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News August 30, 2004 Issue

Van Wagoner Devalued Holdings to Meet 15 Percent Illiquid Limit, SEC Charges

If your fund ó or any client portfolio, for that matter ó is bumping up against a percentage limitation, buy or sell if you need to, but donít rely on valuations to get you where you need to be.

Thatís the key lesson from a significant SEC enforcement case announced August 27 against San Francisco adviser Van Wagoner Capital Management and founder Garrett Van Wagoner. The SEC alleged that Van Wagoner, after realizing that his funds had exceeded a stated 15 percent cap on illiquid securities, fraudulently caused his funds to undergo "extreme devaluations" of some of their pre-IPO technology stocks. In late 2000 and into 2001, several holdings were marked down to zero, even though most of the devalued companies still held significant cash and the firmís private equities analyst was making positive comments about some of the companies. The SEC also alleged that Van Wagoner improperly treated several post-IPO holdings that were publicly traded as liquid, even though the holdings were subject to a six-month lock-up period.

Interestingly, Van Wagonerís valuation issues first came to light in a December 11, 2001 Wall Street Journal article, which noted that his funds had kept the valuations of 23 technology stocks at their original purchase prices, despite the subsequent bursting of the tech bubble. In the article, Van Wagoner defended his firmís valuation methods, reportedly noting that "the fundsí methods pass muster with the firmís auditors and that in the past, routine SEC checks have found nothing amiss." Two months later, the fundsí auditor, Ernst & Young LLP, expressed concern about the lack of documentation of the fundsí fair valuation methodology. Ernst & Young also noted that the funds purchased certain private placements at times when they held illiquid securities that exceeded the fundsí 15 percent limit.

The SEC also asserted that Van Wagoner, who served as his firmís CCO, failed to review his employeesí quarterly transaction reports under the firmís code of ethics. When he learned that the firmís private equities analyst had failed to report her personal trades in securities prohibited under the code, and continued to trade in those securities, Van Wagoner "did not cause the trading to be halted, and did not discipline the employee," said the SEC. The SEC also separately sued the analyst, Audrey Buchner. She agreed to pay $35,000 to settle the SECís case (note: thatís a good case to show your access persons to emphasize the importance of accurate personal trading reports).

Van Wagoner and his firm agreed to jointly pay a civil penalty of $800,000 and to other sanctions. Van Wagoner will resign at the end of the year as an officer of his funds.

But wait, thereís more! In a separate proceeding, the SEC sued Robert Colman, a former Van Wagoner independent director, for purchasing nine privately-placed securities at the time the funds were doing so, without having obtained a Rule 17d-1 exemptive order for the joint transactions. Thatís apparently a first (note to legal jocks: the closest precedent seems to be a 1963 case In Re: Midwest Technical Development Corp.) 

The SEC noted that Colman had been an active trader in private securities before joining the board and had independently identified the private equity investment opportunities. Nonetheless, said the SEC, Colman and Van Wagoner "were aware that the other was making, or had made, an investment in the same round of financing." The director was ordered to disgorge $16,800 of directorsí fees and interest, and to pay a civil penalty of $25,000.

The SECís case against Van Wagoner did not mention the 17d-1 issue.