Don’t Cross the SEC: Adviser Dinged for Inflated Valuations and Conflicted Cross Trades

Today, the SEC announced an enforcement action against an adviser alleging misconduct related to certain illiquid fixed income positions.

According to the SEC’s order, the adviser utilized a third-party pricing service to value its positions in collateralized mortgage obligations (CMOs), but improperly applied the pricing service’s marks (which were intended for round lots) to thousands of “odd lot” positions, which typically trade at a significant discount. In addition to the primary issue of overvaluation, the SEC also alleges that the inflated pricing caused the adviser to make materially misleading statements in its marketing materials, SEC filings, and reports to the boards of the funds that owned the positions.

Further, the order states that there were instances in which the adviser engaged in cross trades involving these illiquid CMO positions without disclosing material conflicts of interest. Specifically, the SEC alleges that in order to satisfy redemption requests for certain clients, the adviser chose to sell the CMO positions to other clients at the round lot price providing by the pricing service rather than selling them in the open market where the odd lots would have traded at a discounted price.

Key Takeaways

Valuation: Advisers must be mindful of using valuations that don’t accurately reflect fair market value where the liquidity profile of the client’s position may be different from the overall liquidity profile of the investment. In this case, the discrepancy arose from the adviser’s clients holding odd lot positions, but this can happen in other circumstances – for example, when a client owns restricted stock subject to Rule 144A.

Cross Trades: The SEC found that a large number of the cross trades at issue were “dealer-interposed,” meaning that the adviser temporarily sold securities from one or more clients to a third-party broker-dealer and then repurchased the securities from the same broker-dealer for other client accounts at a mark-up.  In connection with these trades, the order states: 

“…compliance systems and controls did not detect the unlawful dealer-interposed cross trading, even though the trades involved the same thinly-traded bond being sold and repurchased through the same broker-dealer, in the same odd lot size, and involved [the adviser’s] accounts on both sides of the transaction.”

This is not the first enforcement action in which the SEC took issue with dealer-interposed cross trades – see, e.g., this case from 2014, this case from 2020, and this case from 2023. Clearly, this is an area of concern for the SEC and advisers should consider monitoring for undisclosed dealer-interposed cross if they are not already doing so (particularly advisers to registered investment companies subject to Rule 17a-7 under the Investment Company Act).