Stout recently hosted a conference in Atlanta discussing issues, trends, and best practices related to valuation. The panel focused on recent enforcement actions with private funds and featured the following panelists:
The panel addressed a series of topics including:
The following is the third installment of our review of a recent expert panel discussion on enforcement actions involving private funds. In this third installment, the panel discusses the impact of a recent enforcement action, how a fund can best prepare for an audit and regulatory examination, and how funds can best avoid regulator scrutiny of their valuation process. See the first installment for the panel discussion on why valuation is an enforcement priority for regulators, common valuation related issues, and relevant accounting guidance, and the second installment for the panel discussion on best practices around valuing Level III assets and the benefits of using an independent third-party valuation specialist.
In the SEC enforcement actions related to Visium Asset Management (“Visium”), one of the allegations related to two portfolio managers, Christopher Plaford and Stefan Lumiere, of manipulating the valuation of certain securities held by one of their funds. Specifically, the fund disclosed to investors that it would use “fair value” to price assets, and the fund administrator would value those assets using established pricing sources. Instead, however, Plaford and Lumiere frequently overrode the fund administrator prices with “[their] own, hand-picked, sham quotes, which were U-turned through friendly brokers.” The scheme resulted in the fund overstating its performance and over-charging investors nearly $6 million in management and performance fees.
Brawner indicated there were several “red flags” that stuck out in the Visium actions, including:
Brawner stated that, from an administrator perspective, these “red flags” should have started a discussion as to why they were deviating from policy, what justified the frequent deviations, and why their valuation policy remained unchanged despite the frequent deviations.
Anderson reminded the audience that in cases like Visium, there are serious consequences to valuations that are intentionally misstated. In Visium, Judge Rakoff, Senior U.S. District Judge for the Southern District of New York, sentenced one of the portfolio managers to 18 months in prison. The incentive for obtaining the sham quotes was getting higher management fees and, presumably, higher bonus compensation, but the consequence was going to jail.
Foster provided initial insights based on her experiences working with several funds, and stated that the following are the best ways to prepare for a regulatory exam:
Anderson noted that he has been very public for several years about the SEC traditionally not challenging actual valuations, but rather the absence of a written process and firm not following the agreed upon process. In August, however, the SEC challenged the actual valuation in the aforementioned KPMG/John Riordan matter where the SEC believed that the valuation was inflated and unrealistic based on the facts and circumstances. Anderson noted, despite the KPMG enforcement action which he considered an ‘outlier’, when a fund has a valuation policy that is well documented, the process is disclosed to investors, and the fund follows the process documented in the policy, it is extremely unlikely that the SEC will challenge a valuation and ultimately bring an enforcement action. Additionally, Anderson stressed the importance of the following:
Rogers chimed in to provide a slightly different perspective as a former auditor, regulator, and forensic accountant who typically sees ‘bad actors.’ He observed that one of the biggest obstacles that auditors face is the inherent conflict between exhibiting professional skepticism with their client yet being hired and paid by that client and wanting to retain that business. Accordingly, it frequently makes it tough for auditors to ask the tough questions and to continue asking for documentation and support to meet professional standards that appropriately substantiates management’s assertions and validates their claim.
Rogers and Anderson focused the discussion on the KPMG/John Riordan matter, where Miller Energy paid $4 million to assume certain property rights in Alaska but later reported them in the financials as having a value of $480 million. Both noted that the sheer increase in price between what was paid and what was claimed raised a red flag to the SEC, and the failure on the part of the auditors to identify and question that valuation and obtain sufficient evidence to support the increase.
Anderson noted that the SEC, in the enforcement action, identified a series of other red flags including a “lack of common sense” (i.e., a lack of professional skepticism) which he noted was ‘typical’ in SEC actions involving auditors. Anderson emphasized the importance of reasonableness and making sure that the valuations fundamentally make sense. He also noted that in the KPMG/John Riordan matter there seemed to be “one foot fault after another” in the audit of Miller Energy. Anderson also pointed out that Miller Energy sought to raise money in the public markets which directly relates to the SEC’s function – to protect investors, especially where the company fails shortly after.
Anderson briefly discussed the case, SEC v. Ken Alderman, et al., from June 2013, which was brought as a result of the market distress from 2007-2008 and related to six Morgan Keegan funds. In that case, the SEC brought charges against eight directors of the funds who were ultimately censured as part of a settlement. While lawyers had drafted the valuation related policies and procedures, the main issue in the case was that the directors did not understand, or attempt to understand, the policies, procedures, or process that were implemented by the funds. Anderson noted that in the Consent Order the SEC detailed the responsibilities of the various parties surrounding valuation, and when the parties could rely on information provided.
Finally, there was a question from the audience as to whether there had been any enforcement actions related to the understatement of the valuation of assets. Rogers noted that the SEC has traditionally been focused on the issue of overstatement rather than understatement, however, the SEC will also raise questions where an asset is carried at a low amount but at the time of sale there is a “large” mark-up. He went on further to state that in such a scenario the regulators may believe that that fund is creating a “cookie jar” type reserve, especially when the fund is otherwise performing well relative to the market. Brawner indicated that assets should be valued based on what is occurring in the market, so the valuation of assets should go up and down accordingly – not merely moving in one direction.
Last, Morton reminded that audience that valuation not only needs to be performed on hard-to-value assets, but also liabilities. Accordingly, a lot of the risk of understatement relates to liabilities more than assets – that is, understating a liability.
See the first installment for the panel discussion on why valuation is an enforcement priority for regulators, common valuation related issues, and relevant accounting guidance, and the second installment for the panel discussion on best practices around valuing Level III assets and the benefits of using an independent third-party valuation specialist.