Once upon a time, back in the “Olden Days,” when the SEC’s request list was 11 or 12 items listed on a single page, most of our information about the responsibilities of an investment adviser and the SEC’s examination process came from reading the Advisers Act and the rules under the Act along with a few no-action letters. Today, the examination process and the rules are much more complex and the request list can be more than 20 pages long, but the SEC has provided information on how to address those issues. In addition to the Annual Examination Priorities (published annually since 2013), the SEC has issued Risk Alerts (almost 40 published since 2011). Although the Examination Priorities have been an asset to the industry by identifying areas in which the SEC will focus its examinations, the Risk Alerts have been of greater value by identifying common deficiencies that the SEC has found in examinations of advisers, and in many instances how we as an adviser may address those concerns.
On September 4, 2019, the SEC issued a Risk Alert titled, “Investment Adviser Principal and Agency Cross Trading Compliance Issues,” which identifies the most common deficiencies in this area found in SEC examinations of investment advisers during the last three years.
From the Risk Alert:
Section 206(3) – Principal Trades
“Section 206(3) under the Advisers Act makes it unlawful for any investment adviser, directly or indirectly, acting as principal for his own account knowingly to (a) sell any security to a client or (b) purchase any security from a client (“principal trades”), 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. Section 206(3) requires an adviser entering into a principal trade with a client to satisfy these disclosure and consent requirements on a transaction-by-transaction basis – blanket disclosure and consent are not permitted.” (emphasis added)
Section 206(3) and Rule 206(3)-2 – Agency Cross Trades When Acting as a Broker
“Section 206(3) also prohibits an adviser, directly or indirectly, acting as broker for a person other than the advisory client, from knowingly effecting any sale or purchase of any security for the account of that client (“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. However, Advisers Act 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, at least annually, with a summary of all agency cross transactions during the period; and
(4) the written disclosure documents and confirmations required by the rule conspicuously disclose that consent may be revoked at any time.” (emphasis added)
“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 trade. To ensure that a client’s consent to a principal trade or agency cross transaction is informed, the Commission has stated that Section 206(3) should be read together with Advisers Act Sections 206(1) and (2) to require the adviser to disclose facts necessary to alert the client to the adviser’s potential conflicts of interest in a principal trade or agency cross transaction.”
“Advisers and their broker-dealer affiliates should consider that Section 206(3) may apply to certain situations involving advisers that cause a client to enter into a principal or agency transaction that is effected by a broker-dealer that controls, is controlled by, or is under common control with, such adviser.”
- Section 206(3) requirements not followed.
“OCIE staff observed advisers that did not appear to follow the specific requirements of Section 206(3). For example, OCIE staff observed:
- Advisers that, acting as principal for their own accounts, had purchased securities from, and sold securities to, individual clients without recognizing that such principal trades were subject to Section 206(3). Thus, these advisers did not make the required written disclosures to the clients or obtain the required client consents.
that had recognized that they engaged in principal trades with a client, but
did not meet all of the requirements of Section 206(3), such as:
- Failing to obtain appropriate prior client consent for each principal trade.
- Failing to provide sufficient disclosure regarding the potential conflicts of interest and terms of the transaction.
- Advisers that had obtained client consent to a principal trade after the completion of the transaction.
- Principal trade issues related to pooled investment vehicles.
OCIE staff observed advisers that engaged in certain transactions involving pooled investment vehicle clients where such advisers did not appear to follow the requirements of Section 206(3). For example, OCIE staff observed:
- Advisers that effected trades between advisory clients and an affiliated pooled investment vehicle, but failed to recognize that the advisers’ significant ownership interests in the pooled investment vehicle would cause the transaction to be subject to Section 206(3).
- Advisers that effected principal trades between themselves and pooled investment vehicle clients, but did not obtain effective consent from the pooled investment vehicle prior to completing the transactions.
- Agency cross transactions.
OCIE staff observed advisers’ practices that gave rise to compliance issues in connection with agency cross transactions. For example, OCIE staff observed:
- Advisers that disclosed to clients that they would not engage in agency cross transactions, but in fact engaged in numerous agency cross transactions in reliance on Rule 206(3)-2.
- Advisers that effected numerous agency cross transactions and purported to rely on Rule 206(3)-2, but could not produce any documentation that they had complied with the written consent, confirmation, or disclosure requirements of the rule.
D. Policies and procedures related to Section 206(3).
OCIE staff observed advisers that did not have policies and procedures relating to Section 206(3) even though the advisers engaged in principal trades and agency cross transactions. OCIE staff also observed advisers that established—but failed to follow—policies and procedures regarding principal trades and agency cross transactions.”
Key takeaway: “OCIE encourages advisers to review their written policies and procedures and the implementation of those policies and procedures to ensure that they are compliant with principal trading and agency cross transaction provisions of the Advisers Act and the rules thereunder.”
TMI – Is this Too Much Information? Many of us don’t deal with Principal Trading or Agency Cross Trading, so this Risk Alert is of no value to us! Nay, we say, because if we even appear to be considering principal trading or agency cross trading (see Rule 206(3)-2), we need to make sure we know, or are aware of the SEC requirements. Post-trade disclosures are of negative value in these situations, because by then you have already violated the Rule.
Absent adequate disclosure in advance of principal or cross-trading, and should the client somehow be disadvantaged by a trade, you have put yourself in a precarious situation.
As we say in the South, this Risk Alert is the rattle on the snake.