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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.

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.