Fraudulent Cross Trades and the Limits of Pricing Services

Summary:

On April 3rd, 2023, the Securities and Exchange Commission (“SEC”) settled an action with Chatham Asset Management, LLC (“Chatham”) and Anthony Melchiorre (“Melchiorre”), founder and principal owner of Chatham related to inappropriate cross trades which resulted in the inflation of valuation and NAV-based fees.
Chatham and Melchiorre agreed to pay nearly $20 million in disgorgement, interest, and penalties, and Melchiorre agreed to be barred from associating with an investment company. These are very significant penalties given the size of the firm.

Allegations and Conduct:

Chatham managed private funds and registered investment companies which held bonds of American Media Inc. (“AMI”), the publisher of the National Enquirer. Chatham’s clients owned approximately 83% of all of the outstanding AMI bonds and Chatham clients also held a controlling equity position in AMI.
When certain Chatham clients required liquidity, Chatham and Melchiorre arranged for “rebalancing” trades through friendly brokers where AMI securities were sold from one fund to another through a series of transactions that made it appear as if the trades were exposed to the market. However, the trades were executed at prices set by Melchiorre and were executed either (1) among Chatham clients through one broker over a period of time; or (2) among Chatham clients through a series of broker transactions where one broker would transact with another who would in turn transact with Chatham funds.
In each trade, Melchiorre added a spread to compensate the brokers in the transactions and therefore Chatham’s purchasing funds paid increasingly higher prices for AMI securities even though no fundamental company or market events occurred to increase the securities’ price.
The Chatham rebalancing transactions were reported to pricing services and since the Chatham trades were the majority of the market activity in AMI securities, the Chatham trades were the primary basis on which pricing services relied to report market pricing.
Melchiorre understood this dynamic but used the pricing service data anyway. This had the effect of artificially increasing fund NAV and increasing the fees that Chatham collected.

Key Takeaways:

Rebalancing Transaction Disclosure: Specific disclosure needs to exist to support rebalancing trades and cross trades, if either are a normal part of executing an investment strategy. Managers should also consider adding disclosure about any conflicts of interest inherent in such transactions including valuation conflicts, conflicts between funds with differing amounts of proprietary capital and funds with different fee schedules.
Valuation of Cross Trades: For illiquid securities, it is a manager’s responsibility to ensure that cross trades are fairly valued and the basis of that valuation is documented. This could take the form of valuation memos, practices to ensure market execution, or trade blotter notes. Managers should expect that SEC examiners would review this support during examinations.
Regulatory Intent and Compliance Training: According to the order, Melchiorre was advised to execute cross trades through brokers. While the SEC did not make the exact nature of the advice clear, Melchiorre likely understood that one reason execution through brokers was important was price discovery. Nevertheless, Melchiorre engineered a method to utilize brokers but avoid price discovery. We see this approach – of following a procedure but circumventing the purpose of that procedure – at the heart of many SEC actions involving parties who are not familiar with the structure of regulation. This highlights the importance of accessible compliance training and the need for compliance professionals to be available to business professionals.
Limitation of Pricing Services: Like the BVAL case filed earlier this year, this case demonstrates the limitations of pricing services when thinly traded securities are involved.