Enforcement News: SEC Settles Charges Against Advisory Firm for Overvaluing Assets and Engaging in Unlawful Cross Trades

• Posted on: Sep 23 2024

By: Jeffrey M. Haber

As a general matter, “[a] cross trade is a practice where buy and sell orders for the same asset are offset without recording the trade on the exchange.”[1]

An adviser that arranges for a security to be purchased from or sold to a client from its own account (which can include an affiliate of the advisor) – as opposed to purchasing or selling the security in the secondary markets – is engaging in a “principal trade.” An “agency cross trade” occurs when an adviser arranges for a trade to be executed between a client and another party, and a “cross trade” occurs when an adviser effects a trade between two or more of its advisory clients’ accounts, but does not charge a fee for effecting the transaction (collectively, “cross trades”). An adviser that enters its clients into these types of transactions implicates a variety of legal obligations under the Investment Advisers Act of 1940 (“Advisers Act”), particularly its fiduciary duty.[2]

Cross trades can benefit clients because the practice enables a portfolio manager to move securities among client accounts without having to expose the security to the market thereby saving transaction and market costs that would otherwise be paid to executing broker-dealers.

Conversely, cross trades can also pose substantial risks to clients due to the inherent conflict of interest for the adviser, which has a duty of loyalty and duty of care to seek best execution for each client.

Cross trading involving mutual funds implicates the Investment Company Act of 1940 (“ICA”). Sections 17(a)(1) and 17(a)(2) of the ICA generally prohibit any affiliated person of a registered investment company (“RIC”) or any affiliated person of the affiliated person, acting as principal, from knowingly selling a security to or purchasing a security from the RIC unless the person first obtains an exemptive order from the Securities Exchange Commission (“Commission” or SEC”) under Section 17(b). Rule 17a-7 promulgated under the ICA exempts from these prohibitions certain cross trades where the affiliation between a RIC and its trading counterparty arises solely because the two have a common investment adviser, or investment advisers that are affiliated persons of each other, common directors, or officers, provided that the cross trades are effected in accordance with Rule 17a-7.

Rule 17a-7 requires, among other things, that cross trades be executed at the “independent current market price,” which is defined in relevant part as “the average of the highest current independent bid and lowest current independent offer determined on the basis of reasonable inquiry.” If a brokerage commission, fee, or other remuneration is paid in connection with the cross trade, the cross trade is not eligible for an exemption under Rule 17a-7 and is therefore, impermissible.

Section 48(a) of the ICA prohibits “any person, directly or indirectly, to cause to be done any act or thing through or by means of any other person which it would be unlawful for such person to do” under the ICA or the rules thereunder. The Commission has stated that interpositioning a dealer in cross trades does not remove the cross trades from the prohibitions of Section 17(a).[3]

On July 21, 2021, the Commission’s Division of Examinations issued a Risk Alert on cross trades and principal transactions.[4] Among other things, the SEC Staff opined that with respect to principal trades, to comply with Section 206(3) of the Advisers Act, advisers had to make written disclosures and obtain the consent of the affected client before the transaction was completed. The Staff noted, however, that a more “robust” disclosure regimen, whereby the disclosure includes a description of the nature and significance of the advisers’ conflicts of interest relative to the impacted clients, may be required to comply with Section 206 and Rule 206(3)-2 of the Advisers Act.[5]

The Staff also provided certain “observations on ways to improve compliance,” which apply to principal transaction and cross trade situations on a broad scale). The Staff’s suggestions included:

• Adopt and enforce compliance policies and procedures that: (1) incorporate all applicable legal and regulatory requirements; (2) clearly articulate the activities covered by the advisers’ written compliance policies and procedures; (3) set standards that address the firms’ expectations for each of these activities; (4) include supervisory policies and procedures; and (5) establish controls to determine whether policies and procedures are being properly followed and documented in the required manner.
• Conduct testing for compliance with policies and procedures.
• Provide clients with full and fair disclosure of all material facts surrounding principal and
• cross trades.
• Provide disclosures to clients regarding principal and cross trading practices in multiple documents.
• In addition to written disclosures, discuss the rationale for executing principal trades during verbal conversations with clients.  

