A private fund and CDO manager agreed to pay over $400,000 to settle charges that it facilitated an illegal cross-trade that benefitted one client over another. The SEC alleges that the firm sold securities held by its CDO client to its private fund at an artificially low price because the respondent failed to obtain required third-party bids. Instead, the SEC asserts, based on a record of a phone conversation, that the firm asked friendly firms to provide false bids with assurances that they would not have to purchase the securities. The private fund ultimately sold the securities at a significant profit. The SEC also charged the firm’s Chief Operating Officer (who was fined and barred from the industry) for arranging the transactions and personally benefitting through his investment in the private fund.
Firms should avoid client cross-trades. One side will always benefit, which gives rise to conflict of interest and favoritism allegations. A fiduciary on both sides of a transaction may not be able to cure the conflict with any amount of disclosure.
A large mutual fund company agreed to pay a $1 Million fine and reimburse clients another $1.095 Million for failing to stop a portfolio manager from engaging in unlawful cross-trades. The SEC also fined and barred the portfolio manager. The SEC alleges that the portfolio manager interpositioned a friendly broker to execute cross-trades between clients in a scheme that benefited buying clients over selling clients. Such cross-trades – which were not conducted at the bid-ask spread and which paid commissions – violated the Investment Company Act’s affiliated transactions rules and did not comply with the Rule 17a-7 safe harbor. The SEC faults the firm and its compliance function for failing to further investigate responses from the portfolio management team that uniformly contended that the questioned trades were not prearranged. The SEC also criticizes the compliance function for failing to properly monitor trading practices and for neglecting to train employees.
OUR TAKE: Compliance testing and monitoring does not stop when a questioned employee (with an incentive to engage in violative transactions) denies wrongdoing. While this may avoid personal responsibility in the corporate blame game, it will not satisfy the regulators or fulfill a compli-pro’s obligations to implement reasonable policies and procedures.
OUR TAKE: Moving assets around among client funds may have been common practice before Dodd-Frank required private fund managers to register. However, Section 206(3) specifically limits such transactions by requiring notice and consent.
OUR TAKE: It is very difficult to implement sufficient procedures or provide enough disclosure to sanitize the significant conflicts of interest that arise when cross-trading securities between client accounts. Our compliance advice is to avoid cross-trades and liquidate securities through an independent third party.
OUR TAKE: Failure to disclose cross-transactions between affiliate funds will not go undetected. Eventually, the fund manager must deliver audited financial statements, which will require disclosure. The Advisers Act requires advance disclosure (and consent) of conflicts transactions. There is no win in kicking the disclosure down the road until financials are completed.
OUR TAKE: Private equity firms can overcome conflicts of interest through disclosure to, and consent by, an independent LP committee. However, hiding the ball from the LP committee can result in significant penalties and make your firm look less than transparent.