By Richard D. Marshall, Partner, Katten Muchin Rosenman LLP*
February 22, 2022
Valuation of security positions held in client accounts is an important responsibility. The valuation of positions influences the reported performance of the adviser and the amount of fees it can charge. Frequently, poor performance can be an early warning to clients that the adviser is doing a bad job, and improper valuations can deprive clients of this early warning sign and cause them to pay incorrect amounts of taxes. Improper valuations can also assist an adviser in engaging in self-dealing transactions with clients, such as when the adviser trades with a client on a principal basis using valuations that benefit the adviser at the client’s expense.
While improper conduct by an adviser would normally be associated with valuing client positions too high, even valuing client positions too low is harmful and illegal. Undervaluation can be motivated by a desire to “smooth” investment performance over time, which can create a misleading perception that the adviser’s performance is less volatile than it actually is. Undervaluation can also help an adviser engage in self-dealing, for example when a security an adviser buys from a client is undervalued so that the adviser can profit from the principal trade. Undervaluation of positions held by a pooled vehicle, such as a mutual fund or hedge fund, can also damage investors when they redeem their interests in the pooled vehicle. For example, if the adviser has an incentive to benefit new investors and to harm redeeming investors, undervaluation of the securities held by a pooled vehicle can be motivated by a conflict of interest.
The first question with respect to valuation is determining who is responsible for valuation of client positions. It is not uncommon for a third party, a custodian, or pricing service to be responsible for valuation of client positions. When a third party performs the valuation function, the adviser’s responsibilities are limited. The adviser must determine that the third party is competent to perform its functions and must review this determination periodically. The adviser must also avoid improperly interfering with the work of the third party, such as by providing the third party with information the adviser believes to be inaccurate or by pressuring the third party to change valuations in a manner that benefits the adviser. Generally, the delegation of responsibility for valuation to a third party is permissible and enhances the quality of the valuation process.
In certain cases, such as the valuation of mutual fund positions, the fund’s board has an oversight responsibility. Providing the board with accurate information is critical to permitting the board to perform this function.
When the adviser values client positions, the absence of third-party oversight and/or control over the valuation process imposes heightened responsibilities on the adviser. Advisers frequently have a strong incentive to overvalue positions, so careful monitoring by the adviser’s compliance staff for such abuses is important. Disclosure is particularly important when the adviser values client positions. Clients should be told that the adviser, rather than a third party, is valuing client positions so that clients are aware of the absence of an important safeguard created by third-party valuation.
It is often recommended, but not legally required, to create a valuation committee to oversee the valuation process. Such a committee concentrates expertise and responsibility in a single group. Periodic compliance review of the valuation process can be done by the valuation committee, thereby creating independent testing and control over the process.
Such a committee also creates a forum to resolve disputes relating to valuation.
For a registered investment company, the Investment Company Act sets forth standards for valuation of fund positions. The SEC recently amended and updated its interpretations of these statutory standards. For funds subject to these standards, less disclosure is required about valuation practices. Even for these funds, however, special situations can arise that require special disclosure. For example, a fund can adjust prices available when the New York Stock Exchange closes if it believes these prices do not reflect fair value. As an illustration, a fund that invests in Japanese companies may have prices at 4:00 p.m. ET which do not accurately reflect market events that are expected to occur as soon as the Japanese market opens shortly after 4:00 p.m. eastern time.
For client accounts that are not governed by the Investment Company Act, more detailed disclosures about how client positions are valued are usually necessary. Such disclosure must discuss when and how security positions are valued, the role of third parties in the valuation process, the inputs that are used to value client positions, any conflicts of interest involved in the valuation process (such as where the adviser values or materially influences valuations), and any uncertainties involved in valuations (such as the difficulty of valuing securities for which no market information is available).
Accounting standards divide securities into three categories for valuation. The first category, level one assets, are valued based on readily available prices from trading in liquid, regulated markets. For example, the price of Apple stock is based on the last trade in that stock at the time of valuation, usually 4:00 p.m. ET. As noted above, however, there are situations in which the valuation of actively traded securities can present difficulties, such as valuing a Japanese stock at 4:00 p.m. ET when that price reflects the closing price on a market that closed hours ago and may change when the Japanese markets soon reopen.
At the opposite extreme is the valuation of securities for which no market information is available and relevant, so-called level three assets. For example, the valuation of stock of a private company, the securities of which have never traded, can be very difficult and somewhat subjective. Different methodologies can be used. The company can be valued at its liquidation value – what is expected to be obtained if the company’s assets are sold in a fire sale. Alternatively, the company can be valued based on what is expected to be obtained if the company is sold, which is often difficult to determine since no sales of the company’s stock have occurred. Valuation of level three assets requires careful work, documentation of that work, and disclosure to clients about the methodology used and the uncertainties associated with the valuation process. Third-party experts can be used to assist in the valuation of level three assets, but it is not uncommon for the conclusions of valuation experts to differ. A process should be set in advance to address how to resolve differences in conclusions of several valuation experts.
Between level one and level three assets are level two assets, securities for which relevant market inputs are available but for which there is no trade in the identical securities that is relevant. Many fixed-income instruments fall into this category. For example, tens of thousands of mortgage-backed securities have been issued, but it is not uncommon for a particular bond to trade very infrequently and sometimes not at all. However, a bond with identical terms and credit risks may trade on the day valuation is sought; comparison between the trading in this bond with a bond that has not traded provides useful input in valuing the bond that has not traded. Difficulties arise in determining which security that recently traded is comparable to a security that has not traded. It may also be difficult to adjust trading data for securities that trade in very illiquid markets, where some trading data may be unreliable.
The recent SEC guidance on valuations by registered investment companies suggests that level two assets are closely related to level three assets, so that enhanced disclosure and valuation procedures may be warranted for level two assets.
Compliance always requires the creation of policies and procedures, appropriate training, and appropriate testing. Policies and procedures relating to valuation should specify the valuation process. The procedures should specify who does what, how the process should be documented, how disputes over valuation should be resolved, and what needs to be disclosed about the valuation process.
Training relating to valuation should include a review of the valuation policies and procedures as well as a discussion of key enforcement cases relating to valuation.
Testing should include the static price test – reviewing valuations that remain static for suspiciously long periods – and the so-called acid test – comparing sale prices of securities with valuations of those securities in prior periods. Independent audits of valuations also provide an important test, with special attention devoted to situations in which audits result in the restatement of valuations.
How Should Valuation Errors Be Corrected?
The correction of errors is itself a complex subject and is beyond the scope of this article. A few basic standards should be noted here, however, relating to valuation.
Valuation errors can be costly. Advisers need to monitor the valuation process closely, even when third parties prepare the valuations. As is the case for all activities of an adviser, preventing errors through a good compliance program is the best cure.
Advisers should draft good valuation procedures and follow them, train employees on the procedures, and periodically test the accuracy of valuations of client positions.
*Richard D. Marshall is a Partner at Katten Muchin Rosenman LLP in New York City. He represents financial institutions and executives subject to investigations by the SEC, Department of Justice, Financial Industry Regulatory Authority, and state securities regulators. A former senior attorney at the SEC, he also advises financial services clients on regulatory issues. Marshall can be reached at richard.marshall@katten.com or (212) 940-8765.
This article is for general information purposes and is not intended to be and should not be taken as legal or other advice.
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