On September 4, 2019, the Securities and Exchange Commission’s Office of Compliance Inspections and Examinations (OCIE) issued a Risk Alert relating to rules governing principal transactions and agency cross transactions.

This Risk Alert does not appear necessarily to give any new guidance per se. In many regards, it is a reiteration of Section 206(3) and Rule 206(3)-2 of the Investment Advisers Act of 1940, as amended (the “Advisers Act”). Additionally, it cites how OCIE has specifically observed advisers violating these rules.

OCIE is encouraging investment advisers to read this Risk Alert, then review their own policies and procedures, as well as the implementation of those policies and procedures, to make sure they are compliant with the Advisers Act.

Section 206(3) and Rule 206(3)-2 Refresher

As in often the case with Risk Alerts and other SEC guidance, it is always a good practice to go back to what the actual regulation states and what is required. Although this may seem like a redundant part of the Risk Alert, OCIE clearly believes that advisers are not adequately understanding exactly what constitutes a principal or agency cross transaction.

Principal trades occur when an adviser, directly or indirectly, knowingly (a) sells a security to a client; or (b) purchases a security from a client. When engaging in a principal transaction, the adviser must obtain client consent prior to the completion or settlement of such transaction. Note, that consent can be received after the execution of a trade but must be obtained before settlement. When consent is not received, the adviser is in violation of the Rule, regardless of whether or not the transaction was objectively fair or in a client’s best interest.

Agency cross transactions are when an adviser, or one of its affiliates, act as a broker on a transaction in between a client and another party. A violation would occur when this is not properly disclosed to the client before the completion of the transaction. That said, Rule 206(3)-2 does allow for an adviser to engage in agency cross transactions without having to obtain consent on a transaction-by-transaction basis. The following four items would need to be obtained in writing: (1) client executed written consent prospectively for agency cross transactions after receive a full written disclosure on the conflicts; (2) informs the client before or at the completion of the transaction that such transaction is occurring; (3) the adviser provides at least annually a disclosure statement with a summary of all cross transactions; and (4) the client may revoke any consent at any time.

What OCIE is Seeing in Examinations

One of the more obvious areas that adviser can take some action is in simply identifying principal and cross transactions. OCIE is finding that advisers are not finding them and, as a result, are not receiving or disclosing the proper information. Although it is a good practice to back test for any principal or cross transactions, little can be done after completion or settlement because the Rule would already be broken at that point. Essentially, any disclosure or consent after the fact is still a violation.

Specifically, advisers whose client are pooled investment vehicles may have some specific items to consider. OCIE pointed out that an adviser (including its control persons) who owns a significant ownership stake[1] in a vehicle is engaging in principal transactions with other clients when they sold securities from these accounts to other clients. These advisers failed to identify these transactions as principal transactions. Even when they were identified, advisers failed to obtain the required consent.

Cross transactions had similar issues. In some instances, advisers informed clients that they would not engage in agency cross transactions but in fact did so. Some of the advisers who stated that they were able to rely on Rule 206(3)-2 were unable to prove they complied with the written consent, confirmation or disclosure requirements. Thus, they were, in fact, not able to rely on the Rule.

What To Do With the Risk Alert

The most important thing to do is to review your policies to what the SEC has identified as issues, and what you are actually doing. If it is never the case that you engage in these transactions, all is well. That being said, it may a good practice to review past transactions in order to ensure that no principal transactions or agency cross transaction have occurred. If there are some findings, a policy review would be necessary.

If it is the case the you may from time to time engage in principal transactions, policies and procedures should be reviewed in order to ensure that consent is received, and disclosures are given prior to settlement. A compliance infrastructure that is able to identify any principal transactions is crucial. Likewise, disclosure of conflicts is a very key and vital component of this Risk Alert.

Finally, if engaging in cross transactions, you should review the authority given by clients for such transactions. It is vital that all of this information is kept in writing and able to be offered to the SEC upon request. The four items listed above are what is required and what the SEC expects to see. Again, informed consent is crucial, and disclosure should be exhaustive.

Ultimately, it comes down to having policies and procedures reasonably designed for your business, having adequate disclosures and written consent where required.

The full text of the SEC’s Risk Alert can be found in PDF format here.

[1] “Significant Ownership” generally means ownership in excess of 25%. The Staff previously rule in a no action letter that ownership of 25% or less is not applicable (Gardner Russo & Gardner, June 7, 2006)