More On Legal & Compliancefrom The Advisor's Professional Library
- Trading Practices and Errors When SEC-registered investment advisors conduct annual audits of firm policies and procedures, they should pay close attention to trading practices. Though usually not required to, state-registered advisors should look at their trading practices and revise policies that do not fully protect clients.
- Agency and Principal Transactions In passing Section 206(3) of the Investment Advisers Act, Congress recognized that principal and agency transactions can be harmful to clients. Such transactions create the opportunity for RIAs to engage in self-dealing.
The Securities and Exchange Commission on Monday charged Albany, N.Y.-based hedge fund advisory firm Paradigm Capital Management with engaging in prohibited principal transactions and then retaliating against the firm’s head trader, who reported the trading activity to the SEC.
The SEC charged Paradigm Capital Management and its owner, Candace King Weir, with causing the improper principal transactions. Paradigm and Weir agreed to pay $2.2 million in a settlement announced Monday.
A Commission rule adopted in 2011 under the Dodd-Frank Act authorized the SEC to bring enforcement actions based on retaliation against whistleblowers who report potential securities law violations to the agency.
The Monday action is the first time the SEC has filed a case under its new authority to bring anti-retaliation enforcement actions.
SEC Enforcement Chief Andrew Ceresney said on a Monday conference call with reporters that the action highlights the fact that advisors must “properly manage conflicts” when engaging in principal transactions.
According to the SEC’s order instituting a settled administrative proceeding, Weir conducted transactions between Paradigm and a broker-dealer that she also owns while trading on behalf of a hedge fund client.
Such principal transactions pose conflicts between the interests of the advisor and the client, and therefore advisors are required to disclose that they are participating on both sides of the trade and must obtain the client’s consent, the SEC says.
“Paradigm failed to provide effective written disclosure to the hedge fund and did not obtain its consent as required prior to the completion of each principal transaction,” the SEC said.
The SEC’s order finds that after Paradigm learned that the firm’s head trader had reported potential misconduct to the SEC, the firm engaged in a series of retaliatory actions that ultimately resulted in the head trader’s resignation.
“Those who might consider punishing whistleblowers should realize that such retaliation, in any form, is unacceptable,” Ceresney said.
Paradigm retaliated against the head trader by, among other measures, denying him access to the firm’s systems, stripping him of his trading authority and removing him from the firm’s trading desk.
Ceresney said on the call that the trader will receive a whistleblower award from the agency.
According to the SEC’s order, Paradigm’s head trader reported trading activity revealing that Paradigm engaged in prohibited principal transactions with affiliated broker-dealer C.L. King & Associates while trading on behalf of hedge fund client PCM Partners L.P. II.
The SEC’s subsequent investigation found that Paradigm engaged in the trading strategy from at least 2009 to 2011 to reduce the tax liability of the firm’s hedge fund investors.
According to the SEC’s order, since Weir had a conflicted role as owner of the brokerage firm in addition to advising the PCM Partners hedge fund, merely providing written disclosure to her as the hedge fund’s general partner and obtaining her consent was insufficient. Paradigm attempted to satisfy the written disclosure and consent requirements by establishing a conflicts committee to review and approve each of the principal transactions on behalf of the hedge fund.
The SEC’s order finds that the conflicts committee itself, however, was conflicted, because it consisted of two people: Paradigm’s chief financial officer and chief compliance officer, who each essentially reported to Weir. Furthermore, Paradigm’s CFO also served as C.L. King’s CFO, which placed him in a conflict, the SEC says.