Maybe the Securities and Exchange Commission couldn’t catch Bernard L. Madoff. Maybe there was nothing that can be done when housing prices crater and securities backed by mortgages hit the dumper.
But if you don’t have solid processes and procedures for establishing the value of assets you are still counting on, watch out. The S.E.C. here and its counterpart in the United Kingdom, the Financial Services Authority, are taking note.
At a panel discussion Monday at the Practising Law Institute in New York, the director of enforcement at the S.E.C. made it clear asset valuations were on his mind – and that cases against those who pump them up in the works.
“Valuation issues can lend themselves to violations particularly, when they can have such an impact on performance fees,” said Robert S. Khuzami, who took the job as America’s chief securities regulation enforcer in February. “You can see situations where trades between affiliates, cross trades, can result in improper valuations.”
Where will the crosshairs be focused? Expect it to be on assets that trade in over-the counter markets, such as mortgage-backed securities, commercial mortgage-backed securities, collateralized debt obligations and perhaps even credit default swaps. Like, for instance, when a marketer of such products tries to keep the values high – and to itself – to keep up the flow of fees for “performance.”
“Many structured products are such that valuations can have a high impact on the fees of the sponsors and improper valuations can be used to avoid defaults, under a structured product, and thus maintain and preserve the fees of the sponsor rather than having those fees redirected to the super senior tranches or other holders in the structure,” he said.
The S.E.C. announced no specific actions last week. But the Financial Services Authority did.
The United Kingdom’s chief watchdog over the securities industry fined Nomura International the equivalent of $2.9 million for “widespread systems and controls failings” at its international equity derivatives business.
The global investing group’s systems and controls for pricing the unit’s equities derivatives products “fell far short of those expected by the FSA for a business trading complex and high-risk financial products.”
The bank was found to have violated two FSA policies – failing to conduct its business with due skill, care and diligence and failing to take reasonable care to organize and control its affairs responsibly. One contract had to be revised downward by $17.9 million.
But American companies are not immune. The S.E.C. did take on a California advisory firm known as Cornerstone Capital and its president, Laura Kent, of Redwood City, for taking in $15 million of customer funds and putting them in five different programs that “severely impaired’’ the value of the investors’ assets.
In one of those, known as The Costa Rican Currency Exchange Program, the S.E.C. alleged that $7.7 million from 70 clients went to two brothers there, in both equity and debt investments. Costa Rican authorities raided the currency exchange business, seized all of its assets, and froze its bank accounts, according to the S.E.C. Yet the company “continued to send their clients account statements showing the value of the currency exchange investment at its original cost plus accrued interest.” And kept computing its fee for managing those investments at 1% of their value, each year. That may seem, in the mad world that the credit crisis has spawned, like chicken feed. With the government pouring tens and hundreds of billions to prop up AIG, Bank of America and other one-time financial giants with swagger, a case where only $335,000 had to be paid out may not seem like much. Particularly since those respondents never admitted or denied the findings in the case.
But legal experts sense there is a billion-dollar case lurking in the shadows of the crisis, somewhere. Since “highly illiquid” securities like CDOs are likely involved.
“From a corrective standpoint, you can feel that there’s a lot of heightened enforcement activity around valuation,’’ said Colleen P. Mahoney, partner in Government Enforcement Matters of global law firm Skadden, Arps, Slate, Meagher & Flom, at the same Practising Law Institute panel on which Khusami spoke. “And it is such a highly judgmental area for certain types of illiquid instruments that one takeaway from this should be that you should be careful to make sure you have a real discipline around your valuation judgments.”
But post-valuation logic will not be enough support of those judgments. Be prepared to show “real-time records” of how you reached each valuation, she said.
“Since hindsight is 20/20 and your judgment is likely to be second-guessed, it’s important that you keep sort of a real-time record of the thought process that went into your valuation because (a) you will forget … (but) …(b) the process will be much easier to defend if your have real-time records of how you came to your conclusion,” Mahoney said.
The point was echoed by Barry R. Goldsmith, co-head of the Securities Enforcement Practice Group of Gibson, Dunn & Crutcher in Washington, D.C. “I think the S.E.C. is not in the business of second-guessing valuation.”
What the S.E.C. is worried about is whether companies have a real process for determining the valuation of assets they hold (or buy or sell).
“Have a process. And also if you have a process, stick with it and make sure you’re following it,’’ even if you’re downsizing or going through internal turbulence. “It’s almost worse to have a process that you don’t follow, than no process at all,” he said.
Which means that business is likely to pick up for process helpers, like valuation service providers.
“Greater scrutiny by interested parties, coupled with changing regulations, accounting standards and changing dealer landscapes has made the pricing and valuation process a high visibility, high importance business activity for years to come,” said John Jay senior analyst with Aite Group in a recent research report on valuation. “This is no idle exercise, given that shoddy prices or unverifiable valuations may have a dramatic negative impact on a business’s regulatory capital, financing, compliance, risk management and fees.”
Jay estimated that the pricing and valuation services industry’s revenues will grow from $2.1 billion in 2009 to $2.9 billion by the end of 2012.
BEST PROCESSES: Valuing Assets
1. Establish a Valuation Framework
Create a framework for clear, consistent valuations of all investment positions that includes:
2. Create a Baseline Valuation Policy
The approach should include these steps:
3. Choose Reliable Sources of Prices
Identify and choose sources of prices for different types of investment positions, including
Also see:
More or Less: Some Assets Will Get More Than One Price
http://www.securitiesindustry.com/issues/19_104/-23968-1.html
Accounting for Structured Transactions Forcing System Overhauls
http://www.securitiesindustry.com/issues/19_102/-23840-1.html
HOW TO KEEP: Real-time records
The meaning of “real-time” changes, depending on the instrument involved and how liquid it – or data about it – is. Here are 14 steps to follow.
SOURCE: Pluris Valuation Advisors
[P O S T S C R I P T ]
And finally, as we all head back to work, a quick quiz to (perhaps) keep you in the holiday spirit.
Stung by the bad job market, a handful of brokers and mid-level executives from investment firms have recently made what kind of drastic career change?
(correct answer: 5)
Global hedge fund assets soared over the past decade, hitting $ 2.6 trillion at the beginning of 2008. Keeping in mind that hedge funds experienced steep losses during the second half of 2008, where were assets at the end of the year?
(correct answer: 2)
In February 2008, the $330 billion auction rate securities market (ARS) collapsed. One year and 10 months later, what has been the outcome for ordinary investors?
(correct answers: 2. and 3.)
Two years ago, the SEC’s annual budget totaled less than $882 million. What has Senator Christopher Dodd proposed as a simple solution to giving the cash-strapped agency more money?
(correct answer: 3)
Most Congressional watchers expect a law to be passed requiring hedge fund advisers to register with the SEC. What is a key difference between this year’s effort and the failed 2004 effort to require hedge fund adviser registration?
(correct answer: 4)