SEC Charged Illinois Investment Adviser for Breaching Its Fiduciary Duty and Contravening Its Valuation Policy

Madison Capital Funding LLC (“Madison”), a wholly-owned subsidiary of a large life insurance company (“Parent”), was an Illinois-based registered investment adviser with $3.7 billion under management.Madison’s clients consisted of multiple pooled investment vehicles (the “Funds”).Using funds from the Parent and following an elaborate due diligence and internal credit rating process, Madison would originate certain senior loans for private equity sponsors acquiring lower-middle market companies and sell portions of those loans to the Funds, typically after holding them for a seasoning period of thirty to sixty days.The SEC charged that Madison failed to reasonably determine that the price of those loan sales was at fair market value as required by the Funds’ advisory agreements and representations to investors.

Madison’s practice was to use the par value of the loans less the unamortized loan fee as the fair market value and sale price of the loans.Since there was generally only a short period of time between origination and sale this may have been a reasonable practice during normal or stable times.However, between March 2020 and May 2020 (the “Relevant Period”), at the outset of the coronavirus pandemic and during a severe disruption in the financial markets, Madison continued to sell performing loans it originated before the market disruption but failed to determine the effect of the market disruption on the fair market value of those loans.The world changed but Madison’s valuation practice did not.As a result of the pandemic, credit spreads widened substantially across the fixed income market and there was a resulting decline in prices of many existing fixed income investments.The same was true of the loan market.In fact, many businesses in the restaurant, entertainment and personal physical fitness space suffered dramatic declines in revenue and creditworthiness. Consequently, Madison breached its fiduciary duty to the Funds and failed to act in accordance with its disclosures to investors. 

The SEC’s order found that Madison violated Sections 206(2) and 206(4) of the Investment Advisers Act of 1940, and Rule 206(4)-8 thereunder. Without admitting or denying the findings, Madison agreed to pay a $900,000 penalty to the SEC. Madison also agreed to voluntarily reimburse the Funds over $5 million, plus $200,000 in interest, as compensation for the sale of 143 loans during the Relevant Period that were sold to the Funds at higher than fair market value given the change in the macro-economic climate.Madison also voluntarily made certain enhancements to its disclosures and policies regarding its loan transfer practices.

A significant aggravating factor in this case is that the loans were originated by Madison and then sold from Madison to the Funds; each sale was, therefore, a highly conflicted transaction known as a principal transaction.Each client must consent to such a transaction pursuant to Section 206(3) of the Advisers Act.The mechanism for that consent in this case was an independent review party (the “Funds’ Review Agent”) which would review and consent to each transaction.The Funds’ Review Agent relied on a certification by Madison that each loan sale was at fair market value and was not responsible for making its own determination of fair market value.

The case illustrates the importance of being constantly vigilant to changes in the credit worthiness of individual borrowers and companies as well as changes to the macro economic environment.The valuation policy that states that an adviser values assets at fair market value is simple and elegant; having written valuation procedures and practices that ensure fair value is achieved requires care, diligence and thoughtfulness, particularly in the context of a conflicted transaction. Valuation policies and procedures, especially for illiquid assets, cannot be put on autopilot.