Model governance: who can change what

Graduate · enrolled learners

This lesson opens with Platinum Partners, 2016.

What happened

Platinum Partners was a New York hedge fund that held illiquid, hard-to-price assets, the kind with no observable market quote, and reported steady returns averaging 17 percent a year from 2003 to 2015, with small gains in 85 percent of months. In December 2016 the SEC and federal prosecutors in Brooklyn, who called it a 1 billion dollar investment fraud, charged that it had overvalued those assets to report those returns and keep paying redemptions: its stake in a small oil producer, Golden Gate Oil, was carried at around 170 million dollars, about 19 percent of the main fund's assets at the end of 2013, while the company barely produced oil and never paid interest on its loans, and the SEC alleged that inflation alone overstated the fund's assets by as much as 13 percent at the end of 2014. The fund told investors its valuations were checked by an internal committee and an independent valuation agent, but the SEC alleged that the founder, Mark Nordlicht, often told staff to move values up or down and left them to write the rationale, so the people who benefited from a high value were the people deciding the value. The main fund went into liquidation in the Cayman Islands in 2016. At the 2019 trial the jury acquitted Nordlicht and his co-chief investment officer of the counts tied to the funds' investors and convicted them of a separate scheme to defraud the bondholders of Black Elk Energy, one of the fund's holdings. Nothing in a pricing model failed in a technical sense; the failure, on the regulators' account, was that the value was self-assigned, produced by insiders with every incentive to inflate it and no independent check that actually stopped them. A number that comes from a mark rather than a market is only as honest as the governance over who is allowed to set it.

The decision point

When an asset has no observable market price, its value comes from a mark, a number someone assigns using a model or a judgment, and the entire integrity of that value rests on the governance over who sets it and who can change it, because a mark set by the person who benefits from it is not a valuation but a wish. Platinum Partners is the case: a fund holding illiquid assets with no market price was charged with overvaluing them to report smooth returns, while the independent checks it advertised did not constrain who set the marks, until it went into liquidation in 2016 and prosecutors called it a 1 billion dollar fraud. This extends the prior lesson from models that trade to models that value: in both, the danger is not the mathematics but who controls it, and for a valuation the control is who assigns the mark and whether anyone independent checks it. A value that comes from a market is disciplined by other participants who will trade against a wrong price; a value that comes from a mark has no such discipline unless governance supplies it, so an insider free to set the mark will, under pressure, set it where they need it rather than where it is. So the discipline is to demand independent governance of any model-derived or marked value: to separate the people who benefit from a value from the people who set it, to require independent verification of illiquid marks against real evidence, and to distrust smooth reported returns from hard-to-price assets, because Platinum Partners shows that a valuation no independent party checks is whatever the insider setting it says it is, right up until the day it cannot be sold for anything close.

Orientation and Year One are open: anyone can read them without an account. From Year Two onward the lessons are for enrolled learners, because progress through the later years only means anything if it is tracked against a record.

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