Recently, the Enforcement Division of the SEC has brought three separate matters, all focused on alleged flaws (and fraud) in connection with valuation issues. These matters, KCAP Financial, Inc.,1 Yorkville Advisors,2 and Alderman,3 all involved valuation judgments made during the financial crisis, and all three turn on whether fair value principles were properly applied—that is, whether the values assigned reflected the “price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.”
These matters make clear that the SEC intends to take an increasingly aggressive approach in this area. In each, the SEC emphatically rejected the notion that market distress –indeed, even very great market distress – is sufficient to permit firms to ignore market inputs in reaching valuation decisions. The SEC also focused on process as a critical part of valuation judgments. Finally, each of these actions includes claims against individuals, and Alderman names only individuals. Taken together, these three actions suggest that individuals and corporations alike should focus closely on valuation issues going forward.
On November 28, 2012, the SEC filed and settled In The Matter of KCAP Financial, Inc. This was the first action in which the SEC alleged that a public company had violated the provisions of Financial Accounting Standard (FAS) 157 by failing properly to value certain assets.
FAS 157, which became effective for KCAP in the first quarter of 2008, defines fair value and requires expanded disclosures regarding fair value measurements. Under FAS 157, the “highest priority” is given to quoted prices in active markets for identical assets or liabilities; the “lowest priority” is given to instances where there are no market inputs and management must instead estimate the assumptions that market participants would use in pricing the asset. The preference for market inputs is very strong, and FAS 157 specifically provides that “even in times of market dislocation, it is not appropriate to conclude that all market activity represents forced liquidations or distressed sales.”
According to the SEC's Order, KCAP is a closed-end investment company that is regulated as a business development company. In late 2008 and early 2009, KCAP's valuation decisions affected its two primary types of assets – debt securities and collateralized loan obligations (CLOs). KCAP classified all of its debt securities as illiquid and furthermore made the assumption that certain quotes from a third-party pricing service did not truly reflect fair value. KCAP based this assumption on its belief that the trades reflected distressed transactions and thus were not accurate reflections of the assets' value. This decision led to relatively high values being placed on those securities. For example, KCAP valued a debt instrument issued by Ford Motor Credit Company at 70 percent of par even though market inputs allegedly suggested ranges well below 50 percent of par. KCAP similarly decided not to use market-based pricing in valuing certain CLOs during the same period. Instead, it valued those CLOs at the cost that it paid for them, which also resulted in values much higher than market conditions might have suggested. In May 2010, KCAP restated results for the third quarter of 2008 and the first quarter of 2009. In doing so, KCAP used market values for various debt securities; it also concluded that it had substantially overvalued certain CLOs.
The SEC rejected these judgments and contended that KCAP's pricing decisions violated FAS 157 and thus various provisions of Section 13 of the Exchange Act. In essence, the SEC alleged that KCAP did have market data with which to reach an accurate fair valuation (as evidenced by the restatement) but that KCAP simply did not want to acknowledge the significant loss in value that would result from properly applying FAS 157. Although KCAP itself paid no penalties, three of its officers –its chief executive officer, chief investment officer, and chief financial officer – agreed to pay penalties totaling $125,000 for violating the reporting, books and records, and internal controls provisions of Section 13 of the Exchange Act.
In the Yorkville matter, filed on October 17, 2012, the SEC alleges that Yorkville, a hedge fund advisory firm, and two of its executives deliberately overvalued the amount of assets under management to hide losses and to increase fees. According to the SEC, Yorkville is an investment advisor that typically invests in start-ups or distressed public companies; during the time period at issue, it is alleged to have provided loans to such companies in return for a promissory note or bond. The SEC's complaint alleges that the underlying funds' private placement memoranda and internal policies required Yorkville to follow GAAP, including recording investments at fair value, when calculating the net worth of each fund.
According to the SEC's complaint, before the financial crisis, most of Yorkville's income came from selling converted shares into the open market. The SEC contends, however, that as the market contracted, Yorkville's approach became much less lucrative, and its funds' returns consisted “primarily of unrealized gains from marked-up investments and accrued (and unpaid) interest payments on the loans issued by the Funds as opposed to trading profits.”According to the complaint, these market pressures prompted Yorkville to value its assets improperly, purportedly to inflate the company's net worth and thus management fees. The SEC alleges that, from July 31, 2008, Yorkville “deliberately ignor[ed] obvious decreases in value to certain of its investments, fail[ed] to subject those investments to Yorkville's stated valuation policies, and caus[ed] those investments to be carried at inflated values.” As to the convertibles, which were a particularly important aspect of Yorkville's business, the SEC contends that the valuation committee “simply valued the vast majority of the convertibles at their face value rather than at ‘current, fair and accurate market valuations.’”The complaint identifies seven separate investments that Yorkville purportedly overvalued by at least $50 million as of December 2008 and $47 million as of December 31, 2009.
