Insight Center: Publications

The SEC Is Scrutinizing Asset Valuations-Are You Ready?

Client Alert

Authors: Jay A. Dubow and Andrew J. Pinkston


The Securities and Exchange Commission (SEC) 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, N.J. 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 (BDC), 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 SEC initiated proceedings against eight former members of the boards of directors overseeing five Memphis, Tenn.-based mutual funds for violating their asset pricing responsibilities (Mutual Funds 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 SEC now must do so under the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank).

The KCAP case is notable due to its allegation that ASC Topic 820 was not followed. ASC Topic 820 defines “fair value,” establishes a framework for measuring fair value for purposes of generally accepted accounting principles (GAAP), and expands disclosures about fair value measurements. Issued in September 2006, FAS 157, now ASC Topic 820, was designed to reduce confusion over the varying definitions of fair value and limited guidance for applying those definitions when applying GAAP. While the FASB stated that ASC Topic 820 did not expand the use of fair value in any new circumstances, those subject to this accounting standard must be aware of how it may affect their valuation and disclosure policies. Pursuant to ASC Topic 820 are requirements:

  • defining “fair value” as an exit price, which reflects the price that would be received to sell an asset in an orderly transaction between market participants at the measurement date. ASC Topic 820 is a market-based measurement, not an entity-specific measurement, and should be determined based on assumptions market participants would take into account when pricing the asset, such as credit worthiness and current market conditions
  • identifying three broad approaches to measure fair value: the market approach, the income approach, and/or the cost approach
  • establishing a fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value into three broad levels:
    • Level One inputs: observable inputs, such as quoted prices in active markets for identical assets or liabilities
    • Level Two inputs: observable inputs, such as quoted prices for identical or similar liabilities in markets that are not “active”; inputs other than quoted prices that are observable for the asset or liability; inputs that are derived principally from or corroborated by observable market data
    • Level Three inputs: unobservable inputs, such as the use of the reporting entity’s management estimates of the assumptions that market participants would use in pricing the asset or liability, based on the best information available.
  • requiring disclosures about fair value measurements including a description of transfers between Level One and Level Two assets and the disclosure of inputs used in valuation.

According to the SEC, 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, it was determined that certain KCAP assets had been overvalued by as much as 300 percent. The SEC found that KCAP’s overvaluation and internal control failures violated the reporting, books and records, and internal control provisions of the federal securities laws. As a result of the proceedings, 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 Yorkville action, the SEC alleged 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 executives:

  • failed to adhere to its stated valuation policies
  • ignored negative information about certain investments 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.

In the Mutual Funds Action, significant portions of the funds’ assets contained debt securities backed by subprime mortgages. The SEC determined that from January through August 2007, the funds overstated the value of their securities. 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 (Directors). The SEC 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.

This action is significant in holding directors responsible for valuation failures. Additionally, the SEC’s press release announcing the institution of the Mutual Funds Action stated that the SEC Enforcement Division’s Asset Management Unit “continues to prioritize asset value investigations….” This prioritization is significant, since the passage of Dodd-Frank requires more than 1,500 private fund advisers to be registered with the SEC for the first time. Dodd-Frank also generally extended the Investment Advisers Act of 1940 (the Advisers Act) registration to advisers to hedge funds and many other private funds by eliminating the private adviser exemption.

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 Three inputs to value such assets. In cases in which markets are inactive or where transactions in the market are forced or distressed, Level Three 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 SEC and comply with the Advisers Act and SEC rules.

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 SEC (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:

  • marketing
  • portfolio management
  • conflicts of interest
  • safety of client assets, and
  • valuation.

Pepper Points: 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 Three assets, since such Level Three asset valuation relies 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. We can expect an increase in SEC investigations and enforcement actions relating to asset valuation. It is important to be prepared.

Jay A. Dubow and Andrew J. Pinkston

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