10 December 2021
Main Contributor: Elizabeth Cope, CPA, CSCP, CIPM CEO & Lead Consultant
Before you read the title and stop because you don’t think this applies to you, keep in mind that claiming NOT to engage in the aforementioned practices, is one of the issues the SEC has found in examinations. If it is your policy not to engage in principal, agency, and/or cross transitions, please at least read the definitions and then jump down to the testing section to consider additional tests to implement as part of your annual review.
The SEC has now issued two risk alerts on principal, agency, and cross transitions. The first in 2019 and the most recent one in July of 2021. The most recent risk alert summarized a focus on advisors that engaged in such practices for fixed income securities. It is more common to see such trades in fixed income securities, however, it has happened with illiquid equity securities and even private placement holdings. Therefore, it is important as a compliance officer to read through this blog to familiarize yourself with the requirements and re-visit your policies, disclosures, and testing practices for any necessary updates.
Definitions and Requirements
Principal and Agency Cross Transactions
Principal Transactions apply when the investment advisor is acting as principal for its own account and knowingly buys or sells securities to/from the client. Note: if you, the advisor, or any of your related parties own a controlling interest (25% or more) of a private fund and conduct a transaction between the fund and any advisory clients, this would be considered a principal transaction.
Agency Cross Transactions apply when an investment advisor or an affiliate is also acting as broker dealer when conducting a transaction between advisory clients and non-advisory clients.
Section 206(3) makes it unlawful for an advisor to engage in principal and/or agency cross transactions without obtaining proper consent and disclosing risks and conflicts to the client in writing before each transaction occurs. Blanket disclosures and consent is not allowed.
The SEC has adopted rules under Rule 206(3)-2 that allow advisors to conduct agency cross transactions without having to obtain consent and provide disclosures on a transaction basis, as long as the following requirements are met:
- Client Authorization – the client must prospectively authorize agency cross transactions in writing after receiving full written disclosures.
- Disclosure – the investment advisor must disclose to the client in writing the capacities in which it will act, the conflicts presented, and the responsibilities faced for such transactions.
- Confirmation – every agency transaction must be followed up with a written confirmation to the client at or before the completion of the transaction providing the source and amount of any remuneration, if received.
- Annual Summary – the investment advisor must provide the client with an annual summary of all agency and/or principal transactions.
- Termination – the written disclosure documents and confirmations disclose that the client may terminate the agency cross transaction authority at any time by written notice to the investment advisor.
Note: Just to clarify, consent for principal trades must be obtained on a per-trade basis while consent for agency cross trades can obtained once as long as the above 5 criteria are met.
These requirements alone do not satisfy your fiduciary obligations with respect to principal and/or agency cross transactions. You must still demonstrate that the transactions (for both principal and agency) were in the client’s best interest and achieved with best execution. This type of documentation should be maintained on a transactional basis. Sound policies and procedures and proper training will ensure the staff engaging in such transactions will complete these elements to satisfy the firm’s fiduciary obligations.
Internal Cross Transactions
Internal Cross Transactions apply when you affect a trade between two or more advisory clients or funds managed by your firm. This is also a trade that is pre-arranged with the intention to cross between two client accounts, whether through an intermediary broker-dealer or not.
The SEC has stated that in these situations, where the advisor is not receiving any compensation (commissions – either directly or indirectly), other than its advisory fee, compliance with Section 206(3) does not apply. However, the advisor is still expected to:
- maintain policies and procedures to address this type of trading, how pricing is established, any approvals required, and provide disclosures to clients (often in the ADV) about the practice of internal cross trades and potential conflicts; and
- demonstrate that the trade was in the best interest of both parties and achieved with best execution – which would require a process to document in writing with each transaction.
ERISA: Special Considerations
The Department of Labor (DOL) currently views cross trading, involving employee benefit plan assets, to be a prohibited transaction under Section 406(b) of ERISA. The DOL takes the view that an investment advisor can enter into cross-trades if an explicit exemption is available, however it’s generally recommended to avoid cross transactions due to the difficulty of using the available exemptions. It’s also important to review the terms of the agreement with the ERISA account in which the plan may specify the allowance and/or restriction of cross trades.
Conclusion: Action Items for your Firm
- Read this article and both Risk Alerts – Gain familiarity with the requirements and the concerns identified by the SEC.
- Review your current policies – Make updates where necessary to ensure full compliance; they must include clear definitions, policies consistent with the requirements, and consistency with actual practice.
- Training – Train staff on this topic, whether that is to NOT engage or to follow the procedures IF they engage in such transactions.
- Review disclosures – This includes not only your ADV, but any client agreement and separate disclosure statement provided to clients for such transactions – make updates where necessary to ensure full compliance.
- Test the procedures – Even if you are not engaging in such transactions, you should still obtain blotters to review transactions for possible principal and/or cross transactions. If you are engaging in transactions then you should review blotters, pricing filings, confirmations, client consent, disclosures, and other relevant documents for a sample of transactions as part of your annual review to ensure full compliance with ALL requirements – adjust where necessary.
- Log any violation – As part of this process you may find violations. If you do, log the exceptions, provide adequate detail, and then most importantly document the remedial action taken to prevent re-occurrence.