Morgan Keegan & Co. and an affiliate company will pay a fine of $678,390 to the State of Texas for failing to tell investors about the high-risk assets in seven of its bond funds.
A Consent Order entered by the Texas Securities Commissioner on Feb. 29 also found that Morgan Keegan failed to properly supervise the creator and manager of the funds, James C. Kelsoe Jr., who later agreed to a lifetime ban from the securities industry.
The fine, which will go into the state's General Fund, is Texas' share of a $10 million penalty Morgan Keegan agreed to pay to state regulators in a national settlement. The Memphis, Tenn.-based broker-dealer previously agreed to pay $210 million to investors in a settlement with the SEC and state regulators.
The order found that Morgan Keegan consistently misled investors about the riskiness of the assets in the bond mutual funds and close-end funds, which included securities tied to subprime mortgages. Contrary to the company's promotional material and regulatory filings, six of the seven funds were largely invested in tranches of subordinated, lower-quality debt that carried more risk than senior tranches. Tranches describe a security that can be divided into smaller pieces and sold to investors.
Morgan Asset Management (MAM), a Morgan Keegan affiliate, "did not adequately describe the risks" of owning the lower-quality debt or the amount of it the bond funds, the order states. In SEC and state regulatory filings in 2007, $400 million of what MAM as "corporate bonds and preferred stocks" were in fact tranches of lower-quality debt.
Some Morgan Keegan employees knew about the risk of the bond funds, most of which were intended to be stable, core holdings for investors. In May 2007, the then-president of Morgan Keegan's wealth management division said in an e-mail he was worried about "all the potential risks associated with all that asset-backed exposure."
The e-mail read in part: "Mr. and Mrs. Jones don't expect that kind of risk from their bond funds. The bond exposure is not supposed to be where you take risks. I'd bet that most of the people who hold that fund have no idea what it's actually invested in." The e-mail also expressed the executive's concern that most of Morgan Keegan's financial advisers had no idea about the funds' assets and how much risk investors were taking.
The order found that Morgan Keegan failed to supervise Kelsoe, the former Morgan Asset Management portfolio manager who created and oversaw the funds. The former president of MAM testified under oath that he didn't conduct the same supervisory review of Kelsoe and the bond funds because he was told to "leave Kelsoe alone."
Among other things, this lack of supervision also allowed Kelsoe to improperly influence the net asset value, or per-share price, of the funds.
In 2007, shortly before the collapse of the subprime lending market, MAM consistently lowered the net asset value of the funds. Even as prices of the funds declined, however, Morgan Keegan salespeople advised investors to "hold the course" and not sell the funds.