The SEC settled public administrative proceeding against a London-based hedge fund adviser that is not registered with the SEC (the “Adviser”) and its U.S. based, publicly-traded parent (the “Parent”) with respect to internal control failures that led to the overvaluation of the assets of two hedge funds managed by the Adviser. The SEC found that these failures caused the Parent to make misstatements regarding assets under management in its financial reports that were filed with the SEC resulting in violations Section 13 of the Securities Exchange Act of 1934 (the “Exchange Act”) and various rules thereunder.
This article provides a high level summary of the SEC’s detailed findings, which the Adviser and its Parent (together, the “Respondents”) have neither admitted nor denied, and of the sanctions imposed, as set forth in the settlement order.
The Adviser’s Pricing Policy
The Adviser’s pricing policy specified that all “Level 3” assets would be valued on a monthly basis by an independent pricing committee (the “IPC”) and “comprehensive documentation” would be maintained “to ensure the rationale supporting any judgments made is recorded and available for future reference.” (The term “Level 3” was not used to refer to the concept of Level 3 inputs under U.S. GAAP.)
However, beginning in 2009 the Adviser and the IPC began conducting an undocumented practice of holding “semi-annual private-equity reviews” in January and July, at which the IPC reviewed all the funds’ Level 3 assets. In addition, while there were established procedures for the documentation that was prepared for semi-annual review, there were no such procedures for the monthly reviews. For the monthly reviews, the SEC found that the Adviser’s accounting staff sporadically collected some changes in Level 3 pricing recommendations and other updates from the various fund managers. The SEC found that the lack of an established practice for the monthly reviews created confusion among the Adviser’s staff as to whether relevant information and pricing recommendations should be provided to the IPC monthly or semi-annually.
Pricing Activity Chronology
December 2007: A Cayman-based fund with U.S. investors that was managed by the Adviser (the “Fund”) made a $210 million investment that the Adviser categorized as a Level 3 asset (the “Company” or “the Level 3 Asset”).
Early 2008: The Adviser recommended that the IPC value the Level 3 Asset at $425 million based on, among other factors, the Company’s impending initial public offering, Company management’s aggressive expansion plans, and a recent spike in prices for the Company’s products. The IPC approved the increase and for the next 25 months the valuation of the Level 3 Asset remained at $425 million.
In addition, around this time, the independent auditor for the Adviser’s funds told the Adviser that it needed to give the IPC adequate time before making determinations to ensure that sufficient rigor was exercised with respect to valuations.
November 2008 through December 2010: The Adviser’s employees received, on numerous occasions, information calling into question the $425 million valuation and such information was not provided to the IPC. For example, as early as November, 2008 the Company’s IPO plans had been shelved, there had been a significant decline in the demand for the Company’s products, the Company had experienced significant shortfalls in its projected output, and the Company’s publicly-traded competitors experienced a sharp decline in their share prices. However, during this time period the Adviser did not provide this information to the IPC. In addition, certain of the Adviser’s employees had expressed an intention to obtain a third-party valuation of the Level 3 Asset but such third-party valuation was not obtained until January 2010.
January 2010: The Adviser obtained a third-party valuation in the form of a brief report from one of the fund’s brokers that was not fact-checked and was provided as a client accommodation. The report was obtained to help the Fund divest itself of its interest in the Company and not for the benefit of the IPC. The broker’s report provided a valuation of $350 million.
The Adviser provided the broker’s report to the IPC in a voluminous packet of information for all 37 of the Level 3 assets held by the Adviser’s funds the night before the IPC met for the January semi-annual review. Relying on information the Adviser provided on the cover page of the information packet rather than the third-party valuation inside, the IPC kept the Company’s valuation at $425 million.
June 2010: The Adviser continued its efforts to find a purchaser for the Fund’s interest in the Company and hired a global financial services firm to auction the Level 3 Asset and provide a more thorough valuation report.
September 2010: The Adviser received the valuation report in its final form and the midpoint valuation provided for the Company was $265 million.
January 2011: Despite the fact that the IPC routinely met on a monthly basis the Adviser did not set forth a recommendation to lower the Company’s valuation to $265 million until the January 2011 semi-annual meeting.
SEC Findings of Inadequate Internal Controls
The SEC found that the Adviser (i) failed to implement adequate controls to ensure information relevant to the valuation of Level 3 assets was provided to the IPC and, on various occasions, failed to provide material information to the IPC; (ii) failed to establish a mechanism to ensure the IPC had sufficient time to review pricing recommendations and, in certain instances, failed to provide the IPC with enough time to review recommendations; and (iii) failed to follow its own pricing policy directive that “comprehensive documentation” be maintained “to ensure the rationale supporting any judgments made is recorded and available for future reference.”
The SEC found that such failures resulted in the overvaluation of the Level 3 Asset by $160 million for 25 months, resulting in inflated management fees being remitted to the Adviser and, indirectly, to its Parent, totaling approximately $7.8 million.
The SEC found that the Parent’s SEC filings, press releases and investor presentations contained a number of misstatements related to assets under management that could be traced to the $160 million overvaluation by the Adviser of the Level 3 Asset for 25 months.
The SEC found that, based on the foregoing, the Parent had violated, and the Adviser had caused the Parent to violate: (i) Section 13(b)(2)(B) of the Exchange Act and Rule 13(b)(2)(A) thereunder, which in general terms require public companies to have adequate internal controls, books, and records to support the preparation of accurate financial statements; (ii) Section 13(a) of the Exchange Act and Rules 13a-1, 13a-11, and 13a-13 thereunder, which in general terms require issuers to make factually accurate filings with the SEC; and (iii) Rule 12b-20 under the Exchange Act, which in general terms prohibits issuers from filing misleading information with the SEC.
In addition to a cease and desist order, the Respondents agreed to pay, in total, disgorgement of approximately the $7.7 million received in excess management fees and prejudgment interest of approximately $438,000. The Parent also agreed to pay a civil money penalty of $375,000. Both Respondents agreed to engage a compliance consultant with respect to the Adviser’s procedures for valuing Level 3 assets.