SEC Settles Charges Against Investment Adviser for Improper Fixed Income Securities Trading

Who may be interested: Registered Investment Advisers, Registered Investment Companies, Compliance Staff.

Quick Take: The SEC charged an investment adviser in connection with improper trading in certain fixed income securities. The SEC’s order alleges that the adviser improperly traded the securities between advised clients, resulting in artificial increases in the price of the securities as well as increased advisory fees paid to the adviser. In addition, many of the trades involved mutual funds, resulting in prohibited affiliate transactions under the Investment Company Act that did not comply with applicable exemptive requirements.

The SEC settled charges with an investment adviser and its founder for improper trading in high-yield debt securities from a particular issuer from 2016 through 2018 on behalf of fund clients, which included hedge funds and mutual funds. 

The SEC Order states that the adviser engaged in transactions in the debt securities that resulted in one client selling the securities while a different client purchased the same securities through various broker-dealers. Known as rebalancing trades, the practice allowed the adviser to work around certain portfolio constraints, such as industry or issuer fund concentration limits, to meet investor redemptions and to allocate capital inflows and outflows, according to the SEC Order. Liquid alternative funds advised by the adviser, for example, had limits on concentration in a given issuer or industry and offered their investors daily liquidity; therefore, the adviser rebalanced the portfolios of such clients in order to maintain large investments in the subject debt securities without violating the funds’ concentration limits.

The SEC Order states that trades in the subject debt securities were executed at prices the adviser proposed and had the effect of increasing the price of the securities at a significantly higher rate than the prices of similar securities. The SEC Order found that the adviser’s trading comprised a large majority of the trading in the debt securities (which were otherwise generally illiquid) and thus had a material effect on their pricing.

According to the SEC Order, the adviser calculated the net asset value (NAV) of client funds’ holdings using pricing data that included the trading prices of the subject debt securities, which resulted in higher NAVs for the client funds than if the prohibited affiliated trades were removed from the market for the subject securities. Given that the adviser’s management fee was calculated as a percentage of a fund’s NAV, higher management fees were charged to clients. In addition, the trades involving mutual funds resulted in prohibited affiliate transactions under the Investment Company Act that did not comply with applicable exemptive requirements.

The SEC Order states that the adviser and its founder violated Section 206(2) of the Advisers Act, which prohibits an investment adviser from engaging in any transaction, practice or course of business that operates as a fraud or deceit upon a client, and that they aided and abetted and caused violations under Section 17 of the Investment Company Act (prohibited affiliate transactions). To settle the charges, without admitting or denying the SEC’s findings, the adviser and its founder agreed to pay more than $19.3 million in combined disgorgement, prejudgment interest, and civil penalties. Both the adviser and the founder also received censures, industry bars, and cease-and-desist orders.

The SEC’s order can be found here.