Sometimes it can be difficult to do the right thing. For example, in the SEC’s latest case involving an investment adviser, a valuation error was discovered. A correction was made. The investors were compensated. The adviser, however, failed to follow its own procedures and an enforcement action resulted. In the Matter of Calvert Investment Management, Inc., Admin. Proc. File No. 3-17630 (October 18, 2016).
Calvert, a registered investment adviser, has served as the adviser to the Calvert Funds, open-ended investment companies. Generally, the price at which an investor can purchase or redeem shares of such a fund must be based on its net asset value or NAV. Registered investment companies generally must value any security for which market quotations are not readily available at fair value as determined by the board of directors. That value is generally based on what the fund might reasonably expect to receive for the security from a current sale.
From March 18, 2008 through October 18, 2011 Calvert Funds acquired over $1.2 billion principal amount of Toll Road Bonds which are complex and illiquid securities. In valuing the securities Calvert performed market research and internal modeling. Primarily, however, it utilized an approach based on the output of a third-part analytical tool.
In making the valuation, Calvert did not incorporate indicia of fair value into its calculations. For example, the adviser did not include prices at which the Calvert Funds traded the securities, values assigned by other holders, and other market data. Calvert also did not back-test the fair value determinations, although it used that procedure for other holdings. In a number of instances the fair value price was significantly higher than the prices at which the Calvert Funds had engaged in market purchases of Toll Road Bonds. Thus in 2009 the fair value assigned to the securities was about 65% higher than that assigned by most of the industry participants on the same day.
Subsequently, the firm discovered that the third party analytical tool was flawed. It failed to properly account for future cash flows of the securities. Calvert reassessed the fair market value, lowering it significantly in 2011. Later in the year the adviser announced a price adjustment for Toll Road Bonds held in various taxable bond portfolios. As a result of the improper valuations from March 2008 through October 2011 the Calvert Funds sold and redeemed fund shares at materially overstated NAVs.
On December 27, 2011 Calvert contributed $27 million to the Calvert Funds. The money was distributed to account holders of record as of October 19, 2011. Undistributed amounts were retained by the Funds.
While the payments were an effort to compensate shareholders and the Funds for harm caused by the improper valuation of the Toll Road Bonds, the amount was derived from an insufficient process. That process was not based on complete transactional data. It also was not in accord with existing Fund policies. For example, Calvert lacked certain data concerning underlying shareholder activity in subaccounts then held through certain intermediary accounts. Nevertheless, the Calvert Funds’ filings with the Commission on Form N-CSR and in annual reports to shareholders stated that the harm caused to shareholders by the improper valuation had been identified and that shareholders had been made whole. This is incorrect.
The Order also alleges that Calvert caused prohibited transactions regarding purchases among affiliates and failed to implement appropriate compliance procedures. The Order alleges violations of Advisers Act Sections 206(2) and 206(4) and Sections 17(a) and 34(b) of the Investment Company Act.
To resolve the proceeding the firm agreed to a series of undertakings which include recalculating the fair value price as well as the NAV and making appropriate payments to shareholders in accord with procedures specified in the undertakings. In addition, the firm consented to the entry of a cease and desist order based on the Sections cited in the Order and to a censure. Calvert will pay a penalty of $3.9 million.