0SEC Settles Administrative Proceedings Against London-Based Hedge Fund Adviser and its Parent over Internal Control Failures and Misstatements in the Parent’s Financial Reports Resulting from the Adviser’s Faulty Valuation Practices

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.                                                                                                                                          

In the Matter of GLG Partners, Inc. and GLG Partners, L.P., SEC Release No. 34-71050.

0SEC Settles Administrative Proceedings Against CDO Sponsor and Collateral Manager Over Influence of Hedge Fund Firm on Collateral Selection

The SEC settled public administrative proceedings against Merrill, Lynch, Pierce, Fenner & Smith Inc. (the “Sponsor”) relating to the structuring and marketing of three collateralized debt obligations (“CDOs”) and separately against Scott H. Shannon and Joseph G. Parish III (the “Collateral Manager Principals”), the two principals of the unregistered investment adviser that served as collateral manager for one of the CDOs (the “Collateral Manager”).  The SEC found that the Sponsor (i) made faulty disclosures about the independence of the collateral selection process for two of the CDOs, and (ii) maintained inaccurate books and records for the third CDO.  The SEC found that the Collateral Manager Principals compromised their independent judgment and allowed a third party with its own interests to influence the portfolio selection process for the CDO for which their firm, the Collateral Manager, served as collateral manager.  This article provides a high level summary of the SEC’s detailed findings with respect to the Sponsor and the Collateral Manager Principals, which the respondents have neither admitted nor denied, and of the sanctions imposed, as set forth in each of the settlement orders.

Faulty Disclosures Regarding Collateral Selection Process for CDOs

The SEC found that the Sponsor engaged in misconduct in 2006 and 2007 when it failed to inform investors that a hedge fund firm (the “Hedge Fund Firm”) had a third-party role in and exercised significant influence over the selection of collateral with respect to two of the CDOs. 

The Hedge Fund Firm purchased the lowest quality tranche or “equity” portion in each of those two CDOs (the equity portion of a CDO transaction typically being the hardest to sell, and therefore, the greatest impediment to closing a CDO).  The SEC found that because the Hedge Fund Firm also took short positions opposite certain of the CDOs’ assets to hedge its equity positions in the CDOs, its interests were not necessarily aligned with those of the other investors in the CDOs.  The Hedge Fund Firm was given a contractual right to object to the selection by the collateral manager of one CDO (“CDO I”) of any collateral for inclusion in CDO I’s portfolio.  There was a three party agreement in place between the Sponsor, the collateral manager for CDO I, and the Hedge Fund Firm regarding the selection of collateral, however, disclosure to investors in CDO I incorrectly stated that the agreement was only between the Sponsor and the collateral manager for CDO I.  (The SEC has separately commenced administrative proceedings against this collateral manager and its CEO/CCO.)

The SEC also found that one-third of the assets for the portfolio underlying the second CDO (“CDO II”) were acquired by the Hedge Fund Firm during the “warehouse phase” of CDO II, and not selected by the Collateral Manager, which served as CDO II’s collateral manager.  At first, the Collateral Manager did not know of the acquisitions made by the Hedge Fund Firm on behalf of CDO II, but eventually accepted them despite the fact that the Collateral Manager Principal responsible for the credit default swap (“CDS”) selection process and the Collateral Manager’s credit analysts viewed portions of the Hedge Fund Firm’s CDS selections as undesirable, and further allowed the Hedge Fund Firm approval over certain other collateral selected for inclusion in CDO II’s portfolio.  In contrast, the disclosure that the Sponsor made available to investors in CDO II stated that collateral would be selected solely by the Collateral Manager.  The SEC also found that the Sponsor failed to disclose in its marketing materials for CDO II that (i) CDO II made a $4.5 million payment to the Hedge Fund Firm for sourcing collateral to CDO II and (ii) CDO II gave the Hedge Fund Firm a $35.5 million discount on its investment in CDO II’s equity.


With respect to the third CDO (“CDO III”), the SEC found that Sponsor failed to comply with certain requirements of the Securities Exchange Act of 1934, as amended (the “Exchange Act”) to maintain accurate books and records.  The Sponsor agreed to pay the Hedge Fund Firm an amount equal to the interest or returns accumulated on CDO II’s warehoused assets (a “carry” payment).  The Sponsor improperly recorded 68 of 79 trades made during the “warehouse phase” for this CDO and delayed the recording of such trades on the CDO’s books and records.  As a result of such improper recording, the Sponsor’s obligation to make a carry payment to the Hedge Fund Firm was delayed until a time when it was reasonably certain that the trades would be included in the CDO’s portfolio.

