Amid falling markets, valuation challenges and mis-marking fraud risks rise

In early April, the Wall Street Journal reported that private-equity firms are grappling with how to assess the impact of the current economic turmoil on the value of the illiquid assets held in their portfolios. During periods of economic contraction, valuing illiquid assets becomes challenging, partly due to the amount of debt associated with these assets and partly due to the decreased visibility into already limited mechanisms for price-discovery.

These difficulties mean that during periods of falling markets, illiquid assets are especially susceptible to a form of fraud known as mis-marking, i.e. intentional mispricing – or the perception by regulators and prosecutors that such fraud has occurred. Indeed, federal prosecutors and civil enforcement authorities stepped up anti-fraud enforcement in connection with mis-marking schemes in the wake of the 2009 financial crisis, and they have continued to investigate and bring these cases in recent years. We can expect that mis-marking investigations and enforcement will be similarly active on the heels of the current economic downturn.

SEC proposes new rule on valuation practices

The Securities and Exchange Commission has recognized the risks around valuation of illiquid securities and investments and taken action.  On 21 April the SEC announced that it will be proposing a new rule under the Investment Company Act of 1940 (Act) that would address valuation practices and the role of the board of directors with respect to the fair value of the investments of a registered investment company or business development company. The proposed rule will provide requirements for determining fair value in good faith.  According to the SEC, the proposed rule will address aspects of that fair value determination, including managing and assessing material risks associated with fair value determinations; choosing, applying, and testing fair value methodologies; reviewing and evaluating any pricing services used; adopting and implementing policies and procedures; and maintaining certain records. Registered investment and business development companies will need to monitor this closely as they, like other entities, grapple with what procedure is best to value illiquid investments and securities.

Deviations from valuation policies

Deviations from the procedure by which firms value illiquid assets in their portfolio are generally a primary focus of mis-marking investigations. Successful prosecutions of these cases generally involve a common pattern of employees responsible for marking investments at fair value departing from standard procedures in order to record and attempt to justify higher valuations.

This was a key factor in the prosecutions of employees of a large investment bank brought after the financial crisis for mis-marking the value of certain instruments in their trading book connected to the sub-prime mortgage market. When the housing market started to deteriorate in 2007, the government charged, these traders deviated from the bank’s mark-to-market valuation policy in order to value the assets at artificially high levels, in part to protect their year-end bonuses. Part of the effort included securing favorable but unjustified marks from an outside friend at a financial institution.  Similarly, portfolio managers of the hedge fund Visium Asset Management were charged in 2016 for gaming the fund’s valuation policy to mis-mark illiquid bonds held in their portfolio. Specifically, the Government charged that these managers worked with a friendly, outside broker to submit sham prices for these bonds to the fund’s independent valuation committee.

Mis-marking prosecutions

Mis-marking prosecutions have shown no sign of abating in recent years. The last 18 months featured prosecutions of senior executives of global private equity firm Abraaj Capital Ltd., against the founder of Premium Point Investments and another employee, and against the founder and chief executive of Live Well Financial, Inc., all based in significant part on allegations of mis-marking.

Recent government relief efforts may help mitigate some of the pressures that increase the likelihood of mismarking fraud. For example, the Federal Reserve relief program to purchase corporate bonds initiated in March has helped ease liquidity concerns generally. However, even with such efforts the current economic turmoil is likely to continue for some time and frustrate illiquid asset valuation.

Protective steps

Accordingly, investment firms with illiquid holdings should heed historical trends and prepare for an increase in mis-marking investigations and enforcement in connection with the current economic decline. Firms should be reviewing their marking and valuation procedures to ensure that such procedures are understood by those employees responsible for valuing illiquid assets and positions. Firms should also be on alert for any changes in methodology being used to determine valuations.  Establishing a robust price verification procedure now, including spot-checking valuations, may prove to be an important way to head-off either misunderstanding by regulators, or bad choices made by employees under stress.