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Hedge Fund Fined $5 Million for Weak Valuation Procedures

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.

Hedge Fund Manager Over-Relied on Third Party Pricing Service

A hedge fund manager agreed to pay disgorgement, investor reimbursement, fines and interest for mis-valuing portfolio securities and thereby collecting inflated management fees.  According to the SEC, the fund manager relied almost exclusively on a third-party pricing service to value municipal bonds.  The pricing service significantly over-priced securities by failing to include observable inputs such as broker quotes.  Over the course of at least 2 years, the actual sales prices of bonds were significantly less than their stated valuations.  As a result, the fund manager overstated fund NAVs, which caused an overpayment to redeeming shareholders and inflated management fees.  The SEC faults the firm for failing to value the municipal bonds in accordance with GAAP (ASC 820) and good faith, as described in its Valuation Policy, financial statements and disclosure documents.

OUR TAKE: Fair valuation requires a determination of the price that would be received between market participants.  A fund manager cannot slavishly rely on a third party pricing service especially if the prices result in an ongoing pattern inconsistent with actual transactions.