Violations and Sanctions

The SEC found that the Sponsor willfully violated Sections 17(a)(2) and (3) of the Securities Act of 1933, as amended (the “Securities Act”), and Section 17(a)(1) of the Exchange Act, and Rule 17a-3(a)(2) thereunder.  The Sponsor agreed to pay disgorgement of $56,286,000, prejudgment interest of $19,228,027, and a penalty of $56,286,000.  The Sponsor agreed to a censure and to cease and desist from future violations of Sections 17(a)(2) and (3) of the Securities Act and Section 17(a)(1) of the Exchange Act.

The SEC found that the Collateral Manager Principal principally responsible for selecting the CDS investments that constituted approximately 90% of CDO II’s collateral had violated Sections 206(1) and (2) of the Investment Advisers Act of 1940, as amended (the “Advisers Act”), and that the second Collateral Manager Principal had violated Section 206(2) of the Advisers Act.  The former agreed to be barred from the securities industry for at least two years and to pay disgorgement and prejudgment interest of $140,662 and a penalty of $116,553.  The latter agreed to be suspended from the securities industry for at least one year and to pay disgorgement and prejudgment interest of $140,662 and a penalty of $75,000.  The Collateral Manager Principals agreed to cease and desist from violations of the aforementioned provisions of Sections 206 of the Advisers Act, and to dissolve the Collateral Manager.

In the Matter of Merrill Lynch, Pierce, Fenner & Smith, Incorporated, SEC Release No. 34-71051.

In the Matter of Joseph G. Parish III and Scott H. Shannon, SEC Release No. IA-3735.

0Banking Regulators Say That Volcker Rule Does Not Require Immediate Sale of Collateralized Debt Obligations Backed by Trust Preferred Securities

The FRB, the FDIC, and the OCC (the “Agencies”) issued a joint FAQ clarifying certain aspects of the treatment of interests in collateralized debt obligations backed by trust preferred securities (“TruPS CDOs”) under the Volcker Rule.

The Agencies noted that the final Volcker Rule implementing regulation generally defines a Covered Fund as an issuer that would be an investment company, as defined in the Investment Company Act of 1940 (the “Investment Company Act”), but for Section 3(c)(1) or Section 3(c)(7) of the Investment Company Act.  The Agencies then state that a TruPS CDO that could satisfy the conditions of another Investment Company Act exclusion, such as the exclusion provided by Rule 3a-7 under the Investment Company Act for certain issuers of asset backed securities, would not be a Covered Fund, and therefore a banking entity need not divest its interests in such a TruPS CDO. 

If a TruPS CDO is currently a Covered Fund, however, the Agencies state that the TruPS CDO could potentially be restructured to permit the use of another exclusion or exemption under the Investment Company Act, which would remove it from the “Covered Fund” definition.  The Agencies provide that if the TruPS CDO is restructured such that it is not a Covered Fund as of the end of the conformance period (currently scheduled for July 21, 2015), then it is not necessary for a banking entity to divest its interests.  The Agencies’ position appears to permit banking entities to divest their interest in TruPS CDOs that are Covered Funds, and will not or cannot be restructured so that they will no longer be Covered Funds, during the length of the conformance period rather than requiring immediate divestment of such interests.

The FAQ also lists criteria that banking entities should evaluate to determine whether a security issued by a TruPS CDO is an ownership interest.  Such criteria include whether the security provides the right to participate in the selection or removal of the CDO’s directors or investment adviser, the right to receive a share of the income, gains or profits, and whether the rate of return or amounts payable may increase or decrease based on the CDO’s performance.

As reported in the financial press, banking trade associations have expressed industry concerns that the FAQ leaves several key questions, such as the treatment of collateralized loan obligations, unanswered.  Some industry members also expressed disappointment that the FAQ did not provide a blanket exemption for debt securities issued by TruPS CDOs.  On December 23, 2013 the American Bankers Association (the “ABA”) sent a letter to the Agencies asking them to “suspend” the provisions of the Volcker Rule that treat interests in such securities as ownership interests in a Covered Fund.  The ABA’s letter threatened that the ABA would file a lawsuit in the event the Agencies do not suspend the above-mentioned provisions of the Volcker Rule.

