The SEC Is Scrutinizing Asset Valuations - Are You Ready?

The Securities and Exchange Commission (SEC) recently has set its sights on registered entities and their officers and directors for overvaluing the entities' assets.

On October 17, 2012, the SEC charged Yorkville Advisors LLC (Yorkville), a $1 billion Jersey City, N.J. hedge fund firm, and two of its executives with scheming to overvalue assets and exaggerate reported returns in order to hide losses and increase fees collected from investors. On November 28, 2012, the SEC accepted Offers of Settlement from KCAP Financial, Inc. (KCAP), a closed-end business development company (BDC), and three of its officers. The SEC claimed that KCAP did not record and report the fair value of its assets in accordance with the Statement of Financial Accounting Standards No. 157, "Fair Value Measurement" (FAS 157). FAS 157 is now Financial Accounting Standards Board (FASB) Accounting Standards Codification Topic 820 (ASC Topic 820). More recently, on December 10, 2012, the SEC initiated proceedings against eight former members of the boards of directors overseeing five Memphis, Tenn.-based mutual funds for violating their asset pricing responsibilities (Mutual Funds Action).

These enforcement actions appear to be the start of a wave of such actions, especially since many investment advisers that historically were not required to be registered with the SEC now must do so under the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank).

The KCAP case is notable due to its allegation that ASC Topic 820 was not followed. ASC Topic 820 defines "fair value," establishes a framework for measuring fair value for purposes of generally accepted accounting principles (GAAP), and expands disclosures about fair value measurements. Issued in September 2006, FAS 157, now ASC Topic 820, was designed to reduce confusion over the varying definitions of fair value and limited guidance for applying those definitions when applying GAAP. While the FASB stated that ASC Topic 820 did not expand the use of fair value in any new circumstances, those subject to this accounting standard must be aware of how it may affect their valuation and disclosure policies. Pursuant to ASC Topic 820 are requirements:

defining "fair value" as an exit price, which reflects the price that would be received to sell an asset in an orderly transaction between market participants at the measurement date. ASC Topic 820 is a market-based measurement, not an entity-specific...