The COVID-19 pandemic has caused extreme market turmoil. While it appears that the initial shock is subsiding, there is the possibility that market volatility will continue if there is another surge in COVID-19 cases and as the longer-term economic impacts of the pandemic are realized. Market volatility brings more than just economic challenges—it also increases the risk of fraudulent activity, such as the improper valuation of illiquid assets. During market volatility, the risk of mismarking illiquid assets increases as they become more difficult to value. Recently, federal regulators have already been focused on valuation fraud. Similar to their response after the 2008 financial crisis, regulators will only increase their focus on alleged mismarking during market turmoil.
With the fourth quarter approaching, now is the time for financial institutions that regularly value illiquid assets to update their policies and procedures to guard against any mismarking violation, or the appearance of any mismarking violation. Any other company that holds hard-to-value assets, such as private equity firms, commodities brokers, real estate investment trusts, and insurance companies, should take note as well. Additionally, recent federal enforcement action signals that auditors, accountants, and compliance officers should also pay particular attention to this issue.
Financial institutions are generally required to use market data to value portfolio securities when market quotations are available. But when market quotations are unavailable, such as with illiquid securities and instruments, portfolio securities and other assets are valued by determining their fair value in good faith. Valuation of illiquid assets is an important function for financial institutions and any other company that holds hard-to-value assets. Improper asset valuation can lead to incorrect fee calculations, inaccurate performance reporting, and, at worst, civil and criminal actions and sanctions.
During periods of market turmoil, illiquid assets are more difficult to value because of the debt associated with these instruments and the limited visibility into valuation mechanisms (which are already limited for illiquid assets). The volatility created by the pandemic is no different. For example, the pandemic’s devastating impact on the commercial real estate market is likely to negatively affect valuations of commercial mortgage-backed securities as commercial real estate values continue to plummet and mortgage defaults are expected. The pandemic is also having a major effect on the ability of homeowners to make mortgage payments, which likely will lead to more defaults and possibly another residential mortgage-backed securities crisis. Additionally, collateralized loan obligations (“CLOs”) are rapidly losing value as already risky corporate borrowers are defaulting on loans. This environment creates significant valuation issues for mortgage-backed securities, CLOs, and other credit derivatives.
Case Studies from the 2008 Financial Crisis
During the 2008 financial crisis there was a flurry of enforcement actions for alleged mismarking fraud on allegations that traders deviated from the procedures they were supposed to employ to value illiquid assets. It is instructive to examine these cases to understand the risks at issue today.
The greatest cautionary tale is that of Kareem Serageldin, the only Wall Street executive to go to prison in connection with the 2008 financial crisis. Beginning in August 2007, a team of investment bankers and traders led by Mr. Serageldin at Credit Suisse Group (“Credit Suisse”) allegedly overstated the price of billions of dollars of subprime bonds comprised of mortgage-backed securities. According to the DOJ, in the absence of a liquid market and current market prices of an asset or liability, Credit Suisse traders were required to look to other indicia in order to determine the fair value of the assets on their books. During this time, the ABX Index served as a benchmark for certain securities backed by home loans. It was widely understood within Credit Suisse that traders were to consult the corresponding ABX indices when pricing residential mortgage-backed securities bonds and related products.
The DOJ alleged that, as the subprime market deteriorated in 2007, Mr. Serageldin instructed his team to reach specified profit and loss targets instead of consulting the corresponding ABX indices, resulting in the inflation of the values ascribed to the subprime bonds. In February 2012, the SEC and DOJ both charged Serageldin and his alleged co-conspirators. Serageldin subsequently pled guilty to conspiring to falsify the books and records of Credit Suisse and was sentenced to thirty months in prison and ordered to pay forfeiture of $1 million and a $150,000 fine.
