SEC Issues Risk Alert on Principal and Agency Cross Trading

 

SEC Issues Risk Alert on Principal and Agency Cross Trading

The Securities and Exchange Commission (SEC) recently published an alert detailing the most common compliance failures advisors commit in regards to principal trades and agency cross trades. Principal and agency transactions are two cases in which the advisory firm has an interest in the circumstances or outcome of the client trades. This incentive then becomes a conflict of interest in the discretion or recommendation of that transaction.

Principal Trade:

A “principal trade” occurs when an investment adviser, acting as a principal for its own account, purposefully (i) sells any security to a client or (ii) purchases any security from a client. Section 206(3) prohibits advisers from making principal trades unless the adviser discloses all material information about the proposed trade to and obtains the consent of the client before the completion of the transaction. Notably, disclosure and consent are required for each transaction.

Agency Cross Transaction:

An “agency cross transaction” occurs when an investment adviser, acting as a broker for a person other than the advisory client (themselves included), knowingly makes a sale or purchase of any security for the account of that client. Section 206(3) prohibits investment advisers from making agency cross trades unless the investment adviser discloses material information about the trade to the client prior to the execution of the trade and obtains the consent of the client to the transaction. Under Rule 206(3)-2, it may not be required to effect transaction-by-transaction disclosure and consent for certain agency cross transactions if the advisor takes additional precautions.

In short, advisors must disclose both principal and agency trades in Form ADV Parts 1 and 2A and maintain appropriate documentation to support these transactions. The SEC advised that Section 206(3), Sections 206(1), and (2) be considered together so that the advisor further discloses any potential conflicts of interest revolving around a trade.

Common Deficiencies: 

• Failure to recognize the nature of trade 
• Improper disclosure 
• Non-adherence to policies and procedures

There are many ways for advisers to ensure that they follow the principal and agency cross trading requirements described above, included, but not limited to, the following:

• Maintaining an updated list of principal accounts and requiring pre-approval by the advisor’s Chief Compliance Officer of any proposed trades between an advisory client and an account on that list;
• Utilizing trading or compliance software to flag any trades with principal accounts prior to trade execution;
• Maintaining a comprehensive checklist to be used when executing transactions that raise conflicts of interest (including principal and agency cross trades) to raise awareness of compliance concerns;
• Establishing independent representatives to approve principal and agency cross trades on behalf of private fund and managed account clients to satisfy disclosure and consent requirements; and
• Maintaining books and records of all steps taken to approve transactions that present conflicts of interest (including the disclosure and consent requirements of principal and cross trades);
• Engaging in continuous education regarding principal trades, cross trading, and all other potential conflicts of interest. 

This SEC alert is consistent with the Commission’s focus on conflicts of interest and fiduciary duty in practice. Advisors have a duty to their clients to ensure they follow all regulator rules as well as their own policies and procedures.

Posted in: