Regulatory Challenges in Illiquid Asset Valuation Litigation Lessons Learned and an Outlook for 2020
Regulatory Challenges in Illiquid Asset Valuation Litigation Lessons Learned and an Outlook for 2020
We examine some of the important takeaways from SEC and DOJ investigations and offer guidance for future proceedings.
In August 2019, the American Institute of CPAs (AICPA) issued the Accounting and Valuation Guide: Valuation of Portfolio Company Investments of Venture Capital and Private Equity Funds and Other Investment Companies (the “Guide”). The Guide provides an overview and understanding of the valuation process – in particular for illiquid assets – 13 years after the Financial Accounting Standards Board (FASB) first issued FAS 157 (now ASC 820), kicking so-called mark-to-market accounting into high gear.
Although the AICPA has targeted the Guide toward “professionals working in the [private equity/venture capital] industry,” another group might benefit from the Guide’s practical approach to valuing illiquid assets: attorneys at the Securities and Exchange Commission (SEC) and the Department of Justice (DOJ).
The combination of ASC 820’s fair value hierarchy in late 2006 and the financial crisis in 2007-08, which created massive uncertainty around the value of all kinds of assets, spawned several dozen SEC and DOJ investigations and litigation over the last decade involving allegations of fraudulent valuations. As is commonly the case with litigation by the federal government, most of these cases settled. However, a few high-profile cases that did go through the rigors of litigation fell flat under close judicial scrutiny.
An examination of the government’s challenges in those cases may help avoid future misunderstandings in future SEC or DOJ investigations.
Statistical Aberrations May Not Be Evidence of Fraud
In December 2011, the SEC announced with great fanfare its Aberrational Performance Inquiry (API), which “uses proprietary risk analytics to evaluate hedge fund returns” and identifies “fraudulent valuation of portfolio holdings.”
Less than a year later, in October 2012, the SEC cited the API when it filed a federal lawsuit against a hedge fund advisor that invested in warrants, convertible debt, and convertible securities in small-cap companies and allegedly “fraudulently inflated values of the investments.” The Wall Street Journal’s headline at the time was characteristic of press coverage generally: “SEC Snares Fund Firm in Data Dragnet.”
After six years of litigation and reputational harm, a federal district court judge dismissed most of the case, finding “no material evidence of fraud or negligence,” and the SEC later dismissed the remainder of the case. According to a report about that dramatic reversal, “the majority of [the hedge fund’s] assets under management consisted of privately negotiated, custom securities, so an SEC tool that compared its returns to traditional equity market benchmarks would likely find its results ‘aberrational.’”
Assets and liabilities that are reported at fair value are required to be classified as Level 1, 2, or 3. The information available and its reliability determine at which level an asset can be classified.
- Level 1 values are taken from quoted prices in an active market of identical assets and liabilities.
- Level 2 values can be based on observable prices of similar assets and liabilities. These inputs are used in valuation techniques when there is no quoted price in an active market or where there is not enough frequency of transactions for identical assets.
- Level 3 values require the use of unobservable inputs in order to determine the value of an asset or liability when there is no active market for identical or similar assets or liabilities and there are no observable inputs. The unobservable inputs require independent judgement regarding market participant assumptions about the assets or liabilities and should use available information that can be reasonably found without incurring undue costs.
Given the significant judgement and assumptions regarding unobservable inputs, there is an inherent complexity and subjectivity to the valuation of all Level 3 assets. As a result of each asset and liability’s unique nature, Level 3 values do not fit well into a quantitative, statistically driven valuation or testing framework.
Lesson 1: When relying on statistics to identify valuation fraud, one cannot ignore the reality and complexities of financial valuation protocols.
Reasonable Minds May Disagree on Level 3 Valuations
In July 2016, the SEC brought an administrative action against a fund advisor for, among other things, “withdrawing money from the funds using valuations based on unreasonable assumptions, thereby draining the funds of liquidity at the expense of investors.” The fund had invested in legal receivables in connection with lawsuits, and collection was subject to ongoing litigation risk.
After a year of litigation, in August 2017, the SEC’s own administrative law judge (ALJ) dismissed all of the SEC’s valuation allegations. The SEC alleged that the fund advisor’s valuation method failed to appropriately take into account the litigation risk presented, for example, if a plaintiff’s attorney was unable to collect in a case. The ALJ, however, observed that the fund’s financial statements correctly stressed “the significant judgment and uncertainty” inherent in valuing Level 3 assets.
After several experts and the fund’s auditor testified in support of the fund’s risk discount rate and valuations, the ALJ dismissed the valuation claims, criticizing the SEC’s “implied premise that the valuation model should have explicitly distinguished between ‘something that’s valued at a dollar because there’s a 100% chance you’re going to get the dollar and something that’s valued at a dollar because there’s a 50% chance you’re going to get $2.’”
