SEC Views on Valuation

The Securities and Exchange Commission regulations for investment advisers does not contain any specific requirements on how valuations should be conducted. That means operating under the general anti-fraud provisions. That is, valuations should not be misleading, deceptive or fraudulent. Although there are no specific regulations, there are enforcement actions from the SEC against advisers that the SEC found to have failed in their valuations. Here are four recent cases.

In the Matter of Pacific Investment Management Company LLC (December 1, 2016)

PIMCO Total Return-Exchange-Traded Fund (“BOND”) was one of PIMCO’s first actively managed exchange-traded funds. PIMCO employed an “odd lot” strategy
using non-agency mortgage-backed securities. This strategy involved (1) purchasing odd lot positions that traded at a discount to the round lot prices; (2) valuing those positions in BOND at the higher pricing for institutional round lots; and (3) as a result, obtaining immediate positive returns for BOND.

The securities as a pool should all have the same value. But on exit, PIMCO would have to sell at a discount because part of the sale would be odd lots. I find this a tough call. The problem is that the SEC discovered an email that said “[We] can find you several odd lot positions in the coming days that trade well below round lot levels and therefore pricing marks which will help with performance out of the gate.” I assume the SEC found this statement to indicate an intent to be manipulative.

In the Matter of Equinox Fund Management LLC (January 19, 2016)

An SEC investigation found that Equinox Fund Management LLC calculated management fees contrary to the method described in registration statements for a managed futures fund called The Frontier Fund (TFF), and the firm also deviated from its disclosed valuation methodology for some TFF holdings.

TFF’s registration statements disclosed that Equinox charged management fees based upon the net asset value of each series.  But Equinox actually used the notional trading value of the assets, which is the total amount invested including leverage.  Equinox consequently overcharged the fund $5.4 million in fees from 2004 to 2011.

SEC v. Summit Asset Strategies Investment Management, and LLC Chris Yoo (September 2015)

Summit and its owner Yoo were entitled to a share of profits from an investment fund that Summit advised. Yoo falsely claimed that the fund had purchased 500,000 shares of an entity called Prime Pacific Bank in December 2012 when in reality, the fund did not own this security. Because the Prime Pacific Bank security was purportedly illiquid, Yoo developed a financial model to value this asset. This model showed that the fund’s interest in Prime Pacific Bank had more than tripled in value from the shares’ purchase price of $1.00 per share on December 28, 2012, to $3.81 per share on December 31, 2012. Yoo revised the model to reflect that Prime Pacific Bank had slightly decreased, but still generated a gain from its initial purchase price. Yoo relied on these cumulative gains to justify taking over $2.5 million in fees from the fund.

In the Matter of Alpha Bridge Capital Management (July 1, 2015)

When the Alpha Bridge fund was started in 2001, the adviser told the funds’ investors, administrator, and auditor that the adviser obtained independent, market-grounded price quotes for the securities at issue from registered representatives of two reputable broker-dealers. AlphaBridge’s written valuation policy, stated that AlphaBridge obtained monthly price quotes for certain types of less liquid securities from two independent and reputable broker-dealers and used the arithmetic average of these quotes as AlphaBridge’s price for these securities. However, by 2010, AlphaBridge was providing its valuations to those registered
representatives of the broker-dealers who in turn provided those valuation to the fund’s administrator.