According to recent news reports, the DOJ and the SEC are investigating the possible improper use of third-party broker quotes by hedge fund managers to value illiquid debt securities in their portfolios. Prosecutors are reportedly focused on possible instances where fund managers allegedly solicited predetermined or improper quotes from brokers, and used those estimates to inflate their own valuations of thinly-traded mortgage bonds.

In addition, the co-head of the SEC’s Asset Management Unit recently highlighted that unit’s focus on valuation, particularly where registered advisers failed to follow their own internal procedures when valuing illiquid positions. The SEC’s focus is further demonstrated by a recent action against a fund manager for improperly valuing municipal bonds inconsistently with GAAP.

In light of the SEC’s focus on valuation policies and procedures, fair valuing illiquid assets should be a key concern for fund managers. Although the alleged use of “bogus” marks to inflate the value of a trading book is an extreme example, the regulatory attention to valuation should not be ignored.  As we have noted here before, although valuation can be more art than science, there are heightened regulatory risks in the following areas:

(1) breakdowns in controls/policies/procedures,

(2) violations of Generally Accepted Accounting Principles (GAAP); and

(3) incomplete or inaccurate disclosures to fund investors and auditors.

Why are valuation policies important?

First, managers need to be concerned about potential violations of the anti-fraud provisions (e.g., sections 206(1) and (2) of the Advisers Act).  They should have policies and procedures (and training) in place to ensure that the valuation of all securities is done in an appropriate manner that is consistent with the manager’s fiduciary duties and the disclosures provided to investors.

Second, valuation policies fall under the compliance rule (Rule 206(4)-7 under the Advisers Act). Under this rule, the SEC expects registered advisers to adopt and implement policies and procedures to value client holdings.  SEC staff typically request and scrutinize a firm’s valuation policies either during their exams, or when following up on enforcement tips.  Problems can arise when a fund manager fails to follow its disclosed valuation policies to the letter, turning internal control issues into potential disclosure issues. Even if the government cannot prove that valuations were “wrong” they may allege that disclosures regarding the valuation policies themselves were false or misleading.

Covenant Financial Services:

The SEC’s March 2017 case against hedge fund manager Covenant Financial Services demonstrates how SEC enforcement might approach a typical valuation matter. Covenant settled claims involving its use of a pricing service to value certain municipal bonds.  According to the order, the manager’s valuation policy appeared consistent with GAAP, but in practice, the execution fell short.

Covenant’s policy recognized the principles of Accounting Standards Codification 820 (“ASC 820”). Consistent with ASC 820, the policy prioritized the use of Level 2 inputs (“inputs other than quoted prices . . . that are observable for the asset or liability, either directly or indirectly.”) over Level 3 inputs (“unobservable inputs for the asset or liability.”).

The problem arose because the pricing service used by Covenant estimated values based on a model that used Level 3 unobservable inputs, rather than Level 2 inputs. Covenant allegedly used this model despite being aware of Level 2 indicators that were inconsistent with the model’s valuations, including actual trades it made in the same or similar bonds, and broker quotes and marks it obtained.

The SEC determined that because Covenant allegedly overstated its funds’ performance during those time periods, it violated the anti-fraud provisions of the Advisers Act. In addition, because it failed to follow its own valuation policy, the SEC alleged that the adviser also violated the Compliance Rule by failing to implement its written policies and procedures.

Lessons Learned: What should be included in valuation policies?

Fund managers should follow a disciplined and documented internal process. This process should involve finance/accounting personnel along with investment professionals.  The overarching principles, in our view, are (1) consistency when applying the policies over time and (2) accurate disclosure of the policies (and deviations) to LPs.

Best practice may also include establishing an internal valuation committee. The policies should be reviewed at the outset and periodically by the fund’s valuation committee.  And although a manager may choose to retain an outside valuation firm, the valuation of fund assets is ultimately the manager’s responsibility. Ultimately, the best way to reduce risk is to consistently apply and follow the documented valuation policies.