“The Securities and Exchange Commission for the first time is weighing bringing disciplinary actions against mutual-fund companies that have failed to use so-called fair-value pricing for portfolio holdings with out-of-date market prices, agency officials said,” writes Tom Lauricella in today’s Wall Street Journal.

“The SEC investigations into fair-value pricing practices at an undisclosed number of fund companies are still in the preliminary stages, the officials cautioned. But any resulting disciplinary efforts would open another front in the SEC’s expanded scrutiny of the fund industry and signal that the agency is attaching greater importance to fair-value techniques in the wake of the share-trading scandal.”

“Fair-valuation practices involve using estimates to set the value of portfolio holdings when the securities’ closing market prices become out of date because of later developments. Such mispricing is particularly an issue for U.S. mutual funds holding foreign stocks whose closing values are hours old by the time the funds calculate their share prices at the end of trading for U.S. markets. Funds using such out-of-date prices have been targets of market timers, who are short-term traders who profit by rapidly buying and selling fund shares to the detriment of long-term fund investors.”

“The SEC approved fair-value techniques in 1981 and strongly recommended funds use them, but the agency never directly required funds to adopt such pricing methods. However, under other SEC rules, funds have an obligation to make sure their share prices are as accurate as possible after events such as major swings in U.S. markets after the close of overseas stock trading.”

“As a result, agency officials said the SEC investigation is focusing on whether funds in such circumstances violated their obligations to set the most accurate share prices possible if they didn’t consider using fair-value techniques.”

“Some experts think the probe will result in disciplinary charges if a fund didn’t consider using fair-value practices. ‘It wouldn’t surprise me to see them bring a case,’ says Barry Barbarsh, a former top SEC official now at Shearman & Sterling. The notion that the SEC has wanted funds to make greater use of fair-value techniques ‘has been out there for a while,’ he said.”

“The prospect of new allegations is an added headache for the fund industry that has been enveloped in scandal for seven months because of share-trading abuses as well as cases involving the misuse of investors’ money in promoting the sales of funds. Fund companies have already been hit with $1.7 billion in fines and numerous top executives have lost their jobs.”

“While substituting estimates for market prices can be controversial, the SEC has long held that the practice is preferable to using outdated market prices in setting portfolio values. In 1997, Fidelity Investments drew criticism from some investors when it used fair-value pricing on some of its international stock funds during the turmoil of the Asian financial crisis. The SEC backed Fidelity’s actions, but the practice still hasn’t been widely adopted throughout the industry, often because fund officials worry that using fair-value pricing could open the door to lawsuits.”