Hedge Fund Advisers that Inflate Asset Value Likely to Draw SEC Attention
It may sound like a way to bring in investor dollars, but in reality it is more likely to bring in SEC investigators. Hedge fund advisers tempted to lure new investors and keep existing ones by taking questionable steps to increase fund value run the risk of being taken to court by the SEC for fraud.
New York City-based hedge fund adviser Premium Point Investments and some of its executives last month were charged in the U.S. District Court for the Southern District of New York by the agency with inflating the value of private funds it advised by hundreds of millions of dollars. Now the government is seeking not only disgorgement of any ill-gotten gains, but a civil money penalty – and the defendants may be facing months, if not years, of litigation, as well as the publicity that comes with it.
"Premium Point, a Commission-registered adviser that managed billions of dollars in assets at its height, and the individual defendants engaged in a fraudulent scheme to inflate the value of securities – at times by more than 100 percent – held by several private investment funds Premium Point advised," the agency said in its 28-page complaint. The "fraudulent valuation scheme resulted in Premium Point’s reporting inflated month-end net asset values and inflated month-end and annual performance for the funds to existing and potential investors. These inflated valuations enabled Premium Point to receive excess fees."
The funds were overvalued by an average of more than 14 percent each month from at least September 2015 through March 2016, according to the complaint.
The problematic activity continued, the SEC said, until it basically collapsed of its own weight, as the adviser "faced difficulties in meeting investors’ redemptions because it could not sell securities in the funds’ portfolios at the inflated valuation prices and as the funds’ auditor questioned Premium Point’s valuations."
Firm executives charged
Also charged were Anilesh Ahuja, also known as Neil Ahuja, who founded Premium Point and was its majority owner and served as its chief executive officer and chief investment officer; Amin Majidi, who served as the adviser’s chief risk officer and then as the portfolio manager of one of its funds, and Jeremy Shor, who served as a director and trader of non-agency securities.
The SEC charges are not the only problem the three executives face. The U.S. Attorney’s Office for the Southern District of New York, which conducted a parallel investigation, on May 9 announced that it had arrested and filed criminal charges against Ahuja, Majidi and Shor. Interestingly, the U.S. Attorney’s Office did not name Premium Point in its announcement, simply referring to it as "the Firm."
"Investors rely on a hedge fund’s performance numbers when deciding whom to trust with their capital," said U.S. attorney Audrey Strauss. . . . "By allegedly cooking the books, Ahuja and his co-defendants made the fund appear more attractive to would-be investors and dissuaded current investors from withdrawing their investments."
Valuation and controls
"The case represents how important valuation processes and controls are in a hedge fund organization," said Lowenstein Sandler partner Benjamin Kozinn. He noted that the SEC’s complaint does not expressly mention either the adviser’s chief financial officer or its chief compliance officer, one or both of whom, he said, likely should have been involved when the question of overriding protocols came up. "At the end of the day, were the CFO and/or the COO part of this process?" he asked.
"Valuation of illiquid securities has and will continue to be a hot button topic for regulators and, as shown by the case here, an area of scrutiny by fund auditors," said Shartsis Friese partner Jahan Raissi. "For firms that invest in illiquid securities, best practices dictate that a valuation committee be used that is comprised of both portfolio management personnel and personnel outside of the portfolio management area, such as compliance and operations. The basis and evidence for valuing the illiquid securities should be documented for each valuation period, and the methodology shared with fund auditors from the outset."
Kozinn suggested that any plans by an advisory firm to deviate from broker quotes should be reviewed by an internal committee and be documented, with the records kept. An outside auditor should also be consulted, he said. Such deviations, Kozinn said, "should be the exception, not the rule."
Adviser and its valuation practices
Premium Point, registered with the Commission as an adviser since April 2009, invested in securities, mortgages, loans, real property and consumer receivables during the period in question, according to the SEC’s complaint. It retained custody of the assets of the funds it advised, since it had access to those securities, the agency said. As with most advisory firms, it received fees, partly based on the value of the assets in the funds it managed – with the value of those funds determined by Premium Point’s valuations.
