Beware the Slippery Slope of Valuation Shortcuts
When faced with two roads in a wood, an adviser’s best bet would be to take the one approved by the SEC. It will make all the difference.
Connecticut-based hedge fund adviser AlphaBridge Capital Management may be wishing it kept to that tried-and-true road, if what the SEC alleges is correct. The adviser and its two owners on July 1 settled agency claims that they fraudulently inflated the value of client holdings in order to collect higher management and performance fees.
AlphaBridge, a private fund manager, told investors and its funds’ auditor that it obtained price quotes on residential mortgage-backed securities from two independent broker-dealers, when in reality it gave the broker-dealers internally derived valuations to "pass off as their own," the SEC said. The firm and its co-owners, Thomas Kutzen and Michael Carino, collectively agreed to pay $5 million in disgorgement and civil money penalties. A representative from one of the two broker-dealers involved cooperated with investigators and was handed a $15,000 civil money penalty and barred from the industry for at least one year.
"The integrity of the portfolio valuation process is critical to fund investors, especially when it involves illiquid securities," said the Division of Enforcement’s Asset Management Unit co-chief Julie Riewe. "AlphaBridge claimed to use market-grounded price quotes from brokers when in fact it relied on its own rosy view of market conditions to price its portfolio."
"Valuation issues are, have been and will continue to be a major focus for the SEC, particularly with regard to funds that invest in hard-to-value assets, such as thinly-traded or esoteric securities that do not have easily determined fair market prices," said Foley Hoag partner Daniel Marx. "Advisers must take care to ensure that they have appropriate policies and procedures in place to value those assets, that they scrupulously follow those policies and procedures, and that they accurately and clearly disclose their valuation methodologies to their investors and auditors."
"We have entered into this settlement because we believe the settlement is in the best interests of the AlphaBridge Funds and their investors," the advisory firm said in a statement released by its attorney. An attorney representing Kutzen also said that the settlement "was in the best interest of investors," and an attorney representing Carino did not respond to a voice mail or email seeking comment.
The slippery slope
How did AlphaBridge wind up facing these allegations? The SEC shows the adviser moving from accepting independent quotes from the two broker-dealers to providing them with internally derived figures.
From approximately 2001 to 2008, AlphaBridge did receive price quotes from the two independent broker-dealer representatives they worked with, the agency acknowledged. But, sometime between 2008 and 2010, as the number of securities in the funds’ portfolios grew to more than 100, both of the broker-dealer representatives – referred to as Person A and Person B in the agency’s administrative order – "encountered resistance from traders at their respective broker-dealers because the pricing process for [many of the AlphaBridge Funds’ fixed income holdings] was become time-consuming and subjective," the SEC said.
The two representatives told Carino of their situations. Carino, who was also the firm’s chief compliance officer, suggested to both representatives that, in order to "expedite the monthly pricing process," he share his advisory firm’s prices for the securities, which he said he generated by using his own valuation model, according to the agency.
"When Carino began sharing AlphaBridge’s prices with Person A and Person B, he initially did so orally," the SEC said. "…Carino would email a list of the funds’ holdings to Person A and then would read aloud AlphaBridge’s prices to Person A over the telephone. At Carino’s direction, Person A wrote down the prices, then typed them into the spreadsheet." The prices were then sent to the funds’ administrator and/or auditor. Carino followed a similar pattern with Person B "for some period," but by 2012 was sending spreadsheets to Person B electronically with the prices already filled in, the agency said.
Carino told the two representatives to review his prices and, if they agreed, to pass along the prices to the administrator and auditor, the SEC said. "However," the agency alleged, "as Carino knew or was reckless in not knowing, Person A and Person B did little or nothing to review or check the validity of AlphaBridge’s prices."
"By 2010, the prices that Person A and Person B sent to the administrator and the auditor – as if they were generated by Person A and Person B – in fact were AlphaBridge’s prices as generated by Carino," the SEC said. "By 2012, Person B was sending Carino’s price sheets to the administrator – unaltered – within a few hours, and sometimes within an hour, of receiving the price sheets from Carino."
"One might see the problems at AlphaBridge as having started with simple corner-cutting rather than outright fraud," said Marx. "The lesson: Don’t let efforts to improve efficiency create opportunities to commit fraud, especially where the incentives (such as the management and performance fees based on asset valuations in this case) might tempt people to do just that."
The SEC’s decision to take enforcement action against Carino comes at a time when agency actions against chief compliance officers are the subject of some debate, even within the agency itself (ACA Insight, 6/29/15). However, in this case, the pursuit of Carino, who the SEC said took a lead role in the alleged arrangement with the broker representatives, fits the traditional view that the SEC will take action against CCOs who it believes are active participants in fraud, said Morgan Lewis partner Timothy Burke.
Person A, who later cooperated with the agency in its investigation, raised concerns in approximately mid-2010, according to the administrative order. He "told Carino that AlphaBridge’s prices were not in line with prices that Person A was seeing in actual or potential market transactions in the same or comparable securities."
