On September 4, 2019, the  Office of Compliance Inspections and Examinations (“OCIE”) issued a Risk Alert related to principal trading and agency cross transactions under Section 206(3) of the Advisers Act. These topics were identified in recent examinations of investment advisers.

Principal Trades/ Agency Cross Trades When Acting as a Broker

In a principal transaction, an adviser, acting for its own account, buys a security from, or sells a security to, the account of a client. In an agency transaction, an adviser arranges a transaction between different advisory clients or between a brokerage customer and an advisory client.  Advisory clients can benefit from both types of transactions, depending on the circumstances, by obtaining a more favorable transaction price for the securities being purchased or sold than otherwise available.  Principal and agency transactions, however, also may pose the potential for conflicts between the interests of the adviser and those of the client.

Section 206(3) of the Advisers Act makes it unlawful for any investment adviser, directly or indirectly acting as principal for its own account, knowingly to sell any security to or purchase from any security from a client, act as a broker for a person other than such client, knowingly to effect any sale or purchase of any security for the account of such client, without disclosing to such client in writing before the completion of such transaction, the capacity in which the adviser is acting and obtaining the consent of the client to such transaction.  Therefore, Section 206(3) imposes a prior consent requirement on any adviser that acts as a principal in a transaction with a client or that acts as a broker/agent in connection with a transaction for, or on behalf of a client.

Agency Cross Trades When Acting as a Broker

An agency cross transaction involves a transaction in which a person acts as an investment adviser in relation to a transaction in which such adviser, or any person controlling, controlled by, or under common control with such investment adviser, acts as a broker for both advisory clients and for another person on the other side of the transaction.

Section 206(3) also prohibits such agency cross transactions without disclosing to that client in writing before the completion of the sale or purchase, the capacity in which the adviser is acting and obtaining the consent of the client to the sale or purchase.  Rule 206(3)-2 permits certain agency cross transactions without requiring the adviser to provide transaction-by-transaction disclosure and consent if, among other things:

  1. The client has executed a written consent prospectively authorizing agency cross trades after receiving full written disclosure of the conflicts involved and other information described in the rule;
  2. The adviser provides a written confirmation to the client at or before the completion of each transaction providing, among other things, the source and amount of any remuneration it received;
  3. The adviser provides a written disclosure statement to the client, no less than annually, including a summary of all agency cross transactions during the period; and
  4. The written disclosure documents and confirmation required by the rule clearly disclose that consent may be revoked at any time.

Issues Identified

The SEC Risk Alert identifies some of the most common deficiencies or weaknesses identified by its examination staff in connection with principal trades and agency cross transactions.  Highlights are noted below:

  • Advisers that were acting as principal for their own accounts had purchased securities from, and sold securities to, their individual clients without observing that such principal trades required written disclosures to the clients or obtain the required client consents;
  • Advisers that recognized they engaged in principal trades with a client, but did not meet all of the requirements of Section 206(3);
  • Advisers obtained consent after the completion of the transaction;
  • Principal trade issues related to pooled investment vehicles (“PIV”) where the advisers effected trades between advisory clients and an affiliated PIV, but failed to recognize that the advisers’ ownership interested in the PIV would trigger the requirements pursuant to Section 206(3);
  • Advisers effected numerous agency cross transactions and purported to rely on Rule 206(3)-2 but could not produce any documentation that the adviser had complied with the written consent, confirmation, or disclosure requirements of the rule.

Policies and Procedures

In many instances OCIE staff did not observe written policies and procedures related to Section 206(3) even though the advisers were engaging in principal and agency cross trade transactions.  In other instances, OCIE observed advisers had established written policies and procedures related to principal trades and agency cross transactions but failed to follow them.

Asgard’s Take

Advisers should be mindful of their obligations regarding principal trades and agency cross trades.  Establishing sound compliance and risk management operations including written policies and procedures is paramount to fostering a culture of compliance.  This Risk Alert highlights those deficiencies identified during adviser examinations.  Compliance with the disclosure and consent provisions of Section 206(3) alone may not satisfy an adviser’s fiduciary obligations with respect to a principal or agency cross transaction.  An adviser should be mindful of other fiduciary obligations such as the duty of loyalty.  The duty of loyalty requires that an adviser not subordinate its clients’ interests to its own.  Full and fair disclosure of all material facts relating to the advisory relationship including conflicts of interest should be the adviser’s guiding principle. Further, an adviser has a duty to seek best execution for all client transactions where the adviser has the responsibility of selecting broker-dealers to execute its trades.

We encourage you to evaluate your current written policies and procedures regularly, but no less than annually.  Please contact an ARG Analyst with any questions regarding the matters discussed or for any assistance in evaluating your compliance and risk management operations.

Click here to read the SEC Risk Alert in its entirety.