It is generally bad to have one client trade with another client. Rule 206(3)-2 imposes some very specific requirements and leaves you with a final twist:
This rule shall not be construed as relieving in any way the investment adviser or another person relying on this rule from acting in the best interests of the advisory client, including fulfilling the duty with respect to the best price and execution for the particular transaction for the advisory client ….
The problem is especially enhanced when cross-trade involves illiquid, hard-to-value assets, like complex securities or real estate. Mortgage loans fall into that category. As the investment matures, you find out if the underwritten price was good or bad. One side is likely to make out better than the other.
Talimco added to the problem by acting in bad faith during the cross-trade.
According to the Securities and Exchange Commission charges against Talimco LLC and its former chief operating officer, Grant Gardner Rogers, they manipulated the auction of a commercial real estate mortgage asset on behalf of one client for the benefit of another in a cross-trade.
Talimco was the collateral manager for a collateralized debt obligation client on one hand and a commercial real estate investment fund on the other hand. The CDO had a defaulted mortgage loan participation that it was trying to sell.
As an investment adviser, Talimco owed a general fiduciary duty to the CDO. In addition, the CDO governing documents required Talimco to dispose of the assets in a competitive auction with at least three bids.
The real estate fund wanted the investment at a certain price, so Rogers rigged the auction. Rogers convinced two unwilling bidders to participate in the auction by giving assurances that the bidders would not win the auction. As a result of this manipulation, Talimco’s real estate fund client was the highest bidder and acquired the asset.
To prove the problem with cross-trade, the real estate fund ended up selling the interest for a substantial profit and the CDO ended up underwater. It was going to be a good enough investment that Rogers committed an additional $1 million to the fund during the acquisition. That may have been coincidence, but it looks bad.
Not as bad as the written messages about the rigged auction disclosed in the SEC order:
I get it, for you guys and other people that we’ve talked to it’s like, you know it’s not that attractive. It’s small, it’s a non-controlling participation. But, you know, in order to, for us to purchase this, we need like, we need a bid from three different market makers …. And look, I won’t hit you on this, but I need a bid for it.
“By rigging the auction, Talimco and Rogers failed to fulfill their fiduciary duty to their client,” said Daniel Michael, Chief of the SEC Enforcement Division’s Complex Financial Instruments Unit. “Investment adviser firms are expected to have controls in place to detect and disclose conflicts of interest. This action evidences the vigilance of the SEC’s exam and enforcement staff in identifying investments advisers that exploit client relationships and harm investors.”
Notably, the case started with an examination by the Private Funds Unit, who handed the investigation over to the Complex Financial Instruments Unit and the New York Regional Office.
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