NAV calculations determine the price at which investors enter and exit an unlisted fund vehicle and provide the essential basis for liquidity of shares or other unitised interests in fund entities. If the NAV calculations are incorrect, investors overpay when they acquire their interests or are overpaid when they redeem and dispose of their interests. Recent developments in the financial markets have exposed systemic over-valuation of assets.
Funds may have claims in restitution if it transpires that they overpaid redeeming investors on the basis of overvalued NAV calculations, provided they can re-open the valuation. If they cannot do so, there are only limited circumstances to show that the investor was overpaid on his redemption. Nor can the claims of investors to whom the fund entity still has unpaid redemption liabilities be challenged. It is therefore fundamental to begin by challenging the NAV calculation.
Why and how NAV calculations go wrong
In the current climate the loudest complaint about inaccurate valuations is from investors who have been left with a diminished pool of assets when the music stops. This should not happen. Funds investing in liquid markets are normally required by internal documentation, as well as by applicable financial standards and GAAP, to use current market values for their investments. Less liquid investments tend to be carried at cost.
The system breaks down because of the absence of any genuine objective or transparent price with the consequent scope for suspect valuation methods to emerge. Positions in marketable securities might be valued by soft ‘mark to market’ techniques where the fund manager is permitted to obtain a quote from a dealer, who knows that no trade is on the table. ‘Mark to model’ valuations which established purely theoretical values, supposedly based on comparables, are also heavily criticised because, as it turned out, they had a tendency to produce optimistic pricing. The gulf between such valuations and actual values became obvious when investors began to redeem.
An incentive to overvalue assets and to keep NAVs rising is built into a system where the investors’ returns are theoretical but the manager receives actual income quarterly, based on this theoretical return. Performance and management fees are payable on the value of assets under management. It is not feasible in cases where there is no real transparent market for the fund entity to have removed the fund manager from the process of ascertaining the value of the investments. They may hold meetings but, administrators and directors do not get paid to undertake that work even if they were competent to do so.
Therating agencies may also have their fair share of fault in the debacles surrounding failed SIVs. Apart from the inadequate analysis given to the nature of sub-prime mortgage risk, rating agencies accepted the false assumption that portfolio theory applied. Many of the mortgages packaged in MBS transactions were not properly diversified geographically and were treated as non-correlated when, in reality, they represented a homogenous risk class. The many funds which held direct or indirect interests in these instruments were all infected by the misevaluations that occurred.
Legal effect of conclusive valuation provisions
Typically, an NAV must be struck quarterly for redemptions but investors will also be given more frequent informal estimates of their NAVs. The Articles of Association normally confer the function of determining the NAV on administrators or the board and set out the principles to be used in the valuation. This does not mean that the administrators or the board will physically undertake all the investigations but that the formal function of using this information to determine net assets is given to an organ of the funds. On occasion the fund auditors are given a supervisory role.
The Articles will normally state that the NAV calculation will be “final and binding” or “conclusive”. This is an important provision. NAV calculations are part of the dynamics of the operation of a hedge fund; they enable the fund to operate on a day-to-day basis; they are the foundation for equity investment by investors, but equally they are the foundation for the investors’ decisions to redeem. If NAV calculations were not final, the investors could attack the fund entity or each other regularly to block redemptions or undo them. These challenges could come years after the event and take longer to resolve. All this would bring chaos to an industry which depends on liquidity.
The effect of a conclusive valuation provision in a hedge fund context, where there is an important commercial reason to give the fullest possible effect to it, has yet to be considered. Nevertheless, some indication of what to expect can be gained by looking at how the courts have approached similar clauses in other cases.
Conclusive valuation provisions are binding as far as they go. The Articles constitute a contract between the shareholders inter se and between the shareholders and the company. That does not protect the administrator or the directors from complaints by the company or others for negligence which depend on proving that the NAVs were wrong. These provisions are directed to stop investors challenging each other or the company itself, not to forestall attacks on those who got valuations wrong (who normally have the benefit of separate indemnities).
Nevertheless there appear to be two different types of case where valuations might be upset. The first is well-established but rare in practice. It applies to all valuations, whatever the terms of the contract: if there is fraud or collusion (involving the valuer) the valuation will not be binding. The second attack is more likely to be relevant but less likely to succeed: a valuation may be re-opened if the valuer materially departs from his instructions.
One principle is clear: a mere mistake by the valuer in the carrying out of his instructions is not enough to disturb a valuation where the agreement provides for it to be conclusive. However, the Courts have held that where the valuer “materially departs from instructions” the valuation can be impugned. In Jones v Sherwood1 the Court of Appeal gave examples of such material departure from instructions as being where the valuer had valued the wrong shares, or had valued a particular asset himself, when his instructions said he had to instruct another expert to do so. The distinction between a mistake and ‘departure from instructions’ is an elusive one. In the context of a fund NAV calculation, it might seem straightforward to apply the Court of Appeal’s analysis to show that the administrators had made a ‘material departure from their instructions’ rather than a mere mistake. Articles themselves often provide that GAAP has to be applied in the net asset valuation. Where this has not happened, it would seem logical to assume the NAV could be challenged. But this may be less easy than it seems in practice.
