The SEC fined a hedge fund $5 Million, and its Chief Investment Officer another $250,000, for failing to properly value portfolio securities. The SEC maintains that the firm over-relied on the discretion of traders to value Level 3 mortgage-backed securities rather than use required observable market inputs. The SEC contends that the firm consistently undervalued bonds to maximize profit upon sale. The SEC faults the CIO for failing to properly review valuation decisions and ensure that the traders followed the firm’s valuation procedures. The SEC asserts violations of the compliance rule (206(4)-7) because the firm failed to implement reasonable policies and procedures to ensure fair valuation of portfolio securities. As part of the settlement, the firm hired an experienced Chief Compliance Officer rather than rely on its prior Risk Committee comprised of executives with limited regulatory and valuation experience.
Valuation is about process. Firms that buy Level 3 securities must create a consistent, documented and contemporaneous process based on objective criteria in order to defend pricing decisions. For compli-pros, one way to test valuation is to sample whether liquidation prices vary consistently (either always higher or lower) than the firm’s internal valuations before liquidation.