In May 2018, the Securities and Exchange Commission (“SEC”) brought a case against Premium Point Investments LP (“PPI”) whereby PPI engaged in a fraudulent scheme to inflate the value of fixed income securities (PPI invested in RMBS, Subprime RMBS, and IOs). Among other violations PPI obtained inflated price quotes on securities, or “marks,” from at least one “friendly” registered representative of a brokerage firm in return for directing securities trades to the brokerage firm which would earn commissions from the directed trades. PPI then used these inflated price “marks” to calculate and report the funds’ monthly valuations to investors. However, PPI’s disclosed to investors that they would use the mid-point price of each security, a price halfway between the bid price, the highest price at which a prospective buyer is willing to buy the security, and the ask price, the lowest price at which a prospective seller is willing to sell the security in the funds’ portfolios to value the investment funds. They also disclosed in offering documents that assets were valued in accordance with U.S. Generally Accepted Accounting Principles (“GAAP”). Further, PPI routinely derived, or “imputed,” the mid-point prices of securities, even when PPI could easily obtain a midpoint price for the security from a broker. To do so, PPI 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, thereby significantly inflated the values of securities in the funds’ portfolios.
According to the SEC, PPI’s fraudulent valuation scheme resulted in PPI’s reporting inflated month-end net asset values (“NAVs”) and inflated month-end and annual performance for the funds to existing and potential investors. These inflated valuations enabled PPI to: receive excess fees, inflate performance to deter investor redemptions and raise additional investor money for the funds and another new fund. The scheme collapsed when PPI could not meet investors’ redemptions when it could not sell securities at the inflated valuations.
Accounting Standards Codification Topic 820, Fair Value Measurement, provides a framework for determining fair value in accordance with GAAP. Fair value is defined as “the price at which an orderly transaction to sell the asset or to transfer the liability would take place between market participants at the measurement date under current market conditions”.
We remind portfolio managers that valuation procedures should be consistently followed and tested to ensure that illiquid securities are priced fairly. Pricing can be tested in a number of ways including the use of an independent valuation service provider, obtaining prices from independent broker dealers that do not have an incentive to mark up the securities to be valued, and by conducting periodic look backs where the sale of the security is compared to the same security when it was priced within the portfolio that was recently priced. This last procedure may give you insight as to whether your process is accurate or needs adjustments.
Conduct your ongoing due diligence for pricing services as well as all material service providers. When using less transparent securities as part of your investment strategy, include a review of the pricing service’s process or compare the valuations to your best execution review to ensure pricing is accurate. When prices are awry, take action which may include; challenging the pricing service, or adjusting the portfolio pricing.
If you have any questions regarding the topics discussed herein, please contact your NCSRC Consultant.