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Latest Evergreen Regulatory Scandal Smacks of Poor Stewardship

Pricing procedures were too lax at this troubled shop.

Evergreen Funds has landed in hot water once again. The SEC forced the firm to pay $41.1 million for mispricing mortgage holdings in Evergreen Ultra Short Opportunities--a fund that was liquidated in 2008. Evergreen Investment Management Company is a unit of Wachovia, which was acquired by  Wells Fargo (WFC) in late December 2008. The settlement, which was reached in conjunction with the Massachusetts Securities Division, will require Evergreen to distribute $40.1 million to affected shareholders as a cash payment within nine months.

The regulators say that Evergreen Ultra Short Opportunities overstated its net asset value by as much as 17% because management improperly valued certain nonagency residential mortgage-backed securities in the fund's portfolio. According to the SEC, the fund's managers, who have since left Evergreen, did not take readily available pricing information into account when valuing the bonds in their portfolio and overstated the bonds' value and, thus, the fund's NAV. Evergreen Funds' pricing committee, which consists of the firm's top investors and is responsible for ensuring that securities are priced fairly in the firm's funds, signed off on the fund managers' pricing suggestions, the SEC said.

Unfortunately, Ultra Short Opportunities wasn't the only fund affected by these issues. In a press release issued June 8, 2009, Evergreen has determined "some of these or similar securities" were held in other Evergreen funds, which led to overstated values in other funds as well. Evergreen is still in the process of determining what funds have been affected, but an Evergreen spokesperson yesterday told Morningstar that Evergreen Diversified Income Builder (EKSAX) and a variable annuity product using the same strategy were affected by these mispriced mortgage-backed securities. Evergreen did note that the process of verifying how many funds were impacted by these issues was nearing a close.

The case against Evergreen also alleges a few other disturbing claims. First, only certain shareholders were told of the reasons for the declining NAV when the fund began re-pricing the affected securities. Second, the fund's management team did not adhere to regulatory requirements when cross-trading with other Evergreen funds. Specifically, bonds were sold from Ultra to another fund at a price below the level that a broker was willing to pay for them. And finally, from September 2007 to August 2008, Evergreen's affiliated broker-dealer, Evergreen Investment Services, did not keep a record of certain electronic messages sent via personal digital assistants.

The SEC's findings are very troubling and point to poor stewardship practices at Evergreen. The mutual fund industry has been subject to similar securities pricing scandals in the past (the most notable incident occurred at Heartland nearly a decade ago and also involved pricing of thinly traded bonds), so we're puzzled as to why Evergreen's compliance systems weren't designed to catch similar problems.

Compliance also appears to be lacking when it comes to cross-trades. We saw similar problems in the early 1990s at the former Strong funds, which now--ironically--are also part of the Wells Fargo organization.

Most disturbing, however, is the fact that Evergreen got in trouble in the market-timing scandal and thus had ample reason to boost its compliance efforts and shore up its flagging corporate culture. In addition, we're disappointed that in both cases the firm failed to come clean to investors once the problems were uncovered. This appears to be a serious breach of investors' trust.

Morningstar analysts contributing to this report:

Greg Brown, Fund Analyst
Eric Jacobson, Fixed-Income Specialist
Russel Kinnel, Director of Fund Research
Laura Pavlenko Lutton, Fund Analyst

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