SEC Hits Macquarie with $80 Million Fine for Valuation Fraud and Cross-Trading Violations

A recent enforcement action has fined Australian asset manager Macquarie Investment Management Business Trust (MIMBT) $80 million for misleading investors and breaking trading rules. This punitive measure addresses severe asset allegations of overvaluation and improper cross-trades that skewed financial reports and favored certain clients at the expense of others.

In this article, we will discuss the SEC’s action, explore the importance of proper record-keeping, and discuss strategic steps firms can take to ensure compliance and maintain operational integrity.

Background of the Case

From January 2017 through April 2021, MIMBT managed a strategy focused on mortgage-backed securities, specifically involving collateralized mortgage obligations (CMOs). These securities were primarily “odd lot” CMOs, which are smaller-sized positions that typically trade at a discount compared to larger, institutional-sized lots. However, MIMBT was found to have valued these odd lot CMOs using a pricing service intended for institutional lots without a valid basis for believing such valuations were accurate for smaller lots. This practice led to inflated asset valuations across client accounts, misleading investors about the actual performance of their investments.

The situation was exacerbated by MIMBT’s strategy to manage redemptions. The firm engaged in numerous cross-trades between different client accounts to manage liquidity needs without resorting to market sales, which would have likely resulted in recognizing the lower market value of the overvalued assets. These cross-trades were not conducted at fair market values, further disadvantaging specific clients, particularly retail mutual funds, which ended up with overvalued bonds, thus absorbing losses that should have been borne by other accounts. MIMBT executed 465 internal cross-trades between the selling account and eleven retail mutual funds at prices deemed above independent current market prices. The SEC emphasized that the use of a third-party pricing service does not absolve an investment advisor of their responsibility to ensure assets are valued accurately.

Regulatory Findings and Penalties

The SEC’s investigation concluded that MIMBT violated several key regulatory standards, including the anti-fraud and compliance provisions of the Investment Advisers Act of 1940 and the Investment Company Act of 1940. The firm agreed to pay a $70 million penalty and an additional $9.8 million in disgorgement and prejudgment interest, acknowledging the seriousness of the infractions without admitting or denying the findings.

Macquarie has disputed the allegations, stating they do not align with their usual business practices, and has committed to rectifying the issue for the clients impacted by the incorrect valuations and trades involved in the investigation.

Insights and Implications for Investment Managers

This case highlights critical compliance and operational risks that investment managers must navigate, particularly concerning asset valuation and trading practices.

Valuation Accuracy

Investment managers must ensure that asset valuations are conducted based on valuation policies and procedures that are robust and tailored to the nature of the securities traded, particularly when dealing with less liquid or smaller lot securities. Regular audits, establishing a valuation committee and executive committee to independently review valuations and cross-trades, compiling various broker quotes (identifying whether they were provided by recent trade or indicative), and performing back and forward testing procedures are some examples of how an investment manager can enhance their valuation processes.

Backtesting involves comparing the historical prices of assets with the valuations provided by a pricing model or source to verify its accuracy. This retrospective analysis helps identify any persistent discrepancies and allows for adjustments to improve the model’s reliability. On the other hand, forward testing involves using current models to predict future asset prices and then comparing those predictions with actual market developments. This method tests the model’s effectiveness in real-time market conditions, providing confidence in its ongoing accuracy.

Cross–Trading Policies

While cross-trades help manage liquidity, firms must conduct them fairly and transparently. Firms must ensure that such trades do not favor one group of clients over another and are in line with market prices. Valuation procedures, including approval from a valuation committee or executive committee and extensive documentation, should be maintained to support trades executed in the best interest of all clients.

Compliance and Oversight

Robust compliance frameworks are critical to prevent and detect such breaches. Investment managers should have clear policies that are regularly reviewed and updated to reflect current regulatory expectations and market practices.

Ethical Standards

Maintaining high ethical standards is crucial. Misvaluing and preferentially treating certain clients can severely damage a firm’s reputation and lead to significant regulatory penalties.

The Bottom Line

The SEC’s action against MIMBT is a potent reminder of the importance of compliance with securities laws and the integrity of financial reporting and trading practices. Investment firms must take proactive steps to ensure that their operations are transparent and fair, not only to comply with the law but to uphold the trust and confidence of their investors. As the regulatory environment continues to evolve, staying informed and vigilant is more important than ever.

This case is a reminder for asset managers to reevaluate their controls and practices to safeguard against similar issues. Schedule a discovery call to learn more about how our business advisors can help you.