Insight Analytical Note

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Poorly Implemented Valuation Policies and Procedures

Background:

  • On May 24th 2023, the U.S. Securities and Exchange Commission (“SEC” or “Commission”) charged Sciens Investment Management, LLC and Sciens Diversified Managers LLC (“Sciens”) with violation Rule 206(4)-7, the Compliance Rule by not having sufficient policies and procedures to support the valuation of Level 3 assets.
  • In addition to a fine, Sciens agreed to certain undertakings, including the retention of an Independent Consultant to review its policies and procedures.

Key Facts and Allegations:

  • Valuation of a Level 3 Asset – Sciens Special Situations Master Fund Ltd. (“SSSMF”), the fund in question, charges management fees on net asset value. In 2016, SSSMF’s auditors issued a qualified audit opinion which they later withdrew because they could not obtain sufficient support for the valuation of certain Level 3 assets in the portfolio. This ultimately caused SSSMF to restate its financial statements for the years 2016 to 2019 and write-down its Level 3 investment by a net amount of $32.9 million. Ultimately, Sciens made retroactive adjustments to the management fees charged or accrued for the years between 2016 and 2019.
    • Analysis – The Order describes a significant valuation issue that persisted over a long period of time. It further appears that Sciens was aware of this issue but did not address it for several years. During this time, Sciens not only charged elevated fees but potentially marketed its fund with inflated values. Nevertheless, Sciens ultimately adjusted the marks in question, restated financials, adjusted any management fee overage, and obtained an unqualified audit opinion.
  • Valuation Policies and Procedures – Sciens had adopted written valuation policies and procedures which were documented in its compliance manual. Those policies referenced formation documents and the need to value holdings consistently with GAAP’s ASC 820. However, those policies and procedures did not provide enough substantive guidance or parameters as to how to comply with ASC 820. For example, Sciens policies and procedures did not discuss valuation techniques or methodologies applicable to Level 3 Investments, and further lacked procedures designed to promote consistency in the valuation process.
    • Analysis – While it may make sense to include policies and processes that promote valuation consistency, it could be impractical to implement many of the other elements the SEC flagged as violations. Different assets may require a variety of valuation techniques and approaches making it impractical to enumerate them in a compliance manual. Further, ASC 820, which was referenced in Sciens’ compliance manual, already sets forth a framework for Level 3 valuations and repeating them in a compliance manual would not add any value to a compliance program and would not have prevented the mis-valuation of the Level 3 asset which was caught by SSSMF’s auditors.

Takeaways:

  1. Don’t Ignore Red Flags – Sciens appears to have ignored red flags raised by its auditors over multiple years which resulted in a substantial valuation issue. While Sciens eventually remediated, the firm’s slow response was likely a key fact considered by the SEC when determining whether to pursue this case.
  2. Don’t Change Your Valuation Policies Solely in Response to this Case – Managers should consider this settlement in context and only modify their policies if it makes sense to do so for their business. In fact, implementing some of the elements set forth in the Order could be counterproductive for large firms which use a variety of valuation techniques which if incorporated into a compliance manual would make it unwieldy and less usable.
  3. Stand Alone Policies and Procedures Case – Cases centered around policies and procedures are rare and this should be considered another data point highlighting the aggressiveness of this Commission. However, one should also consider that substantive valuation cases are hard to bring and the conduct in this case was potentially egregious. In such circumstances, a stand-alone policies and procedures case could be the only way to highlight extreme conduct.
  4. Valuation Risk is Real – Valuation cases and exam findings have been rare, but are taking on an increased importance in the current environment. Managers should pay extra attention to the substance of their Level 3 valuations to ensure that all inputs have been correctly incorporated, any assumptions reflect their best estimate of performance and their valuation models are appropriate for the asset that they are applied to.