Reported Criminal Probes Regarding Bond Valuations Highlight the Importance of Valuation Procedures

by Proskauer - Private Equity Litigation

Proskauer - Private Equity Litigation

In addition, the co-head of the SEC’s Asset Management Unit recently highlighted that unit’s focus on valuation, particularly where registered advisers failed to follow their own internal procedures when valuing illiquid positions. The SEC’s focus is further demonstrated by a recent action against a fund manager for improperly valuing municipal bonds inconsistently with GAAP.

In light of the SEC’s focus on valuation policies and procedures, fair valuing illiquid assets should be a key concern for fund managers. Although the alleged use of “bogus” marks to inflate the value of a trading book is an extreme example, the regulatory attention to valuation should not be ignored.  As we have noted here before, although valuation can be more art than science, there are heightened regulatory risks in the following areas:

(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.

Why are valuation policies important?

First, managers need to be concerned about potential violations of the anti-fraud provisions (e.g., sections 206(1) and (2) of the Advisers Act).  They should have policies and procedures (and training) in place to ensure that the valuation of all securities is done in an appropriate manner that is consistent with the manager’s fiduciary duties and the disclosures provided to investors.

Second, valuation policies fall under the compliance rule (Rule 206(4)-7 under the Advisers Act). Under this rule, the SEC expects registered advisers to adopt and implement policies and procedures to value client holdings.  SEC staff typically request and scrutinize a firm’s valuation policies either during their exams, or when following up on enforcement tips.  Problems can arise when a fund manager fails to follow its disclosed valuation policies to the letter, turning internal control issues into potential disclosure issues. Even if the government cannot prove that valuations were “wrong” they may allege that disclosures regarding the valuation policies themselves were false or misleading.

Covenant Financial Services:

The SEC’s March 2017 case against hedge fund manager Covenant Financial Services demonstrates how SEC enforcement might approach a typical valuation matter. Covenant settled claims involving its use of a pricing service to value certain municipal bonds.  According to the order, the manager’s valuation policy appeared consistent with GAAP, but in practice, the execution fell short.

Covenant’s policy recognized the principles of Accounting Standards Codification 820 (“ASC 820”). Consistent with ASC 820, the policy prioritized the use of Level 2 inputs (“inputs other than quoted prices . . . that are observable for the asset or liability, either directly or indirectly.”) over Level 3 inputs (“unobservable inputs for the asset or liability.”).

The problem arose because the pricing service used by Covenant estimated values based on a model that used Level 3 unobservable inputs, rather than Level 2 inputs. Covenant allegedly used this model despite being aware of Level 2 indicators that were inconsistent with the model’s valuations, including actual trades it made in the same or similar bonds, and broker quotes and marks it obtained.

The SEC determined that because Covenant allegedly overstated its funds’ performance during those time periods, it violated the anti-fraud provisions of the Advisers Act. In addition, because it failed to follow its own valuation policy, the SEC alleged that the adviser also violated the Compliance Rule by failing to implement its written policies and procedures.

Lessons Learned: What should be included in valuation policies?

Fund managers should follow a disciplined and documented internal process. This process should involve finance/accounting personnel along with investment professionals.  The overarching principles, in our view, are (1) consistency when applying the policies over time and (2) accurate disclosure of the policies (and deviations) to LPs.

Best practice may also include establishing an internal valuation committee. The policies should be reviewed at the outset and periodically by the fund’s valuation committee.  And although a manager may choose to retain an outside valuation firm, the valuation of fund assets is ultimately the manager’s responsibility. Ultimately, the best way to reduce risk is to consistently apply and follow the documented valuation policies.

[View source.]

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

© Proskauer - Private Equity Litigation | Attorney Advertising

Written by:

Proskauer - Private Equity Litigation

Proskauer - Private Equity Litigation on:

Readers' Choice 2017
Reporters on Deadline

"My best business intelligence, in one easy email…"

Your first step to building a free, personalized, morning email brief covering pertinent authors and topics on JD Supra:
Sign up using*

Already signed up? Log in here

*By using the service, you signify your acceptance of JD Supra's Privacy Policy.
Custom Email Digest
Privacy Policy (Updated: October 8, 2015):

JD Supra provides users with access to its legal industry publishing services (the "Service") through its website (the "Website") as well as through other sources. Our policies with regard to data collection and use of personal information of users of the Service, regardless of the manner in which users access the Service, and visitors to the Website are set forth in this statement ("Policy"). By using the Service, you signify your acceptance of this Policy.

