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News January 29, 2018 Issue

Failure to Disclose Principal Trades May Lead to SEC Charges

The Advisers Act has strict requirements when it comes to self-dealing – and that includes principal trades. Just consider Section 206(3). It prohibits an adviser, while acting as a principal for his own account, from knowingly selling any security to or purchasing any security from any client without first disclosing to the client that he is doing so and obtaining the client’s consent.

John Tarpinian just found this out the hard way. The former managing director of New York City-based adviser and broker-dealer Newport, settled charges with the agency that he engaged in "thousands of principal trades between Newport’s brokerage proprietary trading account and advisory client accounts without first providing written disclosure that he was effecting the trades as a principal or obtaining consent from his clients for such trades," the SEC said in its January 17 administrative order instituting the settlement.

Tarpinian was in the business of providing advice to his clients. While working at Newport, he provided advice on the value, purchase and sale of securities to more than 100 advisory clients, from whom he received an advisory fee based on their respective assets under management. He invested most of his clients’ dollars in structured products, as well as in municipal bonds and equities, the agency said.

Beginning in approximately March 2013 and continuing through December 2015, Tarpinian "knowingly placed approximately 2,785 trades between [his firm’s principal account] and advisory client accounts," the SEC said. These allegedly included instances in which he purchased securities on behalf of his clients directly from the principal account, and instances in which Tarpinian sold securities on behalf of his clients directly to the firm’s principal account.

"Although Tarpinian knew, or recklessly disregarded the fact, that he was required to provide written disclosure that he was acting as a principal and obtain consent from advisory clients for such principal trades prior to their completion, he never did so, nor did Newport," the agency said.

"This is a hand-in-the-cookie-jar case," said Lewis Baach Kaufmann Middlemiss partner Arthur Middlemiss. "If what the SEC is saying is true, he violated his fiduciary duty." The lesson, he said, can be boiled down to this: "If you will benefit personally and you find yourself not telling your client something because he won’t do the trade if you do, you’ve got a problem."

Mark-ups or mark-downs

He made money from doing so, the agency said – approximately $50,000 from advisory clients as mark-ups and mark-downs. He did this by charging fees, according to the administrative order. For most of these principal trades, the SEC said that Tarpinian knowingly charged and Newport’s brokerage arm collected at least 25 basis points per unit purchased or sold by his clients, by either marking up the security the principal account was selling to a client, or by marking down the security the principal account was buying from a client.

Clients sometimes received notification of the principal trade after the principal trades had settled, the SEC said. "These post-settlement notifications did not inform clients that they had been charged a mark-down or a mark-up of at least 25 basis points, in addition to the other applicable fees and commissions," the agency said.

Advisory firms seeking to avoid finding themselves in this kind of situation need to first, recognize to what degree the risk of improper mark-ups or mark-downs exists in their firms, and then, based on what they find, set up a monitoring program to identify outliers and otherwise potentially suspicious activity, Middlemiss said.

"This is yet another message case from the SEC in which the staff took action despite significant mitigating factors," said Paul Hastings partner John Nowak. "The SEC took action despite the fact that the adviser is no longer operating, certain clients received notice of the principal trades post-settlement, and the alleged profit from the mark-up/mark-down appears to have been very small on a per trade basis."

"It is a reminder to internal compliance personnel and counsel to review their trading procedures and practices to ensure strict compliance with the principal trading requirements of the Advisers Act and to educate advisory personnel of those requirements," he said.

The SEC keeps its eye out for undisclosed principal trades. In its 2014 examination priorities, the agency’s Office of Compliance Inspections and Examinations listed "conflicts of interest inherent in certain investment adviser business models" as a priority area. "Over time, the staff has observed [that] instances of non-compliance with the federal securities laws very often arise in situations where there are unaddressed conflicts of interest. Registrants engage in activity that puts their own interests ahead of their clients in contravention of their fiduciary duty and existing laws, rules and regulations. Yet, they too often do not perceive or properly mitigate the conflict."

As examples of cases brought related to these conflicts, OCIE noted two involving principal transactions: the Parallax Investments settlement of November 2013 (ACA Insight, 12/16/13), and the Shadron Stastney settlement of September 2013 (ACA Insight, 10/7/13).

Charges and punishment

As part of the settlement, the SEC found that Tarpinian willfully aided and abetted, as well as caused, Newport’s violations of Section 206(3) of the Advisers Act. He was censured, ordered to pay disgorgement and interest of approximately $53,652; and a civil money penalty of $25,000.

Newport withdrew its registration as a broker-dealer in October 2016 and as an investment adviser in March 2017, "and it has ceased operation," the agency said. An attorney representing Tarpinian did not respond to a voice mail or email seeking comment.