0FRB, FDIC and OCC Propose Addendum to Income Tax Allocation Policy; Agencies Provide Standard Provision to be Included in Tax Allocation Agreements

The FRB, FDIC and OCC (the “Agencies”) jointly issued a Goodwin Procter proposed addendum (the “Proposed Addendum”) to the Interagency Policy Statement on Income Tax Allocation in a Holding Company Structure (the “Policy Statement”).  The Policy Statement is intended to make certain that insured depository institutions (“IDIs”) in a consolidated group (a group in which a bank holding company files consolidated tax returns for its IDIs, itself and its other affiliates) “maintain an appropriate relationship regarding the payment of taxes and treatment of tax refunds.”  As part of the Proposed Addendum the Agencies provide the text of a standard provision (the “Standard Provision”) that the Agencies indicate bank holding companies should include in their tax allocation agreements (in the same or substantially similar language).

The Agencies note that the intent of the Proposed Addendum is to “reduce confusion regarding ownership of any tax refunds.”  The Proposed Addendum would require IDIs and their holding companies to review their tax allocation agreements to confirm that, under the applicable agreements, the holding company receives any tax refunds as an agent for the applicable IDI.  The Proposed Addendum is intended to respond to dispute as to the ownership of tax refunds that have arisen among bank holding company groups in bankruptcy and failed IDIs.  The Proposed Addendum would also clarify the manner in which Sections 23A and 23B of the Federal Reserve Act apply to tax allocations.

The text of the Agencies’ proposed Standard Provision that the Agencies urge be included in tax allocation agreements is:

The [holding company] is an agent for the [IDI and its subsidiaries] (the “Institution”) with respect to all matters related to consolidated tax returns and refund claims, and nothing in this agreement shall be construed to alter or modify this agency relationship.  If the [holding company] receives a tax refund from a taxing authority, these funds are obtained as agent for the Institution.  Any tax refund attributable to income earned, taxes paid, and losses incurred by the Institution is the property of and owned by the Institution, and shall be held in trust by the [holding company] for the benefit of the Institution.  The [holding company] shall forward promptly the amounts held in trust to the Institution.  Nothing in this agreement is intended to be or should be construed to provide the [holding company] with an ownership interest in a tax refund that is attributable to income earned, taxes paid, and losses incurred by the Institution. The [holding company] hereby agrees that this tax sharing agreement does not give it an ownership interest in a tax refund generated by the tax attributes of the Institution.

Comments on the Proposed Addendum are due by January 21, 2014.

0OCC Issues Interpretive Letter Concluding that Bank Investment in Company that Owns Renewable Energy Solar Project is Permissible

The OCC issued an interpretive letter (“Letter #1139”), in which the OCC concluded that a national bank (the “Bank”) could provide financing for a renewable energy solar project (the “Facility”) in which the financing was structured as an investment by the Bank in the company (the “Company”) that owned the Facility.  The structure of the financing was selected to permit the Bank to receive federal renewable energy tax credits and thereby reduce the cost of the financing provided for the Facility.

In concluding that the Bank’s proposed investment in the Facility is permissible, the OCC in Letter #1139 noted that the structure of the financing is consistent with industry practice and would be made at the request of the sponsor of the Facility.  In addition, the Bank was required to represent to the OCC that the Bank’s decision to extend financing for the Facility would be based upon a full credit review of the transaction (including a determination that the proposed financing met the Bank’s standard loan underwriting criteria) and that the credit review, among other things, would demonstrate that the Bank would recoup its investment “in a reasonable period of time (including consideration of tax credits and depreciation benefits) … and would not place undue reliance on disposition of its interest [in the Facility] following expiration of the tax credits.”

Under the facts presented in Letter #1139 the Bank would acquire an approximately 70% membership interest in the Company and the remaining membership interests in the Company would be held by the Facility’s sponsor, which would also serve as the managing member of the Company.  Moreover, the Bank represented to the OCC that it would not participate in the operation of the Facility, the production of the solar energy, or the sale of the solar energy.  Furthermore, if the Facility were to perform poorly, the Bank would have a number of available remedies to attempt to recoup the value of its investment including the right to sell the Bank’s entire interest in the Company.

In reaching its conclusion that the Bank’s proposed investment in the Company would be permissible the OCC determined, that other than the form of interest proposed to be acquired by the Bank, “the proposed financing is substantially identical to a loan transaction” and would be authorized under 12 U.S.C. §24 (Seventh). Among the conditions to the interpretive relief that the OCC granted to the Bank in Letter #1139 are conditions that the Bank: (1) must limit its financing transactions for renewable energy projects to no more than three (3)% of its capital and surplus; and (2) must purchase sufficient insurance to account for the risk of damages to or destruction of the Facility.