Today the SEC issued an Order Instituting Proceedings (OIP) against KCAP Financial, Inc. (KCAP), an internally managed business development company, as well as two current KCAP officers and one former KCAP officer (the Individual Respondents and, together with KCAP, the Respondents). The focus of the OIP is the valuation methodology used by KCAP during the period from the end of 2008 through the middle of 2009, a time when the credit markets suffered a substantial dislocation.

In the OIP, the SEC alleges that the Respondents violated certain reporting, books and records and internal controls requirements under the Securities Exchange Act of 1934 in connection with the alleged deficiencies in KCAP’s valuation practices, which resulted in significant overstatements of KCAP’s net asset value (NAV) in its SEC filings and investor reports. The OIP reminds business development companies and other market participants of the importance of internal controls, and especially proper valuation policies, in reporting accurate financial information to investors. In particular, the SEC noted the certifications included in KCAP’s periodic SEC filings with respect to its internal controls over financial reporting. These certifications were signed by two of the Individual Respondents with respect to KCAP’s Annual Report on Form 10-K and Quarterly Reports on Form 10-Q during the relevant period. The SEC states in the OIP that, “[i]n light of the errors resulting in the restatement [of KCAP’s financial statements] and KCAP’s internal control failures, these certifications were false.”

As described in greater detail in the OIP link below, the SEC maintains that KCAP materially overstated the value of its assets during the relevant period as a result of its failure to account for market-based activity in determining the fair value of its portfolio holdings. The OIP focuses, in particular, on the valuation of certain illiquid debt securities and CLO investments, which KCAP valued at cost, despite the availability of alternative market-based valuation inputs. The SEC asserts that KCAP’s cost-based valuations were inconsistent with FAS 157, which requires fair valuation of assets based on an assumed “exit price” (i.e., the price that would be received in an arm’s-length transaction between willing market participants on the relevant measurement date). The Staff also asserts that this valuation methodology was inconsistent with KCAP’s own public disclosures, which stated that its illiquid debt holdings would be valued using an enterprise value methodology and that its CLO investments would be valued using a discounted cash flow method that incorporated market data. In May of 2010, KCAP restated its financial statements for the relevant periods, resulting in a significant decrease in KCAP’s NAV during the relevant period.

Without admitting or denying the SEC’s allegations, the Respondents submitted offers of settlement and consented to the entry of the OIP, which included the following sanctions:

  • Cease and desist orders against each of the Respondents; and
  • Civil Monetary Penalties against each of the Individual Respondents ranging from $25,000 to $50,000, with the two Individual Respondents who signed KCAP’s SEC filings being assessed the higher penalty.

Click here to access the OIP