The proper valuation of client assets is of critical importance for investment advisers.
A failure on the part of firms to properly value assets adversely affects key areas of fund operations, including but not limited to:
- Over or under payment of withdrawal proceeds
- Incorrect calculation of fees
- Inaccurate performance reporting
In a recent case that demonstrates the attention focused on correct valuation procedures by regulatory officials, Deer Creek Management settled charges handed down by the Securities and Exchange Commission (SEC), which claimed that Deer Creek's advisers had failed to value securities in a method compliant with the law.
The charges led to penalties in excess of $5 million and a cease and desist order prohibiting further violations related to its valuation policies and procedures.
The SEC Action Against Deer Creek: Violating the Compliance Rule
The SEC charged Deer Creek with failing to meet compliance standards contained in Section 206(4) and Rule 206(4)-7 thereunder of the Advisers Act (the Compliance Rule), which specifically require all registered investment advisers (RIAs) to develop, adopt, and effectively implement written policies and procedures reasonably designed to prevent inaccurate valuations and the negative effects that often follow.
"Deer Park's pervasive compliance failures allowed its traders to mark assets up gradually instead of marking them to market, in violation of the accounting principles they were required to follow," said Daniel Michael, Chief of the SEC Enforcement Division's Complex Financial Instruments Unit.
Further, the SEC order specifically states:
"Deer Park may have undervalued certain client assets by failing to maximize relevant observable inputs, such as trade prices. For example, contemporaneous explanations for certain valuations include references to market activity at a higher price than the valuation and "sell[ing] for a profit when needed."
Deer Creek, according to the SEC, failed on all fronts to meet Compliance Rule standards:
- Deer Creek's ineffective valuation policies failed to ensure compliance with Generally Accepted Accounting Principles (GAAP);
- Deer Creek's policies were not reasonably designed to meet the needs of its business practices, considering its use of valuation models and pricing vendors;
- Deer Creek's policies and procedures failed to address the potential conflict of interest stemming from traders determining for themselves the fair value assessment of a portion of the assets they manage; and
- Deer Creek did not effectively implement the limited policies it did have in place, possibly undervaluing certain client assets by failing to maximize relevant observable inputs, including trade prices.
In short, compliance with the applicable laws would have prevented Deer Creek's traders from undervaluing securities and selling for a profit when needed.
The Importance of Proper Valuation Policies and Procedures
Often, valuation can be straightforward when utilizing securities that have readily available market. However, if you're portfolio includes difficult to value securities (i.e., private investments), firms must develop their own valuation processes and procedures.
In the event that your firm falls into the latter category, the Deer Creek case should clearly emphasize to you the importance of:
- Developing effective valuation processes reasonably designed to meet the compliance standards clearly laid out in the law; and
- Conducting frequent reviews that include the testing of those procedures to be sure all involved parties are properly valuing their securities in accordance with firm policies.
The development of compliance policies and procedures related to asset valuations, as well as the implementation of effective testing protocols designed to ensure policies meet regulatory standards, pose significant challenges for many firms.
However, the importance of these policies and procedures cannot be overstated.
Failure in these areas is likely to draw the unwanted attention of regulatory authorities and could result in unwanted enforcement action.
Should your firm require assistance in this area, or if you have any other legal concerns, contact Jacko Law Group, PC.
- Senior Associate
Mr. Boeche provides strategic legal counsel to investment advisers, broker-dealers, private funds and other financial professionals. Mr. Boeche advises clients on all aspects of formation, registration, and ongoing ...
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