As previously noted, the determination of value of a Level 3 asset or liability is based on unobservable inputs. Given the managerial judgement required, the disclosure and presentation of the assumptions used in the valuation methods when determining the fair value of Level 3 assets and liabilities is always a careful exercise meant to be as informative as possible. Fair value standards require issuers to annually disclose the inputs and techniques used to measure fair value as well as any discussions regarding changes in inputs and techniques. While not required by the fair value standards, an understanding and presentation of sensitivity analyses of fair value estimates and inputs should be maintained. Ultimately, a consistent and transparent valuation process will minimize regulatory issues.
Lesson 2: Application of judgment in the face of uncertainty may result in different valuation conclusions that are not necessarily fraudulent.
Failure to Mark Down an Asset in Response to Adverse Events May Not Be Fraudulent
In December 2016, federal prosecutors brought criminal charges against executives at a hedge fund advisor alleging, among other things, a $1 billion securities fraud scheme involving the inflation of the value of illiquid assets. In public statements announcing the indictment, prosecutors said, “The world finally got to see that [the hedge fund] held no more value than a tarnished piece of cheap metal.”
One of the government’s key allegations was that an oil production platform explosion put one of the fund’s primary assets under severe stress and deprived the asset of “the necessary cash flow and profits to justify” the fund’s valuation of that asset.
Almost three years later, in June 2019, and after weeks of trial in front of a jury, the federal judge dismissed the government’s fraudulent valuation claims. The judge observed that the fund advisor hired outside firms to review its valuations at the time, and the government had “not even introduced witnesses who purport to be qualified to challenge these valuations.” The judge noted that “values of Level 3 assets … are, by definition, difficult to value.”
Valuation is a forward-looking exercise. It is the present value of future cash flows that defines value, and therefore historical events are only relevant in so far as they influence and indicate what will likely occur in the future. However, when a severe historical event appears, it should not be viewed in isolation. An example of this is the common practice of adjusting a company’s earnings to exclude the impact of a one-time event prior to the application of a valuation multiple. This practice normalizes historical earnings in an attempt to better estimate future performance.
The valuation of illiquid assets is becoming an increasingly heavily scrutinized topic. Best practice in the valuation of Level 3 assets and liabilities includes:
- Developing and following a valuation policy. A valuation policy should establish a consistent and transparent process for determining the fair value of all financial assets and should address all aspects of the valuation process including:
- Valuation principles and guidelines
- Allocation of responsibility and authority and the functions of a valuation committee
- Process description and procedural guidelines
- Process timeline
- Using an independent third party. The use of an independent firm to assist in the valuation of illiquid assets has become more common. Benefits include an objective valuation perspective, confidence that the latest best practices will be followed, and a decrease in the time that is required to be spent on valuation by funds and managers internally.
- Referencing the AICPA Guide. The Guide was developed to provide guidance, examples, and case studies for preparers of financial statements, independent auditors, management, and boards of directors of investment companies, professionals who prepare valuation analyses, and other interested parties regarding the accounting for and valuation of portfolio company investments of venture capital and private equity as well as other investment companies. The Guide focuses on measuring fair value for financial reporting purposes. Estimating fair value is as much art as science; the principles and examples provided by the Guide are intended to bring clarity and accuracy to the valuation of investments. While the Guide is not authoritative, it has already become the primary source of best practice for the periodic valuation of illiquid assets.
- Documenting all of the above. It is important to document the processes, policies, and procedures taken to ensure a detailed and robust approach that aligns with the Guide. This will help minimize regulatory risk.
Nick Morgan, JD
Partner, Paul Hastings LLP
- Press Release, "SEC Charges Multiple Hedge Fund Managers with Fraud in Inquiry Targeting Suspicious Investment Returns," Securities and Exchange Commission, December 1, 2011.
- Press Release, "SEC Charges Hedge Fund Adviser and Two Executives With Fraud in Continuing Probe of Suspicious Fund Performance," Securities and Exchange Commission, October 17, 2012.
- Jean Eaglesham, "SEC Snares Fund Firm in Data Dragnet," The Wall Street Journal, October 17, 2012.
- Francine McKenna, "How the Pursuit of the Next Bernie Madoff Led to an Embarrassing SEC Loss in Court," MarketWatch, June 5, 2018.
- Securities and Exchange Commission Administrative Proceeding, "In the Matter of RD Legal Capital, LLC and Roni Dersovitz," July 14, 2016.
- Press Release, "Platinum Partners’ Founder and Chief Investment Officer Among Five Indicted in a $1 Billion Investment Fraud," The United States Attorney's Office for the Eastern District of New York, December 19, 2016.