SEC Sues Adviser For Fraudulent Cross-Trading

January 27th, 2011
in Banking, econ_news

ghoul Econintersect:  The SEC has filed suit against Warren Nadel, Glen Cove, NY.  The Long Island investment advisor is accused of cross trading and defrauding clients of more than $8 million.  In order to understand the nature of this alleged fraud, one must understand exactly what "cross-trading" is.

Follow up:

Most trades of securities are carried out on the open market with three parties involved:  (1) a buyer or buyer's agent, (2) a principal or market maker who maintains an inventory in the securityand is responsible for maintaining market liquidity and (3) a seller or seller's agent.  Such trades are presumably executed at "an arm's length" and represent a true price discovery process.

Nadel is accuse of fulfilling all three of the above roles for securities held by his clients and hiding that fact.  As a result he made trades from client A's account at some inflated price and sold those securities into the accounts of other client(s), say "B" and "C".  He reported the capital gain to Client A.

At a later date he would "sell" the same security from accounts of client B and client C at an even higher price and have client D buy them (or client A repurchase).  Now, three clients have capital gains reported to them from the same security.  This process can be continued, compounding fictitious gains for securities that actaully are very illiquid and have no regular market, only the "market" fabricated by the perpetrator.

This is simply a variation on the Ponzi theme and eventually enough clients may want to cash out their accounts and the inflated valuations can no longer be supported.  The available reports do not make it clear whether the Nadel scheme actually collapsed or was uncovered by SEC audit.  Based on what Securities Technology Monitor has published (article by Chris Kentouris), it appears that audits may have uncovered the fraud:

Cross-trading is legal except for funds which fall under the guidelines of the Employee Retirement Income Security Act of 1974; those are typically employee pension plans. The practice-- where a broker executes both a buy and sell order for the same security from one client account to another where both accounts are managed by the same portfolio manager—can sometimes result in a client not getting the best price on its purchase or sale. That is because the trade doesn’t get recorded through an exchange.Therefore, the asset manager must be able to prove to the SEC that the trade was beneficial to both parties and the trade must be recorded as a cross. The asset manager must also disclose the practice to its customers, Nadel did neither.

In his Form ADV – the documentation investment advisers use to register with the SEC, Nadel said that he used the brokerage firm he controlled because that firm would “deal with other brokers or dealers and can provide the best execution for orders on behalf of the accounts.” And Nadel also erroneously said that he valued the securities he traded at “the prevailing market value” by contacting market markers at the end of each month to obtain so-called “inside market (highest bid and lowest offer) prices.

However, the prices Nadel reported on his trade confirmations and those stated in his monthly were reports were “fictitious.” When clients did question him about the difference between his valuations and those contained in his clearing firm’s monthly statements or in independent pricing reports, Nadel touted his “20-year expertise” and his “contacts with market-makers,” the SEC said.

Nadel never maintained any record of the way he valued his client’s holdings and he did not store any order tickets. Primoff would not comment on whether Nadel's clearing firm ever investigated the discrepancies between its monthly statements and the ones Nadel was mailing to customers.

Richard Primoff is the SEC attorney proxecuting the case.

The charges include the following details:

  • Clients paid Nadel over $6 million in commissions from early 2007 through 2009.
  • Clients paid Nadel at least $2.4 million in management fees.
  • Nadel executed at least 11,250 trades over the three years.
  • About 90% of trades were not executed on the open market (ie, they were cross traded). 

From the SEC complaint:

“Had Nadel properly disclosed the nature of each cross-trade and sought client consent, clients would have learned that this supposedly conservative short-term and liquid cash management investment strategy was essentially a sham because there was, in fact, no liquid market for most of these securities at the reported prices, and actual market prices, as reflected in actual market transactions, were in most instances significantly less than the prices defendants were claiming.” 

Sources:  Financial Planning, SEC complaint against Warren D. Nadel and Securities Technology Monitor

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