Every month, many hedge fund managers grapple with a fundamental conflict of interest. The conflict arises when a fund manager, whose compensation is based on fund performance, is charged with determining the value of the complex or illiquid securities in his portfolio. These securities often do not receive reliable market quotes, and may be difficult to value. Accordingly, a fund manager may be tempted to misprice the hard-to-price names in his account in order to bolster fund performance, and increase his own compensation. The situation is somewhat analogous to a chief financial officer calculating his corporation's profits, all the while knowing that his calculations will affect his bonus.
Change, however, is on the horizon. On Dec. 2, 2004, the United States Securities and Exchange Commission amended the Investment Advisers Act of 1940 to require certain hedge fund advisers to register with the commission (the "Rule").1 Under the Rule, registered hedge fund advisers will be required to make their books available to SEC examiners by Feb. 1, 2006, and, in turn, subject their valuation methods and policies to regulatory scrutiny.
The Rule stems, in part, from the commission's concern over a fund manager's financial incentive to manipulate the value of the securities he manages in hopes of achieving better performance. The commission has recognized that "[h]edge funds may invest in highly illiquid securities that may be very hard to value," and that managers often "give themselves significant discretion in valuing securities."2 As a result, the commission has warned investors to "understand a fund's valuation process and know the extent to which a fund's securities are valued by independent sources."3 In fact, the commission has cited the lack of independent checks on an adviser's valuation methods as among their "most serious concerns."4
Recently, the commission's concern has translated into enforcement action. Over the past eighteen months, the commission has brought a string of actions against hedge fund managers and advisers, accusing them of deceiving investors by mispricing the value of their funds.5 For example, the SEC recently settled a case against Beacon Hill Asset Management, LLC, and its four principals.6 In Beacon Hill, the SEC filed a complaint alleging that the firm and its principals made material misrepresentations to investors concerning, among other things, the methodology Beacon Hill used for calculating the net asset values of its hedge funds, and the value and performance of the funds. The SEC also alleged that Beacon Hill fraudulently valued the securities in its hedge funds to support steady and positive returns. Ultimately, Beacon Hill agreed to pay a $2 million penalty and more than $2.4 million in disgorgement and prejudgment interest to resolve the case.
Similarly, the commission brought a settled case against Edward J. Strafaci, a former Lipper & Co. portfolio manager, for making materially false and misleading statements to investors about the value of the securities in his hedge fund, and the value and performance of the fund overall.7 In Strafaci, the SEC alleged, contrary to representations in the relevant offering documents and Strafaci's own oral representations, that Strafaci did not value many of the Lipper funds' convertible securities at or close to the prevailing market prices for those securities, as reflected by major market makers or recent transactions. Instead, according to the SEC, Strafaci priced significant portions of his funds' convertible securities at prices substantially higher than the prevailing market price or the securities' fair value. Ultimately, Strafaci was barred from the securities industry. He had already pleaded guilty to one count of securities fraud in a separate proceeding.
Given the SEC's recent attention to valuation issues,8 and in light of the impending registration requirements, fund advisers should examine their valuation policies and procedures in an attempt to cure any deficiencies in pricing complex or illiquid securities. Set forth below are three recommendations designed to help advisers in this pursuit.
Three steps a hedge fund adviser can take to guard against unfair or deceptive valuations include (A) implementing firm-wide policies and procedures designed to promote consistency in the valuation process; (B) if possible, limiting the fund manager's involvement in the valuation process; and (C) properly disclosing valuation policies and procedures to clients.
A. Policies and Procedures
The first step an adviser can take to minimize the risk of mispricing is to implement a clearly defined set of valuation policies and procedures. A recent survey conducted by PricewaterhouseCoopers revealed that only about half of hedge fund advisers maintain detailed valuation procedures,9 even though such procedures are likely to be the starting point for SEC examiners during their inspections.10
In general, valuation policies and procedures should be drafted to promote fairness and consistency in the valuation process. They should be reproducible, transparent and verifiable.11 More specifically, they should clearly indicate the methods, principles and models that a manager may use to calculate the value of his investments, especially hard-to-price investments such as convertible bonds, mortgages and mortgage-backed securities, credit default swaps, over-the-counter derivatives, bank debt and loans, emerging market securities and micro-cap securities.12 The manager's goal should be to arrive at a fair NAV for the fund in accordance with generally accepted accounting principles or GAAP.13 In addition, deviations from, or exceptions to, the valuation policies should be well documented and disclosed to clients.
