The SEC Pursues Fund Adviser and CFO for Missing Red Flags Associated with Rogue Employees and Fund Valuation

Stay up-to-date with the latest developments in securities law through access to both news and all statutes and regulations. Find relevant corporate filings through a searchable EDGAR database. And...

John Nowak Tram Nguyen Jeanette Kang

By John Nowak, Tram Nguyen, and Jeanette Kang

John Nowak is a partner in the Investigations and White Collar Defense practice at Paul Hastings. He represents corporate entities and their executives and boards in government inquiries and internal investigations involving accounting disclosures, sales practice abuse, securities violations, conflicts of interest, related party transactions and violations of the Foreign Corrupt Practices Act and False Claims Act. A significant portion of his practice has been devoted to representing financial services institutions and investment advisers, as well as their senior principals and traders, before the SEC, DOJ, CFTC, FINRA, and the Federal Reserve.

Tram Nguyen is a partner in the Investment Management practice of Paul Hastings. Ms. Nguyen represents hedge funds, private equity funds, and other private funds on all aspects of fund formation, fund structuring and capital raising. She has experience representing asset managers in structuring hedge fund-linked notes and customized single-investor funds. Ms. Nguyen also advises financial institutions and investment advisers on U.S. regulatory requirements, including registration and reporting requirements.

Jeanette Kang is an associate in the Investigations and White Collar Defense practice of Paul Hastings. She represents corporate entities, board members, officers and employees in government investigations and inquiries, as well as in internal investigations.

The Securities and Exchange Commission (“SEC”) recently announced that it settled charges against a registered investment adviser (the “Adviser”) for allegedly mismarking thinly-traded, over-the-counter debt securities and, as a result, causing the Adviser’s funds to have inflated performance numbers and net asset values. The mismarking conduct was orchestrated by two former portfolio managers (“PMs”), who were convicted of or pleaded guilty to the conduct in 2016 and 2017. The SEC alleged, among other things, that the Adviser missed certain red flags and that the Adviser’s valuation practices were inconsistent with the description of those practices in its written policies and procedures.

The SEC also charged and settled with the Adviser’s Chief Financial Officer (“CFO”) for allegedly failing to supervise the PMs. The SEC alleged that the CFO, who was in charge of fund valuation, missed red flags that should have caused a reasonable supervisor to question whether the PMs were engaged in unlawful conduct. The allegations against the CFO suggest that the SEC believed that the PMs’ conduct might have been uncovered if the CFO had followed securities valuation procedures in the Adviser’s disclosure documents and policies. Notably, the SEC’s theory of supervision was not that the CFO acted as the PMs’ supervisor in the traditional sense, but rather that the CFO supervised the process of fund valuation and thus had authority and control over the PMs in the context of the valuation process.

These settlements demonstrate the SEC’s continued willingness to pursue secondary claims against advisory personnel for the actions of other, rogue employees, and they should act as a reminder to advisory personnel that SEC investigations occur with the benefit of hindsight, where the SEC has the luxury of piecing together facts to identify red flags that may have not been so readily apparent (or so red) when first raised or waived. Advisory personnel are well advised to periodically review internal valuation procedures and practices to ensure their compliance with the Adviser’s written policies and disclosures, especially when confronted with new or unique valuation issues. Advisory personnel should also be mindful that dotted line reporting chains can give rise to secondary liability based on a perceived failure to supervise.

Background Underlying the Enforcement Action

The SEC’s allegations focus on the Adviser’s mismarking of thinly-traded, over-the-counter corporate debt securities to inflate the performance and net asset value (“NAV”) of the Adviser’s funds. According to the SEC, during 2011 and 2012, the two PMs asked outside brokers to supply the PMs with alleged “sham” quotes for securities held by the Adviser’s funds. The brokers allegedly complied with the PMs’ requests and sent fictitious price quotes to the PMs via email or instant message. The PMs in turn used the quotes as purported evidence of bona fide price quotes to support the PMs’ request that the Adviser increase the mark for some of the funds’ securities.

At month end, the funds’ independent administrator typically provided a list of securities prices from established sources to the Adviser to allow the Adviser to value the funds’ portfolio. The SEC alleged that the PMs, on a number of occasions, requested overrides of those prices using the sham broker quotes as support for the change in price. In other instances, when the administrator did not supply prices from established sources, the PMs would use the sham quotes as substitutes for actual prices. The SEC alleged that these false price quotes inflated the funds’ month-end NAV, which resulted in additional management and performance fees.

