspin, the SEC alleges that Kelsoe had his assistant send at least 262 "price adjustments" to the fund accounting group. These adjustments, according to the SEC, "inaccurately inflated the price of certain securities" and "fraudulently forestalled declines in the [net asset values] of the funds."

The adjustments were allegedly sent to "lower level" employees in the fund accounting group, who "relied on Kelsoe's 'price adjustments' ... without obtaining any basis or documentation" supporting them, according to the SEC.

The SEC goes on to say that Morgan Keegan's Joseph Weller, who ran the firm's fund accounting group and also served on its Valuation Committee, is also guilty of fraud, because he either "knew, or was highly reckless in not knowing," that Kelsoe was essentially making up the prices of securities his funds owned.

Further, in conversations with third-party brokers, who were to provide current prices for the sub-prime securities his funds owned, the SEC says that Kelsoe would pressure them to increase their quotes. In one instance, according to the SEC, "Kelsoe communicated his unhappiness" with the low price one broker quoted for a particular security, "and threatened to stop doing business" with the firm unless they increased it. Two days later, the unnamed broker -- apparently more eager to appease an important client than to comply with the law -- allegedly provided a quote far above market value that met with Kelsoe's approval.

If true, the net result of such behavior is that investors who purchased these bond funds during this period paid prices that were artificially inflated, and investors who sold earned undue profits.

There is no denying, as Kelsoe wrote in that 2007 letter, that the markets at that time were unprecedented and extremely difficult. But it is under those circumstances that character is revealed. And unfortunately for the investors who placed their trust -- and their hard-earned assets -- with Kelsoe and his firm, both failed the character test miserably, if indeed the SEC's allegations are true. It's one thing to see one's investment bets go sour -- there was in fact quite a bit of that going on in 2007. It's another thing altogether to fraudulently conceal those losses from the investors you are duty-bound to serve.

So now what? Well, Morgan Keegan plans to "defend vigorously against these charges." Lawsuits, in the meantime, are being filed. And if the past is a reliable guide, it wouldn't be surprising to see the firm settle with the SEC, paying a hefty fine while neither admitting nor denying guilt.

Evergreen Investments followed such a path in a similar case last year, and with that bit of unpleasantness nicely behind them, they've moved on, describing themselves on their website as one of the industry's "premier asset management firm[s]."

While that provides a nice template for a firm accused fraud to follow, investors might do well to have a longer memory, and to wonder just how quickly an organization's culture can change.