In failing to consider the listed factors, the respondents violated Rule 22c-1 of the Investment Company Act because they did not value the securities in good faith.
The administrative law judge further opined that there was no evidence that the respondents ever discussed any unusual situation that would justify valuing the restricted securities at the same price as unrestricted securities or that they considered discounting the restricted shares in accordance with ASR 113. The judge found that the resulting overstatement of valuation demonstrated a reckless disregard for the proper computation of net asset value.
‘Askin Capital Management’
In Matter of Askin Capital Management, L.P.,9 the SEC alleged antifraud violations in connection with the valuation of portfolios invested in mortgage derivative securities and other collateralized mortgage obligations (CMOs) held by Askin Capital Management (ACM) pursuant to the Investment Advisers Act of 1940 and the Securities Act of 1933.
The CMOs involved were not quoted, traded, or listed on any national exchange. The firm’s chief executive officer and principal, and other ACM personnel allegedly issued regular statements informing investors that ACM generally used prices quoted by dealers (dealer quotes) in valuing securities held in ACM-managed portfolios. In preparing portfolio valuations for a certain period, however, the CEO allegedly rejected many of the dealer quotes and instead determined his own, materially higher valuations (“manager marks”) for approximately half of the portfolios’ holdings. The SEC contended that the CEO’s use of manager marks allowed ACM to report higher returns to clients for the relevant period.
The organizational and offering documents for the funds described the methods to be used by ACM to value securities that were not quoted on an exchange, such as the CMOs in which the funds primarily invested. None of these documents permitted ACM or the CEO unilaterally to determine valuations for CMOs.
The respondents consented to the entry of cease and desist orders as part of a settlement where they neither admitted nor denied the SEC’s allegations. ACM’s registration was revoked, and the CEO was barred from association with regulated entities and ordered to pay $50,000 to settle pending or future claims by or on behalf of one or more of its advisory clients.
‘S.E.C. v. Lauer’
In the recent case of S.E.C. v. Lauer,10 the agency brought an action against the founder, sole manager and principal owner of Lancer Management Group, the investment manager of a collection of hedge funds.
The respondent was found liable for violating the anti-fraud provisions of the Securities Act of 1933; §10(b) and Rule 10b-5 of the Securities Exchange Act of 1934; and §§206(1) and 206(2) of the Investment Advisers Act of 1940. Upon the SEC’s motion for summary judgment, the court found that the respondent, among other things, materially overstated the hedge funds’ valuations, manipulated the prices of seven securities that were a material portion of the funds, and failed to provide any basis to substantiate or explain the exorbitant valuations of the shell corporations that saturated the funds’ portfolios.11
The respondent and Lancer Management Group used their discretion to value independently securities when they determined that the value of certain securities was not represented favorably in the market. All in all,
[t]he Funds’ valuation became a function of how [the respondent] wanted his Funds to perform in comparison to those indexes.12
The court ultimately concluded that “[e]vidence of [respondent's] scienter is plentiful;”13 that evidence included: his knowledge that the “model” portfolios he provided to investors were false, his knowledge of the inflated net asset values listed in investor newsletters, and his active role in acquiring non-operating shell corporations with few or no assets in order to control their closing price at month’s end and enhance the artificial valuations in the funds’ portfolios.
Conclusion
Because determining the value of illiquid assets is more of an art than a science, prosecutions and enforcement actions based on inaccurate valuation of the complex securities that are at issue in the credit crisis will present challenges to the authorities. As demonstrated by the actions discussed above, certain factors may be critical in determining whether the government will seek charges, such as:
• lack of documentary support for the value accorded the assets in question;
• failure to follow accounting or other relevant rules in determining valuation; and
• reliance upon a model to value assets where a market exists that could provide a reasonably reliable basis for valuation.
What is not yet known is whether these indicia will be present in the cases the government is investigating, or whether the improper valuations being examined were the result of good faith attempts that simply turned out to be incorrect.
David M. Zornow is the practice leader of Skadden, Arps, Slate, Meagher & Flom’s New York office white collar crime practice. Steven R. Glaser is a partner in Skadden’s New York office white collar crime practice and Brenna K. DeVaney is an associate at the firm. Richard M. Rothblatt, an associate (bar admission pending), assisted in the preparation of this article.
Endnotes:
1. Lori A. Richards, Director, Office of Compliance Inspection & Examinations, “S.E.C., Focus Areas in SEC Examinations of Investment Advisers: the Top 10,” Speech at the IA Compliance Best Practices Summit 2008 (March 20, 2008), available at http://sec.gov/news/speech/2008/spch032008lar.htm.
2. Ivy Schmerken, “Bear CDO Series: Valuation Crisis,” ADVANCED TRADING, Aug. 14, 2007 (citing Randall Smith & Serena Ng, “Seeking Hidden Losses, Regulators Comb Books of Wall Street Titans,” WALL ST. J., Aug. 10, 2007), available at http://www.advancedtrading.com/blog/archives/2007/08/bear_cdo_series.html.
3. Ivy Schmerken, supra note 2.
4. 514 F.3d 1158 (11th Cir. 2008).
5. Second Superseding Indictment, United States v. Masferrer, 2005 WL 5715255 (Sept. 6, 2005 S.D. Fla.).
6. In the Matter of Allied Capital Corp., Administrative Proceeding, File No. 3-12661 (June 20, 2007).
7. Allied Capital Corp., File No. 3-12661, at 3-4.
8. In the Matter of Parnassus Inv., Jerome L. Dodson, Marilyn Chou and David L. Gibson, Administrative Proceeding, File No. 3-9317 (Sept. 3, 1998).
9. In the Matter of Askin Capital Mgmt., L.P., Advisers Act Rel. No. 33-7171 (May 24, 1995).
10. S.E.C. v. Lauer, 2008 WL 4372896, No. 03-80612-CIV (S.D. Fla. Sept. 24, 2008).
11. Lauer, 2008 WL 4372896 at *26-27.
12. Lauer, 2008 WL 4372896 at *13.
13. Lauer, 2008 WL 4372896 at *21.
