The SEC settled public administrative proceedings against a registered investment adviser (the “Adviser”) over (i) its exercise of discretion in valuing securities held by a privately offered fund the Advised managed (the “Fund”) “whose prices were non-widely quoted by an established over-the-counter service or recognized broker-dealers” (“Non-Widely Quoted Securities”), (ii) the Adviser’s failure to review investor disclosures regarding valuation for accuracy on a periodic basis, and (iii) the Adviser’s failure to adopt compliance policies with respect to cross trades between client account. The settlement focuses on the Adviser’s valuation of mortgage-backed securities (“MBS”), asset-backed securities (“ABS”), collateralized debt obligations (“CDO”), convertible securities, and other similar instruments during 2007 and 2008. Under the settlement, which was characterized as addressing “three important areas of private fund management,” the Adviser, which withdrew its SEC registration in December 2009 and ceased operations thereafter, agreed to pay a civil penalty of $250,000.
This article summarizes the SEC’s findings, which the Adviser has neither admitted nor denied, and the sanctions imposed, as set forth in the order.
Background. The Adviser operated the Fund as a master for three feeder funds. The Fund’s stated primary objective was to generate high, risk-adjusted absolute returns that were uncorrelated to traditional fixed income and equity portfolios. The Adviser employed a relative value strategy in managing the Fund and traded in a wide range of assets including MBS, ABS, CDOs, convertible securities, derivatives, and other fixed income and equity instruments. Each of the Adviser’s three principals was responsible for managing a portion of the Fund’s portfolio, with oversight of the entire portfolio exercised by the Adviser’s chief investment officer. At its peak in February 2008, the Fund had approximately $830 million in assets and approximately 50 mostly institutional investors. In April 2009, the Adviser began liquidating the Fund in response to redemption requests and the waning viability of the fund’s relative value strategy as a result of the global financial crisis; the Adviser completed the fund’s liquidation later that year. During the relevant period, the Adviser also managed a $50 million separate account under the same mandate as the Fund (the “Account”). In response to an August 2008 request from the client, the Adviser liquidated the Account by the end of 2008.
Pricing Policies and Procedures. The Adviser had a Pricing Committee comprised of the Adviser’s three principals and chaired by its chief investment officer met monthly that was responsible for final pricing and valuation of the Fund’s holdings. Final authority over pricing was vested in the Adviser’s chief financial officer who also served as the Adviser’s chief compliance officer.
At the Fund’s inception, the Adviser adopted detailed procedures for the valuation of Non-Widely Quoted Securities that were disclosed to investors in the Fund’s private placement memorandum (the “PPM”) and remained unchanged throughout the Fund’s life. As discussed in greater detail in the SEC settlement order, the procedures involved calculating a weighted average of available quotes and dictated particular methods of determining a holding’s valuation using available quotes and other pricing information, with the valuation methods to be used in a prescribed order of priority. The procedures also allowed the Adviser to exercise its discretion to value a security other than according to the specified methods of calculation, e.g., when the Adviser “in its reasonable judgment believes that any pricing does not accurately reflect the value of such security or other asset (including, but not limited to, situations where the price is set by reference to an exchange in a different time zone).” If the Adviser exercised its discretion to price Fund holdings, it was required to fully document the basis for its valuation (and according to a PPM disclosure cited by the SEC, to “allow inspection of such documentation at the [Adviser’s] place of business, by any investor who requests it.”)
Actual Pricing Practice. The SEC found that from January 2007 through December 2008, including during the global financial crisis, the Adviser routinely used its discretion to price the Fund’s Non-Widely Quoted Securities without fully documenting its rationale with the result that the Adviser “was not reasonably positioned to demonstrate whether its use of discretion was resulting in fair valuation of the [F]und’s assets.”
The SEC found that the Adviser varied from the specified calculation methodologies in some cases by modifying quotes, e.g., converting a bid‑side quote to a quote designed to approximate the mean of a bid/ask quote or by discarding quotes deemed to be outliers. As to the latter practice, the SEC cited in particular the pricing of MBS, noting that during 2007 and 2008, the Adviser discarded more than five times as many low MBS quotes (3,111) as high MBS quotes (557), and on an average monthly basis, the ratio of high quotes excluded to low quotes excluded was 85%/15%. In some instances, the portfolio managers overrode the final price without written explanation. The SEC noted that the Pricing Committee “consistently ratified the portfolio managers’ recommended prices and quote overrides.” The SEC found that in none of the foregoing circumstances did the Adviser create records that adequately explained the valuation decisions made.
Review of Valuation Disclosure. The SEC found that as a result of inadequate compliance policies and procedures, the Adviser did not review the Fund’s PPM and other investor disclosures on a regular basis to determine whether they were potentially inaccurate and misleading in describing the Adviser’s valuation practices. In particular, the SEC cited the fact that during the period from January 2007 to December 2008 the PPM’s disclosures on valuation did not reflect the fact that the Adviser “was primarily using its discretion in fair valuing certain of the [Fund’s] non-widely quoted securities without fully documenting its rationale and methodology.”
Lack of Cross Trading Compliance Policies. The SEC found that the Adviser had executed cross trades between the Fund and the Account during the period from December 2007 to November 2008 without having the necessary written policies and procedures to determine for each cross trade (a) the price at which the trade should be effected and (b) that the trade was in the best interests of both clients.
- One series of cross trades was designed to cure a breach in the single security exposure limit for the Account. In these trades, the Adviser had the Account exchange $19.6 million of the MBS causing the breach for an equivalent amount of smaller, different MBS issues with substantially identical investment characteristics. The SEC noted that while these trades resolved the Account’s investment limit breach and provided it with greater diversification consistent with its investment mandate, the Fund was left with a larger position in the MBS issue that caused the breach and with less overall diversification in its MBS holdings.
- Another series of cross trades helped with the liquidation of the Account. With no immediate buyers for the remaining securities in the Account, the Adviser caused the Fund to purchase 16 positions in convertible bonds and MBS held by the Account for approximately $5.6 million in cash. Before executing these cross trades, the Adviser sought broker-dealer quotes, but did not receive any offers to purchase the securities at prices that the Adviser believed represented fair value. Aside from e-mails with broker-dealers, the Adviser maintained no other records documenting its pricing methodology. The SEC found that “[w]hile these trades enabled the [Account] to liquidate its portfolio in the midst of the global financial crisis, when the market for MBS and other fixed income instruments was illiquid . . . , they added more illiquid positions to the [Fund’s] portfolio shortly after fund investors approved a temporary lockup of the fund.” The SEC acknowledged that the Fund ultimately profited from these cross trades.
Violations. The SEC found that the Adviser had violated Section 206(4) of the Investment Advisers Act of 1940 (the “Advisers Act”) and Rule 206(4)-7 thereunder, which in broad terms require a registered adviser to maintain a compliance program reasonably designed to prevent violations of the Advisers Act. Specifically the SEC found that the Adviser had failed to: “(i) implement written policies and procedures reasonably designed to prevent improper valuation of the [Fund’s] assets; (ii) adopt and implement written policies and procedures reasonably designed to prevent [the Adviser] from making inaccurate disclosures to investors in offering materials; and (iii) adopt and implement written policies and procedures reasonably designed to prevent unfair cross trades between clients.”
Sanctions. In addition to censure and cease-and-desist sanctions, Adviser agreed to a $250,000 civil penalty. The Adviser also agreed to provide a copy of the settlement order to investors in the Fund (including its feeders), and to all other persons who were advisory clients at any time during calendar 2007 and 2008.