Prearranged Trades May Set Your Firm Up for SEC Enforcement
Watch out for red flags telling you that portfolio managers prearranged trading to favor one set of clients over another. Failure to act on those flags is likely to prearrange two other results: an SEC investigation followed by an enforcement action.
That’s what the SEC says happened with advisory firm giant Morgan Stanley Investment Management, which on December 22 agreed to pay $8.8 million to settle charges that one of its portfolio managers conducted prearranged trading – a practice known as "parking" – that favored some firm clients over others. The portfolio manager, Sheila Huang, as well as an unaffiliated brokerage firm trader who assisted in the arrangements, were barred from the securities industry (Huang for five years and the portfolio manager for three years) and had to pay individual fines themselves.
From late 2011 through early 2013, Huang engaged in a series of unlawful prearranged sales and buybacks of fixed-income securities with the brokerage firm’s trader, according to the SEC’s administrative order instituting the settlement.
"While effecting sales for accounts that needed to liquidate certain positions, Huang did not simply sell them into the open market or to other accounts advised by Morgan Stanley Investment Management in accordance with the firm’s cross trade rules," the agency said. "Instead, Huang sold to and improperly prearranged a repurchase from [the brokerage firm] at predetermined prices that were based on the initial sales price plus a minimal markup in order to ‘buyback’ the positions in other accounts advised by Morgan Stanley Investment Management."
"Instead of playing by the rules, Huang engaged in prearranged trading schemes that benefitted some clients while harming others," said the SEC Division of Enforcement’s Asset Management Unit co-chief Marshall Sprung. "Morgan Stanley failed to uncover Huang’s misconduct due to its lack of supervisory oversight and failure to implement policies specifically addressing the prearranged trades."
The settlement reemphasizes two important points, said Georgetown University law professor Donald Langevoort. "First, ‘hiding’ assets or liabilities – here, in the form of parking – is wrong. Second, allocating trade gains and losses in a way that discriminates between preferred and non-preferred accounts is wrong. This is hardly the first case saying either, but given the pressures on portfolio managers to demonstrate results, is a useful reminder."
"Besides the parking allegation, this case highlights a number of areas of current focus for the SEC: fixed income trading, cross trading requirements, and supervision," said Willkie Farr partner James Burns. "It serves as a strong reminder that the agency is paying especially close and careful attention to these kinds of issues and is willing to mete out serious punishment when it identifies lapses. Firms should take care to ensure that they are monitoring compliance with cross trading requirements."
"While we regret the actions of the former employee, we are pleased to have resolved this matter," said J.P. Morgan in a statement. "We cooperated with the SEC throughout their investigation and took appropriate compensatory action with respect to clients harmed by the misconduct. The actions of this former employee stand in stark contrast to our firm’s commitment to integrity and the highest standards of ethical conduct." The attorney representing Huang, when contacted, chose not to comment.
The players and the arrangements
New York City-based Morgan Stanley Investment Management, which the administrative order describes as having approximately $175 billion to $250 billion in assets under management from 2011 through 2014, advised clients, among them registered investment companies, pooled investment company vehicles and separately managed accounts.
Huang, the portfolio manager involved, was also head of the firm’s mortgage team, responsible for mortgage-backed and asset-backed securities trading and investment decisions for Morgan Stanley Investment Management clients, the SEC said. As such, according to the agency, she proposed – and [the brokerage firm’s trader] agreed to – six sets of unlawful prearranged trades "without any arm’s length negotiation."
Each of the six sets, some of which involved client accounts that were subject to ERISA, "involved a package of bonds which were sold to [the brokerage firm] and then repurchased by Morgan Stanley Investment Management the next business day at the same price they were sold plus a small markup," the SEC said. The six sets were composed of 81 individual positions, consisting of collateralized mortgage obligations, commercial mortgage-backed securities and asset-backed securities.
In the buyback trades, according to the agency, "Huang typically offered the position to [the brokerage firm’s trader] at the best bid received from other broker-dealers and indicated that the bonds would be bought back at a small markup. Through this arrangement, Huang was able to repurchase positions at a price only slightly above the bid price, which was a more favorable price to the buying accounts than transacting at a price that incorporated the full market based bid-offer spread for these types of securities."
