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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.

© 2019 Proskauer Rose LLP.

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About this Author

Joshua Newville, Proskauer Rose, regulatory enforcement attorney, industry compliance legal counsel, securities exchange commission lawyer
Partner

Joshua M. Newville is a partner in the Litigation Department in New York. His practice focuses on commercial litigation and regulatory investigations. Mr. Newville advises companies and individuals in securities litigation and compliance matters. He also focuses on internal investigations and enforcement matters. Prior to 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...

212-969-3336
Michael R. Hackett, Litigation Attorney, Proskauer Law Firm
Associate

Michael R. Hackett is an associate in the Litigation Department and a member of the Asset Management Litigation practice. His practice focuses on disputes and regulation involving private funds, including private equity, venture capital, hedge, real estate and private credit funds, as well as other limited partnerships, where he regularly advises funds, fund sponsors, investment advisers and institutional and individual investors.

Mike’s experience representing private fund clients runs the gamut, from control contests within advisers, to disputes between limited partners and general partners, to representation of investment advisers in connection with regulatory examinations, investigations and enforcement matters.  Mike also routinely represents fund sponsors and their portfolio companies, including in significant post-closing disputes. 

In addition to his private funds practice, Mike represents public and private companies in a variety of complex commercial and securities litigation matters.

Mike has been named a “Rising Star” by Massachusetts Super Lawyers, and was identified as an “associate to watch” by Chambers USA in 2017 and 2018.

During law school, Mike served as an intern judicial clerk to the Honorable William G. Young of the United States District Court for the District of Massachusetts.

617-526-9723
Timothy W. Mungovan, Litigation Attorney, Proskauer Law Firm
Partner

Timothy Mungovan is a Partner in the Litigation Department, co-head of the Private Investment Funds Disputes practice and a member of the Private Investment Funds Group. Tim has an international practice in complex commercial litigation, advising public and private companies in a variety of areas, including securities, corporate governance, fiduciary obligations, investment management and financial services, fraud and trade secrets.

In addition to his regular commercial litigation practice, Tim focuses on disputes involving private investment...

617-526-9412, 212-969-3201