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Fund Manager Rigged Auction Process in Client Cross-Trades

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. 

Large Fund Company Pays Over $2 Million for Allowing Cross-Trades


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.

Private Fund Manager Did Not Provide Notice or Obtain Consent for Principal and Agency Cross-Trades

 A private fund manager agreed to pay a $500,000 fine for failing to disclose, and obtain consent for, transactions for which it acted as a broker and principal.  The SEC maintains that the fund manager received compensation for two transactions whereby one advisory client purchased assets from another client.  The SEC also asserts that the fund manager engaged in a principal transaction when it caused a subsidiary to purchase assets from one client and then subsequently sell them to another client.  The SEC charges the firm with violating Section 206(3) of the Advisers Act for failing to provide written disclosure and obtain consent for the transactions.

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.

Adviser Cross-Traded at Bid Price to Benefit Certain Clients

The SEC censured and fined an investment adviser $900,000 for effecting client cross-trades at the bid price, rather than the bid-ask midpoint, thereby favoring its buying clients over its selling clients.  According to the SEC, the adviser had an interest in maintaining higher prices for the subject thinly-traded municipal bonds because the adviser often had a controlling, institutional position.  By using the bid price, the adviser generally favored his current clients over terminating clients.   The SEC also accuses the adviser of challenging bids upward to inflate the bonds’ valuation.   Although the adviser did not benefit directly, the SEC faults the firm for favoring certain clients over others and for failing to adopt policies and procedures that obtained independent broker quotes, supervised the portfolio manager, subjected prices to review by a valuation committee, and retained records.

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.


Fund Manager Failed to Disclose Investments into Affiliate Fund


The SEC censured and fined a private fund manager for failing to disclose that one of its funds invested in an affiliate fund formed to help grow the manager’s business by acquiring other advisers.  Although the respondent ultimately made disclosure through the fund’s financial statements, the audited financials were delivered 9 months after they were required to be delivered pursuant to the Advisers Act’s custody rule (206(4)-2).  Also, the firm failed to retain an auditor subject to PCAOB inspection, as required by the Advisers Act.   The SEC noted that advisory clients would not have paid any fees had they invested directly in the acquisition fund rather than through the fund in which they intended to invest, which was focused on foreign currencies.

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.


Cross-Transaction Was Not Consistent with Disclosure to LP Committee

The SEC fined and censured a registered real estate private equity firm for engaging in a cross transaction between two funds it managed on terms that differed from those disclosed to its LP committee.  According to the SEC, the fund manager committed to the selling fund’s investor advisory committee (IAC) that the purchasing fund would reimburse the selling fund for certain development expenses related to the subject property.  The fund manager later determined that the selling price already assumed the development costs and, therefore, declined to reimburse the selling fund.  However, the fund manager never disclosed to the IAC that it would not reimburse the selling fund.  When the transaction was uncovered during an SEC exam, the fund manager paid $4.5 Million to reimburse the selling fund’s limited partners.

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.