Fund advisers may also consider forming a pricing committee to address the difficulty in valuing illiquid and complex securities. The PwC Survey found that only 37% of the survey group had formed such a committee.
Of course, policies, procedures and committees alone are insufficient to protect against mispricing. Advisers also need to be sure that valuation guidelines are followed in practice, especially when pricing decisions are made without resorting to third-party pricing services. In this regard, advisers should institute, and maintain, internal controls specifically designed to monitor the valuation methods used by managers.
B. Limiting the Fund Manager's Involvement
An adviser can further protect against the possibility of mispricing securities by limiting the fund manager's involvement in the valuation process. There are two preferred methods of doing so. One method involves employing a third party administrator or prime broker to price securities and determine a fund's NAV. This should preserve the actual and perceived independence of the fund. At a minimum, advisers ought to employ this method before valuation figures are reported to clients, such as during subscription and redemption periods or in monthly account statements. Note that use of this method does not foreclose the need to employ an outside auditor to examine fund valuations after they have been reported to clients.14
Of course, transferring valuation responsibilities away from the portfolio manager may be impracticable. Many times, portfolio managers are the ones best suited to value the securities in their portfolio because they are the closest to the market, and can quickly determine whether the fund can transact business at a certain price. Other times, third party pricing services may be unreliable. In either instance, it makes sense for fund managers to remain involved in the valuation process.
Should a portfolio manager continue to participate in valuation decisions, however, fund advisers should consider designating an independent party within the firm to oversee the valuation process.15 This method should only be employed, however, if the independent party's compensation is not tied to fund performance, and the party does not report to anyone with a direct financial incentive to overvalue the fund.16 This method can be problematic, however, because the independent party may still be perceived as willing to turn a "blind eye" to mispricing in hopes of improving firm wide numbers. In light of this concern, prudent advisers should seek third party assistance when feasible.
Regardless of whether an adviser chooses to value its securities internally or externally, it should disclose its valuation methods and procedures to all current and prospective clients in the fund's offering documents and financial statements. This disclosure should candidly address any potential conflicts of interest in the valuation process, especially when a manager paid based on performance is charged with the task of pricing complex or illiquid names in his own fund.
It is widely recognized that an adviser's failure to disclose material information to investors may constitute "fraud or deceit" under the Advisers Act.17 More specifically, courts have held that the failure to disclose a conflict of interest, even absent a showing of favoritism or abuse, may also violate the Advisers Act. For example, in Monetta Financial Services Inc. v. SEC, the United States Court of Appeals for the Seventh Circuit found an adviser liable under the Advisers Act for failing to disclose that it allocated shares of initial public offerings ("IPO") to individual clients who also served as directors of other fund clients.18 The court based its decision upon a finding that the undisclosed "potential for abuse" existed in the allocation of IPO shares, even though there was no evidence that the adviser favored its director-clients over its fund clients.
Although distinguishable in fact and principle from the valuation issues discussed herein, Monetta teaches that an adviser would be wise to disclose any "potential for abuse" inherent in the valuation process. Where an adviser uses a third-party administrator to determine a fund's NAV-a situation where the "potential for abuse" is greatly mitigated if not eliminated-the adviser should still consider disclosing its valuation policies and procedures to clients.19
In sum, with registration on the horizon, hedge fund advisers should expect the SEC to place greater emphasis on valuation issues in the near future. Accordingly, advisers should examine their valuation policies and procedures in order to guard against the possibility of mispricing, and to enable the firm to effectively address any valuation concerns that may be raised by clients or regulators.
