The US Securities and Exchange Commission’s recent $3.9 million settlement with social investment manager Calvert Investment Management highlights the operational challenges — and potential legal liabilities– faced by mutual fund companies that must equally compensate all investors for any errors in net asset value calculations .
It isn’t enough to make a best effort. Fund companies must do their homework and treat investors who bought their shares through banks and broker-dealers the same way as those that bought their shares directly through the company. That didn’t happen in the case of Calvert, which is now faced with forking over more money to investors and having to spend millions in administrative fees to clean up the financial mess created between 2008 and 2011. That is when it mispriced several series of bonds issued by the Toll Road Investors Partnership held by by nine of its portfolios.
In its settlement with Calvert, the SEC did not disclose how much additional money Calvert owes investors in those portfolios, because Calvert is still crunching the numbers. The figure could be over US$10 million by some estimates. The SEC did not specify what percentage of the mutual fund complex’s investors were impacted by its pricing and NAV changes, but by some accounts at least 75 percent of Calvert’s investors held shares in Street name — the name of a financial intermediary. Hence, they might be owed the most.
Calvert had bought US$1.2 billion face value of the bonds in question at a deep discount between 2005 and 2011. When the bonds were finally marked down in October 2011, Calvert was forced to decrease the NAV of eight of its portfolios. It did reimburse investors US$27 million the following month. However, the figure is inaccurate says the SEC because Calvert didn’t do the math correctly. As a result, some investors received more than they should have, some received less, and some received no compensation at all.
Founded in 1976, the Bethesda, Maryland headquartered Calvert is considered one of the first mutual fund companies to concentrate on environmental, social and governance issues. Calvert, says the SEC, was able to mitigate a higher penalty because of its cooperation in compensating investors who were shortchanged by its initial reimbursement in late 2011. In October 2014, Calvert hired John Streuer as its president and chief executive replacing Barbara Krumsiek. Streuer, previously head of the Portfolio 21 investment management firm in Portland, Oregon implemented a more rigorous valuation policy and separated its compliance division from its legal division.
The Pivotal Mistake
Had Calvert correctly priced the series of Toll Road Investors Partnership bonds it held in the first place, it would never have faced the need to correct NAVs and reimburse investors. From March 18, 2008 to October 18, 2011 Calvert relied heavily on a “third-party” analytical tool to price several series of bonds issued by the Toll Road Investors Partnership. The SEC never specified whose application Calvert used, but it is common for mutual fund companies to use licensed technology systems which rely on a combination of market data, internal pricing models and methodologies to value so-called hard-to-price securities. Those are financial instruments not traded on an exchange so there is no publicly agreed upon pricing. Therefore, fund companies must implement what is called “fair-value” pricing, which involves some subjectivity.
When Calvert finally discovered its pricing error in October 2011, Calvert was forced to mark down the value of the bonds affected by about 56 percent. That is because the new pricing methodology used by the application took into account future cash flows. The markdown, in turn, required Calvert to decrease the net asset values for eight portfolios. While it is common for mutual fund companies to have to change their valuations of complex assets, not all changes result in changes to NAVs. Likewise, not all changes in NAVs result in investors having to be reimbursed. Industry practice is that it only occurs when the NAV is changed by at least half a percentage.
Why did it take three years for Calvert to discover the initial valuation error? Apparently, Calvert never bothered to do any back-testing during the three years nor did it take into account some glaring evidence that it had mispriced the bonds. On several occasions the firm bought bonds at far less prices than what it had valued them on its books. In fact, at the end of 2009, Calvert had priced the bonds at 65 percent higher than a price assigned by a broker-dealer.
The inflated NAVs during the three year period caused Calvert to charge higher management and administrative fees. In addition, some investors in Calvert purchased shares at a higher price than they should have while others sold shares at a higher price than they should have received, says the SEC. The US$27 million Calvert initially reimbursed investors in December 2011 never took into account the higher fees charged, nor the entire transaction activity of all investors between 2008 and 2011.
