SEC Announces Charges Against Two Houston-Based Firms for Engaging in Thousands of Undisclosed Principal Transactions
The Securities and Exchange Commission today announced charges against two Houston-based investment advisory firms and three executives for engineering thousands of principal transactions through their affiliated brokerage firm without informing their clients.
One of the firms — along with its chief compliance officer — also is charged with violations of the “custody rule” that requires firms to meet certain standards when maintaining custody of client funds or securities.
In a principal transaction, an investment adviser acting for its own account or through an affiliated broker-dealer buys a security from a client account or sells a security to it. Principal transactions can pose potential conflicts between the interests of the adviser and the client, and therefore advisers are required to disclose in writing any financial interest or conflicted role when advising a client on the other side of the trade. They must also obtain the client’s consent.
The SEC’s Enforcement Division alleges that investment advisers Parallax Investments LLC and Tri-Star Advisors engaged in thousands of securities transactions with their clients on a principal basis through their affiliated brokerage firm without making the required disclosures to clients or obtaining their consent beforehand. Parallax’s owner John P. Bott II and Tri-Star Advisors CEO William T. Payne and president Jon C. Vaughan were collectively paid more than $2 million in connection with these trades.
“By failing to disclose principal transactions and obtain consent, Parallax and Tri-Star Advisors deprived their clients of knowing in advance that their advisers stood to benefit substantially by running the trades through an affiliated account,” said Marshall S. Sprung, co-chief of the SEC Enforcement Division’s Asset Management Unit.
According to the SEC’s orders instituting administrative proceedings, Bott initiated and executed at least 2,000 undisclosed principal transactions from 2009 to 2011 without the consent of Parallax clients. In each transaction, Parallax’s affiliated brokerage firm Tri-Star Financial used its inventory account to purchase mortgage-backed bonds for Parallax clients and then transferred the bonds to the applicable client accounts. Bott received nearly half of the $1.9 million in sales credits collected by Tri-Star Financial on these transactions.
According to the SEC’s orders, Payne and Vaughan initiated and executed more than 2,000 undisclosed principal transactions from 2009 to 2011 without the consent of Tri-Star Advisor clients. Tri-Star Financial similarly used its inventory account to purchase mortgage-backed bonds for Tri-Star Advisor clients and then transferred the bonds to the applicable client accounts. Payne and Vaughan together received nearly half of the $1.9 million in gross sales credits collected by the brokerage firm on these transactions.
The SEC’s Enforcement Division further alleges that Parallax failed to comply with the custody rule that requires firms to undergo certain procedures to safeguard and account for client assets. Parallax served as an adviser to a private fund Parallax Capital Partners LP. The custody rule required Parallax to either undergo an annual surprise exam to verify the existence of the fund’s assets, or obtain fund audits by a PCAOB-registered auditor and deliver the financial statements to investors within 120 days after the fiscal year ends. Although Parallax obtained an audit of PCP in 2010, it failed to retain a PCAOB-registered auditor and failed to deliver the financial statements on time.
According to the SEC’s orders, Parallax chief compliance officer F. Robert Falkenberg was aware of the 120-day deadline, but failed to take any steps to ensure that Parallax complied. Even after Falkenberg and Bott learned that the fund’s auditor was not registered with the PCAOB, they retained him to perform the 2010 audit and issue financial statements to investors.
According to the SEC’s orders, Parallax allegedly violated the principal transaction, custody, and compliance provisions of the Investment Advisers Act of 1940, and Bott allegedly aided, abetted, and caused the violations. Falkenberg allegedly aided, abetted, and caused Parallax’s custody and compliance violations. Tri-Star Advisors allegedly violated the principal transaction and compliance provisions of the Advisers Act, and Payne and Vaughan allegedly caused the violations.
The SEC’s investigation was conducted by R. Joann Harris and Asset Management Unit member Barbara L. Gunn of the Fort Worth Regional Office. The SEC’s litigation will be led by Jennifer Brandt.