Investment Adviser Principal and Agency Cross Trading practices was the topic of a recent OCIE Risk Alert. The Investment Adviser’s Act Principal Transactions Section 206(3) indicates “Investment Adviser’s acting as a principal for his own account, knowingly to sell any security to or purchase any security from a client, or acting as broker for a person other than such client, without disclosing to such client in writing before the completion of such transaction the capacity in which he is acting and obtaining consent of the client to such transaction” are prohibited unless the appropriate disclosures and consent procedures are addressed and completed according to the compliance requirements.
Rule 206(3)-2 for Agency Cross Trades When Acting as a Broker
Rule 206(3)-2 addresses requirements for Agency Cross Transactions (Section 206(3) and Rule 206(3)-2) as “the Adviser must have written consent authorizing the Adviser to effect cross transactions for the advisory client, provided that such written consent is obtained after full written disclosure with respect to agency cross transactions the investment adviser or such other person will act as a broker for, receive commissions from, and have a potentially conflicting division of loyalties and responsibilities regarding, both parties to such transactions.” Also, the adviser is required to send to the client at least annually a disclosure pertaining to the total number of transactions since the last statement, outlining all the commissions and any other remunerations received. Additional disclosures and requirements are outlined in the rule regarding participation in Agency Cross Trading.
Some examples include areas such as advisers who engage in Principal Trading transactions but did not address this practice in their policies and procedures. Therefore, appropriate disclosures and consent were not obtained. In other cases, advisers did not obtain the client’s consent until after the transaction was completed. Lastly, there were noted issues with firms that have an affiliated pooled investment vehicle that did not follow the requirements of disclosures and consent.
Regarding Agency Cross Trading, some areas of violations included disclosures that were inconsistent by stating they would not engage in agency cross trading, however; cross trading was identified in the examination. Firms were also identified as having established policies and procedures regarding these trading practices but had failed to adhere to the procedures.
The important reminder of this type of trading practice is the vulnerability to clients. The Rule was written to protect clients against the possibility of fraud, deception and manipulative practices. It further aims to require disclosure to clients about the potential conflicts of interest in recommending these types of trades.
Additionally, the importance of annual testing and testing of policies and procedures cannot be overstated. Involving the trading team in this review process can be beneficial to communicate about the regular trading practices and identification of areas that need to be changed or updated. Also, including the trading practices, especially Principal Trading and Agency Cross Trading in the Best Execution review can be valuable to revealing any misconceptions and/or education about the firm’s trading practices.
Click here to browse other important compliance topics for Registered Investment Advisers.
For more information on the Risk Alert, you can read the full OCIE Risk Alert here – OCIE RISK ALERT.