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.
A direct lending platform agreed to pay a $4 Million fine and reimburse clients another $1 Million for allowing funds it managed to purchase loans in transactions that primarily benefited the parent company. The SEC also barred and fined the firm’s CEO and fined the firm’s CFO. The SEC asserts that the parent company used its controlling position on the Investment Policy Committee to force the funds to purchase loans outside its investment targets. The SEC accuses the firm of using the buying funds as a liquidity source following the loss of two major institutional investors. The SEC also maintains that the firm artificially inflated valuation and fund returns with undisclosed management adjustments. The SEC did not charge the parent company because it self-reported and cooperated and engaged in significant remediation efforts including establishing a new independent governing board, outsourcing valuation, and retaining a third-party compliance consultant.
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.
The SEC fined a large broker-dealer $5.75 Million for failing to allocate sufficient resources to its valuation control function, thereby allowing rogue traders to inflate securities valuations and positions. The firm eliminated 15 valuation control positions as part of a global efficiency initiative, which, according to the SEC, left the control function understaffed and under-trained to adequately implement the firm’s valuation supervision policies. One manager complained internally that four staff members were tasked with verifying prices for more than 20 trading desks that held over $200 Billion in Level 2 and 3 securities. The SEC alleges violations of the books and records and supervision rules.
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.
The SEC censured and fined an investment adviser $900,000 for effecting client cross-trades at the bid price, rather than the bid-ask midpoint, thereby favoring its buying clients over its selling clients. According to the SEC, the adviser had an interest in maintaining higher prices for the subject thinly-traded municipal bonds because the adviser often had a controlling, institutional position. By using the bid price, the adviser generally favored his current clients over terminating clients. The SEC also accuses the adviser of challenging bids upward to inflate the bonds’ valuation. Although the adviser did not benefit directly, the SEC faults the firm for favoring certain clients over others and for failing to adopt policies and procedures that obtained independent broker quotes, supervised the portfolio manager, subjected prices to review by a valuation committee, and retained records.
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.
A hedge fund firm agreed to pay over $10 Million in fines, disgorgement and interest for failing to stop two portfolio managers from using sham broker quotes in a scheme to inflate fund NAVs. The SEC faults the firm for failing to observe its own valuation procedures by allowing the PMs significant influence to override pricing services, failing to conduct adequate due diligence of the brokers, and neglecting to obtain at least 3 broker quotes for a price override. The SEC also fined and barred the firm’s CFO for failure to supervise by ignoring red flags such as the frequency that the PMs overrode prices and that overrides almost always resulted in higher valuations. The SEC previously charged the portfolio managers.
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.
A valuation firm was censured and fined and its principal was fined and barred for misleading its investment firm client about how it valued European options. The valuation firm represented that it valued the options using independent data and Black-Scholes modeling. The SEC charges that the firm merely used the estimated valuations provided by the client and then applied formulaic ranges. The SEC asserts that the valuation firm acted as an unregistered investment adviser because it “provided advice…about the value of securities…in exchange for compensation.” Following therefrom, the SEC charged violations of Section 206(2) of the Advisers Act, which prohibits investment advisers form engaging in any fraudulent activity.
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.
The SEC fined and barred from the industry the principal of a purported private equity firm for looting one fund to pay another by inflating the valuation of an underlying security transferred between the funds. The SEC pleads that the defendant transferred a worthless interest in a start-up company to one of the funds and then had another fund buy that interest at a $2.8 Million valuation in order to pay off investors in the transferring fund. The SEC contends that the defendant failed to (i) properly value the security with third-party input, (ii) disclose the inherent conflicts of interest and (iii) comply with statements made in the offering memorandum. Neither the fund manager nor the principal were registered in any capacity, but the SEC was able to uncover the wrongdoing as a result of litigation brought by the Colorado Division of Securities.
OUR TAKE: The state securities regulators serve a valuable function ferreting out fraud and other wrongdoing by firms that fail to register with the SEC and might otherwise go undetected.
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.