Update on enforcement risks associated with valuation of illiquid securities and investments

Overvaluation by investment advisory firm

On April 28, 2020, the U.S. Securities and Exchange Commission announced a settlement with a New York City based investment advisor, on the basis of what the SEC asserted was the investment advisor’s “overvaluation of certain odd lot positions” in a mutual fund to which it provided investment advisory services.

The investment advisory firm has approximately USD3 billion in assets under management. The mutual fund it advised primarily invested in residential mortgage backed securities. According to the SEC, the over-valuations caused the fund’s reported net asset value to be overstated. The SEC found that the investment advisor failed to disclose that the valuation practices for odd lot positions in bonds were a material contributor to the funds’ performance, and the investment adviser failed to adopt policies and procedures that were reasonably designed to address the public disclosures about performance.

SEC imposes penalty

The SEC imposed a penalty of USD375,000 and required disgorgement of approximately USD103,000. This, even though the investment advisor's role in the valuation was to provide “input” to a valuation committee, and despite the fact that the ultimate responsibility for pricing decisions was with the fund’s board of directors.

Failure to sufficiently challenge third party pricing vendor's prices

As described by the SEC, the investment advisor had the ability to issue a price challenge to the prices established by a third party pricing vendor if the investment advisor believed that the bond price was “not reflective of the present market value of the security.” Apparently, the investment advisor challenged at least some of the prices submitted by the third party vendor. However, the pricing vendor’s response was that the prices it offered were for round lot bond size, not for odd lot bond size, and it left the originally submitted prices unchanged. The SEC took issue with the investment advisor's failure to further challenge the prices, believing that the investment advisor “should have understood” that the prices for round lot bonds were higher than those for odd lot bonds and therefore that the overall valuation was too high. The SEC acknowledged that “depending on the circumstances it is not necessarily inappropriate to value an odd lot position” at a mark established by a third party pricing vendor; however, it found that in this case the investment advisor did not conduct a sufficient contemporaneous review or analysis to determine “whether the third party pricing represented fair value.”

This action by the SEC illustrates the high level of scrutiny of valuation issues by the government, and we can expect additional investigations and enforcement actions by both civil and criminal authorities in the months to come.