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.
The SEC has charged a hedge fund firm and its principals with using false broker quotes and imputed valuations to inflate the value of securities. Facing significant investor redemptions and underperformance versus peer funds, the SEC claims that the principals expressed concerns about going out of business. In response, the SEC alleges, the respondents engaged in a scheme to obtain inflated broker quotes from a broker to whom they promised additional business. In addition, the SEC avers that the respondents used imputed mid-point prices to value securities, contrary to statements made in offering documents. Ultimately, the fund’s auditor questioned the valuations and refused to complete the audit.
OUR TAKE: Bad things happen when firms face failure. Many enforcement cases arise from firms and managers that desperately try to cut regulatory corners to avoid firm collapse. It is better to accept defeat than to try to rescue your career after the SEC names you in an enforcement case.
OUR TAKE: It is noteworthy that the SEC took action against the trader himself rather than his firm, which presumably avoided liability because it had implemented adequate policies and procedures. SEC Commissioner Piwowar has previously indicated that the SEC should pursue individuals rather than firms.
The manager of a large bond ETF agreed to pay nearly $20 Million, including an $18.3 Million penalty, for mis-pricing securities and presenting an incorrect NAV to the Board, investors, and prospects. The SEC charges that the firm inflated reported performance by purchasing odd lot non-agency MBS at a discount but using the higher round lot prices for valuation purposes. The SEC asserts that several people knew about the strategy but failed to ensure that the firm accurately priced the securities. The SEC faults the firm for making misrepresentations to the Board as well as in shareholder reports and marketing materials. In addition to disgorgement and penalties, the respondent agreed to retain an independent compliance consultant. The SEC’s Enforcement Director admonished, “Investment advisers must accurately describe the significant sources of performance and the strategies being used.”
OUR TAKE: When performance looks too good to be true, it probably is. Outperformance in and of itself is a compliance red flag that should draw increased scrutiny.
A large mutual fund firm agreed to reimburse investors approximately $18 Million and pay a $3.9 Million fine for failing to properly remediate NAV pricing errors. According to the SEC, the respondent discovered that its fair valuation process under-valued certain illiquid securities over a 30-month period by failing to include required inputs. The firm attempted remediation by contributing $27 Million to the funds. However, the SEC argues that the contribution failed to examine the impact to every shareholder and ultimately understated the impact to investors. The SEC faults the firm for failing to follow its own fair valuation and NAV error correction policies in violation of the Advisers Act and the Investment Company Act.
OUR TAKE: There is no easy way to correct NAVs over an extended period of time. Re-processing trades is expensive and time-consuming and can lead to fairly significant reimbursement checks. However, trying to shortcut the remediation only leads to bigger problems, such as public enforcement actions. The compliance lesson is to work very diligently on the fair valuation process.