FYI: OCIE issued a Risk Alert today identifying the most frequent compliance issues found in investment adviser examinations relating to principal and agency cross trading.
The Risk Alert strikes a familiar theme by listing deficiencies in almost every key area of Advisers Act Section 206(3) (which governs IA principal and cross trading) and related Rule 206(3)-2 (which IAs can choose to follow when executing certain agency cross trades), such as:
• failing to recognize transactions as principal transactions;
• failing to make the required disclosures;
• failing to obtain required client consents (or failing to obtain them in a timely manner); or
• failing to document written consent, confirmation or disclosure requirements.
Also listed is the now familiar finding about IAs that fail to adopt adequate policies and procedures, in this case addressing principal and cross trading even though the IA engages in those types of trades, and the familiar finding about IAs that have adopted policies and procedures but fail to follow them.
Perhaps most eye-catching in the Risk Alert was the statement that an IA’s compliance with the disclosure and consent provisions of Section 206(3) alone may not satisfy the adviser’s fiduciary obligations with respect to a principal or agency cross trade. The Risk Alert goes out of its way to say that in order to ensure a client’s consent to a principal trade or agency cross transaction is informed, Section 206(3) (which governs principal and cross trades) should be read together with Advisers Act Sections 206(1) and (2), the general Advisers Act anti-fraud provisions which serve as the wellspring for an IA’s federal fiduciary duty. Here, the Risk Alert cites back to the IA Fiduciary Interpretation that the SEC adopted in June 2019 along with Reg BI, which emphasizes that IAs may not subordinate client interests to their own and provides guidance about the disclosure necessary for IAs to discharge their fiduciary obligations under Section 206. It also cites back to a key SEC interpretative release addressing Section 206(3) issued in 1998 (linked below).
Consequently, IAs engaged in principal and cross trading should make sure they are making full and fair disclosure of not only the specific items required by Section 206(3) (or related Rule 206(3)-2), but also all material facts necessary to make the client’s consent informed, including those facts that would alert the client to the IA’s conflicts of interest in the transactions.
The Risk Alert also reiterates these points, which should not be overlooked:
• IAs with the responsibility to select BDs to execute client trades also have a duty to seek best execution of those trades. While IAs that engage in principal or agency cross trading typically do so with the assumption and intention that it will benefit the client (often by lowering execution costs), IAs should still be evaluating their execution periodically and systematically to make sure the net result to the client is the most favorable available under the circumstances as expected. (Note that OCIE issued a Risk Alert on Best Execution in 2018, linked below.)
• IAs should also keep in mind that the SEC applies Section 206(3) to certain situations where IAs engage in client principal or agency cross trades using a BD controlling, controlled by or under common control with the IA. This was also addressed in the SEC’s 1998 interpretative release on Section 206(3).
OCIE Risk Alert on Principal and Cross Trading (September 4, 2019): https://www.sec.gov/files/OCIE%20Risk%20Alert%20-%20Principal%20and%20Agency%20Cross%20Trading.pdf
OCIE Risk Alert on Best Execution (July 11, 2018): https://www.sec.gov/files/OCIE%20Risk%20Alert%20-%20IA%20Best%20Execution.pdf
SEC Interpretation of Section 206(3) of the Investment Advisers Act of 1940 (July 17, 1998): https://www.sec.gov/rules/interp/ia-1732.htm.
* * *