Ethics in Practice: Client Cross Trade 

Category: Ethics

Country or region: Asia Pacific (Overall)

If the headline above sparked your interest, you are one of the thousands of honest, ethical, and well-meaning investment professionals who want to do the right thing when it comes to fulfilling your professional responsibilities. But sometimes the proper course of action is not always straightforward and obvious. To help with those situations, CFA Institute provides guidance through its Code of Ethics and Standards of Professional Conduct (Code and Standards) as well as an Ethical Decision-Making Framework. But just as you need to practice to become proficient at playing a musical instrument, public speaking, or playing a sport, practicing assessing and analyzing situations and making ethical decisions develops your ethical decision-making skills. To promote “ethical exercise,” we are excited to introduce Ethics in Practice.
Each week, we will post a short vignette, drawn from real-world circumstances, regulatory cases, and CFA Institute Professional Conduct investigations, along with possible responses/actions (see below). Later in the week, we will post an analysis of the case and you can see how your response compares! Stay tuned!

We then encourage you to assess the case through the lens of the Ethical Decision-Making Framework and the Code and Standards and let us know which of the choices you believe is the right thing to do and why by using the comment field below.

CASE (Week 71)
Zachary is a portfolio manager for PTM, a large investment management firm with numerous registered investment companies and other clients. Because of market conditions, client investment objectives, portfolio guidelines, liquidations, redemptions, or other reasons, certain PTM clients occasionally need to sell their positions in residential mortgage-backed securities (RMBS). Zachary believes that the securities PTM is required to sell for some clients are good investments at current market prices. So, he wants to move the securities into other PTM client accounts that he believes will benefit from holding the securities he views as desirable. Zachary arranges with broker/dealers to temporarily sell the securities and repurchase them the next business day. The sales are executed based on a single bid for the securities. The repurchases are executed at a small markup over the sale price.
Zachary’s actions are

A. acceptable as long as the RMBS investments are suitable for the clients who purchase those securities.
B. acceptable as long as the markup on the RMBS resale price is reasonable.
C. not acceptable because he is not acting in the best interests of his clients.
D. not acceptable if he does not communicate the trading arrangement to his employer.
E. none of the above. 

Zachary is not treating all PTM clients fairly when executing the sales and purchases of the RMBS investments for their accounts. CFA Institute Standard III(B): Fair Dealing states that CFA Institute members must deal fairly and objectively with all clients when taking investment action. To meet his responsibilities to his clients, Zachary has a duty to execute trades in a manner consistent with his clients’ best interests. He must follow a trading process that seeks to maximize the value of the client’s portfolio within the client’s stated investment objectives and constraints, and he must primarily consider best prices and consistent liquidity when executing trades.
Zachary prearranges dealer-interposed cross trades in which trading counterparties purchase RMBS from certain PTM advisory accounts; he then resells the securities to other PTM advisory accounts. Zachary’s cross trades are not bona fide, arm’s-length transactions, and do not involve actual transfer of risk to PTM’s broker/dealer counterparties. If risk actually passed from PTM’s clients to PTM’s broker/dealer counterparties, they would incorporate market-based bid–offer spreads. Instead, only a single bid is used as the selling price. By cross trading RMBS at the single bid quoted, rather than at an average between the highest current independent bid and the lowest current independent offer, Zachary favors the buyers over the sellers in the transactions, even though both are advisory clients of PTM. Even if the RMBS investments are suitable for the PTM clients who purchase them, Zachary’s prearranged cross trades are not in the best interest of the selling clients. The size of the markup is not relevant because of the favoritism shown to the clients buying the RMBS. Even if Zachary disclosed the trading scheme to PTM (or to the clients), that would not obviate the need for him to act in the best interest of his clients and to treat all clients fairly. Choice C is the best answer.
This case is based on a US Securities and Exchange enforcement action from September 2018.

Have an idea for a case for us to feature? Send it to us at 

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