One of Macquarie Asset Management’s investment advisory subsidiaries in the US was handed an $80m penalty for what the SEC said was a years-long pattern of misconduct within one of its fixed income strategies.

The regulator said its settlement with Macquarie Investment Management Business Trust (MIMBT) would resolve fraud charges relating to overvalued assets and illegal cross trades that, according to the SEC, unfairly benefitted some clients while disadvantaging others.

Overvaluing assets

Those assets and trades occurred between 2017 and 2021 and within MIMBT’s Absolute Return Mortgage-Backed Securities strategy, which primarily invested in mortgage-backed securities, collateralized mortgage obligations (CMOs), and treasury futures. The agency alleged MIMBT overvalued approximately 4,900 CMOs in 20 advisory accounts, including 11 retail mutual funds, and since the CMOs were largely illiquid, this made them particularly difficult to price accurately.

As alleged by the SEC, the strategy’s investments included thousands of smaller-sized, “odd lot” CMO positions that traded at a discount to institutional, larger-sized positions. MIMBT valued the odd lot CMOs using prices obtained from a third-party pricing service that were intended for institutional lots only, and did not provide separate valuations for odd lots.

The SEC’s order found that MIMBT had no reasonable basis to believe it could sell the odd lot CMOs at the pricing vendor’s valuations, and thousands of odd lot CMO positions were marked at inflated prices, resulting in overstating the performance of client accounts holding the overvalued CMOs.

“It is alarming that a fiduciary took advantage of retail mutual funds it advised and executed unlawful cross trades to mitigate its overvaluation of fund assets.”

Eric Bustillo, Director of SEC’s Miami Regional

Additionally, the SEC found MIMBT attempted to minimize losses by arranging cross trades with affiliated accounts rather than sell the CMOs. According to the SEC, this resulted in the retail mutual funds absorbing losses that otherwise would have been borne by the selling account in a market sale.

“MIMBT did not have a reasonable basis to believe that the Pricing Vendor Marks accurately reflected the price the Strategy Accounts could reasonably expect to receive for the odd lot Relevant CMO positions in a current market sale,” the order said.

In a statement submitted in response to the settlement, Macquarie Asset Management said this strategy has been discontinued. “This legacy matter is not consistent with how we do business,” the statement read. “We have already undertaken and are focused on completing additional remedial steps to address the issues identified in the investigation, with clients the priority.”

Fiduciary duty

“It is alarming that a fiduciary took advantage of retail mutual funds it advised and executed unlawful cross trades to mitigate its overvaluation of fund assets,” Eric Bustillo, Director of the SEC’s Miami Regional Office, said in the agency’s press release. “Utilizing a third-party pricing service does not negate an investment adviser’s obligation to value assets accurately.”

The SEC brought similar charges against another registered investment adviser firm in December 2016. In its settlement with Pacific Investment Management Company (PIMCO), the SEC said the company misled investors about the performance of one its first actively managed exchange-traded funds (ETFs) and failed to accurately value certain fund securities.

PIMCO agreed to retain an independent compliance consultant and pay nearly $20m to settle the charges.

According to the SEC’s order issued today, PIMCO’s Total Return ETF attracted significant investor attention as it outperformed even its flagship mutual fund in the four months following its launch in February 2012. 

The initial performance was attributable to buying smaller-sized bonds known as “odd lots” as part of a strategy to help bolster performance out of the gate.  But in monthly and annual reports to investors, PIMCO provided other, misleading reasons for the ETF’s early success and failed to disclose that the resulting performance from the odd lot strategy was not sustainable as the fund grew in size, the SEC alleged.

Penalties and rules

Without admitting or denying the SEC’s findings, MIMBT agreed to a $70m penalty in this case, plus $9.8m in disgorgement and interest, and it committed to hiring a compliance consultant to review its valuation practices and policies related to cross trading.

The SEC charged the Rule 206(4)-7 (the Compliance Program Rule) and 206(4)-8 (an antifraud rule geared to pooled investment vehicles), both of which originated under the Investment Advisers Act of 1940.

And it charged the firm with violating SEC Rule 22c-1, which requires the board of an open-end fund to set the time or times during the day when the fund’s current net asset value is calculated.