On July 21, 2021, the Securities and Exchange Commission’s Division of Examinations (the “Division”) issued a Risk Alert related to fixed income principal and cross trades deficiencies identified during examinations. As a fiduciary to clients, advisers engaging in either principal or cross trades can create certain legal obligations under the Investment Advisers Act of 1940 (the “Advisers Act”), including the use of certain disclosures in fund documents and marketing materials. This Risk Alert is a follow-up to the September 4, 2019 Risk Alert (the “2019 Risk Alert”) highlighting the most common compliance issues observed related to principal and cross trades under the Advisers Act.

A “principal trade” is a trade in which the adviser, or an employee of the adviser, buys from or sells securities to the adviser’s clients or funds from its own account. An “agency cross trade” occurs when an adviser arranges for a trade to be executed between a client/fund and a third party. A “cross trade” occurs when the adviser effects a trade between two or more of its advisory client accounts or funds,  but does not charge a fee for the transaction. Agency cross trades and cross trades will collectively be referred to as “cross trades.”

The Division initiated an examination initiative following the 2019 Risk Alert involving advisers that engaged in principal trades and/or cross trades in fixed income securities (the “FIX Initiative”). The FIX Initiative examined 20 advisers with more than $2 trillion in assets and issued deficiency letters to nearly two-thirds of them. The majority of deficiencies were related to the following areas:

• Compliance programs: More than half of the deficiencies found were related to compliance programs including (1) policies and procedures that were inconsistent with the adviser’s practices, disclosures and regulatory requirements, (2) policies and procedures that lacked certain considerations or guidance, such that the adviser’s personnel did not have the full scope of information necessary to achieve compliance, or (3) policies and procedures were not effectively tested;
• Conflicts of interest: Division staff identified numerous instances of conflicts of interests associated with cross trades that were neither mitigated nor disclosed to investors, such as advisers not using best price or best execution efforts, or not fully disclosing markups and other fees; and
• Written disclosures: About one-third of the examined advisers had disclosure deficiencies, including not disclosing cross trading practices on their Form ADV, advisory agreements and separate written communications to clients.

The Division staff also included suggested ways to improve compliance, each summarized below.

Compliance Programs

• Adopt and enforce compliance policies and procedures that:
  • Incorporate all applicable legal and regulatory requirements;
  • Clearly articulate the activities covered by the advisers’ written compliance policies and procedures, including defining covered activities that constitute principal and/or cross trades;
  • Set standards that address the firms’ expectations for each of these activities that correspond with the adviser’s legal obligation under the Adviser’s Act;
  • Include supervisory policies and procedures; and
  • Establish controls to determine whether policies and procedures are being properly followed and documented in the required manner.
• Conduct testing for compliance with policies and procedures; the Division staff found that firms were more likely to catch undisclosed principal or cross trades with a robust testing program of their written policies and procedures. Some issues included:
  • Advisors did not maintain documentation or information regarding the trade, such as the determination that a fair and equitable price was used, or best execution was achieved;
  • Advisors did not provide full and fair disclosure regarding the trades to clients, or seek consent from clients;
  • Advisors did not identify and/or report these trades or related breaches or risks; or
  • Advisors did not restrict transacting in impermissible or prohibited accounts (e.g., ERISA).
• Place conditions, qualifications or restrictions on the execution of principal trades, cross trades or both within clients’ accounts. The most common of such conditions are identified below:
  • The securities must only be purchased by or sold to another client when there is a need and securities meet each participating client’s investment objectives;
  • The client accounts involved in these trades are not ERISA accounts;
  • The trades received best price and best execution (e.g., several required independent prices for the assets to be obtained from third-party broker-dealers); or
  • The adviser, its affiliated persons and its supervised persons may not receive commissions or any other compensation with respect to these trades.

Written Disclosures

• Provide clients with full and fair disclosure of all material facts surrounding principal and cross trades, which is consistent with the adviser’s fiduciary duty. The disclosures found in the Division’s examinations often included a description of the nature and significance of the advisers’ conflicts of interest relative to the impacted clients. Disclosures should also correspond to the adviser’s obligations under the Advisers Act.
• Provide disclosures to clients regarding principal and cross trading practices in multiple documents, including the Form ADV, Part 2A, advisory agreements, separate written communications to clients and/or private fund offering documents. Some advisers would also explain their rationale for executing principal trades during oral conversations with their clients.

In conclusion, Risk Alerts such as this one are often useful in determining the SEC’s current areas of focus. As such, if your firm is engaged in principal and/cross trades in fixed income securities, we suggest reviewing the full Risk Alert and examining your policies and procedures in light of what the Division’s FIX Initiative has found. If you have any questions, please reach out to your Greyline representative to discuss.

The full Risk Alert can be viewed at SEC.gov.