Having agreed to pay more than $19m to settle charges brought by the SEC relating to improper bond trading, hedge fund Chatham Asset Management is now looking to recoup those costs, plus damages, from its compliance adviser Advisor Compliance Associates (ACA), according to a report by Bloomberg.

The $6bn hedge fund firm founded by Anthony Melchiorre is reportedly pursuing a $100m lawsuit claiming that the outsourced compliance consultancy, which was set up by former regulators, failed to prevent trading practices that ran foul of the regulator.

The case relates to the trading of bonds in A360media (formerly American Media), owner of US tabloid the National Enquirer, which the SEC alleged Chatham carried out improperly by using outside brokerages to move the investments at elevated prices among the funds it managed.

SEC settlement in April

Chatham’s regulatory troubles began when the SEC conducted an on-site examination in 2018 and sought details about whether the firm had conducted cross trades among funds it managed.

In the ultimate settlement of the SEC’s case, Melchiorre and Chatham agreed to pay more than $19m in April to settle the matter.

SEC rules require registered firms are supposed to trade at real market prices, and the SEC’s complaint in the April case said Chatham and Melchiorre violated the rules against “engaging in any transaction, practice, or course of business which operates as a fraud or deceit upon any client or prospective client”.

And the SEC says it violated Rule 17a-7, which regulates trading between two different funds run by the same manager. (As Bloomberg notes, Chatham wasn’t trading directly between two of its funds – it was selling to an outside broker and then buying back from that broker – but, yes, the funds were traded among those in-house.)

“Chatham has not and cannot plead that ACA ever knew specific facts found by the SEC”.

ACA, responding to Chatham’s lawsuit

In the SEC’s press release in April, Sanjay Wadhwa, Deputy Director of the SEC’s Division of Enforcement, said that “Chatham’s trading in AMI bonds had the effect of increasing the prices of those generally illiquid securities in a way that was disconnected from economic reality”.

Chatham filed the lawsuit days after resolving the SEC’s probe without admitting or denying wrongdoing last spring, accusing ACA of gross negligence, negligent misrepresentation, and breach of fiduciary duty.

“Chatham sought, received and followed advice from ACA that certain trading practices did not run afoul of the SEC’s cross-trading rules,” Melchiorre said in a statement through a spokesman. “ACA gave it improper advice and failed to flag these trades as problematic.” The hedge fund intends to vigorously pursue the matter, holding ACA accountable, he said.

ACA’s perspective

ACA says the investment firm is seeking “to foist blame on Adviser Compliance Associates for Chatham’s own violations” of federal securities laws and SEC rules, the consultant’s attorneys wrote last year in the company’s motion to dismiss the lawsuit.

The SEC found the hedge fund and Melchiorre set the prices for the trades in question, the lawyers noted. And nothing in the complaint “alleges that Chatham ever informed ACA that it was pre-arranging the sales prices of the bonds, or that ACA knew of the practice, much less that ACA advised Chatham to engage in it.”

“Chatham fails to make clear that the SEC suggested no wrongdoing by ACA or that ACA knew and advised Chatham of the pre-arranged trading pattern,” the consultant told the court in its bid to have the case tossed out. “Chatham has not and cannot plead that ACA ever knew specific facts found by the SEC”.

We’re not providing this comment to suggest Chatham has a strong case here. ACA might have missed a few clues, but it’s also likely ACA did not know what it took a targeted SEC investigation of Chatham to learn here.

But to avoid litigation costs, service providers like ACA should adhere to certain defensive strategies, such as keeping copious documentation to show the information it relies on in any and all business transactions on behalf of another party.

And it should construct contract terms with legal counsel that anticipate as many trading and other transactional actions as possible, and establish a mutual understanding of those that will be conducted and are permissible under the contract.

Monitoring the achievement of performance metrics as noted in the contract is essential – as is creating processes for monitoring the progress of stated goals.

And service providers should think about who they do business with, as news reports contain some colorful opinions from industry participants regarding Melchiorre.