Fund Adviser Fails to Value Certain Portfolio Securities Correctly

October 18, 2016

The SEC brought an enforcement action against Calvert Investment Management, Inc. (Calvert) for its improper fair valuation of securities issued by Toll Road Investors Partnership II, L.P. (Toll Road Bonds), which were held by mutual funds that Calvert advised (Calvert Funds). Between March 18, 2008 and October 18, 2011, the SEC found that Calvert misvalued the Toll Road Bonds, which, in turn, led the Calvert Funds to be priced at an incorrect net asset value (NAV). The Calvert Funds then executed shareholder transactions at the wrong NAV, and stated inaccurate performance figures. In addition, Calvert collected inflated asset-based fees.
After discovering that it had improperly valued the Toll Road Bonds, Calvert sought to remedy the harm by paying $27 million to the Calvert Funds and shareholders. However, the initial remediation was based, in part, on an estimated loss amount, and Calvert did not precisely calculate fund and shareholder losses in accordance with the Calvert Funds’ NAV error correction procedures. The SEC stated that Calvert and the Calvert Funds never disclosed to investors and prospective investors that the initial remediation did not conform to the Calvert Funds’ NAV error correction procedures, nor did they disclose that the process compensated shareholders differently, depending on whether they invested directly or through an intermediary. As a result, Calvert violated Sections 206(2) and 206(4) of the Advisers Act and Rule 206(4)-8 thereunder, and it caused the Calvert Funds to violate Section 34(b) of the Investment Company Act and Rules 22c-1 and 38a-1 under the Investment Company Act.

Between March 18, 2008 and October 18, 2011, the Calvert Funds acquired more than $1.2 billion principal amount of the Toll Road Bonds. The Toll Road Bonds were complex and illiquid securities that at times had minimal external data points regarding pricing. In conducting its fair value calculations during this period, Calvert, although it performed market research and internal modeling, utilized an approach that was primarily based upon the output of a third-party analytical tool.

Between March 18, 2008 and October 18, 2011, Calvert failed appropriately to incorporate indicia of fair value into its fair value calculations, including, among others, the prices at which the Calvert Funds traded the Toll Road Bonds, values assigned by other holders of the Toll Road Bonds, and other market data. Calvert also failed to back-test fair value determinations for the Toll Road Bonds, despite engaging in such back-testing for other holdings. On several occasions the SEC stated that Calvert’s fair value price was significantly higher than prices at which the Calvert Funds had engaged in market purchases of the Toll Road Bonds, with no clear indication that those trades involved distressed sales that might be afforded less weight in fair value calculations. In addition, at the end of 2009, for example, Calvert fair valued certain Toll Road Bonds at a price that was approximately 65% higher than the price assigned to the same bonds by a major industry participant on that same day.

On October 19, 2011, Calvert discovered that the third-party analytical tool was flawed in that it did not properly account for the future cash flows of the Toll Road Bonds and therefore Calvert’s fair value calculations had not accurately incorporated certain characteristics of the Toll Road Bonds, which had the effect of substantially inflating Calvert’s fair value prices. Calvert then revised its approach and developed its own cash flow model to recalculate the fair value prices of the Toll Road Bonds. As a result of the reassessment, Calvert significantly reduced the fair value prices assigned to the Toll Road Bonds.

Click here to access the enforcement action.