Published in Business Law Today, April 2013. © 2013 by the American Bar Association. Reproduced with permission. All rights reserved. This information or any portion thereof may not be copied or disseminated in any form or by any means or stored in an electronic database or retrieval system without the express written consent of the American Bar Association.
The Securities and Exchange Commission (SEC or Commission) recently has set its sights on registered entities and their officers and directors for overvaluing the entities' assets.
On October 17, 2012, the SEC charged Yorkville Advisors LLC (Yorkville), a $1 billion Jersey City, New Jersey, hedge fund firm, and two of its executives with scheming to overvalue assets and exaggerate reported returns in order to hide losses and increase fees collected from investors. On November 28, 2012, the SEC accepted Offers of Settlement from KCAP Financial, Inc. (KCAP), a closed-end business development company, and three of its officers. The SEC claimed that KCAP did not record and report the fair value of its assets in accordance with the Statement of Financial Accounting Standards No. 157, "Fair Value Measurement" (FAS 157). FAS 157 is now Financial Accounting Standards Board (FASB) Accounting Standards Codification Topic 820 (ASC Topic 820). More recently, on December 10, 2012, the Commission initiated proceedings against eight former members of the boards of directors overseeing five Memphis, Tennessee, based mutual funds, RMK High Income Fund, Inc., RMK Multi-Sector High Income Fund, Inc., RMK Strategic Income Fund, Inc., RMK Advantage Income Fund, Inc., and Morgan Keegan Select Fund, Inc. for violating their asset pricing responsibilities (RMK Action).
These enforcement actions appear to be the start of a wave of such actions, especially since many investment advisers that historically were not required to be registered with the Commission now must do so under the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank).
These actions raise questions about the role and responsibility of an investment adviser or investment company's management and board of directors relating to fair value determinations in financial reporting matters.
In the Yorkville matter, the SEC filed an action in federal court alleging that the firm misreported values in the midst of the financial crisis in 2008 and 2009. The SEC charged that Yorkville's funds were able to attract more than $280 million in new investments from pension and other funds, as well as more than $10 million in excess fees, based on inaccurate asset valuations. In particular, the SEC alleged that Yorkville and its president and CFO failed to adhere to its stated valuation policies; ignored negative information about certain investments held by the fund; withheld adverse information about fund investments from the firm's auditor; and misled investors about the liquidity of funds, collateral underlying investments, and the use of a third-party valuation firm. Yorkville and the two executives are fighting the allegations.
In the KCAP Action, which was settled, the SEC alleged that during the 2008-2009 financial crisis, KCAP did not account for certain market-based activity in determining the fair value of its debt securities. Moreover, KCAP issued materially misleading public filings related to its collateralized loan obligation investments. The company claimed to incorporate market data into its financial valuations but the assets in question were instead valued based on KCAP's historical cost. On May 28, 2010, KCAP restated its financial statements for all four fiscal quarters of 2008 and the first two quarters of 2009. As a result of these restatements, the SEC determined that certain KCAP assets had been overvalued by as much as 300 percent. The Commission found that KCAP's overvaluation and internal control failures violated the reporting, books and records, and internal control provisions of federal securities laws. Two KCAP executives each were ordered to pay $50,000 in civil penalties and a third KCAP executive was ordered to pay a $25,000 civil penalty.
In the RMK Action, the SEC filed an administrative proceeding alleging that the value of significant portions of the funds' assets, which contained debt securities backed by subprime mortgages, were overstated. According to the SEC, this overvaluation was the result of a lack of leadership and guidance on fair valuation determinations by members of the funds' board of directors. The SEC has criticized the directors for delegating fair valuation responsibility to a valuation committee without providing guidance on how fair value determinations should be made, not reviewing the appropriateness of the methods used to value securities, not making meaningful efforts to determine the basis of fair value determinations, and not obtaining appropriate information explaining why particular fair values were assigned to portfolio securities.
Further evidence of heightened scrutiny by the SEC is reflected in a letter dated October 2, 2012, from the SEC Office of Compliance Inspections and Examinations (OCIE) to "Newly Registered Investment Advisers," introducing them to the National Exam Program (NEP). The OCIE examines registered advisers, including firms that advise private funds, to assess whether they are operating in a manner consistent with the federal securities laws. The OCIE is administering the NEP which is an initiative to conduct focused, risk-based examinations of investment advisers to private funds that recently registered with the Commission (Presence Exams). The examination phase is the actual on-site review conducted by the NEP staff that is directed to one or more higher-risk areas of the investment adviser's business and operations.
According to the OCIE, areas of interest include:
With this enhanced focus on valuation by the SEC what should hedge funds, private equity funds and other regulated entities do to avoid scrutiny and be best prepared for examinations?
Expert Accountants and Valuation Professionals are the New Norm
There was a time - not long ago - when the "historical basis" of accounting reigned supreme as the primary method of preparing a balance sheet. A company would record an asset or liability when purchased or incurred and so long as it was not impaired, then depreciate, amortize, or accrete it. There was also a time when accounting standards were far less complicated than today and CPAs did not require five years of university training to qualify. Those days are gone.
