Valuation is a theme which has run through many recent regulatory events, including the financial crisis, and one which is embedded in much of the subsequent reforms. A recent event in London, co-hosted by Thomson Reuters, discussed the challenges involved in managing the valuation process.
The importance of valuation
The financial crisis began in August 2007 when three French hedge funds limited dealings because of concerns about the valuation of their underlying investments in U.S. mortgage debt. The growing realization that valuations were unreliable led to a seizing up of markets which, in autumn the following year, led to the full-blown crisis. It would be an exaggeration to say valuation was a cause of the crisis, but valuation failings made it easier for the behavior that gave rise to the crisis to flourish.
The manipulation of Libor and forex were also examples of deliberate misevaluation, for which the Financial Conduct Authority has fined firms around £2,200 million, and there have been other enforcement actions in the United States.
The FCA’s largest fine against an individual in 2015 concerned Alberto Micalizzi, the CEO of Dynamic Decisions, a now-defunct hedge fund. In late 2008, the fund suffered losses totaling some 85 percent of the fund’s value.
Micalizzi purported to enter into transactions with third parties designed to conceal the losses, with the Upper Tribunal finding that “… events have now shown, beyond doubt, that the bonds were never genuine.” Micalizzi was fined £2.7 million, which was the largest fine levied in 2015 against an individual. He was also given a full prohibition against performing any role in respect of financial services in the future.
In the Keydata case, the firm was involved in the manufacture and distribution of structured investment products that invested in U.S. senior life settlement policies. The firm went into administration in June 2009 and was dissolved in July 2014.
One of the fund's underlying investment vehicles ceased making income payments and Keydata made up those payments from its own funds. This fact was not revealed to the FCA or to the fund investors. This alleged failing, among others, led the FCA to issue a decision notice against Stewart Ford, Keydata’s CEO, in 2014.
[Related: “Compliance Fail? Go to Jail!”]
Ford is contesting the FCA’s case and penalty, but if it is upheld, the penalty of £75 million would become the largest fine levied against an individual.
Getting valuation right
Thomson Reuters, in association with Voltaire Advisors, this week held a Global Fund Valuation Briefing at which the challenges of valuation were discussed. A panel session discussed a number of the challenges that valuation provides for firms and considered the following matters.
Management of conflicts is critical to getting valuations right. Segregation of duties lies at the heart of conflicts management; as an obvious example, a portfolio manager must not have the final say on a valuation, nor must anyone else whose own interests are linked to the valuation.
It is important, in addition, to ensure that the firm can prove its conflicts management approach is working in practice through continuous monitoring and review of the process. In addition, there must be an effective and documented challenge process.
Documenting and disclosing policies and procedures
Policies and procedures must be in place and must be appropriate to the firm. Importantly, they must be of an appropriate length; having extensive documentation reduces the likelihood that it will be followed and increases the possibility that certain technical elements might be breached. It is better not to have a policy at all, than to have one that is not followed. There must be clarity about who “owns” the firm’s approach to valuation. The FCA’s senior managers’ regime is likely, directly or indirectly, to force that requirement on firms when it is rolled out to the wider financial community in 2018.
The way in which exceptions are dealt with will also affect the way the process is managed.
Documentation is vital, as in so many areas of compliance. A firm will have difficulty standing its ground with a regulator if it cannot prove what happened, using contemporaneous documentation.