Compounding the Error
Calvert only based its calculation on the change in NAV affecting shareholders of record as of October 19, 2011. Even so, Calvert lacked data concerning underlying shareholder activity in subaccounts held through certain intermediary accounts for three years and did not obtain that information so it could calculate appropriate contribution and distribution amounts, says the SEC. Holdings of investors who bought and sold shares through financial intermediaries would be displayed on the books of Calvert’s transfer agent as omnibus accounts identifying only banks and broker-dealers as account holders. Calvert would only know the identities of its registered investors or those who bought and sold their shares directly through the mutual fund complex.
What did Calvert do to make all investors whole? “The remediation process was based on a netting out of subscription and redemption activity at the intermediary account level,” says the SEC. As a result, the methodology failed precisely to measure the harm to each underlying shareholder and likely understated the impact of the improper bond valuation. That’s SEC-speak for Calvert still owes lots of investors money.
The SEC also says that Calvert neglected in its filings with the SEC and annual reports to investors to disclose that investors holding shares in their own names on the books of Calvert were treated differently than those who held shares in Street name. All Calvert disclosed was that errors in NAV calculations occurred and that all the investors were reimbursed correctly.
Why wouldn’t Calvert have done its homework the first time around? It is likely that its former management made a judgement call. Do what it could quickly with the information it had or spend millions of dollars and extra time to go the extra mile. It could take Calvert up to a year to make all investors whole through the new rather arduous process.
Calvert now has to do its reimbursement calculations all over again after tracking down each of the investors who were shareholders of record on the entire three years in question. Its transfer agent Boston Financial Data Services (BFDS) has an entire team communicating with financial intermediaries while Calvert has its own group of forensic accountants and other financial accounting specialists working on cleaning up the mess.
Financial intermediaries have 90 days from the time they receive the request for the information from Calvert or its transfer agent to fork it over. If they don’t want to provide the specific names, transaction activity and social security number, they can just provide the transaction activity with dummy codes. Calvert will be responsible for paying financial intermediaries to track down the information and for mailing out any new reimbursement checks. Financial intermediaries that want to mail out the checks themselves will be responsible for incurring those costs. Investors who already were reimbursed more than they should have in 2011 can keep what they were paid. Those who already received nothing or less than the correct amount will receive the difference.
Based on the SEC’s settlement documentation, coming up with the reimbursement figure for each investor will be a mindboggling task. It explains why Calvert might have been hesitant to do the work in the first place. The net asset value for shares in each affected fund must be recalculated for each affected day during the three year period based on not only the adjusted fair value of the bonds in question but also inflated asset-based management and administrative fees. The amount the investor receives must be based on recalculated transactions that occurred at the incorrect NAVs and some type of netting process whereby repriced losses during the three year period will be offset by any gains. Calvert will calculate those gains based on money already sent out to investors plus interest they should have received.
The SEC says that by not compensating investors correctly, Calvert its own policies and procedures as well as the SEC’s rules for investment advisors. However, it could not be confirmed as to how much detail Calvert’s compliance manual outlined the practice of tracking down Street name investors whenever it must compensate investors for errors.
As is typically the case, firms find out about how the SEC interprets its rules when they are forced into a settlement. The mutual fund market timing scandal during 2003 provided the first inkling that the SEC wouldn’t tolerate funds allowing some investors to benefit over others when using unscrupulous trading methods. A 2009 settlement with Evergreen Investment Management also showed that the SEC wouldn’t accept an unequal playing field. The SEC fined Evergreen US$40 million for overstating the value of a fund’s NAV and allowing some shareholders to cash out early to receive the higher price. The inflated NAV was the result of mispriced mortgage-backed securities.
The SEC’s settlement with Calvert is simply a reminder that taking doing the minimal A when it comes to operational work and compensating investors for NAV mistakes will generate a failing grade with the US regulatory agency. Failure means an even more costly fine, more cleanup costs and even reputational risk. No one can afford all that.
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