"According to Person A, Carino told Person A that AlphaBridge was switching to a long-term valuation model for the funds’ portfolio, as opposed to a fair value standard, and that the auditor had approved this change," the SEC said. "Person A accepted Carino’s explanation and agreed to continue to pass along Carino’s prices, as if they were generated by Person A, to the administrator and the auditor until April 2013."
Person B, meanwhile, continued passing along the adviser’s prices through the end of December 2012, according to the agency. That changed in 2013, however, after Person B’s employer established a new, more formalized process for providing pricing information to customers. After being told that he would have to go through this new process to obtain his quotes, "Carino declined and thereafter did not seek further pricing from Person B."
A+B did not equal C
Throughout this period, neither Person A nor Person B told the funds’ administrator or the auditor, or their respective employers, that the prices they obtained and were passing on were from Carino, the SEC said.
Person A was terminated by his employer in May 2013 for providing price quotes in violation of the firm’s policies and procedures, according to the administrative order. Person A later told the SEC that he had informed Carino and Kutzen of his termination, but that neither of the adviser executives shared this news with the funds’ auditor.
Person B, meanwhile, was terminated, also for providing price quotes in contravention of his employer’s policies and procedures, in July 2013.
"In recent years, the SEC has stressed the importance of identifying, mitigating and disclosing potential conflicts of interest, in light of an adviser’s particular business model and circumstances," said Marx. "Here, AlphaBridge allegedly relied exclusively on two broker-dealer representatives to provide critical valuation information, and at least one of those representatives may have been heavily dependent on and arguably beholden to AlphaBridge as his primary customer account. Those facts arguably should have raised a question about whether the representatives were truly independent from AlphaBridge."
Audits and rehearsals
As the slippery slope grew steeper, a "greater disparity" emerged between AlphaBridge’s prices and the prices from a group of valuation professionals consulted by the auditor to assist with the valuation of certain of the funds’ holdings, the SEC said. As a result, as part of the 2011 year-end audit, the auditor and valuation group asked to speak to the two broker-dealer representatives, and Carino arranged a telephone call with Person A, according to the agency.
"Unbeknownst to the auditor or valuation group, Carino spent a significant amount of time preparing Person A for the call, including coaching Person A on what Person A should say on particular topics," the agency said.
Following the phone call, the valuation group provided Carino with additional questions, including for information involving trade data, to pass on to Person A. "Carino emailed the auditor’s questions to Person A along with Carino’s proposed responses," the SEC said. "…Person A ultimately sent the responses, largely as Carino had drafted them, to the auditor and valuation group." More questions and answers followed.
In the end, the valuation group "narrowly concluded" that AlphaBridge’s prices were within the range of prices of comparable securities, according to the administrative order. But "neither the auditor nor the valuation group knew that Carino had crafted the responses that they received from Person A or that the supporting data was gathered by Carino and not by Person A."
However, that was not the last problematic audit – and the slippery slope was turning into a hole, a deep one. "As the valuation group began its work assisting the auditor on the 2012 year-end audit, it observed that AlphaBridge’s [securities] prices had diverged even further from the prices in its internal pricing database," the SEC said. The auditor and valuation group again posed questions and Carino "formulated Person A’s oral and written responses," the SEC said. This time, "the responses were not sufficient to address the auditor’s concerns."
The auditor, in April 2013, then suspended the 2012 year-end audit so that AlphaBridge could retain an outside consultant and switch to a model-based valuation methodology. In January 2014, the funds’ NAV was written down more than 65 percent, from approximately $138 million to approximately $48 million, according to the administrative order.
The fees and the payback
AlphaBridge collected a 2 percent management fee per year from the funds’ assets, payable on a monthly basis. In addition, the adviser could collect an annual performance fee of 20 percent of the funds’ net profits if they achieved positive year-over-year returns, the SEC said.
"During 2011 and 2012, AlphaBridge collected management fees from the funds’ that were calculated based on overstated NAVs, causing ill-gotten gains to AlphaBridge and … Kutzen and Carino," the agency claimed. In addition, the agency said, at the end of both 2011 and 2012, the adviser and its two principals collected performance fees they were not entitled to.
Of the $5 million settlement cost, more than $4 million was for disgorgement of these allegedly ill-gotten gains. AlphaBridge was also handed a $725,000 civil money penalty, Carino a $200,000 civil money penalty, and Kutzen a $50,000 civil money penalty. While Carino was barred from in the industry for at least three years, AlphaBridge and Kutzen were not. They were censured, however.
AlphaBridge allegedly willfully violated, and Carino willfully aided and abetted and caused the violation of, Section 206(1) of the Advisers Act, which prohibits fraud. The adviser also allegedly willfully violated, and both Carino and Kutzen willfully aided, abetted and cause, Section 206(2), which also prohibits fraud. In addition, AlphaBridge willfully violated Section 206(4) of the Advisers Act and its Rule 206(4)-7, the Compliance Program Rule, for having inadequate compliance procedures, according to the administrative order, and Carino willfully aided and abetted that violation, the agency said. The SEC also alleged that the firm willfully violated Rule 206(4)-8 for making untrue statements of material fact to investors, and that Carino and Kutzen willfully aided and abetted and caused that violation. Finally, AlphaBridge and Carino were alleged to have willfully violated Section 207 for making untrue statements on the adviser’s Form ADV.