Finally, on December 10, 2012, the SEC filed an action against eight board members of mutual funds run by Morgan Keegan, including founder Allen B. Morgan. This follows an earlier action against Morgan Asset Management, Inc.; Morgan Keegan & Company, Inc.; James Kelsoe, Jr.; and Joseph T. Weller. That action, which was settled in April 2010, related to many of the same issues alleged in the December 2012 action.
As in the Yorkville and KCAP matters, the SEC's claims challenge decisions made during the financial crisis. The eight funds at issue invested most of their assets in structured products that included collateralized debt obligations, collateralized mortgage obligations, and similar instruments. For many products, no market quotations were readily available, so the funds' boards had to make fair value determinations. The SEC alleges that the funds ultimately materially misstated their net asset values from at least March 31, 2007 through August 9, 2007.
The SEC's claims focus on the board's role in these alleged valuation errors. The order instituting proceedings acknowledges that a board need not determine asset valuations itself but emphasizes that if a board “appoint[s] persons to assist …in the determination of such value,” the board must “continuously review the appropriateness of the method used in valuing each issue of security in the company's portfolio.” The order instituting proceedings asserts that the task of assigning fair values on a daily basis was actually performed by “Fund Accounting,” which was staffed by Morgan Keegan employees. According to the SEC, however, the board did not engage in the requisite “continuous review,”and Fund Accounting did not use “any reasonable analytical method to arrive at fair value.”
Although the order instituting proceedings includes a variety of assertions regarding Fund Accounting's deficiencies,4 the most noteworthy allegations focus on the role of the board members and their alleged failures to involve themselves in valuation decisions or to provide guidance to board delegates. The order instituting proceedings criticizes many aspects of the board's own process and contends that the board both gave and received inadequate information regarding these issues once it had delegated valuation decisions. (For example, the SEC alleges that the report from the valuation committee to the board consisted of a “one-page, two-paragraph narrative that was largely uninformative” because it did not explain how fair values were determined and gave no details on the process used.)
In summary, the SEC contends that the directors:
Taken together, KCAP, Yorkville, and Alderman suggest that the SEC intends to take a much more aggressive approach towards valuation decisions – both substantive valuation determinations and the processes surrounding such determinations – and to increase its focus on individual defendants.
With respect to the valuation issues themselves, all three actions challenge the specific valuation determinations and the extent to which those determinations allegedly deviated from the “true” value of assets.
Importantly, these actions all reject the idea that market dysfunction during the financial crisis justified disregarding actual market inputs. Yorkville and Alderman also examined the processes used in making valuation decisions and criticized allegedly deficient internal processes and alleged failures to implement meaningful guidance. For example, both cases examine closely the purported conduct of valuation committees and how those committees performed their assigned roles.
This focus on complex valuation determinations as well as the processes used to make those decisions is consistent with recent initiatives by the SEC (such as its Aberrational Performance Inquiry) and related public statements. To take but one example, in January 2013, the head of the SEC enforcement division's Asset Management Unit cautioned private equity firms to take particular care in valuing illiquid assets, commenting that the SEC intended to look very closely at these issues. The emphasis on valuation issues is also consistent with the SEC's increasing use of more sophisticated analytical techniques and its improved technological capabilities.
In addition, the actions in Yorkville, KCAP, and Alderman may reflect the pressure that the SEC faces to bring more actions against individuals. All three of these cases focus intensely on the conduct of individuals and the extent to which they personally undertook appropriate steps to properly value assets. Indeed, Alderman names only individuals, and only the individual defendants in KCAP paid penalties.
These three actions suggest that companies and individual officers and directors should focus closely on application of fair value principles, especially for complex or illiquid assets.
Moreover, the processes surrounding those determinations should be scrutinized anew to ensure that board members and individual employees and officers are complying with their obligations. Board members, officers, and responsible employees must make certain that they fully understand the nature of valuation decisions, how those decisions are made, who, precisely, has responsibility for valuing assets, and how those decisions and processes are documented.
Finally, and perhaps most basically, companies and individuals should understand that the SEC is simply not persuaded by the claim that a dysfunctional or volatile market necessarily eliminates the general obligation to rely on market inputs in valuing assets.
Christian Bartholomew is a partner at Weil, Gotshal & Manges LLP and leads the firm's securities enforcement and litigation efforts in Washington and Miami.
Jill Baisinger is counsel in the firm's Washington office and focuses her practice on regulatory and enforcement investigations, corporate counseling, and defense of securities class actions and shareholder derivative litigation in state and federal courts across the country.
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