From at least January 2012 to March 2016, the advisory firm’s valuation policy, according to the SEC, was that:
"Premium Point will query the pricing sources (both securities dealers and pricing vendors) directly and determine the price as follows: If five or more prices are received, the average of the prices (excluding the highest and lowest) price will be used as the fair market value for that security. If four, three or two prices are received, the average of the prices will be used as the fair market value for that security. If one price is received, this price will be used as the fair market value for that security."
The adviser’s month-end valuation practice during this period was to value its funds’ securities at the midpoint between the bid price and the ask price, the SEC said.
The agency, in its complaint, paints a picture of two Premium Point funds "suffering deteriorating performance" from September 2015 through March 2016. Some major investors in one of the funds began requesting large redemptions during this period, the agency said, "which would shrink the fund’s size, decrease Premium Point’s fees, and require Premium Point to sell securities the fund held to satisfy those redemptions."
It added that "Ahuja and Majidi wanted the funds’ performance to track or exceed competitor funds’ performance."
As a result, the SEC alleged, "Ahuja, Majidi and Shor manipulated Premium Point’s valuation process to meet performance targets," in particular by using "sham broker quotes to inflate the funds’ valuations."
How was this done? According to the complaint, before and during the relevant period, Ahuja and Majidi encouraged Shor and [an unnamed] trader to seek from friendly brokers inflated price quotations, or ‘marks,’ on bonds that would then be used to inflate the funds’ valuations." The SEC said that Shor and the trader did so, telling the brokerage firm, also unnamed, that Premium Point would send it trades on which the broker-dealer would earn commissions.
Later in the monthly valuation process, after the advisory firm had received some price quotes from other broker-dealers or independent pricing services, Shor and the trader told the brokerage representative the prices they wanted to see for certain bonds in the funds’ portfolios, the agency said.
Imputed mid-point prices
Getting these "U-turn quotes" from brokers was just the first step in the rigged valuation process, the SEC alleged. It was allegedly followed up by another problematic step: "Premium Point itself routinely derived, or ‘imputed,’ the mid-point prices of securities, even where Premium Point could easily obtain a mid-point price for the security from a broker," the SEC said. "To do so, Premium Point took a bid price for a particular security and added half the spread between the bid and ask prices on a broad sector of securities – not the spread on that particular security – to ‘impute’ a mid-point price for that security."
The end result? "The defendants’ fraudulent valuation scheme resulted in Premium Point’s reporting inflated month-end net asset values and inflated month-end and annual performance for the funds to existing and potential investors. These inflated valuations enabled Premium Point to receive excess fees."
Violations and penalties sought
The SEC charged all four defendants with violating Section 10(b) of the Exchange Act, as well as its Rule 10b-5(a), which prohibits fraud; and with violating Sections 17(a)(1) and (3) of the Securities Act, which also prohibit fraud. Premium Point, Ahuja and Majidi were charged in addition with violating Advisers Act Sections 206(1), (2) and (4), as well as Rule 206(4)-8(a)(2), all of which also prohibit fraud.
Premium Point was separately charged with violating Advisers Act Section 206(4) and its Rule 206(4)-2, the Custody Rule, due to its allegedly having failed to obtain an annual audit of the funds in question by an independent public accountant, having failed to obtain a surprise examination of the funds by an independent public accountant, and having failed to distribute audited financial statements to fund investors within 120 days of the end of the funds’ fiscal years.
Finally, Ahuja and Majidi were additionally charged with having aided and abetted Premium Point’s violations of the Advisers Act, while Shor was charged with having aided and abetted Premium Point’s, Ahuja’s and Majidi’s violations of the Advisers Act.
The SEC asked the court to order the defendants to disgorge, along with prejudgment interest, "all ill-gotten gains" they received, as well as to assess civil money penalties against them, in regard to their alleged actions. Attorneys for Premium Point, Majidi and Shor, when reached, declined an opportunity comment. An attorney representing Ahuja did not respond to a voice mail or email seeking comment.