Recently, the SEC’s Enforcement Division has brought three matters focused on alleged flaws (and fraud) in connection with valuation issues. Together these actions make clear that the SEC is and will be looking hard at how public companies as well as financial firms make difficult and subjective valuation decisions. Specifically, the SEC will be looking to see whether firms, and individuals, followed proper processes and applied the correct inputs in reaching these judgments. These cases also make clear that, even in times of significant market disruption, firms cannot ignore or substantially discount market inputs in making valuation judgment.
In November 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 to properly value certain assets. FAS 157 requires expanded disclosures and incorporates a strong preference for market inputs to determine fair value. According to FAS 157, “[e]ven 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; the order addressed valuation decisions KCAP made in late 2008 and early 2009 relating to its primary assets, debt securities, and collateralized loan obligations (CLOs). Specifically, the SEC’s order found that KCAP had classified all of its debt securities as illiquid and also made the assumption that certain quotes from a third-party pricing service did not truly reflect fair value. KCAP similarly decided not to use market-based pricing in valuing certain CLOs and instead used the cost that it paid for them. In May 2010, KCAP restated results for this time period and, in doing so, used market values for various debt securities; it also concluded that it had substantially overvalued certain CLOs. The SEC’s order found that KCAP’s original pricing decisions violated FAS 157 and, although KCAP itself paid no penalties, three of its officers 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 October 2012, the SEC alleges that 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 allegedly provided loans to such companies in return for a promissory note or bond. The underlying funds’ private placement memoranda and internal policies allegedly required Yorkville to follow GAAP, including recording investments at fair value, when calculating the net worth of each fund.
The SEC’s complaint contends that, before the financial crisis, most of Yorkville’s income came from selling converted shares into the open market. However, as the market contracted, Yorkville’s approach allegedly become much less lucrative. The SEC alleges that, in the face of these financial pressures, 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.
Alderman (Morgan Keegan)
Finally, in December 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., and two individuals. That action, which was settled in April 2010, related to many of the same issues alleged in the December 2012 action.
The SEC contends that defendants improperly valued the assets of eight underlying funds from March 31, 2007 through August 9, 2007. Although the order instituting proceedings includes many assertions regarding day-to-day practices of the board’s delegates, the most noteworthy allegations focus on the board members themselves. The SEC contends that the directors failed to comply with their obligations to “determine the method of arriving at the fair value” of securities for which market quotations were not readily available; did not “continuously review the appropriateness of the method to be used in valuing each issue of security”; upon delegating these responsibilities, did not provide “meaningful substantive guidance” on how valuation determinations should be made; and “made no meaningful effort to learn how fair values were actually being determined.”
Taken together, KCAP, Yorkville, and Alderman suggest that the SEC intends to take a more aggressive approach toward substantive and procedural valuation decisions. All three actions challenge specific valuation determinations and the extent to which those determinations allegedly deviated from the “true” value of assets. Importantly, these actions consistently reject the idea that market dysfunction during the financial crisis justified disregarding actual market inputs. Yorkville and Alderman also focus intensely on the processes used in making valuation decisions, criticizing 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.
In light of these actions, as well as other SEC initiatives that relate to valuation issues, 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.