The SEC’s Division of Examinations (the “Division”) issued a risk alert1 (the “Risk Alert”) on the observations of the Division’s staff (the “Staff”) from examinations of SEC-registered investment advisers (“Advisers”) regarding principal trades and cross trades involving fixed income securities. The Risk Alert defines “principal trades” as when “[a]n adviser that arranges for a security to be purchased from or sold to a client from its own account – as opposed to purchasing or selling the security in the secondary markets…” and a “cross trade” as when an Adviser arranges for a trade to be executed between a client and another party, or when an Adviser effects a trade between two or more of its advisory clients’ accounts, but does not charge a fee for effecting the transaction. The Risk Alert is intended to assist firms in developing and enhancing their compliance practices regarding principal trades and cross trades.
Staff Observations on Deficiencies
The Staff observed the following deficiencies with respect to adviser compliance programs, conflicts of interest and disclosures.
- Compliance Programs.
- Policies and procedures were inconsistent with the Adviser’s practices, its disclosures, and/or regulatory requirements. The Adviser’s compliance program did not include specific procedures to confirm that (1) principal trades, cross trades, or both were completed in a manner consistent with disclosures to clients and its policies and procedures; and (2) appropriate consent was received from, and disclosure provided to, the involved clients prior to completing the transactions. For example, some Advisers prohibited principal trades and cross trades but nevertheless executed them, or required portfolio managers to obtain prior written approval for principal and cross trades, but approval was not obtained.
- Policies and procedures lacked certain considerations or guidance, such that the Adviser’s personnel did not have the full scope of information that may be necessary to achieve compliance. Examples of this include: (1) the Adviser required its advisory personnel to make best interest determinations and use standardized reporting forms, however, the Adviser did not specify in its procedures the factors to be used to make best interest determinations and did not include a section on their forms to document the best interest determinations; (2) the Adviser did not specify in its compliance manual how to address ERISA restrictions, including those prohibiting principal and cross trades; and (3) the Adviser’s policies and procedures required personnel to obtain multiple quotes from different broker dealers for the value of the security or securities to be traded, however, the procedures did not specify which of those quotes/values should be used if the quotes/values differed.
- Policies and procedures were not effectively tested. The Adviser failed to test the implementation of its procedures (e.g., testing for identifying unreported trades). As a result, the Adviser failed to perform annual reviews of cross trading activities, to confirm consent was obtained if required and to perform a best execution analysis of the trades.
- Conflicts of Interest. Advisers often engaged in transactions that were not mitigated, disclosed, or otherwise addressed by their compliance programs. As an example, the Adviser engaged in transactions that were: (1) contrary to its written policies and procedures in that the transactions were not executed at independent market prices for the securities and did not use best price and best execution efforts, which resulted in at least one of the participating clients receiving an unfair price for the securities; and (2) subject to markups or other fees that were not fully disclosed.
- Written Disclosures. The Adviser omitted information concerning cross trading activities in its Form ADVs, advisory agreements and separate written communications to clients regarding the conflicts of interest of the Adviser relating to the transactions.
Staff Observations on Ways to Improve Compliance
The Staff observed the following practices of Advisers with respect to principal and cross trades that appeared to be effective.
- Compliance Programs.
- The Adviser adopted and enforced compliance policies and procedures that had: (i) incorporated all applicable legal and regulatory requirements; (ii) clearly articulated the activities covered by the Adviser’s written compliance policies and procedures; (iii) set standards for addressing the firm’s expectations for each of these activities; (iv) included supervisory policies and procedures; and (v) established controls to determine whether the policies and procedures were being properly followed and documented in the required manner.
- The policies and procedures defined “covered activities,” such as specifying the time frame within which the transactions must occur to be considered cross trades.
- The policies and procedures set standards for evaluating and conducting the trades, including requiring that trade should be fair and equitable to all participating client accounts; the pricing methodologies to be used to execute the transactions; the periodic evaluation of the quality of execution; the periodic reporting of the trade to the legal or compliance departments; clients receive written information regarding the capacity in which the Adviser acted; portfolio managers or traders to obtain advanced written approval from senior management or compliance personnel to execute the trades; and the Adviser to receive the clients’ written consent prior to the completion of each transaction.
- The policies and procedures required testing for compliance with policies and procedures.
- The policies and procedures placed conditions, qualifications, or restrictions on the execution of principal trades, cross trades, or both within clients’ accounts, including that the securities must only be purchased by or sold to another client when there is a need and securities meet each participating client’s investment objectives; the client accounts involved in these trades are not ERISA accounts; the trades received best price and best execution; and the Adviser, its affiliated persons, and its supervised persons may not receive commissions or any other compensation with respect to these trades.
- Written Disclosures.
- The Adviser provided clients with full and fair disclosure of all material facts surrounding principal and cross trades, such as how the Adviser addressed identified conflicts of interest; the circumstances under which the Adviser may engage in these transactions; any costs associated with these transactions, including describing the pricing methodology used by the Adviser to value the securities transactions; the total amount of all commissions or other renumerations received or to be received by the Adviser or any affiliated person in connection with these transactions; the option for clients to revoke their written blanket consent to execute cross trades without penalty, at any time, by written notice to the Adviser; and the total amount of principal trades entered into during the period. Additionally, these disclosures typically appeared in multiple client documents, including Form ADV Part 2A, advisory agreements, separate written communications to clients and private fund offering documents.
The Risk Alert demonstrates that the Staff’s focus on the adoption and implementation of effective compliance programs related to fixed income principal and cross trades.
Seward and Kissel LLP, and our compliance consulting service SKRC (Seward & Kissel Regulatory Compliance), are available to assist Advisers with the issues identified in the Risk Alert.