Information Collection and Use by JD Supra

JD Supra collects users' names, companies, titles, e-mail address and industry. JD Supra also tracks the pages that users visit, logs IP addresses and aggregates non-personally identifiable user data and browser type. This data is gathered using cookies and other technologies.

The information and data collected is used to authenticate users and to send notifications relating to the Service, including email alerts to which users have subscribed; to manage the Service and Website, to improve the Service and to customize the user's experience. This information is also provided to the authors of the content to give them insight into their readership and help them to improve their content, so that it is most useful for our users.

JD Supra does not sell, rent or otherwise provide your details to third parties, other than to the authors of the content on JD Supra.

If you prefer not to enable cookies, you may change your browser settings to disable cookies; however, please note that rejecting cookies while visiting the Website may result in certain parts of the Website not operating correctly or as efficiently as if cookies were allowed.

Email Choice/Opt-out

Users who opt in to receive emails may choose to no longer receive e-mail updates and newsletters by selecting the "opt-out of future email" option in the email they receive from JD Supra or in their JD Supra account management screen.


JD Supra takes reasonable precautions to insure that user information is kept private. We restrict access to user information to those individuals who reasonably need access to perform their job functions, such as our third party email service, customer service personnel and technical staff. However, please note that no method of transmitting or storing data is completely secure and we cannot guarantee the security of user information. Unauthorized entry or use, hardware or software failure, and other factors may compromise the security of user information at any time.

If you have reason to believe that your interaction with us is no longer secure, you must immediately notify us of the problem by contacting us at In the unlikely event that we believe that the security of your user information in our possession or control may have been compromised, we may seek to notify you of that development and, if so, will endeavor to do so as promptly as practicable under the circumstances.

Sharing and Disclosure of Information JD Supra Collects

Except as otherwise described in this privacy statement, JD Supra will not disclose personal information to any third party unless we believe that disclosure is necessary to: (1) comply with applicable laws; (2) respond to governmental inquiries or requests; (3) comply with valid legal process; (4) protect the rights, privacy, safety or property of JD Supra, users of the Service, Website visitors or the public; (5) permit us to pursue available remedies or limit the damages that we may sustain; and (6) enforce our Terms & Conditions of Use.

In the event there is a change in the corporate structure of JD Supra such as, but not limited to, merger, consolidation, sale, liquidation or transfer of substantial assets, JD Supra may, in its sole discretion, transfer, sell or assign information collected on and through the Service to one or more affiliated or unaffiliated third parties.

Links to Other Websites

This Website and the Service may contain links to other websites. The operator of such other websites may collect information about you, including through cookies or other technologies. If you are using the Service through the Website and link to another site, you will leave the Website and this Policy will not apply to your use of and activity on those other sites. We encourage you to read the legal notices posted on those sites, including their privacy policies. We shall have no responsibility or liability for your visitation to, and the data collection and use practices of, such other sites. This Policy applies solely to the information collected in connection with your use of this Website and does not apply to any practices conducted offline or in connection with any other websites.

Changes in Our Privacy Policy

We reserve the right to change this Policy at any time. Please refer to the date at the top of this page to determine when this Policy was last revised. Any changes to our privacy policy will become effective upon posting of the revised policy on the Website. By continuing to use the Service or Website following such changes, you will be deemed to have agreed to such changes. If you do not agree with the terms of this Policy, as it may be amended from time to time, in whole or part, please do not continue using the Service or the Website.

Contacting JD Supra

If you have any questions about this privacy statement, the practices of this site, your dealings with this Web site, or if you would like to change any of the information you have provided to us, please contact us at:

- hide
*With LinkedIn, you don't need to create a separate login to manage your free JD Supra account, and we can make suggestions based on your needs and interests. We will not post anything on LinkedIn in your name. Or, sign up using your email address.