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.
Corporate executives cannot avoid accountability by claiming that they were just following orders. The SEC has maintained that senior executives have a duty to investors and the markets to stop financial wrongdoing at the companies they steward. Once charged, the SEC will often use its leverage to encourage cooperation in cases against others in the C-Suite.
A BDC manager’s compliance failures led to nearly $4 Million in fines, disgorgement and penalties and the loss of its advisory business. The SEC charges the firm with misallocating overhead expenses to the registered Business Development Companies it managed and with overvaluing portfolio companies. The SEC maintains that the registrant used material nonpublic information about BDC portfolio companies to benefit affiliated hedge funds that it managed. In 2014, the firm had over $2.6 Billion in assets under management but withdrew its adviser registration in 2017 following the SEC enforcement action. The SEC asserts violations of the compliance rule (206(4)-7) in addition to a laundry list of other securities laws violations.
Failure to implement an effective compliance program has consequences beyond penalties and fines. The negative impact to a firm’s and its principals’ reputations could ultimately bring down the entire franchise.
OUR TAKE: It is very difficult to cure the conflict of interest inherent in self-dealing transactions where an operating company depends on managed private funds for liquidity, and the funds source their assets only from the parent company. This may be one of those conflicts that can’t be cured regardless of the disclosure.
The SEC censured and fined a private equity manager for lowballing the price offered to liquidate limited partnership interests. The SEC asserts that the private equity manager, through its principal, offered to purchase remaining limited partnership interests at the December 2014 valuation. The SEC faults the firm for failing to revise the price or fully disclose that it had received financial information indicating that the NAV had increased during the first quarter of 2015. The SEC opines that the offer letter, termed “as an accommodation,” made it appear that the limited partners would receive full value for their interests. The SEC charges violations of Rule 206(4)-8, the Advisers Act’s antifraud rule.
OUR TAKE: We generally advise against principal transactions with clients/investors/LPs. Purchasing private interests directly from a client is so rife with conflicts that no amount of disclosure may be sufficient.
OUR TAKE: Having a valuation control function is not the same as having an effective valuation control function. Global firms must consider metrics before gutting compliance and supervisory functions that could ultimately allow bad actors to put the firm at risk. Firm leaders should think of compliance and supervision as the defense to protect assets and the firm’s reputation. And, defense wins championships.
OUR TAKE: It is very difficult to implement sufficient procedures or provide enough disclosure to sanitize the significant conflicts of interest that arise when cross-trading securities between client accounts. Our compliance advice is to avoid cross-trades and liquidate securities through an independent third party.
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: Investment firms and supervisors cannot turn a blind eye to questionable valuations and performance. According to the SEC, the respondent collected over $3 Million in unearned performance and management fees, making the firm ultimately responsible for its employees’ wrongdoing.
OUR TAKE: The SEC uses a tortured reading of the definition of “investment adviser” to hold accountable a third party valuation agent responsible for mis-pricing a fund. All service providers should beware that the SEC will seek to assert its authority through broad use of the securities laws.