On Episode 58, Compliance Consultant Adam Stutz joins us to discuss investment adviser principal trading and agency cross-transactions.
CCO Buzz: Hello and welcome back to Episode 58 of the CCO Buzz! On this Episode, Compliance Consultant Adam Stutz will be discussing principal trading and agency cross-transactions. This is especially relevant in light of the OCIE risk alert recently released on the topic. We hope you enjoy the episode!
Adam Stutz: At the beginning of September, the SEC’s Office of Compliance Inspections and Examinations or “OCIE” published a risk alert on OCIE’s observations from recent exams on investment adviser principal trading and agency cross-transactions. The risk alert highlighted a number of important points that investment advisers may not be considering when thinking about principal and cross-trades. We wanted to take a few minutes to revisit the risk alert and offer a few suggestions on how investment advisers can ensure that their compliance programs adequately address these two important areas of the Advisers Act.
To recap, a principal trade occurs when investment advisers purchase a security from a client or sell a security to a client from their own accounts. Section 206(3) prohibits investment advisers from doing this, unless the investment adviser makes certain disclosures, specifically the investment adviser discloses the trade in writing to the client prior to the completion of the trade and obtains consent from the client for each transaction. It is important to note that this must be done on a trade-by-trade basis and that neither the adviser nor the client may rely on a blanket disclosure and consent to trade.
Agency cross transactions occur when an adviser acts as a broker for a person other than the advisory client and effects any sale or purchase of any security for the account of that client. Section 206(3) and Rule 206(3)-2 prohibit agency cross transactions, unless the adviser discloses that fact to the client in writing prior to the completion of the transaction. Rule 206(3)-2 does, however, permit certain agency cross transactions without requiring the adviser to provide transaction-by transaction disclosure and consent if certain criteria have been met including:
- Receiving written consent from the client authorizing the agency cross trades after receiving full disclosure from the adviser that includes the conflicts of interest involved;
- The adviser provides confirmation at or before the completion of each transaction to the client and discloses the source and amount of any payment the adviser receives for the trade;
- Annually, the adviser discloses all agency cross transactions for the period; and
- Each disclosure document conspicuously acknowledges that the client can revoke consent at any time.
It is important to underline that these steps alone may not meet the requirements of the rule, and therefore advisers should be sure to adequately disclose all of the potential conflicts of interest inherent in these transactions.
While conducting examinations of investment advisers, OCIE outlined where they most often discovered issues investment advisers had when it came to principal trades and agency cross transactions, including:
- A failure to follow the requirements laid out by Section 206(3) and Rule 206(3)-2;
- A failure to recognize that they had executed principal trades;
- A failure to obtain consent for principal trades after the completion of the transaction;
- A failure to obtain consent for each principal trade;
- A failure to properly disclose the conflicts of interest inherent in the principal transaction;
- Disclosing to clients that the adviser did not engage in agency cross transactions when in fact they did;
- A failure to keep proper documentation of client consent and disclosures for agency cross transactions; and,
- A failure to maintain policies and procedures addressing principal and agency cross-transactions.
Based on the examples cited, we feel that there are three key areas that investment advisers and their CCOs should review to ensure compliance with Section 206(3) and Rule 206(3)-2. These areas include:
- Policies and Procedures;
- Training; and,
First, it is important that CCOs and the executive management team review their current disclosures in their investment management agreements and Form ADV Part 2A to ensure that they are consistent, and if the firm is planning to engage in principal or agency-cross transactions, those disclosures are updated with all pertinent conflicts of interest. Additionally, if the investment adviser is engaging in principal and/or agency cross-transactions it should confirm that Items 8.A(1) and 8.B(1) in Form ADV Part 1 are properly updated to reflect that fact.
Second, the CCO should ensure that policies and procedures adequately address [the] requirements for conducting principal and agency-cross transactions and that [the] requirements of Section 206(3) and Rule 206(3)-2 are clearly laid out. If the firm is planning to engage in principal and/or agency cross transactions, it should consider the creation of disclosure language and/or forms that meet the criteria set forth in Section 206(3) and Rule 206(3)-2.
Third, investment advisers should be trained on how to properly disclose, document, and maintain records of the notifications sent to clients and the receipt of their consent. It is imperative that an investment adviser’s staff receive this training to ensure that there isn’t an inadvertent violation of the rules.
Last, the CCO and/or her designee should ensure that they are conducting periodic testing of their trade blotter to ensure that they are monitoring for principal and/or agency cross-transactions and that if the firm is engaging in such transactions that the proper disclosures and consent have been delivered and received.
For more information on principal and agency cross-transactions, we recommend listeners visit www.sec.gov to download a copy of OCIE’s risk alert on principal trading and agency cross transactions. If you have any questions or concerns about principal or agency cross-transactions and your policies and procedures, disclosures, and training, please visit Core Compliance at www.corecls.com or call us at 619-278-0020.
CCO Buzz: Well that’s it for this week’s episode. If you’d like additional information, please check out our website at www.corecls.com. You can also follow us on Facebook, LinkedIn, or Twitter @CoreCls. Thank you, and we hope you tune-in to next week’s episode of the CCO Buzz.