SEC Brings Valuation Charge Against Public Issuer with Takeaways for Certain Investment Managers

On November 22, 2024, the Securities and Exchange Commission (“SEC”) filed a case involving valuation practices at a publicly traded issuer (the “Issuer”)¹. While this case concerns a publicly traded company, it also provides critical takeaways for managers of hard to value assets who may consider hiring a third-party valuation agent.
The Issuer faced charges for various violations of the Exchange Act and paid a $45 million penalty.

Valuation Practices:

The allegations center on how the issuer valued a subsidiary for GAAP purposes. Specifically, the issuer failed to provide its third-party valuation consultant with all relevant information necessary for an independent judgment.
Despite clear red flags, the issuer adopted the consultant’s valuation, disregarding significant contradictory information.

Use of a Third-Party Valuation Agent:

The issuer engaged a third-party valuation agent to assess an underperforming subsidiary. Had the Issuer adopted a valuation lower than its carrying value, a goodwill impairment would have been triggered, negatively impacting earnings. The Issuer provided the third-party misleading information which ultimately led to an inflated value. Specifically:
- Cost Allocation: Issuer provided assumptions relied on an internal cost methodology that shifted expenses away from the subsidiary to a sister division, a benefit unavailable to a prospective buyer who would ultimately be purchasing this division.
- Profit Margins: Issuer provided assumptions excluded shared services (e.g.,accounting, IT) from the cost of running the division, artificially inflating profitability compared to peers.
- Unrealistic Projections: Revenue and margin projections were aggressively optimistic and unsupported by internal analyses.
- Comparable Companies: The agent used non-unionized peers for its comparables analysis despite the subsidiary’s unionized workforce. The Issuer approved this comprables set without disclosing the discrepancy even though it understood that non-unionized companies trade at higher values.

As a result, the valuation was inflated and not GAAP-compliant as GAAP requires that valuations reflect the price at which the division could be sold at the measurement date.

Red Flags Ignored by Issuer:

The issuer relied on the flawed third-party valuation despite clear indications of inaccuracy:

An internal strategy team had previously valued the subsidiary much lower.
Internal performance projections were 50% below those given to the valuation agent.
During a sales process, the subsidiary’s actual value was revealed to be significantly lower. The issuer even accepted a term sheet confirming a substantial discount to both the carrying value and the third-party valuation. This was never disclosed to the third-party valuation agent.

Nevertheless, the issuer used the third-party valuation in its reporting, knowing it was not GAAP-compliant.

Responsibility for Valuations – Even when outsourcing valuations to a third party, investment advisers retain ultimate responsibility for valuation accuracy. Advisers must provide all relevant information to valuation agents and override third-party valuations if they suspect inaccuracies.
Address Red Flags – Engaging a third-party valuation agent reduces regulatory risk but does not absolve responsibility. Advisers must act on red flags such as new information, internal dissent, or concerns about the agent’s competence.
Practical Expedient – Fund investors using practical expedient must still monitor for red flags and override problematic valuations when necessary. Concerns about an underlying manager’s judgment or any information obtained calling valuations into question need to be considered.
Conflict of Interest Heightens Risks – Conflicts of interest heighten valuation risks. In this case, the Issuer aimed to avoid goodwill impairments that would reduce earnings. Compliance officers should evaluate valuations in contexts where conflicts are likely, such as during fundraising or continuation fund transactions for private equity or high subscription/redemption periods for hedge funds.

¹ In the Matter of United Parcel Service Administrative Proceeding Number 3-22327