Putting a Premium on Illiquidity: Some Reflections on the SEC’s Scrutiny of Valuation Practices and Disclosures
Valuation is typically near the top of the list when the SEC’s enforcement division and exam staff disclose their priority topics for private funds. We expect that trend to continue and, if anything, the focus on valuation is likely to increase, especially as the market for unicorns shakes out.
That said, the SEC rarely challenges valuations per se, given the significant judgment required to determine the fair value of Level 3 assets. Instead, the SEC focuses on issues “around” valuation practices, including: (1) breakdowns in controls/policies/procedures; (2) violations of Generally Accepted Accounting Principles (GAAP); and (3) disclosures to investors and auditors.
Recently, the SEC has brought enforcement actions based on the following scenarios:
Allegations that an investment adviser significantly marked up a fund’s largest holding, made misleading disclosures concerning the manner in which assets were to be valued, and failed to adopt and implement adequate compliance policies.
Allegations that an investment advisory firm misled investors by stating that it had obtained independent price quotes for certain unlisted securities, when in fact it had given its own internal valuations to a broker-dealer to pass off as its own.
Allegations that an asset management firm failed to disclose that the valuation methodology used was different from that disclosed in the fund’s public filings, and failed to disclose a material valuation change – the early termination of an option at a materially lower valuation than had been recorded.
These cases underscore the importance of: (i) implementing robust valuation policies and procedures; (ii) ensuring that the manager actually follows them; and (iii) making full, complete, and accurate disclosures regarding asset valuation.
With respect to disclosures, the SEC may pursue claims for antifraud violations that do not require a showing of scienter if the disclosures to investors are materially inaccurate in light of the manager’s valuation practices. Typical examples of claims include alleged violations of Section 206(2) of the Advisers Act (fraudulent transaction, practice or course of business), Section 206(4) and Rule 206(4)-8 under the Act (fraudulent conduct relating to investors in a pooled investment vehicle), and Sections 17(a)(2) and 17(a)(3) of the Securities Act (misstatement/omission and scheme liability, respectively). In addition, the SEC is likely to explore claims under Rule 206(4)-7 under the Advisers Act (the Compliance Rule), for alleged failure to adopt and implement written policies and procedures sufficient to detect and prevent the misleading valuation disclosures.
The SEC may also explore claims based on GAAP accounting violations when valuation concerns are raised. In the context of publicly-traded companies, the SEC has pursued valuation claims focused on improper accounting treatment for real estate assets or CDO-related derivatives that declined in value during the financial crisis. Similar concerns may apply to private fund managers. Accounting issues not only affect valuation disclosures (e.g., regarding GAAP compliance), but also can give rise to violations of the Advisers Act’s books and records provisions as well as the Compliance Rule.
Looking ahead to a potential examination, the first valuation question that an SEC examiner is likely to ask is whether the firm has formal, documented valuation policies. From there, the questions will probe whether the firm has followed those policies to the letter. The examiner is also likely to scrutinize related valuation disclosures made to investors and the fund’s auditors. This is especially true when firms are dealing with Level 3 assets, or otherwise illiquid or hard-to-value assets.
The lesson here is that getting the valuation “right” is necessary but not sufficient. Managers must also implement robust valuation policies and procedures, and follow them to the letter.