United States: OCIE Notifies Investment Advisers Of Principal And Agency Cross Trading Compliance Deficiencies

Last Updated: October 7 2019
Article by Kevin P. Scanlan

Failures by a number of investment advisers to comply with certain rules governing principal and agency cross trades has prompted the compliance inspections staff of the Securities and Exchange Commission (SEC) to issue a risk alert. This alert, among other things, emphasizes the need for investment advisers to have adequate policies and procedures in place related to principal and agency cross trading to meet their compliance obligations as well as their fiduciary duties to their clients.

On Sept. 4, 2019, the SEC’s Office of Compliance Inspections and Examinations (OCIE) posted a risk alert describing frequent compliance issues related to principal trading and agency cross transactions, which it identified in connection with recent examinations of investment advisers.

OCIE reviewed compliance issues related to Section 206(3) of the Investment Advisers Act of 1940 (Advisers Act), which prohibits an investment adviser, acting as principal for his own account, from selling or purchasing securities (principal trades) without disclosing the capacity in which the adviser is acting and obtaining the consent of the client prior to the completion of such principal trade. Section 206(3) also prohibits agency cross transactions (i.e., transactions where an adviser is acting as a broker for a person other than the particular advisory client and effects a purchase or sale of a security for the account of such advisory client) unless adequate disclosure is provided to a client and consent from such client is secured to such transaction. 

OCIE noted several recurring compliance issues among investment advisers engaged in principal trades and agency cross trades. The issues cited most often were:

  • Advisers acting as principal for their own accounts had purchased securities from, or sold securities to, advisory clients without making the required written disclosures to clients or obtaining the necessary client consents.
  • Other advisers recognized that they engaged in principal trades with a client, but still didn’t meet all of the requirements of Section 206(3) because, for example, they failed to secure prior client consent on a transaction-by-transaction basis and failed to provide sufficient disclosure regarding the terms of such transaction and the potential conflicts of interest associated with such transaction.

Additionally, OCIE detected deficiencies among advisers engaged in principal trades involving pooled investment vehicle clients. For example, OCIE observed that:

  • Advisers made trades between advisory clients and an affiliated pooled investment vehicle while failing to recognize the adviser’s significant ownership interests in the investment vehicle caused the transaction to be a principal transaction. In this regard, the risk alert confirms prior guidance issued by the SEC staff indicating that the Section 206(3) principal trade obligations do not apply to a transaction between a client account and a pooled investment vehicle of which the investment adviser and/or its controlling persons, in the aggregate, own 25% or less.
  • Some advisers effected principal trades between themselves and pooled investment vehicle clients without obtaining effective consent from the pooled investment vehicle prior to completing the transactions.

In respect of compliance issues associated with agency cross transactions, OCIE noted that:

  • Some advisers engaged in such transactions without disclosure to clients.
  • Other advisers engaged in agency cross transactions in purported compliance with Section 206(3) and Rule 206(3)-2, but were unable to produce any documentation evidencing compliance with the written consent, confirmation or disclosure requirements of the rule.

According to OCIE, the compliance issues summarized above might be attributed to a lack of communication and accountability among investment advisers regarding policies and procedures. OCIE discovered some advisers didn’t have policies and procedures relating to Section 206(3), even though they engaged in principal trades and agency cross transactions. The SEC staff also noted some advisers had established policies and procedures but failed to follow them.

OCIE set forth these issues in deficiency letters provided to advisers, recommending that they modify their written policies, procedures and practices to ensure compliance with the principal trading and agency cross transaction provisions of the Advisers Act. Further, advisers were prompted to review their implementation of those policies and procedures.

The alert also notes that simply complying with the disclosure and consent provisions of Section 206(3) alone may not satisfy an adviser’s obligations — to ensure that a client’s consent to a principal trade or agency cross transaction is informed, the SEC recommends that Section 206(3) should be read together with Advisers Act Sections 206(1) and (2). Those sections speak to the duty of an adviser “to provide full and fair disclosure to its clients of all material facts relating to the advisory relationship” and “to seek best execution of a client’s transactions where the adviser has the responsibility to select broker-dealers to execute client trades (typically in the case of discretionary accounts).”

If you are an investment adviser, some questions you should consider are:

  1. Do you have policies in place related to client communication and consent that conform to Sections 206(1), (2) and (3) of the Advisers Act?
  2. Have you communicated with your clients with respect to principal and cross trading transactions?
  3. Have you received the appropriate client consents, where needed, and are these consents readily available?

If you have specific questions about these or other compliance matters, you should consult with a qualified legal adviser regarding the most effective and efficient way to remain compliant.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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