The SEC has charged two investment firms in Houston, Parallax Investments LLC and Tri-Star Advisors, along with three of their executives, for “engineering thousands of principal transactions” through a brokerage firm they are affiliated with without disclosing it to their clients.

In addition to these charges, a Chief Compliance Officer of one of the firms was charged with violating the custody rule relating to the holding of client funds or securities.
The charges come down to a conflict of interest.  Since the investment firms used an affiliate, without disclosing it to clients, they had a conflict of interest that clients were not made aware of or able to avoid.

According to the SEC Parallax Investments LLC and Tri-Star Advisors conducted thousands of securities transactions which led to John P. Bott II, owner of Parallax, and William T. Payne and Jon C. Vaughan, CEO and President of Tri-State Advisors receiving over $2 million in compensation.

In other words they used their affiliation to trade client shares and receive large fees for doing so.  Their clients were not informed, nor did they provide consent.  Payne and Vaughan were the primary beneficiaries of the scheme and received over half of the $1.9 million the firms collected for these transactions, over 2,000 total from 2009 to 2011.

Marshall Sprung of the SEC said,“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.”

The investment firms appeared to be full participants as they  used their inventory accounts to buy mortgage-backed bonds from the others clients. They would then transfer the bonds to their own client accounts.  This trading went back and forth between the two companies with executives on both sides pocketing millions of dollars.

These “principal transactions” are when an investment adviser buys from or sells to a client account using an affiliated broker dealer. The SEC requires that clients are informed and agree to these activities in writing in order to avoid a situation like this where clients end up paying millions in fees while their broker receives additional benefit.

The additional custody violations came because Parallax was an adviser to the private fund Parallax Capital Partners LP.  The rule states that Parallax needs to have a suprise exam once a year or have a registered PCAOB-registered auditor audit their fund.  The company did have their fund audited but they didn’t hire a PCAOB-registered auditor in 2010. They also didn’t deliver the financial statements within the required 120 days.

The SEC found that the company and its Chief Compliance Officer, F. Robert Falkenberg were aware of the deadline and that their auditor was not approved but hired the auditor anyway. Falkenberg and Bott are charged with aiding, abetting, and causing the custody and compliance violations that Parallax is facing.  These charges are under the Investment Advisers Act of 1940.

The SEC regularly investigates companies and investment firms to look for fraud.  Investors that are concerned about affiliations between firms or other potential violations can complain using their tips hotline.