Indeed, some might legitimately argue the Codification of Accounting Standards has become as complex as the IRS Code.
What has not changed from the old days is the financial statement preparer's need to employ professional judgment. Financial statement readers must know that accounting estimates pervade the financial reporting realm and preparers often get it wrong - even when good professional judgment has been employed.
Balancing Fair Value against Hindsight
These conditions become amplified when dealing with fair value estimates because fair value is informed by and dependent in large measure on assessed future prospects. One more thing: financial statement readers and regulators enjoy the benefits of 20/20 hindsight.
Identifying Fair Value for Financial Statements
There are many financial statement captions for which a fair value determination must be made. Some examples follow.
Fair Value Hierarchy
Assets and liabilities subject to fair value are categorized into a three-level hierarchy based on the availability and reliability of the inputs used to value them. Level 1 assets and liabilities are simple to value since identical items are actively traded in open markets and price quotes are readily available. Level 2 assets and liabilities are more difficult to value since identical items are not actively traded. In this case, observable prices for similar items are used as a proxy. Level 3 assets and liabilities are the most difficult to value since no active markets exist for identical or similar items. Companies must rely on unobservable inputs based on their judgment and experience to value Level 3 assets.
Companies typically value Level 3 assets and liabilities using complex internal models or they may hire an outside valuation firm. Additional disclosure for Level 3 assets and liabilities is also required in the notes to the financial statements, including the methods and inputs used to arrive at the fair value determinations as well as a reconciliation of the beginning and ending balance. The increased focus on Level 3 assets is meant to give the reader of the financial statements a complete understanding of how the company valued these assets so that they can make more informed decisions.
Due to the highly judgmental nature of valuing Level 3 assets and liabilities, audit firms have come under scrutiny by the PCAOB regarding the sufficiency of audit testing of fair value determinations. The PCAOB (and the SEC) has called for increased audit documentation surrounding assumptions as well as for audit firms to gain a better understanding of the inputs and methodologies used in determining fair value. The increased scrutiny on the auditors will have a direct impact on company management, since the company must ultimately take responsibility and ownership of every fair value determination on the balance sheet - even if an outside valuation firm was used.
Is Your Organization Up to the Task?
Is the company comfortable that it has the expertise in house to value assets and liabilities?
Who is in charge of making fair value determinations (accounting, finance, treasury, separate valuation group)? What is their experience and credentials (CPA, CFA, ABV)?
What are the company policies surrounding determination of fair value and validation of the results? Are there specific policies for specific types of assets and liabilities? Are these policies consistently followed? Are there any exceptions to the policy and how are these exceptions reviewed with management?
What valuation models are used in the fair value determination of each asset or liability? What would be the impact of switching from one model to another or using an average of multiple methods? For key judgments in the fair value calculations (future cash flows, discount rate, risk premium, comparable transactions), how were they determined and what would be the impact on fair value if these key judgments changed (sensitivity analysis)?
Are there any indications of other than temporary impairment (OTTI) for assets in an unrealized loss position?
How are other companies valuing similar assets and liabilities? Can the company justify using the same or different methodologies? Does the company think its method is better than peer methods?
If fair value assets or liabilities were sold or settled during the period, what was the difference between the company's latest fair value determination and the actual sale price? What is the reason for any significant differences? If significant differences exist, is it an indication of a flawed fair value determination?
What percentage of assets or liabilities is fair-value based on internal models versus external pricing quotes? Does the company perform internal valuations to validate external pricing quotes, and vice-versa, does the company obtain external pricing quotes to validate internal valuations?
These cases should serve as a reminder to investment advisers and other regulated entities that the SEC is focused on proper valuation, reporting and oversight with regard to determining the fair value of assets. In particular, understanding ASC Topic 820 and its standards will be important, especially when using Level 3 inputs to value such assets. In cases where markets are inactive or where transactions in the market are forced or distressed, Level 3 unobservable inputs, such as management estimates and assumptions about the market, may be all that are available. ASC Topic 820 requires companies using these inputs to also report the methodology used to determine fair value. Hedge fund, private fund, and mid-sized advisers should take special note of the requirements of ASC Topic 820 as Dodd-Frank requires these advisers to register with the Commission and comply with the Advisers Act as well as SEC rules.
The SEC's stated focus and recent enforcement action should alert investment advisers, hedge funds, BDCs, and similar entities that the SEC plans to look more closely at their investments and methodology for valuing assets. In response, such entities must strengthen internal controls and processes and increase disclosure of decision-making inputs. This is all the more pressing for those entities that must value Level 3 assets since such Level 3 asset valuations rely on unobservable inputs that are usually firm-supplied estimates. There is a higher chance of misstatement or inaccurate assessments if a culture of accountability and review has not been put in place. With the expected increase in SEC investigations and enforcement actions relating to asset valuation, it is important to be prepared.
Jay A. Dubow and Anthony B. Creamer III
The material in this publication was created as of the date set forth above and is based on laws, court decisions, administrative rulings and congressional materials that existed at that time, and should not be construed as legal advice or legal opinions on specific facts. The information in this publication is not intended to create, and the transmission and receipt of it does not constitute, a lawyer-client relationship.