What are the legal concerns resulting from valuing instruments? What are the main legal pitfalls and challenges concerning illiquid instruments?

The problems around valuations are legion. There are concerns about the closer involvement of administrators in valuating investments as well as the inherent conflict of interest when the investment manager values generally illiquid assets. More subjectivity in pricing is needed as well as consistent methodologies. How this particular problem will be resolved is not clear as the legal profession also battles with the issues.

Henry Bregstein at Katten Muchin Rosenman in New York expresses concerns over the general trend over the past few years towards administrators ‘calculating’ net asset value (NAV) as opposed to ‘valuing’ investments. Although the trend is beginning to reverse, he is cautious about the implications.

“Even where an administrator is valuing investments – for example, obtaining independent third-party values and applying a consistent methodology – an issue arises with so called Level 3 assets under FAS 157 which can be thought of as assets that are neither traded on a market nor are analogous to market-traded assets,” explains Bregstein.

These assets, which are generally illiquid, are often only effectively valued by the investment manager. “This implicates a significant conflict of interest and, as has often been the case, the value of illiquid assets has not reflected the liquidation value. This has resulted in investors facing significant losses and managers facing potential legal liability,” he notes.

John Langan at Withers believes there is a fundamental conflict of interest between the compensation a fund manager receives, which is based on a fund’s performance, and the manager’s involvement in determining the value of complex or illiquid securities in the fund’s portfolio.

“Ultimately, investors in a fund want to ensure that the NAVs used as the basis for all subscriptions, redemptions and performance calculations have been calculated fairly,” explains Langan.

He recommends independent valuation, where possible by an independent third party, such as an administrator, over more subjective methods of valuation such as those based on a model.

Nora Bullock and Simon Atiyah at Lovells see the fundamental problem as hedge funds marketing themselves as relatively liquid investments. They say open-ended products such as hedge fund structures historically were not thought to be compatible with the acquisition of illiquid assets. So real estate funds and private equity funds are not considered ‘liquid’ and are not open ended.

Hedge funds, however, are open ended. While the market for a particular hedge fund is in equilibrium – when redemptions do not markedly exceed new subscriptions – problems do not occur. But, cautions Bullock and Atiyah, when redemptions are significant, questions can be raised over the appropriateness of values ascribed to illiquid assets.

Simon Firth at Kaye Scholer believes the lack of an independent valuation can be a problem for US funds. US-based managers are not required to appoint an independent valuer or administrator and there have been cases of fraud arising from false valuations, he points out.

“Illiquid investments can be hard to value and may require specialist valuation beyond what the administrator can provide,” says Firth.

“If illiquid assets are overvalued and they have formed a component of a NAV calculation on the back of which an investor has exited the fund, then continuing investors may have a claim against the fund,” he says.

According to Jonathan Tonge at Walkers, the valuation methodology may be prescribed by the fund’s documents or by the accounting standards the fund follows. “However, in a distressed situation,” he warns, “valuation is likely to become more subjective and therefore more difficult to test. Hard-to-value securities are self-evidently more open to challenge and it is possible to ascribe two different values which are equally justifiable.”

At Brown Rudnick, Sonya Van de Graaff thinks the problems around pricing are different depending on whether the investment is involved in an insolvency or not. “There are two relevant questions: what is the claim under the instrument and what is the recovery rate under the instrument?” she says.

Lehman is an example where it is possible to have a view as to the recovery rate that requires a legal analysis of the instrument including set-off rights and where there is an understanding of what the claim is under the instrument.

“Take the situation of notes issued by Lehman BV. While the issuer is a Dutch entity, the notes may be governed by English law and guaranteed by a Delaware company under a New York law guarantee,” explains Van de Graaff.

“In an insolvency situation you may have to determine under English law what your claim is and submit it in the Dutch bankruptcy process and also in the New York bankruptcy. So, multiple sets of law may need to be analysed,” she says.

Robert Briant at the British Virgin Islands office of Conyers Dill & Pearman believes if there is a miscalculation in the value of an asset, then certain shareholders will benefit while other shareholders will be harmed. “It is the duty of the directors of the hedge fund, as delegated to the administrator or manager, to ensure that an accurate valuation as possible is ascribed to each asset,” says Briant.

For him the main legal concern for failure to properly value an asset is “a breach of fiduciary duty as well as a likely breach of the subscription agreement and memorandum and articles of association, potentially exposing the directors and as a result the manager and administrator to legal action.”

At Conyers Dill & Pearman in the Cayman Islands, Tania Dons and Richard Finlay say the main legal pitfalls and challenges surrounding illiquid assets are how to deal with them without impacting the liquidity of other investments and to enhance recovery from those assets as far as possible. They say the key mechanisms currently used by funds include lock-ups, gates, suspensions and side pockets.

Eliot Simpson at Appleby in the Cayman Islands says the main problems his law firm has seen with valuation are either where the values are difficult to assess or where the reported values come from a manager or advisor but turn out to be dishonest. “In either case the administrator can end up reporting false values. Given that investments and redemptions are determined by NAV, these problems can cause all sorts of headaches,” says Simpson.

“Investors who bought in at an overstated NAV might try to rescind their investment and extract 100% of what they put in, notwithstanding an overall drop in the real value of the fund,” he suggests. Investors redeeming at overstated NAVs might expect to be the subject of ‘claw-back’ claims.

“Pending resolution of these issues redemptions or distributions are likely to remain suspended and investors are unlikely to be able even to extract what limited value is left in their investments. These issues may take many years to resolve,” he says.

At Maples and Calder, Jon Fowler says the main issues include determining who is valuing the assets: the manager, the administrator, both or a third-party valuation agent?

“If a fund wants to have the ability to designate side pockets it needs to have the flexibility in its documents. It is important that the structure is capable of preserving existing rights without encumbering new investors,” advises Fowler.

“The usual model is a separate class of shares either issued to investors following compulsory redemption of their general class shares or by a re-designation of general class shares. The ability to do this needs to be built into the fund documents up front,” he explains.

He concludes valuation policies need to ensure that the competing interests of redeemed and remaining investors are taken into account and are disclosed in the offering documents.