Valuation Remains a Top Regulatory Focus
The SEC charged GLG Partners, L.P. (“GLG”), a UK investment adviser, and GLG Partners, Inc. (“GPI”), its US holding company traded on the NYSE, for failing to maintain adequate controls over the valuation of Level 3 assets.
This is one of several valuation cases settled by the SEC recently. Perhaps the most notable case involved the board of Morgan Keegan mutual funds, in which the SEC alleged that the funds’ directors delegated responsibility to a valuation committee, but failed to exercise meaningful oversight or properly review the committee’s valuation processes.
What’s the lesson here? It’s about leadership. The SEC is looking for “tone at the top” and is highlighting situations where leadership was found wanting. In short, managers must make sure that they and any committees (such as the pricing committee in question in GLG):
(i) consistently do what their policies say, (ii) in a meaningful way–by acquiring all needed information in a timely fashion and devoting the time needed for a full evaluation, and (iii) having done this, maintain a full documentary record.
These cases also raise a second lesson: it is important for committee members and staff generally to have clarity and accountability as to expectations. The SEC found that GLG staff generally was confused as to whether reports on Level 3 assets were to be provided monthly or semi-annually and had little appreciation as to whose responsibility it was to escalate unwelcome information to the pricing committee. A similar lack of understanding of roles existed in the Morgan Keegan case.
No one wants to be the bearer of bad news. However, today more than ever, staff needs to know how to escalate issues to senior management on a timely basis. Senior management needs to know when and how issues are to be shared with other stakeholders; whether they be regulators, investors, the board, or—in the GLG case, the pricing committee. One further note on this issue, the GLG pricing committee had no firmly established membership, but rather was composed of a revolving group of “representatives” from various organizations and staff functions. It’s hard to build expertise, continuity and accountability with a revolving membership. This is especially the case with respect to a pricing or valuation committee that needs to feel ownership for the issues and develop a process for making sure it receives timely information about significant issues.
So what really happened in the GLG case? The adviser’s policies provided that Level 3 assets would be valued as determined by fund directors in good faith and in consultation with the manager and the fund’s administrator. The directors delegated the responsibility for pricing to an independent committee that did not have a fixed membership but required participation by a representative from the fund’s directors, the fund administrator, a representative from GLG senior management and a representative from the GLG risk management team. A member of GLG’s middle office accounting staff coordinated the meetings but did not develop a systematic practice for creating agendas that tracked existing fund policies or captured unwelcome information. It appears the agendas also did not highlight assets whose prices were not changed.
All of this led to the overvaluation of a coal company that was initially purchased for $210 million, but shortly thereafter marked to $425 million. The upward valuation was based on a report prepared by an analyst who noted recent large increases in prices and contemplated a four-fold expansion in coal production. The analyst and several key staff resigned from GLG shortly thereafter. Needless to say, GLG employees over the next few years received information calling into question the valuation. Information was not provided to the pricing committee for a considerable period of time and, when it did reach the committee, it was included in a large report distributed after business hours on the night before a meeting. The asset remained overvalued and GLG received excess management fees as a result.
The undertakings resulting from the GLG case included more than simply requiring the firms to pay monetary fines. In addition, the firms are required to hire a consultant to enhance their policies and controls. This will likely result in a more onerous program than what would have been sufficient if the firms established an appropriate valuation process in the first place. Watch for the consultant requirement to become a typical condition of future SEC settlements.