SEC Settles Charges with Adviser for Fraud Involving Overvaluation of CMOs

Who may be interested: Investment Advisers, Compliance Staff, Registered Investment Companies

Quick Take: The SEC recently announced settled charges against a registered investment adviser for overvaluing approximately 4,900 largely illiquid collateralized mortgage obligations (CMOs) held in 20 advisory accounts, including 11 retail mutual funds, and for carrying out hundreds of cross trades between accounts that favored certain clients over others.

According to the SEC’s order, between January 2017 and April 2021, the adviser managed a fixed-income investment strategy that primarily invested in mortgage-backed securities, treasury futures, and CMOs. The strategy invested in thousands of smaller-sized, “odd lot” CMO positions that traded at a discount to larger-sized institutional positions. The adviser used prices from a third-party pricing service to value the odd lot CMOs, even though the prices were intended for institutional lots only and the pricing service did not provide separate valuations for odd lots. According to the order, the adviser had no reasonable basis to believe it could sell the odd lot CMOs at the pricing vendor’s valuations. Consequently, according to the SEC’s order, the adviser marked the odd lot CMO positions at inflated prices and overstated the performance of client accounts that held the overvalued CMOs.

The SEC’s order further alleged that to prevent investors who made redemptions from incurring large losses, the adviser cross-traded the CMOs at their inflated prices between affiliated accounts instead of selling the CMOs into the market. The adviser also engaged in dealer-interposed cross-trades in which the adviser sold odd lot CMO positions to third-party broker-dealers, then re-bought the positions on behalf of affiliated client accounts, providing liquidity to redeeming investors in an otherwise illiquid market, often at inflated prices. Citing to Section 48(a) of the 1940 Act, the order notes that the SEC has stated that interpositioning a dealer in cross trades does not remove the cross trades from the prohibitions of Section 17(a).

The SEC’s order found that the adviser violated the antifraud and compliance provisions of the Advisers Act and certain provisions of the 1940 Act, including Sections 17(a)(1) and 17(a)(2), Section 34(b) and Rule 22c-1 and Rule 38a-1. Without admitting or denying the charges, the adviser agreed to a cease-and-desist order, to be censured, and to pay a fine of $70 million, along with $9.8 million in disgorgement and prejudgment interest. The adviser also agreed to certain undertakings, including retaining a compliance consultant to review its policies and procedures with respect to, among other things, CMO valuation, associated liquidity risks, and cross trading.

The SEC’s order announcing the settled charges can be found here.