The Securities and Exchange Commission (SEC) recently settled charges against a Kansas-based registered investment adviser (Adviser) for engaging in hundreds of illegal cross trades between its client accounts, including failing to comply with statutory prohibitions regarding impermissible cross trades involving registered investment companies (RICs). Certain of the cross trades were principal transactions made without the disclosures and consent required by the Investment Advisers Act of 1940, as amended (IAA). The SEC order (Order)1 found that the Adviser violated Sections 17(a)(1) and 17(a)(2) of the Investment Company Act of 1940, as amended (ICA), and Rule 38a-1 thereunder, and Sections 206(3) and 206(4) of the IAA, and Rule 206(4)-7 thereunder. The Order was issued approximately one year after the SEC Office of Compliance Inspections and Examinations staff (Staff) published a risk alert (Risk Alert) on compliance issues the Staff observed related to principal trading and agency cross transactions.2
Discussion of the Order
From July 2014 through September 2016, the Adviser effected 351 cross trades between approximately 40 client accounts that it advised. The Adviser effected the cross trades by arranging a simultaneous purchase and sale of the same security between client accounts through an independent broker-dealer. The client on the purchasing side of the cross trade always paid a markup on the sale price of the security, which was retained by the executing broker-dealer.
Sections 17(a)(1) and 17(a)(2) of the ICA generally prohibit cross trades between a RIC and any affiliate (or second-tier affiliate) of the RIC, acting as principal, unless the RIC has obtained a SEC exemptive order pursuant to Section 17(b) or can rely on Rule 17a-7. Rule 17a-7 under the ICA exempts from the prohibitions of Section 17(a) certain purchases and sales between RICs and certain affiliated persons, where the affiliation arises solely because the two have a common investment adviser, common directors, and/or common officers, and the transactions are effected in accordance with the requirements set forth in Rule 17a-7.
The Adviser did not seek exemptive relief under Section 17(b) of the ICA from the general prohibitions against affiliated transactions in Section 17(a), nor did it comply with the requirements of Rule 17a-7 for any of the cross trades involving RICs. The Adviser incorrectly believed that it did not need to comply with the requirements of Rule 17a-7 if the cross trades were executed through an independent broker-dealer and sought to effect cross trades at a market price that it believed was fair to each client account in the transaction. Specifically, the Adviser did not effect the cross trades at the average of the highest current independent bid and lowest current independent offer determined on the basis of a reasonable inquiry, as required by Rule 17a-7. The Adviser caused its clients to incur a markup in connection with the cross trades, and the board of directors for the RICs did not, at least quarterly, determine that the cross trades were effected in compliance with the requirements of Rule 17a-7.
According to the Order, 13 of the cross trades involving clients other than RICs were principal trades. In this regard, trades occurred between private funds advised by the Adviser in which controlling persons of the Adviser owned more than twenty-five percent of the private funds, and other non-RIC advisory clients.3 Therefore, the Adviser was deemed to be acting as a principal for one side of these trades involving those private funds.
The Adviser did not provide prior written disclosure to, or receive consent from, any of its clients who were parties to the principal trades. Consequently, the Adviser was found to have violated Section 206(3) of the IAA, which generally prohibits advisers from making principal trades unless the adviser discloses all material information about the proposed trade to, and obtains the consent of, such client before the completion of the transaction.
The Adviser’s compliance manual in effect at the time of the conduct was largely silent regarding cross trades and stated that the Adviser could effect cross trades “when permitted.” The compliance manual also prohibited principal transactions. The Adviser, however, did not have policies, procedures, or controls in place to identify or monitor cross trades or principal transactions. Furthermore, because the Adviser did not adequately train its employees, those employees failed to understand the requirements surrounding cross trades and principal transactions. Consequently, the Adviser violated Section 206(4) of the IAA and Rule 206(4)-7 thereunder, which require, among other things, that registered investment advisers adopt and implement written policies and procedures reasonably designed to prevent violations, by the investment adviser and its supervised persons, of the IAA and rules thereunder. The Adviser also caused the RICs to violate Rule 38a-1, which requires a registered investment company to adopt and implement written policies and procedures reasonably designed to prevent violations of the federal securities laws.
Without admitting or denying the findings contained in the Order, the Adviser agreed to be censured, cease and desist from committing or causing any violations and any future violations under the ICA and the IAA, and pay a civil money penalty in the amount of $450,000.
In the Risk Alert published in September 2019, a year prior to the Order, the Staff identified compliance issues related to principal trading and agency cross transactions under Section 206(3) of the IAA, including: (i) advisers that did not recognize that they were engaged in principal trades and, consequently, did not make the required written disclosures to clients or obtain the required client consents; (ii) advisers that did recognize they had engaged in principal trades with clients, but did not satisfy all the requirements of Section 206(3); (iii) advisers that had obtained a client’s consent to a principal trade after, but not prior to, the completion of the transaction; and (iv) advisers that either did not have, or did have and failed to follow, policies and procedures relating to Section 206(3) even though they had engaged in principal trades and agency cross transactions.
The Risk Alert and the Order highlight the SEC staff’s continuing focus on compliance issues related to inherent conflicts of interest of investment advisers including in connection with cross trades, particularly principal trades, and the importance in having policies, procedures and controls in place to identify and monitor cross trades and principal transactions. The Order also serves to underscore that simply effecting cross trades through an unaffiliated broker-dealer does not take the cross trades outside the scope of Sections 17(a)(1) and 17(a)(2) of the ICA. It is critical for investment advisers to have, review and follow written policies and procedures that are reasonably designed to ensure that they are compliant with applicable requirements for effecting cross trades and principal trades in accordance with the ICA and IAA.