Undetectable Valuation Fraud

Recently, the SEC announced charges against three executives of Premium Point Investments (“Firm”) for leading a two-year scheme that overvalued the Firm’s mortgage bonds by more than $200 million. Among these three executives, Anilesh Ahuja, Amin Majidi as well as trader Jeremy Shor were accused of mismarking securities in the Firm’s funds to inflate their value.

Profit & greed

In a classic display of excessive Greed and unscrupulous profit-seeking, this scheme was straightforward in allowing the fund to charge higher management and performance fees based on the higher watermark it claims to achieve on an annual basis.

The genesis of this scheme began with monthly demands by Ahuja who required the Firm to maintain its track record of success and keep pace with the performance of peer funds regardless of market conditions or the actual performance of the funds. Traders at the Firm were thus tasked with “reverse engineering” markets in order to meet the targets that were set in place by Ahuja. This resulted in “challenges” to specific marks provided by dealers that were intended for upward revisions in the pricing of these specific marks.

Collusion with brokers

As mere “challenges” gradually became insufficient, the outright mismarking of securities became relied upon to meet the target returns of the fund. A particular Frank Dinucci became increasingly pivotal to this scheme as Ahuja and Majidi secured the bulk of their fraudulent quotes from corrupt brokers. At the end of each month, traders at the Firm provided Jeremy Shor with a list of securities for which they had marks that they wished to challenge. In direct violation of Premium Point’s valuation policy, Shor would then relay to Dinucci this list of securities and request for inflated marks specifically either in person or over the phone. In exchange for supporting these inflated marks, Dinucci expected that Shor and the Firm would use Dinucci and his firm as their broker and the Firm did indeed become Dinucci’s top client at certain relevant times.

Employment of sector spreads

At the same time, a second type of mismarking became employed that was in direct and explicit violation of their valuation policy. For some context, this is how the firm’s valuation policy reads:

Premium Point’s valuation policy: “obtain and average security-specific quotes from broker-dealers and pricing services.”

For securities not listed on an exchange, the valuation policy indicated that the Firm would “query the pricing sources (both securities dealers and pricing vendors)” and take the “average of the prices” as the fair value of that security… “valued at the mean between the ‘bid’ and ‘ask’.”

Extending beyond the mere employment of corrupt brokers, the Firm also employed the use of “sector spreads” to mismark the Firm’s positions. Where “spreads” are typically the difference between a bid and as ask for a given security, “sector spreads” instead refer to the difference between the bid and ask for entire sectors of securities. Given that “sector spreads” reflect the difference between the cheapest and most expensive securities within an entire sector, it would be at least as large then the spread for any given securities within the sector. This “sector spread” was then abused by the Firm to create what is known as an “implied mid” which is really revising the mid of a bond upwards by half of its sector spread. Case in point was a particular bond in the Firm’s portfolio with which the Firm had received a “mid” quote from a broker of $2.63 and a bid quote of $2.36 from a pricing service. The Firm went on to apply a “sector spread” of $3.68 to this price, which resulted in an “imputed mid” of $4.20, or 78% of the quoted bid.

In truth, a leading fund-of-funds had initially challenged the Firm on their use of such spreads to calculate “mids” when valuing securities. In an email to the fund, the managing director at the fund-of-funds had requested for the Firm to make changes to the valuation policy to ensure that the Firm’s valuation process remained objective and separate from the management of the Firm. Even as these changes were approved by the management, the Firm continued to consistently abuse the use of large sector spreads to fraudulently value such securities in the fund. Going as far as to blatantly lie to the leading fund-of-funds when monthly queries were made regarding the valuation policy of the fund.

Perfect financial crime?

This incident had the hallmarks of the perfect financial crime:

1. Opaque markets with thin trade volumes that result in imperfect knowledge

2. Unscrupulous management teams that pursued profits at all costs

3. Lack of readily accessible, independent 3rd party values

Only the presence of an audit for 2015’s fiscal year forced Premium Point to accurately restate their NAVs; revealing the extent of their mismarking scheme where the NAV in each of its funds were found to be overstated between 13% and 15%. Ultimately, a lesson in due diligence can be gleaned from this incident.

The management’s ability to directly influence the pricing of their underlying assets is a dangerous practice that leaves investors’ especially vulnerable to manipulation by the fund’s management. Certainly, there is a pressing need for more reliable checks on the underlying value of assets reported by firms to be made available in order to prevent similar episodes from repeating itself again.

'Greed and Lies on Wall Street' Is Opening Argument in Bond-Marking Trial [Bloomberg]

United States of America v Anilesh Ahuja, a/k/a "Neil," Amin Majidi, and Jeremy Shor, Defendants