On December 1, 2016, the Securities and Exchange Commission (SEC) announced settled administrative proceedings against Pacific Investment Management Company LLC (PIMCO), a registered investment adviser, for misleading investors about the performance of its PIMCO Total Return Exchange-Traded Fund (the Fund), overstating the Fund’s net asset value (NAV) and, consequently, executing shareholder transactions at prices not based on current net asset values.  

According to the SEC’s order, to help increase the Fund’s initial performance after its launch on February 29, 2012, PIMCO used a strategy that involved purchasing odd lot positions (i.e., small-sized pieces) of non-agency mortgage-backed securities (NA MBS) that traded at discounts to round lot positions (i.e., institutional, larger-sized pieces having at least $1 million current face value) and then valuing those positions for purposes of calculating the Fund’s NAV at higher round lot evaluated prices (the Pricing Vendor Marks) provided by a third-party pricing service (the Pricing Vendor).  The SEC order states that PIMCO continued to use this “odd lot” strategy through June 30, 2012 (the Relevant Period) and purchased 156 odd lot NA MBS at discounted odd lot prices that it valued at the higher Pricing Vendor Marks for purposes of calculating the Fund’s NAV.  In this regard, the SEC alleged that throughout the Relevant Period, PIMCO calculated and published an overstated daily NAV for the Fund based on valuations that took advantage of the difference between odd lot and round lot pricing.  The SEC order states that for 43 of the NA MBS positions, PIMCO did not have a “reasonable basis to believe that the Pricing Vendor Mark accurately reflected the exit price [the Fund] would receive for those positions.”

The SEC order alleges that there were numerous variance notifications from the Fund’s administrator that the Pricing Vendor Marks used to value the NA MBS positions may not have reflected fair value under Section 2(a)(41) of the 1940 Act and notes that despite the notifications, the traders responsible for the trades did not challenge the Pricing Vendor Marks.  The SEC order further states that PIMCO’s pricing policies and procedures were not reasonably designed to consider odd lot pricing generally and failed to provide sufficient oversight of the traders’ determinations regarding price or guidance regarding when a trader should elevate significant pricing issues, such as odd lot pricing, to PIMCO’s Pricing Committee or the Valuation Committee of the Fund’s Board of Trustees (the Board).  The order also states that individuals, other than the traders, at PIMCO were aware of the odd lot pricing and its potential impact on the Fund’s NAV but failed to test the Fund’s odd lot pricing methodology to determine whether the use of round lot prices for the NA MBS positions appropriately reflected fair value for these smaller positions.  

In addition, the SEC alleged that PIMCO negligently provided disclosures, in monthly and annual reports to investors, that were misleading regarding the reasons for the Fund’s performance, including the Fund’s outperformance versus the PIMCO Total Return Fund, PIMCO’s flagship mutual fund.  The SEC order states that PIMCO failed to disclose the impact of the “odd lot” strategy and that the performance resulting from this strategy would not be sustainable as the Fund grew in size, and instead attributed the Fund’s exceptional performance to the non-agency sector in general and prices for NA MBS that “rose.”  The SEC stated that these disclosures implied that the Fund’s performance resulted from price appreciation in the non-agency sector, despite internal reports indicating that a significant portion of the Fund’s performance was due to gains from valuing odd lots at the Pricing Vendor Mark.  In addition, the order states that PIMCO failed to disclose the existence or impact of the “odd lot” strategy to the Board when they specifically inquired as to the Fund’s outperformance versus the Total Return Fund.  

As a result of the foregoing conduct, the SEC found that PIMCO violated Sections 206(2) and 206(4) of the Advisers Act and Rules 206(4)-7 and 206(4)-8 thereunder.  The SEC also found that PIMCO violated Section 34(b) of the 1940 Act and Rule 22c-1 thereunder.  Pursuant to the terms of the order, PIMCO agreed to retain an Independent Compliance Consultant to conduct a comprehensive review of PIMCO’s written compliance policies and procedures and to adopt any of the recommended changes or improvements that result from its review.  In addition, PIMCO was censured and agreed to pay a civil money penalty of $18.3 million, as well as $1.3 million in disgorgement, plus interest of approximately $198,000, and agreed to cease and desist from any violations (and future violations) of the laws violated by the foregoing conduct.