Determining the fair value of fund investments is a core compliance obligation, fraught with enforcement risk. The valuation landscape isn’t getting any easier.
As SEC Chairman Jay Clayton recently pointed out, “The way a fund values its investments is critical to our Main Street investors. It affects the fees they pay, the returns they receive, and the value of the fund shares they hold.”
Valuation Issues Examination & Enforcement Mainstays
Valuation issues are mainstays of SEC examinations and enforcement actions involving investment funds. Enforcement actions often include allegations that funds or fund advisers misstated the value of portfolio assets, or that funds failed to provide adequate disclosures around non-GAAP accounting, changes in valuation methodologies or the use of models. Many cases include charges that fund advisers failed to design and implement sound valuation policies and procedures.
This spring, the SEC Enforcement Division brought two actions involving fund valuation issues. These cases aren’t unique—if anything, they are illustrative of valuation issues we’ve seen in recent years—but they are worth considering.
In May, the SEC filed charges against TCA Fund Management Group, alleging the adviser improperly recognized revenue, resulting in inflated asset values and false performance results.
In late April, the SEC settled charges against Semper Capital Management, alleging the adviser overvalued certain “odd lots” positions in a mutual fund’s portfolio and, as a result, misled investors about the fund’s performance. Notably, the SEC was critical of the board’s delegation of valuation responsibilities, the valuation methodology employed by the fund adviser and documentation around the valuation of fund positions—all issues that are likely to feature prominently in future valuation enforcement actions.
It’s important to note that, like Semper, SEC valuation cases don’t always involve allegations of knowing—or fraudulent—misconduct. In fact, they often implicate simple compliance failures. For example, the SEC enforcement staff often points to a 2019 action against Deer Park to highlight valuation compliance issues the SEC is keen to root out.
In that case, the SEC alleged that a fund adviser failed to adopt and implement adequate policies and procedures relating to its valuation of fund assets. Deer Park’s policies and procedures were not reasonably designed, the staff said, “given its use of valuation models and pricing vendors, and the potential conflict of interest arising from traders’ ability to determine the fair value assessment of a portion of the positions they manage.”
Market Volatility Creates Valuation Challenges
Valuation models, pricing vendors and reliance on portfolio managers to price fund investments are standard tools in the valuation toolkit. But market volatility arising from the Covid-19 pandemic laid bare potential limitations of those tools, raising questions about whether (or how) funds can rely on those tools as part of a defensible valuation strategy.
In fact, a stark comment in a WSJ article captures the gravity of the current climate: “Nobody knows how to value a business right now,” said Paul Aversano, managing director at consulting firm Alvarez & Marsal. “There is no precedent for valuations really in this market.”
Addressing valuation challenges in this market, EY has drawn comparisons to the 2008 financial crisis, but the firm cautions that valuation in the time of COVID-19 poses “new challenges,” and regulators around the world are starting to ask questions. The SEC, EY says, is focusing on the accuracy and timeliness of pricing information available to funds and fund advisers.
SEC Rulemaking Will Change the Landscape
Against this backdrop, the SEC has proposed a new rule to modernize the framework within which fund boards can satisfy their valuation obligations. Broadly, the new rule “would establish requirements for determining the fair value in good faith of a fund’s investments and would permit boards to assign the determination to the fund’s investment adviser, subject to board oversight and certain other conditions.”
The proposed rule sets out certain practices that satisfy the “good faith” valuation requirement—things like periodically reassessing risks, testing alternative valuation methodologies, overseeing pricing vendors and treating differently assets for which there are no readily available market quotations. The proposed rule also details expectations for adequate board oversight, including fund advisers’ periodic and prompt reporting to the board.
Importantly, the new rule “would also require the adoption and implementation of written policies and procedures addressing fair value determination and the maintenance of certain records.” At the Securities Enforcement Forum West 2020, the SEC’s Deputy Director of OCIE suggested that documentation is where the rubber meets the road. Funds and fund advisers need more than “high-level” records around their valuation of fund positions. They need to document “qualitative and quantitative factors” the fund considered in determining the fair value of portfolio assets.
Implicit in that guidance is the idea that the valuation of assets for which there are no readily available market quotations involves inherently subjective elements. It is, therefore, critical—certainly, from an enforcement perspective—to detail the methodology and factors the fund or fund advisers considered to show that the fund engaged in a defensible process. This should include evidence that the fund or fund advisers adhered to applicable valuation policies and procedures.
Take Productive Steps in This Market
Establishing, or improving, valuation practices will be necessary not only to comply with the new rule, but to address current market conditions. There will undoubtedly be enforcement actions relating to the valuation of assets during the Covid-19 pandemic.
Funds that are wrestling with valuation issues should carefully document relevant factors considered, changes in their valuation methodology or amendments to applicable valuation policies and procedures. Documentation—building and reflecting a defensible process—will be key to mitigating potential negative enforcement outcomes.
In addition to steps funds and fund advisers can take internally, they should also consider whether to comment on the proposed rulemaking around good faith determinations of fair value. To date, only six comments have been submitted.
Market conditions arising during the Covid-19 pandemic tested firms’ valuation apparatus in relevant ways: how did firms delegate valuation responsibilities, how did boards oversee valuation, how did funds or fund advisers treat assets for which there are no readily available market quotations, how did funds or firms document or disclose changes to valuation procedures?
These issues are all core concepts in the proposed rulemaking. Firms are extraordinarily busy, and writing comment letters on proposed SEC rules may not be a priority, but firms should consider whether they can take what they learned during the pandemic and use it to craft thoughtful comments on the proposed new valuation rule.
Firms have until July 21 to submit comments on the rule proposal.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Kurt Wolfe is a member of Troutman Pepper’s White Collar and Government Investigations team, where he advises public companies, financial institutions, asset management firms, broker-dealers, and individuals in connection with internal investigations and regulatory enforcement actions. Follow him on Twitter at @Enforce_Update.