CEO - CFO - CIO Allegedly Overvalued Assets of Closed-End Fund.

[ by Howard Haykin ]

The SEC on Wednesday charged 3 top executives of KCAP Financial - a New York-based fund registered as a business development company (BDC) - with overstating fund assets during the financial crisis.  The fund’s primarily held corporate debt securities and investments in collateralized loan obligations (CLOs).

Profiles of Respondents.    KCAP Financial, Inc., f/k/a Kohlberg Capital Corporation (“KCAP”), is an internally managed, non-diversified closed-end investment company that elected to be regulated as a BDC under the Investment Company Act of 1940.   Katonah Debt Advisors, a portfolio company wholly-owned by KCAP, manages KCAP's funds. Incorporated in Delaware and headquartered in New York City, KCAP’s common stock is registered with the Commission;  its shares are traded on the NASDAQ Global Select Market.

Dayl Pearson, 57, of Locust Valley, NY, has been KCAP’s President and CEO since December 2006.

Michael Wirth, CPA, 54, of Scarsdale, NY, a currently licensed CPA, served as KCAP's CFO from December 2006 through June 2012. 

Jonathan Corless, 60, of Pound Ridge, NY, has served as KCAP’s Chief Investment Officer since December 2006.
 

Summary of SEC Findings and Allegations.   From the end of 2008 through the middle of 2009, KCAP materially overstated the value of its asset portfolio in its reported financial statements. During the relevant period, KCAP held 2 primary classes of assets in its portfolio: 

• corporate debt consisting of senior secured term loans, junior term loans, mezzanine debt, and bonds issued primarily by privately-held middle market companies (“debt securities”);   and,
• investments in collateralized loan obligation funds (“CLOs”).

The SEC found that, during the 2008-09 financial crisis, KCAP allegedly took the following violative actions:

• did not account for certain market-based activity in determining the fair value of its debt securities.
• did not account for certain market-based activity for its 2 largest CLO investments by fair valuing those investments at KCAP’s cost.
• caused KCAP’s public filings to be materially misleading because they stated that these 2 CLOs were valued using a discounted cash flow method that incorporated market data - when, in fact, they were valued at KCAP’s cost.

Who Committed What Violations?   Everyone contributed their fair share of violations.   Here's a scorecard:

• Dayl Pearson (President+ CEO) and Jonathan Corless (CIO):  calculation of fair value of KCAP’s debt securities.  

• Michael Wirth  (CFO): calculation of fair value of KCAP’s CLOs;  preparation of financial statements;  preparation of disclosures re: valuation methodologies in public filings.

• Dayl Pearson reviewed Wirth's valuation disclosures.

• Thus, Pearson, Wirth, and Corless each caused reporting, books and records, and internal controls violations. 

• P-W-C:  each directly violated Exchange Act Rule 13b2-1 (books & and records)

• Pearson and Wirth: violated Exchange Act Rule 13a-14 (false statements and certifications in public filings - e.g., certified that KCAP had in place sufficient internal controls for financial reporting.

• KCAP:  violated numerous GAAP accounting requirements.

In May 2010, KCAP disclosed that it needed to restate the fair values for certain of its debt securities and CLOs and that it had overstated its Net Asset Value by approximately 27% as of the 12/31/08 valuation date.  Also, KCAP’s internal controls over financial reporting were not properly designed to value its illiquid assets because the company’s valuation procedures did not adequately take into account certain market inputs. KCAP’s asset overvaluation and internal controls failures violated the reporting, books and records, and internal controls provisions of the federal securities laws, namely Sections 13(a), 13(b)(2)(A), and 13(b)(2)(B) of the Exchange Act and Rules 12b-20, 13a-1, 13a-11, and 13a-13 promulgated thereunder.

SEC Settlement Sanctions.    For the above stated violations and other violations, the 3 executives agreed to pay financial penalties to settle the SEC’s charges.  Pearson and Wirth each agreed to pay $50,000 penalties and Corless agreed to pay a $25,000 penalty.

For further details, go to:   [SEC PR 12-242, 11/28/12] and [SEC Order].