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The SEC Regulates Valuation Expert as Investment Adviser

by Brandon Raatikka

A couple weeks ago, the SEC announced a settlement with a financial services valuation firm and a former employee of the firm over charges the SEC brought under the Investment Advisers Act of 1940 through cease-and-desist proceedings. In the process, the SEC showed that it can use the Advisers Act to regulate valuation firms, which may cause some consternation for investment program issuers and their third party valuation experts.

 The facts

SIX Financial Information USA Inc., a Connecticut-based financial services firm, as well as Perry H. Beaumont, a former employee, had been engaged to provide valuation services to an asset management firm, which itself was an investment adviser registered with the SEC. The investment firm was also registered as a commodity pool operator with the U.S. Commodity Futures Trading Commission, and served in that capacity for an unnamed managed futures fund. The fund eventually invested approximately $84 million in European OTC call options that did not have readily determinable fair values (sound familiar?). So, the fund used SIX Financial to provide independent valuations of the European options, and the fund incorporated those values into its own valuation process.

That SIX Financial’s valuations were used to strike a daily NAV disclosed to the investment public explains the SEC’s sensitivity to this matter. The main allegation here is that SIX Financial and Mr. Beaumont were not arriving at their valuations using the Black-Scholes model methods, as they had represented to the investment firm. Instead, they were using a “relatively simple formula” that resulted in valuation ranges that were completely derivative of the investment firm’s own valuations of the options.  Because they did not therefore constitute independent valuations as purported, they operated “as a fraud or deceit upon [the] client.”

 Expanded definition of “investment adviser”

To bring SIX Financial and Mr. Beaumont under the SEC’s jurisdiction as investment advisers, the SEC interpreted the definition of “investment adviser” expansively.  In the past, the SEC has excluded from this definition third party professionals whose investment advisory services were “solely incidental” to their main business. We’re not told whether the valuation firm’s main business was to provide investment advisory services, or whether this kind of activity was incidental to its business. The administrative orders do not contain the words “solely incidental” anywhere near the paraphrased statutory definition of investment adviser that they cite—i.e., a firm that is “engaged in the business of advising others as to the value of securities for compensation.” Without the administrative gloss on the definition, it is indeed very broad on its face.

What this could mean for alternative investment programs

A critical question is how the SEC’s new posture will affect the issuer/valuation firm relationship in the alternative investment context, especially as more public, non-listed programs adopt a daily NAV model for transparency and liquidity purposes. Per its 2016 exam priorities, the SEC is concerned about the quality of valuation controls, and it’s is unlikely that focus will wane any time soon.

In the least, these matters should inspire a deep look at issuer oversight/control over valuation methodologies and valuation firms. Who knows—the newly broadened definition may even cause conservative valuation firms to register as investment advisers. Note, however, that the cease-and-desist orders do not cite failure to register as an investment adviser (either with the SEC or state) as a violation, nor does it impose a registration requirement as part of the sanctions. Thus, absent any fraudulent wrongdoing (or even negligence, which is a very low standard, but not at issue here) the SEC may be unlikely to go after valuation firms just for failure to register. We should keep in mind that this is an unusual fact pattern, dealing with—in the SEC’s opinion—outright deceit or fraud. But at the same time, this may prove to be a troubling precedent. Investment programs and their affiliated advisers (and broker dealers) need to pay close attention to the methodologies used by their independent valuation experts, lest they become an issue that leads to regulatory or reputational consequences.


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Filed Under: Legal and Regulatory