It is not always so easy to determine the difference between a mere mistake and a material departure from instructions, and, with one or two exceptions, the Courts have not addressed this issue head-on. The logical analysis would seem to involve asking two questions: (i) what has the valuer done – what mistake has he made or what departure from his instructions has taken place? and, (ii) as a matter of construction of the contract, did the parties intend that this kind of material departure from instructions should mean that the valuation is not binding?
In Veba Oil Supply & Trading GmbH v Petrotrade Inc2 a similar distinction is apparent in the different approaches of Simon Brown LJ on the one hand, and Dyson LJ on the other. Simon Brown LJ expressed the orthodox: a mistake by the valuer in the carrying out of his instructions will never vitiate the valuation, but a material departure from his instructions always will. The explanation however was more interesting. He explained that in the case of a departure from instructions “the parties have not agreed to be bound” (see paragraph 26). That must logically be a matter of construction of the contract. Dyson LJ approached the matter more directly. He said that if it can be inferred from the contract that the parties intended the valuer’s decision would not be binding in the event that he materially departed from his instructions, the Court would imply a term in the contract to that effect because such a term would be “reasonable and represents the obvious, but unexpressed, intention of the parties [at the time that the contract was made].”3 In Veba Oil, the Court concluded, on the facts, that it would be reasonable to imply such a term. This reasoning shows that it is open to the parties to agree that even the gravest error does not vitiate the valuation.
In the context of a fund NAV it would be difficult to imply a term that anything short of fraud should destroy the valuation. The reasons why it is not reasonable to infer that investors or the fund entity intend to reopen NAV calculations have already been considered. The fact that it was envisaged that the administrator could produce ‘non-speaking’ NAV calculations, and thus not show his methodology at all, reinforces the inference that nobody intends that a failure to follow the valuation methodology set out in the Articles would nullify NAV calculations.
Assuming the hurdle of a conclusive valuation provision can be overcome to nullify the NAV, then the over-payment to the investor should be capable of being recovered by the company under ordinary restitutionary principles (payment by mistake), subject always to the defence of “change of position”4. The claim is that of the fund entity. There are two caveats. There is authority for the proposition that if the transaction has been completed (here the redemption) it is too late to challenge the valuation5. Secondly, if the material departure from instructions is due to the fault or misrepresentation of the party seeking to vitiate the valuation, the court may refuse to allow him to do so, probably on estoppel grounds6.
Even if the NAV calculation is otherwise final and binding, it may be possible to recover the over-payments from investors who had knowledge of the overpayments and can be treated either as insiders or tippees. The fund manager or directors will be insiders with fiduciary obligations. Knowledge of the error in the valuation may be attributable to them. In those circumstances the insider may be subject to a duty to disclose those facts to the fund entity.
If the insider is himself an investor, the valuation and redemption may be set aside, entitling the company to reclaim the entirety of the amount paid to him (not just the amount of the over-valuation) and leaving him in the same position as if he were still a shareholder.7 The fiduciary may also be liable if he has tipped off another investor to redeem.
Recovery direct from the tippee is more difficult in those circumstances because it would have to be shown that the investor acted dishonestly so as to be liable for dishonest assistance8 or that the information provided to them was confidential so as to render him potentially liable to account to the company for profits made9 or damages10.
In the US there is a busy history of clawing back redemption payments under ss544 and 548 of the Bankruptcy Code. These provisions confer rights on the fund entity as well as directly on the shareholders who remain invested in the fund entity. They are able to recover, as against innocent investors, the element of overvaluation in the NAV paid out to investors who redeemed and the entire payment against those who were fraudulent or aware of the overvaluation (see eg. Re Bayou US Bankruptcy Court Sthn Dist of NY Case No 06 B 22306).
However, it is important to bear in mind, whenever these claw-back claims are made, that recovery of redemption payments is not necessarily helpful unless the redemption liability based on the NAV can also be set aside. Assuming that it has not been set aside or vitiated, the fund entity is normally stuck with the liability even if it recovers the payment it made on some other basis. Of course, if the fund entity is insolvent then the redemption creditor only receives a dividend in the liquidation which may be less than his total redemption claim.
There may be scope for setting aside the entire liability when the remedy is equitable but, otherwise, it is far from clear that any other form of claim would achieve this. There is no statutory right to bring this about in the case of a preference recovery in the UK or in the offshore jurisdictions where most of the entities are based. In the US it seems that those liabilities will be disregarded at least in a fraudulent preference claim as can be seen from Re Bayou.
Like many of the legal issues confronting litigators and insolvency lawyers in the hedge fund arena, the precise effect of conclusive valuation provisions and the scope for making claw-back claims has not yet been explored. Such claims have yet to be made outside the US and it is unclear whether it is at all useful to make claw-back claims in the US against innocent recipients of the excessive redemption payment. This is not so if the recipient can rely on his original redemption claim in full and simply set that off against his liability to the fund entity. THFJ
“One principle is clear: a mere mistake by the valuer in the carrying out of his instructions is not enough to disturb a valuation where the agreement provides for it to be conclusive”