"There was an understanding between Huang and [the brokerage firm’s trader] that the positions would be repurchased at a slight markup," the SEC said. "In practice, Huang was simply interposing [the brokerage firm] to effect cross trades and avoid Morgan Stanley Investment Management and regulatory requirements governing cross trades. By not crossing these positions at the midpoint between best bid and best offer, Huang generally allocated the full benefit of the market savings to its purchasing clients, even though the buying and selling clients were owed the same fiduciary duty."
Cross trading requirements
Cross trading in this case was covered not only by Investment Company Act regulations, but by Morgan Stanley Investment Management’s own policies, which was in some ways stricter.
Sections 17(a)(1) and (a)(2) of the Investment Company Act generally prohibit any affiliated person of a registered investment company who is acting as a principal from knowingly selling a security to, or purchasing a security from, the registered fund unless the person first obtains an exemptive order under Section 17(b).
Investment Company Act Rule 17a-7 provides an exemption from these provisions when the investment company and its affiliated person have a common investment adviser, directors and/or officers, provided that the transaction is conducted according to the rule’s requirements. Among those requirements are that cross trades be executed at the independent current market price, defined as "the average of the highest current independent bid and lowest current independent offer, determined on the basis of reasonable inquiry," according to the SEC. In addition, if the adviser pays a brokerage commission, fee or other remuneration, the transaction is not eligible for the exemption.
It should also be noted that ERISA prohibits investment advisers from engaging in cross trades with ERISA regulated accounts. There is an exemption, but only if certain conditions are met, among them that the transaction is effected at the independent current market price, which, according to the SEC’s administrative order in the Morgan Stanley Investment Management settlement, was not the case.
Finally, Morgan Stanley Investment Management’s internal cross trading policies and procedures "provided for even broader restrictions on trade execution," the agency said. For one thing, they prohibited cross trades involving ERISA accounts under any circumstances. The firm’s compliance manual "required all other cross trades to be executed in compliance with Rule 17a-7, regardless of whether the accounts were registered investment companies," according to the administrative order. In addition, the SEC noted, Morgan Stanley Investment Management’s compliance policies required that the firm use its best efforts to obtain best execution for all client transactions, meaning the most favorable price and execution.
Red flags missed
The SEC’s charges against Morgan Stanley Investment Management included allegations that the firm did not properly supervise Huang and failed to properly act on red flags which, according to the agency, included:
Compliance staff noted that some of the trades involving ERISA accounts were crossed using a broker "and that the ERISA-related positions were sold and repurchased at identical markups." The staff notified the firm’s chief compliance officer of the questionable sales and repurchases in the ERISA account and later "identified a prior pattern of matched sales and repurchases by the mortgage team," the agency said.
A form email from the firm’s pricing team, sent on the date of one of the trades, indicated that some of the positions Huang traded with the brokerage firm had traded at a greater than 5 percent margin from the pricing vendor’s price.
Huang "fabricated a list of bids to cover up her failure to obtain competitive bids pursuant to Morgan Stanley Investment Management’s best execution policy."
The firm’s legal department was notified of the potentially problematic trades and conducted an internal investigation, but, according to the SEC, "concluded that although the trades were questionable, they were not problematic." Management then reprimanded Huang, both in person and in writing, but left her in charge of the mortgage team, and took no further action with respect to her prearranged trades until 2014, after being contacted by SEC staff about the matter. Morgan Stanley Investment Management then "re-opened the internal investigation, discovered Huang’s misconduct and terminated her employment in May 2014."
Violations and penalties
Morgan Stanley Investment Management was charged with a variety of violations, among them having willfully violated Section 17(a)(3) of the Securities Act, and Section 206(2) of the Advisers Act, both of which prohibit fraud. It was also charged with having willfully violated Section 206(4) and its Rule 206(4)-7, which requires advisers to adopt and implement written compliance policies and procedures; and Section 203(e)(6), for failure to reasonably supervise Huang.
Instead of disgorgement, Morgan Stanley Investment Management agreed to set up a distribution fund of more than $857,500 to compensate the pooled investment vehicles and the separately managed accounts involved, the agency said. The firm was censured and required to pay a civil money penalty of $8 million.
Huang was charged with having willfully violated Sections 17(a)(1) and 17(a)(3) of the Securities Act, as well as Section 10(b) of the Exchange Act and its Rules 10b-5(a) and (c), which prohibit fraud; and Sections 206(1) and (2) for having willfully aided, abetted and caused fraud. She was barred from the industry for five years, and agreed to pay a civil money penalty of $125,000.