Ethics Case Study of the Week: Cross Trades and Clients' Best Interests

By Gary Sarkissian posted 07-12-2021 08:00


CFA Institute’s Code of Ethics and Standards of Professional Conduct codify the ethical guidelines for the investment profession that are critical to maintaining the integrity of capital markets and investor trust.  Members, candidates, and even firms make a commitment to uphold these standards as they help elevate ethical decision-making universally around the globe.  

As investment professionals, we are certain to face important ethical decisions in our day-to-day activities.  Some scenarios we encounter will be straightforward, while others may be more complex.  No matter what circumstances we face, continuous learning remains imperative in an investment industry that continues to evolve with products undergoing innovation and a regulatory environment continuing to adapt. 

For that reason, each week we feature a sample case from CFA Institute’s Ethics in Practice Casebook.  Many cases are built upon real-life examples that may involve a regulatory matter or even a CFA Institute Professional Conduct investigation.  At the end of each case is a multiple-choice question that addresses the ethical nature of the actions taken in that case.  

This week’s case involves Standard III(B) Fair Dealing.

Cross Trades and Clients' Best Interests
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.

What do you think is the correct choice?  Click the “Analysis” button below to see the analysis for this case, and feel free to discuss in the comments below.  The completion of this case qualifies for 0.25 hour of Standards, Ethics, and Regulation (SER) credit

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.

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© 2019 CFA Institute. All rights reserved. You may copy and distribute this content, without modification and for non-commercial purposes, provided you attribute the content to CFA Institute and retain this copyright notice.  This case was written as a basis for discussion and is not prescriptive of how a business situation or professional conduct matter should or should not be handled or addressed. Certain characters mentioned are fictional to facilitate discussion, and any resemblance to actual persons is coincidental.