Going into 2020, we expected scrutiny over valuation methods to be one of the top regulatory risks for private funds. With ongoing economic uncertainty applying pressure, the SEC will continue to focus on valuation issues surrounding portfolio investments. Fund audit firms are not immune to regulatory scrutiny involving their professional obligations with respect to fund valuation issues.

A recent pair of SEC charges shows this trend in action. In December 2019, the SEC filed a complaint against a private fund manager, SBB Research Group, LLC, and two of its executives for a multi-year fraud involving the overvaluation of structured notes. The charged executives told prospective investors they used “fair value” in recording investments, but allegedly used their own novel valuation method that inflated investment value, causing SBB to overstate historical performance and overcharge investor fees. The complaint also alleged that SBB attempted to cover up the valuation issues from their investors and auditor.

Then, on February 26, 2020, the SEC issued a settled order instituting administrative proceedings against SBB’s auditor, RSM US LLP, for failing to catch SBB’s valuation fraud over years of audits. The SEC found that RSM’s system of quality control in staffing featured deficiencies that led to issues with audits conducted in 2013-2015. Namely, SBB retained two valuation specialists who were unfamiliar with structured note valuations. The specialists misunderstood SBB’s valuation technique, which according to the SEC order, jeopardized “the audit team’s ability to assess the reasonableness of SBB’s valuation assumptions, possible inappropriate management bias, the reliability of SBB’s inputs, and the appropriateness of SBB’s valuation methodology.” In 2016, after the SEC’s pending enforcement investigation and an SEC exam deficiency letter issued to SBB citing flaws in its valuation practices came to light, RSM concluded that a restatement of prior financial statements was unnecessary, despite receiving third-party valuations that were different from SBB’s valuations by amounts that exceeded RSM’s materiality thresholds. RSM later resigned as SBB’s auditor and recalled its audit reports from 2013 through 2017, citing inconsistencies between what SBB told RSM during prior audits and what it revealed to the SEC in the course of the enforcement investigation.

The SEC found that RSM violated professional auditing standards and engaged in improper professional conduct under the Securities Exchange Act and the Commission’s Rules of Practice. The SEC imposed a censure and ordered compliance with a long and detailed list of undertakings, including submission of a policy report and validation plan to SEC staff describing RSM’s review, testing, and assessment of, among other things, quality controls surrounding staffing and procedures used to determine when a valuation specialist is necessary and how he or she is vetted.

Together, these SEC actions suggest a continued regulatory focus on valuation issues, targeting not only those who are directly responsible, but also auditors and other service providers who can be viewed as “enabling” such overvaluations. The RSM order also increases pressure on auditors to treat valuation practices with greater scrutiny, implementing policies that ensure the appointment of qualified specialists to evaluate valuation procedures when necessary.

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Photo of Adam L. Deming Adam L. Deming

Adam Deming is an associate in the Litigation Department and a member of the firm’s Appellate and Product Liability groups, and Asset Management Litigation team. He focuses on complex commercial litigation in federal and state courts, covering a broad spectrum of business disputes…

Adam Deming is an associate in the Litigation Department and a member of the firm’s Appellate and Product Liability groups, and Asset Management Litigation team. He focuses on complex commercial litigation in federal and state courts, covering a broad spectrum of business disputes touching on corporate governance, fiduciary obligations, financial services, securities and insolvency. Adam has also represented clients in appeals spanning various areas, including consumer products, life sciences, bankruptcy, labor relations, patent and constitutional law.

Prior to joining Proskauer, Adam served as a law clerk to the Honorable Patty Shwartz on the United States Court of Appeals for the Third Circuit. Adam was also an associate in the New York office of an international law firm. Adam graduated cum laude from the University of Pennsylvania Law School, where he was the managing editor of the Journal of Constitutional Law and an Arthur C. Littleton Fellow instructor in legal writing.  Before law school, Adam was a Teach for America Corps Member in New Orleans, Louisiana, where he taught middle school English for three years.

Photo of Joshua M. Newville Joshua M. Newville

Joshua M. Newville is a partner in the Litigation Department and a member of Proskauer’s White Collar Defense & Investigations Group and the Asset Management Litigation team.

Josh handles securities litigation, enforcement and regulatory matters, representing corporations and senior executives in civil and…

Joshua M. Newville is a partner in the Litigation Department and a member of Proskauer’s White Collar Defense & Investigations Group and the Asset Management Litigation team.

Josh handles securities litigation, enforcement and regulatory matters, representing corporations and senior executives in civil and criminal investigations. In addition, Josh advises registered investment advisers and private fund managers on regulatory compliance, SEC exams, MNPI/insider trading and related risks.

Before joining Proskauer, Josh was senior counsel in the U.S. Securities and Exchange Commission’s Division of Enforcement, where he investigated and prosecuted violations of the federal securities laws. Josh served in the Enforcement Division’s Asset Management Unit, a specialized unit focusing on investment advisers and the asset management industry. His prior experience with the SEC provides a unique perspective to help asset managers manage risk and handle regulatory issues.