Serageldin’s alleged mismarking scheme resulted in significant consequences for the bank as well. In early 2008, Credit Suisse reported a net income that was later revealed to be materially false because it incorporated the alleged fabricated gains from Mr. Serageldin’s mismarked bond positions. After senior management discovered the pricing abnormality, Credit Suisse was forced to take a $2.65 billion write-down of its 2007 year-end earnings results.
In another example following the 2008 financial crisis, an investment management company paid a significant penalty to the SEC to settle charges that it overstated the value of a mutual fund that invested in mortgage-backed securities by failing to properly take into account readily available information about certain mortgage-backed securities in its valuation process. In yet another example, an international bank agreed to pay a substantial penalty to settle SEC charges associated with filing misstated financial reports during the financial crisis. During the height of the crisis, the bank allegedly altered its methodologies for measuring risk associated with certain leveraged trades, which in turn overvalued a portfolio of derivatives through which the bank purchased loss protection against credit defaults.
Lessons for Today’s COVID-19 Market Turmoil
Regulators were focused on mismarking fraud even before COVID-19. For example, in December 2019, the SEC filed a complaint against a Chicago hedge fund adviser and two executives that alleged that they used their own valuation model to artificially inflate the value of structured notes instead of using “fair value.” Then, in February 2020, the SEC issued a settle order commencing administrative proceedings against the firm’s auditor for missing the alleged valuation fraud.
Now, as the pandemic may create market volatility in the months ahead, history tells us that there will likely be another increase in mismarking fraud cases brought by civil and criminal regulators. Indeed, the SEC has already indicated that it will continue to focus on valuation practices. In May, the SEC obtained a receiver over a Florida investment adviser and its affiliates after alleging the adviser fraudulently inflated net asset values for funds it managed to consistently report positive returns. Additionally, in April, the SEC proposed a new rule under the Investment Company Act of 1940 that would establish a framework for registered investment companies and business development companies to determine value in good faith and clarify how fund boards can satisfy their valuation obligations in light of market developments. The rule would require a board to assess and manage material risks associated with fair value determinations; select, apply, and test fair value methodologies; oversee and evaluate any pricing services used; adopt and implement policies and procedures; and maintain certain records. The comment period for the SEC’s proposal closed on July 21, 2020. The SEC has also announced the creation of its Coronavirus Steering Committee that will coordinate the Division of Enforcement’s response to COVID-related issues. In announcing its Steering Committee, the SEC warned that it is “looking for . . . valuations that may attempt to disguise previously undisclosed problems or weaknesses as coronavirus-related.”
Financial institutions and other companies that hold hard-to-value assets should prepare now to guard against the risk of mismarking illiquid instruments during the economic fallout of the COVID-19 pandemic. Ensuring adequate marking and valuation policies in the following areas can decrease the risk of mismarking fraud:
- Adopting Written Policies and Procedures. Written policies and procedures on asset valuation can decrease the risk of mismarking fraud. This will help create a company culture in which mismarking fraud is not tolerated. If written policies and procedures already exist, companies should review them to ensure that they contain clear instructions on who is responsible for marking illiquid assets and how those assets must be valued.
- Implementing Robust Training. Companies should implement robust training to ensure all relevant employees understand company policies on valuing illiquid assets.
- Increasing Supervision. Increasing supervision of asset managers and traders, and their valuation practices, can decrease the possibility of valuation fraud. This is especially true today when employees are working remotely, which itself increases the chances of valuation errors and mismarking. Supervisors should look for the deviations in standard marking processes that regulators target when bringing mismarking cases.
- Strengthening Price Verification Functions. Companies should strengthen their price verification systems and protocols and conduct regular audits on the prices selected for illiquid instruments.
- Retaining an Independent Third-Party Valuation Provider. Companies should consider contracting with independent firms to obtain an objective valuation to consider as part of the company’s own marking process.
- Keeping Records. Companies should keep and maintain records of their processes used to value illiquid assets.
Finally, it is important to implement these policies and procedures now. It is always preferable to proactively discover and remedy a potential securities law violation than to learn of a potential violation for the first time from the government.