Cross trading, among other things, was at issue in a settled enforcement action with Macquarie Investment Management Business Trust (“MIMBT”), in which the SEC charged MIMBT with overvaluing approximately 4,900 largely illiquid collateralized mortgage obligations (“CMO”) held in 20 advisory accounts, including 11 retail mutual funds, and executing hundreds of cross trades between advisory clients that favored certain clients over others to minimize losses to those clients.

According to the SEC’s order (here), from January 2017 through April 2021, MIMBT managed the Absolute Return Mortgage-Backed Securities strategy, a fixed-income investment strategy primarily invested in mortgage-backed securities, CMOs, and treasury futures. Strategy investments included thousands of smaller-sized, “odd lot” CMO positions that traded at a discount to institutional, larger-sized positions. MIMBT valued the odd lot CMOs using prices obtained from a third-party pricing service that were intended for institutional lots only. The pricing service did not provide separate valuations for odd lots. The SEC found that MIMBT had no reasonable basis to believe it could sell the odd lot CMOs at the pricing vendor’s valuations, and thousands of odd lot CMO positions were marked at inflated prices. This resulted, said the SEC, in MIMBT overstating the performance of client accounts holding the overvalued CMOs.

The SEC further found that MIMBT attempted to minimize losses to redeeming investors by arranging cross trades with affiliated accounts, rather than selling the overvalued CMOs into the market. In one instance, said the SEC, MIMBT executed 465 internal cross trades between a selling account and 11 retail mutual funds above independent current market prices. The SEC noted that these trades resulted in the retail mutual funds absorbing losses that otherwise would have been borne by the selling account in a market sale. The SEC also found that MIMBT arranged for approximately 175 dealer-interposed cross trades in which MIMBT temporarily sold odd lot CMO positions to third-party broker-dealers and then repurchased those same positions for allocation to one or more affiliated client accounts, providing liquidity to redeeming investors in an otherwise illiquid market, often at above-market prices.

“It is alarming that a fiduciary took advantage of retail mutual funds it advised and executed unlawful cross trades to mitigate its overvaluation of fund assets,” said Eric I. Bustillo, Director of the SEC’s Miami Regional Office. “Utilizing a third-party pricing service does not negate an investment adviser’s obligation to value assets accurately.”

The SEC found that MIMBT violated the antifraud and compliance provisions of the Advisers Act, and certain provisions of the ICA. Without admitting or denying the SEC’s findings, MIMBT agreed to a censure, to cease and desist from further violations of the charged provisions, and to pay a $70 million penalty and disgorgement and prejudgment interest, totaling an additional $9.8 million. MIMBT also agreed to comply with certain undertakings, including retaining a compliance consultant to conduct a comprehensive review of its policies and procedures relating to, among other things, valuation of CMOs and associated liquidity risks, and cross trading.

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Jeffrey M. Haber is a partner and co-founder of Freiberger Haber LLP. This article is for informational purposes and is not intended to be and should not be taken as legal advice.

[1] Chen, James, “Cross Trade”, Investopedia (Updated August 6, 2024) (here).

[2] See, e.g., Advisers Act Sections 206(1), (2), and (3) and Rules 206(3)-2 and 206(4)-7. An adviser’s obligation as a fiduciary is enforceable through Section 206 of the Advisers Act.

[3] See Exemption of Certain Purchase or Sale Transactions Between a Registered Investment Company and Certain Affiliated Persons Thereof, Investment Company Act Release No. 11136, 1980 WL 29973, at *2 n.10 (Apr. 21, 1980).

[4] See Risk Alert: Observations Regarding Fixed Income Principal and Cross Trades by Investment Advisers from An Examination Initiative (July 21, 2021) (here). The Risk Alert was issued as a follow up to a 2019 alert, which focused on common cross trade and principal transaction deficiencies observed in examinations conducted over a three-year period. See Risk Alert: Investment Adviser Principal and Agency Cross Trading Compliance Issues (Sept. 4, 2019) (here).

[5] Id.