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Valuation of Assets A Ticking TIme Bomb With Enforcers

By : Tom Steinert-Threlkeld | November, 25 2009
  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:
  • A governance mechanism, such as a valuation committee or other responsible body.
  • Well-documented valuation policies, guidelines for evaluating exceptions and tests for compliance with policies and procedures.
  • Independent valuation personnel separate from the trading or portfolio management function.
2. Create a Baseline Valuation Policy The approach should include these steps:
  • Identify (by title or group) the parties inside and outside the company involved in the valuation process, including fund administrators or third-party valuation firms.
  • Delineate all roles for each party.
  • Establish the appropriate methodologies to be used in valuing each type of investment.
  • Establish appropriate internal documentation procedures to support the valuation for each type of asset.
  • Establish appropriate procedures for recording any material exceptions taken to the Manager’s ordinary valuation policies and the reasons for such exceptions.
  • Provide for procedures and controls to mitigate potential conflicts of interest in the valuation process (including the involvement of portfolio management personnel in the valuation process).
3. Choose Reliable Sources of Prices Identify and choose sources of prices for different types of investment positions, including
  • Automated price feeds from exchanges and liquid OTC Markets.
  • Common models used widely by other market participants and based on market observable inputs such as prices of similar actively traded assets.
  • Broker quotes for certain OTC securities (e.g., for valuing convertible bonds and derivatives.
  • Discounted cash flow analysis and how discount rates are developed (e.g., for valuing a private loan).
  • Customized or proprietary models used for investment positions with unique features, based in part on unobservable (i.e., non-market) inputs (e.g., for valuing a private equity investment).
  • Other valuation methodologies appropriate for the type of asset.
  • The process used to effect valuation adjustments.
Also see: More or Less: Some Assets Will Get More Than One Price Accounting for Structured Transactions Forcing System Overhauls 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.
  1. Determine what records need to be kept.
  2. Find standardized sources of real-time price and data feeds, wherever possible, for inputs (Bloomberg, Thomson Reuters, Interactive Data Corporation).
  3. Update daily, monthly, quarterly or as frequently as needed – or possible.
  4. Make clear that useful comparisons of similar transactions in less liquid or complex instruments, such as asset-backed securities or warrants, may not be frequent or easy to obtain.
  5. In general, recalculate values only when new transaction data and useful comparisons are available.
  6. Use the model and the algorithms that underlie it as the proof of how you came to your valuation.
  7. Explicitly set out the underlying assumptions of the model and how it adheres to the latest Financial Accounting Standards Board definitions of fair value.
  8. Be careful about making communications part of the record. FIX message, email, text message and other communication traffic can be confusing, after the fact.
  9. Provide systematic overview of the data analyzed, the implications of the data, the judgments made and the conclusions.
  10. Create a numbers-driven model and stick to it.
  11. Until you don’t. Resetting valuation models should include bottom-up review of empirical data, reconsideration of the valuation logic and creation of alternative models. Models must at all time be the best available reflection of market realities.
  12. When you change it, document the change.
  13. Then stick to the new model.
  14. Archive records on each valuation in a server dedicated to keeping and time-stamping the records, for review.
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?
  1. They are training to become airline pilots, according to the Airline Pilots’ Assn.
  2. They are organizing co-operative farms in Colorado and Iowa, according to the Denver Post.
  3. They are applying to the U.S. State Dept. for diplomatic posts, particularly in Western Europe, according to the Federal Register.
  4. They are training to become elementary school teachers in record numbers, according to the National Education Assn.
  5. They have turned to the New York Police Department for careers and steady employment, according to a report earlier this month in The New York Times.
(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?
  1. They were about the same, thanks to big gains in the first half of 2008.
  2. They dropped by 30 percent, to $1.8 trillion.
  3. They fell by half, to just over $1.3 trillion.
  4. They increased to $2.9 trillion, thanks to an influx of money from sovereign wealth funds.
  5. They dropped to $1 trillion, due to fallout from the collapse of two Bear Stearns hedge funds.
(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?
  1. They have received their money back, with interest.
  2. Buybacks to date total approximately $61 billion, with numerous large cases still undecided.
  3. Civil penalties have been levied totaling $597 million against bankers and brokers.
  4. They are awaiting a decision in a $300 billion class action suit against the largest banks and brokers.
  5. The government’s bailout program has appropriated $330 billion to make investors whole.
(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?
  1. Charging hedge fund advisers a percentage of their assets to register with the SEC.
  2. Bundling Ponzi schemes into a separate enforcement department that assesses large fines.
  3. Allowing the S.E.C. to retain the $1.5 billion in transaction and registration fees the agency collects annually.
  4. Combining the S.E.C. and the Commodity Futures Trading Commission into a single agency, and doubling its budget.
  5. Merging the SEC’s enforcement department into the Financial Industry Regulatory Authority.
(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?
  1. This time, the bills focus on the fund rather than the adviser.
  2. Registration in 2004 was fee neutral. This time, advisers will have to pay a percentage of their assets to register.
  3. It will have a much bigger impact this time around, because hedge funds all withdrew their registration back in 2006, when the 2004 requirement was struck down by the courts.
  4. In 2004, registration was solidly opposed by the hedge fund industry, represented in Washington by the Managed Funds Assn. This time, the industry supports it.
  5. This year, the funds will be required to dually register with the S.E.C. and the Labor Dept. (those with institutional money).
(correct answer: 4)

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