SEC Asset Valuation Claims Rejected on Summary Judgment

The Commission lost virtually all claims in an asset valuation case brought against a fund and two of its officials. The action was one of several brought as part of the Commission’s Aberrational Performance Inquiry which, prior to this action, had spawned six cases. The Inquiry is a joint project of the Enforcement Division’s Market Abuse Unit and the Office of Compliance, Inspections and Examinations and the Division of Risk, Strategy and Financial Innovation. It focuses on identifying areas of inquiry by using a series of performance metrics to assess the performance of a hedge fund. Stated differently, it seeks to determine if there are outliers suggesting suspicious conduct. SEC v. Yorkville Advisors, LLC, Civil Action No. 12 CIV 7728 (S.D.N.Y. Opinion March 29, 2018).

The complaint

Named as Defendants were prominent hedge fund manager Yorkville Advisor, LLC and two of its principals Mark Angelo and Edward Schinik. Yorkville is a registered investment adviser founded by Mr. Angelo. Mr. Schinik served as CFO and COO. It managed the YA Global Investments (U.S.) LP fund, the YA Offshore Global Investments, Ltd. fund and the YA Global Investments, LP fund.

The investment strategy employed generally called for funds to be put into privately negotiated structured equity and debt in public and private companies. It provided alternative financing for microcap and small-cap publicly traded companies. The investments were structured in various forms including convertible securities, standby equity distribution agreements and convertible preferred securities. An important part of the profits achieved came from sale of securities obtained as part of the overall investment.

Yorkville’s ability to understand the valuation of its investments was critical to its strategy and results. The PPM given to investors specified that GAAP would be followed in calculating the net worth of each fund. Yorkville’s internal policies also required it to mark the funds’ investments at fair value. Until the market crisis the adviser used a valuation method it called in pitch materials the “Yorkville Method” which it claimed was GAAP compliant.

As the market crisis unfolded Yorkville had difficulty liquidating securities it obtained from the investments. In 2008 the adviser altered its branded valuation method, adopting a new approach. While it claimed that the new method was GAAP compliant in fact it was not, according to the complaint. Under the new method most of the convertibles were simply carried at face value rather than at current, fair and accurate valuations as required. No testing was done to validate the values. Indeed, the values of the collateral underlying the convertibles were unknown. As a result Yorkville overvalued a series of investments by at least $50 million as of December 2008 and $47 million as of the end of December 2009. The supporting documentation of the defendants reflected these over valuations, according to the complaint. The over valuations inflated the value of the funds which attracted investors and increased the fees that Yorkville charged.

Misrepresentations were also made to prospective investors to lure them into putting their money in the funds. Those concerned the collateral underlying certain securities obtained as investments, the liquidity of the Funds and their internal procedures.

The complaint alleges violations of each subsection of Securities Act Section 17(a), Exchange Act Section 10(b) and Advisors Act Sections 206(1) and (2) and 204(4). It also alleges control person liability under Exchange Act Section 20(a).

The Court’s Opinion

Defendants moved for summary judgment. The motion focused primarily on the period 2008 and 2009 during which the SEC claimed there were fraudulent misrepresentations regarding the value of 15 Yorkville investments out of the 265 positions held along with certain other misrepresentations regarding the internal procedures and related issues. The Court granted the motion for summary judgment with very limited exceptions – a claim against Mr. Mr. Schinik and a negligence allegation regarding Mr. Angelo where there were conflicts of fact precluding summary judgment. Any liability of the firm would be determined by the outcome of those claims.

The positions at the center of the motion were valued at the lower of cost or market until gains were realized prior to 2008. Under this methodology the firm recognized unrealized losses but not unrealized gains. When FASB Statement 157 was adopted in 2008 the firm implemented fair market value accounting per that pronouncement. For the 15 positions involved here “fair value” was “more of an art rather than a science, due to their low to non-existent market activity,” according to the Court.

The adviser had a valuation committee that considered value issues and used various consultants. The value of the Funds’ assets were listed on various “one-pagers” and other materials furnished to investors. While the documents provided an overall value of the Funds’ assets, the value of each of the 15 positions at issue here was never listed. In addition, the financial statements for the period 2008 and 2009 were audited by an outside firm. As part of that process the audit firm selected certain investments for testing which included the majority of the 15 positions involved here.

The SEC’s allegations fall into two groups, according to the Court. The first group alleged misrepresentations regarding the value of the 15 positions. The second focused on what the Court called “one-off misrepresentations concerning the Fund’s internal procedures and financial health.” In a lengthy opinion reviewing each of the Commission’s claims, the Court concluded that either the evidence supporting the allegation was lacking or the asserted factual support was misstated, with the limited exceptions noted above.

The Court began by considering whether there was evidence supporting a finding of scienter under the motive and opportunity test. The Court rejected the SEC’s claim that motive and opportunity could be established from the firm’s compensation incentives. Neither that policy nor Mr. Angelo’s status as majority owner of the firm is sufficient for purposes of establishing opportunity. Likewise, the fact that the firm was suffering financial stress during the market crisis – what the SEC called being “’caught in a death spiral’” — also failed to establish the test used by the Second Circuit. And, while motive can be demonstrated by factual allegations that “corporate insiders allegedly engaged in misrepresentations in order to sell their own shares at inflated prices” as the SEC claims, that was not the case here. To the contrary “Defendants Angelo and Schinik “made their redemption requests when YA [Yorkville Advisors] was actively marking the Fund down by approximately $33 million . . . in October, November, and December 2008.” (emphasis original).

The Court also rejected the SEC’s claims that the evidence supported a strong inference of scienter. For example, the Commission claimed that Mr. Schinik’s intent was demonstrated by his failure to disclose what it called key documents to the outside auditors during the period as well as his affirmative misrepresentations regarding the 15 positions to the investors and auditors. The Court rejected these claims, noting “First and foremost, internal and external reviews of YA’s valuations of the 15 Positions never showed any evidence of fraud or deceit . . . [the valuation committee] met regularly and attempted to value assets that were inherently difficult to value and required subjective judgments, due to their illiquid and customized nature. There is no evidence that Defendants Schinik or Angelo instructed anyone to withhold material information from the VC [valuation committee], or delay the write down of any investment.”

The Court also rejected claims by the SEC that misrepresentations were made regarding the valuation policies. For example, the Commission argued that a letter to the outside auditors falsely claimed that “’In some cases, the General Partner employed financial models to determine a ‘best estimate’ valuation . . .’” was false because models were not used. The Court found, however, that “the record is replete with instances in which YA used financial models in connection with their investments.”

Finally, a claim by the SEC that red flags were not disclosed to the auditors is not supported by the evidence, according to the Court. For example, the agency claimed that Defendant Angelo did not disclose a “side agreement” he had signed to the audit firm. While this is correct, the SEC “never articulates why YA’s failure to disclose this agreement constituted an intent to defraud McGladrey [outside auditor] with respect to YA’s valuations. The SEC does not point to any specific information YA was trying to hide, let alone why it was material, or what benefit YA would have derived from withholding it. Without these accompanying allegations, the SEC’s accusations concern a mere failure to disclose,” like its other allegations, fail to support its fraud claims.

Program: Insights Into SEC Enforcement, is roundtable discussion of the Former Directors of the SEC’s Division of Enforcement that will be held on April 3, 2018 beginning a 4:30 p.m. at Georgetown University Law School. The program will be followed by a reception. Registration is available here without charge. The program is sponsored by the SEC Historical Society, the Federal Bar Association, and the Association of SEC Alumni.