While the SEC consistently announces that valuation is a “key area of focus,” it is uncommon for regulators to “second guess” valuation determinations in the absence of other potential violations. However, recent actions would suggest that the SEC is particularly interested in the valuations and methodologies behind illiquid securities. As we have noted here before, although valuation can be more art than science, there are heightened regulatory risks in the following areas around valuation:

(1) breakdowns in controls/policies/procedures;

(2) violations of Generally Accepted Accounting Principles (GAAP); and

(3) incomplete or inaccurate disclosures to fund investors and auditors.

The September 2018 settled action against LendingClub Asset Management (LCA) is a prime example of regulatory focus on valuation. The SEC alleged, among other things, that the manager improperly valued asset-backed securities (ABS) held by its funds. LCA disclosed that the relevant funds exclusively owned ABS backed by consumer credit loans, and that it would periodically determine a fair market value for those assets using Level 3 inputs under GAAP. As is typical for Level 3 assets, they lacked observable market inputs and were valued based on management estimates or pricing models. LCA used a discounted cash flow (DCF) model to predict the future performance of the loans discounted to present value.

However, the SEC took issue with two categories of adjustments made by LCA to the model. First, the SEC alleged that the manager improperly incorporated a “floor” for monthly returns that was not based on supportable assumptions. Second, the SEC alleged that the manager made an unjustified change to the discount rate used for its DCF model, which had the result of increasing fund returns. Although LCA later took a series of remedial measures, including outsourcing its monthly valuation to an independent third party, recalculating fund returns and reimbursing investors, the SEC ultimately determined to pursue an enforcement action against LCA and certain individuals affiliated with it.

Similarly, the SEC’s March 2017 case against hedge fund manager Covenant Financial Services illustrates a typical SEC valuation action. Here, the SEC focused on the application of an otherwise GAAP-compliant valuation policy, ultimately finding that the failure to properly apply the valuation policy (by using Level 3 inputs when Level 2 inputs were available, and inconsistent with the Level 3 inputs) resulted in violations of the anti-fraud provisions of the Investment Advisers Act.

An example of a more nuanced valuation action is that which the SEC brought against Enviso Capital in July 2017. The SEC alleged that Enviso Capital failed to use reasonable assumptions and estimation of future cash flows when preparing a DCF model, which resulted in overvaluing a loan (and consequently the fund) where it was probable that the full value would not be collected. As a result of these valuation issues, the SEC asserted that the fund’s performance was overstated and that its financial statements were not GAAP-compliant.

What does this mean? Two things: (1) valuation policies must be carefully analyzed for GAAP compliance and must be accurately disclosed to investors, and (2) valuation policies must be properly and consistently applied over time.

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Photo of Joshua M. Newville Joshua M. Newville

Joshua M. Newville is a partner in the Litigation Department in New York and a member of Proskauer’s White Collar Defense & Investigations Group and the Asset Management Litigation team.

Josh handles securities litigation, enforcement and regulatory matters, representing corporations and senior executives in civil and criminal investigations. In addition, Josh advises registered investment advisers and private fund managers on regulatory compliance, SEC exams and related risks.

Photo of Brian Hooven Brian Hooven

Brian Hooven is an associate in the Litigation Department. He has represented a diverse client base in all phases of litigation, including trial, in both state and federal courts.

Brian also maintains an active pro bono practice, representing individual clients in criminal, family and immigration proceedings.

Prior to law school, Brian worked at the University of Michigan Center for Arrhythmia Research and co-authored Time- and frequency-domain analyses of atrial fibrillation activation rate: The optical mapping reference. (2011) Heart Rhythm.