Derek M. Meisner is Of Counsel at Kirkpatrick & Lockhart Nicholson Graham LLP in Boston (email: firstname.lastname@example.org). His practice focuses on representing clients in enforcement investigations conducted by the SEC, NASD and state securities regulators, litigating securities cases, conducting corporate internal investigations, and advising clients (including hedge funds) on related corporate governance and compliance issues. Prior to joining Kirkpatrick & Lockhart, Mr. Meisner served as a branch chief in the SEC's Division of Enforcement in Washington, where he conducted and supervised prominent investigations relating to corporate financial reporting, broker-dealer/investment adviser practices, hedge fund trading, offerings of unregistered securities and insider trading. Mr. Meisner wishes to thank Jason Pinney, a former associate at Kirkpatrick & Lockhart Nicholson Graham LLP, for his assistance in the preparation of this article.
1 See Registration Under the Advisers Act of Certain Hedge Fund Advisers, Investment Advisers Act Release No. IA-2333
(Dec. 2, 2004) (adopting rule 203(b)(3)-2 and amending rules 203(b)(3)-1, 203A-3, 204-2, 205-3, 206(4)-2, 222-2, and
Form ADV under the Advisers Act) (to be codified in scattered sections of the Code of Federal Regulations) (hereinafter
2 Securities and Exchange Commission, Hedging Your Bets: A Heads Up on Hedge Funds and Funds of Hedge Funds
4 Securities and Exchange Commission, Implications of the Growth of Hedge Funds (Sept. 2003).
5 See, e.g., SEC v. Global Money Mgmt., L.P., Litigation Release No. 18666 (Apr. 12, 2004); SEC v. KS Advisors, Inc., et
al., Litigation Release No. 18600 (Feb. 27, 2004); SEC v. Burton G. Friedlander, Litigation Release No. 18426 (Oct. 24,
2003); SEC v. Michael Lauer, Lancer Mgmt. Group, LLC, and Lancer Mgmt. Group II, LLC, Litigation Release No. 18247
(July 23, 2003).
6 SEC v. Beacon Hill Asset Mgmt., LLC, et al., Litigation Release No. 18950 (Oct. 28, 2004).
7 In the Matter of Edward J. Strafaci, Exchange Act Release No. 50422 (Sept. 22, 2004).
8 As recently as November 19, 2004, a senior member of the SEC's Division of Enforcement confirmed that the staff is
investigating fraudulent valuations in the hedge fund industry. Comments of Lawrence West at the ABA Federal
Regulation of Securities Committee Meeting (Nov. 19, 2004).
9 PricewaterhouseCoopers, Global Hedge Fund Valuation and Risk Management Survey at 3 (Oct. 2004).
10 In requiring registration, the commission noted that "[d]uring an examination, our staff may review [an] advisory firm's
internal controls and procedures; [and] may examine the adequacy of procedures for valuing client assets...." Rule
Release at n.85.
11 Barclays Capital, Summary of Remarks at Managed Funds Association Seminar "Valuation Challenges for Hedge
Funds" at 1 (Jan. 2004) (hereinafter "Valuation Challenges for Hedge Funds").
12 See Christopher Kundro & Stuart Feffer, Valuation Issues and Operational Risk in Hedge Funds, 10 Journal of
Financial Transformation 41, 44-45 (2003) (hereinafter "Valuation Issues").
13 See Managed Funds Assoc., 2003 Sound Practices for Hedge Fund Managers at 12-13 (2003) (hereinafter
"Sound Practices for Hedge Fund Managers").In instances where there is no market price available or the application of a market price would not produce a fair valuation for a given security, fund offering documents typically provide managers with the flexibility necessary to employ valuation methods that are appropriate to the security under the circumstances. Valuation Challenges for Hedge Funds at 1.
14 Valuation Issues at 46.
15 In this respect, many advisers form valuation committees.
16 See Valuation Issues at 45-46.
17 SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180, 181-82 (1963).
18 No. 03-3073, slip op. at 6 (7th Cir. Nov. 30, 2004).
19 See Sound Practices for Hedge Fund Managers at 12.
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