Speak To A Live Person: 888.302.4594 Request A Demo

SEC Imposes Civil Penalty on Firm that Misrepresented Valuation Methods

Sunday, October 15, 2017

The SEC has imposed a $75,000 civil penalty against SIX Financial Information USA Inc. (“SFI”) for misrepresenting the methodology it used to value European OTC Call Options for its client. It should be noted that SFI is not registered with the Commission as an Investment Adviser.

In October 2010, an Investment Firm responsible for determining the daily valuation of investments held by a Managed Futures Fund (“MFF”), retained SFI’s valuation services to determine the valuation of European OTC Call Options held by MFF. In order to cross-check the valuations produced internally by Investment Firm, MFF’s auditor had recommended that the fund obtain an independent valuation of the European Options from a third-party valuation agent. Under Investment Firm’s arrangements with a third intermediary/data-manager, SFI was responsible for completing all steps necessary to value the European options, including determining the valuation methodology, developing valuation model templates, determining the sources for inputs into the models, operating the model templates to generate the daily valuations, and making professional judgments about whether the output valuations demanded adjustments to the models.

SFI represented through its course of dealings with MFF/ Investment Firm that SFI would provide independent valuations. For example in January 2011, when MFF’s auditor asked SFI for a detailed explanation of the model used to value the European Options, SFI’s valuation expert represented that SFI used a “modified Black-Scholes model” to value the options. According to the SEC’s order against SFI, the expert further stated that the model’s volatility component depended upon a combination of implied historical values, that the “implied values are taken from observed exchange-traded options where practicable,” and “historical values are calculated using observed market data points for appropriate underlyings.”

Unlike the model described by SFI’s expert, the model actually used by SFI was neither independent nor especially sophisticated. In fact, contrary to the valuation expert’s representations, SFI’s model used the internal estimated valuations supplied by the Investment Firm and “applied a relatively simple formula” to produce “an upper bound, lower bound, and median valuation range around Investment Firm’s valuations.” Thus, as the SEC order against SFI notes, the valuations provided by SFI “were completely derivative” and did not constitute independent valuations of MFF’s European options. Additionally, SFI “did not use a Black-Sholes-based model,” because such a model uses numerous standard inputs which were absent from SFI’s model.

The SEC determined that SFI was operating as an unregistered investment adviser under Section 202(a)(11) of the Advisers Act because it was engaged in the business of advising others as to the value of securities for compensation. Specifically, SFI provided advice to Investment Firm about the value of securities (the European Options) in exchange for compensation.

Therefore, SFI’s materially misleading statements regarding its valuation methodology constitute a violation of Section 206(2) of Advisers Act, which essentially prohibits investment advisers from defrauding clients.

If you are an investment adviser with concerns about the effectiveness of your valuation procedures or if you are unsure about whether you have adequately disclosed your procedures to clients, then please call us at 888.302.4594 or email us at sales@redoakcompliance.com, and we will be happy to assist.

About Red Oak Compliance Solutions

Red Oak Compliance Solutions is the global advertising review software of choice in the financial services industry. It is a comprehensive suite of SEC 17A-4 compliant features that are 100% books and records compliant and provides clients with 35% faster approvals and 70% fewer touches or better. We also offer Smart Review(SM), which solves for the storage and maintenance of disclosures, helping firms reduce risk, decrease review times, and increase the speed of distribution of marketing materials. Smart Registration(SM) automates the licensing and registration management process to help reduce regulatory risk and time spent on manual processes. Overall, Red Oak allows firms to minimize risk, reduce costs, and increase compliance review process effectiveness and efficiencies.