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"Mismarking": Developments in Valuation Fraud
One of the central business functions performed by an investment fund is the valuation of its positions. Knowing how much its investments are worth allows a fund to redeem investors at accurate levels, demonstrate performance to prospective investors, and charge an appropriate amount in fees. And while some positions can be easy to value — one need look no further than Bloomberg or the Wall Street Journal to know the going rate for, say, Apple stock — more exotic or illiquid holdings can present a challenge for even the most conscientious fund.
They also present an opportunity for fraud. At least according to the Department of Justice (DOJ), which has aggressively targeted valuation or "mismarking" fraud in a number of indictments brought within the last few years. But while these cases create headlines, these are far from easy prosecutions. Recent cases demonstrate the hurdles prosecutors must overcome and the effective defenses that can be raised when so much at trial comes down to whether reasonable judgment and good faith were used in marking a fund's books. And as the DOJ expands its mismarking inquiries beyond stocks and bonds and into areas like private equity, these cases also illuminate the increasing need for robust internal controls designed to eliminate the incentives for an employee or manager to overvalue assets.
Lumiere: "Overriding" the Pricing Services and the Motives to Mismark
From 2011 through 2013, Stefan Lumiere worked at hedge fund Visium Asset Management, which at its peak had a net asset value of approximately $8 billion. Lumiere was a senior analyst and a portfolio manager responsible for a significant portion of Visium's credit fund, which invested principally in bonds and other debt instruments. Like many investment professionals, Lumiere received a percentage of the profits he made on winning positions in the fund.
Many of the bonds in the fund were significantly illiquid — that is, purchases and sales of the bonds were rare. This made valuation tricky. Visium's back office would obtain best estimate market prices from a third-party pricing service, like Markit. But members of the investment team like Lumiere could "override" the pricing service by providing support for their preferred valuation. For example, a quote from an outside broker that it would buy or sell the bond at a given price would suffice.
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