The SEC and the Massachusetts Securities Division (the “Securities Division”) settled administrative enforcement proceedings against an investment adviser (the “Adviser”) and affiliated distributor (the “Distributor”) for a mutual fund (the “Fund”) relating to overstatement of the Fund’s net asset value (“NAV”). This article highlights some of the SEC’s principal findings as presented in the order issued in connection with the settlement (the “Order”) with respect to the Adviser and the Distributor; in each case, the party to the Order consented to the Order without admitting or denying its findings. The SEC’s investigation was conducted in conjunction with the Massachusetts Securities Division, which made similar findings and found similar conduct violative of Massachusetts securities laws.
The SEC found that the Adviser caused the Fund, which invested primarily in mortgage‑backed securities, to overvalue certain of its assets in calculating NAV during the period February 2007 to June 2008. During a three week period prior to the Fund’s liquidation on June 18, 2008, the Fund revalued numerous securities it held downward, resulting in significant declines in NAV relative to normal fluctuations in the Fund’s share price. The Distributor communicated material, non-public information regarding the repricing selectively to Fund shareholders and financial intermediaries, including an affiliated broker-dealer, without issuing a press release or making any other public disclosure regarding the repricing.
The Order includes the following findings by the SEC:
Overstated NAV - The Adviser violated Section 206(2) of the Investment Advisers Act of 1940 (the “Advisers Act”), which generally prohibits an investment adviser from engaging in any transaction, practice or course of business that operates as fraud or deceit on any client or prospective client, by causing the Fund to overstate its NAV from February 2007 until the Fund’s liquidation through the failure by the Fund’s portfolio management team “to factor readily‑available negative information into its recommended valuations of certain [mortgage-backed] securities and its recommending valuations for a significant portion of the Fund’s holdings based on prices provided by [a] Florida broker-dealer, which in turn generated higher advisory fees paid by the Fund.” The Order noted that the Adviser had not performed adequate due diligence on the Florida broker-dealer, almost all of whose valuations were revised downward in the subsequent repricing of the Fund’s portfolio, with some valuations reduced by more than 90%. In addition, the Fund’s portfolio management team withheld information on new developments affecting the value of a Fund holding from the Fund’s valuation committee; when the committee later became aware of the development, the security’s value was reduced to zero. The Fund’s portfolio management team misrepresented a transaction by another mutual fund managed by the Adviser in a security held by the Fund to the Fund’s valuation committee as a “distressed sale” by the counterparty, which meant that the transaction could potentially be disregarded for valuation purposes. The Fund was then valuing the security at ten times the value at which it was purchased by the other fund, but subsequently adopted the latter value when the Fund was repriced.
By virtue of the foregoing conduct, the SEC also found that the Adviser willfully aided and abetted and caused the Fund to sell and redeem its shares at a price other than its current NAV in violation of Rule 22c-1(a) under the Investment Company Act of 1940 (the “1940 Act”). The Distributor was found to have willfully violated Rule 22c-1(a) because while acting as the Fund’s principal underwriter, it sold and redeemed shares of the Fund at a price that was not based on current NAV.
- Selective Disclosure Regarding Repricing - The Adviser and the Distributor violated Section 206(2) of the Advisers Act by disclosing information regarding the repricing of certain Fund holdings to select shareholders and financial intermediaries, specifically including shareholders who were customers of an affiliated broker-dealer, while failing to inform the Fund’s Board of Trustees about these disclosures. The Order indicates that the Adviser knew or should have known that the selective disclosures would lead to substantial redemptions by shareholders at an inaccurately high NAV, thereby diluting the Fund. The Order notes that the Distributor violated Section 206(2) in willfully aiding and abetting the Adviser’s violations by providing substantial assistance to the Adviser by making the selective disclosures to certain shareholders of the Fund. The SEC found related violations of Section 204A of the Advisers Act and Section 15(f) of the Securities Exchange Act of 1934 by the Adviser and Distributor, respectively, for failure to supervise their respective personnel to prevent the misuse of non-public information.
- Affiliated Transactions - The Adviser violated Section 17(a)(2) of the 1940 Act by willfully aiding and abetting the purchase of securities from the Fund by other funds advised by the Adviser in violation of Rule 17a-7 under the 1940 Act, which allows transactions between a mutual fund and certain of its affiliates subject to specified conditions. The Fund’s portfolio management team caused certain other funds managed by the Adviser to purchase securities from the Fund at prices other than those required by the Rule and effected the trades through broker-dealers who received remuneration, contrary to the Rule’s conditions.
- Best Execution - The Adviser willfully violated Section 206(2) of the Advisers Act when a trader for the Adviser refused to consider the prospect of an offer from a broker-dealer to pay a higher price for a particular security held by the Fund on the condition that the broker-dealer be allowed to purchase the security outright rather than being required to immediately re-sell the security to another mutual fund advised by the Adviser. The SEC found that as a result of this conduct, the Adviser failed to seek to obtain best execution of the trade for the Fund and favored another client over the Fund in breach of its fiduciary duty.
Sanctions. Under the terms of the settlement, the Adviser and the Distributor will, among other things, pay $33 million to a Fair Fund to compensate shareholders. The Adviser will also pay disgorgement of approximately $3 million. The Adviser and Distributor each agreed to a civil penalty of $2 million. The Adviser also agreed to review for any NAV errors related to pricing other funds it advises that held the same securities as the Fund or securities for which the Fund’s portfolio management team was responsible for recommending valuations. To the extent that a fund’s NAV was materially overstated as a result of valuation errors, the Adviser will compensate shareholders for any resulting harm in the same manner as Fund shareholders. To the extent that a fund’s NAV was not materially overstated as a result of valuation errors, the Adviser will compensate that fund for any harm caused by processing transactions at an incorrect NAV. The Adviser also agreed to retain an Independent Compliance Consultant to review the Adviser’s procedures for valuing portfolio securities and preventing prohibited cross trades, and to review the Adviser and Distributor’s procedures for preventing the misuse of material, nonpublic information.