IA Charged for Improper Valuations and Cross Trading

An advisory firm settled SEC charges for failing to accurately value mortgage-backed securities ("MBS") and for engaging in improper cross trading practices that favored certain clients over others.

According to the Order, the firm failed to implement adequate controls for pricing illiquid, small-lot positions in MBS. The SEC found that the firm used round-lot pricing for positions that were primarily odd-lots—smaller, less liquid pieces of bonds that typically trade at a significant discount. The SEC said this practice overstated the net asset values of various funds under its management and inflated performance reports.

The SEC also found that the firm engaged in undisclosed cross trades to settle redemption requests. The SEC found that the firm arranged internal trades between its managed accounts to prevent large losses for clients redeeming illiquid securities. The SEC said that these trades, which were not executed at independent market prices, led to "purchasing" clients absorbing losses that should have been borne by the "redeeming" clients. The SEC found other cases in which the firm facilitated trades by selling odd-lot positions to broker-dealers, which would then sell the securities back at inflated prices to the firm's other accounts.

The SEC cited multiple red flags that should have prompted corrective actions, including:

• the firm's reliance on round-lot pricing for largely illiquid, odd-lot positions;
• internal analysis revealing that odd-lots were trading at significant discounts, up to 28 percent, compared to round-lot prices;
• cross trades executed at inflated prices that shifted losses from redeeming clients to other investors; and
• the firm's failure to follow its own compliance policies for pricing and trade reviews.

The SEC determined that the firm violated sections of the Investment Advisers Act Section 206 ("Prohibited transactions by investment advisers") and Rules 206(4)-7 ("Compliance procedures and practices") and 206(4)-8 ("Pooled investment vehicles") as well as Investment Company Act Sections 17(a) ("Transactions of certain affiliated persons and underwriters") and 34(b) (Unlawful representations and names") and Rules 22c-1 ("Pricing of redeemable securities for distribution, redemption and repurchase") and 38a-1 ("Compliance procedures and practices of certain investment companies").

To settle the charges, the firm agreed to (i) a censure, (ii) pay disgorgement of $7,633,671 and prejudgment interest of $2,197,535 and (iii) pay a civil money penalty in the amount of $70,000,000. The firm also agreed to hire an independent compliance consultant to review and improve its policies on asset valuation and cross trading.