The SEC also alleged that the funds issued monthly reports to investors with false fair value classifications under Financial Accounting Standards Board Accounting Standards Codification Topic 820 (“ASC 820”). Essentially, the SEC alleged that the PMs created the perception that there were readily identifiable marks for many of the securities and that, as a result, the Adviser effectively altered the classification of those securities under ASC 820. The SEC alleged that, by altering the classification of the securities, the Adviser concealed the illiquid nature of those securities from the funds’ investors (who viewed liquidity as an important metric for assessing funds).

The SEC also claimed that the Adviser made false and misleading statements because publicly disclosed documents stated that the pricing function would be carried out by the accounting team that was “independent” of the PMs and trading desk. The Adviser’s valuation policies, which were made available to investors and potential investors, also explained that established pricing sources should be used for valuation purposes and that the Adviser could override those pricing sources only when the price provided from the established pricing source was inconsistent with fair value and where the Adviser could provide support for the alternative pricing. These policies noted further that, if an override was sought, it was “preferential” to obtain three dealer quotes, and the Adviser’s valuation committee should discuss and document the alternative pricing.

The CFO’s Supervision and Red Flags

The SEC did not allege that the CFO supervised the PMs in a traditional sense. Instead, the SEC alleged that the CFO supervised the valuation of the funds and was a member of the Adviser’s valuation committee. In that role, the SEC claimed that the CFO supervised the PMs because he had the ability to do the following:

1. to direct the PMs to obtain support for price overrides;

2. to decide how many quotes were required for support of an override; and

3. to reject quotes or overrides altogether.

In fact, the SEC noted that the PMs generally were supervised by the Adviser’s managing partner when it came to their day-to-day investment responsibilities.

The SEC alleged that the CFO missed certain red flags, and that as a result, he was liable for failing to supervise the PMs. Specifically, the SEC claimed that the CFO had visibility into the frequency with which the PMs requested price overrides, which appears to have varied between 8% and 38% during the month-end periods. The SEC also alleged that the CFO received a listing of valuations that identified the prices supplied by the outside administrator and its pricing source and the prices submitted by the PMs as overrides. Finally, the SEC claimed that, on at least three occasions, the CFO received reports indicating that the PMs’ quotes were significantly higher than contemporaneous valuations of securities held in a separately managed account managed by the Adviser. The SEC also noted that the CFO asked one of the PMs about the valuations, but “simply accepted as true” the PM’s representations that the overrides were reliable without taking any additional steps to verify the reliability of the broker quotes. Despite the allegations that there might have been red flags, the SEC did not allege that the CFO or the Adviser’s finance department knew that the PMs were obtaining sham quotes.

Questions and Takeaways

These settlements provide some insight into the SEC’s views on supervisory liability in the advisory context, but raise a number of significant questions. For example, the SEC did not allege that the CFO had any involvement—direct or indirect—in the conduct. The SEC did not even allege that the CFO knew about the PMs’ actions, or that he consciously recognized the import of the purported red flags. Instead, the SEC identified certain reports that were sent to the CFO that, according to the SEC’s analysis—which was performed in hindsight with full knowledge of the PMs’ conduct—demonstrate that the CFO received information showing the frequency of the PMs’ overrides and an apparent disparity between the PMs’ prices and the prices from the established sources. Moreover, the SEC’s allegations make plain that the CFO asked the PMs about the broker prices on occasion and that the PMs stated that the prices were supported by broker quotes. Under these circumstances, what more should the CFO had done? Even if the CFO could have done more, is it appropriate for the SEC to pursue secondary claims where the employees at issue were rogue, acting in apparent collusion with third party brokers? Moreover, why focus on the CFO and not the valuation committee as a whole, which itself allegedly did not document any findings concerning price overrides as acknowledged by the SEC? Lastly, why is it unacceptable (or at what point does it become unacceptable) for a CFO or senior principal to trust the response of a PM where the response is also supported by actual quotes provided by third party brokers?

In light of these settlements, and other recent actions by the SEC, advisory personnel should periodically review internal valuation procedures and practices to ensure that they are in compliance with the adviser’s written compliance policies and disclosures, especially when confronted with new or unique valuation issues documents. In this recent case, contrary to stated policies, the PMs played a substantial role in valuing the illiquid securities, which may have facilitated their ability to bypass polices designed to provide for independent pricing. As a result, Advisory personnel should also review the level of their own responsibility and authority with respect to the adviser’s practices and procedures to make sure that their actions are consistent with the expectations set forth in the adviser’s policies and procedures.

Copyright © 2018 Tax Management Inc. All Rights Reserved.

Request Securities & Capital Markets on Bloomberg Law